The IRS concluded in Chief Counsel Advice (CCA) 201202021 that removing the Sec. 163(j) limitation on the deduction of interest paid on a loan from a related party does not qualify as an accounting method change under Sec. 446. For certain tax years, the taxpayer had limited its interest deduction on certain related-party indebtedness by applying the provisions of Sec. 163(j). During an examination, the IRS determined that the Sec. 163(j) limitation did not apply because the affiliate that had loaned money to the taxpayer was not a related person under Sec. 163(j).
The taxpayer sought to have the favorable removal of the interest limitation treated as an accounting method change to benefit from a negative Sec. 481 adjustment in a single year, so that the taxpayer could have claimed the cumulative effect of missed deductions in tax years that were otherwise closed by statute. However, the Office of Chief Counsel advised that this treatment was not correct.
The taxpayer involved in the CCA was the parent corporation of a U.S. affiliated group that filed a consolidated federal income tax return. The affiliated group was jointly owned indirectly by various foreign entities. One foreign affiliate provided loans to the taxpayer and other members of the affiliated group for certain years. The taxpayer treated the loans from the foreign entity as loans from a related party for purposes of applying the Sec. 163(j) limitation. Sec. 163(j)(4) generally considers a related party as any person who is related within the meaning of Sec. 267(b) or Sec. 707(b)(1).
The taxpayer assumed the lender was a related party within the meaning of Sec. 267(b) or 707(b)(1).Therefore, the taxpayer limited its deduction for interest on the related-party indebtedness by applying the interest limitation provisions under Sec. 163(j). For each year, the taxpayer calculated the excess of the interest deduction that would have been allowed under Sec. 163(a) in the year without regard to Sec. 163(j) over the interest deduction it was permitted after taking into account that limitation. The excess amount was carried to the taxpayer’s succeeding tax years.
Upon examination of the taxpayer, the IRS questioned whether the taxpayer and foreign affiliate that had provided the loans were in fact related parties under Sec. 163(j). The IRS determined that the taxpayer and its foreign affiliate were not related parties under Sec. 163(j) and, therefore, the Sec. 163(j) limitation did not apply to the taxpayer.
This conclusion led to the next logical question of whether the removal of the interest deduction limitation under Sec. 163(j) qualified as a change in accounting method under Sec. 446, or whether this was an error in each of the open tax years.
Law and Analysis
Sec. 163(a) generally allows a deduction for all interest paid or accrued within a tax year on indebtedness, with certain exceptions.
Sec. 163(j) is one of those exceptions, and this provision limits a corporation’s deduction for interest paid or accrued by the taxpayer to a related party where the interest income to the related party is fully or partially exempt from tax. The disallowed amount of the interest deduction each year is generally carried forward to the succeeding tax year under Sec. 163(j)(1)(B) and is treated as paid or accrued in that succeeding tax year.
Regs. Sec. 1.446-1(a)(1) defines the term “method of accounting” to include not only the taxpayer’s overall method of accounting but also the accounting treatment of any item of gross income or deduction. Regs. Sec. 1.446-1(e)(2)(ii)(a) states that an accounting method change “includes a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan” of accounting. Moreover, the regulations provide that “a material item is any item that involves the proper time for the inclusion of the item in income or the taking of a deduction.”
A change in method of accounting does not include adjustment of any item of income or deduction that does not involve the proper time for the inclusion of the item of income or the taking of a deduction (Regs. Sec. 1.446-1(e)(2)(ii)(b)).
The CCA observed that, for purposes of Regs. Sec. 1.446-1(e)(2)(ii)(a), the item involved in the taxpayer’s case was its deduction for interest on certain indebtedness. Further, the CCA concluded that the taxpayer was not changing this item or the treatment of this item. What the taxpayer was changing was the limitation placed on the item. The effect of removing the limitation was that the taxpayer would be able to recognize the full amount of the interest deduction on certain debt that is otherwise deductible under its accounting method in a given tax year. Previously, it was limited under Sec. 163(j) in its recognition of the item.
The IRS indicated that the removal of the Sec. 163(j) limitation could permanently change a taxpayer’s lifetime taxable income because Sec. 163(j) does not provide a mechanism that ensures that in every situation a taxpayer will enjoy the interest deductions that had previously been denied subject to a carryforward to succeeding tax years. Thus, the change was not merely a change in the timing of income and is not a change in method of accounting under Regs. Sec. 1.446-1(e)(2)(ii)(b).
Because the removal of the interest limitation does not qualify as an accounting method change, the taxpayer is left only with the alternative of filing amended returns in order to receive the benefit of the interest deductions that it had erroneously limited. However, the option of filing amended returns would be available only for open years.
If the taxpayer cannot amend a tax return to take the full interest deduction because the tax year is closed, it is still possible that a taxpayer could receive a benefit from the amount of interest that it did not take as a deduction due to the Sec. 163(j) limitation. The IRS concluded in CCA 201151021 that increased interest deductions (due to the IRS’s determination that the Sec. 163(j) interest limitation did not apply) would allow a taxpayer to increase net operating losses (NOLs) from previous tax years even though the statutory period for filing a claim for credit or refund has expired in those tax years under Sec. 6511. While the increased NOLs cannot be carried back or forward to closed years, they could be used in an open carryover year, provided that it can be established that they were not absorbed by taxable income (computed as specified in Sec. 172(b)) in the carryback years or any prior carryover years. If an adjustment in a closed year would have resulted in a reduction of tax and not an NOL, this mechanism for capturing missed deductions in closed tax years would not be available.
Kevin Anderson is a partner, National Tax Services, with BDO USA LLP, in Bethesda, Md.
For additional information about these items, contact Mr. Anderson at 301-634-0222 or email@example.com.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.