Recently proposed regulations on the operation of the new business interest expense deduction under Section 163(j) (Proposed Regulations) provide several rules that are of particular importance to corporate groups with international operations. This Alert focuses on the portions of the Proposed Regulations that are relevant to financial services entities, especially the banking industry.

Section 163(j): Previous and current reach

Previously, Section 163(j) disallowed a deduction for certain interest paid or accrued to related parties (as well as certain other interest payments or accruals by a real estate investment trust (REIT) and certain interest on third-party debt for which there was a disqualified guarantee). The disallowance applied to corporations with a debt-to-equity ratio of over 1.5:1 whose net interest expense exceeded 50% of its "adjusted taxable income" (ATI). Generally, unless the disqualified guarantee rules applied, these rules were not a major concern for US headquartered multinational groups because the definition of disqualified interest excluded payments to unrelated parties or interest on which the recipient would be subject to US tax (under the regulations, this included subpart F income of a controlled foreign corporation (CFC)¹).

As amended by the Tax Cuts and Jobs Act, new Section 163(j) significantly broadens the reach of these rules. A taxpayer generally cannot deduct "business interest expense" for a tax year to the extent that the interest exceeds the sum of (1) the taxpayer's business interest income, (2) 30% of the taxpayer's ATI for that tax year, and (3) current-year floor plan financing interest expense. Business interest expense means any interest paid or accrued on indebtedness properly allocable to a trade or business, and interest income means any interest that is includible in the taxpayer's gross income and properly allocable to a trade or business. ATI for these purposes is taxable income computed without regard to certain non-business items, business interest expense or income, any NOL deduction or certain other deductions. Floor plan financing interest expense is interest paid or accrued on indebtedness used to finance the acquisition of motor vehicles held for sale or lease and secured by the inventory so acquired.²

Unlike old Section 163(j), the new limitation applies to all business interest regardless of whether the payee is a related person and generally applies to all taxpayers, including controlled foreign corporations. Exclusions are provided for taxpayers that fall below an annual gross receipts test, and also for certain trades or businesses, including performing services as an employee, electing real property trades or businesses, electing farming businesses and certain regulated public utilities. Taxpayers must elect to exempt a real property trade or business or a farming business from this limit.³

The Proposed Regulations would significantly broaden the definition of interest for purposes of Section 163(j) (e.g., the Proposed Regulations provide, inter alia, guaranteed payments for the use of capital under Section 707(c) and non-cleared swaps with significant nonperiodic payment, in part, shall be treated as interest for purposes of Section 163(j)).

Further, the Proposed Regulations include detailed rules outside the scope of this Alert on the general application of Section 163(j) to C corporations (including REITs, regulated investment companies, tax-exempt organizations, and members of consolidated groups).⁴

Proposed regulations of particular importance for multinational groups

The Proposed Regulations contain two sections that are of particular interest to multinational groups (Prop. Treas. Reg. Section 1.163(j)-7 and 1.163(j)-8). These sections provide guidance on applying the new Section 163(j) rules to CFCs, their shareholders, and other foreign corporations with effectively connected income to a US trade or business (ECI).

Under Prop. Treas. Reg. Section 1.163(j)-7, the Section 163(j) limitation would generally apply in determining the deductibility of a CFC's business interest expense in the same manner as those rules apply to a domestic C corporation, with certain modifications. Thus, a CFC with business interest expense would apply Section 163(j) to determine the extent to which that expense is deductible for purposes of computing subpart F income and tested income under the global intangible low-taxed income (GILTI) rules.

Additionally, under Prop. Treas. Reg. Section 1.163(j)-8, special rules would apply under Section 163(j) for taxpayers with ECI and expenses properly allocable to ECI.

Application of the business interest deduction limitation to foreign corporations and US shareholders

As noted previously, Prop. Treas. Reg. Section 1.163(j)-7 would apply Section 163(j) to a CFC's business interest expense in the same manner as those rules apply to a domestic C corporation.

