Manufacturers May Suffer Under Business Interest Regs

February 22, 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

Re: Request for Guidance on Limitations on Business Interest Deductions under Section 163(j) (REG-106089-18)

Dear Sirs:

We offer the following comment related to the proposed regulations under section 163(j) issued by the Department of the Treasury (the “Treasury”) and the Internal Revenue Service (the “IRS”) (the “Proposed Regulations”).¹ Specifically, we submit that amounts incurred as depreciation, amortization, or depletion that are properly capitalized by manufacturers and other businesses to inventory under section 263A should be treated as deductions for depreciation, amortization, or depletion² for purposes of section 163(j). For the reasons described below, we believe that this interpretation of section 163(j) is necessary to implement the intent of Congress in modifying section 163(j) and is consistent with Treasury and the IRS's historic positions regarding treatment of deductible expenses that are subject to section 263A.

Background

As revised by the law commonly known as the Tax Cuts and Jobs Act, section 163(j)(1) generally limits the amount deductible as business interest expense for any taxable year to the sum of the taxpayer's business interest income, 30 percent of the taxpayer's adjusted taxable income (“ATI”), and the taxpayer's floor plan financing interest, each as determined for the current year. Section 163(j)(8) defines ATI as the taxable income of the taxpayer computed without regard to certain items. Nonbusiness income or deductions, business interest expense or business interest income, net operating losses, and deductions under section 199A are all excluded from ATI. In addition, for taxable years beginning before January 1, 2022, ATI excludes “any deduction allowable for depreciation, amortization, or depletion.”³ Because depreciation allowances reduce taxable income, their exclusion under section 163(j)(8) increases ATI, and correspondingly increases the amount of business interest expense a taxpayer may deduct under section 163(j). Finally, the statute provides that ATI is “computed with such other adjustments as provided by the Secretary.”⁴

Section 263A and the regulations thereunder, known generally as the Uniform Capitalization (“UNICAP”) rules, govern the cost accounting of property produced and acquired for resale. The UNICAP rules require the allocation of certain direct costs and a proper share of indirect costs, including depreciation, attributable to such property.⁵ Allocable costs are limited to those costs, which are “otherwise deductible” in the taxable year.⁶ For manufacturers, allocable costs are included in inventoriable costs.⁷ As a result, to the extent that depreciation is allocated to manufactured inventory, such amounts are capitalized and subsequently recovered through cost of goods sold, which reduces the taxable income of manufacturers on their federal income tax returns.

The Proposed Regulations

A question therefore arises in interpreting section 163(j)(8) as to whether the application of section 263A changes the status of an amount allowed for depreciation from a “deduction allowable” to something else that is not excluded from the computation of ATI. The Proposed Regulations take the position that it does, providing:

Accordingly, under the Proposed Regulations, manufacturers and others subject to UNICAP would not be permitted to reverse depreciation amounts capitalized into inventory in determining their ATI for purposes of section 163(j), and therefore would be subject to more restrictive limitations on deductions of interest expense than if they were not subject to the UNICAP rules.

The Preamble to the Proposed Regulations does not provide any specific legal basis or other rationale for the disparate treatment of depreciation that is capitalized into inventory, merely stating that Prop. Treas. Reg. § 1.163(j)-1(b)(1) clarifies “an issue raised by a commenter in response to Notice 2018-28.”⁹ As discussed below, this proposed rule is inconsistent with Congressional intent and with previous Treasury interpretations of UNICAP and it leads to incongruous, unjustifiable results.

Treatment of Capitalized Expenses in Other Contexts

The UNICAP rules were enacted as part of the Tax Reform Act of 1986 and subsequently modified and clarified in the Technical and Miscellaneous Revenue Act (“TAMRA”) of 1988. The legislative history reflects that Congress changed the capitalization rules in order to better match the timing of the reduction in taxable income for otherwise deductible amounts with the income that the costs were incurred to generate.¹⁰ However, the legislative history nowhere suggests that Congress imposed the UNICAP rules to convert a currently deductible amount into something other than a deduction for any purpose other than determining the taxable year in which the expense should be taken into account.¹¹ In fact, the legislative history even refers to depreciation that is subject to the UNICAP rules (and therefore would be capitalized in inventory) as “depreciation deductions.”¹² Congress further emphasized that UNICAP is a timing provision only, and should not be interpreted to change existing law regarding whether an item was deductible or not with a refinement included in TAMRA.¹³

