Prop. Regs. § 1.163(j) Earnings stripping rules.
Prop. Regs. § 1.163(j)-0 Table of contents.
Prop. Regs. § 1.163(j)-1 Limitation on deduction for certain interest paid or accrued by a corporation to related persons.
Prop. Regs. § 1.163(j)-2 Definitions.
Prop. Regs. § 1.163(j)-3 Computation of debt-equity ratio.
Prop. Regs. § 1.163(j)-4 Interest not subject to tax.
Prop. Regs. § 1.163(j)-5 Affiliated group rules.
Prop. Regs. § 1.163(j)-6 Limitation on carryforward of tax attributes.
Prop. Regs. § 1.163(j)-7 Relationship to other provisions affecting the deductibility of interest.
Prop. Regs. § 1.163(j)-8 Application of section 163(j) to certain foreign corporations.
Prop. Regs. § 1.163(j)-9 Guarantees and back-to-back loans [reserved].
Prop. Regs. § 1.163(j)-10 Effective dates.
Regs. § 1.881-3 Conduit financing arrangements.
Regs. § 1.881-4 Recordkeeping requirements concerning conduit financing arrangements.
BACKGROUND
This document contains proposed amendments to the Income Tax Regulations (26 CFR part 1) under section 163(j) of the Internal Revenue Code.
EXPLANATION OF PROVISIONS
Section 163(j) was added to the Internal Revenue Code of 1986 by the Omnibus Budget Reconciliation Act of 1989, P.L. 101-239, 103 Stat. 2106, to prevent erosion of the U.S. base by means of excessive deductions for interest paid by a taxable corporation to a tax exempt (or partially tax exempt) related person. The payment of excessive deductible interest that is tax exempt (or partially tax exempt) in the hands of a related person is referred to as "earnings stripping." These proposed regulations implement section 163(j) as follows.
SECTION 1.163(j)-1
Section 1.163(j)-1(a) provides the primary operative rule that no deduction shall be allowed for interest expense paid or accrued directly or indirectly by a corporation to a related person if no tax is imposed with respect to such interest. The disallowance rules do not apply if the payor corporation is either an S corporation or a foreign corporation (except as provided under section 1.163(j)-8, relating to foreign corporations with effectively connected income). Paragraph (a)(2) provides that the amount of disallowed interest expense (the year's disallowed interest expense) is limited to the lesser of exempt related person interest expense (defined in paragraph (a) of section 1.163(j)-2) or excess interest expense (defined in paragraph (b) of section 1.163(j)-2). Paragraph (a)(3) provides that interest expense disallowed in a taxable year is carried forward to succeeding taxable years as disallowed interest expense carryforwards.
Paragraph (b) provides that, in addition to the limitation on disallowance provided under paragraph (a)(2), a deduction for exempt related person interest expense shall not be disallowed for any taxable year in which the debt-equity ratio of the payor corporation is less than or equal to 1.5 to 1 determined on the last day of that year. Although section 163(j)(2)(A)(ii) grants the Service the authority to determine the debt-equity ratio more frequently than annually, a more frequent determination was not adopted because many taxpayers might have difficulty in obtaining the required information prior to the close of their taxable years. However, to prevent possible manipulation of a strictly annual determination of the debt- equity ratio, paragraphs (b)(4) and (c)(5) of section 1.163(j)-3 provide anti-avoidance rules.
Paragraph (c) provides that disallowed interest expense carryforward is allowable in the carryforward year only to the extent of any excess limitation for that year as defined in section 1.163(j)-2(c). In determining whether a deduction is allowed in a carryforward year for disallowed interest expense carryforward, the payor corporation's debt-equity ratio in such year is not relevant.
Paragraph (d) provides rules for the carryforward of excess limitation. Excess limitation is carried forward to each of the three succeeding taxable years and reduces (and is also reduced by) excess interest expense in a carryforward year without regard to whether the payor corporation has exempt related person interest expense or whether the payor corporation satisfies the debt-equity ratio safe harbor test in a carryforward year. Pre-effective date notional excess limitation may be carried forward to post-effective date taxable years in certain cases, as provided under section 1.163(j)- 10(c).
Paragraph (e) provides that the disallowance of interest under section 163(j) does not affect the payor corporation's determination of earnings and profits.
Paragraph (f) provides a general anti-abuse rule to prevent the avoidance of section 163(j) and these regulations.
SECTION 1.163(j)-2
Section 1.163(j)-2 provides definitions. Paragraph (a) defines "exempt related person interest expense" as interest paid or accrued by a corporation described in section 1.163(j)-1 to a related person (as defined in paragraph (g)) if no tax is imposed on such interest under the rules of section 1.163(j)-4. Paragraph (b) defines "excess interest expense" as the excess of the payor corporation's net interest expense over 50 percent of its adjusted taxable income plus the amount of any excess limitation carryforward. Paragraph (c) defines "excess limitation" as the excess of 50 percent of a corporation's adjusted taxable income over its net interest expense. Paragraph (d) defines "net interest expense" as the excess of a corporation's interest expense over its interest income for the taxable year. Net interest expense is computed without regard to any disallowed interest expense carryforward.
Paragraph (e) provides rules for the determination of interest income and expense, including rules dealing with the treatment of bond premium and market discount and rules for determining the interest income and expense of a corporate partner in a partnership. Under these rules, a corporate partner is treated as the payor of its share of the partnership's interest expense. The Internal Revenue Service plans to publish rules which treat interest equivalents as interest for purposes of section 163(j) and solicits comments regarding the scope and operation of such rules. These rules will generally be prospective with respect to transactions entered into in the ordinary course of business. However, in the case of transactions entered into with a purpose of avoiding section 163(j), the rules regarding interest equivalents may be retroactive.
Paragraph (e) also contains an anti-avoidance rule providing that certain substitute payments under section 1058 will be treated as interest expense.
Paragraph (f) defines adjusted taxable income as taxable income computed without regard to carryforwards and disallowances under section 163(j) and with certain adjustments. Some of these adjustments are stipulated in section 163(j); others have been added pursuant to regulatory authority granted by section 163(j)(6)(A)(ii). In general, the purpose of these adjustments is to modify taxable income to more closely reflect the cash flow of the corporation. Thus, for example, paragraph (f) provides for an addback of interest excluded from gross income under section 103, since such amounts increase cash available to the payor corporation. Similarly, cash expended with respect to amounts which are permanently disallowed as deductions under sections 265 and 279 are subtracted under paragraph (f) in computing adjusted taxable income, since such expenditures have reduced the amount of available cash to service loans. Paragraph (f)(4) provides special rules dealing with the effect of an adjusted taxable loss on other computations required by these regulations.
Except as provided in section 1.163(j)-8, only the adjustments prescribed in paragraph (f) shall be made in determining adjusted taxable income. The Service, however, solicits comments on whether particular adjustments should either be added to, or deleted from, paragraph (f). Such comments should address, among other issues, the administrative burden of the proposed rules and any suggested revisions.
Under paragraph (g)(1), a related person is defined as a person related to the taxpayer within the meaning of section 267(b) or 707(b)(1). For this purpose, the attribution rules of section 267(c) apply. In determining whether persons are related, the substance of ownership, rather than its form, controls. Under paragraph (g)(3), the date for testing relatedness is the date upon which an item of interest expense accrues. Thus, changes in the relationship between the payor corporation and the payee after the accrual date are irrelevant. The daily accrual rule of section 1272(a) applies, regardless of the taxpayer's method of accounting. Paragraph (g)(4) provides special rules for certain partnerships regarding relatedness.
SECTION 1.163(j)-3
Section 1.163(j)-3 provides rules for the computation of the debt-equity ratio. Debt is determined under paragraph (b)(1) in accordance with generally applicable tax principles. Thus, in general, a contingent liability for financial accounting purposes that has not accrued for tax purposes will not be treated as a liability for purposes of section 163(j). Paragraph (b)(1) also has special rules for discount obligations consistent with section 163(j)(2)(C)(ii). Paragraph (b)(2)(i) provides a limited exclusion from debt for certain short term liabilities, and paragraph (b)(2)(ii) provides a similar exclusion for commercial financing liabilities. Paragraph (b)(3) provides that liabilities incurred by a partnership are treated as incurred by each partner in accordance with the rules of section 752. Paragraph (b)(4) provides an anti- rollover rule to prevent abuse by a corporation of the year-end determination of the debt-equity ratio.
Equity is defined under paragraph (c)(1) as the sum of money and the adjusted basis of assets (determined according to generally applicable tax principles) reduced, but not below zero, by the corporation's debt. Paragraph (c)(2) provides for adjustments to be made to the basis of stock in certain nonincludible corporations based on the principles of section 864(e)(4). Under paragraph (c)(3), assets are reduced by the amount of short term liabilities excluded from debt under paragraph (b)(2). Paragraph (c)(4) provides that in determining the assets of a corporation that owns an interest in a partnership, the partner shall treat the adjusted basis of its partnership interest as an asset. Paragraph (c)(5) provides a general anti-avoidance rule, plus an anti-stuffing rule to prevent possible abuse by a corporation of the year-end determination of debt-equity ratio.
Paragraph (d) provides that the spot rate on the last day of the taxable year is used to translate the debt and equity of a qualified business unit with a non-dollar functional currency.
