bur -- business research volume2|issue2|december 2009 | 147- … · 2017. 8. 28. · bur --...

BuR -- Business ResearchOfficial Open Access Journal of VHBVerband der Hochschullehrer für Betriebswirtschaft e.V.Volume 2 | Issue 2 | December 2009 | 147--169

Thin Capitalization Rules andEntrepreneurial Capital Structure DecisionsAlexandra Maßbaum, Faculty of Business Administration and Economics, University of Paderborn, Germany, E-mail:[email protected]

Caren Sureth, Faculty of Business Administration and Economics, University of Paderborn, Germany, E-mail: [email protected]

AbstractTax planners often choose debt over equity financing. As this has led to increased corporate debtfinancing, many countries have introduced thin capitalization rules to secure their tax revenues. In ageneral capital structure model we analyze if thin capitalization rules affect dividend and financingdecisions, and whether they can partially explain why corporations receive both debt and equitycapital. We model the Belgian, German and Italian rules as examples. We find that the so-called Millerequilibrium 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.

Keywords: business taxation, capital structure, critical income tax rate, financing decision, Millerequilibrium, tax planning, thin capitalization

Manuscript received March 19, 2009, accepted by Rainer Niemann (Accounting) November 2,2009.

1 IntroductionSeen from a tax perspective it is often attractivefor shareholders of corporations to provide capi-tal as debt instead of equity capital. This has ledto an extensive enlargement of debt financing ofcorporations (OECD 1987: 8 et seq.). To protecttax revenues, the legislators of many countrieshave reacted to this development by increasinglyimplementing so-called thin capitalization rules(e.g., in Italy and the Netherlands, see Gouthière2005 for an overview of different thin capitaliza-tion rules) or by tightening existing rules (e.g., inGermany, Denmark, the UK, Spain, and France).Thin capitalization rules are regulations that limitthe corporate tax deductibility of interest paid toshareholders.Moreover, we observe that corporations issueshares as well as debt. This raises the questionof whether thin capitalization rules cancel out thetax shield of debt financing, which may explainthe attractiveness of one option over the other.Against this background we investigate how suchregulations affect the capital structure decisionsof corporate stockholders. We neglect problemsof information asymmetry between managers and

shareholders in the following.Hence, for simplicitywe abstract from principal-agent conflicts.During the last few decades many authors havecontributed to the field of corporate capital struc-ture decisions (for an overview of different capitalstructure models see Myers 2001 and Graham2006). In line with neoinstitutional theory, thetax based trade-off theory (e.g., Myers 1984) andthe non-tax-oriented pecking-order theory (Don-aldson 1961) have gained attention. Here, the the-ory of Modigliani and Miller (1958) represents aseminal work for many contributions based onneoclassical theory. In this early work, taxes werenot included. Many extensions to Modigliani andMiller (1958) take many different aspects into ac-count. Modigliani and Miller (1963) extend theirmodel themselves and integrate, among other as-pects, a corporate tax. Miller (1977) completes themodel anew and implements an income tax on theshareholder level. In both approaches a classicalcorporate tax system is assumed.Furthermore, in some contributions the incometax effects on the capital structure are modeled ina more refined manner. For instance, capital gainstaxes and, in turn, the asymmetric taxation of div-

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idends and capital gains are highlighted by Farrarand Selwyn (1967), Brennan (1970), and Schneller(1980). Brennan (1970) and Zechner (1990) as-sume a progressive tax scale and allowances forinterest paid.Some papers take account of tax policy detailsin various countries. Swoboda (1991) examinesGermany’s and Austria’s 1991 tax laws in a Millerframework. In this context he considers Germany’scorporate tax, income tax and also property tax, lo-cal business tax and church tax. FungandTheobald(1984) consider the 1984 tax laws of France, Ger-many, the United Kingdom, and the USA. UnlikeSwoboda, they restrict themselves to corporate andincome taxes. Holland and Steiner (1996) extendSwoboda’s approach and investigate the influenceof Germany’s solidarity surcharge on the capitalstructure. Laß (1999) models US tax law between1977 and 1994 as well as German tax law be-tween 1976 and 1998, also using the Miller model.Kruschwitz (2007) models the German tax regimein 2007.Beyond detailed investigations of different taxesthere are many other extensions to the Modiglianiand Miller (1958) model. Hodder and Senbet(1990), Graham (2003), and Desai, Foley, andHines (2004) consider international tax aspects,DeAngelo andMasulis (1980a), DeAngelo andMa-sulis (1980b), and Graham (2000) take account ofnon-debt-tax shields, e.g., Kraus and Litzenberger(1973), Haugen and Senbet (1978), Kim (1978)model bankruptcy costs, and Jensen and Meck-ling (1976) and Leland (1998) integrate agencycosts (see Harris and Raviv 1991). Capital struc-ture models under uncertainty are examined byKim (1982), Zechner (1990), and Swoboda (1991).Miller andScholes (1978)andLitzenbergerandvanHorne (1978) consider dividend policy. Schneller(1980) andGraham (2003) offer amodel that takesaccount of different systems to prevent double tax-ation of dividends. A dynamic model is presentedby Fischer, Heinkel, and Zechner (1989).Beyond this finance-theory-oriented stream of lit-erature we refer to the discussion on intertem-porarily neutral capital income taxation and con-sumption-based tax systems in public finance. Theso-called ACE tax has become particularly popularas an investment and financing-neutral tax systemwith an allowance for corporate equity (ACE) de-ductible from taxable profits, which represents theopportunity costs of equity capital (Wenger 1983;

Boadway and Bruce 1984; Devereux and Freeman1991). This system is supposed to be close to the taxpoliticians’ idea of a fair and efficient tax system(Devereux and Freeman 1991: 4-6; Fehr and Wie-gard 2003: 298). As Belgium is one of the countriesto have introduced an ACE tax and simultaneouslytightened the thin capitalization rules (e.g., Gerard2006) it is interesting to analyze its interdepen-dencies and possible capital structure effects.Although the literatureprovidesdetailed investiga-tions of tax rules, thin capitalization rules have todate only been analyzed by Buettner, Overesch,Schreiber, and Wamser (2006), Overesch andWamser (2006)andOvereschandWamser (2009).The authors empirically investigate financing deci-sions in amultinational firm under a restrictive taxrule for stockholders’ debt financing, which is com-parable to the German thin capitalization rules. Inthis work, the main elements of a thin capital-ization tax rule are considered without modelingcountry-specific details of the regulation. Here,neither a specific debt-capital/equity-capital ratio,safe haven, nor a differentiation between profit-dependent and profit-independent loans are car-ried out. Amore sophisticated analysis of the influ-ence of thin capitalization rules on entrepreneurialcapital structure decisions has not yet been con-ducted.To fill this void, we integrate thin capitalizationrules into a capital structure decision model inthe following analysis. We investigate its influ-ence on corporate financing decisions analytically.It also helps the treasury to decide what typeof thin capitalization rule to implement under agiven tax setting. Our study can be regarded asa first step towards an empirical study on theinfluence of specific thin capitalization rules oncorporate capital structure and thus provides im-portant information to extend the work of Buett-ner, Overesch, Schreiber, and Wamser (2006),Overesch and Wamser (2006) and Overesch andWamser (2009). In contrast to empirical pub-lic finance papers that are often lacking a suffi-cient theoretical foundation or do not account forall relevant tax details (Desai, Foley, and Hines2004; Mintz and Weichenrieder 2005; Huizinga,Laeven, and Nicodème 2006; Weichenrieder andWindischbauer 2008) we provide a detailed the-oretical model. Moreover, future empirical paperscould verify whether the optimal financing anddividend policies we derive are actually practised.

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We consider thin capitalization rules that are char-acterized by a given permitted debt-equity capitalratio because many countries limit debt financingreferring to such a permitted ratio. We take theItalian, German, and Belgian rules as examples tostudy their impact on capital structure decisions.The Italian and the German thin capitalizationrules are no longer in force. They have been substi-tuted by rules that restrict interest deduction irre-spective of apermitteddebt-to-equity ratio in thosecountries. Nevertheless, there are many countriesthat apply this type of thin capitalization rule,e.g., Bulgaria, Czech Republic, Denmark, Hun-gary, Latvia, Lithuania, the Netherlands, Poland,Portugal, Romania, Slovakia, and Slovenia. We re-fer to Belgium, Germany, and Italy as examplesto model all major characteristics of this type ofthin capitalization rule. These examples allow usto elaborate the mechanisms at work for differentimplementations of such rules that are commonor discussed in several countries and to show howthey interact with different tax systems.Our analysis can help investors not only to maketheir dividend and financing decisions under thincapitalization rules with a given permitted debt-equity ratio but also to adjust their decisions whentax laws change. Our analysis is representative ofall thin capitalization rules that refer to such apermitted debt-equity ratio.As the financing behavior of investors is crucial fordesigning thin capitalization rules and as the influ-ence of thin capitalization rules depends on severalother tax parameters (corporate tax rate, taxablefraction of dividends and capital gains, permit-ted ratio of debt to equity capital) it is importantfor the treasury to know how these rules inter-act. Analyzing different types of thin capitalizationrules and performing sensitivity analyses help thetreasury to implement a rule that contributes toa given political aim. Thus, the following investi-gation of different settings of thin capitalizationrules and tax systems is of general relevance fora comprehensive understanding of tax effects oncapital structure decisions.After developing the general model we apply ourmodel to selected countries. We refer to the capitalstructure model by Miller (1977). Miller investi-gates the market for debt capital and shows thatthismarket always leads to an equilibrium inwhichfor every company the capital structure is irrele-vant to the value of the firm. The same after-tax

return arises irrespective of the form of financingbecause this balances out the advantage that debtcapital incurs interest payments that aredeductiblefrom the corporate tax base (tax shield) and theadvantage that equity capital typically leads to rela-tively lower income tax burden (Miller 1977: 269 etseq.).In section 2 we develop a framework for a gen-eral capital structure model on the basis of Miller(1977) that includes thin capitalization rules. Weintegrate the Italian, German and Belgian thincapitalization rules into this model in sections 3to 5 and analyze whether a Miller equilibrium canemerge. If not, we determine the optimal capitalstructure and identify the most important value-driving factors. On the basis of Miller (1977), werefer to a single investor’s indifference towardsproviding capital as a loan or as equity capital toa corporation as a ‘‘Miller equilibrium’’. Note, thatin the following, this ‘‘equilibrium’’ is not a generalmarket equilibrium. In section 6 we summarizeand draw conclusions.This article is supplemented with Excel spread-sheets that provide the calculations that have beenperformed for Belgium, Italy, and Germany.1

