Final regulations on dual consolidated losses.

• Author: Jacobs, Karen
• Position: Part 1, A Practical Guide

EXECUTIVE SUMMARY

* The 2007 DCL regulations generally provide that a DCL of a dual-resident corporation (DRC) or a separate unit of a U.S. corporation is not included in the computation of the taxable income of a consolidated group, unaffiliated DRC, or unaffiliated domestic owner.

* Once the existence of a DRC or separate unit of a U.S. corporation is established, the next step is to determine whether the DRC or separate unit incurred a DCL.

* If a DRC or separate unit has a DCL, the next step is to determine whether the DCL may be included in the computation of taxable income of a consolidated group, unaffiliated DRC, or unaffiliated U.S. owner.

Originally enacted in 1986, the dual consolidated loss (DCL) rules are designed to prevent a corporation from using a net operating loss to offset income both in the U.S. and in a foreign country. Part I of this article will discuss the entities to which the DCL rules are applicable, the computation of a DCL, the limitation on using a DCL to offset U.S. taxable income, and the exceptions to the limitation on utilization of a DCL. Part II, in the October 2007 issue, will discuss triggering events and their consequences, as well as the transition rules from the 1992 regulations to the 2007 regulations.

Originally enacted in 1986, the dual consolidated loss (DCL) rules are designed to prevent a corporation from using a net operating loss (NOL) to offset income both in the U.S. and in a foreign country. (1) Specifically, Secs. 1503(d) (1) and (2) provide that a corporation's DCL cannot reduce the taxable income of any other member of the company's affiliated group unless, to the extent provided in the regulations, the loss does not offset the income of any foreign corporation. The IRS and Treasury issued final regulations under Sec. 1503(d) on March 19, 2007, which update the regulations issued on September 9, 1992, for changes in tax law, including the adoption of the entity-classification regulations in Regs. Secs. 301.7701-1 through -3. Consistent with the statute, the 2007 DCL regulations generally provide that a DCL of a dual-resident corporation (DRC) or a separate unit of a U.S. corporation is not included in the computation of the taxable income of a consolidated group, unaffiliated DRC, or unaffiliated domestic owner (2) (other than to offset income or gain of the DRC or separate unit that, in each case, incurred the DCL), as applicable.

This article is organized to assist taxpayers in determining the applicability of the 2007 DCL regulations and to help practitioners comply with the regulations. Under Regs. Sec. 1503(d)-8(a), the new regulations are generally applicable to DCLs incurred in tax years beginning on or after April 18, 2007. A taxpayer may elect to apply the new regulations, in their entirety, to DCLs incurred in tax years beginning on or after January 1, 2007, by filing its return and attaching to such return the domestic-use agreements, certifications, or other information in accordance with these regulations.

Entities Subject to DCL Rules

The first step in determining whether the DCL rules apply is to review the organizational structure for a DRC or a separate unit of a U.S. corporation. (3) Only a DRC or separate unit can have a DCL.

DRCs

A DRC is a domestic corporation subject to a foreign country's income tax on either a worldwide or a residence basis (Regs. Sec. 1.1503(d)-1(b)(2)). (4) A corporation is taxed on a residence basis if it is taxed as a resident under foreign laws. A typical example of a DRC is a U.S. corporation managed and controlled in the U.K. The fact that a U.S. corporation or foreign entity does not have an actual income tax liability to a foreign country is not taken into account when determining whether it is subject to tax.

A domestic corporation is a corporation, association, joint-stock company, or insurance company created or organized under the laws of the U.S. or any state therein (Secs. 7701(a)(3) and (4)). Under Regs. Sec. 1.1503(d)-1(b)(1), it also includes entities treated as such under the Code, such as (1) stapled entities (Sec. 269B); (2) foreign insurance companies that have elected to be treated as domestic corporations under Sec. 953(d); (3) subsidiaries created under Sec. 1504(d) to comply with foreign law; and (4) Sec. 7874 expatriated entities. A domestic corporation does not include a regulated investment company (RIC), a real estate investment trust (REIT), or an S corporation. Under Regs. Sec. 1.1503(d)-1 (b)(7), a U.S. possession is also not considered a domestic corporation.

