Treasury and the IRS released proposed regulations (REG-105128-23; the proposed regulations) on Aug. 6, 2024, that address the interaction of the Dual Consolidated Loss (DCL) rules with Pillar Two of the OECD’s Global Anti-Base Erosion Model Rules (GloBE Rules) and make several changes to the current DCL rules. The proposed regulations contain reliance language that generally allows taxpayers to rely on the proposed regulations for tax years ending on or after Aug. 6, 2024, and before the date the proposed regulations are finalized.
Background on the DCL rules
A DCL is essentially a net operating loss (as determined under US tax principles) of a dual resident corporation, or a foreign hybrid entity or branch owned by a US corporation.1 The DCL rules were designed to prevent double deduction, single inclusion outcomes where an expense incurred by a dual resident corporation, foreign hybrid entity or foreign branch is used to offset both the income of a US corporation and the income of a foreign corporation that is not subject to US tax.
The DCL rules generally prevent a US corporation that owns the dual resident corporation, foreign hybrid entity or foreign branch from using the loss to offset income earned by other members of the US corporation’s group unless the US corporation makes a domestic use election and certifies for the year of the election and the five subsequent years that foreign use of the DCL has not occurred. Foreign use generally occurs when a portion of the DCL is made available under the income tax laws of a foreign country to reduce the income of another entity that is classified as a foreign corporation for US tax purposes.
Foreign use under Pillar Two taxes
The proposed regulations provide guidance with respect to the foreign use of a DCL under an Income Inclusion Rule (IIR) or a Qualified Domestic Minimum Top-Up Tax (QDMTT) that is consistent with the Pillar Two GloBE Model Rules. Treasury and the IRS indicated in the preamble to the proposed regulations that an income tax for purposes of applying the DCL rules may include a tax that is intended to ensure a minimum level of tax on income which is determined by reference to financial accounting principles, including specifically an IIR or QDMTT.2 As a result, foreign use of a DCL may occur under an IIR or QDMTT due to the calculation of a group’s effective tax rate (ETR) on a jurisdictional basis which aggregates items of income and expense of multiple entities or branches in the same foreign jurisdiction.3 Treasury and the IRS have taken the position that the aggregation of items of income and expense of multiple entities or branches in the same jurisdiction for purposes of calculating the GloBE ETR can result in foreign use.4 If foreign use of a DCL occurs under an IIR or QDMTT, a US corporation that owns the foreign hybrid entity or foreign branch would not be allowed to make a domestic use election to use the DCL to offset income earned by other members of the US corporation’s consolidated group.
Treasury and the IRS have also taken the position that foreign use can occur in the context of applying the Transitional Country-by-country reporting (CbCR) Safe Harbour because the use of the DCL to qualify for the Safe Harbour avoids the tax that would otherwise be imposed under an IIR or QDMTT.5 However, the proposed regulations include a special carve out where the duplicate loss arrangement rules under the Safe Harbour apply to prevent double deduction outcomes.6
The proposed regulations also clarify that the duplicate loss arrangement rules of the CbCR Safe Harbour (and foreign law that is consistent with the EU Anti-Tax Avoidance Directive or ATAD 2) will not be considered mirror legislation because the rules allow the use of a DCL in a foreign jurisdiction if the US owner of the hybrid entity does not make a domestic use election to use the loss in the US.7 This prevents the duplicate loss arrangement rules (and the ATAD 2 rules) from creating deemed foreign use even when the loss is not used to offset income of another branch or entity as part of the ETR calculation.
Treasury and the IRS also stated in the preamble that if a DCL reduces the amount of net GloBE income in a foreign jurisdiction through the application of the ETR calculation, foreign use may occur regardless of whether the tax is collected by another jurisdiction (e.g., the jurisdiction of the ultimate parent of the MNE Group).
