Significant provisions of the 2020 Proposed Regulations addressing the application of section 163(j) to foreign corporations and their shareholders include:

Final regulations under section 163(j), released on July 28 (the Final Regulations), confirm the application of section 163(j) to foreign corporations and finalize a provision of the proposed section 163(j) regulations released in 2018 (the 2018 Proposed Regulations) that generally provided that a foreign corporation’s gross income and allowable deductions are determined under the principles of Treas. Reg. § 1.952-2 or the rules of section 882 for determining ECI or deductions allocable to such income. The Final Regulations also adopt the general rule that a US shareholder may not take into account subpart F income or GILTI inclusions (or the related section 78 gross-ups) in determining its ATI. Finally, the Final Regulations provide that a foreign corporation does not include dividends from related persons in determining its ATI.

 

However, responding to comments, the Final Regulations do not finalize the detailed provisions of the 2018 Proposed Regulations under which a CFC calculated its section 163(j) limitation or the provisions under which section 163(j) applied to foreign persons with ECI other than relevant foreign corporations. Instead, Treasury and the IRS determined that a different approach was necessary and issued new proposed regulations applying section 163(j) to CFCs and foreign persons with ECI simultaneous with the Final Regulations (the 2020 Proposed Regulations), which are discussed in additional detail below.

 

 

Generally, section 163(j) limits a taxpayer’s deduction for business interest expense (BIE) to the sum of 30% of the taxpayer’s adjusted taxable income (ATI), the taxpayer’s current year business interest income (BII) and certain floor plan financing interest expense (FFI). The provision was amended in 2020 by the Coronavirus Aid, Relief, and Economic Security (CARES) Act for taxable years beginning in 2019 and 2020 only, to adjust the limitation to 50% of a taxpayer’s ATI (up from 30%), plus BII and FFI.

 

Section 163(j) does not apply to certain small businesses and excepted trades or businesses (including certain real property, farming and regulated utility businesses). Amounts of BIE that cannot be deducted because of the section 163(j) limitation can be carried forward and treated as BIE in future years.

 

Section 163(j) was amended in 2017 by the Tax Cuts and Jobs Act (TCJA). Proposed regulations under the pre-TCJA version of section 163(j) provided that the interest limitation of that section did not apply to controlled foreign corporations (CFCs) or other foreign corporations that did not have ECI. However, in light of the changes to section 163(j) made by the TCJA, and particularly the addition of the GILTI rules, the Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) determined in the 2018 Proposed Regulations that the new interest limitation of that section should apply to CFCs and detailed the applicability of the limitation to CFCs. As noted above, the 2020 Final Regulations implement certain of these determinations, but the elective treatment of CFC groups has been significantly modified in the 2020 Proposed Regulations.

 

 

I. CFC group election

 

Under the 2020 Final Regulations, the section 163(j) limitation generally applies on a CFC-by-CFC basis. However, the 2020 Proposed Regulations allow a “qualified US person” to make a CFC group election to determine the section 163(j) limitation as applied to CFCs on a group basis in lieu of the CFC-by-CFC determination. A “qualified US person” is a US citizen or resident or a domestic corporation. The election can be made with respect to members of a “specified group,” which generally is a group of CFCs directly or indirectly owned by at least one 10% US shareholder (applicable CFCs) that are at least 80% owned (by value) by a “specified group parent.” The specified group parent may be either a qualified US person or an applicable CFC, and members of a consolidated group are treated as a single person for this purpose. Each member of the specified group is a “specified group member.” If a CFC group election is made with respect to a specified group, the group is referred to as a “CFC group,” and the members are referred to as “CFC group members.”

 

The CFC group election under the 2020 Proposed Regulations is made by each designated US person with respect to the specified group filing a statement with its Federal tax or information return stating that the election is being made. In contrast, under the 2018 Proposed Regulations, a CFC group election was made by the US shareholder by merely computing the amount of a CFC group member’s deduction for BIE, and no separate statement or form evidencing the election was required. Once made, the CFC group election under the 2020 Proposed Regulations cannot be revoked during the 60-month period following the last day of the first specified period for which the election was made, and if revoked such an election cannot be made again during the 60-month period beginning the last day of the specified period for which the election was revoked. In contrast, under the 2018 Proposed Regulations, once a CFC group election was made, it was irrevocable.

 

Unlike the 2018 Proposed Regulations, CFCs with ECI are not excluded from being a CFC group member under the 2020 Proposed Regulations. However, ATI, BIE, BII, and FFI attributable to ECI are not included in a CFC group’s calculations in determining its section 163(j) limitation, as discussed below.

