Loss Limitations as Applied to CFCs

I. Introduction

Before the enactment of the Tax Cuts and Jobs Act,¹ the application of the loss trafficking rules of section 382 to foreign corporations generally did not receive significant attention. As a result of the substantial changes to the tax law made by the TCJA, including the enactment of the global intangible low-taxed income rules of section 951A and the revision of section 163(j), section 382 has increased relevance for controlled foreign corporations.

A central goal of section 382 is to avoid tax-motivated acquisitions of loss companies by persons who might otherwise use attributes of the loss corporation to offset income from profitable operations.² Under section 382, if there is a significant change in ownership of a loss corporation (an ownership change), then, in each year after the ownership change, the loss corporation can offset its income with pre-change net operating loss carryovers, built-in losses, and previously disallowed business interest expense (BIE) carryovers up to the section 382 limitation. Post-TCJA, some of these attributes may be relevant in calculating a CFC’s subpart F income and, significantly, a CFC’s tested income under the GILTI rules. However, section 382(e)(3) provides that the calculation of the section 382 limitation of a foreign corporation takes into account only the value of items treated as connected with the conduct of a U.S. trade or business, unless otherwise provided in regulations. Regulations providing otherwise have not been issued. Thus, while it appears that section 382 applies to limit the use of attributes potentially relevant to a U.S. shareholder’s subpart F and GILTI calculations, not just attributes that could reduce effectively connected income, the amount of the attributes that can be used is based only on the value of ECI items.

This report explains how section 382 might apply under the post-TCJA international tax framework, focusing on potential issues for CFCs and their U.S. shareholders. It also describes potential areas in which Treasury and the IRS may wish to consider issuing guidance.³

II. Section 382

A. Overview

Section 382 polices loss trafficking — that is, the tax-motivated acquisition of a target corporation that has certain tax attributes that may reduce future taxable income. After a significant change in ownership of a loss corporation, a loss corporation can use these attributes to reduce taxable income only up to the section 382 limitation.⁴

The section 382 limitation is calculated under a formula intended to approximate the amount of income the loss corporation would have earned under the old owners. Specifically, the section 382 limitation is an amount equal to the value of the old loss corporation multiplied by the long-term tax-exempt rate.

Section 382 applies in the case of an ownership change, which is a change in ownership by 5-percent shareholders of more than 50 percent of the stock (by value) in a loss corporation over a testing period (generally three years).⁵ A corporation is required to monitor for potential ownership changes.

At a high level, a loss corporation is a corporation with unused tax attributes that would give rise to a deduction. Specifically, section 382(k) provides that a loss corporation is a corporation with one or more of the following: (1) an NOL carryover or NOL for the ownership change year; (2) a net unrealized built-in loss (NUBIL); and (3) for tax years beginning after December 31, 2017, a disallowed BIE carryforward under section 163(j). The regulations further provide that a loss corporation also includes a corporation that is entitled to use a carryover of any of the following tax attributes or incurs (and does not use in the year) any of the following tax attributes in a change year: (1) a net capital loss; (2) excess foreign taxes under section 904(c); (3) a general business credit under section 38; or (4) a minimum tax credit under section 53.⁶ These tax attributes are governed by section 383.

The sections below discuss the NOL, NUBIL, and disallowed BIE carryover rules in further detail, including their relevance or nonrelevance for a CFC (that is, any foreign corporation if more than 50 percent of either the total vote or value of the stock is directly or indirectly owned, or is considered as owned under the constructive ownership rules of section 958(b), by U.S. shareholders on any day during the tax year of that corporation).⁷

B. NOL Carryover

As stated above, a loss corporation includes a corporation that is entitled to use an NOL carryover or has an NOL for the tax year in which the ownership change occurs. As explained later, reg. section 1.952-2 provides that in determining taxable income of a foreign corporation for any tax year, the NOL deduction under section 172(a) is not allowed (nor is a capital loss carryback or carryover). Thus, CFCs (without ECI) are not entitled to use NOL carryovers.

C. NUBIL Rules

A NUBIL is the amount by which the fair market value of the assets of a loss corporation immediately before an ownership change is less than the aggregate adjusted basis of those assets at that time.⁸ A net unrealized built-in gain (NUBIG) is the amount by which the aggregate FMV of the assets of a loss corporation immediately before an ownership change exceeds aggregate adjusted basis.⁹ NUBIL and NUBIG are subject to a threshold requirement: If the amount of the NUBIL or NUBIG, as is relevant, does not exceed the lesser of 15 percent of the FMV of the assets or $10 million, the NUBIL or NUBIG is treated as zero.¹⁰

The application of the section 382 rules to NUBILs is intended to equalize the treatment of recognized losses (as reflected in an NOL) and unrecognized losses. For example, assume that a corporation (ACo) has $200 of NOL carryovers and owns an ordinary asset with a value of $60 and an adjusted basis of $100 at the time of an ownership change. If ACo had sold the asset before the ownership change, ACo would have recognized an ordinary loss of $40 that would be added to its NOL carryovers and subject to section 382. The NUBIL rules operate so that if the acquirer sells the loss asset within five years after the ownership change, the use of that loss is also subject to limitation.

Specifically, if a loss corporation has a NUBIL, any built-in loss recognized for any tax year within a five-year recognition period after the ownership change (RBIL) is treated as a pre-change loss subject to the section 382 limitation.¹¹ RBIL is defined as any loss recognized in the five-year recognition period on the disposition of any asset, except to the extent the new loss corporation establishes that it did not hold the asset on the change date or the loss exceeds the asset’s built-in loss.¹² Also, any item of deduction allowable as a deduction during the five-year recognition period is treated as RBIL if the item is attributable to periods before the change date.¹³ Under section 382(h)(2)(B), allowable depreciation, amortization, or depletion deductions are RBIL except to the extent the loss corporation establishes that the amount of the deduction is not attributable to the asset’s built-in loss on the change date.

