September 25, 2020
IRC Section 163(j) guidance affects the natural resources industry
In final regulations (TD 9905) (the Final Regulations), the Treasury Department addresses the limitation on the deductibility of business interest expense (BIE) under IRC Section 163(j), which was significantly modified by the Tax Cuts and Jobs Act (TCJA) and then temporarily modified by the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). The Final Regulations provide guidance on (1) what constitutes interest for purposes of the limitation, (2) how to calculate the limitation, (3) which taxpayers and trades or business are subject to the limitation and (4) how the limitation applies in certain contexts (e.g., consolidated groups).
Accompanying proposed regulations (REG-107911-18) (the Proposed Regulations) address several other aspects of the limitation, including (1) substantially revised rules for applying the limitation to US shareholders of controlled foreign corporations (CFCs), (2) rules for foreign persons with effectively connected income (ECI) and (3) specific aspects of the limitation as applied to partnerships, including partnerships engaged in the trade or business of trading personal property. See Tax Alert 2020-1961 for a detailed description of the recent guidance.
The Final Regulations and the Proposed Regulations have various implications for natural resource companies and ought to carefully analyzed.
IRC Section 163(j) Final Regulations
IRC Section 163(j) limits the deduction for business interest expense for tax years beginning after December 31, 2017, to the sum of (1) the taxpayer's business interest income (BII), (2) 30% of the taxpayer's adjusted taxable income (ATI) and (3) the taxpayer's floor plan financing interest. BIE is interest that is paid or accrued on indebtedness that is properly allocable to a trade or business. The IRC Section 163(j) limitation does not apply to certain trades or businesses, such as an electing real property trade or business, an electing farming business, certain activities of regulated utilities and qualifying small businesses. Certain activities, such as performing services as an employee and intercompany or related-party services, are excluded from being a trade or business.
CARES Act modifications to IRC Section 163(j)
The CARES Act modified IRC Section 163(j) (see Tax Alert 2020-0786). For most taxpayers, the CARES Act changed the ATI limitation, increasing it from 30% to 50%, but only for tax years that begin in 2019 or 2020, with certain additional elections potentially available.
Under the CARES Act, partnerships continue to apply the 30% ATI limitation (and cannot apply the 50% limitation) for their 2019 tax years (although the percentage increases to 50% of ATI for the 2020 tax year for partnerships). In the 2020 tax year, to the extent a partner was allocated excess business interest expense (EBIE) from a partnership in the 2019 tax year, the partner may treat the interest as paid or accrued by the partner in the partner's 2020 tax year. As a result, that amount ought not to be subject to further limitation under IRC Section 163(j) (i.e., the partner can deduct that 50% portion regardless of the partner's ATI). The remaining 50% of such EBIE ought to be subject to the "normal" testing rules for EBIE at the partner level (i.e., the partner needs to receive an allocation of excess taxable income from that same partnership in future years to potentially free up those amounts).
Final and proposed regulations — natural resource industry implications
Addback of depreciation, depletion or amortization
The Final Regulations address one of the main points of uncertainty in the prior guidance — namely, how to address depreciation, amortization and depletion that is capitalized under IRC Section 263A and recovered through costs of goods sold. Under the proposed regulations released in 2018 (the 2018 proposed regulations), these deductions were not eligible to be added back to taxable income in computing ATI (through tax year 2021).
Many commentators raised questions and concerns about that position and requested that addbacks for depreciation, depletion or amortization include amounts that must be capitalized into inventory under IRC Section 263A. The arguments supporting this clarification were multi-faceted but focused on the theme that Congress may have intended these amounts to be added back (again, through the 2021 tax year). Stated differently, if depreciation, depletion or amortization cannot be added back to ATI in the applicable years, then any company producing or manufacturing items or goods (including oil and gas, mining and metals, and other energy companies, all of which are capital-intensive industries) would be at a disadvantage relative to other businesses.
The Final Regulations permit taxpayers to add back to tentative taxable income any item of depreciation, depletion or amortization that is capitalized into inventory under IRC Section 263A during tax years beginning before January 1, 2022, as a deduction for depreciation, depletion or amortization when calculating ATI. This addback applies upon capitalization, regardless of the period in which the capitalized amount is recovered through cost of goods sold. This a provision is a welcome addition for energy companies in the mining, metals, oil and gas industries, and non-excepted utilities, due to the capital-intensive nature of such businesses.
Electing real property trades or businesses
The Final Regulations also clarify and reiterate what types of businesses can be considered "electing real property trades or businesses" (and thus eligible to be outside of the interest limitation regime). Under amended final IRC Section 469 regulations, "real property" includes land, buildings and other inherently permanent structures that are affixed to land.
The term "land" includes, in part, natural products and deposits that are unsevered from the land. Natural products and deposits, such as ores and minerals, cease to be real property when they are severed, extracted or removed from the land. Accordingly, any trade or business that involves severing, extracting or removing natural products or deposits from land is not a real property trade or business for purposes of IRC Section 469(c)(7)(C) and thus IRC Section 163(j). Further, the storage or maintenance of severed or extracted natural products or deposits, such as ores and minerals, in or upon real property, does not cause the stored property to be recharacterized as real property. Similarly, any trade or business involving the storage or maintenance of severed or extracted natural products or deposits is not a real property trade or business, even though such storage or maintenance otherwise may occur upon or within real property.
