In response to section 163(j) of the Tax Cuts and Jobs Act, Treasury and the IRS have issued proposed regs seeking to help shareholders avoid double counting, as well as interest deduction and income mismatches when computing adjusted taxable income.
Proposed regs (REG-106089-18), released on December 28, 2018, include prop. reg. section 163(j)-7, which limits the interest deductions of certain foreign corporations with shareholders that are U.S. persons. Prop. reg. section 1.163(j)-7 also contains special rules applicable to partnerships and financial service providers.
Section 163(j) and prop. reg. section 1.163(j)-2(b) limit a taxpayer’s interest deduction to the sum of business interest income, 30 percent of ATI, and floor plan financing interest. To the extent business interest exceeds the limit, the disallowed amount is carried forward. The proposed regs under section 1.163(j)-7 basically do two things: They limit the amount of a controlled foreign corporation’s business interest subject to the section 163(j) limitation, and they modify the computation of a CFC’s ATI.
Prop. reg. section 1.163(j)-7(b)(2) generally provides that section 163(j) and the proposed regs apply to determine the deductibility of a CFC’s business interest expense in the same manner as they apply to a domestic C corporation, unless there is a CFC group election under prop. reg. section 1.163(j)-7(b)(3) to apply an alternative method.
CFC Group Election
If a CFC group election is made, then the only portion of a CFC’s interest deduction limited by section 163(j) is the CFC member’s “allocable share” of the CFC group’s applicable net business interest expense. The limit is applied without regard to the business interest and floor plan financing interest provisions in prop. reg. section 1.163(j)-2(b)(1) and (3). Put another way, any interest expense that is not part of that allocable share is not limited by section 163(j).
Allocable share as defined in prop. reg. section 1.163(j)-7(f)(1) is the product of the CFC group’s net business interest expense and a fraction: The numerator is the group member’s interest expense, and the denominator is the sum of the net interest expense of every member of the CFC group.
Applicable net business interest expense is (with respect to a U.S. shareholder and a CFC group) the excess of the sum of the amounts of the interest expense of each CFC group member over the sum of the amounts of interest income of each CFC group member.
A CFC group election is made by computing the amount of a CFC group member’s deduction using the group method and no statement or form is necessary. All CFC group members must make the election, which is irrevocable. A CFC group is two or more CFCs if 80 percent or more of the share value is owned by a single U.S. shareholder or multiple related U.S. shareholders within the meaning of section 267(b) or 707(b)(1).
Excess Taxable Income
Prop. reg. section 1.163(j)-7(c)(3) provides that if a CFC group election is in effect and one CFC group member owns stock in another, the ATI of the upper-tier CFC member includes its pro rata share of the lower-tier member’s excess taxable income (ETI).
ETI is defined in section 1.163(j)-7(f)(5) as the amount that bears the same ratio to the member’s ATI as (a) the excess of 30 percent of the member’s ATI over the member’s allocable share of net interest expense bears to (b) 30 percent of the member’s ATI.
Prop. reg. section 1.163(j)-7(d) contains guidance for a U.S. shareholder computing its ATI. It requires a U.S. shareholder that has included amounts in gross income under sections 78, 951(a), or 951A(a) (called specified deemed inclusions), to subtract from ATI its specified deemed inclusions reduced by any section 250(a)(1) deduction.
If a U.S. shareholder owns stock in a CFC group member with a group election in effect, ATI includes the eligible CFC group ETI with respect to the highest-tier member, but not more than the CFC group inclusions. Eligible CFC group ETI is the amount equal to the U.S. shareholder’s pro rata share of the highest-tier CFC’s ETI multiplied by the member’s specified ETI ratio.
With respect to a higher-tier CFC group member, the specified ETI ratio is a fraction in which the numerator is the sum of the amounts included in a U.S. shareholder’s gross income under sections 951(a) and 951A(a), and the denominator is the CFC group member’s taxable income.
CFC group inclusions are the specified deemed inclusions amounts subtracted from taxable income other than amounts included in gross income under section 78, less any 50 percent section 250 deduction.
