On Monday, November 26, the Treasury and IRS released a 439-page package containing proposed regulations under IRC section 163(j), which provides a limitation on business interest deductions. The Tax Cuts and Jobs Act of 2017 (TCJA) repealed “old” section 163(j), enacted an entirely new section 163(j) that applies to all taxpayers (not just domestic corporations) and all interest deductions (not just interest on related party debt) and tightens the limitation from 50 percent of adjusted taxable income to 30 percent of adjusted taxable income (ATI). For taxable years before 2022, ATI is defined similarly to the definition in old section 163(j), approximating tax EBITDA. There has been uncertainty as to how new section 163(j) applies to partnerships and controlled foreign corporations in combination with the TCJA’s numerous other new provisions (GILTI, BEAT, FDII, etc.).
In general, section 163(j) limits a taxpayer’s ability to deduct business interest expense. A taxpayer may deduct business interest expense up to the sum of its business interest income, plus 30 percent of its adjusted taxable income, and its floor plan financing interest. Any unused business interest expense (excess business interest expense) may be carried forward indefinitely and used in future years. Excepted trades or businesses may elect out of the application of section 163(j). These include certain real property or farming trades or businesses.
The regulations are very long, dense, and complex. The following is a high-level overview of some of the key features of the Proposed Regulations.
- Old section 163(j) Carryforwards: Interest expense disallowed under old section 163(j) and not used prior to the first taxable year subject to new section 163(j) is treated as a business interest carryforward if the interest expense satisfies the provisions of new section 163(j) and the Proposed Regulations.
- Adjusted Taxable Income (ATI): Taxable income is computed as if all business interest expense were deductible, followed by certain additions and subtractions. Treasury has asserted its authority under section 163(j)(8)(B) to provide for numerous additions and subtractions that are not found in the code. For example, the proposed regulations provide special rules regarding disposition of depreciated or amortized property, under which income from the sale of depreciated property may not increase ATI to the extent the depreciation was not deducted from ATI in a prior year.
- Interest: The definition of interest has been expanded to include income and deductions from many items, such as swaps, that have time-value components not treated as interest with respect to domestic taxpayers in the past.
- Trades or Businesses: Business interest is interest derived from a trade or business as defined under section 162.
- Controlled Foreign Corporations:
- Controlled Foreign Corporations (CFCs) are subject to section 163(j) limitation under the general rules as if they were domestic corporations.
- In order to avoid what Treasury terms inappropriate results in related CFC to CFC lending, CFCs may determine section 163(j) limitation on a group basis by making a “CFC Group Election.”
- When this election is made, intercompany debt between CFCs in a CFC Group (related CFCs as defined in the proposed regulations), is disregarded for purposes of section 163(j) limitation so long as there is no third-party interest expense in the CFC group.
- If there is third-party interest expense, each CFC must calculate its own section 163(j) limitation. CFC Excess Taxable Income (essentially excess section 163(j) limitation) flows up through the CFC Group to the CFC(s) owned directly by U.S. shareholders. This roll-up becomes important when calculating a U.S. shareholder’s section 163(j) limitation as discussed below.
- A CFC Group does not include CFCs with income that is Effectively Connected Income (ECI) with a U.S. trade or business.
- U.S. Shareholders of CFCs: A U.S. Shareholder (USSH) of a CFC generally may not include Subpart F inclusions (including GILTI) and the section 78 gross-up in determining ATI. However, when a CFC group election has been made (see above), and the Specified Top Tier CFC has excess section 163(j) limitation, that amount may increase the USSH’s ATI. The section 78 gross-up may never be added to ATI at the USSH level.
- Partnerships: ATI is determined at the partnership level. To the extent the partnership has excess taxable income (ETI), the ETI is allocated to the partners and used in determining each partner’s ATI. If partnership business interest expense exceeds the partnership’s interest limitation, the excess business interest expense is allocated to the partners. Special recharacterization rules may apply where a partner is allocated ETI or excess business interest expense.
- Corporate Partners: While a partnership may have investment interest, expenses, and income, all those items are recharacterized as trade or business items when allocated to a partner that is a C Corporation. However, this rule does not apply where the C Corporation is allocated Subpart F income or GILTI that was treated as investment income at the partnership level.
- Consolidated Groups: The limitation applies at the level of the consolidated tax return. There are no super-affiliation rules under new section 163(j) as was the case with old section 163(j). Members of an affiliated group that do not file a consolidated return are not aggregated for limitation purposes. Partnerships that are wholly owned by members of a consolidated group would also generally not be aggregated with the consolidated group.
Alvarez & Marsal Says: At a hefty 439 pages, the section 163(j) proposed regulations address a multitude of issues. In the coming days, A&M Tax will highlight significant features of the proposed regulations in more detail. Stay tuned for future insights.