A foreign operating subsidiary that never earned revenue still qualifies for an ordinary worthless-stock deduction under Section 165(g)(3)

Plain-English summary

A domestic company formed a foreign subsidiary to run a licensed business, won
the licenses by committing to invest a large sum, but never managed to generate
any revenue because of events outside its control. When the subsidiary abandoned
the licenses, its stock became worthless. Normally worthless stock produces a
capital loss, but Section 165(g)(3) lets a parent take a more valuable ordinary
loss on the stock of an affiliated operating subsidiary, provided the parent owns
enough stock (the ownership test) and more than 90 percent of the subsidiary's
gross receipts over its life came from active business rather than passive sources
like interest, rents, and dividends (the gross receipts test). Two problems arose:
the subsidiary's only income included interest paid on a foreign tax refund, and
it had essentially no gross receipts at all. The IRS ruled (1) the tax-refund
interest was incidental to the subsidiary's active business, not the kind of
passive interest the statute targets, and (2) even though the subsidiary never
booked business receipts, it was a genuine operating company, not a holding or
investment company, so denying the ordinary deduction would defeat the purpose of
the statute. The parent may therefore claim the ordinary worthless-stock
deduction, taken on its short-period return for the year of a related merger.

Ruling snapshot

• Question: Can a parent claim an ordinary (not capital) worthless-stock deduction under Section 165(g)(3) for a foreign operating subsidiary that earned only refund interest and never produced business gross receipts?
• Outcome: Approved (both requested rulings granted)
• Key authorities: IRC § 165(a), (g)(1)-(3); § 1504(a)(2); Rev. Rul. 88-65; Commissioner v. Adam, Meldrum & Anderson Co., 215 F.2d 163 (2d Cir. 1954)

Full text (IRS public release)

Internal Revenue Service                        Department of the Treasury
                                                Washington, DC 20224

Number: 202551026                               [Third Party Communication:
Release Date: 12/19/2025                        Date of Communication: Month DD, YYYY]
Index Number: 165.00-00, 165.06-00,
              165.06-02                          Person To Contact:
                                                -----------------, ID No. -----------------
-------------------                             Telephone Number:
---------------------------------------         --------------------
-------------------------------------           Refer Reply To:
-----------------------------                   CC:ITA:B01
                                                PLR-101609-25
In Re: ----------------------------------------------------
-----------                                     Date:
                                                July 29, 2025


LEGEND

Taxpayer                    =   -----------------------------------------------------------
Foreign Sub                 =   ---------------------------------------
Corporation A               =   ------------------------------------------
Corporation B               =   ---------------------------------------------
Foreign Agency              =   ----------------------------------
Foreign Tax                 =   ----------------------------------------------------------------
Foreign Region A            =   ---------------------------------
Foreign Region B            =   ----------------------
Date 1                      =   --------------------------
Date 2                      =   -----------------------
Date 3                      =   -----------------
Month 1                     =   ------------------
Month 2                     =   ----------------
Month 3                     =   ----------------------
Year 1                      =   -------
Year 2                      =   -------
Year 3                      =   -------
Year 4                      =   -------
Year 5                      =   -------
Year 6                      =   -------
$a                          =   ------------------------
$b                          =   ------------------------
$c                          =   ----------------
$d                          =   --------------------
$e                          =   ----------------
$f                          =   --------------
Licenses                    =   ---------------------------------------------------------------------------------
                                ---------------------------------------------------------------------------------
                                ---------------------------------------------------------------------------------
                                --------------------------
Business A               =   ---------------------------------------------------------------------------------
                             -------------------------------------------------
Business B               =   ---------------------------------------------------------------------------------
                             ---------------------------------------------------------------------------------
                             -------------------------------
Business C               =   ---------------------------------------------------------------------------------
                             ---------------------
Activity                 =   -------------------------------------------


Dear -----------------:

This letter responds to a request for a private letter ruling filed by Taxpayer with the
Internal Revenue Service (Service). In the letter ruling request and subsequent
submissions, Taxpayer seeks the following rulings: (1) the refund interest that
Foreign Sub received from Foreign Agency with respect to a Foreign Tax refund is
not "interest" for purposes of § 165(g)(3)(B) of the Internal Revenue Code (Code);
and (2) as of the end of its taxable year that ended Date 1, despite never generating
gross receipts from its intended business activity, Activity related to certain leases in
Foreign Region A, Foreign Sub meets the gross receipts test provided by §
165(g)(3)(B). Taxpayer's request was filed with our office on Date 2.

                                                 FACTS

Corporation A was a domestic corporation primarily engaged in Business A.
Corporation A controlled a group of subsidiaries and primarily operated domestically.
Corporation B was a domestic corporation primarily engaged in Business B. In Month
1, Corporation A merged with and into a wholly owned subsidiary of Corporation B (the
Merger). Taxpayer is the rebranded combined entity following the Merger.

On Date 3, Corporation A incorporated Foreign Sub under the laws of Foreign Region B
as a wholly owned subsidiary. In Month 2, Corporation A successfully bid for Licenses
by committing to invest approximately $a over the following three years. Also in Month
2, Corporation A transferred Licenses to Foreign Sub, which was formed for the sole
purpose of Business C.

