Tax-Based Collateral Limitations, Borrowing Arrangements and Firm Value
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I examine a tax-related friction that limits U.S. multinational corporations’ ability to use foreign assets as collateral in obtaining U.S. debt financing. I find that tax-based collateral limitations are associated with reduced debt capacity and higher borrowing costs. Additionally, I show that collateral limitations are associated with a decrease in the use of capital covenants and an increase in the use of performance covenants in private debt agreements. While the U.S. House and Senate passed versions of the Tax Cuts and Jobs Act of 2017 that included provisions to eliminate tax-based collateral limitations, the final version surprisingly retained these limitations. I find a negative relation between the extent to which a firm is affected by tax-based collateral limitations and market reactions around the passage of the final version of the Act, suggesting tax-based collateral limitations constrain borrowing arrangements and thereby reduce firm value. The costs associated with these collateral limitations offer one explanation for the under-sheltering puzzle, which suggests firms fail to take advantage of the supposed benefits of tax avoidance strategies.
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