The CARES Act’s Changes to Section 163(j): Partnership, International, and US State Tax Implications

The US Congress enacted The Coronavirus Aid, Relief, and Economic Security Act (the CARES Act) on March 27, 2020. This article describes the changes to the section 163(j) business interest expense limitation as a result of the CARES Act and the impact these changes may have on taxpayers generally, as well as on partnerships and international transactions. This article also discusses the state tax impacts of this change to federal tax law.

Section 163(j)

Section 163(j), in its current form, was enacted as part of the Tax Cuts and Jobs Act of 2017 (the TCJA). Section 163(j) imposes a limit on the deductibility of business interest expense equal to the sum of (i) business interest income, (ii) 30% of “adjusted taxable income” (ATI), and (iii) “floor plan financing interest.” For taxable years beginning before 2022, ATI essentially is equal to a taxpayer’s earnings before interest, taxes, depreciation, amortization and depletion (EBITDA). For later taxable years, depreciation, amortization and depletion will reduce ATI. Business interest expense that is limited under section 163(j) is carried forward to future years by treating it as paid or incurred in the following taxable year.

For partnerships and their partners, the rules are more complicated. First, the section 163(j) limitation is calculated at the partnership level, and not the partner level.

Partnerships with fully deductible business interest expense then allocate both that business interest expense and any “excess taxable income” (ETI) (i.e., partnership ATI that was not needed to offset partnership business interest expense in the section 163(j) calculation) among their partners. Allocated ETI can be used by the partners as ATI in their partner-level 163(j) calculations, while allocated business interest expense is automatically deductible.

Partnerships with business interest expense that is limited under section 163(j) allocate both the allowed interest expense and the disallowed interest expense, known as “excess business interest expense” (EBIE), among their partners. EBIE doesn’t immediately become part of a partner-level section 163(j) calculation. Instead, partners treat EBIE as paid or incurred in future years, but only to the extent that such partners are later allocated ETI from the same partnership. If a partnership never has ETI to allocate to its partners, the partners would never be able to deduct the EBIE previously allocated to them, but the amount of such EBIE would be added back to their partnership interest basis, reducing gain (or increasing loss, as the case may be) on the eventual disposition of their entire partnership interest.

Amendments to Section 163(j): In General

The CARES Act amended section 163(j) to allow taxpayers to deduct more business interest expense for any taxable year that begins in either 2019 or 2020. This will help prevent the Internal Revenue Code from penalizing taxpayers that are now incurring unusually large amounts of debt to weather the current economic storm, and it will help with taxpayers’ cash flow to the extent it (i) reduces current estimated tax payment obligations or (ii) allows taxpayers to carry back net operating losses (NOLs), thanks to the CARES Act permitting NOLs generated in 2018, 2019 or 2020 to be carried back up to five years, and to make refund claims. The ability to potentially increase an NOL through a higher interest deduction in 2019 or 2020 is particularly helpful given that the NOL could be carried back to a pre-TCJA year (where the tax rate was 35%, rather than the current 21%).

For taxpayers generally, the CARES Act increases the 30% ATI limitation to 50% of ATI for taxable years beginning in both 2019 and 2020. Taxpayers can elect to keep the limitation at 30% of ATI for a taxable year, but would need consent to revoke such an election for the taxable year, once made.

Section 163(j) was also amended to give taxpayers the option to use ATI for the last taxable year beginning in 2019 instead of ATI for 2020 in their 2020 section 163(j) calculations. Where short taxable years beginning in 2020 are involved, this option includes provisions for prorating the ATI in the last taxable year beginning in 2019 based on the number of months in the short 2020 year. Because, for many taxpayers, 2019 ATI will be larger than 2020 ATI, this option will generally result in more interest being deductible in 2020 and thus will generally be beneficial to taxpayers.

Amendments to Section 163(j): Special Partnership Rules

For partnerships, the CARES Act increases the ATI limitation to 50% only for taxable years beginning in 2020. For partnership taxable years beginning in 2019, the ATI limitation remains at 30%. However, half of a partnership’s EBIE allocated to a partner for a 2019 taxable year can automatically be treated as deductible interest expense in the partner’s first taxable year beginning in 2020. The other half of the EBIE allocated to the partner is treated as it normally would be. Partners can elect out of treating half of 2019 EBIE as automatically deductible in 2020. On the other hand, partnerships, rather than their partners, are entitled to elect out of the increase in the ATI limitation for 2020.

