The DPL rules are included in proposed regulations that were published on August 7, 2024.[2] The proposed regulations address, among other topics, how the Section 1503(d) dual consolidated loss (DCL) rules apply in the context of Pillar Two taxes. Though the proposed regulations include both DCL and DPL rules and the DPL rules use similar timing and concepts as the DCL rules, the DPL rules operate separately and apply to a different set of circumstances.[3]
While the DCL rules prevent taxpayers from deducting the same loss twice (once in the United States and once in a foreign jurisdiction), the DPL rules target “deduction/no inclusion” (D/NI) outcomes. In a D/NI scenario, a domestic corporation owns a foreign disregarded entity that makes payments to its domestic corporate parent. The payments are regarded for foreign tax purposes and may give rise to a foreign deduction or loss but are disregarded for US tax purposes, so there is no corresponding US income inclusion. Under foreign tax law, the foreign deduction or loss can be used to offset other foreign income and reduce foreign tax.[4]
To prevent D/NI outcomes, the proposed DPL rules identify certain foreign tax losses attributable to disregarded payments and then require the domestic corporate parent to include a corresponding amount of income for US tax purposes. However, the rules are extremely broad and may require US income inclusions where there is no D/NI outcome or potentially when the foreign disregarded entity is not actually in a loss position from a foreign tax perspective.[5]
As explained below, the rules (1) apply only to domestic corporations that are deemed to consent to their application, (2) may require domestic corporations to include a substantial “DPL inclusion amount” as ordinary income with no offsetting deduction, and (3) will require such inclusion whenever one of two triggering events occur, namely, a “foreign use” of the DPL or a failure to satisfy the rules’ certification requirements.
DEEMED CONSENT
The DPL rules apply only to consenting domestic corporations but set a low bar for what this “consent” requires. Essentially, a domestic corporation consents to the rules if it owns a foreign disregarded entity, with the applicability date depending on when the domestic corporation acquired or checked the box on the foreign disregarded entity.
First, a domestic corporation consents to the DPL rules if it directly or indirectly owns interests in a “specified eligible entity”[6] that makes a check-the-box election on or after August 6, 2024, to be a disregarded entity.[7]
Second, a domestic corporate owner is deemed to consent to the DPL rules if, as of August 6, 2025, the entity directly or indirectly owns interests in a disregarded entity and has not otherwise consented to the rules. To avoid such deemed consent with respect to a disregarded entity, the disregarded entity may instead elect to be treated as a corporation prior to August 6, 2025. Of course, the related consequences of such an election can be significant.[8]
THE DPL INCLUSION AMOUNT
Domestic corporations that consent to the rules may be required to include a DPL inclusion amount as income. For a specified eligible entity or foreign branch of a consenting domestic corporation (such specified eligible entity or foreign branch is referred to as a “disregarded payment entity”), the DPL for a given tax year is the disregarded payment entity’s net loss for foreign tax purposes that is composed of certain items of income and deduction that are disregarded for US tax purposes.[9] The notice of proposed rulemaking (NPRM) provides the following example:
[I]f for a foreign taxable year a disregarded payment entity’s only items are a $100x interest deduction and $70x of royalty income, and if each item were disregarded for U.S. tax purposes as a payment between a disregarded entity and its tax owner (but taken into account under foreign law), then the entity would have a $30x disregarded payment loss for the taxable year.
The DPL inclusion amount is the DPL amount reduced by the positive balance of the “DPL cumulative register.” The DPL cumulative register reflects the cumulative amount of disregarded payment income attributable to the disregarded payment entity across multiple years. The NPRM also provides the following example:
[I]f a disregarded payment entity incurs a $100x disregarded payment loss in year 1 and has $80x of disregarded payment income in year 2, only $20x of the disregarded payment loss is likely available under the foreign tax law to be put to a foreign use. As such, if a triggering event occurs at the end of year 2, then the specified domestic owner must include in gross income $20x (rather than the entire $100x of the disregarded payment loss).
Taxpayers who expect to benefit from the DPL cumulative register should keep in mind that the register only reflects disregarded payments that would be interest, royalties, or structured payments if regarded for US tax purposes. It reflects no other disregarded payments, and it reflects no regarded payments of any sort.
Notably, disregarded payment entities “for which the relevant foreign tax law is the same” are generally combined and treated as a single disregarded payment entity for purposes of the DPL rules. As a result, disregarded payments between entities formed in the same foreign jurisdiction generally should not give rise to DPL inclusions. However, this rule applies only where the entities have the same foreign tax year and are owned by the same consenting domestic corporation or by consenting domestic corporations that are members of the same consolidated group. Further, to ensure the items of foreign income and deduction net against one another within the combined disregarded payment entity, taxpayers should analyze the applicable foreign tax rules to confirm that these items accrue in the same foreign taxable year.
THE TRIGGERING EVENTS
Consenting domestic corporations will be forced to include the DPL inclusion amount as ordinary income if one of two triggering events occurs within a certification period. A certification period includes the foreign tax year in which the DPL is incurred, any prior foreign tax year, and the subsequent 60-month period. These certification periods and triggering events are somewhat similar to the ones used in the DCL rules. In the case of the DPL rules, however, there is no ability to make a domestic use election, as for US tax purposes there is no regarded loss that can be used to offset US tax.
