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Highlights of the §163(j) Interest Limitation Guidance Issued on July 28, 2020

By: John V. Aksak Michael L. Dembek Ryan McKenzie Alexis Bergman Jason Carter |

On July 28, 2020, the US Treasury and IRS released final regulations (Final Regulations) and new proposed regulations (Proposed Regulations) (collectively, Final and Proposed Regulations) on the limitation on deductions for business interest expense (BIE) under §163(j) of the Internal Revenue Code (Code).  The §163(j) limitation was modified by the 2017 US tax reform legislation, referred to as the Tax Cuts and Jobs Act (TCJA) (Pub. L. No. 115-97 enacted December 22, 2017). The BIE limitation rule was further modified by the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) in 2020.  Proposed regulations were released on December 28, 2018 (2018 Proposed Regulations).

The IRS also issued two additional pieces of guidance along with the Final and Proposed Regulations: Notice 2020-59 and a set of 11 Frequently Asked Questions (FAQs).  Notice 2020-59 proposes a revenue procedure that would create a safe harbor to allow taxpayers in the business of managing or operating qualified residential living facilities to qualify as an electing real property trade or business.  The FAQs are related to the aggregation rules and the gross receipts test that determine whether a taxpayer is a small business that may claim an exemption from the BIE deduction limitation.

Our analysis of the new §163(j) guidance will come in two parts.  In this Part 1, we will highlight the key issues addressed by the Final and Proposed Regulations with respect to the definitions of interest and adjusted taxable income (ATI), rules for C corporations and controlled foreign corporations (CFCs), and effective dates of the new guidance.  In Part 2 of our analysis, we will highlight issues related to partnerships, S corporations, foreign corporations with effectively connected income (ECI), and the FAQs related to the small business exemption.

Summary

  • The Final Regulations narrow the definition of interest by removing the following items: debt issuance costs, commitment fees, and hedging gains or losses from derivative contracts.
  • The Final Regulations retain and modify the anti-abuse rule that permits the IRS to recharacterize items as “interest” or “non-interest” for purposes of 163(j) if a principal purpose of structuring a transaction is to reduce the amount treated as BIE or to artificially increase business interest income (BII).
  • With respect to ATI, the 2018 Proposed Regulations stated that depreciation, amortization, and depletion (D&A) capitalized into inventory under 263A (§263A D&A), and included in cost of goods sold (COGS), could not be added back when computing ATI. The Final Regulations reverse this position; all D&A is added back to compute ATI for tax years beginning before January 1, 2022, including §263A D&A and regardless of the period in which the capitalized amount is recovered through COGS. 
  • The Final Regulations modify and eliminate certain ordering rules in the 2018 Proposed Regulations, such as removing the ordering rule for §§163(j) and 250.
  • The Final Regulations clarify that the §163(j) limitation is not a method of accounting.
  • The Final Regulations generally maintain the framework from the 2018 Proposed Regulations that applied to C corporations and consolidated groups.
  • BIE that is disallowed due to the 163(j) limitation is carried forward and treated as paid or accrued in the succeeding tax year.
  • Carryforwards are subject to applicable limitations, including 381, §382, and separate return limitation year (SRLY) rules.
  • The Final Regulations retain the “single-entity” approach of the 2018 Proposed Regulations for consolidated groups which computes a single 163(j) limitation at the consolidated group level that is allocated to each member pro rata based on its contribution to consolidated BIE.
  • The Final Regulations maintain the positions that 163(j) applies to CFCs, and that their US shareholders must exclude their specified deemed inclusions (e.g. Subpart F or global intangible low-taxed income (GILTI) inclusions), from the shareholders ATI. However, the Proposed Regulations change the mechanics for computing the limitation for CFC groups.
  • The Final Regulations are generally effective and apply to tax years beginning 60 days after publication in the Federal Register (i.e. January 1, 2021 for calendar-year taxpayers), except for certain provisions with special effective dates.
  • The Proposed Regulations are proposed to become effective and apply to tax years beginning 60 days after they are published as final in the Federal Register.
  • Taxpayers generally have the option to apply the Final Regulations and/or the Proposed Regulations to tax years beginning after December 31, 2017, but only if each regulation is applied consistently and in their entirety. Alternatively, taxpayers may also choose to follow the 2018 Proposed Regulations before the Final Regulations become effective.

Background

As amended by the TCJA and the CARES Act, for tax years beginning after December 31, 2017, §163(j) generally limits a taxpayer’s annual BIE deduction to the sum of: (i) BII, (ii) 30% of ATI (50% in 2019 and 2020), and (iii) floor plan financing income.  Taxpayers may also elect to use their 2019 ATI to compute the limitation in tax year 2020, which is beneficial for taxpayers whose profits declined in 2020.

