Final Regulations on Dual Consolidated Losses: A Practical Guide (Part I)

By Karen Jacobs, CPA; Peg O’Connor, J.D.; and Margie Rollinson, J.D.


Executive Summary

  • The 2007 DCL regulations generally provide that a DCL of a dual-resident corporation (DRC) or a separate unit of a U.S. corporation is not included in the computation of the taxable income of a consolidated group, unaffiliated DRC, or unaffiliated domestic owner.
  • Once the existence of a DRC or separate unit of a U.S. corporation is established, the next step is to determine whether the DRC or separate unit incurred a DCL.
  • If a DRC or separate unit has a DCL, the next step is to determine whether the DCL may be included in the computation of taxable income of a consolidated group, unaffiliated DRC, or unaffiliated U.S. owner.

Originally enacted in 1986, the dual consolidated loss (DCL) rules are designed to prevent a corporation from using a net operating loss (NOL) to offset income both in the U.S. and in a foreign country.1 Specifically, Secs. 1503(d) (1) and (2) provide that a corporation’s DCL cannot reduce the taxable income of any other member of the company’s affiliated group unless, to the extent provided in the regulations, the loss does not offset the income of any foreign corporation. The IRS and Treasury issued final regulations under Sec. 1503(d) on March 19, 2007, which update the regulations issued on September 9, 1992, for changes in tax law, including the adoption of the entity-classification regulations in Regs. Secs. 301.7701-1 through -3. Consistent with the statute, the 2007 DCL regulations generally provide that a DCL of a dual-resident corporation (DRC) or a separate unit of a U.S. corporation is not included in the computation of the taxable income of a consolidated group, unaffiliated DRC, or unaffiliated domestic owner2 (other than to offset income or gain of the DRC or separate unit that, in each case, incurred the DCL), as applicable.

This article is organized to assist taxpayers in determining the applicability of the 2007 DCL regulations and to help practitioners comply with the regulations. Under Regs. Sec. 1503(d)-8(a), the new regulations are generally applicable to DCLs incurred in tax years beginning on or after April 18, 2007. A taxpayer may elect to apply the new regulations, in their entirety, to DCLs incurred in tax years beginning on or after January 1, 2007, by filing its return and attaching to such return the domestic-use agreements, certifications, or other information in accordance with these regulations.

Entities Subject to DCL Rules

The first step in determining whether the DCL rules apply is to review the organizational structure for a DRC or a separate unit of a U.S. corporation.3 Only a DRC or separate unit can have a DCL.

DRCs

A DRC is a domestic corporation subject to a foreign country’s income tax on either a worldwide or a residence basis (Regs. Sec. 1.1503(d)-1(b)(2)).4 A corporation is taxed on a residence basis if it is taxed as a resident under foreign laws. A typical example of a DRC is a U.S. corporation managed and controlled in the U.K. The fact that a U.S. corporation or foreign entity does not have an actual income tax liability to a foreign country is not taken into account when determining whether it is subject to tax.

A domestic corporation is a corporation, association, joint-stock company, or insurance company created or organized under the laws of the U.S. or any state therein (Secs. 7701(a)(3) and (4)). Under Regs. Sec. 1.1503(d)-1(b)(1), it also includes entities treated as such under the Code, such as (1) stapled entities (Sec. 269B); (2) foreign insurance companies that have elected to be treated as domestic corporations under Sec. 953(d); (3) subsidiaries created under Sec. 1504(d) to comply with foreign law; and (4) Sec. 7874 expatriated entities. A domestic corporation does not include a regulated investment company (RIC), a real estate investment trust (REIT), or an S corporation. Under Regs. Sec. 1.1503(d)1(b)(7), a U.S. possession is also not considered a domestic corporation.

Separate Unit

A separate unit includes either of the following that is carried on or owned, directly or indirectly,5 by a U.S. corporation (including a DRC):6 (1) a foreign business operation that, if carried on by a U.S. person, would constitute a foreign branch (foreign-branch separate unit) within the meaning of Temp. Regs. Sec. 1.367(a)-6T(g)(1)7 or (2) an interest in a hybrid entity (hybrid-entity separate unit) under Regs. Sec. 1.1503(d)-1(b)(4)(i). A hybrid entity is an entity that is not taxable for U.S. tax purposes but is subject to a foreign country’s income tax at the entity level on its worldwide income or on a residence basis. If a U.S. corporation that is not a DRC is considered to directly carry on or own a foreign branch, as defined in Temp. Regs. Sec. 1.367(a)6T (g)(1), such business operation will not be characterized as a foreign-branch separate unit, provided the business operation is not treated as a permanent establishment under a U.S. income tax treaty or is not otherwise subject to tax on a net basis under the treaty (Regs. Sec. 1.1503(d)-1(b)(4)(iii)). If the U.S. corporation carries on such business operation through a hybrid entity or a transparent entity, the operation will constitute a foreign-branch separate unit.

