LMSB-04-0307-032
Effective Date: April 10, 2007
Coordinated Issue Paper
All Industries
IRC 1503(d)
Mirror Legislation and the United Kingdom
UIL: 1503.06-00
This issue paper is not an official pronouncement of the law or the position of the Service and cannot be used, cited or relied upon as such.
I. Issue
Whether, under the Income Tax Code of the United States and the Income and Corporation Taxes Act 1988 of the United Kingdom, the dual consolidated loss in each of the following fact patterns may be utilized to offset the income of a domestic affiliate for U.S. federal income tax purposes?
II. Fact Patterns
1. A Delaware corporation which is managed and controlled in the United Kingdom (“U.K.”).
United States (“U.S.”) corporation X, a member of a U.S. consolidated group, owns 100% of Y, an entity incorporated under the laws of Delaware. Y is a financing company which enters into financing arrangements with entities throughout the world. The operations of Y are managed and controlled in the U.K.
During year 1, Y incurs a net operating loss of $100. The loss is not utilized in the U.K. to offset the income of another person. X files an agreement with the U.S. Internal Revenue Service pursuant to Treas. Reg. §1.1503-2T(g)(2) with its year 1 U.S. tax return and the loss is used to offset the income of a domestic affiliate.
Y is a dual resident investing company under section 404 Income and Corporate Taxes Act 1988 (ICTA) in the United Kingdom and subject to the limitations thereunder.
2. A U.K. entity which is disregarded as an entity separate from its owner for U.S. federal income tax purposes.
U.S. corporation, X, a member of a U.S. consolidated group, owns 100% of Y, an entity organized under the laws of the United Kingdom. Y is a financing company which enters into financing arrangements with entities throughout the world. Y is an eligible entity pursuant to Treas. Reg. §301.7701-3(a) and elects to be treated as disregarded as an entity separate from its owner (“disregarded entity”) for U.S. federal income tax purposes.
During year 1, Y incurs a net operating loss of $100. The loss is not utilized in the U.K. to offset the income of another person. X files an agreement with the U.S. Internal Revenue Service pursuant to Treas. Reg. §1.1503-2T(g)(2) with its year 1 U.S. tax return and the loss is used to offset the income of a domestic affiliate.
Y is not a dual resident investing company under section 404 ICTA in the United Kingdom and is not subject to the limitations thereunder.
3. A net operating loss of a disregarded entity offsets under U.K. law the income of another disregarded entity.
U.S. corporations X and W are members of a U.S. consolidated group. X owns 100% of Y, an entity organized under the laws of the United Kingdom. Y is a financing company which enters into financing arrangements with entities throughout the world. Y is an eligible entity pursuant to Treas. Reg. § 301.7701-3(a) and elects to be treated as a disregarded entity for U.S. tax purposes. W owns 100% of Z, an entity organized under the laws of the United Kingdom. Z is also an eligible entity which elects to be treated as a disregarded entity.
During year 1, Y incurs a net operating loss of $100 and Z earns net income of $200. The $100 loss is utilized in the U.K. under the laws of the U.K. to offset $100 of Z’s net income of $200. The U.S. consolidated group files an agreement with the U.S. Internal Revenue Service pursuant to Treas. Reg. §1.1503-2T(g)(2) and the loss of $100 is included on the tax return. The $200 of income earned by Z is also included on the U.S. tax return.
Y is not a dual resident investing company under section 404 ICTA in the United Kingdom and is not subject to the limitations thereunder.
III. Conclusions
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Under fact pattern 1, the NOL of $100 may not be utilized to offset the income of a domestic affiliate for U.S. federal income tax purposes due to the application of the U.K.’s mirror legislation.
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Under fact pattern 2, the NOL may be utilized to offset the income of a domestic affiliate for U.S. federal income tax purposes.
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Under fact pattern 3, the NOL may be utilized to offset the income of a domestic affiliate for U.S. federal income tax purposes.
IV. Legal Authority
A. Relevant U.S. Dual Consolidated Loss Rules 1
A dual consolidated loss (“DCL”) of a dual resident corporation (“DRC”) cannot offset the taxable income of any domestic affiliate in the taxable year in which the loss is recognized or in any other taxable year. Treas. Reg. §1.1503-2(b)(1). A “domestic affiliate” means any member of an affiliated group, without regard to the exceptions contained in section 1504(b) (other than section 1504(b)(3) (foreign corporations)) relating to includible corporations. Treas. Reg. §1.1503-2(c)(13).
