Tier I Issue Loss Importation Transaction - Directive # 1
LMSB Control No: LMSB-4-0110-004
Impacted IRM 4.51.5
June 16, 2010
Walter L. Harris /s/ Walter L. Harris
Tier I Issue Loss Importation Transaction - Directive # 1
This memorandum provides field direction and a uniform format and approach for examiners to evaluate potential compliance risk related to the Loss Importation Transaction (identified as a listed transaction in Notice 2007-57, 2007-2 C.B. 87), and to outline the issue management and oversight process. The Loss Importation Transaction is an international tax avoidance transaction that is often implemented in combination with other listed transactions such as Intermediary Transactions listed in Notice 2008-111, 2008-51 I.R.B. 1299 (which clarified Notice 2001-16, 2001-1 C.B. 730) and Son of Boss Transactions listed in Notice 2000-44, 2000-2 C.B. 255. The issue owner executive is Rosemary Sereti, Director, Field Operations (Manhattan), Financial Services.
In a typical Loss Importation Transaction, a U.S. taxpayer uses offsetting positions with respect to foreign currency or other property for the purpose of importing a loss, but not the corresponding gain, in determining U.S. taxable income. Loss Importation Transactions may be structured in a variety of ways. The variation among the cases with respect to the type of entities used, the property involved, and the method/transaction through which the loss is imported presents a challenge in crafting and correctly applying the appropriate technical and legal arguments to attack these transactions. It has been determined that a strategic approach is necessary to address these transactions. Accordingly, this issue was designed as a Tier I issue and an Issue Management Team (IMT) was formed.
The IMT includes personnel from LMSB, Counsel and Appeals. The IMT is working to establish a consistent Service position on audit, discourage future non-compliance by seeking written guidance, appropriately coordinate with Appeals while respecting its independence, and identify cases where litigation is an appropriate resolution vehicle.
Information regarding some of the variations is provided below.
Listed Transaction Notice Variation
In the variation of the Loss Importation Transaction described in Notice 2007-57, a U.S. taxpayer is a shareholder of an S corporation. The S corporation acquires ownership meeting the requirements of I.R.C. § 1504(a)(2) in a foreign entity. At the time of the acquisition, the foreign entity is classified as a corporation for U.S. tax purposes under Treas. Reg. § 301.7701-2(b)(2) and § 301.7701-3(b)(i)(B), and becomes a controlled foreign corporation (“CFC”) under I.R.C. § 957(a).
After the acquisition, the foreign entity enters into substantially offsetting gain and loss positions in, for example, foreign currency option contracts. Next, the foreign entity disposes of or closes out the gain positions while retaining the loss positions, resulting in the realization of income. The foreign entity is not subject to U.S. taxation on this income and because the foreign entity is a corporation at the time it closes out the gain positions, its income is not recognized by the S corporation or the U.S. taxpayer (further described below). The foreign entity may use the proceeds from the disposition or closing out of the gain position to enter into new positions in foreign currency to offset the retained loss positions so that the foreign entity has very little net economic risk. In addition to virtually eliminating further economic risk by entering into new positions, the foreign entity effectively preserves the loss positions in the foreign currency.
After the foreign entity disposes of or closes out the gain positions, it elects to be treated as a disregarded entity for U.S. tax purposes under Treas. Reg. § 301.7701-3(a) (the check-the-box rules). The timing of the entity classification election is such that the foreign entity is not a CFC for an uninterrupted period of 30 days during its taxable year. Consequently, the S corporation is not required to include any of the foreign entity’s subpart F income in its gross income. I.R.C. § 951(a). The gain from the disposition or closing out of the gain positions is not otherwise subject to U.S. taxation. See, e.g., I.R.C. §§ 881 and 882. The entity classification election results in a deemed liquidation of the foreign entity and the distribution of all its assets and liabilities (including the remaining option contracts) to the S Corporation. Treas. Reg. § 301.7701-3(g)(1)(iii). The S Corporation's exposure to tax under Treas. Reg. § 1.367(b)-3(b)(3) upon the liquidation of the CFC should be minimal. The inclusion of the CFC's earnings and profits is based on a fraction: the number of days the S corporation held the CFC stock over the total number of days the corporation is in existence during its tax year. As in most cases, the S Corporation held the CFC stock for only a few days during the CFC's taxable year, thus only a small fraction of the CFC's earnings and profits for the year is required to be included as a dividend. Moreover, for the taxable year 2000 (in which many of these transactions were entered into), the regulations provided a temporary transition rule that allowed them to avoid any I.R.C. § 367(b) inclusion.
After the entity classification election, some or all of the loss positions are allowed to expire, disposed of, or closed out, and some or all of the new positions are allowed to expire, disposed of, or closed out, resulting in an aggregate net loss to the S Corporation. The U.S. taxpayer recognizes a pro rata share of the net losses. I.R.C. § 1366. The U.S. taxpayer purports to have sufficient basis in its S Corporation stock or in its indebtedness to the S corporation to enable it to claim the loss. In cases where the U.S. taxpayer does not have sufficient basis in its S corporation stock to take advantage of the S corporation’s pro rata share of the losses, the U.S. taxpayer may inflate its basis in the S corporation stock by contributing (1) new offsetting option contracts to the S corporation prior to exercising or closing out the loss legs, (2) assets that have an inflated basis as result of a prior tax shelter transaction, or (3) cash.
Variations exist in the types of entities and forms of loss importation used in the transaction described above.
(1) In one variation of the transaction, a C corporation may be used instead of an S corporation.
(2) The foreign entity may have more than one owner so that the entity classification election results in the foreign entity being classified for U.S. tax purposes as a partnership, rather than as an entity disregarded as separate from its owner.
