The Internal Revenue Service and the Treasury Department recently issued proposed regulations indicating that Section 163(j), as amended by the Tax Cuts and Jobs Act, applies to a controlled foreign corporation (CFC) (among other entities), even if the CFC is not a U.S. taxpayer.  CFCs generally are foreign subsidiaries that are actually or constructively owned by 10% U.S. shareholders. 

Under Section 163(j), deductions for net interest expenses for all business entities generally would be limited to 30% of the business’s EBITDA (or, beginning in 2022, EBIT).  Subject to limitations, any disallowed interest expense may be carried forward indefinitely.  As a result of the proposed regulations, Section 163(j) would limit the extent to which a CFC’s interest expense is deductible for purposes of computing other types of U.S. taxable income (e.g., "GILTI” income and income effectively connected to a United States trade or business) for the CFC and its U.S. shareholders. 

In addition, the proposed regulations permit taxpayers to utilize either the “CFC-by-CFC method” or “CFC group method” in applying Section 163(j).  The CFC-by-CFC method would require the Section 163(j) limitation to be calculated on a CFC-by-CFC basis with no netting of business interest income of one CFC against the business interest expense of another CFC, resulting in surprising and sometimes unfavorable results. For example, when there is intercompany debt between two related CFCs, interest expense may be disallowed to the borrower CFC under section 163(j), while interest income of the lender CFC may result in additional GILTI inclusion or other taxable income.

To prevent this result, the proposed regulations permit taxpayers to elect to utilize the CFC group method which provides that a CFC group may net intercompany interest income and interest expense within the applicable CFC group.  A CFC group is comprised of two or more CFCs owned 80% or more, by value, by a single U.S. shareholder or in the same proportion by multiple related U.S. shareholders.  Members of a consolidated group are generally treated as a single person.  Accordingly, CFCs in separate chains owned by different U.S. shareholders may be members of the same CFC group if the U.S. shareholders are members of the same consolidated group.

The application of the CFC group method is complex, though taxpayers should be aware that the method may be necessary to prevent unexpected tax results if taxpayers use intercompany debt among related CFCs.