The IRS issued substantial guidance on July 28, 2020, under Section 163(j) that will provide many businesses (e.g., manufacturers and real estate companies) significant relief from the limit on interest deductions.
The guidance package consists of a robust set of final regulations (TD 9905), new proposed regulations (REG 107911-18), frequently asked questions (FAQ), and a proposed revenue procedure (Notice 2020-59). The final regulations revise and replace proposed regulations that were issued on Nov. 26, 2018.
Section 163(j) was substantially amended by the Tax Cuts and Jobs Act (TCJA) of 2017 to limit the deduction of business interest for tax years beginning after Dec. 31, 2017. Important developments in the new rules include:
- Retaining a broad definition of interest, but narrowing it importantly in select areas
- Removing a rule requiring manufacturers and other taxpayers to add back amounts capitalized to inventory to determine their adjusted taxable income (ATI)
- Removing an ordering rule for applying the Section 250 deduction to ATI for Section 163(j), and reserving on the issue of ordering for this and other deductions
- Revising depreciation and amortization recapture rules
- Expanding an anti-abuse rule for real estate trades or businesses eligible to elect out of the limit
- Retaining the complex 11-step calculation for partnerships allocating items affecting excess income
- Replacing the unpopular “roll-up” approach for grouping controlled foreign corporation (CFC) excess taxable income
Many of the changes are beneficial and could provide retroactive relief to when the limit first became effective. Although the final regulations are not effective until tax years beginning on or after the date that is 60 days after their publication in the Federal Register, taxpayers may apply most rules in both the final regulations and the 2020 proposed regulations to tax years beginning after Dec. 31, 2017, as discussed further below. Taxpayers should thoroughly assess the impact of the final regulations, the 2020 proposed regulations, and other recent guidance to determine how to proceed with both prospective and previously filed tax returns.
Background
Section 163(j) limits the deduction of business interest to the sum of a taxpayer’s business interest income, floor plan financing interest, and 30% of its ATI for a given taxable year. The Coronavirus Aid, Relief, and Economic Security (CARES) Act modified the limitation to 50% of ATI for tax years beginning in 2019 and 2020 (partnerships have special rules). For more information on the CARES Act changes, see our story “IRS issues guidance for Section 163(j) elections.”
The Section 163(j) limitation applies to business interest expense (business interest), which is interest expense that is properly allocable to a trade or business. Floor plan financing interest is interest paid or accrued on debt used to finance the acquisition of motor vehicles held for sale or lease if such debt is secured by such inventory. Interest that is not deductible under Section 163(j) may generally be carried forward and deducted in succeeding taxable years subject to the limitation.
The statute defines ATI as taxable income without regard to:
- Any item not properly allocable to a trade or business
- Business interest or business interest income
- Net operating loss deduction
- The deduction under Section 199A
- Any deduction for depreciation, amortization, or depletion for taxable years beginning before Jan. 1, 2022
- Other adjustments provided by Treasury
For partnerships and S corporations, the limit is generally determined at the entity level, and any deduction for business interest is taken into account in non-separately stated taxable income of the entity. A partnership is required to allocate the excess business interest expense (i.e., disallowed business interest of such partnership) to its partners in the year generated. Additional partner-level computations may be needed.
The limit does not apply to small businesses with average annual gross receipts not exceeding $25 million (adjusted for inflation) for the three prior taxable years. For purposes of Section 163(j), a “trade or business” does not include certain “excepted trades or businesses” including:
- A trade or business of performing services as an employee
- An electing real property trade or business
- An electing farming business
- An excepted regulated utility trade or business
Thus, interest expense that is properly allocable to an excepted trade or business is generally not subject to Section 163(j).
The final regulations provide key definitions and operating rules for the application of Section 163(j) to different types of taxpayers.
Definition of interest
The final regulations modify the definition of “interest” from the 2018 proposed regulations. The definition of interest is fundamental to the application of Section 163(j) because it establishes which deductions and income may qualify as business interest expense (subject to the limitation) and business interest income. Consistent with the 2018 proposed regulations, the final regulations provide a definition of interest consisting of three categories and an anti-avoidance rule.
The first category is the general rule and is unchanged from the 2018 proposed regulations. This category provides that interest for purposes of Section 163(j) includes an amount paid, received, or accrued for the use or forbearance of money under the terms of a debt instrument. This category includes:
- Original issue discount (OID)
- Qualified stated interest
- Acquisition discount
- Market discount includible in income
- Repurchase premium
- Amounts paid or received in connection with a sale-repurchase agreement that is treated as debt
- Amounts treated as interest under other provisions of the Code, including:
- Deferred payments under Section 483
- Amounts 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)
- Amounts treated as interest under Section 636
The final regulations follow the 2018 proposed regulations closely for the second category, which provides that certain swaps with significant nonperiodic payments are bifurcated as two separate transactions: an on-market, level payment swap and a loan. The time value component associated with the loan is interest under the second category. Notably, the final regulations provide exceptions for a cleared swap and a non-cleared swap subject to certain margin or collateral requirements.
