M&A Under Pressure: How Interest Limitation Rules Are Shaping Corporate Dealmaking

Over the past two decades, governments around the world have been tackling corporate tax avoidance, aiming to clamp down on profit shifting and safeguard tax revenues. Major regulations such as the European Union’s Anti-Tax Avoidance Directive and the U.S. Tax Cuts and Jobs Act illustrate this global trend. Yet, amid these well-intentioned reforms, a critical question remains underexplored: Do these anti-avoidance measures have unintended economic costs? Specifically, do they affect major corporate investments such as mergers and acquisitions (M&A)? Our recent study dives into this issue, focusing on the impact of interest limitation rules— one of the key anti-avoidance policies with potentially strong effects on M&A financing.

M&A deals are one of the most substantial economic investments, amounting to nearly $2.6 trillion worldwide in 2023 alone, fueling innovation, economic growth, and industry restructuring through reallocation of resources in the economy. Debt financing, often preferred for its tax advantages, plays an essential role in funding deals. However, interest limitation rules reduce the tax deductibility of debt costs, thus elevating the cost of borrowing. This increase in costs could potentially discourage firms from pursuing acquisitions.

To explore the impact of recent interest limitation rules on M&A, we analyze the staggered implementation of earnings stripping rules—interest limitation rules based on performance measures—in OECD and EU countries. These rules limit interest deductibility above a fixed percentage (usually around 30%) of EBIT(DA) of a firm. Using rigorous econometric techniques and a large dataset encompassing over 22,000 completed M&A deals from 2005 to 2021, we found robust evidence that interest limitation rules indeed deter M&A activity.

Specifically, our findings show a 15% decline in the likelihood of firms undertaking acquisitions following the introduction of these rules. When viewed at the country-industry level, this translates into an 11% decrease in M&A transactions, representing a significant disruption to corporate investment activities. In monetary terms, the average M&A deal value dropped by approximately $14 million post-regulation.

The negative impact of these regulations predominantly affects deals heavily reliant on debt financing. Fully cash-financed acquisitions, frequently financed through borrowing, are sharply reduced, whereas stock-financed deals remain unaffected. This divergence suggests firms find it challenging to switch the deal financing from debt to equity, highlighting their strategic reliance on debt.

We also uncovered relevant cross-sectional effects consistent with the relevance of debt for deal financing. For example, firms with limited internal cash reserves inherently depend on external debt and face steeper declines in M&A activity. In contrast, firms flush with cash were relatively unaffected. These results underscore that the regulations disproportionately penalize firms that rely on debt financing.

Additionally, the strictness of regulations mattered greatly. Countries adopting stringent interest limitation rules experienced pronounced reductions in deal-making activity, while countries with softer measures saw little to no reductions. Moreover, the effect is concentrated among domestic deals, while we find no effect for cross-border deals, suggesting that cross-border deals might be financed through foreign sources, making them less exposed to local interest limitation rules. We also find that firms exhibit general declines in both debt and investment levels following the introduction of these rules.

Importantly, interest limitation regulations did not just reduce the quantity of deals—they also impaired deal quality. Acquirers in jurisdictions with such rules experienced notably lower abnormal stock returns around acquisition announcements, reduced deal premiums, and more frequent post-deal goodwill write-offs, suggesting that these regulations might be forcing firms into less synergy-generating deals as the best deals become out of reach.

From a policy standpoint, our findings illuminate critical unintended consequences of these regulations. While interest limitation rules aim to curtail aggressive tax avoidance, they inadvertently impose economic costs by stifling M&A transactions and possibly eroding corporate value creation.

The broader implications for policymakers are clear: anti-tax avoidance rules must be carefully designed and evaluated beyond their immediate tax implications. Policymakers should acknowledge and carefully weigh the broader economic impacts, especially considering that M&A activities are crucial drivers of economic growth and innovation.

In conclusion, while fighting tax avoidance is an essential and commendable goal, regulators must act carefully. The unintended economic fallout of interest deduction limits could be substantial. Ultimately, a balanced approach that curtails avoidance without choking corporate M&A investment is vital. The stakes are high, and policymakers should be vigilant in assessing these broader economic consequences to foster sustainable, long-term growth. Our full study will soon be available here.

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Eliezer M. Fich is the Trustee Professor of Finance at Drexel University’s LeBow College of Business, and an ECGI Research Member.

Lisa Hillmann is an Assistant Professor of Financial Accounting and Business Taxation at WHU  – Otto Beisheim School of Mangement. 

Johanna Kling is a Doctoral Student at WHU  – Otto Beisheim School of Mangement. 

Barbara Stage is Assistant Professor for Financial Accounting and Business Taxation at the WHU – Otto Beisheim School of Management.

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