On January 5, the Treasury Department and the IRS released final regulations providing additional guidance on the section 163(j) interest expense limitation for passthrough entities, regulated investment companies, and controlled foreign corporations. The new final regulations (the 2021 Final Regulations)  generally adopt the regulations proposed in 2020 (the 2020 Proposed Regulations). However, there are a few noteworthy modifications that taxpayers should be aware of. Additionally, the 2021 Final Regulations modify some of the rules that were previously finalized in 2020 (the 2020 Final Regulations).

As discussed in greater detail in our prior alert on the 2020 Proposed Regulations and the 2020 Final Regulations, the TCJA limited a taxpayer’s ability to deduct business interest expense (BIE), which is interest expense that is properly allocable to a trade or business, by subjecting it to a new annual deduction limitation (the section 163(j) limitation). This alert highlights several significant changes in the 2021 Final Regulations and discusses open questions and areas where the final regulations reserve.

Specifically, this alert covers the following topics:

• Recapture of Prior Depreciation, Amortization, and Depletion Deductions Self-charged interest
• Self-charged interest
• Controlled Foreign Corporations and U.S. Shareholders
• Final Regulation Reservations

Recapture of Prior Depreciation, Amortization, and Depletion Deductions

The section 163(j) limitation is equal to the sum of the taxpayer’s business interest income (BII), 30% (or 50%, if the CARES Act applies) of the taxpayer’s adjusted taxable income (ATI), and the taxpayer’s floor plan financing interest for the taxable year. For taxable years beginning before 2022, a taxpayer’s ATI is equal to the taxpayer’s tentative taxable income (TTI) with certain adjustments, including adding back depreciation, amortization, and depletion deductions (collectively, “depreciation”). The 2020 Final Regulations provided a recapture rule, not found in the statute, that required depreciation attributable to 2018 through 2021 be to be subtracted from TTI on the sale of the property (or the direct or indirect sale of the stock of the consolidated group member or interest in the partnership that took the depreciation deductions), even if such amounts had not been added to TTI (the recapture rule). Additionally, as discussed previously, the 2020 Proposed Regulations allowed taxpayers to elect to apply the recapture rule to the lesser of the depreciation deductions and the gain that was recognized on the sale.

Reversal on Policy and Rules for Recapture for Prior Depreciation, Amortization and Depletion Deduction

In discussing the recapture rule, the preamble to the 2020 Final Regulations stressed that the recapture rule is merely a timing provision, and not a rule intended to prevent a double benefit (i.e., recapture applied even if the add back of the depreciation did not result in an increased business interest expense deduction).

However, the 2021 Final Regulations reverse course with respect to the underlying policy and application of the recapture rule. Under the 2021 Final Regulations, the recapture rule only applies to the extent the taxpayer benefited from an addition of the depreciation to TTI by way of an increased business interest expense deduction. 

A&M Insight: The limitation on the application of the recapture rule is a welcome change that taxpayers can choose to apply retroactively, so long as they apply all of the 2021 Final Regulations retroactively. However, it is important to note that the rule entails some administrative complexity.

Taxpayers will need to track the extent to which the add back of depreciation increased the BIE deduction each year and the amount of depreciation each property generated in that particular year. For example, if the depreciation addback did not increase the amount of a taxpayer’s BIE that was deducted in 2018 and 2020, but it did impact its BIE deduction in 2019, then the recapture will apply to the depreciation added back to TTI in 2019. This analysis becomes even more complicated if only part of the addback increased the amount of BIE deduction. For example, assume in 2019, the taxpayer’s TTI is $400x (including $180x of depreciation deductions).  As a result, the taxpayer’s ATI is $580x ($400x + $180x), resulting in a section 163(j) limitation of $174x ($580x * 30%). The taxpayer’s BIE for 2019 is $141x. Without the addback of depreciation, the taxpayer’s section 163(j) limitation would be $120x ($400x * 30%). Therefore, an additional $21x of BIE was deducted due to the depreciation addback, which represents the impact of $70x of depreciation ($21x/30%). As a result, it appears that only $70x of the total $180x depreciation is subject to recapture when a property that was held in 2019 is disposed of in a subsequent year.

“Lesser of” Recapture Calculation

The 2021 Final Regulations generally adopt the 2020 Proposed Regulations’ “lesser of” mechanic which allows taxpayers to compute recapture based on the lesser of the amount of depreciation deducted with respect to a property and the amount of gain recognized on the disposition of the property. 

A&M Insight: If taxpayers have previously applied the recapture rule without the “lesser of” mechanic, they should consider whether retroactive application of the 2021 Final Regulations would be beneficial.

Deconsolidation Transactions

The 2020 Final Regulations provided that the deconsolidation of a corporate member of a consolidated group gives rise to recapture of depreciation previously deducted by that member. An exception was provided for certain transactions in which deconsolidation resulted from the acquisition of the group’s common parent by another corporation.  As drafted, this exception did not apply to a transaction treated as a reverse acquisition. The 2021 Final Regulations address this drafting issue by expanding the scope of the rule to include reverse acquisitions.

While this change is taxpayer-favorable and welcome, the 2021 Final Regulations raise questions in certain dispositions of stock of a member. For example, while the intent of the 2021 Final Regulations is clear, the text of the regulations leaves it uncertain as to how to apply the lesser of recapture calculation when a taxpayer disposes of stock of an upper-tier member of a consolidated group and the depreciable property is held at a lower tier. Additionally, there is some uncertainty as to how the “successor” rules apply within the consolidated group.

