On May 11, 2022, as part of the EU’s corporate tax strategy, the European Commission published a proposal for a directive providing for a debt bias reduction deduction DEBRA guideline). The proposed measure aims to help businesses access the financing they need, help them grow and become more resilient, while at the same time encouraging businesses to finance their investments with equity rather than debt.
The pro-debt bias
Currently, most national tax systems within the EU allow companies to deduct interest payments on debt when calculating the tax base for corporation tax purposes. The same treatment does not apply to costs related to equity financing, such as dividends, which are generally not tax deductible. The pro-debt bias of these rules encourages companies to go into debt, instead of increasing equity, in order to finance growth.
The problem with excessive debt levels is that they can threaten the stability of the EU financial system, making companies more vulnerable to unforeseen fluctuations in the economic environment, leading to an increased risk of bankruptcies and, consequently, of unemployment. According to the European Commission, “the total indebtedness of non-financial corporations in the EU amounted to nearly €14.9 billion in 2020, or 111% of GDP“.
What does the new DEBRA directive offer?
In order to counter these concerns and mitigate the pro-debt bias, the European Commission originally presented proposals for the new DEBRA directive last year, in May 2021, and solicited public comments on these proposals, which which then led to the development of the draft directive. published.
The new regime aims to incentivize companies to use increased equity to finance growth, instead of going into debt. The proposed directive aims to achieve this by introducing a form of allowance for new equity-financed investments, so that they receive the same tax treatment as is currently available for debt financing. According to the proposals, once implemented, the DEBRA directive would apply to all companies subject to corporation tax in an EU member state. However, a number of exclusions have been proposed which would apply, for example, to credit institutions, insurance companies, investment companies and certain securitization entities. Unless an exclusion applies, and subject to specific conditions being met, the DEBRA directive would mean that increases in a taxpayer’s equity in a given tax year would be deductible from its base. of taxation.
As written, the DEBRA Directive would incorporate strong and specific anti-avoidance measures to ensure tax fairness, targeting schemes put in place to benefit from the new equity deduction, rather than be motivated by bona fide business justifications.
Interest deduction limitation
Unfortunately, the welcome capital allowance initiative comes with a new limitation on interest deductibility that would also be implemented by the DEBRA directive, which, if introduced in its proposed form, would be enforced in conjunction with the interest limitation rules introduced by the 2021 finance law, effective for accounting periods beginning on 1 January 2022.
This aspect is not welcome given the recent introduction of ATAD’s interest limitation rules, but it is believed that it will in some way “pay” for the additional cost to national treasuries of the abatement for equity.
The additional interest restriction would have the effect of discouraging excessive leverage while taking into account the new notional interest deduction from equity.
A 15 per cent restriction on the deductibility of excess borrowing costs (ie interest paid less interest received) would be introduced. This interest limitation rule would interact with the existing ATAD interest limitation rule such that the deductibility of excess borrowing costs would be calculated under DEBRA and then under the ATAD interest limitation rules. The taxpayer would only be entitled to deduct the lower of the two amounts in a taxation year. If the application of the ATAD rule results in a lower deductible amount, the taxpayer will have the right to carry forward or reverse the difference in accordance with Article 4 of the ATAD.
Implementation schedule?
A consultation period is currently underway and will remain open until July 12, 2022.
Subsequently, the European Commission proposed that the DEBRA Directive be transposed into the national laws of the Member States by 31 December 2021, with the provisions applying from 1 January 2024. However, a deferral period has also proposed for Member States which already apply a tax allowance on equity financing under national law. This includes Belgium, Cyprus, Italy, Malta, Poland and Portugal.
The legal basis for the draft directive is Article 115 of the Treaty on the Functioning of the European Union and therefore the unanimous approval of the European Council will be required before its implementation. It is expected that the proposed directive will undergo some modifications following negotiations between each of the 27 EU member states, in particular by those who already apply some form of tax relief on equity financing. The final form of the DEBRA Directive and the confirmed implementation timelines will of course depend on the outcome of these negotiations.
Practical considerations for businesses?
Companies falling within the scope of the proposed DEBRA directive should consider the potential impact of the proposed directive and keep an eye on the progress of the negotiations and the adoption process.
The full text of the draft DEBRA directive is available here.
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