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Consolidated returns: post-tax reform developments.

Consolidated Returns: Post-Tax Reform Developments (*1)

I. Introduction

A basic principle of the consolidated return regulations is that members of an affiliated group [1] should be treated as a single entity for income tax purposes. For example, losses of one member of an affiliated group may be offset against the profits of other members, and intercompany gains may be deferred until the property involved or the selling member leaves the group.

The drafters of the consolidated return regulations now face the burdensome task of implementing, and in some instances reconciling, this single entity theory with the vast legislative reform of the separate entity rules in 1986 and 1987. Most notably, this task involves (a) applying the single entity theory to the new net operating loss ("NOL") and credit carryover rules (sections 382-84 of the Internal Revenue Code), and (b) determining the extent to wich the investment adjustment rules of the consolidated return regulations should be used to conform the outside stock basis of a subsidiary member's stock to the member's inside net asset basis after repeal of the section 312(k) benefit in determining stock basis (section 1503 (e)) and the General Utilities doctrine (amendments to sections 336-38). These issues are discussed in Part II below.

In keeping with the pace of legislative developments, the Internal Revenue Service has been active in amending the consolidated return regulations. The most significant of these amendments involve (a) deferral provisions for taxable mirror liquidations (Temp. Reg. [subsection] 1.1502-13T and 1.1502-14T); (b) more focused anti-dividend-stripping rules that eliminate the harsh consequences of the previous rules when an owning member continues to own stock of a former subsidiary member (Treas, Reg. [subsection] 1.1502-32T); and (c) new reverse acquisition and intragroup restructuring rules aimed primarily at potential abuses when an affiliated group has a new common parent (Temp. Reg. [subsection] 1.1502-31T, 1.1502-33T, and 1.1503-77T). These new provisions are outlined in Part III below.

II. Single Entity Theory

A. Amendments to Section 382

and New Section 383

Section 382, as amended by the Tax Reform Act of 1986 (the "1986 Act"), provides for a "section 382 imitation" on the ability of a loss corporation to utilize its pre-change losses after an ownership change. In general, the section 382 limitation for any post-change year is equal to the value of the loss corporation immediately before the ownership change multiplied by the long-term tax-exempt rat. In addition, if the loss corporation does not continue its business enterprise for two years after the ownership change, the section 382 limitation is generally zero. Special rules also are provided for built-in losses, built-in gains, and section 338 gain. Section 383 directs the Treasury Department to adopt conforming rules for credit carryovers.

Example 1 was used by Robert J. Mason, Branch Chief, Legislation and Regulations Division, Office of Chief Counsel, Internal Revenue Service, at the IRS National Office--Tax Practitioner's Technical Roundtable (May 15, 1988) to illustrate the single entity approach for applying IRC section 382 in a consolidated return context. According to Mr. Mason:

1. An ownership change as to P would be an ownership change as to all members of P's affiliated group. Thus, even if B had purchased only 51 percent of P, S2 would be subject to the section 382 limitation even though the indirect stock ownership off B in S2 would be less than 50 percent.

2. A consolidated section 382 limitation of $160 per year ($1,500 fair market value of P, plus the $500 value of the minority interest in S2, multiplied by 8 percent would apply after the ownership change. The theory for including the value of the S2 minority interest in the loss corporation value is that S2's losses available to the affiliated group are not limited by the existence of the minority interest.

3. A consolidated continuity of business enterprise rule would apply after the ownership change. Thus, if S1 discontinued its business within two years after the purchase of P's sock by B, the continuity of business requirement of section 382(c)(1) could be satisfied with respect to the entire consolidated loss carryover by either P or S2.

The Conference Report to the 1986 section 382 amendments supports continued application of the separate return limitation year ("SRLY") and consolidated return change-of-ownership ("CRCO") limitations of the consolidated return regulations. See H. Rep. No. 99-841, 99th Cong., 2d Sess., II-194 (1986). Under the SRLY rule, the net operating loss carryovers or carrybacks of a new or former member of an affiliated group can only be used against the portion of the group's consolidated taxable income that, under the applicable rules, is attributable to that member. Treas. Rep. $S 1.1502-21(c). Mr. Mason predicted, however, that if the SRLY rule is continued, it probably should be changed to apply on a subgroup basis rather than a company-by-company basis. Thus, if the P group in Example 1 were purchased by another common parent filing a consolidated return, the income of all members of the former P group should be available, subject to the section 382 limitation, to absorb the P group's SRLY loss.

A CRCO occurs during a taxable year if, at the end of such year, (1) one or more persons described in section 382(a)(2) of the 1954 Code own a percentage of the common parent's stock that is more than 50-percentage points greater than they owned at the beginning of either the taxable year or the preceding taxble year, and (2) such increase in ownership is due to a purchase of such stock or a decrease in the amount of stock outstanding. Treas. Reg. [subsection] 1.1502-1(g). If a CRCO occurs, the NOL arising in taxable years before the CRCO can be used only to offset the income of the old members of the group. Treas. Reg. [subsection] 1.1502-21(d). Mr. Mason questioned whether the CRCO limitation should survive since revised section 382 addresses the same concept. If the CRCO rules are continued, they will need substantial redrafting. [2]

B. New Section 384

Section 384, added by the Revenue Act of 1987 (the "1987 Act"), limits the ability to offset built-in gains of one corporation against the preacquisition losses of a second corporation. If new section 384 applies to an acquisition, [3] income for any recognition period taxable year (to the extent attributable to recognized built-in gains) may not be offset by any preacquisition loss (other than a preacquisition loss of the gain corporation). See section 384(c) for definitions of terms. An exception to these rules is provided for preacquisition losses of a corporation if the corporation and the gain corporation were members of the same controlled group (as defined in section 384(b)) at all times during the five-year period ending on the acquisition date.

