Service Issues Memorandum on Application of Dual Consolidated Loss Rule Applied to a Foreign Entity that is Disregarded for U.S. Income Tax Purposes
In AM-2011-002, the IRS evaluated the separate return limitation on loss provision or “SRLY” with respect to the dual consolidated loss of a foreign disregarded entity under the check the box regulations. As discussed below, the dual consolidated loss rule contained in §1503(d) and corresponding regulations, is designed to prevent a single economic loss from reducing the taxable income base of more than one taxing system, which frequently arises in instances in which one base is used in computing taxable income for U.S. income tax purposes and the other base is used in computing taxable income on a foreign tax return not subject to tax in the United States. The comments set forth herein are limited in scope and analysis and do not cover all of the material rules and issues in this area.
The facts involved in AM-2011-022 involve a common domestic parent, A, of a consolidated group of corporations. A owns 100% of B, a corporate domestic subsidiary included in the AB consolidated group. B owns 100% of C, an entity organized under the laws of a foreign jurisdiction, Country X . C is subject to Country X’s income tax on its worldwide income but is disregarded as an entity separate from B for U.S. federal income tax purposes, i.e., a hybrid entity. C carries on a business in Country X that, if carried on by a U.S. person would be a foreign branch within the meaning of Treas. Reg. §1.367(a)-6T(g)(1) . B’s interest in C consists of a hybrid entity separate unit, and B’s indirect interest in the business operations of C is a foreign branch separate unit. These two individual separate units are combined and treated as a single separate unit.
In Year 1, B generates $120x of net income that is attributable to the C Separate Unit; in Year 2, B incurs a net loss of $100x that is attributable to the C Separate Unit. B has no other items of income or loss for Years 1 and 2. The taxable income attributable to the AB group (without taking into account the C Separate Unit) is $300x and $150x respectively. The $100x net loss attributable to the C Separate Unit is a dual consolidated loss. As an alternative, the administrative guidance release analyzes the results if in Year 1 C generates only $60x of net income that is attributable to the C Separate Unit.
In general, the regulations prohibit the domestic use of a dual consolidated loss, with certain exceptions (including a domestic use election). The domestic use of a dual consolidated loss is deemed to occur when the dual consolidated loss is made available to offset, directly or indirectly, the income of a domestic affiliate in the year in which the dual consolidated loss is recognized or in any other tax year. In addition, a domestic use occurs when the dual consolidated loss is included in the computation of the taxable income of a consolidated group.
When a domestic use limitation applies, the dual consolidated loss is treated as subject to the SRLY limitation set forth in Treas. Reg. §1.1502-21(c), and as modified by Treas. Reg. §1.1503-4. In the event the consolidated group makes a domestic use election under Treas Reg. §1.1503(d)-6(d), the domestic use limitation rules are inapplicable or yield to the rules under the special election procedure.
In general, a corporation’s net operating loss that is subject to the SRLY limitation cannot use such loss to reduce consolidated taxable income, i.e., the loss arises in a separate return limitation year. Accordingly, a net operating loss subject to SRLY can only be used as a carryback or carryforward to the corporation which generated the loss. Unlike the general SRLY limitation, a dual consolidated loss may occur or arise in any taxable year, including a year in which the member is included in a consolidated group are recited in the administrative memorandum. The memorandum issued by the Service addresses when a dual consolidated loss (subject to SRLY), may be used to offset consolidated taxable income in the year the dual consolidated loss is realized despite the fact that under SRLY principles such loss could not be utilized.
The administrative memorandum looks to the current SRLY regulations and the concept known as the “cumulative register.” Under this rule, the consolidated group may use a separate return limitation year net operating loss to reduce consolidated taxable income to the extent the SRLY member has contributed to the cumulative consolidated taxable income during the consolidated return years, as computed under the cumulative register. Because the dual consolidated return regulations fully incorporate the SRLY limitation, the memorandum concludes that the cumulative register concept applies to a dual consolidated loss that is subject to the domestic use limitation. Thus, under the facts of the memorandum, because the C Separate Unit has a positive cumulative register of $120x, the AB group can use the C Separate Unit loss of $100 in determining the group's consolidated taxable income in Year 2. The administrative memorandum further provides it is not necessary for the AB group to make a domestic use election to use the C dual consolidated loss.
