United States

IRS provides guidance on calculation of ATI under section 163(j)

INSIGHT ARTICLE  | 

A recently released Chief Counsel Advice 201721015 (CCA) addresses the common issue of whether to follow the statute or the proposed regulations in calculating the amount of interest disallowed under the earnings stripping rules of the Internal Revenue Code. In light of the CCA, certain taxpayers may have a unique planning opportunity.

Under section 163(j), if a corporation's debt-to-equity ratio exceeds 1.5 to 1, a deduction may not be allowed for a corporation's interest paid, or accrued, if it is ‘disqualified interest.’ This generally occurs when there is too much internal debt between a U.S. corporation and its foreign parent is subject to reduced withholding tax on interest it receives (for example under an income tax treaty). The amount that is disallowed is generally limited to the excess of the corporation’s interest expense over 50 percent of its cash flow (ATI). However, under proposed regulations issued in 1991 (but never finalized), a corporation must make several adjustments in order to calculate ATI.

The CCA, which is an internal IRS email communication, indicates that the IRS will not challenge a taxpayer that follows the statutory rules governing the calculation of ATI even if the taxpayer disregards the more detailed rules contained in the proposed regulations. Citing the Tax Court opinion in 15 West 17th Street LLC v. Commissioner, 147 T.C. No. 19 (Dec. 22, 2016), the CCA justified the taxpayer’s sole reliance on the statute based on the “permissive language of the statute and the lack of an indication in the legislative history that Congress intended the Service to modify the definition of adjusted taxable income.”

Even though the CCA sanctioned the taxpayer’s exclusive reliance on the statute, the CCA does not forbid taxpayers who may benefit from the rules of the proposed regulations from applying those regulations. This presents taxpayers with a unique planning opportunity: taxpayers can ignore the proposed regulations in favor of the statute if the proposed regulations are not beneficial as compared to the statute. However, if the more detailed rules of the proposed regulations provide a taxpayer with greater benefits than might be available under the statute, they may apply the proposed regulations. The CCA provides greater support to taxpayers who choose to apply the statute over the proposed regulations and taxpayers who did not feel comfortable taking positions based solely on the statute may wish to revisit their positions since this may result in a current cash tax benefit.

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