The newest addition to your summer reading list: Section 163(j) regulations arrive just in time for the dog days of summer

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Eversheds Sutherland (US) LLPOn July 28, 2020, the Internal Revenue Service (IRS) and Department of the Treasury (Treasury) issued final1 and newly-proposed2 regulations under section 163(j) that taxpayers and practitioners alike were eagerly awaiting. Since the Tax Cuts and Jobs Act (TCJA)3 modified the rules under section 163(j) in 2017, taxpayers have been looking forward to additional guidance and clarification to properly implement the new business interest expense limitation rules – and with the more recent changes made to section 163(j) by the Coronavirus Aid, Relief, and Economic Security (CARES) Act,4  the need for guidance became ever more pressing. In an expansive 874-page package,5 the IRS addressed many outstanding questions with the issuance of final regulations (the Final Regulations), newly-proposed regulations (the Proposed Regulations) which address additional changes and clarifications to the Final Regulations, as well as Notice 2020-59, containing a proposed revenue procedure providing a safe harbor for a trade or business that manages or operates a qualified residential living facility to be treated as a real property trade or business solely for section 163(j) purposes.  

The Final Regulations will be effective 60 days after the date they are published in the Federal Register, and are generally applicable to taxable years beginning on or after the effective date. Taxpayers may apply the Final Regulations retroactively to taxable years beginning after December 31, 2017, provided the Final Regulations are applied consistently. Taxpayers may instead rely on the 2018 Proposed Regulations for taxable years beginning after December 31, 2017, and before the Final Regulations become effective. Because the Final Regulations make a number of important changes to the 2018 Proposed Regulations, it will be important to carefully review the Final Regulations to determine whether retroactive changes should be implemented. 
 
This legal alert provides a high-level overview of the Final Regulations, with an emphasis placed on accounting methods and tax accounting issues addressed, such as the narrowed definition of interest, more detailed anti-avoidance rules, revised adjusted taxable income (ATI) calculation, clarification as to what constitutes a trade or business, and whether the section 163(j) limitation itself is a method of accounting.
 
Background
 
Section 163(j) under the TCJA
 
The TCJA amended section 163(j) to limit the deduction of business interest expense for tax years beginning after December 31, 2017. Specifically, the business interest expense deduction was limited to the sum of: (1) the taxpayer’s business interest income for the taxable year, (2) 30% of the taxpayer’s ATI for the taxable year, and (3) any floor plan financing interest.6 The section 163(j) limitation generally applies to all taxpayers with business interest expense, as defined by section 163(j)(5), other than taxpayers with annual gross receipts less than $25 million.
Section 163(j)(5) generally provides that “business interest” means any interest allocable to a trade or business. Section 163(j) does not define “trade or business” but it excludes certain types of businesses from, and allows others to elect out of, the business interest deduction limitation. Section 163(j)(7) allows two types of businesses to elect out of the business interest deduction limitation: a “real property business” or a “farming business.” 
Section 163(j)(8) defines ATI as the taxable income of the taxpayer without regard to the following: items not properly allocable to a trade or business; business interest and business interest income; net operating loss (NOL) deductions; and, deductions for qualified business income under section 199A. ATI also generally excludes deductions for depreciation, amortization, and depletion with respect to taxable years beginning before January 1, 2022.
Section 163(j) under the CARES Act
 
The CARES Act added a new section 163(j)(10), which sets forth special rules for 2019 and 2020 tax years in applying the business interest expense deduction limitation. Under section 163(j)(10)(A)(i), the CARES Act increases the 163(j) limitation by increasing the percentage of ATI that can be offset by business interest deduction from 30% to 50% for any tax year beginning in either 2019 or 2020. Under the CARES Act, however, a taxpayer may elect not to apply the 50% ATI limitation to either applicable tax year,7 retaining the 30% ATI limitation generally applicable under section 163(j). The CARES Act also added section 163(j)(10)(B) providing that taxpayers may elect to use 2019 ATI in determining the section 163(j) limitation for any taxable year beginning in 2020. For more information and in-depth analysis of the CARES Act generally, please see Eversheds Sutherland’s March 31, 2020 alert; for a methods-based analysis of the CARES Act, please see the firm’s April 6, 2020 alert.
 
