The Tax Cuts and Jobs Act made significant changes to section 163(j) rules that limit the ability of taxpayers to deduct interest expense. The new rules were further revised by the Coronavirus Aid, Relief, and Economic Security Act (P.L.
116-136).
New final and proposed regs published in September provide comprehensive guidance on the interest deduction limitation, including guidance on its application to controlled foreign corporations and their U.S. shareholders. The new proposed regs contain significant modifications to proposed regs previously issued on December 28, 2018. The modifications are intended to reduce the administrative burdens on taxpayers complying with section 163(j), including allowing CFCs to elect to calculate their interest deduction limitations on a group basis.
The TCJA replaced prior section 163(j)(1) through (9) and added section 163(j)(10), effective for tax years beginning after December 31, 2017. The CARES Act further amended section 163(j) by providing special rules for applying section 163(j) to tax years beginning in 2019 or 2020. Specifically, it amended section 163(j) by redesignating the TCJA’s section 163(j)(10) as new section 163(j)(11) and added new rules via a new section 163(j)(10).
Final regs published on September 14 (T.D. 9905) provide considerable guidance on how to implement the new interest deduction limitation, but contain very little guidance on CFCs and U.S. shareholders. Proposed regs (REG-107911-18) published the same day, however, provide guidance on CFCs and U.S. shareholders. Prop. reg. section 1.163(j)-7(a)-(m) specifically addresses the application of the section 163(j) interest deduction limitation to foreign corporations and their U.S. shareholders.
Section 163(j) generally limits the amount of business interest expense (BIE) that a taxpayer can deduct in the year incurred. Under section 163(j)(1), the amount of BIE allowed as a deduction is limited to the sum of:
the taxpayer’s business interest income (BII);
30 percent of the taxpayer’s adjusted taxable income; and
the taxpayer’s floor plan financing interest expense.
Under section 163(j)(2), any BIE not allowed as a deduction in a tax year because of the above limitation is carried over to a succeeding tax year.
Prop. reg. section 1.163(j)-7(a) contains an overview of the section 163(j) application to CFCs and their U.S. shareholders. It presents a useful summary of the rules in prop. reg. section
1.163(j)-7(a)-(m), including how to:
apply section 163(j) to a CFC;
apply section 163(j) to members of a CFC group;
determine a specified group and specified group members;
treat a specified group member as a CFC group member;
treat a CFC group member that has effectively connected income;
compute a CFC’s ATI;
apply a safe harbor that exempts some stand-alone CFCs and CFC groups from section 163(j); and
compute a U.S. shareholder’s ATI.
Prop. reg. section 1.163(j)-7(k)-(m) also contains 32 definitions, three examples, and two sets of effective dates.
This article will address the rules for specified groups, specified periods, and CFC groups that are generally present in prop. reg. section
1.163(j)-7(c), (d), and (e).
The reg. section 1.163(j)-7(b) general rule applying section 163(j) to relevant foreign corporations was in the final regs and not revised by the proposed regs. It provides that section 163(j) and accompanying regs apply to determine the deductibility of a relevant foreign corporation’s BIE for U.S. income tax purposes in the same manner as a domestic C corporation’s BIE.
Relevant corporation is defined in reg. section 1.163(j)-1(b)(33) as any foreign corporation whose classification is relevant under reg. section 301.7701-3(d)(1) other than solely because of section 881 or 882. Practically speaking, this means foreign corporations whose taxable income is relevant for U.S. tax purposes other than because of having ECI or fixed, determinable, and periodic income.
As noted in the final regs’ preamble, Treasury and the IRS have determined that section 163(j) has applied to foreign corporations since its effective date. They have also determined that it is appropriate to reduce the administrative and compliance burdens of applying section 163(j) to applicable CFCs while still carrying out its provisions and policies.
Accordingly, prop. reg. section 1.163(j)-7 provides a CFC group election to apply section 163(j) on a group basis for applicable CFCs that are “specified group members” of a “specified group.” If the election is made, the specified group members become “CFC group members” and all of the members collectively are referred to as a “CFC group.” Applicable CFC is defined in reg. section 1.163(j)-7(b)(2) as a foreign corporation described in section 957 but only if it has at least one U.S. shareholder.
