Of particular note, the Proposed Regulations
- limit deductions for items that are not generally treated as interest for federal income tax purposes and that arise from transactions that would not generally be viewed as constituting “indebtedness,” including deductions related to hedging transactions, commitment fees, debt issuance costs and partnership guaranteed payments
- provide ordering rules for applying Section 163(j) and other limitations on interest deductions, although they reserve on the interaction of Section 163(j) and Section 59A (the Base Erosion and Anti-Abuse Tax)
- provide that all interest paid or accrued by a C corporation is treated as business interest expense, all interest received or accrued by a C corporation that is includible in the taxpayer’s gross income is treated as business interest income, and all income allocated to a C corporation partner by a partnership are treated as allocable to a trade or business of the C corporation partner
- provide that the Section 163(j) limitation applies on a consolidated basis in the case of consolidated groups of corporations
- generally treat business interest expense carryforwards for a consolidated group in a manner similar to the rules for carryforwards of consolidated net operating losses (NOLs)
- set forth an 11-step process for applying Section 163(j) to partnership interest expense, employing an usual mixture of “entity” and “aggregate” concepts of partnership taxation
- clarify that 163(j) applies to foreign corporations and address the implications for controlled foreign corporations
Under new Section 163(j)(1), the amount allowed as a deduction for business interest expense for any taxable year 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 and (3) the taxpayer’s floor plan financing interest expense for the taxable year. This limitation applies to all taxpayers, except for certain small businesses and certain “excepted” trades or businesses. 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. For taxable years beginning before January 1, 2022, a taxpayer’s ATI roughly corresponds to EBITDA: taxable income with add-backs for interest, depreciation and amortization deductions. For taxable years after 2022, the add-back for depreciation and amortization is eliminated, bringing ATI more in line with earnings before interest and tax (EBIT).
The IRS issued Notice 2018-28 on April 2, 2018, in which it provided a high-level description of rules it intended to issue through proposed regulations. The Proposed Regulations address the issues identified in the notice and a number of issues not identified in it.
II. Summary of the Regulations and Selected Observations
The Proposed Regulations provide detailed rules for the application of Section 163(j) to a variety of contexts. This summary addresses those items of greatest likely interest. Where appropriate, we have noted particular areas of interest or uncertainty in the Proposed Regulations.
A. Prop. Reg. §§ 1.163-1 and 1.163(j)-2: Deduction for business interest expense limited.
1. Limitation on Business Interest and the Definition of Interest
The statutory language of Section 163(j) operates as a limit on deductions that can be taken in respect of “business interest,” defined to include interest paid or accrued on “indebtedness” with respect to a trade or business. Prop. Reg. § 1.163(j)-2(b), by contrast, provides for a general rule that the amount allowed as a deduction for “business interest expense” for a taxable year cannot exceed the sum of (i) the taxpayer’s business interest income for the taxable year, plus (ii) 30 percent of the taxpayer’s ATI for the taxable year, plus (iii) the taxpayer’s floor plan financing interest expense for the taxable year. That is, there appears to be no requirement in the Proposed Regulations that the business interest subject to limitation arise from “indebtedness.” The Proposed Regulations do not appear to address this requirement of the statute and do not articulate the source of Treasury’s authority to expand the scope of Section 163(j) in this manner.
The Proposed Regulations further adopt a broad, generalized definition of interest, defined as “an amount paid, received, or accrued as compensation for the use or forbearance of money under the terms of an instrument or contractual arrangement.” Prop. Reg. § 1.163(j)-1(b)(20). The Proposed Regulations go on to specifically provide that certain amounts are treated as interest for purposes of Section 163(j) of the Code that are not otherwise generally treated as interest under the Code and may not arise in connection with “indebtedness,” including
- certain amounts of premium (both for issuer and holder) in the case of debt instruments issued or acquired at a premium (Prop. Reg. § 1.163(j)-1(b)(20)(iii)(A))
- substitute interest payments (both for payor and recipient) in the case of sale-repurchase agreements or securities lending transactions (Prop. Reg. § 1.163(j)-1(b)(20)(iii)(C))
- income, deduction, gain or loss from a derivative, as defined in Section 59A(h)(4)(A), that alters a taxpayer's effective cost of borrowing with respect to a liability of the taxpayer is treated as an adjustment to interest expense of the taxpayer (Prop. Reg. § 1.163(j)-1(b)(20)(iii)(E))
- certain fees and costs, including commitment fees, certain debt issuance costs and guaranteed payments for the use of capital under Section 707(c) (Prop. Reg.