In order to assist taxpayers’ implementation of the CARES Act changes to section 163(j), the IRS also released Rev. Proc. 2020-22, which describes the time and manner for making elections under section 163(j)(10), the election not to apply the 50% limitation, and the election to use the taxpayer’s 2019 ATI for its 2020 ATI calculation.8 Rev. Proc. 2020-22 also provides an extension of time for taxpayers to file an election under section 163(j)(7) to be treated as an electing real property or farming business for the 2018, 2019 and 2020 taxable years,9 as well as an opportunity for certain taxpayers to withdraw prior elections made under section 163(j)(7) to be treated as an electing real property or farming business.10 For more information and recommendation to consider in light of Rev. Proc. 2020-22, please see Eversheds Sutherland’s April 16, 2020 alert on the guidance.
 
Overview of the Final Regulations
 
Definition of Interest
 
The IRS and Treasury received nearly 120 comment letters, many which observed that the definition of interest in the 2018 Proposed Regulations was overly broad. The IRS and Treasury listened to these comments letters and chose to address this issue with a more nuanced determination of the term “interest.” As an initial matter, the IRS modified the 2018 Proposed Regulations’11 definition of interest to reduce its expansive scope, which many had commented was overly inclusive in its proposed form. Taxpayers and practitioners were frustrated with the government’s inclusion of items that generally were not considered to be interest at all, e.g., commitment fees; debt issuance costs; income, deduction, gain, or loss in a hedging transaction; guaranteed payments for the use of capital; and, other fees more likely deductible under section 162. While the IRS and Treasury were responsive to some of those frustrations, with exclusions for commitment fees and certain debt issuance costs, it will be important to see how these items are addressed in a broader, separately-planned IRS guidance project regarding fees related to debt and other securities.
 
The definition of interest also includes an anti-avoidance rule, under which income, deduction, gain or loss from a hedging transaction may be required to be taken into account for purposes of the section 163(j) calculation. It is important to note, the anti-avoidance rule in the Final Regulations applies only to amounts where a principal purpose of the taxpayer for engaging in a transaction is to artificially reduce the amount of net business interest expense, whether this stems from a decrease in the amounts reported as interest expense or an increase in the amounts reported as interest income. Additionally, guaranteed payments for the use of capital aren’t explicitly excluded from the definition of interest, because there may be examples in which such payments would be characterized as interest for section 163(j) purposes.
 
In addition to these previous items’ inclusion or exclusion from the definition of interest, the IRS and Treasury also addressed commenters’ concerns regarding the inclusion of substitute interest payments in the definition of “interest” for purposes of section 163(j). While commenters were concerned that the inclusion of such amounts as interest would be contrary to longstanding case law and practice, they recommended that should the IRS and Treasury ultimately decide to include substitute interest payments, they limit such inclusion to amounts related to transactions that are economically similar to a borrowing. To the relief of such commenters, the Final Regulations, while retaining substitute interest payments in the definition of interest because such payments are economically equivalent to interest, also provide that substitute interest payments will only be treated as interest expense to the payor if the payment relates to a sale-repurchase or securities lending transaction that is not entered into by the payor in the payor’s ordinary course of business, with similar treatment afforded the recipient of correlating interest income. Taxpayers should appreciate this distinction, as the ordinary course rule appears to provide a reasonable standard and appropriately limit the scope of the definition. 
 
Eversheds Sutherland Perspective:  While the posture taken and changes made in the Final Regulations are certainly helpful to limit the scope of items potentially included in the definition of interest, taxpayers will want to carefully evaluate the application of the anti-avoidance rule to make sure they don’t run afoul of the provision. Compared to its application in the 2018 Proposed Regulations, the anti-avoidance rule in the Final Regulations applies to both interest income and interest expense, thereby increasing the number of transactions to which the rule could potentially apply. Although the anti-abuse rules include subjective standards, there are a number of examples offering clarity in application. Additionally, as noted in the Final Regulations, with the treatment of commitment fees and other debt-related fees the subject of a broader IRS guidance project, taxpayers will want to stay aware of the progress and release of such guidance to determine any impact it may have on the definition of interest for section 163(j) purposes.

