This information is based on the statutes and guidance available as of the date of publication (January 2018) and is subject to change. 

Congress has felt that the corporate interest limitation rules have been outdated for some time. While the rest of the world has moved to a BEPS (“Base Erosion and Profit Shifting” under OECD guidelines) model for determining the limitation of interest expense, the U.S. has imposed a related party debt limitation based on adjusted income and debt to equity ratios.  Tax reform attempted to “refresh” the U.S. rules with a new limitation on deductions for interest expense under §163(j) effective for tax years beginning on or after January 1, 2018.

What Type of Interest is Subject to the New Limitation?

All business interest is subject to limitation under the new rules. Under prior §163(j), only interest paid to or guaranteed by a related party was subject to the limitation rules. The new limitation is applied against all business interest expense.

Since all interest expense of corporations is deemed to be “business interest”, these rules will apply to all interest expense of a corporation including CFCs.  It is possible for individuals and partnerships, however, to have investment interest expense, which would not be subject to these rules.  

The definition of “interest expense” under §163(j) is very broad and includes unexpected items such as premiums, debt issuance costs, and guaranteed payments for use of capital.  If there is doubt, please refer to the regulations on Sec 163(j) in determining all items that are included as “interest” in the limitation.

Certain trade or businesses such as real property businesses can make an irrevocable election to be exempt from the §163(j) imitation, but at the cost of less favorable write-offs.

When Does the Limitation Apply?

The limitation applies to all taxpayers. The limitation applies to all taxpayers. The only exception to this is for “certain small businesses” (including partnerships and sole proprietors) generally defined as taxpayers with average gross receipts of less than $25 million (adjusted for inflation after 2018) for the preceding three tax years. In calculating average gross receipts, affiliated group rules apply to a member of an affiliated group with more than 50% common ownership. Foreign corporations can be included in the definition of affiliated group for this purpose, which could reduce the number of businesses that can claim this exception. This exception may not apply to partnerships with losses 

How is the Limitation Calculated?

The limitation is computed under the following formula:

Business interest income for the year

+      30% of “adjusted taxable income” for the year (not less than $0)

+      “floor plan financing interest” for the year  ← interest expense of car inventory for auto retailers

=      Deductible Interest Expense

“Adjusted Taxable Income” or ATI is calculated as follows:

For tax years 2018 – 2021:

Taxable income before NOL Deduction

+/-  Any item not allocable to a trade or business

+/-  Business Interest Expense or Business Interest Income

+-   §199A Deduction (new qualified business income deduction; n/a for corporations)

+/-  Depreciation, Amortization and Depletion*

- 100% FDII**

+/-  Any other adjustments as prescribed by the Secretary

*Depreciation, amortization or depletion expenses that are subject to capitalization under section 263A and deducted in costs of goods sold are not added back.  For tax years 2022 and after, the calculation is the same as above, but there is no adjustment for depreciation, amortization and depletion.

**FDII amounts must be calculated if there is interest expense, even if the full FDII benefit is limited by taxable income.  However, if there is a loss position prior to FDII, no adjustment to ATI is needed.  For example, if a taxpayer’s ATI is $100 and their full FDII before limitation is $200, the full $200 is included in the ATI adjustment.  If a taxpayer has a net loss of $100 and no FDII at all, there are no adjustments to ATI for FDII.

Note that the limitation is generally computed at the entity level except for consolidated returns which computes the limitation at the consolidated level.  Limitation and carryforwards are allocated among members based on the prorata share of interest expense and ATI.

Carryforward Amounts

Any interest that is limited under §163(j) is not deducted and is carried forward indefinitely to be treated as paid or accrued in the subsequent tax year. Exceptions to this rule for individuals or partnerships are described below.  If a taxpayer calculates an excess limitation (i.e., the 30% of adjusted taxable income exceeds interest expense), this amount is not carried forward as prior §163(j) allowed.

Please note that pre-2018 excess limitation amounts are not carried forward into 2018.

Partnerships

In the partnership context, §163(j) is calculated at the partnership level. The excess interest expense is not carried over by the partnership, rather, it is allocated to each partner in the same manner as any tax item under the partnership agreement. Partnerships with special allocations must follow a complicated 11-step process to properly allocate the limitation or carryforward. Please consult with Rödl & Partner USA if there are §754 elections or partners receiving tax allocations different from economic allocations. 

Example Calculation

Below is an example calculation for a corporate or individual partner in a partnership, XYZ.  

ABC calculates the following interest limitation:

Taxable Income                   $140

+ Interest Expense                 60

Adjusted Taxable Income     $200

Limitation (x 30%)              $  60

All interest expense is deductible.

ABC income allocated to XYZ = $70

ABC income allocated to M = $70

 

On XYZ’s Form 1120, XYZ cannot use the $70 of flow-through income to calculate XYZ’s adjusted taxable income to compute its interest limitation:

Taxable Income                   $(25)

+ Interest Expense                 25

Adjusted Taxable Income      $  0

Limitation (x 30%)               $  0 

All of XYZ’s interest expense is limited. $25 is carried forward by XYZ.

 

Now assume that ABC incurs $40 of interest expense instead of $60 in the previous example:

ABC calculates the following interest limitation:

Taxable Income                        $160

+ Interest Expense                       40

Adjusted Taxable Income           $200

Limitation (x 30%)                    $  60 

All interest expense is deductible.

ABC income allocated to XYZ = $80

ABC income allocated to M = $80

 

Excess taxable income allocated to XYZ =

Excess adjusted taxable income           $ 20 ($60 Limitation less $40 Interest Expense)

Divided by Limitation                           $ 60

Result                                             33.33%

Adjusted Taxable Income                     $200

Excess Taxable Income                     $66.67

ABC excess taxable income allocated to XYZ:   $33.33

ABC excess taxable income allocated to M:       $33.33 

 

XYZ’s interest limitation:

Taxable Income / (Loss)                        $(25)

+ Interest Expense                                   25

Adjusted Taxable Income                       $   0

+ Excess Taxable Income from ABC        $ 33

Adjusted Taxable Income                       $ 33

Limitation (x 30%)                                $ 10

XYZ can deduct $10 of the $25 interest expense.

XYZ carries forward the remaining $15 indefinitely.

Other Considerations Under Interest Limitation Rules

Ordering rules: 

  • 385 debt / equity classification rules continue to apply
  • New §267A rules disallow certain payments to related hybrid entities or pursuant to a hybrid transaction.
  • Traditional §267 related-party rules require payment of the interest expense during the tax year.

 Application to transactions:  

  • Excess interest expense will carryover in a tax-free reorganization.
  • Any §382 change in ownership will limit future utilization of excess interest.

 Guidance for interactions with §59A (“BEAT”) has not yet been released.