Consolidated returns and the single-entity theory: the new intercompany transaction proposed regs.

On Apr. 8, 1994, the IRS issued anxiously awaited proposed regulations(1) under Sec. 1502 that revise the intercompany transaction system of the consolidated return regulations. The goal is to ensure, where practical from a compliance and policy perspective, the same tax treatment to a consolidated group as if the group's business activities were conducted by separate divisions of a single corporation. This article will discuss the proposed regulations and their effect on corporations filing consolidated returns.

In addition to the revisions to the intercompany transaction system, amendments to related regulations were proposed. These additional amendments, to be discussed in a future article, include revisions to the Sec. 267(f) regulations, simplifying rules for intercompany transactions involving inventory when one or both group members use dollar-value LIFO, simplifying rules on reserve accounting, special rules for member stock and obligations, coordination with Sec. 108(b) and rules pertaining to accounting methods and the special inventory adjustment.

Background

The existing intercompany transaction rules are contained in Regs. Secs. 1.1502-13 and -14, and Temp. Regs. Secs. 1.1502-13T and -14T (existing regulations). Regs. Sec. 1.1502-13(a)(1) defines an intercompany transaction as a transaction during a consolidated return year between corporations that are members of the same group immediately after the transaction. An intercompany transaction includes, for example, a sale of property by one group member (selling member, S) to another group member (buying member, B), or the payment of interest or rent by one member (B) to another group member (S) during a consolidated return year. Under Regs. Sec. 1.1502-13(a)(2), a deferred intercompany transaction is an intercompany transaction that is a sale or exchange of property or an expenditure, including expenditures for services that must be capitalized (e.g., builders' fees, architects' fees, prepaid expenses and other expenditures properly included in the basis of property).

The existing regulations employ a deferred sale approach that results in a combination of single-and separate-entity treatment for group members in an intercompany transaction. For the most part, the amount, location, character and source of items in connection with an intercompany transaction are determined as if separate returns were filed. On the other hand, the timing of items is determined on a single-entity basis, as if the members were divisions of a single corporation. These rules were intended to produce neutral tax results for the consolidated group in an intercompany transaction; a consolidated group should be in no better or worse position as the result of such transaction. The method intended for providing this neutrality was the deferral and restoration rules contained in the existing regulations. These rules generally resulted in matching the timing of S's and B's items from the intercompany transaction.

Example 1: Intercompany rental. S owns a building, part of which is leased to B. For the 1994 tax year, B pays $750 rent to S. To achieve neutrality, the 1994 consolidated return would reflect $750 of rental income attributable to S and $750 of rental expense attributable to B, resulting in no net tax effect for the consolidated group from the intercompany transaction.

Example 2: Intercompany sale of property. During 1994, S sells depreciable property with an adjusted basis of zero to B for $500. The $500 gain that S recognizes is deferred under Regs. Sec. 1.1502-13(c). B takes a $500 basis in the property pursuant to Regs. Sec. 1.1502-31(a). The $500 deferred gain will be restored to income as B depreciates the property. If the property is depreciated ratably over a five-year period ($100 per year), $100 of the deferred gain will be restored to income in each of the five years. The net effect is zero for each of the five years ($100 gain offset by $100 depreciation). Not surprisingly, this is the same result that would have occurred had S simply kept the property and used it in its business activities for the five-year period.

While these simple examples may illustrate the above principles, they might also give the false impression that the deferral and restoration rules of the existing regulations yield the desired neutrality in all intercompany transactions. Nothing could be further from the truth. The consolidated return regulations were last significantly rewritten in 1966. Since that time, due to changes in tax law and business practices, various transactions have been devised that yield results inconsistent with the intended neutrality of the existing regulations and with the results that would have occurred had no intercompany transaction taken place. This put the IRS in the unenviable position of being reactive as these transactions surfaced. Over the last several years, transactions such as "corporate CPR," "bump and strip," "dividend stripping" and various descendants of "mirrors" took advantage of literal compliance with the existing intercompany transaction rules to produce unintended results.(2) The IRS responded with various administrative announcements and regulations to curtail these transactions. This reactive posture highlighted the need to the IRS for a complete revamping of the intercompany transaction rules.

The Proposed Regulations

* Policy considerations

As stated in the preamble, "[t]he purpose of the proposed intercompany transaction regulations is to clearly reflect the taxable income (and tax liability) of the group as a whole by preventing intercompany transactions from creating, accelerating, avoiding, or deferring consolidated taxable income (or consolidated tax liability)." For the most part, this purpose is accomplished under the proposed regulations by viewing the respective group members as if they were divisions of a single corporation. However, the IRS did not adopt comprehensive single-entity treatment for intercompany transactions. Single-entity treatment would be expanded, however, to determine, in addition to the timing of a particular item, the character, source and other attributes. Under the proposed regulations, only the amount and location of items would be determined on a separateentity basis.

While the proposed regulations move closer to a single-entity approach, they retain the basic principles found in the existing regulations. This will lead to most intercompany transactions being treated similarly under both sets of regulations. However, while the end result may be the same, the analysis under the proposed regulations to achieve such result will be significantly different. The proposed regulations replace the essentially mechanical rules of the existing regulations with general principles and guidance on policy considerations. This approach enables application of the regulations to a wide variety of intercompany transactions under current tax law and offers sufficient flexibility to deal with changing business conditions and changes in tax law. Only time will tell the extent to which this approach is successful in providing the necessary guidance. Fortunately, the proposed regulations contain a large number of examples, many with several variations, that illustrate their application.