Thus, the Proposed Regulations limit deductions for items that are not generally treated as interest for federal income tax purposes and that arise from transactions that would not generally be viewed as constituting “indebtedness.” Interestingly, the broad scope of the definition of “interest” appears to affect the scope of what is included in both the “business interest expense” and “business interest income” side of the Section 163(j) calculation.
The inclusion of guaranteed payments for the use of capital under Section 707(c) is particularly interesting. Following the passage of the Tax Act, practitioners noted that in the partnership context, the limits on deductibility posed by Section 163(j) could be ameliorated by structuring financing as preferred equity rather than as debt. This structure would be successful only if the preferred equity were respected as equity rather than as debt. The Proposed Regulations, as drafted, would impose an additional hurdle: If the preferred equity return were recharacterized as a guaranteed payment for use of capital, allocations of income or gain to the financing provider could be treated as “interest” pursuant to the provisions of Prop. Reg. § 1.163(j)-1(b)(20)(iii)(I).
2. Calculation of ATI
Consistent with the broad mandate in Section 163(j)(8)(B), the Proposed Regulations identify a number of other adjustments to arrive at ATI. Prop. Reg. § 1.163(j)-1(b)(1)(ii)(C) illustrates an interesting example of the complexity of this regime. The Proposed Regulations set out to prevent “double counting” of depreciation deductions taken before 2022 in the calculation of ATI in instances where the depreciated property is subsequently sold at a gain. Preamble at 13-14. That is, when depreciation deductions are added back to taxable income to arrive at ATI in a year prior to 2022 and then the reduced basis from such depreciation increases the gain from sale upon ultimate disposition, ATI is increased twice for the same depreciation. To prevent this, the Proposed Regulations would essentially “recapture” such depreciation by subtracting it back out of ATI (to the extent of any gain) upon disposition. Prop. Reg. § 1.163(j)-1(b)(1)(ii)(C). The Proposed Regulations contain a number of interesting examples of this sort.
Disallowed business interest expense paid or accrued in a taxable year is carried forward to subsequent years and can be deducted in future years, subject to the limits of 163(j) in those subsequent years. The preamble announces that tracing to particular debt instruments is not required. Preamble at 28.
4. Implications for Structuring Debt in Connection With Merger and Acquisition Activity
Given the lower U.S. corporate income tax rate and new Section 163(j) limitations, companies doing cross-border deals may be less inclined to leverage U.S. entities with a disproportionate amount of third-party debt, while multinational groups would be more inclined to shift debt to non-U.S. jurisdictions.
Particularly in 2022 and later years, for companies with significant expenditures eligible for expensing, there may be little or no capacity for interest deductions due to the change from EBITDA to EBIT. That change would apply to any debt outstanding at that time (no grandfathering), creating a cliff effect, and therefore U.S. borrowers should take into account the switch to EBIT when considering additional leverage prior to 2022.
In addition, the change to EBIT may increase the incentives for taxpayers to accelerate cost recovery deductions (e.g., acquisitions of tangible assets eligible for 100 percent expensing in taxable years before 2022) and thus reduce cost recovery deductions in later years, thus increasing capacity for interest expense deductions in 2022 and later years (because those accelerated depreciation deductions would no longer reduce post-2022 EBIT).
B. Prop. Reg. § 1.163(j)-3: Relationship of business interest deduction limitation to other provisions affecting interest.
The Proposed Regulations recognize that 163(j) depends on robust ordering rules and provide as follows.
- General ordering rule. Section 163(j) applies only to business interest expense that would otherwise be deductible in the current taxable year before the application of Section 163(j).
- Provisions applied before Section 163(j). The section applies after provisions that defer, capitalize or disallow interest expense (e.g., Sections 163(e)(3) and (e)(5) (lobbying and political expenditures), 246A (debt-financed portfolio stock), 263A (capitalization of certain costs), 263(g) (certain carrying costs for straddles), 264(a) (certain amounts paid in connection with insurance contracts), 265 (deductions with respect to tax-exempt income), 267A (deductions arising from hybrid entities), 267(a) (deductions with respect to related taxpayers), 279 (deductions with respect to certain corporate indebtedness), 1277 (deferral of deduction for accrued market discount), and 1282 (deferral of deduction for accrued discount)).
- Provisions applied after Section 163(j). The section applies before the “at risk” rules, the passive activity loss provisions, and the limitation on excess business losses of noncorporate taxpayers (i.e., Sections 465, 469, 461(l)).
- Interaction with Section 59A. The Section 163(j) regulations reserve guidance on the interaction between Sections 163(j) and 59A (i.e., the Base Erosion and Anti-Abuse Tax).
