Sourcing of capital losses under Sections 861, 865, and 904: October 17, 1996.

On October 17, 1996, Tax Executives Institute submitted the following comments on proposed regulations under sections 861, 865, and 904 of the Internal Revenue Code, relating to the allocation of loss on the disposition of stock and for purposes of computing high-taxed income. The comments were prepared under the aegis of the Institute's International Tax Committee, whose chair is Joseph S. Tann, Jr. of Ameritech Corporation. The following members of the committee materially contributed to the development of the Institute's submission: William H. Barnard of Exxon Corp., Richard M. Goldberg of Salomon Inc., and David P. Robichaud of BellSouth Corporation.

On July 5, 1996, the U.S. Department of the Treasury and the Internal Revenue Service issued proposed regulations under sections 861, 865, and 904 of the Internal Revenue Code, relating to the allocation of loss on the disposition of stock and for purposes of computing high-taxed income. The proposed regulations were published in the Federal Register on July 8, 1996 (61 Fed. Reg. 35696) and in the Internal Revenue Bulletin on September 3, 1996 (1996-36 I.R.B. 8).(1)

Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our 5,000 members represent more than 2,700 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works - one that is administrable and that taxpayers can comply with in a cost-efficient manner.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations relating to the allocation of loss on the disposition of stock.

Comments

The United States imposes tax on a taxpayer's worldwide income, and the U.S.-source rules play an important role in the computation of a taxpayer's foreign tax credit limitation. The limitation is applied to carry out the underlying purpose of the credit - to eliminate what otherwise would be anti-competitive double taxation of foreign income without unduly reducing a taxpayer's tax on its U.S. income. For the foreign tax credit mechanism to function properly, each item of income must have a source either within or outside the United States. Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, at 916 (1987) (hereinafter cited as the "General Explanation").

Enacted as part of the Tax Reform Act of 1986, section 865 of the Code provides a general sourcing rule for sales of personal property. The statute states that income from such sales by a U.S. resident shall be sourced in the United States, whereas income from sales by a nonresident are sourced outside the United States. Section 865(j)(1) authorizes the Secretary "to prescribe such regulations as may be necessary or appropriate to carry out the purpose of this section," including regulations relating to the treatment of losses from sales of personal property.

The Treasury Department has exercised this authority in Prop. Reg. [sections] 1.865-2(a), which provides generally that stock losses are allocated in the same manner as stock gains (determined without regard to sections 1248 and 865(f)). Thus, a stock loss is normally allocated to the residence of the seller. Under Prop. Reg. [sections] 1.865-2(c), the general sourcing rule applies to worthless stock deductions under section 165(g) of the Code.

TEI is pleased that the proposed regulations generally provide for the symmetrical sourcing of gains and losses. As we noted in our April 29, 1996, pre-regulation comments, the legislative history of section 865 and the sourcing provisions supports the rule that losses on the sale of stock of a foreign subsidiary should be allocated and apportioned to the same class of income that would have resulted if a gain had been recognized. See General Explanation at 923 (anticipating that regulations will generally provide for symmetrical treatment of gains and losses from sales of personal property); H.R. Rep. No. 99-426, 99th Cong., 1st Sess. 360 (1985) (discussing the source rules for sales of personal property). The general rule in the proposed regulations thus accords with congressional intent. We recommend, however, that the regulations be clarified in several respects.

Prop. Reg. [sections] 1.865-2(b)(2):

Consistency Exception

The proposed regulations provide a consistency exception from the general sourcing rule designed to harmonize the treatment of losses with the foreign-source treatment of certain gains under section 865(f). Section 865(f) provides for the foreign sourcing of any gain resulting from the sale by a U.S. resident of a foreign affiliate's stock if (1) the sale occurs in a foreign country in which the affiliate is engaged in an active trade or business, and (2) more than 50 percent of the foreign affiliate's gross income for the 3 years prior to the sale was derived from that active trade or business. Under Prop. Reg. [sections] 1.865-2(b)(2), loss recognized on the disposition of an 80-percent owned foreign affiliate will reduce foreign-source passive income if, within the past five years, the seller (or a consolidated group member) recognized gain on the disposition of a foreign affiliate that was sourced under section 865(f).

TEI believes that the proposed consistency rule is too far-reaching. The rule is aimed at situations where the taxpayer uses the title passage rule to "elect" foreign sourcing for gains and domestic sourcing for losses. As a practical matter, however, gains previously allocated under section 865(f) are typically treated as passive-basket income and consequently will have attracted U.S. residual tax. Because there would be, at most, a very limited opportunity for gains to absorb excess foreign tax credits, there is no need for the taxpayer to allocate losses to reduce foreign-source income to be consistent with the past allocation of gain under section 865(f). Consequently, the consistency exception serves little purpose and should be deleted.

