Consolidated return intercompany transaction regulations: clearly reflecting income is clearly not simple.

[TABULAR DATA OMITTED]

E. Simplifying Rules

The proposed intercompany transaction rules have not been touted as simplification rules. The regulation writers readily concede that an added degree of complexity has been introduced to the system. But they assert that the regulation is nevertheless justified on the grounds of clear reflection of income and prevention of tax avoidance. In some common transactions, however, the opportunity for abuse is minimal and the administrative difficulty of tracking assets may be extreme. Accordingly, the drafters have provided what are termed "simplifying rules," in Prop. Reg. [sections] 1.1502-13(e).

1. Inventory

Under current law, if S sells property to B, which is inventory in the hands of B, the restoration of S's gain or loss on the intercompany sale will occur based upon B's disposition of the inventory, and determined by reference to B's inventory method, e.g., LIFO or FIFO.(59) Other special rules for inventory are provided to prevent the group from obtaining an indefinite deferral of intercompany gain on inventory sold during the first year for which the group elects to file a consolidated return.(60)

Under Prop. Reg. [sections] 1.1502-13(e)(1), a special rule is provided for the situation in which S sells inventory to B and either member uses dollar-value LIFO to account for intercompany transactions. Dollar-value LIFO is a LIFO inventory method that requires a taxpayer to combine a wide variety of goods in inventory into a single pool. These pools are broader than specific goods groupings. Each year, to the extent that the base-year cost of ending inventory exceeds the base-year cost of opening inventory, a "layer of increment" is created.

If B includes all its inventory costs for the year in the cost of goods sold (which allows B to minimize its income), S must take into account all of the gain or loss from intercompany transactions during the year. The theory is that the inventory acquired from S during the year has been disposed of outside the group. If B includes less than all its inventory costs in the cost of goods sold for the year, only a percentage of S's net intercompany inventory income or loss for the year will be taken into account. The percentage not taken into account may be determined under the "increment average method," the "increment valuation method," or any other method that is expected to reasonably take into account intercompany items and corresponding items from intercompany inventory transactions.(61) Similarly, if S uses a dollar-value LIFO inventory method to account for its intercompany inventory sales, S can use any reasonable method of allocating its LIFO inventory costs to intercompany transactions.(62)

2. Reserve Accounting--Special Status Companies

a. Financial Institutions

The Tax Reform Act of 1986 generally prohibited taxpayers from using the reserve method to account for bad debts. Exceptions were provided for banks and thrift institutions under sections 585 and 593 respectively. Given their special status, financial institutions are permitted under the proposed regulations to take into account the bad debt reserve on a separate entity basis rather than as an intercompany item or corresponding item under the proposed regulations. To the extent the sale of a loan from one member to another is not attributable to recapture of the reserve, however, any gain or loss is taken into account under the general rules.(63)

b. Insurance Companies

As is the case with financial institutions, insurance companies are accorded special status in the Code. Life insurance companies may set up reserves for claims under section 807(c) and property and casualty companies may set up reserves pursuant to section 832(b)(5). Consider the case in which a consolidated group includes a property and casualty company that does business with the general public, but also insures the property of other members of the group. The payment of the premium by the insured member is full deductible under section 162, and the receipt of the payment by the insurance company is currently includible. If the insurance company may claim a current deduction for its addition to reserves, however, the net effect to the group will be a deduction. Nevertheless, the proposed regulations allow the payment of the premium (i.e., the intercompany transaction) to be determined on a separate member basis, not under the matching and acceleration principles of the proposed regulations.(64)

The regulation writers' generosity, however, did not extend to intercompany reinsurance transactions. If one member assumes all or a portion of an insurance contract written by another member, all aspects of the transaction (including reinsurance premiums, benefit payments, reimbursed policyholder dividends, experience rate adjustments, and similar items) are taken into account under the matching principle of the proposed regulations.(65)

3. Obtaining Permission Not to Defer 

As under current law, the proposed regulations contain a procedure whereby a taxpayer may obtain permission not to account for income or gain under the intercompany transaction system described by the proposed regulations, but rather to account for those items on a separate entity basis.(66) Under the proposed regulations, this option is not available for intercompany transactions involving stock and obligations.

To obtain permission not to take items into account on a separate member basis, the common parent must follow the procedures for requesting a private letter ruling. The request must be filed by the due date of the group's consolidated return (without regard to extensions). The consent must be attached to the consolidated return (or amended return) as the Internal Revenue Service may require. Consent may be granted for all items or only certain classes of items. Unless revoked with the consent of the Internal Revenue Service, the election is binding on the group for all subsequent consolidated return years. The consent procedure does not apply, as under current law, to any loss on any intercompany transaction, which is governed independently by section 267(f).(67)

The best reason for accelerating gain from a taxpayer's perspective is to absorb a capital loss or net operating loss (NOL) that is about to expire. If the past is prologue, the IRS will not consent to accelerate gain if the taxpayer has attributes that would otherwise expire. Accordingly, the only acceptable reason for obtaining permission is to avoid the administrative complexity necessary to administer the rules.

F. Stock of Members

Under current regulations, transactions between members of a consolidated group by virtue of their shareholder-corporate relationship are not intercompany transactions. Accordingly, transactions such as liquidations, redemptions, distributions, and contributions are addressed in Treas. Reg. [sections] 1.1502-14. By contrast, the proposed regulations include such transactions within the broader re-definition of intercompany transactions, and provide rules in paragraph (f) of Prop. Reg. [sections] 1.1502-13.

1. Distributions

a. Exclusion of Intercompany Dividends

Since the consolidated return regulations were promulgated in 1966, the treatment of intercompany dividends has been slightly different from the treatment where separate returns are filed. First, a dividend from a subsidiary to an owning member is eliminated.(68) In a separate return, the dividend would be eligible for a 100-percent dividends-received deduction only if the earnings and profits (E&P) out of which the dividend was paid was accumulated in a year in which the distributor was a member of the affiliated group on each day of its taxable year.(69) Of course, if a separate return is filed, the distributee's basis in the distributor's stock is generally not reduced as a result of the distribution (unless section 1059 applies).

The proposed regulations define the term "intercompany distribution" as an intercompany transaction to which section 301 applies.(70) A dividend that is deductible by the payer, such as a patronage dividend under section 1382(c)(1) or a dividend paid to depositors of thrift institutions that are deductible under section 591, are not intercompany distributions.(71) Under the "entitlement rule," an intercompany distribution is treated as taken into account when the shareholder member becomes entitled to it (generally, the record date). For example, if a distributee becomes entitled to a cash distribution before it is made, the distribution is treated as if made when the distributee becomes entitled to it. Thus, notwithstanding Rev. Rul. 62-131,(72) which concludes that the date of payment rather than the date of declaration is controlling for purposes of determining whether a distribution comes out of current E&P, the proposed intercompany transaction regulations apply if the distributor and the distributee are members when the distributee becomes entitled to the distribution.(73)

b. Requisite Stock Basis Reduction

Generally, an intercompany distribution is excluded from the distributee's gross income. This exclusion, however, applies to a distribution from a subsidiary only if the distribution causes a negative basis adjustment to the distributor's stock under Treas. Reg. [sections] 1.1502-32(b)(2)(iv).(74) Thus, if a subsidiary that is about to be sold by a consolidated group declares a dividend to shareholders of record as of the last day before the sale, the distribution will be deemed to have been made on that day (irrespective of the actual date of payment). Accordingly, the dividend will be excluded from the owning member's income, but the owning member's basis in the subsidiary's stock will be reduced under Treas. Reg. [sections] 1.1502-32.

c. Amount and Basis of a Property Distribution

Since 1966, the determination of the amount of an intercompany distribution of property from one member to another has varied slightly from the separate return rule. Historically, the Code required that the amount of the distribution (and the basis of the property in the hands of the distributee thereafter) was the lesser of (1) the fair market value of the property, and (2) the basis of the property in the hands of the distributor plus gain recognized.(75) In a consolidated return, however, the amount was simply the latter--basis plus gain recognized.(76) After the enactment of section 311(b), in the case of appreciated property, fair market value and basis plus gain recognized yielded the same amount. In the case of property with a high basis and low value, however, the amounts would differ, and the consolidated return regulations required that the high basis be carried over.

