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More on consolidated returns and the single entity-theory: the new intercompany transaction proposed regs.

On Apr. 8, 1994, the IRS issued proposed regulations(1) under Sec. 1502 that revise the intercompany transaction system of the consolidated return regulations. The goal is to ensure, when practical from a compliance and policy perspective, the same tax treatment to a consolidated group as if the group's business activities were conducted by separate divisions of a single corporation.

The authors' article published in November 19942 discussed the general rules for intercompany income, gains, deductions and losses, including the matching and acceleration rules, anti-avoidance rules and general effective date provisions. This article will discuss the proposed rules for stock and obligations of group members, revisions to the Sec. 267(f) regulations, and other rules.

Stock of Members

Regs. Secs. 1. 1502-14 and 1. 1502-31(b) provide special rules for distributions and other transactions with respect to stock of members. The proposed regulations generally apply the Code and the matching and acceleration rules to such transactions. They also provide specific rules for intercompany Sec. 301 distributions, boot received in intercompany reorganizations, a member's acquisition of its own stock and limited elective relief from intercompany gain or loss recognition that would otherwise be required in certain liquidations and distributions.

* Intercompany Sec. 301 distributions

Regs. Sec. 1.1502-14 eliminates intercompany dividends from the gross income of the distributee; in contrast, Prop. Regs. Sec. 1.1502-13(f)(2)(ii) provides that an intercompany distribution is not included in the gross income of the distributee member. This exclusion only applies, however, to the extent there is a corresponding negative adjustment reflected under Regs. Sec. 1.1502-32 in the distributee member's basis in the distributing member's stock.(3) Such exclusion is intended to have the same effect as elimination under the existing regulations.(4)

The matching and acceleration rules apply to the distributing member's gain under Sec. 311(b) from intercompany distributions of property. In addition, Prop. Regs. Sec. 1.1502-13(f)(2)(iii) effectively overrides Sec. 311(a) (for loss on intercompany distributions) by providing that the distributing member's loss from an intercompany distribution of property is recognized under Sec. 311(b) and is taken into account under the matching and acceleration rules. Essentially, this places intercompany distributions on par with intercompany sales.

An intercompany distribution is treated as taken into account when the shareholding member becomes entitled to it (generally, on the record date) or, if earlier, when it is taken into account under another Code provision (e.g., under Sec. 305(c)). This contrasts with the normal income tax rules on distributions, which generally include distributions in income when they are actually distributed. Therefore, Prop. Regs. Sec. 1.1502-13(f)(2)(iv) provides that if the distribution is not actually made, it should be reversed as of the date the distribution was taken into account.

Example 1:(5) Dividend exclusion and property distribution. S owns land with a basis of $70 and a fair market value (FMV) of $100. On Jan. 1, 1995, P's basis in S's stock is $100. In 1995, S declares and makes a dividend distribution of the land to P. In 1998, P sells the land to X, an unrelated party, for $110. S's distribution to P is an intercompany distribution. P does not include the $100 dividend in income; rather, P's basis in S's stock is reduced from $100 to $0 in 1995. P's basis in the land is $100. In 1998, S takes its $30 gain into account to reflect the $30 difference between P's $10 gain taken into account and its $40 recomputed gain. P's basis in S's stock is increased from $0 to $30 in 1998.(6)

Example 2: Loss property. The facts are the same as in Example 1, except that S has a $130 (rather than a $70) basis in the land. S has a $30 loss that is taken into account under the matching rule in 1998 to reflect the difference between P's $10 gain taken into account and its $20 recomputed loss. P's basis in S's stock is reduced from $100 to $0 in 1995 and from $0 to a $30 excess loss account in 1998. If P, instead of selling the land to X, distributes it to a nonmember shareholder, the $20 of S's loss that does not offset P's gain is nondeductible under Sec. 311(a).

* Boot received in intercompany reorganizations

Prop. Regs. Sec. 1.1502-13(f)(3) provides that non-qualifying property (i.e., boot) received as part of a reorganization involving only consolidated group members (an intercompany reorganization) is treated as received in a separate transaction rather than as part of the intercompany reorganization (e.g., Secs. 302 and 311 apply, respectively, to the stockholder and distributor, rather than Secs. 356 and 361). Boot received in a transaction to which Sec. 354 would otherwise apply (e.g., acquisitive A, C, D or F asset reorganizations) is deemed received immediately after the reorganization.(7) Boot received in a Sec. 355 transaction is deemed received immediately before the reorganization. In Clark,(8) the Supreme Court applied the Sec. 356 boot-dividend test by assuming that only stock is issued in the reorganization and that after the reorganization, a portion of such stock is redeemed by the acquiring corporation in exchange for the boot. The Clark approach has been adopted in the proposed regulations for acquisitive reorganizations involving members of a consolidated group. However, the proposed regulations take the opposite position with respect to a Sec. 355 transaction between members of a consolidated group by testing the boot payment for dividend equivalence as a pretransaction distribution.

Example 3:(9) Intercompany reorganization. P has a basis of $250 in each of S and B. S and B each have $50 of earnings and profits (E&P). In 1996, when the FMV of S's assets and its stock is $500, S merges into B in a tax-free reorganization. P receives B stock with an FMV of $350 and $150 of cash. P is treated as receiving additional B stock with an FMV of $500 and a basis of $250. Immediately after the merger, $150 of the stock received is treated as redeemed, and the redemption is treated under Sec. 302(d) as a distribution to which Sec. 301 applies. Because B is treated as receiving S's E&P (sec. 381(c)(2)) and the redemption is treated as occurring after the merger, $100 is treated as a dividend and P's basis in B is reduced accordingly. The remaining $50 distribution further reduces P's basis in B.

