Although new rules under proposed hybrid entity reg. sections 245A and 267A (REG-104352-18) address long-standing concerns about a taxpayer’s ability to use net operating losses to offset taxable income, they fail to completely resolve hybrid problems and problems arising from dual consolidated losses (DCL).
Unlike other Tax Cuts and Jobs Act-related proposed regulations relating to consolidated groups, they contain few provisions uniquely applicable to consolidated groups. These provisions address DCLs by amending reg. sections 1.1503(d)-1 to -8.
Pre-Regulation Rules
Section 1503(d) — added in 1986 — contains guidance on computing and paying tax when filing a consolidated return. Its general rule provides that one consolidated group member’s DCL cannot reduce another member’s taxable income. DCL is any NOL of a U.S. corporation subject to income tax in a foreign country, regardless of whether the foreign tax is source- or residence-based. DCL does not, however, include any loss that foreign tax laws disallow against income of a foreign corporation.
Any loss of a U.S. corporation’s separate unit is also subject to the DCL disallowance as if the unit were the corporation’s wholly owned subsidiary.
Congress originally enacted section 1503(d) to prevent “double dipping” of NOLs: using NOLs to offset both foreign taxable income not subject to U.S. tax and U.S. taxable income of an affiliate of the NOL generator. Temporary regulations under section 1503(d) were issued in 1989 (T.D. 8261, 1989-2 C.B. 220). Final regulations issued in 1992 (T.D. 8434, 1992-2 C.B. 240) were updated and amended over the next 11 years leading to regulations finalized in 2007 that contain extensive guidance on how section 1503(d) operates. T.D. 9315, 2007-15 IRB 891.
Reg. section 1.1503-1(b)(5) defines a DCL as:
an NOL of a dual resident corporation (DRC); or
the net loss attributable to a separate unit.
Reg. section 1.1503(d)-1(b) defines a DRC as a domestic corporation subject to income tax of a foreign country on its worldwide income or on a residence basis and defines separate unit as either a foreign branch or an interest in a hybrid entity owned by a domestic corporation (including a DRC).
Reg. section 1.1503(d)-2 defines domestic use as a DCL offsetting the income of a domestic affiliate other than the DRC or separate unit that incurred the DCL, regardless of whether the DCL offsets income under the income tax laws of a foreign country, and regardless of whether any income that the DCL could offset in the foreign country is subject to tax in the United States. Reg. section 1.1503(d)-4(b) provides that domestic use of a DCL is not permitted, with certain exceptions described in reg. section 1.1503(d)-6.
A DRC may offset U.S. income with a DCL if the DCL makes a domestic use election under reg. section 1.1503(d)-6(d) and the taxpayer certifies that there has not been, and will not be, a foreign use of the DCL during a certification period. The certification period is defined in reg. section 1.1503(s)-1(b)(20) as the five-year period following the year the DCL was incurred.
Under reg. section 1.1503(d)-3, foreign use occurs when a DCL is made available under foreign income tax laws to offset income that U.S. tax principles consider to be income of a foreign corporation or hybrid entity owner.
If foreign use or another triggering event occurs during the domestic use certification period, the DCL is recaptured, or added back to taxable income with an interest charge. Other triggering events are listed in reg. section 1.1503(d)-6(e) and include certain transfers of the stock or assets of either a DRC or a separate unit of a domestic corporation.
“Mirror legislation” rules in reg. section 1.1503(d)-3(e) prevent a domestic use election when a foreign jurisdiction has legislation like section 1503(d) preventing foreign use of the DCL. A foreign use is deemed to occur if:
the income tax laws of a foreign country deny any opportunity for foreign use of the DCL because the DRC or separate unit is subject to tax in another country;
the DCL can offset income under the laws of another country; or
the deductibility of a DCL input depends on another country’s laws.
Mirror legislation prevents domestic or foreign use of the DCL, leaving it stranded. If that happens, reg. section 1.1503(d)-6(b) provides another exception to the DCL domestic use limitation. In this exception, the taxpayer can elect to deduct the loss in the United States in accordance with an agreement between the United States and a foreign country implementing an elective procedure through which losses may be used to offset income in only one country.
