If one were to regard the European Commission’s Directive proposal to tackle the debt-equity bias in the tax system as the fruit of a discussion that started around a decade ago, it appears overly complex and unambitious at the same time.
A Commission-published Taxation Paper of July 2012 explored the tax bias in favour of debt financing which arises because, in most corporate tax systems, interest is tax-deductible whereas no comparable deduction in relation to equity financing exists (I say “most corporate tax systems” because six EU Member States do have an equity deduction). As is usually the case, tax alone is not determinative (and the paper refers to research regarding the impact of other factors), but it is a factor that companies take into account – and it is a factor that governments can influence relatively easily. So, it is unsurprising that, in circumstances (such as the economic fallout from a global financial crisis or a pandemic) where Governments may wish to encourage companies to deleverage, a reduction of the debt-equity bias would be considered.
The 2012 paper pointed to three possible solutions - the introduction of an equity allowance, the abolition of interest deductions or a combination of the two – and foreshadowed that revenue-neutrality would likely be a key concern in the policy design. The Commission considered the same types of option and has now proposed a time-limited allowance for new equity, paired with an additional cap on interest deductibility to limit the adverse budgetary impact of the new allowance.
The new allowance is essentially a notional interest deduction on new equity at the 10-year RFR plus 1% (or 1.5% for SMEs) which applies for a period of 10 years. This time limitation is a deliberate policy choice to prevent “that the measure transforms, over time, into a stock-based allowance” (see the Impact assessment report which can be downloaded from this page). But it also limits the efficacy of the allowance in redressing the debt-equity bias as debt could, in theory, be rolled indefinitely (thus, maintaining the interest deductions beyond a limited initial term). In addition, the allowance is subject to a clawback in the case of a decrease in equity which seems, again, quite different from the way interest deductions operate.
The proposed additional interest restriction is intended to limit the deductibility of interest to 85% of the excess borrowing costs (i.e. interest paid minus interest received. It is also intended to sit alongside the 30% of EBITDA interest limitation rule under ATAD and certain carry-forwards and carry-backs would apply to make that co-existence work. Somewhat curiously, the proposed restriction is phrased as an instruction that Member States “shall ensure that a taxpayer is able to deduct…up to an amount (a) corresponding to 85% of such costs” whereas ATAD actually instructs that such costs “shall be deductible…only up to 30 percent of the taxpayer’s” EBITDA (my emphasis). The former wording sounds almost as if it was intended to guarantee a minimum level of interest deductions, but the accompanying documents make clear that the policy intention is to introduce a limitation.
Overall, the Commission’s proposal entails a significant degree of complexity, both in terms of its co-ordination with existing rules, but also in terms of ensuring that the proposal works as intended. Anti-avoidance rules are a key element of this. The proposed Directive includes explicit anti-avoidance provisions, for example to prevent the artificial creation of allowances through group reorganisations, but avoidance-prevention is also designed into the operative provisions. For instance, the allowance base is designed to leave out of account new equity that is simply passed down through a group to prevent a cascading of allowances.
It is likely that, during the legislative process, the question will be asked whether the complexity is worth it, for instance, to encourage deleveraging following an increase in debt during the pandemic. In answering that question, one might look at the experience of the Member States which have introduced equity allowances. One of them is Italy. The OECD’s economic survey published in September 2021 notes that a study estimates that the allowance “reduced the leverage ratio by around 9 percentage points in solvent manufacturing firms with a leverage ratio of around 50%”, but is also notes that its impact has likely been reduced as the allowance has become less generous. And this makes me wonder whether a time-limited allowance set at 10-year RFR plus 1% (or 1.5%) is unlikely to make a significant enough difference to the debt-equity tax bias to be a worthwhile enterprise. It would have been nice to see something bolder from the Commission.