December 6, 2018 Proposed regulations on computing TCJA's interest expense limitation would affect partnerships This Tax Alert focuses on provisions in recently proposed Sections 163(j) regulationsi (REG-106089-18) that are of particular interest to partnerships and their partners. Sections 163(j) limits the deduction for business interest for taxpayers and contains specific rules applicable to partnerships and their partners. The Proposed Regulations would generally apply to tax years ending after the date the Proposed Regulations are published as final regulations. Pending the issuance of the final regulations, however, taxpayers may apply the Proposed Regulations to a tax year beginning after December 31, 2017, provided the taxpayers and their related parties consistently apply the Proposed Regulations to those tax years. For details regarding the Proposed Regulations more generally, please see Tax Alert 2018-2369; for discussion of other aspects of the regulations, see Tax Alerts 2018-2360 (real estate industry implications), 2018-2397 (interaction between Section 163(j) and Section 382) and 2018-2401 (application to consolidated groups). I. Background The Tax Cuts and Jobs Act (the TCJA) amended Section 163(j). For tax years beginning after December 31, 2017, Section 163(j) limits a taxpayer's business interest expense (BIE) deduction to business interest income (BII), plus 30% of adjusted taxable income (ATI), plus floor plan financing interest.1 Ignoring floor plan financing interest, BIE in excess of BII (net BIE) is generally deductible only to the extent of 30% of ATI. Any BIE not deductible in a tax year is generally treated as BIE paid or accrued in the succeeding tax year. For partnerships, Section 163(j) applies both at the partnership and partner level. Partnerships deduct BIE arising at the partnership level to the extent allowed by Section 163(j). Unlike other taxpayers, however, partnerships do not treat BIE suspended under Section 163(j) for a tax year as BIE paid or accrued by the partnership in the succeeding tax year. Instead, the disallowed amount creates a partner-level tax attribute, excess business interest expense (EBIE). The statute provides that a partnership's EBIE is allocated to each partner in the same manner as the partnership's non-separately stated taxable income or loss and that EBIE allocated to a partner may be deducted by that partner only in succeeding tax years to the extent the partner is allocated excess taxable income (ETI) from the same partnership. ETI is generally a partnership's ATI that is not used to support a partnership-level BIE deduction. Thus, for example, a partner that is allocated EBIE in a particular year that also has ATI from other sources in that year will not be able to deduct any of the EBIE to reduce its taxable income from other sources. Instead, the partner will be able to deduct the EBIE only if and when, in a subsequent year, the same partnership allocates the partner ETI. Section 163(j) requires that a partner perform its own Section 163(j) calculation for BIE it incurs. The statute provides that a partner generally computes its ATI without regard to the partner's distributive share of any items of income, gain, deduction, or loss from a partnership. A partner may, however, increase its ATI by the partner's distributive share of a partnership's ETI, which is allocated to each partner in the same manner as the partnership's non-separately stated taxable income or loss. More specifically, ETI must first be used by a partner to apply against any EBIE allocated by the same partnership and carried forward by the partner. Once all such EBIE has been treated as used by the partner as a result of the allocation of ETI, any additional ETI is taken into account by the partner in computing the partner's ATI. Section 163(j) contains several exceptions. The Section 163(j) limitation does not apply to certain small businesses. Moreover, the Section 163(j) limitation does not apply to (i) the trade or business of performing services as an employee; (ii) any electing real property trade or business (RPTB); (iii) any electing farming business; and (iv) certain regulated utility trades or businesses. II. Common definitions used throughout the Proposed Regulations (Prop. Reg. Section 1.163(j)-1) Prop. Reg. Section 1.163(j)-1 provides common definitions used throughout the Proposed Regulations. Some of the more significant definitions provided in Prop. Reg. Section 1.163(j)-1 are discussed next. A. Definition of ATI Under Section 163(j)(8), the term "ATI" means the taxable income of a taxpayer computed without regard to: (i) any item of income, gain, deduction or loss that is not properly allocable to a trade or business; (ii) any BIE or BII; (iii) NOLs; (iv) the amount of any deduction allowed under Section 199A; and (v) for tax years beginning before January 1, 2022, any deduction allowable for depreciation, amortization or depletion. For tax years beginning on and after January 1, 2022, ATI includes any deduction allowable for depreciation, amortization or depletion. Section 163(j)(8)(B) authorizes the Treasury to provide for additional adjustments to ATI. The Proposed Regulations provide a definition of ATI. Under Prop. Reg. Section 1.163(j)-1, the computation of ATI would begin with a taxpayer's taxable income, as determined under Section 63 but computed before the application of Section 163(j) (i.e., treating all BIE as deductible). The Proposed Regulations would require several additions to and subtractions from this initial amount. For example, the Proposed Regulations would add, for tax years beginning before January 1, 2022, certain deductions for depreciation and certain amortization expenditures (including for intangibles) to ATI. Those deductions and amortization expenditures, however, would generally be subtracted from ATI upon the sale or disposition of the underlying property. When a partnership had claimed those deductions and amortization expenditures and allocated those items to a partner, the prior deductions and amortization expenditures would generally be subtracted from the partner's ATI upon the sale or other disposition of the partnership interest. Implications: The computation of ATI continues to be central to the Section 163(j) limitation. The Proposed Regulations' definition includes additional elements, and taxpayers should carefully consider which tax items are included in, and excluded from, their ATI. The Proposed Regulations would also clarify that amounts incurred as depreciation, amortization or depletion that are capitalized under Section 263A and included in cost of goods sold may not be added back to determine ATI. B. Definition of interest The definition of interest is important for Section 163(j) purposes because it defines the scope of the provision's limitation. Moreover, interest items are excluded from ATI. The Proposed Regulations broadly define interest. The Preamble describes the definition of interest provided as a "complete definition of interest that addresses all transactions that are commonly understood