On 11 May 2022 the European Commission has published a draft directive containing regulations that are intended to counteract the favourable tax treatment of debt capital compared to equity capital.
The draft directive is set against the background that debt capital is favoured over equity capital for tax purposes, since debt capital costs are tax deductible at the level of the capital borrower (with exceptions), whereas this does not apply to equity capital costs (profit distribution, dividends). This is intended to provide an incentive for companies to raise financing by borrowing (credit, loan) rather than by raising equity capital (e.g. through a capital increase).
The EU Commission's proposal shall to create equal conditions (from a tax perspective) between equity and debt and intends to eliminate taxation as a factor influencing the decision between debt and equity.
For this purpose, the proposal provides for deductibility through an allowance for equity capital. At the same time, however, the deductibility of interest deduction on borrowed capital is to be restricted.
The proposal is aimed at all taxpayers that are subject to corporate income tax in one or more EU Member States, including permanent establishments in one or more EU Member States of an entity that is resident for tax purposes in a third country. However, certain financial undertakings are exempt, e.g. credit institutions, investment firms, AIFs, AIFMs, UCITS, UCITS management companies, and more)
Allowance on equity
The allowance on equity is calculated by multiplying the difference between the net equity at the end of the current tax year and the net equity at the end of the previous calendar year by a notional interest rate. The net equity is the equity reduced by participations in affiliated companies and own shares.
The notional interest rate to be applied corresponds to the 10-year risk-free interest rate for the respective currency, which is to be increased by a risk premium of 1%. For SMEs, the risk premium shall amount to 1.5%.
The allowance is deductible for ten consecutive tax years as long as it does not exceed 30% of the EBITDA in the corresponding tax year. If the allowance for equity is higher than the taxable income of the taxpayer, the taxpayer may carry forward the excess without any time limit. A tax carry forward of unused allowances exceeding 30% of the EBITDA, however, is possible for five tax years.
If the net equity decreases, a negative deduction amount shall be determined from the decrease, insofar as this was preceded in the past by an increase in equity for which an allowance was granted. This amount increases the income each year over a period of 10 business years. However, the tax liability does not apply if the reduction in equity capital is due to losses or a legal obligation to reduce the capital.
The proposed directive provides for several abuse-avoidance rules and special provisions, such as the exclusion of intra-group transactions, special rules for contributions in kind and the exclusion of certain changes in equity resulting from restructuring measures.
Reduction of the deductibility of interest on borrowed capital
In addition to the allowance for equity capital, the draft directive provides that the deductibility of interest on borrowed capital is to be reduced by 15%. The deductibility of interest on borrowed capital under corporation tax is to be limited to 85% of net interest expenses. The amount resulting thereafter is to be compared with the amount resulting after application of the interest barrier (ATAD I). Only the lower of these two amounts is to be deductible.
Comment and Outlook
The DEBRA proposal (allowance for equity represents, reduction of the deductibility of interest on debt) constitute a significant change of the tax system regarding the treatment of equity and debt. In regard of the (currently) historically low interest rates, measures to strengthen the equity are in principle welcome. On the other hand, the restriction on the deductibility of borrowing costs and the anti-buse provisions, which are likely to complicate the regulation and exclude many companies from the benefit, must be viewed critically.
According to the draft directive, the transposition of the regulations into national law is to take place by 31.12.2023 and the new regulations are to come into force on 01.01.2024.