A U.S. corporation may decide initially to run its foreign operations in branch form if those operations are loss-making and later incorporate the foreign branch when it becomes profitable. The U.S. corporation may use the losses incurred by the branch to reduce its U.S. taxable income in the earlier years and then must recapture prior losses upon the foreign branch's incorporation.
The U.S. corporation thus must consider the applicability of several recapture rules at the time of the incorporation, including the overall foreign loss (OFL) recapture rules of Sec. 904(f)(3), the branch loss recapture rules of Sec. 367(a)(3)(C), and the dual consolidated loss (DCL) recapture rules of Regs. Sec. 1.1503(d)-6. This item discusses the interaction between two of these recapture rules--OFL recapture and branch loss recapture--triggered by a branch incorporation, especially when the losses to be recaptured exceed the gains to be recognized.
Sec. 904(f)(3) Recapture
Sec. 904(f)(1) provides generally that if a taxpayer had a foreign loss that it used to reduce its U.S.-source taxable income and in a later year has foreign-source income, it must treat all or part of the foreign-source income as U.S.-source income. Applied after Sec. 904(f)(1), Sec. 904(f)(3) requires additional recapture in a year in which there is a disposition of trade or business assets used or held for use predominantly outside the United States. Specifically, Sec. 904(f)(3)(A)(i) provides that the taxpayer shall be deemed to have received and recognized taxable income from foreign sources in the tax year of the disposition.
The term "disposition" is defined broadly to include any transfer of property regardless of whether gain or loss otherwise is recognized. Under that definition, the incorporation of a foreign branch constitutes a disposition for purposes of Sec. 904(f)(3), and the U.S. corporation may be required to recognize income to recapture an OFL account. The amount to be recaptured upon a branch incorporation generally is the amount of the built-in gain in the branch assets, limited to the balance in the OFL account (Regs. Sec. 1.904(f)-2(d)(4)(i)).
Sec. 367(a)(3)(C) Recapture
Sec. 367(a)(3)(C) was enacted to prevent a U.S. company from using losses of a foreign branch to offset its taxable income without having to pay U.S. tax on the associated future income after the branch's incorporation. This provision requires a U.S. corporation to recognize any built-in gain in...