Proposed regulations affect form of funding international operations.

• Author: Kingsley, William P.

Recently proposed regulations under Sec. 865(j) generally provide that any loss on the sale of stock in a foreign affiliate by a U.S. shareholder will be considered a U.S. loss. This is a dramatic reversal from the characterization of the loss under existing regulations. However, the U.S.-source treatment for the loss applies only to stock investments in foreign affiliates and does not presently extend to debt, derivative financial products and other common financing arrangements used to fund overseas operations.

Since 1986, Sec. 865 has provided for sourcing gains on the disposition of personal property (including stock), but no guidance had been provided for sourcing losses. Rather, the determination of the source of losses has been based on pre-1987 Regs. Sec. 1.861-8 and affirmed by the courts in Black & Decker, TC Memo 1991-557, aff'd, 4th Cir., 1993.

Gains from personal property sales are sourced to the seller's residence under Sec. 865, with some exceptions. In particular, under Sec. 865(f), the source of the gain will be foreign when a U.S. resident sells stock in a foreign affiliate (defined in Sec. 865(i)(4)), if the sale occurs in a foreign country in which the affiliate is engaged in the active conduct of a trade or business and more than 50% of the affiliate's gross income during the three immediately preceding tax years was derived from the active conduct of a trade or business in that foreign country. Of course, Sec. 865(f) applies only to any gain that exceeds amounts recharacterized as dividends under Sec. 1248 (which generally are sourced to the payor's residence).

Personal property losses have been sourced under the pre-1987 regulations, which matched the source of these losses with the source of the income ordinarily generated by the underlying asset (Regs. Sec. 1.861-8(e) (7)). For example, a bad debt deduction for a worthless note from a foreign subsidiary would be considered foreign, since the interest generated by the note would be foreign source. The courts have supported this treatment In Black & Decker, a loss on the stock of a wholly owned Japanese subsidiary was considered foreign source, since dividends from that stock would be foreign source.

However, Prop. Regs. Sec. 1.865-2(a) would instead allocate the loss on a disposition of stock in a foreign affiliate to the seller's residence. A "disposition" includes a worthless stock...