Explanatory Memorandum to COM(2022)216 - Laying down rules on a debt-equity bias reduction allowance and on limiting the deductibility of interest for corporate income tax purposes - Main contents
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This page contains a limited version of this dossier in the EU Monitor.
| dossier | COM(2022)216 - Laying down rules on a debt-equity bias reduction allowance and on limiting the deductibility of interest for corporate ... |
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| source | COM(2022)216  |
| date | 11-05-2022 |
1. CONTEXT OF THE PROPOSAL
• Reasons for and objectives of the proposal
On 18 May 2021, the European Commission adopted a Communication on Business Taxation for the 21st century 1 to promote a robust, efficient and fair business tax system in the EU. It sets out both a long-term and short-term vision to support Europe's recovery from the COVID-19 pandemic and to ensure adequate public revenues over the coming years. In the same vein, the EU’s Capital Markets Union Action Plan (CMU) 2 aims at helping companies to raise the capital they need and improve their equity position, especially during a recovery period implying higher deficits and debt levels, as well a greater need for equity investment. In particular, Action 4 of the CMU 3 incentivises institutional investors to make more long-term investments and thus supports re-equitisation in the corporate sector, with a view to fostering the sustainable and digital transition of the EU economy. An initiative at EU level to address the debt-equity bias complements the aforementioned Action 4, with the aim to create an equitable and stable business environment, which can boost a sustainable and job-rich growth in the Union.
Tax systems in the EU allow for the deduction of interest payments on debt when calculating the tax base for corporate income tax purposes, while costs related to equity financing, such as dividends, are mostly non-tax deductible. This asymmetry in tax treatment is one of the factors favouring the use of debt over equity for financing investments. Currently, only 6 Member States address the debt-equity bias from a tax perspective and the relevant national measures differ significantly. Unless the tax-induced debt-equity bias is effectively tackled across the single market, EU business will continue to have insufficient incentives towards equity over debt financing and relevant tax planning considerations will continue distorting distribution of investment and growth.
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. It applies to all taxpayers that are subject to corporate tax in one or more Member State, except for financial undertakings. Since small and medium enterprises (SMEs) usually face a higher burden to obtain financing, it is proposed to grant a higher notional interest rate to SMEs.
This proposal also replies to the European Parliament’s expectation that the Commission would put forth a proposal for a debt-equity bias reduction allowance, including effective anti-avoidance provisions to avoid any allowance on equity being used as a new tool for base erosion 4 .
• Consistency with existing and possible future provisions in the policy area
This Directive is part of the EU strategy on business taxation, which aims to ensure a fair and efficient tax system across the EU.
In 2016, the anti-tax avoidance directive (ATAD) 5 was adopted to ensure a fairer tax environment through the coordinated implementation in Member States of key measures against tax avoidance that mostly stemmed from the international Base Erosion and Profit Shifting (BEPS) project actions. While the fight against tax avoidance is not its predominant purpose, this proposal also includes an interest limitation rule. In light of the different objectives between this proposal and the ATAD rule on interest limitation, the two rules on limiting the deductibility of interest should apply in parallel.
Contents
Existing tax instruments at EU level do not contain, however, measures to address the debt-equity bias in the single market by balancing the tax treatment of debt and equity across the EU.
This Directive follows up to the Commission’s Communication on Business Taxation for the 21st century for a robust, efficient and fair business tax system in the EU and reflects one of the policy initiatives envisaged in such Communication. As such, it complements a number of other policy initiatives promoted by the Commission in parallel, in the short- and long-term.
The aforementioned policy initiatives include a proposal for Business in Europe: Framework for Income Taxation (BEFIT), as a single corporate tax rulebook for the EU, based on the key features of having a common tax base and allocating profits between Member States through methods that include a formula (formulary apportionment). While the BEFIT proposal is still in an early stage of development, the two initiatives contribute to the same vision of a fair, effective and sustainable business environment in the EU.
• Consistency with other Union policies
This proposal contributes to the Capital Markets Union. In particular, key objectives of the CMU are to render financing more accessible to EU business and to promote the integration of national capital markets into a genuine single market. By removing the tax-induced debt-equity bias, this proposal is aimed at avoiding over-reliance on debt and encouraging the re-equitisation of businesses. As a result, companies will be in a better position to invest for the future, which will support growth and innovation and support the competitiveness of the EU economy. This will also increase their resilience to unforeseen changes in the business environment and decrease the risk of insolvency, thus contributing to enhancing financial stability.