2 Capital structure underrestricted shareholder debtfinancing

2.1 General assumptions

In the following we integrate thin capitalizationfor shareholder debt financing into Miller’s cap-ital structure model to derive conclusions aboutthe effectiveness of this regulation for financingdecisions in corporations. Our model relies on thefollowing set of assumptions.Weassumeaperfect capitalmarket under certaintyand identical debit and credit interest rates. Theborrower is a domestic corporation. The investorsare assumed to be domestic individuals who holdtheir investment and accordingly the provided cap-ital in private means. On the corporate level taxeson profits are considered. On the shareholder levelthe individual income tax is taken into account.All investors who have to decide to provide eitherequity or debt capital are assumed to be share-holders of the underlying corporation. Further we

1 These Excel files can be downloaded from www.business-research.org.

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assume that the thin capitalization rule appliesto all shareholders and thus to all investors (seeAppendix A2).The interest payment Z amounts to i C, wherei denotes the market rate of return that can beearned on the capital market and C denotes theamount of debt capital provided by an investor.On the corporate level dividends are not tax-deductible, whereas interest payments on debt aregenerally tax-deductible as they are operating ex-penses. In line with Miller, the case of limitedinterest deductibility, particularly due to losses, isnot considered (Miller 1977: 262). We assume thata fraction α of debt is subject to the thin capi-talization rule (see Appendix A2). The permitteddebt-to-equity ratio will be denoted by μ and isassumed to be exceeded. Consequently, not thetotal amount of interest paid to a shareholder isdeductible, but only the interest on the permittedfraction of debt capital multiplied with the corpo-rate equity, thus iμ E. As the thin capitalization ruleapplies to all shareholders, the shareholder’s sharein corporate equity is irrelevant. In the followingthe deductible amount of interest is denoted as theutilized safe havenH. Hence,

(1) H =

{iμ E, if αC > μE;

αi C, if 0 ≤ αC ≤ μE.

Equity capital E provided by the shareholder de-notes the equity capital that has already been pro-vided prior to the point of time when the financ-ing decision is made. The investor’s individualamount of equity is exogenously given. Further, itis assumed that all investors offer the same mixof equity and loans to the corporation and con-sequently all shareholders have an identical safehaven. It is therefore possible to determine theoverall safe haven for all shareholders jointly. It isnot necessary to refer to the single shareholder.Some countries raise additional taxes on profitson the corporate level. National tax rates and taxbases vary significantly. In the following the taxrate of these taxes is denoted by τa, the tax base byF .Under income tax law, earned interest is taxable ata fraction εwith ε ∈ [0,1]. The capital income fromshareholders’ invested equity capital consists ofdistributed dividends of the corporation and real-ized capital gains. The taxable fraction of dividendsD is denoted as γ with γ ∈ [0,1].

In the following the sum of retained earnings isgiven by G (Miller 1977: 268). G is not equal tocapital gains as this variable neglects the internalgrowth caused by reinvesting retained earnings atthe internal after-tax yield i(1 − τc − τa). Further,capital gains are not liable to income tax until theyare realized at shareholder level. We have to takeaccount of the time effect arising from the delayedtaxation of retained earnings. In the following,the time lag of capital gains taxation compared todividend taxation and the internal growth effectfrom retained earnings are both captured in thefactor θ > 0. It is necessary to implement θ into ourstatic model to highlight the difference in taxationof dividends and capital gains and the internalgrowth of retained earnings in present value terms.We obtain

(2) θ =(1 + i[1 − τc − τa])n

(1 + iτ)n,

withθGdenoting thepresent value of capital gains.We abstract from increases in value that are causedby speculative developments. Here, iτ is the after-tax market rate of return that the shareholder isable to earn alternatively on the capital market andis given by iτ = (1 − τiI)i. τiI denotes the investor’spersonal tax rate on interest income. If interestincome is included in the investor’s individualtax assessment, the tax rate τiI is equal to theinvestor’s personal income tax rate τi. If there isa withholding tax on interest income, τiI is thewithholding tax rate. The variable n denotes theperiod in years after which the capital gains arerealized. We assume that n is exogenously givenand hence the investor is not able to decide on theholding period n. Furthermore, we assume thatonly a fraction λ of the capital gain is taxable. Intotal the present value of assessable and taxablecapital gains G is λ θG (see Swoboda 1991: 857,and Laß 1999: 119, who assume that capital gainsare tax-exempt).We abstract from personal allowances, income-related expenses, standardized deductions, per-sonal exemptions, special expenses and extraordi-nary charges in themodel when calculating taxableincome. We assume there is no income from othersources apart from interest income, dividends, andcapital gains. The fractionof interest that is not tax-deductible on the corporate level is requalified ashidden profit distribution and therefore treatedas a dividend. Dividends and hidden distributions

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are subject to an income tax rate τiD, interest pay-ments to an income tax rate τiI and capital gainsto τiG. Although the income tax schedule is pro-gressive in many countries, from the shareholders’perspective the income tax rate can be regarded asexogenously given.

2.2 Integrating taxes

Now we will formally describe all relevant fiscalrules. In a first step we have to determine theamount of interest that can be deducted when de-termining the corporate tax base. In total, interestpayments amounting to I are paid to the investor:

(3) I = i C.

The interest payments can be deducted from thecorporate tax base up to an amount of Id. Interestpayments on a fraction (1 − α) of the loans arecompletely deductible, i.e., I(1 − α), whereas in-terest payments on a fraction α of debt are onlydeductible in the amount of the safe haven H. Aswe assume the safe haven to be exceeded, it is equalto iμ E.

(4) Id = I(1 − α) +H = i C(1 − α) + iμ E.

The amount of non-deductible interest expensesInd which is requalified as a hidden distribution ofprofits is

(5) Ind = I − Id = i Cα − iμ E.

The taxable income in terms of corporate tax re-sults from the deduction of debt-capital interest Idfrom gross profit Π. Corporate tax amounts to:

(6) Tc = τc(Π − Id

)= τc

(Π − i C[1 − α] − iμ E

).

Additional taxes on profits Ta are levied on thecorporate level. The tax base is equal to F; the taxrate amounts to τa.

(7) Ta = τa F .

The taxable interest Itaxable, dividendsDtaxable, andcapital gains Gtaxable are subject to income tax.Additionally, interest that is considered to be ahidden distribution of profits is subject to incometax. The taxable fraction of the hidden distributionof profits is denotedwith Btaxable. Thus, the burdenresulting from income tax is

Ti = τiI Itaxable + τiD(Dtaxable + Btaxable

)(8)

+ τiG Gtaxable.

The interest payments that are subject to incometax are identical to the deductible interest pay-ments Id on the corporate level. A fraction ε of Idis taxable. Hence, the interest payments that areliable to tax amount to

(9) Itaxable = ε Id = ε(i C[1 − α] + iμ E

).

Only the fraction γ of the dividends is subject toincome tax

(10) Dtaxable = γD.

Interest that is interpreted as hidden distributionof profits is treated as dividends and thus likewisetaxable by the fraction γ. The hidden distributionof profits corresponds to non-deductible intereston the corporate level Ind. This amount denotesthe interest payments that exceed the safe haven.

(11) Btaxable = γ B = γ Ind = γ(i Cα − iμ E

).

Retained earnings G result from the differencebetween the profit Π, the corporate tax Tc and theadditional taxes Ta, as well as the dividends D andthe interest I. Thereby, the present value of thecapital gains θG is taxable at the fraction λ. Inpresent value terms we obtain

Gtaxable = λθ(Π − Tc − Ta −D − I

)(12)

= λθ(Π − τc

[Π − i C(1 − α) − iμ E

]︸︷︷︸Tc

− τa F︸︷︷︸Ta

−D − i C︸︷︷︸I

).

Inserting equations (9), (10), (11), and (12) into eq.(8) leads to

Ti = τiI ε(i C [1 − α] + iμ E

)︸︷︷︸Itaxable

(13)

+ τiD γ(D + i Cα − iμ E

)︸︷︷︸Dtaxable+Btaxable

+ τiGλθ(Π − τc

[Π − i C(1 − α) − iμ E

]−τa F −D − i C

).︸︷︷︸

Gtaxable

The total after-tax income of all investors Πτ iscomposed of the difference of the gross profit Π,corporate tax Tc, additional taxes on the corporatelevel Ta and income tax Ti,

(14) Πτ = Π − Tc − Ta − Ti

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Πτ = Π − τc(Π − i C[1 − α] − iμ E

)︸︷︷︸Tc


(15)

− τiIε(i C [1 − α] + iμ E

)− τiDγ

(D + i Cα − iμ E

)− τiGλθ

(Π − τc

[Π − i C(1 − α)

−iμ E]− τa F −D − i C

).︸︷︷︸

Ti

Similar to Miller (1977), to identify the optimalcapital structure based on the total after-tax in-come of all investors, we first have to determinethe optimal dividend policy. In a second step weanalyze the optimal capital structure. Against thebackground of the set of equations outlined above,we are able to investigate both an optimal dividendpolicy and an optimal capital structure under thincapitalization rules in a general capital structuremodel. Furthermore, analyzing the general settingenables us to draw conclusions about a real-worldexample, i.e. Italy. This is possible as the Italianthin capitalization rules are fairly simple and thuscorrespond to those of our general model. Later,we specify the model in more detail to study theimplications of modified and simultaneously morecomplex thin capitalizations rules. Such rules havebeen introduced in several countries. We take Ger-many and Belgium as examples of such modifiedrules and investigate whether the results of thegeneral model are robust under more complexshareholder financing rules.

