August 7, 2020
Final regulations under IRC Section 163(j) have state tax implications
This Tax Alert focuses on the general state corporate income tax effects of final regulations (TD 9905) (the Final Regulations1) that provide guidance on applying the limitation on the deductibility of business interest expense (BIE) under IRC Section2 163(j) which was significantly modified by the Tax Cuts and Jobs Act (TCJA) and then temporarily modified by the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). Nearly every state with an income tax relies upon the IRC in some manner and generally may follow the Final Regulations, except where modified by state tax law. As such, the Final Regulations will have important implications for state and local (collectively, state) income tax reporting purposes.
This Tax Alert highlights the significant provisions of the Final Regulations and broadly analyzes how these provisions could affect state corporate income taxes (i.e., state income taxes imposed on C corporations and other legal entities that are taxed as regular corporations for federal income tax purposes). It does not address the state income or other business tax consequences of the law on any other type of taxpayer, including individuals and pass-through entities (such as partnerships, limited liability companies or S corporations). Unless otherwise stated, it is not intended to provide a detailed analysis of the tax law implications in a particular state. Readers are cautioned that the impact of the Final Regulations on state corporate income taxpayers as described in this Tax Alert may not necessarily be the same impact that applies to other types of state taxpayers.
Background of IRC Section 163(j) and overview of Final Regulations
IRC Section 163(j) limits the deduction for BIE for tax years beginning after December 31, 2017, to the sum of (1) the taxpayer's business interest income (BII), (2) 30% of the taxpayer's adjusted taxable income (ATI)3 and (3) the taxpayer's floor plan financing interest. BIE is interest that is paid or accrued on indebtedness that is properly allocable to a trade or business. The IRC Section 163(j) limitation does not apply to certain trades or businesses, such as certain small businesses,4 an electing real property trade or business,5 an electing farming business and certain activities of regulated utilities. Certain activities, such as performing services as an employee, are excluded from being a trade or business.
In general, any interest expense that is disallowed under IRC Section 163(j)(1) would be carried forward to the next tax year as a disallowed BIE carryforward. In the case of an acquisitive asset reorganization under IRC Section 368 or a liquidation of a subsidiary into its parent corporation under IRC Section 332, any disallowed BIE carryforward of the target or subsidiary corporation, respectively, is available to the acquiror subject to the terms of IRC Section 381. In the case of an "ownership change" (generally, a 50% ownership increase by 5% shareholders) with respect to a corporation with disallowed BIE carryforwards, IRC Section 382 imposes limitations on the use of such disallowed BIE carryforwards (as well as certain other tax attributes).
The Final Regulations provide guidance on what constitutes interest for purposes of the limitation, how to calculate the limitation, which taxpayers and trades or business are subject to the limitation, and how the limitation applies in certain contexts (e.g., federal consolidated groups).
The Final Regulations generally are effective and generally apply to tax years beginning 60 days on or after the date they are published in the Federal Register, with special effective dates for certain provisions. Subject to certain requirements, taxpayers generally may apply the Final Regulations before their applicability date or may apply the proposed regulations released in 2018 (2018 Proposed Regulations), but generally must apply any set of regulations in their entirety.
For a general overview of the Final Regulations and a discussion of the effects on foreign corporations, see Tax Alert 2020-1961.
Select Final Regulations provisions of significance for state corporate income tax purposes
From a state corporate income tax perspective, the following provisions in the Final Regulations are of particular interest:
The Final Regulations use a taxpayer's "tentative taxable income" (TTI) (which is computed without regard to IRC Section 163(j)) as the starting point for determining ATI.
The Final Regulations modify the rules on adjusting ATI upon the sale or other disposition of depreciable property, stock of a federal consolidated group, or interests in a partnership. The Final Regulations also modify rules for transactions within a consolidated group to avoid inappropriate double inclusions, and generally do not treat the transfer of depreciable assets in an IRC Section 381 transaction as a "sale or other disposition" for purposes of adjusting ATI.
Treasury determined that further study is needed to coordinate IRC Section 163(j) with other rules limiting the availability of deductions based on a taxpayer's taxable income (such as income-based deductions under IRC Sections 250(a)(2), 170(b)(2) and 172(a)(2)). Until such guidance is effective, taxpayers may choose any reasonable approach for coordinating these provisions, so long as they apply the approach consistently for all relevant tax years.
