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The 163(j) Package - Key concepts: Interest and adjusted taxable income

Interest and adjusted taxable income

This report provides initial impressions and observations about the 163(j) Package’s key concepts—interest and adjusted taxable income. 

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

Interest

The Final Regulations narrow the definition of “interest” from the 2018 Proposed Regulations.

The Final Regulations maintain the structure of the 2018 Proposed Regulations in that the term “interest” means any amount described in one of four categories:

  • Amounts generally accepted as the traditional meaning of “interest,” that is, amounts paid, received, or accrued as compensation for the use or forbearance of money
  • Amounts treated as interest on swaps with significant nonperiodic payments
  • Amounts that affect the economic yield of a borrowing but that may not be compensation for the use or forbearance of money
  • Amounts covered by an interest anti-avoidance rule

The Final Regulations do not change the first category, which includes amounts treated as interest (compensation for use or forbearance of money) under the Code or regulations, such as stated interest and original issue discount.

In the second category, for significant nonperiodic payments on swaps, the Final Regulations finalize the embedded loan rule, which requires a bifurcation of these contracts into a loan and an on-market, level-payment swap. The Final Regulations add exceptions for cleared swaps and for non-cleared swaps that require the parties to meet the margin or collateral requirements of a federal regulator (or requirements that are substantially similar to a federal regulator). The Final Regulations do not provide guidance to determine if a nonperiodic payment is significant. For purposes of section 163(j), the applicability date of the embedded loan rule is delayed for one year (unless the taxpayer chooses otherwise). Read TaxNewsFlash

In the third category, the Final Regulations exclude several items that were included in the 2018 Proposed Regulations and narrow the rule for substitute interest payments. Debt issuance costs and commitment fees are now excluded from the definition of interest. (The Preamble says that “[t]he treatment of commitment fees and other fees paid in connection with lending transactions will be addressed in future guidance that applies for all purposes of the Code.”)

The definition of interest also now excludes income, deduction, gain, or loss with respect to derivative contracts that alter a taxpayer’s effective cost of borrowing or the effective yield of a debt instrument held by the taxpayer (the “hedging rules”).

The rule for substitute interest is less inclusive than what had been proposed: A substitute interest payment is treated as interest expense by the payor only if the payment relates to a sale-repurchase or securities lending transaction that is not entered into by the payor in the payor’s ordinary course of business. Likewise, a substitute interest payment is treated as interest income to the recipient only if the payment relates to a sale-repurchase or securities lending transaction that is not entered into by the recipient in the recipient’s ordinary course of business.

Although the Final Regulations do not explicitly include guaranteed payments for the use of capital under section 707(c) in the definition of interest, the interest anti-avoidance rule (discussed next) includes an example in which such a guaranteed payment is treated as interest expense and interest income.

The Final Regulations substantially modify the fourth category: those amounts falling within the interest anti-avoidance rule. Importantly, the Final Regulations add a principal purpose requirement to this anti-avoidance rule, even while retaining a broad definition of “any expense or loss economically equivalent to interest.” Specifically, any expense or loss is economically equivalent to interest to the extent that the expense or loss is deductible by the payor, is incurred in a transaction in which the taxpayer secures the use of funds for a period of time, is substantially incurred in consideration of the time value of money, and is not described in one of the other three categories.

For the anti-avoidance rule to apply, a taxpayer must have structured the transaction with a principal purpose of reducing an amount incurred by the taxpayer that otherwise would have been treated as interest under one of the other three categories. The taxpayer’s business purpose for acquiring the funds is not relevant to the principal purpose inquiry, nor is the fact that the taxpayer has obtained funds at a lower pre-tax cost based on the structure of the transaction. Moreover, a holder must treat as interest income an amount received from a payor that the holder knows is treating as interest expense and that is compensation paid in consideration of the time value of money. Also, a transaction that is structured with a principal purpose of artificially increasing a taxpayer’s business interest income (“BII”) is ignored, such as a factoring transaction. For this purpose, the fact that a taxpayer has a business purpose for holding interest-generating assets is not taken into consideration. A purpose may be a principal purpose even though it is outweighed by other purposes (taken together or separately). The Final Regulations include several examples applying this anti-avoidance rule, including examples involving a foreign currency swap, a forward contract for the delivery of gold, a loan guaranteed by a related party in which the related party receives guarantee fees, and guaranteed payments for the use of capital of a partner.

