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Abstract

Thin-capitalization rules (TCRs) aim at limiting the tax advantage of internal debt financing by restricting the tax deductibility of the corresponding interest expenses. This article examines how subsidiaries of multinational firms respond to a change in the German thin-capitalization legislation. The empirical analysis not only demonstrates that the TCR effectively restricts internal debt financing, it also suggests that firms are able to avoid taxation of interest by substituting external for internal debt. The empirical approach applies propensity score matching techniques and exploits the German tax reform 2001 to solve endogeneity problems.