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Business Tax

Proposed business interest regs: C corporation rules

Thomson Reuters Tax & Accounting  

Thomson Reuters Tax & Accounting  

Preamble to Prop Reg REG-106089-18Prop Reg §1.163(j)-4Prop Reg §1.163(j)-5Prop Reg §1.163(j)-11

IRS has issued proposed regs under Code Sec. 163(j), as added by the Tax Cuts and Jobs Act, that limit the business interest expense deduction for certain taxpayers. In this article, we discuss certain rules regarding the computation of items of income and expense under Code Sec. 163(j), and of the disallowed business interest expense carryforward, for taxpayers that are C corporations (including, in certain cases, members of a consolidated group, real estate investment trusts (REITs), and regulated investment companies (RICs)) and tax-exempt corporations.

Background.  For tax years beginning after Dec. 31, 2017, the deduction allowed for business interest for any tax year can’t exceed the sum of (Code Sec. 163(j)(1)): (1) the taxpayer’s business interest income for the tax year; (Code Sec. 163(j)(1)(A)) (2) 30% of the taxpayer’s adjusted taxable income (ATI) for the tax year; plus (Code Sec. 163(j)(1)(B)) (3) the taxpayer’s floor plan financing interest (certain interest paid by vehicle dealers) for the tax year. (Code Sec. 163(j)(1)(C))

Characterization of items of income, deduction etc.  Prop Reg §1.163(j)-4(b) sets out rules for characterizing items of income, deduction etc. of C corporations.

Code Sec. 163(j) excludes from the definition of business interest in Code Sec. 163(j)(5), investment interest within the meaning of Code Sec. 163(d), and excludes from the definition of business interest income, investment income within the meaning of Code Sec. 163(d). However, unlike other taxpayers, corporations are not subject to the rules of Code Sec. 163(d).

Prop Reg § 1.163(j)-4(b) would provide that, solely for purposes of Code Sec. 163(j), and except as otherwise provided in Prop Reg § 1.163(j)-10 (concerning allocations between excepted and non-excepted trades or businesses), all interest paid or accrued by a taxpayer that is a C corporation is treated as business interest expense, and all interest received or accrued by a taxpayer that is a C corporation and that is includible in the taxpayer’s gross income is treated as business interest income. Thus, all of a C corporation’s interest expense would be subject to limitation under Code Sec. 163(j), and all of a C corporation’s interest income would increase the C corporation’s Code Sec. 163(j)limitation, except to the extent such interest expense or interest income is allocable to an excepted trade or business under Prop Reg § 1.163(j)-10.

Prop Reg § 1.163(j)-4(b) would further provide that, solely for purposes of Code Sec. 163(j), and except as otherwise provided in Prop Reg § 1.163(j)-10, all other items of income, gain, deduction, or loss of a taxpayer that is a C corporation are properly allocable to a trade or business. As a result, such tax items would be factored into a C corporation’s calculation of its ATI (except to the extent such items are allocable to an excepted trade or business).

IRS believes that it was Congress’s intent that these rules not apply to S corporations.

Although a C corporation cannot have investment interest, investment expenses, or investment income, within the meaning of Code Sec. 163(d), for purposes of Code Sec. 163(j), a partnership in which a C corporation is a partner may have such tax items. The partnership will allocate such tax items to its partners, including its C corporation partners, as separately stated items. Thus, the question arises how to treat investment interest, investment expenses, and investment income that is allocated by a partnership to a C corporation partner. To address this situation, Prop Reg § 1.163(j)-4(b) would recharacterize investment interest expense that a partnership allocates to a C corporation partner as interest expense properly allocable to a trade or business of the C corporation. Similarly, Prop Reg § 1.163(j)-4(b) would treat investment income and investment expenses that a partnership allocates to a C corporation partner as properly allocable to a trade or business of the C corporation. However, this rule would not apply to the extent a C corporation partner is allocated a share of a domestic partnership’s gross income inclusions under Code Sec. 951(a) (income of controlled foreign corporation shareholders) or Code Sec. 951A(a) (global intangible low-taxed income) that are treated as investment income at the partnership level.

Subject to exceptions contained in the proposed regs, the foregoing rules would apply to RICs and REITs.

These rules also would apply to a corporation that is subject to the unrelated business income tax under Code Sec. 511, but only with respect to such corporation’s items of income, gain, deduction, or loss that are taken into account in computing the corporation’s unrelated business taxable income.

Effect on earnings and profits.   Prop Reg § 1.163(j)-4(c) generally would provide that the disallowance and carryforward of a deduction for a C corporation’s business interest expense under Prop Reg § 1.163(j)-2 will not affect whether or when such business interest expense reduces the taxpayer’s E&P. In other words, C corporations generally should not wait to reduce their E&P for business interest expense until the tax year in which a deduction for such expense is allowed under Code Sec. 163(j).