3 General thin capitalization rules(Italy)

3.1 Critical income tax rate

In the following, we integrate general thin cap-italization rules into our capital structure model.Looking for corresponding real-world ruleswe findthat the rules in section 98 of the Italian IncomeTax Code fully comply with our general model.These rules, which are characterized by a smallnumber of attributes, no complicating exceptions,and simple parameters, can be regarded as anillustrating example of our general setting. Weimplement these rules into our framework to in-vestigate the influence of thin capitalization ruleson a general basis on investors’ financing decisions(see Appendix A1).Under section 98 of the Income Tax Code intereston debt capital that a corporation receives from a

substantial shareholder, i.e. a shareholder with ashareholding of at least 25%, has to be requalifiedas hidden distribution of profits if the permittedratio of debt to equity capital of currently 4:1 is ex-ceeded (Romanelli 2006: 372). Therefore, interestis not considered to be a hidden distribution untilthe debt of a substantial shareholder exceeds fourtimes their equity share.Additionally, a regional tax on productive activities(IRAP) is levied on the net value of the productionF . In line with IRAP interest expenses are nottax-deductible. The tax rate τa currently stands at4.25% (Romanelli 2006: 367 et seq.).Dividends and capital gains are 60% tax-exempt ifthe shareholder holds either 2% of voting poweror 5% of the capital of listed companies, or ifthey hold 20% of voting power or 25% of thecapital of other companies. Otherwise dividendsand capital gains are liable to a final withholdingtax of 12.5% (Romanelli 2006: 377). Aswe considersubstantial shareholders only, a withholding tax isnot applicable.Interest income arising from loans is subject to awithholding tax of 12.5% that is creditable againstthe shareholder’s income tax liability. A final with-holding tax applies to interest on current accountswith bank offices and bonds, but not on loans(Romanelli 2006: 378).Hence, interest payments, dividends, and capitalgains are subject to the same income tax rateτi = τiI = τiD = τiG.This reduces the net profit given by equation (15)to

Πτ = Π − τc(Π − i C[1 − α] − iμ E

)︸︷︷︸Tc


(16)

− τiε(i C [1 − α] + iμ E

)− τiγ

(D + i Cα − iμ E

)− τiλθ

(Π − τc

[Π − i C(1 − α)

−iμ E]− τa F −D − i C

).︸︷︷︸

Ti

To identify the optimal dividend policy, equation(16) has to be differentiated with respect to divi-dends D and set equal to zero:

(17)∂Πτ∂D= τi(λθ − γ) = 0.

We find an investor to be indifferent towards div-idend policy only in two cases, namely if their

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marginal income tax rate τi amounts to τi = 0 or ifthe factor θ amounts to θ = γλ .The condition τi = 0 is only fulfilled if the investorhas no taxable income. Since we assume that theinvestor obtains interest payments and dividendsand/or capital gains, this condition is not fulfilledin our model. Hence, dividend policy is irrelevantonly if θ = γ

λ . Under current legislation we haveγ = λ which leads to θ = 1. The time and growth ef-fects from capital gains are cancelled out perfectlyand thus θ = 1. This is true only if the corporateinternal after-tax yield i(1 − τa − τa) is identical tothe after-tax market rate of return the shareholderis able to earn on the capital market iτ. Beyond thissetting, dividend policymay not be irrelevant. Thatsaid, full retention is always the optimal dividendpolicy. As long as retained earnings are taxed ata lower effective rate than distributed earnings,full retention of profits always leads to the highestnet profit. The same result is achieved by Milleralthough he does not outline it explicitly. Miller’sresults are explained by Swoboda (1991: 853) andLaß (1999: 45-46), who find a different result forthe German tax code. Both base their assumptionson a split corporate tax scale in connectionwith thefull imputation system. From the authors’ point ofview the optimal dividend policy depends on theratio between the personal income tax rate and thecorporate tax rate that is applied when profits areretained. If the personal tax rate is significantlylower than the corporate tax rate, a distribution ofprofits is beneficial to reduce the tax burden fromthe corporate tax rate applied to retained profitsto the lower personal income tax rate (Laß 1999:139-140).To identify the optimal capital structure based onthe optimal dividend policy, equation (16) has to bedifferentiated considering D* = 0 with respect toC. Rearranging finally leads to the critical incometax rate τ*i :

τ*i =[τc

(C[1 − α] + μE

)](18)

·[ε(C[1 − α] + μE

)+ γ(Cα − μE)

+ λθ(τc

[C[1 − α] + μE

]− C

)]-1.

Note that the factor θ is influenced by the after-taxinterest rate iτ and therefore by τ*i . Nevertheless,we assume that θ is exogenously given. To justifythis simplification we have analyzed the interde-pendency of θ and τ*i using an iterative simulation

(see Appendix A2). By means of equation (18) theoptimal financing decision can be determined forevery investor. All investors whose marginal taxrate τi equals the critical income tax rate τ*i are in-different towards the allocation of debt and equitycapital. They are referred to as marginal investors.Investors who have lower tax rates will offer a loanto the corporation, while investors with higher taxrates will offer equity capital (Swoboda 1991: 853).Due to the progressive income tax scale in manycountries, e.g., in Italy (Romanelli 2006: 378),a general irrelevance of the financing policy cannever be achieved for all taxpayers. Irrelevancecan only be achieved for the taxpayers who havemarginal tax rates that are identical to the criticalincome tax rate. Therefore, within this analysis it isonly possible to investigate whether or not aMillerequilibrium can be reached for specific taxpayers.Furthermore, the after-tax profit of a firm cannever be maximized through mixed financing. De-pending on the single parameters, either an equity-only or debt-only financing maximizes after-taxprofit, or themeans of financing is irrelevant to theafter-tax profit of the firm.

3.2 Sensitivity analysis

In the following we analyze the implications of avariation of different model parameters. Changesin gross profit Π and interest rate i do not influ-ence the critical income tax rate and therefore thefinancing decision. Hence, we concentrate on thefactor θ, the tax rates, the taxable fraction of divi-dends γ and capital gains λ, the fraction α of debt,the taxable fraction of interest ε, and the permittedratio of debt to equity μ.

3.2.1 Time and growth factor for capitalgains

To analyze how the different parameters affectthe investor’s financing decisions, all variables areassumed to be constant, except for the factor θ.We assume

τc = 33%; τmaxi = 43%;C = e 100,000; E = e 1,000;

γ = λ = 0.4; μ = 4; ε = 1; i = 6%; α = 1.

Interest payments are fully tax-liable, hence ε = 1.Dividends, hidden distributions, and capital gainsare subject to a shareholder relief system, i.e. theyare all subject to tax at a fraction of 40% (Romanelli

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2006: 377). Hence, in our model we obtain γ = λ =0.4. As the permitted ratio of debt to equity capitalis 4:1, in our model the debt-equity parameter μis equal to 4. All interest payments to substantialshareholders are subject to the thin capitalizationrules (Romanelli 2006: 372). These regulationsimply α = 1.Then, the investor receives interest payments ofe 6,000 and the safe havenH amounts to e 240.We receive the critical income tax rate:

(19) τ*i =79.2

2,544 − 2,368.32θ.

Table 1: Critical income tax rates forvarious θ in the general model (e.g., Italy)

θ τ*i0.01 3.14%

0.25 4.06%

0.5 5.82%

0.75 10.32%

0.85 14.92%

0.9288 23.00%

0.95 26.93%

0.9964 43.00%

1 45.08%

1.07 800.19%

Table 1 shows that the values for the critical in-come tax rate τ*i vary between 3.14% and 800.19%(see Appendix A2). For θ = 1.07 we receive anextremely high critical income tax rate that againindicates that debt financing is always beneficial.If we determine critical income tax rates for highervalues of θ the critical tax rate may change its signand even become negative. A negative critical in-come tax rate is not easy to interpret. A closer lookat these scenarios clarifies that the basic mech-anisms at work do not change. In line with theresult for θ = 1.07 the resulting (negative) criti-cal tax rate again implies that debt financing isgenerally favorable.If θ > 0.9964, the critical tax rate is higher thanthe top tax rate of 43%. In these cases an equilib-rium is not possible for the underlying tax system.Then, investors will always prefer to provide a loaninstead of equity to the corporation leading to thehighest possible net profit Πτ.If θ < 0.9288 the critical income tax rate is lowerthan the minimum tax rate of 23%. In these casesall investors provide equity capital.

Only if 0.9288≤ θ ≤0.9964 will it depend on theinvestor’s individual income tax rate whether debtor equity financing is optimal. If the personal in-come tax rate is lower than the critical tax rate, theinvestor will offer a loan. If it is larger, they willprovide equity capital. If the marginal tax rate isequal to the critical income tax rate, the investoris indifferent to either option. In this case we findthe so-called Miller equilibrium for this investor.Although at first sight the after-tax internal rateof return falls short of the after-tax external rateof return (θ < 1) shareholders are still willing toprovide equity capital as they benefit from prefer-ential capital gains taxation. The time and growthfactorθdoes not reflect effects arising from the tax-able fraction of capital gains λ < 1. Consequently,providing equity capital can be optimal even forθ < 1.The specific outcome of the factor θ mainly de-pends on the ratio of the internal after-tax yieldi(1 − τc − τa) and the after-tax market rate of returniτ. The holding period n exerts only little influenceon θ. Assuming that i(1 − τc − τa) and iτ are al-most equal, leads to θ ≈ 1. Then we see that debtfinancing will be beneficial for most investors.Income from equity capital, namely dividends andcapital gains, is subject to income tax at a fractionof γ = λ =0.4. By contrast, interest income is fullytaxed. Interest incomeamounting to the safe havenis also fully taxable, while the excess is subject totax to a fraction of γ =0.4. The lower taxationof dividends and capital gains on the shareholderlevel compared to interest income usually over-compensates their non-deductibility on the corpo-rate level. Nevertheless, debt capital often is moreadvantageous than equity capital because incomefrom equity capital, i.e. accumulated capital gains,is usually higher than interest income. Differenti-ating equation (19) with respect to θ we obtain the

derivative ∂τ*i∂θ which is always positive:

(20)∂τ*i∂θ=

187,571(2,544 − 2,268θ)2

> 0.

