Press Room: Tax Release
Federal Tax Reform: Amended Sec. 163(j) Interest Expense Limitation and State Tax Conformity Issues
Recent federal tax reform legislation amended Internal Revenue Code (the Code) Sec. 163(j), effective for tax years beginning after 2017. Amended Sec. 163(j) generally limits a business’s annual interest expense deduction to 30% of adjusted taxable income. Currently, and as discussed in detail in this article, there is some ambiguity with regard to applying the provisions of amended Sec. 163(j) at the state income tax level. As states enter their legislative sessions, we expect that there will be state-specific instruction for applying the new law to their respective tax regimes. Until further instruction is provided, application of amended Sec. 163(j) at the state level will likely create complexity for taxpayers.
Current Status of Sec. 163(j)
The limit imposed by amended Sec. 163(j) is based on three discrete items: 1) the annual business interest income of the taxpayer; 2) 30% of the annual adjusted taxable income of the taxpayer; and 3) the annual floor plan financing interest of the taxpayer. The total of these three items creates the maximum amount of business interest a taxpayer can deduct per year. Disallowed interest expense may be carried forward indefinitely.
Floor plan financing interest is the interest incurred on debt used in the acquisition of motor vehicles held for sale. Business interest income, on the other hand, is the amount of interest income includible in gross income for the taxable year that is from a trade or business, not including investment income. Adjusted taxable income (ATI) is federal taxable income before income, gain, deduction, or loss that is not from a trade or business, any business interest expense or business interest income, the amount of any net operating loss deduction under Sec. 172, the amount of any deduction allowed under Sec. 199A, and any deduction for depreciation, amortization, or depletion for taxable years before January 1, 2022. This limit is tailored with additional exemptions and rules for partnerships, small business owners and certain industries such as utilities providers and farmers.
Measurement of the amended Sec. 163(j) interest expense limitation is intended to occur at the taxpayer level. For federal income tax purposes, this will generally require measurement of the limitation on a consolidated or separate company basis contingent on the filing status of the taxpayer. Further instruction for assigning the limitation to members of a consolidated filing group is not provided within amended Sec. 163(j). The prior version of Sec. 163(j) stated that affiliated groups counted as one taxpayer. However, this language was removed and now there is no guidance in the statute for measuring and applying the limitation beyond the term taxpayer.
State Issues: Conformity
The threshold state level concern with federal tax reform is state conformity. States conform to the federal code in one of three ways:
- Rolling conformity- a state adopts federal code provisions as they are in effect, causing states to immediately adopt any changes to the federal tax code.
- Fixed-date conformity - a state has conformity with the federal tax code as it existed as of a certain date, causing a state to possibly use outdated versions of federal tax code sections.
- Selective conformity - a state only elects to incorporate certain provisions from the federal tax code. Any portion of the federal tax code that is not incorporated does not apply and state law needs to fill in those gaps.
Because of these differences in conformity, each state may apply amended Sec. 163(j) differently. For example Kansas, which has rolling conformity, will require a taxpayer to follow the limitations of amended Sec. 163(j). Georgia, however, currently has fixed-date conformity with the federal tax code as of January 1, 2017. Thus, absent state action, the amended Sec. 163(j) limitation would not apply to a 2018 Georgia tax filing. In order to reflect this change, Georgia would require a subtraction modification to federal taxable income of any disallowed interest expense. In prospective years, an addition modification to federal taxable income would be required to offset the impact of any interest expense carryforward amount allowed by operation of Sec. 163(j). If a state updates the date of fixed conformity, the limitations of amended Sec. 163(j) would apply and modification of federal taxable income would no longer be required. Most states with selective conformity conform to amended Sec. 163(j) and will require a taxpayer to follow the limitations of amended Sec. 163(j). In contrast, Arkansas does not selectively conform to amended Sec. 163(j) and modifications to federal taxable income would be required.
State Issues: Definition of Taxpayer
Application of the amended Sec. 163(j) limitation at the taxpayer level creates certain complexities for state corporate net income tax purposes. States will generally define the term taxpayer in a variety of ways, which may not be consistent with the term as contemplated in Sec. 163(j).
The definition of the term taxpayer at the state level may be contingent on the state’s separate, combined, or consolidated filing methodology. States with separate-company filing methodologies may define the term as the separate state filer, while combined-filing states could more broadly define the term to encompass all members of the combined-filing group. Application of the amended Sec. 163(j) limitation determined for federal income tax purposes at the state level may result in unworkable outcomes due to these unique state approaches for identifying the taxpayer.
For example, members of a federal consolidated filing group may be taxable in separate-company filing jurisdictions and will have measured the amended Sec. 163(j) limitation on a consolidated basis for federal income tax purposes. As noted, amended Sec. 163(j) does not provide instruction for assigning the limitation to members of a consolidated filing group. Therefore, it is unclear whether separate-filing states conforming to amended Sec. 163(j) will adopt the limitation measured for federal income tax purposes or require a separate-company state measurement of the limitation. Similar issues may exist in combined-filing states that define the term taxpayer to include only those members of a combined group with taxable nexus in the state.
A possible corollary example for applying the amended Sec. 163(j) limitation to members of a federal consolidated filing group comes from the instruction provided in the former Sec. 199 domestic production activities deduction (DPAD). Under DPAD, the amounts attributable to each member of an expanded affiliate group are aggregated and then the net amount is assigned to each member of the group. It is possible that amended Sec. 163(j) will follow a similar approach, but as of the date of this article there is no guidance on the issue.
State Issues: Interest Expense Carryforward
Interest expense deductions disallowed by operation of amended Sec. 163(j) may be carried forward and deducted from subsequent year income in states conforming to the new law. In states that do not conform to amended Sec. 163(j), a decoupling adjustment (i.e., addition modification) may be necessary to offset the impact of the interest expense carryforward deduction.
In separate-filing states that do not conform to amended Sec. 163(j), the process for measuring the decoupling modification needed to offset the carryforward may be contingent on the methodology used to determine the amended Sec. 163(j) limitation on the federal consolidated return. If the carryforward deduction is applied at the separate entity level, the separate-filing state decoupling adjustment should be equal to the carryforward deduction reflected in each separate entity’s income. Alternatively, if the carryforward deduction is applied as an overlying consolidating adjustment to income, an adjustment to separate-company income may not be necessary given that the income of each separate company included in the federal return has not been adjusted to reflect the amended Sec. 163(j) carryforward deduction.
In combined filing states that do not conform to the new limitations in amended Sec. 163(j), the amount of the decoupling modification should be equal to the amount of the amended Sec. 163(j) carryforward deduction reflected in federal income, if the combined state filing group is the same as the federal consolidated filing group.
State Issues: Related-Party Expense Disallowance
An additional issue exists for the interaction between unique state-specific, related-party interest expense disallowance rules and amended Sec. 163(j). Several states require an addback of certain related-party interest expenses. For those states, the addback of related-party interest expenses may create a possible double limitation on related-party interest expense because the amended Sec. 163(j) limitations apply equally to related- and third-party interest expense. Effectively, a taxpayer subject to both amended Sec. 163(j) and a state’s related-party interest expense disallowance may end up with two separate limitations on the same interest expense. In a worst case situation, there may be a permanent loss of the interest expense deduction in certain states.
Under amended Sec. 163(j), there is a limitation on the amount of net business interest expense that can be deducted. While some uncertainty exists at the federal level, there are additional issues at the state level that should be considered. State application of amended Sec. 163(j) is complex and will be a changing landscape for the foreseeable future as states grapple with its implications. As such, it will be crucial for companies to monitor state developments.