Treasury and the IRS anticipate that prop. reg. section 1.163(j)-7 will significantly reduce the administrative and compliance burdens of applying section 163(j) to applicable CFCs compared with the 2018 proposed regs.
Specified Groups, Members, and Periods
Prop. reg. section 1.163(j)-7(d)(1)-(5) provides rules for determining specified groups and specified group members, which is the basis for determining CFC groups and CFC group members, because a CFC group member is a specified group member of a specified group that has made a CFC group election under prop. reg. section1.163(j)-7(e)(2).
Under prop. reg. section 1.163(j)-7(d)(2), a specified group includes one or more chains of applicable CFCs connected with a specified group parent through stock ownership. This condition is met only if:
the specified group parent owns stock that meets the requirements of section 1504(a)(2)(B) (concerning value) in at least one applicable CFC; and
one or more of the other applicable CFCs or the specified group parent owns stock that meets the requirements of section 1504(a)(2)(B) in each of the applicable CFCs (except the specified group parent).
Unlike the general rules in section 1504, however, the specified group rules have a look-through rule to avoid breaking affiliation with a partnership, foreign trust, or foreign estate. To determine whether stock in an applicable CFC that meets the requirements of section 1504(a)(2)(B) is owned by the specified group parent or other applicable CFCs, prop. reg. section 1.163(j)-7(d)(2) takes into account stock owned directly and indirectly under section 318(a)(2)(A) or (B) through a domestic or foreign partnership, or through a foreign estate or trust.
For example, assume CFC1 and CFC2 are applicable CFCs and specified group members. If CFC1 and CFC2 each own 50 percent of the capital and profits interests in a partnership, and the partnership wholly owns applicable CFC3, CFC3 is also included in the specified group under the look-through rule, although the partnership is not.
The specified group rules also differ from the section 1504 affiliated group rules in that they require that only 80 percent of an applicable CFC’s value (not 80 percent of both vote and value) be owned by the specified group parent or other applicable CFCs to be included in the specified group. Treasury and the IRS determined that limiting the 80 percent threshold to value is appropriate to prevent taxpayers from breaking affiliation by diluting voting power below 80 percent.
A specified group has a single specified group parent, which may be either a qualified U.S. person or an applicable CFC. However, the specified group parent is included in the specified group only if it is an applicable CFC. For this purpose, a qualified U.S. person is a U.S. person that is a citizen or resident of the United States or a domestic corporation, including an S corporation.
In determining the specified group parent, members of a consolidated group are treated as a single corporation, and individuals who file jointly are treated as a single individual because these taxpayers report deemed inclusions from applicable CFCs on a single tax return.
Domestic partnerships are not qualified U.S. persons eligible for specified group parent status. However, if a domestic partnership wholly owns an applicable CFC that wholly owns multiple other applicable CFCs, and no qualified U.S. person owns the required stock in the top-tier CFC, the look-through rule operates to include the applicable CFCs in a specified group and treat the top-tier CFC as the specified group parent. Treasury and the IRS request comments on whether a qualified U.S. person should include domestic estates and trusts and whether the look-through rule should apply to them.
Each specified group has a specified period. This is like a tax year, but it belongs to a specified group, which cannot have a tax year because the specified group members may not have the same tax year.
If the specified group parent is a qualified U.S. person, the specified period generally ends on the last day of the specified group parent’s tax year, and it begins on the first day after that last day. For example, if the specified group parent is a domestic corporation with a calendar-year tax year, the specified period generally begins on January 1 and ends on December 31.
If the specified group parent is an applicable CFC, the specified period generally ends on the last day of the specified group parent’s required year determined under section 898(c)(1), without regard to section 898(c)(2) (generally the majority U.S. shareholder’s tax year). It begins on the first day after that last day.
However, a specified period never begins before the first day the specified group exists, and it never ends after the last day the specified group exists. And like a tax year, a specified period can never be longer than 12 months.
