REG-102144-04

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Internal Revenue Bulletin:

2005-25 June 20, 2005

REG-102144-04

Notice of Proposed Rulemaking and Notice of Public Hearing Dual Consolidated Loss Regulations

AGENCY:

Internal Revenue Service (IRS), Treasury.

ACTION:

Notice of proposed rulemaking and notice of public hearing.

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.

DATES:

Written and electronic comments and outlines of topics to be discussed at the public hearing scheduled for September 7, 2005, at 10:00 a.m., must be received by August 22, 2005.

ADDRESSES:

Send submissions to CC:PA:LPD:PR (REG-102144-04), room 5203, Internal Revenue Service, P.O. Box 7604, Washington, DC 20044. Submissions may be hand delivered between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-102144-04), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC, or sent electronically via the IRS Internet site at www.irs.gov/regs or via the Federal eRulemaking Portal at www.regulations.gov/ (IRS and REG-102144-04). The public hearing will be held in the Auditorium of the Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT:

Concerning the proposed regulations, Kathryn T. Holman, (202) 622-3840 (not a toll-free number); concerning submissions and the hearing, Robin Jones, (202) 622-3521 (not a toll-free number).

SUPPLEMENTARY 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 USC 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, SE:W:CAR:MP:T:T:SP, 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 start-up costs and costs of operation, maintenance, and purchase of service to provide information.

The collections of information in these proposed regulations are in §§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 USC 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 (double-dip).

Congress was concerned that this double-dip 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 1064 - 1065 (1987). Through such double-dipping, 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 (T.D. 8261, 1989-2 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 (T.D. 8434, 1992-2 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 double-dip. 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 double-dip that section 1503(d) is intended to deny. Accordingly, the proposed regulations are designed to minimize these cases of potential over- and under-application.

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 §§301.7701-1 through 301.7701-3. 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 anti-avoidance 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, §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 §1.1502-21 and §1.6043-4T.

B. Definitions and Special Rules for Filings under Section 1503(d) — §1.1503(d)-1

1. Treatment of a separate unit as a domestic corporation and a dual resident corporation Section 1.1503-2(c)(3) and (4) of the current regulations defines a separate unit of a domestic corporation as a foreign branch, within the meaning of §1.367(a)-6T(g), (foreign branch separate unit) and an interest in a partnership, trust or hybrid entity. The 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 1.1503-2(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 §1.1503-2(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 1.1503-2(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 flow-through 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 Non-Hybrid Entity Partnerships and Interests in Non-Hybrid Entity Grantor Trusts Section 1.1503-2(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 (non-hybrid entity partnership and non-hybrid entity grantor trust, respectively) also is treated as a separate unit under the current regulations. §1.1503-2(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 §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 non-hybrid entity partnership or a non-hybrid 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 double-dip. 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 non-hybrid entity grantor trust in the 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 non-hybrid entity partnership and an interest in a non-hybrid 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 1.1503-2(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 §1.1503-2(c)(3)(i)(A) and (c)(4); see also §1.1503-2(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 §1.1503(d)-3(c)).

5. Exception to the definition of a dual consolidated loss Section 1.1503-2(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 double-dipped, 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 1.1503-2(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 inconsistent with the principles of section 1503(d).

7. Domestic use of a dual consolidated loss Section 1.1503-2(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 1.1503-2(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 1.1503-2T(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 §§301.7701-1 through 301.7701-3.

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 double-dip 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 double-dip.

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 double-dip of the dual consolidated loss.

(b) Exception to Foreign Use if no Dilution of an Interest in a Separate Unit Section 1.1503-2(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 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 double-dipped. 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 non-hybrid entity partnership or a non-hybrid 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 1.1503-2(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 double-dip 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 1065-66 (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 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 §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 §301.9100-3.

The IRS and Treasury believe that requiring taxpayers to request relief for an extension of time to file under §301.9100-3 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 §301.9100-3 will not be granted for filings under these proposed regulations. See §301.9100-1(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 Rules — §1.1503(d)-2

1. Application of rules to multiple tiers of separate units Section 1.1503-2(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 upper-tier separate unit were a subsidiary of the domestic corporation, and the lower-tier separate unit were a lower-tier 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 1.1503-2(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, 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 double-dip 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 double-dip 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 Losses — §1.1503(d)-3

1. Items attributable to a separate unit

(a) Overview Section 1.1503-2(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, non-hybrid entity partnerships, or non-hybrid 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 double-dipped.

(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 related-party income under section 864(c)(4)(D) do not apply.

The proposed regulations further provide that the principles of §1.882-5, 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 §1.861-9T(g) for purposes of 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 §1.861-9T.

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 non-resident 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 §1.988-4(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 non-hybrid entity partnership or a non-hybrid 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 §1.988-4(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 Y hybrid entity, Country X likely would take into account items of the Country Y hybrid entity as being items of the Country X branch. It is unlikely, however, that Country X would take into account items of the domestic corporation as items of the Country X branch because Country X views the owner of the Country X branch (the Country Y hybrid entity) as a corporation. Therefore, only the items of income, gain, deduction and loss of the Country Y hybrid entity (and not items of the domestic corporation) should be taken into account for purposes of determining the dual consolidated loss of the Country X branch.

The proposed regulations also provide that only income and assets of such hybrid entity are taken into account for purposes of applying the principles of section 864(c) and §1.882-5, as modified, in determining the items taken into account by the foreign branch separate unit; thus, other income and assets of the domestic owner, for example, are not taken into account for these purposes. This rule is also intended to ensure that the principles under these provisions are applied in a way that best approximates the items that the foreign jurisdiction would recognize as being taken into account by a taxable presence in such jurisdiction.

