A Proposal for a Debt Bias Reduction Allowance (DEBRA) Directive

On May 11, 2022, the European Commission published a proposal for a directive providing for a Debt Bias Reduction Allowance (“DEBRA”). This directive is part of the measures proposed by the Commission to support Europe’s recovery from the COVID-19 pandemic.

Currently, EU tax systems allow interest payments on debt to be deducted when calculating the tax base for corporate tax purposes, while equity financing costs, such as dividends are mostly not tax deductible. DEBRA aims to address this tax-induced leverage bias across the single market and to promote long-term investment and re-ownership in the corporate sector.

The proposed directive establishes rules providing for the tax deductibility of notional interest on capital increases and limiting the deductibility of excess borrowing costs. These measures would apply independently, but the combined measures should ensure that equity and debt financing are treated more equitably for tax purposes. The proposal also contains various anti-abuse measures to prevent any quota from being used as another tool for base erosion.

1. Scope

The proposal would apply to all EU businesses that are subject to corporation tax in one or more EU Member States, including EU permanent establishments of entities resident for taxes in a third country.

However, DEBRA would not apply to financial companies (in particular credit institutions, investment companies, AIF, AIFM, UCITS, insurance companies, etc.).

2. Provision on own funds

The first measure proposed by the European Commission is an equity allowance calculated as follows:

Depreciation on equity = Deduction base * notional interest rate

  • Allocation base corresponds to the difference between the net situation at the end of the current taxation year and the net situation at the end of the previous taxation year.
  • Notional interest rate corresponds to a 10-year risk-free interest rate for the currency concerned, plus a risk premium of 1% (1.5% for SMEs).

Net equity is the difference between the equity (i.e. paid-up capital, share premium, reserves and carried forward profits or losses) of a taxpayer and the sum of the tax value of its participation in the capital of associated companies and its own shares. This specific definition aims to avoid the cascade of allocation through participations.

The equity allowance would be deductible for income tax purposes at up to 30% of the taxpayer’s EBITDA for 10 consecutive tax years and any excess available equity allowance could be carried forward by the taxpayer without time limit. Additionally, any allowances not available due to the 30% EBITDA limit could be carried forward for up to five tax years.

If the basis for the allowance is a negative amount due to a decrease in equity, a proportional amount would be taxable for 10 consecutive years, until the positive allowance previously obtained, unless the taxpayer provides evidence sufficient that this decrease is due to accounting reasons. losses incurred during the tax period, or due to a legal obligation to reduce capital.

3. Anti-abuse rules

The anti-abuse measures provided for in the proposal aim to ensure that the rules on the deductibility of an equity allowance are not used for unintended purposes.

Consequently, capital increases resulting from intra-group loans, intra-group transfers of shareholdings or existing commercial activities and, under certain conditions, contributions in cash would be excluded from the calculation of the net capital increase, unless the taxpayer provides sufficient evidence that the transaction concerned was carried out for valid commercial reasons and does not entail a double deduction of the deduction from equity.

Capital increases resulting from a contribution in kind would also be closely monitored to ensure that the valuations have been determined accurately and that the assets concerned are necessary for the exercise of the taxpayer’s income-generating activity.

Finally, when the capital increase results from a reorganization of a group, this increase would only be considered if it does not have the effect of converting the equity that already existed in the group before the reorganization into new equity. .

4. Limitation of the deduction of interest

On the debt side, DEBRA would also introduce a new limitation on interest deductibility. Interest deductibility would be limited to 85% of the excess borrowing cost (i.e. interest expense minus interest income) and would operate alongside the interest limitation rules introduced by the Anti-Corruption Directive. – tax evasion (“ATAD”).

Under this new limit, a taxpayer would only be allowed to deduct the lesser of the following amounts:

  • 85% of the cost of borrowing overrun; and
  • Exceeding deductible borrowing costs under ATAD rules.

The taxpayer has the right to carry forward or carry back the difference between these two amounts in accordance with ATAD’s limitation rules.

5. Entry into force

Adoption of the proposal requires the unanimity of the 27 EU Member States. Once adopted, Member States will have to transpose these new rules into their national law by December 31, 2023 at the latest for entry into force on January 1, 2024.

Six Member States (Belgium, Cyprus, Italy, Malta, Poland and Portugal) already provide in their national legislation for a deduction for equity financing. These regimes would need to be redesigned to accommodate DEBRA if the proposal were adopted.