Regs. Sec. 1.1503(d)-1(b)(4)(ii) provides that if a U.S. corporation (or two or more U.S. corporations that are members of the same consolidated group) has two or more separate units (individual separate units), all such individual separate units located or subject to income tax on their worldwide income or on a residence basis in the same foreign country are treated as one separate unit (combined separate unit).8 DRCs are not combined under this rule. Generally, when the separate unit combination rule applies, the individual separate unit is no longer treated as a separate entity.

Other Entities

1. Non-hybrid-entity partnerships and grantor trusts: A non-hybrid-entity partnership and a non-hybrid-entity grantor trust9 are not considered DRCs or separate units for purposes of the DCL rules;10 however, they may subject their partners or beneficiaries to the DCL rules if these entities own a DRC or separate unit.

2. Transparent entity: This is an entity directly or indirectly owned by a domestic corporation that is (1) not taxable as an association for federal tax purposes; (2) not subject to foreign income tax at an entity level on its worldwide income or on a residence basis; and (3) not a passthrough entity under the laws of the foreign country (Regs. Sec. 1.1503(d)-1(b)(16)). The relevant foreign country is the country in which the foreign-branch separate unit is located, or the country that subjects the hybrid entity or DRC to an income tax on a worldwide or residence basis. An example of a transparent entity is a U.S. limited liability corporation (LLC) that does not elect to be taxed as an entity for U.S. income tax purposes and is a non-passthrough entity for foreign tax purposes, but not subject to foreign income tax. The 2007 DCL regulations introduced the concept of a transparent entity to ensure that the income and losses attributed to such entity were not attributed to a separate unit.

3. Domestic reverse hybrid: This is an entity taxed as a corporation for U.S. tax purposes but fiscally transparent for foreign tax purposes. These entities are not separate units or DRCs.11

Determining Whether a DRC or a Separate Unit Incurred a DCL

Once the existence of a DRC or separate unit of a U.S. corporation is established, the next step is to determine whether the DRC or separate unit incurred a DCL. Note that, even if a DRC or separate unit did not incur a DCL in the current year, it may have to file an annual certification for a DCL for five years following the year in which the DCL was incurred. In addition, the DRC or the U.S. corporation may be able to offset a prior-year DCL subject to the domestic-use limitation against current-year income earned by the DRC or the separate unit.

DCL of a DRC

A DCL is generally defined as a Sec. 172(c) NOL incurred in a year in which the entity is a DRC (Regs. Sec. 1.1503(d)-1(b)(5)(i)). To determine if the DRC has income or an NOL, only items of income, gain, deduction, or loss incurred by the DRC in the current year will be taken into account.12 Under Regs. Sec. 1.1503(d) 5(b)(2), items that will not be taken into account include (1) the DRC’s net capital losses; (2) carryover or carryback losses; and (3) items of income, gain, deduction, and loss attributable to a separate unit or a transparent entity of the DRC. If a DRC is a member of an affiliated group, the determination of whether it has income or a DCL will be made under Sec. 1502; the treatment of items for foreign tax purposes is irrelevant (Regs. Sec. 1.1503(d)-5(d)).

DCL of a Separate Unit

1. In general: A DCL of a separate unit is generally defined as the net loss attributable to a separate unit (Regs. Sec. 1.1503(d)-1(b)(5)(ii)). It is computed as if the separate unit were a U.S. corporation, considering only those items of income, gain, deduction, and loss of the domestic owner attributable to the separate unit (Regs. Sec. 1.1503(d)-5(c)(1)(ii)). The items must be translated into U.S. dollars at the appropriate exchange rate under Sec. 989(b). Further, items disregarded for U.S. tax purposes should also be disregarded in calculating the separate unit’s income or DCL.

A foreign currency gain or loss of a domestic owner recognized under Sec. 987, resulting from a remittance or transfer between the domestic owner and the separate unit, is not attributed to the separate unit for purposes of determining the existence of a DCL; see Regs. Sec. 1.1503(d)-5(c)(4)(v). However, any income inclusion arising from stock ownership in a foreign corporation through a separate unit—for example, as a result of subpart F, a Sec. 78 gross-up, or a Sec. 986(c) foreign currency gain—is considered an income item of the separate unit if an actual dividend from such foreign corporation would have been so attributed. Also, the amount of recapture income attributable to a separate unit included in the U.S. owner’s income is attributed to the separate unit for purposes of calculating the separate unit’s income or DCL.13

The regulations provide specific rules for attributing a domestic owner’s income and loss to a foreign-branch separate unit, a hybrid-entity separate unit, and a transparent entity.

