Section 163(j) and Disregarded Entities

By Philip D. Morrison, Esq.

Deloitte Tax LLP, Washington, DC 

In an earlier commentary1 I wrote about the confusion that exists, both among practitioners and at the IRS, regarding whether a disregarded entity(a DE) is also disregarded as a person. One area where the confusion exists that I failed to point out is with respect to §163(j).  This confusion could lead to unintended consequences, if not addressed.

As I pointed out in the earlier commentary, "entity" and "person" appear not to be congruent terms. Section 7701(a)(1) defines "person" to include, among other things, a "company." Regs. §301.7701-6 defines "person" to include, among other things, an "unincorporated organization or group." A hybrid (a DE for U.S. purposes) that is, say, a Luxembourg Sarl or German GmbH, should be a "company" and also possibly an "unincorporated organization or group." Therefore, it likely is also a "person," even if it checks the box to be disregarded as an entity, unless something in the Code or regulations provides otherwise. The same is true with regard to a foreign partnership (i.e., a partnership under foreign law) where, because a second owner is a DE owned by the first owner, the foreign partnership would be a DE. Notwithstanding such a default or election, such a DE partnership could still be considered a "person."

I don't see anything in Regs. §301.7701-1, -2, or -3 that deals with "persons" — it's all about "entities," "business entities," "corporations," and "partnerships." Even if a person is disregarded as an entity separate from its owners, I don't see anything that says it's disregarded as a person. "Entity" and "person" apparently are separate words connoting separate concepts. Thus, while some practitioners and government officials refer to DEs as "tax nothings," this commentator, for one, thinks that is wrong or, at a minimum, unclear. A DE may be disregarded as an entity, but it still may be a person.

Let us assume we have a corporate structure where US1, a regarded U.S. corporation, owns US2 and US3, both regarded U.S. corporations.  US2, in turn, owns Forco, a foreign company checked to be a DE for U.S. tax purposes. US3 borrows from US Bank, a third-party lender (taxable in the United States), and Forco guarantees that loan.

[Image]Surprising though it may seem, but for the fact that §267(b) does not appear to deal with DEs, there is an argument that the interest paid by US3 to the US bank might be subject to §163(j). Since it is hard to conceive of a policy reason for such a result, and it is awfully hard to derive from the legislative history or subsequent commentary a conclusion that §163(j) was ever intended to apply to such interest, such an argument ought to fail. As a technical matter, however, the application of §163(j) to such interest is not as absurd as it may seem at first blush.

Section 163(j), as readers know, may limit deductions for interest ("disqualified interest") paid on indebtedness to a related foreign person or guaranteed by a related foreign person where there is no U.S. tax imposed. Under §163(j)(3)(B), disqualified interest includes interest on indebtedness to an unrelated person if: (1) there is a disqualified guarantee; and (2) "no gross basis tax is imposed by this subtitle with respect to such interest." (Emphasis added.)

In the example above there will be no gross basis tax imposed on the interest paid to the bank, of course, because the bank is a U.S. corporation taxed on its worldwide net income, including the interest payment from US3. So we must then determine whether the indebtedness is subject to a "disqualified guarantee."

A "disqualified guarantee" is defined in §163(j)(6)(D). To be a disqualified guarantee, the guarantee must be made by a related person, and that person must be either an exempt organization or a "foreign person." The guarantee must also not fall under one of the enumerated exceptions in §163(j)(6)(D)(ii).

As mentioned above, a "person" may include a company and an unincorporated organization or group. Thus, under this interpretation, Forco in our example is a person. Whether a person that is a DE is also "foreign" is determined under Regs. §301.7701-5. Under that regulation, a business entity, including an entity that is disregarded from its owner, is foreign if it is not domestic. A business entity, including a DE, is domestic only if it is created or organized in, or under the laws of, the United States. Forco, therefore, is a "foreign person."

One of the exceptions under §163(j)(6)(D)(ii) includes a guarantee if the "taxpayer" (presumably the person whose interest deduction may be deferred by §163(j)) owns a controlling interest in the guarantor. For purposes of this exception, a controlling interest means 80% of the vote and value of all classes of stock (of a corporation) or 80% of the profit and capital interests in any other entity. Sections 267(c)(1) and (5) apply for this determination.  Because §267(c)(1) and (5) do not provide for "downward" attribution of ownership, US3 appears not to own a controlling interest in Forco, the guarantor.

