Treasury and IRS Issue Guidance Regarding the Limitation on the Deduction for Business Interest Expense

Written on November 30, 2018

​​Summary

On November 26, 2018, the U.S. Department of the Treasury and the Internal Revenue Service (collectively, Treasury) issued proposed regulations under Section 163(j) (the Proposed Regulations). The Proposed Regulations provide general rules and definitions along with rules for calculating the limitation in consolidated group, partnership and international contexts.

Details

For tax years beginning after December 31, 2017, Section 163(j) generally limits the amount of business interest expense that can be deducted in the current taxable year. Under Section 163(j)(1), the amount allowed as a deduction for business interest expense is limited to the sum of (1) the taxpayer’s business interest income for the taxable year; (2) 30 percent of the taxpayer’s adjusted taxable income (ATI) for the taxable year;[1] and (3) the taxpayer’s floor plan financing interest expense[2] for the taxable year. The limitation under Section 163(j)(1) applies to all taxpayers, except for certain small businesses that meet the gross receipts test in Section 448(c) and certain trades or businesses listed in Section 163(j)(7). Section 163(j)(2) provides that the amount of any business interest not allowed as a deduction for any taxable year as a result of the limitation under Section 163(j)(1) is carried forward and treated as business interest paid or accrued in the next taxable year.

The Proposed Regulations withdraw the prior proposed regulations under the prior version of Section 163(j) and provide guidance regarding the new limitation on the deduction for business interest expense under Section 163(j) (which was added as part of the Tax Cuts and Jobs Act).

This article summarizes some of the key international items detailed in the Proposed Regulations (primarily Prop. Reg. §1.163(j)-7 and -8) and the Preamble to the Proposed Regulations. A separate tax alert discussing rules in the Proposed Regulations outside of the international context is forthcoming.

1. General Items

If for a taxable year, a taxpayer is allowed a deduction under Section 250(a)(1),[3] the taxpayer should take into account the deduction when computing taxable income that is used to calculate ATI, but the Proposed Regulations provide that the taxable income limitation in Section 250(a)(2) does not apply for this purpose. The Preamble notes that taxpayers, however, may be required to make adjustments adding back the Section 250(a)(1) deduction to the extent that some or all of the deduction is attributable to an inclusion under Section 951A.[4]

The Treasury states in the Preamble that a separate set of proposed regulations under development will provide general guidance regarding Section 250, including the computation of the Section 250 deduction and the application of the taxable income limitation in Section 250(a)(2).

The Preamble to the Proposed Regulations notes that the Treasury has received comments on the interaction of Sections 163(j) and 59A, relating to the tax on the base erosion minimum tax amount. The Proposed Regulations reserve on the interaction of these provisions. The Preamble further provides that comments previously received, as well as any additional comments received, will be further considered in conjunction with separate guidance under Section 59A.

2. Proposed Regulations Section 1.163(j)-7: Application of Section 163(j) to Foreign Corporations and their Shareholders

The Proposed Regulations provide the general rule that Section 163(j) and the Section 163(j) regulations apply to determine the deductibility of a controlled foreign corporation’s (CFC’s) business interest expense in the same manner as those provisions apply to determine the deductibility of a domestic C corporation’s business interest expense.[5] Accordingly, a CFC with business interest expense applies Section 163(j) to determine the extent to which that expense is deductible for purposes of computing subpart F income as defined under Section 952, tested income as defined under Section 951A(c)(2)(A), and income which is effectively connected with the conduct of a U.S. trade or business (ECI), as applicable.

The Proposed Regulations, however, provide for an election to apply an alternative method that limits the amount of business interest expense of a CFC group member subject to the Section 163(j) limitation to the amount of the CFC group member’s allocable share of the CFC group’s applicable net business interest expense.[6] The applicable net business interest expense of a CFC group is the excess, if any, of the sum of the amounts of business interest expense of each CFC group member over the sum of the amounts of business interest income of each CFC group member.[7] A CFC group member’s allocable share is computed by multiplying the applicable net business interest expense of the CFC group by a fraction, the numerator of which is the CFC group member’s net business interest expense (computed on a separate company basis), and the denominator of which is the sum of the amounts of the net business interest expense of each CFC group member with net business interest expense (computed on a separate company basis).[8]

Thus, if an election is made to apply the alternative method, and if a CFC group has only intercompany debt within the CFC group, then the amount of the CFC group’s applicable net business interest expense is zero, and no business interest expense of any CFC group member would be subject to the Section 163(j) limitation.

