Naked credits and the interest expense limitation

Final Treasury regulations¹ with guidance on applying the Sec. 163(j) interest expense limitation may change the calculus some companies use in determining the amount of their naked credit.

A deferred tax asset (DTA) is recognized for temporary differences that will result in deductible amounts in future years and for carryforwards. If, based on all available evidence, positive and negative, there is more than a 50% likelihood (i.e., it is more likely than not) that a taxpayer will not realize a portion or all of a DTA, the taxpayer is required to reduce the DTA to its actual value by recognizing a valuation allowance. A taxpayer that has temporary differences that will result in taxable amounts in future years recognizes a deferred tax liability (DTL). DTAs and DTLs can be definite-lived (attributable to assets with a definite useful life) or indefinite-lived (attributable to an indefinite-lived asset, e.g., goodwill).

Definite-lived DTLs can typically be used as a source of future taxable income to support definite-lived DTAs and can be netted against such DTAs. When it is more likely than not that the net DTA will not be realized, a valuation allowance reserve is booked against the net DTA.² Indefinite-lived DTLs, however, are left out of this calculation and often left on the balance sheet, creating a "naked credit," where a company has a full valuation allowance against its net DTAs but also has DTLs that have an indefinite life.

Indefinite-lived DTLs are typically attributed to indefinite-lived intangibles that have a book (or GAAP) basis that is higher than the tax basis. This is created either when an indefinite-lived intangible is purchased in a stock acquisition and the amount of tax basis in the acquired intangible is less than the GAAP basis booked in purchase accounting, or in an asset acquisition when the intangible has the same beginning basis for GAAP and tax but has an indefinite life for GAAP purposes and is being amortized for tax purposes. Before the legislation known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, alternative minimum tax credits were primarily the only indefinite-lived DTAs in the United States. But the TCJA provided that net operating losses (NOLs) incurred after 2017 would never expire and also introduced a new limitation on interest expense, with an indefinite carryforward for the limited interest expense. When there are both definite-lived DTAs and DTLs and indefinite-lived DTAs and DTLs, a valuation allowance assessment requires that two separate buckets of deferred taxes need to be analyzed. In one bucket, the definite-lived DTLs are measured against the definite-lived DTAs, and in the other bucket the indefinite-lived DTLs are measured against the indefinite-lived DTAs.

Definite-lived DTLs can be netted against definite-lived DTAs if it is expected that the DTLs will reverse and become taxable income before the definite-lived DTAs expire. Likewise, indefinite-lived DTLs can be netted against indefinite-lived DTAs because it is assumed that an indefinite-lived DTL will someday turn into taxable income (i.e., when the underlying intangible is sold).

In the valuation allowance assessment, the indefinite-lived DTAs are supported by the assumed income to be generated in the future by the indefinite-lived DTLs. However, statutory limitations on the use of tax attributes must be taken into account. For tax years beginning in 2018 and after 2020, other than where a small business exception applies,³ interest deductions can only be taken to the extent of 30% of adjusted taxable income (ATI) plus business interest income and floor plan financing interest.⁴ Under Sec. 163(j)(10), added by Section 2306(a) of the Coronavirus Aid, Relief, and Economic Security (CARES) Act,⁵ for tax years beginning in 2019 and 2020, the ATI percentage threshold is increased to 50%.

Also, in tax years beginning after 2020, NOLs can only offset up to 80% of taxable income. NOLs arising in tax years before Jan. 1, 2018, may be carried forward up to 20 years. Those arising thereafter, under the TCJA, may be carried forward indefinitely. Therefore, when measuring the amount of a DTL that can be used to support a DTA, the above two limitations must be taken into account. Therefore, in tax years to which they both apply, assuming the taxpayer had DTAs for both indefinite-lived NOLs and suspended interest, before concluding that the indefinite-lived DTL is sufficient to fully support both of these DTAs, the DTL must first be multiplied by 30% (to make sure it covers the interest DTA) and then by 80% (to make sure it covers the NOL DTA). If the indefinite-lived DTL is not large enough, after these two haircuts, to support the DTAs, then a valuation allowance must be placed on that unsupported DTA. This is where the naked credit is born. Here is an example to illustrate the two-bucket valuation allowance analysis:

Example 1: Assume a corporation has DTAs and DTLs, as shown in the table "DTAs and DTLs in Example 1" (below). All amounts are tax-effected. The indefinite-lived DTL was established when the company bought the stock of a business. There was no carryover tax basis in the acquired indefinite-lived intangibles, and the $2 million DTL was established in the purchase accounting for that acquisition.

The above DTAs are categorized (or bucketed) as either indefinite-lived or definite-lived as shown in the table "Categorization of Tax Amounts in Example 1" (below).

The above valuation allowances on both of the interest DTA and the indefinite-lived NOL DTA were measured by applying the proper income limitations to the assumed taxable income to be generated in the future by the indefinite-lived DTL of $2 million as shown in the table "Application of Income Limitations in Example 1" (below).

