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Table of Contents Cover Letter: ............................................................... i 1.
A. Carryforwards ......................................................... 15 B.
(vii) Banks and Other Financial Institutions ............................ 37 9.
A. Legislative History.................................................... 57 B. 16.
This report, prepared by an ad hoc Subcommittee of the Committee on U.S. Activities of Foreign Taxpayers of the Tax Section*, comments on issues that might be addressed by Regulations under Section 163(j) of the Internal Revenue Code.
Consisting of Kimberly S. Blanchard, S. Douglas Borisky, Peter A. Glicklich, James A. Guadiana, Debra G. Gutwillig, Kenneth S. Kail, Richard 0. Loengard, Michael L. Schler, Esta E. Stecher, Lewis R. Steinberg, Suzanne L. Sykora, Willard B. Taylor, Mary Sue Teplitz, John C. Vlahoplus, and Annette S. Werner. The principal draftsman was Willard Taylor. Helpful comments were received from M. Bernard Aidinoff, Renato Beghe, William L. Burke, Peter C. Canellos, John A. Corry, Arthur A. Feder, Sherwin Kamin, Bruce E. Kayle, Richard M. Leder, Robert J. McDermott, James M. Peaslee, Kenneth R. Silbergleit, David R. Tillinghast, and Ralph 0. Winger.
P.L. 101-239, 103 Stat. 2106 [hereinafter cited as the “1989 Act”].
(c) the corporation has “excess interest expense”, defined as the excess of total interest expense, net of any interest income (“net interest expense”), over the sum of (i) 50 percent of adjusted taxable income (i.e., taxable income computed without regard to net interest expense, net operating loss carryovers, and any deduction allowable for depreciation, amortization, or depletion) and (ii) any excess of 50% of adjusted taxable income over net interest expense in the prior three years, to the extent not previously absorbed.
Where interest is subject to a reduced rate of withholding tax under a treaty, only the portion of the interest that corresponds to the reduction will be regarded as tax-exempt.
The purpose of Section 163(j) is to limit the deduction allowed for interest paid by U.S. corporations to controlling foreign shareholders, although in form it also applies to interest paid to related domestic tax-exempt persons. Its structure was shaped, however, by Congress’ desire, on the one hand, not to violate anti-discrimination provisions of U.S. tax treaties by limiting the disallowance to foreign-owned U.S. corporations and, on the other, to avoid the political difficulties (evident from the failure to adopt final Section 385 Regulations) of enacting a limitation on deductible interest that would apply to domestically controlled U.S. corporations as well.
To resolve these conflicting pressures, Congress made the disallowance in Section 163(j) turn on whether the interest is exempt from tax. This has led to a number of difficulties, including uncertainty as to whether, if Regulations extend Section 163(j) to guaranteed third party debt, it will apply if interest paid to the guarantor would have been exempt, notwithstanding that interest paid to the third party lender is fully taxable.
Although relatively brief, Section 163(j) is a microcosm of the complexity of current tax law. It creates a number of new concepts of substantial complexity (“disqualified interest”, “adjusted taxable income”, “net interest expense”); requires other calculations not generally required by the Code, such as a corporation’s debt to equity ratio; creates new carryover items (e.g., excess limitation and interest not deductible under Section 163(j)); and generally touches on every context in which the interest deduction is important, including, for example, the calculation of the branch profits tax imposed by Section 884.
We have in this Report tried to address Section 163(j) comprehensively and have identified the issues set out below. Answering in Regulations all the issues raised by Section 163(j) would be an enormous undertaking by the Internal Revenue Service, however, and just as much of an imposition on those compelled to read and interpret the Regulations. Consideration might be given under these circumstances to addressing only those issues considered to be most important, recognizing that this may leave taxpayers and the Internal Revenue Service at risk with respect to unanswered questions.
purposes of determining the deductibility of interest expense by a U.S. corporation or also for other purposes, such as the calculation of personal holding company income, foreign personal holding company income and accumulated taxable income. See pages 7-8.
foreign exchange gains and losses and market discount and the extent to which interest income and expense will include “interest equivalents”. See pages 8-10.
reduce related party interest expense. See page 10.
interest expense when allowed as a deduction through depreciation or otherwise (and, if so, how it will be identified). See pages 10-12.
reduction in the dividends received deduction in Section 246A. See pages 12-13.
disallowance of interest under Section 163(j). See page 13-14.
that are added to taxable income to arrive at adjusted taxable income will be subtracted from gain recognized on a sale or other disposition of the related asset. See pages 15-16.
listed in Section 163(j)(6)(A)(i)(III), other non-cash deductions (and non-taxable cash receipts) should be added to taxable income to arrive at adjusted taxable income. See pages 16-17.
10. Whether life insurance companies otherwise excluded from the definition of an affiliated group by Section 1504(b)(2) should be included for purposes of the calculation of adjusted taxable income and otherwise. See page 17.
11. Whether there should be any adjustment to gain realized on the sale of capital assets other than that referred to in 8. above and to the extent necessary to prevent “stuffing”. See pages 17-18.
12. Whether an excess of 50% of adjusted taxable income over interest expense for years prior to the effective date of Section 163(j) may be carried forward. See page 19.
13. Whether financial statement values may be used in lieu of adjusted basis to determine assets for purposes of the 1.5 to 1 debt to equity ratio safe harbor of Section 163(j)(2)(A)(ii). See pages 21-25.
of the stock of a subsidiary; adjustments to the basis of stock of corporations not included in the affiliated group to reflect increases and deficits in retained earnings; and whether investments in partnerships should be taken into account by looking at the basis in the partner’s partnership interest or in the partner’s share of the partnership’s assets. See pages 25-33.
15. How debt should be defined in determining debt to equity ratios, including the treatment of defeased debt, contingent liabilities, short-term liabilities, insurance company reserves, commercial financing liabilities and banks and finance business. See pages 33-36.
16. Whether an “anti-stuffing” rule is needed to prevent distortions in the calculation of debt to equity ratios or of adjusted taxable income. See pages 36-38.
17. Whether the determination of whether a partnership is “related” should be made at the partnership level. See pages 36-37.
18. Whether there should be a de minimis exception, similar to that applicable to partnerships, in the case of regulated investment companies and real estate investment trusts with de minimis holdings by tax-exempt shareholders. See pages 38-40. 19.
limitation or disallowed interest carryforward of the acquired corporation. See pages 40-42.
21. How to identify the portion of its U.S. interest expense that is payable to related persons when a foreign corporation carries on business in the United States through a branch or otherwise. See pages 44-48.
22. Whether “excess interest” expense of a foreign corporation that carries on business in the United States through a branch or otherwise should be treated as paid to a related person for purposes of Section 163(j). See pages 48-52.
23. What rules should apply in determining whether there is a back-to-back loan from a related person and whether any such rule should also apply for withholding tax purposes. See pages 56-62.
24. Whether the Regulations need address cases to which Plantation Patterns would apply; what, if anything, should be said with respect to guaranteed third-party debt that is not treated as equity under the holding in that case; and related issues, such as what constitutes a guarantee and the treatment of back-to-back guarantees. See pages 62-68.
25. What standard should be used to determine when a modification of terms will cause a loan to lose its grandfathered status and whether a modification which reduces aggregate interest expense should have this consequence. See pages 68-71.
attributable to the deduction of interest paid to tax-exempt related parties, it would be useful to make it clear that the disallowance is only for that purpose and, for example, does not affect the calculations under Section 535, defining accumulated taxable income; Section 545, defining undistributed personal holding company income; and Section 556, defining undistributed foreign personal holding company income. It might also be questioned whether it should apply for purposes of calculating, under Section 952, the subpart F income of a foreign corporation paying interest to a related person, although the application of Section 163 (j) in such a case could affect the taxable income of U.S. shareholders.