The other exception under §163(j)(6)(D)(ii) is where, in circumstances identified in regulations, the interest on the indebtedness would have been subject to net basis tax if paid to the guarantor.  In our example, if interest were paid to Forco, there would be net basis U.S. tax on such interest because Forco is checked as a DE into US2. Unfortunately, there are no regulations dealing with this exception.  Only if one believes that, at some point, a regulation grant is self-executing (i.e., there are "phantom regulations" that exist in the absence of the IRS's exercise of the grant) would this exception apply to our example.

Finally, Forco must be a "related person" for the guarantee to be a disqualified guarantee. "Related person" is defined in §163(j)(4).  Generally, a related person is any person related to the taxpayer within the meaning of §267(b) or §707(b)(1). Whether Forco is a related person with respect to US3 under those sections is not altogether clear. Section 267(b), while applicable to "persons," provides specific relationship rules for "corporations," "individuals," "members of a family," "trusts," "grantors," "fiduciaries," "section 501 organizations," "executors of an estate," "beneficiaries of an estate," "S corporations," and "partnerships." It does not provide a relationship rule for disregarded entities that, because they are disregarded, are none of the enumerated "persons." One can argue, perhaps successfully, that, while US2 and US3 are clearly related, and while Forco is considered a branch of US2 and therefore logic may dictate it is related to US3, because Forco is a separate "person" from US2 (though the same "entity"), Forco and US3 ought not to be considered related.

Section 707(b)(1) deals with "partnerships" and "persons" owning capital or profits interests in partnerships.  While the latter "persons" could include DEs, this provision is not implicated in our fact pattern.

So, because the sections defining "related person" only deal with DEs inadvertently and in very limited cases, it appears that our case ought not to trigger §163(j) because it appears, as a technical matter, that our guaranteeing foreign person (Forco) is not a related person to the borrower US3 (notwithstanding being a branch of an entity that is clearly a related person). It almost seems more due to luck than technical coordination of Code provisions that this correct policy answer may also be the correct technical answer.

In other cases, however, we are not so lucky. In Illustration 2, US1 and US2 respectively own 75% and 25% of Forco1, which is checked as a partnership for U.S. tax purposes. Forco1 owns Forco2, which is checked as a DE. Forco2 owns 95% of PS, a partnership. PS borrows from US Bank, and Forco2 guarantees the loan.

[Image]For the reasons described previously, Forco2 could be viewed as a "foreign person." Neither US1 nor US2 — the "taxpayers" by virtue of their pro rata shares of PS's interest expense deductions — owns at least 80% of the profit and capital interests in PS for purposes of the carve-out from the definition of disqualified guarantee under §163(j)(6)(D)(ii)(II).  Unless one subscribes to the "phantom reg" theory alluded to above, neither does §163(j)(6)(D)(ii)(I) apply.

Now, however, unlike Illustration 1, our guarantor is probably a "related person" with respect to either the "taxpayers" (US1 and US2) or the borrower (PS). This is because §707(b)(1) makes a partnership and a "person" owning more than 50% of the capital or profits interests in such partnership related persons. And since US1 and US2 are related persons with respect to PS, this may allow a successful assertion that US1 and US2 are related persons with respect to Forco2 (assuming that assertion is necessary, i.e., the relation of Forco2 to PS is insufficient).

This technical result ought not to be the case. PS's interest expense, deductible in part by each of US1 and US2, is paid to a U.S. taxpayer and subject to full net basis U.S. tax. Further, the "foreign person" that is the guarantor is a branch of a partnership 100% of the interests in which are owned by U.S. taxpayers — all of Forco2's income will be subject to U.S. tax as earned — and thus, in essence, the guarantor is a U.S. taxpayer.

The regulations under §163(j) have been in proposed form for nearly 20 years. When they are either re-proposed or finalized, an event I hope (but do not expect) to see before retirement, I hope the unfortunate technical result in Illustration 2 will be corrected, perhaps in a way that would also remove any uncertainty regarding the technical result in Illustration 1.

This commentary also will appear in the April 2011 issue of BNA's  Tax Management International Journal. For more information, in BNA's Tax Management Portfolios, see Daher and Aceves, 536 T.M., Interest Expense Deductions,  and in Tax Practice Series, see ¶2330, Interest Expense.


 1 "Is a Disregarded Entity Still a Person?" 37 Tax Mgmt. Int'l J. 489 (8/8/08).