* Intercompany transactions

Prop. Regs. Sec. 1.1502-13(b)(1) defines an intercompany transaction as a transaction between corporations that are members of the same consolidated group after the transaction. Examples include S's sale of property (or other transfer, such as an exchange or contribution) to B, whether or not gain or loss is recognized(3); S's performance of services for B, and B's payment or accrual of its expenditure for S's performance(4); S's licensing of technology, rental of property or loan of money to B, and B's payment or accrual of its expenditure(5); and S's distribution to B with respect to S's stock.(6) If a transaction occurs in part while S and B are group members and in part while they are not, the transaction is treated under Prop. Regs. Sec. 1.1502-13(b)(1)(ii) as occurring on the earlier of performance by either S or B, or when payment for performance would be taken into account under the proposed regulations if it were an intercompany transaction. Prop. Regs. Sec. 1.1502-13(b)(1)(iii) further provides that each transaction is to be analyzed separately. For example, if S sells two properties to B, one at a gain and the other at a loss, each sale is treated as a separate transaction.

* Intercompany items and corresponding items

Prop. Regs. Sec. 1.1502-13(b)(2)(i)(A) provides that S's income, gain, deduction and loss from an intercompany transaction are its intercompany items. Further, S's gain from the sale of property to B is intercompany gain, and if such sale results in a combination of ordinary income and capital gain, each is treated as a separate intercompany item. In determining S's intercompany items, Prop. Regs. Sec. 1.1502-13(b)(2)(i)(B) provides that S's costs or expenses related to an intercompany transaction are included. For example, deductions for wages are included in determining S's income from performing services for B, and depreciation deductions are included in determining S's income from renting property to B.

B's income, gain, deduction and loss from an intercompany transaction are its corresponding items.(7) B's corresponding items include amounts permanently disallowed or eliminated, whether directly or indirectly.(8) For this purpose, corresponding items include amounts disallowed under Sec. 265, amounts offset under Sec. 171(e) and amounts not recognized under Sec. 311 or 332.

* Deemed intercompany and corresponding items

An adjustment reflected in basis (or to an amount equivalent to basis, such as a loss carryover or an excess loss account) that is a substitute for an intercompany item or a corresponding item, is treated as an intercompany item(9) or a corresponding item,(10) as the case may be, unless the adjustment is made pursuant to a nonrecognition provision. An example of a deemed item could be depreciation on a piece of equipment purchased by B from S that is capitalized as an addition to the basis of a building constructed by B. In addition, Prop. Regs. Sec. 1.1502-13(b)(2)(iii)(C) provides that a deduction or loss is not treated as an intercompany item or corresponding item to the extent it does not reduce basis (or have an equivalent effect, such as decreasing a loss carryover or increasing an excess loss account). An example of a deduction that is not treated as a corresponding item is B's percentage depletion in excess of basis pursuant to Sec. 613A on a property purchased from S.

* Attributes

Prop. Regs. Sec. 1.1502-13(b)(4) provides that attributes of an intercompany item or corresponding item are all of the item's characteristics necessary to determine its effect on taxable income (and tax liability) except amount, location and timing. For this purpose, attributes include character, source, treatment as excluded from gross income or as a noncapital, nondeductible amount, and treatment as built-in gain or loss under Sec. 382(h) or 384. A member's holding period in property, or the fact that property is included in inventory, are not attributes of an item, but do affect the determination of the item's respective attributes.(11)

The Matching Rule

The matching rule is the principal rule for redetermining the timing and attributes of S's intercompany items and B's corresponding items on a single-entity basis. The matching rule applies only to timing and attributes; amount and location of items are determined on a separate-company basis. To understand the application of the matching rule, it is first necessary to understand three general rules and several special operating rules.

General Rules

* Attributes

Prop. Regs. Sec. 1.1502-13(c)(1)(i) requires the redetermination of the attributes of S's intercompany items and B's corresponding items to produce the same effect on consolidated taxable income and tax liability as if S and B were divisions of a single corporation and the intercompany transaction were a transaction between divisions. The activities of both S and B affect the attributes of both intercompany items and corresponding items. Thus, if S holds property for sale to customers in the ordinary course of its trade or business and sells it to B, S's intercompany items and B's corresponding items may be ordinary items solely due to S's activities. The redetermination required by Prop. Regs. Sec. 1.1502-13(c)(1)(i) is a substantive change from existing law, and is the key to preventing a consolidated group from deviating from the results that a single corporation could achieve.

Example 3:(12) Dealer activities. S holds land for investment with a basis of $50. On Jan. 1, 1994, S sells the land to B for $100. B develops the land as residential real estate and sells the developed lots to unrelated parties on Jan. 1, 1995 for $150. If B's ownership of the lots at the time of sale would control in considering B and S as divisions of a single corporation, the entire $100 gain (including S's deferred gain) would be ordinary income. B's holding period with respect to the lots includes the period S held the land.

Under the existing regulations, this transaction would result in the $100 gain being bifurcated into $50 of capital gain to S and $50 of ordinary income to B. The character of the gain under Regs. Sec. 1.1502-13(c)(4) and -13(m)(1) generally depended on the status of the member recognizing the income or loss at the time of the restoration event.

For purposes of making single-entity adjustments, when viewing S and B as divisions, they are treated as engaging in their actual transaction and owning any actual property in the transaction (as opposed to treating the transaction as not occurring).(13) Further, under Prop. Regs. Sec. 1.1502-13(c)(3)(i)(A), S and B are treated as operating separate trades or businesses and may retain their accounting methods as if they were divisions of a single corporation. They are also allowed to retain any special status (e.g., as a bank or life insurance company).(14) For example, under Prop. Regs. Sec. 1.1502-13(c)(3)(iii)(B), if S, a bank to which Sec. 582(c) applies, sells a debt security to nonbank B at a gain, the character of the gain will be ordinary under Sec. 582(c), but the character of B's corresponding items as capital or ordinary is determined without regard to Sec. 582(c). Prop. Regs. Sec. 1.1502-13(c)(3)(i)(B) provides that the fact that a member holds property for sale to customers in the ordinary course of trade or business is not a special status.

