The effect of the notional interest deduction on the ...

UNIVERSITEIT GENT

FACULTEIT ECONOMIE EN BEDRIJFSKUNDE

ACADEMIEJAAR 2008 – 2009

The effect of the notional interest deduction on the dividend policy of

Belgian corporations

Masterproef voorgedragen tot het bekomen van de graad van

Master in de Toegepaste Economische Wetenschappen

Gertjan Janssens

Stefanie Remue

onder leiding van

Prof. Dr. Philippe Van Cauwenberge

Permission Ondergetekenden verklaren dat de inhoud van deze masterproef mag geraadpleegd en/of

gereproduceerd worden, mits bronvermelding.

Gertjan Janssens

Stefanie Remue

I

Preface Writing this master dissertation has not always been easy. Special thanks go to our

promotor, Prof. Dr. Philippe Van Cauwenberge for his time, expertise and useful additions to

our paper. We would also like to express our gratitude to his assistant, Katrien Kestens, for

her support and guidance. Moreover, also our friends deserve a special thank for their moral

support. Last but not least, we owe our parents for all the opportunities they gave us in life.

May 2009,

Gertjan Janssens

Stefanie Remue

II

Table of content

List of used abbreviations ................................................................................................................................ III

List of tables............................................................................................................................................................ IV

Abstract.......................................................................................................................................................................1

I. Introduction ..........................................................................................................................................................2

II. Description of the notional interest deduction ..................................................................................3

III. Allowances for Corporate Equity.............................................................................................................4

IV. Literature Overview.......................................................................................................................................5

Finance theories..........................................................................................................................................5

Dividend theories .......................................................................................................................................6

Hypotheses ....................................................................................................................................................7

V. Effect of NID on MTR: example...................................................................................................................9

VI. Sample Description...................................................................................................................................... 13

Dependent variables .............................................................................................................................. 14

Independent variables .......................................................................................................................... 15

VIII. Results ............................................................................................................................................................ 15

Descriptive Statistics ............................................................................................................................. 15

Regression Results.................................................................................................................................. 18

IX. Conclusion........................................................................................................................................................ 21

References .................................................................................................................................................................V

III

List of used abbreviations

ACE Allowances for Corporate Equity

Belgian GAAP Belgian Generally Accepted Accounting Principles

CBIT Comprehensive Business Income Tax

MTR Marginal Tax Rate

NBB National Bank of Belgium

NID Notional Interest Deduction

NPV Net Present Value

OLO Obligation Linéaire - Lineaire Obligatie

R&D Research and Development

SME Small and Medium-sized Enterprises

TLCF Tax-Loss Carryforward

IV

List of tables

Table 1: Example: Initial Situation.............................................................................................................. 10

Table 2: Example: Adding Interest Cost ................................................................................................... 11

Table 3: Example: Initial Situation with NID.......................................................................................... 11

Table 4: Example: Adding Interest Cost ................................................................................................... 12

Table 5 Panel A: Descriptive Statistics...................................................................................................... 16

Table 5 Panel B: Industry Distribution. .................................................................................................... 16

Table 6 Panel A: Correlation Matrix ........................................................................................................... 17

Table 6 Panel B: Tolerance Levels............................................................................................................... 17

Table 7: Regression Analysis ......................................................................................................................... 19

Table 8: Regression Analysis ......................................................................................................................... 20

1

Abstract

This paper studies the impact of the notional interest deduction (NID) on the

dividend policy of privately held small and medium-sized enterprises in Belgium for 2007.

We use simulated marginal tax rates to incorporate the effect of the notional interest

deduction. Controlling for independent variables typically related to dividend policy

(maturity, growth opportunities, leverage, profitability, failing/non-failing), we find a

marginally significant relation between the NID and the dividend policy of Belgian

corporations.

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I. Introduction

The purpose of the notional interest deduction is on the one hand, to promote

Belgium as a ‘headquarterland’. On the other hand, the NID aims to narrow the

discrimination between financing with equity capital or with loan capital. It could be

expected that this results in an improvement of the financial position of companies, due to

an increase in their equity. The NID is a yearly deduction of a fictitious interest from the

earnings of a corporation. The NID is calculated as the adjusted shareholders’ equity

multiplied by a fictitious interest rate.

This paper studies the impact of the notional interest deduction on the dividend

policy of privately held SMEs in Belgium. The NID was introduced in 2005. While there are

numerous studies dedicated to corporate dividend policy, only very few discuss the dividend

policy of privately held companies (Deloof et al., 2008). Furthermore, there has been no

study about the impact of the NID on the dividend policy of privately held SMEs in Belgium

so far. In addition, Belgium provides a unique context for this study as it is the only European

country to date which currently implements a variant of an ‘Allowance for Corporate Equity’

(ACE) system (Klemm, 2007). This system can be considered as the underlying theoretical

framework of the Belgian NID. In January 2007 103.058 SMEs were active in Belgium of

which all annual accounts are publicly available, as all companies have to deposit their

statements at the Central Balance Sheet Office of the National Bank of Belgium (NBB).

To investigate whether the NID causes a change in the dividend policy of Belgian

SMEs, we run a regression using the changes of our variables between years 2007 and 2005.

Fiscal year 2005 was the last taxable year without application of NID in Belgium.

Furthermore, 2007 as compared to 2006, offered a greater likelihood to find significant

results. Companies need time to enhance their knowledge about the possible (dis-)

advantages of applying the NID. Moreover, some companies lack willingness to implement

the NID. Furthermore, they can face high transaction costs. We find marginally significant

results concerning the NID.

