U.S.: Section 163(j) interest limitation rules
Background on interest expense limitations
A business operating as a corporation, pass through entity, or sole proprietorship is generally allowed a deduction for interest expense paid or accrued in calculating its federal taxable income under Section 163 of the Internal Revenue Code. However, the Internal Revenue Code imposes various limitations on the deductibility of interest expense. The Tax Cuts and Jobs Act overhauled certain aspects of these interest expense limitation rules as discussed below. The changes will have a significant effect on many taxpayers. The new interest limitation rules apply to tax years beginning after December 31, 2017.
Prior to passage of the Tax Cuts and Jobs Act, Section 163(j) (herein, “Old Section 163(j)”) limited the deductibility of interest paid or accrued by a thinly-capitalized corporation (that is, a corporation with a debt to equity ratio exceeding 1.5:1) to a related party in whose hands the interest was exempt from U.S. federal income tax, if the taxpayer paying the interest had excess interest expense. Excess interest expense equals the excess of the taxpayer’s net interest expense over 50% of its adjusted taxable income.
This rule sought to prevent a taxpayer from deducting interest from its U.S. taxable income without a corresponding inclusion in U.S. taxable income by the recipient, thereby stripping earnings from the U.S. tax system.
New interest limitation rules after the tax cuts and jobs act
The old Section 163(j) interest limitation rules affected only corporate taxpayers with a debt-to-equity ratio exceeding 1.5:1 that paid or accrued interest to related parties. In contrast, Section 163(j) as revised by the Tax Cuts and Jobs Act (herein “New Section 163(j)”) is likely to affect a wider group of corporations, pass-through entities and sole proprietorships subject to U.S. federal income tax regardless of the taxpayer’s debt-to equity ratio or relationship to the recipient of the interest.
New Section 163(j) limits a taxpayer’s deduction for business interest expense to the sum of the taxpayer’s:
- Business interest income,
- Floor plan financing interest (applicable only to vehicle dealers), and
- 30% of its adjusted taxable income.
A taxpayer’s adjusted taxable income is generally equal to its taxable income without taking into account any income or expense amount not related to a trade or business, business interest income or expense, net operating loss deductions, qualified business income deduction under Section 199A, and, for tax years beginning before 1 January 2022, any deduction allowable for depreciation, depletion or amortization.
In the case of a foreign person, the definitions of business interest and adjusted taxable income are modified to take in to account only those amounts effectively connected with a U.S. trade or business.
Any amount not currently allowed as a deduction due to New Section 163(j) limitations is treated as paid or accrued in the subsequent taxable year, when the limitations are applied anew.
A partnership or S corporation calculates the limitation at the entity level. A partnership passes through any excess business interest to its partners. The partner may utilize carryovers if and when the partnership allocates excess taxable income to the partner in a future year. In contrast, an S corporation carries forward excess business interest at the entity level.
Amounts subject to the limitation
The term “business interest” means interest paid or accrued on indebtedness properly allocable to the taxpayer’s trade or business. From a technical perspective, the definition of “interest” includes amounts paid or accrued as compensation for the use of money. This definition encompasses items that are not traditionally treated as interest under federal income tax law, such as guaranteed payments made by a partnership for the use of a partner’s capital, loan commitment fees, debt issuance costs, and certain types of lease payments. A proposed anti-avoidance rule treats any expense or loss as interest if it is incurred in consideration of the time value of money and is related to a transaction in which the taxpayer secures the use of funds for a period of time. Accordingly, taxpayers should not rely on the financial accounting designation of an item of income or expense as interest or otherwise. Careful analysis will be required to determine the appropriate treatment of a transaction or financing arrangement when calculating the amount of deductible business interest expense.
New Section 163(j) does not limit the deductibility of a taxpayer’s investment interest; only business interest is limited. None of a Subchapter C corporation’s interest is considered investment interest. However, a partnership or S corporation may have both business interest and investment interest. Taxpayers should keep adequate records to isolate the business interest amounts from investment interest amounts.
Small businesses (a taxpayer whose average annual gross receipts for the prior three taxable years do not exceed US$ 25 million) and certain regulated utility trades or businesses are exempted from the new business interest limitation rules.
Taxpayers can make an irrevocable election out of the New Section 163(j) limitations with respect to certain types of trades or businesses. These elections are made at the trade or business level, not the entity level. It is possible a taxpayer will have one trade or business that may elect out and another that may not. Trades or businesses that may elect out include real property trades or businesses and farming businesses.
A real property trade or business is the development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage of real property. An electing real property trade or business is subject to special depreciation rules.
A farming business is the operation of a farm or nursery, the raising and harvesting of trees, or a specified agricultural or horticultural cooperative.
Foreign companies conducting business in the United States should revisit the efficiency of their capital structures. Recent reductions in the federal corporate income tax rate coupled with newly enacted NOL carryforward limitations and interest expense deduction limitations discussed above may make equity funding US operations more attractive to foreign companies.
Michael Smith - Principal – Global Tax Services
Amanda Hernandez - Senior Associate – Global Tax Services