Effective date for new investment adjustment rules may yield some surprises.

The new consolidated return investment adjustment rules are effective for basis determinations in consolidated return years beginning on or after Jan. 1, 1995. While the new rules apply to determine the basis of a subsidiary's stock in post-1994 years, such basis must be redetermined as if the rules were in effect for all prior consolidated return years. Thus, the new rules generally have retroactive effect on the subsidiary stock if it was not disposed of before 1995.

Some interesting surprises arise because of the retroactive effect of the new rules. For example, when a subsidiary's loss carryover (ordinary or capital) expires, the basis of the stock would need to be reduced by the expired amount. Although the regulations make this negative adjustment prospective as to expiring separate return limitation year losses, retroactive treatment applies to those expired losses originally generated during consolidated return years. Thus, effective for 1995, if a consolidated loss expired in a prior year and a portion of that loss was applicable to a subsidiary presently in the group, the stock of that subsidiary must be reduced by its portion of the expired loss. This could easily occur for capital losses that have only a five-year carry-over period and to net operating losses (NOLs) before 1976, when they were limited to a five-year carryover period.

Another situation that necessitates a redetermination of basis involves the restructuring of a group that took place in a prior consolidated return year. Suppose in 1985 a second-tier subsidiary was moved up to become a first-tier subsidiary. if the transaction was a distribution, Sec. 31 1,(b) would require income (fair market value of stock over basis) to be recognized, albeit deferred under the consolidated return rules. The amount of deferred gain would have been calculated using the stock's basis as determined under the previous rules. If this subsidiary is still within the consolidated group, the Sec. 311(b) deferred gain may need to be redetermined based on the new rules. Further, if the subsidiary was transferred in a Sec. 355 spin-off its basis would take a portion of the distributing company's basis. If these companies are still in the consolidated group, their bases may have to be redetermined under the new rules.

Another example relates to determining the earnings and profits (E&P) of a common parent corporation. Under the pre-1995 rules, the parent's E&P was not reduced by a subsidiary's deficit in E&P to the extent that the subsidiary's corresponding loss was not currently availed of in the consolidated return or carried back. Under the new rules, a subsidiary's negative E&P is tiered up to the common parent, regardless of whether the corresponding loss is used. Once again, since the rules have a retroactive effect, as of Jan. 1, 1995, a common parent's E&P will be less than expected if the group has a consolidated NOL carried into 1995 and a portion of such loss is applicable to a subsidiary. In such a case, the common parent's E&P is redetermined as of Jan. 1, 1995, by taking into account a negative adjustment to E&P in the year that the subsidiary's loss arose. However, such adjustment will have no effect on any dividend distributions made in prior years.