Thin Capitalization Rules and Entrepreneurial Capital Structure Decisions

BuR -- Business Research Official Open Access Journal of VHB Verband der Hochschullehrer für Betriebswirtschaft e.V. Volume2|Issue2|December 2009 | 147--169 Thin Capitalization Rules and Entrepreneurial Capital Structure Decisions

Alexandra 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]

Abstract Tax planners often choose debt over equity financing. As this has led to increased corporate debt financing, many countries have introduced thin capitalization rules to secure their tax revenues. In a general capital structure model we analyze if thin capitalization rules affect dividend and financing decisions, and whether they can partially explain why corporations receive both debt and equity capital. We model the Belgian, German and Italian rules as examples. We find that the so-called Miller equilibrium and definite financing effects depend significantly on the underlying tax system. Further, our results are useful for the treasury to decide what thin capitalization type to implement.

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

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

1 Introduction shareholders in the following. Hence, for simplicity Seen from a tax perspective it is often attractive we abstract from principal-agent conflicts. for shareholders of corporations to provide capi- During the last few decades many authors have tal as debt instead of equity capital. This has led contributed to the field of corporate capital struc- to an extensive enlargement of debt financing of ture decisions (for an overview of different capital corporations (OECD 1987: 8 et seq.). To protect structure models see Myers 2001 and Graham tax revenues, the legislators of many countries 2006). In line with neoinstitutional theory, the have reacted to this development by increasingly tax based trade-off theory (e.g., Myers 1984) and implementing so-called thin capitalization rules the non-tax-oriented pecking-order theory (Don- (e.g., in Italy and the Netherlands, see Gouthière aldson 1961) have gained attention. Here, the the- 2005 for an overview of different thin capitaliza- ory of Modigliani and Miller (1958) represents a tion rules) or by tightening existing rules (e.g., in seminal work for many contributions based on Germany, Denmark, the UK, Spain, and France). neoclassical theory. In this early work, taxes were Thin capitalization rules are regulations that limit not included. Many extensions to Modigliani and the corporate tax deductibility of interest paid to Miller (1958) take many different aspects into ac- shareholders. count. Modigliani and Miller (1963) extend their Moreover, we observe that corporations issue model themselves and integrate, among other as- shares as well as debt. This raises the question pects, a corporate tax. Miller (1977) completes the of whether thin capitalization rules cancel out the model anew and implements an income tax on the tax shield of debt financing, which may explain shareholder level. In both approaches a classical the attractiveness of one option over the other. corporate tax system is assumed. Against this background we investigate how such Furthermore, in some contributions the income regulations affect the capital structure decisions tax effects on the capital structure are modeled in of corporate stockholders. We neglect problems a more refined manner. For instance, capital gains of information asymmetry between managers and taxes and, in turn, the asymmetric taxation of div-

147 BuR -- Business Research Official Open Access Journal of VHB Verband der Hochschullehrer für Betriebswirtschaft e.V. Volume2|Issue2|December 2009 | 147--169

idends and capital gains are highlighted by Farrar Boadway and Bruce 1984; Devereux and Freeman and Selwyn (1967), Brennan (1970), and Schneller 1991). This system is supposed to be close to the tax (1980). Brennan (1970) and Zechner (1990) as- politicians’ idea of a fair and efficient tax system sume a progressive tax scale and allowances for (Devereux and Freeman 1991: 4-6; Fehr and Wie- interest paid. gard 2003: 298). As Belgium is one of the countries Some papers take account of tax policy details to have introduced an ACE tax and simultaneously in various countries. Swoboda (1991) examines tightened the thin capitalization rules (e.g., Gerard Germany’s and Austria’s 1991 tax laws in a Miller 2006) it is interesting to analyze its interdepen- framework. In this context he considers Germany’s dencies and possible capital structure effects. corporate tax, income tax and also property tax, lo- Although the literature provides detailed investiga- cal business tax and church tax. Fung and Theobald tions of tax rules, thin capitalization rules have to (1984) consider the 1984 tax laws of France, Ger- date only been analyzed by Buettner, Overesch, many, the United Kingdom, and the USA. Unlike Schreiber, and Wamser (2006), Overesch and Swoboda, they restrict themselves to corporate and Wamser (2006) and Overesch and Wamser (2009). income taxes. Holland and Steiner (1996) extend The authors empirically investigate financing deci- Swoboda’s approach and investigate the influence sions in a multinational firm under a restrictive tax of Germany’s solidarity surcharge on the capital rule for stockholders’ debt financing, which is com- structure. Laß (1999) models US tax law between parable to the German thin capitalization rules. In 1977 and 1994 as well as German tax law be- this work, the main elements of a thin capital- tween 1976 and 1998, also using the Miller model. ization tax rule are considered without modeling Kruschwitz (2007) models the German tax regime country-specific details of the regulation. Here, in 2007. neither a specific debt-capital/equity-capital ratio, Beyond detailed investigations of different taxes safe haven, nor a differentiation between profit- there are many other extensions to the Modigliani dependent and profit-independent loans are car- and Miller (1958) model. Hodder and Senbet ried out. A more sophisticated analysis of the influ- (1990), Graham (2003), and Desai, Foley, and ence of thin capitalization rules on entrepreneurial Hines (2004) consider international tax aspects, capital structure decisions has not yet been con- DeAngelo and Masulis (1980a), DeAngelo and Ma- ducted. sulis (1980b), and Graham (2000) take account of To fill this void, we integrate thin capitalization non-debt-tax shields, e.g., Kraus and Litzenberger rules into a capital structure decision model in (1973), Haugen and Senbet (1978), Kim (1978) the following analysis. We investigate its influ- model bankruptcy costs, and Jensen and Meck- ence on corporate financing decisions analytically. ling (1976) and Leland (1998) integrate agency It also helps the treasury to decide what type costs (see Harris and Raviv 1991). Capital struc- of thin capitalization rule to implement under a ture models under uncertainty are examined by given tax setting. Our study can be regarded as Kim (1982), Zechner (1990), and Swoboda (1991). a first step towards an empirical study on the Miller and Scholes (1978) and Litzenberger and van influence of specific thin capitalization rules on Horne (1978) consider dividend policy. Schneller corporate capital structure and thus provides im- (1980) and Graham (2003) offer a model that takes portant information to extend the work of Buett- account of different systems to prevent double tax- ner, Overesch, Schreiber, and Wamser (2006), ation of dividends. A dynamic model is presented Overesch and Wamser (2006) and Overesch and by Fischer, Heinkel, and Zechner (1989). Wamser (2009). In contrast to empirical pub- Beyond this finance-theory-oriented stream of lit- lic finance papers that are often lacking a suffi- erature we refer to the discussion on intertem- cient theoretical foundation or do not account for porarily neutral capital income taxation and con- all relevant tax details (Desai, Foley, and Hines sumption-based tax systems in public finance. The 2004; Mintz and Weichenrieder 2005; Huizinga, so-called ACE tax has become particularly popular Laeven, and Nicodème 2006; Weichenrieder and as an investment and financing-neutral tax system Windischbauer 2008) we provide a detailed the- with an allowance for corporate equity (ACE) de- oretical model. Moreover, future empirical papers ductible from taxable profits, which represents the could verify whether the optimal financing and opportunity costs of equity capital (Wenger 1983; dividend policies we derive are actually practised.

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We consider thin capitalization rules that are char- return arises irrespective of the form of financing acterized by a given permitted debt-equity capital because this balances out the advantage that debt ratio because many countries limit debt financing capital incurs interest payments that are deductible referring to such a permitted ratio. We take the from the corporate tax base (tax shield) and the Italian, German, and Belgian rules as examples to advantage that equity capital typically leads to rela- study their impact on capital structure decisions. tively lower income tax burden (Miller 1977: 269 et The Italian and the German thin capitalization seq.). rules are no longer in force. They have been substi- In section 2 we develop a framework for a gen- tuted by rules that restrict interest deduction irre- eral capital structure model on the basis of Miller spective of a permitted debt-to-equity ratio in those (1977) that includes thin capitalization rules. We countries. Nevertheless, there are many countries integrate the Italian, German and Belgian thin that apply this type of thin capitalization rule, capitalization rules into this model in sections 3 e.g., Bulgaria, Czech Republic, Denmark, Hun- to 5 and analyze whether a Miller equilibrium can gary, Latvia, Lithuania, the Netherlands, Poland, emerge. If not, we determine the optimal capital Portugal, Romania, Slovakia, and Slovenia. We re- structure and identify the most important value- fer to Belgium, Germany, and Italy as examples driving factors. On the basis of Miller (1977),we to model all major characteristics of this type of refer to a single investor’s indifference towards thin capitalization rule. These examples allow us providing capital as a loan or as equity capital to to elaborate the mechanisms at work for different a corporation as a ‘‘Miller equilibrium’’. Note, that implementations of such rules that are common in the following, this ‘‘equilibrium’’ is not a general or discussed in several countries and to show how market equilibrium. In section 6 we summarize they interact with different tax systems. and draw conclusions. Our analysis can help investors not only to make This article is supplemented with Excel spread- their dividend and financing decisions under thin sheets that provide the calculations that have been capitalization rules with a given permitted debt- performed for Belgium, Italy, and Germany.1 equity ratio but also to adjust their decisions when tax laws change. Our analysis is representative of 2 Capital structure under all thin capitalization rules that refer to such a permitted debt-equity ratio. restricted shareholder debt As the financing behavior of investors is crucial for financing designing thin capitalization rules and as the influ- 2.1 General assumptions ence of thin capitalization rules depends on several In the following we integrate thin capitalization other tax parameters (corporate tax rate, taxable for shareholder debt financing into Miller’s cap- fraction of dividends and capital gains, permit- ital structure model to derive conclusions about ted ratio of debt to equity capital) it is important the effectiveness of this regulation for financing for the treasury to know how these rules inter- decisions in corporations. Our model relies on the act. Analyzing different types of thin capitalization following set of assumptions. rules and performing sensitivity analyses help the We assume a perfect capital market under certainty treasury to implement a rule that contributes to and identical debit and credit interest rates. The a given political aim. Thus, the following investi- borrower is a domestic corporation. The investors gation of different settings of thin capitalization are assumed to be domestic individuals who hold rules and tax systems is of general relevance for their investment and accordingly the provided cap- a comprehensive understanding of tax effects on ital in private means. On the corporate level taxes capital structure decisions. on profits are considered. On the shareholder level After developing the general model we apply our the individual income tax is taken into account. model to selected countries. We refer to the capital All investors who have to decide to provide either structure model by Miller (1977). Miller investi- equity or debt capital are assumed to be share- gates the market for debt capital and shows that holders of the underlying corporation. Further we this market always leads to an equilibrium in which for every company the capital structure is irrele- 1 These Excel files can be downloaded from www.business- vant to the value of the firm. The same after-tax research.org.

