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This Tax Alert describes the consolidated return aspects of proposed regulations (REG-106089-18) under Section 163(j) (the Proposed Regulations), primarily Prop. Reg. Section 1.163(j)-4 and -5 (2018). In particular, this EY Tax Alert describes (i) the computation of the consolidated group Section 163(j) limitation, (ii) the computation of consolidated business interest expense and business interest income, (iii) the allocation of interest and other items among excepted businesses (ETBs) and non-excepted businesses (NETBs) conducted by members of a consolidated group, (iv) rules for taking into account disallowed interest that is incurred by a partnership and allocated to a member of a consolidated group, (v) ordering rules for absorbing disallowed interest arising in different years, and (vi) the computation of the separate return limitation year (SRLY) limitation on disallowed interest carryforwards originating in SRLYs.

For a general overview of the Proposed Regulations, see Tax Alert 2018-2369; for analysis of the interaction between Section 163(j) and Section 382 under the Proposed Regulations, see Tax Alert 2018-2397.

Consolidated Section 163(j) limitation

Under the Proposed Regulations, a consolidated group has a single Section 163(j) limitation (Limitation). This single Limitation is based upon the consolidated taxable income (CTI) of the group, as adjusted to reflect adjusted taxable income (ATI). Thus, the location of items of income or loss within the group generally would not affect the Limitation, which furthers single-entity principles. This approach avoids the burdens that would otherwise have applied of needing to determine each member's separate ATI, and needing to restructure operations to ensure that the members generating ATI are the same members accruing business interest expense (BIE).

Example 1(a): Consolidated group's Limitation based on CTI

P is the common parent of a consolidated group, and P owns 100% of the stock of S1 and S2, each a member of the P consolidated group. The P group's consolidated ATI is $100, solely attributable to S1's items. S2 accrues $40 of BIE to a bank. Notwithstanding that S2 did not generate any ATI or interest income on a separate-company basis, the P group's consolidated ATI is $100, and thus its consolidated Limitation is $30, all of which is available to S2, because S2 is the only member that paid or accrued BIE. S2 deducts $30 of BIE, and its remaining $10 is a disallowed carryforward to the P group's subsequent consolidated return year.

Affiliated groups that do not file a consolidated return (and other groups of related entities) do not, however, determine ATI on a single-entity basis, except in the context of certain special rules for partnerships and CFCs that effectively tier up excess ATI in certain situations. Thus, these other groups are presumably more likely to consider restructuring operations that align BIE within the entities that generate ATI.

Example 1(b): Affiliated (but not consolidated) group's Limitation based on separate-member basis

This example assumes the same facts as Example 1(a), but the P group does not file a consolidated return. Because S2 has no separate ATI or interest income, it has a zero Limitation, and thus its entire BIE is disallowed and carried forward to its subsequent year. If S1 and S2 were to merge, then the future ATI of the combined entity would be available for the combined entity's future BIE. Assuming S1 and S2 combine in a Section 381 transaction, any Limitation of the combined entity remaining for a year after first being applied to the current BIE incurred in that year would be available to allow deductions for disallowed carryforwards from prior years (with a special limitation applicable to the year of the combination, based on the post-combination portion of the acquiring corporation's Limitation).

The Proposed Regulations did not adopt the "super-affiliation" concept in the now-withdrawn, former proposed regulations (1991-2 C.B. 1040) under former Section 163(j)(6)(C), introduced in 1991.

Extending single-entity principles, the Proposed Regulations provide that a group's consolidated ATI is determined without regard to intercompany items and corresponding items from intercompany transactions to the extent they offset. Thus, even if one group member conducts solely an ETB (e.g., an electing real property business) and another member conducts solely an NETB, transactions between such members would not affect ATI.

Example 2: Consolidated ATI does not take into account offsetting items from intercompany transactions

P is the common parent of a consolidated group, and P owns 100% of the stock of S1 and S2, each a member of the P consolidated group. S1 conducts a real estate business that qualifies as an ETB, generally not subject to Section 163(j). S2 conducts an NETB. S2 makes a $100 deductible payment to S1 for real estate management services, and S1 includes the amount in income. Notwithstanding that the items relating to the ETB conducted by S1 are not included in the P group's consolidated ATI and the items relating to S2's business areincluded in the consolidated ATI, the consolidated ATI is not reduced by S2's $100 deduction. In contrast, if S2 had made a deductible payment to an unrelated party of $100 for comparable services, and S1 received an unrelated $100 payment from a different unrelated party for comparable services, S2's expense would reduce the consolidated ATI by $100, reflecting S2's $100 deduction, and ignoring all of S1's items by reason of S1's business being an ETB (items of income and expense, other than BIE (which is generally allocated by relative asset basis), are generally allocated to the trade or business that generated them).

