Federal Business Interest Expense Limitation and State tax treatment
The New Interest Deduction Limitation Rules
As part of federal tax reform, the Tax Cuts and Jobs Act of 2017 included many provisions that reduced the tax burden of businesses; however, Congress offset part of the cost of the tax cuts by amending Internal Revenue Code Section 163(j) by placing limits on the amount of interest expense that certain businesses can deduct which may result in a higher tax liability for corporations and investors in pass-through entities that finance acquisitions with debt. For purposes of the limitation on the deduction of business interest expense, the definition of interest is broadened and includes debt issuance costs, loan commitment fees and certain amounts associated with the time value of money.
Limitations on Deducting Business Interest Expense
Beginning for tax years starting in 2018, business interest expense that exceeds the sum of (1) 30% of a taxpayer’s “adjusted taxable income”, (2) 100% of business interest income, and (3) 100% of the taxpayer’s floor plan financing interest expense is nondeductible. (Floor plan financing interest essentially consists of interest paid to finance automobile and similar equipment inventory by dealers in that inventory). The nondeductible amount of business interest expense is treated as “excess interest” that may be carried forward indefinitely and re-enters the limitation calculation in succeeding tax years.
Definition of Adjusted Taxable Income
Adjusted taxable income (ATI) is computed by starting with taxable income for the year (disregarding the business interest limitation) and then excluding the following amounts:
- Any item of income, gain, deduction or loss not allocable to the trade or business (e.g. nonbusiness income such as gains from the sale of assets held for investment)
- Business interest income and expense
- Net operating loss deductions
- The 20% qualified business income deduction
- Capital loss carrybacks or carryovers
- Depreciation, depletion or amortization (This adjustment applies only through 2021, so the limitation will be much more restrictive for capital-intensive businesses for tax years starting in 2022)
Exceptions to the Application of Section 163(j)
Taxpayers with average gross receipts of less than $25 million over the preceding three taxable years are generally excluded from the application of Section 163(j). In addition, certain trades or businesses are excluded from the Section 163(j) interest limitation such as certain regulated utility trades or businesses, transportation of gas or steam by pipeline or the trade of business of performing services as an employee. Certain real property and farming businesses can also elect to have their businesses excluded from the application of the Section 163(j) application but at the cost of reduced tax depreciation on certain assets held by those businesses. However, whether making such an election is the better choice will depend on a variety of factors.
Application to Pass-Through Entities
For partnerships, the limitation is applied at the entity level, and then allocated to each partner in the same manner as any non-separately stated taxable income or loss items. It is the partner’s calculation to determine what excess amounts will be included or disallowed and carried forward.
S corporations are treated slightly different and in a more straightforward manner. The limitation is also applied at the entity level; however, any excess amounts are not allocated to the members, but are instead carried forward at the S corporation level. The S corporation allocates any excess taxable income and excess business interest expense to its shareholders on a pro-rata basis.
The business interest limitation applies at the consolidated return level, and a consolidated group has a single limitation. In calculating the limitation, a consolidated group’s business interest expense and business interest income is the sum of its members’ business interest expense and income. Intercompany obligations would be disregarded. Aggregation of members of an affiliated group that does not file a consolidated return would not be required.
The business interest limitation applies to a foreign corporation that is a controlled foreign corporation (CFC) generally in the same manner as it applies to a domestic C corporation.
State Conformity with Federal Business Interest Expense Limitation Rules
States generally conform to the Internal Revenue Code (IRC) in different ways. A state may adopt “rolling’ conformity means that it conforms to the IRC as it is amended. The state would automatically adopt any new federal provisions unless it chooses to specifically “decouple” or adopt its own state specific laws regarding a certain federal provision.
Other states choose to conform to the IRC on a “fixed date” basis meaning that if a state conforms to the IRC as amended through a specific date, the state will not conform to any of the federal tax reform changes after that date unless the state specifically updates its conformity date or enacts legislation adopting a specific federal change.
Currently, about half the states follow the new Section 163(j), either through rolling conformity or by adopting a post-Act conformity date. Several other states have enacted legislation that specifically decouples from the federal limits.
Applying Section 163(j) on a consolidated basis at the federal level creates significant complexities for computing allowable interest expense at the state level. For example, in states that require commonly owned corporations to report income on a separate-company basis, the allowable business interest expense for individual entities of the federal consolidated group could be reduced, increased or eliminated. In addition, separate reporting states that both conform to the new Section 163(j) limitation and that disallow an expense deduction for interest paid to related parties (by an interest addback) will need to address the potential for double taxation.
