On 11 May 2022, the European Commission published a proposal for an EU Directive introducing a debt-equity bias reduction allowance (DEBRA), including a limitation of the tax deductibility of exceeding borrowing costs. The Commission's communication on 'Business Taxation for the 21st Century', published in May, proposed that a debt equity bias reduction allowance be legislated for. This rule would address the bias in most tax regimes towards using debt as a financing option. A company is generally entitled to deduct interest costs attached to debt financing from taxable profits, but not the costs related to equity financing.
Debt-level concerns The European Commission's underlying concern regarding the bias towards debt financing over equity financing has been heightened in light of the overall increase in the debt burden of companies across the EU following the COVID-19 pandemic. The Commission would prefer to see growth and investment in the single market that favours higher equity ratios, thereby reducing systemic risks associated with high levels of debt (including risks associated with insolvency). Scope of the proposal This proposal is set to apply to taxpayers that are subject to corporate tax in one or more Member States, including a permanent establishment in one or more EU Member State(s) of an entity that is tax-resident in a third country. The proposal does not, however, apply to financial undertakings (as defined in the proposal). Equity allowance The proposed equity allowance allows companies to deduct a notional allowance for equity from its taxable base for ten consecutive periods, where a taxpayer increases their equity from one tax period to the next. It is proposed that the allowance be calculated by multiplying the increase in year-on-year equity with a notional interest rate, which is based on a medium- to long-term risk-free rate. Equity is defined in the proposal as "the sum of the taxpayer's paid-up capital, share premium accounts, revaluation reserve and other reserves and profit or loss brought forward". The applicable interest rate is the currency specific risk-free rate for 10-year debt. This rate is combined with a risk premium rate of 1%, with a higher risk premium interest rate (1.5%) proposed for small- and medium-sized entities (SMEs). The allowance is limited to 30% of EBITDA, similar to interest limitation rules. In the case of unused allowances (owing to a lack of taxable profits), the excess may be carried forward indefinitely to future periods. Where equity is reduced following an allowance claim, this will result in taxation of the negative allowance on equity over 10 years unless the taxpayer can demonstrate that the negative equity is a consequence of accounting losses or due to a legal obligation to reduce capital. Limitation to interest deduction To create parity between debt and equity, the allowance for a notional interest deduction on equity is accompanied by a further limitation on the tax deductibility of debt-related interest payments. A proportional restriction will limit the deductibility of interest on debt financing to 85% of "exceeding borrowing costs" (i.e interest expense exceeding interest income). This restriction applies before applying the Anti-Tax Avoidance Directive (ATAD) I interest limitation rules. If the result of applying the interest limitation rules is a deductible amount lower than 85% of exceeding borrowing costs, the taxpayer will be entitled to carry forward (or back) the difference between 85% of exceeding borrowing costs and the amount of deductible interest under ATAD I interest limitation rules. It should be noted that, in an Irish context, the difference could only be carried forward. Anti-abuse provisions The proposal contains anti-abuse measures pertaining to what cannot be included in calculating increases in equity. Next steps Like all proposed directives that relate to direct tax, unanimity is required from all 27 EU Member States for the Directive to progress. If adopted, EU Member States will be required to implement the provisions of the Directive by 31 December 2023 so that they take effect and apply from 1 January 2024. The dates are presented in square brackets in the draft Directive, indicating that they may be subject to change. The four key actions to take now 1. Interaction with existing interest limitation rules While the introduction of an allowance on equity is a welcome proposal, combining it with the introduction of a further, and potentially more impactful, restriction on the ability of a business to deduct exceeding borrowing costs related to debt financing will be an unwelcome surprise for many taxpayers.The interaction with the existing interest limitation rules—and specifically, the interest limitation rules carve-outs (e.g. the equity escape for groups, the group ratio rule, the de-minimis threshold or the long-term public infrastructure exemption)—will require careful consideration by taxpayers. Action: consider whether your business relies on any of the ATAD interest limitation rule carve-outs and how this will be impacted in light of the DEBRA limitations to interest deduction. 2. Pre-existing equity allowance regimes Countries that already have an equity allowance regime (Belgium, Portugal, Poland, Cyprus, Malta and Italy) can defer transposition of the proposal for up to ten years and in no case for a period longer than the duration of the benefit under national law. Action: businesses with entities availing of these existing regimes should follow their approach to the proposal carefully. PwC can advise businesses on the interaction with existing regimes, using our wide network of tax professionals in these countries. 3. Interaction with Pillar Two Financial statements will not account for the notional equity interest deduction and this may have a negative knock-on impact in terms of the effective tax rate recognised for Pillar Two. Action: talk to us today about how the equity interest allowance and the additional restriction on debt interest will impact your effective tax rate for Pillar Two purposes. More details can be found in this Tax Policy Alert. 4. Financial undertakings Financial undertakings, as defined by the proposal, are not included in the scope of this proposal. However, the list of financial undertakings in this proposal differs from the list of financial undertakings provided for ATAD interest limitation rules. Accordingly, some businesses may find that they are subject to interest limitation rules under ATAD, but are unable to claim an equity allowance under this proposal. Action: review the list of financial undertakings in the DEBRA proposal to see if your business is impacted by this extended list of entities. We are here to help you PwC Ireland will follow the progress of the Directive proposal and will contribute to feedback from the PwC network to the EU Commission. If you need help understanding the implications of the proposal on your business, contact us today.