Proposed investment adjustment regulations: consolidated return regulations "delink" basis adjustments from E & P adjustments.

Current tax law concerning affiliated groups filing consolidated returns is complex, with inconsistent tax results for transactions involving the acquisition or disposition of group members. Part of the problem has resulted from the changes in the Code and the regulations made to "fix" the latest loopholes created by tax planners. The IRS now appears to be systematically revising substantial portions of the regulations, which should result in more rational and consistent law in this area.

The current system of determining a group's basis in a subsidiary and its earnings and profits (E&P) is excessively complex and probably does not meet the goal of treating a group of corporations filing a consolidated return as one taxable entity. Proposed regulations issued in November 1992 may present a comprehensive change that will provide a more rational approach to determining a group's basis and E&P. As described in the Treasury release,[1] amendments to the regulations "delink" the adjustments to determine basis from the computation of E&P.

The major change included in the proposed regulations is the amendment of Regs. Sec. 1.1502-32, "Investment adjustments." Major amendments would also be made to Regs. Sec. 1.1502-11, conforming changes for group structure changes; Regs. Sec. 1.1502-19, conforming changes to the excess loss account (ELA) rules; Regs. Sec. 1.1502-20, conforming changes to loss disallowance rules; Regs. Sec. 1.1502-33, simplification of the E&P rules and allocation of taxes continued; and Regs. Sec. 1.1502-76, allocation of income or losses between separate and consolidated return years and elimination of the 30-day rules.

Stock basis and E&P issues related to intercompany transactions are not included in these proposed regulations. The intercompany transaction rules will be revised later to address these issues. Note: For purposes of this article, unless otherwise stated, all corporations have only one class of stock outstanding; all groups file consolidated returns on a calendar-year basis; all transactions are between unrelated persons; and tax liabilities are disregarded. The term "consolidated group" refers to a affiliated group filing consolidated tax returns. P is a member of the consolidated group owning stock of another member of the group. S is a member of the group whose stock is owned, all or in part, by other members of the group

Proposed Rules for Determining Basis

in a Member's Stock

* Investment adjustments

Prop. Regs. Sec. 1.1502-32 would require that a member's basis adjustments in another member's subsidiary stock be determined by reference to taxable income rather than E&P. The stated purpose of the adjustment rules is to treat a consolidated group as a single entity. The basis of a subsidiary (S) owned by another member (P) would be adjusted to reflect amounts recognized by S and taken into account in determining the group's taxable income, and amounts distributed by S. Proper adjustment under these rules should prevent items taken into account in the computation of taxable income or as distributions from resulting in additional income or deductions a second time on P's disposition of S's stock. Items such as tax-exempt income or nondeductible expenses should not be recognized either in the computation of taxable income or as additional gain or loss on a disposition.[2]

Adjustments would be made at the close of each consolidated return year and at any other time when it is necessary to determine S's basis, such as on a disposition of S's stock. P's basis in S's stock would be increased by positive adjustments and reduced by negative adjustments. If negative adjustments result in a negative basis, an ELA would be created and the rules of Prop. Regs. Sec. 1.1502-19 should be consulted.[3]

The adjustment to P's basis in S would be the net amount of:

* Taxable income and gains (positive).

* Taxable losses, deductions and expenses (negative).

* Tax-exempt income (positive).

* Noncapital, nondeductible expenses (negative).

* Distributions with respect to S's stock (negative).[4]

Taxable income or loss: S's taxable income or loss is defined as consolidated taxable income determined by taking into account only S's items of income gain, deduction and loss. Tax losses (deductions and losses exceeding gross income) would be treated as a current negative adjustment if absorbed in the current year by other members of the group or if carried back and absorbed by S or by any member of the group in a prior separate or consolidated tax return. Tax losses carried forward would be treated as a negative adjustment in the year the loss is absorbed by S or by any member of the group. Any gross-up for taxes by operation of Sec. 78 or Sec. 852 would not be taken into consideration.[5]

Example 1: In year 1, the P group has $500 of consolidated taxable income. The P group would have a $100 net operating loss (NOL) if only S's items of income, gain, deduction and loss were considered. P's adjustment to its basis in its S stock - $100, the loss absorbed by the group. If the group could not absorb the loss in year 1 or prior years, P's basis in its S stock would not adjusted for the loss until a later year when the loss was absorbed by S or another member of the group.

