Deloitte Tax Urges Revising Dual Consolidated Loss Regs to Account for Minority Interest Separate Units

Thank you for the opportunity to meet with members of your staffs on May 1, 2012. We sincerely appreciate your receptiveness to taxpayer comments and suggestions about improving the U.S. international tax regime.

This letter focuses on "minority interest separate units." At the meeting we described the issues raised by minority interest separate units as well as a proposal to address these issues. We appreciate the opportunity to provide further detail about these important matters.

Background

Minority interest separate units are separate units that are minority-owned interests in hybrid entities or separate units that are held through minority-owned hybrid entity or partnership interests. At present, the dual consolidated loss ("DCL") regulations do not distinguish between minority interest and non-minority interest separate units. However minority interest separate units present unique issues. While taxpayers generally cannot control whether a foreign use occurs with respect to a minority interest separate unit, such foreign use can disallow or require recapture of DCL amounts that far exceed the loss attributable to the minority interest separate unit. This unlimited application of the all or nothing principle to all same-country separate units presents the single most immediate need for relief under the section 1503(d) regime.

Consider a U.S. consolidated group with a same-country combined separate unit predominantly comprised of foreign branches and disregarded entities. In addition, the U.S. group participates in local joint ventures through minority interest separate units. Notwithstanding the relative size or loss generated by the minority interest separate unit, the U.S. tax treatment of any DCLs attributable to the combined separate unit can be wholly-determined by these minority interests. For example, if a single minority interest separate unit acquires another local entity and files a consolidated return, the U.S. group could be required to recapture prior-year combined separate unit DCLs and subject the current-year loss to the domestic use limitation. This result arises without regard to the U.S. group's percentage ownership in the minority interest separate unit or the U.S. group's advance knowledge of or assent to the consolidation.¹

In light of these risks, well-informed taxpayers most likely will attempt to avoid adding minority interest separate units to their combined separate units that incur DCLs. However revising corporate investment protocols is often intrusive and difficult. Moreover, companies cannot always foresee which combined separate units will generate DCLs. Most notably, pre-existing minority interest separate units are widespread and cannot be easily unwound. Accordingly, in light of these limitations, we respectfully request an adjustment to the regulatory regime that will more effectively address minority interest separate units.

Proposal

The Treasury Department and IRS can address the issues raised by minority interest separate units by applying the foreign use and recapture rules separately with respect to these interests. Pursuant to Treas. Reg. § 1.1503(d)-3(c)(9) (discussed below), this guidance can be stated in a Notice or other guidance published in the Internal Revenue Bulletin.

Discussion

The following points consider various aspects of the proposal:

• Effect: Separate application of the foreign use and recapture rules to minority interest separate units would refine the application of the all or nothing principle to same-country combined separate units in a manner that avoids the disproportionate loss recapture and disallowance results described above. Still, every minority interest separate unit DCL that is subject to a foreign use would be subject to the full effects of the DCL recapture, interest charge, and domestic use limitation rules. In this manner the section 1503(d) anti-double-dipping policy would be fully implemented and respected.

• Minority Interest Separate Unit: As discussed, minority interest separate units are separate units that are minority-owned interests in hybrid entities or separate units that are held through minority-owned hybrid entity or partnership interests. Accordingly, a minority interest separate unit should include any separate unit where less than 50% of the capital or profits interest in the relevant hybrid entity or partnership is owned, directly or indirectly, by or for the U.S. consolidated group (including ownership through foreign corporations). Because the essence of a minority interest separate unit is U.S. group control, 50% or greater direct or indirect ownership by a section 267(f) control group (again, including ownership through foreign corporations) can also disqualify a minority interest separate unit.

• Integration with Current Regulations: The current foreign use and recapture rules apply regardless of the size of the separate unit or the amount of the DCL. Moreover, the regulations already require that taxpayers compute the items of income, gain, deduction and loss attributable to the individual separate units that comprise a same-country combined separate unit. See Treas. Reg. § 1.1503(d)-5(c)(4)(ii). For these reasons, a separate application of the foreign use and recapture rules to minority interest separate units should easily integrate with the current rules and with outstanding domestic use elections.

• Treas. Reg. § 1.1503(d)-3(c)(9): Of course, the Treasury Department and IRS have authority to vary the application of the DCL regulations as appropriate. However, the current proposal also fits within the more specific delegation of Treas. Reg. § 1.1503(d)-3(c)(9), authorizing the Commissioner to provide "that certain events or transactions do or do not result in a foreign use," and to "modify the triggering events and rebuttals" without amending the regulations themselves.

• Interaction with Combined Separate Unit Foreign Use: The essence of the proposal is that a foreign use of a minority interest separate unit DCL should only trigger recapture of the minority interest DCL. A foreign use by a non-minority interest separate unit does not raise the same policy concerns. Accordingly, the proposal would not disturb the rule that a foreign use by a non-minority interest separate unit triggers the full combined DCL, including minority interest DCLs (unless such DCLs were previously recaptured).

• Indirect Foreign Use: The proposal would not vary the definition of foreign use and, as a result, the indirect foreign use rules would apply with respect to minority interest separate unit DCLs. Accordingly the back-to-back arrangements described in Treas. Reg. § 1.1503(d)-3(a)(2) would continue to be addressed, as under current law.

• Ensuring that Taxpayers are not Disadvantaged: This letter addresses current situations where minority interest separate units comprise a very small percentage of a taxpayer's same-country separate units, and have contributed a very small percentage of the losses that make up the taxpayer's combined separate unit DCLs. While we believe that this is the most common scenario, we agree that a minority interest separate unit DCL could exceed its domestic owner's same-country combined DCL. To address this possibility, the rules could provide that the recapture and domestic use limitation rules apply to the lesser of the DCL attributable to the minority interest separate unit or the total combined separate unit DCL. This provision would ensure that no taxpayer is disadvantaged by the proposal and would enable the Treasury and IRS to issue guidance that refines the regulations without any need to make the new provisions elective.

• Reporting: As stated, Treas. Reg. § 1.1503(d)-5(c)(4)(ii) already requires a computation of individual separate unit income or loss. As appropriate, the Treasury Department and IRS could include the reporting of minority interest separate unit DCLs, and the foreign use or recapture of these amounts, as part of taxpayers' domestic use election and annual certification filings.