Long-Awaited Final and New Proposed Regulations Issued Under Section 163(j)

On July 28, 2020, the Internal Revenue Service and the U.S. Department of the Treasury issued final regulations (the “Final Regulations”) under section 163(j) of the Internal Revenue Code (the “Code”).^[1] These regulations finalize many of the provisions of the proposed regulations (REG-106089-18) under section 163(j) issued on November 26, 2018 (the “Proposed Regulations”). As enacted under P.L. 115-97, the Tax Cuts and Jobs Act (TCJA), on December 22, 2017, and as amended by the Coronavirus Aid, Relief, and Economic Security Act (P.L. 116-136) (the “CARES Act”), section 163(j) generally limits the deductibility of net business interest expense to 30% (or for certain years as provided under the CARES Act, 50%) of “adjusted taxable income” for taxable years beginning after December 31, 2017. Concurrently, the government has issued new proposed regulations (REG-107911-18) (the “New Proposed Regulations”) under section 163(j) that would provide a number of important additional changes and clarifications to the Final Regulations.

The Final Regulations will be effective 60 days after the date they are published in the Federal Register (the “Final Regulations Effective Date”), and except as otherwise described below, are generally applicable to taxable years beginning on or after the Final Regulations Effective Date. However, taxpayers may apply the Final Regulations retroactively to taxable years beginning after December 31, 2017, so long as the Final Regulations are applied consistently by a taxpayer and its related parties. Alternatively, taxpayers may instead rely on the Proposed Regulations for taxable years beginning after December 31, 2017 and before the Final Regulations Effective Date, so long as the Proposed Regulations are applied consistently by a taxpayer and its related parties.

The New Proposed Regulations are proposed to apply to taxable years beginning at least 60 days after the date that the Treasury decision adopting the rules as final are published in the Federal Register (the “New Proposed Regulations Effective Date”). However, taxpayers generally may apply certain aspects of the New Proposed Regulations retroactively to taxable years beginning after December 31, 2017, so long as such aspects of the New Proposed Regulations are applied consistently by a taxpayer and its related parties.

This publication provides a high-level summary of the most important aspects of the Final Regulations and the New Proposed Regulations, and where relevant, how such provisions differ from the Proposed Regulations. For more information, please contact any of the Shearman tax lawyers listed on this publication.

General Limitation Under Section 163(j)

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% of adjusted taxable income (ATI) (or for certain years as provided under the CARES Act, 50% 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.

Under a small business exemption, a taxpayer with average annual gross receipts of $25 million or less (subject to inflation) for the three taxable years immediately preceding the current year generally is not subject to the section 163(j) limitation. Regulated utilities generally are not subject to the section 163(j) limitation, and certain real property businesses may elect not to apply the section 163(j) limitation subject to certain conditions.

The Proposed Regulations outlined the general calculation of a taxpayer’s BIE deduction limitation, the method for carrying forward disallowed interest expense, and the application of the small business exemption and the aggregation rules that apply with respect to such exemption. The Final Regulations largely conform to the Proposed Regulations with a few significant differences and clarifications outlined below.

Final Regulation Highlights

• The preamble to the Final Regulations (the “Preamble”) clarifies that the section 163(j) limitation does not constitute a method of accounting for section 446 purposes, because the limitation under section 163(j) can result in a permanent disallowance of a deduction, rather than only a deferral of such deduction.
• The Final Regulations provide rules for the CARES Act provisions that expand the section 163(j) limitation to 50% of ATI for taxable years beginning in 2019 and 2020. Taxpayers are automatically subject to the 50% limitation, unless they elect out of it. The CARES Act also permits a taxpayer to elect to use its 2019 ATI (in lieu of its 2020 ATI) for its 2020 section 163(j) calculations.
• For taxpayers that are not corporations or partnerships, the small business exemption test under section 163(j)(3) is applied as though the taxpayer were a partnership or a corporation. The Final Regulations clarify that the gross receipts test under section 448(c) is applied as though the taxpayer were a partnership or a corporation, but the aggregation rules under section 448(c) are applied in accordance with the taxpayer’s actual entity status.

