A strategy to raise a business’s interest limitation

In the law known as the Tax Cuts and Jobs Act (TCJA),¹ enacted in 2017, Sec. 163(j) was significantly amended by placing limits on the deductibility of business interest for all taxpayers except certain exempt trades or businesses.² The businesses most affected by the new limitation on deducting interest were highly leveraged entities and those with low profit margins. Companies that in previous years have narrowly avoided this interest deductibility limitation should be aware that the limitation is more restrictive for tax years starting after 2021. As suggested below, one way to help reduce the negative impacts of Sec. 163(j) is through strategic adoption of FASB Accounting Standards Codification (ASC) Topic 606, Revenue From Contracts With Customers.

TCJA and the interest expense deduction

First, some background may be helpful. Prior to the passage of the TCJA, Sec. 163(j) had rules in place intended to prevent multinational entities from using interest expense as a method of shifting earnings to lower-income-tax jurisdictions and avoiding U.S. taxation. This original guidance only limited interest expense paid to certain entities and only under specific conditions. As a result, most U.S.-based taxpayers were able to deduct the entire amount of ordinary interest expense to calculate their taxable income.

With the TCJA's amendment to Sec. 163(j), a business's deduction for interest is now limited to the sum of:

1. Business interest income;
2. 30% of the adjusted taxable income (50% for 2019 and 2020, per the CARES Act);³ and
3. Floor plan financing interest — specific financing related to the acquisition of inventory.

Recently the limitation became even more restrictive. The calculation for adjusted taxable income previously had reflected earnings before interest, taxes, depreciation, and amortization (EBITDA). However, for tax years starting after 2021, Sec. 163(j)(8)(A)(v) revises this calculation to reflect earnings before interest and taxes (EBIT) — thus disallowing the addback of depreciation and amortization. This change in calculation will broaden the net of the interest expense limitation, likely affecting many entities that had narrowly escaped the limitation in earlier years.

Any interest expense beyond the amount of the interest limitation is not deductible in the current year but can be carried forward indefinitely to offset future taxable income. However, because the value of disallowed carryforward interest will be included as interest expense of the future year, it will still be subject to the same interest expense deductibility rules. While the idea of carrying forward this excess expense sounds beneficial, the tax benefit is unlikely to be realized for many of the companies operating in industries affected by this provision. One potential financial statement impact of this limitation is a write-down of deferred tax assets.

For instance, in its 2017 10-K, Horizon Pharma PLC showed a year-end debt-to-equity ratio of 3:2 and disclosed that the new interest deductibility rules resulted in a write-down of its deferred tax assets of $59.2 million, accounting for 0.6% of 2017 revenues and translating into a loss of $0.36 per share. While this was a one-time write-down of assets, companies with significant debt financing, such as Horizon Pharma PLC, cannot easily change their capital structure or operating environment, so they may be struggling with this limitation on deductibility of interest for years to come.

Through strategic use of the new revenue recognition standards, however, affected entities may be able to mitigate some of the negative impact of Sec. 163(j)'s interest deduction limitation.

Topic 606 and interest income

Businesses can adopt a strategy based on the Topic 606 standards to help reduce the negative effects of the business interest limitation. The strategy discussed here involves reclassifying certain revenue as business interest income. Business interest income, as noted above, is included in the interest limitation calculation at 100%, while traditional revenues flow into adjusted taxable income, which is counted in the interest limitation calculation at only 30%. As a result of the reclassification, therefore, a company increases the deductible amount of interest expense by up to 70 cents for each dollar recognized as interest income instead of traditional revenues.

Understanding this reclassification strategy for raising the interest deduction ceiling requires first taking several steps back. In May 2014, FASB issued Accounting Standards Update No. 2014-09, Revenue From Contracts With Customers (Topic 606). This guidance provides a framework for companies across various industries to recognize revenues on a more consistent basis. Within this framework, entities are required to identify the transaction price and various performance obligations, then allocate the transaction price across the identified performance obligations.⁴

Importantly for the reclassification strategy under consideration here, a significant portion of business-to-business transactions involves trade receivables and payables and can be considered a form of financing provided to the buyer by the seller.⁵ According to Topic 606, the entity should present the effect of financing separately from revenues derived from sales contracts with customers.⁶ As this could be considered burdensome, firms are allowed to adopt a "practical expedient" and not separately report the effect of financing for receivables expected to be collected within one year.⁷ Due to the availability of this practical expedient and the fact that most business-to-business receivables are collected within one year, most entities have elected not to go through the necessary analysis to allocate the contract price. However, if a company were to take on this burden to allocate a portion of the contracted sales price to interest income, it would effectively be reclassifying a small portion of its revenues as business interest income.

