IRS Notice 2007-57 adds a new category of listed transaction that involves loss importation. The technique involves the most elementary of “planning” techniques: the domestic taxpayer arranges to reflect on its U.S. income tax return the loss leg of a hedge entered into by a foreign entity. In order to avoid also reporting on its U.S. return the gain leg of the hedge, the taxpayer insures that the foreign entity is a “corporation” for U.S. tax purposes when it recognizes the gain. Finally, to close the loop, it is necessary for the U. S. taxpayer not to own the foreign entity long enough as a corporation to have to report its income under subpart F.

Thus, the key elements for the U.S. taxpayer hoping to make this plan work would be: (1) use of the disregarded entity regulations and the impact of a change of status of a foreign entity; (2) use of the narrow exception from subpart F income imputation for foreign corporations owned less than 30 days during the year; and (3) the ability to create offsetting gains and losses without any significant economic impact (according to the IRS).


An S corporation (“S Corporation”) buys a controlling interest in a foreign entity (“X”). X is classified as a corporation for U.S. tax purposes and is a CFC. X enters into offsetting options in foreign currency and recognizes a gain on the gain leg of the hedge. According to the Notice, X “virtually eliminate[s] further economic risk.”

Then X elects to be a disregarded entity for U.S. income tax purposes. Later, X recognizes the loss in its currency options. The loss passes through to S Corporation (and its shareholders). S Corporation purports to have sufficient basis in X to absorb the loss.

Because X was not a CFC for as much as 30 days during its taxable year, S Corporation was not required to include in its income any of X’s subpart F income (the gain on the currency options).

The Notice states that other variations of the transaction can occur. X may be either a disregarded entity or a partnership. Its U.S. owner can be a C corporation. X’s loss can also enter the U.S. tax system through a section 351 exchange or a corporate reorganization.

IRS Analysis

The Notice states that what is wrong with the transaction is that the U.S. taxpayer purports to enjoy the loss but not the gain. It attempts to do this by “exploiting” the entity classification rules and the exception from subpart F income passthrough from CFCs for brief ownerships.

The IRS will attack the claimed losses either by (1) disallowing the losses under sections 165 or 269 or (2) reassigning the loss from the U.S. taxpayer to X under section 482. In addition, the IRS may assert the “economic substance doctrine.”

Scope of Notice

As usual, the Notice covers “substantially similar transactions.” The Notice is drafted so broadly that the IRS could contend that it applies to any offshore hedging transaction with only the loss leg reflected in a U.S. return. The Notice is effective June 20, 2007, but states that some taxpayers may already have filed returns purporting to take the benefits of such transactions. Those taxpayers “should” take corrective action.


Separating losses or deductions from what should be “related” income is a relatively ancient tax planning idea. In the context of incorporating businesses, the IRS long ago required that the business’ income and deduction items travel into the new corporation together, and that income not be deferred nor deductions accelerated. Rev. Rul. 80-198, 1980-2 CB 113.

Even before that, taxpayers attempted to shift income into lower taxed corporations and then “collapse” the corporations when the corporate assets were expected to produce less income.

More recently, sections 304 and 302 have been used to attempt to shift the basis in stock held by a foreign affiliate to a U.S. taxpayer: the affiliate could recognize dividend income under section 304 upon the redemption of the stock and the U.S. taxpayer could claim that the stock basis shifted to it, allowing it to claim a loss on its own stock sale. IRS Notice 2001-45, 2001-2 CB 129.

Now, the target is foreign entities that can check the box to be corporations or not for U.S. tax purposes. Such mechanism offers obvious possibilities for splitting loss and deductions from income. Some of these possibilities were addressed by the anti-loss importation rules of section 362(e), enacted in 2004.

But to aim the “economic substance” doctrine and section 165 and 269 at such losses seems to be an exercise in overkill (or underkill, depending on whether those tools will work for the IRS). Section 165 says losses “sustained” are deductible. Perhaps the IRS will argue the U.S. taxpayer did not sustain a loss; of course if the taxpayer actually obtained a basis in the foreign stock sufficient to absorb the loss, it would appear that the taxpayer stands to recognize future income on the X stock, which should reduce the felony to a misdemeanor of accelerating loss and deferring income.

If the tool the IRS uses is section 269, an IRS victory would be one of the rare ones. More likely would be IRS reliance on the “economic substance” argument, which has shown more vitality lately.

As is often the case with “tax shelters,” the government seems more interested in using broad tools than targeted ones. The main culprit here, assuming one doesn’t think the entity classification regime is a culprit, is the 30-day rule for avoiding subpart F inclusion. Presumably, that is not likely to be changed any time soon.


This Notice illustrates again that there really are not many new ideas in tax planning, only new iterations of old ideas.