Interest barrier rules as a response to highly leveraged transactions

Purpose - The tax advantage of debt is considered an important motivation for highly leveraged transactions. The German government limited the tax deductibility of interest expenses to 30.0 percent of earnings before interest, taxes, depreciation, and amortization (the interest barrier rule) in 2008 to reduce the tax incentives for debt financing. This study aims to evaluate the impact of the introduction of the interest barrier rule. Design/methodology/approach - The paper analyzes the changes in the value of the tax shield for German leveraged buyouts as a result of the promulgation of an interest barrier rule. Tax shields are computed to quantify the wealth transfer from taxpayers to corporations. Findings - Prior to the 2008 tax reform, tax shields contributed 8.4 percent to the transaction price, thereby raising the equity value by 33.0 percent on average. With the introduction of the interest barrier rule, the value of tax shields is reduced by 35.1 percent. Affecting more than 75 percent of buyouts, the rule significantly lessens the tax incentive for high levels of debt. The reduction of the corporate tax rate from 31.7 percent to 26.3 percent further lowers the value creation potential. The limited interest deductibility may therefore reduce the number of leveraged buyouts and hence economic growth, unless other non‐debt forms of financing can fulfill the need for capital. Originality/value - As the first continental European study, this research concentrates on the impact of the German interest barrier rule on value creation in highly leveraged transactions. Conclusions can be drawn in a broader European context.