The final regulations make significant changes to the third category, “other amounts treated as interest,” and exclude the following items that were in the proposed version:
- Loan commitment fees
- Guaranteed payments for the use of capital under Section 707(c)
- The deduction of debt issuance costs
- Hedging transactions
The preamble states that the treatment of commitment fees and other fees paid in connection with lending transactions will be addressed in future guidance. The other items in the third category of the final regulations are consistent with the 2018 proposed regulations with some clarifications and include:
- Premium
- Substitute interest payments related to certain sale-repurchase agreements or securities lending transactions
- Section 1258 gain
- Factoring income
Grant Thornton Insight:
Even though debt issuance costs are generally required to be deducted by the borrower over the term of a debt instrument, it is important to distinguish between debt issuance costs and OID because debt issuance costs are not included in the third category. It is also important to distinguish interest from hedging income or deductions for this reason.
The final regulations also significantly modify the anti-avoidance rule. The final regulations provide that any expense or loss that is economically equivalent to interest is treated as interest expense under Section 163(j) if a principal purpose of structuring the transaction is to reduce an amount otherwise treated as interest expense. The anti-avoidance rule also provides that any income realized in a transaction or series of transactions is not interest income for purposes of Section 163(j) if and to the extent a principal purpose for structuring the transaction is to artificially increase the taxpayer’s business interest income. The fact that a taxpayer has a business purpose does not affect whether there is a principal purpose for reducing interest expense or artificially increasing interest income. The final regulations provide examples that apply the anti-avoidance rules in certain circumstances involving a foreign currency swap, a forward contract related to gold, a fee paid by a corporation to its foreign parent for a guarantee of its debt, and a guaranteed payment to a partner.
Adjusted taxable income
The final regulations clarify further how taxpayers determine their ATI. The determination of ATI is crucial because ATI is the primary component of the Section 163(j) limitation for most taxpayers.
Under the final regulations, the starting point for determining ATI is “tentative taxable income,” which is taxable income determined under Section 63 without regard to the application of the Section 163(j) limitation and determined without regard to any disallowed business interest expense carryforward.
The 2018 proposed regulations contained a special ordering rule providing that ATI for Section 163(j) was determined without regard to the taxable income limitation in Section 250(a)(2). The final regulations remove this rule, and the preamble states that the IRS needs more time to study the appropriate rule to coordinate Section 163(j) with other provisions of the Code that limit deductions based on a taxpayer’s taxable income, such as Section 250 and net operating loss and charitable deductions. Until further guidance is issued, the preamble states that taxpayers may choose any reasonable approach to coordinate taxable income-based provisions so long as the approach is applied consistently to all relevant taxable years. The preamble specifically provides that the rule under the 2018 proposed regulations is considered reasonable.
After determining tentative taxable income, the statute requires specific adjustments. The final regulations provide for the following adjustments that are consistent with the 2018 proposed regulations with some modifications to the depreciation, depletion, and amortization (DD&A) rules --
- Additions to tentative taxable income for:
o Business interest expense
o Net operating loss deduction
o Section 199A deduction
o Deduction or loss not properly allocable to a non-excepted trade or business and
o DD&A for taxable years before Jan. 1, 2022 (or “EBITDA Period DD&A”)
o Any deduction for a capital loss carryback or carryover
- Subtractions to tentative taxable income for:
o Business interest income
o Any floor plan financing interest
o Income or gain not properly allocable to a non-excepted trade or business
The final regulations make important changes to the scope of the EBITDA Period DD&A addition that may offer significant benefits to taxpayers that capitalize certain costs to inventory. The 2018 proposed regulations provided that depreciation, amortization or depletion that is capitalized to inventory under Section 263A is not included in the EBITDA Period DD&A addition. After significant pushback from the taxpayers, the final regulations reverse this treatment and provide that the amount capitalized during the taxable year is included in the EBITDA Period DD&A addition notwithstanding the period which the capitalized amount is recovered. For example, if a taxpayer incurred $100 of depreciation in 2020 that is required to be capitalized to inventory (current year Section 471 costs), the addition to tentative taxable income in 2020 is $100 under the final regulations even though only a portion of that $100 may be recovered through cost of goods sold in 2020, with the rest is recoverable in 2021. Generally, a taxpayer’s EBITDA Period DD&A addition is the total amount of depreciation expense on Form 4562.
Grant Thornton Insight:
The inclusion of depreciation, depletion and amortization that is capitalized to inventory in the EBITDA DD&A addition is a substantial development for businesses that capitalize a high percentage of their EBITDA DD&A to inventory (e.g., manufacturers). While taxpayers may generally apply the final regulations in their entirety for years beginning after Dec. 31, 2017, taxpayers also have the ability to apply this part of the final regulations in tandem with the 2018 proposed regulations for past years.
The final regulations further clarify the meaning of “amortization” for purposes of the addition. The final regulations provide that the term includes amortization of intangibles (e.g., under Sections 167 or 197) and other amortized expenditures (e.g., under Sections 174(b), 195(b)(1)(B), 248, and 1245(a)(2)(C)).