In the Technical Correction Act of 1988, Congress amended sections 301(b) and 301(d), as part of a deadwood clean-up measure, to provide that the amount of a distribution and the basis in the hands of the distributee would simply be fair market value. Unfortunately, in the words of Professor James Eustice, the statutory drafters did not do "a consolidated return environmental impact statement." Upon realizing that the intended deadwood statutory change could have a substantive effect on consolidated returns, the drafters provided footnotes in Senate Finance Committee Report and in the House Ways and Means Committee Report to clarify that the change was not intended to have any substantive effect in consolidated returns.(77) Accordingly, the special consolidated return rule, which allowed high basis/low value property to keep its high basis in the hands of a distributee, was settled and accepted. See Letter Ruling Nos. 8935014 and 8917077, and Treas. Reg. [sections] 1.1502-20(e)(3), Example 6.

Despite the clarity of the rule, many tax policymakers began to question its wisdom. In light of the enactment of section 311(b), as well as the advent of anti-mirror legislation in the late 1980s, it seemed incongruous to allow a group to shift the recognition of a loss on depreciated property to a member other than the one that held the property when the loss economically accrued. For example, assume S has an NOL carryover that is subject to the separate return limitation year (SRLY) limitation, and also holds an asset with a basis of $100 but a value of $10. If the asset were sold by S, S would recognize a $90 loss that could offset other income generated by S, and thus hamper S's ability to fully use its SRLY NOL. On the other hand, if the property were distributed to P, which held the property for a decent interval before a sale at a loss, P would report the loss, and S's ability to use its SRLY NOL would not be diminished.

Under the proposed regulations, a distribution by a subsidiary will create the same tax consequences as a sale.(78) Thus, not only will a subsidiary recognize a gain under section 311(b) on the distribution of appreciated property, but will also recognize a loss on the distribution of depreciated property. Thus, when the loss is taken into account it will be taken into account by the corporation that held the property when the loss accrued. The loss, however, may ultimately be disallowed. If, for example, the property is later distributed to a nonmember shareholder, applying section 311(a) and treating the group as divisions of a single corporation results in a disallowance of loss to all members.(79)

There was some concern among commentators that the replacement of Treas. Reg. [sections] 1.1502-31 under current law with Prop. Reg. [sections] 1.1502-31, which deals solely with group structure changes, could result in the permanent disallowance of a built-in loss with respect to property distributed from one member to another. To avoid the problem, the final investment adjustment regulations (which were filed with the Federal Register on August 12, 1994) added a new provision, Treas. Reg. [sections] 1502-14(a)(14). That provision restates the old rule that the basics of property received in a distribution to which section 301 applies will equal the basis of the property in the hands of the distributor, plus gain recognized. Presumably, the just-promulgated provision will be deleted, along with the rest of Treas. Reg. [sections] 1502-14, when the intercompany transaction regulations are made final.

2. Boot in Intercompany Reorganizations

The proposed regulations provide explicit rules for the treatment of nonqualifying property ("boot") received by one member in an intercompany reorganization.(80) An intercompany reorganization is a reorganization between members of the group. The term does not include a reorganization in which any party either becomes or ceases to be a member. Generally, if a party to a reorganization receives boot, the recipient recognizes gain, if any, on the transactions, but not in excess of the boot received.(81) If the shareholders of the transferor corporation receive a sufficient interest in the acquiring corporation, the effect of the distribution may be a dividend and the distributee must treat it as such.(82)

Under the proposed regulations, nonqualifying property (i.e., boot) received as part of an intercompany reorganization is treated as received by a shareholder in a separate transaction, rather than as part of the intercompany reorganization.(83) Consequently, if a consolidated return is filed and members engage in an intercompany reorganization, any nonqualifying property received by an owning member of the transferor will be treated as distributed in redemption of stock. Since the parties will be related after the reorganization, by virtue of section 302(d) the redemption will be treated as a distribution under section 301, whether or not the shareholders of the transferor would otherwise recognize gain. Furthermore, section 311, rather than section 361, will apply to cause the distributor to recognize gain. Thus, if loss property is distributed, the distributor in a consolidated return will also recognize loss. Any gain or loss will be taken into account upon the occurrence of subsequent events.(84)

The regulations do not address the consequences of a reorganization involving a nonmember. Accordingly, the much-criticized conclusions of Rev. Rul. 72-498,(85) in which the IRS held that the portion of a boot distribution out of E&P that increased basis in the subsidiary/transferor's stock, should not be treated as a dividend, but rather should give rise to capital gain.(86) The questionable validity of the ruling remains unaffected by the proposed regulations.

3. Acquisition by Issuer of its Own Stock

The proposed regulations seek to reverse the controversial conclusion reached by the IRS in General Counsel Memorandum (GCM) 39608 and Letter Ruling No. 8701018. The GCM and private ruling conclude that if a subsidiary that owned appreciated stock in the common parent distributed the stock to the common parent, the subsidiary's gain under section 311(b) would be restored only upon the common parent's actual disposition of those shares. If the common parent buried those particular shares in a time capsule, the deferred gain would never be restored.

The effect of the private ruling is to create an indefinite deferral. Supporters of the ruling argue that an indefinite deferral is proper because it produces the same results as would be achieved if the subsidiary liquidated into the parent. Government attorneys, however, have expressed regret over the issuance of the GCM, especially after taxpayers tried to extend its application. Opponents of the position cite Rev. Rul. 74-503,(87) in which the IRS ruled that treasury shares have a zero basis in the hands of the corporation and become indistinguishable, for tax purposes, from previously unissued shares.(88)

Prop. Reg. [sections] 1.1502-13(f)(4) ends the debate for the near future by stating that "If a member acquires its own stock in an intercompany transaction, the member's basis in that stock is treated as eliminated, and the elimination is taken into account for purposes of applying the rules of this section." Exclusion of the gain apparently does not fall within any of the limitations on intercompany income or gain treated as excluded from gross income described in Prop. Reg. [sections] 1.1502-13(c)(3)(iv).

4. Elective Relief in Certain Stock Transactions

Following an intercompany transaction involving a member's stock, various transactions may cause the stock basis that reflects the intercompany transaction to disappear. Such transactions include a liquidation, a downstream merger, and a distribution to which section 355 applies. In some instances, such as the cancellation of the stock, gain may be taken into account without any corresponding tax benefit ever being realized by the group. To afford taxpayers relief in such cases, Prop. Reg. [sections] 1.1502-13(f)(5) allows a consolidated group to treat certain transactions in a manner different from what would otherwise be the treatment under the general rules of subchapter C and case law.

a. Liquidations of Members previously Transferred in an Intercompany

Transaction

One of the most frequently criticized results under the current regulations involves the case of an intercompany sale (or distribution) of a subsidiary's stock, followed by a liquidation of the subsidiary. Under Treas. Reg. [sections] 1.1502-13(f)(1)(vi), the cancellation of the stock in liquidation is a restoration event.(89) Comment letters to Treasury have suggested that gain should not be taken into account because no actual property has left the group.

