The following article was originally published in Tax Notes Federal, December 2, 2024, p. 1729, and is republished here with permission.
On August 6, Treasury issued proposed regulations (REG-105128-23) concerning the U.S. dual consolidated loss (DCL) rules under section 1503(d) that include1:
- modifications to the consolidated return intercompany transactions rules under section 1502 as they relate to DCLs;
- modifications to the computation of DCLs for certain items;
- guidance concerning the application of the DCL rules to the global anti-base-erosion (GLOBE) rules, including the global minimum tax imposed by pillar 2 of the OECD base erosion and profit-shifting 2.0 initiative; and
- rules regarding disregarded payments giving rise to losses for foreign tax purposes.
The proposed regulations are a direct response to Notice 2023-80, 2023-52 IRB 1583, which said that Treasury would release guidance in the form of regulations discussing the interaction of the U.S. DCL rules with the GLOBE rules and provide further clarification for the computation of DCLs. This article provides commentary regarding the key aspects of the proposed regulations. However, it is imperative to first provide an overview of the DCL rules.
I. Background on the DCL Rules
Generally, the DCL rules attempt to prevent the double dipping of tax losses between the United States and a foreign jurisdiction. Section 1503(d) and the regulations provide that a DCL of a dual resident corporation or a separate unit cannot be made available to offset, directly or indirectly, the income of the domestic affiliate, including the owner of a separate unit (domestic owner), or any other member of the affiliated group of corporations or an interest in a “transparent entity.”2 A dual resident corporation is a domestic corporation that is subject to an income tax of a foreign country on its worldwide income or on a resident basis. A separate unit is an entity that is subject to an income tax as a corporation for foreign income tax purposes but is treated as either (1) an entity disregarded as separate from its owner, or (2) as a partnership; and whose income (all or a portion) flows into a U.S. C corporation under U.S. tax principles (collectively known as a hybrid entity separate unit). A separate unit can also be a foreign branch whose income (all or a portion) flows into a U.S. C corporation under U.S. tax principles. A “domestic owner” means a domestic C corporation. To the extent that more than one separate unit of a domestic owner (or any corporation in the domestic owner’s consolidated group) is in the same foreign jurisdiction, all those separate units must be combined into one separate unit for purposes of calculating its DCL. All transactions that would be disregarded for federal income tax purposes must be eliminated when calculating a DCL.
An exception to the general rule that a DCL cannot be deducted by the dual resident corporation or the domestic owner of a separate unit (that is, the DCL can be deducted) is if a domestic use election is made by that dual resident corporation or a consolidated group. A domestic use election is an agreement stating that a DCL has not been put to a foreign use and that the DCL will be recaptured upon certain triggering events during a five-year certification period. Foreign use occurs when any portion of a DCL is made available under the income tax laws of a foreign country to offset (directly or indirectly) any income and that income is considered under U.S. tax principles to be income of a foreign corporation.
An example helps make sense of these rules and terminology. A domestic C corporation (DC1) owns directly all the ownership interests of DEX1. DEX1 is a Country X corporation that is treated as a disregarded entity for U.S. tax purposes. DEX1 is taxed as a corporation resident in Country X, which has a consolidated income tax regime. After eliminating transactions that would otherwise be disregarded for U.S. tax purposes, DEX1 has a DCL of $100 for the year. DEX1 directly owns FX1, a Country X corporation that is treated as a corporation for U.S. tax purposes. FX1 has net taxable income of $200 under U.S. and foreign tax principles. DEX1 and FX1 file as a Country X consolidated tax group for the year, and the DCL of DEX1 of $100 partially offsets the $200 of net income of FX1 within the Country X consolidated group for the year. DEX1 is a separate unit because it is treated as a corporation for Country X tax purposes and is subject to the Country X income tax and its income or loss flows into DC1 under U.S. tax principles. DC1 is a domestic owner of the DEX1 separate unit. Under the general rule, DC1 cannot deduct DEX1’s DCL of $100 unless DC1 can make a domestic use election. However, DC1 cannot make a domestic use election because the DEX1 DCL has been put to a foreign use. This is because the DEX1 DCL offsets the income of FX1 under the Country X consolidated regime rules and the income of FX1 is treated as income of an entity treated as a foreign corporation under U.S. tax principles. This prevents double dipping of the $100 DCL between the United States and Country X. This example will be used throughout the rest of the article.
