The deduction limit
For tax years beginning after 2017, the new tax law amended Section 163(j) of the Internal Revenue Code to limit the deduction for business interest to the sum of:
- Business interest income for the taxable year;
- 30% of the taxpayer’s adjusted taxable income (ATI) for the tax year; and
- The taxpayer’s floor plan financing interest paid by vehicle dealers for the tax year.
The limit applies to all taxpayers with business interest expense. Any unused interest expense is carried forward indefinitely.
A key exception is for taxpayers (together with all related entities) who have average annual gross receipts of $25 million or less (adjusted annually for inflation). In addition, certain real estate or farming businesses can elect out of the limitation in exchange for longer depreciation periods on certain assets.
For more information on the limitation calculation, see “IRS Sheds Light on New Limit on Business Interest Expense Deductions.”
The new definition of “interest”
Under the newly proposed regulations, the definition of “interest” is defined broadly to include “any amount paid or accrued as compensation for the use or forbearance of money under the terms of an instrument or contractual arrangement, including a series of transactions.” Interest also includes amounts treated as interest, such as original issue discounts and accrued market discounts.
Even if an instrument is not “debt” in form, the tax law could treat it as debt and the interest limitations would apply. Certain amounts that are closely related to interest and affect the economic yield or cost of funds in a transaction involving interest are treated as interest—even if these amounts would not otherwise be treated as interest. Examples include substitute interest payments, as well as certain issuance costs and commitment fees.
An anti-avoidance rule prevents transactions that are essentially financing transactions from avoiding the limit. Under these rules, any expense or loss incurred based on the time value of money is treated as interest when a taxpayer secures the use of funds for a period of time.
Based on the broad definition of interest, certain items could be subject to the business interest limit that are not treated as interest under other tax law provisions. In particular, time-value components that were not previously treated as interest could now be deemed as interest for purposes of the limitation. For example, a swap transaction with significant non-periodic payments would be treated as two separate transactions—an on-market, level payment swap and a loan.
This likely will make it more difficult to negotiate financing deals with lenders structured to increase the borrower’s deductible costs and reduce its costs subject to limit. In the past, a business might negotiate a lower interest rate in exchange for a higher loan commitment fee that it could fully deduct. Now, that fee could be considered interest expense subject to the limitation rules.
Computation of Adjusted Taxable Income
To determine ATI, taxable income for the year is calculated as if all business interest expenses are deductible and then certain adjustments are added or subtracted. The proposed regulations expand on the adjustments already specified in Section 163(j) by adding several additional adjustments.
Sec. 163(j) requires adjustments for:
- Any item of income, gain, deduction or loss that is not properly allocable to a trade or business;
- Business interest and business interest income;
- Net operating loss deductions;
- Deductions for qualified business income; and
- Deductions for depreciation, amortization and depletion for taxable years beginning before January 1, 2022.
The proposed regulations expand that list to include adjustments to prevent double counting and other distortions. For example, the proposed regulations require that capital loss carrybacks or carryovers are added back to income.
Allocation of expense and income between multiple businesses
When a taxpayer is engaged in more than one business, the proposed regulations include rules for allocating a taxpayer’s interest expense and income among the businesses that are subject to the interest expense limits and those that are not.
Generally, the taxpayer must compare its tax basis in the assets used in each business to determine the portion of interest expense that should be allocated to each business. Several exceptions and special rules apply, including rules related to allocation among members of a consolidated group.
Other issues to ponder
The proposed regulations address a range of additional issues, including rules for consolidated groups, partnerships and partners, S corporations and controlled foreign corporations.