From Date 3 to Date 1, Foreign Sub was able to take some steps in its work plan for
Business C but was unable to generate revenue from Activity due to events outside of
its control. However, prior to acquiring Licenses, Taxpayer estimated that Foreign Sub
would generate revenue in excess of its $b total invested capital. Since Foreign Sub
had not commenced revenue generating operations, Foreign Sub did not have any
taxable sales or gross receipts from Business C. Foreign Sub did have four positive
inclusions to income that it reported on Form 5471 during this time: (1) in Year 1, a
refund from Foreign Agency of Foreign Tax included interest of $c; (2) in Year 2,
miscellaneous inclusion of income of $d to reverse additional expense recorded in prior
periods; (3) in Year 3, foreign currency translation of $e; and (4) in Year 3, Foreign Tax
true-up of $f.

Foreign Sub renewed Licenses in Year 4, Year 5, and Year 6. In Month 3, Foreign Sub
submitted its application to formally abandon the Licenses, which was accepted a
month later. Taxpayer represents that the abandonment of the leases resulted in the
stock of Foreign Sub becoming worthless. Taxpayer represents that Corporation A's
stock in Foreign Sub became worthless within the meaning of § 165(g) in Month 3.
Taxpayer represents that from Date 3 to Date 1, Corporation A owned 100% of the
issued and outstanding stock of Foreign Sub.

                                  LAW AND ANALYSIS

Generally, § 165(a) allows a deduction for any loss sustained during the taxable year
and not compensated for by insurance or otherwise. Generally, losses due to
worthlessness are ordinary losses for lack of a sale or exchange under § 1222.
However, §165(g)(1) provides that if any security which is a capital asset becomes
worthless during the taxable year, the resulting loss is treated as a loss from the sale or
exchange of a capital asset on the last day of the taxable year. Section
165(g)(2) defines a security to include stock in a corporation.

An exception to capital loss treatment is provided in § 165(g)(3) which provides that for
purposes of § 165(g)(1), any security in a corporation affiliated with a taxpayer which is
a domestic corporation shall not be treated as a capital asset. For purposes of §
165(g)(3), a corporation is treated as affiliated with a taxpayer only if—

       (A) the taxpayer owns directly stock in such corporation meeting the
       requirements of § 1504(a)(2) (Ownership Test); and

       (B) more than 90 percent of the aggregate of its gross receipts for all taxable
       years has been from sources other than royalties, rents (except rents derived
       from rental of properties to employees of the corporation in the ordinary course of
       its operating business), dividends, interest (except interest received on deferred
       purchase price of operating assets sold), annuities, and gains from sales or
       exchanges of stocks and securities (Gross Receipts Test).

Taxpayer represents that from Date 3 to Date 1, Corporation A owned 100% of the
issued and outstanding stock of Foreign Sub. Therefore, in this case, the Ownership
Test was met.

In Commissioner v. Adam, Meldrum & Anderson Co., a department store owned stock
in a bank that became worthless. The taxpayer argued that the legislative history
indicated that the predecessor to the § 165(g)(3)(B) gross receipts test should not
apply to income from active, operating companies, even the interest of a bank.
However, the Second Circuit held that the bank's gross receipts, which were comprised
mainly of interest, failed the gross receipts test, stating that "the proposed alternative
reading applying to 'all operating companies' would open the door to insurance
companies, finance companies, real estate operating companies, etc., without
suggestion of any workable limitation. Congress has enunciated a clear and simple rule
which, we agree with the Tax Court, is not to be set aside." Commissioner v. Adam,
Meldrum & Anderson Co., 215 F.2d 163, 166-67 (2d Cir. 1954).

Rev. Rul. 88-65, 1988-2 C.B. 32 holds that the significant services performed by a
corporation in connection with the short term leasing of automobiles and trucks, result in
the amounts received under the leases not being "rents," within the meaning of §
165(g)(3)(B). Rev. Rul. 88-65 relies in part on the legislative history of § 165(g)(3),
indicating that Congress intended to allow an ordinary loss deduction for worthless
securities only when the subsidiary is an operating company, as opposed to an
investment or holding company. See S. Rep. No. 91-1530, 91st Cong., 2d Sess. 2
(1970), 1971-1 C.B. 617, 618; S. Rep. No. 77-1631, 77th Cong., 2d Sess. 46 (1942),
1942-2 C.B. 504, 543.

The Revenue Act of 1942, Pub. L. No. 754, section 123(a)(1), 56 Stat. 798, 820
(1942), added § 23(g)(4) (the predecessor to § 165(g)(3)), to provide for an ordinary
loss for worthless stock instead of capital loss treatment of certain affiliated
corporations. The legislative history indicates the purpose of § 23(g)(4) was to allow
a parent corporation to claim an ordinary loss deduction for the stock of its
subsidiary if it becomes worthless, regardless of whether the parent and subsidiary
file a consolidated return or not. S. Rep. No. 77-1631, 77th Cong., 2d Sess. 46
(1942), 1942-2 C.B. 504, 543. Section 23(g)(4) included an ownership test and a
gross income (changed in 1954 to gross receipts) test.

