New Proposed Regulations Would Revise the Application of Section 163(j) to CFCs

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Overview


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 December 28, 2018, the US Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) released an initial set of proposed regulations under section 163(j) (former proposed regulations). Among the former proposed regulations was Prop. Treas. Reg. § 1.163(j)-7, which provided rules for applying section 163(j) to controlled foreign corporations (CFCs). On July 28, 2020, the Treasury and the IRS finalized portions of the former proposed regulations but issued a new set of proposed regulations, including a revised version of Prop. Treas. Reg. § 1.163(j)-7 (new proposed regulations).

In Depth


Although the provision from the former proposed regulations confirming the general applicability of section 163(j) to CFCs was finalized in Treas. Reg. § 1.163(j)-7 (final regulations), the new proposed regulations otherwise made substantial changes to the mechanics of applying section 163(j) to CFCs. These mechanics, as well as their differences in the two sets of proposed regulations, are discussed below.

General Application of the CFC Group Election under the Former Proposed Regulations

The former proposed regulations generally provided that section 163(j) applied in determining the taxable income of a CFC in the same manner as it applied in determining the taxable income of a domestic corporation. Thus, in determining a CFC’s taxable income, the CFC’s interest expense deductions are subject to section 163(j) limitation. However, the former proposed regulations recognized that applying section 163(j) to CFCs could lead to inappropriate results in the context of interest payments between related CFCs. To ameliorate this problem, the former proposed regulations provided that a group of related CFCs could make a “CFC group election,” which applied as follows.

  • If a CFC group election was made, then a single amount, the “net business interest expense,” was calculated for the group. Net business interest expense was generally equal to the sum of the interest expense of all of the CFCs in the group, reduced by the sum of the interest income of all of the CFCs in the group. Since any interest between CFCs in the group would result in offsetting amounts of interest income and interest expense, net business interest expense measured the total amount of interest expense paid by the members of the CFC group to third parties.
  • Once net business interest expense for the CFC group was determined, each CFC in the group was allocated a portion of the net business interest expense. The allocable share was determined by multiplying net business interest expense by a fraction, the numerator of which was the interest expense (net of interest income) incurred by the CFC and the denominator of which was the interest expense (net of interest income) incurred by the CFC group (in both cases taking intercompany interest into account). Once the allocable share with respect to a CFC was determined, the allocable share was the amount of interest expense that the CFC was deemed to have paid for purposes of applying section 163(j).

These basic principles were illustrated in an example in the former proposed regulations. The example involved three sister CFCs: CFC1; CFC2; and CFC3. Each CFC had $100 of ATI. CFC1 paid $90 of interest to a third party on an external obligation, and CFC2 and CFC3 each paid CFC1 $50 of interest on intercompany obligations.

  • Section 163(j), applied without a CFC group election, would not have limited the deductibility of CFC1’s interest expense because CFC1’s $90 of interest expense was less than its $100 of interest income (from CFC2 and CFC3). However, CFC2 and CFC3 would each have had a section 163(j) limitation of $30 (30% of $100 of ATI). Therefore, CFC2 and CFC3 would each have had $20 of their $50 of interest expense disallowed under section 163(j), for a total disallowance of $40 of interest expense.
  • If the three CFCs made a CFC group election, then the total interest expense of the group would have been $190 and the total interest income of the group would have been $100, for net business interest expense of $90. CFC1 would not have been allocated any of this amount, because its interest income was greater than its interest expense. However, CFC2 and CFC3 each would have been allocated half of the net business interest expense and would have been treated as having incurred $45 of interest expense for purposes of applying section 163(j). Therefore, each would have had $15 of interest expense disallowed under section 163(j), for a total disallowance of $30 of interest expense rather than $40.

It should be noted that, although the former proposed regulations mitigate the problem of intercompany obligations in applying section 163(j) to CFCs, the former proposed regulations still fundamentally provide that section 163(j) is applied to a group of CFCs on a separate basis—each CFC has its own ATI, its own section 163(j) limitation and its own allocable share of net business interest expense that is subject to the limitation.

