Here, Law360 explores five important parts of the final regulations that may have initially been overlooked.
Definition of Interest
The Tax Cuts and Jobs Act
limited a deduction on interest available to borrowers under Section 163(j) of the Internal Revenue Code such that the deduction for net business interest expenses is limited to 30% of adjusted taxable income. That means the larger the ATI, the larger the available deduction.
Final rules issued by the Internal Revenue Service on the Tax Cuts and Jobs Act's 30% limit on business interest deductions modify what constitutes interest subject to the deduction limitation. (Chip Somodevilla via Getty Images)
defines business interest as any interest paid or accrued on indebtedness properly allocable to a trade or business. In 2018, the IRS issued proposed rules that adopted an interpretation of that definition that would subject three buckets of items to the 30% cap.The first bucket, which was not substantively changed in the final rules, defines interest as compensation for the use and forbearance of money, which covers items typically thought of as interest under the IRC.
The second bucket added to the definition of interest the interest component of swaps with significant nonperiodic payments, which for purposes of Section 163(j) are divided into two separate transactions: an on-market, level payment swap and a loan. Under this approach, the time value of the loan is treated as interest subject to Section 163(j). The final regulations made technical changes to that second bucket, delaying the rule's effective date for one year and adding exceptions for cleared swaps and noncleared swaps that require the parties to meet the margin or collateral requirements of a federal regulator.
Under the proposed rules, the third bucket defining interest subject to Section 163(j) included several categories of items that can affect a taxpayer's effective cost of borrowing, such as debt issuance expenses or loan commitment fees. That bucket was controversial because it contained items that may not be treated as interest for other federal tax purposes, according to Andy Howlett, a member at Miller & Chevalier Chtd.
After receiving several critical comments, the IRS in the final rules excluded debt issuance costs from the definition of interest.
"A lot of the comments, including from what I'll call some of the heavy-hitter, scholarship parties, like the American Bar Association Section of Taxation … said this category is too broad," Howlett said.
It makes sense to exclude debt issuance costs from Section 163(j) because they are not traditionally thought of as interest, he said. When someone borrows $100 at a 10% interest rate, the borrower does not walk out of the bank with $100 because there can be a charge, say $2, for working with the bank and for the lawyers to paper the loan, so the amount may actually be $98, Howlett said.
Another interesting change, in the partnership context, is the concept of guaranteed payments for the use of capital, in which a member contributes money to the partnership but expects a return for that contribution regardless of the success or failure of the venture, Howlett said. Under the proposed rules, if a partner contributed $1,000 in return for $100 a year, that $100 was treated as interest, but under the final regulations it's not, he said.
The final rules also excluded from the definition of interest another debt-related fee called a commitment fee, charged to a borrower by a lender to pay for a commitment to lend funds to the borrower in the future. However, the U.S. Department of the Treasury did say future guidance would clarify the treatment of commitment fees for all federal tax purposes, Howlett said.
FDII Calculation
Before the Section 163(j) regulations were finalized, practitioners were concerned that the business interest limitation would interact with foreign-derived intangible income under IRC Section 250
.Section 250(a)(1) generally provides a deduction based on the amount of a domestic corporation's FDII and global intangible low-taxed income, while Section 250(a)(2) limits the amount of the deduction based on taxable income.
Libin Zhang, a tax partner at Fried Frank Harris Shriver & Jacobson LLP, said it was not clear how both Section 163(j) and FDII would apply at the same time, and the proposed rules had a complicated solution and example that the final rules eliminated.
In the final rules, the government said that it needed to study the interaction further to figure out the appropriate rule to coordinate Sections 250(a)(2) and 163(j). But until then, any reasonable approach can be used.
"Until such additional guidance is effective, taxpayers may choose any reasonable approach (which could include an ordering rule or the use of simultaneous equations) for coordinating taxable income-based provisions as long as such approach is applied consistently for all relevant taxable years," the final rules said.
One reasonable approach could be to use simultaneous equations, which involves separately figuring out the Section 163(j) and Section 250 amounts and then using simple algebra — two equations with two unknowns — to figure out the two unknowns at the same time, Zhang said.
The IRS used such an approach in Revenue Ruling 79-347
from 1979 to calculate a dividends received deduction under Section 243 along with a percentage depletion deduction for specified income from oil and gas wells under Section 613A ."In my opinion there's one reasonable and accurate method, which is to use simultaneous equations to get to the right number," Zhang said.
Tax Shelters
Section 163(j)'s limitation on interest expense deductions does not apply to a business with gross receipts of $25 million or less; however, tax shelters cannot qualify for the exception.
The proposed regulations said a tax shelter is defined by cross-referencing Section 448
with what is considered a syndicate under Section 1256(e)(3)(B) , which is any partnership or entity other than a corporation that is not an S corporation with more than 35% of losses during the taxable year that are allocated to limited partners.In a comment letter, the American Institute of Certified Public Accountants urged the IRS to grant relief for certain small businesses from the definition of a tax shelter. The group suggested that if an entity has $25 million or less in gross receipts, then it should not matter if the business had a tax loss for that year.