The proposed regulations include a transition rule for ‘legacy DCLs’ which provides that the DCL rules will be applied without taking into account an IIR or QDMTT with respect to losses incurred in tax years beginning before Aug. 6, 2024, subject to an anti-abuse rule.8 The anti-abuse rule applies when a loss was incurred or increased with a view to reduce the amount of tax under a QDMTT or IIR, or to qualify for the Transitional CbCR Safe Harbour (e.g., where a transaction occurs for the purpose of accelerating the recognition of a loss under a QDMTT during the transition period).9
Calculating DCLs By Excluding Items Based on Ownership of Stock
The proposed regulations provide that certain US tax items arising from a foreign hybrid entity’s ownership of shares in a foreign corporation, such as gain from the sale of stock, dividends (including section 1248 dividends), GILTI, Subpart F, and 245A dividend received deductions, will not be taken into account in calculating a DCL.10 Excluding these items from the DCL calculation is intended to address situations where taxpayers may be affirmatively structuring into these rules to eliminate a DCL without creating an income inclusion for foreign tax purposes, essentially producing double-deduction, single inclusion outcomes the DCL rules were designed to address.
The proposed regulations also clarify that when adjusting foreign books and records of a hybrid entity to conform to US tax principles, items that are disregarded for US tax principles (such as items resulting from transactions between a foreign entity that is checked to be disregarded for US tax purposes and its US tax owner) would not be attributed to the hybrid entity under transfer pricing or effectively connected income principles for purposes of calculating a DCL.11
Interaction of DCL Rules with Consolidated Group Rules
The proposed regulations would amend the section 1502 consolidated return regulations to clarify that a member of the US consolidated group with a DCL has special status under Reg. 1.1502-13(c)(5) such that even though section 1503(d) requires certain treatment of the member’s tax items, that treatment does not affect the US tax attributes of the counterparty group member’s tax items. For example, if the DCL rules prevent a US group member from deducting interest on an intercompany loan, the US group member that is a counterparty to the loan would continue to include the interest in income.
The proposed regulations would also provide that the consolidated return intercompany transaction regulations apply first to determine when an intercompany (or corresponding) item is taken into account, before the section 1503(d) rules are applied to compute the DCL loss. As a result, if a US consolidated group member’s loss would otherwise be taken into account in the current year under section 1503(d) and prevent the use of that loss to offset income of another US group member, the intercompany transaction regulations would not redetermine that loss.
Introduction of New Disregarded Payment Loss Rules
The proposed regulations create a new set of rules addressing single deduction/non-inclusion outcomes involving interest, royalties, and structured payments that create deductions for foreign tax purposes but do not result in an income inclusion for US tax purposes because the transaction is disregarded. The proposed disregarded payment loss (DPL) rules would operate independent of the dual consolidated loss rules which, in contrast to the DPL rules, only apply to items that are regarded for US tax purposes.
The DPL rules would apply to US owned entities that elect to be disregarded for US tax purposes and are subject to tax on a residence basis in a foreign jurisdiction. This would include, for example, a US disregarded entity that is managed and controlled outside the US, or a foreign entity that is classified as corporation under foreign law and is disregarded for US tax purposes.
Under the proposed DPL rules, a US corporation that owns the disregarded entity would agree to monitor a net loss (determined under foreign law) of the disregarded entity that results from items that are deductible under foreign law but disregarded for US tax purposes. The US corporate owner of the disregarded entity would then include in gross income the amount of the disregarded payment loss if one of following triggering events occurred during the certification period: (i) foreign use of the disregarded payment loss or (ii) failure to comply with US certification requirements.12
The regulatory authority for creating the new DPL rules would come from the entity classification elections under Reg. 301.7701-3(c). When an eligible entity elects to be disregarded for US tax purposes, the US owner would be deemed to consent to the new rules. The DPL rules would apply to new entity classification elections filed on or after the date the proposed regulations are finalized, and existing disregarded entities starting 12 months after the date the proposed regulations are finalized. Thus, taxpayers with existing disregarded entities would have time to restructure prior to the application of the new DPL rules.
