Proposed consolidated return stock basis and E & P systems.

The current consolidated return stock basis system (Treas. Reg. [sections] 1.1502-32 and related provisions) provides rules for adjusting the basis of the stock of a subsidiary (S) by another member (P). The starting point for adjusting P's S stock basis is S's undistributed earnings and profits (E&P), or deficit thereof, for the consolidated return year (CRY). This adjustment generally reflects amounts recognized by S and taken into account in determining consolidated taxable income and amounts distributed out of current E&P by S to P. The purpose of the adjustment is (1) to prevent these items from being recognized a second time upon P's disposition of its S stock and (2) to cause P to recapture certain losses recognized by S when P has a negative S stock basis (a so-called excess loss account). The adjustment for E&P also takes into account S's tax-exempt income and noncapital, nondeductible expenses in order to prevent these items from resulting in income, gain, or loss from the disposition of P's S stock.(1) *

In a Notice of Proposed Rulemaking (CO-30-92, 1992-48 I.R.B. 27), the Department of the Treasury and the Internal Revenue Service proposed amendments to the stock basis system that would delink it from E&P and create a new E&P system. This article summarizes and explains the most important aspects of the proposed amendments.(2) Part I.A explains Prop. Reg. [sections] 1.1502-32. The principal differences between the current and proposed rules are, follows:

* The proposed rules generally would use S's taxable

income (or loss), adjusted for tax-exempt income and

noncapital, nondeductible expenses -- instead of S's

current E&P (or deficit thereof) -- as the starting

point for making basis adjustments. Because current

law requires similar adjustments to convert taxable

income to current E&P -- and section 1503(e) of the

Internal Revenue Code already requires that depreciation

and certain other E&P adjustments to taxable

income be ignored in computing stock basis -- use of

the proposed adjusted taxable income concept is not

intended to alter materially stock basis adjustments.

* The proposed negative adjustments to account for S's

section 301 distributions (including nondividend distributions

now addressed by Treas. Reg. [sections] 1.1502-14

rather than Treas. Reg. [sections] 1.1502-32) would not depend

on any assumptions regarding whether the distribution

was out of E&P previously reflected in P's S

stock basis. This could adversely affect consolidated

groups that have not distributed S's E&P accumulated 

in an affiliated but separate return year.

Part I.B discusses a number of special rules contained in Prop. Reg. [sections] 1.1502-32 and 1.1502-19 that are designed to --

* correct certain anomalies in

the timing of basis adjustments

(especially section 332

liquidations of lower-tier

subsidiaries);

* cure problems in the allocation 

of adjustments between

preferred and common stock

(especially preferred dividends 

in arrears paid out of

current E&P);

* impose an annual reporting

requirement for stock basis

adjustments;

* narrow the circumstances 

under which P would recapture

any S excess loss account

because of S's becoming

worthless; and

* eliminate P's election to reduce an excess loss account

in exchange for reducing its basis in other S stock.(3)

Part I.C analyzes the effective date of the proposed stock basis system. The proposed rules generally would apply to determinations of stock basis and excess loss accounts on or after the date the final rules are filed with the Federal Register; when applicable, however, the rules apply retroactively. Because the proposed rules could apply retroactively to all CRYs (even pre-1966 CRYs for which stock basis was adjusted for losses but not for income), consolidated groups with older subsidiaries may be benefitted by the proposed changes.

Part II.A-D analyzes Prop. Reg. [sections] 1.1502-33, which would create a separate E&P system. These rules would --

* tier up E&P of S to P, directly rather than by treating

an investment adjustment to P's S stock basis as E&P'

of P;

* restate the effects of the allocation of federal taxes as

E&P;

* replace the anti-dividend stripping rules that had

been adopted in 1988 to replace earlier overreaching 

rules(4); and

* modify the E&P effects of certain group structure

changes.

Part II.E addresses the effective date of the new E&P system. The proposed E&P rules generally would apply with respect to determinations of E&P on or after the date the final rules are filed with the Federal Register.

I. Proposed Stock Basis System

A. Separating Stock Basis Adjustments From Current Earnings and Profits

1. Current Rules and Reasons for Change. Under Treas. Reg. [sections] 1.1502-32, changes in P's S stock basis depend primarily on "investment adjustments" for S's undistributed E&P (or deficit thereof) for the current year. Other investment adjustments prevent P's S stock basis from being reduced by S's losses until the losses are absorbed by the P group. A negative investment adjustment generally, but not always, is also made for a dividend paid to P out of S's accumulated E&P. Whether a negative adjustment is made depends on whether the distributed earnings are deemed reflected in P's S stock basis. (See Chart 1.) No negative adjustment is made, for example, for a dividend out of (1) E&P accumulated in pre-1966 CRYs (because the investment adjustment system was not in effect prior to 1966 to provide for positive stock basis adjustments), and (2) certain pre-consolidation E&P accumulated when P and S were affiliated (because such E&P generally could have been distributed before consolidation without a tax cost or basis reduction).

