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| George Callas |
As part of the trade-off for a lower corporate rate, Congress modified Section 163(j) of the Internal Revenue Code to impose a limitation on business interest expense such that taxpayers generally may not deduct net business interest in excess of 30% of adjusted taxable income.[2] Any interest deductions disallowed by this limitation may be carried forward to future years indefinitely.[3]
Adjusted taxable income is determined by adding back to taxable income any deductions for nonbusiness income, net business interest, net operating losses, qualified business income, and — for taxable years beginning before 2022 — depreciation, amortization and depletion.[4]
Congress intended this definition of adjusted taxable income as a tax code proxy for the financial statement concept of earnings before interest, taxes, depreciation and amortization, or EBITDA.
For taxable years beginning after 2021, however, taxpayers may not add depreciation, amortization and depletion deductions back to taxable income for purposes of computing adjusted taxable income — thus approximating the financial statement concept of earnings before interest and taxes, or EBIT.
EBIT Versus EBITDA
EBIT and EBITDA both are common measures of a company's performance, but they approximate different methods, and that has important implications in designing an effective interest limitation. Investors tend to use EBIT to measure a company's accrual basis operating income, whereas they tend to use EBITDA to measure cash flow.
Given these two options, banks and their regulators generally compare a borrower's debt to its EBITDA to determine the risk of a loan. Similarly, credit agencies use EBITDA to assess a company's probability of defaulting on its debt, and thus to determine that company's credit rating.
With respect to tax policy, international norms also favor EBITDA over EBIT. In 2015, the Organization for Economic Cooperation and Development issued its report — "Limiting Base Erosion Involving Interest Deductions and Other Financial Payments" — on Action 4 of its base erosion and profit shifting, or BEPS, project, and in 2016 the OECD updated that report.[5]
In providing a template for national governments to adopt interest limitations, the OECD recommended using EBITDA to measure overleverage.[6] According to the OECD:
EBITDA is the most common measure of earnings currently used by countries with earnings-based tests. By excluding the two major non-cash costs in a typical income statement (depreciation of fixed assets and amortisation of intangible assets), EBITDA is a guide to the ability of an entity to meet its obligations to pay interest. It is also a measure of earnings which is often used by lenders in deciding how much interest expense an entity can reasonably afford to bear.[7]
In the aftermath of BEPS Action 4, national governments overwhelmingly have adopted EBITDA as the tax law standard for leverage ratios. For instance, of the 27 European OECD member countries, 26 had adopted interest limitations as of 2020.[8]
Of those, four rely exclusively on debt-equity ratios rather than either EBIT or EBITDA. But the other 22 countries all use EBITDA, with 19 countries adopting a 30% limitation and three countries adopting a 25% limitation. As of 2020, none used EBIT.
Legislative History
Congress enacted the business interest limitation due to a concern "that the general deductibility of interest payments on debt may result in companies undertaking more leverage than they would in the absence of the tax system."[9]
With both the financial crisis and the OECD BEPS project still fresh in legislators' minds, Congress saw the tax code as encouraging excessive leverage. Enter IRC Section 163(j) — Congress' attempt to level the playing field between debt financing and equity financing once a certain leverage threshold is reached.[10]
The switch from EBITDA to EBIT four years after the general effective date of the TCJA represents a compromise between the U.S. House of Representatives and U.S. Senate versions of the TCJA.
While both the House and Senate passed similar versions of a business interest limitation, the House-passed bill adopted EBITDA as the permanent definition of adjusted taxable income,[11] while the Senate adopted EBIT. The conference committee compromised by applying EBITDA for four years, and EBIT thereafter.
EBIT Discourages Investment
But what if Congress designed Section 163(j) in such a way that it would discourage, at the margin, additional equity-financed capital investment involving no increase in leverage whatsoever?
And what if, in doing so, Congress inadvertently favored capital investment in other countries vis-à-vis the U.S.? Would that not be contrary to the core purpose of both section 163(j) and the TCJA?
Consider that if a company which is already at or above the 30% limit evaluates a new investment opportunity, under EBIT that company would lose interest deductions even if the investment is made entirely with equity financing. Why? Because even though net interest expense remains unchanged in the numerator of the ratio, the investment will generate depreciation deductions that reduce adjusted taxable income — i.e., the denominator.
Reducing the denominator increases the overall ratio and disallows additional interest expense, causing the new depreciation deductions generated by the investment to be offset partially by lost interest deductions.
Thus, the use of EBIT to calculate adjusted taxable income has the same effect as requiring slower depreciation schedules for taxpayers above the 30% limit, even for investments financed entirely by equity. Making permanent the use of EBITDA as the definition of adjusted taxable income avoids this perverse, negative impact on equity-financed capital investment.
Example
Assume Taxpayer has $300 of net business interest expense and adjusted taxable income of $1,000. Its section 163(j) limitation is 30% of adjusted taxable income, or $300. Thus, Taxpayer initially may deduct interest fully, with no disallowance.
Taxpayer then decides to make a $400 capital investment, which is (1) eligible for 100% bonus depreciation under IRC Section 168(k), and (b) funded entirely out of equity — i.e., without any additional debt financing.
