On August 6, 2024, Treasury and the IRS released proposed regulations that address several long-standing issues related to dual consolidated losses (DCLs) and introduce new rules for "disregarded payment losses" (DPLs). If finalized as proposed, these changes could significantly impact how multinational corporations may use certain deductions and losses to offset their U.S. income. In this alert, we highlight how some of the proposed rules could create more traps for the unwary and identify potential considerations for taxpayers.
UNDERSTANDING THE DCL RULES
What Are the DCL Rules? The DCL rules were enacted in the 1986 tax act to prevent "dual resident corporations" from using a single economic loss twice — once to offset U.S. taxable income and again to offset foreign taxable income. In 1988, these rules were expanded to apply to "separate units" of a domestic corporation, such as foreign branches or hybrid entities.
Why Do the Rules Matter? The DCL rules are crucial for preventing double-deduction outcomes, where the same loss reduces taxable income in both the U.S. and a foreign country. Generally, domestic use of a DCL is prohibited unless a "domestic use election" is made, ensuring the loss is not used in a foreign jurisdiction. The existing and proposed regulations specify situations where a foreign use is deemed to occur, thereby eliminating the option to use the loss to offset U.S. income.
How Are DCLs Calculated? The income or DCL of a dual resident corporation is generally calculated based on the corporation's items of income, gain, deduction, and loss for the year, subject to certain exceptions and considering the consolidated return regulations (where applicable). For a separate unit, the calculation is done as if it were a domestic corporation and based on the items attributable to it. The proposed regulations aim to provide additional clarifications and modifications, which could give rise to unfavorable taxpayer outcomes.
When Are DCLs Recaptured? If a DCL is used in a foreign jurisdiction, the entire amount previously deducted in the U.S. must be recaptured and reported as income in the U.S. Triggering events for recapture include the transfer of assets of a separate unit or failing to meet specific certification requirements.
RULES IMPLICATING FOREIGN USE
What Is the "Mirror Legislation Rule"? The mirror legislation rule addresses foreign tax laws that prevent double-deduction outcomes by denying the use of a DCL. Such laws eliminate the taxpayer's option to choose between domestic or foreign use. However, the proposed regulations clarify that foreign laws denying a loss to avoid double-deduction but still preserving the taxpayer's choice of domestic or foreign use are not considered mirror legislation.
How Do DCL Rules Apply to Pillar 2 Tax Regimes? Under the proposed regulations, the DCL rules generally apply to foreign taxes that ensure a minimum level of income tax, such as the income inclusion rule (IIR) or the qualified domestic minimum top-up tax (QDMTT) under OECD/G20 Pillar 2 global anti-base erosion (GloBE) model rules. Losses that offset income under the IRR or QDMTT may be considered a foreign use of a DCL. Additionally, a foreign entity not taxed as a corporation for U.S. tax purposes may be treated as a hybrid entity separate unit if its income or loss is taken into account under an IIR, potentially subjecting it to DCL rules.
Are There Foreign Use Exemptions for Pillar 2 Taxes? The proposed regulations offer limited foreign use exemptions for losses under the "Transitional Country-by-Country Reporting Safe Harbour" (Safe Harbour). For example, a foreign use will not be deemed to occur if the Safe Harbour is satisfied with no foreign use occurring due to the "duplicate loss arrangement" rules, which exclude an expense or loss from the Safe Harbour calculation if it is also included in the financial statement in another jurisdiction.
However, foreign use could be deemed to occur under the proposed regulations with respect to the Safe Harbour if:
- Absent the Safe Harbour, the loss or expense used to qualify for the Safe Harbour and avoid the GloBE rules would have the same double-deduction effect; or
- A DCL is taken into account under the Safe Harbour and the duplicate loss arrangement rules do not apply.
A&M Insight
While Treasury and the IRS aim to retain taxpayers' ability to choose either a domestic or foreign use of a DCL, some aspects of the proposed regulations limit this option and create pitfalls. For example, a U.S. company may mistakenly believe it can make a domestic use election to deduct a DCL for U.S. tax purposes if the loss cannot be transferred to another affiliate under foreign tax law. However, under the GloBE rules, combining all operations in the same country to compute top-up taxes could make non-transferable loss benefits transferrable for Pillar 2 purposes. These losses will then be considered a foreign use, eliminating the taxpayer's ability to make a domestic use election and rendering the DCL non-deductible for U.S. tax purposes.
