The Tax Reduction and Employment Act has changed the taxation of businesses and international activities once per generation, including a significant broadening of the tax base and a reduction in the corporate tax rate from 35% to 21%. (1)
As part of the compromise for a lower business rate, Congress changed Section 163 (j) of the Internal Revenue Code to limit business interest expense so that taxpayers are generally not allowed to deduct net business interest of more than 30% of the adjusted taxable income. (2) Interest deductions that are not permitted by this restriction can be carried forward for an indefinite period of time for future years. (3)
Adjusted taxable income is determined by adding deductions for non-business income, net business interest, net operating losses, qualified business income, and, for tax years beginning before 2022, depreciation and depreciation and impoverishment, to taxable income. (4)
Congress intended this definition of Adjusted Taxable Income as the tax code for the accounting concept of earnings before interest, taxes, depreciation and EBITDA.
For tax years beginning after 2021, however, taxpayers are not allowed to add write-downs to taxable income for the purpose of calculating adjusted taxable income – and thus approximate the balance sheet concept of earnings before interest and taxes or EBIT.
EBIT versus EBITDA
EBIT and EBITDA are both common measures of a company's performance, but they approach different methods and this has important implications for designing an effective interest cap. Investors tend to use EBIT to measure a company's operating income on an accrual basis, while they use EBITDA to measure cash flow.
Given these two options, banks and their regulators generally compare a borrower's debt to their EBITDA to determine the risk of a loan. Similarly, credit agencies use EBITDA to assess a company's probability of default and thus determine the company's creditworthiness.
In terms of tax policy, international norms also favor EBITDA over EBIT. In 2015, the Organization for Economic Co-operation and Development published its report "Limiting Ground Erosion with Interest Deductions and Other Financial Payments" on Action 4 of its Ground Erosion and Profit Shifting Project (BEPS), and in 2016 the OECD updated this report. (5)
As a template for national governments to introduce interest rate caps, the OECD recommended using EBITDA to measure overfunding. (6) According to the OECD:
EBITDA is currently the most commonly used measure of results for countries with results-based tests. By excluding the two main non-cash costs in a typical income statement (depreciation on property, plant and equipment and depreciation on intangible assets), EBITDA is a guide to a company's ability to meet its interest obligations. It is also a measure of earnings, often used by lenders to help decide how much interest expense a business can reasonably afford. (7)
After BEPS Action 4, the national governments have largely adopted EBITDA as the tax law standard for debt ratios. For example, 26 of the 27 European OECD member countries had introduced interest rate restrictions from 2020. (8th)
Of these, four are based solely on the leverage ratio and not on EBIT or EBITDA. The other 22 countries all use EBITDA, with 19 countries applying a 30% limit and three countries applying a 25% limit. No EBIT was used until 2020.
Congress enacted the corporate interest rate cap because of concerns "that the general deductibility of interest payments on debt could result in companies exerting more leverage than they would without the tax system." (9)
With both the financial crisis and the OECD's BEPS project fresh in the minds of lawmakers, Congress saw excessive leverage in tax legislation. Enter IRC Section 163 (j) – The attempt by Congress to improve the playing field between debt financing and equity financing once a certain leverage threshold is reached. (10)
The move from EBITDA to EBIT four years after the general entry into force of the TCJA represents a compromise between the US House of Representatives and the US Senate versions of the TCJA.
While both the House and Senate passed similar versions of a business interest limitation, the House passed bill passed EBITDA as a permanent definition of adjusted taxable income (11), while the Senate passed EBIT. The conference committee made compromises by applying EBITDA for four years and EBIT thereafter.
EBIT discourages investment
But what if Congress designs Section 163 (j) to marginally discourage additional equity-backed capital investments that do not increase leverage at all?
And what if Congress inadvertently endorsed capital investments in other countries versus the US? Wouldn't that go against the core purpose of Section 163 (j) and the TCJA?
Keep in mind that a company evaluating a new investment opportunity at or above the 30% limit would lose interest deductions from EBIT even if the investment was made entirely with equity financing. Why? Because although the net interest expense in the numerator of the ratio remains unchanged, the investment generates depreciation, which equates to the adjusted taxable income – i.e. H. The denominator – decrease.
By reducing the denominator, the overall quota is increased and additional interest expenses are not allowed, whereby the new depreciation deductions generated by the investment are partially offset by lost interest deductions.
Using EBIT to calculate adjusted taxable income therefore has the same effect as calling for slower depreciation schedules for taxpayers above the 30% threshold, even for investments that are entirely equity-funded. Continuing to use EBITDA as the definition of adjusted taxable income avoids these perverse, negative effects on equity financed capital investments.
For example, suppose the taxpayer has net interest expense of $ 300 and adjusted taxable income of $ 1,000. The limit under Section 163 (j) is 30% of Adjusted Taxable Income, or $ 300. Thus, the taxpayer can initially fully deduct the interest without inadmissibility.
The taxpayer then elects to make an equity investment of $ 400 that is (1) eligible for 100% bonus write-off under IRC Section 168 (k) and (b) funded entirely by equity – i.e. H. Without additional outside financing.
Scenario 1: Adjusted taxable income = EBITDA (before 2022)
|Net interest expense||=||300 dollars|
|Depreciation allowance||=||400 dollars|
|Adjusted taxable income||=||$ 1,000|
|Interest limit according to § 163 (j)||=||$ 300 (30% x $ 1,000)|
|Interest not allowed||=||$ 0|
Using EBITDA, the adjusted taxable income is calculated by ignoring depreciation. So the $ 1,000 is not reduced by the $ 400 depreciation allowance, the taxpayer's leverage does not exceed 30%, and the interest remains fully deductible.
