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Jul 31, 2020

Long-Awaited Final and New Proposed Regulations Issued Under Section 163(j)

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LONG-AWAITED FINAL AND NEW PROPOSED REGULATIONS ISSUED UNDER SECTION 163(J)

On July 28, 2020, the Internal Revenue Service and the U.S. Department of the Treasury issued final regulations (the “Final Regulations”) under section 163(j) of the Internal Revenue Code (the “Code”).[1] These regulations finalize many of the provisions of the proposed regulations (REG-106089-18) under section 163(j) issued on November 26, 2018 (the “Proposed Regulations”). As enacted under P.L. 115-97, the Tax Cuts and Jobs Act (TCJA), on December 22, 2017, and as amended by the Coronavirus Aid, Relief, and Economic Security Act (P.L. 116-136) (the “CARES Act”), section 163(j) generally limits the deductibility of net business interest expense to 30% (or for certain years as provided under the CARES Act, 50%) of “adjusted taxable income” for taxable years beginning after December 31, 2017. Concurrently, the government has issued new proposed regulations (REG-107911-18) (the “New Proposed Regulations”) under section 163(j) that would provide a number of important additional changes and clarifications to the Final Regulations.

The Final Regulations will be effective 60 days after the date they are published in the Federal Register (the “Final Regulations Effective Date”), and except as otherwise described below, are generally applicable to taxable years beginning on or after the Final Regulations Effective Date. However, taxpayers may apply the Final Regulations retroactively to taxable years beginning after December 31, 2017, so long as the Final Regulations are applied consistently by a taxpayer and its related parties. Alternatively, taxpayers may instead rely on the Proposed Regulations for taxable years beginning after December 31, 2017 and before the Final Regulations Effective Date, so long as the Proposed Regulations are applied consistently by a taxpayer and its related parties.

The New Proposed Regulations are proposed to apply to taxable years beginning at least 60 days after the date that the Treasury decision adopting the rules as final are published in the Federal Register (the “New Proposed Regulations Effective Date”). However, taxpayers generally may apply certain aspects of the New Proposed Regulations retroactively to taxable years beginning after December 31, 2017, so long as such aspects of the New Proposed Regulations are applied consistently by a taxpayer and its related parties.

This publication provides a high-level summary of the most important aspects of the Final Regulations and the New Proposed Regulations, and where relevant, how such provisions differ from the Proposed Regulations. For more information, please contact any of the Shearman tax lawyers listed on this publication.

General Limitation Under Section 163(j)

Section 163(j) generally disallows a deduction for business interest expense (BIE) for a taxable year when such BIE exceeds the sum of (i) business interest income (BII) and (ii) 30% of adjusted taxable income (ATI) (or for certain years as provided under the CARES Act, 50% of ATI), each as calculated for such taxable year. To the extent that BIE for a taxable year exceeds this limitation, the taxpayer generally may carry forward the amount of disallowed BIE to the succeeding taxable year and beyond. However, any excess limitation (i.e., when current net interest expense is less than the applicable limitation) may not be carried forward to subsequent taxable years.

Under a small business exemption, a taxpayer with average annual gross receipts of $25 million or less (subject to inflation) for the three taxable years immediately preceding the current year generally is not subject to the section 163(j) limitation. Regulated utilities generally are not subject to the section 163(j) limitation, and certain real property businesses may elect not to apply the section 163(j) limitation subject to certain conditions.

The Proposed Regulations outlined the general calculation of a taxpayer’s BIE deduction limitation, the method for carrying forward disallowed interest expense, and the application of the small business exemption and the aggregation rules that apply with respect to such exemption. The Final Regulations largely conform to the Proposed Regulations with a few significant differences and clarifications outlined below.

Final Regulation Highlights

  • The preamble to the Final Regulations (the “Preamble”) clarifies that the section 163(j) limitation does not constitute a method of accounting for section 446 purposes, because the limitation under section 163(j) can result in a permanent disallowance of a deduction, rather than only a deferral of such deduction.
  • The Final Regulations provide rules for the CARES Act provisions that expand the section 163(j) limitation to 50% of ATI for taxable years beginning in 2019 and 2020. Taxpayers are automatically subject to the 50% limitation, unless they elect out of it. The CARES Act also permits a taxpayer to elect to use its 2019 ATI (in lieu of its 2020 ATI) for its 2020 section 163(j) calculations.
  • For taxpayers that are not corporations or partnerships, the small business exemption test under section 163(j)(3) is applied as though the taxpayer were a partnership or a corporation. The Final Regulations clarify that the gross receipts test under section 448(c) is applied as though the taxpayer were a partnership or a corporation, but the aggregation rules under section 448(c) are applied in accordance with the taxpayer’s actual entity status.

Definition of Interest

The statutory language of section 163(j) provides that the term “business interest,” means “interest paid or accrued on indebtedness properly allocable to a trade or business.” However, the Proposed Regulations expanded this definition, including by excluding the words “on indebtedness” from the definitions of BIE and BII. According to the preamble to the Proposed Regulations, the purpose of such an expansive definition of interest was to address “transactions that are indebtedness in substance even if not in form.” The Proposed Regulations set forth three broad categories of items that are treated as interest under section 163(j): (i) compensation for the use or forbearance of money, (ii) the time value component of swaps with significant nonperiodic payments, and (iii) amounts closely related to interest. The Proposed Regulations also included an anti-avoidance rule.

The first category for amounts paid, received or accrued as compensation for the use or forbearance of money included: qualified stated interest; original issue discount (OID); amounts treated as OID (including de minimis OID) under various statutory or regulatory rules; acquisition discount to the extent includible in income by a holder; repurchase premium to the extent deductible by the issuer; deferred payments treated as interest under section 483; amounts treated as interest under a section 467 rental agreement; amounts treated as interest under section 988; forgone interest under section 7872; redeemable ground rent treated as interest under section 163(c); and amounts treated as interest under section 636.

The second category of “interest” treated the time value component of a swap (other than a cleared swap) with significant nonperiodic payments as interest. Such swaps were treated as two separate transactions consisting of an on-market, level-payment swap and a loan that must be accounted for by the parties independently of the swap.

Under the third category of “interest,” the Proposed Regulations treated as interest certain amounts that are closely related to interest and that affect the economic yield or cost of funds of a transaction involving interest, but may not be compensation for the use or forbearance of money on a stand-alone basis or otherwise treated as interest under general principles. This category included (i) income, deduction, gain or loss from transactions used to hedge interest-bearing assets or liabilities; (ii) substitute interest payments; (iii) any gain treated as ordinary income under section 1258; (iv) yield adjustments with respect to a derivative as defined in section 59A(h)(4)(A); (v) commitment fees; (vi) debt issuance costs; (vii) guaranteed payments for the use of capital; and (viii) factoring income. The Proposed Regulations treated these items as both interest income and interest expense for purposes of section 163(j).

