On July 28, 2020, the Internal Revenue Service (IRS) issued final regulations (T.D. 9905) (the final regulations) concerning the limitation on the deductibility of business interest expense (BIE) under Section 163(j) of the Internal Revenue Code (the Code), as amended by legislation commonly referred to as the Tax Cuts and Jobs Act (enacted Dec. 22, 2017) and the Coronavirus Aid, Relief, and Economic Security Act (enacted March 27, 2020) (the CARES Act).
Section 163(j) generally limits the amount of BIE that can be deducted in a taxable year to the sum of (i) the taxpayer’s business interest income for the taxable year; (2) 30% of adjusted taxable income (ATI) for the taxable year; and (3) floor plan financing interest expense for the taxable year. However, under the CARES Act, the amount of BIE that is deductible for taxable years beginning in 2019 or 2020 is computed using 50% of the taxpayer’s ATI for the taxable year (or, with respect to taxable years beginning in 2020, at the taxpayer’s election using 50% of ATI for the immediately preceding year), unless the taxpayer elects to instead apply the 30% ATI limitation. Special rules apply to partnerships with respect to 2019 and 2020. The Section 163(j) limitation applies to all taxpayers, except for certain small businesses whose gross receipts are below a statutory threshold ($26 million or less for 2019 and 2020, adjusted annually for inflation) and certain enumerated trades or businesses. The amount of BIE not allowed as a deduction for any taxable year as a result of the Section 163(j) limitation is carried forward and treated as business interest paid or accrued in the next taxable year (i.e., it is carried forward indefinitely). Taxpayers must report their business interest and Section 163(j) limitation on IRS Form 8990, “Limitation on BIE Under Section 163(j).”
The final regulations adopt and modify proposed regulations (REG-106089-18) issued in December 2018 (the 2018 proposed regulations). The final regulations alter certain definitions from the 2018 proposed regulations, address exceptions to the Section 163(j) limitation and set forth rules regarding the application of the Section 163(j) limitation to various types of entities. For the most part, practitioners have lauded the taxpayer-favorable changes reflected in the final regulations.
Concurrently with the publication of the final regulations, the IRS issued additional proposed regulations under Section 163(j) (REG-107911-18) (the 2020 proposed regulations). On the same day, the IRS issued Notice 2020-59, 2020-34 IRB 1 (the Notice) and FAQs Regarding the Aggregation Rules Under Section 448(c)(2) that Apply to the Section 163(j) Small Business Exemption (the FAQs).
The final regulations generally are applicable to taxable years beginning on or after Nov. 13, 2020 (or in the case of the anti-avoidance rules, on Sept. 14, 2020). Taxpayers generally may apply the final regulations to earlier years, provided that they do so on a consistent basis. The same discretionary retroactivity generally applies to the 2020 proposed regulations.
The Final Regulations and Concurrent IRS Guidance
The following is a high-level summary of certain key provisions of the final regulations, the Notice, the FAQs and some aspects of the 2020 proposed regulations (the more substantive provisions of which are summarized in a separate section below).
The Definition of ATI
For purposes of Section 163(j), ATI is defined as taxable income subject to certain adjustments and calculated without regard to items not properly allocable to a trade or business; business interest and business interest income; deductions in respect of net operating losses (NOLs); deductions in respect of Section 199A qualified business income; and with respect to pre-2022 years, deductions in respect of depreciation, amortization and depletion. The final regulations provide the following additional guidance regarding the calculation of ATI:
- As noted, ATI is computed without regard to any deduction allowable for depreciation, amortization or depletion for taxable years beginning before Jan. 1, 2022. Section 263A requires certain taxpayers that manufacture or produce inventory to capitalize all direct costs and certain indirect costs into the basis of the property produced or acquired for resale. Depreciation, amortization or depletion that is capitalized into inventory under Section 263A is recovered through cost of goods sold as an offset to gross receipts in computing gross income. Cost of goods sold reduces the amount realized upon the sale of goods that is used to calculate gross income and is technically not a deduction that is applied against gross income in determining taxable income. Therefore, the 2018 proposed regulations provided that depreciation, amortization or depletion expense capitalized into inventory under Section 263A is not a depreciation, amortization or depletion deduction that may be added back to taxable income in computing ATI. Commenters, particularly those from capital-intensive businesses that manufacture or produce inventory, were critical of this regulation. As a result, the final regulations provide that ATI is increased by the amount of any depreciation, amortization or depletion expense that is capitalized into inventory under Section 263A during taxable years beginning before Jan. 1, 2022, regardless of the period in which the capitalized amount is recovered through cost of goods sold. In addition, all interest required to be capitalized is capitalized prior to application of Section 163(j) and is not treated as BIE for purposes of Section 163(j). With respect to the pre-2022 addback for depreciation, amortization and depletion deductions, the final regulations provide anti-duplication rules to ensure that in the consolidated group context, such deductions are only added back once.