Reg. Section 1.163(j)-2 makes corresponding changes to reflect modifications to IRC Section 163(j) made by the CARES Act and adjusts the ATI limitation to 50% for tax years beginning in 2019 and 2020 (though taxpayers may elect out). The 50% ATI limitation does not apply to partnerships for tax years beginning in 2019. Similarly, Reg. Section 1.163(j)-2(b)(3) allows taxpayers to elect to use ATI for the last tax year beginning in 2019 as the ATI for any tax year beginning in 2020. The provision addresses short tax years in 2020 by allowing the ATI in the last tax year beginning in 2019 to be prorated based on the number of months in the short 2020 year.
A federal consolidated group has a single IRC Section 163(j) limitation. The Final Regulations' new concept of TTI is defined for a consolidated group as the group's consolidated taxable income, disregarding IRC Section 163(j) BIE carryforwards and disallowance. For determining a consolidated group's ATI, intercompany items and corresponding items from intercompany transactions are disregarded to the extent they offset in amount. Thus, such items are not included in the group's ATI even if one member, on a stand-alone basis, is engaged in a non-excepted trade or business and the other is engaged in an excepted trade or business. A consolidated group's current-year BIE and BII are the sum of each member's amounts. Interest on an intercompany obligation under Reg. Section 1.1502-13(g) is disregarded for this purpose.
Current-year BIE is deducted before disallowed BIE carryforwards; carryforwards are then deducted on a first-in-first-out (FIFO) basis. For a corporation, this ordering is subject to IRC Section 382; for a member joining a federal consolidated group, the ordering is subject to the separate return limitation year (SRLY) rules.
If a consolidated group has insufficient IRC Section 163(j) limitation to completely deduct its current-year BIE, then each member first deducts interest to the extent of its own BII, and then deducts any remaining interest expense based on its proportion of the entire group's remaining interest expense. Any member with remaining interest expense not allowed in the current year carries it forward to the next year.
If a corporation ceases to be a member of a consolidated group during a year, the member's current year BIE, and its carryforwards arising during its years in the group, are first made available for the consolidated group in that year to the extent allowed. The amount not deducted by the group that year can then be carried forward to the departing member's separate return year. The carryforward would be subject to reduction under the loss duplication rule of Reg. Section 1.1502-36(d)
State corporate income tax responses to IRC Section 163(j)
The state corporate income tax implications of IRC Section 163(j) generally depend upon how each state conforms to the IRC and IRC Section 163(j), in particular. States conform to the IRC in one of several ways: (1) they automatically incorporate the federal tax law as it changes (known as "rolling" conformity); (2) they adopt the federal tax law as of a specific date (known as "fixed" conformity); or (3) they select specific federal tax law provisions and dates to which they conform (known as "selective" conformity). Of states imposing corporate income tax, all but Arkansas, California, and Texas have incorporated a post-TCJA version of the IRC as of the 2020 tax year.
State corporate income tax systems generally use some measure of income determined under the IRC, including federal taxable income (FTI), as a starting point for state corporate income tax calculations. Most states then modify FTI with certain additions or subtractions to arrive at the tax base before state allocation and apportionment. Because IRC Section 163(j) relates to a deduction used to determine FTI, states conforming to a post-TCJA version of the IRC generally will conform, absent state legislation that decouples from or modifies IRC Section 163(j).
