Guidance under section 163(j) affecting business interest deductions
Treasury and the IRS have issued Proposed Regulations (the “Proposed Regulations”) addressing the broadly applicable business interest expense deduction limitation contained in section 163(j) of the Internal Revenue Code (the “Code”) and enacted in December 2017 as part of the Tax Cuts and Jobs Act. Our prior Tax Alerts on section 163(j) are available here and here. Section 163(j) generally limits business interest deductions to the sum of (1) 30 percent of a taxpayer’s adjusted taxable income (ATI) plus (2) business interest income.
Although that deduction limitation formula may seem simple, the Code and the Proposed Regulations set out a very complex set of rules. Many are particular to specific provisions of section 163(j), such as a broad definition of interest, methods for allocating items within groups of related entities, and defining the scope of the exceptions from section 163(j). Many of the rules apply differently to different entity types, adding to the complexity. The rules for partnerships and their partners are both complex and unusual. Taxpayers with significant business interest expense will want to consider these rules when engaging in merger and acquisition activity, making borrowings, planning internal restructurings, reporting financial results, and preparing tax returns. The Proposed Regulations will affect most taxpayers, foreign and domestic, that engage in business activity and are subject to U.S. income tax.
Broad definition of interest
Some items not treated as interest under prior federal income tax rules would be treated as interest for section 163(j) purposes by the Proposed Regulations. Treasury and the IRS consider these items closely related to interest such as substitute interest payments under securities loan or repo arrangements, debt issuance costs, loan commitment fees and certain interest rate hedging income or expense.
Generally, compensation for the use of money (or other property) under a debt obligation represents interest for federal tax purposes. Compensation for the use of money is treated as interest under tax rules even where no debt instrument is present. For section 163(j) purposes, the proposed regulations expand the definition of interest to include more items representing compensation for use of money in the absence of a formal debt instrument. Under an anti-abuse rule, other amounts predominantly associated with the time value of money may be characterized as interest for purposes of section 163(j).
Surprisingly, the proposed regulations would treat as interest some costs that economically do not represent compensation for the use of funds. As a result, the proposed regulations would subject these costs to the 163(j) limitation.
Business interest versus investment interest
Section 163(j) only disallows business interest expense. Business interest is interest allocable to a trade or business, other than ‘investment interest’ within the meaning of section 163(d). Rules under section 163(d) characterize interest as investment interest to the extent the interest relates to assets held for investment. To characterize interest expense, section 163(d) generally requires tracing borrowing proceeds and characterizing the interest depending on how the proceeds are used. These are longstanding rules under section 163(d) and the proposed regulations would not revise them.
Calculating adjusted taxable income
The proposed regulations generally adhere closely to the statutory definition enacted in 2017 closely, but make some adjustments. For example, a taxpayer selling an asset that generated depreciation, amortization, or depletion that previously adjusted ATI upward would be required to adjust ATI downward by the lesser of (1) the same depreciation, amortization, or depletion amount used to adjust ATI upward, or (2) the gain recognized on the property’s sale.
Certain other adjustments would be required under the proposed regulations based on the taxpayer’s tax status. For example, U.S. shareholders of controlled foreign corporations (CFCs) that include in their federal taxable income amounts of subpart F income or global intangible low-taxed income (GILTI) with respect to a CFC do not include that subpart F income or GILTI in their own ATI (and similarly do not include in ATI certain deductions allowed under section 250 in respect of their subpart F income or GILTI). As another example, regulated investment companies (RICS, generally mutually funds) and real estate investment trusts (REITs) do not include the dividends paid deduction when calculating ATI. This special ATI rule for RICs and REITs is intended to maintain RICs’ and REITs’ ability to rely on the dividends paid deduction to attain single level tax on their earnings at the shareholder level.
C corporations may carry forward interest disallowed under 163(j). The corporation’s section 163(j) carryforward is retested each year to determine its deductibility. In addition, the TCJA made section 382 apply to section 163(j) carryforwards. Section 382 limits a corporation’s use of net operating loss (NOL) carryforwards (and certain other tax attributes) after the corporation undergoes an ownership change (as defined in section 382(g), to limit trafficking in NOLs (or other corporate tax attributes). In addition to section 163(j) carryforwards, the proposed regulations would apply section 382 to interest incurred or paid during the year of the ownership change and disallowed for that year under section 163(j).
The Proposed Regulations would extend to 163(j) carryforwards certain principles governing the use of NOL carryforwards. These include, for example, deduction after first accounting for business interest paid or incurred in the current year and timing consolidated stock basis adjustments within a consolidated group to coincide with carryforward absorption (i.e., utilization).
