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The 163(j) Package – Implications for domestic corporations

163(j) Package – Implications for domestic corporations

This report provides initial impressions and observations about the 163(j) Package’s application to domestic corporations.

For a discussion of the general background and applicability dates for the Final Regulations and the 2020 Proposed Regulations, as well as links to other 163(j) Package Focus Reports, read TaxNewsFlash

Treatment of corporations and consolidated groups: Sections 1.163(j)-4, -5

General C corporation rules

The Final Regulations maintain the position provided by the 2018 Proposed Regulations that for purposes of the section 163(j) limitation, all interest expense and interest income of a C corporation per se is business interest expense (“BIE”) and business interest income (“BII”) and allocable to a trade or business. Consistent with the 2018 Proposed Regulations, the Final Regulations generally recharacterize investment interest income and expense of a partnership that is allocable to a C corporation partner as business interest income or expense that is properly allocable to a trade or business of the C corporation (though this latter rule would not apply to the extent a C corporation partner is allocated a share of a domestic partnership’s subpart F or global intangible low-taxed income (“GILTI”) gross income inclusions that are treated as investment income at the partnership level).

KPMG observation

The definition of business interest in section 163(j)(5) specifically excludes “investment interest (within the meaning of [section 163(d)],” and section 163(d)(3) defines investment interest as interest paid or accrued on debt that is properly allocable to property held for investment. Notwithstanding these statutory provisions, the Final Regulations categorically provide that all interest expense of a corporation is treated as properly allocable to a trade or business to ensure that all interest expense of a C corporation is within the reach of the section 163(j) limitation. The Preamble to the Final Regulations justifies this position by reference to a footnote in the TCJA’s legislative history. 

The Final Regulations provide that a C corporation deducts its current-year BIE before it can deduct any disallowed BIE carried forward from an earlier year. When the C corporation has sufficient capacity to deduct disallowed BIE carryforwards, the carryforwards generally are deducted based on the chronological order in which they arose, with the earliest carryforwards deducted first (though subject to limitations, such as section 382).

Under the Final Regulations, a C corporation’s earnings and profits (“E&P”) for a tax year would be calculated without regard to any disallowance of interest expense under section 163(j). Thus, a C corporation with disallowed interest expense for a particular year would calculate its current E&P by subtracting only its current year interest expense, regardless of whether a deduction for some portion or all of that expense is deferred under section 163(j) or whether the corporation can also deduct disallowed interest expense carried forward from an earlier year. The Final Regulations clarify that this rule also generally applies with respect to foreign corporations and with respect to the interest expense of a partnership in which the corporation is a partner (though a special rule applies with respect to excess BIE).

KPMG observation

The Final Regulations retain the same E&P rule as the 2018 Proposed Regulations. This rule will complicate tax attribute calculations, because adjustments to starting numbers for a particular year will have to be made to include nondeductible interest and to remove deductions for previously deferred interest for determining E&P (in contrast, investment adjustments to the stock basis in a consolidated subsidiary are made when the interest is deducted). While this rule is consistent with the rule in the 1991 Proposed Regulations under former section 163(j), it will apply to a substantially larger number of corporations.

Special E&P rules, in lieu of these general rules, apply to RICs and REITs, and with respect to excess BIE allocated from a partnership to a C corporation partner. In the case of RICs and REITs for the tax year in which a deduction for the taxpayer’s BIE is disallowed, or in which the RIC or REIT is allocated any excess BIE from a partnership, the taxpayer’s E&P are adjusted in the tax year or years in which the BIE is actually deductible or, if earlier, in the first tax year for which the taxpayer no longer is a RIC or a REIT.

For a C corporation partner that is allocated any excess BIE from a partnership, if all or a portion of the excess BIE has not yet been treated as BIE of the C corporation partner, the corporation must increase its E&P at such time as it disposes of all or a portion of its interest in the partnership by an amount equal to the amount of the basis adjustment required under section 163(j)(4)(B)(iii)(II).

For further discussion of the application of the 163(j) Package to REITs, read the Passthrough Focus Report

Consolidated return rules

Consistent with the 2018 Proposed Regulations, the Final Regulations generally take a broad, single-entity approach and apply a single section 163(j) limitation to a consolidated group. The Final Regulations also require a group’s adjusted taxable income (“ATI”) to be calculated on a consolidated basis. Thus, the group’s current-year BIE and BII is the sum of the current-year interest items of the members. However, intercompany obligations (indebtedness between members of the same consolidated group) are generally disregarded for purposes of determining the group’s BIE and BII, as well as its consolidated ATI. The Final Regulations create an exception to this rule for repurchase premium arising pursuant to the deemed satisfaction and reissuance rule of Reg. § 1.1502-13(g)(5) when an obligation becomes an intercompany obligation, and treat the repurchase premium as interest expense subject to the section 163(j) limitation although it is paid on an intercompany obligation.