A similar purpose of equalizing pre-ownership change and post-ownership change attributes also applies to gains. If a corporation has a NUBIG, built-in gain recognized in the five-year recognition period after the ownership change (RBIG) increases the section 382 limitation.¹⁴ RBIG is defined as any gain recognized during the five-year recognition period on the disposition of any asset to the extent the new loss corporation establishes that it held the asset on the change date and the gain does not exceed the asset’s built-in gain on the change date.¹⁵ Further, any item of income properly taken into account during the five-year recognition period is treated as RBIG if the item is attributable to periods before the change date.¹⁶

In Notice 2003-65, 2003-2 C.B. 747, the IRS stated that it was studying the circumstances under which items of income, gain, deduction, and loss that a loss corporation recognizes after an ownership change should be treated as RBIG and RBIL. The notice provides two alternative approaches for the identification of built-in items that can be used as safe harbors until the issuance of further guidance: the 1374 approach (based on aspects of the calculation of net recognized built-in gain under section 1374 for C corporations that elect to be S corporations) and the 338 approach (assuming a deemed sale in which a section 338 election is made).¹⁷ Proposed regulations issued under section 382 in September 2019 would withdraw Notice 2003-65 prospectively and require loss corporations to use the 1374 approach for calculating RBIG and RBIL.¹⁸ By requiring the 1374 approach and preventing the use of the 338 approach, those regulations would prevent taxpayers from increasing RBIG by deemed income from built-in gain assets, which is permitted under Notice 2003-65. (The 2019 proposed section 382 regulations were proposed to apply to ownership changes occurring immediately after publication of the final regulations, but in 2020 Treasury and the IRS issued a partial withdrawal of the proposed regulations and a notice of proposed rulemaking that would provide some transition relief.¹⁹)

D. Disallowed BIE Carryovers

For tax years beginning after December 31, 2017, section 382(k)(1) provides that a loss corporation includes any corporation entitled to use a disallowed BIE carryforward under section 163(j)(2). Section 382(d)(3) also provides that a pre-change loss includes any disallowed BIE carryforward. As amended by the TCJA, section 163(j) limits a taxpayer’s deduction of BIE in a tax year to the sum of (1) the taxpayer’s business interest income for the tax year; (2) 30 percent of the taxpayer’s adjusted taxable income for the tax year; and (3) the taxpayer’s floor plan financing interest for the tax year.²⁰ Disallowed BIE is treated as paid or accrued in the succeeding tax year.

Final regulations published under section 163(j) in September 2020 provide that the section 163(j) limitation on the deductibility of interest expense applies to relevant foreign corporations.²¹ In 2021 Treasury and the IRS published additional regulations under section 163(j) that modify the general application of section 163(j) to CFCs in some circumstances, including when a CFC group election or CFC safe harbor election is made.²²

Because amended section 163(j) applies to CFCs, a CFC may be a loss corporation under section 382(k)(1) if it has a disallowed BIE carryforward.

E. Section 383 and Foreign Tax Credits

Section 383 provides limitations that may apply to the use of net capital losses, excess foreign taxes, unused general business credits, and unused minimum tax credits. However, CFCs may not use capital loss carryovers, and business and minimum tax credits do not factor into the calculation of subpart F income and tested income, so section 383 as applied to those attributes is irrelevant to the U.S. taxation of a CFC without ECI.

Section 383(c) provides that if an ownership change occurs for a corporation, the amount of any excess foreign taxes under section 904(c) for any tax year before the first post-change tax year shall be limited under regulations “consistent with the purposes” of sections 383 and 382. Section 904(c) provides for the carryback and carryover of foreign taxes that exceed a taxpayer’s section 904(a) foreign tax credit limitation (generally, the U.S. tax imposed on foreign-source income). The section 904(c) carryback and carryover and FTC limitation are calculated for categories (“baskets”) of income, but the section 904(c) carryback and carryover do not apply to income in the section 951A (GILTI) basket.

Because sections 901 and 904, including the carryback and carryover rules, are applied to the taxpayer claiming a credit, section 383 may apply to limit the carryover and carryback of FTCs for U.S. shareholders that have undergone an ownership change.²³ Section 383 could apply to a CFC with ECI and foreign taxes potentially creditable under section 906. CFCs without ECI are not themselves subject to U.S. net-basis tax and are not entitled to a credit under section 901.²⁴

F. Section 382 Limitation

As stated above, after an ownership change, a loss corporation can offset its income with relevant attributes up to the section 382 limitation. The section 382 limitation is an amount equal to the value of the old loss corporation multiplied by the long-term tax-exempt rate.

In general, under section 382(e)(1), the value of the old loss corporation is the FMV of the stock of the corporation immediately before the ownership change. Section 382(e)(3) provides a special rule for foreign corporations, stating that “except as otherwise provided in regulations, in determining the value of any old loss corporation which is a foreign corporation, there shall be taken into account only items treated as connected with the conduct of a trade or business in the United States.”