- The 2018 proposed regulations included several adjustments to taxable income in computing ATI to address certain sales or other dispositions of depreciable property, stock of a consolidated group member, or interests in a partnership. In the case of the sale or other disposition of depreciable property, in order to avoid duplication of the pre-2022 adjustment for depreciation, amortization or depletion, the lesser of the amount of gain on the disposition or the amount of depreciation, amortization or depletion deductions with respect to the property for the taxable years beginning after Dec. 31, 2017, and before Jan. 1, 2022, is subtracted from taxable income to determine ATI in the year of sale or other disposition (the “lesser of” standard). In the case of the sale or other disposition of stock of a member of a consolidated group, Treasury Regulation Section 1.502-32 investment adjustments with respect to such stock that are attributable to the greater of the allowed or allowable depreciation, amortization or depletion deductions for the taxable years beginning after Dec. 31, 2017, and before Jan. 1, 2022, with respect to such property are subtracted from taxable income. In response to comments, the final regulations provide that the transfer of depreciable assets in certain tax-free reorganizations generally should not trigger the adjustment. However, if a member leaves a consolidated group, that transaction generally is treated as a sale or other disposition, giving rise to the ATI adjustment described above.
- In connection with the ATI adjustments described in the immediately preceding bullet, commenters flagged a discrepancy in the 2018 proposed regulations with respect to the adjustments in asset dispositions (where the lesser-of standard applies) as compared to dispositions of stock of consolidated group members (where the adjustment is based on Treasury Regulation Section 1.1502-32 investment adjustments rather than on the lesser-of standard). The final regulations retain the lesser-of standard for dispositions of assets, and the 2020 proposed regulations give taxpayers the option to apply the lesser-of standard for dispositions of consolidated group member stock, so long as they do so consistently.
- The final regulations reject the request of certain commenters that U.S. shareholders of controlled foreign corporations (CFCs) should be allowed to include their subpart F global intangible low-taxed income (GILTI) and Section 78 gross-up inclusions in calculating ATI. Treasury views this conclusion as appropriate because Section 163(j) applies to CFCs. Thus, the amount of income of such CFCs that is taxable to the U.S. shareholders already reflects a deduction for interest at the level of the CFCs (subject to the Section 163(j) limitation), and including such income in the computation of the U.S. shareholders’ ATI would result in a double-counting of such income. On the other hand, if the CFC has little or no debt, then the Section 163(j) limitation is not being fully utilized under the final regulations. Notwithstanding this general rule, as discussed below, the 2020 proposed regulations permit a portion of such inclusions to be added back to ATI.
- Section 250(a)(1) generally provides a deduction based on the amount of a domestic corporation’s foreign-derived intangible income and GILTI, subject to a statutory taxable income limitation. Under the 2018 proposed regulations, if a taxpayer is allowed a deduction for a taxable year under Section 250(a)(1) that is properly allocable to a nonexcepted trade or business, then the taxpayer’s ATI for that year is determined without regard to the aforementioned taxable income limitation. The final regulations eliminate these provisions, in response to commenters questioning the rationale for the rule, which has the effect of reducing ATI and thus the Section 163(j) limitation. On the other hand, some rule is required to avoid a circularity problem that would otherwise arise when simultaneously applying two taxable income-based provisions, such as Section 163(j) and the income-based limitation in Section 250. Pending additional guidance on the topic, taxpayers may choose any reasonable approach for coordinating these and other taxable income-based provisions (which could include an ordering rule or the use of simultaneous equations).
The Definition of Interest
The final regulations narrow the definition of interest as compared to the broad and heavily criticized definition that was contained in the 2018 proposed regulations. For purposes of Section 163(j), the term “interest” means any amount described in the following four categories:
- First, interest is (i) an amount paid, received, or accrued as compensation for the use or forbearance of money under the terms of an instrument or contractual arrangement, including a series of transactions, that is treated as a debt instrument; or (ii) an amount that is treated as interest under other provisions of the Code (such as original issue discount and accrued market discount). The final regulations did not modify this noncontroversial portion of the definition of interest.
- Second, a swap (other than a cleared swap) with significant nonperiodic payments is bifurcated into an on-market, level-payment swap and a loan. As was the case under the 2018 proposed regulations, the time value component of the loan is treated as interest. The final regulations, however, add exceptions for cleared swaps and for noncleared swaps that require the parties to meet the margin or collateral requirements of a federal regulator or that provide for substantially similar margin or collateral requirements. This exception applies even if there are significant nonperiodic payments. The final regulations also delay the applicability date of this embedded loan rule to one year after publication of the final regulations in the Federal Register unless the taxpayer elects otherwise.