Separate Unit

A separate unit includes either of the following that is carried on or owned, directly or indirectly, (5) by a U.S. corporation (including a DRC): (6) (1) a foreign business operation that, if carried on by a U.S. person, would constitute a foreign branch (foreign-branch separate unit) within the meaning of Temp. Regs. Sec. 1.367(a)-6T(g)(1) (7) or (2) an interest in a hybrid entity (hybrid-entity separate unit) under Regs. Sec. 1.1503(d)-1(b)(4)(i). A hybrid entity is an entity that is not taxable for U.S. tax purposes but is subject to a foreign country's income tax at the entity level on its worldwide income or on a residence basis. If a U.S. corporation that is not a DRC is considered to directly carry on or own a foreign branch, as defined in Temp. Regs. Sec. 1.367(a)-6T (g) (1), such business operation will not be characterized as a foreign-branch separate unit, provided the business operation is not treated as a permanent establishment under a U.S. income tax treaty or is not otherwise subject to tax on a net basis under the treaty (Regs. Sec. 1.1503(d)-1(b)(4)(iii)). If the U.S. corporation carries on such business operation through a hybrid entity or a transparent entity, the operation will constitute a foreign-branch separate unit.

Regs. Sec. 1.1503(d)-1(b)(4)(ii) provides that if a U.S. corporation (or two or more U.S. corporations that are members of the same consolidated group) has two or more separate units (individual separate units), all such individual separate units located or subject to income tax on their worldwide income or on a residence basis in the same foreign country are treated as one separate unit (combined separate unit). (8) DRCs are not combined under this rule. Generally, when the separate unit combination rule applies, the individual separate unit is no longer treated as a separate entity.

Other Entities

1. Non-hybrid-entity partnerships and grantor trusts: A non-hybrid-entity partnership and a non-hybrid-entity grantor trust (9) are not considered DRCs or separate units for purposes of the DCL rules; (10) however, they may subject their partners or beneficiaries to the DCL rules if these entities own a DRC or separate unit.

2. Transparent entity: This is an entity directly or indirectly owned by a domestic corporation that is (1) not taxable as an association for federal tax purposes; (2) not subject to foreign income tax at an entity level on its worldwide income or on a residence basis; and (3) not a passthrough entity under the laws of the foreign country (Regs. Sec. 1.1503(d)-1(b)(16)). The relevant foreign country is the country in which the foreign-branch separate unit is located, or the country that subjects the hybrid entity or DRC to an income tax on a worldwide or residence basis. An example of a transparent entity is a U.S. limited liability corporation (LLC) that does not elect to be taxed as an entity for U.S. income tax purposes and is a non-passthrough entity for foreign tax purposes, but not subject to foreign income tax. The 2007 DCL regulations introduced the concept of a transparent entity to ensure that the income and losses attributed to such entity were not attributed to a separate unit.

3. Domestic reverse hybrid: This is an entity taxed as a corporation for U.S. tax purposes but fiscally transparent for foreign tax purposes. These entities are not separate units or DRCs. (11)

   Determining Whether a DRC or a Separate Unit Incurred a DCL

   Once the existence of a DRC or separate unit of a U.S. corporation is established, the next step is to determine whether the DRC or separate unit incurred a DCL. Note that, even if a DRC or separate unit did not incur a DCL in the current year, it may have to file an annual certification for a DCL for five years following the year in which the DCL was incurred. In addition, the DRC or the U.S. corporation may be able to offset a prior-year DCL subject to the domestic-use limitation against current-year income earned by the DRC or the separate unit.

   DCL of a DRC

   A DCL is generally defined as a Sec. 172(c) NOL incurred in a year in which the entity is a DRC (Regs. Sec. 1.1503(d)-1(b)(5)(i)).To determine if the DRC has income or an NOL, only items of income, gain, deduction, or loss incurred by the DRC in the current year will be taken into account. (12) Under Regs. Sec. 1.1503 (d)-5(b)(2), items that will not be taken into account include (1) the DRC's net capital losses; (2) carryover or carryback losses; and (3) items of income, gain, deduction, and loss attributable to a separate unit or a...