In final regulations (T.D. 10026; Final Regulations) issued 10 January 2025, the United States (US) Department of Treasury (Treasury) and the Internal Revenue Service (IRS) partially implement the proposed DCL regulations issued on 6 August 2024 (REG-105128-23; Proposed Regulations). The Final Regulations finalize two key aspects of the Proposed Regulations: (1) the DPL rules, which require income inclusions for certain disregarded payments that are deductible under foreign law, and (2) an anti-avoidance rule applicable to DCLs and DPLs.

Though generally retaining the framework of the Proposed Regulations, the Final Regulations contain several modifications to the DPL rules. In addition, certain components of the Proposed Regulations were not finalized and are expected to be addressed in future guidance, including the elimination of the "inclusions on stock" rule (other than for portfolio investments) and the interaction of the DCL rules with the intercompany transaction rules under Treas. Reg. Section 1.1502-13. For more on the Proposed Regulations, see Tax Alert 2024-1529.

Detailed discussion of Final Regulations

DPL rules

The DPL rules are intended to prevent certain disregarded entity classifications from avoiding the application of the DCL rules (for example, double-deduction or deduction/non-inclusion outcomes that arise from certain disregarded payments that are deductible in a foreign country and are disregarded for US tax purposes). In general, the DPL rules require domestic owners (DPE owners) of disregarded payment entities (DPEs)¹ to (1) track whether certain payments give rise to potential "double dipping" outcomes, and (2) include in income the amount that would have been included with respect to the payment had the payment been regarded for US tax purposes.

In general, a DPE owner's DPL with respect to a DPE equals the excess, if any, of certain disregarded deductions over certain disregarded payment income (DPI). For this purpose, specific items (structured payments, interest or royalties) are only taken into account if they (1) give rise to deductions or income of the DPE under a foreign tax law (taking into account any foreign hybrid mismatch rules), and (2) are disregarded for US tax purposes. To the extent the DPE owner has a DPL with respect to a DPE in an applicable tax year, similar to DCL reporting, the DPE owner would generally disclose the DPL on an initial certification statement and file annual certifications for the following 60 months affirming there has been no foreign use of the DPL.

To the extent there is a foreign use of the DPL within the certification period, or the DPE owner fails to comply with the certification requirement, the DPE owner must include the DPL in its gross income in the year of the triggering event. The DPL inclusion amount equals the DPL, reduced by the positive balance (if any) in the DPL cumulative register, which is an account that includes DPI but no other income. For US tax purposes, the DPL inclusion is treated as ordinary income and characterized as if it were interest or royalty income paid by a foreign corporation to the DPE owner.

Under a combination rule, DPEs that are subject to the same foreign tax law are treated as a single DPE if they have the same domestic owner or their respective owners are members of the same consolidated US group.

Suspended deductions

The Final Regulations introduced the concept of a "suspended deduction," which a DPE owner establishes in an amount equal to any DPL inclusion amount in the tax year following the DPL inclusion. The DPE owner is then allowed a deduction (i.e., the suspended deduction becomes unsuspended) in the tax year the suspended deduction is established, or subsequent tax years, to the extent of that the DPE owner has (net positive) DPI. The DPE owner must file a statement disclosing the use the of the suspended deduction. A suspended deduction that is claimed as a deduction is characterized and sourced in the same manner as the DPL inclusion amount to which it relates. Neither a suspended deduction nor a DPL inclusion amount may be taken into account for purposes of determining any income or DCL of a separate unit or dual resident corporation.

Exception for license agreements executed before 6 August 2024

The Final Regulations provide an exception from the DPL rules for royalties paid or accrued under a license agreement executed before the date of the Proposed Regulations (i.e., 6 August 2024), unless the agreement undergoes significant modifications, such as changes in parties or rights in consideration for which the royalties are paid. Extensions or term updates without other changes are not considered significant modifications, and combined DPEs are treated as single licensors or licensees.

Limitation for deemed ordering rule

For purposes of determining whether there has been a foreign use (in both the DCL and DPL context), a deemed ordering rule applies such that losses or deductions are first applied to reduce the income that does not constitute a foreign use. Only after these losses or deductions have been fully utilized to offset non-foreign use income are any remaining losses or deductions applied to reduce income that constitutes a foreign use.

The Final Regulations limit the deemed ordering rule by considering only items of income or gain that would be taken into account in determining the DCL (that is, regarded items) for purposes of applying the deemed ordering rule to DCLs. Similarly, for DPLs, the only relevant items are those that are or would be taken into account for determining a DPL or DPI (that is, disregarded interest or royalties).

Clarifications to anti-avoidance rule

The Proposed Regulations introduced an anti-avoidance rule allowing "appropriate adjustments" when taxpayers engaged in a transaction, series of transactions, plan or arrangement with "a view to avoid" the purposes of DCL or DPL rules. These adjustments could involve disregarding the transaction or modifying the items considered in the DCL or DPL calculations of DPE owners.

