New US Interest Expense Deduction Limitation

The US Tax Cuts and Jobs Act (enacted on December 22, 2017) repeals the existing earnings-stripping rules (IRC section 163(j)) applicable to interest paid to foreign related parties. These rules have been replaced with a stricter rule, effective for tax years beginning after 2017, that applies to all business taxpayers (unless the exceptions set out below apply) and to all business interest. Thus, interest paid to both domestic parties and unrelated foreign parties is now subject to limitation. Ambiguities in the new provision are expected to be addressed by future IRS guidance; future corrective legislation is also a possibility.

The business interest affected by the provision is defined as any interest paid or accrued on indebtedness properly allocable to a trade or business. Any amount treated as interest for tax purposes is treated as interest for the purposes of the provision.

The new limitation does not apply to some small businesses—those that have average annual gross receipts for the three-taxable-year period ending with the prior tax year that do not exceed US$25 million. In addition, some taxpayers (such as certain real estate businesses and certain farming businesses) can elect not to have the interest expense limitation apply; businesses making this election are required to use the alternative depreciation system to depreciate certain property.

Subject to certain exceptions, interest expense that exceeds 30 percent of the relevant business's adjusted taxable income will be disallowed. Adjusted taxable income generally is a business's taxable income computed without regard to
  • any item of interest, gain, deduction, or loss that is not properly allocable to a trade or business;

  • business interest or business interest income;

  • the amount of any net operating loss deduction;

  • the 20 percent deduction for certain passthrough income; and

  • in the case of tax years beginning before January 1, 2022, any deduction allowable for depreciation, amortization, or depletion.

For tax years beginning before 2022, adjusted taxable income may be thought of as analogous to EBITDA (earnings before interest, taxes, depreciation, and amortization) calculated using tax principles; for later tax years, it is analogous to EBIT (earnings before interest and taxes) computed using tax principles.

The provision applies to all businesses, regardless of organizational form, and any disallowance or excess limitation will generally be determined at the filer level (for example, at the partnership level rather than the partner level). For a group of affiliated corporations filing a consolidated tax return, the provision is applied at the consolidated return filing level.

Any disallowed business interest will be carried forward indefinitely; however, in the case of business interest that is not allowed as a deduction to a partnership, special carryforward rules apply to partners. The provision will also have an impact on mergers and acquisitions. In particular, the amounts carried forward will be taken into account in the case of certain corporate acquisitions described in IRC section 381, and are subject to limitation under IRC section 382.

The new provision does not address the situation of interest expense deductions denied under the previous regime that were deferred and carried forward; those deductions may still be available. However, it is unclear whether a corporation may treat the disallowed interest expense as business interest paid or accrued in a year after the effective date of the provision (January 1, 2018).

Finally, the provision applies only to the taxpayer's business interest expense. Other existing rules governing interest deduction (IRC sections 267 and 385) remain in place and can limit the amount of the interest deduction allowed. The new legislation also introduces a base erosion anti-abuse tax (BEAT) regime, which imposes a minimum tax based on the difference between regular tax liability and alternative tax liability computed without the benefit of certain base erosion payments (such as interest payments). A US corporation subject to the new IRC section 163(j) may also be subject to BEAT.

Justine Morin
KPMG LLP, Montreal

Canadian Tax Focus
Volume 8, Number 1, February 2018
©2018, Canadian Tax Foundation