# Limitation on Deduction for Business Interest Expense; Allocation of Interest Expense by Passthrough Entities; Dividends Paid by Regulated Investment Companies; Application of Limitation on Deduction for Business Interest Expense to United States Shareholders of Controlled Foreign Corporations and to Foreign Persons With Effectively Connected Income

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URL: https://www.frixlaw.com/law-library/documents/fr%3A2020-16532

## Record

- **Collection:** Federal Register
- **Document type:** Proposed Rule
- **Published:** September 14, 2020
- **Citation:** 85 FR 56846

## Text

DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-107911-18]
RIN 1545-BP73
Limitation on Deduction for Business Interest Expense; Allocation of Interest Expense by Passthrough Entities; Dividends Paid by Regulated Investment Companies; Application of Limitation on Deduction for Business Interest Expense to United States Shareholders of Controlled Foreign Corporations and to Foreign Persons With Effectively Connected Income

AGENCY:

Internal Revenue Service (IRS), Treasury.

ACTION:

Notice of proposed rulemaking.

SUMMARY:

This notice of proposed rulemaking provides rules concerning the limitation on the deduction for business interest expense after amendment of the Internal Revenue Code (Code) by the provisions commonly known as the Tax Cuts and Jobs Act, which was enacted on December 22, 2017, and the Coronavirus Aid, Relief, and Economic Security Act, which was enacted on March 27, 2020. Specifically, these proposed regulations address application of the limitation in contexts involving passthrough entities, regulated investment companies (RICs), United States shareholders of controlled foreign corporations, and foreign persons with effectively connected income in the United States. These proposed regulations also provide guidance regarding the definitions of real property development, real property redevelopment, and a syndicate. These proposed regulations affect taxpayers that have business interest expense, particularly passthrough entities, their partners and shareholders, as well as foreign corporations and their United States shareholders and foreign persons with effectively connected income. These proposed regulations also affect RICs that have business interest income, RIC shareholders that have business interest expense, and members of a consolidated group.

DATES:

Written or electronic comments and requests for a public hearing must be received by November 2, 2020, which is 60 days after the date of filing for public inspection with the Office of the Federal Register.

ADDRESSES:

Commenters are strongly encouraged to submit public comments electronically. Submit electronic submissions via the Federal eRulemaking Portal at
www.regulations.gov
(indicate IRS and REG-107911-18) by following the online instructions for submitting comments. Once submitted to the Federal eRulemaking Portal, comments cannot be edited or withdrawn. The IRS expects to have limited personnel available to process public comments that are submitted on paper through mail. The Department of the Treasury (Treasury Department) and the IRS will publish for public availability any comment submitted electronically, and when practicable on paper, to its public docket.

Send paper submissions to: CC:PA:LPD:PR (REG-107911-18), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044.

FOR FURTHER INFORMATION CONTACT:

Concerning § 1.163(j)-1, Steven Harrison, (202) 317-6842, Michael Chin, (202) 317-6842 or John Lovelace, (202) 317-5363; concerning § 1.163(j)-2, Sophia Wang, (202) 317-4890 or John Lovelace, (202) 317-5363, concerning § 1.163-14, § 1.163(j)-6, or § 1.469-9, William Kostak, (202) 317-5279 or Anthony McQuillen, (202) 317-5027; concerning § 1.163-15, Sophia Wang, (202) 317-4890; concerning § 1.163(j)-7 or § 1.163(j)-8, Azeka J. Abramoff, (202) 317-3800 or Raphael J. Cohen, (202) 317-6938, concerning § 1.1256(e)-2, Sophia Wang, (202) 317-4890 or Pamela Lew, (202) 317-7053; concerning submissions of comments and/or requests for a public hearing, Regina L. Johnson, (202) 317-5177 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

This document contains proposed amendments to the Income Tax Regulations (26 CFR part 1) under sections 163 (in particular section 163(j)), 469 and 1256(e) of the Code. Section 163(j) was amended as part of Public Law 115-97, 131 Stat. 2054 (December 22, 2017), commonly referred to as the Tax Cuts and Jobs Act (TCJA), and the Coronavirus Aid, Relief, and Economic Security Act, Public Law 116-136 (2020) (CARES Act). Section 13301(a) of the TCJA amended section 163(j) by removing prior section 163(j)(1) through (9) and adding section 163(j)(1) through (10). The provisions of section 163(j) as amended by section 13301 of the TCJA are effective for tax years beginning after December 31, 2017. The CARES Act further amended section 163(j) by redesignating section 163(j)(10), as amended by the TCJA, as new section 163(j)(11), and adding a new section 163(j)(10) providing special rules for applying section 163(j) to taxable years beginning in 2019 or 2020.

Section 163(j) generally limits the amount of business interest expense (BIE) that can be deducted in the current taxable year (also referred to in this Preamble as the current year). Under section 163(j)(1), the amount allowed as a deduction for BIE is limited to the sum of (1) the taxpayer's business interest income (BII) for the taxable year; (2) 30 percent of the taxpayer's adjusted taxable income (ATI) for the taxable year (30 percent ATI limitation); and (3) the taxpayer's floor plan financing interest expense for the taxable year (in sum, the section 163(j) limitation). As further described later in this Background section, section 163(j)(10), as amended by the CARES Act, provides special rules relating to the ATI limitation for taxable years beginning in 2019 or 2020. Under section 163(j)(2), the amount of any BIE that is not allowed as a deduction in a taxable year due to the section 163(j) limitation is treated as business interest paid in the succeeding taxable year.

The section 163(j) limitation applies to all taxpayers, except for certain small businesses that meet the gross receipts test in section 448(c) and certain trades or businesses listed in section 163(j)(7). Section 163(j)(3) provides that the section 163(j) limitation does not apply to any taxpayer that meets the gross receipts test under section 448(c), other than a tax shelter prohibited from using the cash receipts and disbursements method of accounting under section 448(a)(3).

Section 163(j)(4) provides special rules for applying section 163(j) in the case of passthrough entities. Section 163(j)(4)(A) requires that the section 163(j) limitation be applied at the partnership level, and that a partner's ATI be increased by the partner's share of excess taxable income, as defined in section 163(j)(4)(C), but not by the partner's distributive share of income, gain, deduction, or loss. Section 163(j)(4)(B) provides that the amount of partnership BIE limited by section 163(j)(1) (EBIE) is carried forward at the partner level. Section 163(j)(4)(B)(ii) provides that EBIE allocated to a partner and carried forward is available to be deducted in a subsequent year only to the extent that the partnership allocates excess taxable income to the partner. As further described later in this Background section, section 163(j)(10), as amended by the CARES Act, provides a special rule for excess business interest expense allocated to a partner in a taxable year beginning in 2019.

Section 163(j)(4)(B)(iii) provides rules for the adjusted basis in a partnership of a partner that is allocated EBIE. Section 163(j)(4)(D) provides that rules similar to the rules of section 163(j)(4)(A) and (C) apply to S corporations and S corporation shareholders.

Section 163(j)(5) and (6) define “business interest” and “business interest income,” respectively, for purposes of section 163(j). Generally, these terms include interest expense and interest includible in gross income that is properly allocable to a trade or business (as defined in section 163(j)(7)) and do not include investment income or investment expense within the meaning of section 163(d). The legislative history states that “a corporation has neither investment interest nor investment income within the meaning of section 163(d). Thus, interest income and interest expense of a corporation is properly allocable to a trade or business, unless such trade or business is otherwise explicitly excluded from the application of the provision.” H. Rept. 115-466, at 386, fn. 688 (2017).

Under section 163(j)(7), the limitation on the deduction for business interest expense in section 163(j)(1) does not apply to certain trades or businesses (excepted trades or businesses). The excepted trades or businesses are the trade or business of providing services as an employee, electing real property businesses, electing farming businesses, and certain regulated utility businesses.

Section 163(j)(8) defines ATI as the taxable income of the taxpayer without regard to the following: Items not properly allocable to a trade or business; business interest and business interest income; net operating loss (NOL) deductions; and deductions for qualified business income under section 199A. ATI also generally excludes deductions for depreciation, amortization, and depletion with respect to taxable years beginning before January 1, 2022, and it includes other adjustments provided by the Secretary of the Treasury.

Section 163(j)(9) defines “floor plan financing interest” as interest paid or accrued on “floor plan financing indebtedness.” These provisions allow taxpayers incurring interest expense for the purpose of securing an inventory of motor vehicles held for sale or lease to deduct the full expense without regard to the section 163(j) limitation.

Under section 163(j)(10)(A)(i), the amount of business interest that is deductible under section 163(j)(1) for taxable years beginning in 2019 or 2020 is computed using 50 percent, rather than 30 percent, of the taxpayer's ATI for the taxable year (50 percent ATI limitation). A taxpayer may elect not to apply the 50 percent ATI limitation to any taxable year beginning in 2019 or 2020, and instead apply the 30 percent ATI limitation. This election must be made separately for each taxable year. Once the taxpayer makes the election, the election may not be revoked without the consent of the Secretary of the Treasury or his delegate. See section 163(j)(10)(A)(iii).

Sections 163(j)(10)(A)(ii)(I) and 163(j)(10)(A)(iii) provide that, in the case of a partnership, the 50 percent ATI limitation does not apply to partnerships for taxable years beginning in 2019, and the election to not apply the 50 percent ATI limitation may be made only for taxable years beginning in 2020, and may be made only by the partnership. Under section 163(j)(10)(A)(ii)(II), however, a partner treats 50 percent of its allocable share of a partnership's excess business interest expense for 2019 as a business interest expense in the partner's first taxable year beginning in 2020 that is not subject to the section 163(j) limitation (50 percent EBIE rule). The remaining 50 percent of the partner's allocable share of the partnership's excess business interest expense remains subject to the section 163(j) limitation applicable to excess business interest expense carried forward at the partner level. A partner may elect out of the 50 percent EBIE rule.

Section 163(j)(10)(B)(i) allows a taxpayer to elect to substitute its ATI for the last taxable year beginning in 2019 (2019 ATI) for the taxpayer's ATI for a taxable year beginning in 2020 (2020 ATI) in determining the taxpayer's section 163(j) limitation for the taxable year beginning in 2020.

Section 163(j)(11) provides cross-references to provisions requiring that electing farming businesses and electing real property businesses excepted from the section 163(j) limitation use the alternative depreciation system (ADS), rather than the general depreciation system, for certain types of property. The required use of ADS results in the inability of these electing trades or businesses to use the additional first-year depreciation deduction under section 168(k) for those types of property.

On December 28, 2018, the Department of the Treasury (Treasury Department) and the IRS (1) published proposed regulations under section 163(j), as amended by the TCJA, in a notice of proposed rulemaking (REG-106089-18) (2018 Proposed Regulations) in the
Federal Register
(83 FR 67490), and (2) withdrew the notice of proposed rulemaking (1991-2 C.B. 1040) published in the
Federal Register
on June 18, 1991 (56 FR 27907 as corrected by 56 FR 40285 (August 14, 1991)) to implement rules under section 163(j) before amendment by the TCJA. The 2018 Proposed Regulations were issued following guidance announcing and describing regulations intended to be issued under section 163(j). See Notice 2018-28, 2018-16 I.R.B. 492 (April 16, 2018).

A public hearing on the 2018 Proposed Regulations was held on February 27, 2019. The Treasury Department and the IRS also received written comments responding to the 2018 Proposed Regulations (available at
http://www.regulations.gov
). In response to certain comments, the Treasury Department and the IRS are publishing this notice of proposed rulemaking to provide additional proposed regulations (these Proposed Regulations) under section 163(j).

Concurrently with the publication of these Proposed Regulations, the Treasury Department and the IRS are publishing in the Rules and Regulations section of this edition of the
Federal Register
(RIN 1545-BO73) final regulations under section 163(j) (the Final Regulations).

On April 10, 2020, the Treasury Department and the IRS released Revenue Procedure 2020-22, 2020-18 I.R.B. 745, to provide the time and manner of making a late election, or withdrawing an election, under section 163(j)(7)(B) to be an electing real property trade or business or section 163(j)(7)(C) to be an electing farming business for taxable years beginning in 2018, 2019, or 2020. Revenue Procedure 2020-22 also provides the time and manner of making or revoking elections provided by the CARES Act under section 163(j)(10) for taxable years beginning in 2019 or 2020. As described earlier in this Background section, these elections are: (1) To not apply the 50 percent ATI limitation under section 163(j)(10)(A)(iii); (2) to use the taxpayer's 2019 ATI to calculate the taxpayer's section 163(j) limitation for any taxable year beginning in 2020 under section 163(j)(10)(B); and (3) for a partner to elect out of the 50 percent EBIE rule under section 163(j)(10)(A)(ii)(II).

