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Mirror Mirror on the Wall: Can I deduct my Losses at all?
Most everyone in taxation knows, and many have suffered through, the vagaries of the dual consolidated loss (DCL) rules. These are the rules that prevent the use of a single loss generated by a dual resident corporation or by a separate unit of a U.S. entity to offset an affiliated or other group member's income in multiple jurisdictions. Many tax practitioners also know that buried deep within the DCL regulations is a provision known as the mirror rule, and whether or not the mirror rule applies in any given situation is based upon a detailed analysis of a foreign country's tax law.
The mirror rule for DCLs is not as restrictive as it once was. Yet it can still be tricky. If only following the mirror rule was as easy as looking into a mirror and getting an answer to all your questions. Especially the one about determining the deductibility of your company's cross border losses.
Generally, the purpose of the mirror rule is to prevent the deduction of a loss in the U.S. where another country has similar, or mirror, legislation that prohibits the loss from being taken in that country for reasons that parallel the U.S.'s DCL rules. In other words, the mirror rule will not allow a loss deduction of last resort in the U.S. when no other country will allow the loss because of provisions similar to our own rules.
Operating in a country that has mirror legislation could adversely affect a U.S. tax liability by disallowing losses thought to be appropriate even with the DCL rules. Knowing what losses may be deductible in the U.S. requires a fairly detailed understanding of the tax law surrounding the use of losses in that other country. For example, a U.S. tax director must understand the U.K. loss use rules to decide if the U.S. mirror rule will affect the company's U.S. tax liabilities-whether the company has activities in the U.K. through a dual resident company (DRC) structure or a U.K. branch of a U.S. entity. On the positive side of the ledger a clear grasp of the relevant rules in both the U.S. and the U.K. could lead to gaining the maximum benefits for any losses incurred, or at least prevent a permanent loss of tax benefits.
Using the U.S./U.K. relationship as an example, here are three recent developments pertaining to DCLs in general and to the mirror rule in particular.
IRS Coordinated Issue Paper on Dual Consolidated Losses under U.S.-U.K. Laws and Treaties: How the Mirror Rules Apply to U.K. Financing Structures
The IRS recently released a Coordinated Issue Paper (CIP) which specifically addresses the application of the U.S. mirror rule to three U.S./U.K. financing structures that involve U.K. dual resident entities. In the late 1980s, the U.K. enacted restrictions that potentially restrict the surrender of certain losses among the members of a U.K. group of companies by a dual resident investing company. While no one usually argues that the U.K. dual resident investing company rules are mirror legislation in the U.S., the CIP clarifies that if a taxpayer files a U.S. Check the Box Election (CTBE) for a U.K. entity to bring its losses within the U.S. tax net, the mirror rule does not apply as long as the U.K. entity is not also a dual resident investing company.
On the other hand, a U.K. dual resident investing company could be subject to the mirror rule-regardless of whether or not its losses are actually surrendered to a related U.K. company. In this instance, classification as a dual resident investing company is not a good thing, since the CIP confirms that its losses are permanently not available for deduction in the U.S. The loss also may not be deductible in the U.K. Here are two examples using the same scenario.
1. A U.S. corporation, the Domestic International Mirrors Company (lovingly referred to by its long-time employees as DIM Mirrors or simply DIM), is a member of a U.S. consolidated group and owns 100 percent of Fine Mirrors and Securities International Ltd (referred to by long-time employees as FLIMSI Mirrors or just plain FLIMSI). FLIMSI Mirrors is an entity organized under the laws of the U.K. and has made a CTBE to be treated as an entity disregarded from its owner for U.S. tax purposes. FLIMSI is a holding and financing company which owns the shares of several U.K. subsidiary companies and has also entered into financing arrangements with related entities all over the world and incurred a net operating loss of $100 in year 1 as a result of its interest expense on debts to third party lending institutions. The loss was not surrendered or otherwise used to offset the income of any other person in the U.K.'s part of its year 1 consolidated U.S. tax return, DIM Mirrors filed the applicable DCL election and used the loss to offset the income of a U.S. domestic consolidated group member.
Under the relevant U.K. tax rules, a dual resident company is generally defined as a company which is resident in the U.K., whether by incorporation or by being centrally managed and controlled in the U.K. A dual resident company is also "within the charge to tax" as a resident of another country. Generally, a dual resident investing company in the U.K. is a dual resident company that does not conduct a significant trade or business other than acquiring and holding shares or securities and paying interest to finance the investments, etc. (i.e. a holding or finance company). FLIMSI is not a dual resident investing company in the U.K. Even though it is an entity managed and controlled in the U.K., the company is considered a U.K. branch of a U.S. company for U.S. tax purposes because it is treated as a disregarded entity of DIM Mirrors. In other words, FLIMSI is not a resident of the U.S. under the applicable U.K. tax rules.
In this first example, FLIMSI's loss is allowable in the U.S. to offset the income of other DIM Mirrors group companies. The loss may also be deductible in the U.K.
2. If, instead of being incorporated in the U.K. let's assume that, FLIMSI Mirrors is a U.S. incorporated company that's also managed and controlled in the U.K. Thus, FLIMSI is a DRC in both the U.S. and the U.K. FLIMSI is also a dual resident investing company since it operates primarily as a holding and financing company.
In this second example, FLIMSI's loss is not allowable in either the U.S. or the U.K. Thus tax benefit for the loss will be obtained only if and when FLIMSI has taxable income in the future.
