Controversial Disregarded Payment Loss Rules Finalized, With Some Relief

Treasury and the IRS have finalized a new "disregarded payment loss" (DPL) regime that can require domestic corporations to include in income amounts with respect to payments that are disregarded for US tax purposes but that are deductible under foreign tax law. Proposed regulations addressing DPLs, as well as aspects of the dual consolidated loss (DCL) regime, were issued in August 2024 (REG-105128-23). Treasury and the IRS have described the purpose of the DPL rules as preventing arrangements involving disregarded entities from avoiding the DCL rules, which are intended to prevent "double dipping" of losses, i.e., the use of a single economic loss to offset income in more than one jurisdiction. Treasury and the IRS received a number of comments criticizing the proposed regulations, including comments questioning Treasury and the IRS’s authority to implement the DPL regime.

This article highlights five key aspects of the final regulations, issued on January 10, 2024.

1. DPL Regime Can Require Income Inclusions from Disregarded Payments. At a high level, the DPL regime can create income inclusions from certain disregarded payments that give rise to a foreign tax deduction. More specifically, the regime requires tracking of interest, royalties, and structured payments (substitute interest or amounts economically equivalent to interest) between a disregarded entity and its owner and, where the payments give rise to a net foreign loss, an income inclusion is required upon certain events, including where the loss is used to offset income or otherwise considered put to a foreign use. In a change from the proposed regulations, the final regulations also treat the income inclusion as giving rise to a deduction that is suspended until the disregarded entity has income from certain disregarded payments, so that the owner’s items of income and deduction are similar to those that it would have if the payments composing the DPL were regarded for US tax purposes.
2. Final Regulations Make Some Substantive Changes. The final regulations slightly narrow the scope of the DPL regime. The DPL regime will not apply to royalties paid pursuant to a license agreement executed before the date of the 2024 proposed regulations. The final regulations also provide a de minimis exception for a DPL incurred in connection with an active trade or business where the DPL amount is less than the lesser of $3 million or 10% of the aggregate amount of all items of the disregarded payment entity that are deductible under a foreign tax law. The final regulations also remove certain unrelated entities from the scope of the rules. The final regulations retain the anti-avoidance rule focused on whether a transaction or arrangement is engaged in “with a view” to avoid the purposes of the rules, but modify the anti-avoidance rule to add examples and clarify that the purpose of the regulations is to prevent double deduction and similar outcomes.
3. Effective Date Extended. The final regulations apply the DPL rules to taxable years beginning on or after January 1, 2026. The proposed regulations would have applied the DPL rules as of August 6, 2024, with a one-year delay for certain entities in existence on that date.
4. Preamble Defends Authority. In the preamble to the final regulations, Treasury and the IRS defend their ability to implement the DPL regime under the authority that allows Treasury and the IRS to implement the "check-the-box" entity classification regime. Treasury and the IRS also argue that the DPL rules "are a reasonable response to significant policy concerns resulting from the check-the-box regulations."
5. Proposed DCL Regulations Were Not Finalized, but Treasury and the IRS Have Provided Additional Transition Relief Related to Pillar 2. The final regulations generally do not contain the changes to the DCL regime proposed in August 2024. The final regulations do, however, extend transition relief with respect to the interaction of the DCL regime and Pillar 2. The August 2024 proposed regulations indicated that Treasury and the IRS regard the use of losses under Pillar 2 jurisdictional blending as giving rise to a foreign use under the US DCL regime, but the revised transition relief essentially means that the DCL rules will not apply to qualified domestic minimum top-up taxes (QDMTTs) or top-up taxes collected under an income inclusion regime (IIR) or undertaxed profits rules (UTPR) incurred in taxable years beginning before August 31, 2025.