The 1988 Bill would clarify that the single entity approach would govern the application of section 384 to an affiliated group. Under proposed section 384(c)(6), all members of the same affiliated group immediately before the acquisition date would be treated as one corporation, except as provided in regulations and certain successor rules. To the extent provided in regulations, an affiliated group for this purpose would include corporations that would be members but for the exclusions in section 1504(b).

Example 2: All the stock of G, a gain corporation, was acquired by P, the common parent of an affiliated group, in 1986 before the effective date of IRC section 384. If proposed section 384(c)(6) is enacted, under a single entity approach all the members of the P group would be treated as a single corporation; thus, it should be possible to subsequently transfer the assets of G to another member of P's affiliated grop in a section 368(a)(1)(D) reorganization without section 384 coming into play.

C. Inside v. Outside Basis Rules

Under the single entity theory, subsidiaries of an affiliated group should be treated as if they were divisions of the common parent. Reconciling the actual existence of stock of subsidiaries with the single entity theory raises conceptual difficulties for the drafters of the consolidated return regulations. The 1987 legislation may have started a movement toward conforming outside stock basis of a member subsidiary to its inside net asset basis.

1. New Section 1503(e). Under the investment adjustment rules of Treas. Reg. [section] 1.1502-32, the basis of the stock of a member subsidiary is adjusted annually. The adjustments reflect changes in the subsidiary's undistributed earnings and profits rather than its taxable income. The owning member increases its basis in the stock of a subsidiary by the amount of the subsidiary's undistributed earnings and profits for the taxable year or reduces its basis in such stock by the amount of any deficit in earnings and profits (at least where the subsidiary's loss is utilized by the affiliated group).

Although the investment adjustment rules generally maintain the original balance between the net asset basis of a subsidiary (including its NOL carryovers) and the owning member's stock basis, section 312(k) produced glaring disparities between outside stock basis and inside net asset basis before the enactment of section 1503(e) by the 1987 Act. These disparities were due to timing differences between tax depreciation and earnings and profits depreciation. Section 312(k) generally provides that, for earnings and profits purposes, a corporation's depreciation shall be deemed to be the amount that would be allowable using the straightline method. If accelerated depreciation is used for income tax purposes, the depreciation charge to earnings and profits in the initial years of an asset's life would be less than the amount of depreciation deducted for income tax purposes. Since investment adjustments are dependent upon earnings and profits, the reduction in the basis of the subsidiary member's stock as a consequence of depreciation in those years would be less than the reduction in the basis of the subsidiary member's assets. Prior to the enactment of new section 1503(e), this difference (the "section 312(k) benefit" resulted in less taxable gain if the stock instead of the subsidiary's assets were sold. [4] See Woods Investment Co. v. Commissioner, 85 T.C. 274 (1985). Section 1503(e) eliminates this section 312(k) benefit by disregarding section 312(k) for purposes of determining gain or loss on the disposition of "intragroup stock" (as defined by section 1503(e)(2)).

Section 1503(e) is effective for any intragroup stock disposed of after December 15, 1987, subject to certain grandfathering rules.

Prior to the enactment of section 1503(e), there was a potential section 312(k) detriment with respect to property acquired by a corporation before it became a member of an affiliated group. In such a case, the charges to earnings and profits for depreciation after affiliation would be greater than the depreciation allowed for income tax purposes. Section 1503(e), as enacted in 1987, would also eliminate any section 312(k) detriment in determining intragroup stock basis. Proposed section 1503(e)(3)(A), as part of the 1988 Bill, however, would authorize regulations making "proper" adjustments in the application of section 1503(e) with respect to any property acquired by the member before affiliation. Thus, the proposed technical correction would allow Treasury to force affiliated groups to bear the burden of an section 312(k) detriment. The legislative history does not state when or under what circumstances it is "proper" for affiliated groups to bear this section 312(k) detriment, although the legislative history does state that inheriting the section 312(k) detriment should not depend on whether the seller derived any corresponding section 312(k) benefit. See H.R. Rep. No. 100-795, 100th Cong., 2d Sess. 408 (1988).

Regulations under section 1503(e) (3)(A) would confront a number of issues. For example, should the section 312(k) detriment apply to an affiliated group that purchased the stock of a subsidiary after the effective date of section 1503(e)? Such a buyer had no reason to assume that section 312(k) would have any bearing on the determination of its stock basis.

Example 3: P, the common parent of an affiliated group, purchased all the stock of S from an individual on December 10, 1987, before the effective date of IRC section 1503 (e). At the time of the purchase, S, a leasing company, had a single asset. The asset was depreciated using accelerated depreciation. Thus, subsequent depreciation for earnings and profits purposes would exceed tax depreciation. If proposed section 1503(e)(3)(A) is enacted and implemented by regulations, P apparently would inherit the built-in section 312(k) detriment for purposes of determining the basis of its S stock.

