Potential Impact of Sec. 1503(d) Rules on Losses Incurred Through a Domestic Partnership

Field Service Advice (FSA) 200101007 applied the dual consolidated loss (DCL) rules to deny the use of losses incurred through a domestic partnership. The FSA may have implications for any domestic corporation that holds an interest in a partnership with losses, regardless of whether the partnership has a foreign presence or files foreign income tax returns.

DCL Rules and Terminology

The DCL rules are designed primarily to prevent dual resident corporations (DRCs) from using a single economic loss in two different jurisdictions. The term "dual consolidated loss" generally means the net operating loss (NOL) of a domestic corporation incurred in a year in which the corporation is a DRC. The term "dual resident corporation" generally means a domestic corporation subject to the income tax of a foreign country on its worldwide income or on a residence basis. A corporation is taxed on a residence basis if it is taxed as a resident under a foreign country's laws.

In addition, any "separate unit" of a domestic corporation is treated as a separate domestic corporation and a DRC. The term "separate unit" includes an interest in a partnership (as well as a "hybrid entity separate unit," which is treated as a partnership for Federal tax purposes and a corporation under foreign law). Thus, the term literally appears to include any interest in a partnership, including an interest in a domestic partnership engaged only in domestic business activities.

Application to Partnerships

Prior to finalization of the DCL regulations in 1992, commentators suggested that the rules should not be applied to partnership interests—apart from cases in which a partnership qualified as a hybrid entity separate unit—on the general ground that a loss of a passthrough entity cannot be used twice. Such comments were not reflected in the final DCL regulations, however, because the IRS had concerns about the potential for abusive double-dipping even with respect to interests in ordinary partnerships.

According to the preamble to the final DCL regulations, the Service is considering whether special rules are needed for items of partnership loss in at least two circumstances in which, because of a special allocation, the loss is used to offset one income stream for U.S. tax purposes and a separate income stream for foreign tax purposes. The final regulations reserved a paragraph to address the treatment of such loss allocations. Accordingly, it appears that the IRS had not fully developed its thinking on the implications of the DCL rules in the partnership context when it finalized the regulations.

FSA 200101007

The recent FSA, therefore, provides valuable insight into the National Office's thinking on these issues. According to the FSA, various members of a U.S. consolidated group (Consolidated Group) held interests in certain domestic partnerships (the Partnerships) and trusts (Trusts) that incurred losses from certain leasing transactions in Countries A and B. The Partnerships were not members of an A tax group and were unable to file group relief elections; instead, they filed stand-alone income tax returns in A. The Trusts, on the other hand, had no taxable presence in any foreign jurisdiction and did not file foreign tax returns.

As the Service noted in the FSA, the regulations do not require a partnership or a trust to file a consolidated tax return, or indeed, any tax return, in a foreign country to be classified as a DRC. In fact, the IRS indicated that such separate units do not need to have any foreign presence. Rather, an interest in a partnership held by a domestic corporation is per se a DRC.

Assuming that the interests in the Partnerships qualify as DRCs, the parent took the position that the NOLs were not DCLs, because the applicable foreign law did not allow them to be used to offset the income of another person. The taxpayer, however, has the burden of proving that the losses never can be used to offset income of another person "by any means" under foreign law, including as a result of corporate reorganizations. According to the Service, the parent failed to meet this burden of proof. Moreover, the IRS expressed the view that taxpayers "rarely" will be able to satisfy this standard. Accordingly, Sec. 1503(d) would apply to prevent the use of DCLs to reduce the taxable income of any member of the affiliated group for the tax year or any other tax year. For this purpose, the domestic owner of a separate unit is considered a domestic affiliate.

Relief may be obtained when a taxpayer enters into an agreement under which it (1) certifies that the DCL has not been, and will not be, used to offset the income of another person under foreign law and (2) agrees to recapture the DCL if a "triggering event" occurs. Failure to file such certifications annually constitutes a triggering event. To be valid, the agreement must be attached to the taxpayer's original, timely filed U.S. income tax return for the tax year in which the DCL is incurred.

In this instance, the parent did not enter into any such agreements with respect to the NOLs of its DRCs. Even if it had filed such agreements, the parent still would have been required to prove that the Partnerships' DCLs would not actually offset the income of any other person in the year that the DCLs were incurred, or any other tax year, for foreign tax purposes. Additionally, to the extent that the Partnerships' tax allocations were different under A's tax laws than under U.S. tax laws, the parent would have been required to prove that the DCLs attributable to each partner's interest in the Partnerships would not be used partially to offset the income of another person for foreign tax purposes. Because the parent failed to prove this, the Partnerships' NOLs were treated as DCLs.

Potential Impact of FSA

The question for other taxpayers is how far the Service will pursue this approach. It appears that the IRS technically could apply the DCL rules to all domestic corporations holding interests in partnerships with losses, regardless of whether the partnerships have a foreign presence or file any foreign tax returns. Thus, the Service, in theory, could apply these rules to partnerships engaged solely in U.S. business activities. Such a broad application of these rules, however, seems unlikely. It appears that the IRS applied the DCL rules in this FSA because it objected to the transactions that created the losses (namely, lease-in, lease-out transactions). Taxpayers engaging in such transactions, or other transactions that the Service may view as "aggressive," need to be cognizant of the DCL rules and their potential application by the IRS.

From Mary Lim, CPA, Washington, DC