Under Treas. Reg. [sections] 1.1502-14, P eliminates any income to P from any section 301 distribution paid by S on P's S stock, and P reduces its S stock basis for any of S's nondividend section 301 distributions (which may cause P to have an S excess loss account). Under Treas. Reg. [sections] 1.1502-33(c)(4)(ii)(a), investment adjustments to P's S stock basis made under Treas. Reg. [sections] 1.1502-32 are treated as E&P of P; other basis adjustments are not so treated.

The adjustments to P's basis in its S stock and other effects of P's undistributed E&P and section 301 distributions after August 9, 1979 -- when S's losses are fully utilized currently by the P group -- are summarized in Chart 1. Example 1 -- Stock Basis and E&P for Single Subsidiary: P, a holding company, owns all the stock of S, which formed P at the end of Year 0 with $100. The changes in P's S stock basis and P's E&P at year-end to reflect S's activities during each year are, as follows:

Tiering up of adjustments: As illustrated in Example 1, P adjusts its current E&P to reflect the investment adjustments to its basis in its S stock. As a result, S's E&P indirectly is "tiered up" to P and becomes P's E&P through the investment adjustment system. If P is a subsidiary of the consolidated group, P's E&P in turn tiers up and ultimately is reflected in the E&P and stock basis of each higher-tier subsidiary and in the E&P of the common parent.

Example 2 -- Stock Basis and E&P for Tiers of Subsidiaries. The facts are the same as in Example 1, except that GP, the common parent of the consolidated group, formed P with $100, and P is a subsidiary of the group. The changes in GP's P stock basis and GP's E&P at year-end to reflect S's activities during each year are reflected in the next column.

The Government's desire to end the current stock basis system's dependence on current E&P can be traced to Treasury's, IRS's, and Congress's costly mishandling of E&P depreciation by consolidated groups and a concern about repeating any similar revenue embarrassment.

The story began in 1969, when the enactment of section 312(k) required E&P depreciation to be determined at a slower rate than accelerated tax depreciation in order to prevent the understatement of E&P and, hence, dividends distributed to shareholders. Congress apparently had not considered the effects of section 312(k) in computing stock basis of consolidated subsidiaries. In Woods Investment Co. v. Commissioner, 85 T.C. 274 (1985), acq. 1986-2 C.B. 1, the section 312(k) benefit' to a consolidated group was confirmed: a consolidated group was not required to account for accelerated tax depreciation in computing P's basis in its S stock, so long as P sold S when S's CRY cumulative tax depreciation exceeded its CRY E&P depreciation.

Based on a straightforward reading of the investment adjustment rules, the Tax Court held that P's basis in its S stock must reflect section 312(k) E&P depreciation rather than accelerated tax depreciation. In other words, if Treasury and the IRS did not like their own regulations, they could fix them without the court's help.(5) Until that time, no adjustment would be required in computing P's basis in its S stock.

As the Treasury and IRS struggled over whether and how to change the investment adjustment rules after their loss in Woods Investment, an impatient Congress in 1987 clumsily attempted a legislative solution. Section 1503(e)(1)(A) was enacted to overrule Woods Investment and reverse the effects of section 312(k) (and (n)) on consolidated return stock basis adjustments, generally for dispositions of S stock after December 15, 1987. In 1988, however, Congress realized that by eliminating the section 312(k) benefit of Woods Investment in the future, it also had eliminated any "section 312(k) detriment" in transitional cases. For example, if a member of a consolidated group (say, P1) had purchased the stock of S from P and later sold the stock of S, P1 would have inherited a built-in basis reduction to its S stock that would have reduced the Government's revenue loss from Woods Investment. This is because S's P1 group's CRY E&P depreciation for property acquired before it became a member of P1's group would have exceeded tax depreciation. Thus, in transitional cases where S was sold by P to P1 on or before December 15, 1987, and P1 sold S after December 15, 1987, Congress essentially gave away the store. P's section 312(k) benefit was preserved by the effective date of section 1503(e), and P1's section 312(k) detriment was eliminated. In 1988, Congress acted to restore the section 312(k) detriment in transitional cases by enacting section 1503(e)(3)(A) as a retroactive technical correction to section 1503(e). Section 1503(e)(3)(A) provides that "[u]nder regulations prescribed by the Secretary, proper adjustments shall be made" in the application of section 1503(e)(1) for property S acquired before consolidation. The legislative history of this provision, however, is a source of confusion rather than enlightenment.(6)

In the face of such confusion, the Treasury and IRS wisely announced in the preamble to Prop. Reg. [subsections] 1.1502-32 and 1.1502-33 that they had no intention of drafting section 1503(e)(3) regulations.(7) Thus, the final chapter to the Woods Investment story may have been written -- that is to say, sections 312(k) and (n) would be ignored in making stock basis adjustments, whether they provide a benefit or a detriment, even in transitional cases.(8)

