In most tax jurisdictions, debt is viewed more favorably than equity as interest is typically deductible while dividends are not. To combat this strategy, many tax jurisdictions will impose restrictions on the deductibility of interest. The US has rules that limit business interest deductions and these restrictions are tightening in 2021.
The Tax Cut and Jobs Act ushered in new Internal Revenue Code Section 163(j) for years ended after December 31, 2017. This code section replaced the previous tax regime, which sought to limit interest deductions by US corporations with debt owing to related foreign parties, whereas the current law seeks to limit the business interest deductions of ALL US taxpayers.
Since 2018, business interest deductions have been limited to the sum of business interest income plus floor plan interest plus 30 percent of a taxpayer’s “adjusted taxable income”. For the years 2019 and 2020, Congress adjusted this 30 percent limitation to a 50 percent limitation to provide relief due to the COVID-19 pandemic. In 2021, however, the 30 percent limitation has returned, and just as importantly, the definition of “adjusted taxable income” changes in 2021.
What Is Adjusted Taxable Income?
Adjusted taxable income is defined as taxable income computed without regard to
- Any item of income, gain, deduction or loss which is not properly allocable to a trade or business,
- Any business interest or business income,
- Any net operating loss deduction,
- Any deduction allowed attributable to the qualified business activity income deduction, and
- Any deduction allowable for depreciation, amortization or depletion.
For tax years beginning on or after January 1, 2022, the adjustment related to depreciation, amortization or depletion has been eliminated. The limitation was roughly 30 percent of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) and beginning in 2022 it will be 30% of EBIT.
Example: Corporation X is a calendar year taxpayer with revenues of $30 million, earnings before interest and depreciation of $15 million, interest of $4 million and depreciation of $6 million for each of 2021 and 2022. There is no business interest limitation for 2021 as Corporation X computes its adjusted taxable income to be $15 million (the sum of taxable income $5 million plus business interest expense $4 million and depreciation of $6 million). Thirty percent of $15 million is $4.5 million which is greater than the actual interest expense of $4 million.
Adjusted taxable income equals $9 million in 2022 because Corporation X can no longer add back depreciation, amortization or depletion. Its business interest deduction is limited to $2.7 million in 2022 (30% of $9 million) thereby disallowing the remaining $1.3 million. The disallowed portion is carried forward indefinitely. Please note though that the excess limitation generated in 2021 does help the limitation in 2022 but is ignored for simplicity in this example.
All US taxpayers should evaluate their capitalization structure in light of these changes to see if they can continue to support their current level of debt. It is very conceivable that US entities with indebtedness to related parties could be denied a deduction for interest expense, but interest is fully taxable to the related party.
Any interest disallowed under this provision is carried forward indefinitely and certain “small taxpayers” are exempt from these restrictive provisions.