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Charles Culmer, I.R.S. Alexa Dubert, I.R.S. Helen Hubbard, I.R.S. Michael Bauer, PwC Jeff Borghino, Grant Thornton LLP
▪ All Events Test under section 451(b)
▪ Business Interest under “new” section 163(j)
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Agenda
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Section 451(b)
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▪ Section 61 provides that gross income means all income from whatever source derived unless excluded by law. Treas. Reg. §1.61-1(a).
▪ Once it is determined that an item of gross income is clearly realized, section 451 and the regulations thereunder provide the general rules as to the timing of when such item is to be included in gross income. Treas. Reg. § 1.61-1(b)(3).
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Section 451(b) - Background
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▪ An accrual basis taxpayer includes an item in gross income when:
(i) all the events have occurred that fix the right to receive such income and the amount thereof can be determined with reasonable accuracy unless an exception permits its deferral or exclusion; or
(ii) a special method of accounting applies. Treas. Reg. §§ 1.446-1(c)(1)(ii) and 1.451-1(a).
▪ "Special methods of accounting are described elsewhere in chapter 1 of the Code and the regulations." Treas. Reg. § 1.446-1(c)(1)(iii).
E.g., section 453, relating to the installment method. Treas. Reg. §1.446-1(c)(1)(iii).
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Section 451(b) - Background
▪ For accrual taxpayers, the TCJA modified section 451 so that the all events test is met no later than the taxable year in which the item is taken into account as revenue in a taxpayer's "applicable financial statement." Section 451(b)(1)(A).
▪ Section 451(b)(1)(B) provides exceptions for: (i) taxpayers with no applicable financial statement (unless specified by the IRS and Treasury in published guidance); and (ii) any item of gross income in connection with mortgage servicing rights.
▪ Section 451(b)(1) does not apply with respect to any item of gross income for which the taxpayer uses a special method of accounting provided under any other provision of this chapter [chapter 1], other than any provision of part V of subchapter P (except with regard to a mortgage servicing contract under the exception). Section 451(b)(2).
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Section 451(b) – TCJA
Part V of subchapter P includes sections 1271 through 1288:
– OID (sections 1271 – 1275);
– de-minimis OID (Treas. Reg. § 1.1273-1(d)(5));
– market discount (sections 1276 - 1278);
– discount on short-term obligations (sections 1281 – 1283); and
– stripped bonds (section 1286).
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Section 451(b) – TCJA
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▪ The provision directs accrual method taxpayers with an applicable financial statement to apply the income recognition rules under section 451 before applying the special rules under part V of subchapter P. Joint Explanatory Statement of the Committee of Conference (p. 276).
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Section 451(b) – Legislative History
Joint Explanatory Statement of the Committee of Conference, Footnote 872:
▪ "The provision does not revise the rules associated with when an item is realized for Federal income tax purposes and, accordingly, does not require the recognition of income in situations where the Federal income tax realization event has not yet occurred.
▪ For example, the provision does not require the recharacterization of a transaction from sale to lease, or vice versa, to conform to how the transaction is reported in the taxpayer's applicable financial statement.
▪ Similarly, the provision does not require the recognition of gain or loss from securities that are marked to market for financial reporting purposes if the gain or loss from such investments is not realized for Federal income tax purposes until such time that the taxpayer sells or otherwise disposes of the investment.
▪ As a further example, income from investments in corporations or partnerships that are accounted for under the equity method for financial reporting purposes will not result in the recognition of income for Federal income tax purposes until such time that the Federal income tax realization even[t] has occurred (e.g., when the taxpayer receives a dividend from the corporation in which it owns less than a controlling interest or when the taxpayer receives its allocable share of income, deductions, gains, and losses on its Schedule K-1 from the partnership)."
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Section 451(b) – Legislative History
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Joint Explanatory Statement of the Committee of Conference, Footnote 874:
▪ "The Committee intends that the provision apply to items of gross income for which the timing of income inclusion is determined using the all events test under present law.
▪ Under the provision, an accrual method taxpayer with an applicable financial statement will include an item in income under section 451 upon the earlier of when the all events test is met or when the taxpayer includes such item in revenue in an applicable financial statement.
▪ However, accrual method taxpayers without an applicable or other specified financial statement will continue to determine income inclusion under the all events test, unless an exception permits deferral or exclusion.
▪ The Committee intends that the financial statement conformity requirement added to section 451 not be construed as preventing the special methods of accounting provided elsewhere in the Code, other than part V of subchapter P (special rules of bonds and other debt instruments) excluding items of gross income in connection with a mortgage servicing contract. For example, it does not preclude the use of the installment method under section 453 or the use of long-term contract methods under section 460."
