Interest Allocation Rules, Financing Patterns, and the Operations of U.S. Multinationals

50 Pages Posted: 13 Aug 2000

See all articles by Kenneth Froot

Kenneth Froot

National Bureau of Economic Research (NBER); Harvard Business School

James R. Hines Jr.

University of Michigan; NBER

Date Written: November 1994

Abstract

This paper examines the impact of the 1986 change in U.S. interest allocation rules on the investment and financing decisions of American multinationals. The 1986 change reduced the tax deductibility of the interest expenses of firms with excess foreign tax credits. The resulting increase in the cost of debt gives firms incentives to substitute away from using debt finance. Furthermore, to the extent that perfect financing substitutes are not available, the overall cost of capital rises as well. The empirical tests indicate that the loss of tax deductibility of parent-company interest expenses appears to reduce significantly borrowing and investing by firms with excess foreign tax credits. The same firms tend to undertake new lease commitments, which may reflect the use of leases as alternatives to capital ownership. In addition, firms affected by the tax change tend to scale back the scope of their foreign and total operations. These results are consistent with the hypothesis that firms substitute away from debt when debt becomes more expensive, and also with the hypothesis that the loss of interest tax shields increases a firm's cost of capital.

Suggested Citation

Froot, Kenneth and Hines, James Rodger, Interest Allocation Rules, Financing Patterns, and the Operations of U.S. Multinationals (November 1994). NBER Working Paper No. w4924. Available at SSRN: https://ssrn.com/abstract=238461

Kenneth Froot (Contact Author)

National Bureau of Economic Research (NBER) ( email )

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Harvard Business School ( email )

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James Rodger Hines

University of Michigan ( email )

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Ann Arbor, MI 48109-1215
United States

NBER

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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