Under the alternative facts, the AB group may use the C dual consolidated loss in Year 2 only to the extent of C Separate Unit’s cumulative register amount of $60x. Where the dual consolidated loss is greater than C Separate Unit's cumulative register, the excess remains subject to the domestic use (SRLY) limitation rule. The memorandum notes that the AB group may not file a domestic use election for a portion of a dual consolidated loss; rather, a domestic use election may be filed for only the entire C Separate Unit dual consolidated loss. The AB group may use the C Separate Unit's cumulative register or file a domestic use election for the entire C dual consolidated loss amount but not both.
Limitation on Use of Dual Consolidated Loss
The United States generally allows a domestic corporation, which is taxable on gross income from sources both within and without the United States, is similarly allowed, in computing taxable income, to deduct items, including losses, regardless of where the corporation incurs those losses. Thus, subject to applicable limitations, a domestic corporation may offset its domestic source income by foreign-source losses. Under the consolidated return regulations, a domestic (eligible) corporation is permitted to file a consolidated tax return with other “affiliated domestic corporations”. §1504. Again, subject to certain limitations, the losses of one member(s) of a consolidated group may be used to offset the gross income of another member(s) in determining consolidated taxable income.
It is also possible for a corporation to be treated as a “domestic” corporation for U.S. income tax purposes while it is also treated as a “resident” of a foreign country for purposes of applying the domestic tax laws of such foreign jurisdiction. For example, the United States views as “domestic” any corporation which is formed or organized by a state situated in the U.S. On the other hand, some foreign countries also regard as “resident” a the place where management and control over the corporation is exercised. See Temp. Reg. § 1.1503-2T(b)(3)(“dual resident corporation”). Thus it is possible for a domestic corporation for U.S. federal income tax purposes to also be a resident of another country based on a differing definition of “resident”, such as in the United Kingdom or Australia. This is known as the concept of a “dual resident corporation”. The application of a relevant tax treaty may avoid the issue or problem of double taxation by resolving a dual residency conflict.
Where a dual consolidated corporation is operating on a deficit basis, it is possible that the same economic losses could be duplicated by being claimed in each jurisdiction of residence and despite the fact that double taxation of income may be avoided. Congress was concerned with the dual resident corporation phenomena and, as part of the Tax Reform Act of 1986, enacted §1503(d). A dual consolidated loss, which includes the net operating loss of a dual resident corporation or the net loss attributable to a separate unit, may not be used to reduce the taxable income of a domestic corporation, including the affiliated member of a consolidated group, unless the loss does not reduce or offset the income of a foreign corporation. See Treas. Reg. §1.1503(d)-1 through Treas. Reg. § 1.1503(d)-7. Final regulations under §1503(d) were promulgated in 1992 and again revised and issued in final form in 2007. What is important to recognize is that boundary of the dual consolidated loss regulations goes well beyond the consolidated return regulations. Indeed, the dual consolidated loss rules may apply to a U.S. corporation that simply owns an interest in a foreign partnership that incurs losses. The regulations also provide for an election to allow the current deduction of losses subject to certain limitations and a recapture provision. The revised regulations address the application of the dual consolidated loss regime with respect to the check-the-box entity classification regulations. The Service has a “no-ruling” position on §1503(d). See Rev. Proc. 2009-7, § 4.01(26), 2009-1 CB 226, 228; Rev. Proc. 2010-7, § 4.01(26), 2010-1 CB 231, 233; Rev. Proc. 2011-7, § 4.01(26), 2011-1 IRB 233, 235.