II. Modifying Consolidated Return Intercompany Transaction Rules
Under the consolidated return rules of section 1502, transactions between members of the consolidated group are treated as if made between separate corporations for some purposes, but as between divisions within a single corporation for other purposes. Thus, if a member of a consolidated group (S) sells to or has income from another member of the group that purchased the item or accrued the expense (B), then the amount, character, timing, etc. of S’s intercompany item and B’s corresponding item are determined on a separate entity basis. However, those items are redetermined to produce the effect of transactions between divisions within a single corporation. Under the matching rule, any gain or loss of S upon the sale of property to B would be deferred until the property leaves the group or either S or B leaves the consolidated group.
The proposed regulations would provide a special status to section 1503(d) members of the consolidated group. This proposed rule would provide that if a section 1503(d) member has a loss that is limited under the DCL rules and is attributable to an intercompany transaction with another member, then the intercompany transaction rules would not redetermine the section 1503(d) member’s loss as not being subject to the DCL limitation. Further, the proposed regulations would clarify that the application of the DCL rules would not modify the counterparty’s item under the intercompany transaction rules. In our earlier example, assume that DC2 is also a member of the consolidated tax group with DC1 and that the $100 DCL of DEX1 is attributable to interest expense on an intercompany loan with DC2. DC2 has $100 of interest income related to the intercompany loan. The proposed regulations would provide that the intercompany transaction rules would not redetermine DC2’s interest income as not includable even though DC1 (via its interest in DEX1) cannot deduct the interest expense under the DCL rules. Even though that result is inconsistent with the treatment as divisions within a single corporation, treating DC2’s interest income as not includable would result in allowing the consolidated group to benefit from the DEX1 DCL, which is inconsistent with the DCL policy.
Finally, the proposed regulations would provide an ordering rule stating that the consolidated return intercompany transactions rules would apply first to an intercompany item (and corresponding item) and then would be subject to the DCL computations. Assume that DEX1’s loss is attributable to the loss on the sale of property to DC2. Under the proposed regulations, the intercompany transaction rules would apply first to defer DEX1’s loss and thus cannot be subject to the DCL rules in the year of sale. In a later year in which DEX1 recognizes the loss under the consolidated return’s matching principle, DEX1’s loss would be recognized and then treated as a DCL and subject to the DCL rules and limitations.
The clarification of the interaction between the intercompany transaction rules of the consolidated tax group rules and the DCL rules is welcome guidance. Taxpayers should assess whether they have historically applied the consolidated return matching rule to allow the deduction of a DCL to determine the impact if the proposed regulations are adopted as final.
III. Modifying the Computation of DCLs
A. Modifying Treatment of Items Arising From Stock Ownership
Under the current DCL rules, to the extent that a separate unit or dual resident corporation has gain or loss, dividend income, or deemed inclusions (that is, under subpart F income, global intangible low-taxed income, etc.) regarding ownership in the stock of a foreign corporation, that income is taken into account when calculating the DCL. The preamble to the proposed regulations states that many foreign jurisdictions’ tax laws generally provide for a participation exemption or foreign tax credits to the owner that would generally exempt that income from foreign taxation at the owner level. The preamble continues that taxpayers can easily contribute stock of a foreign corporation under a separate unit or dual resident corporation that would otherwise have a DCL. This could result in dividend income, deemed inclusions, or gain associated with the stock of the foreign corporate subsidiary and could lower the DCL or create positive taxable income for the separate unit or dual resident corporation. Therefore, the proposed regulations would amend the DCL rules so that items arising from stock ownership would not be taken into consideration when calculating the DCL. However, this rule applies only if the ownership in stock is at least 10 percent of the value of the stock or greater. Assume that FX1 has subpart F income of $100. Under the proposed regulations, the $100 subpart F income would no longer be taken into consideration in determining DEX1’s DCL. Further, the proposed regulations have incorporated an antiabuse rule that is intended to address other similar transactions or contributions that attempt to avoid the purpose of the DCL rules.