However, the Proposed Regulations do not apply all principles governing the utilization of NOLs to 163(j) interest expense carryforwards. For example, the Proposed Regulations do not require attribute reduction otherwise required when a corporation realizes cancellation of debt income excluded from gross income due to bankruptcy or insolvency. While treating 163(j) carryforwards as subject to attribute reduction would be a sensible result, the Proposed Regulations do not address the question. Treasury and the IRS may believe they lack authority to apply attribute reduction to section 163(j) carryforwards.
The Proposed Regulations confirm that a consolidated group of corporations computes its section 163(j) limitation on a group-wide basis. If a consolidated group sells or disposes of a subsidiary it generally would need to determine the amount of section 163(j) carryforward (if any) attributable to that subsidiary. In addition, the Proposed Regulations would essentially disregard intercompany debt when allocating §163(j) carryforwards within the group. Taxpayers must allocate based solely on the debt owed to creditors outside of the group even if an intercompany obligor indirectly bore a substantial portion of the group’s cost of debt service through payments on intercompany debt.
Generally, corporations would reduce earnings and profits (E&P) by §163(j)-disallowed interest expense in the year disallowed. RICs and REITs, however, would not reduce E&P by §163(j)-disallowed interest expense in the year disallowed. This special rule for RICs and REITs is intended to help them meet the special distribution requirements applicable to them under the Code.
S corporations carry forward disallowed interest in a manner similar to C corporations. The S corporation would then retest the section 163(j) carryforward in each year to determine its deductibility. The Proposed Regulations would extend section 382 to S corporations with section 163(j) carryforwards. After an ownership change (as defined in section 382(g)), the amount of the S corporation’s section 163(j) carryforward available for deduction would be limited under section 382.
Under the Code, depending on the context, a partnership may be treated as an entity separate from its partners (entity approach) or an entity that is a collective of all of its partners (aggregate approach). Like the statute itself, the Proposed Regulations under section 163(j) apply a hybrid approach that is complex and potentially confusing.
Consider, for example, a partnership with investment interest expense and a C corporation as a partner. Consistent with the statutory rule, taxpayers must calculate the section 163(j) limitation at the entity level prior to allocating income to the partners. Since the investment interest expense is not a trade or business expense, it is not subject to limitation under section 163(j). The partners are then allocated their share of the partnership items, which they will include in the calculation of their own income tax liability. At the C corporation partner level, the allocable investment interest expense is treated as business interest expense, and subjected to the section 163(j) limitation of the C corporation. Thus, taxpayers must make some determinations at the partnership level and others at the partner level.
The Proposed Regulations outline a complex 11-step process for calculating and allocating the partnership’s deductible business interest expense and so-called section 163(j) excess items. Those items include the partnership’s excess business interest expense (i.e., section 163(j) carryforward), excess taxable income (basically the amount of business income for the year (if any) in excess of the amount needed to permit deduction of the entity’s business interest expense), and excess business interest income (business interest income not needed to permit deduction of business interest expense at the partnership level).
At the beginning of this 11-step process, the partnership must determine its deductible business interest expense and section 163(j) excess items, which is done entirely at the partnership level. The partnership’s adjusted taxable income includes items resulting from section 734(b) basis adjustments but does not include any items resulting section 743(b) basis adjustments or remedial allocations under section 704(c) (these are later taken into account at the partner level). Excess items are then allocated in a manner that generally aims to rationalize the allocation of deductible business interest and excess items on a partner-by-partner basis.
If a taxpayer is allocated excess taxable income from a partnership that enables the taxpayer to release a 163(j) carryforward of interest previously disallowed under section 163(j) at the partnership level, the Proposed Regulations would subject the released carryforward to further 163(j) limitation at the partner level—a harsh result.
Controlled foreign corporations
In line with prior statements from Treasury, the Proposed Regulations reflect the general rule that section 163(j) applies when determining the deductibility of a CFC’s business interest expense. CFCs would apply section 163(j) to determine the deductibility of business interest expense when calculating their subpart F income, GILTI (tested income), and income that is effectively connected with the conduct of a U.S. trade or business (ECI).
However, the proposed regulations provide modifications limiting the amount of a CFC’s business interest expense subject to section 163(j). For example, in situations where interest is paid from one CFC to a related CFC, the section 163(j) limitation could result in an income mismatch. For this situation, the Proposed Regulations provide for an election to apply an alternative method that would limit the amount of business interest expense of a CFC group member subject to the section 163(j) limitation.
