DEBRA, a new acronym that could cause nightmares for tax managers but also for corporate treasurers. It is a new proposal from the EU that could have significant impacts to consider, although its objectives are laudable and logical. The idea is not new to encourage companies to increase their capitalization and reduce their bank debt (partly through more recourse to the capital market - CMU project). As always, the best can very quickly become the enemy of the good. It is certainly a proposal to be followed and monitored to ensure that it does not penalize indebted companies too much.
DEBRA Proposal (« Debt-Equity Bias Reduction Allowance)
In early May, the European Commission unveiled its proposal for a "DEBRA" (Debt-equity bias reduction allowance) Directive, aimed at encouraging companies to finance their investments with equity and capital contributions, instead of resorting to loans (bank or other). What is important to note is the double level of action considered by the EU: (1) the first level is a kind of notional interest ("à la belge" / the Belgian way) and the second (2) a new limitation to the deduction of financial interest (already affected by BEPS). This clearly appears as a reaction measure to the financial crisis (post-COVID) and to previous ones as well, in an attempt to better capitalize European companies to make them more resilient and robust. The idea and the objective are good and cannot be disputed. On the other hand, the manner and consequences must be considered carefully to avoid any slippage or excess.
Two major axes
The project aims to create an "equity allowance" (or notional interest deductibility) and to limit the deductibility of interest payable by companies from their tax liabilities. The equation is simple: “the carrot” of the equity allowance to push for more capital injections and “the stick” of limiting interest on bank loans or capital markets to make them less attractive. A very simple approach indeed... The idea may seem interesting but needs to be further analyzed to avoid any unintended consequences or inappropriate measures.
Scope of the Directive
The Directive would apply to any entity subject to corporate tax in one or more EU countries. There are of course several exceptions such as credit institutions, management companies, insurance companies, (alternative) investment funds... (an exhaustive list exists in the proposal).
A. Concept of notional interest:
It is proposed to introduce notional interest, the idea of which is to allow the deduction during 10 consecutive years of this "synthetic" interest, within the famous limit of 30% of the company's EBITDA. It would be calculated by the difference between the amount of "net" equity at the closing of the accounts and at the opening of the accounts. The amount of notional interest could not exceed 30% (again) of the company's taxable base. Two limitations are already apparent. The one of the durations is problematic and worries the treasurers. The definition of "net equity" is as follows: equity of the company = sum of subscribed capital, share premiums, revaluation reserves, reserves and retained earnings, minus the tax value of the company's holdings in associated companies and the tax value of its own shares. The rate would be calculated based on a 10-year "risk-free interest" rate depending on the currency, increased by a 1% risk premium (1.5% risk premium if the company is an SME as defined by European law). It is also planned to be able to carry forward this interest if, for a given year, this notional interest exceeds the company's net taxable income, the remainder should be carried forward without time limitation for subsequent years. And if this notional interest exceeds the limit of 30% of the company's EBITDA, the remainder should be able to be carried forward for up to 5 years. Finally, it is planned to avoid abuses such as capital increases via loans granted by affiliated companies, transfers of equity securities, etc... A safeguard clause has also been provided (unless the taxpayer proves that these operations were carried out for valid business reasons and do not generate a double deduction based on the equity capital concerned)
B. Limitation of interest deductibility
The deduction of notional interest on increases in net equity is accompanied by a reduction in the deductibility of net financial expenses. In this context, Member States will have to ensure that the taxpayer cannot deduct more than 85% of the net financial charges. The taxpayer will have to determine the deductibility of its net financial expenses based on the ATAD1 rules in force (ATAD1 Directive n°2016/116435):
- If the non-deductible amount is greater than 15% of the net financial expenses, then the non-deductible excess over 15% must be carried forward or backward in accordance with the ATAD1 rules.
- If the non-deductible amount is less than 15%, then the deduction of net finance charges is capped at 85%.
These provisions will apply to net financial expenses incurred on or after the entry into force of the DEBRA Directive.
The Directive provides for appropriate monitoring and reporting. Within three months of the end of each tax year, each Member State must communicate a certain amount of information to the Commission (e.g. number of taxpayers who have benefited from the scheme, total amount of additional borrowing costs, total amount of additional borrowing costs not deducted, number of taxpayers who have been subject to the application of the anti-abuse measures provided for by the DEBRA Directive and the corresponding consequences/penalties etc.). For reporting purposes, the Commission will have to present a report to the European Parliament and the Council of the EU on the implementation of the DEBRA Directive by 31 December 2027, which will be published on its website. This disincentive is intended to reduce the attractiveness of debt financing, regardless of its origin.
Transposition into National law
As always in the case of Directives, they must be transposed by the Member States, which must ensure that they do so before December 31, 2023, for application as of January 1, 2024, that is to say: tomorrow! However, you may think that some countries already have the "Belgian-style" notional interest mechanism, such as Belgium, Italy, Portugal, Poland, Cyprus, and Malta.) For them, a postponement of the application of the provisions by a maximum of 10 years would be possible.
Tax provisions require a majority vote
This text of the proposed Directive is still subject to change, and it requires, at this stage in any case, the unanimity of the Member States of the European Union. This will not be easy, of course. But one can think that in a BEPS world, a world of highly indebted states and in a desire to better enforce taxes while encouraging shareholders to solidify their investments with more equity (versus less bank debt - better gearing), it is not unthinkable to think that this should be adopted by all. Corporate treasurers, through their associations and the EACT, will not fail to defend the interests of companies in the real economy. The consultation must be answered before July 12, 2022. On the side of the States, one can think that everything will depend on the cost versus the benefits of such a measure. By strengthening the companies, the States will accept more deductibility. This calculation is as always delicate and complex to establish precisely.
What should we think about it?
It is reasonable to think that this is a good idea, especially with interest rates rising. But as this would be applied to any company, it will have a huge cost. The Belgians won't argue with that. It is therefore important to make sure that we do not fall into any shortcomings or excesses, and this explains the limitations provided for. It seems logical to avoid having companies that are too leveraged, with WACCs that are maximized to the extreme. Any crisis can be fatal. We have just experienced it again and without the massive intervention of the States, it would have been a bloodbath, without name. The CMU aims to better balance bank financing against capital market financing. DEBRA aims to solidify the capital structure of companies, to make them more resilient. The idea is not new and countries, including Belgium, the founding mother of the concept, can give indications on the benefits but also the risks and consequences. What is paradoxical, or as the saying goes, "the pot calling the kettle black", is that the States, which have increased their debts more than ever, claim to want to strengthen companies by limiting their external debt. After COVID, we understand the interest of the EU's action. They want to reduce systemic risks, strengthen equity ratios, and improve gearing ratios. We believe that such a proposal should be considered with caution by treasurers. The time-limited application seems to pose problems for some companies. Indeed, after ten years, they should or could possibly consider a reduction of their capital, and therefore weaken. The time limit is perhaps not ideal. On the other hand, one can understand and accept limitations on interest deductibility to avoid the high cost to the states of the union. Again, this is laudable, but it should not make EU companies less competitive than non-EU companies, which would not be subject to this external debt limitation. A Singaporean or US company could be more leveraged than a European company. Stability, like everything else, has a price. But it must not be too high.
François Masquelier, CEO of Simply Treasury – Luxembourg June 2022
Disclaimer: This article was prepared by François Masquelier in his personal capacity. The opinion expressed in this article are the author’s own and do not necessarily reflect the view of the European Association of Corporate Treasurers (i.e., EACT).