Meet DEBRA – an EU Tax Initiative
Most countries, including in the European Union, give debt a more favourable tax treatment than equity. They allow interest payments to be deducted from the company’s taxable income, but they do not offer the same treatment to equity.
This is the ‘debt-to-equity bias’ that gives companies a major incentive to borrow, rather than to fund new investments by increasing their share capital. Only six EU Member States tackle the bias : Belgium, Cyprus, Italy, Poland, Portugal and Malta. Belgium pioneered with the notional interest deduction but this has been seriously scaled back.
The European Commission wants to tackle the ‘debt-to-equity bias’ with a proposal of the DEBRA Directive published on 11 May 2022. This proposal is part of the EU strategy on Business Taxation for 21st Century, adopted by the European Commission on 18 May 2021 and aims at ensuring fair taxation and an efficient tax system across the EU.
DEBRA is expected to trigger a positive economic impact notably by promoting a healthier economic environment with higher equity ratios which reduces insolvency/bankruptcy risks, eliminating differences of treatment between EU Member States of rules on notional allowance for equity and providing uniform and effective measures against aggressive tax planning in the EU.
The proposed Directive introduces two separate measures that are applicable independently: (1.) the debt-to-equity bias reduction allowance (DEBRA) which is a tax-deductible notional interest to be computed on equity increases and (2.) a new provision limiting the tax deductibility of so-called “exceeding borrowing costs”.
The Directive will apply to taxpayers that are subject to corporate income tax in one or more Member State and permanent establishments in one or more Member States of entities resident in a third country for tax purposes. Certain financial undertakings identified and listed in the Directive are specifically excluded (e.g., alternative investment funds, insurance and reinsurance companies, etc…).
1. Allowance on equity
The allowance on equity is a deductible allowance on equity which is equal to an allowance base multiplied by a notional interest rate (NIR).
The allowance base is the difference between the net equity at the beginning and at the end of the tax year. “Equity” is 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 notional interest rate (NIR) is the sum of a risk-free interest rate with a maturity of ten years and a risk premium of 1% (1.5% for small and middle-sized enterprises) as they generally incur a higher risk premium).
The allowance on equity is deductible from the taxable base of the taxpayer for ten consecutive tax years and shall be limited to 30% of the taxpayer’s EBITDA (earnings before interest, tax, depreciation and amortization). The taxpayer will be able to carry forward the excess allowance on equity to the following tax years indefinitely.
Additionally, 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 the company reduces its equity after having obtained an allowance on equity, a proportionate amount will become taxable for ten uninterrupted years and up to the total increase of net equity for which the allowance has been claimed. However, the taxpayer can avoid this if he demonstrates that the decrease was generated by losses incurred in the tax 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 (like the interest limitation rules introduced under the anti-tax avoidance directive 2016/1164 (ATAD I) adopted in 2016).
The proposal introduces some anti-abuse measures, where an equity increase is the result of certain transactions (e.g. an equity increase funded by a loan from an associated enterprise) 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 only be tax deductible 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 deductible amount under ATAD I will be carried forward or back in accordance with article 4 of ATAD I.
If the proposal is adopted by all 27 Member States, they will be required to implement the Directive by 31 December 2023 so as to enter into force on 1 January 2024. Member States that already have an allowance on equity (Belgium, Cyprus, Italy, Poland, Portugal and Malta) will be able to defer up to ten years.