When Congress enacted the current version of section 382 in the Tax Reform Act of 1986, the statutory text did not specifically address the application of section 382 to foreign corporations. However, the legislative history addressing a different provision, the repeal of the chain deficit rules of then section 952(d), does mention loss trafficking and foreign corporations. The legislative history states that Congress was concerned that the chain deficit rules allowed U.S. taxpayers operating abroad to shelter too much income from current tax because a non-subpart-F loss in a chain of CFCs could offset subpart F income. According to the conference report, “loss trafficking with respect to foreign corporations is not restricted by any rule corresponding to the special anti-loss trafficking rule (Code sec. 382) applicable to U.S. corporations.”²⁵ (A modified version of the chain deficit rule was later reenacted.)

Section 382(e)(3) was added to the code in the Technical and Miscellaneous Revenue Act of 1988, which contained technical corrections to TRA 1986.²⁶ The legislative history to TAMRA states that “the bill also clarifies that if the old loss corporation is a foreign corporation, except as provided in regulations its value shall be determined taking into account only assets and liabilities treated as connected with the conduct of a trade or business in the United States.”²⁷

The only regulations addressing the value of foreign corporations are in reg. section 1.382-8, which provides guidance on adjusting the value of a loss corporation that is a member of a controlled group of corporations (defined as in section 1563(a), but substituting 50 percent for 80 percent). The general purpose of reg. section 1.382-8 is to ensure that value is not double counted in a controlled group — that is, taken into account in computing the section 382 limitation of a subsidiary that is a loss corporation as well as the section 382 limitation of an owner that is also loss corporation.²⁸

In general, under reg. section 1.382-8, the value of stock of a component member (which is generally a member of the controlled group, including foreign corporations) is reduced by the value of the stock of any other component member directly owned by the component member immediately after the ownership change.²⁹ However, a component member may elect to restore value to its parent.³⁰ The value restored is limited to the lesser of (1) the value of the electing member’s stock immediately before the ownership change, reduced by the value of the stock of any other component member that is directly owned by the electing member, plus any value restored to that electing member by another component member corporation; and (2) the value of the electing member’s stock that is directly owned by the owner member immediately after the ownership change, without adjustment for the value of stock directly owned by the electing member.³¹

Under reg. section 1.382-8(h)(2), each component member that is a foreign corporation (a foreign component member) is deemed to have elected to restore to each other component member the maximum value that would be made under the restoration election described above.³² However, a loss corporation may elect to reduce the amount that would be deemed restored.³³ The deemed restoration election does not apply to foreign corporations with ECI, because reg. section 1.382-8(e)(4)(ii) provides that a foreign corporation with ECI items that it takes into account in determining its value under section 382(e)(3) is not considered a foreign component member.

The special rules for foreign component members were first promulgated as temporary and proposed regulations in 2006.³⁴ Treasury and the IRS stated in the preamble to the regulations that taxpayers generally elect to restore value from component members that are foreign corporations but that taxpayers occasionally failed to make a timely election and filed requests for relief for late elections under reg. section 301.9100-1. As a result, Treasury and the IRS changed the rules to create a default election “to reduce unnecessary elections and section 9100 requests.”³⁵ The regulations were finalized without substantive change in June 2007.³⁶

III. Section 382 and CFCs: Pre-TCJA

Before the TCJA, the application of section 382 to foreign corporations was generally not an area of significant focus. Only a few pre-TCJA IRS analyses discuss the issue, with several noting without significant elaboration that section 382 can apply to foreign corporations.³⁷

A 1997 field service advice memorandum concludes that section 382 may apply to the NUBILs of a CFC.³⁸ Although the memorandum is heavily redacted, it involves whether a foreign corporation without a U.S. trade or business has a NUBIL when the foreign corporation’s only significant asset was stock with a basis in excess of value.

The memorandum states that there is little authority addressing the application of section 382 to foreign corporations and that “a possible explanation [for the ECI rule of section 382(e)(3)] can be extracted from the general theory of section 382.” According to the memorandum, “because NOL carryovers are deductible only against ECI, section 382(e)(3) provides that only ‘items treated as connected with the conduct of a trade or business in the United States are taken into account in approximating the hypothetical . . . earnings that the foreign corporation’s NOL carryovers would have reduced.’”

The IRS concluded that the foreign corporation at issue was a loss corporation and subject to a section 382 limitation. Although the foreign corporation was not engaged in a U.S. trade or business and thus could not have an NOL carryover from losses allocable to ECI, the foreign corporation did have a NUBIL because it had only one significant asset — the stock of another foreign corporation, the basis of which exceeded value.

The IRS stated that one might argue that the treatment of the built-in loss as a NUBIL is inconsistent with the rationale behind section 382(e)(3) because, if the foreign corporation had sold the stock of the other foreign corporation, the loss recognized would not have been allocated to reduce ECI. However, the IRS further stated that under the allocation and apportionment regulations, a loss on the sale of a capital asset is allocated at the time the loss is recognized and, in some cases:

A built-in loss on an asset that is not connected with a U.S. trade or business at the time of the ownership change might nevertheless reduce ECI if the asset is connected with a U.S. business prior to the loss recognition. Furthermore, the built-in loss may be carried over into a domestic corporation that is taxable on its worldwide income and the subsequent recognition of the loss could reduce income subject to U.S. taxation, regardless of whether the asset is connected with a U.S. business.

