New thin capitalization rule potentially applies to most business debt
Congress has passed the Tax Cuts and Jobs Act (the Act), and the President has signed it. The Act generally provides lower tax rates for business income, and moves towards a territorial type system on foreign earnings within corporate subsidiaries, both generally are looked at as favorable to corporate taxpayers.
However, the Act also includes some new unfavorable rules. One of these is the broad limitation on the deductibility of business interest expense under newly amended section 163(j) of the Tax Code. This new rule will limit the ability of many businesses (not just corporations) to deduct interest expense paid or accrued. Business interest deductions generally will not be permitted to the extent net interest expense exceeds an adjusted earnings-based threshold.
Even though it lowers tax rates, Its limitation on interest deductions may result in increased tax liability to corporations and investors in flow-through businesses that finance acquisitions with debt (e.g., business that have undergone private equity-sponsored leveraged buy-outs (LBOs)).
General limitation on deduction for business interest
New section 163(j) limits the net interest expense deduction for most businesses, regardless of form, to 30 percent of adjusted taxable income (ATI). Net interest expense means the amount of interest paid or accrued by the taxpayer during the tax year, less the amount of interest income includable in the taxpayer’s gross income for the year.
Computation of ATI – basis for the deduction limitation amount
The maximum amount of net business interest deductible under the new rule will be 30 percent of ATI, as noted above. ATI generally is a business’s taxable income computed without regard to:
(1) any income, deduction, gain, or loss not properly allocable to a trade or business;
(2) business interest income and expense;
(3) any net operating loss deduction;
(4) the new “qualified business income deduction (i.e., the 20 percent deduction for certain pass-through income under new section 199A); and
(5) for tax years beginning before Jan. 1, 2022, any deduction allowable for depreciation, amortization, or depletion.
The Act authorizes Treasury and the IRS to provide adjustments to the ATI computation. For applying the 30 percent of ATI interest deduction limitation, ATI will not be less than zero.
For tax years beginning in 2018 through 2021, the computation of ATI should approximately reflect a business’ earnings before interest, taxes, depreciation, and amortization (EBITDA). For tax years beginning after 2021, the ATI definition will change automatically. ATI would then approximate earnings before interest and taxes (EBIT), because item (5) above – depreciation, amortization, and depletion deductions will no longer be excluded from ATI. This change generally would decrease ATI and, as a result, decrease the maximum amount of deductible business interest expense.
Carryforward of nondeductible business interest
Taxpayers generally may carry forward any unused business interest expense indefinitely.
Exceptions for certain smaller businesses, floor plan financing, and specified businesses
The new business interest expense limitation generally will not apply to taxpayers with average gross receipts that do not exceed $25 million for the three-taxable-year period ending with the prior taxable year. The $25 million threshold applies in the aggregate to certain related taxpayers.
Floor plan financing interest will not be subject to the new section 163(j) limitation. Floor plan financing interest is interest on debt used to finance the acquisition of motor vehicles held for sale or lease. Motor vehicles, for this purpose, include any self-propelled vehicle designed for transporting persons or property on a public street, highway, or road; boat; or farm machinery or equipment.
The following specified business types are excepted from the new section 163(j) limitation; interest paid or incurred by these businesses are not considered business interest for the purpose of computing the deduction limitation: (i) the business of performing services as an employee, (ii) an electing real property business (generally, a real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business), (iii) an electing farming (or agricultural cooperative) business, and (iv) rate-regulated electrical, water, sewage, gas, or steam sale or distribution businesses.
Application to pass-through entities
Special rules apply to certain pass-through entities and their owners under new section 163(j). This Alert does not address those rules.
Interest deferral and disallowance rules
Other interest rules governing interest capitalization, deduction disallowance, and deduction generally will apply prior to applying new section 163(j), according to the legislative history.
Note that the interest limitation applies to “net” interest expense, which means taxpayers may use their annual interest income (assuming they have any) to offset their annual interest expense, before they apply the 30 percent restriction. The rule allows for the provision of so-called ‘back to back’ loans whereby one taxpayer, such as a domestic corporation, borrows money from a financial institution and makes a corresponding loan of some or all of the funds to another entity such as a foreign subsidiary. The section 163(j) limitation calculation may only apply to the interest expense in excess of the interest received on the corresponding loan.
In addition, the EBITDA approach in determining ATI through 2021 serves to somewhat lessen the blow of the limitation. The goal of simplification of the tax system is certainly not achieved with this provision as it presents additional complexity to almost every business borrower. It is unclear whether and how the Treasury will address non-debt arrangements having time value of money elements in light of this new interest limitation.
Finally, while certain provisions of the Act could increase M&A activity, the section 163(j) limitation may put downward pricing pressure on LBO transactions because the interest deduction limitation may result in lower cash flow projections.