On 11 May 2022, the European Commission published a proposal for a new Council Directive providing for a tax deductibility of notional interest on growth of equity combined with further limitations on the tax deductibility of interest on debt funding in order to tackle the tax bias in favour of debt funding (known as the “DEBRA Directive” – debt-equity bias reduction allowance).
What is the background of the DEBRA Directive?
The proposal intends to address the tax-related asymmetry in treatment of debt and equity thereby aiming at encouraging taxpayers to increasingly raise equity financing for their operations rather than debt funding. The initiative emerged from the European Commission’s Communication on Business Taxation for the 21st century which had been published in May 2021 outlining the vision of a fair and sustainable EU business tax. In the current legislative landscape, six EU Member States (i.e. Belgium, Cyprus, Italy, Malta, Poland and Portugal) have various concepts of notional interest deductions in place.
Who will be affected by the DEBRA Directive?
The DEBRA Directive will apply to all taxpayers that are subject to corporate income tax in an EU Member State, including EU based permanent establishments maintained by non-EU corporations. However, given their specific refinancing needs, financial undertakings such as credit institutions, investments firms, AIFs and their managers, UCITs, (re)insurance undertakings, pension institutions, (securitisation)SPVs and payment institutions will be excluded from the scope of DEBRA Directive, all the more as these are typically already subject to regulatory equity requirements preventing under-equitization.
How will the allowance on equity be calculated?
The allowance on equity shall be computed based on the difference between net equity at the end of the current financial year and net equity as per the previous financial year-end multiplied by a notional interest rate. In determining the net equity, the aggregate tax value of own shares held by the taxpayer as well as the shares held in associated enterprises (assumed e.g. based on voting rights or participation in the share capital exceeding 25%) shall be deducted from the equity position.
The notional interest rate will be referenced to the 10-year risk-free interest rate for the functional currency relevant for a taxpayer as per the 31 December of the year preceding the deduction of the allowance. Such risk-free interest rate shall then be increased by a risk premium of 1% or, in the case of small and medium enterprises (SME), a risk premium of 1.5%. For instance, based on the current yield of German government bonds with a remaining term to maturity of 10 years of 0.31% as per 31 December 2021, the allowance on equity would amount to 1.31% (for SMEs: 1.81%) if it were already applicable in 2022. Pursuant to the DEBRA Directive, the European Commission will be empowered to modify by virtue of delegated acts the 10-year risk-free interest rate subject to certain changes in the economic environment.
The allowance on equity shall be deductible for purposes corporate income taxation over a period of 10 consecutive financial years in each case capped at 30% of the taxable EBITDA. Any allowance on equity exceeding the taxpayer’s taxable income and therefore not being effectively tax deductible in a given year, can be carried forward indefinitely to future financial years, whereas the portion of the allowance on equity not being tax deductible due to lack of EBITDA shall only be carried forward for a maximum of five years.
If, in a given year during the 10-years’ allowance period, a decrease in equity occurs (i.e. there is a negative difference in equity as compared to the previous year), the differing amount shall be added to the taxable income of the taxpayer unless it can be demonstrated that decrease is solely owed to current year losses or to a legal obligation to reduce the equity capital.
What will the anti-abuse rules look like?
The DEBRA Directive provides for three categories of anti-abuse measures:
- Disregarding any increase of equity originating from certain intra-group transactions including cash contributions, loans and transfers of participations;
- Setting forth specific prerequisites for an increase of equity in the form of contributions in kind or investments in assets; and
- Disregarding any increase of equity from reorganizational measures giving rise to a re-categorisation of existing equity into new equity, e.g. by virtue of a liquidation of existing group companies combined with the establishment of new subsidiaries.
How will the deductibility of interest on debt funding be further limited?
As part of EU Commission’s twofold approach to incentivise growth in equity while further penalising debt funding, the DEBRA Directive provides for a limitation on the deductibility of interest to 85% of exceeding borrowing costs (i.e., interest expenses minus interest earnings). The interplay between the interest limitation rules of the DEBRA Directive and the ATAD I Directive is such that the 85% limitation under the DEBRA Directive shall be applied in the first place with the remaining amount of interest not yet disallowed then being subject to the national interest barrier rules of the Member States as implemented in accordance with the ATAD I Directive. In the end, only the lower amount resulting from the application of the DEBRA Directive and the ATAD I Directive shall be tax deductible (with the non-deductible portion being carried forward subject to the national interest barrier rules).
What is the timing provided for by the DEBRA Directive?
As a next step, the DEBRA Directive will be subject to negotiations between the Member States. Once adopted by the European Council based on a unanimous approval of all 27 Member States, the DEBRA Directive is foreseen to be implemented into the national laws of the Member States by 31 December 2023 entering into effect as of 1 January 2024.
Do you require further information?
If you wish to better assess the potential impact of the DEBRA Directive on your operations, please feel free to contact Dr Bert Kimpel or Rudi Hasenberg at Taylor Wessing Germany.