The issue also arises in the context of a sale of a subsidiary's stock with an election under section 338(h)(10). If the subsidiary stock has previously been the subject of an intercompany transaction, the sale created double tax. Under section 338(h)(10), the stock sale is treated as an asset sale followed by a liquidation. If the stock is property that was previously the subject of an intercompany transaction, the section 338(h)(10) transaction causes gain on the subsidiary's assets to be taken into account, and the deemed liquidation causes the deferred gain on the prior stock sale to be taken into account.

In the case of a liquidation of a subsidiary (T) whose stock was previously transferred at a gain in an intercompany transaction, Prop. Reg. [sections] 1.1502-13(f)(5)(ii) allow a group to postpone reporting the gain if substantially all of T's assets are recontributed to a new subsidiary (new T) before the due date (with extensions) of the group's return. The relief is an expansion of the liquidation-reincorporation doctrine, which treats a liquidation and reincorporation that are pursuant to a plan as a reorganization under section 368(a)(1)(D).(90) If the reincorporation occurs by the extended due date, and the group files the election, liquidation-reincorporation treatment would be accorded whether or not the two steps were part of a pre-arranged plan. If the transactions were part of the same plan or arrangement, the transactions would qualify as a D reorganization under the liquidation-reincorporation doctrine. The election would cause the liquidation and reincorporation to be deemed to be part of the same plan or arrangement (even if they were not), to allow the group to delay reporting gain on the intercompany stock sale. The stock in new T would become a successor asset to the stock of old T.(91)

To avoid complexity, relief is limited to cases in which 100 percent of the stock of the liquidated subsidiary (T) is owned by members from the date of the intercompany transaction through the date of the T's liquidation.(92) Presumably, for this purpose stock includes vanilla preferred stock described in section 1504(a)(4).

b. Downstream Mergers

Although a downstream merger of a parent company into its subsidiary may have different tax consequences from a liquidation of the subsidiary into the parent,(93) in either case intercompany gain with respect to a prior transfer of the subsidiary's stock would be taken into account. Accordingly, the regulations provide relief similar to that provided for liquidations in the case of a downstream merger.(94) Thus, a group can undo a downstream merger if it acts before a return is filed, if the merger would otherwise have caused gain from a prior intercompany transfer of the stock of the transferee (T) to be taken into account. To forestall including the gain in income, the parent of T after the merger must organize "new B," contribute T's stock to it, and presumably have T transfer the assets formerly held by B to new B. Thus, the group will have the same structure it had before the downstream merger.

c. Section 338(h)(10) Transactions

Prior to the promulgation of the proposed regulations, the Treasury Department received a number of comments highlighting the problem of double taxation of a single economic gain when stock of a subsidiary was distributed within a consolidated group, and the transferred subsidiary was later sold subject to an election under section 338(h)(10). The problem is illustrated by the following example:

Example. P owns 100 percent of S1's stock and S1 owns 100 percent of S2's stock. S1's basis in S2's stock is $10 and the value of the stock is $100. Similarly, the inside basis and value of S2's assets are $10 and $100, respectively. In year 1, S1 distributes its S2 stock to P. Accordingly, S1 recognizes $90 of gain under section 311(b), but the gain is deferred under Temp. Reg. [sections] 1.1502-14T(a). In year 2, P sells the stock of S2 to an unrelated person, subject to an election under section 338(h)(10).

[CHART OMITTED]

Under the election, the sale of S2's stock is treated as a sale of assets by S2, followed by a liquidation of S2 under section 332. The deemed asset sale causes S2 to recognize $90 of gain, and the deemed liquidation of S2, a restoration event under Treas. Reg. [sections] 1.1502-13(f)(1)(vi), causes the section 311(b) deferred gain to be reported by S1. Consequently, $180 of gain is reported on the consolidated return, notwithstanding that only $90 of economic gain occurred.

Double taxation in the above-described circumstance is generally agreed to be improper. If a subsidiary's stock is treated as an asset, however, gain on the distribution of that stock is taxed under section 311(b), even though the assets within the subsidiary do not achieve a basis step-up. It had been suggested that deferred section 311(b) gain should be eliminated (rather than restored as under current law) if the subsidiary was liquidated in a transaction to which section 332 applies, or is deemed to apply.(95) A potential problem with the elimination of the deferred gain is the opportunity it creates for mirror-type transactions.

The proposed regulations solve the problem by allowing the group to elect to treat the deemed liquidation pursuant to an election under section 338(h)(10) as a liquidation in which gain or loss is recognized to the shareholder under section 331, rather than a tax-free liquidation to which section 332 would generally apply. For all other federal income tax purposes (e.g., the carryover of attributes), the deemed liquidation remains subject to section 332.(96)

Example. S forms T for $100 and T buys land for that amount. The land appreciates and S sells its T stock to B, another member of the consolidated group, for $150. Thereafter, B sells 100 percent of T's stock to X, an unrelated corporation, for $170, and the parties agree to elect the application of section 338(h)(10).

As a result of the deemed asset sale, T will report $70 of gain immediately before its deemed liquidation, which will increase B's basis in its T stock to $220. If the selling group elects under Prop. Reg. [sections] 1.1502-13(f)(5)(iii) to apply section 331 to the deemed liquidation of T, B would report a $50 loss on the liquidating distribution.

Under the loss disallowance regulations, the deemed sale of the land is an extraordinary gain disposition(97) and the loss will generally be disallowed. Under the netting rule, however, because $50 of intercompany gain is taken into account as part of the same transaction that causes the loss to be reported, the $50 loss is allowed to offset the gain.(98)

Complementing the loss disallowance regulations, the proposed intercompany transaction regulations limit the amount of loss on both a share-by-share and an aggregate basis.(99) The loss claimed with respect to any particular share may not exceed the net amount of intercompany income or gain with respect to that share from all prior intercompany transactions. In addition, the aggregate loss claimed cannot exceed the loss that would be taken into account from the deemed liquidation if section 331 applied to all the target's shares. Thus, if a minority owned shares in the target, and the minority would have recognized a gain in the case of a liquidation, the amount of loss the group may claim is reduced by the minority's hypothetical gain.(100)

The proposed regulations limit the election to cases in which the target company has made no substantial noncash distributions during the preceding 12-month period.(101) A substantial noncash distribution is defined as a distribution of anything other than cash or a cash item, any marketable security, or any debt of the distributor or distributee. The rule restricts the prior position taken by the IRS in private letter rulings that a subsidiary could adopt a plan of liquidation, actually distribute some assets tax-free under the plan, and then complete the plan by way of a deemed liquidation under section 338(h)(10).(102)

A far-sighted taxpayer, however, can still get the best of both worlds. Under section 332(b), a liquidation qualifies under section 332 if all property is distributed within three years of the close of the year of the first distribution. Thus, a plan can be adopted and property distributed and 13 months later stock can be sold subject to an election under section 338(h)(10) and Prop. Reg. [sections] 1.1502-13(f)(5)(iii).

d. Cash Mergers

Practitioners and the IRS are aware that the tax consequences of a sale of a subsidiary's stock coupled with an election under section 338(h)(10) can be replicated by a forward cash merger.(103) For example, if a subsidiary merges into another corporation, and the former parent receives solely cash or other non-qualifying consideration, the transaction will not meet the requirements for a reorganization owing to the lack of continuity of interest of the former parent in the transferee's stock. Rather than treating the transaction as a reorganization, the IRS will view the transaction as a sale of assets by the subsidiary, followed by a liquidating distribution of the sale proceeds. If the former shareholder was an 80-percent corporate shareholder, the liquidating distribution is tax-free under section 332.(104) These federal income tax results are identical to those achieved through a sale coupled with an election under section 338(h)(10).

