Title 26—Internal Revenue--Volume 1
PART 1—INCOME TAXES
§ 1.1503(d)-7   Examples.
(a) In general. This section provides examples that illustrate the application of §§ 1.1503(d)-1 through 1.1503(d)-6. This section also provides facts that are presumed for such examples.
(b) Presumed facts for examples. For purposes of the examples in this section, unless otherwise indicated, the following facts are presumed:
(1) Each entity has only a single class of equity outstanding, all of which is held by a single owner.
(2) P, a domestic corporation and the common parent of the P consolidated group, owns S, a domestic corporation and a member of the P consolidated group.
(3) DRC X , a domestic corporation, is subject to Country X tax on its worldwide income or on a residence basis, and is a dual resident corporation.
(4) DE1 X and DE2 X are both Country X entities, subject to Country X tax on their worldwide income or on a residence basis, and disregarded as entities separate from their owners for U.S. tax purposes. DE3 Y is a Country Y entity, subject to Country Y tax on its worldwide income or on a residence basis, and disregarded as an entity separate from its owner for U.S. tax purposes. All the interests in DE1 X , DE2 X , and DE3 Y constitute hybrid entity separate units.
(5) FB X is a Country X business operation that, if carried on by a U.S. person, would constitute a foreign branch, as defined in § 1.367(a)-6T(g)(1), and is a Country X foreign branch separate unit.
(6) Neither the assets nor the activities of an entity constitute a foreign branch separate unit.
(7) FS X is a Country X entity that is subject to Country X tax on its worldwide income or on a residence basis and is classified as a foreign corporation for U.S. tax purposes.
(8) The applicable foreign country has a consolidation regime that—
(i) Includes as members of a consolidated group any commonly controlled branches and permanent establishments in such jurisdiction, and entities that are subject to tax in such jurisdiction on their worldwide income or on a residence basis; and
(ii) Allows the losses of members of consolidated groups to offset income of other members.
(9) There is no mirror legislation, within the meaning of § 1.1503(d)-3(e)(1), in the applicable foreign country.
(10) There is no elective agreement described in § 1.1503(d)-6(b) between the United States and the applicable foreign country.
(11) There is no income tax convention between the United States and the applicable foreign country.
(12) If a domestic use election, within the meaning of § 1.1503(d)-6(d), is made, all the necessary filings related to such election are properly completed on a timely basis.
(13) If there is a triggering event requiring recapture of a dual consolidated loss, the amount of recapture is not reduced pursuant to § 1.1503(d)-6(h)(2).
(14) There are no other items of income, gain, deduction, and loss. In addition, the United States and the applicable foreign country recognize the same items of income, gain, deduction, and loss in each taxable year.
(15) All taxpayers use the calendar year as their taxable year.
(c) Examples. The following examples illustrate the application of §§ 1.1503(d)-1 through 1.1503(d)-6:
(1) Example 1. Separate unit combination rule —(i) Facts. P owns DE3 Y which, in turn, owns DE1 X . DE1 X owns FB X . PRS, an entity treated as a partnership for both U.S. and Country X tax purposes, is owned 50 percent by P and 50 percent by an unrelated foreign person. PRS carries on a business operation in Country X that, if carried on by a U.S. person, would constitute a foreign branch within the meaning of § 1.367(a)-6T(g)(1). In addition, P owns DRC X , a member of the consolidated group of which P is the parent, which carries on business operations in Country X that constitute a foreign branch within the meaning of § 1.367(a)-6T(g)(1). S owns DE2 X .
(ii) Result. Pursuant to § 1.1503(d)-1(b)(4)(ii), the interest in DE1 X , the interest in DE2 X , FB X , P's share of the Country X business operations carried on by PRS (which is owned by P indirectly through its interest in PRS), and DRC X 's Country X business operations are combined and treated as a single separate unit of the consolidated group of which P is the parent. This is the case regardless of whether the losses of each individual separate unit are made available to offset the income of the other individual separate units under Country X tax laws. Because DRC X is a dual resident corporation, it is not combined and treated as part of this combined separate unit and, as a result, DRC X 's income or dual consolidated loss is not taken into account in determining the income or dual consolidated loss of the combined separate unit. In addition, P's interest in DE3 Y is not combined and is another separate unit because it is subject to tax in Country Y, rather than Country X.
(2) Example 2. Definition of a separate unit and application of domestic use limitation—foreign branch separate unit —(i) Facts. P carries on business operations in Country X that constitute a permanent establishment under the U.S.-Country X income tax convention. In year 1, a loss is attributable to P's Country X permanent establishment, as determined under § 1.1503(d)-5.
(ii) Result. Under §§ 1.1503(d)-1(b)(4)(i)(A) and 1.367(a)-6T(g)(1), P's Country X permanent establishment constitutes a foreign branch separate unit. Therefore, the year 1 loss attributable to the foreign branch separate unit constitutes a dual consolidated loss pursuant to § 1.1503(d)-1(b)(5)(ii). The dual consolidated loss rules apply to the dual consolidated loss even though there is no affiliate of the foreign branch separate unit in Country X, because it is still possible that all or a portion of the dual consolidated loss can be put to a foreign use. For example, there may be a foreign use with respect to a Country X affiliate acquired in a year subsequent to the year in which the dual consolidated loss was incurred. See § 1.1503(d)-6(a)(2). Accordingly, unless an exception under § 1.1503(d)-6 applies (such as a domestic use election), the year 1 dual consolidated loss attributable to P's Country X permanent establishment is subject to the domestic use limitation rule of § 1.1503(d)-4(b). As a result, pursuant to § 1.1503(d)-4(c), the year 1 dual consolidated loss cannot offset income of P that is not attributable to its Country X foreign branch separate unit, nor can it offset income of any other domestic affiliate. The loss can, however, offset income of the Country X foreign branch separate unit, subject to the application of § 1.1503(d)-4(c). The result would be the same even if Country X did not have a consolidation regime that includes as members of consolidated groups Country X branches or permanent establishments of nonresident corporations. The dual consolidated loss rules apply even in the absence of a consolidation regime in the foreign country because it is possible that all or a portion of a dual consolidated loss can be put to a foreign use by other means, such as through a sale, merger, or similar transaction. See § 1.1503(d)-6(a)(2).
(iii) Alternative facts. The facts are the same as in paragraph (c)(2)(i) of this section, except that P's Country X business operations constitute a foreign branch as defined in § 1.367(a)-6T(g)(1), but do not constitute a permanent establishment under the U.S.-Country X income tax convention. Although the activities carried on by P in Country X would otherwise constitute a foreign branch separate unit as described in § 1.1503(d)-1(b)(4)(i)(A), the exception under § 1.1503(d)-1(b)(4)(iii) applies because the activities do not constitute a permanent establishment under the U.S.-Country X income tax convention. Thus, the Country X business operations do not constitute a foreign branch separate unit, and the year 1 loss is not subject to the dual consolidated loss rules. If P instead carried on its Country X business operations through DE1 X , then the exception under § 1.1503(d)-1(b)(4)(iii) would not apply because P carries on the business operations through a hybrid entity and, as a result, the business operations would constitute a foreign branch separate unit. Thus, in such a case the year 1 loss would be subject to the dual consolidated loss rules.
(3) Example 3. Domestic use limitation—foreign branch separate unit owned through a partnership —(i) Facts. P and S organize a partnership, PRS X , under the laws of Country X. PRS X is treated as a partnership for both U.S. and Country X tax purposes. PRS X owns FB X . PRS X earns U.S. source income that is unconnected with its FB X branch operations, and such income is not subject to tax by Country X. In addition, such U.S. source income is not attributable to FB X under § 1.1503(d)-5.
(ii) Result. Under § 1.1503(d)-1(b)(4)(i)(A), P's and S's shares of FB X owned indirectly through their interests in PRS X are individual foreign branch separate units. Pursuant to § 1.1503(b)-1(b)(4)(ii), these individual separate units are combined and treated as a single separate unit of the consolidated group of which P is the parent. Unless an exception under § 1.1503(d)-6 applies, any dual consolidated loss attributable to FB X cannot offset income of P or S (other than income attributable to FB X , subject to the application of § 1.1503(d)-4(c)), including their distributive share of the U.S. source income earned through their interests in PRS X , nor can it offset income of any other domestic affiliates.
(4) Example 4. Definition of a separate unit and domestic use limitation—interest in hybrid entity partnership and indirectly owned foreign branch separate unit —(i) Facts. HPS X is a Country X entity that is subject to Country X tax on its worldwide income. HPS X is classified as a partnership for Federal tax purposes. P, S, and FS X , are the sole partners of HPS X . For U.S. tax purposes, P, S, and FS X each has an equal interest in each item of HPS X 's profit or loss. HPS X carries on operations in Country Y that, if carried on by a U.S. person, would constitute a foreign branch within the meaning of § 1.367(a)-6T(g)(1).
(ii) Result. Under § 1.1503(d)-1(b)(4)(i)(B), the partnership interests in HPS X held by P and S are individual hybrid entity separate units. These individual separate units are combined into a single separate unit under § 1.1503(d)-1(b)(4)(ii). In addition, P's and S's share of the Country Y operations owned indirectly through their interests in HPS X are individual foreign branch separate units under § 1.1503(d)-1(b)(4)(i)(B). These individual separate units are also combined into a single separate unit under § 1.1503(d)-1(b)(4)(ii). Unless an exception under § 1.1503(d)-6 applies, dual consolidated losses attributable to P's and S's combined interests in HPS X can only be used to offset income attributable to their combined interests in HPS X (other than income attributable to P's and S's combined interests in the Country Y foreign branch separate unit), subject to the application of § 1.1503(d)-4(c). Similarly, dual consolidated losses attributable to P's and S's combined interests in the Country Y operations of HPS X can only be used to offset income attributable to their combined interests in such Country Y operations, subject to the application of § 1.1503(d)-4(c). Neither FS X 's interest in HPS X , nor its share of the Country Y operations owned by HPS X , is a separate unit because FS X is not a domestic corporation.
(5) Example 5. Foreign use—general rule and de minimis reduction exception —(i) Facts. P owns DE1 X . DE1 X owns FS X . In year 1, there is a $100x loss attributable to P's interest in DE1 X that is a dual consolidated loss. Also in year 1, FS X earns $200x of income. DE1 X and FS X file a Country X consolidated tax return. For Country X tax purposes, the year 1 $100x loss of DE1 X is used to offset $100x of year 1 income generated by FS X . Under Country X tax law, unused losses are carried forward and available to offset income in subsequent taxable years.
(ii) Result. The $100x loss attributable to P's interest in DE1 X is available to, and in fact does, offset FS X 's income under the laws of Country X. In addition, under U.S. tax principles, such income is considered to be an item of FS X , a foreign corporation. As a result, under § 1.1503(d)-3(a), there has been a foreign use of the year 1 dual consolidated loss attributable to P's interest in DE1 X . Therefore, P cannot make a domestic use election with respect to the loss as provided under § 1.1503(d)-6(d)(2), and such loss will be subject to the domestic use limitation rule of § 1.1503(d)-4(b). The result would be the same even if FS X , under Country X tax law, had no income against which the dual consolidated loss of DE1 X could be offset (unless FS X 's ability to use the loss under Country X tax law requires an election, and no such election is made).
(iii) Alternative facts. The facts are the same as in paragraph (c)(5)(i) of this section, except that FS X cannot use the loss of DE1 X under Country X tax law without an election, and no such election is made. Pursuant to the exception in § 1.1503(d)-3(c)(2), there is no foreign use of the year 1 dual consolidated loss attributable to P's interest in DE1 X . In addition, P files a domestic use election with respect to the year 1 dual consolidated loss attributable to its interest in DE1 X and, at the beginning of year 3, P sells its interest in DE1 X to F, a Country Y entity that is a foreign corporation. The sale of the interest in DE1 X to F results in a foreign use triggering event pursuant to § 1.1503(d)-6(e)(1)(i) because, immediately after the sale, the loss attributable to the interest in DE1 X carries over under Country X law and, therefore, is available under U.S. tax principles to offset income of the owner of the interest in DE1 X which, in the hands of F, is not a separate unit. It is also a foreign use because the loss is available under U.S. tax principles to offset the income of F, a foreign corporation. See § 1.1503(d)-3(a)(1). Finally, the transfer is a triggering event pursuant to § 1.1503(d)-6(e)(1)(iv) and (v).
(iv) Alternative facts. The facts are the same as in paragraph (c)(5)(iii) of this section, except that P only sells 5 percent of its interest in DE1 X to F. Pursuant to Rev. Rul. 99-5 (1999-1 CB 434), see § 601.601(d)(2)(ii)( b ) of this chapter, the transaction is treated as if P sold 5 percent of its interest in each of DE1 X 's assets to F, and then immediately thereafter P and F transferred their interests in the assets of DE1 X to a partnership in exchange for an ownership interest therein. The sale of the 5 percent interest in DE1 X generally results in a foreign use triggering event because a portion of the dual consolidated loss carries over under Country X tax law and is available under U.S. tax principles to offset income of the owner of the interest in DE1 X , a hybrid entity, which in the hands of F is not a separate unit. It is also a foreign use because the loss is available under U.S. tax principles to offset the income of F, a foreign corporation. See § 1.1503(d)-3(a)(1). However, pursuant to the exception under § 1.1503(d)-3(c)(5) (relating to a de minimis reduction of an interest in a separate unit), such availability does not result in a foreign use. In addition, pursuant to § 1.1503(d)-6(f)(1) and (3), the deemed transfers pursuant to Rev. Rul. 99-5 as a result of the sale are not treated as triggering events described in § 1.1503(d)-6(e)(1)(iv) or (v).
(6) Example 6. Foreign use and indirect foreign use—foreign reverse hybrid structure and disregarded payments —(i) Facts. P owns DE1 X . DE1 X owns 99 percent and S owns 1 percent of FRH X , a Country X partnership that elected to be treated as a corporation for U.S. tax purposes. FRH X conducts a trade or business in Country X. In year 1, DE1 X incurs interest expense on a third-party loan, which constitutes a dual consolidated loss attributable to P's interest in DE1 X . In year 1, for Country X tax purposes, DE1 X takes into account its distributive share of income generated by FRH X and offsets such income with its interest expense.
(ii) Result. In year 1, the dual consolidated loss attributable to P's interest in DE1 X is available to, and in fact does, offset income recognized in Country X and, under U.S. tax principles, the income is considered to be income of FRH X , a foreign corporation. Accordingly, pursuant to § 1.1503(d)-3(a)(1), there is a foreign use of the dual consolidated loss. Therefore, P cannot make a domestic use election with respect to the year 1 dual consolidated loss attributable to its interest in DE1 X , as provided under § 1.1503(d)-6(d)(2), and such loss will be subject to the domestic use limitation rule of § 1.1503(d)-4(b).
(iii) Alternative facts. (A) The facts are the same as in paragraph (c)(6)(i) of this section, except as follows. Instead of owning DE1 X , P owns DE3 Y which, in turn, owns DE1 X . In addition, DE3 Y , rather than DE1 X , is the obligor on the third-party loan and therefore incurs the interest expense on such loan. Finally, DE3 Y on-lends the loan proceeds from the third-party loan to DE1 X , and DE1 X pays interest to DE3 Y on such loan that is generally disregarded for U.S. tax purposes.
(B) Pursuant to § 1.1503(d)-5(c)(1)(ii), for purposes of calculating income or a dual consolidated loss, DE3 Y and DE1 X do not take into account interest income or interest expense, respectively, with respect to amounts paid on the disregarded loan from DE3 Y to DE1 X . But see § 1.1503(d)-1(d), which takes into account certain payments that are otherwise disregarded for purposes of section 1503(d) and the regulations thereunder. As a result, such items neither create a dual consolidated loss with respect to the interest in DE1 X , nor do they reduce (or eliminate) the dual consolidated loss attributable to the interest in DE3 Y . Thus, in year 1, there is a dual consolidated loss attributable to P's interest in DE3 Y , but not to P's indirect interest in DE1 X .
(C) In year 1, interest expense paid by DE1 X to DE3 Y on the disregarded loan is taken into account as a deduction in computing DE1 X 's taxable income for Country X tax purposes, but does not give rise to a corresponding item of income or gain for U.S. tax purposes (because it is generally disregarded). In addition, such interest has the effect of making an item of deduction or loss composing the dual consolidated loss attributable to P's interest in DE3 Y available for a foreign use. This is the case because it may reduce or offset items of deduction or loss composing the dual consolidated loss for foreign tax purposes, and creates another deduction or loss that may reduce or offset income of DE1 X for foreign tax purposes that, under U.S. tax principles, is treated as income of FRH X , a foreign corporation. Moreover, because the disregarded item is incurred or taken into account as interest for foreign tax purposes, it is deemed to have been incurred or taken into account with a principal purpose of avoiding the provisions of section 1503(d). Accordingly, there is an indirect foreign use of the year 1 dual consolidated loss attributable to P's interest in DE3 Y , and P cannot make a domestic use election with respect to such loss as provided under § 1.1503(d)-6(d)(2). Thus, the loss will be subject to the domestic use limitation rule of § 1.1503(d)-4(b).
(7) Example 7. Indirect foreign use—hybrid instrument —(i) Facts. P owns DE1 X which, in turn, owns FS X . DE1 X borrows cash from an unrelated lender and transfers the cash to FS X in exchange for an instrument (hybrid instrument). The hybrid instrument is treated as equity for U.S. tax purposes and debt for Country X tax purposes. Interest expense on the loan from the unrelated lender results in a dual consolidated loss being attributable to P's interest in DE1 X in year 1. DE1 X does not elect under Country X law to consolidate with FS X . In year 1, FS X distributes its stock as a payment on the hybrid instrument to DE1 X . For U.S. tax purposes, such payment is excluded from P's gross income under section 305. However, for Country X tax purposes, such payment is treated as interest and gives rise to a deduction taken into account in computing FS X 's Country X tax liability; the payment also gives rise to interest income to DE1 X for Country X tax purposes.
(ii) Result. The payment on the hybrid instrument does not give rise to an item of income or gain for U.S. tax purposes and therefore does not reduce (or eliminate) the dual consolidated loss attributable to P's interest in DE1 X . In addition, such payment is taken into account as a deduction in computing FS X 's taxable income for Country X tax purposes. Moreover, such payment has the effect of making an item of deduction or loss composing the dual consolidated loss attributable to P's interest in DE1 X available for a foreign use. This is the case because it may reduce or offset items of deduction or loss composing the dual consolidated loss for foreign tax purposes, and creates a deduction that reduces or offsets income of FS X for foreign tax purposes that, under U.S. tax principles, is income of a foreign corporation. Further, because the item is incurred, or taken into account, using an instrument that is treated as equity for U.S. tax purposes and debt for foreign tax purposes, it is deemed to have been engaged in with the principal purpose of avoiding the provisions of section 1503(d). As a result, there has been an indirect foreign use of the year 1 dual consolidated loss, and P cannot make a domestic use election with respect to such loss, as provided under § 1.1503(d)-6(d)(2). Thus, the year 1 dual consolidated loss will be subject to the domestic use limitation rule of § 1.1503(d)-4(b).
(8) Example 8. No indirect foreign use—transaction entered into in the ordinary course of business —(i) Facts. P owns DE1 X and FB Y . FB Y is a foreign branch separate unit located in Country Y. DE1 X owns FB X and FS X . P's interest in DE1 X and FB X are combined and treated as a single separate unit (Country X separate unit) pursuant to § 1.1503(d)-1(b)(4)(ii). Under Country X tax laws, DE1 X elects to consolidate with FS X . FB Y engages in the business of providing services and, in connection with its ordinary course of business, provides services to unrelated third parties and to DE1 X . As compensation for services, DE1 X makes a payment to FB Y . Under Country X tax law, the payment is deductible. However, the payment is generally disregarded for U.S. tax purposes and, pursuant to § 1.1503(d)-5(c)(1)(ii), is not taken into account in calculating the income or dual consolidated loss attributable to the Country X separate unit or FB Y . In year 1, the Country X separate unit and FB Y each has a dual consolidated loss. The dual consolidated loss attributable to the Country X separate unit is subject to the domestic use limitation under § 1.1503(d)-4(b) because DE1 X and FS X elect to consolidate and, as a result, the dual consolidated loss is put to a foreign use.
