This article answers several questions taxpayers and their advisors will have about the new rules under the Tax Cuts and Jobs Act of 2017 (TCJA) for deducting business interest expense. The answers cover the operational rules, key definitions, information about covered entities, and an example of new special carry-forward rules for partnerships. The authors also describe why the new rules are likely to represent little opportunity to relocate outside of the United States, in general, and conclude with a discussion of the increased costs of borrowing for affected companies.
What Are the Limits on Business Interest Deductibility?
Starting with tax years beginning in 2018, businesses covered under Internal Revenue Code (IRC) section 163(j) will have a new limitation on business interest expense. They may deduct business interest each year that is not in excess of the sum of 1) their business interest income, 2) 30% of their adjusted taxable income, and 3) floor plan financing interest. For many businesses, items 1 and 3 will have less impact on the total limitation than item 2, because business interest income is often not highly material, and floor plan financing interest is likely to be generally limited to motor vehicle dealers. Such interest must be paid or accrued on the purchase of motor vehicles held for sale or lease, as long as the motor vehicles secure the underlying debt. Motor vehicles include self-propelled vehicles designed to transport individuals or property on public roadways, boats, and farm machinery and equipment.
How Is Adjusted Taxable Income Defined under IRC Section 163(j)?
Adjusted taxable income cannot be less than zero under the new law. It is defined as taxable income exclusive of any nonbusiness items, business interest income, business interest expenses, net operating losses (NOL), and the deduction for qualified business income of pass-through entities under the new IRC section 199A. For tax years that begin before January 1, 2022, adjusted taxable income also excludes depreciation, amortization, and depletion; thus, until 2022, adjusted taxable income is analogous to earnings before interest, taxes, depreciation, and amortization (EBITDA), but should not be confused with book EBITDA. Starting in 2022, adjusted taxable income is somewhat analogous to earnings before interest and taxes (EBIT), where earnings would be taxable income rather than book income.
Assume that Corporation A has adjusted taxable income of $760 million, business interest expense of $600 million, no floor plan financing interest, and business interest income of $1 million for the year. Under the prior law, business interest expense would be fully deductible. Under the TCJA, business interest expense is limited to $1 million + 30% × $760 million, or $229 million. The remaining $371 million ($600 million − $229 million) is carried forward to the next tax year and treated as interest expense in that year. This carryforward does not expire.
Which Entities Are Covered?
In general, IRC section 163(j) applies to corporations, S corporations, partnerships, and sole proprietorships alike. Exceptions include—
- small businesses, as long as the business is not disqualified as a tax shelter under IRC section 448(a)(3);
- utility disposal and distribution businesses; and
- real property trades/businesses and farms that elect not to be subject to section 163(j). Such elections are irrevocable, but are also likely to be infeasible due to the requirement that electing businesses must use the alternative depreciation system (ADS).
What Is a Small Business?
To be classified as a small business, a business must maintain average gross receipts of $25 million or less over the three most recent tax years. Consequently, if such businesses wish to maintain a high degree of leverage while avoiding a limitation on their deductible interest expense, they will need to monitor the opportunity costs of internal growth carefully. These organizations may also consider opportunities for external growth, rather than internal growth, by organizing and growing through new entities that have strong and justifiable business purposes.
Are There Any other Differences in Application across Entities?
IRC section 163(j) mainly applies uniformly; however, special carryforward rules for partnerships offer an opportunity for tax planning. Partnership carryforwards fall to the partner level rather than being retained at the partnership level. After deductible business interest expense from the partnership has been determined for the year, these carryforwards can be used to offset business interest expense from nonpartnership activities (Joint Explanatory Statement of the Committee of Conference, 2017, http://bit.ly/2yL0FjB).
S corporations, on the other hand, follow the general carryforward rules; they retain any nondeductible interest expense carryforwards at the entity level. Therefore, the carryforwards cannot be used to offset interest expense from business activities that are not related to the S corporation; when the need for such offset is reasonably anticipated, investing in a business organized as a partnership may be preferable to investing in one organized as an S corporation.
Starting with tax years beginning in 2018, businesses covered under Internal Revenue Code section 163(j) will have a new limitation on business interest expense.
Assume that Bigg Inc, a C corporation, is also a 25% partner in Partnership X. Furthermore, it has a business interest expense carryforward of $2 million from the prior year from Partnership X. In the current year, Partnership X has adjusted taxable income of $100 million, business interest expense of $15 million, no business interest income, and no floor plan financing interest. Bigg generated no adjusted taxable income at the corporate level, but it did generate $500,000 of business interest expense. It has no business interest income or floor plan financing interest.