If the small-business exception rule were kept as proposed, then businesses that fluctuate between having taxable income and losses might be eligible for the exception in some years and not others. Such inconsistency would create administrative burdens for the IRS as well as for small businesses, the AICPA said.
Zhang said the proposed rules' definition of a tax shelter was fairly broad and captures businesses that may not normally be considered tax shelters, such as those that generate significant losses but are owned by passive investors. However, the final rules did not relent and maintained the definition of tax shelter as a syndicate under Section 1256.
"People commented on this and asked for relief, and the IRS basically said, 'No, the statute says what it says and the definition of tax shelter is clear,'" Zhang said. "They did sort of copy a few existing rules about what kinds of losses count for the tax shelter calculation, but otherwise they refused to grant any relief for small businesses that happen to be also a tax shelter."
Calculating the Section 163(j) limitation is done year by year, which, compounded with the economic hit sustained by many small businesses due to the novel coronavirus pandemic, could mean many more small businesses may fit the definition of a tax shelter and not fall under the small business exception, he said.
"Companies that normally make money would have losses and find they are a tax shelter under this rule," Zhang said. "And even though they're a relatively small business, they'd be subject to the 163(j) limitation."
11-Step Partnership Allocation Test
The business interest deduction limits are applied at the partnership level such that the partnership determines its Section 163(j) limitation and allowable business interest deduction, then allocates its aggregate permitted interest deduction among its partners.
Business interest expense that cannot be deducted during a taxable year is treated as a tax attribute called excess business interest. EBI can be deducted by the partner only if the partnership allocates that partner's excess taxable income in a subsequent year. The proposed regulations created a mandatory 11-step process to determine the allocation of the allowable deduction determined at the partnership level as well as EBI and ETI to the individual partners.
The final rules did not follow a request by the ABA tax section and others to allow a partnership to choose either the 11-step method or another approach that is consistent with the rules.
Zhang told Law360 that the decision to keep the 11-step process and not afford any wiggle room would mean that businesses both big and small would still have to figure out the complicated steps and apply them.
While the IRS said keeping that complexity was acceptable because many large companies have to deal with other complex issues, it could be problematic for some smaller businesses with fewer resources that are subject to Section 163(j) because of the tax shelter definition, he said.
"As you can imagine, a lot of small businesses are exempt, but there are small businesses that are tax shelters and are not exempt, so they, like everybody else, have to apply the fairly complicated 11-step process," Zhang said.
Michael Bolotin, a tax partner at Debevoise & Plimpton LLP, said even though the IRS retained the 11-step process for partnerships, it also created a carveout that will let some partnerships avoid calculating a Section 163(j) limitation. If a partnership allocates items pro rata — based on each member's proportionate share — then the partnership doesn't need to use the 11-step process.
There are not a lot of possibilities for people to try to allocate Section 163(j) items to one party that needs them in partnerships with very simple structures, Bolotin said. In a 50/50 partnership in which everything is shared 50/50, Section 163(j) items would be shared 50/50 as well and the 11-step calculation becomes necessary, he said.
Anti-Abuse Rule
The proposed regulations had a broad anti-abuse rule that said any amount incurred in consideration of the time value of money in a transaction is treated as interest and captured under Section 163(j).
For example, a painter who normally charges $100 to paint a house but is booked until December may need that money now, so he may have the customer pay $100 now and offer $10 to the customer in December after the painting is done. According to Howlett, one could argue that under the test in the proposed rules, the $10 rebate could be treated as an interest expense paid by the painter because it was given in consideration for the time value of money, he said.
However, the final regulations steered away from that by changing the anti-abuse test from a predominant test to a principal purpose test: If the main reason behind structuring a transaction is to avoid Section 163(j), then it is recaptured as a business interest expense.
"Any expense or loss economically equivalent to interest is treated as interest expense for purposes of Section 163(j) if a principal purpose of structuring the transaction is to reduce an amount incurred by the taxpayer that otherwise would have been interest expense or treated as interest expense," the final rules said.
Under the final regulations, the test is no longer whether the expense was incurred for the time value of money but whether the principal purpose of the transaction is to avoid Section 163(j), Howlett said.
The final regulations also provide a list of helpful factors the IRS will look at to figure out if a business has a principal purpose of avoiding Section 163(j), he said. In the example of the painter, he is arguably providing the $10 rebate to secure the business of painting a house a few months from now and meet liquidity needs, and not to reduce interest subject to Section 163(j), so the rebate should not be captured under the anti-abuse provision, he said.
Bolotin said the IRS would evaluate transactions based on facts and circumstances, which means a business may have good reasons for structuring a transaction a certain way, but if a principal purpose is to avoid Section 163(j), then it will still be captured by the anti-abuse rule.
--Editing by Robert Rudinger and Neil Cohen.
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