Finally, the Proposed Regulations contained an anti-avoidance rule with respect to the definition of interest (the “Anti-Avoidance Rule”), which generally treated as interest expense for purposes of section 163(j), any amounts that are predominantly associated with the time value of money in a transaction or series of transactions in which the taxpayer secures the use of funds for a period of time (and which is not included in one of the three categories described above). As the Anti-Avoidance Rule only would recharacterize an amount as interest expense, and would not recharacterize an amount as interest income, it would only apply to worsen a taxpayer’s limitation under section 163(j). Further, the Anti-Avoidance Rule under the Proposed Regulations could apply to treat an item as interest expense, even if the taxpayer’s motivation for entering into the relevant transaction did not involve tax avoidance.

Final Regulation Highlights

  • In changes that will be welcomed by many taxpayers, the Final Regulations remove a number of the more problematic items from the overbroad definition of interest in the Proposed Regulations. The result is a definition of interest that is more consistent with other parts of the Code and general tax principles and generally will be easier to implement for taxpayers.
  • While the Final Regulations retain the embedded loan rule for swaps with significant nonperiodic payments, the Final Regulations add exceptions for cleared swaps and for non-cleared swaps that require the parties to meet the margin or collateral requirements of a federal regulator or provide for margin or collateral requirements that are substantially similar to those of a federal regulator. In addition, the Final Regulations delay by one year the applicability date of the embedded loan rule for purposes of section 163(j) (except for purposes of the Anti-Avoidance Rule) to allow taxpayers additional time to develop systems to track the amount of embedded interest accrued with respect to a swap. The Final Regulations make corresponding changes to Treasury regulations section 1.446-3 such that the time value component of non-excepted swaps with significant periodic payments generally is treated as interest for all tax purposes, and not solely for purposes of section 163(j).
  • The Final Regulations provide that a substitute interest payment is treated as interest expense or interest income only if the payment relates to a sale-repurchase or securities lending transaction that is not entered into by the taxpayer in the ordinary course of its business.
  • Commitment fees and other fees paid in connection with lending transactions are removed from the definition of interest under the Final Regulations and will be addressed in future guidance.
  • The Final Regulations also exclude debt issuance costs, guaranteed payments for the use of capital, and hedging income and expense from the definition of interest.
  • However, the Final Regulations retain with important changes the Anti-Avoidance Rule, which generally will require any expense or loss to be treated as interest expense for section 163(j) purposes if (1) the expense or loss is economically equivalent to interest and (2) if a principal purpose of structuring the transaction is to reduce the taxpayer’s interest expense. The Final Regulations provide five examples to illustrate the Anti-Avoidance Rule and to provide insight into how broadly the government intends the Anti-Avoidance Rule to apply.
    • Expense or loss will be economically equivalent to interest to the extent that the expense or loss is (i) deductible by the taxpayer; (ii) incurred in a transaction or series of integrated or related transactions in which the taxpayer secures the use of funds for a period of time; (iii) substantially incurred in consideration of the time value of money; and (iv) not otherwise defined as interest under the Final Regulations.
    • Whether a transaction is entered into with a principal purpose of reducing interest expense will depend on all the facts and circumstances related to the transaction(s), except for the fact that the taxpayer has a business purpose for obtaining the use of funds and the fact that the taxpayer has obtained funds at a lower pre-tax cost based on the structure. The Final Regulations provide that “a purpose may be a principal purpose even though it is outweighed by other purposes (taken together or separately).”
    • The Anti-Avoidance Rule provides for some limited symmetry because if a recipient of an income or gain item “knows” that an expense or loss of the payor with respect to the item is treated by the payor as interest expense under the Anti-Avoidance Rule, the recipient may treat its income or gain as interest income if (1) the recipient provides the use of funds for a period of time in the transaction(s) subject to the Anti-Avoidance Rule; and (2) such income or gain is substantially earned in consideration of the time value of money provided by the taxpayer.
    • The Anti-Avoidance Rule also prevents taxpayers from artificially increasing their interest income. That is, any income realized by a taxpayer in a transaction (or series of integrated or related transactions) will not be treated as interest income of the taxpayer if and to the extent that a principal purpose for structuring the transaction is to artificially increase the taxpayer’s interest income.
    • The Final Regulations clarify that the Anti-Avoidance Rule with respect to the definition of interest, rather than the general anti-avoidance rule of Treasury regulation section 1.163(j)-2(j), applies to determine whether an item is treated as interest expense or income.

New Proposed Regulation Highlights

  • Under the New Proposed Regulations, a RIC that earns BII may pay dividends that certain shareholders may treat as interest income to the extent of the interest income of the RIC.

Definition of Adjusted Taxable Income

The Proposed Regulations provided that the starting point of ATI is to compute taxable income, in accordance with section 63 of the Code, by treating all BIE as deductible without regard to the section 163(j) limitation. Then, the Proposed Regulations provided for ATI to be calculated through adjustments to taxable income specifically required by the statutory language of section 163(j)(8)(A) (e.g., adjustments for any item of income, gain, deduction or loss which is not properly allocable to a trade or business, BIE and BII, net operating loss deductions under section 172, depreciation, amortization and depletion deductions in taxable years beginning before January 1, 2022, etc.), as well as additional adjustments relating to sales or dispositions of property with an adjusted basis that reflects depreciation, amortization or depletion deducted in taxable years beginning between January 1, 2018 and December 31, 2021. These additional adjustments under the Proposed Regulations were intended to prevent taxpayers from increasing their ATI both by the amount of depreciation, amortization or depletion deductions in those years and by the amount of gain recognized as a result of a reduced basis in property that is sold. The government thereby prevented taxpayers from obtaining a double benefit from the depreciation, amortization or depletion in computing its 163(j) limitation. However, under the Proposed Regulations, the ATI adjustments did not include depreciation, amortization or depletion that are capitalized into inventory property under section 263A and included in costs of goods sold rather than deducted, and therefore such depreciation, amortization or depletion would not be added back to determine ATI. The Proposed Regulations did not allow for any other adjustment to ATI that is not specifically listed in the regulations.