 

Calculation of ATI

In addition to heeding many commenters’ suggestions to narrow the definition of interest in the Final Regulations, the IRS and Treasury also were responsive to concerns of taxpayers and practitioners regarding adjustments to ATI for depreciation, amortization, and depletion.
 
Under the 2018 Proposed Regulations, and consistent with the statute, ATI was defined as the taxable income of the taxpayer computed without regard for depreciation, amortization, or depletion for taxable years beginning before January 1, 2022.  Under section 263A, taxpayers that manufacture or produce inventory or acquire inventory for resale must capitalize all direct and certain indirect costs into the basis of the property produced or acquired for resale and recover such expenses through cost of goods sold. These amounts are recovered as an offset to gross receipts in computing gross income; cost of goods sold is not a deduction from gross income but instead reduces the amount realized on the sale of goods.  As such, depreciation, amortization, or depletion capitalized into inventory under section 263A is similarly recovered through cost of goods sold as an offset to gross receipts in computing gross income. For this reason, the 2018 Proposed Regulations provided that depreciation, amortization, or depletion expense capitalized into inventory under section 263A may not be added back to taxable income in computing ATI.  Responsive to concerns of inequity for capital-intensive businesses that manufacture or produce inventory and efforts to reflect Congressional intent to determine ATI using EBITDA through 2021 for all taxpayers, the IRS and Treasury in the Final Regulations changed the ATI calculation to add back any amount of depreciation, amortization, or depletion that is capitalized into inventory under section 263A during taxable years beginning before January 1, 2022, regardless of the period in which the capitalized amount is recovered through cost of goods sold.
 
In addition to allowing the add back of any amount of depreciation, amortization, or depletion that is capitalized into inventory under section 263A during taxable years beginning before January 1, 2022, the Final Regulations also clarify the debate between the language in section 163(j)(8)(A)(iv), which allows an add back of “the amount of any deduction allowed under section 199A,” with section 163(j)(8)(A)(v), which allows an add back of “any deduction allowable for depreciation, amortization, or depletion.” Under the Final Regulations, the amount of any depreciation, amortization, or depletion that is capitalized into inventory under section 263A during taxable years beginning before January 1, 2022, is added back to tentative taxable income as a deduction for depreciation, amortization, or depletion when calculating ATI for that taxable year, regardless of the period in which the capitalized amount is recovered through cost of goods sold. In other words, and as explained in the preamble to the Final Regulations, if a taxpayer capitalized an amount of depreciation to inventory under section 263A in the 2020 taxable year, but the inventory is not sold until the 2021 taxable year, the entire capitalized amount of depreciation is added back to tentative taxable income in the 2020 taxable year, and such capitalized amount of depreciation is not added back to tentative taxable income when the inventory is sold and recovered through cost of goods sold in the 2021 taxable year. Thus, regardless of the period in which the capitalized amount is actually recovered, the entire capitalized amount is deemed to be included in the calculation of the taxpayer’s tentative taxable income for the 2020 taxable year.
 
Eversheds Sutherland Perspective:  Taxpayers and practitioners alike will welcome this change in the Final Regulations, allowing the add back of all depreciation, amortization, or depletion incurred in the taxable year, irrespective of whether it is deductible or capitalized into the cost of inventory under section 263A. Not only will taxpayers appreciate this walk back from the 2018 Proposed Regulations, but in a further favorable move, the Final Regulations also allow such deductions to be added back when calculating ATI in the year the depreciation expense is allowed regardless of the period when an expense is recovered through costs of good sold – this timing should alleviate the complexities of running down when cost recovery allowances are recovered after being capitalized to inventory. This approach should conserve resources for both taxpayers and the IRS. It is important to note, taxpayers seeking to address correction of previous years’ application of the 2018 Proposed Regulations will require an amended return as the Final Regulations indicate, in multiple areas, that the section 163(j) limitation is not a method of accounting. 

