Consultation on a Debt Equity Bias Reduction Allowance

Position

on the European Commission’s

Consultation on a Debt Equity Bias Reduction Allowance

Federation of German Industries e.V. EU Transparency Register: 17718117758-48

Date: 4 October 2021

Consultation on a Debt Equity Bias Reduction Allowance

Contents 1.

General remarks ................................................................... 3

2.

Design of a Debt Equity Bias Reduction Allowance .......... 5 a. Overall design ....................................................................... 5 b. Specific design features ...................................................... 7 c. Additional comments ........................................................... 8

3.

Final remarks ........................................................................ 9

About BDI....................................................................................... 10 Imprint ............................................................................................ 10

Consultation on a Debt Equity Bias Reduction Allowance

1. General remarks Today, many corporate tax systems favour debt financing over equity resulting in a corporate tax bias towards debt financing. To put it bluntly, the debt equity bias penalizes equity finance as it is one of the roots for businesses to favour debt financing over equity. Given this diverging tax burden resulting from different financing sources, we share the European Commission’s assessment which inter alia has been laid down in the Capital Markets Union Action Plan1 that funding for businesses through bonds and private equity is playing an increasingly important role and acts as a complement to bank financing. In our opinion ending the favourable treatment of debt and promoting equity financing would provide a welcomed complement to traditional bank financing arrangements as the corporate sector needs more equity investment. Access to financing is vital for any business at any time. This is especially true for the post Covid-19 recovery period as, inter alia according to the European Systemic Risk Board (ESRB), many businesses are confronted with higher levels of debt.2 In this context, capital markets can play a crucial role in supplying more equity. Making the costs of an investment which is funded through equity financing tax deductible would provide support for businesses not only during economic downturns, but foster investment and long-term growth. This is even more important as European businesses, in contrast to the United States, are still mainly financed by conventional bank loans making European companies potentially more affected by economic crises. The Debt Equity Bias Reduction Allowance (DEBRA) initiative could therefore also help to mitigate the imbalance between Europe and the United States.

BDI therefore strongly welcomes the European Commission’s aim to support the post-Covid-19 recovery and increase equity financing of the private sector via tackling and mitigating the potential tax induced debt-equity bias.

However, the effectiveness of the measure strongly depends on its final design. German industry would especially welcome the creation of an allowance for equity-financed investments by offering a tax deductibility for 1

European Commission, Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions, A Capital Markets Union for people and business-new action plan, Brussels, 24.9.2020, COM(2020) 590 final, 7.

2 European Systemic Risk Board, Prevention and management of a large number of corporate insolvencies, April 2021. The study inter alia concludes that “the worst-hit sectors have seen substantial deterioration in their financial position since the pandemic. Profits have significantly deteriorated, own equity has decreased, and debt levels have risen in the most heavily impacted sectors (…).”

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Consultation on a Debt Equity Bias Reduction Allowance

notional interest on equity. At the same time, this implies that measures that would disallow the deductibility of interest payments would be counterproductive from the standpoint of strengthening equity investment. Interest deductibility is an essential part of the corporate tax system as it ensures tax neutrality of investments. Removing neutrality would raise the overall cost of capital. In order to address the debt financing advantage, the European Commission should therefore make changes to the treatment of equity rather to the treatment of debt. While the favourable tax treatment of debt should be maintained, new incentives for equity financing via allowing the tax deduction of notional interest should be created.

German industry also shares the likely economic impacts laid down in the Inception Impact Assessment, in particular regarding the “obvious benefits in terms of financial stability, as companies with a stronger capital base would be less vulnerable to shocks.” The importance of appropriate capitalization for the recovery from large economic shocks, not only for banks, became all too clear in the most recent crisis.

In any case, any measure which aims to encourage businesses to finance more investment through equity contributions instead via debt should be carefully designed in order to fully develop its potential for economic growth. In light of the possible design of the upcoming measure, the European Commission should strive for an ambitious proposal which is open to companies of all size that places debt and equity financing on equal footing across the EU. Overall, the underlying problem should be considered in a wider context as there are also other factors which play a role when it comes to the financing decisions of a company.

BDI has a long track-record of supporting the deepening of the European capital market in order to improve financing conditions for companies.

Therefore, German industry also welcomes the European Commission’s objective to further strengthen the Capital Markets Union initiative which is designed to increase the capital market orientation of companies in parallel to conventional financing channels in order to remove barriers to investment in the EU. A true single market for capital that reduces the fragmentation of European financial markets can improve access to finance for industry, explore new sources of corporate finance and increase the efficiency and stability of the integrated European capital market. Easier access to the bond and equity markets, especially for larger SMEs, and the promotion of venture capital and equity financing are important areas of action that are highly significant from the perspective of the real economy.

