Transition rules

(a) Overview. This section provides transition rules regarding the section 163(j) limitation. Paragraph (b) of this section provides rules regarding the application of the section 163(j) limitation to a corporation that joins a consolidated group during a taxable year of the group beginning before January 1, 2018 and is subject to the section 163(j) limitation at the time of its change in status. Paragraph (c) of this section provides rules regarding the treatment of carryforwards of disallowed disqualified interest.

(b) Application of section 163(j) limitation if a corporation joins a consolidated group during a taxable year of the group beginning before January 1, 2018—(1) In general. If a corporation (S) joins a consolidated group during a taxable year of the group beginning before January 1, 2018, and if S is subject to the section 163(j) limitation at the time of its change in status, then section 163(j) will apply to S's short taxable year that ends on the day of S's change in status, but section 163(j) will not apply to S's short taxable year that begins the next day (when S is a member of the acquiring consolidated group). Any business interest expense paid or accrued (without regard to section 163(j)) by S in its short taxable year ending on the day of S's change in status for which a deduction is disallowed under section 163(j) will be carried forward to the acquiring group's first taxable year beginning after December 31, 2017. Those disallowed business interest expense carryforwards may be subject to limitation under other provisions of these regulations (see, for example, § 1.163(j)-5(c), (d), (e), and (f)).

(2) Example. Acquiring Group is a consolidated group with a fiscal year end of November 30; Target is a stand-alone calendar-year C corporation. On May 31, 2018, Acquiring Group acquires Target in a transaction that is not an ownership change for purposes of section 382. Acquiring Group is not subject to the section 163(j) limitation during its taxable year beginning December 1, 2017. As a result of the acquisition, Target has a short taxable year beginning January 1, 2018 and ending May 31, 2018. Target is subject to the section 163(j) limitation during this short taxable year. However, Target (as a member of Acquiring Group) is not subject to the section 163(j) limitation during Acquiring Group's taxable year ending November 30, 2018. Any disallowed business interest expense carryforwards from Target's taxable year ending May 31, 2018, will not be available for use in Acquiring Group's taxable year ending November 30, 2018. However, that disallowed business interest expense is carried forward to Acquiring Group's taxable year beginning December 1, 2018, and can be deducted by the group, subject to the separate return limitation year (SRLY) limitation. See § 1.163(j)-5(d).

(c) Treatment of disallowed disqualified interest—(1) In general. Disallowed disqualified interest is carried forward to the taxpayer's first taxable year beginning after December 31, 2017. Disallowed disqualified interest is subject to disallowance as a disallowed business interest expense carryforward under section 163(j) and § 1.163(j)-2 to the extent the interest is properly allocable to a non-excepted trade or business under § 1.163(j)-10. Disallowed disqualified interest that is properly allocable to an excepted trade or business is not subject to the section 163(j) limitation. See § 1.163(j)-10(a)(6) for rules governing the allocation of disallowed disqualified interest between excepted and non-excepted trades or businesses.

(2) Earnings and profits. A taxpayer may not reduce its earnings and profits in a taxable year beginning after December 31, 2017, to reflect any disallowed disqualified interest carryforwards to the extent the payment or accrual of the disallowed disqualified interest reduced the earnings and profits of the taxpayer in a prior taxable year.

(3) Disallowed disqualified interest of members of an affiliated group—(i) Scope. This paragraph (c)(3)(i) applies to corporations that were treated as a single taxpayer under old section 163(j)(6)(C) and that had disallowed disqualified interest.

(ii) Allocation of disallowed disqualified interest to members of the affiliated group—(A) In general. Each member of the affiliated group is allocated its allocable share of the affiliated group's disallowed disqualified interest as provided in paragraph (c)(3)(ii)(B) of this section.

(B) Definitions. The following definitions apply for purposes of paragraph (c)(3)(ii) of this section.

(1) Allocable share of the affiliated group's disallowed disqualified interest. The term allocable share of the affiliated group's disallowed disqualified interest means, with respect to any member of an affiliated group for the member's last taxable year beginning before January 1, 2018, the product of the total amount of the disallowed disqualified interest of all members of the affiliated group under old section 163(j)(6)(C) and the member's disallowed disqualified interest ratio.