See H.R. Rep. No. 247, 101st Cong., 1st Sess. (1989) [hereinafter cited as “House Report”] at 1243.
See Rev. Rul. 75-515, 1975-2 C.B. 117, 118; and I.T. 3253, 1939-1 C.B. 178.
For the purposes of Section 163(j), interest is presumably calculated and determined under normal tax rules and thus will include original issue discount, as determined under Section 1272 et seq. Regulations under Section 988(a)(2) should specify the extent to which foreign exchange gain and loss will be treated as interest income or expense under Section 163(j), and we believe that Regulations under Section 1276(a)(4) should treat market discount as interest income for this purpose. Interest income and interest expense should also be adjusted for amortized bond premium, and interest income should include “acquisition discount” as defined in Section 1283(a)(2).
1989-33 I.R.B. 1 (Aug. 14, 1989).
previously made by the Tax Section,* and (since there is no reason for special treatment) to extend to dealers the treatment afforded other corporations. While there may be somewhat different issues involved in determining interest equivalents under these other Regulations, it would be unnecessarily complex to develop a different definition of interest equivalents for the purposes of Section 163(j).
is reduced by interest income in determining net interest expense, there is no offset of interest paid to related parties by interest received from related parties. If, for example, a corporation has $100X of interest expense, of which $75X is related party interest expense, and $25X of interest income from related parties, the potential disallowance under Section 163(j) is $75X, not $50X. It might be considered whether this is in all cases appropriate -- for example, whether interest paid to a related party should not be reduced by interest received from the same party in determining the amount of interest paid to related parties or, indeed, whether interest received from all related parties should not be netted against interest paid to all related parties.
See the Tax Section’s Report on Regulations Relating to the Definitions of a Controlled Foreign Corporation, Foreign Base Company Income, and Foreign Personal Holding Company Income (February 13, 1989), reprinted in Tax Notes Today, February 21, 1989, and its Report on Temporary Section 861 Regulations Concerning Allocation of Interest and Other Expenses (December 21, 1988).
deduction through the gross income exclusion for cost of goods sold or the deduction allowed for depreciation; if a capital asset is sold at a gain or a loss, whether interest capitalized and included in its basis is to be regarded as allowed as a deduction at that time; and how capitalized interest that is treated as allowed as a deduction in any year will be handled if for that year there is a net operating or capital loss. To be consistent, interest capitalized in years prior to the effective date of Section 163(j) would have to be taken into account as interest expense when allowed as a deduction. All of this will require records that permanently identify and trace capitalized interest as such. We recognize that some interest will escape Section 163(j) if that Section does not apply to capitalized interest, but we believe the leakage does not justify the complexity of identifying and tracing capitalized interest.
Revenue Code, such as Section 265 or Section 279, permanently disallow a deduction for interest. As a logical extension of the legislative history referred to above, such interest should never be taken into account under Section 163(j).
determination of interest expense is relevant for other purposes, such as the allocation and apportionment of interest expense for foreign tax credit and other purposes under Section 861, interest deferred under Section 163(j) would be taken into account when it becomes deductible under that Section. This follows from Section 163(j)(1)(B), which provides that interest deferred under Section 163(j)(1)(A) “shall be treated as disqualified interest paid or accrued in the succeeding taxable year”.
More difficult is the relationship between Section 163(j) and Section 246A. Although Section 246A does not disallow a deduction for interest, where debt is treated as financing the ownership of portfolio stock under that Section there is a corresponding reduction in the dividends received deduction. One approach would be to say that in this case Section 163(j) should apply first -- that is, if interest is not currently deductible under Section 163(j) the related debt should not result in a reduction of the dividends received deduction. The difficulty of this approach, however, is that the interest may become deductible in a year in which there is no longer any dividends received deduction to disallow and, given that possibility, there does not seem to be any alternative to applying both Section 246A and Section 163(j) at the same time and to both disallowing the interest and reducing the dividends received deduction.
Rules might be provided to coordinate Section 163(j) with the passive activity loss limitation rules. If so, the passive loss rules should be applied first, and then Section 163(j). The passive loss rules should then be reapplied but, in order to avoid a circularity problem, Section 163(j) should not be reapplied.
rules would be limited to $80X by Section 163(j). The corporation would then be permitted to deduct an additional $20X of rent and depreciation expense ($8X and $12X, respectively). Its passive loss would remain at $100X, but would consist of $7OX interest expense, $12X rent expense, and $18X depreciation expense.
The disallowance under Section 163(j) is limited to “excess interest expense”, which is the excess of net interest expense over 50% of “adjusted taxable income” plus any excess limitation carryover. Section 163(j)(6)(A)(ii) authorizes Regulations that will adjust the statutory definition of adjusted taxable income. A.
Capital gains and losses would have to be adjusted pursuant to our recommendation in 2(B)(ii) below.
(i) Under Section 163(j)(6)(A)(i)(III), the items added back to taxable income should include all depreciation of intangible personal property (including depreciation or amortization of patents, trade secrets, copyrights and covenants not to compete), recovery deductions and depreciation of tangible personal or real property, amortization of organizational expenses, and depletion deductions (whether cost depletion or percentage depletion).
Statement of Managers at 566. According to Kenneth W. Gideon, Assistant Secretary of the Treasury for Tax Policy, the definition of “adjusted taxable income” against which the interest deduction limitation is measured is modified by the statute (and is to be further modified by regulations) “to reflect more closely actual cash flow”. Letter from Kenneth W. Gideon to Keijino Koyama, dated December 18, 1989 (reprinted in Tax Notes International, January 24, 1990). Treasury apparently believes such an approach to be appropriate because an unrelated lender would be apt to look at cash flow and asset levels to determine whether to lend money. See Matthews, “U.S. and U.K. Branches of I FA Meet to Discuss Common Concerns”, September 18, 1989 edition of Tax Notes at 1320 (summarizing the remarks of Peter Barnes, Associate International Tax Counsel, Department of the Treasury).
gains recognized upon the disposition of the assets that gave rise to the deductions should be subtracted from taxable income to the extent that such gains are attributable to such deductions allowed while the assets were held by the taxpayer or a member of the taxpayer’s affiliated group. The adjustment would be made for depreciation, etc. taken in any year in which it could affect the calculation of adjusted taxable income for purposes of Section 163(j) -- in other words, if our recommendation in 6(A) below is accepted, the three taxable years prior to the first taxable year beginning after July 10, 1989, as well as taxable years beginning after that date. To be consistent, for purposes of Section 163 (j), an adjustment would also have to be made to the investment adjustment rules in Regulations § 1.1502-32 and -32T.
This subtraction will entail additional recordkeeping, but without such a rule adjusted taxable income would be overstated in the year the assets (or the stock of a subsidiary holding the assets) were sold because, for purposes of the modified adjusted taxable income calculation, asset basis would not have been reduced on account of such deductions.
the concept used in Section 163(j)(2)(B)(i)(II) to measure deductibility from taxable income, which is what determines the corporation’s tax liability. Indeed, as a policy matter, it might be questioned whether Congress should have added back depreciation, amortization, or depletion to taxable income except to the extent that the allowable deductions exceed those allowed for earnings and profits purposes.