Tax-exempt income: Tax-exempt income is defined as income recognized but permanently excluded from gross income under applicable law. The most common example of tax-exempt income is municipal bond interest excluded from gross income under Sec. 103.[6]

Example 2: In year 1, the P group has $500 of consolidated taxable income. The P group would have $100 of taxable income if only S's items of income, gain, deduction and loss were considered. In addition, S has $80 of tax-exempt interest income and $60 of expenses related to the production of the tax-exempt interest. P's adjustment to its basis in its S stock is computed as follows:[7]

Net taxable income in year 1         ($100)
Tax-exempt income                       80
Noncapital, nondeductible expenses     (60)
Adjustment to P's basis in S stock   ($ 80)

Equivalent deductions, i.e., deductions or other items that permanently offset items of income, are included in the definition of tax-exempt income.[8] A recovery of capital or an expenditure of money would not be considered an equivalent deduction. The most common example of an equivalent deduction is the dividends-received deduction under Sec. 243.

Example 3: S receives a $100 dividend from a domestic corporation in which it owns less than 20% of the stock. Since S has owned the stock for more than two years, there is no potential for a basis reduction under Sec. 1059. S is entitled to a $70 dividends-received deduction. The deduction is considered an equivalent deduction and $70 of the $100 dividend is treated as tax-exempt income. The resulting investment adjustment in P's basis in S's stock is $100, as follows:

Taxable income $30

Tax-exempt income - equivalent

  deduction                         70
Positive investment adjustment    $100

Discharge of indebtedness that is excluded from taxable income would be treated as tax-exempt income to the extent (1) the discharge amount is used to reduce tax attributes under Secs. 108(b) and 1017, and (2) the attribute reduction is treated as a noncapital, nondeductible expense.[9]

Example 4: P forms S on January 1 of year 1 with a nominal capital contribution. S borrows $200 from an unrelated third party. During year 1, the P group has a $100 NOL when determined by taking into account only S's items of income, gain, deduction and loss. S's assets also decline in value to the point that S is considered insolvent under Sec. 108. None of S's NOL is absorbed by other groups members. In late year 1, $100 of the indebtedness is discharged. Under Sec. 108(b), the $100 NOL is reduced to zero by the discharge.

The indebtedness discharge has two equal and opposing effects on P's basis in its S stock. Because the discharge reduced the NOL under Sec. 108(b), it is treated as a nondeductible, noncapital expense and is a negative adjustment. Because the discharge is applied to reduce a tax attribute and is treated as a nondeductible, noncapital expense, the amount discharged is treated as tax-exempt income and is a positive adjustment. The two adjustments net to zero.[10]

Basis shifts would also be treated as tax-exempt income. A basis shift is an increase in the basis of S's assets to the extent that the increase (1) is not otherwise taken into account in determining P's basis in S's stock; (2) is determined directly by reference to a noncapital, nondeductible expense; and (3) has the effect of treating the expense as deferred rather than permanently disallowed when the group is considered as a whole and this increase is netted with the noncapital, nondeductible expense (for example, investment tax credit (ITC) recapture under Sec. 50(c)).[11] Under Regs. Sec. 1.1502-32(b)(4)(iii)(B), P's basis in S's stock would have been reduced for the decrease in asset basis required when S claimed an ITC. If the asset were disposed of early, recapture of some or all of the ITC recapture would be required, increasing the asset's basis immediately prior to disposition. This increase in basis would be a basis shift and would be a positive adjustment. The Federal income tax increase resulting from the recapture is the requisite noncapital, nondeductible expense.

Noncapital, nondeductible expenses: Noncapital, nondeductible expenses of S are defined as deductions or losses recognized but permanently disallowed and never taken into account for purposes of computing S's taxable income or loss.[12] Federal income taxes represent a common example of this type of expense.

For this purpose, taxes would be allocated to the members of the group using their method elected under Sec. 1552. Compensation of members for the use of deductions and losses of other members would be determined under Prop. Regs. Sec. 1.1502-33(d)(2), using the "wait-and-see" method.[13] If one member owes a payment to another member as a result of these allocations, that amount would be treated as indebtedness. If never paid, that amount would be treated as a distribution or contribution, or both, depending on the relationship between the two members.[14]

Example 5: During year 1, the P group would have $100 of consolidated taxable income of only S's items of income, gain, deduction and loss were considered. Federal income, taxes of $35 are paid on S's income. P's adjustment to its basis in its S stock is computed as follows:

Net taxable income in year 1        $100
Noncapital, nondeductible expense    (35)
Adjustment to P's basis in S stock   $65