Definition of Interest

The statutory language of section 163(j) provides that the term “business interest,” means “interest paid or accrued on indebtedness properly allocable to a trade or business.” However, the Proposed Regulations expanded this definition, including by excluding the words “on indebtedness” from the definitions of BIE and BII. According to the preamble to the Proposed Regulations, the purpose of such an expansive definition of interest was to address “transactions that are indebtedness in substance even if not in form.” The Proposed Regulations set forth three broad categories of items that are treated as interest under section 163(j): (i) compensation for the use or forbearance of money, (ii) the time value component of swaps with significant nonperiodic payments, and (iii) amounts closely related to interest. The Proposed Regulations also included an anti-avoidance rule.

The first category for amounts paid, received or accrued as compensation for the use or forbearance of money included: qualified stated interest; original issue discount (OID); amounts treated as OID (including de minimis OID) under various statutory or regulatory rules; acquisition discount to the extent includible in income by a holder; repurchase premium to the extent deductible by the issuer; deferred payments treated as interest under section 483; amounts treated as interest under a section 467 rental agreement; amounts treated as interest under section 988; forgone interest under section 7872; redeemable ground rent treated as interest under section 163(c); and amounts treated as interest under section 636.

The second category of “interest” treated the time value component of a swap (other than a cleared swap) with significant nonperiodic payments as interest. Such swaps were treated as two separate transactions consisting of an on-market, level-payment swap and a loan that must be accounted for by the parties independently of the swap.

Under the third category of “interest,” the Proposed Regulations treated as interest certain amounts that are closely related to interest and that affect the economic yield or cost of funds of a transaction involving interest, but may not be compensation for the use or forbearance of money on a stand-alone basis or otherwise treated as interest under general principles. This category included (i) income, deduction, gain or loss from transactions used to hedge interest-bearing assets or liabilities; (ii) substitute interest payments; (iii) any gain treated as ordinary income under section 1258; (iv) yield adjustments with respect to a derivative as defined in section 59A(h)(4)(A); (v) commitment fees; (vi) debt issuance costs; (vii) guaranteed payments for the use of capital; and (viii) factoring income. The Proposed Regulations treated these items as both interest income and interest expense for purposes of section 163(j).

Finally, the Proposed Regulations contained an anti-avoidance rule with respect to the definition of interest (the “Anti-Avoidance Rule”), which generally treated as interest expense for purposes of section 163(j), any amounts that are predominantly associated with the time value of money in a transaction or series of transactions in which the taxpayer secures the use of funds for a period of time (and which is not included in one of the three categories described above). As the Anti-Avoidance Rule only would recharacterize an amount as interest expense, and would not recharacterize an amount as interest income, it would only apply to worsen a taxpayer’s limitation under section 163(j). Further, the Anti-Avoidance Rule under the Proposed Regulations could apply to treat an item as interest expense, even if the taxpayer’s motivation for entering into the relevant transaction did not involve tax avoidance.

