Abstract
AbstractTax planners often choose debt over equity financing. As this has led to increased corporate debt financing, many countries have introduced thin capitalization rules to secure their tax revenues. In a general capital structure model we analyze if thin capitalization rules affect dividend and financing decisions, and whether they can partially explain why corporations receive both debt and equity capital. We model the Belgian, German and Italian rules as examples. We find that the so-called Miller equilibrium and definite financing effects depend significantly on the underlying tax system. Further, our results are useful for the treasury to decide what thin capitalization type to implement.
Highlights
Seen from a tax perspective it is often attractive for shareholders of corporations to provide capital as debt instead of equity capital
As the financing behavior of investors is crucial for designing thin capitalization rules and as the influence of thin capitalization rules depends on several other tax parameters it is important for the treasury to know how these rules interact
An allowance for corporate equity (ACE) often is regarded as a means to provide tax neutrality, in Belgium this neutrality property has been undermined by introducing a thin capitalization rule, which obviously exacerbates the discrimination of debt capital (Gerard 2006: 156)
Summary
Seen from a tax perspective it is often attractive for shareholders of corporations to provide capital as debt instead of equity capital. This raises the question of whether thin capitalization rules cancel out the tax shield of debt financing, which may explain the attractiveness of one option over the other Against this background we investigate how such regulations affect the capital structure decisions of corporate stockholders. We refer to Belgium, Germany, and Italy as examples to model all major characteristics of this type of thin capitalization rule These examples allow us to elaborate the mechanisms at work for different implementations of such rules that are common or discussed in several countries and to show how they interact with different tax systems. As the financing behavior of investors is crucial for designing thin capitalization rules and as the influence of thin capitalization rules depends on several other tax parameters (corporate tax rate, taxable fraction of dividends and capital gains, permitted ratio of debt to equity capital) it is important for the treasury to know how these rules interact. This article is supplemented with Excel spreadsheets that provide the calculations that have been performed for Belgium, Italy, and Germany.
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