Whether a partner will be better off or worse off as a result of this special rule for partnerships will depend on the facts and circumstances. For example, suppose a partnership with pro rata allocations and a calendar taxable year has $100 million of ATI in each of 2019 and 2020 (or has less ATI in 2020, but elects to substitute 2019 ATI for 2020 ATI) and no business interest income or floor plan financing interest in each year.

• Case 1 ($40 million of business interest expense each year). For 2019, $30 million of business interest expense is immediately deductible by the partners and the remaining $10 million is EBIE, $5 million of which is automatically deductible by the partners in 2020. The other $5 million is treated by the partners as paid and incurred in a future year, to the extent the partners are allocated ETI from the partnership. For 2020, all $40 million of business interest expense is immediately deductible by the partners, and the partnership has $20 million of ETI (because only $80 million of ATI was needed to support the $40 million of deductible business interest expense). Here, the ETI is large enough that all $5 million of 2019 EBIE (that wasn’t automatically deductible) is treated as paid or incurred in 2020, and the $20 million of ETI is more than sufficient for all $5 million to be deductible in 2020 (assuming the partners don’t have negative ATI in 2020 that is unrelated to their interests in the partnership).In Case 1, all $80 million of business interest expense is deductible, as it would be if partnerships were allowed to use the same amended section 163(j) rules as other taxpayers, but $10 million of 2019 interest expense is deferred to 2020.
• Case 2 ($50 million of business interest expense each year). For 2019, $30 million of business interest expense is immediately deductible by the partners and the remaining $20 million is EBIE, $10 million of which is automatically deductible by the partners in 2020. The other $10 million is treated by the partners as paid and incurred in a future year, to the extent the partners are allocated ETI from the partnership. For 2020, all $50 million of business interest expense is immediately deductible by the partners, and the partnership has $0 of ETI (because all $100 million of ATI was needed to support the $50 million of deductible business interest expense). Therefore, $10 million of EBIE would be deferred past 2020.In Case 2, $10 million of 2019 interest expense is deferred to 2020 and $10 million of 2019 interest expense is deferred past 2020, whereas another type of taxpayer would have been able to deduct all $50 million of interest expense in each of 2019 and 2020.
• Case 3 ($80 million of business interest expense each year). For 2019, $30 million of business interest expense is immediately deductible by the partners and the remaining $50 million is EBIE, $25 million of which is automatically deductible by the partners in 2020. The other $25 million is treated by the partners as paid and incurred in a future year, to the extent the partners are allocated ETI from the partnership. For 2020, only $50 million of business interest expense is immediately deductible by the partners, and the partnership has $30 million of EBIE (and $0 of ETI).In Case 3, the partners would have $55 million of total EBIE, which would be deferred past 2020, $30 million of deductible interest in 2019 and $75 million of deductible interest in 2020, whereas another type of taxpayer would have been able to deduct $50 million of interest expense in each of 2019 and 2020. As with the other cases, the partners still have backloaded interest deductions, but here the total amount deductible is $5 million more than it would have been for another type of taxpayer.

As seen in the examples above, the partnership-specific rules often operate to defer some 2019 interest deductions to 2020, but that will not always be the case for partners that have different taxable years than the partnership. For example, for partners with a calendar taxable year and partnerships with a fiscal year, items from the partnership’s last taxable year beginning in 2019 are reported on the partners’ 2020 tax returns under normal partnership tax rules. For those partners, the amended section 163(j) rule allowing 50% of the partners’ shares of EBIE to be deductible in the partners’ first taxable year beginning in 2020 will result in such interest being deductible on the partners’ same 2020 returns, and such deductions will not be deferred any further.

Partnerships, like other taxpayers, have the option to use ATI for the last taxable year beginning in 2019 instead of ATI for 2020 in their partnership-level 2020 section 163(j) calculations. This election is made by the partnership and affects all its partners. The election will affect both the amount of allowable business interest deductions in 2020 and the amount of any 2020 ETI or EBIE allocated to the partners. The partners would then have the ability to make, or decline to make, this election with respect to their ATI arising from activities outside of the partnership.

