New Regs. for Use of Foreign Losses Included in U.S. Tax Filings: Dual Consolidated Losses

Editor: Anthony S. Bakale, CPA, M.Tax.

On March 19, 2007, new regulations were issued to control the use of losses generated in a foreign jurisdiction and included in a U.S. tax filing; see TD 9315. These final regulations apply to dual consolidated losses (DCLs) incurred in tax years beginning after April 17, 2007. However, a taxpayer may apply the regulations, in their entirety, to DCLs incurred in tax years beginning after 2006. With the proliferation of foreign flowthrough entities (partnerships, disregarded entities and hybrid entities) due to the ease of choice of entity under the check-the-box (CTB) regulations, updating the original DCL rules under Sec. 1503(d) has been on the Service’s international rulemaking agenda for some time. These final regulations address various DCL issues, including exceptions to the general prohibition against using such a loss to reduce the taxable income of any other member of the affiliated group.

On May 24, 2005, the IRS and Treasury published a notice of proposed regulations addressing the following: (1) the potential over- and under-application of the current regulations; (2) various issues arising in the application of the current regulations, particularly in light of the adoption of the CTB regulations (Regs. Secs. 301.7701-1 through -3); and (3) the administrative burden of the current regulations; see REG-102144-04. The final regulations adopt many of the rules contained in the proposed regulations.

Background

Congress enacted the DCL rules under Sec. 1503(d) as part of the Tax Reform Act of 1986, to prevent a dual-resident corporation from using a single economic loss to offset both income subject to U.S. tax but not foreign tax, and income subject to foreign tax
but not U.S. tax (double dip). In 1988, Congress extended the application of Sec. 1503(d) to separate units of domestic corporations and to grant Treasury authority to promulgate regulations to prevent avoidance of the DCL rules by contributing assets to a corporation with a DCL after the loss was sustained.

A DCL is a loss generated in a foreign jurisdiction that is used to offset U.S. taxable income and could later be used to offset income in a foreign jurisdiction. It is the net operating loss (NOL) incurred in a year in which the corporation is a dual-resident corporation and, with certain exceptions, the NOL is attributable to a separate unit. An entity is a dual-resident corporation when a domestic corporation is subject to a foreign country’s income tax on its worldwide income or on a residence basis. A corporation is taxed on a residence basis if it is taxed as a resident under the foreign country’s laws. A dual-resident corporation also includes any foreign insurance company that elects to be treated as a domestic corporation (under Sec. 953(d)) and is treated as a member of an affiliated group, even if the insurance company is not subject to a foreign country’s income tax on its worldwide income or on a residence basis. Certain hybrid entities may also contribute to a DCL situation when they are not otherwise taxable as associations for Federal tax purposes, but are subject to a foreign country’s income tax as corporations (or otherwise at the entity level), either on world-wide income or on a residence basis. With limited exceptions, the domestic use of a DCL is not permitted.

Highlights of Changes Contained in the Final Regs.

The original regulations, issued in TD 8434, included clarifications for certain entities that are domestic corporations but are not generally taxed at the entity level; they are now exempt.

The original regulations provided that an S corporation, which is a domestic corporation, is not treated as a dual-resident corporation. The proposed regulations, and these new final regulations, provide that an S corporation is not treated as a domestic corporation and, thus, cannot be a dual-resident corporation or own a separate unit. In addition, regulated investment companies (RICs) and real estate investment trusts (REITs) are also exempt from the DCL rules. Sec. 1503(d) was intended to apply only to domestic corporations subject to an entity-level tax. Although RICs and REITs are domestic corporations under the Code, unlike most domestic corporations these entities often do not pay tax at the entity level, because they may deduct dividends paid to shareholders from their taxable income.

Losses attributable to interests in transparent entities are also not subject to Sec. 1503(d) under the final regulations; items attributable to these interests should not influence the calculation or use of a DCL of a dual-resident corporation or separate unit in a manner inconsistent with the purposes of Sec. 1503(d). Accordingly, the final regulations provide four new rules that address transparent entities (and interests therein).

First, the final regulations provide a definition of a transparent entity that is consistent with the description and examples in the proposed regulations. Second, the final regulations provide rules for attributing items of income, gain, deduction, and loss to interests in transparent entities. Third, items of income, gain, deduction and loss attributable to interests in transparent entities are not considered when calculating whether a dual-resident corporation that holds an interest in such an entity has income or a DCL. This modification guarantees that when a foreign country in which the dual-resident corporation is subject to tax is unlikely to take into account items of the transparent entity, such items do not inappropriately affect the computation of income or a DCL of the dual-resident corporation. Finally, an interest in a transparent entity will be treated as a domestic affiliate to determine whether there is a domestic use of a DCL. This change prevents a DCL from being used to offset the income of a transparent entity so that there is no inappropriate domestic use of the loss.

The final regulations do not treat transparent entities, or interests therein, as dual-resident corporations or separate units; as a result, these entities (or interests therein) are not subjected to the limits of Sec. 1503(d). Instead, the rules aim to appropriately take into account those entities when applying the DCL rules to dual-resident corporations and separate units.

