The EU has published a draft directive designed to help address the perceived bias in favour of debt funding companies as compared with equity and, accordingly, promote financial stability.
The proposals (known as "DEBRA") are due to come into force as of 1 January 2024 and allow a deduction for corporate income tax purposes by reference to net equity. Member states which already operate similar rules can defer the adoption of DEBRA for up to ten years in relation to taxpayers that already benefit from an allowance on equity (but in no case for a period longer than the duration of the benefit under national law).
The directive applies to taxpayers that are within the scope of corporate income tax in a member state (so not UK companies, unless they have an EU permanent establishment). There is an exclusion for "financial undertakings" which we consider below.
The rules take a carrot and stick approach. The carrot is a deduction calculated as a percentage of increases in equity during the tax year whilst the stick is a new rule which will restrict tax deductions for interest costs.
- What is the allowance on equity?
- What is the new interest restriction?
- What is a "financial undertaking"?
1. What is the allowance on equity?
The allowance is essentially:
increase in "net equity" over the tax year X a notional interest rate
The resulting amount is tax deductible for 10 consecutive years, but capped at 30% of EBITDA.
How the notional interest rate is calculated is clearly important. The draft directive says that this done by taking the 10-year "risk-free interest rate" for the relevant currency (these are EU-wide rates which are published for Solvency II purposes) and increasing it by a 1% "risk premium". SMEs get a higher risk premium of 1.5%.
The meaning of "net" equity is not immediately clear: but the explanatory notes to the directive set out that the intention is to prevent a taxpayer claiming multiple deductions as the same equity is cascaded through group companies.
If the allowance is higher than the taxpayer's income for the year, the excess can be carried forward indefinitely. If the allowance exceeds 30% of EBITDA, it seems that the excess can be carried forward for five tax years (although the explanatory notes are not entirely clear on this point).
There is an anti-avoidance rule to prevent taxpayers injecting equity to claim the deduction and then withdrawing that equity from the business. A clawback can apply if the equity base of a taxpayer decreases. The clawback operates by taxing a proportionate amount over the 10 year period unless the taxpayer can show that the decrease in equity is because of losses they have incurred during the tax year or a legal obligation to reduce capital.
There are other anti-abuse rules too to cover specific situations – for example, where existing equity is converted into new equity as part of a group re-organisation.
2. What is the new interest restriction?
This is a fairly blunt tool. The intention is that taxpayers will be denied deductions for 15% of the amount by which their tax deductible borrowing costs exceed their taxable interest income.
In short, the restriction are intended to bite – broadly speaking - where (in UK-tax speak) a company has a loss on its loan relationships.
The interest restriction is to apply alongside the existing corporate interest restriction ("CIR"). It is envisaged that the new interest restriction would be applied as a first step, with the taxpayer then calculating the limitation applicable in accordance with the CIR. If the result of applying the CIR is a lower deductible amount, the taxpayer can carry forward or back the difference in accordance with the CIR rules.
3. What is a "financial undertaking"?
The draft directive provides a long list of financial undertakings, including most types of investment fund (and their managers), but does not extend to holding companies used by those funds. Some securitisation arrangements will also be excluded.
The DEBRA proposals, if implemented in their current form, are likely to have a significant impact on the funding decision of EU taxpayers. Losers may include taxpayers with existing tax efficient debt funding structures who find that the new rules reduce their after-tax returns or require costly restructurings to be undertaken just to maintain current levels of profitability.
With the ATAD 3 shell company proposals also on the horizon, this is another issue that EU taxpayers will need to factor in to their decision making, in addition to the implementation of the OECD's BEPS Pillar 1 and 2 measures. The proposals may therefore make the UK a more attractive jurisdiction in comparison to rival EU jurisdictions, especially given its recent introduction of the new qualifying asset holding company (QAHC) regime (for more details of which please see our recent webinar).
It is worth noting, however, that the directive is currently in draft and may prove to be politically controversial, so the proposals may not be implemented in their current form.
Read the text of the EU proposals.