Example 4:(10) Divisive transaction. The facts are the same as in Example 3, except that S distributes the stock of a lower-tier subsidiary in a spin-off to which Sec. 355 applies, together with $150 of cash. P is treated as having received the $150 cash immediately before the Sec. 355 distribution, as a distribution to which Sec. 301 applies. Sec. 356(b) does not apply and no basis adjustments are required under Sec. 358. Since the $150 cash distribution is treated as made before the spin-off, P's basis in S is reduced and then allocated between S and the lower-tier subsidiary under Sec. 358(c).

* Member's acquisition of its own stock

Under Prop. Regs. Sec. 1.1502-13(f)(4), if a member acquires its own stock, the member's basis in that stock is treated as eliminated for purposes of taking intercompany items into account with respect to the stock. Thus, if S distributes B stock to B, S's gain or loss from such distribution is taken into account immediately to reflect the elimination of basis.(11) However, under Prop. Regs. Sec. 1.1502-13(c)(3)(iv)(B), S's intercompany gain is excluded from gross income if B's corresponding item is one of the following: (1) a deduction or loss that, in the tax year the item is taken into account, is permanently disallowed directly under another Code provision; (2) a loss realized, but not recognized, under Sec. 311(a); or (3) limited, eliminated, offset, or has no effect on the computations of its taxable income under any provision identified by the IRS. An exception to elimination applies if the stock is exchanged for other stock in a recapitalization or other nonrecognition transaction. Arguably, if S and B were divisions of a single corporation, no gain would be included by a division on the sale of intercompany stock.

Example 5: Recapitalization. S transfers to B the stock of T, and B subsequently transfers the stock to T in exchange for new T stock in an E recapitalization. S's intercompany gain or loss remains deferred and is taken into account by reference to the replacement stock.

Example 6: Member's acquisition of its own stock. S owns P stock with a basis of $130. On Jan. 1, 1995, P purchases all the stock of S. On Jan. 1, 1997, P redeems the P stock held by S for $100 in a transaction that results in a $30 loss under Sec. 302(a). Because P acquires its own stock, P's basis in the stock is treated as eliminated, and this elimination is treated as a corresponding item. S's intercompany loss is not deductible from taxable income; rather, it is taken into account as a noncapital, nondeductible amount. Thus, another one-way street favoring the government is created: intercompany gains on stock are taken into account, but intercompany losses are not.

* Elective relief for certain liquidations and distributions

Prop. Regs. Sec. 1.1502-13(f)(5) provides special limited relief provisions for certain liquidations and distributions.

Sec. 332 liquidations and downstream mergers:

Under Regs. Sec. 1.1502-13(f)(1), the gain deferred on an intercompany sale or distribution of member stock is restored if the member is liquidated under Sec. 332. For example, if S sells all of its stock of wholly owned subsidiary T to B at a gain, and T later liquidates into B in an unrelated transaction to which Sec. 332 applies, S's gain is taken into account on T's liquidation.(12)

Prop. Regs. Sec. 1.1502-13(f)(5)(i) provides an election to allow S's intercompany gain or loss not to be taken into account if (1) B transfers substantially All(13) of T's assets to a new member (new T(14)) by the due date (including extensions) of the group's return for the liquidation year; (2) the liquidation and transfer to new T, if pursuant to the same plan, would qualify as a reorganization described in Sec. 368(a); (3) T was a member and had no nonmember shareholders from the time of the intercompany transaction until the liquidation; and (4) an election is made under Prop. Regs. Sec. 1.1502-13(f)(5)(v) (see the discussion below).

If these conditions are met, the intercompany gain is not reported on the liquidation and the stock of new T is a successor interest under Prop. Regs. Sec. 1.1502-13(j)(1). Thus, S's gain will be taken into account by reference to the stock of new T.

Under Prop. Regs. Sec. 1.1502-13(f)(5)(ii)(B), T's assets that are not contributed to new T are treated as having been transferred to new T in the reorganization and distributed to B immediately after the reorganization. This will cause new intercompany and corresponding items with respect to new T and B.

The election is also available for other transactions that are comparable to a Sec. 332 liquidation. Prop. Regs. Sec. 1.1502-13(f)(5)(ii)(C) provides that a downstream merger of B into T is a comparable transaction. Since the liquidation or downstream merger would most likely have been undertaken for specific business purposes, it is unlikely that these "relief" provisions will be of practical use.

Deemed liquidations pursuant to Sec. 338(h)(10) elections: Under existing regulations, if, subsequent to B's purchase of T stock from S, B sells T to unrelated X in a Sec. 338(h)(10) transaction, T is treated as having sold all of its assets to new T and liquidating under Sec. 332, thereby triggering S's intercompany gain. If an election is made, Prop. Regs. Sec. 1.1502-13(f)(5)(iii)(C) allows B to recognize any loss or deduction it would have recognized (determined after adjusting stock basis under Regs. Sec. 1.1502-32) if B had been deemed liquidated subject to Sec. 331.(15) The loss taken into account for this purpose is the lower of (1) the net intercompany income or gain with respect to each T share resulting from prior intercompany transactions or (2) the net deduction or loss that would be taken into account from the deemed liquidation if Sec. 331 applied with respect to all T shares.

The election is not available if (1) T made "substantial" (undefined) noncash distributions (i.e., other than cash, cash items, marketable stock or securities, or debt of the distributor or distributee member) during the 12-month period ending on the date of the merger or (2) the Prop. Regs. Sec. 1.1502-13(f)(5)(i) election is made.

Similar principles apply under Prop. Regs. Sec. 1.1502-13(f)(5)(iii)(D) to transactions that are comparable to a Sec. 338(h)(10) transaction, such as a forward cash merger of T into a nonmember (i.e., treated as a sale of T's assets followed by a complete liquidation of T) that takes place after S's sale of T stock to B.

Sec. 355 distributions: Subsequent to B's purchase of T stock from S, if T is distributed in a Sec. 355 transaction to another member, S could be required to take its intercompany gain or loss into account because of the redetermination of P's basis in the T stock under Sec. 358. An election may be made under Prop. Regs. Sec. 1.1502-13(f)(5)(iv) to treat B's distribution as subject to Secs. 301 and 31 1, rather than Sec. 355. As a result, B's gain or loss from the recast distribution of the T stock may subsequently be taken into account under the matching or acceleration rule. This prevents S's gain with respect to the stock of T from being taken into account immediately if matching remains possible.

