T +1 215 376 6050
T +1 215 531 8612
T +1 215 701 8856
T +1 215 814 1743
Jamie C. Yesnowitz
T +1 202 521 1504
T +1 312 302 8617
T +1 513 345 4540
On April 29, 2019, the Pennsylvania Department of Revenue issued Corporation Tax Bulletin 2019-03, clarifying Pennsylvania’s treatment of the business interest expense limitation enacted under the Tax Cuts and Jobs Act (TCJA) pursuant to IRC Sec. 163(j). The Bulletin addresses the calculation of related-party interest expense addback in a year in which the interest expense deduction is limited under Sec. 163(j), in addition to the calculation of disqualified amounts to be carried forward for Pennsylvania Corporate Net Income Tax (CNIT) purposes. Additionally, the Bulletin addresses Pennsylvania’s treatment of the interest expense limitation related to nonbusiness income, partnerships with corporate partners, and Personal Income Tax (PIT) purposes. In addition, the Philadelphia Department of Revenue released an advisory notice explaining its treatment of the Sec. 163(j) limitation for purposes of the city’s Business Income and Receipts Tax (BIRT).
Federal treatment of interest expense limitation under IRC Sec. 163(j)
The TCJA amended Sec. 163(j) limiting business interest expense deductions 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.1
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.2
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.3
Pennsylvania treatment of interest expense limitation
Pennsylvania’s Threshold for Purposes of Calculating Limitation
The Bulletin announced that CNIT taxpayers are not expected to calculate a Pennsylvania interest expense deduction limitation unless they are required to calculate an interest expense limitation at the consolidated federal level. If there is no interest expense limitation at the federal consolidated level, then there is no interest expense limitation for Pennsylvania purposes, notwithstanding the fact that Pennsylvania does not allow consolidated CNIT filings. However, if the interest expense limitation applies at the federal consolidated level, then each member of the consolidated group with a CNIT filing obligation must perform its own interest expense limitation calculation on a separate company basis.
Separate company interest expense limitation analysis
Pennsylvania defines taxable income for CNIT purposes as taxable income reported to the IRS.4
In the case where the taxpayer files a consolidated federal tax return, Pennsylvania requires the taxpayer to calculate taxable income as if separate federal tax returns were filed.5
As such, the interest expense limitation analysis and calculation will be performed on a separate company basis without elimination of related-party expenses or receipts. Part of this analysis includes whether each separate company qualifies for the small business exemption, and is therefore not subject to the Sec. 163(j) limitation because it averaged $25 million or less in annual receipts over the preceding three years.6
If the separate company is required to limit its interest expense under Sec. 163(j), the taxpayer should create a separate federal pro-forma return to calculate the limitation amount and future disqualified amounts to be carried forward. Because the interest expense limitation is accounted for differently for federal and Pennsylvania CNIT purposes, a taxpayer will be required to maintain two different sets of Sec. 163(j) workpapers: a federal pro-forma calculation and a Pennsylvania CNIT calculation.
Pennsylvania related-party interest expense addback provision
In addition to calculating the interest expense limitation on a separate company basis, Pennsylvania requires certain related-party interest expenses to be added back. In 2013, Pennsylvania enacted an addback provision (the “Add-back Rule”), which disallows deductions from income subject to CNIT for certain transactions between affiliated members for tax years beginning in 2015 and thereafter.7
Under the Add-back Rule, no deduction is allowed for an interest expense or cost directly related to an intangible expense or cost,8
paid, accrued or incurred directly or indirectly in connection with one or more transactions with an affiliated entity.9
To the extent a taxpayer’s interest expense deduction is both limited under Sec. 163(j) and subject to the Add-back Rule, the Bulletin provides specific rules to calculate the amount of related-party interest expense to add back in the current tax year, and to carry forward to future years. After the amount of federal interest expense limitation and carryforward is calculated on a separate company basis, the taxpayer should calculate the allocated amount of Pennsylvania addback. The allocated addback amount is calculated by using the following formula:
Related-party interest expense subject to addback * (federal allowable interest expense after Sec. 163(j) limitation / total interest expense).
This methodology ensures that the taxpayer is not adding back related-party interest expense for which it was limited in deducting on its federal return. However, this creates a timing difference with respect to when the taxpayer should recognize a related-party interest expense addback. For example, in tax years where the addback is less than 100% of the related-party interest expense, a Pennsylvania carryforward amount will need to be added back in future years when the federal carryforward interest expense which was limited in prior years can be utilized.
Stated differently, a taxpayer should only add back Pennsylvania related-party interest expense on a pro-rata basis between the federal limited interest expense amount and the total federal interest expense amount. The remaining amount (i.e., not added back in the current year) should be carried forward to future years and eventually added back once the federal carryforward is completely deducted on the federal return. It is important to note that this treatment only occurs when there is a federal interest expense limitation resulting in a carryforward. Otherwise, all federal interest expense is deducted in the current year and all related-party interest expense is added back for CNIT purposes. The Bulletin provides illustrative examples clarifying the application of the limitation for CNIT purposes.
Interest expense related to nonbusiness income
The Bulletin establishes that interest expense related to business income can only be used to reduce business income, but not nonbusiness income.10
In the event that interest expense is related to nonbusiness income, such interest expense can only be used to reduce nonbusiness income. Essentially, interest expense can only be related to either business income or nonbusiness income, but not both. Taxpayers reporting nonbusiness income must determine the amount of interest expense associated with the nonbusiness income and allocate an interest limitation to that amount on a pro-rata basis.
