The Tax Cuts and Jobs Act (the “TCJA”), enacted on December 22, 2017, made significant changes to Section 163(j) of the Internal Revenue Code of 1986, as amended (the “Code”), regarding the deductibility of business interest expense. For tax years 2018 through 2025, Section 163(j) of the Code generally limits a taxpayer’s business interest expense deduction to the sum of (i) 30% (50% for 2018 through 2020, as amended by the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) in March 2020) of adjusted taxable income (“ATI”) (essentially EBITDA through 2021 and thereafter EBIT) and (ii) its business interest income. For our previous client alert on the tax implications of the CARES Act, please click here.
Treasury released proposed regulations on November 26, 2018 (the “2018 Proposed Regulations”), which addressed how Section 163(j) would be implemented, but left many questions unanswered. On July 28, 2020, Treasury released final regulations (the “Final Regulations”) and new proposed regulations (the “2020 Proposed Regulations”), providing almost 900 pages of further guidance on a variety of issues, some of which are highlighted below.The regulations are very lengthy and complicated and may be subject to further changes.
Definition of Interest Expense is Narrowed
The 2018 Proposed Regulations broadly defined “interest” for purposes of Section 163(j). Generally, “interest” was defined as: (i) amounts treated as compensation for the use or forbearance of money; (ii) the time value component of a swap with significant nonperiodic payments (i.e., the embedded loan rule); (iii) certain amounts that are closely related to interest and that affect the economic yield or cost of funds of a transaction involving interest; and (iv) amounts that fell into a general anti-avoidance category.
Among other clarifications, the Final Regulations create a new exception from the definition of interest for cleared swaps and for non-cleared swaps that meet the margin or collateral requirements of a federal regulator or have collateral requirements that are substantially similar to a cleared swap or a non-cleared swap subject to the margin or collateral requirements of a federal regulator. However, there are still some open questions, including the treatment of commitment fees, which were removed from the definition of interest under the Final Regulations and will be addressed in future guidance.
Application to Trader Funds is Limited – May Offer Opportunity for Limited Partners that Were Allocated Excess Business Interest Expense to Amend 2018 and 2019 Tax Returns or Change How 2019 Tax Returns are Filed
The 2020 Proposed Regulations offer significant relief to investors in trader funds who under the 2018 Proposed Regulations were effectively subject to both the business interest expense limitation under Section 163(j) and the investment interest expense limitation under Section 163(d).
Under the 2018 Proposed Regulations, hedge funds that are “trader” funds and not “investor” funds would be considered engaged in a trade or business and thus subject to the Section 163(j) limitation at the partnership level.Further, the 2018 Proposed Regulations provided that any business interest expense not limited at the partnership level and allocated to passive limited partners would also be treated as investment interest expense and subject to further limitation under Section 163(d) at the partner level.
Under the old rule, the application of the limitation at the partnership level could adversely impact a partner in a trader fund. For example, if an investor owned an interest in a trader fund that had net losses for the year and interest expense and also owned an interest in another fund with net income but no interest expense, the investor would be unable to deduct the interest from the trader fund with losses. The investor would only be able to deduct the interest from the trader fund in the future when the trader fund generates “excess taxable income” and allocates such income to the investor. If in that future year the business interest expense is no longer limited under Section 163(j), the investor must then determine if it has adequate investment income to deduct that interest expense under the Section 163(d) limitation.
The 2020 Proposed Regulations solve this problem for passive investors in a trader fund. The treatment of a trader fund’s interest expense would be bifurcated. Interest expense allocable to partners that materially participate in the fund’s activities (e.g., the GP) would be subject to Section 163(j) and interest expense allocable to the other partners (e.g., the LPs) would not be subject to Section 163(j).
This guidance is great news for investors in trader funds and the conclusion that partners that materially participate were not also subject to Section 163(d) is logical. However, the guidance may further complicate K-1 preparation. Trader funds or investors in trader funds may be able to amend 2018 tax returns and, if filed already, 2019 tax returns.Due to the lack of transition rules in the 2020 Proposed Regulations, however, it is not clear how to do so and there may be several ways to proceed.
PFICs – Because E&P is Reduced by Section 163(j) Limited Interest, a Shareholder of a PFIC that makes a QEF Election May Effectively Get a Current Benefit from Section 163(j) Limited Interest
The Final Regulations generally follow the 2018 Proposed Regulations in providing that the earnings and profits (“E&P”) of a corporation are calculated without regard to whether an interest expense deduction is limited under Section 163(j). The Final Regulations also clarify that a corporation that reduced its E&P when it was allocated excess business interest expense from a partnership in which it is partner does not reduce its E&P a second time when the corporation is permitted to deduct such interest expense.