A CFC member’s items are included in the specified ETI ratio if it has amounts included in the ratio’s numerator and has ETI without regard to prop. reg. section 1.163(j)-7(c)(3) — that is, it has its own ETI rather than only a lower tier’s.
Examples
Two examples in prop. reg. 1.163(j)-7(g) illustrate how these rules work together.
Example 1 compares CFC group members’ section 163(j) deduction limit when a group election is and isn’t made.
USP is the parent of two wholly owned U.S. subsidiaries that wholly own three CFCs. USP and its subsidiaries file a consolidated return. The USP consolidated group’s tax year is the calendar year, while the CFCs’ tax years end November 30.
CFC1 has a $1,000 third-party loan payable and has relent the proceeds to CFC2 and CFC3 ($500 each). CFC1 has $90 interest expense on the loan payable, and $100 interest income from CFC2 and CFC3. CFC 2 and CFC3 each have $50 interest expense on their loans payable to CFC1. All three CFCs have ATI of $100. (See Figure 1.)
Within the meaning of section 958(a), US1 and US2 own all their CFCs, and therefore all CFCs are applicable CFCs within the meaning of prop. reg. section 1.163(j)-7(f)(2). Because US1 and US2 are members of a consolidated group, they are treated as a single taxpayer. Therefore, because the CFCs are owned by a single U.S. shareholder, they are members of a CFC group as defined in prop. reg. section 1.163(j)-7(f)(6) eligible to make a CFC group election under prop. reg. section 1.163(j)-7(b)(3).
Because the majority U.S. shareholder’s tax year ends on December 31, 2019, if an election is made, the CFC’s specified tax years would be November 30, 2019, which is the tax year that ends within the majority U.S. shareholder’s tax year under prop. reg. section 1.163(j)-7(f)(17).
The CFC group’s applicable net business interest expense is $90, or the group’s total interest expense of $190 minus its interest income of $100. CFC1 has zero net interest expense, while CFC2 and CFC3 each have $50 net interest expense. CFC2 and CFC3 each have a 50 percent allocable share of the group’s $90 of net interest expense, or $45 each. Only this portion of CFC2’s and CFC3’s interest expense is subject to the general 30 percent of ATI limitation rule in section 1.163-2(b).
Under prop. reg. section 1.163(j)-7(b)(3)(i), CFC1’s $90 interest expense and $5 of CFC2’s and CFC3’s interest expense is not subject to the limitation in prop. reg. section 1.163(j)-2(b). Under prop. reg. section 1.163(j)-7(b)(3)(ii), the general rule is applied without regard to prop. reg. section 1.163(j)-2(b)(1) and (3). CFC2’s and CFC3’s limitations are $30, or 30 percent of $100 ATI computed on a separate basis.
The amount of CFC2’s and CFC3’s allocable share of $45 net interest expense limited under prop. reg. section 1.163(j)-7(b)(3) exceeds its $30 limitation; therefore $35 ($30 plus $5 not subject to limitation) of their interest expense is deductible. Under prop. reg. section 1.163(j)-2(c), the remaining $15 can be carried forward.
Finally, because the USP consolidated group has no business interest expense, prop. reg. section 1.163(j)-7(d) (which governs a U.S. shareholder’s ATI computation) is not relevant. (See Table 1.)
| Interest Income | Net Interest Expense | Interest Deduction | Carryforward |
|---|---|---|---|---|
CFC1 | $100 | $0 | $90 | $0 |
CFC2 | $0 | $50 | $35 | $15 |
CFC3 | $0 | $50 | $35 | $15 |
Group | $100 | $190 | $160 | $30 |
If the CFC group makes no election, each CFC must compute its interest deduction limitation under prop. reg. section 1.163(j)-2(b) without regard to prop. reg. section 1.163(j)-7(b)(3). CFC1’s business interest expense of $90 is deductible because it is lower than its business interest income. CFC2’s and CFC3’s interest expense limitations are $30, and the remaining $20 is carried forward. The effect of the group’s election is a deduction that is $10 larger, or $5 for each of CFC2 and CFC3. This represents $5 of their $50 interest expense that is not part of their $45 allocable share of the group’s applicable net business interest expense (See Table 2.)
