Editor: Mary Van Leuven, J.D., LL.M.
The sweeping tax reform known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, overhauled the federal business interest deduction. Beginning with the 2018 tax year, Sec. 163(j) disallows a deduction for net business interest expense to the extent that it exceeds the sum of a taxpayer's business interest income, 30% of adjusted taxable income, plus floor plan financing interest. Unlike the state rules discussed in this item, the federal limitation makes no distinction between related-party and third-party interest expense. Also, unlike certain state rules, the business interest expense disallowed at the federal level is treated as paid or accrued in the next tax year and may be carried forward indefinitely.
Before the TCJA-created interest limitation, many states (mostly those that allow taxpayers to file separate- company returns) disallowed deductions for certain expenses paid (or accrued) to a related party (related-party add-back rules). While the limitations typically target expenses related to intangible assets, a number of states also disallow related-party interest expense deductions (subject to various exceptions). These states do not permit the disallowed interest to be carried forward and deducted in a future year. The disallowance rules of at least 15 states apply to all related-party interest expenses; the disallowance rules of seven other states apply to related-party intangible expenses, including interest related to intangibles. Currently, over two-thirds of these states conform to the post-TCJA version of Sec. 163(j).
Because Sec. 163(j) does not distinguish between related-party and third-party debt, taxpayers with both kinds of debt subject to the Sec. 163(j) limitation must now consider issues that did not exist before the TCJA. Beginning in 2018, taxpayers subject to a Sec. 163(j) limitation that file in states with related-party interest add-back rules must calculate and track the amount of Sec. 163(j) deferred interest expense that is related-party. Said another way: How much of the taxpayer's total interest expense will be subject to expense disallowance in the current tax year?
It is assumed that the Sec. 163(j) limitation is applied before state expense disallowance rules. This is a reasonable assumption, given that state expense disallowance (add-back) rules are modifications to federal taxable income (the starting point in most states for computing state taxable income) and the Sec. 163(j) limitation is applied in calculating federal taxable income, which serves as the starting point in most states for computing state taxable income. Moreover, the few states to issue guidance on the interplay between Sec. 163(j) and state expense disallowance rules all agree with this assumption.
To illustrate the issue, assume a corporation has $1,000 in total interest expense for the year, split evenly between debt owed to a related party and to a third party. Further assume that the Sec. 163(j) limitation is $600 (i.e., $400 in interest expense is deferred). What portion of the current-year interest expense relates to the corporation's related-party debt? In most situations, taxpayers would prefer to categorize debt as third-party and not related-party in the current year. In the example, the corporation would likely prefer that the allowed current-year interest expense consists of the entire $500 of third-party interest expense and only $100 of related-party interest expense. That way, in the current tax year, the taxpayer would have to add back the least amount of related-party debt (in the example, $100). This approach should result, however, in the entire amount of any disallowed interest carried forward to the succeeding tax year being treated as related-party interest.
One approach for addressing this issue would be for the current-year and deferred interest to be split proportionally between related-party and third-party debt, based on the composition of the taxpayer's overall debt load. In this item's example, this would amount to a current-year interest deduction of $600, consisting of $300 of related-party interest and $300 of third-party interest, and a deferral of $400, consisting of $200 each of related-party and third-party interest expense. The few states that have tackled this issue to date seem to take this approach.
Guidance issued by the Alabama Department of Revenue demonstrates the state's adoption of a pro rata approach. The Alabama guidance confirms that the Sec. 163(j) limitation applies before Alabama's add-back adjustment and clarifies that for "purposes of Alabama's add back statute, the net interest deduction limitation will be allocated on a pro-rata basis to the interest income recipients" (Ala. Dep't of Rev., Analysis of Federal Tax Law Revisions on the State of Alabama (July 30, 2018)). The pro rata approach is illustrated by a taxpayer with a current-year interest expense of $10 million, of which $5 million was a payment to a related party. Sec. 163(j) limits the taxpayer's current-year interest deduction to $8 million. The guidance concludes that for purposes of the add-back statute, the taxpayer paid $4 million to the related party for the current year. Although the guidance does not state this outright, presumably, the other $4 million of current-year interest expense is third-party, and the $2 million deferred interest expense is split between $1 million each of third-party and related-party interest expense.
Similarly, the Illinois Department of Revenue addressed the issue in its 2018 Schedule 80/20 Instructions. While Illinois generally requires combined reporting for unitary businesses, entities that conduct 80% or more of their business outside the United States may not be included in the combined group (80/20 companies). Illinois disallows a deduction for interest (and intangible expenses) paid to an 80/20 company in excess of any taxable dividends received from the company, unless an exception applies (35 Ill. Comp. Stat. 5/203(b)(2)(E-12)). The instructions for the 2018 Schedule 80/20, which is used to compute this add-back, provide that, for purposes of applying the Sec. 163(j) limitation to interest paid to the 80/20 company, the following formula applies:
Interest paid to
Interest allowed as a deduction under Sec. 163(j)
Total business interest paid
The instructions provide an example of a taxpayer that paid $1,000 in total business interest, including $100 to an 80/20 affiliate. The taxpayer's Sec. 163(j) limitation is $800 (i.e., a carryforward of $200). Because the federal deduction is limited to $800, the interest considered to have been paid to the 80/20 affiliate and deducted in computing base income equals $80 (the $100 actually paid, multiplied by 80%), with the remaining amount carried forward to the next year.
By statute, New Jersey also appears to have adopted the pro rata approach, although guidance issued by the New Jersey Division of Taxation arguably calls that into question. State law enacted after the TCJA applies the Sec. 163(j) limitation "on a pro-rata basis to interest paid to both related and unrelated parties, regardless of whether the related parties are subject to the [New Jersey] add-back provision" (N.J. Rev. Stat. §54:10A-4(k)(2)(K)). The statute further specifies that it is irrelevant, for dividing the interest expense on a pro rata basis, whether the related party receiving the interest is "subject to" the state's add-back provisions. This appears to mean that it is irrelevant whether the related party qualifies for one of the numerous exceptions to the New Jersey add-back provisions.
