Further Analysis into the Final Regulations for Section163(j)

On July 27, 2020, the U.S. Department of the Treasury (the Treasury) issued final regulations providing guidance on the interest limitation requirement of Internal Revenue Code (IRC) Section 163(j), which was enacted as part of the Tax Cuts and Jobs Act (TCJA). The Treasury and the Internal Revenue Service (IRS) received numerous comments in response to these regulations in their proposed form. The final regulations reflect a number of changes that were made in response to these comments. The charts below provide information on some of the “hot topic” items from the proposed regulations and their treatment under the final regulations.

General

General Original Proposed Regs Final Regs

Definition of Interest - treatment of debt issuance costs

Debt issuance costs are included in the definition of interest expense.

Debt issuance costs are excluded from the definition of interest expense.

Adjusted taxable income (ATI) - Adjustment for depreciation and amortization in cost of goods sold for taxpayers subject to Uniform Capitalization (UNICAP)

Depreciation, amortization or depletion expense that is capitalized to inventoriable goods pursuant to Section 263A is not depreciation, amortization, or depletion that can be added back to ATI. This restriction applies regardless of whether such amounts are related to goods still in inventory at year end or in cost of goods sold (COGS).

Depreciation, amortization or depletion that is required to be capitalized to inventoriable goods pursuant to Section 263A is added back to ATI in the year it is required to be capitalized irrespective of the year it is recovered through COGS.

ATI - Adjustment for lesser of depreciation/amortization/depletion or gain upon sale

In the case of property that is sold or disposed of taxpayers are required to reduce ATI by the lesser of the gain or depreciation, amortization, or depletion deducted during years beginning after Dec. 31, 2017, and before Jan. 1, 2022.

Eliminates the requirement to subtract the "lesser of" and requires that taxpayers reduce ATI for the amount of depreciation deductions taken during the tax year with respect to the disposed property.

However, the concurrently issued proposed regulations allow taxpayers the option to use the "lesser of" approach if applied consistently.

Anti-Abuse Rule for electing Real Property Trade or Business (RPTB)

An anti-abuse rule provides that an RPTB is not eligible to be an electing RPTB if 80 percent or more of the business's real property is leased to a trade or business under common control with the RPTB. This anti-abuse rule is applied even when the related party lease was done for business purposes or was created prior to the Tax Cuts and Jobs Act (TCJA).

The anti-abuse rule has been revised to provide more opportunities for the election.

If an entity leases its real property to an entity which is under common control, the lessor may be eligible to make the election if the lessee operates an excepted trade or business, is an electing RPTB, or if the lessee subleases the property to an unrelated third party.

Inventory Capitalization

Interest capitalized to inventoriable goods under Section 263A is not considered interest expense subject to the Section 163(j) limitation.

The rules of Section 163(j) apply after the applications of provisions that require the capitalization of interest, such as Section 263A. To the extent that any interest expense is required to be capitalized, it will not be considered for Section 163(j).

Other Deferral Provisions

Deferral provisions, such as interest payments made to related taxpayers, apply before Section 163(j).

Other than Sections 461(l), 465 and 469, IRC provisions that defer the deductibility of interest expense apply before the application of Section 163(j).

Individual & Pass-through

Individual & Pass-through Original Proposed Regs Final Regs

Definition of Interest - Guaranteed payments to partners

The proposed regulations state that any guaranteed payment for the use of capital under 707(c) shall be considered business interest expense.

While guaranteed payments for the use of capital are no longer explicitly stated to be business interest expense, any amount incurred by a partnership in which the use of funds is secured for a period of time and substantially incurred in consideration for the time value of money will be deemed business interest expense.

An example is provided where a partnership is considering taking on additional debt from a third party. Instead a partner makes a capital contribution in exchange for a guaranteed payment for the use of funds. This guaranteed payment is considered to be business interest expense.

Application of Small Business Exemption - requirement to separately state interest expense and retest at shareholder or partner level

Entities meeting the definition of a small taxpayer at the entity level were required to pass business interest expense through to its shareholders or partners as a separately stated item.

The business interest expense was then retested again based upon whether the shareholder or partner met the small business definition independently.

Due to the fact that aggregation is required at the entity level for purposes of the small business exemption, in practice further limitation of the business interest expense as a result of the shareholder or partner's inability to meet the small business definition independently was the exception and not the predominate result.

However, due to the fact that many states compute non-resident shareholder/partner withholding and/or composite tax based upon non-separately stated income, the requirement to pass the exempt entities business interest expense through as a separately stated item created a situation in which some non-resident shareholders and partners might have to pay additional state taxes and/or file additional state returns as individuals.