(3) The importation of the loss may be accomplished by methods other than a deemed liquidation occurring in connection with an entity classification election, such as a corporate reorganization described in I.R.C. § 368(a) or a transfer to which I.R.C. § 351 applies. An example of this variation involves a foreign trust (Foreign Trust) that forms a single-member limited liability company (LLC) in the U.S., which is disregarded as an entity separate from its owner for U.S. federal income tax purposes under Treas. Reg. § 301.7701-3(b)(1)(ii). LLC enters into the offsetting positions, and shortly thereafter LLC disposes of, or closes out, half of the positions for a gain, while retaining the offsetting loss positions. The gains from disposing of or closing out the positions are not subject to U.S. taxation. After realizing gains from disposing of the gain positions, Foreign Trust transfers its interest in LLC, which holds the offsetting loss positions, to a domestic (Subpart E) trust (Domestic Trust). As a result, LLC is wholly-owned by Domestic Trust and is disregarded as separate from its owner for U.S. federal income tax purposes. Domestic Trust causes LLC to transfer some or all of the loss positions to one or more corporations subject to U.S. taxation in transactions intended to qualify under I.R.C. § 351. Once the loss positions have been transferred to the corporations, the positions are disposed of, closed out, or allowed to expire, resulting in an aggregate net loss that the corporation uses to offset other income, or is otherwise claimed as a loss for U.S. tax purposes.
(4) Variations also exist in how the offsetting positions may be used in the transaction described above. For example, taxpayers may use positions with respect to property other than options on foreign currency.
Loss Importation Transactions are designed so that taxpayers may claim losses without taking into account the corresponding gain attributable to the offsetting positions. By engaging in these transactions, taxpayers are attempting to exploit the entity classification rules and I.R.C. § 951. The Service has been challenging these transactions by disallowing the loss or allocating the loss to the entity that economically incurred the loss. For transactions after October 22, 2004, I.R.C. §§ 362(e)(1) and 334(b)(1)(B) may prevent importation of losses by providing the transferee or distributee with a fair market value basis in imported assets, thus preventing a later recognition of loss.
Cases that involve these transactions should be identified in the Issue Management System (IMS) with special UIL code 9300.43-00, Loss Importation Transactions. This Code is being used in Compliance, Appeals, and Counsel. Within the ERCS Tracking System, the code to be used for this issue is 9200.
Only a very small number of cases have been brought to the IMT’s attention through listed transaction disclosures under I.R.C. § 6011. In several instances, the existence of a Loss Importation Transaction was uncovered during the examination of other listed transactions, for example, Intermediary Transactions and Son of Boss Transactions. Taxpayers who engaged in Loss Importation Transactions but did not file the required disclosures under I.R.C. § 6011 and associated regulations are subject to penalties under I.R.C. § 6707A. Such taxpayers may also be subject to an extended period of limitations under I.R.C. § 6501(c)(10). Additionally, material advisors who did not file the required disclosures under I.R.C. § 6111 and associated regulations are subject to penalties under I.R.C. § 6707(a).
The IMT believes that these transactions are most frequently detected during the course of an audit. Examiners should look for the following U.S. tax disclosures which may be made in connection with these transactions:
- A Form 8832 (check the box election).
- A Form 5471 with respect to the ownership of the foreign entity for the period it is treated as a corporation for U.S. tax purposes.
- An I.R.C. § 367(b) disclosure with respect to the deemed liquidation of the foreign entity resulting from the check the box election.
- A Form 926 and a I.R.C. § 351 disclosure with respect to the transfer of the option contracts to the foreign entity.
- A Form 8858 or 8865 with respect to the ownership of the foreign entity for the period it is treated as a disregarded entity or partnership for U.S. tax purposes.
LMSB has not uncovered evidence that would suggest widespread promotion of Loss Importation Transactions. However, as previously stated, these transactions may have escaped detection during the course of examinations of other listed transactions such as Intermediary Transactions or Son of Boss Transactions.
Planning and Risk Analysis:
Examination Teams should carefully scrutinize cases where a U.S. taxpayer is using offsetting positions with respect to foreign currency or other property and where the tax disclosures described above were filed or would otherwise be required. In addition, heightened scrutiny should be given to cases already identified as involving Intermediary Transactions or Son of Boss Transactions.
Examination Teams with this issue should contact the Loss Importation Technical Advisor listed below as soon as they identify indicators of this issue. Teams should anticipate communicating regularly with the IMT upon the initial identification of the transaction and throughout the development of the case. All Notices of Proposed Adjustment (“NOPAs”) are required to be shared with the IMT (through Financial Services DFO – Manhattan) for purposes of obtaining the IMT’s approval. There is an expectation that certain key members of the IMT will work closely with the field team and local LMSB counsel to enhance and facilitate the NOPA review and finalization process. The IMT’s approval must be obtained before issuance of the NOPA to the taxpayer. Penalties must be considered in accordance with general LMSB guidance.
Questions regarding the development of the Loss Importation issue should be referred to the International Technical Advisor for Foreign Joint Ventures, Foreign Partnerships, Check-the-Box, Dual Consolidated Losses and Foreign Transactional Gains and Losses Ron Calewarts at (414) 727-5482 or Issue Counsel Michele Gormley at (617) 565-7858.
This Directive is not an official pronouncement of law or the position of the Service and cannot be used, cited, or relied upon as such.
cc: Commissioner, LMSB
Deputy Commissioner, LMSB
Division Counsel, LMSB
Director, Performance, Quality and Analysis & Support
Director, Pre-Filing & Technical Guidance