2. General Proposed Stock Basis Rules. To prevent other tax policy conflicts between the determination of P's S stock basis and the calculations of E&P, the proposed regulations would create separate stock basis and E&P systems. Under Prop. Reg. [sections] 1.1502-32(b)(3), P's annual adjustment to the basis of its S stock would be the net amount of:

S's taxable income or loss(9) Plus: S's tax-exempt income(10) Less: S's noncapital, nondeductible expenses(11) Less: S's section 301 distributions with respect to S's stock(12)

Because the first three items are roughly equivalent to current E&P (ignoring sections 312(k) and (n) as section 1503(e)(1) requires in making investment adjustments), perhaps the most important change from the current investment adjustment rules is the required treatment of all of S's section 301 distributions to P as reducing P's S stock basis, without regard to whether the distributed E&P has been reflected in P's S stock basis. A distribution out of preconsolidation affiliation year E&P, for example, no longer would be permitted to be distributed without a basis reduction.(13)

As discussed in Part I.C, when the proposed regulations apply to a determination of basis, they generally would apply retroactively to all CRYs. Thus, if P owned S before a pre-1966 CRY (positive investment adjustments were introduced in 1966), then P would increase its S stock basis for S's pre-1966, well as S's post-1965, adjusted taxable income.

The adjustments to P's basis in its S stock and other effects of P's undistributed E&P and section 301 distributions under the proposed regulations, when S's losses are fully utilized currently by the P group, are summarized in Chart 2.

Example 3 -- Stock Basis and E&P for Single Subsidiary: The facts are the same as in Example 1, except that P's E&P would be reduced to reflect S's Year 4 loss as of the end of Year 4 rather than Year 5 -- see note 18. P, a holding company, owns all the stock of S, which formed P at the end of Year 0 with $100. If S's adjusted taxable income (or loss) each year equalled S's current E&P (or deficit thereof) in Example 1, then the changes in P's S stock basis and P's E&P at year-end under the proposed regulations to reflect S's activities during each year would be the same as in Example 1.

Tiering up of adjustments: The adjustments to P's S stock basis under Prop. Reg. [sections] 1.1502-32 would be directly taken into account in determining adjustments to higher-tier stock.(17) By contrast, this tiering up occurs indirectly under the current rules by treating investment adjustments by P to its S stork as E&P of P, which in turn affect P's parent's investment adjustments with respect to P when P is a subsidiary of the consolidated group. As discussed in Part II, under Prop. Reg. [sections] 1.1502-33(b), S's E&P also would be tiered up separately in accordance with the applicable principles of Prop. Reg. [sections] 1.1502-32(b).(18)

Example 4 -- Stock Basis and E&P for Tiers of Subsidiaries: The facts are the same as in Example 3, except that GP, the common parent of the consolidated group, formed P with $100, and P is a subsidiary of the group. The changes in GP's P stock basis and GP's E&P at year-end under the proposed regulations to reflect S's activities during each year would be the same as in Example 2, except that P's E&P and GP's E&P would be reduced to reflect S's Year 4 loss at the end of Year 4 rather than Year 5. The mechanics, however, would vary; under the proposed regulations, (i) the nondividend distribution in Year 6 would reduce basis under Prop. Reg. [sections] 1.1502-32 rather than under Treas. Reg. [sections] 1.1502-14, and (ii) a subsidiary's investment and E&P adjustments would tier up, but do so directly under separate stock basis and E&P systems rather than by treating investment adjustments made by P to its S stock basis as E&P of P Special rules also would apply to prevent counterintuitive results -- see note 5.

B. Special Proposed Stock Basis Rules

1. Timing of Adjustments

a. Current Rules and Reasons for Change

* Section 332 Liquidation of Lower-Tier Subsidiary. Under Treas. Reg. [sections] 1.1502-32(a), investment adjustments are made as of the end of each CRY, or, in the event of a "disposition" of S stock before the end of the taxable year, adjustments with respect to such stock are made as of the date of disposition. A "disposition" is defined by cross-reference to the rules for determining when a disposition will trigger recapture of an excess loss account under Treas. Reg. [sections] 1.1502-19. If the current rules were applied literally, P's stock basis in S would be understated by the amount of the final year E&P (or overstated in the amount of a final year deficit of E&P) of any lower-tier consolidated subsidiary of S liquidated into S under section 332.

Example 5 -- Section 332 Liquidation of Lower-Tier Subsidiary: P has a $100 basis in S. S purchased all the stock of S1 for $100 on January 1, Year 1. S1 was completely liquidated into S under section 332 before the end of Year 1. S1 had $20 of E&P in Year 1 before it was liquidated. S inherited S1's $20 of E&P under section 381(c)(2), but that $20 is not taken into account in determining P's S stock basis because it is not "current earnings and profits" of S (see Treas. Reg. [subsections] 1.381(c)(2)-1(a)(2) and (a)(7), Example (1)). Although S's basis in its S1 stock disappears in the section 332 liquidation, investment adjustments by S with respect to its S1 stock basis are needed to prevent understating P's basis in its S stock by $20. Such an investment adjustment would be treated as Year 1 E&P of S and thus result in an investment adjustment by P to its S stock. Without such an adjustment, P will have a $100 basis in S, but the stock will have a value of $120. Thus, if P sold S for $120, S1's $20 of income for Year 1 would be duplicated by P's $20 gain if Treas. Reg. [sections] 1.1502-32 were applied by its literal terms. This is inconsistent with the principles underlying the investment adjustment rules.

