February 26, 2019
CC:PA:LPD:PR (REG-106089-18)
Internal Revenue Service
Room 5203
P.O. Box 7604
Ben Franklin Station Washington, DC 20044
Re: Comments on Proposed Treasury Regulations §§ 1.163(j)-1 through 1.163(j)-11 Dear Sir or Madam:
Thank you for the opportunity to submit our views on proposed Treasury regulations issued under Section 163(j) (relating to the limitation on the deduction for business interest expense). The National Council of Farmer Cooperatives (“NCFC”) would like to respond to a request in the preamble to the proposed regulations to provide comments on the need to provide additional rules for cooperatives. As explained in detail below, we believe rules consistent with those provided to regulated investment companies (“RICs”) and a real estate investment trusts (“REITs”) in the proposed Treasury regulations are warranted.
Since 1929, NCFC has been the voice of America’s farmer-owned cooperatives. NCFC members include regional and national co-ops, which in turn comprise over 2,000 local farmer cooperatives across the country. NCFC members span the country and handle, process and market almost every type of agricultural commodity; furnish farm supplies; and provide credit and related financial services, including export financing.
Section 163(j)(1) generally limits a taxpayer’s deduction for business interest expense to 30% of “adjusted taxable income” (“ATI”). Section 163(j)(8) defines ATI to mean “the taxable income of the taxpayer” computed (A) without regard to certain specified items, and (B) “with such other adjustments as provided by the Secretary.” See, Section 163(j)(8).
As noted in the Preamble, the proposed regulations “include a number of adjustments under the authority granted in Section 163(j)(8)(B).” 83 FR 67490, at 67492. The adjustments include special rules RICs, REITs, consolidated groups, partnerships, S corporations, and certain controlled foreign corporations.
For instance, the proposed regulations provide that the ATI of RICs and REITs is computed without regard to the deduction for dividends paid to owners. See, Prop. Treas. Reg. § 1.163(j)- 4(b)(4)(ii). The Preamble describes the reason for this adjustment:
A RIC or REIT typically pays dividends sufficient to eliminate all or nearly all ICTI [investment company taxable income] or REITTI [real estate investment trust taxable income]. As a result, if the ATI of a RIC or REIT took into account the deduction for dividends paid, the ATI of the RIC or REIT typically would be zero, or close to zero. It would be distortive to treat the deduction for dividends paid as reducing ATI because this deduction is merely the mechanism by which RICs and REITs shift the tax liability associated with their income to their shareholders, as intended pursuant to subchapter M of the Code. Therefore, these proposed regulations would not provide a rule that would cause the ATI of a RIC or REIT to take into account the deduction for dividends paid.1
After noting the special rule for RICs and REITs, the Preamble states:
The Treasury Department and the IRS request comments on whether additional special rules are needed for any other entities that are generally taxed as C corporations, including but not limited to cooperatives (as defined in section 1381(a)) and publicly traded partnerships (as defined in section 7704(b)).2
We believe that the Secretary should exercise discretion in the case of cooperatives (as he has done in the case of RICs and REITs) to provide that cooperative ATI is to be computed without regard to deductions for amounts described in Sections 1382(b)(1) (patronage dividends), 1382(b)(2) (amounts paid in redemption of nonqualified written notices of allocation distributed as patronage dividends) and 1382(c) (certain deductible distributions of Section 521 cooperatives).
Cooperatives described in Section 1381(a) are commonly referred to as Subchapter T cooperatives. They include certain farmers’ cooperatives described in Section 521 (sometimes referred to as “exempt” cooperatives, though they have not been exempt from taxation since 1951) and other corporations “operating on a cooperative basis,” with certain exceptions, (often referred to as “nonexempt” cooperatives).
Subchapter T cooperatives generally are taxed like C corporations. However, Subchapter T provides a mechanism that allows Subchapter T cooperatives to shift taxation on earnings to their patrons3 by distributing such earnings in the form of “patronage dividends.” The term “patronage dividend” is defined in Section 1388(a). It is, among other things, an amount “determined by reference to the net earnings of the organization from business done with or for its patrons.” Section 1388(a)(3).
Subchapter T provides that patronage dividends “shall not be taken into account” in “determining the taxable income of a [Subchapter T cooperative].” See, Section 1382(b), first sentence. Section 1382(b) goes on to provide that patronage dividends which “are not taken into account” in determining taxable income shall “be treated in the same manner as an item of gross income and as a deduction therefrom.” See, Section 1382(b), final sentence.4
All Subchapter T cooperatives are permitted to “not take into account” amounts described in Sections 1382(b)(1) and (2). Section 1382(b)(1) applies to patronage dividends paid in cash, property and qualified written notices of allocation. Section 1382(b)(2) applies to amounts paid in redemption of nonqualified written notices of allocation which were distributed as part of a patronage dividend. In addition, Section 521 cooperatives are allowed to deduct certain distributions to patrons described in Section 1382(c) from other sources.
Amounts that are “not taken into account” by cooperatives pursuant to Section 1382(b)(1) and (2) or deducted by Section 521 cooperatives pursuant to Section 1382(c) must generally be included in income by patrons pursuant to Section 1385.
