The Allowance for Corporate Equity 30 years on


The debate on reforming fundamental features of the corporation tax has been a constant in Judith Freedman’s career. The same questions are asked time and again. How should profit be defined for corporate tax purposes? Should the tax treatment of equity and debt be equalised and, if so, how? Should the corporate tax system follow accounting rules? Should corporate profit be taxed at the corporate and the investor level? How should small businesses be taxed? Should a group of companies be considered as one entity or as separate entities? How should the profit of multinational companies be allocated among countries? But the context in which these questions have been addressed has changed as a result of globalisation, technological advancement, shifting political and public expectations and other factors. Furthermore, practical experimentation and academic work have refined and nuanced some possible answers to these questions. Judith has made important contributions to these fundamental questions over the course of her career, and we are honoured to contribute to this Festschrift.

The Allowance for Corporate Equity (ACE) is a response to the first two fundamental questions posed above: how should profit be defined for corporate tax purposes? And should the tax treatment of equity and debt be equalised and, if so, how? In answer to the first question, the ACE narrows the definition of taxable profit to economic rent. By doing so it removes the traditional corporate tax system’s distortionary impact on decisions on whether and how much to invest. In answer to the second question, the ACE equalises the treatment of debt and equity at the corporate level by providing a notional deduction for the opportunity cost of equity which matches the deductibility of interest payments.

The ACE was first proposed by the Institute for Fiscal Studies (IFS) Capital Taxes Group in 1991[2] and has been a staple in discussions on corporate tax reform ever since. It has been considered in reports on corporate tax reform by the OECD[3] and the IMF,[4] and in individual countries’ tax policy reviews, including the UK (Mirrlees Review)[5] and Australia (Henry Review).[6] Unlike a number of corporate tax reform proposals – including competing proposals such as the Comprehensive Business Income Tax (CBIT)[7] – the ACE, or variations of the ACE, have also been translated into practice. In fact, it has been adopted – and in some cases also repealed – in at least 11 countries.

The IFS Capital Taxes Group proposed the ACE as a way of addressing two of the main economic distortions created by a traditional corporate tax system: the distortion to investment decisions (whether to invest and how much to invest); and to financing decisions (whether to finance corporate activity with debt or with equity). Addressing these distortions may appear uncontroversial at first glance from a policy perspective, but it raises questions on closer examination, which we address in section III. The ACE addresses distortions to investment decisions by excluding the ‘normal’ return from the corporate tax base. Can this be justified in broader tax policy terms, particularly at a time of increasing inequality? The ACE addresses distortions to investment decisions by neutralising the tax treatment of debt and equity at the corporate level. Does this not ignore the investor level? Can the tax bias for debt at the corporate level be offset at the investor level?

Different countries’ experiences with the ACE over the past 30 years have provided the setting and data to undertake empirical research into its economic impact along different margins. They have also brought to the fore some administrative and possible tax planning problems, especially of forms of the ACE that have been introduced in practice. Furthermore, while the ACE was proposed in the context of a source-based corporation tax, thought has been given to the ACE in the context of other international tax arrangements. For example, academic work has explored the introduction of an ACE on a destination basis and the EU Commission has proposed an ACE in the context of a formulary apportionment system. Section IV of this chapter reviews developments related to the ACE over the past 30 years. Section V of this chapter concludes.

Before addressing these questions, though, we first set out the mechanics of the ACE.