Client Alert February 14, 2019

Transcription

1 Tax News and Developments North America Client Alert February 14, 2019 Voluminous Proposed Regulations Interpret Section 163(j) Overview On November 26, 2018, the Treasury and IRS released proposed regulations (the "Proposed Regulations") (REG ) implementing the amendments to Code section 163(j) made by the Tax Cuts and Jobs Act of 2017 (Public Law ) (the "Act" or the "TCJA"). The Proposed Regulations are voluminous (one might argue needlessly so) and address the application of section 163(j) in a variety of circumstances. It is interesting to note that the Treasury and IRS proposed the last set of regulations under section 163(j) in 1991 ("the Old Section 163(j) Proposed Regulations") and never finalized them. Our understanding is that the new Proposed Regulations will not suffer the same fate. We outline below the key provisions of the Proposed Regulations. Key Definitions in the Proposed Regulations Proposed Regulation 1.163(j)-1 defines several key terms for purposes of section 163(j), including adjusted taxable income, interest, trades or businesses and excepted trades or businesses, and floor plan financing interest expense. As discussed in more detail below, the Proposed Regulations include a number of coordination and ordering rules that coordinate the application of section 163(j) with other provisions of the Code, such as sections 250 or 246(b). The preamble to the Proposed Regulations (the "Preamble") requests comments from taxpayers on what other coordination and ordering rules should look like and suggests that such ordering rules will be described in other guidance. Prop. Reg (j)-1(b) defines the term "adjusted taxable income" ("ATI"). Although some commenters recommended that the definition for ATI adopt a cash flow approach, similar to the definition for ATI under the Old Section 163(j) Proposed Regulations, Treasury and IRS explained that they did not adopt this recommendation because neither the statutory language of the TCJA nor the H. Rept (December 15, 2017) (the "Conference Report") requires or suggests that adjustments should be made to ATI to approximate cash flow. Instead, the Proposed Regulations follow the framework established in section 163(j)(8) to determine ATI. First, taxpayers must compute their taxable income under section 63 and treat all business interest expense as deductible without regard to the limitation in section 163(j). Second, taxpayers must make adjustments to this amount as described in the Proposed Regulations to compute their ATI. For purposes of computing ATI, taxpayers may only make the adjustments described in the Proposed Regulations.

2 According to Prop. Reg (j)-1(b)(1)(i), the following items should be added back to taxable income to determine ATI: any business interest expense; NOLs under section 172; any deduction under section 199A; for taxable years beginning before January 1, 2022, any deduction for depreciation under section 167 or 168; for taxable years beginning before January 1, 2022, any deduction for the amortization of intangibles and other amortized expenditures; for taxable years beginning before January 1, 2022, any deduction for depletion under section 611; any deduction for a capital loss carryback or carryover; and any deduction or loss that is not properly allocable to a non-excepted trade or business. According to Prop. Reg (j)-1(b)(1)(ii), the following items should be subtracted from taxable income to determine ATI: any business interest income; any floor plan financing interest expense; with respect to the sale or other disposition of property, the lesser of the gain recognized on the sale or disposition and any depreciation, amortization, or depletion deductions for the taxable years beginning after December 31, 2017 and before January 1, 2022, with respect to the property; with respect to the sale or other disposition of the stock of a consolidated group that includes the selling member, the investment adjustments with respect to the stock that are attributable to deductions for depreciation, amortization, or depletion; with respect to the sale or other disposition of a partnership interest, the taxpayer's distributive share of the deductions for depreciation, amortization, or depletion with respect to the partnership's property held at the time of sale or disposition, to the extent such deductions were allowable under section 704(d); and any income or gain that is not properly allocable to a non-excepted trade or business. Observation: Taxpayers should note that Treasury and IRS announced that they intend to withdraw the Old Section 163(j) Proposed Regulations, and that those regulations provide different guidance on ATI adjustments than the Proposed Regulations. For example, the Old Section 163(j) Proposed Regulations included an exclusion from debt for commercial financing liabilities that is not included in the Proposed Regulations. The Proposed Regulations provide that depreciation, amortization, or depletion expenses that are capitalized into inventory under section 263A and included in COGS are not a depreciation, amortization, or depletion deduction for purposes of adjusting taxable income to compute ATI. 2 Tax News and Developments - Client Alert February 14, 2019

