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Comments on temporary regulations under section 1502 relating to intercompany transactions and distributions of property.

Comments on Temporary Regulations under Section 1502 Relating to Intercompany Transactions and Distributions of Property

On March 9, 1990, the Internal Revenue Service issued temporary and proposed regulations under section 1502 of the Internal Revenue Code, relating to deferred intercompany transactions and distributions of property among members of an affiliated group filing consolidated return. The temporary (designated "temporary and final") regulations (T.D. 8295) were published in the Federal Register on March 14, 1990 (55 Fed. Reg. 9420), and in the April 16, 1990, issue of the Internal Revenue Bulletin (1990-16 I.R.B. 6); the proposed regulations (CO-008-90) were also published in the Federal Register on March 14, 1990 (55 Fed. Reg. 9462), and in the April 16, 1990, issue of the Internal Revenue Bulletin (1990-16 I.R.B. 19).

For simplicity's sake, the regulations are generally referred to as "the temporary regulations" and specific provisions are cited as "Temp. Reg.[Section]." References to page numbers are to the temporary regulations (and preamble) as published in the Internal Revenue Bulletin.

I. Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our nearly 4,500 members represent more than 2,000 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of tax laws, and to reducing the costs and burdens of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works - one that is both administrable and with which taxpayers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax laws relating to the operation of business enterprises. We believe that our diversity and the professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the temporary regulations relating to intercompany transactions and distributions of property for purposes of the consolidated return regulations.(1)

II. Restoration of Deferred Gain

The temporary regulations provide rules concerning the restoration of deferred gain or loss relating to intercompany transactions and distributions of property among members of an affiliated group filing a consolidated return. The regulations endeavor to confirm the original intent of the deferral mechanism - that is, to promote neutrality so that the overall tax consequences to the group are not generally affected by transfers of property among members. 1990-16 I.R.B. at 7.

Temp. Reg. [Section] 1.1502-14T(c)(1) provides that the gain deferred with respect to a distribution of a subsidiary's stock from one member to another shall be taken into account -

(i) upon a disposition ... of the

stock of the subsidiary in an

amount equal to the amount

that would have created or

increased the excess loss account

if the adjustment to the

basis (or the excess loss account)

of the stock of the subsidiary

resulting from the

distribution had not occurred,


(ii) following a disposition, to the

extent distributions with respect

to any stock owned by a

member would exceed the

basis of such stock if the adjustment

to the basis of the

stock resulting from the distribution

had not occurred.

The temporary regulations provide an example - Example 1 under Temp. Reg. [Section] 1.1502-14T(c)(2) - whereby in Year 1 a member of an affiliated group (S) distributes stock of another member (T) (with a basis of $1,000 and a fair market value of $10,000) to the parent (P), creating a section 311(b) gain of $9,000 that is deferred under the consolidated return regulations. P's basis in the T stock is equal to its $10,000 fair market value. Although T has no earnings and profits, in Year 2 T borrows $9,000 which it distributes to P, reducing P's basis to $1,000. In Year 3, T has undistributed earnings and profits of $1,000. When T becomes disaffiliated at the end of Year 3 (through the issuance of stock to a third party), S's deferred intercompany gain must be restored into income, even though P has not disposed of its T stock. The amount of such gain is $7,000 since the $9,000 distribution would have resulted in a $7,000 excess loss account if the basis of the T stock had not been stepped up as a result of the distribution of T's stock to P ($1,000 adjusted basis, minus $9,000 distribution, plus $1,000 undistributed earnings and profits). See Temp. Reg. [Section] 1.1502-14T(c)(2), Example 1.

