On July 28, Treasury and the IRS released long-awaited regulations governing the business interest expense limitation provisions of section 163(j), including both final regulations (the Final Regulations) and new proposed regulations (the 2020 Proposed Regulations). The Final Regulations clear up various uncertainties presented by the previously proposed regulations issued in 2018 (the 2018 Proposed Regulations), adopting rules that in a number of ways are more taxpayer-favorable than those of the 2018 Proposed Regulations (see prior coverage: Proposed interest deduction disallowance regulations issued). These regulations are very wide-ranging; we highlight some key issues in this Alert.
Section 163(j) in general
Section 163(j) limits business interest expense (BIE) deductions. Section 163(j) generally may apply to any taxpayer.1 It generally limits a taxpayer’s business interest deductions for a taxable year to the sum of: (1) 30% (50% for some years) of the taxpayer’s adjusted taxable income (ATI) for that year, (2) its business interest income (BII), and (3) floor plan financing interest.2
Depreciation, depletion and amortization capitalized to inventory under section 263A
Taxpayers’ deductions for depreciation, depletion and amortization (DD&A) generally are added to taxable income when computing ATI for tax years beginning prior to Jan. 1, 2022. The final regulations now allow DD&A that is capitalized into inventory under section 263A during those tax years as an addback when computing ATI. This rule reverses the position of the 2018 Proposed Regulations, which would not allow DD&A expense capitalized into inventory to be treated as a DD&A deduction in computing ATI.
This reversal is welcome news for taxpayers. As pointed out in comments received by the Treasury Department and the IRS, the 2018 Proposed Regulations’ approach would have disadvantaged manufacturers, other capital-intensive businesses, and mineral extraction businesses such as oil producers. The Final Regulations now put these industries on a level playing field with others.
However, the Final Regulations do not specify how taxpayers that did not add back capitalized DD&A should adjust prior year returns if so desired. The Final Regulations note that computing the section 163(j) limitation is not a method of accounting. As a result, taxpayers generally cannot use an accounting method change as a mechanism to ‘catch-up’ any additional interest deduction allowed under the final regulations. Taxpayers should discuss with their tax advisors whether any amended returns (or, in the case of certain partnerships, administrative adjustment requests (AARs)) with respect to previously filed federal income tax returns would be beneficial.3
Definition of Interest
The 2018 Proposed Regulations set out a broad definition of interest that would have covered many items not treated as interest under the Tax Code and applicable case law. The Final Regulations retreat from that overbroad approach, providing a definition of interest that is more consistent with the Code and case law. For example, the Final Regulations generally exclude debt issuance costs, guaranteed payments for the use of capital, and hedging income and expense from the definition of interest for purposes of section 163(j).
However, the Final Regulations also provide an anti-avoidance rule that generally will require certain items to be treated as interest expense for section 163(j) purposes if a principal purpose of their incurrence is to avoid the section 163(j) limitation. An example in the Final Regulations cites a situation in which a partnership takes a capital contribution from a partner, giving a guaranteed payment for the use of capital in return, instead of incurring third-party debt, which it was otherwise considering, as a scenario in which the anti-avoidance rule would apply.
Proposed Guidance on Tiered Partnerships
Prior to release of the 2020 proposed regulations, uncertainty existed regarding the treatment of excess business interest expense (EBIE) in tiered partnership structures. Specifically, whether excess business interest expense (EBIE) allocated to an upper-tier partnership from a lower-tier partnership would be subject to further allocation to the upper-tier partnership’s partners, and how or when the partners’ basis in an upper-tier partnership should be adjusted in relation to such EBIE from a lower-tier partnership.
Two approaches have generally been applied when allocating EBIE from a lower-tier partnership to an upper-tier partnership – the ‘Entity Approach’ in which an upper-tier partnership does not allocate such EBIE to its partners—holding the carryforward at its level, and the ‘Aggregate Approach’ in which the upper-tier partnership does allocate such EBIE to its partners. The Treasury and IRS indicate in the 2020 Proposed Regulations that the Entity Approach is the most consistent approach for partnerships in relation to section 163(j). Under the Entity Approach in the 2020 Proposed Regulations, when a lower-tier partnership allocates EBIE to an upper-tier partnership, the upper-tier partnership reduces its basis in the lower-tier partnership, however, the upper-tier partners do not reduce their basis until the EBIE is treated as paid or accrued by the upper-tier partnership in the future.
Additionally, the 2020 Proposed Regulations specify that even though EBIE does not reduce the basis of the partners in the upper-tier partnership, such EBIE is treated by the upper-tier partnership as reducing the section 704(b) capital accounts of any direct or indirect partners of the upper-tier partnership. Specific provisions provide guidance on the allocation of such EBIE when it is ultimately treated as paid or accrued and transfers of direct interest in the upper-tier partnership, and seek to prevent trafficking in section 163(j) carryforwards. Although the 2020 Proposed Regulations clarify uncertainty that existed previously, treatment of certain items raise additional concerns, for example, regarding how the 2020 Proposed Regulations would apply when an indirect partner in an upper-tier partnership further up the entity structure disposes of its interest, as well as the treatment of partnerships which have previously used the Aggregate Approach.
Section 163(j) rules applicable to C corporations
The Final Regulations address the interaction of section 163(j) with section 382. 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)). In addition to section 163(j) carryforwards, the Final Regulations extend the application of section 382 to interest paid or incurred during the year of the ownership change and disallowed for that year under section 163(j).
