Individual Pushes for Abandonment of Interest Deduction Regs

February 23, 2019

The Honorable David J. Kautter
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

The Honorable Charles P. Rettig
Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

The Honorable William M. Paul
Acting Chief Counsel
Deputy Chief Counsel (Technical)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Re: Comments on Treatment of Guaranteed Payments for the Use of Capital in Proposed Regulations under Section 163(j)

Dear Messrs. Kautter, Rettig, and Paul:

I am pleased to submit the attached paper addressing the treatment of guaranteed payments for the use of capital in the proposed regulations under section 163(j). As discussed in the paper, the government may not have the authority to treat such payments as interest for purposes of section 163(j). This treatment conflicts with both the text of section 707(c) and the way it has long been understood by the government and practitioners alike.

If you have any questions or comments or would like to discuss the analysis and conclusions I reach in the paper, please let me know.

Respectfully submitted,

Alexandre Marcellesi
New York, NY

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SECTION 163(j): WHY TREASURY CANNOT TREAT GUARANTEED
PAYMENTS FOR THE USE OF CAPITAL AS INTEREST^*

Alexandre Marcellesi

1. Introduction

Partners contributing capital to a partnership often require a preferred return on their investment.¹ Such returns are analogous to dividends paid to holders of a corporation's preferred stock.² Just as there are many ways to structure a preferred dividend (conditional vs. unconditional, cumulative vs. noncumulative, etc.), there are many ways to structure a preferred return. In either case, the structure adopted dictates the tax consequences. Preferred stock with debt-like features, for instance, may be classified as debt under section 385, with the result that payments from issuer to holder would be interest that is deductible by the former but ordinary income to the latter.

The Code seemingly provides clear rules regarding the tax treatment of preferred returns. A preferred return that is dependent on partnership income is included in the partner's distributive share of such income under section 704(b) and treated as a distribution under section 731.³ The recipient of such a return will therefore have capital gains to the extent the partnership's income is derived from the sale of capital assets or the receipt of qualified dividend income.

To the extent a preferred return is determined without regard to partnership income, however, it is a guaranteed payment for the use of capital (“GPUC”) under section 707(c). Despite an apparently clear statutory rule, the line between preferred returns that are GPUCs and those that are not is notoriously blurry.⁴ There are few clear-cut cases. A preferred return computed as a percentage of capital invested and required to be paid annually, for instance, is most likely a GPUC.⁵ Practitioners, however, emphasize “the significant uncertainty that currently exists in identifying payments that constitute [GPUCs].”⁶

Whether a preferred return is a GPUC matters because guaranteed payments are treated as payments made by the partnership to a non-partner, “but only for the purposes of section 61(a) (relating to gross income) and, subject to section 263, for purposes of section 162(a) (relating to trade or business expenses).”⁷ As a result, GPUCs are generally understood to be ordinary income to the payee under section 61 and deductible by the payor under section 162, subject to the capitalization requirement of section 263.⁸ It is also generally understood that, for all other purposes of the Code, GPUCs are included in the partner's distribute share of partnership income. Regulations recently proposed by Treasury under section 163(j), however, call this understanding into question.⁹

Section 163 of the Code generally allows taxpayer to deduct interest paid or accrued on indebtedness.¹⁰ The deduction allowed is limited in the case of business interest.¹¹ This limit was amended by P. L. 115-97, the bill signed into law by President Trump on December 22, 2017 and commonly known as the Tax Cuts and Jobs Act (“TCJA”). New section 163(j) generally limits the amount of business interest expense deductible by a taxpayer to the sum of their business interest income and 30 percent of their adjusted taxable income.¹²

Treasury's recently proposed regulations provide that, for purposes of section 163(j), “[a]ny guaranteed payments for the use of capital under section 707(c) are treated as interest.”¹³

This regulation conflicts with the traditional understanding of GPUCs. First, it suggests that partnerships may no longer be able to deduct GPUCs in full under section 162.¹⁴ Second, it treats GPUCs as non-partner payments for the purposes of a Code section other than sections 61(a) or 162(a). It is no surprise, then, that many members of the tax bar were caught off guard by Treasury's decision to propose such a regulation and believe that Treasury is reaching beyond the limits of its power.¹⁵

This article lays out the argument underlying this widely shared impression. In a nutshell, Treasury's regulation, assuming it is finalized without modification, does not pass muster under Chevron and is arbitrary and capricious under section 706(2)(A) of the Administrative Procedure Act (“APA”).¹⁶ There is, moreover, no easy way to modify this regulation to ensure its validity under either Chevron or the APA. Treasury should therefore abandon it.