- Section 381. An acquiring corporation succeeds to disallowed business interest expense carryforwards under Section 381.
- Other interest provisions. Except as otherwise specified, provisions that characterize interest expense as something other than business interest expense under Section 163(j) (e.g., Section 163(d)) govern the treatment of that expense rather than Section 163(j).
C. Prop. Reg. § §1.163(j)-4: General rules applicable to C corporations (including real estate investment trusts or REITs, regulated investment companies or RICs and members of consolidated groups) and tax-exempt corporations.
- Characterization of income, gain, deduction or loss. For purposes of Section 163(j), and except as provided otherwise in Prop. Reg. § 1.163(j)-10 (allocations between excepted and nonexcepted trades or businesses), all interest paid or accrued by a C corporation is treated as business interest expense, and all interest received or accrued by a C corporation that is includible in the taxpayer’s gross income is treated as business interest income. Also, all other items of income, gain, deduction or loss of a C corporation are treated as properly allocable to a trade or business and are thus reflected in ATI. Certain items of investment interest, expense and income allocated to a C corporation partner by a partnership are recharacterized as properly allocable to a trade or business of the C corporation partner, but such recharacterization does not affect the character of the items at the partnership level. With certain exceptions, these rules apply to RICs and REITs as well.
- Effect on earnings and profits. Generally, and with certain exceptions (including exceptions for RICs and REITs), interest expense will still reduce earnings and profits even if the deduction is disallowed.
- Special rules for consolidated groups. The Section 163(j) limitation applies at the consolidated return level. Notably, unlike under old Section 163(j), members of an affiliated group that does not file a consolidated return would not be aggregated for purposes of applying the Section 163(j) limitation. In calculating the consolidated limitation, a group’s business interest expense and business interest income are, respectively, the sum of its members’ business interest expense and business interest income. The consolidated group should calculate ATI using the group’s taxable income as determined under § 1.1502-11 without regard to any carryforwards or disallowances under Section 163(j). Intercompany obligations are disregarded for purposes of determining a member’s business interest expense and business interest income and for purposes of calculating the group’s ATI.
D. Prop. Reg. § § 1.163(j)-5: General rules governing disallowed business interest expense carryforwards for C corporations.
At a high level, the Proposed Regulations would treat business interest expense carryforwards for a consolidated group in a manner similar to the rules for carryforwards of consolidated NOLs.
- Treatment of carryforwards. Generally, current-year business interest expense is deducted before any disallowed business interest expense carryforwards from a prior taxable year. To the extent a deduction is still allowed, carryforwards are then deducted in order of the taxable year in which they arose, beginning with the earliest. Similar rules apply for consolidated groups. Also for consolidated groups, the Proposed Regulations provide a multistep rule for determining which members’ business interest expense and carryforwards are deducted, generally determined on a pro rata basis based on remaining amounts of business interest expense.
- Limits on use of carryforwards. The Proposed Regulations provide rules for situations when the use of business interest expense carryforwards is limited. Notably, the Section 382 limitation applies to business interest expense, including carryforwards, and a coordination rule in Prop. Reg. § 1.1502-98(b) provides that the consolidated Section 382 rules in Treas. Reg. §§ 1.1502-91 through 99 apply. Also, the Proposed Regulations provide for a limitation on carryforwards from a separate return limitation year (SRLY), similar to the rules in Treas. Reg. § 1.1502-21(c) for loss carryovers. Finally, the Proposed Regulations provide rules for the application of Section 381 (carryovers in certain corporate acquisitions).
E. Prop. Reg. § 1.163(j)-6: Application of the business interest deduction limitation to partnerships and subchapter S corporations.
With respect to a partnership, in each taxable year, the business interest deduction of Section 163(j) is applied at the partnership level. Nonetheless, the statute also provides that any business interest not allowed as a deduction in a taxable year is not carried forward to a subsequent year of the partnership but instead provides for allocation of “excess items” to partners that are carried forward at the partner level. The statute thus demands a curious mixture of “entity” and “aggregate” conceptions of partnership taxation.
The Proposed Regulations recognize the necessity of balancing these competing approaches and articulate a method of allocating business interest expense and excess items that (i) calculates the overall 163(j) limitation at the entity level but (ii) allocates business interest expense and excess items among partners in a manner that is consistent with the aggregate treatment of partnerships generally. As stated by the Proposed Regulations, “the primary goal of proposed §1.163(j)-6(f)(2) is to provide the partnership with an array of allocations that recognizes the aggregate nature of partnerships under subchapter K of the Code to the greatest extent possible while still remaining consistent with section 163(j) applying at the partnership level.” Preamble at 67.