Applying Section 163(j) to an applicable CFC and the CFC group election

Under the general rule, as mentioned, Section 163(j) applies to applicable CFCs in the same manner as it does to domestic corporations. For this purpose, an "applicable CFC" is a CFC, but only if the foreign corporation has at least one US shareholder (US SH) that directly or indirectly owns stock of the foreign corporation (i.e., within the meaning of Section 958(a)). However, an election is available, the "CFC Group Election," which provides an alternative approach for computing the deduction for business interest expense of a CFC group (defined later).⁵ The Treasury Department and IRS determined that this alternative method for applying Section 163(j) to a CFC should be elective, rather than required, as the general application of Section 163(j) to a CFC's business interest expense may be preferable. The CFC Group Election is available to any two or more CFCs, when the total share value of all classes of stock of each CFC is at least 80% owned, within the meaning of Section 958(a) (i.e., directly or indirectly), either by a single US SH or by aggregating the ownership of related US SHs that each own stock, in the same proportion, of each CFC (a CFC group).⁶ This election would limit the amount of business interest expense of a member of the CFC group (CFC group member) to the amount of the CFC group member's allocable share of the CFC group's applicable net business interest expense. This election would not be effective unless all CFC group members made the election; if an entity became a CFC group member of a CFC group with an effective election, the entity would have to make the election. The election is irrevocable. It would only terminate if the CFC group ceased to exist; if an entity ceased to be a CFC group member, it would terminate solely for that entity.⁷

When one or more CFC group members, in the aggregate, own more than 80% of the capital or profits interests in a partnership, that partnership would be treated as a CFC group member and, for these purposes, the interests in the partnership would be treated as stock.⁸ Further, a CFC that generates ECI is excluded from the definition of a CFC group member.⁹ While a CFC that generates ECI is excluded from the relevant CFC group, an applicable CFC with ECI would be treated as a CFC group member solely for purposes of determining a CFC group.¹⁰

A CFC group's applicable net business interest expense would be the excess, if any, of the sum of each CFC group member's business interest expense over the sum of each CFC group member's business interest income.¹¹ A CFC group member's allocable share would be computed by multiplying the CFC group's applicable net business interest expense by a fraction, the numerator of which is the CFC group member's net business interest expense (computed on a separate-company basis), and the denominator of which is the sum of each CFC group member's net business interest expense, if any (computed on a separate-company basis).¹² Treasury noted that this approach reflects the position that money is fungible within a group of highly related CFCs and avoids the potential for a mismatch in deduction and inclusion in interest expense payments made between CFCs.

Notably for financial services organizations, if an electing CFC group contains a "financial services subgroup," the CFC Group Election would apply by treating the entities that conduct a financial services business as a separate subgroup (i.e., the relevant calculations would be made separately for the financial services subgroup and the remaining subgroup (i.e., the other CFCs)). A financial services subgroup would be comprised of each CFC group member that conducts a financial services business (a financial services subgroup member). A CFC group member conducts a financial services business if it is (1) an eligible CFC (as defined in Section 954(h)(2)(A)), (2) a qualified insurance company (QIC), as defined in Section 953(e)(3), or (3) eligible for the dealer exception in computing FPHC income under Section 954(c)(2)(C).¹³ Treasury took this subgroup approach because financial services businesses are often highly leveraged with significant amounts of both business interest income and business interest expense.

Treasury chose to define "financial services" for this purpose using Sections 953 and 954, as opposed to referencing an alternative definition, e.g., the definition of "financial services income" under Treas. Reg. Section 1.904-4(e)(2)(i) (i.e., the so-called financial/non-financial rules of Section 904) or as defined in Section 904(d)(2)(D). Thus, a CFC that generally earns financial services-type income would not necessarily be considered a financial services subgroup member under Section 163(j), unless it is determined that the CFC conducts a financial services business, as defined earlier.

Computation of ATI of an applicable CFC and certain CFC group members

For purposes of Section 163(j), the principles of Treas. Reg. Section 1.952-2 apply for purposes of determining an applicable CFC's income and deductions.¹⁴ For an applicable CFC with ECI, however, Section 882 applies for purposes of computing the applicable CFC's taxable income.

To prevent potential double-counting of ATI, the proposed regulations provide that any dividend received by an applicable CFC from a related person under Section 954(d)(3) is subtracted from the distributee's taxable income. Treasury requested comments on whether certain provisions of the Code, which generally only apply for domestic C corporations, should be considered in computing ATI for a CFC (e.g., the Section 245A dividends received deduction).

