EUROPEAN COMMISSION Brussels, 11.5.2022 SWD(2022) 145 final COMMISSION STAFF WORKING DOCUMENT



IMPACT ASSESSMENT REPORT

Accompanying the document Proposal for a COUNCIL DIRECTIVE on laying down rules on a debt-equity bias reduction and on limiting the deductibility of interest for corporate income tax purposes {COM(2022) 216 final} - {SEC(2022) 204 final} - {SWD(2022) 144 final} - {SWD(2022) 146 final}



Table of contents 1.Introduction: Political and legal context 2.Problem definition 2.1. What are the problems? 2.2. What are the problem drivers? 2.3. How will the problem evolve? 2.4. DEBRA in context of the Commission’s Strategic Foresight report 3.Why should the EU act? 3.1. Legal basis 3.2. Subsidiarity 4.Objectives: What is to be achieved? 4.1. General objectives 4.2. Specific objectives 5.What are the available policy options? 5.1. What is the baseline from which options are assessed? 5.2. Policy Options 5.3. Common elements 5.4. Grandfathering of existing allowances for equity 5.5. Options discarded at an early stage

6.What are the impacts of the policy options? 6.1. The modelling approach with CORTAX 6.2. Impacts on debt bias and financing decisions of firms 6.3. Impacts on investment and growth 6.4. Impacts on tax revenue 6.5. Impact on the burden for businesses 6.6. Impact on the burden for tax authorities 6.7. Relevance of the legislative initiative for SMEs 6.8. Fairness impacts 6.9. Sustainable Development Goals 7.How do the options compare? 8.Preferred option – The Allowance on new equity with an interest limitation 9.How will actual impacts be monitored and evaluated? References Annex 1: Procedural information 1.Lead DG, Decide Planning/CWP references 2.Organisation and timing 3.Consultation of the RSB 4.Evidence, sources and quality Annex 2: Stakeholder consultation

1.Summary of feedback to the Inception Impact Assessment 2.Summary of meeting with EESC 3.Summary of the open public consultation Annex 3: Who is affected and how? 1.Practical implications of the initiative 2.Summary of costs and benefits 3.Relevant Sustainable Development Goals Annex 4: Analytical methods 1.CORTAX: A model to simulate corporate tax policies 2.Measuring the cost of capital and effective average tax rates Annex 5: Complementary results from CORTAX 1.Results on economic impacts from the uncompensated approach 2.Increased equity allowance for SMEs 3.Analysis of restricted equity 4.Calibration of the preferred Option 5 Annex 6: Statistics on Corporate Indebtedness 1.ATAD 1 – Interest limitation rules Annex 7: Overview of existing measures in Member States 1.Existing measures of interest allowance for equity in EU Member States 2.Transposition of ATAD 1 interest limitation rules in EU Member States

Annex 8: Anti tax avoidance rules 1.General Anti Avoidance Rule (GAAR) 2.Special Anti Avoidance Rules (SAARS) 3.SAAR based on the Arm’s Length Principle (ALP)



Glossary Term or acronym Meaning or definition CIT Corporate income tax ACC Allowance for corporate capital ACE Allowance for corporate equity ANCE Allowance for new corporate equity ATAD Anti tax avoidance directive CMU Capital market union COVID Corona virus disease DEBRA Debt equity bias reduction allowance EBITD Earnings Before Interest, Taxes, Depreciation, EBITDA Earnings Before Interest, Taxes and Depreciation and Amortization EESC European Economic and Social Committee EIB European Investment Bank EIOPA European Insurance and Occupational Pensions Authority FC Financial corporation GAAR General anti avoidance rule GDP Gross domestic product ILR Interest limitation rules IMF International Monetary Fund MNE Multinational Enterprise NDI Non-deductibility of interest NFC Non-financial corporations NID Notional interest deduction NIR Notional interest rate OPC Open public consultation OECD Organisation for Economic Co-operation and Development RFR Risk free rate SAAR Special anti-avoidance rule SME Small and medium sized enterprise 1.Introduction: Political and legal context The initiative analysed in this impact assessment is embedded in a comprehensive EU tax agenda and results directly from the Communication on Business Taxation for the 21st Century. Therein, the Commission set out both a long-term vision to provide a fair and sustainable business environment and an EU tax system, as well as a tax agenda with targeted measures intended to promote productive investment and entrepreneurship, and ensure effective taxation. Amid those targeted measures, the Commission announced a proposal for addressing the debt-equity bias in corporate taxation – the so-called Debt Equity Bias Reduction Allowance (DEBRA). The initiative is coherent with the other actions set out in the Communication, and, in particular, with the forthcoming “Business in Europe: Framework for Income Taxation” (or BEFIT), which will provide a single corporate tax rulebook for the EU, providing for fairer allocation of taxing rights between Member States, taking into account reforms in the international corporate tax framework. While the BEFIT proposal is still in an early stage of development, the two initiatives contribute to the same vision of a fair and sustainable business environment in the EU. As set out in the Communication, targeted action on specific issues, including on the debt-equity bias is envisaged in the shorter term in order to address current problems in the EU tax system. The initiative is part of and supports the EU’s wider policy agenda; and most notably the European Green Deal, the Commission’s digital agenda, the New Industrial Strategy for Europe and the furthering of the Capital Markets Union. The initiative would, for example, directly contribute to the objective of the EU’s Capital Markets Union Action Plan to help companies avoid over reliance on debt and improve their equity position, at a time when the corporate sector enters the post-COVID recovery period with higher deficits and debt levels, and a greater need for equity investment. More specifically, an initiative at EU level to address the debt-equity bias would complement Action 4 of the Capital Markets Union Action Plan, which aims to incentivise institutional investors to make more long-term investments and thus support re-equitisation in the corporate sector, with a view to fostering the sustainable transition. The Communication explicitly calls for the debt bias in taxation to be addressed in order to remove undue fiscal incentives for debt financing, while also broadly calling for measures that support more stable and long-term financing to companies and infrastructure projects, in particular those contributing to the objective of smart, sustainable and inclusive growth. Finally, the initiative replies to the European Parliament’s expectation that the Commission would put forth a proposal for a debt-equity bias reduction allowance, in which the Parliament urged the Commission to perform a thorough impact assessment and incorporate effective anti-avoidance provisions to avoid any allowance on equity being used as a new tool for base erosion. In the current context of climate change, environmental degradation, globalisation and digitalisation, the EU needs a robust, efficient and fair tax framework that provides direct support to the recovery from the pandemic and the green and digital transitions. But, one that also simultaneously meets fiscal sustainability requirements against a background in which the government debt-to-GDP ratio in the EU has increased from 77.2 % at the end of 2019 to 90.1 % at the end of the third quarter of 2021 and deficits remain high, with an overall EU government deficit at 3.7%. The tax framework must, therefore, work to support and create an environment conducive to fair, sustainable growth and investment, while taking into account fiscal sustainability considerations. Taxation has an important role to play in supporting businesses to invest and grow. The ecological and digital transitions arising from the EU decision to move towards a climate neutral and digital economy will require new technologies and innovation that imply large amounts of investment. In such a context, addressing the debt-equity bias would contribute to the re-equitisation of businesses, which would contribute to more risky investments in vital break-through technologies. Equity financing, for example, can be a viable solution for projects with high risk-return profile that would be too risky for the banking sector to finance. The ways in which current tax systems across the EU treat interest costs creates a persistent pro-debt bias. National tax laws across all Member States accept the deductibility of interest payments on debt for tax purposes, thereby reducing the tax base for the purpose of corporate income taxation. At the same time, costs related to equity financing (dividends paid) are non-tax deductible in most Member States. This asymmetric tax treatment of the deductibility of costs comes from the fact that the cost of debt is fixed, has to be paid whatever the profit or loss of the year, and is part of the firm’s current expenses thereby reducing its revenues. Dividends on equity are variable, depending on the firms’ profits, and are not mandatory. This differentiation induces a bias in investment decisions towards debt financing since a business that finances a new investment with debt will reduce its tax base compared to a situation in which the same company financed the very same investment with an equity increase. The higher the rate of corporate income tax in a given country, the stronger the tax bias towards debt for financing new investments. This tax-induced debt bias is a long-standing issue, one which has even been highlighted in the European Semester in relation to several EU Member States whose statutory corporate income tax rate is higher than the EU average. Of course, there are multiple factors that impact or influence financing decisions. Debt could be chosen to increase the return on equity, because access to equity financing is limited, because debt financing is cheaper than equity financing (especially when interest rates are low), to diversify risk, to reduce tax liabilities, and to avoid the dilution of control/voting rights of existing equity holders (owners). The argument about dilution of control/voting rights when new equity is taken up is especially important in the context of family-held companies and could explain, to some extent, national differences. The Commission’s objective with DEBRA is to address the specific issue of using debt because of the tax benefit it gives; this is where legislative action at the EU level can have an impact and where it can act in complementarity to other initiatives intended to support diversification of funding, longer-term funding options, and incentivise equity. Since the tax induced debt-equity bias incentivises financing investments with debt, it can contribute to an excessive accumulation of debt for non-financial corporations. Excessive debt levels make businesses 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 layoffs. Furthermore, a large number of related non-performing loans can negatively affect financial stability. The total indebtedness of non-financial corporations in the EU amounted to almost EUR 14.9 trillion in 2020 or 111% of GDP. Against such background, it is worth stressing that businesses with a solid capital structure may be less vulnerable to shocks, and more prone to make investments. Therefore, reducing the over-reliance on debt-financing, and thus supporting a possible rebalancing of companies’ capital structure, can on a macroeconomic level positively affect competitiveness and growth. Six EU Member States (Belgium, Cyprus, Italy, Malta, Poland, and Portugal) and other neighbouring jurisdictions (like Liechtenstein or Switzerland) already have legislative measures in place to tackle the tax induced debt-equity bias, by providing some kind of a tax allowance on equity. These domestic measures are heterogeneous and differ in terms of their policy design. They have been introduced for different reasons weighing the pros and cons of different design choices from a domestic point of view. Motivations to introduce a domestic measure might have been to attract investment, or to address specific needs given the capital structures of companies or certain challenges faced. Those Member States that did not introduce such measures made other political choices: for instance, some Member States apply a very low statutory corporate income tax (CIT) rate, another way to mitigate the debt-equity bias. The Commission previously included an Allowance for Growth and Investment (AGI), as part of its 2016 proposals for a Common Consolidated Corporate Tax Base (CCCTB). The CCCTB, in which the AGI was one part of a broader reform, did not reach agreement in Council and will be replaced by the forthcoming BEFIT proposal.