Election mechanics: The common parent must file an election statement with the return for the year in which the applicable transaction occurred. The statement must include the information listed in Prop. Regs. Sec. 1.1502-13(f)(5)(v). A separate statement must be prepared for each transaction claiming such relief.

Obligations of Members

Under Regs. Sec. 1.1502-13, the general rules for intercompany transactions apply to the payment of interest and premium on intercompany obligations. In addition, a member's gain or loss from the disposition of another member's obligation is deferred under Regs. Sec. 1.1502-14(d). If a member's obligation is transferred to a nonmember, or the holding member becomes a nonmember, the deferred gain or loss is generally taken into account ratably over the remaining term of the obligation. On the other hand, if the obligation remains within the consolidated group, the deferred gain or loss is generally taken into account when the obligation is redeemed. Similar rules are provided for a member's deduction for the worthlessness of (and for an addition to a reserve for bad debts with respect to) an obligation.

Under the proposed regulations, the matching and acceleration rules apply to intercompany obligations, defined by Prop. Regs. Sec. 1.1502-13(g)(2)(ii) as obligations between members, but only for the period during which both parties are members. Under Prop. Regs. Sec. 1.1502-13(g)(2)(i), an obligation of a member is any obligation of that member constituting debt under general principles of Federal income tax law (other than an executory obligation to purchase or provide goods or services), any security of that member described in Sec. 475(c)(2)(D) or (E), or any comparable security with respect to commodities. The proposed regulations continue to treat each payment or accrual of interest or premium on an intercompany obligation as a separate intercompany transaction, with the income being matched with the deduction.

Example 7:(16) Interest on intercompany debt. On Jan. 1, 1995, B borrows $200 from S in return for B's note providing for $20 of interest annually at the end of each year, and repayment of $200 at the end of 1999. Under their separate methods of accounting, B accrues a $20 interest deduction annually under Sec. 163, and S accrues $20 of interest income annually under Sec. 61(a)(4). The accrual of interest on B's note is an intercompany transaction; S is the selling member and B is the buying member. Under the matching rule, S takes its $20 of interest income into account in each of 1995 through 1999 to reflect the $20 difference between B's $20 of interest expense taken into account and its $0 recomputed interest expense.

Example 8:(17) OID on intercompany debt. The facts are the same as in Example 7, except that B borrows $180 from S. The principles in Example 7 for stated interest also apply to the $20 of original issue discount (OID). Thus, as B takes into account its corresponding expense under Sec. 163(e), S takes into account its intercompany income.

Example 9:(18) Premium on intercompany debt. The facts are the same as in Example 7, except that B borrows $220 and S elects under Sec. 171 to amortize the $20 premium. Under Sec. 171(e), S's premium deduction is allocated to and reduces its interest income. Under the matching rule, S's corresponding item includes the premium even though it offsets interest income rather than being separately taken into account. Although S is the selling member with respect to the interest, it is the buying member with respect to the premium. As a result, B's intercompany premium income is taken into account under the matching rule to reflect the difference between S's corresponding premium deduction and its recomputed premium deduction. Thus, B takes its premium income into account in each of 1995 through 1999 based on S's amortization and off set of its interest income. If S does not make an election under Sec. 171, but takes the premium into account when the debt is retired at the end of 1999, B would also take the premium into account at that time.

* Special rules for obligations of members

The proposed regulations provide special rules that result in treatment similar to that found under Sec. 108(e)(4) and Regs. Sec. 1.108-2 when a party related to the debtor acquires the debt from an unrelated party. The primary focus of these special rules is to avoid distortions of the tax consequences that could be encountered under a strict single-entity approach. Special rules are provided for two categories of transactions: transactions in which (1) an intercompany obligation becomes a nonintercompany obligation or remains an intercompany obligation but gain or loss is realized with respect to it and (2) a nonintercompany obligation becomes an intercompany obligation. With respect to each category, the obligation is generally deemed to be satisfied and, if it remains outstanding, reissued.

Intercompany obligation becomes nonintercompany obligation: Under Prop. Regs. Sec. 1.1502-13(g)(3), if a member sells an intercompany obligation to a nonmember for cash or other property, the obligation is treated as satisfied in exchange for the consideration paid by the nonmember immediately prior to its transfer outside the group. Since the obligation remains outstanding, it is treated as being reissued, for the consideration paid to the creditor member, to the nonmember as a new obligation. Any cancellation of debt (COD) income, gain, loss or deduction recognized by the group as a result of the deemed satisfaction and reissuance is taken into account immediately prior to the obligation leaving the group. Under Prop. Regs. Sec. 1.1502-13(g)(3)(ii)(B)(1), the limitation on the exclusion of intercompany income or gain from gross income under Prop. Regs. Sec. 1.1502-13(c)(3)(iv) does not apply.

Example 10:(19) Issuance of intercompany obligation followed by transfer outside the group. On Jan. 1, 1995, B borrows $200 from S in return for B's note providing for $20 of interest annually at the end of each year, and repayment of $200 at the end of 2004. On Jan. 1, 1998, S sells B's note to X for $150, which reflects a change in the value of the note as a result of a rise in interest rates. B is solvent within the meaning of Sec. 108(d)(3).

Under the existing regulations, the B note would have an issue price equal to its stated principal amount of $200. The subsequent sale of the note to X for $150 generally would not be treated as an original issue of the note, because the issue price would still be $200. As a result, X would have $50 of market discount in the note taxable under Sec. 1276. Under the market discount rules, X may elect to have the accrued market discount taxed currently under rules similar to Sec. 1272.