To the extent that taxpayers have reduced DCLs in the past for the income associated with stock ownership, determinations should be made regarding whether the elimination of that income would result in DCLs and if so, whether the DCL would be put to foreign use. If a DCL is created because of this new rule in the proposed regulations, taxpayers should consider possible restructuring alternatives to mitigate the effect in anticipation of the proposed regulations becoming final.
B. Modifying Adjustments to Conform to U.S. Tax Principles
As noted, items that would otherwise be disregarded under U.S. tax principles must be eliminated when calculating a DCL. For example, if DEX1 provided services to DC1 and received services income of $500, that income would be disregarded for U.S. tax purposes and thus must be eliminated in calculating DEX1’s DCL. The preamble states that some taxpayers have taken the position that the domestic owners’ regarded income should be allocated or attributed to the separate unit as it is related to the disregarded income of the separate unit. The proposed regulations would modify the DCL computation rules to make it clear that adjustments to conform to U.S. principles do not include attributing items to the separate unit that are not reflected on its books and records.
Taxpayers should determine the ramifications to the extent they have taken the position that regarded income from the domestic owner should be allocated to a separate unit for purposes of calculating the DCL. If finalized, this rule could confirm that a DCL exists when the taxpayer had previously taken the position that one did not. In those cases, a determination should be made about whether those DCLs would be eligible for a domestic use election.
IV. Guidance Concerning Application of DCL Rules to GLOBE Rules
A. Modification of Definitions in DCL Rules and Regs
The proposed regulations represent the first formal regulatory guidance addressing the United States’ interaction with the GLOBE rules initiated by the OECD since the notice released in December 2023. The GLOBE rules are designed to ensure large multinational enterprises pay an effective global minimum tax rate of 15 percent on a jurisdictional basis starting as soon as the 2024 calendar year. Specifically, multinational enterprise groups with at least €750 million of revenue in two of the four preceding fiscal years (MNE groups) are required under the GLOBE rules to prepare complex, data-intensive top-up tax computations and satisfy robust compliance reporting obligations. In preparing top-up tax computations by jurisdiction, the GLOBE rules require MNE groups to aggregate jurisdictional income and losses to avoid distortions from tax consolidation and similar regimes. Any top-up tax obligations arising under the GLOBE rules are to be enforced by jurisdictional enactment of certain charging mechanisms, which include the following:
- qualified domestic minimum top-up tax (QDMTT): a minimum tax that is imposed by the domestic law of a jurisdiction that computes its own top-up tax following the design and purpose of the pillar 2 rules;
- income inclusion rule: a minimum tax that imposes top-up tax at the highest level of an MNE group for low-taxed income at its constituent entities; and
- undertaxed payments rule: a rule that allows a jurisdiction to deny deductions in its own jurisdiction to top up any low-taxed jurisdictions of an MNE group not brought in under the IIR or QDMTT.
Many jurisdictions have enacted QDMTTs and IIRs that are in effect for calendar year 2024, while other jurisdictions have promised to follow this trend by the end of the year. Moreover, some jurisdictions have also taken steps to enact UTPRs, which are set to go into full effect as soon as January 1, 2025.
The proposed regulations modify many definitions in the current DCL regulations to include top-up taxes imposed under the GLOBE rules and provide many illustrative examples as to how the DCL rules would interact with the GLOBE rules if the proposed regulations were to become final. Specifically, the proposed regulations provide that an income tax may include taxes intended to ensure a minimum level of taxation on income or tax regimes computing income or loss by reference to financial accounting net income or loss, like certain top-up taxes initiated by the GLOBE rules. Rejecting requests that the DCL rules be made inapplicable to foreign taxes procured by the GLOBE rules, Treasury said that the jurisdictional blending approach in the top-up tax computation for income and loss can result in the double-deduction outcomes that the DCL rules were intended to address, even if the construct of the top-up taxes imposed by the GLOBE rules differ from more traditional tax regimes.