This article focuses on the narrow legal question of Treasury's authority to issue a regulation treating GPUCs as interest for purposes of section 163(j). It may well be that, from the point of view of sound tax policy, some partnership interests entitling their holders to GPUCs should be treated as partnership debt on which interest may accrue. The problem is that, whereas Congress has given Treasury regulatory authority to make debt-equity determinations in the case of corporate stock — in the form of section 385 — it has so far failed to do so in the case of partnership interests.

2. The Chevron Challenge

In Mayo, the Supreme Court held that the principles underlying Chevron “apply with full force in the tax context.”¹⁷ Not all agency regulations, however, are subject to judicial review under Chevron. Under Mead, this is the case “when it appears that Congress delegated authority to the agency generally to make rules carrying the force of law, and that the agency interpretation claiming deference was promulgated in the exercise of this authority.”¹⁸

Applying Mead to a Treasury regulation in Mayo, the Supreme Court found the fact that the regulation had been issued through the notice-and-comment process and pursuant to Congress's general grant of regulatory authority in section 7805(a) to be “a very good indicator of delegation meriting Chevron treatment” and a “significant sign that a rule merits Chevron deference.”¹⁹

Because Treasury is using the notice-and-comment process to issue the section 163(j) regulations and is doing so pursuant to its section 7805(a) authority, these regulations are subject to review under Chevron.²⁰ Although the Supreme Court sidestepped this issue in Mayo, these features also make the section 163(j) regulations “legislative regulations” subject to the APA.²¹

Judicial review under Chevron is a two-step process.²² The first step requires a court to determine,

Let me here assume that Congress has not directly spoken to the precise question whether GPUCs are “interest” within the meaning of section 163(j).²⁴ Given this assumption, the Chevron analysis can proceed to its second step.

A court's task at Chevron Step Two would be to determine whether Treasury's regulation treating GPUCs as interest for purposes of 163(j) is a permissible construction of the statute.²⁵ A court will defer to Treasury's interpretation unless it is “arbitrary, capricious, or manifestly contrary to the statute.”²⁶ There is no requirement, however, that Treasury's interpretation be the only plausible one.²⁷

Treasury's regulation fails at Chevron Step Two because it is not a permissible interpretation of “interest” in section 163(j). The Supreme Court is clear that, under Chevron, “reasonable statutory interpretation must account for both the specific context in which . . . language is used and the broader context of the statute as a whole.”²⁸ The broader context in which to assess Treasury's interpretation of section 163(j) is the Code.²⁹

Crucially, in the Supreme Court's view, if Treasury's interpretation produces a meaning “inconsistent with the design and structure of the statute as a whole, [it] does not merit deference.”³⁰ Evaluating Treasury's regulation therefore requires one to look at the Code to determine whether this regulation “produces a substantive effect that is compatible with the rest of the law.”³¹

Unfortunately for Treasury, it does not. This regulation conflicts with both the text of section 707(c) and with the traditional understanding of it as providing that GPUCs are only treated as non-partner payments for purposes of sections 61(a) and 162(a). This is particularly significant because this traditional understanding has been embraced by Treasury itself in its regulations, the IRS in various guidance documents, the Joint Committee on Taxation, and the courts.

Section 707(c) was enacted in 1954.³² As mentioned above, it provides that guaranteed payments are treated as payments made to non-partners, “but only for the purposes of section 61(a) (relating to gross income) and, subject to section 263, for purposes of section 162(a) (relating to trade or business expenses).” The language of section 707(c) straightforwardly implies that, for all other purposes, guaranteed payments are treated as made to partners acting in their capacity as such. They are therefore included in the recipient's distributive share of partnership income.

