On July 28, the IRS released final Treasury Regulations (the “Final Regulations”) and proposed new Treasury Regulations (the “2020 Proposed Regulations”) addressing the limitations on interest deductibility contained in Section 163(j) of the Internal Revenue Code (“Section 163(j)”). These regulations provide some relief to private investment funds but also add new complexity.
Section 163(j) of the Code was amended as part of the legislation known as the Tax Cuts and Jobs Act of 2017. Under amended Section 163(j), “business interest expense” is deductible only to the extent of a taxpayer’s business interest income plus 30% of the taxpayer’s “adjusted taxable income.”1 In 2018, the IRS issued proposed regulations (the “2018 Proposed Regulations”) interpreting Section 163(j). Based on feedback received in response to the 2018 Proposed Regulations, the IRS issued the Final Regulations and the 2020 Proposed Regulations.
Application of Section 163(j) to Trader Funds
Prior to the amendment of Section 163(j), the deductibility of investment interest expense by partners in private investment funds was subject to limitation at the partner level under Section 163(d). Under these rules, partners could deduct their share of the investment interest expense of a private fund up to the amount of their investment income (which for this purpose generally excludes long-term capital gains and “qualified dividend income”). This limitation applied to partners regardless of whether the fund was a “trader” in securities or an “investor” in securities for federal income tax purposes.
One of the biggest open questions for the investment funds industry under amended Section 163(j) was whether the limitations on business interest expense deductions applied to funds that are “traders” in securities for U.S. federal income tax purposes. The 2018 Proposed Regulations appeared to take the position that “trader” funds would be subject to the business interest expense limitations at the partnership level. This approach was questioned by many in the industry.
The 2020 Proposed Regulations take a bifurcated approach to “trader” funds. Investors who do not actively participate in the trading activity of the private investment fund would not be subject to the Section 163(j) limitation on business interest expense. Such investors would continue to be subject to the limitations on deductibility of interest expense under the investment interest expense rules. However, investors who do actively participate in the trading activity of the private investment fund (e.g., partners and employees of the fund management company) would be subject to the Section 163(j) limitations on deductibility of business interest expense but would not be subject to the Section 163(d) limitations on deductibility of investment interest expense.
In taking this bifurcated approach, the IRS has created new compliance burdens for private investment funds. Under the 2020 Proposed Regulations, trader funds will effectively need to keep two sets of books to calculate the business interest expense limitation solely with respect to investors who are partners and employees of the fund management company.
The Final Regulations
The Final Regulations also provided helpful relief for investment funds and portfolio companies in a few different areas:
- The 2018 Proposed Regulations had treated many items that were economically equivalent to interest as interest for purposes of these limitations, including embedded loans in swaps, commitment fees for loans and guaranteed payments for the use of capital by partnerships. The Final Regulations no longer treat commitment fees and guaranteed payments as interest for these purposes. The rules applicable to swaps were substantially revised.
- The 2018 Proposed Regulations had excluded the cost of goods sold from the calculation of depreciation in arriving at adjusted taxable income. This reduced the adjusted taxable income of many inventory heavy businesses such as manufacturers and oil producers. Under the Final Regulations, the cost of goods sold is treated as an item of depreciation and hence is added back to the calculation of adjusted taxable income.
For additional information on recent income tax proposals, please contact Ronald P. Cima (212-574-1471), Jonathan P. Brose (212-574-1615), James C. Cofer (212-574-1688), Peter E. Pront (212-574-1221), Daniel C. Murphy (212-574-1210), Brett R. Cotler (212-574-1269) or Tyler Combest (212-574-1472).