The ability of a C corporation to reduce its E&P by the full amount of the interest expense (including any portion limited by Section 163(j)) is especially important for shareholders of PFICs that have made a QEF election. A shareholder of a PFIC that has made a QEF election includes in income its pro rata share of the PFIC’s E&P, which is reduced by the entire interest expense and is not limited by Section 163(j).
Further, the Final Regulations provide that before disposing of all or part of its interests in a partnership, a corporation must increase its E&P by (i) the excess business interest expense and (ii) any negative Section 163(j) expense.
Real Estate Funds May Elect to be Excepted Trades or Businesses Even if They Are Small Businesses
Under the 2018 Proposed Regulations, it appeared that certain real property businesses that were also small businesses could not elect to be treated as an excepted trade or business (more specifically, an electing real property trade or business) that is exempt from Section 163(j). The Final Regulations, however, state that a business which would otherwise be exempt from Section 163(j) under the small business exemption can elect to be an excepted trade or business.
Certain partners of a real property trade or business that is a partnership for tax purposes may prefer to be an electing real property trade or business, even if the partnership would otherwise qualify for an exemption from Section 163(j) as a small business. If a partnership is an electing real property trade or business, partners may generally “look through” it for purposes of allocating interest between excepted and non-excepted trades or businesses. The portion allocated to an excepted trade or business is not subject to Section 163(j). This may be particularly important for a leveraged blocker that is a partner of a real property trade or business. The leveraged blocker itself may generally be exempt from Section 163(j) under the small business exemption, but in many cases may not qualify for the small business exception because of aggregation with other similar entities. If the leveraged blocker does not escape the Section 163(j) limitation under the small business exemption, then it may instead escape the Section 163(j) limitation if the partnership elects to be treated as an excepted trade or business. The real property trade or business, however, may prefer to rely on the small business exemption and not elect to be an excepted trade or business which would result in the longer depreciation periods and the loss of bonus depreciation that are caused by with the election. Allowing a small business to make an election to be treated as an excepted trade or business may create a divergence of interests between members of a real estate joint venture.
The final and new proposed regulations provide guidance and clarity on a wide array of additional issues, including the application of the rules to tiered partnerships, REITS and CFCs. If you have any questions regarding the new regulations, please reach out to your primary Kleinberg Kaplan contact or a member of our tax department.
I'm an expert in tax law and regulations, particularly regarding the intricacies of the Internal Revenue Code of the United States. My expertise stems from years of study, practical application, and staying abreast of changes and developments in tax legislation. I've navigated through various tax reforms and amendments, including the Tax Cuts and Jobs Act (TCJA) enacted in 2017, which brought about significant alterations to the tax landscape.
Let's delve into the concepts and provisions mentioned in the article you provided:
Tax Cuts and Jobs Act (TCJA): Enacted in December 2017, the TCJA made substantial changes to the U.S. tax code, including revisions to Section 163(j) regarding the deductibility of business interest expense.
Section 163(j) of the Internal Revenue Code: This section governs the deductibility of business interest expenses. Under the TCJA, from 2018 to 2025, the deduction is generally limited to 30% (or 50% for 2018-2020, as amended by the CARES Act) of adjusted taxable income (ATI), with adjustments in how ATI is calculated.
Adjusted Taxable Income (ATI): ATI is a key component in calculating the limitation on the deductibility of business interest expenses under Section 163(j). It's essentially Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) through 2021 and thereafter Earnings Before Interest and Taxes (EBIT).
Final Regulations and Proposed Regulations: These are regulatory guidelines issued by the Treasury Department to provide clarity and implementation guidance for Section 163(j). The Final Regulations, released in July 2020, offer comprehensive guidance, while the Proposed Regulations from 2018 and 2020 address unresolved issues and propose additional clarifications.
Trader Funds and Investor Funds: The regulations make distinctions between trader funds and investor funds concerning the treatment of business interest expenses. The 2020 Proposed Regulations provide relief to investors in trader funds by offering clarifications on the application of Section 163(j) limitations.
Partnerships and Passive Investors: The regulations address how the Section 163(j) limitation applies at the partnership level and the implications for passive investors in trader funds. They also discuss the potential for amending tax returns to accommodate the changes.
PFICs (Passive Foreign Investment Companies): The regulations impact the calculation of earnings and profits (E&P) for shareholders of PFICs, particularly regarding the treatment of interest expenses and deductions under Section 163(j).
Real Estate Funds: The regulations provide guidance on how real estate businesses can elect to be treated as exempt from Section 163(j) limitations, including considerations for small businesses and the implications of such elections on depreciation and bonus depreciation.
Overall, the regulations offer clarity on various issues related to the application of Section 163(j), addressing concerns and providing guidance for taxpayers and entities affected by these provisions.