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  • US Tax Cuts and Jobs Act – New Rules on Interest Deductions

    By Daniel Adams / 24 August 2018 / Comments

    One of the changes to US Federal corporate income tax legislation contained in Law H.R.1, informally known as the Tax Cuts and Jobs Act (TCJA), is the new provision to limit an entity’s ability to deduct interest expenses.  In this blog we discuss this change and whether it might impact P3 projects.  This follows on from our blog on the impact of other provisions contained in the TCJA on P3 projects.

    Will the new limitation impact P3 projects?

    The new interest limitation rules contain an exemption for taxpayers that qualify and elect to be treated as a “real property trade or business”.  The term “real property trade or business” is defined as “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business”.

    Based on the activities undertaken during the construction, operation and maintenance phases of typical US P3 projects, a number of them could qualify as a “real property trade or business”.  As a result, the new interest deductibility rules might not be applicable to these types of P3 projects.  However, given that the rules are still relatively new, it is not clear whether all P3 projects will qualify for this exemption.  It is therefore advisable to be aware of these new rules and make sure that they do not apply on a case by case basis.

    In the remainder of this blog we explain the rules and discuss how Operis can help.

    What are the new limitations?

    The TCJA limits the amount of net interest expense that entities can deduct to 30% of ‘income’. Income for tax years beginning after 31 December 2017 and before 1 January 2022 is defined as Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA) and as Earnings Before Interest and Tax (EBIT) for tax years beginning after 31 December 2021.

    There is no grandfathering of pre-existing debt so the rule applies to all interest paid on or after 1 January 2018.  Businesses with average annual gross receipts of $25 million or less for the preceding 3 year period will not be subject to these restrictions.

    A potential cliff edge

    The timing of the change from EBITDA to EBIT is likely to create a ‘cliff edge’ in 2022.  This is because for periods up until 31 December 2021, the amount of tax depreciation does not impact on the total deductible interest because EBITDA is used.  However, in 2022, an immediate deduction for capital expenditure is allowed and this write-off will be taken into account in arriving at EBIT.  Therefore, the immediate deduction for capital expenditure could significantly reduce interest deductible in this year.

    Under MACRS, tax allowances are obtained over a number of years.  Assuming that a corporation continues to incur depreciable expenditure during the tax year, the change to EBIT will decrease income and therefore the maximum amount of interest expenses that can be deducted for tax purposes.  The impact is partly offset by tax depreciation being lower from 1 January 2023 (as less than 100% of costs will be deductible each year).  As a result, the difference between EBIT and EBITDA will start to decrease after 31 December 2022.

    How do the rules relate to partnerships?

    It should be noted that for partnership debt, the 30% cap applies at entity level.  Any net business interest in excess of the cap is not deductible but can be carried forward and deducted in succeeding years to the extent that the partner is allocated “excess taxable income” above the 30% cap in a later year from the same partnership that generated the disallowed interest deduction.

    However, the new rules prevent a partner (or shareholder in an S corporation) from double counting a partnership’s (or S corporation’s) adjusted taxable income when determining the partner’s (or shareholder’s) business interest limitation.

    Example 1

    A partnership is owned equally by a corporation and individual:

    Income US$ 3 million
    Interest Allowable

    (US$ 3 million x 30%)

    US$ 900,000
    Actual interest expense US$ 900,000
    Non-deductible interest

    (US$ 900,000 – US$ 900,000)

    US$ 0
    Excess interest capacity US$ 0
    Income after interest deduction US$ 2.1 million
    Share of income to each partner US$ 1.05 million
    Additional deduction for corporate partner

    (US$ 1.05 million x 30%)

    US$ 315,000
    Total corporate partner interest deduction

    (50% x US$ 900,000 + US$ 315,000)

    US$ 765,000

    This $765,000 of deductible interest is significantly higher than the intended 30% limitation.  If the corporation were another passthrough entity, additional deductions might be available to the partners (or members) of this entity.