Consistent with the statutory language of Section 163(j), the Proposed Regulations provide for no carryforward of excess Limitation to subsequent years. Thus, if a consolidated group's Limitation for a year were not fully utilized to absorb BIE of its members, the excess would be eliminated.

Aggregate BIE and business interest income

A consolidated group's BIE and business interest income (BII) are the aggregate of each member's BIE and BII, but disregarding intercompany obligations. Aggregate BIE and BII of the group thus looks only to external borrowing/lending (including borrowing/lending with nonconsolidated affiliates). Because, as discussed previously, the consolidated Limitation would be determined by reference to CTI, ignoring intercompany obligations for purposes of determining BIE and BII generally should not affect the group's ability to utilize its consolidated Limitation. For example, as illustrated in Example 1(a), it is not necessary for a group member that is an external borrower to itself generate ATI. Rather, it can look to the consolidated ATI. Similarly, if an external borrower on-lends the proceeds to an income-producing group member, the fact that this on-lending would be ignored does not prevent the group from using the consolidated Limitation attributable to the income-producing member to absorb the BIE of the external borrower.

Example 3: Aggregate BIE and BII do not take into account items from intercompany obligations

P is the common parent of a consolidated group, and P owns 100% of the stock of S1 and S2, each a member of the P consolidated group. For the year, P pays an unrelated bank $100 of BIE, S1 pays P $80 of interest, and S2 pays S1 $70 of interest. S2 earns $40 of BII from a different unrelated bank. The intercompany interest income of each of P and S1, and the corresponding interest expense of each of S1 and S2, is disregarded in determining the P group's aggregate BIE and BII, because those items are from intercompany obligations. The P group's aggregate BIE is $100, attributable to P's payment to a bank, and the P group's aggregate BII is $40, attributable to S2's receipt from a different bank.

Allocation of interest and other items between ETBs and NETBs conducted by a consolidated group

The Proposed Regulations determine whether trade or business activity is an ETB or an NETB by reference to the activities conducted by all members of a consolidated group, as if these activities were conducted by a single corporation. This furthers the single-entity approach generally taken by the Proposed Regulations.

After a consolidated group determines its aggregate percentage of BIE allocable to all of its ETBs (generally, by relative asset basis), that percentage would apply to each member's BIE. Thus, a member conducting an ETB would not have a higher percentage (and a member conducting an NETB would not have a lower percentage) of its BIE avoid limitation under Section 163(j).

Consistent with single-entity treatment of a consolidated group, the basis in the creditor position of an intercompany obligation would not be considered an asset for purposes of allocating items between the group's ETBs and NETBs, and neither would the basis in member stock owned by another group member. In addition, member stock transferred to a nonmember would be treated as a transfer by the consolidated group of a proportionate amount of the transferred member's underlying assets. Finally, basis would not include any amounts attributable to gain or loss realized on property transferred in an intercompany transaction (whether or not such gain or loss has been taken into account).

Example 4: Members conduct ETBs and NETBs, and engage in intercompany transactions

P is the common parent of a consolidated group, and P owns 100% of the stock of S, a member of the P consolidated group. P conducts an ETB (which includes leasing buildings) and S conducts an NETB. P leases a 30% portion of a building to S for use in S's NETB, and P leases a 70% portion of the building to an unrelated customer as part of its own ETB. A 30% portion of P's basis is attributable to S's NETB, because S uses that portion in its business, notwithstanding that P owns the building. The 70% portion of the building leased to the unrelated customer is attributable to P's ETB. P's lease to S is disregarded for purposes of determining the nature of the business activity.

Intercompany transactions would also be disregarded for purposes of determining whether an asset is used in an ETB or an NETB, and property would be treated as not used in a trade or business for purposes of these allocation rules if the use derived from intercompany transactions.

