Debt Equity Bias Reduction Allowance

POSITION | TAX POLICY | CORPORATE FINANCE

Debt Equity Bias Reduction Allowance

German industry’s position on the EU Commission’s proposal

Executive Summary

On 11 May 2022, the European Commission published a proposal for a debt equity bias reduction allowance (DEBRA) to address the debt equity bias in taxation, and, on a broader level, to support the integration of European capital markets by reducing tax obstacles which continue to impede cross border investment in the EU and the functioning of the single market As a general principle, German industry welcomes the European Commission’s efforts to address and mitigate the debt equity bias in taxation. An equal tax treatment of investments that are funded through equity financing by making them tax deductible like debt financing arrangements can improve the resilience of businesses during economic downturns and support European businesses’ capital structures, foster investment and long term growth. This is becoming increasingly important since economic recovery is halting, and German industry is heading for a severe recession.

However, introducing an allowance for incremental equity and disallowing a share of interest payment for all debt at the same time cannot be considered as a balanced approach to addressing the debt equity bias in taxation. This is especially true in current times where increasing economic and political uncertainty is accompanied by recent and forthcoming decisions of the European Central Bank to raise interest rates in order to fight inflation Higher interest rates are pushing up investment costs already, and disallowing interest deductions will further increase costs and disproportionately reduce investment incentives A new strict interest deductibility regime would therefore have severe consequences for the European economy. Given that large investments will be needed from the public as well as the private sectors to overcome recession and to achieve the green and digital transformation, these economic consequences would be even more problematic. In this context, tax incentives are a useful tool to steer desired behaviour and foster private investment

As we feel that the current proposal is not sufficiently well thought out from a more general tax systemic perspective, we call on the European Commission to embed the DEBRA initiative in a broader concept which strives for an administrative simplification of European tax law From a German industry point of view, an allowance on new corporate equity would be the most appropriate method as it would support equity financing as a further financing option available to businesses and thereby boost investment and economic growth without creating any kind of distortions. BDI, however, cannot support a measure that would create a competitive disadvantage for European businesses

Introduction

On 11 May 2022, the European Commission released a proposal for a debt equity bias reduction allowance (DEBRA)1 to address the debt-equity bias in taxation. In many corporate tax systems around the world, interest payments associated with debt are generally tax deductible while at the same time costs related to equity financing, such as dividends, are usually not. As dividend income is generally subject to tax, from a tax perspective, equity is treated less favourably than debt. According to the European Commission, this asymmetric tax treatment is one of the causes favouring the use of debt over equity for financing investments

The proposed DEBRA directive lays down rules on an allowance for incremental equity, thereby making new equity tax deductible, and on a limitation of the tax deductibility of interest payments. According to the draft directive, on one hand, the disparity in the treatment of debt and equity financing should be addressed by an equity allowance that is calculated as follows:

This allowance on equity should be tax deductible for ten consecutive tax years, as long as it does not exceed a total of 30% of the taxpayer’s taxable income. On the other hand, the proposal would introduce the limitation of the deductibility of net interest (i.e. interest paid minus interest received) related to debt to 85%

General comments

We shall begin with the observation that equity finance as well as debt finance is gaining significance for companies when they need to raise capital. This view is shared by the European Commission, which noted in its 2020 Capital Markets Union Action Plan whose objective is to “support a green, digital, inclusive and resilient economic recovery” by further easing the access to finance for European companies, that “funding for companies through bonds and private equity has increasingly played an important complementary role to bank lending in recent years.”2 Especially with the green transition ahead and the necessary investments to address climate change, access to different finance sources is of utmost importance for businesses. Therefore, especially an allowance on corporate equity is an idea worth pursuing Businesses with a robust and solid equity base can also enhance the stability of the overall economic system and thereby mitigate the effects of economic crises or external shocks, however debt finance which is equally necessary should not be penalized.

However, in its current form, the proposal is not balanced and would put Europe at a competitive disadvantage compared to other regions of the world where full deductibility of interest remains in place. The proposal seems to assume that every company would have unlimited access to equity if it wished, that companies only do not have higher equity ratios because the tax rules purportedly present a bias towards interest financing. These assumptions do not hold true for the majority of the German companies. As it is known, Germany has a considerable number of family owned SME (the German “Mittelstand”) and of companies owned by foundations. These companies are not listed at stock exchanges and have limited possibilities of increasing their equity ratio. Moreover, companies frequently need to resort to debt in order to be able to remain competitive and survive. This can be clearly seen e.g. in the automotive sector, which is at the heart of the German economy. The increasing international

competitiveness and the technological disruptions of the last decades electric cars, autonomous driving, software as service left no option for this sector but increasing debt financing to enable R&D investment. This structural debt need has been further aggravated by subsequent crises: Covid 19, chip shortage, logistic and other challenges due to the Russian war in Ukraine, increasing gas prices, inflation, etc.