The states that have decoupled from or modified IRC Section 163(j) do so in various ways. Some of these states, such as Connecticut,6 have decoupled from IRC Section 163(j) in its entirety since the first tax year in which it became effective post-TCJA. Iowa7 and other states comprehensively decoupled from IRC Section 163(j) only after some years of conformity. Still other states have merely decoupled from the significant amendments to IRC Section 163(j) enacted with the TCJA. For example, Georgia decouples from IRC Section 163(j) as amended by the TCJA by specifically conforming to the previous version of IRC Section 163(j) that was in effect on December 21, 2017 (the day before the TCJA's enactment).8
Currently, a majority of states conform to IRC Section 163(j). That conformity has spawned new state tax laws and state tax administrator interpretations as to how the IRC Section 163(j) limitation is computed for state income tax purposes. For example, Virginia lawmakers opted to ease the effects of IRC Section 163(j), while still conforming to the limitation itself, by providing a deduction for Virginia purposes equal to 20% of any BIE disallowed under IRC Section 163(j).9
Corporations also must compute for state income tax purposes the underlying components of the IRC Section 163(j) limitation. For many state corporate taxpayers, the most significant of those components is the limitation based on ATI. In arriving at ATI, taxpayers adjust FTI for certain items, including items that often differ for state purposes, such as net operating loss (NOL) deductions determined under IRC Section 172 and depreciation deductions allowed under IRC Section 168(k). Though states generally add to and subtract from FTI, most states do not modify the actual definition of FTI (as it is defined in IRC Section 63). It follows that those states would not arrive at a different calculation of ATI for state purposes than for federal. Some state tax laws, however, do modify the definition of FTI, such that the calculation of ATI for state income tax purposes may differ from the federal calculation. Consider Michigan, where state tax law defines the term "federal taxable income" to mean taxable income as defined in IRC Section 63, but calculated as if IRC Sections 168(k) and 199 were not in effect.10 Consequently the Michigan Department of Treasury advises that, in computing the IRC Section 163(j) limitation for Michigan purposes, ATI should be calculated without regard to bonus depreciation for tax years beginning after December 31, 2021.11
State corporate taxpayers must exercise caution in determining whether an IRC Section 163(j) limitation applies to BIE that was paid to both related and unrelated parties. This is because many states impose related-party interest expense disallowance (or "addback") rules that can intersect and conflict with the IRC Section 163(j) limitation. State lawmakers and taxing authorities have begun to address this nuance. New Jersey tax law requires corporations to apply the IRC Section 163(j) limitation on a pro-rata basis to interest paid to both related and unrelated parties, including intercompany interest already required to be added back to entire net income.12 The law does not define what is meant by the term "pro rata." By contrast, Pennsylvania's Department of Revenue has provided an explicit, formulaic calculation to allocate the federal IRC Section 163(j) limitation to related- and unrelated-party BIE.13
Because IRC Section 163(j) relates to the determination of interest expense deducted in arriving at FTI, and because state related-party addback rules generally result in additions to FTI, it is generally expected that the IRC Section 163(j) limitation applies prior to adding back any related-party interest expense. However, state taxing authorities may advise differently. For example, the Massachusetts Department of Revenue has specifically addressed the interaction of the state's addback rules with the IRC Section 163(j) limitation, requiring that the Massachusetts deduction for BIE should be determined after first reducing current year BIE by the amount of the state related-party addback.14 This, too, can result in different federal and state limitations under IRC Section 163(j).
As noted above, when BIE exceeds the IRC Section 163(j) limitation in a given tax year, IRC Section 163(j) provides for the carryover of that disallowed BIE indefinitely into future tax years. It is possible, but unasserted by a state tax authority, that a taxpayer might be required to carry forward this attribute on a post-apportionment basis for state income tax purposes. The application of IRC Sections 381 and 382, which generally impose limitations on a successor's post-acquisition use of an acquired business's tax attributes, also poses concerns because many states do not follow these IRC provisions or apply their own rules regarding succession to tax attributes.15
State corporate income tax implications of the Final Regulations
We previously highlighted a number of state corporate income tax considerations related to state conformity to the 2018 Proposed Regulations under IRC Section 163(j) (see Tax Alert 2018-2510). The Final Regulations largely adopt the considerations most significant from a state income tax perspective, particularly the rules concerning the calculation of the IRC Section 163(j) limitation for a federal consolidated group.
The preamble to the Final Regulations notes that, "Although Congress did not expressly address this issue, Congress did make clear that the [IRC Section] 163(j) limitation applies at the consolidated group … .Moreover, [IRC Section] 1502 provides broad authority for the Secretary of the Treasury to prescribe regulations to determine the tax liability of a consolidated group in a manner that clearly reflects the income tax liability of the group and that prevents the avoidance of tax liability." Hence, under the Final Regulations, a federal consolidated group has a single IRC Section 163(j) limitation, and that limitation is calculated using the group's BII, BIE and ATI, each aggregated under single-entity principles. The Final Regulations also provide an allocation rule to determine which member deducts interest expense in the event that the federal consolidated group does not have sufficient IRC Section 163(j) limitation to completely deduct its current-year BIE (or its disallowed BIE carryforwards).
Because most states generally do not follow the federal consolidated return regulations, state corporate taxpayers must evaluate whether the federal consolidated group provisions contained in the Final Regulations will be respected for state corporate income tax purposes. As a threshold matter, it is unclear whether states might follow the single-entity principles in the Final Regulations, as those principles are not recorded under IRC Section 1502 (i.e., in Reg. Section 1.1502-1 et seq.). It is possible that state taxing authorities will apply these federal consolidated group rules as an administrative convenience. Pennsylvania, a separate-reporting state, partially adopts this approach in that the Department of Revenue requires recalculation of the IRC Section 163(j) limitation on a separate-company basis only if the federal limitation, computed in accordance with the Final Regulations, results in disallowed BIE.16 This kind of administrative convenience could present positive or negative tax outcomes for some taxpayers, however, when one member of the federal consolidated group is a taxpayer in a state, and other members are not. It might also matter for state income tax purposes whether the federal consolidated group members are not engaged in a unitary business.
