On 11 May 2022 the European Commission put forward proposals for a tax allowance that would reduce the current tax advantage for debt over equity. This allowance would be designed to encourage businesses to access more equity financing and reduce their reliance on debt financing which is often considered to be excessive. Under the debt/equity bias reduction allowance (DEBRA) any increases in equity from one tax year to the next would give rise to a deduction for tax purposes.

Enterprises in the EU currently raise around 70% to 80% of their finance through bank loans, and raise the remaining finance from equity. This has a tax advantage because the interest on loans is deductible for tax purposes, but firms can become vulnerable in a crisis if the banks are unwilling to lend as much as usual. European enterprises may therefore be encouraged by the pro-debt bias of the tax rules to take on debt to finance their growth rather than increasing equity capital. If their debt levels are excessive, they may be vulnerable to any unforeseen developments in the business climate.

EU statistics indicate that the total debt of corporations (excluding financial institutions) totals almost EUR 14.9 trillion which is 111% of the EU’s GDP. If the corporations can reduce their reliance on debt finance and rebalance their capital structure to make it more solid this can have a positive effect on their ability to invest and innovate. This could improve competitiveness and growth in the EU.

By taking a combined approach of introducing an equity allowance and restricting the tax deduction for interest the European Commission estimates that it can increase the investments made by enterprises by 0.26% of GDP and can increase the EU’s GDP by 0.018%. Enterprises can make their decisions on financing on the basis of commercial considerations without the outcome being distorted by tax considerations.

Increases in equity capital can fund investments in innovative technologies and promote the green and digital revolutions. Start up companies and small and medium enterprises (SMEs) often develop innovative technology and need to raise more equity finance as they grow and develop their business model. The allowance for equity finance can help them to raise finance and compete in the wider market.

The proposal on a tax deduction for equity is seen by the EU as part of longer-term plans to create a business environment and tax system that promote investment and entrepreneurship. The tax deduction would also be in line with the EU’s capital markets union action plan, which aims to support companies in raising capital and investing as they recover from the pandemic.