On January 5, 2021, the Internal Revenue Service (the IRS) and the U.S. Department of the Treasury issued final regulations in T.D. 9943 (the "2021 Final Regulations") under section 163(j) of the Internal Revenue Code (the "Code").1 These regulations finalize certain provisions of the proposed regulations (REG-107911-18) under section 163(j) issued on July 28, 2020 (the "2020 Proposed Regulations"). The 2020 Proposed Regulations were issued concurrently with a more extensive package of final regulations under section 163(j) (the "2020 Final Regulations") that finalized regulations that were proposed in 2018 (the "2018 Proposed Regulations").2 The 2021 Final Regulations finalize a number of important clarifications and changes to the rules set forth in the 2020 Final Regulations and, in particular, clarify the application of the section 163(j) limitation in the context of partnerships, controlled foreign corporations (CFCs) and regulated investment companies (RICs). The 2021 Final Regulations reserve on a number of provisions that were included in the 2020 Proposed Regulations that warrant continued study, particularly in the context of partnerships and CFCs.
Applicability Dates
The 2021 Final Regulations will be applicable to taxable years beginning on or after the date that is 60 days after the date they are published in the Federal Register. Taxpayers generally may apply the 2020 Final Regulations as modified by the 2021 Final Regulations and certain other provisions retroactively to taxable years beginning after December 31, 2017, so long as the 2020 Final Regulations and 2021 Final Regulations are applied consistently by a taxpayer and its related parties to such taxable year and each subsequent taxable year. Alternatively, a taxpayer and its related parties may choose to rely on the rules in the 2020 Proposed Regulations to the extent provided in such regulations. With respect to any rule in the 2020 Proposed Regulations that was not finalized, a taxpayer and its related parties may rely on that rule for a taxable year provided they follow all of the rules in the 2020 Proposed Regulations that were not finalized for that taxable year and each subsequent taxable year until such rules are finalized or other guidance is issued.
Notably, for purposes of the Congressional Review Act, the Treasury Department and the IRS have taken the view that the 60-day delay in the effective date after publication in the Federal Register would be unnecessary and contrary to the public interest. Accordingly, the 2021 Final Regulations have an effective date, which is distinct from the applicability dates above, of the date the T.D. is filed for public inspection at the Office of the Federal Register. This distinction may be an effort to avoid the expected freeze on not-yet-effective regulations by the incoming Biden administration.3
General Limitation Under Section 163(j)
As enacted under the Tax Cuts and Jobs Act (P.L. 115-97) (TCJA), and as amended by the Coronavirus Aid, Relief, and Economic Security Act (P.L. 116-136) (the "CARES Act"), section 163(j) generally disallows a deduction for business interest expense (BIE) for a taxable year when such BIE exceeds the sum of (i) business interest income (BII) and (ii) 30 percent of adjusted taxable income (ATI) (or for taxable years beginning in 2019 or 2020 as provided under the CARES Act, 50 percent of ATI), each as calculated for such taxable year. To the extent that BIE for a taxable year exceeds this limitation, the taxpayer generally may carry forward the amount of disallowed BIE to the succeeding taxable year and beyond. However, any excess limitation (i.e., when current net interest expense is less than the applicable limitation) may not be carried forward to subsequent taxable years.
Calculation of Tentative Taxable Income
Tentative taxable income (TTI) refers to the amount to which adjustments are made in calculating ATI. TTI generally is determined in the same manner as taxable income under section 63 but is computed without regard to the application of the section 163(j) limitation or any disallowed BIE carryforwards.