3 Other proposed regulations may affect a taxpayer's ATI computation. For example, forthcoming regulations under section 250 (Foreign Derived Intangible Income and Global Intangible Low-Taxed Income) will provide guidance on the computation of the section 250 deduction and the applicable limitation based on taxable income. Under the Proposed Regulations, taxpayer may only take each adjustment into account once when computing ATI (in other words, a deduction for the depreciation of nonbusiness property can't be treated as an increase in ATI because it's a depreciation deduction and also a deduction item that is not properly allocable to a trade or business). Prop. Reg (j)-1(b)(2) defines the term "business interest expense" as "interest expense that is properly allocable to a non-excepted trade or business or that is floor plan financing interest expense." The term also includes disallowed business interest expense carryforwards. Prop. Reg (j)-1(b)(2) defines the term "business interest income" to mean "interest income which is properly allocable to a non-excepted trade or business." Prop. Reg (j)-1(b)(17) defines the term "floor plan financing interest expense" as interest paid or accrued on floor plan financing indebtedness. The term "floor plan financing indebtedness" means indebtedness that is used to finance the acquisition of motor vehicles held for sale or lease and that is secured by the inventory so acquired. Prop. Reg (j)-1(b)(20) defines the term "interest" for purposes of section 163(j). In formulating this definition, Treasury and IRS note in the Preamble that neither the Code nor its regulations provide a generally applicable rule for when financial instruments are treated as debt for Federal income tax purposes or when a payment is treated as interest. As a result, Treasury and IRS turned to principles identified in past guidance and existing case law to define interest "to include any amount paid or accrued as compensation for the use or forbearance of money under the terms of an instrument or contractual arrangement, including a series of transactions, that is treated as a debt instrument for purposes of section 1275(a) and (d)". In addition, the Preamble notes that the Proposed Regulations include in the definition of interest "certain amounts that are closely related to interest and that affect the economic yield or cost of funds of a transaction involving interest, but that may not be compensation for the use or forbearance of money on a standalone basis." Section 1258 gain, amounts from hedging transactions, guarantee fees, and debt issuance costs subject to Treas. Reg are among the list of other items that are treated as interest for purposes of section 163(j). Finally, the definition of "interest" includes an anti-avoidance rule pursuant to which an expense or loss that is "predominately incurred in consideration of the time value of money" in a transaction (or series of transactions) in which a taxpayer secures the use of funds for a period of time is treated as interest. 3 Tax News and Developments - Client Alert February 14, 2019

4 As the Preamble to the Proposed Regulations acknowledges, the definition of interest in the Proposed Regulations is broader than a traditional definition of interest. The Proposed Regulations provide examples demonstrating the application of the definition of interest for section 163(j) purposes. Prop. Reg (j)-1(b)(38) defines the term "trade or business" for purposes of section 163(j) as a trade or business within the meaning of section 162 (based on the rationale that there is a well-developed and well-understood set of rules, administrative guidance, and case law interpreting the meaning of a trade or business under section 162). The Proposed Regulations also identify the following as excepted trades or businesses that are not subject to the section 163(j) limitation: the trade or business of providing services as an employee; certain real property businesses that elect to be excepted; certain farming businesses that elect to be excepted; and certain regulated utility businesses. The definitions apply to taxable years ending after the date that final regulations are published in the Federal Register, although Treasury and IRS will permit taxpayers to elect to apply the definitions to a taxable year beginning after December 31, 2017, as long as taxpayers apply the rules of section 163(j) consistently. Observation: Of concern to all taxpayers, the definition of "interest" in the Proposed Regulations is extremely broad, which many taxpayers may not have anticipated. If the definition of "interest" is finalized as it was proposed, taxpayers will need to develop new processes and systems to track amounts that they previously did not consider to be interest for tax purposes. Moreover, the disconnect between the definitions of interest income and deductions could lead to an increased limitation for taxpayers. Observation: The Preamble describes some of the other options that Treasury considered in drafting the Proposed Regulations, such as the different approaches that Treasury considered when defining the term "interest." Identifying other regulatory approaches that were considered and explaining why those approaches were not adopted is a relatively new development in tax regulations, but other agencies whose regulations are subject to review by the Office of Management and Budget routinely include such information in the preamble to regulations. This information may provide additional insight into Treasury's decisionmaking process in implementing the TCJA. Operative Section 163(j) Limitation Notwithstanding the otherwise voluminous nature of the Proposed Regulations, Prop. Reg (j)-2 succinctly encapsulates the primary operative rule of section 163(j). Prop. Reg (j)-2(b) provides that the amount allowed as a 4 Tax News and Developments - Client Alert February 14, 2019