To determine when a specified group ceases to exist, taxpayers are directed to the principles of section 1.1502-75(d)(1), (d)(2)(i) through (d)(2)(ii), and (d)(3)(i) through (d)(3)(iv) (regarding when a consolidated group remains in existence). In applying these reg. section 1.1502-75(d) principles, each applicable CFC treated as a specified group member is treated as affiliated with the specified group parent from the beginning to the end of the specified period, without regard to the beginning or end of the applicable CFC’s tax year.
However, this rule does not affect the general rule that, for purposes other than reg. section 1.1502-75(d), like the application of section 163(j) to a CFC group for example, an applicable CFC is a specified group member during a specified period for its tax year ending with or within the specified period.
To illustrate, assume a specified group parent with a calendar year acquires all the stock of applicable CFC1 on June 30, year 1, and sells it on June 30, year 3. CFC1 has a November 30 tax year, and the specified period is the calendar year. CFC1 is included in the specified group on November 30, years 1 and 2, but not 3. As a result, CFC1 is a specified group member for its tax years ending November 30, year 1 and 2, regarding the specified periods ending December 31, year 1 and 2. In other words, solely for purposes of applying the reg. section 1.1502-75(d) principles, CFC1 is treated as affiliated with the specified group parent from January 1, year 1, to December 31, year 2.
Treasury and the IRS request comments as to whether any modifications to the reg. section 1.1502-75(d) principles should be made for specified groups.
Prop. reg. section 1.163(j)-7(d)(3) provides rules for determining a specified group’s specified group members. Whether an applicable CFC is a specified group member is determined for the applicable CFC’s tax year and for the specified group’s specified period. If the applicable CFC is included in a specified group on the last day of its tax year that ends with or within the specified period, the applicable CFC is a specified group member of the specified period for its entire tax year.
To illustrate, assume applicable CFC1 has a tax year beginning December 1, year 1, and ending November 30, year 2. A specified group has a specified period beginning January 1, year 2, and ending December 31, year 2. If CFC1 is included in the specified group on November 30, year 2, then CFC1 is a specified group member during the specified period for its entire tax year ending November 30, year 2.
This is true even if CFC1 is not included in the specified group during part of its tax year ending November 30, year 2 (for example, if all the CFC1 stock is purchased by the specified group on June 1, year 2, and its tax year does not close as a result of joining the specified group). It’s also true if CFC1 ceases to be included in the specified group after November 30, year 2, but before December 31, year 2 (for example, if all the CFC1 stock is sold on December 15, year 2).
CFC Groups
Prop reg. section 1.163(j)-7(c)(1)-(5) provides rules for applying section 163(j) to CFC group members of a CFC group.
Under prop. reg. section 1.163(j)-7(c)(2), a single section 163(j) limitation is computed for a CFC group. For this purpose, the current-year BIE, disallowed BIE carryforwards, BII, floor plan financing interest expense, and ATI of a CFC group are equal to the sums of the current-year amounts of these items for each CFC group member for its specified tax year for the specified period.
A CFC group member’s current-year BIE, BII, floor plan financing interest expense, and ATI for a specified tax year are generally determined on a separate-company basis before being included in the CFC group calculation.
The extent to which a CFC group’s section 163(j) limitation is allocated to a particular CFC group member’s current-year BIE and disallowed BIE carryforwards is determined using the consolidated group rules in prop. reg. section 1.163(j)-5(a)(2) and (b)(3)(ii), as modified by prop. reg. section 1.163(j)-7(c)(3)(i).
Because CFC groups are often owned by consolidated groups, taxpayers will be familiar with the consolidated BIE rules. If the sum of the CFC group’s current-year BIE and disallowed BIE carryforwards exceeds the CFC group’s section 163(j) limitation, then current-year BIE is deducted first before the carryforwards.
If the CFC group’s current-year BIE exceeds the CFC group’s section 163(j) limitation, then each CFC group member deducts the amount of its current-year BIE that does not exceed the sum of its BII and floor plan financing interest expense. Then, if the CFC group has any section 163(j) limitation left, each applicable CFC with remaining current-year BIE deducts a pro rata portion.