Finally, the proposed regulations provide that items generally attributable to an interest in a hybrid entity are not taken into account to the extent they are taken into account by a foreign branch separate unit owned, directly or indirectly (other than through a hybrid entity separate unit), by the hybrid entity. This rule prevents two or more separate units from taking into account the same item of income, gain, deduction or loss under different rules.

(h) Combined Separate Units As discussed above, the proposed regulations combine separate units owned, directly or indirectly, by a single domestic corporation, provided certain requirements are satisfied. Because different rules may apply for purposes of attributing items to individual separate units that may be combined into a single separate unit, special rules are necessary to attribute items to combined separate units.

The proposed regulations provide that in the case of a combined separate unit, items are first attributable to, or otherwise taken into account by, the individual separate units composing the combined separate unit, without regard to the combination rule. The combined separate unit then takes into account all of the items attributable to, or taken into account by, the individual separate units that compose such combined separate unit.

(i) Gain or Loss Recognized on Dispositions of Separate Units The current regulations do not indicate whether items of income, gain, deduction and loss recognized on the sale or disposition of a separate unit, or of an interest in a partnership or grantor trust through which a separate unit is indirectly owned, is attributable to or taken into account by such separate unit for purposes of calculating the dual consolidated loss of the separate unit for the year of the sale (or for purposes of reducing the amount of recapture as a result of a triggering event).

The IRS and Treasury believe that it is appropriate to take into account items of income, gain, deduction and loss recognized on these dispositions. Thus, the proposed regulations provide that items of income, gain, deduction and loss recognized on the disposition of a separate unit (or an interest in a partnership or grantor trust that directly or indirectly owns a separate unit), are attributable to or taken into account by the separate unit to the extent of the gain or loss that would have been recognized had such separate unit sold all its assets in a taxable exchange, immediately before the disposition of the separate unit, for an amount equal to their fair market value. The proposed regulations clarify that for this purpose items of income and gain include loss recapture income or gain under section 367(a)(3)(C) or 904(f)(3).

The proposed regulations also address situations where more than one separate unit is disposed of in the same transaction and items of income, gain, deduction and loss recognized on such disposition are attributable to more than one separate unit. In such a case, items of income, gain, deduction and loss are attributable to or taken into account by each such separate unit based on the gain or loss that would have been recognized by each separate unit if it had sold all of its assets in a taxable exchange, immediately before the disposition of the separate unit, for an amount equal to their fair market value.

(j) Income Inclusion on Stock The current regulations do not indicate whether an amount included in income arising from the ownership of stock in a foreign corporation (income inclusion) is attributable to or taken into account by a separate unit that owns the stock that gave rise to the income inclusion. For example, if a domestic corporation has a section 951(a) inclusion attributable to stock of a controlled foreign corporation that is owned by a hybrid entity separate unit, it is not clear under the current regulations whether such income inclusion is taken into account for purposes of calculating the dual consolidated loss of the hybrid entity separate unit.

The IRS and Treasury believe that, solely for purposes of applying the dual consolidated loss rules, it is appropriate to treat income inclusions arising from the ownership of stock in the same manner that dividend income is treated. Accordingly, the proposed regulations provide that income inclusions are taken into account for purposes of calculating the dual consolidated loss of a separate unit if an actual dividend from such foreign corporation would have been so taken into account.

(k) Section 987 Gain or Loss Section 987 provides that if a taxpayer has one or more qualified business units with a functional currency other than the dollar, the taxpayer must make proper adjustments to take into account foreign currency gain or loss on certain transfers of property between such qualified business units.

In 1991, the IRS and Treasury issued proposed regulations under section 987 that included rules for determining the amount of foreign currency gain or loss recognized on certain transfers of property between qualified business units. On April 3, 2000, the IRS and Treasury issued Notice 2000-20, 2000-14 I.R.B. 851, announcing that the IRS and Treasury intend to review and possibly replace the proposed regulations issued under section 987. The IRS and Treasury have opened a regulations project under section 987 and expect to issue new section 987 regulations in the future.

The current regulations do not provide specific rules that indicate whether section 987 gains or losses of a domestic owner are attributable to, or taken into account by, a separate unit for purposes of calculating the separate unit’s dual consolidated loss. Because the IRS and Treasury have an open regulations project under section 987 and expect to issue new regulations under section 987, the IRS and Treasury do not believe it is appropriate to address this issue in the proposed regulations. The IRS and Treasury request comments on whether section 987 gains and losses of a domestic owner should be attributable to, or taken into account by, a separate unit, particularly with respect to section 987 gains and losses attributable to, or taken into account by, separate units owned indirectly through hybrid entity separate units.

2. Effect of a dual consolidated loss Section 1.1503-2(d)(2) of the current regulations provides that if a dual resident corporation has a dual consolidated loss that is subject to the general rule restricting it from offsetting the income of a domestic affiliate, the consolidated group of which the dual resident corporation is a member must compute its taxable income without taking into account the items of income, gain, deduction or loss taken into account in computing the dual consolidated loss. The current regulations contain a similar rule for separate units.

These rules do not exclude only the dual consolidated loss in computing taxable income, but instead provide that none of the gross tax accounting items that compose the dual consolidated loss are taken into account. While this approach has the same effect on net income as would excluding only the dual consolidated loss, removing all gross items of income, gain, deduction and loss may have a distortive effect on other federal tax calculations.

