Debt-Equity Limitations in Thin Capitalization Rules: Canadian Evidence
38 Pages Posted: 6 Jan 2008
Date Written: January 4, 2008
Effective 2000, Canada's thin capitalization rules required firms to limit their debt-equity ratio at 2:1 from the previous 3:1. This measure was justified by the Department of Finance as better reflecting actual leverage of Canadian firms across all industries. Using both conservative and broad measures of leverage, this study examines the extent to which the new rules reflect leverage ratios of Canadian firms. Results show that industry is a statistically significant determinant of leverage under both definitions of leverage. Under the conservative definition of leverage, which more closely resembles the technical definition in the Income Tax Act, the mean debt-equity (or leverage) ratio was 1.06:1. Of the 64 industries (as classified by two-digit SIC code), only the real estate industry was found to have a leverage ratio (for tax purposes) exceeding 2:1. Under the broad (less conservative) definition of leverage, the mean leverage ratio was 2.66:1, with 32 industries reporting mean leverage ratios exceeding 2:1. The evidence suggests that the 2:1 threshold (or benchmark) in Canada`s thin capitalization rules seems reasonable. Firms in the real estate industry seem to have had the greatest difficulty responding to the ratio change.
Keywords: thin capitalization, Canada, ratios, debt-equity, industry, leverage
JEL Classification: H29, G32, K34, L79
Suggested Citation: Suggested Citation