Other than ECI, the major category of income earned by foreign corporations that could be subject to U.S. tax before the TCJA was subpart F income of CFCs. U.S. shareholders of a CFC must include in income their pro rata share of the CFC’s subpart F income (which shall not exceed the CFC’s earnings and profits).³⁹ The potential application of section 382 to subpart F income does not appear to have received significant attention before the TCJA. Under reg. section 1.952-2, CFCs are not permitted to use NOL carryovers and thus do not have NOLs that could be subject to a section 382 limitation (other than CFCs with ECI). The NUBIL rules might affect subpart F income in a situation in which gross subpart F income is reduced by allocable expenses, such as recognized built-in losses under section 954(b)(5). However, the subpart F E&P limitation rule could mitigate this effect if a loss deferred or disallowed because of section 382 reduces E&P.⁴⁰

IV. Post-TCJA

A. Sections 382, 951A, and 163(j)

Section 382 is now more prominent in the CFC context as a result of the enactment of the section 951A GILTI regime, which significantly expanded CFC income subject to U.S. tax in the hands of a U.S. shareholder. Although CFCs (without ECI) cannot have NOLs potentially subject to section 382, NUBILs may affect the calculation of a CFC’s tested income. In addition, amended section 163(j), which may limit a taxpayer’s deduction of BIE, applies to CFCs, and a CFC’s disallowed BIE carryforwards may be subject to limitation under section 382. However, in determining the section 382 limitation, section 382(e)(3) provides that only the value of ECI items is taken into account. Thus, it appears that section 382 can apply to limit the use of attributes to reduce CFC income other than ECI, but in determining value to calculate the amount of affected attributes that may be used, only the value of ECI items is considered.

Section 951A requires each U.S. shareholder of a CFC to include in gross income the U.S. shareholder’s GILTI for the tax year. GILTI is the excess (if any) of a U.S. shareholder’s net CFC tested income for a tax year over the U.S. shareholder’s net deemed tangible income return for the same tax year. Net deemed tangible income return is, for any U.S. shareholder for a tax year, the excess (if any) of 10 percent of the aggregate of its pro rata share of the qualified business asset investment of each CFC in which the shareholder is a U.S. shareholder over the amount of interest expense taken into account in determining its net CFC tested income for the tax year, to the extent that the interest income attributable to the interest expense is not taken into account in determining its net CFC tested income. QBAI means the average of a CFC’s aggregate adjusted bases in specified tangible property used in a trade or business and that is subject to depreciation under section 167, determined as of the close of each quarter of a tax year.

A U.S. shareholder’s net CFC tested income is the shareholder’s pro rata share of its CFCs’ tested income over its share of its CFCs’ tested loss. Tested income of a CFC is the excess of CFC gross tested income over allowable deductions properly allocable to the gross tested income. Gross tested income means gross income of a CFC without regard to specified excluded items, such as subpart F income and ECI.

Gross income and allowable deductions of a CFC are generally determined under reg. section 1.952-2, which addresses the calculation of gross income and taxable income of foreign corporations for both subpart F and GILTI purposes.⁴¹ In general, the gross income of a foreign corporation for any tax year is determined by treating a foreign corporation as a domestic corporation taxable under section 11 and by applying the principles of section 61 and the regulations thereunder.⁴² Taxable income is similarly generally determined by treating a foreign corporation as a domestic corporation taxable under section 11 and by applying the principles of section 63.⁴³ However, several special rules apply. For example, in determining taxable income of a foreign corporation (without ECI), no NOL deduction is allowed.⁴⁴ In determining income (and E&P), a CFC is generally required to use the alternative depreciation system (ADS) for depreciable property used predominantly outside the United States.⁴⁵

Although CFCs cannot use NOLs to reduce GILTI, CFC losses and other deductions covered by the NUBIL rules may affect tested income. Under section 382(h)(1)(B), when a loss corporation has a NUBIL at the time of an ownership change, RBIL in an amount up to the NUBIL amount is subject to limitation in the same manner as if it were an NOL. Section 382(h)(2)(B) provides that RBIL includes any loss recognized during the five-year recognition period on the disposition of any asset and “any amount allowable as depreciation, amortization, or depletion,” subject to some exceptions.

As stated above, a U.S. shareholder’s GILTI calculation takes into account CFC deemed tangible return, which in turn depends on CFC QBAI, which is the average of a tested income CFC’s aggregate adjusted bases as of the close of each quarter of a CFC inclusion year in specified tangible property that is used in a trade or business of the tested income CFC and is of a type for which a deduction is allowable under section 167.⁴⁶ In general, adjusted basis in specified tangible property is determined by using the cost capitalization methods of accounting used by the CFC in determining the gross income and allowable deductions of the CFC and the ADS under section 168(g) and by allocating the depreciation deduction for that property for a CFC inclusion year ratably to each day during the period in the CFC inclusion year to which the depreciation relates.⁴⁷ Transition rules apply to property placed in service before the first tax year beginning after December 22, 2017.⁴⁸

Because QBAI is based on basis determined by using the cost capitalization methods of accounting used in determining gross income and allowable deductions, it appears that a section 382 limitation could be relevant in determining QBAI. Under section 1016(a)(2) and reg. section 1.1016-3(a)(1)(i), the basis of property is decreased for depreciation and amortization by the greater of (1) the amount allowed as deductions in computing taxable income, to the extent it results in a reduction of the taxpayer’s income taxes; or (2) the amount allowable for the years involved. To the extent a depreciation deduction is RBIL under section 382(h) and is not allowed or allowable, it does not appear to reduce basis.

The section 163(j) limitations on the deductibility of interest expense apply in computing a CFC’s tested income and subpart F income. Because section 163(j) applies to CFCs, and CFCs may have disallowed BIE carryforwards, section 382 could apply to limit the BIE carryforward of a CFC after an ownership change.⁴⁹ The preamble to the 2021 final section 163(j) regulations states that “section 382, by its terms, applies to the disallowed BIE carryforwards of foreign corporations regardless of whether they have ECI.”⁵⁰ The regulations do not, however, address the calculation of value in applying the section 382 limitation to CFCs with disallowed BIE carryforwards.