The 2018 proposed regulations provided for adjustments under the Treasury Secretary’s authority in Section 163(j)(8)(B) for the depreciation recapture upon certain sales or dispositions of depreciable property, stock of a consolidated group, and interests in a partnership. The preamble notes that Congress provided the EBITDA Period DD&A addition to mitigate the impact of Section 163(j) during the EBITDA Period. However, to prevent a double benefit in ATI, the 2018 proposed regulations provided a subtraction adjustment for the lesser of: 1) any gain on the sale or disposition of property; or 2) any EBITDA Period DD&A with respect to such property. The final regulations provide that there is a subtraction to tentative taxable income that is equal to the greater of the EBITDA Period DD&A allowed or allowable with respect to the property (the “Recapture Subtraction”).
Consistent with the 2018 proposed regulations, the final regulations provide for a subtraction to tentative taxable income related to: 1) investment adjustments under Treas. Reg. Sec. 1.1502-32 attributable to EBITDA Period DD&A upon the sale or disposition of the stock of a member of a consolidated group (a “Stock Recapture Subtraction”); and 2) the taxpayer’s distributive share attributable to EBITDA Period DD&A upon the sale or disposition of a partnership interest to the extent such deductions were allowable under Section 704(d) (a “Partnership Recapture Subtraction”).
The preamble states that the change from the “lesser of” calculation for the Recapture Subtraction eliminates many issues that would arise under the 2018 proposed regulations. However, the new 2020 proposed regulations provide taxpayers an option to apply the lesser of calculation to the Recapture Subtraction, the Stock Recapture Subtraction, and the Partnership Recapture Subtraction so long as they apply it consistently.
The final regulations also provide additional operating rules for the Recapture Subtraction, Stock Recapture Subtraction, and Partnership Recapture Subtraction. The operating rules provide: 1) the meaning of a sale or disposition for this purpose; 2) the amount of the adjustment for members of a consolidated group, 3) a successor asset rule for consolidated groups and 4) anti-duplication rules to prevent the Recapture Subtraction and the Stock Recapture Subtraction from both applying for the same deductions.
Grant Thornton Insight:
The changes to the Recapture Subtraction under the final regulations may be less burdensome than the 2018 proposed regulations, but they still present challenges for taxpayers. In addition, taxpayers should consider whether they will benefit from applying the “lesser of calculation” under the 2020 proposed regulations.
Consistent with the 2018 proposed regulations, the final regulations also provide that a U.S. shareholder must subtract from tentative taxable income any inclusions under Subpart F, GILTI or Section 78, reduced for the Section 250(a) benefit on such deemed inclusions.
Small business exemption
The final regulations and the 2020 proposed regulations clarify certain rules regarding the small business exemption. Generally, a taxpayer that qualifies for the small business exemption is not subject to Section 163(j). A taxpayer qualifies for the small business exemption if the taxpayer is not a tax shelter and meets the gross receipts test of Section 448(c). A taxpayer meets the gross receipts test if its average annual gross receipts for the past three years are not more than $25 million, adjusted each year for inflation. Because the gross receipts test is an annual determination, a taxpayer’s status as an exempt small business can change from year to year.
Aggregation rules under Section 448(c)(2) require multiple taxpayers to aggregate their gross receipts for purposes of the gross receipts test if they are treated as a single employer under Sections 52(a) or (b) or Sections 414(m) or (o). Concurrent with the final regulations, the IRS provided FAQs to assist taxpayers through the complexities of these aggregation rules.
The final regulations provide that taxpayers that are not a corporation or a partnership with a C corporation partner must apply Section 448(c) as if they were a corporation or a partnership. However, the preamble clarifies that they should treat themselves as their actual entity type in applying Sections 52(a), 52(b), 414(m), and 414(o).
The preamble also clarifies the attribution rules that apply for purposes of determining a “brother-sister group” under Treas. Reg. Sec. 1.52-1(d)(1)(i). At the time of the 2018 proposed regulations, a “brother-sister group” was defined as entities in which a controlling interest was owned by five or fewer persons who are individuals, estates, or trusts (directly and with the application of Treas. Reg. Sec. 1.414(c)-4(b)(1), which attributes ownership to a person who has an option to purchase an interest in an organization). The preamble acknowledges that a correction on July 11, 2019, clarifies that the cross-reference should have been to Treas. Reg. Sec. 1.414(c)-4, which is a broader set of attribution rules that is not limited to solely option holders.
The 2020 proposed regulations clarify the definition of a tax shelter for purposes of the small business exemption. Generally, a tax shelter is defined in Section 448(d)(3) for purposes of the small business exemption, which references any syndicate under Section 1256(e)(3)(B). A syndicate includes a partnership or other entity (other than a corporation that is not an S corporation) that has more than 35% of its losses during the taxable year allocable to limited partners or limited entrepreneurs.
New 2020 proposed regulations under Section 1256 clarify the definition of syndicate. Specifically, the proposed regulations provide that a syndicate is determined if more than 35% of the entity’s losses are actually allocated to limited partners or limited entrepreneurs in a given taxable year notwithstanding that the statute refers to losses that are “allocable.” The 2020 proposed regulations further clarify that the determination of allocated losses is determined without regard to Section 163(j).
