Within the framework of the project "Business Taxation for the 21st Century", the European Commission is proposing an initiative aimed at supporting the creation of a harmonised tax environment that places debt and equity financing on equal footing across the EU. Working on Article 115 TFEU on the approximation of laws of the Member States, the EU Commission aims at helping to reduce the overall debt-equity ratio of companies by creating a common approach within the EU to mitigate the tax induced debt-equity bias, which directly affect the establishment or functioning of the internal market.
The Background and the Objective
Most current tax systems across the EU accept interest payments on debt as a deductible expense, reducing the tax base for the purpose of corporate income taxation. At the same time, the costs related to equity financing are mostly not tax deductible.3 This asymmetric tax treatment of the costs which are linked to financing via debt, as compared to those linked to financing via equity induces a bias in investment decisions towards debt financing. This debt bias of taxation is a long-standing issue.
The tax induced debt-equity bias can contribute to an excessive accumulation of debt for non-financial corporations. Excessive debt levels make companies vulnerable to unforeseen changes in the business environment and increase their risk of insolvency. Necessary business restructuring following insolvency procedures often comes with considerable social costs in the form of mass layoffs. A resulting large number of non-performing loans can negatively affect financial stability. Total indebtedness of non-financial corporations amounted to almost EUR 14 trillion in 2019 or 99.8% of GDP in the EU-27. The debt to equity ratio in 2019 was 53.3%.
According to the EU Commission, excessive insolvencies and financial instability within the EU market have the potential to spill over to other Member States and affect the EU as a whole. Following the COVID-19 health crisis, substantial equity financing is of central importance for a fast and sound recovery. Companies with a solid capital structure are less vulnerable to shocks and more prone to make investments and to take risks. This can positively affect competitiveness, growth and ultimately employment.
Six Member States (Belgium, Cyprus, Italy, Malta, Poland and Portugal) already have legislative measures in place, in order to tackle the tax induced debt-equity bias. The measures differ in policy design but all provide for a tax allowance on equity. However, the lack of coordination between Member States may lead to tax planning opportunities, resulting in tax evasion and misallocation of investments in the single market. Country specific rules also imply higher compliance costs for businesses active in cross border operations in the single market.
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