Intercompany transaction and loss disallowance relief provisions.
Example 1: A consolidated group disposes of a member's stock. The parent, P, wholly owns subsidiary 1, S, which wholly owns subsidiary 2, T. P wants to divest itself of T's business operations. T's stock has a $100 fair market value (FMV) and a $30 adjusted basis, and the net adjusted basis of the assets inside T is $15 (leaving $85 of "inside" appreciation). S sells T for $100 in a Sec. 338(h)(10) transaction and distributes the proceeds to P. "Old" T recognizes an $85 gain on its asset appreciation, all of which is included in the calculation of the P group's consolidated taxable income. The distribution of the proceeds by S to P does not generate any additional consolidated taxable income within the P group. The P group recognizes only one level of gain on the transaction.
Example 2: The facts are the same as in Example 1, except S first distributes the T stock to P, then P sells T in a Sec. 338(h)(10) transaction. S recognizes a $70 gain on the distribution of T to P, under Sec. 311(b) (i.e., gain resulting from the "outside" appreciation in T's stock (deferred momentarily under Regs. Sec. 1.1502-13)). Additionally, the sale of T in a Sec. 338(h)(10) transaction still results in "old" T recognizing an $85 gain (i.e., from the "inside" appreciation in T's assets). Absent any other provision, distributing the stock of T before the Sec. 338(h)(10) transaction results in the P group recognizing two levels of gain.
From an economic standpoint, P ends up in the exact same financial position in Example 2 as in Example 1. However, the tax consequences of distributing the T stock before the sale differ drastically from those of distributing the proceeds resulting from the sale.
Relief for Example 2
Under Sec. 301(d), P's basis in the T stock received in the distribution from S equals the T stock's FMV on the distribution date, or $100. This "increase" in the T stock basis (from the $30 basis in S's hands) mirrors the $70 of Sec. 311(b) gain recognized (momentarily deferred) by S on the distribution of T. The distribution has no effect on the "inside" basis of T's assets, which remains at $15; thus, $85 of tax appreciation inside T is still waiting to be recognized.
In Example 2 above, P's basis in the T stock is increased by the $85 of "inside" gain "old" T recognized under the Kegs. Sec. 1.1502-32 investment adjustment rules. An additional consequence of the Sec. 338(h)(10) election is a deemed liquidation of "old" T into P immediately after the deemed sale of "old" T's assets. As a result, P would realize an $85 loss on the liquidation--the difference between the $100 distributed to P and P's $185 adjusted basis (calculated by adding P's "original" $100 adjusted basis in the T stock to the $85 basis increase resulting from the application of the investment adjustment regulations). Generally, however, P would not recognize this loss under Sec. 332, leaving the P group with two levels of gain recognition.
Fortunately, the Regs. Sec. 1.1502-13(f)(5)(ii)(C) election prevents the P group from being taxed on "outside" gain, by allowing P to recognize $70 of the $85 loss realized on the deemed liquidation. P may elect to apply Sec. 331 solely for purposes of determining its loss on the T stock resulting from the deemed T liquidation, in lieu of Sec. 332.
The election entitles P to recognize a loss on the T stock to the extent it or another group member recognized a gain on the same T stock. In Example 2, S realized a $70 gain on distributing the T stock to P; P realized an $85 loss on the deemed T liquidation. The Regs. Sec. 1.1502-13(f)(5)(ii)(C) election entitles the P group to net the loss incurred on the deemed liquidation against the gain recognized on the distribution, to the extent of the gain only. As a result, the P group would recognize a net gain from the entire $85 transaction, identical to the result in Example 1 above. What about the loss disallowance rules?
Loss Disallowance--More "Relief"
In general, if a consolidated group member recognizes a loss on a disposition of other group members' stock, the loss is disallowed under Temp. Regs. Sec. 1.337(d)-2T(a)(1). Absent an exception to the loss disallowance rule, the "relief" provided by the intercompany transaction regulations would not be any real relief at all. Fortunately, the IRS has provided a number of exceptions to the loss disallowance rules.
One such exception is the "netting" rule of Temp. Regs. Sec. 1.337(d) 2T(a)(4), under which a loss on a disposition of member stock is not disallowed "to the extent that, as a consequence of the same plan or arrangement, gain is taken into account by members with respect to stock of the same subsidiary having the same material terms." This "netting" rule allows a selling member to claim a loss recognized on a disposition of member stock to the extent it does not exceed gain recognized by other group members for the same member stock under the same disposition plan. In other words, P can claim $70 of loss recognized on the deemed T liquidation (out of $85) to the extent of gains recognized by other group members on the T stock (i.e., S's $70 gain on the distribution of T).
The "Right" Result
In Example 1 above, there was $85 of "inside" appreciation on T's assets. A sale of these assets (or a sale of the T stock for which a Sec. 338(h)(10) election is made) should result in the P group recognizing $85 of gain, regardless of whether T is sold directly by S or distributed to, and sold by, P. The group would recognize only one level of gain on this transaction. The relief provided by Regs. Sec. 1.1502-13(f)(5)(ii)(C), combined with the Temp. Regs. Sec. 1.337(d)-2T netting rule, means that the P group recognizes only one level of gain on the sale of T.
JOHN MICHALOWSKI, CPA, WASHINGTON, DC
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|Publication:||The Tax Adviser|
|Date:||Jul 1, 2004|
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