Since the 2017 tax act enacted the new Internal Revenue Code Section 163(j) limitation on interest deductions, multinationals have been asking whether the limitation applies to controlled foreign corporations (CFCs). Proposed regulations released Nov. 26, 2018, would answer that question in the affirmative. But other questions remain. The biggest decisions now for multinationals are (i) whether to elect into early application of the proposed regulations, starting in 2018, and (ii) whether to make the irrevocable election (CFC Group Election) to apply IRC Section 163(j) to CFCs under modified rules: rules that are generally more favorable, but also far more complex.
The regulations are proposed to apply to tax years ending after final regulations are issued. But taxpayers may elect to apply the proposed regulations early. Taxpayers that choose to early adopt must apply the proposed rules in their entirety to all tax years beginning after Dec. 31, 2017. Thus, calendar-year multinationals will need to make at least a preliminary assessment of the proposed rules as a whole, and the irrevocable election in particular, for their 2018 year-end tax provisions.
IRC Section 163(j) generally limits the amount of business interest that can be deducted in the current year to the sum of: (1) the taxpayer’s business interest income for the taxable year; (2) 30 percent of the taxpayer’s adjusted taxable income (ATI) for the year; and (3) the taxpayer’s floor plan financing interest expense for the taxable year. Any business interest not allowed as a deduction carries forward and can be deducted in a subsequent year, subject to that year’s limitation.
In the case of a C corporation (or a consolidated group), ATI means taxable income computed without regard to (i) interest income, interest expense or NOLs, and (ii) for taxable years beginning before Jan. 1, 2022, depreciation, amortization or depletion. The statute also authorizes the Treasury Department to provide other adjustments
THE GILTI/SUBPART F HAIRCUT
Section 1.163(j)-7 of the proposed regulations would require one very important additional adjustment for U.S. shareholders of CFCs: Their ATI would be computed by subtracting from taxable income the amount of their global intangible low-taxed income (GILTI) inclusions, Subpart F inclusions and the IRC Section 78 gross-up, reduced by the portion of the IRC Section 250 deduction allowed on GILTI or the gross-up on GILTI (determined without regard to the taxable income limitation, IRC Section 250(a)(2)).
The subtraction required by this GILTI/Subpart F taxable income “haircut” will materially reduce the IRC Section 163(j) limitation for many U.S. multinationals. The preamble states that the haircut is needed to avoid double counting a CFC’s taxable income already taken into account in determining the CFC’s IRC Section 163(j) limitation.
The haircut is a bit jarring in light of other positions the government has taken with respect to interest expense and GILTI. The recent expense allocation proposed regulations (Prop. Reg. Section 1.861-8(d)(2)(ii)) would require U.S. taxpayers to allocate and apportion interest expense to the taxable portion of their GILTI. The theory behind this requirement is that money is fungible, and a taxpayer’s borrowings support all of its income and activities, including those conducted through CFCs. But, if a U.S. shareholder’s borrowing supports a CFC’s GILTI-generating activities enough to justify an allocation of interest expense, does the borrowing not also support those activities enough to justify including the U.S. shareholder’s GILTI in the taxable income base to which the IRC Section 163(j) limitation applies? Treasury and the IRS need to adopt a consistent approach. It would seem the drafters of the IRC Section 163(j) rules are not talking to the drafters of the expense allocation rules.
GENERAL RULE FOR APPLYING IRC SECTION163(j) TO CFCs
Section 1.163(j)-7 of the proposed regulations would also generally apply the IRC Section 163(j) limitation to CFCs in the same manner as it applies to domestic C corporations. Thus, a CFC would generally apply IRC Section 163(j) on a separate entity basis to determine the extent to which its interest expense is deductible for purposes of computing Subpart F income, GILTI tested income and ECI. Two modifications would apply in computing a CFC’s ATI: The principles of Reg. Section 1.952-2 (or, for CFCs with ECI, the rules of IRC Section 882) would apply, and dividends from a related person would be backed out of taxable income.