2. Foreign-branch separate unit: The principles of Secs. 864(c)(2), (c)(4), and (c)(5) (as set forth in Regs. Secs. 1.864-4(c) and -5 through -7) apply in determining the loss or income attributable to a foreign-branch separate unit, with modifications (Regs. Sec. 1.1503(d)5(c)(2)(i)). These rules do not apply to hybrid separate units. Sec. 864(c) and the regulations thereunder provide the rules for determining a foreign corporation’s income and deductions effectively connected to such foreign corporation’s U.S. trade or business. For the items of interest expense that should be considered in determining taxable income or loss of a foreign-branch separate unit, Regs. Sec. 1.882-5 applies.14

Finally, if a hybrid or transparent entity owns, directly or indirectly (other than through a hybrid entity or transparent entity), a foreign-branch separate unit, only income, gain, loss, deductions, assets, liabilities, and activities of the U.S. owner’s interest in the hybrid or transparent entity are taken into account.

3. Hybrid-entity separate unit and transparent entity: A hybrid-entity separate unit or transparent entity determines its income or loss according to the items recorded in the domestic owner’s books and records,15 to the extent they are reflected in the records of such hybrid-entity separate unit or transparent entity, adjusted to comply with U.S. tax principles (Regs. Sec. 1.1503(d)-5(c)(3)(i)). The foreign tax treatment is irrelevant. If the Service determines that booking practices of the hybrid- entity separate unit or transparent entity are employed to avoid the principles of Sec. 1503(d), it may reallocate the items attributed to the hybrid entity or transparent entity. This rule should have limited application and could apply when items are treated inconsistently for book purposes or when items are booked in a manner not in accord with the underlying transactions.

If a hybrid or transparent entity owns, directly or indirectly (other than through a hybrid entity or transparent entity), an interest in a disregarded entity, partnership, or grantor trust, but not a hybrid entity or a transparent entity, the items of income, gain, deduction, and loss reflected on the books and records of such disregarded entity, partnership, or grantor trust are treated as reflected on the books and records of the hybrid or transparent entity; see Regs. Sec. 1.1503(d)-5(c)(3)(ii). To determine items attributable to a hybrid-entity separate unit or a transparent entity, the items will not be taken into account to the extent they are already taken into account by the foreign-branch separate unit (Regs. Sec. 1.1503(d)5(c)(4)(i)(B)).

4. Combined separate unit: Under Regs. Sec. 1.1503(d)-5(c)(4)(ii), the items of income, gain, deduction, and loss that are attributable to the combined separate unit are determined as follows:

  • Items of income, gain, deduction, and loss are first attributed to each individual separate unit, without consideration of the separate-unit combination rule; and
  • The combined separate unit takes into account all of the items of income, gain, deduction, and loss attributable to its individual separate units.

5. Attribution of gain or loss: For purposes of attributing items that are recognized on the disposition of a separate unit or transparent entity (or a partnership, grantor trust, or disregarded entity that owns, directly or indirectly, a separate unit or a transparent entity), items taken into account on the disposition include gain or loss recognized by the U.S. corporate seller as the result of a Sec. 338 election and loss-recapture income or gain under Sec. 367(a)(3)(C)16 or 904(f)(3).17 In addition, items taken into account on the disposition are attributable to the separate unit or the transparent entity to the extent of gain or loss that would have been recognized had the separate unit or transparent entity sold all its assets in a taxable exchange, immediately before the sale, exchange, or other disposition (deemed sale) (Regs. Sec. 1.1503(d)5(c)(4)(iii)(A)).

Including DCL in Computing Taxable Income

If a DRC or separate unit has a DCL, the next step is to determine whether the DCL may be included in the computation of the taxable income of a consolidated group, unaffiliated DRC, or unaffiliated U.S. owner.

Domestic-Use Limitation

In general, a domestic use of a DCL is not permitted (domestic-use limitation).18 The domestic-use limitation is applicable even in the absence of a foreign affiliate or a foreign consolidation regime (Regs. Sec. 1.1503(d)6(a)(2)), because there may be a “foreign use” for an affiliate acquired in a year after the incurrence of the DCL. In addition, a foreign use may occur through a sale, merger, or similar transaction. In summary, the domestic-use limitation assumes that the DCL is offsetting foreign income; thus, the DCL is generally ineligible for domestic use, unless the consolidated group, unaffiliated DRC, or unaffiliated domestic owner certifies that there is no “foreign use,” as defined below, of the loss.

