Taxpayers Face Uncertainty on State Treatment of Interest Expense Deduction for Affiliated Groups

With the second filing season underway after the enactment of the 2017 Tax Cuts and Jobs Act (TCJA) many states have yet to provide guidance on how the TCJA’s business interest expense limitation under Sec. 163(j) should be computed by affiliated groups for purposes of their jurisdiction’s income tax. The states that have issued guidance have adopted varied approaches. As a result, uncertainties exist with respect to how states will apply the Sec. 163(j) limitation to taxpayers filing a federal consolidated return. It is also unclear how the Sec. 163(j) limitation will interact with state provisions that disallow deductions for interest expense incurred to a related party. Another question relates to the states’ conformity to the temporary changes to the Sec. 163(j) limitation for the 2019 and 2020 tax years under the federal Coronavirus Aid, Relief, and Economic Security (CARES) Act. This article will describe the approaches currently adopted in New Jersey, Pennsylvania, Tennessee and Massachusetts and highlight the state tax issues for which taxpayers should exercise an abundance of caution.

Signed into law as part of the TCJA, the amended provisions of Sec. 163(j) limit the amount of business interest expense a taxpayer may deduct in a tax year. The limitation applies to taxpayers having average annual gross receipts of more than $25 million based on aggregation principles. The annual business interest expense limitation imposed by Sec. 163(j) is the total of three discrete items including: 1) the business interest income of the taxpayer during the taxable year; 2) 30% of the adjusted taxable income (ATI) of the taxpayer during the taxable year; and 3) any floor plan financing interest of the taxpayer for the taxable year. Any business interest expense in excess of the limitation may not be deducted in the current taxable year but may be carried forward to future years.

Overview of Issues

Subsequent to the enactment of amended Sec. 163(j), practitioners have raised numerous questions regarding the measurement of the Sec. 163(j) limitation for state corporate income tax purposes. State legislatures and administrative authorities have been slow to provide guidance, which has created some uncertainty. This uncertainty is most pronounced for taxpayers filing federal consolidated returns who are subject to different filing methods and rules for state purposes. Questions commonly raised relate to issues such as the:

• measurement of the Sec. 163(j) limitation in separate filing states when a taxpayer is included in a federal consolidated filing;
• measurement of the Sec. 163(j) limitation in unitary combined filing states for taxpayers included in federal consolidated filings that consist of a different filing group;
• interaction between the Sec. 163(j) limitation and existing state rules that disallow deductions for interest expense incurred to a related party; and
• application of the temporary changes to the Sec. 163(j) limitation for the 2019 and 2020 tax years under the federal CARES Act.

During 2018, Internal Revenue Service (IRS) issued proposed regulations addressing the Sec. 163(j) limitation which assist in addressing some of these state issues. In pertinent part, the proposed regulations provide that all entities included in a federal consolidated group are treated as a single taxpayer for purposes of calculating the limitation which is instructive for state unitary combined filing purposes. Additionally, the proposed regulations include a mechanism for allocating the federal consolidated business interest expense deduction (after the Sec. 163(j) limitation) to the individual members of the federal consolidated filing group which may be of assistance in measuring the limitation for separate filing state purposes.

As discussed below, several states conforming to the amended version of Sec. 163(j) have addressed these issues through administrative action and have provided a variety of calculation methodologies including reliance on the concepts addressed in IRS’s proposed regulations.

State Treatment of Section 163(j)

1. New Jersey

On April 12, 2019, the New Jersey Division of Taxation issued TB-87, addressing the state’s treatment of the Sec. 163(j) limitation for New Jersey Corporation Business Tax (CBT) purposes. Beginning with the 2019 tax year, the state has adopted mandatory unitary combined reporting and TB-87 provides guidance for measuring the Sec. 163(j) limitation for both separate and combined CBT returns.

For taxpayers filing a separate company CBT return that were included in a federal consolidated filing group, TB-87 provides that the state’s interest expense deduction is calculated using the allocation mechanism identified in IRS’s proposed regulations. Thus, despite separate-company filing realities, TB-87 suggests that a separate-company limitation should be measured based on the taxpayer’s portion of the allowable federal consolidated deduction (after applying the Sec. 163(j) limitation) instead of using a true separate entity measurement of the limitation.

