Federal Register: May 24, 2005 (Volume 70, Number 99)

DOCID: FR Doc 05-10160

DEPARTMENT OF THE TREASURY

Western Area Power Administration

CFR Citation: 26 CFR Part 1

RIN ID: RIN 1545-BD10

REG ID: [REG-102144-04]

NOTICE: Part III

DOCUMENT ACTION: Notice of proposed rule making and notice of public hearing.

SUBJECT CATEGORY:

Dual Consolidated Loss Regulations

DATES: Written and electronic comments and outlines of topics to be discussed at the public hearing scheduled for September 7, 2005, at 10 a.m., must be received by August 22, 2005.

DOCUMENT SUMMARY:

This document contains proposed regulations under section 1503(d) of the Internal Revenue Code (Code) regarding dual consolidated losses. Section 1503(d) generally provides that a dual consolidated loss of a dual resident corporation cannot reduce the taxable income of any other member of the affiliated group unless, to the extent provided in regulations, such loss does not offset the income of any foreign corporation. Similar rules apply to losses of separate units of domestic corporations. The proposed regulations address various dual consolidated loss issues, including exceptions to the general prohibition against using a dual consolidated loss to reduce the taxable income of any other member of the affiliated group.

SUMMARY:

Treasury Department, Internal Revenue Service,

SUPPLEMENTAL INFORMATION

Paperwork Reduction Act

The collection of information contained in this notice of proposed rulemaking has been submitted to the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)). Comments on the collection of information should be sent to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503, with copies to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, W:CAR:MP:FP:S Washington, DC 20224. Comments on the collection of information should be received by July 25, 2005. Comments are specifically requested concerning:

Whether the proposed collection of information is necessary for the proper performance of the functions of the IRS, including whether the information will have practical utility;

The accuracy of the estimated burden associated with the proposed collection of information (see below);

How the quality, utility, and clarity of the information to be collected may be enhanced;

How the burden of complying with the proposed collection of information may be minimized, including through the application of automated collection techniques or other forms of information technology; and

Estimates of capital or startup costs and costs of operation, maintenance, and purchase of service to provide information.

The collections of information in these proposed regulations are in Sec. Sec. (1.1503(d)1(b)(14), 1.1503(d)1(c)(1), 1.1503(d)2(d), 1.1503(d)4(c)(2), 1.1503(d)4(d), 1.1503(d)4(e)(2), 1.1503(d) 4(f)(2), 1.1503(d)4(g), 1.1503(d)4(h) and 1.1503(d)4(i). The various information is required. First, it notifies the IRS when the taxpayer asserts that it had reasonable cause for failing to comply with certain filing requirements under the regulations. Second, it indicates when the taxpayer attempts to rebut the amount of presumed tainted income. Finally, it provides the IRS various information regarding exceptions to the domestic use limitation, including domestic use elections, domestic use agreements, triggering events and recapture.

The collection of information is in certain cases required and in certain cases voluntary. The likely respondents will be domestic corporations with foreign operations that generate losses.

Estimated total annual reporting and/or recordkeeping burden: 2,665 hours.

Estimated average annual burden hours per respondent and/or recordkeeper: 1.5 hours.

Estimated number of respondents and/or recordkeepers: 1,765.

Estimated annual frequency of responses: Annually.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a valid control number assigned by the Office of Management and Budget.

Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103. Background

The United States taxes the worldwide income of domestic corporations. A domestic corporation is a corporation created or organized in the United States or under the law of the United States or of any State. The United States allows certain domestic corporations to file consolidated returns with other affiliated domestic corporations. When two or more domestic corporations file a consolidated return, losses that one corporation incurs generally may reduce or eliminate tax on income that another corporation earns.

Some countries use criteria other than place of incorporation or organization to determine whether corporations are residents for tax purposes. For example, some countries treat corporations as residents for tax purposes if they are managed or controlled in that country. If one of these countries determines a corporation to be a resident, the corporation is generally subject to income tax of that foreign country on a residence basis. As a result, if such a corporation is a domestic corporation for U.S. tax purposes, it is a dual resident corporation and is subject to the income tax of both the foreign country and the United States on a residence basis.

Prior to the Tax Reform Act of 1986, if a corporation was a resident of both a foreign country and the United States, and the foreign country permitted the losses of the corporation to be used to offset the income of another person (for example, as a result of consolidation), then the dual resident corporation could use any losses it generated twice: once to offset income that was subject to U.S. tax, but not foreign tax, and a second time to offset income subject to foreign tax, but not U.S. tax (doubledip).

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Congress was concerned that this doubledip of a single economic loss could result in an undue tax advantage to certain foreign investors that made investments in domestic corporations, and could create an undue incentive for certain foreign corporations to acquire domestic corporations and for domestic corporations to acquire foreign rather than domestic assets. Staff of Joint Committee on Taxation, 99th Cong., 2nd Sess., General Explanation of the Tax Reform Act of 1986, at 10641065 (1987). Through such doubledipping, worldwide economic income could be rendered partially or fully exempt from current taxation. Moreover, even if the foreign income against which the loss was used would eventually be subject to U.S. tax (upon a repatriation of earnings), there were timing benefits of double dipping that the statute was intended to prevent. Congress responded to this concern by enacting section 1503(d) as part of the Tax Reform Act of 1986.

Section 1503(d) provides that a dual consolidated loss of a corporation cannot reduce the taxable income of any other member of the corporation's affiliated group. The statute defines a dual consolidated loss as a net operating loss of a domestic corporation that is subject to an income tax of a foreign country on its income without regard to the source of its income, or is subject to tax on a residence basis. The statute authorizes the issuance of regulations permitting the use of a dual consolidated loss to offset the income of a domestic affiliate if the loss does not offset the income of a foreign corporation under foreign law.

Section 1503(d) further states that, to the extent provided in regulations, similar rules apply to any loss of a separate unit of a domestic corporation as if such unit where a wholly owned subsidiary of the corporation. Although the statute does not define the term separate unit, the legislative history to the provision refers to the loss of any separate and clearly identifiable unit of a trade or business of a taxpayer and cites as an example a foreign branch of a domestic corporation. See H.R. Rep. No. 795, 100th Cong., 2d Sess. July 26, 1988) at 293.

