The new DCL regulations: new rules and contracts.

Introduction

A. Background and Policy

On March 19, 2007, the U.S. Department of the Treasury and the Internal Revenue Service (collectively, the IRS) filed with the Federal Register final regulations under section 1503(d) of the Internal Revenue Code regarding dual consolidated losses (DCLs). (1) The 2007 Regulations finalize proposed regulations issued on May 19, 2005 and replace existing regulations that were issued in 1992 (the 1992 Regulations) (2) for DCLS incurred in taxable years beginning on or after April 18, 2007. (3)

Congress added section 1503(d) to the Code in 1986. (4) Initially, section 1503(d) was a fairly narrow provision that was enacted to address an "inbound" dual resident acquisition vehicle transaction that provided certain foreign multinationals with a competitive advantage over their domestic corporate counterparts. (5) The transaction involved the acquisition of a domestic corporation (U.S. Target Corporation) through the use of a dual resident acquisition corporation (DRAC). A foreign multinational would form a domestic corporation and make it a resident of the foreign jurisdiction so that the DRAC could join in foreign consolidation and share losses with the foreign multinational group. (6) The DRAC would then borrow acquisition funds and acquire the stock of the U.S. Target Corporation, thus making the DRAC the parent of the U.S. consolidated group. The DRAC would incur a loss on a separate company basis equal to the interest expense attributable to the acquisition debt. The DRAC would reduce the U.S. consolidated taxable income by this loss, and the foreign multinational group would use that same loss in calculating the foreign income tax liability of the foreign multinational group.

Congress concluded that this dual interest deduction (commonly referred to as a "double dip") provided foreign multinationals with a competitive advantage over their domestic corporate counterparts because foreign multinationals that could double dip the deduction would be willing to pay a premium for the U.S. Target Corporation.

Congress decided to address this unfair competitive advantage by amending the Code to include new section 1503(d), which provides:

(d) Dual consolidated loss.

(1) In general. The dual consolidated loss for any taxable year of any corporation shall not be allowed to reduce the taxable income of any other member of the affiliated group for the taxable year or any other taxable year.

(2) Dual consolidated loss. For purposes of this section--

(A) In general. Except as provided in subparagraph (B), the term "dual consolidated loss" means any net operating loss of a domestic corporation which is subject to an income tax of a foreign country on its income without regard to whether such income is from sources in or outside of such country, or is subject to such a tax on a residence basis.

(B) Special rule where loss not used under foreign law. To the extent provided in regulations, the term "dual consolidated loss" shall not include any loss which, under the foreign income tax law, does not offset the income of any foreign corporation.

Section 1503(d) denies the ability of a U.S. consolidated group to use a loss incurred by a DRAC to offset the U.S. consolidated group's taxable income and, thereby, effectively ends the competitive advantage created by the DRAC transaction. Of such virtuous purpose the DCL rules were born, but an interesting thing happened while Congress was making technical corrections to the 1986 Act: Congress apparently extrapolated from the DRAC transaction that nearly all double dipping constituted improper tax arbitrage. Accordingly, in 1988 Congress amended section 1503(d) to include new section 1503(d)(3), which provides:

(3) Treatment of losses of separate business units. To the extent provided in regulations, any loss of a separate unit of a domestic corporation shall be subject to the limitations of this subsection in the same manner as if such unit were a wholly owned subsidiary of such corporation. (7)

In explaining this new provision, Congress said that losses incurred by a "clearly identifiable unit of a trade or business" of a domestic corporation should, pursuant to regulations issued by IRS, be subject to the DCL limitation. (8) Congress used a foreign branch as an example of a "clearly identifiable unit of a trade or business," but it provided no other guidance regarding what it meant when it created the term "separate unit" in section 1503(d)(3). (9)

The IRS responded with Treasury Decisions containing extraordinarily complex regulations. (10) In doing so, the IRS synthesized its own definition of double dipping: the use of single economic deduction to offset or reduce two streams of income, one of which is not immediately subject to U.S. income tax. (11) Although a perfectly logical extension of Congress's stated concern, this definition--coupled with the amorphous notion of "clearly identifiable units"--resulted in the massive expansion of the potential reach and application of the DCL rules to nearly all losses incurred by foreign operations of domestic corporations.

The IRS's mandate in drafting the DCL rules (even though arguably self-augmented) is rather onerous because determining whether each corporate deduction is currently available or will be available to offset two streams of income necessarily requires a detailed analysis of both U.S. law and foreign law. Indeed, some commentators have quipped that the DCL rules result in the IRS and taxpayers chasing deductions around the globe to make sure they are not being used to offset two streams of income. This metaphor is apt and helps explain the mind-numbing complexity of the DCL rules.

In 2000, the IRS issued Rev. Proc. 2000-42, which provides guidance on executing closing agreements pursuant to Treas. Reg. [section] 1.1503-2(g)(2)(iv). (12) In the revenue procedure, the IRS noted that the reach and effect of the DCL regulations was significantly increased by the adoption of the entity classification regulations under Treas. Reg. [section] 301.7701-3 (check-the-box, or CTB, rules).

The 2007 Regulations were issued to address structures and transactions that were not addressed by the 1992 Regulations, to resolve issues created by the CTB rules, to simplify some of the unnecessarily complex rules, and to decrease the attendant compliance burdens. The 2007 Regulations are contained in Treas. Reg. [section][section] 1.1503(d)-1 through -8. The 2007 Regulations (including the Preamble) are long and fill 44 triple-column pages of the Federal Register and contain 58 examples (including the alternate factual scenarios).

B. The Basic Framework

The DCL rules are complex and have been the source of significant frustration for tax professionals since 1989. The 1992 Regulations and the 2007 Regulations employ the same basic regulatory framework, an understanding of which is essential in analyzing the DCL rules. In a nutshell, the DCL rules trap deductions incurred by a DRC (or a separate unit) and ring-fences the deductions so that they are available only to reduce the past or future income of the DRC (or separate unit) that incurred the DCL. The rules then allow the domestic corporate owner of the DRC (or separate unit) to release these deductions--and, therefore, use them to reduce income generated outside the DRC (or separate unit)--by permitting the domestic corporate owner to enter into a contract with the IRS whereby the domestic corporate owner ensures that the deductions have not been and will not be used to reduce income on a foreign income tax return.

Thus, the DCL rules consist of a general rule preventing the use of a DCL to reduce U.S. income and an elective regime that enables the domestic corporate owner to avoid the effect of the general rule. In DCL nomenclature, the general rule prohibits the "Domestic Use" of a DCL, unless the domestic corporate owner files a "Domestic Use Election" for such DCL.

C. Overview of this Article

This article provides an overview of the 2007 Regulations and discusses the most important provisions in detail. In doing so, this article discusses analogous provisions of the 1992 Regulations in order to compare, contrast, and explain reasons for any significant changes. Finally, this article highlights certain traps for the unwary and provides suggestions for analyzing and managing DCL issues.

