On August 6, 2024, the U.S. Department of the Treasury (“Treasury”) issued proposed regulations under Section 1503⁽¹⁾ (the “Proposed Rules”), which address the interaction between the dual consolidated loss rules (“DCL”) and the global anti-base erosion rules (Pillar Two) (“Pillar Two Rules”),⁽²⁾ among other DCL problems.⁽³⁾ If finalized, the proposed regulations would increase the relevance of the DCL rules for many U.S. corporations with foreign subsidiaries above or below those U.S. corporations in jurisdictions that implement the Pillar II Income Inclusion Rule (“IIR”). 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 specify that QDMTTs and IIRs are generally foreign income taxes for purposes of the DCL rules.⁽⁴⁾ Therefore, a DCL can be considered to be used abroad if a loss is taken into account (a) in calculating net income⁽⁵⁾ to calculate a QDMTT or IIR liability,⁽⁶⁾ or (b) for the purposes of qualifying for the temporary 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 UK parent company (“UK Parent”) owns two subsidiaries: one in the Cayman Islands (“Cayman Co”) and the other in the US (“USCo”). USCo in turn owns a disregarded entity in the Cayman Islands (“Cayman DRE”). UK Parent is the ultimate parent of a multinational group of which USCo, Cayman Co and Cayman DRE are constituents, and as such is subject to IIR under UK Pillar 2 legislation. Since UK Parent would generally be required under UK IIR rules to combine the Cayman DRE’s accounting losses with the Cayman Co’s accounting profits to determine the Cayman Islands multinational group’s ETR, under the proposed rules any losses incurred by Cayman DRE would be deemed to be offshored. Because of the deemed foreign use, USCo would be prohibited from (i) relying on the “no opportunity for foreign use” exception under Treasury Regulations Section 1.1503(d)-6(c) and (ii) making a domestic use election under Treasury Regulations Section 1.1503(d)-6(d) with respect to Cayman DRE’s DCL.

The proposed regulations also provide for a limited foreign use exception that specifically applies to the transitional safe harbor for CbCR set out in the OECD Administrative Guidelines of 22 December 2023. Under this exception, foreign use of a DCL is deemed not to occur provided that: (i) the transitional safe harbor for CbCR is met (iethe top-up tax in the relevant jurisdiction is set at zero for the tax year) and (ii) due to the application of the duplicate loss arrangement rules, there is no foreign use under the transitional CbCR Safe Harbour arrangement.⁽⁸⁾ In other words, if a taxpayer makes a domestic use election with respect to the relevant foreign loss such that the “double loss arrangement rules” prevent the taxpayer from using that loss for the purposes of the temporary CbCR safe harbor, the DCL rules will not apply to that loss, provided that the taxpayer qualifies for the temporary CbCR safe harbor in the relevant jurisdiction (ietaking into account the loss disclaimer under the Duplicate Loss Arrangement rules). However, the Treasury Department and the IRS declined to create a comprehensive exception for the foreign use of a DCL for all cases in which a DCL could be used to qualify for the transitional CbCR safe harbor program.

Finally, the proposed regulations extend the relief for “legacy DCLs” previously announced in Notice 2023-80.⁽⁹⁾ Under the proposed rules and subject to an anti-abuse provision⁽¹⁰⁾ the DCL rules apply without regard to QDMTTs or other step-up taxes with respect to losses incurred in taxable years beginning before August 6, 2024, thereby extending the relief period beyond the period contained in Notice 2023-80.⁽¹¹⁾ In addition, the relief provided for in the proposed regulations applies to all DCL rules, including the foreign use rules.

The proposed regulations provide for different applicability dates depending on the provision in question. As noted above, the proposed exception for historical DCLs would apply to losses incurred in taxable years beginning before August 6, 2024. Consistent with this, the proposed rules regarding (i) the foreign use exception applicable to the transitional CbCR safe harbor and (ii) separate entities arising as a result of a QDMTT or IIR would apply to taxable years beginning on or after August 6, 2024. However, a taxpayer may 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 the 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, for any taxable year ending on or after December 11, 2023, and before August 6, 2024, a taxpayer may rely on the foreign use exception described in Notice 2023-80, subject to a consistency requirement for members of a consolidated group until the effective date of the final regulations on this subject.

