The global economic downturn as a result of the COVID-19 pandemic may have created unanticipated losses for foreign subsidiaries of U.S. corporations. In the wake of this downturn, a potential opportunity exists for U.S. corporations to claim an ordinary loss deduction under Internal Revenue Code Section 165(g)(3) for a foreign subsidiary whose business has become worthless.
In general, Section 165(g)(1) provides that if stock in a domestic or foreign corporation becomes worthless during the taxable year, the resulting loss is treated as a sale or exchange of a capital asset on the last day of the year. Thus, a worthless stock loss deduction is subject to the capital loss limitations, even though there was no actual sale or exchange of stock. However, an exception to this general rule is provided in Section 165(g)(3), which allows a U.S. corporation to claim an ordinary loss for worthless stock of an “affiliated” corporation if that corporation becomes worthless during the tax year. For this purpose, a corporation (U.S. or foreign) is treated as affiliated with a U.S. corporation if:
- The U.S. corporation owns at least 80% of the total voting power and value of the subsidiary, and
- More than 90% of the gross receipts for all tax years of the subsidiary are from sources other than passive activities (i.e., royalties, rents, interest, dividends, annuities and gains from the sale of stock).
Establishing Worthlessness for a Foreign Subsidiary
To establish that a foreign subsidiary is worthless, the U.S. corporation must show that the stock of the subsidiary lacks both liquidating value and potential value. A subsidiary will lack liquidating value if the fair market value of its assets, including intangible assets such as goodwill and going concern value, does not exceed its liabilities. Potential value exists if there is a reasonable hope and expectation that the subsidiary’s assets will exceed its liabilities in the future.
In addition, worthlessness must be established by an “identifiable event” during the year that clearly evidences the destruction of both the liquidating and potential values of the subsidiary’s stock. While an actual liquidation of the foreign subsidiary constitutes an identifiable event that fixes the loss with respect to its stock, worthlessness can also be established through a deemed liquidation of the subsidiary by making a check-the-box election to change its U.S. tax classification from a corporation to a disregarded entity. The ability to claim a worthless stock deduction through a check-the-box election for a foreign subsidiary (rather than going through a liquidation process) may provide greater certainty in timing the inclusion of that deduction, and should be administratively easier than implementing a formal corporate dissolution process. Moreover, depending on the facts, it also may be possible to claim a worthless stock loss deduction even if the foreign business continues to operate after the check-the-box election.
The current environment may present an opportunity to claim an ordinary loss deduction under Section 165(g)(3) with respect to the stock of a foreign subsidiary if the parent can establish the subsidiary’s stock is worthless and the other requirements under the statute are satisfied. For more information regarding this opportunity, please contact your local CBIZ tax professional.
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