Deferred expenses would not be considered noncapital, nondeductible expenses. For example, losses deferred under the wash sale provisions are not permanently disallowed and therefore would not qualify as a noncapital, nondeductible expense.[15]

A decrease in the basis of S's assets would be treated as a noncapital, nondeductible expense to the extent (1) the decrease is not otherwise taken into account in determining stock basis and (2) the decrease is not taken into account in determining S's taxable income or loss. A decrease of a loss carryover, a denial of basis for taxable income, or an increase in an ELA would be treated as equivalent to a decrease in basis for this purpose. Consequently, basis reductions under Sec. 50(c)(1), 108(b), 167(e) or Regs. Sec. 1.1502-20(b), reattributed losses under Regs. Sec. 1.1502-20(g) and unrecognized losses under Sec. 311 on a dividend distribution would be treated as nondeductible noncapital expenses. For example, a reduction in the basis of stock owned by S under Regs. Sec. 1.1502-20(b) because of a deconsolidation would be a permanent reduction in the basis of S's assets not otherwise taken into account in determining either P's basis i S's stock or S's taxable income or loss.[16]

Distributions: Distributions from a subsidiary to a higher tier member would be negative adjustments if Sec. 301 applies to the distribution. Sec. 301 applies to any distribution of property to a shareholder unless another provision under sub-chapter C (such as redemption treatment under Sec. 302 or liquidation treatment under Sec. 332) applies to the distribution. The adjustment would be taken into account when the shareholder becomes entitled to the distribution - generally, the record date. This adjustment would be reversed, as of the date of the original adjustment, if it later becomes obvious that the distribution will not be made.[17]

Tiering up of adjustments: Adjustments made by a member to its basis in its subsidiary's stock would be included by that member's parent in the parent's basis in its stock of that member. This process would eventually move the effect of the activity of the lowest tier subsidiaries to the common parent's basis of stock it directly owns in upper tier subsidiaries.[18]

Varying interests: Adjustments would be made to P's basis in its S stock only for P's percentage ownership of S's stock. If P buys or sells S's stock during the year, P would include its share of S's adjustments based on its various percentage ownership at different times during the year. Allocation of income and other adjustment items to the various time periods would be determined under Regs. Sec. 1.1502-76(b), if that regulation applies due to the subsidiary's entrance into or exit from the consolidated group. If the ownership changes do not affect the subsidiary's inclusion in the group, the allocation would be determined based on (1) actual events during the time period or (2) an equal apportionment of the subsidiary's income for the year to each day of the year.[19] Allocation of adjustments among shares of stock: The adjustments to basis would be allocated among a subsidiary's various classes of stock. The allocation must reflect the economic benefits or burdens that each class of stock bears. Some of the factors to be considered include:

* The interest of each share in economic profits and losses, if different than the interest in taxable income.

* The interest of each share in cash flow and other nonliquidating distributions.

* The interest of each share in liquidating distributions.

P's basis in each share of S's common and preferred stock would be redetermined whenever necessary to determined the tax liability of any entity. Redeterminations would generally be required to reflect the effect of cumulative but unpaid preferred dividends. In a year with net positive adjustments, a portion of the adjustments would be allocated to the preferred stock. However, in a later year with net negative adjustments, the allocation to the preferred stock for cumulative dividends has to come from a prior year's net positive adjustments, requiring a reallocation of that prior year's adjustments.[20]

The chart on page 101 provides examples of the various types of adjustments discussed above.

* Excess loss accounts

The ELA rules under Prop. Regs. Sec. 1.1502-19 would continue to be an extension of the investment adjustment rules. An ELA is created when negative adjustments exceed basis.

The owning member would recognize the ELA as income on disposition of the stock, deconsolidation or worthlessness of the stock. Generally, if P is treated as disposing of S's ELA would be taken into account by P as an amount realized on the disposition. P's recognition would be deferred if the disposition is subject to deferral provisions such as Sec. 332, unless one of the corporations or its assets are no longer included in the group. If P transfers S or S's assets outside the group, the deferral provisions would not defer the recognition of the ELA. For example, if P transfers S's stock to a nonmember in a Sec. 351 transaction, P would include the ELA in income.[21]

Worthlessness: The proposed regulation does not treat S's stock as worthless until substantially all of S's assets are treated as disposed of, abandoned or destroyed within the meaning of Sec. 165(a). An asset subject to a liability would not be treated as being worthless unless general tax law would require this result, such as in an abandonment or foreclosure.[22]

Elective basis adjustment: The current ELA rules at one time allowed P to elect to reduce its ELA in S by reducing P's basis in other obligations or stock of S. This election has been limited by Sec. 1503(e)(4) and the loss disallowance rules of Regs. Sec. 1.1502-20. The election is omitted in the proposed regulation.