By way of example, the deduction allowed for compensation paid in stock does not require any cash outlay; on the other hand, we assume that taxable income would not be increased when stock is sold for cash, although that increases cash flow. Other examples of non-cash deductions and non-taxable cash receipts are the dividends received deduction, increases in insurance company reserves, unearned premiums of insurance companies, and tax-exempt interest. Apart from our suggestion in 5(A) above, we would not favor making adjustments for these or any other non-cash deduction (or nontaxable cash receipts) except to the extent required by Section 163(j)(6)(A)(i)(III).
See House Report at 1248.
Section 1504(b)(2) should be treated as a member of the affiliated group.
legislative history to disregard the proceeds of “certain” capital asset dispositions is unclear,* but we think that this should be limited to the recapture of deductions for depreciation, depletion and amortization, as recommended in B(ii) above, and to “stuffing”, i.e., to the appreciation existing at the time of a contribution of any asset to the corporation from a related person. See “Anti-Abuse Rules” in 9. below. Including all other income from asset sales in adjusted taxable income gives taxpayers some ability to time the receipt of income but we see no simple and practical alternative to using that standard.
treatment of income of a foreign corporation that is not effectively connected with a U.S. trade or business but is subject to U.S. withholding tax. We assume that such income will not be taken into account in determining adjusted taxable income and net interest expense.
See Statement of Managers at 566, stating that “[T]he conferees intend that any modified definition [of adjusted taxable income] . . . would disregard, for example, the proceeds of certain capital asset dispositions.” A Treasury representative has indicated that the reference authorizes Treasury to ignore a return of capital even though an unrelated lender would take this cash flow into account (International Fiscal Association Meeting, New York City, December 4, 1989 - Tax Notes, December 11, 1989, p. 5).
Under Section 163(j)(2)(B)(ii), if 50% of adjusted taxable income exceeds net interest expense, there is an “excess limitation” which is carried forward for three years and added to 50% of adjusted taxable income to determine whether there is “excess interest expense” in a carryforward year. Any “excess limitation” remaining after the third year is lost.
Cf. Sections 279(c)(5)(B) and (C).
If a carryforward is allowed, all of the adjustments to taxable income required by Section 163(j)(6)(A) for post-effective taxable years would have to be made to taxable income for preeffective date taxable years.
otherwise be subject to Section 163(j) (for example, have a debt to equity ratio in excess of 1.5 to 1) in order to have an excess limitation for a year. The carryforward operates independently from the debt to equity “safe harbor” of Section 163(j)(2)(A)(ii).
(ii) An excess limitation is automatically carried forward and reduces excess interest expense in three succeeding years, even if in a carryforward year the corporation would have no amount of excess interest expense disallowed (either because its debt to equity ratio is 1.5 to 1 or less or because no disqualified interest was paid or accrued in such year). Although the statute could be more explicit on this point, this interpretation is consistent with the language of Section 163(j)(2)(B)(ii) and the notion that the excess limitation carryforward operates independently of the debt to equity ratio rules.
“net interest expense” in the carryover year.* This point might be confirmed in the Regulations.
As in the case of disqualified interest for the current year, disqualified interest which is carried forward is fully deductible in the carryover year as long as the corporation has no excess interest expense in such year. If the corporation has excess interest expense in the carryover year, but is not subject to the disallowance rule because its debt to equity ratio has been reduced below 1.5 to 1, the same conclusion is reached under Section 163(j)(1)(A).
Regulations under Section 267(a)(2) preserve the related party taint despite subsequent uncoupling.
We have doubts about the statistical basis for the conferees’ understanding. We have found no publicly available statistics which relate levels of corporate debt to the adjusted basis of assets. The Statement of Managers refers to debt-to-equity ratios, not ratios of debt to tax basis. Finally we are not sure that the “median” of debt-to-equity ratios is a sound basis for such an analysis.
Fortune, April 24, 1989, page 354 et seq.
This Fortune 500 listing excludes banks, insurance companies and other financial intermediaries, which generally have very high debt to equity ratios.
Under Section 163 (j)(2)(C)(i), the debt to equity ratio of a corporation or affiliated group is to be determined by using the adjusted tax basis of assets, but with the “adjustments” prescribed in Regulations under Section 163(j)(2)(C)(iii). The use of adjusted basis for determining a corporation’s debt to equity ratio raises a number of problems.
purposes of Section 163(j), and the Section 56(f) Regulations* answer many of the questions that will come up if financial statements are to be used to determine debt to equity ratios under Section 163(j).
basis rule in Section 163(j)(2)(C)(i), we would recommend that a technical correction be sought.
Temp. Reg. § 1.56-1T. See also the use of financial statements in Treas. Reg. § 1.897-2(g)(1)(iii)(C) and, for the purposes of defining indebtedness, Treas. Reg. § 1.279-5(e).
See the Statement of Managers at 569.
assets with a value of $150 and a tax basis of zero. Assume that the price is $150 and that P has financed the purchase with $75 of equity and $75 of debt. It seems absurd on these facts to say that the P/S group has an infinite debt to equity ratio since it has $75 of debt and no assets. The P/S group should plainly be treated as having assets of $150 and debt of $75 and a debt to equity ratio of 1 to 1.
The acquisition case provides an independent reason for our proposal since, if tax basis is used to calculate debt to equity ratios, whether an acquisition is of stock or assets will create a sharp disparity in result.
Apart from acquisitions of stock, the use of adjusted basis is likely to consistently understate the value of stock of foreign subsidiaries (and the stock of any other corporation not included in the affiliated group for purposes of Section 163(j)(6)(C)). This was an issue specifically addressed by Congress in Section 864(e)(4), which generally reflects changes in earnings and profits in the basis of stock of corporations not included in the affiliated group but owned to the extent of 10% or more.
adjusted basis, many of these have been resolved by the Regulations under Section 56(f).
(a) Liabilities excluded “trade accounts payable, accrued operating expenses and taxes, and other similar items”, and a corresponding amount was deducted from the adjusted basis of the corporation’s assets.
(b) The adjusted basis of the corporation’s assets was reduced by reserves for bad debts and “similar asset offsets”.
(c) The adjusted basis of trade accounts receivables to a cash basis taxpayer was their face amount less an appropriate reserve for uncollectibles.
45 Fed. Reg. 86,438, 86,443 (1980). The discussion refers only to the final Section 385 Regulations.
(e) In the case of a corporation that was a bank, or a corporation primarily engaged in the lending or finance business, as defined in Section 279(c)(5), adjustments were made in accordance with the principles of Section 279(c)(5)(A), i.e., to reduce liabilities and assets by the amount of indebtedness owed to the corporation that arose out of its lending or finance business.
(f) In the case of an insurance company, insurance reserves were treated in the same way as trade accounts payable, i.e., as reducing liabilities and assets by the same amount.
(g) Liabilities incurred under a commercial financing agreement (such as an automobile floor plan) to buy inventory were treated as trade accounts payable if secured by the item and due on or before sale of the item.
statements are not used to determine debt to equity ratios, the particular problem of corporate acquisitions could be dealt with by “pushing down” any difference between the basis of shares and the basis of the underlying assets. We recognize, however, that a push down rule will involve complexities and opportunities for dispute.
determination of the amount to be allocated to each asset would be determined in the first instance by the taxpayer and may involve the very same types of valuation disputes that Congress apparently wished to avoid by basing debt to equity ratios on adjusted tax basis. In particular, and unlike the usual case, the acquiror will have an incentive to allocate the bulk of the hypothetical step-up in asset value to goodwill and other nondepreciable and long-lived assets (since this will preserve the effect of the step-up for the longest possible time). Furthermore, even when the S stock is sold by a single seller (as opposed to the public), the seller’s tax and economic position in a stock sale will be unaffected by the allocation and an agreement between the parties would not be at arm’s length.
