Treasury provides guidance on the interaction of DCLs with Pillar Two taxes

Editor: Susan M. Grais, CPA, J.D., LL.M.

In proposed regulations (REG-105128-23) published Aug. 7, 2024, Treasury and the IRS addressed the interaction of the dual consolidated loss (DCL) rules with Pillar Two of the OECD’s global anti-base erosion model rules (GloBE rules). The proposed regulations would also make several other important changes to the current DCL rules.

Background

The DCL rules limit the use of a single economic loss to offset income subject both to U.S. tax and foreign tax, which may occur when a domestic corporation is also resident in a foreign jurisdiction (a dual resident corporation) or when a domestic corporation holds an interest in a hybrid entity or foreign branch. Under Sec. 1503(d), a domestic corporation’s DCL cannot reduce the taxable income of a domestic affiliate (a domestic use). For this purpose, a DCL is generally (1) the net operating loss (NOL) attributable to a dual resident corporation, or (2) the net loss attributable to a domestic corporation’s separate unit (which includes certain hybrid entities and foreign branches).

Exceptions to this limitation on the domestic use of a DCL apply, including when a taxpayer certifies under a domestic-use election and agreement that there has not been and will be no foreign use of the DCL. A foreign use occurs when any portion of a DCL is made available under the income tax laws of a foreign country to reduce income of certain foreign persons (e.g., a foreign entity that is a corporation for U.S. tax purposes).

Interactions between the DCL and GloBE rules

Foreign use arising from a QDMTT or IIR: For purposes of the DCL rules, the proposed regulations provide that an income tax may include a minimum tax that is computed based on financial accounting net income or loss, such as a qualified domestic minimum top-up tax (QDMTT) or under an income inclusion rule (IIR). Therefore, a foreign use of a DCL could occur if a deduction or loss included in a DCL were used (1) to calculate net GloBE income for a QDMTT or IIR, or (2) to qualify for the transitional country-by-country reporting (CbCR) safe harbor (TCSH). However, no foreign use would occur when the OECD’s duplicate loss arrangement rules (released in December 2023) both deny a deduction or loss comprising all or a portion of the DCL under the TCSH and the TCSH is satisfied for that same tax year, such that no top-up tax is imposed under the relevant QDMTT or IIR. The proposed regulations provide no guidance on the undertaxed profits rule (UTPR), as Treasury and the IRS continue to analyze issues related to the UTPR.

Transition rule: In Notice 2023-80, Treasury and the IRS announced a transition rule under which no foreign use of a DCL would occur because of a legacy DCL being taken into account under the GloBE rules. The notice defined a legacy DCL as a DCL incurred in a tax year beginning before Dec. 31, 2023. Subject to the anti-abuse rule described in Prop. Regs. Sec. 1.1503(d)-8(b)(12)(ii), the proposed regulations would extend that relief by treating DCLs incurred in tax years beginning before Aug. 6, 2024, as legacy DCLs and permitting the DCL rules (including those pertaining to foreign use) to apply without regard to Pillar Two taxes.

Expanded scope of “separate unit” definition: Under the current DCL regulations, a foreign branch or hybrid entity constitutes a separate unit only if it is subject to a foreign country’s income tax on its worldwide income or on a residence basis. The proposed regulations would expand those definitions to include certain hybrid entities subject to an IIR and foreign branches subject to a QDMTT or an IIR.

Mirror legislation rule: Under the DCL rules’ mirror-legislation rule, a foreign use of a DCL may be deemed to occur if a foreign income tax law would deny any opportunity for the foreign use of the DCL, provided certain conditions are satisfied. The proposed regulations would also provide that a foreign law, including GloBE rules that adopt the duplicate-loss-arrangement rules as part of implementing a QDMTT or IIR, does not constitute mirror legislation, provided that it generally preserves a taxpayer’s choice between a domestic use or a foreign use of a DCL (but not both).

Elimination of the favorable inclusions-on-stock rule in Regs. Sec. 1.1503(d)-5(c)(4)(iv)

The current DCL rules treat certain inclusions on stock as income attributable to a separate unit for purposes of computing the income or DCL of that separate unit. They also treat dividends and gains, to the extent attributable to the separate unit or earned by a dual resident corporation, as income for this purpose. Under the proposed regulations, the income or DCL of a dual resident corporation or a separate unit would exclude Subpart F income, global intangible low-taxed income, dividends, gain, and any other income arising from the ownership of stock, as well as any deduction or loss with respect to those items. A limited exception would apply to dividends arising from portfolio stock.

