Section 163(j) regulations were finalised in July 2020. The following summarises some of the major changes in the final regulations from a foreign-parented group’s perspective.
For taxpayers engaged in the manufacture, production or other resale of tangible personal property, one major issue concerns how to treat depreciation or amortisation in computing adjusted taxable income (ATI) in taxable years prior to 2022. Congress defined ATI as based on EBITDA for years before 2022 and as based on EBIT thereafter. Depreciation or amortisation expense related to production of inventory is included in the basis of inventory (see §263A) and recovered as cost of goods sold. Since such cost recovery reductions reduce gross income but are not separately deductible as depreciation or amortisation, a question arose as to whether and how such costs are added back in computing ATI.
The final regulations resolve this issue favourably for taxpayers. ATI is calculated by adding back the amount of any depreciation or amortisation that is capitalised into inventory under §263A. The add-back is made in the year in which the depreciation or amortisation expense is incurred rather than the year in which the deductions are recovered as cost of goods sold.
Section 163(j) disallows the deduction for ‘interest expense’. The Proposed Regulations took a very broad view of the definition of ‘interest’, which included not only interest on indebtedness, but also other amounts related to a borrowing, and under an anti-abuse rule, amounts that in substance reflect costs for the use of money.
The final regulations retain the broad and subjective anti-abuse rules but somewhat narrow the definition of interest expense. Commitment fees and debt issuance costs are no longer treated as interest expense. Expenses incurred under a liability hedge generally are not interest expense unless the taxpayer elects to integrate the hedge with the debt instrument. However, under the anti-abuse rule, guarantee fees paid by a domestic subsidiary to its foreign parent may be treated as interest expense and subject to §163(j). Special rules are provided for factoring of receivables.
While the deduction for interest expense is deferred for taxable income purposes, the deferral of interest expense under § 163(j) has no impact on ‘earnings and profits’. Thus, a US subsidiary paying a corporate distribution may be able to treat interest expense more favourably for earnings and profits than for taxable income purposes.
Under the final regulations, §163(j) applies together with other rules that disallow the deduction of interest expense, such as the base erosion and anti-abuse tax (BEAT) or §267A. Interest expense deferred under §267 is taken into account for §163(j) only when it becomes deductible under §267 (generally on the date of payment). This represents a trap for the unwary in that §267 may effectively ‘bunch’ the interest expense of a taxpayer into a single taxable year in which the taxpayer lacks sufficient ATI to deduct the interest. Excess §163(j) limitation from prior taxable years cannot be carried forward to allow interest taken into account in a later year to be deductible. The same issue can arise with ‘repurchase premium’ where the taxpayer refinances or repays debt at a premium due to the change in market interest rates.
US subsidiaries that themselves have non-US subsidiaries that are controlled foreign corporations (CFCs) are subject to additional issues under §163(j). The final regulations generally exclude the subpart F income and global intangible low-taxed income (GILTI) generated by the CFCs in computing the §163(j) limitation. Proposed Regulations, which may be early-adopted by taxpayers, allow CFC income to be included in the computation of ATI provided that the taxpayer also early-adopts complex CFC grouping rules provided by the proposed regulations.
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