Editor: Mary Van Leuven, J.D., LL.M.
More than 18 months after enactment, the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, continues to confound both taxpayers and tax administrators. One of the most vexing provisions has proved to be the new interest expense deduction limitation rules in amended Sec. 163(j). As with most provisions of the Code, Sec. 163(j) cannot be analyzed in a vacuum, and its interaction with other tax provisions must be considered. This not only adds complexity for federal purposes, but also creates significant challenges and uncertainty for taxpayers at the state level.
General federal and state differences
Sec. 163(j) generally limits a taxpayer's business interest expense deduction to the sum of its business interest income, 30% of adjusted taxable income, and any floor plan financing interest expense for the tax year. Any business interest expense in excess of this limitation is carried forward indefinitely and may be deducted in future years. As discussed below, the Sec. 163(j) limitation, and the resulting carryforward amount (if any), may often differ for state purposes.
For taxpayers filing a federal consolidated return, a single Sec. 163(j) limitation is computed for a consolidated group, and intercompany obligations among members of the consolidated group are disregarded (Prop. Regs. Sec. 1.163(j)-4(d)). Many states, however, require members of a federal consolidated group to file a separate-entity return. In these cases, the Sec. 163(j) limitation must generally be computed "as if" the member filed a separate federal return. Additionally, many states that allow or require groups of related corporations to file on a combined basis require the Sec. 163(j) limitation to be computed as if the group member filed a separate federal return before making any adjustments for intercompany amounts.
The Coronavirus Aid, Relief, and Economic Security Act (CARES Act), P.L. 116-136, enacted on March 27, 2020, amended Sec. 163(j) to permit taxpayers to use 50% of their adjusted taxable income in the computation of the interest deduction limitation for tax years beginning in 2019 and 2020. The CARES Act also permits taxpayers to use their 2019 adjusted taxable income to calculate their 2020 Sec. 163(j) limitation. Whether a state adopts Sec. 163(j) as amended or as enacted on a certain date will impact how the Sec. 163(j) limitation is computed for state purposes. For example, a state that adopts Sec. 163(j) as originally enacted in the TCJA will likely not automatically use the higher percentage of adjusted taxable income provided by the CARES Act to calculate the state Sec. 163(j) limitation.
These varying calculation methods can result in differing Sec. 163(j) limitations for federal and state purposes and, consequently, differences in the interest deductions disallowed. Although this creates complexity during the compliance process, these differences can have a favorable state tax effect for some taxpayers. For example, a subsidiary that finds its interest expense deduction to be limited for federal purposes due to a loss at the federal consolidated group level nevertheless may be able to deduct all of its interest expense in certain states if there is sufficient income for that subsidiary.
When these differences lead to significant disallowances of interest deductions at the state level, taxpayers may consider changes to their legal entity structures to assist in mitigating the impact. For example, if a subsidiary finds itself subject to a significant Sec. 163(j) limit in a separate-entity filing state, a taxpayer might evaluate whether that subsidiary could be liquidated or merged into another entity that might result in an increase to the Sec. 163(j) limit.
Although a single Sec. 163(j) limitation is computed for a federal consolidated group, the interest expense of each member is still tracked separately for carryforward purposes (Prop. Regs. Sec. 1.163(j)-5(b)(3)). In general, each member of a consolidated group offsets its interest expense against its own interest income and floor plan financing interest. If there are members with unused interest expense after this step, then the remaining Sec. 163(j) limitation for the group is applied to those members based on a ratio of each member's remaining interest expense to the remaining interest expense of all members. Any interest expense for each group member remaining after the Sec. 163(j) limitation has been applied is carried forward by that member.
In the following year, the same analysis is required for the current-year interest expense, interest income, and floor plan financing. If the Sec. 163(j) limitation exceeds the current-year interest expense, then the excess Sec. 163(j) limitation is applied to the interest expense carryforwards in the order of the tax years in which they arose (i.e., on a first-in, first-out basis). Each year is analyzed individually. If the remaining Sec. 163(j) limit exceeds the carryforwards from a tax year, then all carryforwards from that tax year are deducted and the remaining Sec. 163(j) limit is applied to the carryforwards from the following tax year. If the remaining Sec. 163(j) limit is less than the carryforwards from a tax year, then each member is allocated a portion of the remaining Sec. 163(j) limit based on a ratio of each member's carryforward amount to the carryforward amount of all members.
Differences in computing the federal and state Sec. 163(j) limits will often result in different carryforward amounts. Accordingly, taxpayers should analyze these differences carefully and maintain detailed carryforward schedules. At a minimum, a state-by-state schedule should track the carryforward amounts by entity (if necessary under state rules) and the year in which the carryforward arose, and whether those carryforwards have been deducted in subsequent years. Taxpayers may be able to leverage existing net operating loss (NOL) carryforward schedules for this purpose.
To further complicate matters, however, many states require an addback of certain related-party interest expense unless an exception is met. These exceptions include the interest expense being subject to tax as income by the related member or the related member passing the payment through to an unrelated third party. The pressing question is whether the Sec. 163(j) limitation is applied to interest expense before or after the application of the addback rules.
