On 5 January 2021, Treasury and the IRS released 2021 Final Regulations (T.D. 9943) with guidance on the business interest expense limitation under Code Section 163(j), only about four months after releasing the 2020 Final Regulations (T.D. 9905). The 2017 Tax Cuts and Jobs Act (TCJA) and the 2020 Coronavirus Aid, Relief and Economic Security Act (CARES Act) amended section 163(j) to limit the business interest expense deduction. Under the amended section 163(j)(1), a taxpayer’s business interest expense deductions are limited to the sum of business interest income, 30% (or 50%, as temporarily raised by the CARES Act) of adjusted taxable income (ATI), and the taxpayer’s floor plan financing interest for the tax year. The 2021 final regulations provide important guidance and changes to the rules set forth in the 2020 final regulations and, in particular, clarify the claw-back adjustment for computing ATI.
In general, pursuant to section 163(j)(8)(A), ATI is calculated in a manner similar to earnings before interest, taxes, depreciation and amortization (EBITDA) for tax years beginning prior to 1 January 2022 (“EBITDA period”), but is scheduled to be calculated similar to earnings before interest and taxes (EBIT) for tax years beginning after 31 December 2021. Furthermore, section 163(j)(8)(B) grants Treasury the authority to mandate other adjustments beyond those enumerated in section 163(j)(8)(A). Pursuant to the authority given under section 163(j)(8)(B), Treasury and the IRS provided rules to prevent taxpayers from getting a potential double benefit during the EBITDA period. For instance, the availability of immediate full depreciation of property under section 168(k) increases the 30% of ATI cap, which allows taxpayers to take a larger interest expense deduction. It also allows taxpayers to get another benefit on the recognized gain when such fully depreciated property is sold.
As an example, assume taxpayer B acquires asset M in 2019 for USD 100, which it fully depreciates under section 168(k). B’s 2019 ATI would be increased by the USD 100 of depreciation. In 2021, B sells asset M for USD 50, resulting in a USD 50 gain as the tax basis in fully depreciated asset M is USD 0. B’s 2021 ATI would increase by this USD 50 gain on the sale of asset M. In both years, increased ATI would allow the taxpayer to take larger business interest expense deductions.
To prevent taxpayers from getting a potential double benefit during the EBITDA period, the 2020 final regulations impose an ATI claw-back adjustment with respect to a sale or other disposition of certain property to reverse prior EBITDA period ATI adjustments. For instance, upon a sale of property that has a basis affected by amortization, depreciation or depletion for the EBITDA period, ATI must be reduced by the full amount of the basis adjustments in the property with respect to such amortization, depreciation or depletion. The 2020 final regulations further provide that with respect to the sale or other disposition of stock of a member of a consolidated group by another member, ATI must be reduced by “the investment adjustments under section 1.1502–32 with respect to such stock that are attributable” to any amortization, depreciation or depletion deductions taken during the EBITDA period. For instance, in the same example as above, B’s 2021 ATI includes the USD 50 gain but is also reduced by USD 100 (i.e., the full depreciation amount of the EBITDA period) under the 2020 final regulations.
The 2021 final regulations instead permit a taxpayer to compute its adjustment to ATI upon the disposition of property, member stock or a partnership interest by determining “the lesser of” (i) the amount of gain on the sale of such property, member stock or partnership interest, and (ii) the amount of amortization, depreciation or depletion deductions with respect to such property, member stock or partnership interest for the EBITDA period that would otherwise decrease ATI.
Therefore, in the same example as above, if B elects to apply the “lesser of” rule under the 2021 final regulations with respect to the sale of asset M, B’s 2021 ATI would only be reduced by USD 50, as the USD 50 gain recognized on the sale is less than the USD 100 of depreciation taken during the EBITDA period.
Consolidated Return Rules
For dispositions of a consolidated group member’s stock, complexities arise in determining the claw-back adjustment for computing ATI. Some taxpayers noted that the scope of the final claw-back adjustment was expanded to include “any transaction, even where it doesn’t involve a double benefit.”
As an example, assume P, the parent of a consolidated group, owns the stock of subsidiary 1 (“B”), and B owns the stock of subsidiary 2 (“M”). M acquired depreciable property in 2019 and fully depreciated it in that year. B owns other non-depreciated assets, and in 2021 P sells its B stock to an unrelated buyer, thereby recognizing a gain.
Under the new Treas. Reg. section 1.163(j)-1(b)(1)(iv), such transaction is considered a deemed disposition of the stock of B and M because both subsidiaries are leaving the consolidated group. A plain reading of the regulation indicates that the claw-back adjustment would apply to both B and M even though B does not directly own the depreciated property. This is because the parent’s (P’s) basis in the stock of subsidiary 1 (B) includes investment adjustments potentially attributable to the depreciation deduction (of M’s property).
Regarding this confusion, Milnes-Vasquez clarified that “not all gain on the disposition of subsidiary stock would be subject to claw-back.” She further explained (referring to the above example) that there would only be a claw-back on the gain on the disposition of the M stock and not on the B stock. Yet this would change “if a depreciable property had been held in B when the deduction was claimed and was later transferred to M, then the subsequent sale of B stock by the parent would require assessing the gain on both the B and M stock,” Milnes-Vasquez said.
Milnes-Vasquez acknowledged that the IRS should “go back and clarify” the application of the claw-back adjustment to the consolidated return rules under the section 163(j) regulations. For now, until further guidance is released, such application is limited to the clarification given by the IRS official.