API Recommends Modifications to Dual Consolidated Loss Regs

On behalf of its members, the American Petroleum Institute would like to take this opportunity to submit comments to the proposed regulations addressing Dual Consolidated Losses (REG-102144-04) that were issued May 19, 2005. Should you have any question regarding these comments, please do not hesitate to contact me at 202-682-8455.

Background

Section 1503(d) of the Code, which was adopted by the Tax Reform Act of 1986, provides that a dual consolidated loss shall not offset the income of any other member of the affiliated group. A dual consolidated loss ("DCL") is defined in section 1503(d)(2)(A) of the Code as any net operating loss of a domestic corporation which is subject to an income tax of a foreign country, either on a worldwide basis or on a residence basis, without regard to the source of the income.

The legislative history shows that Congress was concerned that corporate groups were artificially isolating expenses to concentrate losses that could be used to offset income in two separate taxing jurisdictions. In response to such taxpayer conduct, Congress enacted section 1503(d) of the Code, which provides that if a U.S. corporation is subject to a foreign country's tax on either a worldwide income or residence basis, then any net operating loss of such corporation could not reduce the taxable income of any other member of the corporation's U.S. affiliated group. Congress specifically authorized the issuance of regulations that would exclude from the definition of a DCL any loss which, under the foreign income tax law, did not offset the income of any foreign corporation.

The regulations addressing DCLs have gone through a number of changes over the years. The current regulations allow taxpayers to use a DCL in the calculation of its U.S. tax only if the taxpayer certifies that no portion of the loss has been or will be used by another person in calculating the tax imposed by a foreign country.¹ If such foreign use occurs, the taxpayer must recapture the loss as gross income. The proposed regulations maintain much of the structure of the current regulations but they introduce some changes in order to address potential over and under-application of the current rules. The new rules are also meant to address issues arising from the entity classification regulations and reduce the administrative burden of complying with the regulations.

API appreciates the government's effort to streamline and better focus the DCL rules to practical issues facing taxpayers. API also understands that the development of the proposed regulations necessarily took into account many competing issues and interests. However, we wish to comment on several areas of the proposed regulations to highlight problems we see in how the regulations operate and suggest changes that will make the regulations easier to administer.

Administrative Issues Raised By the Proposed Regulations

However, the proposed regulations (including the new domestic use election) and the application of the 7-year certification period would apply on a prospective basis only.⁴ Elections that have been made by a taxpayer in earlier years under the current agreement mechanism will remain in effect and the 15-year certification requirement will still apply. Therefore, the proposed regulations would set up a system whereby taxpayers and the government would be forced to operate under two regimes for a period of time. Indeed, in many instances, taxpayers will have to contend with the old certification regime for older DCLs long after the certification period for the newer DCL expires. This will clearly exacerbate the administrative burdens for both taxpayers and the government, which is contrary to the stated rationale for revising the regulations to include a shorter certification period.

We appreciate the complexities of applying the new methodology contained in the proposed rules to existing taxpayer circumstances, but API and its member companies believe that the prospective nature of the proposed regulations is too restrictive. Mandating a dual tracking system is contrary to the avowed goal of reducing the administrative burden imposed on taxpayers by the regulations. This is especially the case when so many of the operative rules in the proposed regulations (i.e. the definition of a DCL, what constitutes triggering events, how a taxpayer presents rebuttals, etc.) have not undergone substantial change.

As an initial suggestion on the certification process, we urge the IRS and Treasury to revisit the shortened annual certification period and amend it to a 5-year period. Given that there was no stated reason why seven years was chosen to be the new shortened period, we believe the adoption of a 5-year period would certainly mitigate the compliance issues further and be consistent with other certification periods found in the regulations.⁵ In addition, we also suggest that the new regulations allow taxpayers to utilize the shorter certification period for all currently existing, as well as newly created, DCLs. According to the preamble to the proposed regulations, the 15-year certification period is considered to be "unnecessarily burdensome to both taxpayers and the Commissioner". Allowing for a shorter certification period for all DCLs would lead to a significant reduction in the administrative burden, thereby fulfilling the intent of the regulations. The greatest benefit to adopting this approach would be that DCLs that predate the issuance of the final regulations by more than the new certification period would no longer have to be certified. This approach would promote equity among taxpayers, since taxpayers with older DCLs would be effectively punished with longer certification periods than taxpayers that incurred DCLs after the issuance of the final regulations.

In the alternative, we would suggest that taxpayers be allowed to elect to apply the new rules to their existing inventory of DCLs, as if the new rules were in place when older DCLs were created. The election would allow taxpayers to review their structures and DCL situations, such that taxpayers with only basic branch structures would not have much change but would be entitled to the reduced certification period offered by the domestic use election. Taxpayers with potentially substantial separate unit reporting in prior years could assess the administrative burdens and possibly elect to apply the regulations on a prospective basis only.

