In this summary, we cover:
- The tax treatment of business interest expense
- What the business interest expense is pegged to
- How the business interest expense deduction limitation will affect you
- Deductions relating to business interest expense will now be pegged on the Taxable Business Income.
- The deduction of business interest will be limited to the sum of Business Interest Income, 30% of the adjusted taxable income of the business, and Interest from floor plan financing.
- If a business interest deduction is not allowed to a certain partnership, a partner may only be allowed to deduct his or her fair share of interest in future. This will, however, be only against excess taxable income attributed to that specific partner in the said partnership.
- Unused business interest expense may be carried forward by a business; and will be treated as additional interest expense in the years to follow.
- Excess Business Interest can only be carried forward for an unlimited number of years.
December 2017 saw Congress bring to existence a number of reforms in the tax code and this came with its fair share of approval and disapproval from the various sectors. In this article, the focus will be on the Business Interest Deduction and its impact on the tech industry.
One of the much talked about the benefits of the amendment is the lowered corporate tax rate which went down from 35% to the current 21%.
It is anticipated that the lowered tax rate would among other things, allow companies to increase their spending on mergers, research & development, employee benefits, shareholder distributions, and much more.
It is also expected that the major tech firms with offshore investments such as Apple and HP would take advantage of the tax windfall and transfer their investments back home. Well, whether that will happen or not, still remains to be seen.
For now, let’s have a look at the Business Interest Expense and its impact on the tech sector.
Interest Expense is Limited
One of the unfavorable effects the TCJA of 2017 has on tech firms relates to the treatment of Business Interest Expense. The deductibility of corporate interest expense will now be based on Adjusted Taxable Income.
The Interest Expense may be deducted from taxable income but will not exceed 30% of Adjusted Taxable Income.
“Adjustable taxable Income” was initially defined as Income before Interest, Taxes, Depreciation, and Amortization (EBITDA), with a few additional other deductions.
In a nutshell, the deduction of business interest expense will be limited to the sum of;
- Business Interest Income,
- 30% of the adjusted taxable income of the business, and
- Interest from floor plan financing.
Point to note: An amount of Business Interest not eligible for deduction in a given year may be carried forward to be used in the years to come.
This treatment is subject to not only the above limitation but also other applicable interest deduction limitations.
Taxable income essentially means that the taxable income of a given taxpayer has been calculated without considering any item of income, gain, deduction, or loss which is not allocated properly to a specific business or trade and by adding back:
- Any interest income or business interest expense,
- Any amount resulting from net operating loss deduction and for all taxable periods before 1st January 2022, and
- Any allowable deduction for depreciation, depletion, or amortization.
To help you understand how this limitation works, here’s an example of how the Business Interest limitation works.
However, the new interest deductibility limitation does not apply to taxpayers whose annual gross receipts do not exceed $25 million—they will be able to deduct interest expense in full.
When it comes to partnerships, the treatment is a bit different. A business interest that is not allowed to a certain partnership cannot be carried forward by the partnership—rather; it will be allocated to each partner as “excess business interest.” A partner is allowed to deduct his or her fair share of business interest in future.
If a partnership has excess taxable business income for a certain year, a partner is allowed to use his/her fair share of the excess in computing the business interest limitation for use by such a partner in other income sources.
The new limitation on interest deduction may still have a negative impact on tech companies even with a reduced corporate tax rate of 21%. Take, for example, a year with less favorable income. This could result in more taxes for such a business since the deductible interest is tied to the taxable business income. Therefore, this means that periods with lesser incomes could result in increased taxes since the amount of interest to be deducted in that particular year will be reduced due to being contingent in nature.
In addition, investors of flow-through businesses and tech corporations are also likely to be negatively affected if they are to finance those businesses using debt just in case the business doesn’t bring in that much revenue.
For tax periods beginning in 2018 all the way to 2021, the computation of taxable business income of tech firms should be guided by the earnings before interest, tax, depreciation, and amortization (EBITDA). After 2021, the taxable income would then reflect the approximate earnings before interest and tax (EBIT). Subsequently, the taxable income should reduce—leading to a decrease in the maximum amount of deductible business interest expense.
Notable is the fact that the rules surrounding the carried forward interest (in the case of excess business interest) have also been affected by the new tax laws. One such change has to do with the carrying period—this has since been changed to an unlimited number of years.
Generally, the tech sector is doing well in the wake of the changes in the business interest deduction. But still, the techies may need to carefully monitor its long-term impact for a more informed opinion regarding the changes.
It may also be necessary to engage your tax professional for a better understanding of the effect of the business interest deduction on your specific business scenario.