It should be noted that this interpretation of TB-87 indicates that interest paid to a member of the federal consolidated group would not be deductible in a New Jersey separate-company filing because such amounts are eliminated in measuring the federal consolidated interest expense deduction that is the basis for measuring the allowable New Jersey deduction. An alternative and more reasonable interpretation of TB-87 might suggest that the state only intends to apply Sec. 163(j) to the interest actually limited in federal consolidation. Interest paid between members of a federal consolidated group is not subject to Sec. 163(j) because such amounts are eliminated and thus not considered in measuring the federal limitation. As such, where TB-87 suggests conformity to the federal consolidated Sec. 163(j) limitation, it could be inferred that the guidance is only intended to apply to interest paid by the federal consolidated group that was limited on the federal return. Absent further instruction, this is an area of uncertainty impacting separate company filing taxpayers. The uncertainty is mitigated for taxpayers subject to New Jersey’s unitary combined filing mandate effective for the 2019 tax year, which will result in the elimination of the intercompany transactions at issue.

New Jersey also has adopted related-party interest expense disallowance rules which in certain situations operate to disallow deductions for interest paid to affiliated entities. TB-87 provides guidance for situations where a taxpayer’s interest expense deduction is subject to limitation by Sec. 163(j) and the state’s related-party interest expense disallowance rule. Specifically, TB-87 indicates that the Sec. 163(j) limitation must be allocated on a pro-rata basis between expenses paid to related parties and third parties before evaluating the impact of the related-party interest expense disallowance rule. This instruction clarifies that related-party interest deductions already limited by Sec. 163(j) are not subject to further disallowance by the related-party rules.

2. Pennsylvania

On April 29, 2019, Pennsylvania issued CTB 2019-03 providing instruction for measuring the Sec. 163(j) limitation for Pennsylvania corporate net income tax purposes. Pennsylvania implements a mandatory separate company filing method and CTB 2019-03 provides clarifying guidance for measuring the limitation when a taxpayer is included in a federal consolidated return.

The guidance in CTB 2019-03 suggests that taxpayers included in a federal consolidated filing group will not be required to apply a Sec. 163(j) interest expense limitation unless a limitation was applied at the federal consolidated level. Where a taxpayer’s federal consolidated group is subject to limitation, CTB 2019-03 indicates that the Sec. 163(j) limitation should be measured on a separate company basis. Based on this contrasting guidance, Pennsylvania’s rules operate such that the Sec. 163(j) limitation is only applied when a federal consolidated group is subject to limitation but also requires a separate company measurement of the limitation when such a limitation exists.

Pennsylvania has adopted related-party interest expense disallowance rules and CTB 2019-03 addresses the associated interaction with the Sec. 163(j) limitation. To the extent a taxpayer has both a Sec. 163(j) limitation and related-party interest subject to disallowance, the state requires taxpayers to allocate the Sec. 163(j) limitation on a pro-rata basis between related-party interest and third-party interest for purposes of calculating the amount of interest subject to the related-party rule. In other words, Pennsylvania’s rules require application of the Sec. 163(j) limitation before evaluating the impact of the related-party interest expense disallowance rules. Thus, the state’s rules clarify that related-party interest deductions already limited by Sec. 163(j) are not subject to further disallowance by the related-party rules.

3. Tennessee

On August 1, 2019, Tennessee issued Notice No. 19-18, providing the state’s method for measuring the Sec. 163(j) limitation on a separate company Tennessee return. The notice indicates that taxpayers who are members of a federal consolidated group should allocate the federal consolidated group's allowed business interest expense deduction among the group members who had business interest expense during the tax year. The allocation is made based on the ratio of each member's interest expense to the total interest expense paid by all members. In determining a member's allocation ratio, related-party interest expenses paid to other members of the federal consolidated group are excluded.

In addition to the business interest expense amount allocated to each member as described above, the notice indicates that taxpayers may deduct the interest expenses paid to other members of the federal consolidated group, without regard to the Sec. 163(j) limitation. This accommodation results in a unique approach to measuring allowable interest expense given that it exempts intercompany interest payments from the Sec. 163(j) limitation.

4. Massachusetts

On December 18, 2019, Massachusetts finalized TIR 19-17, providing guidance on the state’s treatment of Sec. 163(j) for Massachusetts corporation excise tax purposes. The guidance includes robust instruction for measuring allowable business interest expense in a Massachusetts unitary combined corporate excise tax return.

The guidance in TIR 19-17 indicates that each member of a combined filing group must calculate its business interest expense and Sec. 163(j) limitation on a separate company basis, eliminating transactions between members of the combined group. To the extent that a member’s separate company Massachusetts’ Sec. 163(j) limitation exceeds its business interest expense, the deduction will be allowed without limitation. To the extent a member’s separate company Massachusetts’ business interest expense exceeds its limitation, the excess business interest expense may be shared with another member of the combined group to the extent the other member has unused business interest expense limitation. Business interest expense that exceeds an entity’s limitation and cannot be shared with another member of the combined group may be carried forward.

