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European Union

13 May 2022

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European Commission Proposes Debt Equity Bias Reduction Allowance to Promote Equity Investment

The European Commission has announced its Proposal for a Council Directive introducing a debt-equity bias reduction allowance (DEBRA), which was consulted on in 2021. The allowance is meant to incentivize equity investment, rather than debt, by providing that increases in a taxpayer's equity from one tax year to the next will be deductible from its taxable base, similar to what happens with debt. Further details are provided in a Q&A issued with the announcement.

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Questions and Answers on the Commission's proposal to tackle the debt-equity bias in taxation (DEBRA)

What is the debt-equity bias?

Most countries, including in the European Union, treat debt more favourably than equity from a tax perspective. They do so by allowing interest payments to be deducted from their taxable income, while not offering the same allowance to equity. This gives businesses a major incentive to borrow, rather than to fund new investments by increasing capital.

Why is the debt-equity bias a problem?

The debt-equity bias can encourage companies to make their business decisions based on the related tax treatment, rather than on commercial considerations. This can lead to some companies choosing debt financing over equity, even if it is not the best option for them. Equity should receive similar tax treatment as debt, so that companies can consider both options on an equal footing and choose the source of financing that is best for their business-model.

What are the advantages of tackling the debt-equity bias?

Addressing the debt-equity bias could contribute to the re-equitisation of companies, making them stronger and more resilient to shocks. Equity is also particularly important for fast-growing innovative companies in their early stages and for companies that wish to expand globally.

The green and digital transitions require new investments in innovative technologies. More than 50% of green investment in the coming years is estimated to come from new technologies, requiring more risk financing. Equity will therefore have an important role in fostering the sustainable transition towards a greener economy and in Europe's overall growth and economic stability.

What is the European Commission proposing?

The Commission's proposal will create a level playing field for debt and equity, from a tax perspective, thereby removing taxation as a factor which can influence companies' funding decisions. The proposal would make new equity tax deductible, just as debt currently is.

A more favourable rate of deduction is proposed for SMEs, given that they have more difficulty in accessing equity markets than larger companies.

How will this work in practice?

The equity allowance would be computed based on the difference between net equity at the end of the current tax year and net equity at the end of the previous tax year, multiplied by a notional interest rate. This means that the allowance would be granted only for the sum of equity increases over a specific year.

The notional interest rate is the 10-year risk-free interest rate for the relevant currency, and increased by a risk premium of 1% or, in the case of SMEs, a risk premium of 1,5%.

The allowance on equity is deductible for 10 consecutive tax years, as long as it does not exceed 30% of the taxpayer's taxable income.

Moreover, if the allowance on equity is higher than the taxpayer's net taxable income, the taxpayer may carry forward the excess of allowance on equity without a time limitation.

Taxpayers will also be able to carry forward their unused allowance on equity which exceeds the 30% of taxable income, for a maximum of 5 tax years.

Lastly, the proposal introduces a reduction of debt interest deductibility by 15%, so to better mitigate the debt-equity bias, not only from the equity side but also from the debt side.

How does this fit into the wider Commission tax agenda?

In May 2021, the Commission published its Communication on Business Taxation for the 21st Century, which sets out a long-term vision to provide a fair and sustainable business environment and EU tax system, as well as targeted measures to promote productive investment and entrepreneurship and ensure effective taxation. DEBRA was one of the actions proposed to help businesses left vulnerable by the COVID crisis, preventing insolvencies and instability.

The proposal also contributes to the EU's Capital Markets Union Action Plan (CMU), which aims at helping companies raise the capital they need, particularly as they navigate the post-pandemic period. The CMU incentivises long-term investments to foster the sustainable and digital transition of the EU economy.

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