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Section 451(b) – Legislative History
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Compare TCJA with Camp Proposal
Tax Cuts and Jobs Act
• Applies to an item that is taken into account as revenue
• Includes exception for special methods other than part V of subchapter P
• Includes exception for gross income in connection with a mortgage servicing contract
Camp Proposal
• Would have applied to any item of income
• No exception for special methods
• No exception for mortgage servicing contracts
• Current inclusion of market discount in gross income
• Ordinary loss for ordinary inclusion amount
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▪ Revenues are inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute that entity’s ongoing major or central operations.
▪ Examples of assets increased by revenues include: cash, claims against customers or clients, other goods or services received, or increased value of a product resulting from production.
▪ Examples of revenues include: output, deliveries, sales, fees, interest, dividends, royalties, and rent.
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Statement of Financial Accounting Concepts No. 678. Revenue
▪ Gains are increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from revenues or investments by owners.
▪ Several kinds described or classified in a variety of ways:– Net proceeds over costs: sales of investments in marketable securities, disposition of
used equipment, or settlements of liabilities at other than their carrying amount.
– Non-reciprocal transfers: gifts or donations.
– Change of value in assets or liabilities.
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Statement of Financial Accounting Concepts No. 682. Gains
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Statement of Financial Accounting Concepts No. 687. Revenues, Expenses, Gains, and Losses
Revenues
• Result from an entity's ongoing major or central operations and activities.
• From activities such as producing or delivering goods, rendering services, lending, insuring, investing, and financing.
• Commonly displayed as gross inflows of net assets.
Gains
• Result from incidental or peripheral transactions of an enterprise with other entities and other events and circumstances.
• "Operating" gains may be closely related to revenues.
• Usually displayed as net inflows.
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▪ What is a special method?
– Special methods of accounting are described elsewhere. Treas. Reg. §1.446-1(c)(1)(iii).
– Compare Treas. Reg. §§ 1.446-2, 1.446-3, 1.446-4.
▪ Does section 451(b) affect the application of Rev. Rul. 80-361 to interest accrued under Treas. Reg. § 1.446-2?
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Section 451(b) – Clarifying Questions
▪ What are the special methods provided under part V of subchapter P?
– OID accruals under sections 1272 through 1275?
– De minimis OID under section 1273?
– Market discount under section 1276?
• Section 1276(a)(1) – "gain on the disposition of any market discount bond shall be treated as ordinary income"
• Section 1276(a)(3) – "any partial principal payment on a market discount bond shall be included in gross income as ordinary income"
• Section 1278(b)(1) – "if the taxpayer makes an election…market discount on any market discount bond shall be included in the gross income of the taxpayer"
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Section 451(b) – Scope
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▪ How does ordering apply in the event that "tax" OID and GAAP OID are different amounts?
▪ Should an inclusion under section 451(b) affect the following:
– change in the yield of the debt instrument for the OID rules?
– increase in the adjusted issue price of the debt instrument?
– increase in the tax basis of the holder?
– reporting requirement to the issuer (e.g., Form 1099-OID/INT)?
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Section 451(b) – Application Issues
▪ Assume a taxpayer holds a debt instrument with the following:
– $100 stated principal
– $70 adjusted basis
– $30 of market discount
▪ On the last day of the year, the taxpayer receives a partial payment of principal of $5.
▪ For the year, section 451(b) requires $5 to be included in gross income and there is accrued market discount of $3.
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Section 451(b) – Hypothetical
Section 163(j)
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Snapshot – “Old” Section 163(j) v. “New” Section 163(j)
Provision "Old" Section 163(j) "New" Section 163(j)
Limitation on Deductibility of
Interest Expense
If a taxpayer's debt-to-equity ratio exceeds 1.5 to 1, certain related party interest payments are disallowed to the extent
of the taxpayer's excess interest expense (e.g., amount by which net interest expense exceeds 50% of adjusted taxable income
("ATI")).
Deduction for interest expense attributable to a trade or business limited to the sum of (1)
business interest income; (2) 30% of ATI; and (3) floor plan financing interest. ATI is defined (i) roughly
equivalent to EBIDTA for tax years beginning before January 1, 2022; and (ii) roughly equivalent to EBIT
(i.e., the addback for depreciation, amortization, and depletion is removed) for tax years beginning after
January 1, 2022
Type of Debt Applies to certain related party debt only. Applies to related and third-party debt.
CarryforwardsDisallowed interest expense can be carried forward indefinitely and
excess limitation (e.g., excess of 50% of ATI over net interest expense) can be carried forward for 3 years.
Disallowed business interest can be carried forward indefinitely.
“New” Section 163(j) – the basics:
▪ Net ‘Business’ Interest Expense limited to 30% of ATI: Limits deduction for business
interest expense to sum of business interest income plus 30% of the ‘adjusted taxable
income’ (ATI) of a taxpayer for the tax year (plus floor plan financing interest expense –
discussed later).
