A strategy to raise a business's interest limitation.

AuthorVandenberg, Neal

In the law known as the Tax Cuts and Jobs Act (TCJA), (1) enacted in 2017, Sec. 163(j) was significantly amended by placing limits on the deductibility of business interest for all taxpayers except certain exempt trades or businesses. (2) The businesses most affected by the new limitation on deducting interest were highly leveraged entities and those with low profit margins. Companies that in previous years have narrowly avoided this interest deductibility limitation should be aware that the limitation is more restrictive for tax years starting after 2021. As suggested below, one way to help reduce the negative impacts of Sec. 163(j) is through strategic adoption of FASB Accounting Standards Codification (ASC) Topic 606, Revenue From Contracts With Customers.

TCJA and the interest expense deduction

First, some background may be helpful. Prior to the passage of the TCJA, Sec. 163(j) had rules in place intended to prevent multinational entities from using interest expense as a method of shifting earnings to lower-income-tax jurisdictions and avoiding U.S. taxation. This original guidance only limited interest expense paid to certain entities and only under specific conditions. As a result, most U.S.-based taxpayers were able to deduct the entire amount of ordinary interest expense to calculate their taxable income.

With the TCJA's amendment to Sec. 163(j), a business's deduction for interest is now limited to the sum of:

  1. Business interest income;

  2. 30% of the adjusted taxable income (50% for 2019 and 2020, per the CARES Act); (3) and

  3. Floor plan financing interest--specific financing related to the acquisition of inventory.

    Recently the limitation became even more restrictive. The calculation for adjusted taxable income previously had reflected earnings before interest, taxes, depreciation, and amortization (EBITDA). However, for tax years starting after 2021, Sec. 163(j)(8)(A)(v) revises this calculation to reflect earnings before interest and taxes (EBIT)--thus disallowing the addback of depreciation and amortization. This change in calculation will broaden the net of the interest expense limitation, likely affecting many entities that had narrowly escaped the limitation in earlier years.

    Any interest expense beyond the amount of the interest limitation is not deductible in the current year but can be carried forward indefinitely to offset future taxable income. However, because the value of disallowed carryforward interest will be included as interest expense of the future year, it will still be subject to the same interest expense deductibility rules. While the idea of carrying forward this excess expense sounds beneficial, the tax benefit is unlikely to be realized for many of the companies operating in industries affected by this provision. One potential financial statement impact of this limitation is a write-down of deferred tax assets.

    For instance, in its 2017 10-K, Horizon Pharma PLC showed a year-end debt-to-equity ratio of 3:2 and disclosed that the new interest deductibility rules resulted in a write-down of its deferred tax assets of $59.2 million, accounting for 0.6% of 2017 revenues and translating into a loss of $0.36 per share. While this was a one-time write-down of assets, companies with significant debt financing, such as Horizon Pharma PLC, cannot easily change their capital structure or operating environment, so they may be struggling with this limitation on deductibility of interest for years to come.

    Through strategic use of the new revenue recognition standards, however, affected entities may be able to mitigate some of the negative impact of Sec. 163(j)'s interest deduction limitation.

    Topic 606 and interest income

    Businesses can adopt a strategy based on the Topic 606 standards to help reduce the negative effects of the business interest limitation. The strategy discussed here involves reclassifying certain revenue as business interest income. Business interest income, as noted above, is included in the interest limitation calculation at 100%, while traditional revenues flow into adjusted taxable income, which is counted in the interest limitation calculation at only 30%. As a result of the reclassification, therefore, a company increases the deductible amount of interest expense by up to 70 cents for each dollar recognized as interest income instead of traditional revenues.

    Understanding this reclassification strategy for raising the interest deduction ceiling requires first taking several steps back. In May 2014, FASB issued Accounting Standards Update No. 2014-09, Revenue From Contracts With Customers (Topic 606). This guidance provides a framework for companies across various industries to recognize revenues on a more consistent basis. Within this framework, entities are required to identify the transaction price and various performance obligations, then allocate the transaction price across the identified performance obligations. (4)

    Importantly for the reclassification strategy under consideration here, a significant portion of business-to-business transactions involves trade receivables and payables and can be considered a form of financing provided to the buyer by the seller. (5) According to Topic 606, the entity should present the effect of financing separately from revenues derived...

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