2. LEGAL BASIS, SUBSIDIARITY AND PROPORTIONALITY
• Legal basis
Direct tax legislation falls within the ambit of Article 115 of the Treaty on the Functioning of the EU (TFEU). The clause stipulates that legal measures of approximation under that article shall take the legal form of a Directive.
• Subsidiarity (for non-exclusive competence)
This proposal complies with the principle of subsidiarity. The nature of the subject requires a common initiative across the internal market.
The rules of this Directive aim to tackle the debt-equity bias in the EU corporate sector from a tax perspective and provide a common framework to be implemented into Member States' national laws in a coordinated manner. Such aims cannot be achieved in a satisfactory manner through action undertaken by each Member State while acting on its own.
Tax debt-equity bias arises from the different treatment of debt and equity financing costs for tax purposes and is a problem common to business across EU Member States. Despite this, only 6 Member States have taken tax measures to approximate the tax treatment of debt and equity. Although there is soft law guidance 6 for this type of tax incentives by the Code of Conduct Group (Business Taxation), the relevant national measures of the 6 Member States differ in terms of design elements and anti-tax avoidance rules, especially given the different circumstances and the different policy goals pursued in each Member State.
The complete lack of relevant tax debt bias mitigating measures in 21 Member States along with the existence of significantly different measures in another 6 Member States may create distortions to the function of the internal market and can affect the location of investment in a significant manner.
Furthermore, an EU initiative would add value, as compared to what a multitude of actions taken at national level can attain. A single rule for the EU will ensure legal certainty and allow reducing compliance costs for business as taxpayers will need to comply with a single rule for all their operations in the single market. An EU-wide rule is also expected to boost competition in the single market by ensuring that all businesses, regardless of where they are located, have similar incentives towards appropriate financing.
An EU-wide initiative in the form of a binding legislative proposal is therefore necessary to address in a coordinated and effective manner a problem that is common across the EU. An EU initiative would prevent potential loopholes between diverging national initiatives and would ensure that location of business and investment are not adversely impacted.
• Proportionality
The envisaged measures do not go beyond ensuring the minimum necessary level of protection for the internal market. The Directive lays down rules to provide, across the EU and for all EU taxpayers, for the deductibility of an allowance on equity financing costs complemented by a rule to limit the deductibility of interest on debt financing instruments. The Directive also ensures the sustainability of the measures for Member States’ budgets by virtue of a general rule that limits the deductibility of financing costs from taxpayers’ taxable base. By setting a common EU-wide framework, the Directive allows legal certainty across the single market and the reduction of compliance costs for taxpayers.
Thus, the Directive ensures only the essential degree of coordination within the Union for the purpose of materializing its aims. In this light, the proposal does not go beyond what is necessary to achieve its objectives and is therefore compliant with the principle of proportionality.
• Choice of the instrument
The proposal is for a Directive, which is the only available instrument under the legal base of Article 115 TFEU.
3. RESULTS OF EX-POST EVALUATIONS, STAKEHOLDER CONSULTATIONS AND IMPACT ASSESSMENTS
• Ex-post evaluations/fitness checks of existing legislation
There is no EU legislation addressing the debt-equity bias. Therefore, evaluation is not relevant.
• Stakeholder consultations
On 1 July 2021, TAXUD launched a public consultation on a potential initiative to address the debt-equity bias. It contained a variety of questions aimed, inter alia, at delineating the problem and its drivers and identifying the appropriate form of EU action and the key features of a possible measure. The consultation closed on 7 October 2021 with a total of 67 replies.
The respondents were 37 business associations mainly representing financial organisations of all sizes (including SME), 12 companies/business organisations (mostly tax accountant and financial organisations), 3 academic and research institutions, 8 NGOs or others (mostly chamber of commerce, stock exchanges) and 7 individual citizens. Most respondents came from either Belgium (14/67), Germany (14/67) or France (12/67).
