The IRS recently issued Notice 2018-28 (the Notice) providing interim guidance on the limitation of the deduction of business interest expense under amended IRC §163(j).
Within the Notice, the IRS states that it intends to issue proposed regulations, and identifies certain issues that the proposed regulations will address including:
Application of IRC §163(j) to consolidated groups
The impact of IRC §163(j) to earnings and profits (E&P)
Treating a C corporation’s interest income and expense as business interest income or expense unless specifically carved out from IRC §163(j)
The IRS also stated that until the proposed regulations are issued, taxpayers may rely on the guidance set forth in the Notice for tax years beginning after December 31, 2017.
The Tax Cuts and Jobs Act (TCJA) amended IRC §163(j) which limits the deductibility of interest expense. Prior to the TCJA amendment, former IRC §163(j) disallowed deduction of “disqualified interest” paid or accrued by a corporation if: (1) the payor’s debt-to-equity ratio exceeded 1.5 to 1.0, and (2) the payor’s net interest expense exceeded 50% of its adjusted taxable income (ATI).
Under former IRC §163(j), “disqualified interest” included interest paid or accrued to:
Related parties when no Federal income tax was imposed with respect to such interest;
Unrelated parties in certain instances in which a related party guaranteed the debt; or
A real estate investment trust (REIT) by a taxable REIT subsidiary of that REIT.
Disallowed interest amounts under former IRC §163(j) were treated as interest paid or accrued in the succeeding tax year and could be carried forward indefinitely. Additionally, any excess limitation could be carried forward three years under former IRC §163(j).
NEW PROVISIONS UNDER TCJA
The TCJA amended IRC §163(j) to further limit business interest expense deductions. The amendments apply to tax years beginning after December 31, 2017. A taxpayer’s annual deduction for business interest expense is now limited to the sum of: (1) the taxpayer’s business interest income and (2) 30% of the taxpayer’s adjusted taxable income for the tax year.
The new limitations do not apply to taxpayers that have average annual gross receipts of $25 million or less. However, this exception for small business taxpayers does not apply to tax shelters.
CAUTION: For purposes of amended 163(j)(3), the term, “tax shelter” is broader than many taxpayers assume, and includes a partnership or other flow-through entity if more than 35% of the tax losses of such entity are allocable to limited partners or limited entrepreneurs.1
Also, the new limitations also do not apply to interest expense incurred in connection with:
An electing real property trade or business,
An electing farming business,
Regulated public utilities,
Floor plan financing interest of automotive dealers, or
The performance of services as an employee.
The new provisions apply regardless of whether the interest payment is made to a foreign person or a US person. Further, under the new law, the disallowed business interest expense can be carried forward indefinitely.
TRANSITION GUIDANCE FROM THE NOTICE
In Notice 2018-28, The IRS provides the following guidance which taxpayers can rely on until future regulations are published.
Treatment of Disallowed Disqualified Interest Carryforward
Future regulations will clarify that taxpayers with disallowed business interest are permitted to carryforward the disallowed business interest to the succeeding tax year. Such interest is treated as business interest paid or accrued in the succeeding tax year.
Such regulations will also address the interaction of IRC §163(j) with IRC §59A, relating to the tax on base erosion payments of taxpayers with substantial gross receipts. The future regulations will provide that business interest carried forward from a tax year beginning before January 1, 2018, will be subject to IRC §59A in the same manner as interest paid or accrued in a tax year beginning after December 31, 2017.
Application to Consolidated Groups
Forthcoming regulations will clarify that the limitation found in IRC §163(j)(1) regarding the amount allowed as a deduction for business interest applies at the consolidated group level. As such, a consolidated group’s taxable income for purposes of calculating adjusted taxable income will be its consolidated taxable income. The Notice provides that intercompany obligations will be disregarded for purposes of determining the limitation in IRC §163(j)(1).
The forthcoming consolidated group regulations under IRC §163(j) are not anticipated to apply to affiliated groups that do not file consolidated returns.
Business Interest Income and Expense for C Corporations
The Treasury Department and IRS intend to issue regulations clarifying that all interest paid or accrued by a C corporation on debt of such C corporation will be business interest expense, and all interest income on debt held by a C corporation will be business interest income under the new rules.
No Impact on E&P
The IRS further states in the Notice that forthcoming regulations will clarify that the disallowance of interest and the carryforward of a deduction for a C corporation’s business interest expense will not affect whether or when such business interest expense reduces earnings and profits of the payor C corporation.
Treatment of Excess Limitation Carryforward
The amended IRC §163(j) does not provide for the carryforward of any excess limitation. The Notice states forthcoming regulations will clarify that no amount previously treated as an excess limitation carryforward may be carried to tax years beginning after December 31, 2017.
Business Interest Income and Floor Plan Financing of Partnerships and Partners
Future regulations will provide that a partner’s annual deduction for business interest cannot include the partner’s share of the partnership’s automotive floor plan financing interest. The partner may only include its share of the excess of the partnership’s business interest income over the partnership’s business interest expense (not including automotive floor plan financing). Such regulations are intended to prevent the double counting of business interest income and floor plan financing interest for purposes of the deduction afforded by Sec. 163(j).
WHAT DOES COHNREZNICK THINK?
In Notice 2018-28, the IRS provides helpful guidance to taxpayers and answers some questions regarding how to appropriately apply the §163(j) business interest deduction limitation. However, many unanswered questions remain. For example, the Notice does not address the application of §163(j) to foreign entities, or the interaction between §163(j) and the new global intangible low-taxed income (GILTI) provisions. The Notice also does not address how a consolidated group would allocate the §163(j) limitation where one or more members of the group are exempt from the §163(j) limitation. Treasury and the IRS have requested comments regarding the application of §163(j). We will continue to monitor this area and provide updates as additional guidance becomes available.
For more information, please contact Cheryl Joseph, Partner, National Tax Services, at [email protected] or 301-280-1964 or David Macall, Senior Manager, International Tax Services, [email protected] or 646-601-7774.
1See, IRC Section 1256(e)(3)(B) as cross-referenced via citations in 163(j)(3).