Possible end of the debt-equity bias in the EU: brief overview of the DEBRA proposal

November 2022  |  SPECIAL REPORT: CORPORATE TAX

Financier Worldwide Magazine

November 2022 Issue

On 11 May 2022, the European Commission (EC) published a proposal for a directive laying down rules on an allowance for corporate equity and limitations to interest deductions, known as the ‘debt-equity bias reduction allowance’ (DEBRA) proposal.

The current asymmetry in the tax treatment of financing investments, depending on whether they are financed with equity or debt, has led the EC to develop the DEBRA proposal, which aims to reduce the current bias in favour of debt over equity, as interest payments are tax deductible while costs related to equity financing, such as dividends, are mostly non-deductible for tax purposes.

With a view to addressing the tax-induced debt-equity bias across the single market in a coordinated way, the proposal lays down rules to provide, under certain conditions, for the deductibility for tax purposes of notional interest on increases in equity and to limit the tax deductibility of exceeding borrowing costs.

As outlined in the explanatory memorandum accompanying the proposal, “by removing the tax-induced debt-equity bias, the proposal is aimed at avoiding over-reliance on debt and encouraging the reequitisation of businesses. As a result, it is expected that companies are in a better position to invest for the future, which will support growth and innovation and support the competitiveness of the European Union (EU) economy. This will also increase their resilience to unforeseen changes in the business environment and decrease the risk of insolvency, thus contributing to enhancing financial stability”.

The DEBRA proposal applies to all taxpayers that are subject to corporate income tax in one or more EU member states (including permanent establishments in one or more EU member states of entities resident for tax purposes in a third country), with the exception of financial undertakings, such as credit institutions, investment firms, alternative investment funds or insurance undertakings, among others.

According to the explanatory memorandum, financial undertakings are not in the scope of the measures contained in the proposal because some financial undertakings are subject to regulatory equity requirements that prevent underequitisation. In addition, many are unlikely to be affected by the countervailing interest limitation deduction applicable to exceeding borrowing costs. Therefore, should financial undertakings be included in the scope, the economic burden of the measures would be unequally distributed at the expense of non-financial undertakings.

The DEBRA proposal includes two separate measures that apply independently: an allowance on equity and a limitation on interest deduction.

Allowance on equity

An allowance on equity will be deductible, for 10 consecutive tax periods, from the taxable base of taxpayers for corporate income tax purposes up to 30 percent of the taxpayer’s earnings before interest, tax, depreciation and amortisation (EBITDA).

The reason the allowance is granted for 10 years is to approximate the maturity of most of the debt. The allowance on equity will be calculated by multiplying the allowance base by the relevant notional interest rate.

The allowance base. The allowance base will be calculated as the difference between the level of net equity at the end of the tax period and the level of net equity at the end of the previous tax period.

‘Equity’ is defined by reference to Directive 2013/34/EU (Accounting Directive), meaning the sum of paid-up capital, share premium account, revaluation reserve and reserves and profits or losses carried forward. ‘Net equity’ is then defined as the difference between the equity of a taxpayer and the sum of the tax value of its participation in the capital of associated enterprises (as defined in the proposal) and of its own shares. As clarified in the explanatory memorandum, this definition is meant to prevent cascading the allowance through participations.

The relevant notional interest rate. The relevant notional interest rate is based on two components: the risk-free interest rate and a risk premium. The risk-free interest rate is the risk-free interest rate with a maturity of 10 years, for the currency of the taxpayer. The risk-free interest rate is increased by a risk premium, which is set at 1 percent, to better account for the risk premium that investors actually pay and to better mitigate the bias (the EC is likely to be delegated responsibility for modifying the risk premium rate when certain conditions are met).

A  higher notional interest may be granted to small and medium-sized enterprises (SMEs) – as defined in EU legislation – because they usually face a higher burden when trying to obtain financing. For this reason, the risk premium is set at 1.5 percent for taxpayers qualifying as SMEs.

Questions arising in the application of the allowance on equity. The DEBRA proposal provides answers to a number of questions that may arise in the practical application of this allowance, such as what happens if it is not possible to deduct all the deductible equity allowance due to insufficient taxable income or if the amount of the equity allowance does not reach the maximum limit of 30 percent of EBITDA.

To prevent tax abuse, the deductibility of the allowance is limited to a maximum of 30 percent of the taxpayer’s EBITDA for each tax year, but it may be that a taxpayer cannot deduct all the allowance that is deductible because of insufficient taxable income.

In such cases, the proposal provides that the taxpayer will be able to carry forward, without time limitation, the part of the allowance on equity that could not be deducted in a tax year for the abovementioned reason.

In addition, the proposal states that the taxpayer will be able to carry forward, for a maximum period of five years, unused allowance capacity, where the allowance on equity does not reach the aforementioned maximum amount.

