On 11 May 2022, the European Commission published a Directive proposal to tackle the tax bias in favour of debt funding. The proposal includes both a notional deduction on growth in equity and an additional limitation on interest deduction for corporate income tax purposes. The DEBRA proposal applies to all taxpayers, which are subject to CIT in one or more member states, save for certain financial undertakings. The proposed date of entry into effect is 1 January 2024.
Tax systems in the EU allow for the deduction of interest payments on debt, while costs related to equity financing are mostly non-deductible. This difference in tax treatment is one of the factors favouring the use of debt over equity for financing investments. Currently, only six Member States (Belgium, Portugal, Poland, Cyprus, Malta and Italy) address the debt-equity bias from a tax perspective and the national measures adopted differ significantly. It is the view of the EC that this issue should be addressed across the single market in a coordinated way. The proposed directive lays down rules to provide, under certain conditions, for the tax-deductibility of notional interest on increases in equity and to limit the tax deductibility of exceeding borrowing costs.
Allowance on equity
The deductible expenses related to equity financing (incremental allowance on equity) would be computed as follows:
Allowance on equity = Allowance base X Notional Interest Rate (NIR)
- The first step would be to annually calculate the difference between equity at the end of the current tax year and equity at the end of the previous tax year.
- The second step would be to apply the notional interest rate to the difference in equity. The notional interest rate would be the 10-year risk-free interest rate for the relevant currency and increased by a risk premium of 1% (1.5% in the case of SMEs).
There should be no discretion on the part of the Member States as to whether to apply this higher rate for SMEs or what rate to apply or what rate to apply as the top=up for SMEs in order to avoid selectivity concerns as regards EU State Aid Rules and to ensure a level playing field for SMEs in the EU regardless of their place of residence.
The allowance on equity would be deductible for tax purposes for up to 30% of the taxpayer’s EBITDA for 10 consecutive tax years. This limitation mirrors the deduction limitation applicable to exceeding borrowing costs under the EU Anti-Tax Avoidance Directive’s interest deduction limitation rules. Any excess of available allowance on equity could be carried forward by the taxpayer without a time limitation. Additionally, any unavailable allowance due to the 30% EBITDA limitation could be carried forward for a maximum of five tax years.
Limitation of interest deduction
In addition, the DEBRA proposal includes a new interest deduction limitation. It is proposed that 15% of the exceeding borrowing costs, in short interest expenses minus interest income, will not be deductible for tax purposes. The proposal provides for rules of interaction between this contemplated new limitation and the EU Anti-Tax Avoidance Directive’s interest deduction limitation rules, as well as for carry forward rules of unused amounts.
The proposal contains various anti-abuse measures. Increases in equity that originate from (i) intra-group loans, (ii) intra-group transfers of participations or existing business activities and (iii) under certain conditions cash contributions would be excluded from the calculation of the increase in equity. Similarly certain contributions in kind as well as equity increases following a re-characterization of old capital into new capital through, e.g., liquidation transactions would be excluded from the increase in equity.
The DEBRA proposal, once adopted by the Council, would have to be implemented into Member States’ national law by 31 December 2023 and should come into effect as of 1 January 2024.
Malta already has in place rules whose purpose is to eliminate the bias in favour of debt over equity. Malta introduced the Notional Interest Deduction Rules in 2018 and shortly after, the Maltese Commissioner for Revenue issued guidelines in this respect. The proposed Directive states that those countries such as Malta which have rules in place providing for an allowance on equity increases may defer the application of the provisions of this Directive for the duration of rights already established under domestic rules. Taxpayers that on 1 January 2024, benefit from an allowance on equity under domestic rules will be able to continue to benefit from such an allowance under domestic rules for a period of up to 10 years and in no case for a period which is longer than the duration under national law. The rules of this Directive will apply from their date of application to all other taxpayers in all Member States.