Explanation of Provisions

These Proposed Regulations would provide guidance in addition to the Final Regulations regarding the section 163(j) limitation. These Proposed Regulations would also add or amend regulations under certain other provisions of the Code where necessary

to provide conformity across the Income Tax Regulations. A significant number of the terms used throughout these Proposed Regulations are defined in § 1.163(j)-1 of the Final Regulations and discussed in the Explanation of Provisions section of the 2018 Proposed Regulations and the Summary of Comments and Explanation of Revisions section of the Final Regulations. Some of these terms are further discussed in this Explanation of Provisions section as they relate to specific provisions of these Proposed Regulations.

Part I of this Explanation of Provisions describes proposed rules that would allocate interest expense for purposes of sections 469, 163(d), 163(h), and 163(j) in connection with certain transactions involving passthrough entities. Part II provides proposed rules relating to distributions of debt proceeds from any taxpayer account or from cash so that interest expense may be allocated for purposes of sections 469, 163(d), 163(h), and 163(j). Part III describes proposed modifications to the definitions and general guidance in § 1.163(j)-1, including proposed rules permitting taxpayers to apply a different computational method in determining adjustments to tentative taxable income to address sales or other dispositions of depreciable property, stock of a consolidated group member, or interests in a partnership, and proposed rules allowing RIC shareholders to treat certain RIC dividends as interest income for purposes of section 163(j). Part IV describes proposed modifications to § 1.163(j)-6, relating to the applicability of the section 163(j) limitation to passthrough entities, including proposed rules on the applicability of the section 163(j) limitation to trading partnerships and publicly traded partnerships, the application of the section 163(j) limitation in partnership self-charged lending transactions, proposed rules relating to the treatment of excess business interest expense in tiered partnerships, proposed rules relating to partnership basis adjustments upon partner dispositions, proposed rules regarding the election to substitute 2019 ATI for the partnership's 2020 ATI in determining the partnership's section 163(j) limitation for a taxable year beginning in 2020, and proposed rules regarding excess business interest expense allocated to a partner in a taxable year beginning in 2019.

Part V discusses re-proposed rules regarding the application of the section 163(j) limitation to foreign corporations and United States shareholders (as defined in section 951(b) (U.S. shareholders) of controlled foreign corporations (as defined in section 957(a)) (CFCs). Part VI discusses re-proposed rules regarding the application of the section 163(j) limitation to nonresident alien individuals and foreign corporations with effectively connected income in the United States. Part VII describes proposed modifications to the definition of a real property trade or business under § 1.469-9 for purposes of the passive activity loss rules and the definition of an electing real property trade or business under section 163(j)(7)(B). Part VIII describes proposed rules regarding the definition of a “tax shelter” for purposes of § 1.163(j)-2 and section 1256(e), as well as proposed rules regarding the election to use 2019 ATI in determining the taxpayer's section 163(j) limitation for a taxable year beginning in 2020. Part IX describes proposed modifications regarding the application of the corporate look-through rules to tiered structures.

I. Proposed § 1.163-14: Allocation of Interest Expense With Respect to Passthrough Entities

Section 1.163-8T provides rules regarding the allocation of interest expense for purposes of applying the passive activity loss limitation in section 469, the investment interest limitation in section 163(d), and the personal interest limitation in section 163(h) (such purposes, collectively, § 1.163-8T purposes). Under § 1.163-8T, debt generally is allocated by tracing disbursements of the debt proceeds to specific expenditures and interest expense associated with debt is allocated for § 1.163-8T purposes in the same manner as the debt to which such interest expense relates. When debt proceeds are deposited to the borrower's account, and the account also contains unborrowed funds, § 1.163-8T(c) provides that the debt generally is allocated to expenditures by treating subsequent expenditures from the account as made first from the debt proceeds to the extent thereof. The rules further provide that if the proceeds of two or more debts are deposited in the account, the proceeds are treated as expended in the order in which they were deposited. In addition to these rules, § 1.163-8T also provides specific rules to address reallocation of debt, repayments and refinancing.

The preamble to § 1.163-8T (52 FR 24996) stated that “interest expense of partnerships and S corporations, and of partners and S corporation shareholders, is generally allocated in the same manner as the interest expense of other taxpayers.” The preamble acknowledged the need for special rules for debt financed distributions to owners of partnerships and S corporations, and for cases in which taxpayers incur debt to acquire or increase their capital interest in the passthrough entity, but reserved on these issues and requested comments.

In a series of notices, the Treasury Department and the IRS provided further guidance with respect to the allocation of interest expense in connection with certain transactions involving passthrough entities and owners of passthrough entities. See Notice 88-20, 1988-1 C.B. 487, Notice 88-37, 1988-1 C.B. 522, and Notice 89-35, 1989-1 C.B. 675. Specifically, Notice 89-35 provides, in part, rules addressing the treatment of (1) a passthrough entity owner's debt allocated to contributions to, or purchases of, interests in a passthrough entity (debt-financed contributions or acquisitions), and (2) passthrough entity debt allocated to distributions by the entity to its owners (debt-financed distributions).

In the case of a debt-financed acquisition of an interest in a passthrough entity by purchase (rather than by way of a contribution to the capital of the entity), Notice 89-35 provides that the interest expense of the owner of the passthrough entity, for § 1.163-8T purposes, is allocated among the assets of the entity using any reasonable method. A reasonable method for this purpose includes, for example, allocating the debt among all of the assets of the passthrough entity based on the fair market value, the book value, or the adjusted basis of the assets, reduced by the amount of any debt of the entity or the amount of any debt that the owner of the entity allocates to such assets. Notice 89-35 also provides that interest expense on debt proceeds allocated to a contribution to the capital of a passthrough entity shall be allocated using any reasonable method for § 1.163-8T purposes. For this purpose, any reasonable method includes allocating the debt among the assets of the passthrough entity or tracing the debt proceeds to the expenditures of the passthrough entity.

In the case of debt-financed distributions, Notice 89-35 provides a general allocation rule and an optional allocation rule. The general allocation rule applies the principles of § 1.163-8T to interest expense associated with debt-financed distributions by applying a tracing approach to determine the character of the interest expense for § 1.163-8T purposes. Under this approach, the debt proceeds and the associated interest expense related to a debt-financed distribution are allocated under § 1.163-8T in accordance with

the use of the distributed debt proceeds by the distributee owner of the passthrough entity. To the extent an owner's share of a passthrough entity's interest expense related to the debt-financed distribution exceeds the entity's interest expense on the portion of the debt proceeds distributed to that particular owner, Notice 89-35 provides that the passthrough entity may allocate such excess interest expense using any reasonable method.

The optional allocation rule applicable to debt-financed distributions allows a passthrough entity to allocate distributed debt proceeds and the associated interest expense to one or more expenditures, other than distributions, of the entity that are made during the same taxable year of the entity as the distribution, to the extent that debt proceeds, including other distributed debt proceeds, are not otherwise allocated to such expenditures. Under the optional allocation rule, distributed debt proceeds are traced to the owner's use of the borrowed funds to the extent that such distributed debt proceeds exceed the entity's expenditures, not including distributions, for the taxable year to which debt proceeds are not otherwise allocated.

While the 2018 Proposed Regulations did not include rules to further address the application of § 1.163-8T to passthrough entities, the Treasury Department and the IRS received comments indicating that, for purposes of section 163(j), a tracing rule based on how a passthrough entity owner uses the proceeds of a debt-financed distribution does not align well with the statutory mandate in section 163(j)(4) to apply section 163(j) at the passthrough entity level. Based on these comments and a review of the rules under § 1.163-8T, the Treasury Department and the IRS have determined that additional rules, specific to passthrough entities and their owners, are needed to clarify how the rules under § 1.163-8T work when applied to a passthrough entity and to account for the entity-level limitation under section 163(j)(4).

A. In General

The rules of § 1.163-8T generally apply to partnerships, S corporations, and their owners and the rules in proposed § 1.163-14 would provide additional rules for purposes of applying the § 1.163-8T rules to passthrough entities. As with the rules under § 1.163-8T, proposed § 1.163-14 would provide that interest expense on a debt incurred by a passthrough entity is allocated in the same manner as the debt to which such interest relates is allocated, and that debt is generally allocated by tracing disbursements of the debt proceeds to specific expenditures.

The Treasury Department and the IRS have determined that the scope of § 1.163-8T(a)(4) and (b) is not appropriate in the passthrough entity context. Section 1.163-8T(a)(4) generally provides rules regarding the treatment of interest expense allocated to specific expenditures, which are described in § 1.163-8T(b). However, the list of expenditures described in § 1.163-8T(b) is based on an allocation of interest for purposes of applying sections 163(d), 163(h), and 469, and does not adequately account for the uses of debt proceeds by a passthrough entity (for example, distributions to owners).

To more accurately account for the types of expenditures made by passthrough entities, proposed § 1.163-14(b) would provide rules tailored to passthrough entities. In addition, the framework that proposed § 1.163-14(b) would provide is needed for a passthrough entity to determine how much of its interest expense is allocable to a trade or business for purposes of applying section 163(j). These proposed regulations would apply before a passthrough entity applies any of the rules in section 163(j) (including § 1.163(j)-10).

In application, a passthrough entity would continue to apply the operative rules in § 1.163-8T to allocate debt and the interest expense associated with such debt. However, instead of generally tracing debt proceeds to the types of expenditures described under § 1.163-8T(b) and treating any interest expense associated with such debt proceeds in the manner described under § 1.163-8T(a)(4), a passthrough entity would generally trace debt proceeds to the types of expenditures described under proposed § 1.163-14(b)(2) and treat any interest expense associated with such debt proceeds in the manner provided under proposed § 1.163-14(b)(1).

B. Debt Financed Distributions

Proposed § 1.163-14 would provide that when debt proceeds of a passthrough entity are allocated under § 1.163-8T to distributions to owners of the entity, the debt proceeds distributed to any owner and the associated interest expense shall be allocated under proposed § 1.163-14(d). In general, proposed § 1.163-14(d) would adopt a rule similar to Notice 89-35, but with the following modifications. First, instead of providing that passthrough entities may use the optional allocation rule, proposed § 1.163-14(d) would generally provide that passthrough entities are required to apply a rule that is similar to the optional allocation rule. Second, instead of providing that the passthrough entity may allocate excess interest expense using any reasonable method, proposed § 1.163-14(d) would generally provide that the passthrough entity must allocate excess interest expense based on the adjusted tax basis of the passthrough entity's assets.

Specifically, proposed § 1.163-14(d)(1) would provide a rule based in principle on the optional allocation rule in Notice 89-35. Under this proposed rule, distributed debt proceeds (debt proceeds of a passthrough entity allocated under § 1.163-8T to distributions to owners of the entity) would first be allocated under proposed § 1.163-14(d)(1)(i) to the passthrough entity's available expenditures. Available expenditures are those expenditures of a passthrough entity made in the same taxable year as the distribution, but only to the extent that debt proceeds (including other distributed debt proceeds) are not otherwise allocated to such expenditure. This approach is consistent with the concept that money is fungible (a passthrough entity may be fairly treated as distributing non-debt proceeds rather than debt proceeds and using debt proceeds rather than non-debt proceeds to finance its non-distribution expenditures) and seeks to coordinate the interest allocation rules with the entity-level approach to passthroughs adopted in section 163(j). Where the distributed debt proceeds exceed the passthrough entity's available expenditures, this excess amount of distributed debt proceeds would be allocated to distributions to owners of the passthrough entity (debt financed distributions) under proposed § 1.163-14(d)(1)(ii).

After determining the amount of its distributed debt proceeds allocated to available expenditures and debt financed distributions, a passthrough entity would use this information to determine the tax treatment of each owner's allocable interest expense (that is, an owner's share of interest expense associated with the distributed debt proceeds allocated under section 704(b) or 1366(a)). To aid the passthrough entity and owner in determining the tax treatment of each owner's allocable interest expense, proposed § 1.163-14(d)(2) would provide rules for determining the portion of each owner's allocable interest expense that is (1) debt financed distribution interest expense, (2) expenditure interest expense, and (3) excess interest expense. These three categories of allocable interest expense are mutually

exclusive—
e.g.,
a given dollar of allocable interest expense cannot simultaneously be both debt financed distribution interest expense and expenditure interest expense. The computations in proposed § 1.163-14(d)(2) would ensure this outcome.