If it is not possible to determine the attributes of an item or the allocation of attributes between S and B by treating them as divisions, the determination or allocation is made as follows: (1) the attributes of B's corresponding items on a separateentity basis control if B's items and S's items offset each other and (2) if B's items and S's items do not offset, their attributes are determined on a separate-entity basis to the extent not inconsistent with the purposes of the proposed regulations.(15)

* Holding period

Prop. Regs. Sec. 1.1502-13(c)(1)(ii) provides that the holding period of property transferred in an intercompany transaction is the aggregate of the holding periods of B and S. An exception is provided when the basis of the property transferred is determined by reference to the basis of other property; the property's holding period is determined by reference to the holding period of the other property.(16) For example, the holding period of T stock distributed in an intercompany distribution to which Sec. 355 applies is determined by reference to the holding period of the distributing member's stock. Under existing rules, the holding period of an asset purchased by B from S begins anew at the time of purchase. The aggregation rule in the proposed regulations is more akin to single-entity treatment, since the holding period would not start anew if B and S were divisions of the same corporation.

* Timing

Under Prop. Regs. Sec. 1.1502-13(c)(2)(i), B takes its corresponding items into account under its accounting method on a separate-company basis. To the extent, however, any redetermination is made of the attributes of a corresponding item, the redetermination could affect the timing of such item. For example, if B resells property acquired from S and the property is redetermined to be dealer property solely by reason of S's activities, Sec. 453(b) would prevent B's corresponding item from the resale from being taken into account under the installment method and would affect its timing.

Pursuant to Prop. Regs. Sec. 1.1502-13(c)(2)(ii), S takes its intercompany items into account to reflect the difference for the year between B's corresponding items taken into account and B's recomputed corresponding items that B would take into account if S and B were divisions of a single corporation.

Example 4: S sells property with a basis of $80 to B for $100. B resells the property to an unrelated party for $90. B's corresponding item is a $10 loss ($90 sales price -- $100 purchase price) and its recomputed corresponding item is a $10 gain ($90 sales price -- $80 basis B would have had if S and B were divisions, i.e., carryover basis). The difference of $20 ($10 loss -- $10 gain) is the amount of S's intercompany gain that would be taken into account for the year of the resale.

The process of determining S's intercompany item can be broken down into three steps: (1) determine B's recomputed corresponding item by treating S and B as divisions; (2) subtract B's actual corresponding item from the amount determined in #1; and (3) take into account that portion of B's intercompany item that equals the difference between its actual and recomputed corresponding items.

Example 5: Intercompany sale followed by resale. S holds land for investment with a basis of $50. On Jan. 1, 1994, S sells the land to B for $100. B holds the land for investment and on Jan. 1, 1995, sells it to an unrelated party for $150. S must take its intercompany gain into account in 1995, because the land was sold outside the consolidated group. The amount taken into account by S is the difference between B's recomputed corresponding item of $100 ($150 sales price -- $50 basis) and B's corresponding item of $50 ($150 sales price -- $100 basis). Thus, consolidated taxable income for 1995 would reflect $100 of gain, $50 attributable to each S and B. The holding periods of S and B for the land are aggregated and result in long-term capital gain.(17)

Example 6: Intercompany loss and resale gain. The facts are the same as in Example 5, except that S's basis in the land is $125. The amount taken into account by S in 1995 would be the difference between B's recomputed corresponding item of $25 ($150 sales price -- $125 basis) and B's corresponding item taken into account of $50 ($150 sales price -- $100 basis), or a $25 loss. Thus, consolidated taxable income for 1995 would reflect $25 gain, $25 loss attributable to S and $50 gain attributable to B.(18)

Example 7: Intercompany gain and resale loss. The facts are the same as in Example 5, except that B sells the land for $90. The amount taken into account by S in 1995 would be the difference between B's recomputed corresponding item of $40 gain ($90 sales price -- $50 basis) and B's corresponding item taken into account of $10 loss ($90 sales price -- $100 basis), or a $50 gain. Thus, consolidated taxable income for 1995 would reflect a $40 gain ($50 gain attributable to S and $10 loss attributable to B).(19)

While the analysis of Examples 5, 6 and 7 has changed under the proposed regulations, the results are the same as under the existing regulations. However, one difference under the proposed regulations is the aggregation of S's and B's holding periods for the land.

Example 8: Intercompany sale followed by Sec. 1031 exchange with nonmember. The facts are the same as in Example 5, except that instead of selling the land, B exchanges it for land owned by an unrelated party in a Sec. 1031 exchange. There is no difference in 1995 between B's recomputed corresponding item and B's corresponding item taken into account. Thus, none of S's intercompany gain is taken into account in 1995. Instead, S's intercompany gain is taken into account with respect to the replacement property now owned by B, since B's gain is preserved in the basis of the property. Had B taken gain into account due to the receipt of boot received in the exchange, S's intercompany gain would be taken into account in 1995 to the extent of the difference between B's recomputed gain and its gain taken into account.(20)

The existing regulations give a different result in Example 8. Under Regs. Sec. 1.1502-13(m)(2), an intercompany sale followed by a like-kind exchange outside the group results in an acceleration of the deferred gain on the intercompany sale. The existing regulations achieve a result inconsistent with treating S and B as divisions of a single corporation. Under the proposed regulations, the result in Example 8 is consistent with single-entity treatment and is a welcome change.

