The Dual-Consolidated-Loss Trap

The adoption of the "check-the-box" rules in Regs. Sec. 301.7701-3 has significantly enhanced the tax-planning strategies available to U.S. corporations doing business abroad. This is particularly true for S corporations not eligible to claim indirect foreign tax credits (FTCs) under Sec. 902 on dividends received from their foreign subsidiaries. A check-the-box election to treat a foreign subsidiary as a passthrough entity allows the S corporation (and its shareholders) to claim a direct FTC, under Sec. 901, for the foreign taxes paid by the foreign subsidiary. Moreover, treating the foreign subsidiary as a passthrough entity enables the U.S. corporate shareholder to deduct any losses incurred by the foreign subsidiary against the corporation's domestic taxable income. However, a C or S corporation seeking to claim such foreign losses against its U.S. income must be aware of the special requirements imposed by the dual-consolidated-loss (DCL) rules, which may limit a U.S. corporate shareholder's ability to claim such losses.

The DCL rules in Sec. 1503(d) generally prevent a dual-resident corporation (DRC) from offsetting a DCL against the income of a domestic affiliate (as defined in Sec. 1504(d)). A DRC is any domestic corporation subject to tax in a foreign country either on a worldwide or residence basis. A DCL is a net operating loss (NOL) incurred by the DRC, unless the loss cannot offset, or be carried back or forward to offset, by any means, the income of any other person under the laws of a foreign country. Sec. 1503(d)(3) treats a "separate unit" of a U.S. corporation, such as a branch or a partnership, as if it were a wholly owned subsidiary and, therefore, deemed affiliated with the U.S. corporation under Sec. 1504(d). Thus, the DCL rules may apply to losses incurred by a foreign branch of a U.S. corporation.

Regs. Sec. 1.1503-2(c)(5)(ii) provides two exceptions to the definition of a DCL. One exception is for losses incurred in a foreign country whose income tax laws do not allow such losses to offset income of any other person or entity in the same tax year the loss is incurred, and do not allow such loss to be carried over or back to be used, by any means, to offset the income of any other person in other tax years. The term "by any means" can be construed to mean that the other person whose income might be offset under foreign law by the DCL does not have to exist in the year of the loss, if there is the possibility of a carryover to some other year. This exception is difficult to meet, because most countries provide for loss carryovers.

The second exception allows the domestic corporation not to treat an NOL as a DCL if it is incurred during that part of the year before becoming a DRC, or subsequent to the domestic corporation ceasing to be a DRC. However, the loss allocated to the part of the year in which the corporation was not a DRC cannot exceed the product of the loss and the number of days the corporation was not a dual resident over the number of days in the year.

For purposes of these exceptions, a loss taken into account in computing a DCL is deemed to offset income of another person under the foreign country's income tax laws in the year incurred and made available for the offset. The fact that the other person does not have income to offset against the loss in such year is irrelevant. However, if the laws of a foreign country provide for an election that enables a DRC or separate unit (i.e., branch or partnership) to use its losses to offset income of another person, the loss will be considered to offset such income only if the election is made.

If a domestic corporation is denied the use of a DCL, there are two exceptions to the inability to use such loss. The deduction of a DCL is allowed if there is an agreement between the U.S. and the foreign country that the loss can be used to offset gain only in one country. (Currently, the U.S. has not entered into such agreement with any other country.)

The second exception allows the deduction of a DCL if the DRC or its controlling affiliates enter into an agreement with the IRS, certifying that the loss will not be used to offset another person's income under the foreign country's laws. The information to be included on such election form is provided under Regs. Sec. 1.1503-2(g)(2)(i). This agreement can only be made with a timely filed return. However, relief from filing a late agreement may be available under Sec. 9100.

Example: S corporation B forms a wholly owned limited liability company S in country X and elects to treat S as a foreign branch by filing a check-the-box election under Regs. Sec. 301.7701-3(c). In year 1, S incurs a loss of $1,000, all of which B proposes to offset against its $10,000 domestic income. The fact that S does not have another foreign entity against which it can offset the loss in X is not relevant. The possibility that, under X's laws, a related entity can be formed in the future which will be eligible to use the S loss classifies the S loss as a DCL.

Because the S loss is a DCL, B cannot offset its other income with the loss, unless it follows the elective procedure under Regs. Sec. 1.1503-2(g)(2). Under this procedure, B certifies that the DCL has not been (and will not be) used to offset the income of another person under the laws of a foreign country.

In addition to the initial certification procedure described, a corporation must continue to monitor the use of the foreign loss and file an annual certification for each of the 15 years following the tax year in which it incurs the DCL. Until and unless Form 1120 contains questions pertaining to DCLs, the corporation must file the annual certification with its annual tax return. Regs. Sec. 1.1503-2(g)(2)(vi)(B) describes the information required to be included in the annual certification. Among other things, the corporation must warrant that it has made arrangements to ensure that it will not use the loss to offset the income of another person under the laws of a foreign country.

The initial certification election, when filed, essentially sets forth the taxpayer's agreement to recapture the DCL as taxable income if a "triggering event" occurs. Triggering events include:

1. The use "by any means" of the DCL within a 15-year period after the corporation incurs such loss to offset the income of any other person under foreign law;

2. The departure of a DRC from the group or the group ceases to exist because the common parent is no longer in existence;

3. A transfer of a DRC to a new group;

4. A transfer of assets by a DRC to an entity that can use its loss carryovers under foreign law (a transfer consists of a transaction(s) over a 12-month period representing at least 50% of the fair market value (FMV) of the DRC's assets on the first date of transfer);

5. The transfer or sale of a foreign separate unit's assets that generates losses usable by another person in the foreign country (a transfer consists of a transaction(s) over a 12-month period representing at least 50% of the FMV of the DRC's assets on the first date of transfer);

6. A change of a U.S. corporation into a foreign corporation under foreign law;

7. A domestic owner of a separate unit engages in a transaction(s) over a 12-month period that sells or disposes of 50% or more of the interest in the separate unit (measured by voting power or value) owned on the last day of the tax year in which the DCL was incurred; or

8. The failure of the U.S. entity to file an annual certification.

The DCL regulations provide for a reprieve from the triggering events for nearly all of the exceptions, if a taxpayer demonstrates to the IRS's satisfaction that it did not receive a double benefit from using the DCL.

The rules providing the exception relative to the initial agreement and the annual certifications are buttressed by a "consistency" requirement. The consistency requirement prevents any DCL incurred by a second DRC of the same consolidated group from entering into an agreement with the U.S. if the first DRC has used its DCL to offset income of another person in a foreign country. This requirement ensures the consolidated group applies consistent treatment to all DCLs available for use in a foreign country in a given year. Thus, a corporation may not pick and choose which DCLs to offset against consolidated U.S. income, if the foreign corporation or separate unit files a consolidated return in the foreign country. However, the consistency rule applies only if the foreign country's income tax laws allow DCLs to offset income of another person in the same tax year.

The DCL regime is complex and at times can be quite draconian. This is particularly true when a U.S. corporation resides in a country that has a DCL regime similar to the rules provided under Regs. Sec. 1.1503-2; a loss cannot be applied against income in either country's consolidated group. A tax practitioner should exercise care in resolving compliance and planning issues, including the requirement to file the annual certifications that allow the use of a DCL on the U.S. tax return.

From Michael R. Schuth, CPA, Oak Brook, IL