By Anthony Diosdi
Internal Revenue Code Section 163(j) operates to prevent U.S. and foreign owned companies from eroding the U.S. income tax base through deductible interest payments to tax exempt related parties. The rule used to applied when a debtor’s debt-to-equity ratio exceeded 1.5 to 1 and its total “net interest expense” exceeded 50 percent of its “adjusted taxable income.” In this case, it would result in the disallowance of the portion of its “related party tax-exempt interest.” However, disallowed interest could potentially be carried forward.
The 2017 Tax Cuts and Jobs Act modified Section 163(j) interest expense provisions in several significant ways, most notably eliminating the 1.5 to 1 ratio requirement. The new interest limitation rules under Section 163(j) provides that the deduction allowed for business interest expense in any taxable year generally cannot exceed the sum of 1) the taxpayer’s “business interest income” for the taxable year, plus 2) 30 percent of the taxpayer’s “adjusted taxable income” for the tax year. For example, suppose a taxpayer has $500 of adjusted taxable income and $100 of business interest income. Under the new Section 163(j) rules, the taxpayer can deduct up to $250 of interest expense ($100 business interest income, plus 30 percent of $500 adjusted taxable income).
The term “business interest income” is defined to mean the amount of interest includible in gross income that is allocable to a trade or business, which does not include investment income. See IRC Section 163(j)(6). The term “adjusted taxable income” means the taxpayer’s taxable income, but for tax years beginning before January 1, 2022, computed without regard to any deduction allowable for depreciation, amortization, or deletion (“EBITDA”). For tax years beginning after January 1, 2022, the interest allocation is reduced by depreciation, amortization, or depletion (“EBIT”). Business interest expense that is not deductible because of this limitation may potentially be carried forward indefinitely. See IRC Section 163(j)(2).
The new interest expense limitation provisions provide two notable carve-outs for certain small businesses and real property trades or businesses.
Small businesses- the interest expense limitation does not apply to taxpayers with average annual gross receipts of less than $25 million for the last three years. See IRC Section 163(j)(3). For purposes of applying this exception, gross receipts of all trades or businesses under common control may be aggregated.
Real property trades or businesses- a taxpayer may make an irrevocable election to be excluded from the new interest limitation provisions if he or she is engaged in a real property trade or business under Internal Revenue Code Section 469(c)(7)(C). See IRC Section 163(j)(7)(A)(ii).
On November 26, 2018, the IRS issued proposed regulations on the new business interest expense limitation rules, which expand the foregoing rules. The IRS also released Revenue Procedure 2018-59, which provides a safe harbor that allows taxpayers to treat certain infrastructure trades or businesses as real property trades or businesses for purposes of qualifying as an electing real property trade or business under Internal Revenue Code Section 163(j)(7)(B).
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP. He represents clients in federal tax controversy matters and federal white-collar criminal defense throughout the United States. Anthony Diosdi may be reached at 415.318.3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.