The European Commission published an EU Directive proposal on debt-equity bias reduction allowance (DEBRA) and a limitation of the tax deductibility of exceeding borrowing costs on 11 May 2022. As outlined in the Communication on Business Taxation for the Twenty-First Century, this proposal is one of the Commission’s important initiatives on company tax.
The DEBRA proposal intends to rectify the difference in debt and equity financing treatment by providing a 10-year tax-deductible allowance for equity investments, including lowering the amount of interest that may be deducted on debt investments.
Under Article 4 of the Anti-Tax Avoidance Directive (ATAD) adopted by the Council of the European Union, the debt interest deduction restriction will align with the existing interest limitation rule (ILR) and the taxpayers who are liable for corporate income tax in one or more EU member states will have to adhere to the proposed rules.
Currently, the only six member states (Belgium, Cyprus, Italy, Malta, Poland and Portugal) that have already applied for the capital deduction under national law may postpone the application of the rule for up to 10 years, in any case longer than the benefit period under national law.
Parties who are interested must comment on the proposal through the European Commission‘s website by July 8, 2022.
The increase in external funding by companies in recent years have been remarkable due to the need for cash injection during the pandemic. This is the background of this proposal as stated by the EU Commission.
Due to the different tax treatments of debt and equity finance in jurisdictions around the world, investments in businesses are made through debt rather than equity investment. For this reason, debt loans are considered beneficial to businesses because they can deduct interest on debt from taxable corporate profits.
The commission sees increased equity financing as the key to more sustainable and safer investments in the single market. The DEBRA proposal is said to be one of the measures that complements the transition to a more balanced corporate tax system for operating companies within the political bloc.
What is proposed?
From a tax perspective, The Commission’s proposal creates a fair competition for debt and capital. DEBRA assists businesses in obtaining necessary financing and becoming more resilient. What’s more, it eliminates taxation as a factor that can influence a company’s business decisions.
On the other hand, small and medium-sized enterprises (SMEs) have less access to capital markets than large companies, so more advantageous deduction rates are proposed.
The increases in a taxpayer’s equity from one tax year to the next are deducted from their taxable base, just like debt. As part of the business taxation strategy of EU, this will be beneficial to the Capital Markets Union increasing the availability of finance for EU businesses and supporting the national capital market integration into a true single market. This is according to the initiative by the EU Commission on tax incentive for equity as stated here.
What is the scope?
Under the proposed rules, all companies in the EU are subject to corporate tax in one or more member states. On the other hand, financial companies are excluded from the scope of this policy because they are already subject to regulatory capital requirements that prevent under-capitalisation. Furthermore, the Commission claims that many are unaffected by interest deduction rules and if the rules proposed to combat debt tax distortions are applied to them, the financial burden of the measures will be distributed unequally at the cost of non-financial enterprises.
Limitation of interest deduction
As proposed in the new interest deduction limitation included in DEBRA, the 15 per cent of excess borrowing costs, that is, short-term interest expense minus interest income, cannot be deducted for corporate tax purposes. Rules of interaction are being provided in the proposal between this new planned limit and the interest deduction limit rules of the EU Anti-Tax Avoidance Directive.
Article 5 of the DEBRA proposal covers anti-abuse rules. Adopted by the Code of Conduct Group in 2019, these fraud prevention policies are inspired by the guidance on the conceptual interest deduction rules.
If there are sufficient evidence provided by the taxpayer that proves that the relevant transaction was made for legitimate commercial reasons and does not result in a defined share deduction, these abuse prevention provisions should not apply.
In addition, the proposal states that if the increase in capital is the result of an investment in kind or an asset, member states must take appropriate steps to make sure that the value of the asset is considered in the calculation depending on the necessary performance of the income-generating activity of the taxpayer. The prevention of overvaluation of assets or the purchase of luxury goods to increase the tax base is the main goal of this rule as noted by the Commission.
Once the Council approves the DEBRA proposal after requiring unanimity from all 27 EU Member States, it must be replaced by the national law of the Member State by 31 December 2023 and enter into force on 1 January 2024.
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