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Consultation on a Debt Equity Bias Reduction Allowance

2. Design of a Debt Equity Bias Reduction Allowance Not least the economic crisis in the aftermath of the Covid-19 health crisis has shown that having access to financing is of utmost importance for businesses of all size and sectors so that the solvency of all entities of a group is ensured at all times. Equity investment can play a key role when it comes to supporting growth and job creation as well as fostering innovation. Therefore, German industry welcomes the intention to create a tax framework which aims to eliminate barriers of group financing. In the majority of cases, equity financing or financing via an equity-like instrument may be preferable to debt financing. And yet both financing methods have their special features and are complementary to each other. Offering specific advantages over the other one, the DEBRA initiative should not restrict debt financing but rather promote equity financing.

In its Inception Impact Assessment, the European Commission refers to legislative measures in place in already six EU Member States (Belgium, Cyprus, Italy, Malta, Poland and Portugal) in order to tackle the tax induced debt-equity bias. While the respective measures differ in policy design, they all provide for a tax allowance on equity. The European Commission should therefore study the effectiveness of the systems in place in the respective Member States with a view to enabling the tax deductibility of notional interest for equity in all European Member States. In addition, we would like to refer to two other European Member States where business income is not taxable as long as it is retained and reinvested in the company: Estonia and Latvia. These two countries levy CIT only on corporate profits that are distributed and temporarily exempt undistributed corporate profits. Their tax systems therefore also feature elements with the similar objective of reducing the tax discrimination between debt and equity. Such a deferred taxation does not lead to declining tax revenue, it instead has the potential to promote economic growth and employment which are crucial after overcoming the current crisis. a. Overall design The European Commission discusses different policy options in order to achieve the objectives pursued by the initiative. They could be achieved via “disallowing the deductibility of interest payments” or by “creating an allowance for equity by enabling the tax deductibility of notional interest for equity”. In this context, we want to stress that not all measures which aim to mitigate a potential tax induced debt-equity bias would come along with positive effects for growth and employment. It may be argued that disallowing the deductibility of interest payments might be feasible in order to eliminate

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Consultation on a Debt Equity Bias Reduction Allowance

the debt-equity bias in corporate taxation because several European Member States have already introduced provisions which limit the deductibility of taxpayers’ borrowing costs. However, we would like to refer to the impact assessment accompanying the 2016 proposal for a Council Directive on a Common Corporate Tax Base and a Common Consolidated Corporate Tax Base (CCCTB) which stresses that the “non-deductibility of interest leads to a negative effect on GDP, driven by depressed investment.”3 This would be especially true for innovative businesses which often strongly rely on debt financing in order to finance their growth. An approach which would be based on disallowing the deductibility of interest payments would therefore come along with an additional burden for businesses. Irrespective of the final design of the DEBRA proposal, interest deductibility shall remain applicable in any case as an elimination would run counter the principle of tax neutrality by increasing the cost of capital.

In addition, the non-deductibility of interest could reach German constitutional limits when considering the ability to pay doctrine and the objective net principle stressing the equal treatment of taxpayers: These two principles stress the equal treatment of taxpayers and that only net income, i.e. income after the deduction of business expenses may be subject to income taxation.

In general, interest on capital is considered as an expense for businesses and therefore it is a perfectly legitimate deductible business expense. We would also like to recall that the German Federal Court of Finance (Bundesfinanzhof) ruled that the interest barrier rule which restricts the tax deductibility of net interest expenses to 30 per cent of earnings before interest, taxes, depreciation and amortization (EBITDA) violates the principle of equal treatment.4 At the moment, the final decision on the constitutionality of the interest barrier rule by the German Federal Constitutional Court (BVerfG) is still pending.

As laid down in the Inception Impact Assessment, the European Commission expects the economic advantages of introducing an allowance for equity to be “overall positive” as they “should lead to moderate increases in investment, employment and growth”. We therefore invite the European Commission to follow the approach of creating an allowance for equity by enabling the tax deductibility of notional interest for equity.

Another way of achieving the objective of creating incentives for equity financing would be to create a corporate income tax privilege for retained 3

European Commission, Commission Staff Working Document, Impact Assessment Accompanying the document Proposals for a Council Directive on a Common Corporate Tax Base and a Common Consolidated Corporate Tax Base (CCCTB), Strasbourg, 25.10.2016, SWD(2016) 341 final, 50.

4 Bundesfinanzhof (BFH), case ref. I R 20/15. www.bdi.eu

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Consultation on a Debt Equity Bias Reduction Allowance

profits similar to the Estonian or Latvian model. By making corporate income subject to deferred taxation, businesses can use retained profits for additional investments and the creation of jobs. This also reduces incentives for borrowing and lending while at the same time there is no risk of tax losses. Last but not least, corporate income that remains within the company serves as additional liquidity which is of increased importance especially in times of crisis. b. Specific design features The second type of approach which would grant an additional deduction for equity financing could be achieved through an allowance for a notional interest deduction on either all corporate equity, on new corporate equity or on corporate capital (equity and debt). Among these measures, we believe that a preferential treatment of new corporate equity or new profits would be the most practicable solution. However, a clear definition of equity on which the notional interest can be calculated is a necessary prerequisite.