An increase in θ causes a higher taxation of capitalgains and consequently a higher taxation of equi-ty capital. Hence, the relative advantage of debtcapital increases compared to equity capital.

154


3.2.2 Tax rates

A rise in the corporate tax rate has two counteract-ing effects. On the one hand, the tax advantage ofdebt capital (tax shield) at the corporate level in-creases and so does the relative advantage of debtcapital (see Buettner, Overesch, Schreiber, andWamser 2006: 11, who come to the same conclu-sion in the case of financing a German corporationowned by foreign shareholders). Equity capital ismore burdened by a higher tax rate, as dividendsare not tax-deductible on the corporate level. Onthe other hand, the factor θ decreases because thecorporate internal after-tax yield i(1 − τc − τa) de-clines. A decrease in θ leads, as shown above, to anincreasing relative advantage of equity capital. InItaly the tax-shield effect always dominates, caus-ing an overall increasing advantage of debt capital.Mathematically this result becomes obvious in that

the derivative ∂τ*i∂τcis always positive.

A change in the corporate tax rate has a relativelylow impact on the investor’s financing decision.Assuming a holding period of, e.g., n = 10 years,a decrease in the tax rate from 33% to 10% leadsto changes in the critical income tax rate of 9percentage points. By contrast, an increase in thecorporate tax rate to 50% raises the critical taxrates by 6 percentage points.Varying the IRAP tax rate has no tax-shield effectbecause interest payments are not deductible un-der this tax. A change in the IRAP tax rate onlyamends the factor θ such that the relative advan-tage of equity capital increases. The derivative ∂τ

*i

∂τais always negative. E.g., assuming a holding periodof 10 years a rise in the tax rate from currently4.25% to 10% decreases the critical income tax ratefrom 12.57% to 3.11%.

3.2.3 Taxable fraction of dividends andcapital gains

In Italy dividends and capital gains are subject totax at the same fraction γ = λ =0.4. In this sectionwe analyze the effects of an isolated change inthe taxable fraction of dividends γ and the taxablefraction of capital gains λ, respectively. We alsoinvestigate the influence of a change in the taxablefraction of both dividends and capital gains. A risein the taxable fraction of dividends γ leads to adecrease in critical income tax rate and thereforean increase in the relative advantage of equity

capital:

(21)∂τ*i∂γ=

−1.27 · 108(4,000 + 96,000γ − 39,472θ

)2 < 0.This result, which seems surprising at first glance,can be explained as follows:we have already shownthat companies do not distribute profits in thismodel framework. Instead, payments for equitycapital are always realized as capital gains. If thetaxable fractionof dividends is increased, this leadsto a higher taxation of interest payments from thincapitalization that have to be requalified as hiddendistribution of profits. Therefore, an increase in γimplies a higher taxation of debt capital.Correspondingly, an isolated increase in the tax-able fraction of capital gains λ leads to a highertaxation of equity capital and an increasing rela-tive advantage of debt capital. The critical incometax rate rises when increasing λ:

(22)∂τ*i∂λ=

1.30 · 108θ(42,400 − 98,680λθ)2

> 0.

Focussing on a change in both the taxable fractionof dividends and capital gains (γ = λ), we obtain

(23)∂τ*i∂γ=

−1.27 · 108 + 1.3 · 108θ(4,000 + 1,000γ[9.6 − 9.9θ]

)2 � 0.

The derivative is positive or negative depending on

the factor θ. Figure 1 shows that the derivative ∂τ*i∂γ

is zero if θ =0.9728. A negative derivative arisesif θ is smaller than 0.9728. Then, equity capitalbecomes more attractive. The effect from highertaxation of dividends that leads to an increasedadvantage of equity capital is higher than the effectfrom higher taxation of capital gains that causesan increased advantage of debt capital.

The derivative ∂τ*i∂γ is positive if θ >0.9728. In these

cases the relative advantage of debt capital in-creases. The effect of the higher taxation of capitalgains overcompensates the effect of the higher div-idend taxation because a high value of the factorθ additionally causes a higher taxation of equitycapital.

3.2.4 Fraction of considered debt

At present all interest payments to substantialshareholders are subject to Italian thin capitaliza-tion rules. Therefore, the parameter α has been setequal to 1. Lowering the fraction α leads to a rise inthe critical income tax rate and hence an increas-

155


Figure 1: Derivative ∂τ*i∂γ for various θ in the

general model (Italy)�

�

� �

____ Derivative��

� *i for various � in the general model (Italy)

-2

0.15

0.25

00.2 0.4 0.6 0.8 1

-4

-6

�� *

i

�

ing relative advantage of debt capital compared toequity capital:

∂τ*i∂α=

[−5.4 · 109 + 1.3 · 109θ

](24)

·[102,400 − 60,000α − 26,272θ

− 13,200θα]-2< 0.

This effect is true because the interest paymentswhich are subject to thin capitalization and requal-ified as hidden distributions of profit decrease, asdoes the corporate tax. A reduction in the fractionof considered debt α has a relatively high influenceon the critical income tax rate. A reduction fromα = 1 to α = 0.01 would lead to a rise in the criticalincome tax rate of up to 32 percentage points.

3.2.5 Other model parameters

Assuming a decrease in the taxable fraction ofinterest of ε = 1 to values with ε < 1, we obtain arise in the critical income tax rate. The derivative∂τ*i∂ε is always negative. This effect in turn increasesthe relative advantage of debt capital because alower taxable fraction of interest implies a lowertaxation of debt capital.The influence of the permitted ratio of debt toequity capital μ and of the amount of equity cap-ital E can be analyzed simultaneously since bothvariables only affect the safe haven H = iμ E. Themultiple μE denotes themaximumamount of debtcapital that a substantial shareholder can provideto the corporation while tapping the full potential

of the safe haven. An increasing multiple μE andconsequently an increasing safe haven H leads toa decreasing corporate tax because the amountof deductible interest payments increases. At thesame time the income tax increases because the ad-ditionally deductible interest payments are taxedto the full amount whereas hidden distributionsare only subject to tax at the fraction γ =0.4. Theeffect on the corporate level always dominates.Therefore, the relative advantage of debt capitalcompared to equity capital increases with risingμE. If the permitted ratio of debt to equity capi-tal μ is increased, e.g., from 4 to 20, debt capitalmay be twenty times the equity capital contributedby one shareholder while a change in the criti-cal income tax rate amounts to a maximum of 17percentage points.

3.2.6 Results

We are able to show that except for the gross profitΠ and the interest rate i all model parameters havean influence on the investors’ financing decisions.Whereas the influence of the corporate tax rate,the IRAP tax rate, the taxable fraction of dividends,capital gains, and interest is low, the factor θ, thefraction of considered debt, and the multiple μEexert a high influence on financing decisions. As θismainly driven by the relation of the corporate taxrate to the individual income tax rate, obviouslythe tax rate difference determines the financingdecision significantly if capital gains are taxable. Acloser look clarifies that θ can significantly changethe critical income tax rate whereas a change in thecorporate tax rate cannot. E.g., if the corporate taxrate rises, two partial effects on the critical incometaxcanoccur.Oneeffect is an increase in the criticalincome tax rate because of an increasing tax shieldfrom debt financing. Simultaneously the criticalincome tax rate is reduced because of a decrease inthe factor θ. Consequently, the overall effect of arise in the corporate tax rate on the critical incometax rate determined by these two opposing partialeffects is small. Only the influence of the taxablefraction of dividends seems counterintuitive as arise in the taxable fraction of dividends γ causes arise in the attractiveness of equity capital.Given the Italian tax policy with capital gains tax-ation, the underlying thin capitalization rule witha given permitted debt-to-equity ratio is typicallynot irrelevant with respect to capital structure de-

156


cisions. Here, financing decisions mainly dependon the corporate-income tax rate differential andtherefore the parameter θ. Consequently, the taxscale is an important driver of the financing deci-sion. The treasury needs to know the distributionof investors across tax classes to forecast whetherit is likely that the majority of investors will tendto provide debt instead of equity capital under thethin capitalization rules.We find that changes in some model parametershave a higher impact on the critical income taxrates than changes in other parameters. This dif-ference in sensitivity is due to the functional formof the net profit.Several countrieshave implementedmore complexthin capitalizations rules. Against this backgroundand the results mentioned above, it is worthwhileto find out whether we obtain corresponding ordeviating results undermore specified rules and towhat extent the characteristics of the underlyingtax systemdetermine the effects.We takeGermanyand Belgium as examples and perform an analysisin the following sections.

4 Complex thin capitalizationrules (Germany)

4.1 Critical income tax rate

In this section we integrate the German thin cap-italization rules according to section 8a of theGerman Corporate Tax Code as amended by theKorb II tax reform act (section 8a of the GermanCorporate Tax Code as amended by the Korb IItax reform act dated Dec. 22, 2003, BGBl. I 2003:2841 et seq.) into the model. This rule that wasintroduced in 2004 has been reformed by the Ger-man business tax reform act 2008 where it wassubstituted by an interest barrier (section 4h of theIncome Tax Code and section 8a of the GermanCorporate Tax Code as amended by the GermanBusiness Reform dated Aug. 14, 2007, BGBl. I2007: 1913 et seq., 1927 et seq.). Section 8a is anexample of a complex thin capitalization rule char-acterized by a given permitted debt-equity capitalratio.Under this debt-equity-ratio-based thin capitaliza-tion rule, interest on debt capital that a corporationreceives from a shareholder with a shareholdingof more than 25%, under certain circumstances,has to be requalified as a hidden distribution of

