Dual Consolidated Loss Regulations, 29868-29907 [05-10160]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 70, Number 99 (Tuesday, May 24, 2005)]
[Proposed Rules]
[Pages 29868-29907]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 05-10160]



[[Page 29867]]

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Part III





Department of the Treasury





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Internal Revenue Service



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26 CFR Part 1



Dual Consolidated Loss Regulations; Proposed Rule

Federal Register / Vol. 70, No. 99 / Tuesday, May 24, 2005 / Proposed 
Rules

[[Page 29868]]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-102144-04]
RIN 1545-BD10


Dual Consolidated Loss Regulations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rule making and notice of public hearing.

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SUMMARY: This document contains proposed regulations under section 
1503(d) of the Internal Revenue Code (Code) regarding dual consolidated 
losses. Section 1503(d) generally provides that a dual consolidated 
loss of a dual resident corporation cannot reduce the taxable income of 
any other member of the affiliated group unless, to the extent provided 
in regulations, such loss does not offset the income of any foreign 
corporation. Similar rules apply to losses of separate units of 
domestic corporations. The proposed regulations address various dual 
consolidated loss issues, including exceptions to the general 
prohibition against using a dual consolidated loss to reduce the 
taxable income of any other member of the affiliated group.

DATES: Written and electronic comments and outlines of topics to be 
discussed at the public hearing scheduled for September 7, 2005, at 10 
a.m., must be received by August 22, 2005.

ADDRESSES: Send submissions to CC:PA:LPD:PR (REG-102144-04), room 5203, 
Internal Revenue Service, P.O. Box 7604, Washington, DC 20044. 
Submissions may be hand delivered between the hours of 8 a.m. and 4 
p.m. to CC:PA:LPD:PR (REG-102144-04), Courier's Desk, Internal Revenue 
Service, 1111 Constitution Avenue, NW., Washington, DC, or sent 
electronically via the IRS Internet site at https://www.irs.gov/regs or 
via the Federal eRulemaking Portal at https://www.regulations.gov/ (IRS 
and REG-102144-04). The public hearing will be held in the Auditorium 
of the Internal Revenue Building, 1111 Constitution Avenue, NW., 
Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Kathryn T. Holman, (202) 622-3840 (not a toll-free number); concerning 
submissions and the hearing, Robin Jones, (202) 622-3521 (not a toll-
free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget in 
accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 
3507(d)). Comments on the collection of information should be sent to 
the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, W:CAR:MP:FP:S Washington, 
DC 20224. Comments on the collection of information should be received 
by July 25, 2005. Comments are specifically requested concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the IRS, including whether the 
information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collection of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of service to provide information.
    The collections of information in these proposed regulations are in 
Sec. Sec.  (1.1503(d)-1(b)(14), 1.1503(d)-1(c)(1), 1.1503(d)-2(d), 
1.1503(d)-4(c)(2), 1.1503(d)-4(d), 1.1503(d)-4(e)(2), 1.1503(d)-
4(f)(2), 1.1503(d)-4(g), 1.1503(d)-4(h) and 1.1503(d)-4(i). The various 
information is required. First, it notifies the IRS when the taxpayer 
asserts that it had reasonable cause for failing to comply with certain 
filing requirements under the regulations. Second, it indicates when 
the taxpayer attempts to rebut the amount of presumed tainted income. 
Finally, it provides the IRS various information regarding exceptions 
to the domestic use limitation, including domestic use elections, 
domestic use agreements, triggering events and recapture.
    The collection of information is in certain cases required and in 
certain cases voluntary. The likely respondents will be domestic 
corporations with foreign operations that generate losses.
    Estimated total annual reporting and/or recordkeeping burden: 2,665 
hours.
    Estimated average annual burden hours per respondent and/or 
recordkeeper: 1.5 hours.
    Estimated number of respondents and/or recordkeepers: 1,765.
    Estimated annual frequency of responses: Annually.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    The United States taxes the worldwide income of domestic 
corporations. A domestic corporation is a corporation created or 
organized in the United States or under the law of the United States or 
of any State. The United States allows certain domestic corporations to 
file consolidated returns with other affiliated domestic corporations. 
When two or more domestic corporations file a consolidated return, 
losses that one corporation incurs generally may reduce or eliminate 
tax on income that another corporation earns.
    Some countries use criteria other than place of incorporation or 
organization to determine whether corporations are residents for tax 
purposes. For example, some countries treat corporations as residents 
for tax purposes if they are managed or controlled in that country. If 
one of these countries determines a corporation to be a resident, the 
corporation is generally subject to income tax of that foreign country 
on a residence basis. As a result, if such a corporation is a domestic 
corporation for U.S. tax purposes, it is a dual resident corporation 
and is subject to the income tax of both the foreign country and the 
United States on a residence basis.
    Prior to the Tax Reform Act of 1986, if a corporation was a 
resident of both a foreign country and the United States, and the 
foreign country permitted the losses of the corporation to be used to 
offset the income of another person (for example, as a result of 
consolidation), then the dual resident corporation could use any losses 
it generated twice: once to offset income that was subject to U.S. tax, 
but not foreign tax, and a second time to offset income subject to 
foreign tax, but not U.S. tax (double-dip).

[[Page 29869]]