If the CFC group election is in place, under the 2020 Proposed Regulations a CFC group has a single section 163(j) limitation that is computed using the aggregate BIE, BII, FFI, disallowed BIE carryforwards and ATI of each CFC group member for the group member’s taxable year ending in the specified period, similar to the rules for domestic consolidated groups. Each of these amounts is separately computed prior to being aggregated in the group calculation. If the CFC group’s section 163(j) limitation exceeds its current-year BIE, then the group members deduct their current-year BIE and deduct disallowed BIE carryforwards up to the group’s section 163(j) limitation. If the CFC group’s current-year BIE and disallowed BIE carryforwards exceed the CFC group’s section 163(j) limitation, each CFC group member first deducts its current year BIE up to its BII and FFI. Next, each CFC group member deducts the remaining current-year BIE pro rata based on the CFC’s ATI as compared to the group’s ATI. Special limitations exist for disallowed BIE carryforwards of a CFC group member that joins a CFC group, similar to the limitations on deducting disallowed BIE carryforwards of a consolidated group arising in a separate return limitation year (SRLY).

 

In contrast, under the 2018 Proposed Regulations, the CFC group members determined their BIE (not their section 163(j) limitation) on a group basis by aggregating and netting the group members’ BIE and BII and the net BIE was then allocated to each CFC proportionately based on the CFC’s BIE. Each CFC group member then calculated its separate section 163(j) limitation, and a CFC’s ATI was increased by the ATI of lower-tier CFC group members to the extent their ATI exceeded the amount needed to support a deduction of the amount of the CFC group’s net BIE allocated to such lower-tier CFCs.

 

In making the relevant determinations under the 2020 Proposed Regulations, any ATI, BII, BIE or FFI attributable to the ECI of a CFC group member are disregarded. Such amounts are attributed to a separate CFC, an “ECI deemed corporation,” that has the same taxable year and shareholders as the applicable CFC, but that is not a CFC group member. The ECI deemed corporation must perform a separate section 163(j) calculation with respect to its ECI.

 

The 2020 Proposed Regulations include an anti-abuse rule that may apply to increase the ATI of a CFC (to prevent the creation of a BIE carryforward) if the CFC group election is not made. Specifically, if one CFC includes an amount in income that is attributable to BIE incurred by another CFC, and both CFCs are part of a specified group eligible for a CFC group election but no such election was made, the ATI of the CFC incurring the BIE is increased if (i) the BIE was incurred with a principal purpose of reducing the Federal income tax liability of the US shareholder (e.g., by creating a BIE carryforward that would reduce the US shareholder’s tax liability in a later year) and (ii) if the ATI were not increased, the effect of the payment would be to reduce such tax liability.

2. “Specified period” addresses inconsistent taxable years

Members of a CFC group may not have a consistent taxable year, but a consistent basis must be established for calculating the aggregate section 163(j) limitation for the CFC group. Accordingly, the 2020 Proposed Regulations apply the section 163(j) limitation based on the group’s “specified period.” If the specified group parent is a US person, the specified period is the period ending on the last day of the taxable year of the US person and beginning on the first day after the last day of the specified group’s immediately preceding specified period. If the parent is an applicable CFC, the specified period is the period ending on the last day of the parent’s required year, as determined under section 898(c)(1) and without regard to section 898(c)(2), and beginning on the first day after the last day of the specified group’s immediately preceding specified period. If a CFC is a member of the specified group on the last day of its taxable year, it is treated as a group member with respect to the specified period for its entire taxable year (termed the specified taxable year). Additionally, for purposes of calculating the aggregate section 163(j) limitation for the CFC group, the relevant items of each CFC group member are translated into a single currency, either the US dollar or the functional currency of a plurality of the CFC group members, and the allocable portions of the items of the CFC group are translated back to the functional currency of the particular CFC group member using the average exchange rate for that CFC group member’s specified taxable year.

 

3. CARES Act 50% amount for 2019/2020

 

To give effect to the amendment to section 163(j) by the CARES Act, for a specified period of a CFC group beginning in 2019 or 2020, the 2020 Proposed Regulations provide that the CFC group’s section 163(j) limitation is calculated by using 50%, rather than 30%, of the CFC group’s ATI, without regard to whether the CFC group members’ taxable years begin in 2019 or 2020, unless an election is made to use 30%. An election is also available for the CFC group to calculate the group’s ATI for a specified period of the specified group that begins in 2020 based on the ATIs of CFC group members for their last taxable years that precede their taxable years with respect to the specified period beginning in 2020. For additional information regarding the changes to section 163(j) made by the CARES Act see our prior Legal Alert.