Comments are solicited with respect to determining the debt and assets of financial institutions and insurance companies, including the effect of reserves on such determinations.
SECTION 1.163(j)-4
Section 1.163(j)-4 provides rules addressing whether interest paid or accrued is subject to U.S. tax. Paragraph (a) states the general rule that interest paid or accrued by a corporation is not subject to tax for purposes of section 163(j) if no U.S. tax is imposed under Subtitle A of the Internal Revenue Code or if U.S. tax is reduced under a treaty. Paragraph (b) provides that income subject to U.S. tax at a reduced rate under a treaty will be treated in part as interest subject to tax and in part as tax-exempt interest.
Paragraph (c) provides that the determination as to whether interest is subject to U.S. tax is made on the date the interest is received or accrued by the payee, whichever is relevant for purposes of taxing the payee.
Paragraph (d) provides rules under which certain interest paid to special entities, including controlled foreign corporations ("CFCs"), passive foreign investment companies ("PFICs"), foreign personal holding companies, and DISCs, is treated as subject to U.S. tax. See H.R. Rep. No. 247, 101st Cong., 1st Sess. 1240, 1244 (1989) (hereafter, "House Report"). Paragraph (d)(1) generally provides that interest paid or accrued to a CFC is treated as subject to U.S. tax to the extent that such interest is included in the CFC's net foreign personal holding company income under section 1.954-1T(c) and results in an inclusion in the gross income of a U.S. shareholder under section 951(a)(1)(A)(i). A similar rule is provided for foreign personal holding companies in paragraph (d)(3). Interest paid or accrued to a PFIC that is not a CFC, with respect to which a QEF election has been made by a U.S. shareholder, is treated as subject to U.S. tax to the extent that such interest is included in the QEF's ordinary earnings and results in an inclusion in such shareholder's income under section 1293(a)(1)(A). Producer's loan interest that is treated as a deemed distribution to a DISC's shareholder under section 995(b)(1)(A) also is treated as subject to U.S. tax.
SECTION 1.163(j)-5
Section 1.163(j)-5 implements the directive of section 163(j)(6)(C) that all members of the same affiliated group be treated as one taxpayer. In order to implement this directive, the basic rules of these regulations have been modified as necessary to carry out the purposes of section 163(j). See section 163(j)(7)(A) and (B).
Section 1.163(j)-5(b) applies the rules of section 163(j) (other than the debt-equity ratio computations discussed below) to consolidated groups. For this purpose, all of the members of the consolidated group make the computations required by section 163(j) and these regulations on a consolidated basis. If a corporation ceases to be a member of the consolidated group, any disallowed interest expense carryforward of the group is apportioned to the member based on the ratio of the member's exempt related person interest expense to the group's exempt related person interest expense. However, corporations ceasing to be members of the group generally may not carry forward any portion of the group's excess limitation carryforward to separate return years.
Section 1.163(j)-5(c) provides comparable rules applicable to other affiliated groups. For this purpose, section 1.163(j)-5(a)(3) expands the definition of affiliated groups under section 1504(a) by applying the attribution rules of section 318 to determine stock ownership. Thus, an affiliated group under these rules may include a consolidated group, and the consolidated group is treated as a single member of the affiliated group for purposes of making computations for the affiliated group. Section 1.163(j)-5(c) requires each group member to take into account the relevant items of income, expense, and carryover of all group members. If members of an affiliated group have different taxable years, then the computations required by section 163(j) are separately determined for each member on an affiliated group basis by aggregating the relevant items for all group members whose taxable years end with or within the taxable year of the member making the computations.
Section 1.163(j)-5(c)(2) provides a four step process for making the affiliated group computations and for allocating amounts among group members. The four step process is necessary because the group members do not all join in filing the same return.
Section 1.163(j)-5(d) generally provides that for purposes of applying the debt-equity ratio safe harbor test described in section 1.163(j)-1(b), the debt-equity ratio of a corporation that is a member of an affiliated group (whether or not a consolidated group) is determined by aggregating the separately determined debt and assets of the members (adjusted as described in paragraphs (d)(2) and (d)(3)). Debt and assets arising from certain interaffiliate transactions are disregarded.
Section 163(j)-5(e) provides special rules that address distortions in the debt-equity ratio that may arise in a qualified stock purchase, as defined in section 338(d)(3), if no election is made to step up the basis of the assets of the target corporation and its affiliates. (This distortion may arise because the affiliated group rules of section 163(j) look through to the underlying assets of an acquired corporation rather than its stock basis.) If the purchasing corporation so elects, the special rules of section 1.163(j)-5(e) look to the adjusted basis of the target's stock (adjusted for liabilities) and amortize these amounts (the "special basis") over a fixed period. At the end of any taxable year, a taxpayer may elect out of the fixed stock write-off method and use the adjusted basis of the assets of the target corporation in determining the group's debt-equity ratio.
The Service recognizes the complexity of the affiliated group rules in section 1.163(j)-5 and solicits comments on how these rules might be improved, simplified or clarified, whether in the context of consolidated groups or otherwise. Comments are also solicited as to whether, under what circumstances, and to what extent it might be appropriate to extend the fixed stock write-off method to nontaxable acquisitions of stock or assets. Finally, the Service is considering whether and how to impose a conformity requirement under paragraph (e) of this section that would prevent a group from selectively applying the fixed stock write-off method only when the purchase price of a target company exceeds the target's basis in its assets. The Service solicits comments on the appropriateness of such a rule, and on how such a rule might be implemented.
SECTION 1.163(j)-6
This section limits the carryover of certain tax attributes by corporations which join consolidated groups or affiliated groups (as defined in section 1.163(j)-5(a)), as well as with respect to transactions described in section 381(a).
Paragraph (a) limits the use of disallowed interest expense carried forward from non-affiliation years by corporations joining a group or that transfer or distribute their assets in a transaction described in section 381(a). The only restriction under these regulations on the use of such disallowed interest expense is with respect to the use of non-affiliation year excess limitation carryforward to absorb the disallowed interest expense. The same limitation applies with respect to corporations joining groups, whether the groups are consolidated groups or affiliated groups. See sections 1.163(j)-5(b) (relating to consolidated groups) and (c) (relating to other affiliated groups). Where there is a section 382 ownership change, the disallowed interest expense carryforward may be limited by the section 382 limitation. In addition, the deductibility of a corporation's disallowed interest expense carried forward to a taxable year after it joins a consolidated group may be limited by the separate return limitation year rules under section 1.1502-15.
Paragraph (b)(1) limits the use of excess limitation carried forward from non-affiliation years by corporations joining a group. The limitation is similar to the limitation on the carryover of net operating losses under the "SRLY" rules of section 1.1502-21(c) (i.e., generally such carryforward may be used by the corporation to the extent that it would have been available for use had no affiliation occurred). If a consolidated group acquires another group, whether or not consolidated, the amount of the acquired group's excess limitation carryforward (if any) from non-affiliation years that may be used by the consolidated group is determined by treating the former members of the acquired group as a single member of the acquiring group. Computations with respect to the acquired group are made under section 1.163(j)-5(c), and the results of these computations are taken into account by the group under section 1.163(j)-5(b).
Paragraph (b)(2) provides that a corporation's excess limitation carryforward from a non-affiliation year is reduced to zero immediately after a transfer or distribution of its assets in a transaction described in section 381(a) (other than a transaction described in section 368(a)(1)(F)). Paragraph (b)(3) provides an anti-abuse rule. Paragraphs (c) and (d) provide definitions and anti- duplication rules.
The Service recognizes the complexity of the affiliated group rules and solicits comments on how these rules might be improved, simplified or clarified, whether in the context of consolidated groups or otherwise.
SECTION 1.163(j)-7
This section addresses the interaction of section 163(j) and certain other Code provisions. Paragraph (a) provides that interest expense is not considered paid or accrued for purposes of section 163(j) until such interest would be deductible but for such section.
Paragraph (b) addresses other Code provisions which permanently disallow interest, which defer the deductibility of interest, or which limit the deductibility of certain deductions including interest, specifically the "at risk" rules under section 465 and the passive activity loss rules under section 469. In each of these cases, section 163(j) is applied after the application of such provisions. Thus, section 163(j) will not apply to interest expense which is permanently disallowed as a deduction under provisions such as sections 265 and 279. Where the deductibility of interest expense is deferred as under sections 163(e)(3) and 267(a)(3), section 163(j) will not apply until a deduction for such interest expense is otherwise allowable. Similarly, sections 465 and 469 are applied before section 163(j) to disallow interest expense. Once section 163(j) is applied, section 469 is not reapplied.
Paragraph (b)(4) addresses the interaction of section 163(j) and Code provisions relating to the capitalization of certain interest expense. Under this paragraph, the capitalization rules are applied before section 163(j). For all purposes under section 163(j), capitalized interest is not treated as interest expense. It is anticipated that regulations to be issued under section 263A(f) will provide: (1) that exempt related person interest expense which is attributable to traced debt will be capitalized; and (2) with respect to interest expense that is not attributable to traced debt, interest expense that is not exempt related person interest expense will be capitalized before interest expense that is exempt related person interest expense.