The IRS and Treasury issued temporary regulations under section 1503(d) in 1989 (TD 8261, 19892 C.B. 220). The temporary regulations generally provided that, unless one of three limited exceptions applied, a dual consolidated loss of a dual resident corporation could not offset the income of any other member of the dual resident corporation's affiliated group. The temporary regulations contained similar rules for losses incurred by separate units.

In response to comments that the temporary regulations were unnecessarily restrictive, the IRS and Treasury issued final regulations under section 1503(d) in 1992 (TD 8434, 19922 C.B. 240). These final regulations were updated and amended over the next 11 years (current regulations). The current regulations apply the section 1503(d) limitation more narrowly than the temporary regulations. The current regulations adopt an actual use standard for permitting a dual consolidated loss to offset income of members of the affiliated group. This standard, which applies to both dual resident corporations and separate units, requires taxpayers to certify that no portion of the dual consolidated loss has been or will be used to offset the income of any other person under the income tax laws of a foreign country. If such a certification is made and a subsequent triggering event occurs, the dual consolidated loss must be recaptured in the year of the event (plus an applicable interest charge).

This document proposes amendments to the current regulations under section 1503(d). Conforming amendments are also proposed to related regulations under sections 1502 and 6043.

Overview

In general, the proposed regulations address three fundamental concerns that arise in connection with the current regulations. First, the IRS and Treasury believe that the scope of application of the current regulations should be modified. For example, the current regulations may apply to certain structures where there is little likelihood of a doubledip. Moreover, the IRS and Treasury understand that some taxpayers have taken the position that the current regulations do not apply to certain structures that provide taxpayers the benefits of the type of doubledip that section 1503(d) is intended to deny. Accordingly, the proposed regulations are designed to minimize these cases of potential over and underapplication.

Second, the IRS and Treasury recognize that there are many unresolved issues that arise when applying the current regulations, particularly in light of the adoption of the entity classification regulations under Sec. Sec. 301.77011 through 301.77013. Thus, the proposed regulations modernize the dual consolidated loss regime to take into account the entity classification regulations and to resolve the related issues so that the rules can be applied by taxpayers and the Commissioner with greater certainty.

Finally, the IRS and Treasury believe that, in many cases, the current regulations are administratively burdensome to both taxpayers and the Commissioner. Accordingly, the proposed regulations reduce, to the extent possible, the administrative burden imposed on taxpayers and the Commissioner.
Explanation of Provisions

A. Structure of the Proposed Regulations

The proposed regulations are set forth in six sections. Section 1.1503(d)1 contains definitions and special rules for filings. Section 1.1503(d)2 sets forth operating rules, which include the general rule that prohibits the domestic use of a dual consolidated loss (subject to certain exceptions discussed below), a rule that limits the use of dual consolidated losses following certain transactions, an antiavoidance provision that prevents dual consolidated losses from offsetting income from assets acquired in certain nonrecognition transactions or contributions to capital, and rules for computing foreign tax credit limitations. Section 1.1503(d)3 contains special rules for accounting for dual consolidated losses. These special rules determine the amount of a dual consolidated loss, determine the effect of a dual consolidated loss on domestic affiliates, and provide special basis adjustments. Section 1.1503(d)4 provides exceptions to the general rule that prohibits the domestic use of a dual consolidated loss, including a domestic use election. Section 1.1503(d)5 contains examples that illustrate the application of the proposed regulations. Finally, Sec. 1.1503(d)6 contains the proposed effective date of the proposed regulations.

In addition to the proposed regulatory amendments under section 1503(d), the proposed regulations also include conforming proposed amendments to Sec. 1.150221 and Sec. 1.60434T.
B. Definitions and Special Rules for Filings Under Section 1503(d) Sec. 1.1503(d)1
1. Treatment of a Separate Unit as a Domestic Corporation and a Dual Resident Corporation

Section 1.15032(c)(3) and (4) of the current regulations defines a separate unit of a domestic corporation as a foreign branch, within the meaning of Sec. 1.367(a)6T(g), (foreign branch separate unit) and an interest in a partnership, trust or hybrid entity. The
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current regulations also provide that any separate unit of a domestic corporation is treated as a separate domestic corporation for purposes of applying the dual consolidated loss rules. Section 1.15032(c)(2). In addition, the current regulations provide that, unless otherwise indicated, any reference to a dual resident corporation refers also to a separate unit. As a result of these rules, certain provisions of the current regulations only refer to dual resident corporations, and therefore apply to separate units because they are treated as domestic corporations and dual resident corporations. However, other provisions of the current regulations refer to both dual resident corporations and separate units (for example, see Sec. 1.15032(g)(2)(iii)(A)).

The IRS and Treasury believe that, in certain cases, treating separate units as domestic corporations creates uncertainty in applying the current regulations. This may occur, for example, as a result of certain rules applying to separate units because they are treated as domestic corporations or dual resident corporations, while other rules apply explicitly to separate units themselves. Accordingly, the proposed regulations do not contain a general rule that treats separate units as domestic corporations or dual resident corporations for all purposes of applying the dual consolidated loss regulations. Instead, the proposed regulations explicitly refer to dual resident corporations and separate units where appropriate, treat separate units as domestic corporations only for limited purposes, and modify the operative rules where necessary to take into account differences between dual resident corporations and separate units.

2. Application of Section 1503(d) to S Corporations

Section 1.15032(c)(2) of the current regulations provides that an S corporation, as defined in section 1361, is not a dual resident corporation. The preamble to the current regulations explains that S corporations are so excluded because an S corporation cannot have a domestic corporation as one of its shareholders. The current regulations do not, however, explicitly exclude separate units owned by an S corporation from the definition of a dual resident corporation. As a result, the current regulations can be read to provide that an S corporation, although it cannot itself be a dual resident corporation, could own a separate unit that would be a dual resident corporation.

The IRS and Treasury believe that such a result is inappropriate because an S corporation cannot have a domestic corporation as one of its shareholders and generally is not taxable at the entity level. Accordingly, the proposed regulations provide that for purposes of the dual consolidated loss rules, an S corporation is not treated as a domestic corporation. This modification clarifies that the dual consolidated loss regulations do not apply to the S corporation itself, or to foreign branches or interests in certain flowthrough entities owned by an S corporation.

