Introduction
On the 11th of May 2022, the European Commission (the “Commission”) published a European Union (“EU”) Proposal Directive, laying down rules on a debt-equity bias reduction allowance (“DEBRA”), as well as on the deductibility of exceeding borrowing costs (“EBC”) for corporate tax purposes (the “Proposal”). The Proposal broadly aims to mitigate a possible bias towards debt-based financing schemes, given that taxpayers generally find debt funding preferable than equity financing due to the deductibility of interest charges as opposed to the usual non-deductibility of dividend payments/equity repayments. Such asymmetry in the tax treatment of debt and equity may potentially lead to excessive indebtedness and sway taxpayers towards less optimal financing choices from a pure non-tax standpoint.
The Proposal is, in this respect, put on the table as a possible coordinated counteraction to encourage long-term sustainable and less risky investment decisions within the EU, for which increased levels of equity financing are found to be crucial by the Commission[1]. Nonetheless, it should co-exist with other pre-existent measures (namely within the European tax framework), such that, if its implementation is not properly calibrated, the Proposal might end up overlapping and blurring the scope of application these other measures. Its interaction with Interest Limitation Rules (“ILR”), as governed in the Council Directive (EU) 2016/1164 (“ATAD I”), is, in this regard, of particular importance.
Proposal vs ILR
Taking one step back, the Proposal should apply to “taxpayers that are subject to corporate income tax in one or more Members States, including permanent establishments in one or more Member State of entities resident for tax purposes in third countries”[2]. In brief, it includes two main sets of rules: (i) an allowance on the increases of net equity from the taxpayers’ tax base for ten consecutive periods, computed by multiplying the allowance base by a notional interest rate, as determined under Article 4 of the Proposal, and (ii) an additional limit on the deduction of EBC costs as defined in Article 1(2) of ATAD I, pursuant to which taxpayers shall only be able to deduct up to 85% of such costs incurred during a given tax period for corporate tax purposes (Article 6(1) of the Proposal).
For starters, it seems that the basis at the level of which the deduction cap is set is aligned between Article 6 of the Proposal and ILR, applying broadly over the interest payments (or economically equivalent charges) of a given taxpayer minus interest income received (or economically equivalent revenues). It also seems that the “tax period” accounted for to compute the EBC of a given taxpayer matches. Indeed, whilst ATAD I also refers to “tax year”, such reference being omitted in Article 3(2) of the Proposal, both sets of rules refer, not only to the calendar year, but also to “any other appropriate period relevant for tax purposes”. This mention seems far-reaching enough to encompass tax years diverging from the calendar year, such that the absence of a strict matching of ATAD I and the Proposal’s wording should be immaterial, and there should be no misalignment in what the computation period should be.
The Explanatory Memorandum to the Proposal also clarifies that, given that ILR should serve different objectives, both sets of rules should be maintained, but, ordering wise, the deductibility cap under the Proposal should be calculated before ATAD I’s limitation to 30% of the taxpayers’ earnings before interest, tax, depreciation and amortisation (“EBITDA”) or 3 million euros (“EUR”), whichever is higher[3]. The question may nevertheless boil down as to whether the priority in the calculation of the Proposal’s cap should mean that the starting basis for the computation of EBC under ILR should already account the 85% threshold. A pre-capped definition of EBC though seems rather circular, given that Article 6(1) of the Proposal uses the definition of Article 1(2) of ATAD I as the computation basis (i.e., it would presuppose the application of the Proposal’s deductibility cap to the definition of EBC under ILR before actually determining the calculation base of Article 6(1) of the Proposal for the application of the 85% limitation). As pointed out by some tax literature[4], further clarification is desirable in this respect, given the likely complexity increase that taxpayers may face when determining what should be their EBC.
Differences in the modus operandi of the Proposal and ILR may also be found, being worth highlighting.
Firstly, no de minimis threshold is proposed under Article 6(1) of the Proposal, conversely to ILR, where taxpayers may rely on the EUR 3 million safe harbour rule, intended to strike a balance between compliance and administrative burden, and the need to safeguard the effectiveness of ATAD I’s earnings stripping rule[5].
Secondly, whereas under Article 4(6) of ATAD I, Member States are allowed to devise carry forward and carry back mechanisms of EBC which are not deductible in a given tax period, the Proposal’s additional cap does not allow for the carry forward (or back) of the 15% non-deductible EBC, the deduction of which being therefore permanently lost. It is nevertheless clarified in the Proposal’s Article 6(1) third sentence that, in case the deductible EBC under ILR are lower than 85% of a given taxpayer’s EBC, the difference may be carried forward or back in accordance with the ILR. Yet again, the permanent denial over the 15% of EBC will adversely impact taxpayers, which will end bearing a higher tax burden, hence negatively impacting their tax equity, and ultimately going against the Proposal’s objective to incentivise higher levels of equity funding[6]. Furthermore, and as stressed by some tax literature[7], the peremptory lack of deductibility is particularly prone to give rise to adverse effects in case of forex losses on interest receivables/payables (falling within the definition of EBC), to the extent that no mechanism is envisaged to (at least partially) set them off against potential forex gains generated on the interest component of the same financial instrument in a future year.
