The Department of the Treasury issued proposed regulations under IRC Section 163(j) on November 26, 2018. In addition to providing general rules and definitions, the regulations provide guidance on the application of the limitation to Controlled Foreign Corporations (CFCs) and foreign persons with effectively connected income. The regulations will apply to tax years ending after final regulations are issued, but taxpayers may elect to apply the proposed regulations early.
Section 163(j) generally limits the deduction for business interest expense to the extent of business interest income plus 30 percent of Adjusted Taxable Income (ATI) for tax years beginning after December 31, 2017. For C corporations, ATI equals taxable income calculated without regard to interest income, interest expense or NOLs for depreciation and amortization for taxable years beginning before January 1, 2022. For U.S. shareholders of a CFC, ATI is calculated without regard to global intangible low-taxed income (GILTI), subpart F income and the §78 gross-up or any §250 deduction attributable to the GILTI inclusion.
The proposed regulations generally apply to CFCs in the same manner as a domestic C corporation. Thus, a CFC with business interest expense would apply section 163(j) to determine the extent to which that expense is deductible for purposes of computing subpart F income as defined under section 952, net CFC tested income as defined under section 951A(c)(2)(A) for calculation of the GILTI inclusion, and income which is effectively connected with the conduct of a U.S. trade or business (ECI), as applicable.
In the case that business interest expense is paid by one CFC to a related CFC, the proposed regulations would calculate the limitation at the separate entity level unless the taxpayer makes an irrevocable “CFC Group Election” in which case the limitation is applied at the group level.
Alternative Method: The CFC Group Election
A “CFC Group” includes two or more CFCs when at least 80 percent of the stock by value of each CFC is owned by a single U.S. shareholder or by related U.S. shareholders. Under the group election each member of the CFC Group is allocated a portion of the group’s “applicable net business interest expense.” Applicable net business interest expense is the excess, if any, of the sum of the amounts of business interest expense of each CFC group member over the sum of the amounts of business interest income of each CFC group member. The applicable net business interest expense is then allocated to each CFC group based on its share of net interest expense for the purpose of calculating each CFC’s 163(j) limitation.
If a CFC group election is made, an upper tier CFC group member takes into account a proportionate share of the “excess” ATI of each lower-tier member in which it directly owns stock for purposes of computing the upper tier member’s ATI. Excess ATI, in general, means the amount of a CFC group member’s ATI in excess of the amount needed before there would be disallowed business interest expense. The process of computing and “rolling up” CFC excess taxable income among CFC group members for purposes of computing ATI of each of the CFC group members begins with a lowest-tier member and continues through the chain of ownership to a highest-tier member of the CFC group. If the highest tier has excess ATI, the excess can be used by the U.S. shareholder to increase its ATI, but only to the extent of reduction in ATI for GILTI or subpart F income.
The CFC Group election can result in significant tax benefits when there is intercompany debt between related CFCs; however, careful analysis will be needed to determine if the irrevocable election should be made.
For the 2018 taxable year, taxpayers will also need to determine if early adoption of the regulations is beneficial. Without early adoption, the reduction in ATI for GILTI and subpart F income will not apply, therefore, the early adoption decision will require detailed analysis at both the CFC and US shareholder level.
Partner, DHG International Tax