Investment-adjustment regulations may significantly affect 1995 and later years' E & P determinations.

The final consolidated return regulations under the new investment-adjustment system (IAS) (new Regs. Sec.1.1502-32), effective for tax years beginning on or after Jan. 1, 1995, delink the determination of basis for subsidiaries in a consolidated group from the determinations of earnings and profits (E&P) (new Regs. Sec. 1.1502-33). For E&P determinations in consolidated return years beginning on or after Jan. 1, 1995, E&P generally must be determined or redetermined as if the new consolidated E&P principles were in effect for all years. While the impact on E&P calculations will vary considerably based on a consolidated group's particular history, the most significant impact will be felt by consolidated groups with the following characteristics:

* Groups with subsidiaries that generated net operating losses (NOLs) in consolidated return years that have not been used in consolidation (subsidiary NOL groups).

* Groups with histories that predate 1976 and/or 1996 (old consolidated groups).

* Groups with members that had separate return limitation year (SRLY) NOLs when they entered the group that were subsequently used in consolidation in tax years beginning before Jan. 1, 1995 (subsidiary SRLY NOL group).

The new E&P rules also make changes in the areas of deconsolidations of subsidiaries and group structure changes that generally apply prospectively. Changes to the rules for the allocation of Federal tax liability (in both the IAS and E&P determinations in a consolidated group context) give rise to a one-time opportunity to conform the E&P Federal tax allocation to that used for the IAS.

Affected taxpayers should address the significant changes in E&P calculations as soon as possible, particularly because, in some cases, considerable work and analysis will be necessary to cumulatively determine or redetermine E&P under the new rules. Also, information may be incomplete, unavailable or uneconomical to retrieve - a situation specifically noted in the regulations' preamble.

Summary of New E&P Rules

In the discussion below, P is the common parent and S (unless otherwise indicated) is a wholly owned subsidiary of P. The major changes in the new E&P rules may be summarized as follows:

* Separate tier-up system: E&P of subsidiaries tier up to the parent (from the lowest to the highest tier) under the IAS principles, except that the adjustment is by reference to E&P, not taxable income (e.g., the adjustment for S-generated consolidated return NOLS (unabsorbed/ absorbed) does not apply). Additionally, the actual use in a consolidated return year of any preaffiliation S SRLY NOLs does not give rise to any negative adjustment in S for E&P purposes at the P level (i.e., the E&P deficit represented by S's SRLY NOL does not tier up as an E&P reduction at the P level). The separate E&P system applies to determine the E&P effect of a disposition of a subsidiary's stock (including application of the excess loss account (ELA) rules). The E&P effects of intercompany transactions follow the principles of Regs. (and Temp. Regs.) Secs.1.1502-13 (and -13T).

* Allocation of Federal tax liability: The rules for sharing Federal income tax liability for E&P purposes differ from those for the IAS (but a one-time election may be made to conform the E&P method (either retroactively or prospectively) to the IAS method (percentage method, using a 100% allocation)). Other authorized E&P methods include the so-called "wait and see" method and the percentage method (using a less-than-100% allocation) (see discussion below).

* Affiliated SRY E&P: The reduction in S's E&P from a distribution of E&P accumulated in separate return years (SRYs) other than SRLY years does not give rise to a negative adjustment by P for S's E&P accumulated in an SRY. Therefore, such a distribution increases P's E&P by the amount of the distribution.

* Deconsolidation: On deconsolidation (e.g., sale) of S, S's E&P is eliminated and no corresponding adjustment is made to P's E&R This rule does not apply for certain statutory purposes (e.g., Secs.593(e), 805(a)(4) and 832, and special rules apply for acquisitions of an entire consolidated group and in making E&P allocations in Sec. 355 transactions.

* Group structure change: In the event of a group structure change under the principles of Regs. Sec. 1.1502-75(d)(2) or (3) (using a 50% test rather than the 80% test in the prior regulations), an allocable portion of the E&P (or E&P deficit) of the former common parent is "cloned" into the new common parent. Additionally, special rules provide for the transfer of E&P in certain intragroup member location changes (e.g., intra-group Sec. 351 transactions). A transition rule (identical to Temp. Regs. Sec. 1.1502-33T(b)) applicable to group structure changes before Sept. 7, 1988 (using an 80% test) eliminates the usual negative adjustment for distributions by S to P (thereby effectively moving pre-Sept. 7, 1988 group structure change S E&P to P as distributions are actually made).

* Cumulative redetermination: For tax years beginning after 1994, E&P must, in general, be cumulatively determined or redetermined under the new E&P rules as if those rules were in place from the inception of filing consolidated tax returns. No determination or redetermination, however, is required for deconsolidations or group structure changes occurring before 1995. Consolidated groups in existence for a long time will need to consider the consolidated return principles in effect many years ago in assessing the impact on post-Jan. 1, 1995 E&P calculations: Pre 1976 years: The annual tier-up under the IAS (including E&P) was optional. Pre-1996 years: No annual IAS, but a negative adjustment was required for losses of a subsidiary used in consolidation (to the extent the subsidiary could not have used them on a separate-company basis).

