This report provides initial impressions and observations about the 163(j) Package’s application in the context of state and local taxes.
For a discussion of the general background and applicability dates for the Final Regulations and the 2020 Proposed Regulations, as well as links to other 163(j) Package Focus Reports, read TaxNewsFlash
Differences in federal and state law add complexity in determining how section 163(j) applies at the state level. Those differences generally fall into three categories: (1) filing methodologies; (2) conformity to the Internal Revenue Code; and (3) modifications under state law. With respect to filing methodologies, most states do not follow the federal consolidated return rules and instead require taxpayers to file on a separate company basis or use a combined report with membership that often does not match that of the federal consolidated group. Because the Final Regulations provide for a single section 163(j) limitation for a federal consolidated group, this disconnect with state filing methods necessitates recalculating the section 163(j) limitation for state purposes (possibly multiple times given the lack of a uniform filing method among states). As for conformity to the Internal Revenue Code, approximately 35 states currently adopt section 163(j) for purposes of their corporate income taxes. That conformity, however, is far from uniform. For example, certain states that do not automatically conform to federal tax law changes remain tied to the pre-CARES Act version of section 163(j). Finally, states often require modifications to the calculation of state taxable income that can affect the ability of a taxpayer to deduct its interest expense. Those modifications include more general provisions limiting the ability of taxpayers to deduct certain interest paid to related parties and more specific modifications related to the section 163(j) limitation (e.g., Virginia allows taxpayers a deduction for 20% of the amount disallowed federally by section 163(j)).
One of the key provisions in the Final Regulations with significant implications for state corporate income taxpayers is the confirmation that a federal consolidated group has a single section 163(j) limitation. Under the Final Regulations, the calculation of a consolidated group’s limitation requires intercompany obligations between members of the same consolidated group to be disregarded for purposes of determining business interest expense and business interest income. For groups of affiliated corporations that do not elect to file a federal consolidated return, however, the section 163(j) limitation for each of the members of that group is determined separately and the intercompany obligations are not disregarded in determining the limitation. While providing clarity for federal taxpayers, this approach creates compliance headaches in many states and can result in significant differences between the section 163(j) limitation calculated at the state and federal levels.
For state purposes, a member of the federal consolidated group is often required to file a separate company state return and calculate state taxable income beginning with federal taxable income determined as if the corporation had not elected to file a federal consolidated return. This is the general approach in states that require separate company return filing. Also, certain states that require combined reporting start the calculation of the combined group’s state taxable income with each group member’s separate company federal taxable income. Over half of the states that adopt section 163(j) require these separate company calculations. Even in combined reporting states that do conform to the federal consolidated return rules, taxpayers may find state-specific section 163(j) calculations are necessary. For example, the membership of a state combined group may not mirror the federal consolidated group because of differing rules for which entities must be included in the group (e.g., many states use a greater than 50% ownership threshold for group inclusion rather than the 80% ownership threshold used for a federal consolidated return). For taxpayers filing federal returns on a consolidated basis, this could result in significant differences in the applicable state section 163(j) limitation from what is computed on the taxpayer’s federal consolidated income tax return (and any associated carryovers of disallowed interest expense deductions).
Even in states that generally conform to the federal consolidated return regulations, the application of the consolidated group rules in the Final Regulations could create state-specific issues. For example, some states require or permit groups of related taxpayers to elect a combined or consolidated filing method that often consists of more or less members than the federal consolidated group (e.g., where the ownership threshold for group membership is greater than 50% rather than the 80% ownership requirement for a federal consolidated return group). In those cases, the state section 163(j) limitation may need to be recomputed by applying the consolidated group rules in the Final Regulations to the state combined group.
Of the states that conform to section 163(j), only a handful have issued guidance on translating a federal consolidated group section 163(j) limitation into the calculation of state taxable income. That guidance has not always been intuitive. While not generally conforming to the federal consolidated return rules, New Jersey has released guidance providing that “taxpayers should make adjustments applying the section 163(j) limitation as though they had been included on a single federal consolidated return” to account for situations in which the federal consolidated group may differ from the New Jersey combined group. Also, despite its requirement that corporations file on a separate company basis, the Pennsylvania Department of Revenue has issued guidance providing that no section 163(j) limitation is expected at the state level if there is no limitation for the federal consolidated group of which the separate company is a member. Only if there is a federal limitation at the consolidated group level is the separate Pennsylvania filer required to compute a Pennsylvania limitation.