* Varying Interests. The current rules provide that, if S's E&P is determined before the end of a taxable year, the E&P for the year is prorated on a daily basis. Clear guidance on how stock basis adjustments are to be made if P's interest in S changes, however, is lacking.

b. Proposed Rules

* Section 332 Liquidation of Lower-Tier Subsidiary. To correct the anomaly in Example 5, under Prop. Reg. [sections] 1.1502-32(b)(1), if S1 liquidates during a CRY, adjustments would be made to S's S1 stock basis as of the liquidation. To prevent other similar problems, investment adjustments would not be made under any mechanical rule. Instead, adjustments would be made as of the close of each CRY and "as of any other time if a determination at that time is necessary to determine a tax liability of any person."

* Varying Interests. Under Prop. Reg. [sections] 1.1502-32(b)(4)(vi), if P's interest in S changes, the stock basis adjustments of Prop. Reg. [sections] 1.1502-32 would be made by taking into account P's varying interests under allocation rules that may vary depending on whether S remains in the P group.

2. Allocation of Adjustments between Preferred and Common Stock

a. Current Rules and Reasons for Change. Under Treas. Reg. [sections] 1.1502-32(c), the only positive investment adjustment with respect to P's S preferred stock is for an allocable part of S's undistributed E&P for the taxable year. S's undistributed E&P for the taxable year is allocated first to S's outstanding preferred stock in an amount equal to the excess, if any, of (1) the cumulative dividends in arrears (determined as of the last day of S's taxable year) for all CRYs after 1965, over (2) S's accumulated E&P as of the first day of the taxable year. The balance, if any, of S's undistributed E&P is allocated to S's outstanding common stock.

The only negative investment adjustment with respect to P's S preferred stock is for any dividends out of S's accumulated E&P. In general, this negative adjustment is made under the same rules that apply to dividends paid on S's common stock.

These allocation rules do not function as intended, however, when S pays its preferred dividend arrearage out of current, rather than accumulated, E&P.

Example 6 - Allocation of Stock Basis Adjustments between Preferred and Common Stock: P forms S and takes back preferred stock (paying a 10-percent per annum cumulative dividend) with a value and basis of $1,000 and common stock with a value and basis of $500. In Year 1, S has $100 of E&P but does not pay any dividends. P's basis in its S preferred stock is increased to $1,100 to reflect the dividends in arrears. In Year 2, S has $200 of E&P that it distributes to P with respect to its S preferred stock ($100 for the dividend arrearage and $100 for the dividend accruing in Year 2). No investment adjustments are made for distributions out of current E&P, and S had no Year 2 undistributed E&P to generate any positive investment adjustment. Under a literal reading of the current regulations, P appears to have a $1,100 basis in its S preferred stock and a $500 basis in its S common stock even though there are no preferred dividends in arrears.

b. Proposed Rules. Prop. Reg. [sections] 1.1502-32(c) governs the proposed allocation of investment adjustments among various classes of stock. The negative adjustment for distributions would be allocated to the shares of S stock entitled to the distributions. The remainder of the adjustment (for taxable income (loss) and the adjustments thereto) would be allocated among the shares of S stock. If the adjustment (without regard to distributions) is positive, it would be allocated first to any S preferred stock to cover distributions and arrearages (on a cumulative basis, the allocation is redetermined, as needed), and then to S common stock. If the adjusted taxable income or loss adjustment is negative, it would be allocated only to S common stock.

Example 7 -- Allocation of Stock Basis Adjustments between Preferred and Common Stock: The facts are the same as in Example 6, and S's adjusted taxable income for Year 1 and 2 equals its E&P before distributions. Under the proposed allocation rules, P would increase the basis of its preferred stock by $100 as of the end of Year 1 to reflect the preferred's share of S's adjusted taxable income for dividend arrearage, and it would reduce the basis as of the end of Year 2 by $100 to account for the $200 of preferred dividends in excess of the preferred's $100 share of S's adjusted taxable income. P would increase the basis of its common stock as of the end of Year 2 to reflect the common's $100 share of S's adjusted taxable income and make no change as of the end of Year 2. Thus, P would have a $1,000 basis in its S preferred stock and a $600 basis in its S common stock, which properly reflects the amounts that would be distributed with respect to each class of stock if S were liquidated as of the end of Year 2.

