Limitation on the Deductibility of Net Interest Expense
February 23, 2018
By Simcha David
The Tax Cuts and Jobs Act is the most sweeping tax legislation since the Internal Revenue Code was completely overhauled by then President Ronald Reagan in 1986. The Act has provisions that affect individuals, corporations, flow-through entities, multinational corporations and tax-exempt organizations. One of the provisions of the Act that may have a profound impact on the world of finance is the far reaching limitation on the deductibility of net interest expense (the new IRC Section 163(j)). In the past, Congress, being wary of the possibility of abusing the benefit of the interest expense deduction, had limited the use of the interest expense deduction in only certain very specific situations. The new limitation, however, applies much more broadly.
To illustrate the difference between the old 163(j) and the new 163(j), the old rule applied only to corporations that had related-party debt and had a debt-to-equity ratio that was greater than 1.5:1. By contrast, the new rules apply to all “business interest.” The rules apply to related and non-related party interest; they apply to sole proprietorships, partnerships and corporations; and they apply regardless of the debt-to-equity ratio of the entity.
As with every good piece of legislation, this new rule has a number of exceptions. The new limitation does not apply to any business with average annual gross receipts for the three-taxable-year period ending with the prior taxable year that do not exceed $25 million (aggregation rules apply as they do in IRC Sec. 448(c)). This exception stems from recognition of the difficulty a growing small business might have if it was paying interest expense and not getting the benefit of a deduction for that interest expense. If such interest expense was limited, the business may find itself paying federal income tax on higher net income, even though it did actually pay out a now otherwise non-deductible expense. Since most state and local jurisdictions use federal taxable income as the starting point to determine state and local income taxes, the small business may find itself paying state and local income taxes on that amount as well.
Another important exception to the new rule is that a partnership invested in real estate can elect to be treated as an electing real property trade or business and remove itself from this new limitation. In exchange, the electing real property trade or business must use the ADS methodology of depreciation as opposed to the MACRS methodology for certain assets. In practical terms under the new depreciation rules, also enacted as part of the Act, this extends the depreciable life of the residential real property from 27.5 to 30 years and qualified leasehold improvement property from 15 to 20 years. With certain other tangible property that the electing real property trade or business is not required to use ADS for, such as furniture and fixtures, the new bonus 100% expense deduction would likely apply. The change in depreciable life is a small price to pay for the ability to deduct all of the interest expense generated. The real estate exception does make sense on some level as the industry runs on the use of debt to finance the purchase of real property.
To give a brief overview of the provision, we will start with the definition of business interest. Business interest income is defined as the amount of interest includible in the gross income of the taxpayer for the taxable year, which is properly allocable to a trade or business. Such term does not include investment interest as defined by reference to subsection (d) of IRC Section 163. IRC Section 163(d) limits the deduction of investment interest expense to the amount of net investment income a taxpayer includes in his income in a particular tax year. Otherwise, such interest is non-deductible and is carried forward to future years. In the asset management industry, this limitation is commonly referred to as the net investment interest expense limitation. The interest expense generated by the use of leverage in both trader funds and investor funds should be included in the 163(d) limitation (except perhaps the GP’s portion of the interest expense of a trader fund to which 163(d) does not apply) and as such it would seem that the limited partners share of such interest expense would not be further limited by the new section 163(j) limitation
In general, the amount allowed as a deduction for business interest expense shall not exceed the sum of:
- The business interest income of such taxpayer for such taxable year;
- 30% of the adjusted taxable income (“ATI”) of such taxpayer for such taxable year; PLUS
- The floor plan financing interest of such taxpayer.
Generally, in the financial services area, it is points (1) and (2) that will have the greatest impact unless your underlying portfolio company is an auto dealership. What is still unclear is whether payment of interest on shareholder loans to a blocker corporation whose proceeds are used to invest in an underlying operating partnership is really considered business interest expense.