The recalculation of the IRC Section 163(j) limitation for state purposes could result in meaningfully different results than the federal calculation, particularly in states that require corporate income tax reporting on a separate-company basis. The same may be true in states that require or allow a group filing methodology when the membership in the state combined group differs from the federal consolidated group membership.17 In determining FTI for state income tax purposes, states generally follow references to affiliation definitions in IRC Section 1504, except that states often require the recalculation of any FTI amounts impacted by the filing of federal consolidated returns. Some states, such as Maryland,18 have statutes requiring corporations to determine a pro-forma FTI as if each federal consolidated group member had filed its federal income tax return on a stand-alone basis. Other states, like West Virginia,19 have specifically decoupled from some or all of the federal consolidated return regulations, thus requiring corporations in a federal consolidated group to also make a recalculation of FTI.
Accordingly, some state taxing authorities have interpreted their state tax regimes as requiring the recalculation of the IRC Section 163(j) limitation without applying the single-entity provisions for federal consolidated groups that are contained in the Final Regulations. Guidance from the Virginia Department of Taxation, for example, advises state corporate taxpayers that they must recompute FTI for Virginia purposes if they are part of an affiliated group of corporations with Virginia nexus that files its federal and Virginia returns on a different basis or includes different members in its filings (or both).20 When the affiliated group elects to file separate-company Virginia returns, the relevant example in the guidance demonstrates that federal consolidated return principles do not apply.21
The Final Regulations also raise state corporate income tax concerns for limitations on BIE deductions following mergers and acquisitions. As stated above, in the context of members of a federal consolidated group, the Final Regulations recognize the intersection of the SRLY rules and IRC Section 382 rules for consolidated group members by providing an overlap rule that makes the SRLY rules inapplicable when an IRC Section 382 limitation applies by reason of a concurrent (or within six months) IRC Section 382 ownership change. The intricate SRLY rules limit the use of a consolidated group member's disallowed BIE carryforwards attributable to non-consolidated years, generally following separate entity principles. There could be different results for state purposes since many states do not follow these principles. Additionally, the Final Regulations require the members of a federal consolidated group to make stock basis and earnings and profits (E&P) adjustments to reflect the payment, accrual, or deduction of BIE. Many states, even among combined-reporting states, do not permit these type of adjustments, so applying the Final Regulations for state tax purposes could result in disparate federal and state stock basis and E&P, potentially resulting in significant differences in the federal and state tax treatment of future distributions and stock sales.
IRC Section 163(j) as amended by the TCJA has introduced significant complexity into the state corporate income tax base. The Final Regulations exacerbate this complexity by invoking single-entity principles of a federal consolidated return, which states often do not follow in determining state taxable income. Unfortunately, many states have yet to address, either through taxpayer guidance or lawmaking, the application of IRC Section 163(j) under their state tax laws. Taxpayers should immediately begin to model and assess any benefits and adverse consequences, along with any impact on historic, existing and future federal and state tax attributes and planning (in particular for the 2019 tax year for calendar-year taxpayers). Taxpayers may identify a need for a state tax policy solution to the IRC Section 163(j) queries posed in this Tax Alert, as well as the resulting impacts on state tax compliance and administration.
1 Accompanying proposed regulations (REG-107911-18) (the Proposed Regulations) would provide additional guidance on several other aspects of the limitation, including (i) substantially revised rules for applying the limitation to US shareholders of controlled foreign corporations (CFCs), (ii) rules for foreign persons with effectively connected income (ECI), and (iii) specific aspects of the limitation as applied to partnerships, including partnerships engaged in the trade or business of trading personal property.
2 Except as otherwise indicated, "IRC" refers to the Internal Revenue Code of 1986, as amended; "Section" refers to the relevant section or sections of the IRC; and "Reg. Section" and "Prop. Reg. Section" refer to the relevant section or sections of the Income Tax Regulations promulgated by Treasury under the IRC.
3 The CARES Act adjusted the ATI limitation to 50% for tax years beginning in 2019 and 2020 (though taxpayers may elect out).