Once a passthrough entity categorizes each owner's allocable interest expense as described earlier, it would apply proposed § 1.163-14(d)(3) to determine the tax treatment of such interest expense. The manner in which the tax treatment of allocable interest expense is determined depends on how such allocable interest expense was categorized under proposed § 1.163-14(d)(2).

Conceptually, each of the three categories described earlier, as well as the prescribed tax treatment of interest expense in each category, is discussed in Notice 89-35. Debt financed distribution interest expense is referred to in Notice 89-35 as an owner's share of a passthrough entity's interest expense on debt proceeds allocated to such owner. Similar to Notice 89-35, proposed § 1.163-14(d)(3)(i) would generally provide that such interest expense is allocated under § 1.163-8T in accordance with the owner's use of the debt proceeds. Further, expenditure interest expense is referred to in Notice 89-35 as interest expense allocated under the optional allocation rule. Similar to Notice 89-35, proposed § 1.163-14(d)(3)(ii) would generally provide that the tax treatment of such interest expense is determined based on how the distributed debt proceeds were allocated among available expenditures. Finally, both Notice 89-35 and proposed § 1.163-14(d) would use the term excess interest expense to refer to an owner's share of allocable interest expense in excess of the entity's interest expense on the portion of the debt proceeds distributed to that particular owner. Unlike Notice 89-35, which generally allows any reasonable method for determining the tax treatment of excess interest expense, proposed § 1.163-14(d)(3)(iii) would generally provide that the tax treatment of excess interest expense is determined by allocating the distributed debt proceeds among all the assets of the passthrough entity, pro-rata, based on the adjusted basis of such assets.

Proposed § 1.163-14(d)(4) also would provide rules addressing the tax treatment of the interest expense of a transferee owner where the transferor had previously been allocated debt financed distribution interest expense. In the case of a transfer of an interest in a passthrough entity, any debt financed distribution interest expense of the transferor generally shall be treated as excess interest expense by the transferee. However, in the case of a transfer of an interest in a passthrough entity to a person who is related to the transferor, any debt financed distribution interest expense of the transferor shall continue to be treated as debt financed distribution interest expense by the related party transferee, and the tax treatment of such debt financed distribution expense shall be the same to the related party transferee as it was to the transferor. The term related party means any person who bears a relationship to the taxpayer which is described in section 267(b) or 707(b)(1).

The proposed regulations also would include an anti-avoidance rule to recharacterize arrangements entered into with a principal purpose of avoiding the rules of proposed § 1.163-14(d), including the transfer of an interest in a passthrough entity by an owner who treated a portion of its allocable interest expense as debt financed distribution interest expense to an unrelated party pursuant to a plan to transfer the interest back to the owner who received the debt financed distribution interest expense or to a party who is related to the owner who received the debt financed distribution interest expense.

C. Operational Rules

Proposed § 1.163-14 also would include several operational rules that clarify the application of certain rules under § 1.163-8T as they apply to passthrough entities. Proposed § 1.163-14(e) would provide an ordering rule applicable to repayment of debt by passthrough entities similar to the rules in § 1.163-8T(d)(1). Proposed § 1.163-14(g) would provide that any transfer of an ownership interest in a passthrough entity is not a reallocation event for purposes of § 1.163-8T(j), except as provided for in § 1.163-14(d)(4).

D. Debt-Financed Acquisitions

Proposed § 1.163-14(f) would adopt a rule providing that the tax treatment of an owner's interest expense associated with a debt financed acquisition (either by purchase or contribution) will be determined by allocating the debt proceeds among the assets of the entity. The owner would allocate the debt proceeds (1) in proportion to the relative adjusted tax basis of the entity's assets reduced by any debt allocated to such assets, or (2) based on the adjusted basis of the entity's assets in accordance with the rules in § 1.163(j)-10(c)(5)(i) reduced by any debt allocated to such assets. The Treasury Department and the IRS request comments regarding whether asset basis (either adjusted tax basis or adjusted tax basis based on the rules in § 1.163(j)-10(c)(5)(i)) less the amount of debt allocated to assets under §§ 1.163-14 and 1.163-8T is appropriate as the sole method for allocating interest expense in this context.

II. Proposed § 1.163-15: Debt Proceeds Distributed From Any Taxpayer Account or From Cash

Proposed § 1.163-15 supplements the rules in § 1.163-8T regarding debt proceeds distributed from any taxpayer account or from cash proceeds. Section 1.163-8T(c)(4)(iii)(B) provides that a taxpayer may treat any expenditure made from an account within 15 days after the debt proceeds are deposited in such account as being made from such proceeds, regardless of any other rules in § 1.163-8T(c)(4). Under § 1.163-8T(c)(5)(i), if a taxpayer receives debt proceeds in cash, the taxpayer may treat any cash expenditure made within 15 days after receiving the cash as being made from such debt proceeds, and may treat such expenditure as being made on the date the taxpayer received the cash. Commenters have suggested that the 15-day limit in § 1.163-8T could encourage taxpayers to keep separate accounts, rather than commingled accounts for tracing purposes.

In Notice 88-20, 1988-1 C.B. 487, the IRS announced the intention to issue regulations providing that, for debt proceeds deposited in an account on or before December 31, 1987, taxpayers could treat any expenditure made from any account of the taxpayer or from cash within 30 days before or after debt proceeds are deposited in such account or any other account of the taxpayer as made from such proceeds. The Notice states that the regulations also would provide that for debt proceeds received in cash on or before December 31, 1987, taxpayers may treat any expenditure made from any account of the taxpayer or from cash within 30 days before or after debt proceeds are received in cash as made from such proceeds. Section VI of Notice 89-35 adopts the standard described in Notice 88-20 without the date limitation, although no regulations have been issued.

Consistent with Notice 89-35, proposed § 1.163-15 provides that taxpayers may treat any expenditure made from an account of the taxpayer or from cash within 30 days before or after debt proceeds are deposited in any account of the taxpayer or received in cash as made from such proceeds.

III. Proposed Modifications to § 1.163(j)-1(b): Definitions

A. Adjustments to Tentative Taxable Income

Section 1.163(j)-1(b)(1) requires taxpayers to make certain adjustments to tentative taxable income in computing ATI, including adjustments to address certain sales or other dispositions of depreciable property, stock of a consolidated group member (member stock), or interests in a partnership. More specifically, § 1.163(j)-1(b)(1)(ii)(C) provides that, if property is sold or otherwise disposed of, the greater of the allowed or allowable depreciation, amortization, or depletion of the property for the taxpayer (or, if the taxpayer is a member of a consolidated group, the consolidated group) for taxable years beginning after December 31, 2017, and before January 1, 2022 (such years, the EBITDA period), with respect to such property is subtracted from tentative taxable income. Section 1.163(j)-1(b)(1)(ii)(D) provides that, with respect to the sale or other disposition of stock of a member of a consolidated group by another member, the investment adjustments under § 1.1502-32 with respect to such stock that are attributable to deductions described in § 1.163(j)-1(b)(1)(ii)(C) are subtracted from tentative taxable income. Section 1.163(j)-1(b)(1)(ii)(E) provides that, with respect to the sale or other disposition of an interest in a partnership, the taxpayer's distributive share of deductions described in § 1.163(j)-1(b)(1)(ii)(C) with respect to property held by the partnership at the time of such sale or other disposition is subtracted from tentative taxable income to the extent such deductions were allowable under section 704(d). See the preamble to the Final Regulations for a discussion of the rationale for these adjustments.

The preamble to the Final Regulations noted that, in the 2018 Proposed Regulations, § 1.163(j)-1(b)(1)(ii)(C) incorporated a “lesser of” standard. In other words, the lesser of (i) the amount of gain on the sale or other disposition of property, or (ii) the amount of depreciation deductions with respect to such property for the EBITDA period, was required to be subtracted from tentative taxable income to determine ATI. As explained in the preamble to the Final Regulations, commenters raised several questions regarding this “lesser of” standard. The Final Regulations removed the “lesser of” approach due in part to concerns that this approach would be more difficult to administer than the approach reflected in the Final Regulations.

However, the Treasury Department and the IRS recognize that, in certain cases, the “lesser of” approach might not create administrative difficulties for taxpayers. Thus, these Proposed Regulations permit taxpayers to choose whether to compute the amount of their adjustment using a “lesser of” standard. While the 2018 Proposed Regulations applied this standard solely to dispositions of property, these Proposed Regulations extend this standard to dispositions of partnership interests and member stock to eliminate the discontinuity between the amount of the adjustment for these different types of dispositions. Taxpayers opting to use this alternative computation method must do so for all sales or other dispositions that otherwise would be subject to § 1.163(j)-1(b)(1)(ii)(C), (D), or (E) when the taxpayer computes tentative taxable income.

The Treasury Department and the IRS request comments on the “lesser of” approach, including how such an approach should apply to dispositions of member stock and partnership interests.

B. Dividends From Regulated Investment Company (RIC) Shares

Some commenters on the 2018 Proposed Regulations recommended that dividend income from a RIC be treated as interest income for a shareholder in a RIC, to the extent that the income earned by the RIC is interest income. Because a RIC is a subchapter C corporation, section 163(j) applies at the RIC level, and any BIE that is disallowed at the RIC level is carried forward to subsequent years at the RIC level. Furthermore, because a RIC is a subchapter C corporation, a shareholder in a RIC generally does not take into account a share of the RIC's items of income, deduction, gain, or loss. Thus, if a RIC's BII exceeds its BIE in a taxable year, the RIC may not directly allocate the excess amount to its shareholders (unlike a partnership, which may allocate excess BII to its partners).

Under part 1 of subchapter M and other Code provisions, however, a RIC that has certain items of income or gain may pay dividends that a shareholder in the RIC may treat in the same manner (or a similar manner) as the shareholder would treat the underlying items of income or gain if the shareholder realized the items directly. Although this treatment differs fundamentally from the passthrough treatment of partners or trust beneficiaries, this Explanation of Provisions refers to this treatment as “conduit treatment.” For example, under sections 871(k)(1) and 881(e)(1), a RIC that has qualified interest income within the meaning of section 871(k)(1)(E) may pay interest-related dividends, and no tax generally would be imposed under sections 871(a)(1)(A) or 881(a)(1) on an interest-related dividend paid to a nonresident alien individual or foreign corporation. Section 871(k)(1) provides necessary limits and procedures that apply to interest-related dividends. The Code provides similar conduit treatment for capital gain dividends in section 852(b)(3), exempt-interest dividends in section 852(b)(5), short-term capital gain dividends in section 871(k)(2), dividends eligible for the dividends received deduction in section 854(b)(1)(A), and qualified dividend income in section 854(b)(1)(B).

In response to comments, these Proposed Regulations provide rules under which a RIC that earns BII may pay section 163(j) interest dividends. A shareholder that receives a section 163(j) interest dividend may treat the dividend as interest income for purposes of section 163(j), subject to holding period requirements and other limitations. A section 163(j) interest dividend that meets these requirements is treated as BII if it is properly allocable to a non-excepted trade or business of the shareholder. A section 163(j) interest dividend is treated as interest income solely for purposes of section 163(j).

The rules under which a RIC may report section 163(j) interest dividends are based on the rules for reporting exempt-interest dividends in section 852(b)(5) and interest-related dividends in section 871(k)(1). The total amount of a RIC's section 163(j) interest dividends for a taxable year is limited to the excess of the RIC's BII for the taxable year over the sum of the RIC's BIE for the taxable year and the RIC's other deductions for the taxable year that are properly allocable to the RIC's BII. For some types of income and gain to which conduit treatment applies, the gross amount of the RIC's income or gain of that type serves as the limit on the RIC's corresponding dividends. It would be inconsistent with the purposes of section 163(j) to permit a RIC to pay section 163(j) interest dividends in an amount based on the RIC's gross BII, unreduced by the RIC's BIE. Further reducing the limit on a RIC's section 163(j) interest dividends by the amount of the RIC's other deductions that are properly allocable to the RIC's BII is consistent with the provisions of the Code that provide conduit treatment for types of interest earned by a RIC. For example, the limit on interest-related dividends in section 871(k)(1)(D) is

reduced by the deductions properly allocable to the RIC's qualified interest income. Similarly, the limit on exempt-interest dividends in section 852(b)(5)(A)(iv)(V) is reduced by the amounts disallowed as deductions under sections 265 and 171(a)(2). Taking into account the appropriate share of deductions also reduces the likelihood that the sum of a RIC's items that are eligible for conduit treatment and that are relevant to a particular shareholder will exceed the amount of the dividend distribution paid to the particular shareholder.

