On 11 May 2022, the European Commission (EC) proposed a Directive on a debt-equity bias reduction allowance (DEBRA) by introducing an allowance that will allow for a notional interest deduction on equity increases from one tax year to the next. The objective is to reduce the current tax bias that favours the use of debt over equity. The focus of the proposed measure is on the entity being funded rather than on the lender or equity provider.

The current pro-debt bias of tax rules, where businesses can deduct interest attached to a debt financing, but not the costs related to equity financing,is perceived as incentivising companies to take on debt rather than increase equity to finance their growth and thus creating a more secure financial environment for companies.

DEBRA is a follow-up to the EC’s Communication on Business Taxation for the 21^st Century for a robust and fair business tax system, which sets out its long-term vision to provide a sustainable business environment and EU tax system, as well as targeted measures to promote productive investment and entrepreneurship and ensure effective taxation. It is also part of the EC’s objective in developing a single corporate tax rulebook, including a common tax base and profit allocation between Member States.

The Directive is intended to be transposed into law by EU Member States by 31 December 2023 with a view to coming into effect from 1 January 2024.

The Directive has two principal elements:

• An allowance on equity increases; and
• A limitation on interest deductions (although the EC notes that the predominant purpose of the Directive is not the fight against tax avoidance).

The allowance base is the difference between the equity at the end of two tax years. Equity is broadly in line with the concept of shareholder equity (contributed capital and reserves) and there are some anti-avoidance provisions to prevent artificial manipulation of the concept.

The allowance is a notional interest rate which is comprised of a risk-free rate plus a risk premium, the latter being 1 per cent but increased to 1.5 per cent in the case of SMEs and is granted for 10 years. The resulting allowance cannot exceed 30 per cent of EBITDA.

In regards to the interest limitation element, an account has been taken of the limitation already in place under the Anti-Tax Avoidance Directive (ATAD) under which interest is limited to the higher of 30 per cent of EBITDA or €3 million. The proposed new limitation will be 85 per cent of exceeding borrowing costs (being interest paid minus interest received). This will apply as a first step with the ATAD rule that is being applied and the lower of the two outcomes will apply for the year in question. If the ATAD outcome is higher than DEBRA, the difference can be carried forward.

The press release can be found here

The proposed Directive can be found here.