The EU proposal on reducing the debt-to-equity bias from a Dutch tax perspective

0

On May 11, 2022, the European Commission published the Proposal for a Directive on Debt Bias Reduction Allowance (DEBRA). The proposal introduces a deduction for new equity-financed investments on the one hand, but further limits the deductibility of interest charges on the other hand.

This proposal, once adopted as a directive, should be transposed by Member States into their national legislation by 31 December 2023 and enter into force on 1 January 2024.

EU Member State tax regimes generally allow interest payments on debt to be deducted when calculating the tax base for corporate tax purposes, while equity financing costs, such as dividends, are mostly non-deductible. This leads to a more favorable treatment of debt than equity (from a tax point of view), which gives companies more incentive to borrow rather than finance their investments by increasing their capital.

In the Netherlands, (arm’s length) interest payments made by a Dutch taxpayer are in principle deductible, if the financial instrument qualifies as a debt instrument, unless certain interest deduction rules apply. apply. The Netherlands has specific interest deduction rules and has implemented the income stripping rule of the first EU Anti-Tax Avoidance Directive (ATAD) as follows: the interest deduction is limited to 20 % of earnings before interest, taxes, depreciation, and amortization (EBITDA), with a threshold of 1 million euros ($1.016 million) and a rule for deferral of non-deductible interest.

Notwithstanding the above, the EU still perceives that there is a leverage bias that (among other business-related factors) contributes to excessive build-up of corporate debt. High indebtedness could threaten the financial stability of companies (making them vulnerable to unforeseen changes in the business environment) and increase the risk of bankruptcies (especially in times of crisis, such as the COVID-19 pandemic).

The proposed directive aims to encourage companies to finance their investments with equity rather than debt.

The DEBRA proposal would apply to all taxpayers subject to corporation tax in one or more Member States, with the exception of certain financial undertakings, such as credit institutions, investment undertakings, insurance and certain retirement institutions.

The DEBRA proposal contains two measures that apply independently:

To encourage investments financed with own funds, a deductible allowance on own funds has been introduced. This allowance is calculated by multiplying a base (‘allowance base’) by a rate (‘notional interest rate’).

  • The calculation basis is the difference between the amount of equity (as defined in Article 3(6) and (7) of the proposed DEBRA Directive) at the end of the tax year and the amount of equity at the end of the previous tax year.

  • The rate (notional interest rate) is composed of a risk-free interest rate (specific to each currency) for ten-year debt. This rate is then increased by a risk premium of 1% or, in the case of small and medium-sized enterprises (SMEs), by a risk premium of 1.5% (financing of SMEs is generally perceived as riskier ).

  • The equity deduction calculated in a given year is deductible for ten consecutive tax years. To avoid tax abuse, the deductibility is limited to 30% of EBITDA for each year.

  • If the taxable profit is insufficient to prevent the deduction of part of the calculated allowance, this part may be carried forward without time limit.

Any unused equity deduction in excess of 30% of taxable income can be carried forward, for a maximum of five tax years.

2. Limitation of the interest deduction

On the other hand, to discourage recourse to debt, the proposal introduces a limitation on the deduction of interest. A maximum of 85% of the excess borrowing costs (interest paid less interest received) will be deductible from the tax base. Thus, 15% of these costs will not be deductible.

In order to prevent the capital allowance from being used for unintended purposes, the proposal contains several anti-abuse rules.

Competition between the current ATAD 1 interest limitation rules and the proposed interest deduction limitation may occur. In this case, the DEBRA limitation applies first. The ATAD 1 limitation comes next. If the result after applying the ATAD 1 rules is a lower deductible amount, the difference can be carried forward or back.

Comments from a Dutch tax perspective

The DEBRA proposal encompasses a carrot and a stick for taxpayers.

Many welcome the equity deduction allowance (carrot) as a useful tool to support business recovery from the COVID-19 pandemic and to create an incentive to invest through equity. At the same time, a (further) limitation on the interest deduction further restricts companies in their possibilities for debt financing (stick).

There are also questions about the competition between ATAD 1 and the DEBRA proposal. For example, the interest deduction rule in DEBRA refers to Section 4 of ATAD 1 for the purpose of calculating non-deductible interest. However, EU member states may have implemented ATAD 1 differently, with EBITDA percentages below 30% (such as the Netherlands), still lower deductible borrowing cost overrun thresholds to 3 million euros (such as the Netherlands) or such an EU member state. states may have chosen to introduce the grandfather clause (which DEBRA does not contain).

Consistency between the proposed interest deduction limitation and ATAD 1 could result in the permanent loss of some of the excess funding cost. The proposal could also affect the applicability of the often favorable Dutch participation exemption. The equity allowance may result in a reduced tax burden compared to non-EU entities unable to apply the equity allowance.

The taxability test (ie the income is subject to actual income tax of at least 10%) would be more difficult to pass. Due to the combination of local tax base differences with the proposed equity allowance, it becomes more complex to fully calculate a country’s effective tax rate (especially if it is a subsidiary outside the EU).

Finally, with regard to the second pillar of the OECD (comprehensive minimum tax), the financial statements may not take into account the proposed equity deduction, which could have an impact on the effective tax rate recognized for purposes of the second pillar.

The equity deduction is a welcome incentive for equity financing which can, in particular, help start-ups and scale-ups. While complicated factors such as the effect on the participation exemption and the second pillar make it interesting to see whether the DEBRA proposal in its current form will, and can ultimately, pass, taxpayers would be wise to review their structure of current funding, as well as their future funding mix.

Share.

Comments are closed.