New CFC group election: Possible benefits

Editor: Kevin D. Anderson, CPA, J.D.

Prior to the enactment of the law known as the Tax Cuts and Jobs Act of 2017 (TCJA), P.L. 115-97, the interest expense limitation in former Sec. 163(j) often applied to highly debt-leveraged domestic corporations with foreign related parties. To prevent U.S. corporations from stripping earnings through interest deductions, the Internal Revenue Code provided for thin capitalization rules whereby, under former Sec. 163(j), the deduction for interest expense for corporations was limited in certain situations if the debt-to-equity ratio exceeded 1.5.

The TCJA substantially modified Sec. 163(j) so that the business interest expense in a tax year is limited to the sum of (1) the taxpayer's business interest income, (2) 30% of the taxpayer's adjusted taxable income (ATI) (as defined in Sec. 163(j)(8) and Prop. Regs. Sec. 1.163(j)-1(b)(1)), and the taxpayer's floor plan financing interest (as defined in Sec. 163(j)(9) and Prop. Regs. Sec. 1.163(j)-1(b)(17)).

Prop. Regs. Sec. 1.163(j)-7(b)(2) provides the general rule that Sec. 163(j) applies to determine the deductibility of a controlled foreign corporation's (CFC's) business interest expense in the same manner as the provisions apply to determine the deductibility of a domestic C corporation's business interest expense. This creates issues for the U.S. shareholders of CFCs that have inclusions under the global intangible low-taxed income (GILTI) rules of Sec. 951A and where the CFCs have interest expense.

In the preamble to the proposed regulations (REG-106089-18), Treasury notes that if business interest expense is paid by one CFC to a related CFC, the application of Sec. 163(j) could result in an inappropriate mismatch of a deduction and payee income item. The following example is drawn from one in the preamble:

Example 1: A U.S. person (USP) wholly owns two CFCs (CFC1 and CFC2). CFC1 makes a loan to CFC2 with respect to which CFC1 annually accrues $100x of business interest income that is included in CFC1's tested income; and CFC2 pays or accrues $100x of business interest expense, which, absent Sec. 163(j), would be fully deductible in computing CFC2's tested income or tested loss, as applicable. Thus, the intercompany business interest income and business interest expense would fully offset one another for purposes of computing USP's inclusion under Sec. 951A(a). To the extent that Sec. 163(j) were to disallow a deduction for business interest expense to CFC2 while the business interest income would be included in CFC1's tested income, the amounts would not fully offset, and USP's inclusion under Sec. 951A(a) may be increased solely due to the use of intercompany debt between CFC1 andCFC2.

The proposed regulations provide for an alternative method that would allow for an election to treat the CFCs as a group for purposes of calculating the Sec. 163(j) limitation. The group election would essentially provide two benefits:

• It would allow the group to consolidate its business interest expense and business interest income such that only the CFC group's allocable net business interest expense (ANBIE) (as further detailed below) would be subject to the limitation. Accordingly, if a CFC group has only intercompany debt among the group members, none of the interest expense would be subject to the limitation.
• It would allow a lower-tier CFC group member that did not fully use its 30% of ATI limitation to roll up the excess to a higher-tier CFC group member and include it with the higher-tier CFC's ATI, thereby increasing its interest expense limitation. Further, the group election would also allow the U.S. person to increase its own interest expense limitation by rolling up the excess ATI in the highest-tier CFC and adding the excess to its own ATI.

The group election under Prop. Regs. Sec. 1.163(j)-7(b)(3) can be made for two or more applicable CFCs that are owned 80% or more by a single U.S. shareholder or by multiple U.S. shareholders that are related persons within the meaning of Sec. 267(b) or 707(b)(1) ("related U.S. shareholders"), provided the stock of each applicable CFC is owned in the same proportion by each related U.S. shareholder. There are special rules for determining which entities are eligible to be included in the CFC group, as defined under Regs. Secs. 1.163(j)-7(f)(6) through (11), the discussion of which is beyond the scope of this item.

Determining the interest expense subject to limitation pursuant to a CFC group election

Once an election is made for a specified tax year, as defined in Prop. Regs. Sec. 1.163(j)-7(f)(17), a CFC group member's business interest expense subject to the Sec. 163(j) limitation should not exceed the CFC group member's allocable share of the CFC group's ANBIE. Under Prop. Regs. Sec. 1.163(j)-7(f)(3), a CFC group's ANBIE is the excess, if any, of the sum of the amounts of the business interest expense of each CFC group member for the specified tax year, over the sum of the amounts of business interest income of each CFC group member for the specified tax year.

Further, under Prop. Regs. Sec. 1.163(j)-7(f)(1), each CFC group member's allocable share of the CFC group's ANBIE is determined by multiplying ANBIE by the ratio of the group member's net business interest expense to the sum of the amounts of the net business interest expense of all group CFCs. Special rules apply if there is a financial services subgroup with respect to a CFC group (see Prop. Regs. Sec. 1.163(j)-7(f)(1)(ii)).

Accordingly, if a CFC group has only intercompany debt within the CFC group, and a group election is in effect, then the amount of the CFC group's ANBIE would be zero, and the business interest expense of each CFC group member would not be subject to the Sec. 163(j) limitation.

Determining CFC ATI pursuant to CFC group election

Pursuant to Prop. Regs. Sec. 1.163(j)-7(c)(3), if a CFC group election is in effect, then an upper-tier CFC group member takes into account a proportional share of the "excess" ATI, or excess taxable income (ETI), of each lower-tier member in which it directly owns stock, for purposes of computing the upper-tier member's ATI. ETI is generally calculated as the amount that bears the same ratio to a CFC's ATI as the amount of 30% of the CFC's ATI that exceeds the CFC's deductible business interest expense bears to 30% of the CFC's ATI. For example, if a CFC has taxable income of $90x and interest expense of $10x, its ATI would be $100x ($90x + $10x). The CFC's interest expense limitation would be $30x (30% of $100x). Therefore, the CFC's ETI would be $66.67x ($100x × $20x ÷ $30x).

