DEBRA, do you remember… ACE? The Commission’s latest attempt to tackle leverage bias
It has already been tried. People said it would never happen – but could things be different this time around?
The European Commission has published its long-awaited proposals for a debt bias reduction allowance (or DEBRA) on May 11 (see here). Significantly, the DEBRA proposals not only imply a consideration of notional interest on equity, but also include new limits on interest deductibility.
This is not the first time that the EU has tried to find a balance between the tax treatment of debt and that of equity. When the Commission relaunched its proposals for a Common Consolidated Corporate Tax Base (EXCCIS) in 2016, they included a form of equity provision (AS) in the form of a growth and investment allowance (the AGI). However, while there was some support for the ACE aspects of the CCCTB proposal, others were concerned that Member States were free to choose their own investment incentives. The AGI sank with the ACCIS project as a whole which was felt to be too ambitious a project to succeed. Six years later, is it possible that the tax landscape has changed enough and the proposals are different enough that they become reality this time around?
What is DEBRA and why is it offered?
In his Communication on business taxation for the 21st century (EU BT 21) in May 2021, the Commission explained that the current position encourages companies to finance their investments with debt rather than equity, which can “contribute to an excessive accumulation of debt with possible negative consequences for the EU as a whole”, the debt bias penalizing equity financing of innovation – an issue that has become “more pressing” with rising debt levels post-Covid.
The proposals published on 11 May 2022 show that the Commission remains keen to promote financial stability, avoid excessive recourse to debt and encourage corporate “re-shareholding”. They believe this will support sustainable growth and innovation in the EU, build resilience to unforeseen change and reduce the risk of insolvency – goals which ultimately all support EU ambition. to develop a capital markets union (CMU) able to compete with US markets at a time when one of Europe’s most developed capital markets, the City of London, is now outside the Union.
To this end, the Commission has proposed a draft directive consisting of two independent measures. The first is an allowance for notional interest on new company equity for ten years and the second is a new limitation on the tax deductibility of interest.
It applies to all taxpayers subject to corporation tax in one or more Member States, with one notable exception: financial companies. This term is broadly defined and includes credit institutions, insurers, investment firms, AIFMs, pension institutions, securitization vehicles, electronic money institutions and crypto-asset service providers. One of the reasons given for their exclusion is that their regulatory capital requirements should already prevent them from being undercapitalised. However, given the broad definition of a financial business, many excluded entities will not be subject to these regulatory capital requirements. More persuasive is the alternative explanation given, namely that such entities are unlikely to feel the effects of the limitation on the interest deduction, so it was deemed unfair for them to obtain the benefit of the deduction for equity at the expense of non-financial companies if they did not bear the economic burden of the new rules.
A provision for new equity
The “equity deduction” would be calculated by multiplying the increase in equity during a year by a notional interest rate. This notional interest rate is based on the ten-year risk-free interest rate in the taxpayer’s currency, plus a risk premium of 1%. Recognizing that small and medium enterprises (SME) generally have higher financing costs, a higher risk premium of 1.5% would apply to SMEs. An increase in an entity’s equity excludes earnings triggered by increases in the equity value of the entity’s subsidiaries, to avoid the same underlying earnings triggering an equity provision at both for the subsidiary and its parent entity.
The allowance is limited to a maximum of 30% of the taxpayer’s EBITDA (earnings before interest, taxes, depreciation and amortization) for each taxable year (this restriction is intended as an anti-abuse measure with a nod deliberate eye to existing interest limitation rules). Unused allocation above 30% of EBITDA can be carried forward for five years. To the extent that part of the allowance cannot be deducted during a tax period due to insufficient taxable profits, it can be carried forward indefinitely.
It would not be a modern tax measure without specific anti-avoidance rules, which remain a priority for the EU, and indeed the proposals include measures targeting, for example, schemes which artificially create an increase in funds through reorganizations or intra-group transfers of interests in associates.
