Section 163(j) Prior to TCJA
Prior to the Tax Cuts and Jobs Act (TCJA), Internal Revenue Code (IRC) Section 163(j) operated to limit interest expense deductions only in certain situations. The section was applicable to interest payments made to related parties. Although not exclusively an international tax provision, the section was often applicable to inbound U.S. taxpayers making interest payments to foreign shareholders and other related foreign corporations in situations where treaty relationships reduced the U.S. payer’s withholding obligations to less than 30 percent.
Prior §163(j) contained a safe harbor provision that allowed for related-party interest deductions in situations where the U.S. company’s debt-to-equity ratio was less than 1.5-to-1. If the U.S. taxpayer’s debt-to-equity ratio exceeded that amount, then an interest deduction was allowed only to the extent of 50 percent of adjusted taxable income (ATI). ATI was a cash flow calculation in which depreciation and amortization were added to taxable income and changes in working capital were taken into consideration. In addition, excess limitation amounts for the prior three years could be added to the ATI calculation. To the extent that interest was disallowed, it could be carried forward indefinitely to future tax years.
New IRC §163(j)’s application is no longer limited to related parties but now applies to all business interest payments by U.S. taxpayers with gross receipts exceeding $25 million. Deductions for business interest cannot exceed the sum of 1) business interest income, 2) floor financing interest (specific to the automobile dealership industry) and 3) 30 percent of ATI. As with prior law, disallowed interest is carried forward indefinitely to the next succeeding taxable year.
The section applies to interest incurred in a trade or business but does not include the following:
- Interest deductions related to performing services as an employee
- Electing real property interest (ADS depreciation required under this election)
- Electing farming interest
- Interest related to certain utility transmission companies
The ATI calculation has changed as well. Under new §163(j), ATI is defined as taxable income less 1) business interest, 2) net operating loss deductions, 3) §199A deductions and 4) depreciation and amortization deductions for years before 2022. The new §163(j) calculation no longer includes changes in working capital as an adjustment to ATI. Also, there is no provision to recapture depreciation or amortization deductions on disposition of assets.
Application of New §163(j) to Partnerships & S Corporations
New §163(j) contains complex provisions related to the application to partnerships. In general, the §163(j) limitation is applied at the partnership level and not separately stated to individual partners. However, to the extent the partnership has excess taxable income (ETI)—generally income exceeding the §163(j) limit—the partner receives its distributive share of this amount.
Excess business interest is not carried forward at the partnership level but is allocated to the partners. To the extent excess business interest is allocated to the partners, they can deduct the amount in the next year in which they are allocated ETI. Any excess business interest not used is carried forward.
In a partnership, a partner’s adjusted basis is reduced by excess business interest. However, on disposition of the partnership interest, the adjusted basis is increased for amounts of interest not yet deducted by the partner.
The §163(j) interest limitation also applies to S corps in a manner similar to partnerships. However, excess business interest expense remains as an S corp attribute and is carried forward to succeeding years.
Proposed Regulations Apply New §163(j) to Controlled Foreign Corporations
On November 26, 2018, the Treasury issued proposed regulations that extend §163(j)’s application to controlled foreign corporations (CFC). In general, §163(j) applies to each CFC similarly to the approach for domestic corporations. As a consequence, §163(j) must be considered when calculating Subpart F income and global intangible low-taxed income (GILTI).
Intercompany interest income and expense are taken into account for each CFC separately. This can result in potential mismatch issues for taxpayers who have intercompany debt between different CFCs within the group. For example, interest expense paid by one CFC could be limited, while interest income of a second related CFC could result in taxable income. To provide relief, the proposed regulations permit taxpayers to make an irrevocable election to calculate §163(j) on a group basis (CFC Group Election). The election applies to all 80 percent-owned CFCs and foreign partnerships in the group. The election is made by reporting §163(j) for CFCs on a group basis on the U.S. shareholder’s tax return.