Scenario 1: Adjusted Taxable Income = EBITDA (before 2022)
| Net business interest expense |
= |
$300 |
| Depreciation deduction |
= |
$400 |
| Adjusted taxable income |
= |
$1,000 |
| Interest limit under section 163(j) |
= |
$300 (30% x $1,000) |
| Interest disallowed |
= |
$0 |
Using EBITDA, adjusted taxable income is computed by ignoring depreciation and amortization deductions. So, the $1,000 is not reduced by the $400 depreciation deduction, Taxpayer's leverage ratio does not exceed 30% and interest remains fully deductible.
Scenario 2: EBIT (after 2021)
| Net business interest expense |
= |
$300 |
| Depreciation deduction |
= | $400 |
| Adjusted taxable income |
= |
$600 ($1,000 - $400) |
| Interest limit |
= |
$180 (30% x $600) |
| Interest disallowed |
= |
$120 |
Using EBIT, by making a $400 capital investment and taking a $400 bonus depreciation deduction, Taxpayer reduces $1,000 adjusted taxable income to $600, resulting in disallowance of $120 of interest deductions.
In effect, Taxpayer only enjoys a net deduction of $280 for making a $400 investment — the economic equivalent of having its 100% bonus depreciation deduction reduced to 70%.
This is true even though the investment was funded entirely by equity, making this rule a tax increase on investment, not a tax increase on overleverage.
In fact, this result could be worse than merely replacing 100% bonus depreciation with 70% bonus depreciation. That is because under 70% bonus depreciation, Taxpayer would depreciate the remaining 30% — or $120 — in adjusted basis using the modified accelerated cost recovery system of IRC Section 168, which still provides a form of accelerated depreciation.
In the example above, the $120 of disallowed interest is suspended until a year in which Taxpayer falls under the 30% limitation, at which point Taxpayer may deduct interest carryforwards until its total business interest deduction reaches 30% of adjusted taxable income.
Thus, the $120 in interest carryforwards could take much longer to recover than $120 of basis depreciated under the modified accelerated cost recovery system — and possibly never, if Taxpayer is perpetually above the 30% threshold.
Conclusion
Currently, at least two dozen tax provisions are scheduled to expire after Dec. 31, including the use of EBITDA on Section 163(j).[12]
Of particular significance to metropolitan areas suffering from an affordable housing crisis, a temporary 12.5% increase in the state low-income housing tax credit allocation also expires at the end of 2021.[13]
In addition, Congress might enact temporary tax policies during the course of 2021 in response to the ongoing pandemic and economic recovery needs, with expiration dates at the end of the year.
As Congress considers which of these expiring tax provisions to extend beyond 2021, it should act to save the "DA" in EBITDA by making permanent the definition of adjusted taxable income currently in force, allowing taxpayers to disregard depreciation, amortization and depletion deductions in computing adjusted taxable income.
Inaction, whereby EBIT would come into force, would turn a rule that Congress intended to discourage excessive debt into a rule that instead discourages debt-free investment — especially when compared unfavorably with the EBITDA-based interest limitations adopted by our major competitors. That would be a perverse result indeed.
George Callas is a managing director of the government affairs and public policy, and tax groups at Steptoe & Johnson LLP. He is a regular contributor to Tax Authority Law360.
Disclosure: The author was previously senior tax counsel to former House Speaker Paul Ryan, and was a lead House Republican staff negotiator on the Tax Cuts and Jobs Act, discussed above.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] Pub. L. No. 115-97
.[2] IRC §163(j)(1)
. In 2020, Congress enacted a temporary rule as part of the Coronavirus Aid, Relief and Economic Security, or CARES, Act that increased the 30% limitation to 50% for taxable years beginning in 2019 and 2020. See Pub. L. No. 116-136, § 2306 . That increase is not currently in effect for 2021, but Congress also should consider extending the 50% limit for an additional year given that the economic conditions precipitated by the pandemic — including both higher business debt levels and lower income — continue to push more businesses into the Section 163(j) limitation than otherwise would be the case.[3] IRC §163(j)(2)
.[4] IRC §163(j)(8)
.[5] See "Limiting Base Erosion Involving Interest Deductions and Other Financial Payments Action 4 – 2016 Update," OECD/G20 Base Erosion and Profit Shifting Project, OECD, found at https://www.oecd-ilibrary.org/docserver/9789264268333-en.pdf?expires=1612211514&id=id&accname=guest&checksum=77727A5A9AB12C209A4537C3C06D2C13.
[6] Id. at 49, para. 82.
[7] Id. at 48, para.78. In recommending EBITDA, the OECD also included EBIT as a best practice if some countries decided they prefer EBIT.
[8] "Thin-Cap Rules in Europe," Tax Foundation, found at https://taxfoundation.org/thin-capitalization-rules-thin-cap-rules-europe-2020/.
[9] H. Rep. No. 115-409. at 247.
[10] As mentioned above, this excludes other EBITDA-based federal inter-agency guidance on leveraged lending issued by the Federal Reserve Board, the Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency.
[11] Id. § 3301.
[12] See "List of Expiring Federal Tax Provisions, 2021-2029," JCX-1-21 (January 27, 2021), found at https://www.jct.gov/CMSPages/GetFile.aspx?guid=21679d86-7613-4865-8030-9accef7f7d91. This list includes only 23 provisions because it omits the change from expensing of research expenditures to five-year amortization for expenditures incurred after Dec. 31.
[13] IRC § 42(h)(3)(I)
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