Separately identifying the financing component

How can a seller that wants to use this reclassification strategy to increase its Sec. 163(j) limit allocate the transaction price between the sale of the good or service and the financing component? There are a few situations where a company can easily separate out the financing component of the transaction. If the company allows for credit-risk adjusted prices, cash discounts, or variable pricing based on length of credit terms, then the difference between the cash sale price and the invoice price could be the implied financing component. Where the company allows for sales discounts (pay promptly discounts), any discounts forfeited by the customer who pays late could be considered a financing component. In a situation in which a company cannot extract this information, it can find clarity within the guidance:

The objective when adjusting the promised amount of consideration for a significant financing component is for an entity to recognize revenue at an amount that reflects the price that a customer would have paid for the promised goods or services if the customer had paid cash for those goods or services when (or as) they transfer to the customer (that is, the cash selling price). An entity shall consider all relevant facts and circumstances in assessing whether a contract contains a financing component and whether that financing component is significant to the contract, including both of the following:

1. The difference, if any, between the amount of promised consideration and the cash selling price of the promised goods or services
2. The combined effect of both of the following:
   1. The expected length of time between when the entity transfers the promised goods or services to the customer and when the customer pays for those goods or services
   2. The prevailing interest rates in the relevant market.⁸

Entities that extend credit to their customers will often incur various additional costs necessary for them to offer this type of short-term credit to their customer base — such as increased salaries relating to managing receivables and credit risk, credit insurance, factoring arrangements, working capital loans, and lines of credit. These increased costs are typically incorporated into the sales price of the product and are rarely explicit in the customer contract or the invoice. Due to the fact that these costs are passed on to the customers in the form of higher prices, the seller likely can support the position that the agreed-upon contract price includes a financing component, even when the contract does not explicitly refer to this delay of cash transfer as a form of financing provided to the buyer. This logic is consistent with that of the provided guidance, which states:

In determining the transaction price, an entity shall adjust the promised amount of consideration for the effects of the time value of money if the timing of payments agreed to by the parties to the contract (either explicitly or implicitly) provides the customer or the entity with a significant benefit of financing the transfer of goods or services to the customer. In those circumstances, the contract contains a significant financing component. A significant financing component may exist regardless of whether the promise of financing is explicitly stated in the contract or implied by the payment terms agreed to by the parties to the contract.⁹

The guidance indicates that any significant financing component, explicit or implicit, should not be recognized in the transaction price. Instead, ASC Paragraph 606-10-32-20 provides guidance for determining the circumstances under which an entity should separately report interest income:

An entity shall present the effects of financing (interest income or interest expense) separately from revenue from contracts with customers in the statement of comprehensive income (statement of activities). Interest income or interest expense is recognized only to the extent that a contract asset (or receivable) or a contract liability is recognized in accounting for a contract with a customer. ...

Thus, any significant financing component should be reported as either interest income or interest expense rather than being included in the transaction price and recognized as sales revenue.

The practical expedient

Notably, ASC Paragraph 606-10-32-18 offers preparers a practical expedient:

As a practical expedient, an entity need not adjust the promised amount of consideration for the effects of a significant financing component if the entity expects, at contract inception, that the period between when the entity transfers a promised good or service to a customer and when the customer pays for that good or service will be one year or less.

Under this practical expedient, firms do not need to adjust the transaction price for any significant financing if the customer pays for the good or service within one year. This option is intended to simplify the reporting process. It is important to note that while firms may choose the practical expedient, they are not required to do so.

Businesses should not opt for the practical expedient if they wish to pursue the strategy being discussed here to raise the Sec. 163(j) interest deduction ceiling, because, for this approach to work, it is necessary to separately identify business interest income.

The size of the financing component

One other issue that should be mentioned is whether the financing component can be accounted for separately if it is small. The guidance refers to "a significant financing component." It is possible that in some cases a financing component exists but that there may be some doubt about its significance. The FASB/IASB Joint Transition Resource Group for Revenue Recognition addressed this question. Referring to the Basis for Conclusion paragraph BC234, the group noted that:

As described in this Basis paragraph, the rationale for assessing significance at the contract level was to reduce the burden for entities. That is, it was for practical reasons rather than conceptual reasons. The staff is not aware of any guidance in the standard that would preclude an entity from deciding to account for a financing component that is not significant.

Thus, firms are permitted to ignore financing components that fall below the significant threshold — but they do not have to. This is another instance where, as in the case of the practical expedient, FASB appears to offer preparers means of simplifying the reporting process. For purposes of using the reclassification strategy being discussed here, however, it should not be an issue whether some or all the financing component is deemed insignificant.

The IRS and interest income

For the suggested strategy for increasing the interest limitation to work, the reclassified revenue would need to satisfy relevant tax definitions of "business interest income" and, more broadly, "interest income." Sec. 163(j)(6) defines business interest income as follows:

For purposes of this subsection, the term "business interest income" means 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 shall not include investment income (within the meaning of subsection (d)). [emphasis added]

As a stand-alone term, "interest" is not defined by this section. Although the word's meaning may seem self-explanatory, or perhaps a minor point, the definition becomes important because of the new categorical structure created by the revised Sec. 163(j)(1). To be successful, any strategy to reclassify revenue as business interest income would have to be able to withstand any scrutiny given to the categorization during an IRS examination. The IRS has defined interest by stating that "interest on indebtedness means compensation for the use or forebearance of money."¹⁰ Although this definition was presented in the context of a withholding rule, in the absence of a definition specific to this Code section, it is likely the only relevant guidance.