Given that large investments will be needed from the public as well as the private sectors to achieve the green and digital transformation and to keep companies alive, these economic consequences would be even more problematic. In general terms, tax incentives are a useful tool to steer desired behaviour and foster private investment, both of which are key to supporting the competitiveness of European industry Unlocking investments from the private sector and thereby supporting a strong and innovative industry will help Europe keep pace in the global competition in climate innovation technologies and digitalisation

Relying only on available equity will however be insufficient for financing private investments in climate and environmental protection measures since this requires massive investments across all sectors and from businesses of all sizes.

Allowance on new corporate equity (Article 4)

According to Article 4 of the draft directive, an allowance on incremental equity (the difference between the level of net equity at the end of the tax period and the level of net equity at the end of the previous tax period) would be granted for a period of ten consecutive tax years.

As BDI has already stated in its feedback to the European Commission’s public consultation in preparation of the draft directive, we believe that a preferential treatment of new profits would indeed be the most feasible solution since it would not come at the expense of substantial tax losses. We would like to underpin our argument with an example which can be found later in this paper.

The limitation to ten years as foreseen in Article 4 of the draft directive is too short as the lifetime for a project is usually longer. Moreover, a ten year limitation is not present in any similar legislative measure in EU member states providing for a tax allowance on equity The timing disadvantage becomes clear when equity and debt financing are compared. If investments are financed for several years (e.g. for 15 years) with debt capital, the interest deduction takes place over the entire period of 15 years. In direct comparison to equity capital, the latter would be limited to ten years under the current proposal for a NID. Hence the remaining five years of the investment would be less attractive compared to debt capital.

On top, the current proposal implies that the benefit a company receives through the proposed notional interest deduction (NID) is only temporary, as any later reduction in equity will be penalized with a negative NID over a period of 10 years. This is especially important as it is common business practice to also distribute dividends over the lifetime of an investment and therefore reducing the equity if the capital is not used for investment purposes. Thereby the benefit obtained would be recaptured over the lifetime of the project making the allowance for businesses only a temporary benefit over an investment’s life cycle The proposed allowance on new corporate equity should therefore only be introduced without time limitations as such a cap precludes the aim of putting debt and equity financing on an equal footing across the EU.

Corporations also typically distribute dividends, thereby reducing their capital, especially if the capital is not used for investment purposes This is because in business practice, investors in corporations want to see a return on their investment in form of distributions. Accumulating excessive and unreasonable cash reserves would only make companies less attractive to investors and it may also become unreasonable to undertake all equity financed investments.

Limitation on the deductibility of interest (Article 6)

The second major concern associated with the draft directive is Article 6, which would introduce an additional limitation to interest deduction beyond the provisions under the European Anti Tax Avoidance Directive (ATAD 1). There are considerable concerns that this measure would contradict basic taxation principles such as the ability to pay principle (which states that taxes should be paid according to one’s means) and the objective net principle (guaranteeing the deduction of business costs from the taxable basis) A partial limitation of the deductibility of all interest expenditure could be justified as a derogation from “objective net principle” which is backed by the German Constitution especially referring to Article 3 (1) of the German constitution that lays down the principle of equality.

From an economic policy point of view, one must also keep in mind that interest expenditure is directly related to generating income and is therefore an allowable deduction. Especially in the current changing interest environment, any proposal that limits the deductibility of interest would harm the economy as a whole and European businesses in particular. When it comes to future investment decisions of businesses, the proposal as it stands would be a competitive disadvantage for Europe. Compared to the full deductibility of interest payments in other parts of the world, investments in other countries would always be more beneficial than in the EU with a 15% non deductibility of interest. This might result in an even bigger economic burden in a different interest rate environment.

Partially precluding businesses from a flexible and diversified financing option such as debt financing might even contribute to inefficient capital allocation. The recent economic crisis created by the Covid 19 pandemic can serve as an example where equity markets collapsed, forcing businesses to heavily rely on debt financing due to extraordinary circumstances In such a situation where further increasing a business’ equity base can be very challenging, limiting the deductibility of interest would only lead to a higher risk premium paid to investors in the form of higher interest rates and thus potentially impair the resilience of businesses during an economic downturn.

Asymmetries in the proposal

There are several asymmetries inherent in the proposal which we believe require a significant amount of re thinking and re drafting. As it stands, the draft directive does not form part of a systematic approach concerning the taxation of income from capital and may in the final instance even impede cross border activities of businesses due to uncoordinated provisions.