The process of "rolling up" CFC ETI within the CFC group for purposes of computing ATI of each member of the CFC group begins with a lowest-tier member and continues through the chain of ownership to a highest-tier member of the CFC group. Thus, a lowest-tier member computes its Sec. 163(j) limitation, and if the lowest-tier member has CFC ETI, the CFC ETI is taken into account proportionally by one or more higher-tier members that directly own stock of the lower-tier member, for purposes of computing the higher-tier member's ATI. If the higher-tier member has CFC ETI, that CFC ETI is taken into account by a next-higher-tier member, and so forth.

It should be noted that the proposed regulations do not allow for the ETIs to be added to the ATIs of brother/sister CFCs; and the ETI of a CFC can only be added to the ATI of its parent CFC. In a multi-tier structure, if a middle-tier CFC has no ETI, either due to a loss or due to its entire ATI being used up for purposes of claiming the interest expense deduction, then any ETI from its subsidiary CFC would not be added to its parent CFC.

Example 2: Assume USP wholly owns CFC1; CFC1 wholly owns CFC2; and CFC2 wholly owns CFC3. CFC3 has ATI of $50x and no interest expense; CFC2 has taxable loss of $100x; and CFC1 has ATI of $100x and interest expense of $40x. Pursuant to a group election, CFC3 would have ETI of $50x, which would be added to CFC2's loss of $100x. As CFC2 would have zero ATI even after rolling up CFC3's ETI, CFC1 would not be able to benefit from the ETI in CFC3, CFC1's interest expense limitation would amount to $30x, and $10x of its interest expense would, therefore, be carried forward.

Inclusion of eligible CFC group ETI in US shareholder's ATI

Generally, a U.S. shareholder of a CFC is required to include in its gross income its pro rata share of the CFC's GILTI inclusion, Subpart F income, and investments in U.S. property as defined under Sec. 956. To avoid double-counting, Prop. Regs. Sec. 1.163(j)-7(d)(1)(i) provides the general rule that the ATI of a U.S. shareholder should be computed without regard to any amounts included in gross income under Secs. 78, 951(a), and 951A(a) that are properly allocable to a nonexcepted trade or business of the U.S. shareholder ("specified deemed inclusions") and any deduction under Sec. 250(a)(1)(B) (without regard to the taxable income limitation in Sec. 250(a)(2)) by reason of a specified deemed inclusion (a "specified Sec. 250 deduction").

However, if a CFC group election is in effect, the U.S. shareholder's ATI would increase by the amount of the eligible CFC group ETI, not exceeding the amount of U.S. shareholders' CFC group inclusions.

Eligible CFC group ETI is the eligible CFC ETI of a specified highest-tier member, which is determined by multiplying the CFC ETI by the specified ETI ratio and by the percentage, by value, of the stock of the specified highest-tier member that is owned directly, or indirectly through one or more foreign passthrough entities, by the U.S. shareholder on the last day of the specified tax year. The specified ETI ratio is a fraction (expressed as a percentage) that compares the amounts of taxable income of each specified highest-tier member and each specified lower-tier member of the specified highest-tier member to the portions of the taxable income that gave rise to inclusion under Sec. 951(a) or 951A(a). Under Prop. Regs. Sec. 1.163(j)-7(f)(14), the specified ETI ratio includes in the numerator and the denominator of the fraction only taxable income amounts with respect to CFC group members that have CFC ETI without regard to the rollup of CFC ETI from a lower-tier member.

Planning opportunities

As mentioned above, the group election provides a significant planning opportunity. For groups that have intercompany debt, the default rules could result in a mismatch, whereby the recipient CFC may be required to pick up the entire interest income for purposes of calculating the GILTI inclusion, while the interest expense deduction may be limited for the CFC making the interest payment. The group election would allow for the intercompany debt to be eliminated for purposes of determining the interest expense subject to the limitation, such that only the amount of the CFC group's aggregate interest expense that exceeds the group's aggregate interest income would be subject to limitation under Sec. 163(j). In other words, if a CFC group has only intragroup debt, then, pursuant to the election, the CFC group members may not have any interest expense that is subject to the limitation under Sec. 163(j).

Further, as long as the CFCs have ETI, the election should almost always result in an increased amount of interest expense limitation for higher-tier CFCs and the U.S. shareholders. The election is especially beneficial if a U.S. shareholder has inclusions under the Subpart F or the GILTI regulations, as that would allow a U.S. shareholder to include the eligible CFC group ETI when calculating its ATI. Without the election, the ATI for a U.S. shareholder is calculated without regard to those inclusions, which would result in a lower limitation.

It should be noted that once made, the group election is irrevocable. Further, the election is effective only if all CFC group members make it. If a CFC is liquidated, the group election remains in effect for the other CFCs. Similarly, new eligible CFCs added as subsidiaries of the U.S. shareholder automatically become part of the CFC group. If the election is made, the regulations would need to be monitored closely to determine if any changes are made to the rules relating to the election when the regulations are finalized.

EditorNotes

Kevin D. Anderson, CPA, J.D., is a partner, National Tax Office, with BDO USA LLP in Washington, D.C.

For additional information about these items, contact Mr. Anderson at 202-644-5413 or kdanderson@bdo.com.

Unless otherwise noted, contributors are members of or associated with BDO USA LLP.