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Business Tax

IRS Notice explains new business interest expense limitations

Thomson Reuters Tax & Accounting  

Thomson Reuters Tax & Accounting  

In a Notice and accompanying news release, IRS has provided guidance for computing the business interest expense limitation under Code Sec. 163(j), as amended by the Tax Cuts and Jobs Act (TCJA; P.L. 115-97, 12/22/2017), which limits most large businesses’ interest deduction to any business interest income plus 30% of the business’ adjusted taxable income. Among other things, the Notice describes regs that IRS intends to issue and clarifies the treatment of interest disallowed and carried forward under former Code Sec. 163(j).

Background—pre-TCJA law.  Prior to its amendment, pre-TCJA Code Sec. 163(j) disallowed a deduction for “disqualified interest” paid or accrued by a corporation in a tax year if: (i) the payor’s debt-to-equity ratio exceeded 1.5 to 1.0 (safe harbor ratio); and (ii) the payor’s net interest expense exceeded 50% of its adjusted taxable income (generally, taxable income computed without regard to deductions for net interest expense, net operating losses, domestic production activities under former Code Sec. 199, depreciation, amortization, and depletion).

Disqualified interest for this purpose included interest paid or accrued to: (1) related parties when no Federal income tax was imposed with respect to such interest; (2) unrelated parties in certain instances in which a related party guaranteed the debt; or (3) a real estate investment trust (REIT) by a taxable REIT subsidiary of that REIT. Interest amounts disallowed for any tax year under former Code Sec. 163(j) were treated as interest paid or accrued in the succeeding tax year and could be carried forward indefinitely. In addition, any excess limitation (i.e., the excess, if any, of 50% of the adjusted taxable income of the payor over the payor’s net interest expense) could be carried forward three years.

Former Code Sec. 163(j)(6)(C) provided that “[a]ll members of the same affiliated group (within the meaning of Code Sec. 1504(a)) shall be treated as 1 taxpayer.” In addition, former Code Sec. 163(j)(9)(B) provided IRS with the authority to issue regs providing for adjustments in the case of corporations that are members of an affiliated group as may be appropriate for carrying out the purposes of former Code Sec. 163(j).

IRS issued proposed regs in ’91 that contained “super affiliation rules” under which all members of an affiliated group would be treated as one taxpayer for former Code Sec. 163(j) purposes, without regard to whether the group files a consolidated return. The proposed regs also provided a rule under which, for purposes of former Code Sec. 163(j), if at least 80% of the total voting power and total value of the stock of an “includible corporation” under Code Sec. 1504(b) is owned, directly or indirectly, by another includible corporation, the first corporation would be treated as a member of the affiliated group that includes the other corporation and its affiliates.

Background—interest limitation under current law.  Code Sec. 163(j), as amended by the TCJA, provides new rules limiting the deduction of business interest expense for tax years beginning after Dec. 31, 2017.

For any taxpayer to which Code Sec. 163(j) applies, Code Sec. 163(j)(1) now limits the taxpayer’s annual deduction for business interest expense to the sum of: (1) the taxpayer’s business interest income (as defined in Code Sec. 163(j)(6)) for the tax year; (2) 30% of the taxpayer’s adjusted taxable income (as defined in Code Sec. 163(j)(8)) for the tax year; and (3) the taxpayer’s floor plan financing interest (as defined in Code Sec. 163(j)(9); generally, interest paid or accrued on indebtedness to finance the acquisition of motor vehicles held for sale or lease, or to secure the inventory so acquired) for the tax year.

The limitation in Code Sec. 163(j) applies to all taxpayers, except for certain taxpayers that meet the gross receipts test in Code Sec. 448(c), and to all trades or businesses, except certain trades or businesses listed in Code Sec. 163(j)(7).

Under Code Sec. 163(j)(2), the amount of any business interest not allowed as a deduction for any tax year as a result of the limitation in Code Sec. 163(j)(1) is treated as business interest paid or accrued in the next tax year and may be carried forward. Code Sec. 163(j) does not provide for the carryforward of any excess limitation. Code Sec. 163(j)(6)(C), which treated an affiliated group as one taxpayer, and Code Sec. 163(j)(9)(B), which authorized the super-affiliation rules, were removed by the TCJA.

The TCJA Conference Report states in a footnote describing the House Bill that:

a corporation has neither investment interest nor investment income within the meaning of Code Sec. 163(d). Thus, interest income and interest expense of a corporation is properly allocable to a trade or business, unless such trade or business is otherwise explicitly excluded from the application of the provision.

The Conference Report also notes, in the description of the House Bill, that:

in the case of a group of affiliated corporations that file a consolidated return, the limitation applies at the consolidated tax return filing level.

However, there is no mention in the Conference Report of applying Code Sec. 163(j) to affiliated groups (within the meaning of Code Sec. 1504(a)) that do not file a consolidated return.

New guidance on Code Sec. 163(j), as amended.  Notice 2018-28 provides the following guidance to help taxpayers comply with Code Sec. 163(j), as amended by the TCJA, and describes proposed regs that it intends to issue in the future. The rules described below may be relied upon pending issuance of the proposed regs.

