As Gertrude Stein famously noted nearly a century ago, “A rose is a rose is a rose.” While this aphorism may be accepted in the mundane, it is unfortunately less established when the tax laws address EBITDA.
The common accounting abbreviation EBITDA is used to describe earnings before interest, taxes, depreciation, and amortization. The final two elements of this abbreviation – depreciation and amortization or “DA” – are a key source of consternation for businesses facing new limitations on the tax deduction for interest expense. Proposed regulations released at the end of 2018 would require businesses to classify certain types of depreciation and amortization as something other than what they are, and that classification would drive down the amount of interest that can be deducted, particularly for manufacturers.
Business Interest Limitation Basics
Businesses must limit deductions for interest expense as a result of changes made under the new tax law commonly known as the Tax Cuts and Jobs Act (TCJA). The TCJA specifies under Section 163(j) that businesses can deduct no more interest expense than their interest income plus 30% of adjusted taxable income for a given year. Adjusted taxable income for this purpose is roughly equivalent to tax-basis EBITDA. The proposed regulations provide that adjusted taxable income is computed without regard to business interest expense or business interest income, carryforward deductions for net operating losses and capital losses, the qualified business income deduction, and for tax years beginning before Jan. 1, 2022, deductions for depreciation, amortization, and depletion. Other less common adjustments also apply.
The calculation of earnings before items such as depreciation and amortization means that there is a higher figure for tax-basis earnings upon which the 30% limit is based. This allows businesses to deduct more interest expense for tax years beginning before Jan. 1, 2022. But if certain types of depreciation and amortization are regarded as something different that is required to deducted, then the tax-basis earnings figure drops. This leads to a lower adjusted taxable income figure upon which the 30% limit is based, which in turns means affected businesses can deduct less interest expense.
Controversy under Proposed Regulations
Enter the unexpected rule under the proposed regulations concerning the treatment for certain types of depreciation and amortization. Proposed regulations section 1.163(j)-1(b)(1)(iii) provides:
Depreciation, amortization, or depletion expense that is capitalized to inventory under section 263A is not a depreciation, amortization, or depletion deduction for purposes of this paragraph (b)(1).
Alas, a rose is a rose except when it is not. The position in the proposed regulations seemingly flies in the face of the plain language of the law Congress passed, where adjusted taxable income is computed without regard to any deduction allowable for depreciation, amortization, or depletion. The legislative history to the TCJA (H.R. Rep. 115-466, at 234) also does not indicate an intention to treat one type of depreciation and amortization differently than another. Although the regulation distinguishes an “expense” from a “deduction,” Section 263A requires capitalization of amounts only if they would otherwise be deductible.
For tax purposes, a business generally capitalizes depreciation and amortization costs that are allocable to the production or acquisition of inventory. These capitalized costs are then recovered throughout the year as cost of goods sold, or are recovered in subsequent years to the extent inventory remains on hand. In this sense, all depreciation and amortization that is allocable to the production or acquisition of inventory is initially capitalized, but may not remain capitalized at the end of a tax year if the subject inventory was sold. Under this framework, all depreciation and amortization that is initially capitalized to inventory is treated by the proposed regulations as something other than depreciation and amortization, meaning there is no earnings adjustment for the depreciation and amortization that was deducted as cost of goods sold.
Manufacturing businesses incur large expenditures for depreciation and amortization as a result of their capital intensive industry. They also incur large interest expenditures for the same reason. If the proposed regulations are finalized, this industry will be particularly disadvantaged in the near term as manufacturers will have substantially less tax-basis earnings upon which the 30% interest deduction is based.
Many professionals in the tax community accepted the invitation to comment on the proposed regulations and disagreed strongly with this proposal, which effectively accelerates to today the change in calculation for depreciation and amortization that is not scheduled until Jan. 1, 2022.
The proposed regulations are not effective until there is a Treasury decision that adopts the regulations as final. And of course, the proposed regulations are subject to change until the time they are finalized. But taxpayers have already closed the books for tax years subject to the new Section 163j interest limitations under the TCJA. The proposed regulations permit taxpayers the choice of relying on the proposed regulations in tax returns that must be filed now, provided that all of the rules in the proposed regulations are followed. In other words, taxpayers cannot cherry-pick the parts of the proposed regulations they want and expect to receive the protections afforded by those particular parts.
This puts manufacturers in a precarious position. On the one hand, the proposed regulations provide a sanctuary under which the IRS will not challenge taxpayer positions if they follow all the proposed regulations’ requirements. On the other hand, the controversial treatment of depreciation and amortization may severely limit the deduction for interest expense. And the IRS might heed the advice contained in the various comments that were submitted on this issue, where the final regulations might back off of this requirement after all.
In the meantime, businesses must weigh these choices in a decision to adopt the proposed regulations for tax returns to be filed prior to the time final regulations are published. A decision that runs contrary to the proposed regulations should be made with due consideration to the potential risks involved, and should take into account Congressional intent and the substantial authorities available.
For more information on the interest limitation and how it impacts your business, please contact your local tax professional.
Published on May 07, 2019