Application of sec. 1503(d) to separate units of S corporations.

• Author: Dubert, Carl A.

If an S corporation has a foreign branch, or owns an interest in a foreign partnership, trust or hybrid entity, and the foreign branch, partnership, trust or hybrid entity incurs losses, the potential application of the "dual consolidated loss" (DCL) rules of Sec. 1503(d) should be reviewed carefully.

The DCL rules generally limit the use of losses incurred by a "dual resident corporation" (DRC) to offset the income of affiliated domestic corporations. The definition of DRC provided in Regs. Sec. 1. 1503-2(c)(2) explicitly excludes S corporations. On the basis of this exclusion, taxpayers and practitioners might conclude that the DCL rules simply do not apply to S corporations. As is true with respect to other areas of the tax law, however, the rule here is not as straightforward as might first appear.

The definition of DRC in Regs. Sec. 1.1503-2(c)(2) includes any "separate unit" of a domestic corporation. Regs. Sec. 1.1503-2(c)(3) and (4) provide that the term "separate unit" includes a foreign branch, an interest in a partnership, an interest in a trust, and an interest in "an entity that is not taxable as an association for U.S. income tax purposes but is subject to income tax in a foreign country as a corporation (or otherwise at the entity level) either on its worldwide income or on a residence basis" (i.e., a "hybrid entity").

Regs. Sec. 1.1503-2(c)(1)'provides that the term "domestic corporation" has the meaning assigned to it by Sec. 7701(a)(3) and (4). An S corporation is a "domestic corporation" within the meaning of those provisions. Therefore, if an S corporation has a foreign branch or interest in a foreign partnership, trust or hybrid entity, such branch, partnership, trust or hybrid entity would be considered a DRC. Moreover, pursuant to Regs. Sec. 1.1503-2 (c)(1), a "separate unit" of a domestic corporation is treated as a separate domestic corporation.

Applying the general rule of Regs. Sec.1.1503-2(b)(1), a DCL of a DRC may not offset the taxable income of a "domestic affiliate." The term "domestic affiliate" means any member of an affiliated group, without regard to the exceptions contained in Sec. 1504(b) (other than Sec. 1504(b)(3)). The exception for S corporations is found in Sec. 1504(b)(8). Therefore...