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assume that the thin capitalization rule applies In the following the sum of retained earnings is to all shareholders and thus to all investors (see given by G (Miller 1977: 268). G is not equal to Appendix A2). capital gains as this variable neglects the internal The interest payment Z amounts to iC, where growth caused by reinvesting retained earnings at i denotes the market rate of return that can be the internal after-tax yield i(1 − τc − τa). Further, earned on the capital market and C denotes the capital gains are not liable to income tax until they amount of debt capital provided by an investor. are realized at shareholder level. We have to take On the corporate level dividends are not tax- account of the time effect arising from the delayed deductible, whereas interest payments on debt are taxation of retained earnings. In the following, generally tax-deductible as they are operating ex- the time lag of capital gains taxation compared to penses. In line with Miller, the case of limited dividend taxation and the internal growth effect interest deductibility, particularly due to losses, is from retained earnings are both captured in the not considered (Miller 1977: 262). We assume that factor θ>0. It is necessary to implement θ into our a fraction α of debt is subject to the thin capi- static model to highlight the difference in taxation talization rule (see Appendix A2). The permitted of dividends and capital gains and the internal debt-to-equity ratio will be denoted by μ and is growth of retained earnings in present value terms. assumed to be exceeded. Consequently, not the We obtain total amount of interest paid to a shareholder is n (1 + i[1 − τc − τa]) deductible, but only the interest on the permitted (2) θ = , (1 + i )n fraction of debt capital multiplied with the corpo- τ rate equity, thus iμ E. As the thin capitalization rule with θGdenoting the present value of capital gains. applies to all shareholders, the shareholder’s share We abstract from increases in value that are caused in corporate equity is irrelevant. In the following by speculative developments. Here, iτ is the after- the deductible amount of interest is denoted as the tax market rate of return that the shareholder is utilized safe haven H. Hence, able to earn alternatively on the capital market and is given by iτ =(1−τiI )i. τiI denotes the investor’s iμ E,ifαC >μE; personal tax rate on interest income. If interest (1) H = αi C,if0≤αC ≤ μE. income is included in the investor’s individual tax assessment, the tax rate τiI is equal to the Equity capital E provided by the shareholder de- investor’s personal income tax rate τi. If there is notes the equity capital that has already been pro- a withholding tax on interest income, τiI is the vided prior to the point of time when the financ- withholding tax rate. The variable n denotes the ing decision is made. The investor’s individual period in years after which the capital gains are amount of equity is exogenously given. Further, it realized. We assume that n is exogenously given is assumed that all investors offer the same mix and hence the investor is not able to decide on the of equity and loans to the corporation and con- holding period n. Furthermore, we assume that sequently all shareholders have an identical safe only a fraction λ of the capital gain is taxable. In haven. It is therefore possible to determine the total the present value of assessable and taxable overall safe haven for all shareholders jointly. It is capital gains G is λθG (see Swoboda 1991: 857, not necessary to refer to the single shareholder. and Laß 1999: 119, who assume that capital gains Some countries raise additional taxes on profits are tax-exempt). on the corporate level. National tax rates and tax We abstract from personal allowances, income- bases vary significantly. In the following the tax related expenses, standardized deductions, per- rate of these taxes is denoted by τa, the tax base by sonal exemptions, special expenses and extraordi- F. nary charges in the model when calculating taxable Under income tax law, earned interest is taxable at income. We assume there is no income from other a fraction ε with ε ∈ [0,1]. The capital income from sources apart from interest income, dividends, and shareholders’ invested equity capital consists of capital gains. The fraction of interest that is not tax- distributed dividends of the corporation and real- deductible on the corporate level is requalified as ized capital gains. The taxable fraction of dividends hidden profit distribution and therefore treated D is denoted as γ with γ ∈ [0,1]. as a dividend. Dividends and hidden distributions

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are subject to an income tax rate τiD, interest pay- The interest payments that are subject to income ments to an income tax rate τiI and capital gains tax are identical to the deductible interest pay- to τiG. Although the income tax schedule is pro- ments Id on the corporate level. A fraction ε of Id gressive in many countries, from the shareholders’ is taxable. Hence, the interest payments that are perspective the income tax rate can be regarded as liable to tax amount to exogenously given. (9) Itaxable = εId = ε iC[1 − α]+iμ E .

2.2 Integrating taxes Only the fraction γ of the dividends is subject to Now we will formally describe all relevant fiscal income tax rules. In a first step we have to determine the amount of interest that can be deducted when de- (10) Dtaxable = γD. termining the corporate tax base. In total, interest Interest that is interpreted as hidden distribution payments amounting to I are paid to the investor: of profits is treated as dividends and thus likewise (3) I = iC. taxable by the fraction γ. The hidden distribution of profits corresponds to non-deductible interest The interest payments can be deducted from the on the corporate level Ind. This amount denotes corporate tax base up to an amount of Id. Interest the interest payments that exceed the safe haven. payments on a fraction (1 − α) of the loans are completely deductible, i.e., I(1 − α), whereas in- (11) Btaxable = γB= γInd = γ iCα− iμ E . terest payments on a fraction α of debt are only deductible in the amount of the safe haven H.As Retained earnings G result from the difference Π we assume the safe haven to be exceeded, it is equal between the profit , the corporate tax Tc and the to iμ E. additional taxes Ta, as well as the dividends D and the interest I. Thereby, the present value of the (4) Id = I(1 − α)+H = iC(1 − α)+iμ E. capital gains θG is taxable at the fraction λ.In present value terms we obtain The amount of non-deductible interest expenses Ind which is requalified as a hidden distribution of (12) Gtaxable = λθ Π − Tc − Ta − D − I profits is = λθ Π − τ Π − iC(1 − α)−iμ E c (5) Ind = I − Id = iCα− iμ E. Tc The taxable income in terms of corporate tax re- − τa F −D − iC . sults from the deduction of debt-capital interest Id Ta I from gross profit Π. Corporate tax amounts to: Inserting equations (9), (10), (11), and (12) into eq. Π Π (6) Tc = τc − Id = τc − iC[1 − α]−iμ E . (8) leads to Additional taxes on profits T are levied on the a (13) T = τ ε iC[1−α] + iμ E corporate level. The tax base is equal to F; the tax i iI I rate amounts to τa. taxable + τiD γ D + iCα− iμ E (7) Ta = τa F. Dtaxable+Btaxable The taxable interest Itaxable, dividends Dtaxable, and + τiGλθ Π − τc Π − iC(1 − α)−iμ E capital gains G are subject to income tax. taxable −τ F − D − iC . Additionally, interest that is considered to be a a hidden distribution of profits is subject to income Gtaxable tax. The taxable fraction of the hidden distribution The total after-tax income of all investors Π is of profits is denoted with B . Thus, the burden τ taxable composed of the difference of the gross profit Π, resulting from income tax is corporate tax Tc, additional taxes on the corporate (8) Ti = τiI Itaxable + τiD Dtaxable + Btaxable level Ta and income tax Ti,

+ τiG Gtaxable. (14) Πτ = Π − Tc − Ta − Ti

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(15) Π = Π − τ Π − iC[1 − α]−iμ E − τ F substantial shareholder, i.e. a shareholder with a τ c a shareholding of at least 25%, has to be requalified Tc Ta as hidden distribution of profits if the permitted − τ ε iC[1−α] + iμ E iI ratio of debt to equity capital of currently 4:1 is ex- − τ γ D + iCα− iμ E iD ceeded (Romanelli 2006: 372). Therefore, interest − τ λθ Π − τ Π − iC(1 − α) is not considered to be a hidden distribution until iG c the debt of a substantial shareholder exceeds four −iμ E − τa F − D − iC . times their equity share. Ti Additionally, a regional tax on productive activities Similar to Miller (1977), to identify the optimal (IRAP) is levied on the net value of the production capital structure based on the total after-tax in- F. In line with IRAP interest expenses are not come of all investors, we first have to determine tax-deductible. The tax rate τa currently stands at the optimal dividend policy. In a second step we 4.25% (Romanelli 2006: 367 et seq.). analyze the optimal capital structure. Against the Dividends and capital gains are 60% tax-exempt if background of the set of equations outlined above, the shareholder holds either 2% of voting power we are able to investigate both an optimal dividend or 5% of the capital of listed companies, or if policy and an optimal capital structure under thin they hold 20% of voting power or 25% of the capitalization rules in a general capital structure capital of other companies. Otherwise dividends model. Furthermore, analyzing the general setting and capital gains are liable to a final withholding enables us to draw conclusions about a real-world tax of 12.5% (Romanelli 2006: 377). As we consider example, i.e. Italy. This is possible as the Italian substantial shareholders only, a withholding tax is thin capitalization rules are fairly simple and thus not applicable. correspond to those of our general model. Later, Interest income arising from loans is subject to a we specify the model in more detail to study the withholding tax of 12.5% that is creditable against implications of modified and simultaneously more the shareholder’s income tax liability. A final with- complex thin capitalizations rules. Such rules have holding tax applies to interest on current accounts been introduced in several countries. We take Ger- with bank offices and bonds, but not on loans many and Belgium as examples of such modified (Romanelli 2006: 378). rules and investigate whether the results of the Hence, interest payments, dividends, and capital general model are robust under more complex gains are subject to the same income tax rate shareholder financing rules. τi = τiI = τiD = τiG. This reduces the net profit given by equation (15) 3 General thin capitalization rules to (Italy) (16) Π = Π − τ Π − iC[1 − α]−iμ E − τ F τ c a 3.1 Critical income tax rate T Tc a In the following, we integrate general thin cap- − τiε iC[1−α] + iμ E italization rules into our capital structure model. − τ γ D + iCα− iμ E Looking for corresponding real-world rules we find i − τ λθ Π − τ Π − iC(1 − α) that the rules in section 98 of the Italian Income i c Tax Code fully comply with our general model. −iμ E − τ F − D − iC . a These rules, which are characterized by a small Ti number of attributes, no complicating exceptions, and simple parameters, can be regarded as an To identify the optimal dividend policy, equation illustrating example of our general setting. We (16) has to be differentiated with respect to divi- implement these rules into our framework to in- dends D and set equal to zero: vestigate the influence of thin capitalization rules ∂Π on a general basis on investors’ financing decisions (17) τ = τ (λθ − γ)=0. ∂D i (see Appendix A1). Under section 98 of the Income Tax Code interest We find an investor to be indifferent towards div- on debt capital that a corporation receives from a idend policy only in two cases, namely if their