(2) Disallowed disqualified interest ratio. The term disallowed disqualified interest ratio means, with respect to any member of an affiliated group for the member's last taxable year beginning before January 1, 2018, the ratio of the exempt related person interest expense of the member for the last taxable year beginning before January 1, 2018, to the sum of the amounts of exempt related person interest expense for all members of the affiliated group.

(3) Exempt related person interest expense. The term exempt related person interest expense means interest expense that is, or is treated as, paid or accrued by a domestic C corporation, or by a foreign corporation with income, gain, or loss that is effectively connected, or treated as effectively connected, with the conduct of a trade or business in the United States, to—

(i) Any person related to the taxpayer, within the meaning of sections 267(b) or 707(b)(1), applying the constructive ownership and attribution rules of section 267(c), if no U.S. tax is imposed with respect to the interest under subtitle A of the Code, determined without regard to net operating losses or net operating loss carryovers, and taking into account any applicable treaty obligation of the United States. For this purpose, interest that is subject to a reduced rate of tax under any treaty obligation of the United States applicable to the recipient is treated as, in part, subject to the statutory tax rate under sections 871 or 881 and, in part, not subject to tax, based on the proportion that the rate of tax under the treaty bears to the statutory tax rate. Thus, for purposes of section 163(j), if the statutory tax rate is 30 percent, and pursuant to a treaty U.S. tax is instead limited to a rate of 10 percent, two-thirds of the interest is considered interest not subject to U.S. tax under subtitle A of the Code;

(ii) A person that is not related to the taxpayer, within the meaning of section 267(b) or 707(b)(1), applying the constructive ownership and attribution rules of section 267(c), with respect to indebtedness on which there is a disqualified guarantee, within the meaning of paragraph (6)(D) of old section 163(j), of such indebtedness, and no gross basis U.S. tax is imposed with respect to the interest. For purposes of this paragraph (c)(3)(ii)(B)(3)(ii), a gross basis U.S. tax means any tax imposed by this subtitle A of the Code that is determined by reference to the gross amount of any item of income without any reduction for any deduction allowed by subtitle A of the Code. Interest that is subject to a gross basis U.S. tax that is eligible for a reduced rate of tax under any treaty obligation of the United States applicable to the recipient is treated as, in part, subject to the statutory tax rate under section 871 or 881 and, in part, not subject to a gross basis U.S. tax, based on the proportion that the rate of tax under the treaty bears to the statutory tax rate. Thus, for purposes of section 163(j), if the statutory tax rate is 30 percent, and pursuant to a treaty U.S. tax is instead limited to a rate of 10 percent, two-thirds of the interest is considered interest not subject to a gross basis U.S. tax under subtitle A of the Code; or

(iii) A REIT, directly or indirectly, to the extent that the domestic C corporation, or a foreign corporation with income, gain, or loss that is effectively connected, or treated as effectively connected, with the conduct of a trade or business in the United States, is a taxable REIT subsidiary, as defined in section 856(l), with respect to the REIT.

(iii) Treatment of carryforwards. The amount of disallowed disqualified interest allocated to a taxpayer pursuant to paragraph (c)(3)(ii) of this section is treated in the same manner as described in paragraph (c)(1) of this section.

(4) Application of section 382—(i) Ownership change occurring before November 13, 2020—(A) Pre-change loss. For purposes of section 382(d)(3), unless the rules of § 1.382-2(a)(7) apply, disallowed disqualified interest is not a pre-change loss under § 1.382-2(a) subject to a section 382 limitation with regard to an ownership change on a change date occurring before November 13, 2020. But see section 382(h)(6)(B) (regarding built-in deduction items).

(B) Loss corporation. For purposes of section 382(k)(1), unless the rules of § 1.382-2(a)(7) apply, disallowed disqualified interest is not a carryforward of disallowed interest described in section 381(c)(20) with regard to an ownership change on a change date occurring before November 13, 2020. But see section 382(h)(6) (regarding built-in deductions).

(ii) Ownership change occurring on or after November 13, 2020—(A) Pre-change loss. For rules governing the treatment of disallowed disqualified interest as a pre-change loss for purposes of section 382 with regard to an ownership change on a change date occurring on or after November 13, 2020, see §§ 1.382-2(a)(2) and 1.382-6(c)(3).