Example 9: Performance of services. S drills a well for B and receives a $100 fee. S paid its employees $75 comensation relating to the job. The services performed by S were for the construction of depreciable property. Assuming 10-year straight-line depreciation, B would have $10 depreciation each year. S's intercompany income is $25 ($100 fee income -- $75 related compensation expense). S's $25 intercompany income is taken into account to reflect the $25 difference between B's items to be taken into account based on the $100 cost for the well and B's recomputed items (based on the $75 basis in the property B would have if S and B were divisions of a single corporation). In year 1, S takes into account $75 of fee income and $75 of expenses. In addition, in each of years 1 through 10, S would take into account $2.50 of income to reflect the annual difference between B's $10 depreciation taken into account and its $7.50 recomputed depreciation.(21)

It is not clear from the proposed regulations why the $75 fee income and $75 compensation expense are taken into account in year 1. The same result would occur if S took its full fee income and related compensation expense into account as B depreciated the property. The proposed regulations clear up a concern under the existing regulations when a fee paid to one member was required to be capitalized by another. Under Regs. Sec. 1.1502-13(1), the $100 fee income would be deferred and restored as B depreciated the property. Yet, the $75 of compensation expense, assuming it was otherwise deductible under S's method of accounting, was generally currently deductible in full.

Operating Rules

* Multiple intercompany items or corresponding items

Prop. Regs. Sec. 1.1502-13(c)(3)(ii)(A) provides that if more than one corresponding item can cause an intercompany item to be taken into account, the intercompany item is taken into account in connection with the corresponding item most consistent with treatment of the members as divisions. For example, if B purchases depreciable property from S and the depreciation is capitalized under Sec. 263 as part of B's cost for a building, S's intercompany gain would be taken into account as the building is depreciated or sold, not when the property is depreciated.

* Aggregation of transactions

Prop. Regs. Sec. 1.1502-13(c)(3)(ii)(B) provides an aggregation rule when a member's intercompany item or corresponding item affects accounting for more than one intercompany transaction. Appropriate adjustments are to be made to treat all of the intercompany transactions as transactions between divisions. For example, if land is transferred in successive intercompany transactions, the aggregation rule would treat all of the participating members as divisions for purposes of determining the timing and attributes of each of the items from the land.

* Limitation on treatment of intercompany income or gain

When the attributes of intercompany items or corresponding items are redetermined, S's intercompany items may be treated as excluded from gross income or as noncapital, nondeductible amounts under Prop. Regs. Sec. 1.1502-13(c)(3)(iv)(A). For example, S's intercompany loss from a sale of property to B is treated as a noncapital, nondeductible amount if B distributes such property to an unrelated shareholder at no further gain or loss. When S and B are viewed as divisions, Sec. 311(a) denies B a loss resulting from the dividend distribution; therefore, none of S's intercompany loss will be allowed.

Prop. Regs. Sec. 1.1502-13(c)(3)(iv)(B) limits the exclusion of S's intercompany income or gain (not loss) to the extent one of the following applies: (1) B's corresponding item is a deduction or loss permanently disallowed directly under another provision of the Code or regulations(22); (2) B's corresponding item is a loss realized, but not recognized, under Sec. 311(a)(23); and (3) B's corresponding item is otherwise limited, eliminated, offset or has no effect on the computation of taxable income under any provision identified by the IRS.(24) For purposes of #1, an amount is not permanently disallowed if (1) the disallowance is not permanent because an equivalent amount might be taken into account by B, such as under Sec. 280B or 267(d); (2) the amount is realized but not recognized under Sec. 332; (3) the amount is a deemed item under Prop. Regs. Sec. 1.1502-13(b)(2)(iii); or (4) the amount is a loss that is part of a carryforward that expires in a later year.(25)

* Other matching rule examples

The following examples illustrate the major principles of the proposed regulations and, in some cases, improvements over the existing regulations.

Example 10: Intercompany sale followed by installment sale. The facts are the same as in Example 5, except that B sells the land to an unrelated party on Jan. 1, 1995 for a $150 note. The note bears a market rate of interest in excess of the applicable Federal rate and provides for payments of $75 in 1996 and 1997. The interest charge under Sec. 453A(c) applies to the note. Under the installment method, B would take into account $25 of gain in 1996 and $25 of gain in 1997. Therefore, S would take into account $25 of gain in 1996 and $25 of gain in 1997. The amount taken into account by S reflects the difference between B's $25 gain taken into account and its $50 of recomputed gain for each of 1996 and 1997. Both S's and B's $50 gain are subject to the interest charge beginning in 1995.(26)

Example 11: Election out under Sec. 453(d). The facts are the same as in Example 10, except that the consolidated group wishes to elect not to apply Sec. 453 with respect to S's gain. Thus, an election under Sec. 453(d) must be made for 1995 with respect to B's gain. This election will cause B's $50 gain to be taken into account in 1995 and result in S's $50 gain being taken into account in 1995 under the matching rule. Since S's gain taken into account must reflect the difference between B's gain taken into account and its recomputed gain, an election under Sec. 453(d) solely with respect to S will have no effect.(27)

Example 12: Intercompany sale followed by installment sale (resale loss, overall gain). The facts are the same as in Example 10, except that B resells the land for a $90 note. Since only gain may be reported on the installment method, B's $10 loss is taken into account in 1995. There is an aggregate $50 difference between B's $10 loss and its $40 recomputed gain. Thus, S takes $10 of gain into account in 1995 to reflect the difference between B's $10 loss and its $0 recomputed gain. S also takes $20 into account in both 1996 and 1997 to reflect the difference between B's $0 gain taken into account and its $20 of recomputed gain for those years.(28) By contrast, under the existing regulations, all of S's $50 gain is reported in 1995, along with B's $10 loss (i.e., no installment reporting).

Example 13: Intercompany loss, installment gain. The facts are the same as in Example 10, except that S has a $175 basis in the land. S takes $25 of its loss into account in 1995 to reflect the difference between B's $0 loss taken into account under Sec. 453 and its $25 recomputed loss. The remaining balance of S's $50 loss is taken into account $25 in 1996 and $25 in 1997 to reflect the difference between B's $25 of gain taken into account and its recomputed gain of $0. Since the $25 of gain reflected by B in 1996 and 1997 is offset by S's $25 loss for those years, the gain is not subject to the interest charge under Sec. 453A(c).(29) Under the existing regulations, one-half of S's $75 loss, along with one-half of B's $50 gain, is reported in 1996 and in 1997.

