IRS guidance addresses several unsettled questions
INTRODUCTION – GENERAL BUSINESS INTEREST DEDUCTION LIMITATION UNDER SECTION 163(J)
One of the tax law changes enacted in 2017 imposes a new limitation on deductions for business interest expense. The limitation is earnings-based and is imposed by section 163(j) of the Tax Code. For most taxpayers, deduction of net business interest expense is limited to 30 percent of their adjusted taxable income for tax years beginning after Dec. 31, 2017. For more information on section 163(j), please see our prior Alert: Broad New Limitation on Business Interest Deductions.
NOTICE 2018-28 PROVIDES INTERIM GUIDANCE
The IRS has released Notice 2018-28 addressing section 163(j). The Notice describes aspects of proposed regulations the IRS and Treasury plan to issue concerning the section 163(j) business interest deduction limitation.
The Notice answers some, but not all, of taxpayers’ question about section 163(j). Taxpayers may rely on the rules in the Notice until more comprehensive guidance is developed and released. The Notice generally will represent welcome guidance to taxpayers considering the application of section 163(j) when projecting financial results, calculating a tax provision, estimating tax liability, or preparing a tax return.
RULES SET OUT IN NOTICE 2018-28
The Notice sets out the following rules:
- Consolidated Groups: For groups of corporations filing consolidated federal income tax returns (Consolidated Groups) the business interest deduction limitation will be determined for the Consolidated Group as a whole.
- No double counting for partners and S corporation shareholders: Computation rules will prevent potential ‘Double counting’ the business income of a partnership or S corporation on both its tax return and the tax returns of its owners.
- Base erosion and anti-abuse tax (BEAT): In applying the BEAT under section 59A, interest carried forward under section 163(j) will be accounted for in the year it is deductible (which may differ from the year in which it is paid or accrued).
- Earnings and profits: The computation of a corporation’s annual earnings and profits will not be affected by section 163(j) (even if interest deductions are deferred under section 163(j)).
- Corporations’ interest as business interest: All interest income and expense on debt held by or issued by or held by a C corporation is “business interest” that enters into calculations under section 163(j). This rule does not apply to S corporations. Subsequent guidance will address whether a C corporation partner’s allocable share of partnership interest income and expense should similarly be treated as business interest.
- Old section 163(j): The prior version of section 163(j) (Old 163(j) also contained an interest deduction limitation rule (sometimes known as a thin capitalization rule). That version is no longer effective. Some companies, however, have carryforwards under Old 163(j) rules at the end of their last taxable year beginning prior to Dec. 31, 2017. The Notice addresses these. Disallowed interest carryforwards under Old 163(j) will be treated as business interest accrued in the first taxable year beginning after Dec. 31, 2017. Excess limitation carryforwards under Old 163(j) can no longer be carried forward.
For Consolidated Groups, computation of the section 163(j) business interest deduction limitation at the Consolidated Group level is a welcome and expected rule. Many questions about application of section 163(j) to Consolidated Groups, however, remain unanswered and are intended to be addressed in regulations. These questions include:
- Allocation of the section 163(j) limitation among Consolidated Group members;
- Treatment of disallowed interest carryforwards when a corporation enters or leaves the Consolidated Group;
- Consolidated Group stock basis adjustments with respect to section 163(j) items; and
- Application of section 163(j) when one or more corporations in the group conducts (or is a partner in a partnership that conducts) a trade or business exempt from section 163(j).
Businesses generally exempt from section 163(j) include certain regulated utility businesses, ‘electing real property trade or businesses,’ and ‘electing farming businesses.’ In the latter two categories, the exemption requires an election. Qualifying taxpayers conducting certain real property or farming businesses may benefit from electing out of the section 163(j) business interest deduction limitation for such businesses. However, these elections carry a potentially costly downside. With an election in place, certain assets used in those businesses (generally, real property or farm property with recovery period of 10 years or more) must be depreciated using the Alternative Depreciation System (ADS) – typically a slower cost recovery method than would otherwise apply.
As these elections are irrevocable, prior to making any such election, taxpayers should carefully weigh the anticipated effects of the business interest expense limitation against the effects of using a slower cost recovery system for new and existing designated assets under ADS. The interim guidance of Notice 2018-28 may assist in performing calculations used to weigh these alternatives.
The Notice requires, when applying the BEAT, that companies account for interest disallowed under section 163(j) and carried forward in the year (if any) in which the interest becomes deductible. This generally makes sense, given that the BEAT is intended to prevent erosion of the U.S. corporate tax base, and unless interest is deductible it cannot cause base erosion. The rules for calculating tax liability under the BEAT provisions are complex. It is worth keeping in mind, however, that the BEAT only applies to certain corporate taxpayers with average annual gross receipts of at least $500 million.
Notice 2018-28 has answered some questions about how to apply the section 163(j) interest deduction limitation, but unanswered questions remain. Treasury and the IRS anticipate releasing more guidance to address some remaining unanswered questions. The Notice generally will be welcome guidance to taxpayers projecting financial results, calculating a tax provision, estimating tax liability, or preparing a tax return.