According to legislative history, Congress's primary intent in enacting section 707(c) was “to eliminate the complexity that arose under prior law when compensatory payments to partners exceeded the net income of the partnership.”³³ Congress, in particular, sought to ensure that partners receiving guaranteed payments for services would have to include them in income, even when these payments exceed partnership taxable income and might otherwise be treated as a non-taxable return of capital.³⁴ Although the report of the Senate Finance Committee on the bill introducing section 707(c) refers to GPUCs as “guaranteed interest payments,”³⁵ it also explicitly states that “[section 707(c)] treatment is only provided for purposes of the reporting of income by the partner and the deducting of the payments by the partnership.”³⁶

Consistent with the text and purpose of the statute, the regulations under section 707 issued by Treasury in 1956 explicitly state that section 707(c) treatment only applies to GPUCs for purposes of sections 61(a) and 162(a). According to these regulations,

Treasury's own historical understanding of the scope of section 707(c) could hardly be clearer.

Treasury's reading of section 707(c) was endorsed in 1997 by the Joint Committee on Taxation (“JCT”). According to JCT,

For all other purposes, guaranteed payments are treated in the same manner as a distributive share of partnership income.³⁸

Although JCT has expressed the view that GPUCs “conceptually ressemble[ ] interest on debt,” it has also acknowledged that section 707(c) does not currently treat them as such.³⁹

Consistent with the statutory text and its widely accepted understanding, the IRS has characterized GPUCs as interest for purposes of section 61(a) in two instances. In General Counsel Memorandum (“GCM”) 36702, the IRS held that GPUCs were interest to the payee for purposes of section 61(a)(4).⁴⁰ The IRS confirmed its position on this issue a few years later in GCM 38133.⁴¹ In both cases, however, the IRS also held that, even though the payments were interest to the payee, they were only deductible by the partnership under section 162, not under section 163.⁴² In other words, in the only two instances in which the IRS has treated GPUCs as interest, it was careful to do so within the strict limits set by section 707(c).

By contrast, in Letter Rulings 8639035 and 8728033, the IRS held that GPUCs from a partnership to a REIT partner were part of the REIT's distributive share of partnership gross income, and thus qualified as rental income for purposes of the section 856(c)(3) gross income test.⁴³ Importantly, the IRS based its conclusion on the claim that,

The IRS has therefore followed Treasury and JCT in adopting a literal interpretation of the “but only” language in section 707(c).

Treasury itself has adopted a similarly cautious approach when issuing regulations regarding GPUCs. The regulations under section 263A, for instance, treat certain GPUCs as interest and require partnerships making such GPUCs to capitalize them rather than deduct them currently.⁴⁵ Importantly, however, section 707(c) expressly provides that GPUCs are to be treated as non-partner payments for purposes of section 162(a), subject to the rules of section 263 regarding expenses required to be capitalized. The caveat regarding section 263 is naturally read to extend to section 263A. The latter is, in effect, an addendum to the former, as indicated by its placement in the Code and the fact that it, too, contains rules regarding expenses required to be capitalized.

By contrast, when issuing regulations under Code sections other than sections 61(a), 162(a), or 263/263A, Treasury has refrained from treating GPUCs as non-partner payments, and as interest in particular. Treasury has, for instance, proposed regulations according to which an obligation to make GPUCs is not, “[i]n accordance with U.S. tax principles,” a liability on which interest may accrue for purposes of determining the interest deduction of a foreign corporation engaged in a U.S. trade or business under section 882.⁴⁶

One might object that Treasury proposed and finalized, without objection, a regulation under section 469 which unambiguously treats GPUCs as interest for the purpose of section 469, i.e. for a purpose not contemplated by section 707(c).⁴⁷ Although this observation is correct, Treasury was well aware that the regulation it issued under section 469 was in conflict with its own understanding of section 707(c), as stated in section 1.707-1(c) of the regulations. The preamble to the temporary section 469 regulations, which were finalized without modification, states that the “Service expects that a conforming amendment will be made to § 1.707-1.”⁴⁸

Although the 469 regulations were issued in 1988, no amendment has so far been made to the regulations under section 707. A possible explanation is that Treasury knows it lacks the authority to issue such a regulation, given the clear limits imposed by the text of section 707(c). If so, the existence of this section 469 regulation hardly undermines the argument developed in this article. If anything, this argument supports the view that this regulation is just as invalid as Treasury's section 163(j) regulation treating GPUCs as interest.

