Tom Peters, the management guru, famously observed, "If you're not confused, you're not paying attention."2 Truer words could not be imagined for taxpayers having to apply the limitation on the deduction for business interest expense imposed by Section 163(j) of the Internal Revenue Code of 1986, as amended by the Tax Cuts and Jobs Act ("TCJA") and the CARES Act (the "Code"). The provision is mind-numbingly complex and raises more issues than it answers. Lucky for us, however, on July 28, 2020, the US Department of the Treasury (the "Treasury") and the US Internal Revenue Service (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 Legal Update provides a selective overview of this new guidance.
At the outset, we note that planning for the application of Code § 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
A tax provision has resided in Code § 163(j) for quite some time. The Tax Cuts and Jobs Act, however, overwrote everything that had been in that Code 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 Act 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.5
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.6 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, Code § 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 Code § 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 ringfenced and is deductible only when that partnership generates sufficient income to enable the partner to deduct the suspended business interest.7 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 Code § 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 Code § 163(j).8 The remaining 50% remains subject to the "silo" rules for partnerships under Code § 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 the consent of the IRS. 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 Code § 59A. By keeping deductible interest expense paid to affiliates low, taxpayers subject to the 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 Code § 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 Code § 163(j) (the "2018 Proposed Regulations").9 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. 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
1 The authors are all tax lawyers with the firm of Mayer Brown LLP. They can be reached as follows: Mark Leeds ((212) 506-2499) firstname.lastname@example.org, Lucas Giardelli ((212) 506-2238) email@example.com, Gary Wilcox ((202) 263-3399) firstname.lastname@example.org, Steven Garden ((312) 701-7830) email@example.com, Jeffrey Bruns ((312) 701-8793) firstname.lastname@example.org, Matthew McDonald ((312) 701-8321) email@example.com, JoonBeom Pae ((212) 506-2194) firstname.lastname@example.org, and Alison Appleby ((312) 701-7696) email@example.com.
2 Peters, Thriving on Chaos: Handbook for a Management Revolution (Harper Perennial 1991).
3 Rev. Proc. 2020-23, 2020-18 IRB 1.
4 Code § 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 Code § 163(j) limits. Treas. Reg. § 1.163(j)-3(b)(5)
5 Code § 163(j)(10)(A)(i). The election is made separately for each tax year.
6 Code § 163(j)(8).
7 Code § 163(j)(4).
8 Code § 163(j)(10)(A)(ii)(I).
9 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.
Originally published 21 August, 2020
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