In general, for purposes of the Proposed Regulations, a CFC group means two or more CFCs, if at least 80 percent of the stock by value of each CFC is owned, within the meaning of Section 958(a), by a single U.S. shareholder or, in aggregate, by related U.S. shareholders that own stock of each member in the same proportion.[9] For purposes of identifying a CFC group, members of a consolidated group are treated as a single person, as are individuals filing a joint return, and stock owned by certain pass-through entities is treated as owned by the owners or beneficiaries of the pass-through entity.

The Proposed Regulations also narrow the scope of foreign corporations that are CFCs for this purpose to those foreign corporations in which at least one U.S. shareholder owns stock, within the meaning of Section 958(a)[10] (an applicable CFC).[11]

If one or more CFC group members conduct a financial services business, the alternative method is applied by treating those entities as comprising a separate subgroup (such a subgroup, a “financial services subgroup” and such a member, a “financial services subgroup member”). For this purpose, an entity conducts a financial services business if it is an eligible CFC, as defined in Section 954(h)(2)(A), is a qualified insurance company, as defined in Section 953(e)(3), or is eligible for the dealer exception in computing foreign personal holding company income as described in Section 954(c)(2)(C).

Also, the Proposed Regulations generally treat a controlled partnership (in general, a partnership in which CFC group members own, in aggregate, at least 80 percent of the interests) as a CFC group member and the interest in the controlled partnership is treated as stock.

The Proposed Regulations exclude from the definition of a CFC group member an applicable CFC that has ECI. Thus, an applicable CFC with ECI may not compute its Section 163(j) limitation under the alternative method, and the CFC group, and any financial services subgroup, must exclude such CFC from all group-level computations (for example, in determining the amount of the CFC group’s applicable net business interest expense). However, although an applicable CFC with ECI cannot use the alternative method, an applicable CFC with ECI is treated as a CFC group member solely for purposes of determining a CFC group. Thus, for example, if an applicable CFC with ECI is wholly owned by an upper-tier CFC and the applicable CFC with ECI wholly owns a lower-tier CFC, the lower-tier CFC may still qualify as a CFC group member.

If not all CFC group members have the same taxable year. Then, if the election is made, the Proposed Regulations require that all group-level computations be made with respect to a majority U.S. shareholder taxable year.[12]

The Proposed Regulations provide rules concerning the election (referred to as a “CFC group election”), including the requirements for making the CFC group election, the manner for making the CFC group election and the duration of the CFC group election.[13]

Proposed Regulations Section 1.163(j)-7(c) provides rules for computing the ATI of an applicable CFC. The principles of Regulations Section 1.952-2 for determining the CFC’s income and deductions or, for CFCs with ECI, the rules of Section 882, apply for purposes of computing the CFC’s taxable income.[14]

To mitigate potential double-counting of income in ATI, any dividend received by an applicable CFC from a related person is subtracted from the distributee’s taxable income for purposes of computing ATI as the dividend represents income that could be part of the distributing corporation’s ATI.[15]

If a CFC group election is in effect with respect to a CFC group, then an upper-tier CFC group member takes into account a proportionate share of the “excess” ATI (referred to in the Proposed Regulations as CFC excess taxable income) of each lower-tier member in which it directly owns stock for purposes of computing the upper-tier member’s ATI.[16] The meaning of the term CFC excess taxable income is analogous to the meaning of the term “excess taxable income” in the context of a partnership and S corporation (as defined in Section 163(j)(4)(C)), and, in general, means the amount of a CFC group member’s ATI in excess of the amount needed before there would be disallowed business interest expense.[17] See Proposed Regulations Section 1.163(j)-7 for rules on computing and “rolling up” CFC excess taxable income among CFC group members for purposes of computing ATI of each of the CFC group members.

To avoid double counting of the taxable income of a CFC already taken into account to determine the CFC’s Section 163(j) limitation, Proposed Regulations Section 1.163(j)-7(d)(1)(i) provides the general rule (the double counting rule) that the ATI of a U.S. shareholder is computed without regard to any amounts included in gross income under Sections 78, 951(a), and 951A(a) that are properly allocable to a non-excepted trade or business of the U.S. shareholder (each amount, a “specified deemed inclusion” and such amounts, collectively “specified deemed inclusions”) and any deduction allowable under Section 250(a)(1)(B), without regard to the taxable income limitation in Section 250(a)(2), by reason of a specified deemed inclusion (such a deduction, a “specified Section 250 deduction”).