NGOs and academics are of the view that the main reason companies use debt is to decrease their tax liability and avoid dilution of their shareholders, whereas business associations and companies consider that it is the necessity of finding financing means.
A majority of respondents, among them 100% of academics, 86% of citizens, 50% of corporations and 42% of business associations, find that an EU initiative to address the tax debt-equity bias would be a useful tool to support the recovery of companies from the COVID-19 crisis and incentivise investment through equity in the transition to a greener digitalised economy without creating distortions in the single market. Companies, NGOs and academics strongly think firms should be encouraged, amongst others from a tax perspective, to use more equity and less debt.
Business associations, companies and academics clearly agree that such an initiative will reduce the room for harmful tax practices in the single market. Importantly, a majority of respondents, among them 71% of corporations, 66% of academics, 43% of citizens and 28% of business associations, think that an EU initiative would be beneficial for enterprises operating across the single market.
On the different options, a majority of respondents are very negative on the option of suppressing completely interest deductibility, among them 75% of corporations, 72% of business associations, 71% of citizens and 66% of academics find it the least suitable option and a majority is quite negative about the option for an allowance on corporate financial capital that would replace the tax deduction of interest. It was considered the best option only by 16% of corporations, 14% of citizens, 5% of business associations and no academic. On the contrary, a majority of respondents are favourable to an allowance that provides for the deductibility of a notional interest on new equity (while maintaining the existing interest deductibility). It appears the best option for 66% of academics, 28% of business associations, 25% of corporations and 14% of citizens. Business associations and companies are even more favourable to the option of having an allowance on the stock of equity, while NGOs and academics are less favourable to this option.
Finally, a majority of respondents to this point strongly agree that the initiative should come with robust rules to avoid aggressive tax planning practices, among them 71% of citizens, 66% of academics, 42% of business associations and 33% of corporations.
In designing its proposal, the Commission took into account the results of the consultation. In particular, amongst the various policy options, the Commission decided to proceed with a proposal to give an allowance only to new equity and not to consider eliminating all deductibility of debt. Furthermore, the directive provides a robust anti-abuse framework as the need has been highlighted by the respondents.
In addition, the Commission appreciates that the protection of Member States’ taxable revenues is essential to ensure a sustainable economy and safeguard public finances during the ongoing recovery period after the pandemic. Consequently, the Commission proposes to mitigate the debt-equity bias through measures addressing both the equity and the debt sides, combining an allowance for new equity with a limitation to the deductibility of debt costs.
• Collection and use of expertise
In identifying appropriate measures to tackle the debt-equity bias, the Commission drew on the relevant expertise of Member States that have already put in place similar measures (Belgium, Portugal, Poland, Cyprus, Malta and Italy). The Commission undertook exchanges with some of the relevant tax administrations on the anti-abuse framework and to better understand the impact in terms of costs and benefits of the various measures.
The Commission met with national public authorities/agencies, business associations and civil society groups that participate in the Commission Expert Group “Platform for Tax Good Governance, Aggressive Tax Planning and Double Taxation”. The Commission also had exchanges with the European Economic and Social Committee (EESC).
• Impact assessment
An impact assessment was carried out to prepare this initiative.
On 17 March 2022 the Regulatory Scrutiny Board (RSB) issued a positive opinion with reservations on the submitted impact assessment regarding this proposal, including several suggestions for improvement. 7 The Impact Assessment report (IA) was further revised along these lines, as explained below. The IA examines five policy options in addition to the baseline scenario, i.e. no action.
Option 1 would introduce an allowance on the stock of corporate equity indefinitely, whereas Option 2 would also introduce an allowance but only for new equity and for ten years.
Option 3 would envisage an allowance on corporate capital (i.e. equity and debt) while disallowing current deductibility of interest payments and Option 4 would completely disallow the deductibility of interest expenses. Option 5 would combine an allowance for notional interest on new corporate equity (same as proposed under Option 2) for ten years with a partial limitation of tax deductibility for all companies.
A rate top-up for SMEs 8 would be applied in all cases outlined under policy options 1, 2, 3 and 5..