Massachusetts has adopted related-party interest expense disallowance rules, which are also addressed by TIR 19-17. For purposes of applying the related-party rules, the state requires an adjustment (i.e., addition modification) to total interest expense on a pre-apportioned basis before applying the Sec. 163(j) limitation. A taxpayer’s allowable interest expense deduction is subsequently measured by applying the steps discussed above. Any amount of interest expense that is disallowed due to the Massachusetts addback may not be deducted in the current year and may not be carried forward.

Disallowed Interest Carryforward

For federal purposes, interest expense that is limited by operation of Sec. 163(j) may be carried forward indefinitely and deducted in future tax years. States conforming to these rules will also allow the carryover deduction. However, the carryover for state purposes may be quite different than the federally allowable amount.

For example, separate filing states that allow the deduction of interest paid to members of a federal consolidated group will potentially have carryover amounts that include such intercompany interest payments. In contrast, intercompany payments between members of the federal consolidated group are eliminated and thus not reflected in the federal carryover. As a result, state and federal carryovers may be much different and should be documented and tracked separately.

Additional complexities may arise in states where related-party interest expense disallowance rules also compel taxpayers to allocate the Sec. 163(j) limitation between related and third-party interest expense. Pennsylvania, for example, allocates the Sec. 163(j) limitation between related-party and third-party interest expense on a pro-rata basis. The state’s rules further indicate that related-party interest limited by Sec. 163(j) is then carried over to future years and subject to disallowance in such future years. Given this requirement, it is essential that taxpayers document the amount of their Pennsylvania carryovers with respect to related and third-party expense composition so that the state’s related-party interest expense disallowance rule can be appropriately evaluated in future years.

In states that do not provide guidance similar to Pennsylvania’s, there is uncertainty regarding the amount of carryover interest that may be deducted in a future year. Pennsylvania’s rule clarifies that the amount of the carryover associated with related-party interest is measured using the ratio of related-party to third-party interest expense that existed in the year the expense was incurred. In the absence of this instruction, one could conclude that the ratio of related-party to third-party interest expense existing in the carryover year should be used to determine the amount of the carryover associated with related-party interest. Taxpayers with state interest expense carryovers should evaluate this issue carefully when measuring the allowable carryover deduction.

Temporary Changes Under the CARES Act

On March 27, 2020, the federal CARES Act was signed into law in response to the global COVID-19 pandemic. The Act contains a number of significant tax provisions, including temporary modifications to the business interest expense limitations provided in Sec. 163(j). Specifically, for taxable years beginning in 2019 and 2020, the Sec. 163(j) limitation has been increased from 30% of ATI to 50% of ATI. Furthermore, for any taxable year other than a short taxable year beginning in 2020, taxpayers may elect to calculate the Sec. 163(j) limitation using the taxpayer’s 2019 ATI, rather than 2020 ATI.

The state impact of the CARES Act will be contingent on the state’s method of conformity to the Internal Revenue Code (Code) and whether the state has specifically decoupled from the Sec. 163(j) limitation. For the states decoupling from the provisions of Sec. 163(j), the temporary amendments under the CARES Act will be of no consequence and the amount of business interest expense limited on the federal return will be deductible. A similar outcome exists in any state possessing a fixed conformity date that precedes the adoption of the TCJA.

In the remaining states, the impact of the amendments will be predicated on how and when the state conforms to the Code. States conforming to the Code on a rolling basis will generally adopt the temporary amendments to Sec. 163(j) under the CARES Act without modification. Similarly, states with a fixed Code conformity date may also adopt the amendments if the conformity date encompasses changes to the Code occurring during 2020.

In contrast, the amendments made by the CARES Act are not operative in states possessing a fixed Code. conformity date that follows the enactment of the TCJA but precedes enactment of the CARES Act. For those states, the 30% limitation will still be operative and any interest expense deduction taken on the federal return in excess of the 30% limitation must be added to federal taxable income when calculating state taxable income. As of this writing, the following states must continue to rely on the former 30% limitation set forth in the version of Sec. 163(j) amended by the TCJA: Arizona, Hawaii, Idaho, Iowa, Kentucky, Maine, Michigan, Minnesota, New York, North Carolina, Vermont, and Virginia.

The Takeaway

Many states have yet to provide legislative or administrative guidance on the calculation of the Sec. 163(j) limitation for state corporate income tax purposes. Moreover, the states providing guidance have not adopted a uniform approach. The absence of guidance causes issues in separate-filing states as well as combined-filing states where filing groups differ for state and federal purposes. In these situations, taxpayers should exercise caution when calculating the Sec. 163(j) limitation and related-party interest expense adjustments, if applicable. Furthermore, the adoption of the federal CARES Act in response to the COVID-19 pandemic requires additional analysis with respect to state income tax filings. Andersen will continue to monitor state guidance on the issue and will provide updates when available.