The IRS and Treasury request comments as to whether regulated investment companies (as defined in section 851) or real estate investment trusts (as defined in section 856) should be similarly excluded from the application of the dual consolidated loss rules. 3. Losses of a Foreign Insurance Company Treated as a Domestic Corporation

Section 953(d) generally provides that a foreign corporation that would qualify to be taxed as an insurance company if it were a domestic corporation may, under certain circumstances, elect to be treated as a domestic corporation. Section 953(d)(3) provides that if a corporation elects to be treated as a domestic corporation pursuant to section 953(d) and is treated as a member of an affiliated group, any loss of such corporation is treated as a dual consolidated loss for purposes of section 1503(d), without regard to section 1503(d)(2)(B) (grant of regulatory authority to exclude losses which do not offset the income of foreign corporations from the definition of a dual consolidated loss). Therefore, losses of such corporations are treated as dual consolidated losses regardless of whether the corporation is subject to an income tax of a foreign country on its worldwide income or on a residence basis.

The current regulations do not address the application of section 953(d)(3). However, the definition of a dual resident corporation contained in the proposed regulations includes a foreign insurance company that makes an election to be treated as a domestic corporation pursuant to section 953(d) and is a member of an affiliated group, regardless of how such entity is taxed by the foreign country. 4. Definition of a Separate Unit
(a) Interests in NonHybrid Entity Partnerships and Interests in Non Hybrid Entity Grantor Trusts

Section 1.15032(c)(4) of the current regulations defines a separate unit to include an interest in a hybrid entity (hybrid entity separate unit). The current regulations define a hybrid entity as an entity that is not taxable as an association for U.S. income tax purposes, but is subject to income tax in a foreign jurisdiction as a corporation (or otherwise at the entity level) either on its worldwide income or on a residence basis. This definition includes an interest in such an entity that is treated for U.S. tax purposes as a partnership (hybrid entity partnership) or as a grantor trust (hybrid entity grantor trust). An interest in an entity that is treated as a partnership or a grantor trust for both U.S. and foreign tax purposes (nonhybrid entity partnership and nonhybrid entity grantor trust, respectively) also is treated as a separate unit under the current regulations. Sec. 1.15032(c)(3)(i).

The current regulations also apply to a separate unit owned indirectly through a partnership or grantor trust. Thus, for example, if a partnership owns a foreign branch within the meaning of Sec. 1.367(a)6T(g), a domestic corporate partner's interest in such partnership, and its indirect interest in a portion of the foreign branch owned through the partnership, each constitutes a separate unit.

Under the current regulations, an interest in a nonhybrid entity partnership or a nonhybrid entity grantor trust is also treated as a separate unit, regardless of whether the partnership or grantor trust has any nexus with a foreign jurisdiction. This rule can result in the application of the dual consolidated loss rules when there may be little opportunity for a doubledip. For example, if two domestic corporations each own 50 percent of a domestic partnership that generates losses attributable to activities conducted solely in the United States, the corporate partners would be technically subject to the dual consolidated loss rules and therefore would not be allowed to offset their income with such losses, unless an exception applied. In such a case, however, it may be unlikely that the losses would be available to offset income of another person under the income tax laws of a foreign country.

The IRS and Treasury believe that including an interest in a non hybrid entity partnership and an interest in a nonhybrid entity grantor trust in the
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definition of a separate unit may not be necessary and is
administratively burdensome. In such cases, it may be unlikely that deductions and losses solely attributable to activities of the partnership or grantor trust, that do not rise to the level of a taxable presence in a foreign jurisdiction, can be used to offset income of another person under the income tax laws of a foreign country. As a result, the proposed regulations eliminate from the definition of a separate unit an interest in a nonhybrid entity partnership and an interest in a nonhybrid entity grantor trust. It should be noted, however, that the proposed regulations retain the rule contained in the current regulations that a domestic corporation can own a separate unit indirectly through both hybrid entity and non hybrid entity partnerships, and through both hybrid entity and non hybrid entity grantor trusts.

(b) Separate Unit Combination Rule

Section 1.15032(c)(3)(ii) of the current regulations provides that if two or more foreign branches located in the same foreign country are owned by a single domestic corporation and the losses of each branch are made available to offset the income of the other branches under the tax laws of the foreign country, then the branches are treated as one separate unit. The combination rule in the current regulations does not apply to interests in hybrid entity separate units or to dual resident corporations.

Although a disregarded entity is treated as a branch of its owner for various purposes of the Code, the current regulations distinguish a hybrid entity separate unit that is disregarded as an entity separate from its owner from a foreign branch separate unit. Compare Sec. 1.15032(c)(3)(i)(A) and (c)(4); see also Sec. 1.15032(g)(2)(vi)(C). Accordingly, the combination rule under the current regulations does not apply to an interest in a hybrid entity separate unit, even if the hybrid entity is disregarded as an entity separate from its owner.

The combination rule in the current regulations also requires the foreign branches to be owned by a single domestic corporation. Thus, for example, the current regulations do not permit the combination of foreign branches owned by different domestic corporations, even if such corporations are members of the same consolidated group. In addition, in some cases the current regulations do not allow the combination of foreign branches that are owned indirectly by a single domestic corporation through other separate units because, as discussed above, such other separate units are generally treated as domestic corporations for purposes of applying the dual consolidated loss regulations. As a result, such foreign branches are not treated as being owned by a single domestic corporation.

The IRS and Treasury believe that the application of the combination rule should not be restricted to foreign branch separate units. In addition, the IRS and Treasury believe that the combination rule should not be limited to those cases where the domestic corporation owns the separate units directly. Therefore, provided certain requirements are satisfied, the proposed regulations adopt a broader combination rule that combines all separate units that are directly or indirectly owned by a single domestic corporation.

In order for separate units to be combined under the proposed regulations, the losses of each separate unit must be made available to offset the income of the other separate units under the tax laws of a single foreign country. In addition, if the separate unit is a foreign branch separate unit, it must be located in the foreign country that allows its losses to be made available to offset income of each separate unit; if the separate unit is a hybrid entity separate unit, the hybrid entity must be subject to tax in the foreign country that allows losses to be made available to each separate unit either on its worldwide income or on a residence basis.