- Third, interest includes certain amounts that are closely related to interest and that affect the economic yield or cost of funds of a transaction involving interest, but that may not be compensation for the use or forbearance of money on a stand-alone basis. In the case of substitute interest payments, the final regulations limit interest treatment to such payments in a sale-repurchase or securities lending transaction that is not entered into in the ordinary course of business (in each case, if the transaction is not treated as a loan for federal income tax purposes). The final regulations remove commitment fees and debt issuance costs from the definition of interest (these will be addressed as part of broader guidance regarding the treatment of such payments for all purposes under the Code). The final regulations do not explicitly include guaranteed payments (in the partnership context) or hedging income and loss in the definition of interest, but instead include examples in the anti-avoidance rules of situations in which such payments are treated as interest. For instance, the final regulations include an example in which a partnership with three equal partners considers acquiring an additional loan from a third-party lender but chooses not to because it already has significant BIE. Instead, one partner agrees to make an additional capital contribution to the partnership in exchange for a guaranteed payment for the use of capital. This guaranteed payment is treated as interest for purposes of Section 163(j) because it is economically equivalent to interest and was structured with a principal purpose of reducing the partnership’s Section 163(j) limitation.
- Fourth, the final regulations narrow an anti-avoidance rule that was set forth in the 2018 proposed regulations. Under the final regulations, an expense or loss economically equivalent to interest is treated as interest expense under the anti-avoidance rule only if a principal purpose of structuring the transaction is to reduce an amount that otherwise would have been interest for purposes of Section 163(j). Under the 2018 proposed regulations, the anti-avoidance rule applied more broadly to expenses or losses predominantly incurred in consideration of the time value of money regardless of the purpose of the expense or loss.
The Small Business Exemption, as Clarified in the Concurrent FAQs
Taxpayers who qualify for the “small business exemption” are not subject to the Section 163(j) limitation. The exemption applies if the taxpayer is not a tax shelter and meets the Section 448(c) gross receipts test (i.e., the taxpayer has average annual gross receipts for the past three taxable years of not more than $25 million, adjusted annually for inflation; for taxable years beginning in 2019 and 2020, the inflation-adjusted average annual gross receipts amount is $26 million). In determining whether the gross receipts test is met, aggregation rules generally combine the gross receipts of multiple taxpayers if they are treated as a single employer under other provisions of the Code, including the controlled group rules of Sections 52(a) or 52(b), the affiliated service group rules of Section 414(m), and the rules of Section 414(o). The FAQs provide a general overview of the aggregation rules that apply for purposes of the gross receipts test and for determining whether the small business exemption applies.
Section 448(d)(3) defines a tax shelter by cross-reference to Section 461(i)(3), which defines a tax shelter, in relevant part, as a syndicate within the meaning of Section 1256(e)(3)(B). On the one hand, Treasury Regulation Section 1.448-1T(b)(3) defines a syndicate to be a partnership or other non-C corporation entity if more than 35% of its losses during the taxable year are allocated to limited partners or limited entrepreneurs. On the other hand, Section 1256(e)(3)(B) refers to losses that are allocable to limited partners or limited entrepreneurs. To resolve this inconsistency for purposes of the small business exemption, the 2020 proposed regulations define the term “syndicate” using the actual allocation rule from the definition in Treasury Regulation Section 1.448-1T(b)(3). As a result of this change, only small businesses with passive investors who are actually allocated losses (as opposed to being hypothetically allocated losses) would be considered tax shelters ineligible for the small business exemption.
The Definition of Trade or Business, Elections for Excepted Trades or Businesses, and Safe Harbors
The term “business interest” means any interest that is properly allocable to a trade or business. The final regulations define trade or business as a trade or business within the meaning of Section 162. Certain enumerated businesses, including an “electing real property trade or business” and an “electing farming business,” are excluded. The final regulations provide general rules and procedures for making an election for a trade or business to be an electing real property trade or business or an electing farming business. The elections are irrevocable. One consequence of the election is that electing taxpayers must depreciate certain property over a longer period and are not eligible for bonus depreciation.
For purposes of the electing real property trade or business exception, the final regulations clarify that incidental personal services, even if significant, do not disqualify a business as a real property trade or business. The final regulations also provide that a protective election to treat rental real estate activities as an electing real property trade or business is available for taxpayers who are not certain whether their rental real estate activities rise to the level of a Section 162 trade or business (e.g., taxpayers whose activities constitute a trade or business within the broader meaning of Section 469(c)(7)(C) but do not believe they are engaged in a trade or business within the meaning of Section 162). The 2020 proposed regulations clarify the meaning of real property development and real property redevelopment for purposes of the exception.
