Corporate Tax News Issue 62 - May 2022

Draft directive aims to reduce bias that favours debt financing

On 11 May 2022, the European Commission (EC) published a proposed directive (as well as a Q&A document) that set out rules to level the playing field between debt and equity financing for corporate income tax purposes. The proposed directive is designed to reduce the bias in the tax system in favour of debt financing over equity. To this end, the directive provides for a debt-equity bias reduction allowance—or DEBRA—that would eliminate tax as a factor in a company’s decision to finance through debt or equity by limiting the tax deductibility of interest, but allowing the deductibility of increases in equity in certain instances. The proposed directive also contains targeted anti-avoidance rules.

The tax rules in most countries allow businesses to deduct interest payments on debt in computing their taxable income, but the same rules do not apply to expenses incurred in the context of equity financing (e.g., costs relating to the distribution of dividends), thus creating an incentive for businesses to make their financing decisions based on the tax treatment instead of commercial considerations, even if taking on debt may not be the best option for the business. This inherent bias towards debt can put companies in a more financially vulnerable position and make them less resilient to unforeseen circumstances. It is the EC’s position that equity investments are less susceptible to such circumstances and, therefore, it is taking steps to level the playing field between debt and equity.

The DEBRA directive is part of the EC’s strategy for Business Taxation for the 21st Century, published on 18 May 202, which outlined broad corporate and direct tax policy measures for the EU (for prior coverage, see the article in the July 2021 issue of Corporate Tax News). The policy document announced several initiatives, including DEBRA and a new directive targeting the misuse of shell entities.

If adopted by the EU Council, the DEBRA directive would apply as from 1 January 2024.

Overview of DEBRA

As mentioned above, the EC’s approach in the DEBRA directive is twofold: to introduce an allowance on equity and an additional limitation on the deduction of interest expense, the latter of which is intertwined with the earnings stripping rule in the first Anti-Tax Avoidance Directive (ATAD 1). The DEBRA directive would make new equity tax deductible, thus reducing business’ reliance on debt.


DEBRA will apply to all taxpayers subject to corporate income tax in one or more EU member states, including permanent establishments in one or more member states of entities that are resident for tax purposes outside the EU. However, certain financial undertakings will fall outside the scope of the directive.

Allowance on equity

The equity allowance will provide a deduction that is computed over the allowance base and multiplied by a notional interest rate. The allowance will be limited to 30% of the taxpayer's earnings before interest, tax, depreciation and amortization (EBITDA), which is similar to the earning stripping rules in ATAD 1.

The allowance base will be the difference between the taxpayer’s net equity at the end of the financial year and the net equity at the end of the previous year. Equity will be defined by reference to the EU Accounting Directive. Net equity will be the difference between the taxpayer’s equity and the sum of the tax value of the taxpayer’s participations in associated enterprises and its own shares.

The relevant notional interest rate will be based on two components: the risk-free interest rate and a risk premium. The notional interest rate will be calculated based on the 10-year risk-free interest rate as determined under the EU Solvency II Directive, plus a 1% risk premium. A higher risk premium of 1.5% will apply in the case of small and medium-sized enterprises.

The equity allowance will be deductible for 10 consecutive tax years, i.e., in the current year and the following nine financial years, which the EC equates to the approximate maturity date of most debt.

The deduction of the allowance will be limited to 30% of fiscal EBITDA. However, any allowance exceeding 30% of fiscal EBITDA will be available for carryforward without time limitation. If the equity allowance is lower than 30% of fiscal EBITDA due to insufficient taxable profit, the unused allowance capacity will be able to be carried forward for five years.

If the taxpayer’s net equity at the end of the financial year is lower than the net equity of the previous financial year, a proportionate amount will be taxable in  the following 10 years, although the taxpayer will be permitted to produce evidence that the reduction occurred as a result of losses incurred during the tax period or a legal obligation.

Anti-abuse rules

Anti-abuse measures in the directive aim to ensure that the rules on the deductibility of an equity allowance are not used for unintended purposes and are based on 2019 guidance on existing notional interest regimes (e.g., Belgium, Cyprus, Italy, Malta, Poland and Portugal) adopted by the Code of Conduct Group. The EC is targeting some well-known issues that arise in the context of notional interest regimes and has proposed rules to prevent double deductions of the equity allowance, disregard certain contributions of assets and limit the re-categorisation of equity, as follows: 

  • Double utilization of the equity allowance: To prevent taxpayers from using the equity allowance more than once, the directive states that the allowance base does not include intragroup loans, intragroup transfers of existing business activities and cash contributions from a person resident for tax purposes in a jurisdiction that does not exchange information with the member state in which the taxpayer seeks to deduct the equity allowance. However, if the taxpayer can demonstrate that the transaction is carried out for commercial reasons and does not lead to a double deduction, the transaction may increase the allowance base.
  • Contribution of assets: To prevent contributions in kind or investments in assets from increasing the allowance base by overvaluing the contribution/investment or if they are not required for the taxpayer’s income-generating activities, the directive provides that  contributions in shares will have to be valued at book value and other assets will have to be valued at market value, unless a certified, external auditor provides a different value.
  • Re-categorisation of equity: This rule focuses on reorganizations within a group whereby existing equity may be re-categorised as new equity, potentially increasing the allowance base. If equity is increased via a reorganization, the net equity increase may be taken into account only to the extent it is not existing equity within the group.

Further restriction on interest deductions

To further reduce the debt-equity bias, the proposed directive will limit the tax deductibility of debt-related interest payments to 85% of the net interest balance (interest payments minus interest income). This rule is similar to the ATAD 1 earnings stripping rules, under which interest is deductible only if the net interest balance does not exceed 30% of fiscal EBITDA. As these rules are similar, the proposed directive contains specific rules on the interaction of the two sets of rules, whereby deductible interest under the DEBRA directive is first calculated, followed by a calculation of deductible interest under the ATAD 1 rules. The lower of the two amounts may be deducted, while the difference between the two amounts may be carried forward for a period that is governed by that member states’ implementation of the ATAD 1 earnings stripping rules. Member states will be required to provide specific data to the Commission annually to allow monitoring of the implementation and effects of the new rules.

Effective dates and transition rules

EU member states would be required to implement the DEBRA directive into their domestic law by 31 December 2023, so that it would be effective as from 1 January 2024. Member states whose domestic law already contains a tax allowance on equity funding will be permitted to defer the application of the directive for up to 10 years unless the duration of the domestic law benefit is less than 10 years.


The proposed DEBRA directive aims to negate the impact of taxation on the financing decisions of enterprises. The directive will be beneficial to start-ups and scale-ups, which traditionally are largely equity-funded. Holding companies will not benefit from the rules as any equity value deriving from their investments is not included in the allowance base.

As DEBRA is intended to apply as from 1 January 2024, taxpayers should consider their current financing structure, as well as their financing mix going forward. This will be particularly important as some EU member states have, or are intending, to further restrict the deduction of interest expense.

Frederik Boulogne

Mark Laeven