INTERACTION WITH INTERCOMPANY TRANSACTION RULES
How Are Intercompany Transactions Treated? Intercompany transactions are those between members of a consolidated group, treated similarly to transactions between divisions of the same corporation (single entity treatment). The proposed regulations clarify that the intercompany transaction rules apply first to determine when an item is taken into account before applying the DCL rules.
How Do the DCL Rules Impact the Matching Rule? Under the consolidated matching rule, the "selling member" in an intercompany transaction recognizes income, gain, loss, or deduction when the "buying member" recognizes its corresponding item. The proposed regulations specify that counterparty members are treated as if they are not subject to the DCL rules for purposes of applying the matching rule. As a result:
- DCL rules do not apply to a section 1503(d) member's intercompany (or corresponding) item until it would otherwise be taken into account under the intercompany transaction rules; and
- The intercompany (or corresponding) loss of the section 1503(d) member (the selling member) is exempt from the matching rule, potentially limiting the loss under the DCL rules, even though that outcome is inconsistent with single entity treatment. For example, a counter-party member must include interest income on an intercompany loan in the current year, even if the section 1503(d) member's interest deduction is limited and not currently deductible.
ITEMS ARISING FROM STOCK OWNERSHIP
How Are Items from Stock Ownership Treated? Under current DCL regulations, items of income arising from a dual resident corporation's ownership of stock in a foreign corporation — whether directly or through a separate unit or interest in a transparent entity — are generally attributed to the unit or entity if an actual dividend from the foreign corporation would have been attributed. These items are considered for U.S. tax purposes and are likely to be considered for foreign tax purposes.
How Do New Rules Treat Stock Ownership Items? To prevent double-deduction outcomes, the proposed regulations specify that certain items arising from stock ownership (generally those considered for U.S. tax purposes but not for foreign tax purposes due to participation exemptions or foreign tax credits) will not be considered in computing income or a DCL. These items include:
- Gain recognized on the sale or exchange of stock;
- Dividends;
- Subpart F inclusions; and
- Deductions with respect to subpart F inclusions, including dividends received deductions and deductions for foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI).
An exception is provided for items arising from "portfolio stock" (stock owned by a dual resident corporation or separate unit that represents less than 10% of the value of the corporation).
A&M Insight
The proposed rules for items arising from stock ownership generally align with tax policy, as they exclude items not taxable under foreign laws. However, an inconsistency could arise if these items are taxable in the foreign jurisdiction, albeit a rare occurrence, which could conflict with the intended purpose of the DCL rules.
DISREGARDED ENTITY (DRE) TRAP FOR THE UNWARY
What Is the Potential DRE-DCL Trap for the Unwary? A DRE that conducts foreign operations might inadvertently trigger a DCL if the DRE receives income from its sole owner that is disregarded for U.S. tax purposes. Under one interpretation of the current regulations, the DRE could have no income and only deductions, and therefore a DCL, even though the income that is disregarded for U.S. purposes would have been taxable for foreign tax purposes.
How Have Taxpayers Responded? Some taxpayers that have fallen into this alleged DRE-DCL trap have taken the position that an appropriate amount of the gross income of the U.S. parent company can be allocated to the DRE under existing rules (e.g., rules for transfer pricing or for determining effectively connected income).
What Is the View of Treasury and the IRS? In the preamble to the regulations, Treasury and the IRS unequivocally declare that the taxpayer position described above is incorrect and a misinterpretation of the regulations that require adjustments to conform to U.S. tax principles. To purportedly remove all doubt, the proposed regulations clarify that attribution to a hybrid entity separate unit, or an interest in a transparent entity, is not permitted for any item not reflected on the books and records of those entities. Further, the IRS may challenge positions that are contrary to the proposed rules for open tax years that begin before August 6, 2024.