We would like to support our opinion with the following example which is intended to illustrate the effects of allowing a deduction on new corporate equity. In the example illustrated in Table 1, which is based on the numerical example in Körner (2015)5, the equity deduction is granted for any equity formed in excess of the level existing on January 1, 2021, i.e. for the amount exceeding 100,000.

Table 1 relies on the following assumptions:

5

-

No deduction is granted in the first year, as the equity deduction is granted for any equity formed in excess of the level existing on January 1, 2021

-

If the equity falls below its original level of 100,000, or if the business recorded losses in the years in question, there is no deduction in these years and no carryforward of the equity cost deduction from those years.

-

In 2023 there is no equity deduction, as there is no carryforward of the deduction from loss years.

-

In 2024, no minimum taxation is applied, since losses of less than EUR 1 million are generated and since there is no carry back, e.g. because the carryback is waived.

Körner, Andreas, Alternativkonzept zur Abgeltungssteuer, Der Betrieb 2015, 403p.

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Consultation on a Debt Equity Bias Reduction Allowance

Example 2021 2022 2023 2024 2025 100,000 100,700 102,106 99,106 103,506

(1) Equity for tax purposes 01.01.

(2) Profit / loss before tax of 1,000 2,000 the respective year (3) Profit / loss after loss 1,000 2,000 carry forward (4) Tax before costs of eq300 600 uity (German average 30.0%) (5) Equity base for deduc0 700 tion > 01.01.2021 (6) Equity deduction: 3.0 % 0 21 of (5) (7) Effect: 30.0% of (6) 0 6 (8) Tax after effect = (4) - (7) 300 594 (9) Equity for tax purposes 100,700 102,106 31.12. = (1) + (2) – (8)

-3,000

5,000

1,500

-3,000

2,000

1,500

0

600

450

2,106

0

3,506

63 → 0

0

105

0 0 32 0 0 418 99,106 103,506 104,588

Table 1 (all numbers in units of currency)

The example above shows that in the case the European Commission opts for a preferential treatment of new corporate equity, there is no risk of tax losses.

If the European Commission chooses a solution which taxes distributions and deemed distributions rather than corporate income (similar to the Estonian or Latvian model), a preferential treatment for equity which has been built up after a specified date appears to be the most practicable approach. c. Additional comments We are aware that the European Commission intends to include anti-abuse measures to prevent the use of the allowance for tax avoidance purposes.

However, in case the European Commission opts for introducing an allowance for a notional interest deduction on new corporate equity or for a solution similar to the Latvian or Estonian system, no additional anti-abuse provisions would be necessary. In addition, we would like to recall that there are already several existing provisions with the purpose of preventing abusive behaviour in place. First and foremost, the Anti-Tax-Avoidance Directives (ATAD) I & II, in particular the interest barrier rule, already provide a www.bdi.eu

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Consultation on a Debt Equity Bias Reduction Allowance

sufficient degree of anti-abuse measures in the area of debt-financing. We would therefore invite the European Commission to conduct a review of the regulations already in place.

Eliminating any bias towards any particular kind of financing precisely would also put an end to incentives for tax structuring options. Last, but not least, a uniform and consistent system throughout the EU would prevent arbitrage between tax systems in the EU, moreover, all other (non-EU) cases are sufficiently addressed by existing CFC-legislation. If the European Commission nevertheless considers such measures to be necessary, we suggest focusing on specific and targeted anti-abuse provisions instead of narrowing the scope of DEBRA. 3. Final remarks BDI encourages the European Commission to improve the neutrality between debt and equity financing. In our view, a preferential treatment of new corporate equity or new profits would be the most eligible solution as it is the only way to address the debt equity bias without creating other distortions.

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Consultation on a Debt Equity Bias Reduction Allowance

About BDI The Federation of German Industries (BDI) communicates German industries’ interests to the political authorities concerned. She offers strong support for companies in global competition. The BDI has access to a wide-spread network both within Germany and Europe, to all the important markets and to international organizations. The BDI accompanies the capturing of international markets politically. Also, she offers information and politico-economic guidance on all issues relevant to industries. The BDI is the leading organization of German industries and related service providers. She represents 40 inter-trade organizations and more than 100.000 companies with their approximately 8 million employees. Membership is optional. 15 federal representations are advocating industries’ interests on a regional level.

Imprint Federation of German Industries e.V. (BDI) Breite Straße 29, 10178 Berlin, Germany www.bdi.eu T: +49 30 2028-0 Contact Dr Monika Wünnemann Head of Department Tax and Financial Policy T: +49 30 2028-1507 m.wuennemann@bdi.eu Philipp Gmoser Senior Manager Tax and Financial Policy T: +32 2 79210-12 p.gmoser@bdi.eu BDI document number: D 1450

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