Summary
The Pennsylvania Department of Revenue issued guidance addressing the treatment of the Internal Revenue Code (IRC) Section 163(j) business interest expense limitation for corporation net income tax purposes. The guidance also addresses how Pennsylvania, a separate return jurisdiction, will apply the limitation when a Pennsylvania corporation incurs unrelated party and related party interest expense.
Details
As part of federal tax reform, the tax reform bill known as the Tax Cuts and Jobs Act amended IRC Section 163(j) to change the business interest expense deduction limitation effective for tax years beginning after December 31, 2017. For federal purposes, business interest expense that exceeds the sum of 30 percent of a taxpayer’s “adjusted taxable income” (ATI), business interest income, and the taxpayer’s floor plan financing interest expense is nondeductible in the year of payment or incurrence. The nondeductible amount of business interest expense is treated as “excess interest” that may be carried forward indefinitely and re-enters the limitation calculation for the ensuing tax year(s). The ATI limitation is determined at the filer level (i.e., federal consolidated group, partnership, S corporation, etc.). Certain businesses, including real estate businesses and taxpayers with average annual gross receipts not exceeding $25 million for the three immediate tax years are not subject to IRC Section 163(j).
The Internal Revenue Service issued proposed regulations on November 28, 2018. The proposed regulations provide general rules and definitions, including determination of the ATI limitation for affiliated groups filing federal consolidated returns.
Pennsylvania Corporation Tax Bulletin 2019-03
On April 29, 2019, the Pennsylvania Department of Revenue issued Corporation Tax Bulletin 2019-03 to address the Pennsylvania Corporation Net Income Tax (CNIT) treatment of the IRC Section 163(j) limitations. Pennsylvania requires corporations to file separate returns, regardless of whether they are members of a federal affiliated group that files a federal consolidated return. When a Pennsylvania corporate taxpayer is a member of a federal affiliated group filing a federal consolidated return, it must determine its CNIT starting point as “if separate returns had been made to the Federal Government for the current and prior taxable years . . .” Therefore, taxpayers will need to calculate a Section 163(j) limitation on a separate entity basis if they are members of a federal affiliated group filing a federal consolidated return for CNIT purposes. In addition, the taxpayer will separately apply the federal exceptions to the limitation, including, for example, whether the taxpayer meets the $25 million gross receipts threshold (without elimination of related party receipts) on a separate entity basis.
Further, under the federal proposed IRC Section 163(j) regulations, intercompany items of interest income and expense offset for a federal consolidated return and these items are not included for purposes of calculating the federal consolidated ATI limitation. However, as a separate return jurisdiction, the bulletin points out that Pennsylvania will not follow this treatment. Likewise, the federal consolidated group interest expense and interest income allocation methods will not be followed for CNIT purposes. “Therefore, taxpayers will need to continue to include intercompany and third-party interest in their [separate entity] calculation of interest expense under Code Section 163 generally as well as when calculating the limitation imposed by Code Section 163(j) for purposes of their separate company Federal taxable income.” This will result in a different separate entity Section 163(j) limitation and excess interest carryover amount for CNIT purposes compared to the federal consolidated Section 163(j) limitation and federal excess interest carryover amount.
Pennsylvania also imposes a related party interest expense add-back statute. When a corporate taxpayer has incurred both unrelated and related party interest expense, the bulletin advises taxpayers to allocate the Section 163(j) limitation, as calculated on a separate entity basis, pro-rata between the two types of interest expense. The allocation is done based on a fraction, consisting of business interest expense after application of the limitation over total business interest expense, multiplied by the related party business interest expense. The result is the amount of related party business interest expense subject to the Pennsylvania add-back statute.
For excess interest carryover purposes, corporate taxpayers will be required to track not only their Pennsylvania separate entity excess interest carryover amount, but also the breakout of that amount between unrelated party interest expense and related party interest expense that will be subject to the add-back statute in the ensuing tax year. The bulletin provides examples illustrating application of the pro-rata calculation for the year the related party business interest expense is incurred and for the year(s) to which excess related party business interest expense is carried.
The bulletin also addresses how Pennsylvania corporate taxpayers should apply the Section 163(j) limitation for CNIT purposes when it is associated with nonbusiness income, and CNIT treatment for partnerships with corporate partners (generally following the federal provisions for partnerships, the Section 163(j) limitation and excess interest carryover).
Lastly, the bulletin also discusses the Pennsylvania personal income tax treatment of the Section 163(j) limitation. In short, Section 163 is inapplicable for Pennsylvania personal income tax purposes, and interest expense is fully deductible if it constitutes an ordinary and necessary business expense. However, the bulletin fails to address the personal income tax treatment when a Pennsylvania resident is a partner or an S corporation shareholder. While the Bulletin indicates that the Department will follow the Section 163(j) limitation calculations for partnerships and excess interest carryover treatment and “intends to follow that result for CNIT purposes” (with respect to corporate partners), the Bulletin does not state a similar intent for personal income tax purposes.
Insights
- While several states have either conformed with or decoupled from Section 163(j), Pennsylvania and New Jersey are the only states to issue substantive guidance on how the limitation will apply to unique state corporate income tax regimes.
- The Department of Revenue also indicated that it anticipates issuing further CNIT guidance with respect to Section 163(j) in the future.
- Taxpayers affected by Corporation Tax Bulletin 2019-03 should consult with their financial statement auditor and tax advisor to evaluate and determine the potential financial statement implications under ASC 740, including the impact on current and
- deferred taxes, uncertain tax benefits, and disclosures.
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