The Service proposes to adopt these rules for capitalized interest, notwithstanding the legislative history of section 163(j) (see House Report at 1244), because it believes that other approaches would require substantial additional complexity. The Service will revisit this decision if it believes that the proposed rule gives rise to significant tax avoidance.
Paragraph (b)(5) provides that section 246A is applied before section 163(j). Any reduction in the dividends received deduction under section 246A reduces interest expense taken into account under section 163(j).
SECTION 1.163(j)-8
This section concerns the application of section 163(j) to foreign corporations that have income, gain, or loss that is effectively connected, or deemed effectively connected, with the conduct of a U.S. trade or business. A foreign corporation is permitted to allocate a portion of its worldwide interest expense to the effectively connected income of its U.S. trade or business. This section disallows the exempt related person interest expense of a foreign corporation based on the same principles that apply to disallow a domestic corporation's exempt related person interest expense. To determine if interest allocated to the effectively connected income of the U.S. trade or business is paid to an exempt related person, the rules of section 884(f) apply. Thus, interest paid by the U.S. trade or business (within the meaning of section 884(f)(1)(A)) is treated as paid directly to the recipient of the interest, and will be treated as paid to a related person if the recipient is related to the foreign corporation. Excess interest (within the meaning of section 884(f)(1)(B)) is treated as paid by a wholly owned domestic subsidiary of the foreign corporation to the foreign corporation, and hence is treated as paid to a related person. Additional rules provide that this section does not affect the computation of a foreign corporation's effectively connected earnings and profits or U.S. net equity for purposes of section 884.
SECTION 1.163(j)-9
The Service expects to publish regulations addressing guarantees in the near future. The rules with respect to guarantees will be prospective. Nonetheless, in cases presenting fact patterns similar to that described in Plantation Patterns, Inc. v. Commissioner, 462 F.2d 712 (5th Cir.), cert. denied, 409 U.S. 1076 (1972), the Service will continue to seek to characterize purported guaranteed debt as equity. The Service's position on back-to-back loans is set forth in revenue rulings including Rev. Rul. 84-152, 1984-2 C.B. 381, Rev. Rul. 84-153, 1984-2 C.B. 383, and Rev. Rul. 87-89, 1989-2 C.B. 195.
Comments are solicited on rules regarding guarantees and back- to-back loans.
SECTION 1.163(j)-10
In general, section 163(j) provides for disallowance of interest paid or accrued in taxable years beginning after July 10, 1989. However, interest that would otherwise be disallowed under the general rule will not be disallowed if paid with respect to a fixed- term obligation outstanding on July 10, 1989 (a grandfathered obligation). An obligation will cease to be treated as grandfathered if its term is extended, or if it is revised in a transaction that results in the obligee being deemed to have made an exchange of debt instruments under section 1001 of the Code. Under an anti-avoidance rule, a grandfathered obligation also will cease to be so treated if it is acquired by a person related to the obligor as part of a transaction that otherwise would circumvent the purposes of the effective date rules.
A limited grandfathering also exists under section 163(j) for interest paid with respect to obligations issued pursuant to a written contract binding on July 10, 1989. A contract will be treated as binding for this purpose only if it was enforceable by an unrelated third party on July 10, 1989, and at all times thereafter until the obligation is issued.
A very limited transition rule exists with respect to demand obligations outstanding on July 10, 1989. Interest paid or accrued prior to September 1, 1989, with respect to such demand loans shall not be disallowed by section 163(j) even though it was paid or accrued in a taxable year beginning after July 10, 1989.
A final effective date rule concerns the computation of excess limitation carryforward with respect to the first three taxable years to which section 163(j) applies. In computing a taxpayer's disallowed interest expense under section 163(j), the taxpayer may take into account amounts that would have been excess limitation carryforward had the statute been in effect with respect to interest paid or accrued in taxable years beginning after July 10, 1986.
GENERAL COMMENTS
The Service solicits comments on whether, and to what extent, the rules of section 163(j) and these regulations comport with the arm's length standards for "thin capitalization." In particular, the Service invites comments on the proper application of the arm's length standard to related party debt; on the use of a cash-flow versus a debt-equity standard; and on the problems of tax administration in this area. See H.R. Conf. Rep. No. 386 101st Cong., 1st Sess. 568-570 (1989).
SPECIAL ANALYSES
It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, an initial Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, these regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.
COMMENTS AND PUBLIC HEARING
Before adopting these proposed regulations, consideration will be given to any written comments that are submitted (preferably a signed original and eight copies) to the Internal Revenue Service. All comments will be available for public inspection and copying. A public hearing will be held on September 25, 1991. See notice of hearing published elsewhere in this issue of the Federal Register.
DRAFTING INFORMATION
The principal authors of these regulations are Jack Feldman and Jeffrey Vinnik. However, the principal author of section 1.163(j)-8 is Elizabeth Karzon. Messrs. Feldman and Vinnik and Ms. Karzon are of the Office of Associate Chief Counsel (International), within the Office of Chief Counsel, Internal Revenue Service. Other personnel from the Internal Revenue Service and Treasury Department participated in developing the regulations.
LIST OF SUBJECTS
26 CFR sections 1.161-1 through 1.194-4
Income taxes, Reporting and recordkeeping requirements.
PROPOSED AMENDMENTS TO THE REGULATIONS
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1 -- INCOME TAX REGULATIONS; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953
Paragraph 1. The authority for part 1 continues to read in part:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Sections 1.163(j)-0 through 1.163(j)-10 are added as follows:
SECTION 1.163(j)-0 TABLE OF CONTENTS
This section contains a listing of the major headings of sections 1.163(j)-1 through 1.163(j)-10.
SECTION 1.163(j)-1 LIMITATION ON DEDUCTION FOR CERTAIN INTEREST PAID OR ACCRUED BY A CORPORATION TO RELATED PERSONS
(a) In general
(1) Deduction for exempt related person interest expense disallowed
(2) Limitation on disallowance of deduction
(3) Disallowed interest expense carryforward
(b) Debt-equity ratio safe harbor test
(c) Treatment of disallowed interest expense carryforward
(1) In general
(2) Effect of debt-equity safe harbor
(d) Carryforward of excess limitation
(e) Effect on earnings and profits
(f) Anti-avoidance rule
(g) Examples
(h) Cross-references
SECTION 1.163(j)-2 DEFINITIONS
(a) Exempt related person interest expense
(b) Excess interest expense
(c) Excess limitation
(d) Net interest expense
(e) Interest income and expense
(1) In general
(2) Treatment of bond premium and market discount
(3) Interest equivalents [RESERVED]
(4) Interest income of partnerships
(5) Interest expense of partnerships
(6) Certain substitute payments
(f) Adjusted taxable income
(1) In general
(2) Additions
(3) Subtractions
(4) Effect of adjusted taxable loss
(g) Related persons
(1) In general
(2) Anti-abuse rule
(3) When related person status is tested
(4) Special rule for certain partnerships
(5) Examples
SECTION 1.163(j)-3 COMPUTATION OF DEBT-EQUITY RATIO
(a) In general
(b) Debt
(1) In general
(2) Exclusions
(3) Liabilities of a partnership
(4) Anti-rollover rule
(c) Equity
(1) In general
(2) Treatment of stock of certain nonincludible corporations
(3) Reduction in assets for excluded liabilities
(4) Partnership interests owned by a corporation
(5) Anti-avoidance rule
(d) Determining the debt and equity of a non-dollar functional currency QBU
SECTION 1.163(j)-4 INTEREST NOT SUBJECT TO TAX
(a) In general
(b) Partially exempt interest
(c) Date for determining whether interest is subject to U.S. tax
(d) Certain interest paid to special entities
(1) Controlled foreign corporations
(2) Passive foreign investment companies
(3) Foreign personal holding companies
(4) Producer's loan interest paid to a DISC
SECTION 1.163(j)-5 AFFILIATED GROUP RULES
(a) Certain related corporations treated as one taxpayer
(1) Scope
(2) Affiliated corporations
(3) Certain unaffiliated corporations
(4) Tie-breaker rules
(b) Operative rules for consolidated groups
(1) In general
(2) Items determined on a consolidated basis
(3) Exempt related person interest expense
(4) Deferred intercompany gain
(5) Carryforwards to current taxable year
(6) Members leaving the group
(7) Examples
(c) Operative rules for other groups
(1) In general
(2) Determination and allocation of group items
(3) Examples
(d) Debt-equity ratio of related corporations treated as one taxpayer
(1) In general
(2) Adjustments to group members' debt
(3) Adjustments to group members' assets
(e) Election to use fixed stock write-off method for certain stock acquisitions
(1) In general
(2) Post-acquisition adjustments to special basis
(3) Election out of fixed stock write-off method
(4) Method for making elections
(5) Definitions
(6) Inclusion of target debt notwithstanding use of fixed stock write-off method
SECTION 1.163(j)-6 LIMITATION ON CARRYFORWARD OF TAX ATTRIBUTES
(a) Disallowed interest expense carryforward
(1) Affiliated groups
(2) Section 381(a) transactions
(3) Section 382 and SRLY
(4) Example
(b) Excess limitation carryforward
(1) Affiliated groups
(2) Section 381(a) transactions
(3) Anti-avoidance rules
(c) Affiliation and non-affiliation years
(1) In general
(2) Predecessors and successors
(3) Formation of affiliated groups
(d) Anti-duplication rule
SECTION 1.163(j)-7 RELATIONSHIP TO OTHER PROVISIONS AFFECTING THE DEDUCTIBILITY OF INTEREST
(a) Paid or accrued
(b) Coordination of section 163(j) and certain other provisions
(1) Disallowed interest provisions
(2) Deferred interest provisions
(3) At risk rules and passive activity loss provisions
(4) Capitalized interest expense
(5) Reductions under section 246A
(c) Examples
SECTION 1.163(j)-8 APPLICATION OF SECTION 163(j) TO CERTAIN FOREIGN CORPORATIONS
(a) Scope
(b) Disallowed interest expense
(c) Definitions
(1) In general
(2) Net interest expense
(3) Adjusted taxable income
(4) Excess interest expense
(5) Excess limitation
(d) Determination of interest paid to a related person
(e) Debt-equity ratio
(f) Example
(g) Coordination with branch profits tax
(1) Effect on effectively connected earnings and profits
(2) Effect on U.S. net equity
(3) Example
SECTION 1.163(j)-9 GUARANTEES AND BACK-TO-BACK LOANS. [RESERVED]
SECTION 1.163(j)-10 EFFECTIVE DATES
(a) In general
(b) Exceptions
(1) Interest paid on certain fixed-term obligations outstanding on July 10, 1989
(2) Demand loans
(c) Carryforward of excess limitation from pre-effective date taxable years to post-effective date taxable years
(d) Examples
SECTION 1.163(j)-1 LIMITATION ON DEDUCTION FOR CERTAIN INTEREST PAID OR ACCRUED BY A CORPORATION TO RELATED PERSONS
(a) IN GENERAL
(1) DEDUCTION FOR EXEMPT RELATED PERSON INTEREST EXPENSE DISALLOWED
Except as provided in this section, no deduction shall be allowed for exempt related person interest expense (as defined in section 1.163(j)-2(a)) paid or accrued during the taxable year directly or indirectly by--
(i) A domestic corporation (other than an S corporation as defined in section 1361), or
(ii) Under the special rules described in section 1.163(j)-8, a foreign corporation with income, gain, or loss that is effectively connected (or treated as effectively connected) with the conduct of a trade or business in the United States.