The literal interpretation of the “but only” language in section 707(c) adopted by Treasury, the IRS, and JCT is consistent with case law regarding section 707(c). The principle illustrated by this case law is that section 707(c) treats guaranteed payments, whether for services or for the use of capital, as non-partner payments but only for purposes of section 61(a), section 162(a), and any other section incorporated by reference in either of these two sections.⁴⁹ Sections of the Code that provide an exclusion from gross income, in particular, have been found to be incorporated by reference in section 61(a).

In Carey v. United States, for instance, the Court of Federal Claims held that section 911 — allowing United States citizens residing abroad to exclude any foreign-source earned income from gross income — was incorporated by reference in section 61(a) “by means of the phrase, 'Except as otherwise provided in this subtitle. . . .'.”⁵⁰ The same principle is suggested in Jenkins v. Commissioner with respect to section 104, which excludes certain forms of compensation for injuries or sickness from gross income.⁵¹

This understanding of the “but only” language, which finds its origins in Miller v. Commissioner,⁵² was further confirmed in Kampel v. Commissioner.⁵³ In Kampel, the Tax Court held that section 1348 was not incorporated by reference in section 61(a) and that, as a result, guaranteed payments were a distributive share of partnership income for its purposes. The Tax Court reasoned that, unlike section 911, section 1348 does not provide an exclusion from gross income but merely “alters the tax rate provided by section 1.”⁵⁴ On this basis, it found that “the section 61 phrase 'except as otherwise provided in this subtitle' cannot be read as applying to section 1348.”⁵⁵

Given the standard adopted by the courts, section 163(j) cannot be incorporated by reference in either section 61(a) or section 162(a). Section 163 allows individuals and corporations an itemized deduction for interest paid or accrued on indebtedness. Section 163(j) limits this deduction in the case of business interest expense. Section 163(j) therefore has no conceptual or computational connection to the determination of gross income under section 61(a).

There is no case law addressing the incorporation of any Code provision by reference in section 162(a). Section 163(j), however, cannot be so incorporated. First, unlike section 61(a), section 162(a) does not contain an “except as otherwise provided” caveat which could be used to incorporate other Code sections denying or limiting the deduction allowed by section 162. Although the presence of this caveat should not be determinative, courts have nonetheless found it significant.⁵⁶

Second, and most importantly, the deduction limited by section 163(j) is allowed by section 163(a), not by section 162(a). The preamble to Treasury's proposed regulations notes that section 163(j)(1) limits the amount of business interest expense allowed as a deduction under Chapter 1 of the Code.⁵⁷ The scope of the limit imposed by section 163(j) is thus, “on its face, broader than merely deductions under section 163.”⁵⁸ The only provision of Chapter 1 allowing a deduction for interest expense, however, is section 163(a).⁵⁹ The actual scope of section 163(j) is therefore much narrower than it is “on its face”. One might also interpret Treasury as suggesting that section 163(j) may limit deductions allowed by Code sections other than section 163. This is a highly unorthodox view for which there is no legal authority. It is also, as a result, highly unlikely that a court would find section 163(j) incorporated by reference in section 162(a).

There is yet another reason to think that Treasury's interpretation of “interest” in section 163(j) is impermissible under Chevron Step Two. Section 163(a) allows a deduction for interest paid or accrued on indebtedness. For GPUCs to reasonably be understood to be interest, then, partnership interests held by partners entitled to GPUCs must constitute debt rather than equity.