This approach is similar to the approach that was adopted for the changes in the regulations under section 367 of the Code on the term length for certifying "gain recognition agreements".⁶ Under those regulations, taxpayers electing to apply the new regulations to such transfers were allowed to change existing 10-year gain recognition agreements on stock transfers occurring after December 16, 1987 to 5-year agreements beginning in the taxable year of the initial transfer.⁷ As a result, electing taxpayers with transfers older than five years prior to the date of the election were no longer required to file annual certifications.

We believe the substantial administrative burdens and potential adverse tax impacts of certifying DCLs for these entities are mitigated only slightly by the shorter certification period. There is no indication that DCLs of foreign branch separate units are not currently being tracked by taxpayers or available for review upon audit request. In addition, since failure to certify a DCL is a triggering event, a whole new group of DCLs will be subject to recapture merely because of a formalistic failure to certify.⁹ This will almost certainly result in taxpayers seeking relief under the proposed review process¹⁰ and impose additional burdens on the government, which is already strained by requests for relief stemming from unintentional triggering events (e.g., the failure to certify DCLs for entities covered by the current regulations).

Accordingly, since such DCLs are already accounted for by taxpayers in a manner that can be audited by the IRS, we request that the reporting expansion of the certification requirement to cover foreign branch separate units be removed from the proposed regulations before they are finalized. In the alternative we would urge that the new regulations address practical compliance issues that are sure to arise. For example, in the case where a foreign branch separate unit has deregistered in a foreign jurisdiction, it should no longer have to continue to certify any DCLs. Therefore, a triggering event exception should be available in the regulations or through a revenue procedure for such a situation.

Operative Issues Raised by the Proposed Regulations

Under the current regulations, if two or more foreign branches located in the same country are owned by a single domestic corporation and losses in those branches can offset income of other branches under the laws of the foreign country, then the branches may be treated as one separate unit.¹¹ However, the current regulations do not allow the combination of branches if the branches have different domestic owners, even if those owners are part of the same U.S. consolidated group. The preamble to the proposed regulations asks for comments on whether the government has the authority to allow for the combination of separate units located in the same country but owned by different domestic corporations.

It is our opinion that the IRS and Treasury have authority to allow for the combination of separate units if owned by different domestic corporations within the same U.S. consolidation. The regulatory authority under section 1502 of the Code grants the government the ability to establish broad rules in how tax is to be computed for consolidated groups under section 1503 of the Code. Many of these rules rely upon the assumption that the different domestic corporations of the consolidated group are treated as if they were divisions of the same basic corporation for tax purposes. As the determination of how DCLs are calculated and applied are include in section 1503 of the Code, the government should be able to consider different domestic owners of separate units as divisions of the same domestic corporation for purposes of the DCL rules as well. Ultimately the issue boils down to how the term "a domestic corporation" is defined in section 1503(d)(3) of the Code. The government has already exercised the broad regulatory authority granted to it by Congress in defining the term "domestic corporation", "dual resident corporation" and other similar terms in the current regulations under section 1503 of the Code.¹² API believes that the government would not be exceeding its authority by issuing regulations containing a broader combination rule.

Combining separate units in the manner describe above raises additional questions, however. API would welcome the simplification which would accompany an expanded separate combination rule, but would be concerned about the potential adverse impacts of such a rule in the area of recapturing losses after a triggering event. To minimize the adverse impacts, we urge the adoption of a trigger limitation rule to avoid the wholesale recapture of all the losses of all the combined separate units if a triggering event only involved one of the separate units. We believe the regulation can be crafted to require only for the selective recapture of a separate unit's portion of a combined DCL.

As an initial point, API believes that the government should make a concerted effort to fulfill Congress' intent and negotiate bilateral agreements for loss sharing with the existing foreign mirror jurisdictions rather than just leave taxpayers with denied losses in all jurisdictions. It has been nearly 20 years since the anti-mirror rule was published and there has apparently been no progress in this regard. In addition, in the absence of a governmental effort to negotiate such agreements with foreign jurisdictions, the government should issue guidance, by way of revenue procedure or notice, identifying foreign jurisdictions with mirror legislation rules and how the U.S. rules interact with such rules.

With regard to the anti-mirror provisions, we urge the government to revise the rule to limit its application only to instances where the U.S. taxpayer has more than one entity in the foreign jurisdiction.¹⁴ We do not understand why there should be a concern with foreign use if the dual resident corporation held by the U.S. company is the only operating entity in the applicable foreign jurisdiction. Domestic use of such a loss could be allowed under such circumstances without compromising the intent of the anti-mirror rule, as there is simply no possibility for abuse. Therefore, when the dual resident entity is the only operating entity in the applicable foreign jurisdiction, any losses generated by such an entity should be made available for use on U.S. consolidated tax returns. Certainly, if the domestic corporation acquires or establishes another entity that is not a member of the domestic consolidated group in the jurisdiction with the mirror rule, then a domestic use election would not be available for any new losses generated since the foreign mirror rule would only then have operative effect.

