On August 6, 2024, the U.S. Treasury Department (“Treasury”) issued proposed regulations under section 1503[1] (the “Proposed Regulations”) that address the interaction between the dual consolidated loss (“DCL”) rules and the Global Anti-Base Erosion Rules (Pillar Two) (“Pillar Two Rules”),[2] among other DCL issues.[3] If finalized, the Proposed Regulations would increase the relevance of the DCL rules for many U.S. consolidated groups with foreign affiliates either above or below such U.S. groups in jurisdictions implementing the Income Inclusion Rule (“IIR”) of Pillar Two. The Proposed Regulations would also apply to U.S. corporate groups with branches in jurisdictions with a Qualified Domestic Minimum Top-Up Tax (“QDMTT”).
Discussion of the Proposed Regulations
The Proposed Regulations provide that QDMTTs and IIRs generally are foreign income taxes for purposes of the DCL rules.[4] Therefore, a foreign use of a DCL may be deemed to occur if a loss is taken into account (a) in computing Net GloBE Income[5] for purposes of calculating a QDMTT or IIR liability,[6] or (b) for purposes of qualifying for the Transitional CbCR Safe Harbour.[7] However, the Proposed Regulations do not address the interaction of the DCL rules with the Undertaxed Profits Rule.
For example, consider a structure where a U.K. parent corporation (“U.K. Parent”) owns two subsidiaries: one in the Cayman Islands (“Cayman Co”) and the other in the United States (“USCo”). USCo, in turn, owns a disregarded entity in the Cayman Islands (“Cayman DRE”). U.K. Parent is the ultimate parent entity of an MNE group of which USCo, Cayman Co, and Cayman DRE are constituent entities, and as such is subject to the IIR under the U.K. Pillar Two legislation. Because under the U.K. IIR rules, U.K. Parent would generally be required to combine Cayman DRE’s book losses with Cayman Co’s book income in determining the MNE group’s ETR in the Caymans Islands, under the Proposed Regulations, any losses generated by Cayman DRE would be deemed utilized in a foreign use. As a result of the deemed foreign use, USCo would be prevented from (i) relying on the no possibility of foreign use exception under section 1.1503(d)-6(c) of the Treasury regulations and (ii) making a domestic use election with respect to Cayman DRE’s DCL under section 1.1503(d)-6(d) of the Treasury regulations.
The Proposed Regulations also provide a limited foreign use exception specific to the Transitional CbCR Safe Harbour set forth in the administrative guidance published by the OECD on December 22, 2023. Under the exception, no foreign use of a DCL is treated as occurring provided that: (i) the Transitional CbCR Safe Harbour is satisfied (i.e., the jurisdictional top-up tax in the relevant jurisdiction is deemed to be zero for the taxable year) and (ii) no foreign use occurs under the Transitional CbCR Safe Harbour due to the application of the “duplicate loss arrangement” rules.[8] In other words, if a taxpayer makes a domestic use election with respect to the relevant foreign loss such that the “duplicate loss arrangement rules” prevent the taxpayer from using such loss for purposes of the Transitional CbCR Safe Harbour, the DCL rules would not apply to such loss provided that the taxpayer qualifies for the Transitional CbCR Safe Harbour in the relevant jurisdiction (i.e., taking into account the loss disallowance under the “duplicate loss arrangement” rules). However, Treasury and the IRS refused to create a broad exception for a foreign use of a DCL for all instances where a DCL could be used to qualify for the Transitional CbCR Safe Harbour.
Finally, the Proposed Regulations extend the relief previously announced in Notice 2023-80 for “legacy DCLs.”[9] Under the Proposed Regulations, and subject to an anti-abuse rule,[10] the DCL rules apply without taking into account QDMTTs or other top-up taxes with respect to losses incurred in taxable years beginning before August 6, 2024, thereby extending the relief period beyond that contained in Notice 2023-80.[11] Furthermore, the relief provided under the Proposed Regulations applies with respect to all the DCL rules, including foreign use rule.
The Proposed Regulations provide different applicability dates depending on the provision at issue. As noted above, the proposed exception for historic DCLs would apply to losses incurred in taxable years beginning before August 6, 2024. Consistent with that, the proposed rules concerning (i) the foreign use exception applicable to the Transitional CbCR Safe Harbour and (ii) separate units arising as a result of a QDMTT or IIR would apply to tax years beginning on or after August 6, 2024. A taxpayer may, however, rely on the proposed DCL rules for any taxable year ending on or after August 6, 2024 and beginning on or before the date that regulations finalizing these proposed rules are published in the Federal Register, subject to a consistency requirement for members of a consolidated group until the applicability date of the final regulations. In addition, a taxpayer may rely on the foreign use exception described in Notice 2023-80 for any tax year ending on or after December 11, 2023, and before August 6, 2024, subject to a consistency requirement for members of a consolidated group until the applicability date of the final regulations on this topic.