The first triggering event is a “foreign use” of the DPL. A foreign use is determined under the principles of the DCL rules. Thus, a foreign use generally occurs when any portion of a deduction taken into account in computing the DPL is made available to offset or reduce income under foreign tax law that is considered under US tax law to be income of a related foreign corporation (and certain other entities in limited circumstances).
The second triggering event occurs if the domestic corporation fails to comply with certification requirements. Specifically, where a consenting domestic corporation’s disregarded entity has incurred a DPL, the domestic corporation must certify annually throughout the certification period that no foreign use of the DPL has occurred.
HYBRID MISMATCH RULES AND PILLAR TWO
The DPL rules provide that if a relevant foreign tax law denies a deduction for an item to prevent a D/NI outcome, the item is not taken into account for purposes of computing DPL or disregarded payment income. These so-called “hybrid mismatch rules” go some way toward softening the headache the DPL rules are likely to cause taxpayers.
However, foreign countries’ adoption of Pillar Two rules will exacerbate their impact. The rules make clear that for purposes of a qualified domestic minimum top-up tax (QDMTT) or income inclusion rule (IIR) top-up tax, foreign use is considered to occur where a portion of the deductions or losses that comprise a DPL is taken into account in determining net Global Anti-Base Erosion Rules income for a QDMTT or IIR or in determining qualification for the Transitional Country-by-Country Safe Harbor.[10] There is also a transition rule providing that, for this purpose, QDMTTs and IIRs are not taken into account for taxable years beginning before August 6, 2024.[11] This means that calendar year taxpayers who have not consented early to the DPL rules generally should not have a DPL inclusion amount in 2024 solely as a result of Pillar Two taxes, but, depending on their facts, could have an inclusion next year if proactive measures are not taken.
NEXT STEPS
Now is the time for multinational taxpayers to evaluate their risk under the DPL rules. Taxpayers with a domestic corporation in their structure should think carefully before making check-the-box elections to treat foreign entities as disregarded entities.[12] Moreover, taxpayers should determine whether their domestic corporations own any foreign disregarded entities or other specified entities that will cause them to be deemed to consent to the rules as of August 6, 2025.
Multinational taxpayers also should determine whether they have disregarded interest payments, structured payments, or royalties that fall under the purview of the rules. If so, they should consider whether they will be able to avoid future triggering events or if “foreign uses” of DPLs will be unavoidable. One should pay particular attention to Pillar Two, including the Transitional Country-by-Country Safe Harbor, when considering whether there could be a foreign use.
Taxpayers who cannot avoid triggering events should consider whether, and when, to take some defensive measures. Such actions might include winding up foreign disregarded entities that could be subject to the rules, eliminating disregarded payments that would result in DPL income inclusions,[13] or taking other restructuring steps (e.g., electing to treat certain foreign disregarded entities as associations, as the Treasury suggests). When determining whether to take defensive actions, taxpayers should consider the impact that DPL inclusions could have on their overall tax profile, including sourcing issues, foreign tax credits, and the Section 163(j) limitation on business interest deductions. In terms of timing, taxpayers also should consider whether they have until August 5, 2025, to unwind any arrangements subject to the DPL rules or whether it may be prudent to unwind any such arrangements before the end of the year.
Finally, taxpayers concerned about these rules should watch for news about whether they will be issued in final form. The results of the 2024 US presidential election call into question whether the proposed rules will be finalized or, conceivably, shelved.[14] These considerations further complicate the question of whether and when multinational taxpayers should act in response to the rules, particularly as the clock continues to tick toward the deemed consent date of August 6, 2025.
[1] The proposed regulations also can apply to payments made by a foreign disregarded entity to other foreign disregarded entities owned by the same domestic corporate parent.
[2] REG-105128-23.
[3] Although not analyzed in detail here, the proposed changes to the DCL rules are also significant and taxpayers should consider their impact.
[4] For example, the foreign deduction or loss can be used through a loss surrender or consolidation regime.
[5] For example, this may occur when a foreign disregarded entity makes a payment that is included in another foreign disregarded entity payee’s income for foreign tax purposes.
[6] A specified eligible entity is an eligible entity that is a foreign tax resident or owned by a domestic corporation that has a foreign branch.
[7] The rules also can apply to an entity that is formed or acquired after August 6, 2024, and classified without an election as a disregarded entity.
[8] For example, Section 367 may apply to a deemed contribution to the newly regarded foreign corporation.
[9] Generally, these are items of income and deduction from certain disregarded interest, royalties, and “structured payments” within the meaning of the Section 267A regulations.
[10] A limited exception is available in certain cases where the Pillar Two duplicate loss arrangement rule applies.
[11] This favorable transition rule is subject to an anti-abuse provision that can prevent it from applying.
[12] Taxpayers also should give careful thought to any internal restructurings involving foreign disregarded entities.
[13] Eliminating these payments may, of course, result in a corresponding increase in foreign tax liability.
[14] Commentators to the proposed regulations also have raised substantive invalidity arguments under the Loper Bright framework.