These Proposed Regulations contain an additional limit to prevent inconsistent treatment of RIC dividends by RIC shareholders. Revenue Ruling 2005-31, 2005-1 C.B. 1084, allows a RIC to report the maximum amount of capital gain dividends, exempt-interest dividends, interest-related dividends, short-term capital gain dividends, dividends eligible for the dividends received deduction, and qualified dividend income for a taxable year, even if the sum of the reported amounts exceeds the amount of the RIC's dividends for the taxable year. The ruling allows different categories of shareholders (United States persons and nonresident aliens) to report the dividends they receive by giving effect to the conduit treatment of the items relevant to them. A single shareholder, however, generally does not benefit from the conduit treatment of amounts in excess of the dividend paid to that shareholder, because to do so would require the shareholder to include in its taxable income amounts exceeding the dividend it received. Conduit treatment of BII, however, differs from the conduit treatment of other items, because a section 163(j) interest dividend is treated as interest income only for purposes of section 163(j). Thus, absent a limit, a RIC shareholder could obtain an inappropriate benefit by treating a portion of a RIC dividend as interest income for purposes of section 163(j) while treating the same portion of the dividend as another non-interest type of income, such as a dividend eligible for the dividends received deduction under sections 243 and 854(b). Therefore, these Proposed Regulations limit the amount of a section 163(j) interest dividend that a shareholder may treat as interest income for purposes of section 163(j) to the excess of the amount of the RIC dividend that includes the section 163(j) interest dividend over the sum of the portions of that dividend affected by conduit treatment in the hands of that shareholder, other than interest-related dividends under section 871(k)(1)(C) and section 163(j) interest dividends.

Under these Proposed Regulations, a shareholder generally may not treat a section 163(j) interest dividend as interest income unless it meets certain holding period and similar requirements. The holding period requirements do not apply to (i) dividends paid by a RIC regulated as a money market fund under 17 CFR 270.2a-7 or (ii) certain regular dividends paid by a RIC that declares section 163(j) interest dividends on a daily basis and distributes such dividends on a monthly or more frequent basis. The Treasury Department and the IRS request comments on whether there are other categories of section 163(j) interest dividends for which the holding period requirements should not apply or should be modified. The Treasury Department and the IRS also request comments on whether any payments that are substitutes for section 163(j) interest dividends (for example, in a securities lending or sale-repurchase transaction with respect to RIC shares) should be treated for purposes of section 163(j) as interest expense of taxpayers making the payments or interest income to taxpayers receiving the payments. Cf. § 1.163(j)-1(b)(22)(iii)(C) (addressing certain payments that are substitutes for interest).

These Proposed Regulations, to the extent they concern the payment of section 163(j) interest dividends by a RIC and the treatment of such dividends as interest by a RIC shareholder, are proposed to apply to taxable years beginning on or after the date that is 60 days after the date the Treasury decision adopting these regulations as final regulations is published in the
Federal Register
. Solely in the case of section 163(j) interest dividends that would be exempt from the holding period rules under these Proposed Regulations, the RIC paying such dividends and the shareholders receiving such dividends may rely on the provisions of these Proposed Regulations pertaining to section 163(j) interest dividends for taxable years ending on or after September 14, 2020, and beginning before the date that is 60 days after the date the Treasury decision adopting these regulations as final regulations is published in the
Federal Register
.

IV. Proposed § 1.163(j)-6: Application of the Business Interest Expense Deduction Limitations to Partnerships and Subchapter S Corporations

A. Trading Partnerships

The preamble to the 2018 Proposed Regulations states that the business interest expense of certain passthrough entities, including S corporations, allocable to trade or business activities that are described in section 163(d)(5)(A)(ii) (
i.e.,
activities that are per se non-passive under section 469 in which the taxpayer does not materially participate) and illustrated in Revenue Ruling 2008-12, 2008-1 C.B. 520 (March 10, 2008) (trading activities), will be subject to section 163(j) at the entity level, even if the interest expense is later subject to limitation under section 163(d) at the individual partner or shareholder level. Accordingly, at least with respect to partnerships, to the extent that interest expense from a trading activity is limited under section 163(j) and becomes a carryover item of partners who do not materially participate in the trading activity, the interest expense will be treated as investment interest in the hands of those partners for purposes of section 163(d) once the interest expense is no longer limited under section 163(j). As a result, the interest expense would be subject to two section 163 limitations.

The Treasury Department and the IRS received multiple comments questioning this interpretation of section 163(j)(5) and its interaction with section 163(d)(5)(A)(ii). Specifically, commenters stated that the interpretation improperly results in the application of section 163(j) to partnerships engaged in a trade or business activity of trading personal property (including marketable securities) for the account of owners of interests in the activity, as described in § 1.469-1T(e)(6) (trading partnerships). At issue is the extent to which BIE of trading partnerships should be subject to limitation under section 163(j). This issue involves the definition of BIE under section 163(j)(5) and, more specifically, the second sentence of section 163(j)(5), which generally provides that BIE shall not include investment interest within the meaning of section 163(d).

The approach described in the preamble to the 2018 Proposed Regulations interprets section 163(j)(5) as simply providing that interest expense cannot be both BIE and investment interest expense in the hands of the same taxpayer. Under this interpretation, section 163(j)(5) will treat interest as investment interest

where conflicting provisions may otherwise subject an amount of interest expense to limitation under both section 163(j) and section 163(d) with respect to the same taxpayer (for example, interest expense allocable to business assets comprising “working capital” as that term is used in section 469(e)(1)(B)). In addition, this approach views the partnership as an entity separate from its partners for purposes of section 163(j) to the partnership and section 163(d) at the individual partner level. Several commenters disagreed with this interpretation of section 163(j)(5), asserting that the second sentence of section 163(j)(5) unequivocally provides that interest expense can never be subject to limitation under both section 163(j) and section 163(d) under any circumstances. Based on these comments, the Treasury Department and the IRS considered three alternative approaches for interpreting section 163(j)(5).

One approach would require a partnership engaged in a trading activity to apply section 163(j) at the partnership level to all of the partnership's interest expense from the trading activity. Under this approach, any deductible interest expense from the partnership's trading activity would not be subject to any further limitation under section 163(d) at the individual partner level. This interpretation would respect the partnership as an entity separate from its partners for purposes of section 163(j), but would treat section 163(j)(4) and (5) as superseding section 163(d)(5)(A)(ii).

A second approach would require a partnership engaged in a trading activity to bifurcate its interest expense from a trading activity between partners that materially participate in the trading activity and partners that are passive investors in the activity, and subject only the portion that is allocable to the materially participating partners to limitation under section 163(j). Under this approach, to the extent any interest expense is allocable to passive investors in the trading activity, the interest expense would be subject only to section 163(d) at the partner level and would never be subject to section 163(j) at the partnership level.

A third approach would require a partnership to treat all of the interest expense from a trading activity as investment interest under section 163(d), regardless of whether any individual partners materially participate in the trading activity. Under this approach, the interest expense properly allocable to materially participating partners would never be subject to limitation under section 163(j), even though interest expense allocable to materially participating partners would also not be subject to limitation under section 163(d) at the individual partner level.

After considering the comments, Treasury Department and the IRS have concluded that the approach described in the preamble to the 2018 Proposed Regulations is inconsistent with the statutory language and intent of section 163(j)(5) because the second sentence of section 163(j)(5) specifically states that BIE shall not include investment interest expense. In addition, the Treasury Department and the IRS have determined that the second alternative approach, as described earlier, appears to be the most consistent with the intent of sections 163(d) and 163(j). Accordingly, these Proposed Regulations would interpret section 163(j)(5) as requiring a trading partnership to bifurcate its interest expense from a trading activity between partners that materially participate in the trading activity and partners that are passive investors, and as subjecting only the portion of the interest expense that is allocable to the materially participating partners to limitation under section 163(j) at the partnership level. The portion of interest expense from a trading activity allocable to passive investors will be subject to limitation under section 163(d) at the partner level, as provided in section 163(d)(5)(A)(ii).

In addition, these Proposed Regulations require that a trading partnership bifurcate all of its other items of income, gain, loss and deduction from its trading activity between partners that materially participate in the partnership's trading activity and partners that are passive investors. The portion of the partnership's other items of income, gain, loss or deduction from its trading activity properly allocable to the passive investors in the partnership will not be taken into account at the partnership level as items from a trade or business for purposes of applying section 163(j) at the partnership level. Instead, all such partnership items properly allocable to passive investors will be treated as items from an investment activity of the partnership, for purposes of sections 163(j) and 163(d).

This approach, in order to be effective, adopts the presumption that a trading partnership generally will possess knowledge regarding whether its individual partners are material participants in its trading activity. No rules currently exist requiring a partner to inform the partnership whether the partner has grouped activities of the partnership with other activities of the partner outside of the partnership. Therefore, the partnership might possess little or no knowledge regarding whether an individual partner has made such a grouping. Without this information, a trading partnership may presume that an individual partner is a passive investor in the partnership's trading activity based solely on the partnership's understanding as to the lack of work performed by the partner in that activity, whereas the partner may in fact be treated as a material participant in the partnership's trading activity by grouping that activity with one or more activities of the partner in which the partner materially participates. In order to avoid this result and the potential for abuse, a new rule is proposed for the section 469 activity grouping rules to provide that any activity described in section 163(d)(5)(A)(ii) may not be grouped with any other activity of the taxpayer, including any other activity described in section 163(d)(5)(A)(ii). The Treasury Department and the IRS invite comments regarding whether other approaches may be feasible and preferable to a special rule that prohibits the grouping of trading activities with other activities of a partner, such as adoption of a rule or reporting regime requiring all partners in the partnership to annually certify or report to the partnership whether they are material participants in a grouped activity that includes the partnership's trading activity.

The Treasury Department and the IRS further invite comments regarding whether similar rules should be adopted with respect to S corporations that may also be involved in trading activities, and whether such rules would be compatible with Subchapter S (for example, whether the bifurcation of items from the S corporation's trading activity between material participants and passive investors would run afoul of the second class of stock prohibition).

B. Fungibility of Publicly Traded Partnerships

In order to be freely marketable, each unit of a publicly traded partnership (PTP), as defined in § 1.7704-1, must have identical economic and tax characteristics so that such PTP units are fungible. For PTP units to be fungible, the section 704(b) capital account associated with each unit must be economically equivalent to the section 704(b) capital account of all other units of the same class, and a PTP unit buyer must receive equivalent tax allocations regardless of the specific unit purchased. In other words, from the

perspective of a buyer, a PTP unit cannot have variable tax attributes depending on the identity of the PTP unit seller. In general, to achieve fungibility, a PTP (1) makes a section 754 election, pursuant to which a purchaser can insulate itself from its predecessor's allocable section 704(c) gain or loss through a section 743(b) basis adjustment, and (2) adopts the remedial allocation method under section 704(c) for all of its assets.

Pursuant to § 1.704-3(d)(1), a partnership adopts the section 704(c) remedial allocation method to eliminate distortions caused by the application of the ceiling rule, as defined in § 1.704-3(b)(1), under the section 704(c) traditional method. A partnership adopting the remedial allocation method eliminates ceiling rule distortions by creating remedial items and allocating those items to its partners. Under the remedial allocation method, a partnership first determines the amount of section 704(b) book items under § 1.704-3(d)(2) and the partners' section 704(b) distributive shares of such items. The partnership then allocates the corresponding tax items recognized by the partnership, if any, using the traditional method described in § 1.704-3(b)(1). If the ceiling rule causes the section 704(b) book allocation of an item to a noncontributing partner to differ from the tax allocation of the same item to the noncontributing partner, the partnership creates a remedial item of income, gain, loss, or deduction equal to the full amount of the difference and allocates it to the noncontributing partner. The partnership simultaneously creates an offsetting remedial item in an identical amount and allocates it to the contributing partner. In sum, by coupling the remedial allocation method with a section 754 election, PTP units remain fungible from a net tax perspective, regardless of the PTP unit seller's section 704(c) position.

