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Addressing the debt–equity bias in taxation
Addressing the debt–equity bias in taxation
Pieter Baert, Members' Research Service
Summary
Current corporate tax systems in many EU Member States tend to favour debt over equity, influencing firms' financing decisions. In this context, the tax treatment of equity is a key factor shaping incentives for long-term investment. On 24 February 2026, the European Parliament's Subcommittee on Tax Matters (FISC) will host a public hearing on this topic.
Cost of finance
The availability and cost of different sources of finance play a central role in shaping corporate investment behaviour. Across most EU Member States, corporate tax systems systematically favour debt over equity financing, creating a debt–equity bias. Interest payments on borrowed capital are generally deductible from the corporate tax base, whereas equity-related costs – such as dividends – are not. This asymmetry lowers the effective tax cost of debt relative to equity, influencing corporate financing decisions. Over time, such a distortion can contribute to structurally elevated indebtedness in the corporate sector.
Additionally, as part of its savings and investments union objective, the European Commission has observed that many EU businesses remain under-equitised, a situation that is not due to the debt–equity bias alone but also reflects the limited development of equity markets in Europe. Addressing current investment and competitiveness challenges in the EU will require a large-scale mobilisation of capital, with equity financing playing a central role in supporting high-risk, long-term strategic investments. The situation is especially pressing for small and young companies working on innovative products and services whose long development cycles and high upfront capital needs limit access to bank loans. The challenge is particularly acute in the defence sector, where access to equity financing is essential, as debt is often insufficient or unavailable.
The level of the debt–equity bias varies across Member States, depending on factors such as statutory corporate tax rates and prevailing interest rate levels. For instance, in countries with higher corporate tax rates, the debt–equity bias is typically stronger, since the tax deductibility of interest provides a comparatively greater benefit. Five Member States have introduced measures to mitigate the bias by partially aligning the tax treatment of equity with that of borrowing. The most prominent of these measures are notional interest deduction (NID) regimes, under which companies are allowed to deduct from their taxable base a 'notional' return on qualifying equity, calculated as the annual increase in equity multiplied by a reference interest rate (Table 1). Romania does not operate a conventional NID regime. Instead, it implemented a temporary equity-support measure (2021-2025) in the form of a tax credit of up to 15 % of corporate income tax, dependent on the levels of equity increase.
| Member State | Interest rate applicable in 2024 | Limitations | Calculation of the interest rate |
|---|---|---|---|
| Cyprus | Target rate + 5 pp. | Deduction may not exceed 80 % of taxable profits | Target rate = government bond yield to maturity 10 years of the jurisdiction in which the equity is invested + 5 pp |
| Malta | 8.70 % | Deduction may not exceed 90 % of taxable profits | Maltese government bond yield to maturity 20 years + 5 pp |
| Poland | 6.75 % | Deduction may not exceed PLN 250 000 | National Bank of Poland reference rate + 1 pp |
| Portugal | 7.05 %–7.8 % | Deduction may not exceed the higher of €4 million, or 30 % of EBITDA | 12-month Euribor rate + 2 pp (small businesses) or + 1.5 pp (others); a temporary 50 % increase applied in 2024 |
Data source: Data source: Author's own calculations.
Note: This is a high-level overview; see national legislation for further details. Euribor: Euro Interbank Offered Rate; EBITDA: earnings before interest, tax, depreciation and amortisation; pp: percentage point(s). Belgium and Italy repealed their NID regimes in 2023 and 2024 respectively.
Interest limitation rule
From the opposite perspective, the tax deductibility of interest payments is itself subject to limitations. While interest deductibility has historically contributed to the debt–equity bias, it has also created opportunities for aggressive tax planning, particularly within multinational groups. Through aggressive intra-group financing, companies can increase debt in high-tax jurisdictions by borrowing from related entities in low-tax jurisdictions, shifting profits through deductible interest payments.
In response, Article 4 of the EU Anti-Tax Avoidance Directive (ATAD) introduced a mandatory interest limitation rule, restricting the deductibility of net borrowing costs up to the higher of €3 million or 30 % of taxable earnings before interest, tax, depreciation and amortisation (EBITDA). Member States were required to transpose this rule into national law by 31 December 2018. As the ATAD establishes minimum standards, Member States retain the discretion to apply stricter limitations if deemed necessary, and several have made use of this flexibility.
In the context of the Commission's preparatory work on the forthcoming 'taxation omnibus' simplification package in the second quarter of 2026, some stakeholders have raised concerns regarding the impact of the ATAD's interest limitation rule on investment, while others have warned against loosening the rules.
Debt–equity bias reduction allowance
In May 2022, the European Commission tabled a proposal for a Council directive on a debt–equity bias reduction allowance (DEBRA). Tackling both sides of the bias simultaneously, to limit the proposal's impact on tax revenues, the Commission proposed to reduce the cost of equity and increase the cost of debt. First, businesses that fund new investments by raising capital would be able to benefit for 10 years from an equity allowance, deductible from the tax base and calculated on the annual increase in net equity multiplied by a risk premium, with a higher premium for small and medium-sized enterprises. Second, to reduce the reliance on debt, current limitations on interest deduction would be strengthened. Through these measures, DEBRA aimed to support the re-equitisation of businesses and to reduce compliance costs for companies operating across borders by replacing the diverse national NID regimes with a harmonised framework.
The European Parliament generally endorsed the proposal; however, to account for the economic impact of the COVID‑19 pandemic and limit the proposal's fiscal effects, it supported shortening the equity deduction period to seven years for large company groups, and postponing the application of stricter interest limitation rules for large groups until 2027. In October 2025, Parliament reiterated its position on DEBRA, and underlined the need to increase equity in business financing.
The Council completed an article-by-article examination of the proposal in 2022 but suspended negotiations the same year. Negotiations have not restarted. In its work programme for 2026, the European Commission noted its intention to withdraw the proposal. Commissioner Wopke Hoekstra, responsible for taxation, indicated that the possibility of pursuing DEBRA through enhanced cooperation could be examined at a later stage, provided there is sufficient interest among Member States.
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