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Proposed regulations affect form of funding international operations.

Recently proposed regulations under Sec. 865(j) generally provide that any loss on the sale of stock in a foreign affiliate by a U.S. shareholder will be considered a U.S. loss. This is a dramatic reversal from the characterization of the loss under existing regulations. However, the U.S.-source treatment for the loss applies only to stock investments in foreign affiliates and does not presently extend to debt, derivative financial products and other common financing arrangements used to fund overseas operations.

Since 1986, Sec. 865 has provided for sourcing gains on the disposition of personal property (including stock), but no guidance had been provided for sourcing losses. Rather, the determination of the source of losses has been based on pre-1987 Regs. Sec. 1.861-8 and affirmed by the courts in Black & Decker, TC Memo 1991-557, aff'd, 4th Cir., 1993.

Gains from personal property sales are sourced to the seller's residence under Sec. 865, with some exceptions. In particular, under Sec. 865(f), the source of the gain will be foreign when a U.S. resident sells stock in a foreign affiliate (defined in Sec. 865(i)(4)), if the sale occurs in a foreign country in which the affiliate is engaged in the active conduct of a trade or business and more than 50% of the affiliate's gross income during the three immediately preceding tax years was derived from the active conduct of a trade or business in that foreign country. Of course, Sec. 865(f) applies only to any gain that exceeds amounts recharacterized as dividends under Sec. 1248 (which generally are sourced to the payor's residence).

Personal property losses have been sourced under the pre-1987 regulations, which matched the source of these losses with the source of the income ordinarily generated by the underlying asset (Regs. Sec. 1.861-8(e) (7)). For example, a bad debt deduction for a worthless note from a foreign subsidiary would be considered foreign, since the interest generated by the note would be foreign source. The courts have supported this treatment In Black & Decker, a loss on the stock of a wholly owned Japanese subsidiary was considered foreign source, since dividends from that stock would be foreign source.

However, Prop. Regs. Sec. 1.865-2(a) would instead allocate the loss on a disposition of stock in a foreign affiliate to the seller's residence. A "disposition" includes a worthless stock deduction allowable under Sec. 165(g) (Prop. Regs. Sec. 1.865-2(c)(2)). c. There are exceptions to this general rule if dividends have been paid within the past 24 months or a stock sale resulted in foreign-source gain within a five-year look-back period (Prop. Regs. Sec. 1.865-2(b) (2)). (This look-back period would be phased in so that losses would be tainted only by reason of gains recognized after Sept. 6, 1996.) Similarly, loss recognized by a U.S. resident on the disposition of stock attributable to a foreign branch is allocated to foreign-source income if a gain would have been taxable by the foreign country and the highest marginal tax rate imposed in that country is at least 10% (Prop. Regs. Sec. 1.865-2(a)(2)).

These proposed regulations apply only to stock in a C corporation in which the taxpayer owns, or is considered to own through attribution, 10% or more of the voting power and value (Prop. Regs. Sec. 1.865-1). Therefore, the source of losses attributed to other personal property (such as portfolio stock, debt instruments, partnership interests and S stock) will continue to be governed under the old regulations or other administrative pronouncements (such as Notice 89-58).

The difference in treatment can be dramatic. If a foreign affiliate of a U.S. taxpayer is funded with debt (instead of equity) that becomes worthless, the tax cost will be much higher, due to characterization of the loss as foreign source. If an overall foreign loss results from the bad debt, the limitation on the use of foreign tax credits in succeeding years can be crippling.

Given the different treatment proposed for stock investments in foreign affiliates, taxpayers may need to rethink the form of financing foreign operations.

Note: These regulations generally would be effective for tax years beginning 60 days after publication of the final regulations. However, they may be retroactively elected for all open post-1986 tax years if amended returns are filed within 120 days of the final regulations' publication (Prop. Regs. Sec. 1.865-2(e)(2))
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Author:Kingsley, William P.
Publication:The Tax Adviser
Date:May 1, 1997
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