As for the international context, it should be noted that in the four main EU trading partners (i.e. US, Japan, China, UK), interest payments are a deductible expense while dividends are not. There is thus a debt-equity bias present in these economies as well. They all have interest limitation rules. Only a few have or are considering an allowance on equity. The UK is working on a UK Secondary Capital Raising Review; they plan to publish a report soon. However, the possibility and potential benefits of introducing such measure have been long discussed, including by the IMF, OECD, ECB and other private and public stakeholders. It is also worth noting that it is generally argued – by other international organisations, in EU research, and academia – that equity markets are better developed and that equity supply is generally higher in the US, which may be the reason why an equity allowance is not currently under consideration in the EU’s closest trading partner. Analysis and tax related casework demonstrates that, in the past, tax allowances for equity have been abused for the purpose of facilitating tax avoidance. The important lessons learned, should be used to inform further legislation. Past experiences clearly illustrate the need for a strong anti-tax abuse framework to accompany a tax allowance for equity. Robust anti-tax abuse measures will ensure that the initiative is not undermined by tax avoidance practices and will contribute to a stronger and fairer European market economy. It is against this background that the Commission’s Communication on Business Taxation in the 21st Century already established a commitment that any initiative to address the debt-equity bias would be coupled with robust anti-abuse measures, to ensure that the rules are not used for unintended purposes. The anti-abuse measures will benefit from the thorough review of all six NID regimes undertaken by the Code of Conduct Group for Business Taxation, which led to guidance being issued on 17 October 2019. An EU approach to address the debt-equity bias would allow to apply the same measures to all Member States in a coordinated manner and ensure that equity is treated in a similar way across the single market, removing possible tax related distortions. A majority of respondents to the public consultation are of the view that the debt-equity bias should not be addressed at national level, but at an EU level and that doing so would improve the business environment. 2.Problem definition This section defines and analyses the problems and their drivers and assesses the evolution of these problems in the absence of EU policy intervention. The ‘Problem tree’ in Figure 1 visually presents the problems, their drivers, and their consequences. 2.1. What are the problems? 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 favours using debt over equity for financing investments. The debt-bias can create several problems. As discussed in detail below, the preferential tax treatment of debt can induce businesses to finance their investments with debt. Corporate debt levels are consequently higher than they would be without the bias. This increases the risk of excessive indebtedness in the corporate sector, which makes businesses vulnerable to crisis and increases the risk of insolvency. Excessive indebtedness increases leverage of the financial sector with the potential to lead to financial instability. There are multiple reasons beyond the tax induced debt-equity bias why companies might prefer debt to equity financing. Debt could be chosen to increase the return on equity, because access to equity financing is limited, because debt financing is cheaper than equity financing (especially when interest rates are low), to diversify risk, to reduce tax liabilities, and to avoid the dilution of control/voting rights of existing equity holders (owners). These reasons for the choice of debt have been evaluated in the questionnaire of the open public consultation for DEBRA and stakeholders acknowledged the relevance of all these elements. NGOs and academics respondents think that debt is used mainly by companies to decrease their tax liability and avoid dilution of shareholders, whereas business associations and companies put as main reasons the necessity to find financing means and the opportunity of low interest rates available. In addition to contributing to financial instability, the debt bias also reinforces the disadvantage for young and innovative businesses. These businesses are often deemed risky as investments by commercial banks and other traditional credit providers. In order to thrive, these businesses are therefore often dependent on equity financing, which is scarce in the European markets, making it very hard for them to obtain the funds they need. Reducing the bias would have a positive effect on the availability of equity and would thus promote higher levels of equity investment in the EU market. Investors will be incentivised to invest in the EU through a decrease of the cost of capital, at a time when the digital and climate transition require more investments. The current situation, where only a minority of Member States addresses the debt bias, creates opportunities for aggressive tax planning and has the potential to distort investment decisions in the single market. Moreover, discrepancies in how an allowance for equity is implemented across the subset of Member States where such a measure exists, can hamper the efficient functioning of the Single Market and distort firms’ decisions. These issues have been raised by several stakeholders in the context of DEBRA’s public consultation. Different business associations agree that reducing the debt-equity bias to encourage equity financing would have an overall positive effect on the solvency and financial stability of businesses, especially in times of economic slowdown or crisis. Moreover, stakeholders from business and academic backgrounds acknowledge the need for measures to tackle the debt-equity bias generated by the different tax treatment of these two types of financing. Businesses were supportive of measures to mitigate the debt-equity bias, defending the view that the bias incentivises companies to opt for debt instead of equity, and that high-levels of debt increase risks of bankruptcy, frequently at creditors’ expense. Higher levels of indebtedness and their negative repercussions The debt-equity bias is a long-standing issue, and has been the subject of substantial academic and policy work. There is extensive academic literature establishing the influence that national tax systems have on corporate capital structure (e.g. Huizinga et al. 2008). The literature is condensed in two meta-studies. De Mooij (2011) and Feld and others (2013) which find a typical impact coefficient of the corporate income tax (CIT) rate on the debt-asset ratio of about 0.27. This means that for a CIT rate of 26 percent (the weighted average rate in the EU), the debt-equity bias would be responsible for a 7 percentage-point higher debt-to-equity ratio in an average corporation. The results also indicate that the response increases over time (i.e., the relationship between tax induced debt-bias and capital structure becomes stronger) and that the relationship may not be linear. The first system to address the tax debt bias was originally proposed in 1991 by the Capital Taxes Committee of the Institute for Fiscal Studies. Under the current tax rules of most Member States, a company that finances a new investment with debt will reduce its tax base and therefore maximise its after-tax profit, compared to the situation where the company finances the same investment with an equity increase. Businesses thus tend to favour investments financed by debt. This leads to higher debt-equity ratios compared to a situation in which debt and equity have the same tax treatment. The debt-bias increases with the rate of corporate income taxation in a given country, since a given reduction of the tax base becomes more attractive with higher tax rates. The tax induced debt-bias also increases with the interest rate, since a given amount of debt results in higher deductible interest payments, further reducing the tax base. Of course higher interest rates make debt more costly compared to equity, so that this price effect counteracts the effect on the tax-induced debt-equity bias. There is no available evidence, which of the two effects would be stronger but since the price effect operates directly while the tax-induced debt-equity bias operates mitigated through the tax rate, it seems likely that the price effect might dominate. High debt-equity ratios can have negative repercussions on both the company and macroeconomic levels. At the company level, higher debt-equity ratios can increase the vulnerability to unforeseen changes in the business environment and the risk of insolvency. Contrary to dividends, debt must be served regardless of the financial situation of a company and the business environment. In this context, Giroud and Mueller (2017) find a more pronounced decline in employment during the global financial crisis in businesses with higher debt levels as compared to those with lower debt-leverage. All respondents to the public consultation acknowledge indebtedness of companies in the EU, including SMEs, is too high and that it makes them more vulnerable to insolvency. All respondents also find that an EU initiative to address the debt-equity bias would be a useful tool to support the recovery of companies from the COVID-19 crisis and incentivise investment through equity in the transition to a greener digitalised economy without creating distortions in the single market. Companies, NGOs and academics strongly think firms should be encouraged to use more equity and less debt. At the macroeconomic level, higher debt-equity ratios can constitute systemic credit externalities (Bianchi 2011). Sutherland and Hoeller (2012) find that higher leverage ratios in the non-financial corporate sector are associated with a significantly higher probability of recession. Jordà and others (2013) find that the build-up of corporate debt during expansion periods increase the probability that subsequent recessions are deeper and longer lasting. The link between higher corporate debt levels and economic downturns is also shown by Bernanke et al. (1988) and IMF (2016). Through input-output linkages, the default of one company can spill over to others and amplify aggregate fluctuations in the economy (Acemoglu et al. 2012). Furthermore, a large number of non-performing loans of non-financial corporations (NFCs) can have an indirect negative effect on financial stability and increase the volatility of the business cycle (Sutherland & Hoeller 2012). Higher levels of corporate indebtedness thus increase the risk of financial crises and also contribute to more lengthy recovery processes. An example is the recovery from the 2008-2009 financial crisis (FSC Subgroup on Non-Performing Loans 2017). The debt-bias thus creates allocative distortions, such as higher agency costs or bankruptcy costs that result in welfare losses (Gordon 2010; Kalemli-Ozcan et al. 2014).

