According to in-house tax advisers, the European Commission's latest industry proposal will obstruct tax alignment by introducing deductions into the EU's tax system rather than limiting them as other countries have done.
The debt-equity bias reduction allowance (DEBRA) proposal, which was published on May 11, is intended to correct a long-standing corporate tax bias in the treatment of equity and debt.
The Commission proposes a tax deduction based on the difference between net equity at the end of one tax year and the previous year's end. The difference is then multiplied by the notional interest rate, which is a 10-year risk-free rate that rises 1% annually with annual fees.
More capital for business activities such as mergers and acquisitions means a larger equity difference.
However, the new tax directive, which will take effect on January 1, 2024, will reduce interest deductions by 15% to limit the amount of tax deductions based on debt.
Despite the cap on debt-based deductions, Rhiannon Kinghall Were, the UK-based head of tax policy at Macfarlanes, tells ITR that the total number of corporate benefits in the EU will increase under the DEBRA proposal.
"The equity allowance could more than balance the cap on debt-based interest deductions for corporate income tax purposes for at least some companies," says Kinghall Were.
The upcoming EU directive will apply to any taxpayer with a corporate income tax bill in any member state, with the exception of certain financial entities like undertakings for the collective investment in transferable securities.
The DEBRA proposal will assist businesses in raising additional funds by providing additional tax deductions for using equity rather than debt to fund activities such as mergers and acquisitions.
Intergovernmental reports show deal-making activity that was suspended during the pandemic is slowly returning, prompting some in-house professionals to predict more mergers and acquisitions. The DEBRA directive may have an impact on the cash flow and value of EU companies that are in the process of completing delayed mergers.
Mariano Giralt, managing director of tax services at BNY Mellon in Madrid, believes that once equity is treated the same as debt for corporate income tax purposes, in-house budgets for deal-making activity will rise.
"“The debt-bias means the parent company has a preference of funding subsidiaries with debt instead of equity because interest is deductible and return on equity is not, but this is going to change," according to Giralt.
The DEBRA proposal is supported by large business groups because it will increase business investment in mergers and acquisitions in Europe while lowering compliance costs. Notwithstanding, the proposal is unique in that it allows a tax deduction on equity, despite widespread global rules imposed by the OECD's BEPS project that limit deductions.
"Countries have done several experiments to fix this [the debt-equity bias], but they were all abandoned … and during the BEPS project everyone agreed that imposing a limit of interest deduction at 30% of EBITDA is the way to go ," Giralt continues.
According to sources, there is no reason for a complicated DEBRA proposal to succeed when other proposals have failed. According to ITR's sources, the Commission may be isolating the EU by overcomplicating the bloc's tax system with an equity-based deduction rather than aligning it with the majority of countries that cap the number of allowable deductions.
DEBRA signifies the European Union's acceptance of notional interest deductions for tax purposes. Banks, for example, benefit from the deduction because their assets are primarily intra-company receivables.
However, the tax deduction is "out of sync with the rest of the world," according to one head of direct tax at a Dutch investment firm, and will result in international tax compliance issues in countries outside the EU.
"There are too many rules with not enough thought," he says. "The Commission is eager to lead international tax but lacks the staff numbers to give proposals the depth they require."
There are also concerns about how the Commission can prevent tax avoidance. To boost group equity and take advantage of the DEBRA directive, parent companies might move capital to tax-exempt subsidiaries.
However, several anti-abuse rules apply to the DEBRA proposal's definition of equity to ensure that the tax benefit is not passed from one subsidiary to the next.
Johan Barros, a manager at the Brussels-based professional accounting group Accountancy Europe, believes the Commission should answer a few more questions about how the proposal will interact with anti-abuse laws outside the EU.
Questions include whether misalignments in the incoming EU directive and laws in other countries will result in double taxation issues for banks and other businesses; how the Commission will prevent accounting tricks to boost net equity in EU entities; and whether the deduction will work well with the OECD's global minimum tax calculations, which begin in 2023.
"The directive’s interaction with other rules will pose challenges too," Barros adds.
Large business groups support the DEBRA proposal because it provides additional funding for mergers and other business activities by 2024, but in-house tax experts and advisers say it jeopardizes international tax affairs at a time when most countries are moving toward global tax alignment.
By fLEXI tEAM