On July 28, the Treasury Department issued final regulations (TD 9905) under Section 163(j). The final regulations provide binding guidance for applying the limitation on the deductibility of business interest expense that was enacted as part of the tax law commonly known as the Tax Cuts and Jobs Act (TCJA). Concurrently, Treasury issued proposed regulations (REG-107911-18), which address the application of certain facets of the limitation to partnerships, among other items.
In a Nutshell
The final and proposed regulations contain a number of provisions that are relevant for Private Equity (PE) and Venture Capital (VC) funds and their related entities:
- Updates to certain definitions
- Applicability of Section 163(j) to pass-through entities, including tiered partnerships
- Allocation of interest expense to partners, including where there are distributions of debt proceeds
- Special elections for determination of limitation for tax year beginning in 2020 for partnerships and their partners
The final regulations include updates to several definitions, most importantly that of Adjusted Taxable Income (ATI), interest, and what is considered a trade or business for purposes of Section 163(j). The proposed regulations also provide a definition of a tax shelter for purposes of Section 163(j).
The definition of ATI was revised to reflect a new starting point. The computation of ATI now begins with “tentative taxable income,” which is generally determined in the same manner as taxable income, but without regard to the application of the Section 163(j) limitation or any disallowed business interest expense carryforward. This eliminates a range of potential issues in the calculation of the limitation, including that disallowed business interest expense might be included more than once in testing business interest expense against the limitation.
The final regulations also remove from the definition of interest certain items such as commitment fees, debt issuance costs, and guaranteed payments for the use of capital. This narrowing of the definition is accompanied by an expanded anti-avoidance rule. However, the anti-avoidance rules generally apply to transactions entered into on or after the date the final regulations were published in the Federal Register. Thus, partnerships that have had in place arrangements for guaranteed payments for the use of capital can exclude these guaranteed payments from interest without running afoul of the anti-avoidance rule. On the other hand, the IRS required these guaranteed payments to be treated as interest under the 2018 proposed regulations. Partnerships that want to rely on any parts of the 2018 proposed regulations must follow the 2018 proposed regulations in their entirety.
The 2018 proposed regulations had left uncertainty on the definition of a trade or business for purposes of applying the business interest expense limitation. The preamble to the final regulations confirms that taxpayers should look to the available guidance and case law under Section 162.
Treasury further received several comments on the definition of a tax shelter under the 2018 proposed regulations. The new proposed regulations issued this summer acknowledge that the previous definition left room for confusion. Taxpayers were unclear whether to rely on Reg. Sec. 1.448-1T(b)(3) that defines a tax shelter as a partnership where 35% or more of the losses are allocated to limited partners, or on Section 1256(e)(3)(B) that instead refers to losses that are allocable to limited partners. The 2020 proposed regulations provide clarity and consistency by requiring the use of the actual allocation rule from Reg. Sec. 1.448-1T(b)(3), but providing that losses are determined without regard to Section 163(j).
Clarifications on Application of Limitation to Partnerships
The final regulations generally preserve the 11-step process used to allocate Section 163(j) items that was introduced by the 2018 proposed regulations. Treasury noted that this produces a result that is most consistent with the law’s principle that the amount of business interest expense a taxpayer is permitted to deduct should increase as its ATI and business interest income increase. In a nod toward simplification, the final regulations introduce an exception to the application of steps 3 through 11 of the lengthy 11-step process. This exception is available for partnerships that allocate all items of income and expense on a pro-rata basis.
The final regulations also provide relief for partners of partnerships that are exempt from Section 163(j) as a small business entity. Business interest expense allocated by such partnerships to their partners is not subject to Section 163(j) at the partner level, which is a favorable change from the 2018 proposed regulations. Further, where a partnership previously subject to Section 163(j) is no longer subject to Section 163(j) as a result of the small business exception, any excess business interest expense (EBIE) previously allocated to its partners is treated as business interest expense by the partner in that year and subject to the limitation calculation of the partner. This does not apply to partnerships that no longer are subject to Section 163(j) because of an election to be treated as a real property trade or business. In that case, any EBIE would be suspended indefinitely, as such partnerships will no longer generate excess taxable income or excess business interest income once they made an election under Section 163(j)(7) to be treated as a real property trade or business.
Further, the final regulations also allow for proportionate basis adjustments where partners dispose of a partial partnership interest. This is a change from the previous approach contemplated by the 2018 proposed regulations that only would have allowed for a basis adjustment when there was a disposition of all or substantially all of a partner’s interest in a partnership. Additionally, the proposed regulations provide that the partnership shall increase its inside basis by an amount equal to the increase to the partner’s outside basis in the partnership interest being disposed. The inside basis increase in intended to avoid a disparity between the inside and outside basis.
Treatment of Sec. 163(j) Limitation in Tiered Partnership Structures
The 2018 proposed regulations reserved on the application of Section 163(j) to tiered partnerships. This left PE and VC funds with flow-through portfolio investments resorting to any other guidance that was available. The 2020 proposed regulations provide that any EBIE allocated by a lower-tier partnership to an upper-tier partnership does not get further allocated to the partners of the upper-tier partnership. Instead, the EBIE is suspended at the upper-tier partnership until it becomes deductible under the already existing limitation calculation.
The proposed regulations provide for basis adjustments by the upper-tier partnership with respect to its interest in the lower-tier partnership, but do not permit a corresponding basis adjustment for the partners in the upper-tier partnership. The resulting basis difference is reconciled by the creation of a capital loss asset with a tax basis equal to the amount by which the upper-tier partnership reduced its basis in its interest in the lower-tier partnership. However, the Section 704(b) capital accounts of the upper-tier partnership’s partners are decreased by the amount of the EBIE.
Application to Debt-Financed Distributions
The proposed regulations would require partnerships to classify interest expense associated with debt-financed distributions into one of three categories, similar to the optional allocation rule in Notice 89-35:
- Expenditure interest expense
- Debt-financed distribution interest expense
- Excess interest expense
Each category will need to be further analyzed to allocate interest expense between trade or business, investment and personal interest expense. The partnership would then include the sum of its partners’ share of business expenditure interest expense in its computation of its Section 163(j) limitation for the year. Partners would have to include their share of debt-financed distribution interest expense in their partner-level computation of the limitation. Partnerships would allocate excess interest expense to their assets based on the relative basis of the assets and determine the tax treatment of such excess interest expense based on the character of the assets to which it was allocated.
Elections Available to Partnerships and Partners
The proposed regulations allow partnerships to make an election under the final regulations to use ATI for the last tax year beginning in 2019 for purposes of calculating the Section 163(j) limitation for any tax year beginning in 2020.
Further, a partner may elect to treat 50% of its allocable share of a partnership’s EBIE for 2019 as business interest expense for the partner’s first tax year beginning in 2020 without having to subject it to further limitation under Section 163(j). The remaining 50% of EBIE would continue to be carried forward under the normal rules.
The final regulations are effective on Nov. 13, 2020 and generally apply to tax years beginning on or after Nov. 13, 2020. Taxpayers may rely on the 2020 proposed regulations and can generally choose to apply them to tax years beginning after 2017. Taxpayers that elect to do so must apply all of the rules of the relevant sections. While the final and proposed regulations provide additional clarity and some relief to PE and VC funds, additional complexities are being introduced and uncertainties remain, particularly in the application of these rules to tiered partnerships where Section 704(b) adjustments may need to be made that are not reflected in the partners’ tax capital accounts. For more information, please contact us.
Published on December 04, 2020