If S and B were divisions of a single company, the sale of the B note to X would be treated as an original issue and the $50 excess stated redemption price at maturity over issue price would be accrued currently under Sec. 1272. A different result should not occur merely because the B note is issued to S prior to the sale to X. Under the proposed regulations, to achieve the same result, the B note is treated as satisfied in exchange for the consideration paid by X immediately before the transfer outside the group. The note is then deemed reissued for the consideration paid by X to S. Thus, B recognizes $50 of COD income as a result of the deemed prepayment of the note for $150; S recognizes a corresponding $50 loss. Consistent with these results, the issue price of the note to X is $150; $50 is OID that must be accrued by X under Sec. 1272.

Similar rules apply to comparable transactions, such as marking-to-market an obligation or claiming a bad debt deduction.

Example 11:(20) Bad debt deduction. On Jan. 1, 1995, B borrows $200 from S in return for B's note providing for $20 of interest annually at the end of each year, and repayment of $200 at the end of 1999. For 1997, S claims a $75 bad debt deduction under Sec. 166(a)(2) on a separate-company basis. B is never insolvent within the meaning of Sec. 108(d)(3).

Under Regs. Sec. 1.1502-14(d), gain or loss recognized by S in connection with a disposition of an obligation of B is generally taken into account as follows: (1) if the obligation is transferred outside the group or the member owning the obligation (if other than the member having the deferred gain or loss) leaves the group, such gain or loss is restored over the remaining term of the obligation; and (2) any remaining deferred gain or loss is taken into account on the earliest of the date on which (a) either S or B leaves the group, (b) the obligation is redeemed or canceled or (c) the stock of B is deemed disposed of under Regs. Sec. 1.1502-19(b)(2). Under these rules, a bad debt deduction is treated as a disposition and is deferred. Thus, S's $75 bad debt deduction is taken into account in 1999, when the note is redeemed and canceled. B's corresponding $75 of COD income is also taken into account in 1999.

Under the proposed regulations, B is treated as satisfying its note for $125 immediately before S's bad debt deduction and reissuing a new note with a $125 issue price and a $200 stated redemption price at maturity. As a result, in 1997 B takes into account $75 of COD income and S takes into account a $75 ordinary loss.

An intercompany obligation may also become a nonintercompany obligation and be subject to the special rules if the creditor or the debtor is deconsolidated (if, for example, after S acquires B's note, 25% of the stock of S or B is sold to a nonmember).

Example 12:(21) Creditor deconsolidation. The facts are the same as in Example 10, except that the stock of S is sold to X rather than S selling B's note. Under Prop. Regs. Sec. 1.1502-13(g)(3), the note is treated as satisfied by B for its $150 FMV immediately before S becomes a nonmember. B is also treated as issuing a new note, with an issue price of $150 and a $200 stated redemption price at maturity, to S immediately after S becomes a nonmember. The results for S's $50 loss and B's corresponding COD income are the same as in Example 10. The new note issued by B is not an intercompany obligation and has $50 ($200 stated redemption price at maturity -- $150 issue price) of OID that will be taken into account by B and S under Secs. 163(e) and 1272.

Example 13:(22) Debtor deconsolidation. The facts are the same as in Example 10, except that the stock of B is sold to X rather than S selling B's note. The results are the same as in Example 12.

Exceptions: Under Prop. Regs. Sec. 1.1502-13(g)(3)(i)(B), these rules do not apply (1) to obligations excluded from the application of Sec. 108(e)(4) by Regs. Sec. 1.108-2(e) (principally, certain short-term obligations and obligations acquired by security dealers); (2) to amounts realized by financial institutions from reserve accounting under Sec. 585 or 593; and (3) if treating the obligation as satisfied and reissued will not have a significant effect on any person's tax liability for the year.(23)

Nonintercompany obligation becomes intercompany obligation: Under Prop. Regs. Sec. 1.1502-13(g)(4)(ii), the following rules apply if a nonintercompany obligation becomes an intercompany obligation: Sec. 108(e)(4) does not apply; immediately after the obligation becomes an intercompany obligation, it is treated for all Federal income tax purposes as satisfied and a new obligation reissued to the holder (with a new holding period) in an amount determined under Regs. Sec. 1.108-2(f); the attributes of all items taken into account from the satisfaction are determined on a separate-entity basis, rather than treating S and B as divisions of a single corporation; and any intercompany gain or loss taken into account is treated as not subject to Sec. 354 or 1091.

Example 14:(24) Nonintercompany obligation becomes intercompany obligation. On Jan. 1, 1995, B borrows $200 from unrelated party X in return for B's note providing for $20 of interest annually at the end of each year, and repayment of $200 at the end of 1999. On Jan. 1, 1997, the obligation's FMV is $150 and P, B's parent, buys all of the stock of X. B is solvent within the meaning of Sec. 108(d)(3).

Under Prop. Regs. Sec. 1.1502-13(g)(4), B is treated as satisfying its obligation for $150 immediately after X becomes a member. X's $50 capital loss under Sec. 1271(a)(1) and B's $50 of COD income under Sec. 61(a)(12) are both taken into account in determining consolidated taxable income for 1997. The attributes of items resulting from the satisfaction are determined on a separate-entity basis. B is also treated as issuing a new obligation with a $150 issue price and $200 stated redemption price at maturity. The $50 of OID will be taken into account by B and X.

Example 15:(25) Election to file consolidated return. On Jan. 1, 1995, B borrows $200 from S, but the group does not file consolidated returns until 1997. Under Prop. Regs. Sec. 1.1502-13(g)(4), B's obligation is treated as satisfied and a new obligation reissued immediately after the obligation becomes an intercompany obligation. The satisfaction and reissuance of B's obligation are on Jan. 1, 1997, and are determined at the FMV of the obligation at that time, under Regs. Sec. 1.108-2(f)(2).