Example 14: Intercompany sale of a partnership interest. S owns a 25% interest in the capital and profits of a general partnership. All of the partnership's assets (with the exception of depreciable property) have an equal basis and value. The depreciable property's value is in excess of its basis and the partnership has a Sec. 754 election in effect. On Jan. 1, 1995, S sells its partnership interest to B at a gain. In 1995 through 1999, the partnership depreciates the depreciable property and B's depreciation deduction from the partnership reflects the increase in the basis of the depreciable property under Sec. 743(b). S's gain is taken into account in 1995 through 1999 to reflect the difference each year between B's depreciation deduction from the partnership taken into account and B's recomputed depreciation from the partnership. S's gain taken into account is ordinary income.(30)

Example 15: Partnership sale of assets. The facts are the same as in Example 14, except that on Dec. 31, 1996, the partnership sells the depreciable property to an unrelated party at a gain. In addition to the gain taken into account by S as the result of the additional depreciation, S takes its remaining intercompany gain into account in 1996 to reflect the difference between B's partnership items taken into account from the sale (which reflects the Sec. 743(b) adjustment) and B's recomputed partnership items.(31)

Example 16: Net operating loss (NOL) subject to Sec. 382. On Jan. 1, 1995, P buys all of S's stock. S has an NOL carryover from prior years. The acquisition by P results in an ownership change under Sec. 382 with respect to the NOL carryovers, and S has an unrealized built-in gain within the meaning of Sec. 382(h)(3). S owns a piece of land with a $50 basis and a $100 value. On Jan. 1, 1997, S sells the land to B for $100, and the $50 gain is built-in gain within the meaning of Sec. 382(h)(2) on a separate-entity basis. On Dec. 31, 1998, B sells the land to an unrelated party for $85. S's $50 gain is taken into account in 1998 to reflect the difference between B's $15 loss taken into account and B's recomputed gain of $35. Of S's $50 of gain, $35 is treated as recognized built-in gain and the remaining $15 that is offset by B's loss is treated as unrecognized built-in gain. Thus, $15 of S's gain does not increase the Sec. 382 limitation applicable to S's losses.(32)

Example 17: B's recognized built-in gain. The facts are the same as in Example 16, except that the land declines in value after S becomes a member of the P group, S sells the property to B for its basis of $50, and B sells the land to an unrelated party for $100 during 1997. When S and B are treated as divisions, the sale of the land from S to B does not cause the land to cease to be built-in gain property. Thus, B's $50 gain from the sale of the land to an unrelated party in 1997 is recognized built-in gain that increases the Sec. 382 limitation applicable to S's losses.(33)

Example 18: Separate return limitation year (SRLY) limitation. The facts are the same as in Example 16, except that S's NOLs are subject to the SRLY rules. The amount and location of items are not redetermined under the matching rule. Since S's SRLY limitation is determined solely by its contribution to consolidated taxable income (as determined under Regs. Sec. 1.1502-21(c)), S's SRLY limitation in 1997 includes its entire $50 gain taken into account.(34)

Example 19: Sec. 475. S is a dealer in securities within the meaning of Sec. 475(c). On Mar. 1, 1994, S purchases a security for $100. S holds the security for sale to customers and does not identify it under Sec. 475(b) as an exception to marking to market. Before 1996, S recognizes $40 of net mark-to-market decreases. On Jan. 15, 1996, S sells the security to B for $100. B is not a dealer and holds the security for investment. On Dec. 31, 1996, the fair market value (FMV) of the security is $100 and on July 1, 1997 B sells the security to an unrelated party for $120. S's intercompany gain is taken into account by treating Sec. 475 as applying to S and B as a single corporation that is a dealer in securities as a result of S's activities. S's intercompany gain of $40 ($100 sales price -- $60 basis ($100 cost -- $40 net mark-to-market decreases)) is taken into account in 1996 to reflect the $40 difference between B's $0 gain taken into account and its recomputed gain of $40, which would be taken into account as a result of marking to market under Sec. 475. Under Sec. 475(d)(3), S's gain is ordinary income and B's gain of $20, as a result of the sale to an unrelated party, is capital gain taken into account in 1997.(35)

Example 20: Nondealer to dealer. The facts are the same as in Example 19, except that S purchases the security for $60, is not a dealer and holds the security for investment. B is a dealer to which Sec. 475 applies, and, immediately after acquiring the security from S, B holds the security for sale to customers in the ordinary course of its trade or business. When S and B are treated as divisions of a single corporation, the security is treated as properly identified as held for investment under Sec. 475(b)(1) until it sold to B. Since B holds the security for sale to customers, the security is no longer described in Sec. 475(b)(1) and the mark-to-market requirement applies only to changes in the value of the security after B's acquisition pursuant to Sec. 475(b)(3). In 1997, B has a $20 gain from the sale of the security to an unrelated party, but would have had a $60 gain if S and B were divisions of a single corporation. Therefore, S takes its $40 of gain into account under the matching rule in 1997. S's gain is capital gain under Sec. 475(d)(3), even though B's subsequent gain is ordinary income.(36)

Acceleration Rule

S's intercompany items and B's corresponding items are taken into account under Prop. Regs. Sec. 1.1502-13(d) to the extent they cannot be taken into account to treat S and B as divisions of a single corporation.