(ii) Result. The payment made by DE1 X to FB Y in connection with the performance of services is taken into account as a deduction in computing DE1 X 's taxable income for Country X tax purposes, but does not give rise to an item of income or gain for U.S. tax purposes. In addition, such payment has the effect of making an item of deduction or loss composing the dual consolidated loss attributable to FB Y available for a foreign use. This is the case because it may reduce or offset items of deduction or loss composing the dual consolidated loss of FB Y for foreign tax purposes, and creates another deduction that reduces or offsets income of FS X for foreign tax purposes (because DE1 X and FS X elect to file a consolidated return) that, under U.S. tax principles, is income of a foreign corporation. However, the transaction between DE1 X and FB Y was entered into in the ordinary course of FB Y 's trade or business. As a result, if P can demonstrate to the satisfaction of the Commissioner that the transaction was not entered into with a principal purpose of avoiding the provisions of section 1503(d), FB Y 's year 1 dual consolidated loss will not be treated as having been made available for an indirect foreign use. In such a case, P would be entitled to make a domestic use election with respect to such loss.
(9) Example 9. Foreign use—dual resident corporation with hybrid entity joint venture —(i) Facts. P owns DRC X , a member of the P consolidated group. DRC X owns 80 percent of HPS X , a Country X entity that is subject to Country X tax on its worldwide income. HPS X is classified as a partnership for U.S. tax purposes. FS X owns the remaining 20 percent of HPS X . In year 1, DRC X generates a $100x net operating loss (without regard to items attributable to DRC X 's interest in HPS X ). Also in year 1, HPS X generates $100x of income, $80x of which is attributable to DRC X 's interest in HPS X . DRC X and HPS X file a consolidated tax return for Country X tax purposes, and HPS X offsets its $100x of income with the $100x loss generated by DRC X .
(ii) Result. DRC X and its interest in HPS X are not combined because DRC X is a dual resident corporation and the combination rule under § 1.1503(d)-1(b)(4)(ii) only applies to separate units. The $100x year 1 net operating loss incurred by DRC X (without regard to items attributable to DRC X 's interest in HPS X ) is a dual consolidated loss. In addition, HPS X is a hybrid entity and DRC X 's interest in HPS X is a hybrid entity separate unit; however, there is no dual consolidated loss attributable to such separate unit in year 1 (instead, there is $80x of income attributable to such separate unit). DRC X 's year 1 dual consolidated loss offsets $100x of income for Country X purposes, and $20x of such income is, under U.S. tax principles, income of FS X , which owns an interest in HPS X that is not a separate unit (in addition, FS X is a foreign corporation). As a result, pursuant to § 1.1503(d)-3(a), there is a foreign use of the year 1 dual consolidated loss of DRC X , and P cannot make a domestic use election with respect to such loss pursuant to § 1.1503(d)-6(d)(2). Therefore, such loss will be subject to the domestic use limitation rule of § 1.1503(d)-4(b). The result would be the same even if HPS X , under Country X laws, had no income against which the dual consolidated loss could be offset (unless the ability to use the loss under Country X laws required an election, and no such election is made).
(10) Example 10. Foreign use—foreign parent corporation —(i) Facts. F1 and F2, nonresident alien individuals, each owns 50 percent of FP X , a Country X entity that is subject to Country X tax on its worldwide income. FP X is classified as a foreign corporation for U.S. tax purposes. FP X owns DRC X . DRC X is the parent of a consolidated group that includes as a member DS, a domestic corporation. In year 1, DRC X incurs a dual consolidated loss of $100x and, for Country X tax purposes, FP X generates $100x of income. In year 1, FP X elects to consolidate with DRC X for Country X tax purposes, and the $100x year 1 loss of DRC X is used to offset the income of FP X under the laws of Country X. For U.S. tax purposes, the items of FP X do not constitute items of income in year 1.
(ii) Result. The year 1 dual consolidated loss of DRC X offsets the income of FP X under the laws of Country X. Pursuant to § 1.1503(d)-3(a), the offset constitutes a foreign use because the items constituting such income are considered under U.S. tax principles to be items of a foreign corporation. This is the case even though the United States does not recognize such items as income in year 1. Therefore, DRC X cannot make a domestic use election with respect to its year 1 dual consolidated loss pursuant to § 1.1503(d)-6(d)(2). As a result, such loss will be subject to the domestic use limitation rule of § 1.1503(d)-4(b).
(iii) Alternative facts. The facts are the same as in paragraph (c)(10)(i) of this section, except that FP X is classified as a partnership for U.S. tax purposes. The result would be the same as in paragraph (c)(10)(ii) of this section, because the offset of the income generated by FP X is a foreign use pursuant to § 1.1503(d)-3(a). This is the case because the items constituting such income are considered under U.S. tax principles to be items of F1 and F2, the owners of interests in FP X (a hybrid entity), that are not separate units. Moreover, the result would be the same if F1 and F2 owned their interests in FP X indirectly through another partnership.
(11) Example 11. No foreign use—deemed ordering rule. —(i) Facts. P owns DE1 X and DRC X . DRC X is a member of the P consolidated group and owns FS X . DE1 X owns FB X . P's interest in DE1 X and P's indirect interest in FB X are individual separate units that are combined into a single separate unit (Country X separate unit) pursuant to § 1.1503(d)-1(b)(4)(ii). In year 1, DRC X incurs a $200x net operating loss and $200x of income is attributable to P's Country X separate unit. The $200x net operating loss incurred by DRC X is a dual consolidated loss. FS X also earns $200x of income in year 1. DRC X , DE1 X , and FS X file a Country X consolidated tax return.
(ii) Result. Under § 1.1503(d)-3(c)(3)(i), DRC X 's $200x loss shall be treated as having been made available to offset the $200x of income attributable to P's Country X separate unit. P's Country X separate unit is not, under U.S. tax principles, a foreign corporation, and there is no interest in DE1 X (which is a hybrid entity) that is not a separate unit. As a result, DRC X 's loss being made available to offset the income attributable to P's Country X separate unit is not considered a foreign use of such loss. Therefore, P can make a domestic use election with respect to DRC X 's year 1 dual consolidated loss.
(iii) Alternative facts. The facts are the same as in paragraph (c)(11)(i) of this section, except that in year 1 only $150x of income is attributable to P's Country X separate unit. Because only $150x of income is attributed to P's Country X separate unit, $50x of DRC X 's year 1 dual consolidated loss is treated as being made available to offset the income of FS X , a foreign corporation, and therefore constitutes a foreign use. As a result, DRC X cannot make a domestic use election with respect to its year 1 dual consolidated loss pursuant to § 1.1503(d)-6(d)(2), and such loss will be subject to the domestic use limitation rule of § 1.1503(d)-4(b).
(12) Example 12. No foreign use—absence of foreign loss usage ordering rules —(i) Facts. (A) P owns DRC X , a member of the P consolidated group. DRC X owns FS X . Under the Country X consolidation regime, a consolidated group may elect in any given year to use all or a portion of the losses of one consolidated group member to offset income of other consolidated group members. If no such election is made in a year in which losses are generated by a consolidated member, such losses carry forward and are available, at the election of the consolidated group, to offset income of consolidated group members in subsequent taxable years. Country X law does not provide ordering rules for determining when a loss from a particular taxable year is used because, under Country X law, losses never expire. In addition, Country X law does not provide ordering rules for determining when a particular type of loss (for example, capital or ordinary) is used.
(B) In year 1, DRC X incurs a capital loss of $80x which, under § 1.1503(d)-5(b)(2), is not a dual consolidated loss. DRC X also incurs a net operating loss of $80x in year 1 which is a dual consolidated loss. FS X generates $60x of capital gain in year 1 which, for Country X purposes, can be offset by capital losses and net operating losses. Under the laws of Country X, DRC X elects to use $60x of its total year 1 loss of $160x to offset the $60x of capital gain generated by FS X in year 1; the remaining $100x of year 1 loss carries forward. In both year 2 and year 3, DRC X incurs a net operating loss of $100x, while FS X incurs no income or loss in years 2 and 3. DRC X 's $100x losses incurred in year 2 and year 3 are dual consolidated losses. Because DRC X does not elect under the laws of Country X to use all or a portion of its year 2 or year 3 net operating losses of $100x to offset the income of other members of the Country X consolidated group, P is permitted to make (and in fact does make) a domestic use election with respect to both the year 2 and year 3 dual consolidated losses of DRC X . In year 4, DRC X has a net operating loss of $10x and FS X generates $125x of income. Country X law permits, upon an election, FS X 's $125x of income generated in year 4 to be offset by losses (including carryover losses from prior years) of other group members. Accordingly, in year 4, DRC X elects to use $125x of its accumulated losses to offset the $125x of year 4 income generated by FS X .
(ii) Result. (A) Under the ordering rules of § 1.1503(d)-3(d)(3), a pro rata amount of DRC X 's year 1 net operating loss ($30x) and capital loss ($30x) is considered to be used to offset FS X 's year 1 $60x capital gain. As a result, P cannot make a domestic use election with respect to DRC X 's year 1 $80x dual consolidated loss because a portion of such loss is put to a foreign use.
(B) DRC X 's $10x year 4 net operating loss is also a dual consolidated loss. Under the ordering rules of § 1.1503(d)-3(d)(1), such loss is considered to be used to offset $10x of FS X 's year 4 $125x of income. Consequently, P cannot make a domestic use election with respect to such loss. Under the ordering rules of § 1.1503(d)-3(d)(2), $50x of capital loss carryover and $50x of ordinary loss from year 1 will be considered to offset $100x of FS X 's year 4 income because the income is first deemed to have been offset by losses the use of which would not constitute a triggering event that would result in the recapture of a dual consolidated loss. The remaining $15x of FS X 's year 4 income is considered to be offset by losses from year 3 because it is the most recent taxable year from which a loss may be carried forward. Thus, a portion of the year 3 dual consolidated loss has been put to a foreign use and the entire year 3 dual consolidated loss is recaptured. However, none of DRC X 's $100x year 2 net operating loss will be deemed to offset FS X 's year 4 income. As a result, DRC X 's year 2 dual consolidated loss will not be recaptured.
(13) Example 13. Exception to foreign use through partnership interest —(i) Facts. (A) P owns 80 percent of HPS X , a Country X entity subject to Country X tax on its worldwide income. FS Z , an unrelated foreign corporation, owns the remaining 20 percent of HPS X . HPS X is classified as a partnership for Federal tax purposes and carries on operations in Country X that, if carried on by a U.S. person, would constitute a foreign branch within the meaning of § 1.367(a)-6T(g)(1). P's interest in HPS X and P's indirect interest in the Country X branch are individual separate units that are combined into a single separate unit (Country X separate unit) pursuant to § 1.1503(d)-1(b)(4)(ii).
(B) In year 1, HPS X incurs a loss of $100x, $80x of which is attributable to P's Country X separate unit. The $80x of loss attributable to P's Country X separate unit constitutes a dual consolidated loss and P makes a domestic use election with respect to such loss. In year 2, HPS X generates $50x of income, $40x of which is attributable to P's interest in the Country X separate unit. Under Country X income tax laws, the $100x of year 1 loss incurred by HPS X is carried forward and offsets the $50x of income generated by HPS X in year 2; the remaining $50x of loss is carried forward and is available to offset income generated by HPS X in subsequent years. P and FS Z maintain their ownership interests in HPS X throughout years 1 and 2.
(ii) Result. In year 2, under the laws of Country X, the $100x of year 1 loss, which includes the $80x dual consolidated loss attributable to P's Country X separate unit, is made available to offset income of HPS X . Such income is attributable to P's interest in HPS X , which is a separate unit. Such income also is income of FS Z , a foreign corporation that is an owner of an interest in HPS X , which is not a separate unit. However, pursuant to § 1.1503(d)-3(c)(4), there is no foreign use of the year 1 dual consolidated loss in year 2. This is the case because P's interest in HPS X as of the end of year 1 has not been reduced by more than a de minimis amount, and the portion of the $80x dual consolidated loss was made available for a foreign use in year 2 solely as a result of FS Z 's ownership in HPS X and the allocation or carry forward of the dual consolidated loss as a result of such ownership.
(iii) Alternative facts. The facts are the same as in paragraph (c)(13)(i) of this section, except that P also owns FS X . In addition, FS X and HPS X elect to file a consolidated return under Country X law. The exception to foreign use under § 1.1503(d)-3(c)(4) does not apply because there is a foreign use other than by reason of the dual consolidated loss being made available as a result of FS Z 's ownership in HPS X and the allocation or carry forward of the dual consolidated loss as a result of such ownership. That is, the exception does not apply because there is also a foreign use of the dual consolidated loss as a result of FS X and HPS X filing a consolidated return under Country X law.
(iv) Alternative facts. The facts are the same as in paragraph (c)(13)(i) of this section, except that at the end of year 2, FS Z contributes cash to HPS X in exchange for additional equity of HPS X . As a result of the contribution, FS Z 's interest in HPS X increases from 20 percent to 30 percent, and P's interest in HPS X decreases from 80 percent to 70 percent. P's interest in HPS X is reduced within a single 12-month period by 12.5 percent (10/80), as compared to P's interest in HPS X as of the beginning of such 12-month period. Accordingly, pursuant to § 1.1503(d)-3(c)(4)(iii), the exception to foreign use provided under § 1.1503(d)-3(c)(4)(i) does not apply. Therefore, in year 2 there is a foreign use of the $80x year 1 dual consolidated loss attributable to P's Country X separate unit. Such foreign use constitutes a triggering event in year 2 and the $80x year 1 dual consolidated loss is recaptured. Alternatively, if FS Z were a domestic corporation, there would not be a foreign use of the $80x year 1 dual consolidated loss because the loss would not be available to offset income that, under U.S. tax principles, is income of a foreign corporation or a direct or indirect owner of an interest in a hybrid entity that is not a separate unit.
(14) Example 14. Exception to foreign use through partnership interest—combination rule —(i) Facts. (A) P and FS X form PRS X . P and FS X each own 50 percent of PRS X throughout years 1 and 2. PRS X is treated as a partnership for both U.S. and Country X tax purposes. PRS X owns DE Y . DE Y is a Country Y entity subject to Country Y tax on its worldwide income and disregarded as an entity separate from its owner for U.S. tax purposes. DE Y conducts business operations in Country Y that, if carried on by a U.S. person, would constitute a foreign branch as defined in § 1.367(a)-6T(g)(1). P's interest in the Country Y operations conducted by DE Y is an individual foreign branch separate unit. P's interest in DE Y , owned indirectly through PRS X , is a hybrid entity individual separate unit. P also owns FB Y , a Country Y foreign branch individual separate unit. Under § 1.1503(d)-1(b)(4)(ii), FB Y and P's indirect interests in DE Y and DE Y 's Country Y business operations are treated as a combined separate unit (Country Y separate unit).
(B) In year 1, there is a $100x loss attributable to the Country Y business operations conducted by DE Y . Thus, there is a $50x loss attributable to P's interest in DE Y 's Country Y business operations in year 1. Also in year 1, there is a $200x loss attributable to FB Y . No income or loss is attributable to P's interest in DE Y in year 1. Under § 1.1503(d)-5(c)(4)(ii), the dual consolidated loss attributable to P's combined Country Y separate unit is $250x ($50x loss attributable to P's indirect interest in DE Y 's Country Y operations, plus $200x loss attributable to FB Y ). In year 2, neither DE Y nor DE Y 's Country Y operations generates income or loss. Under Country Y law, the $100x of year 1 loss incurred by DE Y is carried forward and is available to offset income of DE Y in year 2.
(ii) Result. As a result of the carryover of the year 1 $100x loss (which includes $50x of the year 1 dual consolidated loss) under Country Y law, a portion of such loss will be available to offset income of DE Y that is attributable to P's interest in DE Y owned indirectly through PRS X . A portion of such loss will also be available to offset income of DE Y that is attributable to FS X 's indirect ownership of DE Y . Accordingly, under § 1.1503(d)-3(a), there would be a foreign use of a portion of P's $250x year 1 dual consolidated loss because it is available to offset an item of income of the owner of an interest in a hybrid entity, which is not a separate unit (there would also be a foreign use in this case because FS X is a foreign corporation). However, there has not been a reduction of P's interest in DE Y , DE Y has not consolidated under the laws of Country Y, and there has not been any other foreign use of the dual consolidated losses. As a result, no foreign use occurs as a result of the carryforward pursuant to § 1.1503(d)-3(c)(4)(i) and (ii).
(15) Example 15. No foreign use—asset basis carryover exception —(i) Facts. P owns FB X and FS X . In year 1, there is a dual consolidated loss attributable to FB X . P's items of income, gain, deduction, and loss that are taken into account in calculating FB X 's dual consolidated loss include depreciation deductions attributable to FB X 's assets. P makes a domestic use election under § 1.1503(d)-6(d) with respect to the year 1 dual consolidated loss of FB X . At the end of year 2, P contributes a portion of FB X 's assets to FS X , in exchange for stock in FS X . The aggregate adjusted basis of the assets transferred by P to FS X is less than 10 percent of the aggregate adjusted basis of all of FB X 's assets held at the beginning of year 2. In addition, no other assets of FB X are transferred during the certification period. Under Country X law, FS X 's basis in the transferred assets is determined by reference to P's basis in such assets. In addition, under Country X law, a portion of the depreciation deductions that were taken into account in year 1 for U.S. tax purposes, are taken into account in year 2 for Country X tax purposes.
(ii) Result. As a result of the transfer of assets from P to FS X , a portion of the year 1 dual consolidated loss is available for a foreign use. This is the case because a portion of the basis in FB X 's assets, which gave rise to depreciation deductions that were taken into account in computing the year 1 dual consolidated loss, will give rise to a depreciation deduction under Country X laws that will be available, under U.S. tax principles, to offset the income of FS X , a foreign corporation, in year 2. However, the aggregate adjusted basis of all the assets transferred by P to FS X , within the 12-month period ending at the end of year 2, is less than 10 percent of the aggregate adjusted basis of all of FB X 's assets at the beginning of such 12-month period. Moreover, the aggregate adjusted basis of the assets transferred by P to FS X at any time during the certification period is less than 30 percent of the aggregate adjusted basis of FB X 's assets held at the end of year 1. In addition, the item of deduction giving rise to the foreign use is being made available solely as a result of the adjusted basis of the transferred assets being determined in whole, or in part, by reference to the adjusted basis of such transferred assets in the hands of FB X . As a result, this transfer will not result in a foreign use pursuant to § 1.1503(d)-3(c)(6).
(16) Example 16. No foreign use—liability assumption exception —(i) Facts. P owns FB X . In year 1, there is a dual consolidated loss attributable to FB X for which P makes a domestic use election under § 1.1503(d)-6(d). The dual consolidated loss includes a deduction for salary expense that was deductible for U.S. tax purposes at the end of year 1, even though it was not paid until year 2. The deduction was incurred in the ordinary course of FB X 's trade or business. During year 2, and before the accrued salary expense liability was paid, P sells all the assets of FB X to FS X in exchange for cash and FS X 's assumption of the liabilities of the FB X trade or business, including the obligation to pay the accrued salary expense. Under Country X law, the accrued salary expense of FB X is deductible, and is taken into account for purposes of computing the taxable income of FB X , when paid. FB X pays the accrued salary expense after the sale of FB X to FS X .
