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Tax bias and thin capitalization in Albania

A business that aims to maximize profit, based on this logic, can take more debt than it would take in the absence of this incentive. This effect is generally labeled as debt bias.

The tax bias against debt and interest expense is widespread in the corporate sector and in discussions on narrowing tax erosion. In most countries, the tax system allows a discount on the interest paid on the debt, without displaying a similarity in implementation as far as capital is concerned. This means that debt has a relatively small cost to capital, aiming not to distort fiscal incentives and not to violate the principle of neutrality of a corporate finance source.

A company that decides to take on debt always takes into account taxation and also looks at how it will operate with regard to debt interest expenses, based on the fiscal policy applied to their recognition for tax purposes. Usually such decisions have great effects on Albanian resident fiscal large corporations, which are related to the parent company, but in fact this phenomenon affects all debt-bearing companies.

While the financial situation of the majority of resident companies in Albania is in difficult financial security positions and with continued lack of cash situation, change in the law on profit tax (L.8438, A.21, p.4) as part of the 2017 fiscal package, disrupted this status quo that encouraged investments, in favor of the state budget, for some additional revenue. This legal change exacerbated fiscal policy by transforming it into a more aggressive policy towards recognizing the interest expense of financing that the companies have made or will carry out.

In the absence of any public discussion on the fiscal effects that have come to the budget from the recognition as a fiscal expenditure of the financing interests in their history, and in the absence of any effect it has had in the economy to date lending to corporations, it seems that this change will further deepen the credit market. This market is on the verge of decades and with this change the financial market is directly affected by a further breakdown, as long as fiscal recognition of debt interests becomes even more limited.

In a preliminary analysis of the effects that may have come as a result of this fiscal policy, from a summary of Bank of Albania's (BoA) 'Lending Activity Survey Results', for the four quarters of 2017 it is stated that 'Loan demand is reported increased for businesses in the segment of small and medium-sized enterprises and declining for large enterprises '.

Despite the actions taken by the monetary policy authority i.e. BoA, in terms of reducing commissions and the average margin, which are used to ease the lending conditions of businesses, the financial lending situation is thought to be influenced by the changes of fiscal policy on thin capitalization. The change seems to have a restrictive impact on direct investment, especially those involving decisions on strategic and long-term investments (large enterprises). In fact, these investments are the basis for sustainable and long-term development.

They are also the target of government-driven incentive policy through the economic development strategy, sectorial policies for barriers and investment stimulation, and the creation of mitigating economic instruments, and the promotion of the research and development market, which requires funds ready to be developed.

The legal change for the implementation of a policy like that is considered to be related to EU legal practice (thin capitalization) comes at a time when the economy is not absorbing the financial resources offered by the financial market for internal reasons external, objective and subjective. Meanwhile, the need for funding is present in Albania, as investments in energy, tourism, mining, road infrastructure, water supply etc. aim to increase development and competitive capacities for the domestic and regional market demands. While many existing investments have considerable debts from the financial sector and their influence on their continuity is very strong.

Where is going this policy since taken in this direction?

Both the criteria set in the income tax law, (a) recognition of interest expenses up to 30% of Profit before Profit Tax (EBITDA), and (b) the right to extend the expenditure fiscally up to 5 years, give a negative financial effect and not at all stimulating the cash flow and profits of these companies. And this restriction applies both to financing from the Albanian market, as well as from the foreign market (through the parent company or a financial institution).

Actual interest expenditures are higher and the need for the transfer exceeds 5 years term. Even the denial of these limited rights in cases of change of ownership for more than 25% (while in the case of the transfer of losses, this limit is 50%) fails to affect these businesses. In this situation, such a change it is also in contradiction with the announced policy of facilitating tax procedures.

Whereas, if we look at this part of the tax policy in the countries of the region (South East Europe and East Europe, like Macedonia, Serbia, Slovenia, Turkey, Romania, Hungary), it is noted that they continue to apply the existing method that is foreseen by the current Albanian law, where the fiscal recognition of interest expenditures debts lie within the limits of the Debt / Capital ratio of 3 : 1 to 4 : 1. But even the countries from which the reference is made to this proposal do not apply the same rules as are changed by the introduction from fiscal package 2017.

On the other side, the implementation of thin capitalization policy (or low capitalization, according to the law) adopted by the EU, according to the OECD recommendations, is aimed at combating tax evasion that comes from the aggravation of interest expenditures, debts or financing mainly by shareholders or parties connected with multinational corporations that are not yet part of the Albanian market. Given this borrowed situation, which does not coincide as such with the reality of the Albanian economy, it is incorrect to decide the future events for the market.

But, given the present situation, where this law is already in place and the words are without influence to change it, it would be appropriate before this change turns to the opposite of businesses to be kept in mind for future changes:

  • to be applied only to those business cases where the increase in funding and interest expense is greater or to the detriment of domestic and regional competition by seeing it aligned with the strategy for economic development, also mentioned in the progress report 2016 EC;
  • Methods of calculation to be applied with a higher threshold than proposed in the draft law;
  • Fiscal recognition of interest expenditures for fiscal purposes for a longer period of time in relation to the proposal of the law
  • setting a threshold for the fiscal recognition of interest expenditures (according to the experience of the majority of EU countries) by having real value companies and excluding those small and most influenced companies by not knowing them.

The experience of two decades has shown every time that the urgent pursuit of disconnected or premature policy for the economy, which is still underdeveloped and unstructured as well as the problems that still result from widespread informality have adverse effects on businesses / the economy, as well as the budget, as they encourage reactions to evasion or tax evasion. An aggressive policy against to profit in fact leads to lower lending, as well as an increase in fiscal burden.

On the other hand, within the sustainability of corporate tax policy, it would be of added value and also an incentive to the economy if such discontinued policies would be included in the initiative for the new tax law on taxation on capital gains and work (income tax and personal income tax etc.).

These comments, of course, should be the subject of debates and discussions between experts and financial institutions and public finances.