Final Regulations Issued on Disregarded Payment Losses

At a glance

• The main takeaway: Treasury and the IRS issued Final Regulations (T.D. 10026) (the “Final Regulations”) partially implementing 2024 Proposed Regulations (the “Proposed Regulations”) that target Disregarded Payment Losses (“DPLs”) to prevent avoidance of the application of the Dual Consolidated Loss (“DCL”) rules.
• Impact on your business: Corporate taxpayers who directly or indirectly own foreign disregarded entities or foreign branches may need to track whether certain payments give rise to potential “double dipping” outcomes and, if so, include disregarded payments into income.
• Next steps: Reach out to Aprio’s International Tax Team to learn whether the Final Regulations could impact your business.

The full story:

On August 7, 2024, U.S. Department of the Treasury (“Treasury”) and the IRS issued the Proposed Regulations (REG-105128-23) to address perceived gaps within the DCL regime. Generally, the DCL rules aim to prevent repeat utilization of tax losses across jurisdictions. However, application of the DCL rules was originally narrower in scope, permitting certain payments to be deducted under foreign tax law when they were disregarded for U.S. federal income tax purposes. On January 10, 2025, Final Regulations were released to address certain of those circumstances.

What are DPLs?

The Final Regulations on DPLs eliminate certain double-deduction, non-inclusion outcomes due to disregarded entity classification. In general, a DPL can occur when a foreign disregarded entity makes disregarded payments that are deductible under foreign tax law.  To prevent a deduction, no-inclusion outcome, domestic corporate owners of Disregarded Payment Entities (“DPEs”)[1] are required to track whether disregarded interest, royalties, or structured payments give rise to “double dipping” outcomes. If so, the domestic corporate owner may be required to include in income the amount that would have been included with respect to the payment had it been regarded for U.S. federal income tax purposes.

How are DPLs calculated?

The DPL is computed as the excess of certain disregarded payments over certain Disregarded Payment Income (“DPI”).  Disregarded interest, royalties, and structured payments are considered in the computation of DPI and DPL and must give rise to income or a deduction of the DPE under foreign tax law.

If a DPL arises in a tax year, assuming no “foreign use,” the corporate owner must disclose the DPL on an initial certification statement and file annual certifications for the following 60 months. A foreign use of a DPL occurs if any portion of a deduction taken into account in computing the DPL is made available under a relevant foreign tax law to offset an item of income that, for U.S. tax purposes, is an item of income of a foreign corporation related to the DPE owner.

If foreign use occurs in a tax year, the DPE owner must include the DPL in its gross income in the year of such an event. The DPL inclusion is treated as ordinary interest or royalty income paid by a foreign corporation to the DPE owner. A combination rule requires DPEs subject to the same foreign tax law to be treated as a single DPE if they have the same domestic corporate owner or their owners are members of the same U.S. consolidated group.

There are a few exceptions and rules to consider:

• Cumulative Register and Suspended Deductions: The Final Regulations provide for a DPL cumulative register with respect to a DPE, the account the balance of which is computed at the end of each foreign taxable year and is increased by the amount of DPI for the year, and then, after determining the DPL inclusion amount for the year, decreased by the amount of the cumulative register balance that is used.  A reduction by the register amount used precludes a negative balance in the register. Reflecting a DPL inclusion, a “suspended deduction” is established in the following tax year by the DPE owner in an amount equal to the DPL inclusion. The DPE owner can then deduct to the extent that they have net positive DPI in the following or a subsequent tax year.  A disclosure statement is required when utilizing the suspended deduction and its character and source must match the DPL inclusion to which it relates (e.g., ordinary foreign source interest or royalty). 

• Agreement Exception: To determine a DPI or DPL, the Final Regulations require the exclusion of any royalties paid or accrued pursuant to a license agreement entered into before August 6, 2024, assuming there is no change in the licensor or licensee or a significant modification of the rights under the license agreement. Extensions or term updates are not considered significant modifications. As a result, this exception can impact a DPE cumulative register.

• New Anti-Avoidance Rule: The Final Regulations also impose a new anti-avoidance rule applicable to both the DCL and DPL rules which utilizes a purpose-driven assessment to determine whether a transaction or arrangement is engaged “with a view” to avoid the limitations of the DCL and DPL regimes. A taxpayer’s intent and economic realities of the transaction are considered in determining whether the anti-avoidance rules will be applicable to a given transaction. The Final Regulations give examples to illustrate the application of the anti-avoidance rule.  One example considers a situation where a parent and subsidiary corporation file a consolidated return and with a rule avoidance consideration, the parent lends money to the subsidiaries’ foreign disregarded entity which incurs an interest expense. Through application of the consolidated group rules, the result produces a double deduction or similar outcome (i.e., foreign deduction and no U.S. income inclusion) and the anti-abuse rule is considered to apply. Because of a foreign use, the interest deduction is subject to the DPL rules and requires the subsidiary to include DPL income and establish a suspended deduction.

• Other Considerations: The Final Regulations exclude DPEs that are not “related” to the DPE owner within the meaning of Section 954(d)(3) (i.e., generally, more than 50% control by vote or value and applied as if the DPE were a corporation).

A de minimis exception provides that a DPE will not have a DPL if it is generated in the course of an active trade or business and is less than the lesser of $3 million or 10% of the aggregate of all items of the DPE deductible under foreign law, including items that would not be treated as interest, structured payments, or royalties under U.S. tax law. 

The Final Regulations extend transitional relief regarding the interaction of the DCL rules with the GloBE rules. With taxpayer reliance, for tax years beginning before August 31, 2025, future regulations will apply the DCL rules without taking into account qualified domestic minimum top-up taxes (QDMTTs) and top-up taxes collected under an income inclusion rule (IIR) or undertaxed profits rules (UTPR). 

When are the new rules effective?

Per the Final Regulations, DPL rules must be applied to tax years beginning on or after January 1, 2026, much later than the original Proposed Regulations. The anti-avoidance rules apply to DCLs incurred in tax years ending on or after August 6, 2024.

The bottom line

Corporate taxpayers that have financing or licensing arrangements with foreign disregarded entities or foreign branches should be aware of the potential application of the DPL rules and evaluate their current and future structures. Under the Final Regulations, certain disregarded payments can cause unexpected income inclusions. While the new rules may seem to detriment taxpayers, the Final Regulations feature more taxpayer-favorable aspects than the Proposed Regulations, including the modified rule for suspended deductions that reduces a DPL inclusion due to a timing difference.  However, DPI is required in a later year or, if not available, deductions may remain suspended indefinitely. 

To learn more about how the new regulations impact you, schedule a consultation with one of Aprio’s knowledgeable International Tax advisors.

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[1] A DPE includes 1) a disregarded entity that is a foreign tax resident and related to the DPE owner, provided that the DPE owner directly or indirectly own interests in the disregarded entity, 2) a foreign branch of the DPE owner and a foreign branch of an entity that is related to the DPE owner and in which the DPE owner directly or indirectly owns an interest, 3) an entity that is treated as a partnership for U.S. tax purposes that is a foreign tax resident and related to the DPE owner, provided that the DPE owner directly or indirectly own an interest in the entity, and 4) the DPE owner itself if it is a dual resident corporation.