Under these 2007 rules, domestic reverse hybrids have been used to obtain double deduction outcomes because they were not subject to limitation under the section 1503(d) regs. A domestic reverse hybrid is basically a U.S. entity that elects under reg. section 301.7701-3(c) to be treated as a corporation for U.S. tax purposes but is a passthrough (or fiscally transparent) entity under the tax laws of its investors.
In these structures, a foreign corporation typically owns the majority of the domestic reverse hybrid. These structures can lead to double deduction outcomes because, for example, deductions by the domestic reverse hybrid can be used:
under U.S. tax law to offset U.S. taxable income not subject to tax in the foreign parent’s country (like U.S. income of domestic corporations with which the domestic reverse hybrid files a U.S. consolidated return); and
under the foreign parent’s tax law, to offset foreign income not subject to U.S. tax (like income of the foreign parent other than income of the domestic reverse hybrid).
Taxpayers do not consider section 1503(d) regs to apply to these structures because the domestic reverse hybrid is not a DRC (because it isn’t subject to tax on a residence basis or on its worldwide income in the foreign parent country), and it is not a separate unit of a domestic corporation.
A comment on the 2005 proposed regulations and the preamble to the 2007 final regulations both note that this type of structure allows a double dip similar to that which Congress intended to prevent with section 1503(d). These regulations still do not address these structures, however, because the IRS and Treasury also concluded that a domestic reverse hybrid was neither a DRC nor a separate unit and therefore not subject to section 1503(d). The preamble notes, however, that these structures would continue to be studied.
New Regulations
Eleven years later, the new proposed hybrid entity regulations include rules under sections 1503(d) and 7701 that prevent the use of these structures to obtain a double deduction outcome. The definition of DCL in reg. section 1.1503(d)-1(b)(2) has been expanded to include a “domestic consenting corporation” as defined in reg. section 301.7701-3(c)(3)(i), or an entity that has elected to be taxed as an association (that is, a corporation).
New prop. reg. section 1.1503(d)-1(c) reiterates that a domestic consenting corporation is treated as a DRC if both requirements are satisfied:
under the tax laws of a foreign country where a “specified foreign tax resident” resides, the specified foreign tax resident derives items of income or loss of the domestic consenting corporation because, for example, the domestic consenting corporation is fiscally transparent under foreign tax law; and
the specified foreign tax resident bears a relationship to the domestic consenting corporation that is described in section 267(b) or 707(b) (that is to say, direct or attributed ownership of more than 50 percent of value).
Concerning a domestic consenting corporation, fiscal transparency is determined under reg. section 1.894-1(d)(3)(ii) and (iii) (relating to income affected by treaty), regardless of whether a specified foreign tax resident is a resident of a country that has a tax treaty with the United States. Under these rules, “fiscally transparent” basically means that the domestic consenting entity’s tax items flow through to its owners under the laws of the entity’s or the interest holder’s jurisdiction.
A specified foreign tax resident is a corporate body or other entity or body of persons liable as a resident to tax under the tax law of a foreign country.
If a domestic entity has elected to be treated as a corporation before December 20, 2018, the entity is deemed to consent to be treated as a DCR for its first tax year beginning after the end of a 12-month transition period. Deemed consent can be avoided, however, if the entity elects to be treated as a partnership or disregarded entity before then.
The mirror rules in reg. section 1.1503(d)-3(e) will not apply to DCLs of domestic consenting corporations. New prop. reg. section 1.1503-3(e)(3) provides that a foreign country’s mirror rules will not trigger deemed foreign use of a DCL incurred by a domestic consenting corporation that is a DRC. A domestic use election therefore remains available. This exception to the mirror rules is intended to minimize stranded DCLs. The exception does not apply to DCLs of separate units, however, because the United States is the parent jurisdiction in those cases, and so the DCL rules themselves neutralize the double deduction outcome.