…Treatment of carried over disallowed, disqualified interest.  Prior to the TCJA, C corporation taxpayers that could not deduct all of their interest expense under former Code Sec. 163(j)(1)(A) could carry their disallowed disqualified interest forward to the succeeding tax year, and such interest was treated as paid or accrued in that succeeding tax year. Similarly, under Code Sec. 163(j)(2), taxpayers that cannot deduct all of their business interest because of the limitation in Code Sec. 163(j)(1) may carry their disallowed business interest forward to the succeeding tax year, and such interest is treated as business interest paid or accrued in the succeeding tax year.

Consistent with both the former and current law approaches described above, IRS intends to issue regs clarifying that taxpayers with disqualified interest disallowed under former Code Sec. 163(j)(1)(A) for the last tax year beginning before Jan. 1, 2018, may carry such interest forward as business interest to the taxpayer’s first tax year beginning after Dec. 31, 2017. The regs will also clarify that business interest carried forward will be subject to potential disallowance under Code Sec. 163(j) in the same manner as any business interest otherwise paid or accrued in a tax year beginning after Dec. 31, 2017.

The regs will also address the interaction of Code Sec. 163(j) with Code Sec. 59A, the new base erosion minimum tax, by providing that business interest carried forward from a tax year beginning before Jan. 1, 2018, will be subject to Code Sec. 59A in the same manner as interest paid or accrued in a tax year beginning after Dec. 31, 2017, and will clarify how Code Sec. 59A applies to that interest.

In addition, the regs will provide rules for the allocation of business interest from a group treated as affiliated under the pre-TCJA “super-affiliation” rules.

Finally, while former Code Sec. 163(j)(2)(B)(ii) allowed a corporation subject to the former Code Sec. 163(j)(1) limitation to add to its annual limitation any “excess limitation carryforward” from the prior year, Code Sec. 163(j), as amended, does not have a similar provision. Thus, IRS intends to issue regs clarifying that no amount previously treated as an excess limitation carryforward may be carried to tax years beginning after Dec. 31, 2017. (Notice 2018-28, Section 3)

…Business interest, etc. of C corporations.  Consistent with congressional intent as reflected in the Conference Report, IRS intends to issue regs clarifying that, solely for purposes of Code Sec. 163(j), in the case of a taxpayer that is a C corporation, all interest paid or accrued by the C corporation on indebtedness of such C corporation will be business interest within the meaning of Code Sec. 163(j)(5), and all interest on indebtedness held by the C corporation that is includible in gross income of such C corporation will be business interest income within the meaning of Code Sec. 163(j)(6). However, the regs described in the foregoing sentence won’t apply to an S corporation.

Regs also will address whether and to what extent interest paid, accrued, or includible in gross income by a non-corporate entity (e.g., a partnership) in which a C corporation holds an interest, is properly characterized, to such C corporation, as business interest within the meaning of Code Sec. 163(j)(5) or business interest income within the meaning of Code Sec. 163(j)(6). (Notice 2018-28, Section 4)

…Application of new limit to consolidated groups.  Consistent with congressional intent as reflected in the Conference Report, IRS intends to issue regs clarifying that the Code Sec. 163(j)(1) limitation on the amount allowed as a deduction for business interest applies at the level of the consolidated group (as defined in Reg. § 1.1502-1(h)).

Regs will also address other issues concerning the application of Code Sec. 163(j) to consolidated groups including, among others, how to allocate the limitation among group members, and what happens when a member leaves the group. IRS anticipates that such regs will not include a general rule treating an affiliated group that does not file a consolidated return as a single taxpayer for purposes of Code Sec. 163(j). (Notice 2018-28, Section 5)

…Effect of new limit on E&P.  IRS intends to issue regs clarifying that the disallowance and carryforward of a deduction for a C corporation’s business interest expense under Code Sec. 163(j) will not affect whether or when such business interest expense reduces earnings and profits of the payor C corporation. (Notice 2018-28, Section 6)

…Business interest income & floor plan financing—partnerships & partners.  Code Sec. 163(j)(4) requires that the annual limitation on the deduction for business interest expense be applied at the partnership level and that any deduction for business interest be taken into account in determining the non-separately stated taxable income or loss of the partnership. However, while Code Sec. 163(j)(4) is applied at the partnership level with respect to the partnership’s indebtedness, Code Sec. 163(j) may also be applied at the partner level in certain circumstances.

IRS intends to issue regs providing that, for purposes of calculating a partner’s annual deduction for business interest under Code Sec. 163(j)(1), a partner cannot include the partner’s share of the partnership’s business interest income for the tax 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).

Additionally, in order to prevent the “double counting” of business interest income and floor plan financing interest for purposes of the business interest deduction, IRS intends to issue regs providing that a partner cannot include such partner’s share of the partnership’s floor plan financing interest in determining the partner’s annual business interest expense deduction limitation under Code Sec. 163(j). Similar rules will apply to any S corporation and its shareholders. (Notice 2018-28, Section 7)

Comments sought.  IRS seeks comments on the rules described in Notice 2018-28, noted that it expects to issue regs on issues not described in Notice 2018-28 and seeks comments on what additional issues should be addressed in the regs. Comments should be submitted by May 31, 2018, to the address provided in Notice 2018-28, Section 9.

References:  For the post-2017 business interest deduction limitation, see FTC 2d/FIN ¶K-5430 et seq. IR 2018-82, 4/2/2018; Notice 2018-28, 2018-16 IRB

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