The Impact of Thin Capitalization Rules on Subsidiary Financing: Evidence from Belgium

In order to prevent excessive profit shifting using internal debt by multinational firms, several countries have introduced thin capitalization rules limiting the deductibility of interests on internal loans. While prior research has consistently found that firms affected by thin capitalization rules reduce their internal debt-to-equity ratio, the means through which this reduction is achieved are understudied. This paper employs a Comparative Interrupted Time Series methodology to identify the short-term effects of newly introduced thin capitalization rules on subsidiaries' financing preferences, using a new dataset of detailed firm-level accounting data. The results indicate a reduction in internal debt and an increase in equity for affected firms, both by an increase in paid-up capital and by an increase in retained earnings. These findings about the way firms react may help lawmakers to estimate impact of future tax regulations.