Also consistent with the 2018 Proposed Regulations, the Final Regulations provide that intercompany items and corresponding items (within the meaning of Reg. § 1.1502-13) are disregarded for purposes of calculating consolidated adjusted taxable income (“ATI”) to the extent they offset in amount. 

KPMG observation

The Final Regulations impose additional complexity by requiring new, additional consolidated adjustments for purposes of determining the consolidated section 163(j) limitation, calculations that were not required prior to the TCJA. Consolidated corporations with U.S. state tax filing requirements will encounter further compliance complexity. Read the State and Local Tax Focus Report


KPMG observation

Despite receiving comments arguing that interest income and expense on intercompany obligations should be taken into account for purposes of section 163(j), Treasury believed that the simplicity and perceived administrability of the adopted approach outweighed the potential distortive consequences of generally ignoring intercompany obligations. Under this approach, the allocation of BII and expense generally will be driven by which consolidated members receive or pay interest, respectively, to third parties, and thus can be influenced by on-lending arrangements within the group.

Furthermore, consistent with the 2018 Proposed Regulations, the Final Regulations do not aggregate affiliated but non-consolidated entities. For example, a partnership wholly owned by members of a consolidated group is not aggregated with its consolidated partners but generally is regarded as an entity and is subject to the partnership rules described elsewhere [Link to passthroughs focus piece]. The Final Regulations also retain the anti-avoidance rules included in the 2018 Proposed Regulations that are intended to preclude taxpayers from using controlled affiliates to avoid the section 163(j) limitation.

In general, the Final Regulations adopt the five-step approach provided in the 2018 Proposed Regulations to determine a consolidated group’s current year BIE, disallowed BIE carryforward, and utilization of BIE carryforwards. The five steps are:

  • Step 1: determine whether the consolidated section 163(j) limitation for the current year is equal to or exceeds the members’ aggregate current-year BIE. If so, none of the members’ current-year business interest is disallowed (and skip steps 2 and 3);
  • Step 2: if the members’ aggregate current-year BIE exceeds the consolidated section 163(j) limitation for the year, each member deducts its current-year BIE up to the amount of its business interest income or floor plan financing interest expense for the current year;
  • Step 3: if there is any consolidated section 163(j) limitation remaining after step 2, each member with remaining current-year BIE deducts a pro rata amount of its current-year BIE based on its allocable share of the consolidated group’s remain section 163(j) limitation;
  • Step 4: If there is any remaining consolidated section 163(j) limitation, the members’ disallowed BIE carryforwards from prior years are deducted on a pro rata basis under the principles of step 3, beginning with the earliest year (subject to any SRLY (defined below) and section 382 limitations); and
  • Step 5: Any member with remaining BIE carries the expense forward to the succeeding tax year as a disallowed BIE carryforward.

KPMG observation

Although a single-entity approach generally is applied to consolidated groups, groups are still required to determine which member is entitled to a deduction for interest expense (an issue that can be uncertain when multiple members are co-obligors or guarantors on external debt), as well as location of BII and floor plan financing interest expense. 

For purposes of the stock basis/investment adjustment rules of Reg. § 1.1502-32, rules similar to those applicable to the absorption of losses would apply. In particular, basis in the stock of a member with disallowed current-year BIE is adjusted only in the tax year in which the disallowed interest expense is absorbed (and not when initially disallowed). Similarly, investment adjustments with respect to excess BIE from a partnership are made when the excess BIE is converted into BIE and deducted and absorbed in the C corporation partner’s consolidated group.

The Final Regulations provide that a “separate return limitation year” (“SRLY”) limitation applies to disallowed BIE carryforwards. A section 163(j) SRLY limitation does not apply to the extent of an “overlap” in the application of section 382 and the SRLY limitation under the principles of Reg. § 1.1502-21(g) (the current rules applicable to loss carryovers).

KPMG observation: The helpful SRLY-382 overlap rule can be expected to apply to a group’s acquisition of a previously unrelated target with disallowed BIE carryforwards. However, the section 163(j) SRLY limitation remains a trap for the unwary in situations not covered by the overlap rule (e.g., where a consolidated group acquires a target corporation in a transaction that does not constitute a section 382 ownership change, such as an acquisition from a related person).