Foreign Use of a DCL

The original regulations provided that to elect relief from the general limit on the use of a DCL to offset income of a domestic affiliate, the taxpayer must, among other things, certify that no portion of the losses, expenses or deductions taken into account in computing the loss has been, or will be, used to offset the income of any other person under the income tax laws of a foreign country. If, contrary to the certification, the DCL is used, it generally must be recaptured and reported as gross income.

The proposed regulations provided that a foreign use is deemed to occur only if two conditions are satisfied. The first condition is satisfied if any portion of a deduction (or loss) used to compute a DCL is allowed under a foreign country’s income tax laws to offset or reduce, directly or indirectly, any item recognized as income or gain under its laws, regardless of whether (1) income or gain are actually offset and (2) these items are recognized under U.S. tax principles. The second condition is met if items that are (or could be) offset under the first condition are considered, under U.S. tax principles, to be items of (1) a foreign corporation or (2) a direct or indirect (e.g., through a partnership) owner of an interest in a hybrid entity, provided the interest is not considered a separate unit.

When issuing the final regulations, the Service and Treasury believed that it was appropriate to include certain safe harbors under which a foreign use will be deemed not to occur. As a result, additional exceptions to the definition of a foreign use were included. These generally apply when the potential for foreign use is de minimis or when the transaction giving rise to a foreign use occurs as a result of events outside the taxpayer’s control. If the DCL cannot be used in a foreign jurisdiction to offset items of income in a foreign jurisdiction, the loss certification is not considered invalid.

Mirror Legislation

The original final regulations contained a rule that denied a taxpayer the ability to use a DCL to offset the income of a domestic affiliate when the foreign country has enacted legislation that operates in a manner similar to the DCL rules. As a result, it prohibited the taxpayer from claiming the DCL in the foreign country. The mirror legislation rule was designed to prevent the revenue gain resulting from the disallowance of a double dip from inuring solely to the foreign country. As a result, a DCL could be disallowed in the U.S. and in the foreign country.

The final regulations remove this problem. The IRS recently (Oct. 6, 2006) concluded a competent-authority agreement relative to DCL legislation with the U.K.; see Ann. 2006-86. The agreement applies to DCLs attributable to certain U.K. permanent establishments that are otherwise subject to both the U.S. DCL rules and mirror legislation enacted by the U.K. In general, the agreement provides that taxpayers can elect to use or relieve the loss in either the U.K. or the U.S., but not both.

Triggering Events and Related Rules

The proposed regulations contained exceptions to triggering events that generally applied when assets or interests sold or disposed of are acquired, directly or through wholly owned passthrough entities, or by members of the consolidated group that includes the dual-resident corporation or separate unit, or by the unaffiliated domestic owner. The final regulations generally retain these exceptions but modify them to take into account new exceptions to foreign use.

Reasonable-Cause Exception

An important piece of the final regulations allows companies that believed they were otherwise exempted from the DCL provisions an opportunity to cure administrative issues related to the certification of the losses, because there was a 15-year certification period in the original regulations. The original final regulations required various filings (DCL certifications) to be included on a timely filed income tax return (taxpayer certifies that the losses used from a foreign jurisdiction against U.S. taxable income would not be offset against other entities’ foreign taxable income). In addition, taxpayers that failed to include these filings had to request an extension to file under Regs. Secs. 301.9100-1 through -3 to include the certification statement. The proposed regulations eliminated the requirement that a taxpayer obtain an extension of time under Regs. Secs. 301.9100-1 through -3 and instead adopted a reasonable-cause standard.

On Jan. 31, 2006, the IRS published Notice 2006-13, announcing that taxpayers that must file agreements, statements and other information under Sec. 1503(d) may cure any late filings by applying a reasonable-cause exception similar to the standard contained in the proposed regulations, until the proposed regulations become final. The notice also modified the procedures for obtaining reasonable-cause relief to ensure that requests are handled timely and efficiently. The final regulations adopt the reasonable-cause standard contained in the proposed regulations and Notice 2006-13, with some modifications.

Certification Period

The original final regulations provided that if a certification election is made with respect to a DCL of a dual-resident corporation or a hybrid-entity separate unit, the consolidated group, etc., must file with its tax return an annual certification during the 15-year certification period. The filing permitted the DCL to be used in the U.S. to offset a domestic affiliate’s income, but certified that the losses or deductions that make up the DCL have not been used to offset the income of another person under a foreign country’s tax laws. However, the current regulations do not require annual certifications for agreements entered into with respect to DCLs of foreign-branch separate units. In addition, the previous regulations had provided that if a triggering event occurs during the 15-year period following the year in which the DCL was incurred (certification period), the taxpayer must recapture and report as income the amount of the DCL and pay an interest charge. The proposed regulations reduced the certification period from 15 to seven years and expanded the annual certification requirement to include DCLs of foreign-branch separate units. These provisions were adopted as part of the final regulations, but the certification period was reduced to five years.

Note: For a detailed discussion of the DCL rules, see the forthcoming September and October 2007 issues of The Tax Adviser.