to produce interest income and expense, including transactions that may otherwise have been entered into to avoid the application of Section 163(j)." Specifically, the Proposed Regulations would adopt a detailed, but non-exclusive, list of items that are treated as interest for purposes of Section 163(j). These items generally include items that are treated as interest under general federal income tax principles, the Code or regulations. The Proposed Regulations also include in the definition of interest many items that are not treated as interest under general federal income tax principles, the Code or regulations, but that the Treasury and IRS view as "closely related to interest and that affect the economic yield or cost of funds of a transaction involving interest." As a result of this broad conception of interest, the Proposed Regulations would treat, among other items, guaranteed payments for the use of capital under Section 707(c) as interest. Implications: The inclusion of a guaranteed payment for the use of capital as interest reflects the breadth of the Proposed Regulations' definition of interest. This inclusion may result in partnerships reconsidering their equity structures. Moreover, this inclusion places additional pressure on the question of whether a preferred return is characterized as a guaranteed payment for tax purposes. The Proposed Regulations also contain an anti-avoidance rule under which any deductible expense or loss incurred by a taxpayer in a transaction (or series of integrated or related transactions) in which the taxpayer secures the use of funds is treated as interest expense if the expense or loss is predominantly incurred in consideration of the time value of money. Implications: The anti-avoidance rule is one-sided. Unlike other provisions in the Proposed Regulations defining interest, the anti-avoidance rule would apply only to deductible expense or loss (treated as interest expense), and not to income or gain (which apparently is not treated as interest income). C. Definition of trade or business Only items that are allocable to a trade or business can be included in BIE, BII and ATI. Thus, the application of Section 163(j) turns on the existence (or absence) of a trade or business. Section 163(j), however, does not define the term trade or business, and the Code provides no general definition. The Proposed Regulations provide that the term "trade or business" generally has the same meaning as it does under Section 162. Implications: The definition of trade or business in the Proposed Regulations provides limited guidance. Section 162 and its regulations do not define trade or business. The case law and administrative guidance under Section 162 (and other Code provisions using the Section 162 standard) generally adopt an all-facts-and-circumstances approach to the inquiry. Relevant considerations include whether the taxpayer engages in the activity with continuity and regularity and with an income or profit motive.2 Thus, the identification of a trade or business for Section 163(j) purposes will rest on an examination of the facts in each case, and existing guidance may be insufficient to reach clear conclusions in many fact patterns. Similarly, the proposed regulations under recently-enacted Section 199A also define trade or business by reference to Section 162. The Proposed Regulations provide additional guidance on excepted trades or businesses, including the trade or business of providing services as an employee and electing RPTBs. It is, moreover, worth noting that, for purposes of the allocation rules in Prop. Reg. Section 1.163(j)-10 (discussed later), a taxpayer's activities are not treated as a trade or business if those activities do not involve the provision of services or products to a person other than the taxpayer. III. General rules relating to the computation of a taxpayer's Section 163(j) limitation (Prop. Reg. Section 1.163(j)-2) Prop. Reg. Section 1.163(j)-2 provides rules that are consistent with the statutory language for determining the amount of business interest that is generally deductible. Prop. Reg. Section 1.163(j)-2 also details the exception for certain small businesses and contains a broad anti-abuse rule. A. Exception for certain small businesses Under the Code, the Section 163(j) limitation does not apply to certain small businesses. Section 163(j)(3), to determine whether a business is small, uses a $25 million gross receipts test and indicates that the small-business exception is not available for a "tax shelter" within the meaning of Section 448(a)(3). Aggregation rules may apply to attribute gross receipts among affiliates as well. The Proposed Regulations generally follow the statutory language, reiterating that the small-business exception is available to small-business taxpayers other than tax shelters as defined in Section 448(d)(3). The Proposed Regulations do not provide additional guidance on the definition of a tax shelter. Tax shelter (as defined in Section 448(d)(3)) can be interpreted as including a broad range of partnership structures. A tax shelter within the meaning of Section 448(d)(3) includes any partnership or other entity (other than a corporation that is not an S corporation) if more than 35% of the losses of that entity during the tax year are allocable to limited partners or limited entrepreneurs (within the meaning of Section 461(k)(4)). The term "limited entrepreneur," under Section 461(k)(4), means a person who (i) has an interest in an enterprise other than as a limited partner, and (ii) does not actively participate in the management of that enterprise. A tax shelter within the meaning of Section 448(d)(3) also includes a partnership, entity, plan or arrangement, a significant purpose of which is the avoidance or evasion of federal income tax. Implications: The carve-out for a partnership that is treated as a tax shelter as defined in Section 448(d)(3) will make the small-business exception unavailable for many partnerships that satisfy the gross-receipts requirement. The Proposed Regulations provide computational guidance on the $25 million gross receipts test. A taxpayer would use its average annual gross receipts, tested for the three tax years immediately preceding the current tax year. Partners would include a share of partnership gross receipts when applying the small-business exception at their level.3 The Proposed Regulations (in Prop. Reg. Section 1.163(j)-6) further provide that, if a partnership is not subject to Section 163(j) by reason of the small-business exception (i.e., is an "exempt entity"), each partner of the exempt entity (i) is allocated BIE from the exempt entity and the allocated BIE is subject to the partner's own Section 163(j) limitation; (ii) includes items of income, gain, loss or deduction of the exempt entity when calculating its ATI; and (iii) includes BII of the exempt entity in its own Section 163(j) limitations. IV. Ordering rules and other rules regarding the relationship of the Section 163(j) limitation and other provisions of the Code affecting interest (Prop. Reg. Section 1.163(j)-3) Prop. Reg. Section 1.163(j)-3 addresses the interaction between Section 163(j) and various other sections of the Code that affect the treatment of interest. Generally, Section 163(j) would apply only to BIE that would otherwise be deductible in the current tax year, absent application of Section 163(j). Thus, Section 163(j) would apply after the application of the various provisions that subject interest expense to disallowance, deferral, capitalization or some other limitation, but before the application of Sections 465, 469 and 461(l). The Proposed Regulations reserve on the interaction of Section 163(j) and Section 59A (the base erosion and anti-abuse tax or BEAT), and the Preamble specifically requests comments on the interaction of Section 163(j) and the rules regarding the discharge of indebtedness under Section 108. Implications: The Proposed Regulations make clear that satisfying Section 163(j) is necessary, but not always sufficient, to fully deduct BIE in a given year. Other limitations must be considered and coordinated with Section 163(j). Moreover, as discussed later, the Proposed Regulations (in Prop. Reg. Section 1.163(j)-6) provide rules that coordinate Section 163(j) with Section 704(d). V. Rules applicable to C corporations (including REITs, RICs and consolidated group members) (Prop. Reg. Section 1.163(j)-4 and Prop. Reg. Section 1.163(j)-5) Prop. Reg. Section 1.163(j)-4 provides rules on the computation of items of income and expense under Section 163(j) for C corporations (including members of a consolidated group, REITs and RICs) and tax-exempt corporations. Prop. Reg. Section 1.163(j)-5 includes ordering rules for carrying forward BIE that is incurred by a C corporation and disallowed under Section 163(j)(1). Some of the more significant provisions for partnerships and their partners in Prop. Reg. Section 1.163(j)-4 are discussed next. A. C corporations that are partners — Treatment of partnership-level investment items BIE does not include investment interest (as defined in Section 163(d)), and business income does not include investment income (as defined in Section 163(d)). Section 163(d) defines, and provides rules regarding, investment interest expense and investment income. The Conference Report to the TCJA, in a footnote, states: "A corporation has neither investment interest nor investment income within the meaning of Section 163(d). Thus, interest income and interest expense of a corporation is properly allocable to a trade or business, unless such trade or business is otherwise explicitly excluded from the application of the provision [Section 163(j)]." This indicates that no interest paid or accrued by a corporation is investment interest expense and that no interest received or accrued by a corporation is investment income. In contrast, a partnership computes its income as an individual, subject to certain modifications, and is generally viewed as having both investment income and investment interest expense. Thus, uncertainty existed in terms of whether partnership-level investment interest expense allocable to a C corporation partner would be tested as BIE, and potentially limited under Section 163(j), at the partnership level. In addition, it was unclear whether investment income of a partnership allocable to a C corporation partner could be recharacterized as properly allocable to a trade or business (so that those amounts would be includable in ATI), which would make the result reasonably aligned with subjecting the investment interest expense to Section 163(j) in the first place and avoid a potential mismatch. The uncertainty regarding how the IRS and Treasury would address these types of situation was amplified by Section 163(j)(4)(A)(ii)'s language, which states that each partner's ATI "shall be determined without regard to [the] partner's distributive share of any items of income, gain, deduction, or loss of [the] partnership." The Proposed Regulations would generally treat investment interest expense that a partnership allocates to a C corporation partner as investment interest expense at the partnership level. This means that the interest expense would not be tested at the partnership level under Section 163(j). At the C corporation partner level, the Proposed Regulations would treat the interest expense as properly allocable to a trade or business of the C corporation partner. This means that the interest expense would be potentially subject to Section 163(j) at the partner level. Similarly, this provision of the Proposed Regulations would generally treat investment income that a partnership allocates to a C corporation partner as properly allocable to a trade or business of the C corporation partner. The recharacterization of investment items at the C corporation partner level under the Proposed Regulations would not affect the character of these items at the partnership level. It also would not affect the character of the investment interest, investment income and investment expenses allocated to other (non-C corporation) partners. Investment interest expense of a partnership that is treated as BIE by the C corporation partner would not be treated as EBIE. Similarly, investment income of a partnership that is treated as BII by the C corporation partner would not be treated as ETI. Implication: These rules are welcome guidance as they generally spare investment interest expense of a partnership from being tested as BIE and potentially limited under Section 163(j) at the partnership level. These rules also may increase a C corporation partner's potential ATI as a result of an allocation of partnership income to the C corporation partner so that the C corporation partner may have more ATI with which to support the "recharacterized" interest expense allocated to it by the partnership. B. C corporations that are partners — E&P rules Prop. Reg. Section 1.163(j)-4(b) also provides other rules specific to C corporations that are partners, including rules on earning and profits (E&P). A C corporation partner would generally reduce its E&P to reflect expense allocations (including of EBIE) from a partnership. A C corporation partner may increase its E&P upon the disposition of a partnership interest (if it has unused EBIE with respect to its partnership interest). C. Partnerships owned by consolidated group members Prop. Reg. Section 1.163(j)-4 provides that a consolidated group has a single Section 163(j) limitation and would generally treat all members of the consolidated group as a single taxpayer for Section 163(j) purposes. Special rules are provided for intercompany items. Under the Proposed Regulations, however, partnerships wholly owned by members of a single consolidated group would not be treated as part of the consolidated group for Section 163(j) purposes. The Proposed Regulations also provide rules on certain transfers of a partnership interest in an intercompany transaction (i.e., between members of a consolidated group). Specifically, the Proposed Regulations provide would treat the transfer of a partnership interest in