The Final Regulations provide guidance on how to calculate the new interest deduction limitation; describe what constitutes interest for purposes of the limitation; address which taxpayers and trade or businesses are subject to the new interest deduction limitation; and describe how the limitation applies to consolidated groups, partnerships, and certain international companies.

Along with the Final Regulations, the IRS also issued the Proposed Regulations that provide additional guidance on various issues including the application of §163(j) to partnerships (and their partners), S corporations, CFCs and their US shareholders, and foreign persons with ECI.

Taxpayers exempt from § 163(j)

Certain small businesses may be exempt from the §163(j) limitation in taxable years when their average annual gross receipts for the three prior tax years is less than a threshold amount that is adjusted annually for inflation.  For taxable years beginning in 2019 and 2020, the inflation adjusted threshold amount is $26 million.  The IRS issued a set of 11 FAQs on the aggregation rules under §448(c)(2) that apply to the exemption for small businesses, which will be discussed further in Part 2 of our analysis of the new §163(j) guidance.

Qualifying taxpayers who elect to be treated as a real property trade or business, or a farming business, may also be excluded from the BIE limitation.  However, taxpayers making these elections cannot claim the additional first-year depreciation deductions that are otherwise allowed for certain types of property purchased by the electing trade or business.

Effective Dates

The Final Regulations generally apply to tax years beginning 60 days after publication in the Federal Register (i.e. January 1, 2021 for calendar-year taxpayers), although special effective dates apply to specific provisions (e.g. the interest anti-avoidance rules in Reg. § 1.163(j)-1(b)(22)(iv) apply to transactions entered into after publication of the Final Regulations).  However, taxpayers (and related parties) may choose to apply the Final Regulations in their entirety to tax years beginning after December 31, 2017.  Alternatively, taxpayers may choose to apply the 2018 Proposed Regulations before the Final Regulations become effective, but only if applied consistently to such taxable years.

The Proposed Regulations are proposed to apply 60 days after they are published as final in the Federal Register, but they allow taxpayers and related parties to apply them in tax years beginning after December 31, 2017, and before final regulations are published, provided that the §163(j) regulations are applied consistently in those years.

TPC Observation: Taxpayers who otherwise choose to apply the 2018 Proposed Regulations may still apply Treas. Reg. § 1.163(j)-1(b)(1)(iii) from the Final Regulations, which allows for the addback of §263A D&A when computing ATI, to taxable years beginning after December 31, 2017.

TPC Observation: Taxpayers should create models computing the limitation by applying the Final and Proposed Regulations as well as the 2018 Proposed Regulations for tax years 2018, 2019 and 2020 and compared the aggregate benefit or detriment for all three years, before deciding which set of regulations to apply.

FINAL REGULATIONS

Definition of Interest Expense

The Final Regulations narrowed the definition of “interest” from the 2018 Proposed Regulations, but followed the framework of establishing the following categories of interest:

  • amounts paid, received or accrued on indebtedness and other items treated as interest under other sections of the Code or the Regulations (including original issue discount (OID), market discount, repurchase premium, and deferred payments treated as interest under §483)
  • Significant non-periodic payments on swaps
  • Other items treated as interest for purposes of §163(j) under the anti-avoidance rule

The 2018 Proposed Regulations contained a definition of interest expense that was criticized in taxpayer comments as overly broad.  The Final Regulations narrow the definition of interest by removing the following items:

  • Debt issuance costs
  • Commitment fees
  • Partnership guaranteed payments for the use of capital (GPUCs)
  • Hedging gains or losses

Despite taxpayer comments, the Final Regulations retain substitute interest payments in the definition of interest because such payments are economically equivalent to interest, but they provide that the substitute interest payments will only be treated as interest expense to the payor if the payment relates to a sale-repurchase or securities lending transaction that is not entered into by the payor in the payor’s ordinary course of business, with similar treatment applied to the recipient of correlating interest income.

The Proposed Regulations also treat certain dividends attributable to interest income of a regulated investment company (RIC) as interest income by a RIC shareholder.

Furthermore, the Final Regulations note that the treatment of commitment fees and other debt-related fees are the subject of a broader IRS guidance project, so that taxpayers should monitor the progress of this guidance in order to determine the impact on the definition of interest for §163(j) purposes.