Separate Return Limitation Year

If the DRC or U.S. owner of a separate unit incurs a DCL and is unable to take advantage of any of the exceptions to the domestic-use limitation discussed below, the DCL is treated as a loss incurred by the DRC or separate unit in a separate return limitation year (SRLY).19 Specifically, the unaffiliated DRC, consolidated group that includes the DRC, unaffiliated U.S. owner of a separate unit, or consolidated group that includes a U.S. owner of a separate unit must compute its taxable income (or loss), or consolidated taxable income (or loss), without taking into account those items of deduction and loss that make up the DRC’s or separate unit’s DCL (the SRLY limitation).20 The DCL, subject to the SRLY limitation, may be carried over or back for use in other tax years as a separate NOL carryover or carryback of the DRC or separate unit arising in the year incurred.21

DCL Elimination after Certain Transactions

1. Sec. 381(a) transactions: A DCL of a DRC or of a domestic owner attributable to a separate unit, subject to the domestic-use limitation rule, will generally not carry over to another corporation in a transaction described in Sec. 381(a) (Regs. Sec. 1.1503(d)-4(d)(1)(i)). However, the DCL of a DRC will not be eliminated if the DRC undergoes a Type F reorganization in which the resulting corporation is a U.S. corporation (Regs. Sec. 1.1503(d)-4(d)(2)(i)). In addition, if a DRC transfers its assets to another DRC in a transaction described in Sec. 381(a), and the transferee corporation is a resident of (or is taxed on its worldwide income by) the same foreign country of which the transferor was a resident (or was taxed on its worldwide income), the domestic-use limitation will continue to apply as if the transferee incurred the DCL (Regs. Sec. 1.1503(d)-4(d)(2)(ii)).

2. Cessation of separate unit status: When a separate unit of an unaffiliated domestic owner ceases to be a separate unit of its domestic owner, or when a separate unit of an affiliated domestic owner ceases to be a separate unit of its domestic owner and all other members of the affiliated domestic owner’s consolidated group, except as provided below, a DCL of the domestic owner attributable to such separate unit, that is subject to the domestic-use limitation, will be eliminated (Regs. Sec. 1.1503(d)4(d)(1)(ii)). A separate unit may cease to be a separate unit if, for example, it is dissolved, liquidated, terminated, sold, or otherwise disposed of.

3. Exceptions: When a domestic owner transfers either a combined separate unit or an individual separate unit to a transferee corporation that is not a member of its consolidated group in a Sec. 381(a) transaction, and the transferee corporation, or a member of the transferee’s consolidated group, is a domestic owner of the transferred separate unit immediately after the transaction, the DCL is not eliminated (Regs. Sec. 1.1503(d)-4(d)(2)(iii)(A)(1)).

When a transferred separate unit is combined with another separate unit of the transferee or another member of the transferee’s consolidated group, income generated by the transferee or another member of the transferee’s consolidated group that is attributable to the combined separate unit may be offset by the carryover DCLs attributable to the transferred separate unit (subject to the domestic-use limitation) (Regs. Sec. 1.1503(d)-4(d)(2)(iii)(A)(2)).

When an affiliated domestic owner transfers its assets to another member of its consolidated group in a Sec. 381(a) transaction, and the transferee corporation or another member of such consolidated group is a domestic owner of the separate unit to which the DCL was attributable, the DCL will not be eliminated (Regs. Sec. 1.1503(d)-4(d)(2)(iii)(B)).

Tainted Income

DCLs incurred by a DRC that are subject to the domestic-use limitation rule cannot be used to offset tainted income earned by the corporation after it ceases to be a DRC (Regs. Sec. 1.1503(d)-4(e)(1)). Tainted income is income or gain recognized on the sale or other disposition of tainted assets, and income derived as a result of holding tainted assets.

FTC Implications

If a DCL is subject to the domestic-use limitation rule, the consolidated group, unaffiliated DRC, or unaffiliated domestic owner will not take into account the items constituting the DCL until the year in which such items are absorbed in computing its foreign tax credit (FTC) limitation (Regs. Sec. 1.1503(d)-4(f)).

Exceptions to Domestic-Use Limitation

If there is not an actual or deemed foreign use of the DCL, a DRC or U.S. owner of a separate unit may elect to offset the DCL against income of a domestic affiliate. The DRC or U.S. owner of a separate unit has three options for electing such domestic use: domestic-use election, elective agreement in place between the U.S. and a foreign country, and no possibility of foreign use.22

Domestic-Use Election

A DCL may be included in taxable income of a domestic affiliate if the consolidated group, unaffiliated DRC, or unaffiliated domestic owner (electors) files a domestic-use election agreement in conformity with the regulations (Regs. Sec. 1.1503(d)6(d)). The domestic-use agreement certifies that there has not been, and will not be for at least five years after the year in which the DCL was incurred (the certification period), any foreign use (as defined below) of the DCL.23 An elector must file a domestic-use agreement by the due date (including extensions) of the elector’s U.S. income tax return for the tax year in which the DCL is incurred. Such agreement must follow the format and include the required information under Regs. Sec. 1.1503(d)-6(d)(1).

