Interest Limitation Rules Alter Naked Credit Determinations

The 2025 tax law‘s permanent restoration of an EBITDA-based §163(j) interest expense limitation is a widely welcomed development for taxpayers. However, this change may carry with it an often-overlooked consequence for companies maintaining valuation allowances against their deferred tax assets. Treasury Department regulations, issued after the Tax Cuts and Jobs Act (TCJA) passed in 2017, prevented a “double tax benefit” from depreciation or amortization taken during the original §163(j) 2018-21 EBITDA period. These regulations likely will need to be updated to cover post-2024 depreciation and amortization. For companies with naked credit deferred tax positions, this expansion could have meaningful implications for their 2025 ASC 740 calculations. This article examines how the interest limitation rules interact with naked credit deferred tax analyses and illustrates the potential impact through detailed examples.

Interest Expense Limitation

TCJA. Under the TCJA, §163(j) introduced a limitation on the deduction for business interest expense. As originally passed, interest was limited to 30% of adjusted taxable income (ATI) plus business interest income. Any disallowed interest expense was to be carried forward indefinitely.

The limitation was phased in so that between 2018 and 2021, ATI was computed by adding back depreciation and amortization to taxable income, effectively an EBITDA-based calculation. For tax years 2022 through 2024, the TCJA shifted to an EBIT-based calculation (excluding the depreciation/amortization add-back), which made the limitation more restrictive.

OBBBA. The 2025 legislation (known as the One Big Beautiful Bill Act or OBBBA) permanently restored the EBITDA-based calculation effective for tax years beginning after December 31, 2024, meaning depreciation and amortization are once again added back to ATI.

Understanding Naked Credits

Companies must evaluate their deferred tax assets (DTAs) for realizability. When a DTA fails to meet the more-likely-than-not realization threshold, a valuation allowance must be established. In making this assessment, deferred tax liabilities (DTLs) can often serve as a source of future taxable income to support DTA realization.

A naked credit arises when a company requires a full valuation allowance against its net DTAs and has DTLs that are not available to offset those DTAs. This typically occurs with indefinite-lived DTLs, where it is not possible to predict with certainty when the liability will reverse into taxable income. For example, certain intangible assets are not amortized for book purposes but are amortized for tax, creating a DTL for the basis difference. Because that DTL will only reverse upon a sale or impairment of the intangible, the timing remains inherently unpredictable. As a result, the indefinite-lived DTL cannot reliably support the definite-lived DTA realization.

The valuation allowance assessment is very complex and often requires companies to evaluate definite-lived DTAs and DTLs separately from their indefinite-lived counterparts. In making this assessment, companies will “bucket” their definite-lived and indefinite-lived deferred taxes and analyze each separately.

The valuation allowance analysis of indefinite-lived net operating losses (NOLs) and suspended interest DTAs will involve forecasting the turnaround of indefinite-lived DTLs. However, before concluding that an indefinite-lived DTL is sufficient to fully support these DTAs, there are two limitations on those DTAs that must be considered. Both the TCJA and OBBBA impose limits on the utilization of interest expense deductions and net operating losses. Suspended interest utilization is capped at 30% of ATI, and post-2017 NOLs can offset only 80% of taxable income.

The following example illustrates this bucketing exercise and how the statutory limitations on suspended interest and NOL DTAs are considered.

Example 1: Assume the following:

• Corporation has DTAs and DTLs and all amounts are tax-affected.
• Indefinite-lived DTL was established when the company bought the stock of a business.
• No carryover tax basis in the acquired indefinite-lived intangibles.
• $2 million DTL was established in the purchase accounting for that acquisition.

The above DTAs are categorized (or bucketed) as either indefinite-lived or definite-lived as shown below.

The above valuation allowances on both interest DTA and the indefinite-lived NOL DTA were measured by applying the proper income limitations to the assumed taxable income to be generated in the future by the indefinite-lived DTL of $2 million as shown below.

The deferred interest DTA can be supported by only $600,000 of the indefinite-lived DTL, so a valuation allowance of $100,000 ($700,000 less $600,000) was required against the deferred interest DTA. The indefinite-lived NOL DTA can be supported by only $1,120,000 of the indefinite-lived DTL, so a valuation allowance of $2,880,000 ($4 million less $1,120,000) was required against the indefinite-lived NOL DTA. The combination of the two valuation allowances of $100,000 and $2,880,000 results in a net naked credit of $280,000.