    Congress was concerned that this double-dip of a single economic 
loss could result in an undue tax advantage to certain foreign 
investors that made investments in domestic corporations, and could 
create an undue incentive for certain foreign corporations to acquire 
domestic corporations and for domestic corporations to acquire foreign 
rather than domestic assets. Staff of Joint Committee on Taxation, 99th 
Cong., 2nd Sess., General Explanation of the Tax Reform Act of 1986, at 
1064-1065 (1987). Through such double-dipping, worldwide economic 
income could be rendered partially or fully exempt from current 
taxation. Moreover, even if the foreign income against which the loss 
was used would eventually be subject to U.S. tax (upon a repatriation 
of earnings), there were timing benefits of double dipping that the 
statute was intended to prevent. Congress responded to this concern by 
enacting section 1503(d) as part of the Tax Reform Act of 1986.
    Section 1503(d) provides that a dual consolidated loss of a 
corporation cannot reduce the taxable income of any other member of the 
corporation's affiliated group. The statute defines a dual consolidated 
loss as a net operating loss of a domestic corporation that is subject 
to an income tax of a foreign country on its income without regard to 
the source of its income, or is subject to tax on a residence basis. 
The statute authorizes the issuance of regulations permitting the use 
of a dual consolidated loss to offset the income of a domestic 
affiliate if the loss does not offset the income of a foreign 
corporation under foreign law.
    Section 1503(d) further states that, to the extent provided in 
regulations, similar rules apply to any loss of a separate unit of a 
domestic corporation as if such unit where a wholly owned subsidiary of 
the corporation. Although the statute does not define the term separate 
unit, the legislative history to the provision refers to the loss of 
any separate and clearly identifiable unit of a trade or business of a 
taxpayer and cites as an example a foreign branch of a domestic 
corporation. See H.R. Rep. No. 795, 100th Cong., 2d Sess. July 26, 
1988) at 293.
    The IRS and Treasury issued temporary regulations under section 
1503(d) in 1989 (TD 8261, 1989-2 C.B. 220). The temporary regulations 
generally provided that, unless one of three limited exceptions 
applied, a dual consolidated loss of a dual resident corporation could 
not offset the income of any other member of the dual resident 
corporation's affiliated group. The temporary regulations contained 
similar rules for losses incurred by separate units.
    In response to comments that the temporary regulations were 
unnecessarily restrictive, the IRS and Treasury issued final 
regulations under section 1503(d) in 1992 (TD 8434, 1992-2 C.B. 240). 
These final regulations were updated and amended over the next 11 years 
(current regulations). The current regulations apply the section 
1503(d) limitation more narrowly than the temporary regulations. The 
current regulations adopt an actual use standard for permitting a dual 
consolidated loss to offset income of members of the affiliated group. 
This standard, which applies to both dual resident corporations and 
separate units, requires taxpayers to 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 a foreign country. If 
such a certification is made and a subsequent triggering event occurs, 
the dual consolidated loss must be recaptured in the year of the event 
(plus an applicable interest charge).
    This document proposes amendments to the current regulations under 
section 1503(d). Conforming amendments are also proposed to related 
regulations under sections 1502 and 6043.

Overview

    In general, the proposed regulations address three fundamental 
concerns that arise in connection with the current regulations. First, 
the IRS and Treasury believe that the scope of application of the 
current regulations should be modified. For example, the current 
regulations may apply to certain structures where there is little 
likelihood of a double-dip. Moreover, the IRS and Treasury understand 
that some taxpayers have taken the position that the current 
regulations do not apply to certain structures that provide taxpayers 
the benefits of the type of double-dip that section 1503(d) is intended 
to deny. Accordingly, the proposed regulations are designed to minimize 
these cases of potential over- and under-application.
    Second, the IRS and Treasury recognize that there are many 
unresolved issues that arise when applying the current regulations, 
particularly in light of the adoption of the entity classification 
regulations under Sec. Sec.  301.7701-1 through 301.7701-3. Thus, the 
proposed regulations modernize the dual consolidated loss regime to 
take into account the entity classification regulations and to resolve 
the related issues so that the rules can be applied by taxpayers and 
the Commissioner with greater certainty.
    Finally, the IRS and Treasury believe that, in many cases, the 
current regulations are administratively burdensome to both taxpayers 
and the Commissioner. Accordingly, the proposed regulations reduce, to 
the extent possible, the administrative burden imposed on taxpayers and 
the Commissioner.

Explanation of Provisions

A. Structure of the Proposed Regulations

    The proposed regulations are set forth in six sections. Section 
1.1503(d)-1 contains definitions and special rules for filings. Section 
1.1503(d)-2 sets forth operating rules, which include the general rule 
that prohibits the domestic use of a dual consolidated loss (subject to 
certain exceptions discussed below), a rule that limits the use of dual 
consolidated losses following certain transactions, an anti-avoidance 
provision that prevents dual consolidated losses from offsetting income 
from assets acquired in certain nonrecognition transactions or 
contributions to capital, and rules for computing foreign tax credit 
limitations. Section 1.1503(d)-3 contains special rules for accounting 
for dual consolidated losses. These special rules determine the amount 
of a dual consolidated loss, determine the effect of a dual 
consolidated loss on domestic affiliates, and provide special basis 
adjustments. Section 1.1503(d)-4 provides exceptions to the general 
rule that prohibits the domestic use of a dual consolidated loss, 
including a domestic use election. Section 1.1503(d)-5 contains 
examples that illustrate the application of the proposed regulations. 
Finally, Sec.  1.1503(d)-6 contains the proposed effective date of the 
proposed regulations.
    In addition to the proposed regulatory amendments under section 
1503(d), the proposed regulations also include conforming proposed 
amendments to Sec.  1.1502-21 and Sec.  1.6043-4T.

B. Definitions and Special Rules for Filings Under Section 1503(d)--
Sec.  1.1503(d)-1

1. Treatment of a Separate Unit as a Domestic Corporation and a Dual 
Resident Corporation
    Section 1.1503-2(c)(3) and (4) of the current regulations defines a 
separate unit of a domestic corporation as a foreign branch, within the 
meaning of Sec.  1.367(a)-6T(g), (foreign branch separate unit) and an 
interest in a partnership, trust or hybrid entity. The

