T +1 212 542 9960
T +1 732 516 7637
T +1 215 531 8612
New York – Manhattan
T +1 215 656 3053
Jamie C. Yesnowitz
T +1 202 521 1504
T +1 312 602 8517
T +1 513 345 4540
T +1 215 814 1743
Adoption of the Internal Revenue Code (IRC) Sec. 163(j) limitation on the business interest expense deduction under the Tax Cuts and Jobs Act (TCJA) has resulted in novel conformity issues that states are still trying to address more than 18 months after enactment. New Jersey’s consideration of how to address IRC Sec. 163(j) has been challenging for a number of reasons, including its recent shift from separate to mandatory unitary combined reporting under the Corporate Business Tax (CBT).
The issuance of Technical Bulletin TB-87 in April 2019 (Bulletin) by the New Jersey Division of Taxation (Division) was designed to clarify New Jersey’s treatment of the Sec. 163(j) limitation for CBT purposes under separate and combined reporting regimes.1
More recently, the Division has provided informal guidance on its website with respect to how the limitation is applied for purposes of the New Jersey Gross Income Tax (GIT).2
Even with such guidance, however, questions remain on how to perform the Sec. 163(j) calculation in New Jersey. This Alert addresses the Division guidance issued to date, along with some of the challenges still to be overcome.
Federal treatment of interest expense limitation under IRC Sec. 163(j)
The TCJA amended Sec. 163(j), limiting the business interest expense deduction for tax years beginning after Dec. 31, 2017, to the sum of 30% of the taxpayer’s adjusted taxable income plus the taxpayer’s floor plan interest, plus the taxpayer’s business interest income.3
The nondeductible amount of business interest expense is treated as “excess interest” that may be carried forward indefinitely. Businesses with average annual gross receipts not exceeding $25 million for three consecutive tax years are not subject to the Sec. 163(j) limitation.4
On Nov. 26, 2018, the IRS issued proposed Treasury regulations clarifying that a federal consolidated filing group should calculate its interest expense limitation as though it is a single taxpayer.5
Specifically, if a consolidated federal group has an interest expense greater than 30% of its consolidated adjusted taxable income, then an interest expense limitation calculation would be performed at the consolidated level. This results in intercompany transactions being eliminated at the federal level, and therefore not considered in the interest expense limitation. The IRS held a public hearing on the proposed regulations at the conclusion of the comment period in late February and expects to issue final regulations addressing the Sec. 163(j) limitation by late summer or early fall.6
New Jersey treatment of interest expense limitation
As part of budget legislation enacted in July 2018, New Jersey implemented significant changes to the CBT structure, including the adoption of mandatory combined reporting for corporations engaged in a unitary business with other affiliates as of tax years ending on or after July 31, 2019.7
As part of legislation enacted in response to the TCJA, New Jersey also conformed to the Sec. 163(j) limitation. Specifically, the legislation provided that for tax periods beginning after Dec. 31, 2017, the business interest deduction limitation under Sec. 163(j) applies on a pro-rata basis to interest paid to both related and unrelated parties, regardless of whether the related parties are subject to the state’s addback requirements.8
The Division announced that further guidance would be issued regarding the state’s treatment of the Sec. 163(j) limitation.9
On April 12, 2019, the Division issued the Bulletin to provide guidance regarding the New Jersey CBT treatment of the Sec. 163(j) limitation in greater detail. The Bulletin explains that under New Jersey law, the starting point for taxable income is entire net income (ENI) before net operating losses, special deductions and New Jersey modifications.10
Historically, New Jersey has been a separate company reporting state and accordingly, ENI was determined on a separate entity basis as if the federal return had not been a consolidated return. Relying on New Jersey judicial precedent, the Division concluded that a taxpayer’s ENI for New Jersey CBT purposes will equal the amount reported on the federal consolidated return, even if the taxpayer files CBT returns on a separate entity basis.11
The Division recognized that New Jersey’s recent legislative changes did not address the calculation of the Sec. 163(j) limitation for CBT purposes, including whether the limitation should be computed with or without regard to whether the taxpayer is included in a federal consolidated return. Consistent with judicial precedent, the Division concluded that the Sec. 163(j) limitation reported for federal purposes will be used for New Jersey CBT purposes regardless of whether the taxpayer files a separate CBT return or as part of a New Jersey combined group. As such, taxpayers will follow the interest allocation methods adopted in the federal proposed regulations to determine the New Jersey pro-rata calculation applicable to third-party interest expense and related-party interest paid outside the federal consolidated group. Any related-party addbacks are applied after the Sec. 163(j) limitation.
