Craig Gibian is a Principal with Deloitte Tax LLP and is a member of Deloitte’s Washington National Tax (WNT) Financial Instruments group. In his current role, Mr. Gibian assists clients with the taxation of debt and financial derivatives in a variety of contexts, including investment management, and mergers and acquisitions.
David Levine is a Tax Senior Manager with Deloitte Tax LLP and is a member of Deloitte’s WNT group. In his current role, Mr. Levine advises U.S.- and foreign-based multinationals on a wide range of international tax matters, including cross-border mergers and acquisitions, restructurings, and financing.
Paul Epstein is a Managing Director with Deloitte Tax LLP and is a member of Deloitte’s WNT International group. In his current role, Mr. Epstein advises primarily on foreign taxpayer investment, operations, and financings in the U.S.
The foregoing Deloitte practitioners answered the following questions for BEPS Global Currents on December 24, 2018, regarding the Section 163(j) interest expense limitation proposed regs (REG-106089-18) released on November 26, 2018 (the “Proposed Section 163(j) Regs”):
Q: Even if taxpayers have already modelled the impact of new Section 163(j) on their financing structures, should they now re-evaluate the structures in light of the broad “interest” definition in the Proposed Section 163(j) Regs?
A: The broad definition of “interest” in the Proposed Section 163(j) Regs will likely force many taxpayers to re-evaluate their potential interest expense limitation under Section 163(j). It is unlikely that a taxpayer modelling the potential for an interest expense limitation under Section 163(j) would have taken into account certain of the items that would be treated as “interest” for this purpose if the Proposed Section 163(j) Regs are finalized in their current form. For example, debt issuance costs subject to Treas. Reg. 1.446-5 are included in the definition of “interest” under the Proposed Section 163(j) Regs, but such items have not historically been considered interest and traditionally have been deducted under Section 162 as ordinary and necessary business expenses. The same could be said of expense relating to derivatives that affect a taxpayer’s cost of borrowing, such as interest rate hedges, as well as a number of other items set forth in the Proposed Section 163(j) Regs. In this regard, the preamble to the Proposed Section 163(j) Regs does acknowledge that the broad definition of interest is intended to cover items previously deducted under Section 162, and not subject to interest expense limitation provisions.
While the inclusion of deferred financing costs would necessarily work to increase the potential for deferred interest under Section 163(j), the inclusion of items that affect a taxpayer’s cost of borrowing could cut either way, because of the potential for a reduction in interest expense. That being said, the inclusion of items not typically considered interest may be difficult to model and would greatly complicate compliance with Section 163(j). In addition to deferred financing costs and items affecting the cost of borrowings, commitment fees also stand out as an area that will create further complexity. Taxpayers and practitioners have also begun to identify many of the complexities that the broad definition of “interest” will create in the foreign currency area.
Q: Unlike all other TCJA proposed regs issued so far, the Proposed Section 163(j) Regs would not be retroactive to the date of TCJA enactment, unless a taxpayer elects retroactivity. What impact(s) may this have on taxpayers? Do you see the broad interest definition in the Proposed Section 163(j) Regs as being a significant factor in taxpayer’s deciding whether to elect retroactive application of the Proposed Section 163(j) Regs?
A: Many taxpayers will have to make a decision regarding whether to adopt the Proposed Section 163(j) Regs. As described above, the inclusion of certain items of expense not typically considered interest, such as debt issuance costs, would have a negative impact on a taxpayer’s Section 163(j) limitation. On the other hand, the Proposed Section 163(j) Regs would also treat as “interest” certain items of income that may not otherwise be considered interest (such as income from derivatives affecting a taxpayer’s cost of borrowing), which could be beneficial. So taxpayers will need to consider these items, which could cut either way, and decide whether adopting the Proposed Section 163(j) Regs is beneficial as compared to a position based on the statutory language. Of course, there are other areas of the Proposed Section 163(j) Regs that may prove beneficial or detrimental to taxpayers, including in the areas of the treatment of partnerships, consolidated groups and controlled foreign corporations (CFCs). In the end, this may be another modelling exercise, which is complicated, time-consuming and subject to many uncertainties (including the appropriate position under Section 163(j) in the absence of the Proposed Section 163(j) Regs).