Anti-Avoidance Rules

The Final Regulations retain and amplify the anti-abuse rule that permits the IRS to recharacterize items as “interest” or “non-interest” for purposes of §163(j) if a principal purpose of structuring a transaction is to reduce the amount treated as BIE or to artificially increase BII. The rule sets forth a multi-factor test for determining whether any expense or loss is economically equivalent to interest, which generally occurs if the item is:

  • deductible by the taxpayer;
  • incurred in a transaction (or series of transactions) where the taxpayer secures the use of funds for a period of time;
  • substantially incurred in consideration of the time value of money; and
  • is not otherwise described in Treas. Reg. Section 1.163(j)-1(b).

This rule applies to both interest income and interest expense, and the Final Regulations include a number of examples that include the following transactions:

  • Foreign currency swaps
  • A forward contract on gold
  • Guarantee fees paid to a related party
  • GPUCs

TPC Observation: Notably, the anti-avoidance rule specifically states that factors such as whether the taxpayer has a valid business purpose for obtaining funds, or if the funds were obtained at a lower pre-tax cost, do not affect the determination of whether a transaction has a principal purpose of reducing interest expense.  Similarly, having a principal purpose of holding interest-generating assets does not affect determinations of whether transactions were designed to artificially increase interest income.  Therefore, taxpayers should carefully scrutinize transactions through the lens of this new anti-avoidance rule in order to avoid the unintended consequences that could result from having items recharacterized for the purpose of computing the §163(j) limitation.

Determination of Adjusted Taxable Income (ATI)

The Final Regulations use “tentative taxable income” (TTI) as the starting point for computing ATI, which is defined as taxable income determined without regard to the § 163(j) limitation or any disallowed business interest expense carryforward. Then, ATI is calculated through adjustments to TTI that are specifically required by the statutory language of the Code, including adjustments for:

  • Items of income, gain , deduction or loss which are not properly allocable to a trade or business;
  • BIE and BII;
  • Net operating loss (NOL) deductions;
  • Business income deductions under § 199A;
  • D&A before January 1, 2022; and
  • In the case of sales or dispositions of property, adjustments for previous amounts of depreciation or amortization deductions claimed for such property between January 1, 2018 and December 31, 2021.

The Final Regulations also retain an unfavorable adjustment that was established in the 2018 Proposed Regulations, but is not explicitly mandated by the Code, which requires US Shareholders of CFCs to subtract their deemed inclusions (e.g. Subpart F and GILTI) from TTI in order to compute ATI.

Rule for §263A Depreciation, Amortization & Depletion

The 2018 Proposed Regulations stated that D&A capitalized into inventory under §263A, and included in cost of goods sold (COGS), could not be added back to ATI.

Due to taxpayer comments and in order to reflect Congressional intent, the Final Regulations reverse this position, such that all D&A are added back to ATI for tax years beginning before January 1, 2022, including §263A D&A, regardless of when the capitalized amount is recovered through COGS.

TPC Observation: The taxpayer-friendly decision to remove the rule from the 2018 Proposed Regulations prohibiting addbacks for §263A D&A is welcome news for manufacturers and other taxpayers with significant costs that are capitalized into inventory.  Since the Final Regulations allow Taxpayers to retroactively adopt this rule, even if otherwise following the 2018 Proposed Regulations before the Final Regulations become effective, Taxpayers who failed to add back §263A D&A in 2018 and/or 2019 should consider whether they could benefit from amending returns for those years.

Ordering Rules

The Final Regulations generally follow the ordering rules in the 2018 Proposed Regulations that generally required computing the §163(j) limitation after other provisions of the Code that defer, capitalize, disallow or otherwise limit the deductibility of interest expense. Thus, the limit is applied to the amount of interest expense that otherwise could be deducted but for the §163(j) limitation.  Interest expense that has been deferred, capitalized, disallowed, or otherwise limited in the current taxable year, or that has not yet accrued, is not taken into account.

However, there are exceptions to this ordering rule that require computing the §163(j) limitation before the excess business loss rules, at-risk rules, and passive activity loss rules in §§461(l), 465 and 469, respectively.  Due to commenter’s concerns that the rule in the 2018 Proposed Regulations was too restrictive by only referencing §263A and §263(g), the Final Regulations were modified to cover the capitalization of interest under any provision.

The IRS also did not clarify the interaction between §§163(j) and 108 (discharge of indebtedness income), stating further guidance may be forthcoming after additional time to study this issue.

Coordination with Deductions Limited by Taxable Income:  The Final Regulations eliminate the ordering rule from the 2018 Proposed Regulations that coordinates the computations of §§163(j) and 250, both of which are limited by taxable income.  The Preamble states that additional time is necessary to consider the appropriate manner of coordinating “taxable-income based provisions,” including §§163(j), 250, and 172.  Until additional guidance is released and becomes effective, taxpayers may choose any reasonable approach for coordinating taxable income-based limitations, including using simultaneous equations or following the approach from the 2018 Proposed Regulations, as long as such approach is applied consistently for all relevant taxable years.

