Deloitte Tax Suggests Changes to U.S. Dual Consolidated Loss Rules to Relieve Burdens

Dear Mr. Caballero and Mr. Musher:

On behalf of a client, this letter describes issues that merit review of the undue burdens imposed by the section 1503(d) dual consolidated loss (DCL) regulations that apply to U.S. multinational corporations operating outside of the United States through branches or hybrid entities. These issues arise as a result of the interaction of three aspects of the regulations: the separate unit combination rule, "the all or nothing" principle, and the de minimis exceptions to foreign use of dual consolidated losses. Together, these rules impose unnecessary restrictions on U.S. corporations, and do not further the statutory objective of section 1503(d). We do not believe that either Congress or the Treasury and IRS intended the DCL rules to apply in this manner.

After providing some background, this letter describes the current application of the regulations with two "real life examples." It then discusses each of the separate unit combination, all or nothing, and de minimis rules and recommends modifications to each rule to address the concerns illustrated by the examples.

Background

Combination Rule

A threshold inquiry under the DCL rules is whether a taxpayer's loss was incurred by an entity subject to the DCL rules. Accordingly, the definition of a "dual resident corporation" and a "separate unit" are essential elements of the section 1503(d) regime. The 2007 regulations define a separate unit to include both U.S. domestic corporations' foreign branches (foreign branch separate units) and their interests in hybrid entities (hybrid entity separate units). Equally important are the instances when these units are combined.

The 2007 final regulations state a very broad separate unit combination rule. Treas. Reg. § 1.1503(d)-1(b)(4)(ii) generally combines all "same-country" separate units within a U.S. consolidated group, regardless of whether the units are owned by the same or different group members, and regardless of whether the separate units are affiliated or even related under local law. For this purpose, "same country" separate units are those units that are located in a foreign country (foreign branch separate units) or that are subject to the same foreign income tax on either their worldwide income or on a residence basis (hybrid entity separate units).

While the regulations require taxpayers to compute the items of income and loss attributable to each individual separate unit, the combination rule applies for purposes of determining a taxpayer's country-by-country DCL for the year, as well as for the triggering event and recapture rules. Moreover, the combination rule is mandatory: if the regulatory requirements are met a consolidated group must combine all of its same-country separate units. In contrast, the 1992 DCL regulations' combination rule only applied to foreign branches held by a single domestic owner.

Foreign Use

The definition of foreign use is central to the 2007 Regulations. The existence or absence of a foreign use determines whether or not a DCL can be used to offset the income of a domestic affiliate. If a foreign use exists, then the domestic use limitation applies to restrict the amount of the DCL that may offset a domestic affiliate's income. In addition, any foreign use of a DCL that was previously the subject of a domestic use election will invoke the DCL recapture and interest charge rules.

The 2007 Regulations look to both foreign and U.S. income tax law to determine whether a foreign use has occurred. Under Treas. Reg. § 1.1503(d)-3(a)(1), a foreign use is generally deemed to occur when:

The All or Nothing Principle

As applied in the context of foreign use, the all or nothing principle states that a single dollar or unit of foreign use taints the entire DCL. As noted above, a foreign use arises "if any portion" of a DCL is made available for a foreign use. Similarly, for purposes of the Treas. Reg. § 1.1503(d)-6(e)(2) triggering event rebuttals, the all or nothing rule provides that a year's DCL cannot be rebutted if there can be any foreign use of the DCL following the presumed trigger, or if any item comprising the DCL carries over as a result of an asset transfer.

De Minimis Exceptions to Foreign Use

The 2007 regulations state two "de minimis exceptions" to the definition of foreign use. Treas. Reg. § 1.1503(d)-3(c)(5) provides an exception for a foreign use that arises as a result of a reduction in a domestic owner's interest in the separate unit. Under this exception, a reduction in a domestic owner's interest will not be considered de minimis if:

Treas. Reg. § 1.1503(d)-3(c)(6) states a similar exception for a foreign use that arises as a result of a transfer of a separate unit's or dual resident corporation's assets. This exception provides a 10 percent and 30 percent cap. In particular, the de minimis asset transfer exception does not apply if:

In light of the broad definition of a foreign use and its risk of "over inclusion," the 2007 regulations contain several additional exceptions to narrow the application of the foreign use rules. Moreover, the regulations provide a "catch all provision" to allow the Treasury and the IRS to refine the foreign use definition. Pursuant to Treas. Reg. § 1.1503(d)-3(c)(9) "[t]he Commissioner may provide, by guidance published in the Internal Revenue Bulletin, that certain events or transactions do or do not result in a foreign use." This provision allows Treasury and the IRS to clarify and refine the scope of the foreign use rule without amending the regulations themselves.