General Rule and Definitions

A. The General Rule

Although oddly placed in the middle of the regulations, the general rule under the 2007 Regulations is elegant in its simplicity and brevity: "Except as provided in [section] 1.1503(d)-6, the domestic use of a dual consolidated loss is not permitted." (13) The elegance of this rule is illustrated by simple contrast to the general rule contained in the 1992 Regulations, which accomplishes essentially the same result:

   Except as otherwise provided in this section, a dual consolidated
   loss of a dual resident corporation cannot offset the taxable
   income of any domestic affiliate in the taxable year in which
   the loss is recognized or in any other taxable year, regardless
   of whether the loss offsets income of another person under the
   income tax laws of a foreign country and regardless of whether
   the income that the loss may offset in the foreign country is,
   has been, or will be subject to tax in the United States. (14)

The general rule contained in the 2007 Regulations achieves its simplicity by assigning much of its operation to the definition of "Domestic Use," a term that does not exist in the 1992 Regulations. The prefatory clause of the general rule referring to Treas. Reg. [section] 1.1503(d)-6 is, generally, a reference to the Domestic Use Election regime. (15)

B. Dual Consolidated Loss

A DCL is, generally, a net operating loss (NOL) of a DRC or a "net loss attributable to" a separate unit (SU). (16) A number of complex attribution rules apply in calculating a DCL. (17)

C. Dual Resident Corporation

A DRC is a "domestic corporation that is subject to an income tax of a foreign country on its worldwide income or on a residence basis. A corporation is taxed on a residence basis if it is taxed as a resident under the law of the foreign country." (18)

This definition parrots section 1503(d)(2)(A) of the Code and is identical to the corresponding definition in the 1992 Regulations. (19) Although the text of the 2007 Regulations did not change the definition of DRC, the IRS provided some guidance in the Preamble to the 2007 Regulations regarding domestic partnerships that file elections under the CTB rules to be classified as domestic corporations (also known as a "domestic reverse hybrid" or a DRH). In particular, the IRS stated it "believe[s] that a domestic reverse hybrid is neither a dual resident corporation nor a separate unit and, therefore, is not subject to section 1503(d)." (20) Although most tax professionals were reasonably comfortable that most DRH structures were not within the reach of the DCL rules, the IRS's express recognition of this position is welcomed.

D. Separate Unit

1. In General. The term SU includes a "foreign branch separate unit" (FBSU) and a "hybrid entity separate unit" (HESU). (21) A FBSU is, generally, a foreign branch (as that term is defined in Treas. Reg. [section] 1.367(a)-6T(g)(1)) that is owned (directly or indirectly) (22) by a domestic corporation. (23) Business activities that meet the definition of foreign branch (as defined in Treas. Reg. [section] 1.367(a)-6T(g)(1)) will not, however, constitute a FBSU if a domestic corporation directly owns the business activities and the activities would not constitute a "permanent establishment" or be subject to net basis taxation under an applicable income tax treaty between the United States and the country where the activities Occur. (24)

A HESU is "an entity that is not taxable as an association for Federal tax purposes but is subject to the income tax of a foreign country as a corporation (or otherwise at the entity level) either on its worldwide income or on a residence basis." (25) A HESU, therefore, includes foreign entities that are taxed as corporations for foreign tax purposes but have filed CTB elections to be treated for U.S. income tax purposes as either a disregarded entity (in the case of only one owner) (DE), a hybrid partnership (in the case of two or more owners) (HP), or a hybrid trust. (26)

The 2007 Regulations make explicit that the DCL rules require tiering of SUs, rather than aggregating SUs that are owned through disregarded entities and partnerships. Example 1 illustrates the point.

EXAMPLE 1

USCo is a domestic corporation that owns the following: (a) FB1, a foreign branch located in Country A; (b) DE1, a foreign disregarded entity organized under the laws of Country B and taxed as a corporation in Country B; and (c) a 40 percent interest in HP1, a foreign entity that is taxed as a corporation in Country C but has filed a CTB election to be treated as a partnership for U.S. income tax purposes--the remaining 60 percent is owned by an unrelated party. DE1 owns: (a) FB2, which consists of activities conducted in Country B that would constitute a foreign branch if conducted directly by a domestic corporation; and (b) FB3, which consists of activities conducted in Country D that would constitute a foreign branch if conducted directly by a domestic corporation. HP1 owns: (a) FB4, which consists of activities conducted in Country C that would constitute a foreign branch if conducted directly by a domestic corporation; and (b) DE2, a foreign disregarded entity organized under the laws of Country E and taxed as a corporation in Country E.

[ILLUSTRATION OMITTED]

The parties in Example 1 are all individual SUs, and USCo must determine whether each SU has generated a DCL by using the attribution rules contained in Treas. Reg. [section] 1.1503(d)-5. (27) In the case of DE1, USCo must determine which items of income, gain, loss, and deduction are property attributable to DE1, FB2, and FB3 because each of these SUs is a separate SU and can incur DCL, even if the other SUs earn profits in excess of the loss of the unprofitable SU. In the case of HP1, USCo must perform the same analysis for HP1, FB4, and DE2 to the extent of USCo's 40 percent interest in each.

Finally, the 2007 Regulations remove from the definition of SU partnerships and trusts that are not taxable as corporations (or otherwise at the entity level) for foreign income tax purposes. (28) This is a welcomed change because the 1992 Regulations created uncertainty regarding the application of the DCL rules to non-hybrid partnerships and trusts that had little or no foreign nexus. (29)

2. The SU Combination Rule. The 2007 Regulations contain an SU Combination rule that treats certain SUs owned (directly or indirectly) by a single domestic corporation or owned (directly or indirectly) by two or more members of a consolidated group as a single Combined SU. (30) The SUs that are combined under this rule are all FBSUs located in the same foreign country together with all HESUs that are subject to income tax in the same foreign country. (31) The effect of this rule is that the income tax results for all qualifying SUs are combined and treated as a single SU for purposes of the DCL rules. (32) Assume, for example, that a domestic corporation owns two foreign branches in the same foreign country and that one of the foreign branches earns $60 and the other loses $80. The SU Combination Rule treats the two branches as a single Combined SU with a $20 DCL, rather than two independent SUs, one of which is $60 profitable (thus not subject to the DCL rules) the other of which incurs an $80 DCL.

The SU Combination Rule is an expansion of the Foreign Branch Aggregation Rule contained in the 1992 Regulations. (33) The Foreign Branch Aggregation Rule is fairly narrow and applies only to two or more foreign branches located in the same foreign country and only if: (1) the foreign branches are owned by a single domestic corporation; and (2) the foreign branches are allowed to consolidate under foreign law. Example 2 illustrates the differences between the Foreign Branch Aggregation Rule and the SU Combination Rule.

EXAMPLE 2

USP is a domestic corporation and a parent of a U.S. consolidated group. USP owns all stock of USS1 and USS2, both of which are domestic corporations and members of the USP consolidated group. USP also owns all stock of DRC1, a dual resident corporation that is subject to income tax in Country X on a residence basis. USS1 owns the following: (a) a 40-percent interest in HP1, a foreign entity that is taxed as a corporation in Country X but has filed a CTB election to be treated as a partnership for U.S. income tax purposes--the remaining 60 percent is owned by a related party; (b) FB1, a foreign branch located in Country X; and (c) FB2, a foreign branch located in Country Y. HP1 owns FB3, which consists of activities conducted in Country X that would constitute a foreign branch if conducted directly by a domestic corporation. USS2 owns the following: (a) DE1, a foreign disregarded entity organized under the laws of Country X and taxed as a corporation in Country X but which has no operations other than a single outstanding debt obligation; (b) FB4, a foreign branch located in Country X; and (c) FB5, a foreign branch located in Country X. DRC1 owns FB6, a foreign branch located in Country X.

[ILLUSTRATION OMITTED]

The Foreign Branch Aggregation Rule applies to only FB4 and FB5--and they are combined only if Country X income tax law allows FB4 and FB5 to consolidate. (34) All other interests are treated as independent separate units. The SU Combination Rule yields a much different result. Under the SU Combination Rule the tax items of the following SUs are combined: (i) 40 percent of HP1 (excluding FB3's items); (ii) FB1; (iii) 40 percent of FB3; (iv) DE1; (v) FB4; (vi) FB5; and (vii) FB6. Thus, all of USP's foreign operations are combined into a single Country X Combined SU, except the operations of FB2 and DRC1. (35) The tax items of FB2 do not combine with the USP's Country X Combined SU because FB2 is located in Country Y, rather than Country X. DRC1 is a little more complicated. The 2007 Regulations explicitly state that a DRC will have a FBSU if it has activities that constitute a foreign branch, even if those activities are conducted in the DRC's country of residence. (36) The 2007 Regulations also make clear that a DRC that owns an SU (both HESU and FBSU) must separate the items of income, gain, loss, and deduction attributable to the SU from its own items and calculate whether each has incurred a DCL using only the items properly attributable to each. By The result of these rules is that the tax items that are properly attributable to FB6 are part of USP's Country X Combined SU, but the tax items that are properly attributable to DRC1 are not included in the USP's Country X Combined SU and will amount to a separate DCL, if such amounts result in an NOL.