152 BuR -- Business Research Official Open Access Journal of VHB Verband der Hochschullehrer für Betriebswirtschaft e.V. Volume2|Issue2|December 2009 | 147--169

marginal income tax rate τi amounts to τi =0orif (see Appendix A2). By means of equation (18) the γ the factor θ amounts to θ = λ . optimal financing decision can be determined for The condition τi = 0 is only fulfilled if the investor every investor. All investors whose marginal tax * has no taxable income. Since we assume that the rate τi equals the critical income tax rate τi are in- investor obtains interest payments and dividends different towards the allocation of debt and equity and/or capital gains, this condition is not fulfilled capital. They are referred to as marginal investors. in our model. Hence, dividend policy is irrelevant Investors who have lower tax rates will offer a loan γ only if θ = λ . Under current legislation we have to the corporation, while investors with higher tax γ = λ which leads to θ = 1. The time and growth ef- rates will offer equity capital (Swoboda 1991: 853). fects from capital gains are cancelled out perfectly Due to the progressive income tax scale in many and thus θ = 1. This is true only if the corporate countries, e.g., in Italy (Romanelli 2006: 378), internal after-tax yield i(1 − τa − τa) is identical to a general irrelevance of the financing policy can the after-tax market rate of return the shareholder never be achieved for all taxpayers. Irrelevance is able to earn on the capital market iτ. Beyond this can only be achieved for the taxpayers who have setting, dividend policy may not be irrelevant. That marginal tax rates that are identical to the critical said, full retention is always the optimal dividend income tax rate. Therefore, within this analysis it is policy. As long as retained earnings are taxed at only possible to investigate whether or not a Miller a lower effective rate than distributed earnings, equilibrium can be reached for specific taxpayers. full retention of profits always leads to the highest Furthermore, the after-tax profit of a firm can net profit. The same result is achieved by Miller never be maximized through mixed financing. De- although he does not outline it explicitly. Miller’s pending on the single parameters, either an equity- results are explained by Swoboda (1991: 853) and only or debt-only financing maximizes after-tax Laß (1999: 45-46), who find a different result for profit, or the means of financing is irrelevant to the the German tax code. Both base their assumptions after-tax profit of the firm. on a split corporate tax scale in connection with the full imputation system. From the authors’ point of 3.2 Sensitivity analysis view the optimal dividend policy depends on the In the following we analyze the implications of a ratio between the personal income tax rate and the variation of different model parameters. Changes corporate tax rate that is applied when profits are in gross profit Π and interest rate i do not influ- retained. If the personal tax rate is significantly ence the critical income tax rate and therefore the lower than the corporate tax rate, a distribution of financing decision. Hence, we concentrate on the profits is beneficial to reduce the tax burden from factor θ, the tax rates, the taxable fraction of divi- the corporate tax rate applied to retained profits dends γ and capital gains λ, the fraction α of debt, to the lower personal income tax rate (Laß 1999: the taxable fraction of interest ε, and the permitted 139-140). ratio of debt to equity μ. To identify the optimal capital structure based on the optimal dividend policy, equation (16) has to be 3.2.1 Time and growth factor for capital * differentiated considering D = 0 with respect to gains C. Rearranging finally leads to the critical income * To analyze how the different parameters affect tax rate τi : the investor’s financing decisions, all variables are * (18) τi = τc C[1 − α]+μE assumed to be constant, except for the factor θ. We assume · ε C[1 − α]+μE + γ( Cα − μE) max -1 τc = 33%; τi = 43%; + λθ τc C[1 − α]+μE − C . C = e 100,000; E = e 1,000; γ = λ = 0.4; μ =4;ε =1;i =6%;α =1. Note that the factor θ is influenced by the after-tax * interest rate iτ and therefore by τi . Nevertheless, Interest payments are fully tax-liable, hence ε =1. we assume that θ is exogenously given. To justify Dividends, hidden distributions, and capital gains this simplification we have analyzed the interde- are subject to a shareholder relief system, i.e. they * pendency of θ and τi using an iterative simulation are all subject to tax at a fraction of 40% (Romanelli

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2006: 377). Hence, in our model we obtain γ = λ = Only if 0.9288≤ θ ≤0.9964 will it depend on the 0.4. As the permitted ratio of debt to equity capital investor’s individual income tax rate whether debt is 4:1, in our model the debt-equity parameter μ or equity financing is optimal. If the personal in- is equal to 4. All interest payments to substantial come tax rate is lower than the critical tax rate, the shareholders are subject to the thin capitalization investor will offer a loan. If it is larger, they will rules (Romanelli 2006: 372). These regulations provide equity capital. If the marginal tax rate is imply α =1. equal to the critical income tax rate, the investor Then, the investor receives interest payments of is indifferent to either option. In this case we find e 6,000 and the safe haven H amounts to e 240. the so-called Miller equilibrium for this investor. We receive the critical income tax rate: Although at first sight the after-tax internal rate 79.2 of return falls short of the after-tax external rate (19) τ* = . i 2,544 − 2,368.32θ of return (θ<1) shareholders are still willing to provide equity capital as they benefit from prefer- ential capital gains taxation. The time and growth Table 1: Critical income tax rates for factor θ does not reflect effects arising from the tax- various θ in the general model (e.g., Italy) able fraction of capital gains λ<1. Consequently, * θτi providing equity capital can be optimal even for 0.01 3.14% θ<1. 0.25 4.06% The specific outcome of the factor θ mainly de- 0.5 5.82% pends on the ratio of the internal after-tax yield 0.75 10.32% i(1 − τc − τa) and the after-tax market rate of return 0.85 14.92% iτ. The holding period n exerts only little influence 0.9288 23.00% on θ. Assuming that i(1 − τc − τa) and iτ are al- 0.95 26.93% most equal, leads to θ ≈ 1. Then we see that debt 0.9964 43.00% financing will be beneficial for most investors. 1 45.08% Income from equity capital, namely dividends and 1.07 800.19% capital gains, is subject to income tax at a fraction of γ = λ =0.4. By contrast, interest income is fully Table 1 shows that the values for the critical in- taxed. Interest income amounting to the safe haven * come tax rate τi vary between 3.14% and 800.19% is also fully taxable, while the excess is subject to (see Appendix A2). For θ = 1.07 we receive an tax to a fraction of γ =0.4. The lower taxation extremely high critical income tax rate that again of dividends and capital gains on the shareholder indicates that debt financing is always beneficial. level compared to interest income usually over- If we determine critical income tax rates for higher compensates their non-deductibility on the corpo- values of θ the critical tax rate may change its sign rate level. Nevertheless, debt capital often is more and even become negative. A negative critical in- advantageous than equity capital because income come tax rate is not easy to interpret. A closer look from equity capital, i.e. accumulated capital gains, at these scenarios clarifies that the basic mech- is usually higher than interest income. Differenti- anisms at work do not change. In line with the ating equation (19) with respect to θ we obtain the ∂τ* result for θ = 1.07 the resulting (negative) criti- i derivative ∂θ which is always positive: cal tax rate again implies that debt financing is generally favorable. ∂τ* 187,571 If θ>0.9964, the critical tax rate is higher than (20) i = > 0. the top tax rate of 43%. In these cases an equilib- ∂θ (2,544 − 2,268θ)2 rium is not possible for the underlying tax system. Then, investors will always prefer to provide a loan An increase in θ causes a higher taxation of capital instead of equity to the corporation leading to the gains and consequently a higher taxation of equi- Π highest possible net profit τ. ty capital. Hence, the relative advantage of debt If θ<0.9288 the critical income tax rate is lower capital increases compared to equity capital. than the minimum tax rate of 23%. In these cases all investors provide equity capital.

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3.2.2 Tax rates capital: ∂τ* −1.27 · 108 A rise in the corporate tax rate has two counteract- i (21) = 2 < 0. ing effects. On the one hand, the tax advantage of ∂γ 4,000 + 96,000γ − 39,472θ debt capital (tax shield) at the corporate level in- This result, which seems surprising at first glance, creases and so does the relative advantage of debt can be explained as follows: we have already shown capital (see Buettner, Overesch, Schreiber, and that companies do not distribute profits in this Wamser 2006: 11, who come to the same conclu- model framework. Instead, payments for equity sion in the case of financing a German corporation capital are always realized as capital gains. If the owned by foreign shareholders). Equity capital is taxable fraction of dividends is increased, this leads more burdened by a higher tax rate, as dividends to a higher taxation of interest payments from thin are not tax-deductible on the corporate level. On capitalization that have to be requalified as hidden the other hand, the factor θ decreases because the distribution of profits. Therefore, an increase in γ corporate internal after-tax yield i(1 − τc − τa) de- implies a higher taxation of debt capital. clines. A decrease in θ leads, as shown above, to an Correspondingly, an isolated increase in the tax- increasing relative advantage of equity capital. In able fraction of capital gains λ leads to a higher Italy the tax-shield effect always dominates, caus- taxation of equity capital and an increasing rela- ing an overall increasing advantage of debt capital. tive advantage of debt capital. The critical income Mathematically this result becomes obvious in that * tax rate rises when increasing λ: ∂τi the derivative is always positive. * 8 ∂τc ∂τ 1.30 · 10 θ A change in the corporate tax rate has a relatively (22) i = > 0. ∂λ (42,400 − 98,680λθ)2 low impact on the investor’s financing decision. Assuming a holding period of, e.g., n = 10 years, Focussing on a change in both the taxable fraction a decrease in the tax rate from 33% to 10% leads of dividends and capital gains (γ = λ), we obtain to changes in the critical income tax rate of 9 ∂τ* −1.27 · 108 + 1.3 · 108θ i (23) = 2 0. percentage points. By contrast, an increase in the ∂γ 4,000 + 1,000γ[9.6 − 9.9θ] corporate tax rate to 50% raises the critical tax The derivative is positive or negative depending on rates by 6 percentage points. * ∂τi Varying the IRAP tax rate has no tax-shield effect the factor θ. Figure 1 shows that the derivative ∂γ because interest payments are not deductible un- is zero if θ =0.9728. A negative derivative arises der this tax. A change in the IRAP tax rate only if θ is smaller than 0.9728. Then, equity capital amends the factor θ such that the relative advan- becomes more attractive. The effect from higher ∂τ* tage of equity capital increases. The derivative i taxation of dividends that leads to an increased ∂τa is always negative. E.g., assuming a holding period advantage of equity capital is higher than the effect of 10 years a rise in the tax rate from currently from higher taxation of capital gains that causes 4.25% to 10% decreases the critical income tax rate an increased advantage of debt capital. * ∂τi from 12.57% to 3.11%. The derivative ∂γ is positive if θ>0.9728. In these cases the relative advantage of debt capital increases. The effect of the higher taxation of capital 3.2.3 Taxable fraction of dividends and gains overcompensates the effect of the higher div- capital gains idend taxation because a high value of the factor In Italy dividends and capital gains are subject to θ additionally causes a higher taxation of equity tax at the same fraction γ = λ =0.4. In this section capital. we analyze the effects of an isolated change in the taxable fraction of dividends γ and the taxable 3.2.4 Fraction of considered debt fraction of capital gains λ, respectively. We also investigate the influence of a change in the taxable At present all interest payments to substantial fraction of both dividends and capital gains. A rise shareholders are subject to Italian thin capitaliza- in the taxable fraction of dividends γ leads to a tion rules. Therefore, the parameter α has been set decrease in critical income tax rate and therefore equal to 1. Lowering the fraction α leads to a rise in an increase in the relative advantage of equity the critical income tax rate and hence an increas-

