Unraveling the Complexities of the Revised Section 163(j): A Comprehensive Overview

Unraveling the Complexities of the Revised Section 163(j): A Comprehensive Overview

In April 2018, the Treasury Department and the IRS unveiled Notice 2018-28, offering crucial guidance to taxpayers navigating the intricacies of the revised rules under section 163(j) that impose limitations on deductions for interest expenses. This notice serves as a compass for taxpayers until the release of proposed regulations in this domain. In this comprehensive overview, we will explore the evolution from the old rules, as explained in the notice, to the new rules introduced by the Tax Cuts and Jobs Act (TCJA) in December 2017.

Old Rules: Pre-TCJA Landscape

Before the TCJA reshaped the tax landscape, section 163(j) governed the denial of deductions for disqualified interest. Two key thresholds determined the denial of deductions:

Debt-to-Equity Ratio: 

The payor's debt-to-equity ratio needed to exceed the safe harbor threshold of 1.5-to-1.0.

Net Interest Expense: 

The payor's net interest expense had to exceed 50% of its adjusted taxable income.

Disqualified interest encompassed interest paid or accrued to related parties without federal income tax imposition, interest paid under a related party guarantee, or interest paid to a Real Estate Investment Trust (REIT) by a taxable REIT subsidiary. The disallowed interest could be carried forward indefinitely, and any excess limitation had a three-year carryforward period.

New Rules Introduced by TCJA

The TCJA introduced a significant overhaul to section 163(j), creating a novel limitation on interest deductions. The new rules, applicable to taxable years beginning after December 31, 2017, restrict the deduction of business interest expense to the sum of three components:

Business Interest Income: The taxpayer's business interest income.

30% of Adjusted Taxable Income: A limitation set at 30% of the taxpayer's adjusted taxable income.

Floor Plan Financing Interest: Limited to dealers of self-propelled motor vehicles, boats, and farm equipment.

Under the new rules, any unallowed business interest deduction is treated as paid or accrued in the subsequent taxable year and can be carried forward indefinitely. Unlike the old rules, the amended section 163(j) doesn't provide for the carryforward of excess limitations.

For taxable years before January 1, 2022, adjusted taxable income was defined as earnings before interest, taxes, depreciation, and amortization (EBITDA), excluding net operating losses and deductions under section 199A.

For taxable years on or after January 1, 2022, adjusted taxable income is defined as earnings before interest and taxes (EBIT), allowing deductions for depreciation, amortization, and depletion.

Applicability and Exceptions

The new limitation extends to all taxpayers, with exceptions for those with average gross receipts under $25 million in the preceding three taxable years. Additionally, certain utility, real property, and farming businesses are exempt.

Pending Regulations and Future Considerations

Notice 2018-28 assures taxpayers that forthcoming regulations will address critical aspects, including the calculation of the limitation for consolidated groups, the treatment of amounts disallowed and carried forward from old rules, and the calculation of the new limitation for partnerships and S corporations.

The notice provides essential clarifications for C corporations, stipulating that all interest expenses will be considered properly allocable to a trade or business. Simultaneously, all interest income will be deemed business interest income, leaving no room for exclusion as investment items under the new rules.

Coordinating with BEAT Provisions

The notice offers valuable insights into the coordination of the new section 163(j) rules with the base erosion and anti-abuse tax (BEAT) provisions under section 59A. This guidance is particularly beneficial for both U.S.-based and foreign-based multinationals contemplating operational restructuring in response to the newly introduced international provisions.

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