It might be possible to base debt to equity ratios on a pushed down asset basis and also to achieve relative simplicity by the use of some arbitrary rule -- for example, requiring that the resulting initial stock basis must be adjusted (on a straight-line basis) over a period of years reflecting a reasonable debt amortization period (perhaps 10 or 15 years). Of course, the adjusted stock basis would still be increased or decreased from time to time by profits, losses, and distributions from and contributions to the corporation, although amortization of the basis would be based on the original purchase price. Push down accounting could be limited to recent acquisitions -- for example, those after the July 10, 1989 effective date or within the three years preceding the first taxable year beginning after July 10, 1989 and taxable years beginning after that date.
original acquisition had been an asset acquisition. The Regulations could adopt a rule stating that while only actual depreciation would be taken into account to reduce stock basis, no gain on dispositions of such originally held assets would increase such stock basis, all losses on such assets would reduce such basis, and all distributions would reduce stock basis in an amount equal to the current fair market value of the asset (without increase by the Section 311 gain on the asset to the target). The case of a Section 332 liquidation of the target is more difficult, and we see no good alternative to a return to underlying asset basis (disregarding post-acquisition depreciation) in that situation. While the latter result is unfortunate, it is probably no more unfortunate to the taxpayer than is the resulting loss in the high stock basis for other reasons (e.g., if the business is ever sold).
We are not in favor of allowing an acquiring corporation in calculating its debt to equity patio after an acquisition of stock to exclude acquisition debt to the extent of the appreciation in the subsidiary’s assets at the time of the acquisition. This approach would produce results that are inconsistent with the underlying purpose of the debt to equity ratio calculation and economic reality.
An alternative approach would take debt into account only in the same proportion that the basis of S’s assets bears to their value. For example, if the target’s assets had a basis of $25 and value of $100, and P’s acquisition was financed with $60 of debt and $40 of equity, under this approach only 25% of the debt, or $15, would be taken into account. The P/S group would be deemed to have $25 of assets and $15 of debt, for a debt to equity ratio of 1.5 to 1, which is the right answer based on $60 of debt and $40 of equity.
However, this approach results in extreme pro-taxpayer distortions when P is a pre-existing corporation with assets and liabilities. Suppose P has $80 of assets and $40 of liabilities, and wishes to acquire S (with assets having a tax basis of $20 and value of $100). The correct economic answer is that to maintain a 1.5 to 1 ratio after the acquisition, P can additionally borrow up to $68 of the $100 purchase price (giving the P/S group assets of $180 and liabilities of $108). However, under the suggested proportionality rule, P could borrow the entire $100 purchase price, since it would then be deemed to have assets of $100 ($80 plus $20) and liabilities of $60 ($40 plus $20), and would have a nominal debt to equity ratio of 1.5 to 1. In reality, P would then have assets of $180 and liabilities of $140, for a ratio of 3.5 to 1, but this would be irrelevant and all interest would be fully deductible. This result is obviously unacceptable.
are based on the adjusted basis of assets, rather than financial statements, a further problem is the treatment of an investment in a partnership -- specifically, whether a corporate partner should take into account its basis in the partnership or a share of the partnership’s basis in its assets and how a corporate partner should determine its share of partnership liabilities.
Using the partner’s basis in its partnership interest, rather than a share of the partnership’s basis in its assets, is the simplest and most sensible approach. The asset for purposes of Section 163(j) would then be the basis in the partnership interest (including the partner’s share of liabilities included in that basis), and the debt for purposes of Section 163(j) would be the debt of the partnership included in such basis.
See the Tax Section’s Report on Temporary Section 861 Regulations Concerning Allocation of Interest and Other Expenses (December 21, 1988).
adopted in the case of a partner that contributes appreciated or depreciated assets (or where the partnership’s assets are otherwise booked up under Treas. Reg. § 1.704-l(b)(2)(iv)(g) to reflect unrealized appreciation or depreciation) to a partnership that maintains capital accounts in accordance with the Section 704 Regulations. In this case, a corporate partner’s debt to equity ratio would be determined by taking into account its share of the partnership’s liabilities and its book capital account increased by its share of liabilities. For example, if P contributes assets having a fair market value of $100 and an adjusted tax basis of $25 to a partnership, and another party contributes $100 of cash to the partnership, and each receives a 50% partnership interest in exchange therefor, we believe that P should be allowed to treat its partnership interest as having an adjusted basis of $100 for purposes of calculating its debt to equity ratio. This approach could be limited to cases involving partnerships among unrelated partners and could be made optional.
Since contributed property must be booked into the partnership’s capital accounts at fair market value and since the capital accounts ultimately control the amount of cash and property each partner is entitled to receive from the partnership, a partner’s capital account provides an objective standard, assuming that the partners are otherwise unrelated, for determining the fair market value (net of liabilities) of the contributed assets. Since the capital accounts will also be charged with the amount of book depreciation, amortization or depletion allocated to the partner, they will continue to reflect the partner’s overall net equity investment in the partnership over time. Furthermore, since the capital accounts will already be maintained for other purposes, adoption of this approach will not require a corporation to keep an entirely different set of books solely for purposes of determining its debt to equity ratio.
Section 163(j) does not define “indebtedness” except to state that it includes accrued original issue discount, and the legislative history adds nothing other than to state that the 1.5 to 1 safe harbor was based on the conferees’ understanding that the median debt to equity ratio for U.S. corporations is less than 1.5 to 1. There is, of course, no statutory reason why Regulations defining indebtedness could not use financial statement indebtedness (which is what the Section 279 Regulations do *).
If, as we have suggested, financial statements are used to determine assets, they would also be used to determine liabilities. We would recommend, however, that financial statement liabilities and assets be adjusted to include any interest bearing debt and related asset that is not included on the financial statements, other than defeased debt and the related assets, and, in addition, to make the adjustments described in (i), (iii), (vi) and (vii) below. If financial statements are not used, these adjustments should still be made and the Regulations might also make the adjustments described in (ii), (iv) and (v) below.
163(j) and that there should generally be a corresponding reduction in assets.
(ii) Defeased Debt. For financial accounting purposes, “defeased” debt (i.e., debt as to which a pool of liquid assets has been transferred to a trustee for repayment) and the related assets are removed from the balance sheet. For tax purposes such debt is not viewed as having been extinguished unless the debtor is legally released from the obligation. The issue is not specifically addressed by either Section 385 or Section 279, although the Section 279 Regulations would seem to exclude defeased debt since they define indebtedness by the use of generally accepted accounting principles.* The financial accounting approach seems reasonable for purposes of Section 163(j).
treated insurance reserves of an insurance company as trade accounts payable and thus excluded them and a corresponding amount of assets from the debt to equity ratio calculation. We understand that, under financial accounting principles, such reserves are ordinarily reflected as liabilities on the balance sheet. The issue is not as such addressed by Section 279 (although, as noted, the Section 279 Regulations generally look to financial statements to define debt).
Treas. Reg. § 1.279-5(e)(1). We would not, however, favor excluding nonrecourse debt and the related assets, notwithstanding that they may be excluded for financial statement purposes.
(although an increase in reserves is deductible), it would seem inconsistent with Section 163(j) to include them in the debt to equity computation. Consistent with the Section 385 Regulations, insurance reserves should be excluded from debt and a corresponding amount of assets removed from the debt to equity ratio calculation on the theory that the reserves are for claims of policyholders rather than the leveraging of an investment in the company.
(iv) Contingent Liabilities. The Section 385 Regulations did not address the treatment of contingent liabilities. Section 279 includes in indebtedness contingent liabilities such as (a) those arising out of discounted notes, (b) the assignment of accounts receivable, and (c) guarantees of liabilities, but (in accordance with the financial statement definition of debt) only if the contingency is likely to become a reality. This approach, which was intended to reflect financial statement treatment, seems sensible to us.