 

Definition of Trade or Business

Under section 163(j)(5), business interest is defined as an interest properly allocable to a trade or business. As the preamble to the Final Regulations notes, neither section 163(j) nor the legislative history define the term “trade or business,” and the 2018 Proposed Regulations merely defined the term by reference to section 162, which permits a deduction for all the ordinary and necessary expenses paid of incurred in carrying on a trade or business. Commenters requested additional guidance regarding whether an activity constitutes a section 162 trade or business, and similar to their response to commenters’ requests for guidance regarding the interplay of section 163(j) and section 168(k), the IRS and Treasury declined to further define the term in the Final Regulations, indicating specific guidance under section 162, as with section 168(k), is beyond the scope of the Final Regulations. 
 
In the preamble to the Final Regulations, the IRS directed taxpayers with questions regarding the availability of section 168(k) for taxpayers that have had floor plan financing interest expense, to section 168(k) itself and the proposed regulations under Treas. Reg. §1.168(k)-2(b)(2)(ii)(G). Commenters had requested clarification because under section 168(k)(9)(B) the additional first-year depreciation deduction is not allowed for any property used in a trade or business that has had floor plan financing indebtedness as defined in section 163(j)(9).
 
Commenters further sought guidance to determine how to delineate separate section 162 trades or businesses within an entity, and when an entity’s combined activities should be considered a single section 162 trade or business. While recognizing that an entity can conduct more than one trade or business under section 162 and may use different methods of accounting for separate and distinct trades or businesses, the Final Regulations still chose to define “trade or business” as a trade or business within the meaning of section 162, and went no further as such guidance would be beyond the scope of the Final Regulations. To assist taxpayers in evaluating what constitutes a separate and distinct trade or business under section 162, the Final Regulations, consistent with the 2018 Proposed Regulations, provide that maintaining separate books and records for all excepted and non-excepted trades or businesses can be one indication that a particular asset is used in a particular trade or business.
 
Eversheds Sutherland Perspective:  Although taxpayers may be disappointed with the lack of additional guidance provided in the Final Regulations regarding what constitutes a “trade or business” for section 163(j) purposes, the discussion provided in the preamble to the regulation package should provide a roadmap, if not reinforce previous assumptions, regarding how taxpayers should evaluate whether an activity constitutes a trade or business. As indicated in the preamble to the Final Regulations, the evaluation of what constitutes a section 162 trade or business is inherently factual, and generally founded in the judicial requirements of a profit motive and considerable, regular and continuous activity. Additionally, taxpayers should appreciate the IRS’s acknowledgement in the preamble regarding the ability for an entity to carry on more than one trade or business (reflected in the allocation rules in proposed Treas. Reg. §1.163(j)-10(c)(3)), and the resulting multiple methods of accounting that may be maintained for such distinct trades or businesses.

 

The Section 163(j) Limitation as a Method of Accounting

Subsequent to the 2018 Proposed Regulations, many commenters sought clarification regarding whether the section 163(j) limitation was a method of accounting. The Final Regulations clarify, in multiple areas, that the section 163(j) limitation is not a method of accounting.
 
Questions arose because the rules under section 163(j) seem to defer, rather than permanently disallow, a deduction for disallowed business interest expense and disallowed disqualified interest, specifically allowing the carryforward of both amounts. At a cursory glance, the limitation may in fact appear to merely affect the timing of such amounts, which would indicate that the section 163(j) limitation is a method of accounting. However, as noted by the IRS and Treasury in the preamble to the Final Regulations, the carryover rules in section 163(j)(2) do not guarantee that a taxpayer will be able to deduct the business interest expense that the taxpayer was not permitted to deduct in one taxable year and was required to carry forward into succeeding taxable years.12 Thus, because the limitation may result in a permanent change in the taxpayer’s lifetime income, and also because the limitation does not involve an “item” as it is not a recurring element of income or expense, the IRS and Treasury determined the section 163(j) limitation is not a method of accounting.
 