Figure 1: Problem Tree Total indebtedness of non-financial corporations in the EU amounted to almost EUR 14.9 Trillion in 2020 or 111% of GDP, compared to EUR 11 Trillion or 100.4 % of GDP in 2010. COVID pandemic has increased economic risks The COVID-19 pandemic has made it even more important to address the debt bias, as it is expected to exacerbate debt financing. Economic losses resulting from the COVID-19 crisis have significantly weakened the equity position of many businesses. A drastic reduction in incoming cash flows has prompted many European businesses to raise additional debt to meet their short-term financial obligations. As a result, the capital structure of a number of businesses has become more fragile, putting some on the verge of insolvency. Researchers at the IMF estimate that about 2 to 3 percent of GDP will be needed to close the equity gap and provide firms in Europe sufficient equity, so that they would no longer be in difficulty (Ebeke et al. 2021). It is therefore of utmost importance to address the corporate debt-bias and promote the equitisation of European businesses in order to minimise future risks. Such a measure should also have positive effects at the macro level. The ECB’s financial risk assessment further strengthens such a conclusion. In November 2020, the ECB found that “the deterioration in NFC financial health was largely driven by a drop in sales, lower actual and expected profitability, and an increase in leverage and indebtedness” (ECB 2020). In May 2021, the ECB showed that the situation is especially dire for already vulnerable businesses with high debt-to-equity ratios since reliance on debt has increased among vulnerable businesses, amid higher rollover risks. Among the highest leveraged businesses, the 90th percentile debt-to-equity ratios has increased from 220% at end-2019 to over 270% in the final quarter of 2020 (see Figure 2, left panel). Corporate earnings expectations for the euro area have remained below pre-pandemic levels, while corporate funding conditions remained around the tightest levels seen since the pandemic started, especially for SMEs, highlighting elevated refinancing risks” (ECB 2021). According to IMF a share of maybe 20% of businesses face over-indebtedness and risk insolvency. The IMF also identifies an extremely high insolvency risk for SMEs under its current projections, potentially resulting in a loss of 1 in 10 SME jobs. The major cause of insolvency risk is a lack of equity financing (Diez et al. 2021). Figure 2: Debt-to-equity ratios for Non-Financial Businesses and expected insolvencies. Notes: left panel, Q1-Q4 refers to quarter 1 to 4 of the respective year; right panel, t refers to the year the respective crisis started as shown in the legend, t+1 indicates the following year and so on. The legend indicates that for each crisis a four year interval is considered. Source: ECB, Financial stability review May 2021, https://www.ecb.europa.eu/pub/financial-stability/fsr/html/ecb.fsr202105~757f727fe4.en.html The COVID-19 pandemic has resulted in high debt levels, not only at company but also at the sovereign level. Member States will need to identify means to lower current debt levels and increase revenues in order to engender a sustainable recovery and take pressure off public finances in the near-term. Measures such as the interest deduction that is currently applied across all Member States have an impact in this respect. They can entail potentially important losses in revenues for Member States. If we were to assume, for example, that the average interest rate of debt were 3%, and 70% of all debt is serviced by tax deductible interest payments, applying an EU-average corporate income tax rate of 26% would provide a very rough estimate of the costs of the existing deductibility of interest of EUR 64 billion for non-financial corporations and EUR 206 billion for financial corporations. Specific investment needs require more equity Specific investment needs required for the green and digital transitions of the economy and society provide further justification for tackling the debt-equity bias. These twin transitions constitute a policy priority for the EU, one that will require many risky investments, which in themselves will require greater equity investments. The EIB provides evidence that “green investments are specific in nature. They enhance welfare but are risky for investors.. Hence, the transition is likelier to be financed by risk-taking and risk-absorbing instruments such as equity. Longer-term investors also need to be attracted.” (EIB 2021, Chapter 6.). The importance of equity to foster the twin green and digital transitions has been highlighted by one of the business associations that responded to the public consultation. According to this business association, the twin transitions will require important levels of investment from both the public and the private sector, which means that businesses will need to find more diversified sources of financing. Therefore, measures that would reduce the debt-equity bias will be welcome to facilitate equity financing. Insufficient equity financing The insufficient supply of equity financing discourages investment in projects with higher risks which also have prospects for higher than average future returns. As such, it hampers innovation and growth. The scarcity and the higher cost of equity finance affects all companies, but is particularly problematic for young and innovative, businesses, which due to their risk profile, often have limited access to external debt funding. This problem is aggravated by limited access to alternative sources of finance such as venture capital. A number of Member States (especially France, Belgian and Italy) have introduced tax incentives to promote venture capital and business angel funding, but these types of finance represent only a small proportion of the current total funding mix. Consequently, small and innovative businesses, often perceived by banks and financial institutions to be higher risk, might be at a particular disadvantage, despite their importance in generating future growth. This problem also extends to businesses in need of scale-up-financing (e.g. Aernoudt 2017). The European Investment Bank (EIB) shows that the availability of sufficient equity financing has further diminished during the COVID-19 crisis. Especially young and small enterprises as well as SMEs face an adverse environment. The slump in demand is more pronounced in sectors with many smaller firms, which have less flexible cost structures and more restricted access to finance. “Survey indicators suggest that various sources of finance specific to young enterprises and SMEs – such as private equity, venture capital and business angels – may dry up. This should cause concern as these sources of finance were already not sufficiently developed in Europe prior to the crisis” (EIB 2021).

At the same time the impact of insufficient equity financing has become direr because of the heightened specific investment needs related to the digital and green transition. This could limit the opportunities especially for SMEs to engage in profitable investments, due to their limited access to financing. This initiative could thus also support the recovery of SMEs and help them adapt to the new business environment. The view that equity financing is insufficient in the EU is shared by some of the stakeholders that responded to the public consultation. According to a national business association, apart from a favourable tax treatment of debt over equity, capital markets are very hard to reach for SMEs, “as external private equity seems to be constrained to specific types of entrepreneurship.” Another business association highlights the fact that because European businesses are still widely financed by bank loans, these are more vulnerable to shocks than American businesses which tend to have more access to other sources of financing. Of course, this situation is not due to the debt bias alone; but this initiative would contribute to the objective of the EU’s Capital Markets Union. In particular, and as previously highlighted, it would complement Action 4 of the Capital Markets Union Action Plan – which aims to incentivise institutional investors to make more long-term investments and thus support re-equitisation in the corporate sector – by addressing undue fiscal incentives for debt financing stemming from the differentiated tax treatment of debt and equity costs. On top of this broad policy objective of incentivising equity and diversifying financing, specific provisions of the initiative would align with other broader tax policy objectives – such as the fight against tax avoidance and evasion. Limited number of measures to mitigate the debt-equity bias through an allowance on equity Currently, only six Member States (Belgium, Cyprus, Italy, Malta, Poland and Portugal) have some form of tax allowance for equity in place in order to mitigate the debt-equity bias (see Table A7.1 in Annex 7 for an overview). Table 1 below indicates the actual debt-equity bias in those countries. The table reports effective average tax rates for retained earnings, new equity and debt, based on a notional interest rate on equity and retained earnings as applied in the respective Member States. The model used by ZEW to calculate these effective rates assumes a nominal interest rate of 7.1%. If the notional interest rate were equal to the nominal interest rate of 7.1%, only Cyprus would still have a small debt bias due to the construction of its measure. The appropriate choice of the notional interest rate can eliminate the debt bias (see ZEW 2020 and Annex 5). Table 1: Effective average tax rates and debt-equity bias with actual notional interest rate. Belgium Cyprus Italy Malta Poland Portugal Notional interest rate 0% 5.536% 1.3% 6.43% 1.5% 7.0% Retained Earnings 7 5.6 6.6 4.8 5.8 4.4 New Equity 7 5.6 6.6 4.8 5.8 4.4 Debt 4.7 4.9 4.8 4.4 4.7 4.3 Mean 6.2 5.4 6 4.6 5.4 4.3 Debt Bias* 2.3 0.7 1.8 0.4 1.1 0.1 Source: ZEW (2020) Although all these measures provide for a tax allowance on equity, they differ in policy design (e.g., interest rate of the allowance, calculation of the basis for the allowance, type and severity of anti-tax avoidance measures). Such differences can have negative consequences for the single market. Firstly, the interaction between different measures, combined with the absence of equivalent measures in other Member States, can lead businesses to base their investment financing decisions on the availability (or not) and the generosity of rules that allow deductions for equity costs. This creates distortions and a misallocation of investments in the single market. Secondly, these measures, when applied at the national level only, without a harmonised anti-tax avoidance framework, can create loopholes that can be exploited for aggressive tax planning purposes and increase harmful tax competition among Member States, leading to tax avoidance and evasion. Finally, different country-specific approaches to mitigate the debt-equity bias increase compliance costs for businesses active across borders. The need for measures to tackle the debt-equity bias, was recognized by some of the stakeholders during the public consultation. One business association expressed the belief that promoting equity financing is essential to promoting strong and sustainable business growth. This view was shared by another stakeholder which specifically stated that: “Tax measures that aim at facilitating equity financing will be welcome, provided they are coherent with the overarching economic policies.” Business associations, companies and academics respondents clearly agree that such an initiative will reduce tax competition between Member States. Importantly, all respondents think that an EU initiative would be beneficial for enterprises operating across countries in the single market. 2.2. What are the problem drivers? The debt-equity bias and its determinants How large is the debt-equity bias? One approach to measure the debt-equity bias is to compare the cost of capital for equity-financed investments with that of debt-financed investments. Figure 3 shows the debt bias in corporate taxation, measured as the difference in cost of capital between new equity and debt-financed investment. One can see that the Member States which have implemented an allowance for equity (i.e., Belgium, Cyprus, Italy, Malta, Poland and Portugal) have no or a very low debt-equity bias. Hence, the introduction of a specific measure on equity can lead to a reduction of even the elimination of the bias. Figure 3: Debt-equity bias in corporate financing 2010 and 2020 Source: Annual Report on Taxation (European Commission 2021) Notes: (1) The cost of capital measures the required minimum pre-tax return of a real investment (the ‘marginal investment’) to achieve a 5% after tax real return. (2) To reflect the allowance for corporate equity in Belgium, Cyprus, Italy, Malta, Poland and Portugal, the assumption is that the rates of these allowances equal the market interest rate in the model. For Belgium, the debt-equity bias could be non-zero due to the notional interest rate being relatively low, while the eligible equity only covers the average annual increase over the previous 5 years. For Cyprus, the bias is small, since the allowance does not apply to investments in financial assets. One can also see that countries with high statutory CIT rates tend to have a higher debt-equity bias. Ceteris paribus, the advantage of tax deductibility of interest payments increases with the statutory tax rate. The higher the rate of the corporate income tax in a given country, the stronger is the bias towards debt for the financing of new investments. In the last decade, while the debt-equity bias has increased or remained stable for some countries, it has decreased for others. The decrease is probably driven by the downward trend of CIT rates in the EU and the consistent decline in interest rates. However, this is a reversible trend such that specific measures might be needed to avoid a possible increase in the debt bias due to changes in macroeconomic variables. The prevailing interest rate also affects the debt-equity bias. A higher interest rate results in higher interest payments that significantly reduce the taxable base of businesses. This means less tax is due. The tax-induced bias for debt is thus stronger. However, everything else being equal, one would expect that higher interest rates reduce the demand for debt with a possible negative impact on investment. In a similar vein, rising interest rates increase the burden for a company to service a given debt level. The ECB points out that “higher (risk-free) rates would increase debt servicing costs from historical lows and could raise medium-term risks in countries with elevated debt levels” (ECB, 2021). Increasing interest rates thus increase the business risk associated with indebtedness and aggravate the problem of high debt levels.

