Treasury Finalizes DPL Rules, Extends Transitional DCL Relief for Pillar Two Taxes

BACKGROUND

The DCL regulations under section 1503(d) focus on preventing US corporations from using the same loss in both the United States and a foreign jurisdiction (or “double-dipping”). In August 2024, Treasury and the Internal Revenue Service (IRS) released proposed DCL regulations that addressed how the DCL rules interact with Pillar Two taxes and the intercompany transaction rules, and included an anti-avoidance rule. At the same time, they surprised taxpayers with an entirely new set of disregarded payment loss (DPL) rules. Under the proposed DPL rules, domestic corporations would have income inclusions with respect to certain disregarded payments. For additional discussion of the proposed DCL/DPL rules, see here.

VALIDITY

Many taxpayers submitted comments challenging the authority of Treasury and the IRS to issue the DPL rules. Unsurprisingly, Treasury and the IRS vehemently defend their authority to issue the DPL regulations. The preamble to the final regulations notes that the DPL rules are intended to prevent taxpayers from circumventing the DCL rules through an inappropriate use of check-the-box elections and asserts that the rules are consistent with other provisions that “regard” disregarded entities for certain purposes. In contrast, the proposed regulations emphasized that the DPL rules were intended to prevent “deduction/no-inclusion” outcomes. The preamble notes this change in emphasis as a “clarification.”

DELAYED DPL APPLICABILITY DATE

The applicability date of the DPL regulations is delayed to taxable years of disregarded payment entity (DPE) owners (i.e., domestic corporations that directly or indirectly own disregarded entities) beginning on or after January 1, 2026. Calendar-year taxpayers now have almost one year to assess the risk of being subject to the DPL rules and take any remedial steps before the rules apply. The final regulations further simplify the applicability date by removing the proposed regulations’ references to “consent” and “deemed consent” in the DPL regime. Also, effective August 6, 2024, the 60-month limitation on changing an entity classification election is turned off for disregarded entities that elect to be treated as corporations before the DPE owner’s 2026 tax year. As a result, taxpayers can currently elect to treat first-tier disregarded entities as corporations without regard to the 60-month limitation.

CALCULATION OF DISREGARDED PAYMENT INCOME (DPI) AND DPL

The final regulations clarify that items incurred in the portion of a foreign taxable year that an entity or foreign branch is not a DPE are not taken into account for purposes of calculating DPI or DPL. This means that if a DPE inbounds by migrating to become a US entity on, say, February 15, 2026, then only interest and royalties accrued through February 15 will be included in calculating DPI and DPL. In other words, there is no cliff effect in case an entity is a DPE for part, but not all, of a taxable year.

DEDUCTION FOR DPL INCLUSIONS

Under the proposed regulations, a taxpayer could suffer a DPL income inclusion without any offsetting deduction. This treatment differs from the treatment of DCLs, which are allowable as deductions to the extent that the relevant separate unit recognizes income from a US tax perspective.

In response to comments, and perhaps to better align the DPL rules with the structure of the DCL rules, the final regulations provide the DPE owner a deduction (not to exceed the DPL inclusion) to the extent that the DPE derives DPI in a year following the year of the DPL inclusion. This deduction has the same character and source as the DPL inclusion to which it relates.

DEEMED ORDERING RULE

A DPE that has a DPL may also earn income that is regarded from a US tax perspective, or disregarded income that is excluded from the calculation of DPI. The proposed regulations provided that “foreign use” of the DPL was determined under the principles of the DCL rules for foreign use in Treas. Reg. § 1.1503(d)-3. Under these rules, a DCL is presumed to first offset income that does not give rise to a foreign use before giving rise to a foreign use (the “Deemed Ordering Rule”). Applying the Deemed Ordering Rule, taxpayers could reasonably treat DCLs as first offsetting foreign law income that is disregarded for US tax purposes, therefore preventing a foreign use. Comments requested clarification on how the Deemed Ordering Rule applied in the DPL context.