In addition to the domestic-use agreement, the elector must file a certification, labeled “Certification of Dual Consolidated Loss” at the top of the page, by the due date (including extensions) of its income tax return for each year during the five-year certification period. The certification must follow the format and include the required information as provided under Regs. Sec. 1.1503(d)-6(g). If the elector is filing the annual certification as part of the stand-alone exception to the mirror legislation rule, there are additional requirements (previously noted).

Elective Agreement Between the U.S. and a Foreign Country

A DCL may be offset against income of a domestic affiliate under an agreement entered into between the U.S. and a foreign country that puts into place an elective procedure through which losses in a particular year may be used to offset income in only one country (Regs. Sec. 1.1503(d)-6(b)). The election to apply this agreement will terminate any existing stand-alone domestic-use agreements for the mirror-legislation rule (Regs. Sec. 1.1503(d)3(e)(2)(iii)). As of the publication of this article, the U.S. has entered into only one agreement that would qualify under this rule, with the U.K., to take into account the interaction between U.S. and U.K. loss-limitation rules. However, this agreement has limited application.24

No Possibility of Foreign Use

There is no limitation on the domestic use of a DCL if the consolidated group, DRC, or any unaffiliated domestic owner of a separate unit can demonstrate to the satisfaction of the IRS that there is no foreign use in the year that the DCL is incurred and there is no possibility of foreign use of the DCL in any other year by any means (Regs. Sec. 1.1503(d)-6(c)). A statement must be attached to, and filed by the due date (including extensions) of, the U.S. income tax return for the tax year in which the DCL is incurred. Such statement must follow the format and include the required information as provided under Regs. Sec. 1.1503(d)-6(c)(2).

Foreign Use

1. Direct foreign use: Foreign use of a DCL is deemed to occur when a DCL, or any portion thereof, is made available to offset, directly or indirectly, any item recognized as income or gain under foreign laws (Regs. Sec. 1.1503(d)-3(a)(1)). Under U.S. tax principles, the item offset must be an item of a foreign corporation (as determined under U.S. entity-classification rules) or a direct or indirect owner of an interest in a hybrid entity, provided such interest is not a separate unit. A deduction is available for use regardless of whether it reduces gain or income under foreign law or whether the items offset are regarded as income under U.S. laws (Regs. Sec. 1.1503(d)-3(b)). One obvious situation would be if a DRC were included in a foreign consolidated return. A less obvious situation is described in Example 1.

Example 1: P, a U.S. corporation, owns DX, a country X corporation that is disregarded for U.S. tax purposes. DX owns 99% and S, a U.S. corporation and member of the common parent P consolidated group, owns 1% of FX, a country X partnership that elected to be treated as a corporation for U.S. tax purposes. FX conducts a trade or business in country X. In year 1, DX incurs interest expense on a third-party loan, which constitutes a DCL attributable to P’s interest in DX. In year 1, for country X tax purposes, DX takes into account its distributive share of income generated by FX and offsets such income with its interest expense.

Result: In year 1, the DCL attributable to P’s interest in DX is available to, and in fact does, offset income recognized in country X; under U.S. tax principles, the income is considered to be income of FX, a foreign corporation. Accordingly, there is a foreign use of the DCL and, as such, P (or any other domestic affiliate) is ineligible for an exception to the domestic-use limitation and is prohibited from including the DCL in taxable income. DX may offset such DCL with any income attributable to DX. 25

2. Indirect foreign use: An indirect foreign use is deemed to occur if deductions or losses are taken into account for foreign tax purposes but do not give rise to corresponding income or gain for U.S. tax purposes, and the deduction or loss composing the DCL is thus made indirectly available for foreign use (Regs. Sec. 1.1503(d)-3(a)(2)(i)).

Example 2: The facts are the same as in Example 1, except instead of owning DX, P owns DY, a country Y corporation that is disregarded for U.S. tax purposes, which, in turn, owns DX. In addition, DY, rather than DX, is the obligor on the third-party loan and therefore incurs the interest expense on such loan. Finally, DY lends the loan proceeds from the third-party loan to DX, and DX pays interest to DY on such loan (which is generally disregarded for U.S. tax purposes).

