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The Illinois Department of Revenue (Department) proposed amendments (44 Ill. Reg. 1785) to 86 Ill. Adm. Code Section 100.2430 (Proposed Regulation) clarifying the interaction of the 30% business interest expense limitation rules under IRC Section 163(j) and Illinois's related-party interest expense add-back rules. In short, the Proposed Regulation would apply the federal business interest expense limitation first before determining the Illinois interest expense add-back.

Background

IRC Section 163(j), as amended by the Tax Cuts and Jobs Act (TCJA), limits a taxpayer's federal income tax deduction for business interest paid to the sum of (1) the taxpayer's business interest income, (2) 30% of its adjusted taxable income, and (3) its floor financing interest. Any business interest expense over that computed amount is carried forward and treated as interest paid in the following year. Under proposed Treasury regulations (REG-106089-18), the limitation is to be computed on a consolidated basis. (See Tax Alert 2018-2401.)

The Illinois Income Tax Act requires taxpayers to add back interest expense paid, accrued, or incurred to a related person that would be a member of the Illinois unitary business group, but for the fact the related person (either foreign or domestic) is excluded from the unitary group under Illinois's 80/20 rules (an 80/20 company). While various exceptions apply to the add-back requirement, the Proposed Regulation focuses on computing the amount of deductible interest expense attributable to an 80/20 company subject to Illinois's own interest add-back rule.

Illinois generally conforms to the IRC on a rolling basis; because the state has not specifically decoupled from IRC Section 163(j), the Proposed Regulation acknowledges that it conforms to this provision. Illinois also applies the federal consolidated return regulations for purposes of computing combined group income. As a result, Illinois should conform to the federal proposed regulations, which would require computing the IRC Section 163(j) limitation on a consolidated basis. Thus, when computing combined group income, Illinois taxpayers would have to compute federal taxable income for the group on a pro forma basis for only to those amounts derived from the members of the Illinois combined group. Given that the federal interest expense deduction would be computed at the group level, it is unclear how much of that deduction, and corresponding carryforward, would be attributable to interest expense paid or accrued to an 80/20 company. The Proposed Regulation is intended to address this problem.

Proposed computation

Under the Proposed Regulation, the interest expense deemed paid to an 80/20 company is the business income paid to that 80/20 company in the tax year, multiplied by a fraction equal to (1) the IRC Section 163(j) deduction allowed, over (2) the total business interest paid for that tax year. Likewise, the amount of interest expense paid to an 80/20 company and carried forward to the next year is the amount of business interest paid to that 80/20 company in the tax year, multiplied by a fraction equal to (1) the amount of business interest to be carried forward to the next tax year, over (2) the total business interest paid for the tax year.

Implications

While not explicitly addressed in the Proposed Regulation, the IRC Section 163(j) deduction or carryforward (i.e., the numerators in the fractions previously described) are those accumulated amounts the members of the Illinois combined group would have reported for federal income tax purposes if the Illinois combined group collectively joined in filing a federal consolidated return for the year. Therefore, when the membership of the federal consolidated group is identical to the membership of the Illinois combined group, the IRC Section 163(j) computations will be the same. If, however, the membership of the two groups differs, the Illinois combined group must recompute its IRC Section 163(j) limitation by applying the relevant consolidated return rules, but only to the members of that combined group.

The Proposed Regulation would affect those taxpayers paying interest to 80/20 companies. Those taxpayers will need to apply this pro rata approach to determine how much of that interest expense is subject to Illinois's addback rules. There are exceptions to the Illinois add-back requirement (e.g., if the 80/20 company is subject to tax on the interest income it receives) that could render the interest add-back rules unnecessary. In recent years, however, the Department's auditors have shown a renewed focus on challenging taxpayers claiming these add-back exceptions. Thus, if any taxpayer argues an exception applies, it will be important to determine the appropriate amount of interest expense under Illinois's add-back rules to fully evaluate an audit strategy.

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