On January 5, 2021, Treasury and the IRS issued a second set of final regulations on the deduction of business interest expense (the 2021 final regulations) that provide additional rules to reflect changes to Internal Revenue Code Section 163(j) made by the 2017 Tax Cuts and Jobs Act (TCJA) and the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). These final rules implement certain aspects of the proposed regulations that were published in September 2020 (the 2020 proposed regulations) concurrently with the first set of final regulations (the 2020 final regulations). The 2020 final regulations largely adopted the 2018 proposed regulations, with revisions to certain controversial rules. The new 2021 final regulations similarly follow the 2020 proposed regulations, with a few significant changes.
Section 163(j) generally limits the amount of business interest expense (BIE) that can be deducted in the current taxable year. The amount allowed as a deduction for BIE, or the Section 163(j) limitation, is limited to the sum of (1) the taxpayer’s business interest income (BII) for the taxable year, (2) 30% of the taxpayer’s adjusted taxable income (ATI) for the taxable year and (3) the taxpayer’s floor plan financing interest expense for the taxable year. The CARES Act increases the amount of the Section 163(j) deduction from 30% of ATI to 50% for taxpayers other than partnerships for taxable years beginning in 2019 and 2020 (although the taxpayer can elect to continue to use the 30% of ATI). For partnerships, the increased 50% ATI rule only applies to taxable years beginning in 2020. For taxable years beginning in 2019, 50% of a partnership’s EBIE allocated to a partner may be treated as deductible interest expense in the partner’s first taxable year beginning in 2020. Additionally, partnerships may elect to use 2019 ATI instead of 2020 ATI for purposes of computing the partnership level Section 163(j) limitation amount.
ATI is the taxable income of the taxpayer computed without regard to items not properly allocable to a trade or business; BIE and BII; net operating loss (NOL) deductions; deductions for qualified business income under Section 199A; deductions for depreciation, amortization and depletion with respect to taxable years beginning after December 31, 2017, and before January 1, 2022, and various other less common adjustments provided by the IRS.
The Section 163(j) limitation rules apply only to interest attributable to a trade or business, whether active or passive, but do not apply to investment income or investment expense, home mortgage interest, or personal interest. The term “trade or business” is generally defined with reference to Section 162 but does not, for purposes of Section 163(j), include the trade or business of performing services as an employee, an electing real property trade or business, an electing farming business, or certain utilities. Also excepted from these rules are taxpayers (other than tax shelters) that meet the small business exemption amount, which are defined as taxpayers that have average annual gross receipts for the prior three years of $26 million or less (as adjusted for inflation).
The 2021 final regulations address several rules that apply to all taxpayers including small business taxpayer exemption and the calculation of ATI. The 2021 final regulations also address certain provisions that are specific to partnerships and controlled foreign corporations. This alert summarizes the prominent rules that apply to all taxpayers. BDO has issued separate alerts to address the application of the new to partnerships and controlled foreign corporations.
Small Business Taxpayer Exemption
As discussed above, the Section 163(j) small business exemption does not apply to a taxpayer that is considered a tax shelter. A tax shelter includes, among other entities, any syndicate as defined under the Code. There had always been uncertainty as to how to determine whether an entity is considered a syndicate.
The 2021 final regulations adopted the rules from the 2020 proposed regulations by defining a syndicate as any partnership or other entity (other than a corporation that is not an S corporation) if more than 35% of the losses of such entity during the taxable year are allocated to limited partners or limited entrepreneurs. In other words, an entity whose losses are allocable to limited partners or limited entrepreneurs would be considered a syndicate only if this entity actually allocates more than 35% losses to limited partners and limited entrepreneurs in a given year.
Calculation of ATI
One key issue addressed by the 2021 final regulations relates to how a taxpayer’s ATI would be affected when the taxpayer disposes of depreciable or amortizable properties or equity interests in a partnership or member of a consolidated group that owns such depreciable or amortizable properties.
When the regulations under Section 163(j) were first proposed in 2018 (the 2018 proposed regulations), Treasury and the IRS proposed that, when a taxpayer disposes of depreciable or amortizable properties, the taxpayer would subtract from ATI the lesser of (1) any gains recognized on such disposal or (2) any deductions for depreciation, amortization and depletion taken on such properties (depreciation deductions) for taxable years beginning after December 31, 2017 and before January 1, 2022 (the EBITDA period). The rationale for this rule is that when depreciation deductions are taken during the EBITDA period, these deductions are added back to increase the taxpayer’s ATI, so when the same properties are disposed of, a corresponding amount must be subtracted from the taxpayer’s ATI.
