Thin capitalisation rules and corporate leverage

Jennifer Blouin, Harry Huizinga, Luc Laeven, Gaëtan Nicodème, 29 March 2014



A company’s interest expense generally is deductible from its taxable corporate income. This provides firms with an incentive to finance their operations through debt rather than equity, especially if the corporate tax rate is high. Correspondingly, leverage tends to be positively related to the corporate tax rate (see Graham 2003, and Feld et al. 2013).

Multinationals can reduce their worldwide tax incidence by concentrating their debt in relatively high-tax countries. Hence, the leverage of a multinational firm is particularly sensitive to a jurisdiction’s tax rate (see Huizinga et al. 2008), and tax authorities face declining corporate tax receipts from multinational firms that use excessively high leverage and concomitant interest deductions.

To counter this base erosion, many countries have instituted thin capitalisation rules that restrict the deductibility of interest from taxable corporate income. Typically a thin capitalisation rule denies complete interest deductibility if a particular leverage ratio reaches a certain limit.1 In our new paper we document thin capitalisation rules in 54 countries, and consider the impact of thin capitalisation rules on the leverage of the foreign affiliates of US multinational firms over the years 1982-2004, using confidential data from the US Bureau of Economic Analysis (Blouin et al. 2013).2

Thin capitalisation rules are found to have a substantial impact on affiliate leverage. However, their effectiveness is severely reduced if tax authorities can use discretion in their application, taking into account information on leverage at other firms instead of applying the rules automatically. International tax policy makers should take note of this finding as they discuss the optimal design of thin capitalisation regimes within the framework of the OECD.

Thin capitalisation rules are quite common

In 2004, 27 countries – exactly half of the countries we cover in our analysis – had enacted a thin capitalisation regime that restricted interest deductibility if a debt ratio exceeded a certain limit. Two main categories of thin capitalisation rules can be distinguished. First, 16 countries restricted interest deductibility if the total debt-to-equity ratio exceeded a certain numerical value. The United Kingdom, for instance, maintained a maximum total debt-to-equity ratio of one. Alternatively, 11 countries restricted the ratio of internal debt-to-equity, where internal debt means debt to the parent firm or another related party. Germany, for instance, had a maximum ratio of internal debt-to-equity of 1.5.

Thin capitalisation regimes differ in whether their application on reaching the maximum debt ratio is automatic or instead discretionary. In the latter case, indebtedness above the maximum allowed ratio triggers an investigation by the tax authorities of whether the indebtedness is indeed deemed excessive (leading to reduced interest deductibility), taking into account the leverage of other comparable firms. Only 17 countries applied their thin capitalisation rule automatically, while 10 countries could use some discretion in the application of their thin capitalisation rule.

Well-designed thin capitalisation rules reduce leverage

On average, a restriction on the total debt-to-equity ratio (which also constrains the firm’s total debt-to-assets ratio) reduces the total debt-to-assets ratio of the affiliates of US multinational firms by 1.9%. The decline in the total debt-to-assets ratio is larger if the maximum allowed total debt-to-equity ratio is more restrictive.

Thin capitalisation rules that instead limit the internal debt-to-equity ratio on average reduce this leverage ratio by 6.3%, while the decline is larger if the maximum allowed debt ratio is lower. The sensitivity of the affiliates’ internal debt ratio to thin capitalisation rules may reflect that multinationals can easily substitute internal equity for internal debt in case the tax advantage of internal debt is diminished on account of a thin capitalisation rule.3 This also suggests that thin capitalisation rules can be effective instruments to counter tax planning activities via the use of internal debt.

The effectiveness of thin capitalisation rules depends importantly on whether they are applied automatically or with discretion. A thin capitalisation rule reduces the total debt-to-assets ratio by an average of 2.8% if it is automatically applied, but only by 1.1% if it is applied with discretion. The possibility of using discretion reduces the efficacy of thin capitalisation rules, perhaps because tax authorities find it too burdensome to enforce thin capitalisation rules that are not automatic.

The OECD should develop a standard for thin capitalisation rules

Last year, the OECD (2013) launched its Base Erosion and Profit Shifting (BEPS) Action Plan to reduce the overall non-taxation of the income of multinational firms resulting from tax avoidance and evasion. Action #4 of this plan specifically aims to enact reform to “limit base erosion via interest deductions and other financial payments”. The OECD Action Plan provides that the OECD will publish recommendations regarding the design of domestic rules related to interest deductibility by September 2015. These recommendations could take the form of a standard for thin capitalisation rules intended for adoption by OECD member states and other countries – if they wish to maintain a thin capitalisation regime at all.

Concluding remarks

Our evidence suggests that such rules would only be effective in reducing leverage – and in increasing tax revenues – if their application upon reaching the maximum leverage ratio is automatic. If instead, discretion is made a feature of a common thin capitalisation regime, then tax policy makers may appear to have succeeded by adopting a seemingly coordinated policy – but in reality the multinationals would continue to benefit from interest deductions, thus reducing tax revenues.

Authors' note: The views expressed herein are those of the authors and should not be attributed to the European Commission, the IMF, its Executive Board, or its management.


Blouin, J., H. Huizinga, L. Laeven, and G. Nicodème, (2013), “Thin capitalization rules and multinational firm capital structure”, CEPR DP 9830.

Buettner, T., M. Overesch, U. Schreiber, U. and G. Wamser, (2012), “The impact of thin-capitalization rules on the capital structure of multinational firms”, Journal of Public Economics 96, 930-938.

Desai, M., F. Foley, and J. R. Hines, (2004), “A multinational perspective on capital structure choice and internal capital markets”, Journal of Finance 59, 2451-87.

Feld, L., J. Heckemeyer, and M. Overesch, (2013), “Capital structure choice and company taxation: A meta-study”, Journal of Banking and Finance 37, 2850-2866.

Graham, J., (2003), “Taxes and corporate finance: A review”, Review of Financial Studies 16, 1074-1128.

Huizinga, H., L. Laeven, and G. Nicodème, (2008), “Capital structure and international debt shifting”, Journal of Financial Economics 88, 80-118.

OECD, (2013), Action Plan on Base Erosion and Profit Shifting, Paris.

1 Previously, Buettner et al. (2012) found that thin capitalization rules reduce the tax sensitivity of the leverage of the subsidiaries of German multinationals in 29 countries over the 1996-2004 period
2 Desai et al. (2004) show that tax rates are a determinant of the leverage of the foreign affiliates of US multinationals using the same data source.
3 A high responsiveness of internal debt ratio to the pertinent restrictions suggests that such restrictions can have a material impact on an affiliate’s total debt ratio as well. Indeed, we find that the existence of restrictions on internal indebtedness on average reduces the total debt-to-assets ratio by 0.8%. An impact of restrictions on internal indebtedness on total indebtedness suggests that such restrictions distort the operation of the capital market internal to the multinational firm.

Topics: Financial markets, International finance, Taxation
Tags: debt finance, debt-to-leverage ratio, international policy coordination

Associate Professor of Accounting, Wharton School, University of Pennsylvania
Professor of International Economics in the Department of Economics, Tilburg University and CEPR Research Fellow
Deputy Division Chief in the Research Department of the International Monetary Fund and CEPR Research Fellow
Lecturer at the Solvay Business School at the Free University of Brussels