Effect of the intercompany transaction regulations

The proposed regulations would modify the existing intercompany transaction regulations under Regs. Sec. 1.1502-13, generally shifting the application of the existing regulations toward separate-entity treatment for purposes of the DCL rules. If a member of a consolidated group is a dual resident corporation or a domestic corporation that owns a separate unit, the proposed regulations would clarify that:

• The member (a Sec. 1503(d) member) has special status for purposes of applying the DCL rules so that the attributes of its items from intercompany transactions are not redetermined for purposes of the DCL rules and these items are taken into account in the DCL computations of the Sec. 1503(d) member; and
• The counterparty consolidated group member’s income or gain from the intercompany transaction is not deferred, despite the Sec. 1503(d) member’s deduction or loss being limited under the DCL rules, if the Sec. 1503(d) member’s use of a deduction or loss from an intercompany transaction is limited under the DCL rules.

Notwithstanding the foregoing separate-return treatment, the proposed regulations would apply the intercompany transaction regulations to determine when a Sec. 1503(d) member’s item from an intercompany transaction would be taken into account and first become subject to the DCL rules. For example, if the Sec. 1503(d) member’s loss from selling property to a counterparty member is deferred until a later year (e.g., when the counterparty resells the property to an unrelated person), the intercompany transaction regulations would defer the Sec. 1503(d) member’s loss until the later year of resale, and the loss would not be subject to the DCL rules until the resale year (rather than in the year of the intercompany sale).

Disregarded-payment losses

The proposed regulations also introduce new “disregarded-payment-loss” rules that are intended to address potential deduction/ noninclusion outcomes arising from certain disregarded payments that are deductible in a foreign country but not included in U.S. taxable income by reason of being disregarded.

Scope: Generally, the disregarded-payment-loss rules would require domestic corporations that own “disregarded-payment entities” to recognize deemed income under certain circumstances. Absent specific statutory authorization for deeming such income, the proposed regulations would condition certain entity-classification elections on the domestic corporation consenting to be subject to the disregarded-payment-loss rules.

Specifically, the proposed regulations would require any domestic corporation (a “specified domestic owner”) that owns interests in a specified eligible entity (a domestic or foreign eligible entity that is either a foreign tax resident or is owned by a domestic corporation that has a foreign branch) to consent to be subject to the disregarded-payment-loss rules if the specified eligible entity were to elect to be disregarded as an entity separate from its owner (a disregarded entity) or is classified as a disregarded entity upon formation without an election.

Under the proposed regulations’ deemed-consent rule, a domestic corporation that owns interests in a specified eligible entity would be deemed to consent to be subject to the disregarded-payment-loss rules beginning on Aug. 6, 2025, to the extent it has not otherwise so consented. In the preamble, Treasury and the IRS indicated that this delayed consent date is intended to provide taxpayers an opportunity to restructure existing arrangements to avoid the application of the disregarded-payment-loss rules. A dual resident corporation would be treated as consenting to be subject to the disregarded-payment- loss rules if it owns an interest in a disregarded entity on the effective date of the election.

Computation of a disregarded-payment loss and a disregarded-payment-loss inclusion amount: Under its consent (deemed or actual), a specified domestic owner would agree to recognize income under certain conditions if a specified eligible entity or foreign branch (each, a disregarded-payment entity) were to incur a disregarded-payment loss. If the disregarded-payment entity incurred a disregarded-payment loss, the specified domestic owner would be required to include in gross income a disregarded-payment-loss inclusion amount upon the occurrence of any triggering event during the certification period. The certification period is the foreign tax year in which the disregarded-payment loss is incurred, any prior foreign tax year, and the subsequent 60-month period.

A disregarded-payment loss would equal the excess, if any, of certain disregarded deduction items over certain disregarded income items, i.e., interest, royalty, or structured payments made by a disregarded-payment entity and taken into account for foreign tax purposes in the disregarded-payment entity’s foreign tax year. The disregarded-payment-loss computation also includes a deduction for equity (including deemed equity of a foreign branch) or a deduction for an imputed interest payment on a debt instrument. A structured payment, defined in Regs. Sec. 1.267A-5(b)(ii), includes certain financing transactions.

Triggering events would include either a foreign use of the disregarded-payment loss or a failure to comply with certification requirements during the disregarded-payment-loss certification period (generally, 60 months).