However, the Code Sec. 163(j) regs would contain several modifications to or clarifications of the general rule regarding E&P. For example, a taxpayer would not reduce its E&P in a taxable year beginning after Dec. 31, 2017, to reflect any carryforwards of disallowed disqualified interest (within the meaning of former Code Section 163(j)) to the extent the taxpayer previously reduced its E&P to reflect those interest payments in a prior tax year. For additional information on this exception, see Prop Reg § 1.163(j)-11(b).

REITs and RICs. RICs and REITs are C corporations and are generally subject to the rules that apply to other C corporations, unless a provision in subchapter M of chapter 1 of the Code makes the rules inapplicable. There are no rules in subchapter M or Code Sec. 163(j) that make Code Sec. 163(j) inapplicable to REITs or RICs. Therefore, under the proposed regs, RICs and REITs would be subject to Code Sec. 163(j). IRS notes, however, that some REITs may not have any business interest expense subject to limitation under Code Sec. 163(j) because they have only electing real property trades or businesses, i.e. businesses which Code Sec. 163(j)(7)(B) provides are not subject to Code Sec. 163(j).

RICs and REITs often derive a significant amount (if not all) of their income from property held for investment. However, under the proposed regs, RICs and REITs would apply the same rules as other C corporations in determining which items are properly allocable to a trade or business. Thus, solely for purposes of Code Sec. 163(j), all of the interest expense and interest income of a RIC or REIT would be treated as business interest expense and business interest income, and all other items of income, gain, deduction, or loss of a RIC or REIT would be treated as properly allocable to a trade or business under Prop Reg § 1.163(j)-4(b), except as otherwise provided in Prop Reg § 1.163(j)-10.

RICs and REITs differ from other taxpayers because the income tax liability of a RIC or REIT is not based directly on its taxable income. Instead, tax is imposed on a RIC’s investment company taxable income (ICTI) and a REIT’s real estate investment trust taxable income (REITTI), each of which is determined by making certain adjustments to taxable income. These adjustments include the allowance of the deduction for dividends paid and the disallowance of the special corporate deductions in part VIII of subchapter B of chapter 1 of the Code (Code Sec. 241 and following) except Code Sec. 248.

Under Code Sec. 163(j)(8), a taxpayer’s ATI generally is based on its taxable income, and there is no statutory requirement under which the ATI of a RIC or REIT would be based on ICTI or REITTI. Therefore, unless regs provide otherwise, the ATI of a RIC or REIT does not reflect the deduction for dividends paid. And, under the proposed regs, the ATI of a RIC or REIT would be increased by the amounts of these special corporate deductions, which decreased the RIC’s or REIT’s taxable income.

Special rules for consolidated groups.  The legislative history of Code Sec. 163(j) states that, “[i]n the case of a group of affiliated corporations that file a consolidated return, the limitation applies at the consolidated tax return filing level.” H. Rept. 115-466, at 386 (2017).

Thus, Prop Reg § 1.163(j)-4(d) generally would provide that a consolidated group (as defined in Reg. §1.1502-1(h)) has a single Code Sec. 163(j) limitation. In contrast, members of an affiliated group that does not file a consolidated return would not be aggregated for purposes of applying the Code Sec. 163(j) limitation. Additionally, partnerships that are wholly owned by members of a consolidated group would not be aggregated with the consolidated group for purposes of applying the Code Sec. 163(j) limitation.

Prop Reg § 1.163(j)-4(d) would provide specific rules regarding the calculation of the Code Sec. 163(j) limitation for a consolidated group. In particular, Prop Reg § 1.163(j)-4(d) would provide that the relevant taxable income in computing the group’s ATI is the group’s consolidated taxable income determined under Reg. § 1.1502-11 without regard to any carryforwards or disallowances under Code Sec. 163(j). Additionally, if for a tax year a member of a consolidated group is allowed a deduction under Code Sec. 250(a)(1) (deduction with respect to certain foreign income) that is properly allocable to a non-excepted trade or business, then, for purposes of calculating ATI, consolidated taxable income for the tax year is determined as if the deduction were not subject to the limitation in Code Sec. 250(a)(2) and the regs thereunder. For this purpose, the amount of the deduction allowed under Code Sec. 250(a)(1) is determined without regard to the application of Code Sec. 163(j) and the Code Sec. 163(j) regs.

Moreover, for purposes of calculating the group’s Code Sec. 163(j) limitation, the group’s current-year business interest expense and business interest income, respectively, would be the sum of the current-year business interest expense and business interest income of all members of the group. For purposes of the proposed Code Sec. 163(j) regs, the term “current-year business interest expense” means business interest expense that would be deductible in the current tax year without regard to Code Sec. 163(j) and that is not a disallowed business interest expense carryforward from a prior tax year (see Prop Reg § 1.163(j)-5(a)(2)(i)).

