It has been tried before. People said it would never happen – but could things be different this time round?
The European Commission published its much-anticipated proposals for a debt-equity bias reduction allowance (or DEBRA) on 11 May (see here). Significantly, the DEBRA proposals do not just involve an allowance for notional interest on equity but also include new limits on the deductibility of interest.
This is not the first time that the EU has tried to address the balance between the tax treatment of debt and equity. When the Commission re-launched its proposals for a Common Consolidated Corporate Tax Base (CCCTB) in 2016, they included a form of allowance for corporate equity (ACE) in the shape of an Allowance for Growth and Investment (the AGI). However, even though there was some support for the ACE aspects of the CCCTB proposal, others were concerned that Member States should be free to choose their own incentives for investment. The AGI sank with the CCCTB project as a whole which was felt to be just too ambitious a project to succeed. Six years on, is it possible that the tax landscape has shifted enough and are the proposals different enough for them to become a reality this time?
What is DEBRA and why is it being proposed?
In its Communication on Business Taxation for the 21st Century (EU BT 21) in May 2021, the Commission explained that the existing position incentivises companies to finance investment through debt rather than equity which can “contribute to an excessive accumulation of debts with possible negative spill-over effects for the EU as a whole”, with the debt bias penalising the financing of innovation through equity – an issue that has become “more pressing” with increasing levels of debt post-Covid.
It is clear from the proposals published on 11 May 2022 that the Commission remains keen to promote financial stability, avoid over-reliance on debt and encourage the "re-equitisation" of businesses. They believe this will support sustainable growth and innovation in the EU, increase resilience to unforeseen changes and decrease the risk of insolvency – objectives that all ultimately support the EU’s ambition to develop a Capital Markets Union (CMU) able to compete with the US markets at a time where one of Europe’s most developed capital markets, the City of London, is now out of the Union.
With this goal in mind, the Commission has proposed a draft directive made up of two independent measures. The first is an allowance for notional interest on new corporate equity for ten years and the second, a new limitation on the tax deductibility of interest.
It applies to all taxpayers that are subject to corporate tax in one or more Member States, with one notable exception: financial undertakings. This term is widely defined and includes credit institutions, insurers, investment firms, AIFMs, pension institutions, securitisation vehicles, electronic money institutions and crypto-asset service providers. One reason given for their exclusion is that their regulatory capital requirements should already prevent them being under-capitalised. However, given the breadth of the definition of financial undertaking, many entities that fall within the exclusion will not be subject to such regulatory capital requirements. More convincing is the alternative explanation given, which is that such entities are unlikely to feel the effects of the interest deduction limitation so it was thought unfair that they should get the upside of the equity allowance at the expense of non-financial undertakings if they did not bear the economic burden of the new rules.
An allowance for new equity
The “allowance on equity” would be calculated by multiplying the increase in equity in a year by a notional interest rate. This notional interest rate is based on the ten-year risk-free interest rate in the currency of the taxpayer, with the addition of a risk premium of 1 per cent. Recognising that small and medium enterprises (SMEs) typically have higher financing costs, a higher risk premium of 1.5 per cent would apply to SMEs. The increase in equity of an entity excludes profits triggered by increases in the equity value of the entity’s subsidiaries, to prevent the same underlying profits triggering an allowance on equity for both the subsidiary and its parent entity.
The allowance is limited to a maximum of 30 per cent of the taxpayer’s EBITDA (earnings before interest, tax, depreciation and amortisation) for each tax year (this restriction is framed as an anti-abuse measure with a deliberate nod to existing interest limitation rules). Unused allowance in excess of 30 per cent EBITDA can be carried forward for five years. To the extent that any part of the allowance cannot be deducted in a tax period due to insufficient taxable profits, this may be carried forward indefinitely.
It wouldn’t be a modern tax measure without specific anti-avoidance rules, which remains a priority for the EU, and indeed the proposals include measures targeting, for instance, schemes that artificially create an increase in equity through intra-group reorganisations or transfers of participations in associated enterprises.
