by Marc Schwartz
Prior law focused on and impacted members of international groups and some real estate investment trust (“REITs”). We’ve long had to consider whether business interest expense is deductible, but outside the REIT environment, IRC §163(j)’s earnings stripping rules generally applied in a global structure. These rules limited a corporation’s interest deductions if three (3) items applied to the payor:
(1) Debt : equity ratio exceeded 1.5 : 1;
(2) Net interest expense exceeded fifty percent (50%) of its adjusted taxable income (“ATI”) [ATI was generally taxable income calculated on a modified cash flow basis excluding deductions for net interest expense, net operating losses (“NOLs”), domestic production activities (old IRC §199) and depreciation/amortization/depletion. There was disagreement between the House and the Senate on what should comprise ATI, and the definition in fact changes a few years out, as noted below.]; and
(3) Interest was “disqualified interest”. That meant it was between related parties when there was no US income tax (e.g., reduced by a tax treaty); between unrelated parties where a related foreign party (or an organization exempt from tax under the subtitle) guaranteed the debt; or to a REIT by a taxable REIT subsidiary of the trust. The disallowed interest could be carried forward indefinitely. Excess limitation could be carried forward three (3) years. Excess limitation was essentially the opposite of what caused the limitation; Excess Limitation = the excess of 50% of ATI over the payor’s net interest expense.
Amended IRC §163(j) applies to a broader category of taxpayers. It doesn’t just impact international groups or REITs. [Note: New §59A will specifically impact international groups by imposing tax on certain base erosion payments paid or accrued by a taxpayer to a foreign person which is a related party. But, we’re not going into that discussion now, other than to note that payments to foreign persons have historically been an easy target for Congress.] It impacts business interest and also applies to partnerships and S corporations. But, and this is important, there is a small business exemption based on a gross receipts test. A taxpayer meets this test, and the interest deduction is not limited by the section if the average annual gross receipts of such entity for the 3 taxable year period ending with the taxable year which precedes such taxable year does not exceed $25M. This limitation would seem to apply after other interest disallowance provisions, per the Conference Report, but unless I missed something, the statute doesn’t explicitly provide this result. Perhaps the issue will be clarified in the regulations.
Again, business interest expense is §163(j)’s focus, not non-business interest, such as investment interest.
Like the prior §163(j), this one also focuses on an ATI concept. The deduction for business interest shall not exceed the sum of:
- The business interest income;
- 30% of the ATI; plus
- The floor plan financing interest.
So, what’s ATI? First, ATI as used in the above formula shall not be less than zero. §163(j)(8) defines ATI as taxable income without regard to any item of income, gain, deduction or loss which is not properly allocable to a trade or business; any business interest or business interest income; the amount of any NOL deduction under §172 or any deduction allowed under §199A (and of course there’s room for the Secretary of the Treasury to provide other adjustments). This is also important and why I put it in a separate sentence – in the case of taxable years beginning before January 1, 2022, ATI is computed without any deduction allowable for depreciation, amortization or depletion. That means ATI is likely higher, which is taxpayer-favorable as 30% of a larger number is a larger number. So, that lasts just for taxable years beginning before January 1, 2022. For future periods ATI is reduced by depreciation, amortization or depletion, likely reducing interest deductions, all else equal. Disallowed interest deductions have an unlimited carryforward period.
Partnerships and their partners also must face these rules. The rules apply at the partnership level and any deduction is considered in determining the non-separately stated partnership taxable income or loss. There’s also guidance for a partner’s ATI which is determined without regard to the partner’s distributive share of income, etc. of the partnership, and the ATI is increased by such partner’s distributive share of the partnership’s excess taxable income. Excess taxable income is – well, since Congress has a way of putting things, let’s start with what Congress wrote as §163(j)(4)(C):
EXCESS TAXABLE INCOME.—The term ‘excess taxable income’ means, with respect to any partnership, the amount which bears the same ratio to the partnership’s adjusted taxable income as
(i) the excess (if any) of—
(I) the amount determined for the partnership under paragraph (1)(B) [That’s 30% of ATI], over
(II) the amount (if any) by which the business interest of the partnership, reduced by the floor plan financing interest, exceeds the business interest income of the partnership, bears to
(ii) the amount determined for the partnership under paragraph (1)(B).
In more plain language, and how my smaller brain can try to understand, it’s what I call a cushion created when 30% ATI exceeds net interest expense (i.e., generally speaking, business interest expense less business interest income [we’re not focusing on floor plan financing interest for now]). This rule effectively allows a partner to deduct additional interest expense incurred to the extent the partnership could have deducted more business interest.
There must be a trade or business for amended IRC §163(j) to apply. §163(j)(7) defines trade or business in the negative as excluding,
(i) the trade or business of performing services as an employee,
(ii) any electing real property trade or business,
(iii) any electing farming business, or
(iv) the trade or business of the furnishing or sale of—
(I) electrical energy, water, or sewage disposal services,
(II) gas or steam through a local distribution system, or
(III) transportation of gas or steam by pipeline, if the rates for such furnishing or sale, as the case may be, have been established or approved by a State or political subdivision thereof, by any agency or instrumentality of the United States, by a public service or public utility commission or other similar body of any State or political subdivision thereof, or by the governing or ratemaking body of an electric cooperative.
I was particularly intrigued by the electing real property trade or business, defined as any trade or business which is described in section 469(c)(7)(C) and which makes an election under this subparagraph. Any such election shall be made at such time and in such manner as the Secretary shall prescribe, and, once made, shall be irrevocable.
§469(c)(7)(C) defines real property trade or business as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. So, numerous and significant portions of the real estate industry catch a break by not being subject to these interest deduction limitation rules. I’m not commenting on whether that’s good or bad but just trying to wrap my mind around the policy – why there’s certain winners and losers.
There are two additional items to mention in this overview. One, floor plan financing interest focuses on indebtedness used to finance the acquisition of motor vehicles held for sale or lease and secured by the inventory so acquired. Motor vehicle includes any self-propelled vehicle designed for transporting persons or property on a public street, highway or road. It also includes boats and farm machinery or equipment. The other item is there are rules for the carryforward of disallowed business interest in certain corporate acquisitions and therefore there are relevant changes to §381 and §382.
Amended §163(j) is applicable to taxable years beginning after December 31, 2017.