If the small business exemption applies to a partnership or an S corporation (an exempt entity), Section 163(j) does not limit the deduction for business interest expense of the exempt entity. The final regulations also provide that the exempt entity’s business interest expense is not subject to the Section 163(j) limitation at the partner or S corporation level, which is a significant change from the 2018 proposed regulations. Furthermore, a partner or S corporation shareholder may include its share of non-excepted trade or business income, deduction, gain, or loss from an exempt entity for determining ATI but does not include a net loss allocation.
Excepted trades or businesses
The final regulations provide more guidance related to the election that a real property trade or business or a farming business may make to opt out of the Section 163(j) limitation.
The final regulations provide that a taxpayer can make this election under Section 163(j)(7) regardless whether the taxpayer also meets the requirements for the small business exemption, reversing the 2018 proposed regulations, which had specifically precluded the election for taxpayers qualifying for the small business exception. In addition, the final regulations specify that an election for an electing real property trade or business is available regardless whether it is actually considered a trade or business under Section 162.
Consistent with the 2018 proposed regulations, the final regulations include an anti-abuse rule that prohibits an otherwise qualifying real property trade or business from making an election if at least 80% of the business’s real property was leased to related parties. This anti-abuse rule does not apply for certain REITs in either the proposed or final version. However, the 2018 proposed regulations based the test on the fair market value of the business’s real property leased, and the final regulations based the test on the fair market rental value of the real property used in the business. For this purpose, the fair market rental value of the real property is the amount of rent that an unrelated lessee would be willing to pay for a rental interest in the real property.
The final regulations also add exceptions to the rule that were not in the 2018 proposed regulations. The first exception applies if at least 90% of the lessor’s real property is leased to any combination of unrelated parties and related parties that operate excepted trades or businesses. The second exception applies a “look-through” approach that takes into account if a lessee that subleases to such parties. The exceptions do not apply when the lessor and the lessees are members of the same consolidated group.
For purposes of Section 163(j), a real property trade or business is defined by reference to Section 469(c)(7)(C) as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. The 2020 proposed regulations add definitions for two of these categories: development and redevelopment. Under these definitions, the establishment and maintenance of timberlands qualifies as a real property trade or business.
Concurrent with the final regulations, the IRS released Notice 2020-59, which provides notice of a proposed revenue procedure detailing a safe harbor under which residential living facilities can qualify as a real property trade or business.
The proposed regulations included a safe harbor that allows a REIT to be treated as a real property trade or business if it holds assets that meet the definition of “real property.” The final regulations expand this safe harbor to partnerships controlled by REITs and clarify that taxpayers can look through to the assets of indirectly controlled REITs and partnerships in applying the safe harbor.
Finally, under the 2018 proposed regulations, utilities that sell or furnish regulated items at rates established or approved by a governing body, other than an electric cooperative, were automatically an excepted trades or business only to the extent that their rates were determined on a “cost of service and rate of return” basis. The final regulations allow utilities with other rate structures established or approved by a regulatory body to elect to be treated as an excepted regulated utility trade or business.
Section 382
The final regulations generally retain the rules in the 2018 proposed regulations regarding the computation of the limitation specific to C corporations, with a notable change related to Section 382.
The final regulations clarify and modify the consequences of a Section 382 ownership change when the taxpayer has disallowed interest expense carryovers under Section 163(j). Before the final regulations, it was unclear how such current year disallowed amount was treated. Section 382(d) appeared to state that only carryovers from a prior tax year were pre-change losses subject to limitation. Under that interpretation, if a taxpayer had $100 of disallowed business interest from 2018 and $200 of disallowed business interest from 2019 with a Section 382 change in the middle of 2019, only the 2018 disallowed interest expense was subject to the limitation. The final regulations instead treat current year disallowed business interest expense allocable to the pre-ownership change period as subject to Section 382 limitation.
The 2018 proposed regulations modified the definitions of a pre-change loss under Treas. Reg. Sec. 1.382-2 to provide that the daily pro rata amount of 2019 disallowed interest expense allocable to the pre-change period was also subject to the Section 382 limitation. The final regulations retain the general definition notwithstanding the arguable statutory ambiguity but provide that taxpayers may elect to close the books for the allocation of Section 163(j) amounts in the current tax year of an ownership change similar to how taxpayers may elect to close the books for NOLs.
The final regulations also clarify a rule requiring a bankrupt taxpayer applying Section 382(l)(5) (wherein a taxpayer may avoid Section 382 when qualified creditors obtain control of the company post-bankruptcy) to back out the interest expense for the two-year period prior to the ownership change. The final regulations clarify that such interest expense haircut also applies to disallowed business interest expense.
Consolidated groups
The final regulations also generally retain the approach to treat a consolidated group as a single entity for purposes of Section 163(j) with some alterations to the rules.
Consistent with the 2018 proposed regulations, the final regulations generally provide that intercompany obligations are disregarded for purposes of determining a member’s business interest expense and business interest income, and for purposes of calculating the consolidated group’s ATI. However, the final regulations provide an exception that deductible repurchase premium from a deemed satisfaction of an intercompany obligation as the result of Treas. Reg. Sec. 1.1502-13(g)(5) is treated as interest subject to Section 163(j).