General Application of CFC Group Election under the New Proposed Regulations

In response to the former proposed regulations, several commentators had argued that section 163(j) should not apply to CFCs at all or should only apply to CFCs in a limited fashion. The Treasury and the IRS rejected these comments and finalized the portion of the former proposed regulations, stating that CFCs were generally subject to section 163(j) in determining interest expense deductions. The Treasury and the IRS noted that the taxable income of a CFC is generally determined under the Code in the same manner as the taxable income of a domestic corporation, including the application of section 163(j), and that the TCJA did not specifically exempt CFCs from the application of section 163(j).

However, the Treasury and the IRS were receptive to the argument that the former proposed regulations would impose significant complexity and administrative burdens on taxpayers in determining the taxable income of CFCs, particularly in the case of multinational taxpayers with hundreds of CFCs in the corporate structure. As a result, the new proposed regulations, while reiterating that section 163(j) generally applied to CFCs, substantially revised the consequences of making a CFC group election, as follows.

  • As noted, if a CFC group election was made under the former proposed regulations, section 163(j) was still fundamentally applied on a separate basis to each CFC in the group, albeit with certain modifications.
  • However, under the new proposed regulations, if a CFC group election is made, section 163(j) generally applies 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. Generally, the CFC group’s ATI, interest income and interest expense is 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.

To illustrate the difference between the former proposed regulations and the new proposed regulations, consider the example above.

  • Under the former proposed regulations, the CFC group was able to eliminate $10 of disallowance under section 163(j), but $30 of interest expense deductions were still disallowed.
  • Under the new proposed regulations, the CFC group would have group ATI of $300 and group interest income of $100, which would result in a group section 163(j) limitation of $190. The group would also have $190 of interest expense. Because the group’s interest expense does not exceed its section 163(j) limitation, no interest deductions would be disallowed under section 163(j) at all. This difference is due to the fact that, under the new proposed regulations, CFC1’s $100 of ATI is taken into account in determining the group’s section 163(j) limitation. By contrast, under the former proposed regulations, CFC1’s ATI was only relevant to CFC1, and all of the group’s interest expense was deemed to have been incurred by CFC2 and CFC3.

It should be noted that, even under the new proposed regulations, individual CFCs are still allocated shares of group-wide items. For example, to the extent that group-wide interest expense exceeds the group-wide section 163(j) limitation, the group’s disallowed interest expense carryforward is allocated to each member based on the rules that apply to consolidated groups under Treas. Reg. § 1.163(j)-5, subject to certain modifications. These allocations are necessary because allocable shares of such items are still relevant under the new proposed regulations in certain contexts, such as in the situation where a CFC leaves or joins the group.

New Proposed Regulations Would Remove Excess Taxable Income “Roll-Ups” to Higher-Tier CFCs

In addition to mitigating the effect of intercompany obligations, the CFC group election under the former proposed regulations included a “roll-up” provision which enabled certain income of lower-tier CFCs in the group to be included in the ATI of higher-tier CFCs in the group, thereby increasing the higher-tier CFCs’ section 163(j) limitation. Specifically, under a CFC group election, a higher-tier CFC generally could include in its ATI the “excess taxable income” of its lower-tier CFCs. “Excess taxable income” was generally defined as the lower-tier CFC’s ATI, multiplied by the percentage of the lower-tier CFC’s section 163(j) limitation that was not consumed by the lower-tier CFC’s allocable share of net business interest expense.

An example in the former proposed regulations illustrated the application of the roll-up provision. In the example (simplified somewhat here), a higher-tier CFC, CFC1, owned all of the stock of two lower-tier CFCs, CFC2 and CFC3. CFC1 had $0 of ATI and $5 of interest expense. CFC2 and CFC3 each had $100 of ATI, and their interest expense was $15 and $40, respectively.

Applying section 163(j) on a separate basis, CFC2 and CFC3 each had a separate $30 section 163(j) limitation. Because CFC3’s interest expense ($40) was greater than its section 163(j) limitation, $10 of CFC3’s interest expense was disallowed and CFC3 did not have any excess taxable income. However, CFC2 only used half ($15) of its section 163(j) limitation, so its excess taxable income was $50 (i.e., 50% of its $100 of ATI). Therefore, CFC1—which otherwise would have had no ATI—was deemed to have $50 of ATI and a $15 section 163(j) limitation. This meant that CFC1 would be able to deduct its $5 of interest expense that otherwise would not have been deductible.

