New Jersey Issues Technical Bulletin to Address Corporation Business Tax Treatment of the Business Interest Expense Deduction

Summary

New Jersey issued guidance addressing the treatment of the Internal Revenue Code (IRC) Section 163(j) business interest expense limitation for corporation business tax purposes.  The approach could be considered unique compared to other states for New Jersey 2018 separate returns and for some New Jersey combined reports starting with tax years ending on or after July 31, 2019.  New Jersey also updated its website guidance regarding Section 163(j) for gross income tax purposes. 
 

Details

As part of federal tax reform, the 2017 tax reform known as the Tax Cuts and Jobs Act amended Section 163(j) to change the business interest expense deduction limitation effective for tax years beginning after December 31, 2017. For federal income tax purposes, business interest expense that exceeds the sum of 30 percent of the taxpayer’s “adjusted taxable income” (ATI), business interest income, and the taxpayer’s floor plan financing interest expense is nondeductible in the year of payment or incurrence. The nondeductible amount of business interest expense is treated as “excess interest” that may be carried forward indefinitely and re-enters the limitation calculation for the ensuing tax year(s). The ATI limitation is determined at the filer level (i.e., federal consolidated group, partnership, S corporation, etc.). Certain businesses, including real estate businesses and taxpayers with average annual gross receipts not exceeding $25 million for the three immediate tax years are not subject to IRC Section 163(j). 
 
The Internal Revenue Service issued proposed regulations on November 28, 2018. The proposed regulations provide general rules and definitions, including determination of the ATI limitation for affiliated groups filing federal consolidated returns. 
 

New Jersey Division of Taxation Technical Bulletin, TB-87

As part of New Jersey’s 2018 tax reform legislation, New Jersey conformed to Section 163(j), but the legislation also provided that the Section 163(j) limitation “shall apply on a pro-rata basis to interest paid to both related and unrelated parties . . .” On April 12, 2019, the New Jersey Division of Taxation issued a Technical Bulletin, TB-87, which addresses the New Jersey Corporation Business Tax (CBT) treatment of the Section 163(j) limitation.  For tax years ending prior to July 31, 2019, New Jersey requires corporations to file separate returns.  However, for tax years ending on or after July 31, 2019, New Jersey requires corporations that are engaged in a unitary business with other affiliates to file a New Jersey unitary combined report. See our tax alerts issued in July 2018 and November 2018 for more information on New Jersey’s mandatory unitary combined reporting and other 2018 New Jersey tax reform provisions.
 
Under the New Jersey CBT statute, New Jersey “entire net income” is “deemed prima facie to be equal in amount to the taxable income, before net operating loss deduction and special deductions, which the taxpayer is required to report . . . for federal tax purposes.”  Prior to New Jersey’s 2018 tax reform legislation mandating unitary combined reporting, New Jersey historically was a separate return taxing jurisdiction. Indeed, New Jersey’s CBT regulations still provide that “entire net income shall be determined on a separate entity basis as if the contemporaneous Federal return had not been a consolidated return.” Nonetheless, in MCI Communication Services, Inc. v. Director, Division of Taxation (2015) the New Jersey Tax Court agreed with the Division of Taxation that taxable income, as reported on a federal consolidated return, constitutes a taxpayer’s “entire net income” for New Jersey CBT purposes. 
 
TB-87 relies on the reasoning of MCI Communication Services and the federal proposed Section 163(j) regulations for purposes of determining the New Jersey’s treatment of the Section 163(j) limitation and the pro-rata calculation applicable to related and unrelated party interest expense.  Accordingly, the federal consolidated group Section 163(j) ATI limitation that is reported for federal purposes is used for purposes of the New Jersey ATI limitation irrespective of whether the New Jersey taxpayer files a separate CBT return or as part of a New Jersey combined group. The portion of the federal consolidated group’s Section 163(j) limitation that is used for CBT purposes is the portion of the limitation that is allocated to the New Jersey taxpayer(s) under the federal consolidated return rules.  Furthermore, because intercompany items of interest income and expense offset within the federal consolidated return, they are not subject to the federal ATI limitation under the proposed regulations.
 
CBT treatment of the Section 163(j) limitation is consistent with the federal proposed regulations in that the federal consolidated return ATI limitation is allocated to each federal affiliate in proportion to each member’s share of the federal group’s interest expense paid to parties outside the group. Interest expense paid between members of the group is fully deductible, but subject to the New Jersey related party interest expense add-back statute to the extent applicable.
 

Gross Income Tax Treatment of the Limitation

Separately, the New Jersey Division of Taxation updated its guidance to address the topic of personal gross income tax treatment of the Section 163(j) limitation. The guidance clarifies that New Jersey does not conform to Section 163(j) for gross income tax purposes.  As a result, New Jersey will allow a partnership to deduct the full amount of interest expense without any Section 163(j) limitation in the year the expense is incurred as an “other subtraction” on the NJ-1065. However, the federal excess interest carryover amount in a future year will need to be added back by the partnership as an “other addition” to prevent a double deduction, since the interest expense was fully deducted in the prior year.  Because New Jersey does conform with Section 163(j) for CBT purposes, corporate partners may need to unwind the New Jersey partnership’s “other subtraction” from their New Jersey K-1 when filing a New Jersey CBT return. Further, the guidance does not address S corporations with New Jersey resident shareholders that make a New Jersey S corporation election.
 

BDO Insight

• TB-87 provides a clear ordering rule: First, apply the federal Section 163(j) limitation, then apply the state’s related-party interest addback provisions.  
• Regardless of whether a separate New Jersey CBT return is filed or a New Jersey combined group membership differs from a federal consolidated group’s affiliated members, the federal consolidated return ATI limitation and the federal consolidated interest expense and income allocation methods will apply for New Jersey CBT purposes, as set forth in the federal proposed Section 163(j) regulations.
• For New Jersey CBT purposes, the federal consolidated return ATI limitation will apply only to interest expense paid to related and unrelated parties outside of the federal consolidated group.  The portion of the ATI limitation that is used by a New Jersey taxpayer is based on the pro-rata calculation that allocates the limitation within a federal consolidated group.  The allowable interest expense that results from the ATI limitation will then be further divided into interest paid to related parties outside of the federal consolidated group and third-parties.  Any intercompany interest expense paid between members of a federal consolidated return is not limited by Section 163(j) and is fully deductible on a taxpayer’s New Jersey return, but is subject to New Jersey’s related party interest expense add-back statute. 
• Taxpayers affected by TB-87 should consult with their financial statement auditor and tax advisor to evaluate and determine the potential financial statement implications under ASC740, including the impact on current and deferred taxes, uncertain tax benefits, and disclosures. 

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