The new federal interest expense limitation is no different. In many states, it is unclear whether the federal interest expense limitation is tested on a separate-company or combined-group basis. Despite the significant impact this distinction can have on a corporate taxpayer’s state income tax liability, many states have yet to issue guidance. Although Massachusetts is one of several states without specific interest expense limitation guidance, the answer on how the limitation is tested may already be in regulations promulgated by the Department of Revenue.
New Internal Revenue Code section 163(j) limits a taxpayer’s interest expense to the sum of business interest income, 30 percent of adjusted taxable income (generally, taxable income before net operating loss, business interest, and depreciation), and floor plan financing interest.1 The IRC requires taxpayers to compute the limitation on an entity-by-entity basis. While Treasury regulations applicable to taxpayers electing to file a consolidated federal return require taxpayers to compute the limitation on a consolidated-group basis, most states do not conform to these regulations.2 Thus, a mechanical application of the law in states that do not conform to the regulations generally
requires a taxpayer to follow the IRC and test the limitation on a separate-company basis — even if the state has adopted combined reporting.
There is no sound policy justification for applying this mechanical, separate-company testing approach — a method that is often detrimental to taxpayers. This is especially true in
states that require combined reporting. The same rationale that applies at the federal level to test the limitation on a consolidated-group basis applies at the state level to test the limitation on a combined-group basis. That is, there is no reason to prevent deductible interest payments among members of the consolidated or combined group when their income is combined in computing the tax base.
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- IRC section 163(j)(1), (8). The new limitation is effective for tax years beginning after December 31, 2017, and does not apply to all taxpayers (e.g., businesses with average gross receipts of less than $25 million over the prior three years). Section 163(j)(3). For tax years beginning after December 31, 2021, ATI reflects depreciation, so section 163(j) will potentially affect more taxpayers. Section 163(j)(8).
- Prop. reg. section 1.163(j)-4(d).