Introduction
Debt is cheaper than equity partly because interest is tax-deductible. Since 2018, US tax law has capped that advantage. Under Section 163(j), a company can deduct net business interest only up to 30% of its adjusted taxable income, and for three years, from 2022 to 2024, that income was measured after depreciation and amortization, a far tighter test for capital-intensive and highly leveraged businesses. Many leveraged companies paid tax on income they had spent on interest. At the end of 2024, Uber alone carried a $760 million deferred tax asset for interest it had not yet been able to deduct, according to its 2024 annual report.
The 2025 tax law restored the looser, EBITDA-based measure. But the cap remains one of the most important tax rules for anyone modeling a leveraged buyout or a heavily indebted company, because it decides how much of the interest tax shield actually exists.
How the Limit Works
The deduction for business interest expense in a year cannot exceed the sum of three amounts: the company's business interest income, 30% of its adjusted taxable income, and any floor plan financing interest, which matters mainly for vehicle dealers. Interest above the limit is disallowed for the year and carried forward indefinitely, to be deducted in a later year when the company has spare capacity. The starting point is taxable income, so the book-tax differences explained in book vs tax accounting carry straight into the calculation.
- Adjusted taxable income
The measure of income that sets the Section 163(j) cap: taxable income computed without business interest, net operating loss deductions and certain other items, and, for tax years beginning after 2024 and before 2022, before depreciation, amortization and depletion. It is a tax measure, built from the tax return, not from reported EBITDA.
Several businesses are outside the cap. Small companies whose average annual gross receipts over the prior three years do not exceed an inflation-adjusted threshold, $32 million for tax years beginning in 2026, are exempt. Real property businesses, such as real estate developers and landlords, can elect out if they accept slower depreciation on their buildings, and farming businesses have a similar election. Regulated utilities are excluded. Partnerships apply the limit at the partnership level, with excess amounts allocated to their partners.
EBITDA or EBIT: The Changing Definition
The definition of adjusted taxable income has changed twice. From 2018 to 2021, it added back depreciation and amortization, so it resembled EBITDA (and for 2019 and 2020, pandemic relief temporarily raised the cap to 50%). From 2022 to 2024, the add-back expired under the original 2017 law, so it resembled EBIT. The One Big Beautiful Bill Act, enacted in July 2025, restored the EBITDA-based measure permanently for tax years beginning after 2024, as Paul Weiss's summary of the law sets out. For tax years beginning after 2025, it also excludes certain foreign income inclusions from the calculation and applies the cap to most interest that companies would otherwise capitalize into the cost of assets.
The difference is large for a leveraged company with heavy depreciation or acquired intangibles. Take a company with $1,000 of tax EBITDA, $400 of tax depreciation and amortization, and $450 of interest expense:
| Line item | EBITDA basis, 2025 onward | EBIT basis, 2022 to 2024 |
|---|---|---|
| Tax EBITDA | 1,000 | 1,000 |
| Tax depreciation and amortization | (400) | (400) |
| Taxable income before interest | 600 | 600 |
| Adjusted taxable income | 1,000 | 600 |
| Interest deduction cap at 30% | 300 | 180 |
| Interest deducted, of 450 paid | (300) | (180) |
| Taxable income | 300 | 420 |
| Interest disallowed and carried forward | 150 | 270 |
| Federal tax at 21% | 63 | 88 |
Without any limit, the full 450 of interest would be deductible, taxable income would be 150 and federal tax about 32.
Under the EBITDA basis, the company deducts $300 of its $450 of interest and pays about $63 of federal tax. Under the EBIT basis, it deducts only $180 and pays about $88, nearly three times the $32 it would pay with no limit at all. The extra tax is not permanent, since disallowed interest carries forward, but it is paid in cash now, in the years when a leveraged company can least afford it.
How Disallowed Interest Is Recorded
In the financial statements, a disallowed interest carryforward is a deductible temporary difference: the interest has been expensed in the books but will be deducted for tax only later. It creates a deferred tax asset, measured at the tax rate, and like any deferred tax asset it is subject to the valuation allowance test explained in deferred tax assets and valuation allowances. If the company expects to have enough capacity to use the carryforward, the effective tax rate is unaffected and only cash taxes rise.
If it does not, the carryforward is reserved and the disallowed interest raises the effective tax rate. The rate reconciliation in Carvana's 2024 Form 10-K, for example, shows disallowed interest adding 3.8 percentage points to its effective tax rate, with almost all of its $302 million interest carryforward asset reserved. Carryforwards of disallowed interest are also subject to the same limits after an ownership change as net operating losses, covered in net operating losses, so their value to a buyer depends on the deal itself.
Why It Matters in Leveraged Finance
For most investment-grade companies, the cap does not bind: interest is a small fraction of income. It matters for leveraged buyouts, where interest can consume a large share of EBITDA, and for distressed companies whose income has fallen while their debt has not. A company paying interest equal to 30% of its adjusted taxable income has used its full allowance; every additional dollar of interest is deductible only later, if at all.
In a buyout model, that changes the calculation in three ways. Cash taxes in the early years, when leverage is highest, must be computed with the cap, not as a simple rate times pre-tax income. The value of the interest tax shield, often treated in valuation as tax rate times interest, is smaller than that formula implies once interest exceeds the cap. And the carryforward builds up a tax asset that becomes valuable as leverage falls, or when the company is sold to a buyer with spare capacity.
The cap also interacts with other parts of the tax picture. With 100% bonus depreciation restored in 2025, tax depreciation can be very large for companies that invest heavily, which under an EBIT-based test would have shrunk the cap; under the EBITDA basis, it does not. The cash tax rates that result belong in the forecast described in effective, statutory and cash tax rates.
Structuring Around the Cap
When the cap bites, financing structures have to adapt. A sponsor facing the EBIT-based test of 2022 to 2024 could use less debt, or more preferred equity and other instruments whose returns are not deductible interest, accepting a higher cost of capital in exchange for less disallowed interest, and had to weigh the lost tax shield when deciding how far to lever a deal. The restoration of the EBITDA basis widened capacity again, but the cap still sets the point beyond which extra leverage no longer reduces current tax.
Similar rules apply outside the US. The European Union's Anti-Tax Avoidance Directive requires member states to limit net interest deductions to 30% of tax EBITDA, with a de minimis threshold of up to €3 million, and the UK applies its own corporate interest restriction on the same 30% basis. For a cross-border buyout, the cap has to be modeled jurisdiction by jurisdiction, wherever the debt sits.
Section 163(j) turns the simple statement that interest is tax-deductible into a conditional one. For bankers structuring or valuing leveraged companies, the condition can decide whether the next turn of leverage saves tax at all, and the definition of adjusted taxable income in force for the years being modeled matters as much as the rate.