The Notice contains a proposed revenue procedure detailing a proposed safe harbor under which a taxpayer engaged in a trade or business that manages or operates a residential living facility and that also provides supplemental assistive, nursing, and other routine medical services may be an electing real property trade or business. The safe harbor applies only to such a facility that satisfies the following criteria: (i) the facility consists of multiple rental dwelling units within one or more buildings or structures that generally serve as primary residences on a permanent or semipermanent basis for individual customers or patients; (ii) the facility includes the provision of supplemental assistive, nursing or other routine medical services; and (iii) the facility has an average period of customer or patient use of the individual rental dwelling units that is 90 days or more.
The final regulations retain and modify the real estate investment trust (REIT) safe harbor, which generally provides that if a REIT holds real property, interests in partnerships holding real property or shares in other REITs holding real property, 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 a REIT so elects and the value of its real property financing assets (primarily loans secured by real property) at the close of the taxable year is no more than 10% of the value of the REIT’s total assets at the close of the taxable year, then all of the REIT’s assets are treated as assets of an excepted trade or business (otherwise income and expense must be bifurcated between the REIT’s businesses). The final regulations clarify that a REIT may also be eligible for the safe harbor if it holds interests in one or more partnerships or other REITs holding real property indirectly through other partnerships or shares in other REITs. The final regulations provide that a partnership may apply the REIT safe harbor election at the partnership level for the benefit of all partners if one or more REITs own, directly or indirectly, at least 50% of the partnership’s capital and profits and if other requirements are met.
The final regulations also expand the exceptions to an anti-abuse rule that prohibits an otherwise qualifying real property trade or business from becoming an electing real property trade or business if at least 80% of the fair market value of the business’s real property is leased to a trade or business under common control with the real property trade or business. The 2018 proposed regulations contained an exception to this anti-abuse rule for REITs leasing qualified lodging facilities and qualified health care properties. The final regulations expand this exception to apply to partnerships as to which a REIT is eligible to make the safe harbor election described above that lease qualified lodging facilities and qualified health care properties, and also provide two new additional exceptions. Under the de minimis exception, if at least 90% of a lessor’s real property, determined by fair market rental value, is leased to a related party that operates an excepted trade or business and/or to unrelated parties, the lessor is eligible to make an election to be an electing real property trade or business for its entire trade or business. Under the look-through exception, a lessor is eligible to make an election to be an electing real property trade or business to the extent that it leases real property to an unrelated party or to an electing trade or business under common control with the lessor or lessee, and to the extent that the lessee trade or business under common control subleases (or licenses) to unrelated third parties and/or related parties that operate an excepted trade or business.
Allocation of Interest Income and Expense to an Excepted Trade or Business
The 2018 proposed regulations provided that interest income and expense are allocated between excepted and nonexcepted trades or businesses based on the relative amounts of the taxpayer’s adjusted basis in the assets used in its trades or businesses. The final regulations retain this asset-basis allocation approach, rejecting an earnings-based approach that was recommended by some commenters.
The final regulations modify the 2018 proposed regulations by permitting a taxpayer to compute asset basis in its excepted and nonexcepted trades or businesses by averaging asset basis at the beginning and end of the year (relieving taxpayers of the overly burdensome quarterly testing that the 2018 proposed regulations required), provided that if at least 90% of the taxpayer’s asset basis for the taxable year is allocable to either excepted or nonexcepted trades or businesses, then all of the taxpayer’s interest expense and interest income for that year that is properly allocable to a trade or business is treated as allocable to either excepted or nonexcepted trades or businesses, respectively.
The final regulations include several de minimis rules from the 2018 proposed regulations and adopt an ordering rule with respect to them.
The final regulations, like the 2018 proposed regulations, provide that if an asset is used in more than one trade or business during a determination period, the taxpayer’s adjusted basis in the asset must be allocated to each trade or business using whichever of the following methodologies most reasonably reflects the use of the asset in each trade or business during that determination period: (i) the relative amounts of gross income that an asset generates, has generated, or may reasonably be expected to generate with respect to the trades or businesses; (ii) in the case of land or inherently permanent structures, the relative amounts of physical space used by the trades or businesses; or (iii) if the trades or businesses generate the same unit of output, the relative amounts of output of those trades or businesses. The final regulations permit a taxpayer to change its methodology after a period of five taxable years without IRS consent.
