International Implications of Revised Section 163(j) – Application to Controlled Foreign Corporations
On November 26, 2018, the Treasury released extensive proposed regulations on Section 163(j).
General Application of 163(j)
Prior to its amendment by the Tax Cuts and Jobs Act (“TCJA”), Section 163(j) (the “earnings stripping” limitation) limited the amount of interest deductions that could be taken by certain corporations if the interest was paid or accrued to, or guaranteed by, certain related persons. The TCJA replaced prior Section 163(j) in its entirety with a general cap on net business interest expense equal to 30% of net business income (i.e., “adjusted taxable income” or “ATI”), regardless of who the lender or guarantor is. Under new Section 163(j), there is no longer any international or related party prerequisite to the application of the interest expense limitation, which applies to businesses regardless of whether the interest crosses borders or whether the loan involves a related party. In addition, the application of the section has been extended to individuals, partnerships and S corporations.
Application of Section 163(j) to CFCs
The proposed regulations apply the Section 163(j) limitation to controlled foreign corporations (CFCs). Under a general rule, the Section 163(j) limitation applies on a separate entity basis to determine the deductibility of a CFC business interest expense in the same manner as the limitation applies to a domestic corporation. CFCs with business interest expense would apply Section 163(j) to determine Subpart F income (under Section 952), Global Intangible Low-Taxed Income (“GILTI”)-tested income (under Section 951A(c)(2)(A)) and income effectively connected with a U.S. trade or business (for purposes of Section 882).1 If a CFC is a partner in a partnership, the proposed regulations provide that Section 163(j) and the related regulations apply to the partnership as if the CFC were a domestic C corporation.
Election to Apply Section 163(j) on a CFC Group Basis
The preamble to the proposed regulations observes that the general rule described above, which applies Section 163(j) to related CFCs on an entity-by-entity basis, may be inappropriate in certain circumstances. For example, where CFC1 lends funds to a related CFC2, CFC2 would have an interest deduction that could be limited by Section 163(j), whereas CFC1 would have interest income that may be taxable to the U.S. shareholder of both CFCs as GILTI.
The proposed regulations provide for an irrevocable election that allows the members of a “CFC Group” to apply Section 163(j) on a group basis (the “Alternative Method”). A CFC Group is two or more applicable CFCs if at least 80% of the stock by value of each applicable CFC is owned, within the meaning of Section 958(a), by a single U.S. shareholder or, in the aggregate, by related U.S. shareholders if each U.S. shareholder owns the stock of each applicable CFC in the same proportion.
Under the Alternative Method, no member of an applicable CFC Group would be subject to the Section 163(j) limitation if a CFC Group has only intra-CFC Group debt. Any net business interest expense that remains after the netting of intercompany business interest income and business interest expense (that is, third-party debt or debt from entities outside of the CFC Group) would be subject to limitation under Section 163(j), and this calculation would be done at the separate CFC level.
The Alternative Method does not eliminate the need for CFC-by-CFC computations if the CFC Group has any interest expense paid to non-CFC Group members.
Impact on Non-U.S. Entities and Persons that Have Effectively Connected Income (“ECI”)
Foreign entities and persons that have ECI are subject to Section 163(j). The application of Section 163(j) and the general rules under the proposed regulations are modified so that the Section 163(j) limitation is calculated only with respect to the foreign person’s ECI.
Significantly, the proposed rules do not relate back to the enactment of Section 163(j). Rather, the rules would be applicable for taxable years ending after the date on which the final regulations are published in the Federal Register.
Taxpayers and related parties determined under Sections 267(b) and 707(b)(1)) have the discretion to apply all the Section 163(j) proposed rules retroactively to a taxable year beginning after December 31, 2017, but they must apply such rules on a consistent basis. Therefore, retroactive application would be binding on the taxpayer and all its related parties (or shareholders in certain cases). Further, although there are separate effective date provisions within the proposed rules, taxpayers cannot pick and choose which provisions of the proposed rules they want to apply retroactively. Taxpayers should review the retroactive effect of the provisions in the proposed regulations.
1 The Section 163(j) limitation is taken into account when calculating the above types of taxable income; the earnings and profits of a CFC are reduced by interest expense that is subject to the Section 163(j) limitation for purposes of limiting the Subpart F inclusion under Section 952(c). If a CFC has only Subpart F income, the Section 163(j) limitation should have little effect regarding Subpart F income; however, GILTI income could be increased.