Disallowed interest incurred by a partnership allocated to a subsidiary of a group

A detailed explanation of the application of Section 163(j) to partnerships is outside the scope of this EY Tax Alert, but Section 163(j) generally applies to partnerships at the partnership level. If the partnership does not have sufficient Limitation, the partner carries forward its allocable share of disallowed partnership BIE until it is allocated excess taxable income (ETI) from the partnership. ETI generally is any excess of the partnership's ATI over the amount of ATI that would have been necessary to fully utilize all of the partnership's BIE for the year. The partner reduces its outside basis in the partnership interest in the year the BIE is disallowed, as opposed to waiting until the BIE is absorbed. Thereafter, if the partner disposes of the partnership interest (even in a nonrecognition transaction) before the BIE is taken into account, the BIE carryforward is eliminated, and immediately before the disposition, the partner increases its outside basis in the partnership interest to reverse the prior reduction.

When a subsidiary of a consolidated group is the partner in the partnership with disallowed BIE, the Reg. Section 1.1502-32 system of investment adjustments to a higher-tier member's basis in the stock of a subsidiary member works differently than the basis adjustments to the subsidiary's basis in the partnership. In particular, there is no downward adjustment in member stock basis when the partnership's BIE is disallowed, despite the subsidiary's reduction to its own partnership interest basis, and there is no upward adjustment in member stock basis immediately before the subsidiary disposes of the partnership interest, despite the subsidiary's increase to its own partnership interest basis. Rather, the member's basis in subsidiary stock does not change by reason of the disallowance and subsequent elimination of BIE; it only is reduced if and when the subsidiary's BIE is absorbed by the group. This creates temporary inside/outside basis disparity with respect to the member's basis in the subsidiary's stock and the subsidiary's basis in its own assets. Taxpayers should be particularly aware of this disparity when they perform calculations that focus on basis in the group (e.g., consolidated built-in gain or loss under Reg. Section 1.1502-91(g), and net inside attributes under Reg. Section 1.1502-36(d)).

Example 5(a): Member's disposition of interest in a partnership with disallowed BIE

P is the common parent of a consolidated group. P owns 100% of the stock of S, a member of the P consolidated group, and S is a partner in PRS. P's basis in S stock is $100, and S's basis in its PRS interest is $100. PRS allocates $20 of disallowed BIE to S under Section 704, and S carries forward this disallowed BIE until it is allocated ETI from PRS. At the time the disallowed BIE is allocated under Section 704, S's basis in PRS is reduced from $100 to $80, but P's basis in S is not reduced, and instead remains at $100. In a subsequent year, S sells its partnership interest to an unrelated party. Immediately before the disposition, S's basis in PRS increases by $20 from $80 to $100, but P's basis in S does not increase, and instead remains at $100. (In each case, the adjustments assume there are no other interim adjustments).

Example 5(b): Intercompany disposition of partnership interest to another member

This example assumes the same facts as Example 5(a), except S's disposes of its interest in PRS to another member of the P consolidated group in an intercompany transaction (other than in a transaction in which the partnership terminates, a transaction on which the Proposed Regulations reserve). The stock basis and partnership interest basis results are the same. The disposition of a partnership interest in an intercompany transaction is a disposition for purposes of the partnership basis adjustment rules described previously. Following the intercompany transaction, the matching and acceleration rules of Reg. Section 1.1502-13(c) and (d) govern the timing and attributes of S's items and the items of the member purchasing the PRS interest from S.

In contrast to an actual disposition of a partnership interest, if a consolidated group member that is a partner leaves the consolidated group while owning its partnership interest, that deconsolidation would not be treated as an indirect disposition of the partnership interest. In such a case, the normal rules governing disallowed BIE incurred by a partnership would continue to apply to the departing member.

Ordering rules for absorbing disallowed interest

A group's consolidated Limitation includes not only its consolidated ATI but also the group's aggregate BII. If the aggregate of each member's BIE exceeds the group's consolidated Limitation for a year, then each member would first deduct interest to the extent of its own BII; if the consolidated Limitation remains, then each member would deduct its allocable share of the group's remaining consolidated Limitation, in proportion to that member's net interest expense (i.e., each member's BIE reduced by its BII) as a share of the group's net interest expense.

