Foreign Income & Taxpayers
Globalization has led United States-based organizations to have legal entity structures that span the globe. U.S.-based businesses are constantly expanding into overseas markets. Reasons for expansion can vary greatly, but often they are tied to new market opportunities, enhanced procurement possibilities, and/or access to a cost-effective labor pool. Once a U.S.-based business has decided to enter a foreign country, it generally has several options for establishing a presence in the host country. Under most countries’ laws, corporations, partnerships, branches, or some combination thereof can be established to conduct business. The choice of the type of legal entity to establish in a foreign country is usually contingent upon a number of tax and legal requirements. The legal entity should carefully consider all of the organization’s needs, including, but not limited to, local employment law, currency restrictions, and intellectual property law. Once a legal entity has been formed in the foreign jurisdiction, the entity must determine how it will be treated for U.S. tax purposes.
Generally, under Regs. Sec. 301.7701-1, commonly referred to as the “check-the-box” regulations, the foreign entity can elect how it is treated for U.S. tax purposes. The regulations allow an entity to be treated differently for U.S. tax purposes than for the host country’s tax purposes. For instance, a foreign entity that is incorporated in India as a private limited company is generally taxed as a corporation under Indian tax law. Notwithstanding the Indian characterization, the check-the-box rules in the United States allow the foreign entity to elect to be treated as a passthrough entity for U.S. tax purposes. If the foreign entity has two owners, it will be treated as a partnership. If the foreign entity has one owner, it will be treated as a disregarded entity. On the other hand, an Indian partnership, for example, could elect to be taxed as a corporation in the United States. The regulations do not allow certain foreign entities to make this election; however, a discussion of these entities is beyond the scope of this item.
If a U.S. corporation owns all the outstanding interest in a foreign legal entity that is eligible and elects to be treated as a passthrough entity, it becomes disregarded for virtually all U.S. tax purposes. As a result, when the U.S. owner files its U.S. tax return, the U.S. owner includes all the foreign entity’s items of income, expense, gain, and loss in its taxable income as if it had incurred those items directly. For U.S. tax reporting purposes, the disregarded entity’s U.S. owner is required to include a Form 8858, Information Return of U.S. Persons with Respect to Foreign Disregarded Entities, with its U.S. tax return. This form reflects the books and records, and it reports certain other information about the disregarded entity.
Once a foreign entity checks the box and becomes disregarded for U.S. tax purposes, it gains a hybrid status. In other words, the entity is taxed differently in the two tax jurisdictions. Its host country taxes the entity as a separate entity, but in the United States it is taxed as a flowthrough entity. This hybrid status can subject the U.S. owner and the foreign entity to the dual consolidated loss (DCL) regulations.
It is important to first discuss the purpose of the rules and regulations related to DCLs. Congress enacted Sec. 1503(d), and Treasury promulgated the regulations thereunder, to prevent a dual-resident corporation, an entity that is subject to tax in two taxing jurisdictions, from “double dipping.” Double dipping occurs when a dual-resident corporation uses a single economic loss to offset income in two tax jurisdictions. The example in the next section illustrates the practice of double dipping.
Sec. 1503(d)(2)(A) defines a DCL as “any net operating loss of a domestic corporation which is subject to an income tax of a foreign country . . . or is subject to such a tax on a residence basis.” In other words, if a U.S. domestic corporation is also taxed in a foreign jurisdiction and has a net operating loss (or NOL, which is defined in the next paragraph), the U.S. domestic corporation has a DCL and must adhere to the regulations under Sec. 1503(d). These regulations generally disallow the “domestic use” of a DCL. Domestic use is “deemed to occur when the dual consolidated loss is made available to offset, directly or indirectly, the income of a domestic affiliate . . . in the taxable year in which the dual consolidated loss is recognized, or in any other taxable year” (Regs. Sec. 1.1503(d)-2). Under this regulation, a domestic use of a DCL can occur even if the U.S. operations of the U.S. owner generate a loss position. Domestic use of the DCL would increase the U.S. NOL, which would be carried forward and then used to offset U.S. taxable income in future tax years.
Regs. Sec. 1.1503(d)-5 provides the rules for calculating the DCL. The starting point for calculating a DCL is always the books and records of the foreign entity translated (if necessary) into U.S. dollars. Tax adjustments (e.g., depreciation, M&E limits, and other items) are made to the book income to arrive at taxable income under U.S. tax principles. The regulations also provide other adjustments that must be made, but the discussion of all of these items is beyond the scope of this item. However, Regs. Sec. 1.1503(d)-5(c)(1)(ii) is very important. Overlooking this subparagraph can often cause a potential DCL to go unrecognized. The last sentence of the paragraph states that “items of income, gain, deduction, and loss that are otherwise disregarded for U.S. tax purposes shall not be regarded or taken into account for purposes of this section.” This concept is very important in cases where the foreign entity’s only source of income is payments received from its U.S. owner. The foreign entity’s books and records appear to reflect a net income position. However, because the income received from the U.S. owner is disregarded, the foreign entity is left with only its expenses. Therefore, the disregarded entity is considered to incur an NOL for U.S. tax purposes and is subject to the DCL rules.