Generally, corporations would reduce earnings and profits (E&P) by section 163(j)-disallowed interest expense in the year disallowed. However, under both the 2018 Proposed Regulations, and these Final Regulations, RICs and REITs would not reduce E&P by section 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. The Final Regulations apply a similar principle to cooperatives, which typically rely on the deduction for patronage dividends. ATI is not reduced for certain amounts deducted under section 1382 (involving earnings passed on to members).
Special section 163(j) issues for S corporations
S corporations carry forward disallowed interest in a manner similar to C corporations. The S corporation retests the section 163(j) carryforward in each year to determine its deductibility. The regulations (both Proposed and Final) 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 is limited under section 382.
The Final Regulations also provide that a separate section 163(j) limitation should be applied to each of an S corporation’s short taxable years, or similar partial-year tax periods, stemming from, for example, a shareholder interest termination or a qualifying disposition.
Application of section 163(j) to controlled foreign corporations
The Final Regulations confirm the application of section 163(j) to controlled foreign corporations (CFCs), but do not otherwise implement the 2018 Proposed Regulations. Instead, the Treasury Department and IRS issued new proposed regulations alongside the final regulations to address how section 163(j) applies to CFCs. Highlights of the 2020 Proposed Regulations include:
- Highly related CFCs form a Specified Group and can make an election to compute their section 163(j) limitation on a group basis.
- Standalone CFCs and CFC Groups can make a safe harbor election to minimize the compliance associated with section 163(j).
Highly related CFCs means CFCs that are owned 80% (directly or indirectly, by value) by a U.S. person or another CFC from a Specified Group. A Specified Group can elect to combine current year BIE, disallowed BIE carryforward, BII, floor plan financing interest expense and ATI. The section 163(j) limitation is then computed on a combined basis with a limitation amount allocated to each CFC utilizing rules that apply to domestic consolidated groups.
Standalone CFCs or CFC Groups that have BIE that does not exceed the lesser of 30% of (1) tentative taxable income (taxable income determined by only taking into account items subject to section 163(j)) or (2) the sum of Subpart F and GILTI (including any deduction under section 250) can make an annual election to not compute their section 163(j) limitation.
The Final Regulations are effective for tax years beginning on or after 60 days after publication in the Federal Register. For calendar year taxpayers, this typically means tax year 2021 is the first year for which the Final Regulations will be binding. For tax years beginning on or after Dec. 31, 2017, but before the effective date of the Final Regulations, taxpayers may choose to rely on either the Final Regulations, or the 2018 Proposed Regulations, in their entirety. The new 2020 Proposed Regulations generally would be effective for tax years beginning on or after 60 days after they are finalized, but also carry similar reliance language, albeit in an apparently more flexible manner than the 2018 Proposed Regulations.
The Final Regulations revise the 2018 proposed regulations with respect to many other situations, including:
- Additional guidance for the application of section 163(j) to corporate consolidated groups
- Clarification of the interactions with numerous other limitation provisions, such as the passive activity loss limitations
- Applicability of section 163(j) to foreign taxpayers with income effectively connected with a U.S. trade or business
- Rules governing the qualification of entities as small business taxpayers, exempt from section 163(j)
- Treatment of taxpayers that do qualify for the small business exemption from section 163(j), including some favorable provisions for owners of pass-through entities that qualify as small business taxpayers
- Availability of a proportional basis increase on partial disposition of a partnership interest with unused section 163(j) carryforwards attached
Additional guidance provided in the 2020 Proposed Regulations covers, amongst other items:
- Favorable rules for self-charged interest between a partnership (but not an S corporation) and its owner(s)
- Treatment of interest on debt expenditures traceable to distributions from, or acquisitions of, pass-through entities (including for non-section 163(j) purposes)
- Interactions between section 163(j) and the investment interest expense limitation of section 163(d) for hedge funds and other partnerships which are engaged in the business of trading securities and commodities
- Conduit treatment for certain business interest income received by a regulated investment company (RIC)
- Rules to preserve the tax fungibility of publicly traded partnership (PTP) units
- Provisions relating to the CARES Act (the primary COVID-19 relief law to date, see prior coverage: Section 163(j) interest deduction limitation COVID-19 relief)
Further articles will be forthcoming, going into additional detail on selections from the above topics. In addition, these regulations have state and local tax implications, which are closely tied to each state’s conformity to the 163(j) provisions in both the TCJA and the CARES Act, as well as general conformity to the federal Treasury Regulations. Key structural federal-to-state differences in partially or fully conforming states, such as differences between the federal and state reporting groups, may also have a significant state-level impact.
Although not universally so, the Final Regulations and 2020 Proposed Regulations are generally taxpayer favorable, especially when compared to the 2018 Proposed Regulations. Taxpayers who would find themselves favorably affected by the final regulations with respect to returns they have already filed should consider whether amendments (or, in the case of certain partnerships, AARs) to previously filed returns would be beneficial. In any case, taxpayers should consult with their tax advisors to determine their best course of action with respect to this guidance.
1Section 163(j) may apply, for example, to corporations, partnerships or individuals. However, there is a small business exemption from section 163(j) for a business whose gross receipts, together with gross receipts of certain related parties, does not exceed a threshold on a three-year average basis (the threshold is $26 million for 2019 and is indexed for inflation). Certain farming and real estate business are excepted from section 163(j) on an elective basis. In addition, certain public utility business are excepted from section 163(j) on a mandatory (non-elective) basis.
2Floor plan financing interest generally is interest expense on certain debt funding vehicle inventory purchases.
32018 Proposed Regulations included a rule addressing ‘recapture’ of DD&A previously added to adjusted taxable income, to the extent giving rise to later gain on disposition of the subject property. The final regulations would allow taxpayers to either recapture the full amount of such depreciation, or the lesser of the prior depreciation or the actual gain on disposition of the subject property.