As a general matter, outside the consolidated group context and the reg. section 1.382-8 rules for adjusting the value of a loss corporation that is a member of a controlled group, section 382 is applied entity by entity. As a result, when an ownership change occurs, each CFC must be analyzed to determine whether it is a loss corporation and to what extent its attributes are subject to limitation.

B. Example

The issues discussed above may be illustrated by a simple example: A U.S. corporation, USP, owns 100 percent of the stock of a foreign corporation, CFC X. The FMV of USP is $500 million (including the value of the CFC X stock), and the FMV of CFC X is $100 million. USP undergoes an ownership change at the end of year 1. Assume that the section 382(c) continuity of business enterprise requirement is satisfied and that the section 382(h) de minimis threshold for NUBIG or NUBIL is not applicable.

CFC X does not generate subpart F income, does not conduct a U.S. trade or business, and has no ECI. At the time of the ownership change, the adjusted basis of its assets is $120 million. CFC X’s assets include tangible property, originally purchased for $100 million, for which a depreciation deduction under section 167 is allowable. Assume that under the ADS of section 168(k), the property is depreciable over five years on a straight-line basis. Also assume that for ease of calculation, the depreciation deductions equal $20 million for each of the five years (that is, there is no half-year convention). CFC X has taken three years of depreciation deductions for these depreciable assets, which now have an adjusted basis of $40 million and an FMV of $20 million. After the ownership change, CFC X has two years of remaining depreciation. Further, at the time of the ownership change, CFC X owns another business asset with an adjusted basis of $20 million and an FMV of $10 million. CFC X has other assets with an aggregate adjusted basis of $60 million and an FMV of $70 million. CFC X also has a $10 million carryforward of BIE previously disallowed under current section 163(j).

In year 2, the first year after the ownership change, CFC X generates $250 million of gross income from its active business. Before taking into account any potential limitations, its deductions consist of $20 million depreciation, $20 million interest expense ($10 million of current interest expense and, as mentioned above, $10 million of carryforward of BIE previously disallowed under current section 163(j), which would not otherwise be subject to section 163(j) in year 2), and $20 million of current-year salary and miscellaneous other expenses. CFC X also sells its other business asset for $10 million, generating an ordinary loss of $10 million.

At the time of the ownership change, CFC X was a loss corporation under section 382(k)(1). In year 2, CFC X has three amounts of RBIL: the $20 million depreciation deduction; the $10 million BIE carryforward; and the $10 million loss from the sale of its business asset. Under section 382(h)(1)(B), the RBIL is subject to the section 382 limitation. The extent to which the recognition of these built-in deductions is limited by section 382 will affect CFC X’s tested income. Also, the extent to which the $20 million depreciation is allowed will affect CFC X’s asset basis for purposes of its QBAI calculations.

A central question in determining the extent to which CFC X may take into account these attributes is the value of CFC X in determining the section 382 limitation (the value of the old loss corporation multiplied by the long-term tax-exempt rate). Section 382(e)(3) states: “Except as otherwise provided in regulations, in determining the value of any old loss corporation which is a foreign corporation, there shall be taken into account only items treated as connected with the conduct of a trade or business in the United States.” Thus, in the absence of items treated as connected with a U.S. trade or business, section 382(e)(3) indicates that the value of the foreign corporation is zero, except as otherwise provided in regulations.

Under reg. section 1.382-8, CFC X would be a foreign component member and would be deemed to have elected to restore value to USP.⁵¹ Thus, in the absence of an election out of this default rule, the value of USP for purposes of USP’s section 382 limitation is $500 million, which takes into account the $100 million value of CFC X. The regulations under reg. section 1.382-8 do not explain how value of a foreign corporation is determined for purposes of the deemed restoration election, but they appear to presume that, at least in determining USP’s value, a foreign corporation without ECI (the only type of foreign corporation that can be a foreign component member) has some value, or else the deemed restoration rule and the related election not to restore value would have no consequences.

Under reg. section 1.382-8(h), the value of the CFC X stock will be deemed restored to USP because CFC X has no ECI. If CFC X elects out of the deemed restoration election, under section 382(e)(3), only the ECI items of CFC X are taken into account in computing the value of CFC X. As a result, in the absence of ECI, CFC X has no value amount factored into its own section 382 limitation, which appears to prevent CFC X from taking into account its RBIL in determining its tested income. Given the TCJA’s significant expansion of taxation of CFC income and potential application of section 382 to limit attributes that would otherwise reduce the amount of income subject to tax, this appears to be an inappropriate result.

C. Areas for Potential Guidance

1. Need for guidance.

Taking a step back, one might question whether CFCs present enough of a loss trafficking concern to justify applying the section 382 rules to them in the first place. We are unaware of any empirical data addressing this issue.⁵² One might view the GILTI rules as a quasi-worldwide tax system (subject to a reduced rate, allowance for a deemed tangible return, and limited FTC), in which case loss trafficking is possible, at least theoretically. In any event, as now written, there is nothing in the statute that prevents section 382 from applying to CFCs.

