Interest deductibility restrictions and organizational form

Abstract

Using a theoretical model for risky investment decisions, we study the effect of interest deductibility restrictions on the choice of organizational form. We analyze the two most widely used approaches: first, rules that limit the interest deductibility if the firm’s leverage exceeds a specific level, and second, rules that restrict the interest deduction if the interest expenses exceed a specific percentage of the firm’s earnings. Although these restrictions apply uniformly for partnerships and corporations in many countries, we find that they usually distort the choice of organizational form. We demonstrate that only leverage-based interest deductibility restrictions can in theory be modified to achieve organizational form neutrality. However, this requires a legal form dependent application or absence of dividend taxation and in any case a full loss offset which is in contrast to current law in many countries. If one considers corporate loss offset limitations, both types of interest deductibility restrictions always distort the choice of organizational form. Thus, the introduction of interest deductibility restrictions is actually in conflict with the legislators’ often declared aim to design tax systems that are neutral with respect to the choice of organizational form.