IRS Issues Interim Guidance on Business Interest Limitation Rules Effective in 2018

(Parker Tax Publishing April 2018)

The IRS has announced its intention to issue proposed regulations to assist taxpayers in complying with the interest expenses limitation rules enacted by the Tax Cuts and Jobs Act of 2017 (TCJA). Until such regulations are issued, the IRS is providing interim rules, including guidance allowing taxpayers to carryover disallowed interest under pre-TCJA rules for the last tax year beginning before January 1, 2018, to the taxpayer's first tax year beginning after December 31, 2017. Notice 2018-28.

Background

Before the Tax Cuts and Jobs Act of 2017 (TCJA), Code Sec. 163(j) disallowed a deduction for disqualified interest paid or accrued by a corporation in a tax year if two threshold tests were satisfied. The first threshold test was satisfied if the payor's debt-to-equity ratio exceeded 1.5 to 1.0 (i.e., safe harbor ratio). The second threshold test was satisfied if the payor's net interest expense exceeded 50 percent of its adjusted taxable income (generally, taxable income computed without regard to deductions for net interest expense, net operating losses, the domestic production activities deduction, depreciation, amortization, and depletion).

For purposes of pre-TCJA Code Sec. 163(j), disqualified interest included interest paid or accrued to (1) related parties when no federal income tax was imposed with respect to such interest; (2) unrelated parties in certain instances in which a related party guaranteed the debt; or (3) a real estate investment trust (REIT) by a taxable REIT subsidiary of that REIT.

Interest amounts disallowed for any tax year under pre-TCJA 163(j) were treated as interest paid or accrued in the succeeding tax year and could be carried forward indefinitely. In addition, any excess limitation (i.e., the excess, if any, of 50 percent of the adjusted taxable income of the payor over the payor's net interest expense) could be carried forward three years.

Pre-TCJA Code Sec. 163(j)(6)(C) provided that all members of the same affiliated group were treated as one taxpayer. In addition, Code Sec. 163(j)(9)(B) provided the IRS with the authority to issue regulations providing for adjustments in the case of corporations that are members of an affiliated group as may be appropriate for carrying out the purposes of Code Sec. 163(j). Proposed regulations under pre-TCJA Code Sec. 163(j) were issued on June 18, 1991, and contained a rule that would treat all members of an affiliated group as one taxpayer for purposes of Code Sec. 163(j), without regard to whether such affiliated group filed a consolidated return, as well as other rules relating to affiliated corporations.

TCJA amended Code Sec. 163(j) to provide new rules limiting the deduction of business interest expense for tax years beginning after December 31, 2017. For any taxpayer to which Code Sec. 163(j) applies, Code Sec. 163(j)(1) now limits the taxpayer's annual deduction for business interest expense to the sum of: (1) the taxpayer's business interest income for the tax year; (2) 30 percent of the taxpayer's adjusted taxable income for the tax year; and (3) the taxpayer's floor plan financing interest (generally interest incurred in purchasing large items such as vehicles from showroom floors or lots) for the tax year. The limitation applies to all taxpayers, except for certain taxpayers that meet the gross receipts test in Code Sec. 448(c) (i.e., taxpayer generally with $25 million or less in gross sales for the three-tax-year period ending with the prior tax year), and applies to all trades or businesses, except certain trades or businesses listed in Code Sec. 163(j)(7) (which includes any electing real property trade or business or any electing farming business). The amount of any business interest not allowed as a deduction for any tax year as a result of the business interest expense limitation is treated as business interest paid or accrued in the next tax year and may be carried forward. Code Sec. 163(j) does not provide for the carryforward of any excess limitation. The pre-TCJA provision which treated an affiliated group as one taxpayer, and which authorized super affiliation rules, were removed by TCJA and no equivalent provisions were provided in Code Sec. 163(j), as amended by TCJA.

The Conference Report to TCJA notes that interest income and interest expense of a corporation is properly allocable to a trade or business, unless such trade or business is otherwise explicitly excluded from the application of the provision. The Conference Report also notes that in the case of a group of affiliated corporations that file a consolidated return, the limitation applies at the consolidated tax return filing level. There is no mention in the Conference Report of applying Code Sec. 163(j) to affiliated groups that do not file a consolidated return.