ATI is defined as the taxable income of the taxpayer computed without regard to: (i) any item of income, gain, deduction or loss which is not properly allocated to a trade or business; (ii) any business interest or business interest income; (iii) the amount of any net operating loss deduction; (iv) the amount of any deduction allowed under IRC Sec. 199A (which is the new 20% deduction for pass-through entities) and (v) in the case of taxable years beginning before January 1, 2022, any deduction allowable for depreciation, amortization or depletion. ATI for tax years beginning before January 1, 2022 for the most part would reflect the EBITDA of an entity. ATI for tax years beginning after January 1, 2022, would reflect EBIT.
The Act also allows for any disallowed business interest expense to be carried forward indefinitely. While the limitation and carryforward are straightforward when it comes to corporations, the rules are bit more nuanced when it comes to partnerships.
Application to Partnerships:
The application to partnerships is new. The same limitation applies to partnerships and seems to apply at the partnership level. The business interest deduction will be taken into account in determining the non-separately stated taxable income or loss of the partnership (essentially the net business income of the partnership). The Act puts into place rules to ensure that a partner in a partnership does not include the flow-through income of the partnership in order to be able to take additional interest expense at the partner level using the same income initially utilized at the partnership level. Without this provision, the partnership would deduct interest and the partner would be able to deduct even more interest expense if the partner had the ability to increase his adjusted taxable income with the already fully utilized flow-through income from the partnership. The Act does allow for a partner to increase his ATI from the underlying partnership by including the partnership’s “excess taxable income.” This provision allows a partner to take advantage of the partner’s allocable share of the excess limitation that the partnership was not able to utilize because of the lack of additional interest expense at the partnership level.
For example, if a partnership has $200 of ATI, this would allow the partnership a $60 deduction for interest expense ($200*.30=$60). If the partnership has only $40 of interest expense to deduct, the extra $20 will be allowed at the partner level (assuming the partners have additional partner level (non flow-through) interest expense) by increasing the partners’ own ATI by the partnership excess taxable income.
If the partnership has interest expense that is not deductible in the current year, it allocates that non-deductible interest expense to its partners and the partners will immediately decrease their outside basis in the partnership accordingly. In future years, if the partnership that generated the non-deductible interest expense flows-through to its partners any excess taxable income, the partners may utilize such income and deduct the non-deductible interest in that future year. In such future years, the partner must first utilize excess taxable income that flows from a particular partnership to offset any non-deductible interest expense carry overs from prior years from the same partnership before including the excess taxable income in its own ATI to allow for a deduction of any partner level interest expense.
For example, assume the same facts as above, except that Partnership A has $80 worth of interest expense in year one. Only $60 is deductible and so Partnership A will pass $20 of non-deductible interest expense to its partners in year one. In year two, if the ATI of Partnership A is again $200 but Partnership A has only $40 of interest expense to deduct, there will be a component of excess taxable income (enough to allow for an additional $20 of interest expense) flowing up from Partnership A to its partners in year two. Even if the partners have partner level (non flow-through) interest expense of their own to deduct, they must first deduct the prior year non-deductible interest expense of $20 in year two because there is sufficient excess taxable income flowing to them from Partnership A in year two to allow for the deduction. If, on the other hand, the partners receive excess taxable income in year two from Partnership B and not Partnership A, they would not be able to deduct the $20 of prior year non-deductible interest expense allocated to them from Partnership A, although the partners may include the Partnership B excess taxable income in their own ATI to take their own partner-level interest expense.
If on the sale of the partnership interest the partner still has a balance of non-deductible interest expense from that partnership, the partner may increase the basis of his partnership interest by the amount of the non-deductible interest expense, thereby lowering the capital gain on the sale of the partnership interest. It is unclear how this basis add-back would apply, if at all, to a partnership distribution in excess of basis that gives rise to capital gains.
While the new limitation will affect the portfolio companies of PE funds, it will also have an effect on certain fund level structures, such as the use of levered blockers. As mentioned above, it may put a limitation on the ability of the GP of a trader fund to deduct interest expense allocated to it from the fund. This rule could also significantly increase the after tax cost of LBO financing and may make preferred equity financing or other interest equivalents more attractive than debt financing.
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