The Graphic Guide to Section 163(j): A visual breakdown of this important aspect of the TCJA.

• Author: Doyle, Diana S.
• Position: Part 1 - Special Section on the Tax Cuts and Jobs Act

As children, we learned new and difficult concepts, such as our first words, by associating them with pictures. Who could forget the Dr. Seuss classic Hop on Pop? In this article, we take you back to your childhood by offering a series of pictures to simplify the most significant aspects of new Section 163(j), (1) enacted as part of the Tax Cuts and Jobs Act (TCJA), (2) and the recently proposed regulations thereunder. (3) Each section includes a figure and an explanation.

In general, Section 163(j) limits interest deductibility for taxpayers by imposing a thirty percent general cap on net business interest, computed as follows:

Section 163(j) Limitation (4) = business interest income + thirty percent of ATI + floor plan financing interest

Broad Definition of "Interest" (5) (Figure 1)

Taxpayers should be mindful of the broad definition of "interest" under the proposed regulations. In addition to interest on a debt instrument, the following are listed as examples of interest for the purposes of Section 163(j):

* debt issuance costs and, if any amounts have been borrowed, commitment fees;

* original issue discount, accrued market discount, and repurchase premium;

* premium in the case of debt instruments issued or acquired at a premium;

* guaranteed payments by partnerships for the use of capital under Section 707(c); (6)

* income and deductions as well as gains and losses resulting from certain transactions used to hedge interest-bearing assets or liabilities (regardless of whether such transactions are integrated with the assets or liabilities hedged);

* substitute interest payments on securities lending or sale-repurchase transactions;

* time value components for non-cleared swaps with significant nonperiodic payments; and

* ordinary income or loss arising from contingent payment debt instruments.

Furthermore, an anti-abuse rule provides that any expense or loss "predominantly incurred in consideration of the time value of money" in transactions in which the taxpayer secures the use of funds for certain time periods is considered interest.

As illustrated in Figure 1 and listed previously, amounts like guaranteed payments for the use of capital under Section 707(c) will be subject to Section 163(j) under the proposed regulations. On the other hand, rent paid under a true sale-leaseback and interest expense capitalized into the basis of assets under Sections 263A and 263(g) will not be treated as interest expense. In view of this broad definition of interest, taxpayers now must examine closely all costs associated with borrowing and hedging and any business income that may produce "interest."

Definition of "Adjusted Taxable Income" (7) (Figure 2)

As shown in Figure 2, the adjusted taxable income (ATI) of a C corporation or a consolidated group generally is its taxable income computed without regard to the application of the Section 163(j) limitation and with certain adjustments. Consistent with the theme of Section 163(j), ATI for a partnership and its partners is not as simple. A partnership's ATI includes Section 734(b) basis adjustments but excludes partner-level adjustments, such as Section 743(b) basis adjustments, built-in loss amounts with respect to partnership property under Section 704(c)(1)(C), and remedial allocations of income, gain, loss, or deduction to a partner pursuant to Section 704(c). Instead, a partner takes into account these partner-level adjustments in determining its own ATI. The partner's ATI excludes 1) the partner's distributive share of any items of income, gain, deduction, or loss of the partnership (except for "excess taxable income," or ETI, once all of the partner's EBIE (as discussed below in the Partnership Complications section), including any carryforwards, has been treated as paid or accrued); 2) business interest income from the partnership subject to Section 163(j) (except to the extent the amount of business interest income exceeds business interest expense at the partnership level); and 3) the partners allocable share of the partnership's floor plan financing interest.

Figure 2. General adjusted taxable income (ATI) formula. Taxable Income Tax Years Beginning After 12/31/2017 Through 12/31/2021 Subtract (-) income and gain not properly allocable to a non-excepted trade/business [check] (-) business interest income and floor plan financing interest expense [check] (-) gain from sale or disposition of property in an amount not to exceed the amount [check] of depreciation, amortization, or depletion Add Back (+) deductions/losses not properly allocable to non-excepted trade/business [check] (+) business interest expense [check] (+) net operating losses [check] (+) Section 199A deductions [check] (+) depreciation, amortization, and depletion [check] (including bonus depreciation) = ATI (8) closely resembles EBITDA Taxable Income Tax Years Beginning on or After 1/1/2022 Subtract (-) income and gain not properly allocable to a non-excepted trade/business [check] (-) business interest income and floor plan financing interest expense [check] (-) gain from sale or disposition of property in an amount not to exceed the amount X of depreciation, amortization, or depletion Add Back (+) deductions/losses not properly allocable to non-excepted trade/business [check] (+) business interest expense [check] (+) net operating losses [check] (+) Section 199A deductions [check] (+) depreciation, amortization, and depletion X (including bonus depreciation) = ATI (8) closely resembles EBIT C Corporations and Consolidated Groups-"Simple" Rules (9) (Figure 3)

In comparison to partnerships and non-U.S. entities, the Section 163(j) rules applicable to C corporations and...