5 deduction for business interest expense for a taxable year cannot exceed the sum of: 1) the taxpayer s business interest income for the taxable year; 2) 30% of the taxpayer s ATI for the taxable year (or zero if the taxpayer s ATI for the taxable year is less than zero); and 3) the taxpayer s floor plan financing interest expense for the taxable year. Under Prop. Reg. 163(j)-2(c), any business interest expense (or any disallowed disqualified interest that is properly allocable to a nonexcepted trade or business under 1.163(j)-10) disallowed in any taxable year under the foregoing rule is carried forward to the next succeeding taxable year as business interest expense also subject to limitation (unless the small business exemption applies to the taxpayer in such succeeding year). The interest expense disallowed or carried forward does not directly trace to interest expense in respect of any particular debt obligation of the taxpayer but rather is determined by reference to the total amount of business interest expense of the taxpayer in a taxable year. Observation: Disallowed business interest expense may be carried forward by the taxpayer indefinitely. In addition, pursuant to Prop. Reg (j)-3(b)(7), such disallowed interest expense carryforwards are items to which an acquiring corporation succeeds under section 381. Under the small business exemption of Prop. Reg (j)-2(d), the limitation of section 163(j) does not apply to a taxpayer (other than a tax shelter as defined in section 448(d)(3)) in a taxable year if, under section 448(c), the average annual gross receipts of such taxpayer for the 3-year period ending with the taxable year which precedes such taxable year does not exceed $25,000,000. Prop. Reg (j)-2(g) offers a number of simple examples intended to illustrate the application of the limitation under section 163(j) including the computation of ATI as discussed previously. In Example 3 of Prop. Reg (j)-2(g), for its 2019 taxable year, Y has taxable income of $30x (without regard to the application of section 163(j)) including $20x of business interest income, $50x of business interest expense (including $10x of floor plan financing interest expense), $25x of net operating loss deduction under section 172, and $15x of depreciation deduction under section 167. Example 3 concludes that Y has ATI of $90x computed by subtracting from taxable income of $30x, $10x of floor plan financing, and $20x of business interest income resulting in a provisional ATI of $0x. However, Example 3 then builds Y's ATI back up by adding back $50x of business interest expense, the $25x net operating loss deduction and the $15x depreciation deduction because ATI is computed without regard to these items. For taxable years beginning on or after January 1, 2022, deductions for depreciation, amortization, and depletion are not added back in computing ATI. Treas. Reg (j)-2(h) provides a somewhat open-ended anti-avoidance rule under section 163(j) even though the statute itself provides relatively little discretion to the Secretary (other than in providing for the computation of ATI with such other adjustments as provided by the Secretary under section 163(j)(8)(B)). Specifically, according to Treas. Reg (j)-2(h), "the Commissioner of the IRS" may disregard or recharacterize arrangements entered into with a principal 5 Tax News and Developments - Client Alert February 14, 2019

6 purpose of avoiding the rules of section 163(j) or the Proposed Regulations to the extent necessary to carry out the purposes of section 163(j). Presumably, the Treasury believes it has the authority to promulgate this broad anti-abuse rule under the authority of section Coordination Rules While Treasury and IRS have solicited additional comments from taxpayers in the Preamble, Prop. Reg (j)-3 does set forth some basic rules regarding the relationship between the section 163(j) limitation and certain other provisions of the Code. Prop. Reg. 163(j)-3(b) provides that section 163(j) and the Proposed Regulations only apply to business interest expense that would be deductible in the current taxable year without regard to section 163(j). Thus, in general, section 163(j) applies after the application of all other provisions that disallow, defer, capitalize, or otherwise limit the deduction of interest expense. However, Prop. Reg (j)-3 also sets forth a series of specific operating and ordering rules. For example, except as otherwise provided, provisions that characterize interest expense as something other than business interest expense under section 163(j), such as section 163(d), govern the treatment of that interest expense (and such interest expense is not be treated as business interest expense for any purpose under section 163(j)). For purposes of applying section 163(j), business interest expense does not include interest expense that is permanently disallowed under another provision of the Code, including sections 163(e)(5)(A)(i), 163(f), 163(l), 163(m), 264(a), 265, 267A and 279. Other than sections 461(l), 465, and 469, provisions that defer the deduction of interest expense, such as sections 163(e)(3) and 163(e)(5)(A)(ii), 267(a)(2) and (3), 1277, or 1282, apply before the application of section 163(j). For purposes other than sections 465 and 469, interest expense is taken into account for purposes of section 163(j) in the taxable year when it is no longer deferred under another section of the Code. Sections 263A and 263(g) apply before the application of section 163(j) and capitalized interest expense under those sections is not treated as business interest expense for purposes of section 163(j). Section 246A applies before section 163(j) and any reduction in the dividends received deduction under section 246A reduces the amount of business interest expense taken into account under section 163(j). In contrast, section 163(j) does apply before the application of sections 461(l), 465 and 469. Example 3 of Prop. Reg (j)-3(c) illustrates the last ordering rule (i.e., the application of section 163(j) before the application of section 469). In that example, US resident individual D is engaged in a passive rental activity within the meaning of section 469. In 2019, D has $200x of rental income and incurs $300x of expenses all properly allocable to the rental activity, consisting of $150x of interest expense, $60x of maintenance expenses, and $90x of depreciation expense. In addition, D s ATI is $400x. In the example, the section 163(j) limitation applies first to limit D's deductible interest expense to $120x, or 30% of D's ATI of $400x. D's passive activity loss under section 469 is then determined only taking into account the $120x of allowable interest deduction under section 163(j) (rather than the $150x of actual interest expense). 6 Tax News and Developments - Client Alert February 14, 2019

