The EU Commission’s proposal to strengthen equity

In May 2022, the European Commission unveiled a draft directive to equal out the tax treatment of equity and debt, which allows for the deduction of notional interest on equity on the one hand, and also contains a limitation on interest deduction on the other.

The draft directive goes back to the EU Commission communication published on 18 May 2021 on the creation of a robust, efficient and fair business tax system in the EU. The present draft directive addresses the varying treatment of equity and debt for income tax and lays down solutions to equalise taxation: the debt-equity-bias reduction allowance – DEBRA.

Its objective is to limit the funding of EU undertakings with debt, which often has a tax-related motivation due to the interest deduction available, and thus to create a stronger incentive for businesses to be funded with equity. This should allow businesses to be better equipped for crises, for example. The directive is due to be transposed into national law by 31 December 2023 and be applied from 2024. For countries that currently already allow notional interest deduction on equity, generous transitional rules are planned.

It should be noted, however, that this is still a draft, and it is not clear when, or even if, it will be implemented. A major hurdle here is the unanimity which is required for such directives among the Member States of the Council.

Personal scope

The directive applies to all taxpayers who are liable to corporate income tax in one or more Member States. It also covers the EU permanent establishments of third-country companies. The directive is not to apply to financial undertakings.

Notional interest deduction

To motivate the funding of businesses with equity the draft directive envisages allowing a notional interest deduction for an ‘increase in equity’ over a ten-year period.
This notional interest deduction is calculated as follows:

‘Increase in equity’ x ‘notional interest rate’ = notional interest deduction

‘Increase in equity’ is the amount by which net equity at the end of the financial year exceeds net equity at the beginning of the financial year, thus the growth in equity over one year.

If the directive is actually implemented and is applicable from 2024, this would mean, for example, that a notional interest deduction could not be claimed in future for the equity a business reports as at 31 December 2023. Only increases in equity starting from 2024 would be able to take advantage of a notional interest deduction. Hence, the planned implementation leads, at least until the end of 2023 and contrary to the original intention, to an incentive to fund businesses with debt instead of equity and to make a change from debt to equity only after the directives have been implemented.

In determining net equity, the following items among others are deducted from equity to avoid cascading effects across associated undertakings:

• Participations in subsidiaries and loans to associated enterprises
• Equity that was created by restructuring within associated enterprises
• Certain contributions, particularly contributions in kind.

The precise formulation of these kinds of anti-abuse provisions are still quite unclear.
The ‘notional interest rate’ is composed of the ten-year risk-free interest plus a premium of 1 or 1.5 percent for small and medium-sized enterprises.

The notional interest deduction calculated in this way can then be deducted in the relevant assessment period and in the nine assessment periods that follow.

A clawback, that is a tax determination of notional interest income over a ten-year period, applies in the case of certain reductions in equity. The notional interest income is limited to the amount of the notional interest expenses previously claimed. This does not apply to reductions in equity that occur as the result of losses. The deduction of notional interest is limited to a total of 30 percent of EBITDA.

Further limitation on interest deduction

For reciprocal financing and to discourage businesses investing with debt, the proposed directive envisages net interest (that is, interest expense less interest income) generally only being deductible up to 85%.

The limitation of the deductibility of net interest expense to 85 percent should take precedence over other existing restrictions on interest deduction (e.g., the ‘interest barrier’ (Zinsschranke). Net interest exceeding 85% may not be carried forward and is therefore ultimately not deductible – similarly to how it currently stands in Germany with the 25% trade tax addition of interest expenses.

Practical note

Implementation of the proposed directive should continue to be observed to determine the effects notional interest deduction and further restriction of interest deduction will have and to make any adjustments to the equity and debt funding of businesses at the right time. Since increases in equity may only benefit from a notional interest deduction starting from 2024 (assuming the rules apply from 2024), any planned equity increases should be delayed. But we also point out again that due to the requirement for unanimity among the Member States, it is highly uncertain if or when the proposed directive will be implemented.