The combination rule in the proposed regulations does not combine separate units owned by different domestic corporations, even if the domestic corporations are included in the same consolidated group. The IRS and Treasury believe this approach is consistent with section 1503(d)(3), which provides that, to the extent provided in regulations, a loss of a separate unit of a domestic corporation is subject to the dual consolidated loss rules as if it were a wholly owned subsidiary of such domestic corporation. In addition, the combination rule contained in the proposed regulations only applies to separate units and therefore does not apply to dual resident corporations.

The IRS and Treasury, however, request comments as to whether there is authority to expand the combination rule and, if so, whether the combination rule should be expanded to include separate units that are owned directly or indirectly by domestic corporations that are members of the same consolidated group. Similarly, comments are requested as to whether the combination rule should be extended to apply to dual resident corporations. Further, the IRS and Treasury request comments on the application of the operative provisions of the proposed regulations to combined separate units owned by different domestic corporations (for example, the SRLY limitation under Sec. 1.1503(d) 3(c)).

5. Exception to the Definition of a Dual Consolidated Loss

Section 1.15032(c)(5)(ii)(A) of the current regulations provides a very limited exception to the definition of a dual consolidated loss where the income tax laws of a foreign country do not permit the dual resident corporation to either: (1) Use its losses, expenses, or deductions to offset the income of any other person in the same taxable year; or (2) carry over or carry back its losses, expenses, or deductions to be used, by any means, to offset the income of any other person in other taxable years. This exception only applies in rare and unusual cases where the income tax laws of the foreign country do not allow any portion of the dual consolidated loss to be used to offset income of another person under any circumstances.

The IRS and Treasury understand that some taxpayers have improperly interpreted this provision in a manner inconsistent with the policies of the dual consolidated loss rules. As a result, the proposed regulations eliminate this exception to the definition of a dual consolidated loss. As discussed below, however, the proposed regulations contain a new exception to the general rule restricting the use of a dual consolidated loss to offset income of a domestic affiliate. In general, this new exception applies when there is no possibility that any portion of the dual consolidated loss can be doubledipped, and operates in a manner that is similar to the manner in which the exception to the definition of a dual consolidated loss contained in the current regulations operates.

6. Partnership Special Allocations

Section 1.15032(c)(5)(iii) of the current regulations reserves on the treatment of dual consolidated losses of separate units that are partnership interests, including interests in hybrid entities. The preamble to the current regulations explains that the reservation was principally the result of concerns regarding partnership special allocations.

The proposed regulations no longer reserve on the treatment of separate units that are partnership interests. However, the IRS will continue to challenge structures that attempt to use special allocations in a manner that is
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inconsistent with the principles of section 1503(d).

7. Domestic Use of a Dual Consolidated Loss

Section 1.15032(b)(1) of the current regulations states that, except as otherwise provided, a dual consolidated loss cannot offset the taxable income of any domestic affiliate, regardless of whether the loss offsets income of another person under the income tax laws of a foreign country, and regardless of whether the income that the loss may offset in the foreign country is, has been, or will be subject to tax in the United States. Section 1.15032(c)(13) defines the term domestic affiliate to mean any member of an affiliated group, without regard to exceptions contained in section 1504(b) (other than section 1504(b)(3)) relating to includible corporations.

The proposed regulations retain the general prohibition against using a dual consolidated loss to offset income of domestic affiliates contained in the current regulations, with modifications, and refer to such usage as a domestic use of a dual consolidated loss. This general prohibition is subject to a number of exceptions, discussed below. In addition, because the proposed regulations do not treat separate units as domestic corporations and dual resident corporations (other than for limited purposes) the proposed regulations expand the definition of a domestic affiliate to include separate units. This expanded definition is necessary for purposes of applying the domestic use limitation rule. 8. Foreign use of a dual consolidated loss

(a) General Rule

Section 1.15032T(g)(2)(i) of the current regulations provides that, in order to elect relief from the general limitation on the use of a dual consolidated loss to offset income of a domestic affiliate with respect to a dual consolidated loss ((g)(2)(i) election), the taxpayer must, among other things, certify that no portion of the losses, expenses, or deductions taken into account in computing the dual consolidated loss has been, or will be, used to offset the income of any other person under the income tax laws of a foreign country. If, contrary to this certification, there is such a use, the dual consolidated loss subject to the (g)(2)(i) election generally must be recaptured and reported as gross income.

The IRS and Treasury understand that issues arise involving the application of the use rule contained in the current regulations. For example, issues may arise where items of income, gain, deduction and loss are treated as being generated or incurred by different persons under U.S. and foreign law. Similarly, issues may arise due to different definitions of a person under U.S. and foreign law. These issues have become more prevalent since the adoption of the entity classification regulations under Sec. Sec. 301.77011 through 301.77013.

The IRS and Treasury also understand that taxpayers have taken positions under the current regulations regarding the use of a dual consolidated loss that are inconsistent with the policies underlying section 1503(d). On the other hand, the IRS and Treasury believe that, under the current regulations, a use can be deemed to occur in certain cases where there may be little likelihood of the type of doubledip that section 1503(d) was intended to prevent.

For the reasons discussed above, the proposed regulations modify the definition of use and provide a rule based on foreign use. These modifications are intended to minimize the potential over and under application of the dual consolidated loss rules that can occur under the current regulations. Under the proposed regulations, the foreign use definition is intended to minimize the opportunity for a double dip. However, the new definition is also intended to minimize the situations in which a foreign use will occur in cases where there may be little likelihood of a doubledip.

The proposed regulations provide that a foreign use is deemed to occur only if two conditions are satisfied. The first condition is satisfied if any portion of a loss or deduction taken into account in computing the dual consolidated loss is made available under the income tax laws of a foreign country to offset or reduce, directly or indirectly, any item that is recognized as income or gain under such laws (including items of income or gain generated by the dual resident corporation or separate unit itself), regardless of whether income or gain is actually offset, and regardless of whether such items are recognized under U.S. tax principles. This condition ensures that there will not be a foreign use unless all or a portion of the dual consolidated loss offsets or reduces, or is made available to offset or reduce, income or gain for foreign tax purposes.

