The Advice Memo
The Large Business & International Division of the IRS recently issued CCA Memo 202325007, addressing the question of whether losses sustained by a corporation, related to its subsidiary’s stockholdings in three CFCs of which it was the sole shareholder, occurred in a federally declared disaster area. IRS counsel concluded that losses incurred by that subsidiary in the three CFCs did not occur in a federally declared disaster area and as such did not qualify as disaster losses under IRC section 165(i).
In March 2020, then-President Donald Trump declared that the outbreak of COVID-19 in the United States qualified as a nationwide natural disaster under the Robert T. Stafford Disaster Relief and Emergency Assistance Act (42 USC sections 5121-5207). This “COVID declaration” applied retroactively to January 20, 2020, and “COVID disaster areas” were approved for all 50 states, the District of Columbia, the U.S. Virgin Islands, the Commonwealth of Puerto Rico, American Samoa, the Northern Mariana Islands, Guam, and a number of tribes. This determination was important, because only losses that occurred within a COVID disaster area qualify as disaster losses under the COVID Declaration.
The Facts
In this specific case, a particular corporation (all identifying information such as names, locations, and amounts have been redacted) was the common parent of an affiliated group of corporations. The group filed a consolidated U.S. federal income tax return as “Taxpayer.” Included in the group was a subsidiary that was the sole owner of three CFCs, none of which derived material revenue from customers in the United States. This subsidiary was a domestic eligible entity treated as an association taxable as a corporation. The three CFCs were originally organized as follows:
- Country 1 CFC—a limited liability company that was a disregarded entity for U.S. federal income tax purposes,
- Country 2 CFC—a foreign eligible entity treated as an association taxable as a corporation and was a holding company for some of Taxpayer’s operations, and
- Country 3 CFC—a foreign eligible entity treated as an association taxable as a corporation.
During the pandemic, Taxpayer entered into a restructuring plan that included each of the CFCs changing its entity classification. These changes each resulted in a deemed liquidation under Treasury Regulations section 301.7701-3(g)(1) (iii). In each instance, Subsidiary claimed a worthless securities deduction with respect to its shares of stock in each CFC immediately before its deemed liquidation. Subsidiary elected to claim this deduction on Taxpayer’s consolidated U.S. federal income tax return pursuant to IRC section 165(i) (1). This section relates to losses attributable to a disaster occurring in an area subsequently determined by the U.S. President to warrant federal assistance under the Stafford Act. The section provides that Taxpayer may elect to claim a deduction for that loss on Taxpayer’s federal income tax return for the taxable year immediately preceding the taxable year in which the disaster occurred. By claiming these loss deductions, it enabled Taxpayer to carry back these losses to prior tax returns, which triggered beneficial tax consequences.
The COVID National Emergency was in effect when Taxpayer implemented the restructuring transactions. During the pandemic, Taxpayer closed some of its U.S. operations in order to comply with government mandates. This resulted in a decrease in cash flow that had been used to support CFC’s operations. Without that support, the CFCs became insolvent, which caused the subsidiary to determine that its equity investments in the CFCs had become worthless. Taxpayer then claimed these worthless securities losses related to the CFCs as disaster losses under IRC section 165(i).
Application of the Law
Although IRC section 165(a) provides for a loss deduction that is not compensated by insurance, as it relates to securities, no deduction is allowed solely on account of a decline in the value of stock when the decline is due to a fluctuation in the market price of the stock. The stock loss, however, is recognized upon the sale or exchange of stock or with respect to worthless stock. Under section 165(g), if any security (including a share of stock in a corporation) that is a capital asset becomes worthless during the taxable year, said loss is treated as a capital loss on the last day of the taxable year. Section 165(i)(1), however, provides that a taxpayer may elect to claim any loss occurring in a disaster area which can be attributed to a federally declared disaster in the taxable year immediately preceding the taxable year in which the disaster occurred. For purposes of this code section, the term “federally declared disaster” means any disaster that the President of the United States determines warrants assistance from the federal government under the Stafford Act. The COVID National Emergency meets this criterion. The term “disaster area” refers to the area that warrants this federal assistance. Hence, the COVID disaster area is considered a disaster area under section 165(i).
A loss must meet two criteria to qualify as an IRC section 165(i) loss: 1) the loss must occur in a disaster area, and 2) the loss must be attributable to a federally declared disaster. The worthless securities losses incurred by the subsidiary in its CFCs did not occur in the COVID disaster area and as such, do not qualify as disaster losses under section 165(i).
Although the issue of where a loss sustained with respect to stock in a foreign corporation occurs has never been specifically clarified, previous disasters that gave rise to the accelerated deduction were the result of a specific event such as a natural disaster like a tornado, drought, or flood related to a specific geographically confined disaster zone. This requirement that the loss occur in a specific disaster area is seemingly motivated by a concern that the economic decrease in the value of property that resulted in the loss must have a connection or link to the location of the disaster itself.
Location of the Loss
One approach to locating where a loss related to stock in a foreign corporation arose would be to view it from an economic standpoint and consider business metrics that apply to the foreign corporation. This approach would consider evaluating the income producing assets, customers, employees, and revenue streams of the foreign corporations in relation to the COVID disaster area. In this situation, none of the CFCs derived substantially all of their revenues from U.S. customers. Likewise, the income producing assets, employees, and revenue streams all occurred or were located outside the United States, not in the COVID disaster area.
Another approach would be to consider the location of the event of the disposition itself rather than the location of the cause of the loss. Under IRC section 865(a), this approach generally focuses on the residence of the seller. This approach seems illogical, however, as the location of the occurrence of the loss is fundamentally different from the location of the shareholder’s residence, which likewise has no direct bearing on location of the foreign corporation’s operations. It would be counterintuitive to grant section 165(i) relief to a shareholder who owns stock in a foreign corporation that is headquartered in the United States but actually operates outside the United States. Again, if the event of the disposition of the stock is considered, then it would not meet the criterion of being in the COVID disaster area.
Other Deductible Loss Possibilities
There could be other reasons this loss does not meet the criteria set forth in IRC section 165(i):
- If the loss meets the second requirement above that the loss sustained by the subsidiary with respect to its CFC stock holdings was attributable to a “federally declared disaster”;
- Whether a loss with respect to either domestic or foreign stock can qualify as a disaster loss under section 165(i);
- Whether the stock of the CFC’s was in fact worthless under section 165(g); or
- Whether the steps involved in Taxpayer’s restructuring plan were appropriate under U.S. tax principles.
None of these issues has been considered by IRS counsel. The only criterion addressed in the CCA was if the loss related to the stock in the CFCs occurred in the COVID disaster area; the conclusion was that it did not.