(1) Proposed Treasury Decision CO-30-92 (11/12/92). (2) Prop. Regs. Sec. 1.1502-82(a) (3) Prop. Regs. Sec. 1.1502-32(b)(1) and (2). (4) Prop. Regs. Sec. 1.1502-32(b)(3). (5) Prop. Regs. Sec. 1.1502-32(b)(4)(i). (6) Prop. Regs. Sec. 1.1502-32(b)(4)(ii)(A). (7) Prop. Regs. Sec. 1.1502-32(b)(5), Example 3. (8) Prop. Regs. Sec. 1.1502-32(b)(4)(ii)(B). (9) Prop. Regs. Sec. 1.1502-32(b)(4)(ii)(C). (10) Prop. Regs. Sec. 1.1502-32(b)(5), Example 4. (11) Prop. Regs. Sec. 1.1502-32(b)(4)(ii)(D). (12) Prop. Regs. Sec. 1.1502-32(b)(4)(iii). (13) Prop. Regs. Sec. 1.1502-33(d) allow for other methods of compensating one member for another member's use of its losses or requires the use of the "wait-and-see" method for purposes of determining basis adjustments. (14) Prop. Regs. Sec. 1.1502-32(b)(4)(vii). (15) Prop. Regs. Sec. 1.1502-32(b)(4)(iii). (16) Prop. Regs. Sec. 1.1502-32(b)(4)(iii)(B). (17) Prop. Regs. Sec. 1.1502-32(b)(4)(iv). (18) Prop. Regs. Sec. 1.1502-32(b)(4)(v). (19) Prop. Regs. Sec. 1.1502-32(b)(4)(vi). (20) Prop. Regs. Sec. 1.1502-32(c). (21) Prop. Regs. Sec. 1.1502-19(b). (22) Prop. Regs. Sec. 1.1502-19(c)(1)(iii).

* Reciprocal basis adjustments

Prop. Regs. Sec. 1.1502-11(b) would limit deductions or losses of S in computing consolidated taxable income in the tax year in which P disposes of S's stock. The group's deduction for S's losses would be limited to amounts of S's losses that can be used to offset the group's taxable income. This taxable income limitation would be computed by not including the gain or loss on the sale of S's stock and not including the effect of S's losses. S's losses in excess of the limitation would become separate net operating or net capital losses arising in the year of disposition.

Example 6: On January 1, P has a $500 basis is S's stock. During the year, P has ordinary income of $30 (not including the effect of the sale of S's stock) and S has an $80 ordinary loss. On December 31, P sells S's stock for $520.

The use of S's loss is limited to P's ordinary income - $30. P's basis in its S stock is reduced to $470 and P has a $50 gain on the disposition of S's stock. Consolidated taxable income is $50 ($30 - $30 + $50). S's excess loss of $50 ($80 - $30) is a separate NOL apportioned to S and carried forward to S's separate return year.(23)

* Allocation of income between separate and

consolidated returns and elimination of the

30-day rules

Prop. Regs. Sec. 1.1502-76(b) would change the method of allocating items of income, gain, deduction, loss and credit between a corporation's separate return and consolidated return in a year a corporation is acquired or ceases to be a member of the group. In general, the regulation would require a midyear closing to determine includible items. However, by affirmative election of the taxpayer, these items could be ratably allocated to the consolidated and separate years based on the number of days in the member's original year.

The proposed regulation would require that extraordinary items be allocated to the day that they affect income. Extraordinary items include income, gains or losses derived from the following:

* Disposition of capital assets, as defined in Sec. 1221.

* Disposition of assets used in a trade or business, as defined in Sec. 1231(b) (determined without the application of any holding period requirement).

* Other assets described in Sec. 1221, if substantially all the assets in a category are disposed of in one transaction or a series of transactions.

* Assets disposed of in an applicable asset acquisition, as defined in Sec. 1060(c).

* Net operating or net capital losses carried to or from any portion of the original year and any Sec. 481 (a) adjustment.

* Certain effects of a change in accounting method.

* Discharge of indebtedness.