As noted above, the computation of the ATI of a consolidated group has some nuances in determining the Recapture Subtraction, the Stock Recapture Subtraction, and the Partnership Recapture Subtraction. The final regulations provide new operating rules that specifically apply to the subtractions for consolidated groups. First, a “sale or disposition” that triggers the subtraction does not include an intercompany transaction; however, a deconsolidation of a member is generally treated as a sale or disposition. The final regulations also clarify that the amount of the adjustment is the EBITDA Period DD&A allowed or allowable of any member of the consolidated group with respect to the underlying property. In addition, a successor asset rule applies if a group member has EBITDA Period DD&A and either the depreciable property or the stock of that group member is transferred to another member in an intercompany transaction resulting in the transferor receiving the other member’s stock. Finally, the final regulations provide an anti-duplication rule, which limits the aggregate subtraction of the group with respect to an item of property to the aggregate amount of the group members’ deductions. The anti-duplication rule was necessary because certain scenarios under the 2018 proposed regulations could result in both a Recapture Subtraction and a Stock Recapture Subtraction for the same EBITDA Period DD&A.
A significant change relates to the rules applying the separate return limitation year (SRLY) principles to disallowed business interest carryforwards of a group member. The Final Regulations changed the SRLY calculation rules from the rules in the 2018 proposed regulations. The 2018 proposed regulations provided for an annual computation methodology and the final regulations have a more taxpayer-logical cumulative register methodology. When a consolidated group seeks to use a net operating loss (NOL) from a SRLY, the group must compute a cumulative register to determine the aggregate amount of a member’s SRLY NOL that may potentially be absorbed by a group as of the end of a consolidated return year. The cumulative register is the member’s aggregate contribution to the group’s consolidated taxable income as of the end of the year. Thus, if the member has only been contributing losses to the group, no SRLY NOL will be freed up for group usage.
This methodology, in part, helps preserve the treatment of the entity whether the group is consolidated or not. The TCJA added disallowed business interest under Section 163(j) as a loss attribute, but the 2018 proposed regulations looked at disallowed business interest carryovers from a SRLY based on an annual register since the Section 163(j) limitation calculation itself is annual in nature. However, such a construct has the potential to treat a consolidated group differently than what would have occurred outside of consolidation. The final regulations adopt a cumulative Section 163(j) register approach whereby the amount of allowable Section 163(j) carryforwards may not exceed the aggregate Section 163(j) limitation for all consolidated return years of the group determined only by reference to the member’s items reduced by such member’s business interest expense absorbed by the group. Intercompany items are included in that calculation but not interest from intercompany obligations. The final regulations provide examples that clarify that in order to determine a member’s SRLY allowable Section 163(j) disallowed business interest carryforwards, the group must first determine current-year interest expense allowed and adjust the SRLY Section 163(j) register accordingly.
Partnerships: Final regulations
The final regulations generally retain the framework set forth in the 2018 proposed regulations for applying the Section 163(j) limit to partnerships, but several new partnership issues are addressed in the 2020 proposed regulations.
Though there were not many changes in the final regulations, several items are noteworthy, including the exclusion of guaranteed payments for the use of capital under Section 707(c) from the definition of interest as discussed above. However, an example under the anti-avoidance rules indicates that there may be instances in which, based on the facts and circumstances, a guaranteed payment is treated as interest for purposes of Section 163(j).
The final regulations do not include a separate provision on partnership mergers and divisions. The preamble explained that the regulations under Treas. Reg. Sec. 1.708-1(c) and (d) provide a construct for analyzing the tax effects of a partnership merger or division, and the IRS continues to study these issues.
The detailed 11-step calculation for allocation of Section 163(j) excess items remains intact, with a few clarifications, except for the addition of an exception from steps 3 through 11 for partnerships that allocates all Section 163(j) items in step 2 of the calculation proportionately. Commenters had requested alternative methods or adjustments to the 11-step calculation based on concerns about the complexity. However, the IRS declined to add any other methods, other than agreeing with a comment for an exception for pro rata allocations (resulting in the exception described above) and providing a worksheet and multiple examples, explaining that the 11-step calculation “produces the result that is most consistent with the normative principle in the statute that the amount of business interest expense a taxpayer is capable of deducting should increase as its ATI and business interest income increase.”
The final regulations confirm that the 11-step calculation meets Section 704(b) requirements. The preamble states that any calculations in the 11-step calculation are solely for the purpose of determining each partner’s Section 163(j) excess items, and do not otherwise affect any other provision under the Code, such as Section 704(b). Thus, the 11-step calculation does not affect the total interest expense that would be allocated to a partner under partnership tax principles but instead serves as the mechanism to determine what portion of the interest expense allocated to a partner is deductible business interest expense versus excess business interest expense.
In response to comments recommending that the basis addback rule for a disposition of all or substantially all of a partnership interest (i.e., adding back the entire amount of the remaining excess business interest expense), the final regulations expand the basis addback rule to partial dispositions. For determining the amount of the basis addback, the final regulations adopt a proportionate approach that adds back the basis of the partnership interest disposed. The proportionate approach applies the equitable apportionment principles of Treas. Reg. Sec. 1.61-6, which is referenced in Rev. Rul. 84-53. Though a distribution of money or other property in complete liquidation of a partner’s interest in a partnership is a disposition for purposes of the final regulations, a current distribution of money or other property to a partner as consideration for an interest apparently is not a disposition that triggers a basis addback. However, the IRS requested comments on whether such a current distribution should also trigger an addback.