In 2017 Congress significantly expanded the U.S. taxation of CFC income in the TCJA but did not amend section 382(e)(3) and its focus on ECI items. Congress did amend section 382(d), however, to take into account revised section 163(j) and to provide that section 382 applies to disallowed BIE carryforwards. One could argue that the absence of changes to section 382(e)(3) indicates that Congress did not contemplate that section 382 would apply to foreign corporations outside the ECI context and thus felt no need to revise that provision to take into account the new GILTI regime.⁵³ On the other hand, one could also argue that a lack of change to section 382(e)(3) indicates that Congress wanted to continue having the section 382 limitation for a foreign corporation take into account only the value of ECI items. However, it seems most likely that these issues were not specifically considered, in which case it seems inappropriate to draw an inference one way or another from congressional silence.

2. CFC value.

A central question under section 382 is the value of a loss corporation. Section 382(e)(3) provides that “in determining the value of any old loss corporation which is a foreign corporation, there shall be taken into account only items treated as connected with the conduct of a trade or business in the United States.” However, this rule applies “except as otherwise provided in regulations.” In addition, section 382(m) provides a broad grant of regulatory authority, permitting Treasury and the IRS “to prescribe such regulations as may be necessary or appropriate to carry out the purposes of this section and section 383.” We believe that in the absence of further elaboration from Congress addressing the application of section 382 in the CFC context, Treasury and the IRS have regulatory authority under section 382(e)(3) and (m) to address the determination of CFC value and other issues relating to CFCs in a manner that takes into account the TCJA’s significant expansion of the taxation of CFC income.

We acknowledge that drafting rules on these issues presents several challenges. There are numerous technical questions, some of which we describe below. At a high level, one approach would be for Treasury and the IRS to write rules requiring assets, liabilities, income, deductions, and attributes to be traced to tested income, subpart F income, and ECI, which are subject to different rules and different tax rates. Under that approach, there would be separate section 382 limitations for each of subpart F, GILTI, and ECI. Another approach would be for Treasury and the IRS to allow taxpayers to use a single CFC value, taking into account all CFC assets, to calculate a single section 382 limitation that would be applied to all affected attributes. In deciding whether to adopt one of these approaches, or an intermediate approach, Treasury and the IRS may consider the likelihood of CFC loss trafficking as well as the extent to which a new complex regime and new compliance responsibilities are needed to police potential abuse or minimize controversy.

Because the TCJA significantly expanded the taxation of CFC income, we suggest that Treasury and the IRS consider providing guidance to address the central problem created by section 382(e)(3), which is that in computing the section 382 limitation, value takes into account only ECI items, even though the limitation can apply to more than just ECI items. We suggest that Treasury and the IRS consider providing guidance allowing taxpayers to use a single CFC value, taking into account all CFC assets and liabilities, for purposes of the section 382 limitation. Taxpayers that wish to use CFC value at the CFC level could elect out of the deemed restoration election (or Treasury and the IRS could eliminate the deemed restoration election and permit taxpayers to elect to relinquish value to the parent). At a minimum, the CFC value guidance could be done on an interim basis until numerous technical issues, including those described below, are considered and any final guidance is issued.

Turning to an overview of technical issues, we begin with the meaning of section 382(e)(3), which states that the value determination should take “into account only items treated as connected with the conduct” of a U.S. trade or business. This provision raises several ambiguities. For example, it is unclear what is meant by “items” in this context. Does “items” equate to “assets” and “liabilities”?⁵⁴ As mentioned above, the legislative history of the law enacting section 382(e)(3) states, “The bill also clarifies that if the old loss corporation is a foreign corporation, except as provided in regulations its value shall be determined taking into account only assets and liabilities treated as connected with the conduct of a trade or business in the United States.”⁵⁵ (Emphasis added.) Or does “items” mean “attributes”?⁵⁶ It seems more likely that “items” in this context refers to assets and liabilities because it seems more logical for the value of assets and liabilities to be considered in determining the section 382 limitation.

Assuming that the reference to “items” in section 382(e)(3) means assets and liabilities, there is also a question of how the value of assets and liabilities (items) treated as connected with the conduct of a U.S. trade or business is determined. Existing regulatory regimes may provide a starting point. For example, for purposes of the branch profits tax rules, reg. section 1.884-1(d) contains a definition of the term “U.S. asset” that looks to whether an asset of a foreign corporation produces ECI or would produce ECI upon a disposition. Similarly, reg. section 1.884-1(e) contains a definition of the term “U.S. liability.” The reg. section 1.884-1(d) definition is also adopted, with modifications, in the reg. section 1.882-5 rules for determining interest expense allocable to ECI.

Further, there is a question what it means to “take into account” those “items” for purposes of the value determination. Is the gross FMV of the ECI assets, minus associated liabilities, used to determine the section 382 limitation? Or should the value of the stock of the CFC be used and multiplied by a ratio equal to ECI net asset FMV over total net asset FMV? Perhaps the latter formulation is more appropriate because under section 382(e)(1) the value of a loss corporation in computing the section 382 limitation is determined by reference to the value of the stock of the loss corporation.

When a CFC has non-ECI assets, additional questions arise. In a simple case, when a CFC has no ECI and no ECI assets, a straightforward approach would be to allow the taxpayer to use CFC value, calculated by reference to all the CFC’s assets. This approach might also be used when a CFC has a mix of tested income, subpart F income, and ECI. For example, if the value of the CFC as a whole is $100 million and the long-term tax-exempt rate is 2 percent, the section 382 limitation of the CFC would be $2 million. As indicated above, we suggest that Treasury and IRS consider adopting this approach.