Taxpayers have been asking whether the IRC Section 163(j) limitation applies to CFCs for almost a year. Proposed regulations under the old, pre-2018 IRC Section 163(j) excepted CFCs from the rules. There is no compelling reason why the new IRC Section 163(j) regulations could not do the same. If the CFC’s country of residence allows interest expense to be deducted over and above the 30 percent limitation, disallowing the excess interest expense in the U.S. shareholder’s GILTI calculation will create a mismatch. Moreover, the statutory GILTI calculation has its own, separate way of limiting the amount by which CFC interest expense deductions can reduce GILTI: IRC Section 951A(b)(2)(B) reduces the U.S. shareholder’s net deemed tangible income return by the amount of net interest expense in the CFC system. It is difficult to see how applying IRC Section 163(j) to CFCs advances the policies behind the IRC Section 163(j) rules or the GILTI rules.
THE IRREVOCABLE CFC GROUP ELECTION
As an alternative to separate entity application of IRC Section 163(j), the proposed regulations offer an election for CFCs in a closely-related CFC group (CFC Group Election). If the election is made, a CFC group member’s IRC Section 163(j) limitation is recomputed, taking into account the interest income and interest expense of the other CFC group members, as follows: If the group as a whole does not have net interest expense, IRC Section 163(j) does not limit any group member’s interest expense deduction. That would be the case, for example, where CFCs in the group only borrowed from other CFCs in the group.
If the group as a whole has net interest expense, each member that has net interest expense on a separate entity basis is allocated a proportionate share of the group’s net interest expense. A CFC member’s interest expense deduction is disallowed only to the extent that its allocated share of the group’s net interest expense exceeds 30 percent of its adjusted taxable income.
When the CFC Group Election is made, it alters the application of IRC Section 163(j) in other ways as well. In computing its ATI, an upper-tier CFC can use any “excess” ATI of each lower-tier CFC in its group that it owns directly. The ATI of each member of a CFC group is thus computed through a “tiering up” process, starting with the lowest-tier CFC in the group. At each level, the member computes its IRC Section 163(j) limitation. Any excess ATI—i.e., ATI in excess of the amount needed to deduct all of the CFC’s interest expense—tiers up to the next higher-tier member, which then computes its IRC Section 163(j) limitation taking into account any tiered up excess ATI. This process continues up the chain of ownership to the first-tier member.
Additionally, a first-tier CFC’s excess ATI tiers up to the CFC’s U.S. shareholder. This excess ATI can be used by the U.S. shareholder to increase its IRC Section 163(j) limitation, but only to the extent of the GILTI/Subpart F haircut that was previously subtracted from the U.S. shareholder’s taxable income in computing its ATI.
The proposed regulations provide that these alternative rules apply only if each CFC within a CFC group and all related CFCs make the CFC Group Election. Once made, the CFC Group Election is irrevocable.
WEIGHING THE CFC GROUP ELECTION
Multinationals will need to carefully consider whether to make the CFC Group Election. There are substantial downsides to making the election. Once made, the election can never be revoked. The election also adds significant complexity to the calculation of a CFC’s (and a U.S. shareholder’s) IRC Section 163(j) limitation. Layers of calculations are required that otherwise would be unnecessary. Taxpayers who wish to make the election before the regulations are finalized will also have to early adopt the proposed regulations’ CFC rules. The proposed rules allow for early adoption, but only if all CFCs, their U.S. shareholders, and all related parties consistently apply all of the proposed regulations. That will include, for example, the GILTI/Subpart F haircut, which would not apply absent the regulations.
On the other hand, the CFC Group Election can provide significant benefits. Without the election, a taxpayer’s GILTI inclusion could be increased solely due to intercompany debt between related CFCs. The election could materially reduce, or even eliminate, that increased GILTI inclusion. The tiering up of excess ATI also could be very important to CFC groups where one CFC borrows to fund the operations of other CFCs. A CFC holding company, for example, might have no taxable income of its own. Absent the CFC Group Election, its interest expense could be completely disallowed under IRC Section 163(j). Of course, even if the interest expense is allowed, ultimately, it might not reduce the U.S. shareholder’s GILTI inclusion as a result of the IRC Section 951A(b)(2)(B) reduction to the net deemed tangible income return for CFC interest expense with no corresponding CFC interest income.
Consequently, multinationals will need to carefully weigh the pros and cons of making the irrevocable election. The mere availability of the election may require U.S. companies to model all of its impacts in order to make an informed decision.
Adam Halpern is the Chair of the Tax Group at Fenwick & West LLP. Ariel Love is an associate in the Tax Group.