TPC Observation: Taxpayers should consider computing comparative models for 2018 through the current tax period to determine whether there is a benefit to retroactively changing the order for computing their §163(j) limitation and other taxable-income based provisions, including whether to file an amended return to ensure consistent application across all relevant tax years.

Method of Accounting

The Final Regulations clarify that the manner of computing a taxpayer’s §163(j) limitation is not a method of accounting.  Therefore, taxpayers are not required to file Form 3115, Application for Change in Accounting Method, nor compute a §481(a) adjustment in order to change how they compute their §163(j) limitation (e.g. when adopting new rules in the Final Regulations).

Treatment of C Corporations

The Final Regulations generally maintain the framework applicable to C corporations and consolidated groups that was included in the 2018 Proposed Regulations.  All of a C corporation’s items of income and expenses (including BIE and BII) are allocated to a trade or business, except for any portion allocable to an excepted trade or business.  This includes a corporate partner’s allocable share of the partnership’s investment income and expenses which are recharacterized as trade or business activity of the corporate partner.

BIE that is limited under §163(j) is carried forward as a “disallowed BIE carryforward” and treated as paid or accrued in the succeeding tax year.  The Final Regulations provide the following ordering rule:

  • Current-year BIE is deducted before any carryforwards from a prior taxable year, and
  • BIE carryforwards are deducted in the order in which they arose.

Carryforwards are subject to applicable limitations, including §381, §382, and the SRLY rules.

Consolidated Group Rules:  The Final Regulations retain the general “single-entity” approach of the 2018 Proposed Regulations for consolidated groups.  Intercompany transactions are disregarded when computing the group’s ATI, and the group’s §163(j) limitation is computed at the consolidated group level utilizing the consolidated group’s TII.  Intercompany obligations are ignored in determining a member’s BIE and BII.  The Final Regulations also retain the multi-step approach to allocating the consolidated §163(j) limitation to each member, including the current-year BIE limitation and BIE carryforwards.

However, the Final Regulations deviate from the approach in the 2018 Proposed Regulations regarding carryforwards of disallowed BIE generated during a member’s SRLY.  The Final Regulations provide for a “cumulative register” approach by limiting the amount of a member’s BIE carryforward from a SRLY that can be included in the group’s BIE for any taxable year to the aggregate of the member’s §163(j) limitation for all of the consolidated return years with the group, determined only by reference to that member’s activity.  The member’s aggregate §163(j) limitation also takes into account intercompany items, other than BIE and BII, from intercompany obligations.

A departing member may retain its current-year BIE and carryforwards, to the extent they are not used by the consolidated group for the taxable year that includes the departure date.  Generally, stock basis adjustments apply at the time disallowed BIE is utilized by the group.

The single entity approach was not extended to partnerships wholly-owned by consolidated group members or members of an affiliated, non-consolidated group.  Treasury and the IRS are continuing to study the proper treatment of intercompany transfers of partnership interest that do not result in the termination of the partnership, intercompany partnership interest transfers in nonrecognition transactions, and intercompany transfers that do result in the termination of the partnership.

E&P Adjustments:  The Final Regulations follow the 2018 Proposed Regulations in providing that a C corporation’s earnings and profits (E&P) for a taxable year is determined without regard to any disallowance and carryforward of BIE under §163(j), but add new rules for C corporations who are partners in a partnership.

  • 381(a) transactions: In a §381(a) transaction, the acquiring corporation succeeds to the carryover of disallowed business interest under §163(j)(2). The Final Regulations follow the 2018 Proposed Regulations by:
  • Clarifying that the carryover item includes disallowed BIE from the taxable year ending on the date of distribution or transfer, and
  • Limiting the acquiring corporation’s ability to use carryforwards in its first taxable year ending after the acquisition, consistent with the treatment of NOLs under Treas. Reg. §1.381(c)(1)-1 and -2.
  • 382 and §383: A carryover of BIE is a “pre-change loss” subject to §382. The Final Regulations adopt the rules in the 2018 Proposed Regulations with one exception that specifically allows for a closing-of-the-books election to allocate current-year disallowed BIE to the pre-change period.  The Final Regulations also finalize a proposed regulation that §382 disallowed BIE carryforwards are not treated as a recognized built-in loss.  They also retain the §383 reordering rules of the 2018 Proposed Regulations, which provide that pre-change losses for disallowed BIE are utilized before NOLs, and losses subject to a §382 limitation are utilized before non-limited losses of the same type and from the same taxable year.