Observations

In practice, this means that the QDMTT and IIR rules generally require a aggregation of profits and losses by jurisdiction – with a narrow exception for the temporary CbCR safe harbour (see above). Therefore, the proposed regulations would significantly broaden the scope of the DCL rules for multinational enterprises large enough to be subject to a QDMTT or IIR.⁽¹²⁾

Many U.S. taxpayers have built their current operating structures based on the ability to claim U.S. deductions with respect to DCLs. Indeed, potential DCL issues have historically been managed through careful planning to ensure that a separate entity does not become part of a foreign tax consolidation or other loss-sharing regime, allowing a domestic use election to be made with respect to a foreign loss. However, unlike other regimes, Pillar 2 rules do not provide taxpayers with the flexibility to avoid consolidating or sharing losses between entities within a given jurisdiction. Therefore, if the Pillar II rules are treated as triggering foreign use of a DCL, U.S. taxpayers would face significant limitations on their ability to (i) rely on the exception to the domestic use limitation rule under Treasury Regulations section 1.1503(d)-6(c) and (ii) make the domestic use election under Treasury Regulations section 1.1503(d)-6(d).

Accordingly, taxpayers should continue to monitor Treasury’s finalization of the proposed regulations and consider whether potential DCL inefficiencies can be addressed by changes to their non-U.S. structures, such as by merging or consolidating entities in a particular jurisdiction or by selecting checkboxes to designate existing non-U.S. subsidiaries as disregarded entities for U.S. federal income tax purposes. However, taxpayers should carefully consider any U.S. federal income tax consequences of such changes to their structures.

Footnotes

(1) All references to “sections” in this document refer to the Internal Revenue Code of 1986, as amended.

(2) OECD, Tax challenges due to the digitalization of the economy — Global rules for the model to combat base erosion (second pillar) (14 December 2021).

(3) The proposed rules also address, inter alia, the impact of intra-group transactions and items arising from shareholdings on the calculation of the DCL and provide new rules for dealing with so-called ‘disregarded payment losses’.

(4) However, under the proposed rules, a domestic enterprise will not be treated as a dual residence enterprise or a hybrid enterprise solely because the income or losses of the domestic enterprise are taken into account in determining the amount of an IIR. See For an example of the treatment of domestic corporations under an IIR, see Prop. Reg. § 1.1503(d)-7(c)(3)(iii).

(5) The net GloBE income of the jurisdiction shall be determined by aggregating the GloBE income or losses of all enterprises of the multinational enterprise group (‘MNE’) 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 temporary safe harbour for CbCRs is intended to reduce the compliance burden associated with performing full GloBE calculations during the transition period.iefiscal years beginning on or before 31 December 2026, but not a fiscal year ending after 30 June 2028) by limiting the circumstances in which a multinational enterprise must make such calculations to a smaller number of higher-risk jurisdictions.

(8) In general, an arrangement is considered a double loss arrangement if an expense or loss on the balance sheet of one company also results in a double amount that is deductible in determining the taxable income of another company in another jurisdiction. The rules for double loss arrangements are set out in the OECD Administrative Guidelines of December 2023, which prescribe certain adjustments for ‘double loss arrangements’ when assessing the temporary CbCR safe harbour. See OECD, Tax challenges due to the digitalization of the economy — Administrative guidelines on the global model rules to combat base erosion (second pillar) (Dec. 2023), §2.6.3.

(9) In Notice 2023-80 (published December 11, 2023), the Treasury Department and the IRS specified that future proposed regulations should specify that implementation of the Pillar II rules may not result in a ‘foreign use’ of a DCL arising in a taxable year ending on or before December 31, 2023, or in certain taxable 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 second pillar rules apply to multinational enterprises which have achieved a consolidated annual turnover of at least EUR 750 million in at least two of the last four years.

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