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∂τ* of the safe haven. An increasing multiple μE and i Figure 1: Derivative ∂γ for various θ in the 0.25 consequently an increasing safe haven H leads to general model (Italy) a decreasing corporate tax because the amount * i of deductible interest payments increases. At the 0.15 same time the income tax increases because the ad- 0 ditionally deductible interest payments are taxed 0.2 0.4 0.6 0.8 1 to the full amount whereas hidden distributions -2 are only subject to tax at the fraction γ =0.4. The effect on the corporate level always dominates.

-4 Therefore, the relative advantage of debt capital compared to equity capital increases with rising μE. If the permitted ratio of debt to equity capi- -6 tal μ is increased, e.g., from 4 to 20, debt capital may be twenty times the equity capital contributed by one shareholder while a change in the criti- * ____ i cal income tax rate amounts to a maximum of 17 Derivative for various in the general model (Italy) percentage points. ing relative advantage of debt capital compared to 3.2.6 Results equity capital: We are able to show that except for the gross profit ∂τ* Π and the interest rate i all model parameters have (24) i = −5.4 · 109 + 1.3 · 109θ ∂α an influence on the investors’ financing decisions. · 102,400 − 60,000α − 26,272θ Whereas the influence of the corporate tax rate, -2 the IRAP tax rate, the taxable fraction of dividends, − 13,200θα < 0. capital gains, and interest is low, the factor θ, the This effect is true because the interest payments fraction of considered debt, and the multiple μE which are subject to thin capitalization and requal- exert a high influence on financing decisions. As θ ified as hidden distributions of profit decrease, as is mainly driven by the relation of the corporate tax does the corporate tax. A reduction in the fraction rate to the individual income tax rate, obviously of considered debt α has a relatively high influence the tax rate difference determines the financing on the critical income tax rate. A reduction from decision significantly if capital gains are taxable. A α =1toα = 0.01 would lead to a rise in the critical closer look clarifies that θ can significantly change income tax rate of up to 32 percentage points. the critical income tax rate whereas a change in the corporate tax rate cannot. E.g., if the corporate tax rate rises, two partial effects on the critical income 3.2.5 Other model parameters tax can occur. One effect is an increase in the critical Assuming a decrease in the taxable fraction of income tax rate because of an increasing tax shield interest of ε = 1 to values with ε<1, we obtain a from debt financing. Simultaneously the critical rise in the critical income tax rate. The derivative income tax rate is reduced because of a decrease in * ∂τi ∂ε is always negative. This effect in turn increases the factor θ. Consequently, the overall effect of a the relative advantage of debt capital because a rise in the corporate tax rate on the critical income lower taxable fraction of interest implies a lower tax rate determined by these two opposing partial taxation of debt capital. effects is small. Only the influence of the taxable The influence of the permitted ratio of debt to fraction of dividends seems counterintuitive as a equity capital μ and of the amount of equity cap- rise in the taxable fraction of dividends γ causes a ital E can be analyzed simultaneously since both rise in the attractiveness of equity capital. variables only affect the safe haven H = iμ E.The Given the Italian tax policy with capital gains tax- multiple μEdenotes the maximum amount of debt ation, the underlying thin capitalization rule with capital that a substantial shareholder can provide a given permitted debt-to-equity ratio is typically to the corporation while tapping the full potential not irrelevant with respect to capital structure de-

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cisions. Here, financing decisions mainly depend profits. This regulation only holds if the share- on the corporate-income tax rate differential and holder’s capital commitment is long term and if therefore the parameter θ. Consequently, the tax the tax allowance of e 250,000 of interest on debt scale is an important driver of the financing deci- is exceeded. The permitted ratio of debt to eq- sion. The treasury needs to know the distribution uity capital is 1.5:1 (section 8a para 1 no. 2 of of investors across tax classes to forecast whether the German Corporate Tax Code). As only interest it is likely that the majority of investors will tend payments for long-term debt are subject to this to provide debt instead of equity capital under the regulation, the parameter α represents the fraction thin capitalization rules. of long-term debt in Germany. The tax allowance We find that changes in some model parameters (section 8a para 1 of the German Corporate Tax have a higher impact on the critical income tax Code) of e 250,000 of interest is assumed to be rates than changes in other parameters. This dif- exceeded. ference in sensitivity is due to the functional form In addition to the corporate tax the German local of the net profit. business tax has to be taken into account on the Several countries have implemented more complex corporate level. This tax treats equity and debt dif- thin capitalizations rules. Against this background ferently. To integrate effects of the local business and the results mentioned above, it is worthwhile tax into the model further assumptions are neces- to find out whether we obtain corresponding or sary. Corporate income as defined in the German deviating results under more specified rules and to Corporate Tax Code is the basis for determining what extent the characteristics of the underlying the local business tax base F (section 7 sentence 1 tax system determine the effects. We take Germany of the German Local Business Tax Code). Since the and Belgium as examples and perform an analysis local business tax itself is an operating expense, it in the following sections. is deductible from its own tax base. We consider this deductibility by introducing an effective local business tax rate τa (see Appendix A1). Further- 4 Complex thin capitalization more, amongst the various tax base adjustments listed in section 8 of the German Local Business rules (Germany) Tax Code, only the addition of 50% of the interest 4.1 Critical income tax rate payments for long-term debt (section 8 no. 1 of In this section we integrate the German thin cap- the German Local Business Tax Code) is consid- italization rules according to section 8a of the ered in the model. Splitting debt into long-term German Corporate Tax Code as amended by the and short-term debt indirectly introduces a time Korb II tax reform act (section 8a of the German dimension into the model. Although we develop a Corporate Tax Code as amended by the Korb II static model that by definition does not account for tax reform act dated Dec. 22, 2003, BGBl. I 2003: timing effects, a differentiation between long-term 2841 et seq.) into the model. This rule that was and short-term debt is necessary to distinguish be- introduced in 2004 has been reformed by the Ger- tween different types of interest for local business man business tax reform act 2008 where it was tax and thin capitalization purposes. Nevertheless, substituted by an interest barrier (section 4h of the the model remains static. Reductions according to Income Tax Code and section 8a of the German section 9 of the German Local Business Tax Code Corporate Tax Code as amended by the German are not considered at all. The fraction of the in- Business Reform dated Aug. 14, 2007, BGBl. I terest that is long-term debt (section 8 no. 1 of 2007: 1913 et seq., 1927 et seq.). Section 8a is an the German Local Business Tax Code) is denoted example of a complex thin capitalization rule char- by α ∈ (0,1]. If α = 0, section 8a of the German acterized by a given permitted debt-equity capital Corporate Tax Code does not apply. Hence, the ratio. addition of interest payments for long-term debt is Under this debt-equity-ratio-based thin capitaliza- equal to 0.5 Id. tion rule, interest on debt capital that a corporation Dividends, hidden distributions, and capital gains receives from a shareholder with a shareholding are subject to the same income tax rate τi = τiI = of more than 25%, under certain circumstances, τiD = τiG. has to be requalified as a hidden distribution of Taking into account the local business tax, the net

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Π profit τ is equal to (see Maßbaum and Sureth + λθ τa C(1 − α) + 0.5 μE 2008 for a more detailed analysis of the influence of the German section 8a thin capitalization rule + τc C(1 − α)+μE on capital structure decisions) -1 − τa C(1 − α) + 0.5 μE − C . (25) Πτ = Π −τa Π − iC(1 − α) − 0.5 iμ E Ta 4.2 Sensitivity analysis − τ Π − iC(1 − α)−iμ E c Π As in the general model, the gross profit and −τa Π − iC(1 − α) − 0.5 iμ E the interest rate i have no influence on the critical income tax rate and therefore on investors’ finan- Tc cing decisions. The other model parameters exert − τiε iC(1−α) + iμ E an influence on the critical income tax rate. The degree of sensitivity of the critical tax rate towards − τiγ D + iCα− iμ E variation in the different parameters varies signifi-

cantly. Therefore, we highlight the most important − τiλθ Π − τa Π − iC(1 − α) value drivers. − 0.5 iμ E − τ Π − iC(1 − α)−iμ E 4.2.1 Time and growth factor for capital c gains − τ Π − iDC(1 − α) − 0.5 iμ E a To analyze the influence of the factor θ all other −D − iC . model parameters remain constant. We assume