The remainder of the paper is structured as follows. Section II gives a description of

the notional interest deduction. Section III briefly handles the broader framework of NID, i.e.

Allowances for Corporate Equity. Section IV provides a short literature overview and

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describes our hypotheses and expected relationships with the dividend policy. In section V

we use a simple example to illustrate the effects of the NID on the marginal tax rate (MTR).

Section VI outlines the sample, followed by a discussion of our variables in section VII.

Results are reported in section VIII. We draw our conclusions in section IX.

II. Description of the notional interest deduction

The law of June 22nd 2005 and the Royal Decree of September 17th 2005 introduced

a tax deduction for risk capital. The law itself has been in effect since assessment year 2007

and is referred to as the notional interest deduction.

The NID is a yearly deduction of a fictitious interest from the earnings of a

corporation. The deduction is allowed as long as the company is profitable. When the

deduction surpasses the profit of the current book year, the unused deductible amount is

transferable to the next year, with a maximum of seven years.

The NID is calculated as the adjusted shareholders’ equity multiplied by a fictitious

interest rate.

The calculation of the adjusted shareholder’s equity starts with the company’s equity

capital at the end of the previous taxable period. According to Belgian GAAP “equity capital”

covers the following accounts: capital, share premiums, revaluation gains, reserves (legal

reserves, unavailable reserves, tax exempt reserves and available reserves), retained

earnings and capital investment subsidies. To calculate the adjusted shareholders’ equity,

however, several deductions have to be implemented. The deductions can be classified into

four categories. The first category consists of shares and participations: fiscal net value of

own shares held on the balance sheet, shares in other companies and shares issued by

investment companies. The second category concerns assets not taxed in Belgium: net

worth of permanent establishments and foreign real estate located abroad. The third

category encompasses avoiding abuses and excluding unreasonable investments: net value

of assets exceeding business needs, net value of assets not generating taxable periodic

income (e.g. works of art, jewelry, …) and real estate used by company directors, their

spouse or their children. The final category encloses tax-deductible items: capital grants,

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tax-free revaluation gains (including revaluation gains incorporated in capital) and tax-credit

for research and development.

The notional interest rate corresponds to the annual average of the monthly

reported indices of 10-yearly government bonds (OLOs). The interest rate for any given

assessment year will be the rate of the calendar year that precedes the previous assessment

year (e.g. for assessment year 2009, reference is made to the rate of calendar year 2007).

The maximum notional interest rate is 6,5% and the maximum fluctuation is 1% per year.

The applicable rate for the notional interest deduction for assessment year 2008 is 3,781%.

For SMEs, however, a different rate applies, namely 4,281%. This is the normal rate

augmented with 0,5%.

In the following section the Allowances for Corporate Equity system will be discussed.

This system can be regarded as the underlying theoretical framework of the Belgian NID.

III. Allowances for Corporate Equity

In most countries, the tax system allows deductibility of interest, while a deduction

for dividends is not permitted. This dissimilarity in treatment is often referred to as fiscal

discrimination between debt and equity financing.

The general objective of an ACE system is to pursue neutrality between debt and

equity financing by permitting firms to deduct a notional interest rate on their equity, next

to the interest deduction on debt financing (Klemm, 2007).

The ACE or the notional return is determined as equity at the end of the previous

year (Et-1) multiplied with a notional interest rate (î): ACE = Et-1 x î. The notional interest rate

could be approximated by the rate on government bonds.

Furthermore, the neutrality aspect is not the only characteristic of an ACE tax system.

The system is not affected by inflation as the interest rate is based on government bonds,

which already incorporate inflation. This eliminates the need for indexation. Additionally,

the method of tax depreciation is irrelevant. An enlargement in depreciation in the early

years would result in a diminishing equity base. Thus, in the later years the ACE will

experience a decline as well. This drop compensates any benefit from earlier depreciation in

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net present value terms. The ACE system also guarantees neutrality in financing decisions.

Companies are indifferent against financing with debt or equity as long as the company tax is

the only aspect taken into account.

On the other hand, governments that introduce an ACE system must take into

account a narrower tax base. To retrieve the same amount of revenue, a higher tax rate is

necessary. This might be harmful in the current globalised economy. Moreover, doubt arises

whether other countries will accept an ACE system as a basis for double tax treaties. In

addition, an ACE system only guarantees companies to be indifferent towards equity and

debt financing when (1) these companies only take corporate tax into account. Other costs,

i.e. bankruptcy costs, information costs, … are not considered here (2) dividends and

interests are taxed equally.

Another example of pursuing neutrality between debt and equity financing is

comprehensive business income tax (CBIT) (Radulescu & Stimmelmayr, 2006). Under this

system, however, deduction is not allowed for both dividends and interest.

Croatia was the first country to put into practice an ACE in 1994. Italy and Austria

followed soon thereafter. In 2000, however, Croatia announced that it was returning to a

standard corporate income tax system in 2001. Italy and Austria withdrew their ACE system

as well in the following years. Outside Europe Brazil has applied a variant of an ACE since

1996. Belgium introduced the notional interest deduction, a variant of ACE, in 2006 (Klemm,

2007).

IV. Literature Overview

Finance theories

The notional interest deduction can have an impact on the financing decision of

companies, and the capital structure as one of the objectives of the NID is to strengthen the

financial position of companies by increasing their equity. Over the years, the irrelevance

principle of Modigliani and Miller has given rise to two competing capital structure theories:

the trade-off theory and the pecking order theory.