Eversheds Sutherland Perspective:  Taxpayers may also appreciate the additional clarification provided by the IRS and Treasury that the section 163(j) limitation is not a method of accounting. While generally the carryover rules in section 163(j)(2) do provide that disallowed business interest expense and disallowed disqualified interest may be carried forward to a future taxable year, the fact that there is no mechanism to ensure the taxpayer may claim the full amount of the carryover does in fact leave open the possibility that a taxpayer may not be able to deduct the business interest expense in a later year that the taxpayer was not able to deduct in the current taxable year. The potential for a permanent change in the taxpayer’s lifetime taxable income not only prevents the limitation from being considered a method of accounting, but also relieves a taxpayer from having to file a change in method of accounting to the extent the taxpayer modifies its section 163 limitation calculation. Depending on a taxpayer’s underlying facts and circumstances, this may be a favorable outcome.

In light of this determination made in the Final Regulations, a company seeking to change or modify its calculation of the section 163(j) limitation in prior years will have to file an amended return – the preamble to the Final Regulations makes clear the limitation is not a method of accounting, and, therefore, a change in calculating such limitation does not require a change in method of accounting to be filed. Such requirement is akin to the directive in Rev. Proc. 2020-22 that taxpayers seeking to withdraw prior elections made under section 163(j)(7), as well as make a late election, must correct such earlier decisions with a timely-filed amended return.  

 

Relationship of Section 163(j) Limitation to Other Provisions

In the 2018 Proposed Regulations, the ordering and operating rules provided that provisions that require interest to be capitalized, such as sections 263A and 263(g), apply before section 163(j). In response to commenters’ concerns that solely referencing sections 263A and 263(g) was too restrictive, the Final Regulations revised the 2018 Proposed Regulations to account for any possible additional provisions that could require interest to be capitalized.  Unlike the prioritization of sections 263A and 263(g) ahead of section 163(j), the Final Regulations expand the position taken in the 2018 Proposed Regulations to clarify that sections 461(l), 465 and 469 all apply after the application of section 163(j). To further clarify these ordering principles, the Final Regulations contain a number of examples that demonstrate the calculation of ATI if a loss tentatively is suspended in the calculation of tentative taxable income, and if a loss is carried forward from a prior taxable year under section 469. 
 
Unlike the clarification provided in the Final Regulations regarding capitalized interest, in response to commenters’ concerns regarding the interaction of sections 163(j) and section 108, the IRS and Treasury stated further consideration was required and such interaction may be the subject of future guidance.  Commenters were concerned whether cancellation of indebtedness income under section 61(a)(11) arises when the taxpayer only receives a benefit in the form of a disallowed business interest expense carryforward, or whether any exclusions, such as sections 108(e)(2) or 111, or any tax benefit principles, applied.
 
Conclusion

While the Final Regulations generally maintain and merely clarify the rules provided in the 2018 Proposed Regulations, there are a number of differences and distinctions which, as discussed above, merit close evaluation. Taxpayers will want to pay close attention to the narrowed definition of interest to ensure they are applying the more nuanced definition in the Final Regulations and not falling suspect to the new, more detailed anti-avoidance rules. Additionally, revisions to the ATI calculation, i.e., the change to allow adding back all depreciation, amortization, or depletion incurred in the taxable year, irrespective of whether it is deductible or capitalized into the cost of inventory under section 263A, while helpful should be carefully applied. Taxpayers seeking to change previous years’ application of the 2018 Proposed Regulations will require an amended return as the Final Regulations indicate, in multiple areas, that the section 163(j) limitation is not a method of accounting. Due to these changes, taxpayers should begin to evaluate the advantages and disadvantages of implementing the new Final Regulations, not only to past, but current and future tax years.
------------------------------------------
1 T.D. 9905.
2 REG-107911-18.
3 P.L. 115-97 (December 22, 2017).
4 P.L. 116-136 (March 27, 2020).
5 The final regulations coming in at 575 pages, the proposed regulations at 285 pages, and 14-page notice.
6 I.R.C. § 163(j)(1).
7 See I.R.C. § 163(j)(10)(A)(iii).
8 2020-18 I.R.B. 1, § 6.
9 Id. at § 4.01.
10 Id. at § 5.01.
11 REG-106089-18 (December 28, 2018).
12 See T.D. 9905, at 81.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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