If a CFC Group Election is made, the group first calculates the group’s net interest expense (CFC interest expense less CFC interest income). Next, net interest expense is allocated to a group member by the ratio of the member’s net interest expense divided by net interest expense of all group members (individual CFC net interest expense/group CFC net interest expense). The CFC Group Election also permits the roll-up of lower-tier CFC ETI to upper-tier CFCs. This can then be used at the upper-tier CFC level to increase ATI and therefore the §163(j) limitation.
Section 163(j) does not affect the calculation of earnings and profits (E&P) of a CFC. In addition, §163(j) will not affect the E&P calculations required for purposes of Subpart F.
Application of New §163(j) to the GILTI Provisions
The §163(j) proposed regulations address the GILTI provisions. Under the TCJA, taxpayers owning CFCs must compare the taxable income of the company’s CFCs to a deemed routine return amount calculated as 10 percent of the CFCs’ fixed assets calculated using ADS lives and rates. Any income in excess of the routine return is considered to be intangible income and subject to the GILTI provisions. GILTI together with §78 gross-up is reported as U.S. taxable income. U.S. corporate shareholders can reduce taxable income with a 50 percent deduction (reduced to 37.5 percent for years beginning after December 31, 2025). Foreign tax credits limited to 80 percent of foreign taxes paid or accrued can be claimed to offset GILTI tax liability. GILTI will be limited to the extent that GILTI and foreign-derived intangible income (FDII) together exceed the U.S. corporation’s taxable income.
The proposed regulations provide that GILTI (or Subpart F income) and §78 gross-up will not directly increase §163(j) ATI of the U.S. shareholder. In addition, the 50 percent GILTI deduction will not affect ATI. However, this rule fails to provide a benefit to U.S. shareholders owning CFCs that have ATI in excess of the 30 percent limitation.
The proposed regulations provide relief. If a CFC Group Election is made and the U.S. shareholder has a GILTI or Subpart F inclusion, then the U.S. shareholder can increase its ATI by the eligible CFC group ETI, limited to Subpart F or GILTI inclusions. Eligible group CFC ETI is calculated by first determining the taxable income of the group exceeding the 30 percent limitation and then multiplying this amount by the percentage of the CFC group’s income that is GILTI or Subpart F. For example, assume a CFC group has $200 of GILTI, $400 of total income and ETI of $50. In this case, the U.S. parent would increase ATI by $25 (50*(200/400)).
Application of New §163(j) to FDII Provisions
Under the TCJA, taxpayers are allowed a deduction for FDII. This can include foreign sales, services provided to a foreign party and foreign royalties or rents. The deduction amount is calculated by first determining deemed intangible income (defined as deduction eligible income less a deemed routine return calculated at 10 percent of the company’s fixed assets calculated using ADS lives and rates). Deemed intangible income is then multiplied by a fraction—the numerator of which is foreign-derived, deduction-eligible income and the denominator is deduction-eligible income. The result of this computation is FDII, which is subject to a 37.5 percent deduction for U.S. corporations (reduced to 21.875 percent for years beginning after December 31, 2025). FDII will be limited to the extent that FDII and GILTI together exceed the U.S. corporation’s taxable income.
The proposed regulations provide that FDII will reduce ATI for purposes of the §163(j) calculation. However, the reduction of ATI is based on a modified FDII calculation that does not take into account §163(j) limitations. The modified FDII calculation also does not take into account the FDII and GILTI taxable income limitations.
U.S. taxpayers with CFCs should carefully consider making a CFC Group Election for their tax returns beginning in 2018. Given the many complicated interrelationships between §163(j) and foreign tax provisions, it will be important to model the tax consequences of the new rules. §163(j) should be part of the decision with respect to whether to structure new loans in the U.S. or in foreign jurisdictions. Modeling will be especially important for years beginning in 2022 when depreciation and amortization deductions are no longer added back in the ATI calculation.
For more information, contact Bob, Elena or your trusted BKD advisor.