The Combined SU rule is generally taxpayer favorable because, by combining profitable SUs with loss SUs, taxpayers can often reduce or eliminate DCLs incurred by individual SUs. The Combined SU rule, however, is not elective and can work to a taxpayer's disadvantage. Assume USCo owns two SUs located in Country X. In Year 1, SU1 incurs a $100 loss and SU2 earns $60. The Combined SU incurs a $40 DCL. As discussed later, USCo must make a special election to use the Combined SU's $40 DCL to reduce its other income. As part of that election, USCo must promise to recapture a DCL as gross income upon the occurrence of certain "triggering events." Depending on the particular facts, USCo's disposition of the SU2 can be a triggering event. In that case, USCo will be forced to recapture as gross income the $40 DCL, even though SU2 was always profitable. If USCo were not required to combine the SUs, USCo would have had a $100 DCL in Year 1 (attributable to SU1) but would not have been encumbered by the DCL rules with respect to SU2.

E. Domestic Use

The general rule prohibits a Domestic Use of a DCL, unless a taxpayer makes a Domestic Use Election for such DCL. A Domestic Use occurs when a DCL is made available (in any year) to offset (directly or indirectly) the income of any "Domestic Affiliate," except the DRC or SU that incurred the DCL. (38) A Domestic Use is deemed to occur if the DCL is included in the computation of taxable income of the owner of the DRC or SU and does not require an actual U.S. income tax benefit. (39) Thus, a Domestic Use occurs if a DCL is included in an NOL carryover.

A Domestic Affiliate is: (i) a member of an affiliated group (as defined in section 1504(a)), without regard to the exceptions contained in section 1504(b) (other than foreign corporations); (ii) a "Domestic Owner"; (iii) an SU; or (iv) a "Transparent Entity." (40)

A Domestic Owner is: (i) a domestic corporation (including a DRC) that owns one or more SUs or Transparent Entities; and (ii) in the case of a Combined SU, a domestic corporation (including a DRC) that owns one or more SUs within the Combined SU. (41)

A Transparent Entity is, generally, an entity that is: (i) not taxable as an association for U.S. income tax purposes; (ii) not subject to tax in a foreign country as a corporation either on its worldwide income or on a residence basis; and (iii) is not a pass-through entity under foreign income tax law. (42) Thus, a U.S. LLC that has not filed a CTB election to be treated as a coporation for U.S. income tax purposes is a Transparent Entity.

In short, a Domestic Use of a DCL occurs if the DCL reduces the income of any entity (or operation in the case of a FBSU) other than the DRC or SU that incurred the DCL. A DCL subject to the general rule is treated as a loss incurred in a separate return limitation year (SRLY) and is subject to the provisions contained in Treas. Reg. [section] 1.1502-21(c). (43)

Attribution Rules

The 2007 Regulations contain two definitions of DCL, one for DRCs and one for SUs. (44) A DRC has a DCL if it incurs an NOL. A SU incurs a DCL if it incurs a net loss. Special attribution rules contained in Treas. Reg. [section] 1.1503(d)-5 apply for determining which items of income, gain, loss, and expense are attributable to a DRC or SU for purposes of calculating whether such DRC or SU has incurred a DCL.

A. DRCs

In the case of an affiliated DRC (i.e., a member of a consolidated group as defined in Treas. Reg. [section] 1.1502-1(h)), the DRC calculates its income or loss in accordance with the regulations under section 1502 governing the computation of consolidated taxable income with certain modifications (described below). (45) In the case of an unaffiliated DRC, the DRC calculates its income or loss in accordance with the applicable provisions of the Code with certain modifications (described below). (46) In determining whether a DRC has incurred a DCL, the DRC must make the following modifications to its calculation of taxable income or loss:

(i) the DRC does not include any net capital loss of the DRC;

(ii) the DRC does not include any carryover or carryback losses; and

(iii) the DRC does not include any items of income, gain, deduction, and loss that are attributable to an SU or a Transparent Entity. (47)

B. SUs

The attribution rules for SUs are significantly more complicated and have different rules, depending on whether the SU is FBSU and HESU. (48) In the case of FBSUs, there are two sets of attribution rules: (i) rules solely for attributing interest expense to a FBSU; (49) and (ii) rules for attributing all other items of income, gain, loss, and deduction to a FBSU. (50)

1. FBSU. For interest expense, the DCL attribution rules incorporate by cross-reference the formulaic interest allocation rules contained in Treas. Reg. [section] 1.882-5 and provide certain modifications to the rules in order to tailor the rules for the FBSU DCL calculation. (51) The rules contained in Treas. Reg. [section] 1.882-5 are designed to properly allocate a portion of a foreign corporation's interest expense to its U.S. trade or business for purposes of calculating the effectively connected income (ECI) of the U.S. trade or business. In the context of calulating ECI, these rules can have the effect of disallowing an interest expense with respect to liabilities booked in the United States or can have the effect of attributing to the U.S. trade or business interest expense that is booked by the foreign corporation outside the United States.

The DCL attribution rules incorporate these rules and modify them such that the domestic corporate owner is treated in the same manner as the foreign corporation, and the FBSU is treated in the same manner as the U.S. trade or business. (52) Thus, interest incurred by the domestic owner can be attributed to a FBSU, and interest expense booked by a FBSU can be deemed attributable to the foreign owner. Thus, in the DCL context, these rules (as modified) can create, increase, reduce, or eliminate a DCL in a FBSU.

For other items of income, gain, loss, and deduction, the DCL attribution rules incorporate by cross-reference the fact-based tests (such as the "asset-use" and "business activities") contained in Treas. Reg. [section][section] 1.864(c)-4(c) and 1.864-5 through 1.864-7. (53) These rules were also written for purposes of calculating a foreign person's ECI and, therefore, are modified for purposes of the DCL rules.

2. HESU. The attribution rules for HESUs are fairly straightforward and adopt a modified books and records approach. (54) That is to say, a HESU calculates whether it has incurred a DCL by using the items that appear on the HESU's books and records and adjusts them to conform to U.S. income tax principles. Such adjustments include using U.S. income tax principles for amortization, depreciation, basis, and realization and recognition events. Also, any items that are disregarded for U.S. income tax purposes (e.g., a transaction between a DE and its Domestic Owner, a transaction between two DEs owned by the same Domestic Owner, or a transaction between a DE and a Transparent Entity owned by the same Domestic Owner) are disregarded for all DCL purposes. (55)

The HESU attribution rules, however, become complicated if the HESU owns an interest in another HESU, a FBSU, a Transparent Entity, a partnership, or a grantor trust. In such a case, the rules contain another layer of complex attribution rules. (56)

C. Other Attribution Rules

The 2007 Regulations also contain a number of other attribution rules that apply to both FBSUs and HESUs. This article briefly discusses two of these rules. First, any income amount included by the Domestic Owner arising from ownership of stock in a foreign corporation is properly attributable to an SU to the extent that a dividend from such foreign corporation would be properly attributable to the SU.By Thus, in calculating whether an SU has incurred a DCL, the SU must include in its calculation subpart F income amounts, section 78 gross-up amounts, and amounts includible under section 986(c), to the extent that a dividend from such foreign corporation would be properly attributable to such SU. Whether a dividend of the foreign corporation would be properly attributable to such SU is determined by using the previously discussed attribution rules. (58)

Second, section 987 foreign currency gain or loss is not properly attributable to any SU or Transparent Entity. (59) Thus, any section 987 gain or loss of a Domestic Owner resulting from remittances or transfers is not includable in an SU's DCL calculation.