Because the CFC group election under the new proposed regulations generally applies section 163(j) to CFCs on a group-wide basis, individual CFCs generally do not have separate ATIs or separate section 163(j) limitations. Consistent with this change, the new proposed regulations remove the roll-up provision with respect to higher-tier CFCs, because there is no need under the new proposed regulations for a provision that adjusts an individual CFC’s separate ATI.

To illustrate, consider the example above. Under the new proposed regulations, the three CFCs would have $200 of group-wide ATI, a $60 group-wide section 163(j) limitation and $60 of group-wide interest expense. Thus, all of the group’s interest expense would be deductible. In particular, CFC1’s interest expense would be fully deductible, as under the former proposed regulations, and CFC3’s interest expense—$10 of which would still have been disallowed under the former proposed regulations—would also be fully deductible.

New Proposed Regulations Would Retain Excess Taxable Income “Roll-Ups” to US Shareholders

In addition to a roll-up provision that adjusted the ATI of higher-tier CFCs, the former proposed regulations also contained a roll-up provision that adjusted the ATI of US shareholders of a CFC group by a portion of the income inclusions attributable to the CFCs. Although the new proposed regulations removed the roll-up provision as applied to higher-tier CFCs, they retain, in slightly modified fashion, the roll-up provision as applied to US shareholders. It should be noted that, under both the former and new proposed regulations, the roll-up to US shareholders generally applies only if a CFC group election is in effect, and any increase to the ATI of US shareholders does not take into account any section 78 gross-up inclusions.

Under the former proposed regulations, a US shareholder’s ATI was increased by the “eligible CFC group ETI” of the highest-tier CFC in the CFC group. Eligible CFC group ETI was generally defined as the highest-tier CFC’s excess taxable income (which took into account lower-tier CFCs’ excess taxable income pursuant to the CFC roll-up provision) multiplied by a fraction, the numerator of which was the total amount of income inclusions taken into account by the US shareholder with respect to the CFCs in the CFC group, and the denominator of which was the total taxable income of the CFCs in the CFC group. In other words, a US shareholder’s ATI was increased by the rolled-up excess taxable income of the CFC group, in proportion to the extent that the taxable income of the CFC group was included in the income of the US shareholder (i.e., as subpart F or global intangible low-taxed income (GILTI) inclusions). Note that the denominator of the fraction is taxable income, not ATI (i.e., interest expense is taken into account).

The former proposed regulations provided an example of the roll-up as applied to US shareholders. In the example (simplified for convenience), a domestic corporation, USP, owned all of the stock of CFC. CFC had $100 of ATI and $20 of interest expense. Furthermore, 50% of CFC’s income constituted subpart F income, and 50% of its interest expense was allocable to the subpart F income. Thus, USP had a $40 subpart F inclusion with respect to CFC.

The former proposed regulations provided that USP’s ATI was increased by $16.66. Specifically, the CFC’s excess taxable income was $33.33, because it did not use one-third of its $30 section 163(j) limitation. Furthermore, USP’s income included half ($40) of CFC’s $80 of taxable income as a subpart F inclusion. Because USP’s income included half of CFC’s taxable income, USP was entitled to increase its ATI by half of CFC’s excess taxable income. Therefore, USP’s ATI was increased by $16.66, resulting in a $5 increase in its section 163(j) limitation. Note that this $5 represents half of CFC’s unused section 163(j) limitation—in other words, the roll-up provision under the former proposed regulations generally permitted US shareholders to take advantage of its CFCs’ excess section 163(j) limitation, in proportion to the extent that the CFCs’ taxable income was actually included in the income of the US shareholder.

The new proposed regulations generally retain the roll-up to US shareholders while modifying the formula. Under the new proposed regulations, a US shareholder’s ATI is increased, with respect to a given CFC in the CFC group, by the amount of income inclusions taken into account by the US shareholder multiplied by a fraction, the numerator of which is the CFC’s excess taxable income and the denominator of which is the CFC’s ATI. In other words, the new proposed regulations use the CFC’s income inclusions as the base and adjust the base proportionally with respect to the CFC’s excess taxable income in relation to its ATI. By contrast, the former proposed regulations used excess taxable income as the base and adjusted the base proportionally with respect to the CFC’s income inclusions in relation to its taxable income (taking interest expense into account).