The IRS and Treasury believe that this distortive effect will be minimized if only the dual consolidated loss itself is not taken into account. Accordingly, the proposed regulations provide that only a pro rata portion of each item of deduction and loss taken into account in computing the dual consolidated loss are excluded in computing taxable income. In addition, to the extent that a dual consolidated loss is carried over or carried back and, subject to §1.1502-21(c) (as modified in the proposed regulations), is made available to offset income generated by the dual resident corporation or separate unit, the proposed regulations treat items composing the dual consolidated loss as being used on a pro rata basis.

3. Basis adjustments Section 1.1503-2(d)(3) of the current regulations contains special basis adjustment rules that override the normal investment adjustment rules under §1.1502-32 for stock of affiliated dual resident corporations or affiliated domestic owners owned by other members of the consolidated group. These rules provide that stock basis is reduced by a dual consolidated loss, even though such loss is subject to the general limitation on the use of a dual consolidated loss to offset income of a domestic affiliate. To avoid reducing the stock basis a second time for the same dual consolidated loss, the rules also provide that no negative adjustment shall be made for the amount of dual consolidated loss subject to the general limitation that is subsequently absorbed in a carryover or carryback year. Finally, the rules provide that there is no basis increase for recapture income recognized as a result of a triggering event. Similar rules apply to separate units arising from ownership of an interest in a partnership. These special basis adjustment rules are generally intended to prevent an indirect deduction of a dual consolidated loss.

The proposed regulations retain the special stock basis adjustment rules, as modified, to prevent the indirect use of a dual consolidated loss. In addition, the proposed regulations retain the rules addressing the effect of a dual consolidated loss on a partner’s adjusted basis in its partnership interest in cases where the partnership interest is a separate unit, or a separate unit is owned indirectly through a partnership. These rules require the partner to adjust its basis in accordance with the principles of section 705, subject to certain modifications.

The IRS and Treasury recognize that these rules may lead to harsh results, particularly in light of the fact that the indirect use of the dual consolidated loss would only arise through the disposition of the stock of a dual resident corporation (or a partnership interest) that may not occur for many years after the dual consolidated loss is incurred. In addition, upon such subsequent disposition the resulting deduction or loss would generally be capital in nature, and the definition of a dual consolidated loss excludes capital losses incurred by the dual resident corporation or separate unit. As a result, the IRS and Treasury request comments regarding concerns over these types of indirect uses and whether the special basis rules should be retained. These comments should consider whether the policies underlying section 1503(d) require basis adjustment rules that differ from other basis adjustment rules that apply to non-capital, non-deductible expenses (for example, rules under sections 705 and 1367, and §1.1502-32(b))

E. Exceptions to the Domestic Use Limitation Rule — §1.1503(d)-4

1. No possibility of foreign use The proposed regulations provide a new exception to the general rule prohibiting the domestic use of a dual consolidated loss. To qualify under this exception, the consolidated group, unaffiliated dual resident corporation, or unaffiliated domestic owner must: (1) demonstrate, to the satisfaction of the Commissioner, that there can be no foreign use of the dual consolidated loss at any time; and (2) prepare a statement and attach it to its tax return for the taxable year in which the dual consolidated loss is incurred. This statement must include an analysis, in reasonable detail and specificity, supported with an official or certified English translation of the relevant provisions of foreign law, of the treatment of the losses and deductions composing the dual consolidated loss, and the reasons supporting the conclusion that there cannot be a foreign use of the dual consolidated loss by any means at any time.

This exception is intended to replace the exception to the definition of a dual consolidated loss contained in §1.1503-2(c)(5)(ii)(A) of the current regulations. Thus, under the proposed regulations the question of foreign use is not relevant to the definition of a dual consolidated loss; the issue will instead be whether an exception to the domestic use limitation applies. Consistent with the exception to the definition of a dual consolidated loss contained in the current regulations, the IRS and Treasury believe that this new exception to the domestic use limitation rule contained in the proposed regulations will apply only in rare and unusual circumstances due to the definition of foreign use and general principles of foreign law. For example, if the foreign jurisdiction recognizes any item of deduction or loss composing the dual consolidated loss (regardless of whether recognized currently or deferred, for example, by being reflected in the basis of assets), and such item is available for foreign use through a form of consolidation, carryover or carryback, or a transaction (for example, a merger, basis carryover transaction, or entity classification election), then the exception will not apply.

2. Domestic use election and agreement As discussed above, the current regulations provide an exception to the general rule prohibiting the use of a dual consolidated loss to offset the income of a domestic affiliate if a (g)(2)(i) election is made. Under this exception, the consolidated group, unaffiliated dual resident corporation, or unaffiliated domestic owner must enter into an agreement ((g)(2)(i) agreement) certifying, among other things, that no portion of the deductions or losses taken into account in computing the dual consolidated loss have been, or will be, used to offset the income of any other person under the income tax laws of a foreign country.

The proposed regulations retain this elective exception, with modifications, and refer to it as a domestic use election. In addition, the proposed regulations refer to the consolidated group, unaffiliated dual resident corporation, or unaffiliated domestic owner, as the case may be, that makes a domestic use election as an elector. In order to elect relief under this exception, the proposed regulations require the elector to enter into a domestic use agreement, which is similar to the (g)(2)(i) agreement required by the current regulations.

3. Certification period Under the current regulations, a (g)(2)(i) agreement generally provides that if there is a triggering event during the 15-year period following the year in which the dual consolidated loss was incurred (certification period), the taxpayer must recapture and report as income the amount of the dual consolidated loss, and pay an interest charge. See §1.1503-2(g)(2)(iii)(A).