This potential section 312(k) detriment is another reason to consider making a section 338(h)(10) election (when acquiring a new member from another affiliated group.

Section 1503(e) also eliminates certain disparities between outside basis and inside basis attributable to section 312(n) and the exclusion of amounts from gross income under section 108 (involving discharge of indebtedness).

2. General Utilities Repeal and Notice 87-14. In Notice 87-14, 1987-1 C.B. 445, the IRS announced that regulations will be promulgated restricting the extent to which an affiliated group's basis in the stock of a subsidiary can be adjusted upward under the investment adjustment rules as a result of the recognition of built-in gains. The regulations will be effective with respect to stock in a target that was acquired after January 6, 1987.

Example 4: Individual A has owned all the stock ($100 basis and $120 fair market value) of T since 1980. T has two nondepreciable assets (each asset has a $25 basis and $60 fair market value) and no liabilities. P, the common parent of an affiliated group, purchases the stock of T in 1988 for $120. P sells one of T's assets for its fair market value, and the affiliated group reports a $35 gain. P pays the group's tax for the year of sale. Should P be permitted to increase the basis of its T stock for the $35 of earnings and profits generated by the sale? If it could, P could sell the T stock for $120 and report a $35 loss that (ignoring possible differences in the character of the gain or loss and time value of money considerations) would shelter the earlier gain on the disposition of T's first asset.

Apparently based on the premise that the investment adjustment rules should not be so applied after the repeal of the General Utilities doctrine in 1986 (specifically, amendments to IRC sections 336, 337 and 338 that require recognition of gain on corporate liquidating sales and distributions where the transferee takes a cost basis for the property received), notice 87-14 would prevent such a $35 investment adjustment. If the regulations announced by Notice 87-14 did not prevent the step up in T's stock basis, the net result of the foregoing transactions would be a step up in the basis of the first T asset sold, without a corporate level tax.

Example 5: Same facts as Example 4 except that A is corporation and filed a consolidated return with T. What tax policy would be served by applying Notice 87-14 to prevent P from stepping up the basis of the T stock after the sale of T's assets? While it is true that the transactions would result in a steppedup basis in the asset sold without a corporate level tax, A could undertake the same steps taken by P and would be grandfathered from Notice 87-14 since A acquired T before January 7, 1987.

According to Notice 87-14, the regulations will also prevent an investment adjustment for earnings and profits arising from gain recognized under section 311(b) on a distribution by one member to another. The regulations will further advance the single entity theory by reducing the disparities between outside stock basis and inside net asset basis.

3. Other Possible Conforming Basis Rules. Under the Report of the Committee of the Budget of the House of Representatives (H.R. Rep. No. 391, 100th Cong., 1st Sess. 1089 (1987)) and first Finance Committee Report on the Revenue Bill of 1987 (H.R. Con. Res. 9o, S. Rep. No. 100-76, 100th Cong., 1st Sess. 176 (1987)), Treasury would have been directed to conform the outside and inside basis rules:

Nonetheless, the committee does not believe that the consequences of a disposition of stock in a member of the group should be more favorable than if the operations of the subsidiary had been conducted (and the assets had been owned) directly by the parent corporation. The amendments made by this provision are intended to prevent this result, and the committee expects that appropriate modifications will be made not only to the basis adjustment rules, but to other provisions of the consolidated return regulations, in furtherance of this objective.

This broad conforming basis mandate, however, was deleted from the final 1987 Act. Nevertheless, Treasury's appetite for conforming basis rules may have been whetted. Among other possibilities, the consolidated return regulations might be amended to provide that the stock basis of a new member will be deemed to be equal to the member's net asset basis as of the date of acquisition; [5] the basis of a new member's assets also might be marked to market solely for purposes of determining its earnings and profits for investment adjustment purposes.

A final conforming basis point illustrates the need to consider unused CNOLs in comparing outside stock basis and inside net asset basis:

Example 6: P, the common parent of an affiliated group contributes $100 to a new member, S. S loses the $100, thereby creating a consolidated NOL that is not used by the group. Under the current investment adjustment rules (ignoring de facto liquidation issues to make the point) the basis of the S stock would be decreased by $100 for the deficit in earnings and profits and increased by $100 to reflect the $100 loss carryover. Ordinarily, the $100 stock basis would be reduced to zero when the loss is absorbed on the consolidated return. What if S is sold in the interim? What is S's net asset basis? Should S's share of the loss leave the group as is currently provided for? Should the answer to this question affect whether P is entitled to a capital loss on the sale of the S stock measured by reference to a $100 stock basis?

III. New Consolidated Return

Regulations

A. New Regulations Dealing with

Taxable Mirror Liquidations

1. Purpose. The prior consolidated return regulations provided that any gain recognized by the distributing corporation in a complete liquidation would be accounted for as though separate returns were filed. Treas. Reg. [section] 1.1502-14(c)(2). Thus, any gain would be taxable immediately without any deferral.

