Confusion Cubed: New Regulations Address Deductions Of Business Interest Expense - Income Tax

Tom Peters, the management guru, famously observed, ''If you're not confused, you're not paying attention.''¹ Truer words could not be imagined for taxpayers having to apply the limitation on the deduction for business interest expense imposed by §163(j).² The provision is mind-numbingly complex and raises more issues than it answers. Lucky for us, however, on July 28, 2020, the Department of the Treasury (the ''Treasury'') and the IRS sought to answer some of those questions by replacing prior proposed regulations with 575 pages of explanation and final regulations (the ''Final Regulations'') and 285 pages of new proposed regulations (the ''2020 Proposed Regulations''). This article provides a selective overview of this new guidance.

At the outset, we note that planning for the application of §163(j) is very important because if a taxpayer has unused capacity to deduct business interest in a particular year, it cannot carry over such unused capacity to another tax year. Conversely, however, any business interest that is not currently deductible carries forward and is deemed to arise in subsequent years until it can be deducted. Thus, taxpayers are keenly incentivized not to generate more business interest income (BII) and adjusted taxable income (ATI) than business interest expense (BIE) in a year if they expect the situation to reverse in subsequent years. In addition, partnerships desiring to take advantage of the new regulations without having to seek IRS permission must act by September 30, 2020.³

BACKGROUND

A tax provision has resided in §163(j) for quite some time. The Tax Cut and Jobs Act, however, overwrote everything that had been in that I.R.C. section for tax years beginning after December 31, 2017. Under the revised provision before the CARES Act amendments, a taxpayer is limited in the amount of ''business interest'' that it can deduct to the sum of the taxpayer's BII plus 30% of its ATI.⁴ Section 2306 of the CARES Act⁵ amended and loosened these rules for a limited period of time. For tax years beginning in 2019 and 2020, taxpayers may elect to deduct business interest to the extent it does not exceed the sum of BII and 50% of the taxpayer's ATI.⁶

The ATI definition is key here. ATI does not include items of non-business income and expense and is not reduced by net operating loss (NOL) deductions. As originally written, ATI for years prior to 2022 was equal to taxable income after adding back deductions for depreciation, amortization, and depletion.⁷ This limited time add-back provides a robust ATI base against which interest can be deducted. The Final Regulations make a significant change to the ATI definition (from the definition in the prior proposed regulations) by allowing taxpayers to add back depreciation and similar expenses that have been capitalized into inventory. After these add-backs expire, however, §163(j) will severely limit interest deductions for many taxpayers.

The rules for taxpayers invested in partnerships are unique. A taxpayer does not simply aggregate her share of partnership income and expense and apply the §163(j) limit at the partner level. Instead, if a partnership generates BIE in excess of its BII and ATI limit, such excess interest is ring-fenced and is deductible only when that partnership generates sufficient income to enable the partner to deduct the suspended business interest.⁸ Conversely, however, if the partnership generates BII and ATI that is not utilized to deduct business interest at the partnership level, the partner may add those items to its limitation in determining its business interest deduction.

The CARES Act also amended how §163(j) applies to partnerships. The amendments allow partnerships to elect to partially suspend the ''silo'' treatment for 2019. Under the temporary rule, the partnership first nets its 2019 BIE against BII and 30% of the partnership's ATI. Then, for 2020 only, 50% of any excess business interest expense (EBIE) is treated as paid or accrued by the partner, and that amount may be deducted without being subject to limitation under §163(j).⁹ The remaining 50% remains subject to the ''silo'' rules for partnerships under §163(j). These revised rules are elective.

A taxpayer may elect to not apply this increased limitation, but once such an election is made it can only be revoked with IRS consent. This election is made by the partnership, not the partner. The ability granted by the CARES Act to stay within the current regime will be very helpful for taxpayers grappling with strategies to minimize their base erosion and anti-avoidance tax (BEAT) liability imposed by §59A. By keeping deductible interest expense paid to affiliates low, taxpayers subject to BEAT can avoid making base erosion payments and/or avoid having to waive the deduction to minimize their BEAT liability.