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The trade-off theory, in essence, says that a company chooses how much debt and

equity it uses, by balancing the costs and benefits of additional debt. The theory states that

there are advantages of financing with debt and there is a cost of financing with debt, the

costs of financial distress. The major benefits include the tax benefits of debt and controlling

for free cash flow problems (cf. agency/rent theory). The deductibility of interest payments

pushes firms toward a higher leverage target. The downside of a more leveraged firm are

higher bankruptcy costs and non-bankruptcy costs (e.g. staff leaving, unfavorable conditions

with suppliers, …). Expected bankruptcy costs are higher when profitability is lower, and the

threat of these costs pushes less profitable firms toward lower leverage targets. Similar

conclusion can be drawn for firms with volatile earnings and smaller less-diversified firms

(Fama & French, 2002). To sum up, a firm will borrow up to an optimal point, where the

marginal value of tax shields on additional debt is just offset by the marginal cost of financial

distress. The deductibility of interest pushes more profitable and less volatile firms toward

higher leverage. Application of the NID has altered this optimal point due to a decline in

MTR. This makes equity financing more attractive as it results in a larger equity base and

thus a larger NID.

Alternatively, according to Myers and Majluf there is no optimal capital structure.

They posit that firms try to minimize asymmetric information costs by financing initially with

internally generated cash flows. When this does not suffice, preference will be given to debt.

Only as a last option will companies issue new shares. This is why this argumentation is

called the pecking order theory. Consequently, the capital structure is but a mere

coincidental result and not the outcome of striving for a specific optimal debt-equity ratio.

Myers (2001) argues that dividends are sticky. Dividend cuts are not used to finance capital

expenditure. Therefore, changes in cash requirements are not reflected in short-run

dividend changes. In other words, changes in net cash cause changes in external financing.

Dividend theories

A large part of dividend studies is founded on either signaling theory or agency/rent

extraction theory (Deloof et al., 2008). Signaling theories explain that the dividend serves as

a signal to outside investors about future expected cash flows. Traditionally, dividend

income has been taxed less favorably than capital gains. Moreover, dispersing dividends may

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lead to underinvestment or high cost of external financing. As a consequence, this signal

should be taken seriously because it is an expensive signal. Only companies who truly expect

a higher future cash flow will give this signal. The agency/rent extraction theory suggests

that the interests of managers are not always identical to those of shareholders. Managers

are inclined to waste free cash flow (the excess of cash earnings over profitable investments)

on investments with a negative NPV or use it for their own benefit. Dispersing dividends

tackles this problem by obligating managers to pay out the firm’s excess cash (Fama &

French, 2002). These theories, however, appear to be less important for privately held

companies (Deloof et al., 2008).

Lintner (1956) investigated the dividend policy of American companies. One of the

main conclusions was that the management derives their dividend policy from an estimation

of the part of the companies’ earnings, which they consider as persistent. Management

requires time to examine whether an increase in earnings is persistent or not. Moreover,

managers are reluctant to make dividend changes that might be reversed. As a consequence,

dividend changes follow shifts in long-run or sustainable levels of earnings rather than short-

run changes in earnings. This, in turn, results that dividends are considered stable.

Hypotheses

Grullon et al. (2002) state that as firms become more mature, their investment

opportunities become smaller. This is expressed in a declining rate of reinvestment. The

declining reinvestment rate gives rise to excess cash, which should be ultimately paid out

(cf. agency/rent extraction theory). Grullon et al. (2002) refer to this explanation as the

maturity hypothesis. We use age and size as proxies for maturity. Older companies typically

find themselves in later growth stages. Other studies find a positive relationship between

company size and dividend payout (Fama & French, 2001, Megginson & von Eije, 2006).

Alternatively DeAngelo et al. (2006) apply a life-cycle theory to check whether the

probability of a firm to pay a dividend is positively related to its mix of earned and

contributed capital. In other words, firms with a high ratio of retained earnings to total

equity have a higher probability of paying out a dividend. This approach however, is not

suitable for this study since DeAngelo et al. (2006) focus on publicly traded industrial firms in

the USA.

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Dividend studies typically find a positive relationship between the current dividend

and the profitability of the previous year (Deloof et al., 2008; Fama & French, 2002; Denis &

Osobov, 2008). A higher level of profit implies a higher level of internal funds, which may not

be allocated entirely for reinvestment, thus more dividends may be expected.

The pecking order theory suggests that when a company is faced with growth

opportunities, i.e. investment projects with a positive NPV, it will first use internally

generated cash flows to finance these projects. Hence, we expect to find a negative

relationship between growth opportunities and dividend payout, since the cash flows will be

primarily allocated to the investment project (Fama & French, 2001; Denis & Osobov, 2008).

Only if there is any money left, this might be used to pay out a dividend. Moreover, Barclay

et al. (1995) suggest a higher dividend payout in stable low-growth companies, since these

companies distribute a dividend to reduce agency problems. As these companies have fewer

major investment opportunities, and thus possibly have excess cash (cf. free cash flow), they

can limit managers urge to overinvest by paying out a larger percentage of their earnings.

We use sales growth as a proxy for growth opportunities, as increases in sales can indicate

the necessity for investment in the future.

When a company becomes more leveraged, a larger obligation towards the debt

holders exists. Therefore, cash flows that would be used to pay out dividend now have to be

used to pay interest on the loan and to pay back the principal amount. Thus, we expect a

negative relationship between leverage and dividend policy (Deloof et al., 2008; von Eije &

Megginson, 2006). Goossens (2005) states that smaller companies rather finance with

short-term debt than larger companies. Therefore, we make a distinction between

short- and long-term leverage. The most important reasons for this differentiation are based

on the fact that SMEs suffer higher information costs, hold a higher risk and incur larger

transaction costs when issuing long-term debt.