In recognition of the comparability of the transactions, the proposed regulations permit the same election to apply section 331 to the deemed liquidation in a forward cash merger as is provided in the case of stock sales subject to section 338(h)(10).(105)

e. Spin-Offs

The disapearing basis consequence that results from a liquidation to which section 332 applies results also from a spin-off to which section 355 applies. If, for example, S1 distributes its stock of S2 to P, P must allocate the basis in its S1 stock between S2 and the stock in S1 that it continues to hold.(106) S1's basis in the S2 stock that was distributed disappears. If S1's basis in the S2's stock reflected a prior intercompany transaction, gain or loss on that transaction would be taken into account under the acceleration rule.(107) Consequently, the prior intercompany transaction would have had the sole consequence of causing a recognition of gain or loss, but no asset would exist whose basis reflected the transaction.

To provide taxpayers with relief, the proposed regulations allow taxpayers to elect to treat the distribution as subject to sections 301 and 311, rather than section 355. If S1, in the above example, acquired S2 in a prior intercompany transaction from S, the election would avoid S's gain or loss being taken into account immediately, but would cause S1 to have potential gain or loss on the distribution, which would not be the case if section 355 applied.(108)

f. Time for and Manner of Making Election

If a consolidated group wishes to avail itself of relief in any of the situations described in Prop. Reg. [sections] 1.1502-13(f)(5), a statement must be attached to the group's return for the year of the transaction.(109) The regulations do not specify that the election must be made before the due date of the original return. Presumably, therefore, the election may be made on an amended return. In the case of liquidation, however, the new subsidiary must be formed before the extended due date of the return, so the election in those cases is effectively limited to the extended due date.

The statement must be captioned "[Insert Name and Employer Identification Number of Common Parent] HEREBY ELECTS THE APPLICATION OF [sections] 1.1502-13(f)." The statement must specify the situation to which the election applies and how it changes the tax consequences that would result absent the election, including the amount of gain that is not taken into account by reason of the election. If the group has more than one transaction during the taxable year to which the election may apply, a separate statement is required for each transaction. By implication, the requirement indicates that an election may be made for one transaction but not made for another transaction.(110)

G. Obligations of Members

1. Definition of Intercompany Obligation

Paragraph (g) of Prop. Reg. [sections] 1.1502-13 contains rules governing the treatment of intercompany obligations. An intercompany obligation is defined as "an obligation between members, but only for the period during which both parties are members."(111) Thus, an obligation that is an intercompany obligation when created can cease to be one if the debtor or creditor becomes a nonmember. Similarly, an obligation that is not an intercompany obligation when created can become one if a member acquires the debt of another member from outside the group or the parties become members of the same group. For this purpose, an obligation includes certain derivative contracts, such as an interest rate notional principal contracts between members, described in sections 475(c)(2)(D) and (E).(112)

2. Accrual of Interest

The accrual of interest on an obligation is treated as an intercompany transaction, with the creditor member treated as the selling member and the debtor member treated as the buying member. Under the matching principle, the difference in the debtor's interest expense and its zerorecomputed expense causes the creditor to take the amount of the interest expense into income. Similar rules apply for taking into account original issue discount and premiums.(113) These results are similar to the results under current law.(114)

3. Disposition Outside Group Treated as Satisfaction and Resissuance

Under the single entity approach, the Treasury Department determined that regardless of whether a member (S) issued its debt to a nonmember or issued the debt to another member that later transferred S's debt to an nonmember, the tax consequences should be identical. Thus, if a member holds another member's obligation and realizes gain or loss on the disposition or extinguishment of the obligation, the obligation is treated for all federal income tax purposes as satisfied and, if it remains outstanding, reissued.(115) If the creditor member sells the intercompany obligation to a nonmember for cash, the debt is treated as new debt (with a new holding period) issued by the debtor member immediately after the sale for the amount of cash.

Thus, if the sale price differs from the face of the obligation, the purchaser and the debtor will take into account either the premium or original issue discount. Similar rules apply if an intercompany debt ceases to be an intercompany debt by reason of either party becoming a nonmember.

The regulations provide several exceptions to the general rule for reissuance treatment when an intercompany obligation ceases to be an intercompany obligation.(116) Reissuance treatment does not apply to obligations excluded from the application of section 108(e)(4) under Treas. Reg. [sections] 1.108-2(e) (relating to short-term obligations acquired by security dalers), amounts realized by financial institution under reserve accounting, and when treating the obligation as satishfied and reissued will not have a significant effect on any person's federal income tax liability for any year. The limitation on treatment of intercompany income or gain as excluded from gross income(117) is expressly made inapplicable to prevent any intercompany income or gain from being excluded.(118)

If the debtor or creditor becomes a nonmember, the obligation is treated as a new obligation issued for an amount of cash equal to its fair market value immediately after the party becomes a nonmember.(119) The rule will apply even if both parties continue to be affiliated, but become members of a different group as the result of a single transaction.

4. Acquisition by Member of Other Member's Obligation

By the same token, an obligation that is not an intercompany transaction can become one if either another member acquires the issuers debt from a nonmember or a nonmember debtor or creditor joins the other party's group. In such a case, the debt is treated for all federal income tax purposes as satisfied and a new debt issued to the holder (with a new holding period).(120) Furthermore, any gian or loss taken into account under the regulations upon a "nonintercompany" obligation becoming an intercompany obligation will not be subject to the nonrecognition rules of sections 354 and 1091 (relating to exchanges of stock and securities in certain reorganizations and wash sales, respectively).(121) Further, exceptions similar to the exceptions applicable when an intercompany debt ceases to be an intercompany debt apply.(122)

5. Non-Application of AHYDO Rules

Prop. Reg. [sections] 1.1502-80(f) corrects a technical problem in the operation of the rules on applicable high yield discount obligations (AHYDOs), where one member of a consolidated group holds the obligation of another member. The technical problem is corrected simply by making section 163(e)(5) inapplicable to intercompany obligations.

Section 163(i) defines an AHYDO as an instrument with a maturity date in excess of five years, whose yield to maturity equals or exceeds the applicable federal rate by five points, and which has significant OID. Under section 163(e)(5), the yield on the instrument is bifurcated between interest and a disqualified amount, which is treated as a dividend on preferred stock. The amount treated as a divident is not deductible by the issuer, but for purposes of the dividends-received deduction will be treated as dividend to a corporate holder. If, however, the corporate holder is a member of the issuer's consolidated group, Treas. Reg. [sections] 1.1502-26(a) disallows a dividends-received deduction. Accordingly, the issuer will be disallowed a deduction but the payee member will report divident income--a mismatch. Again, the problem is solved by Prop. Reg. [sections] 1.1502-80(f), which makes section 163(e)(5) inapplicable to intercompany obligations.

The proposed regulations apply only to instruments issued on or after the regulations are made final. In the case of a previously issued instrument, current law still applies with improper, and probably unintended, results.

H. Drafting Conventions

Paragraph (i) of Prop. Reg. [sections] 1.1502-13 is reserved. For those who may wonder what the Treasury Department may yet spring upon unsuspecting practitioners in this portion of the regulations, the concern is unfounded. To avoid confusion between the letter "i" (in a paragraph designation) and the small roman numeral "i" in the regulations, good drafters always reserve paragraph (i).

