For noncorporate taxpayers (e.g., individuals, partnerships) deductions for investment interest expense are limited to investment income. To avoid this limitation, noncorporate taxpayers routinely took steps to characterize interest expense as business interest expense prior to the Tax Cuts and Jobs Act (TCJA). However, the interaction of two provisions within the TCJA, the Global Intangible Low Taxed Income (GILTI) rules and the business interest expense limitation (the 163(j) limitation), may cause noncorporate taxpayers to re-evaluate how to characterize interest expense. Noncorporate taxpayers may now have an opportunity to reduce their tax liability on a GILTI inclusion and to maximize their interest expense deduction by characterizing interest expense as investment interest expense.
The TCJA subjects U.S. shareholders of controlled foreign corporations (CFCs) to U.S. tax on their pro share of the CFC’s GILTI. For noncorporate taxpayers the highest marginal tax rate on this amount generally is 37 percent. U.S. tax on a GILTI inclusion would generally be in addition to any foreign tax payments made by a CFC.
Noncorporate taxpayers must differentiate between business interest expense and investment interest expense. Interest expense is characterized as investment interest expense or business interest expense based on tracing rules. How debt is utilized – either in the acquisition of property that generates business income, or investment income – determines whether interest expense is business or investment expense. Income generated from a CFC is generally characterized as investment income.
The TCJA limits the deductibility of business interest expense to the sum of the following:
- 30 percent of adjusted taxable income (ATI),
- business interest income, and
- floor plan financing expense.
Prior to the passage of the TCJA, taxpayers could generally deduct all business interest expense; only in very specific circumstances was the ability of corporate taxpayers to deduct business interest expense limited. Even before the passage of the TCJA, the deductibility of investment interest expense was limited to investment interest income (also referred to as the section 163(d) limitation).
However, noncorporate taxpayers have flexibility in characterizing interest as business interest or investment interest because such taxpayers must use tracing rules to distinguish business interest from investment interest. Since money is fungible, noncorporate taxpayers can associate debt with assets that generate investment income. Thus, to the extent a GILTI inclusion is anticipated, noncorporate taxpayers should consider characterizing interest expense as investment interest expense to reduce the tax liability on a GILTI inclusion and increase deductible interest expense overall.
Inapplicability to C corporations
Corporate taxpayers with a GILTI inclusion are treated differently. While the corporate tax rate is 21 percent, corporate taxpayers may claim a deduction of up to 50 percent on their GILTI inclusion (referred to as a section 250 deduction). Corporate taxpayers can also claim as a tax credit up to 80 percent of the foreign tax payments associated with their GILTI inclusion. The combination of the 21 percent corporate tax rate, the ability to claim a section 250 deduction and the ability to utilize 80 percent of the foreign tax credits associated with a GILTI inclusion results in no incremental U.S. tax on a GILTI inclusion if such inclusion is subject to foreign tax at an effective tax rate of 13.125 percent.
Corporate taxpayers treat all interest expense as business interest expense, subject to the 163(j) limitation. In addition, corporate taxpayers with a GILTI inclusion can potentially make an election (the CFC Group Election) and thereby increase their 163(j) limitation. Before making a CFC Group Election a complex multi-step computation needs to be undertaken. However, a CFC Group Election by a non-corporate taxpayer may have benefits but it will not increase a taxpayer’s ATI for the purposes of the section 163(j) limitation. The specific benefits of a CFC Group Election are beyond the scope of this article and are discussed in another article: Benefits of a CFC Group Election.
For non-corporate taxpayers, the section 163(j) limitation may make generating business interest expense less desirable. However, noncorporate taxpayers should consider whether tracing debt to property that generates investment income creates a benefit by treating more interest as investment interest instead of business interest.