Observations
Practically speaking, because the QDMTT and IIR rules require jurisdictional blending of income and losses as a matter of course, with a narrow exception for the Transitional CbCR Safe Harbour (discussed above), the Proposed Regulations would greatly expand the application of the DCL rules for multinational enterprises large enough to be subject to a QDMTT or IIR.[12]
Many U.S. taxpayers have established their current operating structures predicated on the ability to claim U.S. deductions with respect to DCLs. Indeed, historically, potential DCL issues have been managed through careful planning to ensure that a separate unit does not become part of a foreign tax consolidation or other loss-sharing regime, thus allowing a domestic use election to be made with respect to a foreign loss. However, unlike other regimes, the Pillar Two rules do not allow taxpayers the flexibility to avoid consolidating or sharing losses among entities within a specific jurisdiction. Therefore, if the Pillar Two rules are treated as triggering a foreign use of a DCL, U.S. taxpayers would face substantial restrictions on their ability to (i) rely on the exception to the domestic use limitation rule under section 1.1503(d)-6(c) of the Treasury regulations and (ii) make the domestic use election under section 1.1503(d)-6(d) of the Treasury regulations.
Accordingly, taxpayers should continue to monitor Treasury’s finalization of the Proposed Regulations and begin considering whether possible DCL inefficiencies can be managed through changes to their non-U.S. structures, including by merging or combining entities in a particular jurisdiction or making check-the-box elections to cause existing non-U.S. corporate subsidiaries to be classified as disregarded entities for U.S. federal income tax purposes. However, taxpayers will want to carefully consider all of the U.S. federal income tax consequences of any such modifications to their structures.
Footnotes
[1] All “section” references herein are to the Internal Revenue Code of 1986, as amended.
[2] OECD, Tax Challenges Arising from the Digitalisation of the Economy — Global Anti-Base Erosion Model Rules (Pillar Two) (Dec. 14, 2021).
[3] Among other rules, the proposed regulations also address the effect of intercompany transactions and items arising from stock ownership in calculating a DCL, and provide for new rules addressing so-called “disregarded payment losses.”
[4] However, under the Proposed Regulations, a domestic entity is not treated as a dual resident corporation or a hybrid entity solely as a result of the domestic entity’s income or loss being taken into account in determining the amount of an IIR. See Prop. Reg. § 1.1503(d)-7(c)(3)(iii) for an example illustrating the treatment of domestic entities under an IIR.
[5] The Net GloBE Income of the jurisdiction is determined by aggregating the GloBE Income or Loss of all Constituent Entities of the multinational enterprise (“MNE”) group located in the same jurisdiction.
[6] See Prop. Reg. § 1.1503(d)-7(c)(3)(ii) for an example illustrating the application of the DCL rules with respect to a QDMTT.
[7] The Transitional CbCR Safe Harbour is designed to ameliorate the compliance burden of undertaking full GloBE calculations during the Transition Period (i.e., fiscal years beginning on or before December 31, 2026, but not including a fiscal year that ends after June 30, 2028) by limiting the circumstances in which an MNE will be required to perform such calculations to a smaller number of higher-risk jurisdictions.
[8] Generally, an arrangement qualifies as a duplicate loss arrangement if an expense or loss in the financial statements of a Constituent Entity also gives rise to a duplicate amount that is deductible in determining the taxable income of another Constituent Entity in another jurisdiction. The duplicate loss arrangement rules are contained in the administrative guidance issued by the OECD in December of 2023 to require certain adjustments for “duplicate loss arrangements” when assessing the Transitional CbCR Safe Harbour. See OECD, Tax Challenges Arising from the Digitalisation of the Economy — Administrative Guidance on the Global Anti-Base Erosion Model Rules (Pillar Two) (Dec. 2023), §2.6.3.
[9] In Notice 2023-80 (released on December 11, 2023), Treasury and the IRS provided that forthcoming proposed regulations would establish that the implementation of the Pillar Two Rules should not result in a “foreign use” of a DCL arising in a taxable year ending on or before December 31, 2023, or certain fiscal years beginning before January 1, 2024, and ending after December 31, 2023.
[10] See Prop. Reg. § 1.1503(d)-8(b)(12)(ii).
[11] See Prop. Reg. § 1.1503(d)-8(b)(12)(i).
[12] The Pillar Two Rules apply to MNEs with annual consolidated revenues of at least €750 million in at least two out of the last four years.
