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The green and digital transition requires new investments in innovative technologies. Taxation has an important role to play in encouraging and enabling businesses to develop and grow sustainably. An allowance for equity financing can facilitate bold investments in cutting-edge technologies, notably for start-ups and SMEs. Equity is particularly important for fast-growing European innovative companies in their early stages and scale-ups willing to compete globally.
In corporate taxation (globally and in the EU member states), corporate entities usually treat debt more favorably than equity; besides, businesses are allowed deduct interest payments from their taxable income, while not offering the same allowance to equity. This gives businesses a major incentive to borrow, rather than to fund new investments by increasing capital.
In May 2022, the Commission proposed a debt-equity bias reduction allowance, or DEBRA, in short, to help businesses access the financing they need and to become more resilient. This measure will support businesses by introducing an allowance that will grant to equity the same tax treatment as debt. The proposal stipulates that increases in a taxpayer’s equity from one tax year to the next will be deductible from its taxable base, similarly to what happens to debt.
Current European “pro-debt-bias” of tax rules, where businesses can deduct interest attached to a debt financing – but not the costs related to equity financing – can incentivise companies to take on debt rather than increase equity to finance their growth. Therefore, excessive debt levels make companies vulnerable to unforeseen changes in the business environment.
General information in: https://ec.europa.eu/commission/presscorner/detail/en/qanda_22_2885
Total indebtedness of non-financial corporations in the EU amounted to almost €14.9 trillion in 2020 or 111% of GDP. Against this background, it is worth stressing that businesses with a solid capital structure may be less vulnerable to shocks, and more prone to make investments and innovate. Therefore, reducing the over-reliance on debt-financing, and supporting a possible rebalancing of companies’ capital structure, can positively affect competitiveness and growth. The combined approach of equity allowance and limited interest deduction is expected to increase investments by 0.26% of GDP.
More in: https://ec.europa.eu/commission/presscorner/detail/en/IP_22_2884
Commission’s DEBRA proposal is expected to create a level playing field for corporate debt and equity issues (from a tax perspective), thereby removing taxation as an influence factor in various companies’ funding decisions. In part, the new proposal would make new equity tax deductible, just as debt currently is in most companies. Besides, a more favourable rate of deduction is proposed for SMEs, given that they have more difficulty in accessing equity markets than larger companies.
Corporate taxation: legislative and managerial aspects
The DEBRA’s initiative is part of the EU strategy on business taxation, which aims to ensure a fair and efficient tax system across the EU-27 states; besides, it contributes to the Capital Markets Union (CMU), making financing more accessible to EU business and promoting the integration of national capital markets into a genuine single market. In part, the CMU will support a green, digital, inclusive and resilient national economic recovery by making financing more accessible to European companies.
On taxation issues in the CMU in: https://ec.europa.eu/info/business-economy-euro/growth-and-investment/capital-markets-union/capital-markets-union-2020-action-plan_en
Historically, in May 2021, the European Commission published “Communication on Business Taxation for the 21st century”, where two main aspects in corporate taxation’s strategy are revealed: a) providing a fair and sustainable business environment and EU tax system, in general; and b) a Union’s tax agenda for the next two years, with targeted measures that promote productive investment, active entrepreneurship and ensuring socially-effective taxation.
The context for EU business taxation policy has changed radically during last couple of years: the public health challenges in post-pandemic turned into dramatic socio-economic crisis in the EU history, e.g. causing rising inequality and deeply impacting social safety nets. The pandemic has also accelerated existing trends (such as digitalisation) and highlighted at least three main problems with the current corporate taxation:
• The current international corporate tax system was designed more than a century ago and is based on outdated principles of tax residence and source. Developments in globalisation and digitalisation made these principles generally outdated and not answering modern economic development patterns: thus making increasingly difficult to apply existing tax rules to modern business realities.
• In the EU, the system of national corporate taxation has been creating complexities for businesses operating across the EU single market; particularly, “grappling with 27 different national corporate tax systems” already created difficulties for SMEs, start-ups and other types of businesses looking for growth, expansion and cross-border trade. All that has been hurting such corporate activities as investment, growth and competitiveness.
• On one side, corporate income is taxed at the national level, whereas business models are becoming ever more international, complex and digital; these factors create high compliance costs for business and risks of double taxation. At the same time, some companies exploit loopholes between tax systems through aggressive tax planning strategies. This also makes it difficult for citizens to know how much companies are actually paying in tax, which risks undermining trust in the tax system as a whole.
In the long-term, the Communication intends to create a new framework for business taxation among the EU-27 in order to reduce administrative burdens, remove tax obstacles and foster a more business-friendly environment in the European single market. This framework is called “Business in Europe: Framework for Income Taxation” (or BEFIT) and it will provide a single corporate tax rulebook for the Union, based on a formulary apportionment agreed and controlled a common tax base. BEFIT will cut red tape, reduce compliance costs, reduce tax avoidance opportunities and support jobs, growth and investment in the EU.
The EU is expected to formulate a final proposal for BEFIT somewhere in 2023, associated with a common European tax rulebook, which in liaison will provide a fairer allocation of corporate taxation framework among EU member states.
More in: https://ec.europa.eu/taxation_customs/communication-business-taxation-21st-century_en
Thus, DEBRA is a follow-up to the Communication on Business Taxation for the 21st Century, which sets out a long-term vision for a fair and sustainable business environment and EU tax system, as well as initiates targeted measures to promote productive investment and entrepreneurship to ensure effective taxation. The DEBRA proposal also contributes to the EU’s Capital Markets Union Action Plan (CMU), which aims at helping companies raise the capital they need, particularly during the post-pandemic period. The CMU incentivises, generally, long-term investments in order to foster sustainable and digital transition of national economies. In this regard, the debt-equity bias can encourage companies to make their business decisions based on the related tax treatment, rather than on commercial considerations. This can lead to some companies choosing debt financing over equity, even if it is not the best option for them. Equity should receive similar tax treatment as debt, so that companies can consider both options on an equal footing and choose the source of financing that is best for their business-model.
Practical implementation
Harmonised solution to the debt-equity bias will make Europe’s business environment more predictable and competitive, spurring the development of our capital markets union. Our proposal will help companies build up more solid capital, making them less vulnerable and more likely to invest and take risks. And that will be good news for jobs and growth in Europe. As part of the EU’s agenda to ensure a fair and efficient tax system, it will make financing more accessible for EU businesses, particularly start-ups and SMEs, and help to create a genuine single market for capital. This will be important for the green and digital transitions, which require new investments in innovative technologies that could be funded by increased equity.
The equity allowance would be computed based on the difference between net equity at the end of the current tax year and net equity at the end of the previous tax year, multiplied by a notional interest rate. This means that the allowance would be granted only for the sum of equity increases over a specific year.
The notional interest rate is the 10-year risk-free interest rate for the relevant currency, and increased by a risk premium of 1% or, in the case of SMEs, a risk premium of 1,5%.
The allowance on equity is deductible for 10 consecutive tax years, as long as it does not exceed 30% of the taxpayer’s taxable income. Moreover, if the allowance on equity is higher than the taxpayer’s net taxable income, the taxpayer may carry forward the excess of allowance on equity without a time limitation.
Taxpayers will also be able to carry forward their unused allowance on equity which exceeds the 30% of taxable income, for a maximum of 5 tax years.
Lastly, the proposal introduces a reduction of debt interest deductibility by 15%, so to better mitigate the debt-equity bias, not only from the equity side but also from the debt side.
More in the Commission proposal (May 2022) in: https://ec.europa.eu/commission/presscorner/detail/en/QANDA_22_2885