The 2020 Final Regulations provide for certain additions and certain subtractions to TTI in computing ATI. In particular, upon a disposition of property that has a basis affected by amortization, depreciation or depletion for taxable years beginning after December 31, 2017, and before January 1, 2022 (such years, the EBITDA period), TTI must be reduced by the full amount of the basis adjustments in the property with respect to such amortization, depreciation or depletion. Further, the 2020 Final Regulations provide that with respect to the sale or other disposition of stock of a member of a consolidated group by another member, investment adjustments with respect to such stock that are attributable to depreciation, amortization or depletion deductions are subtracted from TTI. Lastly, with respect to the sale or other disposition of an interest in a partnership, the taxpayer's distributive share of amortization, depreciation or depletion deductions during the EBITDA Period with respect to property held by the partnership at the time of such sale or other disposition is subtracted from TTI to the extent such deductions were allowable under section 704(d). In each of these cases, TTI could be reduced even if the taxpayer does not recognize any gain on the sale of such property, member stock or partnership interest.
In contrast, the 2021 Final Regulations (consistent with the 2020 Proposed Regulations) permit a taxpayer to compute its adjustment to TTI upon the disposition of property, member stock or a partnership interest by determining "the lesser of" (i) the amount of gain on the sale of such property, member stock or partnership interest and (ii) the amount of amortization, depreciation or depletion deductions with respect to such property, member stock or partnership interest for the EBITDA period that would otherwise decrease TTI.
The preamble to the 2021 Final Regulations (the "Preamble") notes that the additions to TTI for depreciation, amortization and depletion during the EBITDA Period do not necessarily increase a taxpayer's ability to deduct BIE. Thus, the 2021 Final Regulations provide that the negative adjustments to TTI described above are reduced to the extent that the taxpayer establishes that the additions to TTI for depreciation, deduction or depletion during the EBITDA Period did not result in an increase in the amount allowed as a deduction for BIE for such year.
Application of Section 163(j) to Partnerships
The section 163(j) limitation with respect to partnerships applies at the partnership level. To the extent that a partnership's BIE does not exceed its section 163(j) limitation, such BIE is allocated by the partnership to the partners, and is not subject to further limitations under section 163(j) at the partner level. The partnership's ATI, once applied in calculating the partnership's section 163(j) limitation is not treated as ATI when allocated to its partners. Instead, a partner's ATI is increased by the partner's distributive share of the "unused" portion of the partnership's ATI (referred to as ETI). The portion of a partnership's excess BIE (referred to as the EBIE) is allocated to and carried forward by its partners. EBIE can be deducted by a partner (to the extent not otherwise limited by section 163(j) at the partner level) only to the extent that the partner is allocated either ETI or excess business interest income (EBII) from the same partnership.
The 2021 Final Regulations reserve on several provisions of the 2020 Proposed Regulations related to section 163(j)'s application to partnerships, including in relation to: partnership deductions capitalized by a partner, partner basis adjustments upon liquidating distributions, partnership basis adjustments upon partner dispositions and tiered partnerships. Thus, the 2020 Proposed Regulations remain in effect with respect to each of these concepts, which may be relied upon if applied consistently, in each case pending release of future final regulations incorporating the results of further analysis by the Treasury Department and the IRS.
Trading Partnerships
The 2021 Final Regulations address the application of section 163(j) to partnerships engaged in a trade or business activity of trading personal property (including marketable securities) for the account of owners of interests in the activity (a "Trading Partnership"). Consistent with the 2020 Proposed Regulations, the 2021 Final Regulations provide that a Trading Partnership is required to bifurcate its interest expense from the trading activity between partners that are passive investors (i.e., taxpayers that do not "materially participate" in the activity as determined under section 469) in the trading activity and all other partners, and subject only the portion of the interest expense that is allocable to the non-passive investors to the limitation under section 163(j) at the partnership level. The portion of interest expense from the trading activity allocable to passive investors is subject to limitation under section 163(d) at the partner level. The 2021 Final Regulations adopt the rule contained in the 2020 Proposed Regulations that for purposes of section 469 any Trading Partnership activity in which a partner does not materially participate may not be grouped with any other activity of the taxpayer (whether or not such other activity relates to a trading business).
