Section 163(j), which was codified in the Tax Cuts and Jobs Act, generally limits a taxpayer’s annual business interest expense deductions to the sum of business interest income plus 30% of EBITDA (or EBIT, beginning in 2022). Certain real estate businesses and businesses with gross receipts of $25 million or less are exempt from the limitation. In addition, the CARES Act generally increases the 30% threshold to 50% for 2019 and 2020.
The final regulations largely adopt the proposed regulations, which we reported on here, with some important modifications. New proposed regulations provide additional guidance. Here are some of the key features of the regulations package:
Definition of Interest
In general. The final regulations significantly narrow the definition of interest that was included in the original proposed regulations. Subject to the exceptions discussed below, the final regulations generally treat as interest only amounts that otherwise are considered interest for U.S. tax purposes. Accordingly, in contrast to the original proposed regulations, the final regulations generally do not treat the following items as interest:
- Commitment fees and debt issuance costs;
- Partnership guaranteed payments for the use of capital;
- Gains or losses from interest rate hedges; and
- Substitute interest on repos and securities loans entered into in the ordinary course of the taxpayer’s business.
Upfront swap payments. Like the original proposed regulations, the final regulations bifurcate a swap that provides for one or more “significant nonperiodic payments” into (1) an on-market level-payment swap and (2) a loan that generates imputed interest. However, the final regulations exclude from this rule (A) cleared swaps and (B) non-cleared swaps that require the parties to meet a federal regulator’s margin or collateral requirements or that provide for margin or collateral requirements that are substantially similar to a cleared swap or a non-cleared swap subject to a federal regulator’s margin or collateral requirements. This embedded loan rule and its exceptions apply for all U.S. tax purposes, and not only for purposes of Section 163(j).
The final regulations do not define what constitutes a “significant nonperiodic payment.” However, the preamble to the final regulations acknowledges that the embedded loan rule reinstates an earlier regulation, under which a nonperiodic payment was significant when it equaled approximately 40% of the present value of the swap’s periodic payments and was not significant when it equaled approximately 10%.
Substitute interest. The final regulations treat substitute interest on repos and securities loans not otherwise treated as debt for U.S. tax purposes as interest for purposes of Section 163(j) only if the repo or securities loan is not entered into in the ordinary course of the taxpayer’s business.
RIC dividends. The new proposed regulations provide that shareholders of a mutual fund that is treated as a regulated investment company for U.S. tax purposes generally may treat dividends paid by the mutual fund as business interest for Section 163(j) purposes if the mutual fund properly designates the dividends as attributable to business interest income.
Anti-avoidance rule. The final regulations contain an anti-avoidance rule that treats an expense or loss as interest if it is “economically equivalent to interest” and “a principal purpose” of structuring the transaction is to reduce the taxpayer’s interest expense for purposes of Section 163(j). Correspondingly, a recipient’s income is treated as interest income if the recipient knows that the associated expense or loss is treated as interest expense under the anti-abuse rule. A taxpayer may be treated as structuring a transaction with a principal purpose of reducing its Section 163(j) interest expense even if the structure allows the taxpayer to borrow at a lower pre-tax cost. Accordingly, even though the final regulations generally narrow the definition of interest that was included in the original proposed regulations, the anti-avoidance rule still could treat as interest certain items that are not otherwise considered interest for U.S. tax purposes.
Application to Partnerships
In general. The Section 163(j) business interest expense limitation generally applies first at the partnership level and then at the partner level.
Accordingly, a partner cannot currently deduct its allocable share of any business interest expense that is disallowed at the partnership level (Excess Business Interest Expense). Instead, the partner carries the Excess Business Interest Expense forward and may deduct it in future years only to the extent of the partner’s allocable share of the partnership’s Excess Section 163(j) Limitation in those future years (which, generally, is the partnership’s business income in excess of the amount necessary to deduct all of its business interest expense), subject to the partner’s own general Section 163(j) limitation for those years.
By contrast, a partner can currently deduct its allocable share of any business interest expense that is allowed at the partnership level, regardless of the partner’s own general Section 163(j) limitation for non-partnership items. Moreover, a partner’s allocable share of a partnership’s Excess Section 163(j) Limitation augments the partner’s own Section 163(j) position.
Basis adjustments. A partner’s allocable share of a partnership’s Excess Business Interest Expense reduces the partner’s basis in its partnership interest. However, immediately before a sale of the partnership interest, the partner increases its basis by the amount of any suspended Excess Business Interest Expense. If the partner sells only a portion of its partnership interest, then it increases its basis in the sold portion (and correspondingly reduces its Excess Business Interest Expense carryover) proportionately based on fair market value.
Trading partnerships. Under Section 163(d), non-corporate taxpayers can deduct investment interest expense only to the extent of their net investment income. For this purpose, a non-corporate partner’s allocable share of a trading partnership’s interest expense is treated as investment interest expense unless the partner “materially participates” in the partnership’s activities.
To prevent passive partners in trading partnerships from being subject to both Sections 163(d) and 163(j), the final regulations require trading partnerships with both passive and non-passive partners to apply Section 163(j) only to their business interest income and expense items that are allocable to non-passive partners. Business interest and expense items that are allocable to their passive partners are subject to Section 163(d) at the partner level.
The final regulations generally apply to tax years beginning on or after the date that is 60 days after they are published in the Federal Register and taxpayers may apply them in their entirety to tax years beginning after 2017. Taxpayers also generally may rely on the new proposed regulations in their entirety for tax years beginning after 2017.