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11 August 2024 United States | US Treasury provides guidance on the interaction of DCLs with Pillar Two taxes and introduces new "disregarded payment losses" rules
In proposed regulations (REG-105128-23; Proposed Regulations) published August 6, 2024, the United States (US) Department of Treasury and the Internal Revenue Service (IRS) address the interaction of the DCL rules with Pillar Two of the OECD's Global Anti-Base Erosion Model Rules (GloBE Rules). The Proposed Regulations would also make several other important changes to the current DCL rules. The DCL rules limit the use of a single economic loss to offset income subject both to US tax and foreign tax, which may occur when a domestic corporation is also resident in a foreign jurisdiction (a dual resident corporation) or when a domestic corporation holds an interest in a hybrid entity or foreign branch. Under IRC Section 1503(d), a DCL of a domestic corporation cannot reduce the taxable income of a domestic affiliate (a domestic use). For this purpose, a DCL is generally (i) the net operating loss (NOL) attributable to a dual resident corporation, or (ii) the net loss attributable to a domestic corporation's separate unit (which includes certain hybrid entities and foreign branches). Exceptions to this limitation on the domestic use of a DCL apply, including when a taxpayer certifies under a "domestic use election and agreement" that there has not been and will be no foreign use of the DCL. A foreign use occurs when any portion of a DCL is made available under the income tax laws of a foreign country to reduce income of certain foreign persons (e.g., a foreign entity that is a corporation for US tax purposes). For purposes of the DCL rules, the Proposed Regulations provide that an income tax may include a minimum tax that is computed based on financial accounting net income or loss, such as a QDMTT or an IIR. Therefore, a foreign use of a DCL could occur if a deduction or loss included in a DCL were used to (i) calculate Net GloBE Income for a QDMTT or IIR, or (ii) qualify for the Transitional CbCR Safe Harbour (TCSH). However, no foreign use would occur when the OECD's duplicate loss arrangement rules (released in December 2023) both deny a deduction or loss comprising all or a portion of the DCL under the TCSH and the TCSH is satisfied for that same tax year, such that no top-up tax is imposed under the relevant QDMTT or IIR. The Proposed Regulations provide no guidance on the UTPR, as Treasury continues to analyze issues related to the UTPR. In Notice 2023-80, Treasury announced a transition rule under which no foreign use of a DCL would occur by reason of a legacy DCL being taken into account under the GloBE rules. The notice defined a legacy DCL as a DCL incurred in a tax year beginning before December 31, 2023. Subject to the anti-abuse rule described later, the Proposed Regulations would extend that relief by treating DCLs incurred in tax years beginning before 6 August 2024, as legacy DCLs and permitting the DCL rules (including those pertaining to foreign use) to apply without regard to Pillar Two taxes. Under the current DCL regulations, a foreign branch or hybrid entity constitutes a separate unit only if it is subject to an income tax of a foreign country on its worldwide income or on a residence basis. The Proposed Regulations would expand those definitions to include certain hybrid entities subject to an IIR and foreign branches subject to a QDMTT or an IIR. Under the DCL rules' mirror-legislation rule, a foreign use of a DCL may be deemed to occur if a foreign income tax law would deny any opportunity for the foreign use of the DCL, provided certain conditions are satisfied. The Proposed Regulations would also provide that a foreign law, including GloBE Rules that adopt the duplicate-loss-arrangement rules as part of implementing a QDMTT or IIR, does not constitute mirror legislation, provided that it generally preserves a taxpayer's choice between a domestic use or a foreign use of a DCL (but not both). The current DCL rules treat certain inclusions on stock as income attributable to a separate unit for purposes of computing the income or DCL of that separate unit. They also treat dividends and gains, to the extent attributable to the separate unit or earned by a dual resident corporation, as income for this purpose. Under the Proposed Regulations, the income or DCL of a dual resident corporation or a separate unit would exclude subpart F income, GILTI, dividends, gain, and any other income arising from the ownership of stock, as well as any deduction or loss with respect to those items. A limited exception would apply to dividends arising from portfolio stock. The Proposed Regulations would modify the existing intercompany transaction regulations under Treas. Reg. Section 1.1502-13, generally shifting the application of the existing regulations toward separate-entity treatment for purposes of the DCL rules. If a member of a consolidated group is a dual resident corporation or a domestic corporation that owns a separate unit, the Proposed Regulations would "clarify" that:
Notwithstanding the foregoing separate-return treatment, the Proposed Regulations would apply the intercompany transaction regulations to determine when a section 1503(d) member's item from an intercompany transaction would be taken into account and first become subject to the DCL rules. For example, if the section 1503(d) member's loss from selling property to a counterparty member is deferred until a later year (e.g., when the counterparty resells the property to an unrelated person), the intercompany transaction regulations would defer the section 1503(d) member's loss until the later year of resale and the loss would not be subject to the DCL rules until the resale year (rather than in the year of the intercompany sale). The Proposed Regulations also introduce new "disregarded payment loss" rules that are intended to address potential deduction/non-inclusion outcomes arising from certain disregarded payments that are deductible in a foreign country but not included in US taxable income by reason of being disregarded. Generally, the disregarded payment loss rules would require domestic corporations that own "disregarded payment entities" to recognize deemed income under certain circumstances. Absent specific statutory authorization for deeming such income, the Proposed Regulations would condition certain entity-classification elections on the domestic corporation consenting to be subject to the disregarded payment loss rules. Specifically, any domestic corporation (a specified domestic owner) that owns interests in a specified eligible entity would be required to consent to be subject to the disregarded payment loss rules if the specified eligible entity were to elect to be disregarded as an entity separate from its owner (a disregarded entity) or is classified as a disregarded entity upon formation without an election.1 Under a deemed-consent rule, a domestic corporation that owns interests in a specified eligible entity would be deemed to consent to be subject to the disregarded payment loss rules beginning on August 6, 2025. In the Preamble, Treasury indicated that this delayed consent date was intended to provide taxpayers an opportunity to restructure existing arrangements to avoid the application of the disregarded payment loss rules.2 Under its consent (deemed or actual), a specified domestic owner would agree to recognize income under certain conditions if a specified eligible entity or foreign branch (each, a disregarded payment entity) were to incur a disregarded payment loss. If the disregarded payment entity were to incur a disregarded payment loss, the specified domestic owner would be required to include in gross income a "DPL inclusion amount" upon the occurrence of any triggering event during a 60-month certification period. A disregarded payment loss would equal the excess, if any, of certain disregarded deduction items over certain disregarded income items: i.e., interest, royalty, or structured payments made by a disregarded payment entity and taken into account for foreign tax purposes in the disregarded payment entity's foreign tax year.3 Triggering events would include either a foreign use of the disregarded payment loss or a failure to comply with certification requirements during the DPL certification period (generally, 60 months). The DPL inclusion amount would equal the lesser of (i) the amount of the disregarded payment loss or (ii) the disregarded payment loss reduced by a DPL register, which is an account that includes disregarded payment income but no other income. Although the disregarded payment losses are intended to work in parallel with the DCL rules, they would require inclusions where no DCL would arise even if all the transactions at issue were regarded. Under a combination rule, disregarded payment entities that are subject to the same foreign tax law would be treated as a single disregarded payment entity if they were to have the same domestic owner or their respective owners were members of the same consolidated group.4 Under Treas. Reg. Section 1.1503(d)-5(c)(3)(i), a hybrid entity separate unit's income or DCL computation is generally based on its books and records "as adjusted to conform to U.S. tax principles." The Proposed Regulations would clarify that items that have not been, and will not be, reflected on the books and records of a hybrid entity separate unit are not included in the separate unit's income or DCL computation. According to Treasury, this clarification is intended to address positions taken by taxpayers that a hybrid entity separate unit may be allocated income on the books and records of its domestic owner under, for example, IRC Sections 482 or 864(c), where the domestic owner makes a disregarded payment to the hybrid entity separate unit. The Proposed Regulations would include a new anti-avoidance rule authorizing "appropriate adjustments" where taxpayers engage in a transaction, series of transactions, plan or arrangement with a view to avoiding the purposes of the DCL rules (including the disregarded payment loss rules). These adjustments may include disregarding the transaction, series of transactions, plan, or arrangement, or modifying the items that are taken into account in the income or DCL of a dual resident corporation or a separate unit. The Proposed Regulations would generally apply to tax years ending on or after 6 August 2024. The changes to the intercompany transaction regulations under Treas. Reg. Section 1.1502-13 would apply to tax years for which the original US federal income tax return is due (without extensions) after the date that final regulations are filed with the Federal Register. For example, if the changes were to be finalized by 15 April 2025, the final regulations would apply to calendar-year consolidated groups for their 2024 tax year. Once the changes are finalized, taxpayers may choose to apply the final regulations retroactively to prior open tax years, subject to a consistency requirement for members of a consolidated group. Although the disregarded payment loss rules generally would apply to tax years ending on or after 6 August 2024, the provisions deeming owners of existing specified eligible entities to consent to those rules would apply on or after 6 August 2025. The Proposed Regulations include significant changes to the DCL rules, the majority of which are proposed to apply retroactively to the beginning of taxpayers' current tax year. Further, the transitional Pillar Two relief period will end for calendar-year taxpayers in December; many fiscal-year taxpayers will have an even shorter relief period. Taxpayers implicated by the interplay with Pillar Two and the DCL rules or those taxpayers currently relying on the inclusions-on-stock rule or the intercompany-transaction regulations to limit DCLs should consider the impact of the Proposed Regulations. Many such taxpayers may need to restructure their current operations to mitigate adverse consequences. Taxpayers hoping for more extensive relief from the interaction of the DCL rules and Pillar Two should consider commenting on the Proposed Regulations and suggesting revisions, possibly including relief when a DCL, though made available to compute GloBE income, has no impact on QDMTT or IIR liability. Lastly, the disregarded payment loss rules may impact taxpayers that have financing or licensing transactions involving US-owned DREs or foreign branches. Those rules would result in income inclusions in many unexpected, and seemingly innocuous, fact patterns. Restructuring transactions may be necessary to avoid those unexpected outcomes. We understand the Proposed Regulations as "clarifying" the interaction of the DCL rules with Treas. Reg. Section 1.1502-13 in that they prospectively resolve differences in views among practitioners regarding the interaction under current law. Consolidated groups should consider whether to apply future final regulations retroactively to prior open years, but we expect most groups will find the final regulations currently reflected in the Proposed Regulations not to be advantageous from a tax perspective.
Document ID: 2024-1529 | ||||||||
