Since the Tax Cuts and Jobs Act was enacted in 2017, the use of foreign disregarded entities (FDEs), often achieved via the check-the-box election, has increased. FDEs are often used to reduce U.S. federal income tax, commonly with respect to global intangible low-taxed income (GILTI) inclusions, but also in other circumstances, including the base erosion and anti-abuse tax and intellectual property repatriation. In many cases, the use of FDEs has been an effective strategy and relatively easy to implement with minimal tax cost. However, two sets of recently promulgated U.S. tax regulations have altered the scales by creating potential new challenges for U.S. owners of FDEs beginning in 2025.
Background
From a U.S. tax perspective, the use of FDEs can effectively achieve several tax planning objectives with little downside. For example, FDEs can simplify the application of the passive foreign investment company (PFIC) rules, eliminate various Subpart F inclusions, and reduce GILTI inclusions by aggregating qualified business assets or absorbing the activities of a loss-making entity. Additionally, from a compliance standpoint, FDEs generally require simpler and less comprehensive federal tax filings (Form 8858, Information Return of U.S. Persons With Respect to Foreign Disregarded Entities (FDEs) and Foreign Branches (FBs)) compared to the much lengthier and onerous Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations, that is required for controlled foreign corporations.
2024 Brings New US Complexity
On December 11, 2024, the IRS released final and proposed regulations under Internal Revenue Code Section 987 with respect to foreign currency gains and losses. Accounting for foreign currency fluctuations is not a new concept, and there have been multiple rounds of proposed but never finalized regulations on this complex topic dating as far back as 1991. As a result of the prolonged uncertainty, taxpayers have generally been able to use “any reasonable method” consistently applied.
As a result of the final Section 987 regulations, accounting for foreign currency fluctuations will become more complex for FDEs. Unfortunately, there is virtually no time to prepare for this difficult exercise because the final regulations are generally effective for tax years beginning after December 31, 2024, that is, 2025 for calendar year taxpayers. For publicly traded companies, this complexity will need to be addressed in the first quarter to account for provision implications.
The new regulations address the calculation of currency gains or losses to be reported by the tax owner of “qualified business units” (which generally include operational FDEs) when the tax owner and the FDE have different functional currencies. The final regulations provide detailed guidance requiring current and historical data points that may be quite difficult for many taxpayers to access. For example, Treas. Reg. §1.987-4 provides guidance for calculating the foreign currency gains and losses related to ongoing operations and Treas. Reg. §1.987-10 on the complex transition from previously used approaches to the new approach, and whether a transition gain should be taxed all at once or spread over 10 years. Treas. Reg. §1.987-11 and §1.987-12 discuss the approach to be taken when there is a transition loss.
The final regulations offer several elections that may significantly simplify the calculation of currency gains or losses. Additionally, the proposed regulations that were simultaneously released provide an alternative election that may further simplify reporting. Some taxpayers could benefit from early adoption of the proposed regulations and should assess the implications of doing so, especially since early adoption requires application of the proposed regulations in their entirety, not a piecemeal selection of some portions of the proposed regulations.
The second set of final regulations creating complexity for taxpayers with FDEs in their structure is the disregarded payment loss (DPL) rules. This is a subset of longstanding regulations regarding dual consolidated losses (DCLs), which are applicable to U.S. tax owners of (direct or indirect) FDEs and aimed at preventing “double dipping” whereby a single economic loss is used twice, once to offset foreign taxable income and again to offset U.S. taxable income.
Historically, the calculation of a DCL ignored disregarded transactions. This is still the case; however, the new regulations, specifically Treas. Reg. §1.1503(d)-1, now require a U.S. tax owner of FDEs to recognize income equal to a “disregarded payment loss,” which is the net loss attributable to disregarded payments of interest or royalties that are deductible under foreign tax law.
Pursuant to the final DPL regulations published on January 14, 2025, taxpayers must now maintain a complex and extremely detailed registry of transactions between disregarded entities and the ultimate U.S. tax owner and calculate U.S. income inclusions to create a symmetry that is directionally more in line with the historical concerns of foreign countries. Consequently, to the extent the disregarded payments involve interest or royalties, the DPL regulations may result in a new tax inclusion to the U.S. taxpayer. These rules are effective for tax years of the U.S. tax owners beginning on or after January 1, 2026. Like the foreign currency regulations, U.S. tax accounting for transactions involving FDEs’ foreign currency fluctuations will be more complex than transactions involving subsidiaries classified as corporations for U.S. tax purposes.
Foreign Country Considerations
Many foreign countries have expressed concerns about the potential lack of symmetry, that can occur when FDEs are used, in particular the opportunity to create a local tax deduction without a corresponding income inclusion in the U.S. Several countries have responded by unilaterally adopting a variety of anti-abuse regimes, often referred to as anti-hybrid rules. While this country-by-country approach continues (for example, Germany finalized its anti-hybrid rules in December 2024), a coordinated effort led by the OECD has produced a more global approach to anti-hybrid rules. In particular, the Pillar Two regime takes direct aim at hybrid structures and generally disregards U.S. tax classification elections altogether. Thus, the new 15% minimum tax introduced as part of the global anti-base erosion (GloBE) rules applies to every entity without regard to the entity’s classification as a corporation or disregarded entity for U.S. tax purposes.
How BDO Can Help
As a direct result of recent U.S. tax regulations and ongoing Pillar Two and country-specific developments, the tax implications of using FDEs have become significantly more complicated. Incorporating an FDE into a structure may have unforeseen implication given the changes to the tax law and thus will require further consideration. Taxpayers assessing the prospective use of FDEs should weigh these considerations before implementing an FDE in their structure, while taxpayers with existing FDEs should consider go-forward implications under the new rules.
Please visit BDO’s International Tax Services page for more information on how BDO can help.