Final Regulation Highlights

  • To avoid confusion with section 63 taxable income, the Final Regulations use the term “tentative taxable income” (TTI) to refer to the amount to which adjustments are made in calculating ATI. TTI generally is determined in the same manner as taxable income under section 63, but is computed without regard to the application of the section 163(j) limitation or any disallowed BIE carryforwards.
  • The government reconsidered its position that ATI adjustments should not include depreciation, amortization or depletion deductions that are capitalized into inventory property under section 263A, in part because the provision did not reflect Congressional intent, which was to determine ATI using earnings before interest, tax, depreciation, and amortization (EBITDA) through taxable year 2021 and using earnings before interest and tax (EBIT) thereafter. Accordingly, the Final Regulations provide that the amount of any depreciation, amortization or depletion that is capitalized into inventory under section 263A during taxable years beginning before January 2022 is added back to TTI as a deduction for depreciation, amortization or depletion when calculating ATI for that taxable year, regardless of the period in which the capitalized amount is recovered through cost of goods sold.
  • A taxpayer generally must reduce its adjusted basis in an asset when the taxpayer takes depreciation deductions with respect to such asset. Thus, upon selling the asset, the taxpayer will recognize more gain or less loss. Other than with respect to timing benefits, the depreciation deductions generally have no net effect. Congress allowed depreciation deductions to be added back to taxable income during the EBITDA period as an acceleration of the excess gain that would be recognized upon sale. However, if a taxpayer sells the asset on which it took depreciation deductions after it added the amount of those deductions to ATI, the taxpayer’s ATI would be increased again. In the consolidated return context, ATI would also be increased twice where a member sold the stock of another member that holds depreciable property after making negative adjustments to its basis in its stock of the other member. The Proposed Regulations addressed these situations by ensuring that the positive adjustment to ATI for depreciation deductions merely defers depreciation deductions and does not permanently exclude them. The Final Regulations adopt these provisions and further provide that upon disposition of property that has a basis affected by amortization, depreciation or depletion during the EBITDA period, ATI must be reduced by the full amount of the basis adjustments in the property with respect to such amortization, depreciation or depletion, whether or not the taxpayer recognized gain on the disposition of the property.
  • The Final Regulations require ATI to be decreased by the amount of a taxpayer’s subpart F and GILTI income inclusions (net of any section 250(a) deduction) that are properly allocable to a non-excepted trade or business. A taxpayer’s ability to include such income in ATI under the New Proposed Regulations is discussed in “Application of Section 163(j) to Controlled Foreign Corporations and US Shareholders” below.

Ordering Rules

The Proposed Regulations provided that section 163(j) is generally applied after other provisions of the Code that defer, capitalize, disallow or otherwise limit the deductibility of interest expense. Therefore, the section 163(j) limitation generally applies to interest expense that otherwise could be deducted but for the section 163(j) limitation. Interest expense that has been deferred, capitalized, disallowed or otherwise limited in the current taxable year, or that has not yet been accrued, is not taken into account for purposes of section 163(j) (except with respect to interest deferred under another provision, which is taken into account for purposes of section 163(j), once the deferral provision no longer applies). The Final Regulations substantially adopt this approach, with certain exceptions noted below.

Specifically, like the Proposed Regulations, the Final Regulations provide that for purposes of section 163(j): (i) BIE does not include interest expense permanently disallowed as a deduction, such as in section 163(e)(5)(A)(i), (f), (l) or (m), section 264(a), section 265, section 267A, or section 279; (ii) Code provisions that defer the deductibility of interest expense, such as section 163(e)(3) and section 267(a)(2) and (3), section 1277, or section 1282, apply before section 163(j); (iii) the capitalization of interest under sections 263A and 263(g) applies before section 163(j); and (iv) section 246A applies before section 163(j).

The Final Regulations also follow the Proposed Regulations in providing that section 163(j) is applied before the excess business loss rules in section 461(l) and the at-risk rules and passive activity loss rules in sections 465 and 469, respectively.

Final Regulation Highlights

  • The Proposed Regulations referred specifically to sections 263A and 263(g) as applying before the application of section 163(j), without specifically mentioning any other provisions of the Code or Treasury regulations that could result in the capitalization of interest expense. The Final Regulations have expanded this provision so that the capitalization of interest under any provision (including, but not limited to, sections 263A and 263(g)) applies before the application of section 163(j).
  • The Final Regulations reserve on the interaction between the rules governing discharge of indebtedness income (section 108) and 163(j) (and specifically and to what extent such income should be treated as BII), stating in the Preamble that this requires further consideration and may be subject to further guidance.

Application to C Corporations Generally

The Proposed Regulations provided that all interest expense and interest income of a C corporation (including, in certain cases and subject to adjustment, members of a consolidated group, real estate investment trusts (REITs) and regulated investment companies (RICs)) would be treated as BIE and BII, as the case may be, for purposes of section 163(j), except to the extent that such amounts are allocable to an excepted trade or business. Furthermore, although a C corporation cannot have investment interest, investment expense or investment income, within the meaning of section 163(d), the Proposed Regulations provided that a C corporation’s allocable share of investment interest expense or investment interest income of a partnership would be recharacterized as BIE or BII of the C corporation partner (except to the extent the C corporation partner was allocated a share of a domestic partnership’s subpart F or GILTI inclusions that are not properly allocable to a trade or business of the domestic partnership). Therefore, under the Proposed Regulations, all of a C corporation’s interest expense was generally subject to the section 163(j) limitation, and generally all of a C corporation’s interest income increased the section 163(j) limitation, except to the extent that a portion of such interest expense or interest income was allocable to an excepted trade or business.

Final Regulation Highlights

  • The Final Regulations generally follow the approach set forth in the Proposed Regulations regarding the treatment of interest expense of a C corporation and C corporation partners. However, the Final Regulations do expand on the Proposed Regulations by providing that, in addition to any investment interest, investment income or investment expense (within the meaning of section 163(d)), any separately stated tax items that are allocated to a C corporation partner and that are neither properly attributable to a trade or business of the partnership nor subject to section 163(d) are treated as properly allocable to a trade or business of the C corporation partner. The Preamble provides, as an example of such rule, tax items allocable to rental activities that do not rise to the level of a section 162 trade or business that otherwise give rise to allowable deductions.

Application of Section 163(j) to Consolidated Groups

Under the Proposed Regulations, members of a consolidated group were aggregated for purposes of section 163(j), resulting in the consolidated group having a single section 163(j) limitation. However, partnerships that were wholly owned by members of a consolidated group were not aggregated with the consolidated group for purposes of section 163(j) (meaning that a section 163(j) limitation would apply separately at the partnership level).

The Proposed Regulations provided that the consolidated group’s ATI would generally be determined based on such consolidated group’s consolidated taxable income, as determined under Treasury regulations section 1.1502-11, determined without regard to any carryforwards or disallowances under section 163(j). However, (a) intercompany and corresponding items arising from intercompany transactions were disregarded for purposes of computing the consolidated group’s ATI, to the extent such items offset in amount; and (b) the deduction under section 250(a)(1) was determined (i) as if it were not subject to the taxable income limitation under section 250(a)(2); and (ii) without regard to the application of section 163(j). Furthermore, the Proposed Regulations provided that for purposes of computing a consolidated group’s BII, BIE and ATI, intercompany obligations (indebtedness between members of the same consolidated group) were disregarded (meaning that interest expense and income from intercompany obligations would not be treated as BIE or BII).

Additionally, the Proposed Regulations contained specific rules addressing the utilization of current-year BIE and carryforwards of disallowed BIE. Under these rules, if the aggregate current-year BIE of the consolidated group exceeded the consolidated group’s section 163(j) limitation for such year, then each member of the consolidated group with current-year BIE and current-year BII would generally deduct its own current-year BIE to the extent of its current-year BII. If the consolidated group had any remaining section 163(j) limitation, each member of the group with remaining current-year BIE would deduct an amount equal to its pro rata share of the consolidated group’s remaining section 163(j) limitation (based on its relative remaining BIE). Finally, if the consolidated group had any remaining current-year section 163(j) limitation, disallowed BIE carryforwards would be deducted by the consolidated group in the order of the taxable year in which they arose.

