On Jan. 19, 2021, the U.S. Treasury Department (Treasury) and the Internal Revenue Service (IRS) published in the Federal Register a second batch of final regulations (T.D. 9943) providing, among other things, helpful guidance on the section 163(j) interest expense limitation for U.S. based multinational businesses and their controlled foreign corporations (CFCs) (2021 Final Regulations). The 2021 Final Regulations adopt, with certain modifications, portions of the proposed regulations under section 163(j) published in the Federal Register on Sep. 14, 2020 (REG-107911-18) (2020 Proposed Regulations).
The 2020 Proposed Regulations were accompanied by an initial set of final regulations under section 163(j) (T.D. 9905) (2020 Final Regulations) that finalized regulations that were proposed in 2018 (REG-106089-18) (2018 Proposed Regulations).
This alert discusses the application of the section 163(j) limitation to U.S. based multinational businesses and their CFCs, and to foreign persons with effectively connected income (ECI) in the U.S. Please see our Jan. 11, 2020, alerts for a general discussion of the 2021 Final Regulations (Additional section 163(j) final regulations released) and for the application of section 163(j) to partnerships and partners (IRS partially finalizes passthrough interest limitation regulations).
Applicability dates
The 2021 Final Regulations generally apply to tax years beginning on or after March 22, 2021. However, taxpayers (and their related parties) may choose to apply them early for tax years beginning after Dec. 31, 2017, provided that they apply both the 2020 and 2021 Final Regulations under section 163(j) consistently to that tax year and all subsequent tax years. The Preamble to the 2021 Final Regulations also provides that taxpayers (and their related parties) may continue to rely on portions of the 2020 Proposed Regulations not finalized by the 2021 Final Regulations, subject to certain exceptions.
For purposes of the Congressional Review Act, the 2021 Final Regulations have an effective date, which is different from the applicability dates above, of Jan. 13, 2021, the date the 2021 Final Regulations were filed for public inspection at the Office of the Federal Register. This difference is likely an effort to dodge the Biden administration’s (then expected) freeze on “midnight regulations” (i.e., regulations published after Election Day that have not taken effect by Inauguration Day).
General rules
The 2017 Tax Cuts and Jobs Act (TCJA) amended section 163(j) in its entirety and created a new set of rules that limit the amount of deductible business interest expense for a given year to the sum of:
- The taxpayer’s business interest income;
- 30% of the taxpayer’s adjusted taxable income (ATI); and
- The taxpayer’s floor plan financing interest.
The 2020 Coronavirus Aid, Relief, and Economic Security Act (CARES Act) temporarily allows the 30% ATI factor in the above formula to be increased to 50% for tax years beginning in 2019 or 2020.
Business interest expense is interest expense that is properly allocable to a trade or business. Floor plan financing interest is interest paid or accrued on debt used to finance the acquisition of motor vehicles held for sale or lease if such debt is secured by such inventory.
Taxpayers generally determine their ATI by starting with “tentative taxable income,” which is taxable income determined under section 63, but without regard to the section 163(j) limitation and without regard to any disallowed business interest expense carryforwards. Taxpayers then apply certain additions and subtractions as specified in the regulations. One of the adjustments is the subtraction for Subpart F, GILTI, and section 78 income inclusions (net of any related section 250 deduction).
Section 163(j) does not apply to certain small businesses and excepted trades or businesses (including electing real property businesses, farming businesses and certain regulated utility businesses). Amounts of business interest expense that cannot be deducted because of the section 163(j) limitation can be carried forward and treated as business interest expense in future years.
International aspects
With each batch of proposed and final regulations, Treasury and the IRS have confirmed and reconfirmed their position that section 163(j) applies to CFCs in the same manner as it applies to domestic corporations and ATI is computed under the principles of regulation section 1.952-2 or section 882 (when applicable). Thus, a CFC with business interest expense applies section 163(j) to determine the deduction limitation for purposes of computing Subpart F income, GILTI tested income and income effectively connected with a U.S. trade or business (ECI).
The 2018 Proposed Regulations provided that the section 163(j) limitation applies to CFCs on a CFC-by-CFC basis but allowed a group of highly related CFCs to make an irrevocable CFC group election to compute a single amount of net business interest expense for the group. The 2020 Final Regulations finalize much of the 2018 Proposed Regulations, including the default CFC-by-CFC rule. The 2020 Final Regulations also provide that a CFC does not include dividends from related persons in determining its ATI. However, in response to comments, the 2020 Final Regulations did not adopt the CFC group election rules. Instead, Treasury and the IRS proposed an entirely new CFC group election regime as part of the 2020 Proposed Regulations.
2020 Proposed Regulations highlights
- New CFC group election regime. Under the new CFC group regime, similar to the rules for domestic consolidated groups, a single section 163(j) limitation is computed for a CFC group. For this purpose, current year business interest expense, disallowed business interest expense carryforwards, business interest income and ATI are determined first on a separate-company basis for each CFC group member. The CFC group then sums these separately determined amounts to compute the single section 163(j) limitation for the CFC group.
In calculating the separate company amounts (and unlike the consolidated group rules), intercompany transactions between group members are generally respected. Anti-abuse provisions, however, disregard any transaction that is between members of a CFC group and entered into with a principal purpose of increasing or decreasing ATI of a CFC group member or the CFC group.