Ti τ = 25%; τmax = 42%; τ = 16.28%; To identify the optimal dividend policy, equation c i a C = e 100,000; E = e 1,000; (25) has to be differentiated with respect to D: γ = λ = 0.5; μ = 1.5; ε =1;i =6%;α =1. ∂Π (26) τ = τ (λθ − γ)=0. ∂D i We obtain the effective local business tax rate We see that the investor is only indifferent towards τa by considering the average collection rate of dividend policy in two cases, namely if the income h =389%(Federal Statistical Office 2007) and a γ tax rate τi = 0 or if the factor θ = λ . This is the same taxable business value of m = 5%. As the permitted result we obtained for Italy (see section 3.1 and ratio of debt to equity capital is 1.5:1, the parameter Appendix A2). Beyond these cases full retention is μ is equal to 1.5. The fraction of long-term debt is always the optimal dividend policy. represented by the parameter α. Under income To obtain the optimal capital structure equation tax law earned interest is fully taxable (section 20 (25) has to be differentiated with respect to D* =0 para 1 no. 7 of the Income Tax Code), therefore to C and it has to be set to zero. As a result we get ε is equal to 1. The distributed profits D, hidden * the critical income tax rate τi , distributions, and capital gains are subject to the half-income system and thus only 50% of this type of capital income is taxable, i.e. γ = λ = (27) τ* = τ C(1 − α) + 0.5 μE i a 0.5 (section 20 para 1 no. 1 in conjunction with section 3 no. 40 d) of the Income Tax Code, see + τ C(1 − α)+μE c Appendix A1). The investor receives total interest I of e 6,000. − τ C(1 − α) + 0.5 μE · a Within the safe haven interest of I = H = e 90 is d tax-deductible at the corporate level. ε C(1 − α)+μE + γ( Cα − μE) Inserting the assumptions the critical income tax rate as a function of θ is

466.575 (28) τ* = . i 50,750 − 49,766.71θ

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Table 2 shows the critical income tax rates for in comparison to debt capital than in Italy. Only different values of the factor θ (see Appendix A2). if θ>0.9986 is debt capital more attractive in Germany than in Italy. Table 2: Critical income tax rates for various θ in Germany Figure 2: Critical income tax rates for * various θ in Germany and Italy θτi 0.01 0.93% * 0 25 1 22 i . . % 50%50%

0.5 1.80% 45% 0.75 3.48% 40%40% 0.95725 15.00% 35% 0.99845 42.00% 30%30% 25% 1 47.45% 20%20% 1 015 197 04 . . % 15%

10%10% We see that the values for the critical income 5% 0%0 tax rate vary between 0.93% and 197.04%. If the 0.2 0.4 0.6 0.8 1 factor θ is higher than 0.99845, the critical income tax rate is higher than the top tax rate of 42%. ____ Critical income tax rates for various under general thin capitalization rules (Italy) In these cases, debt capital is advantageous for all shareholders. If θ is lower than 0.95725, the critical ----- Critical income tax rates for various under specified thin capitalization rules (Germany) income tax rate is lower than the minimum income tax rate of 15% and all investors will provide equity capital. Only if 0.95725≤ θ ≤ 0.99845, it depends Debt capital is usually less attractive in Germany on the investors’ marginal tax rate as to whether than in Italy, because debt capital is more severely debt or equity capital is favorable (section 3.2.1). burdened due to the addition of a fraction of the For θ = 1.015 we receive an extremely high criti- interest payments for long-term debt for local busi- cal income tax rate that again indicates that debt ness tax purposes and the lower permitted ratio of financing is always beneficial. If we determine crit- debt to equity capital. If the factor θ increases ical income tax rates for higher values of θ the crit- this implies a higher effective taxation of capital ical tax rate may change its sign and even become gains and consequently a reduced attractiveness negative (see section 3.2.1 for an interpretation of of equity capital in both Italy and Germany. As these effects). the nominal taxation of capital gains λ is lower in * ∂τi Italy than in Germany, equity capital becomes less We obtain the derivative ∂θ by differentiating equation (27) with respect to θ and inserting the as- unattractive in Italy than in Germany. sumptions. As in the general model this derivative is also positive in Germany. Therefore, an increas- 4.2.2 Tax rates ing θ leads to an increasing relative advantage of A rise in the corporate tax rate τc incurs an in- debt capital compared to equity capital (section creasing critical income tax rate and therefore an 3.2.1). increasing advantage of debt capital over equity capital. This result is in line with the result we ∂τ* 23,220 obtained for Italy (section 3.2.2). (29) i = > 0. ∂θ (50,750 − 49,766.71θ)2 By contrast, an increase in the local business tax rate τa decreases the critical income tax rate and In Figure 2 we compare the German and Italian therefore leads to an increasing relative tax advan- critical income tax rates. We see that the German tage of equity capital. In this case the tax shield tax rates are usually lower than the Italian tax rates. effect invoking a higher advantage of debt cap- Only if θ is higher than 0.9986 are the German tax ital is lower than the opposing effect caused by rates higher than the Italian. This implies that in the negative impact of rising τa on θ, because in Germany equity capital is usually more attractive Germany the fraction of interest payments that is

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tax-deductible with respect to the local business influence of the taxable fraction of dividends and tax is lower than for corporate tax purposes. capital gains on the critical income tax rate and Assuming a holding period of n = 10 years ex- therefore on investors’ financing decisions. emplifies that a decrease in the corporate tax rate from 25% to 10% leads to a reduction in the critical 4.2.4 Fraction of considered debt income tax rate of only 0.7 percentage points, a corresponding increase in the corporate tax rate Assuming a change in the fraction of considered to an increase of only 0.5 percentage points. Sim- debt α we obtain the following derivative: ilarly, changes in the local business tax rate also ∂τ* only have a low influence on the critical income (33) i = -1.86508 · 109 + 1.8605 · 109θ tax rate. Assuming a decrease in the local business ∂α tax to 10% raises the critical income tax rate by · 100,750 − 50,000α -2 0.2 percentage points, an increase to 30% results − 31,162θ − 18,605αθ < 0. in a change in the critical income tax rate of 0.3 percentage points. In Germany only long-term debt capital is subject to the thin capitalization rules of section 8a of 4.2.3 Taxable fraction of dividends and the German Corporate Tax Code. Therefore, the capital gains investor can influence the parameter α by pro- As in Italy, in Germany dividends and capital gains viding long-term or short-term debt, respectively. are subject to the same taxable fraction γ = λ. Lowering the fraction of long-term debt leads to An exclusive rise in the taxable fraction of divi- an increasing relative advantage of debt capital dends γ, as in Italy, lowers the critical income tax compared to equity capital. rate and therefore increases the relative advantage of equity capital (section 3.2.3): 4.2.5 Other model parameters Considering changes in the taxable fraction of in- ∂τ* -4.60 · 107 i terest ε and the multiple of the permitted ratio of (30) = 2 < 0. ∂γ (1,500 + 98,500γ − 49,767θ) debt to equity capital and the amount of equity capital μE we obtain the same influences as in Analyzing c.p. an increased capital gains taxation, Italy (section 3.2.5). i.e. an increase in λ, we obtain the following deriva- A decrease in the taxable fraction ε of interest tive that is, as in Italy, always positive (section leads to an increasing relative advantage of debt * 3.2.3): ∂τi capital. The first derivative ∂ε is always negative. Considering a rise in the multiple μE we obtain a ∂τ* 4.64 · 107θ (31) i = > 0. higher relative attractiveness of debt capital. ∂λ (50,750 − 99,533λθ)2 4.2.6 Results A change in the taxable fraction of both dividends and capital gains γ leads to a derivative that is, To study the influence of the German thin capi- depending on the factor θ, positive, negative or talization rules on financing decisions we had to zero: extend the general model to include the local business tax. This tax is quite different from the Italian ∂τ* -4.6 · 107 + 4.64 · 107θ IRAP as the resulting tax burden depends on the (32) i = 0. ∂γ (1,500 + 98,500γ − 99,533γθ)2 investor’s financing decision. In spite of the introduction of this tax we obtain very similar results The derivative is positive if θ is higher than 0.9896, for both Germany and Italy. We can show that in negative if θ is lower than 0.9896, and equal to both countries the gross profit and the interest rate zero if θ is 0.9896. For Italy we obtain a similar do not influence the investors’ financing decisions, value of θ = 0.9728. Hence, the integration of the whereas changes in the other model parameters local business tax and the different values of the exert the same influences in both countries. A model parameters do not substantially affect the change in the German local business tax rate has a

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less severe influence on the critical income tax rate individual assessment in section 5.2. We only con- than a change in the Italian IRAP tax rate because sider the case that the investor chooses to include interest payments are not tax-deductible under an both interest and dividends into assessment. For IRAP. For this reason a variation of the IRAP tax reasons of transparency we do not model mixed rate does not invoke a tax shield. scenarios. Capital gains are not subject to tax, therefore τiG =0(Offermanns 2006: 76). In a first step 5 Complex thin capitalization we assume that capital gains are also subject to rules (Belgium) the withholding tax of 25%. This assumption en- After having considered the Italian and German ables us to isolate the effects of the introduction thin capitalization rules we now analyze the in- of a capital gains tax. Hence, we assume that τiG = fluence of another debt-equity-ratio-based rule, 25%. namely the Belgian regulation on shareholders’ financing decisions which was introduced in 1997. 5.1 Withholding tax In Belgium interest payments are requalified as 5.1.1 Critical income tax rate hidden distribution of profits and therefore treated as dividends if the permitted ratio of debt to equity Considering the withholding tax we assume capital of 1:1 is exceeded. The Belgian thin capi- τ = τ = 25%; τ = 15%. talization rules are applicable to all shareholders. iD iG iI

A minimum shareholding is not necessary. The We obtain the following net profit Πτ thin capitalization rules include all loans that a shareholder provides the corporation (Offermanns (34) Πτ = Π − τc Π − iC(1 − α)−iμ E − in E 2006: 73). A notional interest deduction for equity capital Tc is granted to corporations. Thus, the Belgian sys- − 0.15 ε iC(1−α) + iμ E tem applies an Allowance for Corporate Equity (ACE) device which was intended to account for − 0.25 γ D + iCα− iμ E the distinction of interest payments to external Π Π providers of capital compared to those from as- − 0.25 λθ − τc − iC(1 − α) sociated members of corporations. Introducing an −iμ E − in E − D − iC . ACE was regarded as a step towards a more neutral tax system and towards improving Belgium as Ti an investment location (Gerard 2006: 156). The deduction is based on the book value of the com- By differentiating equation (34) with respect to the pany’s equity. It is calculated by multiplying the dividends D the following dividend policy turns equity by a fixed percentage determined by the out to be optimal: government. For 2007 the percentage is equal to in = 3.442%. The notional interest rate is set by ∂Π (35) τ = λθ − γ =0. the government on the basis of the interest rate ∂D on 10-year government bonds (Cowley, Gutiérrez, Kesti, and Soo 2008: 91). The investor is only indifferent towards the div- In contrast to Italy and Germany, additional taxes idend policy if λθ = γ. As capital gains are not τa are not levied on the corporate level. subject to tax in Belgium at present, we receive Dividends and interest income are subject to a λθ = 0. The condition only holds if γ = 0, namely withholding tax of τiD = 25% and τiI = 15% re- if dividends are not subject to tax. Since dividends spectively (Offermanns 2006: 78). Alternatively, are fully taxable in Belgium, hence γ = 1 and in- the investor can choose to include dividends and difference to the dividend policy is not possible at interest income into their individual assessment if present. Instead full retention is always the opti- this leads to a lower taxation. In this case τiD = τiI . mal dividend policy. Because capital gains are not In the following we analyze both cases, the sce- subject to tax whereas dividends are, full retention nario with withholding tax in section 5.1 and with always leads to the highest net profit.