Moreover, the consistency exception requires foreign sourcing of all losses if as little as $1 of gain has been sourced under section 865(f) in the past five years. Such a provision is punitive and unduly harsh. If the exception is retained in the final regulations, it should be limited to the amount of gain that was foreign-sourced under section 865(f) in the past five years. Placing such a limit would also be consistent with the dividend-recapture exception provided in Prop. Reg. [sections] 1.865-2(b)(1). TEI recommends that the first sentence of Prop. Reg. [sections] 1.865-2(b)(2) be amended, as follows:

Except to the extent provided in paragraph (b)(1) [the dividend recapture rule] of this section, loss recognized by a taxpayer with respect to the sale or other disposition of stock of a foreign affiliate... shall be allocated to reduce foreign source income to the extent the taxpayer... recognized gain on the disposition of any stock that was sourced under section 865(f) within the five-year period ending on the last day of the taxable year in which the loss was recognized.

The exception should also be fine-tuned to exclude situations where passage of title in a foreign country is legally required.

Prop. Reg. [sections] 1.865-2(e)(2):

Prior-year Election

Prop. Reg. [sections] 1.865-2(e)(1) provides that the effective date of the regulations will be 60 days after final regulations are published in the Federal Register. Prop. Reg. [sections] 1.865-2(e)(2) provides that after the regulations become final the taxpayer may elect to apply the rules on a retroactive basis to all open tax years beginning after December 31, 1986. This election must be filed within 120 days of the date final regulations are published. The proposed regulations require the taxpayer to file an amended return for each year an election is made and to include a detailed election statement. This election is effective only if the taxpayer satisfies all the requirements specified in Prop. Reg. [sections] 1.865-2(e)(2)(ii).

A. Amended Return Requirement. TEI believes that the amended return requirement set forth in Prop. Reg. [sections] 1.865-2(e)(2)(ii)(a) is too broad. The filing of an amended federal return can trigger numerous filing requirements in respect of state and local returns, even in situations where there is no change in the tax liability We therefore recommend that an amended return not be required for tax years in which there were no stock losses or for tax years where the retroactive application of the proposed regulations will result in no change in tax liability. In addition, an amended return should not be required for tax years currently under audit with the Internal Revenue Service or for taxpayers under continual audit under the Coordinated Examination Program. In these situations, the final regulations should provide only for the filing of the election statement.

Furthermore, to the extent an election is made for a year in which a worthless stock loss deduction was taken, and it is later determined the section 165(g) deduction should have been taken in a different tax year, the election should be deemed made with respect to that stock loss in the year the stock is ultimately determined to have become worthless. Such a clarification would eliminate the need to file protective elections.

B. Second Notice Requirement. Prop. Reg. [sections] 1.865-2(e)(2)(ii)(B) provides that an electing taxpayer not under examination must furnish a copy of the election statement to the revenue agent within 20 days after receiving a notice of examination. Failure to adhere to this second notification requirement could technically invalidate an otherwise valid prior-year election.

TEI believes that this second notification requirement constitutes an unnecessary "trap" for taxpayers and recommends that it be deleted. Since the taxpayer would have previously filed an election statement, a required duplicate submission - potentially years later - unnecessarily complicates federal compliance. To eliminate possible confusion concerning the appropriate IRS representative to be furnished with a copy of the statement (e.g., where many different agents work on the examination), if the requirement is retained, we recommend that the final regulations provide that the statement be furnished to the district director, rather than the revenue agent responsible for the examination of the return. (In the case of CEP taxpayers, the district director may wish to designate the case manager or team coordinator as the appropriate individual to receive the statement.) Moreover, the time for furnishing the statement should be expanded from 20 to 60 days.

C. Election Statement. Prop. Reg. [sections] 1.865-2(e)(2)(ii)(C), which details tails the contents of the election statement, is unclear concerning whether a separate statement is required for each year or whether one statement is required that covers all years subject to the election. It is also unclear whether a separate election must be made for each affiliate. TEI recommends that taxpayers be permitted to file the election statement on a consolidated basis.

Conclusion

Tax Executives Institute appreciates his opportunity to present our views on the proposed regulations relating to the allocation of loss on the disposition of stock. If you have any questions, please do not hesitate to call Joseph S. Tann, Jr., chair of TEI's International Tax Committee, at [phone] or Mary L. Fahey of the Institute's professional staff at [phone].

(1) For simplicity's sake, the proposed regulations are referred to as the "proposed regulations"; specific provisions of the proposed regulations are cited as "Prop. Reg. [sections]," Reference to page numbers are to the proposed regulations (and preamble) as published in the Internal Revenue