European Commission's proposals on the DEBRA Directive – introducing a tax deduction for equity funding
European Commission’s proposals on the DEBRA Directive – introducing a tax deduction for equity funding
On 11 May 2022, as part of the EU's strategy on business taxation, the European Commission released a proposal for a directive providing for a debt-equity bias reduction allowance (the DEBRA Directive). The proposed measure is intended to help businesses to access financing they need, help them grow and become more resilient, while simultaneously encouraging businesses to finance investment with equity, rather than debt-financing.
The pro-debt bias
Currently, most domestic tax systems within the EU allow businesses to deduct interest payments on debt when calculating the tax base for corporate income tax purposes. The same treatment does not apply to the costs related to equity financing, such as dividends, which are usually non-tax deductible. The pro-debt bias of these rules incentivises companies to take on debt, instead of increasing equity, in order to finance growth.
The concern with excessive debt levels, is that it can threaten the stability of the EU's financial system, making businesses more vulnerable to unanticipated fluctuations in the economic environment, leading to increased risk of bankruptcies and consequentially, unemployment. According to the European Commission, "the total indebtedness of non-financial corporations in the EU amounted to almost €14.9tr in 2020 or 111% of GDP".
What is proposed under the new DEBRA Directive?
In order to counter such concerns and mitigate the pro-debt bias, the European Commission initially put forward proposals for the new DEBRA Directive last year, in May 2021, and sought public feedback on such proposals, which has subsequently led to the draft directive being released.
The new scheme aims to incentivise businesses to use increased equity in order to finance growth, as an alternative to taking on debt. The proposed directive looks to achieve this by introducing a form of allowance in respect of equity-financed new investment, so that it receives the same tax treatment currently available for debt financing. Under the proposals, once implemented, the DEBRA Directive would apply to all undertakings that are subject to corporation tax in an EU Member State. A number of exclusions have however been proposed which would apply to, for example, credit institutions, insurance undertakings, investment firms and certain securitisation entities. Unless an exclusion applies, and provided specific conditions are met, the DEBRA Directive would mean that increases in a taxpayer's equity in a given tax year would be deductible from its tax base.
As drafted, the DEBRA Directive would incorporate robust and specific anti-tax avoidance measures to ensure tax fairness, targeting arrangements that are put in place for the purpose of availing of the new equity allowance, rather than being motivated by bona fide commercial justifications.
Limitation on interest deduction
Unfortunately the welcome equity allowance initiative is accompanied by a new limitation on interest deductibility that would also be implemented by the DEBRA Directive, which, if introduced in its proposed form, would be applied in conjunction with the interest limitation rules introduced by the Finance Act 2021, effective for accounting periods commencing from 1 January 2022.
This is an unwelcome aspect given the recent introduction of the ATAD interest limitation rules, but it is thought it will in some way "pay" for the additional cost to national exchequers of the equity allowance.
The additional interest restriction would act to discourage excessive debt while at the same time taking account of the new notional interest deductibility allowance on equity.
A restriction of 15 per cent on the deductibility of exceeding borrowing costs (i.e. 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 exceeding borrowing costs would be calculated under the DEBRA Directive and then under the ATAD interest limitation rules. The taxpayer would only be entitled to deduct the lower the two amounts in a tax year. If applying the ATAD rule results in a lower deductible amount the taxpayer will be entitled to carry forward or back the difference in line with Article 4 of ATAD.
Timing for implementation?
A consultation period is currently underway which will remain open until 12 July 2022.
Thereafter, the European Commission has proposed that the DEBRA Directive should be transposed into domestic laws of Member States by 31 December 2023, with the provisions applying from 1 January 2024. However, a deferment period has also been proposed for those Member States which already apply a tax allowance on equity funding under domestic law. This includes Belgium, Cyprus, Italy, Malta, Poland and Portugal.
The legal basis for the draft directive is Article 115 of the Treaty of the Functioning of the European Union and so unanimous approval of the European Council will be required prior to implementation. It is anticipated that the proposed directive will undergo some changes following negotiations between each of the 27 EU Member States, in particular from those which already apply a form of tax allowance on equity funding. The final form of the DEBRA Directive, and confirmed timeframes for implementation, will of course depend on the outcome of such negotiations.
Practical considerations for businesses?
Businesses falling within scope of the proposed DEBRA Directive should consider the potential impact of the draft directive and keep an eye out for developments with respect to negotiations and the adoption process.
Full text of the draft DEBRA Directive can be found here.