A DRC is a domestic corporation that is subject to the income tax of a foreign country on its worldwide income or on a residence basis. Treas. Reg. §1.1503-2(c)(2). In addition, any “separate unit” of a domestic corporation is treated as a DRC. Id.
A “separate unit” includes a foreign branch that is owned either directly by a domestic corporation or indirectly by a domestic corporation through ownership of a partnership or trust interest; an interest in a partnership; or an interest in a trust. Treas. Reg. §1.1503-2(c)(3)(i).
The term “separate unit” also includes an interest in a hybrid entity (“hybrid entity separate unit”). Treas. Reg. §1.1503-2(c)(4). A hybrid entity separate unit is an entity that is not taxable as an association for U.S. tax purposes but is subject to income tax in a foreign country as a corporation (or otherwise at the entity level) either on its worldwide income or on a residence basis. Id..
In general, a DCL of a DRC can not offset the taxable income of a domestic affiliate in the taxable year of the loss or any other year. Treas. Reg. §1.1503-2(b)(1). The regulations provide two exceptions to this general rule.
First, Treas. Reg. §1.1503-2(g)(1) provides that a dual resident corporation or domestic owner of a separate unit may elect to deduct the loss in the U.S. pursuant to an agreement entered into between the U.S. and a foreign country that puts into place an elective procedure through which losses offset income in only one country.
Second, Treas. Reg. §1.1503-2T(g)(2) provides a second exception to the general rule by permitting the use of a DCL where the taxpayer certifies that no portion of the DCL will be used to offset the income of another person under the income tax laws of a foreign country (colloquially referred to as a “(g)(2) election” or “(g)(2) agreement”). The taxpayer must attach an agreement, signed under penalties of perjury, to its timely filed U.S. return certifying that the loss has not been, and will not be used to offset the income of any other person under foreign law.
The primary focus of the (g)(2) agreement is whether any portion of the loss is used to offset the income of another person under the laws of a foreign country. The regulations provide specific rules in determining when a loss is treated as “used” in a foreign country.
Treas. Reg. §1.1503-2(c)(15)(iii) provides that the losses, expenses or deductions taken into account in computing a DRC’s or separate unit’s DCL shall not be deemed to offset income of another person under the income tax laws of a foreign country, if under the laws of the foreign country the losses, expenses, or deductions of the DRC are used to offset the income of another DRC or separate unit within the same consolidated group (or income of another separate unit that is owned by the unaffiliated domestic owner of the first separate unit).
Treas. Reg. §1.1503-2(c)(15)(iv) provides that “where the income tax laws of a foreign country deny the use of losses, expenses, or deductions of a dual resident corporation to offset the income of another person because the dual resident corporation is also subject to income taxation by another country on its world wide income or on a residence basis, the dual resident corporation shall be treated as if it actually had offset its dual consolidated loss against the income of another person in such foreign country.”
Treas. Reg. §1.1503-2(c)(15)(iv) is referred to as the “mirror legislation” provision. Where the provision applies, the DCL of a DRC is deemed to have been used to offset the income of another person in the foreign country; therefore a (g)(2) election may not be made. Whether a foreign “mirror legislation” applies to a DCL of a DRC is a question of foreign law.
1 This Coordinated Issue Paper analyzes the fact patterns under the existing statutory and regulatory authority, including the existing final and temporary dual consolidated loss regulations. On May 24, 2005, Treasury and the IRS published proposed regulations revising the existing final and temporary dual consolidated loss regulations. REG-102144-04 (May 24, 2005). The proposed regulations are proposed to apply to dual consolidated losses incurred in taxable years beginning after the date the proposed regulations are published as final regulations in the Federal Register. This Paper does not address the proposed regulations.
B. United Kingdom Dual Consolidated Loss Provision (“Mirror Legislation”) Section 404 ICTA
U.K. law generally permits the loss of a company to offset the income of another member of its group (“group relief”). However, the operation of the U.K.’s dual consolidated loss provisions may prevent group relief in certain circumstances. The U.K. enacted mirror legislation in the Income and Corporate Taxes Act of 1988 which was intended to curtail double-dipping by dual resident investing companies.
