Final Interest Limitation Regulations
August 26, 2020
By Murray J. Solomon, CPA
Definition of Interest Expense and Calculation of Adjusted Taxable Income
On July 28, Treasury and the IRS issued long-awaited final and proposed regulations for the interest deduction limitation provision that was enacted as part of the Tax Cuts and Jobs Act. The final regulations are 575 pages (including the preamble) and include guidance on a myriad of issues including rules for consolidated groups, partnerships, and controlled foreign corporations, just to name a few. We are publishing various alerts on different areas of these regulations. This alert focuses on three topics that have wide applicability to commercial operating companies: the clarification of the definition of interest for purposes of the limitation; the impact on the calculation of adjusted taxable income (“ATI”) from sales of depreciable assets; and the impact on the calculation of ATI from depreciation and amortization expense that was capitalized to inventory.
Definition of Interest
In a taxpayer-favorable move and in response to comments on the proposed regulations, the final regulations scale back the definition of business interest from the more broad definitions in the proposed regulations.
Under the final regulations, commitment fees, debt issuance costs, and hedging items are not considered to be interest expense. All of these items would have been interest under the proposed regulations. Guaranteed payments for the use of capital also are not treated as interest expense.
The final regulations do, however, temper this good news by including anti-avoidance provisions. The anti-avoidance rules treat as interest expense any expense or loss economically equivalent to interest “if a principal purpose of structuring the transaction(s) is to reduce an amount incurred by the taxpayer that otherwise would have been interest expense or treated as interest expense” under the IRC Sec. 163(j) regulations. Examples are included illustrating the application of the anti-avoidance rules in a number of situations.
Gains from the Sale of Assets
For taxable years between 2017 and 2022, IRC Sec. 163(j) limits interest expense deductions to 30% of ATI, which is taxable income calculated without regard to net interest expense, NOLs, depreciation, and amortization (“EBITDA”). Beginning in 2022, ATI will be calculated only without regard to net interest expense or NOLs. In other words, beginning in 2022 ATI will take into account deductions for depreciation and amortization. The proposed regulations contained a provision where ATI would need to be reduced for gains from sales of assets to the extent those gains resulted from depreciation or amortization that was incurred after 2017 and before 2022. The theory was that a company was receiving a double benefit from such depreciation or amortization. For example, a company could increase its ATI with depreciation deductions taken in 2018 and 2019 and if the related asset were sold in 2020, the reduced tax basis would result in a larger taxable gain which would lead to a higher ATI in that year.
The final regulations have retained this provision and thus ATI will need to be reduced by the lesser of the gain from the sale of depreciable (or amortizable) assets and any depreciation or amortization taken between December 31, 2017 and January 1, 2022 on such sold assets (these years are known as the EBITDA period). This provision is intended to eliminate the potential double benefit from the depreciation or amortization taken between 2017 and 2022.
The final regulations also contain similar provisions to eliminate double benefits from depreciation and amortization in the case of sales of subsidiaries in a consolidated group and sales of partnership interests.
Depreciation and Amortization Capitalized to Inventory
Most manufacturing companies must capitalize part of their depreciation and amortization expense to inventory that they produce (under IRC Sec. 263A). The tax benefit for that capitalized depreciation and amortization is obtained through cost of goods sold when the related inventory is sold. The proposed regulations did not allow an increase in ATI for depreciation or amortization that was capitalized to inventory. This lowered the interest limitation and effectively increased the cost of borrowing for manufactures since they could not deduct as much interest expense in a given year.
Treasury and the IRS listened to the many commentators who argued that the proposed regulations were moving beyond Congressional intent and would harm capital-intensive businesses. The final regulations remove this restriction and allow an add-back to ATI for depreciation and amortization even if it were capitalized to inventory. For example, if a taxpayer capitalized an amount of depreciation to inventory under IRC Sec. 263A in the 2020 taxable year, but the inventory is not sold until the 2021 taxable year, the entire capitalized amount of depreciation is added back to tentative taxable income in the 2020 taxable year, and such capitalized amount of depreciation is not added back to tentative taxable income when the inventory is sold and recovered through cost of goods sold in the 2021 taxable year.
The final regulations are effective 60 days after publication in the Federal Register. However, taxpayers can choose to apply these regulations as of January 1, 2018 as long as all provisions of the regulations are followed. The IRS is, however, allowing taxpayers to follow the proposed regulations in their entirety until the final regulations are effective, but still apply the final regulations as they relate to depreciation and amortization that is capitalized to inventory.
This means that taxpayers may choose to amend 2018 tax returns for either the more liberal definition of interest or if the changes to the ATI calculations described above would reduce 2018 taxable income (or increase a taxable loss). Note that the benefit of creating, or increasing, a net operating loss in 2018 is that such losses can potentially be carried back five years for refunds at a higher tax rate under the CARES Act. Also under the CARES Act is the ability for a company to elect to use the 2019 ATI in 2020. Therefore, a company with a significant gain from the sale of assets in 2019, can benefit from that gain’s positive impact on ATI in two years.
 In general, when a taxpayer takes depreciation deductions with respect to an asset, the taxpayer must reduce its adjusted basis in the asset accordingly. As a result, the taxpayer will realize additional gain (or less loss) upon the subsequent disposition of the asset than the taxpayer would have realized absent depreciation deductions. Thus, except with regard to timing, depreciation deductions should have no net effect on a taxpayer’s taxable income.