Sourcing of losses on foreign subsidiary stock sales.

• Author: Goodman, Mark E.

On duly 8,1996, the IRS issued proposed regulations under Sec. 865 setting forth rules for sourcing losses from stock sales. The preamble to the proposed regulations states that they are "necessary to modify existing guidance with respect to stock losses."

Prior to 1987, taxpayers that derived income from the sale of personal property sourced such income under the "title passage" rule. This rule allowed taxpayers enormous flexibility in determining the sourcing of such income. In 1986, Congress enacted Sec. 865 as part of the Tax Reform Act of 1986 (TRA), which provides that the sale of noninventory personal property generally will be sourced at the seller's residence.

In enacting Sec. 865, Congress intended to modify the general "title passage" rule, with the goal of preventing the easy manipulation of sourcing the income from domestic to foreign source. Therefore, as a general rule under Sec. 865(a), income derived from the sale of personal property is sourced to the seller's residence.

In explaining the purpose behind the residency rule, the House Committee Report stated:

Source rules for sales of personal property should reflect the location of the economic activity generating the income at issue or the place of utilization of the assets generating that income....Because the residence of the seller generally is the location of much of the underlying activity that generates income derived from sales of personal property, the committee believes that sales income generally should be sourced there.

In Sec. 865(j)(1), Congress also directed the Service to issue regulations that would provide that losses from sales of noninventory personal property generally will be allocated consistently with the source of income that gains would generate. Under pre-TRA law, the source of losses on stock sales was governed by Sec. 861(b). In this regard, Regs. Sec. 1.861-8(e)(7)(i) provides that such losses are allocable to the class of gross income to which such asset ordinarily gives rise in the hands of the taxpayer.

In its 1991 decision in Black & Decker Corp., TC Memo 1991-557, aff'd, 986 F2d 60 (4th Cir. 1993), the Tax Court held that a 1981 worthless stock loss claimed when the taxpayer's stock in its wholly owned Japanese subsidiary became worthless was entirely allocable to sources outside the U.S. The court found that the taxpayer's investment in the stock of its foreign subsidiary would ordinarily give rise to foreign -source dividend income...