Notice: Corporate Income Tax Treatment of the IRC 163(j) Business Interest Limitation

NOTICE: CORPORATE INCOME TAX TREATMENT OF THE IRC 163(j) BUSINESS INTEREST LIMITATION

Issued: June 8, 2020

The Federal Tax Cuts and Jobs Act  imposed a limitation on the deduction of business interest expense (BIE) effective for tax years beginning after December 31, 2017.[1] The Coronavirus Aid, Relief and Economic Security (CARES) Act amended the BIE limitation for tax years beginning in 2019 or 2020.[2] BIE is deducted in arriving at federal taxable income (FTI), which is the starting point for Michigan’s Corporate Income Tax (CIT).[3] This Notice provides guidance on how the business interest expense limitation (BIEL) under Internal Revenue Code (IRC) section 163(j) impacts Michigan’s CIT, especially for unitary business groups (UBGs).

FEDERAL TREATMENT OF IRC 163(j)

General

Under IRC 163(j), the deduction allowed for BIE for any tax year generally cannot exceed the sum of:

  1. The taxpayer's business interest income for the taxyear,
  2. 50% of the taxpayer's adjusted taxable income (ATI),[4]
  3. The taxpayer's floorplan financing interest (certain interest paid by vehicle dealers) for the tax year.

However, the limitation does not apply to the tax year of a taxpayer (other than a tax shelter) if the taxpayer’s average annual gross receipts for the preceding three-year period do not exceed

$25 million (referred to as the exemption for small businesses).[5] In addition, BIE allocable to certain excepted trades or businesses is not subject to this limitation.[6]

BIE subject to the limitation is specifically defined for purposes of IRC 163(j), and references in this notice to BIE mean “business interest” as defined in IRC 163(j)(5).

BIE that is not deductible because of the limitation is treated as BIE paid or accrued in the following tax year and may generally be carried forward by corporations indefinitely, in chronological order.[7]

A group of persons that is an “affiliated group”[8] may elect to file a consolidated federal return.[9] Generally, for federal income tax, the IRC 163(j) BIEL applies at the consolidated return level, and a consolidated return has a single limitation.

Proposed regulations for 163(j) were issued by the IRS in late 2018.[10] The Department’s analysis and conclusions are premised on the guidance provided in these proposed regulations. To the extent the final regulations contain guidance that materially differs from the proposed regulations, the conclusions set forth in this Notice may diverge. The Department will provide guidance regarding the areas where the conclusions change due to any changes in that federal guidance.

MICHIGAN TREATMENT OF IRC 163(j)

General

Michigan conforms to the current IRC[11] and has not decoupled from the BIEL of IRC 163(j); therefore, Michigan conforms to the federal limitation when computing CIT liability.

A taxpayer begins computing its CIT tax base with FTI, which already incorporates any BIE deducted at the federal level. A CIT taxpayer or UBG member that files a separate federal return has no further adjustments to make to report FTI on its Michigan return. Conversely, a UBG member or CIT taxpayer that filed a federal consolidated return will have additional calculations.

For federal income tax, an affiliated group may elect to file a consolidated return.[12] In contrast, the CIT requires a UBG to file a combined return.[13] The Department has consistently recognized that consolidated and combined filing are not the same and has required each UBG member that is included on a federal consolidated return to separately compute a pro forma federal return. In other words, all the components of a federal return are separately computed to arrive at a member’s pro forma FTI. Each member’s pro forma FTI is reported on Form 4897, line 21 and amounts for all members are summed together to determine the UBG’s FTI. The combined pro- forma FTI of a UBG will not necessarily equal the FTI on the federal consolidated return, even if membership in the two returns is the same. The Department relies primarily on section 691 of the CIT for these propositions.

[A] unitary business group shall file a combined return that includes each United States person that is included in the unitary business group. Each United States person included in a unitary business group or included in a combined return shall be treated as a single person[14]

A C corporation that is part of a federal consolidated return but files separately for Michigan purposes (i.e., is not included in a UBG of standard taxpayers) has also historically been required to compute its pro forma federal return to report its pro forma FTI on Form 4891, line 12. A C corporation that is required to prepare a pro forma federal return as described in this section is referred to in this Notice as a “pro forma corporation.”

It is the general intent of the Department that when consistent with Michigan statute, the IRC and supporting regulations will be followed when computing pro forma BIE, including the meaning and calculations of BIE, business interest income, ATI, floor plan financing interest, and the applications of the small business exemption and excepted trade or business activity (including elections).

Small Business Exemption and Excepted Trades or Businesses:

If the consolidated group return in which a pro forma corporation filed was exempt from the BIEL for federal purposes, that pro forma corporation is exempt from the BIEL in computing its pro forma FTI for CIT purposes. This includes pro forma corporations in consolidated groups that meet the small business exemption as well as those engaged (or treated as engaged) in an excepted trade or business. Conversely, if a pro forma corporation was subject to a BIEL on its federal consolidated return, it is likewise subject to a BIEL in computing pro forma FTI for CIT purposes.

CIT Tax Base for Pro forma Corporations

Federally, the BIEL applies at the consolidated return level, and a consolidated return has a single limitation. Despite the results of the consolidated return, each pro forma corporation that was subject to BIEL federally must separately calculate (like the other components of FTI) a pro forma BIE to arrive at its pro forma FTI. BIE allowed in pro forma FTI is computed using the rules set out in IRC 163(j) and its supporting regulations, as applied to a pro forma corporation on a standalone basis. For example, a pro forma corporation considers only its own BIE, business interest income, and ATI in determining its limitation for CIT purposes. In addition, for purposes of computing its pro forma BIEL, a pro forma corporation does not eliminate transactions with companies that were included in the federal consolidated return.[15]

If a UBG member’s BIEL exceeds its BIE, no other members of the UBG are permitted to use that member’s excess (“unused”) limit.  Conversely, if a UBG member's BIE exceeds its BIEL, that UBG member carries forward the unused BIE as that UBG member’s (and only that member’s) BIE in subsequent years.