(v) Amortizable Bond Premium. The Section 385 Regulations included unamortized bond premium in indebtedness. We understand that for financial accounting purposes such premium is taken into account as debt and thus would presumably also be taken into account for purposes of Section 279. In our view the unamortized portion should be taken into account for purposes of determining the debt to equity ratio. This would be consistent with the treatment of original issue discount under Section 163(j)(2)(C)(ii).
in a similar manner does not seem unreasonable; and whatever rule applies, financed receivables should be given the same treatment. See the discussion of trade payables in (i) above.
and other financing businesses will inevitably fall out of the 1.5 to 1 debt to equity ratio, but at least where their principal income is interest they will be able to offset interest expense with interest income in determining net interest expense. Will this be sufficient? If the income of the finance company is not in the form of interest (e.g., is rental income), it may not be. Both Section 279 and the Section 385 Regulations would have excluded debt incurred in the ordinary course of a banking, lending or finance business and an equivalent amount of assets in determining debt to equity ratios.
Consideration should be given to “anti-stuffing” and other anti-abuse rules.
analogous “anti-stuffing” problem in the branch profits tax area* or under the now withdrawn Section 385 Regulations. ** Alternatively, it may be sufficient to prescribe, under Section 163(j)(2)(A)(ii), additional testing dates during the year to determine whether the corporation’s debt to equity ratio meets the safe harbor. For example, the debt to equity ratio might be based on an average of four quarterly ratios.
See Treas. Reg. §§ 1.884-1T(d)(13)(iii), (e)(3).
See withdrawn Prop. Reg. § 1.385-6(g)(5)(vi), stating that debt to equity ratios shall be computed without regard to distortions created by a temporary contribution to equity or any similar contrivance.
serve to allow the use of the subsidiary’s interest deduction.
The partnership would be related to the corporation only as set out in Section 267(b)(10), i.e., only if the same persons owned more than 50% in value of the paying corporation and more than 50% in the capital or profits interest of the partnership.
There are at least two problems in the application of Section 163(j) to “pass-thru entities” other than partnerships.
See the second sentence of Section 163(j)(5)(A) which provides that a rule similar to that in the first sentence of (A) will apply to determine whether interest is tax-exempt.
See House Report at 1246. Since an S corporation cannot have a tax-exempt shareholder, it should not be a “pass-thru entity” for the purposes of Section 163(j).
right to the payor) unless the interest of tax-exempt persons in the entity is 10% or more.
or a real estate investment trust are tax exempt and no amount of certification is likely to provide a solution.
There is a need for guidance on the effect of an acquisition of a corporation that has a carryforward of either of these items. For example, a corporation that is acquired may have an excess limitation for each of the three years preceding an acquisition of its stock by another corporation. The corporation will have to determine whether that excess can be used in determining the deductibility of the corporation’s interest expense and of the interest expense of other members of its new affiliated group.
There may also be a carryforward of interest that has been deferred (for example, by Section 163(e)) and not taken into account for purposes of Section 163(j).
Section 163(j) attributes in the absence of Regulations under, or possibly an amendment to, Section 381.
The resolution of these issues raises the same issues, and thus the same enormous complexity, that are involved in the treatment of net operating loss and other carryovers.
use those items in determining the deductibility of its own interest expense so long as there is no stuffing or other transaction that has the effect of allowing the deductions when they would not otherwise be allowed. Section 269 would apply to the use of disqualified interest carryforward, and disqualified interest would presumably be an item of built-in loss for purposes of Section 382; in the absence of Regulations, however, it is not clear that either Section 269 or Section 382 would prevent the use of an excess limitation carryover -- for example, leveraging up an acquired corporation that had an excess limitation carryover.
corporation is acquired in the usual Section 368(a)(2)(D) reorganization.
163(j) should be taken into account in determining the deductibility of interest expense of other members of an affiliated group of which the corporation becomes a member. A similar rule should apply where a corporation’s assets are acquired in a taxfree acquisition and the acquiring corporation has significant other assets; while in such a case it might be equally reasonable to apportion the allowance, any apportionment may be more complex than the problem would justify.
exempt from tax under a tax treaty.* Where interest is subject to a treaty- reduced rate of tax, it is regarded as tax exempt to the extent of the reduction -- for example, if the rate is reduced to 5%, as it would be in the case of a Swiss corporation, 25/30ths of the interest would be regarded as tax-exempt.
The legislative history indicates that interest is not to be regarded as tax-exempt if it “is currently included under section 951 in the gross income of a U.S. shareholder . . . .” ** This seems to us to provide an enormous opportunity for complexity, but if this rule is incorporated in Regulations at all, it should likewise apply (i) to interest that is subject to U.S. tax because included in income of a United States person under Section 551 or Section 1293*** or because it is considered to be included in dividends paid to a U.S. shareholder (using rules similar to those in Section 904(d)(3)) by a controlled foreign corporation, and (ii) to interest paid to a regulated investment company or real estate investment trust that is distributed by the recipient as a dividend if the dividend is subject to tax. The treaty reduction rule in Section 163(j)(5) would be applied to dividends paid by a regulated investment company or real estate investment trust.
Interest income of a private foundation would not be tax-exempt because the tax levied upon such foundations under Section 4948 is an excise tax imposed by subtitle D, not an income tax imposed by subtitle A.
Cf. Notice 89-84, 1989-31 I.R.B. 8 (July 31, 1989), relating to Section 163(e).
the year will be regarded as paid or accrued to a related person.
Section 163(j)(7)(C) authorizes regulations to coordinate the application of Section 163(j) with the branch tax imposed by Section 884.
Interest”. The fundamental problem with applying a limitation on deductibility of interest by a foreign corporation that is engaged in trade or business in the United States arises from the fact, illustrated below, that a foreign corporation’s interest deduction is based upon the assumption that all of its funds are “fungible”. In contrast, the limitation under Section 163(j), and similar rules, such as Section 163(e)(3), assume that interest can be traced to a particular liability.
As an alternative to use of an “actual ratio”, a foreign corporation can apply a “fixed ratio”, which is 95% for corporations involved in a banking, financing or similar business, and 50% for all other corporations.
interest deduction. * Thus, for example, assume that a foreign corporation has assets of $1000, $600 of which are used in its U.S. business, and has total liabilities of $500, which bear interest at 10%.** Assume further that $300 of the liabilities are owed to related foreign lenders, and that the remaining $200 of liabilities, from unrelated lenders, has been reflected on the books of FC’s U.S. business. Under Treas. Reg. § 1.882-5, the foreign corporation’s U.S. connected liabilities would be $300 (or $500/$1000 times $600), and its U.S. interest expense, before the application of Section 163(j), would be $30.
In general, an average interest rate is determined each year for the liabilities “shown on the books of the U.S. trade or business” for that year (the “average U.S. connected interest rate”), and that rate is applied to the “U.S. connected liabilities”. However, if (i) the “U.S. connected liabilities” exceed the liabilities shown on such books, and (ii) the foreign corporation has more than a de minimis amount of U.S. dollar liabilities on the books of its offices and branches outside the U.S., then (iii) an average interest rate is determined for such other U.S. dollar liabilities (or, in lieu thereof, a reasonable approximation may be used, e.g., with reference to LIBOR for an appropriate maturity), and (iv) the average U.S. connected rate is applied to the liabilities shown on the books and the rate described in (iii) is applied to the excess “U.S. connected liabilities”.