Final Regulation Highlights

• In changes that will be welcomed by many taxpayers, the Final Regulations remove a number of the more problematic items from the overbroad definition of interest in the Proposed Regulations. The result is a definition of interest that is more consistent with other parts of the Code and general tax principles and generally will be easier to implement for taxpayers.
• While the Final Regulations retain the embedded loan rule for swaps with significant nonperiodic payments, the Final Regulations add exceptions for cleared swaps and for non-cleared swaps that require the parties to meet the margin or collateral requirements of a federal regulator or provide for margin or collateral requirements that are substantially similar to those of a federal regulator. In addition, the Final Regulations delay by one year the applicability date of the embedded loan rule for purposes of section 163(j) (except for purposes of the Anti-Avoidance Rule) to allow taxpayers additional time to develop systems to track the amount of embedded interest accrued with respect to a swap. The Final Regulations make corresponding changes to Treasury regulations section 1.446-3 such that the time value component of non-excepted swaps with significant periodic payments generally is treated as interest for all tax purposes, and not solely for purposes of section 163(j).
• The Final Regulations provide that a substitute interest payment is treated as interest expense or interest income only if the payment relates to a sale-repurchase or securities lending transaction that is not entered into by the taxpayer in the ordinary course of its business.
• Commitment fees and other fees paid in connection with lending transactions are removed from the definition of interest under the Final Regulations and will be addressed in future guidance.
• The Final Regulations also exclude debt issuance costs, guaranteed payments for the use of capital, and hedging income and expense from the definition of interest.
• However, the Final Regulations retain with important changes the Anti-Avoidance Rule, which generally will require any expense or loss to be treated as interest expense for section 163(j) purposes if (1) the expense or loss is economically equivalent to interest and (2) if a principal purpose of structuring the transaction is to reduce the taxpayer’s interest expense. The Final Regulations provide five examples to illustrate the Anti-Avoidance Rule and to provide insight into how broadly the government intends the Anti-Avoidance Rule to apply.
  • Expense or loss will be economically equivalent to interest to the extent that the expense or loss is (i) deductible by the taxpayer; (ii) incurred in a transaction or series of integrated or related transactions in which the taxpayer secures the use of funds for a period of time; (iii) substantially incurred in consideration of the time value of money; and (iv) not otherwise defined as interest under the Final Regulations.
  • Whether a transaction is entered into with a principal purpose of reducing interest expense will depend on all the facts and circumstances related to the transaction(s), except for the fact that the taxpayer has a business purpose for obtaining the use of funds and the fact that the taxpayer has obtained funds at a lower pre-tax cost based on the structure. The Final Regulations provide that “a purpose may be a principal purpose even though it is outweighed by other purposes (taken together or separately).”
  • The Anti-Avoidance Rule provides for some limited symmetry because if a recipient of an income or gain item “knows” that an expense or loss of the payor with respect to the item is treated by the payor as interest expense under the Anti-Avoidance Rule, the recipient may treat its income or gain as interest income if (1) the recipient provides the use of funds for a period of time in the transaction(s) subject to the Anti-Avoidance Rule; and (2) such income or gain is substantially earned in consideration of the time value of money provided by the taxpayer.
  • The Anti-Avoidance Rule also prevents taxpayers from artificially increasing their interest income. That is, any income realized by a taxpayer in a transaction (or series of integrated or related transactions) will not be treated as interest income of the taxpayer if and to the extent that a principal purpose for structuring the transaction is to artificially increase the taxpayer’s interest income.
  • The Final Regulations clarify that the Anti-Avoidance Rule with respect to the definition of interest, rather than the general anti-avoidance rule of Treasury regulation section 1.163(j)-2(j), applies to determine whether an item is treated as interest expense or income.

New Proposed Regulation Highlights

• Under the New Proposed Regulations, a RIC that earns BII may pay dividends that certain shareholders may treat as interest income to the extent of the interest income of the RIC.

Definition of Adjusted Taxable Income

The Proposed Regulations provided that the starting point of ATI is to compute taxable income, in accordance with section 63 of the Code, by treating all BIE as deductible without regard to the section 163(j) limitation. Then, the Proposed Regulations provided for ATI to be calculated through adjustments to taxable income specifically required by the statutory language of section 163(j)(8)(A) (e.g., adjustments for any item of income, gain, deduction or loss which is not properly allocable to a trade or business, BIE and BII, net operating loss deductions under section 172, depreciation, amortization and depletion deductions in taxable years beginning before January 1, 2022, etc.), as well as additional adjustments relating to sales or dispositions of property with an adjusted basis that reflects depreciation, amortization or depletion deducted in taxable years beginning between January 1, 2018 and December 31, 2021. These additional adjustments under the Proposed Regulations were intended to prevent taxpayers from increasing their ATI both by the amount of depreciation, amortization or depletion deductions in those years and by the amount of gain recognized as a result of a reduced basis in property that is sold. The government thereby prevented taxpayers from obtaining a double benefit from the depreciation, amortization or depletion in computing its 163(j) limitation. However, under the Proposed Regulations, the ATI adjustments did not include depreciation, amortization or depletion that are capitalized into inventory property under section 263A and included in costs of goods sold rather than deducted, and therefore such depreciation, amortization or depletion would not be added back to determine ATI. The Proposed Regulations did not allow for any other adjustment to ATI that is not specifically listed in the regulations.