(2) LIMITATION ON DISALLOWANCE OF DEDUCTION
The amount of exempt related person interest expense disallowed as a deduction in any taxable year (described hereafter as the year's "disallowed interest expense") shall not exceed the payor corporation's excess interest expense (as defined in section 1.163(j)-2(b)) for that year.
(3) DISALLOWED INTEREST EXPENSE CARRYFORWARD
Disallowed interest expense shall be carried forward to the succeeding taxable year (hereafter, a "disallowed interest expense carryforward"). A deduction for disallowed interest expense carryforward may be allowed as provided in paragraph (c) of this section.
(b) DEBT-EQUITY RATIO SAFE HARBOR TEST
No deduction shall be disallowed under paragraph (a) of this section for exempt related person interest expense paid or accrued in any taxable year in which the payor corporation's debt-equity ratio (determined as provided in section 1.163(j)-3) is less than or equal to 1.5 to 1 on the last day of the taxable year.
(c) TREATMENT OF DISALLOWED INTEREST EXPENSE CARRYFORWARD
(1) IN GENERAL
A deduction for disallowed interest expense carryforward is allowed in a carryforward year if and to the extent that there is excess limitation (as defined in section 1.163(j)-2(c)) for such year. Any disallowed interest expense carryforward not so deductible shall be carried forward to the succeeding taxable year.
(2) EFFECT OF DEBT-EQUITY SAFE HARBOR
The debt-equity ratio in a carryforward year is not relevant in determining whether disallowed interest expense carryforward is deductible in such year. Rather, disallowed interest expense carryforward is deductible only to the extent of the excess limitation for such year.
(d) CARRYFORWARD OF EXCESS LIMITATION
If a corporation has excess limitation (as defined in section 1.163(j)-2(c)) for any taxable year, the amount of such excess limitation, reduced by disallowed interest expense carryforward to that year, shall be carried forward to each of the three succeeding taxable years. In each of those years, such carryforward shall reduce, and be reduced by, the amount, if any, of the corporation's excess interest expense for such year computed without regard to the carryforward. The excess limitation carryforward shall reduce, and be reduced by, excess interest expense in a carryforward year without regard to whether the corporation pays or accrues any exempt related person interest expense in that year, or whether the corporation satisfies the debt- equity ratio safe harbor test described in paragraph (b) of this section for that year. If a corporation has carryforwards from more than one taxable year, such carryforwards shall reduce, and be reduced by, excess interest expense in the order in which they arose. For purposes of all the reductions described in this paragraph, excess limitation, excess limitation carryforward, and excess interest expense shall not be reduced below zero. For rules regarding the effect of an adjusted taxable loss with respect to excess limitation carryforward, see section 1.163(j)-2(f)(4)(ii).
(e) EFFECT ON EARNINGS AND PROFITS
The disallowance and carryforward of a deduction for interest expense under this section shall not affect whether or when such interest expense reduces earnings and profits of the payor corporation.
(f) ANTI-AVOIDANCE RULE
Arrangements, including the use of partnerships or trusts, entered into with a principal purpose of avoiding the rules of section 163(j) and these regulations shall be disregarded or recharacterized to the extent necessary to carry out the purposes of section 163(j).
(g) EXAMPLES
The following examples illustrate the rules of this section.
EXAMPLE 1
(i) A, a domestic corporation, is a wholly owned subsidiary of F, a foreign corporation. During its taxable year ending December 31, 1990, A has adjusted taxable income of $100, which includes $20 of interest income, and $90 of interest expense, of which $60 is paid or accrued to F. The balance of the interest expense is paid to unrelated persons. Interest paid to F by A is not subject to U.S. tax due to a tax treaty. A does not satisfy the debt-equity ratio safe harbor test in 1990, and has no excess limitation carried forward to that year.
(ii) A's excess interest expense for 1990 is $20, which is the difference between its net interest expense and 50 percent of its adjusted taxable income ($70 - $50 = $20). Since for 1990, the amount of A's exempt related person interest expense ($60) is greater than its excess interest expense ($20), a deduction for $20 of A's exempt related person interest expense is disallowed under paragraph (a) of this section. A's 1990 disallowed interest expense is carried forward to A's succeeding taxable year.
EXAMPLE 2
(i) The facts are the same as in paragraph (i) of Example 1. In 1991, A has $120 of adjusted taxable income, net interest expense of $50, and $20 of disallowed interest expense carried forward from 1990. All of A's interest expense for 1991 is paid to unrelated persons. A does not satisfy the debt-equity ratio safe harbor test in 1991.
(ii) A has excess limitation (as defined in section 1.163(j)-2(c)) of $10 ($60 (50% of adjusted taxable income) - $50 (net interest expense)) in 1991. In 1991, A may deduct the interest expense paid or accrued in that year to unrelated persons, plus $10 of disallowed interest expense carryforward from 1990. The balance of A's disallowed interest expense carryforward from 1990 ($10) is carried forward to A's 1992 taxable year.
EXAMPLE 3
(i) The facts are the same as in paragraph (i) of Example 2. In 1992, A satisfies the debt-equity ratio safe harbor test, has adjusted taxable income of $210, and net interest expense of $100. All A's interest expense for 1992 is paid or accrued to F.
(ii) In 1992, A has excess limitation of $5 ($105 (50% of adjusted taxable income) - $100 (net interest expense)). Applying the principles of paragraph (c) of this section, A's $10 of disallowed interest expense carryforward from 1991 (see Example 2, paragraph (ii)) is allowed in 1992 only to the extent of the $5 of excess limitation for that year. The remaining $5 of disallowed interest expense carried forward from 1991 is carried forward to A's 1993 taxable year.
EXAMPLE 4
(i) The facts are the same as in paragraph (i) of Example 3. In 1993, A satisfies the debt-equity ratio safe harbor test, has adjusted taxable income of $100, and has net interest expense of $75, all of which is paid or accrued to F.
(ii) A's excess interest expense for 1993 is $25 ($75 (A's net interest expense) - $50 (50% of its adjusted taxable income)). Applying the principles of paragraphs (a) and (b) of this section, section 163(j) does not disallow a deduction in 1993 for any of A's excess interest expense that is exempt related person interest expense. Under paragraph (c) of this section, A's $5 of disallowed interest expense carryforward from 1992 (see Example 3, paragraph (ii)) is not deductible in 1993, and is carried forward to A's 1994 taxable year.
(h) CROSS-REFERENCES
For rules regarding affiliated groups for purposes of section 163(j), see section 1.163(j)-5. For rules limiting the deductibility of disallowed interest expense carryforward and restricting the use of excess limitation carried forward to taxable years after the occurrence of certain corporate transactions, see section 1.163(j)-6.
SECTION 1.163(j)-2 DEFINITIONS
(a) EXEMPT RELATED PERSON INTEREST EXPENSE
The term "exempt related person interest expense" means interest expense that is (or is treated as) paid or accrued by a corporation described in section 1.163(j)-1(a) to a related person (within the meaning of paragraph (g) of this section) if no tax is imposed with respect to such interest under rules provided in section 1.163(j)-4.
