Sec. 163(j) final regs. address the classification of lender fees

By Evan Adams, J.D., LL.M., Washington, D.C.

Editor: Greg A. Fairbanks, J.D., LL.M.

One of the most notable elements of the final regulations the IRS and Treasury issued last summer on the Sec. 163(j) business interest expense limitation was the reworked definition of "interest," which now does not include debt issuance costs or commitment fees (T.D. 9905). The exclusion of these loan fees was a complete reversal of the November 2018 proposed regulations (REG-106089-18), which had required taxpayers to treat certain debt issuance costs and certain commitment fees as interest and, therefore, as subject to the deduction limitation of Sec. 163(j).

This change to the definition of interest is generally taxpayer-favorable, because it means these loan fees do not count toward the Sec. 163(j) interest expense limit. However, it also introduces a significant trap for the unwary in the treatment of fees paid by borrowers, especially those paid to lenders. As discussed in depth below, each financing fee must be analyzed on an individual level to determine whether it should be treated as interest expense or as a debt issuance cost for tax purposes. A taxpayer that treats all financing fees as interest expense may be subjecting non-interest amounts to the Sec. 163(j) limitation. On the other hand, a taxpayer that treats all financing fees as debt issuance costs and none as interest may be in danger of understating its interest expense.

This discussion focuses on when loan fees are considered interest expense for purposes of Sec. 163(j)'s interest expense limitation.

Original issue discount

The Supreme Court has defined "interest" as "compensation for the use or forbearance of money" (Deputy v. Du Pont, 308 U.S. 488 (1940)). One form of interest is original issue discount (OID).

OID is defined as the excess of a debt instrument's stated redemption price at maturity (SRPM) — in many cases, equal to the face amount of a loan — over its issue price (Sec. 1273(a)(1)). SRPM is defined as the sum of all payments provided by the debt instrument other than qualified stated interest. In the case of a loan that is issued for money, the issue price of the loan is the amount paid for it.

To illustrate, if a lender pays a borrower $95 cash for a $100 note, the discount of $5 is treated as OID (the excess of the $100 SRPM over the $95 issue price). OID is interest expense to the borrower deductible under Sec. 163(e) and is included in the definition of interest expense for Sec. 163(j) purposes under both the proposed regulations and the final regulations.

Lender fees, generally

Stepping back for a moment, Regs. Sec. 1.1273-2(g) is helpful in analyzing when financing fees are considered interest expense for purposes of Sec. 163(j). The regulation dictates the tax treatment of four types of cash payments made incident to lending transactions:

  • A payment from the borrower to the lender reduces the issue price of the loan — except if the payment is for property or services provided by the lender, such as commitment fees or loan processing costs.
  • A payment from a lender to the borrower is treated as an amount loaned.
  • A payment from a third party to a lender may be characterized as made from the third party to the borrower followed by a payment in the same amount from the borrower to the lender.
  • A payment from a lender to a third party may be characterized as an additional amount loaned to the borrower and then paid by the borrower to the third party.

Interestingly, the regulation does not address payments from a borrower to a third party or payments from a third party to a borrower, which will be discussed further below.

Since 2017, the IRS and Treasury have included a project on the treatment of fees relating to debt instruments and other securities on their Priority Guidance Plan.

Upfront fees

Upfront fees are generally considered interest expense. An upfront fee is paid by a borrower to the lenders of a credit facility on the closing date of the loan. Generally, the upfront fee is calculated based on a percentage of the amount loaned and is paid pro rata to the lenders according to the amount each lender loaned. An upfront fee may also be referred to by the parties as a closing fee, participation fee, or simply as OID.

An upfront fee paid to the lenders on a term loan is a straightforward example of a payment from the borrower to the lender that is not a payment for services provided by the lender. As such, Regs. Sec. 1.1273-2(g) requires the issue price of the loan to be reduced by the amount of the upfront fee. Accordingly, upfront fees are generally OID and are subject to the interest limitation of Sec. 163(j).

Arrangement fees

This type of fee is generally not considered interest expense. The terms arrangement fee (or arranger fee), syndication fee, and underwriting fee can have distinct meanings but are often used interchangeably to describe a fee paid for the services performed by the bank that serves as the arranging bank of a credit facility or bond issuance. These services can include negotiating the terms of a loan and finding lenders to participate.

A bank that arranges a loan may or may not end up as a lender on that loan. Even if the arranger is a lender, an arrangement fee is not generally required to reduce the issue price of the loan under Regs. Sec. 1.1273-2(g) because the fee is paid for services provided by the lender rather than as compensation for the use or forbearance of money.

Commitment fees

As noted earlier, the final regulations do not include commitment fees in the definition of interest. A commitment fee is paid by a borrower to compensate the lender for its commitment to lend. Two common forms of commitment fees include: (1) periodic payments for the right to borrow under a revolving credit commitment and (2) upfront fees for delayed draw loan arrangements.

In a revolving credit arrangement or revolver, the borrower may borrow loans up to a maximum commitment amount. Loans issued under a revolver may be repaid and reborrowed at any time during the term of the facility. In this context, a commitment fee is generally a fee that is periodically paid from the borrower to the lender for the right to borrow under the revolver. The IRS has twice issued guidance on the tax treatment of revolver commitment fees. In Technical Advice Memorandum 200514020, the borrower was required to pay a quarterly facility fee based on the total commitment under the revolver. In Field Attorney Advice 20182502F, the borrower was also required to pay a quarterly facility fee, but this fee was calculated by reference to the amount of the total commitment that had remained undrawn in the prior quarter. In both cases, the IRS concluded that the commitment fees were deductible under Sec. 162 as business expenses rather than under Sec. 163 as interest.