* Interest expense allocable under Sec. 172(h) to a corporate equity reduction transaction causing the allocation rules to apply.

* Credit arising from activities or items not ratably allocated, such as rehabilitation credit based on the date placed in service.

* Deemed income inclusion from a foreign corporation or deferred tax amount on an excess distribution from a passive foreign investment company under Sec. 1291.

* Any item which, in the IRS's opinion, would, if ratably allocated, result in a substantial distortion of income.(24)

* Stock basis after a group structure change

Prop. Regs. Sec. 1.1502-31 would replace the former final regulation entitled "Basis of property" and the temporary regulation entitled "Basis of stock of subsidiary." The proposed regulation generally provides rules for adjusting members' basis in the stock of the former common parent when another corporation succeeds the former common parent in a group structure change.(25)

A group structure change is defined as a transaction in which - the old parent ceases to exist because all of its assets are transferred to other group members and the group continues under Regs. Sec. 1.1502-75(d)(2); 75(he old parent ceases to exist because of a mere change in identity, form or place of organization in a Sec. 368(a)(1)(F) reorganization and the group continues under Regs. Sec. 1.1502-75(d)(2); or - the old parent is succeeded by a new parent because a reverse acquisition, as defined in Regs. Sec. 1.1502-75(d)(3), occurs.

If a corporation acquires the former common parent's assets (and any liabilities) in a group structure change, the member's basis in the stock of the acquiring corporation would be adjusted to reflect the former common parent's net basis in the assets. If a corporation acquires stock of the former common parent in a group structure change, the corporation's basis in the former common parent's stock would generally be adjusted to reflect the former common parent's net asset basis. In an asset acquisition, basis in stock held before the change would not be taken into account.(26)

Appropriate adjustments would be made for consideration not provided by the member, receipts of less than all of the former common parent's assets, ownership of less than all of the former common parent's stock, multiple classes of stock, and members in different tiers of the group owning stock of the former common parent.(27)

E&P adjustments would also be required in a group structure change. The change are discussed in the section "Replicating E&P," below.

Example 7:P is the common parent of one group and T is the common parent of another group. T has assets with an aggregate basis of $60 and fair market value of $100, and no liabilities. T's shareholders have an aggregate basis of $50 in T's stock. Pursuant to a plan, P forms S and T mergers into S, with the T shareholders receiving P stock in exchange for their T stock. The transaction is a triangular merger under Sec. 368(a)(1)(A) and (a)(2)(D). It is also a reverse acquisition under Regs. Sec. 1.1502-75, which characterizes the transaction as a group structure change.aaa

P's basis in S's stock is adjusted to reflect T's net asset basis. Consequently, P's basis in the S stock immediately after the transaction is $60, the aggregate basis T'S assets.(28)

See example 8 on page 103 for an all-inclusive illustration of the effect of transaction on taxable income and E&P.

Proposed Rules for Determining

the Group's E&P

* Direct tiering up of E&P

The principal purpose of the E&P provisions in the consolidated return regulations is to reflect the E&P of the entire group in the E&P of the common parent for the purpose of determining the character of distributions made to the shareholders of the common parent. Unlike the current system, the proposed system would be separate from the investment adjustment system.

In general, the E&P of each member would continue to be determined by applying the general provisions of law, including the provisions of Sec. 312. For example, depreciation is computed under the straight-line method as required in Sec. 312(k).

Prop. Regs. Sec. 1.1502-33, on E&P, refers to principles discussed in detail in Prop. Regs. Sec. 1.1502-32, on the investment adjustment system. The principles applicable to the investment adjustment rules would be applied to the E&P adjustment for purposes of tiering up E&P from lower tier subsidiaries to upper level subsidiaries and ultimately to the common parent, and allocating E&P among shares of stock.

* Retention of tax-sharing agreement rules

The tax-sharing agreement rules of current Regs. Sec. 1.1502-33 would be retained. The proposed regulation contains the same elective methods but in a rewritten form to improve comprehension. Additional provisions affecting the allocation of alternative minimum tax are included in proposed regulations issued in December 1992.(29)

* Eliminating E&P

The E&P elimination rules would deal with the effect of dividends paid after a former member becomes a nonmember. Under Prop. Regs. Sec. 1.1502-33(e)(1), E&P of a subsidiary would generally be eliminated immediately before the subsidiary becomes a nonmember. No adjustment would be made to the E&P of members owning subsidiary stock.

