Restricting Interest Deductions in Corporate Tax Systems: Its Impact on Investment Decisions and Capital Markets

Abstract

Recently, some European Union member states implemented corporate tax rules restricting the deductibility of interest payments. Most prominently, Denmark extended its thin capitalization rule by an interest stripping rule restricting a firm's interest deductions to 80 percent of EBIT. Similar rules have been introduced in Germany and Italy since the beginning of the year 2008. This paper discusses the economic impact of an interest stripping rule in the context of the European system of corporate taxation. Among others it is argued that impact on cost of capital will be highest for those firms that have little ability to reduce their debt exposure because of equity-rationing. This is most likely the case for SMEs. Large multinational firms could mitigate the effect of the interest stripping rule by substituting debt with equity.

Highly leveraged firms will also clearly be hit by the interest stripping rule. This is typically the case for private equity backed firms. However, it should be noted that the economic burden of this rule is borne by the national economy and not by the private equity investor. The latter will simply reduce the purchase price for new acquisitions in order to offset the negative impact of the interest stripping rule. On the markets, however, company values will decrease.

Keywords: Interest stripping rule, thin capitalization rule, corporate tax system

JEL Classification: G12, G32, G15, H25, H26