The various Options have been compared against the following criteria: a) Making the tax system neutral for financing decisions, b) Enhancing the fairness of the tax system, c) Reducing distortions in the single market and d) Stimulating growth and investment in the EU. The comparison revealed that Options 1, 2, 3 and 4 can be expected to be to some degree effective in meeting some of the objectives of this initiative. However, Option 5 is the preferred option, because it successfully addresses the debt-equity bias, while balancing the budgetary impacts and addressing the fairness aspects of the tax system. It is expected to have a positive impact on investment and GDP, and moderate impacts on employment.
For the assessment of the economic impacts the modelling was done by the European Commission’s Joint Research Centre based on the CORTAX model.
The preferred option (Option 5) is expected to have a positive economic impact. As main direct benefit, it will favour higher equity ratios and so reduce insolvency risks. By increasing equity investments across the EU, this option is expected to indirectly promote the development of innovative technology. Equity is particularly important for fast-growing innovative companies in their early stages and scale-ups willing to compete globally. The green and digital transition requires new and innovative investments that will benefit from the measure. By benefiting from a higher notional interest rate, SMEs will have an increased access to the equity market. Positive effects on competitiveness, innovation, growth and employment in the EU are expected. It will also tackle fragmentation of the single market by eliminating different treatment under different national allowance for equity measures and providing same administrative rules in all EU Member States. Finally, it will provide uniform and effective measures against aggressive tax planning in the EU.
The costs related to the selected option are essentially an increase in compliance costs for businesses and tax administrations. Tax compliance costs for business are expected to increase in a limited manner. Overall, costs should be relatively limited because the additional data to be reported to benefit from the allowance should be relatively simple to provide. For tax administrations, costs are also expected to increase modestly. This proposal does not significantly increase compliance burden for firms or for tax administrations.
The RSB issued a positive opinion with reservations on the IA. In particular, it was noted that IA should better highlight how the preferred option best achieves the objectives. Furthermore, the RSB noted that the IA should be enhanced as regards the possibility to use non regulatory measures and should better reflect the different stakeholder views throughout the main analysis and annexes. Annex I to the Impact Assessment explains how the RSB reservations were addressed. Several parts of the IA were revised. First, the IA has been revised in order to clarify that a non-regulatory option could not be effective Second, the IA has been expanded in order to reflect in detail the scale of anticipated effects on equity investment and the impact of the preferred option on tax revenues in absolute terms. The IA was also enhanced with further analysis of the reasons why an option acting both on the equity and debt sides has been considered as fit for purpose. Third, several sections of the main part of the IA were revised in order to include relevant stakeholder input, gathered through the open public consultation procedure.
4. BUDGETARY IMPLICATIONS
See Legislative Financial Statement.
5. OTHER ELEMENTS
• Implementation plans and monitoring, evaluation and reporting arrangements
This proposal, once adopted as a Directive, should be transposed into Member States’ national law by 31 December 2023 and come into effect as of 1 January 2024. For the purpose of monitoring and evaluation of the implementation of the Directive, Member States will have to provide the Commission, on a yearly basis, with relevant information per tax year, including a list of statistical data. The relevant information is set out in Article 7 of the Directive.
The Commission shall submit a report on the application of this Directive to the European Parliament and to the Council every five years, which should start counting after [1 January 2024]. The results of this proposal will be included in the report to the European Parliament and to the Council that will be issued by [1 January 2029].
• Detailed explanation of the specific provisions of the proposal
This proposal applies to all taxpayers which are subject to corporate income tax in one or more Member States, with the exception of financial undertakings, as defined in Article 3 i.
It includes two separate measures that apply independently: 1) an allowance on equity; and 2) a limitation to interest deduction. Financial undertakings are not in the scope of the measures. Some financial undertakings are subject to regulatory equity requirements that prevent under-equitisation. In addition, many are unlikely to be affected by the countervailing interest limitation deduction applicable to exceeding borrowing costs. Therefore, should financial undertakings be included in the scope, the economic burden of the measures would be unequally distributed at the expense of non-financial undertakings.
• Allowance on equity
The allowance on equity is computed by multiplying the allowance base with the relevant notional interest rate.
Allowance on equity = Allowance Base X Notional Interest Rate (NIR)
The allowance base is equal to the difference between equity at the end of the tax year and equity at the end of the previous tax year that is the year-on-year increase in equity.