– Unlike “old” section 163(j), applies equally to related party and third-party interest
expense
▪ Unlike fine wine… it gets worse with time: Adjusted taxable income is defined similar to
EBITDA for tax years beginning after 2017 and before 2022, and similar to EBIT (computed
without regard to any deduction for depreciation, amortization, or depletion, and without
regard to section 199) for tax years beginning after 2021.
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Interest expense limitation
“New” Section 163(j) – the basics (con’d):
▪ Unlimited Carryforward: Similar to “old” section 163(j), allows disallowed interest
deductions to be carried forward indefinitely (but no “excess limitation carryforward”).
– No guidance on carryforwards from old section 163(j).
▪ Applied at Consolidated Group Level?
– Does not indicate whether the limitation applies to the consolidated group as a single
taxpayer.
– Informal guidance (as well as the Conference Report) suggest it will be applied at the
consolidated group level.
▪ BEAT Overlap
– For purposes of applying BEAT, interest deductions disallowed under section 163(j) are
treated as first allocable to interest paid or accrued on debt issued to third-parties.
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Interest expense limitation
Computation of Adjusted Taxable Income:
(A) computed without regard to
(i) any item of income, gain, deduction, or loss which is not properly allocable to a trade or
business,
(ii) any business interest or business interest income,
(ii) the amount of any net operating loss deduction under section 172
(iv) the amount of any deduction allowed under section 199A [qualified business income of pass-
through entities], and
(v) in the case of taxable years beginning before January 1, 2022, any deduction allowable for
depreciation, amortization, or depletion, and
(B) Computed with such other adjustments as provided by the Secretary.
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Interest expense limitation – Adjusted Taxable Income
Exemptions:
▪ Exemptions from new section 163(j):
– Types of interest expense:
• Interest paid or accrued on floor plan financing interest (i.e., interest paid/accrued on
purchase of certain motor vehicles held for sale/lease);
• Investment Interest
– Query how to allocate interest between business interest and investment interest.
– Types of taxpayers
• Certain small businesses with average gross receipts less than $25 million;
• Employee services businesses;
– E.g., lawyers and accountants
• Certain regulated utilities; and
• Electing real property and farming businesses
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Interest expense limitation – Exceptions/Limitations
At the partnership level:
• In the case of a partnership and S corporation, section 163(j) is applied at the entity level
• At the passthrough level: Any deduction for business interest is taken into account in determining the non-separately stated income or loss of the entity
- The passthrough determines its ATI
- The passthrough may deduct business interest in an amount up to 30% of its ATI against non-separately stated income
- The passthrough may also deduct any non-business (e.g., investment) interest
- Disallowed interest expense is retained at the S corporation while partnerships allocate disallowed interest expense to their partners
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Interest expense limitation – Passthrough Entities
At the partner level:
• ATI of each partner is determined without regard to the partner’s distributive share of the partnership’s items of income, gain, deduction or loss; and
• Each partner’s ATI is increased by its distributive share of the partnership’s ‘excess taxable income,’ which is a percentage of partnership ATI equal to unused limitation/total limitation
• Excess taxable income represents excess capacity of the partnership (e.g., based on its ATI, it could have deducted more interest expense). This “asset” flows up to the partners.
• A partner’s distributive share of excess taxable income is equal to its share of non-separately stated income
- Non-separately stated income is the ‘Ordinary business income or loss’ reflected on Form 1065 (US Return of Partnership Income) (see Box 1 of Schedule K-1 (Form 1065))
• A partner can use its share of the partnership’s ‘excess taxable income’ to offset the partner’s business interest at the partner level (including carryforwards)
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Interest expense limitation – Passthrough Entities
Basis adjustment and carryforward by partner
• To the extent interest is not deductible at the partnership level, the carryforward (‘excess business interest’) is at the partner level
• The interest expense carryforward may only be offset by the partner’s share of ‘excess taxable income’ of the partnership in the next taxable year (not business income from other sources)
• Consider a corporation that is a partner in two partnerships. The corporate partner cannot use ETI from one partnership to deduct excess business interest from another partnership.
• Each partner’s outside basis is reduced by its share of disallowed interest expense (i.e., basis is not available to support distributions), but basis is restored upon transfer of the interest in a taxable or non-taxable transaction
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Interest expense limitation – Passthrough Entities
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Interest expense limitation – Passthrough Entities
Example 1:
• Pship has business income
• P has net interest expense
• All of Pship business income should flow through to P as excess taxable income
• Excess taxable income is included in P’s ATI calculation
• If Pship has interest income, does that flow through as a separately stated item that P can net against itsinterest expense? Pship
Interest Expense
Business Income
P
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Interest expense limitation – Passthrough Entities
Interest Expense
Business Income
Example 2:
• Pship has interest expense
• P has business income
• Assume no deduction at P
• Interest expense is treated as being incurred by P in next taxable year
• P reduces basis in Pship
• P may use the expense carried forward only against future excess taxable income of Pship
P
Pship