profits. This regulation only holds if the share-holder’s capital commitment is long term and ifthe tax allowance of e 250,000 of interest on debtis exceeded. The permitted ratio of debt to eq-uity capital is 1.5:1 (section 8a para 1 no. 2 ofthe German Corporate Tax Code). As only interestpayments for long-term debt are subject to thisregulation, the parameter α represents the fractionof long-term debt in Germany. The tax allowance(section 8a para 1 of the German Corporate TaxCode) of e 250,000 of interest is assumed to beexceeded.In addition to the corporate tax the German localbusiness tax has to be taken into account on thecorporate level. This tax treats equity and debt dif-ferently. To integrate effects of the local businesstax into the model further assumptions are neces-sary. Corporate income as defined in the GermanCorporate Tax Code is the basis for determiningthe local business tax base F (section 7 sentence 1of the German Local Business Tax Code). Since thelocal business tax itself is an operating expense, itis deductible from its own tax base. We considerthis deductibility by introducing an effective localbusiness tax rate τa (see Appendix A1). Further-more, amongst the various tax base adjustmentslisted in section 8 of the German Local BusinessTax Code, only the addition of 50% of the interestpayments for long-term debt (section 8 no. 1 ofthe German Local Business Tax Code) is consid-ered in the model. Splitting debt into long-termand short-term debt indirectly introduces a timedimension into the model. Although we develop astaticmodel that by definition does not account fortiming effects, a differentiation between long-termand short-term debt is necessary to distinguish be-tween different types of interest for local businesstax and thin capitalization purposes. Nevertheless,the model remains static. Reductions according tosection 9 of the German Local Business Tax Codeare not considered at all. The fraction of the in-terest that is long-term debt (section 8 no. 1 ofthe German Local Business Tax Code) is denotedby α ∈ (0,1]. If α = 0, section 8a of the GermanCorporate Tax Code does not apply. Hence, theaddition of interest payments for long-term debt isequal to 0.5 Id.Dividends, hidden distributions, and capital gainsare subject to the same income tax rate τi = τiI =τiD = τiG.Taking into account the local business tax, the net

157


profit Πτ is equal to (see Maßbaum and Sureth2008 for a more detailed analysis of the influenceof the German section 8a thin capitalization ruleon capital structure decisions)

Πτ = Π−τa[Π − i C(1 − α) − 0.5 iμ E

]︸︷︷︸

Ta

(25)

− τc[Π − i C(1 − α) − iμ E

−τa(Π − i C(1 − α) − 0.5 iμ E

)]︸︷︷︸

Tc

− τiε[i C (1 − α) + iμ E

]− τiγ

[D + i Cα − iμ E

]− τiλθ

[Π − τa

(Π − i C(1 − α)

− 0.5 iμ E)

− τc(Π − i C(1 − α) − iμ E

− τa[Π − iDC(1 − α) − 0.5 iμ E

])−D − i C

].︸︷︷︸Ti

To identify the optimal dividend policy, equation(25) has to be differentiated with respect to D:

(26)∂Πτ∂D= τi(λθ − γ) = 0.

We see that the investor is only indifferent towardsdividend policy in two cases, namely if the incometax rate τi = 0or if the factor θ =

γλ . This is the same

result we obtained for Italy (see section 3.1 andAppendix A2). Beyond these cases full retention isalways the optimal dividend policy.To obtain the optimal capital structure equation(25) has to be differentiated with respect to D* = 0to C and it has to be set to zero. As a result we getthe critical income tax rate τ*i ,

τ*i =

[τa

[C(1 − α) + 0.5μE

](27)

+ τc[C(1 − α) + μE

− τa(C(1 − α) + 0.5μE

)]]·

[ε[C(1 − α) + μE

]+ γ(Cα − μE)

+ λθ(τa

[C(1 − α) + 0.5μE

]+ τc

[C(1 − α) + μE

− τa(C(1 − α) + 0.5μE

)]− C

)]-1.

4.2 Sensitivity analysis

As in the general model, the gross profit Π andthe interest rate i have no influence on the criticalincome tax rate and therefore on investors’ finan-cing decisions. The other model parameters exertan influence on the critical income tax rate. Thedegree of sensitivity of the critical tax rate towardsvariation in the different parameters varies signifi-cantly. Therefore, we highlight the most importantvalue drivers.

4.2.1 Time and growth factor for capitalgains

To analyze the influence of the factor θ all othermodel parameters remain constant. We assume

τc = 25%; τmaxi = 42%; τa = 16.28%;C = e 100,000; E = e 1,000;

γ = λ = 0.5; μ = 1.5; ε = 1; i = 6%; α = 1.

We obtain the effective local business tax rateτa by considering the average collection rate ofh = 389% (Federal Statistical Office 2007) and ataxable business value ofm = 5%. As the permittedratio of debt to equity capital is 1.5:1, the parameterμ is equal to 1.5. The fraction of long-term debt isrepresented by the parameter α. Under incometax law earned interest is fully taxable (section 20para 1 no. 7 of the Income Tax Code), thereforeε is equal to 1. The distributed profits D, hiddendistributions, and capital gains are subject to thehalf-income system and thus only 50% of thistype of capital income is taxable, i.e. γ = λ =0.5 (section 20 para 1 no. 1 in conjunction withsection 3 no. 40 d) of the Income Tax Code, seeAppendix A1).The investor receives total interest I of e 6,000.Within the safe haven interest of Id = H = e 90 istax-deductible at the corporate level.Inserting the assumptions the critical income taxrate as a function of θ is

(28) τ*i =466.575

50,750 − 49,766.71θ.

158


Table 2 shows the critical income tax rates fordifferent values of the factor θ (see Appendix A2).

Table 2: Critical income tax rates forvarious θ in Germany

θ τ*i0.01 0.93%

0.25 1.22%

0.5 1.80%

0.75 3.48%

0.95725 15.00%

0.99845 42.00%

1 47.45%

1.015 197.04%

We see that the values for the critical incometax rate vary between 0.93% and 197.04%. If thefactor θ is higher than 0.99845, the critical incometax rate is higher than the top tax rate of 42%.In these cases, debt capital is advantageous for allshareholders. If θ is lower than0.95725, the criticalincome tax rate is lower than theminimum incometax rate of 15% and all investors will provide equitycapital. Only if 0.95725≤ θ ≤ 0.99845, it dependson the investors’ marginal tax rate as to whetherdebt or equity capital is favorable (section 3.2.1).For θ = 1.015 we receive an extremely high criti-cal income tax rate that again indicates that debtfinancing is always beneficial. If we determine crit-ical income tax rates for higher values of θ the crit-ical tax rate may change its sign and even becomenegative (see section 3.2.1 for an interpretation ofthese effects).

We obtain the derivative ∂τ*i∂θ by differentiating

equation (27)with respect toθ and inserting the as-sumptions. As in the general model this derivativeis also positive in Germany. Therefore, an increas-ing θ leads to an increasing relative advantage ofdebt capital compared to equity capital (section3.2.1).

(29)∂τ*i∂θ=

23,220(50,750 − 49,766.71θ)2

> 0.

In Figure 2 we compare the German and Italiancritical income tax rates. We see that the Germantax rates areusually lower than the Italian tax rates.Only if θ is higher than 0.9986 are the German taxrates higher than the Italian. This implies that inGermany equity capital is usually more attractive

in comparison to debt capital than in Italy. Onlyif θ > 0.9986 is debt capital more attractive inGermany than in Italy.

Figure 2: Critical income tax rates forvarious θ in Germany and Italy

�

�

�

____ Critical income tax rates for various � �under general thin capitalization rules (Italy)

----- Critical income tax rates for various � under specified thin capitalization rules (Germany)

�

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

00.2 0.4 0.6 0.8 1 �

*i�

10%

20%

30%

50%

40%

Debt capital is usually less attractive in Germanythan in Italy, because debt capital is more severelyburdened due to the addition of a fraction of theinterest payments for long-termdebt for local busi-ness tax purposes and the lower permitted ratio ofdebt to equity capital. If the factor θ increasesthis implies a higher effective taxation of capitalgains and consequently a reduced attractivenessof equity capital in both Italy and Germany. Asthe nominal taxation of capital gains λ is lower inItaly than in Germany, equity capital becomes lessunattractive in Italy than in Germany.

4.2.2 Tax rates

A rise in the corporate tax rate τc incurs an in-creasing critical income tax rate and therefore anincreasing advantage of debt capital over equitycapital. This result is in line with the result weobtained for Italy (section 3.2.2).By contrast, an increase in the local business taxrate τa decreases the critical income tax rate andtherefore leads to an increasing relative tax advan-tage of equity capital. In this case the tax shieldeffect invoking a higher advantage of debt cap-ital is lower than the opposing effect caused bythe negative impact of rising τa on θ, because inGermany the fraction of interest payments that is

159


tax-deductible with respect to the local businesstax is lower than for corporate tax purposes.Assuming a holding period of n = 10 years ex-emplifies that a decrease in the corporate tax ratefrom 25% to 10% leads to a reduction in the criticalincome tax rate of only 0.7 percentage points, acorresponding increase in the corporate tax rateto an increase of only 0.5 percentage points. Sim-ilarly, changes in the local business tax rate alsoonly have a low influence on the critical incometax rate. Assuming a decrease in the local businesstax to 10% raises the critical income tax rate by0.2 percentage points, an increase to 30% resultsin a change in the critical income tax rate of 0.3percentage points.

4.2.3 Taxable fraction of dividends andcapital gains

As in Italy, in Germany dividends and capital gainsare subject to the same taxable fraction γ = λ.An exclusive rise in the taxable fraction of divi-dends γ, as in Italy, lowers the critical income taxrate and therefore increases the relative advantageof equity capital (section 3.2.3):

(30)∂τ*i∂γ=

-4.60 · 107

(1,500 + 98,500γ − 49,767θ)2< 0.

Analyzing c.p. an increased capital gains taxation,i.e. an increase in λ, we obtain the following deriva-tive that is, as in Italy, always positive (section3.2.3):

(31)∂τ*i∂λ=

4.64 · 107θ(50,750 − 99,533λθ)2

> 0.

A change in the taxable fraction of both dividendsand capital gains γ leads to a derivative that is,depending on the factor θ, positive, negative orzero:

(32)∂τ*i∂γ=

-4.6 · 107 + 4.64 · 107θ(1,500 + 98,500γ − 99,533γθ)2

� 0.