Result: For purposes of calculating income or a DCL, DY and DX do not take into account interest income or interest expense, respectively, for amounts paid on the disregarded loan from DY to DX. Thus, in year 1, there is a DCL attributable to P’s interest in DY, but not to P’s indirect interest in DX. In year 1, interest expense paid by DX to DY on the disregarded loan is taken into account as a deduction in computing DX’s taxable income for X tax purposes, but it does not give rise to a corresponding item of income or gain for U.S. tax purposes (because it is generally disregarded). In addition, such interest has the effect of making an item of deduction or loss composing the DCL attributable to P’s interest in DY available for a foreign use. This is because it may reduce or offset items of deduction or loss composing the DCL for foreign tax purposes, and it creates another deduction or loss that may reduce or offset income of DX for foreign tax purposes that, under U.S. tax principles, is treated as income of FX, a foreign corporation. Moreover, because the disregarded item is incurred or taken into account as interest for foreign tax purposes, it is deemed to have been incurred or taken into account with a principal purpose of avoiding the provisions of Sec. 1503(d). Accordingly, there is an indirect foreign use of the year 1 DCL attributable to P’s interest in DY. 26

An indirect foreign use will not be deemed to occur if the consolidated group, unaffiliated domestic owner, or unaffiliated DRC demonstrate, to the satisfaction of the Service, that the item or items that gave rise to the indirect foreign use:

1. Were not incurred, or taken into account, with the principal purpose of avoiding Sec. 1503(d). The following will be deemed to have a principal purpose of avoiding Sec. 1503(d): An item treated as interest for foreign tax purposes but disregarded for U.S. tax purposes; and an item incurred or taken into account as a result of an instrument that is treated as equity for U.S. tax purposes and debt for foreign tax purposes; and

2. Were incurred, or taken into account, in the ordinary course of the DRC’s or separate unit’s trade or business (Regs. Sec. 1.1503(d)-3(a)(2)(ii)).

3. Ordering rules: The final regulations provide ordering rules for determining the foreign use of losses in the event that a foreign country allows for the use of losses of a DRC or a separate unit, but does not provide rules for the order in which such losses are used in a tax year. Specifically, any net loss, or net income, of the DRC or separate unit for the tax year first offsets net income, or loss, recognized by its affiliates in the same tax year before considering carryover losses (Regs. Sec. 1.1503(d)-3(d)(1)). If the DRC or separate unit has losses from different tax years under foreign law, it will use first the losses that would not constitute a triggering event that would result in the recapture of the DCL (Regs. Sec. 1.1503(d)-3(d)(2)). It will use first the losses from the most recent tax year from which a loss may be carried forward or back under foreign law. Different losses (e.g., capital losses and ordinary losses) incurred in the same tax year and available for foreign use will be deemed to be used on a pro-rata basis (Regs. Sec. 1.1503(d)-3(d)(3)).

4. Exceptions to foreign use: There are several exceptions to the above definition of foreign use:

1. If foreign use is available only on an election, sale, merger, or similar transaction under the laws of a foreign country, a foreign use will not occur if there is no such election, sale, merger, or similar transaction (Regs. Sec. 1.1503(d)-3(c)(2)).

2. If a DCL is made available to reduce income that would constitute a foreign use and income that would not constitute a foreign use, and the foreign country does not provide rules for the order of offset, the DCL will be considered to first reduce the income that does not constitute a foreign use (Regs. Sec. 1.1503(d)3(c)(3)).

3. For DCLs attributable to a hybrid-entity partnership or a hybrid-entity grantor trust, or to a separate unit owned indirectly through a partnership or grantor trust, a foreign use will not occur if the foreign use is solely due to another person’s ownership of the grantor trust or partnership, and the carryforward or allocation of an item of deduction or loss composing such DCL as a result of such ownership. This exception applies to the portion of the DCL of a combined separate unit attributable to the individual separate unit. The exception will not apply if in a year subsequent to the incurrence of the DCL there is more than a de minimis reduction in the U.S. owner’s percentage interest in the partnership or grantor trust (Regs. Sec. 1.1503(d)-3(c)(4)).

4. In general, a foreign use will not occur for a DCL as a result of an item of deduction or loss composing such DCL being made available solely as a result of a direct or indirect reduction in the domestic owner’s interest in the separate unit (Regs. Sec. 1.1503(d)-3(c)(5)(i)). This includes a reduction resulting from another person acquiring an interest in the foreign branch or hybrid entity (Regs. Sec. 1.1503(d)-3(c)(5)(iii)). An interest in a hybrid entity partnership or a separate unit carried on through a partnership is determined by reference to the owner’s interest in the profits and capital of such unit. For purposes of this exception, the combination rule does not apply, and the exception is applied to the uncombined partnership. The exception will not apply if, during any 12-month period, the domestic owner’s percentage interest in the separate unit decreases by 10% or more, compared with the domestic owner’s interest at the beginning of the 12-month period; or, at any time the domestic owner’s percentage interest in the separate unit is reduced by 30% or more, compared with the domestic owner’s interest at the end of the tax year in which the DCL was incurred (Regs. Sec. 1.1503(d)-3(c)(5)(ii)).