In keeping with this understanding of the scope of section 263A, Treasury and the IRS have consistently interpreted other sections of the Code that refer to “deductions” for depreciation as including depreciation taken into account in inventory under UNICAP. For example, section 1016(a)(2) provides for the reduction of basis to account for depreciation to the extent the depreciable amounts are “allowed as deductions in computing taxable income . . . but not less than the amount allowable.”¹⁴ Notwithstanding the language of section 1016, there can be little doubt that the basis of depreciable property is reduced even if the depreciation is capitalized under the UNICAP rules rather than taken as a deduction on the taxpayer's return.¹⁵

In a generic legal advice from 2008, the IRS addressed whether environmental remediation costs and workers compensation costs that were capitalized under the UNICAP rules, as required by IRS guidance,¹⁶ could give rise to specified liability losses (“SLLs”) within the meaning of section 172(f).¹⁷ Like depreciation allowances, manufacturers are required to capitalize their environmental and workers compensation expenses to inventory. Section 172(f), as in effect in 2008, required that the environmental remediation costs be “allowable as a deduction” in order to be taken into account in determining an SLL. This led the examiner to question whether manufacturers that included these expenses in cost of goods sold could avail themselves of the extended NOL carryback rules that applied to SLLs.

The IRS determined that such amounts were eligible to be treated as SLLs despite their being included in inventory rather than reflected on the taxpayer's return as section 162 deductions. Consistent with the application of section 1016, the IRS concluded that Congress used the phrase “allowable as a deduction . . . to mean amounts that may be taken into account in computing taxable income.” The legal advice reasons that in referencing deductions in section 162(f), “Congress did not mean to distinguish 'deductions' from 'cost of goods sold',” but rather to distinguish disallowed deductions from those allowed, just as section 263A itself does.

Interpretation of Section 163(j)(8)

Consistent with the above examples, the “deduction allowable” language in section 163(j)(8) should not be understood as distinguishing between expenses that are capitalized under the UNICAP rules and those that are not. There is no reason to think that when Congress used that phrase to define ATI in section 163(j)(8), it meant anything other than “amounts that may be taken into account in computing taxable income.” As stated above, references to amounts “allowable” as a deduction have been interpreted in this manner numerous times since UNICAP was enacted.

More broadly, the treatment of depreciation capitalized into inventory adopted by the Proposed Regulations creates arbitrary and unjustifiable results for taxpayers subject to the UNICAP rules. Under the Proposed Regulations, unlike other taxpayers, taxpayers subject to UNICAP would not be able to increase their ATI by reversing their depreciation allowances, and would therefore be subject to stricter limitations on interest expense deductions. There is no apparent policy reason that would account for this disparate treatment between those taxpayers subject to the UNICAP rules (generally including manufacturers, retailers, utilities and defense companies) and those taxpayers that are not (service industries and small taxpayers).

Equally importantly, this adverse disparate treatment in the Proposed Regulations is directly contrary to one of the clear aims of the Tax Cuts and Jobs Act, which is to foster US manufacturing in order to boost the US economy. The revisions to sections 168, 179 and other sections of the Code are designed to encourage manufacturers to purchase property, plant, and equipment and to put it into service during the several years immediately following passage of the Tax Cuts and Jobs Act. It would be anomalous for Congress to encourage the purchase of equipment with these Code sections and then to treat manufacturers considerably more adversely with respect to expenses related to financing these same purchases. At the least, if Congress had intended this disparate adverse treatment for manufacturers when it drafted the language of section 163(j), it would have explained the reason for this treatment.¹⁸ The interpretation of section 163(j)(8) adopted by the Proposed Regulations is inconsistent with intent of Congress and as such is not a valid interpretation of the statute.

Finally, as noted above, section 163(j)(8)(A)(v) provides that ATI will be computed with “such other adjustments as provided by the Secretary.” Thus, even if “deduction allowable” were properly read to exclude depreciation capitalized pursuant to the UNICAP rules, Treasury has the authority to provide an adjustment for such depreciation. As discussed above, such an adjustment is necessary to effect the intent of Congress in enacting the Tax Cuts and Jobs Act and in order to avoid the obviously unintended disparate treatment of American manufacturers.

If you have any questions, please feel free to contact me.

Sincerely,

Aaron Payne
Eversheds Sutherland (US) LLP
Washington, DC

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

Krishna Vallabhaneni
Acting Tax Legislative Counsel
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Ellen Martin
Tax Policy Advisor
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Scott Dinwiddie
Associate Chief Counsel (Income Tax & Accounting)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Charles Gorham
Special Counsel to Associate Chief Counsel (Income Tax & Accounting)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224