New section 163(j) regulations aim to simplify certain rules

The U.S. Department of the Treasury and the IRS issued the much-anticipated final and proposed regulations for computing the business interest deduction limitation under Section 163(j) on July 27, 2020. Along with the regulations, the IRS issued Notice 2020-59 dealing with assisted living facilities and FAQs to help with rules related to gross receipts aggregation determinations.

The final regulations will be effective for tax years beginning after their publication, but may be relied upon for tax years beginning after Dec. 31, 2017.

Below are some highlights from the new guidance.

Determination of adjusted taxable income

Under Section 163(j), for tax years beginning before 2022, adjusted taxable income (ATI) excludes deductions allowable for depreciation, amortization, or depletion. The 2018 proposed regulations concluded that depreciation, amortization and depletion capitalized to inventory under Section 263A, and included in cost of goods, couldn’t be added back to ATI.

However, the IRS and the Treasury have reversed course under the final regulations. They provide that depreciation, amortization and depletion capitalized under Section 263A for tax years beginning before Jan. 1, 2022, are added back to ATI regardless of the period in which the capitalized amount is recovered through cost of goods sold.

Definition of interest

The 2018 proposed regulations contained an expansive definition of interest expense that was highly criticized. The final regulations narrow the definition of interest and remove items including:

• Commitment fees
• Debt issuance costs
• Guaranteed payments

However, the final regulations have retained and modified the anti-abuse rule to potentially recast transactions with a principal purpose of avoiding Section 163(j) as a business interest expense.

Additional guidance for pass-throughs

The new proposed regulations address the treatment of tiered partnerships and Section 163(j). The Treasury and the IRS chose the entity approach for applying Section 163(j) in tiered structures.

Where a lower tier partnership allocates excess business interest expenses (EBIE) to an upper tier partnership, the upper tier reduces its basis in the lower tier partnership. However, upper tier partners don’t reduce their basis in the upper tier partnership.