An additional limitation on interest deductibility
The quid pro quo for the allowance on equity is a new limitation on the tax deductibility of debt-related interest payments. Specifically, a proportional restriction will limit the deductibility of interest to 85 per cent of “exceeding borrowing costs”. This is defined in the explanatory notes, although not the directive itself, as interest paid minus interest received.
In terms of the interaction between this and the existing interest limitation rules under the Anti-Tax Avoidance Directive (ATAD), the explanatory notes state that, given the different objectives between the new rules and the existing ATAD interest limitation rules, both rules would be maintained. From a compliance perspective, this adds yet another layer of complexity to tax computations, with taxpayers having to calculate both the deductibility of exceeding borrowing costs under the new Directive as well as any limitation on deductibility of interest under ATAD – the highest limitation (i.e. the most unfavourable for the taxpayer) applies.
Further thought will also need to be given to how the rules will interact with the OECD’s pillar two rules providing for a global minimum rate of tax. To the extent that DEBRA provides for a notional deduction, this is likely to depress the effective tax rate (ETR) for those able to use the new equity allowance. This could have the effect of pushing a taxpayer’s ETR below 15 per cent even in jurisdictions where the headline tax rate exceeds 15 per cent.
Will it happen?
It is by no means a foregone conclusion that these proposals will be passed. These are not new ideas, various iterations of an ACE have been discussed in an EU context for over a decade without being implemented. And of course the need for unanimous support from 27 Member States is always a high hurdle to overcome.
However, the tax landscape has changed since ACE was proposed as part of the 2016 CCCTB package. One reason that the CCCTB proposals failed was around the difficulties in finding agreement on a common tax base, but we are operating in a different environment now and DEBRA is not interlinked with the EU’s latest proposal for a common tax base ("BEFIT").
The OECD’s two-pillar project (which you can read more about here) has seen unprecedented levels of international co-operation. The EU is hoping to capitalise on this with its BEFIT proposal, which draws on aspects of both pillars, and seems more plausible than ever before.
The EU has reached agreement in record time on tax matters that would never before have been thought possible, such as DAC 6, ATAD 1 and ATAD 2, notably due to political and public pressure to foster “tax fairness” in the EU. That said, those proposals were anti-avoidance measures and, in the current climate, it is near-impossible for Member States to be seen to be opposing these. Whereas DEBRA is not a measure about making companies “pay their fair share”, so there may be more scope for dissent on this initiative.
Indeed, certain Member States, notably France, Germany and Italy have already voiced concerns about the cost of DEBRA. Mindful of this, the design features of the current proposals do seek to limit loss of revenue by restricting the application of the allowance to increases in equity only and the inclusion of anti-avoidance rules – perhaps learning from the experiences of the existing Belgian domestic ACE regime which triggered substantial revenue losses. The limitation on interest deductions is also intended to mitigate revenue losses and it is clearly hoped this will help allay some of these concerns.
However, although there are potential benefits to Member States in terms of limiting revenue loss through this new limitation on interest deductibility, this aspect of the proposal will be concerning for taxpayers who are already grappling with other rules which overlap with these proposals, such as the OECD's pillar two. Member States may have concerns that this aspect of the new rules could lead to business shifting out of a Member State and erosion of its tax base. Pan-EU implementation would, of course, mitigate against such effects as between Member States – although the risk of pushing investment outside the EU would remain.
A further hurdle to implementation is the thorny issue of constitutional compatibility. The existing German interest limitation rules that implement ATAD are still subject to an ongoing constitutional challenge in the German courts. Could a similar challenge jeopardise the new interest deductibility restriction aspects of the DEBRA proposals?
The draft directive is open for feedback until 11 July. Member States will shortly start their examination of the proposal in the Council and, while the Commission is hoping to get an agreement in the Autumn, it is unclear whether any deal can realistically be agreed by the end of the year. If adopted as a Directive, it would have to be transposed into Member States’ national law by 31 December 2023 and come into effect as of 1 January 2024.
For more on the EU BT 21 package, see our dedicated webpages at Navigating EU BT 21 | Freshfields Bruckhaus Deringer.