We need to make a distinction between healthy and failing firms. When a company

finds itself in financial difficulties, it is likely the company will not give out a dividend. The

Z-score of Altman is an often used multiple discriminant model to assess the financial health

of a company. In this model firms are classified into failing or non-failing groups by

comparing their Z-score with a certain cut-off score. If the Z-score is higher than 3 a

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company is classified as healthy. Thus, we expect a positive relationship, the higher the

Z-score, the healthier the company and hence a higher probability of a dividend payout.

Recently, however, Altman (2000) made a revised Z-score model for privately held

companies, i.e. Z’-score. As we conduct our study for private SMEs our preference goes to

this revised failure prediction model.

The effect of the NID will be incorporated through simulations of MTRs for the

companies of our sample. Graham (2001) defines the marginal tax rate of a company in

period T, as the change in the present value of the tax liability as a result of earning an extra

dollar of income in period T. This will be illustrated in the next section with a simple

example. A company will experience a decline in its MTR when applying the NID, thus pay

fewer taxes and a higher probability of giving out a dividend. Nonetheless, given the fact

that the NID is calculated on the adjusted shareholders’ equity, we expect that this tax

advantage will be fully incorporated into equity in order to create a higher NID for the

following year. As a consequence, we expect that companies will not distribute a higher

dividend. Moreover, we hypothesize that companies will disperse a smaller dividend in order

to benefit from a higher NID. A decline in MTR in combination with a decrease in dividend

payout results in an expected positive relationship.

V. Effect of NID on MTR: example

In this section we will illustrate how the NID can influence the MTR. To illustrate this

effect we will utilize the method Graham developed. We adapt Graham’s definition, outlined

in the previous section, to see how incurring an extra dollar of interest in period T, has an

impact on the change in the present value of the tax liability, in period T.

Because the definition of MTR incorporates future tax liabilities, it is necessary to

generate estimations of earnings before interest and taxes (EBIT) for the upcoming periods

(i.e. T+1, T+2, …). All of this is best demonstrated by a numerical example in which we also

will incorporate the NID.

Before starting, some issues need to be addressed. First of all, we consider a limited

time frame of seven periods. This assumption is based on the reasoning that losses due to

NID are only transferable up to seven years. We must acknowledge, however, that this is not

10

the case for tax loss carryforwards (TLCFs), which are unlimitedly transferable in time

according to Belgian tax code. Moreover, the effect of the discounted values of tax liabilities

after period T+7, based on decisions of period T, might be limited. Secondly, we do not take

into account the progressive nature of the Belgian corporate tax code but apply a statutory

tax rate of t, 33,99%. Furthermore, we assume an interest rate on debt of 4,85%, which will

also serve as our discount rate. In addition, the notional interest rate for SMEs is 4,281% in

tax year 2007. Finally we assume that all earnings after taxes are incorporated into equity.

In our example (Table 1) we hypothesize an EBIT of €133 in period T from which we

subtract €35 of interest and a one-time TLCF of €5. This gives us a taxable income of €93.

Applying the statutory tax rate of 33,99% culminates in a tax liability of €31,61. In period

T+1, the company has an EBIT of €160, interest costs remain the same and no outstanding

TLCFs. Given the taxable income of €125, we have a tax liability of €42,49. With the

assumption of a discount rate of 4,85%, the net present value of the tax liability in T+1 is

€40,52 (=42,49/1,0485). For the remaining periods we make use of the same calculus. The

expected discounted future tax liabilities over the periods sums up to a total of €234,82.

Table 1: Initial Situation

Interest cost T 35

Tax loss carryforwards T 5

Period T Period T+1 Period T+2 Period T+3 Period T+4 Periode T+5 Periode T+6 Periode T+7

EBIT 133 160 127 127 147 140 127 133

Less: interest 35 35 35 35 35 35 35 35

Less: TLCFs from previous years 5 0 0 0 0 0 0 0

Taxable income 93 125 92 92 112 105 92 98

Taxes (@ 33,99%) 31,61 42,49 31,27 31,27 38,07 35,69 31,27 33,31

Earnings after taxes 61,39 82,51 60,73 60,73 73,93 69,31 60,73 64,69

PV Tax liability 31,61 40,52 28,44 27,13 31,50 28,16 23,54 23,91

Sum of PV tax liabilities 234,82

To determine the MTRNONID (Table 2) we increase the amount of debt, only for period

T, until we experience a rise of interest cost of €1. For periods T+1 and beyond the interest

cost remains €35, so the additional euro of interest in T will not cause any differences in tax

liabilities for the remaining periods. Taking the extra euro of interest in T into account the

taxable income will become €92, which results in a tax liability of €31,27. As the interest

expense does not change in the following periods, the calculations stay the same as in

Table 1. If we compare the sum of the present values of the tax liabilities, with and without

an extra euro of interest, we observe a decrease of €0,3399 (= €234,82 - €234,48). As

Graham (2001) illustrates in his paper ‘Estimating the tax benefit of debt’ for an additional

11

dollar of income, we can conclude that, due to an additional euro of interest cost, the

MTRNONID equals the statutory tax rate of 33,99%.

Table 2: Adding Interest Cost

Interest cost T 35



EBIT 133 160 127 127 147 140 127 133

Less: interest 36 35 35 35 35 35 35 35


Taxable income 92 125 92 92 112 105 92 98

Taxes (@ 33,99%) 31,27 42,49 31,27 31,27 38,07 35,69 31,27 33,31


PV Tax liability 31,27 40,52 28,44 27,13 31,50 28,16 23,54 23,91


Next, we are going to include the NID into our example (Table 3), to demonstrate the

effect of the NID on the MTR. Belgian law requires that the deduction of NID should be made

before the subtraction of TLCFs. As mentioned earlier, the interest rate on equity to

calculate the NID is 4,281% for SMEs. To compute the NID for period T we first have to

determine the adjusted shareholders’ equity for period T. Equity (€500) minus revaluation

surplus (€100) and capital subsidies (€0) leads to an adjusted shareholders’ equity of €400.

