European Union: European Commission seeks to address debt-equity bias

In brief

On 18 May 2021, the European Commission (EC) published a new communication setting out the EC's views on the future of business taxation within the European Union (EU), particularly in light of the envisaged post-COVID-19 recovery.

In view of business taxation for the 21st century, the EC has proposed a range of new measures. One of these measures consists of the creation of a Debt Equity Bias Reduction Allowance (DEBRA).


Contents

The DEBRA measures aim to encourage companies to finance their investments through equity rather than debt financing by the creation of a harmonized tax environment that would place debt and equity financing on an equal footing across the EU. The EC's rationale behind the DEBRA measures is that the debt bias in business financing has led to an increasing reliance on debt financing rather than equity. This (over-indebtedness) could, ultimately, jeopardize the stability of the financial system and therefore increase the risk of insolvencies, which in turn would increase unemployment.

On 14 June 2021, the EC issued its Inception Impact Assessment for DEBRA (which is typically the start of the public part of a Commission legislative initiative, with a public consultation to follow soon). In this tax alert, we will provide the key takeaways from the Impact Assessment.

In depth

The EC notes that, within the European corporate tax systems, debt financing is generally encouraged through the tax deductibility of related interest payments. In contrast, costs associated with equity financing, such as the payment of dividends, are not deductible.

In 2019, the total debt of non-financial corporations amounted to almost EUR 14 trillion or 99.8% of GDP in the EU-27. The debt-to-equity ratio was 53.3% in 2019. The EC notes that this imbalance between debt and equity is a potential risk for the entire EU as insolvencies and financial instability easily spread from one EU Member State to another. Some Member States (i.e., Belgium, Cyprus, Italy, Malta, Poland and Portugal) have already introduced measures to counteract the tax-induced imbalance between debt and equity. However, according to the EC, a lack of coordination can lead to tax planning, tax evasion and a skewed allocation of investment. Therefore, the EC proposes to introduce common, harmonized rules applicable throughout the EU.

Proposed measures

The EC envisions two options for balancing the ratios of equity and debt:

  • The first approach concerns the exclusion of the deductibility of interest payments.
  • The second option the EC has in mind is to establish a deduction for equity by allowing the tax deductibility of a notional interest for equity on all outstanding shares of companies, new shares of companies or total capital of companies (equity + debt).

However, the EC states that the proposed measures need to be combined with a series of anti-avoidance provisions in order to prevent tax leakage.

The EC also notes that special measures could possibly be designed for SMEs, as access to equity financing is more difficult for SMEs.

Key takeaways

  • Excess use of debt financing in the Covid era and related intercompany structuring of funding has come under close scrutiny by the EC. Developments on DEBRA should be followed closely to prepare for any potential changes in respect of the tax treatment of corporate debt-equity financing.
  • Harmonizing rules among Member States may be challenging, as unilateral actions have already been taken across the EU.
  • The use of debt by multinationals is motivated by various reasons, including the inability to raise significant equity especially for non-investment grade rated companies. The contemplated measures may contradict with the (corporate) finance objectives – e.g., the funding mix of multinational corporations.
  • The macro impacts of the measures would need to be assessed and modelled appropriately e.g., introducing tax deductibility for a notional interest on equity (second option) will change the cost of capital of companies and in turn may distort their valuations.

Next Steps

As Baker McKenzie, we are closely monitoring this development, actively contributing to the discussion, and we will keep our clients informed of any new developments. If you have any questions regarding the DEBRA proposal, please do not hesitate to reach out to us.

Feedback on the Inception Impact Assessment can be provided until 12 July 2021. Should you wish to provide feedback, our team of experts is available to assist.


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