Illustration. X is a corporation formed in Pennsylvania and owns all of the stock of Y, a foreign corporation organized under the laws of Country A. X also has a wholly owned US subsidiary, Z. Y and Z are engaged in business operations in Country A and A is also the jurisdiction where management is sitused for both Y (foreign sub) and Z (domestic organized sub). Under the laws of Country A, Z is a dual resident corporation and its worldwide income is subject to tax in the U.S. and Country A. Both FS and DS conduct most of their business in Country X. Country X is also the place of effective management for both FS and DS. Under the laws of Country X, DS is a domestic resident and is taxable by Country X on its worldwide income. Thus, DS is a dual resident corporation, whose worldwide income is subject to tax in both the United States and Country X. In 2011, X has taxable income of $100M, Y has taxable income of $100M and Z has losses from operations of $100M. Country A’s tax law permits Z (domestic sub) loss of $100M to reduce Y (foreign sub) income of $100M to eliminate any tax owed to Country A. Under §§1503(d) and 1503(d)(2), domestic sub Z’s $100M net operating loss constitutes a “dual consolidated loss” and therefore such loss can not be used to reduce X’s income of $100M for U.S. income tax purposes. Y(foreign sub) can not join in the filing of a consolidated return with X since it is a foreign corporation. The consolidated taxable income of X and Y for the taxable year is $100.
For U.S. income tax purposes, Z (domestic sub) has a $100M dual consolidated loss carryover which loss may be used to offset DS's future income which it realizes. This loss may not, however, offset the income of X or any other member of the affiliated group (except Z) in any future year. future year.
The disallowance rule contained in §1503(d) applies only to a dual consolidated loss incurred by a “domestic corporation”. See §§7701(a)(3), 7701(a)(4). The term also includes “any corporation treated as a domestic corporation by the Internal Revenue Code.” See, e.g., §269B which may result in treating a foreign corporation as a domestic corporation if the foreign corporation and any domestic corporation are “stapled entities.” It may also include a Canadian or Mexican corporation treated as domestic per §1504(d). It is further important to recognize that under the regulations, a “separate unit” or “branch” of a domestic corporation may be treated as a separate domestic corporation (and as a dual resident corporation) for purposes of §1503(d). See Treas. Reg. §1.367(a)-6T(g)(1). The regulations define “separate unit” as including an interest in a partnership, a trust, a foreign branch or an interest in an entity that is not taxable for U.S. corporation for U.S. purposes, but is subject to tax in a foreign country as a corporation either on its worldwide income or on a residence basis. This last category of a “separate unit” applies to a “hybrid entity separate unit” owned directly or indirectly by a domestic corporation. A domestic reverse hybrid is not treated as a dual resident corporation.
Exceptions to Dual Consolidated Loss Rule.
If a foreign business operation is not a “permanent establishment” for treaty purposes or is not taxed on a net basis, it is not a separate unit provided the business is not carried on directly or indirectly by a hybrid or transparent entity. Treas. Regs. §§ 1.1503(d)-1(b)(4)(iii), 1.1503(d)-7(c). Other special rules are provided in the regulations.
Under section 1503(d)(2) and accompanying reulgations, section 1503(d) will not apply to a net operating loss, which, under the foreign income tax law, does not offset the income of any foreign corporation. In other words a “dual consolidated loss” does not include a net operating loss realized in a foreign country where such country’s income tax laws: (i) do not permit the dual resident corporation to use its losses to offset any other person's income that is recognized in the same taxable year; and (ii) do not permit the losses of the dual resident corporation to be carried over or back to offset the income of any other person in any other taxable years.
SRLY Treatment. Generally, i.e., except as provided in Treas. Reg. §1.1503(d)-6, the domestic use of dual consolidated loss is not allowed except to offset, directly or indirectly, the income of a domestic affiliate (other than the dual resident corporation or separate unit which realized the loss) in the taxable year of the dual consolidated loss or any other year or when the dual consolidate loss is included in the computation of consolidated taxable income or the income of an unaffiliated owner. Where in a particular year in which a separate unit or dual resident corporation realizes a dual consolidated loss, such loss consists of a pro rata portion of each item of deduction and loss which is taken into account in computing the dual consolidated loss.
The dual consolidated loss is treated as incurred in a separate return limitation year (“SRLY”) by the dual resident corporation or separate unit. See Treas. Reg. §1.1502-21(c). It generally is eliminated in a §381 transaction except for Type F reorganizations involving a domestic corporation as the surviving entity. The SRLY limitation on remains in effect even after the loss corporation ceases to be a DRC. Other special rules apply.
Overall, this is a complex provision and requires much thought and evaluation in advising corporate clients engaged in domestic and international business operations.
