New regulations on business interest expense deductions have been announced as a follow-up to the temporary guidelines set in April.
The new proposed regulations from the IRS include a variety of noteworthy provisions, including a broader definition of interest than businesses have applied in the past.
The new definition of “interest”
The proposed regulations define “interest” as “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.” Also included are amounts treated as interest under other tax code provisions or tax regulations (i.e., original issue discounts and accrued market discounts).
The new, more inclusive definition encompasses interest on conventional debt instruments as well as interest associated with transactions that are debt in substance, even if not in form. By definition, interest now can include certain amounts that are closely related to interest and affect the economic yield or cost of funds in a transaction involving interest, even when the amounts are compensation for the use or forbearance of money on a standalone basis. Examples include substitute interest payments, certain debt issuance costs, and certain commitment fees.
The proposed regulations also include an anti-avoidance rule to prevent transactions that are essentially financing transactions from avoiding the limit. It considers interest expense to be any expense or loss predominantly incurred based on the time value of money when a taxpayer secures the use of funds for a set time. Amounts associated with time-value components that weren’t previously treated as interest now would be deemed interest. A swap transaction with significant nonperiodic payments, for instance, would be treated as two separate transactions — an on-market, level payment swap and a loan.
The IRS acknowledges that, in some cases, certain items could be tested under the business interest limit that aren’t treated as interest under other tax law provisions. For example, an amount that was previously fully deductible as a business expense under Section 162 could now be tested as a business interest expense subject to limitation.
This likely will make it more difficult to negotiate financing deals with lenders that are structured to increase the borrower’s deductible costs and reduce its costs subject to limit. For example, in the past, a business might negotiate a lower interest rate in exchange for a higher loan commitment fee that it could fully deduct. But now, that fee could be considered interest expense. The impact will, of course, be greater as a company takes on more debt or interest rates edge higher.
The deduction limit — then and now
Prior to the Tax Cuts and Jobs Act (TCJA), corporations were not allowed to deduct disqualified interest expense. This happened when the borrower’s debt equaled more than one-and-a-half times its equity and net interest expenses exceeded 50 percent of its adjusted taxable income (ATI), as computed without regard to deductions for net interest expense, net operating losses, domestic production activities, depreciation, amortization, and depletion.
Taxpayers could indefinitely carry forward excess interest — meaning any interest that couldn’t be deducted due to the 50 percent of ATI limit. Any interest that exceeds the limit (the excess of 50 percent of the borrower’s ATI over its net interest expense) could be carried forward for three years.
For tax years beginning after 2017, the TCJA amended Section 163(j) of the Internal Revenue Code to limit the deduction for business interest incurred by both corporate and noncorporate taxpayers to the sum of:
- Business interest income for the taxable year,
- 30 percent of the taxpayer’s 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, except those with average annual gross receipts of $25 million or less (adjusted annually for inflation); real estate or farming businesses that elect to exempt themselves; certain regulated utilities; and certain trades or businesses, including those performing services as an employee.
The amended rules allow for the indefinite carryforward of any business interest not deducted because of the limit. However, (with some exceptions) taxpayers can’t carry forward interest amounts that exceed the limit to years beginning after Dec. 31, 2017.
Computation of ATI
To determine ATI, compute the taxable income for the year as if all business interest expense is deductible and apply certain adjustments as either additions or subtractions. The proposed regulations include both the adjustments already specified in Sec. 163(j) along with several additional adjustments not in the tax provision.
Sec. 163(j) requires adjustments for:
- Any item of income, gain, deduction or loss that isn’t 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 Jan. 1, 2022.
The IRS has added adjustments to prevent double counting and other distortions. For example, the proposed regulations require the addition of capital loss carrybacks or carryovers.
Allocation of expense and income to excepted businesses
The proposed regulations include rules to determine the amount of a taxpayer’s interest expense and income that should be allocated to a business that’s subject to the business interest deduction limit when the taxpayer also is engaged in an “excepted” business that isn’t.
The taxpayer generally must compare its basis in the assets used in the included business with its basis in the assets used in the excepted business to determine the portion that should be allocated. Several exceptions and special rules apply, including rules related to allocation among members of a consolidated group.
Much to ponder
The proposed regulations address a range of additional issues, including the application of the rules to consolidated groups, partnerships and partners, S corporations, and controlled foreign corporations. KraftCPAs can help you understand the proposed regulations and how they might affect your business. Contact us with questions.