The Tax Cuts and Jobs Act (“TCJA”), also known as U.S. Tax Reform, brought on many changes to the U.S. tax landscape, perhaps none further reaching than the changes to interest expense deductibility. Prior to 2018, Internal Revenue Code (“IRC”) Section 163(j) applied to interest paid or accrued by a U.S. corporation to a related party and disqualified some or all of the deduction if two thresholds were met – an excessive debt-to-equity ratio and excessive interest expense compared to adjusted taxable income (“ATI”).
In the post-TCJA tax world, IRC Section 163(j) is a larger catch-all. All taxpayers are now subject to this interest expense provision that, generally speaking, limits the deduction of business interest expense to the sum of business interest income plus 30% of ATI. The calculation for ATI is now akin to tax adjusted EBITDA (note: after 2021, the formula will change to simply tax EBIT). In response to the COVID-19 pandemic, the Coronavirus Aid, Relief and Economic Security (“CARES”) Act raised the limitation temporarily to 50% instead of 30%.
Final Regulations Under IRC Section 163(j)
Last year and earlier this year, final regulations were issued under IRC Section 163(j) that added clarity to the mechanics of the calculation and covered issues like:
- The add-back of depreciation and amortization deductions that were capitalized under the inventory cost capitalization rules of IRC Section 263A
- The subtraction of recaptured depreciation and amortization deductions when tangible and intangible assets are sold
- The treatment of certain types of equity capitalization transactions as debt transactions
- The treatment of business interest expense attributed through a tiered partnership structure
- The limitation of carryforward business interest expense when there is a change of ownership
- Self-charged interest remedy when a partner lends money to a partnership
Certain regulations remain in proposed form including the rules related to the application of IRC Section 163(j) to foreign persons with income effectively connected with a U.S. trade or business (“ECI”). Among other provisions, the proposed regulation states that a foreign person’s business interest expense, business interest income and ATI is only measured using ECI items. For foreign persons who are allocated ECI from a partnership, the proposed regulation defines how the foreign partner’s distributable shares of IRC Section 163(j) items are determined. The proposed rule also sets out to keep the calculation of branch profits tax unaffected by any impacts of IRC Section 163(j).
Why The Calculation of Branch Profits is Important
Why is this important? When a foreign investor enters the U.S. market, whether via a U.S. branch, an interest in a U.S. partnership, or by organizing a legal entity subsidiary, there is a decision to be made about how to fund those operations – debt or equity? There is an inclination to choose debt in order to take advantage of an interest expense deduction. However, in addition to IRC Section 163(j), there are more considerations spread throughout the IRC that make the decision to choose debt a bit less clear-cut. Here are a few more:
- Since U.S. Tax Reform was enacted, the U.S. is no longer the high tax jurisdiction it once was when compared to the rest of the world after the corporate tax rate was cut from 35% to 21%. Therefore, pushing expenses into the U.S. while shifting [interest] income to another jurisdiction may not always create a favorable result. When debt is in fact pushed down, transfer pricing principles should be considered to ensure proper arms-length rates are used.
- Before IRC Section 163(j) is considered, there are other provisions that come first in the ordering rules that could affect how much interest is potentially deductible. For example, certain provisions can permanently disallow interest expense. Notably, rules and regulations under IRC Section 267 can disallow interest expense accrued to a foreign related party unless those amounts were actually paid. After the provisions that disallow interest expense, a foreign corporation that does business directly in the U.S. through a branch or via an interest in a partnership must apportion its interest expense based on the complex set of rules under IRC Section 882. The takeaway is that debt pushed down to a foreign person’s U.S. business may not get a deduction of interest expense at full face value of the note.
- The aforementioned provision of IRC Section 267 that requires foreign related party interest expense to be deducted on the cash method brings with it additional complexities. When cash interest payments are made to a foreign person, the U.S. by statute levies a 30% withholding tax against such payments. While that withholding tax can be reduced or even eliminated under an applicable income tax treaty, the global landscape has shifted over the years to require corporations to have a substantive presence in a jurisdiction in order to qualify for treaty benefits.
While there are pitfalls related to debt-funded U.S. operations, there are also opportunities. A U.S. corporation may, in lieu of a cash distribution, issue a dividend payable to its shareholder(s). This payable effectively creates debt in the U.S. subsidiary and allows for an interest deduction. There are provisions to disallow this treatment and recast it as equity under IRC Section 385, but there are exceptions to the rule that still allow for this type of transaction. The interest expense is still subject to the limitation rules discussed above, but it is nevertheless a method to create a deduction out of an equity transaction.
Debt vs. Equity Funding of U.S. Operations
To summarize, the TCJA has added a level of complexity to the debate of debt vs. equity funding of U.S. operations. While debt is not necessarily an antiquated strategy, the ability to deduct interest expense is subject to various rules, regulations, and limitations that a foreign investor should consider before making that important decision. With the recent change in the political regime in the U.S., we patiently await what new rules we will have to consider in the future.