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current regulations also provide that any separate unit of a domestic 
corporation is treated as a separate domestic corporation for purposes 
of applying the dual consolidated loss rules. Section 1.1503-2(c)(2). 
In addition, the current regulations provide that, unless otherwise 
indicated, any reference to a dual resident corporation refers also to 
a separate unit. As a result of these rules, certain provisions of the 
current regulations only refer to dual resident corporations, and 
therefore apply to separate units because they are treated as domestic 
corporations and dual resident corporations. However, other provisions 
of the current regulations refer to both dual resident corporations and 
separate units (for example, see Sec.  1.1503-2(g)(2)(iii)(A)).
    The IRS and Treasury believe that, in certain cases, treating 
separate units as domestic corporations creates uncertainty in applying 
the current regulations. This may occur, for example, as a result of 
certain rules applying to separate units because they are treated as 
domestic corporations or dual resident corporations, while other rules 
apply explicitly to separate units themselves. Accordingly, the 
proposed regulations do not contain a general rule that treats separate 
units as domestic corporations or dual resident corporations for all 
purposes of applying the dual consolidated loss regulations. Instead, 
the proposed regulations explicitly refer to dual resident corporations 
and separate units where appropriate, treat separate units as domestic 
corporations only for limited purposes, and modify the operative rules 
where necessary to take into account differences between dual resident 
corporations and separate units.
2. Application of Section 1503(d) to S Corporations
    Section 1.1503-2(c)(2) of the current regulations provides that an 
S corporation, as defined in section 1361, is not a dual resident 
corporation. The preamble to the current regulations explains that S 
corporations are so excluded because an S corporation cannot have a 
domestic corporation as one of its shareholders. The current 
regulations do not, however, explicitly exclude separate units owned by 
an S corporation from the definition of a dual resident corporation. As 
a result, the current regulations can be read to provide that an S 
corporation, although it cannot itself be a dual resident corporation, 
could own a separate unit that would be a dual resident corporation.
    The IRS and Treasury believe that such a result is inappropriate 
because an S corporation cannot have a domestic corporation as one of 
its shareholders and generally is not taxable at the entity level. 
Accordingly, the proposed regulations provide that for purposes of the 
dual consolidated loss rules, an S corporation is not treated as a 
domestic corporation. This modification clarifies that the dual 
consolidated loss regulations do not apply to the S corporation itself, 
or to foreign branches or interests in certain flow-through entities 
owned by an S corporation.
    The IRS and Treasury request comments as to whether regulated 
investment companies (as defined in section 851) or real estate 
investment trusts (as defined in section 856) should be similarly 
excluded from the application of the dual consolidated loss rules.
3. Losses of a Foreign Insurance Company Treated as a Domestic 
Corporation
    Section 953(d) generally provides that a foreign corporation that 
would qualify to be taxed as an insurance company if it were a domestic 
corporation may, under certain circumstances, elect to be treated as a 
domestic corporation. Section 953(d)(3) provides that if a corporation 
elects to be treated as a domestic corporation pursuant to section 
953(d) and is treated as a member of an affiliated group, any loss of 
such corporation is treated as a dual consolidated loss for purposes of 
section 1503(d), without regard to section 1503(d)(2)(B) (grant of 
regulatory authority to exclude losses which do not offset the income 
of foreign corporations from the definition of a dual consolidated 
loss). Therefore, losses of such corporations are treated as dual 
consolidated losses regardless of whether the corporation is subject to 
an income tax of a foreign country on its worldwide income or on a 
residence basis.
    The current regulations do not address the application of section 
953(d)(3). However, the definition of a dual resident corporation 
contained in the proposed regulations includes a foreign insurance 
company that makes an election to be treated as a domestic corporation 
pursuant to section 953(d) and is a member of an affiliated group, 
regardless of how such entity is taxed by the foreign country.
4. Definition of a Separate Unit
(a) Interests in Non-Hybrid Entity Partnerships and Interests in Non-
Hybrid Entity Grantor Trusts
    Section 1.1503-2(c)(4) of the current regulations defines a 
separate unit to include an interest in a hybrid entity (hybrid entity 
separate unit). The current regulations define a hybrid entity as an 
entity that is not taxable as an association for U.S. income tax 
purposes, but is subject to income tax in a foreign jurisdiction as a 
corporation (or otherwise at the entity level) either on its worldwide 
income or on a residence basis. This definition includes an interest in 
such an entity that is treated for U.S. tax purposes as a partnership 
(hybrid entity partnership) or as a grantor trust (hybrid entity 
grantor trust). An interest in an entity that is treated as a 
partnership or a grantor trust for both U.S. and foreign tax purposes 
(non-hybrid entity partnership and non-hybrid entity grantor trust, 
respectively) also is treated as a separate unit under the current 
regulations. Sec.  1.1503-2(c)(3)(i).
    The current regulations also apply to a separate unit owned 
indirectly through a partnership or grantor trust. Thus, for example, 
if a partnership owns a foreign branch within the meaning of Sec.  
1.367(a)-6T(g), a domestic corporate partner's interest in such 
partnership, and its indirect interest in a portion of the foreign 
branch owned through the partnership, each constitutes a separate unit.
    Under the current regulations, an interest in a non-hybrid entity 
partnership or a non-hybrid entity grantor trust is also treated as a 
separate unit, regardless of whether the partnership or grantor trust 
has any nexus with a foreign jurisdiction. This rule can result in the 
application of the dual consolidated loss rules when there may be 
little opportunity for a double-dip. For example, if two domestic 
corporations each own 50 percent of a domestic partnership that 
generates losses attributable to activities conducted solely in the 
United States, the corporate partners would be technically subject to 
the dual consolidated loss rules and therefore would not be allowed to 
offset their income with such losses, unless an exception applied. In 
such a case, however, it may be unlikely that the losses would be 
available to offset income of another person under the income tax laws 
of a foreign country.
    The IRS and Treasury believe that including an interest in a non-
hybrid entity partnership and an interest in a non-hybrid entity 
grantor trust in the

