Effect of consolidated return investment adjustment principles on E&P determinations.

Consolidated groups that have member subsidiaries with net operating losses (NOLs) and that are anticipating making, or have made, distributions must consider the impact of Regs. Secs. 1.1502-32 and -33 on the calculation of earnings and profits (E&P). Affiliated groups filing consolidated returns must apply these provisions in determining the E&P of group members. In practice, operation of these rules often results in E&P determinations that may be counterintuitive to many taxpayers, since the detailed principles of Regs. Secs. 1.1502-32 and -33 for calculating E&P are not well-known by nontax financial professionals and lesser experienced tax personnel. Additionally, because of these rules, radically different E&P results can occur depending on whether a business is operated as a branch or a subsidiary.

Basic investment adjustment rules

In general, Regs. Sec. 1.1502-33(c)(4)(ii) provides that investment adjustments made to the basis of subsidiary stock must also be reflected in E&P. More specifically, a group member's E&P must reflect that member's net negative adjustment (under Regs. Sec. 1.1502-32(e)(1)) or net positive adjustment (under Regs. Sec. 1.1502-32(e)(2)) made with respect to a subsidiary of that member. A negative adjustment includes an allocable part of the deficit in the subsidiary's E&P for the year (Regs. Sec. 1.1502-32(b)(2)(i)). A negative adjustment also includes an allocable part of any NOL or capital loss incurred by the subsidiary in a separate return year, or incurred in a prior consolidated return year and attributable to the subsidiary, if that NOL or capital loss is carried over and used in the current year (Regs. Sec. 1.1502-32 (b)(2)(ii)). A positive adjustment includes an allocable part of the undistributed E&P of a subsidiary for the year (Regs. Sec. 1.1502-32 (b)(1)(i)). A positive adjustment also includes an allocable part of any consolidated NOL or capital loss attributable to the subsidiary that cannot be carried back and used in a prior year (Regs. Sec. 1.1502-32(b)(1)(ii)).

Consolidated loss year--member's current year NOLs

When the negative adjustment for a subsidiary is less than the positive adjustment (e.g., because of slower recovery of depreciable property (Sec. 312(k))), the parent company may have current year E&P even though the group has a consolidated NOL for the year. This may surprise an individual shareholder of the parent who may be expecting that a distribution will be treated as a return of capital rather than as a taxable dividend. Example 1: Individual A forms P in 1991 with $110. P contributes $100 to a newly formed subsidiary, S. S buys $100 of depreciable property. S's depreciation is $10 for regular tax purposes and $6 for E&P purposes. Since the PS group has no other items of income/deduction or other items of E&P, the PS consolidated return shows an NOL of $10. P has $4 of current year E&P for 1991, calculated as follows.

P's "own" E&P                      $ 0
Negative adjustment
  from S's E&P deficit              (6)
Positive adjustment
  from S's portion of unused NOL    10
P's current E&P                    $ 4

Thus, if P distributed $5 to A in 1991, $4 is taxable and $1 is return of capital.

Consolidated profit year--effect of subsidiary's prior year NOL

When the parent of a consolidated group realizes significant current year income, use of a subsidiary's prior year NOL to offset such income in a consolidated return may operate to reduce the parent's current year E&P. This may surprise a parent's corporate shareholder that is expecting to apply the dividends-received deduction (Sec. 243) against the distribution of the parent's current year E&P. (For simplicity, the following example ignores the effect of current year taxes on the amount of E&P.) Example 2: P, the parent of the calendar year PS group, made a large asset sale during the current year. P's current year separate company taxable income is $90 and separate company E&P is $100. S had an $80 apportioned consolidated NOL carryover to the current year. If S has no current year taxable income or E&P, P has $20 of current E&P, calculated as follows.

P's "own" E&P                      $100
Negative adjustment
  from S's share
  of NOL carryover used             (80)
P's current E&P                    $ 20

Thus, if P distributed $30 to its shareholders during the current year, only $20 would be a dividend (assuming P had no accumulated E&P at the end of the preceding year).

Branch operations

The results in Examples 1 and 2 would be markedly different had P operated S as a branch of P rather than as a subsidiary. In such case, P would have had a deficit in current E&P in Example 1 and sufficient current E&P in Example 2 to cover the entire distribution.