The Final Regulations provide that disallowed BIE carryforwards of a member rising in a SRLY can be deducted by the consolidated group in the current year to the extent the excess of (i) the aggregate section 163(j) limitation of such member determined by reference only to the member’s items of income, gain, deduction, and loss while it has been a member of the consolidated group, over (ii) the member’s BIE (including disallowed BIE carryforwards) absorbed by the group in all consolidated return years. The mechanics of the section 163(j) SRLY limitation can result in a negative section 163(j) SRLY limitation under the Final Regulations. In computing the member’s section 163(j) SRLY limitation, intercompany items generally are included, with the exception of interest items with regard to intercompany obligations. Further, SRLY-limited BIE carryforwards are deducted on a pro rata basis with non-SRLY-limited disallowed BIE carryforwards from tax years ending on the same date. The Final Regulations provide that the section 163(j) SRLY limitation applies on a subgroup basis, under the principals of the subgroup rules applicable to SRLY-limited NOLs, with appropriate adjustments. 

KPMG observation

After considering comments received on the 2018 Proposed Regulations, Treasury replaced the “annual” register approach of the 2018 Proposed Regulations with the “cumulative” register described above. This is consistent with the SRLY limitations applied to other attributes, which generally operate on a cumulative basis, although the Preamble to the Final Regulations notes that the section 163(j) SRLY limitation is separate and distinct from the cumulative register for NOLs.

The Final Regulations appear to disregard any losses generated by a member in a particular year in determining its “cumulative” section 163(j) SRLY limitation register. For example, if a corporation had $250 of disallowed BIE carryforwards that were subject to a SRLY limitation at the time it joined a consolidated group, and it generated $100 of section 163(j) limitation in its first year in the group but was only able to deduct $30 of its carryforwards due to the group’s section 163(j) limitation, the corporation’s section 163(j) SRLY limitation register would be $70 (the $100 capacity less the $30 actually deducted in the year). If, in the following year, the corporation generated a $40 loss and the group as a whole had a $0 section 163(j) limitation, the corporation’s section 163(j) SRLY limitation register would not be reduced by its loss for the year. This seems to cause the “cumulative” section 163(j) SRLY register to operate more like the alternative “catch and release” approach suggested by commenters and rejected by Treasury. It is unclear whether the drafters of the Final Regulations intended this result. A corporation’s section 163(j) SRLY limitation register can go negative in situations where non-SRLY limited interest is deducted. For example, if the corporation in the prior example generated $120 of current year BIE in its third year in the group and was able to fully deduct that interest, the corporation’s cumulative register would be reduced by the $120 of business interest deductions, from $70 to a negative $50. This occurs because the rules require current year BIE to be deducted before carryforwards, and because the corporation’s current year BIE is generated within a consolidated year of the group and thus is not subject to a SRLY limitation in that group.

A member with disallowed BIE that departs a consolidated group generally takes its carryforwards with it. However, as is the case with NOLs, the group has the priority claim to deduct in the year of departure the departing member’s BIE items, to the extent available under section 163(j), including both the departing member’s current-year BIE (through the date of departure) as well as the departing member’s disallowed BIE carryforwards from prior years. Also, consistent with the rules applicable to NOLs, a departing member’s disallowed BIE carryovers potentially are subject to attribute reduction under the consolidated unified loss rule of Reg. § 1.1502-36(d) (“ULR”). Disallowed BIE carryovers generally are treated as deferred deductions under Category C of Reg. § 1.1502-36(d)(4), and thus potentially available for a reattribution election under Reg. § 1.1502-36(d)(6)(B) to the extent they otherwise would be subject to reduction under the ULR (excess BIE from a partnership, however, is treated as a Category D attribute, and thus cannot be reattributed). A departing member’s carryforwards of disallowed BIE that survive this gauntlet of rules are carried forward to its first separate return year, albeit potentially subject to section 382 limitation (or, if applicable, to the section 163(j) SRLY limitation in an acquiring group). The Final Regulations do not provide further guidance on the treatment of disallowed BIE carryforwards of a consolidated group in the context of a life-nonlife group. 

Section 381(a) transactions

An acquiring corporation in a section 381(a) transaction (generally, a tax-free section 368(a)(1) asset reorganization or a section 332 subsidiary liquidation) succeeds to the disallowed BIE carryforwards of a target corporation. The Final Regulations, consistent with the 2018 Proposed Regulations, include provisions which generally limit the amount of the target’s disallowed BIE carryforwards that the acquirer can deduct in the acquirer’s first tax year ending after the acquisition. These rules are similar to the rules in Reg. §§ 1.381(c)(1)-1 and 1.381(c)(1)-2 that apply to an acquiring corporation’s use of a target corporation’s losses in the acquisition year.