Section 404 Income and Corporate Taxes Act 1988 (ICTA) provides, in part, that “notwithstanding any other provision of this Chapter, no loss or other amount shall be available for set off by way of group relief in accordance with section 403 if, in the material accounting period of the company which would otherwise be the surrendering company, the company is for the purpose of this section a dual resident investing company.”
For purposes of section 404 ICTA, a “dual resident” company is defined as a company that is-
(a) resident in the United Kingdom (either because it is U.K. incorporated or centrally managed or controlled) and
(b) “within the charge to tax” under the laws of a foreign “territory” because:
(i) it derives status as a company from those laws;
(ii) its place of management is in that territory; or
(iii) under those laws it is for any other reason regarded as a resident in that territory for the purpose of the charge. Section 404(4) ICTA.
An “investing company” is a company that throughout any accounting period is not a “trading company”. Section 404(5) ICTA. A “trading company” is defined as “a company the business of which consists wholly or mainly in the carrying on of a trade or trades.” Section 413(3)(c) ICTA.
A “trading company” will be an “investing company” if during an accounting period there is any period of time during which the whole or main business of the company does not consist of carrying on a trade. Further, a trading company is an “investing company” if the company carries on a trade but its main function, or one of its main functions, consists, in particular, of acquiring and holding shares, securities, or investments, paying amounts giving rise to interest deductions under the U.K. corporate debt legislation or charges on income or similar payments, or borrowing money in connection with such activities. Section 404(6)(a) ICTA.
V. Analysis
Fact pattern 1. A Delaware corporation which is managed and controlled in the U.K.
U.S. corporation, X, a member of a U.S. consolidated group, owns 100% of Y, an entity incorporated under the laws of Delaware. Y is a financing company which enters into financing arrangements with entities throughout the world. The operations of Y are managed and controlled in the U.K.
During year 1, Y incurs a net operating loss of $100. The loss is not utilized in the U.K. to offset the income of another person. X files an agreement with the U.S. Internal Revenue Service pursuant to Treas. Reg. §1.1503-2T(g)(2) with its year 1 U.S. tax return, and the loss is used to offset the income of a domestic affiliate.
Since Y is managed and controlled in the U.K., it is treated as a resident of the U.K. and is subject to U.K. tax as a resident. Therefore, Y is a DRC pursuant to Treas. Reg. §1.1503-2(c)(2). The $100 NOL incurred by Y during year 1 is a dual consolidated loss pursuant to Treas. Reg. §1.1503-2(c)(5).
To date, the U.S. has not entered into an agreement with the U.K. which would be considered an agreement under Treas. Reg. 1.1503-2(g)(1) with respect to the use of a DCL which is subject to section 404 ICTA. 2
2 In 2000 the U.K. extended group relief to U.K. branches (i.e., branches in the U.K. under U.K. law) or U.K. permanent establishments (under an income tax treaty) of non-U.K. companies but subjected the surrender of losses of such U.K. branches or permanent establishments to a mirror legislation limitation. See sections 403D(1)(c) and 403D(6) ICTA. On October 6, 2006 the competent authorities of the United States and the United Kingdom, pursuant to paragraph 3 of Article 26 of the U.S.-U.K. income tax treaty, entered into an agreement (“DCL competent authority agreement”). The DCL competent authority agreement allows taxpayers to elect to use DCL’s subject to the United States DCL rules (including the mirror legislation rule of Treas. Reg. §1.1503-2(c)(15)(iv)) and sections 403D(1)(c) and 403D(6) ICTA, in either the United States or the United Kingdom but not both. See 2006 TNT 196-24 (October 11, 2006). For a taxpayer to elect under the DCL competent authority agreement, the losses must relate, for U.K. tax purposes, to accounting periods ending on or after April 1, 2000. The DCL competent authority agreement explicitly does not apply to losses incurred by, inter alia, a DRC within the meaning of Treas. Reg. §1.1503-2(c)(2) (other than to the extent a UK permanent establishment is treated as a DRC) or a hybrid entity separate unit within the meaning of Treas. Reg. §1.1503-2(c)(4). None of the three fact patterns in this paper involve an entity which is treated as a branch under U.K. law or a permanent establishment under the U.S.-U.K. treaty. Fact pattern 1 involves a DRC which is not a UK branch or permanent establishment. Fact pattern 2 and 3 each involves a hybrid entity separate unit. Therefore, sections 403D(1)(c) and 403 D(6) ICTA do not apply , and the DCL competent authority agreement is not applicable to the fact patterns in this paper.
