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Interest capitalization provisions may reduce Section 163(j) interest disallowance
October 2022
In brief
The 2017 tax reform act amended Section 163(j) to limit the amount of business interest a taxpayer may deduct. A taxpayer may reduce the amount of disallowed interest by increasing the amount of capitalized interest, which is not subject to disallowance. Several provisions under the Code —including Sections 263(a), 263A, and 266 -- require or allow taxpayers to capitalize interest to property. Interest that is capitalized into tangible property is recovered over a period of time as depreciation, while interest that is capitalized into inventory is recovered as cost of goods sold.
For consideration: Taxpayers with significant interest subject to disallowance may want to conduct modeling to determine if the decrease in deductions and corresponding effect on taxable income as a result of capitalizing additional interest is offset by the reduction in the amount of interest disallowed under Section 163(j).
In detail
Section 163(j)
Amended Section 163(j) limits a taxpayer’s deduction for business interest to the sum of (1) business interest income, (2) 30% of adjusted taxable income (ATI, 50% for tax years beginning in 2019 or 2020, by election), and (3) floor plan financing interest.
Regulations provide that Section 163(j) applies after the application of provisions that subject interest expense to disallowance, deferral, capitalization, or other limitation. Capitalized interest loses its character as interest for purposes of Section 163(j) and is not subject to disallowance.
Although the regulations identify specifically only Section 263(g) (requiring capitalization of interest and carrying charges properly allocable to personal property that is part of a straddle, defined in Section 1092(c))1016 and Section 263A(f) as provisions providing for capitalization of interest, these sections are given only as examples. Other provisions that allow interest to be capitalized to property include Sections 263(a) and 266.
Section 263A
Taxpayers that produce self-constructed property that is designated property must capitalize interest costs on debt that could have been avoided during production of the property. Designated property generally is real or tangible personal property that has (1) a class life of 20 years or more, (2) an estimated production period exceeding two years, or (3) an estimated production period exceeding one year and an estimated cost of production exceeding $1 million. Various methodologies are available that could increase or decrease the capitalized interest allocated to the designated property.
Capitalized interest is added to the basis of the property produced and is recovered through depreciation beginning when the asset is placed in service.
Section 263(a)
Section 263(a) and the related regulations generally require taxpayers to capitalize amounts expended for tangible as well as intangible property. Regulations require taxpayers to capitalize costs to acquire, produce, or improve tangible property, including inventory, as well as costs that facilitate the acquisition or production of tangible property. For intangible property, taxpayers generally must capitalize expenses to acquire intangible property, create certain capitalizable intangibles, create a separate and distinct intangible asset, facilitate the acquisition or creation of a capitalizable intangible asset, or facilitate certain transactions such as the acquisition of a trade or business, an ownership interest in a business, or a restructuring or recapitalization of a business.
Taxpayers are not required, but may elect, to capitalize overhead costs that facilitate the acquisition of tangible or intangible property. Under generally accepted accounting and tax principles, ‘overhead’ generally includes interest. An amount facilitates a transaction if it is paid or incurred in the process of investigating or otherwise pursuing the transaction. Accordingly, taxpayers may be able to include interest that facilitates the acquisition or production of tangible property, including self-constructed assets or inventory, in the basis of the property to be recovered through depreciation or in inventory costs to be recovered as cost of goods sold.
Section 266
Section 266 provides that a taxpayer may elect, as provided in regulations, to charge to a capital account (either as a component of original cost or other basis under Section 1012 or as an adjustment to basis under Section 1016(a)(1)) otherwise deductible amounts paid or accrued for taxes and carrying charges relating to property. Specifically, regulations under Section 266 allow taxpayers to capitalize:
- Annual taxes, mortgage interest, and other carrying charges for unimproved and unproductive real property,
- Loan interest, certain taxes, and other necessary expenditures paid or incurred to develop or improve real property up to the time the development or construction work has been completed,
- Interest on a loan to purchase, transport, or install personal property, and certain taxes relating to personal property paid or incurred up to the later of the date installation or when the property is first put into use by the taxpayer, and
- Other taxes and carrying charges relating to property that otherwise are deductible and that in the opinion of the IRS are chargeable to a capital account, applying sound accounting principles.
Observation: The regulations do not further define ‘sound accounting principles.’ Arguably, the rule should apply to costs that may be capitalized for book purposes under generally accepted accounting principles (GAAP). Thus, for example, a taxpayer may be able to finance the acquisition and installation of software by means of a loan and capitalize the interest to the basis of the software when interest may be capitalizable under GAAP.
Under the Section 266 regulations, a taxpayer first must capitalize interest under Section 263A if the property is designated property. After applying the Section 263A rules, the taxpayer may elect to capitalize interest to designated property under Section 266 if the capitalization does not materially distort any computation under the Internal Revenue Code.
Observation: Capitalizing interest and other costs — and thereby increasing taxable income --- also may benefit taxpayers by, for example, utilizing expiring tax attributes such as net operating losses, minimizing the base erosion and anti-abuse tax, increasing the foreign-derived intangible income deduction, or reducing the book minimum tax.
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