Commentators have questioned whether under the current regulations the 15-year certification period applies only to the use triggering event, or whether it applies to all triggering events. These commentators note that, under this interpretation, triggering events other than use could occur after the expiration of the certification period. The IRS and Treasury believe that the certification period applies to all triggering events. Accordingly, the proposed regulations clarify that all triggering events are subject to the certification period and, therefore, a triggering event cannot occur after the expiration of the certification period.

The IRS and Treasury also believe that a 15-year certification period is not required to deter and monitor double-dipping of losses and deductions. Moreover, the IRS and Treasury believe that requiring taxpayers to comply with the dual consolidated loss regulations, including the need to monitor potential triggering events and to comply with the various filing requirements, for a 15-year period is unnecessarily burdensome to both taxpayers and the Commissioner. As a result, the proposed regulations reduce the certification period from 15 years to seven years with respect to a domestic use election.

4. Consistency rule Section 1.1503-2(g)(2)(ii) of the current regulations contains a consistency rule. Under this rule, if any losses, expenses, or deductions taken into account in computing the dual consolidated loss of a dual resident corporation or separate unit are used to offset the income of another person under the laws of a single foreign country while the dual resident corporation or separate unit is owned by the domestic owner or member of the consolidated group, the losses, expenses, or deductions taken into account in computing the dual consolidated losses of other dual resident corporations or separate units owned by the same consolidated group (or other separate units owned by the unaffiliated domestic owner of the first separate unit) in that year are deemed to offset income of another person in the same foreign country. This rule only applies, however, if such losses, expenses, or deductions are recognized in the foreign country in the same taxable year. Moreover, this rule does not apply if, under foreign law, the other dual resident corporation or separate unit cannot use its losses, expenses, or deductions to offset income of another person in such taxable year.

The consistency rule is intended to ensure that a consolidated group or domestic owner treats uniformly all dual consolidated losses of dual resident corporations or separate units that it owns that are available for use in a foreign country in a given year. The rule is also intended to minimize the administrative burden associated with identifying the items of loss or deduction of a particular dual consolidated loss that are used to offset income of another person under the income tax laws of a foreign country.

Commentators have questioned the need for the consistency rule, noting that it can lead to harsh results.

The IRS and Treasury believe that, despite concerns raised by commentators, the consistency rule continues to be necessary to promote the uniform treatment of dual consolidated losses of dual resident corporations and separate units owned by the consolidated group or domestic owner, and to minimize administrative burdens. As a result, the proposed regulations retain the consistency rule, as modified.

In addition, the proposed regulations clarify that the consistency rule only applies to a dual consolidated loss that is subject to a domestic use agreement (other than a new domestic use agreement). In other words, the proposed regulations clarify that the consistency rule does not apply to a foreign use of a dual consolidated loss that occurs subsequent to a triggering event that terminates the domestic use agreement filed with respect to such dual consolidated loss.

5. Restrictions on domestic use elections The current regulations do not explicitly address situations where a triggering event (discussed below) with respect to a dual consolidated loss occurs in the year in which the dual consolidated loss is incurred. The proposed regulations, however, make clear that a domestic use election cannot be made for a dual consolidated loss incurred in the same year in which a triggering event with respect to such loss occurs.

The current regulations also do not explicitly address the application of section 953(d)(3) (limiting losses of foreign insurance companies that elect to be treated as domestic corporations). The proposed regulations, however, provide that a foreign insurance company that has elected to be treated as a domestic corporation pursuant to section 953(d) may not make a domestic use election. This rule is consistent with section 953(d)(3), which broadly prohibits regulatory exceptions to the general prohibition on the domestic use of dual consolidated losses in such cases.

6. Triggering events

(a) In General Section 1.1503-2(g)(2)(iii) of the current regulations provides rules relating to certain events which require the recapture of previously allowed dual consolidated losses. Under these rules, if a consolidated group, unaffiliated dual resident corporation, or unaffiliated domestic owner, as the case may be, makes a (g)(2)(i) election, the dual resident corporation or separate unit must recapture, and the consolidated group, unaffiliated dual resident corporation or unaffiliated domestic owner must report as income the amount of the dual consolidated loss (and pay an interest charge) if a triggering event occurs during the certification period. Taxpayers may, however, rebut these triggering events upon making certain showings to the satisfaction of the Commissioner.

The proposed regulations generally retain the triggering event rules contained in the proposed regulations, as modified, if a taxpayer makes a domestic use election.

(b) Carryover of Losses, Deductions, and Basis Under the current regulations, certain asset transfers by a dual resident corporation that result, under the laws of a foreign country, in a carryover of losses, expenses, or deductions are triggering events. The current regulations contain a similar rule for such transfers by separate units. See §1.1503-2(g)(2)(iii)(A)(4) and (5).

The proposed regulations retain these triggering events, as modified, and combine them into a single triggering event. The proposed regulations also clarify that certain asset transfers that result in the carryover of basis in assets under the laws of a foreign country also qualify as triggering events. This is the case because asset basis generally will, at some point in the future, be converted into a loss or deduction as a result of the depreciation, amortization or disposition of the asset. Accordingly, under foreign law, a transaction that results in the carryover of asset basis generally has the same effect as a transaction that results in the carryover of losses or deductions and therefore should be treated similarly.