Amendments to Section 163(j): International Tax Impact

The ability to use the pre-CARES Act section 163(j) rules (i.e., elect out of the increase in the ATI limitation or not elect to use 2019 ATI for the 2020 year) could be very helpful in the context of the base erosion and anti-abuse tax of section 59A (the BEAT). For example, taxpayers who could become subject to the BEAT by reason of the higher interest deductions may want to apply the pre-CARES Act section 163(j) ATI limitation (and thus carry forward disallowed interest expense indefinitely), rather than permanently waive deductions to get under the applicable BEAT threshold. Taxpayer who are currently subject to the BEAT may make the same choice in order to avoid paying additional BEAT tax on the increased interest deductions.

In addition, if the increased interest deduction results in an NOL (or an increased NOL), the interaction of the NOL rules with the new international tax provisions of the TCJA should be considered. For instance, if a calendar year taxpayer has an NOL in 2020 that is carried back to 2015, and the taxpayer did not have sufficient income to absorb the loss in 2015 through 2017 (taking into account a section 965(n) election that is deemed made for the 2017 year under the NOL carryback rules), the NOL could be carried back to 2018 (a post-TCJA year). The NOL could increase BEAT liability in post-TCJA years. In addition, in analyzing the impact of the NOL in post-TCJA years, a 21% NOL would in effect be “lost” to the extent that it offsets income that would otherwise be subject to an effective tax rate lower than 21%. For instance, the effective tax rate on income under the FDII or the GILTI regimes could be significantly lower than 21% and yet the NOL could unfortunately be “used up” in offsetting such income.

Amendments to Section 163(j): State Tax Impact

From a state corporate income tax perspective, the states that conform to section 163(j) should allow the increased expense allowance in the CARES Act but only if the state law has rolling conformity to the Internal Revenue Code. In static conformity states (i.e., states that conform to the Internal Revenue Code in effect on a specific date), the CARES Act amendments would not flow-through to the state unless the state updates its conformity to the Internal Revenue Code and applies such updated conformity retroactively to 2019. This presents a significant issue in static conformity states that conform to section 163(j). In such states, not only will taxpayers not get the benefit of the increased interest expense allowance unless such states update their laws for 2019 and 2020, but such nonconformity will cause even more of a compliance burden at the state level.

The issue is best illustrated with an example. Virginia is a static conformity state that conforms to the Internal Revenue Code as in effect on December 31, 2019. Virginia conforms to section 163(j) but also allows a state deduction equal to 20% of the amount disallowed at the federal level under section 163(j) (see Va. Code Ann. § 58.1-402(G)). Guidance issued by the Virginia Department of Taxation provides that in administering the section 163(j) limitation, the limitation must be recomputed based on the separate entity Virginia filer or based on the group that files a combined return (which is called a “consolidated return”) in Virginia. So, assuming Virginia does not update its conformity, the taxpayer would have to re-compute the federal limitation using the 30% limitation to determine the 20% expense allowance that Virginia will allow. The taxpayer would then also have to re-compute the state limitation on a separate entity or Virginia filing group basis. Of course, the process will be complicated even further if the taxpayer elects to compute the federal section 163(j) limitation in 2020 based on 2019 ATI. Thankfully, Virginia updates its Internal Revenue Code conformity regularly, but in order to give taxpayers full relief on this issue the legislature would have to update its conformity to the Internal Revenue Code effective retroactively to 2019.

While the section 163(j) amendments in the CARES Act do provide some relief for taxpayers at the federal and possibly the state level, they also result in more compliance difficulties at the state level. As a result of the CARES Act, multistate taxpayers may have to compute their section 163(j) limitations in several ways:

1. The section 163(j) limitation as it applied under the Internal Revenue Code before the CARES Act amendments for states that do not conform to the Internal Revenue Code as amended by the CARES Act
2. Re-computation of the former section 163(j) limitation based on the state taxpayer or filing group in states that do not conform to the Internal Revenue Code as amended by the CARES Act
3. The section 163(j) limitation as amended by the CARES Act and reported for federal purposes in states that conform to the Internal Revenue Code as amended by the CARES Act
4. Re-computation of the current section 163(j) limitation based on the state taxpayer or filing group in states that conform to the Internal Revenue Code, as amended by the CARES Act.

On top of that, carryforwards of disallowed interest expense amounts must be tracked on a state by state basis as well.