* S's items

To the extent S's intercompany items cannot be taken into account to treat S and B as divisions of a single corporation, the items are taken into account immediately before it first becomes impossible to achieve this effect. The effect of treating S and B as divisions of a single corporation cannot be achieved to the extent that (1) an intercompany item or corresponding item will not be taken into account in determining the group's consolidated taxable income (or consolidated tax liability) under the matching rule(37); or (2) a nonmember reflects, directly or indirectly, any aspect of the intercompany transaction. While not explicitly stated in the proposed regulations, it appears that the amount of S's intercompany item to be restored under the acceleration rule is the full amount of such item.

Example 21: Sec. 351 transaction with nonmeber. In 1994, S sells an asset for $100 (with basis $70) to B. In 1997, B transfers the asset to X, a nonmember, in a Sec. 351 transaction. X remains a nonmember. Since there is no difference between B's corresponding items taken into account and its recomputed items, none of S's intercompany gain is taken into account under the matching rule as a result of the Sec. 351 transfer. However, since X reflects B's $100 cost basis in the asset under Sec. 362, S's entire gain is taken into account in 1997 under the acceleration rule.(38)

Instead of accelerating S's intercompany item as a result of the Sec. 351 transfer in Example 21, the basis of the transferred property simply could have been reduced to $70 (i.e., basis immediately preceding the intercompany transaction). The matching rule would be applied by reference to the X stock. However, this solution was not adopted, because it has the potential for shifting the location of the gain. In Example 21, the gain would be shifted from S to B as a result of the intercompany transaction. Measure designed to prevent this shifting would invariably be overly complex, especially when dealing with a transfer of multiple properties. Absent such preventative measures, this type of transaction could be structured to use B's losses that are otherwise limited by the SRLY rules. Given the potential problems and the complexity of prevention, it is understandable why the acceleration rule should apply in Example 21. The same analysis applies to a transfer under Sec. 721 to a partnership.

The attributes of S's intercompany items taken into account under the acceleration rule depend on whether the item is from (1) a sale, exchange or distribution of property, or (2) other intercompany transaction. If the item is from a sale, exchange or distribution of property, its attributes are determined under matching rule principles as if B resold the property to a nonmember affiliate at the time the item is taken into account, for a cash payment equal to B's adjusted basis in the property.

Example 22: Sale, exchange or distribution. S holds land for investment with a basis of $70. On Jan. 1, 1994, S sells the land to B for $100. B holds the land for sale and expends substantial resources over a two-year period subdividing, developing and marketing the land. On July 1, 1997, before B has sold any land, P sells 60% of S's stock to X for $60; as a result, S becomes a nonmember. Under the acceleration rule, the attributes of S's gain are redetermined under the principles of the matching rule as if B resold the land to a nonmember affiliate for a cash payment of $100, i.e., B's adjusted basis in the land. Thus, whether S's gain is capital gain or ordinary income depends on the activities of both S and B.(39)

If the item is from an intercompany transaction that is not a sale, exchange or distribution of property, its attributes are determined on a separateentity basis.

Example 23: Other intercompany transaction. In 1994, S performs services for B for $10. B capitalizes the $10 cost of S's services under Sec. 263 as part of S's cost to acquire land from X. S incurs $8 of expenses that would be taken into account in 1994 under its separate-entity method of accounting. B holds the real property for investment. P sells all of S's stock and S becomes a nonmember on July 1, 1997. S's $2 of intercompany income is taken into account immediately before S becomes a nonmember. Because S's intercompany income is not from an intercompany sale, exchange or distribution of property, the attributes of the intercompany income are determined on a separate-entity basis. Thus, S's $2 of intercompany income is ordinary income.(40)

The proposed regulations continue the acceleration of gain from an intercompany transaction when either S or B leaves the group. This result is currently required by Regs. Sec. 1.1502-13(f)(1)(iii). However, the proposed regulations reach a result inconsistent with the single-entity theory when the property involved in the intercompany transaction is depreciable.

Example 24: Depreciable property. On Jan. 1, 1994, S sells a piece of equipment with an adjusted basis of $25 to B for $150. S's $125 gain consists of $75 of Sec. 1245 recapture and $50 of Sec. 1231 gain. During 1994, B takes $15 depreciation based on its $150 basis in the equipment. On Jan. 1, 1995, P sells all of the stock of B to an unrelated party. As a result, B departs from the P consolidated group and the P Sec. 267(f) control group. Under Regs. Sec. 1.1502-13(f)(1)(iii), B's $15 depreciation in 1994 will cause S to restore $15 of Sec. 1245 recapture in 1994. B's departure from the group in 1995 requires S to restore the remaining $110 gain. The $110 restored gain should consist of $60 of Sec. 1245 recapture and $50 of Sec. 1231 gain, unless the entire gain is recharacterized as ordinary income under Sec. 1239. The better reasoning under current law is that the event causing the restoration is a transaction that makes B an unrelated party for purposes of Sec. 1239. Thus, Regs. Sec. 1.1502-13(m) should not cause the Sec. 1231 gain to be converted to ordinary income. Therefore, while not completely certain, under current law S should report $60 of Sec. 1245 recapture and $50 of Sec. 1231 gain on B's deconsolidation. The acceleration rule of the proposed regulations does not change the timing of the $110 of S's restored gain. However, as to the attributes of such gain, Prop. Regs. Sec. 1.1502-13(d)(1)(ii)(A) provides that B is treated as if it resold the equipment to a nonmember affiliate. As a result, Sec. 1239 will apply and require all of the gain to be ordinary income.(41)

The result in Example 24 is not consistent with treating S and B as divisions of a single corporation. The desired result should be consistent with the result that would occur had the equipment been sold for $125 to B after the stock of B was sold. Based on the above facts, this would result in $75 of Sec. 1245 recapture and $50 of Sec. 1231 gain. Sec. 1239 should be implicated only if B, subsequent to the sale, is a Sec. 1239(b) related party with the P group. If B is not a member of the P Sec. 267(f) control group, Sec. 1239 should not intervene.