The debt-equity bias can also be addressed through the tax-treatment of corporate debt. Many countries have implemented interest limitation rules or thin capitalization rules. Such rules limit the amount of interest that can actually be deducted. It has been shown that these rules increase the cost of debt and thus indeed reduce the debt-equity bias. Common interest limitation rules in the EU have been introduced by the first Anti-Tax Avoidance Directive (ATAD 1) with the primary objective of countering tax avoidance and aggressive tax planning. As indicated, these rules do to some extent also contribute to mitigating the debt-equity bias and related over-indebtedness. The EU’s interest limitation rule is laid down in Article 4 of ATAD 1 and prescribes that the total annual borrowing costs can be fully deductible for tax purposes to the extent that they do not exceed taxable interest and other economically equivalent taxable revenues. The deductibility of any excess borrowing costs (without distinction of whether the costs derive from domestic or cross-border transactions) is limited to the higher of: ·A Safe Harbour of EUR 3 million, or ·30% of EBITDA (Earnings before interest, tax, depreciation and amortisation) These are de-minimis provisions and Member States have implemented these rules differently. Some Member States have gone further, for example, by applying a lower Safe Harbour, a lower percentage limit than foreseen in the ATAD provision, or introducing the limit based on earnings before interest, tax and depreciation (EBITD) instead of EBITDA. An overview of the specific interest limitation rules applied in the EU is provided in Table A7.2 in Annex 7. 2.3. How will the problem evolve? Most problems that are directly or indirectly related to the debt-equity bias will not change as long as the debt-equity bias persists and no specific measures to address it are introduced. The bias emanates from the different tax treatment of debt versus equity and there are no external drivers that, if addressed, would permanently solve or mitigate the issue. In other words, if no action is taken in the field of taxation, the debt bias and the associated negative repercussions will persist. As detailed above, low CIT rates and low interest rates could reduce the bias. However, such measures depend on the macroeconomic situation more generally and might change. For example, an increase in inflation might lead to an increase in interest rates. Member States could also individually implement actions that reduce the debt bias and the ‘price’ of equity. So far, only a few Member States have used such measures, while the issue has been a long-lasting one. Accordingly, one may expect that it would take time for additional Member States to take action while some may continue to choose to take no action at all. Moreover, actions taken at national level can result in a patchwork of different rules, increasing regulatory complexity across the EU for businesses and creating opportunities for tax planning and tax avoidance and evasion. Several EU policies that aim to provide incentives and access to financing, notably to meet the investment needs related to the recovery and the digital and green transitions, could contribute to reducing the cost of equity. The EU’s Recovery and Resilience Facility (RRF) provides emergency financing for the recovery, containing minimum thresholds for investments and reforms geared towards the green and digital transitions. The RRF, however, is very much a country-led process in terms of the design and choice of policies, so it would not necessarily address the issue of cross-country differences. The Action Plan for the Capital Market Union has also announced several policy measures aimed at improving the access to equity financing, such as encouraging more long-term and equity financing from institutional investors and increasing the visibility of businesses to cross-border investors. However, such measures do not directly address the tax-system induced treatment that incentivises or favours the use of debt over equity, which means the debt-equity bias will nonetheless persist. This is precisely why, as previously mentioned, both the Capital Markets Union Action Plan itself and the Commission’s Communication on Taxation for the 21st Century seek action to specifically alleviate the tax associated burden in cross-border investment. 2.4. DEBRA in context of the Commission’s Strategic Foresight report An initiative to address the debt-equity bias is expected to foster an increase of equity investments in the EU and mitigate tax-related incentives that help sustain high leverage and overreliance on debt. Consequently, the DEBRA initiative could be expected to contribute positively to three of the ten areas identified in the EU’s 2021 Strategic Foresight Report (“SFR”). On the area of “Digital hyper connectivity and technological transformations” the SFR states that the EU lags behind its main competitors in the availability of “private investment into research”. By reducing the treatment differences between debt and equity, DEBRA may create incentives to increase private investments in the EU. The same applies to the area of environmental and energy innovation. According to the SFR, the EU will need EUR 470 billion in investment to reach its 2030 climate and environmental objectives; and new technologies will be key to ensuring that energy decarbonisation objectives are reached. These investments will require a massive mobilization of private capital. Addressing the debt-equity bias and introducing a means of incentivising equity would facilitate an increase in private investment in green innovative technology and thus help the EU reach its 2030 climate objectives. Lastly, the initiative is also in line with the EU’s objectives of creating resilient and stable economies that are prepared for future shocks. According to the SFR, solid economic fundamentals, productivity, investments and reforms will determine the EU’s future economic performance, linked with positive financing conditions for the public and private sector. High-levels of debt increase risks of bankruptcy and of a systemic crisis. By reducing incentives to debt financing and promoting equity investments, DEBRA would lower debt levels of EU companies and contribute to a more robust economy. 3.Why should the EU act? The debt-equity bias is a long-standing issue that has gained much attention globally from business and academic research. With this initiative, the EU, one of the world’s major economic actors and one of the largest capital markets globally, would act to remedy the bias in a coordinated and harmonised way, with a strong homogenous anti-tax abuse framework applicable across the EU, mitigating mismatches and loopholes. Only an EU-wide measure can mitigate the problem across the EU for all EU businesses, while not leaving room for harmful tax practices. 3.1. Legal basis The legal base for this initiative is Article 115 TFEU on the approximation of laws of the Member States, which directly affect the establishment or functioning of the internal market. The identified problems, their underlying causes and reasons for coordinated action are common to all Member States. The article provides for the adoption of legislation through directives, following the special legislative procedure, which requires a unanimous vote by Member States in Council. The European Parliament and the Economic and Social Committee have to be consulted but do not hold decision-making power. Directives are addressed to Member States and solely bind them as to the result to be achieved while leaving the means (for doing so) to national transposition measures. The current initiative complements the new framework for business taxation in the EU that the Commission is committed to present by 2023. The “Business in Europe: Framework for Income Taxation” (or BEFIT) will provide a single corporate tax rulebook for the EU, providing for fairer allocation of taxing rights between Member States. BEFIT will replace the 2016 CCCTB proposals, which also included a proposal for an Allowance for Growth and Investment. Concerning the anti-tax abuse framework that will need to accompany the rules on the deductibility of equity costs, the Code of Conduct Group on Business Taxation has issued guidance on notional interest deduction regimes and this blueprint will guide the work on the anti-tax avoidance rules that will be integrated in the legal proposal.