The New Jersey Division of Taxation subsequently issued guidance regarding the Division's approach to Sec. 163(j). The guidance indicates that, for New Jersey taxpayers that file as part of a federal consolidated group:
[T]axpayers will use the interest expense and interest income allocation methods adopted in the federal regulations as the pro-rata calculation for New Jersey purposes (N.J.S.A. 54:10A-4(k)(2)(K)) and any related party addbacks must be applied after the [Sec. 163(j)] limitation. [emphasis added] (N.J. Div. of Tax'n, Tech. Bull. 87 (Apr. 12, 2019)).
This statement could be interpreted to mean that the Division will treat the taxpayer's portion of the consolidated group's overall Sec. 163(j) limitation "as the pro-rata calculation for New Jersey purposes." In other words, there would be no additional pro rata partition of the taxpayer's interest expense between related-party and third-party debt. If that is the case, New Jersey's add-back provisions would simply apply to all of the taxpayer's related-party debt in year 1, up to the amount that interest expense is allowed under Sec. 163(j). If this is an accurate assessment of the Division's position, it would arguably be contrary to the statutory language applying Sec. 163(j) "on a pro-rata basis to interest paid to both related and unrelated parties." The Division has indicated that additional guidance is forthcoming.
Although Alabama, Illinois, and New Jersey issued guidance in this area, taxpayers with Sec. 163(j)-limited interest expense may find themselves deciding how to deal with this issue without guidance elsewhere. In some states, this may prove difficult. For example, Virginia conforms to the post-TCJA Sec. 163(j) limitation but allows a subtraction from federal taxable income equal to 20% of the business interest disallowed as a current-year deduction under Sec. 163(j) (Va. Code §58.1-402(G)). Separately, Virginia also disallows related-party interest expenses (subject to various exceptions) (Va. Code §58.1-402(B)(9)). Thus, Virginia taxpayers are in the unique position of needing to determine (1) the amount of related-party current-year federal interest deduction; (2) the amount of related-party Sec. 163(j)-deferred interest; (3) how much of the 20% subtraction is attributable to related-party interest; and (4) whether any exceptions to Virginia's related-party interest add-back rules apply. Ideally, the same approach would be taken for each determination (other than the application of exceptions to the interest add-back rule).
In the states that lack guidance on this issue, additional support for a pro rata approach may exist in the Sec. 163(j) proposed federal regulations. Although Sec. 163(j) and its proposed regulations obviously do not address state tax treatment of related-party interest, they do require taxpayers to use a pro rata approach for applying the interest limitation rules in the context of passive activity losses. Sec. 469 requires segregation of income and deductions from passive and active activities. Proposed regulations address how a taxpayer with interest expense and both passive and nonpassive activity losses applies Secs. 163(j) and 469 (Prop. Regs. Secs. 1.163(j)-3(b) and (c), Example (4)).
As a preliminary matter, the proposed regulations make clear that the Sec. 163(j) limitation is calculated prior to the passive activity loss limitation, analogous to the ordering of the Sec. 163(j) limitation and state related-party add-back provisions. The proposed regulations give the example of a taxpayer with a total interest expense of $1,000 and a Sec. 163(j) limitation of $300. The $1,000 interest expense is 90% allocable to a passive activity and 10% allocable to a nonpassive activity in which the taxpayer materially participates. When the Sec. 469 limitation is applied to the $300 business interest expense deduction allowable in the current year, $270 (0.90 × $300) is business interest expense included in determining the taxpayer's Sec. 469 passive activity loss limitation. The remaining $30 (0.10 × $300) is business interest expense excluded from the passive activity loss limitation.
Regardless of how states split Sec. 163(j)-deferred interest between related- and third-party debt, filing complexities will arise in the states that conform to Sec. 163(j) and disallow related-party interest expenses. All taxpayers will need to track carryforwards of Sec. 163(j) deferred debt expense. Taxpayers in any state with interest expense disallowance rules will also need to track how much of the carryforward amount is related-party interest expense. This could be complicated by the fact that Sec. 163(j)-deferred debt can be carried forward indefinitely, and states have different definitions of "related party" in their add-back provisions.
Further, state interest expense disallowance provisions have numerous and varying exceptions. Those exceptions include situations when a related party is subject to tax in another state or foreign country with a U.S. income tax treaty, or when a related party that acts as a "conduit" and pays the same interest expense to a third-party lender. In a future year when related-party debt carried forward under Sec. 163(j) can be deducted, a determination must be made as to whether an exception applies. It is unclear which set of facts and circumstances will apply: (1) those that existed when the interest expense was incurred, or (2) those that exist when the expense is allowed as a federal deduction. If the former, all the facts and circumstances relevant to exceptions must also be tracked. Given the complexity of these exceptions and the diversity of treatment among the states, this will be no easy task.
Taxpayers will soon need to determine — and then begin tracking — the portion of their Sec. 163(j)-deferred interest expense that is related-party. So far, only Alabama, Illinois, and New Jersey have provided guidance on this issue, and each of those states appears to have taken an approach consistent with the federal proposed regulations on Sec. 163(j) and passive activity losses (although the New Jersey guidance creates some uncertainty on this point). With other states thus far silent on the issue, the interplay between Sec. 163(j) and state expense disallowance leaves taxpayers in a position of having to make important decisions in a vacuum of guidance.
Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or firstname.lastname@example.org..
Contributors are members of or associated with KPMG LLP. These articles represent the views of the author(s) only, and do not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.