On April 2, 2018, the US Treasury Department and the Internal Revenue Service (“IRS”) issued Notice 2018-28 (the “Notice”) providing guidance relating to the limitation on interest expense deductibility under new Section 163(j) of the Internal Revenue Code enacted pursuant to the “Tax Cuts and Jobs Act” (the “Tax Act”).1 In general, Section 163(j) disallows (and defers) the deduction of a taxpayer’s net interest expense to the extent it exceeds 30% of the taxpayer’s adjusted taxable income. The Notice describes regulations that the Treasury Department and the IRS intend to issue to clarify some aspects of this limitation. Significantly taxpayers may rely on the Notice until the proposed regulations are published.
As discussed below, the Notice provides clarity on important questions, including the application of the limitation to consolidated groups and the fate of pre-2018 deductions disallowed under former Section 163(j). That said, a number of other questions remain outstanding and will possibly be the subject of future guidance (for example, the application of Section 163(j) to controlled foreign corporations).
Section 163(j) Applies on a Consolidated Basis
Consistent with the legislative history of the Tax Act, the Notice confirms that the interest deduction limitation of Section 163(j) applies at the level of the US tax consolidated group. Therefore, interest on intercompany obligations will be disregarded, while interest expense payable to persons outside of the consolidated group will be subject to the 30% limitation. Similarly, the consolidated group’s taxable income will be considered for purposes of calculating adjusted taxable income. The Notice clarifies that an affiliated group that does not file a consolidated return will not be treated as a single taxpayer for purposes of Section 163(j).
According to the Notice, forthcoming regulations will also address other issues relating to the application of Section 163(j) to consolidated groups, including the allocation of the limitation among consolidated group members, intra-group stock basis adjustments resulting from the limitation and the treatment of carry-forwards of disallowed deductions for members that join or leave the group.
Pre-2018 Disallowed Interest May Be Carried Forward
Prior to the issuance of the Notice, there was some uncertainty as to how taxpayers would treat interest deductions that had been disallowed under former Section 163(j) in the new Section 163(j) regime.
The Notice clarifies that taxpayers may carry forward those disallowed interest deductions to their first taxable year beginning after December 31, 2017. However, those carry-forwards will be subject to the new Section 163(j) limitation as well as to the new base erosion alternative tax (“BEAT”) of Section 59A in the same manner as interest paid or accrued in a taxable year beginning after December 31, 2017.
In addition, taxpayers will not be able to carry forward “excess limitation” amounts to taxable years beginning after December 31, 2017, given that, unlike old Section 163(j), new Section 163(j) does not contemplate the carry forward of excess limitation.
Section 163(j) Does Not Apply for E&P Purposes
Pursuant to the Notice, the disallowance of an interest expense deduction of a C corporation under Section 163(j) will not affect whether and when such interest expense reduces the earnings and profits of such corporation.
All Interest Expense and Interest Income of a C Corporation Is “Business Interest”
The Section 163(j) limitation applies only to the net “business interest” expense (that is, the excess of a taxpayer’s business interest expense over its business interest income). The Notice clarifies that all interest paid or accrued on indebtedness of a C corporation, and all interest that is includible in the C corporation’s gross income, will be treated as “business interest” for purposes of this limitation. This rule will not apply to S corporations.
The regulations to be issued will address whether and to what extent interest paid, accrued or includible in gross income by a non-corporate entity (e.g., a partnership) in which a C corporation holds an interest is properly characterized as business interest expense or income of the C corporation.
Business Interest Income of Partnerships and S Corporations
The Notice also announced that regulations will be issued to prevent “double counting” of business income by partners in partnerships and S corporation shareholders. Specifically, a partner can only include its share of the partnership’s business interest income to the extent of that partner’s share of the net business interest income of the partnership (i.e., the excess of the partnership’s business interest income over the partnership’s business interest expense).
1 For an overview of the Tax Act’s main provisions, please see “The Good, the Bad and the Ugly—Fundamental Tax Reform Is Enacted Into Law.”