New final regulations issued under Sec. 163(j)

The IRS issued additional final regulations (TD 9943) under Section 163(j) on Jan. 5. The new final regulations expand on final regulations released in July 2020, adopting proposed regulations issued alongside those final rules with some modifications and clarifications.

The final regulations may have a substantial impact on certain taxpayers. Notable changes include further clarification on determining adjusted taxable income (ATI) and additional guidance on the application of Section 163(j) to partnerships, controlled foreign corporations (CFCs) and foreign persons and shareholders of a regulated investment company (RIC).

The new final regulations are effective for tax years beginning on or after 60 days after the date of their publication in the Federal Register. However, taxpayers and their related parties may choose to apply them early for tax years beginning after Dec. 31, 2017, provided that they and their related parties apply both the 2020 and 2021 final regulations under Section 163(j) consistently to that taxable year and all subsequent taxable years. As such, taxpayers should assess their positions under Section 163(j) considering the new regulations in tandem with existing guidance.

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 CARES Act modified the limitation to 50% of ATI for tax years beginning in 2019 and 2020 (partnerships have special rules). The CARES Act also provided that a taxpayer may elect to use its ATI for the last taxable year beginning in 2019, subject to modifications for short taxable years, to determine the limitation under Section 163(j) for any taxable year beginning in 2020. For more information on the CARES Act changes, see our story “IRS issues guidance for Section 163(j) elections.”

The IRS released final regulations and proposed regulations in July 2020, which provided key definitions and operating rules for Section 163(j). For more background on these regulations, see our story “Sec. 163(j) guidance offers retroactive benefits.”

Adjusted taxable income

The new regulations clarify further how taxpayers determine their ATI.

Taxpayers generally determine their ATI by starting with “tentative taxable income” and applying additions and subtractions as specified in the existing final regulations consistent with the statute. One of the adjustments is the addition for depreciation, depletion and amortization for taxable years beginning after Dec. 31, 2017, but before Jan. 1, 2022 (EBITDA Period DD&A).

To prevent a double benefit in ATI, the existing final regulations provide a subtraction to tentative taxable income upon the sale or disposition of depreciable property that is equal to the greater of the EBITDA Period DD&A allowed or allowable with respect to the property (the “Recapture Subtraction”).

The existing final regulations also provide 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 Interest Recapture Subtraction”).

The new regulations provide taxpayers the option of an alternative method in determining Recapture Subtraction consistent with the proposed regulations. Specifically, the Recapture Subtraction may be computed as the lesser of:

1. Any gain recognized on the sale or disposition of such property
2. Any EBITDA Period DD&A with respect to such property.

The alternative method is available similarly for the Stock Recapture Subtraction and the Partnership Interest Recapture Subtraction. Taxpayers may compute amounts under the alternative method provided that the alternative method is used for all dispositions for which there is a Recapture Subtraction, Stock Recapture Subtraction, or Partnership Interest Recapture Subtraction.

A significant development in the new regulations is a cap on the Recapture Subtraction, Stock Recapture Subtraction, and Partnership Interest Recapture Subtraction (the “Negative Adjustment Cap”). The Negative Adjustment Cap provides that the subtraction is required only to the extent that the positive adjustment for EBITDA Period DD&A resulted in an increase in the amount allowed as a deduction for business interest expense in the year of the EBITDA Period DD&A.

The new regulations provide examples that illustrate how to compute the extent that EBITDA Period DD&A resulted in an increase in the deduction for business interest expense.

In one example, A is a calendar-year individual taxpayer with no disallowed business interest expense carryforward. In 2021, A has $100 of business interest expense, no business interest income or floor-plan financing interest expense, and $400 of tentative taxable income. After taking into account all adjustments to tentative taxable income, other than the adjustments relating to EBITDA Period DD&A, A has tentative taxable income of $450. A increases tentative taxable income by $30 (from $450 to $480) for EBITDA Period DD&A. Thus A would have a Section 163(j) limitation of $135 ($450 times 30%) without regard to the adjustments due to EBITDA Period DD&A, and a 163(j) limitation of $144 ($480 times 30%) after factoring in the adjustments due to EBITDA Period DD&A. In 2022, A sells the asset that gave rise to the $30 EBITDA Period DD&A adjustment for a gain of $50. The example concludes that A is not required to reduce its 2022 tentative taxable income due to the sale because the $30 addition to tentative taxable income in 2021 resulted in no increase in the amount allowed as a deduction for business interest expense (A’s business interest expense of $100 was less than the $135 limitation calculated without regard to the adjustments due to EBITDA Period DD&A).

The new regulations also clarify the meaning of a sale or disposition for purposes of the Recapture Subtraction, Stock Recapture Subtraction, and Partnership Interest Recapture Subtraction. Other rules in the new regulations entail:

• The amount of the adjustment for members of a consolidated group
• Successor rules for successor assets and successor entities
• Anti-duplication rules to prevent the Recapture Subtraction and the Stock Recapture Subtraction from both applying for the same deductions.

