This report provides initial impressions and observations about the 163(j) Package’s application to foreign 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
Consistent with the 2018 Proposed Regulations, the Final Regulations explicitly apply section 163(j) to controlled foreign corporations (“CFCs”). The Final Regulations apply the section 163(j) limitation on a CFC-by-CFC basis in the same manner as the “Default Rule” under the 2018 Proposed Regulations, which precludes netting of business interest income (“BII”) of one CFC against the business interest expense (“BIE”) of another CFC. The Final Regulations also adopt unchanged the rule in the 2018 Proposed Regulations for computing CFC tentative taxable income, which requires that CFC-level tentative taxable income be calculated based on Reg. § 1.952-2 principles (or under the rules of section 882), and excludes dividends from related persons (as defined within the meaning of section 954(d)(3)) from the recipient CFC’s tentative taxable income.
In addition, U.S. shareholder adjusted taxable income (“ATI”) excludes CFC income inclusion items under the Final Regulations, such as amounts included in the gross income of a U.S. shareholder under sections 78, 951(a), or 951A(a).
The Final Regulations provide only skeletal rules that apply to CFCs. In response to taxpayer comments concerning administrative and compliance burdens relating to the application of section 163(j) to CFCs under the elective “CFC Group Method” in the 2018 Proposed Regulations, the Final Regulations fully reserve on all rules administering the CFC Group Method. Instead, Treasury re-proposed substantially modified rules pertaining to the CFC Group Method in the 2020 Proposed Regulations.
Single Section 163(j) Limitation for a CFC Group
Under the 2020 Proposed Regulations, a single section 163(j) limitation is computed for a CFC Group. For this purpose, the current-year BIE, disallowed BIE carryforwards, BII, and ATI would be determined first on a separate-company basis for each CFC Group Member. The CFC Group’s single section 163(j) limitation would be computed based on the sum of all of these separately determined amounts.
Under the 2018 Proposed Regulations’ CFC Group Method, lower-tier CFC Group Members would be permitted to “share” their excess taxable income (“ETI”) with upper-tier CFCs in the same chain of ownership (the “CFC ETI tiered roll-up” rule). The CFC ETI tiered roll-up rule, however, would preclude the allocation of an upper-tier CFC’s ETI to a lower-tier CFC as well as the sharing of CFC ETI to cross-chain CFCs.
Treasury’s decision to reject the CFC ETI tiered roll-up framework introduced in the 2018 Proposed Regulations in favor of a single CFC Group-wide section 163(j) limitation amount is intended to address administrability and legal entity or operational restructuring concerns expressed in certain taxpayer comments.
Application of U.S. consolidated return group principles to CFC Groups
The 2020 Proposed Regulations generally would apply U.S. consolidated return group principles, subject to certain modifications, to CFC Groups for purposes of allocating the single section 163(j) limitation amount to the CFC Group Members. The 2020 Proposed Regulations also provide ordering rules that would determine the deductibility of a CFC Group’s current-year BIE and disallowed BIE carryforwards. Generally, current-year BIE would be deducted first and the deductibility of disallowed BIE carryforwards would be determined using a FIFO approach.
Consistent with the U.S. consolidated return group rules approach, the 2020 Proposed Regulations would apply SRLY principles to disallowed BIE carryforwards of a CFC Group member generated before it joined the CFC Group (“pre-group disallowed BIE carryforwards”). SRLY subgroup rules would apply to pre-group subgroups, subject to certain modifications in the CFC context.
Reg. § 1.1502-75(d) principles (regarding when a U.S. consolidated group remains in existence) would also apply for purposes of determining when a CFC group ceases to exist.
The application of U.S. consolidated return group principles to CFCs would be a seismic change to the determination of CFC-level attributes. Although the preamble speaks of the changes made as intended to ‘reduce [certain] administrative and compliances burdens,’ consolidated return principles are themselves far from simple to apply. Thus, it seems difficult to assess the extent to which the 2020 Proposed Regulations really represent a reduction in compliance burden as compared to the 2018 Proposed Regulations.
Definition of specified and CFC Groups
In response to taxpayer comments criticizing the very strict eligibility requirements of the prior CFC Group Method under the 2018 Proposed Regulations, the 2020 Proposed Regulations would broaden the potential applicability of CFC Group Method.
Under the 2018 Proposed Regulations, a “CFC Group” is defined as two or more applicable CFCs (that is, CFCs with one or more section 958(a) U.S. shareholders), if at least 80% of the stock measured by value of each CFC member is directly or indirectly owned within the meaning of section 958(a) by a (1) a single U.S. shareholder or (2) certain related U.S. shareholders that own stock of each CFC member in the same proportions.