(c) Disposition by a Separate Unit or Dual Resident Corporation of an Interest in a Separate Unit or Stock of a Dual Resident Corporation The current regulations provide that certain sales or other dispositions of 50 percent or more of the assets of a separate unit or dual resident corporation are deemed to be triggering events. See §1.1503-2(g)(2)(iii)(A)(4) and (5). For this purpose, an interest in a separate unit and stock of a dual resident corporation are treated as assets of the separate unit or dual resident corporation. One commentator stated that, as a result of this rule, the disposition of an interest in one separate unit by another separate unit may inappropriately result in a triggering event for both separate units. Accordingly, the commentator suggested that the disposition of the interest in the lower-tier separate unit should not result in a triggering event with respect to dual consolidated losses of the separate unit that disposed of such interest.

The IRS and Treasury believe that the disposition of an interest in a lower-tier separate unit (or the shares of a dual resident corporation) by an upper-tier separate unit (or dual resident corporation) typically will not result in the carryover of the dual consolidated loss of the upper-tier separate unit (or dual resident corporation) under the laws of the foreign jurisdiction such that it could be put to a foreign use. Therefore, the proposed regulations provide that for purposes of determining whether 50 percent or more of the separate unit’s or dual resident corporation’s assets is disposed of, an interest in a separate unit and the stock of a dual resident corporation shall not be treated as assets of the separate unit or dual resident corporation making such disposition. The IRS and Treasury request comments as to other assets the disposition of which should be excluded from the 50 percent test under this triggering event.

(d) Fifty Percent Threshold for Asset Transfer Triggering Events Section 1.1503-2(g)(2)(iii)(A)(7) of the current regulations provides that a triggering event occurs if, within a 12-month period, the domestic owner of a separate unit disposes of 50 percent or more (by voting power or value) of the interest in the separate unit that was owned by the domestic owner on the last day of the taxable year in which the dual consolidated loss was incurred. As noted above, the current regulations also provide that a triggering event occurs if a domestic owner of a separate unit transfers assets of the separate unit in a transaction that results, under the laws of a foreign country, in a carryover of the separate unit’s losses, expenses, or deductions. Section 1.1503-2(g)(2)(iii)(A)(5). Moreover, the current regulations deem such an asset transfer to be a triggering event if 50 percent or more of the separate unit’s assets (measured by fair market value at the time of transfer) are disposed of within a 12-month period.

One commentator noted that the two triggering events discussed above operate differently in that any transfer of assets of a separate unit may constitute a triggering event, while the transfer of an interest in a separate unit constitutes a triggering event only if a 50 percent threshold is met.

The IRS and Treasury believe that these two triggering events should operate in a consistent manner. As a result, the proposed regulations provide that both the asset transfer triggering event and the separate unit interest transfer triggering event occur only if a 50 percent threshold is satisfied. It should be noted, however, that transfers of assets of a dual resident corporation or separate unit, and transfers of interests of separate units, in many cases will subsequently result in a foreign use triggering event, even though the 50 percent threshold for the asset transfer triggering event and the separate unit interest transfer triggering event are not satisfied. For example, if a domestic owner of an interest in a hybrid entity separate unit transfers 25 percent of its interest in the hybrid entity separate unit to a foreign corporation, all or a portion of a dual consolidated loss attributable to such separate unit in a prior year may be available to offset subsequent income of the owner of the transferred interest (that is not a separate unit after such transfer because it is held by a foreign corporation) and therefore may result in a foreign use triggering event.

(d) S Corporation Conversion Under the current regulations, if either an affiliated dual resident corporation or an affiliated domestic owner that has filed a (g)(2)(i) agreement with respect to a dual consolidated loss elects to be an S corporation pursuant to section 1362(a), such election results in a triggering event because it terminates the consolidated group and the affiliated dual resident corporation or affiliated domestic owner ceases to be a member of a consolidated group. See §1.1503-2(g)(2)(iii)(A)(2). The current regulations do not, however, address an election to be an S corporation by either an unaffiliated dual resident corporation or an unaffiliated domestic owner that has made a (g)(2)(i) election.

The IRS and Treasury believe that the election by an unaffiliated dual resident corporation or unaffiliated domestic owner to be an S corporation should be treated in the same manner as an election by an affiliated dual resident corporation or affiliated domestic owner that is a member of a consolidated group. Accordingly, the proposed regulations add as a new triggering event the election of either an unaffiliated dual resident corporation or unaffiliated domestic owner to be an S corporation.

(f) Consolidated Group Remains in Existence As stated above, and subject to exceptions, the current regulations provide that a triggering event occurs with respect to a dual consolidated loss of an affiliated dual resident corporation or affiliated domestic owner if such dual resident corporation or affiliated domestic owner ceases to be a member of the consolidated group of which it was a member when the dual consolidated loss was incurred. The current regulations also provide that an affiliated dual resident corporation or affiliated domestic owner is considered to cease to be a member of a consolidated group if the consolidated group ceases to exist (group termination triggering event) because, for example, the common parent is no longer in existence. Section 1.1503-2(g)(2)(iii)(A)(2).

One commentator stated that language contained in Revenue Procedure 2000-42, 2000-2 C.B. 394, may imply that there is a group termination triggering event if the common parent of a consolidated group that made a (g)(2)(i) election ceases to exist, or is a party to a reverse acquisition, even though the consolidated group remains in existence. This interpretation is contrary to the principles underlying the triggering events. Accordingly, the proposed regulations clarify that such transactions do not constitute group termination triggering events. See §1.1503(d)-5(c) Example 47.