3. Annual Reporting of Adjustments

a. Current Rules and Reasons for Change. Except for a handful of diligent companies (typically public utilities), even Fortune 500 Companies generally do not keep track of stock basis and E&P of their consolidated subsidiaries on an annual basis. Except for consolidated groups confronted by an audit controversy over an anomaly or counterintuitive regulation, most taxpayers closely examine the stock basis system only at the eleventh hour when a disposition of a consolidated subsidiary is contemplated. Without annual stock basis and E&P records, costly studies may be required when P ultimately disposes of S.

b. Proposed Rules. Under Prop. Reg. [sections] 1.1502-32(g), a statement of adjustments would be required with each of the consolidated group's tax returns. Most important, the statement would be required to contain the net amount of the adjustment to P's S stock under Prop. Reg. [sections] 1.1502-32(b) for the CRY or other applicable period. The proposed annual reporting requirement thus would require better recordkeeping of the annual investment adjustment changes in stock basis for adjustments relating to taxable years beginning after the date the final regulations are filed with the Federal Register.(19) Procrastinating consolidated groups still would be permitted to defer a determination of earlier basis adjustments until P disposes of S.

4. Excess Loss Account Worthlessness and Elective Basis Reductions

a. Current Rules and Reasons for Change. To the extent the consolidated return adjustments to P's S stock basis exceed P's basis in its S stock, P has the equivalent of a negative stock basis in S, ordinarily when S has lost more than P's basis in the equity capital P has provided S or made excess distributions to R This negative basis, called an "excess loss account," is generally -- but not always -- recaptured as gain from the sale of the stock when there is a "disposition" of the S stock.

* Worthlessness. Worthlessness of S is treated as a disposition requiring P to recapture its S excess loss account (generally as ordinary income since S is insolvent). If P is required to include the excess loss account in income before S recognizes any corresponding gain in respect of its assets and liabilities, however, S's gain may have been duplicated by P For example, if S borrows and loses funds, thereby causing P to have an S excess loss account, P's recapture of the excess loss account in income may duplicate the group's later income associated with S's discharge of the debt. Once the excess loss account is included in income, Treas. Reg. [sections] 1.1502-20 prevents S's subsequent discharge income from being offset by a loss on P's disposition of its S stock.

* Elective Basis Reduction. Under the current rules, P may elect to reduce its S excess loss account in exchange for reducing its basis in other stock of S. The scope of the election had been reduced by recent legislation (previously the election could be made in exchange for reducing P's basis in obligations of S) and by the loss disallowance regulations if the election had the effect of netting stock gains and losses in a manner that is inconsistent with Treas. Reg. [sections] 1.1502-20. Thus, the election had a limited remaining applicability.

b. Proposed Rules(20)

* Worthlessness. To prevent duplication of income, Prop. Reg. [sections] 1.1502-19(c)(1)(iii)(A) would provide that P's S stock will generally not be treated as worthless until substantially all of S's assets are treated as disposed of, abandoned, or destroyed within the meaning of section 165(a). S's assets also would be considered disposed of if they were maintained for the principal purpose of avoiding a disposition of, S's stock. Under Prop. Reg. [sections] 1.1502-19(c)(1)(iii)(B), however, P's S stock would be treated as worthless on any day that an indebtedness of S is discharged, if the amount discharged and excluded from gross income under section 108(a) exceeds the amount of tax attributes reduced under sections 108(b) and 1017 as a result of the exclusion.

* Elective Basis Reduction. The proposed rules would eliminate the elective basis reduction, apparently in the name of simplification.

C. Effective Dates of Proposed Rules

The proposed stock basis system would apply with respect to determinations (e.g., for purposes of determining basis in connection with a sale of S stock) on or after the date the final regulations are filed with the Federal Register.(21) Subject to some significant exceptions, the new regulations would apply as if the new system had been in effect for all CRYs of the group. In other words, the proposed regulations generally would apply retroactively in determining stock basis for dispositions on or after their effective date.

The excess loss account rule redefining worthlessness, however, would apply to any CRY ending on or after the date the final rules are filed with the Federal Register.(22)

II. Proposed E&P System

As a result of the delinking of the stock basis system from E&P, Prop. Reg. [sections] 1.1502-33 would create a separate E&P system.

A. Direct Tiering up of Earnings and Profits

The indirect tiering up of E&P by treating investment adjustments as E&P under the current stock basis system is illustrated by Example 2. The direct tiering up of E&P under the proposed rules is illustrated by Example 4. The proposed rules also provide for separately adjusting P's S stock basis for E&P purposes to determine P's E&P from the disposition of its S stock. This avoids duplicating E&P

B. Retention of Tax-Sharing Agreement Rules

Each member must adjust its E&P for an allocable part of the taxability of the consolidated group, as determined under section 1552. Treas. Reg. [sections] 1.1502-33(d) provides elective methods by which a consolidated group may allocate additional amounts of E&P to profitable members in order to compensate loss members for the use of their losses. The proposed regulations retain the elective methods of Treas. Reg. [sections] 1.1502-33(d) but rewrite the rules to improve comprehension.