Exceptions: Under Prop. Regs. Sec. 1.1502-13(g)(4)(i)(B), the above rules do not apply to obligations (1) that are excluded from the application of Sec. 108(e)(4) by Regs. Sec. 1.108-2(e) (principally, certain short-term obligations and obligations acquired by security dealers); and (2) that, if treated as satisfied and reissued, will not have a significant effect on any person's tax liability for the year.(26)

Bad debt reserve: Under Prop. Regs. Sec. 1.1502-13(g)(5), a financial institution's deduction under Sec. 585 or 593 for an addition to its reserve for bad debts with respect to an intercompany obligation is not taken into account until the intercompany obligation becomes a nonintercompany obligation, or, if earlier, the redemption or collection of less than the "recorded amount" of the obligation. For these purposes, an addition to a reserve that results from charging off an intercompany obligation is treated with respect to the intercompany obligation.

Application of HYDO rules: Under Prop. Regs. Sec. 1.1502-80(f), the high-yield discount obligation (HYDO) rules of Sec. 163(e)(5) do not apply to an intercompany obligation.(27) However, the HYDO rules will apply if an intercompany obligation loses its status. For example, if an intercompany obligation becomes owned by a nonmember and, hence, loses its status as an intercompany obligation, the HYDO rules could restrict an issuer's OID deductions.

Sec. 267(f) Regulations

Prop. Regs. Sec. 1.267(f) retains the existing regulations' approach of deferring losses and deductions from certain transactions between members of a controlled group, but simplifies their operation by eliminating a provision that transforms a loss into additional basis and by more generally incorporating the consolidated return rules. Loss deferral is intended to prevent the tax avoidance that would occur from allowing S's loss or deduction without B's corresponding inclusion. The Sec. 267(f) proposed regulations apply the timing principles of the matching and acceleration rules of Prop. Regs. Sec. 1.1502-13 on a controlled group basis rather than on consolidated group basis; however, they generally do not apply the source, character or holding period rules of the proposed consolidated return regulations. Sec. 267(f) defines a controlled group by referring to Sec. 1563(a), and substituting a "more-than-50%" ownership requirement of vote or value of all classes of stock for the 80% vote or value requirement for a consolidated group. Corporations may be controlled group members without joining in the filing of consolidated returns or being owned through a common parent, and remain members of a controlled group as long as they remain in a controlled group relationship with one another.

* Matching and acceleration rules

In a consolidated group context, the matching rule of Prop. Regs. Sec. 1.1502-13(c) redetermines the character, source and other attributes of intercompany items and corresponding items on a single-entity basis. However, under Prop. Regs. Sec. 1.267(f)-1(c)(1), the matching and acceleration rules are not applied to affect the attributes of an item or cause it to be taken into account before it is taken into account under the member's method of accounting on a separate-entity basis. Thus, S's losses or deductions subject to Sec. 267(f) are determined on a separate-entity basis, and the matching and acceleration rules do not apply to affect the timing or attributes of B's items.

Example 16:(28) Matching rule. S holds land for investment with a basis of $130. On Jan. 1, 1995, S sells the land to B for $100. On a separate-entity basis, S's loss is a long-term capital loss. B holds the land for sale to customers in the ordinary course of business. On July 1, 1997, B sells the land to X for $110.

Prop. Regs. Sec. 1.267(f)-1(c)(1) directs that S's $30 loss is taken into account under the timing principles of the matching rule of Prop. Regs. Sec. 1.1502-13(c) to reflect the difference for the year between B's corresponding items taken into account and B's recomputed corresponding items (the corresponding items that B would take into account for the year if S and B were divisions of a single corporation). If S and B were divisions of a single corporation and the intercompany sale were a transfer between the divisions, B would succeed to S's $130 basis in the land and would have a $20 loss from the sale to X. Thus, S takes no loss into account in 1995 or 1996, and takes the entire $30 loss into account in 1997 to reflect the $30 difference in that year between the $10 gain B takes into account and its $20 recomputed loss. The attributes of S's intercompany items and B's corresponding items are determined on a separate-entity basis. Consequently, S's $30 loss is long-term capital loss and B's $10 gain is ordinary income.

Example 17:(29) Acceleration resulting from sale of B stock. The facts are the same as in Example 16, except that on July 1, 1997, P sells all of its B stock to X, rather than B selling the land to X. Under Prop. Regs. Sec. 1.267(f)-1(c)(1), S's $30 loss is taken into account under the timing principles of the acceleration rule of Prop. Regs. Sec. 1.1502-13(d) immediately before the effect of treating S and B as divisions of a single corporation cannot be produced. Because the effect cannot be produced once B becomes a nonmember, S takes its $30 loss into account in 1997 immediately before B becomes a nonmember. S's loss is a long-term capital loss.

* The subgroup approach

The consolidated return proposed regulations generally apply a single-entity approach; however, both the Sec. 267(f) existing and proposed regulations focus on the individual members participating in the transaction rather than the group. The reason for this subgroup approach is that the deferral of loss is based on the relationship of S and B to each other, rather than on their membership in a particular controlled group. Although there are no subgroup rules for intercompany transactions between members of a consolidated group, the existing temporary regulations provide that the deferral of loss continues under Sec. 267(f) as long as S and B remain in a controlled group relationship with each other. The existing regulations further provide that if S sells property to B at a loss, and the property is still owned by B when S ceases to be a member of the same controlled group, S never takes the loss into account. Instead, B's basis in the property is increased by the amount of S's unrestored loss. The proposed regulations attempt to simplify this approach by eliminating the rule that transforms S's loss into additional basis in the property transferred to B when S ceases to be a member of the controlled group. The proposed regulations generally allow S's loss immediately before it ceases to be a member. This conforms to the consolidated return rules and eliminates the need for special rules.

Example 18:(30) Subgroup principles applicable to sale of S and B stock. The facts are the same as in Example 16, except that on July 1, 1997, P sells all of its S and B stock to X, rather than B selling the land to X. Prop. Regs. Sec. 1.267(f)-1(b)(3) provides that S and B are still considered to remain members of a controlled group as long as they remain in a controlled group relationship with each other. There is no requirement that S and B remain in the original controlled group. P's sale of stock does not affect the controlled group relationship of S and B with each other. As a result, S's loss is not taken into account at the time of the stock sale; rather, S's loss is taken into account based on subsequent events (e.g., B's sale of the land to a nonmember of the controlled group).