(ii) Result. (A) As a result of FS X 's assumption of the FB X liabilities, including the accrued salary expense, a portion of the dual consolidated loss is available for a foreign use in year 2. This is the case because the deduction that was taken into account in year 1 in computing the dual consolidated loss under U.S. tax principles will, under Country X tax law, be taken into account and will be available to offset the income of FS X , a foreign corporation, in year 2. However, because this item of expense is made available solely as a result of the assumption of a liability of FB X , and such liability was incurred in the ordinary course of FB X 's trade or business, there will not be a foreign use of the year 1 dual consolidated loss pursuant to § 1.1503(d)-3(c)(7).
(B) The transfer of all the assets of FB X to FS X is a triggering event under § 1.1503(d)-6(e)(1)(iv), unless P can rebut the triggering event under § 1.1503(d)-6(e)(2). For purposes of determining whether, under § 1.1503(d)-6(e)(2)(ii), the transfer of assets resulted in a carryover under foreign law of FB X 's losses, expenses, or deductions, the exception to foreign use for the assumption of liabilities is taken into account. However, the other exceptions to foreign use do not apply for this purpose (or for purposes of demonstrating that no foreign use of a dual consolidated loss can occur in any other year under § 1.1503(d)-6(c), (e)(2)(i) or (j)(2)). See § 1.1503(d)-3(c)(1). Provided the other requirements of § 1.1503(d)-6(e)(2)(ii) and (iii) are satisfied, P may be able to rebut the occurrence of a triggering event upon the transfer of FB X 's assets to FS X .
(17) Example 17. Mirror legislation rule—dual resident corporation and hybrid entity separate unit —(i) Facts. P owns DRC X , a member of the P consolidated group. DRC X owns FS X . In year 1, DRC X incurs a $100x net operating loss that is a dual consolidated loss. To prevent corporations like DRC X from offsetting losses both against income of affiliates in Country X and against income of foreign affiliates under the tax laws of another country, Country X mirror legislation prevents a corporation that is subject to the income tax of another country on its worldwide income or on a residence basis from using the Country X form of consolidation. Accordingly, the Country X mirror legislation prevents the loss of DRC X from being made available to offset income of FS X .
(ii) Result. Under § 1.1503(d)-3(e), because the losses of DRC X are subject to Country X's mirror legislation, there is a deemed foreign use of DRC X 's year 1 dual consolidated loss. The stand-alone exception to the mirror rule in § 1.1503(d)-3(e)(2) does not apply because, absent the mirror legislation, DRC X 's year 1 dual consolidated loss would be available for a foreign use (as defined in § 1.1503(d)-3), without regard to whether such availability is limited by election or similar procedure. That is, absent the mirror legislation, all or a portion of the dual consolidated loss would be available to offset the income of FS X under the Country X consolidation regime. This is the case even if Country X did not recognize DRC X as having a loss in year 1. Therefore, P may not make a domestic use election with respect to DRC X 's year 1 dual consolidated loss pursuant to § 1.1503(d)-3(d)(2).
(iii) Alternative facts. The facts are the same as in paragraph (c)(17)(i) of this section, except that P owns DE1 X (rather than DRC X ) and, in year 1, there is a $100 dual consolidated loss attributable to P's interest in DE1 X (rather than of DRC X ). The Country X mirror legislation only applies to Country X dual resident corporations and, therefore, does not apply to losses attributable to P's interest in DE1 X . As a result, the mirror legislation rule under § 1.1503(d)-3(e) would not deny the opportunity of such loss from being put to a foreign use (for example, by offsetting the income of FS X through the Country X consolidation regime). Therefore, a domestic use election can be made with respect to the dual consolidated loss (provided the conditions for such an election are otherwise satisfied).
(18) Example 18. Mirror legislation rule—standalone foreign branch separate unit —(i) Facts. P owns FB X . In year 1, there is a $100x dual consolidated loss attributable to FB X . Country X enacted mirror legislation to prevent Country X branches and permanent establishments of nonresident corporations from offsetting losses both against income of Country X affiliates and against other income of its owner (or foreign affiliates thereof) under the tax laws of another country. The Country X mirror legislation prevents a Country X branch or permanent establishment of a nonresident corporation from offsetting its losses against the income of Country X affiliates if such losses may be deductible against income (other than income of the Country X branch or permanent establishment) under the laws of another country.
(ii) Result. In general, under § 1.1503(d)-3(e), because the losses of FB X are subject to Country X's mirror legislation, there is a deemed foreign use of FB X 's year 1 dual consolidated loss. However, in the absence of the Country X mirror legislation, no item of deduction or loss composing FB X 's year 1 dual consolidated loss would be available in the year incurred for a foreign use (as defined in § 1.1503(d)-3), without regard to whether such availability is limited by election or otherwise. This is the case because there is no Country X entity through which the dual consolidated loss could be put to a foreign use (absent a sale, merger, or similar transaction involving FB X ). As a result, the stand-alone exception in § 1.1503(d)-3(e)(2) may apply, provided P complies with the requirements of § 1.1503(d)-3(e)(2)(ii). Accordingly, P may make a domestic use election with respect to the year 1 dual consolidated loss of FB X pursuant to § 1.1503(d)-6(d). If, however, any item of the dual consolidated loss would otherwise be available for a foreign use during the certification period (for example, as a result of P acquiring a foreign corporation that is organized under the laws of Country X such that losses of FB X could be put to a foreign use through consolidation or similar means), then such loss would be recaptured pursuant to § 1.1503(d)-6(e)(1)(ix).
(iii) Alternative facts. The facts are the same as in paragraph (c)(18)(i) of this section, except that the Country X mirror legislation operates in a manner similar to the rules under section 1503(d). That is, it allows the taxpayer to elect to use the loss to either offset income of an affiliate in Country X, or income of an affiliate (or other income of the owner of the Country X branch or permanent establishment) in the other country, but not both. Because the Country X mirror legislation permits the taxpayer to choose to put the dual consolidated loss to a foreign use, it does not deny the opportunity to put the loss to a foreign use. Therefore, there is no deemed foreign use of the dual consolidated loss pursuant to § 1.1503(d)-4(e) and a domestic use election can be made for such loss.
(19) Example 19. Application of mirror legislation rule to combined separate unit —(i) Facts. P owns FB X , FS X , and DE1 X . In year 1, there is a $50x dual consolidated loss attributable to FB X and $10x of income attributable to P's interest in DE1 X . FS X has income of $100x. Pursuant to § 1.1503(d)-1(b)(4)(ii), FB X and P's interest in DE1 X are combined and treated as a single separate unit (Country X separate unit) which has a year 1 dual consolidated loss of $40x. Country X enacted mirror legislation to prevent Country X branches or permanent establishments of nonresident corporations from offsetting losses both against income of Country X affiliates and against other income of its owner (or foreign affiliates thereof) under the tax laws of another country. The Country X mirror legislation prevents a Country X branch or permanent establishment of a nonresident corporation from offsetting its losses against the income of Country X affiliates if such losses may be deductible against income (other than income of the Country X branch or permanent establishment) under the laws of another country. However, the United States and Country X have entered into an agreement described in § 1.1503(d)-6(b) pursuant to the U.S.-Country X income tax convention (mirror agreement). The mirror agreement applies to Country X foreign branch separate units of domestic corporations, but not to Country X hybrid entity separate units. The mirror agreement provides that neither the Country X mirror legislation nor the mirror legislation rule under § 1.1503(d)-3(e) will apply to losses attributable to Country X foreign branch separate units, provided certain conditions and reporting requirements are satisfied (including a domestic use election, if the loss is to be used to offset income of a domestic affiliate). Thus, losses attributable to Country X foreign branch separate units can, subject to the requirements of the mirror agreement, be used to offset income of a domestic affiliate or a Country X affiliate (but not both).
(ii) Result. The Country X mirror legislation only applies to Country X foreign branch separate units and does not apply to hybrid entity separate units. In addition, if P complies with the terms and conditions of the mirror agreement, the Country X mirror legislation would not apply to FB X . As a result, the income tax laws of Country X would not deny the opportunity of a loss of either individual separate unit that composes P's combined Country X separate unit from being put to a foreign use. Therefore, notwithstanding § 1.1503(d)-3(e), a domestic use election can be made with respect to the dual consolidated loss attributable to P's Country X separate unit, provided the terms and conditions of the mirror agreement are satisfied. See § 1.1503(d)-6(b)(2).
(iii) Alternative facts. The facts are the same as in paragraph (c)(19)(i) of this section, except that the Country X mirror legislation also applies to losses attributable to DE1 X , but the mirror agreement does not apply to such losses. The mirror legislation rule would apply with respect to P's interest in DE1 X and, as a result, there is a deemed foreign use of the dual consolidated loss attributable to the Country X separate unit and a domestic use election cannot be made for such loss. This is the case even though, pursuant to § 1.1503(d)-5(c)(4)(ii)(A), P's interest in DE1 X (which is subject to the Country X mirror legislation) does not, as an individual separate unit, have a dual consolidated loss in year 1. Further, the stand-alone exception to the mirror legislation rule in § 1.1503(d)-3(e)(2) does not apply because, absent the mirror legislation, the Country X combined separate unit's dual consolidated loss would be available in the year incurred for a foreign use (as defined in § 1.1503(d)-3) because it could be used to offset income of FS X under the Country X consolidation regime. This is the case even if Country X requires an election to consolidate and no such election is made. The result would be the same even if Country X did not recognize DE1 X as having a loss.
(20) Example 20. Dual consolidated loss limitation after section 381 transaction. disposition of assets and subsequent liquidation of dual resident corporation —(i) Facts. P owns DRC X , a member of the P consolidated group. In year 1, DRC X incurs a dual consolidated loss and P does not make a domestic use election with respect to such loss. Under § 1.1503(d)-4(b), DRC X 's year 1 dual consolidated loss is subject to the limitations under § 1.1503(d)-4(c) and, therefore, may not be used to offset the income of P or S (or any other domestic affiliate) on the group's U.S. income tax return. At the beginning of year 2, DRC X sells all of its assets for cash and distributes the cash to P pursuant to a liquidation that qualifies under section 332.
(ii) Result. In general, under section 381, P would succeed to, and be permitted to use, DRC X 's net operating loss carryover. However, § 1.1503(d)-4(d)(1)(i) prohibits the dual consolidated loss of DRC X from carrying over to P. Therefore, DRC X 's year 1 net operating loss carryover is eliminated.
(21) Example 21. Dual consolidated loss limitation applied to a separate unit transferred in a section 381 transaction —(i) Facts. S owns DE1 X which, in turn, owns FB X . S's interest in DE1 X and its indirect interest in FB X are combined and treated as a single separate unit (Country X separate unit) pursuant to § 1.1503(d)-1(b)(4)(ii). In year 1, a dual consolidated loss is attributable to the Country X separate unit, and P does not make a domestic use election with respect to such loss. Under § 1.1503(d)-4(b), the year 1 dual consolidated loss attributable to the Country X separate unit may not be used to offset the income of P or S (other than income attributable to the Country X separate unit, subject to the application of § 1.1503(d)-4(c)) on the group's consolidated U.S. income tax return (nor may it be used to offset the income of any other domestic affiliates). At the beginning of year 2, S transfers its entire interest in DE1 X , and thus its entire indirect interest in FB X , to FS X in a transaction described in section 381.
(ii) Result. Section 1.1503(d)-4(d)(1)(ii) provides that the dual consolidated loss attributable to a separate unit that is subject to the domestic use limitation under § 1.1503(d)-4(b) is eliminated if the separate unit ceases to be a separate unit of its affiliated domestic owner and all other members of the affiliated domestic owner's separate group. As a result of the transfer of the Country X separate unit to FS X , the Country X separate unit ceases to be a separate unit of S, and is not a separate unit of any other member of the P consolidated group. In addition, the exceptions in § 1.1503(d)-4(d)(2)(iii) do not apply because FS X is not a domestic corporation. Thus, the year 1 dual consolidated loss attributable to the Country X separate unit is eliminated.
(iii) Alternative facts. Assume the same facts as in paragraph (c)(21)(i) of this section, except S transfers its assets to DC, a domestic corporation that is not a member of the P consolidated group, in a transaction described in section 381(a). Immediately after the transaction, the Country X separate unit is a separate unit of DC. Under § 1.1503(d)-4(d)(1)(ii), the year 1 dual consolidated loss of the Country X separate unit would be eliminated because it ceases to be a separate unit of S, and is not a separate unit of any other member of the P consolidated group. However, because the transferee is a domestic corporation and the Country X separate unit is a separate unit in the hands of DC immediately after the transaction, the exception under § 1.1503(d)-4(d)(2)(iii)(A) applies. As a result, the year 1 dual consolidated loss of the Country X separate unit is not eliminated and any income generated by DC that is attributable to the Country X separate unit following the transfer may be offset by the carryover dual consolidated losses attributable to the Country X separate unit, subject to the limitations of § 1.1503(d)-4(b) and (c) applied as if DC generated the dual consolidated loss and such loss was attributable to the Country X separate unit.
(iv) Alternative facts. Assume the same facts as in paragraph (c)(21)(iii) of this section, except that P owns DE2 X and the interest in DE2 X is combined with and therefore included in the Country X separate unit. In addition, a portion of the dual consolidated loss of the Country X separate unit is attributable to P's interest in DE2 X . Pursuant to § 1.1503(d)-4(d)(2)(iii)(A), the result would be the same as in paragraph (c)(21)(iii) of this section, with respect to the portion of the dual consolidated loss attributable to the combined separate unit that is succeeded to and taken into account by DC pursuant to section 381. The portion of the dual consolidated loss attributable to P's interest in DE2 X , however, does not carry over to DC but is retained by P and continues to be subject to the limitations of § 1.1503(d)-4(b) and (c) with respect to P's interest in DE2 X .
(v) Alternative facts. Assume the same facts as in paragraph (c)(21)(iv) of this section, except that DC is a member of the P consolidated group. Pursuant to § 1.1503(d)-4(d)(2)(iii)(B), the dual consolidated loss of the Country X separate unit is not eliminated and income attributable to the Country X separate unit may continue to be offset by the dual consolidated loss that is succeeded to and taken into account by DC pursuant to section 381, subject to the limitations of § 1.1503(d)-4(b) and (c). The result would be the same even if the interest in DE1 X ceased to be a separate unit in the hands of DC (for example, because it dissolved under Country X law in connection with the transaction), provided P, or another member of the P consolidated group, continued to own a portion of the Country X separate unit.
(22) Example 22. Tainted income —(i) Facts. P owns 100 percent of DRC Z , a domestic corporation that is included as a member of the P consolidated group. DRC Z conducts a business in the United States. During year 1, DRC Z was managed and controlled in Country Z and therefore was subject to tax as a resident of Country Z and was a dual resident corporation. In year 1, DRC Z incurred a dual consolidated loss of $200x, and P did not make a domestic use election with respect to such loss. As a result, such loss is subject to the domestic use limitation rule of § 1.1503(d)-4(b). At the end of year 1, DRC Z moved its management and control to the United States and, as a result, ceased being a dual resident corporation. At the beginning of year 2, P transferred asset A, a non-depreciable asset, to DRC Z in exchange for common stock in a transaction that qualified for nonrecognition under section 351. At the time of the transfer, P's tax basis in asset A equaled $50x and the fair market value of asset A equaled $100x. The tax basis of asset A in the hands of DRC Z immediately after the transfer equaled $50x pursuant to section 362. Asset A did not constitute replacement property acquired in the ordinary course of business. DRC Z did not generate income or gain during years 2, 3, or 4. On June 30, year 5, DRC Z sold asset A to a third party for $100x, its fair market value at the time of the sale, and recognized $50x of income on such sale. In addition to the $50x income generated on the sale of asset A, DRC Z generated $100x of operating income in year 5. At the end of year 5, the fair market value of all the assets of DRC Z was $400x.
(ii) Result. DRC Z ceased being a dual resident corporation at the end of year 1. Therefore, its year 1 dual consolidated loss cannot be offset by tainted income. Asset A is a tainted asset because it was acquired in a nonrecognition transaction after DRC Z ceased being a dual resident corporation (and was not replacement property acquired in the ordinary course of business). As a result, the $50x of income recognized by DRC Z on the disposition of asset A is tainted income and cannot be offset by the year 1 dual consolidated loss of DRC Z . In addition, absent evidence establishing the actual amount of tainted income, $25x of the $100x year 5 operating income of DRC Z (($100x/$400x) × $100x) also is treated as tainted income and cannot be offset by the year 1 dual consolidated loss of DRC Z under § 1.1503(d)-4(e)(2)(ii). Therefore, $75x of the $150x year 5 income of DRC Z constitutes tainted income and may not be offset by the year 1 dual consolidated loss of DRC Z ; however, the remaining $75x of year 5 income of DRC Z may be offset by such dual consolidated loss. The result would be the same if, instead of P transferring asset A to DRC Z , such asset was received from a separate unit or a transparent entity of DRC Z .
(23) Example 23. Treatment of disregarded item and books and records of a hybrid entity —(i) Facts. P owns DE1 X which, in turn, owns FS X . In year 1, P borrows from a third party and on-lends the proceeds to DE1 X . In year 1, P incurs interest expense attributable to the third-party loan. Also in year 1, DE1 X incurs interest expense attributable to its loan from P, but such expense is generally disregarded for U.S. tax purposes because DE1 X is disregarded as an entity separate from P. The third-party loan and related interest expense are reflected on the books and records of P (and not on the books and records of DE1 X ). The loan from P to DE1 X and related interest expense are reflected on the books and records of DE1 X . There are no other items of income, gain, deduction, or loss reflected on the books and records of DE1 X in year 1.
(ii) Result. Because the interest expense on P's third-party loan is not reflected on the books and records of DE1 X , no portion of such expense is attributable to P's interest in DE1 X pursuant to § 1.1503(d)-5(c)(3) for purposes of calculating the year 1 dual consolidated loss, if any, attributable to such interest. In addition, even though P's interest in DE1 X is treated as a separate domestic corporation for purposes of determining the amount of income or dual consolidated loss attributable to it pursuant to § 1.1503(d)-5(c)(1)(ii), such treatment does not cause the interest expense incurred on the loan from P to DE1 X that is generally disregarded for U.S. tax purposes to be regarded for purposes of calculating the year 1 dual consolidated loss, if any, attributable to P's interest in DE1 X . As a result, even though the disregarded interest expense is reflected on the books and records of DE1 X , it is not taken into account for purposes of calculating income or a dual consolidated loss. But see § 1.1503(d)-1(d), which takes into account certain payments that are otherwise disregarded for purposes of section 1503(d) and the regulations thereunder. Therefore, there is no dual consolidated loss attributable to P's interest in DE1 X in year 1.
(24) Example 24. Dividend income attributable to a separate unit —(i) Facts. P owns DE1 X which, in turn, owns FB X . P's interest in DE1 X and its indirect interest in FB X are combined and treated as a single separate unit (Country X separate unit) pursuant to § 1.1503(d)-1(b)(4)(ii). DE1 X owns DE3 Y . DE3 Y owns the stock of FS X . P's Country X separate unit would, without regard to year 1 dividend income (or related section 78 gross-up) received from FS X , have a dual consolidated loss of $75x in year 1. In year 1, FS X distributes $50x to DE3 Y that is taxable as a dividend. DE3 Y distributes the same amount to DE1 X . P computes foreign taxes deemed paid on the dividend under section 902 of $25x and includes that amount in gross income under section 78.
