Sourcing of losses on foreign subsidiary stock sales.

On duly 8,1996, the IRS issued proposed regulations under Sec. 865 setting forth rules for sourcing losses from stock sales. The preamble to the proposed regulations states that they are "necessary to modify existing guidance with respect to stock losses."

Prior to 1987, taxpayers that derived income from the sale of personal property sourced such income under the "title passage" rule. This rule allowed taxpayers enormous flexibility in determining the sourcing of such income. In 1986, Congress enacted Sec. 865 as part of the Tax Reform Act of 1986 (TRA), which provides that the sale of noninventory personal property generally will be sourced at the seller's residence.

In enacting Sec. 865, Congress intended to modify the general "title passage" rule, with the goal of preventing the easy manipulation of sourcing the income from domestic to foreign source. Therefore, as a general rule under Sec. 865(a), income derived from the sale of personal property is sourced to the seller's residence.

In explaining the purpose behind the residency rule, the House Committee Report stated:

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....Because the residence of the seller generally is the location of much of the underlying activity that generates income derived from sales of personal property, the committee believes that sales income generally should be sourced there.

In Sec. 865(j)(1), Congress also directed the Service to issue regulations that would provide that losses from sales of noninventory personal property generally will be allocated consistently with the source of income that gains would generate. Under pre-TRA law, the source of losses on stock sales was governed by Sec. 861(b). In this regard, Regs. Sec. 1.861-8(e)(7)(i) provides that such losses are allocable to the class of gross income to which such asset ordinarily gives rise in the hands of the taxpayer.

In its 1991 decision in Black & Decker Corp., TC Memo 1991-557, aff'd, 986 F2d 60 (4th Cir. 1993), the Tax Court held that a 1981 worthless stock loss claimed when the taxpayer's stock in its wholly owned Japanese subsidiary became worthless was entirely allocable to sources outside the U.S. The court found that the taxpayer's investment in the stock of its foreign subsidiary would ordinarily give rise to foreign -source dividend income. Therefore, under Regs. Sec. 1.861-8(e)(7)(i), the taxpayer's worthless stock loss was allocable entirely to foreign-source income.

Prop. Regs. Sec. 1.865-2(a) provides that a loss on the sale of stock is allocated to the class of gross income with respect to which the gain from the sale of stock would give rise. Thus, loss generally is allocated to the seller's residence. Therefore, the proposed regulations, if adopted in their current form, would source losses at the seller's residence. Under Prop. Regs. Sec. 1.865-2(c)(2), worthlessness with respect to stock deducted under Sec. 165(g) is treated as a disposition of stock for Sec. 865 purposes. Accordingly, the worthless stock loss is sourced according to the taxpayer's residence.

It should be noted that not all stock: sales are governed under Prop. Regs. Sec. 1.865-2. For example, under Prop. Regs. Sec. 1.865-1, the allocation of losses on the disposition of portfolio: stock, stock of a regulated investment company, S stock, and other personal property not governed by Prop. Regs. Sec. 1.865-2, will still be governed by Regs. Sec. 1.861-8. Portfolio stock is defined as stock in a corporation in which the taxpayer owns less than 10% of the total combined voting power and value.

Prop. Regs. Sec. 1.865-2(b) also provides other exceptions to the general rule. Prop. Regs. Sec. 1.865-2(b)(1) provides a dividend recapture rule that applies to losses realized on the disposition of stock within 24 months following the inclusion of a dividend or similar amount with respect to the stock Prop. Regs. Sec. 1.865-2(b)(2) provides a consistency rule generally requiring that loss recognized on the disposition of an 80%-owned foreign affiliate reduces foreign-source passive income if, within the past five years, the seller or any member of its consolidated group recognized gain on the disposition of a foreign affiliate that was sourced under Sec. 865(f).

The proposed regulations clearly would change the result in Black & Decker Corp. Although the proposed regulations generally will be effective for tax years beginning 60 days after they are finalized, taxpayers will be allowed to elect to apply the new rules to all tax years beginning after 1986. Therefore, subject to the exceptions set forth in the proposed regulations, all post-1986 losses attributable to foreign stock ownership, including worthless stock losses, will be sourced outside of the U.S.

In view of the retroactive election available under the proposed regulations, the IRS would be expected to apply the rules therein pending the issuance of final regulations. Surprisingly, this has not been the case. In International Multifoods Corp., 108 TC No. 26 (1997), the Service sought to apply the pre-TRA rules to a post-1986 transaction. The IRS had taken the position that losses from the sale of personal property are allocated under Regs. Sec. 1.861-8 based on the type of income generated by the property. The Service contended that Sec. 865 applies solely to sourcing of income. The court ruled that the IRS's reliance on Secs. 861 and 862 to justify the application of Regs. Sec. 1.861-8(e)(7) was misplaced, as these sections were inapplicable in the case. The court noted that the TRA amended these sections to eliminate their applicability to the sale of noninventory personal property. Consequently, the pre-1987 versions of Secs. 861 and 862 are no longer applicable to determine the source of gain or loss from the sale of noninventory personal property.

The Service also cited Black & Decker Corp., stating that the taxpayer's loss from the sale of a foreign subsidiary would ordinarily give rise to foreign-source dividend income and, therefore, the taxpayer's loss on the disposition of its foreign subsidiary's stock constitutes a foreign-source loss. The court further ruled that the IRS's reliance on Black & Decker Corp. was misplaced. The court noted that the transaction involved in Black & Decker Corp. was governed by the 1954 Code, not the 1986 Code. Further, the Service's failure to issue regulations under Sec. 865 could not be a basis for thwarting the 1986 legislative objective to change the rules on the allocation of losses realized on the sale of noninventory personal property, including losses on foreign stock sales.

With the issuance of the Tax Court's decision in International Multifoods Corp., it is hoped that the IRS will quickly finalize the Sec. 865 regulations to avoid further disputes on the source of foreign stock losses.

FROM MARK E. GOODMAN, CPA, OAK BROOK, ILL.