IRS to Allow Carryover of Pre-TCJA Disallowed Interest to Post-TCJA Years

Before TCJA, C corporations that could not deduct all of their interest expense under Code Sec. 163(j)(1)(A) could carry their disallowed disqualified interest forward to the succeeding tax year. Such interest was treated as paid or accrued in the succeeding tax year. Similarly, under Code Sec. 163(j)(2), as amended by TCJA, taxpayers that cannot deduct all of their business interest because of the limitation in Code Sec. 163(j)(1) may carry their disallowed business interest forward to the succeeding tax year, and such interest is treated as business interest paid or accrued in the succeeding tax year.

In Notice 2018-28, the IRS announced that it intends to issue regulations clarifying that taxpayers with disqualified interest disallowed under pre-TCJA 163(j)(1)(A) for the last tax year beginning before January 1, 2018, may carry such interest forward as business interest to the taxpayer's first tax year beginning after December 31, 2017. The regulations will also clarify that business interest carried forward will be subject to potential disallowance under Code Sec. 163(j), as amended by TCJA, in the same manner as any other business interest otherwise paid or accrued in a tax year beginning after December 31, 2017.

The regulations will also address the interaction of Code Sec. 163(j) with Code Sec. 59A, relating to the tax on base erosion payments of taxpayers with substantial gross receipts. The regulations will provide that business interest carried forward from a tax year beginning before January 1, 2018, will be subject to Code Sec. 59A in the same manner as interest paid or accrued in a tax year beginning after December 31, 2017, and will clarify how Code Sec. 59A applies to that interest.

For tax years beginning before 2018, a corporation that was subject to the limitation in Code Sec. 163(j)(1) was allowed to add to its annual limitation any "excess limitation carryforward" from the prior year. As amended by TCJA, Code Sec. 163(j) does not have a provision that would allow an excess limitation carryforward. Thus, the IRS intends to issue regulations clarifying that no amount previously treated as an excess limitation carryforward may be carried to tax years beginning after December 31, 2017.

All Interest Paid or Accrued by C Corporation Is Business Interest Expense and Income

The IRS also intends to clarify in future regulations that, solely for purposes of Code Sec. 163(j), in the case of a taxpayer that is a C corporation, all interest paid or accrued by the C corporation on indebtedness of such C corporation will be considered business interest, and all interest on indebtedness held by the C corporation that is includible in gross income of such C corporation will be business interest income. Such regulations will not apply to S corporations. Regulations also will address whether and to what extent interest paid, accrued, or includible in gross income by a non-corporate entity such as a partnership in which a C corporation holds an interest is properly characterized, to such C corporation, as business interest within the meaning of Code Sec. 163(j)(5) or business interest income within the meaning of Code Sec. 163(j)(6).

Application to Consolidated Groups

Consistent with congressional intent as reflected in the Conference Report, the IRS intends to clarify in future regulations that the limitation on the amount allowed as a deduction for business interest applies at the level of the consolidated group.

Impact on Earnings and Profits

The IRS said the future regulations will clarify that the disallowance and carryforward of a deduction for a C corporation's business interest expense will not affect whether or when such business interest expense reduces earnings and profits of the payor C corporation.

Business Interest Income and Floor Plan Financing of Certain Pass-Thru Entities

Under Code Sec. 163(j)(4), the annual limitation on the deduction for business interest expense must be applied at the partnership level and any deduction for business interest must be taken into account in determining the non-separately stated taxable income or loss of the partnership. According to the IRS, although Code Sec. 163(j)(4) is applied at the partnership level with respect to the partnership's indebtedness, Code Sec. 163(j) may also be applied at the partner level in certain circumstances. The IRS intends that future regulations will provide that, for purposes of calculating a partner's annual deduction for business interest under Code Sec. 163(j)(1), a partner cannot include the partner's share of the partnership's business interest income for the tax year except 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). Additionally, the IRS intends to issue regulations providing that a partner cannot include such partner's share of the partnership's floor plan financing interest in determining the partner's annual business interest expense deduction limitation under Code Sec. 163(j). Similar rules will apply to any S corporation and its shareholders.

For a discussion of the business interest expense limitation as enacted by TCJA, see Parker Tax ¶92,323.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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