Another question that taxpayers must consider is whether a particular position means that they have either adopted or not adopted the Proposed Section 163(j) Regs. While a taxpayer should not be entitled to adopt only the favorable aspects of the Proposed Section 163(j) Regs, taking a position that is consistent with the Proposed Section 163(j) Regs does not mean that the taxpayer has necessarily adopted the Proposed Section 163(j) Regs. That is, a taxpayer may determine that a position exists under the statutory language that is merely reinforced by the Proposed Section 163(j) Regs and the taxpayer is not relying on the Proposed Section 163(j) Regs for its position. This will be a facts and circumstances determination where caution and judgement will be important.
Q: The Proposed Section 163(j) Regs do not address the interaction of new Section 163(j) with the base erosion and anti-abuse tax (BEAT) rules (Section 59A), despite Treasury saying in Notice 2018-28 that it intends to address the issue. What proposed rules on this point are you hoping Treasury will provide?
A: The proposed BEAT regulations (REG-104259-18) of December 13, 2018, provide detailed rules to address the coordination of the BEAT and Section 163(j) rules, which generally follow the statutory coordination rule in Section 59A. The Proposed Section 163(j) Regs provide a welcome departure from a rule announced in IRS Notice 2018-28 regarding the potential application of the BEAT to interest carried forward from the “old” Section 163(j) regime; unlike IRS Notice 2018-28, the Proposed Section 163(j) Regs generally provide that disallowed interest expense carried forward from such “pre-BEAT” years does not give rise to base erosion payments, if deducted in a tax year to which the BEAT applies.
Q: To the extent the IRS and Treasury limit deductions for business interest expense on loans between related CFCs, this could lead to a higher GILTI inclusion for the U.S. shareholder under Section 951A. Can you speak about the Proposed Section 163(j) Regs election to apply an alternative method to avoid inappropriate U.S. federal income tax mismatches?
A: Treasury’s and the IRS’s decision to provide relief for the “phantom GILTI” problem created by CFC-to-CFC loans – full income inclusion for the lender CFC but disallowance of all or a portion of the interest deduction of the borrower CFC in calculating tested income – was welcome news to many taxpayers. However, in doing so, they created a regime that added substantial complexity. Treasury and the IRS attempted to solve the phantom GILTI problem through the elective “CFC group” rules, but we wonder whether certain taxpayers would have preferred a simpler regime that instead simply disregards such internal loans.
Furthermore, one could question why Treasury and the IRS did not provide broader relief to CFCs and their U.S. shareholders. Although the CFC group rules allow “sharing” of excess Section 163(j) capacity among CFCs, they only permit sharing in one direction, “upward” to CFCs that are in the chain of direct ownership. In addition, the rules do not permit U.S. shareholders to increase their adjusted taxable income (ATI) by any portion of their GILTI and Subpart F inclusions, unless a CFC group election is made; it is difficult to see why this benefit should be conditioned on the election, especially in situations where the election is not available.
Q: The Proposed Section 163(j) Regs modify various tax attribution definitions for Section 163(j) purposes (e.g., “business interest income”) for foreign persons with income that is effectively connected with a U.S. trade or business (ECI). Do you have any issues with this part of the Proposed Section 163(j) Regs?
A: In general, the ECI provisions essentially require application of the general rules of Section 163(j), but limit their application to the amount that apportions to ECI. Although the Proposed Section 163(j) Regs are a good first step, we believe they will require further development to coordinate the general rules of Section 163(j) with the inbound provisions. For example, although the Proposed Section 163(j) Regs contain seven examples, none of them address situations in which the foreign corporation has interest income. Further, none of the examples demonstrate the application of the interest equivalent or hedging rules in an ECI context. In addition, although Prop. Reg. 1.163(j)-8 coordinates with Treas. Reg. 1.882-5, it does not provide any coordination with the 1996 Prop. Reg. 1.882-5 and the U.S. asset rules in the 1996 Prop. Reg. 1.884-1(d).
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