Negative income

Although commenters had requested clarification on the treatment of negative interest, Treasury declined to do so, stating that the issue is beyond the scope of the Final Regulations.

Floor plan financing interest expense

The Final Regulations do not address the interaction between sections 163(j) and 168(k)(9) regarding floor plan financing interest expense.  The Final Regulations do not exclude commercial financing liabilities from the section 163(j) limitation as requested by commenters.

Section 163(j) interest dividends

The 2020 Proposed Regulations would provide rules under which a regulated investment company (“RIC”) that earns business interest income BII may pay “section 163(j) interest dividends,” and rules under which a RIC’s shareholder that receives a section 163(j) interest dividend may treat the dividend as interest income solely for purposes of section 163(j).  The total amount of a RIC’s section 163(j) interest dividends for a tax year would be limited to the excess of the RIC’s BII over the RIC’s business interest expense (“BIE”) and other deductions that are properly allocable to the RIC’s BII for the tax year. The amount of a section 163(j) interest dividend that a shareholder may treat as interest income for purposes of section 163(j) would be limited to the excess of the amount of the RIC dividend that includes the section 163(j) interest dividend over the sum of the “conduit amounts” other than interest-related dividends under section 871(k)(a)(C) and section 163(j) interest dividends (for example, capital gain dividends, exempt-interest dividends, and dividends eligible for the dividends received deduction). The Preamble to the 2020 Proposed Regulations explains that, absent this reduction for conduit amounts, a RIC shareholder could obtain an “inappropriate” benefit by treating a portion of a RIC dividend as interest income for purposes of section 163(j), while treating the same portion of the dividend as another non-interest type of income.

In addition, a shareholder generally would not be able to treat a section 163(j) interest dividend as interest income unless it meets certain holding period requirements. However, such holding period requirements would not apply to dividends paid by a money market fund or certain regular dividends paid by a RIC that declares section 163(j) interest dividends on a daily basis and distributes such dividends on a monthly or more frequent basis.

Only a RIC paying dividends that would be exempt from the holding period requirements and shareholders receiving such dividends may rely on the 2020 Proposed Regulations pertaining to section 163(j) interest dividends for tax years ending on or after the date of publication of the 2020 Proposed Regulations in the Federal Register.

Disallowed business interest expense

The Final Regulations revise the definition of “disallowed business interest expense” to reflect that for purposes of section 163(j), disallowed business interest expense is treated as “paid or accrued” in the tax year in which the expense is taken into account for Federal income tax purposes (without regard to section 163(j)), or in a succeeding tax year in which the expense can be deducted by the taxpayer under section 163(j), as the context may require.

The Preamble explains that the term “paid or accrued” as used in section 163(j)(2) is to provide a mechanism for disallowed business interest expense to be carried forward to and deducted in a subsequent tax year; it is not intended that interest be treated as paid or accrued in a later tax year for all purposes because that would be inconsistent with the purposes of other Code provisions. One example discussed in the Preamble is the interaction with section 382: If a disallowed business interest expense were treated as paid or accrued only in a future tax year in which such expense could be deducted after the application of section 163(j), then section 382 never would apply to such expense because disallowed business interest expense carryforwards never would be pre-change losses. The Preamble also says if a disallowed business interest expense were treated as paid or accrued in a future tax year for purposes of section 163(j)(8)(A)(ii), then such expense would be added back to tentative taxable income in determining ATI for that tax year (and for all future tax years to which such expense is carried forward under section 163(j)(2)), thereby artificially increasing the taxpayer’s section 163(j) limitation.

