Cap on interest deductions explained
The Internal Revenue Service filled in detail in July in 860 pages of new regulations about how the cap works on the interest expense that a company can deduct each year.
The cap has the potential to make borrowing more expensive.
It was part of tax reforms that the US adopted at the end of December 2017. The cap has been temporarily increased for 2019 and 2020 as an economic relief measure in response to COVID-19. (See "Coronavirus: Economic Relief Measures for Companies" in the April 2020 NewsWire.)
Interest on debt cannot be deducted to the extent a company's net interest expense exceeds 30% of its adjusted taxable income. The cap is 50% for tax years starting in 2019 and 2020, unless the company is a partnership, in which case the higher cap applies only in 2020.
A company's income for this purpose means income ignoring interest expense, interest income, NOLs and — only through 2021 — depreciation, amortization and depletion. Thus, the limit on interest deductions is less likely to come into play through 2021 than after (when the cap will be the cap percentage of a smaller number).
There was uncertainty about whether power companies can add back depreciation through 2021 to income for calculating the cap. The IRS said in 2018 that depreciation that is treated as a cost of producing "inventory" is not added back to income. The IRS takes the position that electricity is inventory.
However, the IRS backtracked in July. It is now allowing power companies and other manufacturers to add back depreciation and amortization.
A company can use its 2019 income tax to calculate its cap in 2020. Congress worried that companies will have to borrow to ride out COVID-19 while the economic lockdowns leave them with less income.
The limit is on net interest expense. Interest expense is first netted against any interest income for the year. The cap limits the deduction of what remains.
Any interest that cannot be deducted in a year can be carried forward indefinitely.
The limit on interest deductions does not apply to any business with average gross receipts of $25 million or less.
It does not apply to regulated public utilities. It is elective for real estate businesses.
Congress estimated that 95% of businesses will not be affected through 2021.
The limit is calculated at the partnership level where a project is owned by a partnership. Any interest that cannot be deducted by the partnership because of the limit is allocated to the partners and held by the partners for use solely to offset any future "excess" income they are allocated by the partnership.
There is no transition relief for existing debt. Interest on debt that was already in place when the cap was enacted in late 2017 is subject to the cap just like interest payments on new debt.
The IRS issued final regulations in July 2020 to implement the cap.
It proposed in 2018 to define interest payments that are subject to the cap more broadly than some in the market expected, but then narrowed the definition in July 2020.
Commitment fees on loans are considered interest for this purpose to the extent the financing is actually provided.
Debt issuance costs are not interest.
"Guaranteed payments" that a partnership makes to partners for use of capital are not considered interest, unless they are economically equivalent to interest. A guaranteed payment is an amount the partnership is required to pay a partner for use of capital the partner contributed or for services regardless of whether the partnership has income to cover the payment. The partnership deducts such payments, unlike normal cash distributions where there is no deduction at the partnership level. The IRS regulations include an example where a partnership is considering borrowing from a bank, but decides to have one of the partners make a capital contribution instead in exchange for guaranteed payments. In this case, the payments are treated as interest. They are interest if they are incurred for the use of funds for a "period of time" and are "substantially incurred in consideration of the time value of money."
Some tax counsel have speculated that preferred cash distributions to a tax equity partner could fall into this category, but the preferred cash distributions would have to be a debt by the partnership to the partner rather than simply a first use of cash to the extent there is cash to make the payment.
A fee paid by a US subsidiary to its foreign parent company to guarantee repayment of a bank loan to the subsidiary is subject to the cap as interest.
Prepaid rent in a sale-leaseback transaction is considered a loan by the lessee to the lessor that is worked off over the lease term. The imputed interest on such a loan may not be deductible by the lessor unless there is room within its cap.
Many projects in the project finance market are owned by partnerships.
The cap is applied at the partnership level.
The partnership calculates its income or loss for the year. The income or loss is allocated to the partners. In the process, the partnership must determine its cap on the amount of interest expense it can deduct. It determines that by first calculating its "adjusted taxable income" or what the IRS calls "ATI."
Its ATI is its taxable income calculated normally and then adjusted by backing out interest expense, interest income, NOLs and — only through 2021 — depreciation, amortization and depletion.
The cap on interest the partnership can deduct is 30% of ATI (50% in 2020) plus any interest income the partnership earned during the year.
To the extent there is room within the cap to deduct all the interest the partnership incurred during a year, then interest deductions at the partnership level are simply reflected in the shares of partnership net income that are allocated to each partner.
If the partnership had room within its cap to deduct more interest, then the extra room is called "excess taxable income."
If the partnership does not have room within its cap to deduct all the interest it incurred, then the interest it could not deduct is called "excess interest expense."
The partnership must report to each partner at the end of each year the partner's share of ATI at the partnership level, the gross interest expense and gross interest income at the partnership level, and any excess taxable income (unused cap) or excess interest expense (interest that the partnership could not deduct because of the cap).
The calculations then move to the partner level.
First, each partner adjusts its "outside basis" in its partnership interest by its share of the ATI at the partnership level minus the gross partnership-level interest expense that it is allocated. For example, if its share of partnership ATI is $50 and its share of partnership-level interest expense is $20, then its outside basis goes up by $30, even if the partnership has a cap that allows only $15 of the $20 in interest expense to be deducted when calculating partnership income.
Next, each partner must determine whether it can use any excess interest expense (interest that could not be deducted by the partnership due to the partnership-level cap).
It must jump through three hoops to do so.
First, it must not have run out of outside basis. If the partner has run out of outside basis, then use of the excess interest deduction is suspended.