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definition of a separate unit may not be necessary and is 
administratively burdensome. In such cases, it may be unlikely that 
deductions and losses solely attributable to activities of the 
partnership or grantor trust, that do not rise to the level of a 
taxable presence in a foreign jurisdiction, can be used to offset 
income of another person under the income tax laws of a foreign 
country. As a result, the proposed regulations eliminate from the 
definition of a separate unit an interest in a non-hybrid entity 
partnership and an interest in a non-hybrid entity grantor trust. It 
should be noted, however, that the proposed regulations retain the rule 
contained in the current regulations that a domestic corporation can 
own a separate unit indirectly through both hybrid entity and non-
hybrid entity partnerships, and through both hybrid entity and non-
hybrid entity grantor trusts.
(b) Separate Unit Combination Rule
    Section 1.1503-2(c)(3)(ii) of the current regulations provides that 
if two or more foreign branches located in the same foreign country are 
owned by a single domestic corporation and the losses of each branch 
are made available to offset the income of the other branches under the 
tax laws of the foreign country, then the branches are treated as one 
separate unit. The combination rule in the current regulations does not 
apply to interests in hybrid entity separate units or to dual resident 
corporations.
    Although a disregarded entity is treated as a branch of its owner 
for various purposes of the Code, the current regulations distinguish a 
hybrid entity separate unit that is disregarded as an entity separate 
from its owner from a foreign branch separate unit. Compare Sec.  
1.1503-2(c)(3)(i)(A) and (c)(4); see also Sec.  1.1503-2(g)(2)(vi)(C). 
Accordingly, the combination rule under the current regulations does 
not apply to an interest in a hybrid entity separate unit, even if the 
hybrid entity is disregarded as an entity separate from its owner.
    The combination rule in the current regulations also requires the 
foreign branches to be owned by a single domestic corporation. Thus, 
for example, the current regulations do not permit the combination of 
foreign branches owned by different domestic corporations, even if such 
corporations are members of the same consolidated group. In addition, 
in some cases the current regulations do not allow the combination of 
foreign branches that are owned indirectly by a single domestic 
corporation through other separate units because, as discussed above, 
such other separate units are generally treated as domestic 
corporations for purposes of applying the dual consolidated loss 
regulations. As a result, such foreign branches are not treated as 
being owned by a single domestic corporation.
    The IRS and Treasury believe that the application of the 
combination rule should not be restricted to foreign branch separate 
units. In addition, the IRS and Treasury believe that the combination 
rule should not be limited to those cases where the domestic 
corporation owns the separate units directly. Therefore, provided 
certain requirements are satisfied, the proposed regulations adopt a 
broader combination rule that combines all separate units that are 
directly or indirectly owned by a single domestic corporation.
    In order for separate units to be combined under the proposed 
regulations, the losses of each separate unit must be made available to 
offset the income of the other separate units under the tax laws of a 
single foreign country. In addition, if the separate unit is a foreign 
branch separate unit, it must be located in the foreign country that 
allows its losses to be made available to offset income of each 
separate unit; if the separate unit is a hybrid entity separate unit, 
the hybrid entity must be subject to tax in the foreign country that 
allows losses to be made available to each separate unit either on its 
worldwide income or on a residence basis.
    The combination rule in the proposed regulations does not combine 
separate units owned by different domestic corporations, even if the 
domestic corporations are included in the same consolidated group. The 
IRS and Treasury believe this approach is consistent with section 
1503(d)(3), which provides that, to the extent provided in regulations, 
a loss of a separate unit of a domestic corporation is subject to the 
dual consolidated loss rules as if it were a wholly owned subsidiary of 
such domestic corporation. In addition, the combination rule contained 
in the proposed regulations only applies to separate units and 
therefore does not apply to dual resident corporations.
    The IRS and Treasury, however, request comments as to whether there 
is authority to expand the combination rule and, if so, whether the 
combination rule should be expanded to include separate units that are 
owned directly or indirectly by domestic corporations that are members 
of the same consolidated group. Similarly, comments are requested as to 
whether the combination rule should be extended to apply to dual 
resident corporations. Further, the IRS and Treasury request comments 
on the application of the operative provisions of the proposed 
regulations to combined separate units owned by different domestic 
corporations (for example, the SRLY limitation under Sec.  1.1503(d)-
3(c)).
5. Exception to the Definition of a Dual Consolidated Loss
    Section 1.1503-2(c)(5)(ii)(A) of the current regulations provides a 
very limited exception to the definition of a dual consolidated loss 
where the income tax laws of a foreign country do not permit the dual 
resident corporation to either: (1) Use its losses, expenses, or 
deductions to offset the income of any other person in the same taxable 
year; or (2) carry over or carry back its losses, expenses, or 
deductions to be used, by any means, to offset the income of any other 
person in other taxable years. This exception only applies in rare and 
unusual cases where the income tax laws of the foreign country do not 
allow any portion of the dual consolidated loss to be used to offset 
income of another person under any circumstances.
    The IRS and Treasury understand that some taxpayers have improperly 
interpreted this provision in a manner inconsistent with the policies 
of the dual consolidated loss rules. As a result, the proposed 
regulations eliminate this exception to the definition of a dual 
consolidated loss. As discussed below, however, the proposed 
regulations contain a new exception to the general rule restricting the 
use of a dual consolidated loss to offset income of a domestic 
affiliate. In general, this new exception applies when there is no 
possibility that any portion of the dual consolidated loss can be 
double-dipped, and operates in a manner that is similar to the manner 
in which the exception to the definition of a dual consolidated loss 
contained in the current regulations operates.
6. Partnership Special Allocations
    Section 1.1503-2(c)(5)(iii) of the current regulations reserves on 
the treatment of dual consolidated losses of separate units that are 
partnership interests, including interests in hybrid entities. The 
preamble to the current regulations explains that the reservation was 
principally the result of concerns regarding partnership special 
allocations.
    The proposed regulations no longer reserve on the treatment of 
separate units that are partnership interests. However, the IRS will 
continue to challenge structures that attempt to use special 
allocations in a manner that is

[[Page 29872]]