If the allowance base of a taxpayer that has already benefitted from an allowance on equity under the rules of this Directive, is negative in a given tax period (equity decrease), a proportionate amount will become taxable for 10 consecutive tax periods and up to the total increase of net equity for which such allowance has been obtained, unless the taxpayer provides evidence that this is due to losses incurred during the tax period or due to a legal obligation.
Equity is defined by reference to Directive 2013/34/EU (Accounting Directive) 9 , meaning the sum of Paid-up Capital, Share premium account, Revaluation reserve and Reserves 10 and Profits or Losses carried forward. Net equity is then defined as the difference between the equity of a taxpayer and the sum of the tax value of its participation in the capital of associated enterprises and of its own shares. This definition is meant to prevent cascading the allowance through participations.
The relevant notional interest rate is based on two components: the risk-free interest rate and a risk premium. The risk-free interest rate is the risk-free interest rate with a maturity of ten years, as laid down in the implementing acts to Article 77e(2) of Directive 2009/138/EC 11 , in which the allowance is claimed, for the currency of the taxpayer. The risk premium is set at 1%, to better account for the risk premium that investors actually pay and better mitigate the bias. The risk premium is set at 1.5% in the case of taxpayers qualifying as small or medium-sized enterprises, to better reflect the higher risk premium they incur to obtain financing. There should be no discretion on the part of Member States as to whether to apply this higher rate for SMEs or what rate to apply as the top-up for SMEs in order to avoid selectivity concerns as regards EU State Aids rules and to ensure a level playing field for SMEs in the EU regardless of their place of residence.
NIR = Risk Free Rate + Risk Premium
Risk Premium = 1% (or 1.5% for SMEs)
The notional interest rate is hence equal to the currency specific risk-free rate plus 1% or 1.5% (NIR = risk free rate + 1% or, for SMEs, NIR = risk free rate + 1.5%). This approach ensures that the measure has an impact while remains simple to implement and does not harm Member States’ budgets. It also ensures that the specific circumstances of different businesses are taken into account. A specific currency rate better ensures the balance of tax treatment between equity and debt since it takes into account the currency risk separately for each currency and reflects the specific situation of each taxpayer.
The allowance is granted for ten years to approximate the maturity of most debt, while keeping the overall budgetary cost of the allowance on equity under control. This means that if an increase in a taxpayer’s equity qualifies for an allowance on equity under this proposal, the relevant allowance, computed as above, shall be deductible in the year it was incurred (TY) and in the next successive nine years (TY+9). If, in the following year (TY+1), a new increase in a taxpayer’s equity also qualifies for an allowance on equity under this proposal, the new allowance on equity will also be deductible for the tax year it was incurred and the following nine years since its incurrence (until TY+10).
By way of example, if a company having equity of 100, decides to increase in year t its equity by 20, an allowance will be deducted from its taxable base every year for ten years (until t+9) calculated as 20 times the notional interest rate, i.e. 20 times the risk-free interest rate for the relevant currency plus 20 (20 times the risk premium defined as 1).
Equity of Company A 120 100
Allowance base = 120 – 100 = 20
Allowance = Allowance base X NIR = 20 X NIR
The allowance will be available for 10 consecutive years : t, t+1, t+2, ….t+9
If the company is a small or medium enterprise, the allowance will be calculated in the same way. The NIR will simply be different since the risk premium is higher (1.5 % instead of 1%).
To prevent tax abuse, the deductibility of the allowance is limited to a maximum of 30% of the taxpayer’s EBITDA (earnings before interest, tax, depreciation and amortization) for each tax year. A taxpayer will be able to carry forward, without time limitation, the part of the allowance on equity that would not be deducted in a tax year due to insufficient taxable profit. In addition, the taxpayer will be able to carry forward, for a period of maximum five years, unused allowance capacity, where the allowance on equity does not reach the aforementioned maximum amount.
Robust anti-abuse measures will ensure that the rules on the deductibility of an allowance on equity are not used for unintended purposes. These anti-abuse rules are inspired from the Guidance on notional interest deduction regimes which was adopted by the Code of Conduct Group in 2019 and address well-known existing schemes, such as cascading the allowance within a group.