3.2. Subsidiarity According to the subsidiarity principle laid down in Article 5(3) TFEU, action at EU level should be taken only when the aims envisaged cannot be achieved sufficiently by Member States acting alone and in addition, by reason of the scale or effects of the proposed action, can be better achieved by the EU. 3.2.1. Subsidiarity: Necessity of EU action There are a number of reasons why EU level action, rather than national action, is needed to mitigate the tax debt-equity bias. First, the problem described in Chapter 2 is widespread across the EU and common to all Member States. Most Member States’ corporate tax systems allow a company to deduct for tax purposes interests that arise from debt financing while the costs related to equity financing (notably, payments of dividends) are not tax deductible. It must be note that interest deductions are already subject to some kind of limitations according to existing EU rules (ATAD1). Second, six Member States have already unilaterally addressed the debt-equity bias at national level through the introduction of a tax allowance on equity. However, these measures differ considerably in policy design (e.g. interest rate of the allowance, calculation of the basis for the allowance, type and severity of anti-tax avoidance measures). The interaction between these disparate national frameworks, combined with the absence of equity-side measures in other Member States, may lead to market distortions and a misallocation of investments in the single market, as businesses may base their investment decisions on the availability (or not) and the generosity of rules that allow deductions for equity costs. In addition, the interaction of widely divergent national measures with a non-harmonised anti-tax avoidance framework may inadvertently create loopholes, which can be exploited for aggressive corporate tax planning purposes. While these elements are not the only drivers, their combined effect is that the differentiation across the EU27 may result in increasing harmful tax competition among Member States. These opportunities encourage practices of tax avoidance and evasion in the EU. Existing EU legislation cannot address such distortions, resulting from the differentiated tax treatment of debt and equity. Finally, different country specific rules also imply higher compliance costs for businesses active in cross-border operations within the single market, as they are called on to comply with various sets of different rules. Such compliance costs will be significantly reduced if a single EU-wide rule applies. In other words, there is a problem that is common to Member States and can only partly be addressed by national action. In addition, national action may even have undesirable implications, by leaving open a margin for harmful tax practices. This conclusion is supported by some stakeholders, which state that an EU-wide initiative, establishing a common approach, would reduce tax competition and fragmentation, establishing a common approach. Stakeholders further highlighted that a common approach would help reduce administrative burdens and facilitate access to the benefits of the measure. During bilateral contacts with the Commission services, a Member State shared the outcome of their study into a more equal treatment of equity and debt. This study concludes that a more equal tax treatment of equity and debt is desirable to reduce the debt bias and strengthen the financial resilience of the business community and that it is preferable to achieve this objective in an international or multilateral context. This study also states that a European coordinated approach within the EU contributes to the prevention of mismatches, tax avoidance and leads to less excessive debt financing. 3.2.2. Subsidiarity and Proportionality: Added value of EU action An EU level initiative will provide wider benefits for the single market compared to the present fragmented situation of national initiatives. It would alleviate distortions in the single market, which are potentially caused by practices of harmful tax competition amongst Member States that are enabled due to fragmentation. In addition to a harmonisation of rules, it would also provide a sound anti-tax abuse framework, based on measures discussed and evaluated in the Code of Conduct group, to tackle aggressive tax practices often linked to opportunities that arise when equity costs are made deductible. Varying national rules for notional allowances on equity can be exploited for aggressive tax planning purposes. Operating one set of rules across the EU will help reduce aggressive tax planning in the single market. It will limit the scope for mismatches between disparate rules and the loopholes that businesses can take advantage of. A harmonised tax environment for businesses in this field could also create legal certainty for taxpayers that the rules on the deductibility of equity costs are compliant with EU law. A single set of rules could help taxpayers ascertain that all national tax administrations apply these rules in a similar manner and hence lower the risk of disputes. In the same vein, a measure at EU level would also simplify the compliance burden. Given the cross-border dimension of the potential tax avoidance schemes linked to the deduction of equity-financing costs, diverging anti-tax abuse rules, different definitions of equity and the availability of various ways for integrating such measures in the overall framework of tax deductions naturally increase compliance costs. For businesses active across the EU, this initiative will thus bring gains in terms of simplification of compliance. This cannot be effectively achieved through soft law instruments, as has been proven in practice. Following a binding legislative initiative, a company, no matter in which Member States it is active, would operate in the same legal context regarding the tax treatment of equity financing. In addition, all affected businesses would benefit from the same measure and face the same obligations, which would promote a level playing field in the single market. An action at EU level will also be more effective than individual fragmented actions taken at Member State level and at Member States’ discretion to address the tax-induced debt bias. National measures can only be used by SMEs located in those Member States that apply debt bias mitigating measures, or by MNEs that can afford to locate the financing company of the group in such Member States. SMEs located in Member States that do not have any tax debt bias mitigating measure can, as such, face higher costs for equity financing as compared to SMEs in other Member States. An EU level initiative will provide for a single solution to mitigating the tax-induced debt bias that all businesses across Europe can avail themselves of, regardless of their size or Member State of tax residence. Finally, by reducing in all Member States the preferential tax treatment of debt which comes at the expense of other financial instruments (in particular equity), the initiative will contribute to making financing more accessible to all European businesses, a key objective of the 2020 Communication on a Capital Markets Union (CMU) for people and businesses. By providing for a common approach to mitigating the debt bias, this initiative will also contribute to the integration of national capital markets into a genuine single market, another key objective of the CMU communication. By removing the tax debt bias, which leads businesses to favour investment financed by debt, the initiative will contribute to the re-equitisation of European businesses. This will increase their resilience to unforeseen changes in the business environment and decrease the risk of insolvency, thereby indirectly contributing to bringing more financial stability in the EU. 4.Objectives: What is to be achieved? This section defines the general and specific objectives of the initiative. The ‘Intervention Logic’ in Figure 4 visually presents the problems, their drivers, the specific objectives and the general objective of DEBRA. 4.1. General objectives

The first important objective of this initiative is to establish the conditions necessary such that financing decisions are made based on an appropriate risk management profile, taking into account financing needs, without distortions being created by differentiated tax treatments. While it is clear that a multiplicity of legitimate determinants influence businesses’ investment decisions, provisions of the tax system should not influence the choice between equity and debt. The second objective is to reduce distortions in the single market created by the interaction between disparate national measures combined with the absence of equivalent measures in other Member States. The third important objective of this initiative is to mitigate the risk that businesses take advantage of the interaction among tax systems with and without debt-equity bias mitigating measures and with non-harmonised anti-tax abuse frameworks for tax avoidance and tax evasion practices. A fourth objective is to increase the stability of the financial system such that action is taken that will support growth and investment 4.2. Specific objectives This initiative supports the creation of a harmonised tax environment that places debt and capital financing on an equal footing across the EU. This will encourage investment in equity, help reduce distortions in the single market and facilitate cross-border activity. This initiative aims to contribute to the re-equitisation of EU-based businesses, thereby supporting wider EU policies such as the European Green Deal, the Commission’s digital agenda and the New Industrial Strategy for Europe. It aims to boost competitiveness, growth and ultimately employment in the EU. Following the COVID-19 health crisis and in the framework of the transition to a green and digitalised economy, substantial equity financed investments are of central importance for a fast and sound recovery. The ecological and digital transitions that the EU and its Member States are undertaking will require new technologies and innovation that imply large investment. Break-through technologies will likely require, like all risky investments, greater equity financing. Moreover, businesses with a solid capital structure are less vulnerable to shocks and more prone to make investments and to take risks. By addressing the asymmetric tax treatment between equity- and debt-related costs, the initiative will help reduce the accumulation of debt for non-financial corporations, thereby decreasing insolvency risks. It will contribute to building a fully functioning and integrated market for capital, allowing the EU’s economy to grow in a sustainable way and be more competitive as set out in the 2020 Communication on Capital Markets Union. In addition, this initiative is expected to further remove distortions in the single market, as it will be combined with a comprehensive set of anti-tax abuse provisions to prevent businesses from circumventing the measure. Figure 4. Intervention logic 5.What are the available policy options? 5.1. What is the baseline from which options are assessed? The baseline scenario is established on the premise that, in the absence of intervention at the EU level, the tax induced debt-equity bias will persist in most Member States and the minority of Member States that have been frontrunners in adopting measures to mitigate the debt-equity bias at national level will continue to apply non harmonised tax-allowances on equity financing. Businesses’ investment decisions will thus continue to be distorted by the availability (or not) and the generosity of rules that allow notional deductions for the cost of equity capital. In a baseline scenario, the distortions and misallocations of investment in the single market as outlined earlier in this assessment will persist alongside the other factors that impact or influence financing decisions, such as avoiding the dilution of control/voting rights of existing equity owners, limited access to equity financing, or debt financing being cheaper than equity financing. In the absence of an EU-wide initiative to tackle the tax induced debt-equity bias, it is likely that compliance costs and the fragmentation of the legal framework in place will persist or could even increase. As detailed in Chapters 2 and 3, maintaining diverse national measures against the tax induced debt-equity bias across the Union is likely to compromise the effectiveness and efficiency of these rules even at national level. Given the close integration of European economies and the fact that corporate groups usually operate across several Member States, compliance costs for groups faced with several different national measures to mitigate the bias are higher compared to a situation in which an EU-wide measure were to be in place. Concerning SMEs specifically, these specific types of businesses can benefit from national measures only if they are located in one of the Member States that have debt bias mitigating measures in place. SMEs located in Member States that do not have any tax debt-bias mitigating measure face a higher cost for their equity financing in comparison to other SMEs in the EU. This can act as a barrier for such SMEs, preventing them from scaling up or making riskier investments that would support their growth and stability, reducing the competitiveness of the European economy as a whole. At this stage, the EU Code of Conduct for business taxation is the sole instrument that provides for a harmonised framework against abuse of Member States’ notional interest deduction schemes. In 2019, the Code of Conduct issued “Guidance on the assessment of NID Regimes”. This Guidance mentions a number of limitations to the scope and anti-tax abuse measures that should be in place in order to prevent tax planning and address abusive situations when applying notional interest deduction regimes. However, the Code, as a soft law instrument, which relies on a political commitment by Member States, does not provide for a fully harmonised anti-tax abuse framework for national measures. The Code’s conclusions have not led to a similar approach to addressing the debt-equity bias in those Member States who have implemented measures at national level. A binding measure at EU level would tackle the specific issues at stake in a more efficient and effective manner than the current mix of purely national measures and soft law. This is even more important in the current context of ecological and digital transitions, which will require major equity investments to finance the new technologies and innovation needed. This legislative action at the EU level aims at addressing the specific point of the tax debt equity bias; it will act in complementarity to other initiatives intended to support diversification of funding, longer-term funding options, and incentivise equity. 5.2. Policy Options The following policy options would be applied to all businesses in the EU. 5.