inconsistent with the principles of section 1503(d).
7. Domestic Use of a Dual Consolidated Loss
    Section 1.1503-2(b)(1) of the current regulations states that, 
except as otherwise provided, a dual consolidated loss cannot offset 
the taxable income of any domestic affiliate, regardless of whether the 
loss offsets income of another person under the income tax laws of a 
foreign country, and regardless of whether the income that the loss may 
offset in the foreign country is, has been, or will be subject to tax 
in the United States. Section 1.1503-2(c)(13) defines the term domestic 
affiliate to mean any member of an affiliated group, without regard to 
exceptions contained in section 1504(b) (other than section 1504(b)(3)) 
relating to includible corporations.
    The proposed regulations retain the general prohibition against 
using a dual consolidated loss to offset income of domestic affiliates 
contained in the current regulations, with modifications, and refer to 
such usage as a domestic use of a dual consolidated loss. This general 
prohibition is subject to a number of exceptions, discussed below. In 
addition, because the proposed regulations do not treat separate units 
as domestic corporations and dual resident corporations (other than for 
limited purposes) the proposed regulations expand the definition of a 
domestic affiliate to include separate units. This expanded definition 
is necessary for purposes of applying the domestic use limitation rule.
8. Foreign use of a dual consolidated loss
(a) General Rule
    Section 1.1503-2T(g)(2)(i) of the current regulations provides 
that, in order to elect relief from the general limitation on the use 
of a dual consolidated loss to offset income of a domestic affiliate 
with respect to a dual consolidated loss ((g)(2)(i) election), the 
taxpayer must, among other things, certify that no portion of the 
losses, expenses, or deductions taken into account in computing the 
dual consolidated loss has been, or will be, used to offset the income 
of any other person under the income tax laws of a foreign country. If, 
contrary to this certification, there is such a use, the dual 
consolidated loss subject to the (g)(2)(i) election generally must be 
recaptured and reported as gross income.
    The IRS and Treasury understand that issues arise involving the 
application of the use rule contained in the current regulations. For 
example, issues may arise where items of income, gain, deduction and 
loss are treated as being generated or incurred by different persons 
under U.S. and foreign law. Similarly, issues may arise due to 
different definitions of a person under U.S. and foreign law. These 
issues have become more prevalent since the adoption of the entity 
classification regulations under Sec. Sec.  301.7701-1 through 
301.7701-3.
    The IRS and Treasury also understand that taxpayers have taken 
positions under the current regulations regarding the use of a dual 
consolidated loss that are inconsistent with the policies underlying 
section 1503(d). On the other hand, the IRS and Treasury believe that, 
under the current regulations, a use can be deemed to occur in certain 
cases where there may be little likelihood of the type of double-dip 
that section 1503(d) was intended to prevent.
    For the reasons discussed above, the proposed regulations modify 
the definition of use and provide a rule based on foreign use. These 
modifications are intended to minimize the potential over- and under-
application of the dual consolidated loss rules that can occur under 
the current regulations. Under the proposed regulations, the foreign 
use definition is intended to minimize the opportunity for a double-
dip. However, the new definition is also intended to minimize the 
situations in which a foreign use will occur in cases where there may 
be little likelihood of a double-dip.
    The proposed regulations provide that a foreign use is deemed to 
occur only if two conditions are satisfied. The first condition is 
satisfied if any portion of a loss or deduction taken into account in 
computing the dual consolidated loss is made available under the income 
tax laws of a foreign country to offset or reduce, directly or 
indirectly, any item that is recognized as income or gain under such 
laws (including items of income or gain generated by the dual resident 
corporation or separate unit itself), regardless of whether income or 
gain is actually offset, and regardless of whether such items are 
recognized under U.S. tax principles. This condition ensures that there 
will not be a foreign use unless all or a portion of the dual 
consolidated loss offsets or reduces, or is made available to offset or 
reduce, income or gain for foreign tax purposes.
    The second condition is satisfied if items that are (or could be) 
offset pursuant to the first condition are considered, under U.S. tax 
principles, to be items of: (1) A foreign corporation; or (2) a direct 
or indirect (for example, through a partnership) owner of an interest 
in a hybrid entity, provided such interest is not a separate unit. This 
condition is intended to limit a foreign use to situations where the 
foreign income that is (or could be) offset by the dual consolidated 
loss is not currently subject to U.S. corporate income tax. In general, 
if the foreign income that is offset is currently subject to U.S. 
corporate income tax, there is no double-dip of the dual consolidated 
loss.
(b) Exception to Foreign Use If No Dilution of an Interest in a 
Separate Unit
    Section 1.1503-2(c)(15) of the current regulations employs a so-
called actual use standard for determining whether there has been a use 
of a dual consolidated loss to offset the income of another person 
under the laws of a foreign country. Although referred to as an actual 
use standard, this rule provides that a use is considered to occur in 
the year in which a loss, expense or deduction taken into account in 
computing the dual consolidated loss is made available for such an 
offset, unless an exception applies. The fact that the other person 
does not have sufficient income in that year to benefit from such an 
offset is not taken into account.
    The available component of the actual use standard was adopted 
because of the administrative complexity that would result from having 
a use occur only when income is actually offset. For example, if in the 
year that a portion of the dual consolidated loss is made available to 
be used by another person, the other person itself generates a loss (or 
has a loss carryover), then in many cases the portion of the dual 
consolidated loss would become part of the loss carryover. Such loss 
therefore would be available to be carried forward or carried back to 
offset income in different taxable years. Under this approach, the 
portion of the loss carryforward or carryback that was taken into 
account in computing the dual consolidated loss would need to be 
identified and tracked, which would require detailed ordering rules for 
determining when such losses were used. Timing and base differences 
between the U.S. and foreign jurisdiction would further complicate such 
an approach.
    Because of the administrative complexities discussed above, the 
foreign use definition contained in the proposed regulations retains 
the available for use standard. However, because the available for use 
standard is

[[Page 29873]]