(ii) Result. The $50x dividend is reflected on the books and records of DE3 Y and, therefore, is attributable to P's interest in DE3 Y pursuant to § 1.1503(d)-5(c)(3)(i). In addition, the $25x section 78 gross-up is attributable to P's interest in DE3 Y pursuant to § 1.1503(d)-5(c)(4)(iv). The distribution of $50x from DE3 Y to DE1 X is generally disregarded for U.S. tax purposes and, therefore, does not give rise to an item that is taken into account for purposes of calculating income or a dual consolidated loss. This is the case even though the item would be reflected on the books and records of DE1 X . In addition, pursuant to § 1.1503(d)-5(c)(1)(iii), each separate unit must calculate its own income or dual consolidated loss, and each item of income, gain, deduction, and loss must be taken into account only once. As a result, the dual consolidated loss of $75x attributable to P's Country X separate unit in year 1 is not reduced by the amount of dividend income attributable to P's indirect interest in DE3 Y .
(25) Example 25. Items reflected on books and records of a combined separate unit —(i) Facts. P owns DE1 X which, in turn, owns FB X . P's interest in DE1 X and its indirect interest in FB X are combined and treated as a single separate unit (Country X separate unit) pursuant to § 1.1503(d)-1(b)(4)(ii). The following items are reflected on the books and records of DE1 X in year 1: Sales, depreciation expense, a political contribution, royalty expense paid to P, repairs and maintenance expense paid to a third party, and Country X income tax expense. The amount of sales under U.S. tax principles equals the amount of sales reported for accounting purposes. The depreciation expense is calculated on a straight-line basis over the useful life of the asset for accounting purposes, but is subject to accelerated depreciation for U.S. tax purposes. In addition, the repairs and maintenance expense, which is deducted when paid for accounting purposes, is properly capitalized and amortized over five years for U.S. tax purposes. Finally, P elects to claim as a credit under section 901 the Country X income tax expense that was paid in year 1.
(ii) Result. (A) For purposes of determining the income or dual consolidated loss attributable to P's Country X separate unit, items of income, gain, deduction, and loss must first be attributed to the individual separate units (that is, P's interest in DE1 X and its indirect interest in FB X ). For purposes of attributing items to P's interest in DE1 X , P's items that are reflected on DE1 X 's books and records, as adjusted to conform to U.S. tax principles, are taken into account. See § 1.1503(d)-5(c)(3)(i). For purposes of attributing items (other than interest expense) to FB X , the principles of section 864(c)(2), (c)(4), and (c)(5) (as set forth in § 1.864-4(c) and §§ 1.864-5 through 1.864-7) must be applied and, for interest expense, the principles of § 1.882-5, as modified under § 1.1503(d)-5(c)(2)(ii), must be applied; however, for these purposes, pursuant to § 1.1503(d)-5(c)(4)(i)(A), FB X only takes into account items attributable to P's interest in DE1 X and the assets, liabilities, and activities of such interest. In addition, to the extent such items are taken into account by FB X , they are not taken into account in determining the items attributable to P's interest in DE1 X . § 1.1503(d)-5(c)(4)(i)(B). Because P's interest in DE1 X has no assets or liabilities, and conducts no activities, other than through its ownership of FB X , all of the items that are reflected on the books and records of DE1 X , as adjusted to conform to U.S. tax principles, are attributable to FB X ; no items are attributable to P's interest in DE1 X .
(B) The items reflected on the books and records of DE1 X must be adjusted to conform to U.S. tax principles. No adjustment is required to sales because the amount of sales under U.S. tax principles equals the amount of sales for accounting purposes. The amount of straight-line depreciation expense reflected on DE1 X 's books and records must be adjusted to reflect the amount of depreciation on the asset that is allowable for U.S. tax purposes. The political contribution is not taken into account because it is not deductible for U.S. tax purposes. Similarly, because the royalty expense is paid to P, and therefore is generally disregarded for U.S. tax purposes, it is not taken into account. But see § 1.1503(d)-1(d), which takes into account certain payments that are otherwise disregarded for purposes of section 1503(d) and the regulations thereunder. The repair and maintenance expense that is deducted in year 1 for accounting purposes also must be adjusted to conform to U.S. tax principles. Thus, the repair and maintenance expense will be taken into account in computing the income or dual consolidated loss attributable to P's Country X separate unit over five years (even though no item related to such expense would be reflected on the books and records of DE1 X for years 2 through 5). Finally, because P elected to claim as a credit the Country X foreign taxes paid during year 1, no deduction is allowed for such amount pursuant to section 275(a)(4) and, therefore, the Country X tax expense is not taken into account.
(C) Pursuant to § 1.1503(d)-5(c)(4)(ii)(B), the combined Country X separate unit of P calculates its income or dual consolidated loss by taking into account all the items of income, gain, deduction, and loss that were separately attributable to P's interest in DE1 X and FB X . However, in this case, there are no items attributable to P's interest in DE1 X . Therefore, the items attributable to the Country X separate unit are the items attributable to FB X .
(26) Example 26. Items attributable to a combined separate unit —(i) Facts. P owns DE1 X . DE1 X owns a 50 percent interest in PRS Z , a Country Z entity that is classified as a partnership both for Country Z tax purposes and for U.S. tax purposes. FS X , which is unrelated to P, owns the remaining 50 percent interest in PRS Z . PRS Z carries on operations in Country X that, if carried on by a U.S. person, would constitute a foreign branch as defined in § 1.367(a)-6T(g)(1). Therefore, P's share of the Country X operations carried on by PRS Z constitutes a foreign branch separate unit. PRS Z also owns assets that do not constitute a part of its Country X branch, including all of the interests in TE T , a disregarded entity. TE T is an entity incorporated under the laws of Country T, a country that does not have an income tax. Under the laws of Country X, an interest holder of TE T does not take into account on a current basis the interest holder's share of items of income, gain, deduction, and loss of TE T .
(ii) Result. (A) Pursuant to § 1.1503(d)-1(b)(4)(ii), P's interest in DE1 X , and P's indirect ownership of a portion of the Country X operations carried on by PRS Z , are combined and treated as a single separate unit (Country X separate unit). Pursuant to § 1.1503(d)-5(c)(4)(ii)(A), for purposes of determining P's items of income, gain, deduction, and loss attributable to the Country X separate unit, the items of P are first attributed to each separate unit that composes the Country X separate unit.
(B) Pursuant to § 1.1503(d)-5(c)(2)(i), the principles of section 864(c)(2), (c)(4), and (c)(5) (as set forth in § 1.864-4(c) and §§ 1.864-5 through 1.864-7), apply for purposes of determining P's items of income, gain, deduction (other than interest expense), and loss that are attributable to P's indirect interest in the Country X operations carried on by PRS Z . For purposes of determining P's interest expense that is attributable to P's indirect interest in the Country X operations carried on by PRS Z , the principles of § 1.882-5, as modified under § 1.1503(d)-5(c)(2)(ii), shall apply. For purposes of applying these rules, P is treated as a foreign corporation, the Country X operations carried on by PRS Z are treated as a trade or business within the United States, and the assets of P (including its share of the PRS Z assets, other than those of the Country X operations) are treated as assets that are not U.S. assets. In addition, because P carries on its share of the Country X operations through DE1 X , a hybrid entity, § 1.1503(d)-5(c)(4)(i)(A) provides that only the items attributable to P's interest in DE1 X , and only the assets, liabilities, and activities of P's interest in DE1 X , are taken into account for purposes of this determination.
(C) TE T is a transparent entity as defined in § 1.1503(d)-1(b)(16) because it is not taxable as an association for Federal tax purposes, is not subject to income tax in a foreign country as a corporation (or otherwise at the entity level) either on its worldwide income or on a residence basis, and is not treated as a pass-through entity under the laws of Country X (the applicable foreign country). TE T is not a pass-through entity under the laws of Country X because a Country X holder of an interest in TE T does not take into account on a current basis the interest holder's share of items of income, gain, deduction, and loss of TE T . For purposes of determining P's items of income, gain, deduction, and loss that are attributable to P's interest in TE T , only those items of P that are reflected on the books and records of TE T , as adjusted to conform to U.S. tax principles, are taken into account. § 1.1503(d)-5(c)(3)(i). Because the interest in TE T is not a separate unit, a loss attributable to such interest is not a dual consolidated loss and is not subject to section 1503(d) and these regulations. Items must nevertheless be attributed to the interests in TE T . For example, such attribution is required for purposes of calculating the income or dual consolidated loss attributable to the Country X separate unit, and for purposes of applying the domestic use limitation under § 1.1503(d)-4(b) to a dual consolidated loss attributable to the Country X separate unit.
(D) For purposes of determining P's items of income, gain, deduction, and loss that are attributable to P's interest in DE1 X , only those items of P that are reflected on the books and records of DE1 X , as adjusted to conform to U.S. tax principles, are taken into account. § 1.1503(d)-5(c)(3)(i). For this purpose, DE1 X 's distributive share of the items of income, gain, deduction, and loss that are reflected on the books and records of PRS Z , as adjusted to conform to U.S. tax principles, are treated as being reflected on the books and records of DE1 X , except to the extent such items are taken into account by the Country X operations of PRS Z . See § 1.1503(d)-5(c)(3)(ii) and (4)(i)(B). Because TE T is a transparent entity, the items reflected on its books and records are not treated as being reflected on the books and records of DE1 X .
(E) Pursuant to § 1.1503(d)-5(c)(4)(ii)(B), the combined Country X separate unit of P calculates its income or dual consolidated loss by taking into account all the items of income, gain, deduction, and loss that were separately attributable to P's interest in DE1 X and the Country X operations of PRS Z owned indirectly by P.
(27) Example 27. Sale of separate unit by another separate unit —(i) Facts. P owns DE3 Y which, in turn, owns DE1 X . DE3 Y also owns other assets that do not constitute a foreign branch separate unit. DE1 X owns FB X . Pursuant to § 1.1503(d)-1(b)(4)(ii), P's indirect interests in DE1 X and FB X are combined and treated as one Country X separate unit (Country X separate unit). DE3 Y sells its interest in DE1 X at the end of year 1 to an unrelated foreign person for cash. The sale results in an ordinary loss of $30x. Items of income, gain, deduction, and loss derived from the assets that gave rise to the $30x loss would be attributable to the Country X separate unit under § 1.1503(d)-5(c) through (e). Without regard to the sale of DE1 X , no items of income, gain, deduction, and loss are attributable to P's Country X separate unit in year 1.
(ii) Result. Pursuant to § 1.1503(d)-5(c)(4)(iii)(A), the $30x ordinary loss recognized on the sale is attributable to the Country X separate unit, and not P's interest in DE3 Y . This is the case because the Country X separate unit is treated as owning the assets that gave rise to the loss under § 1.1503(d)-5(f). Thus, the loss attributable to the sale creates a year 1 dual consolidated loss attributable to the Country X separate unit. In addition, pursuant to § 1.1503(d)-6(d)(2), P cannot make a domestic use election with respect to the dual consolidated loss because the sale of the interest in DE1 X is a triggering event described in § 1.1503(d)-6(e)(1)(iv) and (v). Further, although the year 1 dual consolidated loss would otherwise be subject to the domestic use limitation rule of § 1.1503(d)-4(b), it is eliminated pursuant to § 1.1503(d)-4(d)(1)(ii). Finally, if there were a dual consolidated loss attributable to P's interest in DE3 Y , the sale of the interest in DE1 X would not be taken into account for purposes of determining whether there is an asset triggering event with respect to such dual consolidated loss under § 1.1503(d)-6(e)(1)(iv).
(28) Example 28. Gain on sale of tiered separate units —(i) Facts. P owns 75 percent of HPS X , a Country X entity subject to Country X tax on its worldwide income. FS X owns the remaining 25 percent of HPS X . HPS X is classified as a partnership for Federal tax purposes. HPS X carries on operations in Country Y that, if carried on by a U.S. person, would constitute a foreign branch within the meaning of § 1.367(a)-6T(g)(1). HPS X also owns assets that do not constitute a part of its Country Y operations and would not themselves constitute a foreign branch within the meaning of § 1.367(a)-6T(g)(1) if owned by a U.S. person. Neither HPS X nor the Country Y operations has liabilities. P's indirect interest in the Country Y operations carried on by HPS X , and P's interest in HPS X , are each separate units. P sells its interest in HPS X and recognizes a gain of $150x on such sale. Immediately prior to P's sale of its interest in HPS X , P's portion of the assets of the Country Y operations (that is, assets the income, gain, deduction and loss from which would be attributable to P's Country Y foreign branch separate unit) had a built-in gain of $200x, and P's portion of HPS X 's other assets (that is, assets the income, gain, deduction and loss from which would be attributable to P's interest in HPS X ) had a built-in gain of $100x.
(ii) Result. Pursuant to § 1.1503(d)-5(c)(4)(iii)(B), $100x of the total $150x of gain recognized ($200x/$300x × $150x) is attributable to P's indirect interest in its share of the Country Y operations carried on by HPS X . Similarly, $50x of such gain ($100x/$300x × $150x) is attributable to P's interest in HPS X .
(29) Example 29. Effect on domestic affiliate —(i) Facts. (A) P owns DE1 X which, in turn, owns FB X . P's interest in DE1 X and its indirect interest in FB X are combined and treated as a single separate unit (Country X separate unit) pursuant to § 1.1503(d)-1(b)(4)(ii). In years 1 and 2, the items of income, gain, deduction, and loss that are attributable to P's Country X separate unit pursuant to § 1.1503(d)-5 are as follows:
Table 1 to paragraph (c)(29)(i)(A)
(B) P does not make a domestic use election with respect to the year 1 dual consolidated loss attributable to its Country X separate unit. Pursuant to § 1.1503(d)-4(b) and (c)(2), the year 1 dual consolidated loss of $50x is treated as a loss incurred by a separate domestic corporation and is subject to the limitations under § 1.1503(d)-4(c)(3). The P consolidated group has $100x of consolidated taxable income in year 2.
(ii) Result. (A) P must compute its taxable income for year 1 without taking into account the $50x dual consolidated loss, pursuant to § 1.1503(d)-4(c)(2). Such amount consists of a pro rata portion of the expenses that were taken into account in calculating the year 1 dual consolidated loss. Thus, the items of the dual consolidated loss that are not taken into account by P in computing its taxable income are as follows: $25x of salary expense ($75x/$150x × $50x); $16.67x of research and experimental expense ($50x/$150x × $50x); and $8.33x of interest expense ($25x/$150x × $50x). The remaining amounts of each of these items, together with the $100x of sales income, are taken into account by P in computing its taxable income for year 1 as follows: $50x of salary expense ($75x − $25x); $33.33x of research and experimental expense ($50x − $16.67x); and $16.67x of interest expense ($25x − $8.33x).
(B) Subject to the limitations provided under § 1.1503(d)-4(c), the year 1 $50x dual consolidated loss is carried forward and is available to offset the $10x of income attributable to the Country X separate unit in year 2. Pursuant to § 1.1503(d)-4(c)(4), a pro rata portion of each item of deduction or loss included in such dual consolidated loss is considered to be used to offset the $10x of income, as follows: $5x of salary expense ($25x / $50x × $10x); $3.33x of research and experimental expense ($16.67x/$50x × $10x); and $1.67x of interest expense ($8.33x / $50x × $10x). The remaining amount of each item shall continue to be subject to the limitations under § 1.1503(d)-4(c).
(30) Example 30. Exception to domestic use limitation—no possibility of foreign use because items are not deducted or capitalized under foreign law —(i) Facts. P owns DE1 X which, in turn, owns FS X . In year 1, the sole item of income, gain, deduction, and loss attributable to P's interest in DE1 X , as provided under § 1.1503(d)-5, is $100x of interest expense paid on a loan to an unrelated lender. For Country X tax purposes, the $100x interest expense attributable to P's interest in DE1 X in year 1 is treated as a repayment of principal and therefore cannot be deducted (at any time) or capitalized.
(ii) Result. The $100x of interest expense attributable to P's interest in DE1 X constitutes a dual consolidated loss. However, because the sole item constituting the dual consolidated loss cannot be deducted or capitalized (at any time) for Country X tax purposes, P can demonstrate that there can be no foreign use of the dual consolidated loss at any time. As a result, pursuant to § 1.1503(d)-6(c)(1), if P prepares a statement described in § 1.1503(d)-6(c)(2) and attaches it to its timely filed tax return, the year 1 dual consolidated loss attributable to P's interest in DE1 X will not be subject to the domestic use limitation rule of § 1.1503(d)-4(b).
(31) Example 31. No exception to domestic use limitation—inability to demonstrate no possibility of foreign use —(i) Facts. P owns DE1 X which, in turn, owns FB X . P's interest in DE1 X and its indirect interest in FB X are combined and treated as a single separate unit (Country X separate unit) pursuant to § 1.1503(d)-1(b)(4)(ii). In year 1, the sole items of income, gain, deduction, and loss attributable to P's Country X separate unit, as provided under § 1.1503(d)-5, are $75x of sales income and $100x of depreciation expense. For Country X tax purposes, DE1 X also generates $75x of sales income in year 1, but the $100x of depreciation expense is not deductible until year 2.
(ii) Result. The year 1 $25x net loss attributable to P's interest in the Country X separate unit constitutes a dual consolidated loss. In addition, even though DE1 X has positive income in year 1 for Country X tax purposes, P cannot demonstrate that there is no possibility of foreign use with respect to the Country X separate unit's dual consolidated loss as provided under § 1.1503(d)-6(c)(1)(i). P cannot make such a demonstration because the depreciation expense, an item composing the year 1 dual consolidated loss, is deductible (in a later year) for Country X tax purposes and, therefore, may be available to offset or reduce income for Country X purposes that would constitute a foreign use. For example, if DE1 X elected to be classified as a corporation pursuant to § 301.7701-3(c) of this chapter effective as of the end of year 1, and the deferred depreciation expense were available for Country X tax purposes to offset year 2 income of DE1 X , an entity treated as a foreign corporation in year 2 for U.S. tax purposes, there would be a foreign use.
(iii) Alternative facts. (A) The facts are the same as in paragraph (c)(31)(i) of this section, except as follows. In year 1, the sole items of income, gain, deduction, and loss attributable to P's Country X separate unit, as provided in § 1.1503(d)-5, are $75x of sales income, $100x of interest expense, and $25x of depreciation expense. For Country X tax purposes, DE1 X generates $75x of sales income in year 1; the $100x interest expense is treated as a repayment of principal and therefore cannot be deducted or capitalized (at any time); and the $25x of depreciation expense is not deductible in year 1, but is deductible in year 2.
(B) In year 1, the $50x net loss attributable to P's Country X separate unit constitutes a dual consolidated loss. Even though the $100x interest expense, a nondeductible and noncapital item for Country X tax purposes, exceeds the $50x year 1 dual consolidated loss attributable to P's Country X separate unit, P cannot demonstrate that there is no possibility of foreign use of the dual consolidated loss as provided under § 1.1503(d)-6(c)(1)(i). P cannot make such a demonstration because the $25x depreciation expense, an item of deduction or loss composing the year 1 dual consolidated loss, is deductible under Country X law (in year 2) and, therefore, may be available to offset or reduce income for Country X tax purposes that would constitute a foreign use.
(32) Example 32. Triggering event rebuttal—expiration of losses in foreign country —(i) Facts. P owns DRC X , a member of the P consolidated group. In year 1, DRC X incurs a dual consolidated loss of $100x. P makes a domestic use election with respect to DRC X 's year 1 dual consolidated loss and such loss therefore is included in the computation of the P group's consolidated taxable income. DRC X has no income or loss in year 2 through year 5. In year 5, P sells the stock of DRC X to FS X . At the time of the sale of the stock of DRC X , all of the losses and deductions that were included in the computation of the year 1 dual consolidated loss of DRC X had expired for Country X tax purposes because the laws of Country X only provide for a three-year carryover period for such items.
