Introduction

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:

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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

1 COM(2022) 216 final. 2 COM(2020) 590 final, 6f.