Importantly, deemed-dividend elections (for pre-1996 consolidated return years or non-SRLY SRYs) made in prior years are treated as an actual distribution and contribution to capital, thus tiering up any S E&P.

The preamble specifically recognizes that when information is incomplete (e.g., in pre-1996 years), taxpayers should use "reasonable methods" to apply the final regulations "based on available information, including income tax returns, financial statements, and statements of retained earnings." As a practical matter, each situation needs to be evaluated based on its particular facts and circumstances and the taxpayer's E&P relevance profile.

Examples of Application of

Impact of New E&P Rules

The following examples illustrate the effect of the new E&P rules in subsidiary NOL group and old consolidated group situations. They do not illustrate all the fact patterns that might be encountered.

Example 1 - Subsidiary with NOLs: PS group is a calendar-year taxpayer; P formed S in 1993 with $110. P as no other subsidiaries or activity. In 1993, S had $(20) in E&P and NOLs of $35; in 1994, $(30) in E&P and NOLs of $40. P made a $5 distribution to its shareholders in 1994.

                      Old     New
                      E&P     E&P
                      rules   rules

1993:
S's E&P (deficit)     $(20)   $(20)
Adjustment for NOLs     35      --
1994:
S's E&P (deficit)      (30)    (30)
Adjustment for NOLs     40      --
Distribution            (5)     (5)
P's E&P (deficit)
  as of 1/1/95         $20    $(55)

Example 2 - Group with long history: PS group is a calendar-year taxpayer; P formed S in 1964 with $1,000. P has no other subsidiaries or activity. S has never made a distribution to P. S had the following E&P: In 1964, $(200); 1965, $100; 1996-1975, $400 (assume no election in effect for these years to tier up subsidiary E&P); 1976-1994, $500.

                 Old     New
                 E&P     E&P
                rules   rules
1964             $---   $(200)
1965              ---     100
1966 - 1975       ---     400
1976 - 1994       500     500
P's E&P
  as of 1/1/95   $500    $800

(Note: A deemed-dividend election would not have been relevant in this fact pattern since S's pre-1966 E&P was a deficit ($100). Deemed-dividend elections, where relevant, would have tiered up pre-1966 S E&P to P such that no further adjustment would be necessary in the cumulative redetermination process.)

Comments on Allocation of

Federal Tax Liability

As noted, the allocation of Federal income tax liability election for E&P purposes under prior law remains in effect unless the taxpayer elects to conform (retroactively or prospectively) the method with the method required for the new IAS. The conforming election must be made with the consolidated group's return for the first tax year beginning after Jan. 1, 1995. Other general observations include:

* In consolidated groups in which the subsidiaries are 100%-owned by the parent and the amount of E&P allocable to a subsidiary is not tax or regulatorily relevant, consider making the election to conform the E&P tax allocation to the method used for purposes of the IAS retroactively, to minimize administrative effort. A change from a Method 1 or 2 allocation under Sec. 1552 (a)(1) or (a) (2) might affect separate-company E&P, but would not affect consolidated (P) level E&P.

* In consolidated groups in which the subsidiaries are not 100%-owned by the parent and for the amount of E&P allocable to a subsidiary is tax or regulatorily relevant (e.g., the existence of subsidiaries preferred stock held by nonmembers and/or the parent or a member is subject to government regulation (e.g., a utility)), additional analysis is required to ascertain the effect of the conforming election (either retroactively or prospectively), due to the significant difference between the "old" Method 1 or 2 allocations under Sec. 1552(a)(1) and (a)(2) and the IAS method and/or the effect of differences between the contractual tax-sharing agreement and the IAS method (i.e., due to allocations of "cushion" and/or deferred taxes maintained at the parent level),treated as constructive distributions/ contributions. Differences in allocations causing constructive distributions from S to P affect S E&P, but differences in allocations causing constructive contributions to S from P do not affect S E&P (but do have an impact on P's basis in S).

Example 3 - Allocation of Federal taxes: P owns 80% of S and is taxed at a 35% rate. Taxable income and E&P are the same. P has $200 taxable income and S has $(100) taxable income.

                                      Contractual
                    Old        IAS       tax
                  method 1   method   allocation
Tax allocation:

P                   $35        $70       $75
S                   ---        (35)      (38)
                    $35        $35       $37

E&P:
P (consolidated)    $85(*)     $78(**)
S (separate)        (100)      (65)

(*) ($200 - $35) + (80% x $(100)).
(**) ($200 - $70) + [80% x ($(100) - $(35)].
The difference between $35 and $38 (IAS
versus contractual tax collection) is treated as
a $3 capital contribution from P to S with
no S E&P effect.