7 Example 2 of Prop. Reg (j)-3(c) illustrates the opposite ordering rule (i.e., the application of section 163(j) after the application of section 267). In 2019, domestic corporation Y has no business interest income, $120x of ATI, and $70x of interest expense. Of Y s interest expense, $30x is not currently deductible under section 267(a)(2). Accordingly, $30x of Y s interest expense cannot be taken into consideration for purposes of section 163(j) in 2019 because it is not currently deductible under section 267(a)(2). Y has $4x of disallowed interest expense because its interest expense allowable under section 267(a)(2), $40x, exceeds 30% of its ATI, $36x. The $30x of interest expense not currently deductible under section 267(a)(2) may become deductible in a subsequent year provided the requirements of section 267(a)(2) are satisfied in which case section 163(j) would then be applied. Observation: The Proposed Regulations reserve on the interaction of sections 163(j) and 59A (i.e., the tax on base erosion payments of taxpayers with substantial gross receipts). However, separate proposed regulations under section 59A, issued on December 13, 2018 (and summarized in a separate client alert), address such interaction in some detail. General Provisions Applicable to C Corporations As discussed herein, section 163(j) may limit the ability of a taxpayer, including a C corporation, to deduct business interest expense but does not limit investment interest expense. Section 163(d) applies to limit the deduction of investment interest expense but does not apply to C corporations. Consistent with this statutory scheme and the Conference Report accompanying the enactment of section 163(j), Prop. Reg (j)-4(b)(1) treats all interest expense of a C corporation as allocable to a trade or business, and all interest income that is includible in gross income of a C corporation as allocable to a trade or business. Indeed, according to Prop. Reg (j)-4(b)(2), solely for purposes of section 163(j), all items of income, gain, deduction, or loss of a C corporation are treated as properly allocable to a trade or business. As a definitional matter, such items are treated as "business interest" or "business interest expense" if they are not allocated to an excepted trade or business (or, in the case of interest expense, floor plan financing interest expense). Prop. Reg (j)-4(b)(3) also provide rules for treatment of separately stated investment items that a C Corporation may be allocated when it is a partner in a partnership. The Proposed Regulations provide that when investment items, such as investment income, investment interest income, or investment interest expense are allocated to a C corporation from a partnership in which the C corporation is a partner, these items would be characterized as items properly allocable to a trade or business of the corporation, thus including these investment items in the calculations of ATI and the section 163(j) limitation. The recharacterization of such items at the C corporation partner level would not affect the character of these items at the partnership level or at the level of other partners in such partnership. However, investment interest expense of a partnership that is treated as business interest expense by a C corporation 7 Tax News and Developments - Client Alert February 14, 2019

8 partner is not treated as excess business interest expense (notwithstanding its treatment at the partnership level) nor is investment interest income of a partnership that is treated as business interest income by a C corporation partner treated as excess taxable income ("ETI"). Observation: When a partnership is engaged in a trade or business, it is possible that a partner, including a C corporation, may be allocated business interest expense that is treated as excess business interest expense for purposes of section 163(j). See, e.g., Example 2(C) of Prop. Reg (j)-4(b)(6). The foregoing rules generally apply in the case of RICs, REITs and tax-exempt organizations with certain modifications. Pursuant to Prop. Reg (j)-4(c), section 163(j) generally does not affect the calculation of the earnings and profits ("E&P") of a C corporation. In other words, even if interest expense of a C corporation is disallowed as a deduction under section 163(j) in any given year, the C corporation should nonetheless reduce its E&P by the full amount of interest expense in that year, including any disallowed portion, even though the disallowed portion is carried forward and may be deducted in one or more future tax years. There are also certain special rules that modify the calculation of E&P. For example, a taxpayer does not reduce its E&P to reflect any carryforwards of disallowed interest expense under the old section 163(j) to the extent the taxpayer previously reduced its E&P in the prior taxable years. Additionally, a taxpayer that is a RIC or a REIT for the taxable year in which a deduction is disallowed under section 163(j) does not reduce its E&P in the year the expense is paid or accrued but rather in the taxable year(s) in which the business interest expense is deductible (or, if earlier, in the first taxable year for which the taxpayer is no longer a RIC or a REIT). A C corporation partner must currently reduce its E&P to reflect expense allocations from the partnership, including allocations of excess business interest expense. However, with respect to excess business interest expense in particular, the C corporation partner must increase its E&P upon the disposition of the partnership interest to reflect the amount of excess business interest expense that the partner did not take into account while it held the partnership interest. With respect to carryforwards, the Proposed Regulations require C corporations to 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. Treatment of C Corporation Carryforwards All taxpayers must calculate their section 163(j) limitation anew each year based on the taxpayer s taxable income for that year. Prop. Reg (j)-5(b) provides that any interest expense of a C corporation that is disallowed under section 163(j)(1) is carried forward to the next year as a disallowed interest expense carryforward. The Proposed Regulations also provide an ordering rule under which the current-year deductible business interest expense of a C 8 Tax News and Developments - Client Alert February 14, 2019