The new regulations also clarify that the Recapture Subtraction, the Stock Recapture Subtraction, and the Partnership Interest Recapture Subtraction apply with respect to EBITDA Period DD&A that is capitalized under Section 263A.

Election to use 2019 ATI

The new regulations clarify that the amount of 2019 ATI of an acquiring corporation in a Section 381 transaction is the amount of the acquiring corporation’s ATI for its last taxable year beginning in 2019. For example, assume that a corporation, T, has 2019 ATI of $100 and another corporation, A, has 2019 ATI of $200. If T merged into A during A’s 2020 taxable year, and A makes the election under Section 163(j)(10)(B)(i) to use its 2019 ATI for 2020, A’s 2019 ATI for purposes of the election is $200.

The new regulations also provide the 2019 ATI of a consolidated group is the amount of the consolidated group’s ATI for its last taxable year beginning in 2019 notwithstanding whether any members departed the group.

Partnerships

The new regulations provide additional guidance on the application of Section 163(j) to partnerships, although they reserved on several key issues. Specifically, the new regulations did not provide further guidance on the Section 163(j) treatment of:

• Partnership deductions capitalized by a partner
• Partner basis adjustments upon liquidating distributions or dispositions of partnership interests
• Tiered partnerships

Many practitioners hoped that the new regulations clarify the complex rules governing Section 163(j) and tiered partnerships contained in the proposed regulations. However, the preamble to the new regulations indicates the IRS will continue to study the issue.

The new regulations maintain the proposed regulations’ approach for applying Section 163(j) to partnerships engaged in a trade or business activity of trading personal property (including marketable securities), so-called trading partnerships. Under both the 2020 proposed regulations and the new regulations, a trading partnership must bifurcate its interest expense from the trading activity between the portion allocable to its passive partners (partners that do not materially participate in the activity for purposes of Section 469) and its non-passive partners. Only the portion of the interest expense from the trading activity that is allocable to the non-passive partners is subject to Section 163(j) at the partnership level, while the portion allocable to passive partners is evaluated at the partner level under the investment interest rules of Section 163(d) instead. In order to allow a trading partnership to more easily determine which of its partners are active participants in its trading activity, and to prevent potential abuse of the grouping rules under the Section 469 passive activity loss, the new regulations also modify the grouping rules to prohibit taxpayers from grouping a partnership’s trading activity with any other activity.

The IRS acknowledged that some trading partnerships that relied on the 2018 proposed regulations may have previously allocated excess business interest expense (EBIE) to their passive partners. Under the new regulations, however, trading partnerships will not allocate passive partners any excess taxable income (ETI) or excess business interest income (EBII), which could have potentially allowed such partners to deduct their share of EBIE at the partner level. Accordingly, the final regulations provide a transition rule to permit passive partners in a trading partnership to deduct the EBIE allocated to them from the partnership, in the first taxable year ending on or after the effective date of the final regulations without regard to the amount of ETI or EBII that may be allocated to the partner.

The IRS also finalized rules in the new regulations, which provide a partner that lends money to a partnership may treat interest income from the loan as EBII from the partnership to the extent of the lending partner’s allocation of EBIE. This “self-charged lending” rule can provide relief to lending partners where Section 163(j) disallows the borrowing partnership’s deduction for interest paid or accrued on the partner’s loans. The new regulations clarify that the self-charged lending rule only applies to situations in which a lender partner holds a direct interest in the borrower partnership; the new regulations declined to expand the scope of the self-charged lending rule to include situations in which a partnership’s creditor is a related party to a partner, or where a creditor holds an indirect interest in a partnership through another entity. The preamble states that the pro rata allocation requirements applicable to S corporations make it difficult to adopt similar rules for S corporations, and accordingly the new regulations do not provide such a self-charged lending rule for S corporations.

The new regulations also include provisions concerning the application of the CARES Act provisions to partnerships. Regarding the CARES Act provision permitting 50% of any EBIE allocated to a partner for any taxable year beginning in 2019 being treated as BIE paid or accrued by the partner in the partner’s first taxable year beginning in 2020, the new regulations clarify that partners may elect out of the 50% EBIE rule on a partnership-by-partnership basis. Also, with regard to the 50% EBIE rule, the new regulations also provide a clarification concerning an example of a partner that sold a partnership interest in 2019. In the example, a partner is allocated EBIE in 2018 and 2019 and sells its partnership interest in 2019. Fifty percent of the 2019 EBIE is treated as paid or accrued by the partner in 2020 and is not subject to the Section 163(j) limitation at the partner’s level. Immediately before the partnership interest sale, the partner’s basis in its partnership interest is increased by the amount of EBIE from 2018 and the portion of the 2019 EBIE that is not applied in 2020. The new regulations clarify that the 2019 EBIE can be deducted by the disposing partner only to the extent such deduction would not have been limited under Section 704(d) immediately before the disposition.

CFCs and foreign persons

The new regulations provide rules regarding the application of the Section 163(j) limitation to foreign corporations and U.S. shareholders. In addition, the new regulations reserve on the application of Section 163(j) to nonresident aliens and foreign corporations. The July 2020 proposed regulations created a framework for applying the interest limitation rules in the context of relevant foreign corporations and U.S. shareholders of such corporations.