    A double counting rule prevents this by providing that the corporation has adjusted taxable income computed excluding the share of income from the partnership.  The corporation therefore has adjusted taxable income (assuming no other sources of income) of $0.  The corporation’s deduction for business interest is limited to $0 (30% of $0).

    Example 2

    Same partnership as Example 1 but interest expense is US$ 600,000:

    Income US$ 3 million
    Interest Allowable

    (US$ 3 million x 30%)

    US$ 900,000
    Actual interest expense US$ 600,000
    Non-deductible interest

    (actual interest expense is lower than interest allowable)

    US$ 0
    Excess interest capacity US$ 300,000
    Excess taxable income of partnership

    (US$ 300,000/US$ 900,000 x US$ 3 million)

    US$ 1 million
    Share of excess income to each partner US$ 500,000
    Additional deduction for corporate partner

    (US$ 500,000 x 30% + US$0 x 30%)

    US$ 150,000
    Total corporate partner interest deduction

    (50% x US$ 600,000 + US$ 150,000)

    US$ 450,000

    This interest deduction of US$ 450,000 is equal to the corporation’s share of 30% of the partnership’s maximum interest deduction (50% x 30% x $3 million).

    In addition, while all interest earned and paid by a corporation is likely to be treated as business interest under the 30% cap, partnerships carrying on a trade or business that also have investment assets will be required to appropriately allocate interest to their trade or business.  This may provide planning opportunities for such partnerships.  If a partnership is a pure investment partnership with no trade or business, none of its deductions would be subject to the 30% cap on business interest at the partnership level.

    Other points

    1. What are interest expenses
    The 30% cap generally does not apply to non-interest expenses, including embedded interest in derivative instruments or contracts (unless such instruments or contracts are treated in whole or in part as debt, or integrated with debt, for US federal income tax purposes), even if such expenses may represent financing costs and/or time value of money akin to interest.  For example, leasing or rental expenses as well as periodic payments made under certain swaps, non-equity forward contracts, or other derivative instruments, properly characterised as non-debt for tax purposes will continue to be deductible.

    2. Interaction with other tax rules
    A taxpayer would be allowed to reduce taxable income in future years first by the amount of carried over disallowed interest, subject to the 30% cap for that year, before applying the 80% of taxable income limitation on the use of Net Operating Losses (NOLs).

    The repeal of Alternative Minimum Tax (AMT) along with an immediate deduction for qualifying expenditure and lowering of the tax rate (discussed in more detail in our blog on the impact of changes contained in the TCJA on P3 projects) should lead to tax being lower in the early years of projects but these effects will be partly offset by the interest deduction limitation.

    The amount of Interest incurred on loans taken out to fund construction costs is highest but EBITDA is typically lowest at the start of projects.  Therefore, 30% of EBITDA is more likely to be lower than the interest expense in early years than towards the end of the project and this could lead to interest incurred being added back in the corporate income tax computation.

    3. Interaction with US GAAP
    Under US GAAP, disallowed net interest expense would generally be treated as a timing issue and give rise to a deferred tax asset.

    4. Interaction with existing interest deductibility rules
    These limitations on net interest deductibility replace the existing ‘earnings stripping’ limitations.

    Conclusion

    Whilst the new interest deductibility rules might not impact on P3 projects if they qualify as a “real property trade or business”, financial modelling enables the likely impact of the new interest deductibility rules to be analysed where they do apply.

    Operis can look at a number of potential funding options such as a combination of Private Activity Bonds, TIFIA loans and other loans and evaluate how these rules might impact on the amount and timing of interest deductibility on different sources of finance.  We can also review how different forecast income, depreciation and amortisation profiles influence interest deductibility given the change in the definition of income due to occur in 2022.

    If you have any questions regarding the above or would like to speak to someone at Operis about potential issues relating to the impact of the interest deductibility provisions within the TCJA, please don’t hesitate to get in touch.

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