(ii) Result. The sale of DRC X to FS X generally would be a triggering event under § 1.1503(d)-6(e)(1)(ii), which would require DRC X to recapture the year 1 dual consolidated loss (and pay an applicable interest charge) on the P consolidated group's tax return for the year that includes the date on which DRC X ceases to be a member of the P consolidated group. However, upon adequate documentation that the losses and deductions have expired for Country X tax purposes, P can rebut the presumption that a triggering event has occurred pursuant to § 1.1503(d)-6(e)(2)(i). If the triggering event presumption is rebutted, the domestic use agreement filed by the P consolidated group with respect to the year 1 dual consolidated loss of DRC X is terminated and has no further effect pursuant to § 1.1503(d)-6(j)(1)(i). If the presumptive triggering event is not rebutted, the domestic use agreement would terminate and have no further effect pursuant to § 1.1503(d)-6(j)(1)(iii) because the dual consolidated loss would be recaptured.
(33) Example 33. Triggering events and rebuttals—tax basis carryover transaction —(i) Facts. (A) P owns DE1 X . DE1 X 's sole asset is A, which it acquired at the beginning of year 1 for $100x. DE1 X does not have any liabilities. For U.S. tax purposes, DE1 X 's tax basis in A at the beginning of year 1 is $100x and DE1 X 's sole item of income, gain, deduction, and loss for year 1 is a $20x depreciation deduction attributable to A. As a result, the $20x depreciation deduction constitutes a dual consolidated loss attributable to P's interest in DE1 X . P makes a domestic use election with respect to the year 1 dual consolidated loss.
(B) For Country X tax purposes, DE1 X has a $100x tax basis in A at the beginning of year 1, but A is not a depreciable asset. As a result, DE1 X does not have any items of income, gain, deduction, and loss in year 1 for Country X tax purposes.
(C) During year 2, P sells its interest in DE1 X to FS X for $80x. P's disposition of its interest in DE1 X constitutes a presumptive triggering event under § 1.1503(d)-6(e)(1)(iv) and (v) requiring the recapture of the year 1 $20x dual consolidated loss (plus the applicable interest charge). For Country X tax purposes, DE1 X retains its tax basis of $100x in A following the sale.
(ii) Result. The year 1 dual consolidated loss is a result of the $20x depreciation deduction attributable to A. Although no item of deduction or loss was recognized by DE1 X at the time of the sale for Country X tax purposes, the deduction composing the dual consolidated loss was retained by DE1 X after the sale in the form of tax basis in A. As a result, a portion of the dual consolidated loss may be available to offset income for Country X tax purposes in a manner that would constitute a foreign use. For example, if DE1 X were to dispose of A, the amount of gain recognized by DE1 X would be reduced (or an amount of loss recognized by DE1 X would be increased) and, therefore, an item composing the dual consolidated loss would be available, under U.S. tax principles, to reduce income of a foreign corporation (and an owner of an interest in a hybrid entity that is not a separate unit). Thus, P cannot demonstrate pursuant to § 1.1503(d)-6(e)(2)(i) that there can be no foreign use of the year 1 dual consolidated loss following the triggering event, and must recapture the year 1 dual consolidated loss. Pursuant to § 1.1503(d)-6(j)(1)(iii), the domestic use agreement filed by the P consolidated group with respect to the year 1 dual consolidated loss is terminated and has no further effect.
(iii) Alternative facts. The facts are the same as paragraph (c)(33)(i) of this section, except that instead of P selling its interest in DE1 X to FS X , DE1 X sells asset A to FS X for $80x and, for Country X tax purposes, FS X 's tax basis in A immediately after the sale is $80x. P's disposition of Asset A constitutes a presumptive triggering event under § 1.1503(d)-6(e)(1)(iv) requiring the recapture of the year 1 $20x dual consolidated loss (plus the applicable interest charge). For Country X tax purposes, FS X 's tax basis in A was not determined, in whole or in part, by reference to the basis of A in the hands of DE1 X . As a result, the deduction composing the dual consolidated loss will not give rise to an item of deduction or loss in the form of tax basis for Country X tax purposes (for example, when FS X disposes of A). Therefore, P may be able to demonstrate (for example, by obtaining the opinion of a Country X tax advisor) pursuant to § 1.1503(d)-6(e)(2)(i) that there can be no foreign use of the year 1 dual consolidated loss and, thus, would not be required to recapture the year 1 dual consolidated loss.
(34) Example 34. Triggering event resulting in a single consolidated group where acquirer files a new domestic use agreement —(i) Facts. P owns DRC X , a member of the P consolidated group. In year 1, DRC X incurs a dual consolidated loss and P makes a domestic use election with respect to such loss. No member of the P consolidated group incurs a dual consolidated loss in year 2. At the end of year 2, T, the parent of the T consolidated group, acquires all the stock of P, and all the members of the P group, including DRC X , become members of a consolidated group of which T is the common parent.
(ii) Result. (A) Under § 1.1503(d)-6(f)(2)(ii)(B), the acquisition by T of the P consolidated group is not an event described in § 1.1503(d)-6(e)(1)(ii) requiring the recapture of the year 1 dual consolidated loss of DRC X (and the payment of an interest charge), provided that the T consolidated group files a new domestic use agreement described in § 1.1503(d)-6(f)(2)(iii)(A). If a new domestic use agreement is filed, then pursuant to § 1.1503(d)-6(j)(1)(ii), the domestic use agreement filed by the P consolidated group with respect to the year 1 dual consolidated loss of DRC X is terminated and has no further effect.
(B) Assume that T files a new domestic use agreement and a triggering event occurs at the end of year 3. As a result, the T consolidated group must recapture the dual consolidated loss that DRC X incurred in year 1 (and pay an interest charge), as provided in § 1.1503(d)-6(h). Each member of the T consolidated group, including DRC X and any former members of the P consolidated group, is severally liable for the additional tax (and the interest charge) due upon the recapture of the dual consolidated loss of DRC X . In addition, pursuant to § 1.1503(d)-6(j)(1)(iii), the new domestic use agreement filed by the T group with respect to the year 1 dual consolidated loss of DRC X is terminated and has no further effect.
(35) Example 35. Triggering event exceptions for certain deemed transfers —(i) Facts. P owns DE1 X . In year 1, there is a $100x dual consolidated loss attributable to P's interest in DE1 X . P files a domestic use agreement under § 1.1503(d)-6(d) with respect to such loss. During year 2, P sells 33 percent of its interest in DE1 X to T, an unrelated domestic corporation.
(ii) Result. Pursuant to Rev. Rul. 99-5, the transaction is treated as if P sold 33 percent of its interest in each of DE1 X 's assets to T and then immediately thereafter P and T transferred their interests in the assets of DE1 X to a partnership in exchange for an ownership interest therein. Upon the transfer of 33 percent of P's interest to T, a domestic corporation, no foreign use occurs and, therefore, there is no foreign use triggering event. However, P's deemed transfer of 67 percent of its interest in the assets of DE1 X to a partnership is nominally a triggering event under § 1.1503(d)-6(e)(1)(iv). Because the initial transfer of 33 percent of DE1 X 's interest was to a domestic corporation and there is only a triggering event because of the deemed transfer under Rev. Rul. 99-5, the deemed asset transfer is not treated as resulting in a triggering event pursuant to § 1.1503(d)-6(f)(4).
(iii) Alternative facts. The facts are the same as in paragraph (c)(35)(i) of this section, except that P sells 60 percent (rather than 33 percent) of its interest in DE1 X to T. The sale is a triggering event under § 1.1503(d)-6(e)(1)(iv) and (v) without regard to the occurrence of a deemed transaction. Therefore, § 1.1503(d)-6(f)(4) does not apply.
(36) Example 36. Triggering event exception involving multiple parties —(i) Facts. P owns DE1 X which, in turn, owns FB X . P's interest in DE1 X and its indirect interest in FB X are combined and treated as a single separate unit (Country X separate unit) pursuant to § 1.1503(d)-1(b)(4)(ii). In year 1, there is a $100x dual consolidated loss attributable to P's Country X separate unit and P makes a domestic use election with respect to such loss. No member of the P consolidated group incurs a dual consolidated loss in year 2. At the end of year 2, T, the parent of the T consolidated group, acquires all of P's interest in DE1 X for cash.
(ii) Result. (A) Under § 1.1503(d)-6(f)(2)(i)(B), the acquisition by T of the interest in DE1 X is not an event described in § 1.1503(d)-6(e)(1)(iv) or (v) requiring the recapture of the year 1 dual consolidated loss attributable to the Country X separate unit (and the payment of an interest charge), provided: (1) the T consolidated group files a new domestic use agreement described in § 1.1503(d)-6(f)(2)(iii)(A) with respect to the year 1 dual consolidated loss of the Country X separate unit; and (2) the P consolidated group files a statement described in § 1.1503(d)-6(f)(2)(iii)(B) with respect to the year 1 dual consolidated loss. If these requirements are satisfied, then pursuant to § 1.1503(d)-6(j)(1)(ii) the domestic use agreement filed by the P consolidated group with respect to the year 1 dual consolidated loss is terminated and has no further effect (if these requirements are not satisfied such that the P consolidated group recaptures the dual consolidated loss, the domestic use agreement would terminate pursuant to § 1.1503(d)-6(j)(1)(iii)).
(B) Assume a triggering event occurs at the end of year 3 that requires recapture by the T consolidated group of the year 1 dual consolidated loss, as well as the payment of an interest charge, as provided in § 1.1503(d)-6(h). T continues to own the Country X separate unit after the triggering event. In that case, each member of the T consolidated group is severally liable for the additional tax (and the interest charge) due upon the recapture of the year 1 dual consolidated loss. The T consolidated group must prepare a statement that computes the recapture tax amount as provided under § 1.1503(d)-6(h)(3)(iii). Pursuant to § 1.1503(d)-6(h)(3)(iv)(A), the recapture tax amount is assessed as an income tax liability of the T consolidated group and is considered as having been properly assessed as an income tax liability of the P consolidated group. If the T consolidated group does not pay in full the income tax liability attributable to the recapture tax amount, the unpaid balance of such recapture tax amount may be collected from the P consolidated group in accordance with the provisions of § 1.1503(d)-6(h)(3)(iv)(B). Pursuant to § 1.1503(d)-6(j)(1)(iii), the new domestic use agreement filed by the T consolidated group is terminated and has no further effect. Finally, pursuant to § 1.1503(d)-6(h)(6)(iii), T is treated as if it incurred the dual consolidated loss that is recaptured for purposes of applying § 1.1503(d)-6(h)(6)(i). Thus, T has a reconstituted net operating loss equal to the amount of the year 1 dual consolidated loss that was recaptured, and such loss is attributable to the Country X separate unit (and subject to the rules and limitations under § 1.1503(d)-6(h)(6)(i)). Because T is treated as if it incurred the year 1 dual consolidated loss, P shall not be treated as having a net operating loss under § 1.1503(d)-6(h)(6)(i).
(37) Example 37. No foreign use following multiple-party event exception to triggering event —(i) Facts. P owns DE1 X which, in turn, owns FB X . P's interest in DE1 X and its indirect interest in FB X are combined and treated as a single separate unit (Country X separate unit) pursuant to § 1.1503(d)-1(b)(4)(ii). In year 1, there is a $100x dual consolidated loss attributable to P's Country X separate unit and P makes a domestic use election with respect to such loss. T, a domestic corporation unrelated to P, owns 95 percent of PRS, a partnership. FS X owns the remaining 5 percent of PRS. At the beginning of year 3, PRS purchases 100 percent of the interest in DE1 X from P for cash. For Country X tax purposes, the $100x loss incurred by DE1 X in year 1 carries forward and is available to offset income of DE1 X in subsequent years.
(ii) Result. P's sale of its interest in DE1 X is a triggering event under § 1.1503(d)-6(e)(1)(iv) and (v). However, if P and T comply with the requirements under § 1.1503(d)-6(f)(2)(iii), the sale would qualify for the multiple-party event exception under § 1.1503(d)-6(f)(2)(i). In addition, because the $100x loss of DE1 X carries forward to subsequent years for Country X purposes and is available to offset income of DE1 X , there would be a foreign use of the dual consolidated loss immediately after the sale pursuant to § 1.1503(d)-3(a)(1). This is the case because the dual consolidated loss would be available to offset or reduce income that is considered, under U.S. tax principles, to be an item of FS X , a foreign corporation (it would also be a foreign use because FS X is an indirect owner of an interest in a hybrid entity that is not a separate unit). However, there is no foreign use in this case as a result of FS X 's 5 percent interest in DE1 X pursuant to § 1.1503(d)-3(c)(8).
(38) Example 38. Character and source of recapture income —(i) Facts. (A) P owns FB X . In year 1, the items of income, gain, deduction, and loss that are attributable to FB X for purposes of determining whether it has a dual consolidated loss are as follows:
Table 2 to paragraph (c)(38)(i)(A)
(B) P makes a domestic use election with respect to the year 1 dual consolidated loss attributable to FB X and, thus, the $25x dual consolidated loss is used to offset the P group's consolidated taxable income.
(C) Pursuant to § 1.861-8, the $75x of salary expense incurred by FB X is allocated and apportioned entirely to foreign source general limitation income. Pursuant to § 1.861-9T, $25x of the $50x interest expense attributable to FB X is allocated and apportioned to domestic source income, $15x of such interest expense is allocated and apportioned to foreign source general limitation income, and the remaining $10x of such interest expense is allocated and apportioned to foreign source passive income.
(D) During year 2, $5x of income is attributable to FB X under the rules of § 1.1503(d)-5, and the P consolidated group has $100x of consolidated taxable income. At the end of year 2, FB X undergoes a triggering event described in § 1.1503(d)-6(e)(1), and P continues to own FB X following the triggering event. Pursuant to § 1.1503(d)-6(h)(2)(i), P is able to demonstrate to the satisfaction of the Commissioner that the $25x dual consolidated loss attributable to FB X in year 1 would have offset the $5x of income attributable to FB X in year 2, if no domestic use election were made with respect to the year 1 loss such that it was subject to the limitations of § 1.1503(d)-4(b) and (c).
(ii) Result. P must recapture and report as ordinary income $20x ($25x − $5x) of FB X 's year 1 dual consolidated loss, plus applicable interest. The $20x recapture income is attributable to FB X pursuant to § 1.1503(d)-5(c)(4)(vi). Pursuant to § 1.1503(d)-6(h)(5), the recapture income is treated as ordinary income whose source and character (including section 904 separate limitation character) is determined by reference to the manner in which the recaptured items of expense or loss taken into account in calculating the dual consolidated loss were allocated and apportioned. Further, pursuant to § 1.1503(d)-6(h)(5), the pro rata computation described in § 1.1503(d)-4(c)(4) shall apply. Thus, the character and source of the recapture income is determined in the same proportion as each item of deduction or loss that contributed to the dual consolidated loss being recaptured. Accordingly, P's $20x of recapture income is characterized and sourced as follows: $4x of domestic source income (($25x/$125x) × $20x); $14.4x of foreign source general limitation income (($75x + $15x)/$125x) × $20x); and $1.6x of foreign source passive income (($10x/$125x) × $20x). Pursuant to § 1.1503(d)-6(h)(6)(i), commencing in year 3, the $20x recapture amount is reconstituted and treated as a net operating loss incurred by FB X in a separate return limitation year, subject to the limitation under § 1.1503(d)-4(b) (and therefore subject to the restrictions of § 1.1503(d)-4(c)). Pursuant to § 1.1503(d)-6(j)(1)(iii), the domestic use agreement filed by the P consolidated group with respect to the year 1 dual consolidated loss of FB X is terminated and has no further effect.
(39) Example 39. Interest charge without recapture —(i) Facts. P owns DE1 X which, in turn, owns FB X . P's interest in DE1 X and its indirect interest in FB X are combined and treated as a single separate unit (Country X separate unit) pursuant to § 1.1503(d)-1(b)(4)(ii). In year 1, a dual consolidated loss of $100x is attributable to P's Country X separate unit. P makes a domestic use election with respect to such loss and uses the loss to offset the P group's consolidated taxable income. In year 2, there is $100x of income attributable to P's Country X separate unit and the P consolidated group has $200x of consolidated taxable income. At the end of year 2, the Country X separate unit undergoes a triggering event within the meaning of § 1.1503(d)-6(e)(1). P demonstrates, to the satisfaction of the Commissioner, that if no domestic use election were made with respect to the year 1 dual consolidated loss such that it was subject to the limitations of § 1.1503(d)-4(b) and (c), the year 1 $100x dual consolidated loss would have been offset by the $100x of year 2 income.
(ii) Result. There is no recapture of the year 1 dual consolidated loss attributable to P's Country X separate unit because it is reduced to zero under § 1.1503(d)-6(h)(2)(i). However, P is liable for one year of interest charge under § 1.1503(d)-6(h)(1)(ii), even though P's recapture amount is zero. This is the case because the P consolidated group had the benefit of the dual consolidated loss in year 1, and the income that offset the recapture income was not recognized until year 2. Pursuant to § 1.1503(d)-6(j)(1)(iii), the domestic use agreement filed by the P consolidated group with respect to the year 1 dual consolidated loss is terminated and has no further effect.
(40) Example 40. Reduced recapture and interest charge, and reconstituted dual consolidated loss —(i) Facts. S owns DE1 X which, in turn, owns FB X . S's interest in DE1 X and its indirect interest in FB X are combined and treated as a single separate unit (Country X separate unit) pursuant to § 1.1503(d)-1(b)(4)(ii). In year 1, there is a $100x dual consolidated loss attributable to S's Country X separate unit, and P earns $100x. P makes a domestic use election with respect to the Country X separate unit's year 1 dual consolidated loss. Therefore, the consolidated group is permitted to offset P's $100x of income with the Country X separate unit's $100x dual consolidated loss. In year 2, $30x of income is attributable to the Country X separate unit under the rules of § 1.1503(d)-5 and such income is offset by a $30x net operating loss incurred by P in such year. In year 3, $25x of income is attributable to the Country X separate unit under the rules of § 1.1503(d)-5, and P earns $15x of income. In addition, at the end of year 3 there is a foreign use of the year 1 dual consolidated loss that constitutes a triggering event. S continues to own the Country X separate unit after the triggering event.
(ii) Result. (A) Under the presumptive rule of § 1.1503(d)-6(h)(1)(i), S must recapture $100x (plus applicable interest). However, under § 1.1503(d)-6(h)(2)(i), S may be able to demonstrate that a lesser amount is subject to recapture. The lesser amount is the amount of the $100x dual consolidated loss that would have remained subject to § 1.1503(d)-4(c) at the time of the foreign use triggering event if a domestic use election had not been made for such loss.
(B) Although the combined separate unit earned $30x of income in year 2, there was no consolidated taxable income in such year. As a result, as of the end of year 2 the $100x dual consolidated loss would continue to be subject to § 1.1503(d)-4(c) if a domestic use election had not been made for such loss. However, the $30x earned in year 2 can be carried forward to subsequent taxable years and may reduce the recapture income to the extent of consolidated taxable income generated in subsequent years. In year 3, $25x of income was attributable to the Country X separate unit and P earns $15x of income. Thus, the P consolidated group has $40x of consolidated taxable income in year 3. As a result, the $100x of recapture income can be reduced by $40x. This is the case because if a domestic use election had not been made for the $100x year 1 dual consolidated loss such that it was subject to the limitations of § 1.1503(d)-4(b) and (c), only $60x of the loss would have remained subject to such limitations at the time of the foreign use triggering event. Accordingly, if S can adequately document the lesser amount, the amount of recapture income is $60x ($100x − $40x). The $60x recapture income is attributable to the Country X separate unit pursuant to § 1.1503(d)-5(c)(4)(vi).
