Within the EU a widespread asymmetry exists between debt and equity financing. Usually, interest is tax deductible from the corporate income tax base while dividends do not benefit from such advantage. This so-called ‘debt-to-equity bias’, is currently only addressed by six EU Member States.
In view of addressing this bias, the European Commission published, on 11 May 2022, a proposal for a directive laying down rules on a debt-to-equity bias reduction allowance and limiting the deductibility of interest for corporate income tax purposes (DEBRA Directive or Directive). The proposed Directive introduces two separate measures applicable independently and which include (i) a deductible notional interest to be computed on equity increases and (ii) a new provision limiting the tax deductibility of so-called “exceeding borrowing costs”.
This proposal is part of the EU strategy on business taxation for 21st century (as adopted by the European Commission on 18 May 2021) and aims at ensuring fair taxation and an efficient tax system across the EU. This Directive is expected to trigger a positive economic impact notably by (i) promoting a healthier economic environment with higher equity ratios which reduces insolvency/bankruptcy risks (ii) eliminating differences of treatment between EU Member States of rules on notional allowance for equity and (iii) providing uniform and effective measures against aggressive tax planning in the EU.
The main provisions of the proposed Directive can be summarized as follows.
Scope – The provisions of the Directive will apply to (i) taxpayers that are subject to corporate income tax in one or more Member State and (ii) permanent establishments in one or more Member States of entities resident in a third country for tax purposes.
Certain financial undertakings as identified and listed by the Directive (e.g., alternative investment funds within the meaning of the AIFMD, insurance and reinsurance undertakings, alternative investment fund etc.,) would be specifically excluded.
Measures - The Directive includes two main measures that apply separately:
1. Allowance on equity: the Directive provides for a deductible allowance on equity which is equal to an allowance base multiplied by a notional interest rate (NIR).
The allowance base corresponds to the difference between the net equity at the end of the tax year and the net equity at the end of the previous tax year. For the purposes of the Directive, the term “equity” would be defined as the sum of the taxpayer’s paid-up capital, share premium accounts, revaluation reserve and other reserves and profit or loss brought forward (in the same terms as in the EU Accounting Directive).
The NIR is the sum of two components: (i) a risk-free interest rate with a maturity of ten years and (ii) a risk premium of 1% (or 1.5% for taxpayers which qualify as small or medium sized enterprises (SME) which generally incur a higher risk premium).
Example – Company A has equity of 100 in year N and decides to increase it by 20 in year N+1. An allowance computed as follows will be deductible from taxable base every year for 10 years (N+10).
Allowance base in N+1= 120 – 100 = 20
Allowance = 20 x NIR (i.e., EUR risk-free rate + 1)
Allowance if Company A is a SME = 20 x NIR (i.e., EUR risk-free rate + 1,5)
The allowance on equity is deductible for 10 consecutive tax years from the taxable base of the taxpayer and shall be limited to 30% of the taxpayer’s earnings before interest, tax, depreciation and amortization (EBITDA). The taxpayer would have the possibility to carry forward, indefinitely, the excess allowance on equity to the following periods. In addition, the taxpayer would be able to carry forward the unused allowance (when such allowance does not reach the above 30% threshold) for a maximum of 5 years.
If after having obtained an allowance on equity, the allowance base of equity of the taxpayer is negative (i.e., there is an equity decrease), a proportionate amount would become taxable for 10 uninterrupted years and up to the total increase of net equity for which the allowance has been claimed. This, except if the taxpayer demonstrates that such decrease was generated by losses incurred in such fiscal year or the consequence of meeting a legal obligation.
The Directive also includes a limitation for the allowance up to 30% EBITDA with a carry forward mechanism (similar to the interest limitation rules introduced under the anti-tax avoidance directive 2016/1164 (ATAD I) adopted in 2016).
The proposal provides for some anti-abuse measures, where an equity increase which is the result of certain transactions (such an equity increase funded by a loan from an associated enterprises) shall not be taken into consideration for the computation of the allowance base unless the taxpayer provides evidence that the transaction has been for valid economic reasons and does not result in a double deduction of the allowance on equity.
In the context of a group’s reorganization an equity increase would only be considered to the extent that there is a real equity increase and not the conversion of the group’s pre-existing equity.
2. Interest deduction limitation: in view of increasing neutrality between the tax treatment of debt and equity, exceeding borrowing costs (i.e., difference between interest paid and received) would be tax deductible only up to 85%. Taxpayers would have to apply (the interest deduction limitation rules under the present Directive first before applying the interest deduction rule under Article 4 of ATAD I. The taxpayer would be allowed to deduct only the lower of the two amounts in the tax year. The difference between the deductible amount under the present Directive and the one under ATAD I will be carried forward or back in accordance with article 4 of ATAD I.
Implementation – If adopted, Member States will be required to implement the Directive by 31 December 2023 for an application as from 1 January 2024. A deferral up to 10 years will be possible for Member States applying already an allowance on equity under domestic law (Belgium, Cyprus, Italy, Poland, Portugal and Malta).