Under the 1987 Act, gain is recognized by the distributing corporation in mirror subsidiary liquidations. See section 337(c). The IRS has stated that it is unaware of any circumstances in which this gain or loss recognized on the complete liquidation of a subsidiary member should not be deferred. Accordingly, the new regulations provide rules for such deferral.

2. Description. Temp. Reg. [section] 1.1502-14T provides for the deferral of any gain or loss recognized by the distributing corporation on a distribution described in Treas. Reg. $S 1.1502-14 (a) or (b), which includes a mirror liquidation. Thus, there is deferral in mirror liquidations as well as in dividend distributions.

Temp. Reg. [section] 1.1502-13T provides new rules for how the deferral works for gain or loss recognized in liquidations to which section 381 applies, which includes a mirror liquidation. First, the regulations clarify that deferral does not end because the liquidated subsidiary ceases to be a member of the group. The deferred gain is inherited by the member receiving the greatest portion of the assets (measured by fair market value) in the liquidation. If two or more members receive the same portion (which is greater than that received by any other member), the common parent selects one of the members to inherit the deferred gain.

These new regulations apply to distributions that occur in taxable years for which the due date (without extensions) of the income tax return is after April 14, 1988.

B. New Regulations Dealing

with Potential Dividend

Stripping with Respect to

Stock of Former Members

1. Purpose. The purpose of Temp. Reg. [section] 1.1502-32T is to prevent dividend stripping after a subsidiary member is disaffiliated but without the harsh consequences of the prior rules. See prior provisions of Treas. Reg. [section] 1.1502-32(g). Some form of an antidividend stripping rule is necessary to deal with the situation where the owning members retain some stock of the former subsidiary member. Without an anti-dividend stripping rule, the former subsidiary member could distribute its consolidated earnings and profits without the distributee-member making a corresponding negative investment adjustment in the basis of its retained stock. Thus, in separate return years, the owning member could retain the high basis in the retained stock that was obtained through prior positive investment adjustments for earnings and profits during consolidated years, and a separate return year distribution of those consolidated earnings and profits would set the state for an artificial loss on the sale of the retained stock.

The prior rule, Treas. Reg. [section] 1.1502-32(g), required the owning member, on the first day of the first separate return year of either the owning member or of the subsidiary, to decrease the basis for such retained stock by the amount of net positive investment adjustments made for all previous consolidated years. The basis reduction so required could produce harsh consequences because the basis reduction occurred whether or not a dividend was subsequently distributed. If no dividends were distributed, a sale of the stock would produce an unwarranted gain. In addition, Treas. Reg. [section] 1.1502-32(g) appeared to apply where both the owning member and subsidiary left one affiliated group and joined another affiliated group, even though there was no need for such a basis reduction at the time of disaffiliation from the first group. If the subsidiary subsequently paid a dividend to the owning member out of earnings and profits that previously resulted in a positive investment adjustment while the subsidiary was in the first group, the dividend would result in a negative investment adjustment since both corporations were members of the second group.

Example 7: P and S are members of an affiliated group. S was formed with $100 contributed by P. S has $200 of earnings and profits, which increases P's basis in the S stock by $200. On January 1, 1988, individual A purchases 50 percent of the stock of S for $150. Absent an anti-dividend stripping rule, S could create an artificial loss in its stock basis retained by P by distributing its $200 of earnings and profits ($100 to each of P and A) on January 2, 1988. Since S left P's affiliated group, no downward investment adjustment would be made to reflect the distribution. P's basis in the S stock would remain $150, even though the value of the retained stock would be reduced to $50 after the distribution. Thus, P could sell the remaining 50 percent of the S stock and recognize an artificial $100 loss.

Under the prior rules, no dividend stripping would be possible because the basis of the S stock retained by P would be reduced automatically by $100, the portion of the $200 positive investment adjustment resulting from S's earnings and profits that is attributable to P's retained 50-percent stock ownership of S. However, the basis reduction occurred even if the retained S stock were subsequently sold without an intervening dividend distribution.

Example 8: Same facts as prior example except that both P and S are acquired by X, the common parent of a separate affiliated group. Under the prior rules, many commentators believed that the basis of P's stock in S would be reduced by $200 even though subsequent dividend distributions would produce negative investment adjustments under Treas. Reg. $S 1.1502-32.

2. Description. The new regulations do not change the amount of the potential basis reduction. They also continue to treat the excess of the basis reduction over the adjusted basis of the stock as immediately includible in income as income described in Treas. Reg. [section] 1.1502-19(c).

The new regulations, however, do not require an immediate basis reduction when the subsidiary member (or owning member) leaves the affiliated group. Instead, the basis reduction is deferred, generally until the subsidiary makes a dividend distribution.

The deferral of the basis reduction is accomplished through the establishment of a "basis reduction account" that applies to the stock of the subsidiary retained by the member. If, subsequently, there is a dividend distribution with respect to the stock, the basis of the stock is reduced by the amount of the distribution, but only to the extent of the basis reduction account for such stock. The basis reduction account also is decreased by distributions from such account.