Partnerships: New proposed regulations
Notable provisions in the 2020 proposed regulations involving partnerships including self-charged lending transactions, debt financed distributions and acquisitions, partnership basis adjustments for disposition of partnership interests, trading partnerships, and tiered partnerships.
With regard to self-charged lending transactions, the 2020 proposed regulations address situations where a partner is a lender to its partnership. The 2020 proposed regulations would treat any business interest expense (BIE) of the borrowing partnership in a self-charged lending transaction attributable to the self-charged lending transaction as BIE of the borrowing partnership. In a year where the partner is allocated excess business interest expense (EBIE) and has interest income that is attributable to the self-charged lending transaction, the partner is deemed to receive an allocation of excess business interest income (EBII) from the borrowing partnership in such tax year. Thus, the 2020 proposed regulations effectively enable a lending partner to avoid having its share of partnership level interest expense arising from the self-charged lending transaction from being limited. To prevent double counting of business interest income (BII), the lending partner would include interest income that was re-characterized as EBII pursuant to the 2020 proposed regulations only once when calculating the lending partner’s own Section 163(j) limitation. In recognition of situations where the lending partner is not a C corporation and has interest income that is investment income and is in excess of the amount re-characterized as EBII, the 2020 proposed regulations provide that such excess amount of interest income will continue to be treated as investment income of the lending partner for that year for purposes of Section 163(d). Notably, these proposed rules on self-charged lending would not apply in the case of an S corporation.
The 2020 proposed regulations would align the inside basis of partnership assets to correspond with the basis addback for a partner’s partnership interest immediately before a transfer of the partnership interest. Thus, the 2020 proposed regulations would provide that if a partner disposes of its partnership interest, the partnership increases the adjusted basis of partnership property by an amount equal to the amount of the outside basis addback.
The 2020 proposed regulations also address important pieces related to tiered partnerships, which had been reserved in the 2018 proposed regulations. Most notably, the 2020 proposed regulations apply an entity approach to the treatment of excess business interest expense in tiered partnerships. Thus, if a lower-tier partnership (LTP) allocates excess business interest expense to an upper-tier partnership (UTP), then the UTP must reduce its basis in LTP, but the partners of the UTP do not reduce the bases of their UTP interests until UTP treats the excess business interest expense as business interest expense paid or accrued. Other detailed rules in the context of tiered partnerships include the treatment by a UTP of excess business interest expense allocated to it by a LTP (that is not suspended under Section 704(d)) as a non-depreciable capital asset (with a fair market value of zero and basis equal to UTP’s basis reduction in its LTP interest), and the impact of negative basis adjustments under Sections 734(b) and 743(b). The 2020 proposed regulations also include anti-loss trafficking rules to prevent the trafficking of business interest expense.
S corporations
The final regulations leave the rules in the 2018 proposed regulations related to S corporations largely unchanged in the final regulations with some notable clarifications.
First, the 2018 proposed regulations provided that Section 382 applied to S corporations with respect to disallowed business interest expense carryforwards and requested comments. The preamble of the final regulations states that Section 382 applies only to the attributes that are carried forward at the entity level, and the application of Section 382 to S corporations for Section 163(j) purposes should not be construed to create any inference that Section 382 applies to S corporations for other purposes.
The preamble also states that Section 382 only applies to an S corporation in the event of an ownership change under Section 382(g). For example, Section 382 would not apply solely as the result of a qualified disposition that resulted in a 20% ownership change even if there was an election to terminate the S corporation’s year. The final regulations clarify that the S corporation’s business interest expense is allocated between the pre-change period and the post-change period under Treas. Reg. Sec. 1.382-6 in the event of an ownership change.
Another notable change provides rules to determine a separate Section 163(j) limitation for each hypothetical short taxable year under certain specific S corporation rules.
Trading partnerships
The 2020 proposed regulations also address the treatment of BIE of trading partnerships, and whether BIE includes investment interest within the meaning of Section 163(d). Rev. Rul. 2008-12 illustrates a situation in which a noncorporate limited partner’s distributive share of the interest expense allocable to the partnership’s trade or business of trading securities is investment interest, subject to Section 163(d)(1), if the limited partner does not materially participate in the trading activity.
The 2020 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. Only the portion of the internet expense that is allocable to the materially participating partners would be subject to the Section 163(j) limitation at the partnership level.
Additionally, the 2020 proposed regulations 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. The portion of the partnership’s other items from its trading activity properly allocable to the passive investors would not be taken into account at the entity level as items from a trade or business for purposes of applying Section 163(j) at the partnership level. Instead, such items would be treated as items from an investment activity of the partnership for purposes of Sections 163(j) and 163(d). Because there are no rules requiring a partner to inform the partnership whether for purposes of Section 469 the partner has grouped activities of the partnership with other activities outside of the partnership, the partnership might not possess knowledge about an individual partner’s grouping decisions. Thus, the proposed regulations add a new rule to the activity grouping rules in Section 469 that provides any non-passive partnership trade or business activity in which a partner does not materially participate (whether or not a trading business) may not be grouped with any other activity of the taxpayer.