The 2020 Proposed Regulations generally apply consolidated group section 163(j) principles for purposes of allocating the single section 163(j) limitation amount to the CFC group members. Consolidated return principles also apply for purposes of determining whether CFC groups survive following certain mergers and internal restructuring transactions. Further, consolidated return separate return limitation year (SRLY) principles apply with respect to CFCs with disallowed business interest expense carryforwards that join a CFC group.
Once a CFC group election is made, it cannot be revoked for a 60-month period following the last day of the first period for which the election was made, and, once revoked, cannot be made again for 60-month following the last day of the period for which the election was revoked.
- Annual safe harbor election. The 2020 Proposed Regulations added an annual safe harbor election that exempts certain CFCs from the application of section 163(j). Only stand-alone CFCs or CFCs for which a CFC group election has been made are eligible for the safe harbor. The safe-harbor election is available if interest expense of the eligible stand-alone CFC or CFC group is less than 30% (50% for taxable years beginning in 2019 or 2020) of the lesser of “qualified tentative taxable income” (generally tentative taxable income attributable to non-excepted trades or businesses) or its “eligible amount” (generally the sum of the potential Subpart F income plus the approximate amount of GILTI inclusions). The safe harbor election cannot be made by a CFC group if any group member has pre-group disallowed business interest expense carryforward.
- ATl of US shareholder. As previously noted, Subpart F, GILTI and section 78 income inclusions are excluded from a U.S. shareholder’s ATI. However, the 2020 Proposed Regulations allow a U.S. shareholder of a stand-alone CFC or a CFC group member for whom a CFC group election is in effect to add-back to ATI a portion of its Subpart F and GILTI income inclusions (without regard to the section 78 amount) from such CFCs. Such portion is generally the ratio of the CFC’s (or the CFC group’s) excess taxable income to ATI. No amount, though, will be included in a U.S. shareholder’s ATI with respect to an eligible stand-alone CFC or CFC group that makes the safe harbor election.
- Foreign persons with ECI. The 2020 Proposed Regulations include complex rules concerning the application of section 163(j) to specified foreign persons with ECI. Because a foreign person is taxed only on its ECI rather than all of its income, certain definitions (ATI, business interest expense, business interest income and floor plan financing interest expense) are modified to take into account only ECI items. Additionally, for specified foreign persons, only ECI items and assets that are U.S. assets are taken into account in determining the amount of interest income and interest expense allocable to a trade or business (based on proportionate ATI). Disallowed business interest expense is characterized as ECI or not ECI in the year in which it arises, and it retains its characterization in later years.
2021 Final Regulations highlights
The 2021 Final Regulations adopt much of the 2020 Proposed Regulations, but modify and clarify some significant provisions relating to the application of section 163(j) to CFCs and to CFC groups, including:
- No-negative ATI rule. Under the 2020 Proposed Regulations, a taxpayer's ATI cannot be less than zero (known as the no-negative ATI rule). The 2021 Final Regulations clarify that the no-negative ATI rule applies to the ATI of a CFC group but not to the ATI of each CFC group member.
- Foreign income taxes. The 2021 Final Regulations clarify that a deduction for foreign income taxes that are eligible to be claimed as a foreign tax credit is not taken into account when computing CFC ATI.
- Annual safe harbor election. The 2021 Final Regulations modify the annual safe harbor election to also include a stand-alone CFC or CFC group if its business interest expense does not exceed its business interest income. Therefore, a stand-alone CFC or CFC group is eligible for the safe harbor election if its business interest expense does not exceed either its business interest or 30% (50% for taxable years beginning in 2019 or 2020) of the lesser of its qualified tentative taxable income or eligible amount.
- Anti-abuse rule. The 2021 Final Regulations modify the anti-abuse rule so that it may also apply to disregard intragroup transactions that are entered into with a principal purpose of manipulating a CFC group or group member’s section 163(j) limitation by increasing the group or group member’s business interest income.
- Making the CFC group election. Where a CFC group exists but no group election is made, the 2021 Final Regulations clarify that the 60-month waiting period would not be imposed. The Preamble also notes that Treasury and the IRS are studying whether an exemption to the 60-month rules would be appropriate when there is an ownership change.
The 2020 Proposed Regulations required taxpayers making a CFC group election to attach a statement with their return for the year in which the CFC group election is made or revoked. The 2021 Final Regulations keep this requirement, but add that taxpayers are also required to attach a statement to their return for each year for which a CFC group election is in effect. However, the 2021 Final Regulations say that even if the required statement is not filed the CFC group election will remain in effect.
The 2021 Final Regulations also reserve for further consideration certain important provisions of the 2020 Proposed Regulations relating to CFCs and their U.S. shareholders. The provisions reserved include:
- How to treat a CFC as a single corporation for purposes of allocations to an excepted trade or business.
- How to treat a CFC group as a single corporation for purposes of treating amounts as interest.
- The application of an ordering rule when a CFC group member generates ECI.
- The add-back of GILTI and subpart F income when calculating a U.S. shareholder’s ATI.
- The treatment of foreign persons with ECI.
Takeaway
Taxpayers and their advisors should be studying the impact of the 2021 Final Regulations on their financial statements and cash tax forecasts. Taxpayers and their advisors should also be carefully modeling out whether to apply the 2021 Final Regulations (and the reserved 2020 Proposed Regulations) retroactively.