9 corporation is deducted before any carryforwards from prior years. If carryforwards can be used, they must be used in the order in which they arose. Observation: In contrast to the section 163(j) limitation in existence prior to the Act, section 163(j) does not provide for the carryforward of any excess limitation. The section 163(j) limitation is calculated anew each year based on the taxpayer s taxable income for that year, and no excess limitation from prior taxable years carries forward to succeeding taxable years. The ability to carry forward disallowed interest expense under section 163(j) in effect creates a new tax attribute for a C corporation. As noted above, section 381(c)(20), as added by the TCJA, provides that section 163(j) carryforwards can be acquired by successor corporations in certain tax-free liquidations and reorganizations. The Proposed Regulations confirm that section 163(j) carryforwards can be acquired in a transaction to which section 381(a) applies. The Proposed Regulations also cross-reference proposed regulations under section 382 for rules addressing the interaction of section 382 with disallowed interest expense carryforwards under section 163(j). Broadly, under Prop. Reg (a), a carryforward of disallowed business interest expense is treated, for purposes of section 382, as a separate attribute, and a C corporation can be a "loss corporation" even if its only attribute is one or more disallowed business interest expense carryforwards. Rules Applicable to Members of Consolidated Groups Generally, the Proposed Regulations adopt rules for members of consolidated groups that are similar to the rules applicable to C corporations that are not members of consolidated groups. See generally Prop. Reg (j)-4(d). For consolidated groups, the section 163(j) limitation applies at the consolidated tax return filing level. Pursuant to Prop. Reg (j)-4(d)(2), the section 163(j) limitation is determined on a single entity basis without regard to intercompany obligations or intercompany and corresponding items. Broadly, consolidated taxable income ( CTI ) is first determined without regard to section 163(j) and with making certain adjustments in order to calculate consolidated ATI. The principal adjustments include the reduction of CTI by any interest income earned for the year and by any floor plan financing interest paid or accrued for the year. The consolidated section 163(j) limitation is then determined to be the sum of 30% of the group's consolidated ATI for the year, plus the aggregate amount of the group's interest income for the year, plus the aggregate amount floor plan financing interest paid or accrued for the year. The consolidated limitation is then allocated among the members of the consolidated group incurring interest expense using the ratio of member interest expense to total interest expense of all members with interest expense. Each member then applies its allocable share of the consolidated section 163(j) limitation in determining the extent to which its interest expense is allowed as a deduction for the year. Any disallowed interest expense becomes a carryforward to the following tax year. 9 Tax News and Developments - Client Alert February 14, 2019

10 The Proposed Regulations provide that a consolidated group s disallowed business interest expense carryforwards for the current consolidated return year are the carryforwards from the group s prior consolidated return years plus any carryforwards from separate return years. As with the rules applicable to C corporations that are not members of a consolidated group, all current-year business interest expense of members of a consolidated group is deducted in the current year before any disallowed business interest expense carryforwards from prior taxable years are deducted in the current year. Disallowed business interest expense carryforwards from prior taxable years are deducted in the order of the taxable years in which they arose, beginning with the earliest taxable year, subject to certain limitations. Prop. Reg (j)-5(d) provides rules addressing the treatment of disallowed interest expense carryforwards of a consolidated group member that arose in a separate return limitation year (SRLY). Generally, a SRLY is any year during which the member was not part of the current consolidated group. In general, the taxable income of a consolidated group is determined by aggregating the income and losses of each member. Thus, a consolidated group may offset the income earned by profitable members against the losses incurred by other members. The SRLY limitation for a member's disallowed business interest expense carryforwards would be based upon a member s section 163(j) limitation for the consolidated return year under consideration, determined by reference to only the member s tax items. As a result, a member may not carry forward its unused section 163(j) SRLY limitation from one year to the next. Observation: One interesting aspect of the rules applicable to members of consolidated groups is a shift of the deduction for floor plan financing interest expense ( FPFIE ). For example, P files a calendar year consolidated return for 2019 that includes the items of P and S for the entire year. For 2019, (i) the P group s consolidated ATI is $133.33, (ii) S has FPFIE of $100 and $100 of interest income, and (iii) P has $200 of interest expense and no interest income. The consolidated section 163(j) limitation is 30% x $ ($40) + $100 (FPFIE) + $100 (S s interest income) = $240. $80 of the limitation is allocated to S ($240 x $100/$300) and $160 is allocated to P ($240 x $200/$300). Consequently, S deducts $80 of its $100 of FPFIE and P deducts $160 of its $200 of interest expense. The P group has a disallowed business interest expense carryforward of $60, allocated $20 to S and $40 to P. Interestingly, even though S would have a least a $200 section 163(j) limitation ($100 of FPFIE plus $100 of interest income) as a separate entity, more than enough for all of its FPFIE to be deducted, because it is a member of a consolidated group, $20 of its FPFIE becomes a disallowed business interest expense carryforward. For 2020 and later years, presumably the $20 disallowed business interest expense carryforward loses its status as FPFIE since there is no mechanism for tracing the source of carryforwards. 10 Tax News and Developments - Client Alert February 14, 2019