The Proposed Regulations contained specific rules regarding the intercompany transfers of partnership interests. In particular, the Proposed Regulations provided that the transfer of a partnership interest in an intercompany transaction that did not result in the termination of the partnership would be treated as a “disposition” for purposes of the partnership interest basis adjustment rule discussed below (resulting in an increase in the basis of the partnership interest immediately before the transfer), regardless of whether the transfer was taxable or non-taxable. Furthermore, the Proposed Regulations provided that a change in status of a member (becoming or ceasing to be a member) would not be treated as a “disposition” for this purpose.

The Proposed Regulations also provided for separate return limitation year (SRLY) and section 382 limitations for disallowed BIE carryforwards of a consolidated group. The SRLY limitation set forth in the Proposed Regulations would apply only to the extent that there was not “overlap” in the application of section 382 and the SRLY limitation. The section 163(j) SRLY limitation provided that the amount of disallowed BIE carryforwards of a member arising in a SRLY that could be used by the consolidated group could not exceed the lesser of (a) the section 163(j) limitation for that year (determined by reference solely to the member’s items for such year (and not on a cumulative basis)) and (b) the consolidated group’s overall section 163(j) limitation (after reducing such limitation by current-year BIE and disallowed BIE carryforwards arising in prior years).

Final Regulation Highlights

  • The Final Regulations clarify that where a member of a consolidated group acquires a debt instrument of another member of the consolidated group at a premium and the debt instrument is deemed satisfied and reissued at a premium under the intercompany obligation rules, the deductible repurchase premium of the debtor member arising as a result of such deemed satisfaction and reissuance is treated as interest expense of the debtor member for purposes of section 163(j). Under the Proposed Regulations, it appears that such repurchase premium would have been deductible by the debtor member without limitation under section 163(j), because the Proposed Regulations generally provided that intercompany obligations were disregarded for purposes of computing a member’s BIE. Because the Final Regulations only address the treatment of the debtor-member’s repurchase premium, it is unclear whether cancellation of debt income arising from a deemed satisfaction and reissuance (if the debt was repurchased at a discount) would be included in the debtor-member’s ATI or if it would be disregarded.
  • The Final Regulations reserve as to whether a taxable or non-taxable transfer of a partnership interest between members of a consolidated group that does not result in a termination of the partnership will be treated as a “disposition” for purposes of the partnership interest disposition rule. The Proposed Regulations provided that a transfer of a partnership interest between members of the same consolidated group would result in a “disposition” of the partnership interest.
  • The Final Regulations provide that, for purposes of applying the unified loss rule set forth in Treasury regulations section 1.1502-36, excess BIE (EBIE) will be treated as an attribute that is taken into account in the calculation of the “net inside attribute amount” for purposes of both Treasury regulations sections 1.1502-36(c) and 1.1502-36(d). Furthermore, the Final Regulations provide that EBIE will be treated as a “Category D” attribute. This expands on the Proposed Regulations, which treated disallowed BIE carryforwards, but not EBIE from a partnership, as deferred deductions that are included in the calculation of the “net inside attribute amount.”
  • The Final Regulations provide that a member’s (or SRLY subgroup’s) “cumulate section 163(j) SRLY limitation” with respect to any disallowed BIE arising in a SRLY will equal (a) the member’s (or SRLY subgroup’s) aggregate section 163(j) limitation for all consolidated return years of the group (taking into account items of income and loss from intercompany transactions (other than intercompany debt instruments)) less (b) the member’s (or SRLY subgroup’s) BIE (including disallowed BIE carryforwards) that are absorbed by the consolidated group for all consolidated return years of the group.
  • The Final Regulations provide that, while depreciation and amortization taken in taxable years beginning before January 1, 2022 are added back to a member’s ATI, (i) when the subject property is sold or disposed of by the member, such member’s ATI is reduced by an amount of the allowed depreciation and amortization of the member of the consolidated group) and (ii) when the stock of the member that claimed the depreciation or amortization deductions is sold or disposed of by another member of the consolidated group, the selling member’s ATI is reduced in an amount equal to the investment adjustments under Treasury regulations section 1.1502-32 with respect to the sold stock that are attributable to depreciation and amortization deductions taken by the subsidiary-member with respect to the subject property described in clause (i). In order to avoid a duplicative reduction to ATI, the Final Regulations include an anti-duplication rule which provides that once ATI has been reduced on an account of one of such events, it will not subsequently be reduced on account of the other event.

Effect of Section 163(j) Interest Deductibility on Earnings and Profits

The Proposed Regulations provided that a C corporation’s earnings and profits (E&P) for a taxable year would be determined without regard to any disallowance and carryforward of interest expense under section 163(j). Therefore, under the Proposed Regulations, a C corporation with disallowed BIE for a particular taxable year would calculate its current E&P by subtracting its BIE for the year, including the portion of the BIE that was disallowed under section 163(j). Under the Proposed Regulations, if a C corporation that was a partner in a partnership was allocated EBIE from a partnership, the C corporation was required to increase its E&P immediately before disposing of all or substantially all its partnership interest by its allocable share of the partnership EBIE that was not previously treated as BIE paid or accrued by such C corporation partner.

In the case of a REIT or a RIC, the Proposed Regulations stated that E&P of the REIT or RIC would be adjusted in the taxable year in which the BIE is deductible by the RIC or REIT, or if earlier, in the first taxable year for which the entity is no longer a RIC or a REIT.

Final Regulation Highlights

  • The Final Regulations clarify that because a C corporation that is a partner in a partnership reduces its E&P when it is allocated EBIE from the partnership, the corporation cannot reduce its E&P a second time when the C corporation is later permitted to deduct such EBIE.
  • The Final Regulations continue to provide that, immediately before disposing of all or a portion of its interest in the partnership, a C corporation partner in a partnership must increase its E&P by the amount of its allocable share of partnership EBIE that was not treated as BIE paid or accrued by such C corporation partner. In addition, the Final Regulations provide that a C corporation partner that disposes of an interest in a partnership must also increase its E&P upon such disposition to reflect the negative section 163(j) expense (which is created when section 704(d) suspends the allocation of a BIE deduction) that the partner did not take into account while it held the transferred partnership interest.

Application of Section 382 to Disallowed BIE

Section 382 and related Code provisions limit the ability of a “loss corporation” to utilize losses and credits following an “ownership change” to offset post-ownership change income. Section 382 generally defines an “ownership change” as a 50 percent or greater change in ownership within a certain period of time. Losses limited as a result of ownership changes under section 382 are “pre-change losses” that are subjected to a “section 382 limitation.” Section 382, as amended by the TCJA, generally treats disallowed BIE carryforwards as attributes potentially subject to limitation in a manner similar to pre-change losses.

The Proposed Regulations stated that, in addition to disallowed BIE from a taxable year ending before an ownership change, a pre-change loss included the portion of any disallowed BIE that was paid or accrued by the old loss corporation in the taxable year of the ownership change and that was attributable to the pre-ownership change period. Under the Proposed Regulations, for purposes of allocating the current-year BIE between the pre-ownership change period and the post-ownership change period, the loss corporation’s deduction for current-year BIE was required to be ratably allocated throughout the taxable year of the ownership change, even if the debt giving rise to the BIE was incurred after the date of the ownership change or repaid on the date of the ownership change.

