Sourcing of capital losses

Tax Executive, The, May-June, 1996

On April 29, 1996, Tax Executives Institute submitted the following comments to Michael Danilack, IRS Assistant Chief Counsel (International), concerning regulations to be issued under section 865(j) of the Internal Revenue Code. The comments were prepared under the aegis of TEI's International Tax Committee whose chair is Joseph S. Tann, Jr. of Ameritech Inc.

On behalf of Tax Executives Institute, I am pleased to submit the following comments on the regulations to be issued under section 865(j) of the Internal Revenue Code, relating to the sourcing of losses from the disposition of stock. TEI commends the IRS for including this project on their priorities list for 1996.

Background

The United States imposes tax on a taxpayer's worldwide income and the U.S.-source rules play an important role in the computation of a taxpayer's foreign tax credit limitation. The limitation is applied to carry out the underlying purpose of the credit - to eliminate what otherwise would be anti-competitive double taxation of foreign income without unduly reducing a taxpayer's tax on its U.S. income. For the foreign tax credit mechanism to function properly, each item of income must have a source either within or outside the United States. Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, at 916 (1987) (hereinafter cited as the "General Explanation").

Enacted as part of the Tax Reform Act of 1986, section 865 of the Code provides a general sourcing rule for sales of personal property. The statute states that income from such sales by a U.S. resident shall be sourced in the United States, whereas income from sales by a nonresident are sourced outside the United States. Section 865(j)(1) authorizes the Secretary "to prescribe such regulations as may be necessary or appropriate to carry out the purpose of this section," including regulations relating to the treatment of losses from sales of personal property.

A. The Legislative History of Section 865 Supports Symmetrical Sourcing of Gains and Losses. Logically, losses on the sale of stock of a foreign subsidiary should be allocated and apportioned to the same class of income that would have resulted if a gain had been recognized on the sale of the stock. The Joint Committee report supports symmetrical treatment of gains and losses:

It is anticipated that regulations will provide that losses from sales of personal property generally will be allocated consistently with the source of income that gains would generate but that variations of this principle may be necessary.

General Explanation 923. There should be no question that this congressional intent should be respected and that any "variations" should be narrowly circumscribed and adequately justified.(1)

B. The Legislative History of the Sourcing Rules Also Supports Symmetrical Sourcing of Gains and Losses. The symmetrical approach is also consistent with the policy underlying the 1986 Act's changes to the sourcing rules -- that foreign source taxable income should be commensurate with the amount that foreign jurisdictions are likely to tax consistent with international norms. In this regard, the House Report on the 1986 Act provides:

Source rules for sales of personal property should reflect the location of the economic activity generating the income at issue or the place of utilization of the assets generating that income. In addition, source rules should operate clearly without the necessity for burdensome factual determinations, limit erosion of the U.S. tax base, and, in connection with the foreign tax credit limitation, generally not treat as foreign income any income that foreign countries do not or should not tax.

H.R. Rep. No. 99-426, 99th Cong. 1st Sess. 360 (1985) (emphasis added).

This principle prescribes that losses on stock should not be allocated and apportioned to a class of income when foreign tax on that income is not reduced by the loss. If amounts that are generally not subject to foreign tax are excluded from the appropriate foreign source limitation "basket," then the amount of income in that basket should not be reduced by a specific allocation of losses.

This approach also accords with the 1986 enactment of section 988(a)(3), which generally provides that the source of any foreign currency gain or loss attributable to a section 988 transaction is determined by reference to the taxpayer's residence or the taxpayer's qualified business unit on whose books the asset is properly reflected. In the legislative history of this provision, Congress suggested that losses under section 865 should be similarly treated:

The [Senate Finance] committee determined that the overriding consideration should be to provide certainty regarding the source of exchange gain or loss. The bill accomplishes this result by providing definitive rules that are consistent with the treatment of foreign currency as personal property and the amendments to the sourcing rules in section 611 of the bill [which includes section 865].,,