 

II. Safe harbor election

 

The 2020 Proposed Regulations also provide an annual safe-harbor election for an eligible applicable CFC that is not a member of a specified group (stand-alone CFC) or an eligible CFC group. If the election is made, no portion of the BIE of the stand-alone CFC or the CFC group is disallowed under section 163(j). However, to be eligible for the election, the BIE of a stand-alone CFC or the CFC group generally must not exceed 30% of the lesser of (i) the “tentative taxable income” of a stand-alone CFC attributable to non-excepted trades or businesses, or the aggregate of such amounts with respect to CFC group members, and (ii) the “eligible amount” of a stand-alone CFC or the aggregate eligible amounts with respect to CFC group members. “Tentative taxable income” is generally a CFC’s taxable income, prior to adjustments under section 163(j), such as excluding BIE. The “eligible amount” for a CFC is the sum of the CFC’s subpart F income and the GILTI inclusions (net of the section 250 deduction) its US shareholders would have if the CFC were wholly owned by domestic corporations that had no tested losses and were not subject to the taxable income limitation on the section 250 deduction.

 

III. Effect on ATI of US shareholders

 

As noted above, under the 2020 Final Regulations, a US shareholder generally may not take into account subpart F and GILTI inclusions from CFCs in determining its ATI. Under the 2020 Proposed Regulations, this rule applies to inclusions with respect to any CFC that is a member of a specified group for which a CFC group election is not made. It also applies to inclusions with respect to any other CFCs if the safe-harbor election is in effect. However, a 10% US shareholder of a stand-alone CFC or a CFC group member for which a safe-harbor election is not in effect generally may increase its ATI based on the product of (i) the specified deemed inclusions attributable to the applicable CFC and (ii) the ratio of the CFC’s excess taxable income to the CFC’s ATI. A US shareholder’s specified deemed inclusions generally are amounts includable in the income of the US shareholder with respect to subpart F income or GILTI of an applicable CFC (not including any section 78 gross-up), net of the deduction under section 250 related to the GILTI inclusion. A stand-alone CFC’s excess taxable income is determined by multiplying (a) the excess of 30% of the CFC’s ATI over the CFC’s net BIE plus FFI by (b) 3 and 1/3 (i.e., 100% over 30%). A CFC group member’s excess taxable income is the CFC’s proportionate share (based on ATI) of the amount determined by multiplying (a) the excess of 30% of the CFC group’s ATI over the CFC group’s net BIE plus FFI by (b) 3 and 1/3 (i.e., 100% over 30%).

 

Eversheds Sutherland Observation: While the safe-harbor election may marginally reduce the burden of applying section 163(j) to CFCs, as noted above, if the safe harbor election is made US shareholders cannot take into account any subpart F income or GILTI inclusions with respect to the relevant CFCs in calculating their ATI. As a result, taxpayers may largely forego the safe-harbor election in favor of potential increases to US shareholder ATI.

IV. Application of section 163(j) to foreign persons with ECI

 

Under the 2020 Proposed Regulations, foreign nonresident aliens and foreign corporations the classification of which as corporations is not relevant for US tax purposes other than with respect to section 881 or 882 (each termed a “specified foreign person”) may also be subject to the section 163(j) limitation if those persons have ECI. For this purpose, the definitions of ATI, BIE, BII and FFI are limited to items that are or are allocable to ECI.

 

Special rules also apply in determining a specified foreign partner’s allocable share of relevant items related to ECI, generally based on the partner’s distributive share of ECI items vs. non-ECI items of the partnership. A specified foreign partner is a specified foreign person or a foreign corporation that is a partner with respect to a partnership that has ECI. A specified foreign partner’s allocable share of deductible BIE that is characterized as ECI is generally determined by applying section 163(j) to a hypothetical partnership to which only the ECI items are attributed. Similar rules apply to allocate deductible and disallowed BIE of a relevant foreign corporation to ECI and non-ECI.

 

V. Effective date

 

The 2020 Proposed Regulations generally are proposed to apply to taxable years beginning 60 days or more after the regulations are published as final in the Federal Register, although taxpayers may apply the provisions prior to that date.

 

Note that if a CFC group election had been made under the 2018 Proposed Regulations, that election applies only for taxable years in which a taxpayer relies on the 2018 Proposed Regulations and has no effect on whether a CFC group election under the 2020 Proposed Regulations can be made or applies for any taxable year in which the taxpayer relies on the 2020 Proposed Regulations.