an intercompany transaction that did not result in the termination of the partnership as a disposition for purposes of the basis adjustment rule in Section 163(j)(4)(B)(iii)(II) (discussed later), regardless of whether the transfer was one in which gain or loss was recognized. Moreover, a change in status of a member (becoming or ceasing to be a member of the consolidated group) would not be treated as a disposition for purposes of Section 163(j)(4)(B)(iii)(II). VI. Rules applicable to partnerships and their partners and S corporations and their shareholders (Prop. Reg. Section 1.163(j)-6) Prop. Reg. Section 1.163(j)-6 contains rules applicable to partnerships and their partners and S corporations and their shareholders. These rules are inordinately complex. Key highlights of the rules applicable to partnerships and their partners immediately follow. A. Computation of partnership ATI and partner ATI — Effect of partner-specific items and no-double counting rule Section 163(j) requires a partnership-level calculation and application of the Section 163(j) limitation but does not address the effect, if any, on partnership ATI (which provides the partnership with its Section 163(j) limitation) of certain partner-specific items, such as Section 743(b) adjustments. Under the Proposed Regulations, Section 743(b) adjustments, Section 704(c)(1)(C) amounts and remedial allocations under Section 704(c) (collectively, partner-level adjustments) would not be taken into account at the partnership level. Instead, partner-level adjustments would be taken into account at the partner level in computing the partner's ATI. Implications: The Proposed Regulation's special rule for remedial allocations will require taxpayers to consider the effect of Section 163(j) when considering which method to adopt under Section 704(c). Consistent with the statute, the Proposed Regulations would also preclude the double counting of partnership ATI by generally requiring a partner to calculate its ATI without regard to the partner's distributive share of partnership items, and instead by increasing the partner's ATI only by its share of partnership ETI. Similarly, consistent with Notice 2018-28, the Proposed Regulations would preclude the double counting of BII: only excess business interest income (EBII) would be taken into account for purposes of any partner-level limitation determination. Also excluded from the partner-level calculation would be partnership-level floor plan financing interest expense. B. Allocation of partnership EBIE and ETI — Meaning of non-separately stated taxable income or loss and the 11-step process Section 163(j)(4) generally allocates partnership EBIE (which is not allowed as a deduction in the current year) and partnership ETI to each partner in the same manner as the non-separately stated taxable income or loss of the partnership. The Proposed Regulations would not subject a partnership's "deductible business interest expense" allocated to a partner to further Section 163(j) limitations at the partner level. BIE (including deductible business interest expense) would otherwise retain its character as interest at the partner level and thus may be subject to other limitations, such as Section 163(d). The Proposed Regulations would also clarify that any EBIE retains its character as interest for most purposes of the Code. Moreover, for a partnership that is engaged in a trade or business but generates Section 163(d) investment interest expense for noncorporate partners that do not materially participate in the partnership's activities (such as a securities trading partnership — see, e.g., Revenue Ruling 2008-12), the Preamble states that the partnership's BIE would potentially be subject to two limitations: first, Section 163(j) at the partnership level; and second, to the extent that the BIE flows up to noncorporate partners that do not materially participate in the partnership's activities, Section 163(d) at the partner level. The Proposed Regulations, moreover, provide rules that are particularly important for partnerships that make special allocations of partnership items. Specifically, the Proposed Regulations address the fact that a partnership may make special allocations under Section 704(b) of items such as interest expense, interest income and items that are included in the ATI computation. Although Section 163(j)(4) states that a partner's distributive share of ETI and EBIE are determined "in the same manner as the partner's distributive share of non-separately stated taxable income or loss of the partnership," it was not clear how to apply that concept to special allocations. The Preamble states that a partner's distributive share of non-separately stated taxable income or loss of the partnership is a concept not defined in the Code or regulations. As a result, the Proposed Regulations would treat the allocation of ETI, EBII, and EBIE (collectively, Section 163(j) excess items) and deductible business interest expense as made in the same manner as non-separately stated income or loss only if the partnership follows an 11-step process. The Preamble to the Proposed Regulations states that the 11-step process "preserves the entity-level calculation requirement set forth in [Section] 163(j)(4), while also preserving the economics of the partnership and respecting any special allocations made by the partnership in accordance with [Section] 704 and the regulations thereunder." Prop. Reg. Section 1.163(j)-6 would also add a complex new regime for allocating EBI, ETI and deductible interest expense among partners for Section 163(j) purposes. At a high level, these rules attempt to coordinate the partnership-level determinations of these attributes mandated by Section 163(j)(4) with the rules of Section 704(b), notably a partnership's ability to specially allocate items to partners, and Section 704(c). Conceptually, the rules try, subject to certain limitations, to align deductible business interest expense with the income (specifically the ATI and/or BII) that supported it. The following summary of an example taken from the Proposed Regulations (Example 11 of Prop. Reg. Section 1.163(j)-6(o)) helps explain the purposes and mechanics of the 11-step process. Assume a partnership (Partnership) has equal partners A and B. Partnership has $100 of ATI, $20 of BII, and $60 of BIE. It allocates 100% of its $100 ofATI to A, and allocates $10 of BII and $30 of BIE to each of A and B. Partnership also has investment income and floor plan financing interest expense. The investment income is not a Section 163(j) item, and floor plan financing interest expense is not subject to the 11-step process; therefore, those items generally are ignored in the following discussion of the 11-step process. a) Step 1 — Partnership Section 163(j) Items Step 1 would require Partnership to calculate its Section 163(j) limitation under Prop. Reg. Section 1.163(j)-2(b), which would generally limit a partnership's BIE deduction to BII, plus 30% of ATI. Partnership has a "Section 163(j) capacity" of $50 ($20 of BII plus 30% of $100 ATI), $50 