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Governments should stop privileging debt over equity

No OIC (Organisation of Islamic Cooperation) has tried to reduce the privilege that tax relief for interest expense gives to debt over equity.

Posted 20 September 2022

Every country I know gives tax relief for interest expense paid by trading companies. This has the effect of encouraging companies to take on more debt, rather than issuing equity.

Some countries have experimented with ways of reducing or eliminating this tax privilege for debt. However, even though Islamic finance scholars prohibit explicit interest payments, as far as I am aware no Muslim majority country has sought to reduce the tax privilege for debt.

I wrote about this in my June column in the magazine "Islamic Finance News." You can read it below.

Governments should stop privileging debt over equity

Islamic banking is often described as banking without interest. Since finance isn’t free, Islamic banks charge in other ways for providing finance such as using murabaha contracts. (Buying something for the customer and selling it on at a higher price with a disclosed markup.)

The UK and some other countries have rewritten their tax laws to ensure that the party being financed (the “borrower”) gets tax relief for such quasi-interest, provided that it corresponds to a charge for finance at market interest rates.

A wider question often arises in tax policy discussions.

Is it sensible that interest (the cost of debt) is tax deductible when there is no tax relief for the cost of equity capital? Especially since such tax relief for interest expense often leads to companies taking on more debt than they should, making financial distress more likely.

Simply abolishing tax relief for interest expense is not easy, even putting to one side the predictable howls of outrage from corporate borrowers. The reason is that “lenders” and “borrowers” will, instead of having explicit interest provisions in their finance agreements, devise workarounds. For examples of such workarounds, look at the range of contracts used in Islamic finance.

There would then follow a game of “whack a mole.” Tax advisers would devise innovative ways of paying for quasi-debt finance in ways that obtained tax relief, while tax authorities regularly changed their tax laws to shut down such tax relief.

When you consider the likely political outcry if governments try to simply abolish tax relief for interest expense, and the extensive tax avoidance efforts that would follow on the part of corporate borrowers, it is more realistic to consider an alternative way of removing the current privilege that debt enjoys.

That is to introduce a new tax relief for the cost of equity, normally called an “Allowance for Corporate Equity.”

The concept is very simple. Paid in share capital and retained earnings would receive tax relief each year at a specified interest rate.

For example,

Tax relief for interest expense would remain unchanged, but there would no longer be an artificial privilege for raising finance in the form of debt compared with raising finance in the form of equity capital.

Since the introduction of tax relief for corporate equity would increase the total tax deductions available to the corporate sector, the way to compensate the government is to raise corporate tax rates so that, overall, the corporate sector pays the same amount of corporate tax after the change as it did before.

A small number of countries, such as Italy, Portugal, and Latvia, have introduced schemes of this kind. However, I am not aware of any OIC country having done so, perhaps illustrating the general lack of policy innovation in the OIC. Logically an allowance for corporate equity should be particularly appealing to OIC countries given many Muslims’ distaste for interest paying finance.

Mohammed Amin is an Islamic finance consultant and former tax partner at PwC in the UK.

 

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