An anti-duplication rule is provided to deal with cases where a dividend would result in a basis reduction under both Temp. Reg. [section] 1.1502-32T and some other provision, such as the negative investment adjustment under Treas. Reg. [section] 1.1502-32(b)(2)(iii). Nevertheless, the basis reduction account is still reduced, except to the extent that the dividend was out of earnings and profits earned after the establishment of the basis reduction account (i.e., after the former subsidiary member left the group).

Subject to certain exceptions for exahanges in substituted basis transactions and transfers to members, the basis reduction account is eliminated if stock subject to the basis reduction account is disposed of. If the stock is transferred to a nonmember that is related to the transferor within the meaning of section 304, the basis of the stock is reduced, immediately before the transfer, by the amount of the basis reduction account, and the basis reduction account is eliminated.

The new regulations apply, and Treas. Reg. [section]1.1502-32(g) does not apply, to stock of a subsidiary that ceases to be a member of the affiliated group during a taxable year of the group ending after November 30, 1987. Members continuing to own stock of a former subsidiary that ceased to be a member in a taxable year ending on or before November 30, 1987, may elect to apply the new rules to retained stock that is disposed of in a taxable year of the group ending after November 30, 1987.

C. New Regulations Dealing

with Chances in Structure of

the Group

1. Temp. Regs [subsection]1.1502-31T

a. Purpose. This new regulation provides rules for determining the basis of members' stock following a change in structure of the group, where the group remains in existence and stockholders of the former common parent before the change own 80 percent or more of value of the new common parent after the change. The principal transaction covered by the new regulations involves a new holding company where the group remains in existence because the transaction is a reverse acquisition under Treas. Reg. [section]1.1502-75(d)(3). The purpose of the new regulation is to provide the same tax treatment for different transactions that have similar effects on the group's structure.

Example 9:

(i) If a new holding company structure is created by a common parent transferring all its assets in a section 351 transactions to a newly organized subsidiary, the basis of the subsidiary's stock in the hands of the parent is the basis of assets transferred reduced by liabilities (i.e., net asset basis). See action 358.

(ii) If a new holding company structure is created by transfering stock of the common parent to a newly organized holding company by stockholders of the common parent in a transaction that qualifies under section 351 or section 368(a)(1)(B), the basis of the former common parent's in the hands of the new common parent is the basis of the stock in the hands of the former stockholders. See section 362.

The difference in the results for the transactions is considered inappropriate . The new regulations treat both transactions as a drop down of assets.

b. Description. The new regulations apply to a nonrecognition transaction after September 7, 1988, that qualifies as a "group structure change." Such a change occurs where (1) the common parent of the affiliated group ceases to be the common parent; (2) the group remains in existence under Treas. Reg. [section]1.1502-75(d)(2) or (d)(3); and (3) the stockholders of the former common parent own 80 percent or more of the fair market value of outstanding stock of the new common parent. Groups that undergo a group structure change to which the new regulations would apply if the change had occurred after their effective data can elect to make the regulations applicable.

If the former common parent remains in existence, the basis of stock of the former common parent in the hands of the owning members equals the sum of (1) the net inside basis of former common parent's property (other than property received in the group structure change); (2) the owning member's basis (or excess loss account) in the stock of any corporation whose assets or liabilities were acquired by the former parent in the change ("merged corporation"); and (3) the amount (whether positive or negative) determined by subtracting the liabilities of the owning member assumed in the change by the former parent from the basis of property transferred by the owning member to the merged corporation and not transferred to the former common parent's stockholders.

The owning member only takes into account the percentage of the inside basis attributable to the percentage of the former common parent's stock owned by the owning member immediately after the change. If the former common parent has more than one class of stock, the net inside basis must be allocated among the classes in proportion to the value of each class.

The basis in the former common parent's stock is reduced by the fair market value of property furnished by the merge corporation and transferred by the former common parent to its stockholder. Negative basis is treated like an excess loss account.

A special rule is provided for higher-tier adjustments if the former common parent is owned by members other than the new common parent.

Subsequent distributions by the former common parent after the change are deemed to be out of earnings and profits accumulated in post-1965 consolidated return years.

If the former common parent does not remain in existence, the owning member's basis in the stock of each member acquiring the property or liabilities of the former common parent ("acquiring member") immediately after the group structure change equals the sum of (i) the owning member's basis (or excess loss account) in the stock of the acquiring member before the acquisition; (ii) the former common parent's net basis in assets acquired by the acquiring member; and (iii) the net basis of property acquired by the acquiring member from the owning member and not transfered to the former common parent or its shareholders.

The basis as determined above is first decreased by the fair market value of assets furnished by the acquiring corporation in exchange for the former common parent's assets, and then increased by the gain recognized by the former common parent on the transfer.

Other special rules also are provided for higher-tier adjustments and subsequent distributions by the acquiring member out of earnings and profits acquired from the former common parent. These rules are comparable to those previously described and are designed to prevent duplicative investment adjustments.

2. Temp. Regs. [section]1.1502-33T

a. Purpose. The new rgulations provide rules for determining earnings and profits of members of a group where there is a change in the structure of the group. In particular, the new regulations deal with the earnings and profits of the new common parent and the group after the change.

The purpose of the new regulations is to ensure that distributions by the new common parent will be treated as dividends where the group has sufficient earnings and profits. Generally, when a higher-tier member receives a dividend, its earnings and profits are not changed because the increase in earnings and profits is offset by the decrease in earnings and profits caused by the negative investment adjustment in the basis of the stock of the lowertier, distributing member.