Examples

Basic Facts: U.S. Parent (USP) is the parent of an affiliated group of corporations that files a consolidated federal income tax return. The USP group has substantial operations in Country A that it conducts through foreign branches and disregarded entities. In addition, the USP group participates in Country A joint ventures through hybrid partnerships, including ventures where the USP group holds minority non-controlling interests, some 2 percent-or-less interests.

The USP group Country A combined separate unit has incurred substantial prior- and current-year losses. The group has made domestic use elections with respect to the prior-year losses, and expects to file an election for the current-year loss as well.

Situation I: During the current taxable year, the USP group disposes of 10% of the assets of its Country A combined separate unit. This transaction does not give rise to a foreign use, as defined in Treas. Reg. § 1.1503(d)-3(a)(1) because there is no foreign use without reliance on any of the foreign use exceptions.

Also in the current year, a USP Country A disregarded entity transfers an employee to a wholly owned Country A Subsidiary. (Subsidiary is a foreign corporation for U.S. income tax purposes.) Under local company protocols, employee retains his company-issued laptop computer when reassigned. Laptops have a longer useful life under Country A law, which also treats the laptop transfer as a carryover basis transaction.

Situation II: During the current taxable year, the USP group disposes of 10% of the interest in its Country A combined separate unit. This transaction does not give rise to a foreign use, as defined in Treas. Reg. § 1.1503(d)-3(a)(1) because there is no foreign use without reliance on any of the foreign use exceptions.

Also in the current year, a 2 percent USP group-owned hybrid partnership acquires another Country A Entity. (Entity is a foreign corporation for U.S. income tax purposes.) Without USP group assent or knowledge, the hybrid partnership and its new subsidiary decide to file a Country A consolidated return. The USP group learns of this decision and considers whether it should sell this investment to its local co-owners. The investment represents less than 1 percent of the USP group combined separate unit.

Discussion

Both Situation I and Situation II illustrate the extraordinary breadth of the current DCL regime. Under the regulations, both Situations would require the USP group to recapture its prior-year Country A DCLs, plus interest, and would subject the current-year Country A loss to the Treas. Reg. § 1.1503(d)-4 domestic use limitation. The only way to avoid this result would be for the USP group to substantially alter its business conduct.

With respect to Situation I, the USP group would have had to forgo disposing of 10% of the Country A combined separate unit assets, regardless of the fact that such a disposition in no way gives rise to a foreign use. Alternatively, the group would have to attempt to monitor and micro-manage its Country A intra-group employee or asset transfers in an effort to prevent any deferred deductions under local law.

With respect to Situation II, the USP group would have had to forgo disposing of 10% of its interest in its Country A combined separate unit, again regardless that such disposition does not give rise to a foreign use. As a minority owner in Situation II, USP cannot affect the decision to file a local consolidated return.¹ Also, while USP can sell its 2 percent interest to a local co-owner, such sale would not avoid a foreign use and triggering event.

These Situations arise from the current regulations' separate unit combination and all or nothing rules, abetted by the limited scope of the de minimis exceptions to foreign use. Treas. Reg. § 1.1503(d)-1(b)(4)(ii) requires a U.S. consolidated group to combine its same-country foreign branch and hybrid entity interests, no matter how numerous or disparate. Under the all or nothing principle a single dollar of foreign use taints the entire year's DCL, including DCLs of combined separate units of any size. Finally, the Treas. Reg. § 1.1503(d)-3(c) de minimis exceptions, which do not apply in any 12-month period when a U.S. group disposes of 10% of its combined separate unit interest or assets (regardless of whether that disposition in any way gives rise to a foreign use), too often do not apply to vary the regulations' results.

The following recommendations suggest improvements to the separate unit combination, all or nothing, and de minimis rules in light of the concerns illustrated by Situations I and II. In compiling these points, we have been mindful of the section 1503(d) statutory mandate, as well as IRS administrative concerns.

Recommendations

1. Revise the mandatory application of the separate unit combination rule.

• The preamble to the 2007 final regulations lists consistency with the policies underlying section 1503(d), reducing complexity, and refining application of the DCL rules among the rationales supporting the final regulations' expanded combination rule.² While separate unit combination can sometimes achieve these goals, it too often has the opposite effect. A mandatory same-country separate unit combination rule, applicable to all members of a consolidated group, for all countries and for all years, regardless of the size or nature of the separate units, regardless of how the units are held by the group, and regardless of the presence of local loss surrender, is simply overbroad. Situations I and II illustrate the severe results that can arise from this "over-combination."