(b) EXCESS INTEREST EXPENSE
The term "excess interest expense" means the excess, if any, of a corporation's net interest expense (as defined in paragraph (d) of this section) over the sum of 50 percent of its adjusted taxable income (as defined in paragraph (f) of this section) plus any excess limitation carried forward to the taxable year (under the rules of section 1.163(j)-1(d)). See paragraph (f)(4)(ii) of this section for rules regarding the effect of an adjusted taxable loss on the computation of excess interest expense.
(c) EXCESS LIMITATION
The term "excess limitation" means the excess, if any, of 50 percent of a corporation's adjusted taxable income (as defined in paragraph (f) of this section) over its net interest expense (as defined in paragraph (d) of this section).
(d) NET INTEREST EXPENSE
The term "net interest expense" means the excess, if any, of the amount of interest expense paid or accrued (directly or indirectly) by a corporation during the taxable year over the amount of interest includible (directly or indirectly) in its gross income for such year.
(e) INTEREST INCOME AND EXPENSE
(1) IN GENERAL
Interest income shall generally be determined under section 61 and shall include original issue discount as provided in sections 1272 through 1275 (adjusted, under section 1272(a)(7), for any acquisition premium paid by a subsequent holder), acquisition discount as provided in sections 1281 through 1283, and amounts that are treated as original issue discount under section 1286 (pertaining to stripped bonds). Interest expense shall generally be determined under section 163 (a) and shall include original issue discount as provided in section 163(e). Interest expense for a taxable year does not take into account any disallowed interest expense carried forward to that year under the rules of section 1.163(j)-1. Interest income or expense with respect to a debt instrument denominated in a nonfunctional currency (or the payments of which are determined with reference to a nonfunctional currency) shall be determined in accordance with section 988 and the regulations thereunder. For rules regarding the relationship of section 163(j) to other Code provisions under which a deduction for interest expense may be disallowed or deferred, see section 1.163(j)-7.
(2) TREATMENT OF BOND PREMIUM AND MARKET DISCOUNT
(i) BOND PREMIUM
In the case of any bond with respect to which an election made under section 171(c) is in effect, amortizable bond premium (as defined in section 171(b)) shall reduce interest income. Bond premium included in income by the issuer under the principles of section 1.61-12 (or the successor provision thereof) shall reduce interest expense.
(ii) MARKET DISCOUNT
Gain treated as ordinary income on the disposition of a market discount bond under section 1276(a) shall be treated as interest income.
(3) INTEREST EQUIVALENTS. [RESERVED]
(4) INTEREST INCOME OF PARTNERSHIPS
Interest paid or accrued to a partnership shall be treated under section 163(j) and these regulations (other than paragraph (g) of this section) as paid or accrued to the partners of the partnership in proportion to each partner's distributive share (as defined in section 704) of the partnership's interest income for the taxable year.
(5) INTEREST EXPENSE OF PARTNERSHIPS
Interest expense paid or accrued by a partnership and the tax exempt interest expense of a partnership (within the meaning of section 1.163(j)-4) shall be treated for all purposes under section 163(j) and these regulations as paid or accrued by the partners of the partnership in proportion to each partner's distributive share (as defined in section 704) of the partnership's interest expense and tax exempt interest expense, respectively, for the taxable year. Thus, a corporation which is a partner in a partnership shall be treated as paying or accruing its share of the partnership's interest expense, and is treated as the payor of such interest expense.
(6) CERTAIN SUBSTITUTE PAYMENTS
(i) IN GENERAL. If pursuant to an agreement meeting the requirements of section 1058 (b), there is a transfer of securities (as defined in section 1236(c)) between related persons (within the meaning of paragraph (g) of this section), payments described in section 1058(b)(2) with respect to such transferred securities ("substitute payments") shall be treated as interest expense for purposes of section 163(j) and these regulations.
(ii) EFFECTIVE DATE
This paragraph (e)(6) shall be effective with respect to substitute payments paid or accrued after [30 DAYS AFTER DATE THIS PROPOSED REGULATION IS PUBLISHED IN THE FEDERAL REGISTER].
(f) ADJUSTED TAXABLE INCOME
(1) IN GENERAL
The term "adjusted taxable income" means a corporation's taxable income for the taxable year, computed without regard to any carryforwards or disallowances under section 163(j), and determined with the modifications described in paragraphs (f)(2) and (f)(3) of this section. A corporation's adjusted taxable income may be a negative amount (i.e. an adjusted taxable loss). See paragraph (f)(4) of this section for rules regarding the effect of an adjusted taxable loss.
(2) ADDITIONS
The following amounts shall be added to a corporation's taxable income to determine its adjusted taxable income:
(i) The net interest expense (as defined in paragraph (d) of this section) for the taxable year;
(ii) The net operating loss deduction under section 172;
(iii) Deductions for depreciation under sections 167 and 168;
(iv) Deductions for the amortization of intangibles and other amortized expenditures (e.g., start-up expenditures under section 195 and organizational expenditures under section 248);
(v) Deductions for depletion under section 611;
(vi) Carryovers of excess charitable contributions (within the meaning of section 170(d)(2)), to the extent allowable as a deduction in the taxable year;
(vii) The increase, if any, between the end of the preceding year and the end of the current year in accounts payable (other than interest payable) that are included in the computation of taxable income;
(viii) The decrease, if any, between the end of the preceding taxable year and the end of the current taxable year in accounts receivable (other than interest receivable) that are included in the computation of taxable income;
(ix) Interest which is excluded from gross income under section 103;
(x) The dividends received deduction as provided under section 243 (other than deductions under section 243(a)(3));
(xi) The increase, if any, in the LIFO recapture amount (as defined in section 312(n)(4)(B)) between the end of the preceding taxable year and the end of the current taxable year; and
(xii) Any deduction in the taxable year for capital loss carrybacks or carryovers.
(3) SUBTRACTIONS
The following amounts shall be subtracted from taxable income to determine adjusted taxable income:
(i) With respect to the sale or disposition of property (including a sale or disposition of property by a partnership), any depreciation, amortization, or depletion deductions which were allowed or allowable for the taxpayer's taxable years beginning after July 10, 1986, with respect to such property;
(ii) With respect to the sale or disposition of stock of a member of a consolidated group that includes the selling corporation, an amount equal to the investment adjustments (as defined under sections 1.1502-32 and 1.1502-32T) with respect to such stock that are attributable to deductions described in paragraph (f)(3)(i) of this section;
(iii) With respect to the sale or other disposition of an interest in a partnership, an amount equal to the taxpayer's distributive share of deductions described in paragraph (f)(3)(i) of this section with respect to property held by the partnership at the time of such sale or other disposition;
(iv) The decrease, if any, between the end of the preceding taxable year and the end of the current taxable year in accounts payable (other than interest payable) which are included in the computation of the corporation's taxable income;
(v) The increase, if any, between the end of the preceding taxable year and the end of the current taxable year in accounts receivable (other than interest receivable) which are included in the computation of the corporation's taxable income;
(vi) Amounts that would be deductible but for section 265 (regarding expenses and interest relating to tax-exempt income) or 279 (regarding interest on indebtedness incurred by a corporation to acquire stock or assets of another corporation);
(vii) The amount of any charitable contribution (as defined in section 170(c)) made during the taxable year that exceeds the amount deductible in that year by reason of Section 170(b)(2);
(viii) The decrease, if any, in the LIFO recapture amount (as defined in section 312(n)(4)(B)) between the end of the preceding taxable year and the end of the current taxable year; and
(ix) The amount of any net capital loss (as defined in section 1222(10)) for the taxable year.
(4) EFFECT OF ADJUSTED TAXABLE LOSS
(i) IN GENERAL
If a payor corporation has an adjusted taxable loss for the taxable year, then its adjusted taxable income shall be treated as zero.
(ii) EFFECT ON EXCESS LIMITATION CARRYFORWARD
The amount of an adjusted taxable loss reduces excess limitation carryforward for the purpose of determining whether there is excess interest expense for a taxable year.
(iii) ADJUSTED TAXABLE LOSS NOT CARRIED FORWARD
An adjusted taxable loss in one taxable year shall not affect the determination of a corporation's adjusted taxable income for any other taxable year.
(g) RELATED PERSONS
(1) IN GENERAL
The term "related person" means any person who is related to the taxpayer within the meaning of sections 267(b) or 707(b)(1). For this purpose, the constructive ownership and attribution rules of section 267(c) shall apply.
(2) ANTI-ABUSE RULE
In determining whether persons are related, the substance, rather than the form, of ownership is controlling. Thus, for example, the principles of section 1.957-1(b)(2) shall apply to determine whether an arrangement to shift formal voting power or formal ownership of shares away from any person for the purpose of avoiding the application of section 163 (j) shall be given effect.
(3) WHEN RELATED PERSON STATUS IS TESTED
Whether a person is related to a payor corporation under section 163(j) is determined with respect to an item of interest expense when such interest expense accrues. For this purpose (notwithstanding the rules in section 1.163(j)-7), interest expense (including amounts treated as interest under this section) shall be treated as accruing daily under principles similar to section 1272(a). Also for this purpose, interest described in paragraph (e)(5) of this section shall be treated as accrued by a partner as it is accrued, under the principles of the preceding sentence, by the partnership. Changes in the relationship between the payor corporation and the payee after an item of interest expense accrues shall not be taken into account.