Section 108 and cancellation of debt income

In the Preamble to the 2018 Proposed Regulations, Treasury requested comments on the interaction between section 163(j) and rules governing income from the discharge of indebtedness (“CODI”). In response, commenters sought clarification on whether CODI arises under section 61(a)(11) when a taxpayer receives a benefit only in the form of disallowed interest expense carryforwards, and how section 108(e)(2), section 111, and tax benefit principles apply. The Preamble states that “[i]n light of the complex and novel issues” raised in the comments, this interaction “requires further consideration and may be the subject of future guidance.”

KPMG observation

The lack of guidance leaves taxpayers with an interpretative challenge. In general, section 108(e)(2) provides that no CODI arises to the extent that payment of the cancelled liability would have given rise to a deduction. The application of this provision to the cancellation of a liability for accrued, unpaid interest is unclear. The uncertainty is compounded where the deduction for the underlying accrued interest has been deferred as a result of the section 163(j) limitation, and because, as noted earlier, the tax year in which disallowed business interest expense is treated as paid or accrued can depend on the meaning of the phrase “as the context may require” in the definition of disallowed business interest expense. The potential consequence of CODI with respect to a liability for accrued interest can be unexpected, given that disallowed business interest expense carryovers are not among the tax attributes that can be reduced under section 108(b) in the case of excluded CODI (i.e., CODI excluded from income due to the debtor’s insolvency).    

Adjusted taxable income

General rules

The Final Regulations define adjusted taxable income (“ATI”) as the “tentative taxable income” of the taxpayer for the tax year with certain adjustments.

Tentative taxable income, a new term added in the Final Regulations, is computed in accordance with section 63, but without regard to the application of the section 163(j) limitation and without regard to disallowed business interest expense carryforwards (i.e., all current-year business interest expense is treated as deductible for purposes of calculating tentative taxable income).

KPMG observation

The use of the new term tentative taxable income and the exclusion of disallowed business interest expense carryforwards are intended to correct an “unintended” aspect of the 2018 Proposed Regulations. Under the 2018 Proposed Regulations, disallowed business interest expense carryforwards would have resulted in a net positive adjustment to ATI. For example, a corporation that generated no net taxable income in 2019 and that had no other ATI adjustments for the year (i.e., no depreciation deductions or current-year interest expense), and that had a carryover of $100 in disallowed business interest expense from 2018, would have had ATI of $100 in 2019, thus allowing $30 of the 2018 disallowed business interest expense carryforward to be deducted in 2019 (and creating a $30 net operating loss (“NOL”)).

 

KPMG observation

Ordering rules had been included in the 2018 Proposed Regulations to mitigate a circularity problem between the ATI determination and the section 250 deduction for foreign-derived intangible income (“FDII”) and global intangible low-taxed income (“GILTI”). Circularity issues arise because (i) the section 163(j) limitation is based on taxable income after giving effect to the section 250 deduction, (ii) the section 250 deduction is itself subject to a taxable income limitation based on taxable income after the section 163 deduction for interest and the section 172 deduction for NOLs, and (iii) under the Tax Cuts and Jobs Act, as amended by the CARES Act, the deduction under section 172 for post-2017 NOLs will be subject to an 80% of taxable income limitation in tax years beginning after 2020, with taxable income determined after the section 163 deduction for interest (but before the section 250 deduction). In addition, the Code contains other non-coordinated taxable income limitations, such as those in sections 170(b)(2) (corporate charitable contributions), 246(b) (dividends received deductions), and 613(a) and 613A(d) (percentage depletion), each of which can present a circularity issue.

The proposed ordering rules are not included in the Final Regulations. The Preamble to the Final Regulations states that “further study is required to determine the appropriate rule for coordinating” these provisions. This dovetails with a similar comment made recently in the preamble to the final regulations under section 250. Both preambles state that until further guidance is provided, taxpayers may choose any reasonable approach (including simultaneous equations) for coordinating taxable income-based provisions, provided the approach is applied consistently for all relevant tax years.


ATI is then adjusted by adding the following to tentative taxable income:

  • Any business interest expense (other than disallowed business interest expense carryforwards);
  • Any NOL deduction under section 172 (including NOLs arising in tax years before the Final Regulations and carried forward);
  • Any deductions under section 199A;
  • For tax years beginning before January 1, 2022, any deduction for depreciation, amortization (and amortized expenditures), and depletion (including special allowances under section 168(k));
  • 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.

