U.S. Treasury issues important guidance on the limitation on deductibility of business interest.
On July 28, 2020, the U.S. Treasury Department released final and proposed regulations under section 163(j) of the Internal Revenue Code, which generally limits deductibility of net business interest expense to 30% of adjusted taxable income ("ATI"). The final regulations will be effective for taxable years beginning on or after the date 60 days after their date of publication in the Federal Register (with publication scheduled for September 14, 2020), and the new proposed regulations will be effective for taxable years beginning on or after the date 60 days after the date they are published as final regulations in the Federal Register. However, both may be applied retroactively to taxable years beginning after 2017 if applied consistently. The final regulations adopt, with modifications, prior proposed regulations issued in November 2018. The new proposed regulations provide separate guidance, including guidance relating to changes to section 163(j) made by the Coronavirus Aid, Relief, and Economic Security Act ("CARES Act").
Notable Aspects of the Final and Proposed Regulations
50% Limitation for 2019 and 2020. The new proposed regulations (consistent with the CARES Act) increase the limitation for taxable years beginning in 2019 or 2020 to 50% of ATI, and allow taxpayers to use 2019 ATI to calculate their 2020 limitation. Significantly, as increased deductibility of interest could generate a net operating loss ("NOL"), the CARES Act permits a five-year carryback of NOLs from taxable years beginning after 2017 and before 2021.
Refined Definition of "Interest." While the final regulations still define "interest" expansively, subject to an anti-avoidance rule, they now exclude commitment fees, debt issuance costs, partnership guaranteed payments, and hedging gains or losses.
New ATI Calculation. To determine ATI, taxpayers compute their taxable income and then add/subtract specified adjustments, including, for taxable years beginning before 2022, adding back depreciation and amortization. Unlike in the prior proposed regulations, the final regulations provide that any depreciation, amortization, or depletion capitalized to inventory and included in cost of goods sold may be added back in the year capitalized—welcome news for inventory-rich taxpayers.
Excepted Businesses. Business interest includes only interest allocable to a trade or business, and certain businesses are excepted from section 163(j) (e.g., taxpayers with average annual gross receipts of $25 million or less, regulated utilities, electing real property businesses). Real estate businesses that may not rise to the level of a trade or business (e.g., rental operations) or may qualify for the small business exception from section 163(j) can now make a protective election to be treated as an electing real property business.
Foreign Corporations. As in prior proposed regulations, section 163(j) generally determines the deductibility of a controlled foreign corporation's ("CFC") interest expense in the same manner as a U.S. corporation with certain complex modifications—typically, on a CFC-by-CFC basis. The new proposed regulations permit CFC group members with overlapping ownership to calculate a single limitation under consolidated group principles.
Partnerships. The limitation is computed at the partnership level, and disallowed interest is carried forward by the partners. While the prior proposed regulations were silent on tiered partnerships, the new proposed regulations provide that if a lower-tier partnership allocates disallowed interest to an upper-tier partnership, the disallowed interest is carried forward by the upper-tier partnership (not that partnership's partners), and only the upper-tier partnership (not that partnership's partners) reduces its basis in its partnership interest for the allocated interest.
Consolidated Groups. As in the prior proposed regulations, consolidated groups calculate a single limitation.