Final Regulation Highlights

• To avoid confusion with section 63 taxable income, the Final Regulations use the term “tentative taxable income” (TTI) to refer 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 government reconsidered its position that ATI adjustments should not include depreciation, amortization or depletion deductions that are capitalized into inventory property under section 263A, in part because the provision did not reflect Congressional intent, which was to determine ATI using earnings before interest, tax, depreciation, and amortization (EBITDA) through taxable year 2021 and using earnings before interest and tax (EBIT) thereafter. Accordingly, the Final Regulations provide that the amount of any depreciation, amortization or depletion that is capitalized into inventory under section 263A during taxable years beginning before January 2022 is added back to TTI 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.
• A taxpayer generally must reduce its adjusted basis in an asset when the taxpayer takes depreciation deductions with respect to such asset. Thus, upon selling the asset, the taxpayer will recognize more gain or less loss. Other than with respect to timing benefits, the depreciation deductions generally have no net effect. Congress allowed depreciation deductions to be added back to taxable income during the EBITDA period as an acceleration of the excess gain that would be recognized upon sale. However, if a taxpayer sells the asset on which it took depreciation deductions after it added the amount of those deductions to ATI, the taxpayer’s ATI would be increased again. In the consolidated return context, ATI would also be increased twice where a member sold the stock of another member that holds depreciable property after making negative adjustments to its basis in its stock of the other member. The Proposed Regulations addressed these situations by ensuring that the positive adjustment to ATI for depreciation deductions merely defers depreciation deductions and does not permanently exclude them. The Final Regulations adopt these provisions and further provide that upon disposition of property that has a basis affected by amortization, depreciation or depletion during the EBITDA period, ATI must be reduced by the full amount of the basis adjustments in the property with respect to such amortization, depreciation or depletion, whether or not the taxpayer recognized gain on the disposition of the property.
• The Final Regulations require ATI to be decreased by the amount of a taxpayer’s subpart F and GILTI income inclusions (net of any section 250(a) deduction) that are properly allocable to a non-excepted trade or business. A taxpayer’s ability to include such income in ATI under the New Proposed Regulations is discussed in “Application of Section 163(j) to Controlled Foreign Corporations and US Shareholders” below.

Ordering Rules

The Proposed Regulations provided that section 163(j) is generally applied after other provisions of the Code that defer, capitalize, disallow or otherwise limit the deductibility of interest expense. Therefore, the section 163(j) limitation generally applies to interest expense that otherwise could be deducted but for the section 163(j) limitation. Interest expense that has been deferred, capitalized, disallowed or otherwise limited in the current taxable year, or that has not yet been accrued, is not taken into account for purposes of section 163(j) (except with respect to interest deferred under another provision, which is taken into account for purposes of section 163(j), once the deferral provision no longer applies). The Final Regulations substantially adopt this approach, with certain exceptions noted below.

Specifically, like the Proposed Regulations, the Final Regulations provide that for purposes of section 163(j): (i) BIE does not include interest expense permanently disallowed as a deduction, such as in section 163(e)(5)(A)(i), (f), (l) or (m), section 264(a), section 265, section 267A, or section 279; (ii) Code provisions that defer the deductibility of interest expense, such as section 163(e)(3) and section 267(a)(2) and (3), section 1277, or section 1282, apply before section 163(j); (iii) the capitalization of interest under sections 263A and 263(g) applies before section 163(j); and (iv) section 246A applies before section 163(j).