I. Miscellaneous Operating Rules

Prop. Reg. [sections] 1.1502-13(j) contains various miscellaneous operating rules. These include rules regarding successors (both persons and assets), the acquisition of an entire group by another group, cessation of the group by the liquidation of a sole subsidiary, as well as rules for becoming a nonmember, and recordkeeping requirements.

1. Successor Assets

Prop. Reg. [sections] 1.1502-13(j)(1)(i) states that "[a]ny reference to an asset includes, as the context may require, a reference to any other asset the basis of which is determined, directly or indirectly, in whole or in part, by reference to the first asset." This innocuous looking rule, like other rules contained in the regulations, has consequences, consciously intended by the drafters, that are not readily apparent without resort to the examples.

For instance, assume S sells land with a basis of $20 to B for $100. Thereafter, B contributes the asset to Newco, a domestic corporation, in exchange for 100 percent of Newco's stock, in a transaction to which section 351(a) applies. Since the land continues to be held by a member (Newco), the gain is not taken into account by reason of the transfer. Suppose, however, that B sells 20 percent of the Newco stock to a nonmember. Since the basis of Newco's stock is determined by reference to the basis of the land, the Newco stock is considered a successor asset. Thus, B's sale of 20 percent of its Newco stock will cause 20 percent of S's gain on the prior sale of the land to be taken into account under the matching rule. If the land is later sold to a nonmember, S will be required to take into account the amount of the remaining unrecovered gain.(123) Under current law, gain would not be restored upon the disposition of Newco stock, so long as Newco continued to be a member of the group, because such a transaction is not a restoration event under Treas. Reg. [sections] 1.1502-13(f)(1).

2. Successor Persons

Any reference to a person includes, as the context may require, a reference to a predecessor or successor.(124) A predecessor is defined as a transferor in any of hour enumerated types of transactions:

* transactions to which section 381(a) applies,

* transactions in which substantially all of the transferor's assets are transferred to a member in complete liquidation,

* with respect to transferred assets only, transactions in which a transferee member receives assets with a basis determined by reference to the transferor's basis, and

* intercompany transactions in which the transferor was the buying member in a prior intercompany transaction.(125)

The second-listed item might apply in a rare case where section 332 does not apply to the liquidation of a subsidiary. In general, a complete liquidation of a subsidiary will be governed by section 332, which is a transaction described in section 381(a). Such a liquidation would not be governed by section 332, however, if the plan were adopted before the subsidiary became a member of the group. In such a case, the liquidation would be subject to section 331 and the liquidating corporation would take gain into account immediately. Under the successor rule, the member that received the liquidating corporation's assets in the complete liquidation would be the successor and any gain or loss recognized by the liquidating corporation under section 336 would not be taken into account until subsequently.

3. Lonely-Parent Rule

If the group terminates because the common parent is the only remaining member (e.g., as a result of a liquidation of a sole subsidiary into the common parent), the common parent succeeds to the treatment of the terminated group.(126) Thus, the stand-alone corporation will continue to take into account gain or loss on an intercompany transaction as both the buyer and the seller, if, for example, the corporation holds depreciable property that was previously sold in an intercompany transaction. If the former common parent, however, becomes a member of an affiliated group filing separate returns, or becomes a non-includible corporation, described in section 1504(b), any remaining gain or loss on a prior intercompany transaction will be taken into account.(127)

4. Acquisition of Group

Under current law, gain or loss on a deferred intercompany transaction will not be restored when the group goes out of existence if the stock of the common parent is acquired by another group or if substantially all the assets of the common parent are acquired in a reorganization. Similarly, if the group terminates as a result of acquiring another company in a reverse acquisition, any deferred gain between members of the terminated group will continue to be deferred.(128)

Under Prop. Reg. [sections] 1.1502-13(j)(2), deferral of gain or loss between members of the terminating group is continued, as under current law, if the stocks of the common parent is aquired, or if substantially all of the common parent's assets are acquired in a reorganization. The requirement that all members of the terminating group become members of the surviving group is deleted.

5. Recordkeeping Requirement

The proposed regulations require that intercompany and corresponding items be reflected on permanent records (including work papers).(129) In addition to providing employment for accountants, the requirement is obviously intended to facilitate audits for compliance with the new rules.

The regulations cite section 6001 as authority under which the Secretary may require certain records to be kept. The sanctions for failure comply, however, are not clear. Although professional advisers may warn their clients to comply, it will not be surprising if many consolidated groups, especially those without sophisticated in-house tax departments, continue to treat intercompany transactions casually.

J. Anti-Avoidance Rules

1. General Rule

Not content to prescribe general rules and a plethora of examples illustrating their application, the Treasury Department included in the proposed regulations a pervasive anti-avoidance rule. To thwart (or at least chill) transactions that reach what the IRS may regard as improper results, a broad (and deliberately vague) anti-avoidance rule was included. Prop. Reg. [sections] 1.1502-13(h)(1) contains what has become almost boiler-plate language in the consolidated return regulations:

If a transaction is engaed in or structured with a principal purpose to avoid treatment as an intercompany transaction, or to avoid the purposes of this section, adjustments must be made to carry out the purposes of this section.(130)

The purpose of the anti-abuse rules is to discourage transactions that clever tax planners may deviseto circumvent the purposes of the regulations. Nevertheless, one must wonder whether such rules would be sustained if challenged on grounds of vagueness. Some of the transactions contained in the examples to illustrate the operation of the rule by no means constitute clear violations of the purposes of the regulations. Whether by example or on a case-by-case basis, it is questionable whether the Commissioner can simply assert ipse dixit that the results of a transaction achieved under the literal language of the regulation contradict the purposes of the regulations and therefore may be ignored.(131)

Resort to a non-specific anti-avoidance rule is reminiscent of the argument proffered by the government in Woods. In that case, the government argued that stock basis should be adjusted to reflect tax depreciation, rather than depreciation for E&P purposes, contrary to the language of its own consolidated return regulations. The government brief cited, among other things, the general override rule of Treas. Reg. [sections] 1.1016-6(a): Adjustments must always be made to eliminate double deductions or their equivalent. Thus, in the case of the stock of a subsidiary company, the basis thereof must be properly adjusted for the amount of the subsidiary company's losses for the years in which consolidated returns were made.

A unanimous Tax Court rejected the argument stating: We do not believe that the language of section 1.1016-6(a), Income Tax Regs., should be read to override the more specific provisions contained in section 1.1502-32, Income Tax Regs.... We find that respondent prescribed in 1966 the proper adjustments to basis when he promulgated specific adjustment rules in section 1.1502-32, Income Tax Regs., and chose earnings and profits to be the exclusive measuring rod. Thus, the "proper adjustment" required by section 1.1016-6(a), Income Tax Regs., is set forth in section 1.1502-32, Income Tax Regs., which bases the adjustment solely on earnings and profits.(132)

In the same vein, an argument that the literal language of the intercompany transaction regulations should not apply to a transaction because some other unspecified adjustment is "proper"--simply because the taxpayer structured the transaction in the most tax efficient manner--may not get a warm reception from the courts.

There are clearly transactions that in the past have been designed to frustrate the purposes of the intercompany transaction regulations.(133) Nevertheless, there will inevitably be cases in which a transaction was not anticipated by the regulation writers, and it is far from clear whether the results frustrate the purposes of the regulations. Unless the purpose of the proposed intercompany transaction rules is simply to maximize the taxpayer's tax liability whenever the Commissioner wants to, general anti-avoidance rules create more confusion than clarity.