However, even when the remedial allocation method is coupled with a section 754 election, the application of section 163(j) in the partnership context results in variable tax attributes for a buyer depending upon the tax characteristics of the interest held by the seller. The Treasury Department and the IRS have determined this is an inappropriate result for PTPs because PTPs, unlike other partnerships, always require that tax attributes be proportionate to economic attributes to retain the fungibility of their units. The Treasury Department and the IRS have determined that the manner in which section 163(j) applies in the partnership context should not result in the non-fungibility of PTP units. Accordingly, these Proposed Regulations provide a method, solely for PTPs, for applying section 163(j) in a manner that does not result in PTP units lacking fungibility.

Specifically, commenters identified three ways in which the 2018 Proposed Regulations may cause PTP units to be non-fungible. First, the method for allocating excess items may cause PTP units to be non-fungible. In general, under § 1.163(j)-6(f)(2), the allocation of the components of ATI dictate the allocation of a partnership's deductible BIE and section 163(j) excess items. Consequently, the unequal sharing of inside basis, including cost-recovery deductions, amortization, gain, and loss affects the ratio in which a partnership's section 163(j) excess items, as defined in § 1.163(j)-6(b)(6), are shared. A partner's share of section 163(j) excess items affects the tax treatment and economic consequences of the partner. For example, a greater share of excess taxable income enables a partner subject to section 163(j) to deduct more interest.

The Treasury Department and the IRS recognize that a non-pro rata sharing of inside basis could result in a non-pro rata allocation of excess items, which may result in PTP units lacking fungibility. Therefore, these Proposed Regulations would amend § 1.163(j)-6(f)(1)(iii) to provide that, solely for purposes of section 163(j), a PTP allocates section 163(j) excess items in accordance with the partners' shares of corresponding section 704(b) items that comprise ATI.

Second, the required adjustments to partner ATI for partner basis items (
e.g.,
section 743(b) income and loss) may cause PTP units to lack fungibility. A non-pro rata sharing of inside basis may result in a different allocation of partner basis items, as defined in § 1.163(j)-6(b)(2), and section 704(c) remedial items, as defined in § 1.163(j)-6(b)(3), among partners. Pursuant to § 1.163(j)-6(d)(2), partner basis items and remedial items are not taken into account in determining a partnership's ATI under § 1.163(j)-1(b)(1). Instead, partner basis items and section 704(c) remedial items affect the tax treatment and economic consequences of the partner. Similar to the disproportionate sharing of excess items discussed earlier, the disproportionate sharing of partner basis items and section 704(c) remedial items among partners may cause PTP units to lack fungibility.

The Treasury Department and the IRS recognize that a non-pro rata sharing of inside basis could result in different partner basis items and remedial items being allocated to different partners. Therefore, these Proposed Regulations would amend § 1.163(j)-6(e)(2)(ii) to provide that, solely for the purpose of determining remedial items under section 163(j), a PTP either allocates gain or loss that would otherwise be allocated under section 704(c) to a specific partner to all partners based on each partner's section 704(b) sharing ratio, or, for purposes of allocating cost recovery deductions under section 704(c), determines each partner's remedial items based on an allocation of the partnership's inside basis items among its partners in proportion to their share of corresponding section 704(b) items, rather than applying the traditional method as described in § 1.704-3(b).

Third, the treatment of section 704(c) remedial income allocations for taxable years beginning before 2022 may cause PTP units to lack fungibility. For taxable years beginning before January 1, 2022, when tentative taxable income is not reduced by depreciation and amortization deductions for purposes of determining ATI, a buyer acquiring PTP units with section 704(c) remedial income allocations (and an offsetting section 743(b) adjustment) will have an increase to its ATI that exceeds that of a buyer of the same number of otherwise fungible units that is not stepping into section 704(c) remedial income (with no corresponding section 743(b) deduction). While the net amount of the section 743(b) and section 704(c) remedial items is the same to both buyers, for taxable years beginning before January 1, 2022, different units would affect a buyer's ATI differently. The section 704(c) remedial income of a buyer of units with section 704(c) remedial income would be included in its ATI, while the section 743(b) deductions would not. Thus, a buyer of units with section 704(c) remedial income would increase its ATI each year (before 2022). A buyer of units with no section 704(c) remedial income, however, would add back any remedial depreciation and amortization deductions before 2022, and its ATI would be unaffected by the remedial deductions for such years.

The Treasury Department and the IRS recognize that, before 2022, a buyer of PTP units with inherent section 704(c) gain would include any remedial income and would not include section 743(b) deductions in its ATI. Therefore, these Proposed Regulations would amend § 1.163(j)-6(d)(2)(ii) to provide that, solely for purposes of section 163(j), a PTP treats the amount of any section 743(b) adjustment of a purchaser of a partnership unit that relates to a remedial item that the purchaser inherits from the seller as an offset to

the related section 704(c) remedial item. The Treasury Department and the IRS request comments as to whether the approaches outlined adequately resolves the fungibility issues created by section 163(j).

C. Treatment of Business Interest Income and Business Interest Expense With Respect to Lending Transactions Between a Partnership and a Partner (Self-Charged Lending Transactions)

The 2018 Proposed Regulations reserved on the treatment of BII and BIE with respect to lending transactions between a partnership and a partner (self-charged lending transactions). The preamble to the 2018 Proposed Regulations requested comments regarding self-charged lending transactions. One commenter recommended the final regulations include rules under § 1.163(j)-6(n) akin to those contained in § 1.469-7 to identify self-charged interest income and expense and further allow such self-charged interest income and expense to be excluded from the definition of BIE and BII under section 163(j)(5) and (6), respectively. The same commenter recommended that the final regulations retain the rule in § 1.163(j)-3(b)(4), as set forth in the 2018 Proposed Regulations, which applies the section 163(j) limitation prior to the application of the passive activity loss rules of section 469. Other commenters recommended the Final Regulations exclude BIE and BII from the section 163(j) calculation where a partner or S-corporation shareholder lends to, or borrows from, a passthrough entity. These commenters recommended that the amount excluded be based on the amount of income or expense recognized by partners or shareholders that are lenders or borrowers, as well as partners or shareholders that are related to a lender or borrower partner within the meaning of section 267(b) because it would be appropriate to exclude the BII and BIE realized by the related parties for purposes of the section 163(j) calculation.

In response to these comments, the Treasury Department and the IRS propose adding a rule in proposed § 1.163(j)-6(n) to provide that, in the case of a lending transaction between a partner (lending partner) and partnership (borrowing partnership) in which the lending partner owns a direct interest (self-charged lending transaction), any BIE of the borrowing partnership attributable to the self-charged lending transaction is BIE of the borrowing partnership for purposes of § 1.163(j)-6. If in a given taxable year the lending partner is allocated EBIE from the borrowing partnership and has interest income attributable to the self-charged lending transaction (interest income), the lending partner shall treat such interest income as an allocation of excess business interest income (EBII) from the borrowing partnership in such taxable year, but only to the extent of the lending partner's allocation of EBIE from the borrowing partnership in such taxable year. To prevent the double counting of BII, the lending partner includes interest income that was re-characterized as EBII pursuant to proposed § 1.163(j)-6(n) only once when calculating the lending partner's own section 163(j) limitation. In cases where the lending partner is not a C corporation, to the extent that any interest income exceeds the lending partner's allocation of EBIE from the borrowing partnership for the taxable year, and such interest income otherwise would be properly treated as investment income of the lending partner for purposes of section 163(d) for that year, such excess amount of interest income will continue to be treated as investment income of the lending partner for that year for purposes of section 163(d).

The Treasury Department and the IRS generally agree that lending partners should not be adversely affected by the fact that, without special rules, the interest income received at the partner level from such lending transactions generally will be treated as investment income if the partner is not engaged in the trade or business of lending money, while the BIE of the partnership will be subject to section 163(j) and potentially limited at the partner level as EBIE. This situation would create a mismatch between the character of the interest income and of the interest expense at the partner level from the same lending transaction. These proposed rules would apply only to items of interest income attributable to the lending transaction and EBIE from the same partnership that arise in the same taxable year of the lending partner. By applying these proposed rules only to correct a mismatch in character that may occur at the partner level during a single taxable year, these proposed rules otherwise ensure that a partnership engaged in a self-charged lending transaction will be subject to the rules of section 163(j) to the same extent regardless of the sources of its loans.

These proposed rules will not apply in the case of an S corporation because BIE of an S corporation is carried over by the S corporation as a corporate-level attribute rather than immediately passed through to its shareholders. In the year such disallowed BIE is deductible at the corporate level, it is not separately stated, and it is not subject to further limitation under section 163(j) at either the S corporation or shareholder level. Therefore, a limited self-charged rule to ensure proper matching of the character of interest income and BIE at the shareholder level is not necessary. This approach is consistent with the treatment of S corporations as separate entities from their owners, both generally and specifically with respect to section 163(j).

However, the Treasury Department and the IRS recognize that issues analogous to the issues faced by partnerships in self-charged lending transactions exist with respect to lending transactions between S corporations and their shareholders. The Treasury Department and the IRS request comments on whether a similar rule is appropriate for S corporations in light of section 163(j)(4)(B) not applying and, if so, how such rule should be structured.

D. Partnership Basis Adjustments Upon Partner Dispositions

In general, a partnership's disallowed BIE is allocated to its partners as EBIE rather than carried forward at the partnership level in order to prevent the trafficking of deductions for BIE carryforwards in the partnership context. To achieve this, section 163(j)(4)(B)(iii)(I) provides that the adjusted basis of a partner in a partnership interest is reduced (but not below zero) by the amount of EBIE allocated to the partner. If a partner disposes of a partnership interest, section 163(j)(4)(B)(iii)(II) provides that the adjusted basis of the partner in the partnership interest is increased immediately before the disposition by the amount of any EBIE that was not treated as BIE paid or accrued by the partner prior to the disposition. Further, under section 163(j)(4)(B)(iii)(II), no deduction shall be allowed to the transferor or transferee for any EBIE resulting in a basis increase.

The Treasury Department and the IRS have determined that the basis increase required by section 163(j)(4)(B)(iii)(II) is not fully descriptive of what is occurring when a partner with EBIE disposes of its partnership interest. If EBIE is not treated as BIE paid or accrued by the partner pursuant to § 1.163(j)-6(g) prior to the partner disposing of its partnership interest (nondeductible EBIE), section 163(j)(4)(B)(iii)(II) treats such nondeductible EBIE as though it were a nondeductible expense of the partnership.

This nondeductible expense is not a nondeductible, non-capitalizable expense under section 705(a)(2)(B). If it were, the partner's basis in its partnership interest at the time of the disposition would already reflect such an expense. Instead, section 163(j)(4)(B)(iii)(II) requires the partner to increase its basis immediately before the disposition—in effect, treating the partner as though the partnership made a payment that decreased the value of the partnership interest but did not affect the partner's basis in its partnership interest. Thus, upon a disposition, section 163(j)(4) treats nondeductible EBIE as though it were a nondeductible, capitalizable expense of the partnership.

While the statute is clear that a partner increases the basis in its partnership interest immediately prior to a disposition by any nondeductible EBIE, it does not specifically state that there must also be a corresponding increase to the basis of partnership assets to account for the nondeductible, capitalized expense (
i.e.,
the nondeductible EBIE). The absence of a corresponding increase to the partnership's basis immediately before the partner's disposition would create distortions that are inconsistent with the intent of both section 163(j) and subchapter K of the Code.

For example, the basis increase attributable to nondeductible EBIE immediately before a liquidating distribution results in less gain recognized under section 731(a)(1) (or more loss recognized under section 731(a)(2)) for the partner disposing of its partnership interest. Consequently, following a liquidating distribution to a partner with EBIE, section 163(j)(4)(B)(iii)(II) causes a reduced section 734(b) adjustment if the partnership has a section 754 election in effect (versus the partner basis increase not occurring), resulting in basis disparity between the partnership's basis in its assets and the aggregate outside basis of the remaining partners.

To illustrate, consider the following example. In Year 1, A, B, and C formed partnership PRS by each contributing $1,000 cash. PRS borrowed $900, causing each partner's basis in PRS to increase by $300. Also in Year 1, PRS purchased Capital Asset X for $200. In Year 2, PRS pays $300 of BIE, all of which is disallowed and treated as EBIE. PRS allocated the $300 of EBIE to its partners, $100 each. Pursuant to § 1.163(j)-6(h)(2), each partner reduced its outside basis by its $100 allocation of EBIE to $1,200. In Year 3, when the fair market value of Capital Asset X is $3,200 and no partner's basis in PRS has changed, PRS distributed $1,900 to C in complete liquidation of C's partnership interest. PRS has a section 754 election in effect in Year 3.