The few states that provided guidance on the issue generally require the Sec. 163(j) limitation to be first applied to interest expense (on both related-party and third-party debt) before applying the related-party addback rules, and use a pro rata approach for determining what portion of the deductible interest expense is related-party interest (subject to the addback provision) or third-party interest. For example, Alabama, Illinois, New Jersey, and Pennsylvania published guidance indicating that they will apply this ordering and pro rata approach. Other jurisdictions, such as the District of Columbia and Kentucky, indicated that the Sec. 163(j) limitation applies prior to the related-party addback rules but are silent as to how the 163(j) limitation is allocated between interest expense on related-party and third-party debt. Conversely, Massachusetts indicated that the Sec. 163(j) limitation is applied after the application of the related-party addback rules (Massachusetts Technical Information Release No. 19-17, 12/18/2019). Notably, none of the states that published guidance on this issue have permitted taxpayers to allocate intercompany interest entirely to the interest that exceeds the Sec. 163(j) limitation.
Until more states release guidance on the interaction between Sec. 163(j) and the related-party addback rules, taxpayers will need to determine an approach that best fits their facts, which may create a great deal of uncertainty. And, in states that published guidance, taxpayers will need to incorporate the states' approaches to intercompany interest addback provisions into their Sec. 163(j) carryforward schedules.
Interaction with other Code provisions
The interaction of Sec. 163(j) with other provisions of the Code should also be considered. Because carryforwards are tracked for each member of a federal consolidated group, it is especially important to properly calculate and track the carryforward amounts in mergers and acquisitions and restructuring situations. Given the differences in computing the Sec. 163(j) limit for federal and state purposes, the state carryforward amounts could potentially have significant value in the future.
Interaction with Secs. 381 and 382: Sec. 381 generally allows an acquiring corporation to succeed to certain tax attributes in Sec. 332 liquidations and Sec. 368 reorganizations. The TCJA amended Sec. 381 by adding Sec. 163(j) carryforwards to the list of tax attributes subject to Sec. 381 (Sec. 381(c)(20)). Sec. 382 generally limits a corporation's ability to use prechange losses (e.g., NOL carryforwards, net unrealized built-in losses) from an acquired corporation that existed at the time of an acquisition. The TCJA amended Sec. 382 by adding Sec. 163(j) carryforwards to the definition of prechange losses (Sec. 382(d)(3)).
Most states have adopted Secs. 381 and 382, so it is important not only for federal purposes, but also for state purposes, to accurately calculate and track the Sec. 163(j) carryforward amounts. However, taxpayers should consider whether a state modifies the application of Secs. 381 and 382 for state tax attributes. For example, some states require the federal Sec. 382 limit to be apportioned to arrive at the state Sec. 382 limit that is applied to state NOLs. In the few states that do not adopt Secs. 381 and/or 382, taxpayers should consider whether there are equivalent provisions that are sufficiently broad to capture Sec. 163(j) carryforwards.
Interaction with SRLY rules: Although for federal purposes the Sec. 163(j) limitation is applied at the consolidated level, the proposed regulations recognize the need for determining the amount of any carryforwards that follow a member when it leaves the group (Prop. Regs. Sec. 1.163(j)-5(d)). The proposed regulations also address the application of limitations on the use of Sec. 163(j) carryforwards when a corporation with carryforwards joins a new or existing federal consolidated group. These proposed rules generally follow the approach historically applied to NOLs by limiting the consolidated group's use of a member's Sec. 163(j) carryforwards from a separate return limitation year (SRLY) (i.e., a year prior to it joining the consolidated group). In other words, a member's Sec. 163(j) carryforward from an SRLY can only be deducted in the current year up to the Sec. 163(j) SRLY limitation, which is computed by reference solely to that member's items for the current year.
A number of states that require or allow taxpayers to file on a combined basis adopt the federal consolidated return regulations. In those states, Sec. 163(j) carryforwards from an SRLY may be treated in the same manner. However, many states also require or allow taxpayers to file on a combined or consolidated basis but do not conform to the federal consolidated return regulations. In these states, taxpayers should consider whether there are any rules similar to the federal SRLY rules that would limit the deductibility of Sec. 163(j) carryforwards of entities joining or leaving the state combined group.
Handling the interaction of federal and state rules
A limitation on the deductibility of business interest expense starts off as a seemingly innocuous provision. However, once Sec. 163(j)'s interaction with other Code provisions and state laws is considered, it becomes clear that taxpayers will need to focus on compliance with this provision to minimize the loss of state tax attributes and the risk of miscalculations creating significant assessments during state audits.
As discussed above, there are many reasons it is important for taxpayers to accurately calculate and track state-specific Sec. 163(j) carryforwards. To the extent differences in the federal and state Sec. 163(j) carryforwards result in unfavorable state income tax impacts, taxpayers should review their existing structures to determine whether a more efficient structure from a Sec. 163(j) perspective is possible.
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.
Unless otherwise noted, 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.