Further, the proposed regulations change definitions in the DCL regulations regarding hybrid entities, hybrid entity separate units, and other terms. The proposed regulations provide that if a foreign entity is not taxed as an association for U.S. tax purposes and is subject to an IIR in another jurisdiction, then a U.S. corporation’s interest (direct or indirect) in the foreign entity is to be treated as a hybrid entity separate unit even though the jurisdiction in which the entity is a tax resident does not have an income tax. This principle is best illustrated through a continuation of the earlier example. In that example, assume that Country X does not have an income tax. DEX1 would not be a separate unit because it is a resident in a country that does not have an income tax. Thus, its $200 loss would not be a DCL because the loss could not be subject to the double dip between the United States and a foreign jurisdiction. However, if Country X were to enact a QDMTT, then for purposes of computing the Country X QDMTT, the loss of DEX1 and the income of FX1 would presumably be combined, and the DEX1 loss would effectively reduce the tax under the Country X QDMTT. This highlights Treasury’s concerns that jurisdictional blending presents the opportunity for the double dip of the $100 loss because this loss could be a deduction for U.S. tax purposes to DC1 but also reduces the income of FX1 (a foreign corporation for U.S. tax) under the QDMTT regime. Under the proposed regulations, DEX1 would be treated as a separate unit and thus subject to the DCL rules even though Country X does not have a traditional income tax regime.
Moreover, the proposed regulations would apply the combined separate unit rule based on where an entity is located for purposes of an IIR or QDMTT. In our example, assume that DC1 owns DEY1, which is incorporated under the laws of Country Y. DEY1 is treated as a disregarded entity for U.S. tax. DEY1 owns DEX1, and DEX1 owns FS1. Assume that Country X does not have an income tax regime or a QDMTT. Further assume that Country Y has an IIR. Under the Country Y IIR, the $100 loss of DEX1 is combined with the $200 income of FS1. The net $100 of income is subject to the Country Y IIR, and DEY1 pays the top-up tax. DEX1 would be considered a hybrid entity separate unit because it is an entity that is not considered a corporation for U.S. tax purposes and DEX1’s income or loss is taken into account in determining an IIR. Further, because DEX1 is located in Country X and DEY1 is located in Country Y for purposes of the Country Y IIR, then DEX1 and DEY1 would not be considered part of the same combined separate unit. In this example, DEX1 is a separate unit and thus has a DCL of $100, which would be put to a foreign use and would not be allowed as a deduction to DC1.
With some exceptions potentially applicable, the proposed regulations also provide that places of business treated as permanent establishments outside the United States when computing top-up tax calculations for QDMTTs or IIRs are to be treated as foreign branch separate units for purposes of applying the DCL rules. These definitional modifications would in turn require tax calculations to be performed separately from the U.S. corporation to which each respective entity type is associated, which could trigger a foreign use. In expanding these definitions to ensure separate tax computations are made, Treasury denotes the concern that double-deduction outcomes may arise even though the IIR, as commentators note, is not based on the traditional tax concept of tax residency. Further elaborating its position, Treasury provides for similar outcomes for stateless entities in MNE groups but says that an interest in a tax-transparent entity under the GLOBE rules that is subject to the IIR would not create a hybrid separate entity unit.
The expansion and modifications to the definitions included in the current DCL regulations that are provided for in the proposed regulations would seem to affect many in-scope taxpayers with projected DCLs, regardless of how taxpayers are choosing to comply with pillar 2 reporting obligations. This result is apparent because an essential premise of the GLOBE rules is the requirement for jurisdictional blending of losses and income, which sets the foundation of a foreign use according to the views of Treasury. Without a shift in course by Treasury, in-scope taxpayers with projected DCLs are encouraged to evaluate their foreign branch structures to ascertain how these definitional changes affect them from a DCL perspective and may find it beneficial to evaluate their legal entity organizational structures to consider whether there are planning alternatives that would mitigate any effects potentially imposed by the proposed regulations in conjunction with the GLOBE rules today.