D. Conclusions Regarding the Attribution Rules

The attribution rules contained in the 2007 Regulations differ dramatically from the rules in the 1992 Regulations. With respect to attributing items of income, gain, loss, and deduction to SUs, the 1992 Regulations simply state that an SU shall compute its income "using only those items of income, expense, deduction, and loss that are otherwise attributable to such separate unit." (60) There is no guidance on which items are "otherwise attributable" to such SUs.

The 2007 Regulations are indeed a significant improvement over the 1992 Regulations in this respect. Reliance on rules that were written and designed to achieve a different purpose, (i.e., calculating ECI rather than a DCL) however, is always fraught with uncertainty because there are often unintended consequences resulting from this drafting technique. These unintended consequences will undoubtedly arise as taxpayers begin to apply these new rules to their facts. These attribution rules may also prove challenging because most U.S. multinationals have little or no experience with the ECI rules and have not historically kept foreign branch books and records in contemplation of applying the principles of the ECI rules.

Domestic Use Elections

A. In General.

A taxpayer may put a DCL to a Domestic Use if the taxpayer executes and complies with the requirements of a Domestic Use Election. (61) To make a Domestic Use Election, the taxpayer must attach to its timely filed U.S. income tax return an agreement described in Treas. Reg. [section] 1.1503(d)-6(d)(1). The Domestic Use Election is a contract that contains several administrative and substantive requirements, the most important of which are: (i) a certification that there has not been and there will not be a "Foreign Use" of the DCL during the "Certification Period"; (62) (ii) a promise to recapture the DCL as gross income (plus an interest charge) upon the occurrence of a "Triggering Event" within the Certification Period; (63) and (iii) a promise to file an "Annual Certification" with respect to such DCL with each income tax return due during the Certification Period. (64)

The Domestic Use Election regime facilitates the DCL policy (no double dipping of DCLs) because it requires a taxpayer to certify that there has not been and will not be a Foreign Use of a DCL, requires the taxpayer to recapture a DCL (and thus eliminate the U.S. income tax benefit) upon the occurrence of a Triggering Event, and requires the taxpayer to continually monitor (during the Certification Period) whether there has been a Foreign Use of a DCL (or some other Triggering Event).

The 2007 Regulations' Domestic Use Election regime replaces the 1992 Regulations' elective regime contained in Treas. Reg. [section] 1.15032(g)(2) ((g)(2) Elections). Although closely resembling its predecessor, the Domestic Use Election regime is far superior to the (g)(2) Election regime because the new rules account for transactions and structures made possible by the CTB rules. The new rules also eliminate the awkward and time-consuming closing agreement procedure, which is used to avoid recapture of certain DCLs upon the occurrence of certain triggering events. (65) Most important, the 2007 Regulations reduce the Certification Period from 15 years (under the 1992 Regulations) to 5 years; in addition, the 2007 Regulations reduce to 5 years the applicable period for (g)(2) Elections, Annual Certification requirements, and closing agreements executed under the 1992 Regulations. (66)

B. Foreign Use: The Direct and Indirect Rules

The Foreign Use definition is perhaps the most complicated and controversial provision in the 2007 Regulations. The 1992 Regulations do not contain the term Foreign Use; instead, the 1992 Regulations require a taxpayer making a (g)(2) Election for a DCL to certify that:

   no portion of the dual resident corporation's or separate unit's
   losses, expenses, or deductions taken into account in computing the
   dual consolidated loss has been, or will be, used to offset the
   income of any other person under the income tax laws of a foreign
   country.... (67)

This certification is designed to ensure that there will not be a double dip of a DCL. This provision, however, proved to be difficult to apply and ambiguous, particularly after the adoption of the CTB rules.

The 2007 Regulations replace this provision with the term Foreign Use. (68) The Foreign Use definition contains a Direct Foreign Use definition and an Indirect Foreign Use definition, each of which is designed to prevent the double dip of a DCL. The Direct Foreign Use definition states that there is a Foreign Use of a DCL if any portion of any item of deduction or loss taken into account in computing a DCL:

   is made available under the income tax laws of a foreign country to
   offset or reduce ... any item that is recognized as income or gain
   under such laws and that is, or would be, considered under U.S. tax
   principles to be an item of--

(i) A foreign corporation as defined in section 7701(a)(3) and (a)(5); or

(ii) A direct or indirect owner of an interest in a hybrid entity, provided such interest is not a separate unit. (69)

Treas. Reg. [section] 1.1503(d)-3(b) provides that--

   [a] foreign use shall be deemed to occur in the year in which any
   portion of a deduction or loss taken into account in computing the
   dual consolidated loss is made available for an offset described in
   [Treas. Reg. [section] 1.1503(d)-3(a)], regardless of whether it
   actually offsets or reduces any items of income or gain under the
   income tax laws of the foreign country in such year, and regardless
   of whether any of the items that may be so offset or reduced are
   regarded as income under U.S. tax principles.

These definitions are designed, in part, to address a number of financing transactions involving foreign partnerships that are treated as foreign corporations for U.S. income tax purposes (Foreign Reverse Hybrid or FRH). Example 3 illustrates the type of transactions that are addressed by the Direct Foreign Use definition.

EXAMPLE 3

USCo owns DE1, which is an entity that is taxable as a corporation under the laws of Country X but which has filed CTB election to be treated as a disregarded entity for U.S. income tax purposes. DE1 has a 99-percent interest in FRH1, which is a partnership organized under the law of Country X but which has filed a CTB election to be treated as a foreign corporation for U.S. income tax purposes. DE1 incurs a $100 interest expense on a loan from a third party; this is DE1's only tax item for U.S. income tax purpose. FRH1 has a trade or business in Country X that generates $100 of income. (70)

[ILLUSTRATION OMITTED]

Because DE1 is a HESU and has incurred a net loss, it has incurred a $100 DCL. The general rule prevents USCo from using DE1's DCL to offset USCo's income, unless USCo can make a Domestic Use Election for such DCL. USCo may make a Domestic Use Election for DE1's DCL only if it can certify that there has not been and will not be a Foreign Use of the DCL. USCo cannot make such a certification because DE1's $100 interest expense deduction is being made available (for Country X purposes) to offset $99 of income that is an income item of a foreign corporation (from a U.S. income tax perspective).

In other words, even though DE1 is the Country X taxpayer that will be using its interest expense to offset its share of FRH1 partnership income, that income item does not flow through to DE1 for U.S. income tax purposes and is, instead, an item of income of a foreign corporation. (71)

The Indirect Foreign Use definition states:

An item of deduction or loss shall be deemed to be made available indirectly if--

(A) One or more items are taken into account as deductions or losses for foreign tax purposes, but do not give rise to corresponding items of income or gain for U.S. tax purposes; and

(B) The item or items described in [(A) above] have the effect of making an item of deduction or loss composing the dual consolidated loss available for a [Direct Foreign Use]. (72)

The Indirect Foreign Use definition is very broad and potentially applies to many common financing structures. Example 4 illustrates the Indirect Foreign Use rule.

EXAMPLE 4

USCo owns FC, a foreign corporation, and De1, an entity that is taxable as a corporation under the law of Country X but which has filed CTB election to be treated as a disregarded entity for U.S. income tax purposes. DE1 borrows from a third-party lender and on-lends the proceeds to FC as part of a hybrid instrument transaction that is treated as debt for non-U.S. tax purposes and as equity for U.S. tax purposes.

[ILLUSTRATION OMITTED]

Under this hybrid instrument transaction, FC's interest payments to DE1 are made in FC stock and are treated as section 305 stock dividends. Accordingly, under section 305, FC's interest payments are not taxable to USCo. (73) DE1 is a HESU and incurs a DCL equal to its interest expense on the loan from the third-party lender (the interest payments from FC are not included in U.S. taxable income because they are section 305 stock dividends). As such, USCo must make a Domestic Use Election to use DE1's DCL to reduce its income.