The disregarded-payment-loss inclusion amount would equal the lesser of (1) the amount of the disregarded-payment loss or (2) the disregarded-payment loss reduced by a disregarded-payment-loss register, which is an account that includes disregarded-payment income but no other income. Although the disregarded-payment losses are intended to work in parallel with the DCL rules, they require inclusions where no DCL arises even if all the transactions at issue were regarded.

Under the proposed regulation’s combination rule, disregarded-payment entities that are subject to the same foreign tax law would be treated as a single disregarded-payment entity if they have the same domestic owner or their respective owners are members of the same consolidated group. A dual resident corporation that is a disregarded-payment entity is excluded from the combination rule.

Adjustments to conform to US tax principles

Under Regs. Sec. 1.1503(d)-5(c)(3)(i), a hybrid entity separate unit’s income or DCL computation is generally based on its books and records as adjusted to conform to U.S. tax principles. The proposed regulations clarify that items that have not been, and will not be, reflected on the books and records of a hybrid entity separate unit are not included in the separate unit’s income or DCL computation. According to Treasury and the IRS, this clarification is intended to address positions taken by taxpayers that a hybrid entity separate unit may be allocated income on the books and records of its domestic owner under, for example, Sec. 482 or 864(c), where the domestic owner makes a disregarded payment to the hybrid entity separate unit.

Anti-avoidance rule

The proposed regulations include a new anti-avoidance rule authorizing “appropriate adjustments” where taxpayers engage in a transaction, series of transactions, plan, or arrangement with a view to avoiding the purposes of the DCL rules (including the disregarded-payment-loss rules). These adjustments may include disregarding the transaction, series of transactions, plan, or arrangement, or modifying the items that are taken into account in the income or DCL of a dual resident corporation or a separate unit.

Applicability dates

The proposed regulations would generally apply to tax years ending on or after Aug. 6, 2024. Although the disregarded-payment-loss rules generally would apply to tax years ending on or after Aug. 6, 2024, the provisions deeming owners of existing specified eligible entities to consent to those rules would apply on or after Aug. 6, 2025.

The changes to the intercompany transaction regulations under Regs. Sec. 1.1502-13 would apply to tax years for which the original U.S. federal income tax return is due (without extensions) after the date that final regulations are filed with the Federal Register. For example, if the changes were finalized by April 15, 2025, the final regulations would apply to calendar-year consolidated groups for their 2024 tax year.

Once the changes are finalized, taxpayers may choose to apply the final regulations retroactively to prior open tax years, subject to a consistency requirement for members of a consolidated group.

Implications

The proposed regulations include significant changes to the DCL rules, the majority of which are proposed to apply retroactively to the beginning of taxpayers’ current tax year. Further, the transitional Pillar Two relief period will end for calendar-year taxpayers in December 2024; many fiscal-year taxpayers will have an even shorter relief period. Taxpayers implicated by the interplay with Pillar Two and the DCL rules or those taxpayers currently relying on the inclusions-on-stock rule or the intercompany-transaction regulations to limit DCLs should consider the impact of the proposed regulations. Many such taxpayers may need to restructure their current operations to mitigate adverse consequences.

Taxpayers hoping for more extensive relief from the interaction of the DCL rules and Pillar Two had until Oct. 7, 2024, to comment on the proposed regulations and suggest revisions, possibly including relief when a DCL, though made available to compute GloBE income, has no impact on QDMTT or IIR liability.

Lastly, the disregarded-payment-loss rules may impact taxpayers that have financing or licensing transactions involving U.S.-owned disregarded entities or foreign branches. Those rules would result in income inclusions in many unexpected, and seemingly innocuous, fact patterns. Restructuring transactions may be necessary to avoid those unexpected outcomes.

The proposed regulations can be understood as clarifying the interaction of the DCL rules with Regs. Sec. 1.1502-13 in that they prospectively resolve differences in views among practitioners regarding the interaction under current law. Consolidated groups should consider whether to apply future final regulations retroactively to prior open years, but most groups likely will find the final regulations, as currently reflected in the proposed regulations, not to be advantageous from a tax perspective.

Editor Notes

Susan M. Grais, CPA, J.D., LL.M., is a managing director at Ernst & Young LLP in Washington, D.C. For additional information about these items, contact Grais at susan.grais@ey.com. Contributors are members of or associated with Ernst & Young LLP.

The views expressed are those of the authors and are not necessarily those of Ernst & Young LLP or other members of the global EY organization. This information is provided solely for the purpose of enhancing knowledge on tax matters. It does not provide accounting, tax, or other professional advice.