A first measure would exclude from the base of the allowance equity increases that originate from (i) intra-group loans, (ii) intra-group transfers of participations or existing business activities and (iii) cash contributions under certain conditions. Thus, for example, as regards intra-group loans, the measure should prevent that an equity injection granted to company A located in Member State A is used to grant a loan to a related company B located in Member State B. This is because in such case, company B would also use this money to inject equity in another related company C, located in Member State C. This would lead to multiplying the allowance on equity with only one genuine equity increase at group level.
Another measure sets out specific conditions for taking into account equity increases originating from contributions in kind or investments in assets. It aims to prevent the overvaluation of assets or purchase of luxury goods for the purpose of increasing the base of the allowance. Thus, for example, the value of an asset and the related costs should not exceed reasonable professional needs and any part of the value of the asset contributed or recorded in the taxpayer’s accounting books over its market value should be deducted from the base of the allowance.
A third measure targets the re-categorisation of old capital as new capital, which would qualify as an equity increase for the purpose of the allowance. Such re-categorisation could be achieved through a liquidation and the creation of start-ups. For example, if an existing company, with retained earnings, is liquidated, there will be an increase in the equity of the parent company due to the incorporation of the retained earnings. If a new subsidiary is subsequently created and is no longer held by the parent, the previously increased base of allowance of the parent would not be reduced by the value of the participation in the subsidiary.
• Limitation to interest deduction
On the debt side, the allowance for notional interest on equity is accompanied by a limitation to the tax deductibility of debt-related interest payments. In particular, a proportional restriction will limit the deductibility of interest to 85% of exceeding borrowing costs (i.e. interest paid minus interest received). Such an approach allows addressing the debt-equity bias simultaneously from both the equity and the debt side, which is most efficient and preserves the sustainability of Member States’ public finances.
Given that interest limitation rules already apply in the EU under Article 4 of the ATAD, the taxpayer will apply the rule of Article 6 of this proposal as a first step and then, calculate the limitation applicable in accordance with article 4 of ATAD. If the result of applying the ATAD rule is a lower deductible amount, the taxpayer will be entitled to carry forward or back the difference in accordance with Article 4 of ATAD.
By way of example, if company A has exceeding borrowing costs of 100, it should:
First, apply Article 6 of this directive proposal that limits the deductibility to 85% of 100 = 85 and thus renders a non-deductible amount of 15.
Second, compute the amount that would be deductible under Article 4 of the ATAD. If the deductible amount is lower, e.g. 80 (and subsequently the non-deductible higher, i.e. 20), the difference in the deductibility, i.e. the additional non-deductible amount (i.e. 85-80 = 5) would be carried forward or back in accordance with the conditions of Article 4 of ATAD, as transposed in national law.
The outcome for company A is that 15 (100 - 85) of interest borrowing costs are non-deductible and a further 5 (85 – 80) of interest borrowing costs are carried forward or back.
• Monitoring and reporting
Member States will provide specific data to the Commission on a yearly basis in order to allow monitoring the implementation and effects of the new rules. The Commission will rely on these data, amongst others, in order to evaluate the implementation of the Directive and report accordingly.
• Delegation
The Commission will have the power to modify the risk premium rate by adopting delegated acts. The Commission may exercise such power only under specific circumstances, i.e. where inflation and/or economic growth trends require an increase or decrease of the risk premium and provided that relevant data, reports and statistics, including those provided by Member States, conclude that the EU average of the financing conditions of debt of the companies in scope of the directive have doubled or halved since the last determination of the risk premium. In such cases it is in fact essential to be able to change applicable rates to reflect real market conditions quickly and smoothly, without recourse to a full legislative procedure. The power of the Commission is however duly restricted and revocable.
• Transposition
Member States that have rules in place providing for an allowance on equity increases may defer the application of the provisions of this directive for the duration of rights already established under domestic rules (grandfathering)Taxpayers that, on [1 January 2024] benefit from an allowance on equity , under domestic law (in Belgium, Cyprus, Italy, Malta, Poland and Portugal) will be able to continue to benefit from such allowance under national law for a period of up to 10 years and in no case for a period longer than the duration of the benefit under national law. Conversely the rules of this directive will apply from their date of application to all other taxpayers in all Member States.