The derivative is positive if θ is higher than 0.9896,negative if θ is lower than 0.9896, and equal tozero if θ is 0.9896. For Italy we obtain a similarvalue of θ = 0.9728. Hence, the integration of thelocal business tax and the different values of themodel parameters do not substantially affect the

influence of the taxable fraction of dividends andcapital gains on the critical income tax rate andtherefore on investors’ financing decisions.

4.2.4 Fraction of considered debt

Assuming a change in the fraction of considereddebt α we obtain the following derivative:

∂τ*i∂α=

[-1.86508 · 109 + 1.8605 · 109θ

](33)

·[100,750 − 50,000α

− 31,162θ − 18,605αθ]-2< 0.

In Germany only long-term debt capital is subjectto the thin capitalization rules of section 8a ofthe German Corporate Tax Code. Therefore, theinvestor can influence the parameter α by pro-viding long-term or short-term debt, respectively.Lowering the fraction of long-term debt leads toan increasing relative advantage of debt capitalcompared to equity capital.

4.2.5 Other model parameters

Considering changes in the taxable fraction of in-terest ε and the multiple of the permitted ratio ofdebt to equity capital and the amount of equitycapital μE we obtain the same influences as inItaly (section 3.2.5).A decrease in the taxable fraction ε of interestleads to an increasing relative advantage of debt

capital. The first derivative ∂τ*i∂ε is always negative.

Considering a rise in the multiple μE we obtain ahigher relative attractiveness of debt capital.

4.2.6 Results

To study the influence of the German thin capi-talization rules on financing decisions we had toextend the general model to include the local busi-ness tax. This tax is quite different from the ItalianIRAP as the resulting tax burden depends on theinvestor’s financing decision. In spite of the intro-duction of this tax we obtain very similar resultsfor both Germany and Italy. We can show that inboth countries the gross profit and the interest ratedo not influence the investors’ financing decisions,whereas changes in the other model parametersexert the same influences in both countries. Achange in the German local business tax rate has a

160


less severe influence on the critical income tax ratethan a change in the Italian IRAP tax rate becauseinterest payments are not tax-deductible under anIRAP. For this reason a variation of the IRAP taxrate does not invoke a tax shield.

5 Complex thin capitalizationrules (Belgium)

After having considered the Italian and Germanthin capitalization rules we now analyze the in-fluence of another debt-equity-ratio-based rule,namely the Belgian regulation on shareholders’financing decisions which was introduced in 1997.In Belgium interest payments are requalified ashidden distribution of profits and therefore treatedas dividends if the permitted ratio of debt to equitycapital of 1:1 is exceeded. The Belgian thin capi-talization rules are applicable to all shareholders.A minimum shareholding is not necessary. Thethin capitalization rules include all loans that ashareholder provides the corporation (Offermanns2006: 73).A notional interest deduction for equity capitalis granted to corporations. Thus, the Belgian sys-tem applies an Allowance for Corporate Equity(ACE) device which was intended to account forthe distinction of interest payments to externalproviders of capital compared to those from as-sociated members of corporations. Introducing anACE was regarded as a step towards a more neu-tral tax system and towards improving Belgium asan investment location (Gerard 2006: 156). Thededuction is based on the book value of the com-pany’s equity. It is calculated by multiplying theequity by a fixed percentage determined by thegovernment. For 2007 the percentage is equal toin = 3.442%. The notional interest rate is set bythe government on the basis of the interest rateon 10-year government bonds (Cowley, Gutiérrez,Kesti, and Soo 2008: 91).In contrast to Italy and Germany, additional taxesτa are not levied on the corporate level.Dividends and interest income are subject to awithholding tax of τiD = 25% and τiI = 15% re-spectively (Offermanns 2006: 78). Alternatively,the investor can choose to include dividends andinterest income into their individual assessment ifthis leads to a lower taxation. In this case τiD = τiI .In the following we analyze both cases, the sce-nario with withholding tax in section 5.1 and with

individual assessment in section 5.2. We only con-sider the case that the investor chooses to includeboth interest and dividends into assessment. Forreasons of transparency we do not model mixedscenarios.Capital gains are not subject to tax, thereforeτiG = 0 (Offermanns 2006: 76). In a first stepwe assume that capital gains are also subject tothe withholding tax of 25%. This assumption en-ables us to isolate the effects of the introductionof a capital gains tax. Hence, we assume that τiG =25%.

5.1 Withholding tax

5.1.1 Critical income tax rate

Considering the withholding tax we assume

τiD = τiG = 25%; τiI = 15%.

We obtain the following net profit Πτ

Πτ = Π − τc(Π − i C(1 − α) − iμ E − in E

)︸︷︷︸

Tc

(34)

− 0.15 ε(i C (1 − α) + iμ E

)− 0.25 γ


]− 0.25 λθ

(Π − τc

[Π − i C(1 − α)

−iμ E − in E]−D − i C

).︸︷︷︸

Ti

By differentiating equation (34) with respect to thedividends D the following dividend policy turnsout to be optimal:

(35)∂Πτ∂D= λθ − γ = 0.

The investor is only indifferent towards the div-idend policy if λθ = γ. As capital gains are notsubject to tax in Belgium at present, we receiveλθ = 0. The condition only holds if γ = 0, namelyif dividends are not subject to tax. Since dividendsare fully taxable in Belgium, hence γ = 1 and in-difference to the dividend policy is not possible atpresent. Instead full retention is always the opti-mal dividend policy. Because capital gains are notsubject to tax whereas dividends are, full retentionalways leads to the highest net profit.

161


Taking account of the withholding tax the incometax rate is no longer a function of the tax basebut exogenously given, because τiI = 15% andτiD = τiG = 25%. Thus, a critical income tax rate τ*icannot be determined. The optimal capital struc-ture decision does not depend on the investor’smarginal income tax rate but only on the values ofthe other model parameters.

5.1.2 Sensitivity analysis

In the followingweanalyze the influenceof selectedmodel parameters on the investor’s financing de-cisions.For the basic scenario we assume

τc = 33%; τmaxi = 50%; in = 3.442%; i = 6%;C = e 100,000; E = e 1,000; Π = e 10,000;

γ = 1; λ = 0; μ = 1; ε = 1; α = 1.

Corporations with a tax base up to e 322,500 aresubject to a progressive tax scale. Corporationswith a higher tax base are subject to a tax rate of33% (Offermanns 2006: 65, see Appendix A1). Weassume that the tax base exceeds e 322,500. Theshareholders are subject to a progressive incometax scale. The top tax rate τmaxi to the amount of50% is imposed if the tax base exceeds e 31,700(Offermanns 2006: 77, see Appendix A1).Dividends, interest payments, andhiddendistribu-tions are subject to income tax to the full amount,hence ε = γ = 1. Capital gains are tax-exempt,hence λ = 0. The thin capitalization rules are ap-plicable for all loans provided by shareholders, i.e.α = 1. The permitted ratio of debt capital to equitycapital is 1:1, i.e. μ = 1.Inserting the assumptions into equation (34) weobtain a net profit of e 6,711 in the case of equityfinancing and a net profit of e 5,237 in the case ofdebt financing. The investors will therefore decideto provide equity capital instead of debt capital.Payments for equity financing are only taxed withcorporate tax at 33%. In line with notional interestdeduction, a notional amount of interest can bededucted from the corporate tax base. The pay-ments for equity are not taxed on the shareholderlevel because full retention is the optimal dividendpolicy and capital gains are tax-exempt.Interest payments are tax-deductible on the corpo-rate level up to the safe haven. Those that exceedthe safe haven are non-deductible and thereforesubject to corporate tax of 33%. On the share-

holder level interest payments up to the safe havenare subject to the withholding tax rate of 15%whilethe excess is subject to the withholding tax of 25%.Consequently, interest payments amounting to thesafe haven are possibly taxed lower than paymentsfor equity capital. But interest payments that ex-ceed the safe haven are taxed considerably higher(33% corporate tax plus 25% withholding tax).Since we assume the safe haven always to be ex-ceeded and since Belgium has a very low safehaven, interest payments are always taxed higherthan capital gains.As in Italy and Germany, a variation of the grossprofit and the interest rate has no influence on thefinancing decisions. The same is true for changesin the notional interest rate.As long as capital gains are not subject to tax, i.e.λ = 0, a change in the time and growth factor forcapital gains θ has no influence on the investor’sfinancing decisions. If capital gains are not tax-exempt, i.e. λ > 0, a variation of θ influences theinvestor’s financing decisions. Since capital gainsare subject to tax at λθ, a change in the factor θ hasthe same influence on the financing decisions as achange in the taxable fraction λ.As in Italy and Germany, an increasing corporatetax rate leads basically to an increasing relative ad-vantage of debt capital compared to equity capital(section 3.2.2). The increasing relative advantageof debt capital is very low, due to the notional in-terest deduction for payments for equity capital. Asτc ∈ [0,1] an irrelevance of the financing decisionor even an advantage of debt capital cannot occurin Belgium.Investigating the effects of an isolated decreasingtaxable fraction of dividendswe find a rising attrac-tiveness of debt capital (section3.2.3). The investoris only indifferent towards debt and equity capitalif γ = -0.00038. As γ ∈ [0,1] a change in the tax-ation of dividends does not change the financingdecision. Equity capital is always advantageous.The introduction of a capital gains taxation, whileassuming that dividends are subject to tax to thefull amount, i.e. γ = 1, leads to an increased relativeadvantage of debt capital (section 3.2.3).Neverthe-less, debt capital would become advantageous onlyfor negative λ-values. As λ ∈ [0,1], equity capital isalways advantageous.In Italy and Germany, a change in the taxablefraction of both dividends and capital gains (γ =λ) leads, depending on the value of the factor

