On November 26, 2018, the IRS released proposed regulations on the Tax Cuts and Jobs Act’s (TCJA) business interest expense deduction limitation. Specific to the investment industry, the guidance will impact regulated investment companies (RICs) using debt — most notably many closed-end funds and funds that use lines of credit, and funds that make payments in lieu of dividends in connection with short sales. This guidance will affect tax years as early as those ending December 31, 2018.
>> Read more about the general impact of the new regs in “Proposed Regulations on Business Interest Expense Deduction Limitations Provide Additional Clarity.”
The TCJA placed a limitation on the deductibility of interest expense, providing that a business could only deduct interest expense up to 30% of its adjusted taxable income (ATI). Questions arose as to whether a RIC would have business or investment interest expense; and, if the former, how ATI would be calculated. Specifically, a major concern in the initial law was that the dividends paid deduction was not specifically listed as an addback for this calculation of ATI — meaning a fund that paid out all of its income via distributions essentially would have a nondeductible expense for interest.
The proposed regulations clarify that corporations (including RICs but not including S Corporations) generally do not have investment interest expenses. Their activities are considered a trade or business by default and, as such, the limitation on business interest expense would be placed on the entities accordingly. This treatment seems consistent with much of the investment industry’s viewpoint on the impact of the TCJA.
In addition, the calculation of ATI was clarified. The proposed regulations calculate adjusted taxable income by adding back any deduction for capital loss carryforwards and require a deduction for business interest income in calculating ATI. Most importantly, the proposed regs require the dividends paid deduction for RICs to be an addback for the purpose of this calculation.
Accordingly, it appears a RIC could generally calculate ATI as investment company taxable income (ICTI), before the deduction for dividends paid, plus net capital gain, less business interest income to calculate the 30% limitation on business interest expense. An interesting result is that any disallowed interest expense is carried over and is eligible for deductions in future years, creating an ordinary deduction in those years.
The proposed regs also state that earnings and profits of a RIC is only adjusted in the taxable year or years in which the business interest expense is deductible, a rule that differs from the general corporate rule.
Note since these rules are relevant for full-year RICs for tax years beginning after the date of the TCJA’s enactment, the first tax year-end applicable would be December 31, 2018. Accordingly, funds should address any potential limitations in their taxable income calculations for both fiscal and excise tax purposes.
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