For purposes of allocating a taxpayer’s asset basis between excepted and nonexcepted trades or businesses, a partnership interest or stock owned by the taxpayer is generally treated as an asset of the taxpayer. However, a partner generally may look through to its share of the partnership’s basis in its assets (with certain modifications and limitations), provided that such look-through is mandatory for 80% or greater partners. Similar rules apply to S corporations. The look-through rule also mandatorily applies to shareholders of a domestic nonconsolidated C corporation or a CFC who satisfy the ownership requirements of Section 1504(a)(2) (ownership of at least 80% by vote and value). In addition, if a shareholder receives a dividend that is not investment income and the shareholder looks through to the assets of the payor corporation, the shareholder must also look through to the activities of the payor corporation to allocate the dividend between the shareholder’s excepted and nonexcepted businesses. Upon the request of commenters, the final regulations permit a taxpayer to look through its stock in a domestic nonconsolidated C corporation or a CFC if the taxpayer owns at least 80% of such stock by value (regardless of vote); corresponding changes were made to the look-through rule for dividends. The 2020 proposed regulations modify the look-through rule for nonconsolidated C corporations to provide that any such corporation whose stock is being looked through may not itself apply the look-through rule. The final regulations permit a shareholder to apply the basis look-through with respect to an 80% controlled entity eligible for the small business exemption that makes a protective election to apply the excepted trade or business rules.
The final regulations retain the anti-abuse rule contained in the 2018 proposed regulations, which provides that additional basis in an asset or change in use of an asset is not taken into account for purposes of the allocation if a principal purpose for the acquisition, disposition, or change in use of an asset was to artificially shift the amount of basis allocable to excepted or nonexcepted trades or businesses on a determination date.
The final regulations make other clarifying corrections to the rules for determining basis for purposes of the allocation.
Rules Applicable to C Corporations
The final regulations retain the general rule set forth in the 2018 proposed regulations that all C corporation interest expense and interest income constitute BIE and business interest income allocable to a trade or business for purposes of Section 163(j). As with NOLs, C corporations deduct current-year BIE and then BIE carryforwards, in chronological order of the year in which the carryforwards were generated. Nonconsolidated C corporations generally should not be aggregated for purposes of applying the Section 163(j) limitation, although the anti-avoidance rules in the final regulations prevent the use of a controlled corporation or lower-tier partnership to avoid the Section 163(j) limitation. Under the final regulations, a C corporation’s earnings and profits are calculated without regard to the Section 163(j) limitation.
In the case of a Section 382 ownership change, excess BIE carryforwards are subject to limitation as pre-change losses. The amount of a corporation’s deduction for current-year BIE is calculated based on a ratable allocation for purposes of calculating the corporation’s taxable income attributable to the pre-change period unless the taxpayer makes the closing of the books election (such election was not available with respect to BIE carryforwards under the 2018 proposed regulations). A taxpayer’s Section 382 limitation is absorbed by excess BIE carryforwards before being absorbed by NOLs. Section 382(l)(5) provides an exception to the general Section 382 loss limitation rule for a loss corporation in a Title 11 proceeding or similar case if the shareholders and “old and cold” creditors of such corporation own at least 50% of the stock of the new loss corporation as a result of being shareholders or old-and-cold creditors. If Section 382(l)(5) applies to an ownership change, under Section 382(l)(5)(B) the corporation must reduce its losses (which under the 2018 proposed regulations includes BIE carryforwards for these purposes) by the amount of interest accrued during the three-year period preceding the change year (or during the pre-change period in the change year) to the extent attributable to debt that is exchanged for equity pursuant to the Title 11 or similar case. This rule does not appear to apply to BIE carryforwards generated prior to the three-year period and carried forward into such period. The final regulations made no substantive changes to these rules.
Rules Applicable to Consolidated Groups
In the case of consolidated groups of corporations, three principles apply: (i) a consolidated group has a single Section 163(j) limitation; (ii) the group’s ATI is calculated based on the group’s consolidated taxable income, and intercompany items and corresponding items are disregarded to the extent they offset in amount; and (iii) for purposes of calculating the group’s ATI and determining the BIE and business interest income of each member, all intercompany obligations are disregarded. In connection with the third principle, the final regulations clarify that if any member of a consolidated group purchases a member’s note from a third party at a premium, the deductible repurchase premium is treated as interest expense for purposes of Section 163(j), regardless of whether the repurchase premium is treated as paid on intercompany indebtedness. The final regulations reserve on issues relating to intercompany partnership interest transfers.
In allocating interest income and expense between excepted and nonexcepted trades or businesses, all members of a consolidated group are treated as a single corporation for purposes of the asset-basis allocation, intercompany transactions are disregarded for computing asset basis, and property is allocated to a trade or business based on the activities of the group as if the members of the group were divisions of a single corporation.