162


θ, to a change in the relative advantage of debtover equity capital (section 3.2.3). In Belgium, achange in these parameters does not change theshareholder’s financing decision. A decreasing γand λ leads to an increasing relative advantageof debt capital, but an advantage of debt capitaltowards equity capital can only occur for negativevalues of γ and λ.A decrease in the fraction of considered debt frompresently α = 1 to α < 1 reduces the drawback ofdebt over equity caused by the thin capitalizationrule (section 3.2.5). If α = 0.4242 the investor isindifferent towards debt and equity financing. Ifthe tax law is modified accordingly, which is ratherunlikely, the net profit is identical for bothdebt andequity financing. Only if the fraction of considereddebt is lower than 0.4242 do we find an advantageof debt financing because then, net profit increaseswith an increasing gearing rate.A tax reform changing α directly to alleviate in-terest deduction restrictions is very unlikely to bediscussed. It is more likely that thin capitalizationrules are alleviated by restricting their applica-tion to long-term debt as is the case in Germany,for instance. If the Belgian government only re-ferred to interest payments on long-term debt intheir modified thin capitalization rules, a fractionof long-term debt of 42.42% would be equal to afraction of α = 0.4242. In this case, the investorcan benefit from debt financing if their intereston long-term debt does not exceed 42.42% of theinterest on short-term debt.Given that interest payments are subject to tax tothe full amount, namely ε = 1, a decrease in thetaxable fraction ε leads to an increasing relativeadvantage of debt capital. Concentrating on theinfluence of a change in ε on the financing decision,we find that the investor is indifferent towards debtand equity financing if ε = -164. Since ε ∈ [0,1]in fact an indifference cannot arise. Instead, theinvestorwill alwaysprefer toprovideequity capital.In contrast to Italy and Germany a change in thepermitted ratio of debt to equity capital μ and inthe amount of equity capital E cannot be analyzedjointly, because a change in equity capital notonly influences the safe haven H = iμ E, but alsothe notional interest deduction in E. Assuming anincreasing μ or an increasing E we obtain a risingrelative advantage of debt capital (section 3.2.5).Capital structure irrelevance arises if μ is increasedto 58or if debt capital is increased to 104,000.Debt

capital will be preferred if μ > 58 or E > 104,000.

5.1.3 Results

Considering the Belgian thin capitalization rules inthe light of the withholding tax option, the finan-cing decision, unlike in Italy and Germany, doesnot depend on the investor’s marginal income taxrate but only on the othermodel parameters. Vary-ing different model parameters leads to similarfinancing decision patterns as under the Italian-type and German-type rules. Whereas in Italy andGermany capital structure irrelevance is gener-ally possible when assuming currently codifiedtax rates and debt-to-equity ratio, providing eq-uity capital is always favorable in Belgium becausecapital gains are exempt from taxation, thin cap-italization rules discriminate debt financing anda notional interest deduction on equity capital isgranted. Although an ACE often is regarded as ameans to provide tax neutrality, in Belgium thisneutrality property has been undermined by intro-ducing a thin capitalization rule, which obviouslyexacerbates thediscriminationofdebt capital (Ger-ard 2006: 156).

5.2 Assessment

5.2.1 Critical income tax rate

The shareholder can optionally include dividendsinto the individual tax assessment. In this casedividends and interest are not subject to the with-holding tax of 25% or 15% but to the shareholder’sindividual income tax rate. Hence, the option toinclude dividends or interest in the assessment isonly reasonable for shareholders with an incometax rate less than 25% and 15% respectively. Forsimplicity we only consider the case that the choiceto include income in the assessment is beneficialfor both dividends and interest.If dividends and interest income are included inthe assessment, all sources of income are subjectto the same income tax rate. Therefore, we have

τiD = τiI = τiG = τi.

The net profit is thus equal to

Πτ = Π − τc(Π − i C(1 − α) − iμ E − in E

)︸︷︷︸

Tc

(36)

163


− τiε(i C (1 − α) + iμ E

)− τiγ


]− τiλθ

(Π − τc

[Π − i C(1 − α)

−iμ E − in E]−D − i C

)︸︷︷︸

Ti

.

We obtain the same optimal dividend policy asfor Italy and for Germany. The investor is onlyindifferent towards debt and equity financing ifτi = 0, namely if they have no taxable income, orif λθ = γ (section 3.1). Otherwise full retention isalways the optimal dividend policy.We obtain the following critical income tax rate bydifferentiating equation (36) with respect to C:

τ*i =[τc

[C(1 − α) + μE

]](37)

·[ε[C(1 − α) + μE

]+ γ(Cα − μE)

+ λθ(τc

[C(1 − α) + μE

]− C

)]-1.

5.2.2 Sensitivity Analysis

Just like in the other countries the gross profit andthe interest rates do not influence the investor’sfinancing decisions. The other model parametersinfluence the critical income tax rate and thereforethe financing decisions.We assume

τc =33%; τmaxi =15%; in =3.442%; i=6%;C = e 100,000; E = e 1,000; γ =1;

λ =0; ε=1; μ =1; α =1.

The top tax rate τmaxi is equal to 15% because onlyshareholders with an income tax rate of less than15% will decide to include dividends and interestincome in their individual assessment. Insertingthe assumptions into equation (37) we obtain

(38) τ*i = 0.33%.

All investors have a marginal income tax rate thatis higher than the critical income tax rate. To con-clude for all investors we have to abstract fromthe typically rather small group of investors with amarginal income tax rate between zero and 0.33%.Therefore, all investors prefer to provide equitycapital instead of debt capital. This result corre-

sponds to that obtained for the withholding tax(section 5.1.2).A variation of the factor θ has no influence onthe critical income tax rate because capital gainsare tax-exempt. Only if λ > 0 will a change in thefactor θ affect the investor’s financing decisions. Inthese cases a change in this factor influences thefinancing decisions in the same way as a change inthe taxable fraction of capital gains λ does.In line with the results for the other countries,we obtain a rising critical income tax rate and anincreased relative advantage of debt capital if weassume a rising corporate tax rate (section 3.2.2).Varying the taxable fraction of dividends γ whileassuming that capital gains are tax-free leads to anegative derivative. We find that lowering γ causesa rising advantage of debt capital (section 3.2.3):

(39)∂τ*i∂γ=

-117,612(60 + 5,940γ

)2 < 0.We obtain critical income tax rates higher than15% and therefore an attractiveness of the with-holding tax for interest income over the individualassessment for γ < 0.0121.Assuming a taxation of capital gains, i.e. λ > 0, anda taxation of dividends to the full amount, i.e. γ =1,we obtain the following positive first derivative:

(40)∂τ*i∂λ=

118,408θ(6,000 − 5,980λθ

)2 > 0.As expected, implementing a capital gains tax in-vokes a higher relative advantage of debt capital(section 3.2.3). The effect of a rising λ on the criticalincome tax rate is very low. We obtain critical in-come tax rates of over 15%only for very high capitalgains taxes with only hypothetical relevance (λθ >0.98124).A change in the taxable fraction of both dividendsand capital gains (γ = λ) leads to the followingderivative that is a function of the value of thefactor θ and may take positive or negative values:

(41)∂τ*i∂γ=

-117,612 + 118,408θ(60 + 5,940γ − 5,980γθ

)2 � 0.

If θ > 0.993, the partial derivative is positive. Ifθ < 0.993, it is negative.

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As in the previously analyzed countries a decreas-ing fraction of considered debt leads to an in-creased critical income tax rate that implies an in-creasing advantage of debt capital (section 3.2.5).

The derivative ∂τ*i∂α is always negative. Lowering the

fraction of considered debt α from 1 to 0.5 leads toa rise in the critical income tax rate from 0.33% to16.83%. Lowering α to 0.25 leads to τ*i = 25.08%.If α = 0.5, the investor therefore will decide infavor of the withholding tax for interest income. Ifα = 0.25, they will prefer the withholding tax fordividends.Decreasing the taxable fraction of interest εwe finda rise in the relative advantage of debt capital. The

partial derivative ∂τ*i∂ε is always negative.

A rise in the permitted ratio of debt to equitycapital μ or the amount of equity capital E leadsto an increase in the relative advantage of debt

capital. The first derivatives ∂τ*i∂μ and

∂τ*i∂ E are always

positive (section 3.2.5). To obtain a critical tax rateof more than 15% the permitted ratio of debt toequity capital has to be increased to 46:1 or debtcapital has to be increased to e 46,000.

5.2.3 Results

Assuming assessment is attractive for investors,their financing decisions depend, as in Italy andGermany, on their marginal income tax rate. Thedifferent model parameters exert an influence onthe decision that corresponds to the one identi-fied for the other countries. As in the case of thewithholding tax, equity capital is always beneficialwhen considering currently codified tax rates anddebt-to-equity-capital ratio because capital gainsare exempt from taxation and a notional inter-est deduction is granted for equity capital. If thethin capitalization rule was abolished we wouldobtain a critical income tax rate that is equal to thecorporate tax rate. This result is in line with theneutrality property of an ACE tax and implies that,given the assumption of a perfect capital market,we lose capital structure irrelevance as soon as theincome tax rate differs from the corporate tax rate.The analysis of theBelgian tax systemclarifies that,given a neutral corporate tax, the political aim tofoster equity financing and prevent a drain of taxrevenues due to debt financing, a thin capitaliza-tion rule with a given permitted debt-to-equityratio may help to achieve this aim irrespective ofthe investors’ income tax rates.

