Proposal for EU Directive introducing debt-equity bias reduction allowance (DEBRA)

The European Commission published a proposal for Directive to address the debt-to-equity bias in corporate taxation following earlier agreed initiatives to promote an efficient and fair tax system in the EU.

Bulgaria like other Member States accepts the deductibility of interest payments on debt with certain limits while the “costs” of equity financing (i.e., dividends) remain non-tax deductible at all. Theory says that this creates bias in financial management decisions towards debt financing opposed to the use of equity.

The proposed Directive aims at neutralizing the preference of debt over equity tax wise by featuring two separate measures that incentivize equity funding while at the same time further limit the deduction of borrowing costs.

Measure 1: Allowance on equity

Under the proposed rules, companies falling within the scope of the Directive will be allowed to deduct equity allowance from its tax base for 10 consecutive tax periods. The latter will be generally determined by multiplying the difference in the equity levels year on year with notional interest rate comprised of the 10-year risk-free interest rate for the relevant currency plus a risk premium (i.e., the former being 1% and up to 1.5% in case of SMEs). Similar to the debt limitation provisions based on the EU Anti-Tax Avoidance rules, the deductibility of the allowance cannot exceed 30% of the company’s EBITDA for each tax year. According to the proposal, the non-deducted equity allowance (where cannot be used due to insufficient taxable profits) under the new regime can be carried forward.

Measure 2: Limited tax deductibility of debt financing costs

Along with the equity allowance, the proposal introduces a restriction of 15% on the deductibility on exceeding borrowing costs. 

Scope

The new rules once adopted by the Member States would apply to all taxpayers subject to corporate income tax in Bulgaria, with certain exceptions such as for financial undertakings, specific investment vehicles and institutions.

Deadline

Bulgaria should have to transpose the new provisions by 31 December 2023 with entering into force on 1 January 2024.

Impact in Bulgaria

Bulgaria already has in place a number of tax rules that work alongside to restrict the deductibility of finance costs. The thin capitalization regime targets related party debt arrangements of highly leveraged entities, while the “interest barrier” regime imposes an ultimate 30% EBITDA cap on all borrowing costs. This comes on top of the more stringent regime that denies deduction of interest on specific hybrid debt arrangements.  

Unless a wider overhaul could replace the intertwined sets of rules, DEBRA would likely add yet another layer of complexity when it comes to computing deductible finance costs. On the other hand, the introduction of deductible equity costs could provide opportunities for optimizing the tax position of highly capitalized entities. The new regime is set to take place eventually along with the introduction of minimum 15% corporate tax in the EU.