11 Application to RICS and REITS As discussed herein, 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. As a result, the provisions of the Proposed Regulations that apply to C corporations also generally apply to RICs and REITs. However, in certain cases, the general rules are modified, and the Proposed Regulations apply special rules to RICs and REITs. For example, in determining which items are properly allocable to a trade or business (and thus are included in the calculation of section 163(j) limitation on deductibility of business interest expense), the rules applicable to C corporations would also generally apply to RICs and REITs, which derive a significant amount (if not all) of their income from property held for investment. Thus, under the general rule applicable to C corporations, RICs and REITs would treat all of their interest expense and interest income as items properly allocable to a trade or business (with certain exceptions relating to excepted trade or business ). Similarly, as discussed above, a special rule applicable to RICs and REITs would provide that E&P would not be reduced by a disallowed business interest expense deduction in the year it is disallowed, or by any excess business interest expense allocated to RICs and REITs from a partnership. Application of Section 163(j) to Partnerships and Subchapter S Corporations Prop. Reg. Section 1.163(j)-6 contains rules applicable to partnerships and their partners and S corporations and their shareholders. For partnerships, the section 163(j) limitation applies at both the partnership and partner level. As a result, partnerships deduct the business interest expense allowed by Section 163(j). The section 163(j) limitation applies at the partnership level and any deduction for business interest expense within the meaning of section 163(j) is taken into account in determining the nonseparately stated taxable income or loss of the partnership. Once a partnership determines its business interest expense, business interest income, ATI, and floor plan financing interest expense, the partnership calculates its section 163(j) limitation by applying the rules of Prop. Reg (j)-2(b) and Prop. Reg (j)-6. Consistent with Notice , the Proposed Regulations would preclude the double counting of business interest income. Prop. Reg (j)-6(c) provides that if a partnership has deductible business interest expense, the deductible business interest expense is not subject to further Section 163(j) limitations at the partner level. However, deductible and excess business interest expense of the partnership retain their character at the partner level. Nonbusiness interest expense and income of a partnership becomes business interest expense and income in the hands of a corporate partner. 11 Tax News and Developments - Client Alert February 14, 2019

12 Prop. Reg (j)-6(d) provides rules related to the ATI of a partnership. A partnership s ATI takes into account Section 734(b) basis adjustments to partnership property, but partner-specific basis adjustments (such as Section 743(b) adjustments and Section 704(c)(1)(C)(i) built-in loss amounts) and remedial items of income or loss are taken into account at the partner level in determining a partner s ATI and separate section 163(j) limitation. After a partnership has calculated its section 163(j) limitation, Example 11 of Prop. Reg (j)-6(o) illustrates an 11-step process for allocating the partnership s ATI, deductible and excess business interest expense, and business interest income to its partners. The Preamble to the Proposed Regulations states that the 11-step process "preserves the entity-level calculation requirement set forth in [Section] 163(j)(4), while also preserving the economics of the partnership and respecting any special allocations made by the partnership in accordance with [Section] 704 and the regulations thereunder." The 11-step process generally requires that the partnership s business interest expense be tested at both the partnership and partner levels. Generally, retesting at the partner level (aggregate) will not cause business interest expense to be suspended if the partnership agreement does not contain special allocations and business interest expense was deductible when tested at the partnership level (entity). Step 1 (Prop. Reg (j)-6(o)(11)(i)) would require the partnership to calculate its Section 163(j) limitation under Prop. Reg. Section 1.163(j)-2(b), which would generally limit the partnership's business interest expense deduction to business interest income, plus 30% of ATI.. The second step (Prop. Reg (j)-6(o)(11)(ii)) would require the partnership to determine each partner's share of "Section 163(j) items" (business interest expense, business interest income, and items comprising ATI). Steps 3 through 5 (Prop. Reg (j)- 6(o)(11)(iii)-(v)) require the partnership to compare each partner's share of allocable business interest income to its share of allocable business interest expense to determine each partner's "remaining business interest expense" (the excess of allocable business interest expense over allocable business interest income). Steps 6 through 11 (Prop. Reg (j)-6(o)(11)(vi)-(xi)) require the partnership to adjust the allocations of ATI and related excess items (such as ATI capacity excess and ATI capacity deficit) among the partners. Section 163(j)(4)(B)(ii) provides rules for the carryforward of excess business interest expense. Prop. Reg (j)-6(g) restates Section 163(j)(4)(B)(ii). Excess business interest expense is allocated to the partner, who carries it forward at the partner level. First, excess business interest expense is treated as paid or accrued by the partner, to the extent of ETI allocated to that partner. Second, excess business interest expense may be deducted to the extent of the partner s business interest income plus 30% of adjusted taxable income. In the event a partner has excess business interest expense from a prior taxable year and is allocated ETI or excess business interest income from the same partnership in a succeeding taxable year, the partner must treat, for purposes of section 163(j), the excess business interest expense as business interest expense paid or accrued by the partner in an amount equal to the partner's share of the partnership's ETI or excess business interest income in such succeeding taxable year. 12 Tax News and Developments - Client Alert February 14, 2019

