The Tax Cuts and Jobs Act amended IRC Section 163(j) to limit the deduction for net business interest expense in excess of interest income. The limitation is based on a percentage (30% for most years) of adjusted taxable income (ATI) computed under Section 163(j).
Prior to 2022, taxpayers were allowed to add back tax depreciation and amortization, effectively increasing ATI similar to the financial statement EBITDA measurement. For taxable years beginning after Dec. 31, 2021, the rules for computing ATI changed. Basically, the change limits interest deductions to 30% of a tax-adjusted “EBIT” (earnings before interest and taxes), meaning taxpayers can no longer add back depreciation and amortization in computing ATI. This change has made planning opportunities that focus on increasing depreciation and amortization no longer beneficial. The increasing interest rates and maturing debt loads which have already caused turmoil in the banking sector threaten to exacerbate the problem.
House Republicans have released a tax bill, The Build in America Act (H.R. 3938) that would restore the EBITDA regime for computing ATI through 2026 and provide retroactive relief. However, the bill is not expected to be enacted in its current form and likely will not be addressed until year-end if at all.
Some companies will be affected disproportionately, including those which carry heavier debt loads, such as private equity firms and their portfolio companies, as well as companies with heavy capital expenditures such as manufacturing. But all companies should explore any potential planning opportunities if their interest deductions are limited by Section 163(j).
In considering the impact of the change to Section 163(j) and potential planning opportunities, tax and accounting teams should ask these threshold questions:
- Do we have a sizeable interest expense?
- Are those interest rates going up?
- Will that effect deductibility?
- Is my company borrowing for capital/inventory purchases or to help fund the organization?
- Does my organization have significant capital expenditures or inventory acquisitions in 2023?
- Are we paying cash taxes?
Look closely at expenses and strategy
One planning opportunity to consider is required or elective recharacterization of interest to other items. Grant Thornton Washington National Tax Office Partner Ellen Martin said, “We’re helping clients look at interest expenses. Where do the tax rules either allow or require you to take interest and allocate it as part of something else? For example, is a portion of the interest expense allocable to the cost of inventory or assets that would cause it to lose its character as interest?”
Depending on your business, you may be able to allocate interest to the research and development, production, construction or acquisition of a wide range of tangible and intangible property. Once recharacterized to other items, the interest becomes part of the cost of the other item and recovered using the accounting method applicable to that item. For example, if interest is recharacterized to a fixed asset it would be recovered through depreciation deductions.
Grant Thornton Senior Manager Trevor Salzmann said that CFOs likely will ask their team one simple question: “Is 163(j) going to be a problem for the organization?” Grant Thornton Managing Director John Suttora said, “If the answer is yes, then the follow-up should specify how the organization might be limited, now or in the future, and what response options might be, including both accounting and strategic options.”
For example, if a growth or modernization initiative is dependent on debt-heavy capital expenditures, the company may want to be consider other options for financing. Similarly, any proposed elections or changes in accounting methods, related to recharacterizing interest, will need to be evaluated for their overall strategic impact.
Act quickly and revisit regularly
Most of the planning opportunities around recharacterizing interest are limited to the year in which the interest is incurred and the items are being acquired, constructed or produced. Which means that timing is important, and companies should start this planning now. Interest expenses in 2022 which companies fail to electively recharacterize cannot be recovered in subsequent years.
“If companies are severely limited, with no current projections to use interest carryforwards they may be require to set up a valuation allowance against the carryforward,” Martin said. “And while the interest limitation doesn’t expire, it can start to look permanently disallowed if companies are continuing to take on more and more debt with higher interest rates. So, anything you can do now will start eating away at that limitation.”
And while you need to respond promptly, it’s also important to revisit that decision every year, said Grant Thornton Senior Manager Jon Terrill. “It's not like you just consider it in 2022 and set and forget. This can benefit you over multiple years.”
Such planning can help restore certainty and it may have positive impacts even if Congress restores the EBITDA model. Terrill said, “They were a lot of companies that had interest expense issues even under the EBITDA model. This planning would benefit companies under the old rules as well.”
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