Business interest expense of entities meeting the small business exemption is not required to be passed through as a separately stated item and generally is not subject to the Section 163(j) limitation at the shareholder or partner level.

However, a shareholder or partner of an exempt small business entity includes its share of non-excepted trade or business items of income, gain, loss and deduction (including business interest income and business interest expense) of such exempt entity when computing its ATI unless such items allocated to the shareholder or partner by the exempt entity result in a net loss allocation. In the case of a net loss allocation from a small business exempt entity, then such net loss allocation will not reduce the shareholder or partner's ATI.

Application of Small Business Exemption - interaction with real property and farming elections

Entities meeting the definition of a small taxpayer were, due to their exempt status, considered ineligible to make an election out of Section 163(j) under the provisions of Section 163(j)(7)(B) or Section 163(j)(7)(C) at the entity level even though the entity was a real property trade or business or farming business.

As a result, pass-through entities meeting the small business definition for exemption were required to separately state business interest expense and retest at the shareholder or partner level.

The ability to make the election out of Section 163(j) as a qualified real property trade or business or a qualified farming trade or business is available regardless of whether the entity also meets the small business exemption.

In light of the fact that the final regulations provide for a singular determination of small business qualification at the entity level and remove the requirement to separately passthrough business interest expense of an exempt small business, these elections in many instances will no longer be beneficial if the entity also meets the definition of a small business.

Application of Small Business Exemption - definition of tax shelter

To the extent that more than 35 percent of losses are allocated to limited entrepreneurs, the taxpayer will be considered a tax shelter and will not be able to use the small business exception.

The final regulations adopt the position of the proposed regulations. Also, new proposed rules were added to clarify that the test for the losses is based on the losses actually allocated during the year, not hypothetically allocable losses. Additionally, the proposed rules provide that the loss rules are applied without regard to Section 163(j), meaning whether or not a taxpayer has losses to allocate is based upon the income before applying any limitation under Section 163(j).

Definition of gross receipts for individuals

An individual taxpayer’s gross receipts include all items specified as gross receipts in regulations under Section 448(c), whether or not derived in the ordinary course of the taxpayer’s trade or business. For purposes of Section 163(j), an individual taxpayer’s gross receipts do not include inherently personal amounts, including, but not limited to, personal injury awards or settlements with respect to an injury of the individual taxpayer, disability benefits, Social Security benefits received by the taxpayer during the taxable year and wages received as an employee that are reported on Form W-2.

The final regulations adopt the position of the proposed regulations.

Gross receipts test - partners and shareholders

Each partner in a partnership includes a share of partnership gross receipts in proportion to such partner’s distributive share (as determined under Section 704) of items of gross income that were taken into account by the partnership under Section 703. Additionally, each shareholder in an S-corporation includes a pro rata share of S-corporation gross receipts.

The final regulations adopt the position of the proposed regulations.

Domestic C-Corporations

Domestic C-Corporations Original Proposed Regs Final Regs

Business Interest Defined for Corporations

The proposed regulations specify that for purposes of Section 163(j), all of a C-corporation's interest income and expense items are treated as allocable to a trade or business. Accordingly, all interest expense is subject to the Section 163(j) limitation and all interest income may be used to increase the taxpayer's limitation. This differs from the treatment of other entity types where a distinction is made between business and non-business interest.

The final regulations adopt the position of the proposed regulations.

Income and Deductions Defined for Corporations

The proposed regulations specify that for purposes of Section 163(j), all of a C-corporation's income, gain, deduction or loss items are treated as allocable to a trade or business. Accordingly, all such items are included in the taxpayer's calculation of ATI. This differs from the treatment of other entity types where a distinction is made between business and non-business activities.

The final regulations adopt the position of the proposed regulations.

Treatment of Consolidated Groups

The proposed regulations provide that a consolidated group of C-corporations is treated as a single taxpayer for purposes of calculating the Section 163(j) limitation and applying that limitation to the group.

In order to calculate the limitation on a consolidated basis, the taxpayer should sum each member's current year business interest income and expense. This sum should exclude any intercompany obligations as such amounts are not treated as business interest income or expense for purposes of Section 163(j).

ATI is calculated using the group's consolidated taxable income, disregarding any intercompany items to the extent they offset in consolidation.

The final regulations adopt the consolidated group treatment of the proposed regulations, but provide additional guidance on repurchase premiums as described in Reg 1.1502-13(g)(5). Such amounts are treated as business interest expense for purposes of calculating the Section 163(j) limitation of the consolidated group.