The Final Regulations clarify that the purpose of the anti-avoidance rule is to prevent double deductions and similar outcomes; restructuring arrangements so they avoid the application of the DCL rules or DPL rules without resulting in such outcomes are not within the scope of the rule. The Final Regulations also provide additional examples that illustrate the application, and nonapplication, of the anti-avoidance rule.

The Final Regulations illustrate the scope of the anti-avoidance rule through new examples that appear to assume the new DPL rules apply, with new Treas. Reg. Section 1.1503(d)-7(c) Examples 44 and 45 being particularly noteworthy:

• In Example 44, P and S join in filing a US federal consolidated income tax return. Acting with a prohibited view, P lends cash to S's foreign disregarded subsidiary in exchange for a note with terms subjecting S's $100x interest expense deduction to disallowance under IRC Section 163(l). The parties apply Treas. Reg. Section 1.1502-13 to match this disallowance by redetermining P's $100x of interest income to be treated as tax-exempt income. Because the results produce a double deduction or similar outcome, the anti-abuse rule applies to (1) treat S's $100x interest deduction each year as a disregarded amount subject to the DPL rules, and (2) require S to include a $100x DPL income inclusion each year (and establish a $100x suspended deduction).
• In Example 45, P and S join in filing a US federal consolidated income tax return. P owns a foreign disregarded subsidiary, and also holds an interest-bearing note issued by the disregarded subsidiary. Acting with a prohibited view, P contributes its creditor interest to S, with the interest under the note thereafter being regarded and the foreign subsidiary's $100x annual interest deduction being subject to the DCL rules. Because the deduction is subject to DCL domestic use limitation, the anti-abuse rule does not apply. But the example does not address the treatment of S's matching $100x of annual interest income; based on statements in the Preamble accompanying the Final Regulations, it is unclear whether (1) Treas. Reg. Section 1.1502-13 applies to treat the income as deferred in order to match the deduction's deferral, or (2) the income must be taken into account currently despite the deduction's deferral in order to simulate the results for the consolidated group of the DPL rules for disregarded transactions.

The anti-avoidance rule does not apply to the reduction or elimination of a DCL solely by reason of (1) intercompany transactions, (2) the stock ownership rule, (3) >attributing items to a hybrid entity separate unit (or to an interest in a transparent entity) that have not been and will not be reflected on the entity's books and records, or (4) applying DCL rules to the OECD's Global Anti-Base Erosion Model Rules (GloBE Rules).

Minority investor exception

The Final Regulations revise the definition of a DPE to exclude entities that are not "related" to a DPE owner within the meaning of IRC Section 954(d)(3) (applied by treating a disregarded entity as a corporation, as the case may be). In addition, the Final Regulations remove the Proposed Regulations' requirement to apply the DPL rules on a proportionate basis based on value when a DPE owner indirectly owns less than all the interest in a DPE.

De minimis exception

The Final Regulations also added a de minimis exception. Under this exception, a DPE will be considered to have no DPL if it is generated in the course of an active trade or business and is less than the lesser of $3 million or 10% of the aggregate of all items of the DPE that are deductible under foreign law, including items that would not be treated as interest, structured payments or royalties under US tax law.

Additional Pillar Two transitional relief

The Final Regulations extend transitional relief regarding the interaction of DCL rules with the GloBE Rules. Future regulations will apply the DCL rules 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) in tax years beginning before 31 August 2025. Taxpayers may rely on this transitional relief until such future final regulations are published in the Federal Register.

Applicability dates

The Final Regulations apply the DPL rules to tax years beginning on or after 1 January 2026, a significant delay from the effective date in the Proposed Regulations, which would have applied these rules to tax years ending on or after 6 August 2024. The anti-avoidance rule applies to DCLs incurred in tax years ending on or after 6 August 2024, and to DPLs in tax years beginning on or after 1 January 2026. The changes to the deemed ordering rule apply to DCLs and DPLs incurred in tax years beginning on or after 1 January 2026.

Implications

The introduction of the DPL rules in the Proposed Regulations came as a surprise to many taxpayers, especially to those that have financing or licensing transactions involving US-owned disregarded entities or foreign branches. While the Final Regulations introduced several taxpayer-favorable modifications, the DPL rules still have the potential to result in income inclusions in many fact patterns. For example, although the Final Regulations introduced the concept of a suspended deduction, which is intended to effectively reduce a DPL inclusion to a timing difference, to the extent a DPE does not have DPI in a subsequent tax year, the suspended deduction remains suspended indefinitely, and the additional US income recognized as a result of the DPL inclusion becomes permanent.

With more time available before these rules take effect, taxpayers should evaluate their current and future structures to optimize their tax positions by restructuring transactions where necessary and leveraging available exceptions and transitional relief.