Application of sec. 1503(d) to separate units of S corporations.

If an S corporation has a foreign branch, or owns an interest in a foreign partnership, trust or hybrid entity, and the foreign branch, partnership, trust or hybrid entity incurs losses, the potential application of the "dual consolidated loss" (DCL) rules of Sec. 1503(d) should be reviewed carefully.

The DCL rules generally limit the use of losses incurred by a "dual resident corporation" (DRC) to offset the income of affiliated domestic corporations. The definition of DRC provided in Regs. Sec. 1. 1503-2(c)(2) explicitly excludes S corporations. On the basis of this exclusion, taxpayers and practitioners might conclude that the DCL rules simply do not apply to S corporations. As is true with respect to other areas of the tax law, however, the rule here is not as straightforward as might first appear.

The definition of DRC in Regs. Sec. 1.1503-2(c)(2) includes any "separate unit" of a domestic corporation. Regs. Sec. 1.1503-2(c)(3) and (4) provide that the term "separate unit" includes a foreign branch, an interest in a partnership, an interest in a trust, and an interest in "an entity that is not taxable as an association for U.S. income tax purposes but is subject to income tax in a foreign country as a corporation (or otherwise at the entity level) either on its worldwide income or on a residence basis" (i.e., a "hybrid entity").

Regs. Sec. 1.1503-2(c)(1)'provides that the term "domestic corporation" has the meaning assigned to it by Sec. 7701(a)(3) and (4). An S corporation is a "domestic corporation" within the meaning of those provisions. Therefore, if an S corporation has a foreign branch or interest in a foreign partnership, trust or hybrid entity, such branch, partnership, trust or hybrid entity would be considered a DRC. Moreover, pursuant to Regs. Sec. 1.1503-2 (c)(1), a "separate unit" of a domestic corporation is treated as a separate domestic corporation.

Applying the general rule of Regs. Sec.1.1503-2(b)(1), a DCL of a DRC may not offset the taxable income of a "domestic affiliate." The term "domestic affiliate" means any member of an affiliated group, without regard to the exceptions contained in Sec. 1504(b) (other than Sec. 1504(b)(3)). The exception for S corporations is found in Sec. 1504(b)(8). Therefore, based on a literal reading of the regulations, an S corporation may be considered a "domestic affiliate" of its branch, partnership, trust or hybrid entity. Accordingly, the DCL provisions may apply, limiting the use of the losses of the branch, partnership, trust or hybrid entity to offset other income of the S corporation.

This application of the DCL rules to S corporations does not appear to be in accordance with congressional intent underlying the enactment of Sec. 1503(d). This intent, as described in the Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, under "Reasons for Change," was to preclude double deductions of losses at the corporate level. Given that S corporations generally are not subject to tax at the corporate level (Sec. 1363(a)), it is difficult to imagine how such double deductions could occur in the case of an S corporation with a foreign branch, partnership, trust or hybrid entity.

Nonetheless, given that the regulations literally seem to apply, taxpayers would be well-advised to consider how to limit or eliminate the potentially detrimental effects of the DCL rules. For example, in many cases, the elective relief provision of Regs. Sec. 1.1503-2(g)(2) may be available. This provision allows the use of a DCL to offset the income of a domestic affiliate, if no portion of the DRC's or separate unit's losses, expenses or deductions taken into account in computing the DCL has been (or will be) used to offset the income of any other person under the income tax laws of a foreign country.

To take advantage of this relief provision, under Regs. Sec. 1.1503-2(g)(2)(i), the taxpayer must attach a number of statements to its timely filed U.S. income tax return for the year in which the DCL is incurred. Moreover, the taxpayer must provide the IRS with an annual certification (meeting the requirements of Regs. Sec. 1.1503-2(g)(2)(vi)) for 15 years after the loss is incurred.