• Recommendation: Make the separate unit combination rule elective. The election could take a variety of forms, including country-by-country, year-by-year, or consolidated group member-by-member. In addition, taxpayers should be able to exclude minority-interest separate units, where the taxpayer lacks the ownership or voting interest necessary to avoid an unintended foreign use. If Treasury and the IRS deem necessary, a "separate unit separation" election could be binding for a specific period, such as three years. Consistent with other DCL filings, this election could be required on a timely filed return.

• Recommendation: Exclude de minimis ownership interests from the definition of a separate unit. As illustrated by Situation II, minority-owner taxpayers lack the control to affect the occurrence of a foreign use. In addition, such taxpayers often lack the information to even determine the occurrence of a foreign use. Section 1503(d)(3) states broad authority for such an exclusion, which would make the regulations more administrable both for taxpayers as well as the IRS. The de minimis interest threshold should exclude any separate unit interest that represents less than 2% of a taxpayer's same-country separate unit, based on asset values (regardless of whether the taxpayer elects application of the separate unit combination rule).

• The preamble to the 2007 final regulations describes several taxpayer suggestions to refine the long-controversial all or nothing principle. While the preamble rejects these suggestions based on administrative concerns, it adds that "the IRS and Treasury Department believe that the application of the all or nothing rule will be significantly reduced under these regulations as a result of the new exceptions to foreign use and the further reduction of the term of the certification period."³ This objective has not been realized. Instead, because of its interaction with the mandatory separate unit combination rule, the all or nothing principle often has greater consequence under the 2007 regulations than under the prior regulations. As a result, recommendations to restrict the application of the all or nothing rule should be re-considered.

• Recommendation: If (or to the extent) separate unit combination is retained, permit DCL recapture on an individual separate unit basis. This suggestion, discussed in the 2007 preamble, satisfies the tax administration criteria of avoiding substantial analysis of foreign law. Moreover, because Treas. Reg. § 1.1503(d)-5(c)(4)(ii) requires taxpayers to determine the items of income, gain, deduction, and loss attributable to individual separate units before combination, this information should be readily available.

• Recommendation: Exclude from the DCL computation deductions that would be taken into account under section 901(m)(3) in determining the disqualified portion of a foreign tax. Congress has identified these amounts as "permanent differences" between the U.S. and foreign bases; moreover, Congress has mandated that taxpayers compute these amounts. Because these items do not "exist" under foreign law, they cannot be made available under foreign law or give rise to a foreign use. Accordingly, these identified amounts are appropriately excluded from the DCL computation. This exclusion would present an additional administrable alternative that does not involve substantial analysis of foreign law (beyond the analysis required under section 901(m)).

• Taxpayers appreciate the 2007 final regulations' inclusion of de minimis exceptions to foreign use. Such exceptions are essential to ameliorating the results that can otherwise arise under the DCL regime. However, as currently stated, the Treas. Reg. § 1.1503(d)-3(c) de minimis exceptions are insufficient to address the severe difficulties generated by the regulations.

• Recommendation: Revise the de minimis rule to focus on de minimis foreign use. Absent a "true de minimis rule," i.e., a rule that is measured by the extent of the DCL that is subject to a foreign use, taxpayers continue to face the possibility of recapturing substantial DCLs as a result of a single dollar or unit of loss carryover or a single carryover basis asset that arises in the context of a larger (more than 10%) transfer. Such a de minimis rule should exclude a foreign use of less than 1% of the DCL. While this approach requires an analysis of foreign law, it is administrable. First, as mentioned, the regulations already require taxpayers to determine the income and loss items attributable to the individual components of a combined separate unit. Second, in determining the foreign use arising with respect to an individual separate unit, the regulations could state a substantiation requirement similar to those currently required under the Treas. Reg. § 1.1503(d)-6 "foreign law rebuttal" and "no possibility of foreign use" rules.

• Recommendation: Revise the de minimis rules to only consider interest or asset transfers that give rise to a foreign use. The minimal transfer described in Situations I and II fall outside the current de minimis exceptions because the USP group separately disposed of 10% of its Country A combined separate unit assets or interest in transactions that did not give rise to a foreign use. Unrelated, no-foreign use transfers should not disqualify otherwise de minimis transfers such as those described in Situations I and II.

• Recommendation: Clarify that the Treas. Reg. § 1.1503(d)-6(f)(1) intra-group exceptions apply for purposes of the de minimis rules. For example, a liquidation of a Country A disregarded entity and the transfer of its assets to another member of the USP group should not affect the de minimis rule computations.

² 72 Fed. Reg. 12,903 (2007).

³ 72 Fed. Reg. 12,910 (2007).