For over two decades, policymakers worldwide have worked to combat profit shifting and tax avoidance, leading to the widespread adoption of anti-tax avoidance regulations. Notable examples include the European Union’s Anti-Tax Avoidance Directive and the Tax Cuts and Jobs Act in the United States. Despite these efforts, the overall costs and benefits of such regulations remain unclear. While some research suggests that these rules have reduced profit shifting, other studies indicate that firms are finding ways to bypass the rules or justify reporting their profits in low-tax jurisdictions through legitimate business activities. In a new study, we explored whether these regulations have negative real effects on resource allocation in the economy.

The focus of our research is on interest limitation rules, a key anti-tax avoidance measure in many countries, and their impact on resource allocation through mergers and acquisitions (M&A). Investments in M&A play a critical role in economic growth and innovation, totaling nearly $2.6 trillion globally in 2023. Debt financing is particularly important for M&A because interest payments are deductible. However, interest limitation rules reduce their deductibility, raising the cost of debt financing and acquisitions. We hypothesize that these rules will reduce M&A activity, as the increased cost of debt raises the investment hurdle rate. However, this hypothesis may not hold if acquirers can bypass the rules by exploiting exceptions or by shifting from debt to equity financing.

Our study leverages the staggered introduction of performance-based interest limitation rules (also known as earnings stripping rules) in OECD and EU countries to examine their impact on M&A investments. These rules cap the deductibility of interest if it exceeds a fixed percentage of a performance measure, such as EBITDA. The staggered adoption of these rules provides quasi-exogenous variation, which we use in a stacked difference-in-differences (DiD) analysis. This econometric strategy addresses concerns about potential bias in staggered DiD models. We form separate cohorts for each of the 17 interest limitation rules introduced during the sample period. The treated group includes countries that implemented a performance-based interest limitation rule, while the control group comprises countries that did not. Using linear probability models with firm and industry-year fixed effects, we compare the likelihood of firms engaging in at least one M&A deal per year before and after the introduction of interest limitation rules in treated and control countries.

Data on deals come from the Securities Data Company’s Platinum M&A database, while financial data are from Datastream. Our final sample consists of 187,716 firm-year observations from firms headquartered in OECD and EU countries, including 22,333 completed M&A deals announced between 2005 and 2021. The baseline analysis reveals that the likelihood of an acquisition decreases by 1.6 percentage points following the implementation of interest limitation regulations, representing a 15 percent decrease in M&A activity compared with the unconditional probability in the sample. Aggregated at the country-industry level, there is an 11 percent decline in M&A activity. Additionally, using deal value as an alternative dependent variable, the average decline is $11.2 million. These findings are both statistically significant and economically meaningful.

The results hold up across a variety of robustness checks. By excluding periods potentially confounded by other reforms, we address concerns that the introduction of interest limitation rules may be correlated with economic conditions or other tax reforms affecting M&A activity. The findings persist even with changes in sample selection, different fixed effects, entropy balancing, logit regressions, and staggered DiD models.

We evaluate two key conditions necessary for interest limitation rules to affect M&A activity. First, we find that leverage decreases in firms subject to these rules, consistent with prior literature. Second, we show that the effect of interest limitation rules on M&A activity is concentrated on deals more reliant on debt financing. Indeed, we observe a significant decline in fully cash-financed deals, where cash is typically borrowed, while fully stock-financed deals remain unaffected. The lack of impact on stock-financed deals suggests that firms may not be able to easily switch their financing from debt to equity.

To further test whether the findings are driven by reduced debt financing, we conduct cross-sectional tests to examine differences in the likelihood of using debt as a source of deal financing. Following the pecking-order theory, acquirers with sufficient internally generated cash are more likely to use their cash reserves for M&A transactions, while those with insufficient funds will rely on debt financing. Consistent with this theory, we find that M&A activity after the reform declined more at firms with low cash flows than at firms with higher cash flows. According to agency theory, managers who prioritize personal interests over shareholder wealth may view debt as less attractive, leading better-governed acquirers to reduce the number of acquisitions they do more than those with weaker governance. We find evidence that supports this possibility.

We validate the main findings in two ways. First, we expect firms with lower interest-deduction capacity (i.e., a lower profit-to-interest ratio) to reduce M&A activity, as they are more likely to be affected by the regulations. Consistent with this conjecture, we find that these firms show a significantly greater decline in deal probability compared with those that have higher interest deduction capacity. Second, we examine the impact of the strictness of interest limitation rules by considering regulation-specific factors. Our results indicate that firms in countries with stricter rules significantly reduce M&A activity, while firms in countries with more lenient rules do not.

Finally, we investigate how interest limitations affect the quality of deals. We expect deal quality to decline on average after the introduction of these rules. Neoclassical theory suggests that increased debt financing costs, leading to a restricted set of potential targets, will result in suboptimal outcomes. Consistent with this, acquirers experience lower cumulative abnormal returns (CARs) during the three-day window surrounding M&A announcements involving cash deals after interest limitation rules are enacted. Multivariate tests indicate a 0.56 percentage point decline in CAR for cash acquirers in countries with stringent interest limitation rules. We observe no such effect on stock-financed deals. Overall, the results show that interest limitation rules not only reduce M&A activity but also diminish the quality of the deals, indicating that these rules hinder M&A synergies.

Our paper makes several novel contributions to the literature. First, it advances the broad literature on the real effects of anti-tax avoidance regulations by providing insights into the direct economic costs of such rules. It shows that interest limitation rules reduce M&A activity and lead to a decline in deal quality, highlighting their adverse impact on resource allocation in the economy. Second, our study contributes to the literature on interest limitation rules, focusing on earnings-stripping rules, which are currently the most widely adopted form of such regulations. Our findings show that these rules have a significant negative impact on large investments, such as M&A, making them more restrictive than previous thin-capitalization rules. Third, our paper advances the M&A literature by examining a setting where the cost of debt financing increases, revealing that debt plays a crucial role in deal financing that cannot easily be replaced.

Finally, our findings have important policy implications. While interest limitation rules and other anti-tax avoidance measures aim to reduce profit shifting, our study highlights their adverse effects on M&A investments, suggesting significant economic costs. Therefore, our results should inform policymakers as they evaluate the costs and benefits of anti-tax avoidance regulations, particularly considering the growing implementation of such rules.

This post comes to us from Eliezer M. Fich at Drexel University and Lisa Hillmann, Johanna Kling, and Barbara Stage at WHU – Otto Beisheim School of Management. It is based on their recent paper, “The Real Effects of Interest Limitation Rules: Evidence from M&A Investments,” available here.