• The Debt Equity Bias Reduction Allowance (DEBRA)

    Currently, only six Member States address the debt-equity bias from a tax perspective and the relevant national measures differ significantly.

The Debt Equity Bias Reduction Allowance (DEBRA)

Josef Mercieca, Tax Partner |

17 May 2022

On the 11th May 2022, the EC published a proposal for a Directive meant to reduce the present inequality resulting from financing of an enterprise through equity (no tax deduction) versus debt (tax deduction for interest).

The proposed Directive instrument is referred to as the Debt Equity Bias Reduction Allowance (DEBRA).

Tax systems in the EU allow for the deduction of interest payments on debt when calculating the tax base for corporate income tax purposes, while costs related to equity financing, such as dividends, are mostly non-tax deductible.

This asymmetry in tax treatment is one of the factors favouring the use of debt over equity for financing investments.

Currently, only six Member States address the debt-equity bias from a tax perspective and the relevant national measures differ significantly. With a view to addressing the tax-induced debt-equity bias across the single market in a coordinated way, the proposed directive lays down rules to provide, under certain conditions, for the deductibility for tax purposes of notional interest on increases in equity and to limit the tax deductibility of exceeding borrowing costs.

It applies to all taxpayers that are subject to corporate tax in one or more Member State, except for financial undertakings. Since small and medium enterprises (SMEs) usually face a higher burden to obtain financing, it is proposed to grant a higher notional interest rate to SMEs.

The proposal includes two separate measures that apply independently:

  1. an allowance on equity; and
  2. a limitation to interest deduction.

Financial undertakings are not in the scope of the measures.

Allowance on equity

The allowance on equity is computed by multiplying the allowance base with the relevant notional interest rate. 

Allowance on equity = Allowance Base X Notional Interest Rate (NIR)

The allowance base is equal to the difference between equity at the end of the tax year and equity at the end of the previous tax year that is the year-on-year increase in equity (Equity is defined by reference to Directive 2013/34/EU (Accounting Directive), meaning the sum of Paid-up Capital, Share premium account, Revaluation reserve and Reserves and  Profits or Losses carried forward).

However, if the allowance base of a taxpayer that has already benefitted from an allowance on equity under the rules of this Directive, is negative in a given tax period (equity decrease), a proportionate amount will become taxable for 10 consecutive tax periods and up to the total increase of net equity for which such allowance has been obtained, unless the taxpayer provides evidence that this is due to losses incurred during the tax period or due to a legal obligation.

The relevant notional interest rate is based on two components: the risk-free interest rate and a risk premium. The risk-free interest rate is the risk-free interest rate with a maturity of ten years. The risk premium is set at 1%, but increased to 1.5% in the case of taxpayers qualifying as small or medium-sized enterprises, to better reflect the higher risk premium they incur to obtain financing.

There should be no discretion on the part of Member States as to whether to apply this higher rate for SMEs or what rate to apply as the top-up for SMEs in order to avoid selectivity concerns as regards EU State Aids rules and to ensure a level playing field for SMEs in the EU regardless of their place of residence.

The notional interest rate is hence equal to the currency specific risk-free rate plus 1% or 1.5%.  

The allowance is granted for ten years to approximate the maturity of most debt. This means that if an increase in a taxpayer’s equity qualifies for an allowance on equity under this proposal, the relevant allowance, computed as above, shall be deductible in the year it was incurred (TY) and in the next successive nine years (TY+9).

If, in the following year (TY+1), a new increase in a taxpayer’s equity also qualifies for an allowance on equity under this proposal, the new allowance on equity will also be deductible for the tax year it was incurred and the following nine years since its incurrence (until TY+10).

By way of example, if a company having equity of 100, decides to increase in year its equity by 20, an allowance will be deducted from its taxable base every year for ten years (until t+9) calculated as 20 times the notional interest rate, i.e. 20 times the risk-free interest rate for the relevant currency plus 20 (20 times the risk premium defined as 1).

Year  t t-1
Equity of Company A     120 100


Allowance base = 120 – 100 = 20

Allowance = Allowance base X NIR = 20 X NIR

The allowance will be available for 10 consecutive years : t, t+1, t+2, ….t+9

To prevent tax abuse, the deductibility of the allowance is limited to a maximum of 30% of the taxpayer’s EBITDA (earnings before interest, tax, depreciation and amortization) for each tax year.

A taxpayer will be able to carry forward, without time limitation, the part of the allowance on equity that would not be deducted in a tax year due to insufficient taxable profit. In addition, the taxpayer will be able to carry forward, for a period of maximum five years, unused allowance capacity, where the allowance on equity does not reach the aforementioned maximum amount. 

Robust anti-abuse measures will ensure that the rules on the deductibility of an allowance on equity are not used for unintended purposes. A first measure would exclude from the base of the allowance equity increases that originate from (i) intra-group loans, (ii) intra-group transfers of participations or existing business activities and (iii) cash contributions under certain conditions.

Thus, for example, as regards intra-group loans, the measure should prevent that an equity injection granted to company A located in Member State A is used to grant a loan to a related company B located in Member State B. This is because in such case, company B would also use this money to inject equity in another related company C, located in Member State C. This would lead to multiplying the allowance on equity with only one genuine equity increase at group level.

Another measure sets out specific conditions for taking into account equity increases originating from contributions in kind or investments in assets. It aims to prevent the overvaluation of assets or purchase of luxury goods for the purpose of increasing the base of the allowance.

Thus, for example, the value of an asset and the related costs should not exceed reasonable professional needs and any part of the value of the asset contributed or recorded in the taxpayer’s accounting books over its market value should be deducted from the base of the allowance.

A third measure targets the re-categorisation of old capital as new capital, which would qualify as an equity increase for the purpose of the allowance. Such re-categorisation could be achieved through a liquidation and the creation of start-ups. For example, if an existing company, with retained earnings, is liquidated, there will be an increase in the equity of the parent company due to the incorporation of the retained earnings. If a new subsidiary is subsequently created and is no longer held by the parent, the previously increased base of allowance of the parent would not be reduced by the value of the participation in the subsidiary.

Limitation to interest deduction

On the debt side, the allowance for notional interest on equity is accompanied by a limitation to the tax deductibility of debt-related interest payments. In particular, a proportional restriction will limit the deductibility of interest to 85% of exceeding borrowing costs (i.e. interest paid minus interest received).

Given that interest limitation rules already apply in the EU under Article 4 of the ATAD, the taxpayer will apply the rule of Article 6 of this proposal as a first step and then, calculate the limitation applicable in accordance with article 4 of ATAD.

If the result of applying the ATAD rule is a lower deductible amount, the taxpayer will be entitled to carry forward or back the difference in accordance with Article 4 of ATAD. 

By way of example, if company A has exceeding borrowing costs of 100, it should:

(1) First, apply Article 6 of this directive proposal that limits the deductibility to 85% of 100 = 85 and thus renders a non-deductible amount of 15. 

(2) Second, compute the amount that would be deductible under Article 4 of the ATAD. If the deductible amount is lower, e.g. 80 (and subsequently the non-deductible higher, i.e. 20), the difference in the deductibility, i.e. the additional non-deductible amount (i.e. 85-80 = 5) would be carried forward or back in accordance with the conditions of Article 4 of ATAD, as transposed in national law.

The outcome for company A is that 15 (100 - 85) of interest borrowing costs are non-deductible and a further 5 (85 – 80) of interest borrowing costs are carried forward or back.


The proposed Directive is meant to be transposed by 31/12/2023 and effective from 1 January 2024.

Article prepared by our BDO Tax Team