2. Purported Location Abuse

Example 1 of Prop. Reg. [sections] 1.1502-13(h)(2) is worth studying in detail to appreciate the far-reaching effects and, indeed, the vulnerability of anti-avoidance rules: Sale of a partnership interest. (a) Facts. S owns land with a $10 basis and $100 value. B has net operating losses from separate return years (SRLYs) subject to limitations under [sections] 1.1502-21(c). Pursuant to a plan to absorb the losses without limitation by the SRLY rules, S transfers the land to an unrelated, calendar-year partnership in exchange for a 10% interest in the capital and profits of the partnership in a transaction to which section 721 applies. The partnership does not have a section 721 applies. The partnership does not have a section 754 election in effect. S later sells its partnership interest to B for $100. In the following year, the partnership sells the land to X for $100. Because the partnership does not have a section 754 election in effect, its $10 basis in the land does not reflect B's $100 basis in the partnership interest. Under section 704(c), the partnership's $90 built-in gain is allocated to B, and B's basis in the partnership interest increases to $190 under section 705. In a later year, B sells the partnership interest to X for $100. (b) Adjustments. Under [sections] 1.1502-21(c), the partnership's $90 built-in gain allocated to B ordinarily increases the amount of B's SRLY limitation, and B's $90 loss from its sale of the partnership interest ordinarily is not subject to the SRLY rules. Under paragraph (h)(1) of this section, however, B's allocable share of the partnership's gain from its sale of the land is treated as not increasing the amount of B's SRLY limitation.

The example is aimed at what may be termed "location abuse." That is to say, the transaction is structured through the partnership in order to have the built-in gain reported by the member with the SRLY loss rather than the member that initially holds the appreciated property but does not have a loss. The same result, of course, could be more simply achieved by having S contribute the property to B in exchange for B stock in a transaction to which section 351(a) applies. See Treas. Reg. [sections] 1.1502-34 and Rev. Rul. 89-46, 1989-2 C.B. 272. The land would take a carryover basis in B's hands and upon B's sale of the land, after waiting a decent interval, B's SRLY loss would offset the gain. Government attorneys have informally opined that such a transaction would not violate the anti-abuse rules.

Assuming that to be true, it is difficult to understand how the transaction described in the example--which accomplished the same results that could be achieved through a contribution of the land--would be considered to avoid the purposes of the intercompany transaction regulations. Stated differently, if the transaction is accomplished in one manner it will be respected, but if accomplished in another manner it will subject to whatever adjustments the government, on an ad hoc basis, believes is a more proper result. Thus is the slippery slope of anti-avoidance rules.(134) Broad anti-abuse rules may chill transactions, but the courts may ultimately give such rules the cold shoulder.

3. Mirror Transactions

a. 80-Percent Distributee

If the stock of a liquidating subsidiary is owned by more than one member (e.g., the typical mirror transaction structure), section 332 will apply to all owning members.(135) Without great elaboration, Prop. Reg. [sections] 1.1502-13(j)(1)(ii)(B) states: If two or more successor members acquire assets of the predecessor, the successors take into account the predecessor's intercompany items in a manner that is consistently applied and reasonably carries out the purposes of this section and applicable provisions of law.

This vague statement is intended to put an end to the "modified mirror transaction," which allowed for the acquisition of groups, followed by a bust-up of the group without current tax liability. Under current law, Treas. Reg. [sections] 1.1502-13(c)(6) and Temp Reg. [sections] 1.1502-13T(c) provide for a single successor rule if the assets of a member that sold assets in a deferred intercompany transaction are acquired by several members in a transaction to which section 381(a) applies. The regulations explicitly state that in such a case the member acquiring the greatest portion of the assets (measured by fair market value) of the selling member shall be subject to the deferred intercompany transaction restoration rules on the entire remaining balance of any deferred gain or loss. If two or more members acquire equal portions, then the common parent can select the member that will inherit the deferral. If, however, a member other than the member receiving the greatest portion of assets in the liquidation can independently qualify for nonrecognition treatment under section 332, a tax-free bust-up acquisition may be possible. Example. P wishes to acquire T for $1,000. T has two assets, Wanted with an FMV of $600 and Unwanted with an FMV of $400. Both assets have a low basis in T's hands. Accordingly, P forms S1 and S2 with $600 and $400, respectively. S1 purchases all of T's preferred stock, described in section 1504(a)(4), for $600 and S2 purchases all of T's common stock for $400. Immediately after the acquisition, T is liquidated. S1 receives Wanted and S2 receives Unwanted. Under Temp. Reg. [sections] 1.1502-13T(c), the successor corporation is the corporation that receives the greatest portion of the fair market value of the assets. Accordingly, S1 becomes the successor with respect to the gain on Wanted, which it receives. S2, on the other hand, holds Unwanted and will be sold. The liquidation of T, however, did not result in any gain under section 336 with respect to Unwanted, because S2, standing alone, owned 80 percent of T's common stock (stock described in section 1504(a)(4) is not taken into account) and therefore independently satisfied the requirements of sections 332 and 337(c). Consequently, S2's basis in Unwanted is the same as T's basis in Unwanted. A sale of S2 for $400 will not result in the recognition of any gain.

An example similar to the one described above, in which one distributee satisfies the requirements of section 332 independently, is contained in Prop. Reg. [sections] 1.1502-13(j)(6), Example 4. Consequently, by reason of section 337(a), the liquidating corporation does not recognizes gain under section 336 with respect to the assets distributed to that distributee. The example concludes that in order to carry out the purposes of the intercompany transaction regulations, the distributee to which section 381(a) applies (S2 in the above example) is the successor to the intercompany gain on the assets distributed to S1. Accordingly, a sale of S2's stock will cause the intercompany gain to be taken into account under the acceleration rule. This result is entirely reasonable and fortifies the attempts by Congress to prevent circumvention of the repeal of General Utilities.(136)

b. No 80-Percent Distributee

Although the Treasury Department is justified in prescribing a rule, by example, that requires a section 381(a) transferee to inherit any deferred gain or loss, the proposed regulations contain an unfortunate example involving a mirror liquidation in which there is no section 381(a) transferee. Rather than being an example of an avoidance transaction, as the regulations writers intended, the example illustrates the Treasury Department's overreach in its efforts to prevent circumvention of the repeal of General Utilities and the problem with anti-avoid-ance rules in general. Those efforts do not always stop at what is reasonable--evidence the loss the disallowance regulations.(137)

Prop. Reg. [sections] 1.1502-13(j)(6), Example 5 describes a transaction in which a liquidating subsidiary, X, distributes appreciated assets to each of its two owning members, S and B. The assets distributed to S had a value of $60 and a basis of zero immediately prior to the liquidation, and the assets distributed to B had a value of $40 and a basis of zero immediately prior to the liquidation. In the example, neither member holds sufficient stock of the liquidating subsidiary to independently satisfy the requirements of section 332. Therefore, X is treated under section 336 as having sold an asset to S and to B. X is therefore treated as the selling member and the distributee corporation is treated as the buying member.

Since X is not a member immediately after its liquidation, the transaction does not meet the literal definition of an intercompany transaction. Prop. Reg. [sections] 1.1502-13(b). Nevertheless, the regulation writers concluded, consistent with current law, that the gain should not be taken into account at the time of the liquidating distribution since no asset has left the group. Temp. Reg. [sections] 1.1502-14T(c). The key question is which of the distributees, S or B, succeeds X as the selling member with respect to the gain recognized by X under section 336.

As an illustration of everything that is wrong with substantive "anti-avoidance" regulations, Prop. Reg. [sections] 1.1502-13(f)(6), Example 5 concludes, without elaboration: Under paragraph (j)(1)(ii)(B) of this section, to be consistent with the anti-avoidance rules of paragraph (h)(1) of this section, S succeeds to X's $40 intercompany gain with respect to the assets distributed to B, and B succeds to X's $60 intercompany gain with respect to the assets distributed to S. The gain will be taken into account by S and B under the matching and acceleration rules of this section based on subsequent events.