The 2020 final regulations modified the subtraction rule by removing the “lesser of” test, requiring instead that, with respect to disposed properties, any depreciation deductions that were added back to ATI during the EBITDA period would be subtracted from ATI in the year of disposal. Thus, the amount of gain recognized from the disposition would no longer be relevant to calculate ATI. Understanding that removing the “lesser of” test could be disadvantageous to many taxpayers who generally do not recognize any gains when depreciable properties are disposed of, Treasury and the IRS re-proposed the “lesser of” test as an elective alternative for taxpayers in the 2020 proposed regulations. This election was adopted by the 2021 final regulations, with modifications.
One of the modifications to the ATI “lesser of” test provides that, to the extent that a taxpayer did not benefit from the addback of depreciation deductions to ATI during the EBITDA period, the taxpayer would not be required to subtract such portion of the deductions when the properties are disposed of. Consider this example: In a taxable year during the EBITDA period, X had ATI of $100 including an addback of depreciation deductions of $20. If the addback was not applied, X would have had ATI of $80. In the same taxable year, X had no BIE and therefore derives no benefit from the $20 increase in ATI as a result of the addback. As such, X is not required to subtract $20 from ATI in the year the properties are disposed of.
The 2021 final regulations also clarify that, for purposes of computing ATI, the amount of gain taken into account by a consolidated group upon a “sale or other disposition” includes the “net gain” the group would take into account, including as a result of intercompany transactions.
For example, assume that S (a member of the P group) would recognize $100 of gain upon the sale of property to a nonmember. However, rather than selling the property directly to a nonmember, S first might sell the property to member B and recognize $60 of gain, and B then could sell the property to the nonmember and recognize an additional $40 of gain. In either case, the group would recognize a net gain of $100 in relation to the property. Under the 2021 final regulations, that net gain of $100 is taken into account in determining the amount of any subtractions to ATI.
The “lesser of” standard does not override the rules for deconsolidating transactions (i.e., when ownership of a consolidated subsidiary falls below the 80% vote and value threshold for consolidation), which could trigger excess loss accounts and deferred intercompany gains into income. A deemed disposition of affiliated member stock can include certain nonrecognition transactions (i.e., tax-free stock transfers) and thus would also be subject to the “lesser of” rule. However, an exception exists for Section 381 transactions (e.g., tax-free asset reorganizations, such as statutory mergers, or tax-free liquidations, where one entity goes out of existence).
Regulated Investment Companies
The 2021 final regulations adopted the 2020 proposed regulations for certain rules related to Regulated Investment Companies (RICs. If an RIC has certain items of income or gain, the RIC may pay dividends that a shareholder in the RIC may treat in the same manner (or a similar manner) as the shareholder would treat the underlying item of income or gain if the shareholder realized it directly.
The 2021 final regulations also provide rules under which an RIC that earns BII may pay Section 163(j) interest dividends. The total amount of a RIC’s Section 163(j) interest dividends for a taxable year is limited to the excess of the RIC’s BII for the taxable year over the sum of the RIC’s BIE for the taxable year and the RIC’s other deductions for the taxable year that are properly allocable to the RIC’s BII.
The 2021 final regulations provide that an RIC shareholder that receives a Section 163(j) interest dividend may treat the dividend as interest income for purposes of Section 163(j), subject to holding period requirements and other limitations.
The 2021 final regulations apply to taxable years beginning on or after the date that is 60 days after the regulations are published in the Federal Register. Taxpayers and their related parties are permitted to retroactively apply the 2021 final regulations to a taxable year beginning after December 31, 2017 and before the 2021 final regulations are otherwise applicable, if the 2020 final regulations are also consistently applied to those taxable years.
It is mentioned in the preamble to the 2021 final regulations that the rules will take effect on the date the regulations are filed with the Office of the Federal Register for public inspection (instead of 60 days after the regulations are published in the Federal Register). The means that the effective dates of the final regulations will be 60 days earlier than the applicability dates. For the avoidance of doubt, the effective dates do not control when the rules are applied; instead, the applicability dates summarized herein control.
To the extent that a rule in the 2020 proposed regulations was not finalized under the 2021 final regulations, taxpayers and their related parties may rely on the rules in the 2020 proposed regulations for a taxable year beginning on or after the date that is 60 days after the date the 2021 final regulations are published in the Federal Register, provided that they consistently follow all of the rules in the 2020 proposed regulations that are not finalized to that taxable year and each subsequent taxable year beginning on or before the date the Treasury decision adopting that rule as final is applicable or other guidance regarding continued reliance is issued. It is worth noting that when the 2020 proposed regulations were published, taxpayers and their related parties were generally permitted to rely on the 2020 proposed regulations retroactively to a taxable year beginning after December 31, 2017 as long as certain consistency reequipments are met.
The 2020 proposed regulations contain special effective date rules regarding certain proposed provisions. Taxpayers are recommended to look closely into such special effective date rules before retroactively adopting the 2020 proposed regulations.