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FEI Expresses Reservations Over Proposed Regs on Dual Consolidated Losses

JAN. 27, 2006

FEI Expresses Reservations Over Proposed Regs on Dual Consolidated Losses

DATED JAN. 27, 2006
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January 27, 2006

 

 

Commissioner

 

IRS

 

P.O. Box 7604

 

Ben Franklin Station

 

Washington, DC 20044

 

 

Attention: Kathyrn T. Holman

 

CC:PA:LPD:PR (REG-102144-04)

 

 

Re: Comments on Proposed Regulations Section 1.1503(d)

 

 

Dear Commissioner:

I am writing on behalf of the Committee on Taxation of Financial Executives International ("FEI") to submit comments on the proposed regulations regarding dual consolidated losses under section 1503(d), REG-102144-04, published in the Federal Register on May 19, 2005 (the "Proposed Regulations").

FEI is a professional association representing the interests of more than 15,000 CFOs, treasurers, controllers, tax directors, and other senior financial executives from over 8,000 major companies throughout the United States and Canada. FEI represents both providers and users of financial information. The Tax Committee formulates tax policy for FEI in line with the views of the membership. This letter represents the views of the Tax Committee and not necessarily the views of FEI.

We commend the Treasury and the IRS for their significant efforts in developing the Proposed Regulations. The Proposed Regulations provide more detailed guidance than the existing regulations under section 1503(d) and resolve numerous issues that have been the subject of much debate among tax practitioners in recent years. The Tax Committee, however, has reservations about several aspects of the Proposed Regulations, which are set forth below.

Foreign Use: Dilution of Domestic Owner's Interest

Under the Proposed Regulations, a foreign use generally is deemed to occur when a loss of a hybrid entity partnership is carried forward.1 An exception exists if no dilution (i.e., reduction in the domestic owner's percentage interest) occurs.2 However, if any dilution occurs and the person that increased its interest is not a domestic corporation, then the general rule applies and a foreign use generally is deemed to occur (the "dilution rule").3 As a result, the DCL cannot be claimed on the U.S. return and prior DCLs must be recaptured.4

The dilution rule presumably was intended to further the fundamental policy of section 1503(d), which is to prevent the use of a loss to offset income on a U.S. corporate return when such loss can also offset income on a foreign corporate return for foreign tax purposes that is not currently subject to U.S. tax as income of a U.S. corporation. We believe, however, that this policy must be balanced against the impact of the rule on legitimate business operations. As proposed, this rule will discourage U.S. corporations from forming joint ventures with foreign persons to conduct business abroad. For this reason, we believe the dilution rule should be eliminated or narrowed in scope.

If Treasury and the IRS continue to believe that a dilution rule of some sort is necessary to thwart abuse, we recommend that the rule be narrowed such that a dilution would result in a deemed foreign use only if the U.S. corporation's percentage interest in the entity is reduced by a substantial amount (i.e., 50 percent or more). In addition, recapture should be required only to the extent of the amount of income of the hybrid partnership (for each year remaining in the certification period) that would have been allocated to the U.S. corporation had the dilution not occurred. For example, if $100,000 of income was allocated to foreign persons that would have been allocated to U.S. persons had no dilution occurred, the recapture of DCLs should only apply up to $100,000. For reasons of administrative ease (for the government as well as taxpayers), income for this purpose should be measured under U.S. tax principles.

If the foregoing recommendation is not adopted, an alternative would be to provide that a dilution resulting from a capital contribution by a new or existing partner (other than a domestic corporation) would result in a deemed foreign use only if, during the remainder of the certification period, the hybrid partnership disposes of an asset contributed by that partner in a transaction to which section 704(c)(1)(A) applies (such that the gain is allocated to the contributing partner for U.S. tax purposes). Such a rule would seem to provide a relatively administrable way to distinguish between legitimate business ventures and structures fabricated to achieve a dual use of a single loss.

Foreign Use: Mirror Legislation Rule

Foreign countries increasingly are adopting rules similar to the U.S. dual consolidated loss rules ("mirror legislation").5 Evidently in response to this phenomenon, the Proposed Regulations significantly broaden the anti-mirror legislation rule, as compared to the cognate rule in the current regulations.6

Congress intended that Treasury pursue bilateral agreements with countries that have mirror legislation, in order to allow the use of the loss of a dual resident corporation or separate unit to offset income of an affiliate in one of the two countries. To date, no such bilateral agreement has been put in place. While we appreciate the difficulties that Treasury must face in seeking the necessary concessions from foreign governments to reach a bilateral agreement of this kind, we are concerned about taxpayers who are caught in the middle.

As a result of the broad anti-mirror rule in the Proposed Regulations and the absence of bilateral agreements, U.S. persons will increasingly not be able to claim these economic losses abroad or in the United States (except on a SRLY basis). As with the dilution rule discussed above, we believe that the policy concerns underlying section 1503(d) must be balanced against the impact of the rules on legitimate business operations. We believe the proposed anti-mirror rule is overbroad and will discourage U.S. persons from doing business abroad.

We applaud the IRS and Treasury for clarifying that the mere existence of mirror legislation in the country of the dual resident corporation or separate unit does not result in a deemed foreign use, but rather, a deemed foreign use results only if the mirror legislation actually applies to the dual resident corporation or separate unit. We believe, however, that this principle should be taken one step further. If the dual resident corporation or separate unit has no foreign affiliate in the relevant jurisdiction, the application of the mirror legislation arguably has no meaningful effect. Accordingly, it should not trigger the application of the anti-mirror rule. Therefore, we recommend that the Proposed Regulations be amended to provide that the anti-mirror rule does not apply unless a foreign affiliate exists.