Pursuant to § 1.163(j)-6(h)(3), C increases the adjusted basis of its partnership interest by $100 immediately before the disposition. Thus, C's section 731(a)(1) gain recognized on the disposition of its partnership interest is $900 (($1,900 cash + $300 relief of liabilities)−($1,200 outside basis + $100 EBIE add-back)). Because the election under section 754 is in effect, PRS has a section 734(b) increase to the basis of its assets of $900 (the amount of section 731(a)(1) gain recognized by C). Under section 755, the entire adjustment is allocated to Capital Asset X. As a result, PRS's basis for Capital Asset X is $1,100 ($200 + $900 section 734(b) adjustment). Following the liquidation of C, PRS's basis in its assets ($1,500 of cash + $1,100 of Capital Asset X) does not equal the aggregate outside basis of partners A and B ($2,700).

The Treasury Department and the IRS have determined that basis disparity resulting from the absence of a corresponding inside basis increase, as described earlier, is an inappropriate result. Accordingly, these Proposed Regulations would provide for a corresponding inside basis increase that would serve as the partnership analog of section 163(j)(4)(B)(iii)(II). Specifically, proposed § 1.163(j)-6(h)(5) would provide that if a partner (transferor) disposes of its partnership interest, the partnership shall increase the adjusted basis of partnership property by an amount equal to the amount of the increase required under § 1.163(j)-6(h)(3), if any, to the adjusted basis of the partnership interest being disposed of by the transferor. Such increase in the adjusted basis of partnership property (§ 1.163(j)-6(h)(5) basis adjustment) shall be allocated among partnership properties in the same manner as a positive section 734(b) adjustment. Because a § 1.163(j)-6(h)(5) basis adjustment is taken into account when determining the gain or loss upon a sale of the asset, a § 1.163(j)-6(h)(5) basis adjustment prevents the shifting of built-in gain to the remaining partners.

These Proposed Regulations would adopt an approach that treats the increase in the adjusted basis of any partnership property resulting from a § 1.163(j)-6(h)(5) basis adjustment as not depreciable or amortizable under any section of the Code, regardless of whether the partnership property allocated such § 1.163(j)-6(h)(5) basis adjustment is otherwise generally depreciable or amortizable. This approach perceives EBIE as a deduction that was disallowed to the partnership (consistent with section 163(j)(4)(B)(iii)(II)), and thus should not result in a depreciable section 734(b) basis adjustment.

The Treasury Department and the IRS request comments on this approach. An alternative approach considered by the Treasury Department and the IRS would treat a § 1.163(j)-6(h)(5) basis adjustment as depreciable or amortizable if it is allocated to depreciable or amortizable property. However, section 163(j)(4)(B)(iii)(II) provides that no deduction shall be allowed to the transferor or transferee for any EBIE resulting in a basis increase to the partner that disposed of its interest. If a § 1.163(j)-6(h)(5) basis adjustment were depreciable or amortizable, a partnership—which can arguably be viewed as a transferee in a transaction in which a partner receives a distribution in complete liquidation of its partnership interest—could effectively deduct an expense that section 163(j)(4)(B)(iii)(II) states is permanently disallowed. The Treasury Department and the IRS request comments on whether treating a § 1.163(j)-6(h)(5) basis adjustment as potentially depreciable or amortizable is consistent with section 163(j)(4)(B)(iii)(II).

E. Treatment of Excess Business Interest Expense in Tiered Partnerships

1. Entity Approach

The preamble to the 2018 Proposed Regulations reserved and requested comments on the application of section 163(j)(4) to tiered partnership structures. Specifically, the preamble to the 2018 Proposed Regulations requested comments regarding whether, in a tiered partnership structure, EBIE should be allocated through an upper-tier partnership to the partners of upper-tier partnership. Additionally, comments were requested regarding how and when the basis of an upper-tier partnership partner should be adjusted when a lower-tier partnership has BIE that is limited under section 163(j).

In response, commenters recommended approaches that, in general, either (1) allocated EBIE through upper-tier partnership to the partners of upper-tier partnership (Aggregate Approach), or (2) did not allocate EBIE through upper-tier partnership to the partners of upper-tier partnership (Entity Approach). Commenters stated that both approaches reasonably implement Congressional intent of applying section 163(j) at the partnership level; however, the Entity

Approach reflects a stronger allegiance to entity treatment of partnerships for purposes of section 163(j). Commenters noted that the ultimate determination of which approach is more appropriate should rest, in large part, on whether partnerships or partners are more able to comply with the provision. The Entity Approach places more of that burden on partnerships, and the Aggregate Approach places more of the burden on partners. Commenters recommended that partnerships are better able to comply with an Entity Approach than partners are able to comply with an Aggregate Approach. Further, because the Entity Approach centers a significant portion of the compliance effort with partnerships, the Entity Approach may increase compliance and simplify Service review.

The Treasury Department and the IRS have concluded that an Entity Approach is the most consistent with the approach taken to partnerships under section 163(j)(4). Further, the Treasury Department and the IRS agree with commenters that partnerships are better able to comply with section 163(j) tiered partnership rules than partners. Accordingly, proposed § 1.163(j)-6(j)(3) would provide that if lower-tier partnership allocates excess business interest expense to upper-tier partnership, then upper-tier partnership reduces its basis in lower-tier partnership pursuant to § 1.163(j)-6(h)(2). Upper-tier partnership partners do not, however, reduce the bases of their upper-tier partnership interests pursuant to § 1.163(j)-6(h)(2) until upper-tier partnership treats such excess business interest expense as business interest expense paid or accrued pursuant to § 1.163(j)-6(g).

Although proposed § 1.163(j)-6(j)(3) would provide that EBIE allocated from a lower-tier partnership to an upper-tier partnership is not subject to further allocation by the upper-tier partnership, such EBIE necessarily reflects a reduction in the value of lower-tier partnership by the amount of the economic outlay that resulted in such EBIE. Accordingly, proposed § 1.163(j)-6(j)(2) would provide that if lower-tier partnership pays or accrues business interest expense and allocates such business interest expense to upper-tier partnership, then both upper-tier partnership and any direct or indirect partners of upper-tier partnership shall, solely for purposes of section 704(b) and the regulations thereunder, treat such business interest expense as a section 705(a)(2)(B) expenditure. Any section 704(b) capital account reduction resulting from such treatment occurs regardless of whether such business interest expense is characterized under this section as excess business interest expense or deductible business interest expense by lower-tier partnership. If upper-tier partnership subsequently treats any excess business interest expense allocated from lower-tier partnership as business interest expense paid or accrued pursuant to § 1.163(j)-6(g), the section 704(b) capital accounts of any direct or indirect partners of upper-tier partnership are not further reduced.

2. Basis and Carryforward Component of EBIE

Some commenters stated that an Entity Approach—that is, the approach these Proposed Regulations would adopt—would result in basis disparity between upper-tier partnership's basis in its assets and the aggregate basis of the upper-tier partners' interests in upper-tier partnership. The Treasury Department and the IRS do not agree. EBIE is neither an item of deduction nor a section 705(a)(2)(B) expense. If an allocation of EBIE from lower-tier partnership results in a reduction of the upper-tier partnership's basis in its lower-tier partnership interest, there is not a net reduction in the tax attributes of the upper-tier partnership. Rather, in such an event, upper-tier partnership merely exchanges one tax attribute (tax basis in its lower-tier partnership interest) for a different tax attribute (EBIE, which, in a subsequent year, could result in either a deduction or a basis adjustment). Thus, basis is preserved in this exchange.

Accordingly, proposed § 1.163(j)-6(j)(4) would provide that if lower-tier partnership allocates excess business interest expense to upper-tier partnership and such excess business interest expense is not suspended under section 704(d), then upper-tier partnership shall treat such excess business interest expense (UTP EBIE) as a nondepreciable capital asset, with a fair market value of zero and basis equal to the amount by which upper-tier partnership reduced its basis in lower-tier partnership pursuant to § 1.163(j)-6(h)(2) due to the allocation of such excess business interest expense. The fair market value of UTP EBIE, described in the preceding sentence, is not adjusted by any revaluations occurring under § 1.704-1(b)(2)(iv)(f).

In addition to generally treating UTP EBIE as having a basis component in excess of fair market value and, thus, built-in loss property, proposed § 1.163(j)-6(j)(4) would also provide that upper-tier partnership shall also treat UTP EBIE as having a carryforward component associated with it. The carryforward component of UTP EBIE shall equal the amount of excess business interest expense allocated from lower-tier partnership to upper-tier partnership under § 1.163(j)-6(f)(2) that is treated as such under § 1.163(j)-6(h)(2) by upper-tier partnership.

The carryforward component of UTP EBIE and the basis component of such UTP EBIE will always be equal immediately following the allocation of such EBIE from lower-tier partnership to upper-tier partnership if, at the time of such allocation, upper-tier partnership was required to reduce its section 704(b) capital account pursuant to proposed § 1.163(j)-6(j)(2) due to such allocation. However, subsequent to such initial allocation of EBIE from lower-tier partnership to upper-tier partnership, disparities between the carryforward component of UTP EBIE and the basis component of such UTP EBIE may arise as a result of proposed § 1.163(j)-6(j)(7).

Similar to the treatment of partner basis items (which do not affect the ATI of a partnership), proposed § 1.163(j)-6(j)(7)(i) would provide that negative basis adjustments under sections 734(b) and 743(b) allocated to UTP EBIE do not affect the carryforward component of such UTP EBIE; rather, negative basis adjustments under sections 734(b) and 743(b) affect only the basis component of such UTP EBIE. Although section 734(b) adjustments do affect a partnership's computation of ATI, the Treasury Department and the IRS have determined that negative section 734(b) adjustments, if allocated to UTP EBIE, should not reduce the carryforward component of such UTP EBIE. The purpose of proposed § 1.163(j)-6(j)(7)—in addition to preventing the duplication of loss—is to make partners indifferent for section 163(j) purposes as to whether a partner exiting upper-tier partnership sells its interest or receives a liquidating distribution from upper-tier partnership. Excluding negative section 734(b) adjustments from proposed § 1.163(j)-6(j)(7) would frustrate this purpose.

3. UTP EBIE Conversion Events

Proposed § 1.163(j)-6(j)(4) would further provide that if an allocation of excess business interest expense from lower-tier partnership is treated as UTP EBIE of upper-tier partnership, upper-tier partnership shall treat such allocation of excess business interest expense from lower-tier partnership as UTP EBIE until the occurrence of an UTP EBIE conversion event described in proposed § 1.163(j)-6(j)(5). In the non-tiered context, EBIE generally has two types of conversion events. The first EBIE conversion event is when EBIE is

treated as BIE paid or accrued pursuant to § 1.163(j)-6(g). The second EBIE conversion event is the basis addback that occurs pursuant to proposed § 1.163(j)-6(h)(3) when a partner disposes of its interest in a partnership. Proposed § 1.163(j)-6(j)(5)(i) and (ii), respectively, would provide guidance regarding these two types of conversion events in the tiered partnership context.

a. First Type of Conversion Event—UTP EBIE Treated as Paid or Accrued

Regarding the first type of conversion event, proposed § 1.163(j)-6(j)(5)(i) would provide that to the extent upper-tier partnership is allocated excess taxable income (or excess business interest income) from lower-tier partnership, or § 1.163(j)-6 (m)(3) applies, upper-tier partnership shall apply proposed § 1.163(j)-6(j)(5)(i)(A) through (C).

First, proposed § 1.163(j)-6(j)(5)(i)(A) requires upper-tier partnership to apply the rules in § 1.163(j)-6(g) to its UTP EBIE, using any reasonable method (including, for example, FIFO and LIFO) to determine which UTP EBIE is treated as business interest expense paid or accrued pursuant § 1.163(j)-6(g). If § 1.163(j)-6(m)(3) applies, upper-tier partnership shall treat all of its UTP EBIE from lower-tier partnership as paid or accrued.

