Thin Capitalization Rule vs Interest Barrier

Abstract

In 2008, Germany introduced an interest barrier which allows the deduction of interest only if a company’s net interest expenditure does not exceed 30% of the company’s EBITDA. The regulation aims at preventing excessive debt financing of companies resident in Germany and distinguishes neither between long- or short-term liabilities nor between resident and non-resident creditors. It further covers all types of debt capital and does not differentiate whether the debt capital was granted by third parties or by shareholders. That is why the interest barrier was criticized extensively as being too strict and demanding.

By applying a binominal model which considers economic risks, this paper elaborates on the effects of both an interest barrier and a thin capitalization rule on an internationally operating group of companies. Further, the impact of debt and hybrid financing on group companies subject to either a thin cap or an interest barrier is measured.

I find that the thin cap is more advantageous under economic certainty and in situations of low risk, whilst the interest barrier tends to be advantageous in risky situations. In very risky situations there is almost no measurable difference between thin cap and interest barrier in case of debt financing. In case of hybrid financing, the interest barrier is advantageous also in very risky situations. Further, companies are less likely to go bankrupt and the group terminal value is higher.

Keywords: Interest barrier, thin capitalization rule, debt financing, hybrid finance, simulation

JEL Classification: G11, G32, G38, M41