Addback of certain partner-level items to ATI
The 2018 proposed regulations reduced partnership ATI by deductions claimed under IRC Sections 173 (circulation expenditures), 174(a) (research and experimental expenditures), 263(c) (intangible drilling and development expenditures), 616(a) (mine development expenditures), and 617(a) (mining exploration expenditures) (collectively, "qualified expenditures"). As a result, deductions for qualified expenditures reduced the amount of BIE a partnership could potentially deduct.
A partner may elect to capitalize its distributive share of the partnership's qualified expenditures under IRC Section 59(e)(4)(C) or may be required to capitalize a portion of its distributive share of certain qualified expenditures of the partnership under IRC Section 291(b). As a result, the taxable income that is reported by a partner in a tax year and attributable to its ownership of a partnership interest may exceed the amount of taxable income reported to the partner on a Schedule K-1.
Commenters on the 2018 proposed regulations recommended that a distributive share of partnership deductions capitalized by a partner under IRC Section 59(e) or IRC Section 291(b) increase the partner's ATI because qualified expenditures reduce both partnership ATI and excess taxable income but may not reduce the partner's taxable income. Two different approaches for achieving this result were suggested: (1) adjust the excess taxable income of the partnership, resulting in an increase to partner ATI and (2) increase the partner's ATI directly, without adjusting partnership excess taxable income.
In the Proposed Regulations, the Treasury Department and IRS agreed that a distributive share of partnership deductions capitalized by a partner under IRC Section 59(e) should increase the partner's ATI and adopted the recommended approach of increasing the partner's ATI directly, adjusting partnership excess taxable income. Accordingly, the Proposed Regulations would increase a partner's ATI by the partner's allocable share of qualified expenditures (as defined in IRC Section 59(e)(2)) to which an election under IRC Section 59(e) applies.
The Treasury Department and IRS also note that they are aware that a similar issue exists in the context of depletion and request comments on whether a similar partner-level add-back is appropriate. Further, the Treasury Department and IRS are aware that a partner may be required to capitalize certain qualified expenditures of the partnership under IRC Section 291(b) and request comments on whether a similar partner-level add-back is appropriate.
Fungibility issues for publicly traded partnerships (PTPs)
Although the market has evolved over the past couple of years, numerous natural resource companies continue to operate in the PTP format. To be freely marketable, each PTP 's unit must have identical economic and tax characteristics so that the units are fungible. For PTP units to be fungible, the IRC Section 704(b) capital account associated with each unit must be economically equivalent to the IRC Section 704(b) capital account of all other units of the same class; a PTP unit buyer must receive equivalent tax allocations regardless of the specific unit purchased. In other words, from a buyer's perspective , a PTP unit cannot have variable tax attributes depending on the identity of the PTP unit seller.
To achieve fungibility, a PTP generally (1) makes an IRC Section 754 election, under which a purchaser can insulate itself from its predecessor's allocable IRC Section 704(c) gain or loss through an IRC Section 743(b) basis adjustment and (2) adopts the remedial allocation method under IRC Section 704(c) for all of its assets. Even when the remedial allocation method is coupled with an IRC Section 754 election, however, the application of IRC Section 163(j) in the partnership context results in variable tax attributes for a buyer depending upon the tax characteristics of the interest held by the seller.
The rote application of the 2018 proposed regulations created an inappropriate result for PTPs because PTPs, unlike other partnerships, always require tax attributes to be proportionate to economic attributes to retain the fungibility of their units. Accordingly, in the Proposed Regulations, the Treasury Department and the IRS have determined that the manner in which IRC Section 163(j) applies in the partnership context should not result in the non-fungibility of PTP units.
The Proposed Regulations accordingly provide a method, solely for PTPs, for applying IRC Section 163(j) in a manner that does not result in PTP units lacking fungibility by addressing three main "fixes":
The Treasury and IRS request comments on whether the outlined approaches adequately resolve the fungibility issues created by IRC Section 163(j).
The ability under the Final Regulations for companies to add back to ATI items of depreciation, depletion and amortization is a welcome change and ought to be well received by taxpayers. Natural resource companies throughout the value chain ought to carefully analyze the effects that both the Final Regulations and the Proposed Regulations could have on net interest expense.
For multinational natural resource companies, numerous international provisions could have material impacts and ought to be thoroughly reviewed. For a detailed explanation of the international tax implications and application, please see Tax Alert 2020-1961.
The Final Regulations generally are effective and generally apply to tax years beginning 60 days on or after the date the regulations are published in the Federal Register, with special effective dates for certain provisions. The Proposed Regulations would generally apply to tax years beginning 60 days after the date the Proposed Regulations are published as final. Subject to certain requirements, taxpayers generally may apply the Final and Proposed Regulations before their applicability date, or may apply the 2018 proposed regulations, but generally must apply any set of regulations in their entirety. As a result, taxpayers should immediately begin to model and assess any benefits and adverse consequences resulting from this choice, along with its impact on historic, existing, and future tax attributes and planning (in particular for the 2019 tax year for calendar-year taxpayers).