The preamble to the proposed section 163(j) regulations states that Treasury intended to include in its definition of “interest” any amount paid or accrued on an instrument treated as debt for purposes of section 1275 of the Code and section 1.1275-1(d) of the regulations.⁶⁰ Under the latter, a debt instrument is “any instrument or contractual arrangement that constitutes indebtedness under general principles of the Federal income tax law (including, for example, a certificate of deposit or a loan).”⁶¹ Treasury therefore claims that its definition of interest as encompassing GPUCs rests on general principles of Federal income tax law.

The IRS, however, has acknowledged that the obligation for a partnership to make GPUCs to a partner does not create indebtedness. Thus, in GCM. 36702, the IRS recognized that “true indebtedness . . . by definition is not present when Code § 707(c) applies.” The proposed section 885 regulation mentioned above also reflect Treasury's understanding that, “[i]n accordance with U.S. tax principles,” an obligation to make a guaranteed payment is not a partnership liability.⁶² The general principles of Federal income tax law invoked by Treasury thus do not, by its own lights, justify treating GPUCs as interest. Although this objection applies to any proposed treatment of GPUCs as interest, it applies with particular force to proposals to treat GPUCs as interest for purposes not sanctioned by section 707(c), since these proposals lack a sound foundation in the first place.

Interpreting “interest” in section 163(j) as encompassing GPUCs contradicts both the text of section 707(c) and the way Treasury, the IRS, JCT, and the courts have long understood it. It also contradicts the view embraced by Treasury and the IRS that partnership interests entitling their holders to GPUCs are not debt. This evidence strongly supports the claim that Treasury's interpretation is manifestly contrary to the statute and impermissible under Chevron Step Two. This is especially the case given the Supreme Court's willingness to strike down agency interpretations that are, by the agency's own lights, inconsistent with the broader statutory scheme.⁶³

This argument is not affected by the existence of Notice 2004-31.⁶⁴ This notice purports to limit the ability of corporate partners to avoid old section 163(j) by inappropriately converting interest payments into GPUCs that may be fully deductible under section 162. It does so by classifying certain transactions as “listed transactions,” which triggers an obligation for taxpayers to disclose them to the IRS.⁶⁵ Although the IRS may have legal authority to challenge certain arrangements intended by the parties to be GPUCs as constituting payments of interest on indebtedness instead, this does not imply that Treasury or the IRS have legal authority to treat all GPUCs as interest, regardless of factual circumstances or of the statutory text.

Additionally, Treasury's section 163(j) regulation would make Notice 2004-31 redundant. If GPUCs are interest for purposes of section 163(j), then a partnership can only deduct them within the limits set by this section and so it cannot escape these limits by converting interest payments into GPUCs. If anything, Notice 2004-31 shows that the IRS's historical view is that GPUCs are not subject to the limits of section 163(j) and that section 163(j) does not limit the deduction allowed by section 162. This notice is thus further evidence that, in the IRS's own view, “interest” in section 163(j) is not properly interpreted as encompassing GPUCs.

3. Policy Reversals, Chevron, and the APA

Treasury's historical view is that GPUCs are only treated as non-partner payments for purposes of sections 61(a) and 162(a). Treasury's decision to propose a regulation treating GPUCs as interest for purposes of section 163(j) thus represents a departure from its prior policy and practice.

Although agency interpretations that change over time may be entitled to Chevron deference, Treasury must “display awareness that it is changing position” and “show that there are good reasons for the new policy.”⁶⁶ In particular, Treasury cannot “depart from a prior policy sub silentio. . . .”⁶⁷ Treasury is therefore required to acknowledge and explain its decision to radically change its understanding of GPUCs. It has so far failed to do so.

The preamble to the proposed section 163(j) regulations does not explicitly discuss GPUCs. In discussing its definition of “interest,” Treasury simply claims to have adopted a definition of interest “that addresses all transactions that are commonly understood to produce interest income and expense, including transactions that may otherwise have been entered into to avoid the application of section 163(j).”⁶⁸ The evidence presented above, however, shows that GPUCs have not commonly been understood to produce interest income and expense.