Interaction with IRC Section 381

IRC Section 381 provides generally for the survival and transfer of corporate tax attributes following a merger or acquisition. Such tax attributes typically include things like net operating loss carryovers, accounting methods, certain tax credit carryovers, etc. The proposed regulations provide that a carryover of excess interest expense under Section 163(j) is considered a tax attribute subject to the carryover provisions of Section 381 following a specified transaction.

The final regulations adopt the position of the proposed regulations and provide some additional examples and clarifying language for certain situations.

Interaction with IRC Section 382

IRC Section 382 provides a complex framework for limiting the utilization of tax attributes following a specified change in control. The primary purpose of Section 382 is to limit the trafficking of tax attributes where a corporation has little market value, but has significant tax attribute carryovers available (net operating losses, tax credits, etc.). The limitation is based on the equity value of the company at the time of the change in control. The proposed regulations provide that a carryover of excess interest expense under Section 163(j) is considered a tax attribute subject to the limitations of Section 382 following a specified change in control.

The final regulations adopt the position of the proposed regulations and provide some additional examples and clarifying language for certain situations.

Treatment of Carryforwards under pre-TCJA IRC Section 163(j)

Prior to the enactment of the TCJA, Section 163(j) limited the deduction of “disqualified interest” based on a debt-to-equity methodology. Disqualified interest was generally interest on obligations owed to or guaranteed by a related party not subject to income tax in the U.S. This provision most widely applied to interest paid or accrued to foreign related parties. It also applied to certain real estate investment trusts. The limited portion of disqualified interest became a carryforward that could be used in the future if the limitation calculation permitted. This regime was removed and replaced in the TCJA and is now often referred to as “Old Section 163(j)”.

The proposed regulations allow taxpayers with an interest carryforward under old Section 163(j) to continue that item as a carryforward under new Section 163(j) and to deduct the carryforward amount when there is sufficient limitation to do so under the rules of new Section 163(j).

The final regulations adopt the position of the proposed regulations with only some slight clarifications to the language addressing excepted trades or businesses.

Treatment of Deduction under IRC Section 250

The TCJA included the new IRC Section 250, which provides a deduction for foreign derived intangible income (FDII). Many of the deductions modified by the TCJA, including the Section 163(j) limitation and Section 250 deduction for FDII and GILTI, are limited to the taxpayer’s adjusted taxable income, which creates a circularity issue with respect to which adjusted taxable income amount governs. The Proposed Section 163(j) Regulations attempted to resolve this circularity by including ordering rules, requiring taxpayers to compute and include the Section 250 deduction without regard to Section 250(a)(2)'s taxable income limitation (the tentative Section 250 deduction) for purposes of determining the subtraction that would be included for purposes of calculating the adjusted taxable income limitation for Section 163(j).

During the comment period for the proposed regulations, numerous taxpayers commented that the current adjusted taxable income ordering rules were unclear and generally lead to unfavorable results not contemplated by Congress in its enactment of these TCJA provisions. The IRS agreed with commentators and as an attempt to reconcile those taxpayer's concerns, the final regulations permit taxpayers to adopt the method prescribed under the proposed regulations, but no longer require taxpayers follow such method so long as the taxpayer uses "any reasonable approach" to coordinate Section 250 with the Section 163(j) adjusted taxable income limitation. The Treasury notes that it anticipates studying the interaction between Sections 163(j) and 250 in future guidance.

Impact on Earnings and Profits

The proposed regulations provide that to the extent a C- corporation's interest expense deduction is limited under Section 163(j), that disallowance does not impact the calculation of the taxpayer's current earnings and profits. C-corporations should reduce earnings and profits by the full amount of interest expense without considering any disallowance or carryforward of a deduction under Section 163(j). Special rules apply to taxpayers classified as a RIC or REIT.

The final regulations did not change the effect of the Section 163(j) limitation on the calculation of earnings and profits. However, the final regulations expanded the discussion to 1) specifically include both domestic and foreign corporations and 2) clarify that such rules also apply to interest expense of a partnership in which the taxpayer is a partner. This clarification ensures corporate partners do not reduce earnings and profits twice with respect to business interest expense incurred by a partnership.

International

International Original Proposed Regs Final Regs

Application of Section 163(j) to Controlled Foreign Corporations (CFC).

The 2018 proposed regulations provided rules that require U.S. taxpayers apply the Section 163(j) limitation at the CFC's level when determining taxable income or loss of a CFC for any taxable year, clarifying that Section 163(j) applies to certain foreign corporations that constitute an "Applicable CFC" and partnerships owned by an Applicable CFC. Under the general rules of the proposed regulations, an Applicable CFCs deduction for business interest expense would be determined in the same manner as a domestic C-corporation's deduction for business interest expense.