of deductible BIE (equal to the Section 163(j) capacity of $50) and $10 of EBIE ($60 of total BIE, less $50 of deductible BIE). Partnership has no ETI. b) Step 2 — Partner-allocated Section 163(j) Items The second step would require Partnership to determine each partner's share of "Section 163(j) items" (BIE, BII and items comprising ATI). A has $100 of allocable ATI, $10 of allocable BII and $30 of allocable BIE. B has $0 of allocable ATI, $10 of allocable BII and $30 of allocable BIE. c) Steps 3 - 5 — Comparison of allocated BII to allocated BIE Steps 3 through 5 compare each partner's share of allocable BII to its share of allocable BIE to arrive at each partner's "remaining business interest expense" (remaining BIE). Step 3 compares each partner's allocable BII to its allocable BIE. In this example, each partner has an "allocable BII deficit" of $20 as each partner's share of allocable BIE ($30) exceeds its share of allocable BII ($10) by $20. Step 4 determines each partner's "final allocable business interest income excess." This concept would apply only if a partner's share of allocable BII exceeds the partner's share of allocable BIE. On these facts, no partner has such an amount, as each partner's share of allocable BIE exceeds its share of allocable BII. Under Step 5, Partnership would compute each partner's remaining BIE by reducing each partner's allocable BII deficit by an amount determined by reference to any "allocable BII excess." As stated previously, no partner has a final allocable BII excess. As such, each partner has a remaining BIE of $20. In summary, on these facts, each partner is allocated BII of $10 and BIE of $30, resulting in each partner having a $20 remaining BIE. d) Steps 6 - 8 — Comparison of allocated ATI to allocated BIE In Step 6, Partnership would determine each partner's "final allocable ATI." Partnership allocated 100% of its ATI to A and allocated no items comprising ATI to B. As a result, A has a final allocable ATI of $100 and B has a final allocable ATI of $0. Step 7 would compare each partner's "ATI capacity" to the partner's remaining BIE. A's ATI capacity is $30 (30% of $100), and B's ATI capacity is $0 (30% of $0). A's ATI capacity of $30 exceeds its remaining BIE of $20 by $10. Thus, A has $10 of ATI capacity excess. B's ATI capacity of $0 is less than its remaining BIE of $20 by $20. Thus, B has a $20 "ATI capacity deficit." Step 8 would apply only if three requirements were satisfied, including the presence of "total negative allocable ATI" (i.e., at least one partner has a share of "negative allocable ATI" from Step 2). On these facts, there is no total negative allocable ATI, as Partnership did not allocate to a partner (i) items of deduction and loss comprising ATI in excess of (ii) items of income and gain comprising ATI. Implications: Careful consideration should be given to whether the adjustments described in Step 8 are required. If Step 8 applies, each partner's "final ATI capacity excess" in Step 9 would always be $0. e) Steps 9 - 10 — Reallocation of ATI Capacity Excess and Reduction of ATI Capacity Deficit In Step 9, Partnership would determine each partner's "final ATI capacity excess." On these facts, Step 8 did not apply, and A's $10 of ATI capacity excess is reduced (not below $0) by the product of the total $20 ATI capacity deficit and the ratio of A's ATI capacity excess ($10) to the "total ATI capacity excess" ($10). As a result, A's $10 ATI capacity excess is reduced to $0 (or $10 less $20 times 100%, but not below $0). After Step 9, the total ATI capacity excess equals the partnership's ETI. In this case, Partnership has $0 ETI; thus, neither A nor B have ATI capacity excess after Step 9. In Step 10, Partnership would determine each partner's "final ATI capacity deficit." B's $20 of ATI capacity deficit is reduced (not below $0) by the product of the total $10 ATI capacity excess and the ratio of B's ATI capacity deficit ($20) to the "total ATI capacity deficit" ($20). As a result, B's $20 ATI capacity deficit is reduced to a $10 final ATI capacity deficit. After Step 10, the total ATI capacity deficit equals the partnership's EBIE. In this case, Partnership has $10 of EBIE; thus, B has a $10 final ATI capacity deficit after Step 10. f) Step 11 — Final determination of Section 163(j) excess items and character of BIE Step 11 provides the following:
Partnership allocates its EBIE to B, the partner with a final ATI capacity deficit amount. Partnership then allocates its $50 of deductible BIE to A and B. (Partnership has no ETI to allocate.) Partnership allocates $30 of deductible BIE to A (the excess of A's $30 allocated BIE over A's $0 share of EBIE) and $20 of deductible BIE to B (the excess of B's $30 allocated BIE over B's $10 share of EBIE). No rule in the 11-step process prohibits a partnership from making a special allocation of any partnership item that is permitted under Section 704 and the applicable regulations. Implications: The 11-step process is complicated and will require significant analysis for partnerships with special allocations of partnership items such as interest income, interest expense and items that are included in the computation of ATI. In all events, however, the 11-step process would not affect a partnership's Section 704 allocation (as reflected in Step 2) of ATI, BII or BIE, and instead would only affect a partnership's allocation of ETI, EBIE, EBII and deductible BIE (as determined in Step 11). Said differently, the 11-step process merely determines the attributes of the partner's allocable share of ATI, BII or BIE and would not cause those items to be reallocated. C. Treatment of EBIE Section 163(j)(4)(B)(i) requires EBIE allocated to a partner to be deducted by that partner only in succeeding tax years to extent the partner is allocated ETI from the same partnership. Section 163(j)(4)(B)(ii) provides rules for the carryforward of EBIE. Specifically, Section 163(j)(4)(B)(ii)(I) provides that carried-forward EBIE deductions "shall be treated as business interest paid or accrued by the partner in the next succeeding tax year in which the partner is allocated excess taxable income from such partnership, but only to the extent of such excess taxable income." Section 163(j)(4)(B)(ii)(I), read literally, provides that $1 of ETI from the partnership frees up at the partner level $1 of carryover EBIE deductions, even though that same $1 would have enabled the partnership at the partnership level to utilize only 30 cents of BIE deductions. Similarly, the Proposed Regulations would treat a partner's carryforward EBIE as paid or accrued to extent the partner is allocated partnership ETI on a dollar-for-dollar basis, but would clarify that each $1 of ETI can absorb only 30 cents of EBIE deductions. Also, the Proposed Regulations provide that EBII flowing through to a partner will permit the partner to utilize EBIE allocated by the partnership to the partner in prior years. Although consistent with the purpose of Section 163(j), this result was not provided under the statute and thus was in doubt until the