IRS interim guidance on the tax treatment of disallowed earnings stripping interest to inbound foreign investors in United States real estate
The Tax Cuts and Jobs Act (“TCJA”) changed the law on the deductibility of interest expense for foreign inbound investors in United States real estate. Prior to the TCJA, the tax law had a provision called the earnings stripping rules. These were intended to prevent related parties from using excess leverage to convert what should be taxable dividends into tax free interest. The earnings stripping rules accomplished this by limiting the amount of interest a U.S. blocker C corporation was allowed to deduct. It applied to direct loans from the foreign lender and unrelated party loans guaranteed by the foreign related party to the extent a related foreign lender did not incur U.S. taxes on the interest income earned. . The limitations on the amount of interest was triggered when the debt to equity ratio exceeded 1.5 to 1 and the debtor’s net interest expense exceeded 50 percent of its adjusted taxable income (taxable income before net operating loss deduction, interest expense, depreciation and amortization). A related party was defined as a person or entity that owned more than 50 percent of the borrower. Any disallowed interest was carried forward indefinitely subject to these rules.
When the Tax Cuts and Jobs Act (TCJA) was passed in December 2017, the law on the deductibility of interest was changed for tax years beginning after December 31, 2017. The old earnings stripping law was repealed. The new law allows a taxpayer to deduct interest expense up to 30 percent of adjusted taxable income plus its interest income. For a blocker corporation, adjusted taxable income is taxable income before the net operating loss deduction, depreciation and amortization. The new law applies whether the lender is foreign or domestic.
The new limitation does not apply to taxpayers that have average annual gross receipts of $25 million or less. However, this exception does not apply to taxpayers where 35% or more of the losses are allocated to limited partners or limited entrepreneurs (members of an LLC that do not manage the LLC). Any disallowed interest is carried forward. The limitations do not apply to an electing real property trade or business, which is one that elects ADS depreciation. ADS depreciable life is 40 years for nonresidential realty versus 39 years under the general depreciation system, and 30 years for residential realty versus 27.5 years under the general depreciation system.
After the TCJA was passed, it was unclear what would be the treatment of the disallowed and suspended interest under the old earnings stripping rules. In IRS notice 2018-28, the IRS stated that the suspended interest would not be subject to any limitation based on the old rules. Any interest that had been limited by the interest stripping rules and were being carried forward into 2018, would be treated as if the interest was incurred in 2018 and only be subject to the new rules under the TCJA discussed above.
Application to BEAT tax
The IRS stated that the interest expense carried forward from tax years before 2018 would be subject to the base erosion anti abuse tax (“BEAT”) in the year it is deductible. The BEAT tax, enacted as part of the TCJA, applies to interest paid or accrued by the blocker corporation to the related foreign party lender if it is 3 percent or more of the corporation’s deductible expenses. The BEAT tax rate is a 10 percent minimum tax (5 percent in 2018) on the corporation’s taxable income excluding the interest payment. The BEAT tax is a minimum tax and only applies to the extent it is higher than the regular income tax. The BEAT tax does not apply to corporations with average annual gross receipts of less than $500 million for the three preceding years. The gross receipts of a controlled group of blocker corporations must be aggregated in determining whether the $500 million gross receipts threshold is met. To determine if there is a controlled group, a related party is any person who owns at least 25 percent of the total voting power of all classes entitled to vote or who owns at least 25 percent of the total value of all classes of stock of the blocker corporation. In calculating gross receipts, a blocker corporation would presumably use its share of gross receipts from the LLC that owns the property, rather than its share of the distributable taxable income or loss from the LLC. Interest payments subject to US withholding tax are not subject to the BEAT tax. The rule applies on a proportionate basis if a treaty allows a rate lower than 30 percent.
Application to Earnings and Profits (E&P)
Even if interest was deferred under the earnings stripping rules for regular tax, the interest was deductible in the year it was incurred for E&P purposes. Therefore The IRS has stated that the carried forward interest would have no effect on E&P of the blocker C Corporation for the year it was being carried to. The significance of E&P in this context occurs if a blocker C Corporation has current or accumulated E&P and makes a nonliquidating distribution to the foreign parent. To the extent of the current or accumulated E&P a 30% noncreditable and nonrefundable Federal withholding tax is due, unless reduced by a treaty.
E&P is similar to taxable income but has a few modifications. Examples would include nondeductible expenses and a depreciation adjustment for the difference between MACRS depreciation and ADS depreciation. The depreciation adjustment will not exist after 2017 if the taxpayer elects ADS depreciation to avoid the interest limitation.
Proposed regulations coming
The IRS notice is interim guidance which may be relied on until the IRS issues proposed regulations. The IRS stated the proposed regulations will be in accordance with the interim guidance.