The deferred interest DTA can be supported by only $600,000 of the indefinite-lived DTL, so a valuation allowance of $100,000 ($700,000 less $600,000) was required against the deferred interest DTA. The indefinite-lived NOL DTA can be supported by only $1,120,000 of the indefinite-lived DTL, so a valuation allowance of $2,880,000 ($4 million less $1,120,000) was required against the indefinite-lived NOL DTA. The combination of the two valuation allowances of $100,000 and $2,880,000 results in a net naked credit of $280,000.⁶

Now we finally come to the impact that the final interest limitation regulations could have on the naked credit. The final regulations⁷ contain a provision where ATI would need to be reduced for gains from sales of assets when those gains resulted from depreciation or amortization that was incurred after 2017 and before 2022. The theory is that a company could receive a double tax benefit from such depreciation or amortization. For example, without this ATI reduction, a company that increased its ATI for depreciation or amortization deductions taken in 2018 and 2019 and then sold the related assets in 2020 would benefit from having ATI increases in both the two earlier years and an increase in ATI from the gain in 2020.⁸

Under the final regulations, in a year when there is a gain from sold property, ATI will need to be reduced by any amortization or depreciation that was taken between Dec. 31, 2017, and Jan. 1, 2022 (these years are referred to as the EBITDA period) on such property. Two months after the final regulations were issued, Treasury issued new proposed regulations⁹ that somewhat relaxed this rule by providing a "lesser of" approach. Under these September 2020 proposed regulations, the amount to be added back to ATI is the lesser of: (1) the gain from the sale of the depreciable or amortizable assets; or (2) the related depreciation or amortization taken during the EBITDA period on such sold assets.

Thus, taxpayers will need to assess whether the alternative method is more beneficial and consider early adoption of the latest proposed regulations if it provides a more favorable answer, assuming that those proposed regulations have not been withdrawn by the date of analysis. Both the final and proposed regulations may have the effect of eliminating the potential double benefit from the depreciation or amortization taken in the years between 2017 and 2022.

Because of the final regulations, which were published in the third quarter of 2020, the indefinite-lived intangible DTL used to support an interest DTA must now be reduced by an appropriate amount of tax amortization that was taken in 2018 through 2021. This reduction must be made before the 30% limitation is placed on the DTL. This is a new third limitation (in addition to the 30% and 80% limitations) that may cause a company to place an additional valuation allowance on its indefinite-lived DTAs and could result in a larger naked credit.

The following example illustrates the potential impact from the final Sec. 163(j) regulations:

Example 2: Assume the same facts as Example 1 with one significant difference: The $2 million DTL relates to the acquisition of a business that was made through an asset purchase. In this case, the company began with equal book and tax basis in the acquired intangibles. However, the intangibles were amortized for tax (and not for books), which led to the creation of the $2 million DTL over a period of several years. Between 2018 and 2021, the tax amortization for these intangibles was $1 million.

In this case, the capacity for realizing a suspended interest DTA must be measured by reducing the assumed future taxable income generated from the $2 million DTL by the $1 million of 2018-2021 tax amortization. As shown in the table "Application of Income Limitations in Example 2" (below), this changes the maximum interest DTA to $300,000 and has an impact on the maximum NOL DTA that can be allowed.

This results in a total valuation allowance and naked credit as shown in the table "Total Valuation and Naked Credit in Example 2" (below).

Companies have been aware of the 30% and 80% limitations when calculating naked credits since the TCJA was passed at the end of 2017. This new, third limitation came about in the third quarter of 2020, but it may not have affected many companies because of the relaxed interest limitations provided by the CARES Act. However, now that the 30% interest limitation is back in effect for 2021 and following, companies in a naked credit position should be aware of the potential impact of the final and subsequently proposed Sec. 163(j) regulations.

Footnotes

¹T.D. 9905. 

²The valuation allowance assessment is made using guidance provided in FASB ASC Paragraph 740-10-30-18.

³Sec. 163(j)(3). The business interest limitation does not apply for any tax year to a taxpayer (other than a tax shelter described in Sec. 448(a)(3)) that meets the test of Sec. 448(c) of having no more than $25 million in average annual gross receipts for the three preceding tax years. 

⁴Sec. 163(j)(1). Any limited interest expense can be carried forward without expiration. Between 2018 and 2021, ATI is taxable income plus depreciation and amortization, net interest expense, and net operating losses. Beginning in 2022 ATI is just taxable income plus net interest expense and net operating losses.

⁵Coronavirus Aid, Relief, and Economic Security Act, P.L. 116-136.

⁶Note that definite-lived DTLs can also offset indefinite-lived DTAs, as the indefinite-lived DTA (e.g., the indefinite-lived NOL carryover) will be available to offset the reversal of the definite-lived DTL when it turns. In a case when there is no definite-lived NOL, a net definite-lived DTL should be included in the indefinite-lived deferred tax "bucket" (to be subject also to the 80% limitation in the year of reversal).

⁷Regs. Sec. 1.163(j)-1(b)(1)(ii)(C).

⁸In 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 over a period of years.

⁹REG-107911-18.