Revamped dual consolidated loss regs.

The Service recently published proposed regulations revising the existing regulations on the treatment of dual consolidated losses (DCLs) under Sec. 1503(d); see REG-102144-04 (5/24/05). In general, the proposed rules address three specific areas:

* Scope of application of the current regulations;

* Increased certainty of application of the regulations in connection with the existing entity-classification regulations; and

* Reduction of some of the administrative burdens on taxpayers and the IRS imposed by the current regulations.

Background

The proposed regulations' preamble states that the U.S. taxes the worldwide income of domestic corporations. A domestic corporation is one that is created or organized in the U.S. or under the law of the U.S. or of any state. The U.S. allows certain domestic corporations to file consolidated returns with other affiliated domestic corporations. When two or more file a consolidated return, the losses of one may reduce or eliminate the tax on the other's income.

Some foreign countries treat a corporation as a resident subject to its tax laws based on whether the entity is managed or controlled in that country, rather than on the basis of place of incorporation. As a result, such a corporation can be a dual-resident corporation, subject to both foreign country and U.S. income tax, based on residence.

If a corporation was a resident of both a foreign country and the U.S., and the foreign country permitted the corporation to use its losses to offset another person's income (as in the case of consolidated returns), then the dual-resident corporation could use any losses it generated twice--once to offset income subject to U.S. tax (but not foreign tax), and again to offset income subject to foreign tax (but not U.S. tax)--the so-called "double-dip."

To prevent this, the Tax Reform Act of 1986 enacted Sec. 1503(d), which generally provides that a corporation's DCL cannot reduce the taxable income of any other member of its affiliated group. Sec. 1503(d)(2) defines a DCL as a net operating loss of a domestic corporation subject to a foreign country income tax on its income, without regard to the income's source, or subject to tax on a residence basis. Generally, the DCL is treated as a separate-return-limitation-year loss that can offset the dual-resident corporation's own income in subsequent years, but not its domestic affiliates' income. The IRS and Treasury issued temporary regulations under Sec. 1503(d) (TD 8261) in 1989 and final regulations in 1992 (TD 8434).

Treatment of Separate Units

Sec. 1503(d) applies to domestic corporations and their separate units. Current Regs. Sec. 1.1503-2(c)(3) and (4) define a "separate unit" as a foreign branch, and an interest in a partnership, trust or hybrid entity, which is treated as a separate domestic corporation for DCL rule purposes. Specifically, any rule that applies to a domestic corporation also applies to a separate unit. The proposed rules narrow the definition of a separate unit to include only foreign branches and hybrid entities, regardless of whether they are directly or indirectly owned.

Separate units would be treated as domestic corporations only for limited purposes. Treasury and the IRS believe that treating a separate unit as a domestic corporation for all purposes includes situations in which double-dipping is not possible or unlikely, such as when the unit is not taxable in the foreign country. Thus, partnerships and trusts that are not hybrid entities are not treated as domestic corporations under the proposed regulations. According to current Regs. Sec. 1.1503-2(c)(3)(ii), if two or more foreign branches located in the same foreign country are owned by a single domestic corporation and the losses of each are made available to offset the income of the other branches under the foreign country's tax laws, the branches are treated as one separate unit. The current combination rule does not apply to interests in hybrid-entity separate units or dual-resident corporations.

The proposed regulations adopt a combination rule that is broader in scope and combines all separate units directly or indirectly owned by a single domestic corporation. For separate units to be combined under the proposed regulations, the losses of each must be available to offer the income of the others under the tax laws of a single foreign country. By broadening the scope of combining separate units, the proposed regulations reduce the number of a domestic corporation's separate units for purposes of computing and determining the DCL (if any). The proposed regulations also provide more definitive rules for determining a separate unit's DCL (or income); see Prop. Regs. Sec. 1.1503(d)-3.

Foreign Use of DCL

Under current Temp. Regs. Sec. 1.1503-2T(g)(2)(i), to elect relief from the general limit on using a DCL to offset a domestic affiliate's income with respect to a DCL (i.e., a "(g)(2)(i) election"), the taxpayer must certify that no portion of the losses, expenses or deductions taken into account in computing the DCL has been, or will be, used to offset any other person's income under a foreign country's income tax laws. If, despite this certification, there is such use, the DCL subject to the (g)(2)(i) election must be recaptured in income.

The proposed regulations alter the definition of "use" and provide a new rule based on foreign use. Foreign use is deemed to occur only in two cases: if (1) any portion of the loss or deduction taken into account in computing the DCL is made available under the foreign country's income tax laws to reduce (directly or indirectly) any item recognized as income or gain under such laws, regardless of whether (i) income or gain is actually offset and (ii) such items are recognized under U.S. tax principles; and (2) items that are (or could be) offset per the first condition are deemed to be items of a foreign corporation or a direct or indirect owner of an interest in a hybrid entity that is not a separate unit. This condition is intended to limit foreign use to situations in which the foreign income that would be offset by the DCL is not currently subject to U.S corporate income tax. If the foreign income that is offset is subject to U.S. corporate income tax, there is no double-dip of the DCL. Prop. Regs. Sec. 1.1503(d)-5(c), Example 7, demonstrates foreign use in a foreign reverse hybrid structure.

