Consolidated returns and E&P - application of Sec. 1503(e) to preaffiliation property.

Legislation enacted after the decision in Woods Investment Co., 85 TC 274 11985L eliminates the so-called "Woods benefit" and requires that tax depreciation, instead of earnings and profits (E&PJ depreciation, be used to calculate the basis of stock on a disposition of a subsidiary in a consolidated group. The application of this rule, however, is unclear when the subsidiary owns property that was acquired before the subsidiary became a member of the consolidated group (preaffiliation property). In many cases, significant adjustments may be necessary to correctly compute gain or loss on disposition.

Sec. 15031e)provides for adjustment to the basis of stock of a consolidated group member to reverse any "Woods effect" on a disposition (e.g., sale or exchange, loss from worthlessness) of the stock. It is unclear how this provision applies to property acquired by a group member before it joined the consolidated group ("preaffiliation property"), and the only IRS guidance (Letter Ruling 9039003) further adds to the confusion. The potential application of Sec. 15031e1 to preaffiliation property can be significant, particularly in capital-intensive industries that are supporting their business operations through divestiture of subsidiaries in stock sales without Sec. 338 elections.

Taxpayers who have made for are contemplating) dispositions of a subsidiary owning preaffiliation property should verify whether they have properly considered the application of Sec. 1503(e), particularly in the situation illustrated below. Identification of this issue may uncover potential refund claims and other unusual or technical applications of the law and regulations that influence the proper determination of the subsidiary's stock basis.

Sec. 1503(e) was added by the Revenue Act of 1987 and modified by the Technical and Miscellaneous Revenue Act of 1988 ITAMRA), the Omnibus Budget Reconciliation Act of 1989 and the Revenue Reconciliation Act of 1990. Sec. 1503(e)(1) provides that in determining gain (including any excess loss account recapture) or loss on the disposition of stock of a consolidated group member, the E&P used to calculate the stock's basis under Regs. Sec. 1.1502-32 is determined as though Sec. 312 were applied for the tax year (and all preceding consolidated years of the member with respect to such group) without regard to Sec. 312(k)and (n). Thus, for depreciation purposes, Sec. 3121k) is disregarded and actual tax depreciation is used in making E&P and stock basis calculations used to determine gain/loss on disposition.

The committee reports to the Revenue Act of 1987 directed the Treasury Department to promulgate regulations addressing cases in which a "prior owner was not subject to this provision." No regulations have been issued, however, and the intended scope of any such regulations under this congressional directive is unclear (see below).

The TAMRA added Sec. 1503(e)(3), providing that "under regulations prescribed by the Secretary, proper adjustments shall be made" in the application of Sec. 1503(eJ( l)for the difference in the tax basis and E&P basis for property acquired by a corporation before it joins a consolidated group. The technical necessity for Sec. 1503(e)(3) is questionable, given the flush language of Sec. 1503(e)(1). The committee reports underlying Sec. 1503(e)(3) indicated that situations requiring such adjustment include, but are not limited to, cases in which the corporation that holds the preaffiliation property was not formerly a member of another affiliated group filing a consolidated return or was the common parent of such a group. (Note: The committee reports do not expressly state that relief under Sec. 1503(e) is available if the preaffiliation property was acquired while a member of another consolidated group.)

The committee reports went on to state that in cases involving preaffiliation property within the purview of Sec. 1503(e)(3), "it is expected that regulations will provide that, instead of the adjustments prescribed by section 1503(e)(1), the stock basis that would otherwise result from the application of the section 3121k) earnings and profits basis will generally be adjusted [downward] only to the extent of the excess, if any, of tax depreciation over [Sec. 312(k)] earnings and profits depreciation during the period the property is owned by the affiliated group filing the consolidated return." (Emphasis added.) Similar adjustments to the application of Sec. 1503(e)(1) are also intended to apply to the treatment of items under Sec. 312(n) (e.g., intangible drilling costs, LIFO inventory adjustment). The committee reports, however, did not directly reflect on the upward stock basis adjustment that equitably should be allowed in the opposite situation, i.e., the tax depreciation taken on preaffiliation property during the consolidation period is less than E&P depreciation, as illustrated by the example at left.

Letter Ruling 9039003 is the only IRS interpretation to date of the operation of Sec. 1503(e)(13) as to preaffiliation property. Unfortunately, however, this ruling is unclear both as to whether the subsidiary owning the preaffiliation property was a member of a group that filed a consolidated return (although the ruling implies it was such a member), and as to the mechanical application of the "adjustment" under Sec. 1503(e)(3). Presumably, however, the ruling was favorable to the taxpayer; otherwise the taxpayer likely would have withdrawn the ruling request before the ruling was issued.

Whether W and X in the example filed a consolidated return appears to be immaterial, failure to allow the $50 positive adjustment to Y would turn the reversal of the Woods benefit, which in essence was only a timing benefit, into a permanent denial of tax benefit for any item described in Sec. 312(k) and (n). (Note: The result should not be different if X had been sold to Y on or before Dec. 15, 1987, given the judicial holding in Woods before the effective date of Sec. 1503(e).1 Pending the issuance of regulations under Sec. 1503(e)(3), one approach for applying Sec. 1503(e) would be to make a negative or positive adjustment (as the ease may be)only for the postaffiliation regular depreciation-E&P depreciation differential attributable to the difference between regular tax depreciable basis and E&P depreciable basis (as of the time of affiliation) for preaffiliation property owned by a corporation entering a consolidated group, regardless of whether the member owning such property was included in a prior consolidated group. (Note that, according to Letter Ruling 9039003, these calculations should be made on an asset-by-asset basis.)

From David W. Blair, CPA, Houston, Tex., and William J. Tiedemann, CPA, New York, N.Y.