Tax News Update    Email this document    Print this document  

On November 26, 2018, the Treasury Department (Treasury) and the Internal Revenue Service (IRS) released proposed regulations under Section 163(j), which was amended as part of the Tax Cuts and Jobs Act (TCJA).

New Section 163(j) limits the amount of business interest expense that can be deducted by a taxpayer in a tax year. Under Section 163(j)(1), the amount allowed as a deduction for business interest expense is limited to the sum of (i) the taxpayer's business interest income for the tax year; (ii) 30% of the taxpayer's adjusted taxable income for the tax year; and (iii) the taxpayer's floor plan financing interest expense (Section 163(j) limitation). Section 163(j)(2) provides that the amount of any business interest not allowed as a deduction for any tax year as a result of the Section 163(j) limitation (the disallowed business interest expense) is carried forward and treated as business interest paid or accrued in the following tax year (a disallowed business interest expense carryforward). Because disallowed business interest expense carryforwards are treated as a business interest expense in the following tax year (i.e., treated as paid or accrued in the following year), any such amount that is not allowed as a deduction as a result of the Section 163(j) limitation in the following year is considered a "disallowed business interest expense" in that year.

Following the amendments to Sections 163(j) and 382(d), many taxpayers questioned the utilization of disallowed business interest expense carryforwards and the interaction with Section 382. The proposed regulations, as highlighted next, address many of the questions that taxpayers and their advisors raised in the wake of the TCJA.

Ordering rules for use of disallowed business interest expense carryforwards

The proposed regulations would clarify that, for purposes of the Section 163(j) limitation, business interest expense that is generated in the current year (current-year business interest expense) is deducted in the current tax year before disallowed business interest expense carryforwards. (Prop. Reg. Section 1.163(j)-5(b)(2).) The proposed regulations further provide that disallowed business interest expense carryforwards are deducted in the order of the tax years in which they arose, beginning with the earliest year. Id.

For example, assume Corporation A, which is not a member of a consolidated group, has $100x of disallowed business interest expense carryforwards ($60x from Year 1 and $40x from Year 2) and current-year business interest expense of $100x in Year 3 with a Section 163(j) limitation of $120x. Under these facts, assuming no other limitations apply (e.g., Section 382), all of the $100x of current-year business interest expense is allowed as a deduction in Year 3, as well as $20x of the disallowed business interest expense carryforward from Year 1. Therefore, $80x of the disallowed business interest expense carryforwards is considered disallowed business interest expense in Year 3. Note that Prop. Reg. Section 1.163(j)-5(b)(2) provides similar rules for consolidated groups, which are addressed in Tax Alert 2018-2401.

One reason for this ordering rule was to preserve a taxpayer's Section 382 limitation for other net operating losses (NOLs) or other attributes subject to Section 382. Specifically, if taxpayers were required to deduct disallowed business interest expense carryforwards before or simultaneously with current-year business interest expense, they could end up using some or all of their Section 382 limitation on disallowed business carryforwards rather than other Section 382 limited attributes.

Interaction between Section 163(j) and Section 382

Prop. Reg. Section 1.163(j)-3 provides operating rules for the interaction between the Section 163(j) limitation and other provisions of the Internal Revenue Code (Code). Specifically, with certain exceptions, Section 163(j) applies after the application of other Code provisions that subject interest expense to disallowance, deferral, capitalization, or some other limitation. Therefore, any disallowed business interest expense carryforwards that are subject to Section 382 may be deducted under Section 163(j) to the extent not otherwise disallowed under Section 382. In effect, to the extent there is additional Section 163(j) limitation after using all current-year business interest expense, the disallowed business interest expense carryforwards may be used up to the lower of the Section 163(j) limitation or the Section 382 limitation.

Section 382 generally limits the amount of a loss corporation's taxable income that can be offset by "pre-change losses" following an ownership change. Under Section 382(d)(1), the term "pre-change loss" includes (i) any NOL carryforward of the old loss corporation that is carried to the tax year ending with the ownership change or in which the ownership change occurs (change year), and (ii) the NOL incurred by the old loss corporation in the change year, to the extent allocable to the pre-change period. The TCJA added Section 382(d)(3), which provides that the term "pre-change loss" includes carryovers of disallowed interest described in Section 163(j)(2) under rules similar to the rules in Section 382(d)(1).