Additionally, the Proposed Regulations set forth detailed rules regarding the application of section 163(j) to non-CFC foreign persons with ECI. Because such foreign persons are only taxed on their ECI, the Proposed Regulations include modifications to the section 163(j) limitation. Specifically, definitions such as adjusted taxable income, business interest expense, and business interest income are modified to limit these amounts to the income or expense that is properly attributable to ECI.
Taxpayers with exempt and non-exempt businesses
Section 163(j) excepts certain types of businesses from its interest deduction limitation rules: (i) the business of performing services as an employee, (ii) an electing real property business (generally, a real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business), (iii) an electing farming (or agricultural cooperative) business, and (iv) rate-regulated electrical, water, sewage, gas, or steam sale or distribution businesses. The Proposed Regulations provide guidance for taxpayers with both section 163(j)-excepted and non-excepted businesses.
In general, a taxpayer with multiple trades or businesses will be required to allocate their interest income and expense amongst their various excepted and non-excepted trades or businesses based on the relative amounts of the taxpayer’s adjusted tax basis in the assets used in its respective businesses. Section 163(j) carryovers, however, would not be re-allocated between non-excepted and excepted trades or businesses in subsequent taxable years.
There are exceptions to the general rule where a taxpayer can or must directly allocate interest expense to specific trade or business assets. For instance, a taxpayer with qualified nonrecourse (“QNR”) debt must directly allocate interest expense related to the QNR debt to the taxpayer’s business asset that was acquired with the QNR debt proceeds. There is also a general de minimis rule – if 90 percent or more of the taxpayer’s basis in its assets are allocable to either excepted or non-excepted trades or businesses, then all of the taxpayer’s business interest income and expense is allocable to that excepted or non-excepted category. Additional industry-specific de minimis rules in the Proposed Regulations would apply to regulated utilities and REITs.
The “adjusted basis” of an asset (Adjusted Basis) may differ from the asset’s tax basis used for computing depreciation deductions and other federal tax purposes. For example, the Adjusted Basis of depreciable property other than inherently permanent structures is determined by depreciating the property using the alternative depreciation system (also known as ADS). The Adjusted Basis of land and inherently permanent structures, on the other hand, would be equal to their unadjusted basis. Based on these departures from general tax basis rules, many taxpayers with multiple trades or business would need to prepare additional tax basis balance sheets for purposes of section 163(j).
The Proposed Regulations outline permissible methodologies for allocating asset basis between multiple trades or businesses, which would in turn drive the allocation of interest between businesses. Once an allocation method is chosen, the taxpayer would need the consent of the IRS to change their method.
Small business taxpayer exception
Small business taxpayers are exempt from the business interest expense limitation rules of §163(j). To qualify, the taxpayer must have average annual gross receipts of $25 million or less for the 3 years preceding the current taxable year. The $25 million threshold will be indexed for inflation.
The entity aggregation rules of sections 52 and 414 are applied for purposes of the annual gross receipts test. “Tax shelters” as defined under section 448(a)(3) cannot qualify for the small business exception. We note that the applicable tax shelter definition has some complexity, and can encompass business entities that do not meet a common sense concept of a “tax shelter.”
A taxpayer’s status as a small business taxpayer is an annual determination that can change from year to year. If a taxpayer with a section 163(j) carryforward becomes eligible for the small business exception in a later year, the Proposed Regulations include a favorable rule providing a that section 163(j) cannot apply to limit deduction of the carryforward in that later year.
Under the Proposed Regulations, a partner’s (or an S Corporation shareholder’s) allocation of business interest expense from a partnership (or S corporation) that is a small business taxpayer will be subject to the partner’s own section 163(j) limitation, provided that the partner is not also a small business taxpayer or otherwise exempt. The partner must include its allocable share of income, gain, loss, or deduction from the partnership that is a small business taxpayer in its own section 163(j) limitation computation. This approach–testing the business interest deduction at the owner (or S corporation level) would stand in contrast to the general rule for non-exempt businesses, which requires testing at the partnership (or S corporation) level.
The Proposed Regulations would be effective for taxable years ending after the date they are finalized. They also indicate that taxpayers may rely on the Proposed Regulations for taxable years ending after Dec. 31, 2017 if the taxpayer and certain related parties consistently apply the rules of the Proposed Regulations for those years.
The issuance of Proposed Regulations under section 163(j) by Treasury and the IRS was highly anticipated and the regulations will be a great help in determining tax results for business taxpayers with interest expense. However, the proposed rules are in many instances very complex and in some instances unfavorable to taxpayers. Taxpayers with significant business interest expense should consult with their tax advisors and consider these rules when engaging in merger and acquisition activity, making borrowings, planning internal restructurings, reporting financial results, and preparing tax returns.