The role of escape clauses: Firm response to thin capitalization rules

Multinational firms can use internal debt to shift taxable income across jurisdictions. To limit such profit shifting and protect the corporate tax base, many countries use thin capitalization rules that restrict interest deductibility. These rules often include escape clauses that exempt firms below specified thresholds, but such thresholds may create incentives for avoidance within corporate groups. This paper evaluates Norway’s 2014 thin capitalization rule using difference-in-differences, bunching, and regression discontinuity designs. We find that exposed firms sharply reduce leverage after the reform, driven by lower intra-group borrowing and interest costs, with no detectable effects on firm performance. At the corporate-group level, leverage remains unchanged, indicating that firm-level responses primarily reflect intra-group debt reallocation. We document substantial bunching below the rule’s exemption thresholds, especially among newly created subsidiaries, and show that internal debt is disproportionately shifted to these bunching firms. Although firms eliminate most of their initial exposure to the rule itself, this happens largely through reduced internal lending, and we find suggestive evidence of higher taxable income in the medium run. Because we observe only the Norwegian parts of multinational groups, we cannot provide conclusive evidence on cross-border profit shifting. Overall, the findings show that firm-level escape clauses generate strategic avoidance responses within corporate groups, while also suggesting that the reform may have protected the Norwegian tax base.