Pennsylvania Corporation Tax Bulletin 2019-03
On April 29, 2019 the Pennsylvania Department of Revenue issued Corporation Tax Bulletin 2019-03 to address the Pennsylvania Corporation Net Income Tax (CNIT) treatment of the IRC Section 163(j) limitations. Pennsylvania requires corporations to file separate returns, regardless of whether they are members of a federal affiliated group that files a federal consolidated return. Generally, taxpayers will need to calculate their federal interest expense deduction on a separate entity basis for Pennsylvania purposes regardless of whether they are members of a federal affiliated group that file a federal consolidated return for CNIT purposes. In addition, the taxpayer will separately apply the federal exceptions to the limitation, including, for example, whether the taxpayer meets the $25 million gross receipts threshold on a separate entity basis.
Pennsylvania Treatment of Intercompany Interest and Related-Party Interest
Under the federal proposed IRC Section 163(j) regulations, intercompany interest income and expense are offset for a federal consolidated return and not included for purposes of calculating the federal consolidated ATI limitation. However, as a separate return jurisdiction, Pennsylvania will not follow this treatment. Taxpayers will need to continue to include intercompany and third-party interest in their separate entity calculations of interest expense under IRC Section 163(j).
Pennsylvania also imposes a related party interest expense add-back statute. When a corporate taxpayer has incurred both unrelated and related party interest expense, taxpayers must allocate the Section 163(j) limitation, as calculated on a separate entity basis, pro-rata between the two types of interest expense. The allocation is done based on a fraction, consisting of business interest expense after application of the limitation over total business interest expense multiplied by the related party interest expense. The resulting amount is the related party business interest expense subject to the Pennsylvania add-back statute.
Since the federal carryforward provisions makes no distinction between related party and third-party interest, disallowed related party interest would carry forward and potentially be deductible for federal separate company purposes in future periods for PA CNIT reporting. As a result, taxpayers should track not only their federal separate company interest deduction carryforwards, but also the breakout of that amount between third party interest expense and related party interest expense.
Pennsylvania Interest Expense Associated with Nonbusiness Income
In previous years, to the extent interest expense related to business income, it was used to reduce business income and to the extent it was associated with nonbusiness income the interest expense served to reduce the nonbusiness income. For periods starting after December 31, 2017 to the extent a PA corporate taxpayer has a business interest expense limitation and also reports nonbusiness income, it should make a determination of the amount of overall interest expense associated with the nonbusiness income and allocate an interest limitation to that amount on a pro-rata basis. In future years, the interest expense carryforward associated with the taxpayer’s nonbusiness income can only be used to offset nonbusiness income.
Pennsylvania Treatment of Interest Expense Amounts for Partnerships with Corporate Partners
For federal purposes, the interest expense limitation is calculated for partnerships at the partnership level itself but then applied at the partner level which Pennsylvania intends to follow for CNIT purposes. It is also important to note that while for purposes of calculating federal ATI all interest of a C-corporation is treated as “business interest” unless the amounts are designated to a specifically excluded type of business. However, this same treatment does not extend to the interest limitation calculation that must be made by a partnership. Ultimately, the corporate taxpayer will need to determine whether the interest amounts flowing through form the partnership represent business or nonbusiness income for PA CNIT purposes.
How to Comply with the New Federal and PA Limitations on Interest Deductions
Even with a lowered corporate income tax rate, applying the new limitations on interest deductions may result in unfavorable tax liabilities for your business. With new lower limitations tying the amount of deductible business interest to a business’s adjusted taxable income, an unsuccessful revenue year could mean more tax liability by reducing the amount of interest the business can deduct that year. It is likely the new limitations will also negatively impact corporations and investors of flow-through businesses that finance acquisitions with debt.
While several states have either conformed with or decoupled from Section 163(j), Pennsylvania and New Jersey are the only states to issue substantive guidance on how the limitation will apply to their corporate income tax regimes. Separate interest limitation calculations will need to be done for PA CNIT purposes which may differ from the limitation required for federal purposes. The Pennsylvania Department of Revenue indicated that it anticipates issued further CNIT guidance with respect to 163(j) in the future.
The business interest limitation rules are complex and can significantly impact your tax liability. We suggest that you meet with us as soon as possible to discuss strategies to minimize the impact of the limitation, including determining whether your business qualifies to make an election to be excepted from the limitation. In addition, we can evaluate and determine the potential financial statement implications under ASC 740, including the impact on current and deferred taxes, uncertain tax benefits, and disclosures.