The proposed Section 382 regulations provide that a "pre-change loss" includes any "Section 382 disallowed business interest carryforward," which includes (i) the business interest expense carryforwards of the loss corporation as of the ownership change, and (ii) the portion of any disallowed business interest expense of the loss corporation that is paid or accrued in the tax year of the ownership change that is attributable to the pre-change period. Prop. Reg. Section 1.382-2(a)(7). Accordingly, for an ownership change that occurs at the end of the loss corporation's tax year, or that causes the loss corporation to have a short tax year, any disallowed business interest expense carryforward from the pre-change tax year would be subject to Section 382. Moreover, the proposed Section 382 regulations would clarify that, in the event of a mid-year ownership change, the portion of the disallowed business interest expense that is allocable to the pre-change period is subject to Section 382 in the post-change period.

For purposes of determining the portion of any disallowed business interest expense that is attributable to the pre-change period, the proposed Section 382 regulations would require disallowed business interest expense to be ratably allocated to each day in the year. Prop. Reg. Section 1.382-2(a)(7)(ii). For example, assume Corporation A, a calendar-year taxpayer that is not a member of a consolidated group, experiences a mid-year ownership change on May 26, 2019 and has $100x of current-year business interest expense that is subject to a Section 163(j) limitation of $80x. Under these facts, for calendar year 2019, Corporation A may deduct $80x of its current-year business interest expense (note that Section 382 does not limit the use of current-year business interest expense for the 2019 year). Of the $20x of disallowed business interest expense in calendar year 2019, $8x ($20x x (146 days/365 days)) is allocable to the pre-change period and is a pre-change loss subject to Section 382 in post-2019 years. Even if a taxpayer had a closing-of-the-books election in effect for the change year, the taxpayer would be required to ratably allocate its 2019 disallowed business interest expense between the pre- and post-change periods of 2019, for purposes of determining what portion of the disallowed business interest expense carryforward from 2019 is treated as a pre-change loss in succeeding years.

Application of Reg. Section 1.383-1(d) ordering rules to disallowed business interest expense

Reg. Section 1.383-1(d) contains ordering rules for the utilization of pre-change losses and pre-change credits for the absorption of the Section 382 limitation and the Section 383 credit limitation. Under the current regulations, the a loss corporation's Section 382 limitation and the Section 383 credit limitation are absorbed by pre-change losses and pre-change credits in the following order: (i) pre-change capital losses, (ii) recognized built-in losses, (iii) NOLs, (iv) other pre-change losses, and (v) pre-change credits. Prop. Reg. Section 1.383-1(d)(2) provides that disallowed business interest expense carryforwards are absorbed after pre-change capital losses and all recognized built-in losses, but before NOLs. According to the Preamble, Treasury and the IRS's decision to have disallowed business interest expense carryforwards absorbed before NOLs was based on the fact that taxpayers must calculate their current-year income or loss in order to determine whether an NOL can be used in the tax year, and deductions for business interest expense factor into the calculation of current-year income or loss.

In addition, Prop. Reg. Section 1.383-1(d)(1)(ii) provides that a loss corporation's taxable income is offset first by losses subject to the Section 382 limitation, provided the Section 382 limitation has not been fully absorbed, before being offset by losses of the same type from the same tax year. Therefore, if the loss corporation has a disallowed business interest expense carryforward from a particular year, some of which constitutes a pre-change loss under Section 382 (e.g., the portion ratably allocated to the pre-change period as a result of a mid-year ownership change), the loss corporation's income for the year will be offset by the portion of the carryforward that is a pre-change loss before the portion of the disallowed business interest expense carryforward from the same year that is not subject to Section 382.

Implications

The proposed regulations provide guidance on many of the major issues regarding the interaction between Sections 163(j) and 382. Nevertheless, given the significant complexity of the proposed regulations, taxpayers will need to carefully consider how Section 163(j) and Section 382 affect their ability to utilize their disallowed business interest expense carryforwards.

———————————————