The second condition is satisfied if items that are (or could be) offset pursuant to the first condition are considered, under U.S. tax principles, to be items of: (1) A foreign corporation; or (2) a direct or indirect (for example, through a partnership) owner of an interest in a hybrid entity, provided such interest is not a separate unit. This condition is intended to limit a foreign use to situations where the foreign income that is (or could be) offset by the dual consolidated loss is not currently subject to U.S. corporate income tax. In general, if the foreign income that is offset is currently subject to U.S. corporate income tax, there is no doubledip of the dual consolidated loss.
(b) Exception to Foreign Use If No Dilution of an Interest in a Separate Unit

Section 1.15032(c)(15) of the current regulations employs a so called actual use standard for determining whether there has been a use of a dual consolidated loss to offset the income of another person under the laws of a foreign country. Although referred to as an actual use standard, this rule provides that a use is considered to occur in the year in which a loss, expense or deduction taken into account in computing the dual consolidated loss is made available for such an offset, unless an exception applies. The fact that the other person does not have sufficient income in that year to benefit from such an offset is not taken into account.

The available component of the actual use standard was adopted because of the administrative complexity that would result from having a use occur only when income is actually offset. For example, if in the year that a portion of the dual consolidated loss is made available to be used by another person, the other person itself generates a loss (or has a loss carryover), then in many cases the portion of the dual consolidated loss would become part of the loss carryover. Such loss therefore would be available to be carried forward or carried back to offset income in different taxable years. Under this approach, the portion of the loss carryforward or carryback that was taken into account in computing the dual consolidated loss would need to be identified and tracked, which would require detailed ordering rules for determining when such losses were used. Timing and base differences between the U.S. and foreign jurisdiction would further complicate such an approach.

Because of the administrative complexities discussed above, the foreign use definition contained in the proposed regulations retains the available for use standard. However, because the available for use standard is
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retained, there are many cases in which a foreign use of a dual consolidated loss attributable to interests in hybrid entity partnerships and hybrid entity grantor trusts, and separate units owned indirectly through partnerships and grantor trusts, occurs, even though no portion of any item of deduction or loss comprising the dual consolidated loss is doubledipped. In the case of interests in hybrid entity partnerships and hybrid entity grantor trusts, a portion of the dual consolidated loss attributable to an interest in such entity in many cases would be made available to offset income or gain of a direct or indirect owner of an interest in such hybrid entity, provided such interest is not a separate unit. This typically would occur because under foreign law the hybrid entity is taxed as a corporation (or otherwise at the entity level) and its net losses may be carried forward or carried back. A similar result may occur in the case of a separate unit owned indirectly through a nonhybrid entity partnership or a nonhybrid entity grantor trust because of timing and base differences between the laws of the United States and the foreign jurisdiction.

The IRS and Treasury believe this is an inappropriate result in many cases. For example, the IRS and Treasury believe that if there is no dilution of the domestic owner's interest in the separate unit, it is unlikely that any portion of the dual consolidated loss attributable to such separate unit can be put to a foreign use (other than through an election to consolidate or similar method, discussed below). Therefore, the proposed regulations include three new exceptions to the definition of a foreign use where there is no dilution of an interest in a separate unit. The new exceptions to foreign use apply to dual consolidated losses attributable to two types of separate units: (1) Interests in hybrid entity partnerships and interests in hybrid entity grantor trusts; and (2) separate units owned indirectly through partnerships and grantor trusts.

The first exception to foreign use provides that, in general, no foreign use shall be considered to occur with respect to a dual consolidated loss attributable to an interest in a hybrid entity partnership or a hybrid entity grantor trust, solely because an item of deduction or loss taken into account in computing such dual consolidated loss is made available, under the income tax laws of a foreign country, to offset or reduce, directly or indirectly, any item that is recognized as income or gain under such laws and is considered under U.S. tax principles to be an item of the direct or indirect owner of an interest in such hybrid entity that is not a separate unit.

The second exception to foreign use provides that, in general, no foreign use shall be considered to occur with respect to a dual consolidated loss attributable to or taken into account by a separate unit owned indirectly through a partnership or grantor trust solely because an item of deduction or loss taken into account in computing such dual consolidated loss is made available, under the income tax laws of a foreign country, to offset or reduce, directly or indirectly, any item that is recognized as income or gain under such laws and is considered under U.S. tax principles to be an item of a direct or indirect owner of an interest in such partnership or trust.

Finally, the proposed regulations provide a similar exception for combined separate units that include individual separate units to which one of the other dilution exceptions would apply, but for the separate unit combination rule.

The new exceptions to foreign use are subject to certain limitations, however. First, the exceptions will not apply if there has been a dilution of the interest in the separate unit. That is, the exception will not apply if during any taxable year the domestic owner's percentage interest in the separate unit, as compared to its interest in the separate unit as of the last day of the taxable year in which such dual consolidated loss was incurred, is reduced as a result of another person acquiring through sale, exchange, contribution or other means an interest in such partnership or grantor trust, unless the taxpayer demonstrates, to the satisfaction of the Commissioner, that the other person that acquired the interest in the partnership or grantor trust was a domestic corporation. The exceptions to foreign use should not apply when a person (other than a domestic corporation) acquires an interest in the separate unit because the dilution would typically result in an actual foreign use.

Second, the exceptions do not apply if the availability does not arise solely from the ownership in such partnership or trust and the allocation of the item of deduction or loss, or the offsetting by such deduction or loss, of an item of income or gain of the partnership or trust. For example, the exception does not apply in the case where the item of loss or deduction is made available through a foreign consolidation regime.

The IRS and Treasury request comments on the issues discussed above in connection with the availability component of the foreign use definition. Comments are specifically requested as to whether the dilution rules are appropriate and, if so, whether a de minimis exception should be provided.

9. Mirror Legislation Rule

Section 1.15032(c)(15)(iv) of the current regulations contains a mirror legislation rule that addresses legislation enacted by foreign jurisdictions that operates in a manner similar to the dual consolidated loss rules. This rule was designed to prevent the revenue gain resulting from the disallowance of the doubledip benefit of a dual consolidated loss from inuring solely to the foreign jurisdiction (to the detriment of the United States). Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, at 106566 (J. Comm. Print 1987).