In this example, for the sake of simplicity, all figures are expressed in U.S. dollars and the effective interest rate is assumed to be the same on all of FC’s liabilities.
There appear to be at least three ways to apply a liability-specific interest disallowance rule to a foreign corporation doing business in the United States. These methods are described briefly below in order to contrast their effects.
One approach (resulting in maximum disallowance) would be to disallow all deductions for interest paid or incurred on indebtedness included in the disallowed category. Assume in the preceding example that the related foreign lenders are not subject to any U.S. tax on the interest because they are “qualified residents” of a relevant treaty country.* The maximum disallowance method would treat all $300 of the foreign corporation’s U.S. connected liabilities as related-party debt (causing all $30 of its U.S. interest expense to be subject to the Section 163(j) limitation).
i.e., 60% of $300*), would be subject to disallowance under Section 163(j).
60% equals $300/$500 x 100%.
See Section 163(j)(7)(C). See House Report at 1248, stating that “. . . the determination . . . of disqualified interest . . . and net interest expense would take into account only . . . deductions allocable” to the U.S. business.
In the example above, interest on $200 of the foreign corporation’s liabilities might be considered to have been paid by the FC’s U.S. trade or business since $200 of liabilities was reflected on its books. Since none of the $200 is debt to related foreign persons, interest on the $200 (or $20) would not be subject to the Section 163 (j) limitation. However, the foreign corporation also has “excess interest” for the purposes of Section 884(f)(1)(B) (i.e., “Section 884(f)(1)(B) excess interest”) since its deductible interest ($30) exceeds the $20 of interest it is considered to have paid. There is the further question, therefore, of whether some or all of the foreign corporation’s excess interest of $10 is subject to the Section 163(j) limitation.
Treatment of Section 884(f)(1)(B) Excess Interest.
The Temporary Regulations also include disallowed interest, including capitalized interest, in this calculation.
See New York State Bar Association Tax Section, Report on Temporary Branch Profits Tax Regulations (Dec. 8, 1988), reprinted in Tax Notes Today (Dec. 12, 1988)(the “Branch Profits Tax Report”) at 39-41.
There is some potential circularity inherent in the computation of excess interest and the application of the various interest-disallowance rules. To avoid such circularity, it appears that the amount of the interest deduction available to a foreign corporation must initially be computed without regard to the disallowance rules.
See Sections 163(j)(4)(A), 267(b)(3) and 267(f).
A treaty could also provide a reduced rate of tax on the excess interest. See Temp. Reg. § 1.884-4T(c)(3)(i).
borrowing by the foreign corporation, such as bank deposits. * The Temporary Regulations issued under Section 884 do not follow this suggestion, presumably for reasons of simplicity and administrative convenience. Notice 89-80, 1989-30 I.R.B. 10, indicates, however, that at least in the case of bank deposits, the final Regulations will ignore the fictional subsidiary-to-parent characterization of the interest payment and will instead give effect to the actual borrowings of the foreign corporation and any exemptions from tax that may apply thereto.
See discussion in Branch Profits Tax Report at 34-35.
In the example, this would be the case if none of the $500 of liabilities were to related parties, and the $10 of excess interest were treated as paid to a hypothetical parent.
interest rules, the bank deposit rules, the effectively connected rules, all relevant treaties, and any other possible exemptions. By contrast, identification for Section 163(j) purposes merely requires that a foreign corporation determine which of its non-U.S. trade or business liabilities are owed to unrelated persons, a relatively simple determination.
Although ambiguous, the legislative history to Section 163(j) seems to support the view that the Section 884(f)(1)(B) excess interest should be allocated to specific liabilities for purposes of applying Section 163(j).* In order to prevent abuse by taxpayers, however, rather than permitting the foreign corporation to specifically allocate the excess interest to non-U.S. trade or business liabilities owed to unrelated persons, the regulations should require a proration of the non-U.S. trade or business liabilities.
As an illustration, assume that the foreign corporation in the example above is a United Kingdom company and, therefore, its $10 of Section 884(f)(1)(B) excess interest qualifies. for a treaty exemption from U.S. tax. Since all $300 of non-U.S. trade or business liabilities are owed to related foreign persons, the full $10 could be treated as disqualified interest subject to Section 163(j). If, however, only $150 of the non-U.S. trade or business liabilities were owed to related foreign persons, only $5 ($10 x 150/300) of the Section 884(f)(1)(B) excess interest should be treated as disqualified interest subject to Section 163 (j). Furthermore, if no portion of the $300 of liabilities were owed to related foreign persons, no portion of the $10 of excess interest should be treated as disqualified interest.
The House Report at 1248 states that Regulations shall treat the tax on excess interest under Section 884(f)(1)(B) as imposed on the “recipient” and require that the exempt status of the interest recipient be determined prior to the application of the deduction disallowance rules.
deduction allowed under Treas. Reg. § 1.882-5 is less than interest deemed paid under the branch profits tax regulations, there is an “interest shortfall”. Any such shortfall is, under the Temporary Regulations, used to reduce the amount of interest considered paid by a U.S. trade or business, in the order set forth in Temp. Reg. § 1.884-4T(b)(6).* Presumably, the same rule would be applied for purposes of the Section 163(j) limitation; however, serious consideration should be given to the recommendation in the Branch Profits Tax Report, at 42-44, that, rather than adjusting the interest considered paid by the foreign corporation’s U.S. business, there should be a carryover of the interest shortfall.
Accrual vs. Payment Dates. The rules under Treas.
Reg. § 1.882-5 generally take into account the foreign corporation’s method of accounting for interest. A separate determination must be made under Section 163(j), however, concerning when the relationship between the borrower and the lender is to be determined.
Corporation. If interest expense of a foreign corporation is disallowed under Section 163(j), the excess is treated as disallowed interest paid in the next succeeding year.
Under the branch profits tax Regulations, disallowed interest is also included in this calculation.
or business under Section 884(f)(1)(A)] in the year the interest was paid or incurred”.* This is clearly correct. For similar reasons, however, it would be incorrect to suggest from this language in the legislative history that carryovers of disqualified interest that were treated as “excess interest” under Section 884(f)(1)(B) may again be tested under the substantive Section 884(f)(1)(B) rules. This should be clarified in the regulations.
See House Report at 1248-49.
Section 7210(b)(2) of the 1989 Act similarly provides that in the case of any demand loan, or other loan without a fixed term, which was outstanding on July 10, 1989, interest on such loan, to the extent attributable to periods before September 1, 1989, shall not be treated as disqualified interest for purposes of Section 163(j).
limitation.* Similarly, in determining whether any Section 884(f)(1)(B) excess interest is attributable to excluded indebtedness, the same identification rules that apply for purposes of the general Section 163(j) limitation should apply here as well.
a tax equal to 30% of the “dividend equivalent amount” of a foreign corporation. The term “dividend equivalent amount” is defined as the foreign corporation’s effectively connected earnings and profits for a taxable year, as adjusted for certain increases and decreases in its “U.S. net equity”. The legislative history** to the 1989 Act indicates that only income that is effectively connected with a U.S. trade or business, and deductions allocable thereto, are to be taken into account in determining the Section 163(j) limitation. This seems clearly correct.
The amount of any such excluded interest may depend upon either the actual interest rate on the debt or, perhaps, on any averaging convention used for purposes of Section 884(f)(1)(A) and/or Section 163(j).
special adjustment to U.S. net equity appears to be required. Alternatively, if a current earnings and profits reduction is not permitted, it would appear that, in order to give effect to Congress’ intent, an upward adjustment in U.S. net equity over what it would otherwise have been will be required for interest that is disallowed under Section 163(j), with such adjustment presumably to be reversed when the deduction is allowed. Under this alternative view, unless there were to be such an upward adjustment, U.S. net equity would generally reflect a decrease for the disallowed interest automatically either as reduction in U.S. assets or as an increase in U.S. liabilities. Under this alternative view, an amendment to the Section 884 regulations would be required to reflect this special adjustment to U.S. net equity.