issuance of the Proposed Regulations. Implications: The Proposed Regulations would allow EBII to free up EBIE. This clarification is taxpayer-favorable. Moreover, the Proposed Regulations address what appeared to be uncertainty under the statute regarding how much ETI was needed to free up previously allocated EBI and whether EBIE freed up in a subsequent tax year would be subject to a partner-level limitation under Section 163(j), including the 30% of ATI limitation. Under Section 163(j)(4)(B)(iii)(I), a partner's adjusted basis in its partnership interest is reduced (but not below zero) by the amount of EBIE allocated to the partner. If a partner disposes of a partnership interest, Section 163(j)(4)(B)(iii)(II) generally provides for an increase in outside basis for unused carried-forward EBIE. The Proposed Regulations would limit the Section 163(j)(4)(B)(iii)(II) basis adjustment to only dispositions (whether by reason of taxable or non-taxable transaction) of all or substantially all of the partner's interest in the partnership. Implications: The Proposed Regulations create uncertainty by failing to define "substantially all." D. Other key provisions The Proposed Regulations address several issues stemming from the entity-level application of Section 163(j) to partnerships. For example, the Proposed Regulations provide rules regarding the treatment of gain or loss from the sale of a partnership interest on a partner's ATI calculation. While Section 163(j) does not explicitly address whether gain or loss from the sale of a partnership interest affects ATI, the Proposed Regulations address the issue. Specifically, if a partner sells a partnership interest and the partnership in which the interest is sold owns only non-excepted trade or business assets (i.e., assets used in a trade or business subject to Section 163(j) or assets used by a partnership eligible for the small-business exception), 100% of the gain or loss from the sale of the partnership interest may be included in the partner's ATI. Under the Proposed Regulations' definition of ATI, however, the taxpayer's distributive share of partnership depreciation and amortization (e.g., from prior years) may also be subtracted from ATI upon the sale or other disposition of the partnership interest. If the partnership in which the interest is sold owns both excepted trade or business assets (e.g., assets used in an electing RPTB) and non-excepted trade or business assets, a pro rata rule would be used. This pro rata rule uses the methodology set forth in Prop. Reg. Section 1.163(j)-10 to determine the amount properly allocable to a non-excepted trade or business and thus includible in the partner's ATI. Implications: The presence of both excepted and non-excepted trades or businesses in a partnership will create significant compliance burdens, both in terms of allocating the partnership's interest expense (if any) among the two or more businesses but also in the context of allocating proceeds between them. This burden appears to exist even if the partnership does not have any interest expense. The Proposed Regulations also provide detailed rules coordinating Section 163(j) with Section 704(d). The Section 704(d) limitation would be spread among loss classes, treating deductible business interest expense, prior-year EBIE, current-year EBIE and EBIE from a prior year suspended under Section 704(d) as a single class (negative Section 163(j) expense class). Once the loss limitation is spread to the negative Section 163(j) expense class, deductible business interest expense would be taken into account before any EBIE or "negative Section 163(j) expense." Implications: Section 163(j) did not provide rules for coordination with Section 704(d). The detailed rules coordinating Section 163(j) with Section 704(d) in the Proposed Regulations are complex and will require significant analysis depending on the facts of a particular situation. E. Prop. Reg. Section 1.163(j)-6 reserves on key issues — Tiered partnerships, partnership mergers and divisions, and self-charged interest Section 163(j) does not address tiered-partnership structures, mergers, or divisions. The Proposed Regulations reserve on whether BIE carryforwards allocated to a pass-through partner are further allocated to such partner's partners. Similarly, the Proposed Regulations reserve on whether any basis adjustments made to a partner's basis in the partner's upper-tier partnership. The Proposed Regulations also reserve on the effects of partnership mergers and divisions. Implications: Both before and after the issuance of the Proposed Regulations, the application of Section 163(j) in tiered structures is uncertain. It remains unclear whether items allocated to an upper-tier partnership from a lower-tier partnership (such as ETI and EBIE) are further allocated to the upper-tier partnership's partners. Furthermore, because the Proposed Regulations reserve on the effects of partnership mergers, they do not address, for example, whether a resulting partnership with ETI may free up EBIE of a formerly separate partnership. Section 163(j) on its face applies to all business interest and does not make an exception for so-called self-charged interest (resulting from a loan between a partner and a partnership). The Preamble indicates that self-charged interest income and expense should be excluded from the partnership's and its partners' Section 163(j) limitation calculations. The Preamble notes that the IRS and the Treasury are considering adopting Treas. Reg. Section 1.469-7's approach, which effectively nets the lender's interest income and the borrower's interest expense. The Proposed Regulations, however, reserve on the issue. Implications: In the absence of regulations or other guidance on point, taxpayers should consider that the statute does not provide a rule addressing the treatment of self-charged interest, suggesting that self-charged interest is treated as any other interest that may be subject to the Section 163(j) limitation. VII. Rules applicable to foreign corporations and their shareholders (Prop. Reg. Section 1.163(j)-7) Prop. Reg. Section 1.163(j)-7 provides rules for applying the Section 163(j) limitation to foreign corporations and their shareholders. In general terms, Prop. Reg. Section 1.163(j)-7 would clarify that Section 163(j) applies to a foreign corporation that constitutes an "Applicable CFC" and to partnerships owned by an Applicable CFC and provides detailed rules and definitions for determining the Section 163(j) limitation, as well as the ATI of Applicable CFCs and their US shareholders. For purposes of the Proposed Regulations, an Applicable CFC is a controlled foreign corporation described in Section 957, but only if at least one US shareholder (within the meaning of Section 951(b)) owns stock (within the meaning of Section 958(a)) in the foreign corporation. For a more detailed description of these rules, please see Tax Alert 2018-2369. VIII. Rules applicable to foreign persons with effectively connected income (Prop. Reg. Section 1.163(j)-8) Prop. Reg. Section 1.163(j)-8 