By way of background, Section 163(j) is applicable to most foreign corporations with direct or indirect U.S. shareholders. The rules function to determine the deductibility of business interest expense when determining the foreign corporation’s income under U.S. tax principles. This is relevant to the calculations of Subpart F, tested income and other CFC related items.

In regard to CFCs and foreign persons, the final regulations maintain the basic structure of the proposed regulations with minor modifications and clarifications. Similarly, the preamble notes aspects of the final regulations that the IRS has reserved on and will continue to study.

The proposed regulations introduced the concept of Section 163(j) on a group basis with respect to applicable CFCs that are “specified group members” of a “specified group.” Specified group treatment is elective for the taxpayer. Under the proposed regulations, a “specified group” calculates a single Section 163(j) limitation for a specified period of a CFC group based on the sum of the current-year business interest expense, disallowed BIE carryforwards, BII, floor plan financing interest expense and ATI of each CFC group member. In order to compute these amounts, the taxpayer started at a separate-entity basis and then combined all amounts. Under this approach, there was ambiguity as to whether the ATI of a group member could be less than zero. In general, Section 163(j) has a “no-negative” ATI rule. To clarify, the new regulations provide that the ATI of CFC group members should take into account amounts less than zero for purposes of determining the ATI of a CFC group. This approach required taxpayers to include a CFC group member’s negative ATI, if any when determining the ATI of the CFC group.

In the proposed regulations, an anti-abuse rule was put into place regarding certain intragroup transactions that affect ATI. Under the new regulations, this rule is expanded so that it may also apply to intragroup transactions entered into with a principal purpose of affecting a CFC group or a CFC group member’s Section 163(j) limitation by increasing the CFC group or a CFC group member’s BII. The expansion is intended to prevent artificial inflation of BII or BIE with a CFC group for a specified period in order to shift disallowed BIE from one CFC group member to another or change the timing of deductions of BIE.

When determining a specified group and specified group members, the new regulations make three modifications to rules for clarification. The definition of a specified group includes a qualified U.S. person’s direct ownership in all applicable CFCs rather than just owning one or more chains of CFCs. In order for an applicable CFC to be considered a specified group member and be eligible for the election, the new regulations modify the definition and state that there must be at least two applicable CFCs in a specified group. In addition, when a specified group ceases to exist the rule is modified to clarify that references to the common parent are treated as references to the specified group parent.

Consistent with the proposed regulations, once a CFC group election was made it 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 months following the last day of the period for which the election was revoked. The final regulations clarify that the 60-month waiting period is not imposed on a specified group for which a CFC group election is not made for the first specified period in which a specified group exists. The final regulations clarify that each designated U.S. person much attach a statement regarding the CFC group election for every year the CFC group election is in effect to its relevant federal income tax or information return. However, the new regulations state that even if the required statement is not filed the CFC group election will remain in effect.

Unlike the proposed regulations, the new regulations determined that for purposes of computing ATI of a relevant foreign corporation it does not take into account a deduction for foreign income taxes that are creditable foreign taxes. Thus, foreign income taxes do not to reduce ATI regardless whether an election is made to claim a foreign tax credit.

As discussed in our prior guidance, the proposed regulations provided a new, annual “safe-harbor election” that exempts certain applicable CFCs from the application of Section 163(j). The new regulations expand this election to also include an applicable CFC or CFC group if its BIE does not exceed its BII. Therefore, an applicable CFC or CFC group is eligible for the safe harbor election if its BII does not exceed either its BII or 30% of the lesser of its “qualified tentative taxable income” or “eligible amount.”

As noted above, the new regulations are generally applicable to tax years beginning after their publication in the federal register, but taxpayers may choose to apply the new regulations to earlier taxable years so long as they apply them consistently as specified in the new regulations.

However, taxpayers also may choose to apply the proposed regulations in certain instances. To the extent that a rule in the 2020 proposed regulations is not finalized in the new regulations, taxpayers and their related parties may rely on that rule for a taxable year beginning on or after 60 days after publication in the Federal Register, provided that they consistently follow all of the rules in the 2020 proposed regulations that are not being finalized to that taxable year and each subsequent taxable year beginning on or before the date the Treasury decision adopting that rule as final is applicable, or other guidance regarding continued reliance is issued.

Regulated Investment Company shares

The new regulations provide rules that provide a “Section 163(j) interest dividend” paid by a RIC is treated as interest income for purposes of Section 163(j) subject to certain limitations. A RIC shareholder that receives a Section 163(j) interest dividend may treat such dividend as interest income for purposes of Section 163(j) subject to holding period requirements and other limitations. The preamble to the final regulations stated that the IRS will continue to consider whether similar treatment should be extended to shareholders in real estate investment trusts (REITs).

Next steps

The new regulations finalize rules that could have a significant impact on taxpayers depending on their circumstances. Because the new regulations may be applied retroactively and before they become effective, taxpayers should assess their positions under Section 163(j) considering the new regulations in tandem with existing guidance.