(4) SPECIAL RULE FOR CERTAIN PARTNERSHIPS
(i) LESS THAN 10 PERCENT OF PARTNERSHIP HELD BY TAX EXEMPT PERSONS
Any interest expense paid or accrued to a partnership directly or indirectly by a payor corporation that (without regard to this paragraph (g)(4)) is related to the partnership within the meaning of this paragraph (g) shall not be treated as paid or accrued to a related person if less than 10 percent of the capital and profits interests in such partnership are held by persons with respect to whom no tax is imposed on such interest by subtitle A of the Internal Revenue Code under rules provided in section 1.163(j)-4. However, the preceding sentence shall not apply to treat as interest paid to an unrelated person any interest that (under rules described in this section) is includible in the gross income of a partner in such a partnership who is itself a related person with respect to the payor of such interest.
(ii) REDUCTION OF TAX BY TREATY
If a treaty between the United States and a foreign country reduces the rate of tax imposed by subtitle A of the Code on a partner's distributive share of any interest paid or accrued to a partnership, such partner's interest in the partnership shall, for purposes of section 1.163(j)-2(g)(4)(i), be treated as held in part by a taxable person and in part by a tax exempt person in accordance with the rules described in section 1.163(j)-4(b).
(5) EXAMPLES
The principles of this paragraph (g) are illustrated by the following examples.
EXAMPLE 1
(i) Fifty-one percent of the total combined voting power and value of domestic corporation A is owned by a domestic tax-exempt corporation, D1; the remainder is owned by foreign corporation F1. F1 is organized under the laws of country Z. Under a U.S. tax treaty with country Z, interest paid by A to F1 is exempt from U.S. tax under the rules of section 1.163(j)-4.
(ii) Under these facts, D1 is related to A under section 267(b)(3) (because D1 and A are members of the same controlled group of corporations, as defined in section 267(f)), and interest payments made by A to D1 are exempt related person interest expense, a deduction for which may be disallowed under section 163(j). F1 is not related to A within the meaning of sections 267(b) or 707(b)(1). Deductions for interest paid by A to F1 are not subject to disallowance under section 163(j).
EXAMPLE 2
(i) The facts are the same as in paragraph (i) of Example 1, except that D1 and F1 each own 50 percent of the vote and value of X's stock.
(ii) Unless the substance of D1's and F1's ownership differs from its form, so that paragraph (g)(2) of this section (regarding abusive ownership structures) applies, none of the interest paid by A to D1 or F1 is subject to disallowance under section 163(j).
EXAMPLE 3
(i) A, a domestic corporation whose taxable year is the calendar year, is a wholly owned subsidiary of F, a foreign corporation. A is a partner, with a one-third share in the capital and profits interests, of P, a domestic partnership whose taxable year is the calendar year. During its taxable year ending December 31, 1990, and taking into account its interest in P, A has adjusted taxable income of $126.67. A's directly incurred interest income and expense for the taxable year are $20 and $90. Of the $90 of interest expense, $60 is paid or accrued to F.
(ii) P's interest income and interest expense for the taxable year of the partnership ending December 31, 1990, are $20 and $50, respectively. A's share of these amounts (determined under rules described in section 1.163(j)-2) are $6.67 and $16.67, respectively. Of P's $50 interest expense for the taxable year, $20 is paid or accrued to F, and the balance is paid or accrued to persons unrelated to A or to any of the other partners of P.
(iii) Interest paid or treated as paid to F by A is not subject to U.S. tax due to a tax treaty. Taking into account A's investment in the partnership (under rules described in section 1.163(j)-3), A does not satisfy the debt-equity ratio safe harbor test in 1990.
(iv) Under section 1.163(j)-1(a) and paragraphs (e)(4) and (5) of this section, in its taxable year ending December 31, 1990, A is required to take into account the interest income and interest expense it directly incurs, plus its share of P's interest income and interest expense. Thus, A's interest income for 1990 is $26.67, and its interest expense is $106.67. A's excess interest expense for 1990 is $16.67, which is the difference between its net interest expense ($106.67 (interest expense) - $26.67 (interest income) = $80) and 50 percent of its adjusted taxable income (($126.67 x 50% = $63.33).
(v) For 1990, under the rule described in paragraph (e)(5) of this section, the amount of A's exempt related person interest expense is $66.67 ($60 + $6.67 = $66.67). Since that amount is greater than its excess interest expense ($16.67), section 163(j) disallows a deduction for $16.67 of A's interest expense for the taxable year. That disallowed interest expense is carried forward to A's 1991 taxable year.
EXAMPLE 4
(i) X, a domestic corporation, is wholly owned by Y, a partnership. A treaty between the United States and foreign country U reduces the rate of tax on interest paid to residents of country U from 30 percent (the applicable rate for related person interest under sections 871 and 881 in the absence of a treaty) to 15 percent. Nineteen percent of the capital and profits interests of partnership Y are held by Z, a country U corporation entitled to claim the reduced (treaty) rate of tax on interest income; the balance is held by unrelated persons not exempt from U.S. tax on their distributive shares of interest paid by the corporation to the partnership.
(ii) Under paragraph (g)(4) of this section, less than ten percent (19 percent divided by two (30/15)) of Y's capital and profits interests are treated as held by persons who are tax exempt. Accordingly, all interest paid to partnership Y by corporation X is treated as paid to an unrelated person.
SECTION 1.163(j)-3 COMPUTATION OF DEBT-EQUITY RATIO.
(a) IN GENERAL
For purposes of section 163(j), the term "debt- equity ratio" means the ratio that the debt of the corporation bears to the equity of the corporation. For rules defining debt and equity, see paragraphs (b) and (c) of this section. For rules regarding the computation of the debt and equity of an affiliated group or a foreign corporation, see sections 1.163(j)-5 or 1.163(j)-8, respectively.
(b) DEBT
(1) IN GENERAL
The debt of a corporation means its liabilities determined according to generally applicable tax principles. Thus, the amount taken into account on the issue date with respect to a debt instrument which is not issued at a discount or a premium shall be the issue price. The amount taken into account with respect to any debt with original issue discount shall be its issue price plus the portion of the original issue discount previously accrued as determined under the rules of section 1272 (determined without regard to section 1272(a)(7) or (b)(4)). In addition, with respect to the issuer, unamortized bond premium shall be treated as debt.
(2) EXCLUSIONS
Short-term liabilities as defined in paragraph (b)(2)(i) of this section and commercial financing liabilities as defined in paragraph (b)(2)(ii) of this section shall be excluded from characterization as debt.
(i) SHORT-TERM LIABILITIES
The term "short-term liabilities" means accrued operating expenses, accrued taxes payable, and any account payable for the first 90 days of its existence provided that no interest is accrued with respect to any portion of such 90 day period.
(ii) COMMERCIAL FINANCING LIABILITIES
The term "commercial financing liabilities" means any liability if it--
(A) Is incurred by the obligor under a commercial financing agreement (such as an automobile "floorplan" agreement) to buy an item of inventory;
(B) Is secured by the item;
(C) Is due on or before sale of the item; and
(D) If entered into between related parties, has terms that are comparable to the terms of such financing agreements between unrelated parties in the same (or a similar) industry.
(3) LIABILITIES OF A PARTNERSHIP
In determining the debt of a corporation that owns an interest in a partnership (directly or indirectly through one or more pass-through entities), liabilities of the partnership shall be treated as liabilities incurred directly by each partner in the same manner and proportions that the liabilities of the partnership are treated as shared by its partners under section 752.
(4) ANTI-ROLLOVER RULE
Decreases in a corporation's aggregate debt during the last 90 days of its taxable year shall be disregarded to the extent that the corporation's aggregate debt is increased during the first 90 days of the succeeding taxable year.
(c) EQUITY
(1) IN GENERAL
Equity means the sum of money and the adjusted basis of all other assets of the corporation reduced (but not below zero) by the taxpayer's debt (as defined in paragraph (b) of this section). Whether an item constitutes an asset shall be determined according to generally applicable tax principles.
(2) TREATMENT OF STOCK OF CERTAIN NONINCLUDIBLE CORPORATIONS
Under the general rule of paragraph (c)(1) of this section, assets include the adjusted basis of stock of any corporation which is not an includible corporation (as defined under section 1504(b)). The adjusted basis of stock held in a corporation which is not an includible corporation shall be further adjusted under principles similar to those in section 864(e)(4) if the taxpayer (or the members of an affiliated group of which the taxpayer is a member) owns stock in the corporation satisfying the requirements of section 864(e)(4)(B)(ii). Cf. section 1.861-12T(c)(2).
(3) REDUCTION IN ASSETS FOR EXCLUDED LIABILITIES
The amount of a taxpayer's equity under paragraph (c)(1) and (2) of this section shall be reduced (but not below zero) by an amount equal to the amount of liabilities excluded under paragraph (b)(2) of this section.
(4) PARTNERSHIP INTERESTS OWNED BY A CORPORATION
In determining the assets of a corporation that owns an interest in a partnership, the corporation shall treat as an asset the adjusted basis of its partnership interest.