Treatment of CFCs

The Proposed Regulations follow the 2018 Proposed Regulations in providing that §163(j) is applied to CFC’s in the same way, and using the same percentage of ATI, as it is applied in determining the taxable income of a domestic corporation for the purpose of determining the US Shareholder’s deemed inclusions.  However, the Proposed Regulations make significant changes to the mechanics of applying §163(j) to CFC groups compared to the 2018 Proposed Regulations.

The 2018 Proposed Regulations provided that a group of related CFCs could make a “CFC group election” in order to compute a single amount of “net BIE” for the group.  Net BIE was generally equal to the sum of the interest expense of all of the CFCs in the group, reduced by the sum of the interest income of all of the CFCs in the group.

Once net BIE for the CFC group was determined, each CFC in the group was allocated a portion of the net BIE.  The allocable share was determined by multiplying net BIE by a fraction, the numerator of which was the net interest expense (interest expense minus interest income) incurred by the CFC, and the denominator of which was the net interest expense incurred by the CFC group (in both cases taking intercompany interest into account).  Then, each CFC’s allocation of net BIE was limited to its own separately computed §163(j) limitation.

In response to comments from taxpayers about the administrative burden of the proposed CFC group election from the 2018 Proposed Regulations, Treasury and the IRS amended this rule for the Proposed Regulations, which now state that when a group CFC election is made, §163(j) generally applies on a group-wide basis.  Therefore, the CFC group computes a group-wide §163(j) limitation, and a group-wide amount of interest expense that is subject to the limitation.  To the extent that group-wide interest expense exceeds the group-wide §163(j) limitation, the group’s disallowed interest expense carryforward is allocated to each member based on the rules that apply to consolidated groups under Treas. Reg. §1.163(j)-5.

“Roll-Up” Provision

The Proposed Regulations remove the “roll-up” (or “tier-up”) provision that enabled certain income of lower-tier CFCs in the group to be included in the ATI of higher-tier CFCs, thereby increasing the higher-tier CFCs’ §163(j) limitation.  Because the CFC group election applies the §163(j) limitation to CFCs on a group-wide basis rather than to individual CFCs, there is no need for a provision that adjusts an individual CFC’s separate ATI.

“Roll-Up” Provision for US Shareholders of a CFC Group

The 2018 Proposed Regulations also included a “roll-up” provision that adjusted the ATI of US shareholders of a CFC group by a portion of the income inclusions attributable to the CFCs.  The Proposed Regulations retain this “roll-up” provision but modify the formula used to determine the US shareholder’s ATI.

Under the Proposed Regulations, a US shareholder’s ATI is increased by the amount of income inclusions taken into account by the US shareholder multiplied by a fraction, the numerator of which is the CFC’s excess taxable income and the denominator of which is the CFC’s ATI.

Other Changes in the Proposed Regulations

The Proposed Regulations also make the following miscellaneous changes and additions to the rules used for applying §163(j) to CFCs.

  • Five-year binding election: A formal statement making a CFC group election is required, and once made, the election is binding for five years.
  • Determination of CFC group: Rules are included for determining the period that 163(j) is applied to the CFC group, for determining when and how a CFC is deemed to join or leave the CFC group, and for determining the amount of a joining CFC’s pre-group disallowed BIE carryforward that can be used by the CFC group as well as how much of a group’s disallowed BIE is allocated to a departing member of the CFC group.
  • Safe harbor: There is an annual safe-harbor election available that may exclude CFCs from §163(j) if its BIE does not exceed 30% (or 50% in 2019 or 2020) of the lesser of: (i) its TTI attributable to non-excepted trades or businesses; or (ii) its “eligible amount” for the taxable year.  The eligible amount equals the sum of the CFC’s subpart F income plus the approximate amount of the US shareholder’s GILTI inclusion before considering any §250 deduction.
  • CARES Act changes: Changes made by the CARES Act (as described above) are incorporated including provisions to implement the changes for groups of CFCs with different taxable years.
  • Stand-alone CFCs: The “roll-up” provision for US shareholders can be applied to stand-alone CFCs.
  • Anti-Abuse Rule: An anti-abuse rule addresses cases where taxpayers may be incentivized to have disallowed BIE in one year in order to use the resulting carryforwards in a future year.

Going Forward

TPC will provide additional information on this topic in part 2 of our analysis. Please contact a member of your TPC engagement team if you have any questions or to learn more about how TPC can help.