retained, there are many cases in which a foreign use of a dual 
consolidated loss attributable to interests in hybrid entity 
partnerships and hybrid entity grantor trusts, and separate units owned 
indirectly through partnerships and grantor trusts, occurs, even though 
no portion of any item of deduction or loss comprising the dual 
consolidated loss is double-dipped. In the case of interests in hybrid 
entity partnerships and hybrid entity grantor trusts, a portion of the 
dual consolidated loss attributable to an interest in such entity in 
many cases would be made available to offset income or gain of a direct 
or indirect owner of an interest in such hybrid entity, provided such 
interest is not a separate unit. This typically would occur because 
under foreign law the hybrid entity is taxed as a corporation (or 
otherwise at the entity level) and its net losses may be carried 
forward or carried back. A similar result may occur in the case of a 
separate unit owned indirectly through a non-hybrid entity partnership 
or a non-hybrid entity grantor trust because of timing and base 
differences between the laws of the United States and the foreign 
jurisdiction.
    The IRS and Treasury believe this is an inappropriate result in 
many cases. For example, the IRS and Treasury believe that if there is 
no dilution of the domestic owner's interest in the separate unit, it 
is unlikely that any portion of the dual consolidated loss attributable 
to such separate unit can be put to a foreign use (other than through 
an election to consolidate or similar method, discussed below). 
Therefore, the proposed regulations include three new exceptions to the 
definition of a foreign use where there is no dilution of an interest 
in a separate unit. The new exceptions to foreign use apply to dual 
consolidated losses attributable to two types of separate units: (1) 
Interests in hybrid entity partnerships and interests in hybrid entity 
grantor trusts; and (2) separate units owned indirectly through 
partnerships and grantor trusts.
    The first exception to foreign use provides that, in general, no 
foreign use shall be considered to occur with respect to a dual 
consolidated loss attributable to an interest in a hybrid entity 
partnership or a hybrid entity grantor trust, solely because an item of 
deduction or loss taken into account in computing such dual 
consolidated loss is made available, under the income tax laws of a 
foreign country, to offset or reduce, directly or indirectly, any item 
that is recognized as income or gain under such laws and is considered 
under U.S. tax principles to be an item of the direct or indirect owner 
of an interest in such hybrid entity that is not a separate unit.
    The second exception to foreign use provides that, in general, no 
foreign use shall be considered to occur with respect to a dual 
consolidated loss attributable to or taken into account by a separate 
unit owned indirectly through a partnership or grantor trust solely 
because an item of deduction or loss taken into account in computing 
such dual consolidated loss is made available, under the income tax 
laws of a foreign country, to offset or reduce, directly or indirectly, 
any item that is recognized as income or gain under such laws and is 
considered under U.S. tax principles to be an item of a direct or 
indirect owner of an interest in such partnership or trust.
    Finally, the proposed regulations provide a similar exception for 
combined separate units that include individual separate units to which 
one of the other dilution exceptions would apply, but for the separate 
unit combination rule.
    The new exceptions to foreign use are subject to certain 
limitations, however. First, the exceptions will not apply if there has 
been a dilution of the interest in the separate unit. That is, the 
exception will not apply if during any taxable year the domestic 
owner's percentage interest in the separate unit, as compared to its 
interest in the separate unit as of the last day of the taxable year in 
which such dual consolidated loss was incurred, is reduced as a result 
of another person acquiring through sale, exchange, contribution or 
other means an interest in such partnership or grantor trust, unless 
the taxpayer demonstrates, to the satisfaction of the Commissioner, 
that the other person that acquired the interest in the partnership or 
grantor trust was a domestic corporation. The exceptions to foreign use 
should not apply when a person (other than a domestic corporation) 
acquires an interest in the separate unit because the dilution would 
typically result in an actual foreign use.
    Second, the exceptions do not apply if the availability does not 
arise solely from the ownership in such partnership or trust and the 
allocation of the item of deduction or loss, or the offsetting by such 
deduction or loss, of an item of income or gain of the partnership or 
trust. For example, the exception does not apply in the case where the 
item of loss or deduction is made available through a foreign 
consolidation regime.
    The IRS and Treasury request comments on the issues discussed above 
in connection with the availability component of the foreign use 
definition. Comments are specifically requested as to whether the 
dilution rules are appropriate and, if so, whether a de minimis 
exception should be provided.
9. Mirror Legislation Rule
    Section 1.1503-2(c)(15)(iv) of the current regulations contains a 
mirror legislation rule that addresses legislation enacted by foreign 
jurisdictions that operates in a manner similar to the dual 
consolidated loss rules. This rule was designed to prevent the revenue 
gain resulting from the disallowance of the double-dip benefit of a 
dual consolidated loss from inuring solely to the foreign jurisdiction 
(to the detriment of the United States). Staff of the Joint Committee 
on Taxation, General Explanation of the Tax Reform Act of 1986, at 
1065-66 (J. Comm. Print 1987).
    Congress recognized that mirror legislation in a foreign 
jurisdiction, in conjunction with a mirror legislation rule such as 
that contained in the current regulations, could result in the 
disallowance of a dual consolidated loss in both the United States and 
in the foreign jurisdiction. In such a case, Congress intended that 
Treasury pursue with the appropriate authorities in the foreign 
jurisdiction a bilateral agreement that would allow the use of the loss 
of a dual resident corporation to offset income of an affiliate in only 
one country. Staff of the Joint Committee on Taxation, General 
Explanation of the Tax Reform Act of 1986, at 1066. The mirror rule was 
specifically held to be valid by the Court of Appeals for the Federal 
Circuit. British Car Auctions, Inc. v. United States, 35 Fed. Cl. 123 
(1996), aff'd without op., 116 F.3d 1497 (Fed. Cir. 1997).
    The mirror legislation rule contained in the current regulations 
provides that if the laws of a foreign country deny the use of a loss 
of a dual resident corporation (or separate unit) to offset the income 
of another person because the dual resident corporation (or separate 
unit) is also subject to tax by another country on its worldwide income 
or on a residence basis, the loss is deemed to be used against the 
income of another person in such foreign country such that no (g)(2)(i) 
election can be made with respect to such loss. This rule is intended 
to prevent the foreign jurisdiction from enacting legislation that 
gives taxpayers no choice but to use the dual consolidated loss to 
offset income in the United States. This result is contrary to the 
general policy underlying the structure of the current regulations that 
provides taxpayers the choice of using the dual consolidated loss to 
either offset income

[[Page 29874]]

in the United States or income in the foreign jurisdiction (but not 
both).
    As a result of the consistency rule (discussed below), the deemed 
use of a dual consolidated loss pursuant to the mirror legislation rule 
may also restrict the ability to use other dual consolidated losses to 
offset the income of domestic affiliates, even if such losses are not 
subject to the mirror legislation.
    Subsequent to the issuance of the current regulations, several 
foreign jurisdictions enacted various forms of mirror legislation that, 
absent the mirror legislation rule, would have the effect of forcing 
certain taxpayers to use dual consolidated losses to offset income of 
domestic affiliates.
    Given the relevant legislative history and British Car Auctions, 
the IRS and Treasury believe that the mirror legislation rule remains 
necessary. This is particularly true in light of the prevalence of 
mirror legislation in foreign jurisdictions. As a result, the proposed 
regulations retain the mirror legislation rule. The proposed 
regulations modify the mirror legislation rule, however, to address its 
proper application with respect to mirror legislation enacted 
subsequent to the issuance of the current regulations, and to modify 
its application to better take into account the policies underlying the 
consistency rule.
    In general, the mirror legislation rule contained in the proposed 
regulations applies when the opportunity for a foreign use is denied 
because: (1) The loss is incurred by a dual resident corporation that 
is subject to income taxation by another country on its worldwide 
income or on a residence basis; (2) the loss may be available to offset 
income other than income of the dual resident corporation or separate 
unit under the laws of another country; or (3) the deductibility of any 
portion of a loss or deduction taken into account in computing the dual 
consolidated loss depends on whether such amount is deductible under 
the laws of another country.
    The IRS and Treasury understand that there may be uncertainty as to 
the application of the mirror legislation rule in a given case when the 
mirror legislation is limited in its application. Mirror legislation 
may or may not apply to a particular dual resident corporation or 
separate unit depending on various factors, including the type of 
entity or structure that generates the loss, the ownership of the 
operation or entity that generates the loss, the manner in which the 
operation or entity is taxed in another jurisdiction, or the ability of 
the losses to be deducted in another jurisdiction. As a result, the 
proposed regulations clarify that the mere existence of mirror 
legislation, regardless of whether it applies to the particular dual 
resident corporation, may not result in a deemed foreign use. For 
example, see Sec.  1.1503(d)-5(c) Example 23.
    The proposed regulations also clarify that the absence of an 
affiliate in the foreign jurisdiction, or the failure to make an 
election to enable a foreign use, does not prevent the opportunity for 
a foreign use. Thus, for example, the mirror legislation rule may apply 
even if there are no affiliates of the dual resident corporation in the 
foreign jurisdiction or, even where there is such an affiliate, no 
election is made to consolidate.
    As discussed below, the consistency rule is intended to promote 
uniformity and reduce administrative burdens. The IRS and Treasury 
believe that these concerns may not be significant, however, where 
there is only a deemed foreign use of a dual consolidated loss as a 
result of the mirror legislation rule. Accordingly, the mirror 
legislation rule contained in the proposed regulations provides that a 
deemed foreign use is not treated as a foreign use for purposes of 
applying the consistency rule.
10. Reasonable Cause Exception
    The current regulations require various filings to be included on a 
timely filed tax return. In addition, taxpayers that fail to include 
such filings on a timely filed tax return must request an extension of 
time to file under Sec.  301.9100-3.
    The IRS and Treasury believe that requiring taxpayers to request 
relief for an extension of time to file under Sec.  301.9100-3 results 
in an unnecessary administrative burden on both taxpayers and the 
Commissioner. The IRS and Treasury believe that a reasonable cause 
standard, similar to that used in other international provisions of the 
Code (such as sections 367(a) and 6038B), is a more appropriate and 
less burdensome means for taxpayers to cure compliance defects under 
section 1503(d). As a result, the proposed regulations adopt a 
reasonable cause standard. Moreover, extensions of time under Sec.  
301.9100-3 will not be granted for filings under these proposed 
regulations. See Sec.  301.9100-1(d).
    Under the reasonable cause standard, if a person that is permitted 
or required to file an election, agreement, statement, rebuttal, 
computation, or other information under the regulations fails to make 
such a filing in a timely manner, such person shall be considered to 
have satisfied the timeliness requirement with respect to such filing 
if the person is able to demonstrate, to the satisfaction of the 
Director of Field Operations having jurisdiction of the taxpayer's tax 
return for the taxable year, that such failure was due to reasonable 
cause and not willful neglect. Once the person becomes aware of the 
failure, the person must make this demonstration and comply by 
attaching all the necessary filings to an amended tax return (that 
amends the tax return to which the filings should have been attached), 
and including a written statement explaining the reasons for the 
failure to comply.
    In determining whether the taxpayer has reasonable cause, the 
Director of Field Operations shall consider whether the taxpayer acted 
reasonably and in good faith. Whether the taxpayer acted reasonably and 
in good faith will be determined after considering all the facts and 
circumstances. The Director of Field Operations shall notify the person 
in writing within 120 days of the filing if it is determined that the 
failure to comply was not due to reasonable cause, or if additional 
time will be needed to make such determination.