Example: FRHx conducts an active business in country X. DE1x's only asset is a 99% interest in FRHx. S owns 1% of FRHx. DE1x's sole item of income, gain, deduction or loss for year 1, for purposes of calculating a DCL attributable to P's interest in DE1x, is interest expense incurred on a loan from an unrelated party. DE1x's year 1 interest expense is a DCL. In year 1, for X tax purposes, DE1x takes into account its distributive share of income generated by FRHx and offsets such income with its interest expense; see the exhibit on p. 660.

[ILLUSTRATION OMITTED]

DE1x is a hybrid entity treated as a disregarded entity for U.S. tax purposes and as a corporation for X purposes, while FRHx is treated as a partnership for X purposes and as a corporation for U.S tax purposes. In year 1, the DCL attributable to P's interest in DE1x offsets income recognized in X and, under U.S. tax principles, the income is considered to be that of FRHx, a foreign corporation. Under Prop. Kegs. Sec. 1.1503(d)-1(b)(14)(i), there is a foreign use of the DCL; thus, P cannot make a domestic-use election with respect to DE1x's year 1 DCL, and such loss will be subject to the domestic-use limitation rule under Regs. Sec. 1.1503(d)2(b); see below for a discussion.

The proposed regulations' definition of foreign use retains the available-for-use standard. The available component of the actual-use standard is adopted because of the administrative complexity that would result from having a use occur only when income is actually offset.

Domestic Use of DCL

Under Kegs. Sec. 1.1503-2(b)(i), a DCL cannot offset the taxable income of any domestic affiliate, regardless of whether the (1) loss offsets income of another person under a foreign country's income tax laws and (2) income that the loss may offset in the foreign country is, has been or will be subject to tax in the U.S. The proposed regulations retain the ban on using a DCL to offset domestic affiliates' income, with exceptions, and refer to such usage as a domestic use of a DCL.

Exceptions: The first exception is for "no possibility of foreign use." To qualify, a consolidated group, an unaffiliated dual-resident corporation or unaffiliated domestic owner must (1) demonstrate to the IRS's satisfaction that there can be no foreign me of the DCL at any time and (2) prepare a statement and attach it to its tax return for the tax year in which the DCL occurs. This statement must include an analysis (supported with relevant provisions of foreign law) of the treatment of the losses and deductions comprising the DCL, and the reasons supporting the conclusion that there cannot be foreign use of the DCL by any means at any me. Thus, under the proposed regulations, the question of foreign use is not relevant to the definition of a DCL; the issue is whether an exception to the domestic-use limitation applies.

As mentioned above, the current regulations provide an exception to the prohibition of using a DCL to offset domestic affiliate income if a (g)(2)(i) election is made. The proposed regulations retain this elective exception (with changes) and call it a domestic-use election. To obtain this relief, the consolidated group, unaffiliated dual-resident corporation or unaffiliated domestic owner enters into a domestic-use agreement (similar to a (g)(2)(i) agreement). Under current Kegs. Sec. 1.1503-2(g)(2)(iii)(A), a (g)(2)(i) agreement provides that if there is a triggering event during the 15-year period following the year in which the DCL occurs (the certification period), the DCL must be recaptured in income, and there is an interest charge on the deferral. The proposed regulations reduce the certification period from 15 years to seven and extend the annual certifications to DCLs of foreign branches (separate units currently not required to make such certifications).

Triggering events: The proposed regulations generally retain the triggering-event rules contained in current Kegs. Sec. 1.1503-2(g)(2)(iii)(A), as modified, if a taxpayer makes a domestic-use election. In general, the triggering events causing income recapture include:

1. Foreign use of the DCL;

2. Disaffiliation with the consolidated group;

3. Transfer of at least 50% of a separate unit's assets;

4. Transfer of at least 50% of an interest (by vote or value) in a dual-resident corporation or separate unit; and

5. Conversion to a foreign corporation or an S corporation by the dual-resident corporation.

Rebuttal: In general, under Current Regs. Sec. 1.1503-2(g)(2)(iii)(A)(2)-(7), a triggering event is rebutted if the taxpayer demonstrates to the Service's satisfaction that, depending on the triggering event, either (1) the dual-resident corporation's (or separate unit's) losses, expenses or deductions cannot be used to offset another person's income under a foreign country's laws or (2) the asset transfer did not result in a carryover under foreign law of the dual-resident corporation's (or separate unit's) losses, expenses or deductions to the asset transferee.

Under the proposed regulations, taxpayers may rebut a triggering event if they can demonstrate to the IRS's satisfaction that there can be no foreign use of the DCL. In addition, unlike the current regulations, which have different standards for different triggering events, the proposed regulations apply the same standard to all triggering events (other than a foreign-use triggering event, which cannot be rebutted) . Transfers within a U.S. consolidated group and transfers to a new domestic owner or a new consolidated group, when the acquirer enters into a new domestic-use agreement, are not considered triggering events for DCL rule purposes.

Conclusion

The proposed regulations apply to DCLs incurred in tax years beginning after the date the rules are published as final in the Federal Register. The IRS and Treasury request comments on their application, including whether, when finalized, they should contain an election that would allow taxpayers to apply all or a portion of the regulations retroactively. Further, comments are requested as to possible transition rules, including the application of the proposed regulations, when finalized, to existing (g)(2)(i) agreements.

FROM FRANK LANDRENEAU, CPA, PKF OF TEXAS, HOUSTON, TX