If a CFC Group Election were made, an upper-tier CFC group member would take into account a proportionate share of the excess ATI (if any) of each lower-tier CFC group member in which it directly owns stock. In general, excess taxable income (ETI) means the amount of a CFC group member's ATI over the amount required before business interest expense would be disallowed. For ordering purposes, this rule would apply starting with the lowest-tier CFC group member in the chain of ownership. Thus, if the lowest-tier member has ETI, the ETI would be taken into account proportionately by each CFC group member directly owning stock of the lowest-tier member, continuing up the chain of ownership.¹⁵

Computing ATI of a US SH

To prevent potential double-counting, the ATI of a US SH would be computed without regard to any amounts included in gross income under Sections 78 (gross-up for deemed paid foreign tax credit), 951(a) (deemed inclusions under subpart F), and 951A(a) (deemed inclusions under GILTI) that are properly allocable to a non-excepted trade or business of the US SH and any deduction allowable under Section 250(a)(1)(B), without regard to the taxable income limitation in Section 250(a)(2), by reason of a specified deemed inclusion.¹⁶ The Proposed Regulations refer to each amount included in gross income under Sections 78, 951(a), and 951A(a) that is properly allocable to a non-excepted trade or business as a "specified deemed inclusion" and to those amounts collectively as "specified deemed inclusions."

If a CFC Group Election is in effect, an add-back rule is provided for US SHs that own highest-tier CFC group member stock, either directly or through a foreign partnership, which would allow the US SH to add back to its taxable income its proportionate share of "eligible" ETI of highest-tier CFC group members.¹⁷ Accordingly, Prop. Reg. Section 1.167(j)-7(d)(2)(ii) defines Eligible CFC group ETI, providing a calculation that is generally meant to approximate a US SH's allocable portion of the income of entities within the CFC group that would exceed the Section 163(j) limitation. For this purpose, members of a consolidated group would be treated as a single US SH. The amount of this add-back would be limited to the total CFC group inclusions under Sections 951 and 951A.

The add-back limitation would be computed without regard to amounts included in gross income under Section 78 for CFC group members. Treasury noted that it is appropriate to exclude Section 78 since its purpose is solely to require a deemed income inclusion to carry out the purposes of the foreign tax credit provisions.

Generally, if a US SH of a CFC group member were a domestic partnership, the add-back rule would not apply to determine the ATI of the US SH partnership.¹⁸ If a US SH partnership had a domestic C corporation partner, however, the add-back rule would apply, with certain modifications, to the corporate partner for purposes of computing the corporate partner's ATI. In addition, for purposes of determining the corporate partner's pro rata share of "eligible" ETI of a specified highest-tier member, the US SH partnership would be treated as if it were a foreign partnership.

Effect on earnings and profits

The Proposed Regulations provide that the disallowance and carryforward of a deduction of a foreign corporation's business interest expense does not affect whether and when the expense reduces the corporation's earnings and profits. As a result, a CFC's earnings and profits limitation under Section 952(c) would not be affected by any disallowance or carryforward of a deduction for business interest expense.¹⁹

Applying Section 163(j) to foreign persons with ECI

Nonresident alien individuals or foreign corporations that are not CFCs with ECI are also subject to Section 163(j). These rules require modification, however, as these foreign persons are only taxed on their ECI. As such, the definitions of ATI, business interest expense, business interest income, and floor plan financings would be modified to limit such amounts to income that is effectively connected with a US trade or business.

For partnerships, Section 163(j) applies at the partnership level. The ATI of a partner would increase by the partnership's ETI, and the partnership's excess business interest expense would be allocated to the partner as disallowed business interest expense carryforward. This carryforward would be deductible when the partners are allocated ETI from the partnership, but only to the extent of such excess. A nonresident alien individual or a non-CFC foreign corporation that is a partner in a partnership that is engaged in a US trade or business would modify application of the general allocation rules in Prop. Reg. Section 1.163(j)-6 for ETI, excess business interest expense, and excess business interest income of the partnership to take into account the limitation of the foreign person's liability for US tax to its ECI. As a result, the excess amounts of the partnership can be used by the nonresident alien individual or non-CFC foreign corporation only to the extent of the partnership's income that would be ECI in the hands of the foreign partner. The amount of the ETI would be determined by multiplying the amount of ETI or the excess business interest allocated under Prop. Reg. Section 1.163(j)-6 by a ratio equal to the ATI of the partnership, with the adjustments described previously to limit that amount to only ECI or expense items, by the ATI of the partnership determined under Prop. Reg. Section 1.163(j)-6(d).