Example 10. P, the common parent of an affiliated group, is a holding company whose only asset is the stock of S. If S have $200 of earnings and profits, P also will have $200 of earnings and profits due to the investment adjustments in its S stock. If S subsequently distributes a $200 divident, P's earnings and profits will not change.

The problem addressed by Temp. Reg. [section]1.1502-33T arises when a change in the group's structure results in a new common parent with no earnings and profits. Under the prior rules, distributions from the former common parent would not increase the new common parent's earnings and profits, with the result that subsequent distributions by the new common parent would not be taxed as dividends.

Example 11: Assume the same facts as in Example 10. If P distributes its $200, the distribution will be taxed as a dividend to the P stockholders. Instead, P's stockholders contribute all of their P stock to a new corporation X, which becomes the new common parent of the P group. P then distributes its $200 to X. X's earnings and profits are increased by $200 and then reduced by $200 due to the negative investment adjustment in its P stock. Thus, X's earnings and profits remain at zero. Thus, X's earnings and profits remain at zero. Now, if X distributes its $200, the distribution would not be taxed as a dividend.

b. Description. Change in Common Parent. If the transaction is a "group structure change" as defined in Temp. Reg. [section]1.1502-31T, the earnings and profits of the new common parent are adjusted to reflect the earnings and profits of the former common parent at the time of change.

Changes in Subsidiaries. If the position of any other member or chain is changed (including a change in structure described in the preceding paragraph), proper adjustments also will be made to earnings and profits of members other than the new common parent. For example, this provision apparently provides the IRS the flexibility to determine the proper earnings and profits adjustments for section 304 sales between brother and sister members.

Other Changes in Group Structure. If the foregoing rules do not apply to a change in the structure of a group, but the group remains in existence under Treas. Reg. [section]1.1502-75(d)(2) and (d)(3), the earnings and profits of the new common parent do not reflect the earnings and profits of the former common parent. The earnings and profits of a distributee member receiving subsequent distributions, however, are not reduced by negative investment adjustments where the distribution is made out of earnings and profits that are not reflected in earnings and profits of the distributee.

Example 12: On January 1, 1989, P, the common parent of an affiliated group, is acquired in a reverse acquisition by X, a common parent of a separate affiliated group. The former stockholders of P exchange their P stock for stock representing more than 80 percent of the outstanding stock of X after the exchange. Before the transaction, the earnings and profits of P and X were $100 and $20, respectively.

Since the transaction is a group structure change, the earnings and profits of P and X immediately after the transaction are $100 and $120, respectively.

If the transaction occurred before the effective date of the new regulations (September 7, 1988) and the election to have Temp. Reg. [section]1.1502-31T apply was not made, the earnings and profits of X would remain at $20. If P subsequently distributes its $100 of earnings and profits accumulated before the transaction, X's earnings and profits will be increased by the $100. The negative investment adjustment to the stock of P owned by X will not reduce X's earnings and profits. This also would be the result if the P stockholders acquired less than 80 percent of the X stock, but the P group remained in existence under Treas. Reg. [section]1.1502-75(d)(3) (involving reverse acquisitions).

3. Temp. Reg. [section]1.1502-77T.

a. Purpose. The new regulation provides for alternative agents for an affiliated group if the common parent ceases to be the common parent, regardless of whether the group remains in existence. The scope of the agency provided in the new regulation is limited to receiving notices of deficiency and executing waivers of statutes of limitations.

b. Description. The alternative agents include (i) the common parent for all or part of the year to which the notice or waiver applies; (ii) the successor to the former common parent in a seciton 381 (a) transaction; (iii) the agent designated by the affiliated group under Treas. Reg. [section]1.1502-77(d); and (iv) if the group remains in existence under Treas. Reg. [section]1.1502-75(d)(2) or (d)(3) the common parent at the time the notice or waiver is given.

Footnotes -- consolidated Returns: Post-Tax Reform Developments

(1) Reference herein to an "affiliated group" are to an affiliated group filing a consolidated return; references to a "member" are to a member of such an affiliated group.

(2) For other consolidated return issues raised by the 1986 amendments to section 382, see Goldman, Consolidated Return Issues Raised by Section 382 of the Internal Revenue Code of 1986, NYU Inst. Conference on Consolidated Returns (May 21, 1987); ABA Section of Taxation, Committee on Affiliated and Related Corporations, Section 382 and Consolidated Return Task Force Report (May 13, 1988). The Task Force Report also discusses the argument that a tax return may be filed under the single entity approach to section 382 on the authority of the statute alone. This is important to affiliated groups filing returns before the applicable consolidated return regulations become effective.

(3) The scope of section 384 will depend on whether the technical corrections proposed as part of the Miscellaneous Revenue, (or Technical Corrections) Bill of 1988 (the "1988 Bill") are enacted. As enacted in 1987, the provision would apply to (1) stock acquisitions in which control (as defined in section 1504(a)(2)) of gain corporations (those with net unrealized built-in gains) is acquired and (2) asset acquisitions of gain corporations under section 332 and section 368(a)(1)(A), (C) or (D). If the proposed technical corrections are enacted, the section would be substantially revised. Among other changes, the section would apply whether the gain corporation was the acquired or acquiring party and would not apply to section 332 liquidations.