7. Rebuttal of triggering events Under the current regulations, taxpayers may rebut all but two of the triggering events such that there is no dual consolidated loss recapture (or related interest charge) as a result of a putative triggering event. In general, under the current regulations, a triggering event is rebutted if the taxpayer demonstrates to the satisfaction of the Commissioner that, depending on the triggering event, either: (1) the losses, expenses or deductions of the dual resident corporation (or separate unit) cannot be used to offset income of another person under the laws of a foreign country or; (2) the transfer of assets did not result in a carryover under foreign law of the losses, expenses, or deductions of the dual resident corporation (or separate unit) to the transferee of the assets. See §1.1503-2(g)(2)(iii)(A)(2) through (7). The policies underpinning the dual consolidated loss rules do not require recapture or an interest charge in such cases because there is no opportunity for any portion of the dual consolidated loss to be used to offset income of any other person under the income tax laws of a foreign country.

The rebuttal rules impose a standard of proof on taxpayers that in many cases is difficult and burdensome to meet, even though there may be little likelihood that any portion of the dual consolidated loss could be used to offset the income of any other person under the income tax laws of a foreign country. For example, demonstrating that no portion of the dual consolidated loss can be used by another person as a result of typical loss carryover transactions under foreign law may not satisfy the burden if there is some potential that any portion of losses or deductions composing the dual consolidated loss could be so used as a result of a transaction that is rare, commercially impractical, or not reasonably foreseeable. In addition, because there are often significant differences between U.S. and foreign law, ruling out the various types of transactions that under U.S. law would allow all or a portion of the dual consolidated loss to be used by another person also may not be sufficient to rebut a triggering event.

Commentators have noted that under the current regulations it may not be possible to rebut certain triggering events if the tax basis of a single asset carries over to another person under foreign law, even though as a result of the transaction recognized losses and accrued deductions generally do not carry over to another person under foreign law. This is the case because the person that receives the carryover asset basis may at some point in the future enjoy the benefit of a loss or deduction as a result of the depreciation, amortization or disposition of the asset. As a result, the carryover of a nominal amount of asset tax basis causes the entire dual consolidated loss to be recaptured. Similar issues arise in connection with assumptions of liabilities that, for example, result in deductions for U.S. tax purposes on an accrual basis, but are deductible under the laws of the foreign jurisdiction at a later time when paid. This result is consistent with the all or nothing principle, discussed below.

The IRS and Treasury recognize that in some of these cases the use of a portion of a dual consolidated loss may be denied in both the United States and the foreign jurisdiction. Further, commentators have stated that denying a loss or deduction from offsetting income in both the United States and the foreign jurisdiction generally is inconsistent with the principles underlying section 1503(d) because the statute’s purpose is to prevent the use of the same loss or deduction to offset income in multiple jurisdictions.

The proposed regulations retain the rebuttal standard contained in the current regulations, with modifications. Taxpayers may rebut a triggering event under the proposed regulations if it can be demonstrated, to the satisfaction of the Commissioner, that there can be no foreign use of the dual consolidated loss. In addition, unlike the current regulations that have different standards for different triggering events, the proposed regulations apply the same standard to all triggering events (other than a foreign use triggering event, which cannot be rebutted).

The IRS and Treasury believe that when the proposed regulations are finalized the number of transactions undertaken by taxpayers that result in triggering events will be significantly reduced, as compared to the current regulations, because of the significant reduction in the term of the certification period. Nevertheless, the IRS and Treasury believe that the current rebuttal standard may exceed that required to address adequately the concern that all or a portion of a dual consolidated loss could be put to a foreign use. Moreover, the IRS and Treasury believe that more definitive and administrable rebuttal rules should be provided to assist taxpayers and the Commissioner in determining whether the triggering event has been rebutted, and to minimize situations where there is recapture of a dual consolidated loss even though it may be unlikely that a significant portion of the dual consolidated loss could be put to a foreign use. Therefore, it is anticipated that, prior to the finalization of these proposed regulations, a revenue procedure will be issued that will provide safe harbors whereby triggering events will be deemed to be rebutted if the taxpayer satisfies various conditions. The revenue procedure may be issued in proposed form and then made final contemporaneously with these regulations.

It is anticipated that the conditions contained in the revenue procedure would include the requirement that taxpayers demonstrate, to the satisfaction of the Commissioner, that there can be no foreign use of any significant portion of the dual consolidated loss as a result of certain enumerated transactions. It is also anticipated that the revenue procedure will address, and in some cases provide relief for, transactions that result in a de minimis carry over of asset basis under foreign law and are difficult or impossible to rebut under the current regulations. Finally, the revenue procedure may provide relief for triggering events resulting from the assumption of liabilities in connection with the acquisition of a trade or business as a result of liabilities incurred in the ordinary course of business being deductible at different times under U.S. law and the law of the foreign jurisdiction.

The IRS and Treasury request comments regarding the transactions that should be included in the revenue procedure, approaches to address basis carryover transactions and liabilities assumed in the ordinary course of business, and other ways to minimize the administrative burden associated with rebutting the triggering events, while ensuring that there is little or no likelihood that a significant portion of the dual consolidated loss can be put to a foreign use.

8. Triggering event exception for acquisition by an unaffiliated domestic corporation or a new consolidated group Section 1.1503-2(g)(2)(iv)(B)(1) of the current regulations provides that if certain requirements are satisfied, the following events do not constitute triggering events: (1) an affiliated dual resident corporation or affiliated domestic owner becomes an unaffiliated domestic corporation or a member of a new consolidated group (unless such transaction also qualifies under another exception); (2) assets of a dual resident corporation or a separate unit are acquired by an unaffiliated domestic corporation or a member of a new consolidated group; or (3) a domestic owner of a separate unit transfers its interest in the separate unit to an unaffiliated domestic corporation or to a member of a new consolidated group.