But if the CFC group’s section 163(j) limitation exceeds its current-year BIE, CFC group members may deduct all their current-year BIE and BIE carryforwards not in excess of the CFC group’s remaining section 163(j) limitation. BIE carryforwards are deducted in the order of the tax years in which they arose, beginning with the earliest tax year. BIE carryforwards that arose in the same tax year are deducted on a pro rata basis.
These ordering rules are consistent with the consolidated BIE rules. However, prop. reg. section 1.163(j)-7 has special rules for BIE carryforwards when CFC group members have different tax years, or a CFC group member has multiple tax years in the CFC group’s specified period. Unlike consolidated group members, CFC group members will not all have the same tax years. And not all CFC group members will have the same tax year as the CFC group’s parent. A CFC group member is included in a CFC group for its entire tax year that ends with or within a specified period.
For example, assume a multinational group parented by a U.S. consolidated group has a calendar tax year. The group includes applicable CFCs that also have calendar tax years but also includes applicable CFCs that have November 30 tax years.
In that case, the specified period of the CFC group for 2020 would begin on January 1, 2020, and end on December 31, 2020. The specified tax year of a CFC group member with a calendar tax year is its tax year ending December 31, 2020. The specified tax year of a CFC group member with a November 30 tax year is its tax year ending November 30, 2020, the tax year that ends with or within the specified period.
A CFC group member can also have multiple tax years within a specified period. For example, a CFC group member may have a short tax year because of an election under section 1.245A-5T(e)(3)(i) to close its tax year because an extraordinary reduction has occurred.
If a CFC group member has BIE carryforwards when it joins a CFC group, the carryforwards are subject to the CFC group section 163(j) limitation and are deducted pro rata with other CFC group BIE carryforwards. However, pre-group BIE carryforwards are subject to additional limitations that are similar to the limitations on deducting a consolidated group’s BIE carryforwards that arise in a separate return limitation year (as defined in reg. section 1.1502-1(f)) or that are treated as arising in a separate return limitation year (under the principles of reg. section 1.1502-21(c) and (g)).
If a CFC group member with pre-group BIE carryforwards leaves one CFC group and joins another, the loss member and each other CFC group member that left the former group and joined the current group comprises a “pre-group subgroup.”
Unlike separate return limitation year subgroups, all members of a pre-group subgroup are not required to join the CFC group at the same time, because each applicable CFC is treated as joining a CFC group on the first day of its tax year. Therefore, even if multiple applicable CFCs are acquired on the same day in a single transaction, they could still join a CFC group on different days if they have different tax years.
To address the CARES Act changes to section 163(j)(10), prop. reg. section 1.163(j)-7(c)(5) provides special rules for specified periods beginning in 2019 or 2020. These rules will be the subject of a later article.
Specified Groups as CFC Groups
Prop. reg. section 1.163(j)-7(e)(1)-(5) provides rules and procedures for treating specified group members as CFC group members and for determining a CFC group. Prop. reg. section 1.163(j)-7(e)(2) defines CFC group and CFC group member. A CFC group member is a specified group member of a specified group that has made a CFC group election. The specified group member is a CFC group member for a specified tax year during a specified period. A CFC group is all CFC group members for their specified tax years during a specified period. A specified tax year is defined in prop. reg. section 1.163(j)-7(k)(30) as the tax year of an applicable CFC specified group member that ends with or within a specified period.
Therefore, if a CFC group election is in effect, the terms “specified group members,” “CFC group members,” and “CFC group” refer to the same applicable CFCs. The term “specified group” may not always refer to the same applicable CFCs, however, because it is determined at a moment in time. Under prop. reg. section 1.163(j)-7(e)(3), after a CFC group election is made, the CFC group continues until the CFC group election is revoked or until the end of the specified group’s last specified period.
When a CFC group election is in effect, if an applicable CFC becomes a specified group member for a specified group’s specified period, the CFC group election applies to the applicable CFC and it becomes a CFC group member. Under prop. reg. section 1.163(j)-7(e)(4), when an applicable CFC ceases to be a specified group member during a specified group’s specified period, the CFC group election terminates only for the applicable CFC.