The Proposed Regulations also contained a special rule that provided that a loss corporation’s section 382 limitation would be absorbed first by disallowed BIE carryforwards before being absorbed by the loss corporation’s net operating loss carryforwards.

Final Regulation Highlights

  • The Final Regulations no longer mandate that a loss corporation allocate disallowed BIE between the pre- and post-ownership portions of its taxable year that includes the date of an ownership change on a daily prorated basis. Instead, a loss corporations that elects under Treasury regulations section 1.382-6(b) to allocate its net operating income or loss and net capital loss or modified capital gain net income as if its books were closed on the date of the ownership change may allocate disallowed BIE between the pre- and post-change portions of the taxable year of the ownership change on a closing of the books basis.
    • Accordingly, a loss corporation that undergoes an ownership change will need to determine its pre- and post-change items of income, loss and deduction under a daily prorated methodology and a closing of the books methodology to determine which approach is more advantageous. For example, a loss corporation that incurred a significant amount of disallowed BIE following the ownership change may determine that the closing of the books election is more advantageous. On the other hand, a loss corporation that repaid a significant amount of indebtedness around the time of the ownership change (and therefore incurred a disproportionate amount of disallowed BIE in the pre-ownership change period) may determine that the daily proration methodology is more advantageous. However, loss corporations will also need to consider the impact of such elections on the allocation of items of income or loss other than BIE.
  • The Final Regulations finalized a portion of the Treasury regulations under section 382 proposed in September of 2019 that provided that the utilization of disallowed BIE carryforwards would not be treated as a recognized built-in loss for purposes of section 382(h).
  • The Preamble notes that the government is continuing to study the application of section 382(e)(3) to foreign corporations with disallowed BIE carryforwards. In particular, section 382(e)(3) provided that, except as otherwise provided in regulations, only items connected with the conduct of a U.S. trade or business are taken into account in determining the value of the equity of a loss corporation that is a foreign corporation. This would mean that section 382(e)(3) would limit the disallowed BIE carryforwards of most foreign corporations to $0, which may be of particular relevance to the calculation of a CFC’s GILTI and subpart F inclusions.
    • We believe that this result was not intended by Congress when amending section 163(j) and section 382 and anticipate that the government will promulgate regulations addressing this issue.

Application of Section 163(j) to Partnerships

The section 163(j) limitation with respect to partnerships applies at the partnership level. To the extent that a partnership’s BIE is deductible under section 163(j) (i.e., its BIE does not exceed its section 163(j) limitation), such BIE is allocated by the partnership to the partners as part of the nonseparately stated taxable income or loss of the partnership (e.g., ordinary income or loss from the partnership’s trade or business activities reported in Box 1 on Schedule K-1). As a result, deductible BIE determined at the partnership level loses its tax character for purposes of Section 163(j) in the hands of the partner to whom it is allocated, and thus is not subject to further limitations under section 163(j) at the partner level. Consistent with this principle, the partnership’s ATI, once applied in calculating the partnership’s section 163(j) limitation, is not treated as ATI when allocated to its partners. Instead, a partner’s ATI is determined separately and is increased by the partner’s distributive share of the “unused” portion of the partnership’s ATI (referred to as the partnership’s “excess taxable income” or ETI). The portion of a partnership’s interest expense that is disallowed as a deduction at the partnership level (referred to as the EBIE) is not carried forward by the partnership, but instead is allocated to and carried forward by its partners.

EBIE of a partner with respect to a partnership is treated as paid or accrued by the partner in a subsequent taxable year (and thus can be deducted by the partner to the extent not otherwise limited by section 163(j) at the partner level) only to the extent that the partner is allocated either ETI or excess business interest income (BII less BIE, referred to as EBII and together with EBIE and ETI, “excess items”) from the same partnership. For purposes of determining ATI of a partnership, partner-level adjustments (for example, section 743(b) adjustments, built-in loss amounts under section 704(c)(1)(C), and remedial allocations of income, gain, loss or deduction to a partner pursuant to section 704(c)), are not taken into account. Instead, such partner-level adjustments are taken into account at the partner level as items derived directly by the partner in determining its own section 163(j) limitation.

Final Regulation Highlights

Eleven-Step Process for Allocating Deductible Business Interest Expense and Excess Items

  • Section 163(j) specifies that deductible BIE and excess items are allocated to partners in the same manner as “nonseparately stated taxable income or loss of the partnership.” In order to accomplish this, the Proposed Regulations created an eleven-step computation for determining a partner’s share of the partnership’s deductible BIE and excess items.
  • Many commenters had noted the complexity of the eleven-step process and urged the government to allow taxpayers to rely on a simpler alternative method or any reasonable method consistently applied. The government generally rejected these comments, and thus the Final Regulations provide that such items be allocated in the manner determined in the eleven-step process and that no alternative may be used.
  • However, the Final Regulations provide that where a partnership determines that each partner has a share of the partnership’s allocable ATI, the partnership may bypass the eleven-step process and simply allocate its deductible BIE and excess items in the same proportion.

Addition of EBIE to Basis Upon Disposition of a Partnership Interest

  • The Proposed Regulations stated that, if a partner disposes of all or substantially all of its partnership interest, the partner’s basis in its partnership interest would be increased immediately before such disposition to the extent of the partner’s EBIE that has not been deemed paid or accrued by the partner.
  • In response to comments that allowing the addback to basis only upon the disposition of all or substantially all of a partnership interest would be distortive, the Final Regulations permit a proportionate addback of EBIE to basis where only a portion of the partner’s partnership interest is transferred.
  • Further, where there has been a partnership interest disposition, the New Proposed Regulations would provide for an inside basis increase at the partnership level equal to the amount of the increase in the seller’s outside basis in the partnership interest being sold. Such increase would be allocated among partnership properties in the same manner as a positive section 734(b) adjustment, but would not be depreciable or amortizable.

Allocation of Business Interest Expense from Exempt Entities

  • The Proposed Regulations provided that if a partner is allocated BIE from an exempt entity (e.g., a partnership excluded from the section 163(j) limitation under the exception for small businesses), that allocated BIE is treated as BIE subject to the partner’s section 163(j) limitations.
  • In response to comments asserting that subjecting a partner’s share of BIE from an exempt entity to the section 163(j) limitation at the partner level was inconsistent with the requirement to test partnership-level BIE at the partnership level, the Final Regulations now provide that BIE of an exempt partnership does not retain its character as BIE. Thus, BIE of an exempt entity generally is not subject to the section 163(j) limitation either at the partnership level or at the partner level.