5.1. 5.2. 5.2.1.Allowance for a notional interest on all corporate equity (Allowance for corporate equity (ACE) - Option 1) Option 1 provides for a legislative initiative that would envisage an allowance on the stock of corporate equity. Equity is defined as the sum of paid-up capital, the share premium accounts, revaluation reserve and reserves and profit or loss brought forward. The value of the allowance is determined by multiplying the allowance base with the notional interest rate. The allowance base of a taxpayer in a given tax year is defined by the difference between the stock of equity at the end of the tax year minus the tax value of its participation in the capital of associated enterprises and the value of its own shares. Participations and the value of own shares are excluded from the allowance base in order to prevent cascading of the allowance through participations (for details see section 5.3.2 on associated enterprises below). Since the allowance is granted on the stock of corporate equity, the duration of the allowance is implicitly unlimited. As long as the value of equity in a company is higher than the value of its participations, the company can request the allowance. 5.2.2.Allowance for a notional interest on new corporate equity (Allowance for new corporate equity (ANCE) - Option 2) Option 2 provides for a legislative initiative that would envisage a notional interest allowance on new equity. Equity is defined like in option 1 as the sum of paid-up capital, the share premium accounts, revaluation reserve and reserves and profit or loss brought forward. The value of the allowance is determined by multiplying the allowance base with the notional interest rate.. This option entails an incremental allowance, meaning that it is granted on the difference in the level of net equity at the end of the tax year compared to the level of net equity at the end of the previous tax year multiplied by the notional interest rate. Net equity is defined as the difference between the equity of a taxpayer as defined in the previous paragraph and the tax value of its participation in the capital of associated enterprises and its own shares. Participations and the value of own shares are excluded from the allowance base in order to prevent cascading of the allowance through participations (for details see 5.3.2. on associated businesses below). In case of a net equity decrease, an amount equal to the allowance equity base decrease multiplied by the notional interest rate would become taxable. This allowance is granted for ten years in order to emulate the average maturity of debt and limit the fiscal cost. In case the allowance base is negative in a given tax year, an amount equal to the decrease in the allowance base multiplied by the notional interest rate becomes taxable. This is important to prevent that the same equity is repeatedly re-introduced into a company to obtain repeated allowances. In addition, this option should be coupled with specific anti-tax abuse rules to ensure that new capital can only benefit once from the deductibility no re-categorisation of old equity as new equity. Since only increases in equity will qualify for an allowance, this option will create much stronger incentives for businesses to take up new equity compared to Option 1. 5.2.3.Allowance for a notional interest on corporate capital: equity+debt (Allowance for corporate capital (ACC) - Option 3) Option 3 provides for a legislative initiative that would envisage a new allowance for notional interest on corporate capital (i.e., equity, as per also Options 1 & 2) and debt, while deductibility of actual interest payments is disallowed. The value of the allowance is determined by multiplying the allowance base with the notional interest rate. The allowance base in this case is defined as the total amount of debt and equity (debt + paid-up capital + share premium account + reserves + profit or loss brought forward). In this option, the notional interest rate for equity and debt is identical by construction. The cost of equity and the cost of debt are thus perfectly equated. This options is being evaluated for its ability to perfectly eliminate the debt-equity bias. The fiscal implications of the measure will depend on the level of the notional interest rate chosen. Businesses will receive a notional allowance for equity and debt alike. They would thus generally profit from the measure since it would reduce effective tax rates. Only for companies with very high interest payments or if the notional interest rate is very low, could the loss of deducibility of interest payments outweigh the positive effect of obtaining an allowance for equity. Since the allowance is based on the full stock of capital, the duration is implicitly unlimited. 5.2.4.Non-deductibility of interest payments (NDI - Option 4) Policy Option 4 provides for a legislative initiative that would completely disallow the deductibility of interest expenses. This fully aligns the tax treatment of debt and equity costs by making both non-deductible. Debt already existing by the time the measure is announced would be grandfathered for its full maturity in order to mitigate immediate impacts on businesses. Long term debt, which will be signed after approval of the measure but before implementation, would be grandfathered for a duration of ten years. This limited grandfathering would limit the incentive to roll-over existing debt just for the sake of being grandfathered. Under option 4 as under all other options, the adoption of the DEBRA directive would be accompanied by the abolition of existing national schemes providing an allowance on equity. 5.2.5.Combination of equity and debt related measures (Option 5)

Option 5 provides for a legislative initiative that would combine an allowance for notional interest on new corporate equity (same as proposed under Option 2) with a partial limitation of tax deductibility. The combination of an equity allowance with a partial interest limitation rule would tackle the debt-equity bias simultaneously from the debt and equity side. At the same time, the limitation of interest deductibility would help finance the allowance for equity. As per Options 1, 2 and 3, equity is defined as the sum of paid-up capital, the share premium accounts, revaluation reserve and reserves and profit or loss brought forward. The allowance would also be incremental – i.e., granted on a base equal to the difference in the level of net equity at the end of the tax year compared to the level of net equity at the end of the previous tax year (new corporate equity). In the same vein, and as per Option 2, net equity is defined as the difference between the equity of a taxpayer (paid-up capital + share premium account + reserves + profit or loss brought forward) and the tax value of its participation in the capital of associated enterprises and its own shares. The allowance could be granted for 10 years in order to emulate the average maturity of debt. The partial limitation of tax deductibility of interest expenses could be implemented by simply reducing interest deductibility by a given proportion of x% for all companies. The parameter x would need to be further defined. Such a proportional interest limitation in the context of DEBRA would also need to define the interaction with existing interest limitation rules (ILRs), specifically the ILR contained in the EU’s Anti Tax Avoidance Directive 1 (ATAD 1). The ATAD 1 ILR states that net interest expenses can only be deducted up to a value of 30% of the company’s EBITDA with a safe haven of EUR 3 million (as minimum requirement). It could be decided to keep ATAD 1 and DEBRA ILRs mutually exclusive, with the more stringent ILR being applied. This would imply that companies affected by ATAD 1 ILR, would fall under ATAD 1 ILR while all other companies would fall under the proportional DEBRA ILR. At first sight such an approach seems even-handed, since each company would be captured under the more stringent ILR. The ATAD 1 ILR however allows in several Member States the carry forward of non-deductible excess interest expenses so that eventually all interest expenses can potentially be deducted, albeit at a later point in time. In contrast, the DEBRA ILR would not allow for any carry forward of non-deductible interest expenses. Companies being captured under ATAD 1 would thus be treated preferentially compared to all other companies for which the DEBRA ILR would apply. As a consequence the interaction between DEBRA ILR and ATAD 1 ILR might thus be preferably designed in a sequential way. Under such sequential treatment, all companies would first apply the proportional DEBRA ILR. In a second step the ATAD 1 ILR would be applied. Relevant net interest expenses to be capped at 30% of EBITDA or the safe harbour of EUR 3 million would only bel those net interest expenses which have not been already limited by the DEBRA ILR. (In the case where the DEBRA ILR is 20% so that 80% of net interest expenses are deductible and the company has net interest expense of EUR 500000, EUR 100000 of net interest expenses would not be deductible under DEBRA ILR. The remaining EUR 400000 would now be applied to ATAD 1 ILR. Since there is a safe harbour of EUR 3 million or at least 1 million, the company would not further fall under ATAD 1 ILR). Table 2 provides an overview over the five different policy options. Table 2. Overview of policy options Policy options Approach Allowance base and equity definition Other design elements Option 1 Notional interest deduction; no specific action on the debt side. All equity, net of participations and value of own shares; Equity definition comprises paid-up capital, the share premium accounts, revaluation reserve and reserves and profit or loss brought forward. Notional interest rate, definition of associated enterprises, anti-abuse framework Option 2 Notional interest deduction; ; no specific action on the debt side. New equity, i.e. year on year increase in equity, net of year on year increase in participations and own stocks; Equity definition comprises paid-up capital, the share premium accounts, revaluation reserve and reserves and profit or loss brought forward. Notional interest rate, definition of associated enterprises, anti-abuse framework Option 3 Notional interest deduction; Current deduction on debt related interest is disallowed. But debt is included in the base for the notional allowance. All corporate capital, i.e. equity (paid-up capital, the share premium accounts, revaluation reserve and reserves and profit or loss brought forward) and debt, net of participations and value of own shares. Notional interest rate, definition of associated enterprises, anti-abuse framework Option 4 No deduction of interest payments. Measure focuses on the debt side only. Deduction of interests paid on debt is fully disallowed. No allowance of any kind is granted. n.a. Option 5 Notional interest deduction for equity plus partial limitation of interest deductibility New equity (as under Option 2), i.e. year on year increase in equity, net of year on year increase in participations and own stocks; Equity definition (as under Option 2) comprises paid-up capital, the share premium accounts, revaluation reserve and reserves and profit or loss brought forward. Introduce limitation of interest paid on debt (e.g. proportional limitation rule). Notional interest rate, definition of associated enterprises, anti-abuse framework, interest limitation rule 5.3. Common elements This section discusses the notional interest rate, associated enterprises and the anti-abuse framework. These are elements common to all policy options that allow a notional interest deduction (options 1, 2, 3, 5). 5.3.1. The notional interest rate The choice of the notional interest rate (NIR) is an important parameter, relevant for all options granting an allowance for equity (i.e. options 1, 2, 3, 5). The notional interest rate is one of the determinants of the value of the allowance and thus affects the cost of equity as well as the reduction of taxable income. In the construction of a notional interest rate, there is a trade-off between simplicity and exactness. Three approaches can be envisaged: (1) One single NIR could be applied across the EU. (2) There could be a currency specific NIR for each currency in the EU, or (3) there could be a specific NIR for each Member State. One unique notional interest rate for the EU would be simple to apply and would provide for a high degree of harmonisation across Member States. A single EU-wide rate however would disregard differences in financing conditions, amongst others currency risks, between Member States leading to possible distortions which could result in (dis)advantages for Member States not in the Euro-area. The opposite case of a unique EU-wide NIR would be a country specific NIR which would reflect the specific average financing conditions in each Member State. Such an approach however creates complexity due to a large number of NIRs. The risk-free rate strongly depends on the currency, because of characteristics like inflation and central bank policy. A currency specific notional interest rate is the intermediate approach between the two extremes, accounting for currency risks and some country specificities while limiting the number of different NIRs. In general, the notional interest rate (NIR) could be determined with reference to an interest rate for risk-free investments (risk free interest rate, RFR) adding a risk premium (x) to take into account the fact that private borrowers usually face higher interest rates than risk free borrowers. NIR = RFR + x (RFR is the risk free interest rate, x the risk premium) The reference to the risk free rate will capture changing market conditions. The European Insurance and Occupation Pensions Authority (EIOPA) regularly publishes risk free interest rate schedules for a wide range of maturities. A transparent and peer-reviewed methodology for determining the risk free rates has been determined and serves as basis for implementation of EU legislation (Solvency II). The applied method results in risk free rates for each currency. Such an approach would thus have the additional benefit of assuring consistency across EU legislation. The currency specific EIOPA 10-year risk-free-rate published in December could thus be used as the reference risk-free rate for the following tax year. The risk premium could be determined in different ways.