In accordance with the current style of regulations, Prop. Regs. Sec. 1.267(f)-1(1)(2) provides an anti-avoidance rule that allows the IRS to make adjustments to carry out the purposes of Sec. 267(f) if a transaction has been structured so that a principal purpose is to avoid the application of that section. Such anti-avoidance rules permit the IRS to challenge questionable transactions that, while not specifically foreseen when the regulations were written, lack the spirit of the guidance. Thus, while the proposed regulations are written in a simpler form than the existing regulations, in effect, they have a broader scope.

* Sec. 267(f)'s interplay with consolidated rules

The proposed regulations under Sec. 267(f) provide for different treatment of S's losses or deductions on the distribution of loss property, depending on whether S is in a controlled group or a consolidated group. Under Prop. Regs. Sec. 1.267(f)-1(b)(2), unless an intercompany sale is also an intercompany transaction to which Prop. Regs. Sec. 1.1502-13 applies, S's losses or deductions subject to Sec. 267 are determined on a separate-entity basis. Thus, in a controlled group situation, Prop. Regs. Sec. 1.1502-13 would not apply to S's loss. The following example illustrates the interplay between Sec. 267 and Prop. Regs. Sec. 1.1502-13(f)(2)(iii), which applies the Sec. 311(b) gain recognition principles to consolidated return losses.

Example 19:(31) Timing and attributes within a controlled group, S holds land with a basis of $130 and an FMV of $100. On Jan. 1, 1995, S distributes the land to P in a transaction to which Sec. 311 applies. On July 1, 1997, P sells the land to X for $1 10. Under Prop. Regs. Sec. 1.267(f)-1(b)(2), because P and S are not members of a consolidated group, Prop. Regs. Sec. 1.1502-13(f)(2)(iii) does not apply to cause S to recognize a $30 loss under Sec. 311(b). Thus, S has no loss to be taken into account. However, if P and S were members of a consolidated group, Prop. Regs. Sec. 1.1502-13(f)(2)(iii) would apply to S's loss, and the lose would be taken into account in 1997 as a result of P's sale to X.

Example 20:(32) Timing and attributes within a consolidated group. P owns all of the stock of S and B, and the P group is a consolidated group. S holds land for investment with a basis of $130. On Jan. 1, 1995, S sells land to B for $100. B holds the land for sale to customers in the ordinary course of business. On July 1, 1997, P sells 25% of B's stock to X. As a result of P's sale, B becomes a nonmember of the P consolidated group, but S and B remain in a controlled group relationship with each other for purposes of Sec. 267(f). Assume that if S and B were divisions of a single corporation, the items of S and B from the land would be ordinary by reason of B's activities.

Prop. Regs. Sec. 1.267(f)-1(a)(3) provides that S's sale to B is subject to both Prop. Regs. Sec. 1.1502-13 and the Sec. 267(f) proposed regulations. Under Prop. Regs. Sec. 1.1502 13, S's loss is recharacterized as an ordinary loss by reason of B's activities. Under Prop. Regs. Sec. 1.267(f)-1(b)(3), because S and B remain in a controlled group relationship with each other, the loss is not taken into account under the acceleration rule of Prop. Regs. Sec. 1.1502-13(d) as modified by Prop. Regs. Sec. 1.267(f)-1(c). Nevertheless, S's loss is recharacterized by Prop. Regs. Sec. 1.1502-13 as an ordinary loss, and the character of the loss is not further redetermined under the Sec. 267 rules. Thus, the loss continues to be deferred under Sec. 267, and will be taken into account as an ordinary loss based on subsequent events (e.g., B's sale of the land to a nonmember).

Sec. 267 may also apply concurrently with Sec. 269, which applies to acquisitions to evade or avoid income tax, and Sec. 482, regarding allocations among commonly controlled taxpayers. Any loss or deduction taken into account under Sec. 267 can be deferred, disallowed or eliminated under other applicable law. For example, if a transaction is a wash sale to which Sec. 1091 applies, Sec. 1091 would eliminate the loss on the transaction.

* Transfers to a nonmember

Prop. Regs. Sec. 1.267(f)-1(c)(2) provides adjustments to the timing principles of Prop. Regs. Sec. 1.1502-13(c) and (d) if there is a transfer to a Sec. 267(b) related person. To the extent S's loss or deduction is taken into account under the Sec. 267 rules as a result of B's transfer to a nonmember who is a person related to any member under Sec. 267(b), the loss or deduction is taken into account but allowed only to the extent of any income or gain taken into account as a result of the transfer. The balance not allowed is treated as a loss referred to in Sec. 267(d) if it is from a sale or exchange by B (rather than a distribution). Sec. 267(d) provides that when the taxpayer sells or disposes of the property for which the loss was disallowed, the gain from the disposition will only be recognized to the extent that it exceeds the previously disallowed loss. This result is consistent with the existing regulations, which provide that to the extent a deferred loss is in excess of the amount of gain recognized on the sale to a Sec. 267(b) related person, it is never restored.

Example 21:(33) Timing issues in a Sec. 721 transfer to a Sec. 267(b) nonmember. S owns land with a basis of $130. On Jan. 1, 1995, S sells the land to B for $100. On July 1, 1997, B transfers the land to a partnership in exchange for a 40% interest in capital and profits in a transaction to which Sec. 721 applies. P also owns a 25% interest in the capital and profits of the partnership. Under Prop. Regs. Sec. 1.267(f)-1(c)(2)(ii), S's $30 loss is taken into account in 1997 but disallowed because the partnership is a nonmember that is a related person under Sec. 267(b). Moreover, subsequent gain recognized by the partnership with respect to the property is limited under Sec. 267(d). The results would be the same if the P group were a consolidated group, and S's sale to B were also subject to Prop. Regs. Sec. 1.1502-13.

