Michigan Department of Treasury Issues Notice on the Corporate Income Tax Treatment of IRC 163(j)

June 2020

Summary

On June 8, 2020, the Michigan Department of Treasury (Treasury) issued “Notice: Corporate Income Tax Treatment of the IRC 163(j) Business Interest Limitation.” The guidance discusses how Michigan conforms to the business interest expense limitation found under Internal Revenue Code (IRC) Section 163(j). More importantly, the guidance discusses how the limitation from the Tax Cuts and Jobs Act (TCJA), which was recently modified by the Coronavirus Aid, Relief and Economic Security (CARES) Act, affects Michigan’s corporate income tax (CIT), especially for unitary business groups (UBGs).
 

Details of the Notice

 

General Federal Treatment of IRC Section 163(j)

For federal income tax purposes, a taxpayer’s business interest expense deduction is limited by IRC Section 163(j). Under the TCJA, the limit was the sum of (1) the business interest income for the year, (2) 30% of the adjusted taxable income (ATI) for the year, and (3) the taxpayer’s floor plan financing interest expense for the year. Affiliates that elect to file a federal consolidated return calculate a single limitation under IRC Section 163(j) and apply it at the consolidated return level. For the 2019 and 2020 tax years, the CARES Act increases the ATI limitation to 50%. In addition, the CARES Act also allows taxpayers to elect to substitute 2019 ATI for 2020 ATI and permit taxpayers to elect out of the ATI limitation increase.
 

General Michigan Treatment of IRC Section 163(j)

Michigan conforms to IRC Section 163, including subsection (j). The IRC Section 163 business interest expense, as limited by Section 163(j), is deducted in calculating a taxpayer’s federal taxable income (FTI), which is a taxpayer’s starting point for CIT purposes. Therefore, a CIT taxpayer or UBG member that files a separate federal return will not have to make any adjustments related to IRC Section 163(j) to report FTI on its Michigan return.
 
However, a CIT taxpayer or UBG member that files as part of a federal consolidated return will have to make additional modifications. According to the notice, Treasury has consistently required each UBG member that files as part of a federal consolidated return, referred to as a “pro forma corporation,” to separately compute a pro forma federal return. Consequently, all components of a federal return – including IRC Section 163(j) – are separately calculated to arrive at each member’s pro forma FTI.
 

CIT Tax Base for Pro Forma Corporations

Unlike the business interest expense limitation (BIEL) that is calculated and applied at the federal consolidated return level, each pro forma corporation must separately calculate a pro forma BIEL to arrive at its pro forma FTI. According to the notice, a pro forma corporation considers only its own business interest expense, business interest income, and ATI in determining its limitation for CIT purposes. Additionally, when calculating its pro forma limit, a pro forma corporation does not eliminate transactions with companies that were included in the federal consolidated return.
 
If a UBG member’s BIEL exceeds its business interest expense, then no other member of the UBG is allowed to use that member’s excess, “unused” limit. Further, if a UBG member has excess business interest expense, then only that member can carry forward the disallowed business interest expense and utilize it in subsequent tax years when the member again calculates its separate or pro forma Section 163(j) limitation in those years.
 

Michigan Eliminations for UBGs

Michigan requires transactions between members of a UBG to be eliminated from the corporate income tax base. Therefore, a UBG member must eliminate the pro forma business interest expense attributable to transactions with other members of the UBG. If a member’s pro forma business interest expense is limited, then that member should eliminate the pro forma business interest expense to the extent it was deducted in arriving at the pro forma FTI. Additionally, a UBG member that extends credit to another member must eliminate its interest income on that intercompany debt instrument to the extent that it is included in that member’s pro forma FTI.
 
In situations where interest is paid to a UBG member and an outside lender, if a UBG member’s pro forma business interest expense is limited by IRC Section 163(j), then the limit is attributed proportionately to the different types of interest expense. The BIEL is multiplied by a fraction. The numerator is business interest expense before limitation paid to other UBG members, and the denominator is business interest expense before limitation paid to all lenders. This percentage is applied to the member’s total intercompany interest expense which then establishes the portion of the total deductible interest that is intercompany and thus subject to elimination from the corporate income tax base.
 

Michigan Carryforward of Disallowed Interest for Combined Returns

Michigan requires a pro forma corporation to report and track any Michigan carryforward of disallowed business interest expense. As stated above, a UBG member cannot use the carryforward or disallowed business interest expense or unused limit of another UBG member.
 

Reasonable Cause Penalty Waiver

Treasury will waive penalties for a tax deficiency if a taxpayer can show reasonable cause. According to the notice, if the only reason for a tax deficiency is due to not calculating business interest expense correctly, in accordance with Treasury’s guidance, Treasury will consider that reasonable cause and waive the penalty upon a taxpayer’s request.
 
 

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