(B) Loss corporation. For rules governing when disallowed disqualified interest causes a corporation to be a loss corporation with regard to an ownership change occurring on or after November 13, 2020, see § 1.382-2(a)(1)(i)(A).

(5) Treatment of excess limitation from taxable years beginning before January 1, 2018. No amount of excess limitation under old section 163(j)(2)(B) may be carried forward to taxable years beginning after December 31, 2017.

(6) Example: Members of an affiliated group—(i) Facts. A, B, and C are calendar-year domestic C corporations that are members of an affiliated group (within the meaning of section 1504(a)) that was treated as a single taxpayer under old section 163(j)(6)(C) and the proposed regulations in this part under old section 163(j) (see formerly proposed § 1.163(j)-5). For the taxable year ending December 31, 2017, the separately determined amounts of exempt related person interest expense of A, B, and C were $0, $600x, and $150x, respectively (for a total of $750x). The affiliated group has $200x of disallowed disqualified interest in that year.

(ii) Analysis. The affiliated group's disallowed disqualified interest expense for the 2017 taxable year ($200x) is allocated among A, B, and C based on the ratio of each member's exempt related person interest expense to the group's exempt related person interest expense. Because A has no exempt related person interest expense, no disallowed disqualified interest is allocated to A. Disallowed disqualified interest of $160x is allocated to B (($600x/$750x) × $200x), and disallowed disqualified interest of $40x is allocated to C (($150x/$750x) × $200x). Thus, B and C have $160x and $40x, respectively, of disallowed disqualified interest that is carried forward to the first taxable year beginning after December 31, 2017. No excess limitation that was allocated to A, B, or C under old section 163(j) will carry forward to a taxable year beginning after December 31, 2017.

(iii) Carryforward of disallowed disqualified interest to 2018 taxable year. The facts are the same as in the Example in paragraph (c)(7)(i) of this section, except that, for the taxable year ending December 31, 2018, A, B, and C are members of a consolidated group that has a section 163(j) limitation of $140x, current-year business interest expense (as defined in § 1.163(j)-1(b)(9)) of $80x, and no excepted trade or business. Under paragraph (c)(1) of this section, disallowed disqualified interest is carried to the taxpayer's first taxable year beginning after December 31, 2017, and is subject to disallowance under section 163(j) and § 1.163(j)-2. Under § 1.163(j)-5(b)(3)(ii)(D)(1), a consolidated group that has section 163(j) limitation remaining for the current year after deducting all current-year business interest expense deducts each member's disallowed disqualified interest carryforwards from prior taxable years, starting with the earliest taxable year, on a pro rata basis (subject to certain limitations). In accordance with paragraph (c)(1) of this section, the rule in § 1.163(j)-5(b)(3)(ii)(D)(1) applies to disallowed disqualified interest carried forward to the taxpayer's first taxable year beginning after December 31, 2017. Accordingly, after deducting $80x of current-year business interest expense in 2018, the group may deduct $60x of its $200x disallowed disqualified interest carryforwards. Under paragraph (c)(3) of this section, B has $160x of disallowed disqualified interest carryforwards, and C has $40x of disallowed disqualified interest carryforwards. Thus, $48x (($160x/$200x) × $60x) of B's disallowed disqualified interest carryforwards, and $12x (($40x/$200x) × $60x) of C's disallowed disqualified interest carryforwards, are deducted by the consolidated group in the 2018 taxable year.

(d) Applicability date. This section applies to taxable years beginning on or after November 13, 2020. However, taxpayers and their related parties, within the meaning of sections 267(b) and 707(b)(1), may choose to apply the rules of this section to a taxable year beginning after December 31, 2017, so long as the taxpayers and their related parties consistently apply the rules of the section 163(j) regulations, and, if applicable, §§ 1.263A-9, 1.263A-15, 1.381(c)(20)-1, 1.382-1, 1.382-2, 1.382-5, 1.382-6, 1.382-7, 1.383-0, 1.383-1, 1.469-9, 1.469-11, 1.704-1, 1.882-5, 1.1362-3, 1.1368-1, 1.1377-1, 1.1502-13, 1.1502-21, 1.1502-36, 1.1502-79, 1.1502-91 through 1.1502-99 (to the extent they effectuate the rules of §§ 1.382-2, 1.382-5, 1.382-6, and 1.383-1), and 1.1504-4, to that taxable year.