The preamble to the 2018 Proposed Regulations stated that the BIE of passthrough entities allocable to trade or business activities that are per se passive under section 469 or to activities with respect to which the taxpayer does not materially participate are subject to section 163(j) at the partnership level, even where the interest expense is also subject to the investment interest limitation under section 163(d) at the partner level. Thus, under the approach of the 2018 Proposed Regulations, interest expense of a partnership engaged in a trade or business would potentially have been subject to the functional equivalent of two section 163 limitations: one limitation under section 163(j) at the partnership level; and a second limitation under section 163(d) at the partner level. Partnerships that relied on the 2018 Proposed Regulations may have allocated EBIE to partners who did not materially participate in the trading activity of the partnership, and, under the 2021 Final Regulations, such investors will no longer be allocated any ETI or EBII from that partnership in future years against which they can offset the EBIE. Accordingly, the 2021 Final Regulations provide a transition rule that permits passive investors in a Trading Partnership generally to deduct, in the first taxable year ending on or after the effective date of the 2021 Final Regulations, EBIE allocated to them from the partnership in any taxable year ending prior to the effective date of the 2021 Final Regulations without regard to the amount of ETI or EBII that may be allocated by the partnership to the partner and without being subject to the investment interest limitation under section 163(d) with respect to such interest.
Self-Charged Lending Transactions
The 2021 Final Regulations address the treatment of BII and BIE with respect to lending transactions between a partnership and a partner (generally referred to as "self-charged lending transactions"). In particular, the 2021 Final Regulations (consistent with the 2020 Proposed Regulations) provide that in the case of a self-charged lending transaction between a lending partner and a borrowing partnership in which the lending partner owns a direct interest, any BIE of the borrowing partnership attributable to a self-charged lending transaction is BIE of the borrowing partnership. However, if in a given taxable year a partner that lends to a partnership is allocated EBIE from the borrowing partnership and has interest income attributable to the self-charged loan, the lending partner may treat such interest income as an allocation of EBII from the borrowing partnership in such taxable year to the extent of the lending partner's allocation of EBIE from the borrowing partnership in such taxable year.
To prevent the potential double counting of BII, the lending partner includes interest income re-characterized as EBII only once when calculating the lending partner's own section 163(j) limitation. In cases where the lending partner is not a C corporation, to the extent that any interest income exceeds the lending partner's allocation of EBIE from the borrowing partnership for the taxable year, and such interest income otherwise would be properly treated as investment income of the lending partner for purposes of section 163(d) for that year, such excess amount of interest income will continue to be treated as investment income of the lending partner for that year for purposes of section 163(d).
The 2021 Final Regulations rejected comments asking for the self-charged lending transaction rule to be extended to loans made to a partnership by an indirect partner or certain parties related to a partner. Consequently, taxpayers using related party debt to fund partnership activities should carefully consider how to structure such debt in order to minimize the potential impact of section 163(j).
Cares Act Partnership Rules
The 2021 Final Regulations provide special rules for partnerships with respect to taxable years beginning in 2019 and 2020 to reflect the changes to the section 163(j) limitation under the CARES Act.
As implemented by the CARES Act, the 2021 Final Regulations (consistent with the 2020 Proposed Regulations) clarify that 50 percent of any EBIE allocated to a partner in its 2019 taxable year is treated as BIE paid or accrued by the partner in the partner's 2020 taxable year (the "50 Percent EBIE Rule"). The amount that is treated as BIE under the 50 Percent EBIE Rule is not subject to a section 163(j) limitation at the partner level. The 2021 Final Regulations clarify that if a partner disposes of its interest in a partnership in such partnership's 2019 or 2020 taxable year, the amount treated as BIE by the partner under the 50 Percent EBIE Rule is deductible by the partner (but only to the extent that such deduction would not have been limited under section 704(d) immediately prior to the disposition) and does not result in a basis increase in the partner's partnership interest. The 2021 Final Regulations permit taxpayers to elect out of the 50 Percent EBIE rule on a partnership-by-partnership basis.
