The new DCL regulations: new rules and contracts.

• Author: Bracuti, Guy A.
• Position: Dual consolidated losses

Introduction

1. Background and Policy

   On March 19, 2007, the U.S. Department of the Treasury and the Internal Revenue Service (collectively, the IRS) filed with the Federal Register final regulations under section 1503(d) of the Internal Revenue Code regarding dual consolidated losses (DCLs). (1) The 2007 Regulations finalize proposed regulations issued on May 19, 2005 and replace existing regulations that were issued in 1992 (the 1992 Regulations) (2) for DCLS incurred in taxable years beginning on or after April 18, 2007. (3)

   Congress added section 1503(d) to the Code in 1986. (4) Initially, section 1503(d) was a fairly narrow provision that was enacted to address an "inbound" dual resident acquisition vehicle transaction that provided certain foreign multinationals with a competitive advantage over their domestic corporate counterparts. (5) The transaction involved the acquisition of a domestic corporation (U.S. Target Corporation) through the use of a dual resident acquisition corporation (DRAC). A foreign multinational would form a domestic corporation and make it a resident of the foreign jurisdiction so that the DRAC could join in foreign consolidation and share losses with the foreign multinational group. (6) The DRAC would then borrow acquisition funds and acquire the stock of the U.S. Target Corporation, thus making the DRAC the parent of the U.S. consolidated group. The DRAC would incur a loss on a separate company basis equal to the interest expense attributable to the acquisition debt. The DRAC would reduce the U.S. consolidated taxable income by this loss, and the foreign multinational group would use that same loss in calculating the foreign income tax liability of the foreign multinational group.

   Congress concluded that this dual interest deduction (commonly referred to as a "double dip") provided foreign multinationals with a competitive advantage over their domestic corporate counterparts because foreign multinationals that could double dip the deduction would be willing to pay a premium for the U.S. Target Corporation.

   Congress decided to address this unfair competitive advantage by amending the Code to include new section 1503(d), which provides:

   (d) Dual consolidated loss.

   (1) In general. The dual consolidated loss for any taxable year of any corporation shall not be allowed to reduce the taxable income of any other member of the affiliated group for the taxable year or any other taxable year.

   (2) Dual consolidated loss. For purposes of this section--

   (A) In general. Except as provided in subparagraph (B), the term "dual consolidated loss" means any net operating loss of a domestic corporation which is subject to an income tax of a foreign country on its income without regard to whether such income is from sources in or outside of such country, or is subject to such a tax on a residence basis.

   (B) Special rule where loss not used under foreign law. To the extent provided in regulations, the term "dual consolidated loss" shall not include any loss which, under the foreign income tax law, does not offset the income of any foreign corporation.

   Section 1503(d) denies the ability of a U.S. consolidated group to use a loss incurred by a DRAC to offset the U.S. consolidated group's taxable income and, thereby, effectively ends the competitive advantage created by the DRAC transaction. Of such virtuous purpose the DCL rules were born, but an interesting thing happened while Congress was making technical corrections to the 1986 Act: Congress apparently extrapolated from the DRAC transaction that nearly all double dipping constituted improper tax arbitrage. Accordingly, in 1988 Congress amended section 1503(d) to include new section 1503(d)(3), which provides:

   (3) Treatment of losses of separate business units. To the extent provided in regulations, any loss of a separate unit of a domestic corporation shall be subject to the limitations of this subsection in the same manner as if such unit were a wholly owned subsidiary of such corporation. (7)

   In explaining this new provision, Congress said that losses incurred by a "clearly identifiable unit of a trade or business" of a domestic corporation should, pursuant to regulations issued by IRS, be subject to the DCL limitation. (8) Congress used a foreign branch as an example of a "clearly identifiable unit of a trade or business," but it provided no other guidance regarding what it meant when it created the term "separate unit" in section 1503(d)(3). (9)

   The IRS responded with Treasury Decisions containing extraordinarily complex regulations. (10) In doing so, the IRS synthesized its own definition of double dipping: the use of single economic deduction to offset or reduce two streams of income, one of which is not immediately subject to U.S. income tax. (11) Although a perfectly logical extension of Congress's stated concern, this definition--coupled with the amorphous notion of "clearly identifiable units"--resulted in the massive expansion of the potential reach and application of the DCL rules to nearly all losses incurred by foreign operations of domestic corporations.