4 At the same time that the Treasury Department released the Final Regulations, the IRS also released FAQs on the aggregation rules that apply for purposes of the gross receipts test and determining whether a taxpayer is a small business exempt from the IRC Section 163(j) limitation. The FAQs provide a brief summary of existing authorities but do not shed any new light on the aggregation rules.
5 At the same time that the Treasury Department released the Final Regulations, the IRS also issued Notice 2020-59 which creates a safe harbor allowing taxpayers that manage or operate qualified residential living facilities to be treated as a real property trade or business solely for purposes of qualifying as an electing real property trade or business.
6 For tax years beginning on or after January 1, 2018, Connecticut decouples from IRC Section 163(j) for purposes of calculating Connecticut taxable income for corporate income tax purposes. Conn. Gen. Stat. Section 12-217(a)(6).
7 Iowa HF 2641, signed into law on June 29, 2020, generally decouples from Section 163(j) for tax years beginning on or after January 1, 2020.
8 Ga. Code Ann. Section 48-1-2.
9 Va. Code Ann. Section 58.1-402 (applicable for tax years beginning on and after January 1, 2018).
10 Mich. Comp. Laws Ann. Section 206.607(1).
11 Michigan Department of Treasury, Notice: Corporate Income Tax Treatment of the IRC [Section] 163(j) Business Interest Limitation (issued June 8, 2020). This Michigan guidance was also the first to explicitly address the small business exception under IRC Section 163(j)(e). That exception is based on a measure of gross receipts that is, in turn, determined using complex rules for the aggregation of certain affiliated persons.
12 N.J. Rev. Stat. Section 54:10A-4(k)(2)(K).
13 Pennsylvania Department of Revenue, Corporation Tax Bulletin 2019-03: Pennsylvania Corporate Net Income Tax Treatment of IRC [Section] 163(j) (issued April 29, 2019). This guidance requires that when a taxpayer has interest expense or costs that would be subject to the state's related-party expense disallowance rule, the taxpayer must allocate its federal IRC Section 163(j) limitation on a pro-rata basis to the relevant related and unrelated party amounts. The taxpayer must use a fraction consisting of the post-limitation federal interest expense over total interest expense without regard to the limitation, multiplied by the taxpayer's Pennsylvania "Interest expense or cost" to determine the amount of current year related-party interest potentially subject to addback.
14 Massachusetts Department of Revenue, Technical Information Release TIR 19-17: Application of IRC [Section] 163(j) Interest Expense Limitation to Corporate Taxpayers (issued December 18, 2019). Other aspects of the guidance may lead to a Massachusetts BIE limitation that is different from the federal limitation as a result of related-party transactions. For example, the guidance requires that, the ATI for an entity subject to Massachusetts net income tax is its separately determined current-year federal ATI without federal eliminations for intercompany transactions. Additional rules apply.
15 For example, Mont. Code Ann. Section 15-31-119(8) prohibits, in a corporate merger or consolidation, the surviving or new corporate entity from deducting NOLs sustained by corporations before the merger or consolidation.
16 Pennsylvania Department of Revenue, supra note 13.
17 For example, Wisconsin law authorizes the state's taxing authority to promulgate any rules necessary to create uniformity between the treatment of transactions entered into by members of a federal consolidated group and treatment of transactions entered into by members of a Wisconsin combined group. Wis. Stat. Section 71.255(11). This example demonstrates the impact of differences in federal and state filing methods on the taxable income, generally. Note that Wisconsin decouples from IRC Section 163(j), specifically. Wis. Stat. Section 71.26(2)(b)(12)(c)-(d).
18 Pursuant to Md. Regs. Code 03.04.03.03, corporations included in a consolidated federal return must file separate Maryland returns, and each separate corporation must "report its taxable income without regard to any consolidation for federal income tax purposes."
19 West Virginia, a combined-reporting state, specifically incorporates Treas. Reg. Section 1.1502-13 (concerning intercompany transactions) for certain purposes but provides that such conformity "in no way implies conformity to any other regulation under [IRC Section] 1502." W. Va. Code R. Section 110-24-13d(1)(b).
20 Virginia Department of Taxation, Guidelines Regarding the Business Interest Limitation (effective December 26, 2019). The guidance also provides that the recomputed FTI must be used to determine the amount of BIE deductions allowable for the current year, the amount of BIE deductions to be carried forward to future years, and the amount of BIE deduction carryforwards to be used in such future years.
21 Id. (see Example 2).