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Taking account of the withholding tax the income holder level interest payments up to the safe haven tax rate is no longer a function of the tax base are subject to the withholding tax rate of 15% while but exogenously given, because τiI = 15% and the excess is subject to the withholding tax of 25%. * τiD = τiG = 25%. Thus, a critical income tax rate τi Consequently, interest payments amounting to the cannot be determined. The optimal capital struc- safe haven are possibly taxed lower than payments ture decision does not depend on the investor’s for equity capital. But interest payments that ex- marginal income tax rate but only on the values of ceed the safe haven are taxed considerably higher the other model parameters. (33% corporate tax plus 25% withholding tax). Since we assume the safe haven always to be ex- 5.1.2 Sensitivity analysis ceeded and since Belgium has a very low safe haven, interest payments are always taxed higher In the following we analyze the influence of selected than capital gains. model parameters on the investor’s financing de- As in Italy and Germany, a variation of the gross cisions. profit and the interest rate has no influence on the For the basic scenario we assume financing decisions. The same is true for changes max in the notional interest rate. τc = 33%; τi =50%;in = 3.442%; i =6%; C = e 100,000; E = e 1,000; Π = e 10,000; As long as capital gains are not subject to tax, i.e. γ =1;λ =0;μ =1;ε =1;α =1. λ = 0, a change in the time and growth factor for capital gains θ has no influence on the investor’s Corporations with a tax base up to e 322,500 are financing decisions. If capital gains are not tax- subject to a progressive tax scale. Corporations exempt, i.e. λ>0, a variation of θ influences the with a higher tax base are subject to a tax rate of investor’s financing decisions. Since capital gains 33% (Offermanns 2006: 65, see Appendix A1). We are subject to tax at λθ, a change in the factor θ has assume that the tax base exceeds e 322,500. The the same influence on the financing decisions as a shareholders are subject to a progressive income change in the taxable fraction λ. max tax scale. The top tax rate τi to the amount of As in Italy and Germany, an increasing corporate 50% is imposed if the tax base exceeds e 31,700 tax rate leads basically to an increasing relative ad- (Offermanns 2006: 77, see Appendix A1). vantage of debt capital compared to equity capital Dividends, interest payments, and hidden distribu- (section 3.2.2). The increasing relative advantage tions are subject to income tax to the full amount, of debt capital is very low, due to the notional in- hence ε = γ = 1. Capital gains are tax-exempt, terest deduction for payments for equity capital. As hence λ = 0. The thin capitalization rules are ap- τc ∈ [0,1] an irrelevance of the financing decision plicable for all loans provided by shareholders, i.e. or even an advantage of debt capital cannot occur α = 1. The permitted ratio of debt capital to equity in Belgium. capital is 1:1, i.e. μ =1. Investigating the effects of an isolated decreasing Inserting the assumptions into equation (34) we taxable fraction of dividends we find a rising attrac- obtain a net profit of e 6,711 in the case of equity tiveness of debt capital (section 3.2.3). The investor financing and a net profit of e 5,237 in the case of is only indifferent towards debt and equity capital debt financing. The investors will therefore decide if γ = -0.00038. As γ ∈ [0,1] a change in the tax- to provide equity capital instead of debt capital. ation of dividends does not change the financing Payments for equity financing are only taxed with decision. Equity capital is always advantageous. corporate tax at 33%. In line with notional interest The introduction of a capital gains taxation, while deduction, a notional amount of interest can be assuming that dividends are subject to tax to the deducted from the corporate tax base. The pay- full amount, i.e. γ = 1, leads to an increased relative ments for equity are not taxed on the shareholder advantage of debt capital (section 3.2.3). Neverthe- level because full retention is the optimal dividend less, debt capital would become advantageous only policy and capital gains are tax-exempt. for negative λ-values. As λ ∈ [0,1], equity capital is Interest payments are tax-deductible on the corpo- always advantageous. rate level up to the safe haven. Those that exceed In Italy and Germany, a change in the taxable the safe haven are non-deductible and therefore fraction of both dividends and capital gains (γ = subject to corporate tax of 33%. On the share- λ) leads, depending on the value of the factor

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θ, to a change in the relative advantage of debt capital will be preferred if μ>58 or E>104,000. over equity capital (section 3.2.3). In Belgium, a change in these parameters does not change the 5.1.3 Results shareholder’s financing decision. A decreasing γ Considering the Belgian thin capitalization rules in and λ leads to an increasing relative advantage the light of the withholding tax option, the finan- of debt capital, but an advantage of debt capital cing decision, unlike in Italy and Germany, does towards equity capital can only occur for negative not depend on the investor’s marginal income tax values of γ and λ. rate but only on the other model parameters. Vary- A decrease in the fraction of considered debt from ing different model parameters leads to similar presently α =1toα<1 reduces the drawback of financing decision patterns as under the Italian- debt over equity caused by the thin capitalization type and German-type rules. Whereas in Italy and rule (section 3.2.5). If α = 0.4242 the investor is Germany capital structure irrelevance is gener- indifferent towards debt and equity financing. If ally possible when assuming currently codified the tax law is modified accordingly, which is rather tax rates and debt-to-equity ratio, providing eq- unlikely, the net profit is identical for both debt and uity capital is always favorable in Belgium because equity financing. Only if the fraction of considered capital gains are exempt from taxation, thin cap- debt is lower than 0.4242 do we find an advantage italization rules discriminate debt financing and of debt financing because then, net profit increases a notional interest deduction on equity capital is with an increasing gearing rate. granted. Although an ACE often is regarded as a A tax reform changing α directly to alleviate in- means to provide tax neutrality, in Belgium this terest deduction restrictions is very unlikely to be neutrality property has been undermined by intro- discussed. It is more likely that thin capitalization ducing a thin capitalization rule, which obviously rules are alleviated by restricting their applica- exacerbates the discrimination of debt capital (Ger- tion to long-term debt as is the case in Germany, ard 2006: 156). for instance. If the Belgian government only referred to interest payments on long-term debt in their modified thin capitalization rules, a fraction 5.2 Assessment of long-term debt of 42.42% would be equal to a 5.2.1 Critical income tax rate fraction of α = 0.4242. In this case, the investor The shareholder can optionally include dividends can benefit from debt financing if their interest into the individual tax assessment. In this case on long-term debt does not exceed 42.42% of the dividends and interest are not subject to the with- interest on short-term debt. holding tax of 25% or 15% but to the shareholder’s Given that interest payments are subject to tax to individual income tax rate. Hence, the option to the full amount, namely ε = 1, a decrease in the include dividends or interest in the assessment is taxable fraction ε leads to an increasing relative only reasonable for shareholders with an income advantage of debt capital. Concentrating on the tax rate less than 25% and 15% respectively. For influence of a change in ε on the financing decision, simplicity we only consider the case that the choice we find that the investor is indifferent towards debt to include income in the assessment is beneficial ∈ and equity financing if ε = -164. Since ε [0,1] for both dividends and interest. in fact an indifference cannot arise. Instead, the If dividends and interest income are included in investor will always prefer to provide equity capital. the assessment, all sources of income are subject In contrast to Italy and Germany a change in the to the same income tax rate. Therefore, we have permitted ratio of debt to equity capital μ and in the amount of equity capital E cannot be analyzed τiD = τiI = τiG = τi. jointly, because a change in equity capital not only influences the safe haven H = iμ E, but also The net profit is thus equal to the notional interest deduction in E. Assuming an increasing μ or an increasing E we obtain a rising (36) Πτ = Π − τc Π − iC(1 − α)−iμ E − in E relative advantage of debt capital (section 3.2.5). T Capital structure irrelevance arises if μ is increased c to 58 or if debt capital is increased to 104,000. Debt

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− τiε iC(1−α) + iμ E sponds to that obtained for the withholding tax (section 5.1.2). − τiγ D + iCα− iμ E A variation of the factor θ has no influence on the critical income tax rate because capital gains − τ λθ Π − τ Π − iC(1 − α) i c are tax-exempt. Only if λ>0 will a change in the factor θ affect the investor’s financing decisions. In −iμ E − in E − D − iC . these cases a change in this factor influences the Ti financing decisions in the same way as a change in the taxable fraction of capital gains λ does. We obtain the same optimal dividend policy as In line with the results for the other countries, for Italy and for Germany. The investor is only we obtain a rising critical income tax rate and an indifferent towards debt and equity financing if increased relative advantage of debt capital if we τi = 0, namely if they have no taxable income, or assume a rising corporate tax rate (section 3.2.2). if λθ = γ (section 3.1). Otherwise full retention is Varying the taxable fraction of dividends γ while always the optimal dividend policy. assuming that capital gains are tax-free leads to a We obtain the following critical income tax rate by negative derivative. We find that lowering γ causes differentiating equation (36) with respect to C: a rising advantage of debt capital (section 3.2.3): * ∂τ* -117,612 (37) τi = τc C(1 − α)+μE i (39) = 2 < 0. ∂γ 60 + 5,940γ · ε C(1 − α)+μE + γ( Cα − μE) -1 We obtain critical income tax rates higher than + λθ τc C(1 − α)+μE − C . 15% and therefore an attractiveness of the withholding tax for interest income over the individual 5.2.2 Sensitivity Analysis assessment for γ<0.0121. Just like in the other countries the gross profit and Assuming a taxation of capital gains, i.e. λ>0, and the interest rates do not influence the investor’s a taxation of dividends to the full amount, i.e. γ =1, financing decisions. The other model parameters we obtain the following positive first derivative: influence the critical income tax rate and therefore ∂τ* 118,408θ the financing decisions. i (40) = 2 > 0. We assume ∂λ 6,000 − 5,980λθ max τc =33%; τi =15%; in =3.442%; i=6%; C = e 100,000; E = e 1,000; γ =1; As expected, implementing a capital gains tax in- λ =0; ε=1; μ =1; α =1. vokes a higher relative advantage of debt capital (section 3.2.3). The effect of a rising λ on the critical max The top tax rate τi is equal to 15% because only income tax rate is very low. We obtain critical in- shareholders with an income tax rate of less than come tax rates of over 15% only for very high capital 15% will decide to include dividends and interest gains taxes with only hypothetical relevance (λθ > income in their individual assessment. Inserting 0.98124). the assumptions into equation (37) we obtain A change in the taxable fraction of both dividends and capital gains (γ = λ) leads to the following * (38) τi = 0.33%. derivative that is a function of the value of the factor θ and may take positive or negative values: All investors have a marginal income tax rate that is higher than the critical income tax rate. To con- ∂τ* -117,612 + 118,408θ i (41) = 2 0. clude for all investors we have to abstract from ∂γ 60 + 5,940γ − 5,980γθ the typically rather small group of investors with a marginal income tax rate between zero and 0.33%. If θ>0.993, the partial derivative is positive. If Therefore, all investors prefer to provide equity θ<0.993, it is negative. capital instead of debt capital. This result corre-

