• New winds in the European Union - Conditional interest deduction on retained earnings

New winds in the European Union - Conditional interest deduction on retained earnings

09 September 2021

On 18 May 2021, the European Commission (EC) published the long-awaited Communication on Business Taxation for the 21st Century, which set out both the EC's short-term and long-term vision for the EU's tax policy agenda. The Communication proposed the introduction of a Debt Equity Bias Reduction Allowance (DEBRA), which would provide for a notional interest deduction on retained earnings. The purpose of DEBRA is to encourage companies to finance their investments through equity contributions rather than debt financing. EC notes, that due to the COVID‑19 pandemic the incurred corporate liabilities significantly increased.

Currently, companies can deduct interest related to debt financing, but not the costs related to the financing of equity. Thus, tax system stimulates companies to accumulate liabilities, that could lead to high waves of insolvency, which in turn would have a negative impact on the overall EU economy. The initiative will encourage equity investment. According to the EC it shall facilitate entrepreneurship and benefit the investment climate in the EU. The EC proposal will also help to rebalance companies that are financially vulnerable due to the COVID-19 crisis.

Similar support is already being implemented in six EU Member States (Belgium, Cyprus, Italy, Malta, Poland and Portugal). Until 2014, there was a similar relief available in Latvia - the deduction of notional interest on retained earnings.

From July 2021, there will be a public consultation on the initiative, which will last at least 14 weeks. The EC is expected to present a proposal for an EU-wide directive in the first quarter of 2022. All interested parties are invited to comment on the proposal and its possible development, as well as on the objectives of the initiative, implementation options and their possible elements here.

It should be mentioned that it is quite clear how such tax relief works in the “classical” CIT system (was in force in Latvia until 2018). However, it could be challenging to introduce such relief in Latvia and Estonia, where the CIT system differs and simultaneously meet the requirements of the EU Directive, which is mandatory for all EU Member States.

BDO Latvia will follow up on the EC proposal and publish information on its progress.