A&M Insight: If taxpayers underwent a reverse acquisition and applied the depreciation recapture rule, then they should consider whether retroactive application of the 2021 Final Regulations would be beneficial. However, it is important that taxpayers reach out to their advisers to discuss the potential application of the depreciation recapture rules if they have a disposition of stock of a member of a consolidated group.

Self-charged Interest

Self-charged interest is interest paid by a pass-through entity on a loan from one of its members or stockholders. The 2020 Proposed Regulations included a narrow rule for self-charged interest expense involving a partnership. Specifically, if a lending partner is allocated excess BIE from the borrowing partnership, then the lending partner is deemed to receive an allocation of excess BII equal to the lesser of: (1) the excess BIE from the borrowing partnership or (2) the interest income on the loan for the taxable year. This in effect allows the partner to net all or part of the interest received from the partnership against their share of the partnership’s excess business interest expense. The 2020 Final Regulations generally adopt the 2020 Proposed Regulations and declined to expand the rule to apply to loans between S corporations and their shareholders or to loans made by partners owning an indirect interest in the borrowing partnership through a tiered partnership structure.

A&M Insight: Taxpayers who may have structured transactions in anticipation of the expansion of the self-charged interest rule may need to reconsider those arrangements or the tax treatment of such transactions on filed returns.

Controlled Foreign Corporations and U.S. Shareholders

As highlighted below, the 2021 Final Regulations reserved for further consideration many aspects of the proposed regulations relating to controlled foreign corporations (CFCs) and their US shareholders. However, the final regulations do resolve some open questions relating to the application of section 163(j) to CFCs and to CFC groups. Specifically, under the 2021 Final Regulations:

• A CFC group computes its section 163(j) limitation on a group-wide basis, thereby requiring losses of one CFC group member to offset the income of another CFC group member in calculating the ATI of the group. As a result, CFC group’s section 163(j) limitation may be lower than it would be if only the positive ATI of group members were taken into account.
• The final regulations expand the anti-abuse rule to disregard intragroup transactions that are entered into with a principal purpose of manipulating a CFC group or group member’s section 163(j) limitation by increasing the group or group member’s BII.
• The section 163(j) limitation is computed without regard to whether a CFC elects to apply the subpart F or GILTI high-taxed income exceptions. As a result, a CFC’s high-taxed income could either increase or reduce the deduction for BIE that is properly allocable to lower-taxed income.

Additionally, the 2021 Final Regulations expanded the safe harbor under which a standalone CFC or a CFC group can elect out of section 163(j). In order to be eligible for the revised safe harbor, the BIE of the CFC or the group must be less than or equal to either: (1) 30% of the sum of its subpart F income and GILTI income (not to exceed its taxable income) or (2) its BII.

A&M Insight: The safe harbor is intended to “reduce the compliance burden” of CFCs. However, the mechanics of computing whether the safe harbor actually applies may be just as administratively difficult as computing the section 163(j) limitation. Additionally, an expansion of the safe harbor is generally welcome. However, the expansion here is to include situations where the BIE of a CFC or group is equal to or less than BII. In those cases, section 163(j) should generally not impact the CFC or group adversely, because BIE would not be subject to limitation and most taxpayers would not have gone through the administrative difficulty of calculating a section 163(j) limitation. Therefore, the expansion is of questionable importance.

Final Regulation Reservations

Treasury and the IRS must have been excited by the recent changes to the deductibility for restaurant business meals, because they made several reservations in the 2021 Final Regulations. 

In the partnership and S corporation arena, the areas reserved include:

• The impact on a partner’s or shareholder’s ATI calculation for partnership or S corporation deductions that are capitalized by a partner or shareholder.
• Whether a distribution by a partnership is treated as a disposition of a partnership interest for purposes of triggering the partnership basis adjustment rules.
• Whether a partnership adjusts its basis in its assets, if a partner disposes of its partnership interest.
• The rules governing tiered partnerships.

In the CFC arena, the areas reserved include:

• How to treat the CFC group as a single corporation for purposes of allocations between an excepted and non-excepted trader or business.
• How to treat the CFC group as a single corporation for purposes of determining what constitutes “interest.”
• The application of an ordering rule when a CFC group member has effectively connected income.
• The addback of GILTI and subpart F income when calculating a U.S. Shareholder’s ATI.

A&M Insight: The reservation with respect to addback of GILTI and subpart F inclusions creates a situation in which the reductions from TTI for the inclusions are in final regulations, but the potential addback remains in proposed regulations. As a result, taxpayers will not be able to obtain an ATI benefit from inclusions with respect to controlled foreign corporations, unless they elect to apply the non-finalized portions of the 2020 Proposed Regulations.

A&M Taxand Says

Because the 2021 Final Regulations are effective upon the date on which they are filed for public inspection (which generally is the date they are listed on the Federal Register website), so long as they are filed for public inspection by January 20th, they will avoid any regulatory freeze imposed by President-elect Biden when he takes office. Rules that are left outstanding, however, would be subject to a freeze.

The final section 163(j) regulations are still very much a work in process. With the help of comments from the public, the IRS and Treasury have identified and addressed many, but by no means all, of the uncertainties in the application of the statute and the regulations.  Taxpayers may continue to rely on the 2020 Proposed Regulations in areas Treasury and the IRS chose to reserve and left the proposed regulations outstanding.

As always, Alvarez and Marsal Taxand is ready and able to help taxpayers navigate the maze of final and proposed rules under section 163(j), and make appropriate choices among the various provisions that may apply in a given fact situation.