(5) ANTI-AVOIDANCE RULES
(i) IN GENERAL
An asset of the taxpayer shall be disregarded in computing the taxpayer's debt- equity ratio if the principal purpose for acquiring the asset was to reduce the taxpayer's debt-equity ratio.
(ii) ANTI-STUFFING RULE
In determining a corporation's equity, any transfer of assets made by a related person to the corporation during the last 90 days of its taxable year shall be disregarded to the extent that there is a transfer of the same or similar assets by the corporation to a related person during the first 90 days of the corporation's succeeding taxable year. However, this rule shall not apply to the extent that there is full consideration for a transfer in money or property (as that term is defined in section 317(a)).
(d) DETERMINING THE DEBT AND EQUITY OF A NON-DOLLAR FUNCTIONAL CURRENCY QBU
In determining the dollar value of liabilities and assets on the books of a qualified business unit that has a functional currency other than the dollar, such liabilities and assets shall be translated at the spot rate on the last day of the taxable year.
SECTION 1.163(j)-4 INTEREST NOT SUBJECT TO TAX.
(a) IN GENERAL
Interest paid or accrued by a corporation under the rules of section 1.163(j)-1 is not subject to tax for purposes of section 163(j) if no U.S. tax is imposed with respect to such interest under subtitle A of the Internal Revenue Code (determined without regard to net operating losses or net operating loss carryovers), taking into account any applicable treaty obligation of the United States. For this purpose, whether interest paid or accrued to a partnership is subject to tax is determined at the partner level.
(b) PARTIALLY EXEMPT INTEREST
Interest that is subject to a reduced rate of tax under any treaty obligation of the United States applicable to the recipient shall be treated as in part subject to the statutory tax rate under sections 871 or 881 and in part not subject to tax, based on the proportion that the rate of tax under the treaty bears to the statutory tax rate. Thus, for purposes of section 163(j), if the statutory tax rate is 30 percent, and pursuant to a treaty U.S. tax is instead limited to a rate of 10 percent, two- thirds of such interest shall be considered interest not subject to tax.
(c) DATE FOR DETERMINING WHETHER INTEREST IS SUBJECT TO U.S. TAX
The determination of whether interest is subject to U.S. tax is made on the date the interest is received or accrued by the payee, whichever is relevant under normally applicable U.S. tax principles for purposes of determining the tax, if any, on the payee.
(d) CERTAIN INTEREST PAID TO SPECIAL ENTITIES
(1) CONTROLLED FOREIGN CORPORATIONS
(i) IN GENERAL
Interest that is paid or accrued to a foreign corporation described in section 957(a) (a "controlled foreign corporation") and that is not otherwise subject to tax under paragraph (a) of this section shall be deemed subject to tax to the extent that such interest is included in the foreign corporation's net foreign personal holding company income under section 1.954-1T(c) and results in an inclusion in the gross income of a United States shareholder under section 951(a)(1)(A)(i) (or would have been included in a United States shareholder's gross income but for an election under section 1.954-1T(d)).
(ii) EFFECT OF SECTION 952(c)(1)(A) (EARNINGS AND PROFITS) LIMITATION
For purposes of paragraph (d)(1) of this section, if a controlled foreign corporation's subpart F income for the taxable year is limited under section 952(c)(1)(A), each category of subpart F income described in section 952(a), and, within each such category, each component thereof, shall be treated as reduced ratably.
(iii) NET FOREIGN PERSONAL HOLDING COMPANY INCOME
To determine whether an item of interest income is included in a controlled foreign corporation's net foreign personal holding company income for the taxable year, the expenses allocable to such interest shall be deemed to bear the same ratio to the total expenses allocable to the controlled foreign corporation's net foreign personal holding company income (determined pursuant to section 1.954-1T(c)) as the amount of such interest bears to the controlled foreign corporation's gross foreign personal holding company income (determined under section 1.954-1T(a)(2)(i)).
(iv) RELATED PERSON INTEREST
If related person interest is allocated to the item of interest under the provisions of section 1.904-5(c)(2) and paragraph (d)(1)(iii) of this section, and if the United States shareholder receiving such related person interest is subject to United States tax, then, for purposes of paragraph (d)(1)(i) of this section, such allocable related person interest shall be deemed to be net foreign personal holding company income that results in an inclusion under section 951(a)(1)(A)(i).
(v) SECTION 78 AMOUNT
Any foreign taxes that are allocable to an item of interest income satisfying the requirements of paragraph (d)(1)(i) of this section and that are included in a United States shareholder's income under section 78 (or would have been included, but for an election under section 1.954-1T(d)) shall, for purposes of paragraph (d)(1)(i) of this section, be deemed to be net foreign personal holding company income that results in an inclusion under section 951(a)(1)(A)(i).
(2) PASSIVE FOREIGN INVESTMENT COMPANIES
(i) IN GENERAL
Interest that is not otherwise subject to tax under paragraph (a) of this section, and that is paid or accrued to a passive foreign investment company (as defined in section 1296) that is not a controlled foreign corporation, and which a U.S. person has elected under section 1295 to treat as a qualified electing fund ("QEF"), shall be treated as subject to tax to the extent that such interest is included in the QEF's ordinary earnings (as defined in section 1293(e)(1)) and results in an inclusion in income of such U.S. person under section 1293(a)(1)(A).
(ii) ORDINARY EARNINGS
In determining whether an item of interest income is included in the ordinary earnings of a passive foreign investment company, the item shall be reduced by deductions allocable and apportionable to that item under sections 1.861-8 through 1.861-14T.
(iii) SECTION 78 AMOUNT
Any foreign taxes that are allocable to an item of interest income satisfying the requirements of paragraph (d)(2)(i) of this section and that are included in a U.S. person's income under section 78 pursuant to section 1293(f) shall, for purposes of paragraph (d)(2)(i) of this section, be deemed to be ordinary earnings that are included in the income of a U.S. person under section 1293(a)(1)(A).
(3) FOREIGN PERSONAL HOLDING COMPANIES
(i) IN GENERAL
Interest that is not otherwise subject to tax under paragraph (a) of this section, and that is paid or accrued to a foreign personal holding company (as defined in section 552) that is neither a passive foreign investment company nor a controlled foreign corporation, shall be treated as subject to tax to the extent that such interest is included in the company's undistributed foreign personal holding company income (as defined in section 556) and results in an inclusion in income of a U.S. person under section 551(a).
(ii) UNDISTRIBUTED FOREIGN PERSONAL COMPANY INCOME
In determining whether an item of interest income is included in the undistributed foreign personal holding company income of a foreign personal holding company, the item shall be reduced by deductions allocable and apportionable to that item under sections 1.861-8 through 1.861-14T.
(iii) EFFECT OF DISTRIBUTIONS
Any amount that would be treated as subject to tax by virtue of this paragraph (d)(3) but for a dividends paid deduction under section 561 shall be treated as subject to tax.
(4) PRODUCER'S LOAN INTEREST PAID TO A DISC
Interest paid or accrued with respect to a DISC (as defined in section 992) that is treated as interest with respect to a producer's loan (as defined in section 993(d)) is treated as subject to U.S. tax if such interest is taxed to the shareholders of the DISC under section 995(b)(1)(A).
SECTION 1.163(j)-5 AFFILIATED GROUP RULES.
(a) CERTAIN RELATED CORPORATIONS TREATED AS ONE TAXPAYER
(1) SCOPE
This section applies section 163(j) to certain related corporations which are (or are treated as) members of an affiliated group and which under section 163(j)(6)(C) and (7) are treated as a single taxpayer. Paragraphs (a)(2) and (a)(3) of this section describe the corporations that are subject to such treatment. (For purposes of section 163(j) and these regulations, the rules in regulations under section 1502 apply, but unless the context otherwise requires, the term "member" means a corporation that is, or is treated as, a member of an affiliated group under this paragraph (a), and the term "group" refers collectively to the member and the other corporations that are so treated.) Paragraph (a)(4) of this section provides rules that treat a corporation as a member of a single affiliated group if the rules of this paragraph (a) would otherwise cause it to be treated as a member of more than one affiliated group. Paragraph (b) of this section provides rules regarding the computation of items of income, expense, and carryovers under section 163(j) for an affiliated group of corporations if all of the members of such group join in the filing of a single consolidated return for the taxable year under section 1501. Paragraph (c) of this section provides rules for corporations that are not members of a consolidated groups which are subject to the rules of section 1.163(j)-5 (b). Paragraph (d) of this section provides rules regarding the computation of the debt-equity ratio for purposes of applying the debt-equity ratio safe harbor test described in section 1.163(j)-1(b). Paragraph (e) of this section provides rules regarding the treatment of, and an election pertaining to, assets of certain acquired corporations.
(2) AFFILIATED CORPORATIONS
To the extent provided in this section, all the members of an affiliated group (as defined in section 1504(a)) of which a corporation is a member on the last day of its taxable year shall be treated as one taxpayer for purposes of section 163(j) and this section, without regard to whether such affiliated group files a consolidated return pursuant to section 1501.