The first requirement necessary for this exception to apply is that the consolidated group, unaffiliated dual resident corporation, or unaffiliated domestic owner that made the (g)(2)(i) election, and the unaffiliated domestic corporation or new consolidated group must enter into a closing agreement with the IRS providing that both parties will be jointly and severally liable for the total amount of the recapture of the dual consolidated loss and interest charge upon a subsequent triggering event. Second, the unaffiliated domestic corporation or new consolidated group must agree to treat any potential recapture as unrealized built-in gain for purposes of section 384, subject to any applicable exceptions thereunder. Finally, the unaffiliated domestic corporation or new consolidated group must file with its timely filed income tax return for the year in which the event occurs a (g)(2)(i) agreement (new (g)(2)(i) agreement), whereby it assumes the same obligations with respect to the dual consolidated loss as the corporation or consolidated group that filed the original (g)(2)(i) agreement with respect to that loss.

On July 30, 2003, the IRS and Treasury issued final regulations (T.D. 9084, 2003-2 C.B. 742) (2003 regulations), published in the Federal Register at 68 FR 44616, that limited the need for closing agreements to avoid triggering events to only those three transactions described above. The preamble to the 2003 regulations explained that in certain cases the requirement for a closing agreement resulted in an unnecessary administrative burden because the several liability imposed by §1.1502-6, in conjunction with the original (g)(2)(i) agreement and a new (g)(2)(i) agreement, provided for liability sufficiently comparable to that imposed under a closing agreement. Accordingly, the 2003 regulations provided that if a new (g)(2)(i) agreement is filed by the unaffiliated domestic corporation or new consolidated group, a closing agreement is not required in the following two instances: (1) an unaffiliated dual resident corporation or unaffiliated domestic owner that filed a (g)(2)(i) agreement becomes a member of a consolidated group; and (2) a consolidated group that filed a (g)(2)(i) agreement ceases to exist as a result of a transaction described in §1.1502-13(j)(5)(i) (unless a member of the terminating group, or successor-in-interest of such member, is not a member of the surviving group immediately after the terminating group ceases to exist).

The preamble to the 2003 regulations noted that the IRS and Treasury were continuing to consider other alternatives to further reduce the administrative and compliance burdens under section 1503(d). After further consideration, the IRS and Treasury believe that, as a result of various requirements contained in the proposed regulations, there are sufficient protections, independent of a closing agreement, in all cases in which a closing agreement is otherwise required under the current regulations. As a result, the proposed regulations eliminate the closing agreement requirement contained in the current regulations and provide an exception to triggering events in all such cases (subsequent elector events) if: (1) the unaffiliated domestic corporation or new consolidated group (subsequent elector) enters into a domestic use agreement (new domestic use agreement); and (2) the corporation or consolidated group that filed the original domestic use agreement (original elector) files a statement with its tax return for the year of the event.

Pursuant to the new domestic use agreement, the subsequent elector must: (1) agree to assume the same obligations with respect to the dual consolidated loss as the original elector had pursuant to its domestic use agreement; (2) agree to treat any potential recapture of the dual consolidated loss at issue as unrealized built-in gain pursuant to section 384, subject to any applicable exceptions thereunder; (3) agree to be subject to the successor elector rules, discussed below; and (4) identify the original elector (and subsequent electors, if any). Pursuant to the statement filed by the original elector, the original elector must agree to be subject to the subsequent elector rules and must identify the subsequent elector.

9. Triggering event exception — private letter ruling and closing agreement option Under the current regulations, only specific triggering events can qualify for an exception as a result of the parties entering into a closing agreement. Therefore, the IRS will not consider entering into a closing agreement in other circumstances, even though the government’s interests may be adequately protected in such circumstances such that recapture may not be necessary.

Although the proposed regulations eliminate the need for a closing agreement to qualify for an exception to triggering events, discussed above, the IRS and Treasury are considering whether in limited cases it may be appropriate for the Commissioner, in its sole discretion and subject to the taxpayer satisfying conditions specified by the Commissioner, to enter into closing agreements with taxpayers such that certain other events would not be triggering events. Comments are requested as to the specific and limited types of triggering events that may be suitable for this exception, taking into account the policies underlying section 1503(d), administrative burdens, and the general interests of the U.S. government.

10. Annual certification reporting requirement Section 1.1503-2T(g)(2)(vi)(B) of the current regulations provides that if a (g)(2)(i) election is made with respect to a dual consolidated loss of a dual resident corporation or a hybrid entity separate unit, the consolidated group, unaffiliated dual resident corporation, or unaffiliated domestic owner, as the case may be, must file with its tax return an annual certification during the certification period. This filing certifies that the losses or deductions that make up the dual consolidated loss have not been used to offset the income of another person under the tax laws of a foreign country. The filing also warrants that arrangements have been made to ensure that there will be no such use of the dual consolidated loss and that the taxpayer will be informed if any such use were to occur. The current regulations do not, however, require annual certifications for dual consolidated losses of foreign branch separate units.

The IRS and Treasury believe that annual certifications of dual consolidated losses improve taxpayer compliance with the dual consolidated loss rules and are beneficial to the Commissioner in monitoring such compliance. The IRS and Treasury also believe that foreign branch separate units, hybrid entity separate units, and dual resident corporations should, to the extent possible, be treated consistently to reduce complexity. As a result, the proposed regulations expand the annual certification requirement to include dual consolidated losses of foreign branch separate units. However, the reduction in the certification period from 15 years to seven years should substantially reduce the overall compliance burden of this requirement.

