The proposal of the European Commission, published in May 2022, addresses the issue of asymmetrical tax treatment of the use of debt and equity (the “DEBRA Proposal”). According to the EU, the tax-driven debt-equity bias results in favouring the use of debt over equity for investment financing, creating an unstable and vulnerable economic environment. The DEBRA Proposal aiming to tackle this bias, is expected to be applicable as from January 1, 2024 in the EU Member States. A grandfathering clause would apply for EU Member States, where domestic rules on allowance for equity financing are already in place, securing a transitional period up to 10 years.
The DEBRA Proposal targets all taxpayers that are subject to corporate income tax in one or more Member States, except for financial undertakings such as credit institutions, investment firms, AIFs, AIFMs, UCITS, UCITs management companies, insurance and reinsurance undertakings, pension institutions, securitization vehicles and crypto-asset service providers.
The DEBRA Proposal lays down rules (i) to provide, under certain conditions, for the tax deductibility of notional interest on increases in equity and (ii) to limit the deductibility for tax purposes of the exceeding borrowing costs.
Allowance on equity
A new tax allowance for equity increase would be applicable with the following major conditions:
- the allowance base is calculated as the positive difference of the equity of a given tax year and the following one;
- the allowance base is then multiplied by the notional interest rate (NIR), composed by two elements: the currency specific risk-free rate, plus a risk premium of 1% (1.5% for SMEs), resulting in the allowance amount;
- the allowance amount shall be deductible for 10 years, starting from the tax year of granting; the deductibility is however limited up to 30% of the EBITDA of the given year with the possibility to carry forward the exceeding amount.
The allowance base will not include equity increases that result from the following transactions:
- Intra-group loans, intra-group transfer of assets and cash contributions from a person resident in a jurisdiction that does not exchange information with the taxpayer’s Member, unless the taxpayer would provide sufficient evidence that the relevant transaction has been carried out for valid commercial reasons and does not lead to a double deduction of the allowance on equity;
- Contribution in kind or investment in an asset, where the relevant asset is not necessary for the performance of the taxpayer’s income-generating activity;
- Reorganisation of a group that results in converting into new equity the equity that already existed in the group before the reorganisation.
Limitation of interest deductibility
The DEBRA Proposal would also introduce a new limitation on interest deductibility that would be limited to 85% of the exceeding borrowing cost (i.e. interest expenses minus interest income) and which would be applied in parallel with the existing interest limitation rule provided for in Article 4 of Council Directive (EU) 2016/1164 (the “ATAD”). The rule in the DEBRA Proposal would apply first, meaning that where the ATAD rule produced a lower interest deduction allowance, the taxpayer would be entitled to carry forward or back the difference in accordance with Article 4 of ATAD.