ATI would also be adjusted by subtracting the following:

  • Any business interest income included in the tentative taxable income;
  • Any floor plan financing interest expense for the tax year included in the tentative taxable income; and
  • Any income or gain that is not properly allocable to a non-excepted trade or business.
  • Any specified deemed inclusions with respect to an applicable controlled foreign corporation (“CFC”), as adjusted to reflect deductions under section 250 and other amounts.

Section 263A—depreciation, amortization, and depletion

The 2018 Proposed Regulations provided that depreciation, amortization, or depletion allocated to and capitalized with respect to inventory property under section 263A and included in cost of goods sold, was not a deduction for depreciation, amortization, or depletion for purposes of determining ATI. Thus, under the Proposed Regulations, ATI was not increased by such amounts, resulting in a lower section 163(j) limitation.

Under the Final Regulations, Treasury reverses course and permits depreciation, amortization, or depletion that is capitalized into inventory under section 263A to be added back to tentative taxable income during tax years beginning before January 1, 2022. The Final Regulations clarify that any depreciation, amortization, or depletion allocable to inventory is added back, regardless of the period in which the capitalized amount is recovered through cost of goods sold.

A taxpayer that relied on the 2018 Proposed Regulations in their entirety for tax years beginning before the Final Regulations are effective can choose to follow the Final Regulations’ section 263A rule rather than the 2018 Proposed Regulations’ section 263A rule. Thus, if a calendar year taxpayer did not increase its tentative taxable income for 2018 or 2019 in the amount of any depreciation, amortization, or depletion allocable under section 263A, the taxpayer may amend its returns for those years, but only if the taxpayer also applies the 2018 Proposed Regulations in their entirety. A taxpayer that applied the more favorable rule for depreciation in the Final Regulations before 2020 but did not adopt the 2018 Proposed Regulations in their entirety will have to consider whether to defend its position as an acceptable interpretation of the statute. 

Capitalization of interest expense

The 2018 Proposed Regulations provided that sections 263(g) and 263A apply to interest required to be capitalized under those sections before section 163(j). The Final Regulations expand this rule to apply to all interest required to be capitalized, now listing sections 263(g) and 263A as examples of the general rule. The Final Regulations retain the rule that such capitalized interest is not treated as business interest expense for purposes of section 163(j).

Section 263A(f)

The Final Regulations generally apply only to business interest expense that would be deductible in the current tax year without regard to section 163(j). Thus, subject to certain exceptions, the section 163(j) limit applies after interest is capitalized interest under sections 263A and 263(g). Under the Final Regulations, capitalized interest expense is not treated as business interest expense for purposes of section 163(j). In capitalizing interest under the avoided cost method, the Final Regulations require a taxpayer to capitalize all interest that is neither investment interest under section 163(d), business interest expense under section 163(j), nor passive interest under section 469 before capitalizing any interest that is either investment interest, business interest expense, or passive interest.

Subtractions to reverse prior depreciation, amortization, and depletion adjustments

Furthermore, the Final Regulations impose an ATI “claw back” adjustment for sales and dispositions of certain property to reverse prior ATI adjustments for depreciation, amortization, and depletion. In particular, because deductions for depreciation, amortization, and depletion for tax years beginning after December 31, 2017 and before January 1, 2022 (the “Potential Double Counted Deductions”) are added back to taxable income in computing ATI, the Final Regulations provide that with respect to the sale or other disposition of property, any Potential Double Counted Deductions with respect to such property must be subtracted from ATI, even in tax years after 2021.

KPMG observation

The Preamble to the Final Regulations states that Congress intended the ATI add-back for depreciation, amortization, and depletion from 2018-2021 “to be a timing provision that delays the inclusion of depreciation deductions in calculating a taxpayer’s section 163(j) limitation.” The rule requiring an ATI reduction upon a sale or other disposition of the property is intended to “ensure that the positive adjustment for depreciation deductions during the [2018-2021] EBITDA period merely defers (rather than permanently excludes) depreciation deductions from a taxpayer’s calculation of the section 163(j) limitation.” 