DCL Example and Application
The DCL rules can apply to several fact patterns. The provision of services by a foreign disregarded entity to its U.S. parent is common business practice that can implicate the DCL rules. Assume that USP is a U.S. corporation that is in the business of selling widgets, which are manufactured and sold in the United States. In year 1, USP sets up a wholly owned corporation in India called DRE1. DRE1 is treated as a corporation for Indian tax purposes, but elects under check-the-box regulations to become disregarded for U.S. tax purposes. DRE1 serves as the customer service center for USP. DRE1 generates revenue from USP each month via an intercompany services agreement. DRE1 is compensated by USP for its expenses plus a markup. In general, the amount of the markup and other aspects are subject to the transfer-pricing rules, the consequences of which are beyond the scope of this item. Assume that these payments are the only source of income for DRE1.
In the example above, USP’s arrangement with DRE1 provides the potential for USP to benefit from its expense in two taxing jurisdictions, and therefore USP must consider the DCL regulations. USP is a dual-resident corporation that is taxed in the United States and in India through its ownership of DRE1. The payment from USP to DRE1 is disregarded under Regs. Sec. 1.1503(d)-5(c)(1)(ii). As a result, DRE1 incurs an NOL as defined above for U.S. tax purposes. Generally, USP cannot use this NOL to offset income in the United States under Regs. Sec. 1.1503(d)-2.
Tax Planning Ideas/Solutions
If USP found itself in a situation similar to the one described above, there are ways to avoid loss disallowance under the DCL regulations. The most common solution is for USP to meet one of the exceptions under Regs. Sec. 1.1503(d)-6(a)(1). In addition, USP could consider structuring its operations so that DRE1 is considered a foreign partnership or changing the payer of the foreign entity.
Regs. Sec. 1.1503(d)-6(a)(1) provides three exceptions to the domestic use limitation. The three exceptions are bilateral-elective agreements (Regs. Sec. 1.1503(d)-6(b)), “no possibility of a foreign use” (Regs. Sec. 1.1503(d)-6(c)), and domestic-use elections (Regs. Secs. 1.1503(d)-6(d) through (h)). The first two exceptions are beyond the scope of this item. However, the domestic-use election is a common exception for many taxpayers. The domestic-use election is a statement the taxpayer attaches to its tax return. In the statement, the taxpayer agrees to notify the IRS if certain “triggering events” occur in future tax years. Then the taxpayer certifies for each of the next five tax years that it has not had a triggering event during that year. If the taxpayer does have a triggering event, the taxpayer may be required to recapture the certified DCL and pay the tax and interest on the recaptured amount. There are special rules and exceptions to triggering events and recapture; however, they are beyond the scope of this item.
In addition to the exceptions, USP could also structure its operations or intercompany transactions in a manner that may mitigate the DCL issue. For example, USP could engage in tax planning so that DRE1 is a foreign partnership instead of a foreign disregarded entity, or USP could structure its intercompany agreements so that USP is not the payer of the revenue to DRE1. If DRE1 is treated as a foreign partnership, it is no longer treated as a disregarded entity for U.S. tax purposes, and the intercompany payments would therefore likely be respected for purposes of calculating USP’s DCL with respect to DRE1. Alternatively, USP could cause the intercompany revenue being paid to DRE1 to be paid by an entity other than USP. If the payment is carefully structured, USP may be able to cause the payment to be respected for U.S. tax purposes.
Both of these techniques would likely eliminate the DCL issues arising under Regs. Sec. 1.1503(d)-5(c)(1)(ii), which disregards the payment from USP to DRE1 for purposes of calculating the DCL. Both of these situations assume the foreign entity’s books and records reflect positive taxable income. If the foreign entity is in a loss position (while still including the payment), it could still be subject to DCL rules. In addition, there are possible triggering events that the taxpayers should consider if setting up these structures involving entities that have previously unrecaptured DCLs.
The rules and regulations pertaining to DCLs are very complex, and this item only scratches the surface. DCLs can also be very costly if the taxpayer has a domestic use of a DCL without filing a domestic-use agreement and annual certifications. However, the regulations provide a reasonable cause relief provision. Regs. Sec. 1.1503(d)-1(c)(1) provides a list of steps taxpayers can take to potentially remedy missed agreement and/or certification filings. Taxpayers and tax practitioners should always be diligent and aware of possible DCL scenarios, especially if they have a structure similar to the one described in the example above. The consequences of missing a DCL can be very costly.
Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, DC.
For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.