Lastly, whilst the Commission mentions that only a limited number of taxpayers will end up moving from ILR to the Proposal’s cap[8], the carve-outs governed under Article 2 of the Proposal leave out some of the exclusions provided by Article 4 of ATAD I. Indeed, taxpayers who rely on the equity-escape carve out rule of Article 4(5)(a) of ATAD I, falling outside the scope of ILR’s cap, will face a new permanent denial of 15% of their EBC. The same should hold true for other carve-outs, such as the exception for loan financing of long-term infrastructure projects (defined as projects “to provide, upgrade, operate and/or maintain a large-scale asset that is considered in the general public interest by a Member State” – Article 4(4)(b) of ATAD I) and the exception for standalone entities (Article 4(3)(b) of ATAD I). Moreover, taxpayers availing themselves of the group ratio rule of Article 4(5)(b) of ATAD I to increase their deductibility ratio above 30% of their EBITA will see their subsidiaries being subject to a deductibility cap of 85% of their EBC[9]. Arguably, this misalignment would not come as surprising given the different policy objectives followed by the two sets of rules at stake. Yet, even that being the case, it could still be questioned whether the deliberate omission to namely the long-term infrastructure projects carve-out would be adequate in light of the EU’s objective outlined by the Proposal itself to foster a “fair and sustainable business environment, including through targeted tax measures that incentivise investment and growth” [10]. Due to the additional deductibility cap, investors might be less willing to debt finance such businesses.
For the above-mentioned reasons, and arguing that the additional deductibility cap may bar taxpayers (particularly small and medium enterprises) from accessing equity markets[11], some stakeholders stated during the EU public consultation on the Proposal that the latter should be optional[12], or even that the additional debt deductibility cap should be discarded, whilst maintaining the equity allowance[13].
Conclusion
The impact of the Proposal’s new earnings stripping rule seems undoubtful, being particularly prone to affect highly leveraged taxpayers and distressed companies[14]. Taxpayers may see their day-to-day operations compromised by the additional bar to access or grant debt financing, which would have enabled them greater flexibility to serve cash flow, treasury and repatriation needs, as well as to adjust to business and economic cycles. DEBRA’s interaction with ILR should in this respect be thoroughly clarified and coordinated, not only to shelter taxpayers against disproportionate compliance burden, but also to prevent unjustified complexity. Ultimately, these sets of rules are targeted to achieve the common market, and therefore adequate coordination is needed to build up a coherent EU tax framework.
Vasco Chuaqui
December 2022
[1] Explanatory Memorandum to Proposal, point 1.
[2] Article 2 of the Proposal.
[3] Explanatory Memorandum to the Proposal, point 6.
[4] DEBRA (& ILR) – The Commission’s New Tax Initiative to Create a Level Playing Field for Debt and Equity, Marco Dietrich & Cormac Golden.
[5] ATAD I preamble, point 8.
[6] B. Graßl & L. Engeln, The EU DEBRA Directive: A Critical Appraisal from a German Corporate Income Tax Perspective of the European Commission’s Proposal to Reduce Debt-Equity Bias through an Equity Allowance and Interest Expense Limitation, 76 Bull. Intl. Taxn. 10 (2022), Journal Articles & Opinion Pieces IBFD.
[7] L. Hulten, J. Korving & A. Nolten, DEBRA: A Good Idea?, 23 Fin. & Cap. Mkts 3 (2022), Journal Articles & Opinion Pieces IBFD.
[8] Annex 6, Section 1.2, COMMISSION STAFF WORKING DOCUMENT IMPACT ASSESSMENT REPORT Accompanying the document Proposal for a COUNCIL DIRECTIVE on laying down rules on a debt-equity bias reduction allowance and on limiting the deductibility of interest for corporate income tax purposes.
[9] PwC Tax Policy Alert, 17 May 2022, EU Commission publishes proposal to implement debt-equity bias reduction allowance (‘DEBRA’).
[10] Explanatory Memorandum to Proposal, point 1.
[11] Public consultation document on the Proposal, Union des Entreprises Luxembourgeoises.
[12] Public consultation document on the Proposal, Association of the Luxembourg Fund Industry.
[13] Public consultation document on the Proposal, Union des Entreprises Luxembourgeoises.
[14] B. Graßl & L. Engeln, The EU DEBRA Directive: A Critical Appraisal from a German Corporate Income Tax Perspective of the European Commission’s Proposal to Reduce Debt-Equity Bias through an Equity Allowance and Interest Expense Limitation, 76 Bull. Intl. Taxn. 10 (2022), Journal Articles & Opinion Pieces IBFD.