TEI believes that Temp. Reg. [Section] 1.1502-14T(c)(1)(ii) is too sweeping in scope. TEI's concerns can be illustrated by modifying Example 1 to show the effect if T does not borrow the $9,000 which is distributed to P, but rather makes a distribution to P out of current and accumulated earnings and profits. Consider the following:

Assure that in Year 2 T does

not borrow and distribute the

$9,000 to P. In that event, P's

basis in the T stock will remain

at $10,000. Assume further

that in Year 3, T has $1,000 of

undistributed earnings and

profits and that at the end of

Year 3, T issues stock to X (so

that X becomes a 30-percent

shareholder of T), thereby

causing a disposition of stock

under Treas. Reg. [section] 1.1502-19.

Finally, assume that T has

$5,000 of current earnings and

profits in Year 4. If T distributes

$7,000 to P (and $3,000 to

X) at the end of Year 4, what is

the correct amount of deferred

gain that should be recognized?

In the above modified example, $4,200 of the $7,000 distribution to P constitutes a dividend under section 301(c)(1) to the extent of P's 70-percent share of T's current ($5,000) and accumulated ($1,000) earnings and profits. Under Temp. Reg. [Section] 1.1502-32T(a)(3), the dividend reduces the basis of the stock by the amount of the net prior investment adjustments ($1,000) to $10,000. The balance of the distribution ($2,800) is applied against P's basis in accordance with section 301(c)(2), thereby reducing P's basis in the T stock to $7,200.

In modified Example 1, if the stock distribution had not occurred in Year 1, the basis of the T stock immediately after deconsolidation in Year 3 would be $2,000, rather than $11,000. The $7,000 distribution in Year 4 would still represent a $4,200 divided (reducing the basis of the T stock to $1,000 under Temp. Reg. [Section] 1.1502-32T(a)(3)). The remainder of the distribution ($2,800) should operate under section 301(c)(2) to reduce S's basis in the stock to $0 and under section 301(c)(3) to generate gain to S of $1,800.

Thus, but for the distribution of T stock to P in Year 1, the $7,000 distribution in modified Example 1 would exceed S's basis in the T stock by $1,800. Consequently, as a result of the T stock distribution, the P group would derive a benefit that should warrant restoring no more than $1,800 of the deferred section 311(b) gain under Temp. Reg. [Section] 1.1502-14T. The temporary regulations should thus be modified to provide that deferred section 311(b) gain must be taken into income to the extent that the section 311(b) distribution causes a portion of the post-disposition distributions to be treated as a reduction in basis under section 301(c)(2), rather than as a taxable gain under section 301(c)(3). Of course, if the T stock were sold, the restoration rules of the consolidated return regulations would require that the remaining $7,200 of deferred section 311(b) gain be taken into income.

A literal reading of Temp. Reg. [Section] 1.1502-14T(c)(1)(ii) apparently requires that $5,000 of section 311(b) gain be recognized. This result is clearly unwarranted. Deferred gains should be triggered only to the extent that the basis increase resulting from the stock distribution reduced the amount of gain which otherwise would have been recognized. In the above modified example, this would be limited to $1,800.

In light of the foregoing, TEI recommends that post-disposition distributions should trigger a restoration of the deferred gain only to the extent that such distributions would be characterized as a section 301(c)(3) gain had the adjustment to the stock basis resulting from the section 311(b) distribution not occurred. Such an approach would be consistent with the regulations' purpose of ensuring that the deferral provisions operate as intended.

TEI thus recommends that Temp. Reg. [Section] 1.1502-14T(c)(1)(ii) be amended to read, as follows:

(ii) following a disposition, to the

extent distributions with respect

to any stock owned by a

member would have been

treated as gain under section

301(c)(3) had the adjustment

to the basis of the stock resulting

from the distribution

not occurred.

III. Long-Term Contracts

The temporary regulations provide a special rule for long-term contracts subject to section 460 of the Code (which generally requires use of the percentage-of-completion method of accounting). Under Temp. Reg. [Section] 1.502-13T(n), the deferral rule does not apply to gain or loss attributable to any income and expense (i) accounted for in accordance with the percentage-of-completion method and (ii) arising from any activity performed by the selling member for the benefit of a long-term contract entered into between a member and a third party. Thus, the temporary regulations provide that if a parent company enters into a long-term contract required to be accounted for under the percentage-of-completion method, any subsidiary supplying goods and services to the parent in connection with that contract must report its income under the percentage-of-completion method and cannot defer gain under Treas. Reg. [section] 1.502-13(c).