Taxpayers using the reclassification strategy under discussion here should verify that the amount reclassified as business interest income satisfies this definition. Although no specific guidance on this point could be identified, the above definition of "interest" seems compatible with the identification of a financing component through an analysis under Topic 606. The timing of interest income recognition for tax purposes would generally follow recognition in the audited financial statements.¹¹

A final tax consideration is whether changing the calculation under Topic 606 — rejecting the practical expedient if already in place — would be considered an accounting method change. Sec. 446 provides that a change of a material item affecting timing is a change in accounting method and generally requires the IRS's permission to change. However, various IRS revenue procedures allow for certain changes to be made automatically, without express permission. Although the contemplated reclassification of income into the business interest category involves items within a single year, the effect it would have on the carryforward amount has timing implications and would be considered a change in accounting method. If the change follows financial accounting treatment, then the change would most likely be automatic and would not require IRS permission.¹²

How would such a reclassification of revenues impact the interest expense limitation of Sec. 163(j)? The interest expense deduction, as noted earlier, is limited to the sum of (1) business interest income; (2) 30% of the adjusted taxable income; and (3) floor plan financing interest. Business interest income is included in the interest limitation calculation at 100%, while traditional revenues flow into adjusted taxable income, which is included in the interest limitation calculation at only 30%. The effect of this reclassification would be to allow the company to increase the deductible amount of interest expense by up to 70% for each dollar recognized as interest income instead of traditional revenues.

Illustrative example

To illustrate the potential impact of this choice, consider the following example:

Example: A firm has gross receipts of $1 billion; cost of goods sold (COGS) of $600 million; various business deductions (excluding depreciation, amortization, and depletion) of $275 million; depreciation, amortization, and depletion of $50 million; average annual receivables of $400 million; and a cost of capital implicit in the receivables of 5%. (See the table "Example Assumptions" below.)

The table "Excerpts From Form 1120" (below) presents excerpts from Form 1120, U.S. Corporation Income Tax Return, under two scenarios for tax years 2021 and 2022 using the assumed facts. The notable difference between these years is that for 2022 the addback of depreciation, amortization, and depletion is removed from the calculation of the limitation on business interest expense.

The table "Excerpts From Form 8990" (below) presents excerpts from Form 8990, Limitation on Business Interest Expense Under Section 163(j), under two scenarios for tax years 2021 and 2022 under the assumed facts.

In the tables "Excerpts From Form 1120" and "Excerpts From Form 8990," the columns labeled "Practical Expedient" show the results of making the choice to ignore the time value of money when calculating the transaction price under Topic 606. The columns labeled "Topic 606" present the consequences of not implementing the practical expedient.

In this example, the firm reclassifies approximately $20 million (5% annual interest, $400 million in gross receivables) as interest income. This increases the allowed business interest expense (see the table "Excerpts From Form 8990," line 30) by $12.5 million under 2021 rules and $14 million under 2022 rules. This leads to less taxable income and consequent tax (see the table "Excerpts From Form 1120," line 31): $2,625,000 less in 2021 and $2,940,000 less in 2022.

A potential strategy

In summary, this article outlines a potential strategy for taxpayers negatively affected by the interest deductibility limits imposed by Sec. 163(j). By choosing to forgo the practical expedient, adjusting the transaction price for the financing component, and presenting the effects of interest income separately from revenue from contracts, more interest can be treated under the 100% deductible category, possibly resulting in significant tax savings. As long as the taxpayer is properly applying Topic 606, and the timing of income recognition is not affected, the current tax law should support this allocation.

Footnotes

¹ P.L. 115-97.

² Sec. 163(j)(3).

³ Coronavirus Aid, Relief, and Economic Security Act, P.L. 116-136, §2306(a).

⁴ Under ASC Paragraph 606-10-32-3, an entity is required to “consider the effects of all of the following” to determine the transaction price: (1) variable consideration; (2) constraining estimates of variable consideration; (3) the existence of a significant financing component in the contract; (4) noncash consideration; and (5) consideration payable to a customer.

⁵ FASB ASC Subtopic 310-10.

⁶ ASC Paragraph 606-10-32-20.

⁷ ASC Paragraph 606-10-32-18.

⁸ ASC Paragraph 606-10-32-16.

⁹ ASC Paragraph 606-10-32-15.

¹⁰ Rev. Rul. 72-458; Deputy v. DuPont, 308 U.S. 458 (1940).

¹¹ Regs. Sec. 1.451-3(a)(11).

¹² See generally Rev. Proc. 2019-43, §16.10. A complete discussion of the requirements to change an accounting method is beyond the scope of this article.