To achieve this result, the Proposed Regulations mandate an 11-step process. While the specific details of the steps are very complicated, they can be summarized as follows:
- Calculate the overall Section 163(j) limitation for the partnership as a whole as well as any resulting “excess items” (the “section 163(j) excess items”) (Prop. Reg.
- Allocate 163(j) items among the partners in accordance with their distributive share, as determined under Section 704(b) and Section 704(c) principles (Prop. Reg.
- Adjust the allocations of the business interest income and business interest expense excess items among the partners (Prop. Reg. § 1.163(j)-6(f)(2)(iii)-(v)).
- Adjust the allocations of ATI and related excess items among the partners (Prop. Reg. § 1.163(j)-6(f)(2)(vi-xi)).
The Proposed Regulations contain a number of examples that illustrate the application of the rules.
In most regards, the 163(j) regulations apply to S corporations in the same way they do to partnerships. Some exceptions:
- Sections 381(c)(20) (inclusion of disallowed business interest in list of Section 381 tax attributes), 382(d)(3) (inclusion of disallowed business interest in prechange loss) and 382(k)(1) (inclusion of disallowed business interest in definition of loss corporation) apply to S corporations for purposes of Section 163(j).
- If a qualified subchapter S subsidiary terminates, the parent S corporation will succeed to all disallowed business interest expense carryforwards of the former subsidiary.
F. Prop. Reg. § 1.163(j)-7 and -8: Application of Section 163(j) to foreign corporations and their shareholders and to foreign corporations with effectively connected income (ECI).
The Proposed Regulations clarify that 163(j) applies to foreign corporation as well as domestic corporations. Thus, the rules of 163(j) are relevant to determining the extent to which interest expense is included in determining Subpart F income under Section 952 of the Code, tested income for global intangible low-taxed income (GILTI) purposes under 951A(c)(2)(A) and income effectively connected with the conduct of a U.S. trade or business.
The Proposed Regulations provide a number of rules intended to harmonize these different regimes.
- Recognizing that intercompany debt between controlled foreign corporations can distort these calculations, the Proposed Regulations permit a taxpayer to elect to apply the Section 163(j) rules to a group of closely related controlled foreign corporations (a “CFC group”) in a manner that ignores intergroup debt.
- The Proposed Regulations provide rules intended to avoid double counting in a U.S. shareholder’s ATI items of taxable income of a CFC that are already reflected in such CFC’s Section 163(j) limitation.
- The Proposed Regulations under Section 1.163(j)-8 provide rules to coordinate 163(j) with the rules for taxation of ECI, including modifying the relevant calculations to take account only of items of income that are ECI, and items of expenses that are allocable to ECI.
G. Prop. Reg. § 1.163(j)-9: Elections for excepted trades or businesses; safe harbor for certain REITs.
Sections 163(j)(7)(A)(ii) and (iii) exclude from the application of Section 163(j) an “electing real property trade or business” and an “electing farming business,” respectively. However, under Sections 168(g)(1)(F) and (G), electing trades or businesses must use an alternative depreciation system, which may be less advantageous (at least for real property trades or businesses) because of slightly longer depreciation periods for rental property. Prop. Reg. § 1.163(j)-9 provides for how elections for this status are made and terminated.
- Scope and effect of election. Elections are made with respect to each eligible trade or business of a taxpayer. Elections are irrevocable and apply for the year in which they are made as well as all subsequent years until the election is terminated.
- Time and manner of the election. Elections must be attached to the taxpayer’s federal income tax return and shall include information about the taxpayer and a description of the electing trade or business.
- Termination of election. Generally, an election terminates if the taxpayer (1) ceases to engage in the electing trade or business or (2) terminates its existence for federal income tax purposes. However, there is an exception for the transfer of substantially all of the trade or business’s assets to a related party and an anti-abuse rule that applies if, after a transfer of the assets of the trade or business, the taxpayer reacquires the assets and resumes conducting the trade or business within 60 months.
- Safe harbor for certain REITS. Generally, if a REIT holds “real property” (as defined in Treas. Reg. 1.856-10) directly or indirectly through other REITs, a safe harbor provides that the REIT is eligible to make an election to be an electing real property trade or business for all or part of its assets. If less than 10 percent of the REIT’s assets at the close of a taxable year represent financial assets such as mortgages, all of the REITs assets are treated as assets of an excepted trade or business. Otherwise, the rules of Prop. Reg. § 1.163-10 would apply to allocate items between excepted and nonexcepted trades or businesses.