5. No foreign use will be considered to occur if the items composing the DCL are made available only as a result of the transfer of assets of a DRC or separate unit (Regs. Sec. 1.1503(d)3(c)(6)), provided that:

  • Such items are made available solely due to the basis of the transferred assets being determined under foreign law in whole or in part by reference to the basis of the assets in the hands of the DRC or separate unit;
  • The aggregate adjusted U.S. tax basis of all the assets so transferred during any 12-month period is less than 10% of the aggregate adjusted U.S. tax basis of all the DRC’s or separate unit’s assets, compared with the assets held at the beginning of the 12-month period; and
  • The aggregate adjusted U.S. tax basis of all the assets so transferred at any time is less than 30% of the aggregate adjusted U.S. tax basis of all the DRC’s or separate unit’s assets, compared with the assets held at the end of the tax year in which the DCL was generated.

6. A foreign use will not be considered to occur solely as a result of an item composing a DCL being made available through the assumption of liabilities of a DRC or separate unit (Regs. Sec. 1.1503(d)3(c)(7)(i)). This applies only if the availability is a result of the liabilities giving rise to the deduction or loss. This exception is limited to liabilities incurred in the ordinary course of the DRC’s, or separate unit’s, trade or business (Regs. Sec. 1.1503(d)3(c)(7)(ii)). Liabilities incurred in the ordinary course of a trade or business include debt taken on to finance the trade or business of the DRC or separate unit.

5. Mirror-legislation rule: Without regard to the exceptions above, a foreign use will be deemed to occur if the foreign income tax laws deny any opportunity for the foreign use of the DCL in the year in which the DCL is incurred (the mirror-legislation rule) (Regs. Sec. 1.1503(d)3(e)(1)). This is determined by assuming that such foreign country had recognized the DCL in such year.

Regs. Sec. 1.1503(d)-3(e)(2) provides a limited “stand-alone” exception to the deemed foreign use of a DCL under the mirror-legislation rule. This exception applies if, in the absence of the mirror legislation, no item of deduction or loss composing the DCL of such DRC or separate unit would otherwise be available for a foreign use in the tax year in which such DCL is incurred. Foreign use will still be considered to occur if an election is required to enable foreign use, but no such election is made. To qualify for the stand-alone exception, the consolidated group, unaffiliated DRC, or unaffiliated domestic owner must file a domestic-use agreement, as described above, and add the additional items listed in Regs. Sec. 1.1503(d)3(e)(2)(ii).

Conclusion

Part II, in the October 2007 issue, will discuss triggering events and their consequences, as well as the transition rules from the 1992 regulations to the 2007 regulations.

For information about this article, contact Ms. Rollinson at margie.rollinson@ey.com, Ms. O’Connor at margaret.oconnor@ey.com, or Ms. Jacobs at karen.jacobs@ey.com.


Notes

Authors’ note: The authors wish to thank Maria Martinez and John Karasek for their assistance with this article.

1 P.L. 99-514, 99th Congress, HR 3838, JCS-10-87 (Part 14 of 19 Parts), General Explanation of the Tax Reform Act of 1986 at E.9.

2 For purposes of the 2007 DCL regulations, “domestic owner” generally means a U.S. corporation (including a DRC) that owns one or more separate units or transparent entities; Regs. Sec. 1.1503(d)-1(b)(9).

3 The 1992 DCL regulations provided that a separate unit was treated as a DRC or domestic corporation for certain parts of the regulations, but not for others. The 2007 DCL regulations do not carry forward this rule, but rather explicitly refer to separate units and DRCs when the rules are applicable to those entities.

4 A DRC also includes foreign insurance corporations treated as U.S. corporations under Sec. 953(d) that are also members of an affiliated group, regardless of whether such corporations are subject to foreign income tax.

5 Indirect ownership means through a partnership, disregarded entity, or grantor trust, regardless of whether such entities are U.S. persons. This definition of indirect ownership is the same throughout the 2007 DCL regulations; see Regs. Sec. 1.1503 (d )-1(b)(19).

6 The definition of a U.S. corporation here is the same as described above. Thus, not only are S corporations, RICs, and REITs not DRCs, they also cannot own a separate unit. Thus, the DCL rules are not applicable to those entities.

7 In general, a foreign branch is an integral business operation carried on by a U.S. person outside the U.S.

8 Separate units of a foreign insurance company treated as a DRC are not combined with separate units of any other U.S. corporation.