If the full $200 of interest expense reduces earnings and profits (and, thus, effectively connected earnings and profits), there is no need to adjust the U.S. net equity in order to avoid a branch profits tax. This is because the dividend equivalent amount will be 0 (negative $100 effectively connected earnings and profits for the year plus $100 decrease in U.S. net equity).
If, however, a reduction in earnings and profits is permitted for only $50 of the interest expense, the foreign corporation will have current year effectively connected earnings and profits of $50. In order to avoid an inappropriate branch profits tax on this $50, as well as on $100 of previously accumulated effectively connected earnings and profits (on account of the $100 reduction in U.S. net equity), the $150 of disallowed interest expense should be treated as a U.S. asset. Then, rather than being reduced by $100, the U.S. net equity would be considered to have been increased by $50.
For ease of illustration, this example ignores income taxes.
See House Report at 1246, stating that, “Under current law, back-to-back loans that have no substance are collapsed. See Rev. Rul. 84-152, 1984-2 C.B. 381, Rev. Rul. 84-153, 1984-2 C.B. 383, and Rev. Rul. 87-89, 1987-2 C.B. 195. The bill directs the Secretary to issue such regulations as may be appropriate to prevent the avoidance of the purposes of the bill. The committee intends that such regulations will treat back-to- back loans through third parties (whether related or unrelated), as well as similar arrangements, like direct loans to related parties.
One approach that the Regulations might take with respect to back-to-back loans would be to say nothing -- in other words, to leave the matter to the published rulings, which would presumably apply for the purposes of Section 163(j) as well as for the purposes stated therein. Because the rulings in this area do not apply consistent criteria, we think it might be better for regulations to specifically address the treatment of back-to-back loans but, as noted below, we believe any such project should consider developing a single formulation of back-to-back loan rules for purposes both of Section 163(j) and for the purposes of determining whether the interest is subject to withholding tax.
In Rev. Rul. 84-152, 1984-2 C.B. 381, a Swiss parent with a U.S. and an Antilles subsidiary loaned funds to its Antilles subsidiary at an annual interest rate of 10 percent and the Antilles subsidiary in turn loaned the funds at an 11 percent rate to the U.S. subsidiary, which required a significant increase in working capital. The Antilles subsidiary was not sufficiently liquid to make the loan to the U.S. subsidiary without the funds from the Swiss parent. Similarly, in Rev. Rul. 84-153, 1984-2 C.B. 383, an Antilles subsidiary of a U.S. parent issued bonds to foreign persons in public offerings and loaned the proceeds (at a rate of interest one percentage point higher than the rate payable on the bonds) to a U.S. subsidiary of its U.S. parent, which required funds for working capital. The U.S. subsidiary made timely interest payments to the Antilles subsidiary who in turn made timely interest payments to the bondholders.
In the first situation, a foreign corporation organized in a country that does not have an income tax treaty with the United States deposited 100x dollars as a demand deposit in an unrelated foreign bank organized and engaged in business in a country with an income tax treaty with the United States under the terms of which interest paid by a U.S. person to a resident of that country is exempt from U.S. income tax. The foreign bank loaned 80x dollars to the foreign corporation's U.S. subsidiary for expanding its business. The difference between the interest paid by the bank and that it charged to the U.S. corporation was less than one percent. This interest rate would have been different absent the foreign corporation's deposit. The second situation in the ruling was the same as the first except that the entity in which the foreign corporation deposited funds was not a bank and was organized in the same country as the foreign corporation and the deposit was in the nature of a long-term, short-term, or demand loan. In the third situation, a foreign subsidiary of a U.S. operating company deposited 100x dollars as a demand deposit in an unrelated foreign bank organized and engaged in business in a country with an income tax treaty with the United States under the terms of which interest paid by a U.S. person to a resident of that country is exempt from U.S. income tax. The bank loaned 8 Ox dollars to the U.S. parent for use in expanding its business. The difference between the interest paid by the bank and that it charged to the U.S. corporation was less than one percent. This interest rate would have been different absent the foreign corporation's deposit.
determination of whether a deposit with a bank or a loan to an unrelated party should be collapsed with a loan by the bank or unrelated party to an affiliate of the depositing or lending corporation (and treated as a loan between the affiliated corporations) was based upon whether the deposit and loan are “independent transactions” which would be the case if the loan from the bank “would be made or maintained on the same terms irrespective of” the deposit.
rulings with respect to back-to-back loans involve a number of difficult issues, including, for example, why there should be such a sharp distinction drawn between back-to-back loans and related party guarantees. Since the use of the back-to-back rulings for purposes of Section 163(j) is specifically endorsed by the legislative history, it can be argued that these issues are irrelevant under that Section of the Code, but we think the better view is that these issues should be addressed if Regulations are issued and that there should be a single formulation of the backto-back loan rule for both Section 163 (j) and withholding tax purposes.
By way of illustration, if a foreign parent (P) deposits money in a U.S. bank and the bank loans money to P’s U.S. subsidiary, the application of Section 163(j) requires a determination of whether the interest will for purposes of that Section be treated as paid to P and of whether the interest will be subject to U.S. withholding tax under Section 882 and 1442. We do not see how the two issues can sensibly be dealt with separately.
subject generally and any Regulations should initially be issued in proposed form with an opportunity for comment.
If our recommendation that Regulations deal generally with back-to-back loans is not adopted, we have the following suggestions with respect to what Regulations might say with respect to back-to-back loans under Section 163(j).
Of the rulings cited in the legislative history, we believe that the more specific standard of Rev. Rul. 87-89 is preferable. We note, however, that its test (whether the loan would not have been made or maintained but for the deposit or other backup loan) is much easier to state than to apply and that it would therefore be useful for Regulations to set out the criteria that might be regarded as evidencing that fact. In addition, in order to avoid the application of Rev. Rul. 87-89 to normal banking relationships, we think that there should be modifications to this rule to exclude, for example, a case where the loan that backs up the loan to the U.S. corporation is a bank deposit and is relatively small in comparison to the loan.
As suggested by Rev. Rul. 87-89, the presence of a contractual or legal right of offset should constitute presumptive evidence that the loan would not have been made on the same basis without the deposit. This should not be conclusive, however, since in complex banking relationships the presence of a right of offset may not necessarily establish that the loan would not have been made without the deposit.
Assuming that the rates or terms on the loan to the U.S. subsidiary are different as a result of the foreign parent making a loan to the accommodation party, interest payments should be subject to Section 163 (j) and the above standard should apply to these loans.
See Rev. Rul. 84-153, cited in the legislative history.
The legislative history of Section 163(j) provides that the Internal Revenue Service may require statements from foreign controlled U.S. corporations to the effect that interest is not paid pursuant to back-to-back loan or like arrangements. Claiming a deduction for interest is in effect such a statement,** and we do not see the need for anything more.
More troubling than back-to-back loans is the proper treatment of guarantees and similar credit enhancements which, we believe, persent issues quite different than those presented by back-to-back loans. While we have set out below issues that need to be addressed if Regulations with respect to guarantees are issued, we believe there are significant arguments for not issuing such Regulations.
See House Report at 1245.