Disposition Adjustment: Original Rules and the OBBBA Gap

Purpose of the disposition adjustment. The disposition adjustment in Treas. Reg. §1.163(j)-1(b)(1)(ii)(C) was designed to prevent a “double benefit” from depreciation and amortization (“D&A”). When D&A is added back to ATI, a company benefits by increasing its interest expense limitation. As that same D&A reduces the company’s tax basis in an asset, the company recognizes additional gain (or less loss) upon disposition of the asset. Without an adjustment, the company would benefit from both the (1) ATI increase from the D&A add-back, and (2) ATI increase from the additional gain on sale.

Under the regulations, in a year when there is a gain from sold property, ATI will need to be reduced by any amortization or depreciation that was taken between December 31, 2017, and January 1, 2022, (the EBITDA period) on such property. Two months after the final regulations were issued, Treasury issued proposed regulations that somewhat relaxed this rule by providing a lesser-of approach. Under the September 2020 proposed regulations, the amount to be added back to ATI is the lesser of the (1) gain from the sale of the depreciable or amortizable assets; or (2) related depreciation or amortization taken during the EBITDA period on such sold assets.

Current regulatory definition. Under the current regulations, the “EBITDA period” includes “taxable years beginning after December 31, 2017, and before January 1, 2022.” This definition made sense when it was drafted because the TCJA had scheduled the D&A add-back to expire after 2021. The disposition adjustment was intended to recapture the benefit of D&A add-backs that occurred during this limited window.

OBBBA creates a regulatory gap. With the OBBBA’s permanent restoration of the EBITDA-based ATI calculation, the same rationale for the disposition adjustment now applies to all depreciation and amortization taken from 2025 forward, indefinitely. However, the current regulations only capture D&A taken during the 2018-21 window.

This creates a significant gap. A company that takes D&A in 2025 and later sells the related asset will have benefited from both the D&A add-back to ATI and the gain recognition—exactly the double benefits the regulations were designed to prevent. Yet under the current regulatory language, no disposition adjustment would be required for post-2024 D&A.

Treasury will need to update the regulations to address this gap, likely by either expanding the “EBITDA period” definition to include tax years beginning after December 31, 2024; or creating a new parallel construct for post-2024 D&A add-backs.

Implication for Naked Credit Calculations

Companies in a naked credit position will need to reevaluate their valuation allowance scheduling exercises beginning in 2025. When scheduling the turnaround of DTLs to support the utilization of DTAs, companies should be wary of utilizing a DTL from an intangible which was generated from post-2024 amortization to the extent that amortization increased post-2024 ATI.

This can be illustrated in the following example:

Example 2: Assume the same facts as Example 1 with one significant difference:

• $2 million DTL relates to the acquisition of a business that was made through an asset purchase.
• Company began with equal book and tax basis in the acquired intangibles. However, the intangibles were amortized for tax (and not for books), which led to the creation of the $2 million DTL over a period of several years.
• Between 2018 and 2021, and after 2024, the tax amortization for these intangibles was $1 million.

In this case, the capacity for realizing a suspended interest DTA must be measured by reducing the assumed future taxable income generated from the $2 million DTL by the $1 million of 2018-21 and post-2024 tax amortization. As shown below, this changes the maximum interest DTA to $300,000 and has an impact on the maximum NOL DTA that can be allowed.

This results in a total valuation allowance and naked credit as shown below.

Takeaways

As a result of the restoration of the EBITDA-based ATI calculation, companies should reassess naked credit positions in their 2025 financial statements. Companies should also monitor Treasury guidance under §163(j) which is expected to be forthcoming. Given the current regulatory uncertainty, companies should discuss their approach with external auditors to ensure alignment on the appropriate ASC 740 treatment.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Murray J. Solomon, CPA, is a partner at Eisner Advisory Group LLC and specializes in corporate taxation, ASC 740 tax accounting, and the structuring of corporate transactions, with more than 35 years of experience advising multinational public companies.

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