C. Anti-Dividend Stripping Rules

1. Current Rules and Reasons for Change. Treas. Reg. [sections] 1.1502-32T recognizes the potential for dividend stripping if (a) the basis of P's S stock is increased under the investment adjustment rules to reflect S's E&P, and (b) after S becomes a nonmember, S distributes the E&P under the separate return rules without a corresponding basis reduction. Under the current rules, negative adjustments are generally deferred until S actually makes distributions to P with respect to its retained stock. Temp. Reg. [sections] 1.1502-32T was promulgated in 1988 to replace the overreaching rules of prior law (Treas. Reg. [sections] 1.1502-32(g)). Under the prior rules, whenever S became a nonmember of the P group but P retained some or all of S's stock, then P's net positive investment adjustments reflected in its retained S stock were eliminated immediately before S became a nonmember. The IRS had interpreted Treas. Reg. [sections] 1.1502-32(g) as applying even if dividend stripping was impossible, for example, because P1 acquired P (still owning S), and the P1 group filed a consolidated return. If the IRS's interpretation were correct, P could suffer duplicate reductions to its S stock basis for a distribution of S E&P accumulated during P group's CRYs and reflected in P's S stock basis but distributed in P1 group's CRYs. One basis reduction would occur under Treas. Reg. [sections] 1.1502-32(g) before P and S left the P group, and the other would occur under Treas. Reg. [sections] 1.1502-32(b)(2)(iii) when S paid a dividend to P during a P1 group's CRY. Although Temp. Reg. [sections] 1.1502-32T was an improvement over the earlier rules, it had to be elected in certain transitional cases and was exceedingly complex.

Consolidated groups could eliminate part of S's E&P by making a deemed dividend election under Treas. Reg. [sections] 1.1502-32(f): P was treated as receiving S's accumulated E&P (measured as of the end of the prior taxable year) and as recontributing such amount to S.

2. Proposed Rules. Under Prop. Reg. [sections] 1.1502-33(e), P's S stock basis adjustments during P group's CRYs are preserved, but S's E&P arising in the P group is generally eliminated immediately before S becomes a nonmember. Thus, if S makes a distribution to P under the separate return rules before earning post-consolidated E&P, P's basis in its S stock would be reduced under the general rules of section 301(c)(2) (or the distribution may exceed stock basis and be taxed under section 301(c)(3)). The elimination of S's E&P does not tier up to eliminate a corresponding amount of P's E&P Because S's E&P earned during CRYs would automatically be eliminated, the role of the deemed dividend election would be quite limited, and it would be eliminated.

An exception to E&P elimination would be provided if S's E&P would be eliminated by reason of an acquisition of the group. In keeping with the principles of section 312(h), special rules would be provided to allocate E&P in transactions in which section 312(h) would allocate E&P if the corporations filed separate returns.

D. Group Structure Changes

1. Current Rules and Reasons for Change. Under Treas. Reg. [sections] 1.1502-33, the E&P of any member, including the common parent, generally reflects the E&P of that member and its share of the E&P of every member below it in the chain earned during CRYs. Treas. Reg. [sections] 1.1502-33 did not adjust a member's E&P following certain structural changes in the group. For example, it was possible to transfer the stock of P to a new holding corporation and have the holding corporation pull out P's E&P and distribute it to P's former shareholders as a tax-free return of capital. This was possible because such a section 351 transfer does not shift P's E&P to the holding corporation, and the investment adjustment rules permit a member to pull out a lower-tier member's accumulated E&P without creating E&P in the higher-tier member. This was because, in the ordinary case, the lower-tier member's E&P was already reflected in the higher-tier member's E&P. Temp. Reg. [sections] 1.1502-33T(a) was added in 1988 to change this result.

Example 8 -- Formation of Holding Company: P owns all the stock of S. S has $300 of E&P, and P has $300 of E&P reflecting investment adjustments to its S stock. If P distributed $300 to its shareholders, the distribution would be taxed as a dividend. Instead, P's shareholders contribute all their P stock to a new holding corporation, HC, which becomes the new common parent of the P group.(23) Because HC is a new corporation and the transfer is not a section 381 transfer, HC has no E&P. In addition, if P distributes its $300 to HC, the E&P of HC is first increased by the amount of the dividend, and then decreased by the amount of the negative investment adjustment with respect to the dividend, so that after the distribution HC's E&P remains a zero. Thus, HC could distribute $300 to its shareholders and the distribution would not be taxed as a dividend.

Temp. Reg. [sections] 1.1502-33T changes this result. It provides, in general, that if there is a change in the common parent of the consolidated group, but the group remains in existence and the stockholders of the former common parent immediately before the change own 80 percent or more of the value of the stock of the new common parent after the change, then the E&P of the new common parent is adjusted to reflect the E&P of the former common parent. Thus, HC's E&P should be $300 after the change in structure of the group, and the $300 distribution by HC to its shareholders should be taxed as a dividend.

