The Tax Cuts and Jobs Act (TCJA) of 2017 significantly restricted the deduction of business-related interest expense under Section 163(j), limiting the deduction to 30% of adjusted taxable income (ATI) plus business interest income and floor plan financing interest. Initially, ATI was calculated like EBITDA, but since 2022, the add-back of depreciation and amortization has expired, increasing tax liabilities for higher-leveraged taxpayers.

To mitigate or eliminate the limitations, several strategies are available:

Small Business Exception

Businesses with average annual gross receipts of less than $30 million in 2024 may qualify for an exception under Sec. 163(j)(3), although aggregation rules may apply for related businesses.

Real Property Trade or Business (RPTOB) Election

Real property businesses, such as those involved in development, construction, or leasing, may elect to opt out of the interest deduction limitation, though they must switch to an alternative depreciation system and forgo bonus depreciation.

Self-Charged Interest

For partner loans to partnerships, the final 2021 regulations offer some relief by allowing certain interest expense allocations back to the lending partner.

Capitalization Strategies

Taxpayers can capitalize interest on certain properties including inventories, reducing their business interest expense. This applies after any required interest capitalization under Sec. 263A.  This allows for elective capitalization of certain costs, like interest, improving timing for deductions.

Buy vs. Lease Considerations

Taxpayers must weigh the benefits of leasing versus buying assets, considering both tax and financial reporting. With changes to depreciation and interest deduction limits, capital leases (now finance leases under GAAP) might be less attractive than before, as operating leases may allow for more flexible deductions.

Overall, the Sec. 163(j) limitation presents challenges but also opportunities for strategic tax planning, particularly in choosing between exceptions, capitalization, or restructuring to optimize deductions.

IRS Practice Units, developed by the IRS’s Large Business and International (LB&I) division, serve as training and guidance tools to help examiners and agents navigate complex tax laws consistently and effectively. These materials often focus on key areas of tax law subject to audits or enforcement actions, such as international tax, transfer pricing, and corporate tax matters.

One notable area that taxpayers should watch closely is the "U-turn" transaction concept, which was first introduced in Battelstein v. Commissioner and Davison v. Commissioner. The May 2023 LB&I Concept Unit addresses the interest expense limitation on related foreign party loans under IRC section 267(a)(3). The concept of U-turn transactions was reintroduced in Chief Counsel Advice (CCA) 201334037, and the IRS has since applied this concept to disallow deductions for interest payments in specific situations.

In CCA 201334037, the IRS concluded that wire transfers of funds to related foreign persons, which the taxpayer claimed as interest payments, were not deductible under IRC section 267(a)(3). The taxpayer, USS, recorded what it considered interest payments for funds advanced by FP, a related foreign party. However, the IRS found that USS obtained sufficient funds to cover these payments either through additional loans from FP or through draw-downs on lines of credit with FP, which were credited to USS’s general account shortly before or after the claimed interest payments. Citing Battelstein and Davison, the IRS disallowed these deductions, citing the circular nature of the cash flow.

The IRS’s position was that when funds are loaned by FP to the taxpayer and "paid" back via wire transfers, the U-turn transaction does not alter the economic position of either the lender or borrower. While the wire transfers appeared in form to be interest payments, they did not lead to any substantive economic change. Additionally, because FP had an equity interest in the taxpayer, it was willing to indefinitely defer the realization of returns on its investment. Applying the Tax Court’s analysis in these cases, the IRS concluded that the borrowed funds used to “satisfy” the interest obligation were, in essence, the same funds advanced by FP. Consequently, the claimed interest payments were deemed superficial, and the taxpayer was not entitled to a deduction for interest under the cash method of accounting.

Once again, the IRS’s characterization of transactions for tax purposes hinges on substance rather than solely on form. Enterprises with debt arrangements involving foreign parents or affiliates should carefully consider the U-turn transaction concept to avoid conflicts with the IRS when deducting interest payments.

For additional details, please see LB&I Concept Unit May 16, 2023  Interest Expense Limitation on Related Foreign Party Loans Under IRC 267(a)(3) (irs.gov)

For tax years beginning after 2022, the Inflation Reduction Act of 2022 amended section 55 to impose a new corporate alternative minimum tax (CAMT) based on the adjusted financial statement income (AFSI) of an applicable corporation.

An appliable corporation is liable for the corporate alternative minimum tax to the extent that its “tentative minimum tax” exceeds its regular U.S. federal income tax liability plus its liability for the base-erosion and anti-abuse tax (BEAT). An applicable corporation’s tentative minimum tax is 15% of its adjusted financial statement income to the extent the tax exceeds the corporate alternative minimum tax foreign tax credit for the tax year. The corporate alternative minimum tax applies to any corporation (other than an S corporation, regulated investment company, or real estate investment trust) whose average annual adjusted financial statement income exceeds $1 billion for any three consecutive tax years preceding the tax year. When determining adjusted financial statement income for the $1 billion qualification test, the act generally treats adjusted financial statement income of all persons considered a single employer with a corporation under Sec. 52(a) or (b) as adjusted financial statement income of the corporation.

For a corporation that is a member of a foreign-parented multinational group, (1) the three-year average annual adjusted financial statement income must be over $1 billion from all members of the foreign-parented multinational group (without regard to certain adjustments as specified in Sec. 59(k)(2)(A)), and (2) the corporation must have average annual adjusted financial statement income, determined without regard to loss carryovers, of $100 million or more. A foreign-parented multinational group means two or more entities if (1) at least one entity is a domestic corporation and another is a foreign corporation; (2) the entities are included in the same applicable financial statement; and (3) the common parent of those entities is a foreign corporation (or the entities are treated as having a common parent that is a foreign corporation).

The IRS has issued series of notices providing targeted guidance.  The following notices contain interim rules, prior to the issuance of Treasury regulations, related to CAMT:

• Notice 2023-3, Internal Revenue Bulletin: 2023-03 | Internal Revenue Service (irs.gov)
• Notice 2023-10, Internal Revenue Bulletin: 2023-10 | Internal Revenue Service (irs.gov)
• Notice 2023-26, Internal Revenue Bulletin: 2023-26 | Internal Revenue Service (irs.gov)
• Notice 2023-40, Internal Revenue Bulletin: 2023-40 | Internal Revenue Service (irs.gov)
• Notice 2024-03, Internal Revenue Bulletin: 2024-03 | Internal Revenue Service (irs.gov)

As the CAMT is effective for tax years beginning after December 31, 2022, taxpayers potentially subject to the CAMT should consider how guidance in the Notice may impact previous positions that may have been taken based on a reasonable interpretation of the statute and prior interim guidance. Treasury and the IRS have indicated an intent to issue proposed regulations in early 2024 consistent with the interim guidance provided in, and modified and clarified by, the Notice.