In this alert we provide an outline of two recent EU developments: (1) the proposal for an EU Directive which introduces a tax deductible allowance on equity and a limitation on the deductibility of interest costs, and (2) amendments proposed by EU parliament to the ATAD 3 Directive, the Directive on the misuse of shell entities for tax purposes.
DEBRA: Debt Equity Bias Reduction Allowance – Draft EU legislation providing an allowance on equity
On May 11, 2022 the European Commission published a proposal for an EU Directive laying down rules to introduce a tax deductible allowance on equity and rules further limiting the deductibility of interest costs (“DEBRA”). The Directive should become effective as per January 1, 2024 and would apply to all taxpayers that are subject to corporate income tax in one or more EU Member States, with the exception of financial undertakings.
Below we provide an outline of the key features of DEBRA.
The DEBRA Directive is part of the EU strategy on business taxation and addresses the tax related asymmetry in the treatment of equity versus debt financing. This asymmetry currently exists because costs related to debt financing are typically tax deductible while costs related to equity financing are not. The latter incentivizes EU companies to take on debt rather than equity to finance their growth. By introducing a tax deductible allowance on equity and further limiting the deductibility of interest costs, EU businesses should be incentivized to take on equity financing to finance their growth.
Allowance on equity
The DEBRA proposal introduces a tax deductible allowance on equity (Allowance) that is computed by multiplying the Allowance Base with the relevant Notional Interest Rate (NIR).
The Allowance Base is the year-on-year increase in equity where equity is defined as the sum of paid-in capital, share premium, revaluation reserves, other reserves and profit or loss brought forward. The year-on-year increase in equity is calculated by deducting the net equity at the end of the tax year from the net equity at the end of the previous tax year. Net equity is defined as the difference between the equity of the taxpayer and the sum of the tax value of the taxpayer’s participation in the capital of associated enterprises and of its own shares.
The NIR is based on two components: the risk-free interest rate for a 10-year debt plus a risk premium (1% or 1.5% for SME’s is currently proposed).
In short the Allowance is therefore calculated as follows:
Allowance on equity = Allowance Base X Notional Interest Rate
The Allowance is granted for ten years to approximate the maturity of most debt. This means that if an increase in a taxpayer’s equity qualifies for an Allowance under this proposal, the relevant Allowance shall be tax deductible in the year it was incurred and in the next consecutive nine years.
For the purpose of preventing tax abuse the deductibility of the Allowance is limited to a maximum of 30% of the taxpayer’s EBITDA for each tax year. A taxpayer will be able to indefinitely carry forward the part of the Allowance that would not be deducted in a tax year due to insufficient taxable profit. In addition, the taxpayer will be able to carry forward, for a period of maximum five years, unused allowance capacity, where the Allowance on equity does not reach the aforementioned maximum amount.
In case the computation as shown above results in a negative amount (e.g. due to equity decrease), this will result in an increase of the taxable income, unless the taxpayer provides evidence that this is due to losses incurred during the tax period or due to a legal obligation to reduce capital.
On a final note, there are three anti-abuse measures in place to ensure that the rules on the deductibility of an allowance on equity are not used for unintended purposes:
- No allowance is granted in case of equity increases that originate from (i) intra-group loans, (ii) intra-group transfers of participations or existing business activities and (iii) cash contributions under certain conditions.
- No allowance is granted in case of equity increases that originate from contributions in kind or investments in assets, in order to prevent the overvaluation of assets.
- No allowance is granted in case of equity increases following a re-characterization of old capital into new capital (e.g. through a liquidation or the creation of start-ups).
Interest deduction limitation
The deductible allowance on equity is accompanied by a limitation to the tax deductibility of debt-related interest payments. More specifically, a restriction will limit the deductibility of interest to 85% of exceeding borrowing costs (i.e. interest paid minus interest received).
This interest deduction limitation has some interaction with the earning stripping measure of ATAD1, where in short this new limitation expands the non-deductibility of interest costs to 85% of the exceeding borrowing costs in case the earnings stripping measure is not resulting in the non-deductibility of interest costs to 85% of the exceeding borrowing costs. With this approach the EU is addressing the debt-equity bias simultaneously from both the equity and the debt side.
Amendment ATAD 3 Directive (misuse of shell entities) by EU Parliament
On December 22, 2021 the European Commission published a proposal for a Directive that is laying down rules to prevent the misuse of shell entities for tax purposes (Anti-Tax Avoidance Directive 3 abbreviated to “ATAD3”). In effect, ATAD3 could result in the disallowance of certain tax benefits for EU entities in scope of the Directive. Recently, officials of Ireland noted and acknowledged during EU meetings that ATAD3 was prepared hastily. Hence, it is expected that various chapters will be significantly rewritten as ATAD3 contains a too wide reaching scope and does not take into account many of the genuine reasons of why shell entities and outsourcing is necessary.
European Parliament published an amended proposal of ATAD3 on May 12, 2022. The most significant proposed changes for now seem to include:
- Change in the outsourcing Gateway criterion whereby outsourcing of the administration of day-to-day-operations and the decision-making on significant functions to an associated enterprise within the same jurisdiction should not lead to fulfilling the outsourcing Gateway.
- It is now expected that ATAD3 will not enter into force until January 1, 2025 which would result in the look back-period to start as of January 1, 2023.
We recommend clients to be aware that, although ATAD3 is postponed, the general trend is that tax benefits are granted to entities with economic substance.
With this update we have provided you with a high-level overview of the recent EU developments. If you already would like to understand more about the impact of these developments on the tax position of your company, please feel free to reach out to us. We would be happy to schedule a meeting with you at one of our offices or virtually through a MSTeams meeting to discuss the proposals in more detail.