Congress recognized that mirror legislation in a foreign jurisdiction, in conjunction with a mirror legislation rule such as that contained in the current regulations, could result in the disallowance of a dual consolidated loss in both the United States and in the foreign jurisdiction. In such a case, Congress intended that Treasury pursue with the appropriate authorities in the foreign jurisdiction a bilateral agreement that would allow the use of the loss of a dual resident corporation to offset income of an affiliate in only one country. Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, at 1066. The mirror rule was specifically held to be valid by the Court of Appeals for the Federal Circuit. British Car Auctions, Inc. v. United States, 35 Fed. Cl. 123 (1996), aff'd without op., 116 F.3d 1497 (Fed. Cir. 1997).

The mirror legislation rule contained in the current regulations provides that if the laws of a foreign country deny the use of a loss of a dual resident corporation (or separate unit) to offset the income of another person because the dual resident corporation (or separate unit) is also subject to tax by another country on its worldwide income or on a residence basis, the loss is deemed to be used against the income of another person in such foreign country such that no (g)(2)(i) election can be made with respect to such loss. This rule is intended to prevent the foreign jurisdiction from enacting legislation that gives taxpayers no choice but to use the dual consolidated loss to offset income in the United States. This result is contrary to the general policy underlying the structure of the current regulations that provides taxpayers the choice of using the dual consolidated loss to either offset income
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in the United States or income in the foreign jurisdiction (but not both).

As a result of the consistency rule (discussed below), the deemed use of a dual consolidated loss pursuant to the mirror legislation rule may also restrict the ability to use other dual consolidated losses to offset the income of domestic affiliates, even if such losses are not subject to the mirror legislation.

Subsequent to the issuance of the current regulations, several foreign jurisdictions enacted various forms of mirror legislation that, absent the mirror legislation rule, would have the effect of forcing certain taxpayers to use dual consolidated losses to offset income of domestic affiliates.

Given the relevant legislative history and British Car Auctions, the IRS and Treasury believe that the mirror legislation rule remains necessary. This is particularly true in light of the prevalence of mirror legislation in foreign jurisdictions. As a result, the proposed regulations retain the mirror legislation rule. The proposed regulations modify the mirror legislation rule, however, to address its proper application with respect to mirror legislation enacted subsequent to the issuance of the current regulations, and to modify its application to better take into account the policies underlying the consistency rule.

In general, the mirror legislation rule contained in the proposed regulations applies when the opportunity for a foreign use is denied because: (1) The loss is incurred by a dual resident corporation that is subject to income taxation by another country on its worldwide income or on a residence basis; (2) the loss may be available to offset income other than income of the dual resident corporation or separate unit under the laws of another country; or (3) the deductibility of any portion of a loss or deduction taken into account in computing the dual consolidated loss depends on whether such amount is deductible under the laws of another country.

The IRS and Treasury understand that there may be uncertainty as to the application of the mirror legislation rule in a given case when the mirror legislation is limited in its application. Mirror legislation may or may not apply to a particular dual resident corporation or separate unit depending on various factors, including the type of entity or structure that generates the loss, the ownership of the operation or entity that generates the loss, the manner in which the operation or entity is taxed in another jurisdiction, or the ability of the losses to be deducted in another jurisdiction. As a result, the proposed regulations clarify that the mere existence of mirror legislation, regardless of whether it applies to the particular dual resident corporation, may not result in a deemed foreign use. For example, see Sec. 1.1503(d)5(c) Example 23.

The proposed regulations also clarify that the absence of an affiliate in the foreign jurisdiction, or the failure to make an election to enable a foreign use, does not prevent the opportunity for a foreign use. Thus, for example, the mirror legislation rule may apply even if there are no affiliates of the dual resident corporation in the foreign jurisdiction or, even where there is such an affiliate, no election is made to consolidate.

As discussed below, the consistency rule is intended to promote uniformity and reduce administrative burdens. The IRS and Treasury believe that these concerns may not be significant, however, where there is only a deemed foreign use of a dual consolidated loss as a result of the mirror legislation rule. Accordingly, the mirror legislation rule contained in the proposed regulations provides that a deemed foreign use is not treated as a foreign use for purposes of applying the consistency rule.

10. Reasonable Cause Exception

The current regulations require various filings to be included on a timely filed tax return. In addition, taxpayers that fail to include such filings on a timely filed tax return must request an extension of time to file under Sec. 301.91003.

The IRS and Treasury believe that requiring taxpayers to request relief for an extension of time to file under Sec. 301.91003 results in an unnecessary administrative burden on both taxpayers and the Commissioner. The IRS and Treasury believe that a reasonable cause standard, similar to that used in other international provisions of the Code (such as sections 367(a) and 6038B), is a more appropriate and less burdensome means for taxpayers to cure compliance defects under section 1503(d). As a result, the proposed regulations adopt a reasonable cause standard. Moreover, extensions of time under Sec. 301.91003 will not be granted for filings under these proposed regulations. See Sec. 301.91001(d).

Under the reasonable cause standard, if a person that is permitted or required to file an election, agreement, statement, rebuttal, computation, or other information under the regulations fails to make such a filing in a timely manner, such person shall be considered to have satisfied the timeliness requirement with respect to such filing if the person is able to demonstrate, to the satisfaction of the Director of Field Operations having jurisdiction of the taxpayer's tax return for the taxable year, that such failure was due to reasonable cause and not willful neglect. Once the person becomes aware of the failure, the person must make this demonstration and comply by attaching all the necessary filings to an amended tax return (that amends the tax return to which the filings should have been attached), and including a written statement explaining the reasons for the failure to comply.

In determining whether the taxpayer has reasonable cause, the Director of Field Operations shall consider whether the taxpayer acted reasonably and in good faith. Whether the taxpayer acted reasonably and in good faith will be determined after considering all the facts and circumstances. The Director of Field Operations shall notify the person in writing within 120 days of the filing if it is determined that the failure to comply was not due to reasonable cause, or if additional time will be needed to make such determination.
C. Operating RulesSec. 1.1503(d)2
1. Application of Rules to Multiple Tiers of Separate Units

Section 1.15032(b)(3) of the current regulations provides that if a separate unit of a domestic corporation is owned indirectly through another separate unit, limitations on the dual consolidated losses of the separate units apply as if the uppertier separate unit were a subsidiary of the domestic corporation, and the lowertier separate unit were a lowertier subsidiary. In light of changes made to other provisions of the proposed regulations, this rule is no longer necessary. As a result, the proposed regulations do not contain this provision.