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As in the previously analyzed countries a decreas- 6 Conclusions and future research ing fraction of considered debt leads to an in- From a tax planner’s point of view, it is often creased critical income tax rate that implies an in- attractive to choose debt over equity financing. creasing advantage of debt capital (section 3.2.5). * Nevertheless, corporations issue shares as well as ∂τi The derivative ∂α is always negative. Lowering the debt, raising the question on possible causes. As fraction of considered debt α from 1 to 0.5 leads to individual tax planning has led to an increase in a rise in the critical income tax rate from 0.33% to debt financing of corporations, many countries * 16.83%. Lowering α to 0.25 leads to τi = 25.08%. have introduced thin capitalization rules to secure If α = 0.5, the investor therefore will decide in their tax revenues. These thin capitalization rules favor of the withholding tax for interest income. If might explain why corporations still issue both α = 0.25, they will prefer the withholding tax for debt and equity. dividends. Against this background we investigate how such Decreasing the taxable fraction of interest ε we find regulations affect the capital structure decisions a rise in the relative advantage of debt capital. The of stockholders of corporations. We examine gen- * ∂τi partial derivative ∂ε is always negative. eral thin capitalization rules and more specific A rise in the permitted ratio of debt to equity and complex examples of regulations to restrict capital μ or the amount of equity capital E leads shareholder financing as to their impact on financ- to an increase in the relative advantage of debt ing decisions of shareholders of corporations. The * * ∂τi ∂τi general case is exemplified by the Italian rules of capital. The first derivatives ∂μ and ∂E are always positive (section 3.2.5). To obtain a critical tax rate the 2007 tax law and the more specific regulations of more than 15% the permitted ratio of debt to are illustrated by the examples of the German and equity capital has to be increased to 46:1 or debt Belgian thin capitalization rules of the 2007 tax capital has to be increased to e 46,000. law. The selected rules can be regarded as representative examples of many countries’ thin capital- 5.2.3 Results ization rules that are characterized by a permitted debt-to-equity ratio. As a corresponding regulation Assuming assessment is attractive for investors, exists in several countries, the knowledge gained their financing decisions depend, as in Italy and in our study can be used as the basis for follow-up Germany, on their marginal income tax rate. The empirical studies on the impact of thin capitaliza- different model parameters exert an influence on tion rules on capital structure decisions in these the decision that corresponds to the one identi- countries. fied for the other countries. As in the case of the Furthermore, as the financing behavior of in- withholding tax, equity capital is always beneficial vestors is crucial for designing thin capitalization when considering currently codified tax rates and rules and as the influence of thin capitalization debt-to-equity-capital ratio because capital gains rules depends heavily on a lot of other tax param- are exempt from taxation and a notional inter- eters (corporate tax rate, taxable fraction of div- est deduction is granted for equity capital. If the idends and capital gains, permitted ratio of debt thin capitalization rule was abolished we would to equity capital) it is important for the treasury obtain a critical income tax rate that is equal to the to know how these rules interact. Our results help corporate tax rate. This result is in line with the the treasury to implement a rule that contributes neutrality property of an ACE tax and implies that, to their given political aim in a given tax setting. given the assumption of a perfect capital market, Taking into account the relevant tax rates and the we lose capital structure irrelevance as soon as the codified debt-equity ratio we find similar results income tax rate differs from the corporate tax rate. for Italy and Germany. In particular, a so-called The analysis of the Belgian tax system clarifies that, Miller equilibrium is possible when the difference given a neutral corporate tax, the political aim to of the corporate tax rate and the individual in- foster equity financing and prevent a drain of tax come tax rate is relatively low and when the pro- revenues due to debt financing, a thin capitaliza- vided debt comprises a small fraction of considered tion rule with a given permitted debt-to-equity debt. The fraction of considered debt is presently ratio may help to achieve this aim irrespective of only limited under the German-type rule because the investors’ income tax rates.

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there only long-term debt is taken into account. 2007: 1913 et seq., 1927 et seq.), in principle in- In Belgium equity capital always incorporates an terest payable is deductible up to an amount that advantage considering current tax rates and the corresponds to the interest earned by the company. current debt-to-equity-capital ratio because even The residual interest payable can be deducted from though Belgium has introduced a supposedly neu- the tax base up to an amount of 30% of the residual tral ACE tax debt capital is discriminated by a thin profit, plus depreciation and interest expenses and capitalization rule. This result holds in the case of less interest income. Interest expenses that remain both withholding tax and assessment. non-deductible according to this regulation have Investigating changes in the model parameters we to be carried forward and, subject to the same con- obtain similar results for all underlying tax sys- ditions, increase interest expenses in subsequent tems. In particular, varying the fraction of consid- financial years. In this regard, the non-deductible ered debt as well as the ratio of corporate tax rate interest expenses are not classified as hidden dis- and income tax rate and the permitted ratio of debt tribution of profit. Hence, on the shareholder level to equity capital have a substantial impact on the they are treated as interest income. The tax al- critical income tax rate and make a Miller equi- lowance up to which the regulation is not applied librium possible. Among these parameters, only amounts to e 3,000,000. With respect to the in- the permitted ratio of debt to equity capital and terest barrier, initially only statements about the the tax rates can be influenced by the legislator. tendency can be made. The remaining parameters can be changed by the On the corporate level debt capital is advantageous, taxpayers themselves. because interest payments are at least partially tax- There is a broad range of issues that should be deductible, whereas dividends and capital gains addressed in future research. Although the present are not. In contrast, on the shareholder level in- analysis only focuses on individual shareholders, terest income is fully taxable and subject to the corporate shareholders can easily be integrated shareholder’s individual income tax rate (see Ap- into the model by changing the denotation ‘‘in- pendix A1). A withholding tax amounting to 25% come tax’’ to ‘‘corporate tax’’ on the shareholder is on principle levied on dividends and capital level and changing the values of the taxable fraction gains (see Kiesewetter and Lachmund 2004 who of dividends γ and capital gains λ in the sensitiv- investigate and demonstrate the effects of a final ity analysis. As thin capitalization rules, especially withholding tax on the capital structure of enter- in Europe, are applicable to both domestic and prises with the help of investment appraisal and foreign investors, for simplicity we focus only on who design, based on the achieved results, a with- domestic shareholders. An extension of the model holding tax that is independent of the financing with respect to international investors is possible. form). The shareholder can also choose to include Effects on financing decisions arising from interna- dividends and capital gains in their assessment. A tional tax base or tax rate differentials are captured substantial shareholder with a holding of at least in our sensitivity analysis in sections 3.2, 4.2, 5.1.2 25% can additionally choose a shareholder relief and 5.2.2. The basic results remain the same in system for dividends and capital gains. In this the international context. In the case of different case they are subject to the shareholder’s individ- interpretations of income (dividend or interest in- ual income tax rate, but only taxed at a fraction come) that has been requalified as dividends under of 60%. The shareholder relief system is always a thin capitalization rule we have to fall back on a advantageous unless the shareholder exhibits an single-case analysis. General results can no longer individual income tax rate of 42%. To sum up, div- be deduced. idends and capital gains are usually lower taxed on In 2008 both Germany and Italy (see Marino and the shareholder level than interest income. Hence, Russo 2008 for an overview of the new Italian capital structure irrelevance is possible since the regulation) changed their thin capitalization rules lower taxation of income from equity on the share- and implemented an interest barrier. Under Ger- holder level counteracts the lower taxation of in- many’s 2008 business tax reform (section 4h of the come from interest on the company level caused Income Tax Code and section 8a of the German by the (partial) deductibility of interest payments. Corporate Tax Code as amended by the German If the capital company incurs losses over a longer Business Reform dated Aug. 14, 2007, BGBl. I period and interest payments hence cannot be de-

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ducted in the same period, the attractiveness of relief system. equity financing compared to debt financing increases. In the extreme case, if interest on debt From 2009 on a withholding tax amounting to cannot be deducted at all, equity financing always 25% is on principle levied on dividends and capital generates the highest net profit. gains. The withholding tax is not applicable to a To gain more precise results for Germany a quan- shareholding of at least 10% (see section 32d of the titative analysis including all items of Germany’s Income Tax Code for an overview of the taxation 2008 Tax Reform Act is necessary. Furthermore, of income from equity capital). an analysis of the new Italian thin capitalization rules and a comparison of the results of the German Italy and Italian regulation is reasonable. We relegate this issue to future research. We consider Italy’s thin capitalization rule in 2007. For now, our analysis highlights that for com- For an overview of this regulation see, for example, panies in countries with thin capitalization rules Gusmeroli and Russo (2004). This regulation was and a permitted debt-equity ratio, debt financing introduced in 2004. In 2008 Italy replaced its can typically be tax-optimized by shareholders. former rules with a regulation similar to the new However, under certain circumstances the capital German interest barrier. See Marino and Russo structure can become irrelevant. (2008) for an overview of this new regime.