6 Conclusions and future researchFrom a tax planner’s point of view, it is oftenattractive to choose debt over equity financing.Nevertheless, corporations issue shares as well asdebt, raising the question on possible causes. Asindividual tax planning has led to an increase indebt financing of corporations, many countrieshave introduced thin capitalization rules to securetheir tax revenues. These thin capitalization rulesmight explain why corporations still issue bothdebt and equity.Against this background we investigate how suchregulations affect the capital structure decisionsof stockholders of corporations. We examine gen-eral thin capitalization rules and more specificand complex examples of regulations to restrictshareholder financing as to their impact on financ-ing decisions of shareholders of corporations. Thegeneral case is exemplified by the Italian rules ofthe 2007 tax law and the more specific regulationsare illustrated by the examples of the German andBelgian thin capitalization rules of the 2007 taxlaw. The selected rules can be regarded as repre-sentative examples ofmany countries’ thin capital-ization rules that are characterized by a permitteddebt-to-equity ratio. As a corresponding regulationexists in several countries, the knowledge gainedin our study can be used as the basis for follow-upempirical studies on the impact of thin capitaliza-tion rules on capital structure decisions in thesecountries.Furthermore, as the financing behavior of in-vestors is crucial for designing thin capitalizationrules and as the influence of thin capitalizationrules depends heavily on a lot of other tax param-eters (corporate tax rate, taxable fraction of div-idends and capital gains, permitted ratio of debtto equity capital) it is important for the treasuryto know how these rules interact. Our results helpthe treasury to implement a rule that contributesto their given political aim in a given tax setting.Taking into account the relevant tax rates and thecodified debt-equity ratio we find similar resultsfor Italy and Germany. In particular, a so-calledMiller equilibrium is possible when the differenceof the corporate tax rate and the individual in-come tax rate is relatively low and when the pro-videddebt comprises a small fraction of considereddebt. The fraction of considered debt is presentlyonly limited under the German-type rule because

165


there only long-term debt is taken into account.In Belgium equity capital always incorporates anadvantage considering current tax rates and thecurrent debt-to-equity-capital ratio because eventhough Belgium has introduced a supposedly neu-tral ACE tax debt capital is discriminated by a thincapitalization rule. This result holds in the case ofboth withholding tax and assessment.Investigating changes in the model parameters weobtain similar results for all underlying tax sys-tems. In particular, varying the fraction of consid-ered debt as well as the ratio of corporate tax rateand income tax rate and the permitted ratio of debtto equity capital have a substantial impact on thecritical income tax rate and make a Miller equi-librium possible. Among these parameters, onlythe permitted ratio of debt to equity capital andthe tax rates can be influenced by the legislator.The remaining parameters can be changed by thetaxpayers themselves.There is a broad range of issues that should beaddressed in future research. Although the presentanalysis only focuses on individual shareholders,corporate shareholders can easily be integratedinto the model by changing the denotation ‘‘in-come tax’’ to ‘‘corporate tax’’ on the shareholderlevel and changing the values of the taxable fractionof dividends γ and capital gains λ in the sensitiv-ity analysis. As thin capitalization rules, especiallyin Europe, are applicable to both domestic andforeign investors, for simplicity we focus only ondomestic shareholders. An extension of the modelwith respect to international investors is possible.Effects on financingdecisions arising from interna-tional tax base or tax rate differentials are capturedin our sensitivity analysis in sections 3.2, 4.2, 5.1.2and 5.2.2. The basic results remain the same inthe international context. In the case of differentinterpretations of income (dividend or interest in-come) that has been requalified as dividends undera thin capitalization rule we have to fall back on asingle-case analysis. General results can no longerbe deduced.In 2008 both Germany and Italy (see Marino andRusso 2008 for an overview of the new Italianregulation) changed their thin capitalization rulesand implemented an interest barrier. Under Ger-many’s 2008 business tax reform (section 4h of theIncome Tax Code and section 8a of the GermanCorporate Tax Code as amended by the GermanBusiness Reform dated Aug. 14, 2007, BGBl. I

2007: 1913 et seq., 1927 et seq.), in principle in-terest payable is deductible up to an amount thatcorresponds to the interest earnedby the company.The residual interest payable can be deducted fromthe tax base up to an amount of 30% of the residualprofit, plus depreciation and interest expenses andless interest income. Interest expenses that remainnon-deductible according to this regulation haveto be carried forward and, subject to the same con-ditions, increase interest expenses in subsequentfinancial years. In this regard, the non-deductibleinterest expenses are not classified as hidden dis-tribution of profit. Hence, on the shareholder levelthey are treated as interest income. The tax al-lowance up to which the regulation is not appliedamounts to e 3,000,000. With respect to the in-terest barrier, initially only statements about thetendency can be made.On the corporate level debt capital is advantageous,because interest payments are at least partially tax-deductible, whereas dividends and capital gainsare not. In contrast, on the shareholder level in-terest income is fully taxable and subject to theshareholder’s individual income tax rate (see Ap-pendix A1). A withholding tax amounting to 25%is on principle levied on dividends and capitalgains (see Kiesewetter and Lachmund 2004 whoinvestigate and demonstrate the effects of a finalwithholding tax on the capital structure of enter-prises with the help of investment appraisal andwho design, based on the achieved results, a with-holding tax that is independent of the financingform). The shareholder can also choose to includedividends and capital gains in their assessment. Asubstantial shareholder with a holding of at least25% can additionally choose a shareholder reliefsystem for dividends and capital gains. In thiscase they are subject to the shareholder’s individ-ual income tax rate, but only taxed at a fractionof 60%. The shareholder relief system is alwaysadvantageous unless the shareholder exhibits anindividual income tax rate of 42%. To sum up, div-idends and capital gains are usually lower taxed onthe shareholder level than interest income. Hence,capital structure irrelevance is possible since thelower taxation of income from equity on the share-holder level counteracts the lower taxation of in-come from interest on the company level causedby the (partial) deductibility of interest payments.If the capital company incurs losses over a longerperiod and interest payments hence cannot be de-

166


ducted in the same period, the attractiveness ofequity financing compared to debt financing in-creases. In the extreme case, if interest on debtcannot be deducted at all, equity financing alwaysgenerates the highest net profit.To gain more precise results for Germany a quan-titative analysis including all items of Germany’s2008 Tax Reform Act is necessary. Furthermore,an analysis of the new Italian thin capitalizationrules anda comparisonof the results of theGermanand Italian regulation is reasonable. We relegatethis issue to future research.For now, our analysis highlights that for com-panies in countries with thin capitalization rulesand a permitted debt-equity ratio, debt financingcan typically be tax-optimized by shareholders.However, under certain circumstances the capitalstructure can become irrelevant.

AppendixA1: Supplementary information on thenational tax laws

Belgium

TheBelgian thin capitalization rulewas introducedin 1997 and is still in force.

Belgium raises a surcharge of 3% of the corporatetax. We neglect this surcharge.

Belgium raises local surcharges on the income tax.We neglect these local surcharges.

Germany

The German thin capitalization rule was intro-duced in2004. It hasbeen reformedby theGermanbusiness tax reform act 2008 where it was sub-stituted by an interest barrier.

From 2008 on the local business tax is not de-ductible as an operating expense anymore.

The half-income system was abolished in 2009and replaced by a final flat tax on capital income of25%. A modified shareholder relief system is onlyapplicable to capital income from corporate sharesheld as business assets. Substantial shareholderswith a shareholding of at least 25% can choosebetween the withholding tax and the shareholder

relief system.

From 2009 on a withholding tax amounting to25% is on principle levied on dividends and capitalgains. The withholding tax is not applicable to ashareholding of at least 10% (see section 32d of theIncome Tax Code for an overview of the taxationof income from equity capital).

Italy

Weconsider Italy’s thin capitalization rule in 2007.For an overview of this regulation see, for example,Gusmeroli and Russo (2004). This regulation wasintroduced in 2004. In 2008 Italy replaced itsformer rules with a regulation similar to the newGerman interest barrier. See Marino and Russo(2008) for an overview of this new regime.

A2: Supplementary information on theanalysis

We assume that the thin capitalization rule ap-plies to all shareholders and thus to all investors.The thin capitalization rule is for example appli-cable to all shareholders in Belgium and Spain. Inmany other countries, including Germany, Italy,the Netherlands and Portugal, thin capitalizationrules only apply to what are known as substantialshareholders. These are shareholders with a givenminimum shareholding. Loans from third partiesand non-substantial shareholders can easily be in-tegrated into the model. As interest payments tothird parties and to non-substantial shareholdersdo not induce a thin capitalization treatment, theseextensions do not yield any new insights for ouranalysis.

We assume that a fractionα of debt is subject to thethin capitalization rule. In Germany the regulationonly applies to interest paid on long-term debt.Other countries apply the regulation to all interestpayments to specific shareholders.

The values in Table 1 neglect that the factor θshould be endogenously determined. As the influ-ence of τ*i on θ cannot be derived analytically wehave to fall back on simulation. To point out thatthe resulting changes in our results are very smallwe have performed an iterative simulation. By it-eration we can account for the interdependencyof τ*i and θ. We find that the resulting critical tax

167


rates are slightly higher. At a maximum we iden-tify a deviation of 3.75 percentage points from therates determined for an exogenously given θ. Wefind similar deviations if we vary other model pa-rameters. Against this background, it is acceptableto conduct the following investigation abstractingfrom this interdependency. We hence do not haveto fall back on numerical results on optimal cap-ital structure; instead, analytical and thus moregeneral results can be obtained.

In Germany the investor is indifferent towardsdividend policy if the income tax rate τi = 0 or ifthe factor θ = γλ . The condition τi = 0 is true if thetaxable income of the investor is lower than thebasic allowance ofe 7,664 for singles ande 15,328for married couples (see section 32a of the IncomeTax Code).

The values in Table 2 neglect the influence of τ*ion θ. By iteration we can show that the criticaltax rates are slightly higher. At a maximum weidentify a deviation of 0.6 percentage points fromthe rates determined for an exogenously given θ.We find similar deviations if we vary other modelparameters.

Acknowledgements

We are indebted to two anonymous referees andthe department editor, Rainer Niemann, for theirvery valuable suggestions,whichhelped to improvethe paper considerably. We thank the participantsof the European Accounting Association AnnualCongress 2008 in Rotterdam and 2009 in Tam-pere for fruitful discussions. Furthermore, we areparticularly grateful for very helpful commentsfrom Rolf König and Lutz Kruschwitz. The usualdisclaimer applies.

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Biographies

Alexandra Maßbaum is doctoral student and re-search assistant at the Chair of Business Administration,esp. Business Taxation at the University of Paderborn.She received her diploma degree in Business Adminis-tration with specialization in accounting, taxation, au-diting, andmanagement accounting, aswell as corporateand tax law from the University of Osnabrück.

Caren Sureth is Professor and Chair of Business Ad-ministration, esp. Business Taxation since 2004 and alsoHead of the Center for Tax Research at the Unversity ofPaderborn. She received her doctorate from the Univer-sity of Bielefeld, where she also reached her habilitation.She studied Business Administration, English, French,and Chinese and received her Diploma Degree at theUniversity of Passau. Her main fields of research arethe impact of taxation on entrepreneurial decisions, taxplanning, and taxation under uncertainty.

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