Tax news and developments August 2024

In brief

The new disregarded payment loss rules could create material, adverse tax consequences for taxpayers that make check-the-box elections for foreign disregarded entities within a US consolidated group (or otherwise form new foreign disregarded entities). As a result, taxpayers should assess their exposure under the disregarded payment loss rules before making any such elections or forming such entities within the US consolidated group.

In more detail

The new disregarded payment loss rules in Prop. Reg. § 1.1503(d)-1(d) (“DPL Rules”) primarily impact taxpayers that have foreign disregarded entities (DREs) that both (1) are part of a US consolidated group and (2) have disregarded interest or royalty expenses. In light of the DPL Rules, taxpayers should carefully consider making any check-the-box elections (or otherwise forming new foreign DREs) that would result in a foreign entity being a DRE of a US corporation. Forming DREs under foreign corporations (regarded as such for US tax purposes) should not result in concerns under the proposed regulations. 

The DPL Rules can create large, uneconomic amounts of US taxable income for many taxpayers. Depending on how Treasury promulgates the final DPL Rules, this additional taxable income can result in double taxation because the DPL Rules effectively subject income earned by a US corporation through its profitable foreign DREs to US taxation twice. First, under current law, the United States imposes taxation on the net income of the foreign DRE. Second, under the DPL Rules, the United States would also impose taxation on a “DPL inclusion amount” as defined in Prop. Treas. Reg. § 1.1503(d)-1(d)(2). In some situations (and depending on how Treasury ultimately applies the “foreign use” rules to the DPL Rules), the DPL inclusion amount will effectively represent a second inclusion of the foreign DRE’s income that was already subject to tax in the United States. Taxpayers must carefully review their structures to ensure that the DPL Rules do not create these double income inclusions. While we hope that Treasury will scale back the DPL Rules before Treasury finalizes the regulations, it is unclear what, if any, changes Treasury will make.

Taxpayers need to be aware that the proposed regulations provide that a US corporation consents to the DPL Rules when the taxpayer makes a check-the-box election for a foreign entity that would become disregarded from the US corporation (or otherwise forms a foreign entity that defaults into DRE status). See Prop. Reg. § 301.7701-3(c)(4)(i). By consenting to the DPL Rules, taxpayers may be accelerating the application of the DPL Rules. Moreover, the DPL Rules are not based on any statute, so it is not clear what limits Treasury sees in its authority to issue new provisions in the final DPL Rules.

In light of the uncertainty regarding future Treasury actions and the double-tax issues already created by the DPL Rules, we therefore advise clients to reassess making check-the-box elections for foreign entities that would become disregarded from members of the US consolidated group (or otherwise forming new foreign entities that default into DRE status) until taxpayers have analyzed the DPL Rules.

We address the DPL Rules in greater detail in The Proposed DCL and DPL Rules: A Tale of Dreams and Nightmares, first published in the Tax Management International Journal on August 14, 2024.