As part of the US’s 2017 Tax Reform Package, Rules were passed to preclude certain US partnerships from deducting all or a portion of their US interest expenses. Below we will outline a brief summary of these rules and will walk through a few strategies to avoid or mitigate the impact of these rules.
The Basic Rule
The new law precludes certain US entities from deducting interest expense to the extent that said expense exceeds 30% of the Adjusted Taxable Income of the entity (i.e. taxable income plus non-cash items such as depreciation, amortization and not interest expense itself). Disallowed interest could be deferred until deductible under these rules by the entity.
The rules were intended to apply to entities with average annual aggregate gross revenue in its affiliated group for the prior three years of the $25 million USD. However, as a result of an error in the haphazard drafting of the law, any flow through entity (regardless of its gross revenue) could be subject to these rules to the extent that at least 35% of its losses in a tax year are allocated to limited, non-participating partners.
Applicability to the Real Estate Industry
Recognizing the profound effect these rules could have on the real estate industry, which relies heavily on leverage, the US Congress provided a “pick your poison” exception to the interest disallowance rule.
Under the exception, a full interest deduction could be taken if the taxpayer or entity elected to lengthen the depreciation life of its assets, in particular in reference to the following:
- Nonresidential real property life increased from 39 years to 40 year.
- Residential real property acquired before 2018 increased from 27.5 years to 40 years.
- Residential real property acquired after 2017 increased from 27.5 years to 30 years.
Practical Challenges Caused By the New Rules
The change in depreciation lives has minimal effect on real estate partnerships, which own non-residential real property. However, the increase in useful life from 27.5 to 40 years could result in a situation where US taxable income is generated in a year where there is a loss in Canada.
The first challenge with this income is in regards to the extent US tax is generated in a year where no Canadian tax is due can result in a foreign tax credit mismatch, thereby creating an ultimate double tax. The second challenge being the extent that US income is generated, federal as well as certain states require the remittance of unbudgeted withholding tax on said income, thereby reducing partner distribution amounts.
Potential Solutions to the Challenges
- Consider accessing the Section 179 deduction which allows a 100% write off on certain assets such as new applicants purchased for the partnership (i.e. subject to certain quantitative limitations). The deduction cannot reduce taxable income below zero, thereby avoiding the potential loss allocation to limited partners which will trigger application of these rules.
- US accruals may only be deducted if paid either by year-end or within a certain time frame after year-end, the timing depends on the nature of the deduction. Consider delaying certain payments to potentially generate a nominal amount of taxable income for the partnership. For example, if the partnership has $1,000 in taxable income, the payment of a few hundred dollars of withholding tax may be a relatively painless way to avoid the rules which would have otherwise applied had there been a taxable loss.
- If the application of these rules result in US taxable income, then limiting Canadian CCA to align the Canadian taxable income number with the US taxable income number might be the best way to circumvent potential double taxation as the US tax liability could be taken as a foreign tax credit against any Canadian tax liability from the same year.