Prop. reg. section 1.163(j)-7(e)(5) provides rules for making and revoking a CFC group election. A CFC group election applies for a specified period of a specified group. Accordingly, the CFC group election applies to each specified group member for its entire specified tax year that ends with or within the specified period.
A CFC group election cannot be revoked for any specified period of the specified group that begins during the 60-month period following the last day of the first specified period for which the election was made. Once revoked, a CFC group election cannot be made again for five years from the last day of the specified period for which the election was revoked.
Treasury and the IRS request comments regarding whether a specified group that does not make a CFC group election when it first exists should be prohibited from making a CFC group election for any specified period beginning during the five-year period following that period.
Examples
Examples 1 and 2 illustrate the operation of the rules for specified periods of specified groups and the CFC group rules.
Example 1 illustrates specified tax years included in a specified period of a specified group. As of June 30, year 1, domestic corporation USP owns 60 percent of foreign corporation FP’s stock, and an unrelated foreign corporation owns the remaining 40 percent. FP wholly owns FC1, FC2, and FC3, which are all applicable CFCs.
FP acquired the FC3 stock from an unrelated person on March 22, year 1, and the acquisition did not cause a change in or close of FC3’s tax year. USP’s interest in FP and FP’s interest in FC1 and FC2 have been the same for several years. USP has a tax year ending June 30, year 1, which is not a short year. Under section 898(c)(2), FP and FC1 have tax years ending May 31, year 1, and under section 898(c)(1), FC2 and FC3 have tax years ending June 30, year 1.
The first step is to determine the specified group and its specified period. Under prop. reg. section 1.163(j)-7(d), FP, FC1, FC2, and FC3 are members of a specified group, and FP is the specified group parent. Because the specified group parent is an applicable CFC, the specified group’s specified period is the period:
ending on June 30, year 1, which is the last day of FP’s required year described in section 898(c)(1) without regard to 898(c)(2); and
beginning on July 1, year 0, which is the first day following the last day of the specified group’s immediately preceding period (the last day of the preceding period being June 30, year 0).
After the specified group’s specified period is determined, the next step is to determine the specified tax years of the specified period.
Under prop. reg. section 1.163(j)-7(d)(3), because FP and FC1 are in the specified group on the last day of their tax years ending May 31, year 1, and those tax years end with or within the specified period ending June 30, year 1, FP and FC1 are specified group members in the specified period ending June 30, year 1, for their entire tax years ending May 31, year 1, and those tax years are specified tax years.
Similarly, because FC2 and FC3 are included in the specified group on the last day of their tax years ending June 30, year 1, and those tax years end with or within the specified period ending June 30, year 1, FC2 and FC3 are specified group members during the specified period ending June 30, year 1, for their entire tax years ending June 30, year 1, and those tax years are specified tax years. That FC3 was acquired on March 22, year 1, does not prevent it from being a specified group member during the specified period for the portion of its specified tax year before the March 22, year 1, acquisition date.
Example 2 illustrates the CFC group rules. The facts are the same as in Example 1, except that a CFC group election is in place for the specified period ending June 30, year 1. Because a CFC group election is in place, under prop. reg. section 1.163(j)-7(e)(2)(ii), each specified group member is also a CFC group member for its specified tax year ending with or within the specified period.
Therefore, FP, FC1, FC2, and FC3 are CFC group members for the specified period ending June 30, year 1, for their specified tax years ending May 31 and June 30, year 1, respectively. Under prop. reg. section 1.163(j)-7(e)(2)(i), the CFC group for the specified period ending June 30, year 1, consists of FP, FC1, FC2, and FC3 for their specified tax years ending May 31 and June 30, year 1, respectively.
Under prop. reg. section1.163(j)-7(c)(2), a single section 163(j) limitation is computed for the specified period ending June 30, year 1. That section 163(j) calculation will include FP, FC1’s, FC2’s, and FC3’s specified tax years ending May 31 and June 30, year 1, respectively.