 

KPMG observation

The phrase “sale or other disposition” is intended to have a broad meaning and includes certain section 351 exchanges and transactions in which a member of a consolidated group leaves the group (other than in a whole group acquisition). However, the Final Regulations contain an exception for non-deconsolidating transfers to acquiring corporations in section 381 transactions (generally, asset reorganizations and tax-free subsidiary liquidations). There is also an exception for transfers between members of the same consolidated group, although successor asset rules will apply.

 

KPMG observation

In response to comments regarding the administrative burden of tracking dispositions of relevant assets, the Preamble to the Final Regulations states that members of consolidated groups are already required to track depreciation deductions to calculate separate taxable income and preserve the location of tax items, and that all taxpayers are required to track depreciation deductions on an asset-by-asset basis for purposes of the recapture provisions of section 1245. Thus, the Preamble asserts, the ATI claw-back rule “should not impose a significant administration burden in many situations.” 

 

KPMG observation

The Final Regulations do not include the provision from the 2018 Proposed Regulations that would have limited the ATI reduction adjustment with respect to the sale or other disposition of an asset to the lesser of (i) the amount of gain realized on the sale or other disposition of the asset or (ii) the amount of the Potential Double Counted Deductions. The Preamble states that the gain limitation rule was eliminated on the basis of administrability and to harmonize the rule that applies to direct sales or other dispositions of property with the application of the rule to sales or other dispositions of stock of consolidated subsidiaries.

However, the 2020 Proposed Regulations would allow taxpayers to use an “alternative computation method” to determine ATI, under which taxpayers can apply the gain limitation rule not only to sales or other dispositions of assets (as provided by the 2018 Proposed Regulations), but also to sales or other dispositions of interests in certain consolidated subsidiaries or partnerships. As a condition to using the alternative computation method, a taxpayer would be required to apply the gain limitation rule to all dispositions of assets, stock of consolidated subsidiaries, and partnership interests for which an adjustment is required. (The ability to rely on the 2020 Proposed Regulations is addressed elsewhere in TaxNewsFlash).


A similar rule would apply to claw back the benefit of Potential Double Counted Deductions in the context of a sale or other disposition of stock of a member of a consolidated group. This is necessary because under the investment adjustment rules of Reg. § 1.1502-32, a group member’s tax basis in the stock of a subsidiary member generally is reduced to reflect deductions claimed by that member (an adjustment that can “tier-up” and result in adjustments to the stock basis of higher-tier members). Thus, basis in member stock can indirectly reflect Potential Double Counted Deductions.

In addition, a similar rule would apply to claw back the benefit of Potential Double Counted Deductions in the context of a sale or other disposition of an interest in a partnership with respect to the taxpayer’s distributive share of any Potential Double Counted Deductions with respect to property held by the partnership at the time of sale or other disposition, to the extent such Potential Double Counted Deductions were allowable under section 704(d).

The Final Regulations also include a new Anti-Duplication rule to preclude multiple ATI reductions with respect to the same Potential Double Counted Deduction.

KPMG observation

The addition of a requested Anti-Duplication rule in the Final Regulations is expected to reduce or eliminate the likelihood of multiple ATI reductions in the context of consolidated taxpayers, and thus is welcomed. However, it is not expected to reduce the potential for complexity in the determination of consolidated ATI. For example, due to the consolidated rules that cause a tier-up of investment adjustments in the stock of higher-tier members, the restructurings or transfers of stock in lower-tier subsidiaries can result in the replication of stock basis adjustments that were originally attributable to 2018-2021 depreciation, amortization, and depletion deductions, and that may be difficult to track. In addition, with respect to a corporation departing a consolidated group, because (i) the group’s ATI is reduced in the year of departure to claw back the departing member’s Potential Double Counted Deductions in that group and no further ATI reductions are required with respect to the departing member, (ii) the group should model the reduction to its ATI and any resulting deferral of interest deductions in determining the economic cost of selling the departing member (and in evaluating whether to pursue or consent to a section 338(h)(10) election, if otherwise available). 