13 Section 163(j)(4)(B)(iii)(I) generally provides that a partner s adjusted basis in its partnership interest is reduced (but not below zero) by the amount of excess business interest expense allocated to the partner. If a partner disposes of a partnership interest, section 163(j)(4)(B)(iii)(II) generally provides for an increase in outside basis for unused carried-forward excess business interest expense. Prop. Reg (j)-6(h) would limit the section 163(j)(4)(B)(iii)(II) basis adjustment to only dispositions (whether by reason of taxable or non-taxable transaction) of all or substantially all of the partner's interest in the partnership. In most regards, the Proposed Regulations apply to S corporations in the same way they do to partnerships. Prop. Reg (j)-6(l)(1) provides that the section 163(j) limitation applies at the S corporation level and is determined in the same manner as for partnerships. The same rule prohibiting double counting of business interest income and floor plan financing interest expense applies to S corporations and their shareholders, and allocations of ETI and excess business interest income are made in accordance with the shareholders respective pro rata interests in the S corporation. Prop. Reg (j)-6(l) also provides rules that are specific to S corporations. Prop. Reg (j)-6(l)(5) generally provides that if an S corporation has disallowed business interest expense, it is carried forward to the succeeding year by the S corporation, instead of being allocated to its shareholders. In contrast, partners in partnerships carry forward their share of a partnership s disallowed business interest expense. Prop. Reg (j)-6(l)(8) provides that if a corporation's qualified subchapter S subsidiary election terminates and any disallowed business interest expense carryforward is attributable to the activities of the qualified subchapter S subsidiary at the time of termination, then such disallowed business interest expense carryforward remains with the parent S corporation and no portion of these items is allocable to the former qualified subchapter S subsidiary. Observation: The Proposed Regulations reserve on issues involving tiered partnerships, partnership mergers and divisions, and self-charged interest. Application to CFCs In Prop. Reg (j)-7 and portions of Prop. Reg (j)-8, Treasury and IRS establish rules for applying the section 163(j) limitation to controlled foreign corporations ( CFCs ). Application of the limitation to CFCs is a significant change from prior law, which limited the scope of section 163(j) to domestic corporations and foreign corporations with income effectively connected to a US trade or business ( ECI ). Prop. Reg (j)-8 appears to be in line with the original scope of the limitation in applying section 163(j) to any foreign corporation with ECI, while Prop. Reg (j)-7 ventures into unchartered territory by applying section 163(j) to CFCs regardless of whether they derive ECI. The changes made to section 163(j) by the TCJA are significant (indeed a complete re-write). However, the Preamble to the Proposed Regulations does not identify which of the significant amendments made to section 163(j) under the 13 Tax News and Developments - Client Alert February 14, 2019

14 TCJA provide Treasury with the authority to apply section 163(j) to CFCs. While the provision was amended to apply to non-corporate business entities and to interest paid to both related and unrelated parties, none of these amendments suggested a change in the geographic scope of section 163(j). The legislative history also fails to indicate that Congress intended for the provision to apply to CFCs. As a result, it appears that Treasury has simply decided to change course from the approach adopted in the prior regulations. This shift should be scrutinized in light of Congress' decision to forgo a worldwide group ratio limitation during tax reform. The limitation under section 163(j) was originally supplemented with a new section 163(n) in both the House and Senate versions of the TCJA. That provision would have applied to US corporations that were members of international financial reporting groups. Under section 163(n), a US corporation's interest expense would have been limited to the extent that corporation's share of the group's global net interest expense exceeded 110% of the US corporation's share of the group's global EBITDA. The conference committee dropped this provision from the final bill, leaving no worldwide limitation provision in section 163. The fact that section 163(n) was removed from the bill during the conference committee process suggests that Congress considered--and rejected--the approach adopted by Treasury in the Proposed Regulations. Observation: In light of the lack of statutory authority supporting the application of section 163(j) as revised by the TCJA to CFCs, the legislative history indicating that Congress considered and rejected a worldwide thin capitalization rule, and the general shift to a territorial regime under the TCJA, the decision to extend section 163(j) to CFCs appears to be on weak footing. We expect commenters to strenuously object to Treasury's approach in their comments on the Proposed Regulations. As a general rule, the Proposed Regulations provide that section 163(j) applies to "applicable CFCs" for purposes of determining the deductibility of an "applicable CFC s" business interest expense when computing the "applicable CFC s" taxable income. Under Prop. Reg (j)-7(f)(2), an "applicable CFC" is a CFC as defined in section 957, provided that the CFC has at least one US shareholder that holds its stock directly or through a foreign corporation, partnership, trust, or estate. Prop. Reg (j)-7(b)(2) provides that section 163(j) and the section 163(j) regulations apply to determine the deductibility of an applicable CFC's business interest expense for purposes of computing its taxable income in generally the same manner as those provisions apply to a domestic C corporation. Importantly, under Prop. Reg (j)-7(e), the disallowance and carryforward of a deduction for a CFC does not affect whether and when such business interest expense reduces the CFC's E&P. In addition, if an applicable CFC is a partner in a partnership, section 163(j) and the section 163(j) regulations apply to the partnership in the same manner as those provisions would apply if the applicable CFC were a domestic C corporation. 14 Tax News and Developments - Client Alert February 14, 2019