The final regulations modify the Deemed Ordering Rule for DPLs and, notably, also for DCLs. Under the final regulations, the Deemed Ordering Rule is applied separately for each regime, with items of income or gain taken into account only to the extent such items are or would be taken into account in determining the amount of income or loss under the relevant regime. Thus, in determining foreign use for a DCL, only regarded income of the separate unit is taken into account, and in determining foreign use for a DPL, only DPI is taken into account. This change applies for DCLs and DPLs arising in tax years beginning on or after January 1, 2026.

ANTI-AVOIDANCE RULE

The final regulations retain the DCL and DPL anti-avoidance rule for transactions engaged in “with a view” to avoiding the purposes of section 1503(d) and the regulations thereunder. The final regulations clarify that the purpose of section 1503(d) and the regulations thereunder is to prevent double deductions and similar outcomes. This means that the rule does not apply if the arrangement does not give rise to the potential for both a US and a foreign tax deduction. The final regulations identify specific exceptions to the anti-avoidance rule.

For example, the final regulations state that the anti-avoidance rule “does not apply to a reduction or elimination of a DCL solely by reason of … items of income arising from the ownership of stock…” This is a particularly welcome clarification for taxpayers who were caught off-guard by the provision in the proposed DCL regulations that removes taxpayers’ ability to include income from the ownership of stock – including dividends and global intangible low-taxed income (GILTI) and subpart F inclusions – in their DCL calculations. However, the preamble notes that these exceptions would be removed or modified if the proposed DCL regulations are finalized.

The final regulations also retain from the proposed regulations an example (Example 43) that shows that the anti-avoidance rule would apply where a taxpayer avoids having a DCL by contributing US branch assets to a disregarded entity. The final regulations add two further examples illustrating the anti-avoidance rule.

PARTNERSHIPS AND DPES

The final rules “clarify” that a foreign branch owned indirectly through a partnership can be a DPE. Additionally, in certain circumstances an entity that is a foreign tax resident and is treated as a partnership for US tax purposes can be a DPE.

OTHER COMMENTS

The general structure of the rules, including the “all or nothing” rule for foreign use of a DPL, has not changed. However, a few helpful provisions were added. A new de minimis rule creates an exception for a DPL if it is less than the lesser of $3 million or 10% of the aggregate amount of the DPE’s deductible items under foreign law. A grandfathering rule applies to royalties paid on license arrangements in existence before August 6, 2024, provided that the license arrangement has not be significantly modified within the meaning of the final regulations. Finally, a mirror legislation rule provides that the denial of a deduction for a disregarded payment under foreign hybrid mismatch rules does not give rise to a DPL or a foreign use of a DPL.

TRANSITIONAL RELIEF FOR PILLAR TWO TAXES EXTENDED

Significantly, the transitional relief for Pillar Two taxes for the DCL rules was extended further. The regulations state that the DCL rules, when finalized, will provide that the DCL rules will apply 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 rule (UTPR) incurred in taxable years beginning before August 31, 2025.

PROPOSED DCL RULES NOT FINALIZED

Treasury notes its intention to finalize the other proposed DCL rules at some point in the future. These rules include:

• Modifications to the intercompany transaction rules in Treas. Reg. § 1.1502-13.
• The Pillar 2 and DCL foreign use rules and related updates to the separate unit definition.
• Removal of items of income arising from stock, such as subpart F and GILTI inclusions, from the computation of a DCL or cumulative register.
• Clarification of separate unit books and records adjustments to “conform to U.S. tax principles”
• Modification of “certification period” and “foreign use” definition to include prior taxable years.

It remains to be seen whether the new administration will continue to focus on finalizing these rules, or whether it will shift to other priorities; we will know more once the priority guidance plan is released.

CONCLUSION

Taxpayers now have more time to consider whether to modify structures that may give rise to income inclusions under the DPL rules, or whether they are interested in challenging the validity of the final regulations.