The Proposed Regulations also provide coordination between Section 163(j) and the rules under Treas. Reg. Section 1.882-5, for allocating a foreign corporation's interest expense as ECI. These rules would require a foreign corporation to first determine its allocation before applying Section 163(j). If a foreign corporation were also a partner in a partnership that has ECI, the foreign corporation would have to back out that portion of the business interest expense that is determined under Treas. Reg. Section 1.882-5 and deemed to have come from the partnership, as that business interest expense was already subject to Section 163(j) at the partnership level and the foreign corporation would then be left with only the non-partnership business interest expense. Should a partnership also have disallowed business interest expense, a portion of the partnership-level interest expense that was backed out would also be disallowed business interest expense. Disallowed business interest expense determined at either the partner-level or the partnership level would be subject to the Section 163(j) limitation.

Implications and conclusion

As described previously, the Proposed Regulations involve detailed calculations that will require careful consideration by multinationals. The CFC group election and the financial services subgroup rules warrant particular attention, as a multinational's structure will have a dramatic effect on its limitation under Section 163(j). The implications could be far reaching. For example, certain CFCs within a financial services entity's organization will have positive net interest margin and Section 163(j) should not be particularly relevant. Depending upon the nature of the standalone CFC's business, however, Section 163(j) limitations could occur. The requirement to create financial and non-financial subgroups may provide full relief in many instances but limitations could occur in other instances. It is also worth considering the impact of Federal Reserve Regulation W when a bank CFC confers a benefit on a non-bank chain entity.

Taxpayers should conduct a thorough review of their organizational structures and financing needs to determine whether to make a CFC group election, and the best course of action to limit the potential negative effects of new Section 163(j).

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ENDNOTES

¹ Section 163(j)(4)(B)(ii). See H.R. Rep. No. 247, 101st Cong., 1st Sess. 1244 (1989), at 1244.

² Prop. Reg. Section 1.163(j)-1(b)(16).

³ Section 163(j)(7).

⁴ The Proposed Regulations also provide detailed rules on partnerships and subchapter S corporations.

⁵ Prop. Reg. Section 1.163(j)-7(b)(3).

⁶ Prop. Reg. Section 1.163(j)-7(f)(6). For purposes of identifying a CFC group, consolidated group members, as well as individuals filing a joint return, would be treated as a single person. Further, stock owned by certain pass-through entities would be treated as owned by the owners or beneficiaries of the pass-through entity.

⁷ Prop. Reg. Section 1.163(j)-7(b)(5)(iii).

⁸ Prop. Reg. Section 1.163(j)-7(b)(4). If the CFC group contains a financial services subgroup, this rule would only apply if all, or none, of the CFC group members are financial services subgroup members. A partnership would not be treated as a CFC group member, however, if the partnership were engaged in a US trade or business, directly or indirectly, one or more partners had income effectively connected with the conduct of a US trade or business (ECI), and at least one of the partners were not exempt from US tax under an applicable US tax treaty.

⁹ Prop. Reg. Section 1.163(j)-7(f)(8).

¹⁰ Id.

¹¹ Prop. Reg. Section 1.163(j)-7(f)(3). If not all CFC group members have the same tax year, and the alternative election is made, the Proposed Regulations would require all group-level computations to be made for a majority US SH tax year.

¹² Prop. Reg. Section 1.163(j)-7(f)(1).

¹³ Prop. Reg. Section 1.163(j)-7(f)(6).

¹⁴ Prop. Reg. Section 1.163(j)-7(c).

¹⁵ A CFC group member that is a partnership would not have ETI because the ETI would be allocated to its partners. A higher-tier partnership may take into account a pro rata share of the ETI of a lower-tier non-partnership member without ETI, for purposes of computing the higher-tier partnership's adjusted taxable income and determining if the higher-tier partnership has ETI that may be allocated to its partners that are CFC group members.

¹⁶ Prop. Reg. Section 1.163(j)-7(d). Separately, Prop. Reg. Section 1.163(j)-1 also provides that, to the extent a US SH includes amounts in gross income under Sections 78, 951(a) or 951A(a) that are not properly allocable to a non-excepted trade or business, then those amounts are not included in adjusted taxable income.

¹⁷ Prop. Reg. Section 1.163(j)-7(d)(2).

¹⁸ Prop. Reg. Section 1.163(j)-7(d)(3).

¹⁹ Prop. Reg. Section 1.163(j)-7(e).