On March 27, 2020, President Trump signed into law the Coronavirus Aid, Relief, and Economic Security Act (the CARES Act). The CARES Act introduces several forms of taxpayer relief, including the relaxation of the Section 163(j) interest deductibility limitation for tax years beginning in 2019 and 2020. While the updated Section 163(j) limitation is intended to benefit larger businesses, multinational corporations should carefully consider the implications of these new rules and whether certain tax elections should be made in order to avoid unintended tax inefficiencies.
Existing Section 163(j) Rules
The 2017 Tax Cuts and Jobs Act (the TCJA) reformulated Section 163(j) to impose a limitation on the amount of business interest a taxpayer can deduct, equal to the sum of (i) 30% of the taxpayer's adjusted taxable income (ATI), (ii) the taxpayer's business interest income, and (iii) floor plan financing interest. Any business interest that is disallowed under Section 163(j) can be carried forward indefinitely.
In the partnership context, partners must analyze Section 163(j) at the individual level in addition to the partnership-level interest exclusion calculation. Any excess business interest (i.e., interest of the partnership disallowed under Section 163(j)) at the partnership is allocated among its partners and is treated as being paid in future years to the extent that such partners are later allocated excess taxable income (i.e., ATI that is not offset by interest expense because interest was fully deductible in that year). If a partnership does not generate excess taxable income in the future, the partners are prohibited from deducting any previously allocated excess business interest, and the expense will be capitalized in the basis of their partnership interests.
Changes to Section 163(j) Under the CARES Act
The CARES Act generally increases the Section 163(j) limitation from 30% of ATI to 50% of ATI for taxable years beginning in 2019 and 2020. Moreover, to maximize interest deductions in 2020, taxpayers can elect to use ATI from the last taxable year beginning in 2019 instead of 2020 ATI, which might be lower because of the COVID-19 crisis. ATI will be annualized to the extent the last taxable year in 2019 is a short year.
For partnerships, the limitation increase applies only for taxable years beginning in 2020. However, with respect to excess business interest for the partnership's taxable year beginning in 2019, (i) 50% will be subject to the same Section 163(j) rules that were previously in place, and (ii) the remaining 50% will be automatically deductible in the first taxable year beginning in 2020.
Limited Immediate Benefits to Taxpayers
Though the CARES Act is generally aimed at improving short-term cash flow for distressed taxpayers, the benefits of the relaxed Section 163(j) limitation are expected to be limited. In particular, the provision applies only to larger businesses that earn more than $25 million average annual gross receipts over the three proceeding years. Additionally, certain industries are exempt from the regime, including real property, farming, and regulated utility businesses.
For taxpayers to whom Section 163(j) applies, the CARES Act modifications will generally allow for larger interest deductions, which could result in net operating losses (NOLs) in 2019 or 2020. Under other provisions of the CARES Act, a taxpayer can carry back such losses to the prior five tax years and apply for a refund. However, taxpayers must file a final 2019 tax return in order to apply for a refund. This is likely impractical for most taxpayers, since the Internal Revenue Service has deferred the 2019 federal income tax deadline to July 15, 2020 for calendar-year taxpayers, not taking extensions into account.
For more details regarding the NOL provisions of the CARES Act, see Relaxed NOL Limitations Should Provide Relief to Taxpayers.
Opting Out of Relaxed Section 163(j) Limitation
Taxpayers are permitted to elect to apply the 30% limitation for a taxable year instead of the 50% limitation provided under the CARES Act. However, this election can be revoked only with consent of the IRS. Though it may seem counterintuitive, the election to opt out of the relaxed Section 163(j) limitation could potentially be beneficial in several scenarios.
To the extent a U.S. corporation's interest expense is largely paid to related foreign entities, the increased interest deduction could tip a taxpayer into the Base Erosion and Anti-Abuse Tax (BEAT) regime. BEAT applies only to C-corporations that (i) earn more than $500 million average annual gross receipts over the three proceeding years, and (ii) have more than 3% of total deductions made to foreign affiliates. BEAT imposes a minimum tax that is equal to 10% of modified taxable income. Taxpayers should consider whether an increase in interest deductions attributable to foreign affiliates would cause them to surpass the 3% threshold, in which case they may benefit from opting out of the increased interest expense limitation.
The relaxed Section 163(j) limitation could also result in loss of foreign tax credits (FTCs) for taxpayers whose controlled foreign corporations (CFCs) have significant third-party interest expense. The Global Intangible Low-Taxed Income (GILTI) regime imposes an effective tax of 10.5% on the excess of the CFC's net income over its net-deemed tangible income return. Because FTCs attributable to GILTI expire if not used, while Section 163(j) excess interest carries forward indefinitely, taxpayers may prefer a lower interest deduction in order to maximize the use of their expiring FTCs.
Alternative Method Election
Multinational businesses that want to further maximize their interest deductions should consider making an election to use an alternative method of calculating the Section 163(j) limitation (the Alternative Method Election), to the extent that they have not already done so. Without the Alternative Method Election, intercompany interest among CFCs is subject to Section 163(j), and a U.S. shareholder cannot include GILTI in its ATI for purposes of applying the Section 163(j) limitation. The Alternative Method Election is generally available to taxpayers with at least two CFCs. This election allows a taxpayer to net its interest expense among CFCs such that intercompany expense is generally not subject to the Section 163(j) limitation. The election also allows a portion of lower-tier CFC income in excess of the CFC's Section 163(j) limitation to roll up to its U.S. shareholders, not to exceed their net GILTI inclusions. Once made, the Alternative Method Election is irrevocable and will be applied to all current and future CFCs.
How Venable Can Help
The CARES Act modification to Section 163(j) can result in unexpected tax consequences. Venable's international tax team can help clients understand the tax and financial impact of the relaxed Section 163(j) limitations and implement tax planning strategies to best exploit their interest expenses.