Bigg does not qualify for the small business exception, which is based on gross receipts, not on net income. Partnership X has $15 million ($100 million × 30% − $15 million) of unused interest expense in the current year. Bigg owns 25% of this excess, which is $3.75 million (25% × $15 million of unused interest). Bigg’s interest expense limitation for the current year is $3.75 million, calculated as 30% of its own adjusted taxable income (i.e., $0) plus its share of the unused interest limitation.
Thus, Bigg can use the $2 million carryforward from the prior year, despite having no corporate adjusted taxable income in the current year. It can also offset the remaining $1.75 million carryforward ($3.75 million – $2 million) against the $500,000 of interest expense generated at the corporate level. The remaining portion of the carryforward ($1.25 million) is carried forward to the next tax year. Had Partnership X been organized as an S corporation, offsetting Bigg’s $500,000 of business interest expense would not have been possible because the S corporation’s carryforward would have been held at the entity level.
Will Companies Relocate to Avoid IRC Section 163(j)?
Although highly leveraged companies might consider organizing outside of the United States to avoid IRC section 163(j), opportunities to do so may be limited and are likely to diminish over time due to Action 4 of the OECD/G20 Base Erosion and Profit Shifting Project, Limiting Base Erosion Involving Interest Deductions and Other Financial Payments(http://bit.ly/2tH2Tuv). Action 4 provides an international framework for limiting interest expense to 10–30% of tax-based EBITDA; at a minimum, it aims to prevent income shifting and tax avoidance via interest expense deductions taken by multinational corporations. It also encourages limiting interest expense for both domestic and stand-alone business entities.
The authors believe that the TCJA may have a fundamental impact on how much debt some companies decide to issue in the future, as well as on whether these companies decide to retire existing debt.
EU nations have agreed to incorporate a modified form of Action 4 into their tax laws by 2019 (EU Developments: Anti-Tax Avoidance Directive, Deloitte, 2016, http://bit.ly/2yKW3da), and many other countries have rules limiting debt capitalization or limiting interest expense directly (BEPS Actions Implementation by Country, Deloitte 2017, http://bit.ly/2KojJZj). These rules may prove problematic for highly leveraged companies looking to leave the United States.
Will IRC Section 163(j) Influence the Amount of Debt Businesses Issue?
The authors believe that the TCJA may have a fundamental impact on how much debt some companies decide to issue in the future, as well as on whether these companies decide to retire existing debt. The U.S. tax code has long favored the issuance of debt over equity because interest paid on debt has been fully tax deductible and dividends are not. The higher marginal tax rates have been in the past, the greater the advantage of issuing debt over equity. (For more discussion on capital structure decisions, see P. Marsh, “The Choice Between Equity and Debt: An Empirical Study,” Journal of Finance, vol. 37, no. 1, 1982, pp. 121–144; F. Modigliani and M. H. Miller, “Corporate Income Taxes and the Cost of Capital: A Correction,” American Economic Review,vol. 53, no. 3, 1963, pp. 433–443.)
Under the prior law, Corporation Y targeted its capital structure (i.e., debt to equity mix) as 30% debt, 60% equity, and 10% preferred equity. It had a 35% marginal tax rate under prior law and will have a 21% tax rate under new law. The company’s average yield to maturity (YTM), which is generally the market’s required rate of return on debt, is 8%; the required rate of return on common equity is 12%, and the required rate on preferred equity is 7.5%. Corporation Y is sufficiently leveraged so that only 30% of its business interest expense will be deductible under new law.
Previously, the cost to Corporation Y of funding this capital structure could be determined via the Weighted Average Cost of Capital (WACC) formula; under the old law, this would be 9.51%. Considering the new tax rate alone, the new WACC would be 9.85%; factoring in the 30% of deductible business interest, it rises to 10.20%, almost 70 basis points higher.
Given this increase, and all else being equal, one would expect businesses to adjust their capital structures to reflect the TCJA’s new restrictions on the deductibility of business interest expense, coupled with its generally lower business tax rates. In addition, a higher rate of return will be required for new projects and investments to be approved, based on the premises that return on investment should exceed the WACC and the WACC will tend to drift upwards for applicable businesses. Finally, organizations considering going private through a leveraged buyout may no longer find such restructuring arrangements to be economically feasible due to limitations on the deductibility of business interest expense.