The Senate Finance Committee Report that accompanied the legislation enacting Subchapter T described the effect of Subchapter T as follows:
Generally, the effect of the treatment specified above for patrons taken together with that also outlined above for cooperatives is to obtain a single current tax with respect to the income of the cooperative, either at the level of the cooperative or at the level of the patron.
- Rep. No. 1881, 1962-3 C.B. 707, 822.
The “General Explanation of Public Law 115-97,” prepared by the Staff of the Joint Committee on Taxation, JCS-1-18 (December 2018) (“Blue Book”) describes the effect of Subchapter T similarly:
For Federal income tax purposes, a cooperative subject to the cooperative tax rules of subchapter T generally computes its income as if it were a taxable corporation, except that, in determining its taxable income, the cooperative does not take into account amounts paid for the taxable year as (1) patronage dividends
… and (2) per-unit retain allocations …1943
… Because a patron of a cooperative that receives patronage dividends or per-unit retain allocations generally must include such amounts in gross income, excluding patronage dividends and per-unit retain allocations paid by the cooperative from the cooperative’s taxable income in effect allows the cooperative to be a conduit with respect to profits derived from transactions with its patrons.
——————–
1943… In determining its taxable income, the cooperative also does not take into account amounts paid in money or other property in redemption of a nonqualified written notice of allocation … or in redemption of a nonqualified per-unit retain certificate…
Blue Book, 425-426.
Section 1382(b) creates some ambiguity as to the status of patronage dividends for purposes of Section 163(j) purposes by first providing that they “shall not be taken into account” in determining a cooperative’s taxable income, but then stating that they shall “be treated in the same manner as an item of gross income and as a deduction therefrom.”
Many Subchapter T cooperatives will have little or no ATI if the cooperatives are required to follow the deductible treatment provided in Section 1382(b) for the amounts described in Sections 1382(b)(1) and (2) and Section 1382(c) in determining their ATI. In this regard, cooperatives face the same problem that RICS and REITs would have faced if their dividends paid deduction was taken into account in determining ATI.
The rationale for special treatment of dividends paid by REITs and RICs applies with equal strength to cooperatives:
It would be distortive to treat the deduction for [patronage dividends] as reducing ATI because this deduction is merely the mechanism by which [Subchapter T cooperatives] shift the tax liability associated with their income to their [patrons], as intended by Subchapter [T].5
An example illustrates the problem that will face many Subchapter T cooperatives if nothing is done.
Assumed facts. A Subchapter T cooperative has $1 million of net earnings from business done with or for patrons, determined after deducting expenses including $100,000 of interest. The cooperative distributes the entire amount as patronage dividends so that patrons, rather than the cooperative, are taxed on the net earnings. The only adjustment the cooperative is entitled to make pursuant to Section 163(j)(8)(A) is the adjustment for interest expense.6
Analysis. If the deduction for patronage dividend is not disregarded in determining cooperative ATI, the ATI of the cooperative will be $100,000. The cooperative’s interest deduction for the year will be limited to $30,000 (30% x$100,000). While the cooperative is permitted to carryforward the nondeductible portion of the interest, it is unlikely that most cooperatives will ever benefit from a carryover so long as they continue to operate on a cooperative basis.
Other taxpayers are not treated in this manner. Assuming the same earnings and interest expense, a C corporation’s limitation would be $330,000 (30% x ($1,000,000 + $100,000)). A partnership or S corporation’s limitation would be the same. There would be no disallowed interest expense.
Section 163(j)(3) is intended to limit the deductibility of interest in situations where businesses are highly leveraged, measured initially by comparing interest expense to EBITDA and, after 2021, to EBIT. The report of the House Ways and Means Committee explained the reason for limiting the deductibility of interest as follows:
The Committee believes that the general deductibility of interest payments on debt may result in companies undertaking more leverage than they would in the absence of the tax system. … The Committee believes that it is necessary to apply the limitation on the deductibility of interest to businesses regardless of the form in which such businesses are organized so as not to create distortions in the choice of entity.
The Committee believes that limitations on the deductibility of interest should be applied to those businesses with the greatest levels of leverage. Such firms may pose the greatest societal costs in times of financial distress.
H.R. Rep. No. 115-409, 115th Cong., 1st Sess. (November 13, 2017), 247-248.
If distributions described in Sections 1382(b)(1) and (b)(2) and Section 1382(c) reduce the ATI of Subchapter T cooperatives, the Section 163(j) limitation generally will be converted into a provision that limits Subchapter T cooperatives to a deduction equal to 30% of interest paid with respect to patronage activities without regard to the degree their business is leveraged.
If, in the example above, the interest paid was $10,000, the limitation would be $3,000 (30% x ($0 + $10,000)). If, as in the example, interest paid was $100,000, the limitation would be $30,000 (30% x ($0 + $100,000). If interest paid was $500,000, the limitation would be $150,000 (30% x ($0 + $500,000). Moreover, while Section 163(j) allows interest in excess of the limitation to be carried over and used in the future if a taxpayer has excess limitation, it is very unlikely that a Subchapter T cooperative will ever have excess limitation so long as it continues to operate as a cooperative and distributes all of its earnings as patronage dividends.
