SECTION 2. BACKGROUND

The United States taxes the worldwide income of domestic corporations. 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.

Because other countries may apply different standards for determining the residence and taxability of a corporation (e.g., based on the management and control of the corporation), some domestic corporations are dual resident corporations and, as such, are also subject to the income tax of a foreign country on their income on a residence basis (and not on a source basis). Foreign countries often have provisions that permit commonly owned entities to combine their income and losses through consolidation or some other form of combined reporting for income tax purposes.

Prior to the Tax Reform Act of 1986, if a dual resident corporation were a resident of a foreign country with tax laws that permitted the losses of the corporation to be used to offset the income of another person (e.g., under a consolidated return provision), then the dual resident corporation could use any losses it generated twice:

once to offset the income of affiliates resident in the United States (but not abroad), and again to offset the income of its affiliates resident only in the other country. Thus, such a dual resident corporation could use a single economic loss to offset two separate items of income in two jurisdictions. Congress expressed concerns that this dual use of a 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, 99 ^th

Cong., 2 ^nd Sess., General Explanation of the Tax Reform Act of 1986, at 1064 – 1065 (1987). As part of the Tax Reform Act of 1986, Congress responded by enacting §1503(d) to prevent the use of DCLs that resulted from consolidation in multiple jurisdictions.

The Treasury and Service issued temporary regulations under §1503(d) in 1989 (T.D. 8261, 1989–2 C.B. 220), and final regulations in 1992 (T.D. 8434, 1992–2 C.B. 240). The final regulations in §1.1503–2 are generally effective for taxable years beginning on or after October 1, 1992; the temporary regulations in §1.1503–2A are effective for taxable years beginning after December 31, 1986, and before October 1, 1992. The temporary regulations were initially designated as §1.1503–2T, but were redesignated as §1.1503–2A by the final regulations.

Section 1503(d) provides that a DCL of a dual resident corporation shall not be allowed to reduce the taxable income of any other member of the corporation’s affiliated group for any taxable year. The term dual resident corporation includes a domestic corporation that is subject to the income tax of a foreign country on its worldwide income or on a residence basis and a separate unit of a domestic corporation (e.g., a foreign branch, an interest in a partnership, an interest in a trust, or a disregarded entity that a foreign country taxes at the entity level). See Treas. Reg. §1.1503–2(c)(2) – (4). This revenue procedure will collectively refer to dual resident corporations and separate units as “DRCs.”

The final §1503(d) regulations permit a taxpayer to elect to use a DCL of a DRC

by entering into an agreement under §1.1503–2(g)(2)(i) in which the taxpayer 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. Certain subsequent events, known as “triggering events” require the taxpayer to recapture the losses as income, including an interest charge. Treas. Reg. §§1.1503–2(g)(2)(iii) and (vii). If a taxpayer fails to comply with the §1503(d) recapture provisions upon the occurrence of a triggering event, then the DRC (or a successor-in-interest) that incurred the DCL generally will not be eligible for relief to use any DCLs incurred in the five (5) taxable years beginning with the year in which recapture is required. Treas. Reg. §1.1503–2(g)(2)(vii)(F)(1).

Triggering events occur when: (1) any portion of the loss taken into account in computing the DCL is used by any means to offset the income of any other person for foreign tax purposes within fifteen (15) years; (2) a DRC or domestic owner of a separate unit ceases to be a member of the consolidated group that filed the agreement at a time when there is a continuing ability to use the DCL to offset income of another person for foreign tax purposes; (3) an unaffiliated DRC or unaffiliated domestic owner of a separate unit becomes a member of a consolidated group, unless there is no continuing ability to use the DCL to offset income of another person for foreign tax purposes; (4) a DRC transfers its assets to a transferee in a transaction that results, under the laws of a foreign country, in a carryover of the losses, expenses, or deductions that make up the DCL; (5) a domestic owner of a separate unit disposes of fifty (50) percent or more of the assets of, or its interest in, the separate unit at a time when there is a continuing ability to use the DCL to offset income of another person for foreign tax purposes; (6) an unaffiliated DRC or unaffiliated domestic owner of a separate unit becomes a foreign corporation in a transaction that, for foreign tax purposes, is not treated as involving a transfer of assets to a new entity, unless there is no continuing ability to use the DCL to offset income of another person for foreign tax purposes; or (7) the taxpayer fails to file an annual certification required under §1.1503–2(g)(2)(vi)(B). Treas. Reg. §1.1503–2(g)(2)(iii)(A).

2000–43 I.R.B. 395 October 23, 2000

The final regulations provide two exceptions to events described as triggering events, making the events not triggering events requiring recapture of losses and an interest charge. The first exception, under §1.1503–2(g)(2)(iv)(A), applies when a DRC, or its assets, is acquired by another member of the DRC’s consolidated group. The second exception, under §1.1503–2(g)(2)(iv)(B), applies, provided the taxpayer enters into a closing agreement, when a DRC or a domestic owner of a separate unit becomes disaffiliated from its consolidated group, or when an unaffiliated domestic corporation or new consolidated group acquires the DRC or its assets.

The Service is aware that as a result of taxpayers’ ability to elect entity classification under the §7701 elective Federal tax classification regulations that became effective as of January 1, 1997 (i.e., the check-the-box regulations), the number of DRCs may increase, and taxpayers may become subject to the §1503(d) DCL provisions, including the recapture provisions. For instance, the conversion of a foreign branch to a foreign corporation may be treated as a triggering event under the final §1503(d) regulations. See Treas. Reg. §§1.1503–2(g)(2)(iii)(A)(4) – (7) and Treas. Reg. §301.7701–3(g)(1). Therefore, this procedure is also intended to publicize the Service’s procedures and requirements that will prevent certain reorganization and disposition transactions involving DRCs from resulting in §1503(d) recapture consequences.