To the extent a U.S. shareholder includes amounts in gross income under Section 78, 951(a), or 951A(a) that are not properly allocable to a non-excepted trade or business, for example, because such amounts are treated as investment income, within the meaning of Section 163(d), of the U.S. shareholder, then such amounts are not included in ATI.[18] To prevent income inclusions under Sections 951(a) and 951A(a) that are treated as investment income with respect to a domestic partnership from being included in the ATI of a corporate partner,[19] the Proposed Regulations provide that a C corporation partner may not treat such amounts as properly allocable to a trade or business of the C corporation partner.[20]

If a U.S. shareholder owns, directly or indirectly through one or more foreign partnerships, stock of a CFC group member that is a specified highest-tier member for which a CFC group election is in effect, and the specified highest-tier member has CFC excess taxable income that is treated as being attributable to taxable income of the CFC group that resulted in the U.S. shareholder having specified income inclusions, the U.S. shareholder may add to its taxable income an amount equal to its proportionate share of the “eligible” CFC excess taxable income of the specified highest-tier member and any other highest-tier members (the addback rule).[21] However, the addition to taxable income under the addback rule is limited to the portion of the specified deemed inclusions, all of which are subtracted from taxable income of any U.S. shareholder under the double-counting rule, that is with respect to CFC group members, reduced by the portion of any specified Section 250 deduction that is allowable by reason of such specified deemed inclusions. The Proposed Regulations refer to the portion described in the preceding sentence as “CFC group inclusions.”[22]Furthermore, the limitation is computed without regard to amounts included in gross income by reason of Section 78 with respect to CFC group members.

Proposed Regulations Section 1.163(j)-7(d)(2) contains rules in calculating the amount of “eligible” CFC excess taxable income (ETI) of a highest-tier member along with the specified ETI ratio. The Preamble notes that the purpose of the specified ETI ratio is to address the fact that within the CFC group, income of a lower-tier member CFC that is neither subpart F income nor tested income to the extent of GILTI[23] is included in CFC excess taxable income and may be used by an upper-tier CFC group member. The specified ETI ratio is intended to provide an estimate of the portion of CFC excess taxable income attributable to this income.

Proposed Regulations Section 1.163(j)-7(d)(3) includes rules for when a U.S. shareholder of a CFC group with a CFC group election in effect is a domestic partnership.

Under Proposed Regulations Section 1.163(j)-7(e), and consistent with the rules in Proposed Regulations Section 1.163(j)-4(c), the disallowance and carryforward of a deduction for a foreign corporation’s business interest expense does not affect whether and when such business interest expense reduces the corporation’s earnings and profits.

3. Proposed Regulations Section 1.163(j)-8: Application of Section 163(j) to Foreign Persons with Effectively Connected Income

With regards to a nonresident alien individual or a foreign corporation that is not an applicable CFC (a non-CFC FC) that has ECI, the definitions for ATI, business interest expense, business interest income, and floor plan financing interest expense in Proposed Regulations Section 1.163(j)-1 are modified to limit such amounts to income which is effectively connected income and expenses properly allocable to effectively connected income.[24]

Pursuant to Section 163(j)(8)(B), which permits adjustments to the computation of ATI, a nonresident alien individual or non-CFC FC that is a partner in a partnership that is engaged in a U.S. trade or business modifies the application of the general allocation rules in Proposed Regulations Section 1.163(j)-6 with respect to excess taxable income, excess business interest expense, and excess business interest income of the partnership to take into account the limitation of such foreign person’s liability for U.S. tax to its ECI. The excess amounts of the partnership, can be used by the nonresident alien individual or non-CFC foreign corporation only to the extent of the partnership’s income that would be effectively connected income with respect to the foreign partner. The amount of excess taxable income and excess business interest expense that can be used by such partner is determined by multiplying the amount of the excess taxable income or the excess business interest allocated under Proposed Regulations Section 1.163(j)-6 by a ratio equal to the ATI of the partnership, with the adjustments described previously to limit such amount to only effectively connected income or expense items, over the ATI of the partnership determined under Proposed Regulations Section 1.163(j)-6(d). The amount of excess business interest income that can be used by such partner is limited to ECI business interest income over allocable ECI business interest expense.[25]

The Proposed Regulations coordinate Section 163(j) and Treasury Regulations Section 1.882-5. The Proposed Regulations require that a foreign corporation that has ECI must first determine its business interest expense allocable to ECI under Regulation Section 1.882-5 before applying Section 163(j). The foreign corporation then applies Section 163(j) to its business interest expense to determine if any of that business interest expense is disallowed business interest expense. If the foreign corporation is also a partner in a partnership that has ECI, the foreign corporation must back out that portion of the business interest expense determined under Regulation Section 1.882-5 which is deemed to have come from the partnership as such business interest expense has already been subject to Section 163(j) at the partnership level and the foreign corporation is then left with only the non-partnership business interest expense. If the partnership also had disallowed business interest expense, a portion of the partnership-level interest expense that was backed out of the amount determined under Regulation Section 1.882-5 will also be disallowed business interest expense. Disallowed business interest expense determined at either the partner-level or partnership level, as appropriate, will not be taken into account for the purpose of determining interest expense under Proposed Regulations Section 1.882-5 in subsequent tax years, but rather will be subject to the limitations of Section 163(j).