During the comment period of the proposed regulations, numerous taxpayers commented that Section 163(j) should not be applied at the CFC level because Congress in its enactment of the TCJA did not explicitly require such application. Rejecting this argument, the Treasury notes in the preamble of the final regulations that CFCs are required to compute taxable income or loss at the CFC level utilizing U.S. taxable income principles in accordance with Reg 1.952-2, which would purportedly include application of the Section 163(j) limitation for deductible business interest expense. Therefore, consistent with the 2018 proposed regulations, the final regulations require that a CFC compute its respective Section 163(j) limitation when determining its taxable income or loss for any taxable year, noting that a foreign corporation is treated as a domestic corporation when computing its taxable income or loss, including by application of Section 163(j).

Modified CFC Group election for Section 163(j) Limitation

As an attempt to provide U.S. shareholder's with additional limitation for their respective Section 163(j) limitation computations, the proposed regulations provided a complex elective alternative method for computing the Applicable CFC's Section 163(j) limitation if the Applicable CFC is a member of a "CFC Group" and all members of the CFC Group properly make a "CFC Group Election". In so doing, the 2018 proposed regulations generally involved a computation that required a roll up method starting at the lowest tier CFC for computing the CFC group's Section 163(j) limitation.

After receiving multiple complaints from taxpayers regarding the complexity for applying the CFC group election included in the 2018 proposed regulations, the Treasury did not finalize this respective provision in the final regulations; but instead released a modified CFC group election in the new proposed Section 163(j) regulations that would alter the application of the CFC Group election for computing the Section 163(j) limitation. Under the modified CFC group election in the new proposed regulations, CFC groups would now adopt an approach similar to the Section 163(j) computation for domestic consolidated groups whereas all of the items of the CFC Group's applicable CFCs would be aggregated to compute one singular Section 163(j) limitation on behalf of the CFC Group followed by an allocation of the CFC Group's Section 163(j) limitation to each applicable CFC. Subject to certain modifications, the extent of which the CFC's Group's Section 163(j) limitation is allocable to an applicable CFC's business interest expense and carryforwards is generally determined under the rules applicable to consolidated groups under Reg. 1.163(j)-5. Finally, unlike the 2018 proposed regulations, the new proposed regulations generally permit taxpayers to revoke a CFC group election subject to certain requirements.

Application of Section 163(j) with respect to income effectively connected to a U.S. trade or business

The proposed regulations provided rules for the application of Section 163(j) with respect to specified foreign persons who generate income effectively connected with a U.S. trade or business (ECI). Specified foreign persons were defined to generally include non-resident aliens and certain foreign corporations that are not Applicable CFCs. In applying the Section 163(j) limitation to ECI, the proposed regulations contained rules that modified the general rules for computing the Section 163(j) limitation in order to only target the items generally related to a specified foreign person's ECI.

In the preamble to the new proposed regulations under Section 163(j), the Treasury notes that it did not receive any comments during the comment period for the 2018 proposed regulations but acknowledges that new proposed regulations were necessary to reconcile certain distortions that could arise with respect to applying the 2018 proposed regulations, mainly with respect to partnership items attributable to ECI and business interest expense carryforwards among other items. Further refining the rules in the 2018 proposed regulations, the new proposed regulations generally modify key terms in the 2018 proposed regulations designed to attribute partnership items with respect to ECI and also includes ordering rules that effectively characterize business interest expense carryforwards as related to ECI on the basis of the year in which the carryforward had arose.

Along with the final regulations, the IRS also issued additional guidance for Section 163(j) in the form of new proposed regulations which added clarifications and rules for previously unaddressed items. In addition, the IRS issued a notice for trades or businesses managing or operating qualified residential living facilities and FAQs on aggregations.

Taxpayers will want to consult with their advisors to determine what impact the full final regulations and additional guidance may have on their tax situation. Many of the changes reflected in the final regulations would be considered taxpayer-friendly.

Generally, the final regulations allow taxpayers and their related parties to elect to apply the final regulations to tax years beginning after Dec. 31, 2017. Taxpayers who applied the proposed regulations when filing their prior year tax return(s) may wish to consult their tax advisor on whether retroactive application of the final regulations might provide opportunities for favorable amendments.

For more information, please reach out to us at tax@dhg.com.

CONTRIBUTORS

Fran Randall
Partner, International Tax

Adam Neporadny
Managing Director, Tax

Phil Laminack
Senior Manager, Federal Corporate Tax

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