In states that require combined reporting but that may not follow the federal consolidated return rules, states have taken different approaches for addressing whether and to what extent one member’s excess limitation may be used by other members of the group. Massachusetts, for example, allows a combined group to apply one entity’s excess limitation to offset another entity’s excess business interest expense. Conversely, Michigan does not allow an entity’s excess limitation to be shared among group members.
As if the state specific computations were not complicated enough, there will be additional complexities on 2019 returns because certain states do not adopt the changes in the CARES Act that increase the amount of interest allowed to be deducted to 50% of Adjusted Taxable Income (“ATI”).
Interest expense deductions disallowed under section 163(j) may generally be carried forward indefinitely. In states that require the calculation of the section 163(j) limitation to be done on a separate company basis, the carryforwards of disallowed interest deductions may be significantly different from those calculated for federal purposes. With respect to those carryforwards, the Final Regulations provide guidance on the application of section 382 limitations and SRLY-type rules for federal consolidated groups. In states that require corporations to file on a separate company basis or use their own rules for allocating tax attributes to members of a combined group, a complicated analysis may be required to determine which entities may carry forward unused section 163(j) interest expense deduction carryforwards and whether any limits apply to the use of those carryforwards in the state, especially in situations in which there is a merger or acquisition. Few states have provided guidance on this issue to date.
Of the states that conform to section 163(j), almost half currently have rules that disallow the deduction of interest or intangible-related interest paid to related parties. The intersection of these two provisions creates an ordering problem unique to state corporate income tax: Is the state related-party interest limitation applied before or after the section 163(j) limitation?
How a state answers this question also affects future years when a taxpayer deducts interest disallowed in a prior year under section 163(j). The taxpayer in that case would need to trace which portion of the federal limitation related to interest subject to the state addback provision in the year it was limited by section 163(j).
Fewer than 10 states have released guidance addressing this issue. Generally, taxpayers are required to proportionally apply the limitation to related and third-party interest expense. At least one state (Massachusetts), however, applies a different approach. Massachusetts requires taxpayers to apply the section 163(j) limitation after applying the related party addback rules. The Massachusetts approach is generally more favorable to taxpayers because the section 163(j) limit is not computed using related party interest expense that may be disallowed.
As with corporations, the effects of section 163(j) on the state taxation of partnerships and their partners vary depending on whether states conform to the federal provision. Even if a state adopts section 163(j) generally, it may not conform to the recent amendments to section 163(j) in the CARES Act, or it may have its own state law provisions that alter the application of section 163(j) for state purposes. For a state that does not conform to a computation used in determining federal taxable income, such as section 163(j), a disconnect arises that leads to separate computations, reporting, and tracking.
For example, if a decoupling state does not apply section 163(j) to a partnership and its partners in a year in which section 163(j) would limit the partnership’s interest deduction, the partnership and its partners would likely be allowed a greater interest deduction in that state than would be allowed federally. In a subsequent tax year, if the partnership’s “excess items” result in the partners taking a deduction for the interest expense from the prior tax year on their federal returns, then the partners, who already deducted this interest expense for the prior tax year in the decoupling state, would not be permitted another deduction for this same interest expense on the tax return filed with this decoupling state. Tracking is required as a result of the variance in timing of deductibility between the potential future tax year federal deduction for this interest expense at the partner level and the current state deduction taken for unlimited interest expense in a decoupling state at the partnership and partner levels.
In the partnership context, the various filings that are potentially affected by section 163(j) limitations can include tax returns for partnerships taxed at the entity level, partnership filings that report state income to partners, nonresident withholding returns, partner composite tax returns, and partner individual or corporate tax returns. While partnerships are required to report state source income and nonresident withholding credits up through multiple layers of tiered partnerships, for conforming states, the “entity approach” retained by the 2020 Proposed Regulations correspondingly limits the state reporting for section 163(j) to the direct partner level. However, for decoupling states, the additional deduction for interest expense paid or accrued in the current tax year results in the need to report that adjustment up through multiple tiers. This also requires reporting a corresponding adjustment in a later tax year if the interest expense disallowed by section 163(j) becomes deductible in computing federal income, so that the expense is not deducted again in computing income for that decoupling state.
Both the Final Regulations and the 2020 Proposed Regulations include various provisions regarding partner basis. State decoupling from section 163(j) can result in the requirement to track state-specific partner basis in certain states. For example, California has not conformed to section 163(j) and requires partners to track California-specific basis values. Adjustments may also be needed in jurisdictions like New York State and City, which conform to section 163(j) under the Tax Cuts and Jobs Act, but that have generally decoupled from the more recent CARES Act changes to section 163(j). This also affects entity-level taxes imposed on partnerships such as the New York City Unincorporated Business Tax.
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