According to Treas. Reg. [section] 1.1503(d)-7(c), Example 7, USCo cannot make a Domestic Use Election for DE1's DCL because there has been an Indirect Foreign Use of the DCL. In particular the example states that: (A) there is an item of deduction for foreign tax purposes (DE1's interest expense) and no corresponding item of income or gain for U.S. tax purposes (DE1's interest income is in section 305 stock dividends); and (B) DE1's interest expense has the effect of making an item of deduction composing DE1's DCL available to offset FC's income--that is, the hybrid financing arrangement resulted in a duplication of DE1's interest expense in FC without corresponding interest income to DE1 or USCo for U.S. income tax purposes.

C. Diminution of Interest in HESUs

A Direct Foreign Use can occur merely by the diminution of a Domestic Owner's direct or indirect interest in a HESU. (74) The reason for this rule is that a diminution in a Domestic Owner's interest in a HESU (subsequent to the time that the HESU incurs a DCL) can result in an inappropriate deflection of income from the Domestic Owner to the other interest holder. An example illustrates the point. Assume that USCo owns all in interests in DE1, an entity that is taxable as a corporation under the laws of Country X but which has filed a CTB election to be disregarded for U.S. income tax purposes. In Year 1, DE1 incurs a $100 DCL for which USCo makes a Domestic Use Election. In Year 2, FC, a foreign corporation, acquires a 50 percent interest in DE1 (either by capital contribution or by acquiring interests from USCo), thus making DE1 an HP. This diminution of USCo's interest in DE1 is a deemed Foreign Use because a portion of HP's subsequent income would not be allocated to USCo for U.S. income tax purposes. (75)

There are two important exceptions to this Foreign Use rule. First, if the acquirer is a domestic corporation the diminution in interest rule does not apply because the Foreign Use Rule requires that a DCL is made available to offset the income of a foreign corporation. (76) Second, there is no Foreign Use if the Domestic Owner has a De Minimis Reduction in its interest in the HESU. (77) A De Minimis Reduction occurs only if: (1) the Domestic Owner's interest is reduced less than 10 percent over any 12-month period; and (2) the Domestic Owner's interest is not reduced by 30 percent or more at any time after the year in which the DCL was incurred. (78) Presumably, whether De Minimis Reduction has occurred is measured by reference to the Combined Separate Unit (rather than any individual SU), but the issue is not free from doubt. (78A)

D. Mirror Legislation Rule

The 2007 Regulations also contain a Mirror Legislation Rule that deems a Foreign Use of any DCL that is subject to a foreign mirror rule. (79) A foreign mirror rule is, generally, any foreign legislation (or other rule) that denies a deduction for the same reason that the U.S. DCL rules deny a deduction, i.e., because the deduction was incurred by an entity that is subject to income tax in a foreign jurisdiction (e.g., the United States) or because the deduction is available to offset income of another entity on a foreign (e.g., U.S.) income tax return. (80) Accordingly, if the Mirror Legislation Rule applies to a DCL, no Domestic Use Election may be made for the DCL, and the DCL is effectively treated as a SRLY loss for both U.S. income tax purposes and foreign income tax purposes. (81)

Whether the Mirror Legislation Rule applies to a particular DCL has been (and will probably continue to be) a vexingly complex matter because the inquiry involves interrelated questions of fact and foreign law. The 1992 Regulations' Mirror Legislation Rule is vague and raises an issue whether the mere existence of a foreign mirror rule could implicate the U.S. Mirror Legislation Rule, even if the foreign legislation could not, under any constellation of fact and law, apply to the particular DCL. (82)

The 2007 Regulations attempt to eliminate the more metaphysical Mirror Legislation Rule issues by creating a Stand-Alone Exception that enables a taxpayer to make a special Domestic Use Election for DCLs that would not "otherwise be available for foreign use in the taxable year in which such [DCL] is incurred.'' (83) Whether the Stand-Alone Exception eliminates all of the metaphysical issues is unclear.

The 2007 Regulations also contain a provision for DCLs that are subject to a special bilateral agreement entered into by the U.S. and a foreign country. (84) Under this provision, the Domestic Owner may make a modified Domestic Use Election for the DCL that insures that losses can be used in only one country. There is currently only one such bilateral agreement, even though the provision authorizing such agreements has been in the DCL rules since 1989. (85) This agreement is limited to losses subject to UK ICTA 403D, which applies to losses attributable to a foreign corporation's permanent establishment located in the United Kingdom. Because of the complexity of the Mirror Legislation Rule and its Draconian effect (losses SRLY'd in both countries with no regulatory relief), additional bilateral agreements would be very helpful to taxpayers operating in countries containing a foreign mirror rule.

E. Triggering Events

The 2007 Regulations contain nine designated Triggering Events that will require recapture of a DCL. The Triggering Events are simply stated but can be complicated in application. This section briefly discusses each triggering event as well as some rebuttal rules.

1. Triggering Events

(a) Foreign Use. A Foreign Use of a DCL within the Certification Period requires recapture of a DCL. (86) This is the most important Triggering Event because a Foreign Use of a DCL is the double-dip that the DCL rules are designed to prevent. The remaining Triggering Events are more prophylactic in nature because they address not whether there has been a Foreign Use of a DCL, but whether the taxpayer making the Domestic Use Election will be able to continue monitoring whether there will be a Foreign Use of the DCL.

(b) Disaffiliation. A Disaffiliation Triggering Event occurs if an Affiliated DRC or the Affiliated Domestic Owner of an SU ceases to be a member of the consolidated group that filed a Domestic Use Agreement with respect to a DCL. (87)

(c) Affiliation. An Affiliation Triggering Event occurs if an Unaffiliated DRC or an Unaffiliated Domestic Owner of an SU becomes a member of consolidated group. (88)

(d) Transfer of Assets. A Transfer of Assets will be a Triggering Event if fifty percent (or more) of a DRC or SU's gross assets are sold or otherwise disposed of within a twelve-month period. (89)

(e) Transfer of an Interest in a SU. A Transfer of an Interest in an SU that incurred a DCL subject to a Domestic Use Election will be a Triggering Event if a Domestic Owner sells or otherwise disposes of fifty percent or more of its interests in such SU within a twelvemonth period. (90)

(f) Conversion to a Foreign Corporation. A Triggering Event occurs if an Unaffiliated DRC, an Unaffiliated Domestic Owner, or a HESU that incurred a DCL for which a Domestic Use Election has been filed becomes a foreign corporation. (91)

(g) Conversion to a RIC, REIT, or S Corporation. A Triggering Event occurs if an Unaffiliated DRC or Unaffiliated Domestic Owner elects to be a regulated investment company (RIC) pursuant to section 851(b)(1), a real estate investment trust (REIT) pursuant to section 856(c)(1), or an S corporation pursuant to section 1362(a). (92)

(h) Failure to File Annual Certification. A failure to file an Annual Certification for a DCL subject to a Domestic Use Election is a Triggering Event. (93)

(i) Cessation of Stand-Alone Status. If a taxpayer makes a special modified Domestic Use Election for a DCL under the Mirror Legislation Rule Stand-Alone Exception, the taxpayer must annually certify (during the Certification Period) that the DRC or SU that incurred the DCL continues to satisfy the Stand-Alone Status described in Treas. Reg. [section] 1.1503(d)-3(e)(2)(i). The failure of the DRC or SU to continue to satisfy the Stand-Alone Status during the Certification Period will trigger recapture of the DCL for which the special Domestic Use Election has been made. (94)

(j) Exceptions. There are several exceptions to the Triggering Events. These exceptions include situations in which the entity (or assets) that generated the DCL remain in the consolidated group or unaffiliated domestic corporation, (95) situations in which an acquiring consolidated group or acquiring unaffiliated domestic corporation assumes the obligations under the Domestic Use Election, (96) transactions involving a de minimis diminution in interests in a HESU, (97) certain deemed transactions that do not result in a Foreign Use, (98) and certain compulsory transfers. (99)

2. Rebuttal Rule. A taxpayer may avoid recapturing a DCL if the taxpayer can demonstrate that there can be no Foreign Use of the DCL, "by any means," during the remainder of the Certification Period. (100) The inclusion of this rebuttal rule illustrates the prophylactic nature of all of the Triggering Events other than the Foreign Use Triggering Event. That is, the Triggering Events (other than the Foreign Use Triggering Event) are included because these enumerated transactions are transactions in which the U.S. consolidated group (or Unaffiliated Domestic Owner) would likely lose the ability to monitor and control whether any DCL (or component item thereof) will be put to a Foreign Use.