The Final Regulations also follow the Proposed Regulations in providing that section 163(j) is applied before the excess business loss rules in section 461(l) and the at-risk rules and passive activity loss rules in sections 465 and 469, respectively.

Final Regulation Highlights

• The Proposed Regulations referred specifically to sections 263A and 263(g) as applying before the application of section 163(j), without specifically mentioning any other provisions of the Code or Treasury regulations that could result in the capitalization of interest expense. The Final Regulations have expanded this provision so that the capitalization of interest under any provision (including, but not limited to, sections 263A and 263(g)) applies before the application of section 163(j).
• The Final Regulations reserve on the interaction between the rules governing discharge of indebtedness income (section 108) and 163(j) (and specifically and to what extent such income should be treated as BII), stating in the Preamble that this requires further consideration and may be subject to further guidance.

Application to C Corporations Generally

The Proposed Regulations provided that all interest expense and interest income of a C corporation (including, in certain cases and subject to adjustment, members of a consolidated group, real estate investment trusts (REITs) and regulated investment companies (RICs)) would be treated as BIE and BII, as the case may be, for purposes of section 163(j), except to the extent that such amounts are allocable to an excepted trade or business. Furthermore, although a C corporation cannot have investment interest, investment expense or investment income, within the meaning of section 163(d), the Proposed Regulations provided that a C corporation’s allocable share of investment interest expense or investment interest income of a partnership would be recharacterized as BIE or BII of the C corporation partner (except to the extent the C corporation partner was allocated a share of a domestic partnership’s subpart F or GILTI inclusions that are not properly allocable to a trade or business of the domestic partnership). Therefore, under the Proposed Regulations, all of a C corporation’s interest expense was generally subject to the section 163(j) limitation, and generally all of a C corporation’s interest income increased the section 163(j) limitation, except to the extent that a portion of such interest expense or interest income was allocable to an excepted trade or business.

Final Regulation Highlights

• The Final Regulations generally follow the approach set forth in the Proposed Regulations regarding the treatment of interest expense of a C corporation and C corporation partners. However, the Final Regulations do expand on the Proposed Regulations by providing that, in addition to any investment interest, investment income or investment expense (within the meaning of section 163(d)), any separately stated tax items that are allocated to a C corporation partner and that are neither properly attributable to a trade or business of the partnership nor subject to section 163(d) are treated as properly allocable to a trade or business of the C corporation partner. The Preamble provides, as an example of such rule, tax items allocable to rental activities that do not rise to the level of a section 162 trade or business that otherwise give rise to allowable deductions.

Application of Section 163(j) to Consolidated Groups

Under the Proposed Regulations, members of a consolidated group were aggregated for purposes of section 163(j), resulting in the consolidated group having a single section 163(j) limitation. However, partnerships that were wholly owned by members of a consolidated group were not aggregated with the consolidated group for purposes of section 163(j) (meaning that a section 163(j) limitation would apply separately at the partnership level).

The Proposed Regulations provided that the consolidated group’s ATI would generally be determined based on such consolidated group’s consolidated taxable income, as determined under Treasury regulations section 1.1502-11, determined without regard to any carryforwards or disallowances under section 163(j). However, (a) intercompany and corresponding items arising from intercompany transactions were disregarded for purposes of computing the consolidated group’s ATI, to the extent such items offset in amount; and (b) the deduction under section 250(a)(1) was determined (i) as if it were not subject to the taxable income limitation under section 250(a)(2); and (ii) without regard to the application of section 163(j). Furthermore, the Proposed Regulations provided that for purposes of computing a consolidated group’s BII, BIE and ATI, intercompany obligations (indebtedness between members of the same consolidated group) were disregarded (meaning that interest expense and income from intercompany obligations would not be treated as BIE or BII).