provides rules for applying the Section 163(j) limitation to foreign persons with income effectively connected with the conduct of a US trade or business. Because nonresident individuals and foreign corporations engaged in a US trade or business are only subject to US tax on effectively connected income (ECI) or income treated as ECI, the Proposed Regulations modify the definitions for ATI, BIE, BII and floor plan financing interest expense to limit these items to income that is or is treated as ECI and expenses allocable to ECI or income treated as ECI when applying the Section 163(j) limitation to these foreign persons. The Proposed Regulations modify Prop. Reg. Section 1.163(j)-6 to apply in instances in which a nonresident alien or foreign corporation is a partner in a partnership that engages in a US trade or business. The ETI, EBIE and EBII of the partnership is modified to take into account the limitation on the foreign person's US tax liability to income that is ECI or treated as ECI. For a more detailed description of these rules, please see Tax Alert 2018-2369. IX. Rules regarding elections for excepted trades or businesses (e.g., electing RPTBs) as well as a safe harbor for certain REITs (Prop. Reg. Section 1.163(j)-9) Prop. Reg. Section 1.163(j)-9 provides rules regarding elections for excepted trades or businesses, including electing RPTBs, along with a safe harbor for certain REITS. Because many partnerships are engaged in real estate activities and many REITs operate using partnerships, discussion of key provisions immediately follows. For a more detailed description of these rules, please see Tax Alert 2018-2360. A. Electing real property trade or business Under the Code, Section 163(j) does not apply to any electing RPTB. An electing RPTB includes "any trade or business which is described in [Section] 469(c)(7)(C) and which makes an election under this subparagraph [Section 163(j)(7)(B)]." Once the election is made, it is irrevocable. An electing RPTB must depreciate its nonresidential real property, residential rental property and qualified improvement property using the alternative depreciation system (ADS). A trade or business described in Section 469(c)(7)(C) includes any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. Under the Proposed Regulations, the election under Section 163(j)(7)(B) to be an electing RPTB would have to be made for each eligible trade or business of the taxpayer. Implications: Taxpayers will have to determine whether their activities rise to the level of a trade or business and, if so, whether the activities constitute a single trade or business or multiple trades or businesses for purposes of Section 162 (and thus Section 163(j)(7)(B)). Case law provides very limited guidance on the single-vs.-multiple trades or businesses issue. The same determination must be made under Section 199A and its proposed regulations. As noted, under the Proposed Regulations, and consistent with the statute, the election to be an electing RPTB is irrevocable. The Proposed Regulations, however, provide that the election terminates if the taxpayer ceases to engage in the electing trade or business. The Proposed Regulations further delineate when a cessation of an electing trade or business is deemed to occur. An anti-abuse rule provides that an RPTB is not eligible to be an electing RPTB if 80% or more of the business's real property is leased to a trade or business under common control with the RPTB. The anti-abuse rule, however, does not apply to a REIT's lease of qualified lodging facilities and/or qualified health care properties to a taxable REIT subsidiary. Implications: The rule's language may be broad enough to apply to structures for which taxpayers had no tax motive (including certain structures existing before the enactment of amended Section 163(j), if an RPTB election were to be made for part of the structure). B. Safe harbors for REITs Under the Proposed Regulations, if a REIT holds real property (as defined in Treas. Reg. Section 1.856-10), interests in partnerships holding real property or shares in other REITs holding real property, the REIT could generally elect to be an electing real property trade or business for all or part of its assets. Under the Proposed Regulations, if a REIT makes the election and the value of the REIT's real property financing assets (defined to include interests in mortgages) at the close of the tax year is 10% or less of the value of the REIT's total assets at the close of the tax year, then all of the REIT's assets would be treated as assets of an excepted trade or business. If the value of the REIT's real property financing assets were more than 10% of the value of the REIT's total assets, a pro rata rule (based on the rules in Prop. Reg. Section 1.163(j)-10) would apply. Implications: This is a generally favorable rule for REITs, though most mortgage REITs, as expected, will not qualify as electing RPTBs. X. Rules to allocate expense and income between non-excepted and excepted trades or businesses (Prop. Reg. Section 1.163(j)-10) Section 163(j)(7), Prop. Reg. Section 1.163(j)-2 and Prop. Reg. Section 1.163(j)-9 exempt certain trades or businesses from the application of Section 163(j), including electing RPTBs, electing farming businesses, regulated utility trades or businesses, and the trade or business of performing services as an employee. Prop. Reg. Section 1.163(j)-10 provides the exclusive rules for allocating tax items, including BIE and BII, between excepted trades or businesses and non-excepted trades or businesses for purposes of Section 163(j). Implications: Partnerships with both excepted and non-excepted trades or businesses (and their partners) will need to apply the allocation rules to determine the potential applicability of Section 163(j). In addition, if a partnership is not subject to Section 163(j), either because the partnership is an eligible small business under Section 163(j)(3) (i.e., is an exempt entity) or to the extent that partnership has an excepted trade or business, its partners will need to apply the allocation rules to determine the potential applicability of Section 163(j) at the partner level. Finally, in computing ATI upon the sale of a partnership interest when the underlying partnership has both excepted and non-excepted trades or businesses, a selling partner will need to apply the allocation rules to determine how much of the resultant gain or loss relates to excepted and non-excepted trades or businesses. A. Allocation of tax items other than interest income and expense In general, a taxpayer's gross income (other than dividends and interest income) would be allocated to the trade or business that generates the income. Special "look-through" rules may apply to certain dividends and gain or loss from the disposition of non-consolidated C corporation stock, S corporation stock, and partnership interests. Expenses (other than interest expense), losses and other deductions (collectively, deductions) that are "definitely" related to a trade or business would be allocable to the trade or