The temporary regulations supplement Notice 89-15, 1989-1 C.B. 634, which requires a taxpayer with a manufacturing contract to take into account all activities of related parties for purposes of determining whether the contract is more than 12 months in duration (and thus subject to percentage-of-completion reporting rules). Notice 89-15, Q&A 5. The notice also requires the related party to account for the transaction as a long-term contract subject to the percentage-of-completion rules. Notice 89-15, Q&A 8.

Section 460(h) of the Code provides the Secretary with authority to prescribe regulations necessary to prevent the use of related parties to avoid application of section 460. The legislative history of section 460(h) provides:

For example, the committee

anticipates that these regulations

will consider the production

activities of related parties

in determining whether a

manufactured item normally

requires more than 12 calendar

months to complete. In addition,

it is anticipated that

these regulations generally will

consider costs incurred by related

parties in determining

the percentage of any long-term

contract that is completed during

any taxable year.

H.R. Rep. No. 100-795, 100th Cong., 2d Sess. 470 (1988).

Consider the following example: Assume a parent company (P) agrees to manufacture an item for a third-party customer (C). P's subsidiary (S) enters into a contract to supply certain components that take seven months to manufacture. Once the manufactured components and other materials are delivered, it will take P an additional eight months to complete the manufacturing process.

Pursuant to the legislative history of section 460(h), the regulations may properly require P to "tack" its manufacturing time onto S's time, resulting in a 15-month contract subject to the percentage-of-completion rules. It may also be appropriate to require that P include the price paid to S for the components for purposes of estimating P's total contract costs and determining its costs incurred to date. There is no authority, however, for requiring S to use the percentage-of-completion method in respect of its contract with P and for eliminating the deferral of gain on the P-S intercompany transaction.

TEI submits that S should be permitted to defer recognition of all gain until such time as the revenue it generates on the intercompany sale is recognized as a deduction by P. This will occur when P is required to report as a cost any amount it properly accrues as payable to S. See Notice 89-15, Q&A 8. This approach is analogous to permitting deferral of gain recognition until the related member recognizes income on a sale to an unrelated person.

TEI also recommends that a special rule be adopted in respect of subcontracts. Under section 460(b)(5) of the Code, percentage-of-completion reporting is not required for long-term contracts until 10 percent of the forecasted costs have been incurred. A similar 10-percent rule should be adopted for tacking completion time of subcontracts: if a subcontract with a related party represents less than 10 percent of the estimated costs, the time for completion of that subcontract should not be added to the time for completion of the principal contract. In addition, gain or loss on the contract should continue to be deferred under Treas. Reg. [Section] 1.1502-13(c). To prevent abuse of this rule, the regulations could place a limit on the number of subsidiaries that could come within this safe harbor.


Tax Executives Institute appreciates this opportunity to present its views on the temporary regulations relating to intercompany transactions and distributions of property for purposes of the consolidated return regulations. If you should have any questions, please do not hesitate to call either Lester D. Ezrati, Chair of TEI's Federal Tax Committee, at (415) 857-2089, or TEI's professional staff (Timothy J. McCormally or Mary L. Fahey) at (202) 638-5601.

(1) The temporary regulation were issued on March 9, 1990, without prior notice and public hearing as required by the Administrative Procedure Act (APA). TEI's concerns about issuance of temporary regulations in violation of the APA, which were most recently expressed in its June 19, 1990, comments concerning the loss disallowance regulations (under Temp. Reg. [Section] 1.1502-20T), are equally applicable here.
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Publication:Tax Executive
Date:Sep 1, 1990
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