   The IRS's mandate in drafting the DCL rules (even though arguably self-augmented) is rather onerous because determining whether each corporate deduction is currently available or will be available to offset two streams of income necessarily requires a detailed analysis of both U.S. law and foreign law. Indeed, some commentators have quipped that the DCL rules result in the IRS and taxpayers chasing deductions around the globe to make sure they are not being used to offset two streams of income. This metaphor is apt and helps explain the mind-numbing complexity of the DCL rules.

   In 2000, the IRS issued Rev. Proc. 2000-42, which provides guidance on executing closing agreements pursuant to Treas. Reg. [section] 1.1503-2(g)(2)(iv). (12) In the revenue procedure, the IRS noted that the reach and effect of the DCL regulations was significantly increased by the adoption of the entity classification regulations under Treas. Reg. [section] 301.7701-3 (check-the-box, or CTB, rules).

   The 2007 Regulations were issued to address structures and transactions that were not addressed by the 1992 Regulations, to resolve issues created by the CTB rules, to simplify some of the unnecessarily complex rules, and to decrease the attendant compliance burdens. The 2007 Regulations are contained in Treas. Reg. [section][section] 1.1503(d)-1 through -8. The 2007 Regulations (including the Preamble) are long and fill 44 triple-column pages of the Federal Register and contain 58 examples (including the alternate factual scenarios).

2. The Basic Framework

   The DCL rules are complex and have been the source of significant frustration for tax professionals since 1989. The 1992 Regulations and the 2007 Regulations employ the same basic regulatory framework, an understanding of which is essential in analyzing the DCL rules. In a nutshell, the DCL rules trap deductions incurred by a DRC (or a separate unit) and ring-fences the deductions so that they are available only to reduce the past or future income of the DRC (or separate unit) that incurred the DCL. The rules then allow the domestic corporate owner of the DRC (or separate unit) to release these deductions--and, therefore, use them to reduce income generated outside the DRC (or separate unit)--by permitting the domestic corporate owner to enter into a contract with the IRS whereby the domestic corporate owner ensures that the deductions have not been and will not be used to reduce income on a foreign income tax return.

   Thus, the DCL rules consist of a general rule preventing the use of a DCL to reduce U.S. income and an elective regime that enables the domestic corporate owner to avoid the effect of the general rule. In DCL nomenclature, the general rule prohibits the "Domestic Use" of a DCL, unless the domestic corporate owner files a "Domestic Use Election" for such DCL.

3. Overview of this Article

   This article provides an overview of the 2007 Regulations and discusses the most important provisions in detail. In doing so, this article discusses analogous provisions of the 1992 Regulations in order to compare, contrast, and explain reasons for any significant changes. Finally, this article highlights certain traps for the unwary and provides suggestions for analyzing and managing DCL issues.

   General Rule and Definitions

1. The General Rule

   Although oddly placed in the middle of the regulations, the general rule under the 2007 Regulations is elegant in its simplicity and brevity: "Except as provided in [section] 1.1503(d)-6, the domestic use of a dual consolidated loss is not permitted." (13) The elegance of this rule is illustrated by simple contrast to the general rule contained in the 1992 Regulations, which accomplishes essentially the same result:

   Except as otherwise provided in this section, a dual consolidated loss of a dual resident corporation cannot offset the taxable income of any domestic affiliate in the taxable year in which the loss is recognized or in any other taxable year, regardless of whether the loss offsets income of another person under the income tax laws of a foreign country and regardless of whether the income that the loss may offset in the foreign country is, has been, or will be subject to tax in the United States. (14) The general rule contained in the 2007 Regulations achieves its simplicity by assigning much of its operation to the definition of "Domestic Use," a term that does not exist in the 1992 Regulations. The prefatory clause of the general rule referring to Treas. Reg. [section] 1.1503(d)-6 is, generally, a reference to the Domestic Use Election regime. (15)

2. Dual Consolidated Loss

   A DCL is, generally, a net operating loss (NOL) of a DRC or a "net loss attributable to" a separate unit (SU). (16) A number of complex attribution rules apply in calculating a DCL. (17)

3. Dual Resident Corporation

   A DRC is a...