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Financing decisions may get easier and harder under the new EU Debra proposal

Tom Maguire discusses the EU Debra proposal in his Business Post column

I’ve been talking about corporate tax deductions for interest for some time in this column because as we know cash, sourced from either debt or equity, is the lifeblood of business. In general, tax deductions are given where a company finances its activities by debt and not equity (the so-called debt equity bias).

On 11 May 2022, the European Commission released a draft for a new directive to address this tax-induced debt-equity bias. The proposal includes both a debt-equity bias reduction allowance (Debra) in the form of a notional interest deduction on equity and a general limitation on the tax deductibility of debt-related interest payments. Regular readers of this column will be asking the question; don’t we already have a limitation on interest rules? I’ll get to that in a minute.

According to the European Commission, encouraging companies to accumulate debt may lead to a high incidence of insolvency, with a negative effect for the EU as a whole. The debt bias also penalises the financing of innovation through equity. So the European Commission proposes to tackle the debt-equity bias by introducing two separate rules that would operate independently and apply to all taxpayers that are subject to corporate tax in one or more member states, except for certain financial undertakings.

The draft directive proposes an allowance on equity by providing for the tax deductibility of notional interest on increases in net equity. The deductible amount would be computed by multiplying the relevant equity by the applicable notional interest rate (NIR). The allowance is based on the year-on-year increase in net equity, i.e., the difference between the net equity at the end of the relevant tax year and the net equity at the end of the previous one.
The NIR consists of two components, the currency specific risk-free rate and a risk premium. The risk-free rate is based on the Solvency II directive and the risk premium generally would be set at 1%. However, a higher rate of 1.5% is proposed for small and medium-sized enterprises to acknowledge that they usually face a higher burden in obtaining finance.

The allowance on equity would be granted for 10 years, meaning that it would be deductible in the year it was incurred and in the next successive nine years. To prevent tax abuse, the deductibility of the allowance for each tax year would be limited to a maximum of 30% of the taxpayer’s earnings before interest, taxes, depreciation, and amortisation (EBITDA). Any excess allowance that cannot be deducted as a consequence of the 30% limitation would be able to be carried forward indefinitely. Any unused allowance capacity could be carried forward for five years, where the allowance on equity does not reach the maximum amount.

In addition to the 30% EBITDA rule, the directive proposal contains several other anti-abuse provisions to prevent the use of the allowance as a new mechanism for base erosion and to prevent effecting an equity increase in an abusive manner. The anti-abuse measures address among other issues, intragroup loans, certain cash contributions, and equity increases as result of a contribution in kind or investment in assets. If a taxpayer’s equity decreases in a certain year after the taxpayer has been granted the allowance on equity in a preceding year, the rules provide that a proportionate amount (calculated in the same way as the allowance) would become taxable for 10 years, unless the decrease is caused exclusively by losses or a legal obligation.

The allowance on equity is accompanied on the debt side by a rule limiting the deductibility of interest. This rule limits the deductibility of interest to 85% of the taxpayer’s exceeding borrowing costs, i.e., the excess of interest paid over interest received. All EU member states either already have implemented a general interest limitation rule in accordance with the EU’s Anti-Tax Avoidance Directive (ATAD), or are continuing to apply equally effective existing domestic measures through 1 January 2024 under transitional provisions in ATAD. We brought in the new-fangled Interest ATAD Limitation Rule as part of last year’s finance act.

The European Commission has indicated that the ATAD interest limitation rules should apply in parallel with the interest limitation rule proposed in this directive. Companies would first calculate the deductibility of exceeding borrowing costs under the Debra rule and then under ATAD, with the lower of the two amounts being deductible. In the event that the parallel application resulted in a lower deductible amount under the ATAD rule, the taxpayer would be entitled to carry the difference forward and/or back in accordance with the domestic implementation of the ATAD rule.

For the directive proposal to be adopted, member states would need unanimously to agree in the Council of the EU on the draft text. The European Parliament and European Economic and Social Committee also must be consulted and give their opinion, although this is not binding. The proposal may, therefore, be viewed as the starting point for discussions.

If adopted, EU member states would be required to transpose the directive into their domestic legislation. Currently, the implementation deadline is set at 31 December 2023 and it’s proposed that member states apply the directive as from 1 January 2024. The six member states (Belgium, Cyprus, Italy, Malta, Poland, and Portugal) that already have rules in place providing for an allowance on equity may choose to apply a “grandfathering” clause. This means that taxpayers that already benefit from a domestic allowance on equity as at the date of entry into force of the directive would be able to continue to benefit from the specific national allowance for a period of up to 10 years.

In Ireland, achieving a tax deduction for interest on debt financing is already galactically complex and that’s before you get to the ATAD restriction. That’s why we had said our laws were equally effective to ATAD before we legislated for it. Making such deductions more complex is not a good move. Allowing a deduction for interest on equity would be attractive, but further restricting interest deductions in the process where we have already brought about the complex ATAD version seems a bridge too far to me. This is still at proposal stage so hopefully the latter could be revisited before the proposal may become law here. In my view, we should be looking to simplify what we already have before we go any further because in terms of investment decisions simplicity eats complexity for breakfast.

Please note this article first featured in the Business Post on Sunday 12 June 2022 and was re-published kindly with their permission on our website.

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