The 2020 Proposed Regulations modify and break apart the 2018 Proposed Regulations’ definition of a CFC Group into two defined terms – a Specified Group and a CFC Group. The term “Specified Group” broadly retains the modified section 1504(a) affiliated group stock ownership thresholds as applied between applicable CFCs under the prior CFC Group definition; however, the 2020 Proposed Regulations would no longer require that a U.S. shareholder (or group of related U.S. shareholders) be the highly related parent of the CFC Group. Instead, the definition of a Specified Group provides that a Specified Group parent may be either a “qualified U.S. person” or an applicable CFC. A “qualified U.S. person” is a single corporation (including an S corporation) or a U.S. citizen or tax resident. Consistent with the 2018 Proposed Regulations, a U.S. consolidated return group is treated as a single corporation for this purpose.
In addition to the modified affiliated group relatedness requirement, the 2020 Proposed Regulations also provide a detailed “with or within” specified period rule that identifies when an applicable CFC may qualify as a Specified Group Member with respect to a Specified Group. An applicable CFC would be a Specified Group Member of a Specified Group for a particular year only if the following conditions are satisfied:
The 2020 Proposed Regulations also introduce detailed rules that apply to mid-year joining and departing member scenarios.
Under the 2020 Proposed Regulations, a “CFC Group” generally refers to all Specified Group Members of a Specified Group for which a CFC Group Election is in effect.
Inclusion of CFCs with ECI and financial services CFCs in CFC Groups
The 2018 Proposed Regulations excluded applicable CFCs with US ECI and certain financial services CFCs from being CFC Group Members. Unlike the 2018 Proposed Regulations, the 2020 Proposed Regulations do not provide for CFC financial services subgroups. Instead, applicable CFCs engaged in financial services could be included in a CFC Group under the 2020 Proposed Regulations.
Also, the 2020 Proposed Regulations would provide that an applicable CFC with ECI is not precluded from being a CFC Group member. The ECI items of the applicable CFC, however, would not be included in the CFC Group calculations. The ECI of the applicable CFC would be treated as income of a separate CFC (an “ECI Deemed Corporation”), which would be excluded from the CFC Group and subject to a separate section 163(j) calculation for its ECI in accordance with the proposed rules that apply to foreign persons with ECI.
Making or revoking a CFC Group Election
Unlike the 2018 Proposed Regulations, the 2020 Proposed Regulations require taxpayers to affirmatively file a CFC Group Election statement in accordance with certain time and manner instructions provided therein to apply the CFC Group Method.
In response to taxpayer comments to the 2018 Proposed Regulations, the 2020 Proposed Regulations provide that the CFC Group Election is not irrevocable. Rather, a CFC Group Election cannot be revoked for at least 60-months following the end of the specified period for which it was made. Once revoked, the CFC Group election cannot be made again for another 60-month period.
Once a CFC Group election is made under the 2020 Proposed Regulations, the CFC Group remains in existence until the CFC Group election is revoked or until the end of the specified group’s last specified period.
If a taxpayer elected to apply the CFC Group Method under the 2018 Proposed Regulations for a tax year, such election would not remain in effect for any tax year in which the taxpayer relies on the 2020 Proposed Regulations. Instead, the taxpayer would need to make a CFC Group Election in accordance with the rules provided in the 2020 Proposed Regulations for a year in which the taxpayer follows the 2020 Proposed Regulations to apply the CFC Group Method.
Consistent with the 2018 Proposed Regulations, the Final and 2020 Proposed Regulations) provide that U.S. shareholder ATI generally excludes CFC income inclusion items, such as amounts included in the gross income of a U.S. shareholder under sections 78, 951(a), or 951A(a).
If, however, a CFC Group Election is made, the U.S. shareholder would be allowed to include in ATI a certain amount of CFC Group ETI not to exceed the U.S. shareholder subpart F and GILTI inclusions (without regard to the section 78 amount) with respect to the CFC Group. Unlike the 2018 Proposed Regulations, the 2020 Proposed Regulations would also allow U.S. shareholder ATI to include a portion of its deemed income inclusions attributable to the ETI of any “stand-alone applicable CFC”, which is defined as an applicable CFC that fails to qualify as a specified member of a specified group.
163(j) limitation based on 50% of ATI for 2019 & 2020 and election to use 2019 ATI in 2020
The 2020 Proposed Regulations provide special rules for applying the 2019 and 2020 ATI-related provisions in section 163(j)(10) enacted under the CARES Act to CFC Groups.
Specifically, the 2020 Proposed Regulations would provide that the ATI of the CFC Group would be determined by reference to the CFC Group’s 2019 and 2020 specified periods, as applicable, without regard to whether the tax years of the individual CFC Group Members actually begin in 2019 or 2020. The 2020 Proposed Regulations provide detailed rules for identifying which tax years of the constituent CFC Group Members would be included in a CFC Group’s 2019 and/or 2020 specified periods for purposes of computing CFC Group ATI.