Pro forma Adjusted Taxable Income

Adjusted taxable income is defined to mean, in part,

[T]he taxable income of the taxpayer…computed without regard to—

(v) in the case of taxable years beginning before January 1, 2022, any deduction allowable for depreciation, amortization, or depletion…[16]

In that context, allowable depreciation includes bonus depreciation under IRC 168(k). However, for purposes of Michigan CIT, FTI is defined as though IRC 168(k) were not in effect since its inception for all tax years beginning after December 31, 2011.[17]  Similarly, in computing pro forma BIEL, pro forma ATI should be calculated without regard to bonus depreciation for tax years beginning after December 31, 2021.   

Michigan Eliminations for UBGs

Section 691 provides,

Each United States person included in a unitary business group or included in a combined return shall be treated as a single person, and all transactions between those persons included in the unitary business group shall be eliminated from the corporate income tax base[18]

Therefore, to the extent included in the “corporate income tax base,” a UBG member must eliminate (among other intra-UBG transactions) the pro forma BIE attributable to transactions with other members of the UBG. If a member’s pro forma BIE deducted in arriving at pro forma FTI is limited due to IRC 163(j), that member should eliminate pro forma BIE only to the extent that it was deducted in arriving at pro forma FTI. In addition, a UBG member that lent to another member must eliminate its interest income to the extent included in that member's pro forma FTI (generally, the entire amount).

If a UBG member’s pro forma BIE is limited by IRC 163(j) and that BIE is attributable to more than one lender—specifically, some interest is paid to a fellow UBG member and other interest is paid to a lender that is not a member of the UBG—for purposes of eliminations, the limited BIE is attributed proportionally using a fraction, the numerator of which is BIE before limitation to the fellow UBG member and the denominator of which is BIE before limitation to all sources. The BIE attributed to fellow UBG members must be eliminated from the corporate income tax base.

Michigan Carryforward of Disallowed Interest for Consolidated Returns

A pro forma corporation is required to track in its books and records, and report in an attachment to its CIT return, any Michigan carryforward of disallowed BIE. Michigan BIE carryforward is computed using the rules set out in IRC 163(j) and its regulations, as applied to a pro forma corporation on a standalone basis. For instance, current year pro forma BIE must be used before Michigan carryforward BIE from prior years, and Michigan carryforward BIE can be carried forward indefinitely in chronological order. Michigan carryforward BIE may differ from the entity’s federal carryforward amounts.

A UBG member is not permitted to use the carryforward or disallowed BIE of another UBG member.

Reasonable Cause Penalty Waivers

If a taxpayer fails to file a return or pay a tax within the time specified and incurs a penalty for that failure, the Department shall waive that penalty if the taxpayer shows to the satisfaction of the Department that the failure was due to reasonable cause and not to willful neglect.[19] If there is a tax deficiency due to not calculating BIE correctly in accordance with Department guidance, and that is the only reason for the deficiency, the Department will consider that as sufficient factual evidence of reasonable cause to justify waiver of penalty upon a taxpayer’s request. For information on how to seek a waiver request for reasonable cause, which must be in writing, see Michigan Administrative Code Rule 205.1013 and Revenue Administrative Bulletin 2005-3.

 

[1] P.L. 115-97, § 13301.

[2] P.L. 116-136, § 2306.

[3] This notice addresses only the income tax levied under Part 2 of the Michigan Income Tax Act of 1967, MCL 206.601 et seq. and is not applicable to the income tax on individuals, trusts, and estates under Part 1, the premiums tax under Chapter 12,  or the franchise tax under Chapter 13.

[4] The ATI limitation for tax years beginning in 2019 or 2020 is 50%, subject to a taxpayer’s election to use a 30% limit.  For tax year 2020, a taxpayer may elect to use its 2019 ATI as the base in computing its 2020 ATI limit. IRC 163(j)(10). The ATI limit for tax year 2018 and tax years beginning after 2020 is 30%.

[5] IRC 163(j)(3), which relies on IRC 448(c)’s gross receipts test. The amount used for the test is indexed for inflation. IRC 448(c)(4).

[6] IRC 163(j)(5)-(7), Prop. Reg. 1.163(j)-9 and 1.163(j)-10.

[7] IRC 163(j)(2); Prop. Reg. 1.163(j)-5.

[8] IRC 1504.

[9] IRC 1501.

[10] Notice of proposed rulemaking REG-106089-18.

[11] MCL 206.607(6). Alternatively, a taxpayer may conform to the IRC in effect as of January 1, 2018.

[12] IRC 1501.

[13] MCL 206.691.

[14] MCL 206.691, emphasis added.

[15] As opposed to computing ATI and a member’s business interest income and BIE for a consolidated return, which require intercompany transactions and obligations to be disregarded. Prop. Reg. 1.163(j)-4(d)(2)(iv) and (v). Because this pro-forma corporation is treated as a single person for purposes of its Michigan return, there are no “intercompany” transactions or obligations.

[16] IRC 163(j)(8).

[17] MCL 206.607(1).

[18] MCL 206.691, emphasis added. Corporate income tax base means a taxpayer’s business income subject to additions, subtractions, allocation or apportionment. MCL 206.623(2). Therefore, UBG eliminations are required after the UBG has reached its business income, which is arrived at after group-level pro-forma FTI.

[19] MCL 205.24(2), (4).