To illustrate the difference in result from the two approaches, consider the above example.

  • Under the former proposed regulations, USP’s ATI was increased by $16.66, which represented CFC’s $33.33 of excess taxable income multiplied by 50%, the proportion of CFC’s taxable income that constituted a subpart F inclusion.
  • Under the new proposed regulations, USP’s ATI is increased by $40 (USP’s subpart F inclusion) multiplied by 33%, the proportion of CFC’s ATI that constitutes excess taxable income, for a total increase of $13.33.

Miscellaneous Changes Made by the New Proposed Regulations

In addition to the major changes made to CFC group elections, the new proposed regulations made various supplementary additions and changes to the application of section 163(j) to CFCs as follows:

  • Five-year binding election: The former proposed regulations provided that no formal statement was required to make a CFC group election and that a taxpayer was deemed to have made the CFC group election simply by applying section 163(j) accordingly. However, the former proposed regulations also provided that a CFC group election, once made, was generally irrevocable. By contrast, the new proposed regulations require a formal statement making a CFC group election and generally provide that a CFC group election, once made, is binding for five years.
  • Determination of CFC group and related rules: Because the new proposed regulations apply section 163(j) on a group-wide basis in a manner similar to a consolidation regime, the new proposed regulations contain extensive rules regarding the determination of the CFCs included in a CFC group and associated issues. For example, the new proposed regulations provide rules for determining the period with respect to which section 163(j) is applied to the CFC group, rules for determining when and how a CFC is deemed to join or leave the CFC group, and rules for determining the extent to which a joining CFC’s pre-group disallowed interest expense carryforwards can be used by the group and the extent to which a departing CFC is allocated disallowed interest expense carryforwards of the group.
  • Safe harbor: The new proposed regulations contain a safe harbor election, pursuant to which a CFC group is not subject to the section 163(j) limitation. The safe harbor election is available only if a CFC group election is in effect, and unlike the CFC group election, the safe harbor election is an annual election. Generally, a CFC group is eligible to make a safe harbor election if the group’s interest expense is less than or equal to 30% of the lesser of: (i) the sum of the taxable income of the CFCs in the group determined without regard to section 163(j); and (ii) the sum of the subpart F and GILTI inclusions with respect to the CFCs in the group. However, roll-ups of excess taxable income to US shareholders is not permitted with respect to CFC groups for which a safe harbor election is in effect.
  • Provisions to conform to the Coronavirus Aid, Relief and Economic Security (CARES) Act: The CARES Act made changes to section 163(j) to provide taxpayer relief in light of the COVID-19 pandemic. The changes generally increased the ATI percentage from 30% to 50% in calculating the section 163(j) limitation for 2019 and 2020, and permitted taxpayers to use 2019 ATI to determine the section 163(j) limitation for 2020. The new proposed regulations contain various provisions designed to incorporate these changes, such as provisions to implement the changes in the context of a group of CFCs having different taxable years.
  • Stand-alone CFCs: The former proposed regulations only applied to groups of CFCs, so the roll-up to US shareholders did not apply in the context of a US shareholder with a single CFC. The new proposed regulations modify the roll-up to permit its application to stand-alone CFCs.
  • Anti-abuse rule: The new proposed regulations contain an anti-abuse rule addressing situations where taxpayers may be incentivized to affirmatively plan to have interest expense deductions disallowed under section 163(j), with the intent to use the resulting carryforwards in a future year. Such a situation could arise if the negative effect of a CFC’s interest expense disallowance (e.g., an increase in tested income) does not result in increased US federal income tax liability (e.g., due to excess GILTI foreign tax credits that can offset the increase). The anti-abuse rule generally provides that, in such situations, the ATI of the CFC paying the interest is increased such that the interest expense paid pursuant to such a plan is not limited by section 163(j).

The final regulations stating that CFCs are generally subject to section 163(j) apply to taxable years beginning on or after the date that is 60 days after the recently finalized section 163(j) regulations are published in the Federal Register. The new proposed regulations apply to taxable years beginning on or after the date that is 60 days after the finalized version of the new proposed regulations are published in the Federal Register. However, taxpayers generally can apply both the final regulations and the new proposed regulations to taxable years beginning after December 31, 2017, and before their respective applicability dates, provided that the section 163(j) regulations are applied consistently.