B. Extension and Expansion of Temporary Relief From Notice 2023-80
The proposed regulations adopt and expand the relief provided in Notice 2023-80 providing that a QDMTT or IIR will not cause foreign use of a DCL incurred in tax years beginning before the effective date of filing of the proposed regulations (that is, August 6, 2024). The proposed regulations also extended this relief beyond just foreign use. In so doing, Treasury says that it is appropriate to extend, for a limited period, relief from the application of the DCL rules in conjunction with the GLOBE rules to give taxpayers more certainty and time to adapt to the proposed regulations.
The notice applied temporary relief only to legacy DCLs, or DCLs incurred before the effective tax years in which the GLOBE rules were applicable. Expanding this threshold not only to legacy DCLs but also to DCLs incurred before the effective date of the proposed regulations should give in-scope taxpayers more certainty during the transition years as the GLOBE rules go into effect, and additional time to evaluate any future guidance to be released by the OECD or Treasury. While this relief is certainly welcome, taxpayers will still need to consider what happens regarding forecast DCLs and their interaction with the GLOBE rules prospectively.
C. Foreign Use Exception for Transitional CbC Reporting Safe Harbor Test
The proposed regulations generally provide that a foreign use may be present for taxpayers using the safe harbor relief procured by the OECD during the transition period. Acknowledging the administrative burden imposed on MNE groups by the GLOBE rules, the OECD has provided simplified safe harbor rules for the transition period, or all the fiscal years beginning on or before December 31, 2026 (but not including any fiscal year that ends after June 30, 2028). Under these simplified safe harbor rules, MNE groups may apply three safe harbor tests for each jurisdiction (the transitional country-by-country reporting safe harbor tests) using CbC reporting data, qualified financial statements, and substance-based income exclusion data identified in the GLOBE rules to simplify pillar 2 compliance during the transition period.
Under the transitional CbC reporting safe harbor tests, if an MNE group passes at least one of three tests in a jurisdiction for a fiscal year during the transition period, the MNE group is entitled to simplified reporting obligations and is treated as compliant regarding its pillar 2 top-up tax liability for that year. The three tests are: (1) a de minimis test, (2) a simplified effective tax rate test, and (3) a routine profits test. Under the de minimis test, a jurisdiction passes if its cumulative revenue is less than €10 million and net income or loss is less than €1 million for the fiscal year. The simplified ETR test is satisfied if the adjusted income tax expense (accounting for uncertain tax positions and certain hybrid arbitrage arrangements affecting covered taxes) from the financial statements compared with the net income before income tax is greater than or equal to the transition rate. Finally, the routine profits test is satisfied if the total substance-based income exclusion amount in a jurisdiction is greater than or equal to net income or loss before income tax. Based on application, it is possible a particular subsidiary of an MNE group does not qualify under any of these tests, and as a result, no safe harbor rule applies during the transition period. In that case, the failing subsidiary is no longer able to apply the transitional CbC reporting safe harbor tests for any subsequent fiscal year and must resort to preparing full-scope calculations following the GLOBE rules (under the “once out, always out” rule).
The proposed regulations note that a foreign use may be triggered by reason of a loss being used in one of the three transitional CbC reporting safe harbor tests for the IIR and QDMTT despite no top-up tax having been computed in these calculations. Many commentators find this assertion noteworthy since the transitional CbC reporting safe harbor tests are designed to simply deem a jurisdiction’s top-up tax as zero by applying a simplified method as taxpayers adopt the necessary data systems and infrastructure to comply with the GLOBE rules. In the preamble to the proposed regulations, Treasury acknowledges this point but says this application is still sufficient to conclude DCLs could be made available, so potential double-deduction outcomes may arise.
While this application for the transitional CbC reporting safe harbor tests may be problematic for some taxpayers, the proposed regulations provide a limited foreign use exception under which the transitional CbC reporting safe harbor tests are satisfied, and no foreign use occurs by application of the duplicate loss arrangement rules. In providing this relief, Treasury says that this foreign use exception does not preclude a foreign use from occurring if the duplicate loss arrangement rules do not apply and a DCL is used in testing one of the three tests in the transitional CbC reporting safe harbor test.