However, we acknowledge that additional considerations and complexities may arise because of the rate differential between tested income, subpart F income, and ECI. Assuming a shareholder of a CFC is a U.S. corporation, tested income taken into account as GILTI is generally subject to a lower effective tax rate (10.5 percent when considering the section 250 deduction) than subpart F income and ECI (21 percent). Thus, if most CFC assets are held in connection with the production of tested income that would generally be taxed at a 10.5 percent rate, a question arises whether the value of those assets should be taken into account in the section 382 limitation applied, for example, to attributes used against ECI (taxed at a 21 percent rate). (Additional questions may arise concerning assets that produce QBAI, the return from which is not subject to U.S. tax.) Thus, there is a question whether different values should be used to determine the section 382 limitation for different types of income, and, if so, how those values should be calculated. As stated above, the determination of whether different value rules are needed should consider the potential complexity of those rules compared with the likelihood of CFC loss trafficking and potential rate arbitrage.

If section 382 were to apply for different types of income, tracing would be necessary for assets, liabilities, income, deductions, and attributes covered by section 382. Existing expense allocation rules provide a basis for tracing expenses to categories of income. For example, for BIE carryovers, existing expense allocation rules address the allocation of interest expense to tested income and subpart F income.⁵⁷ Under reg. section 1.861-9(c)(5), in the tax year that any deduction is permitted for BIE with respect to a disallowed BIE carryforward, that BIE is apportioned under those expense allocation rules as though the interest were incurred in the tax year in which the expense is deducted. Regarding ECI, Treasury and the IRS have not yet released final regulations providing a comprehensive set of rules addressing the application of section 163(j) to foreign corporations with ECI. Proposed regulations addressing these issues (prop. reg. section 1.163(j)-8) were released in 2018.⁵⁸ The regulations were re-proposed in 2020.⁵⁹ The proposed regulations released in 2020 provide that, in applying section 163(j) to a specified foreign person, certain definitions, including BIE, are modified to take into account only ECI items.

3. NUBIG and RBIG.

Questions also arise regarding the application of the NUBIG and RBIG rules. Assume that a U.S. corporation, USP, owns 100 percent of the stock of a foreign corporation, CFC Y. The FMV of USP is $500 million, and the FMV of CFC Y is $100 million. USP undergoes an ownership change. Assume that the section 382(c) continuity of business enterprise requirement is satisfied and that the section 382(h) de minimis threshold for NUBIG or NUBIL is not applicable. CFC Y does not generate subpart F income, does not conduct a U.S. trade or business, and has no ECI.

Assume that CFC Y has a $10 million carryforward of BIE and is thus treated as a loss corporation under section 382(k). The basis of CFC Y’s assets is $25 million because of significant prior depreciation and amortization. Because the FMV of CFC Y’s assets is $100 million, CFC Y has a NUBIG. As a result, any RBIG within the five-year recognition period increases the section 382 limitation.⁶⁰ RBIG is any gain recognized during the five-year recognition period on the disposition of any asset to the extent the new loss corporation establishes that (1) it held the asset on the change date and (2) that gain does not exceed the asset’s built-in gain on the change date.⁶¹

Section 382(e)(3) provides that “in determining the value of any old loss corporation which is a foreign corporation,” only ECI items shall be taken into account. This limitation is relevant to calculating a loss corporation’s post-change-year section 382 limitation, which under section 382(b)(1) is “the value of the old loss corporation” multiplied by the long-term tax-exempt rate. Under section 382(h)(1)(A)(i), “the section 382 limitation for any recognition period taxable year shall be increased by the recognized built-in gains for such taxable year.” Unlike section 382(e)(3), this provision is not limited by reference to ECI assets. Assuming CFC Y’s initial section 382 limitation is zero under current law because CFC Y has no ECI items, if CFC sells an asset for a $5 million gain, does this RBIG, regardless of whether it is associated with ECI, increase CFC Y’s section 382 limitation applied to CFC Y’s BIE carryforwards? Further, what is the impact of the deemed RBIG under the 338 approach described in Notice 2003-65?

If guidance applies section 382 to different categories of income of a CFC, it appears the guidance should also provide rules for categorizing RBIG as a type of income (for example, tested income) and then allowing RBIG to increase the section 382 limitation only for that category. The rate differential issues described above in connection with the calculation of the section 382 limitation would also arise (for example, whether gain taxed at a reduced rate should be permitted to increase the section 382 limitation for use of a loss that would reduce income subject to tax at a higher rate).

4. Section 163(j) and group calculation issues.

The 2021 final section 163(j) regulations modify the general application of section 163(j) to CFCs in some circumstances, including when a CFC group election or CFC safe harbor election (which may apply to stand-alone CFCs or CFC groups) is made.

A CFC group election may be made to compute a single section 163(j) limitation for a “specified period” of a “CFC group.”⁶² A specified group is determined in a manner similar to U.S. consolidated groups, generally looking to CFCs connected through 80 percent ownership.⁶³ Each CFC group member determines, generally on a separate-company basis, its current-year BIE, disallowed BIE carryforward (subject to some special rules), business interest income, floor plan financing interest expense, and ATI.⁶⁴ Each CFC group member’s amounts of each item are then added together to determine CFC group amounts for each item and to determine a group section 163(j) limitation.⁶⁵ The CFC group’s limitation is then allocated to each CFC member using allocation rules similar to those that apply to U.S. consolidated groups.⁶⁶

A CFC safe harbor election for either stand-alone CFCs or CFC groups allows a simplified calculation. At a high level, it looks to whether the CFC’s or CFC group’s, as applicable, BIE is less than or equal to either (1) business interest income or (2) 30 percent of the lesser of (A) tentative taxable income and (B) the sum of subpart F income and U.S. shareholders’ GILTI inclusions, minus the section 250(a) deduction, using simplifying assumptions and taking into account only amounts attributable to a non-excepted trade or business. If the conditions of the safe harbor are met and the election is made, no portion of the BIE of the stand-alone applicable CFC or of each CFC group member (as applicable) is disallowed under the section 163(j) limitation.⁶⁷