Key takeaway
Multinational companies subject to the GloBE Rules may lose the ability to take a US deduction for losses incurred by foreign hybrid entities and foreign branches owned by a US group member if Treasury and the IRS finalize the proposed regulations. The US deduction may be disallowed under the proposed regulations if the losses are used to offset other income earned in the jurisdiction by the multinational group as part of the GloBE ETR calculation, even if the multinational group is not subject to an IIR or QDMTT because the ETR in the jurisdiction is above 15% or the Transitional CbCR Safe Harbour applies. Multinational companies affected by the interaction of Pillar Two and the proposed DCL rules should consult with their tax advisor and may want to consider restructuring to minimize any adverse tax consequences.
1 A hybrid entity is an entity that is taxed as a corporation on a residence basis in a foreign country but is a partnership or disregarded for US tax purposes. See Reg. 1.1503(d)-1(b)(3). The Proposed Regulations would expand the definition to include stateless companies that are organized in a foreign country and subject to an IIR. See Prop. Reg. 1.1503(d)-1(b)(4)(B)(2).
2 The Proposed Regulations do not provide guidance regarding a UTPR.
3 The GloBE Model Rules create a system of minimum taxation intended to ensure that certain large Multinational Enterprise Groups (MNE Groups) pay a minimum level of tax based on the income, determine under modified financial accounting principles, arising in each jurisdiction in which they operate. The minimum level of tax is imposed generally through an IIR or QDMTT and applies if the effective tax rate in a jurisdiction is less than 15%. The effective tax rate in a jurisdiction is based on the taxes and net income paid by all entities and branches of the MNE Group operating in that jurisdiction. Additionally, in contrast to many existing foreign fiscal consolidation and loss sharing tax regimes, the aggregation of expenses for multiple entities or branches in a jurisdiction under the GloBE Model Rules is not elective.
4 Treasury and the IRS also clarified in the preamble to the Proposed Regulations that a loss incurred by a US entity that is not resident in a foreign jurisdiction would not be subject to the DCL rules even though the loss is taken into account in determining the IIR imposed on a foreign parent of the US entity.
5 Under the Transitional CbCR Safe Harbour, the IIR or QDMTT is deemed to be zero if the MNE Group has an ETR that is equal to or greater than a transitional rate or the MNE Group’s profit or loss in such jurisdiction is equal to or less than the Substance-based Income Exclusion amount.
6 Prop. Reg. 1.1503(d)-3(c)(9). A “duplicate loss arrangement” includes an arrangement that results in an expense or loss being included in the financial statement of a member of the MNE Group if the arrangement also results in a duplicate amount that is deductible in determining the taxable income of another group member in another jurisdiction.
7 “Mirror legislation” is essentially a foreign law that would deny any opportunity to use the DCL for any of the following reasons: (i) the dual resident corporation or separate unity that incurred the loss is subject to the income tax of another country on a residence basis, (ii) the loss may be available to offset income other than the income of the dual resident corporation or separate unit) under the laws of another country, or (iii) the deductibility of any portion of the DCL depends on whether the amount is deductible under the laws of another country.
8 This extends Notice 2023-80 to provide relief to DCLs incurred in 2024 and broadens the scope of the relief to include issues other than foreign use (e.g., filing a domestic use election and certifying no foreign use occurred based on an IIR or QDMTT).
9 Prop. Reg. 1.1503(d)-8(b)(12)(ii).
10 Prop. Reg. 1.1503(d)-5(b)(2) and (c)(4). Dividends would not be disregarded if the foreign hybrid entity held less than 10% of the foreign corporation’s shares.
11 However, for purposes of calculating the DCL of a foreign branch, US tax items of the US corporate owner are attributed to the foreign branch under section 864(c) effectively connected income principles by treating the US corporate owner as a foreign corporation and the foreign branch as a US trade or business.
12 The certification period under the Proposed Regulations is five years following the year the loss was incurred.