Additionally, the Proposed Regulations contained specific rules addressing the utilization of current-year BIE and carryforwards of disallowed BIE. Under these rules, if the aggregate current-year BIE of the consolidated group exceeded the consolidated group’s section 163(j) limitation for such year, then each member of the consolidated group with current-year BIE and current-year BII would generally deduct its own current-year BIE to the extent of its current-year BII. If the consolidated group had any remaining section 163(j) limitation, each member of the group with remaining current-year BIE would deduct an amount equal to its pro rata share of the consolidated group’s remaining section 163(j) limitation (based on its relative remaining BIE). Finally, if the consolidated group had any remaining current-year section 163(j) limitation, disallowed BIE carryforwards would be deducted by the consolidated group in the order of the taxable year in which they arose.

The Proposed Regulations contained specific rules regarding the intercompany transfers of partnership interests. In particular, the Proposed Regulations provided that the transfer of a partnership interest in an intercompany transaction that did not result in the termination of the partnership would be treated as a “disposition” for purposes of the partnership interest basis adjustment rule discussed below (resulting in an increase in the basis of the partnership interest immediately before the transfer), regardless of whether the transfer was taxable or non-taxable. Furthermore, the Proposed Regulations provided that a change in status of a member (becoming or ceasing to be a member) would not be treated as a “disposition” for this purpose.

The Proposed Regulations also provided for separate return limitation year (SRLY) and section 382 limitations for disallowed BIE carryforwards of a consolidated group. The SRLY limitation set forth in the Proposed Regulations would apply only to the extent that there was not “overlap” in the application of section 382 and the SRLY limitation. The section 163(j) SRLY limitation provided that the amount of disallowed BIE carryforwards of a member arising in a SRLY that could be used by the consolidated group could not exceed the lesser of (a) the section 163(j) limitation for that year (determined by reference solely to the member’s items for such year (and not on a cumulative basis)) and (b) the consolidated group’s overall section 163(j) limitation (after reducing such limitation by current-year BIE and disallowed BIE carryforwards arising in prior years).

Final Regulation Highlights

• The Final Regulations clarify that where a member of a consolidated group acquires a debt instrument of another member of the consolidated group at a premium and the debt instrument is deemed satisfied and reissued at a premium under the intercompany obligation rules, the deductible repurchase premium of the debtor member arising as a result of such deemed satisfaction and reissuance is treated as interest expense of the debtor member for purposes of section 163(j). Under the Proposed Regulations, it appears that such repurchase premium would have been deductible by the debtor member without limitation under section 163(j), because the Proposed Regulations generally provided that intercompany obligations were disregarded for purposes of computing a member’s BIE. Because the Final Regulations only address the treatment of the debtor-member’s repurchase premium, it is unclear whether cancellation of debt income arising from a deemed satisfaction and reissuance (if the debt was repurchased at a discount) would be included in the debtor-member’s ATI or if it would be disregarded.
• The Final Regulations reserve as to whether a taxable or non-taxable transfer of a partnership interest between members of a consolidated group that does not result in a termination of the partnership will be treated as a “disposition” for purposes of the partnership interest disposition rule. The Proposed Regulations provided that a transfer of a partnership interest between members of the same consolidated group would result in a “disposition” of the partnership interest.
• The Final Regulations provide that, for purposes of applying the unified loss rule set forth in Treasury regulations section 1.1502-36, excess BIE (EBIE) will be treated as an attribute that is taken into account in the calculation of the “net inside attribute amount” for purposes of both Treasury regulations sections 1.1502-36(c) and 1.1502-36(d). Furthermore, the Final Regulations provide that EBIE will be treated as a “Category D” attribute. This expands on the Proposed Regulations, which treated disallowed BIE carryforwards, but not EBIE from a partnership, as deferred deductions that are included in the calculation of the “net inside attribute amount.”