 

KPMG observation

The application of the consolidated ATI claw-back and Anti-Duplication rules in certain circumstances appears uncertain. The Final Regulations contain an example in which a member of a group generates $100 of depreciation deductions in 2021 and has 50% of its stock sold to an unrelated person in 2024 while it continues to hold the depreciated item of property. (The sale of a 50% interest in the member results in the member’s departure from the selling group at the end of the day of the sale.) The ATI claw-back rule provides that a transaction in which a member leaves a group is treated as a sale or disposition. However, it is unclear whether the deemed sale or disposition is of the depreciated asset, or of the member stock that reflects investment adjustments attributable to the depreciation deduction. The regulatory example concludes that the selling group’s ATI is reduced by $50 in 2024 because of the 2021 depreciation deduction. The example implies that the reduction is with respect to the investment adjustment in the stock of the member (and only with respect to the shares actually sold). At the same time, it appears that the Anti-Duplication rule is intended to provide that deductions in a consolidated return year of a group are to be disregarded in separate return years of the corporation, and thus no further ATI claw-back is to be applied to a corporation after its departure from the selling group. This suggests that only $50 of the 2021 depreciation deduction would be subjected to an ATI claw-back under the facts of the example. 

Calculating ATI for cooperatives

The Final Regulations address the rules for calculating ATI for cooperatives. As explained in the Preamble to the Final Regulations, Prop. Reg. § 1.163(j)-1(b)(1) defines ATI as the taxable income of the taxpayer for the tax year, with certain adjustments. Prop. Reg. § 1.163(j)-4(b)(4) provides a special rule for calculating the ATI of a RIC or REIT, allowing the RIC or REIT not to reduce its taxable income by the amount of any deduction for dividends paid. The Preamble to the 2018 Proposed Regulations also requested comments on whether additional special rules are needed for specific types of taxpayers, including cooperatives.

A commenter asked that the Final Regulations include a special rule for calculating the ATI of cooperatives subject to taxation under subchapter T (“sections 1381 through 1388”) of the Code. Under this special rule, taxable income would not be reduced by amounts deducted under section 1382(b)(1) (patronage dividends), section 1382(b)(2) (amounts paid in redemption of nonqualified written notices of allocation distributed as patronage dividends), or section 1382(c) (certain amounts incurred by farm cooperatives described in sections 521 and 1381(a)(1)). The commenter reasoned that such amounts are earnings passed on to members and are therefore analogous to dividends paid by a RIC or REIT to its investor.

Treasury agreed that, for purposes of section 163(j), amounts deducted by cooperatives under sections 1382(b)(1), (b)(2), and (c) are similar to amounts deducted by RICs and REITs for dividends paid to their investors. The Final Regulations therefore adopt a rule providing that, for purposes of calculating ATI, the tentative taxable income of a cooperative subject to taxation under subchapter T of the Code is not reduced by such amounts. In order to provide similar treatment to similarly situated taxpayers, the Final Regulations also provide that, for purposes of calculating ATI, the tentative taxable income of cooperatives not subject to taxation under subchapter T of the Code is not reduced by the amount of deductions equivalent to the amounts deducted by cooperatives under sections 1382(b)(1), (b)(2), and (c).

KPMG observation

The Final Regulations’ new rule applies to both Subchapter T and non-Subchapter T cooperatives. With respect to Subchapter T cooperatives, the rule applies to both non-exempt cooperatives and section 521 farmers’ cooperatives. The Final Regulations’ new rule does not modify the determination of tentative taxable income of a cooperative with respect to deductions for cooperative per-unit retain allocations to patrons of the cooperative pursuant to sections 1382(b)(3) and (b)(4). This result is consistent with the flush language of section 1382(b), which treats amounts described in sections 1382(b)(3) and (b)(4) as a deduction in arriving at gross income (e.g. such payments are typically viewed as analogous to a non-cooperative’s purchase of inventory, the cost of which ultimately is deducted as cost of goods sold). 

Contact us

For more information, contact a KPMG tax professional:

Drake Jenkins | +1 (212) 872 6525 | drakejenkins@kpmg.com

David Antoni | +1 (267) 256 1627 | dantoni@kpmg.com