The US Department of the Treasury and the Internal Revenue Service on April 2 issued “Initial Guidance Under Section 163(j) as Applicable to Taxable Years Beginning After December 31, 2017” (Notice 2018-28), which announces the government’s plan to issue regulations addressing certain computational matters for the new Section 163(j) business interest expense limitation enacted under the recent tax reform. Notice 2018-28 (on which taxpayers may currently rely) and the forthcoming regulations should give taxpayers comfort for certain factual situations, most notably for consolidated groups and for taxpayers with disallowed and carried forward losses under the prior Section 163(j) interest limitation provision.
The upcoming regulations for the new business interest expense limitation (discussed briefly in a previous LawFlash) will largely implement or expand upon the rules contemplated by the Joint Committee on Taxation report for the tax reform legislation. In particular, the regulations will provide guidance on the following:
- Characterization of interest paid and/or received by C corporations
- Treatment of disqualified interest that was disallowed and carried forward under prior Section 163(j)
- Application of the new limitation to consolidated groups
- Application of the new limitation to partnerships and partners
Taxpayers may rely on the Notice 2018-28 guidance prior to the government issuing proposed regulations under Section 163(j).
Overview of New Section 163(j)
Enacted on December 22, 2017 with the tax reform legislation, new Section 163(j)(1) limits a taxpayer’s annual deduction for business interest to the sum of
- its business interest income for the taxable year;
- 30% of its adjusted taxable income for the taxable year; and
- its floor plan financing interest for the taxable year.
For purposes of computing this limitation, “business interest”is defined as “any interest paid or accrued on indebtedness properly allocable to a trade or business.” Investment interest is generally excluded. “Business interest income” is the amount of interest includible in the gross income of the taxpayer for the taxable year that is properly allocable to a trade or business.
“Adjusted taxable income” is defined as taxable income exclusive of
- items not allocable to a trade or business;
- business interest or business interest income;
- net operating losses;
- deductions under new Section 199A (20% deduction for “qualified business income”);
- beginning in 2022, depreciation, amortization, and/or depletion deductions; and
- any other adjustments as provided by the IRS.
Lastly, “floor plan financing interest” is interest on indebtedness used to finance the acquisition of certain motor vehicles held for sale or lease.
Unlike former Section 163(j) (which only applied to corporations and was considered primarily to address what the government viewed to be earnings-stripping cross-border debt financings), new Section 163(j) applies to corporate and noncorporate taxpayers alike, and applies regardless of the taxpayer’s debt-to-equity ratio and the payee’s relationship with the taxpayer. Certain small businesses are exempted (in general, those with average annual gross receipts under $25 million).
New Section 163(j) applies to taxable years beginning after December 31, 2017 for all debt instruments, including those issued prior to the provision’s effective date.
In Notice 2018-28, the government indicates that it intends to issue regulations providing as follows:
All interest paid or received by a C corporation is business interest and affects C corporation earnings and profits (E&P). Future regulations will require that, for purposes of Section 163(j), all interest paid or accrued by a C corporation will be “business interest” within the meaning of Section 163(j)(5). In addition, all interest received by a C corporation will be “business interest income” within the meaning of Section 163(j)(6). As a result, all interest income and interest expense of a C corporation will apparently be taken into account in applying Section 163(j), regardless of whether the C corporation in fact has a trade or business under general federal income tax principles. This treatment is consistent with a footnote in the Joint Committee on Taxation’s report on the legislation.
The forthcoming regulations will address whether and to what extent a C corporation holding an interest in a noncorporate entity (such as a partnership) will be able to treat the C corporation’s share of the interest income and expense of the noncorporate entity as business interest income and expense. The regulations will also clarify that the limitation of a C corporation’s deduction for interest expense under Section 163(j) will not affect the computation of the corporation’s E&P.
Disqualified interest from last taxable year beginning before 2018 can be carried forward as business interest, with some caveats. Notice 2018-28 indicates that—under forthcoming regulations—interest disallowed under old Section 163(j)(1)(A) for the last taxable year beginning before January 1, 2018 may be carried forward as “business interest”; however, that interest will be subject to potential disallowance under new Section 163(j) in the same manner as if actually paid or accrued in a taxable year beginning after December 31, 2017. In addition, the carried-forward interest will be subject to the new base erosion and anti-abuse tax (the so-called BEAT) of Section 59A, which applies to certain large multinational corporation taxpayers. Lastly, since new Section 163(j) does not allow for the carryforward of excess limitations, the IRS intends to issue regulations clarifying that no amount previously treated as an excess limitation carryforward under the prior Section 163(j) may be carried to taxable years beginning after December 31, 2017.
Section 163(j)(1) limitation applies at the level of the consolidated group. The forthcoming regulations described by Notice 2018-28 will generally treat a consolidated group as a single person for purposes of applying Section 163(j). Specifically, the regulations will treat “consolidated taxable income” (as determined under Section 1.1502-11) as the basis for computing a consolidated group’s Section 163(j)(8) “adjusted taxable income.” Moreover, the regulations will disregard intercompany obligations between members of the consolidated group. According to Notice 2018-28, Treasury and the IRS do not anticipate that the regulations will include a general rule treating an affiliated group of corporations that does not file a consolidated return as a single taxpayer for purposes of Section 163(j).
The new regulations will address a number of additional issues relating to the application of Section 163(j)(1) in the consolidated return context, including how to allocate the limitation among group members, and the treatment of disallowed interest deduction carryforwards when a member leaves or joins the consolidated group. Unfortunately, Notice 2018-28 does not include any detail as to what these regulations will provide.
Partners and S corporation shareholders cannot inappropriately “double count” the business interest income of a partnership or S corporation. The forthcoming regulations will prevent the double counting of business interest income and floor plan financing interest in the context of partnerships and S corporations. The regulations will provide that a partner may only include its share of the partnership’s business interest income for the taxable year to the extent of the partner’s share of the excess of (1) the partnership’s business interest income, over (2) the partnership’s business interest expense (not including floor plan financing). In addition, the regulations will provide that a partner cannot include its share of the partnership’s floor plan financing interest in determining its annual interest expense deduction limitation under Section 163(j). Similar rules will apply to S corporations and their shareholders.
In the Interim
The IRS confirmed that taxpayers may rely on the substance of Notice 2018-28 until the IRS issues proposed regulations. This should allow certain taxpayers to take reasonable positions based on Notice 2018-28 and may be important, for example, to entities with short taxable years that are subject to new Section 163(j) before regulations could be proposed.
However, Notice 2018-28 leaves a number of questions unanswered. It provides no specific guidance, for example, on the interaction between Section 163(j) and the controlled foreign corporation rules, including new Section 951A, relating to global intangible low-taxed income (GILTI) inclusions; nor does it provide specific guidance on the interaction between Section 163(j) and new Section 267A, which disallows deductions for certain amounts paid to a “hybrid entity” or pursuant to a “hybrid transaction.”
Notice 2018-28 indicates that Treasury and the IRS plan to issue additional guidance in the future. In the interim, the IRS requests comments on the rules described in the notice, and is looking for feedback on what additional guidance should be issued to assist taxpayers in complying with the new rules. Comments must be submitted by May 31, 2018.