In addition, reporting of transactions with related foreign persons is required by Section 6038A.
difficult to formulate sensible rules for applying the section to guaranteed loans that are not recharacterized as loans from the guarantor for all federal income tax purposes.
guaranteed debt that is treated as equity under Plantation Patterns* and like cases is, wholly apart from Section 163(j), not deductible, and we see no need to say anything in Regulations under Section 163(j) about guaranteed debt that is already treated as equity. These cases, however, have treated guaranteed debt as equity only in the most extreme cases and provide little protection against the use of guarantees as a substitute for direct loans from a related party.
See Plantation Patterns, Inc. v. Comm’r, 462 F.2d 712, 721 (5th Cir. 1972), cert, denied, 409 U.S. 1076 (1972), in which a corporation with a debt to equity ratio of 30 to 1 borrowed funds with guarantees from its individual shareholder and his controlled investment corporation; after such borrowings, the borrowing corporation’s debt to equity ratio was approximately 150 to 1. The court held that the loan was to be treated as made to the shareholder who in turn contributed the proceeds to the corporation.
The statement construes the Treasury’s authority under Section 163(j)(7)(A) to issue such regulations “as may be appropriate to prevent the avoidance of the purposes of” Section 163(j) -- in other words, to treat interest on guaranteed debt as paid to a related party only when the guaranteed debt was incurred to avoid Section 163(j).
Since the authority to issue Regulations on guaranteed third-party debt is in Section 163(j)(7)(A), it follows that the first step is to determine the purpose of Section 163(j). Section 163(j)(7)(A) only authorizes regulations “to prevent the avoidance of the purposes of” Section 163(j). This is not a simple inquiry.
The deductibility of interest under Section 163 (j) turns on whether the interest is tax-exempt to the recipient. The purpose of the guarantee rule, therefore, might have been to disallow interest deductions where (a) the interest was not subject to U.S. tax in the hands of the recipient or (b) the interest would not have been taxed if paid to the guarantor.
Both views have their problems and we make no recommendation as to which should be followed.
between guaranteed debt from U.S. and foreign lenders and have the peculiar consequence of discriminating against unrelated lenders that are covered by U.S. tax treaties.
Under the second view (the “tax-exempt guarantor” approach), interest would be subject to Section 163(j) if it would have been tax-exempt had it been paid to the guarantor. As a consequence, for example, interest paid to a U.S. bank might be subject to Section 163(j) if the loan were guaranteed by a U.K. parent but not if it were guaranteed by a Saudi Arabian parent. In each case the interest would have been subject to U.S. tax in the hands of the bank, but in the first it may also be non-deductible by the issuer because the guarantor is covered by a tax treaty that eliminates withholding on interest that is not portfolio interest. Although the same rule would apply to debt guaranteed by a U.S. tax-exempt investor, thus avoiding any treaty violation, the result is likely to be regarded by U.S. treaty partners as absurd.
Under tax exempt guarantor approach, it would also be necessary to deal with the common practice of multiple, or “cross”, guarantees –- e g., to determine how the rule would apply if there were two guarantors and the interest that would be paid to one was exempt but the interest that would be paid to the other was not.
may be far higher than any revenue gains that will be produced by Section 163(j).
We are aware that a number of foreign countries have rules that apply different, more stringent rules to the deductibility interest on debt held by foreign shareholders and that some take the view that these rules do not violate tax treaties with the United States. This may suggest that the long run solution to some of the difficulties outlined above would be to develop a standardized treaty approach to the treatment of shareholder debt, including shareholder- guaranteed debt.
When a choice has been made between these two approaches, the next step is to determine when guaranteed debt will be subject to Section 163 (j) and when it is not since, as noted at the outset, the Statement of Managers does not authorize regulations that treat all guaranteed debt as subject to Section 163(j) and specifically indicates that a guarantee given in the ordinary course to reduce interest rates will not be so regarded.
What is needed, if Regulations on guaranteed debt are issued, is a clear line since in the absence of certainty borrowers may be forced to do what Congress sought to avoid, i.e., borrow without a guarantee at a higher rate in order to be certain of deductibility. This is an issue that Congress did not come to grips with and as a consequence the legislative history provides no guidance whatsoever on how that line should be drawn.
and, in addition, to try to establish presumptions and safe harbors using objective criteria such as the corporation’s debt to equity ratio at the time of borrowing, its projected earnings to interest coverage, other factors that would be regarded as important by unrelated lenders, the presence or absence (and the amount) of unguaranteed third-party debt and other objective indications of the corporation’s ability or inability to borrow on an unguaranteed basis. Objective criteria should obviously be developed only with the assistance of banks and other members of the financial community.
Thus, for example, Regulations might specify that interest on guaranteed debt would not be subject to Section 163(j) if the issuer could have borrowed the same amount without the guarantee, albeit at a higher interest rate and with more onerous financial covenants; and that it would always be regarded as meeting that test if the issuer had a specified debt to equity ratio and projected a specified earnings to interest coverage or had an amount of unguaranteed third-party debt that was significant in relation to its guaranteed debt or was otherwise able to show (for example, by credible third-party evidence) that the principal function of the guarantee was to reduce the interest rate and that substantially the same amount could have been borrowed on substantially the same terms (albeit at a different interest rate) without a guarantee. Conversely, Regulations might specify that guaranteed debt would presumptively be subject to Section 163(j) if the issuer had a debt to equity ratio and/or projected an earnings to interest coverage that fell below stated ratios and there was no other objective evidence to show that the borrowing could not have been made without the guarantee.
(e.g., the extent to which it will include a pledge of the assets or stock of another corporation) and back-to-back guarantees.
Section 163(j) to guaranteed debt should, as indicated in the legislative history,* apply only to debt issued after the date the Regulations are issued. Until that time, Plantation Patterns will be the only relevant rule. In view of the substantial uncertainty as to what Congress contemplated and the importance of clear and certain rules, moreover, we believe that any such Regulations should be issued in proposed form in the first instance.
interest paid or accrued in taxable years beginning after July 10, 1989, but Section 163(j)(3)(B) provides that the term “disqualified interest” excludes interest paid or accrued on fixed-term debt “issued” on or before July 10, 1989, or issued after such date pursuant to a written, binding contract in effect on that date and all times thereafter.
Statement of Managers at 567.
if an unrelated third party could enforce the debtor’s obligation to repay the related lender.
General guidance with respect to the “binding contract” rules in the 1989 Act is given in Notice 90-6,* including that an otherwise binding contract will not be regarded as not binding because “it is subject to a condition outside the control of the parties”. We interpret this to mean that a written contract to issue debt will not be considered unenforceable merely because laws respecting creditors’ rights and bankruptcy may limit such enforceability.
states that “debt instruments that are renegotiated, assumed, reissued, extended, modified, or otherwise revised after July 10, 1989, shall be treated . . . as new debt instruments that were not outstanding on July 10, 1989”.* Legal precedents developed under Section 1001 contain analogous tests for distinguishing taxable exchanges of debt from mere modifications of a debt instrument.** With the qualification set out below, we suggest that the rules applied under Section 163(j) be conformed to the rules applicable under Section 1001.
See House Report at 1249.
See Rev. Rul. 73-160, 1973-1 C.B. 365; Rev. Rul. 56 435, 1956-2 C.B. 506, mod. by Rev. Rul. 81-169, 1981-1 B. 429; Rev. Rul. 87-19, 1987-1 C.B. 249; Rev. Rul. 89-122, 1989-47 I.R.B. 6 (Nov. 20, 1989).
is shortened, or if the interest rate thereon is reduced, the debt should not be treated as modified for purposes of these rules, assuming no other offsetting changes.
See House Report at 1250.
Report "New York State Bar Association"

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