As a part of the Tax Cuts and Jobs Act (“TCJA”) enacted in December 2017, Internal Revenue Code §163(j) was substantially modified, broadening its application to nearly all companies with interest expense. Prior to Tax Reform, §163(j) was intended to limit deductions only for related party interest expense incurred in connection with thinly-capitalized subsidiaries of foreign parent companies.
For having such a broad reach, the revised §163(j) was quite succinct, leaving many tax professionals eagerly awaiting regulatory guidance from the IRS. Quite simply, the new §163(j) indicated that interest expense cannot exceed 30% of “adjusted taxable income”. The subsections further describing §163(j) go on to define “adjusted taxable income” as taxable income without regard to business interest expenses or income, NOL deductions, the amount of any deductions allowed under IRC 199A, and for any tax years beginning before January 1, 2022, without regards to depreciation, depletion, or amortization. Any interest expense which is so limited carries forward indefinitely and is available for deduction subject to the §163(j) limitation, just like regular interest expense in those future years.
The Coronavirus Aid, Relief, and Economic Security (“CARES”) Act provided temporary relief from the provision of §163(j) for tax years 2019 and 2020. Some of the significant developments offered by the CARES Act include: (1) expansion of deductible interest expense up to 50% of “adjusted taxable income” for tax years 2019 and 2020 for most taxpayers, and (2) permitted election to utilize 2019 “adjusted taxable income” to determine deductibility of interest expense in 2020. For many companies, these changes will allow for a higher interest deduction capacity, even if facing operating losses due to the economic environment.
IRS Issues Regulatory Guidance
The IRS first issued proposed regulations related to the new §163(j) in November of 2018. Final regulations, coupled with additional proposed regulations, were subsequently issued in late July 2020. Included in the final regulations were clarifications and responses to comments provided on the 2018 proposed regulations, several of which benefit manufacturing companies specifically, and seem to align with what many believed to be the intent of Congress when the TCJA was enacted. This article is intended only to cover a small subset of the developments contained in the final and additional proposed regulations released in 2020.
One of the welcome changes between the 2018 proposed regulations and the 2020 finalized regulations was the clarification that all depreciation through 2021, even to the extent it is subject to the Uniform Capitalization rules (UNICAP) for tax purposes, is subject to addback for purposes of computing a taxpayer’s annual adjusted taxable income, regardless of the period in which it is recognized in cost of goods sold for tax purposes. This clarification ensures that manufacturers who are availing themselves of bonus or other depreciation on manufacturing equipment and manufacturing facilities do not find their interest expense limited by such depreciation.
Noting that effective for tax years beginning January 1, 2022 or after, companies will no longer be entitled to add depreciation, depletion or amortization back to taxable income for purposes of determining interest expense deductibility thresholds. Taxpayers (and especially manufacturers) should be diligent in planning and modeling the relationship of capital expenditures, accelerated tax depreciation, and interest expense deductions to future cash taxes. A taxpayer using debt to finance significant capital investments after January 1, 2022 (thereby creating accelerated tax depreciation) may find a temporarily lost deduction for interest expense until such time as the adjusted taxable income is sufficiently restored.
There is a pre-TCJA election under §266 to capitalize certain interest and other expenses into the cost of inventory. The §163(j) regulations leave open the question of whether an election under §266 might bypass the §163(j) limitation with respect to the capitalized interest. We continue to monitor this topic, as this election could be an effective mitigation technique if available.
Application to Overseas Investments
Many U.S. manufacturers utilize subsidiaries in foreign locations to support the global manufacturing process. For U.S. companies with controlled foreign corporation (“CFC”) subsidiaries, the TCJA substantially altered the U.S. tax system through the enactment of the Global Intangible Low Tax Income “GILTI” regime. A notable consequence of the GILTI regime is that it essentially operates in opposition to the touted shift to a territorial tax system, requiring an annual inclusion of a CFC’s earnings in the U.S. shareholder’s taxable income, regardless of whether or not they are distributed. Rather than GILTI being limited to a foreign subsidiary’s earnings and profits, GILTI requires a U.S. shareholder to compute a CFC’s taxable income ‘as if’ it were a U.S. taxpayer. The 2018 proposed §163(j) regulations asserted that the §163(j) rules also applied to the calculation of GILTI income for CFCs; the planning and modeling for the §163(j) limitation applies to CFC subsidiaries just as it does for U.S. taxpayers.
The 2020 final regulations affirmed the application of §163(j) to controlled foreign corporations for purposes of GILTI, but they did not include final guidance on implementation of the controlled foreign corporation ‘group method’ elections for purposes of applying §163(j) on a grouped or aggregate basis rather than on an entity-by-entity basis. Instead, the IRS issued additional proposed regulations expanding the definitions of potential CFC groups, and potentially likening the effect and treatment of §163(j) across CFC groups to the treatment of consolidated U.S. taxpayers-as if a single taxpayer. U.S. taxpayers will need to analyze their CFC operations and application of the §163(j) limitation to determine whether the group method election would be advantageous.
Additional FAQs are Published
Concurrent with the release of the final and proposed regulations, the IRS also published guidance in the form of FAQs related to the aggregation rules of gross receipts for purposes of identifying taxpayers subject to §163(j). These rules affirm that the gross receipts of companies with certain relationships can be aggregated – thus potentially subjecting companies with gross receipts individually below the small business receipts thresholds to §163(j) limitations in an attempt to deter manipulation of interest and gross receipts. Companies should be diligent in reviewing these FAQs to ensure that all gross receipts are factored for purposes of determining whether the voluminous and complex rules of §163(j) apply. In some cases, this may be a challenging determination to make, in that it requires information pertaining to the gross receipts of parties that may have common legal or ownership relationships but operate and function completely separate from these related parties.
Internal Revenue Code §163(j) is complex and evolving. Many of the §163(j) effects dovetail with other novel and challenging areas of the Internal Revenue Code, and necessarily require both a robust understanding of the interrelatedness, but also a diligent outlook on forthcoming guidance so as to proactively and preemptively manage adverse effects. For manufacturers with operations in both the U.S. and abroad, the deluge of §163(j) legislative and interpretive guidance will be especially challenging to respond to, and more importantly plan for.
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Rebecca Leshman is a Principal on our Tax Preparation and Consulting Services team and specializes in helping customers identify tax-planning opportunities and manage the increasing volume of multi-jurisdictional tax compliance deliverables. Prior to joining Elliott Davis, she worked for a large international public accounting firm, where she focused on tax provision and tax compliance services.
The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change as a result of evolving legislative developments and government guidance.
 IRC §163(j)(8)
 PL 116-136
 IRC §951A
 IRC §448(c)(2) limits the application of §163(j) to companies with average annual gross receipts in excess of $25M (indexed for inflation)