New Proposed Regulation Highlights

Application of Limitation to Trading Partnerships (Interaction with Section 163(d))

  • The preamble to the Proposed Regulations stated that the BIE of passthrough entities allocable to trade or business activities that are per se passive under section 469 or to activities with respect to which the taxpayer does not materially participate are subject to section 163(j) at the partnership level, even where the interest expense is also subject to the investment interest limitation under section 163(d) at the partner level. Accordingly, interest expense of a partnership engaged in a trade or business would potentially have been subject to the functional equivalent of two section 163 limitations: one limitation under section 163(j) at the partnership level; and a second limitation under section 163(d) at the partner level.
  • Many commenters asserted that the interpretation set forth in the preamble to the Proposed Regulations (i.e., that interest expense could be subject to limitation under both section 163(d) and 163(j)) was at odds with section 163(j)(5), which generally provides that BIE does not include investment interest within the meaning of section 163(d). Specifically, commenters stated that the interpretation improperly results in an application of section 163(j) to a partnership engaged in the trade or business of trading personal property (including marketable securities) for the account of owners of interests in the activity (i.e., a trading partnership).
  • In response to these comments, the New Proposed Regulations would require a trading partnership to bifurcate its interest expense from a trading activity between partners that materially participate in the trading activity and partners that are passive investors (as determined under section 469), and would subject only the portion of the interest expense that is allocable to the materially participating partners to limitation under section 163(j) at the partnership level.
  • The New Proposed Regulations also require that a trading partnership bifurcate all of its other items of income, gain, loss and deduction from its trading activity between partners that materially participate in the partnership’s trading activity and partners that are passive investors, so that such items that are properly allocable to the passive investors in the partnership will not be taken into account at the partnership level for purposes of determining the partnership’s ATI.
  • Under current law, a trading partnership may not possess sufficient information to determine whether a partner materially participates in a partnership for purposes of section 469 because the partner may be treated as a material participant in the partnership’s trading activity by grouping that activity with other activities of the partner. In order to avoid this result, the New Proposed Regulations would provide that for purposes of section 469, any non-passive partnership trade or business activity in which a partner does not materially participate (whether or not related to a trading business) may not be grouped with any other activity of the taxpayer.

Fungibility of Publicly Traded Partnership Interests

  • In order to be readily tradeable, each unit of a publicly traded partnership (PTP) must have identical tax characteristics so that such PTP units are fungible. In order to achieve fungibility, a PTP both (i) makes a section 754 election and (ii) adopts the remedial allocation method under section 704(c) for all of its assets. However, notwithstanding the use of a section 754 election and the remedial method, the application of section 163(j) to a PTP can result in different tax attributes for a buyer depending upon the tax characteristics of the interest held by the seller.
  • The New Proposed Regulations would provide a method, to be applied solely to PTPs, for applying section 163(j) in a manner that is intended to allow PTP units to retain their fungibility. Specifically, the New Proposed Regulations would permit a PTP to make special allocations of section 163(j) excess items and section 704(c) remedial items in a manner that preserves fungibility, and would provide that, solely for purposes of section 163(j), a PTP must treat the amount of any section 743(b) adjustment of a purchaser of a partnership unit that relates to a remedial item that the purchaser inherits from the seller as an offset to the related section 704(c) remedial item.

Self-Charged Lending Transactions

  • The Proposed Regulations had reserved on the treatment of BII and BIE with respect to lending transactions between a partnership and a partner (generally referred to as “self-charged lending transactions”).
  • The New Proposed Regulations address self-charged lending transactions by providing that, if in a given taxable year a partner that lends to a partnership is allocated EBIE from the borrowing partnership and has interest income attributable to the self-charged loan, the lending partner would treat such interest income as an allocation of EBII from the borrowing partnership in such taxable year to the extent of the lending partner’s allocation of EBIE from the borrowing partnership in such taxable year.

Treatment of Excess Business Interest Expense in Tiered Partnerships

  • The New Proposed Regulations would take an “entity approach” to tiered partnerships by providing that if a lower-tier partnership allocates EBIE to an upper-tier partnership, the EBIE is carried forward by the upper-tier partnership (rather than that partnership’s partners), and basis reduction occurs only in the upper-tier partnership’s basis in the lower-tier partnership (and not in the basis of the partners in the upper-tier partnership). However, such EBIE would be treated as a section 705(a)(2)(B) expenditure and reduce the section 704(b) capital accounts of the upper-tier partnership’s partners.
  • The New Proposed Regulations would also include anti-loss trafficking rules intended to prevent the trafficking of EBIE of upper-tier partnerships.

Excepted Businesses and Allocations to Excepted Businesses

Section 163(j) provides that real property trades or businesses (as defined in section 469(c)(7)(C)) may elect not to be treated as a trade or business for purposes of the section 163(j) limitation. As a result, any such electing business would be exempt from the limitation and would be treated as an “excepted trade or business” within the meaning of the Proposed Regulations. However, a trade or business that has elected to be an excepted trade or business must use the ADS method of depreciation, which generally requires assets to be depreciated over a longer period than MACRS and makes the assets ineligible for immediate expensing under section 168(k) that might otherwise be available.

The amount of a taxpayer’s interest expense that is allocated to excepted businesses is not subject to limitation under section 163(j). But a taxpayer’s items of income, gain, deduction or loss (including interest income) that is properly allocable to excepted businesses is excluded from the calculation of the taxpayer’s ATI and section 163(j) limitation.

Each election applies to the taxable year for which the election is made and all subsequent taxable years and is generally irrevocable. For any partnership that conducts an eligible trade or business, the election must be made at the partnership level on an election statement attached to the partnership’s U.S. federal income tax return. The Proposed Regulations clarified that a taxpayer, including a partnership, can make an election for some but not all of its trades or businesses.

The Proposed Regulations generally required interest expense and interest income of non-corporate taxpayers first to be allocated between trades or businesses and non-trades or businesses, generally using tracing methodologies. Interest expense and interest income allocable to trades or businesses are further allocated to excepted and non-excepted businesses based on the relative amounts of the taxpayer’s basis in the assets used in its excepted and non-excepted businesses (other than the taxpayer’s basis in cash and cash equivalents and customer receivables). However, a taxpayer with qualified nonrecourse indebtedness is required to directly allocate interest expense from such indebtedness to the taxpayer’s assets that secure such debt.

Other items of expense and gross income generally are allocated to the business to which the items of expense relate or that generated the gross income, in each case with reference to relevant provisions of the section 861 regulations.

Final Regulation Highlights

Expanded Eligibility to Elect Excepted Business Status

  • The Final Regulations provide that a taxpayer engaged in rental real estate activities that would be eligible to be an electing real property trade or business (ERPTB) if such activities rose to the level of a section 162 trade or business may elect for such activities to be treated as an ERPTB.
  • The Final Regulations also provide that a business that would be eligible to be an ERPTB if it did not qualify for the small business exemption can elect to be an ERPTB instead of an exempt small business. In the case of a partnership that this new rule allows to make an ERPTB election, the partners in the partnership may be benefited because the election allows them to characterize their partnership interests as belonging to an excepted business by looking through to the assets of the partnership, which is not permitted in the case of a partnership without an ERPTB election.