(3) CERTAIN UNAFFILIATED CORPORATIONS
(i) IN GENERAL
If at least 80 percent of the total voting power and total value of the stock of an includible corporation (as defined in section 1504(b)) is owned, directly or indirectly, by another includible corporation, the first corporation shall be treated as a member of an affiliated group that includes the other corporation and its affiliates. The attribution rules of section 318 shall apply for purposes of determining indirect stock ownership under this paragraph (a)(3).
(ii) EXAMPLE
The principles of this paragraph (a)(3) are illustrated by the following example.
EXAMPLE
X and Y are wholly owned domestic subsidiaries of F, a foreign corporation. X and Y are not members of an affiliated group under section 1504(a) because F is not itself an includible corporation under section 1504(b)(3). However, under paragraph (a)(3) of this section, X and Y are treated as members of an affiliated group, since, under section 318(a)(3)(C), X is treated as owning indirectly 100 percent of Y, and Y is treated as owning indirectly 100 percent of X.
(4) TIE-BREAKER RULES
If the rules of this paragraph (a) would treat a corporation as a member of more than one affiliated group, then the principles of section 1563(b)(4) and the regulations thereunder shall determine the group of which such corporation shall be treated as a member.
(b) OPERATIVE RULES FOR CONSOLIDATED GROUPS
(1) IN GENERAL
If all of the members of the affiliated group are members of a single consolidated group for the taxable year, the computations required by section 163(j) and these regulations (other than the computation of the group's debt-equity ratio under paragraph (d) of this section) shall be made in accordance with the rules of this paragraph (b). See paragraph (c) of this section for rules applicable to affiliated groups not described in the preceding sentence.
(2) ITEMS DETERMINED ON A CONSOLIDATED BASIS
The computations required by section 163(j) and these regulations shall be determined for the group on a consolidated basis. For example, the group's taxable income shall be the consolidated taxable income determined under section 1.1502-11 (without regard to any carryforwards or disallowances under section 163(j)), and the group's net interest expense shall be the excess, if any, of the group's aggregate interest expense over the group's aggregate interest income (as provided in sections 1.163(j)-2(d) and (e)). Similarly, the group's excess interest expense shall be determined by reference to the group's net interest expense, adjusted taxable income, and excess limitation carryforward (as determined under paragraph (b)(5) of this section). Except as provided in paragraphs (b)(5) and (6) of this section, disallowed interest expense carryforwards and excess limitation carryforwards shall also be determined on a consolidated basis.
(3) EXEMPT RELATED PERSON INTEREST EXPENSE
In determining the group's exempt related person interest expense, interest expense shall be treated as paid or accrued to a related person (within the meaning of section 1.163(j)-2(g)) if it would be so treated if paid or accrued to the same payee by any member of the group.
(4) DEFERRED INTERCOMPANY GAIN
For purposes of determining the adjusted taxable income of the group, the following special rules shall apply--
(i) Any gain on a deferred intercompany transaction (including any gain described in section 1.1502-14T(a)) that is restored in accordance with the rules under sections 1.1502-13(d) or 1.1502-13T(1) shall be subtracted from the group's consolidated taxable income.
(ii) If property is disposed of under section 1.1502-13(e)(2) or (f) or section 1.1502-13T(m), any amount subtracted from the group's consolidated taxable income in a previous taxable year with respect to such property under paragraph (b)(4)(i) of this section shall be added to the group's consolidated taxable income.
(iii) EXAMPLE
The principles of this paragraph (b)(4) are illustrated by the following example.
EXAMPLE
(i) On January I, 1991, X, a member of an affiliated group which files a consolidated return for the calendar year, purchases property for $200 from an unrelated person. X depreciates the property over a 5-year period. On January 1, 1996, when X's basis in the property is $0, X sells the property to Y, another member of the group, for $200, which is the property's fair market value at such time. The sale is a deferred intercompany transaction under section 1.1502-13, and X's gain of $200 is deferred under section 1.1502-13(c). In the hands of Y, the property is once again depreciable over a 5-year period. The group claims a depreciation deduction with respect to the property of $40 in 1996, which results in the restoration of $40 of X's deferred gain under section 1.1502-13T(1) for such year.
(ii) As provided in paragraph (b)(3)(i) of this section, the group's taxable income for 1996 is reduced by $40, the amount of restored gain under section 1.1502-13T(1) with respect to the transferred property. In addition, as provided in section 1.163(j)-2(f)(2)(iii) and paragraph (b)(2) of this section, the group's taxable income for 1996 is increased by $40, the amount of the group's depreciation deduction with respect to the transferred property for such year.
(iii) On January 1, 1997, Y sells the property for $200 to an unrelated person and recognizes gain of $40. The sale results in restoration of $160 of gain under section 1.1502-13T(m) with respect to the earlier transfer of property from X to Y. Thus, Y's sale results in the group's 1997 consolidated taxable income increasing by $200 prior to any adjustment under section 163(j). Under section 1.163(j)-2(f)(3)(i), the consolidated taxable income is reduced by $240 to reflect previous depreciation deductions with respect to such property. In addition, as provided in paragraph (b)(4)(ii) of this section, the consolidated taxable income is increased by $40, the amount subtracted from the group's 1996 consolidated taxable income by virtue of the restoration of $40 of deferred gain in that year.
(5) CARRYFORWARDS TO CURRENT TAXABLE YEAR
The group's disallowed interest expense carryforward or excess limitation carryforwards to the current taxable year shall be the relevant carryforwards from the group's prior taxable years, plus any disallowed interest expense carryforward or excess limitation carryforwards from separate return years permitted to be used by the group under the rules of section 1.163(j)-6.
(6) MEMBERS LEAVING THE GROUP
(i) DISALLOWED INTEREST EXPENSE CARRYFORWARD
A member leaving the group shall carry forward to its separate return years a portion of the group disallowed interest expense carryforward determined as of the end of the last consolidated return year during which the corporation was a member of the group. Such portion shall equal the amount of the group's disallowed interest expense carryforward multiplied by a fraction, the numerator of which is the aggregate amount of exempt related person interest expense paid or accrued by such member during the period when it was a member of the group, and the denominator of which is the aggregate amount of exempt related person interest expense paid or accrued by all members of the group. If a member has pre-affiliation disallowed interest expense carryforward upon entering the group, the amount of such member's disallowed interest expense carryforward shall be treated as exempt related person interest expense of both the member and the group. Further, the group's disallowed interest expense carryforward shall be reduced by the amount allocated to the member. If the member leaves the group during the consolidated return year, rules similar to the rules of section 1.1502-21(b)(2) shall apply.
(ii) EXCESS LIMITATION CARRYFORWARD
A member leaving the group shall not carry forward to its separate return years any portion of the group's excess limitation carryforward, and the group's excess limitation carryforward shall not be reduced by virtue of such member's departure from the group. However, if all the members of a consolidated group become members of another consolidated group, the acquired group's excess limitation carryforward shall become excess limitation carryforward of the corporation that was the common parent of the acquired group. For purposes of determining the extent to which this excess limitation carryforward becomes excess limitation carryforward of the acquiring group under paragraph (b)(5) of this section, see section 1.163(j)-6(b).
(7) EXAMPLES
The following examples illustrate the principles of this paragraph (b).
EXAMPLE 1
(i) X, Y, and Z are domestic corporations that are members of a newly formed consolidated group described in paragraph (b) of this section. X owns 100 percent of the stock of Y, and Y owns 80 percent of the stock of Z. F1, a foreign corporation, owns 60 percent of the stock of X. Any interest paid or accrued by X, Y, or Z to F1 is exempt under section 163 (j) because it is exempt from U.S. withholding tax under a treaty with F1's country of residence. Such interest (including interest paid by Z) is also paid or accrued to a related person within the meaning of section 1.163(j)-2(g) and paragraph (b)(3) of this section.
(ii) For 1991, the group's first taxable year, X, Y, and Z have the following relevant items of income and expense--
Exempt Related Interest Interest Person Interest Company Income Expense Expense ----------- ---------- ---------- ---------------- X $600 $500 $ -- Y 200 900 600 Z -- 200 150 ---------- ---------- ---------------- Total $800 $1,600 $750
(iii) Under section 1.1502-11, the group's consolidated taxable income for the 1991 year is $150. Adjustments to consolidated taxable income total $50, resulting in consolidated adjusted taxable income of $200. The group's net interest expense for 1991 is $800 ($1,600 - $800), and its excess interest expense is $300 ($800 - ($1,000/2)). The group's exempt related person interest expense for 1991 is $750. The group's disallowed interest expense for 1991 is the lesser of its excess interest expense or its exempt related person interest expense, or $300. This $300 is a group disallowed interest expense carryforward to the group's 1992 taxable year.
EXAMPLE 2
(i) The facts are the same as in Example 1. In the group's 1992 taxable year, the members have the following relevant items of income and expense--
Exempt Related Interest Interest Person Interest Company Income Expense Expense ----------- ---------- ---------- ---------------- X $600 $500 $ 50 Y 200 900 600 Z -- 200 150 ---------- ---------- ---------------- Total $800 $1,600 $800
(ii) Under section 1.1502-11, the group's consolidated taxable income for 1992 is $1,100. Adjustments to consolidated taxable income total $200, resulting in consolidated adjusted taxable income of $1,300. The group's net interest