It took a detailed analysis of the relevant U.K. law to reach the conclusions in both examples.
U.S./U.K. Dual Consolidated Loss Competent Authority Agreement: Elective Use of Losses in U.K. Branches of U.S. Companies in the U.S. or the U.K.
The second development was a Competent Authority Agreement signed by the U.K. and U.S. It allows companies to use certain losses against group income under the U.K./U.S. income tax treaty that might not have been available for use in either jurisdiction due to the mirror legislation provision in each country's tax laws.
The agreement allows a U.S. company that has a "real" permanent establishment (PE) in the U.K. to elect whether its losses will be used in one country or the other, but not both. Absent the agreement, the loss arising from a real PE of a U.S. company operating in the U.K. could potentially not be used in either country. This is because the U.K. has enacted mirror legislation to prevent U.K. branches and PEs of nonresident corporations from offsetting losses both against income of U.K. affiliates and against income of the PE's owner in another country.
The agreement is relatively narrow in that it pertains only to real branches or PEs. It cannot apply to dual resident investing company structures.
It's the only agreement of its kind, breaking new ground in the DCL arena after 15 years of DCL regulations. It's very good news for those companies that can take advantage of it.
The agreement provides relief from the disallowance of loses related to accounting periods ending on or after April 1, 2000, but only in instances where the statute of limitations is still open in both countries. This allows for the possibility to deduct losses that were disallowed in previous tax years. Although the agreement only applies to real branches, the ability to make elections for past years can provide a potentially significant tax planning opportunity.
For example, using the DIM Mirrors scenario, DIM operates primarily in the U.S. However, the company also has a branch in the U.K., where it operates a manufacturing facility. The plant operations result in DIM Mirrors having a permanent establishment in the U.K. In year 1, the branch generates a loss of $100. Prior to the competent authority agreement, this loss would have been restricted under both the applicable U.K. loss limitation and the U.S. DCL rules. Therefore, it only could have been used if and when the branch actually realized taxable income in the future. With the competent authority agreement in place, DIM Mirrors can now elect to deduct the loss currently in one of the two jurisdictions, but not both.
The agreement provides detailed procedures for how to make the election and the type of information to furnish to the U.S. and U.K. tax authorities, depending upon the country in which the taxpayer wishes to use the loss. If the company elects to use the loss in the U.S., it must make the election separately for each year on a timely filed U.S. tax return. Once it is made it may not be revoked.
There are a couple of potential tax planning opportunities that come to mind from reading through the agreement.
As mentioned above, it's possible to obtain relief for prior restricted losses, assuming that the statute of limitations remains open.
Since the election may be changed each year, it's possible to establish procedures that ensure the loss is claimed in the country that offers the maximum benefit each year.
It's possible to do a little retroactive tax planning each year, since the taxpayer does not have to make the election until the company's U.S. tax return is filed.
New U.S. DCL Rules: Just Finalized
The long awaited revised DCL regulations have just been finalized. As expected, the final regulations are more taxpayer friendly than their predecessors; however, the dreaded mirror rule is still alive and well in basically its old familiar form.
The mirror rule does contain a potentially important new exception-the stand alone exception. Under the stand alone exception, a U.S. company may elect to deduct an otherwise restricted loss in the U.S. that arises in either a DRC, a real branch, or a hybrid entity-if the loss could not practically be used in the other country except by sale or merger. This situation could happen if there were no other entity in the foreign country whose income could absorb the loss.
This new election will provide important relief from one of the more irritating results under old DCL rules: no loss could be used in the U.S. when the foreign country had mirror rules similar to the U.S., even though there was no practical possibility to use the loss in that country.
On the downside, the new rules do contain one very important snag. And companies will have to deal with it for a long time. If a loss becomes available for foreign use (whether or not it is actually used) because of an acquisition, merger, or other transaction during a specified future period, the original tax benefit of the loss must be recaptured in the U.S. at that time-and there will be an interest charge on the subsequent tax due. Therefore, in each instance where the stand alone exception is used, a company must monitor whether any of the loss is required to be recaptured in the future.
Back to DIM Mirrors for an example. Let's assume that other than DIM Mirrors' branch/PE, there are no other entities in the U.K. that could benefit from the branch's DCL. Since the U.K. has mirror legislation to prevent the use of losses generated by nonresident corporate branches by other U.K. affiliates generally, the branch's loss would not be used. However, if the U.K. mirror legislation did not exist, no item of deduction or loss composing the $100 loss of the branch would be available for surrender in the year the loss was incurred. This is because there is no other entity in the U.K. through which the DCL would be put to foreign use unless a sale, merger, or similar transaction took place involving the PE. As a result of this new exception, DIM Mirrors may make an election to use the loss of its U.K. entity in the U.S.
So once again, because the stand alone election can only be made in certain cases which are dependent upon the practical ability to use the loss in the local country, a clear understanding of the loss use rules in the local country is essential.
Alvarez & Marsal Taxand Says:
Think of these rules as a two-way mirror. Standing on one side, the unwary tax director may not see the potential tax benefits of DCLs incurred in DRCs, branches, and hybrid entities waiting on the other side. Study the three new developments, because they'll give you more certainty, flexibility, and even some tax planning opportunities. And get immersed in the other country's tax laws. While we focused on the U.K. today, other countries, including Australia and Germany, have also enacted similar rules. You'll be the fairest of them all once you're armed with the right information and insight.
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