Thus, the NID equals €17,12 (= €400 * 4,281%). The NID causes a decrease in the amount of

taxable income (€75,88) and tax liability (€25,79). For the following periods the same

calculus applies. As we assume that all earnings are retained, we have to take into account

that the adjusted shareholders’ equity will vary. For example, the adjusted shareholders’

equity for T+1 equals the initial amount in T, € 400, plus the earnings after taxes in T, €50,09.

So to calculate the NID for period T+1 we apply the interest rate of 4,281% on €450,09 which

equals €19,27. For the remaining periods we follow the same computations.

Table 3: Initial Situation with NID

Equity T 500

Revaluation surplus T 100

Capital subsidies 0

Adjusted shareholders' equity T 400

Interest cost T 35



EBIT 133 160 127 127 147 140 127 133

Less: interest 35 35 35 35 35 35 35 35

Less: notional interest deduction 17,12 19,27 22,26 24,23 26,14 28,57 30,73 32,46


Taxable income 75,88 105,73 69,74 67,77 85,86 76,43 61,27 65,54

Taxes (@ 33,99%) 25,79 35,94 23,71 23,04 29,18 25,98 20,83 22,28


PV Tax liability 25,79 34,28 21,56 19,98 24,15 20,50 15,67 15,99


Adjusted Shareholders' Equity T+r (r= 1,2, …, 7) 450,09 519,88 565,92 610,65 667,33 717,78 758,23

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To value the MTRNID (Table 4) we consider a one-time increase in debt in period T,

which results in an interest cost of €36. The increase in debt, however, results in a decline of

the equity base with €20,62 (= 1/0,0485). This also means a smaller adjusted shareholders’

equity and thus a lowering in NID of €0,88 (= 0,04281 * €20,62) for period T. Consequently,

in this scenario we have to take into account that there is trade-off between interest cost

deduction and NID. When the NID is lower, we are faced with a higher taxable income. This

offsetting results in a tax base decrease of 0,12 (= 1- 0,88). The related tax liability in period T

is lowered with €0,041 (= 0,12 * 0,3399) due to an additional euro of interest cost.

As of period T+1 the interest cost is back to €35. There are no future tax

consequences of the additional euro of interest cost in period T because the €1 was entirely

deducted in T. To calculate MTRNID we have to compare the sum of the present value tax

liabilities of Table 3 and 4, respectively €177,93 and €177,89. The MTRNID is equal to 3,38%

(= 177,93 - 177,89). The incorporation of the NID in the corporate tax system, in this

example, gives rise to a tax benefit of 30,61% (= 33,99% - 3,38%) percentage points, equaling

the difference between MTRNONID and MTRNID.

Table 4: Adding Interest Cost

Equity T 500

Revaluation surplus T 100

Capital subsidies 0

Adjusted shareholders' equity T 400

Interest cost T 35



EBIT 133 160 127 127 147 140 127 133

Less: interest 36 35 35 35 35 35 35 35

Less: notional interest deduction 16,24 19,26 22,25 24,22 26,14 28,57 30,73 32,46


Taxable income 75,76 105,74 69,75 67,78 85,86 76,43 61,27 65,54

Taxes (@ 33,99%) 25,75 35,94 23,71 23,04 29,18 25,98 20,83 22,28


PV Tax liability 25,75 34,28 21,56 19,99 24,15 20,50 15,68 15,99


Adjusted Shareholders' Equity T+r (r= 1,2, …, 7) 450,01 519,80 565,84 610,58 667,26 717,71 758,16

In conclusion, the foregoing assumptions hold under the following conditions: (1)

equity must be positive, if not, NID cannot be applied (2) all earnings are retained, no

dividends are distributed (3) EBIT of T should be adequate to fully incorporate the deduction

of interest expenses, NID and TLCFs. If this is not the case one cannot fully take in the

increase of interest cost during period T.

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VI. Sample Description

Our focus is on Belgian SMEs. We target these companies because it is an area, which

lacks significant studies. In addition, SMEs account for an important part of the Belgian

economy. Moreover, all records of financial statements are publicly available at the NBB. We

need to remark that there is some disunity about the correct criteria to define an SME. We

make use of article 15 § 1 in Belgian Code of company law, upon which the law of NID is

based. This article considers a company as an SME when it meets one of the following three

criteria in the last two previous book years (unless it has more than 100 employees): (1) less

than 50 employees (2) turnover (VAT excluded) no more than €7.300.000 and (3) balance

sheet total of no more than €3.650.000. If a company meets two or all three criteria, it is

considered a large company.

We gathered our data using the Bel-First database of Bureau Van Dyck. A SME has

the option to deposit either an abbreviated or a complete format of his annual statements

to the NBB. We only include SMEs who present their statements in the complete format,

because only this format allows us to conduct our study. The former requisites reduce our

sample size to 4.252 SMEs.

As financial and insurance companies have their own specific financial behavior and

legislation, these were also left out of the sample. This reduced our sample size to 4.168

SMEs. Next, companies that are not independent were also removed from the sample. The

financial structure of a subsidiary might be influenced by strategic considerations of the

management at the level of the group. Deloof et al. (2008) define a company as independent

when no shareholders are recorded with no more than 25% of direct or total ownership.