Since S is the buying member with respect to the assets it receives and is the selling member with respect to the assets received by B, if S were to become a nonmember the full $100 of gain would be taken into account. Why, however, is treating S as the selling member with respect to the assets received by B (and B the selling member with respect to assets received by S) consistent with the anti-avoidance rules? The regulations do not explain, and practitioners who have analyzed the rule have no clue. What is the abuse that would result from having the distributee member be both the buying member and the selling member with respect to the property it receives? Do the anti-avoidance provisions authorize the Commissioner to impose tax results contrary to the language of the regulations on a case-by-case basis when she believes a different result would be more proper?

Apart from the general objections to the anti-abuse rule, the conclusion reached in Example 5 of Prop. Reg. [sections] 1.1502-13(f)(6) (i.e., that a member other than the distributee of an asset is the successor selling member with respect to the asset) raises more questions than it answers. Furthermore, the rule does not stop the well-advised taxpayer from achieving a different result using the proper structure. For example, if a subsidiary is liquidated into more than two subsidiaries, which of the subsidiaries will be treated as the selling member of which assets. Assume a liquidation into 100 owning members (or mirror subsidiaries). Will each distributee be treated as the successor with respect to the assets received by every other distributee? What tax consequences result if one of the 100 distributees becomes a nonmember? Will the section 336 gain with respect to all the assets be taken into account? That is a very scary prospect.

Consider again the simple case of a subsidiary with only two owning members. If the group wants to segregate one group of assets in a different corporation from other assets and have the holder of the assets also treated as the selling member, a redemption of the stock held by only one owning member, rather than a liquidation of the subsidiary, should be considered. Example. T's stock is held by two subsidiaries of the same consolidated group. S1 owns 60 percent of T's stock and S2 owns 40 percent of T's stock. T holds two assets, W, with an FMV of $60, and U, with a FMV of $40. Both assets have a zero basis in T's hands. S2 is merely a holding company that has no assets other than its stock of T. Rather than liquidating, T redeems its stock held by S2 in exchange for U. After the redemption, S1 owns all of T's stock. Under the attribution rules of section 318, after the redemption S2 is deemed to own the stock in T that S1 owns (100 percent). Accordingly, the redemption is treated as a distribution under sections 302(d) and 301 rather than as a capital transaction under section 302(a). Thus, T is treated as having sold U to S2 and T recognizes gain under section 311(b), which will be taken into account at some future time under the matching rules and the acceleration rules. If S2 ceases to be a member, under the acceleration rule only the $40 gain with respect to the intercompany transfer of U will be taken into account at that time. The built-in gain with respect to W, which continues to be held by T, will not be taken into account. By contrast, if T had liquidated, distributing U to S2 and W to S1, and S2 then ceased to be a member, under Example 5 of Prop. Reg. [sections] 1.1502-13(f)(6), $100 of gain would be taken into account.

K. Effective Dates

1. General Rule

In general, the proposed regulations apply to intercompany transactions occurring on or after the date the final regulations are filed with the Federal Register. If, as the result of an overlap between the current and the proposed regulations, an item would be either eliminated or duplicated, the current regulations, not the proposed regulations, apply. For example, under the entitlement rule(138), a member is treated as receiving a dividend from another member when it becomes entitled to the dividend. Under current law, the dividend is treated as occurring when, in fact, the distribution occurs. Suppose a dividend were declared before the regulations are made final, but paid after final regulations are promulgated. The proposed regulations would not apply when the dividend was declared, and the current regulations would not apply when the dividend was paid. Accordingly, absent a special rule, the dividend could be omitted entirely.(139)

2. Anti-Avoidance Rule

In addition to the general effective date rule, the proposed regulations contain a highly controversial special rule for what are termed "avoidance transactions." If a transaction is engaged in or structured after April 8, 1994 (the date the proposed regulations were filed with the Federal Register), with "a principal purpose" to avoid the proposed regulations applicable to a transaction occurring after the regulation would otherwise be effective, to duplicate, omit, or eliminate an item in determining taxable income, or to treat an item inconsistently, Prop. Reg. [sections] 1.1502-13(1)(2) applies. If that provision applies, "appropriate adjustments must be made in years beginning on or after [the date the final regulations are filed with the Federal Register], to prevent the avoidance, duplication, omission, elimination or inconsistency." If, however, both the intercompany transaction and the corresponding item that causes the intercompany transaction to be taken account, occur before the regulations are made final, the anti-avoidance rule should not apply.

The Treasury Department is obviously concerned that once the new regulations have been unveiled, taxpayers might believe that there is a small window of opportunity to exploit current law and rush to do transactions before the new regulations become effective. Even more trouble-some, a member could sell property to another member before the proposed regulations are made final and thereby grandfather the old law consequences forever. Among the prerequisites for the application of the special effective date rule is that there be "a principal purpose to avoid" the new rules. Thus, if the taxpayer is simply planning a transaction without the benefit of adequate tax counsel, a tax avoidance purpose would be absent. On the other hand, if the taxpayer is advised of the tax benefits from not delaying the transaction, a principal purpose to avoid the new rules may be implied.

To have any hope of applying the anti-avoidance rule to an intercompany transaction by a calendar-year group occurring after April 8, 1994, but before January 1, 1995, the Treasury Department must make the proposed regulations final before March 15, 1995. Under section 1503(a), a consolidated group must determine its tax liability in accordance with regulations prescribed before the due date (presumably without extensions) of its return. Therefore, if the final regulations are not filed with the Federal Register on or before March 14, 1995, the regulations cannot be applied to transactions of calendar-year groups occurring in 1994. Since taxpayers cannot know during 1994 whether final regulations will be promulgated by March 14, 1995, most groups will proceed cautiously. Consequently, the proposed anti-avoidance effective date will likely accomplish its goal of immediately chilling aggressive transactions.

L. Concluding Observations

For those readers who have persevered through the two parts of this article or through the proposed regulations--Congratulations. Even among practitioners who spend a large portion of their time dealing with consolidated return issues, the proposed regulations are difficult. Although the basic principles set forth in the proposed regulations may seem simple enough on their face, as the examples amply demonstrate, application of the principles to specific fact patterns result in sometimes subtle and surprising tax consequences.

A number of speakers at the first IRS hearing on the regulations suggested the proposed regulations be scrapped, not because of the substantive results achieved in most cases, but because of the regulations' difficulty. The response from the government panel was that the complexity was regrettable, but nonetheless unavoidable if tax avoidance was to be prevented. Submission of specific suggestions for simplification that would not open the door for "abusive transactions" was encouraged. Given the response to comments at the hearing, the proposed regulations are unlikely to be withdrawn or fundamentally modified. More likely, optimistic projections concerning quick finalization (i.e., before the end of 1994) will not be realized. In the interim, the anti-avoidance rules in the effective date provisions will have the effect of immediately chilling aggressive transactions that the Treasury Department finds most objectionable.

For consolidated groups with a clean heart that simply wish to avoid the complexity of the regulations, self-help simplification may take the form of intercompany sales exactly at tax basis. Obviously, such convenient pricing could run afoul of section 482 (expressly made applicable to consolidated groups in Treas. Reg. [sections] 1.1502-80(a)), but if the consequences to the group of a redetermination would be a zero tax adjustment, an agent is unlikely to disturb such intercompany pricing. That practical solution may prove to be the wave of the future.

