In late July, the Internal Revenue Service (IRS) issued final regulations on Internal Revenue Code (IRC) Section 163(j) that limits the deductibility of business interest expense. The Tax Cuts and Jobs Act, enacted in December 2017, had limited the deductibility of business interest expense to, generally, 30% of “adjusted taxable income” (ATI), making it, in essence, a tax-based on EBITDA. This provision was quite detrimental to private equity-owned and other highly leveraged businesses, including capital-intensive manufacturers.
Proposed regulations to IRC 163(j), issued by the Treasury in late 2018, contained a provision that did not permit taxpayers to add back depreciation subject to capitalization under the IRC Section 263A (UNICAP) rules to their calculation of ATI. This was particularly impactful to manufacturers and producers whose depreciation expense is largely related to machinery and equipment used in the production process, and the depreciation thereon generally subject to capitalization under IRC Section 263A.
Additionally, the proposed regs defined business interest to include financing commitment fees and debt issuance costs, which are typically amortized. As such, these expenses that were fully deductible prior to 2018 also became subject to the 30% of ATI limitation. It became quite common to see significant amounts of business interest expense deductions disallowed on taxpayers’ returns for tax year 2018 and 2019 (at least those filed in the first half of 2020).
The final 163(j) regulations issued in July provide relief in these two areas, which is welcome news for producers and private equity-owned companies. The final regs provide that all depreciation and amortization is added back in determining ATI, which should allow for additional business interest expense deductions. Separately, the final regulations also remove commitment fees and debt issuance costs from the definition of business interest, which will allow for greater tax deductions for these expenses (similar to pre-2018). These provisions can be retroactive to January 1, 2018, so there may be opportunity to amend 2018 and 2019 returns to take advantage of the changes.
Manufacturers and private equity-owned companies should also be mindful of changes to the deductibility of business interest expense under the CARES Act, which temporarily increased the deductibility to 50% of ATI for tax years 2019 and 2020 (with exceptions to the rules for partnerships). Additionally, for 2020, taxpayers may elect to use their 2019 ATI in determining their 2020 business interest expense limitation, which will likely be beneficial to many companies whose business operations are reduced in 2020 as result of the COVID-19 pandemic.
Please consult your Schneider Downs tax advisor if you have any questions.
