The Tax Cuts and Jobs Act (TCJA), enacted in late 2017, transformed the landscape of the Internal Revenue Code by giving birth to several new tax code sections. One of those new sections is Section 163(j), which limits the business interest expense deductible for certain taxpayers, with the disallowed amount carried forward to future tax years. The newly enacted Section 163(j) replaced its predecessor of the same name. To distinguish them, the prior law will be referred to as “Old §163(j)” and the new law referred to as “New §163(j).” Despite their common name, the old and new laws vary greatly, both in their rule structures and their effect on taxpayers.

Old §163(j)’s rules targeted certain earnings stripping transactions conducted by taxpayers with foreign affiliates, while also discouraging taxpayers from assuming too much debt. In contrast, New §163(j) appears less concerned with earnings stripping or debt assumptions, and for many taxpayers, it drives their business interest deduction most substantially by taxable income.

The old law: “Old §163(j)”

Old §163(j) was commonly referred to as the “earnings stripping rules” because one of the primary goals of the statute was to prevent multinational taxpayers from “earnings stripping.” A foundational principle of U.S. tax law is to balance deductions taken with income recognized. In the case of interest payments on debt, the payor is generally permitted to deduct the interest paid as interest expense, while the payee is required to recognize the interest payment as taxable income. Earnings stripping occurs when this interaction falls out of balance. Multinational groups of corporations would set up transactions to enable the payor of interest to deduct the interest expense for U.S. tax law purposes while enabling the payee to escape U.S. income tax recognition on interest payments received. Consequently, the U.S. Department of the Treasury was shortchanged; taxpayers received a tax benefit from the interest deduction without feeling the tax burden on the interest income. Old §163(j) intends to help restore the balance.

Old §163(j) limited interest deductions by prescribing certain rules to prevent parties from escaping U.S. taxation as well as encouraging taxpayers to maintain a debt-to-equity ratio.

For Old §163(j) to apply, the following conditions had to be present:

• A U.S. corporation or U.S. branch of a foreign corporation had to pay interest to either a related or unrelated person when there was a “disqualifying guarantee” of the underlying debt.
• The payee was either exempt from U.S. tax on some of the income or paid less tax due to a tax treaty in place.
• The payor corporation did not meet the debt-to-equity ratio of 1.5 to 1.
• The corporation’s net interest expense exceeded 50% of adjusted taxable income (ATI) plus any excess limitation carryforward.

ATI under Old §163(j) was the sum of taxable income with the following deductions added back:

• Net interest expense
• Net operating losses
• Section 199 deduction, and
• Depreciation, amortization, and depletion

These rules intended to mitigate earnings stripping, hindering taxpayers’ ability to allocate interest expense into the U.S. when the corresponding interest income escaped U.S. tax recognition. 

Importantly, Old §163(j) not only targeted groups of taxpayers involved in earnings stripping but also built in a debt-to-equity ratio. Requiring taxpayers to maintain a debt-to-equity ratio of 1.5 to 1 served to not only prevent taxpayers from paying too much interest on debt, but also had the very tangible effect of discouraging taxpayers from becoming too highly leveraged. In this way, Old §163(j) accomplished the twofold task of inhibiting earnings stripping while also ensuring taxpayers maintained a “safe” amount of equity in their businesses.

The new law: “New §163(j)”

Exclusion from New §163(j)

The TCJA enacted New §163(j) effective for tax years beginning after Dec. 31, 2017. In contrast to Old §163(j), which did not extend to taxpayers with only domestic affiliations, New §163(j) applies to all businesses, domestic or multinational, with certain exceptions. New §163(j) does not apply to taxpayers that come under the “small business exemption” or to certain trades or businesses that are eligible and choose to elect out.

The small business exception applies to businesses that meet the gross receipts test of Section §448(c). To come within this exception and be exempt from New §163(j), the average annual gross receipts of the entity for the preceding three years, ending with the prior tax year, must be less than $25 million. For instance, if an entity were being tested for the 2018 taxable year, then the average annual gross receipts for tax years 2015, 2016, and 2017 would have to be less than $25 million to fall within the exception.

Certain trades or businesses may elect out of the §163(j) requirements. These excepted trades or businesses include:

• Performing services as an employee
• Electing real property trades or businesses
• Electing farming businesses
• Certain utility trades or businesses

Real property trades or businesses include any of the following:

• Development
• Construction
• Acquisition
• Conversion
• Rental
• Operation
• Management
• Leasing
• Brokerage trades or businesses

In exchange for exemption from the strictures of New §163(j), electing real property trades or businesses must use the alternative depreciation system (ADS) for qualified improvement property, residential rental property, and nonresidential rental property. Electing farming businesses must use the ADS method for any property with a recovery period of 10 years or more.

The ADS method is a slower cost recovery method than the general depreciation system generally used by real property trades or businesses. Therefore, electing real property trades or businesses and electing farming trades or businesses may deduct less deprecation each year in exchange for being excepted from New §163(j).

In contrast to its predecessor, New §163(j) relieves certain taxpayers from business interest expense limitation without any apparent concern of preventing earnings stripping. Taxpayers excepted from or able to elect out of New §163(j) seem to have been chosen more on the character and size of their operations than on a desire to curb tax abuse by affiliated parties.

New §163(j) calculation

Under the New §163(j), businesses may deduct business interest expense up to the sum of:

• Business interest income
• 30% of the adjusted taxable income (ATI)
• Floor plan financing interest expense

The New §163(j) ATI calculation as well as the floor plan financing interest merit further clarification.

ATI for New §163(j) means taxable income without regard to:

• Any income, gain, deduction, or loss that is not allocable to a trade or business
• Any business interest income or expense
• Net operating losses
• ·§199A deduction for qualified business income of pass-through entities
• Depreciation, amortization, or depletion for tax years beginning before Jan. 1, 2022

Floor plan financing interest expense is interest on debt used to finance the acquisition of motor vehicles held for sale or lease where the debt is secured by the acquired property.

For many taxpayers, floor plan financing and business interest income, due to its narrowly defined definition, will not factor heavily into their business interest limitation. Therefore, the New §163(j) business interest limitation for many taxpayers is largely driven by taxpayer ATI, derived from the taxpayer’s taxable income. This effectively grants higher business interest deductions to taxpayers with higher taxable income and limits business interest deductions for taxpayers with lower taxable income. It is now largely taxable income, as opposed to taxable income and the debt-to-equity ratio of the old law, that drives the business interest deductions available.

Conclusion

New §163(j)’s effects on taxpayers are tangibly different than Old §163(j)’s. While Old §163(j) restrained taxpayers from becoming too highly leveraged and simultaneously inhibited sophisticated earnings stripping transactions, New §163(j) seems to lead taxpayers on a different course. The new law has much further reach than the old law, impacting both domestic and multinational taxpayers with a few exceptions. However, the pivotal role played by taxable income in New §163(j)’s limitation equation, as well as the absence of any limitation on debt assumed by taxpayers, appears to all but guarantee that New §163(j) will chart a very different course for taxpayers than its predecessor did.  

Michael I. Billet, JD, CPA works in National Tax Services for CohnReznick LLP. He can be reached at Michael.Billet@CohnReznick.com.