Limits on Business Interest Deductions Under the Coronavirus Aid, Relief, and Economic Security (CARES) Act

Limits on Business Interest Deductions Under the Coronavirus Aid, Relief, and Economic Security (CARES) Act

INSIGHTi

Limits on Business Interest Deductions Under
the Coronavirus Aid, Relief, and Economic
Security (CARES) Act
Updated June 1, 2020
Thin capitalization rules, broadly, limit the amount of debt that can generate deductible interest for the
purpose of calculating taxable income. Limits on the tax deduction for business interest restrictions have
been relaxed by the Coronavirus Aid, Relief, and Economic Security (CARES) Act (H.R. 748, as
amended) providing economic stimulus and relief for taxpayers due to the expected slowdown of the
economy because of the coronavirus pandemic. These restrictions, also referred to by their Internal
Revenue Code Section 163(j), were expanded by the 2017 tax revision, P.L. 115-97.
Changes in P.L. 115-97, Popularly Known as the “Tax
Cuts and Jobs Act (TCJA)”
Restrictions on net interest deductions were significantly tightened in the 2017 tax legislation. Taken as a
whole, the tax revision was a tax cut, although a number of provisions were enacted to limit certain
deductions, among them the restrictions on interest deductions.
Rules Prior to TCJA
Prior to the TCJA, the thin capitalization rules were narrowly focused and limited. They applied only to
corporations and only to interest paid to related parties. Their objective was largely to limit earnings
stripping by multinational corporations that located debt in the United States. Even so, the rules could be
viewed as relatively liberal. They applied only to firms whose debt to equity ratio exceeded 1.5 to 1.
Interest deductions were limited to 50% of earnings before interest, taxes, depreciation, amortization, and
depletion (EBITDA). Disallowed deductions could be carried forward for three years.
Proposals to further restrict the thin capitalization rules had been made for some time to address corporate
inversions, in which firms shifted their headquarters to a foreign country in order to reduce profits in the
United States, in some cases by earnings stripping through locating debt in the United States.
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Changes in TCJA
The TCJA tightened the limit on net interest deductions by eliminating a safe harbor for debt-to-equity
ratios at 1.5 to 1 and below and by reducing the interest deduction cap to 30%. The TCJA also changed
the income measure to income before interest and taxes (EBIT), which defined a narrower measure of
income and thus imposed a further limit on interest deductions, although this change was not scheduled to
take place until 2022. These changes became part of a host of changes that affected the international tax
regime.
The restrictions were also broadened to shift the focus toward borrowing in general by applying the rules
to all interest, not just related party interest, and by increasing the coverage to all businesses, not just
corporations.
Certain businesses were exempt from the changes. Smaller businesses with less than an average of $25
million in gross receipts in the past three years were excluded. (This exclusion aggregated businesses
under common control.) Certain regulated utilities are exempt. Real estate businesses can elect out of the
interest restriction by adopting longer depreciation periods: 30 years rather than 27.5 years for residential
structures and 40 years rather than 39 years for nonresidential structures. Farm businesses can also elect
out by using longer depreciation periods (generally 15 years or 20 years rather than 10 years) and slower
methods for certain assets (structures, land improvements, and certain trees and vines). Interest used to
finance inventory for motor vehicles is exempt, although the exemption does not apply to vehicles that are
not self-propelled, an exclusion that has raised some concerns about non-self-propelled trailers and
campers.
Any unused interest deductions can be carried forward indefinitely.
The change made by the TCJA was estimated to raise $18 billion in its first full fiscal year (FY2019), and
$20 billion in FY2020. The revenue gain was projected to increase to $30 billion after the change from
EBITDA to EBIT was fully reflected, in FY2023.
Reasons for Change
In the House Report on the legislation, the reason given for the expanded restrictions was to reduce the
differentials between debt and equity finance (debt-financed investments are more favorably treated). The
extension to all forms of business organizations was made to reduce differentials arising from choice of
entity form. The exclusion for smaller businesses was provided because these businesses, even if heavily
leveraged, are not as likely to have as big an effect on the economy in times of financial distress and
because they have less access to public equity markets. This rationale suggests a concern about excessive
leveraging making firms more prone to failure. The exclusions for certain industries were in recognition
that these industries have special characteristics.
Temporarily Relaxing the Interest Restrictions in the
CARES Act
The CARES Act increases the limit on interest deductions from 30% to 50% for 2019 and 2020. It also
allows firms to use 2019 incomes for the 2020 limitation. The expected downturn in the economy would
make the effect of the interest restriction more widely felt, as firms’ profits fell, leading to a smaller base
to calculate the interest cap in 2020. The increased deduction will increase liquidity for firms that have or
take on more debt and firms subject to the interest cap would find borrowing, which might be needed to
meet basic business needs as revenues fell, less costly. Guidance has been issued on making elections or

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opting out of certain prior elections. A survey of manufacturers indicated that 3.7% of firms had taken
advantage of the increased limit on interest deductions.
The provision is estimated to cost $13.4 billion for the two-year period.

Author Information

Jane G. Gravelle

Senior Specialist in Economic Policy

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IN11287 · VERSION 4 · UPDATED