Notes

(59)Treas. Reg. [sections] 1.1502-13(f)(1)(i).

(60)See Treas. Reg. [sections] 1.1502-18.

(61)Prop. Reg. [sections] 1.1502-13(e)(1)(ii).

(62)Prop. Reg. [sections] 1.1502-13(e)(1)(iii).

(63)Prop. Reg. [sections] 1.1502-13(e)(2)(i).

(64)Prop. Reg. [sections] 1.1502-13(e)(2)(ii)(A).

(65)Prop. Reg. [sections] 1.1502-13(e)(2)(ii)(B).

(66)Compare Treas. Reg. [sections] 1.1502-13(c)(3) with Prop. Reg. [sections] 1.1502-13(e)(3).

(67)Prop. Reg. [sections] 1.1502-13(e)(3)(ii).

(68)Treas. Reg. [sections] 1.1502-14(a)(1).

(69)I.R.C. [sections] 243(b)(1)(B)(i).

(70)Prop. Reg. [sections] 1.1502-13(f)(2)(i).

(71)Prop. Reg. [sections] 1.1502-13(f)(2)(i).

(72)1962-2 C.B. 94.

(73)Prop. Reg. [sections] 1.1502-13(f)(2)(iv).

(74)Prop. Reg. [sections] 1.1502-13(f)(2)(ii). The exclusion will not apply to a dividend paid on a share of the common parent's stock owned by a subsidiary.

(75)I.R.C. [sections] 301(b)(1)(B), prior to amendments made by the Technical Correction Act of 1988.

(76)Treas. Reg. [sections] 1.1502-31(b)(1).

(77)S. Rep. No. 100-445, 100th Cong., 2d Sess. 62 n.31 (1988), and H.R. Rep. No. 100-795, 100th Cong., 2d Sess. 59 n.31 (1988), respectively.

(78)Prop. Reg. [sections] 1.1502-13(f)(6), Example 1.

(79)Prop. Reg. [sections] 1.1502-13(f)(2)(iii).

(80)Prop. Reg. [sections] 1.1502-13(f)(3).

(81)I.R.C. [sections] 356(a)(1).

(82)See I.R.C. [sections] 356(a)(2); Clark v. Commissioner, 489 U.S. 726 (1989).

(83)Prop. Reg. [sections] 1.1502-13(f)(3)(ii).

(84)See Prop. Reg. [sections] 1.1502-13(f)(6), Example 3.

(85)1972-2 C.B. 516.

(86)J. Crestol, K. Hennessey & R. Yates, The Consolidated Tax Return: Principles, Practice, and Planning [paragraph] 4.04[2] (5th Ed. 1993).

(87)1974-2 C.B. 117.

(88)See Firestone Tire & Rubber Co. v. Commissioner, 2 T.C. 827 (1943), acq., 1945 C.B. 3, withdrawing nonacq., 1944 C.B. 38.

(89)Arguably, the liquidation also constitutes a disposition outside the group to invoke the restoration rule in Treas. Reg. [sections] 1.1502-13(f)(1)(i).

(90)See Telephone Answering Service Co., 63 T.C. 423 (1974), aff'd per curiam, 546 F.2d 423 (4th Cir. 1976), cert. denied, 431 U.S. 914 (1977).

(91)Prop. Reg. [sections] 1.1502-13(j)(1).

(92)Prop. Reg. [sections] 1.1502-13(f)(5)(i).

(93)Rev. Rul. 70-223, 1970-1 C.B. 79.

(94)Prop. Reg. [sections] 1.1502-13(f)(5)(ii)(C).

(95)See Tax Notes, May 27, 1991, at 981.

(96)Prop. Reg. [sections] 1.1502-13(f)(5)(iii).

(97)Treas. Reg. [sections] 1.1502-20(c)(1)(i).

(98)Treas. Reg. [sections] 1.1502-20(a)(4).

(99)Prop. Reg. [sections] 1.1502-13(f)(5)(iii)(C).

(100)Prop. Reg. [sections] 1.1502-13(f)(5)(iii)(C).

(101)Prop. Reg. [sections] 1.1502-13(f)(5)(iii)(A).

(102)Letter Ruling Nos. 8938036, 9044063, and 9303006.

(103)Rev. Rul. 69-6, 1969-1 C.B. 104.

(104)Letter Ruling Nos. 8337065 and 8521057.

(105)Prop. Reg. [sections] 1.1502-13(f)(5)(iii)(D).

(106)I.R.C. [sections] 358.

(107)Prop. Reg. [sections] 1.1502-13(d).

(108)Prop. Reg. [sections] 1.1502-13(f)(5)(iv).

(109)Prop. Reg. [sections] 1.1502-13(f)(5)(v).

(110)Prop. Reg. [sections] 1.1502-13(f)(5)(v).

(111)Prop. Reg. [sections] 1.1502-13(g)(2)(ii).

(112)Prop. Reg. [sections] 1.1502-13(g)(6), Example 5.

(113)Prop. Reg. [sections] 1.1502-13(g)(6), Example 1.

(114)Treas. Reg. [sections] 1.1502-13(b)(1).

(115)Prop. Reg. [sections] 1.1502-13(g)(3)(i)(A).

(116)Prop. Reg. [sections] 1.1502-13(g)(3)(i)(B).

(117)Prop. Reg. [sections] 1.1502-13(c)(3)(iv).

(118)Prop. Reg. [sections] 1.1502-13(g)(3)(ii)(B)(1).

(119)Prop. Reg. [sections] 1.1502-13(g)(3)(iii).

(120)Prop. Reg. [sections] 1.1502-13(g)(4)(i)(A).

(121)Prop. Reg. [sections] 1.1502-13(g)(4)(ii)(D).

(122)Prop. Reg. [sections][sections] 1.1502-13(g)(4) and -13(g)(6), Example 4.

(123)Prop. Reg. [sections] 1.1502-13(j)(6), Example 1.

(124)Prop. Reg. [sections] 1.1502-13(j)(1)(ii).

(125)Prop. Reg. [sections] 1.1502-13(j)(1)(ii)(A).

(126)Prop. Reg. [sections] 1.1502-13(j)(3).

(127)Prop. Reg. [sections] 1.1502-13(j)(3).

(128)A troublesome requirement under existing law is that all members of the terminated group immediately before the termination must contiue to be members immediately after. Treas. Reg. [sections] 1.1502-13(f)(2)(i).

(129)Prop. Reg. [sections] 1.1502-13(j)(5).

(130)Compare other consolidated return anti-avoidance rules in Treas. Reg. [sections] 1.1502-20(e)(1) and Prop. Reg. [sections] 1.1502-32(e)(1). In each case, the regulations state that if "a principal purpose" of a transaction is to frustrate the general purposes of the regulations, the Commissioner can assert a liability or make an adjustment, not-withstanding the literal language of the regulations.

(131)See Woods Investment Co. v. Commissioner, 85 T.C. 274 (1985), and Gregory v. Helvering, 293 U.S. 465 (1935).

(132)85 T.C. 274, 283 (1985).

(133)See Rev. Rul. 89-85, 1989-2 C.B. 218.

(134)For another example of a transaction that purportedly violates the anti-abuse rules, but without any supplied rationale, see Prop. Reg. [sections] 1.1502-13(j)(6), Example 5.

(135)Treas. Reg. [sections] 1.1502-34.

(136)I.R.C. [sections] 337(d).

(137)Treas. Reg. [sections] 1.1502-20.

(138)Prop. Reg. [sections] 1.1502-13 (f)(2)(iv).

(139)Prop. Reg. [sections] 1.1502-13(l)(1).