* Receivables

Prop. Regs. Sec. 1.267(f)-1(f) follows the existing temporary regulations with respect to receivables. In a controlled group context, if S has income or gain from a receivable as a result of selling goods or services to a nonmember, and S sells the receivable at FMV to B, any loss or deduction of S from its sale to B is not deferred to the extent that it does not exceed S's income or gain from the sale to the nonmember. This result is consistent with the purpose of the deferred loss rules, because S recognized any gain inherent in the receivable at the time it sold the underlying goods or services to the nonmember. Thus, the proposed regulations once again take a separate-entity approach and allow S to recognize any loss on the transfer of the receivable to B. However, if S and B are consolidated group members, the matching rule, which applies a single-entity approach, overrides Sec. 267(f) to require that S's loss be deferred until B either becomes a nonmember of the consolidated group or transfers the receivable outside of the group. At that time, if B remains in a controlled group situation with S, Prop. Regs. Sec. 1.267(f)-1(f) would apply to limit S's loss to the gain previously recognized.

Example 22:(34) Receivables transferred within a controlled group. S owns goods with a $60 basis. In 1995, S sells the goods to X for X's $100 note. The note bears a market rate of interest in excess of the applicable Federal rate (AFR), and provides for payment of principal in 1999. S takes into account $40 of income in 1995 under its method of accounting. In 1996, the FMV of X's note falls to $90 due to an increase in prevailing market interest rates, and S sells the note to B for its $90 FMV. Under Prop. Regs. Sec. 1.267(f)-1(f), S takes its $10 loss into account in 1996. However, if the sale were not at FMV, Prop. Regs. Sec. 1.267(f)-1(f) would not apply and none of S's loss would be taken into account in 1996.

Example 23:(35) Receivables transferred within a consolidated group. The facts are the same as in Example 22, except that P owns all of the stock of S and B, and the P group is a consolidated group. In 1995, S sells to X goods having a basis of $90 for X's $100 note, which bears a market rate of interest in excess of the AFR. The note provides for payment in 1999, and S takes $10 into income in 1995. In 1996, S sells the receivable to B for its $85 FMV. In 1997, P sells 25% of B's stock to X. Although Prop. Regs. Sec. 1.267(f)-1(f) provides that $10 of S's loss (i.e., the extent to which S's $15 loss does not exceed its $10 of income) is not deferred under Sec. 267, S's entire $15 loss is subject to Prop. Regs. Sec. 1.1502-13 and none of the loss is taken into account in 1996 under the matching rule of Prop. Regs. Sec. 1.1502-13(c). P's sale of B stock results in B becoming a nonmember of the P consolidated group in 1997. Thus, S's $15 loss is taken into account in 1997 under the acceleration rule in Prop. Regs. Sec. 1.1502 13(d). In any event, B remains in a controlled group relationship with S and Prop. Regs. Sec. 1.267(f)-1(f) permits only $10 of S's loss to be taken into account in 1997. The remaining $5 of S's loss continues to be deferred under Sec. 267 and taken into account based on subsequent events, such as B's collection of the note or P's sale of the remaining B stock to a nonmember.

The proposed regulations' most significant deviation from the existing regulations is the elimination of the basis adjustment provision that transforms S's loss into additional basis in the transferred property when S ceases to be a member of the controlled group. Under the proposed regulations, in the year in which the loss property is transferred outside of the controlled group, S takes the loss into account with the same character that it would have had if S had recognized the loss at the time of the transfer.

The existing regulations attempt to specifically define and address deferred loss problems that may arise in a controlled group context. This considerable complexity is largely due to the extensive cross-referencing of the consolidated return regulations. While the result in many situations is the same under either the existing regulations or the proposed regulations, the proposed regulations achieve the same result in a less complex manner than the existing regulations. The Sec. 267(f) proposed regulations contain a more general reference to the incorporation of the consolidated return provisions, and add a general anti-abuse enforcement mechanism. Thus, the proposed regulations need not specifically address the "laundry list" of transactions that creative tax advisers may possibly structure.

Other Rules

* Accounting methods

Under Regs. Sec. 1.1502-17, a newly formed corporation is permitted to select an accounting method. Thus, an existing member of a consolidated group that wanted to change its accounting method with respect to a business activity but did not want to ask the IRS for consent could simply form a new corporation to conduct the activity. Prop. Regs. Sec. 1.1502-17(c) provides an anti-avoidance rule such that if one member (B) directly or indirectly acquires an activity of another member (S) or undertakes S's activity, with the principal purpose of availing the group of an accounting method that would be unavailable without securing IRS consent if S and B were treated as divisions of a single corporation, B must either use the accounting method that would be imposed on it if it acquired the business in a transaction described in Sec. 381, or secure IRS consent.

Example 24:(36) Adopting methods. S is a service provider with substantial parts and supplies on hand for use in its repair service business. S capitalizes its cost for the parts and supplies and deducts the cost under Regs. Sec. 1.162-3. S is unable to adopt a LIFO inventory method under Sec. 472 because the parts and supplies are used solely in its service business. S forms corporation B, with the principal purpose to use a LIFO inventory method, and B begins to purchase and maintain all of the parts and supplies using a LIFO inventory method. S purchases the parts and supplies that it needs from B, and B's only customer is S. Under Prop. Regs. Sec. 1.1502-17(c), B must account for the parts and supplies under Regs. Sec. 1.162-3, rather than adopting a LIFO inventory method.

* New Sec. 108(b) attributes

No mention is made in the existing regulations as to whether deferred intercompany gain or loss constitutes member attributes for purposes of Sec. 108(b). This can lead to rather interesting results.

Example 25: Deferred loss and Sec. 108(b). S owns property with a basis of $500 and an FMV of $300. S has no other attributes and no other assets. During a tax year in which S has $100 of COD income that is excluded under Sec. 108(a), S sells the property to B for $300, recognizing a $200 loss.