business to which they relate. (A deduction is definitely related to a trade or business if the item giving rise to the deduction is incurred as a result of, or incident to, an activity of the trade or business or in connection with property used in the trade or business.) Deductions definitely related to one or more excepted and non-excepted trades or businesses would be apportioned based on the relative amounts of the taxpayer's adjusted tax basis in the assets used in those trades or businesses. Deductions not definitely related to a trade or business would be ratably apportioned based on gross income. B. Allocation of interest expense and interest income Interest expense and interest income generally are allocated among excepted and non-excepted trades or businesses based upon the relative amounts of the taxpayer's adjusted tax basis in the assets used in those trades or businesses, determined as of the last day of each quarter of the taxpayer's tax year. The average of those amounts is used as the relative amounts of asset basis for the taxpayer's excepted and non-excepted trades or businesses for that year. A de minimis exception may apply to the extent that 90% or more of the taxpayer's adjusted tax basis in its assets is allocable to either excepted or non-excepted trades or businesses. Implications: These rules would require that a taxpayer determine its adjusted tax basis in assets used in its trades or businesses quarterly, a calculation many taxpayers have not performed previously. Under certain circumstances, the allocation rules based on adjusted tax basis would not apply to interest expense and interest income. If a taxpayer has qualified nonrecourse indebtedness (within the meaning of Treas. Reg. Section. 1.861-10T(b)), the taxpayer would be required to directly allocate interest expense from that indebtedness to the taxpayer's assets, as provided in Treas. Reg. Section 1.861-10T(b). If a taxpayer is engaged in the trade or business of banking, insurance, financing or a similar business, the taxpayer would be required to directly allocate interest expense and interest income from that business to the taxpayer's assets. C. Other key rules Additional rules on allocating asset basis between excepted and non-excepted trades or businesses would apply to specific items such as depreciable property other than land and inherently permanent structures. For example, for depreciable property other than inherently permanent structures, adjusted tax basis generally would have to be determined by using ADS under Section 168(g) before applying additional first-year depreciation deductions (e.g., under Section 168(k)). Implications: Because most taxpayers do not maintain ADS depreciation schedules for their domestic assets, complying with the allocation rules under Prop. Reg. Section 1.163(j)-10 may be administratively burdensome for some taxpayers. Further, in determining the extent to which a taxpayer's adjusted tax basis in a partnership interest is allocable to excepted or non-excepted trades or businesses, the taxpayer generally would be permitted to look through the partnership interest (a taxpayer with an 80% or greater direct and indirect interest in a partnership would be required to look through the partnership interest). The allocation rules based on relative adjusted tax basis would not apply to disallowed BIE carryforwards (except disallowed disqualified interest) or floor plan financing interest expense. The allocation rules based on relative adjusted tax basis also would not apply to investment items. Specifically, interest expense would first be allocated under Treas. Reg. Section 1.163-8T between investment interest expense under Section 163(d) and interest expense properly allocable to trades or businesses (which for this purpose appears to include both excepted and non-excepted trades or businesses). As a second step, interest expense properly allocable to excepted and non-excepted trades or businesses would then be subject to the Prop. Reg. Section 1.163(j)-10 allocation rules as between those trades or businesses. XI. Transition rules (Prop. Reg. Section 1.163(j)-11) Prop. Reg. Section 1.163-11 provides transition rules. Among other topics addressed, these rules address the effect on an excess limitation under old Section 163(j)(2)(B). XII. Request for comments The Treasury and IRS have requested comments on a number of specific topics, including a number of partnership topics. Furthermore, the Treasury and IRS have scheduled a public hearing on February 25, 2019, regarding the Proposed Regulations. Persons who wish to participate in the public hearing must submit a request February 5, 2018. XIII. Conclusion The Proposed Regulations address many issues raised by Section 163(j) and its relationship to subchapter K. As drafted, the Proposed Regulations would add certainty in many respects but would also create significant complexity. Certain issues, including a number of matters impacting partnerships and their partners, have been reserved for future guidance. Taxpayers should consider the effect of the Proposed Regulations on their partnership structures and consider whether restructuring, including changes in capital structures, is warranted. Some taxpayers may find that certain concerns under Section 163(j) have been alleviated. For example, partnerships with investment interest expense would not be treated as having BIE that is tested under Section 163(j) at the partnership level merely because one or more partners is a C corporation. Other taxpayers however, may identify potential limitations provided by the Proposed Regulations that were unexpected (such as partnerships that make guaranteed payments for the use of capital). In short, determining the effect of Section 163(j) and the Proposed Regulations to a particular partnership and a particular partner will require careful analysis and be heavily fact-dependent. ———————————————
——————————————— 1 Floor plan financing interest is defined as interest paid or accrued on floor plan financing indebtedness. Floor plan financing indebtedness is defined as indebtedness that a taxpayer uses to finance acquisition of motor vehicles held for sale or lease as long as the indebtedness is secured by the inventory acquired. 2 See e.g., Commissioner v. Groetzinger, 480 U.S. 23 (1987) ("We accept the fact that to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer's primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement diversion does not qualify."). 3 Specifically, a partner includes a share of partnership gross receipts in proportion to that partner's distributive share (as determined under Section 704) of items of gross income that were taken into account by the partnership under Section 703. i The proposed regulations package also includes proposed regulations under Sections 381, 382, 383, 469, 860C and 1502 (collectively and with the proposed regulations issued under Section 163(j), the Proposed Regulations). Among other topics, the Proposed Regulations under Section 163(j) provide:
| |||||||||||||||||||
| |||||||||||||||||||
