On 11 May 2022, the European Commission proposed a debt-equity bias reduction allowance, or DEBRA, to help businesses become more resilient and access the financing they need.
DEBRA will support businesses by introducing an allowance that will grant the same tax treatment to equity as debt. The proposal stipulates that a notional interest on increases in a taxpayer's equity from one tax year to the next will be deductible from its taxable base, similar to what happens to debt. On the other side, the deductibility of interest on debt will be limited.
Why this proposal?
Most countries, including EU countries, treat debt more favourably than equity. They do so by allowing interest payments to be deducted from taxable income while not offering the same allowance when funding through equity. This gives businesses a major incentive to borrow rather than raise capital.
The debt-equity bias can encourage companies to make business decisions based on tax benefits rather than sound management considerations. This may cause some companies to choose debt financing over equity, even if it is not the best option for them. Equity should receive similar tax treatment as debt, so that companies can consider both options on an equal footing and choose the source of financing that is best for their business model.
How will it work?
The Commission’s proposal will create a level playing field for debt and equity from a tax perspective, thereby removing taxation as a factor which can influence companies’ commercial decisions.
The proposal will address the debt-equity bias from both sides of the issue. It will make a notional interest on new equity tax deductible, just as debt currently is to mitigate the debt-equity bias from the equity side. The proposal will also introduce a reduction of debt interest deductibility by 15% to also mitigate the debt-equity bias from the debt side.
A more favourable rate of deduction is proposed for SMEs, given that they have more difficulty in accessing equity markets than larger companies.
The equity allowance would be computed based on the difference between net equity at the end of the current tax year and net equity at the end of the previous tax year, multiplied by a notional interest rate. This means that the allowance would be granted only for the sum of equity increases over a specific year.
The notional interest rate is the 10-year risk-free interest rate for the relevant currency, and increased by a risk premium of 1% or, in the case of SMEs, a risk premium of 1,5%.
The allowance on equity is deductible for 10 consecutive tax years, as long as it does not exceed 30% of the taxpayer's taxable income.
Moreover, if the allowance on equity is higher than the taxpayer’s net taxable income, the taxpayer may carry forward the excess allowance on equity without a time limitation.
Taxpayers will also be able to carry forward their unused allowance on equity which exceeds the 30% of taxable income, for a maximum of 5 tax years.
Lastly, the proposal introduces a reduction of debt interest deductibility by 15% to better mitigate the debt-equity bias from the debt side and from the equity side.
Advantages
Addressing the debt-equity bias could contribute to the re-equitisation of companies, making them stronger and more resilient to shocks. Equity is also particularly important for fast-growing innovative companies in their early stages and for companies that wish to expand globally.
The green and digital transitions require new investments in innovative technologies. More than 50% of green investment in the coming years is estimated to come from new technologies, requiring more risk financing. Equity will therefore have an important role in fostering a sustainable transition towards a greener economy and in Europe’s overall growth and economic stability.
Context
DEBRA was proposed by the Commission in May 2021 as part of its Communication on Business Taxation for the 21st Century, which sets out a long-term vision to provide a fair and sustainable business environment and EU tax system, as well as targeted measures to promote productive investment and entrepreneurship while ensuring effective taxation. It is one of the actions proposed to help businesses left vulnerable by the COVID crisis.
The proposal is also in line with the EU’s Capital Markets Union Action Plan (CMU), which helps companies raise the capital they need, particularly in the post-pandemic period. The CMU incentivises long-term investments to foster sustainable and digital transition of the EU economy.
Documents and legal texts
- Proposal COM (2022) 216 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
- Impact Assessment Report SWD (2022)145 accompanying Proposal COM (2022) 216
- Executive Summary of Impact Assessment Report SWD (2022) 146
- Subsidiarity Grid SWD (2022) 144 accompanying Proposal COM (2022) 216
- Regulatory Scrutiny Board Opinion SEC (2022) 204 on Proposal COM (2022) 216