The current rules for replicating E&P, however, are limited to group structure changes where there is at least 80-percent continuity in the ownership in the group. If the group continues but there is less than 80-percent continuity, E&P is not replicated but other adjustments are provided to cause the group's E&P to be reflected in the new common parent's E&P.

Under Temp. Reg. [sections] 1.1502-33T(a)(2), similar rules apply to change in structure among lower-tier members. "Appropriate adjustments" to E&P are made when the position of a member in a chain of includible corporations changes, and the group remains in existence. The purposes underlying this provision, however, were unclear.

2. Proposed Rules. Prop. Reg. [sections] 1.1502-33(f) would replace Temp. Reg. [sections] 1.1502-33T. It would provide that, if P succeeds another corporation under the reverse acquisition principles of Treas. Reg. [sections] 1.1502-75(d)(2) or (3) as the common parent of a group, the E&P of P would be adjusted immediately after it becomes the new common parent to reflect the E&P of the other corporation immediately before the other corporation ceases to be the common parent. The adjustment would be made as if P succeeds to the E&P of the other corporation in a section 381 transaction. Thus, the proposed rules would cause the common parent's E&P to reflect the group's E&P without regard to continuity in the ownership of the group, provided the group survives. In addition, unlike the current rules, replication of E&P is not limited to nonrecognition transactions.

Temp. Reg. [sections] 1.1502-33T(a)(2), which authorizes appropriate adjustments to E&P of a subsidiary if it changes its location in the group, would be eliminated.

E. Effective Date of Proposed Rules

Consistent with the effective date rules of the proposed stock basis system, the proposed E&P system generally would apply with respect to determinations of E&P on or after the date the final rules are filed with the Federal Register.(24) If the proposed rules apply, E&P would be determined retroactively as if the proposed rules had been in effect for all CRYs of the group. The anti-dividend stripping rule that eliminates E&P of a member and the replicating rule for group structure changes would apply only to deconsolidations and group structure changes on or after the date the final rules are filed with the Federal Register. In addition, deemed dividends under the current rules would be taken into account under the proposed rules.

III. Observations

The proposed amendments to Treas. Reg. [subsections] 1.1502-32 and 1.1502-33 and related provisions represent a welcome step forward in developing understandable stock basis and E&P rules. The annual reporting of stock basis adjustments, while adding to the tax return burdens of consolidated groups, may be viewed more favorably when a subsidiary is disposed of and the usual eleventh-hour stock basis study fire drill is avoided. In order to prevent duplicate consolidated return rules on an indefinite basis (i.e., until all consolidated subsidiaries were sold), Treasury and the IRS generally would apply the proposed rules retroactively for dispositions on or after the date the rules become final. As usual, this simplifying approach arbitrarily will create some significant winners and losers.