(C) Pursuant to § 1.1503(d)-6(h)(6)(i), commencing in year 4, the $60x recapture amount is reconstituted and treated as a net operating loss incurred by the Country X separate unit of S in a separate return limitation year, subject to the limitation under § 1.1503(d)-4(b) (and therefore subject to the restrictions of § 1.1503(d)-4(c)). The loss is only available for carryover to taxable years after year 3 (and is not available for carryback). The carryover period of the loss, for purposes of section 172(b), will start from year 1, when the dual consolidated loss that was subject to recapture was incurred. In addition, such reconstituted net operating loss is not eligible for the exceptions contained in § 1.1503(d)-6(b) through (d). Pursuant to § 1.1503(d)-6(j)(1)(iii), the domestic use agreement filed by the P consolidated group with respect to the year 1 dual consolidated loss of the Country X separate unit is terminated and has no further effect.
(iii) Alternative facts. The facts are the same as in paragraph (c)(40)(i) of this section, except that the triggering event that occurs at the end of year 3 is a sale by S of its entire interest in DE1 X to B, an unrelated domestic corporation. The sale does not qualify as a transaction described in section 381. The results are the same as in paragraph (c)(40)(ii) of this section, except that pursuant to § 1.1503(d)-6(h)(6)(ii) the $60x net operating loss is not reconstituted (with respect to either S or B). The loss is not reconstituted with respect to S because the Country X separate unit ceases to be a separate unit of S (or any other member of the consolidated group that includes S) and therefore would have been eliminated pursuant to § 1.1503(d)-4(d)(1)(ii) if no domestic use election had been made with respect to such loss. The loss is not reconstituted with respect to B because B was not the domestic owner of the combined separate unit when the dual consolidated loss that is recaptured was incurred, and B did not acquire the Country X separate unit in a section 381 transaction.
(41) Example 41. Domestic consenting corporation—treated as dual resident corporation —(i) Facts. FSZ1, a Country Z entity that is subject to Country Z tax on its worldwide income or on a residence basis and is classified as a foreign corporation for U.S. tax purposes, owns all the interests in DCC, a domestic eligible entity that has filed an election to be classified as an association. Under Country Z tax law, DCC is fiscally transparent. For taxable year 1, DCC's only item of income, gain, deduction, or loss is a $100x deduction and such deduction comprises a $100x net operating loss of DCC. For Country Z tax purposes, FSZ1's only item of income, gain, deduction, or loss, other than the $100x loss attributable to DCC, is $60x of operating income.
(ii) Result. DCC is a domestic consenting corporation because by electing to be classified as an association, it consents to be treated as a dual resident corporation for purposes of section 1503(d). See § 301.7701-3(c)(3) of this chapter. For taxable year 1, DCC is treated as a dual resident corporation under § 1.1503(d)-1(b)(2)(iii) because FSZ1 (a specified foreign tax resident that bears a relationship to DCC that is described in section 267(b) or 707(b)) derives or incurs items of income, gain, deduction, or loss of DCC. See § 1.1503(d)-1(c). FSZ1 derives or incurs items of income, gain, deduction, or loss of DCC because, under Country Z tax law, DCC is fiscally transparent. Thus, DCC has a $100x dual consolidated loss for taxable year 1. See § 1.1503(d)-1(b)(5). Because the loss is available to, and in fact does, offset income of FSZ1 under Country Z tax law, there is a foreign use of the dual consolidated loss in year 1. Accordingly, the dual consolidated loss is subject to the domestic use limitation rule of § 1.1503(d)-4(b). The result would be the same if FSZ1 were to indirectly own its DCC stock through an intermediate entity that is fiscally transparent under Country Z tax law, or if an individual were to wholly own FSZ1 and FSZ1 were a disregarded entity. In addition, the result would be the same if FSZ1 had no items of income, gain, deduction, or loss, other than the $100x loss attributable to DCC.
(iii) Alternative facts—DCC not treated as a dual resident corporation. The facts are the same as in paragraph (c)(41)(i) of this section, except that DCC is not fiscally transparent under Country Z tax law and thus under Country Z tax law FSZ1 does not derive or incur items of income, gain, deduction, or loss of DCC. Accordingly, DCC is not treated as a dual resident corporation under § 1.1503(d)-1(b)(2)(iii) for year 1 and, consequently, its $100x net operating loss in that year is not a dual consolidated loss.
(iv) Alternative facts—mirror legislation. The facts are the same as in paragraph (c)(41)(i) of this section, except that, under provisions of Country Z tax law that constitute mirror legislation under § 1.1503(d)-3(e)(1) and that are substantially similar to the recommendations in Chapter 6 of OECD/G-20, Neutralising the Effects of Hybrid Mismatch Arrangements, Action 2: 2015 Final Report (October 2015), Country Z tax law prohibits the $100x loss attributable to DCC from offsetting FSZ1's income that is not also subject to U.S. tax. As is the case in paragraph (c)(41)(ii) of this section, DCC is treated as a dual resident corporation under § 1.1503(d)-1(b)(2)(iii) for year 1 and its $100x net operating loss is a dual consolidated loss. Pursuant to § 1.1503(d)-3(e)(3), however, the dual consolidated loss is not deemed to be put to a foreign use by virtue of the Country Z mirror legislation. Therefore, DCC is eligible to make a domestic use election for the dual consolidated loss.
(42) Example 42. Disregarded payment loss rules—triggering event resulting in DPL inclusion amount and suspended deduction —(i) Facts. P owns DE1X, and DE1X owns FSX. In year 1, DE1X pays $100x to P pursuant to a note. For U.S. tax purposes, the payment is disregarded as a transaction between DE1X and P, but if the payment were regarded it would be interest within the meaning of § 1.267A-5(a)(12). Under Country X tax law, the $100x is interest for which DE1X is allowed a deduction in year 1. In year 1, pursuant to a Country X group relief regime, DE1X's $100x deduction is made available to offset income of FSX. At the end of year 1, DE1X extinguishes the note by repaying the outstanding principal. In year 2, P enters into a licensing arrangement with DE1X pursuant to which P makes a $60x payment to DE1X in each of years 2 and 3. For U.S. tax purposes, the payment is disregarded as a transaction between DE1X and P, but if the payment were regarded it would be a royalty within the meaning of § 1.267A-5(a)(16). Under Country X tax law, the $60x is a royalty and included in the income of DE1X in years 2 and 3.
(ii) Result. —(A) Year 1. Because P owns all of the interests in DE1X, a disregarded entity, P is a DPE owner. See § 1.1503(d)-1(d)(1). In addition, DE1X, a disregarded payment entity with respect to P, incurs a $100x disregarded payment loss with respect to its Country X taxable year for year 1. See § 1.1503(d)-1(d)(5)(i)(A) and (d)(5)(ii)(B). DE1X's $100x deduction being made available to offset income of FSX pursuant to the Country X group relief regime constitutes a foreign use of, and thus a triggering event with respect to, the disregarded payment loss during the DPL certification period. See § 1.1503(d)-1(d)(3)(i) and (d)(5)(iii). As a result, in year 1, P must include in gross income $100x, the DPL inclusion amount with respect to the disregarded payment loss. See § 1.1503(d)-1(d)(1) and (d)(2)(i). The $100x DPL inclusion amount is treated for U.S. tax purposes as ordinary interest income, the source and character of which is determined as if DE1X were a foreign corporation, and the amount were interest income paid by the foreign corporation to P. See § 1.1503(d)-1(d)(2)(iv)(A). The result would be the same if DE1X recognized income in year 1 that was regarded for both U.S. and Country X tax purposes, or if P made payments (other than interest, structured payments, or royalties) to DE1X that were disregarded for U.S. tax purposes but regarded for Country X tax purposes. See § 1.1503(d)-1(d)(3)(i) (describing the application of the principles of the deemed ordering rule in § 1.1503(d)-3(c)(3)).
(B) Years 2 and 3. In year 2, P establishes a suspended deduction of $100x related to the year 1 DPL inclusion amount. See § 1.1503(d)-1(d)(1) and (d)(2)(ii). In each of years 2 and 3, DE1X derives $60x of disregarded payment income with respect to its Country X taxable year. See § 1.1503(d)-1(d)(5)(ii)(A). For year 2, P is allowed a $60x deduction with respect to the suspended deduction, and $40x remains suspended. See § 1.1503(d)-1(d)(2)(ii). For year 3, P is allowed a $40x deduction with respect to the suspended deduction. See id. Thus, in years 2 and 3 P is allowed a $60x deduction and $40x deduction, respectively, with respect to the suspended deduction relating to the year 1 DPL inclusion amount. The deductions are treated as interest deductions the source and character of which are determined in the same manner as the income for the DPL inclusion amount to which they relate. See § 1.1503(d)-1(d)(2)(iv)(B). At the end of year 3, the DPL cumulative register is $20x (that is, the $120x of disregarded payment income for years 2 and 3, less the $100 of DPL cumulative register that is used under § 1.1503(d)-1(d)(2)(ii) in years 2 and 3). See § 1.1503(d)-1(d)(2)(iii).
(43) Example 43. Income from U.S. business operations to avoid the purposes of the dual consolidated loss rules —(i) Facts. P owns DE1X. DE1X owns FSX. DE1X and FSX file a consolidated tax return for Country X tax purposes such that deductions and losses of DE1X are available to offset income of FSX. P conducts business operations in the United States that are expected to generate items of income or gain (U.S. business operations). With a view to avoid the purposes of the rules under §§ 1.1503(d)-1 through 1.1503(d)-8 by eliminating what would otherwise be a dual consolidated loss and obtaining a double deduction outcome, P transfers the U.S. business operations to DE1X. But for P's items of income or gain from the U.S. business operations (held indirectly through DE1X), there would be a dual consolidated loss attributable to P's interest in DE1X and a foreign use of that dual consolidated loss (as a result of the Country X consolidation regime). For purposes of determining taxable income under the income tax laws of Country X, items of income, gain, deduction, and loss attributable to a permanent establishment (or similar taxable presence) in another country, which would include the U.S. business operations, are not taken into account.
(ii) Result. Because P transferred the U.S. business operations to DE1X with a view to avoid the purposes of the rules under §§ 1.1503(d)-1 through 1.1503(d)-8, and the transfer would otherwise result in a double deduction outcome (that is, in effect putting DE1X's items of deduction or loss that would compose a dual consolidated loss to both a domestic use and a foreign use), the anti-avoidance rule in § 1.1503(d)-1(f)(1) applies. As a result, the income or gain that P takes into account from the U.S. business operations (held indirectly through DE1X) is not taken into account for purposes of determining the amount of income or dual consolidated loss attributable to P's interest in DE1X under § 1.1503(d)-5(c). The result would be the same if, instead of the income tax laws of Country X not taking into account the items of income, gain, deduction, and loss attributable to a permanent establishment (or similar taxable presence) in another country for purposes of determining taxable income, the income tax laws of Country X took such items into account for this purpose but provided a foreign tax credit with respect to taxes paid on the taxable income determined by taking such items into account.
(44) Example 44. Disallowed interest deductions —(i) Facts. P owns S. S owns DE1X, a disregarded entity and, thus, is a DPE owner. See § 1.1503(d)-1(d)(1). DE1X owns FSX. DE1X and FSX file a consolidated tax return for Country X tax purposes such that deductions and losses of DE1X are available to offset income of FSX. With a view to avoid the purposes of the rules under §§ 1.1503(d)-1 through 1.1503(d)-8, and obtain a double deduction or similar outcome, P transfers cash to DE1X in exchange for an interest-bearing note. Under the terms of the note, payments of interest are made in cash or, at the option of DE1X, in stock of S. In year 1, DE1X accrues $100x of interest expense under the note. The taxpayer takes the position that for U.S. tax purposes, the interest expense deductions are disallowed under section 163(l) because DE1X has the option to pay the interest with S stock. Further, because S's interest expense deductions on the note held by P are disallowed, the taxpayer takes the position that P's interest income on the loan is treated as tax-exempt income under the intercompany transaction rules in § 1.1502-13. In year 1, DE1X is allowed a $100x interest expense deduction for Country X tax purposes; the $100x deduction is available to offset FSX's income for Country X tax purposes.
(ii) Result. DE1X issued the note to P in exchange for cash with a view to avoid the purposes of §§ 1.1503(d)-1 through 1.1503(d)-8. Moreover, under the taxpayer's position, the issuance would otherwise result in a double deduction or similar outcome (that is, a foreign use of DE1X's $100x interest expense deduction where P does not recognize a corresponding income inclusion for U.S. tax purposes). Accordingly, the anti-avoidance rule in § 1.1503(d)-1(f)(1) applies. As a result, adjustments are made such that the $100x interest expense deduction is treated as a disregarded payment loss of DE1X, a disregarded payment entity. This is the case even though the $100x interest payment is not disregarded for U.S. tax purposes as a transaction between a disregarded entity and its tax owner or between disregarded entities with the same tax owner under § 1.1503(d)-1(d)(5)(ii)(C)( 2 ). Because the $100x disregarded payment loss is made available under the Country X consolidation regime to offset income of FSX, a foreign corporation, a foreign use triggering event (within the meaning of § 1.1503(d)-1(d)(3)(i)) occurs. As a result, S includes in income a $100x DPL inclusion amount in year 1 and establishes a suspended deduction of $100x in year 2. See § 1.1503(d)-1(d)(1), (d)(2)(i), and (d)(2)(ii).
(45) Example 45. Restructuring to avoid the application of the DPL rules —(i) Facts. P owns DE1X and S. DE1X owns FSX. DE1X and FSX file a consolidated tax return for Country X tax purposes such that deductions and losses of DE1X are available to offset income of FSX. P holds an interest-bearing note issued by DE1X. For U.S. tax purposes, interest accrued and paid on the note is disregarded. For Country X tax purposes, DE1X is allowed a $100x interest expense deduction each year for interest accrued under the note. At the end of year 1, and with a view to avoid the application of the disregarded payment loss rules under § 1.1503(d)-1(d) in year 2, P transfers the note to S. In year 2, DE1X is allowed a $100x interest expense deduction for Country X tax purposes. For U.S. tax purposes, the $100x interest expense deduction in year 2 gives rise to a dual consolidated loss attributable to P's interest in DE1X, a hybrid entity separate unit, and that loss is subject to the domestic use limitation rule of § 1.1503(d)-4(b).
(ii) Result. Although P transferred the note to S with a view to avoid the application of the disregarded payment loss rules under § 1.1503(d)-1(d), the anti-avoidance rule in § 1.1503(d)-1(f)(1) does not apply with respect to the transfer. This is because the resulting year 2 $100x dual consolidated loss is subject to the domestic use limitation rule of § 1.1503(d)-4(b) (or the terms of a domestic use agreement, if a domestic use election were to be made) and thus cannot be put to both a domestic use and a foreign use (that is, it does not result in a double deduction or similar outcome). The same result would obtain if, instead of P transferring the note to S at the end of year 1, DE1X extinguished the note at the end of year 1 such that there are no disregarded payments in year 2 and, thus, no double non-taxation outcome.
(iii) Alternative facts. The facts are the same as in paragraph (c)(45)(i) of this section, except that P does not transfer the note to S in year 1. Instead, with a view to prevent a foreign use of a disregarded payment loss attributable to DE1X, at the end of year 1 FSX distributes all its property to DE1X in a complete liquidation described in section 332. The anti-avoidance rule in § 1.1503(d)-1(f)(1) does not apply because the disregarded payment loss is not put to a foreign use (that is, there is no double deduction or similar outcome).
(46) Example 46. Disregarded payment loss rules—scope —(i) Facts. P owns DE1X. DE1X owns FBZ. FBZ is a foreign branch, within the meaning of § 1.1503(d)-1(d)(5)(iv), located in Country Z. DE1X makes a $10x payment to P, which, under the laws of Country Z, gives rise to a $10x deduction allowable to FBZ. If such payment were regarded for U.S. tax purposes, it would be interest within the meaning of § 1.267A-5(a)(12). In addition, under the laws of Country Z, FBZ is allowed a $60x interest deduction for an accrual or other transaction between FBZ and DE1X, and if such item were regarded for U.S. tax purposes, it would be interest within the meaning of § 1.267A-5(a)(12).
(ii) Result. P is a DPE owner because it owns DE1X, a disregarded entity. See § 1.1503(d)-1(d)(1). As such, P determines disregarded payment income or disregarded payment loss of DE1X, a disregarded payment entity described in § 1.1503(d)-1(d)(5)(i)(A), and of FBZ, a disregarded payment entity described in § 1.1503(d)-1(d)(5)(i)(B). See § 1.1503(d)-1(d)(1). The payment from DE1X to P is disregarded for U.S. tax purposes as a transaction between a disregarded entity (DE1X) and its tax owner (P) and therefore satisfies the condition in § 1.1503(d)-1(d)(5)(ii)(C)( 2 ). The payment also satisfies the conditions described in § 1.1503(d)-1(d)(5)(ii)(C)( 1 ) and ( 3 ) because FBZ is allowed a deduction under Country Z law for a payment that, if regarded for U.S. tax purposes, would be interest within the meaning of § 1.267A-5(a)(12). As such, the $10x deduction attributable to the payment from DE1X to P is taken into account in determining whether FBZ has disregarded payment income or a disregarded payment loss under § 1.1503(d)-1(d)(5)(ii)(A) and (B), respectively. The $60x item of deduction allowed to FBZ, however, does not satisfy the condition described in § 1.1503(d)-1(d)(5)(ii)(C)( 2 ), because the accrual or other transaction giving rise to the deduction is not between a disregarded entity and its tax owner (here, P), or between disregarded entities with the same tax owner. Accordingly, the $60x item of deduction is not taken into account in determining whether FBZ has disregarded payment income or a disregarded payment loss. The result would be the same with respect to the $60x deduction allowed to FBZ under the laws of Country Z if, instead of P owning FBZ indirectly through DE1X, P owned FBZ directly and the accrual or other transaction giving rise to the deduction is between FBZ and P.
§ 1.1503(d)-8   Applicability dates.
(a) General rule. Except as provided in paragraph (b) of this section, this paragraph (a) provides the dates of applicability of §§ 1.1503(d)-1 through 1.1503(d)-7. Sections 1.1503(d)-1 through 1.1503(d)-7 apply to dual consolidated losses incurred in taxable years beginning on or after April 18, 2007. However, a taxpayer may apply §§ 1.1503(d)-1 through 1.1503(d)-7, in their entirety, to dual consolidated losses incurred in taxable years beginning on or after January 1, 2007, by filing its return and attaching to such return the domestic use agreements, certifications, or other information in accordance with these regulations. For purposes of this section, the term application date means either April 18, 2007, or, if the taxpayer applies these regulations pursuant to the preceding sentence, January 1, 2007. Section 1.1503-2, as contained in 26 CFR part 1, revised as of April 1, 2024, applies for dual consolidated losses incurred in taxable years beginning on or after October 1, 1992, and before the application date.
(b) Special rules —
(1)-(2) [Reserved]
(3) Relief for untimely filings. Paragraphs (b)(3)(i) through (iii) of this section set forth the effective dates for rules that provide relief for the failure to make timely filings of an election, agreement, statement, rebuttal, computation, closing agreement, or other information, pursuant to section 1503(d) and these regulations.
(i) General rule. Except as provided in paragraphs (b)(3)(ii) and (iii) of this section, the reasonable cause relief standard of § 1.1503(d)-1(d) applies for all untimely filings with respect to dual consolidated losses, including with respect to dual consolidated losses incurred in taxable years beginning before the application date.
(ii)-(iii) [Reserved]
(4) [Reserved]
(5) Basis adjustment rules. Taxpayers may apply the basis adjustment rules of § 1.1503(d)-5(g) for all open years in which such basis is relevant, even if the basis adjustment is attributable to a dual consolidated loss incurred (or recaptured) in a closed taxable year. Taxpayers applying the provisions of § 1.1503(d)-5(g), however, must do so consistently for all open years.
