Sourcing of capital losses.

On April 29, 1996, Tax Executives Institute submitted the following comments to Michael Danilack, IRS Assistant Chief Counsel (International), concerning regulations to be issued under section 865(j) of the Internal Revenue Code. The comments were prepared under the aegis of TEI's International Tax Committee whose chair is Joseph S. Tann, Jr. of Ameritech Inc.

On behalf of Tax Executives Institute, I am pleased to submit the following comments on the regulations to be issued under section 865(j) of the Internal Revenue Code, relating to the sourcing of losses from the disposition of stock. TEI commends the IRS for including this project on their priorities list for 1996.

Background

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.

A. The Legislative History of Section 865 Supports Symmetrical Sourcing of Gains and Losses. Logically, 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 on the sale of the stock. The Joint Committee report supports symmetrical treatment of gains and losses:

It is anticipated that regulations will provide that losses from sales of personal property generally will be allocated consistently with the source of income that gains would generate but that variations of this principle may be necessary.

General Explanation 923. There should be no question that this congressional intent should be respected and that any "variations" should be narrowly circumscribed and adequately justified.(1)

B. The Legislative History of the Sourcing Rules Also Supports Symmetrical Sourcing of Gains and Losses. The symmetrical approach is also consistent with the policy underlying the 1986 Act's changes to the sourcing rules -- that foreign source taxable income should be commensurate with the amount that foreign jurisdictions are likely to tax consistent with international norms. In this regard, the House Report on the 1986 Act provides:

Source rules for sales of personal property should reflect the location of the economic activity generating the income at issue or the place of utilization of the assets generating that income. In addition, source rules should operate clearly without the necessity for burdensome factual determinations, limit erosion of the U.S. tax base, and, in connection with the foreign tax credit limitation, generally not treat as foreign income any income that foreign countries do not or should not tax.

H.R. Rep. No. 99-426, 99th Cong. 1st Sess. 360 (1985) (emphasis added).

This principle prescribes that losses on stock should not be allocated and apportioned to a class of income when foreign tax on that income is not reduced by the loss. If amounts that are generally not subject to foreign tax are excluded from the appropriate foreign source limitation "basket," then the amount of income in that basket should not be reduced by a specific allocation of losses.

This approach also accords with the 1986 enactment of section 988(a)(3), which generally provides that the source of any foreign currency gain or loss attributable to a section 988 transaction is determined by reference to the taxpayer's residence or the taxpayer's qualified business unit on whose books the asset is properly reflected. In the legislative history of this provision, Congress suggested that losses under section 865 should be similarly treated:

The [Senate Finance] committee determined that the overriding consideration should be to provide certainty regarding the source of exchange gain or loss. The bill accomplishes this result by providing definitive rules that are consistent with the treatment of foreign currency as personal property and the amendments to the sourcing rules in section 611 of the bill [which includes section 865].,,

S. Rep. No. 99-313, 99th Cong., 2d Sess. 453 (1986). See also General Explanation 1089.

C. Treasury Regulations Support Consistent Sourcing of Stock Gains and Losses. Moreover, the IRS itself has recognized the appropriateness of allocating and apportioning stock losses to the same class of income that a stock gain would have produced, at least in respect of the oil and gas industry. Under regulations relating to the computation of gross foreign oil and gas extraction income (FOGEI), a stock loss is allocated and apportioned to the same class of income that would have been produced if there were capital gain from the sale. See Treas. Reg. [sections] 1.907(c)-1(e)(4).(2)

Recommendation

The regulations under section 865 should accord with congressional intent and provide for the symmetrical treatment on the source of gains and losses from the sale of stock of foreign affiliates. The regulations should include a consistency rule to protect a U.S. taxpayer from the whipsaw resulting where losses on the sale of stock of a foreign affiliate are allocated to foreign-source income. For example, assume a U.S. taxpayer sells the stock of a foreign affiliate, recognizing gain on some shares and loss on others. The capital gain resulting from the sale would normally be treated as U.S.-source income under section 685(a) (assuming section 865(f) were inapplicable). If the regulations do not provide for consistent treatment, the taxpayer may have a U.S. taxable capital gain and a foreign-source capital loss. The increase in overall tax cost of foreign investments resulting from this inconsistency would undermine congressional intent and disadvantage U.S. taxpayers in the world marketplace.

Conclusion

Tax Executives Institute is pleased to be able to submit these comments on the regulations to be issued under section 865(j) of the Code. If you have any questions concerning the Institute's comments, please feel free to contact Joseph S. Tann, Jr., chair of the Institute's International Tax Committee, at [phone] or Mary L. Fahey of the Institute's professional staff at [phone].

(1) Black & Decker v. Commissioner, 986 F.2d 60 (4th Cir. 1993), holds that a worthless stock loss should be allocated to the class of gross income to which such property ordinarily gives rise in the hands of the taxpayer, i.e., foreign source dividend income. Black & Decker, however, involved a taxable year (1981) prior to the enactment of section 865 in 1986. It is thus inapposite in respect of post-1986 years. In addition, from a tax policy standpoint consistent sourcing of stock gains and losses under both sections 865 and 165(g)(3) would be simpler and would obviate the time-consuming factual inquiry required under the Black & Decker case. See H.R. Rep. No. 99-426, 99th Cong., 1st Sess. 360 (1985) ("source rules should operate clearly without the necessity for burdensome factual determinations").

(2) Although the section 907 rules apply only to a narrow class of income, these rules were specifically mentioned in section 904(f)(5)(E)(iii), relating to the treatment of separate limitation losses for purposes of the foreign loss recapture rules. The cross reference to the FOGEI principles here gives support to their application to a broader class of income.