"Outside basis" is a way of tracking what each partner put into the partnership and is allowed to take out. It is one of two metrics for doing this. (The other is called a "capital account.") A partner cannot deduct losses allocated to it by a partnership once it has run out of outside basis. Use of the losses is suspended until the partner has more outside basis. Two things give it more outside basis: being allocated income in the future by the partnership or making a capital contribution to the partnership.
Second, even if the partner has enough outside basis to use the excess interest expense allocated to it by the partnership, it must wait until it is allocated excess taxable income against which to use the excess interest expense. Basically, it can only deduct the extra interest as the partnership allocates it unused partnership-level cap in a future year.
Third, the partner must do its own cap calculation to determine whether there is room within its own cap to deduct the amount. The partner does this by calculating its own adjusted taxable income or ATI, but in so doing it ignores everything allocated to it by the partnership other than any allocation of "excess taxable income" (unused cap at the partnership level). For example, a partnership with $200 in ATI can deduct up to $60 in net interest expense (30% x $200). Suppose it is has only $30 in interest expense. It will have used only half of its cap for the year. The unused half of the cap translates into $100 in ATI. The $100 is "excess taxable income."
If a partner sells its entire partnership interest before it is able to deduct the excess interest deductions it was allocated by the partnership, then the un-deducted amount is added back to its outside basis immediately before the sale. This reduces its gain on sale.
Utilities and Real Estate
The regulated utilities made a trade with Congress. They gave up the ability to write off the full cost of new and used assets put in service during the year — called a 100% "depreciation bonus" — in exchange for being freed from the cap on interest deductions.
The trade applies to the extent a company is engaged in the business of furnishing electricity, water, sewage services, local gas or steam distribution or pipeline transportation of gas or steam where the rates at which these services are provided are established or approved by a federal, state or local government agency. The rates do not have to be set on a cost-of-service or rate-of-return basis. The IRS said rates are considered "established or approved" for this purpose by a company whose electricity is sold at negotiated rates if the company must file a "schedule of such rates with a regulatory body that has the power to approve, disapprove, alter the rates, or substitute a rate determined in an alternate manner."
Electric cooperatives are treated as regulated utilities for this purpose if their rates must be reviewed by "the governing or ratemaking body of an electric cooperative."
Real estate businesses can take the same trade. They do so by filing an election with the IRS.
Groups of corporations that join in filing a consolidated federal income tax return are treated as a single company.
This creates complications. Many utilities have a utility holding company that joins in filing a consolidated return with a regulated utility subsidiary. The group usually also has other companies engaged in non-regulated businesses.
Interest deductions are capped to the extent the interest relates to the non-regulated business. This requires calculation of the ATI of the non-regulated businesses and a determination on which side of the company the interest expense resides.
The IRS regulations treat money as fungible. Therefore, interest expense anywhere in the consolidated group must be allocated between the regulated and non-regulated parts of the group in the same ratio as the assets owned by each part. The group looks at its adjusted bases in the assets. The IRS felt this would be easier for companies to track than using the relative fair market values of the assets.
Depreciation for adjusting asset bases in equipment is calculated under the old depreciation rules immediately before MACRS depreciation was enacted in 1986. The original cost basis is used for land, buildings and other "inherently permanent structures" like gas pipelines or electric transmission lines, wind towers, and steel uprights and underground wires at utility-scale solar facilities. The basis is not reduced as buildings and other "inherently permanent structures" are depreciated.
Assets are ignored until they are placed in service. Thus, no interest is allocated to projects while they are still under construction.
The only interest expense that does not have to be allocated across all assets is interest on "qualified" nonrecourse debt. This is debt, in theory, that was borrowed on a nonrecourse basis secured solely by particular assets. It is not considered fungible. However, it is hard for most nonrecourse debt to qualify in practice.
All other deductions are allocated to the part of the business to which they are directly related. An example is property taxes.
Intercompany transactions between members of a consolidated group are ignored. Stock in a subsidiary that is also part of the consolidated group is not counted as an asset when allocating interest expense between the regulated and non-regulated parts of the group by asset basis.
If 90% or more of the company's tax basis in assets in a year is in either the regulated or non-regulated part of the business, then the company can treat all the interest that year as tied to the 90%-or-more side of the business.
The IRS said in a revenue procedure in 2018 that public-private partnerships undertaking certain kinds of infrastructure projects can opt out of the interest cap.
Any such project opting out will be treated like a real estate business, which also has the option to opt out. Depreciation on any project that has opted out would have to be taken on a straight-line basis over a longer "class life" for the type of assets rather than the normal depreciation period. However, this would be required anyway to the extent the project is financed with tax-exempt bonds.
The project would have to jump through several hoops to qualify to opt out.
First, it would have to be a type of project that can be financed by issuing tax-exempt private activity bonds. Examples are hydroelectric power plants, power plants whose electricity remains within a two-county area or one city and one county, local district heating and cooling facilities, airports, roads, ports and high-speed intercity rail lines.
Second, the private company undertaking the project would have to have a contract with a government with a term longer than five years that requires it to build, manage or operate and maintain the project. The project must be made available for use by the general public.
Third, the assets must be owned by a government or, if they are privately owned, they cannot be used in a regulated utility business whose rates are regulated by a body like a state public utility commission or the Federal Energy Regulatory Commission on a cost-or-service or rate-of-return basis. However, the rates charged the general public for use of the assets must be subject to regulatory or contractual control by a government or to government approval.
The conditions for opting out are in Rev. Proc. 2018-59.