As provided in Proposed Regulations Section 1.163(j)-8(d), an applicable CFC that has ECI must first apply the general rules of Section 163(j) and the Section 163(j) regulations, pursuant to Prop. Reg. §1.163(j)-7(b)(2), to determine how Section 163(j) applies to the applicable CFC. If, after applying Section 163(j) and the Section 163(j) regulations, the applicable CFC has disallowed business interest expense, the applicable CFC then must apportion a part of its disallowed business interest expense to interest expense allocable to effectively connected income as determined under Proposed Regulations Section 1.882-5.

The Proposed Regulations also provide that disallowed business interest expense and disallowed business interest expense carryforwards will not affect the determination of effectively connected earnings and profits or U.S. net equity for purposes of the branch profits tax under Section 884.[26]

The rules discussed in this Tax Alert are proposed to be effective for taxable years ending after the date the Treasury decision adopting these regulations as final is published in the Federal Register. However, taxpayers and their related parties, within the meaning of Sections 267(b) and 707(b)(1), may apply these regulations to a taxable year beginning after December 31, 2017, so long as the taxpayers and their related parties consistently apply the rules of Prop. Reg. §§ 1.163(j)-1, 1.163(j)-2, 1.163(j)-3, 1.163(j)-4, 1.163(j)-5, 1.163(j)-6, 1.163(j)-7, 1.163(j)-8, 1.163(j)-9, 1.163(j)-10, and 1.163(j)-11, and if applicable, Reg. §§1.263A-9, 1.381(c)(20)-1, 1.382-6, 1.383-1, 1.469-9, 1.882-5, 1.1502-13, 1.1502-21, 1.1502-36, 1.1502-79, 1.1502-91 through 1.1502-99 (to the extent they effectuate the rules of §§1.382-6 and 1.383-1), and 1.1504-4 to those taxable years.

Insights

The CFC group election for computing the amount of interest subject to Section 163(j) for a CFC group may be beneficial to taxpayers in most situations, but at the same time, will likely increase the complexity and costs in complying with the Proposed Regulations.

[1] See Section 163(j)(8) for the definition of ATI.

[2] See Section 163(j)(9) for the definition of floor plan financing interest.

[3] Section 250(a)(1) permits a domestic C corporation a deduction for a portion of its foreign-derived intangible income (as defined in Section 250(b)), the global intangible low taxed income (GITLI) amount (if any) which is included in the gross income of such domestic corporation under Section 951A for such taxable year, and the amount treated as a dividend under Section 78 with regards to the global intangible low taxed income amount. See Sections 250 and 951A along with the proposed regulations under Section 951A for additional details.

[4] See Prop. Reg. §1.163(j)-7(d).

[5] See Prop. Reg. §1.163(j)-7(b)(2).

[6] See Prop. Reg. §1.163(j)-7(b)(3).

[7] See Prop. Reg. §1.163(j)-7(f)(3).

[8] See Prop. Reg. §1.163(j)-7(f)(1).

[9] See Prop. Reg. §1.163(j)-7(f)(6).

[10] Section 958(a) provides that “stock owned” means stock owned directly and stock owned through foreign entities.

[11] See Prop. Reg. §1.163(j)-7(f)(2).

[12] See Prop. Reg. §1.163(j)-7(f)(11).

[13] See Prop. Reg. §1.163(j)-7(b)(5).

[14] See Prop. Reg. §1.163(j)-7(c)(1).

[15] See Prop. Reg. §1.163(j)-7(c)(2).

[16] See Prop. Reg. §1.163(j)-7(c)(3).

[17] See Prop. Reg. §1.163(j)-7(f)(5).

[18] See Prop. Reg. §1.163(j)-1(b)(1)(ii)(F)).

[19] See Prop. Reg. §1.163(j)-4(b)(3).

[20] See Prop. Reg. §1.163(j)-7(d)(1)(ii).

[21] See Prop. Reg. §1.163(j)-7(d)(2).

[22] See Prop. Reg. §1.163(j)-7(d)(2)(iii).

[23] See foot note 2.

[24] See Prop. Reg. §1.163(j)-8(b).

[25] See Prop. Reg. §1.163(j)-8(c).

[26] See Prop. Reg. §§1.163(j)-4(c) and 1.163(j)-8(f).

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