(4) Section 312(f) provides a special basis rule for purposes of determining the earnings and profits resulting from the disposition of an asset that compensates for the section 312(k) benefit.

(5) Conpare Tech. Reg. [section]1.1502-33T, discussed in Part III, where the formation of a holding company by transferring stock of a common parent to a new corporation controlled by the common parent's shareholders is treated as a drop down of assets, thereby creating a stock basis in the new corporation measured primarily by the net asset basis of the former common parent.

principal transaction covered by the new regulations involves a new holding company where the group remains in existence because the transaction is a reverse acquisition under Treas. Reg. [Section]1.1502-75(d)(3). The purpose of the new regulation is to provide the same tax treatment for different transactions that have similar effects on the group's structure.

Example 9:

(i) If a new holding company structure is created by a common parent transferring all its assets in a section 351 transaction to a newly organized subsidiary, the basis of the subsidiary's stock in the hands of the parent is the basis of assets transferred reduced by liabilities (i.e., net asset basis). See section 358.

(ii) If a new holding company structure is created by transferring stock of the common parent to a newly organized holding company by stockholders of the common parent in a transaction that qualifies under section 351 or section 368(a)(1)(B), the basis of the former common parent's stock in the hands of the new common parent is the basis of the stock in the hands of the former stockholders. See section 362.

The difference in the results for the transactions is considered inappropriate. The new regulations treat both transactions as a drop down of assets.

b. Description. The new regulations apply to a nonrecognition transaction after September 7, 1988, that qualifies as a "group structure change." Such a change occurs where (1) the common parent of the affiliated group ceases to be the common parent; (2) the group remains in existence under Treas. Reg. [Section]1.1502-75(d)(2) or (d)(3); and (3) the stockholders of the former common parent own 80 percent or more of the fair market value of outstanding stock of the new common parent. Groups that undergo a group structure change to which the new regulations would apply if the change had occurred after their effective date can elect to make the regulations applicable.

If the former common parent remains in existence, the basis of stock of the former common parent in the hands of the owning members equals the sum of (1) the net inside basis of former common parent's property (other than property received in the group structure change); (2) the owning member's basis (or excess loss account) in the stock of any corporation whose assets or liabilities were acquired by the former parent in the change ("merged corporation"); and (3) the amount (whether positive or negative) determined by subtracting the liabilities of the owning member assumed in the change by the former parent from the basis of property transferred by the owning member to the merged corporation and not transferred to the former common parent's stockholders.

The owning member only takes into account the percentage of the inside basis attributable to the percentage of the former common parent's stock owned by the owning member immediately after the change. If the former common parent has more than one class of stock, the net inside basis must be allocated among the classes in proportion to the value of each class.

The basis in the former common parent's stock is reduced by the fair market value of property furnished by the merged corporation and transferred by the former common parent to its stockholders. Negative basis is treated like an excess loss account.

A special rule is provided for highertier adjustments if the former common parent is owned by members other than the new common parent.

Subsequent distributions by the former common parent after the change are deemed to be out of earnings and profits accumulated in post-1965 consolidated return years.

If the former common parent does not remain in existence, the owning member's basis in the stock of each member acquiring the property or liabilities of the former common parent ("acquiring member") immediately after the group structure change equals the sum of (i) the owning member's basis (or excess loss account) in the stock of the acquiring member before the acquisition; (ii) the former common parent's net basis in assets acquired by the acquiring member; and (iii) the net basis of property acquired by the acquiring member from the owning member and not transferred to the former common parent or its shareholders.

The basis as determined above is first decreased by the fair market value of assets furnished by the acquiring corporation in exchange for the former common parent's assets, and then increased by the gain recognized by the former common parent on the transfer.

Other special rules also are provided for higher-tier adjustments and subsequent distributions by the acquiring member out of earnings and profits acquired from the former common parent. These rules are comparable to those previously described and are designed to prevent duplicative investment adjustments.

2. Temp. Regs. [Section]1.1502-33T

a. Purpose. The new regulations provide rules for determining earnings and profits of members of a group where there is a change in the structure of the group. In particular the new regulations deal with the earnings and profits of the new common parent and the group after the change.

The purpose of the new regulations is to ensure that distributions by the new common parent will be treated as dividends where the group has sufficient earnings and profits. Generally, when a higher-tier member receives a dividend, its earnings and profits are not changed because the increase in earnings and profits is offset by the decrease in earnings and profits caused by the negative investment adjustment in the basis of the stock of the lower-tier, distributing member.

Example 10. P, the common parent of an affiliated group, is a holding company whose only asset is the stock of S. If S has $200 of earnings and profits, P also will have $200 of earnings and profits due to the investment adjustments in its S stock. If S subsequently distributes a $200 dividend, P's earnings and profits will not change.

The problem addressed by Temp. Reg. [Section]1.1502-33T arises when a change in the group's structure results in a new common parent with no earnings and profits. Under the prior rules, distributions from the former common parent would not increase the new common parent's earnings and profits, with the result that subsequent distributions by the new common parent would not be taxed as dividends.