* Exception

Prop. Regs. Sec. 1.1502-13(j)(2) provides an exception to the restoration of S's intercompany items under the acceleration rule when S and B depart from the old group and become members of a new group. The intercompany items continue to be accounted for under the matching rule in the new group, provided the departure of S and B results from (1) the acquisition by a member of the new group of either the assets of the common parent of the old group in a reorganization described in Sec. 381(a)(2) or the stock of the common parent of the old group; or (2) a transaction described in Regs. Sec. 1.1502-75(d)(2), or the termination of the old group by a reverse acquisition described in Regs. Sec. 1.1502-75(d)(3). This exception is similar to the exception to restoration found in Regs. Sec. 1.1502-13(f)(2). However, unlike the exception in the existing regulations, there is no requirement that all members of the old group become members of the new group.

The exception is limited to the acquisition of the common parent of the old group. Thus, it does not apply when the new group acquires only the subgroup of S and B if neither is the common parent of the old group. The exception was not extended to the acquisition of the subgroup because of the potential for double taxation. This would occur when the intercompany gain is not accelerated to the old group as a result of the acquisition, and thereby is not reflected in P's basis in its S stock. The gain would be recognized first by P as a result of the sale of the S stock and again by the new group when the gain is restored.

* B's items

If the acceleration rule applies to S, B continues to take its corresponding items into account under its accounting method. The attributes of B's corresponding items continue to be redetermined under the matching rule(42) with adjustments, depending on whether S and B continue to join each other in the filing of consolidated returns. If S and B continue to join each other in the filing of consolidated returns, the attributes of B's corresponding items (and any applicable holding periods) are determined by continuing to treat S and B as divisions of a single corporation. Once S and B no longer join in the filing of consolidated returns, the attributes of B's corresponding items are determined as if the S division (but not the B division) were transferred by the single corporation to an unrelated person.

Example 25: Deconsolidation. S sells investment land to B for $100 (with basis $70). B develops the land with the intention to sell it. Before B sells the land, P sells 60% of S's stock to X. Because S and B no longer join in the filing of a consolidated return, the attributes of B's corresponding items from its subsequent sale of the land are redetermined as if the S division (but not the B division) were transferred by the single corporation to an unrelated person at the time of P's sale of the S stock. Thus, B continues to take into account the activities of S with respect to the land before the intercompany transaction.(43)

Anti-Avoidance Rules

Prop. Regs. Sec. 1.1502-13(h) adds an anti-abuse rule under which adjustments must be made if a transaction is engaged in or structured with a principal purpose to avoid treatment as an intercompany transaction, or to avoid the purposes of the proposed regulations.(44) The preamble uses the example of a "mirror subsidiary" transaction. In this case, the adjustment would generally conform to the intent of the mirror subsidiary legislation to "require the recognition of corporate-level gain whenever an appreciated subsidiary is sold or distributed outside of the economic unit of an affiliated group."(45)

Example 26: Sale of partnership interest. S owns land with a $10 basis and $100 value. B has NOLs from SRLYs subject to limitation under Regs. Sec. 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 partnership, N, for a 10% interest in N's capital and profits in a transaction to which Sec. 721 applies. S later sells its interest in N to B for $100. N does not have a Sec. 754 election in effect. N sells the land for $100. Under Sec. 704(c), N's $90 built-in gain is allocated to B, and B's basis in N increases to $190 under Sec. 705. B subsequently sells its N interest.

Ordinarily, B's $90 gain from N increases B's SRLY limitation, and B's $90 loss from its sale of N is not subject to limitation under the SRLY rules. Under Prop. Regs. Sec. 1.1502-13(h), however, B's allocable share of N's gain from the sale of the land is treated as not increasing B's SRLY limitation.(46)

In addition to adjustments discussed in Prop. Regs. Sec. 1.1502-13(h), Secs. 337(d), 446 and 482 and general principles of tax law (e.g., substance over form and the tax benefit rule) can apply to require "proper" measurement of taxable income (and tax liability). The addition of an anti-abuse rule is a common theme in recent proposed regulations. The broad language used in the anti-abuse rule adds an unnecessary uncertainty to dealing with the regulation.

Effective Dates

In general, the proposed regulations are effective for transactions occurring in years beginning on or after the date the proposed regulations are finalized.(47) If both the proposed regulations and prior law apply to a transaction, or neither applies, with the result that items are duplicated, omitted or eliminated in determining taxable income (or tax liability), or items are treated inconsistently, prior law applies to the transaction.

* Avoidance transactions

A special rule applies to transactions engaged in or structured after Apr. 8, 1994, with a principal purpose of avoiding the proposed regulations.(48) If the special rule applies, "appropriate adjustments" must be made in years beginning on or after the date the proposed regulations are finalized to prevent any avoidance, duplication, omission, elimination or inconsistency. The drafters of the regulations, in oral comments at the May 4, 1994 IRS hearing, interpreted this special rule as a one-way street for the government. If a more taxpayer-favorable result would be produced by the proposed regulations, the taxpayer must use the existing regulations until the proposed regulations are finalized. However, if the taxpayer would obtain a more favorable result under the existing regulations, and a purpose for the transaction is tax avoidance, the proposed regulations will apply. This one-way street approach is very disturbing.

Conclusion

The approach taken in the proposed regulations, providing conceptual principles, highlights the dilemma facing the IRS--the best way to provide appropriate guidance and, at the same time, administratively deal with transactions that literally comply with the existing technical rules, and yet, reach a result inconsistent with the spirit and intent of such rules. The proposed regulations appear to balance these diametrically opposed goals. The rules are designed to enable compliance for intercompany transactions under current tax law, as well as such transactions that will arise due to changing business conditions and changes in the tax law. Only time will tell the extent to which these regulations will be successful in achieving these lofty goals.