The preamble of the 2020 proposed regulations invite comments whether similar rules should be adopted for S corporations and whether the bifurcation of items would run afoul of a second class of stock.
Allocation of interest expense for passthrough entities
The 2020 proposed regulations include new rules for allocating interest expense of pass-through entities (partnerships and S corporations) between trade or business activities and other activities, such as investment activities and personal expenditures.
Generally, pass-through entities apply Treas. Reg. Sec. 1.163-8T, with the new proposed regulations providing additional rules. The proposed rules provide that a passthrough entity allocates interest expense on a debt in the same manner as the debt related to such interest is allocated, and the debt is generally allocated by tracing disbursements of the debt proceeds to specific expenditures.
Interest expense allocated to trade or business expenditures is taken into account at the pass-through entity level (i.e., potentially subject to Section 163(j)). Interest expense allocated to other expenditures, such as investment expenditures or personal expenditures, is taken into account at the partner or shareholder level and subject to other interest limitation provisions.
When the rules determine that debt proceeds are allocated to distributions to the owners of a pass-through entity (distributed debt proceeds), the 2020 proposed regulations provide a complex series of calculations to allocate the interest expense related to the distributed debt proceeds.
Similar to the non-distribution context, interest expense is allocated according to how the distributed debt proceeds are allocated. First, the distributed debt proceeds are allocated to the pass-through entity’s available expenditures, which gives rise to “expenditure interest expense.” Similar to the general rule, expenditure interest expense allocated to business expenditures is taken into account at the pass-through level and subject to Section 163(j), while interest allocable to other expenditures is taken into account at the partner or shareholder level and subject to other interest limitation provisions.
If the distributed debt proceeds exceed the amount of available expenditures, each partner or shareholder that received a distribution must apply a formula to determine the amount of interest expense that must be characterized as “debt financed distribution interest expense.” The tax treatment of debt financed interest expense is determined by the owner’s use of any distributed debt proceeds.
Finally, a partner’s or shareholder’s allocable share of interest expense may exceed the aggregate of expenditure interest expense and debt financed distribution interest expense. In this instance, such “excess interest expense” is allocated according to the pass-through entity’s tax basis in its assets. For example, if a partnership had business assets of $75 and investment assets of $25 for a total asset basis of $100, 75% of the excess interest expense would be taken into account at the pass-through entity level, potentially subject to Section 163(j), and the remaining 25% would be subject to the investment interest limitation at the partner level.
If a pass-through interest is transferred to an unrelated third party, the transferee may treat any debt financed distribution interest expense as excess interest expense instead. If a pass-through interest is transferred to a related party, any debt financed distribution interest expense of the transferor would continue to be debt financed distribution interest expense of the related party transferee, and the tax treatment to the related party transferee would be the same as to the transferor.
The 2020 proposed regulations also provide that interest on debt used to purchase an interest in a pass-through entity, or a contribution to capital, must be allocated according to the pass-through entity’s relative basis in its assets.
CFCs and foreign persons
The final regulations provide rules regarding the application of the Section 163(j) limitation to foreign corporations and U.S. shareholders. Consistent with the 2018 proposed regulations, the final regulations apply Section 163(j) to applicable controlled foreign corporations (CFCs) and other foreign corporations whose income is relevant for U.S. tax purposes. Several commenters requested that the regulations exempt or otherwise exclude certain foreign corporations from the scope of Section 163(j). However, the IRS determined that Section 163(j) applies to foreign corporations and does so in generally the same manner as it applies to determine the deductibility of a domestic C corporation’s business interest expense for purposes of computing its taxable income.
As noted above, the final regulations continue to require adjustments to ATI for amounts included in income by U.S. shareholders under the Subpart F or GILTI regimes as well as any corresponding gross-ups under Section 78.
This is largely where the similarities in the international rules end between the final regulations and the 2018 proposed regulations. in the final regulations, the IRS reserved on most of the issues covered in the 2018 proposed regulations, including treatment of groups of CFCs, U.S. shareholders access to excess taxable income of CFCs, and rules addressing effectively connected income. In the preamble, the IRS acknowledged that the 2018 proposed regulations addressing foreign corporations may have placed an unnecessary compliance and administrative burden on taxpayers and may have created distortions. Accordingly, the IRS developed new rules, considering the comments received, that substantially modify the 2018 proposed regulations. these rules were issued as part of the 2020 proposed regulations.
The 2020 proposed regulations address general rules that were reserved on in the final regulations, regarding the application of the Section 163(j) limitation to foreign corporations and U.S. shareholders of CFCs, and provide rules for how Section 163(j) applies to a nonresident alien individual or foreign corporation that is not an applicable CFC with effectively connected income. An applicable CFC means a foreign corporation described in Section 957 (i.e., the general CFC definition), but only if the foreign corporation has at least one United States shareholder that owns, within the meaning of Section 958(a), stock of the foreign corporation.
