Selected aspects of the Maltese notional interest deduction : a comparative study

Abstract

As explained by Modigliani and Miller (1958), an issue faced by corporations seeking external finance is whether to opt for debt or equity financing. In practice, and as a result of market frictions such as taxation, corporations are not indifferent to debt and equity financing, and a firm typically attains its maximum valuation when it is highly geared, due to a tax deduction for interest, as opposed to no deduction for dividends. This creates a disparity between debt and equity, making the cost of borrowing debt cheaper than the cost of obtaining equity. Such distortion is known as the debt equity bias. As a response to such bias, the Maltese legislator has introduced the notional interest deduction rules in accordance with Article 14(1)(o) of the Income Tax Act. These rules, first introduced in October 2017, have been effective as from year of assessment 2018. Notional interest deduction rules are not the only policy solution to mitigating the bias. In fact, the debt equity bias may be curbed using a positive or a negative approach, with some countries having opted for a combination of both approaches. This paper identifies the different policy options available to mitigate such bias, and provides insight to their overall effectiveness. This is followed by a comparison between the Maltese notional interest deduction rules and similar rules implemented in other countries, as well as a comparison to the allowance for growth and investment in the CCCTB. In the conclusion, this paper provides comments on the Maltese anti-abuse framework and the general interplay between Malta’s notional interest deduction rules and the interest limitation rule introduced by L.N. 411 of 2018.