A2: Supplementary information on the Appendix analysis A1: Supplementary information on the We assume that the thin capitalization rule ap- national tax laws plies to all shareholders and thus to all investors. The thin capitalization rule is for example appli- Belgium cable to all shareholders in Belgium and Spain. In many other countries, including Germany, Italy, The Belgian thin capitalization rule was introduced the Netherlands and Portugal, thin capitalization in 1997 and is still in force. rules only apply to what are known as substantial shareholders. These are shareholders with a given Belgium raises a surcharge of 3% of the corporate minimum shareholding. Loans from third parties tax. We neglect this surcharge. and non-substantial shareholders can easily be integrated into the model. As interest payments to Belgium raises local surcharges on the income tax. third parties and to non-substantial shareholders We neglect these local surcharges. do not induce a thin capitalization treatment, these extensions do not yield any new insights for our Germany analysis. The German thin capitalization rule was introduced in 2004. It has been reformed by the German We assume that a fraction α of debt is subject to the business tax reform act 2008 where it was sub- thin capitalization rule. In Germany the regulation stituted by an interest barrier. only applies to interest paid on long-term debt. Other countries apply the regulation to all interest From 2008 on the local business tax is not de- payments to specific shareholders. ductible as an operating expense anymore. The values in Table 1 neglect that the factor θ The half-income system was abolished in 2009 should be endogenously determined. As the influ- * and replaced by a final flat tax on capital income of ence of τi on θ cannot be derived analytically we 25%. A modified shareholder relief system is only have to fall back on simulation. To point out that applicable to capital income from corporate shares the resulting changes in our results are very small held as business assets. Substantial shareholders we have performed an iterative simulation. By it- with a shareholding of at least 25% can choose eration we can account for the interdependency * between the withholding tax and the shareholder of τi and θ. We find that the resulting critical tax

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rates are slightly higher. At a maximum we iden- DeAngelo, Harry and Ronald W. Masulis (1980a): Optimal Cap- tify a deviation of 3.75 percentage points from the ital Structure under Corporate and Personal Taxation, Journal of Financial Economics, 8 (1): 3-29. rates determined for an exogenously given θ.We DeAngelo, Harry and Ronald W. Masulis (1980b): Leverage and find similar deviations if we vary other model pa- Dividend Irrelevancy under Corporate and Personal Taxation, rameters. Against this background, it is acceptable Journal of Finance, 35 (2): 453-464. to conduct the following investigation abstracting Desai, Mihir A., C. Fritz Foley, and James R. Hines (2004): from this interdependency. We hence do not have A Multinational Perspective on Capital Structure Choice and Internal Capital Markets, Journal of Finance, 59 (6): 2451- to fall back on numerical results on optimal cap- 2487. ital structure; instead, analytical and thus more Devereux, Michael and Harold Freeman (1991): A General general results can be obtained. Neutral Profits Tax, Fiscal Studies,12(3):1-15. Donaldson, Gordon (1961): Corporate Debt Capacity: A Study In Germany the investor is indifferent towards of Corporate Debt Policy and the Determination of Corpo- rate Debt Capacity, Division of Research, Graduate School of dividend policy if the income tax rate τi =0orif Business Administration, Harvard University: Boston. γ the factor θ = λ . The condition τi = 0 is true if the Farrar, Donald E. and Lee L. Selwyn (1967): Taxes, Corpo- taxable income of the investor is lower than the rate Financial Policy, and Return to Investors, National Tax basic allowance of e 7,664 for singles and e 15,328 Journal, 20 (4): 444-454. for married couples (see section 32a of the Income Federal Statistical Office (2007): Trade tax rates rose slightly on a federal average in 2006, press release dated 08/22/2007, Tax Code). http://www.destatis.de/jetspeed/portal/cms/Sites/destatis/ Internet/EN/press/pr/2007/08/PE07__329__735.psml. * (Access Date: 2009-01-29). The values in Table 2 neglect the influence of τi on θ. By iteration we can show that the critical Fehr, Hans and Wolfgang Wiegard (2003): ACE for Germany? Fighting for a Better Tax System, in: Michael Ahlheim, Heinz- tax rates are slightly higher. At a maximum we Dieter Wenzel, and Wolfgang Wiegard (eds.), Steuerpolitik - identify a deviation of 0.6 percentage points from Von der Theorie zur Praxis: Festschrift für Manfred Rose, the rates determined for an exogenously given θ. Springer: Berlin et al., 297-324. We find similar deviations if we vary other model Fischer, Edwin O., Robert Heinkel, and Josef Zechner (1989): Dynamic Capital Structure Choice: Theory and Tests, Journal parameters. of Finance, 44 (1): 19-40. Fung, William K.H. and Michael F. Theobald (1984): Dividends Acknowledgements and Debt under Alternative Tax Systems, Journal of Financial We are indebted to two anonymous referees and and Quantitative Analysis,19(1):59-72. the department editor, Rainer Niemann, for their Gerard, Marcel (2006): Belgium Moves to Dual Allowance for Corporate Equity, European Taxation, 46 (4): 156-162. very valuable suggestions, which helped to improve Gouthière, Bruno (2005): A Comparative Study of the Thin the paper considerably. 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Huizinga, Harry, Luc Laeven, and Gaëtan Nicodème (2006): Overesch, Michael and Georg Wamser (2006): German Capital Structure and International Debt Shifting in Europe, Inbound Investment, Corporate Tax Planning, and Thin- ETPF Research Paper, European Tax Policy Forum: London. Capitalization Rules - a Difference-in-Differences Approach, Discussion Paper No. 06-075, Zentrum für Europäische International Bureau of Fiscal Documentation (2006): Euro- Wirtschaftsforschung: Mannheim. pean Tax Handbook 2006, C.F. IBFD: Amsterdam. Overesch, Michael and Georg Wamser (2009): Corporate Jensen, Michael C. and William H. Meckling (1976): Theory of Tax Planning and Thin-Capitalization Rules: Evidence from the Firm: Managerial Behavior, Agency Costs and Ownership a Quasi-Experiment, Applied Economics, forthcoming. Structure, Journal of Financial Economics, 3 (4): 305-360. Romanelli, Luca (2006): Italy, in: Juhani Kesti (ed.): European Kiesewetter, Dirk and Andreas Lachmund (2004): Wirkungen Tax Handbook 2006, International Bureau of Fiscal Documen- einer Abgeltungssteuer auf Investitionsentscheidungen und tation, Amsterdam: 363-382. Kapitalstruktur von Unternehmen, Die Betriebswirtschaft,64 (4): 395-411. Schneller, Meir I. (1980): Taxes and the Optimal Capital Struc- ture of the Firm, Journal of Finance, 35 (1): 119-127. Kim, E. Han (1978): A Mean-Variance Theory of Optimal Capi- tal Structure and Corporate Debt Capacity, Journal of Finance, Swoboda, Peter (1991): Irrelevanz oder Relevanz der Kapital- 33 (1): 45-63. struktur und Dividendenpolitik von Kapitalgesellschaften in Deutschland und Österreich nach der Steuerreform 1990 bzw. Kim, E. Han (1982): Miller’s Equilibrium, Shareholder Leverage 1989?, Zeitschrift für betriebswirtschaftliche Forschung,43 Clienteles, and Optimal Capital Structure, Journal of Finance, (10): 851-866. 37 (2): 301-319. Weichenrieder, Alfons J. and Helen Windischbauer (2008): Kraus, Alan and Robert H. Litzenberger (1973): A State- Thin-Capitalization Rules and Company Responses. Experience Preference Model of Optimal Financial Leverage, Journal of from German Legislation, CESifo Working Paper 2456, Center Finance, 28 (4): 911-922. for Economic Studies: Munich. Kruschwitz, Lutz (2007): Finanzierung und Investition, 5th Wenger, Ekkehard (1983): Gleichmäßigkeit der Besteuerung ed., Oldenbourg: München et al. von Arbeits- und Vermögenseinkünften, Finanzarchiv,41(2): Laß, Frank (1999): Der Einfluß der Besteuerung auf 207-252. unternehmerische Finanzierungsentscheidungen, Shaker: Zechner, Josef (1990): Tax Clienteles and Optimal Capital Aachen. Structure under Uncertainty, The Journal of Business,63(4): Leland, Hayne E. (1998): Agency Costs, Risk Management, and 465-491. Capital Structure, Journal of Finance, 53 (4): 1213-1243. Litzenberger, Robert H. and James C. van Horne (1978): Eli- mination of the Double Taxation of Dividends and Corporate Biographies Financial Policy, Journal of Finance, 33 (3): 737-750. Alexandra Maßbaum is doctoral student and re- Marino, Tancredi and Massimiliano Russo (2008): Italian search assistant at the Chair of Business Administration, Restyling of Interest Deduction Rules: the Amendments of the Italian Finance Bill for 2008, Intertax, 36 (5): 204-210. esp. Business Taxation at the University of Paderborn. She received her diploma degree in Business Adminis- Maßbaum, Alexandra and Caren Sureth (2008): The Im- tration with specialization in accounting, taxation, au- pact of Thin Capitalization Rules on Shareholder Financ- ing, http://www.arqus.info/paper/arqus_39.pdf (Access Date: diting, and management accounting, as well as corporate 2009-11-10). and tax law from the University of Osnabrück. Miller, Merton H. and Myron S. Scholes (1978): Dividends and Caren Sureth is Professor and Chair of Business Ad- Taxes, Journal of Financial Economics, 6 (4): 333-364. ministration, esp. Business Taxation since 2004 and also Mintz, Jack and Alfons J. Weichenrieder (2005): Taxation Head of the Center for Tax Research at the Unversity of and the Financial Structure of German Outbound FDI, CESifo Paderborn. She received her doctorate from the Univer- Working Paper 1612, Center for Economic Studies: Munich. sity of Bielefeld, where she also reached her habilitation. Modigliani, Franco and Merton H. Miller (1958): The Cost of She studied Business Administration, English, French, Capital, Corporation Finance and the Theory of Investment, and Chinese and received her Diploma Degree at the American Economic Review 48 (3): 261-297. University of Passau. Her main fields of research are Modigliani, Franco and Merton H. Miller (1963): Corporate the impact of taxation on entrepreneurial decisions, tax Income Taxes and the Cost of Capital: a Correction, American planning, and taxation under uncertainty. Economic Review, 53 (3): 433-443. Myers, Stewart C. (1984): The Capital Structure Puzzle, Journal of Finance, 39 (3): 575-592. Myers, Stewart C. (2001): Capital Structure, Journal of Eco- nomic Perspectives, 15 (2): 81-102. OECD (1987): Issues in International Taxation, No 2, Thin Capitalization: Organisation for Economic Co-Operation and Development: Paris. Offermanns, René (2006): Belgium, in: Juhani Kesti (ed.): European Tax Handbook 2006, International Bureau of Fiscal Documentation, Amsterdam: 63-82.

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