If, in conjunction with such an amendment, the IRS and Treasury were to create a new triggering event relating to a subsequent acquisition of a foreign affiliate during the certification period, such a triggering event should be limited to cases in which the dual consolidated losses would have been available for use by the foreign affiliate but for the mirror legislation. For example, a taxpayer should be permitted to show that the acquisition occurred after the expiration of the loss carryforward period under the relevant foreign law.

Calculating the DCL of a Separate Unit: Gain on a Disposition of a Partnership Interest

The Proposed Regulations provide that gain or loss on the sale of a separate unit ("outside" gain or loss) is attributable to the separate unit to the extent that the gain or loss would have been recognized had such separate unit sold all its assets in a taxable exchange immediately before the disposition of the separate unit for amount equal to the fair market value of the assets ("inside" gain or loss).7 Gain on the disposition of a separate unit is used to determine the amount of the dual consolidated loss ("DCL") in the year of the disposition and to rebut the amount of the DCL required to be recaptured.

The Proposed Regulations do not address how or whether recourse liabilities of an entity affect the calculation of the inside gain or loss. For example, assume that a hybrid entity that is taxed as a corporation for foreign purposes but as a partnership for U.S. tax purposes borrows money from an unrelated person with no guaranties by any partner (or related party). Further, assume that the value of the hybrid entity's assets decline over time. If a domestic owner of the hybrid entity sells its interest, all the liabilities of the hybrid entity are taken into account in determining the outside gain or loss. Under the partnership liability allocation rules, the liabilities of the hybrid entity partnership will be treated as nonrecourse liabilities and the partners will include their share of such liabilities in their partnership tax basis. Accordingly, when the interest is sold, the assumption of the liabilities will be included in the selling partner's amount realized and in the tax basis of the partnership interest.

It is unclear, however, whether the liabilities that are recourse at the entity level but non-recourse to the members are taken into account in determining the inside gain or loss from the hypothetical sale of the hybrid entity's assets "in a taxable exchange . . . for an amount equal to their fair market value." That is, it is unclear whether cancellation of indebtedness income -- which would be triggered if there were an actual sale of the assets for fair market value and a subsequent cancellation of any recourse liabilities to the extent the sales proceeds were not sufficient to repay such obligations -- is included in the calculation of inside gain or loss. If these liabilities are not taken into account in determining the inside gain, the inside gain will be smaller than the outside gain. Depending on the facts, there may even be an inside loss.

We recommend that the Proposed Regulations be amended to provide that liabilities taken into account in determining the outside gain or loss also are taken into account in determining the domestic owner's share of the inside gain or loss by including them in the amount realized on the deemed sale.

We recognize that this rule may need to be modified for cases involving foreign branch separate units owned indirectly through partnerships that are not hybrid entities, because the partnership liabilities may not relate entirely to the branch operations. Accordingly, for such cases, we recommend that a proportionate amount of the liabilities be taken into account, with the proportion determined by applying the same methodology that is used for allocating partnership interest expense to the foreign branch separate unit.

Triggering Events: Transfer of an Interest in a Separate Unit.

The Proposed Regulations, as well as the existing regulations, provide that the sale or disposition of 50 percent or more of the interest in a separate unit measured by voting power or value within a 12-month period of time is a triggering event that requires the recapture of DCLs.8 According to the preamble to the existing regulations, the triggering event rules were intended to target transactions that either increase the likelihood that the DCL will be used to offset the income of another person for foreign tax purposes or increase the difficulty of monitoring such foreign use.9

Upon a cursory review, a U.S. taxpayer's voting interest in a hybrid entity separate unit may seem relevant to these purposes, in that a reduction in voting power could affect the taxpayer's ability to influence the tax matters of the joint venture or to obtain relevant information about the joint venture's tax affairs. Yet, even a taxpayer with no voting interest in a hybrid entity separate unit can make a domestic use election with respect to a DCL. The government's interest in that case is protected by the taxpayer's certification that arrangements have been made to ensure that there will be no foreign use of the DCL during the certification period, and that the taxpayer will be informed of any such foreign use during such period.10

We believe that the same certification provides the same protection to the government's interest in the event that a taxpayer with a voting interest when the DCL is incurred subsequently engages in a transaction whereby this voting interest is reduced. Accordingly, FEI recommends that the Proposed Regulations be amended to eliminate reductions in voting interest as a triggering event.

We appreciate the opportunity to share our views on this important matter. Should you have any questions or need additional information about the Tax Committee's views, please contact Mark Prysock at 202.626.7804.

Respectfully submitted,

 

 

Mike Reilly

 

Chairman

 

FEI Committee on Taxation

 

Washington, DC

 

FOOTNOTES

 

 

1 Prop. Reg. Sec. 1.1503(d)-1(b)(14)(i).

2 Prop. Reg. Secs. 1.1503(d)-1(b)(14)(iii)(C)(l) and 1.1503(d)-3(b)(2)(v).

3 Prop. Reg. Sec. 1.1503(d)-1(b)(14)(iii)(C)(2).

4 Prop. Reg. Sec. 1.1503(d)-4(d) and 1.1503(d)- 4(e)(1)(i).

5 See, for example, the new U.K. rules set forth in sections 24 and 25, Finance (No. 2) Act 2005.

6 Prop. Reg. Sec. 1.1503(d)-1(b)(14)(v).

7 Prop. Reg. Sec. 1.1503(d)-3(b)(2)(vii)(C).

8 Prop. Reg. Sec. 1.1503(d)-4(e)(1)(v).

9 T.D. 8434 (Sep. 9, 1992).

10 Prop. Reg. Sec. 1.1503(d)-4(d)(1)(vi)

 

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