The DCL may not be used to offset the income of a domestic affiliate unless an election is permitted and made pursuant to Treas. Reg. §1.1503-2T(g)(2). In order for an election to be effective under Treas. Reg. §1.1503-2T(g)(2), the taxpayer must certify, in part, that no portion of the dual consolidated loss has been, or will be, used to offset the income of any other person under the income tax laws of the foreign country.
Treas. Reg. § 1.1503-2(c)(15)(iv), the “mirror legislation” provision, provides that a dual resident corporation will be treated as if it actually had offset its dual consolidated loss against the income of another person in a foreign country “where the income tax laws of a foreign country deny the use of losses, expenses, or deductions of a dual resident corporation to offset the income of another person because the dual resident corporation is also subject to income taxation by another country on its world wide income or on a residence basis”.
Therefore, it must be determined whether U.K. law denies the use of Y’s loss to offset the income of another person in the U.K. because Y is also subject to income tax by the U.S. on its worldwide income or on a residence basis.
Section 404 ICTA provides, “notwithstanding any other provision of this Chapter, no loss or other amount shall be available for set off by way of group relief in accordance with section 403 if, in the material accounting period of the company which would otherwise be the surrendering company, the company is for the purpose of this section a dual resident investing company.” Therefore, section 404 ICTA only applies to entities which are “dual resident investing companies.”
For purposes of section 404 ICTA, a “dual resident” company is defined as a company that is-
(a) resident in the United Kingdom (either because it is U.K. incorporated or centrally managed or controlled) and
(b) “within the charge to tax” under the laws of a foreign “territory” because:
(i) it derives status as a company from those laws;
(ii) its place of management is in that territory; or
(iii) under those laws it is for any other reason regarded as a resident in that territory for the purpose of the charge. Section 404(4) ICTA.
An “investing company” includes a company which carries on a trade but its main function, or one of its main functions, consists, in particular, of acquiring and holding shares, securities, or investments, paying amounts giving rise to interest deductions under the U.K. corporate debt legislation or charges on income or similar payments, or borrowing money in connection with such activities. Section 404(6)(a) ICTA.
Y is managed and controlled in the U.K. and is subject to tax in the U.S. because it is incorporated in Delaware; therefore it is a “dual resident” under U.K. law section 404(4) ICTA. In addition, its main functions involve providing financing through lending and thus it qualifies as an “investing company” under section 404(6) ICTA. Therefore, Y is a “dual resident investing company” pursuant to section 404(4) and (6) ICTA. As such, U.K. law denies “group relief” with respect to the loss since Y is subject to tax in the U.S. as a resident and is an investing company.
Pursuant to Treas. Reg. §1.1503-2(c)(15)(iv), since the U.K. law section 404 ICTA denies “group relief” due to Y’s status as a resident of the U.S. for income tax purposes, the dual consolidated loss is treated as if it actually had offset the income of another person in the U.K. As such, a (g)(2) election is not possible and not permitted with respect to the $100 DCL incurred during year 1. Although X filed a (g)(2) election, the election is invalid and the loss is disallowed.
Fact pattern 2. A U.K. entity which is treated for U.S. federal income tax purposes as a disregarded entity.
U.S. corporation, X, a member of a U.S. consolidated group, owns 100% of Y, an entity organized under the laws of the United Kingdom. Y is a financing company which enters into financing arrangements with entities throughout the world. Y is an eligible entity pursuant to Treas. Reg. §301.7701-3(a) and elects to be treated as a disregarded entity for U.S. tax purposes.
During year 1, Y incurs a net operating loss of $100. The loss is not utilized in the U.K. to offset the income of another person. X files an agreement with the U.S. Internal Revenue Service pursuant to Treas. Reg. §1.1503(d)-2T(g)(2) with its year 1 U.S. tax return, and the loss is used to offset the income of a domestic affiliate.
