New election may provide enhanced interest deduction to multinationals
Special election in new interest regulation may benefit CFCs
INSIGHT ARTICLE |
The Tax Cuts and Jobs Act (TCJA) enacted a limit on the deductibility of business interest expense (the section 163(j) limitation). Under this limit, a taxpayer’s deduction for business interest for the tax year may not exceed the sum of (1) business income plus (2) 30 percent of the adjusted taxable income plus (3) the taxpayer’s 'floor plan financing' interest, if any. The TCJA also enacted section 951A to require the U.S. shareholders of controlled foreign corporations (CFC) to include in income their allocable share of global intangible low taxed income (GILTI) earned by CFCs. The intersection of the limitation on the deductibility of business interest expense and the inclusion of GILTI potentially creates certain adverse results, as described below.
Proposed regulations, issued on Nov. 26, 2018, provide an alternative method for CFCs to determine the amount of interest expense subject to the section 163(j) limitation that may increase the amount of deductible interest a U.S. shareholder can deduct.
Taxpayers must compute the section 163(j) limitation on a CFC by CFC basis (e.g., The business interest income of one CFC is not netted against the business interest expense of a related CFC.). However, GILTI is determined on an aggregate basis, in particular, U.S. shareholders must aggregate the taxable income (referred to as tested income) of all of their CFCs including those with losses. Without the section 163(j) limitation, a U.S. shareholder in a CFC that lends money to a related CFC would have interest income (which increases tested income) offset by a corresponding deduction for interest expense (which decreases tested income). However, if a portion of interest expense is disallowed because of the section 163(j) limitation, intercompany interest income would not be fully offset by intercompany interest expense and tested income increases, which could result in additional GILTI. The following illustration depicts this result:
CFC1 $100 of interest income increases net tested income
CFC2 $100 of interest payment may not decrease net tested income
To address this result, proposed regulations allow taxpayers to elect an approach (the alternative method) that effectively allows related CFCs to net intercompany interest income and expense amounts when determining the amount of interest expense subject to the section 163(j) limitation. For CFCs that only have intercompany interest amounts, the section 163(j) limitation would not result in disallowed interest expense if the election is made. For CFCs with both intercompany and nonintercompany interest amounts, their disallowed business interest expense could potentially be lower with an election in place. The alternative method can be elected if at least 80 percent of the value of the stock of at least two CFCs is directly or indirectly owned by a single U.S. shareholder or related U.S. shareholders that own stock of each CFC member in the same proportions. Members of a consolidated group would be treated as a single person. Special rules apply when CFCs own more than 80 percent of a controlled foreign partnership or when CFCs conduct financial services business. The election to choose the alternative method is irrevocable.
As an added benefit, when the alternative method is utilized, a U.S. taxpayer can include in ATI a portion of their subpart F or GILTI income, potentially increasing the amount of interest expense a U.S. taxpayer can deduct.
In sum, the intersection of section 163(j) and section 951A can result in an inappropriate mismatch that can artificially increase a taxpayer’s GILTI inclusion. However, proposed regulations address the issue by providing an elective alternative method for determining the amount of interest expense subject to the section 163(j) limitation. The alternative method also provides for an added benefit of potentially allowing a U.S. taxpayer to deduct additional interest expense.
These rules are very complex and taxpayers should consult their advisors for further advice on how the proposed regulations may affect them.