Example 11: Assume the same facts as in Example 10. If P distributes its $200, the distribution will be taxed as a dividend to the P stockholders. Instead, P's stockholders contribute all of their P stock to anew corporation X, which becomes the new common parent of the P group. P then distibutes its $200 to X. X's earnings and profits are increased by $200 and then reduced by $200 due to negative investment adjustment in its P stock. Thus, X's earnings and profits remain at zero. Now, if X distributes its $200, the distribution would not be taxed as a dividend.

b. Description. Change in Common Parent. If the transaction is a "group structure change" as defined in Temp. Reg. [section]1.1502-31T, the earnings and profits of the new common parent are adjusted to reflect the earnings and profit of the former common parent at the time of change.

Changes in Subsidiaries. If the position of any other member or chain is changed (including a change in structure described in the preceding paragraph), proper adjustments also will be made to earnings and profit of members other than the new comon parent. For example, this provision apparently provides the IRS the flexibility to determine the proper earnings and profits adjustments for section 304 sales between brother and sister members.

Other Changes in Group Structure. If the foregoing rules do not apply to a change in the structure of a group, but the grouop remains in existence under Treas. Reg. [section]1.1503-75(d)(2) and (d)(3), the earnings and profits of the new common parent do not reflect the earnings and profits of the former common parent. The earnings and profit of a distributee member receiving subsequent distributions, however, are not reduced by negative investment adjustments where the distribution is made out of earnings and profit that are not reflected in earnings and profit of the distributee.

Example 12: On January 1, 1989, P, the common parent of an affiliated group, is acquired in a reverse acquisition by X, a common parent of a separate affiliated group. the former stockholders of P exchange their P stock for stock representing more than 80 percent of the outstanding stock of X after the exchange. Before the transaction, the earnings and profits of P and X were $100 and $200, respectively.

Since the transaction is a group structure change, the earnings and profits of P and X immediately after the transaction are $100 and $200, respectively.

If the transaction occured before the effective date of the new regulations (September 7, 1988) and the election to have Temp. Reg. [section] 1.1502-31T apply was not made, the earnings and profits of X would remain at $20. If P subsequently distributes its $100 of earnings and profits accumulated before the transaction, X's earnings and profits will be increased by the $100. The negative investment adjustment to the stock of P owned by X will not reduced X's earnings and profits. This also would be the result if the P stockholders acquired less than 80 percent of the X stock, but the P group remained in existence under Treas. Reg. [section] 1.1502-75(d)(3) (involving reverse acquisitions).

3. Temp. Reg. [section]1.1502-77T.

a. Purpose. The new regulation provides for alternative agents for an affiliated group if the common parent ceases to be the common parent, regardless of whether the group remains in existence. The scope of the agency provided in the new regulation is limited to receiving notices of deficiency and executing waivers of statutes of limitations.

b. Description. The alternative agents include (i) the common parent for all or part of the year to which the notice or waiver applies; (ii) the successor to the former common parent in a section 381 (a) transaction; (iii) the agent designated by the affiliated group under Treas. Reg. [section] 1.1502-77(d); and (iv) if the group remains in existence under Treas. Reg. [section] 1.1502-75(d)(2) or (d)(3), the common parent at the time the notice or waiver is given.

Footnotes -- Consolidated returns: Post-Tax Reform Developments

(1) References herein to an "affiliated group" are to an affiliated group filing a consolidated return; references to a "member" are to a member of such an affiliated group.

(2) For other consolidated retun issue raised by the 1986 amendments to section 382, see Goldman, Consolidated Return Issue Raised by Section 382 of the International Revenue Code of 1986, NYU Inst. Conference on Consolidated Returns (May 21,1987); ABA Section of Taxation, Committee on Affiliated and Related Corporations, Section 382 and Consolidated Return Task Force Report (May 13,1988). The Task Force Report also discuss the argument that a tax retun may be filed under the single entity approached to section 382 on the authority of the statute alone. This is important to affiliated groups filing returns before the applicable consolidated retun regulations become effective.

(3) The scope of section 384 will depend on whether the technical corrections proposed as part of the Miscellaneous Revenue, (or Technical Corrections) Bill of 1988 (the "1988 Bill") are enacted. As enacted in 1987, the provision would apply to (1) stock acquisitions in which control (as defined in section 1504(a)(2)) of gain corporations (those with net unrealized build-in gains) is acquired and (2) asset acquisitions of gain corporations under section 332 and section 368(a)(1)(A), (C) or (D). If the propsed technical corrections are enacted, the section would be substantially revised. Among other changes, the section would apply whether the gain corporation was the acquired or acquiring party and would not apply to section 332 liquidations.

(4) Section 312(f) provides a special basis rule for purposes of determining the earnings and profits resulting from the disposition of an asset that compensates for the section 312(k) benefit.

(5) Compare Temp. Reg. [section] 1 .1502-33T, discussed in Part III, where the formation of a holding company by transferring stock of a common parent to a new corporation controlled by the common parent's shareholders is treated as a drop down of assets, thereby creating a stock basis in the new corporation measured primarily by the net asset basis of the former common parent.
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Author:Warner, James C.
Publication:Tax Executive
Date:Sep 22, 1988
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