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IRS Illuminates Complications in Drafting Interest Regs

Posted on Sep. 23, 2020

Some complexities that arose in developing regulations to implement the business interest deduction rules under the coronavirus pandemic relief legislation were left on the table to be resolved later, according to an IRS official. 

The recently issued section 163(j) guidance to implement the Coronavirus Aid, Relief, and Economic Security Act (P.L. 116-136) “was on a really fast track given the exigent circumstances of the time,” which precluded addressing some issues, John Lovelace, branch 5 attorney, IRS Office of Associate Chief Counsel (Corporate), said during a September 22 webinar sponsored by the District of Columbia Bar Taxation Community

The Tax Cuts and Jobs Act amended section 163(j) to limit the business interest expense deduction to the sum of business interest income, 30 percent of adjusted taxable income, and floor plan financing interest. 

The CARES Act enacted in March increased the net business interest deduction limit computation from 30 percent of ATI to 50 percent for tax years beginning in 2019 or 2020, with special rules provided for partnerships. For tax years beginning in 2020, taxpayers may elect to compute the interest expense limitation based on their 2019 ATI — a benefit for companies expecting lower income this year from the effects of the pandemic or otherwise. 

The proposed section 163(j) regulations (REG-107911-18), which accompanied final rules (T.D. 9905) initially issued July 28 and published in the Federal Register September 14, provided, among other things, rules to implement provisions of the CARES Act. 

In one somewhat surprising rule, the government proposed that if a corporation acquires a target in a section 381 transaction in 2020 and elects to use its 2019 ATI for determining its 2020 business interest deduction limit, the acquiring corporation would use its 2019 ATI but exclude the target’s 2019 ATI, said Lisa M. Zarlenga of Steptoe & Johnson LLP

Lovelace explained that the IRS originally intended to address the inclusion of the target’s income in the guidance, “and perhaps permitting it, but when we dug into the issue, it was a bit more complicated than perhaps we had first appreciated.” 

One complexity arises in situations in which a member of a consolidated group is acquired, but not the entire group, Lovelace said. In those cases, “you would have to determine how much of the group’s ATI goes with that member, which is not something you would ordinarily really determine,” he said. He added that other challenges included how to handle midyear acquisitions in 2019 and 2020. 

“Rather than put something out that we weren’t particularly happy with that [would be] extremely limited, we [decided to] go with a very easy rule and request comments for something that was a little more robust,” Lovelace explained. 

In the proposed regs’ preamble, Treasury and the IRS requested comments on whether the target’s income should be included in the calculation of the acquiring corporation’s 2019 ATI and “how such a rule would address more complex fact patterns, such as situations where the acquiring corporation is acquired in a subsequent transaction described in section 381, or where the acquired corporation and the acquiring corporation have different tax years.” 

Anti-Double-Counting Rules 

The section 163(j) regs provide rules that prevent taxpayers from getting a benefit in computing the business interest deduction cap for those tax years with immediate full expensing of property available under section 168(k) and then getting another boost on the gain recognized when selling the asset. 

That potential double benefit also occurs in the consolidated group context when one member sells shares of another member that held depreciable property, and in the sales of partnership interests. 

For sales or other dispositions of property, reg. section 1.163(j)-1(b)(1)(ii)(C) requires that the greater of the allowed or allowable depreciation, amortization, or depletion of the property for tax years beginning in 2018 through 2021 be subtracted from tentative taxable income. 

Under reg. section 1.163(j)-1(b)(1)(ii)(D), consolidated groups must reduce tentative taxable income upon the sale or other disposition of stock of a group member by another member by the reg. section 1.1502-32 investment adjustment attributable to the depreciation and similar deductions on the property. 

Treasury and the IRS clarified in the consolidated group context that intercompany transactions and section 381(a) transactions aren’t treated as a sale or other disposition that would trigger a negative adjustment in determining ATI.  

William Pauls of Deloitte Tax LLP inquired why an exception was provided for section 381 transactions but not for section 351 transactions involving property that had been subject to depreciation, amortization, or depletion. 

The IRS considered extending the exception to section 351 transactions but ultimately decided that section 381 transactions were “where we were going to draw the line,” Lovelace said, adding that comments are welcome “if people think we didn’t get it right or think we did get it right.” 

“There are some of us that work in the space where a 351 transaction [has] . . . a quasi-381 feel,” such as the transaction addressed in Rev. Rul. 94-45, 1994-2 C.B. 39, Pauls said, suggesting that it might be something to keep in mind as the rules are further developed.

The final regs also include a deconsolidation rule under which any transaction in which a member leaves a consolidated group — except for some transactions described in the intercompany transaction regs’ whole-group acquisition exception rule (reg. section 1.1502-13(j)(5)(A)) — is treated as a sale or other disposition requiring a reduction in computing the ATI of the group that benefited from depreciation addback in tax years before 2022. 

An anti-duplication rule prevents an asset sale of depreciable property that follows a stock sale of the member that held the property, or vice versa, from causing a second reduction in tentative taxable income if a subtraction for the same economic amount already was required under reg. section 1.163(j)-1(b)(1)(ii)(C) or (D).  

For adjustments following deconsolidation, the regs state that “depreciation, amortization, or depletion deductions allowed or allowable for a corporation for a consolidated return year of a group are disregarded” following deconsolidation for any year that constitutes a separate return year. 

Zarlenga asked how the whole group acquisition exception, which wouldn’t trigger the anti-double-counting rule, interacts with the anti-duplication rule — a question also raised by other practitioners

Lovelace concurred that if the exception to the deconsolidation rule applied, “not only would you not get an adjustment on the deconsolidation . . . you wouldn’t trigger any adjustment in the future.” 

“We’re thinking about what to do about that, but we don’t have a solution right now,” Lovelace said.

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