| Interest Income | Net Interest Expense | Interest Deduction | Carryforward |
|---|---|---|---|---|
CFC1 | $100 | $0 | $90 | $0 |
CFC2 | $0 | $50 | $30 | $20 |
CFC3 | $0 | $50 | $30 | $20 |
Group | $100 | $190 | $150 | $40 |
Example 2 provides guidance for computing and allocating ETI.
USP wholly owns CFC1, which wholly owns CFC2, which wholly owns CFC3 and CFC4. All entities have a calendar tax year. In year 1, prior to the application of section 163(j):
CFC1 has no items of income, gain, deduction, or loss;
CFC2 has a taxable loss of $5, including $5 of business interest expense, and none of its items of income or deduction are tested income or tested loss for GILTI purposes;
CFC3 has taxable income of $85, including $15 of business interest expense; 50 percent of its income is subpart F income; 50 percent of its deductions are allocable to subpart F income; and none of the remaining 50 percent is tested income or tested loss; and
CFC4 has $60 of taxable income, including $40 of business interest expense; all of CFC4’s income is tested income; and all of its deductions are allocable to tested income.
A group election is in effect; there is no intercompany debt; and no CFC has qualified business asset investments. For purposes of computing ATI, there are no subtractions or additions to taxable income other than for business interest expense. No foreign income taxes are paid by any CFC. Finally, in addition to USP’s gross income inclusions under subpart F and GILTI, it has $20 of its own business interest expense. (See Figure 2.)
Under prop. reg. section 1.163(j)-7(f)(3), the CFC group’s applicable net business interest expense is $60 ($0 + $5 + $15 + $40). Because there is no intercompany debt, however, each of the CFCs’ allocable shares of the $60 total is equal to its actual business interest expense.
Each entity’s tax results are computed by starting at the lower tiers and rolling the results up through the ownership layers to USP.
CFC4’s ATI is $100 (or $60 taxable income plus $40 interest expense), so its 30 percent interest deduction limitation is $30. CFC4’s interest expense ($40) exceeds its limitation ($30), and so $10 of its interest expense is not deductible and will be carried forward, increasing CFC4’s tested income to $70.
CFC3’s ATI is also $100 ($85 income plus $15 interest expense), limiting CFC3’s interest deduction to $30. CFC3’s $15 interest expense is lower than its 30 percent limitation, so all of CFC3’s interest expense is deductible. As noted, CFC3’s subpart F income is $42.50, or 50 percent of its $85 taxable income. Moreover, CFC3 has ETI of $50, or $100 x $15/$30.
Under prop. reg. section 1.163(j)-7(c)(3), CFC2’s ATI is $50, or its $5 taxable loss + $5 interest expense + $50, which is its 100 percent pro rata share of CFC3’s ETI. Under prop. reg. section 1.163(j)-2(b), CFC2’s interest expense limitation is $15, or 30 percent of ATI. Because CFC2’s interest expense is lower than its limitation, all of CFC2’s $5 interest expense is deductible. Moreover, CFC2 also has ETI of $33.33 ($50 x $10/$15).
Under prop. reg. section 1.163(j)-7(c)(3), CFC1’s ATI is $33.33 (or $0 of its own taxable income + its 100 percent pro rata share of CFC2’s ETI). Unlike CFC2, CFC1 has zero of its own interest expense.
Under subpart F, USP includes $42.40 in gross income with respect to CFC3; and under GILTI, USP includes $70 in gross income with respect to CFC4, which is reduced by 50 percent to $35 via the section 250(a)(1)(B) deduction. The total amount of USP’s CFC group inclusions is $77.50 ($42.50 subpart F + $35 GILTI), and its taxable income prior to section 163(j) is $57.50 ($77.50 inclusions - $20 interest expense).