Satisfying the rebuttal standard requires a more searching inquiry than merely asking whether a foreign NOL account exists. Indeed, the requirement that the taxpayer demonstrate that there can be no Foreign Use "by any means" means just what it says. That is to say, the taxpayer must demonstrate that no portion of any item of deduction or loss taken into account in computing the DCL can be used (directly or indirectly) by any method to reduce or offset income of any foreign corporation during the remainder of the Certification Period. The specificity of this inquiry requires a taxpayer to analyze every deduction, including amortization deductions and whether an assets basis carryover can result in a duplication of a deduction. (101) Example 5 example illustrates the point.

EXAMPLE 5

USCo owns FBSU, a foreign branch separate unit operating in Country X. FBSU's sole asset is a widget making machine with an adjusted basis of $100. The widget making machine is fully depreciable for both U.S. and Country X income tax purposes. In Year 1, FBSU takes a $ 40 depreciation deduction for U.S. income tax purposes but is allowed only a $10 depreciation deduction for Country X income tax purposes. FBSU incurs a $40 DCL in Year 1, and USCo makes a Domestic Use Election in order to use the $40 loss to reduce its home office income. In Year 2, USCo transfers its FBSU operation into FC, a foreign corporation organized in Country X, in a tax-free transaction described in section 351 of the Code. FC takes a $90 carryover basis in the widget making machine for Country X income tax purposes. The transfer is an Asset Transfer Triggering Event described in Treas. Reg. [section] 1.1503(d)6(e)(iv) requiring a recapture of the $40 DCL (plus interest), unless USCo can rebut the presumption of a Triggering Event by demonstrating that there can be no Foreign Use of any portion of the DCL by any means during the remainder of the Certification Period. In this situation, USCo cannot meet this burden because the widget making machine has a $90 adjusted basis for Country X tax purposes and $30 of that basis generated a deduction that was taken into account in FBSU's Year 1 $40 DCL. (102)

A taxpayer exercising it rights under the rebuttal rule must file a "Rebuttal Statement" with its timely filed income tax return for the taxable year in which the Triggering Event occurs. (103) The Rebuttal Statement must demonstrate to the satisfaction of the Commissioner that there can be no Foreign Use of the DCL, by any means, during the remainder of the Certification Period. The Rebuttal Statement must include a detailed discussion of the relevant facts and foreign law, must apply the law to the facts, and must support the no Foreign Use conclusion. (104) The required Rebuttal Statement required by 1992 Regulations, by contrast, is vague and only requires a taxpayer to "attach documents demonstrating such facts to its timely filed U.S. income tax return." (105)

Sundry Items

There are also a number of generally taxpayer favorable sundry items contained in the 2007 Regulations. For instance, the DCL rules are not applicable RICs, REITs, and subchapter S corporations. (106) This includes situations in which the RIC, REIT, or subchapter S corporations own SUs as well. (107)

The 2007 Regulation also adopt a "Reasonable Cause Procedure" to cure missed or imperfect filings required under the DCL rules. (108) The 2007 Regulations make clear that the Reasonable Cause Procedure is the sole method by which to cure DCL filing defects under all DCL regulations (i.e., the 1989 Regulations, the 1992 Regulations, and the 2007 Regulations) and that the procedure described in Treas. Reg. [section][section] 301.9100-1 through 3 is no longer available for most DCL filings. (109)

Conclusion

The 2007 Regulations overhaul the DCL regime that has been applicable for the past 15 years. These new rules eliminate much confusion surrounding the 1992 Regulations and provide new rules that target some relatively common financing structures that were not within the ambit or technical application of the 1992 Regulations. The 2007 Regulations are a tremendous improvement over the 1992 Regulations, but, because of the inherently complex nature the rules, the 2007 Regulations remain complicated and are full of traps for the unwary. U.S. multinationals (and any domestic corporations with any foreign operations) should become very familiar with these rules and should be particularly conscientious with respect to financing structures and compliance issues.

(1.) See T.D. 9315, 2007-15 I.R.B. 891. These regulations will be hereinafter referred to as "the 2007 Regulations."

(2.) See Treas. Reg. [section][section] 1.1503-2, 1.1503-2T, and 1.1503-2A.

(3.) See Treas. Reg. [section] 1.1503(d)-8(a). Taxpayers may elect to apply the 2007 Regulations to DCLs incurred in taxable years beginning on or after January 1, 2007. See id.

(4.) See Tax Reform Act of 1986, Public Law No. 99-514, [section] 1249(a).

(5.) See S. Rep. No. 99-313, 99th Cong., 2d Sess. 419-21 (1986); H.R. Rep. No. 99-841, 99th Cong., 2d Sess., Vol. II, at 656-58 (1986).

(6.) For instance, under the income tax laws of the United Kingdom, a corporation is a resident corporation and, therefore, eligible to join in group relief if the corporation is controlled or managed in the United Kingdom.

(7.) See Technical and Miscellaneous Revenue Act of 1988 (TAMRA), Public Law No. 100-647, [section] 1012(u). Some commentators contend that Congress amended section 1503(d) to avoid discrimination claims, but there is no evidence that this was the reason for the change. But see S. Rep. No. 99-313 99th Cong., 2d Sess. 420 (1986) (nondiscrimination discussed in explaining the 1986 DCL legislation). Congress also included an anti-stuffing provision in the TAMRA amendments. See I.R.C. [section] 1503(d)(4); Treas. Reg. [section] 1.1503(d). The anti-stuffing provision is fairly narrow and is not discussed in this article.

(8.) H.R. Rep. No. 100-795, 100th Cong., 2d Sess. 293 (1988); S. Rep. No. 100-445, 100th Cong., 2d Sess. 307 (1988).

(9.) Section 1503(d)(3) also had the effect of expanding the scope of the DCL rules to domestic corporations that are not included as part of a U.S. consolidated group. Thus, a stand-alone domestic corporation that has an unprofitable foreign branch is subject to the DCL rules. The DCL rules refer to such a domestic corporation as an "Unaffiliated Domestic Owner." See Treas. Reg. [section] 1.1503(d)-l(b)(11).

(10.) See T.D. 8261, 1989-2 C.B. 220 (1989 Temporary Regulations issued as Treas. Reg. [section] 1.1503-2T); T.D. 8434, 1992-2 C.B. 240 (the 1992 Final Regulations issued as Treas. Reg. [section] 1.1503-2). In T.D. 8434, the IRS also promulgated the 1989 Temporary Regulations as Final Regulations issued as Treas. Reg. [section] 1.1503-2A. The 1989 Final Regulations are generally applicable for taxable years beginning after December 31, 1986, and before October 1, 1992, and the 1992 Final Regulations are generally applicable for taxable years beginning on or after October 1, 1992, and before April 18, 2007. See Treas. Reg. [section][section] 1.1503-2(h)(1), 1.1503(d)-8(a).

(11.) T.D. 8434, 1992-2 C.B. at 241. See also T.D. 9315, 2007-15 I.R.B at 891.

(12.) See 2002-2 C.B. 394.

(13.) Treas. Reg. [section] 1.1503(d)-4(b).

(14.) Treas. Reg. [section] 1.1503-2(b)(1).