H. Prop. Reg. § 1.163(j)-10: Allocation of interest expense, interest income and other items of expense and gross income to an excepted trade or business.
At a high level, the Proposed Regulations reject a “tracing approach” to allocating interest expense and interest income among excepted and nonexcepted businesses in favor of allocation based on relative tax basis of assets used in the different trades or businesses.
- Certain in-house activities disregarded. For purposes of applying the allocation rules, a taxpayer’s activities are not treated as a trade or business if those activities do not involve the provision of services or products to a person other than the taxpayer. For example, if a taxpayer engaged in a manufacturing trade or business has in-house legal personnel that provide legal services solely to the taxpayer, the taxpayer is not treated as engaged in the trade or business of providing legal services.
- Allocating items other than interest expense and interest income. Generally, for purposes of calculating ATI, gross income other than interest income is allocated to the trade or business that generated the income, while expenses, losses and other deductions are allocated to the trade or business to which they relate. However, for certain items of dividend income or gains or losses from dispositions of stock or partnership interests, taxpayers look through to the business activities of the paying C corporation, partnership etc.
- Allocating interest expense and interest income. Generally, interest expense and interest income are allocated among excepted and nonexcepted trades or businesses based on the relative amounts of the taxpayer’s adjusted basis in the assets used in its excepted and nonexcepted trades or businesses. There are, however, exceptions for certain situations where a limited tracing rule or direct allocation is more appropriate. Where the general rule does apply, there are numerous special rules for determining asset basis under different circumstances. Finally, under a de minimis rule, if 90 percent or more of the taxpayer’s basis in its assets is allocable to either excepted or nonexcepted trades or businesses, then all of the taxpayer’s interest expense and interest income properly allocable to a trade or business is treated as allocable to the excepted or nonexcepted trades or businesses, respectively.
As noted above, the Proposed Regulations explicitly reject a “tracing approach” to allocating interest expense and income to trades or businesses on the grounds that “interest expense is attributable to all activities and property, regardless of any specific purposes for incurring an obligation on which interest is paid.” Preamble at 121.
This assumption may not always be appropriate. For instance, a single-member LLC may be disregarded as separate from its owner for federal income tax purposes but will generally be respected as a separate entity for local-law purposes. In that circumstance, a third-party lender that lends to a disregarded LLC without recourse to the parent will not be looking to “all activities and properties” of the taxpayer (that is, the owner of the LLC) to service the debt. In addition, it is not at all uncommon for a third-party lender to specify the uses to which loaned funds can be put and to require restrictions on the distribution of money or property from the obligor until the debt is repaid or unless specific financial covenants are met. Under such circumstances, the assumptions adopted by the Proposed Regulations do not appear to match the commercial arrangements of the parties.
I. Prop. Reg. § 1.163(j)-11: Transition rules.
Prop. Reg. § 1.163(j)-11 provides certain transition rules, including rules for interest expense for which a deduction was disallowed under the old, pre-Tax Act Section 163(j). Such interest expense is carried forward to the taxpayer’s first taxable year beginning after December 31, 2017 and is subject to disallowance under Section 163(j) and Prop. Reg. § 1.163(j)-2.
J. Effective Date
The Proposed Regulations are proposed to be effective for taxable years ending after the date the Treasury decision adopting the regulations as final is published in the Federal Register. However, taxpayers and certain related parties may generally apply these rules to any taxable year beginning after December 31, 2017, so long as all the rules of the Proposed Regulations are consistently applied.
K. Open Questions - New and Old
The Proposed Regulations reserve on and request comment on a number of issues:
- the interaction of Sections 163(j) and 59A (the “BEAT,” or Base Erosion and Anti-Abuse minimum tax scheme)
- the treatment of business interest expense and income with respect to lending transactions between a pass-through entity and an owner of the entity
- the treatment of tiered partnerships generally and the treatment of partnership mergers and divisions
- whether the Section 163(j) limitations should be subject to the special subgroup rules applicable to life/nonlife consolidated groups in Treas. Reg. § 1.1502-47.
The Proposed Regulations are extraordinary complex, by necessity, as Section 163(j) affects virtually every type of taxpayer. Taxpayers should carefully consider their group structure and business goals in evaluating the impact of Section 163(j) on their operations.
Sidley Austin LLP provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship.
Attorney Advertising - For purposes of compliance with New York State Bar rules, our headquarters are Sidley Austin LLP, 787 Seventh Avenue, New York, NY 10019, 212.839.5300; One South Dearborn, Chicago, IL 60603, 312.853.7000; and 1501 K Street, N.W., Washington, D.C. 20005, 202.736.8000.