Guidance for separate and combined CBT return filers
Against this backdrop, the Division provided specific guidance to address the computation of the Sec. 163(j) limitation for separate company and combined CBT return filers. The Bulletin establishes that taxpayers filing separate CBT returns but a single federal consolidated return are treated as one taxpayer for purposes of the Sec. 163(j) limitation. The separate filer’s Sec. 163(j) limit will be the entity’s portion of the overall consolidated group limitation under the interest income and expense allocation provisions contained in the proposed federal regulations. Thus, if there is no interest expense limitation at the federal consolidated level, it would imply that an interest expense limitation does not apply to that entity for CBT purposes.
With respect to combined CBT return filers, taxpayers are instructed to use the same accounting method for CBT purposes that is used for federal purposes. Recognizing that taxpayers included as members of a New Jersey combined group may have a different makeup from the members filing a federal consolidated return,12
the Division concluded that it is “fair and equitable” to treat the members of the New Jersey combined return group as though they had filed a single federal consolidated return. The Division stated that it would apply the single federal consolidated return rules as contemplated in the proposed federal regulations. Accordingly, the members of the New Jersey combined group are treated as one taxpayer for purposes of applying the Sec. 163(j) limitation.
The Division provides several examples to illustrate this concept. A group of taxpayers that are included in the same federal consolidated return, but are not unitary for CBT purposes, are treated as one taxpayer for purposes of the Sec. 163(j) limitation. Conversely, New Jersey combined group members not included on the same federal consolidated return should make adjustments that apply the Sec. 163(j) limitation as though they had been included on a single federal consolidated return. This implies the need to develop a pro forma federal consolidated return and a Sec. 163(j) limitation that mirrors the entities included in the NJ combined group. Taxpayers will report such information on an accompanying schedule currently in development by the Division. Further, the Bulletin states that the single federal return rule will also apply to taxpayers not included in the same CBT combined return, but included in the same federal consolidated return as one or all members of the combined CBT return. The Bulletin specifies that the taxpayer should include a rider explaining why it was not included in the New Jersey combined return along with a copy of the federal consolidated return.
The Bulletin provides ordering rules for both separate company and combined return filers, stating that the Sec. 163(j) limitation rules are applied before the adjustments required by New Jersey’s related party addback rules, if applicable. Under CBT rules, the related-party addback rules do not apply to transactions between members of a combined group reported on the same combined return.
Importantly, informal guidance on the Division’s website indicates that New Jersey does not conform to Sec. 163(j) for GIT purposes. Consequently, New Jersey will allow a partnership or other pass-through entity to deduct the full amount of interest expense without any Sec. 163(j) limitation in the year the expense is incurred as an “other subtraction” on Form NJ-1065. The federal excess interest carryover amount in a future year will need to be added back as an “other addition” to prevent a double deduction, since the interest expense will have been fully deducted in the prior year.
Given that New Jersey conforms to the Sec. 163(j) limitation for CBT purposes, and that the non-resident partners’ share of tax in columns H through K of the partners’ directory on Form NJ-1065 is driven by the CBT statutes and Federal Form K-1, taxpayers will need to consider this issue when calculating non-resident tax for both corporate and non-corporate partners.13
Additionally, corporate partners may be required to add back their allocated portion of the New Jersey partnership’s “other subtraction” from their New Jersey Form K-1 distributive share income when filing a New Jersey CBT return.