Scenario 2: EBIT (after 2021)
|Net interest expense||=||300 dollars|
|Depreciation allowance||=||400 dollars|
|Adjusted taxable income||=||$ 600 ($ 1,000 to $ 400)|
|Interest limit||=||$ 180 (30% x $ 600)|
|Interest not allowed||=||$ 120|
Using EBIT, the taxpayer reduces adjusted taxable income from $ 1,000 to $ 600 by making a capital investment of $ 400 and a bonus depreciation allowance of $ 400, resulting in a disallowed interest deduction of $ 120.
In fact, the taxpayer only gets a net deduction of $ 280 for an investment of $ 400 – the economic equivalent of reducing the 100% bonus amortization deduction to 70%.
This is true even if the investment was funded entirely from equity, which makes this rule a tax hike for investments rather than a tax hike for overfunding.
In fact, this result could be worse than just replacing 100% bonus depreciation with 70% bonus depreciation. This is because if the bonus write-off was 70%, the taxpayer would write off the remaining 30% – or $ 120 – on an adjusted basis using IRC Section 168's modified accelerated cost recovery system, which still provides some form of accelerated write-off.
In the example above, the $ 120 unapproved interest will be suspended for up to a year in which the taxpayer falls below the 30% limit. From that point on, the taxpayer can deduct interest carryforwards until his total business interest deduction reaches 30% of adjusted taxable income.
Therefore, the $ 120 interest carryforward could take much longer to recover than the base of $ 120 amortized under the modified accelerated recovery system – and possibly never if the taxpayer crossed the 30% threshold. permanently exceeds.
Currently, at least two dozen tax rules will expire after December 31, including the use of Section 163 (j) EBITDA. (12)
Of particular importance for metropolitan areas suffering from a crisis in affordable housing, a temporary increase in the state tax credit for low-income residential property by 12.5% will expire at the end of 2021. (13)
Additionally, Congress could enact a temporary tax policy during 2021 to respond to ongoing pandemic and economic recovery needs, which expire at the end of the year.
As Congress is considering which of these expiring tax regulations should extend beyond 2021, it should cut the "DA" in EBITDA by making the current definition of adjusted taxable income permanent and allowing taxpayers to apply depreciation, amortization and exhaustion deductions Ignore the calculation of adjusted taxable income.
Inaction, which would make EBIT come into effect, would turn a rule that Congress was trying to discourage excessive debt into one that instead discourages debt-free investment – especially when compared to the EBITDA-based interest rate restrictions passed by our main competitors . That would be a perverse result indeed.
George Callas is the executive director of government affairs, public order and tax groups at Steptoe & Johnson LLP. He is a regular contributor to the Tax Authority Law360.
Disclosure: The author was previously the senior tax advisor to former Speaker of Parliament Paul Ryan and was a senior negotiator to the House Republican staff on the Tax Cut and Employment Act discussed above.
The opinions expressed are those of the authors and do not necessarily reflect the views of the company, its clients, or Portfolio Media Inc. or any of its or their respective affiliates. This article is for general informational purposes and is not intended and should not be viewed as legal advice.
(1) Pub. L. No. 115-97 .
(2) IRC §163 (j) (1) . In 2020, Congress passed a temporary regulation under the Coronavirus Aid, Relief and Economic Security (CARES) Act This increased the 30% limit for tax years from 2019 and 2020 to 50%. See pub. L. No. 116-136, § 2306 . That hike isn't currently in effect for 2021, but Congress should also consider extending the 50% limit for another year as economic conditions – including higher corporate debt and lower incomes – keep pushing more companies to do so the restriction under Section 163 (j) than otherwise would be the case.
(3) IRC §163 (j) (2) .
(4) IRC §163 (j) (8) .
(5) See "Limiting Ground Erosion through Interest Deductions and Other Financial Payments, Action 4 – 2016 Update", OECD / G20 Project on Ground Erosion and Profit Shifting, OECD, at https://www.oecd-ilibrary.org/docserver/ 9789264268333 -de.pdf? Expires = 1612211514 & id = id & accname = guest & checksum = 77727A5A9AB12C209A4537C3C06D2C13.
(6) Id. At 49, para. 82.
(7) Id. At 48, Para. 78. When recommending EBITDA, the OECD also considered EBIT as best practice if some countries decided that they prefer EBIT.
(8) "Thin-Cap-Rules in Europa", Tax Foundation, to be found at https://taxfoundation.org/thin-capitalization-rules-thin-cap-rules-europe-2020/.
(9) H. Rep. No. 115-409. at 247.
(10) As noted above, this excludes other EBITDA-based federal cross-agency guidance on leveraged lending issued by the Federal Reserve Board, the Federal Deposit Insurance Corporation, and the Office of the Currency Auditor.
(11) Id. § 3301.
(12) See "List of Expiring Federal Tax Regulations, 2021-2029", JCX-1-21 (January 27, 2021), to be found at https://www.jct.gov/CMSPages/GetFile.aspx?guid=21679d86 – 7613-4865-8030-9accef7f7d91. There are only 23 provisions in this list, as it eliminates the need to switch from research spending to a five-year amortization for spending after December 31st.
(13) IRC § 42 (h) (3) (I) .
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