As amended by the Tax Cuts and Jobs Act (TCJA), section 163(j) of the Internal Revenue Code (the Code) provides that a taxpayer’s interest expense is deductible only to the extent of the sum of: (i) the taxpayer’s interest income; (ii) 30% of the taxpayer’s adjusted taxable income (ATI); and (iii) the taxpayer’s floor plan financing interest. On July 28, 2020, the US Department of the Treasury and the Internal Revenue Service (IRS) issued final regulations confirming the application of section 163(j) to controlled foreign corporations (CFC), along with proposed regulations (2020 proposed regulations), which, among other things, provided rules for applying section 163(j) to CFCs. For a detailed analysis of the 2020 proposed regulations, please see our earlier On the Subject here.
On January 5, 2021, the Treasury and the IRS released a finalized version of the 2020 proposed regulations (final regulations). As discussed below, the final regulations generally retain the structure of the 2020 proposed regulations, while making certain changes and reserving on certain issues.
CFC Group Treatment Modeled after Consolidated Group Rules
Under the 2020 proposed regulations, if a group of CFCs made a „CFC group election,“ then section 163(j) generally applied to the CFCs on a group-wide basis—the CFC group as a whole has a group-wide ATI, a group-wide amount of interest income, a group-wide section 163(j) limitation and a group-wide amount of interest expense that is subject to the limitation. The group-wide interest expense generally could be deductible to the extent of the group-wide section 163(j) limitation without regard to which particular CFCs in the group incurred the interest expense or earned the interest income or ATI. Generally, the CFC group’s ATI, interest income and interest expense are the sum of each CFC’s ATI, interest income and interest expense, respectively, and the group’s section 163(j) limitation is equal to the group’s interest income plus 30% of the group’s ATI and the group’s floor plan financing interest.
The final regulations retain the general group-wide structure of the 2020 proposed regulations. As discussed in the preamble to the final regulations, the final regulations generally apply section 163(j) to CFC groups in a similar manner as section 163(j) applies to US consolidated groups. The final regulations contain numerous examples of this principle, including the following:
The 2020 proposed regulations provided that a CFC group’s ATI was equal to the sum of the ATI of each of the CFCs in the group, as determined on a separate-entity basis. Previously finalized regulations under section 163(j) had provided that a taxpayer’s ATI could not be less than zero, and commenters noted that the 2020 proposed regulations were ambiguous as to whether this „no-negative“ rule applied in determining the separate ATIs of the CFCs in a CFC group. The final regulations removed this ambiguity, providing that the no-negative ATI rule applied with respect to the CFC group, not with respect to the CFC group members. In other words, one CFC group member’s negative ATI could offset another CFC group member’s positive ATI (although the group-wide ATI could not be less than zero). The preamble noted that this rule aligned the treatment of CFC groups with the treatment of US consolidated groups, where a single ATI amount was calculated for the group, but losses of consolidated group members were taken into account.
Certain comments to the 2020 proposed regulations had proposed a multi-step approach for coordinating the application of section 163(j) and the application of the global intangible low-taxed income (GILTI) and subpart F high-tax exceptions. The proposed approach generally would have first applied section 163(j) to CFC group members on a separate-entity basis, then applied the high-tax exceptions to the CFCs, and finally excluded income eligible for the high-tax exceptions from the group-wide section 163(j) determination. The Treasury and the IRS rejected this proposal, citing the administrative burden and noting that the proposal was inconsistent with a consolidated approach because it would increase the relevance of the location of debt and ATI within a CFC group.
The 2020 proposed regulations contained rules limiting the extent to which a CFC group could carry forward disallowed interest expense attributable to a CFC group member that arose in a taxable year prior to that member joining the group. This limitation is determined in a manner similar to the limitation applicable to the use of carryovers of a member of a consolidated group arising in a separate return limitation year (SRLY). The Treasury and the IRS rejected the proposal to replace this SRLY-like limitation with an anti-abuse rule. Further, a comment to the 2020 proposed regulations suggested that these limitations should not apply to the extent that they overlap with the limitations imposed under section 382, in a manner similar to an existing „overlap rule“ that applied in the context of US consolidated groups. The Treasury and the IRS stated that they were continuing to study the application of an overlap rule to CFCs joining or leaving a CFC group and noted that they may address this issue in future guidance.
Certain comments to the 2020 proposed regulations had requested that the 80% ownership threshold required for affiliation in a CFC group be reduced to 50% or subject to certain exceptions. The IRS rejected these requests, stating that the application of section 163(j) to a CFC group is modeled on the rules applicable to US consolidated groups, including the 80% affiliation threshold under section 1504.
The 2020 proposed regulations provided that foreign income taxes were taken into account in determining the ATI of the members of a CFC group. In a taxpayer-friendly move, the final regulations remove this requirement, providing that the ATI of CFCs is determined without taking into account any deduction for foreign income taxes (regardless of whether an election is made to claim a credit for these foreign income taxes). The preamble to the final regulations notes the comments supporting this treatment, including providing parity between CFCs and domestic corporations, which do not deduct US federal income taxes in determining their ATI, and conforming the ATI of a CFC with that of a domestic corporation doing business through a foreign branch that elects to credit foreign income taxes.
