On August 7, 2024, the U.S. Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) published proposed regulations (the Proposed Regulations) regarding dual consolidated losses (DCLs) and certain disregarded payments. The proposed amendments to the DCL rules follow the December 2023 announcement in Notice 2023-80 that the government was studying the interaction of the DCL rules with the Pillar Two Global Anti-Base Erosion (GloBE) Model Rules, now enacted in EU member states and other countries. Generally, the Proposed Regulations would provide that if a DCL is taken into account for purposes of the GloBE rules or transitional safe harbor, a "foreign use" will be deemed to have occurred and the use of the loss may be limited for U.S. tax purposes. The Proposed Regulations also provide rules regarding so-called disregarded payment losses (the proposed DPL rules), which were not previewed in Notice 2023-80, that would have the effect of treating foreign tax losses arising from certain disregarded payments as if they were DCLs and requiring a corresponding income inclusion for U.S. tax purposes.

In addition, the Proposed Regulations also address certain issues arising from the interaction of the DCL rules and the consolidated return intercompany transaction rules and the treatment of items arising from stock ownership for purposes of the DCL rules. 

Corrections to the proposed regulations were issued on September 3, 2024, and comments are due October 7, 2024. The proposed DPL rules in particular are unexpected and can have harsh results. U.S. corporate taxpayers that own foreign disregarded entities are advised to review the potential effect of the rules, options for mitigation, and whether to submit comments.

Proposed Disregarded Payment Loss (DPL) Rules

The proposed DPL rules of Prop. Treas. Reg. § 1.1503(d)-1(d) apply to a domestic owner of a disregarded entity (DRE) that is a foreign tax resident (a "specified eligible entity") where the domestic owner consents or is deemed to consent to be subject to the DPL rules. The DPL rules generally require the owner of such a DRE to compute and annually certify the DRE's net foreign loss generated by interest, royalties, or structured payments that are disregarded for U.S. tax purposes. If there is a foreign use of the DPL (or the domestic owner fails to comply with the certification requirements) within 60 months, the domestic owner must include in income the amount of the DPL (reduced by certain disregarded income items). A foreign use occurs if the DPL offsets the income of a related foreign person. 

The Proposed Regulations do not change the general rule in Treas. Reg. § 1.1503(d)-5(c)(1)(ii) that disregarded payments are not taken into account in computing a DCL. That said, the effect of the DPL rules is to take such payments into account and to apply loss limitations similar to the DCL rules to disregarded payments. Because the relevant items considered in determining a DPL are limited to disregarded interest, royalties, and structured payments, the DPL rules can apply even where a specified eligible entity is profitable. The DPL rules are implemented in part under the authority of section 7701 and the entity classification regulations. 

Taxpayers who filed a check-the-box election to treat a specified eligible entity as a DRE on or after August 6, 2024, or who acquire an interest in a foreign DRE after that date, are considered to consent to be subject to the DPL rules. In addition, the Proposed Regulations provide that domestic owners of pre-existing foreign DREs will be deemed to consent to be subject to the DPL rules on or after August 6, 2025. Treasury and the IRS have stated that "the twelve-month delay for deemed consent provides an opportunity to restructure existing arrangements to avoid the application of the disregarded payment loss rules without changing the classification of a specified eligible entity." Taxpayers that do not consent, or are not deemed to consent, to be subject to the DPL rules with respect to a DRE will be unable to treat the otherwise eligible entity as such; instead, the eligible entity will be treated as a corporation.

DCL and GloBE Interaction

Notice 2023-80 highlighted, but ultimately left unaddressed, whether a DCL that is aggregated with other entities' income or loss in the same jurisdiction (i.e., in the calculation of the net GloBE income) for purposes of calculating a Pillar Two top-up tax constitutes a "foreign use" that prevents a taxpayer from benefiting from a DCL on a U.S. tax return. That Notice however provided that a foreign use would not occur for DCLs incurred in 2023 or in earlier tax years ("legacy DCLs") that are taken into account in determining the effective tax rate for Pillar Two purposes. The Proposed Regulations expand these legacy DCLs to include all DCLs incurred in taxable years ending on or before August 6, 2024. In addition, the Proposed Regulations extended the scope of the transition relief to apply to all DCL rules, rather than DCL rules solely related to foreign use, in order to relieve the administrative burden of having to otherwise file a domestic use election and annual certifications. 

Outside of legacy DCLs, the Proposed Regulations provide generally that a foreign use occurs if a DCL is used to offset a tax that is intended to ensure a minimum level of taxation, or any tax that computes income or loss by reference to financial accounting net income loss. As a result, a foreign use of a DCL occurs if it is used to reduce or eliminate GloBE income for purposes of a Qualified Domestic Minimum Top-Up Tax (QDMTT) or an Income Inclusion Rule (IIR). A foreign use occurs regardless of whether the DCL arises in the same jurisdiction that is imposing the tax. 

In addition, a foreign use of a DCL may also occur if the DCL is used to qualify for the Pillar Two Transitional Country-by-Country Report (CbCR) Safe Harbor. However, the Proposed Regulations provide that no foreign use occurs if the taxpayer would otherwise satisfy the Transitional CbCR Safe Harbor threshold without the use of the DCL. 

The Proposed Regulations do not address the Undertaxed Profits Rule (UTPR), which has yet to take effect, as Treasury and the IRS continue to analyze the interaction between the UTPR and the DCL rules. The Proposed Regulations also clarify that the duplicate loss arrangement rules under the Transitional CbCR Safe Harbor do not constitute mirror legislation (and therefore do not implicate the rules that would otherwise deem a foreign use to have occurred if the foreign law categorically denies the use of a DCL). 

The rules addressing DCLs and Pillar Two are proposed to apply to taxable years ending on or after August 6, 2024. In addition, taxpayers 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, provided that the taxpayer and all members of its consolidated group comprehensively and consistently apply the rules for all tax years. 

For more information, please contact:

Layla J. Asali, lasali@milchev.com, 202-626-5866

Rocco V. Femia, remia@milchev.com, 202-626-5823

Caroline R. Reaves, creaves@milchev.com, 202-626-5939

Candice C. James, cjames@milchev.com, 202-626-5810

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