15 As noted in the Preamble, Treasury and IRS determined that it is appropriate to modify the general 30%-of-ATI limitation in Prop. Reg (j)-2 for purposes of applying the limitation to CFCs. The Proposed Regulations do so in two ways: (1) by modifying the computation of ATI, and (2) by providing an alternative approach for determining the limitation for a group of related CFCs. In terms of modifications, Prop. Reg (j)-7(c)(1) provides that the CFC s gross income and allowable deductions are determined under the principles of Treas. Reg (or, for CFCs deriving ECI, the rules under section 882). In order to mitigate double counting of income, under Prop. Reg (j)- 7(c)(2), dividends received from related parties are excluded for purposes of computing ATI. A payor is related for purposes of this rule if the payor is controlled by the recipient CFC, or if both the payor and the recipient are controlled by the same person. "Control" is defined as direct or indirect ownership of 50% of total voting power or value of the stock in the corporation. Observation: In the Preamble, Treasury and IRS request comments on whether, for purposes of determining ATI, a CFC should be allowed a deduction that is expressly limited to domestic corporations under the Code. For example, Treasury and IRS request comments on whether the dividends-received deduction under section 245A should apply for this purpose. Under Prop. Reg (j)-7(d)(1), certain adjustments are also made to the ATI of a US shareholder of CFCs. If a US shareholder of an applicable CFC has a "specified deemed inclusion" with respect to its CFCs, the US shareholder's ATI is reduced by the amount of the specified deemed inclusion. A specified deemed inclusion is an inclusion into gross income under sections 951(a) (i.e. subpart F income) or 951A(a) (i.e. GILTI), along with the associated section 78 gross up inclusion. These specified deemed inclusions, reduced by any deduction allowed under section 250(a)(1) (without regard to the taxable income limitation of section 250(a)(2)) by reason of such specified deemed inclusions, are subtracted from taxable income. The Preamble to the Proposed Regulations frames the alternative approach established in Prop. Reg (j)-7(b)(3) as a solution to the negative impact that applying section 163(j) to CFCs would have on provisions like GILTI. For example, without application of section 163(j), if one CFC accrues interest expense on a note issued to a related CFC, the corresponding interest expense and interest income would ordinarily offset for purposes of computing the common US shareholder's GILTI inclusion. However, if section 163(j) is applied to this scenario, the interest expense may be limited and would not fully offset the corresponding interest income to the related CFC. As a result, there would be a net increase in the recipient CFC's tested income, increasing the US shareholder's GILTI inclusion. The Preamble notes that Treasury and IRS considered simply disregarding related party interest income and interest expense to address the above concern. However, Treasury and IRS believe that this solution would not address situations where a CFC ("CFC finco") borrows from a third party and on-lends to 15 Tax News and Developments - Client Alert February 14, 2019

16 a related CFC ("funded CFC"). Under that scenario, if the interest income received from the funded CFC by the CFC finco were disregarded, the CFC finco would have no interest income and its interest expense paid to a third party would be subject to the limitation. According to the Preamble, Treasury and IRS "determined that an approach that better reflects the reality of borrowings by related CFCs is one that takes into account the principle that money is fungible within a group of highly related CFCs." The elective alternative approach for groups of related CFCs calculates a group member's limitation based on its allocable share of the CFC group's net business interest expense. There is a parallel set of rules for CFCs engaged in financial services that allows such CFCs to be treated as a sub-group, as well as for certain partnerships. Under Prop. Reg (j)-7(b)(5), the election to apply the alternative approach is irrevocable, must be applied consistently to all CFC group members, and is made simply by applying the alternative approach (separate statements or forms need not be filed). Prop. Reg (j)-7(f)(6)(i) provides that a "CFC group" for purposes of the alternative approach is any group of two or more applicable CFCs of which either a single US shareholder or a group of related US shareholders own 80% or more of the total value of each CFC in the same proportion. For purposes of assessing whether the 80% ownership threshold is met, the attribution rules under section 958(a) apply, and members of a consolidated group are treated as a single person. In addition, under Prop. Reg (j)-7(f)(6)(ii), if a US person indirectly owns shares in a CFC through a passthrough entity in which the US person has a more than 80% interest (e.g., if the intermediary passthrough entity is a partnership, 80% of the capital or profits), then the US person will be considered to hold the CFC shares held by the passthrough entity. Note that an entity that derives non-exempt ECI is not treated as a member of the CFC group, except for purposes of determining whether another entity is a member of the CFC group. Further, Prop. Reg (j)-7(b)(4) provides that, if one or more CFC group members of the same CFC group, in the aggregate, own more than 80% of the interests in the capital or profits in a partnership, then, unless that partnership has ECI, the partnership is treated as a CFC group member. The alternative approach applies a modified version of the general limitation in Prop. Reg (j)-2(b) to a portion of each CFC group member's business interest expense. If the election is made, the general limitation is applied without regard to Prop. Reg (j)-2(b)(1) and (3), meaning that the limitation is simply 30% of the CFC's ATI for the taxable year. The portion of a CFC group member's business interest expense that is subject to the modified limitation is the CFC group member's allocable share of the CFC group's applicable net business interest expense. Under Prop. Reg (j)-7(f)(3), the CFC group's applicable net business interest expense ("NBIE") is the excess of the aggregate business interest expense of each CFC group member for the taxable year, over the aggregate business interest income of each CFC group member for the same year. Prop. Reg (j)-7(f)(1) provides that a CFC group member's allocable share is determined by multiplying the CFC group's NBIE by the ratio of the group member's NBIE to the CFC group's NBIE, as illustrated below. 16 Tax News and Developments - Client Alert February 14, 2019