Interest expense amounts for partnerships with corporate partners
The Bulletin provides guidance on Pennsylvania’s treatment of interest expense amounts limited under Sec. 163(j) for partnerships with corporate partners. In general, Pennsylvania conforms to the federal treatment of the interest expense limitation for partnerships, which means that the interest expense limitation is calculated at the partnership level, and then flows through to the partner level. Once the interest expense flows to the partner level, the partner must follow the federal rules in determining how to treat the interest expense limitation. If the partner is a C corporation, the partner would follow the federal and Pennsylvania interest expense limitation rules, as outlined above.
Partnerships must clearly indicate whether the interest expense is related to business income or nonbusiness income. Unlike C corporations, where the default treatment of interest expense is business interest expense, partnerships need to explicitly classify interest as either business or nonbusiness interest. Ultimately, the corporate partner must make a determination whether the interest amounts that flows through from the partnership would be classified as business or nonbusiness interest expense.
The Bulletin clarifies that the determination of deductible interest expenses should remain unchanged for PIT purposes under the TCJA because Pennsylvania does not conform to the IRC for PIT purposes. Instead, the deductibility of interest expenses is determined based on whether such expenses constitute ordinary and necessary business expenses. The Bulletin also addresses application of the resident credit taken for taxes paid to other states as a result of increased income realized in other states resulting from the Sec. 163(j) limitation. Reasoning that the resident credit will be limited to the Pennsylvania PIT liability on such income as calculated under Pennsylvania law, the Department determined that calculation of the resident credit should remain unchanged post-TCJA.
Philadelphia treatment of interest expense limitation
On May 29, 2019, the Philadelphia Department of Revenue issued an advisory notice explaining the city’s treatment of the federal interest expense limitation for purposes of the net income portion of the BIRT.11
Philadelphia’s treatment is generally consistent with Pennsylvania's treatment of the Sec. 163(j) limitation and is only applicable for BIRT Method II taxpayers.12
Absent Pennsylvania legislation decoupling a taxpayer's federal interest deduction amount for Philadelphia BIRT purposes, taxpayers must use the federal interest expense deduction calculated on a separate entity basis. Similar to the Pennsylvania guidance, consolidated federal filers reporting an interest limitation under Sec. 163(j) must calculate the federal interest expense limitation on a separate entity basis for purposes of the BIRT.
The Philadelphia BIRT applies as an entity-level tax on pass-through entities such as partnerships and S corporations. Therefore, any Sec. 163(j) limitation calculated for pass-through entities must be reported by the entity on its BIRT return. Because the Sec. 163(j) limitation is not reflected on a taxpayer's books and records, this adjustment is not applicable to BIRT Method I taxpayers, or unincorporated entities subject to the Net Profits Tax.13
The Pennsylvania Department of Revenue has made a concerted effort to provide much needed technical guidance in light of the TCJA.14
This Bulletin continues that trend with the Department attempting to stay ahead of issues that could arise from Pennsylvania’s conformity with Sec. 163(j). While this Bulletin provides helpful technical guidance regarding Pennsylvania’s treatment of Sec. 163(j), there are several points warranting further discussion.
Although Pennsylvania does not allow taxpayers filing a consolidated federal tax return to file a consolidated CNIT return, the Bulletin establishes that a Pennsylvania taxpayer is not required to limit its interest expense if the interest expense was not limited under Sec. 163(j) at the federal consolidated level. This simplifying convention is helpful in determining whether or not a Pennsylvania taxpayer filing a federal consolidated return needs to perform a Sec. 163(j) analysis and calculation. In essence, if the Sec. 163(j) interest expense limitation is not a factor at the federal level, then the Bulletin concludes that it should not be a factor for Pennsylvania CNIT purposes. Therefore, it may be desirable to explore all available options to prevent the application of the federal Sec. 163(j) limitation, including by making elections to include controlled foreign corporations (CFCs) into the consolidated group.
While the Bulletin provides guidance on how to account for related-party interest expense addbacks in a tax year in which Sec. 163(j) limited overall interest expense at the federal level, taxpayers will be required to create two separate calculations to track the disqualified Sec. 163(j) interest expense amount at the federal level as well as the disqualified related-party interest expense addback at the Pennsylvania level. This will help ensure that the disqualified amounts are carried forward to future years and utilized appropriately, whether a deduction on the federal return or an addback on the Pennsylvania CNIT return. Prior to adding back any related-party interest expense, the taxpayer should first analyze whether the interest expense is required to be added back.
There are several exceptions to the Add-back Rule that could potentially impact the interest expense limitation calculation for Pennsylvania purposes. First, the adjustment does not apply to transactions that: (i) do not have the principal purpose of tax avoidance; and (ii) that are conducted at arm’s length rates and terms.15
The first element of the exception requires proof that the principal purpose of the transaction that generated the intangible expense was not to avoid Pennsylvania CNIT.16
The principal purpose must be a valid business purpose that was the primary motivation for entering into the transaction.17
Taxpayers having related-party interest expenses and are subject to Sec. 163(j) limitations should consider performing a transfer pricing study to support their Pennsylvania filing positions.
Although the Philadelphia advisory notice indicates that the city will generally follow Pennsylvania’s treatment of the Sec. 163(j) limitation, Pennsylvania’s related-party addback rules do not apply for purposes of the BIRT, so differences in the city and state calculations of the limitation may arise. In the case of pass-through entities, the limitation is calculated at the partnership level for Pennsylvania purposes and the amounts will flow through to the corporate partners but will not affect individual partners, as the limitation does not apply to Pennsylvania PIT. In contrast, since the BIRT is an entity-level tax, the limitation will apply at the partnership level for purposes of the BIRT. Finally, new BIRT taxpayers having nexus in Philadelphia may consider whether it would be more advantageous to make a Method I election for purposes of calculating the net income portion of the BIRT, given that the Sec. 163(j) limitation applies to Method II taxpayers only.18
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.