April 6, 2018 Forthcoming proposed regulations will offer some clarity on Section 163(j) business interest expense limitation In Notice 2018-28 (the Notice), issued April 2, 2018, the Internal Revenue Service (the IRS) and Department of the Treasury (the Treasury Department) announced their intent to issue proposed regulations under Section 163(j), as amended by the Tax Cuts and Jobs Act (TCJA). The Notice describes several issues that the proposed regulations will address. Background Section 163(j) limits the deduction for business interest expense for tax years beginning after December 31, 2017. Specifically, for any taxpayer subject to the provisions, Section 163(j)(1) limits the amount of business interest expense that may be deducted in a tax year to the sum of (1) the taxpayer's business interest income, as defined in Section 163(j)(6), (2) 30% of the taxpayer's adjusted taxable income (ATI, as defined in Section 163(j)(8)), and (3) the taxpayer's floor plan financing interest, as defined in Section 163(j)(9). For purposes of Section 163(j), business interest expense is interest that is paid or accrued on indebtedness that is properly allocable to a trade or business. An exception to Section 163(j) is provided for certain trades or business (e.g., an electing real property trade or business). Interim guidance As described below, the Notice describes several issues regarding the application of Section 163(j) that are expected to be clarified in forthcoming proposed regulations. Importantly, the Notice clarifies that prior to the issuance of such proposed regulations, taxpayers may rely on the rules described in sections 3 through 7 of the Notice. Treatment of tax attributes generated under prior Section 163(j)(1)(A) Proposed regulations are expected to address the treatment of tax attributes that relate to rules under prior Section 163(j)(1)(A) (Prior Law). Namely, interest expense disallowed under Prior Law may be carried forward as business interest to the taxpayer's first tax year beginning after December 31, 2017, and subject to potential disallowance under Section 163(j) in the same manner as any other business interest paid or accrued in a tax year beginning after December 31, 2017. Proposed Regulations will further provide that a business interest carried forward under Prior Law, will be subject to Section 59A (which treats interest paid to a related foreign person as a base erosion payment) in the same manner as business interest paid or accrued in tax years beginning after December 31, 2017. Such regulations are expected to provide guidance on the interaction of Section 59A and Section 163(j) generally and how Section 59A applies to that interest. Notably, the proposed regulations will clarify that no amount previously treated as an excess limitation carry forward under Prior Law may be carried to tax years beginning after December 31, 2017. Corporate business interest expense and business interest income Proposed regulations are expected to clarify that, solely for purposes of Section 163(j), all interest paid or accrued by a C corporation will qualify as business interest within the meaning of Section 163(j)(5), and all interest on indebtedness held by the C corporation that is includible in gross income will be business interest income within the meaning of Section 163(j)(6). This proposed regulation will not apply to an S corporation. Although no specifics were given, the Notice indicates that proposed regulations will take up whether and to what extent interest expense or interest income of a non-corporate entity (e.g., a partnership) in which a C corporation holds an interest, is properly characterized as business interest (as defined in Section 163(j)(5)) or business income (as defined in Section 163(j)(6)) of the corporate partner(s). Consolidated groups Proposed regulations will address the application of the Section 163(j)(1) limitation to consolidated groups. The regulations are expected to clarify that the limitation in Section 163(j)(1) on the amount allowed as a deduction for business interest applies at the level of the consolidated group. Thus, for example, a consolidated group's taxable income for purposes of calculating its ATI will be its consolidated taxable income. However, the IRS and the Treasury Department do not anticipate including a general rule treating an affiliated group that does not file a consolidated return as a single taxpayer for purposes of Section 163(j). The Notice lists other issues related to the application of the Section 163(j)(1) limitation to consolidated groups that will also be addressed by the proposed regulations. Earnings and profits The IRS and the Treasury Department intend that the proposed regulations will clarify that the disallowance and carryforward of a deduction for a C corporation's business interest expense under Section 163(j) will not affect whether or when such business interest expense reduces earnings and profits of the payor C corporation. Presumably, this means that a corporation's interest expense reduces its earning and profits when paid or accrued, even if such interest expense is disallowed under section 163(j). As appropriate, consideration generally should be given to whether an accounting method has been established for interest expense and, if so, whether such method is proper. Partnerships and S corporations Proposed regulations are expected to include rules governing the calculation of the annual deduction for business interest under Section 163(j)(1) by a partner in a partnership. The rules are expected to provide that a partner generally cannot include their share of the partnership's business interest income for the tax year, except to the extent of their share of the excess of (1) the partnership's business interest income, over (2) the partnership's business interest expense (excluding floor plan financing). The proposed regulations will also provide that a partner cannot include its share of the partnership's floor plan financing interest in determining the partner's annual business interest expense deduction limitation under Section 163(j). These rules are intended to prevent the double counting of business interest income and floor plan financing interest. It is intended that similar rules will apply to any S corporation and its shareholders. Implications The Notice provides some much needed guidance to taxpayers that are subject to Section 163(j). However, the Notice leaves many questions unanswered. For example, while the Notice makes clear that interest expense that was disallowed under prior Section 163(j)(1)(A) will be subject to Section 59A, it is silent as to whether such interest would also be subject to other provisions enacted as part of the TCJA, such as Section 267A, which disallows a deduction for certain interest that is characterized as a disqualified related party amount paid or accrued pursuant to a "hybrid transaction" or by or to a "hybrid entity". Likewise, the Notice does not discuss whether Section 163(j) applies to controlled foreign corporations, which would be relevant for, among other issues, the application of global intangible low-taxed income (GILTI) under new Section 951A. Finally, the Notice does not discuss the manner in which Section 163(j) applies to a partnership with a corporate partner or to a partnership that is in the trade or business of trading stocks, securities, or similar investment assets. ———————————————
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