This column describes new proposed Code Sec. 163(n) and the proposed general removal of expense allocation to GILTI in the Build Back Better Act (the “BBBA”). This column focuses on the version of the BBBA proposed on November 3, 2021.
General Removal of Expense Allocation to GILT I
The BBBA would largely remove expense allocation to GILTI for foreign tax credit purposes. More specifically, the BBBA would replace Code Sec. 904(b)(4), which would provide that in the case of a domestic corporation and solely for purposes of the foreign tax credit limitation in Code Sec. 904(a) with respect to amounts described in Code Sec. 904(d)(1)(A) (GILTI category income), the taxpayer’s taxable income from sources without the United States is determined by allocating and apportioning any deduction allowed under Code Sec. 250(a)(2) (and any deduction allowed under Code Sec. 164(a)(3) for taxes imposed on amounts described in Code Sec. 250(a)(2)) to such income. In addition, other deductions may be allocated and apportioned to such GILTI category income only if the Secretary determines that such deduction is directly allocable to such income. Any deduction which would, but for the rules described above, have been allocated or apportioned to GILTI category income would only be allocated or apportioned to income which is from sources within the United States (and would not be allocable and apportioned, for example, to foreign source, general category income). Subject to very limited exceptions, this would effectively repeal the allocation and apportionment of expenses to GILTI for foreign tax credit purposes. As previously discussed, allocation and apportionment of expenses to GILTI category for foreign tax credit purposes limits the utilization of foreign tax credits with respect to GILTI and often results in U.S. tax on GILTI, even if the foreign tax rate is above 13.125 percent.
Addition of Proposed Code Sec. 163(n)
The BBBA would add new Code Sec. 163(n), which would cap the amount of deduction for interest expense (that exceeds interest income) at the “allowable percentage” of 110 percent of such excess. The allowable percentage is the domestic corporation’s “allocable share” of the group’s reported net interest expense (as reported in an applicable financial statement) over such corporation’s reported net interest expense (as reported in books and records in preparing such group’s applicable financial statement). The allocable share of the group’s reported net interest expense is the group’s reported net interest expense times the ratio of the domestic corporation’s EBITDA to the EBITDA of the group. The worse of the limit under Code Sec. 163(j) or Code Sec. 163(n)(1) applies.
Code Sec. 163(n) is applicable to a domestic corporation which is a member of a multinational group that prepares consolidated financial statements, and which has averaged net interest expense for the three-year reporting period of more than $12 million annually. Unlike prior proposals that would be limited to U.S. subsidiaries of foreign-parented groups, the BBBA’s version of Code Sec. 163(n) would apply to U.S. corporations of both foreign-parented and U.S.-parented groups.
Under new Code Sec. 163(o), the amount of any interest not allowed as a deduction by reason of Code Sec. 163(j) or (n)(1) (whichever imposes the lower limitation with respect to such taxable year) is treated as paid or accrued in the succeeding taxable year (with an unlimited carryforward period).
As an example, assume USCo’s EBITDA comprises 50 percent of the EBITDA of the group, and the group has $100 of reported net interest expense (as reported in its Form 10-K). Also assume that USCo has $100 of reported net interest expense (as reported in books and records in preparing the group’s Form 10-K) and $100 of net interest expense for U.S. tax purposes. USCo’s allocable share of the group’s reported net interest expense would be $50 (EBITDA of USCo/EBITDA of group × group reported net interest expense of $100). The allowable percentage would also be 50 percent (USCo’s allocable share of the group’s reported net interest expense of $50/USCo’s reported net interest expense of $100). Thus, Code Sec. 163(n) would limit the interest expense to $55 (allowable percentage of 50 percent × 110 percent × $100 net interest expense for U.S. tax purposes), and $45 of interest expense is carried forward to the following year.
Although the addition of Code Sec. 163(n) is not framed as a replacement of expense allocation to GILTI, the two provisions are loosely correlated. For taxpayers that have excess taxes in the GILTI category, expense allocation effectively disallows a deduction for interest expense for every dollar of interest expense allocated and apportioned to GILTI category income. As previously discussed, because GILTI is essentially a full-inclusion system, it is odd to effectuate U.S. tax rates on foreign subsidiary income through the foreign tax credit system, especially given that expense allocation often results in taxing high-taxed income, rather than low-taxed income. In contrast, Code Sec. 163(n) provides for a direct disallowance of a deduction for interest expense. Lawmakers may have also viewed a direct disallowance approach as more administrable than expense allocation in the context of a move to applying Code Sec. 904(a) limitation on a country-by-country, taxable unit basis. The move to country-by-country limitation and country-by-country GILTI will be enormously complex, even without unnecessary complications from expense allocation.
Generally, Code Sec. 163(n) will adversely impact large U.S. taxpayers with significant (third-party or related-party) debt, and the corporate group which includes the U.S. taxpayer has significant foreign operations. Code Sec. 163(n) increases the cost of debt financing for these U.S. companies, and particularly impacts U.S. companies in industries that rely on debt financing. The impact of Code Sec. 163(n) could be significant. For instance, in the simple example above, nearly half of the interest expense incurred by the U.S. corporation is disallowed in the year (without regard to whether the U.S. corporation is thinly capitalized or not). If a prospective new investment in the United States were to be financed in part by new debt by a U.S. member of the group, nearly half the interest rate for that prospective investment would be disallowed under the simple facts above, increasing the hurdle rate for profitability.
Unlike Code Sec. 163(j), foreign jurisdictions do not have a provision anything like Code Sec. 163(n). Many of the international tax proposals in BBBA are intended to line up with the OECD’s Pillar 2 framework (such as the move to country-by-country), and the OECD Pillar 2 framework does not include a provision similar to Code Sec. 163(n). Tax is one out of many considerations, and Code Sec. 163(n) could in certain circumstances nudge towards offshore borrowing, either through offshore third-party borrowing or the U.S. company on-lending the proceeds to foreign affiliates.
Deference to Financial Accounting
One interesting aspect of new Code Sec. 163(n) is its deference to financial accounting in computing interest deduction disallowance for U.S. federal income tax purposes. For example, as noted above, a corporation’s “allocable share” of the group’s reported net interest expense is based on the ratio of the EBITDA of the corporation over the EBITDA of the group. EBITDA means EBITDA5 as determined in the group’s financial statements (such as the Form 10-K), or as determined in the books and records of the group which are used in preparing such statements. Thus, EBITDA for this purpose means EBITDA as determined for financial accounting purposes. Similarly, “reported net interest expense” is determined under financial accounting rules. However, financial accounting is designed to address policies different from U.S. tax principles, and there could be intentional differences between the financial accounting treatment and the U.S. tax treatment of interest income, interest expense, or EBITDA. The impact of the deference to financial accounting for tax purposes is highly important in the proposed 15-percent minimum tax on “adjusted financial statement income”.
To alleviate these issues, Code Sec. 163(n)(7) provides the Secretary may issue such regulations or other guidance as are necessary or appropriate to carry out the purposes of Code Sec. 163(n), including, among other things, regulations or other guidance which allows or requires the adjustment of amounts reported on applicable financial statements. It remains to be seen how, and to the extent, Treasury would exercise its authority under Code Sec. 163(n)(7).
The changes to expense allocation and Code Secs. 163(n) and (o) apply to taxable years beginning after December 31, 2022.
To better understand the tax impact of Code Secs. 163(n) and (o), taxpayers may want to better understand the reporting of interest expense, interest income, and EBITDA for financial accounting purposes. Taxpayers should model the impact of new Code Secs. 163(n) and (o) and the general removal of expense allocation to determine the impact of these changes on their particular facts.