C. Operating Rules--Sec.  1.1503(d)-2

1. Application of Rules to Multiple Tiers of Separate Units
    Section 1.1503-2(b)(3) of the current regulations provides that if 
a separate unit of a domestic corporation is owned indirectly through 
another separate unit, limitations on the dual consolidated losses of 
the separate units apply as if the upper-tier separate unit were a 
subsidiary of the domestic corporation, and the lower-tier separate 
unit were a lower-tier subsidiary. In light of changes made to other 
provisions of the proposed regulations, this rule is no longer 
necessary. As a result, the proposed regulations do not contain this 
provision.
2. Tainted Income
    Section 1.1503-2(e) of the current regulations prevents the dual 
consolidated loss of a dual resident corporation that ceases being a 
dual resident corporation from offsetting tainted income of such 
corporation. Subject to certain exceptions, tainted income is defined 
as income derived from assets that are acquired by a dual resident 
corporation in a nonrecognition transaction, or as a contribution to 
capital, at any time during the three taxable years immediately 
preceding the tax year in which the corporation ceases to be a dual 
resident corporation, or at any time thereafter. The current 
regulations also contain a rule that,

[[Page 29875]]

absent proof to the contrary, presumes an amount of income generated 
during a taxable year as being tainted income. Such amount is the 
corporation's taxable income for the year multiplied by a fraction, the 
numerator of which is the fair market value of the tainted assets at 
the end of the year, and the denominator of which is the fair market 
value of the total assets owned by each domestic corporation at the end 
of each year.
    The tainted income rule is intended to prevent taxpayers from 
obtaining a double-dip with respect to a dual consolidated loss by 
stuffing assets into a dual resident corporation after, or in certain 
cases before, it terminates its status as a dual resident corporation. 
A double-dip may be obtained in such case because the income that 
offsets the dual consolidated loss generally would not be subject to 
tax in the foreign jurisdiction after the dual resident status of the 
corporation terminates.
    The proposed regulations retain the tainted income rule, subject to 
the following modifications. The proposed regulations clarify that 
tainted income includes both income or gain recognized on the sale or 
other disposition of tainted assets and income derived as a result of 
holding tainted assets. The proposed regulations also modify the rule 
defining the amount of income presumed to be tainted income. The 
proposed regulations clarify that the presumptive rule only applies to 
income derived as a result of holding tainted assets; income or gain 
recognized on the sale or other disposition of tainted assets should be 
readily determinable such that the presumptive rule need not apply. The 
proposed regulations also provide that the numerator in the presumptive 
income fraction is the fair market value of tainted assets determined 
at the time such assets were acquired by the corporation, as opposed to 
being determined at the end of the taxable year. The IRS and Treasury 
believe that this approach is more administrable because value should 
be more readily determinable on the acquisition date. In addition, this 
approach does not require tainted assets to be traced over time.