Another type of commitment fee, also referred to as a standby charge, is an upfront amount paid by a borrower for the right to borrow loans over a set term. In Rev. Rul. 81-160, the IRS stated that such fees are "similar to the cost of an option, which becomes part of the cost of the property acquired upon exercise of the option." Therefore, the IRS concluded that if the right is exercised, the commitment fee becomes a cost of acquiring the loan and must be deducted ratably over the term of the loan, and if the right is not exercised, the taxpayer may be entitled to a loss deduction under Sec. 165 when the right expires. Rev. Rul. 81-160 does not discuss whether a standby charge that does not become a cost of issuing a loan should be treated as interest expense. As noted above, however, Regs. Sec. 1.1273-2(g) includes commitment fees as an example of a payment for services provided by the lender (as opposed to a payment for the use or forbearance of money).

The proposed regulations treated any fees in respect of a lender commitment to provide financing as interest if any portion of such financing is actually provided. The IRS reversed course in the final regulations, removing commitment fees from the definition of interest and noting the uncertainty that exists as to whether to characterize these fees as fees for services or property or as compensation for the use or forbearance of money. In the preamble to the final regulations, the IRS referred to the pending guidance project on debt fees, noting that the treatment of commitment fees and other fees paid in connection with lending transactions will be addressed in future guidance that applies for all purposes of the Code.

Borrower's payment of lender's expenses

The question of whether these expenses should be classified as interest expense or debt issuance costs is a thorny one. In negotiating and closing a debt arrangement, borrowers and lenders are generally represented by separate counsel, and in addition to paying their own lawyers, borrowers are often required to pay the lenders' legal expenses.

As discussed above, Regs. Sec. 1.1273-2(g) provides characterizations for payments from (1) borrowers to lenders; (2) lenders to borrowers; (3) third parties to lenders; and (4) lenders to the third parties. Noticeably absent is a provision recharacterizing payments between a borrower and a third party. Arguably, this omission implies that the IRS did not intend payments between a borrower and a third-party service provider to be characterized as interest, even when the service provider was providing services to the lender.

On the other hand, Sec. 162 only allows deductions for ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business. Generally, payment by one taxpayer of the obligation of another taxpayer is not ordinary and necessary and as such may not be claimed as a deduction under Sec. 162 (Welch v. Helvering, 290 U.S. 111 (1933)). When one taxpayer pays an expense that is properly treated as the obligation of another taxpayer, there is often a recharacterization as (1) first, a payment from the original payer to the proper taxpayer and (2) second, a payment from the proper taxpayer to the payee. For example, if a shareholder is a primary beneficiary of a corporate expenditure made to a payee, such expenditure is treated as a distribution from the corporation to the shareholder and then as a payment from the shareholder to the payee (see, e.g., Hood, 115 T.C. 172 (2000)). Similarly, where a shareholder makes unreimbursed payments on behalf of the corporation to a payee, such payments are recharacterized as contributions to the capital of the corporation followed by payment by the corporation to the payee (see, e.g., Specialty Restaurants Corp., T.C. Memo. 1992-221).

Where a borrower pays a lender's legal expenses, these principles could require recharacterization, first, as a payment from the borrower to the lender, and then, as a payment from the lender to the service provider. Under this recast, the issue price of the loan would be reduced by the amount of the legal expenses under Regs. Sec. 1.1273-2(g), as there would be a deemed payment from the borrower to the lender and the payment would not be for services provided by the lender to the borrower. Potentially, then, the IRS would consider these expenses interest for purposes of Sec. 163(j).

Substance over form

The label given to a particular fee is not determinative of the classification of that fee. Instead, taxpayers should look to the substance of the transaction between a borrower and a lender to determine whether a fee should be treated as interest or as a debt issuance cost.

The Tax Court has held that a "crucial" factor in establishing that a particular payment constitutes interest is whether the payment bears some relationship to the amount borrowed (Fort Howard Corp. & Subs., 103 T.C. 345 (1994)). A fee paid to a lender, then, is more likely to be regarded as interest if it is determined by reference to the amount loaned by that lender. For example, a fee labeled as an "arrangement fee" is more susceptible to challenge as being interest if it is calculated by reference to the amount loaned only by the arranger than if it is calculated by reference to the total amount of debt in the credit facility.

Taxpayers should be aware that the final regulations include an explicit anti-avoidance rule that can operate to recharacterize debt issuance costs as interest for purposes of Sec. 163(j). Under the anti-avoidance rule, any expense or loss economically equivalent to interest is treated as interest expense for purposes of Sec. 163(j) if a principal purpose of structuring the transaction is to reduce an amount incurred by the taxpayer that otherwise would have been interest expense. Any expense or loss that does not meet the general definition of interest is economically equivalent to interest to the extent that the expense or loss is (1) deductible by the taxpayer; (2) incurred by the taxpayer in a transaction or series of integrated or related transactions in which the taxpayer secures the use of funds for a period of time; and (3) substantially incurred in consideration of the time value of money.

Ensure proper classification as interest

The narrowing of the definition of interest in the final regulations can provide a significant benefit. However, this change in the final regulations also magnifies the risk taxpayers are inadvertently understating or overstating interest expense, which can have considerable consequences to taxpayers limited by Sec. 163(j). Taxpayers that issue loans are advised to carefully examine their debt fees, particularly those paid to lenders, to determine whether those fees are properly classified as interest.


Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or

Contributors are members of or associated with Grant Thornton LLP.

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