(6) Rules regarding domestic consenting corporations. Section 1.1503(d)-1(b)(2)(iii) and (c), as well § 1.1503(d)-3(e)(1) and (3), apply to determinations under §§ 1.1503(d)-1 through 1.1503(d)-7 relating to taxable years ending on or after December 20, 2018. For taxable years ending before December 20, 2018, see § 1.1503(d)-3(e)(1) as contained in 26 CFR part 1 revised as of April 1, 2018.
(7) Compulsory transfer triggering event exception. Section 1.1503(d)-6(f)(5)(i) through (iii) applies to transfers that occur on or after December 20, 2018. For transfers occurring before December 20, 2018, see § 1.1503(d)-6(f)(5)(i) through (iii) as contained in 26 CFR part 1 revised as of April 1, 2018. However, taxpayers may consistently apply § 1.1503(d)-6(f)(5)(i) through (iii) to transfers occurring before December 20, 2018.
(8) Rule providing that SRLY limitation applies without regard to § 1.1502-21(c)(1)(i)(E). Section 1.1503(d)-4(c)(3)(v) applies to any period to which § 1.1502-21(c)(1)(i)(E) applies.
(9)-(10) [Reserved]
(11) Disregarded payment loss rules. Section 1.1503(d)-1(d) applies to taxable years beginning on or after January 1, 2026. See also § 301.7701-2(e)(10) of this chapter (applicability dates for the entity classification provisions relevant to the disregarded payment loss rules).
(12)-(14) [Reserved]
(15) Anti-avoidance rule. Section 1.1503(d)-1(f) applies to dual consolidated losses incurred in taxable years ending on or after August 6, 2024, and to disregarded payment losses in taxable years beginning on or after January 1, 2026.
(16) [Reserved].
(17) Deemed ordering rule. Section 1.1503(d)-3(c)(3) applies to dual consolidated losses incurred in taxable years beginning on or after January 1, 2026, and to disregarded payment losses in taxable years beginning on or after January 1, 2026. For the application of the deemed ordering rule to dual consolidated losses incurred in taxable years beginning before January 1, 2026, but on or after April 18, 2007, see § 1.1503(d)-3(c)(3) as contained in 26 CFR part 1 revised as of April 1, 2024.
§ 1.1504-0   Outline of provisions.
In order to facilitate the use of §§ 1.1504-1 through 1.1504-4, this section lists the captions contained in §§ 1.1504-1 through 1.1504-4.
(a) Introduction.
(1) General rule.
(2) Exceptions.
(b) Options not treated as stock or as exercised.
(1) General rule.
(2) Options treated as exercised.
(i) In general.
(ii) Aggregation of options.
(iii) Effect of treating option as exercised.
(A) In general.
(B) Cash settlement options, phantom stock, stock appreciation rights, or similar interests.
(iv) Valuation.
(3) Example.
(c) Definitions.
(1) Issuing corporation.
(2) Related or sequential option.
(3) Related persons.
(4) Measurement date.
(i) General rule.
(ii) Issuances, transfers, or adjustments not treated as measurement dates.
(iii) Transactions increasing likelihood of exercise.
(iv) Measurement date for options issued pursuant to a plan.
(v) Measurement date for related or sequential options.
(vi) Example.
(5) In-the-money.
(d) Options.
(1) Instruments treated as options.
(2) Instruments generally not treated as options.
(i) Options on section 1504(a)(4) stock.
(ii) Certain publicly traded options.
(A) General rule.
(B) Exception.
(iii) Stock purchase agreements.
(iv) Escrow, pledge, or other security agreements.
(v) Compensatory options.
(A) General rule.
(B) Exceptions.
(vi) Options granted in connection with a loan.
(vii) Options created pursuant to a title 11 or similar case.
(viii) Convertible preferred stock.
(ix) Other enumerated instruments.
(e) Elimination of federal income tax liability.
(f) Substantial amount of federal income tax liability.
(g) Reasonable certainty of exercise.
(1) Generally.
(i) Purchase price.
(ii) In-the-money option.
(iii) Not in-the-money option.
(iv) Exercise price.
(v) Time of exercise.
(vi) Related or sequential options.
(vii) Stockholder rights.
(viii) Restrictive covenants.
(ix) Intention to alter value.
(x) Contingencies.
(2) Cash settlement options, phantom stock, stock appreciation rights, or similar interests.
(3) Safe harbors.
(i) Options to acquire stock.
(ii) Options to sell stock.
(iii) Options exercisable at fair market value.
(iv) Exceptions.
(v) Failure to satisfy safe harbor.
(h) Examples.
(i) Effective date.
§ 1.1504-1   Definitions.
The privilege of filing consolidated returns is extended to all includible corporations constituting affiliated groups as defined in section 1504. See the regulations under § 1.1502 for a description of an affiliated group and the corporations which may be considered as includible corporations.
§ 1.1504-2   [Reserved]
§ 1.1504-3   Treatment of stock in a QOF C corporation for purposes of consolidation.
(a) Scope and definitions —(1) Scope. This section provides rules regarding the treatment of stock in a QOF C corporation for purposes of determining whether such corporation can join in the filing of a consolidated return. Paragraph (b) of this section generally prevents a subsidiary QOF C corporation from joining in the filing of a consolidated return, but it provides an election to consolidate a subsidiary QOF C corporation (subject to certain conditions). Paragraph (c) of this section provides instructions for making the election provided by paragraph (b) of this section. Paragraph (d) of this section provides an example. Paragraph (e) of this section provides the applicability dates.
(2) Definitions. The definitions provided in §§ 1.1400Z2(a)-1(b) and 1.1502-14Z(a)(2)(ii) apply for purposes of this section.
(b) QOF stock not stock for purposes of consolidation —(1) In general. Except as otherwise provided in paragraph (b)(2) of this section, stock in a QOF C corporation (whether qualifying QOF stock or otherwise) is not treated as stock under section 1504 for purposes of determining whether any corporation may join in the filing of a consolidated return under section 1501. Therefore, a QOF C corporation can be the common parent of a consolidated group, and a QOF C corporation generally can be a member of an affiliated group for purposes of section 1504, but a QOF C corporation cannot join in the filing of a consolidated return as a subsidiary member (except as provided in paragraph (b)(2) of this section).
(2) Election to consolidate a subsidiary QOF C corporation —(i) In general. Notwithstanding paragraph (b)(1) of this section, a consolidated group may elect to consolidate a subsidiary QOF C corporation that was formed, or section 1504 control of which was acquired, by the consolidated group after May 1, 2019, and that otherwise meets the affiliation requirements under section 1504. If a pre-existing corporation was a member of the consolidated group prior to becoming a QOF C corporation, a consolidated group may elect to continue to consolidate such pre-existing corporation if it self-certified to be a QOF after May 1, 2019. The consolidated group must make the election under this paragraph (b)(2) with regard to the first taxable year during which the subsidiary QOF C corporation otherwise meets the section 1504 affiliation requirements (without regard to paragraph (b)(1) of this section). See § 1.1502-14Z(f)(3) for an election available with regard to a subsidiary QOF C corporation that met the section 1504 affiliation requirements as of May 1, 2019. The election under this paragraph (b)(2) is effective on the later of May 1, 2019, or the first date on which the QOF C corporation otherwise meets the requirements of section 1504. If a consolidated group makes the election under this paragraph (b)(2), then the conditions in paragraph (b)(2)(ii) of this section apply to the consolidated group and to the QOF member. See paragraph (c) of this section for the form and manner of making this election.
(ii) Conditions to consolidate a subsidiary QOF C corporation —(A) Ownership status of QOF investor member. On and at all times after the date of the investment, the common parent must directly or indirectly own all shares of all classes of stock (including non-qualified preferred stock) issued by any QOF investor member.
(B) Direct investment. Except as provided in § 1.1502-14Z(c), each QOF investor member must maintain direct ownership of its qualifying investment (see, for example, § 1.1400Z2(b)-1(c), which generally treats transfers of a qualifying investment as an inclusion event). See § 1.1502-14Z(c)(4) for rules regarding the treatment of intercompany transfers as qualifying investments in a QOF member. See also § 1.1502-14Z(c)(2) and (c)(3)(ii) for rules regarding actual and deemed intercompany transfers of qualifying investments.
(3) Failure of continued qualification. Consolidation of a subsidiary QOF C corporation is contingent upon continued satisfaction of all of the conditions of paragraph (b)(2)(ii) of this section. The requirements of paragraph (b)(2) of this section continue to apply (with appropriate modifications to reflect single-entity treatment) following any intercompany transfer of the QOF member stock that is subject to § 1.1502-14Z(c)(3)(ii). For example, following an intercompany transfer of the QOF member stock that is subject to § 1.1502-14Z(c)(3)(ii), the buying member must maintain a direct investment in the QOF member. On the failure to satisfy any condition of paragraph (b)(2), the QOF member will deconsolidate, and § 1.1502-14Z(g) will apply with respect to such deconsolidation.
(c) Election under paragraph (b)(2) of this section to consolidate a subsidiary QOF C corporation —(1) In general. The election under paragraph (b)(2) of this section is irrevocable and is made in the form provided in paragraph (c)(2) of this section.
(2) Form of election. The election under paragraph (b)(2) of this section must be made in the form of a statement titled “THIS IS AN ELECTION UNDER § 1.1504-3(b)(2) TO CONSOLIDATE [insert name and employer identification number (E.I.N.) of subsidiary QOF C corporation] as of [insert date].” The statement must be included with the consolidated group's timely filed return (original, superseding, or amended return, as applicable, including extensions) for the year the election under § 1.1504-3(b)(2) is made.
(d) Example. The following example illustrates the treatment of QOF stock as not stock for purposes of affiliation as described in paragraph (b)(1) of this section.
(1) QOF stock as not stock for purposes of affiliation to join in the filing of a consolidated return —(i) Facts. P wholly owns S, which wholly owns corporation Q1. P, S, and Q1 are members of the P group. In 2021, S sells an asset to an unrelated party and realizes $500x of eligible gain. S contributes $500x to Q1 and properly elects to defer the eligible gain under section 1400Z-2(a) and § 1.1400Z2(a)-1. At such time, Q1 qualifies and elects to be treated as a QOF, but the P group does not elect to consolidate Q1 under paragraph (b)(2) of this section.
(ii) Analysis. Under paragraph (b)(1) of this section, stock of a QOF C corporation (qualifying or otherwise) is not treated as stock for purposes of determining whether the QOF C corporation may join in the filing of a consolidated return. Thus, because no election has been made under paragraph (b)(2) of this section, once Q1 becomes a QOF, Q1 ceases to be affiliated with the P group members for purposes of section 1501, and it deconsolidates from the P group. See the consolidated return regulations generally for the consequences of deconsolidation.
(2) [Reserved]
(e) Applicability dates —(1) In general. This section applies for taxable years beginning after March 13, 2020.
(2) Prior periods. With respect to the portion of a consolidated group's first taxable year ending after December 21, 2017, and for taxable years beginning after December 21, 2017, and on or before March 13, 2020, a consolidated group may choose either—
(i) To apply the section 1400Z-2 regulations, if applied in a consistent manner for all such taxable years; or
(ii) To rely on the rules in proposed § 1.1400Z2(g)-1 contained in the notice of proposed rulemaking (REG-120186-18) published on May 1, 2019, but only if applied in a consistent manner for all such taxable years.
§ 1.1504-4   Treatment of warrants, options, convertible obligations, and other similar interests.
(a) Introduction —(1) General rule. This section provides regulations under section 1504(a)(5) (A) and (B) regarding the circumstances in which warrants, options, obligations convertible into stock, and other similar interests are treated as exercised for purposes of determining whether a corporation is a member of an affiliated group. The fact that an instrument may be treated as an option under these regulations does not prevent such instrument from being treated as stock under general principles of law. Except as provided in paragraph (a)(2) of this section, this section applies to all provisions under the Internal Revenue Code and the regulations to which affiliation within the meaning of section 1504(a) (with or without the exceptions in section 1504(b)) is relevant, including those provisions that refer to section 1504(a)(2) (with or without the exceptions in section 1504(b)) without referring to affiliation, provided that the 80 percent voting power and 80 percent value requirements of section 1504(a)(2) are not modified therein.
(2) Exceptions. This section does not apply to sections 864(e) or 904(i) or to the regulations thereunder. This section also does not apply to any other provision specified by the Internal Revenue Service in regulations, a revenue ruling, or revenue procedure. See § 601.601(d)(2)(ii)( b ) of this chapter.
(b) Options not treated as stock or as exercised —(1) General rule. Except as provided in paragraph (b)(2) of this section, an option is not considered either as stock or as exercised. Thus, options are disregarded in determining whether a corporation is a member of an affiliated group unless they are described in paragraph (b)(2) of this section.
(2) Options treated as exercised —(i) In general. Solely for purposes of determining whether a corporation is a member of an affiliated group, an option is treated as exercised if, on a measurement date with respect to such option—
(A) It could reasonably be anticipated that, if not for this section, the issuance or transfer of the option in lieu of the issuance, redemption, or transfer of the underlying stock would result in the elimination of a substantial amount of federal income tax liability (as described in paragraphs (e) and (f) of this section); and
(B) It is reasonably certain that the option will be exercised (as described in paragraph (g) of this section).
(ii) Aggregation of options. All options with the same measurement date are aggregated in determining whether the issuance or transfer of an option in lieu of the issuance, redemption, or transfer of the underlying stock would result in the elimination of a substantial amount of federal income tax liability.
(iii) Effect of treating option as exercised —(A) In general. An option that is treated as exercised is treated as exercised for purposes of determining the percentage of the value of stock owned by the holder and other parties, but is not treated as exercised for purposes of determining the percentage of the voting power of stock owned by the holder and other parties.
(B) Cash settlement options, phantom stock, stock appreciation rights, or similar interests. If a cash settlement option, phantom stock, stock appreciation right, or similar interest is treated as exercised, the option is treated as having been converted into stock of the issuing corporation. If the amount to be received upon the exercise of such an option is determined by reference to a multiple of the increase in the value of a share of the issuing corporation's stock on the exercise date over the value of a share of the stock on the date the option is issued, the option is treated as converted into a corresponding number of shares of such stock. Appropriate adjustments must be made in any situation in which the amount to be received upon exercise of the option is determined in another manner.
(iv) Valuation. For purposes of section 1504(a)(2)(B) and this section, all shares of stock within a single class are considered to have the same value. Thus, control premiums and minority and blockage discounts within a single class are not taken into account.
(3) Example. The provisions of paragraph (b)(2) of this section may be illustrated by the following example:
(ii) If, under the provisions of this section, the option is treated as exercised, then, solely for purposes of determining affiliation, P is treated as owning only 20 percent of the value of the outstanding S stock and X is treated as owing the remaining 80 percent of the value of the S stock. P is still treated as owning all of the voting power of S. Accordingly, because P is treated as owning less than 80 percent of the value of the outstanding S stock, P and S are no longer affiliated. However, because X is not treated as owning any of the voting power of S, X and S are also not affiliated.
(c) Definitions. For purposes of this section—
(1) Issuing corporation. “Issuing corporation” means the corporation whose stock is subject to an option.
(2) Related or sequential option. “Related or sequential option” means an option that is one of a series of options issued to the same or related persons. For purposes of this section, any options issued to the same person or related persons within a two-year period are presumed to be part of a series of options. This presumption may be rebutted if the facts and circumstances clearly establish that the options are not part of a series of options. Any options issued to the same person or related persons more than two years apart are presumed not to be part of a series of options. This presumption may be rebutted if the facts and circumstances clearly establish that the options are part of a series of options.
(3) Related persons. Persons are related if they are related within the meaning of section 267(b) (without the application of sections 267(c) and 1563(e)(1)) or 707(b)(1), substituting “10 percent” for “50 percent” wherever it appears.
(4) Measurement date —(i) General rule. “Measurement date” means a date on which an option is issued or transferred or on which the terms of an existing option or the underlying stock are adjusted (including an adjustment pursuant to the terms of the option or the underlying stock).
(ii) Issuances, transfers, or adjustments not treated as measurement dates. A measurement date does not include a date on which—
(A) An option is issued or transferred by gift, at death, or between spouses or former spouses under section 1041;
(B) An option is issued or transferred—
( 1 ) Between members of an affiliated group (determined with the exceptions in section 1504(b) and without the application of this section); or
( 2 ) Between persons none of which is a member of the affiliated group (determined without the exceptions in section 1504(b) and without the application of this section), if any, of which the issuing corporation is a member, unless—
( i ) Any such person is related to (or acting in concert with) the issuing corporation or any member of its affiliated group; and
( ii ) The issuance or transfer is pursuant to a plan a principal purpose of which is to avoid the application of section 1504 and this section;
(C) An adjustment occurs in the terms or pursuant to the terms of an option or the underlying stock that does not materially increase the likelihood that the option will be exercised; or
(D) A change occurs in the exercise price of an option or in the number of shares that may be issued or transferred pursuant to the option as determined by a bona fide, reasonable, adjustment formula that has the effect of preventing dilution of the interests of the holders of the options.
(iii) Transactions increasing likelihood of exercise. If a change or alteration referred to in this paragraph (c)(4)(iii) is made for a principal purpose of increasing the likelihood that an option will be exercised, a measurement date also includes any date on which—
(A) The capital structure of the issuing corporation is changed; or
(B) The fair market value of the stock of the issuing corporation is altered through a transfer of assets to or from the issuing corporation (other than regular, ordinary dividends) or by any other means.
(iv) Measurement date for options issued pursuant to a plan. In the case of options issued pursuant to a plan, a measurement date for any of the options constitutes a measurement date for all options issued pursuant to the plan that are outstanding on the measurement date.
(v) Measurement date for related or sequential options. In the case of related or sequential options, a measurement date for any of the options constitutes a measurement date for all related or sequential options that are outstanding on the measurement date.
(vi) Example. The provisions of paragraph (c)(4)(v) of this section may be illustrated by the following example.
(ii) January 1, 1992, July 1, 1992, and January 1, 1993, constitute measurement dates for the first warrant, the second warrant, and the third warrant, respectively, because the warrants were issued on those dates.
(iii) Because the first and second warrants were issued within two years of each other, and both warrants were issued to U, the warrants constitute related or sequential options. Accordingly, July 1, 1992, constitutes a measurement date for the first warrant as well as for the second warrant.
(iv) Because the first, second, and third warrants were all issued within two years of each other, and were all issued to the same or related persons, the warrants constitute related or sequential options. Accordingly, January 1, 1993, constitutes a measurement date for the first and second warrants, as well as for the third warrant.
(5) In-the-money. “In-the-money” means the exercise price of the option is less than (or in the case of an option to sell stock, greater than) the fair market value of the underlying stock.
(d) Options —(1) Instruments treated as options. For purposes of this section, except to the extent otherwise provided in this paragraph (d), the following are treated as options:
(i) A call option, warrant, convertible obligation, put option, redemption agreement (including a right to cause the redemption of stock), or any other instrument that provides for the right to issue, redeem, or transfer stock (including an option on an option); and
(ii) A cash settlement option, phantom stock, stock appreciation right, or any other similar interest (except for stock).
