The Tax Cuts and Jobs Act (TCJA) contains many changes that could act as potential traps for the unwary. Included among these are deductions that were eliminated or limited by the TCJA. In this installment, we will be discussing three of these, namely the interest deduction limitation, the disallowance of interest deductions in hybrid transactions, and the much-publicized limitation on the state and local tax deduction.
Perhaps the provision that has had the most widespread impact on financial and other corporate transactions is the limitation on the deductibility of interest. Under the TCJA, interest on indebtedness generally may be deducted only up to an amount equal to the sum of business interest income and 30% of adjusted gross income (referred to as the “Interest Deduction Limit”); the disallowed interest may be carried forward indefinitely to succeeding taxable years (click here for more). There are exceptions for small taxpayers whose annual gross receipts over a prior three year period do not exceed $25 million and for certain businesses that are regulated utilities, as well as special rules for partners in partnerships. While the full impact of the Interest Deduction Limit still is unclear, companies appeared to at least initially consider alternative methods of financing operations and acquisitions, which caused many to ponder whether there would be a meaningful decrease in debt financing (particularly acquisition financing). However, despite this new limitation and banks’ continued insistence on strict compliance with restrictive covenants and related penalties as conditions to lending, we have not observed an obvious dip in the debt financing market that can be directly traced to the new rules. This may be due in part to the numerous issues contained in the new rules that require explanation and clarification, including with respect to the application of the new limits to partnership debt, as well as the allocation of the limit in affiliated groups and holding company structures where, for example, one business qualifies for an exception and one does not. It also may be due to the repeal of the old “earnings stripping” rules that limited deductibility of interest paid to or guaranteed by certain foreign related parties. Interestingly, levelling the playing field for interest deduction limits for related parties may have encouraged more “straight debt” from foreign parents to subsidiaries, which often is funded by third party borrowing by the parent. Of course, related party loan transactions still are subject to scrutiny under traditional debt/equity rules that require the debt to have debt-like features and, most importantly, require the parties to show that the borrower reasonably can be expected to service the debt in accordance with the terms (which themselves are expected to be similar to the terms of a third party loan).
Indeed, although the Interest Deduction Limit only will affect debt financing borrowers in the United States, interest deductibility comes up again in an international provision designed to target financing structures that take advantage of differences between countries’ tax laws. Specifically, the TCJA denies a deduction for interest payments to a foreign related party paid (i) pursuant to hybrid transactions, where such interest payments are not subject to taxation in the jurisdiction of the foreign related party, and (ii) to hybrid entities, which are entities treated as transparent in the United States but as nontransparent in the recipient’s country, or vice-versa (click here for more). This change has rendered impractical certain transactions involving residents of foreign jurisdictions whose tax law treats certain payments as nontaxable returns of capital or nontaxed foreign earnings, while such payments are treated as interest payments for U.S. federal income tax purposes (such as so-called tower structures). Before the TCJA was passed, there were rumblings throughout the international community that the new provision violates international treaty laws, but we have yet to see any action taken on this front.
Finally, the strict limitations on deductions for state and local taxes also will negatively impact certain businesses, particularly those located in California and the greater New York area (comprised of New York, Connecticut and New Jersey). These states all have some of the highest state taxes in the country, with New York City also leveling relatively high local taxes. Of particular concern is the non-deductibility of property taxes, which are particularly high in these states due to both the tax rates themselves and the high value of real property (upon which such taxes are imposed). However, it is critical to note that corporations may continue to deduct these taxes, while individuals (and therefore shareholders in companies operating as pass throughs) will have their deductions limited to $10,000 annually. Certainly, this would not be the first time we have seen predictions regarding tax burdens causing mass exodus from places such as New York City. However, this historic change in the federal tax law that eliminates the ability to mitigate the high cost of living in these areas seems more likely to lead businesses or individuals to relocate. This could lead to a mismatch in job-related supply and demand, resulting in companies having difficulty filling positions requiring a certain expertise or background and individuals finding it difficult to find positions in their desired field. Of course, real property values in these geographic areas, while dipping for short periods over the years during recessions, tend to hold steady and rebound from such short-term financial crises. If past patterns are an indication, we may not be seeing relocations as much as we may see changes in compensation structures for national businesses that relied on the deductibility of state and local taxes as a means of levelling the field for their workers in high tax jurisdictions. Indeed, as this report goes to press, news has broken regarding a law suit filed by New York, Connecticut, New Jersey and Maryland against Treasury, the IRS and the United States challenging the constitutionality of this limitation. We will continue to monitor this case and report on any related developments.