The Tax Cut and Jobs Act of 2017 made a plethora of changes to the Internal Revenue Code, (1) some of which dramatically shifted how the United States taxes business entities and income. While much discussion has focused on the so-called "repatriation tax" on profits of foreign subsidiaries of U.S. companies, certain new exemptions and deductions for foreign-derived profits, and various changes to the taxation of individual taxpayers, not nearly as much discussion has focused on the changes in [section]163(j) of the code affecting the deductibility of interest expenses by businesses. Nevertheless, lawyers representing businesses, particularly transactional lawyers, should be cognizant that new rules on the deductibility of business interest can affect a whole host of clients. This article provides the non-tax lawyer some of the highlights (or low-lights, as the case may be) of new [section]163(j).
For decades, businesses and tax lawyers have found significant advantages to using debt in the capital structure of a business alongside equity. From a business perspective, the owners of a business may prefer (in certain circumstances) debt to common or preferred equity because the business owners may give up less of the control of the business or its future profits to the debt holders. For some businesses, debt (and, correspondingly, payment of interest) can be an essential part of the business model. For example, debt is integral to many operators of real estate businesses and private equity firms because financing is used to acquire new assets or improve existing assets. Likewise, many new businesses (including non-private equity businesses) use a leverage strategy as a way to fuel business growth. Further, interest expense paid on debt, unlike preferred or common dividends, are deductible for a business. Thus, the economic cost of the interest expense payments is mitigated by the tax deductibility of such payments.
Practitioners quickly discovered that they could play a sort of "arbitrage" when advising the U.S. business seeking foreign investment or the foreign investor looking to invest in the U.S. In some circumstances, investments could be structured using a combination of debt and equity. If structured properly, interest on the debt would be deductible for U.S. tax purposes for the business but would not be subject to tax in the U.S. to the investor. If the investor's home jurisdiction does not tax the interest, the investor has effectively "stripped" the earnings (that is, profits) from the U.S. business without having to pay any tax at all on the earnings to the extent of such interest payments. In response to these types of transactions, Congress enacted [section]163(j), which targeted interest paid on loans made to U.S. businesses by foreign related-party lenders. However, old [section]163(j) applied only to corporations and still provided opportunities for a taxpayer to calibrate its debt to strip significant earnings out of the U.S. or avoid the application of [section]163(j) altogether. In response to these issues, Congress completely rewrote [section]163(j). These revisions, as discussed below, will affect significantly a wide swath of taxpayers--not just taxpayers trying to "strip" earnings out of the U.S. without paying tax on such earnings. In particular, these revisions could have significant negative tax effects on businesses that have made the business judgment to use debt from unrelated lenders to advance their business agenda.
The first change Congress made was to apply [section]163(j) to all taxpayers, not just corporations. Under the old law, inbound investors could invest in the U.S. through a partnership structure. If there were no corporations in the ownership structure, the [section]163(j) limitations would not apply. If the ultimate beneficial owners were resident in a treaty-favorable jurisdiction, the taxpayers could remove significant earnings from the U.S. with no U.S. tax using a highly leveraged, flow-through investment structure. In contrast, new [section]163(j) now applies to all taxpayers regardless of form: corporations, partnerships, sole proprietorships, and subchapter S corporations. (2)
Further, the limitations imposed by the previous version of [section]163(j) only applied to a corporation's disqualified interest if 1) the corporation's ratio of debt to equity exceeded 1.5 to 1 and; 2) the corporation's net interest expense exceeded 50 percent of the corporation's adjusted taxable income. (3) Disqualified interest was interest paid to a related party when the related party was not subject to U.S. income tax on the interest or paid to an unrelated party but a related party guaranteed the debt and no gross basis tax is imposed on such interest. (4) If all interest was owed to unrelated lenders, old [section]163(j) imposed no limitation on such interest's deductibility. (5) Now, the provision disallows any interest expense incurred by the taxpayer if the interest expense exceeds the sum of 1) business interest income; 2) 30 percent of the taxpayer's adjusted taxable income; and 3) the floor...