This CARES Act section also affords taxpayers the ability to elect to use their 2019 ATI for purposes of computing their 2020 taxable year interest expense limitation. The policy behind this election is that the Covid-19 pandemic is likely to cause taxpayers to derive less income in tax year 2020 than 2019. Accordingly, by permitting the use of 2019 ATI, taxpayers will have a greater §163(j) threshold, thereby increasing the amount of deductible interest. Again, the ability to elect not to use 2019 ATI may assist with BEAT planning and, because its use is elective, not disadvantage taxpayers with higher 2020 ATI than 2019 ATI.

In November 2018, the IRS issued proposed regulations to implement the rules contained in §163(j) (the ''2018 Proposed Regulations'').¹⁰ These regulations are replaced by the Final Regulations. The Final Regulations will apply to tax years beginning on or after 60 days after they are published in the Federal Register.¹¹ Taxpayers may elect to apply the Final Regulations to all tax years beginning after December 31, 2017, or instead elect to apply the 2018 Proposed Regulations to tax years before the Final Regulations apply.

THE DEFINITION OF BUSINESS INTEREST INCOME AND EXPENSE

One of the most controversial aspects of the 2018 Proposed Regulations was the attempt by the IRS to sweep a substantial amount of deductions other than deductions for interest under the §163(j) limit. Although the IRS vigorously defended its right to issue regulations that subject non-interest deductions to the §163(j) limit, the Final Regulations reverse the most over-reaching positions taken in the 2018 Proposed Regulations. The 2018 Proposed Regulations created four categories of deductions that were proposed to be limited by the application of §163(j), and these categories remain, as revised, under the Final Regulations:

Any amount treated as interest under another provision of the I.R.C. (this rule was adopted without change in the Final Regulations);¹²
Embedded interest in over-the-counter (OTC) notional principal contract (swap) payments;
. Amounts that the IRS deems to be for the time value of money but are not otherwise treated as interest for tax purposes (including substitute interest payments in securities lending transactions); and
Amounts treated as interest under an antiabuse rule.

Swaps: The IRS retained the rule that treats OTC (but not exchange-cleared) swaps with significant payments as creating interest (income for the recipient and deduction for the payer), but made some technical corrections to clarify the rule.¹³ First, the interest component is ignored for swaps with significant payments if a federal regulator requires that the swap be collateralized. Second, unless the swap is entered into with a principal purpose of avoiding the application of §163(j), the rule that treats embedded interest in prepaid swaps is delayed for one year to allow financial institutions to develop systems to track the interest component

Footnotes

1 Peters, Thriving on Chaos: Handbook for a Management Revolution (Harper Perennial 1991).

2 All section references herein are to the Internal Revenue Code of 1986, as amended (the ''Code''), or the Treasury regulations promulgated thereunder, unless otherwise indicated.

3 Rev. Proc. 2020-23.

4 §163(j)(1). The provision also increases the taxpayer's ability to deduct business interest expense by the amount of its floor plan financing interest. This latter limitation will be ignored in text. Interest that must be capitalized is not subject to §163(j) limits. Reg. §1.163(j)-3(b)(5).

5 Pub. L. No. 116-136.

6 §163(j)(10)(A)(i). The election is made separately for each tax year.

7 §163(j)(8).

8 §163(j)(4).

9 §163(j)(10)(A)(ii)(I).

10 REG-106089-18. Please see https://www.mayerbrown.com/ en/perspectives-events/publications/2018/11/overview-of-the-newproposed-regulations-on-intere for Mayer Brown's coverage of the 2018 Proposed Regulations.

11 As of the date of publication, the Final Regulations have not been published in the Federal Register despite being publicly released on July 28, 2020.

12 Reg. §1.163(j)-1(b)(22)(i)(A)-§1.163(j)-1(b)(22)(i)(P).

13 Reg. §1.163(j)-1(b)(22)(ii).

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Originally published by Bloomberg Tax, 27 August 2020

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