Treasury Proposes Interest Expense Regulations

On November 26, the IRS and Treasury issued proposed regulations under Section 163(j) of the tax code.  Section 163(j), which was enacted as part of the Tax Cuts and Jobs Act, generally limits the deductibility of net business interest expense to 30% of EBITDA (or EBIT, beginning in 2022).

Here are some of the items addressed in the proposed regulations:

  • Expansive definition of "interest."  The proposed regulations define interest to include original issue discount, acquisition discount, commitment fees, substitute interest on repos and securities loans, and certain other amounts that are paid or accrued as compensation for the use or forbearance of money or are otherwise closely related to interest.  However, the proposed regulations generally do not define interest to include "purely" synthetic interest, such as the floating-rate leg of an on-market swap.  Accordingly, a taxpayer that borrows money at LIBOR+x% to acquire assets, and then enters into a total return swap (that is respected as a derivative for tax purposes) with respect to those assets on which the taxpayer receives synthetic interest at LIBOR+x%, may be subject to the interest expense deduction limitation, since the synthetic interest income would not offset the actual interest expense for purposes of Section 163(j).
  • Anti-abuse rule.  By its terms, Section 163(j) applies only to interest payments.  Accordingly, absent an anti-abuse rule, a partnership might issue debt-like preferred equity that is not subject to Section 163(j) and that causes partnership income to be allocated away from other partners.  However, the proposed regulations contain an anti-abuse rule under which expense or loss predominantly incurred in consideration of the time value of money may be treated as interest.  Accordingly, debt-like partnership equity might, under the anti-abuse rule, be treated as interest that is subject to Section 163(j).  By contrast, a taxpayer that invests in any such recharacterized instrument generally would not be treated as receiving business interest income, and thus could not offset its return on the instrument against its own interest expense for purposes of section 163(j).
  • All corporate interest is business interest.  As expected by most tax practitioners, the proposed regulations deem all interest income and expense of a corporation to be business interest and expense.
  • Application to partnerships.  The proposed regulations contain a complex set of rules for the application of Section 163(j) to partnerships, whereby the interest expense limitation generally is applied first at the partnership level and then at the partner level.
  • No effect on E&P.  The proposed regulations clarify that Section 163(j) would have no effect on a corporation's earnings and profits.  Accordingly, Section 163(j) might create a further incentive for U.S. taxpayers to invest in certain leveraged funds through foreign feeder funds that are treated as corporations for U.S. tax purposes:  under the "PFIC" or "CFC" rules, the U.S. taxpayers generally would include in income each year their pro rata shares of the feeder fund's earnings and profits, which could be fully reduced by interest expense.  
  • Disapplication to REMICs.  The proposed regulations provide that Section 163(j) does not apply to real estate mortgage investment conduits.
 

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