Anti-Abuse Rule Regarding Captive Real Property Trades or Businesses

  • The Final Regulations follow the Proposed Regulations in prohibiting an otherwise qualifying real property business from electing to be an ERPTB if at least 80 percent of the business’s real property (by value) is leased to a business under common control with it (i.e., interest paid to a PropCo in a so-called “OpCo/PropCo structure”). But the Final Regulations provide that:
    • If at least 90 percent of a lessor’s real property is leased to a related party that operates an excepted business and/or to unrelated parties, the lessor may make an ERPTB election, or
    • if a lessor leases real property to a lessee business under common control (lessee), the lessor is eligible to make an ERPTB election for the portion of its business that is equivalent to the portion of the real property that is ultimately leased to (or used by) unrelated parties and/or related parties that operate an excepted business.

Safe Harbor for Certain REITs

  • The Proposed Regulations provided a safe harbor for REITs that directly or indirectly hold real property (which does not include mortgages and other debt obligations) that allows such REITs to elect to be an ERPTB for all or part of its assets. If a REIT makes the election and the value of its real property financing assets (such as mortgages) for the particular taxable year is 10 percent or less of the value of the REIT’s total assets, the Proposed Regulations treated all of the REIT’s assets as assets of an ERPTB. However, if the value of the REIT’s real property financing assets were more than 10 percent of the REIT’s total assets, the Proposed Regulations required the REIT to allocate items between its excepted and non-excepted businesses. The Final Regulations generally adopt this REIT safe harbor with the modifications noted below.
  • The Final Regulations provide that a partnership may apply the REIT safe harbor election at the partnership level if one or more REITs own, directly or indirectly, at least 50 percent of the partnership’s capital and profits, the partnership would satisfy the REIT income and assets requirements if the partnership were a REIT, and the partnership satisfies the requirements to qualify for the REIT safe harbor election as if the partnership were a REIT.
  • The Final Regulations also clarify that a REIT or a partnership that chooses not to apply the REIT safe harbor election may still elect the benefits of an ERPTB election for one or more of its trades or businesses if such businesses are otherwise eligible for the election.

Effect of Qualified Nonrecourse Indebtedness

  • The Final Regulations clarify that, in calculating the relative amounts of basis in the assets used in the taxpayer’s excepted and non-excepted businesses, the taxpayer disregards only an amount of basis in the assets encumbered by qualified nonrecourse indebtedness which does not exceed the amount of the obligation (rather than the full basis of such assets, as under the Proposed Regulations).

Change to De Minimis Rule for Allocating Asset Basis

  • The Final Regulations remove a de minimis rule contained in the Proposed Regulations which provided that if at least 90 percent of gross income generated by an asset is with respect to either excepted or non-excepted businesses, then the entire basis in the asset is allocated to either excepted or non-excepted businesses, respectively.

Basis of Partnership Interests and Stock in a Non-Consolidated C Corporation

  • The Final Regulations largely retain the Proposed Regulations’ look-through rules and other rules governing the treatment of basis in stock and partnership interests owned by the taxpayer.
  • The Final Regulations provide that a partner may look through to the assets of a partnership that qualifies for the small business exemption, but only if the partnership’s businesses are excepted businesses pursuant to an election by the partnership.
  • In allocating the basis of stock of a domestic non-consolidated C corporation or a CFC, the shareholder must look through to the assets of the corporation if the shareholder’s direct and indirect interest in the corporation (determined under the constructive ownership rules of section 318(a)) is at least 80 percent by vote and value, and in a change from the Proposed Regulations, may choose to look through to the corporation’s assets only if it directly owns at least 80 percent of its stock by value.

Carryforwards of Interest Expense Disallowed Under Old Section 163(j)

  • Section 163(j) as it existed prior to the enactment of the TCJA (“old section 163(j)”) disallowed certain interest deductions, including deductions for “excess interest expense” paid by certain corporations to foreign related parties, to the extent the related-party interest payments were not subjected to U.S. federal tax. Such disallowed deductions were carried forward indefinitely, with the result that some taxpayers have carried forward to taxable years subject to the TCJA-enacted version of section 163(j) amounts disallowed under old section 163(j) (“disallowed disqualified interest”). Under the Final Regulations, a taxpayer allocates disallowed disqualified interest between excepted and non-excepted businesses by using either (i) the historical approach, in which the allocation rules described above are applied to all of the taxpayer’s disallowed disqualified interest in the taxable year(s) in which the disallowed disqualified interest was paid or accrued; or (ii) the effective date approach, in which all of the taxpayer’s disallowed disqualified interest is treated as if it were paid or accrued in the taxpayer’s first taxable year beginning after December 31, 2017.

Carryforwards of BIE to Non-Excepted and Excepted Businesses

  • The Final Regulations provide that a taxpayer’s disallowed BIE that is carried forward is not re-allocated between its non-excepted and excepted businesses in a succeeding year. Rather, all disallowed BIE that is carried forward is treated as allocable to a non-excepted trade or business.

Anti-Abuse Rule Regarding Acquisition, Disposition, or Change in Use of an Asset

  • The Final Regulations retain the Proposed Regulations’ anti-abuse rule specifically aimed at preventing the distortion of allocations between excepted and non-excepted businesses, which provides that if a principal purpose for the acquisition, disposition or change in use of an asset was to artificially shift the amount of basis allocable to excepted or non-excepted businesses, the additional basis or change in use is not taken into account. An example added by the Final Regulations to the general anti-avoidance rule of Treasury regulation section 1.163(j)-2(j) to illustrate its scope suggests that transactions (particularly those not involving unrelated parties) that have as one of their purposes improving the section 163(j) position of one or more taxpayers by reducing allocations of interest expense to non-excepted businesses and/or increasing allocations of interest expense to excepted businesses may be subject to attack as having a “principal purpose of avoiding the rules of section 163(j) or the regulations” under section 163(j). 

Application of Section 163(j) to Controlled Foreign Corporations and US Shareholders

Controversially, the Proposed Regulations extended the application of section 163(j) to controlled foreign corporations (CFCs). The Final Regulations finalize the general rule applying section 163(j) to CFCs and other foreign corporations for which taxable income must be calculated for U.S. federal income tax purposes. In addition, the Final Regulations exclude dividends received from related parties from the calculation of the ATI of CFCs and other foreign corporations. However, the more specific rules addressing the application of section 163(j) to CFCs and other foreign corporations were substantially revised and issued only as part of the New Proposed Regulations. In general, a CFC with BIE applies section 163(j) to determine the amount of its deductible interest expense for purposes of computing subpart F income, tested income under section 951A, and income that is effectively connected with a U.S. trade or business (ECI). The New Proposed Regulations regarding the application of section 163(j) to subpart F income and tested income under section 951A are described below.