The 2018 proposed regulations included a “CFC group election” under which an upper-tier CFC group member takes into account a proportionate share of any “CFC excess taxable income” of a lower-tier CFC group member in which it directly owns stock for purposes of computing the upper-tier member’s ATI, referred to as the roll-up approach. The election to apply the roll-up approach was irrevocable. The roll-up approach taken in the 2018 proposed regulations was widely criticized by commenters as burdensome and could have required restructuring of foreign operations to access excess taxable income generated by overseas operations.
The 2020 proposed regulations significantly modify the approach to groups of CFCs, referred to as “specified groups” in the rules. Under the 2020 regulations, the new CFC group election allows the application of Section 163(j) on a group basis with respect to applicable CFCs that are “specified group members” of a “specified group.” The rules operate on a combined basis and apply in a similar manner as the rules apply to consolidated groups of U.S. domestic C corporations. Once made, a CFC group election cannot be revoked for a 60-month period following the last day of the first period for which the election was made, and, once revoked, cannot be made again for 60-month following the last day of the period for which the election was revoked.
The 2020 proposed regulations allow a U.S. shareholder to include in its ATI a portion of its specified deemed inclusions that are attributable to either a stand-alone applicable CFC or a CFC group, except to the extent attributable to Section 78 gross-up inclusions. The increase in ATI for the U.S. shareholder is limited to the amount of specified deemed inclusion which bears the same ratio as the applicable CFC’s “CFC excess taxable income” to its ATI. The increase is only available for a CFC group member if a CFC group election is in effect.
The 2020 proposed regulations also provide a new, annual “safe-harbor election” that exempts certain applicable CFCs from the application of Section 163(j). The safe-harbor election is available for stand-alone applicable CFCs (which is an applicable CFC that is not a specified group member of a specified group) and CFC group members. The election is not available for an applicable CFC that is a specified group member but not a CFC group member because a CFC group election is not in effect. The safe-harbor election is only available if interest expense of the applicable CFC, or of the CFC group, is less than 30% of the “qualified tentative taxable income” or its “eligible amount” (generally the sum of the potential Subpart F income plus the approximate amount of GILTI inclusions). However, it does come with drawbacks. If the election is made, then no portion of any CFC excess taxable income is included in a U.S. shareholder’s ATI.
Nonresident alien individuals or foreign corporations that are not applicable CFCs are subject to Section 163(j) and its regulations, but with certain modifications. An applicable CFC is generally a CFC with at least one direct or indirect U.S. shareholder. Modifications are required because foreign persons that are not applicable CFCs are only taxed on their income that is effectively connected with a U.S. trade or business. Similar, to the 2018 proposed regulations, the 2020 proposed regulations modify the definitions for ATI, business interest, business interest income and floor-plan financing interest to limit such amounts to income which is effectively connected income and any properly allocable expenses.
Taxpayers and their related parties, within the meaning of Sections 267(b) and 707(b)(1), who choose to apply the final regulations to taxable years beginning after Dec. 31, 2017, and before 60 days after the date the final regulations are published in the Federal Register, may rely on Prop. Treas. Reg. Secs. 1.163(j)-7 and 1.163(j)-8 (i.e., the 2020 proposed regulations addressing CFCs and foreign persons) for those taxable years. Taxpayers who choose not to apply the final regulations for those taxable years may not rely on either Prop. Treas. Reg.§1.163(j)-7 or 1.163(j)-8 for those taxable years.
Grant Thornton Insight:
The new proposed regulations provide several new opportunities and the potential for retroactive application may allow for refund claims on amended returns. In many circumstances, the new combined approach to a CFC group’s Section 163(j) has the potential to produce a better outcome than was achievable under the 2018 proposed regulations. Taxpayers should carefully weigh this and other elements of the 2020 proposed regulations when evaluating whether to apply them to a particular tax year.
Applicability and effective date
The final regulations are effective for taxable years beginning on or after the date that is 60 days after their publication in the Federal Register. However, taxpayers and their related parties may apply most of the final regulations to taxable years beginning after Dec. 31, 2017, so long as they apply the final regulations to those tax years consistently.
The 2020 proposed regulations are not proposed to be effective until after they become final regulations. However, taxpayers and their related parties may apply the 2020 proposed regulations to taxable years beginning after Dec. 31, 2017, so long as they consistently apply them. The consistency requirements of the 2020 proposed regulations vary depending on the rule, and some rules in the 2020 proposed regulations can only be applied for tax years that the taxpayer also applies the final regulations.
Given the flexibility for applying the final regulations and the 2020 proposed regulations, the IRS addressed whether Section 163(j) constitutes an accounting method in the preamble of the final regulations. The preamble states that the IRS does not view the Section 163(j) limitation as a method of accounting.
Grant Thornton Insight:
The applicability of the final regulations is flexible, but taxpayers will need to weigh the cost and benefits of their retroactive application.
Next steps
Uncertainty remains for issues that were not addressed in the new regulations, for example, the interaction between Section 163(j) and Section 108 related to cancellation of debt income. Nevertheless, the final regulations have significant changes, some of which, are favorable to many taxpayers. Taxpayers should reassess their previously taken positions under Section 163(j). The ability to retroactively apply recent guidance under Section 163(j), including the final regulations and the 2020 proposed regulations, provides potential benefits to taxpayers and the opportunity to reassess prior tax returns and previously made elections.
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