In the Bulletin, the Division attempts to provide clarity for taxpayers that will be filing as members of a combined group for CBT purposes when New Jersey’s combined reporting rules become effective for tax years ending on or after July 31, 2019. The Bulletin outlines that such members will be treated as one taxpayer for purposes of applying the new Sec. 163(j) limitation even if some of the combined group members included in the New Jersey combined group are not included on the same federal consolidated return. In the case of taxpayers comprising the same federal consolidated return that are not included on the same New Jersey combined return, such taxpayers should still be treated as one taxpayer for purposes of applying the Sec. 163(j) limitation. For example, if 10 corporations file a single federal consolidated return, but only seven of these corporations file a New Jersey combined return, it would appear that the 10 corporations should compute the Sec. 163(j) limitation as if they were one taxpayer, with a pro rata share of the resulting limitation allocated to the seven New Jersey CBT combined filers. Accordingly, the members of a New Jersey combined group should calculate their Sec. 163(j) limitation as if they filed a single consolidated return regardless of what was actually filed for federal purposes. Additional guidance in the form of specific, detailed examples to help taxpayers visualize different scenarios that may occur would be helpful. The Division indicated that it expects to issue additional guidance in the near future.
The analysis can become even more complex in the context of a group of entities, some of which file as part of a New Jersey combined return, and some of which file New Jersey separate returns (for example, if such entities are prohibited from filing with the New Jersey combined group). To slightly change the facts in the above example, assume that instead, there are five New Jersey combined group members, with the remaining two New Jersey entities required to file CBT returns on a separate basis. In that situation, a pure application of the single federal consolidated return concept would require that the Sec. 163(j) limitation be calculated as though all seven New Jersey entities had filed a single federal consolidated return. Likewise, in the event that the two New Jersey entities filing separately instead had to file as a standalone New Jersey combined group, the Sec. 163(j) limitation would still be calculated as though all the New Jersey filers had filed one federal consolidated return. Again, confirmation from the Division on how to apply the Sec. 163(j) limitations in these instances would be warranted.
Based on the Division’s guidance in the Bulletin, some conclusions regarding how to allocate the Sec. 163(j) limitation between a related party and a third party may be drawn. For example, assume that a federal consolidated return filer has $1 million in adjusted taxable income and $500,000 in business interest expense split equally between a related party that is not part of the federal consolidated group, and a third party. In this case, the taxpayer would therefore be limited to a total business interest expense deduction of $300,000 (30% of adjusted taxable income) for federal purposes. Under the proposed federal regulations and for CBT purposes, the $200,000 in disallowed interest expense (the $500,000 business interest expense, less the $300,000 interest expense deduction limitation) would be allocated proportionally according to the interest payment amounts. Accordingly, $100,000 would be allocated to related party interest expense, and the remaining $100,000 allocated to third party interest expense. Any related-party addbacks would apply after the Sec. 163(j) limitation rules are applied.
However, the Bulletin is silent with respect to the treatment and calculation of related-party debt for separate CBT return filers. In the federal calculation of interest expense limitations for a federal consolidated group that is treated as a single taxpayer, intercompany payments of interest expense are eliminated. As a result, the amounts of allowed and disallowed interest expense at the federal consolidated level all relate to debt with unrelated parties or debt with related parties outside the federal consolidated group. Therefore, if a taxpayer filing a separate New Jersey CBT return has related-party debt, the amount of interest expense on such debt will not always be included in the taxpayer’s federal consolidated calculations, which based on the Bulletin is the starting point for the New Jersey calculations. Likewise, there is uncertainty surrounding how the related-party debt calculation works when the underlying transaction involves a non-U.S. corporation that is not part of the federal consolidated group.
Finally, beyond the Sec. 163(j) limitation, taxpayers should also consider the broader implications of New Jersey’s application of federal consolidated return rules to separate company filings when determining their ENI on line 28 of Schedule A of the CBT-100.
It is hoped that the Division will supplement the Bulletin with further guidance as necessary in the future, with a focus on resolving urgent interpretive issues. Impacted taxpayers should consider financial statement implications under ASC 740 as a result of New Jersey’s treatment of the Sec. 163(j) limitation.
This content supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.
The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.