The Belgian notional interest deduction: Practical uses of a unique corporate income tax feature

1. Introduction

The Belgian Notional Interest Deduction (NID), is a unique, straightforward and beneficial tax measure contributing to Belgium’s status as a centre for corporate headquarters and intra-group financing entities.  It reduces the effective corporate income tax (CIT) rate, increases the after tax return on investment, and stimulates capital intensive investments allowing in many instances for a close to nil rate for equity funded intra-group financing, treasury centres, factoring etc.(1)

The NID operates as a deduction from taxable income based on a company’s qualifying equity funding.  In essence, under the NID regime, a company is treated for tax purposes as if it had borrowed its own funds (equity) at a rate equal to that of the ten-year government bond.  As such, a “notional” interest is calculated and deducted from the company’s taxable base and the different tax treatment of debt and equity funding is partially abolished.

Due to the NID regime Belgium’s CIT rate (currently at 33.99%) is generally pushed down to about 27-26%(2), while the effective tax burden might drop substantially lower depending on the financing set-up of a business.  Moreover, due to the NID some companies have no effective tax burden at all, e.g. a fully equity funded company that is primarily holding short term interest bearing assets with a return which is lower than the NID available (hence creating opportunities to shelter other income from CIT).

2. Scope

2.1 Eligible entities

The NID regime applies automatically to entities subject to Belgian CIT as to non-resident entities subject to the Belgian non-resident tax (due to a Belgian permanent establishment or Belgian real estate)(3).  Therefore, the NID, contrary to many foreign tax incentives, does not require a ruling nor the approval by any authority.

2.2 Deductible amount

A. Starting point: "risk capital"

A company’s “risk capital” corresponds to its accounting equity as it appears in its non-consolidated annual accounts of the preceding accounting year.  Equity includes a company’s capital, share premiums, retained earnings and reserves.  

B. Adjustments to the "risk capital"

Certain changes to the company’s accounting equity need to be made, which serve a double purpose, i.e. avoiding double counts (e.g. where NID would otherwise be combined with tax exempt income) and potential misuses (e.g. the artificial inflation of the computation base of the NID).

Therefore, the following items need to be deducted from the accounting equity:

• The fiscal net value of own shares held on the balance sheet, of shares accounted for as fixed financial assets and of shares issued by investment companies;
• The net equity assigned to a foreign permanent establishment and to foreign real property or rights.
• The net book value of tangible fixed assets that clearly exceed reasonable business needs; the book value of passive investment (e.g. art, jewellery, and collectibles); as well as the book value of real estate the use of which is made available to the company’s officers or his family.
• Finally, certain tax exempt elements that are part of the net equity need to be deducted, i.e. reserves resulting from the mere re-evaluation of assets (which, in principle, is not a taxable event in Belgian tax law) and capital subsidies (as a rule subject to deferred taxation)

Changes to the NID computation base during the accounting year are taken into account on a pro rata (i.e. weighted average) basis. 

C. Rate

The base rate is the interest rate applicable to ten-year government bonds (“OLO bonds”), as an average rate of the year before the accounting period to which the taxable period refers. For tax year 2012 (financial year 2011) the applicable rate is set at 3.425%.  For qualifying small companies the base rate is increased with 0.5%.

D. Carry-Forward

In the absence of (sufficient) profit from which the amount of NID could be deducted entirely, the unused portion can be carried-forward during the following seven years.

3. NID In A Wider Scope

The NID regime is best viewed, not as a stand-alone tax incentive, but together with other favourable features of the Belgian tax regime, such as:

• Absence of capital duty;
• A participation exemption regime (95% dividend received deduction and  100% capital gain exemption for qualifying shareholdings);
• Absence of dividend withholding tax to qualifying parent companies established in the EU and treaty countries;
• A foreign tax credit against withholding tax on foreign source interest & royalties;
• The full tax deductibility of arm’s length financing charges relating to acquisitions;
• A Patent Income Deduction (PID), resulting in an effective tax rate of maximum 6.8%;
• An Extensive and expanding treaty network covering about 90 countries, with particular access to the East and Middle East;
• A well-established and efficient ruling practice, as a rule, issuing rulings within a three-month time frame;
• Absence of effective thin capitalisation rules, Controlled Foreign Company (CFC) legislation, sophisticated TP-regulations and burdensome TP-documentation requirements.

4. Some Examples From Practice

4.1 General Remarks

The potential benefit of the NID regime may be larger for entities established in countries that apply a dividend exemption regime.  In principle, dividends paid out after application of NID (thus sheltered from Belgian CIT) qualify for exemption under the EU Parent Subsidiary Directive and for reduced or zero-rate withholding taxes under Belgium’s tax treaties.  The NID regime is even more attractive if that jurisdiction allows for a (full) interest deduction related to the funding of the shareholding.  Such a combined effect is available in a number of jurisdictions, subject to applicable thin cap and other general rules limiting the interest deduction:

The NID regime can also positively affect US based groups that aim at reducing or avoiding excess foreign tax credit situations since the benefit is generally available to all types of entities.

CFC legislation could, in principle, largely undo the benefit of the Belgian NID regime. However, an entity can also elect not to apply the NID, e.g. to comply with CFC legislation, or can opt for a partial application of the available deduction, so as to manage the level of effective tax paid. In such case the NID for that year is (partially) lost and cannot be deferred to another year.

4.2 NID Deduction Enhancement

Belgian entities have gradually adapted the manner in which their own funds and debt financing arrangements are structured, as well as the manner in which equity participations in subsidiaries are being held.

In order to maintain the own funds basis, the conversion of (subordinated) loan financing into non-voting preferred shared issues have been organised.  Equity investments held by a company are increasingly structured as convertible subordinated debt instruments, partnership contributions and in the form of various types of derivatives.  The purpose of which is to avoid having shares on the asset side of the balance sheet.

4.3 Finance Companies

The NID is highly beneficial for any company with a good solvency ratio e.g. finance companies, such as treasury centres or an intra-group bank.

Finance companies are only taxable on the spread of the interest income received and the available NID on the finance company’s available qualifying equity.  For example, a finance company funded with an equity contribution for an amount of € 100 mil, granting loans carrying 4% interest, will have its effective tax base in Belgium  reduced to a spread of 0.575 (4%-3,425%), resulting in an effective tax rate of only 4.89%.

4.4 IP-Companies

The NID is also largely advantageous for IP companies, due to the combination of the NID regime with the PID regime, which allows for a 80% deduction on qualifying income, i.e. income from royalties and income deemed to be sourced from patented intellectual property, resulting  in a maximum effective tax rate of 6.8%.

In practice, however, the effective tax rate will be even lower as the IP-company will only be taxable on the spread between the income received on the IP acquired by, or contributed to, the IP-company on the one hand and (a) the NID on qualifying equity, (b) depreciation on the IP and (c) a domestic tax sparing, due to the foreign tax credit on inbound royalty income. 

5. Conclusion

The NID as a stand-alone measure has considerable impact on businesses in Belgium, as it substantially lowers their effective tax rate. However, the power of the regime lies in its combination with various other tax incentives of the Belgian tax system.  Therefore, it is advisable to review, (re)structure and (re)finance businesses specifically around these beneficial tax regimes, including a.o. spinning off or pushing-down certain asset portfolios, adding short term financing activities to operating entities, distinguishing between operating and finance entities on the one hand and holding company functions on the other hand etc. By doing so, the effective tax rate for certain types of businesses can be drastically reduced.