The IRS’s proposed regulations (REG-106089-18
) on the new limit on interest deductions under Section 163(j) would not allow taxpayers to add back depreciation capitalized under the uniform capitalization (UNICAP) rules in Section 263A in the calculation of adjusted taxable income, potentially subjecting more manufacturers to the interest limit.
The Tax Cuts and Jobs Act amended Section 163(j) to cap a taxpayer’s deduction for net business interest expense in excess of interest income at 30% of adjusted taxable income (ATI). ATI is currently calculated by taking taxable income and adding back deductions for depreciation, amortization and depletion, and making several other adjustments (See our Tax Flash on Section 163(j) for more information
The proposed regulations under Section 163(j) provide that any depreciation that is capitalized under the UNICAP rules is not considered depreciation for the calculation of ATI. Therefore, such depreciation cannot be added back to taxable income for purposes of determining ATI. This is true whether the capitalized amount remains in ending inventory or has been expensed through cost of goods sold.
UNICAP generally requires manufacturers to capitalize to inventory significant amounts of depreciation relating to their investments in equipment and facilities. These amounts are capitalized to inventory and reduce taxable income through cost of goods sold. The inability to increase ATI by adding back depreciation amounts that are capitalized to inventory will depress ATI and lower the threshold at which the interest deduction limit applies.
If finalized in their current form, the proposed regulations could subject more manufacturers to the limit on interest deductions, particularly those that debt-financed investments in equipment. Manufacturers should assess the potential impact under the current version of the proposed regulations. Automatic accounting method changes may be available to reduce the amount of depreciation that is capitalized to inventory under Section 263A, particularly for those manufacturers using a simplified production method to allocate additional Section 263A costs and book/tax differences such as bonus depreciation. However, caution should be exercised in requesting these changes, as adjustments to the company’s UNICAP methods may adversely impact other areas.
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