a)A fixed risk premium, following the example of existing measures for an equity allowance. b)A risk premium conditioned on available market rates. The credit risk premium is the compensation that investors ask for investing into risky debt instruments. It can be assessed as a spread between yields on risky debt instruments and risk free bonds. The risk premium would be determined as difference between the market rate and the risk-free rate: x = MR – RFR where MR is the yield on risky debt instruments. The notional interest rate would be determined as follows: NIR = RFR + x èNIR = RFR + MR – RFR èNIR = MR Accordingly, a market index reflecting the overall corporate market could be directly used to obtain the yields of risky debt instruments and thus to determine the notional interest rate. Different relevant indexes would have to be considered. A fixed risk premium provides simplicity, clarity and predictability. In contrast, conditioning the risk premium to market rates might result in “dramatic variation over time” and “co-movement with macroeconomic indicators, even after controlling for expecting default losses” (Berndt et al., 2018). The use of market indices as reference rate would further have the issue that most available market indices are proprietary and not freely available. They are created and could be modified or discontinued by financial service institutions, which themselves could benefit from DEBRA. In order to assure tax certainty for taxpayers and to mitigate the volatility of the reference rate, the notional interest rate should be linked to a value of the reference rate in the past. Given the above-mentioned considerations and issues, it is proposed to determine the Notional Interest rate (NIR) of the allowance under DEBRA by taking the currency specific EIOPA risk free rate as the reference and adding a fixed risk premium. Based on European Commission empirical analysis, taking into account credit and equity costs, the rsik premium could take alternative values between 0% and 6%. Higher values of the risk premium generally imply a stronger reduction of equity costs for companies but also higher fiscal costs for Member States. There is generally no analytical solution to balance this trade-off so that the decision for the appropriate risk premium needs to be based on a value judgment taking into account the broader context. 5.3.2 Associated enterprises Cascading an allowance on equity through participations is a well-known way of abusing equity allowance measures. In this type of scheme, a first amount of genuine equity injection is transferred to other related businesses through participations, in order to easily multiply the allowance deduction. The number of cascades is virtually unlimited. To prevent cascading the allowance through participations, the participation in associated enterprises will be deducted from the allowance base in the options where this is relevant (options 1, 2, 3, 5). Associated enterprises are defined using a 25% control threshold as under the DAC 6 definition. 5.3.3. Anti-Tax Abuse Framework The measure will encompass an anti-tax abuse framework. A set of Specific Anti Abuse Rules (SAARs) – inspired from the Guidance on notional interest deduction regimes adopted in 2019 by the Code of Conduct (Business Taxation) – will address the well-known avoidance schemes using this type of measure (e.g. cascading within a group by means of loans, acquisition of businesses held by associated enterprises, etc.). A set of potential anti avoidance rules are presented in Annex 8. 5.3.4. Interest limitation rules included in ATAD 1 Under options 1, 2 and 3, the current ATAD rules would stay in place. Under Option 4, the deductibility of interest payments would be completely disallowed; the interest limitation rule of ATAD 1 would thus become obsolete. Option 5 combines an allowance for equity with a partial restriction of interest deductibility. ATAD 1 rules would still remain in place. The measure however has to define the interaction between ATAD 1 ILR and DEBRA ILR. The rules could be applied mutually exclusive or sequentially. Under exclusive treatment, the more stringent rule would apply, while under sequential treatment the proportional DEBRA ILR would first be applied to all companies, with ATAD 1 ILR then being applied to the remaining net interest expenses. 5.3.5. Exclusion of the financial sector The measure will apply to all sectors except Financial Corporations. The reason for this is that an equity allowance and an interest limitation have very different impacts on Financial Companies (FCs) and Non-Financial Companies (NFCs). FCs usually have more interest received than interest paid. Therefore, the interest limitation would not apply for them since the basis (interest paid-interest received) would be negative. This means that NFCs would finance the allowance on equity of the FCs. Moreover, FCs are subject to regulation on their capitalisation, which means that the issue of under capitalisation is addressed in another way. The possibility of limiting the allowance to companies active in certain sectors was explored within the Commission. One option would have been to base the choice on sectors on the EU’s Taxonomy Regulation, as this has already engendered much debate and is based on a prevailing agreement with Member States. The outcome of this reflexion was that firstly, the DEBRA would have become extremely complex if not impossible to implement in practice. Companies would have to be individually checked (against the taxonomy) in order to be granted the allowance, introducing a potentially enormous burden on tax administrations. The changing nature of what could potentially constitute ‘eligible sectors’ at any given time could have also meant discrepancies in the treatment of companies in the same sector over time. Second, the objective of the DEBRA is to address the debt-equity bias in the EU, and not only in certain sectors. This possibility was therefore discarded and not considered as a viable design element of a possible allowance on equity. 5.4. Increased allowance for SMEs SMEs often face a higher burden to obtain financing. Especially young and innovative companies need equity financing due to their specific risk structure. The measure could thus grant a higher notional interest rate for SMEs to meet SMEs higher financing costs and equity demand. Such a rate top-up can be applied in all cases outlined under policy options 1, 2, 3 and the allowance element of Option 5. The measures proposed in these policy options would apply in exactly the same way to all businesses, irrespective of their size or sector; it is only the notional interest rate applied as part of the allowance that would be higher for SMEs. SMEs would be defined as per Article 3 of the Accounting Directive. In addition it would be required that for a company to be considered a SME, it must not be part of a group of businesses which, at consolidated level, exceeds at least two of the three limits under the Accounting Directive. The application of an increased notional interest rate for SMEs would have to be implemented in all Member States. There should be no discretion on the part of Member States as to whether to apply a 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.