Significance of the No-Negative ATI Rule
In particular, the clarification regarding the „no-negative“ ATI rule removes a significant area of uncertainty that companies and practitioners were grappling with in the application of the CFC group election. As noted in a comment to the 2020 proposed regulations, application of the no-negative ATI rule on a separate-CFC basis would result in inefficient use of tax attributes. However, it was difficult to conclude that the rule only applied to the CFC group (not each CFC group member) solely based on the language of the 2020 proposed regulations.
For example, suppose a CFC group consists of two CFCs, one of which has a tested loss for GILTI purposes without taking into account interest expense, and the other of which has an offsetting amount of tested income, with the result that the US shareholder has no GILTI inclusion even without taking into account interest expense deductions. In this situation, applying the no-negative rule on a separate-CFC basis would mean treating the tested loss CFC’s ATI as zero, rather than as negative, which would mean that the CFC group would have positive ATI (due to the CFC with tested income). Therefore, the CFC group would be able to deduct a portion of the group’s interest expense, which reduces the amount of interest expense that the group would otherwise be able to carry forward. This is an undesirable result, because the CFC group is using up interest expense which could be carried forward to future years and could, for example, reduce the group’s net positive tested income in such years. In exchange, the CFC group has a larger net tested loss in the current year, which is irrelevant since the US shareholder already had a net tested loss to begin with and tested losses cannot be carried forward to future years.
The Treasury and the IRS noted that situations like the example described above were an inappropriate result and clarified in the final regulations that the no-negative ATI rule was only applied on a CFC group basis. This is a welcome clarification, as it will, for example, allow a group-wide net tested loss to be mitigated by the creation of disallowed interest expense carryforwards.
Reservation on ATI „Roll-Ups“ to US Shareholders
As discussed in our earlier On the Subject, the 2020 proposed regulations contained a „roll-up“ provision that increased the ATI of the US shareholders of a CFC group by a portion of the income inclusions (i.e., subpart F and GILTI inclusions) attributable to the CFCs in the group. The roll-up provision generally operated by permitting the US shareholders to increase their ATI by the amount of their income inclusions with respect to the CFC group, in proportion to the extent of the CFC group’s unused section 163(j) limitation. This US shareholder roll-up is one of the primary benefits of making a CFC group election, as it is available only if a CFC group election is made and could significantly increase the amount of interest expense deductible by multinational corporations with highly leveraged US operations.
The formula for the roll-up in the 2020 proposed regulations was revised from the formula used in an earlier iteration of proposed section 163(j) regulations issued in 2018, and the new formula generally resulted in a smaller roll-up amount. In the preamble to the final regulations, the Treasury and the IRS stated that they were continuing to study the proper method for determining the appropriate amount of the US shareholder roll-up. Therefore, the final regulations reserve on rules regarding the roll-up. The Treasury and IRS‘ reservation on this issue does not mean that they do not believe that a roll-up should apply—taxpayers who wish to make a CFC group election may rely on the 2020 proposed regulations in calculating the roll-up. However, it is important to note that the 2020 proposed regulations stipulate that their provisions must be applied consistently—therefore, taxpayers may not apply the 2020 proposed regulations generally while choosing to apply the more favorable roll-up found in earlier proposed regulations.
Other Changes Made by the Final Regulations
In addition to the changes described above, the final regulations made various other notable changes to the 2020 proposed regulations, including the following:
Annual reporting requirement: Under the 2020 proposed regulations, the US person making a CFC group election was required to attach a reporting statement to its relevant federal income tax return for the year of the election. The final regulations expand the reporting requirement by requiring such US person (or persons) to attach a reporting statement with respect to the CFC group to its federal income tax returns for each taxable year for which the CFC group election is in effect.
Expansion of safe harbor: As discussed in our earlier On the Subject, the 2020 proposed regulations contained a safe harbor election, which generally provided that a CFC group is not subject to the section 163(j) limitation if the group’s interest expense is less than or equal to 30% of the sum of the subpart F and GILTI inclusions with respect to CFC group members. The final regulations expand this safe harbor by providing that it applies if the group’s interest expense is less than or equal to the group’s interest income plus the sum of the subpart F and GILTI inclusions with respect to the CFC group members.
Expansion of intragroup transaction anti-abuse rule: The 2020 proposed regulations contained an anti-abuse rule, which generally disregarded an intragroup transaction if a principal purpose of entering into the transaction was to affect the CFC group or a CFC group member’s section 163(j) limitation by increasing or decreasing the group or group member’s ATI. The final regulations expand this anti-abuse rule by providing that it also applies to intragroup transactions with a principal purpose of increasing the group or a group member’s interest income.
The final regulations took effect upon filing with the Federal Register and apply to taxable years beginning on or after the date that is 60 days after the publication of the final regulations in the Federal Register; publication occurred on January 19, 2021 (i.e., prior to President Biden’s inauguration and thus outside the scope of the new administration’s regulation freeze). Taxpayers generally can apply the final regulations to a taxable year beginning after December 31, 2017, and before the applicability date, provided that the final regulations are applied consistently. To the extent that a rule in the 2020 proposed regulations is not finalized in the final regulations, taxpayers may rely on the rules in the 2020 proposed regulations to the extent provided in the 2020 proposed regulations, provided that such rules are applied consistently.