Application of Section 163(j) to CFCs
The 2020 Final Regulations apply section 163(j) to CFCs and other foreign corporations for which taxable income is required to be calculated for U.S. federal income tax purposes. In general, a CFC with BIE applies section 163(j) to determine the amount of its deductible interest expense for purposes of computing subpart F income, tested income under section 951A and income that is effectively connected with a U.S. trade or business (ECI). The 2020 Final Regulations apply the section 163(j) limitation on a CFC-by-CFC basis and prohibits the netting of BII of one CFC against the BIE of another CFC. However, more specific rules addressing the application of section 163(j) to CFCs (including an election to apply section 163(j) on a group basis) and other foreign corporations were issued as part of the 2020 Proposed Regulations. The 2021 Final Regulations generally adopt the 2020 Proposed Regulations with respect to CFCs with some clarifications.
The 2021 Final Regulations reserve on several provisions addressed in the 2020 Proposed Regulations including rules related to (i) treating a CFC as a single C corporation for purposes of allocations to an excepted trade or business, (ii) treating a CFC group as a single taxpayer for purposes of treating amounts as interest, (iii) ordering rules in the case that a CFC group member generates ECI and (iv) the computation of ATI of certain U.S. shareholders of applicable CFCs.
Specified Groups and Specified Group Members
A "CFC group" election can be made to apply section 163(j) on a group basis with respect to "applicable CFCs" (i.e., CFCs that have U.S. shareholders that directly or indirectly own stock of the CFC) that are "specified group members" of a "specified group."
The 2021 Final Regulations (consistent with the 2020 Proposed Regulations) provide that a specified group includes one or more chains of applicable CFCs with a specified group parent connected through 80 percent stock ownership by value under section 1504(a)(2)(B) in at least one applicable CFC, and stock meeting the requirements of section 1504(a)(2)(B) in each of the applicable CFCs. Indirect ownership through a partnership or through a foreign estate or trust are taken into account for this purpose. C corporations, S corporations, qualified U.S. individuals and certain CFCs, but not domestic partnerships, can be treated as specified group parents.
The 2021 Final Regulations clarify that a "specified group" may exist when a qualified U.S. person directly owns all of its applicable CFCs rather than owning one or more chains of applicable CFCs. Further, there must be at least two applicable CFCs in a specified group in order for any applicable CFC to be a specified group member and for a CFC group election to be available. The government rejected requests to lower the specified group ownership threshold and to have special rules for CFCs with high-tax income.
CFC Group Election
The 2021 Final Regulations (consistent with the 2020 Proposed Regulations) provide that once a CFC group election is made, it cannot be revoked for 60 months following the end of the first period for which it is made. Similarly, once a CFC group election is revoked, a new group election cannot be made for 60 months following the end of the first period for which it is revoked. The government decided that it is not necessary to impose a 60-month waiting period on specified groups that have not made or revoked a CFC group election. According to the Preamble, the Treasury Department and the IRS continue to study whether an exemption to the 60-month rules is appropriate in the case of an ownership change.
Computation of Section 163(j) Limitation for a CFC Group
CFC group members are required to compute their BIE, disallowed BIE carryforwards, BII and ATI separately. The CFC group then combines the separate company amounts to determine the section 163(j) limitation for the CFC group. While a taxpayer generally cannot have negative ATI, the 2021 Final Regulations clarify that the negative ATI of CFC group members should be taken into account in determining the ATI of the overall CFC group.
Intragroup transactions generally are taken into account in calculating a CFC group's section 163(j) limitation. However, the 2021 Final Regulations (consistent with the 2020 Proposed Regulations) disregard certain intragroup transactions between CFC group members if a principal purpose of the transaction was to affect the section 163(j) limitation by increasing or decreasing the CFC group or a CFC group member's ATI. The 2021 Final Regulations expand the scope of the anti-abuse rule beyond that of the 2020 Proposed Regulations by applying to intragroup transactions entered into with the principal purpose of increasing BII. According to the Preamble, this rule is intended to prevent taxpayers from artificially increasing the total amount of BII and BIE within a CFC group for a specified period in order to shift disallowed BIE from one CFC group member to another or change the timing of deductions of BIE.