Under current law, there is no requirement to reduce a deferred intercompany loss under Sec. 108(b) to reflect excluded COD income. Therefore, it appears that the deferred loss is not reduced under Sec. 108(b).

Had S not sold the property to B until the following year, the property's basis would have been reduced under Sec. 108(b) to $400. Thus, S would have a built-in loss of only $100. Prop. Regs. Sec. 1.108-3(a) addresses this inconsistency by treating any loss deferred under Sec. 267(f) or Prop. Regs. Sec. 1.1502-13 as basis in property owned by S, thereby requiring such built-in loss to be reduced to $100 under Sec. 108(b).

* Inventory adjustments from NON-SRLYs/SRLYs

Under Regs. Sec. 1.1502-18, complex adjustments are required to avoid distortions of inventories that were on hand during a separate return limitation year (SRLY) of a corporation that was a member of an affiliated group that did not file consolidated returns. Prop. Regs. Sec. 1.1502-18(g) repealed this rule, because the complexity it caused was not justified by the abuse sought to be curbed.

Conclusion

The proposed regulations appear to reach a good balance of providing appropriate guidance while dealing administratively with transactions that rely on literal compliance with the technical rules, but reach a result inconsistent with their spirit and intent. They are designed to enable compliance under current and future tax law. The extent to which these regulations will be successful in achieving these lofty goals remains to be seen.

(1) Notice of Proposed Rulemaking (CO-11-91), published in the Federal Register (4/15/94). (2) See Choate and Mason, "Consolidated Returns and the Single Entity Theory," 25 The Tax Adviser 655 (Nov. 1994). (3) The allowance of the exclusion only when there is a negative basis adjustment is aimed at dividend-stripping transactions. (4) For example, the holdings of Rev. Rul. 72-230, 1972-1 CB 209 (the effect of dividend elimination on the source of dividends paid under Sec. 861(a)(2)) and Rev. Rul. 79-60,1979-1 CB211 (the effect of dividends eliminated on personal holding company status) and the application of Sec. 1059 should not be affected. (5) In each of the examples, unless otherwise stated, P is the common parent of the P consolidated group, S and B arc P's wholly owned subsidiaries, the tax year of all persons is the calendar year, all parties are accrual-method taxpayers, tax liabilities are ignored and the facts set forth the only corporate activity. (6) Prop. Regs. Sec. 1.1502-13(f)(6), Example 1. (7) However, Prop. Regs. Sec. 1.1502-13(f)(3)(ii) does not apply to a reorganization if any participant becomes a member or a nonmember as part of the same plan or arrangement. (8) Donald E. Clark, 489 US 726 (1989)(63 AFTR2d 89-860, 89-1 USTC [paragraph] 9230), aff'g 828 F2d 221 (4th Cir. 1987)(60 AFTR2d 87 5592, 87-2 USTC [paragraph] 9504). (9) Prop. Regs. Sec. 1.1502-13(f)(6), Example 3. (10) Prop. Regs. Sec. 1.1502-13(f)(6), Example 3(d). (11) This rule overrides GCM 39608 (3/5/87), which permitted such gain to be deferred even though the stock became treasury stock. (12) If the basis of T's assets equals the basis of its stock before the sale by S, S's gain from the T stock on the liquidation will be duplicated by gain that the group later recognizes from the assets of the former T (because B will succeed to T's basis in the assets). (13) No definition is given of "substantially all" of the assets. Presumably, guidance can be found in the 70% of FMV of gross/90% of FMV of net assets tests of Rev. Proc. 77-37, 1977-2 CB 568. (14) It is not clear why the proposed regulations require new T to be a newly created member. Query whether final regulations will allow a transfer of substantially all of T's assets to an existing member. (15) The deemed liquidation under Sec. 332 is respected f or all other Federal income tax purposes. (16) Prop. Regs. Sec. 1.1502-13(g)(6), Example 1(a) and (b). (17) Prop. Regs. Sec. 1.1502-13(g)(6), Example 1(c). (18) Prop. Regs. Sec. 1.1502-13(g)(6), Example 1(d). (19) Prop. Regs. Sec. 1.1502-13(g)(6), Example 2. (20) Prop. Regs. Sec. 1.1502-13(g)(6), Example 3(a) and (b). (21) Prop. Regs. Sec. 1.1502-13(g)(6), Example 2(d). (22) Prop. Regs. Sec. 1.1502-13(g)(6), Example 2(e). (23) No definition is provided for when an effect will be "significant." Absent more definitive guidance, it will be difficult (if not impossible) to determine whether a transaction will have a "significant" effect on any person's income tax liability at the time of the satisfaction and reissuance of the obligation. (24) Prop. Regs. Sec. 1.1502-13(g)(6), Example 4(a) and (b). (25) Prop. Regs. Sec. 1.1502-13(g)(6), Example 4(c). (26) See note 23. (27) For a detailed discussion, see Mason, Grudzinski and Choate, "Restructuring Leveraged Buyouts," 17 Journal of Corporate Taxation 303 (Winter 1991). (28) Prop. Regs. Sec. 1.267(f)-1(j), Example 1(a). Unless otherwise stated, the following facts apply to Examples 16-23: P owns 75% of the only class of stock of subsidiaries S and B. Thus, the P group is a controlled group, because P owns more than 50% of the subsidiaries' stock, but is not a consolidated group because it does not meet the 80% threshold. X is an unrelated party. (29) Prop. Regs. Sec. 1.267(f)-1(j), Example 1(c). (30) Prop. Regs. Sec. 1.267(f)-1(j), Example 1(d). (31) Prop. Regs. Sec. 1.267(f)-1(j), Example 2. (32) Prop. Regs. Sec. 1.267(f)-1(j), Example 4. (33) Prop. Regs. Sec. 1.267(f)-1(j), Example 6. (34) Prop. Regs. Sec. 1.267(f)-1(j), Example 7. (35) Prop. Regs. Sec. 1.267(f)-1(j), Example 7(c). (36) Prop. Regs. Sec. 1.1502-17(d), Example 2.
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