Under prop. reg. section 1.163(j)-1(b)(1) and prop. reg. section 1.163(j)-7(d)(2), USP’s ATI is only $16.67, which is equal to $57.50 of its taxable income + $20 of interest expense - $77.50 of CFC group inclusions (or zero) + $16.67 of group ETI. The eligible CFC group ETI is $33.33 (CFC1’s excess taxable income) x 50 percent (CFC1’s specified ETI ratio) x USP’s 100 percent pro rata share.
CFC1’s 50 percent specified ETI ratio under prop. reg. section 1.163(j)-7(f)(14) is $42.50/$85, the numerator being the amount of USP’s subpart F inclusion with respect to CFC3, and the denominator being CFC3’s taxable income.
This fraction does not include amounts with respect to any other CFC, because none of them has ETI without regard to prop. reg. section 1.163(j)-7(c)(3). Moreover, USP includes no subpart F income or GILTI in gross income with respect to CFC1 or CFC2.
Under prop. reg. section 1.163(j)-2(b), USP’s section 163(j) limitation is $5 (or 30 percent of $16.67 ATI). USP’s $20 interest expense exceeds its limitation, and so $15 of the expense is disallowed and carried forward. (See Table 3.)
| CFC4 | CFC3 | CFC2 | CFC1 | USP |
|---|---|---|---|---|---|
Interest Expense | $40 | $15 | $5 | $0 | $20 |
ETI | — | $50 | $33.33 | $33.33 | — |
ETI Fraction -7(f)(5) | — | $15/$30 | $10/$15 | — | — |
ETI Ratio -7(f)(14) | — | — | — | $42.50/$85 | — |
ATI | $100 | $100 | $50 | $33.33 | $16.67 |
Deduction | $30 | $15 | $5 | $0 | $5 |
Carryforward | $10 | $0 | $0 | $0 | $15 |
Rationale
Understanding the rationale behind these rules helps to predict how to properly apply them. These rules reflect Treasury and the IRS’s awareness that section 163(j) could cause a mismatch of interest deduction and income items when interest is paid by one CFC to a related CFC, which could affect the calculation of a U.S. shareholder’s tax liability under subpart F and GILTI. To avoid the mismatch, they devised an approach acknowledging that money is fungible within a group of related CFCs — hence, the CFC group concept.
This alternative method limits the amount of a CFC group member’s interest expense that is subject to section 163(j). The amount is the CFC group member’s allocable share of the group’s applicable net business expense, which is the excess of interest expense of each CFC group member over the sum of the amounts of interest income of each group member.
If an election is made and if a CFC only has intercompany debt, then the amount of the CFC group’s applicable net business interest expense is zero, and no interest expense of any CFC group member is subject to the section 163(j) limitation. As a result, there is no increase in GILTI solely because of intercompany debt.
On the other hand, if a CFC group has applicable net business interest expense, each group member determines its allocable share of expense subject to the section 163(j) limitation.
Moreover, in computing a CFC’s ATI, an upper-tier CFC group member can consider a proportionate share of ETI, or the “excess” ATI of a lower-tier group member. This is the amount of a CFC group member’s ATI above the amount needed before there would be disallowed interest expense.
Additionally, absent regulations, a U.S. shareholder of a CFC would have ATI to the extent it includes subpart F income or GILTI in gross income. To avoid double counting the taxable income of a CFC that has already been taken into account to determine the CFC’s section 163(j) limitation, there is a general rule that the ATI of a U.S. shareholder is computed without regard to amounts included in gross income under sections 78, 951(a), and 951A(a) that are allocable to a non-excepted trade or business.
Finally, the purpose of the specified ETI ratio is to address the fact that within a group, income of a lower-tier member CFC that is not subpart F income nor tested income for GILTI purposes is included in the CFC’s ETI and can be used by an upper-tier member. It is distortive for a U.S. shareholder to get an increase in ATI in respect of that income because it is not taxed in the U.S. The specified ETI ratio formula is intended to estimate the portion of the CFC’s ETI attributable to this income, as a direct tracing approach would increase complexity.