Rebuttal of Triggering Events

Under the current regulations, a taxpayer must recapture a DCL upon a triggering event if it has elected to use the DCL in calculating its U.S. income tax.¹⁵ The triggering events identified in the current regulations are, with slight modifications, generally carried over and included in the proposed regulations. Further, the proposed regulations follow the current regulations and still allow taxpayers the ability to rebut triggering events upon demonstrating to the satisfaction of the Commissioner that there is no opportunity for any portion of the DCL to be used to offset the income of any other person under the income tax laws of a foreign country or the transfer of assets did not result in a carry over under foreign law of the losses to the transferee.

In bolstering its effort to better guide taxpayers and alleviate some of the administrative burden associated with rebuttal claims, the government anticipates issuing a revenue procedure listing safe harbors that, if applicable, will allow that triggering event to be deemed rebutted. API and its member companies believe that the idea of clarity on the rebuttal process and safe harbors outlining rebuttal situations will be of great administrative benefit to taxpayers and the government. Toward that end, and in response to requests for comments on transactions or situations that could be included in the revenue procedure, we offer the following suggestions for consideration.

First we suggest that the triggering mechanism contained in the proposed regulations be applied only in circumstances where the amount of the foreign use of a DCL exceeds a certain de minimis level. Under this proposal, if a taxpayer can demonstrate that the foreign use of DCL does not exceed the de minimis threshold, the foreign use would not trigger the entire DCL. For purposes of this proposal, we believe that the de minimis level should be 10 percent of the certified DCL.

Additionally, we urge the adoption of a blanket rule that would exempt foreign use of DCLs of $5 million from the triggering and recapture rules. API believes that adopting a de minimis exception to the triggering events will promote administrative efficiency and lessen burdens on taxpayers. To the extent that the government is concerned with potential taxpayer abuses, an additional rule could be adopted which would prevent taxpayers from converting the de minimis exception into a vehicle to systematically make foreign use of DCLs in amounts which would not be triggered under the de minimis rules.

In addition, API would also support the use of a pro rata recapture rule to alleviate the results from the all-or-nothing approach. A pro rata approach would recognize that the foreign use of DCLs may be limited in the case of a triggering event, especially where the DCLs of several entities are consolidated under the combination rule. In that case, the transfer of one of the entities or the sale of assets may not allow for the foreign use of all the combined losses. A pro rata approach could, therefore, add some equity and fairness in these situations.

In a somewhat similar situation, sometimes the locations in which our operations take place could be subject to various governmental sanctions, limiting our companies' ability to legally conduct business. In these situations, the separate unit may be forced by the local government to default on the license leading to a transfer of the right and a triggering event. In other situations, the local government may nationalize the interest outright. Both situations are the result of political actions that are out of the control of the dual resident entity. However, they might be seen as triggering events under the current rules. To avoid this unfair outcome, we believe that such situations should be included as de facto rebuttals to the triggering event included in any upcoming revenue procedure.

We note, though, that the government is contemplating the use of closing agreements that taxpayers can enter into with the Commissioner such that certain other events will not constitute a triggering event. API and its members believe that this is an appropriate alternative for the government to consider in cases where the facts may not be squarely covered by the revenue procedure but still meet similar criteria. Should the fact situations noted above not be covered by the revenue procedure, we would suggest that some indication be given that they could still be candidates for such agreements. Certainly, inclusion of these situations within the upcoming revenue procedure would provide a quicker and more automatic method for addressing the potential triggering event. However, absent that inclusion, we would appreciate consideration of these transactions under any closing agreement framework structured by the government.

Conclusion

The API and its member companies appreciate the opportunity to comment on these proposed regulations. We recognize that the situations in which they apply can be quite complex and applaud the effort to reduce the complexity and administrative burdens associated with the current rules. However, we believe that the proposals outlined above will further reduce the complexities without undermining the general purpose of the regulations. Should you have any questions regarding our suggestions or wish to discuss them further, please do not hesitate to call Stephen Comstock at 202-682-8455.

² Prop. Treas. Reg. § 1.1503(d)-4(d)(1)(v).

³ Treas. Reg. § 1.1503-2T(g)(2)(vi)(B).

⁴ Prop. Treas. Reg. § 1.1503(d)-6.

⁵ Treas. Reg. § 1.367(a)-8(b)(5).

⁶ Treas. Reg. § 1.367(a)-3(e)(2).

⁷ Treas. Reg. § 1.367(a)-3(f).

⁸ Prop. Treas. Reg. § 1.1503(d)-4(g).

⁹ Prop. Treas. Reg. § 1.1503(d)-4(e)(viii)

¹⁰ Prop. Treas. Reg. § 1.1503-1(c)(1).

¹¹ Treas. Reg. § 1.1503-2(c)(3)(ii).

¹² Treas. Reg. § 1.1503-2(c).

¹³ Prop. Treas. Reg. § 1.1503(d)-1(b)(14)(v).

¹⁴See, Prop. Treas. Reg. § 1.1503(d)-5(c) Example 21.

¹⁵ Treas. Reg. § 1.1503-2(g)(2)(iii).

¹⁶ Treas. Reg. § 1.1503-2(g)(2)(iii)(A)(4). Prop. Treas. Reg. § 1.1503(d)-4(e)(1)(iv).