The IRS issues initial guidance for computing the Business Interest Expense Limitation under amended Section 163(j)



April 06, 2018

Tax Alert

Author(s): Sean Clancy, Frank J. Emmons, Shahzad A. Malik, Brian W. Mahoney

On December 22, 2017, President Trump signed into law a bill generally referred to as the Tax Cuts and Jobs Act (the “Act”). The Act amended Section 163(j) of the Internal Revenue Code (the “Code”) to provide that for certain businesses, the annual deduction for business interest expense is limited to the sum of: (i) its business interest income for the taxable year; (ii) 30% of its “adjusted taxable income” for the taxable year; and (iii) its floor plan financing interest (essentially interest on loans used to purchase cars, trucks, boats and the like for resale) for the taxable year. “Adjusted taxable income” for purposes of Section 163(j) is essentially earnings before interest, taxes, depreciation and amortization (“EBITDA”) for tax years beginning before January 1, 2022, and earnings before interest and taxes (“EBIT”) for tax years beginning on or after that date.

Section 163(j) only applies to businesses other than: (i) businesses with average gross receipts over the prior three years of less than $25 million (i.e., small businesses); (ii) employees (the Code defines employees as trades or businesses); (iii) businesses that furnish or sell certain types of energy; (iv) electing farming businesses; and (v) electing real property trades or businesses.

On April 2, 2018, the IRS published Notice 2018-28 (the “Notice”), announcing the IRS’s intention to issue proposed regulations to clarify Section 163(j). The Notice also provides interim guidance upon which taxpayers are permitted to rely until the IRS issues proposed regulations. Finally, the Notice withdraws previously issued proposed regulations under Section 163(j). The interim guidance provided by the Notice is summarized as follows.

Treatment of pre-Act disqualified interest expense

Before the Act, Section 163(j) disallowed a deduction for “disqualified interest” if the taxpayer’s debt-equity ratio exceeded 1.5 to 1 and the taxpayer’s net interest expense exceeded 50% of its “adjusted taxable income,” essentially EBITDA. Disqualified interest included interest paid or accrued to: (i) related parties when no federal income tax was imposed with respect to such interest; (ii) unrelated parties in certain instances in which a related party guaranteed the debt; or (iii) a real estate investment trust (“REIT”) by a taxable REIT subsidiary. Disqualified interest expense disallowed could be carried forward indefinitely and any excess limitation (i.e., the excess, if any, of 50% of the taxpayer’s adjusted taxable income over the taxpayer’s net disqualified interest expense) could be carried forward three years.

The Notice provides that taxpayers with disqualified interest disallowed under the previous Section 163(j) for the last taxable year beginning before January 1, 2018, may carry such interest forward as a business interest expense to the taxpayer’s first taxable year beginning after December 31, 2017. Such business interest expense carried forward will be subject to potential disallowance under the new Section 163(j), as amended by the Act and the base erosion and anti-abuse tax (“BEAT”).

For example, if interest paid or accrued by a taxpayer to a foreign person that is a related party under the BEAT is carried forward to a taxable year beginning after December 31, 2017, and a deduction is otherwise allowable for such interest, then the interest is treated as a “base erosion payment” and is subject to the BEAT. For more information on the BEAT, see our alert titled “ Introduction to the BEAT (Base Erosion Anti-Abuse Tax) for investors in tax credit projects.” Furthermore, consistent with new Section 163(j) that applies the limitation on a year-by-year basis, no amount previously treated as excess limitation may be carried forward to taxable years beginning after December 31, 2017.

Super-affiliation rules apply to new Section 163(j)

The Notice provides that groups treated as affiliated under the super-affiliation rules of previously proposed regulations under Section 163(j) will be treated as affiliated under the new Section 163(j), as amended by the Act. These rules were aimed at preventing taxpayers from circumventing the restrictions on debt by using related entities. However, although the super-affiliation rules treat all members of an affiliated group as one taxpayer, without regard to whether such affiliated group files a consolidated return, the IRS and Treasury Department anticipate that the proposed regulations under the new Section 163(j) will not include a general rule treating an affiliated group as a single taxpayer if such consolidated group does not file a consolidated return. The proposed regulations will provide rules for allocating business interest expense from a group treated as affiliated under the prior Section 163(j) to taxpayers under the new Section 163(j), as amended.

Business interest expenses and income of C corporations

The Notice provides that all interest paid or accrued by a C corporation on indebtedness of such C corporation will be treated as business interest expense for purposes of Section 163(j). Similarly, all interest on indebtedness held by such C corporation that is includible in gross income of the C corporation will be business interest income for purposes of Section 163(j). S corporations may differentiate between investment interest expense, not subject to Section 163(j), and business interest expense, subject to Section 163(j).

The IRS’s forthcoming proposed regulations under Section 163(j) will address whether interest expense and interest income that flows from a pass-through entity, such as a partnership, to a C corporation that holds an interest in the entity is automatically characterized to such C corporation as business interest expense or income within the meaning of Section 163(j).

Section 163(j)’s application at the consolidated group level

Section 163(j) provides that the limitation on the amount allowed as a deduction for business interest expense applies at the level of the consolidated group. The Notice provides that a consolidated group’s taxable income for purposes of calculating adjusted taxable income under Section 163(j) will be its consolidated taxable income. Intercompany obligations will be disregarded for purposes of determining the limitation.

The Notice provides that the IRS’s forthcoming proposed regulations will address other issues concerning the application of Section 163(j) to consolidated groups, including:

  • allocation of the business interest expense limitation among group members;
  • treatment of disallowed interest deduction carryforwards when a member leaves or joins the group (including whether such carryforwards are subject to a separate return limitation year (“SRLY”) limitation);
  • rules for adjusting the basis of the stock of a subsidiary owned by another member of the consolidated group when the subsidiary has disallowed business interest expense deductions; and
  • issues related to groups with one or more members that (i) conduct an electing farming business, an electing real property trade or business, or a business that furnishes or sells certain types of energy; or (ii) whose members hold an interest in a non-corporate entity such as a partnership that conducts such a trade or business.

The IRS’s forthcoming proposed regulations will not include a general rule that treats an affiliated group that does not file a consolidated return as a single taxpayer for purposes of Section 163(j).

The impact of Section 163(j) on earnings and profits

The Notice provides that the disallowance and carryforward of a deduction for a C corporation’s business interest expense under Section 163(j) will not affect whether or when such business interest expense reduces earnings and profits of the taxpayer C corporation.

Certain rules for partners/shareholders/members of pass-through entities

Section 163(j) provides that the annual limitation on the deduction for business interest expense is applied at the partnership level and that any deduction for business interest is taken into account in determining the non-separately stated taxable income or loss of the partnership.

To prevent the double-counting of business interest expense by a partner of a partnership, the Notice provides that for purposes of calculating a partner’s annual deduction for business interest under Section 163(j), a partner cannot include the partner’s share of the partnership’s business interest income for the taxable year except to the extent of the partner’s share of the excess of (i) the partnership’s business interest income over (ii) the partnership’s business interest expense (not including floor plan financing interest expense). Furthermore, a partner cannot include such partner’s share of the partnership’s floor plan financing interest expense in determining the partner’s annual business interest expense deduction limitation under Section 163(j).

Such rules will also apply to S corporations and their shareholders. Such rules will also apply to S corporations and their shareholders.

Conclusion

The Notice provides interim answers to some of the questions posed by taxpayers regarding the new Section 163(j), as amended by the Act. The IRS requests comments on additional guidance that should be issued to assist taxpayers in computing the business interest expense limitation under Section 163(j).

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.

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