The subsidiary's E&P would not be eliminated if the group is acquired in the following situations:

* The stock or assets of the group's common parent are acquired in a nontaxable reorganization and, immediately thereafter, there is a surviving group that become a consolidated group.

* The parent ceases to exist because all of its assets are transferred to other group members and the group continues under Regs. Sec. 1.1502-75(d)(2).

* The parent ceases to exist because of a mere change in identity, form a place or organization in a Sec. 368(a)(1)(F) reorganization and the group continues under Regs. Sec. 1.1502-75(d)(2).

* The old parent is succeeded by a new parent due to a reverse acquisition as defined in Regs. Sec. 1.1502-75(d)(3).(30)

In a corporate reorganization under Sec. 368(a)(1)(C) or (D) or a separation under Sec. 355, Sec. 312(h) would require an allocation of E&P between the resulting corporations. Prog. Regs. Sec. 1.1502-33(e)(3) requires that an appropriate amount of E&P be eliminated and that P's E&P may be eliminated rather than S's E&P.

Example 9: distributes S's stock in a Sec. 355 transaction. A portion of P's E&P may be properly allocable to the resulting nonmember corporation and must be eliminated immediately prior to the transaction. S's E&P is not eliminated in this case.(31)

* Replicating E&P

The replication rules would ensure that the E&P of a group's common parent reflects the E&P of the entire group. The E&P of a new common parent would be adjusted to reflect the E&P of the old common parent immediately before the change if: 1. The old parent ceases to exist because all of its assets are transferred to other group members and the group continues under Regs. Sec. 1.1502-75(d)(2); 2. The old parent ceases to exist because of a mere change in identify, form or place of organization in a Sec. 368(a)(1)(F) reorganization and the group continues under Regs. Sec. 1.1502-75(d)(2); or 3. The old parent is succeeded by the new parent because a reverse acquisition, as defined in Regs. Sec. 1.1502-75(d)(3), occurs. The adjustment would be made as if the new common parent succeeds to the E&P of the old common parent in a transaction described in Sec. 381(a).(32)

Example 10: P is the common parent of a group with $100 of E & P. X is the common parent of another group and has $20 of E&P. X acquires all of the stock of P in exchange for 70% of X's stock, with the former P shareholders becoming X shareholders. The exchange is a reverse acquisition and the P group is treated as remaining in existence with X as the new common parent. X's E&P is adjusted to include P's E&P. After the transaction, X has $120 of E&P. P continues to have $100 of E&P. Although the X group terminates on X's acquisition of P's stock, no adjustments are made to the E&P of any of the members of the X group other than X.(33)

Transition Rules and Miscellaneous Provisions

* Effective dates

The investment adjustment regulation would generally apply to the determination of stock basis in connection with a stock disposition after the date the final regulations are issued. For dispositions and other transactions to which this regulation applies, basis and ELAs would be determined or redetermined as if the regulation were in effect for all consolidated return years of the group.

However, the effect of some provisions of the regulations before this amendment would continue to be applied in making redeterminations of basis after the proposed regulations take effect. Gains or losses from dispositions of S stock by P before the effective date would not be redetermined. Deferred amounts under the deferred intercompany transaction rules(34) and the intercompany distribution rules(35) would be treated as if the disposition occurred at the time the gain or loss it taken into account. The deemed distribution and recontribution under a deemed dividend election before the final issuance of the new regulation would continue to be treated as a distribution and recontribution. Distributions out of E&P before the effective date that did not cause of negative adjustment to basis would not be treated as a negative adjustment in the redetermination of basis under the new regulation.(36)

The E&P regulation would generally apply to the determination of E&P in connection with group changes after the date the final regulations are issued. For transactions to which this regulation applies, E&P would be determined or redetermined as if the regulation were in effect for all consolidated return years of the group. The deemed distribution and recontribution under a deemed dividend election before the final issuance of the new regulation would continue to be treated as a distribution and recontribution. These provisions would not prevent an increase in an owning member's E&P as a result of distributions out of a subsidiary's E&P before the effective date that did not cause a negative adjustment to basis. However, complex provisions may require that redeterminations after the effective date be affected by transactions completed before the effective date.(37)

Prop. Regs. Sec. 1.1502-31 would apply to group structure changes occurring after the final regulations are issued.(38)

Prop. Regs. Sec. 1.1502-11(b), relating to the elimination of circular stock basis adjustments, would apply to consolidated return years beginning on or after the date the regulations are made final.(39)

