The DEBRA Directive: The beginning of the end for the bias

The European Commission published a proposal for the so-called DEBRA Directive the past month. DEBRA stands for Debt-to-Equity Bias Reduction Allowance and its aim is to counteract the tendency of companies having a preference for debt financing due to the fiscal deductibility of its costs, namely interest, for the purpose of corporate income tax.

Equity financing does not benefit from the same tax treatment in terms of benefits, such as the deductibility of costs associated with the financing, and thus companies may be led to resort mainly to debt financing, which increases the risk of over-indebtedness and all other deriving risks.

What the new directive proposal lays out is a set of rules that should present equity financing as equally or at least similarly attractive for companies, as well as for equity investors themselves. The regime is built upon the granting of an allowance to the encompassed companies, which will be able to deduct such amount to the taxable profits.

Regarding the amount of the allowance to be deducted, it is compounded through the multiplication of the allowance base for the notional interest rate that is to be applied. The allowance base consists essentially of the net equity increase in a given tax year, meaning it is the difference between the level of net equity at the end of the tax period and the level of net equity at the end of the previous tax period.

The notional interest rate will consist of a risk-free interest rate for the currency of the taxpayer, which may be increased through the addition of a risk premium of 1%, or of 1.5% if the taxpayer is an SME. This risk-free interest rate will essentially be the the risk-free interest rate with a maturity of 10 years for such currency, as laid down in the implementing acts adopted pursuant to Article 77e(2) of Directive 2009/138/EC, for the reference date of 31 December of the year preceding the relevant tax period

Taxpayers will not be allowed to deduct more than 30% of its EBITDA in on tax year. If the allowance exceeds that threshold, the exceeding amount may be carried forward.

Adding to the equity allowance deduction, the Proposal includes a limitation of 15% for the deductibility of debt financing costs (i. e. interest), as well as a number of anti-abuse norms.

Curiously enough, despite there not being any harmonized legislation on the matter yet, the Portuguese tax legislation already includes a similar regime – the Remuneração Convencional do Capital Social, which translates to Conventional Share Capital Remuneration – which has been in place since 2014.

The regime provided for in Article 41-A of the Statute of Tax Benefits allows a company to deduct from its taxable profits an amount corresponding to remuneration of share capital at a rate of 7% in each tax year on such equity contributions, which can be up to a maximum of € 2M.

This should be the beginning of the end for the debt-to-equity bias in Europe, as the fiscal legislation of all member-states will now provide for similar or increasingly similar benefits for both debt and equity financing, without tipping the scales in favor of the former.

José Miguel Saraiva

Julho 2022