IFA 2012 BOSTON CONGRESS SUBJECT 2: THE DEBT-EQUITY CONUNDRUM

1. IFA 2012 BOSTON CONGRESSSUBJECT 2: THE DEBT-EQUITY CONUNDRUM David Southern UK Reporter

2. IFA Brief • Morecombe E: • ‘You’re playing all the wrong notes.’ • ‘I’m playing all the right notes – but not necessarily in the right order.’

3. Core distinctions (1) interest on debt is deductible in computing the profits of the company, dividends on shares are non-deductible; (2) debt is a liability to third parties which appears in the top half of the balance sheet; equity is a liability to the proprietors which appears in the bottom half of the balance sheet.

4. Thesis • There is an inherent distinction between debt and interest/equity and dividends • Company law, accounting and tax law locate the division in different places • Hence in practice the distinction is economic not legal, relative not binary • Is the distinction worth maintaining?

5. Plan • What is the debt-equity conundrum? • What is equity? • The distinction in tax law • The distinction in company law • The distinction in accounting • Whither in tax law the equity/debt divide?

6. The conundrum • What is the difference between a riddle and two elephants sitting on a bun?

7. Examples • Shares treated as liabilities • Debt-equity swaps • Contingent convertibles • Shareholder loans • Loans to overseas subsidiaries • Bifurcation of convertibles

8. What is equity? • 1292 – control of courts transferred from church to Crown • Created secular legal profession • Courts of common law and courts of equity • Mortgages of land • Equity = residual interest in property • Co-partners in joint stock companies

9. Tax law distinction • 1806 Income Tax Act • Principle of deduction at source • One exception – Schedule D, Case I • Statutory code of deductible items • Interest added back, WHT accounted for and deducted from total income • Bodies of persons

10. Tax policy • Distinction between bodies of persons/ partnerships depended upon (a) numbers, and (b) transferability of share of profits fund • Dividends not taxed because paid out of taxed profits • Distinction between debt/equity irrelevant for tax purposes

11. Black Book of Lincoln’s Inn, Vol 2, p332-333, 28 January 1636 • ‘The Bishop [of Chichester] … did enter into a discourse, wherein hee did intimate the over-increase in lawyers in these tymes, vouching a transcript of King Edward the first … that seaven score lawyers were sufficient for this whole kingdome; And also the lawyers of Lincolne’s Inn were not incorporate, neither by Act of Parliament nor by any Letters Pattents from the King’s Matie; And made an appologie for his not having Councell to pleade his cause, inasmuch as he himselfe had spent some time in reading of the books of the lawe, and would now invade upon their profession, as some of them had done upon his.’

12. Limited liability companies • 1855 – liability of shareholders limited • Consequent requirement for accounts • Companies Act 1856 – double entry bookkeeping • Standard accounts formats • Companies Act 1948 – ‘true and fair view’

13. Companies Act 1856 • ‘Every Item of Expenditure fairly chargeable against the year’s Income shall be brought into Account, so that a just Balance of Profit and Loss may be laid before the Meeting, and in cases where any Item of Expenditure which may in fairness be distributed over several Years has been incurred in any One Year the whole Amount of such Item shall be stated, with the addition of Reasons why only a Portion of such Expenditure is charged against the Income of the Year.’

14. Purpose of company law • Allocate risks between shareholders and creditors • Form-based approach

15. Shareholder debentures • Roman Law: universitas/ societas • The first use of the term persona ficta to describe a universitas was by Sinibald Freschi who in 1243 became Pope Benedict IV • ‘the father of the fiction theory’ (Gierke) • Carl Friedrich von Savigny • Fiction theory of the company

16. Different theories • Savigny: ‘The relation between the corporation and its members may be compared to that between a lunatic and the committee of his estate.’ • Beseler: ‘Savigny has populated the legal world with hopeless idiots and their state-supported curators.’ • Gierke: ‘real existence of associations’

17. Salomon v Salomon & Co Ltd • [1897] AC 22 • Issue was priority on liquidation of debenture granted to sole shareholder and claims of unsecured creditors • High Court and Court of Appeal found for unsecured creditors • Reversed in House of Lords • Adoption of Savigny theory

18. Accounting distinction • Central concern: identification of realised profits • Reconciliation of balance sheet and profit and loss account • Accounts format and obligations product of company law • Substance-based approach

19. Modern position • Separate system of corporation tax 1965 • Imputation system 1973 • Cost of debt finance < equity finance cost • Internationally debt taxed on residence basis/equity taxed on residence basis • Discrimination against international investors • Freedom of establishment in EC

20. Abolition of ACT • With effect from 1 April 1999 • Disinvestment in shares • 1997 – 32% of UK shares owned by pension funds • 2008 – 12.8% • Switch to debt funding • Super-abundant credit inflated asset values

21. Conclusion • Equity financing stable • Debt financing unstable • Weaknesses brought out in recession • Is the tax distinction worth maintaining? • No consistent or principled policy basis • Make interest and dividends alike deductible and subject to withholding tax