Y is a “hybrid entity separate unit” and a DRC pursuant to Treas. Reg. §1.1503-2(c)(4). The $100 NOL is a DCL and is not permitted to be used to offset the income of an affiliated domestic corporation unless an election is permitted pursuant to Treas. Reg. §1.1503-2T(g)(2).
In order to make an election under Treas. Reg. §1.1503-2T(g)(2), the taxpayer must certify that no portion of the dual consolidated loss has been, or will be, used to offset the income of any other person under the income tax laws of the foreign country. X has certified that the DCL has not been, and will not be, used to offset the income of any person under foreign law.
The U.K.’s mirror legislation does not appear to apply to Y. Y is managed and controlled in the U.K. and therefore is considered a resident in the U.K. for purpose of section 404 ICTA. See section 404(4)(a) ICTA. However, the income of Y is subject to U.S. tax only because Y, for U.S. federal income tax purposes, is treated as an entity disregarded as separate from its owner, X, and a U.K. branch operation of X. Y’s U.S. tax exposure does not result from (i) its status as a company under U.S. law; (ii) having its place of management in the U.S.; or (iii) being treated under U.S. law as a resident of the U.S. for any other reason. See section 404(4)(b)(i)-(iii) ICTA. As such, section 404(4)(b) ICTA is not met, Y is not considered a “dual resident” for purposes of section 404 ICTA and, therefore, section 404 ICTA does not apply to the DCL of Y.
Since the U.K.’s mirror legislation does not appear to apply to Y, Treas. Reg. 1.1503-2(c)(15)(iv) does not apply and therefore does not operate to treat Y as if it actually had offset its $100 DCL against the income of another person in the U.K.. As such, a (g)(2) election is permitted with respect to the $100 DCL incurred during year 1.
Fact pattern 3. Loss of a disregarded entity offsets the income of another disregarded entity in the U.K.
U.S. corporations X and W are members of a U.S. consolidated group. X owns 100% of Y, an entity organized under the laws of the United Kingdom. Y is a financing company which enters into financing arrangements with entities throughout the world. Y is an eligible entity pursuant to Treas. Reg. §301.7701-3(a) and elects to be treated as a disregarded entity for U.S. tax purposes. W owns 100% of Z, an entity organized under the laws of the United Kingdom. Z is also an eligible entity which elects to be treated as a disregarded entity.
During year 1, Y incurs a net operating loss of $100 and Z earns net income of $200. The $100 loss is utilized in the U.K. under the laws of the U.K. to offset $100 of Z’s net income of $200. The U.S. consolidated group files an agreement with the U.S. Internal Revenue Service pursuant to Treas. Reg. §1.1503-2T(g)(2) and the loss of $100 is included on the tax return. The $200 of income earned by Z is also included on the U.S. tax return.
As discussed in the analysis of fact pattern 2 above, the U.K. mirror legislation does not apply to Y since it is a hybrid entity separate unit. Therefore, the mirror legislation rule of Treas. Reg. §1.1502-2(c)(15)(iv) does not deem the loss to be used to offset the income of another person under foreign law and will not prevent a (g)(2) election from being be filed.
Treas. Reg. §1.1503-2(c)(15)(iii) provides that the losses, expenses or deductions taken into account in computing a DRC’s or separate unit’s DCL shall not be deemed to offset the income of another person under the income tax laws of a foreign country, if under the laws of the foreign country the losses, expenses, or deductions of the DRC are used to offset the income of another DRC or separate unit within the same consolidated group (or income of another separate unit that is owned by the unaffiliated domestic owner of the first separate unit).
In fact pattern 3, despite the use of the Y loss to offset the income of Z, the U.S. consolidated group is permitted to file a (g)(2) agreement with the Internal Revenue Service because, given Treas. Reg. §1.1503-2(c)(15)(iii), it can still certify that no portion of the dual consolidated loss has been, or will be, used to offset the income of any other person under the income tax laws of the foreign country. Y and Z are “hybrid entity separate units” and DRCs pursuant to Treas. Reg. §1.1503-2(c)(4). Y’s $100 NOL is a DCL and is not permitted to be used to offset the income of an affiliated domestic corporation unless an election is permitted pursuant to Treas. Reg. §1.1503-2(g)(2). Therefore, since the fact pattern provides that a (g)(2) election was made, the loss of $100 may be included on the U.S. tax return.
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