What Is the Section 279 Deduction Limitation?
This article clarifies the tax framework of Section 279, detailing how the structure of acquisition financing can impact a corporation's interest deductions.
Internal Revenue Code Section 279 is a provision that limits the amount of interest a corporation can deduct on debt used to acquire another company. This rule addresses situations where the financing for an acquisition has characteristics more like an equity investment than a traditional loan. The intent is to discourage corporate takeovers that are heavily financed with debt, which could otherwise create significant tax savings through interest deductions. This provision does not prevent a company from taking on acquisition debt, but it limits the tax benefits by reclassifying certain debt instruments.
Identifying Corporate Acquisition Indebtedness
For an interest deduction to be limited by this provision, the underlying debt must be classified as “corporate acquisition indebtedness.” This classification applies only if the debt obligation meets four specific tests. All four conditions must be satisfied for the debt to fall under this category and for the interest limitation to apply. The rules are mechanical, meaning if the debt fits the criteria, it is subject to the limitation regardless of the company’s intent.
The first of these is the purpose test, which examines why the debt was issued. The obligation must be issued to provide the funds for acquiring stock in another corporation or for acquiring at least two-thirds of the operating assets of another corporation. The rule also applies if the debt is used to acquire a controlling interest, defined as owning 5 percent or more of the target corporation’s total combined voting power.
A subordination test must also be met. This test is satisfied if the debt instrument is subordinated to the claims of the company’s general trade creditors or to any substantial amount of other unsecured debt the corporation has outstanding. This feature makes the debt riskier for the holder, and it is one of the characteristics that makes the debt appear similar to an equity interest from a risk perspective.
The final two criteria involve a convertibility feature and specific financial ratios. The convertibility test requires that the debt obligation be convertible into the stock of the issuing corporation. Alternatively, this test is met if the debt is issued as part of an investment unit that includes an option, such as a warrant, to purchase stock in the issuing corporation.
The financial ratio test is composed of two separate metrics, and only one must be met. The first metric is a debt-to-equity ratio that exceeds 2-to-1 at the end of the tax year in which the acquisition occurs. The second is an earnings-to-interest coverage ratio, which is met if the corporation’s projected earnings do not cover its annual interest expense by at least three times.
Calculating the Disallowed Interest
Once a corporation determines it has corporate acquisition indebtedness, it must calculate the disallowed interest deduction. The calculation provides a $5 million allowance, meaning the first $5 million of interest paid on such debt during a tax year is fully deductible. The limitation only applies to the interest expense that exceeds this amount.
The $5 million allowance must be reduced by interest paid on certain other acquisition-related debts that do not qualify as corporate acquisition indebtedness. If a corporation has acquisition debt that fails the subordination, convertibility, or financial ratio tests, the interest on that debt reduces the $5 million allowance dollar-for-dollar. This prevents companies from structuring multiple layers of acquisition debt to circumvent the limitation.
For example, consider a corporation that pays $8 million in annual interest on debt that qualifies as corporate acquisition indebtedness and has no other acquisition-related debt. The disallowed portion of the interest deduction would be $3 million, which is the amount of interest exceeding the $5 million threshold. The corporation could still deduct the initial $5 million of interest expense.
If the same corporation also paid $1 million in interest on a separate, non-subordinated acquisition debt, the calculation changes. The $1 million of interest on this non-qualifying debt would first reduce the $5 million allowance to $4 million. Consequently, of the $8 million in interest on the corporate acquisition indebtedness, only $4 million would be deductible, and the remaining $4 million would be disallowed.
Application to Affiliated Groups
The rules have specific applications for an affiliated group of corporations that files a consolidated tax return. The analysis is performed on a group-wide basis, treating all members as a single entity to prevent companies from using subsidiaries to bypass the limitations. This means the financial ratio tests are determined by aggregating the data of all members. For example, the total debt of the entire group is compared to its total equity. Similarly, the $5 million interest allowance is applied once for the entire affiliated group, not for each member separately.