Proposed § 1.163(j)-6(j)(5)(i)(A) would provide that upper-tier partnership must determine which of its UTP EBIE is treated as paid or accrued, as opposed to just providing that upper-tier partnership reduces its UTP EBIE, because UTP EBIE is not necessarily a unified tax attribute of upper-tier partnership. UTP EBIE of upper-tier partnership could have been allocated in different years, have different bases, and have different specified partners (defined in the next paragraph). For example, assume $30 of UTP EBIE was allocated a negative $10 section 734(b) adjustment, resulting in the aggregate of upper-tier partnership's UTP EBIE having a carryforward component of $30 and basis component of $20. Thus, such UTP EBIE could, at most, result in $20 of deduction (the basis of such UTP EBIE). However, upper-tier partnership does not necessarily need $100 of ETI (or $30 of EBII) to deduct such $20. Rather, if upper-tier partnership was allocated $20 of EBII, upper-tier partnership could deduct $20 of business interest expense if, using a reasonable method, it determined the $20 of UTP EBIE with full basis was the UTP EBIE treated as business interest expense paid or accrued pursuant to § 1.163(j)-6(j)(5)(i)(A). Following such treatment, upper-tier partnership would still have $10 of UTP EBIE with $0 basis remaining (that is, $10 of carryforward component and $0 of basis component).

Second, with respect to any UTP EBIE treated as business interest expense paid or accrued in proposed § 1.163(j)-6(j)(5)(i)(A), proposed § 1.163(j)-6(j)(5)(i)(B) would require upper-tier partnership to allocate any business interest expense that was formerly such UTP EBIE to its specified partner. For purposes of proposed § 1.163(j)-6(j), the term specified partner refers to the partner of upper-tier partnership that, due to the initial allocation of excess business interest expense from lower-tier partnership to upper-tier partnership, was required to reduce its section 704(b) capital account pursuant to proposed § 1.163(j)-6(j)(2). Similar principles apply if the specified partner of such business interest expense is itself a partnership.

Proposed § 1.163(j)-6(j)(6) would provide rules if a specified partner disposes of its interest. Specifically, proposed § 1.163(j)-6(j)(6)(i) would provide that if a specified partner (transferor) disposes of an upper-tier partnership interest (or an interest in a partnership that itself is a specified partner), the portion of any UTP EBIE to which the transferor's status as specified partner relates is not reduced pursuant to proposed § 1.163(j)-6(j)(5)(ii). Stated otherwise, if a partner of an upper-tier partnership disposes of its interest in the upper-tier partnership, an interest in the lower-tier partnership held by upper-tier partnership is not deemed to have been similarly disposed of for purposes of proposed § 1.163(j)-6(j)(5)(ii). See Rev. Rul. 87-115. Rather, such UTP EBIE attributable to the interest disposed of is retained by upper-tier partnership and the transferee is treated as the specified partner for purposes of proposed § 1.163(j)-6(j) with respect to such UTP EBIE. Thus, upper-tier partnership must allocate any business interest expense that was formerly such UTP EBIE to the transferee.

Additionally, proposed § 1.163(j)-6(j)(6)(ii) would provide special rules regarding the specified partner of UTP EBIE following certain nonrecognition transactions. Proposed § 1.163(j)-6(j)(6)(ii)(A) would provide that if a specified partner receives a distribution of property in complete liquidation of an upper-tier partnership interest, the portion of UTP EBIE of upper-tier partnership attributable to the liquidated interest shall not have a specified partner. If a specified partner (transferee) receives a distribution of an interest in upper-tier partnership in complete liquidation of a partnership interest, the transferee is the specified partner with respect to UTP EBIE of upper-tier partnership only to the same extent it was prior to the distribution. Similar principles apply where an interest in a partnership that is a specified partner is distributed in complete liquidation of a transferee's partnership interest.

Proposed § 1.163(j)-6(j)(6)(ii)(B) would further provide that if a specified partner (transferor) contributes an upper-tier partnership interest to a partnership (transferee), the transferee is treated as the specified partner for purposes of proposed § 1.163(j)-6(j) with respect to the portion of the UTP EBIE attributable to the contributed interest. Following the transaction, the transferor continues to be the specified partner with respect to the UTP EBIE attributable to the contributed interest. Similar principles apply where an interest in a partnership that is a specified partner is contributed to a partnership.

Finally, after determining the specified partner of the UTP EBIE treated as business interest expense paid or accrued in proposed § 1.163(j)-6(j)(5)(i)(A) and allocating such business interest expense to its specified partner pursuant to proposed § 1.163(j)-6(j)(5)(i)(B), proposed § 1.163(j)-6(j)(5)(i)(C) would require upper-tier partnership to, in the manner provided in proposed § 1.163(j)-6(j)(7)(ii) (or (iii), as the case may be), take into account any negative basis adjustments under section 734(b) previously made to the UTP EBIE treated as business interest expense paid or accrued in (A) earlier. Additionally, persons treated as specified partners with respect to the UTP EBIE treated as business interest expense paid or accrued in (A) earlier shall take any negative basis adjustments under section 743(b) into account in the manner provided in proposed § 1.163(j)-6(j)(7)(ii) (or (iii), as the case may be).

Proposed § 1.163(j)-6(j)(7)(ii) would provide that if UTP EBIE that was allocated a negative section 734(b) adjustment is subsequently treated as deductible business interest expense, then such deductible business interest expense does not result in a deduction to the upper-tier partnership or the specified partner of such deductible business interest expense. If UTP EBIE that was allocated a negative section 743(b) adjustment is subsequently treated as deductible business interest expense, the specified partner of such deductible business interest expense recovers any negative section 743(b) adjustment attributable to such deductible business interest expense

(effectively eliminating any deduction for such deductible business interest expense).

Proposed § 1.163(j)-6(j)(7)(iii) would provide that if UTP EBIE that was allocated a negative section 734(b) or 743(b) adjustment is subsequently treated as excess business interest expense, the specified partner's basis decrease in its upper-tier partnership interest required under proposed § 1.163(j)-6(h)(2) is reduced by the amount of the negative section 734(b) or 743(b) adjustment previously made to such excess business interest expense. If such excess business interest expense is subsequently treated as business interest expense paid or accrued by the specified partner, no deduction shall be allowed for any of such business interest expense. If the specified partner of such excess business interest expense is a partnership, such excess business interest expense is considered UTP EBIE that was previously allocated a negative section 734(b) adjustment for purposes of proposed § 1.163(j)-6(j).

b. Second Type of Conversion Event—UTP EBIE Reduction

Regarding the second type of conversion event, proposed § 1.163(j)-6(j)(5)(ii) would provide that if upper-tier partnership disposes of a lower-tier partnership interest (transferred interest), upper-tier partnership shall apply proposed § 1.163(j)-6(j)(5)(ii)(A) through (C).

First, proposed § 1.163(j)-6(j)(5)(ii)(A) would require upper-tier partnership to apply the rules in § 1.163(j)-6(h)(3) (except as provided in (B) and (C) later), using any reasonable method (including, for example, FIFO and LIFO) to determine which UTP EBIE is reduced pursuant to § 1.163(j)-6(h)(3). Stated otherwise, proposed § 1.163(j)-6(j)(5)(ii)(A) would require upper-tier partnership to apply all of the rules in § 1.163(j)-6(h)(3), except for the rule that determines the amount of the basis increase immediately before the disposition to the disposed of interest (the first sentence of § 1.163(j)-6(h)(3)). In lieu of applying the first sentence of § 1.163(j)-6(h)(3), upper-tier partnership would apply proposed § 1.163(j)-6(j)(5)(ii)(B) and (C) to determine the amount of such basis increase.

Second, proposed § 1.163(j)-6(j)(5)(ii)(B) would require upper-tier partnership to increase the adjusted basis of the transferred interest immediately before the disposition by the total amount of the UTP EBIE that was reduced in (A) earlier (the amount of UTP EBIE proportionate to the transferred interest). For example, if upper-tier partnership disposed of half of its lower-tier partnership interest while it held $40 of UTP EBIE allocated from lower tier partnership, upper-tier partnership would increase the adjusted basis of the disposed of lower-tier partnership interest by $20. However, immediately before the disposition, such $20 increase may be reduced pursuant to proposed § 1.163(j)-6(j)(5)(ii)(C).

Third, proposed § 1.163(j)-6(j)(5)(ii)(C) would require upper-tier partnership to, in the manner provided in proposed § 1.163(j)-6(j)(7)(iv), take into account any negative basis adjustments under sections 734(b) and 743(b) previously made to the UTP EBIE that was reduced in (A) earlier. Proposed § 1.163(j)-6(j)(7)(iv) would provide that if UTP EBIE that was allocated a negative section 734(b) or 743(b) adjustment is reduced pursuant to proposed § 1.163(j)-6(j)(5)(ii)(A), the amount of upper-tier partnership's basis increase under proposed § 1.163(j)-6(j)(5)(ii)(B) to the disposed of lower-tier partnership interest is reduced by the amount of the negative section 734(b) or 743(b) adjustment previously made to such UTP EBIE.

Continuing with the previous example, assume that $5 of the $20 of UTP EBIE reduced pursuant to proposed § 1.163(j)-6(j)(5)(ii)(A) was previously allocated a $5 negative section 743(b) adjustment. Pursuant to proposed § 1.163(j)-6(j)(5)(ii)(C), upper-tier partnership would reduce the $20 increase it determined under proposed § 1.163(j)-6(j)(5)(ii)(B) by $5. Thus, the adjusted basis of the lower-tier partnership interest being disposed of would be increased by $15 immediately before the disposition. Consequently, lower-tier partnership would have a corresponding § 1.163(j)-6(h)(5) basis adjustment to its property of $15.

4. Anti-Loss Trafficking Rules

Proposed § 1.163(j)-6(j) generally relies on negative sections 734(b) and 743(b) adjustments to prevent a partner from deducting business interest expense that was formerly UTP EBIE if such partner did not bear the economic cost of such business interest expense payment. To the extent a negative section 734(b) or 743(b) adjustment fails to prohibit such a deduction (or basis increase under proposed § 1.163(j)-6(j)(5)(ii)), the anti-loss trafficking rules in proposed § 1.163(j)-6(j)(8) would prohibit such a deduction (or basis addback under proposed § 1.163(j)-6(j)(5)(ii)).

The anti-loss trafficking rule under proposed § 1.163(j)-6(j)(8)(i) would prohibit the trafficking of business interest expense by providing that no deduction shall be allowed to any transferee specified partner for any business interest expense derived from a transferor's share of UTP EBIE. For purposes of proposed § 1.163(j)-6(j), the term transferee specified partner refers to any specified partner that did not reduce its section 704(b) capital account upon the initial allocation of excess business interest expense from lower-tier partnership to upper-tier partnership pursuant to proposed § 1.163(j)-6(j)(2). However, the transferee described in proposed § 1.163(j)-6(j)(ii)(B) is not a transferee specified partner for purposes of proposed § 1.163(j)-6(j).

Proposed § 1.163(j)-6(j)(8)(i) would also provide the mechanism for disallowing such BIE. Proposed § 1.163(j)-6(j)(8)(i) would provide that if, pursuant to proposed § 1.163(j)-6(j)(5)(i)(B), a transferee specified partner is allocated business interest expense derived from a transferor's share of UTP EBIE (business interest expense to which the partner's status as transferee specified partner relates), the transferee specified partner is deemed to recover a negative section 743(b) adjustment with respect to, and in the amount of, such business interest expense and takes such negative section 743(b) adjustment into account in the manner provided in proposed § 1.163(j)-6(j)(7)(ii) (or (iii), as the case may be), regardless of whether a section 754 election was in effect or a substantial built-in loss existed at the time of the transfer by which the transferee specified partner acquired the transferred interest. However, to the extent a negative section 734(b) or 743(b) adjustment was previously made to such business interest expense, the transferee specified partner does not recover an additional negative section 743(b) adjustment pursuant to this paragraph.

Additionally, the anti-loss trafficking rule under proposed § 1.163(j)-6(j)(8)(ii) would prohibit the trafficking of BIE that was formerly the UTP EBIE of a specified partner that received a distribution in complete liquidation of its upper-tier partnership interest. Specifically, proposed § 1.163(j)-6(j)(8)(ii) would provide that if UTP EBIE does not have a specified partner (as the result of a transaction described in proposed § 1.163(j)-6(j)(6)(ii)(A)), upper-tier partnership shall not allocate any business interest expense that was formerly such UTP EBIE to its partners. Rather, for purposes of applying § 1.163(j)-6(f)(2), upper-tier partnership shall treat such business interest expense as the allocable business interest expense (as defined in

§ 1.163(j)-6(f)(2)(ii)) of a § 1.163(j)-6(j)(8)(ii) account.

Any deductible business interest expense and excess business interest expense allocated to a § 1.163(j)-6(j)(8)(ii) account at the conclusion of the eleven-step computation set forth in § 1.163(j)-6(f)(2) is not tracked in future years. Treating such business interest expense as the allocable business interest expense of a separate account for purposes of applying § 1.163(j)-6(f)(2)(ii) ensures that partners of upper-tier partnership do not support a deduction for such business interest expense (for which no deduction will be allowed) using their shares of allocable ATI and allocable business interest income before supporting a deduction for their own shares of allocable business interest expense (for which a deduction may be allowed).

