United States: Government Issues Proposed Regulations On Business Interest Expense Deduction Limitation: Overview And Impact On Leveraged Finance Market

On November 26, 2018, the Treasury Department and the Internal Revenue Service issued highly-anticipated regulations regarding the new section 163(j) limitation on business interest deductions. Section 163(j) was modified as part of the Tax Cuts and Jobs Act of 2017 to more broadly limit business interest deductions. The proposed regulations (the "Regulations") add important details that will assist corporations and partnership in computing their limitations, but they also propose some significant expansions from the Code.

Section 163(j)

Under the new section 163(j) rules, net business interest expenses (i.e., after offsetting business interest income) generally can only be deducted up to the 30% of the taxpayer's adjusted taxable income on a yearly basis. The limitation applies to all deductible interest, including interest that is "paid in kind." Adjusted taxable income is the taxable income of the taxpayer, computed without regard to interest, net operating loss deductions, if any, and the section 199A deduction for certain qualified business income. For taxable years beginning before January 1, 2022, adjusted taxable income is computed without regard to depreciation, amortization and depletion (i.e., similar to EBITDA). Beginning on January 1, 2022, adjusted taxable income will take into account depreciation, amortization and depletion (i.e., similar to EBIT).

Interest expense that cannot be deducted in the taxable year in which it is incurred can be carried forward indefinitely, and the carried-forward interest deductions could be used in subsequent years subject to the general 30% adjusted taxable income limitation in such years. This interest deduction limitation applies to taxable years that begin after December 31, 2017, and there are no grandfathering provisions for any preexisting debt instruments or business interest deductions that were carried forward from prior years. Note that the Regulations do not discuss how 163(j) coordinates with other Tax Cuts and Jobs Act provisions, such as the section 250 deduction or the section 59A base erosion and anti-abuse tax.

Below Are Some of the Important Additions And Clarifications Contained in the Regulations:

  • The Regulations define "interest" very broadly for the purposes of section 163(j). Any transactions which have the substance of a loan, regardless of form, can be considered to produce interest income or expense. Interest equivalents will be treated as interest. Preferred stock dividends generally would not be subject to these rules. In recent years there has been an increased use of preferred stock in mezzanine and other financing, although this has been utilized more for non-tax considerations.
  • The Regulations also introduce a broad anti-avoidance provision. Expenses or losses incurred through arrangements that are entered into in order to avoid the application of section 163(j) can be disregarded or recharacterized by IRS as needed to fulfill the purpose of section 163(j). Therefore, payments that are not formally interest may end up being recharacterized as interest if the IRS determines that those payments are primarily being made to avoid the interest expense deduction limit.

    • The Regulations only apply this provision to business interest expense and does not correspondingly allow for increasing business interest income for netting purposes.
  • The Regulations make a series of changes to the definition of adjusted taxable income.

    • The Regulations clarify that expenses incurred as depreciation, amortization or depletion that are capitalized to inventory and included in the cost of goods sold are not included within the definition of deductions for depreciation, amortization or depletion for the purposes of section 163(j).
    • The Regulations state that taxpayers may need to add the section 250(a)(1) deduction back when calculating adjusted taxable income if some or all of the deduction was included under the GILTI provision.
  • The Regulations clarify that the business interest expense deduction limitation applies at the consolidated group level. However, each individual member's interest expense or income is offset at the member level, without taking into account whether the interest relates to an intercompany obligation.
  • The Regulations clarify that for taxpayers with both excepted and non-excepted businesses, interest will be allocated according to the adjusted basis of the assets used, rather than according to income or through a tracing scheme.
  • The Regulations also apply the separate return limitation year rules to the business interest carryover of a joining member of consolidated group, though on an annual basis.
  • The Regulations provide that the section 163(j) deduction limitation will apply to controlled foreign corporations, and they provide detailed rules for applying the limitation to CFCs.

Leveraged Finance Market

Highly levered companies are, as a general rule, negatively impacted by the business interest expense deduction limitation. As a simple rule of thumb, if a borrower's consolidated fixed charge coverage ratio is approaching or below 2.00x, the cap on deductibility will likely become increasingly important. With PIK interest being included in the cap, the escape hatch for non-cash pay debt solutions to this cap is closed off. As a borrower spirals down towards a liquidity crunch or bankruptcy event, the risk is that the business interest expense deduction limitation accelerates that spiral. This tax rule has a pro cyclical effect i.e., it does not help stabilize a borrower in financial crisis, rather it puts a further choke hold on its ability to service debt obligations after tax payments.

Leveraged buyouts, a staple of private equity firms, should (theoretically and on a stand-alone basis) be negatively impacted by the business interest expense deduction limitation. If lenders are less willing to extend credit due to the reduced (after tax) cash flow available to service the capital structure, then the total debt available to a buyer in a leveraged transaction should decrease; and, assuming the purchase price remains the same, the level of required equity will increase. The limitation incrementally incentivizes the use of equity over debt (all else being equal). Our survey of senior leveraged finance professionals indicates that this rule has had (so far) no meaningful impact on non-distressed leveraged finance transactions. The market has accepted the rule and moved steadily along. In light of the overall tax reforms enacted under the current administration, the leveraged finance market has been robust and resilient in 2018.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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