In May 2021, the European Commission launched a series of tax initiatives to promote productive investment and entrepreneurship while ensuring fair and efficient taxation. A year later, a draft directive known as DEBRA was published that would introduce an additional allowance that companies could deduct from their corporate tax base.
This measure is intended to use the tax system to improve the financing of EU companies through equity. Currently, companies’ equity payments take the form of dividend distributions that are not deductible from their corporate tax base, whereas their interest payments generally are. The draft directive would restore a certain balance between companies’ use of debt financing versus equity financing by creating a notional tax-deductible allowance, calculated on the increase in their equity during the year. The allowance would be equal to this increase multiplied by the 10-year risk-free interest rate for the relevant currency, plus a risk premium of 1% (or 1.5% for SMEs). This allowance could theoretically be applied each year for 10 years.
However, there are some limitations and anti-abuse provisions attached to the measure that may dampen its appeal. In particular, the annual allowance is limited to 30% of a company’s EBITDA (earnings before interest, taxes, depreciation and amortisation). The limit is similar to that applied to the tax deductibility of interest (as this provision followed Luxembourg’s implementation of the EU anti-tax avoidance directive, or ATAD). However, the draft DEBRA directive does not indicate whether the 30% limit should be calculated on the tax-EBITDA – for which tax-exempt income is subtracted, which would result in a lower limit. It also remains to be seen whether the EBITDA can include, for example, financial income from long-term receivables financed by equity. Depending on which approach to these cases is chosen, equity financing could sometimes prove slightly more attractive than debt financing from a corporate tax perspective.
A further limitation is that companies will not be permitted to calculate the allowance on increases in equity arising from loans, or from transfers of intra-group holdings (which generally entail a participation of at least 25%). This is meant to prevent cascading equity deductions down the corporate chain. So, where equity-financed company A uses its equity to finance company B with loans, and company B uses those funds to finance company C with equity, only company A is allowed benefit from the deduction on that equity. In such a case, it might make better tax sense to finance company C with debt.
There are also other limitations to take into account. For example, where an equity increase results from a contribution in kind or an investment in assets, the assets in question must be deemed necessary for the company’s business. Contributed assets are to be valued at their market value, and shares at their book value. Finally, in the case of group reorganisations, companies may not count capital increases from equity that already existed within the group.
In parallel, the draft directive provides for an adjustment of the rules limiting interest deductibility (out of the above-mentioned EU directive ATAD, inserted into Article 168bis of Luxembourg’s income tax law). As a result, companies will only be able to deduct 85% of their exceeding borrowing costs (essentially the excess of interest expense over interest income). If this amount is higher than that calculated under ATAD rules, only the lower amount will be deductible, while the difference can be carried forward under current law.
Note that these rules will apply to taxpayers resident in an EU Member State and subject to corporate income tax (in Luxembourg, the impôt sur le revenu des collectivités). They will not apply to a whole list of taxpayers that are considered financial undertakings, such as credit institutions, investment firms, hedge funds, hedge fund managers, UCITS, UCITS management companies, insurance and reinsurance undertakings, pension institutions, securitisation vehicles (covered by Regulation (EU) 2017/2402) and crypto-asset service providers.
Taken together, we believe that the provisions of the draft DEBRA directive could offer a fair solution from a corporate tax perspective for companies looking to increase their equity financing and reduce their debt.
However, Luxembourg has always substantially penalised companies for increasing their equity financing. This is part of the cost represented by wealth tax. This tax is calculated annually on companies’ equity at the rate of 0.5% (or 0.05% for taxable assets over €500 million), and a minimum applies. However, this amount can be reduced if the company is required to pay enough corporate income tax. At the same time, dividends paid by Luxembourg companies are generally subject to 15% withholding tax (unless an exemption or legal reduction applies), whereas interest is not subject to withholding tax as a rule.
Consequently, it is our view that the DEBRA proposal will only be able to encourage Luxembourg companies to use (majority) equity financing to the extent that there is a parallel provision limiting or even eliminating the impact of wealth tax. Remember that Luxembourg is one of the few countries that still levies an annual tax on companies’ equity. Beyond the fact that, for a financial centre that is supposed to attract capital and promote its accumulation, such a tax constitutes a major paradox (one that we have highlighted for many years), we do not see maintaining the wealth tax as reconcilable with DEBRA and the logic put forward by the Commission.
As the DEBRA proposal is meant to be implemented and applied by Member States from 1 January 2024, now is the time to consider abolishing the wealth tax and introducing compensatory budgetary measures as part of the next tax reform.
Ratio d’endettement des sociétés: quelles opportunités pour le Luxembourg? (Paperjam)
