The US Department of the Treasury and the IRS issued the much-anticipated final and proposed regulations for computing the business interest deduction limitation under Section 163(j) on July 27, 2020. Along with the regulations, the IRS issued Notice 2020-59 dealing with assisted living facilities and FAQs to help with rules related to gross receipts aggregation determinations.
The final regulations will be effective for tax years beginning after their publication, but may be relied upon for tax years beginning after December 31, 2017.
Below are some highlights from the new guidance.
Determination of Adjusted Taxable Income
Under Section 163(j), for tax years beginning before 2022, adjusted taxable income (ATI) excludes deductions allowable for depreciation, amortization, or depletion. The 2018 proposed regulations concluded that depreciation, amortization and depletion capitalized to inventory under Section 263A, and included in cost of goods, couldn’t be added back to ATI.
However, the IRS and the Treasury have reversed course under the final regulations. They provide that depreciation, amortization and depletion capitalized under Section 263A for tax years beginning before January 1, 2022, are added back to ATI regardless of the period in which the capitalized amount is recovered through cost of goods sold.
Definition of Interest
The 2018 proposed regulations contained an expansive definition of interest expense that was highly criticized. The final regulations narrow the definition of interest and remove items including:
- Commitment fees
- Debt issuance costs
- Guaranteed payments
However, the final regulations have retained and modified the anti-abuse rule to potentially recast transactions with a principal purpose of avoiding Section 163(j) as a business interest expense.
Additional Guidance for Pass-Throughs
The new proposed regulations address the treatment of tiered partnerships and Section 163(j). The Treasury and the IRS chose the entity approach for applying Section 163(j) in tiered structures.
Where a lower tier partnership allocates excess business interest expenses (EBIE) to an upper tier partnership, the upper tier reduces its basis in the lower tier partnership. However, upper tier partners don’t reduce their basis in the upper tier partnership.
The proposed regulations also provide guidance for pass-through entities related to interest tracing on debt-financed distributions and self-charged interest.
The Treasury and the IRS have maintained their position that Section 163(j) applies to controlled foreign corporations (CFCs) and “other foreign corporations whose income is relevant for U.S. tax purposes.”
However, they have substantially modified the 2018 proposed rules. Consequently, new regulations have been issued in proposed form for applying the Section 163(j) limitation to CFCs and other foreign corporations. The Treasury believes the modifications will significantly reduce the related compliance and administrative burdens.
Real Estate Businesses
Taxpayers who make a real property trade or business election aren’t subject to the interest limitation rules of Section 163(j). The final regulations provide additional favorable rules for taxpayers to make the real property trade or business election under Section 163(j)(7)(B). For example, they allow otherwise exempt small businesses to make the real property trade or business election. This may provide clarity when applying the tests to determine small business status may be overly burdensome or when such determination is unclear.
In addition, the regulations allow the election to be made regardless of whether the business is considered a trade or business under Section 162. This provides an opportunity for taxpayers engaged in real estate activities—but unsure of whether their activities rise to the level of a trade or business under Section 162—to obtain certainty as to their deduction of business interest.
We’re Here to Help
The new regulations appear to address some of the more significant concerns from the initial 2018 proposed regulations, but some questions remain.
If you have any questions about how the new Section 163(j) regulations impact your business, please contact your Moss Adams professional.