The European Commission has published an inception impact assessment seeking feedback on the initiative to reduce the debt- equity tax bias in the EU, as part of the recent corporate tax reform proposal within the Communication for Business Taxation of the 21 Century.
It is widely acknowledged in the academic literature that the debt-equity tax bias is highly distortive of investment decisions. Interest as a return on debt is tax planning efficient, whereas similar tax benefits are ordinarily not in place for equity investment. As a result, companies often become highly leveraged for taxation purposes, which hinders innovative investment through equity whilst piling debt. At present tax legislation of only six EU Member states includes some form of allowance for corporate equity (ACE). An ACE would retain the deduction for interest expenses but would also add a similar deduction for the normal return on equity.
Various studies have looked at how the tax benefits of debt financing can potentially influence financing decisions. It has been argued that by financing a company through debt the tax liability is reduced as repayments (cash outflows) create a tax deduction. GrantThornton (2016) predicts that the leading tax benefit is derived from the tax deduction obtained for interest
expenses. Debt bestows a tax benefit on companies when interest payments are deductible from taxable income.
The EU Commission is seeking feedback on two proposed options:
- Disallowing the deductibility of interest payments, or creating an allowance for equity (ACE) by enabling the tax deductibility of notional interest for equity;
- Introducing allowance for a notional interest deduction on all corporate equity, new corporate equity or corporate capital (equity and debt).