Avoiding potential disallowance of foreign branch losses.

• Author: Kral, Kenneth H.

Some U.S. companies may unknowingly be improperly deducting post-1986 foreign branch losses in their U.S. returns if the "dual consolidated loss" (DCL) rules of Sec. 1503(d) are applicable to their foreign branch.

Prior to the enactment of Sec. 1503(d), multinational corporations could obtain double deductions by establishing dual resident corporations (DRCs). These entities would typically generate losses through interest expense deductions. On consolidation, these DCLs would offset taxable income of affiliates in both the United States and the foreign jurisdiction

In response to such "double dipping" of losses, See. 1503(d) was enacted as part of the Tax Reform Act of 1986. Sec. 1503(d) generally disallows DCLS of such DRCs from being used to offset income of any other affiliated U.S. corporation. Additionally, the regulations broaden the definition of DRC to include certain partnerships and branches of domestic corporations that are "separate units. "

Temporary regulations under Sec. 1503(d) were issued in September 1989 and became effective for tax years beginning after Dec. 31, 1986. Generally, a DCL cannot reduce the U.S. taxable income of any affiliate for that or any tax year. It is irrelevant whether the losses actually offset income of another corporation under the income tax laws of a foreign country.

Under the temporary regulations, certain taxpayers were nonetheless able to use DCLS to offset U.S. income of other affiliates if an agreement under Regs. Sec. 1.1503-2A(c)(3)(B)(ii) or a certification under Regs. Sec. 1.1503-2A(d) 2A(d)(3) was filed. An agreement could be used if the DCL was generated by a traditional DRC. A certification could be used if the loss was generated by certain separate units not taxed in the foreign country on worldwide income or on a residence basis. Many U.S. corporations with foreign branches may have failed to make these certifications in post-1986. years

Example: USCO is a large U.S. company operating a small manufacturing branch in the United Kingdom. If the U.K. branch operation were incorporated in the United Kingdom, under U.K. tax law, a net operating loss (NOLI) carryforward of the branch generally can carry over to the newly incorporated U.K. entity, provided the entity maintains the same trade as the (former) branch. For U.S. tax purposes, the branch is considered a separate unit subject to the DCL rules because the branch's losses could be used by another person (i.e., a newly incorporated...