An analysis of the proposal by Leitner Leitner
On 11 May 2022, the European Commission published a Proposal for a Council Directive on laying down rules on a debt-equity bias reduction allowance and on limiting the deductibility of interest for corporate income tax purposes. According to the Proposal, taxpayers subject to corporate income tax in one or more Member States will, under certain conditions, be able to deduct a notional interest on increases in equity.
Our Austrian firm, Leitner Leitner, provides an analysis of the proposal. Read the full article below…
Overview and background
According to the existing tax regimes of most EU Member States, there is an unequal treatment between equity and debt financing: Whereas interest payments on debt usually are deductible when calculating the tax base for corporate income tax purposes, costs in connection with equity financing (e.g. dividends) are mostly non-tax deductible. This asymmetry is an incentive for companies to finance investments and growth with debt instead of equity.
To counteract the tax-induced debt-equity bias, the European Commission on 11 May 2022 published a Proposal for a Council Directive on laying down rules on a debt-equity bias reduction allowance (“DEBRA”) and on limiting the deductibility of interest for corporate income tax purposes. According to the Proposal, taxpayers subject to corporate income tax in one or more Member States will under certain conditions be able to deduct a notional interest on increases in equity. Thereby, the tax treatment of equity shall be approximated to that of debt financing which in turn shall improve companies’ equity position in order to foster their robustness against shocks. In parallel, however, the proposal also restricts the tax deductibility of interest in connection with debt.
DEBRA is part of the EU Commission’s package of measures published on 18 May 2021 to promote a fair and efficient business tax system across the EU and to support Europe’s recovery from the COVID-19 pandemic. According to the Proposal, the DEBRA Directive should be transposed into Member States’ national law by 31 December 2023 and come into effect as of 1 January 2024. Therefore, companies should deal with the potential tax implications already at an early stage.
Introduction of a notional equity interest deduction
The personal scope of the draft DEBRA Directive covers taxpayers which are subject to corporate income tax in one or more Member States, including EU permanent establishments of entities resident in third countries (Art. 2 draft DEBRA Directive). However, certain financial undertakings are excluded, as such undertakings are usually already subject to regulatory equity requirements that prevent under-equitisation.
The central measure to make equity financing more attractive is the deductibility of notional interest on increases in equity provided for in Art. 4 of the draft DEBRA Directive. The amount of this notional interest (allowance on equity) is calculated as the difference between the net equity at the end of the current tax period and the net equity at the end of the previous tax period (allowance base), multiplied by the notional interest rate (NIR).
Net equity corresponds to the sum of the taxpayer’s paid-up capital, share premium accounts, revaluation reserve, other reserves and profit or loss brought forward, less the sum of the tax value of the taxpayer’s participation in the capital of associated enterprises and the taxpayer’s own shares (Art. 3 para. 6 and para. 7 draft DEBRA Directive). The net equity thus determined shall be multiplied by the NIR. The NIR corresponds to the 10-year risk-free interest rate for the relevant currency, increased by a risk premium of 1% or, where the taxpayer is an SME, an increased risk premium of 1.5% (Art. 4 para. 2 draft DEBRA Directive).
The increased risk premium for SMEs is due to the difficulties they face when obtaining financing. The allowance on equity calculated in this way is deductible in the year it was incurred and in the next 9 years. This is illustrated by the following simple example:
|Basis of assessment (difference)||20|
|Allowance base||20 * NIR|
|Allowance available for 10 consecutive years||t, t+1, t+2, … t+9|
The allowance is granted for a total of 10 years to approximate the maturity of most loans, while keeping the overall budgetary cost under control. If in a further year (e.g. t+1) there is again a qualified increase in net equity, a new allowance for the year in question and the 9 following years will also be available (t+1, t+2, t+3 … t+10).
In order to avoid cases of abuse, the allowance is limited to a maximum of 30% of the taxpayer’s EBITDA. A taxpayer will be able to carry forward, without time limitation, the part of the allowance on equity that would not be deducted in a tax year due to insufficient taxable profit. In addition, the taxpayer will be able to carry forward, for a period of maximum five years, unused allowance capacity, where the allowance on equity does not reach the aforementioned maximum amount.
It should be noted, however, that the draft DEBRA Directive also provides for a taxable “negative allowance”: If, after having obtained an allowance on equity, the base of the allowance on equity is negative in a tax period, an amount equal to the negative allowance on equity shall become taxable for 10 consecutive tax periods, up to the overall increase of net equity for which such allowance has been obtained, unless the taxpayer provides sufficient evidence that this is due to accounting losses incurred during the tax period or due to a legal obligation to reduce capital.
To ensure that companies do not abusively increase their net equity, the Member States shall take appropriate measures to ensure that the allowance base does not include any increases resulting from:
In addition, where an increase in equity is the result of a contribution in kind or investment in an asset, Member States shall take the appropriate measures to ensure that the value of the asset is taken into account for the calculation of the base of the allowance only where the asset is necessary for the performance of the taxpayer’s income-generating activity. Furthermore, where an increase in equity is the result of a reorganisation of a group, such increase shall only be taken into account for the calculation of the allowance base to the extent that it does not result in converting into new equity the equity (or part thereof) that already existed in the group before the reorganisation.
Restriction of interest deduction for debt financing
The big downside of the draft DEBRA Directive is that it also restricts the tax deductibility of debt-related interest payments. This is intended to reduce the preference for debt financing over equity financing not only on the equity side, but also on the debt side.
More specifically, the tax deductibility of interest will be limited to 85% of excess borrowing costs (i.e. interest paid minus interest received) according to Art. 6 of the draft DEBRA Directive. With respect to the definition of “excess borrowing costs”, reference is made to the interest limitation rule in Art. 4 ATAD (Directive EU 2016/1164). With respect to relationship to the interest limitation rule in Art. 4 of the ATAD (which will remain applicable), taxpayers will first have to apply Art. 6 of the DEBRA-Directive and then calculate the limitation applicable in accordance with Art. 4 of ATAD.
With the present Proposal for a Directive on a debt-equity bias reduction allowance (“DEBRA”), the EU plans to create a new tax framework for equity and debt financing. The envisaged deductibility of a notional interest on increases in equity for tax purposes, which has been demanded by practice for some time, is to be welcomed. However, the Commission’s approach to limit the tax deductibility of the net interest expenses to 85% must be rejected. It remains to be seen whether or with what amendments the present Proposal will be adopted and how Member States will subsequently implement the measures at national level. We will keep you informed about this.
Clemens Nowotny, Martin Eckerstorfer
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