11. Amount of recapture As stated above, under the current regulations a triggering event (other than a foreign use) generally can be rebutted only if no portion of the dual consolidated loss can be used by (or carries over to) another person under foreign law. See §1.1503-2(g)(2)(iii)(A)(2) through (7). Thus, if even a de minimis portion of the dual consolidated loss can be used by (or carries over to) another person, the triggering event cannot be rebutted. Similarly, §1.1503-2(g)(2)(vii)(A) of the current regulations provides that if a triggering event occurs, the entire dual consolidated loss subject to the (g)(2)(i) agreement (reduced by income earned subsequently by the dual resident corporation or separate unit) is recaptured and reported as income, regardless of the amount of the dual consolidated loss used by the other person. Thus, even a de minimis foreign use will cause the entire amount of the dual consolidated loss to be recaptured and reported as income.

This so-called all or nothing principle is included in the current regulations primarily due to administrative concerns. In many cases, the exact amount of the dual consolidated loss that is used by another person cannot be readily determined. This inability is due, in part, to differences between U.S. and foreign law. For example, there may be temporary and permanent differences in the treatment of items of income, gain, deduction and loss. There may also be differences in loss carryover provisions. These concerns are exacerbated by the principle that certain deductions are fungible and, therefore, cannot easily be traced to a particular loss incurred in a particular year.

Commentators have noted that in some cases the all or nothing principle results in a disallowance of deductions in both the United States and the foreign jurisdiction. Nevertheless, the IRS and Treasury believe that making a precise determination as to the amount of the dual consolidated loss put to a foreign use would require the Commissioner and taxpayers to analyze foreign law in great detail and, in some cases, compare the treatment of items under foreign law with their treatment under U.S. law. Such an analysis, however, is inconsistent with the principle underlying the regulations that, to the extent possible, the Commissioner and taxpayers should not be required to analyze foreign law. Moreover, departing from the all or nothing principle would likely require detailed ordering, stacking, and tracing rules to determine the amount and nature of dual consolidated losses that are recaptured upon a use. Such rules would add considerable complexity to the regulations. As a result, the proposed regulations retain the all or nothing rule contained in the current regulations. However, the IRS and Treasury request comments regarding administrable alternatives to the all or nothing rule that would not involve substantial analyses of foreign law. For example, comments are requested as to whether a pro rata recapture rule with respect to dispositions of separate units would be consistent with the general framework of the proposed regulations and would be administrable.

12. Subsequent elector rules Neither the current regulations nor Rev. Proc. 2000-42, 2000-2 C.B. 394, explicitly address the consequences resulting from a triggering event (to which no exception applies) with respect to a dual consolidated loss that was not recaptured due to an earlier triggering event as a result of the parties entering into a closing agreement. In such a case, both parties are jointly and severally liable for the total amount of the recapture of the dual consolidated loss and interest charge resulting from such a subsequent triggering event. However, it is unclear which taxpayer must report the recapture income (and related interest charge) on its tax return upon the subsequent triggering event. In addition, there is little or no procedural guidance outlining how, pursuant to a closing agreement, the IRS would collect recapture tax and the related interest charge from the parties to the closing agreement.

Accordingly, the proposed regulations contain rules regarding subsequent electors. These rules apply when, subsequent to an event that is not a triggering event because the unaffiliated domestic corporation or new consolidated group enters into a new domestic use agreement and satisfies other requirements (excepted event), a triggering event occurs, and no exception applies to such event (subsequent triggering event). The proposed regulations also provide rules that apply in the case of multiple subsequent electors (when subsequent to an excepted event, another excepted event occurs).

The proposed regulations first provide that, except to the extent provided under the subsequent elector rules, the original elector (and in the case of multiple excepted events, any prior subsequent elector) is not subject to the general recapture and interest charge rules provided under the regulations. As a result, only the subsequent elector that owns the dual resident corporation or separate unit at the time of the subsequent triggering event is subject to the general recapture and interest charge rules.

The proposed regulations also provide that, upon a subsequent triggering event to which no exception applies, the subsequent elector must calculate the recapture tax amount with respect to the dual consolidated loss subject to the new domestic use agreement and include it, along with an identification of the dual consolidated losses at issue and the original elector, on a statement attached to its tax return. The subsequent elector calculates the recapture tax amount based on a with and without calculation. The recapture tax amount equals the excess (if any) of the income tax liability of the subsequent elector for the taxable year of the subsequent triggering event, over the income tax liability of the subsequent elector for such taxable year computed by excluding the amount of recapture and related interest charge with respect to the dual consolidated losses at issue.

In addition, the proposed regulations provide rules regarding tax assessment and collection procedures. The proposed regulations provide that an assessment identifying an income tax liability of the subsequent elector is considered an assessment of the recapture tax amount where such amount is part of the income tax liability being assessed and the recapture tax amount is reflected in the statement attached to the subsequent elector’s tax return. The recapture tax amount is considered to be properly assessed as an income tax liability of the original elector, and each prior subsequent elector, if any, on the same date the income tax liability of the subsequent elector was properly assessed. This liability is joint and several.

The proposed regulations also provide procedures pursuant to which any unpaid balance of the recapture tax amount may be collected from the original elector and the prior subsequent elector, if any. Such amounts may be collected from the original elector, and/or any prior subsequent el