(2) Instruments generally not treated as options. For purposes of this section, the following will not be treated as options:
(i) Options on section 1504(a)(4) stock. Options on stock described in section 1504(a)(4);
(ii) Certain publicly traded options —(A) General rule. Options which on the measurement date are traded on (or subject to the rules of) a qualified board or exchange as defined in section 1256(g)(7), or on any other exchange, board of trade, or market specified by the Internal Revenue Service in regulations, a revenue ruling, or revenue procedure. See § 601.601(d)(2)(ii)( b ) of this chapter;
(B) Exception. Paragraph (d)(2)(ii)(A) of this section does not apply to options issued, transferred, or listed with a principal purpose of avoiding the application of section 1504 and this section. For example, a principal purpose of avoiding the application of section 1504 and this section may exist if warrants, convertible or exchangeable debt instruments, or other similar instruments have an exercise price (or, in the case of convertible or exchangeable instruments, a conversion or exchange premium) that is materially less than, or a term that is materially longer than, those that are customary for publicly traded instruments of their type. A principal purpose may also exist if a large percentage of an issuance of an instrument is placed with one investor (or group of investors) and a very small percentage of the issuance is traded on a qualified board or exchange;
(iii) Stock purchase agreements. Stock purchase agreements or similar arrangements whose terms are commercially reasonable and in which the parties' obligations to complete the transaction are subject only to reasonable closing conditions;
(iv) Escrow, pledge, or other security agreements. Agreements for holding stock in escrow or under a pledge or other security agreement that are part of a typical commercial transaction and that are subject to customary commercial conditions;
(v) Compensatory options —(A) General rule. Stock appreciation rights, warrants, stock options, phantom stock, or other similar instruments provided to employees, directors, or independent contractors in connection with the performance of services for the corporation or a related corporation (and that is not excessive by reference to the services performed) and which—
( 1 ) Are nontransferable within the meaning of § 1.83-3(d); and
( 2 ) Do not have a readily ascertainable fair market value as defined in § 1.83-7(b) on the measurement date;
(B) Exceptions. ( 1 ) Paragraph (d)(2)(v)(A) of this section does not apply to options issued or transferred with a principal purpose of avoiding the application of section 1504 and this section; and
( 2 ) Paragraph (d)(2)(v)(A) of this section ceases to apply to options that become transferable;
(vi) Options granted in connection with a loan. Options granted in connection with a loan if the lender is actively and regularly engaged in the business of lending and the options are issued in connection with a loan to the issuing corporation that is commercially reasonable. This paragraph (d)(2)(vi) continues to apply if the option is transferred with the loan (or if a portion of the option is transferred with a corresponding portion of the loan). However, if the option is transferred without a corresponding portion of the loan, this paragraph (d)(2)(vi) ceases to apply;
(vii) Options created pursuant to a title 11 or similar case. Options created by the solicitation or receipt of acceptances to a plan of reorganization in a title 11 or similar case (within the meaning of section 368(a)(3)(A)), the option created by the confirmation of the plan, and any option created under the plan prior to the time the plan becomes effective;
(viii) Convertible preferred stock. Convertible preferred stock, provided the terms of the conversion feature do not permit or require the tender of any consideration other than the stock being converted; and
(ix) Other enumerated instruments. Any other instruments specified by the Internal Revenue Service in regulations, a revenue ruling, or revenue procedure. See § 601.601(d)(2)(ii)( b ) of this chapter.
(e) Elimination of federal income tax liability. For purposes of this section, the elimination of federal income tax liability includes the elimination or deferral of federal income tax liability. In determining whether there is an elimination of federal income tax liability, the tax consequences to all involved parties are considered. Examples of elimination of federal income tax liability include the use of a loss or deduction that would not otherwise be utilized, the acceleration of a loss or deduction to a year earlier than the year in which the loss or deduction would otherwise be utilized, the deferral of gain or income to a year later than the year in which the gain or income would otherwise be reported, and the acceleration of gain or income to a year earlier than the year in which the gain or income would otherwise be reported, if such gain or income is offset by a net operating loss or net capital loss that would otherwise expire unused. The elimination of federal income tax liability does not include the deferral of gain with respect to the stock subject to the option that would be recognized if such stock were sold on a measurement date.
(f) Substantial amount of federal income tax liability. The determination of what constitutes a substantial amount of federal income tax liability is based on all the facts and circumstances, including the absolute amount of the elimination, the amount of the elimination relative to overall tax liability, and the timing of items of income and deductions, taking into account present value concepts.
(g) Reasonable certainty of exercise —(1) Generally. The determination of whether, as of a measurement date, an option is reasonably certain to be exercised is based on all the facts and circumstances, including:
(i) Purchase price. The purchase price of the option in absolute terms and in relation to the fair market value of the stock or the exercise price of the option;
(ii) In-the-money option. Whether and to what extent the option is in-the-money on the measurement date;
(iii) Not in-the-money option. If the option is not in-the-money on the measurement date, the amount or percentage by which the exercise price of the option is greater than (or in the case of an option to sell stock, is less than) the fair market value of the underlying stock;
(iv) Exercise price. Whether the exercise price of the option is fixed or fluctuates depending on the earnings, value, or other indication of economic performance of the issuing corporation;
(v) Time of exercise. The time at which, or the period of time during which, the option can be exercised;
(vi) Related or sequential options. Whether the option is one in a series of related or sequential options;
(vii) Stockholder rights. The existence of an arrangement (either within the option agreement or in a related agreement) that, directly or indirectly, affords managerial or economic rights in the issuing corporation that ordinarily would be afforded to owners of the issuing corporation's stock (e.g., voting rights, dividend rights, or rights to proceeds on liquidation) to the person who would acquire the stock upon exercise of the option or a person related to such person. For this purpose, managerial or economic rights in the issuing corporation possessed because of actual stock ownership in the issuing corporation are not taken into account;
(viii) Restrictive covenants. The existence of restrictive covenants or similar arrangements (either within the option agreement or in a related agreement) that, directly or indirectly, prevent or limit the ability of the issuing corporation to undertake certain activities while the option is outstanding (e.g., covenants limiting the payment of dividends or borrowing of funds);
(ix) Intention to alter value. Whether it was intended that through a change in the capital structure of the issuing corporation or a transfer of assets to or from the issuing corporation (other than regular, ordinary dividends) or by any other means, the fair market value of the stock of the issuing corporation would be altered for a principal purpose of increasing the likelihood that the option would be exercised; and
(x) Contingencies. Any contingency (other than the mere passage of time) to which the exercise of the option is subject (e.g., a public offering of the issuing corporation's stock or reaching a certain level of earnings).
(2) Cash settlement options, phantom stock, stock appreciation rights, or similar interests. A cash settlement option, phantom stock, stock appreciation right, or similar interest is treated as reasonably certain to be exercised if it is reasonably certain that the option will have value at some time during the period in which the option may be exercised.
(3) Safe harbors —(i) Options to acquire stock. Except as provided in paragraph (g)(3)(iv) of this section, an option to acquire stock is not considered reasonably certain, as of a measurement date, to be exercised if—
(A) The option may be exercised no more than 24 months after the measurement date and the exercise price is equal to or greater than 90 percent of the fair market value of the underlying stock on the measurement date; or
(B) The terms of the option provide that the exercise price of the option is equal to or greater than the fair market value of the underlying stock on the exercise date.
(ii) Options to sell stock. Except as provided in paragraph (g)(3)(iv) of this section, an option to sell stock is not considered reasonably certain, as of a measurement date, to be exercised if—
(A) The option may be exercised no more than 24 months after the measurement date and the exercise price is equal to or less than 110 percent of the fair market value of the underlying stock on the measurement date; or
(B) The terms of the option provide that the exercise price of the option is equal to or less than the fair market value of the underlying stock on the exercise date.
(iii) Options exercisable at fair market value. For purposes of paragraphs (g)(3)(i)(B) and (g)(3)(ii)(B) of this section, an option whose exercise price is determined by a formula is considered to have an exercise price equal to the fair market value of the underlying stock on the exercise date if the formula is agreed upon by the parties when the option is issued in a bona fide attempt to arrive at fair market value on the exercise date and is to be applied based upon the facts in existence on the exercise date.
(iv) Exceptions. The safe harbors of this paragraph (g)(3) do not apply if—
(A) An arrangement exists that provides the holder or a related party with stockholder rights described in paragraph (g)(1)(vii) of this section (except for rights arising upon a default under the option or a related agreement);
(B) It is intended that through a change in the capital structure of the issuing corporation or a transfer of assets to or from the issuing corporation (other than regular, ordinary dividends) or by any other means, the fair market value of the stock of the issuing corporation will be altered for a principal purpose of increasing the likelihood that the option will be exercised; or
(C) The option is one in a series of related or sequential options, unless all such options satisfy paragraph (g)(3) (i) or (ii) of this section.
(v) Failure to satisfy safe harbor. Failure of an option to satisfy one of the safe harbors of this paragraph (g)(3) does not affect the determination of whether an option is treated as reasonably certain to be exercised.
(h) Examples. The provisions of this section may be illustrated by the following examples. These examples assume that the measurement dates set forth in the examples are the only measurement dates that have taken place or will take place.
(ii) If P, S, and T continue to file consolidated returns after June 30, 1992, it could reasonably be anticipated that P, S, and T would eliminate a substantial amount of federal income tax liability by using P's and T's future losses to offset S's income in consolidated returns. Furthermore, based on the difference between the exercise price of the option and the fair market value of the S stock, it is reasonably certain, on June 30, 1992, a measurement date, that the option will be exercised. Therefore, the option held by U is treated as exercised. As a result, for purposes of determining whether P and S are affiliated, P is treated as owning only 60 percent of the value of outstanding shares of S stock and U is treated as owning the remaining 40 percent. P is still treated as owning 100 percent of the voting power. Because members of the P group are no longer treated as owning stock possessing 80 percent of the total value of the S stock as of June 30, 1992, S is no longer a member of the P group. Additionally, P is not entitled to a 100 percent dividends received deduction under section 243(a)(3) because P and S are also treated as not affiliated for purposes of section 243. P is only entitled to an 80 percent dividends received deduction under section 243(c).
(ii) Because the options issued to U1 and U2 were issued pursuant to a plan, July 2, 1992, constitutes a measurement data for both options. Therefore, both options are aggregated in determining whether the issuance of the options, rather than the sale of the S stock, would result in the elimination of a substantial amount of federal income tax liability. Accordingly, as in Example 1, because the continued affiliation of P, S, and T could reasonably be anticipated to result in the elimination of a substantial amount of federal income tax liability and the options are reasonably certain to be exercised, the options are treated as exercised for purposes of determining whether P and S are affiliated, and P and S are no longer affiliated as of July 2, 1992.
(ii) If P sold the S stock, in lieu of the option, to U, S would become a member of the U group. Because the U group files consolidated returns, if P sold the S stock to U, U would be able to use its future losses to offset future income of S. When viewing the transaction from the effect on all parties, the sale of the option, in lieu of the underlying S stock, does not result in the elimination of federal income tax liability because S's income would be offset by the losses of members of either the P or U group. Accordingly, the option is disregarded and S remains a member of the P group.
(ii) Because the exercise price of the call option is equal to or greater than 90 percent of the fair market value of the S stock on August 31, 1992, a measurement date, the option may be exercised no more than 24 months after the measurement date, and none of the items described in paragraph (g)(3)(iv) of this section that preclude application of the safe harbor are present, the safe harbor of paragraph (g)(3)(i) of this section applies and the call option is treated as if it is not reasonably certain to be exercised. Therefore, regardless of whether the continued affiliation of P and S would result in the elimination of a substantial amount of federal income tax liability, the call option is disregarded in determining whether S remains a member of the P group.
(ii) Under paragraph (g)(3)(iv) of this section, the safe harbor of paragraph (g)(3)(i) of this section does not apply because the call option entitles U to voting rights equivalent to that of a shareholder. Accordingly, all of the facts and circumstances surrounding the sale of the call option must be taken into consideration in determining whether it is reasonably certain that the call option will be exercised.
(ii) Under the terms of this arrangement, it is reasonably certain on September 30, 1992, a measurement date, that on September 30, 1995, either through Y's exercise of its conversion right or X's right to put S stock to Y, that Y will own 50 percent of the S stock. Additionally, it could reasonably be anticipated, on September 30, 1992, a measurement date, that the affiliation of X and S would result in the elimination of a substantial amount of federal income tax liability. Accordingly, for purposes of determining whether X and S are affiliated, X is treated as owning only 50 percent of the value of the S stock as of September 30, 1992, a measurement date, and S is not a member of the X affiliated group.
(ii) In contrast to Example 6, because of the true business risks involved in the start-up of S and whether the business venture will ultimately succeed, along with the fact that X does not have an option to put S stock to Y, it is not reasonably certain on September 30, 1992, a measurement date, that the option will be exercised and that X will only own 50 percent of the S stock on September 30, 1995. Accordingly, the option is disregarded in determining whether S is a member of the X group.
(i) Effective date. This section applies, generally, to options with a measurement date on or after February 28, 1992. This section does not apply to options issued prior to February 28, 1992, which have a measurement date on or after February 28, 1992, if the measurement date for the option occurs solely because of an adjustment in the terms of the option pursuant to the terms of the option as it existed on February 28, 1992. Paragraph (b)(2)(iv) of this section applies to stock outstanding on or after February 28, 1992. Paragraph (a)(2) of this section applies with respect to taxable years beginning on or after November 13, 2020. However, taxpayers and their related parties, within the meaning of sections 267(b) and 707(b)(1), may choose to apply the rules of this section to a taxable year beginning after December 31, 2017, so long as the taxpayers and their related parties consistently apply the rules of this section, the section 163(j) regulations (as defined in § 1.163(j)-1(b)(37)), and, if applicable, §§ 1.263A-9, 1.263A-15, 1.381(c)(20)-1, 1.382-1, 1.382-2, 1.382-5, 1.382-6, 1.382-7, 1.383-0, 1.383-1, 1.469-9, 1.469-11, 1.704-1, 1.882-5, 1.1362-3, 1.1368-1, 1.1377-1, 1.1502-13, 1.1502-21, 1.1502-36, 1.1502-79, 1.1502-91 through 1.1502-99 (to the extent they effectuate the rules of §§ 1.382-2, 1.382-5, 1.382-6, 1.382-7, and 1.383-1), to that taxable year.
§ 1.1502-77A   Common parent agent for subsidiaries applicable for consolidated return years beginning before June 28, 2002.
(a) Scope of agency of common parent corporation. The common parent, for all purposes (other than the making of the consent required by paragraph (a)(1) of § 1.1502-75, the making of an election under section 936(e), the making of an election to be treated as a DISC under § 1.992-2, and a change of the annual accounting period pursuant to paragraph (b)(3)(ii) of § 1.991-1) shall be the sole agent for each subsidiary in the group, duly authorized to act in its own name in all matters relating to the tax liability for the consolidated return year. Except as provided in the preceding sentence, no subsidiary shall have authority to act for or to represent itself in any such matter. For example, any election available to a subsidiary corporation in the computation of its separate taxable income must be made by the common parent, as must any change in an election previously made by the subsidiary corporation; all correspondence will be carried on directly with the common parent; the common parent shall file for all extensions of time including extensions of time for payment of tax under section 6164; notices of deficiencies will be mailed only to the common parent, and the mailing to the common parent shall be considered as a mailing to each subsidiary in the group; notice and demand for payment of taxes will be given only to the common parent and such notice and demand will be considered as a notice and demand to each subsidiary; the common parent will file petitions and conduct proceedings before the Tax Court of the United States, and any such petition shall be considered as also having been filed by each such subsidiary. The common parent will file claims for refund or credit, and any refund will be made directly to and in the name of the common parent and will discharge any liability of the Government in respect thereof to any such subsidiary; and the common parent in its name will give waivers, give bonds, and execute closing agreements, offers in compromise, and all other documents, and any waiver or bond so given, or agreement, offer in compromise, or any other document so executed, shall be considered as having also been given or executed by each such subsidiary. Notwithstanding the provisions of this paragraph, any notice of deficiency, in respect of the tax for a consolidated return year, will name each corporation which was a member of the group during any part of such period (but a failure to include the name of any such member will not affect the validity of the notice of deficiency as to the other members); any notice and demand for payment will name each corporation which was a member of the group during any part of such period (but a failure to include the name of any such member will not affect the validity of the notice and demand as to the other members); and any levy, any notice of a lien, or any other proceeding to collect the amount of any assessment, after the assessment has been made, will name the corporation from which such collection is to be made. The provisions of this paragraph shall apply whether or not a consolidated return is made for any subsequent year, and whether or not one or more subsidiaries have become or have ceased to be members of the group at any time. Notwithstanding the provisions of this paragraph, the Commissioner may, upon notifying the common parent, deal directly with any member of the group in respect of its liability, in which event such member shall have full authority to act for itself.
(b) Notification of deficiency to corporation which has ceased to be a member of the group. If a subsidiary has ceased to be a member of the group and if such subsidiary files written notice of such cessation with the Commissioner, then the Commissioner upon request of such subsidiary will furnish it with a copy of any notice of deficiency in respect of the tax for a consolidated return year for which it was a member and a copy of any notice and demand for payment of such deficiency. The filing of such written notification and request by a corporation shall not have the effect of limiting the scope of the agency of the common parent provided for in paragraph (a) of this section and a failure by the Commissioner to comply with such written request shall not have the effect of limiting the tax liability of such corporation provided for in § 1.1502-6.
(c) Effect of waiver given by common parent. Unless the Commissioner agrees to the contrary, an agreement entered into by the common parent extending the time within which an assessment may be made or levy or proceeding in court begun in respect of the tax for a consolidated return year shall be applicable:
(1) To each corporation which was a member of the group during any part of such taxable year, and
(2) To each corporation the income of which was included in the consolidated return for such taxable year, notwithstanding that the tax liability of any such corporation is subsequently computed on the basis of a separate return under the provisions of § 1.1502-75.
(d) Effect of dissolution of common parent corporation. If the common parent corporation contemplates dissolution, or is about to be dissolved, or if for any other reason its existence is about to terminate, it must forthwith notify the Commissioner of such fact and designate, subject to the approval of the Commissioner, another member to act as agent in its place to the same extent and subject to the same conditions and limitations as are applicable to the common parent. If the notice thus required is not given by the common parent, or the designation is not approved by the Commissioner, the remaining members may, subject to the approval of the Commissioner, designate another member to act as such agent, and notice of such designation must be given to the Commissioner. Until a notice in writing designating a new agent has been approved by the Commissioner, any notice of deficiency or other communication mailed to the common parent will be considered as having been properly mailed to the agent of the group; or, if the Commissioner has reason to believe that the existence of the common parent has terminated, the Commissioner may deal directly with any member in respect of its liability.
(e) General rules —(1) Scope. This section applies if the corporation that is the common parent of the group ceases to be the common parent, whether or not the group remains in existence under § 1.1502-75(d).
(2) Notice of deficiency. A notice of deficiency mailed to any one or more corporations referred to in paragraph (e)(4) of this section is deemed for purposes of § 1.1502-77A to be mailed to the agent of the group. If the group has designated an agent that has been approved by the Commissioner under § 1.1502-77A(d), a notice of deficiency shall be mailed to that designated agent in addition to any other corporation referred to in paragraph (e)(4) of this section. However, failure by the Commissioner to mail a notice of deficiency to that designated agent shall not invalidate the notice of deficiency mailed to any other corporation referred to in paragraph (e)(4) of this section.
(3) Waiver of statute of limitations. A waiver of the statute of limitations with respect to the group given by any one or more corporations referred to in paragraph (e)(4) of this section is deemed to be given by the agent of the group.
(4) Alternative agents. The corporations referred to in paragraph (e) (2) and (3) of this section are—
(i) The common parent of the group for all or any part of the year to which the notice or waiver applies,
(ii) A successor to the former common parent in a transaction to which section 381(a) applies,
(iii) The agent designated by the group under § 1.1502-77A(d), or
(iv) If the group remains in existence under § 1.1502-75(d) (2) or (3), the common parent of the group at the time the notice is mailed or the waiver given.
(f) Cross-reference. For further rules applicable to groups that include insolvent financial institutions, see § 301.6402-7 of this chapter.
(g) Effective/applicability dates. This section applies to taxable years beginning before June 28, 2002, except paragraph (e) of this section applies to statutory notices and waivers of the statute of limitations for taxable years for which the due date (without extensions) of the consolidated return is after September 7, 1988, and which begin before June 28, 2002.