In response to comments and in a change from the 2020 Proposed Regulations, the 2021 Final Regulations provide that no deduction for foreign income taxes that are eligible to be claimed as a foreign tax credit is taken into account for purposes of determining a foreign corporation's ATI.
Limitation on Pre-CFC Group Disallowed BIE Carryforward
The 2021 Final Regulations rejected a comment to remove the rule that disallowed BIE carryforwards of a CFC group member that arose in a taxable year before it joined the CFC group in excess of the cumulative section 163(j) pre-group carryforward limitation. Consolidated return separate return limitation year (SRLY) principles apply with respect to CFCs with disallowed BIE carryforwards that join a CFC group. The government continues to study the application of section 163(j) and section 382 to foreign corporations.
CFC Safe Harbor
The 2020 Proposed Regulations provided a safe harbor, which was a year-by-year election, that would exempt certain CFCs from section 163(j) if the safe harbor requirements are satisfied.
The 2021 Final Regulations expand the scope of this safe harbor election, which may be made with respect to a stand-alone applicable CFC or CFC group if its BIE does not exceed either (i) its BII, or (ii) 30 percent (50 percent for taxable years beginning in 2019 or 2020) of the lesser of its qualified tentative taxable income or the sum of its eligible amounts. "Qualified tentative taxable income" is TTI attributable to non-excepted trades or businesses. "Eligible amounts" are the combined subpart F income and GILTI inclusions, reduced by any deductions under section 245A, a domestic corporation would include in gross income as if the CFC (or CFC group members) were wholly owned by such domestic corporation that had no other assets and no other items of income, gain, deduction or loss. Thus, under the 2021 Final Regulations, if either a standalone applicable CFC or a CFC group has BII that is greater than or equal to its BIE, it is not necessary to determine its qualified tentative taxable income or eligible amount in order to make the safe-harbor election. However, consistent with the 2020 Proposed Regulations, the election may not be made for a CFC group that has pre-group disallowed BIE carryforwards.
CARES Act CFC Rules
The 2021 Final Regulations (consistent with the 2020 Proposed Regulations) provide for special rules implementing the temporary section 163(j) limitation increase to 50 percent of ATI provided under the CARES Act for CFC groups (rather than the CFC group member). The 2021 Final Regulations also provide rules for CFC groups seeking to make the election provided under the CARES Act to use 2019 ATI instead of 2020 ATI for purposes of calculating their 2020 section 163(j) limitation.
RIC Interest Dividends
For certain items, a shareholder in a RIC may treat a dividend received by the RIC in the same manner (or a similar manner) as the shareholder would treat the underlying item of income or gain if the shareholder realized it directly. The 2020 Proposed Regulations extended this "conduit treatment" to "section 163(j) interest dividends," which are limited to the excess of (A) the RIC's BII for the taxable year over (B) the sum of (i) the RIC's BIE for the taxable year and (ii) the RIC's other deductions for the taxable year that are properly allocable to the RIC's BII. Like the 2020 Proposed Regulations, the 2021 Final Regulations provide that a RIC shareholder that receives a section 163(j) interest dividend may treat the dividend as interest income for purposes of section 163(j), subject to holding period requirements and other limitations.
Qualifying Real Property Businesses
Subject to certain conditions, a trade or business can elect not to apply the section 163(j) limitation if it qualifies as a real property trade or business as defined in section 469(c)(7)(C) (a "Real Property Business"). Section 469(c)(7)(C) defines a Real Property Business as "any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental operation, management, leasing, or brokerage trade or business." The Code does not define, however, the meaning of all of these listed terms. The 2021 Final Regulations rejected a comment to revise these definitions and instead adopt the definitions of "real property development" and "real property redevelopment" as provided in the 2020 Proposed Regulations.
Special thanks to Ale x Liebmann for his contribution to this publication.
Footnotes
1. Unless otherwise indicated, all "section" references contained herein are to sections of the Code.
2. See prior coverage.
3. Several media outlets have reported that the Biden administration intends to issue an order halting or delaying any so-called "midnight regulations" (i.e., regulations issued after election day that have not taken effect by January 20, 2021).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