2. Tainted Income

Section 1.15032(e) of the current regulations prevents the dual consolidated loss of a dual resident corporation that ceases being a dual resident corporation from offsetting tainted income of such corporation. Subject to certain exceptions, tainted income is defined as income derived from assets that are acquired by a dual resident corporation in a nonrecognition transaction, or as a contribution to capital, at any time during the three taxable years immediately preceding the tax year in which the corporation ceases to be a dual resident corporation, or at any time thereafter. The current regulations also contain a rule that,
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absent proof to the contrary, presumes an amount of income generated during a taxable year as being tainted income. Such amount is the corporation's taxable income for the year multiplied by a fraction, the numerator of which is the fair market value of the tainted assets at the end of the year, and the denominator of which is the fair market value of the total assets owned by each domestic corporation at the end of each year.

The tainted income rule is intended to prevent taxpayers from obtaining a doubledip with respect to a dual consolidated loss by stuffing assets into a dual resident corporation after, or in certain cases before, it terminates its status as a dual resident corporation. A doubledip may be obtained in such case because the income that offsets the dual consolidated loss generally would not be subject to tax in the foreign jurisdiction after the dual resident status of the corporation terminates.

The proposed regulations retain the tainted income rule, subject to the following modifications. The proposed regulations clarify that tainted income includes both income or gain recognized on the sale or other disposition of tainted assets and income derived as a result of holding tainted assets. The proposed regulations also modify the rule defining the amount of income presumed to be tainted income. The proposed regulations clarify that the presumptive rule only applies to income derived as a result of holding tainted assets; income or gain recognized on the sale or other disposition of tainted assets should be readily determinable such that the presumptive rule need not apply. The proposed regulations also provide that the numerator in the presumptive income fraction is the fair market value of tainted assets determined at the time such assets were acquired by the corporation, as opposed to being determined at the end of the taxable year. The IRS and Treasury believe that this approach is more administrable because value should be more readily determinable on the acquisition date. In addition, this approach does not require tainted assets to be traced over time. D. Special Rules for Accounting for Dual Consolidated LossesSec. 1.1503(d)3
1. Items Attributable to a Separate Unit

(a) Overview

Section 1.15032(d)(1)(ii) of the current regulations provides a rule for determining whether a separate unit has a dual consolidated loss. Under this rule, the separate unit must compute its taxable income as if it were a separate domestic corporation that is a dual resident corporation, using only those items of income, expense, deduction, and loss that are otherwise attributable to such separate unit.

The current regulations do not provide any guidance for determining the items of income, gain, deduction and loss that are otherwise attributable to a separate unit. The IRS and Treasury understand that the absence of such guidance has resulted in considerable uncertainty. For example, commentators have questioned whether all or any portion of the interest expense of a domestic owner is attributable to a separate unit.

It is also unclear the extent to which a separate unit is treated as a separate domestic corporation under this rule. For example, commentators have questioned whether a transaction between a separate unit and its owner that is generally disregarded for federal tax purposes (for example, interest paid by a disregarded entity on an obligation held by its owner) can create an item of income, gain, deduction or loss for purposes of calculating a dual consolidated loss.

Commentators have also questioned whether each separate unit in a tiered separate unit structure (that is, where one separate unit owns another separate unit) must separately determine whether it has a dual consolidated loss, or whether such separate units are combined for this purpose.

The proposed regulations provide more definitive rules for determining the amount of a dual consolidated loss (or income) of a separate unit. These rules apply solely for purposes of section 1503(d) and, therefore, do not apply for other purposes of the Code (for example, section 987). The proposed regulations first provide general rules that apply for purposes of calculating dual consolidated losses (or income) for both foreign branch separate units and hybrid entity separate units. The proposed regulations provide additional rules for calculating the dual consolidated losses (or income) of foreign branch separate units, hybrid entity separate units, and separate units owned indirectly through other separate units, nonhybrid entity
partnerships, or nonhybrid entity grantor trusts. Finally, the proposed regulations provide special rules that apply to tiered separate units, combined separate units, dispositions of separate units, and the treatment of certain income inclusions on stock. (b) General Rules

The proposed regulations clarify that only existing tax accounting items of income, gain, deduction and loss (translated into U.S. dollars) should be taken into account for purposes of calculating the dual consolidated loss of a separate unit. In other words, treating a separate unit as a separate domestic corporation does not cause items that are disregarded for U.S. tax purposes (for example, interest paid by a disregarded entity on an obligation held by its owner) to be regarded for purposes of calculating a separate unit's dual consolidated loss.

The proposed regulations also clarify that in the case of tiered separate units, each separate unit must calculate its own dual consolidated loss and no item of income, gain, deduction and loss may be taken into account in determining the taxable income or loss of more than one separate unit. Similarly, the proposed regulations clarify that items of one separate unit cannot offset or otherwise be taken into account by another separate unit for purposes of calculating a dual consolidated loss (unless the separate unit combination rule applies). These rules ensure that the dual consolidated loss calculation is computed separately for each separate unit, which is necessary to prevent deductions and losses from being doubledipped. (c) Foreign Branch Separate Unit

The proposed regulations provide that the asset use and business activities principles of section 864(c) apply for purposes of determining the items of income, gain, deduction (other than interest) and loss that are taken into account in determining the taxable income or loss of a foreign branch separate unit. For this purpose, the trading safe harbors of section 864(b) do not apply for purposes of determining whether a trade or business exists within a foreign country or whether income may be treated as effectively connected to a foreign branch separate unit. In addition, the limitations on effectively connected treatment of foreign source relatedparty income under section 864(c)(4)(D) do not apply.