Prop. Regs. Sec. 1.1502-76(b), relating to allocation between separate and consolidated returns and eliminating the 30-day rules, would apply to corporations becoming or ceasing to be members of consolidated groups on or after the date the final regulations are issued.(40)

* Overriding adjustments

Prop. Regs. Sec. 1.1502-32(e)(1) provides that adjustments would be made as necessary to carry out the purposes of the proposed investment adjustment system. The regulation cites specific examples of situations requiring overriding adjustments: the transfer of appreciated or depreciated assets, or the deconsolidation of a corporation to manipulate the effect of the system.(41)

The E&P regulation contains a similar provision. Adjustments would be made to carry out the purposes of the regulation if any person acts with a principal purpose to avoid its effect.(42)

* Predecessors and successors

For purposes of the investment adjustment rules, the stock of predecessors and successors of a corporation would be treated as the stock of the corporation. To be included in the definition of a predecessor or successor, the basis of the successor stock must be determined with references to the basis of the predecessor stock.

The ELA rules,(43) the E&P rules(44) and the rules related to basis after a group structure change(45) all contain similar provisions.

* Annual reporting

A statement entitled "Statement of Adjustments Under [sections] 1.1502-32(g)" would be required to be attached to the consolidated group's tax return each year. The statement must contain:

1. The name and employer identification number of each subsidiary with respect to which adjustments under this section may be made;

2. The net amount of the adjustment with respect to the subsidiary's stock under the regulations for the consolidated return year or other period;

3. The allocation of the basis adjustment among the shares of the subsidiary's stock owned by members; and

4. A description of any reallocation of adjustments or redeterminations.(46)

Planning Opportunity

Affiliates groups with a history that includes separate return years should consider a deemed dividend election. The primary effect of such an election is to increase an owning member's basis in a subsidiary. The new regulations, if adopted, would respect a deemed dividend election occurring before the adoption date of the regulations.

Conclusion

The proposed regulations, if adopted, would serve to simplify basis computations by members of a consolidated group. However, additional computational and reporting requirements would add to a business's recording-keeping requirements. On the whole, the regulations propose a rational system of investment adjustments that would solve many problems in a comprehensive manner.

Types of Adjustments

Examples of tax-exempt income:

1. Interest excluded from gross income under Sec. 103. 2. Discharge of indebtedness income under Sec. 108 to the extent (a) the discharged amount is applied to reduce tax attributes under Secs. 108(b) and 1017 and (b) the attribute reduction is treated as a noncapital, nondeductible expense. 3. Proceeds of life insurance contracts payable by reason of death excluded under Sec. 101(a)(1). 4. Basis increase under Sec. 50, relating to ITC recapture.

Examples of equivalent deductions (treated as tax-exemption income): 1. Dividends-received deduction under Sec. 343, unless accompanied by a basis reduction under Sec. 1059. 2. Percentage depletion in excess of basis under Sec. 613.

Examples of noncapital, nondeductible expenses: 1. Federal taxes described in Sec. 275, including Federal income taxes. 2. Basis reductions under Sec. 50, relating to ITC. 3. Basis reductions under Sec. 108, relating to a discharge of indebtedness. 4. Basis reductions under Sec. 167(e) relating to depreciation on a term interest when the remainder interest is held by a related individual. 5. Basis reductions under Regs. Sec. 1.1502-20(b), relating to stock retained on deconsolidation of a subsidiary. 6. Losses reattributed under Regs. Sec, 1.1502-20(g), relating to disallowed losses on the disposition of a subsidiary. 7. Losses realized but not recognized under Sec. 311, relating to depreciated property distributed as a dividend. 8. Deductions disallowed under Sec. 265, relating to the production of tax-exempt income.

Example 8: Effect of Transactions on Taxable Income and E&P

On January 1 of year 1, P forms S with an investment of $1,000. P owns all of S's stock for the entire year. S has only one class of stock outstanding. S owns no stock of lower tier members. The P group files consolidated returns on a calendar-year basis.

In year 1, the P group has consolidated taxable income. The P group have $500 of taxable income if only S's items of income, gain, deduction and loss were considered. For purposes of computing E&P, the P group would have $650 of income if only S's items of income, gain, deduction and loss were considered, because straight-line depreciation expense is $150 less than the amount allowed for regular tax purposes. On January 1 of year 2, S makes a distribution of $500 to P. On January 2 of year 2. P sells its S stock for $1,200 and, alternatively, for $900.

