M&A - Debt vs Equity from a tax perspective

Cian O’Sullivan, Tax Director, BDO: From a tax perspective, the key determinant for deciding between debt and equity is generally whether the company can obtain a tax deduction for any interest expense. An Irish company would generally need to rely on obtaining relief for the interest expense as an “interest as a charge”. This would require the company to meet certain criteria such as having a “material interest” (5%) in the investee company and having at least one director in common with the investee company.

Following the passing of Anti-Tax Avoidance Directives by the EU, Ireland introduced legislation in recent years which has had the effect of curtailing the level of interest deductibility, the most relevant of which are the Interest Limitation Rules (ILR), which may limit the net interest deduction to 30% of EBITDA (earnings before interest, taxes, depreciation and amortisation).

Interest relief is generally available for companies to some degree. However, the costs of raising equity are currently not deductible for tax purposes in Ireland. This is also the case in most other jurisdictions. In order to address the disparity between the tax deductibility of expenses related to debt versus equity, the European Commission presented a proposal on 11 May 2022 for a debt-equity bias reduction allowance (DEBRA).

There are two elements to DEBRA. The first of which is a tax allowance on increases in equity, which is calculated by multiplying the year-on-year increase in equity by a notional interest rate. The allowance will be deductible for ten consecutive tax periods with the annual allowance being limited to 30% of EBITDA.

The second element is a limitation of interest deductions to 85% of excess borrowing costs, which will work in tandem with the ILR. Unlike the ILR, this limitation would be permanent so that the disallowed interest may not be carried forward.

The introduction of certain rules resulting in the possible denial or restriction of deductions for interest expenses, and the potential introduction of equity deduction, has the potential to make equity a more attractive form of raising finance for a company where previously debt would have been the preferred option. Of course, this is solely looking at matters through a tax lens, and there are many legal and commercial considerations that often lead the debt v equity decision making process.

Content adapted from Finance Dublin’s Irish Tax Monitor.