Example 6: Allocating a group's consolidated Limitation among members

P is the common parent of a consolidated group, and P owns 100% of the stock of S1 and S2, each a member of the P consolidated group. The P group's consolidated ATI is $100, S1 has BII of $10, so the P group's consolidated Limitation is $40 ([$100 * 30%] + $10). In addition, each of S1 and S2 incurs $30 of BIE, and thus the P group's aggregate of $60. Because the aggregate BIE of $60 exceeds the group's consolidated Limitation of $40, first, S1 deducts $10 of BIE, an amount equal to its own BII. That leaves $20 of remaining BIE for S1 and the entire $30 of BIE for S2, as well as $30 of remaining consolidated Limitation. S1 and S2 deduct their respective remaining BIE to the extent of the remaining consolidated Limitation, in proportion to their respective share of net interest expense, with such proportion equaling 40% for S1 ($20 out of the $50 aggregate) and 60% for S2 ($30 out of the $50 aggregate). Thus, of the remaining $30 Limitation, S1 deducts $12 and carries $8 forward, and S2 deducts $18 and carries $12 forward.

As Example 6 illustrates, the location of BII within a consolidated group can affect the allocation of the group's consolidated Limitation. Effectively, this gives a member earning BII priority to access the consolidated Limitation to the extent it contributed to the group's consolidated Limitation with its BII. This contrasts with the contribution of each member to the group's consolidated ATI, for which no priority allocation of Limitation is given. As discussed earlier, the location of items of income or loss among members of a group is generally not relevant for purposes of the amount of, or allocation of, the group's Limitation. Rather, other than to the extent of a member's BII as discussed previously, a group's consolidated Limitation would be allocated by relative BIE.

If, instead, a group's consolidated Limitation for a year exceeds the aggregate of each member's BIE, then all of the year's BIE can be deducted, and any remaining consolidated Limitation can be used to deduct BIE carryforwards (Carryforwards) from prior years, beginning with earliest year (i.e., a FIFO approach). If there were Carryforwards from the same year for different members, then these Carryforwards would be deducted pro rata, in proportion to each such member's net BIE (similar to the allocation of insufficient Limitation in the current year, described previously). Presumably, in the original year that the BIE was incurred, Section 163(j) would not have prohibited the member from deducting the BIE to the extent of that member's BII. Thus, in allocating excess current year Limitation to prior-year Carryforwards, the appropriate proportion would be by relative net BIE (as opposed to relative gross BIE, which would effectively double-count some or all of the BIE of a member with BII).

Example 7: Deducting Carryforwards and allocating deduction among members

P is the common parent, and owns 100% of the stock of S1 and S2, each a member of the P consolidated group. The P group's consolidated ATI for Year 3 is $100, so the P group's consolidated Limitation is $30 ($100 * 30%). Each of S1 and S2 incurs $10 of BIE, for P group aggregate BIE of $20. Section 163(j) does not disallow any of S1's or S2's BIE in Year 3, and there is $10 remaining Limitation. In Year 1, S1 had $8 of disallowed BIE and in Year 2, S2 had $8 of disallowed BIE. The $10 of remaining Limitation from Year 3 is used to deduct S1's and S2's prior-year disallowed BIE, starting with the earliest year, so all $8 of S1's Year 1 BIE can be deducted, and $2 of S2's $8 Year 2 BIE can be deducted.

Disallowed interest Carryforwards arising in SRLYs

The Proposed Regulations would extend the principles of the existing consolidated group (SRLY) rules, with modifications, to Carryforwards. The SRLY rules generally limit the ability of a consolidated group to absorb certain losses and credits generated in a SRLY and carried into the group (e.g., a corporation joins the group with SRLY attributes). The SRLY limitation is computed based on the amount of positive income and tax liability that the member with the SRLY has contributed to the group's CTI while it has been a member.

In the case of Carryforwards, the Proposed Regulations would apply the SRLY rules by providing generally that a member's SRLY Carryforwards may not exceed the group's consolidated Limitation attributable solely to the SRLY member. The SRLY limitation on Carryforwards would apply on a subgroup basis when applicable, but the SRLY limitation would be recomputed annually rather than applied on a cumulative basis. In addition to the SRLY limitation on Carryforwards, the group could deduct the SRLY Carryforwards only to the extent that (1) the group had sufficient consolidated Limitation in the current year to absorb the SRLY Carryforwards, and (2) the member's SRLY limitation exceeded the member's BIE for the current year (i.e., the SRLY limitation applicable to the current year would be effectively reduced by current year BIE of the SRLY member). SRLY Carryforwards from the same year as non-SRLY Carryforwards would be deducted pro rata in proportion to the net BIE of the members.

