The New Limitation on Interest Expense
In April 2018, the Treasury Department and IRS issued Notice 2018-28, which provides guidance to taxpayers for complying with the new rules under section 163(j) that limit deductions for interest expense.
Notice 2018-28 (the Notice) states that the Treasury Department and IRS will be issuing proposed regulations in this area, but until then, taxpayers can rely on the guidance outlined in the publication.
The Notice explains that prior to the Tax Cuts and Jobs Act (TCJA), disqualified interest under section 163(j) was denied a deduction if two thresholds were satisfied.
- The payor’s debt-to-equity ratio exceeded 1.5-to-1.0 (safe harbor).
- The payor’s net interest expense exceeded 50% of its adjusted taxable income.
Under the old rules, 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 were treated as paid or accrued in the succeeding taxable year and could be carried forward indefinitely. Any excess limitation could be carried forward three years.
The TCJA passed by Congress in December 2017 amended the rules under section 163(j) by creating a new limitation for interest deductions. The new rules limit the deduction of business interest expense in taxable years beginning after December 31, 2017 to the sum of:
- The taxpayer’s business interest income,
- 30% of the taxpayer’s adjusted taxable income, AND
- The taxpayer’s floor plan financing interest for the taxable year.
The last item, floor plan financing, is only applicable to dealers of self-propelled motor vehicles, boats, and farm equipment. Thus, under the new rules, a taxpayer’s limitation on net interest expense will generally be 30% of adjusted taxable income plus business interest income. Any business interest not allowed as a deduction for a taxable year as a result of the limitation is treated as business interest paid or accrued in the next taxable year and may be carried forward indefinitely. Section 163(j), as amended by the Act, does not provide for the carryforward of any excess limitation.
For taxable years beginning before January 1, 2022, adjusted taxable income is defined as earnings before interest, taxes, depreciation and amortization (EBITDA). Net operating losses and deductions under the new section 199A are excluded as well.
For taxable years beginning on or after January 1, 2022, adjusted taxable income is defined as earnings before interest and taxes (EBIT). This means deductions for depreciation, amortization and depletion will be allowed in the future.
The new limitation applies to all taxpayers, except for those with average gross receipts less than $25 million over the three preceding taxable years and certain utility, real property, and farming businesses.
The Notice states that the forthcoming regulations will address how consolidated groups should calculate the limitation, and how amounts disallowed and carried forward under the old rules will be treated under the new provisions. It also outlines how partnerships and S corporations should calculate the new limitation.
With respect to C corporations, the Notice clarifies that all interest expense will be considered properly allocable to a trade or businesses. It also provides that all interest income will be considered business interest income. This means that a C corporation cannot exclude interest expense or interest income as investment items under the new rules.
Lastly, the Notice provides guidance on the coordination of the new section 163(j) rules with the new base erosion and anti-abuse tax (BEAT) provisions under section 59A. This information is helpful to both U.S.-based multinationals and foreign-based multinationals, especially those considering restructuring their operations as a result of the new international provisions.
Tara Fisher has been practicing international tax for nearly 20 years. Her professional background includes working for the U.S. Congress Joint Committee on Taxation, the national tax practice of PricewaterhouseCoopers, the University of Pittsburgh, and American University in Washington D.C. She is a licensed CPA and holds both an undergraduate and graduate degree in accounting from the University of Virginia.