The final regulations adopt a cumulative Section 163(j) separate return limitation year (SRLY) register for consolidated groups. The cumulative section 163(j) SRLY register operates in a manner similar to, but is separate and distinct from, the cumulative register for NOLs described in Treasury Regulation Section 1.1502- 21(c).
The final regulations retain the provisions from the 2018 proposed regulations that require netting business interest income and floor plan financing interest expense against BIE at the member level, although Treasury acknowledges that this deviates from a “pure” single-entity approach.
Rules Applicable to Partnerships
The Section 163(j) limitation is generally applied at the partnership level, and a partner’s ATI is increased by the partner’s share of the partnership’s excess taxable income but not by the partner’s distributive share of the partnership’s income, gain, deduction or loss. The amount of partnership BIE limited by Section 163(j) is carried forward at the partner level. Excess BIE allocated to a partner and carried forward is treated as business interest paid or accrued by the partner in succeeding taxable years in which the partner is allocated excess taxable income from such partnership, but only to the extent of such excess taxable income.
Under the CARES Act, the increase of the ATI limitation from 30% to 50% does not apply to partnerships for taxable years beginning in 2019, and the election to not apply the 50% ATI limitation may be made only for taxable years beginning in 2020 (such election is made at the partnership level). However, a partner treats 50% of its allocable share of a partnership’s excess BIE for 2019 as a BIE in the partner’s first taxable year beginning in 2020 that is not subject to the Section 163(j) limitation. The remaining 50% of the partner’s allocable share of the partnership’s excess BIE remains subject to the Section 163(j) limitation applicable to excess BIE carried forward at the partner level. A partner may elect out of this 50% excess BIE rule. The 2020 proposed regulations contain guidance on this election in the partnership context.
Excess taxable income and excess business interest income or expense is allocated to each partner in the same manner as the non-separately stated taxable income or loss of the partnership. In order to effectuate this allocation, the 2018 proposed regulations provided an 11-step calculation. In response to comments, the final regulations made several changes to the 11-step calculation, including the following:
- A new regulation is added to clarify that if the 11-step calculation is satisfied, the allocation of Section 163(j) excess items will be deemed to be in accordance with the partners’ interests in the partnership.
- The final regulations essentially provide a shortcut to the 11-step calculation for partnerships that allocate all Section 163(j) items proportionately.
- Despite commenter requests for modifications, the final regulations retain the provision from the 2018 proposed regulations that any excess BIE allocated to the partner in the current taxable year and any excess BIE from a prior taxable year that was suspended under Section 704(d) are not treated as excess BIE in any subsequent year until such amount is no longer suspended under Section 704(d). Moreover, any deductible BIE and any BIE of an exempt partnership (whether allocated to the partner in the current taxable year or suspended under Section 704(d) in a prior taxable year) are taken into account under Section 704(d) before any excess BIE.
- The final regulations provide that a partial disposition of a partnership interest triggers a proportionate excess BIE basis addback and corresponding decrease in such partner’s excess BIE carryover (discussed below).
- The final regulations provide that BIE of an exempt partnership (such as a partnership engaged in an electing real property trade or business) does not retain its character as BIE and, as a result, is not subject to the Section 163(j) limitation at the partner level.
- The final regulations provide that if a partner is allocated excess BIE from a partnership and, in a succeeding taxable year, such partnership engages in excepted trades or businesses, then the partner shall not treat any of its excess BIE that was previously allocated from such partnership as BIE paid or accrued by the partner in such succeeding taxable year by reason of the partnership engaging in excepted trades or businesses. Instead, such excess BIE shall remain as excess BIE until such time as it is treated as BIE paid or accrued by the partner as described above.
The 2020 proposed regulations, described in more detail below, set forth additional proposed rules regarding the application of Section 163(j) to partnerships.
Rules Applicable to S Corporations
Like for partnerships, the Section 163(j) limitation is applied at the entity level, and a shareholder’s ATI is increased by the shareholder’s share of the S corporation’s excess taxable income. However, unlike for partnerships, any limitation of an S corporation’s BIE is carried forward at the S corporation and potentially deducted by the S corporation in future tax years.
The final regulations provide that the S corporation’s excess BIE carryforwards will be treated as pre-change losses subject to a Section 382 limitation following an S corporation’s ownership change, as is the case for C corporations. The final regulations provide that BIE of an exempt S corporation does not retain its character as BIE and, as a result, is not subject to the Section 163(j) limitation at the shareholder level.