S's taxable income would increase P's basis in the S stock by $500.(1) Because of the difference in regular tax depreciation and E&P depreciation, S's E&P would increase by $650, with a corresponding increase in P's E&P.(2)

The $500 distribution by S to P would result in a $500 dividend(3) to P that would have no effect on the group's taxable income; it would be eliminated in consolidation. However, the effect f the dividend income would be to increase P's E&P. The distribution would result in a $500 reduction in S's E&P with a resultant reduction in P's E&P. It would also result in a $500 reduction in P's basis in its S stock.(4)

P's sale of S's stock for $1,200 would result in a gain of $200 ($1,200 - $1,000), with its basis in the S stock reduced to zero. P's gain for E&P purposes would be recomputed due to the different E&P adjustment when taxable income for year 1 was recorded.(5) P's E&P "basis" would be $1,150, resulting in an E&P "gain" of only $50. S's E&P would be eliminated immediately before the sale.(6)

The results for P's sale of S's stock for $900 would be similar, except that the resulting loss would be disallowed.(7)

The chart below summarizes this scenario.

Abbreviations Commonly Used in The Tax Adviser

TTA The Tax Adviser AFTR2d American Federal Tax Reports,

second series (Prentice-Hall) Ann. IRS Announcement CB Cumulative Bulletin Cir. Court of Appeals Cl. Ct. Claims Court COBRA Consolidated Omnibus Budget

Reconciliation Act of 1985 Cong. Rec. Congressional Record DC District Court DRA Deficit Reduction Act of 1984 ERISA Employee Retirement Income

Security Act of 1974 ERTA Economic Recovery Tax Act of 1981 Fed. Reg. Federal Register F2d Federal Reports, second series F Supp Federal Supplement GCM General Counsel's Memorandum H. Rep. House Ways and Means

Committee Report IR Internal Revenue News Release IRB Internal Revenue Bulletin LTR IRS Letter Ruling PL Public Law Regs. Sec. Treasury Regulation Rev. Proc. Revenue Procedure Rev. Rul. Revenue Ruling RRA  Revenue Reconciliation Act of 1990 Sec. Section (refers to the Internal

Revenue Code of 1986 unless

otherwise indicated) S. Rep. Senate Finance Committee Report SSRA Subchapter Revision Act of 1982 Sup. Ct. Supreme Court TAM Technical Advice Memorandum TAMRA  Technical and Miscellaneous

Revenue Act of 1988 TC Tax Court (regular decision)

TC Memo Tax Court (memorandum decision)

TD Treasury Decision TEFRA  Tax Equity and Fiscal

Responsibility Act of 1982 TRA  Tax Reform Act of 1986 USTC  United States Tax Cases

(Commmerce Clearing House)

(23) Prop. Regs. Sec. 1.1502-11(b)(2)(iii), Example 1. (24) Prop. Regs. Sec. 1.1502-76(b)(2)(C). (25) Prop. Regs. Sec. 1.1502-31(a). (26) Prop. Regs. Sec. 1.1502-31(b). (27) Prop. Regs. Sec. 1.1502-31(d). (28) Prop. Regs. Sec. 1.1502-31(f), Example 1 (29) 57 FR 62251 (12/30/92). (30) Prop. Regs. Sec. 1.1502-33(e)(2). (31) Prop. Regs. Sec. 1.1502-33(e)(5), Example (e). (32) Prop. Regs. Sec. 1.1502-33(f)(1). (33) Prop. Regs. Sec. 1.1502-33(f)(4), Example 1. (34) Regs. Sec. 1.1502-13 and Temp. Regs. Sec. 1.1502-13T. (35) Regs. Sec. 1.1502-14 and Temp. Regs. Sec. 1.1502-14T. (36) Prop. Regs. Sec. 1.1502-32(h). (37) Prop. Regs. Sec. 1.1502-33(j). (38) Prop. Regs. Sec. 1.1502-31(g). (39) Prop. Regs. Sec. 1.1502-11(b)(5). (40) Prop. Regs. Sec. 1.1502-76(b)(4). (41) Prop. Regs. Sec. 1.1502-32(e)(2) and (3). (42) Prop. Regs. Sec. 1.1502-33(g). (43) Prop. Regs. Sec. 1.1502-19(f). (44) Prop. Regs. Sec. 1.1502-33(h). (45) Prop. Regs. Sec. 1.1502-31(e). (46) Prop. Regs. Sec. 1.1502-32(g).