These restrictions further reduce our sample to 1.550 SMEs. Moreover, we require

companies that are capable of distributing a dividend. Article 617 in Belgian Code of

company law states that the sum of accumulated profit (loss), tax exempt reserves, available

reserves minus not yet depreciated formation expenses and R&D costs needs to be positive

before any profit of the current year may be turned out to the shareholders. Taken into

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account the available data regarding the simulated MTRs1, we obtain a final sample of 398

companies.

We conduct our study for fiscal year 2007, one year after the NID was introduced. We

focus on 2007, since we expect a higher probability to find effects of the NID, in contrast to

2006. Companies need time to enhance their knowledge about the possible (dis-)

advantages of applying the NID. In addition, SMEs have the choice between adapting NID or

continued use of the investment reserve. For some SMEs the benefits of using the

investment reserve outweigh the possible gains of implementing the NID. As a consequence,

companies require time to thoroughly study this company specific decision.

VII. Variables

We gathered all of our data, with the exception of the MTR-variable, from the

Bel-First-DVD of Bureau Van Dyck. The Bel-First-DVD is a database, which contains

accounting data from the unconsolidated financial statements deposited at the NBB.

To investigate whether the NID causes a change in the dividend policy of Belgian

SMEs, we run a regression using the changes of our variables between years 2007 and 2005.

We make use of fiscal year 2005, as this is the last taxable year without application of NID in

Belgium, and fiscal year 2007 for reasons mentioned earlier.

Dependent variables

We consider two measures for the change in dividend policy. Firstly we use change in

dividend-to-cash flow (∆Dividend-to-CF). This proxy is defined as the amount of total

dividends paid in year T over the cash flow in year T-1. La Porta et al. (1999) state that this

ratio has a logical economic interpretation since it is the ratio of the cash distributed to cash

generated in a period. As a second measure, we make use of the ratio dividend-to-total

assets (∆Dividend-to-TA), where the denominator is replaced by total assets in year T-1. We

have to take into account that these variables are not exact measures and may be easily

manipulated by accounting tricks (La Porta et al., 1999).

1 The data concerning the simulated MTRs was received from a PhD student at the Faculty of Economics and

Business Administration of Ghent University

15

Independent variables

Age is the natural logarithm of the number of years since the company was founded.

This is the only variable computed as a level value2, since taking the difference would result

in adding a constant term to the equation. We use ∆Size, measured as the change in the

natural logarithm of total assets in 2007 and 2005. ∆Profitability is calculated as the

difference in the ratio of earnings before interest and taxes in year T-1 to total assets of year

T-1, for 2007 and 2005. We use ∆Sales Growth as a proxy for growth opportunities

calculated by the natural logarithm of the ratio of sales at the beginning of the year, T-1, to

sales of the previous year, T-2. As a proxy for the change in leverage, we calculate the

change in short-term (∆LeverageST) as well as the change long-term debt to total assets

(∆LeverageLT), both at the beginning of the year. To make a distinction between healthy and

failing firms (∆Z’-Score), we make use of the revised Z’-Score model of Altman (Altman,

2000). This discriminant function looks as follows:

Z’ = 0.717X1 + 0.847X2 + 3.107X3 + 0.420X4 + 0.998X5

With X1: working capitalt / total assetst

X2: retained earningst / total assetst

X3: EBITt / total assetst

X4: Book value of equityt / book value of total liabilitiest

X5: Salest / total assetst

Our last independent variable is the change in marginal tax rate (∆MTR). These figures

were calculated using a forecasting model based on Graham (2001).

VIII. Results

Descriptive Statistics

Descriptive statistics on the variables used in the regression models are presented in

panel A of Table 5. The average change in dividend-to-cash flow for the sample companies

was -0,0447. The mean change in dividend-to-total assets was 0,0031. Moreover, we notice

a small increase in the average change in profitability of the firms. A decrease in both the

change in short-term leverage and the change in long-term leverage is also observed. Finally,

the average change in MTR has gone down with 0,2420. Consistent with the illustrative

2 As the relevant time frame of our study is 2007, age is calculated as follows: Ln (2007 - year of incorporation)

16

example in section V, this decrease is linked to the introduction of the notional interest

deduction. For both dividend measures, three outliers were removed from the sample.

Table 5

Panel A: Descriptive Statistics (in € 1.000)

Minimum Maximum Std. Dev. Variance

∆Dividend-to-CF -5,3518 3,6765 0,8178 0,6690

∆Dividend-to-TA -0,5461 1,3931 0,1317 0,0170

Age 1,7900 4,6600 0,6611 0,4370

∆Size -1,3200 2,0700 0,3530 0,1250

∆Profitability -0,6600 0,6400 0,1265 0,0160

∆Sales Growth -6,0734 2,7699 0,6246 0,3900

∆LeverageST -0,6963 0,6615 0,1589 0,0250

∆LeverageLT -0,7000 0,6600 0,1589 0,0250

∆Z'-Score -9,2900 5,4300 1,0390 1,0800

∆MTR -0,3432 0,0283 0,0984 0,0100

Panel B: Sample Industry Distribution

NACE-BEL #

33 Industry 55

43 Construction 24

47 Retail 151

53 Transportation 37

56 Hotel 3

61 Communication 5

82 Real Estate 114

96 Community 6

∑ 395

Mean

-0,0447

0,0031

-0,0131

0,0133

-0,2420

3,0126

0,1300

0,0005

-0,0480

-0,0131

Panel B of Table 5 reports the industry distribution within our sample, classified by

NACE-BEL code. The companies are grouped into eight different industries: industry,

construction, retail, transportation, hotel, communication, real estate and community. We

have to note, however, that the majority of the companies in our sample are in the retail or

real estate industry. This limits the external validity of the results towards Belgian SMEs.

