European Commission proposes a Directive for debt-equity bias reduction allowance
The European Commission has issued a proposal for a Directive which aims to create a level playing field for debt and equity from a tax perspective.
The European Commission has issued a proposal for a Directive which aims to create a level
On 11 May 2022 the European Commission (the Commission) issued a proposal for a new debt-equity bias reduction allowance (DEBRA) Directive (the Directive) that, subject to certain conditions, would provide for a tax deduction in respect of increases in equity in a given tax year. In general, tax systems in the EU allow for the deduction of interest payments on debt when calculating corporate income tax, while costs related to equity financing, such as dividends, are mostly non-tax deductible. The Commission has noted that this unequal tax treatment of financing costs creates a bias in investment decisions towards debt financing, hampering efficient capital market financing. The Commission’s view is that equity investment should be encouraged because companies with a strong capital base are perceived as less vulnerable to shocks.
The Directive would apply to all undertakings that are subject to corporate income tax in an EU Member State, including EU permanent establishments of non-EU entities. An exclusion would apply for certain financial undertakings, such as alternative investment funds or credit institutions, to account for their special features which require a specific tax treatment.
The Commission decided to mitigate the debt-equity bias through measures in the Directive addressing both equity and debt (as opposed to debt or equity in isolation), combining an allowance for new equity with a limitation on the deductibility of debt costs.
The Directive provides for an allowance on equity, calculated by multiplying the allowance base (i.e. the increase in net equity in one year) with a notional interest rate which would be calculated based on the 10-year risk-free interest rate for the relevant currency, increased by a specified risk premium.
The deduction of the allowance would be limited to 30 percent of the taxpayer’s earnings before interest, tax, depreciation and amortisation (EBITDA), and would be available for 10 years (which is seen by the Commission as being approximately the typical maturity of debt). Unused allowances can be carried forward in certain situations.
Further qualifying increases in equity would trigger a new allowance also deductible in the year incurred and the following nine years. A decrease in equity in a tax year where the taxpayer has been subject to an allowance would result in some clawback (again over ten years) unless the taxpayer can show the decrease relates exclusively to losses incurred or to a legal obligation.
The Directive provides for specific anti-abuse measures to target arrangements put in place to artificially benefit from the allowance on equity.
In order to further level up the asymmetry between debt and equity, the Directive would also introduce a new restriction of 15 percent on the deductibility of excess borrowing costs (i.e. interest paid minus interest received).
The Commission proposes that Member States should transpose the rules into domestic law by 31 December 2023 and the provisions of the Directive should apply as of 1 January 2024. The Directive would also provide for transitional rules in respect of those Member States which currently already apply a tax allowance on equity funding under national law.
The successful adoption of the Directive will depend on a number of factors. Firstly, Member State views on the impact of DEBRA on their economies and national budgets. Secondly, it remains to be seen whether the six Member States that already provide for an allowance on equity funding in national law (Belgium, Cyprus, Italy, Malta, Poland and Portugal) would agree to the proposal and to changing their current tax rules, which differ significantly in terms of policy design.
For a more in-depth analysis please refer to our Euro Tax Flash from KPMG's EU Tax Centre.