9 A grantor trust is defined under Regs. Sec. 1.1503 (d )-1( b)(15) as “a trust, any portion of which is treated as being owned by the grantor or another person under subpart E or subchapter J” of the Code.

10 This is a change from the 1992 DCL regulations, which included non-hybrid-entity partnerships and non-hybrid-entity grantor trusts in the definition of separate unit. See Regs. Sec. 1.1503-2(c)(3)(i)(B) and (C) of the 1992 DCL regulations.

11 Preamble to TD 9315 (3/9/07).

12 Regs. Sec. 1.1503(d )-5( b)(1). Items recognized by the DRC in the current year by virtue of an election under Sec. 338 will also be taken into account.

13 Regs. Sec. 1.1503(d)-5(c)(4)(vi). Recapture income and the determination of this amount are discussed in Part II of this article.

14 If the foreign branch is in a jurisdiction where taxable income or loss of a permanent establishment or branch are determined only with reference to the items recorded in its books and records, the principles in Regs. Sec. 1.882-5 will not apply. In that case, only items of the domestic owner’s interest expense reflected on the foreign branch’s books and records, adjusted to conform to U.S. tax principles, are attributed to the foreign-branch separate unit; see Regs. Sec. 1.1503(d)-5(c)(2)(iii). Regs. Sec. 1.882-5 provides a three-step process for allocating the interest expense of a foreign corporation to the effectively connected income of its U.S. trade or business. Those steps include (1) determining the total value of U.S. assets of the foreign corporation; (2) determining the U.S.-connected liabilities; and (3) adjusting the interest paid or accrued on U.S.-booked liabilities for interest expense attributable to the difference between U.S.-connected liabilities and U.S.-booked liabilities. When applying the principles of Sec. 864(c) and Regs. Sec. 1.882-5, the foreign-branch separate unit’s U.S. owner should be treated as a foreign corporation, the foreign-branch separate unit should be treated as a trade or business within the U.S., and the other assets of the U.S. owner should be treated as assets that are not U.S. assets.

15 The term “books and records” is defined in Regs. Sec. 1.989(a)-1(d).

16 Sec. 367(a)(3)(C) requires gain recognition on certain transfers of foreign-branch assets to a foreign corporation.

17 Regs. Sec. 1.1503(d)-5(c)(4)(iii)(A). Sec. 904(f )(3) provides rules for determining gain and source of income on the disposal of property predominantly used outside the U.S.

18 Regs. Sec. 1.1503(d)-4( b). A domestic use of a DCL occurs “when the dual consolidated loss is made available to offset, directly or indirectly, the income of a domestic affiliate (other than the dual resident corporation or separate unit that, in each case, incurred the dual consolidated loss) in the taxable year in which the dual consolidated loss is recognized, or in any other taxable year,” even if the DCL does not offset foreign taxable income and even if the foreign taxable income is or will not be subject to U.S. tax; see Regs. Sec. 1.1503(d)-2. A domestic use occurs in the year the DCL is included in the consolidated group, unaffiliated DRC, or unaffiliated domestic owner’s taxable income, even if there is no tax benefit resulting from such inclusion in the current year. A domestic affiliate is a member of an affiliated group, without consideration of the exceptions in Sec. 1504( b) (other than Sec. 1504( b)(3)). A domestic affiliate also includes a domestic owner, a separate unit, and a transparent entity; see Regs. Sec. 1.1503(d)-1( b)(12).

19 The loss is subject to all of the SRLY limitations under Regs. Sec. 1.1502-21(c), with certain modifications; see Regs. Sec. 1.1503(d )-4(c)(3).

20 Regs. Sec. 1.1503(d)-4(c)(1) and (2). The DCL is treated as a pro-rata portion of each item of deduction and loss of the DRC or separate unit taken into account in calculating the DCL.

21 Id. For this purpose, the DCL rules adopt the SRLY cumulative register concepts of Regs. Sec. 1.1502-21(c).

22 The exceptions do not apply to losses incurred or carried over under a Sec. 381(a) transaction for a foreign insurance company that is a DRC or for a separate unit of such foreign insurance company; see Regs. Sec. 1.1503(d)-6(a)(3).

23 The certification period has been reduced from the 15-year period in the 1992 DCL regulations; see Regs. Sec. 1.1503(d )-1(b)(20) under the 1992 DCL regulations.

24 United Kingdom/United States Dual Consolidated Loss Competent Authority Agreement, Convention between the Government of the United States of America and the Government of the United Kingdom of Great Britain and Northern Ireland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and on Capital Gains, October 6, 2006 (2006 TNT 196-24).

25 Regs. Sec. 1.1503(d)-7(c), Example (6)(i) and (ii).

26 Regs. Sec. 1.1503(d)-7(c), Example (6)(iii).

 

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