An additional limitation on interest deductibility
The counterpart of the equity deduction is a further limitation on the tax deductibility of debt-related interest payments. Specifically, a proportional restriction will limit interest deductibility to 85% of “excess borrowing costs”. This is defined in the explanatory notes, but not in the directive itself, as interest paid minus interest received.
With regard to the interaction between this and the existing interest limitation rules under the Anti-Tax Avoidance Directive (ATAD), the explanatory notes indicate that, given the different objectives between the new rules and the current ATAD interest limitation rules, both rules would be maintained. From a compliance perspective, this adds yet another layer of complexity to tax calculations, with taxpayers having to calculate both the deductibility of excess borrowing costs under the new directive as well as any limitations on the deductibility of interest under ATAD – the higher limit (i.e. the most unfavorable for the taxpayer) applies.
Further thought will also need to be given to how the rules will interact with OECD second pillar rules providing for an overall minimum tax rate. To the extent that DEBRA provides a notional deduction, it is likely to lower the effective tax rate (TEN) for those who are able to use the new equity deduction. This could have the effect of pushing a taxpayer’s ETR below 15%, even in jurisdictions where the nominal tax rate exceeds 15%.
Will it happen?
It is by no means certain that these proposals will be adopted. These are not new ideas, various iterations of an EAC have been discussed in a European context for over a decade without being implemented. And of course, the need for unanimous support from all 27 member states is still a big hurdle to overcome.
However, the tax landscape has changed since the ACE was proposed as part of the 2016 CCCTB package. One of the reasons for the failure of the CCCTB proposals was the difficulty in reaching agreement on a common tax base , but we are now operating in a different environment and DEBRA is not tied to the latest EU proposal for a common tax base (“BEFIT”).
The OECD’s two-pillar project (which you can read more about here) has seen unprecedented levels of international cooperation. The EU hopes to build on this with its BEFIT proposal, which builds on aspects of both pillars and looks more plausible than ever.
The EU has reached agreement in record time on tax issues that would never have been thought possible before, such as DAC 6, ATAD 1 and ATAD 2, not least due to political and public pressure to promote “the ‘tax fairness’ in the EU. That said, these proposals were anti-tax avoidance measures and in the current climate it is almost impossible for Member States to oppose them. While DEBRA is not a measure to force companies to “pay their fair share”, there may therefore be more room for dissent on this initiative.
Indeed, some Member States, notably France, Germany and Italy have already raised concerns about the cost of DEBRA. Bearing this in mind, the design features of the current proposals seek to limit the loss of revenue by limiting the application of the allowance to capital increases only and by including anti-avoidance rules – perhaps by drawing on the experiences of the existing Belgian national ACE. scheme which resulted in significant revenue losses. Limiting interest deductions is also intended to mitigate revenue losses and it is clearly hoped that this will help alleviate some of these concerns.
However, while this new limitation on interest deductibility has potential benefits for Member States in terms of limiting revenue losses, this aspect of the proposal will be of concern to taxpayers who are already struggling with other rules which overlap with these proposals, such as the OECD’s second pillar. Member States may fear that this aspect of the new rules could lead to the relocation of companies outside a Member State and an erosion of its tax base. A pan-European implementation would, of course, mitigate such effects between member states, although the risk of pushing investment outside the EU would remain.
Another impediment to implementation is the thorny issue of constitutional compatibility. The existing German interest limitation rules that implement ATAD are still the subject of an ongoing constitutional challenge in German courts. Could a similar challenge undermine the new interest deductibility restriction aspects of the DEBRA proposals?
And then ?
The draft directive is open for comments until July 11. Member states will soon begin their consideration of the proposal in the Council and, while the Commission hopes to secure an agreement in the autumn, it is uncertain whether an agreement can realistically be reached by the end of the year. ‘year. If adopted as a directive, it should be transposed into the national law of the Member States by 31 December 2023 at the latest and enter into force on 1 January 2024.