V. Disregarded Payments Giving Rise to Losses for Foreign Tax Purposes
The proposed regulations also provide for rules that address certain items that are disregarded for U.S. tax purposes that could give rise to a deduction/noninclusion outcome but that would not be addressed by the DCL rules. In our example, assume that DC1 forms DEX1 and loans funds to DEX1 for the purpose of acquiring FS1. DEX1’s only item is interest expense that is paid to DC1 that is disregarded for U.S. tax purposes. Thus, this $100 loss of DEX1 is not a DCL. However, the $100 loss of DEX1 is regarded as a deductible item for Country X tax law. DEX1 and FS1 file a consolidated Country X tax return, and DEX1’s $100 loss is able to offset FS1’s $200 of taxable income. This situation gives rise to a deduction/noninclusion outcome because the $100 of DEX1’s interest deduction is able to offset income of an entity that is classified as a foreign corporation, but the interest income is not taxed by any jurisdiction.
To address this and similar issues, the proposed regulations (proposed under the DCL and entity classification election regulations) would establish the disregarded payment loss (DPL) rules. Under these rules, if a “specified eligible entity” elects to be a disregarded entity, then any domestic corporation that owns, directly or indirectly, the specified eligible entity consents to be subject to the DPL rules. A specified eligible entity is any eligible entity (whether domestic or foreign) that is a foreign tax resident or that is owned by a domestic corporation that has a foreign branch.3 If that specified eligible entity incurs a DPL and a triggering event occurs within the specified certification period, then the specified domestic owner must include in gross income the “DPL inclusion amount.”4
A DPL is defined as the entity’s net loss for foreign tax purposes that consists only of items that are disregarded for U.S. tax purposes. The only items (income or deductions) that make up the entity’s DPL are items that, if regarded for U.S. tax, would consist of interest, a structured payment, and royalty (as defined under the regulations of section 267A).
There are two triggering events that would require inclusion in gross income during the certification period. The first is a foreign use (under the principles of the DCL rules) of the DPL, and the second is the failure to annually certify that no foreign use of the DPL has occurred.
Concerning the occurrence of a triggering event, the DPL inclusion amount would be treated as ordinary income and characterized in the same manner as interest or royalty income paid by a foreign corporation. The DPL inclusion amount is reduced by any “DPL cumulative register.”
Returning to our example, if the DPL rules of the proposed regulations were to apply, DC1 would be required to include the $100 DPL of DEX1 in its taxable income as interest income because the $100 has been put to a foreign use via the Country X consolidated filing with FS1.
The DPL rules apply independently of the DCL rules because the DPL rules only apply to disregarded items and the DCL rules only apply to regarded items. To the extent that taxpayers have structured transactions to achieve a deduction/noninclusion outcome via disregarded payments of disregarded entities that are tax resident in a foreign country, consideration should be given to whether those structures should be altered to not run afoul of the DPL rules or the U.S. tax implications of leaving the structure intact.
VI. Conclusion
The proposed regulations, if finalized by Treasury, are expected to translate into considerable changes to the U.S. tax rules concerning the use of DCLs in corporate structures. Thus, taxpayers should expect increased administrative costs and complexity, especially in navigating the DPL rules and the interactions with the GLOBE rules. Further, taxpayers may want to consider or revisit restructuring plans because of the modification to the treatment of items arising from stock ownership when computing DCLs and their current structure may result in larger DCLs. It is also expected that implementation of the proposed regulations may result in additional tax tracking attributes. Finally, it remains to be seen how the catchall antiavoidance rule included in the proposed regulations will be applied, so taxpayers should monitor its application with U.S. tax authorities to understand how it will affect DCL rules.
- 1The proposed regulations also include an antiavoidance rule as a catchall that would allow adjustments to be made in cases in which taxpayers partake in a transaction or series of transactions to avoid the purposes of the DCL rules and regulations (the catchall antiavoidance rule).
- 2A transparent entity is not treated as a corporation for U.S. tax purposes, is not subject to an income tax of a foreign country, and is not treated as a passthrough entity under foreign law (e.g., a U.S. limited liability company).
- 3Reg. section 301.7701-3.
- 4REG-105128-23 preamble.