Treasury therefore displayed no awareness that it was changing position regarding GPUCs and did not, a fortiori, explain this change. Treasury's failure to acknowledge that its proposed section 163(j) regulation conflicts with section 1.707-1(c) of its own regulations is particularly striking. This failure further undermines any claim that Treasury's interpretation of “interest” as encompassing GPUCs is permissible under Chevron Step Two. As the DC Circuit has held, “[a] statutory interpretation . . . that results from an unexplained departure from prior policy and practice is not a reasonable one.”⁶⁹

Instead of challenging Treasury's section 163(j) regulation under Chevron, a taxpayer could so under section 706(2)(A) of the APA.⁷⁰ The APA provides that agency action is “unlawful” if it is “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law. . . .”⁷¹ As Patrick J. Smith points out, the APA's “arbitrary and capricious” standard is “a powerful tool for taxpayers to use in challenging IRS regulations. . . .”⁷²

In State Farm, the Supreme Court interpreted the “arbitrary and capricious” standard as requiring (1) that agencies offer contemporaneous explanations of their policy decisions and (2) that such explanations demonstrate reasoned decision-making.⁷³ This standard is fairly deferential. In the Supreme Court's words, “[t]he scope of review under the 'arbitrary and capricious' standard is narrow and a court is not to substitute its judgment for that of the agency.”⁷⁴ When agencies change course, however, they are “obligated to supply a reasoned analysis for the change beyond that which may be required when an agency does not act in the first instance.”⁷⁵

Whereas Treasury once believed that, “[f]or the purposes of other provisions of the internal revenue laws [i.e. provisions other than sections 61(a) and 162(a)], guaranteed payments are regarded as a partner's distributive share of ordinary income,” it now believes that GPUCs should be treated as interest for purposes of section 163(j). Because Treasury changed its policy regarding GPUCs without acknowledging, let alone explaining, this change, it did not “supply a reasoned analysis for the change,” as required by State Farm.⁷⁶ This makes the section 163(j) regulation treating GPUCs as interest arbitrary and capricious and therefore invalid under section 706(2)(A) of the APA.

The Supreme Court has suggested that the APA's arbitrary and capricious standard and Chevron Step Two are equivalent in that, under both standards, the key question is whether the agency's interpretation is “arbitrary or capricious in substance.”⁷⁷ As the Tax Court also put it in Altera, “whether State Farm or Chevron supplies the standard of review is immaterial because Chevron step 2 incorporates the reasoned decisionmaking standard of State Farm.”⁷⁸ The argument that Treasury's section 163(j) regulation fails at Chevron Step Two thus further supports the conclusion that this regulation is arbitrary and capricious under State Farm and the APA.

To be sure, the section 163(j) regulation treating GPUCs as interest has not been finalized yet. This means that Treasury still has the opportunity to acknowledge and explain its policy change. It is unclear, however, how Treasury could provide an explanation reconciling its proposed section 163(j) regulation with its existing section 1.707-1(c) regulation. One cannot coherently hold that GPUCs are interest for purposes of section 163(j) and that, for purposes of Code sections other than sections 61(a) and 162(a), “guaranteed payments are regarded as a partner's distributive share of ordinary income.”⁷⁹ The only way to reconcile these two claims would be to hold that section 163(j) is somehow incorporated by reference in section 162(a). As I argued above, however, there is no legal authority for this claim.

4. Conclusion

Treasury's recently proposed section 163(j) regulation treating GPUCs as interest, assuming it is finalized without modification, is invalid. It fails at Chevron Step Two because it is not a permissible interpretation of the statute. It contradicts both the text of section 707(c) and the way Treasury, the IRS, JCT, and the courts have long understood it. It also conflicts with the view embraced by Treasury and the IRS that partnership interests entitling their holders to GPUCs are not debt.

The fact that this regulation also constitutes an (as yet) unacknowledged and unexplained policy change on Treasury's part both further supports the claim that it fails at Chevron Step Two and supports the claim that it is arbitrary and capricious under State Farm and section 706(2)(A) of the APA.

Because Treasury is unlikely to be able to reconcile its proposed section 163(j) regulation with its section 1.707-1(c) regulation and, more generally, with the traditional understanding of GPUCs and of the scope of section 707(c), it should abandon its proposed section 163(j) regulation.