Notes

(1) See generally James C. Warner, Consolidated Returns: Stock Basis, Loss Disallowance, and Intercompany Transactions (CCH Tax Trans. Lib.). (2) The Notice of Proposed Rulemaking also proposes amendments to Treas. Reg. [subsections] 1.1502-13, 1.1502-20, 1.1502-31, 1.1502-76, and 1.1502-80, which are beyond the scope of this article. (3) Prop. Reg. [sections] 1.1502-11(b) would simplify the anti-circular basis rules. These rules, which defy summarization, apply when S has a final year loss or a loss carryover to S's final year. For example, any gain on P's sale of the S stock generates consolidated taxable income that changes the amount of S's final year loss or loss carryover that is absorbed by the consolidated group, in turn changing the basis of P's S stock, P's gain on the disposition of S, and so forth. See generally James C. Warner, supra note 1, at [paragraph] 108.060. (4) Under the proposed rules, S's E&P arising in the P group immediately before S becomes a nonmember generally would be eliminated, thereby ending a trap for the unwary who failed to elect the 1988 rules upon disposition of a S when S's parent and S had been acquired from another consolidated group before the effective date of the 1988 rules. (5) Even the Treasury and IRS learn from their mistakes. See Prop. Reg. [subsections] 1.1502-32(a)(2) and 1.1502-33(a)(2) (laying the groundwork for a result-oriented court to correct any counterintuitive regulation) and Prop. Reg. [subsections] 1.1502-32(e) and 1.1502-33(g) (providing for overriding adjustments as necessary to carry out the purposes of the regulations). (6) H.R. Rep. No. 795, 100th Cong., 2d Sess. 408 (1988); S. Rep. No. 445, 100th Cong., 2d Sess. 432 (1988). (7) The Treasury and IRS speculated that section 1503(e)(3) may have served some of the same purposes as the loss disallowance rules of Treas. Reg. [sections] 1.1502-20. (8) The preamble to the proposed regulations states that section 1503(e)(3) would not apply to any disposition on or after the date the final rules are filed with the Federal Register. The preamble is silent on the effect of section 1503(e)(3) on earlier dispositions. Because section 1503(e)(3) by its terms applies only "[u]nder regulations prescribed by the Secretary," however, it seems a safe bet that section 1503(e)(3) will never be enforced if Prop. Reg. [subsections] 1.1502-32 and 1.1502-33 are finalized without addressing section 1503(e). (9) See Prop. Reg. [sections] 1.1502-32(b)(4)(i). S's taxable income or loss would be consolidated taxable income (taking into account such provisions as the deferral of intercompany items) determined by taking into account only S's items. S's tax loss. would be treated as a tax loss only to the extent that it is absorbed by any member of the consolidated group, including S, except that the loss would be treated as a tax loss in the year in which it arises to the extent that S's tax loss is absorbed as a carryback to a prior year (whether consolidated or separate) by any member of the group, including S. See Prop. Reg. [sections] 1.1502-32(b)(5), Example 2 (which also illustrates the effects of a tax refund paid to S when S's loss is absorbed as a carryback). (10) See Prop. Reg. [sections] 1.1502-32(b)(4)(ii). S's tax-exempt income would be income that is recognized by S but is permanently excluded from S's gross income under applicable law. To the extent an item of S's income is permanently offset by a deduction or other item that does not represent a recovery of basis or an expenditure of money, the item of income would be treated as tax-exempt income for these purposes. In addition, the item of income and offsetting deduction would be taken into account. Discharge of S's indebtedness that is excluded from gross income but is not applied to reduce tax attributes would not be treated as tax-exempt income. An increase in the basis of S's assets (or its equivalent, such as an increase in a loss carryover) also would be treated as tax-exempt income in certain situations. See Prop. Reg. [sections] 1.1502-32(b)(4)(ii)(d). (11) See Prop. Reg. [sections] 1.1502-32(b)(4)(iii). Noncapital, nondeductible expenses of S would be deductions or losses that are recognized by S but are permanently disallowed under applicable law in determining S's taxable income or loss. Special rules would apply to determine whether a nondeductible basis recovery or its equivalent (a decrease in a loss carryover, a denial of basis for taxable income, or an increase in an excess loss account) would be treated as a noncapital, nondeductible expense. Under Prop. Reg. [sections] 1.1502-32(b)(4), taxes would be taken into account by applying the principles of section 1552 and the percentage method under Prop. Reg. [sections] 1.1502-33(d)(2) and by assuming a 100-percent allocation of any decreased tax liability. (12) See Prop. Reg. [sections] 1.1502-32(b)(4)(iv). In contrast to the current rules, a distribution would generally be taken into account when P becomes entitled to the distribution (generally on the record date), rather than under cash method concepts. (13) The proposed negative investment adjustment for all section 301 distributions would not apply to distributions made before the effective date of the proposed rules, of earnings and profits accumulated in affiliated, nonconsolidated return years. Prop. Reg. [sections] 1.1502-32(h)(4)(ii); Treas. Reg. [subsections] 1.1502-32(b)(2)(iii)(c) and 1.1502-1(f)(2)(ii). (14) Adjusted taxable income first would have to be converted to earnings and profits. See, e.g., I.R.C. [subsections] 312(k) and (n). (15) See Prop. Reg. [sections] 1.1502-33(b)(3), Example 1(c). (16) See Prop. Reg. [sections] 1.1502-33(b)(3), Example 1(b). (17) See Prop. Reg. [sections] 1.1502-32(b)(4)(v). (18) The deferral of a negative adjustment for unabsorbed losses under Prop. Reg. [sections] 1.1502-32(b)(4)(i), however, would not apply, and the tax sharing rules under Prop. Reg. [sections] 1.1502-33(d) would apply rather than the principles of Prop. Reg. [sections] 1.1502-32(b)(4)(vii). See Prop. [sections] 1.1502-33(b)(3), Example 1(d). (19) See Prop. Reg. [sections] 1.1502-32(h)(5). (20) For rules changing the treatment of an internal spinoff of S when P has an excess loss account, see Prop. Reg. [sections] 1.1502-19(e), Example 2. (21) Prop. Reg. [subsections] 1.1502-32(h)(1) and 1.1502-19(g)(1). (22) Prop. Reg. [sections] 1.1502-19(g)(4). (23) See GCM 39420 (July 30, 1985) (treating transfers of stock of the former common parent to a new holding company as a transfer of assets to a subsidiary under Treas. Reg. [sections] 1.1502-75(d)(2), thereby keeping the consolidated group in existence with the holding corporation as the new common parent). (24) See Prop. Reg. [sections] 1.1502-330).

JAMES C. WARNER is a partner in the Washington, D.C., law firm of Lee, Toomey & Kent and an adjunct professor at the Georgetown University Law Center. He holds B.A., J.D., and LL.M. degrees, and is also a certified public accountant. Mr. Warner is the author of Consolidated Returns: Stock Basis, Loss Disallowance, and Intercompany Transactions, which is part of Commerce Clearing House's Tax Transactions Library. He is a frequent lecturer before Tax Executives Institute, TEI Education Fund, and other professional organizations. Mr. Warner was formerly an attorney-advisor for the IRS Office of Chief Counsel and for Judge William M. Drennen of the United States Tax Court.