Tax Division Fall Meeting to Feature Top Speakers

The AICPA Fall Tax Division Meeting will feature top speakers from the IRS, Treasury and Capitol Hill, as well as tax experts from the accounting profession. The program will be held at The Pointe on South Mountain, in Phoenix, Arizona, on Dec. 5-7, 1994. Committee meetings on December 5 and 7 and educational sessions on December 6 will brief members on current political, technical and practice issues. Eight hours of CPE credit will be given for attending all sessions on December 6. This conference is expected to reach capacity quickly, and there is no guarantee that on-site registration will be available, so please register early. An information letter as well as hotel and airline materials were sent to all Tax Division members in early September and a complete registration package followed in October. For registration material or information on joining the Tax Division, please call Kristina Korte at [phone].

(1)Notice of Proposed Rulemaking (CO-11-91), published in the Federal Register (4/15/94).

(2)See Mason and Choate, "The IRS Updates the Consolidated Return Regulations," 21 The Tax Adviser 397 (July 1990).

(3)Prop. Regs. Sec. 1.1502-13(b)(1)(i)(A).

(4)Prop. Regs. Sec. 1.1502-13(b)(1)(i)(B).

(5)Prop. Regs. Sec. 1.1502-13(b)(1)(i)(C).

(6)Prop. Regs. Sec. 1.1502-13(b)(1)(i)(D).

(7)Prop. Regs. Sec. 1.1502-13(b)(2)(ii)(A).

(8)Prop. Regs. Sec. 1.1502-13(b)(2)(ii)(B).

(9)Prop. Regs. Sec. 1.1502-13(b)(2)(iii)(A).

(10)Prop. Regs. Sec. 1.1502-13(b)(2)(iii)(B).

(11)Prop. Regs. Sec. 1.1502-13(b)(4).

(12)In each of the examples, unless otherwise stated, P is the common parent of the P consolidated group, S and B are P's wholly owned subsidiaries, the tax year of all persons is the calendar year, tax liabilities are ignored, and the facts set forth the only corporate activity.

(13)Prop. Regs. Sec. 1.1502-13(c)(3)(i).

(14)Prop. Regs. Sec. 1.1502-13(c)(3)(i)(B).

(15)Prop. Regs. Sec. 1.1502-13(c)(3)(iii)(A).

(16)Prop. Regs. Sec. 1.1502-13(c)(1)(ii).

(17)Prop. Regs. Sec. 1.1502-13(c)(3)(iv)(B)(4)(ii), Example 1.

(18)Prop. Regs. Sec. 1.1502-13(c)(3)(iv)(B)(4)(ii), Example 1(e).

(19)Prop. Regs. Sec. 1.1502-13(c)(3)(iv)(B)(4)(ii), Example 1(f).

(20)Prop. Regs. Sec. 1.1502-13(c)(3)(iv)(B)(4)(ii), Example 1(g).

(21)Prop. Regs. Sec. 1.1502-13(c)(3)(iv)(B)(4)(ii), Example 7.

(22)Prop. Regs. Sec. 1.1502-13(c)(3)(iv)(B)(1).

(23)Prop. Regs. Sec. 1.1502-13(c)(3)(iv)(B)(2).

(24)Prop. Regs. Sec. 1.1502-13(c)(3)(iv)(B)(3).

(25)Prop. Regs. Sec. 1.1502-13(c)(3)(iv)(B)(1).

(26)Prop. Regs. Sec. 1.1502-13(c)(3)(iv)(B)(4)(ii), Example 5.

(27)Prop. Regs. Sec. 1.1502-13(c)(3)(iv)(B)(4)(ii), Example 5(c).

(28)Prop. Regs. Sec. 1.1502-13(c)(3)(iv)(B)(4)(ii), Example 5(d).

(29)Prop. Regs. Sec. 1.1502-13(c)(3)(iv)(B)(4)(ii), Example 5(e).

(30)Prop. Regs. Sec. 1.1502-13(c)(3)(iv)(B)(4)(ii), Example 10(a) and (b).

(31)Prop. Regs. Sec. 1.1502-13(c)(3)(iv)(B)(4)(ii), Example 10(c).

(32)Prop. Regs. Sec. 1.1502-13(c)(3)(iv)(B)(4)(ii), Example 11(a) and (b).

(33)Prop. Regs. Sec. 1.1502-13(c)(3)(iv)(B)(4)(ii), Example 11(c).

(34)Prop. Regs. Sec. 1.1502-13(c)(3)(iv)(B)(4)(ii), Example 11(e).

(35)Prop. Regs. Sec. 1.1502-13(c)(3)(iv)(B)(4)(ii), Example 13(a)-(c).

(36)Prop. Regs. Sec. 1.1502-13(c)(3)(iv)(B)(4)(ii), Example 13(d).

(37)This would happen if S or B became a nonmember.

(38)Prop. Regs. Sec. 1.1502-13(c)(3)(iv)(B)(4)(ii), Example 1(h).

(39)Prop. Regs. Sec. 1.1502-13(d)(3), Example 2.

(40)Prop. Regs. Sec. 1.1502-13(d)(3), Example 3(d)

(41)Prop. Regs. Sec. 1.1502-13(d)(3), Example 2(c).

(42)Such redetermination may affect timing.

(43)Prop. Regs. Sec. 1.1502-13(d)(3), Example 2(a) and (b).

(44)Only a principal purpose to avoid the regulations is necessary; it is not necessary for the principal purpose of the transaction to be avoidance.

(45)See H. Rep. No. 100-391, 100th Cong., 1st Sess. 1081 (1987).

(46)Prop. Regs. Sec. 1.1502-13(h)(2), Example 1.

(47)Prop. Regs. Sec. 1.1502-13(l)(1).

(48)Prop. Regs. Sec. 1.1502-13(l)(2).