The final regulations also clarify that a separate Section 163(j) limitation should be calculated for, and applied to, each actual or “hypothetical short taxable year” of an S corporation. In the event that a shareholder completely terminates its interest, the S corporation and affected shareholders can elect to treat its taxable year as if the taxable year consisted of two taxable years, the first of which ends on the date of the termination. Each such year is a “hypothetical short taxable year.”
The final regulations also set forth rules applicable to regulated investment companies, certain regulated utilities, cooperatives, trusts and tax-exempt organizations.
Cancellation of Indebtedness Income
Upon Treasury’s request, commenters highlighted uncertainty regarding whether cancellation of indebtedness income arises to the extent a taxpayer is relieved of an obligation to pay interest that is a disallowed BIE carryforward, or whether any exclusions should apply. In addition, the final regulations provide no clarity regarding the absence of Section 163(j) carryforwards from the enumerated list of attributes subject to reduction under Section 108(b), perpetuating the assumption that Section 163(j) carryforwards are not subject to such reduction. Treasury and the IRS have determined that the interaction between Section 163(j) and Section 108 requires further consideration and may be the subject of future guidance.
The 2020 Proposed Regulations
The 2020 proposed regulations contain rules that focus on pass-through entities and their partners and shareholders, as well as foreign corporations and their U.S. shareholders and foreign persons with effectively connected income. The following is a summary of certain key provisions of the 2020 proposed regulations, to the extent they are not described above.
Allocation of Interest Expense with Respect to Pass-Through Entities
For purposes of applying the Code’s passive activity loss limitation, investment interest limitation and personal interest limitation, debt generally is allocated by tracing disbursements of debt proceeds to specific expenditures, and interest expense associated with debt is allocated in the same manner as the debt to which such interest expense relates. Prior guidance by the IRS set forth alternative approaches for allocating interest expense attributable to partnership debt whose proceeds are distributed to partners, including an approach that allocates such interest expense based on the partners’ expenditures of such debt-financed distribution. Commenters pointed out that a tracing rule of this sort does not align well with the pass-through entity-level application of Section 163(j). The 2020 proposed regulations contain rules regarding the allocation of interest expense specific to pass-through entities that are intended to reconcile the tracing rule and the entity-level application of Section 163(j). While the 2020 proposed regulations retain a tracing approach, the groupings of pass-through expenditures for Section 163(j) purposes differ from those that apply generally for other purposes. In addition, interest on debt whose proceeds are distributed to pass-through owners is first allocated to entity-level expenditures (notwithstanding a tracing of the debt proceeds to the distribution) with only any excess allocable to the distribution. The treatment of interest allocable to such excess is determined separately by each owner and is not treated as interest expense of the entity. The proposed regulations also provide rules for allocating such interest expense with respect to a pass-through owner that acquires an equity interest from an unrelated person who had previously received a debt-financed distribution, as well as rules for allocating interest expense of debt-financed acquisitions of interests in a pass-through entity.
In addition, the 2020 proposed regulations require a trading partnership to bifurcate its interest expense from a trading activity between partners that materially participate in the trading activity and partners that are passive investors, and subject only the portion of the interest expense that is allocable to the materially participating partners to limitation under Section 163(j) at the partnership level.
Fungibility of Publicly Traded Partnerships (PTPs)
Application of Section 163(j) in the partnership context results in variable tax attributes for a buyer depending on the tax characteristics of the interest held by the seller, even when the remedial allocation method is coupled with a Section 754 election. Treasury has determined that this result is inappropriate for PTPs because PTPs must have tax attributes proportionate to economic attributes to retain fungibility. The 2020 proposed regulations set forth a method for applying Section 163(j) in a manner that is intended to preserve fungibility among PTP units.
Self-Charged Lending Transactions
The 2020 proposed regulations provide rules for self-charged lending transactions (i.e., where a partner or related person loans money to a partnership in which the partner owns a direct interest), which apply to correct a mismatch in character that may occur at the partner level. Absent a special rule, a partner’s interest income from a loan to a partnership may be treated as investment interest, while any excess business interest allocated to it from the partnership attributable to the same loan would be subject to the Section 163(j) limitations and only deductible to the extent of excess ATI or excess business interest income from such partnership in subsequent years. To avoid this mismatch, the 2020 proposed regulations treat the partner’s interest income as excess business interest income allocated to it from the partnership to the extent of the excess BIE allocated to the lending partner attributable to the partner loan in such year. While preventing mismatch at the partner level, the proposed rules are also designed to ensure that a partnership engaged in a self-charged lending transaction will be subject to the rules of Section 163(j) to the same extent regardless of the source of its loans, which would not be the case if a portion of the partnership’s BIE and a share of the partner’s corresponding interest income were simply disregarded in applying Section 163(j), as some commenters had suggested. These proposed rules do not apply in the case of S corporations because BIE carries over to the S corporation and is not passed through to shareholders.