The Pearson correlation coefficients of the dependent and independent variables are

presented in Panel A of Table 6. ∆Dividend-to-CF is positively correlated with ∆Dividend-to-

TA, which can be expected as both serve as measures for dividend policy. The change in size

is also significantly correlated with the change in dividend-to-cash flow. Here, however, a

negative correlation is observed. Both dependent variables are significantly negatively

correlated with the change in short-term leverage. The correlations between the

independent variables pose no problems for our regressions, as the tolerance levels for our

independent variables are close to one (Panel B Table 6).

17

Ta

ble

6:

Co

llin

ea

rity

Sta

tist

ics

Pa

ne

l A

: C

orr

ela

tio

n M

atr

ix

∆D

ivid

en

d-t

o-C

F∆

Div

ide

nd

-to

-TA

Ag

e∆

Siz

e∆

Pro

fita

bili

ty∆

Sale

s G

row

th∆

Lev

era

ge

ST∆

Leve

rage

LT∆

Z'-

Sco

re∆

MT

R

∆D

ivid

en

d-t

o-C

F1

0,4

93

**

0,0

00

-0,1

06

*-0

,01

90

,10

0-0

,13

9*

*-0

,02

70

,06

90

,07

0

∆D

ivid

en

d-t

o-T

A1

-0,0

27

0,0

36

-0,0

62

0,0

12

-0,2

09

**

-0,0

73

0,0

73

0,0

49

Ag

e1

-0,0

38

0,0

24

0,0

43

0,0

51

-0,0

07

0,0

23

0,1

57

**

∆S

ize

10

,02

20

,04

40

,14

6*

*-0

,01

3-0

,15

0*

*-0

,08

3

∆P

rofi

tab

ilit

y1

0,2

11

**

-0,0

23

-0,0

21

0,2

59

**

0,2

21

**

∆S

ale

s G

row

th1

0,0

90

-0,0

03

0,0

78

0,2

02

**

∆Le

vera

ge

ST1

-0,2

97

**

0,0

77

-0,0

41

∆Le

vera

ge

LT1

-0,0

47

-0,0

77

∆Z

'-S

core

10

,02

4

∆M

TR

1

(*)

corr

ela

tio

n is

sig

nif

ica

nt

at

the

0,0

5 le

ve

l (2

-ta

ile

d)

(**

) co

rre

lati

on

is s

ign

ific

an

t a

t th

e 0

,01

leve

l (2

-ta

iled

)

Pa

ne

l B

: T

ole

ran

ce L

ev

els

To

lera

nce

VIF

To

lera

nce

VIF

Ag

e0

,96

01

,04

20

,95

91

,04

2

∆S

ize

0,9

20

1,0

88

0,9

46

1,0

57

∆P

rofi

tab

ilit

y0

,89

41

,11

90

,87

31

,14

6

∆S

ale

s G

row

th0

,91

61

,09

20

,91

81

,08

9

∆Le

vera

ge

ST0

,89

21

,12

10

,89

21

,12

1

∆Le

vera

ge

LT0

,91

01

,09

90

,91

11

,09

7

∆Z

'-S

core

0,9

00

1,1

11

0,9

07

1,1

03

∆M

TR

0,8

97

1,1

15

0,9

01

1,1

10

∆D

ivid

en

d-t

o-C

F∆

Div

ide

nd

-to

-TA

18

Regression Results

Results from the dividend regressions appear in Table 7 and 8. We run two models to

illustrate the effect of the change in marginal tax rate most clearly. Model 1 regresses the

dividend measure on the seven independent variables included in the main regression

model. Model 2 regresses the dividend measure on the seven independent variables and on

our test-variable, change in marginal tax rate. In both models a constant is included.

Table 7 reports the results using dividend-to-cash flow as a dividend measure. Both

models report significant F-statistics, which indicates that the coefficients have significant

meaning and can be interpreted accordingly. We find that our proxies for maturity, age

(0,037) and the change in size (0,326), positively relate to the dividend measure. This is

consistent with the hypothesis that mature companies are more likely to pay out a dividend

(DeAngelo et al., 2006, Fama & French, 2001). The age coefficient, however, is not

significant. Subsequently, the change in profitability (-0,067) is significant at a five percent

level. The direction of the relationship is, however, not what we had hypothesized. The

proxy for growth opportunities, the change in sales growth (-0,026), relates negatively to the

dividend-to-cash flow proxy. This result corresponds with the expected relationship. Firms

with growth opportunities retain their earning and do not disperse a dividend (Megginson &

von Eije, 2006, Fama & French, 2001). The coefficient, though, is not significant. The change

in short-term debt (-1,182) has a significant negative impact on the change of dividend-to-

cash flow. Unexpectedly, we find the same significant result for the change in long-term debt

(-1,553). Moreover, the coefficient has a higher impact. If the financial condition of a

company improves, a positive change in dividend policy might be expected. A significant

positive result for the change in Z’-score (0,255) confirms this expectation, at one percent

significance level.

19

Table 7: Regression Analysis

Coeff. t Sig. Coeff. t Sig.

