Jamie C. Yesnowitz
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On Nov. 1, 2019, the Virginia Department of Taxation issued proposed guidelines clarifying Virginia’s treatment of the Internal Revenue Code (IRC) Section 163(j) business interest deduction limitation pursuant to the Tax Cuts and Jobs Act (TCJA).1
Earlier this year, Virginia had advanced its conformity to the IRC to Dec. 31, 2018, thus adopting the interest expense limitation of Section 163(j).2
Additionally, as part of its budget bill, the Virginia General Assembly enacted a provision requiring the Department to convene a Section 163(j) working group to solicit public input from affected parties, study the impact of Section 163(j) on Virginia’s various filing methodologies, and issue these guidelines.3
The Department’s guidelines address numerous aspects of the business interest expense deduction under Section 163(j), including the Commonwealth’s calculation of the current year interest limitation, disallowed interest carryforward provisions, Virginia’s additional deduction for 20% of disallowed interest expense, and the impact of Virginia nexus upon the limitation and carryforwards. The Department’s guidelines also provide guidance on computing the business interest limitation under each of Virginia’s combined, consolidated, and separate company filing elections. Finally, the guidelines provide direction regarding Virginia’s fixed date conformity modification adjustments, and their impact upon the limitation.
Federal treatment of interest expense limitation under Section 163(j)
The TCJA amended Section 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.4
On Nov. 26, 2018, the Internal Revenue Service (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 percent 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 may issue final regulations addressing the Sec. 163(j) limitation by the end of this year.6
Virginia business interest limitation
The recently issued Virginia guidelines provide the general rule that the Commonwealth conforms to the IRC as its starting point,7
and thus any limitation under IRC Section 163(j) generally applies to any taxpayer to the extent its business interest deduction is limited on its federal income tax return. Taxpayers may carry forward and deduct the business interest deduction in the same manner for Virginia purposes as allowed for federal income tax purposes. A consequence of Virginia’s broad-based federal conformity is that taxpayers who become subject to the Virginia income tax receive a benefit of a carryover even if the taxpayer was not subject to tax in years where interest was limited. Conversely, a taxpayer that becomes no longer subject to tax in Virginia loses the benefit of a deduction in Virginia, even if the taxpayer was subject to Virginia income tax in the year where interest was limited.
Virginia’s guidance additionally establishes that taxpayers that do not claim a federal deduction for business interest or are provided an exception are not subject to the limitation for Virginia income tax purposes. Presumably, this provision confirms Virginia’s conformity to the electing real property or farming trade or business exemptions contained in Sec. 163(j),8
as well as the small business exemption for taxpayers averaging $25 million or less in annual receipts over the preceding three years.9
In part to offset some of the effect of the federal Sec. 163(j) limitation, Virginia allows a deduction equal to 20% of the amount of business interest that is disallowed pursuant to Sec. 163(j).10
The Department’s guidelines reinforce that this additional deduction offered by Virginia is the acceleration of the federal deduction rather than a permanent decoupling. The guidelines suggest that in subsequent years, the federal limitation carryover must be reduced by the additional 20% deduction taken in prior years. The Department’s guidelines have not provided detailed guidance on the additional 20% deduction, though form instructions will be created in an effort to provide additional guidance on this topic.
Computation of Section 163(j) limitation under various Virginia filing methods
In Virginia, taxpayers that are in an affiliated group may elect either separate company filing, nexus combined filing or nexus consolidated filing.11
Virginia’s Sec. 163(j) guidelines provide direction on the computation of the business interest limitation under each method, as illustrated by several examples.
Across each of Virginia’s filing methodologies, the guidelines explain that if Virginia returns are filed on a different basis than the federal return, the taxpayer’s federal taxable income (FTI) must be recomputed based upon the Virginia filing election chosen by the taxpayer. This recomputed pro forma FTI is utilized to determine the taxpayer’s Virginia adjusted taxable income (ATI), and thus the business interest deduction allowable to the current year, any limitation carryforwards to future years, and the amount of carryforwards that may be utilized in future years. The Department’s guidelines indicate that the Sec. 163(j) limitation is intended to be applied using similar principles to those used by the Commonwealth in carrying forward other attributes such as charitable contribution and federal NOL carryovers.
The Department’s working group raised the possibility of adopting the approach embraced by Pennsylvania, which would require the existence of a federal consolidated limitation as a threshold requirement to impose a state limitation. Examples outlined in the guidelines, however, appear to reject this approach in favor of a separate company computation. Instead, the Department points to its existing regulations to explain how income and deductions must be computed under each filing methodology.12
These regulations generally take a federal pro forma approach to computing Virginia taxable income. As a result, the regulations deviate from the single entity approach used in computing the Sec. 163(j) limitation for consolidated federal income tax purposes.
Virginia consolidated filers
For Virginia consolidated filers, the Department’s guidelines explain that the Section 163(j) limitation is computed based upon the consolidated income of the Virginia affiliated group, applying federal consolidation principles. As illustrated in the example provided, ATI from one member of the consolidated group may be considered in determining the overall business interest limitation, even though the interest expense may be derived by another member of the Virginia consolidated group. Conversely, a limitation may exist at the consolidated level, even though a member of the consolidated group may not be separately limited on a separate company pro forma basis. The example clarifies that the Virginia affiliated group may differ from the federal consolidated group, and if so, the taxpayer must recompute its FTI based upon the consolidated FTI of the Virginia consolidated group. In certain cases, the overall business interest deduction and carryforwards may substantially differ from the federally consolidated amounts, based on Virginia group composition.