Congress recognized that there might be situations where special adjustments to ATI would be needed to make Section 163(j) apply properly and thus added Section 163(j)(8)(B) which provides that ATI shall be “… computed with such other adjustments as provided by the Secretary.” Explaining that provision, the House Ways and Means Committee Report stated that “the Committee recognizes that certain types of trades or businesses have particular characteristics that warrant special rules related to interest deductibility.” H.R. Rep. No. 115- 409, 115th Cong., 1st Sess. (November 13, 2017), 248.
Consistent with this, the Preamble states that “the proposed regulations prescribe adjustments to the calculation of ATI … to provide relief for particular types of taxpayers in particular circumstances to ensure that such taxpayers are treated similarly to other taxpayers when calculating ATI.”7
Such relief is needed for Subchapter T cooperatives for the reasons described above.
Allowing ATI to be determined without regard to any deduction for distributions described in Sections 1382(b)(1) and (2) and Section 1382(c) will not read Section 163(j) out of the Code for cooperatives. Rather, the limitation will apply to highly-leveraged cooperatives just as it would apply to other highly-leveraged taxpayers.
For example, assume a cooperative has interest expense of $200,000 and net earnings from business done with or for patrons of $300,000. Assume that the cooperative distributes all of its net earnings as patronage dividends. Then, if ATI is figured without regard to patronage dividends, the Section 163(j) limitation will be $150,000 (30% x ($300,000 + $200,000)). Part of the interest paid by the cooperative would not be deductible.
Some Subchapter T cooperatives may be able to elect pursuant to Section 163(j)(7)(C) to avoid Section 163(j) limitations by foregoing some accelerated depreciation. However, this election is available only to a subset of Subchapter T cooperatives, namely those that are “specified agricultural or horticultural cooperatives” within the meaning of Section 199A(g)(4). Many Subchapter T cooperatives do not fall into this subset.
The possibility that some Subchapter T cooperatives may be able to make this election is not a reason for denying the requested relief. Many (but not all) REITs are eligible to select to be treated as an “electing real property trade or business” pursuant to Section 163(j)(7)(B) which has consequences similar to an election under Section 163(j)(7)(C). This did not result in relief being limited to RICs, or for that matter, to REITs not eligible to make an election.
The problem that needs to be addressed is a structural problem. Correcting it so the provisions of Section 163(j) apply to cooperatives as they do to other taxpayers does not leave the special election provided in Section 163(j)(7)(C) meaningless. Subchapter T cooperatives that are highly leveraged may still choose to make the election. Subchapter T cooperatives that are not highly leveraged should not be forced to make the election to compensate for a structural deficiency that could and should be addressed in the final regulations.
Thank you for the opportunity to provide these comments. If you have any questions or comments, please do not hesitate to contact Marlis Carson, Senior Vice President and General Counsel, NCFC (202-879-0825).
Sincerely,
Charles F. Conner
President and CEO
1 83 FR 67490, at 67499
2 Id., at 67498 (emphasis added).
3 Most patrons of farmer cooperatives are farmers with gross receipts of less than $25 million, who are exempt from Section 163(j) as “small businesses.” See, Section 163(j)(3). Large farmer patrons are eligible to elect out of Section 163(j) as “electing farming businesses.” See, Section 163(j)(7)(C)(i). A few farmer cooperatives have other farmer cooperatives as patrons. As noted below, such farmer cooperatives that are “specified agricultural or horticultural cooperatives” are also eligible to elect out of Section 163(j). See, Section 163(j)(7)(C)(ii).
4 Similar language applies to the treatment of amounts paid in redemption of nonqualified written notices of allocation.
5 Paraphrasing the language from the Preamble, 83 FR 67490, at 67499, but substituting “patronage dividends” for “the deduction for dividends paid,” “Subchapter T cooperatives” for “RICs and REITs,” “patrons” for “shareholders,” and “T” for “M.”
6 The example does not include an add-back for depreciation, amortization and depletion under Section 163(j)(8)(A)(v). It does not do so for two reasons. First, this add-back will go away after 2021. Second, prior to 2022, the impact of that add-back for cooperatives (as for other businesses) may be limited. Cooperatives anticipated adding add back depreciation, amortization and depletion pursuant to Section 163(j)(8)(A)(v) for taxable years beginning before January 1, 2022 to mitigate the potentially distortive impact of Section 163(j). However, this relief may be limited in many cases as a result of the interpretation taken in Prop. Treas. Reg. § 1.163(j)-1(b)(1)(iii) that “[d]epreciation, amortization, or depletion expense that is capitalized to inventory under Section 263A is not a depreciation, amortization, or depletion deduction for purposes of this paragraph (b)(1).” Cooperatives question the correctness of this interpretation. Depreciation should not lose its status as “depreciation” by reason of being depreciation recovered as cost of goods sold.
7 83 FR 67490, at 67526-67527 (emphasis added).