Another question that arises concerns a taxpayer that has already benefitted from an allowance on equity increase under the rules of the directive and that, in a given tax period, has an equity decrease and thus a negative allowance base. The proposal provides that an amount equal to the negative allowance on equity will become taxable for 10 consecutive tax periods.

Anti-abuse measures. The DEBRA proposal also lays down a number of measures to ensure that the rules on the deductibility of an allowance on equity are not used for unintended purposes.

One measure would exclude from the base of the allowance equity increases that originate from intragroup loans, intragroup transfers of participations or existing business activities and cash contributions under certain conditions.

Another measure sets out specific conditions for taking into account equity increases originating from contributions in kind or investments in assets. It aims to prevent the overvaluation of assets or purchase of luxury goods for the purpose of increasing the base of the allowance.

A third measure targets the recategorisation of old capital as new capital, which would qualify as an equity increase for the purpose of the allowance. Such recategorisation could be achieved through liquidation and the creation of start-ups.

EU countries with current national equity allowances. Six EU member states currently provide for equity allowances under their national legislation (Belgium, Cyprus, Italy, Malta, Poland and Portugal). It is noteworthy that domestic regulation of equity allowances in these countries differs considerably both in scope of application and in calculation of the allowance base.

Thus, for example, in Belgium, only SMEs may actually benefit from equity allowances in the 2022 tax year, whereas in other countries such allowances are applicable to all companies regardless of size. As to differences in calculating the allowance base, it is worth mentioning that Portugal takes into account both the initial capital contributions that take place at the time of incorporation and subsequent capital increases, whereas other countries only take into account capital increases.

As mentioned in the explanatory memorandum, “the complete lack of relevant tax debt bias mitigating measures in 21 member states along with the existence of significantly different measures in another six member states may create distortions to the function of the internal market and can affect the location of investment in a significant manner”. Establishing a harmonised equity allowance appears to be a sound solution, but the reaction of the six member states that already have notional deductions in their domestic legislation remains to be seen.

Limitation to interest deduction

The second measure contained in the proposal affects the deductibility of interest by limiting the amount of interest that can actually be deducted. According to the proposal, taxpayers will be able to deduct from their taxable base for income tax purposes exceeding borrowing costs (which, for the avoidance of doubt, do not include notional interest on increases in equity) up to 85 percent of such costs incurred during the tax period.

Interaction between the DEBRA proposal and the Anti-Tax Avoidance Directive (ATAD). Given that interest limitation rules already apply in the EU under article 4 of the ATAD, the DEBRA proposal clarifies that the taxpayer will apply the rule contained in the proposal as a first step and then calculate the limitation applicable in accordance with article 4 of the ATAD. If the result of applying the ATAD rule is a lower deductible amount, the taxpayer will be entitled to carry forward or back the difference in accordance with article 4 of the ATAD.

Next steps

The DEBRA proposal, once unanimously adopted as a directive, should be transposed into member states’ national law by 31 December 2023 and come into effect on 1 January 2024. It remains to be seen, however, the extent to which the proposal will be unanimously backed, and from when it would be applied in member states.

The six member states that have rules in place for an allowance on equity increases may defer application of this directive to taxpayers that on 1 January 2024 benefit from an allowance on equity under domestic law for a period of up to 10 years and in no case for a period longer than the duration of the benefit under national law. Conversely, the rules of the directive will apply from their date of application to all other taxpayers in all member states.

Final remarks

This a new attempt by the EC to eliminate the debt-equity bias and to further harmonise corporate tax bases step by step (in fact, the development of a notional interest deduction for equity financing was already foreseen in the proposal for a Common Corporate Tax Base (CCTB) Directive, which, after six years, has not yet been approved). Given this precedent and the differing views among member states, it remains to be seen whether and when the DEBRA proposal will be adopted.

 

Eduardo Gracia is practice group head of tax and Lorena Viñas is a senior expertise lawyer at Ashurst. Mr Gracia can be contacted on +34 (91) 364 9854 or by email: eduardo.gracia​@ashurst.com. Ms Viñas can be contacted on +34 (91) 364 9417 or by email: lorena.vinas​@ashurst.com.

© Financier Worldwide

BY

Eduardo Gracia and Lorena Viñas

Ashurst

©2001-2024 Financier Worldwide Ltd. All rights reserved. Any statements expressed on this website are understood to be general opinions and should not be relied upon as legal, financial or any other form of professional advice. Opinions expressed do not necessarily represent the views of the authors’ current or previous employers, or clients. The publisher, authors and authors' firms are not responsible for any loss third parties may suffer in connection with information or materials presented on this website, or use of any such information or materials by any third parties.