Separate company filers
Under the separate fling methodology, each taxpayer must compute its own business interest limitation and carryforward on a standalone federal pro forma basis. Only the ATI of a particular member of an affiliated group may be considered in determining the business interest limitation of that entity. Accordingly, taxpayers filing on a separate company basis may incur an interest limitation, although no limitation exists at the federal consolidated level. Further, a taxpayer may be able to deduct interest, even though it is disallowed from a federal consolidated perspective. The example in the guidelines shows that the business interest deduction and carryforward amounts may substantially differ when using the Virginia separate filing method in comparison to the Virginia consolidated filing method.
Virginia combined filers
The Department’s guidelines explain that taxpayers filing a Virginia combined return are treated similarly to taxpayers filing on a separate entity basis. Deductible interest expense and carryforwards are determined as if the taxpayer filed separate company Virginia returns, and no offset is available between combined group members. Taxpayers will be required to track limitations and carryforwards on a separate entity basis, and apply carryforwards to each specific entity in future years.
Fixed date conformity modifications
Virginia employs fixed date conformity to the IRC and currently conforms to the IRC as amended through Dec. 31, 2018.13
Like most states, Virginia requires several modification adjustments to arrive at Virginia taxable income. Virginia, however, differentiates certain modification adjustments required as a result of the Commonwealth’s fixed date conformity to arrive at FTI for Virginia purposes, from other addition and subtraction modifications required to arrive at Virginia taxable income. The Commonwealth has outlined these adjustments in Va. Code Ann. Sec. 58.1-301, and refers to them as “fixed date conformity modifications.”
In computing ATI for Virginia purposes, taxpayers must recompute their FTI to include the impact of fixed date conformity modifications. The Department’s guidelines explain that the Virginia business interest limitation will be based upon the recomputed Virginia ATI rather than pro forma federal ATI. Among the most notable of the Commonwealth’s fixed date conformity adjustments is federal bonus depreciation under Section 168(k).14
As Virginia does not conform to bonus depreciation, including the TCJA’s expanded expensing provisions permitting 100% expensing of qualified property, an addition or subtraction modification often will be required for taxpayers. As the examples in the Department’s guidelines illustrate, the net bonus depreciation adjustment results in modified ATI, leading to a modified pro forma Section 163(j) limitation.
The Department has provided some clarity on several of the issues surrounding the Commonwealth’s conformity to Section 163(j), though pressing questions remain unanswered. As far as the issues addressed by the Department, much of what was published does not raise significant controversy. The principles used to apply the business interest limitation are consistent with the Department’s application to charitable contributions and net operating loss (NOL) carryforwards. Provisions surrounding the nexus impact of the limitations are generally consistent with other federal deductions relating to timing and accounting methods that are included in Virginia FTI. The Department’s guidance is welcome for taxpayers who have been adversely impacted by the Section 163(j) limitation for federal and state income tax purposes, and could serve as the impetus to explore potential changes to their business operations that could provide some prospective relief.
The Department’s guidance related to filing methodologies largely defers to policies in existing regulations, and is generally consistent with the treatment of other business deductions and NOLs. One area that departs from Virginia’s treatment of NOLs is the treatment of the limitation carryforward for combined filers. For Virginia combined NOLs, an allocation methodology is applied to allocate NOLs back to the appropriate group member. Query whether a similar approach might be more appropriate with regard to the Virginia Section 163(j) limitation carryforward in the combined return context.
A taxpayer’s Section 163(j) limitation resulting from its Virginia historical filing election may potentially have draconian results. The Department has historically maintained very rigid requirements for allowing a change in filing election. Based upon the Department’s historical policy, it is doubtful that even sweeping legislation such as the TCJA will constitute sufficient grounds for a discretionary change in filing methodology. To the extent that taxpayers experience unfavorable Section 163(j) consequences due to their filing election, taxpayers may wish to consider the potential effect of internal reorganizations that could lessen the effect of the interest limitation in Virginia, as well as other states that generally conform to Section 163.
While the Department’s guidance relating to fixed date conformity modifications will likely be immediately favorable from a Section 163(j) perspective to most taxpayers electing bonus depreciation, these provisions also add a high degree of complexity and additional administrative burden. Pro forma FTI will differ from the Virginia FTI used in computing the 163(j) limitation. Taxpayers will need to create both federal pro forma and Virginia pro forma returns and forms 8990, to compute the limitation amount at the separate company level, and to consider the impact of Virginia’s fixed date conformity adjustments. Taxpayers will also need to maintain corresponding records in order to track the business interest limitation carryforwards and any utilization of the limitation in future years. As bonus depreciation adjustments in later years result in a net subtraction modification, the impact of fixed date conformity adjustments may have an unfavorable impact on the Virginia Section 163(j) limitation. This may be particularly relevant starting in 2022 when ATI is based upon an earnings before interest and taxes (EBIT) calculation rather than earnings before interest, taxes, depreciation and amortization (EBITDA). Overall, however, these provisions maintain the policy objective of balancing the deductibility of interest and depreciation.
The Department’s guidelines are also notable for the issues that were not addressed. While the Department solicited public comments through the formation of its working group, the Department declined to address several issues that were raised. Notably, the Department cited the uncertainty regarding federal proposed regulations in limiting its guidance to corporate taxpayers. The Department also did not address the interaction of the Section 163(j) limitation with the state’s intercompany interest addback. While Virginia only requires the addback of intangible-related interest, uncertainty exists for affected taxpayers as to whether one limitation takes precedence over the other, or whether the interest addback and limitation may be applied on a pro rata basis. Further, while the additional 20% deduction appears relatively straightforward, the examples are silent on the impact of the additional 20% deduction. The omission of this deduction from the examples, and the signal toward future guidance raise concern as to how the Department may proceed in this area. Given the imminent Nov. 15 extended due date for 2018 Virginia corporation income tax filers, it appears inevitable that amended returns will need to be filed once the Department’s additional guidance is released.
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