In order to create a harmonized tax environment for businesses that allows businesses to make better use of the advantages associated with the Single Market (which is the aim of the upcoming ‘BEFIT’ initiative), the DEBRA initiative should be embedded in a broader concept striving for an administrative simplification of European tax law. Otherwise, there is a severe risk that a well intentioned initiative may only come along with an additional layer of complexity to an already highly intricate framework for corporate taxation. This can outweigh the intended benefits associated with the proposal.

The need to refine the proposal is further underlined by the fact that the new interest limitation rule under the DEBRA may also accelerate an economic downturn because in times of crises, businesses often have little or no access to equity markets. Together with a changing overall interest rate situation as we see it today, limiting the deductibility of interest wouldonly further harm the economy and businesses At atime where businesses might struggle with generating new equity financing sources, they would also need to deal with a partial deductibility of interest payments (capped at 85%).

Furthermore, the underlying rationale of the proposal is imbalanced. Not only will all businesses subject to corporate income tax be affected by Article 6 of the draft directive that limits the deductibility of interest payments to 85%, but the NID will also benefit only a limited amount of companies. The advantage for businesses associated with the NID would be even more limited as businesses with a comparatively high equity base will benefit less than others with a low equity ratio. In this context, too, the DEBRA as it stands could contribute to inefficient allocation of capital

From a more general tax systemic perspective, the provisions of Article 4 and Article 6 cannot plausibly be related to each other as they are based on different reference values While on the one hand the allowance on new corporate equity refers to a delta value (being a change in equity), the additional interest limitation rule represents a fixed quantity

Example

We would like to illustrate the effects of introducing an allowance on new corporate equity by referring to the following example3 and has been laid out in the aforementioned BDI response to the public consultation It is based on the assumptions listed below:

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As the equity deduction is granted for equity formed in excess of the level existing on 1 January 2022, no deduction is granted in the first year.

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In case the equity either falls below its original level of 100,000 or if the businesses recorded losses in the years in question, no deduction will be applicable in these years and no carryforward of the equity cost deduction from those years will apply.

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In the year 2024 there is no equity deduction, as there is no carryforward of the deduction from loss years.

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In 2025, no minimum taxation is applied since losses of less than EUR 1 million are generated and carryback is waived

based on Körner, Andreas, Alternativkonzept zur Abgeltungsteuer, Der Betrieb 2015, 403p.

Example 2022 2023 2024 2025 2026

(1) Equity for tax purposes per 01.01. 100,000 100,700 102,106 99,106 103,506

(2) Profit / loss before tax of the respective year 1,000 2,000 3,000 5,000 1,500

(3) Profit / loss after loss carry forward 1,000 2,000 3,000 2,000 1,500

(4) Tax before costs of equity (rate 30.0%) 300 600 0 600 450

(5) Equity base for deduction 0 700 2,106 0 3,506

(6) Equity deduction 0 21 63 → 0 0 105

(7) Effect: 30.0% of (6) 0 6 0 0 32

(8) Tax after effect = (4) - (7) 300 594 0 0 418 (9) Equity for tax purposes per 31.12. = (1) + (2) (8) 100,700 102,106 99,106 103,506 104,588

All numbers in units of currency.

In this case, 2022 would be the starting point after which the allowance would be granted to new corporate equity based on accumulated earnings or accumulated equity. The example illustrates that by limiting the allowance to new corporate equity, potential tax losses can be mitigated Hence there is no need for introducing a new interest limitation rule to limit the fiscal costs of the overall proposal as this can also be achieved by limiting the allowance to new corporate equity

Final remarks

From a German industry point of view, the potential advantages of the proposed allowance on new corporate equity are in no relation to the disadvantages applicable to all debt financing arrangements

This is all the more true because the proposed notional interest deduction (NID) would provide only a temporary, limited benefit for businesses while at the same time the partial interest limitation would come along with a permanent disadvantage for businesses

With the transition to a green and digital economy ahead of us, not only the public, but also the private sector will be needed to deliver on investments in order to make these transformations a success. An allowance on new corporate equity should therefore only be introduced without any restriction by a pre defined period on the one hand and without the foreseen restriction of 15% on the deductibility of debt related interest payments on the other hand. These modifications will help put debt and equity financing on an equal footing across the EU.

Imprint

Bundesverband der Deutschen Industrie e.V. (BDI) Breite Straße 29, 10178 Berlin www.bdi.eu T: +49 30 2028 0

German Lobbyregister Number R000534

Editorial

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 2 792 1012 p.gmoser@bdi.eu

BDI Document number: D 1663