Certain triggering events, like stock or asset transfers, require recapturing a DCL that was under a domestic use election, with certain exceptions. Proposed reg. section 1.1503(d)-6(f)(5) provides that compulsory transfers involving foreign governments will not be triggering events. Compulsory transfers include transfers of the asset or stock of a DRC or separate unit that are legally required by a foreign government as a condition of doing business, are compelled by a threat of expropriation, or are the result of expropriation. The new regs expand the exception so that it applies to compulsory transfers involving the U.S. government as well as foreign governments. The exception applies to transfers after December 20, 2018, but taxpayers may apply the rules to earlier transfers.
The new rules are illustrated by new Example 41 in prop. reg. section 1.1503(d)-7(c). FSZ1 is a Country Z resident subject to Country Z tax and is a foreign corporation for U.S. tax purposes. It wholly owns DCC, a domestic eligible entity that elected to be classified as a corporation. Under Country Z tax law, DCC is fiscally transparent. In year 1, DCC’s only tax item is a $100 NOL. For Country Z’s tax purposes, FSZ1’s only item other than DCC’s NOL is $60 of operating income.
DCC is a domestic consenting corporation because, by electing to be classified as an association, it consents to be treated as a DRC. DCC is treated as a DRC because both requirements are met:
FSZ1 (a specified foreign tax resident) incurs an NOL of DCC because under Country Z tax law, DCC is fiscally transparent; and
FSZ1 bears a relationship to DCC described in section 267(b) or 707(b).
As a DRC, DCC has a $100 DCL in year 1.
Because the DCL offsets income of FSZ1 under Country Z tax law, there is a foreign use of the DCL in year 1. It is therefore subject to the domestic use limitation rule of reg. section 1.1503(d)-4(b). The result would be the same if FSZ1 indirectly owned its DCC stock through a fiscally transparent intermediary, if an individual wholly-owned FSZ1 and FSZ1 was a disregarded entity, or if FSZ1 had no tax items other than DCC’s NOL.
If, on the other hand, DCC is not fiscally transparent under Country Z tax law, and FSZ1 does not incur DCC’s NOL, DCC is not treated as a DRC and its NOL is not a DCL.
Finally, if DCC is fiscally transparent but Country Z’s tax laws contain mirror legislation that prohibits DCC’s NOL from offsetting FSZ1’s income not subject to U.S. tax, DCC is treated as a DRC and its NOL is a DCL. However, the DCL is not deemed to be put to a foreign use because of the mirror legislation, and so DCC is eligible to make a domestic use election for the DCL.
Unfinished Business
The new proposed 1503(d) regs resolve the domestic reverse hybrid problem by treating these as DRCs if they elect to be treated as corporations in the United States and are fiscally transparent in their investor jurisdiction. They also resolved the stranded DCL problem and provided compulsory transfer reciprocity. There is still one problem, however, saved for another day: disregarded payments made to domestic corporations.
The new proposed section 267A regs address the deduction with no inclusion problem for interest and royalty payments that are regarded for U.S. tax purposes but disregarded for foreign tax purposes. These regulations do not, however, address payments to domestic corporations regarded for foreign tax purposes, but disregarded for U.S. tax purposes.
For example, interest paid to a U.S. corporation (USS) by its wholly owned foreign disregarded entity (FDE) is disregarded in the United States, but an interest deduction is allowed in the FDE’s country. Under section 1503(d) regs, the loan does not cause a DCL attributable to USS’s interest in FDE because interest paid on the loan is not regarded for U.S. tax purposes; only regarded items are taken into account for purposes of determining a DCL under reg. section 1.1503-5(c)(1)(ii), illustrated by reg. section 1.1503(d)-7(c), Example 23.
As with domestic reverse hybrids, the IRS and Treasury determined that these transactions raise policy concerns. They are like transactions that result in a deduction with no inclusion outcome, addressed in the section 267A proposed regs, and the double deduction outcome, addressed in section 1503(d) proposed regs. At this time, however, the IRS and Treasury will only study the transactions and request comments.