Partnership Basis Adjustments upon Partner Dispositions
In general, a partnership’s excess BIE is allocated to its partners as excess BIE rather than carried forward at the partnership level, in order to prevent the trafficking of deductions for BIE carryforwards in the partnership context. A partner increases the basis in its partnership interest immediately prior to a disposition by any nondeductible excess BIE. The 2020 proposed regulations clarify that the basis increase is accompanied by a corresponding increase to the basis of partnership assets (i.e., to account for the nondeductible excess BIE), allocated among partnership properties in the same manner as a positive Section 734(b) adjustment. The basis adjustment is not depreciable or amortizable, even if allocated to otherwise depreciable or amortizable property. While the adjustment mechanism makes sense in the context of a partnership redemption, when a partner sells its interest to a third party, the adjustment would appear to work better if it were allocated solely to the transferee partner and determined in the same manner as a Section 743(b) adjustment.
In the 2020 proposed regulations, Treasury adopts an entity-level approach for tiered partnerships, whereby excess BIE is not allocated through an upper-tier partnership to the partners of the upper-tier partnership. Thus, an allocation of excess BIE to the upper-tier partnership results in the upper-tier partnership reducing its basis in the lower-tier partnership, but no similar basis reduction occurs with respect to basis in the upper-tier partnership. However, the capital accounts of the partners in both the upper-tier partnership and the lower-tier partnership are reduced.
The 2020 proposed regulations further provide that if a lower-tier partnership allocates excess BIE to an upper-tier partnership (and such expense is not suspended), then the upper-tier partnership treats such excess BIE as a nondepreciable capital asset, with a fair market value of zero and basis equal to the amount by which the upper-tier partnership reduced its basis in the lower-tier partnership due to the allocation of such excess BIE. (This is similar to the basis adjustment upon partner dispositions, described above.) The basis is subject to reduction in connection with subsequent Section 734(b) and 743(b) negative adjustments. This results in the upper-tier partnership owning built-in loss property and treats the excess BIE as having a carryforward component associated with it, equal to the amount of excess BIE allocated from the lower-tier partnership to the upper-tier partnership.
The 2020 proposed regulations provide that if an allocation of excess BIE from a lower-tier partnership is treated as excess BIE of an upper-tier partnership, such treatment remains until the excess BIE is treated as BIE paid or accrued or until the basis addback upon disposition of a partnership interest occurs. The 2020 proposed regulations also provide anti-trafficking rules.
The 2020 proposed regulations provide rules for applying the 11-step calculation to allocate excess business interest income or expense, described in more detail above, to a tiered partnership.
Rules Applicable to U.S. Shareholders of CFCs
As described above, Section 163(j) applies to applicable CFCs and other foreign corporations whose income is relevant for U.S. tax purposes. In an expansion of a more limited rule set forth in the proposed regulations, the 2020 proposed regulations allow a U.S. shareholder of certain qualifying stand-alone CFCs or a member of a CFC group to include in the U.S. shareholder’s ATI a portion of its deemed income inclusions attributable to the applicable CFC (without regard to the Section 78 amount). Such portion is generally the ratio of the CFC’s (or the CFC group’s) excess taxable income to ATI. The U.S. shareholder’s inclusion in ATI is not permitted with respect to (i) a CFC as to which a safe harbor election is made as described below (because the Section 163(j) limitation does not apply to such CFC) or (ii) a CFC that is not a stand-alone CFC but that has not elected to be part of a CFC group for Section 163(j) purposes (this limitation was added to prevent abuse of the addback rule). Under the 2020 proposed regulations, a single Section 163(j) limitation is computed for a CFC group and allocated among the group’s members. The 2020 proposed regulations contain an anti-avoidance rule and also provide for an annual safe harbor election, which, if applicable, provides that no portion of the BIE of the CFC or CFC group, as applicable, is disallowed under Section 163(j).
Rules Applicable to Foreign Persons with Effectively Connected Income (ECI)
The 2020 proposed regulations contain rules for determining the amount of deductible BIE and disallowed BIE carryforward of a nonresident alien, foreign corporation or partnership that is properly allocable to ECI. At a high level, these rules provide that definitions such as ATI are modified to take into account only ECI items. For specified foreign persons, only ECI items and assets that are U.S. assets are taken into account in determining the amount of interest income and interest expense allocable to a trade or business (based on proportionate ATI). Disallowed BIE is characterized as ECI or not ECI in the year in which it arises, and it retains its characterization in subsequent years.