D. Special Rules for Accounting for Dual Consolidated Losses--Sec.  
1.1503(d)-3

1. Items Attributable to a Separate Unit
(a) Overview
    Section 1.1503-2(d)(1)(ii) of the current regulations provides a 
rule for determining whether a separate unit has a dual consolidated 
loss. Under this rule, the separate unit must compute its taxable 
income as if it were a separate domestic corporation that is a dual 
resident corporation, using only those items of income, expense, 
deduction, and loss that are otherwise attributable to such separate 
unit.
    The current regulations do not provide any guidance for determining 
the items of income, gain, deduction and loss that are otherwise 
attributable to a separate unit. The IRS and Treasury understand that 
the absence of such guidance has resulted in considerable uncertainty. 
For example, commentators have questioned whether all or any portion of 
the interest expense of a domestic owner is attributable to a separate 
unit.
    It is also unclear the extent to which a separate unit is treated 
as a separate domestic corporation under this rule. For example, 
commentators have questioned whether a transaction between a separate 
unit and its owner that is generally disregarded for federal tax 
purposes (for example, interest paid by a disregarded entity on an 
obligation held by its owner) can create an item of income, gain, 
deduction or loss for purposes of calculating a dual consolidated loss.
    Commentators have also questioned whether each separate unit in a 
tiered separate unit structure (that is, where one separate unit owns 
another separate unit) must separately determine whether it has a dual 
consolidated loss, or whether such separate units are combined for this 
purpose.
    The proposed regulations provide more definitive rules for 
determining the amount of a dual consolidated loss (or income) of a 
separate unit. These rules apply solely for purposes of section 1503(d) 
and, therefore, do not apply for other purposes of the Code (for 
example, section 987). The proposed regulations first provide general 
rules that apply for purposes of calculating dual consolidated losses 
(or income) for both foreign branch separate units and hybrid entity 
separate units. The proposed regulations provide additional rules for 
calculating the dual consolidated losses (or income) of foreign branch 
separate units, hybrid entity separate units, and separate units owned 
indirectly through other separate units, non-hybrid entity 
partnerships, or non-hybrid entity grantor trusts. Finally, the 
proposed regulations provide special rules that apply to tiered 
separate units, combined separate units, dispositions of separate 
units, and the treatment of certain income inclusions on stock.
(b) General Rules
    The proposed regulations clarify that only existing tax accounting 
items of income, gain, deduction and loss (translated into U.S. 
dollars) should be taken into account for purposes of calculating the 
dual consolidated loss of a separate unit. In other words, treating a 
separate unit as a separate domestic corporation does not cause items 
that are disregarded for U.S. tax purposes (for example, interest paid 
by a disregarded entity on an obligation held by its owner) to be 
regarded for purposes of calculating a separate unit's dual 
consolidated loss.
    The proposed regulations also clarify that in the case of tiered 
separate units, each separate unit must calculate its own dual 
consolidated loss and no item of income, gain, deduction and loss may 
be taken into account in determining the taxable income or loss of more 
than one separate unit. Similarly, the proposed regulations clarify 
that items of one separate unit cannot offset or otherwise be taken 
into account by another separate unit for purposes of calculating a 
dual consolidated loss (unless the separate unit combination rule 
applies). These rules ensure that the dual consolidated loss 
calculation is computed separately for each separate unit, which is 
necessary to prevent deductions and losses from being double-dipped.
(c) Foreign Branch Separate Unit
    The proposed regulations provide that the asset use and business 
activities principles of section 864(c) apply for purposes of 
determining the items of income, gain, deduction (other than interest) 
and loss that are taken into account in determining the taxable income 
or loss of a foreign branch separate unit. For this purpose, the 
trading safe harbors of section 864(b) do not apply for purposes of 
determining whether a trade or business exists within a foreign country 
or whether income may be treated as effectively connected to a foreign 
branch separate unit. In addition, the limitations on effectively 
connected treatment of foreign source related-party income under 
section 864(c)(4)(D) do not apply.
    The proposed regulations further provide that the principles of 
Sec.  1.882-5, as modified, apply for purposes of determining the items 
of interest expense that are taken into account in determining the 
taxable income or loss of a foreign branch separate unit. The rules 
provide that a taxpayer must use U.S. tax principles to determine both 
the classification and amounts of the assets and liabilities when the 
actual worldwide ratio is used. The valuation of assets must be 
determined under the same methodology the taxpayer uses under Sec.  
1.861-9T(g) for purposes of

[[Page 29876]]

allocating and apportioning interest expense under section 864(e). 
Further, and solely for these purposes, the domestic owner of the 
foreign branch separate unit is treated as a foreign corporation, the 
foreign branch separate unit is treated as a trade or business within 
the United States, and assets other than those of the foreign branch 
separate unit are treated as assets that are not U.S. assets. 
Accordingly, only the interest expense of the domestic owner of the 
foreign branch separate unit is subject to allocation for purposes of 
computing the dual consolidated loss. The IRS and Treasury believe that 
the application of these principles will better harmonize the borrowing 
rate and effective interest costs that both the United States and the 
foreign country take into account in determining the dual consolidated 
loss, as compared to the use of Sec.  1.861-9T.
    The IRS and Treasury believe that taking items into account in 
determining the taxable income or loss of a foreign branch separate 
unit under these standards is administrable because of the existing 
guidance provided under these provisions. In addition, the IRS and 
Treasury believe that this approach furthers the policy underlying 
section 1503(d) because it serves as a reasonable approximation of the 
items that the foreign jurisdiction may recognize as being taken into 
account in determining the taxable income or loss of a branch or 
permanent establishment of a non-resident corporation in such 
jurisdiction. Nevertheless, the IRS and Treasury solicit comments on 
these provisions and whether other administrable approaches (that 
approximate the items taken into account by the foreign jurisdiction) 
should be considered.
(d) Hybrid Entity
    The proposed regulations provide rules for attributing items of 
income, gain, deduction and loss to a hybrid entity. These rules are 
necessary to determine the items that are attributable to an interest 
in a hybrid entity that constitutes a separate unit.
    The proposed regulations provide that, in general, the items of 
income, gain, deduction and loss that are attributable to a hybrid 
entity are those items that are properly reflected on its books and 
records, as adjusted to conform to U.S. tax principles. The principles 
of Sec.  1.988-4(b)(2) apply for purposes of making this determination. 
These principles generally provide that the determination is a question 
of fact and must be consistently applied. These principles also provide 
that the Commissioner may allocate items of income, gain, deduction and 
loss between the domestic corporation (and intervening entities, if 
any) that own the hybrid entity separate unit, and the hybrid entity 
separate unit, if such items are not properly reflected on the books 
and records of the hybrid entity.
    The proposed regulations also provide that if a hybrid entity owns 
an interest in either a non-hybrid entity partnership or a non-hybrid 
entity grantor trust, items of income, gain, deduction and loss that 
are properly reflected on the books and records of such partnership or 
grantor trust (under the principles of Sec.  1.988-4(b)(2), as adjusted 
to conform to U.S. tax principles), are treated as being properly 
reflected on the books and records of the hybrid entity. However, such 
items are treated as being properly reflected on the books and records 
of the hybrid entity only to the extent they are taken into account by 
the hybrid entity under principles of subchapter K, chapter 1 of the 
Code, or the principles of subpart E, subchapter J, chapter 1 of the 
Code, as the case may be.
    The IRS and Treasury believe that attributing items to a hybrid 
entity under this standard is administrable because it is generally 
consistent with the accounting treatment of the items. The IRS and 
Treasury also believe that this standard furthers the policy underlying 
section 1503(d) because the items that are properly reflected on the 
books and records of the hybrid entity (as adjusted to conform to U.S. 
tax principles) represent the best approximation of items that the 
foreign jurisdiction would recognize as being attributable to the 
entity. For example, it is likely that a foreign jurisdiction would 
recognize and take into account as being attributable to a hybrid 
entity the interest expense pr