(15.) Treas. Reg. [section] 1.1503(d)-6 contains two other minor provisions: (1) a bilateral elective agreement rule; and (2) an exception for DCLs that taxpayers can establish have no possibility of being put to a "Foreign Use." These provisions and the Domestic Use Election are discussed in the text that follows.

(16.) See Treas. Reg. [section] 1.1503(d)-1(b)(5). For ease of reference, this article refers to "a net loss attributable to an SU' simply as "NOL of an SU."

(17.) See Treas. Reg. [section] 1.1503(d)-5. These attribution rules are discussed in a separate section of this article.

(18.) Treas. Reg. [section] 1.1503(d)-1(b)(2)(i). A DRC also includes a foreign corporation that has made an election to be treated as a domestic corporation under section 953(d), irrespective of whether the foreign corporation is subject to income in a foreign country. See Treas. Reg. [section] 1.1503(d)-1(b)(2)(ii). Theses special rules addressing DCLs incurred by corporations that have made elections under section 953(d) are beyond the scope of this article.

(19.) See I.R.C. [section] 1503(d)(2)(A); Treas. Reg. [section] 1.1503-2(c)(2).

(20.) T.D. 9315, 2007-15 I.R.B. at 894. The IRS did note, however, that it believed that certain structures involving the use of DRHs resulted in the same type of double dips that Congress intended to address in drafting the DCL legislation and that the IRS would "continue to study" such structures. Id.

(21.) See Treas. Reg. [section] 1.1503(d)-1(b)(4).

(22.) For purposes of the 2007 Regulations, the term "indirect" means ownership through a partnership, disregarded entity, or grantor trust. See Treas. Reg. [section] 1.1503(d)-l(b)(19).

(23.) See Treas. Reg. [section] 1.1503(d)-1(b)(4)(i)(A). A DRC can own a FBSU, even if the foreign branch activities are located in the same country as the place of organization or incorporation of the DRC.

(24.) See Treas. Reg. [section] 1.1503(d)-1(b)(4)(iii).

(25.) Treas. Reg. [section][section] 1.1503(d)-1(b)(3), (b)(4)(i)(B).

(26.) See Treas. Reg. [section] 301.7701-3(b)(2)(i). This article discusses DEs and HPs, but not hybrid trusts (though the hybrid trust rules are substantially similar to the DE and HP rules).

(27.) These attribution rules are discussed in the text that follows.

(28.) Compare Treas. Reg. [section][section] 1.1503-2(c)(3)(i)(B), (C) with Treas. Reg. [section] 1.1503(d)-1(b)(4).

(29.) See, e.g., FSA 200101007 (January 5, 2001).

(30.) See Treas. Reg. [section] 1.1503(d)-1(b)(4)(ii).

(31.) See id.

(32.) The domestic owner of Combined SUs, however, must first attribute all items of income, gain, loss, and expense to each SU and then combine them. See Treas. Reg. [section] 1.1503(d)-5(c)(4)(ii).

(33.) See Treas. Reg. [section] 1.1503-2(c)(3)(ii).

(34.) There is, however, significant debate over whether DE1 could also be aggregated with FB4 and FB5 for purposes of the Foreign Branch Aggregation Rule in the 1992 Regulations. See, e.g., PLR 200716010 (April 20, 2007).

(35.) This is the case irrespective of whether Country X allows all or any of these operations to consolidate for Country X income tax purposes.

(36.) See Treas. Reg. [section] 1.1503(d)-1(b)(4)(i). See also Treas. Reg. [section] 1.1503(d)7(c), Ex. 1.

(37.) See Treas. Reg. [section] 1.1503(d)-5(b)(2)(iii).

(38.) See Treas. Reg. [section] 1.1503(d)-2.

(39.) See id.

(40.) See Treas. Reg. [section] 1.1503(d)-l(b)(12).

(41.) See Treas. Reg. [section] 1.1503(d)-1(b)(9).

(42.) See Treas. Reg. [section] 1.1503(d)-1(b)(16).

(43.) See Treas. Reg. [section] 1.1503(d)-4(a).

(44.) See Treas. Reg. [section] 1.1503(d)-l(b)(5).

(45.) See Treas. Reg. [section] 1.1503(d)-5(b)(1).

(46.) See id.

(47.) See Treas. Reg. [section] 1.1503(d)-5(b)(2).

(48.) See Treas. Reg. [section] 1.1503(d)-5(c).

(49.) See Treas. Reg. [section] 1.1503(d)-5(c)(2)(ii)

(50.) See Treas. Reg. [section] 1.1503(d)-5(c)(2)(i).

(51.) See Treas. Reg. [section] 1.1503(d)-5(c)(2)(i), (ii). These formulaic modified interest attribution rules do not apply if the applicable foreign country determines the FBSU net income taxation based on a strict books and records method. See Treas. Reg. [section] 1.1503(d)-5(c)(2)(iii).

(52.) See Treas. Reg. [section] 1.1503(d)-5(c)(2)(i).

(53.) See id.

(54.) See Treas. Reg. [section] 1.1503(d)-5(c)(3)(i).

(55.) See Treas. Reg. [section] 1.1503(d)-5(c)(1)(ii).

(56.) See Treas. Reg. [section][section] 1.1503(d)-5(c)(3)(ii), (4)(i).

(57.) See Treas. Reg. [section] 1.1503(d)-5(c)(4)(iv).

(58.) See Treas. Reg. [section][section] 1.1503(d)-5(c)(4)(iv), (f).

(59.) See Treas. Reg. [section] 1.1503(d)-5(c)(4)(v).

(60.) Treas. Reg. [section] 1.1503-2(d)(1)(ii).

(61.) See Treas. Reg. [section] 1.1503(d)-6(d).

(62.) See Treas. Reg. [section] 1.1503(d)-6(d)(1)(v). As discussed in the text that follows, the Foreign Use definition reflects the general double dip definition, viz., the use of one deduction to offset two streams of income, one of which is not immediately subject to U.S. income tax. The Certification Period is the period beginning in the taxable year in which the DCL is incurred and up to and including the fifth taxable year following the year the DCL was incurred. See Treas. Reg. [section] 1.1503(d)1(b)(20).

(63.) See Treas. Reg. [section][section] 1.1503(d)-6(d)(1)(iii), (e). Presumptively, the recapture amount includes the entire DCL amount; a taxpayer may reduce the recapture amount, however, by attaching to its income tax return a special accounting that demonstrates that the taxpayer did not obtain a U.S. Income tax benefit by virture of making the Domestic Use election. See Treas. Reg. [section]1.1503(d)-6(h).

(64.) See Treas. Reg. [section][section] 1.1503(d)-6(d)(1)(iii), (g). The sum and substance of the Annual Certification is a certification that there has been no Foreign Use of the DCL for which a prior year Domestic Use Election has been filed. For instance, assume USCo's FBSU incurs a $100 DCL in Year 1. USCo makes a Domestic Use Election for FBSU's $100 DCL in order to reduce USCo's other U.S. income by FBSU's $100 DCL. USCo must file with its Years 2 through 6 U.S. income tax return an Annual Certification for FBSU's Year 1 DCL. The Annual Certification must, inter alia, certify that there has been no Foreign Use of FBSU's Year 1 DCL.

(65.) See Treas. Reg. [section] 1.1503-2(g)(2)(iv)(B)(3)(i).

(66.) See Treas. Reg. [section] 1.1503(d)-8(b).

(67.) See Treas. Reg. [section] 1.1503-2(g)(2)(i)(E).

(68.) See Treas. Reg. [section] 1.1503(d)-3.

(69.) Treas. Reg. [section] 1.1503(d)-3(a)(1).

(70.) See Treas. Reg. [section] 1.1503(d)-7(c), Ex. 6. There are many iterations of this basic structure.

(71.) There is significant debate regarding whether a taxpayer can make the requisite (g)(2) Election certification in this situation. If, however, FRH makes a $99 distribution to DE1, the distribution would be a dividend for U.S. income tax purposes (to the extent of earnings and profits) that would be absorbed by DE1 and would reduce DE1's DCL to $1. See Treas. Reg. [section] 1.1503(d)-5(c)(4)(iv).

