The IRS has released additional final regulations for Internal Revenue Code (IRC) Section 163(j), a provision that limits the amount of business interest expense a taxpayer can deduct. The business interest expense limitation, established by the tax reform law commonly known as the Tax Cuts and Jobs Act (TCJA) generally stipulates that 30% of adjusted taxable income (ATI) may be deducted by affected taxpayers in any given year. Any amount disallowed is carried forward indefinitely and may be deducted in a subsequent year. A small business exemption to the business interest limitation applies to taxpayers with average annual gross receipts for the three prior tax years of $26 million or less. Aggregation rules may make it more difficult to apply this small business exemption to portfolio companies owned by private equity (PE) and venture capital (VC) firms. Businesses that qualify as real property trades or businesses are also excluded from the limitation.
In December 2018, the IRS issued proposed regulations to the Section 163(j) rules that were finalized in July 2020. Additionally, the IRS issued a second set of proposed regulations in July 2020, which were recently finalized. These latest final regulations adopt most of the proposed regulations from July 2020, retaining the same basic structure, but there were a number of revisions based on comments received. Additionally, some of the July 2020 proposed regulations were tabled for future efforts to allow additional time to consider the comments received in a piecemeal fashion.
Below are some of the clarifications finalized that may be of particular interest to PE and VC firms. The 2021 final regulations include revisions to, and clarification of, certain rules proposed in 2020 on how the Section 163(j) limitation applies to partnership, corporations, and U.S. shareholders of controlled foreign corporations (CFCs).
2020 Changes Recap
The business interest limitation was temporarily modified by the Coronavirus Aid, Relief, and Economic Security (CARES) Act to increase the limit on business interest expense to be business interest income plus 50% of ATI for tax years beginning in 2019 and 2020, unless the taxpayer elects to apply the 30% limit instead. However, partnerships are not permitted the increased 50% limitation for tax years beginning in 2019. Instead, partners treat 50% of the disallowed business interest expense allocated to them in 2019 as deductible business interest expense in 2020 that is not subject to further limitation under Section 163(j). The remaining 50% of such excess business interest expense (EBIE) remains subject to the limitation. Partners may elect out of this 50% EBIE rule. Taxpayers may further elect to use 2019 ATI when calculating their business interest limitation for the 2020 tax year.
Adjustments to Key Concepts
The final regulations updated the definition of interest with respect to interest dividends received by shareholders of a regulated investment company (RIC). They may treat these as interest income but they do not have to reduce their ATI by the deductions for dividends paid. Their ATI is reduced by the deduction for dividends received. This does not extend to shareholders for foreign investment funds, money market funds, or real estate investment trusts (REITs).
The final regulations also provide further clarity on how to calculate ATI when there was a sale or disposition of an asset by the taxpayer. They retain the “lesser of” standard from the proposed regulations. This “lesser of” standard requires taxpayers to subtract the lesser of the following from their ATI:
- Gain or sale recognized on the disposition of property, or
- Greater of allowable or allowed depreciation for the 2018-2021 tax years, or the allocable share of depreciation for those tax years in the case of the sale of a partnership interest.
Special rules apply to the sale of member stock in consolidated groups of corporations, but will not affect the treatment of deconsolidating transactions. The disposition of property, member stock, or partnership interests in a nonrecognition transaction would also have to be treated as taxable for purposes of the gain prong.
Finalized Domestic Partnership Rules
A few of the finalized rules apply specifically to partnerships.
Syndicate Clarification: The final rules confirm the definition of syndicates as seen in the proposed regulations issued last year. Syndicates, which are defined as partnerships or other entities (other than corporations that are not S-corporations) with more than 35% of losses allocated to limited partners or limited entrepreneurs, continue to be ineligible for the small business exception to Section 163(j).
Trading Partnerships: The bifurcation rule provides that income and deduction items are to be allocated in trading partnerships between partners that materially participate and partners who are passive investors. The regulations also modify the activity grouping rules to provide that any per se non-passive activity in which the partner does not materially participate may not be grouped with other activities of the partner.
Self-Charged Lending Transactions: Lending partners with interest income attributable to a self-charged lending transaction will treat that as an allocation of excess business interest income, but only to the extent of an allocation of excess business interest expense from the borrowing partnership in that year.
Publicly Traded Partnerships: Partnerships that are public do not apply the 11-step allocation rules and instead allocate excess items on a pro-rata basis.
Reserved Pass-Through Entity Rules Updates
Final guidance was not issued on the application of the Section 163(j) rules to specific pass-through entity provisions, including rules for:
- Tiered partnerships
- Partnership mergers and divisions
- Determining partner basis adjustments when there are liquidating distributions
- Determining partnership basis adjustments for partner distributions
- Allocation of interest expense associated with debt proceeds
Until more guidance is issued on these topics, pass-through entities may rely on the July 2020 proposed regulations.
Finalized Rules: All Entities
Several additional rules for Section 163(j) were finalized, including:
Safe Harbor & Bifurcation for Real Property Trades or Businesses: Businesses operating or managing qualified residential living facilities, including supplemental assistive, nursing, or routine medical services were added to the list of trades or business that qualify as real property trades or businesses, solely for purposes of the business interest expense limitation.
Anti-Abuse Rules: Final regulations clarify that the look-through rules do not apply to nonconsolidated C corporations where the principal purpose of an upper tier borrowing funds is to allow the amount of the taxpayer's basis allocable to trades or businesses not subject to Section 163(j) to increase.
Business Interest Limitation Guidance for PE and VC Funds with International Structures
The final regulations specify that the no-negative ATI rule applies to the CFC group as a whole, rather than disallowing negative ATI of an individual CFC group member when computing the group’s ATI.
CFCs may not deduct foreign income taxes in their calculation of ATI, regardless of the U.S. shareholder’s election to deduct or credit these taxes.
Anti-abuse rules for intragroup transactions were expanded to include transactions with a principal purpose of affecting the CFC group’s Section 163(j) limitation by increasing or decreasing not only ATI, but also by adjusting business interest income.
The CFC group election will not be an annual election but each designated U.S. person must attach a statement about the CFC group election to relevant federal income tax or information returns for each taxable year in which the election is in effect.
Additional regulations are being examined for applying the Section 163(j) limitation to CFCs and U.S. persons with effectively connected income (ECI).
These final regulations were part of a last minute push by the Trump Administration to issue guidance following the enactment of the TCJA. They were published in the Federal Register on Jan. 19, 2021. They took effect on Jan. 13, 2021 and are applicable to tax years beginning on or after March 14, 2021. However, President Biden has asked agencies to consider a 60-day delay on effective dates for rules published in the Federal Register as of his inauguration. It is unclear if Treasury and the IRS will grant this request.
These final regulations provide in many aspects much-needed clarification of the 2020 proposed regulations and taxpayers may rely on them in their entirety for tax years beginning after Dec. 31, 2017.
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