Sections 382 and 163(j)

Congress provided in section 163(j) that disallowed BIE carryovers are subject to the section 382 loss limitation rules following an “ownership change” (generally, a cumulative greater-than-50-percentage-point change in the stock ownership of a corporation over a three-year period).

For a tax year in which a mid-year ownership change occurs, the Final Regulations provide a default rule that requires the pro rata allocation of current-year BIE between the pre- and post-ownership change periods based on the number of days in each period. At the same time, the Final Regulations provide that if a closing-of-the-books election is made under Reg. § 1.382-6(b), current-year BII and expense is allocated to the pre- and post-ownership change periods as if the corporation’s books were closed on the date of the ownership change.

The Final Regulations also address the allocation of disallowed BIE carryforwards to the pre- and post-ownership change periods, an issue that had not been explicitly addressed by the 2018 Proposed Regulations. The Final Regulations provide that, in the absence of a closing-of-the-books election, disallowed BIE carryforwards are allocated pro rata to each day in the year of the ownership change, whereas if a closing-of-the-books election is made, such carryforwards are allocated ratably to the pre- and post-ownership change periods based on the relative excess section 163(j) capacity in each period (calculated under specific steps provided in the Final Regulations). 

KPMG observations

The 2018 Proposed Regulations would have mandated the daily pro rata allocation method for all BIE. A mandatory pro rata allocation could have been distortive in the context of a leveraged acquisition, because it could result in the allocation of a disproportionate amount of post-acquisition interest expense to the pre-acquisition period (thus potentially subjecting it to limitation under section 382). In response to practitioner requests, the Final Regulations authorize the closing-of-the-books method when an election to apply that method is made for section 382 purposes. This is a welcome development.

Consistent with the 2018 Proposed Regulations, the Final Regulations modify the existing ordering rule governing the absorption of pre-change losses and tax credits subject to limitation under sections 382 and 383, to provide that disallowed BIE carryforwards are absorbed after pre-change capital losses and all recognized built-in losses, but before NOLs, other pre-change losses, and pre-change credits.

Moreover, the Final Regulations clarify that section 382 disallowed business interest carryforwards are not treated as recognized built-in losses under section 382(h)(6) (to confirm there is no “double detriment” under section 382 with respect to such carryforwards).

The Final Regulations do not provide guidance regarding the application of section 382(e)(3) in the context of section 163(j). Section 382(e)(3) generally provides that, in determining the value of a foreign loss corporation, taxpayers can take into account only items connected with conduct of a U.S. trade or business. Under this rule, if a foreign corporation with no U.S. trade or business undergoes an ownership change, its section 382 limitation can be zero, meaning its disallowed BIE carryforwards cannot be used after the ownership change.

KPMG observations

With the section 163(j) limitation applying to BIE incurred by controlled foreign corporations (“CFCs”), the above result is potentially onerous and unintended. The Preamble of the Final Regulations states that Treasury is “ aware of this issue and other issues relating to the application of section 382 to CFCs,” and that it will “continue to study the application of section 382 to CFCs and may address this issue in further guidance.” 

CARES Act changes to section 163(j)

The CARES Act amended section 163(j) to allow a taxpayer to elect to utilize its ATI from the last tax year beginning in 2019 (“2019 ATI”) as its ATI for a tax year beginning in 2020 for purposes of calculating its section 163(j) limitation (subject to a proration rule for short tax years). For purposes of that election, the 2020 Proposed Regulations generally provide that the 2019 ATI of an acquiring corporation in a section 381(a) transaction equals the acquiring corporation’s 2019 ATI (i.e., the ATI of a target corporation prior to its acquisition is not included in 2019 ATI).

KPMG observation

The 2020 Proposed Regulations do not take into account the target’s pre-acquisition ATI, even though it may be significantly larger than the acquirer’s ATI and even if the acquisition occurs in a section 381(a) transaction, which generally represents a continuation of the target and its activities. For taxpayers choosing not to elect to follow the 2020 Proposed Regulations, the treatment of section 381(a) transactions for purposes of the calculation of 2019 ATI is not entirely clear.

Contact us

For more information, contact a tax professional with KPMG's Washington National Tax:

Erik Corwin | +1 (202) 533 3655 |

Mark Hoffenberg | +1 (202) 533 4058 |

Timothy Nichols | +1 (202) 533 4033 |

Maury Passman | +1 (202) 533 3775 |

Jeffrey Vogel | +1 (202) 533 5554 |