(72.) Treas. Reg. [section] 1.1503(d)-3(a)(2).

(73.) These hybrid instrument transactions often involve interrelated purchase agreements and can be structured in a number of ways. See IRS NSAR AM 2006-01 (Sept. 26, 2006).

(74.) See Treas. Reg. [section][section] 1.1503(d)-3(a), (b) and 1.1503(d)-7(c), Ex. 5(iii).

(75.) The same Foreign Use rule would apply if USCo owned an HP in Year 1 and had a diminution of its HP interest in Year 2.

(76.) See Treas. Reg. [section] 1.1503(d)-3(a). This transaction, however, could be a Triggering Event under Treas. Reg. [section] 1.1503(d)-6(e)(1)(iv) or (v).

(77.) See Treas. Reg. [section][section] 1.1503(d)-3(c)(5)(i); 1.1503(d)-6(f)(3).

(78.) See Treas. Reg. [section] 1.1503(d)-3(c)(5)(ii).

(78A.) Compare Treas. Reg. [section] 1.1503(d)-1(b)(4)(ii) (last sentence) with Treas. Reg. [section][section] 1.1503-3(c)(4)(ii) and (iii). There are also some complex rules regarding a deemed Foreign Use as a result of certain asset basis carryover transactions and certain assumptions of liabilities. See Treas. Reg. [section] 1.1503(d)-3(c)(6), (7). The asset basis carryover Foreign Use concept is addressed in a different context in Example 5 of this article.

(79.) See Treas. Reg. [section] 1.1503(d)-3(e). The 1992 Regulations also contain a Mirror Legislation Rule. See Treas. Reg. [section] 1.1503-2(c)(15)(iv). See also British Car Auctions v. United States, 35 Fed. Cl. 123 (1996), aff'd without opinion, 113 F.3d 1497 (Fed. Cir. 1997) (upholding validity of the Mirror Legislation Rules).

(80.) See Treas. Reg. [section][section] 1.1503(d)-3(e)(1)(i-iii).

(81.) The United Kingdom, Germany, Australia, and New Zealand have forms of legislation that could be considered a foreign mirror rules. Other jurisdictions are purportedly considering enacting anti-arbitrage legislation that could be within the ambit of this rule.

(82.) See Kenneth Krupsky, DCL Regulations: The Mirror Is Cracked (and the Service Should Fix It), 32 Tax Mgmt Int'l J. 155 (March 14, 2003).

(83.) Treas. Reg. [section] 1.1503(d)-3(e)(2).

(84.) See Treas. Reg. [section] 1.1503(d)-6(b). See also Treas. Reg. [section] 1.1503-2(g)(1); Treas. Reg. [section] 1.1503-2A(c)(2).

(85.) See United Kingdom/United States Dual Consolidated Loss Competent Authority Agreement, Announcement 2006-86, 2006-45 I.R.B. 842.

(86.) See Treas. Reg. [section] 1.1503(d)-6(e)(i).

(87.) See Treas. Reg. [section] 1.1503(d)-6(e)(ii).

(88.) See Treas. Reg. [section] 1.1503(d)-6(e)(iii).

(89.) See Treas. Reg. [section] 1.1503(d)-6(e)(iv). Asset dispositions occurring in the ordinary course of business are not included in determining the fifty percent threshold. See id.

(90.) See Treas. Reg. [section] 1.1503(d)-6(e)(v). The interests are measured by voting power or value at the time of the transaction, or for multiple transactions, at the time of the first transaction. See id.

(91.) See Treas. Reg. [section] 1.1503(d)-6(e)(vi). This occurs in an outbound reorganization in the case of an Unaffiliated DRC or Unaffiliated Domestic Owner. For a HESU, this transaction can occur if the HESU makes a CTB election to be treated as a foreign corporation.

(92.) See Treas. Reg. [section] 1.1503(d)-6(e)(vii). As discussed below, the 2007 Regulations have exempted RICs and REITs from the DCL rules for taxable years beginning on or after April 18, 2007 (or if a taxpayer has elected to apply the 2007 Regulations to taxable years beginning on or after January 1, 2007). The Preamble to the Proposed Regulations clarifies that subchapter S corporations were never subject to the DCL rules.

(93.) See Treas. Reg. [section] 1.1503(d)-6(e)(viii).

(94.) See Treas. Reg. [section] 1.1503(d)-6(e)(ix).

(95.) See Treas. Reg. [section] 1.1503(d)-6(f)(1).

(96.) See Treas. Reg. [section] 1.1503(d)-6(f)(2).

(97.) See Treas. Reg. [section] 1.1503(d)-6(f)(3).

(98.) See Treas. Reg. [section] 1.1503(d)-6(f)(4)

(99.) See Treas. Reg. [section] 1.1503(d)-6(f)(5).

(100.) See Treas. Reg. [section] 1.1503(d)-6(e)(2).

(101.) See Treas. Reg. [section] 1.1503(d)-3(c)(6). This "by any means" standard also makes very rare the opportunity to avail oneself of the exception to the general rule contained in Treas. Reg. [section] 1.1503(d)-6(c). The no Foreign Use standard in this exception is more narrow than the rebuttal standard because a taxpayer must meet the no Foreign Use standard for all years, not just for the remainder of the Certification Period.

(102.) There is a de minimis exception that applies to certain asset basis carryover transactions. See Treas. Reg. [section] 1.1503(d)-3(c)(6). Moreover, any asset basis carryover transaction is a potential deemed Foreign Use and, therefore, a potential triggering event. See Treas. Reg. [section] 1.1503(d)-3(c)(6). Thus, a DRC or SU does not have to transfer 50 percent (or more) of its assets to have a triggering event requiring recapture of a DCL.

(103.) See Treas. Reg. [section] 1.1503(d)-6(e)(2)(iii).

(104.) See Treas. Reg. [section][section] 1.1503(d)-6(e)(2)(iii), (c)(2)(iv).

(105.) See Treas. Reg. [section] 1.1503-2(g)(2)(iii)(B).

(106.) See Treas. Reg. [section] 1.1503(d)-1(b)(1).

(107.) The exception for RICs and REITs is new and applies only to DCLs that are subject to the 2007 Regulations. The exception for subchapter S corporations is a clarification of the exception for subchapter S corporations that has existed since 1992. See Preamble to 2005 Proposed Regulation [section] 1.1503(d), 70 Fed. Reg. 29867 (May 24, 2005).

(108.) See Treas. Reg. [section] 1.1503(d)-1(c).

(109.) See Treas. Reg. [section] 1.1503(d)-8(b)(3)(i). The procedure for relief under Treas. Reg. [section][section] 301.9100-1 through 3 is still applicable for requests for closing agreements described in Treas. Reg. [section] 1.1503-2(g)(2)(iv)(B)(3)(i) and request for relief under Treas. Reg. [section][section] 301.9100-1 through 3 that were pending as of March 19, 2007. See Treas. Reg. [section][section] 1.1503(d)8(b)(3)(ii) and (iii).

Guy A. Bracuti is a Principal in the International Corporate Services group of KPMG LLP's Washington National Tax practice. He has extensive experience in international mergers and acquisitions and in structuring the U.S. and foreign operations of multinational corporations. Before joining KPMG, Mr. Bracuti served as attorney-adviser for the Internal Revenue Service, Office of Chief Counsel (International) and attorney-adviser with the Office of the Chief Counsel (Domestic) Field Service. Mr. Bracuti received an LL.M. degree in Taxation from Georgetown University Law Center, J.D. degree from George Washington University National Law Center, and B.A. degree from Rutgers College. He is a member of the Bar Associations of New York and New Jersey, and an adjunct professor at the George Mason University School of Law. He may be reached at [e-mail]. The author expresses his appreciation to Douglas Holland for his contribution to this article.