Constant -0,240 -1,215 0,225 -0,260 -0,107 0,915

Age 0,037 0,594 0,553 0,020 0,318 0,751

∆Size 0,326 2,566 0,011 (**) 0,344 2,702 0,007 (*)

∆Profitability -0,986 -2,838 0,005 (*) -1,074 -3,055 0,002 (*)

∆Sales Growth -0,026 -0,362 0,718 -0,430 -0,584 0,560

∆LeverageST -1,182 -4,220 0,000 (*) -1,162 -4,155 0,000 (*)

∆LeverageLT -1,553 -2,715 0,007 (*) -1,484 -2,590 0,010 (**)

∆Z'-Score 0,255 5,991 0,000 (*) 0,259 6,096 0,000 (*)

∆MTR 0,676 1,514 0,131

R Square 0,143 0,149

Adjusted R Square 0,126 0,129

Model F-test 8,227 7,512

Number of observations 353 353

(*) is significant at 1% level, (**) is significant at 5% level

∆Dividend-to-CF = β1Age + β2∆Size + β3∆Profitability + β4∆SalesGrowth + β5∆LeverageST + β6∆LeverageLT

+ β7∆Z'-Score + β8∆MTR + ε

Model 1 Model 2

For the seven variables of the first model, similar conclusions can be drawn in the

second model. The same variables are significant and identical relationships can be

observed. The only noticeable difference is that some significance levels vary. Concerning

the MTR-variable we find that it has a positive influence (0,676) on the dividend policy of

Belgian SMEs. As hypothesized earlier, the application of the NID leads to a positive relation

between ∆MTR and ∆Dividend-to-CF. The coefficient, however, is not significant at the 5%-

level, nor at the 10%-level. Nevertheless, if tested one-tailed, a marginal significant relation

can be found at the 10%-level.

We compare the adjusted R² from the two models to determine whether the

addition of the MTR-variable increases the explanatory power of the model. At first glance,

the adding of the MTR-variable increases the adjusted R² with 0,003. This increase, however,

may not be fully attributed to the MTR-variable, as this variable is not significant in the

regression.

Table 8 presents the results for the dividend-to-total assets measure. Both reported

models are significant. The results for model 1 and 2 are generally in line with the reported

results obtained in Table 7. In contrast, Table 8 reports a slight negative relationship for the

age coefficient (-0,002), although again not significant. Profitability reports only a small

20

negative relationship (-0,067) and is no longer significant. The results for size, sales growth,

both short- and long-term leverage and Z’-score are more or less identical to those of

Table 7. Relating to the MTR-variable, model 2 reports similar results as in Table 7. Although

the coefficient is still positive (0,106), it is smaller and less significant. The adding of the

MTR-variable to the regression model reports an increase of the adjusted R² with 0,003 here

as well.

Table 8: Regression Analysis

Coeff. t Sig. Coeff. t Sig.

Constant -0,004 -0,116 0,908 0,030 0,767 0,444

Age -0,002 -0,218 0,827 -0,005 -0,478 0,633

∆Size 0,062 3,121 0,002 (*) 0,064 3,223 0,001 (*)

∆Profitability -0,067 -1,189 0,235 -0,081 -1,414 0,158

∆Sales Growth -0,003 -0,258 0,796 -0,005 -0,460 0,646

∆LeverageST -0,228 -4,961 0,000 (*) -0,225 -4,899 0,000 (*)

∆LeverageLT -0,262 -2,780 0,006 (*) -0,251 -2,662 0,008 (*)

∆Z'-Score 0,020 2,922 0,004 (*) 0,020 3,001 0,003 (*)

∆MTR 0,106 1,451 0,148

R Square 0,098 0,103

Adjusted R Square 0,080 0,083

Model F-test 5,576 5,158

Number of observations 369 369

(*) is significant at 1% level, (**) is significant at 5% level

Model 1 Model 2

∆Dividend-to-TA= β1Age + β2∆Size + β3∆Profitability + β4∆SalesGrowth + β5∆LeverageST + β6∆LeverageLT

+ β7∆Z'-Score + β8∆MTR + ε

A possible explanation for the marginal significant relationship of the MTR-variable

can be found in the work of Lintner (1956). Lintner states that companies try to pursue a

stable dividend policy and as the NID has only been in effect for three years, this study might

have been conducted prematurely. Moreover, managers want to avoid that dividend

changes have to be reversed in the future. As a consequence, dividends follow shifts in long-

run, sustainable levels of earnings. The NID increases the earnings as it serves as a tax shield.

Companies, however, need time to assess whether this increase can be regarded as

persistent. A second limitation of this study is the composition of our sample. Two industry

classifications account for a large part of the sample. This given distorts the external validity

of the results towards Belgian SMEs.

21

IX. Conclusion

In this paper we have studied the impact of the NID on the dividend policy of

Belgian privately held SMEs. Our results suggest that there is a positive change in the

dividend policy when companies are larger and healthier. A negative change in dividend

policy can be observed when the companies are more leveraged. Also for profitability we

find a negative relationship. This, however, is an adverse result. Regarding the introduction

of the NID, we expected that the decline in MTR would be followed by a negative change in

dividend policy. The results confirm this positive relationship, although only marginally

significant. This can partially be explained by the work of Lintner (1956), which states that

managers want to avoid that dividend changes have to be reversed in the future. As a

consequence, dividends follow shifts in long-run, sustainable levels of earnings. The NID

increases the earnings as it serves as a tax shield. Companies, however, need time to assess

whether this increase can be regarded as persistent. This assessment is complicated as the

European Commission recently challenged certain restrictions of the NID regime. According

to the European Commission the NID regime is in violation of the freedom of establishment

and the freedom of capital. The Commission states that Belgian companies may be

dissuaded from setting up a branch or investing in real estate in a foreign country as the NID

do not apply for investments outside Belgium. As the NID has only been in effect since 2006,

we suggest conducting a similar study in the near future.

V

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