Intercompany obligations (as defined in Reg. §1.1502-13(g)(2)(ii)) would be disregarded for purposes of determining a member’s current-year business interest expense and business interest income and for purposes of calculating the consolidated group’s ATI, and intercompany items and corresponding items would be disregarded for purposes of calculating the group’s ATI to the extent those items offset in amount.

Prop Reg § 1.163(j)-4(d) also cross-references the rules in Reg. §1.1502-32(b), which govern investment adjustments within a consolidated group. Under those rules, if a member has current-year business interest expense for which a d,eduction is disallowed in the current taxable year under Code Sec. 163(j), basis in the member’s stock would be adjusted in a later taxable year when the expense is absorbed by the group.

Prop Reg § 1.163(j)-11(a) provides rules that apply if a corporation (S) that is subject to the Code Sec. 163(j) limitation joins a consolidated group whose tax year began before Jan. 1, 2018, and thus is not currently subject to the Code Sec. 163(j) limitation. For example, assume that S is a calendar-year, stand-alone C corporation, and that S is acquired by Acquiring Group (with a November 30 fiscal year) on May 31, 2018. Acquiring Group is not subject to the Code Sec. 163(j) limitation during its tax year beginning Dec. 1, 2017, but S is subject to the Code Sec. 163(j) limitation for its short tax year beginning Jan. 1, 2018. Prop Reg § 1.163(j)-11(a) provides that, in such situations, the status of the acquiring group will control the application of Code Sec. 163(j) to a target during the period that the target is included in the group. Thus, if S is subject to the Code Sec. 163(j) limitation at the time of its acquisition by a consolidated group with a tax year beginning before Jan. 1, 2018, then S will not be subject to the Code Sec. 163(j) limitation for the portion of the acquiring group’s tax year in which S is a member.

In addition, any disallowed business interest expense carryforwards from S’s tax year that ended on the date of S’s change in status will be carried forward to the acquiring group’s first tax year beginning after Dec. 31, 2017.

Disallowed business interest expense carryforwards.  Prop Reg § 1.163(j)-5 would provide certain rules regarding disallowed business interest expense carryforwards for taxpayers that are C corporations, including members of a consolidated group.

Prop Reg § 1.163(j)-5(b)(2) generally would provide that, for a C corporation taxpayer that is not a member of a consolidated group, current-year business interest expense is deducted in the current tax year before any disallowed business interest expense carryforwards from a prior tax year are deducted in that year. Disallowed business interest expense carryforwards are then deducted in the order of the tax years in which they arose, beginning with the earliest tax year, subject to certain limitations.

Prop Reg § 1.163(j)-5(b)(3) would provide similar rules applicable to consolidated groups. In addition, disallowed business interest expense carryforwards from prior separate limitation years (as defined in Reg. §1.1502-1(e)) would be subject to the separate return limitation year (SRLY) limitation.

The proposed regs provide several reasons for the above ordering rules. For instance, IRS notes that, under Prop Reg § 1.163(j)-4(c) (see above), C corporations must track their disallowed business interest expense carryforwards by the year in which such items arose (and in which an E&P adjustment was made) to ensure that E&P is not further reduced in a subsequent year in which the carryforward is deducted. Thus, IRS has determined that these proposed rules should not create an additional administrative burden for C corporations.

And, Prop Reg § 1.163(j)-5(b)(3) would further provide rules regarding which member’s business interest expense would be deducted by the consolidated group in the current tax year. That proposed reg provides ordering rules that would apply if the aggregate amount of business interest expense, including carryforwards, of all members exceeds the group’s Code Sec. 163(j) limitation for the year.

In addition:

Prop Reg § 1.163(j)-5(c) would provide rules with respect to disallowed business interest expense carryforwards in transactions to which Code Sec. 381(a) (carryovers in certain corporate acquisitions) applies.

Prop Reg § 1.163(j)-5(d) would provide rules or limitations on disallowed business interest expense carryforwards from separate return limitation years (SRLYs).

… The Code Sec. 382 limitation limits a taxpayer’s ability to reduce its taxable income simply by acquiring a loss corporation. Prop Reg § 1.163(j)-5(e) lists various aspects of the interaction between Code Sec. 382 and the business interest expense rules and cross-references to where rules on those aspects are provided.

Prop Reg § 1.163(j)-5(f) would provide rules regarding the overlap of the SRLY limitation with Code Sec. 382.

References: For the post-2017 business interest deduction limitation, see FTC 2d/FIN ¶K-5430 et seq.; United States Tax Reporter ¶1634.061.

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