The European Commission (EC) has proposed a new tax incentive to encourage funding new investment by increasing capital. The objective of the proposal is to tackle the debt-equity bias by introducing a new corporate tax relief to level the playing field for debt and equity.

The EC was presented with two courses of action when deciding how to tackle the debt bias: they could further limit interest deductibility or introduce a deduction for equity. Early indications surrounding the proposals were pointing towards the latter, particularly in light of widespread rules to limit interest deductions (prompted by the OECD's BEPS project and implemented in the EU through ATAD 1). However, the EC has proposed both options, so in addition to the new equity allowance, further restrictions on interest deductions are also proposed. In reality, changes to interest restriction rules were never really off the table. The budget constraints of individual Member States meant this would inevitably be under consideration at a domestic government level. The EC proposal at least harmonises the limitation.

The debt-equity bias reduction allowance (DEBRA) will allow new equity to be deductible for corporation tax purposes just as debt interest currently is across many tax systems. The allowance is calculated based on the difference between net equity over two consecutive tax years, multiplied by a notional interest rate (the 10-year risk-free interest rate for the relevant currency plus a risk premium set at 1% or 1.5% for SMEs).

The Limitation to Interest Deduction (LID) rule accompanies DEBRA and will work in parallel to existing ATAD interest restriction rules by limiting the deductibility of interest to 85% of net interest costs. If the ATAD rule results in a higher non-deductible amount then the difference will be carried forward or back.

As with any new proposal working through the definitions and practical implications will be important. The definition of equity is subject to a number of anti-abuse rules to ensure the allowance is not cascaded through subsidiaries, equity increases from contributions in kind, and re-categorising old capital as new capital.

The rules exclude certain regulated entities including AIFMs, AIFs, UCITS and certain securitisation vehicles. As with the current ATAD 3 proposals these exclusions apply on an entity-by-entity basis and so, unless there is a change to the contrary, these exclusions should not be seen as group wide with a potential exposure for entities sitting below the regulated entity.

Interaction with other rules will also pose challenges. The LID works in parallel with existing interest restriction rules however the reference points are different. LID caps deductions to 15% of net borrowing costs whereas ATAD limits interest deductions to 30% of taxable income (EBITDA). Clearly the implications of this will depend on the profile of the group. The timing of this proposal is also curious given the OECD's Pillar Two proposals that seek to harmonise the tax base through a global minimum tax. As the Pillar Two rules do not take into account an equity allowance, its provision may create a top-up tax liability - thus negating the benefit of the allowance.

As with any EU Directive, there is a long journey ahead. Introducing a new tax incentive is a different proposition for Member States to consider and therefore budget constraints may be a factor in deciding whether DEBRA and LID are adopted.

With a view to addressing the tax-induced debt-equity bias across the single market in a coordinated way, this directive lays down rules to provide, under certain conditions, for the deductibility for tax purposes of notional interest on increases in equity and to limit the tax deductibility of exceeding borrowing costs.