New Proposed Regulation Highlights

  • A “CFC group” election can be made to apply section 163(j) on a group basis with respect to “applicable CFCs” (i.e., CFCs that have U.S. shareholders that directly or indirectly own stock of the CFC) that are “specified group members” of a “specified group.”
    • A specified group includes one or more chains of applicable CFCs with a specified group parent connected through 80 percent stock ownership by value (rather than vote and value) under section 1504(a)(2)(B) in at least one applicable CFC, and stock meeting the requirements of section 1504(a)(2)(B) in each of the applicable CFCs.
    • C corporations, S corporations and qualified U.S. individuals can be specified CFC group parents. However, domestic partnerships cannot be. In certain circumstances, a CFC may also be a CFC group parent.
  • The New Proposed Regulations generally require CFC group members to compute their BIE, disallowed BIE carryforwards, BII and ATI separately. In calculating these separate company amounts, transactions between CFC group members are disregarded if entered into with a principal purpose of increasing or decreasing ATI of a CFC group member or the CFC group. The CFC group then sums these amounts to determine the section 163(j) limitation for the CFC group.
  • The New Proposed Regulations generally apply the consolidated group section 163(j) principles discussed above for purposes of determining the amount of each CFC group member’s BIE or disallowed BIE carryforward that is deductible for any year for which an election is in effect. Consolidated return principles also apply for purposes of determining whether CFC groups survive following certain mergers and internal restructuring transactions. Consolidated return separate return limitation year (SRLY) principles apply with respect to CFCs with disallowed BIE carryforwards that join a CFC group.
  • Once a CFC group election is made, it cannot be revoked for 60 months following the end of the first period for which it is made. Similarly, once a CFC group election is revoked, it cannot be made for 60 months following the end of the first period for which it is revoked.
    • Taxpayers relying on the Proposed Regulations for earlier periods can make a CFC group election under the rules previously provided. However, a CFC group election under the Proposed Regulations will have no impact on an election under the New Proposed Regulations.
  • The New Proposed Regulations provide a safe harbor that exempts certain CFCs from 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 is a year-by-year election. If the safe harbor requirements are satisfied, no section 163(j) limitation will apply to the eligible stand-alone CFC or CFC group.
    • To be eligible for the safe harbor election for a taxable year, the BIE of the eligible stand-alone CFC or CFC group cannot exceed 30 percent (50 percent for taxable years beginning in 2019 or 2020) of the lesser of “qualified tentative taxable income” or the sum of the “eligible amounts” of the CFC or CFC group. “Qualified tentative taxable income” is TTI attributable to non-excepted trades or businesses. “Eligible amounts” are the combined subpart F income and GILTI inclusions the CFC (or CFC group members) would have if it were wholly owned by domestic corporations that had no tested losses and that were not subject to the section 250(a)(2) limitation on the section 250(a)(1) deduction. The safe harbor election cannot be made by a CFC group if any group member has pre-group disallowed BIE carryforward.
  • The New Proposed Regulations provide special rules implementing the temporary section 163(j) limitation increase to 50 percent of ATI provided under the CARES Act for CFC groups. The New Proposed Regulations also provide rules for CFC groups seeking to make the election provided under the CARES Act to use 2019 ATI instead of 2020 ATI for purposes of calculating their 2020 section 163(j) limitation.
  • The New Proposed Regulations have an anti-abuse rule that increases ATI of a CFC specified group member that incurs BIE to another CFC specified group member if the BIE is incurred with a principal purpose of reducing the U.S. tax liability of a U.S. shareholder of a specified group member and no CFC group election is in effect.
  • The New Proposed Regulations allow a U.S. shareholder of a stand-alone CFC or a CFC specified group member for whom a CFC group election is in effect to include a portion of its subpart F and GILTI income inclusions from such CFCs in ATI. The amount of such inclusions includible in the ATI of the U.S. shareholder is proportionate to the portion of the CFCs’ ATI that is ETI of the CFCs. However, no amount 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 described above.

Application of Section 163(j) to Foreign Persons with Effectively Connected Income

While the Proposed Regulations included rules related to the application of section 163(j) for certain foreign persons with ECI, the government decided to reserve on issuing final regulations with respect to foreign persons with ECI and instead reissued proposed regulations. Under the New Proposed Regulations, the section 163(j) limitation will be applied to foreign persons with ECI. For purposes of applying the section 163(j) limitation to such foreign persons, the definitions of ATI, BIE and BII were modified to take into account only ECI items. The New Proposed Regulations provide specific rules applicable to partnerships with ECI, foreign corporations with ECI, and coordination rules with the branch profits tax as described below. In most respects, the New Proposed Regulations are similar to the Proposed Regulations. However, the government wanted more time to consider section 163(j) issues related to ECI.

New Proposed Regulation Highlights

  • The New Proposed Regulations clarify that a U.S. branch of a foreign person must first determine its interest expense under Treasury regulation section 1.882-5 before applying section 163(j) and the New Proposed Regulations.
  • As a general matter, a partnership is required to apply the section 163(j) limitation at the partnership level. These New Proposed Regulations address the manner in which a foreign partner determines how much of the partnership’s deductible BIE and the foreign partner’s allocations of ETI and EBIE are considered to be attributable to ECI.
    • A foreign partner determines the amount of deductible partnership BIE that is deductible against ECI by the partner through a multi-step process. The partnership must make section 163(j) calculations as if it were divided into two hypothetical partnerships. One hypothetical partnership takes into account only the foreign partner’s allocable share of ECI items, and the other hypothetical partnership takes into account only the foreign partner’s allocable share of non-ECI items. The deductible BIE of each hypothetical partnership is determined under the section 163(j) partnership rules described above. The actual partnership deductible BIE allocated to the foreign partner is allocated pro rata to ECI and non-ECI based on the relative amounts of deductible BIE of the two hypothetical partnerships.
    • The foreign partner’s BIE attributable to ECI is limited to the lesser of the hypothetical ECI partnership’s section 163(j) limitation and the foreign partner’s allocable share of BIE attributable to ECI under the foregoing calculation. The foreign partner’s BIE attributable to non-ECI is also limited to the lesser of the hypothetical non-ECI partnership’s section 163(j) limitation and the foreign partner’s allocable share of BIE attributable to non-ECI.
    • Any deductible partnership BIE in excess of the hypothetical partnership limitations is then, however, characterized as ECI or non-ECI in proportion to the remaining amounts of the specified foreign partner’s allocable share of partnership BIE.
    • The portion of ETI allocated to a foreign partner from a partnership that is ECI generally is determined based on the proportion of the foreign partner’s distributive share of partnership items that is ECI. The portion of EBII that is ECI is proportionate to the BII allocable to the partner that is ECI.
  • With respect to foreign corporations that have ECI, the New Proposed Regulations provide specific rules for determining the portion of deductible and disallowed BIE. The rules are similar to the rules for a foreign partner’s allocable share of BIE attributable to ECI and non-ECI in that the foreign corporation must calculate a hypothetical section 163(j) limitation for two hypothetical foreign corporations, a foreign corporation with ECI and a foreign corporation without ECI. The foreign corporation then must allocate the BIE between the two corporations, with the BIE allocated to the foreign corporation with ECI being potentially subject to limitation under section 163(j).
  • The New Proposed Regulations provide that after determining whether BIE is attributable to ECI or non-ECI, if such BIE is disallowed in a particular year, the BIE retains its ECI or non-ECI character in subsequent years. The New Proposed Regulations also provide ordering rules to determine the amount of EBIE that is treated as paid or accrued in a subsequent year.

Footnotes

[1]   Unless otherwise indicated, all “section” references contained herein are to sections of the Code.

Special thanks to Alex Liebmann for his contribution to this publication.

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