Example 8(a): SRLY limitation applied to Carryforward

Individual A owned 100% of the stock of each of P and S. During Year 1, S incurred $20 of BIE but all of it was disallowed under Section 163(j) because S had no Limitation. At the beginning of Year 2, P acquired S, and S joined P's consolidated group with a $20 SRLY Carryforward. For Year 2, the P group's consolidated ATI is $100, and thus the P group's consolidated Limitation is $30. Of the $100 consolidated ATI in Year 2, $50 is attributable to P and $50 is attributable to S. Thus, $15 of the P group's Limitation is attributable to S, so S's SRLY limitation for its $20 SRLY Carryforwards is $15. Neither P nor S incur any BIE in Year 2. The P group can deduct $15 of S's $20 SRLY Carryforward in Year 2 as BIE. S's remaining $5 SRLY Carryforward is carried to the P group's Year 3.

Example 8(b): Group has insufficient consolidated Limitation to absorb entire SRLY Carryforward

This example assumes the same facts as Example 8(a), but in Year 2, instead of $100 of consolidated ATI, the P group's consolidated ATI is only $40, comprised of P's $10 loss and S's $50 income. Similar to Example 8(a), S's SRLY limitation for $20 SRLY Carryforwards is $15. Unlike Example 8(a), however, the P group cannot deduct the full $15 of S's $20 SRLY Carryforward available under the SRLY rules. Instead, because the P group's ATI is only $40, only $12 (30% * $40) of S's SRLY Carryforward can be deducted as BIE. S's remaining $8 SRLY Carryforward is carried to the P group's Year 3, S's $3 of remaining SRLY limitation from Year 2 is eliminated, and S's Year 3 SRLY limitation is computed based solely on S's Year 3 items.

Example 8(c): SRLY member has BIE in year of absorption of its SRLY Carryforward

This example also assumes the same facts as Example 8(a), but in Year 2, S also incurs $5 of BIE. Similar to Example 8(a), S's SRLY limitation for its $20 SRLY Carryforward is $15. Unlike Example 8(a), however, the P group cannot deduct the full $15 of S's $20 SRLY Carryforward available under the SRLY rules. Instead, because S incurs $5 of BIE in Year 2, only $10 (the excess of S's $15 SRLY limitation over S's $5 of Year 2 BIE) can be deducted. S's remaining $10 SRLY Carryforward is carried to the P group's Year 3, S's $5 of remaining SRLY limitation from Year 2 is eliminated, and S's Year 3 SRLY limitation is computed based solely on S's Year 3 items.

Implications

The Proposed Regulations are helpful in addressing many questions facing consolidated groups under new Section 163(j), and the Government's design choices appear largely reasonable and administrable. In particular, the Government adopted a relatively simplified approach in applying Section 163(j) to consolidated return groups by generally favoring a uniform single-entity approach (e.g., eliminating intercompany transactions from all consideration, including their effect on allocations between ETBs and NETBs). In contrast, the failure of the Proposed Regulations to retain the earlier proposed "super-affiliation" concept likely will lead to non-consolidated taxpayers finding their member-by-member application of Section 163(j) more daunting. Perhaps the principal exception to the proposed single-entity approach is the requirement for each member to first "net" its own BII and BIE, with only the member's net amount interacting with other members. Finally, consolidated groups will need to maintain awareness of inside/outside basis disparities when they perform calculations that focus on basis within the group (e.g., consolidated built-in gain or loss under Reg. Section 1.1502-91(g), and net inside attributes under Reg. Section 1.1502-36(d)).

As a stylistic matter, the rules for consolidated return groups appear under Section 163(j) in the Proposed Regulations (i.e., no significant proposed regulations appear under Section 1502; instead, see, e.g., Prop. Reg. Section 1.163(j)-4(d) (2018)). In contrast, the recently proposed regulations under Section 951A include detailed proposed regulations under Section 1502 (e.g., Prop. Reg. Section 1.1502-51 (2018), and amendments to existing Prop. Reg. Section 1.1502-32).

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