5.5. Treatment of loss-making companies and option for benefit carry-forward Loss making companies do not pay corporate income taxes. They can thus not profit from an allowance on equity. Similarly, the reduction of interest deduction as proposed in option 4 and 5 would not hurt a loss-making company, since there is not taxable income from which to deduct. In order to assure that companies can profit from the full ten years of equity allowance, it could be considered to grant a carry-forward for the allowance so that companies can carry forward the unused allowance through loss-making years. Such a benefit carry forward could be applied for a specific number of tax years or ad infinitum. In case of losses, the loss of year t will appear in retained earnings of year t+1 which will negatively affect the base of the allowance leading to a taxable allowance. However, this allowance will only actually be taxed when the company is making profits again and after all the losses brought forward from previous exercises have been offset by profits. A provision could be included in the legal draft stating that the taxable allowance shall not apply if the taxpayer provides sufficient evidence that the negative allowance base is due to losses and does not come from the distribution of profits used to benefit a second time from the deduction of the allowance on equity without a genuine increase of equity. 5.6. Grandfathering of existing allowances for equity There are currently six Member States that have an allowance for equity in place. In order to mitigate the negative effects on businesses of a sudden change in the equity allowance regime in place in these countries, the DEBRA would allow for a grandfathering for those companies that have already benefitted from an equity allowance under the regimes in place at the time that the EU Directive’s comes into force. 5.7. Options discarded at an early stage This impact assessment considers all possible means of addressing the debt-equity bias, and various designs in some cases, among the policy options for consideration and analysis. The only option that was discarded ex-ante is the option of a soft-law approach. Previous experience with recommendations in the direct taxation field have demonstrated that such soft law does not lead to a harmonised approach being taken across Member States Given the sensitivities around the field of taxation, a general recommendation to address the debt-equity bias would most likely not ensure a common set of anti-abuse rules, nor a homogeneous treatment of the key building blocks of such an initiative (base of the allowance, notional interest rate, number of years the allowance is granted, possible carves-out). Even if all Member States were incentivised to take action, a differentiated approach on critical design elements would instead contribute to even more fragmentation of the single market. The Code of Conduct Group (“the Code”) already considered and assessed notional interest deduction regimes and published Guidance on the issue in 2019. This guidance provides views on a preferred approach in relation to a number of critical questions regarding the anti-abuse framework and presents a non-exhaustive list of elements and characteristics which indicate that a Notional Interest Deduction Regime may be harmful when assessed against the criteria of the Code of Conduct. Despite the existence of these assessments and Guidance issued at EU level, the six national measures currently in force across the EU differ significantly and segment the common market. In particular, the Guidance did not lead to a general adoption by Member States of a harmonised anti-abuse framework for NIDs. The Code guidance focusses on ways to avoid that notional interest deduction (NID) regimes are abused and prescribes that NID regimes should have certain limitations in scope and be properly constrained by appropriate anti-abuse measures to make them less vulnerable to aggressive tax planning. The objective of fighting tax avoidance is generally shared and well supported by Member States; but even on such non-controversial and limited aspects of design, the guidance of the Code did not manage to lead to a holistic or common approach by Member States. This lack of action following on soft-law guidance, or the divergence in approach where action was taken, is precisely why the Commission has not considered another soft law measure among the current policy options. Such approach was considered but discarded in view of the fact that it did not provide sufficient impetus for a harmonised approach to address the challenge at hand. It was, therefore, considered more appropriate to take a more stable and harmonised approach to the tax debt equity bias at EU level. 6.What are the impacts of the policy options? This section examines the different options to address the debt-equity bias in terms of effectiveness and efficiency. As discussed in Section 5, the available options are: •An allowance for all corporate equity (ACE) (Option 1), •An allowance for new corporate equity (ANCE) (Option 2), •An allowance for corporate capital (ACC) (Option 3), •Non-deductibility of interest payments (NDI) (Option 4),

•An allowance for new equity coupled with a reduction of interest deductibility (Option 5) Several methods are used to analyse the impacts of the different policy options, namely desk research, stakeholder feedback through a public consultation and individual meetings, discussions with Member State, own calculations, and the use of the CORTAX computable general equilibrium (CGE) model, provided by the JRC, to assess macroeconomic impacts. The options are not expected to have environmental impacts. 6.1. Data limitations and methodological short-comings The observable quantity, which should be impacted by the debt-equity bias, is the debt-equity ratio. In most EU Member States the debt-equity ratio was exceptionally high around the time of the great recession (ca. 2007-2010) and has gone down since. This might, to some extent, be driven by a reduction of CIT rates, lower interest rates, newly introduced thin capitalisation rules (debt-equity ratio rules and interest limitation rules), and other regulations aimed at increasing equity of companies after the financial crisis. It is very difficult to exactly assess or identify how important the debt-equity bias is for debt-equity ratios, compared to other factors (international investment climate, stock market performance, business cycle, interest rates, inflation etc.). These elements of finance and economy are intertwined. The studies discussed in Chapter 2 have established an empirical link between tax rates and levels of debt-leverage, this is however not enough to determine the importance of the debt-equity bias. The analysis of DEBRA is supported by the CORTAX general equilibrium model run by the Joint Research Centre (JRC). In addition, two sources of data have been used to try to understand further empirical aspects of DEBRA: national financial account data and ORBIS company-level data. CORTAX is a highly stylized general equilibrium model which will be further discussed in the next section. Economic modelling approaches like CORTAX mostly rely on standard assumptions of neoclassical economics with perfect markets and complete information. As a consequence there will always be a market clearing price for debt and equity which implies that no agents will be restricted in their choices. In reality we know that there are companies which are restricted in their financing choices because neither equity nor debt can be accessed. While such assumptions are unproblematic when comparing different policy options and understanding their impact on the economy, they become relevant when exact predictions about specific policy choices are required. In other words, CORTAX is very useful to compare different policy options. It is however problematic to rely too heavily on the point estimates of CORTAX. In order to identify and overcome potential short-comings of the modelling approach and to complement the analysis, two alternative data sources are used: macro-data from national financial accounts and company level data from the ORBIS data-set. There are a number of problems also related to these data, which prevent a complete analysis of all policy design aspects of the policy options. National financial accounts (NFAs) are an element of national accounting. NFAs contain aggregate information on equity, interest paid and interest received per sector of the economy. For the analysis of DEBRA there are however a few challenges. The category of equity in NFAs contains a few elements that would likely not qualify as equity under DERBA. In addition, equity is reported as the market value of traded and non-traded shares. The market value of shares might differ considerably from the book value of equity, which is the relevant base for the equity allowance. For interest payments, the aggregation means that relevant interest payments might be averaged out, whereas the interest limitation of option 4 or 5 would be applied to net interest payments, i.e. interest paid minus interest received. In the dataset, gross interest payments are about four times larger than net-interest payments. ORBIS provides company level data. A major problem of ORBIS is, sample bias and incompleteness. ORBIS can consequently not be used to calculate absolute values (like the equity allowance costs in billion EUR) since only a fraction of companies is covered and the coverage differs across Member States. However, ORBIS can be used to analyse ratios, such as what share of benefits of an equity allowance on the company level are balanced out by a loss in interest deductibility. Another data-limitation with ORBIS is that it does not have information about interest received but only about interest paid. While CORTAX accounts for the behavioural adaptation of agents to changing relative prices, all estimates derived from ORBIS or national financial accounts are static, i.e. no growth effects can be considered. 6.2. The modelling approach with CORTAX CORTAX is a highly stylized computable general equilibrium model, designed to evaluate the effects of corporate tax reforms in the 27 EU Member States. The model assumes optimal behaviour of all agents and each country is assumed to have the same structure in terms of consumption, savings, production and public finances (though the data are country-specific). Countries are linked via international trade in goods markets, intermediate goods markets and investment by multinationals. The model also includes the EU’s main trading partners. Results are provided at the country level reporting changes in tax rates, tax revenues, investment, employment, wages and GDP. CORTAX is a single sector model excluding the possibility of sectorial analysis. There is no time in the model and changes have to be interpreted as change between the old equilibrium pathway and the new equilibrium pathway. The estimations with CORTAX are performed with two different approaches. The first approach is a compensated approach where changes in the effective tax rates due to the policy are compensated with commensurate changes in statutory corporate income tax rates so as to assure revenue neutrality. The second approach is an uncompensated approach where statutory tax rates remain unchanged. On top of the structural effects of the measure driving the results in the compensated approach, the uncompensated approach thus also accounts for budgetary implications. While policy option 4 has no parameters, all other policy options could assume alternative parameter values for the risk premium (and thus the notional interest rate) and in the case of option 5 for the level of interest limitation. In order to compare the structural characteristics of the policy options it is assume that the policy options entailing an allowance for equity would have a notional interest rate (NIR) of 2.2% on average, applied for all types of businesses. When considering policy options with an SME top-up, the NIR is 2.5% on average. These values are derived from the ECB’s Survey on the access to finance of enterprises (SAFE). Separate analysis have been conducted for member state specific NIRs and an EU wide NIR. The intermittent case of currency specific NIRs provides results strictly in between those two extreme cases. Ceteris paribus the Member State specific NIRs indicate on average lower impacts than a currency specific or EU-wide NIRs. In order to simplify the presentation and to provide a conservative lower-bound estimate for effects, the analysis of Chapter 6 is based on Member State specific NIRs. Annex 5.1. provides further details. The risk free rate at the time of analysis was about 0.2%, implying an assumed risk premium for the analysis of 2%. The complexity of the analysis (with at least eight different calibrations required for each option) makes it impossible to fully explore the parameter space for alternative values of the risk premium or NIR. To understand the structural implications of the different options it is important to compare options with the same NIR. For the comparison of options any viable NIR could be used since the relative performance of the options would not change when the NIR (or risk premium) is changed. Option 5 proposes an allowance for equity as in Option 2 in combination with a proportional limitation of interest deduction by 25% in order to mitigate budgetary impacts. The level of interest limitation (25%) is chosen so as to assure fiscal neutrality of option 5 on average in the dynamic modelling context of CORTAX. ATAD 1 also includes an interest limitation rule (ILR) which provides a minimal provision to limit the deductibility of net interest expenses to 30% of EBITDA with a safe harbour of EUR 3 million. While there are issues of data availability, which make it very difficult to perform a detailed analysis of ILRs, some preliminary analysis suggest that very few companies are captured under the ATAD 1 ILR. Since the companies currently falling under ATAD 1 are already restricted in their deductibility, these companies would not provide new resources to compensate for the equity allowance, when falling under the proportional ILR of option 5 instead. Further details on the estimates are provided in Annex 6. CORTAX does not explicitly model