The proposed regulations further provide that the principles of Sec. 1.8825, as modified, apply for purposes of determining the items of interest expense that are taken into account in determining the taxable income or loss of a foreign branch separate unit. The rules provide that a taxpayer must use U.S. tax principles to determine both the classification and amounts of the assets and liabilities when the actual worldwide ratio is used. The valuation of assets must be determined under the same methodology the taxpayer uses under Sec. 1.8619T(g) for purposes of
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allocating and apportioning interest expense under section 864(e). Further, and solely for these purposes, the domestic owner of the foreign branch separate unit is treated as a foreign corporation, the foreign branch separate unit is treated as a trade or business within the United States, and assets other than those of the foreign branch separate unit are treated as assets that are not U.S. assets. Accordingly, only the interest expense of the domestic owner of the foreign branch separate unit is subject to allocation for purposes of computing the dual consolidated loss. The IRS and Treasury believe that the application of these principles will better harmonize the borrowing rate and effective interest costs that both the United States and the foreign country take into account in determining the dual consolidated loss, as compared to the use of Sec. 1.8619T.

The IRS and Treasury believe that taking items into account in determining the taxable income or loss of a foreign branch separate unit under these standards is administrable because of the existing guidance provided under these provisions. In addition, the IRS and Treasury believe that this approach furthers the policy underlying section 1503(d) because it serves as a reasonable approximation of the items that the foreign jurisdiction may recognize as being taken into account in determining the taxable income or loss of a branch or permanent establishment of a nonresident corporation in such jurisdiction. Nevertheless, the IRS and Treasury solicit comments on these provisions and whether other administrable approaches (that approximate the items taken into account by the foreign jurisdiction) should be considered.

(d) Hybrid Entity

The proposed regulations provide rules for attributing items of income, gain, deduction and loss to a hybrid entity. These rules are necessary to determine the items that are attributable to an interest in a hybrid entity that constitutes a separate unit.

The proposed regulations provide that, in general, the items of income, gain, deduction and loss that are attributable to a hybrid entity are those items that are properly reflected on its books and records, as adjusted to conform to U.S. tax principles. The principles of Sec. 1.9884(b)(2) apply for purposes of making this determination. These principles generally provide that the determination is a question of fact and must be consistently applied. These principles also provide that the Commissioner may allocate items of income, gain, deduction and loss between the domestic corporation (and intervening entities, if any) that own the hybrid entity separate unit, and the hybrid entity separate unit, if such items are not properly reflected on the books and records of the hybrid entity.

The proposed regulations also provide that if a hybrid entity owns an interest in either a nonhybrid entity partnership or a nonhybrid entity grantor trust, items of income, gain, deduction and loss that are properly reflected on the books and records of such partnership or grantor trust (under the principles of Sec. 1.9884(b)(2), as adjusted to conform to U.S. tax principles), are treated as being properly reflected on the books and records of the hybrid entity. However, such items are treated as being properly reflected on the books and records of the hybrid entity only to the extent they are taken into account by the hybrid entity under principles of subchapter K, chapter 1 of the Code, or the principles of subpart E, subchapter J, chapter 1 of the Code, as the case may be.

The IRS and Treasury believe that attributing items to a hybrid entity under this standard is administrable because it is generally consistent with the accounting treatment of the items. The IRS and Treasury also believe that this standard furthers the policy underlying section 1503(d) because the items that are properly reflected on the books and records of the hybrid entity (as adjusted to conform to U.S. tax principles) represent the best approximation of items that the foreign jurisdiction would recognize as being attributable to the entity. For example, it is likely that a foreign jurisdiction would recognize and take into account as being attributable to a hybrid entity the interest expense properly reflected on the books and records of the hybrid entity; however, it is unlikely that a foreign jurisdiction would recognize, and take into account as being attributable to a hybrid entity, interest expense of a domestic corporation that owns an interest in the hybrid entity.

(e) Interest in a Disregarded Hybrid Entity

The proposed regulations provide that, except to the extent otherwise provided under special rules (discussed below), items that are attributable to an interest in a hybrid entity that is disregarded as an entity separate from its owner are those items that are attributable to such hybrid entity itself.
(f) Interests in Hybrid Entity Partnerships, Interests in Hybrid Entity Grantor Trusts, and Separate Units Owned Indirectly Through Partnerships and Grantor Trusts

The proposed regulations provide rules for determining the extent to which: (1) Items of income, gain, deduction and loss that are attributable to a hybrid entity that is a partnership are attributable to an interest in such hybrid entity partnership; and (2) items of income, gain, deduction and loss of a separate unit that is owned indirectly through a partnership are taken into account by a partner in such partnership. These items are taken into account to the extent they are includible in the partner's distributive share of the partnership income, gain, deduction or loss, as determined under the rules and principles of subchapter K, chapter 1 of the Code.

The proposed regulations also provide rules for determining the extent to which: (1) Items of income, gain, deduction and loss attributable to a hybrid entity that is a grantor trust are attributable to an interest in such hybrid entity grantor trust; and (2) the items of income, gain, deduction and loss of a separate unit owned indirectly through a grantor trust are taken into account by an owner of such grantor trust. These items are taken into account to the extent they are attributable to trust property that the holder of the trust interest is treated as owning under the rules and principles of subpart E, subchapter J, chapter 1 of the Code.
(g) Allocation of Items Between Certain Indirectly Owned Separate Units

The proposed regulations provide special rules for allocating items of income, gain, deduction and loss to foreign branch separate units that are owned, directly or indirectly (other than through a hybrid entity separate unit) by hybrid entities. In such a case, only items that are attributable to the hybrid entity that owns such separate unit (and intervening entities, if any, that are not themselves separate units) are taken into account.

This rule is intended to minimize the items taken into account by a foreign branch separate unit that the foreign jurisdiction would not recognize as being so taken into account. This may occur in these cases because the foreign jurisdiction taxes the hybrid entity as a corporation (or otherwise at the entity level) and therefore likely would not take into account items of its owner. For example, if a domestic corporation indirectly owns a Country X foreign branch separate unit through a Country
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Y hybrid entity, Country X likely would take into account items of the Count

FOR FURTHER INFORMATION CONTACT

Concerning the proposed regulations, Kathryn T. Holman, (202) 6223840 (not a tollfree number); concerning submissions and the hearing, Robin Jones, (202) 6223521 (not a toll free number).