Shortly after its enactment, § 23(g)(4) was amended by Congress to provide that
certain rents and interest earned by an operating company were to be treated as
operating income, rather than passive income, in applying the gross income test.
See Pub. L. No. 235, section 112(a), 58 Stat. 21, 35 (1944); S. Rep. No. 91-1530,
91st Cong., 2d Sess. 2 (1970), 1971-1 C.B. 617, 618; S. Rep. No. 77-1631, 77th
Cong., 2d Sess. 46 (1942), 1942-2 C.B 504, 543; 90 Cong. Rec. S121-122 (daily
ed. Jan. 12, 1944) (statement of Sen. Davis). In introducing the amendment,
Senator Davis noted that Congress' intent in enacting the gross income test was to
permit the loss as an ordinary loss only when the subsidiary was an operating
company as opposed to an investment or holding company. The intent of the
change, as explained by Senator Davis, was to exclude certain rents and interest
derived by a company that was solely an operating company from the scope of
passive income in accordance with the intent of Congress. The rent and interest
from the sources described were viewed as "incidental to the operating activities of
the company" and as arising from a "direct result of its activities as an operating
company." 90 Cong. Rec. S at 122.

Taxpayer had identified numerous administrative rulings that have not strictly applied
the statutory language in § 165(g)(3)(B) and has even suggested that an active/passive
test has overtaken the statutory test based on the nature of the gross receipts that the
subsidiary derived. We disagree with this interpretation of the administrative guidance;
though we do agree that in limited cases the legislative history may have value in
interpreting the statute.

Issue 1. Whether the refund interest that Foreign Sub received from Foreign Agency
with respect to a Foreign Tax refund is not "interest" for purposes of § 165(g)(3)(B).

Foreign Sub was registered with Foreign Agency as doing business subject to its
jurisdiction. As such, Foreign Sub was legally obligated to collect Foreign Tax on its
revenues, pay Foreign Tax as part of its purchases of equipment and supplies related to
Business C, and remit excess collections to Foreign Agency. Since Foreign Sub was
unable to generate revenue, it was entitled to a Foreign Tax refund from Foreign
Agency. Foreign Agency paid Foreign Sub interest on the Foreign Tax refund.
Therefore, the interest Foreign Sub received from Foreign Agency was related to
Foreign Sub's active conduct of a business.

The interest was not passive or investment income and was not a return on an
investment. In addition, in comparison to the amount Foreign Sub invested in its
operations, the interest amount is de minimis. Therefore, although Foreign Sub
received interest from the taxing authority with a tax refund and that amount is interest
in a literal sense, it was not the passive return on investments that § 165(g)(3)(B)
contemplates and was more incidental to the operating activities of the company.

Issue 2. Whether Foreign Sub meets the Gross Receipts Test as of the end of its
taxable year that ended Date 1, despite never generating gross receipts from
Activity.

Taxpayer represents that Foreign Sub was formed as an operating entity that was
meant to generate revenue from Activity. Foreign Sub's actions demonstrate that
Foreign Sub was an active operating company as opposed to an investment or holding
company, and that its activities were intended to generate ordinary income. However,
Foreign Sub was never able to generate those ordinary gross receipts due to
circumstances beyond its control.

Although Foreign Sub did not generate any gross receipts from Activity due to
events outside its control, it did take significant steps to try to generate gross
receipts from Activity, including obtaining Licenses, buying equipment, and
completing some of its work plan. In effect, while not yet collecting income, it was
directly engaged in a business.       The lack of gross receipts from the business
raises an issue under the Gross Receipts Test, and it is arguable that the test is
failed in such a case. However, such a result would be contrary to the purpose of
the statute. Accordingly, in such a case it is appropriate to look to the legislative
history of the provision, focusing on the distinction between an operating company
and a nonoperating or holding company. Because the entity here was an operating
company, the deduction under § 165(g)(3) is appropriate.

                                               CONCLUSION

Based on the facts and representations submitted, we conclude that Taxpayer has
satisfied the burden associated with claiming an ordinary deduction under § 165(g)(3)
with respect to the stock of Foreign Sub. To the extent that Corporation A properly files
a short-period return for the taxable year ending on the effective date of the Merger, the
worthless securities deduction with respect to the stock of Foreign Sub will be part of
Corporation A's short-period return for such taxable year.

The ruling contained in this letter is based upon information and representations
submitted by the taxpayer and accompanied by penalty of perjury statements executed
by the appropriate parties. Specifically, we have accepted Taxpayer's representation
that the stock of Foreign Sub became worthless in Month 3. This office has not verified
any of the materials submitted in support of the request for a ruling and the information
materials are subject to verification on examination.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

A copy of this ruling should be attached to Taxpayer's federal tax returns for the tax
years affected. Alternatively, taxpayers filing their returns electronically may satisfy this
requirement by attaching a statement to their return that provides the date and control
number of the letter ruling.
                                      Sincerely,

                                                /s/

                                                Sean M. Dwyer
                                                Senior Technician Reviewer, Branch 1
                                                (Income Tax & Accounting)


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