For a CFC group, the 2021 final section 163(j) regulations contain rules to limit the use of BIE carryforwards of a CFC group member that arose in a tax year before the member joined a CFC group. Under reg. section 1.163(j)-7(c)(3)(iv)(A)(1), a CFC group member cannot deduct pre-group disallowed BIE carryforwards exceeding the aggregate section 163(j) limitation for all specified periods of the CFC group, determined by reference only to the CFC group member’s items of income, gain, deduction, and loss, and reduced (including below zero) by the CFC group member’s BIE (including carryforwards) taken into account as a deduction by the CFC group member in all specified tax years in which the CFC group member has continuously been a CFC group member.

These pre-CFC group BIE carryforward limitation rules are somewhat similar to the separate return limitation year (SRLY) rules applicable in the domestic context to consolidated groups. When a loss corporation joins a consolidated group, the consolidated group may use the losses and disallowed BIE carryforwards of the new member only to the extent the member contributes to consolidated taxable income. However, under an overlap rule that applies to attributes including BIE carryforwards, the domestic consolidated SRLY rules do not apply if section 382 applies.⁶⁸ The current regulations do not include a similar overlap rule for BIE carryforwards of new group members in the CFC context.

Given that there is an overlap rule prioritizing section 382 over the SRLY rules in the domestic consolidated group context, there is a question about whether an overlap rule is appropriate in the CFC group context to prioritize section 382 over the pre-CFC group BIE carryforward limitation rules. In the preamble to the 2021 final section 163(j) regulations, Treasury and the IRS state that they retained the limitation on the deduction of pre-CFC group disallowed BIE carryforwards because “loss trafficking concerns may arise anytime the ATI or [business interest income] of one CFC group member is used to allow a deduction for BIE of another CFC group member attributable to a taxable year before the other CFC group member joined the CFC group.”⁶⁹ However, Treasury and the IRS “continue to study certain aspects of the application of sections 163(j) and 382 to foreign corporations, including the possible application of a SRLY overlap rule to applicable CFCs joining or leaving a CFC group, as well as the computation of any relevant section 382(a) limitation.”

5. Transition rules.

Questions also arise regarding potential transition rules. Given the absence of guidance and novel issues raised by the TCJA, it seems appropriate to apply any new rules prospectively to ownership changes occurring after the effective date of final regulations.

6. Application to U.S. shareholders of CFCs and interaction with CFC rules.

The discussion above focuses on the application of section 382 at the CFC level. The changes made by the TCJA have already caused Treasury and the IRS to revisit some rules in the domestic context relevant to calculating the section 382 limitation. As discussed above, in Notice 2003-65, the IRS stated that it was studying the circumstances under which items of income, gain, deduction, and loss that a loss corporation recognizes after an ownership change should be treated as RBIG and RBIL. The notice provides two alternative approaches for the identification of built-in items that could be used as safe harbors until further guidance is issued: the 1374 approach and the 338 approach.

The 2019 proposed section 382 regulations include a method for identifying RBIG or RBIL that is similar to the 1374 approach described in Notice 2003-65, with some modifications and elaborations. Under the 2019 proposed section 382 regulations, income included as a dividend under section 61(a)(7) and income inclusions for stock (excluding gain recognized on the disposition of stock) are not treated as RBIG. Thus, neither gain from the disposition of stock of a foreign corporation that is taxable as a dividend under section 1248 nor amounts included in a U.S. corporate shareholder’s income as subpart F income or GILTI are treated as RBIG that may increase a U.S. corporate shareholder’s section 382 limitation.⁷⁰ In the preamble to the 2019 proposed section 382 regulations, Treasury and the IRS state that gain taxable as a dividend under section 1248 would generally give rise to the dividends received deduction under section 245A, with no net income being generated, and, accordingly “because no losses would be required to offset this item of income, the Treasury Department and the IRS have determined that this income item should not give rise to RBIG.”⁷¹

Note, however, that there can be situations in which the section 245A dividends received deduction does not apply to amounts treated as a dividend under section 1248, such as if the holding period requirements are not met or if the hybrid dividend rules of section 245A(e) apply. Commentators have requested that Treasury and the IRS consider refining the dividend rules to consider the potential unavailability of a dividends received deduction.⁷²

V. Conclusion

When current section 382 was added to the code in 1986 and later amended to add section 382(e)(3) in 1988, it appears that Congress did not focus on the application of the provision to foreign corporations outside the ECI context, likely due to an assumption that U.S. loss attributes were generally not significant for foreign corporations unless a foreign corporation was itself subject to U.S. tax because of ECI. As a result, section 382(e)(3) provides that, except as provided in regulations, the section 382 limitation of foreign corporations only takes into account the value of ECI items. After the TCJA, this limitation regarding ECI items remains, despite the significant expansion of CFC income subject to U.S. tax that is potentially affected by loss limitation rules. In our view, Treasury and the IRS have regulatory authority under section 382(e)(3) and (m) to address the determination of CFC value and other issues relating to CFCs in a manner that takes into account the TCJA’s expansion of taxation of CFC income. Treasury and the IRS should consider addressing this area in a post-TCJA world, including considering providing guidance allowing taxpayers to use a single CFC value, taking into account all CFC assets and liabilities, for purposes of the section 382 limitation for CFCs.

FOOTNOTES

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