Additionally, if UTP EBIE that does not have a specified partner (as the result of a transaction described in proposed § 1.163(j)-6(j)(6)(ii)(A)) is treated as paid or accrued pursuant to § 1.163(j)-6(g), upper-tier partnership shall make a § 1.163(j)-6(h)(5) basis adjustment to its property in the amount of the adjusted basis (if any) of such UTP EBIE at the time such UTP EBIE is treated as business interest expense paid or accrued pursuant to § 1.163(j)-6(g). The purpose of this § 1.163(j)-6(h)(5) basis adjustment is to preserve basis in the system.

Thus, any time upper-tier partnership treats UTP EBIE as business interest expense paid or accrued pursuant to proposed § 1.163(j)-6(j)(5)(i)(A) it must apply proposed § 1.163(j)-6(j)(8)(i) and (ii). In application, upper-tier partnership would generally undertake the following analysis when applying proposed § 1.163(j)-6(j)(8)(i) and (ii). With respect to any UTP EBIE treated as business interest expense paid or accrued pursuant to proposed § 1.163(j)-6(j)(5)(i)(A) (UTP BIE), upper-tier partnership must first determine whether such UTP BIE has a specified partner. If it does not have a specified partner, upper-tier partnership must apply proposed § 1.163(j)-6(j)(8)(ii), which, in general, requires upper-tier partnership to capitalize the basis (if any) of such UTP BIE into the basis of upper-tier partnership property via a § 1.163(j)-6(h)(5) basis adjustment.

If UTP BIE does have a specified partner, upper-tier partnership must next determine whether the specified partner of such UTP BIE reduced its section 704(b) capital account upon the initial allocation of such excess business interest expense from lower-tier partnership to upper-tier partnership pursuant to proposed § 1.163(j)-6(j)(2). If the specified partner did reduce its section 704(b) capital account upon such initial allocation, then any deduction for such UTP BIE is not disallowed under proposed § 1.163(j)-6(j)(8)(i). However, if the specified partner did not reduce its section 704(b) capital account upon such initial allocation, upper-tier partnership must next determine whether such specified partner is a transferee described in proposed § 1.163(j)-6(j)(6)(ii)(B). If it is, then any deduction for such UTP BIE is not disallowed under proposed § 1.163(j)-6(j)(8)(i). However, if the specified partner is not a transferee described in proposed § 1.163(j)-6(j)(6)(ii)(B), then it is a transferee specified partner, as defined in proposed § 1.163(j)-6(j)(8)(i). As a result, any deduction for such UTP BIE is disallowed under proposed § 1.163(j)-6(j)(8)(i). If there are multiple tiers of partnerships, each tier must apply these rules.

Finally, proposed § 1.163(j)-6(j)(8)(iii) would provide a similar mechanism to proposed § 1.163(j)-6(j)(8)(i) for disallowing basis addbacks under § 1.163(j)-6(h)(3) for certain UTP EBIE. Specifically, proposed § 1.163(j)-6(j)(8)(iii) would provide that no basis increase under proposed § 1.163(j)-6(j)(5)(ii) shall be allowed to upper-tier partnership for any disallowed UTP EBIE. For purposes of § 1.163(j)-6, the term disallowed UTP EBIE refers to any UTP EBIE that has a specified partner that is a transferee specified partner (as defined in proposed § 1.163(j)-6(j)(8)(i)) and any UTP EBIE that does not have a specified partner (as the result of a transaction described in proposed § 1.163(j)-6(j)(6)(ii)(A)). For purposes of applying proposed § 1.163(j)-6(j)(5)(ii), upper-tier partnership shall treat any disallowed UTP EBIE in the same manner as UTP EBIE that has previously been allocated a negative section 734(b) adjustment. However, upper-tier partnership does not treat disallowed UTP EBIE as though it were allocated a negative section 734(b) adjustment pursuant to this paragraph to the extent a negative section 734(b) or 743(b) adjustment was previously made to such disallowed UTP EBIE.

5. Foundational Determinations

In general, the rules under proposed § 1.163(j)-6(j) are derived from the following three foundational determinations made by the Treasury Department and the IRS. First, basis is preserved when upper-tier partnership exchanges basis in its lower-tier partnership for EBIE allocated from lower-tier partnership (UTP EBIE). Thus, upper-tier partnership generally must treat UTP EBIE in the same manner as built-in loss property. Second, UTP EBIE has two components—a basis component and a carryforward component. In general, negative basis adjustments under section 734(b) and 743(b) reduce the basis component of UTP EBIE (and thus, any possible deduction for UTP EBIE), but do not reduce the carryforward component of UTP EBIE; only the two conversion events in proposed § 1.163(j)-6(j)(5) are capable of reducing the carryforward component of UTP EBIE. Third, upper-tier partnership must allocate any business interest expense that was formerly UTP EBIE to its specified partner—that is, the partner that reduced its section 704(b) capital account at the time of the initial allocation of the UTP EBIE from lower-tier partnership to upper-tier partnership. If there is a transfer of a partnership interest, the transferor generally steps into the shoes of the transferee's status as specified partner, but may not deduct any business interest expense derived from the transferor's share of UTP EBIE.

The Treasury Department and the IRS request comments on this approach. Specifically, the Treasury Department and the IRS request comments on whether further guidance on the treatment of UTP EBIE under the rules of subchapter K of the Code is necessary.

F. Partner Basis Adjustments Upon a Distribution

Under the 2018 Proposed Regulations, if a partner disposed of all or substantially all of its partnership interest, the adjusted basis of the partnership interest was increased immediately before the disposition by the entire amount of the EBIE not previously treated as paid or accrued by the partner. If a partner disposed of less than substantially all of its interest in a partnership, the partner could not increase its basis by any portion of the EBIE not previously treated as paid or accrued by the partner. The Treasury Department and the IRS requested comments on this approach in the preamble to the 2018 Proposed Regulations.

As discussed in the preamble to Final Regulations, commenters cited multiple concerns with the approach adopted in the 2018 Proposed Regulations and recommended that the Final Regulations adopt a proportionate approach. Under such an approach, a partial disposition of a partnership interest would trigger a proportionate EBIE basis addback and corresponding decrease in such partner's EBIE carryover. The Treasury

Department and the IRS agreed with commenters. Accordingly, § 1.163(j)-6(h)(3) provides for a proportionate approach.

In general, a distribution from a partnership is either a current distribution or a liquidating distribution; the concept of a redemptive distribution does not exist in the partnership context. Accordingly, proposed § 1.163(j)-6(h)(4) would provide that, for purposes of § 1.163(j)-6(h)(3), a disposition includes a distribution of money or other property by the partnership to a partner in complete liquidation of the partner's interest in the partnership. Proposed § 1.163(j)-6(h)(4) would further provide that, for purposes of § 1.163(j)-6(h)(3), a current distribution of money or other property by the partnership to a continuing partner is not a disposition for purposes of § 1.163(j)-6(h)(3). The Treasury Department and the IRS request comments on whether a current distribution of money or other property by the partnership to a continuing partner as consideration for an interest in the partnership should also trigger an addback and, if so, how to determine the appropriate amount of the addback.

G. Allocable ATI and Allocable Business Interest Income of Upper-Tier Partnership Partners

Section 1.163(j)-6(f)(2) provides an eleven-step computation necessary for properly allocating a partnership's deductible BIE and section 163(j) excess items among its partners. Pursuant to § 1.163(j)-6(f)(2)(ii), a partnership must determine each of its partner's allocable share of each section 163(j) item under section 704(b) and the regulations under section 704 of the Code, including any allocations under section 704(c), other than remedial items. Further, § 1.163(j)-6(f)(2)(ii) provides that the term allocable ATI means a partner's distributive share of the partnership's ATI (that is, a partner's distributive share of gross income and gain items comprising ATI less such partner's distributive share of gross loss and deduction items comprising ATI), and the term allocable business interest income means a partner's distributive share of the partnership's business interest income.

In general, if a partnership is not a partner in a partnership, each dollar of taxable income that is properly allocable to a trade or business will have a corresponding dollar of ATI associated with it. Accordingly, in the non-tiered partnership context, if a partner's share of gross income and gain items comprising ATI less such partner's share of gross loss and deduction items comprising ATI equals $1, such partner will have $1 of allocable ATI for purposes of § 1.163(j)-6(f)(2)(ii).

However, if a partnership is a partner in a partnership, each dollar of taxable income that is properly allocable to a trade or business may not have a full dollar of ATI associated with it. Section 163(j)(4)(A)(ii)(I) provides that the ATI of a partner in a partnership is determined without regard to such partner's distributive share of any items of income, gain, deduction, or loss of such partnership. Further, section 163(j)(4)(A)(ii)(II) provides that a partner only increases its ATI by its distributive share of a partnership's ETI.

To illustrate, consider the following example. LTP has $100 of income and $100 of loss properly allocable to a trade or business. Thus, LTP has $0 of ATI. LTP specially allocates the $100 of income to partner UTP. Under section 163(j)(4)(A)(ii)(I), UTP does not treat such $100 of income as ATI. Additionally, UTP has $300 of income properly allocable to a trade or business, which UTP properly treats as ATI. Here, UTP's taxable income that is properly allocable to a trade or business ($400) does not equal the amount of its ATI ($300).

The Treasury Department and the IRS recognize that a special rule is necessary to coordinate situations like the one illustrated earlier with the general requirement under § 1.163(j)-6(f)(2)(ii) for partnerships to determine a partner's allocable ATI based on such partner's allocation of items comprising the ATI of the partnership. Accordingly, proposed § 1.163(j)-6(j)(9) would provide that, when applying § 1.163(j)-6(f)(2)(ii), an upper-tier partnership determines the allocable ATI and allocable business interest income of each of its partners in the manner provided in proposed § 1.163(j)-6(j)(9). Specifically, if an upper-tier partnership's net amount of tax items that comprise (or have ever comprised) ATI is greater than or equal to its ATI, upper-tier partnership applies the rules in paragraph (j)(9)(ii)(A) to determine each partner's allocable ATI. However, if an upper-tier partnership's net amount of tax items that comprise (or have ever comprised) ATI is less than its ATI, upper-tier partnership applies the rules in proposed § 1.163(j)-6(j)(9)(ii)(B) to determine each partner's allocable ATI. To determine each partner's allocable business interest income, an upper-tier partnership applies the rules in proposed § 1.163(j)-6(j)(9)(iii).

H. Qualified Expenditures

The 2018 Proposed Regulations provided that partnership ATI is reduced by deductions claimed under sections 173 (relating to circulation expenditures), 174(a) (relating to research and experimental expenditures), 263(c) (relating to intangible drilling and development expenditures), 616(a) (relating to mine development expenditures), and 617(a) (relating to mining exploration expenditures) (collectively “qualified expenditures”). As a result, deductions for qualified expenditures reduced the amount of business interest expense a partnership could potentially deduct.

A partner may elect to capitalize its distributive share of any qualified expenditures of a partnership under section 59(e)(4)(C) or may be required to capitalize a portion of its distributive share of certain qualified expenditures of a partnership under section 291(b). As a result, the taxable income reported by a partner in a taxable year attributable to the ownership of a partnership interest may exceed the amount of taxable income reported to the partner on a Schedule K-1.

Commenters on the 2018 Proposed Regulations recommended that a distributive share of partnership deductions capitalized by a partner under section 59(e) or section 291(b) increase the ATI of the partner because qualified expenditures reduce both partnership ATI and excess taxable income, but may not reduce the taxable income of a partner. Two different approaches for achieving this result were suggested: (1) Adjust the excess taxable income of the partnership, resulting in an increase to partner ATI, and (2) increase the ATI of the partner directly, without making any adjustments to partnership excess taxable income.

The Treasury Department and IRS agree that a distributive share of partnership deductions capitalized by a partner under section 59(e) should increase the ATI of the partner and adopt the recommended approach of increasing the ATI of the partner directly, without making any adjustments to partnership excess taxable income. The approach of increasing partner ATI by adjusting partnership excess taxable income is rejected, as it would result in partnerships with more excess taxable income than ATI—a result not possible under the current statutory conceptual framework. The Treasury Department and IRS have the authority to adjust

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2020-16532. Public record. Not legal advice.