Tax deductions

EU offers tax deductions for equity, but with additional restrictions on interest

The EU has released a draft directive aimed at addressing the perceived bias in favor of debt finance companies over capital and, therefore, promoting financial stability.

The proposals (called “DEBRA”) are due to take effect on January 1, 2024 and allow a deduction for corporation tax purposes by reference to equity. Member States which already apply similar rules may defer the adoption of DEBRA for up to ten years for taxpayers who already benefit from an equity relief (but in no case for a period longer than the duration of the benefit under national law).

The Directive applies to taxpayers who fall within the scope of corporation tax in a Member State (so not to UK companies, unless they have a permanent establishment in the EU). There is an exclusion for “financial businesses” which we examine 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 while the stick is a new rule that will limit tax deductions for interest expense.

  1. What is the capital allowance?
  2. What is the new interest restriction?
  3. What is a “financial commitment”?
  4. Comment

1. What is the equity provision?

The compensation is essentially:

increase in “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 obviously important. The draft guidance says this is done by taking the 10-year “risk-free interest rate” for the relevant currency (these are the EU-wide rates that are published for Solvency II purposes ) and increasing it by a “risk premium” of 1%. SMEs benefit from a higher risk premium of 1.5%.

The meaning of “net” equity is not immediately clear: but the guidance’s explanatory notes clarify that the intention is to prevent a taxpayer from claiming multiple deductions because the same equity is cascaded across companies in the band.

If the allowance is greater than the taxpayer’s income for the year, the excess can be carried forward indefinitely. If the abatement exceeds 30% of EBITDA, it appears that the excess can be carried forward for five fiscal years (although the explanatory notes are not entirely clear on this point).

There is an anti-avoidance rule to prevent taxpayers from injecting equity to claim the deduction and then withdrawing that equity from the business. A clawback may apply if a taxpayer’s equity decreases. Clawback works by taxing a proportionate amount over the 10-year period, unless the taxpayer can demonstrate that the decrease in equity is due to losses incurred during the tax year or an obligation legal to reduce capital.

There are also other anti-abuse rules to cover specific situations – for example, when existing equity is converted into new equity as part of a group reorganization.

2. What is the new interest restriction?

It’s a pretty crude tool. The intention is that taxpayers will be denied deductions equal to 15% of the amount by which their tax-deductible borrowing costs exceed their taxable interest income.

In short, the restriction is intended to bite – broadly – where (in UK tax terms) a business suffers a loss on its lending relationships.

The interest restriction must operate alongside the existing interest restriction (“CIR”). It is envisaged that the new interest limitation will be applied initially, with the taxpayer then calculating the applicable limitation in accordance with the CIR. If the result of the application of the CIR is a lower deductible amount, the taxpayer can carry forward or retrospectively the difference in accordance with the rules of the CIR.

3. What is a “financial commitment”?

The draft directive provides a long list of financial undertakings, including most types of investment funds (and their managers), but does not extend to the holding companies used by these funds. Certain securitization agreements will also be excluded.

4. Comment

The DEBRA proposals, if implemented in their current form, are likely to have a significant impact on the financing decision of EU taxpayers. Losers may include taxpayers with tax-efficient debt financing structures who find that the new rules reduce their after-tax returns or require costly restructurings just to maintain current levels of profitability.

With the ATAD 3 shell company proposals also on the horizon, this is another issue for EU taxpayers to consider in their decision-making, in addition to the implementation of BEPS measures. of pillars 1 and 2 of the OECD. The proposals could therefore make the UK a more attractive jurisdiction compared to competing European jurisdictions, particularly given the recent introduction of the new Qualifying Asset Holding Company (QAHC) regime (for further details please see our recent webinar).

It should be noted, however, that the directive is currently in draft form and may prove politically controversial, so the proposals may not be implemented in their current form.

Read the text of the EU proposals.