The 2020 Proposed Regulations also provide certain time and manner rules for making the elections allowed under section 163(j)(10) for the CFC Group. If a taxpayer relies on the 2020 Proposed Regulations for their 2019 and/or 2020 tax year, then the rules in the 2020 Proposed Regulations would modify the application of the time and manner rules under Revenue Procedure 2020-22 for CFC Groups and CFC Group Members.
New anti-abuse rule
The 2020 Proposed Regulations contain a new anti-abuse rule that would apply in certain situations when U.S. shareholders may affirmatively plan to limit BIE deductions as part of a tax-planning transaction. The anti-abuse rule generally ought not to apply if a CFC Group Election is in effect. In those situations to which the anti-abuse rule would apply, CFC-level ATI would be increased to undo the effects of the affirmative planning on the BIE deduction limitation.
A new anti-abuse rule applies in certain situations when U.S. shareholders may inappropriately affirmatively plan to limit BIE deductions as part of a tax-planning transaction. See 2020 Prop. Reg. § 1.163(j)-7(g)(4). For example, if a US shareholder projects excess GILTI credits in Year 1 and excess GILTI limitation Year 2, and accordingly executes a tax-planning transaction resulting in BIE limitation for a CFC in Year 1 with the intent to carry forward the BIE deduction to Year 2, such transaction may be subject to the anti-abuse rule.
For tax years in which the Final Regulations are effective or otherwise followed (e.g., 2021 and beyond for calendar-year taxpayers not electing retroactivity), the section 163(j) limitation must be applied to CFCs on a CFC-by-CFC basis and U.S. shareholder ATI must exclude any CFC income inclusion items unless the taxpayer were to follow the 2020 Proposed Regulations for those same tax years. Accordingly, many taxpayers will likely rely on the 2020 Proposed Regulations for any tax year for which the Final Regulations apply.
Foreign persons are subject to net basis U.S. taxation only on their income that is effectively connected with a U.S. trade or business. Accordingly, the 2020 Proposed Regulations would modify the application of section 163(j) to “scale” the limitation to the applicable U.S. tax base.
The 2018 Proposed Regulations also provided rules with respect to the application of section 163(j) to foreign persons with ECI. But “the Treasury Department and the IRS [became] aware of certain distortions that can result under the 2018 Proposed Regulations. Accordingly, proposed Section 1.163(j)-8 [was] revised, and re-proposed [with an effective date of tax years beginning on or after 60 days after the date the final regulations are published in the Federal Register, the same effective date as the -7 regulations].”
Section 882 principles would apply for purposes of determining the foreign person’s BIE allocable to ECI, and thus permit a taxpayer to determine ATI, taking into account only ECI items. The 2020 Proposed Regulations provide for two different computation methods: one for a “relevant foreign corporation”, a foreign corporation whose entity classification is relevant under the check-the-box rules (i.e., its classification affects the U.S. federal income tax liability of any person, other than its liability solely under section 881 or 882), and a second one for nonresident alien individuals and foreign corporations whose entity classification does not affect the liability of any person under the check-the-box rules (in which case the only relevant tax liability is the foreign corporation’s own tax liability under section 881 or 882).
The 2018 proposed regulations provided for a separate computational method for all CFCs that had ECI. Since the ECI of many CFCs, after section 958(b) repeal, would not affect the U.S. federal income tax liability of any person (other than its own liability under section 881 or 882 which would already be covered under the general rules applicable to non-CFC foreign corporations), the proposed rules now provide a separate computation method only if the corporation’s classification might affect the U.S. federal income tax liability of any person, other than the corporation’s own liability solely under section 881 or 882 (e.g., a separate computation method would apply to a CFC only if it has a section 951(b) U.S. shareholder that owns, within the meaning of section 958(a), stock of the CFC).
The definitions for ATI, BIE, BII, etc. are modified to limit such amounts to ECI and expenses properly allocable thereto. A non-resident alien individual or a foreign corporation (including a relevant foreign corporation) would first determine its interest expense under section 1.882-5 and then determine the amount of disallowed BIE under section 163(j).
A nonresident alien individual or foreign corporation other than a relevant foreign corporation then determines its 163(j) calculation by taking into account only the portion of the relevant items (e.g., ATI, BIE, BII, etc.) that relate to ECI. A relevant foreign corporation allocates its deductible BIE under a formulary method to ECI and non-ECI amounts proportionately based on the relative amounts of ECI and non-ECI BIE in each category.
In the case of a relevant foreign corporation that is a CFC that is part of a CFC group (under the -7 rules), the ECI items are hived off and are treated as items of a separate corporation that is not included in the CFC group but rather is subject to these rules.
Consistent with the overall theme of treating partnerships as entities for purposes of section 163(j), different rules apply to the extent foreign persons (including relevant foreign corporations) earn ECI through partnerships.
The proposed rules also provide that the section 163(j) limitation does not affect the determination of U.S. net equity for purposes of applying the branch profits tax under section 884.
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