A&M Insight
The government's position on the treatment of disregarded income for purposes of determining the DCL is debatable. Nonetheless, taxpayers should consider structuring related-party arrangements such that the applicable income comes from an entity that does not own the separate unit, and therefore would not be disregarded. Additionally, under the IRS's interpretation, failure to make a domestic use election could render all or a portion of out-of-pocket expenses of the DRE non-deductible for U.S. tax purposes. For open tax years, U.S. companies with foreign operations conducted through one or more DREs that receive a substantial portion of its gross income from the U.S. company should evaluate their exposure and develop a plan to mitigate any risk.
GENERAL ANTI-AVOIDANCE RULE
Rather than continuing to play whack-a-mole, by enacting new regulations to specifically address every new abusive strategy to obtain a double deduction while avoiding the application of the DCL rules, Treasury and the IRS propose a general anti-avoidance rule. Under that rule, the IRS could (and taxpayers may be required to) make "appropriate adjustments" if the taxpayer engages in "a transaction, series of transactions, plan, or arrangement . . . with a view to avoid the purposes of section 1503(d) and the regulations."
DISREGARDED PAYMENT LOSS (DPL) RULES
What Is a DPL? A DPL arises under foreign tax law when a "specified eligible entity" — which includes an entity that is disregarded for U.S. tax purposes — makes a payment to its domestic corporate owner that is regarded for foreign tax purposes but disregarded for U.S. tax purposes. The concern is that DPLs can give rise to a deduction/no-inclusion outcome very similar to that which the DCL rules were intended to prevent but is not covered by the existing DCL regulations.
How Will the DPL Be Treated? A domestic corporation that owns or acquires interests in a specified eligible entity will have to consent to being subject to the following proposed rules:
- If the specified eligible entity incurs a DPL during a defined "certification period" and a "triggering event" occurs with respect to that loss, the domestic corporation will include the DPL inclusion amount in its gross income; and
- The DPL inclusion will be treated as ordinary income for U.S. tax purposes and characterized similar to interest or royalty income payments by a foreign corporation.
What Is a Triggering Event? The proposed triggering events are (1) foreign use of the disregarded payment loss (including by related persons but not unrelated persons) or (2) failure to certify that a foreign use has not occurred.
A&M Insight
If a U.S. company conducts foreign operations through a DRE and a substantial portion of the deductions of the DRE consists of disregarded interest, royalty, or structured income payments to the U.S. company, a DPL may exist, requiring the company to make annual certifications. It appears that a U.S. company that fails to comply with these certification requirements could be required to report phantom income, even though no abuse of the type contemplated by the DCL or DPL rules has occurred. Because the proposed DPL rules only apply to an entity that is disregarded as an entity separate from its owner, a domestic corporate owner of the entity could instead have the entity elect to be classified as a corporation for U.S. tax purposes.
EFFECTIVE DATES AND TRANSITION RULE
The proposed DCL regulations generally apply to tax years ending on or after August 6, 2024, and provide a transition rule, under which a Pillar 2 top-up tax will not cause a foreign use of a DCL to be incurred in a tax year beginning before August 6, 2024.
The intercompany transaction rules will apply to taxable years for federal income tax returns due (without extensions) after the date that final regulations are published in the Federal Register, although taxpayers may elect to apply the rules retroactively.
The DPL consent rules will apply to entity-classification elections filed on or after August 6, 2024. The rules that deem owners of disregarded entities to consent to the DPL rules, will apply on or after August 6, 2025, which should allow taxpayers time to restructure existing arrangements to avoid the application of the DPL rules.
A&M TAX SAYS
The proposed regulations to prevent double deductions and deduction/no-inclusion outcomes for multinational corporations clarify some rules but create more traps for the unwary. Taxpayers should assess how the regulations could affect their ability to deduct losses against their U.S. income and potential strategies to mitigate the risks. For example, taxpayers may want to reconsider how they structure foreign operations because a foreign branch (as compared to a foreign subsidiary) of a domestic company may become even less desirable (adding on to existing reasons, such as the foreign tax credit limitations for taxes on foreign branch income). If you would like to discuss how the proposed regulations regarding DCLs and DPLs could affect your business and tax planning and potential options to consider, please contact Kevin M. Jacobs or Kenneth Brewer of our National Tax Office.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.