Proposed intercompany transaction regulations under section 1502.
On April 11, 1994, the Internal Revenue Service issued proposed regulations under section 1502 of the Internal Revenue Code, concerning the rules for intercompany transactions among corporations that join in filing a consolidated return.
The proposed regulations (CO-11-91) were published in the Federal Register on April 15, 1994 (59 Fed. Reg. 18011), and in the Internal Revenue Bulletin (1994-18 I.R.B. 48).(1)* Public hearings on the proposed rules were held on May 4, and August 8, 1994. Tax Executives Institute is pleased to submit the following comments on the proposed regulations.
Tax Executives Institute (TEI) is the principal association of business tax executives in North America. The Institute's approximately 5,000 members represent more than 2,700 of the largest companies in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and the government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works ae one that is administrable and with which taxpayers can comply.
TEI members are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations relating to intercompany transactions among members of affiliated groups filing consolidated tax returns.
The proposed regulations on intercompany transactions represent the third part of a series of regulation projects initiated in February 1991 to overhaul the core of the consolidated return rules. The first project (CO-132-87 CO-78-90) revamps the separate return limitation year (SRLY) rules affecting loss carryovers under section 382. The second project (CO-30-92), finalized in T.D. 8560(2), revises the investment adjustment and earnings and profits rules contained generally in Treas. Reg. [sub-sections] 1.1502-32 and -33. This project completes the 1991 trilogy. The proposed intercompany transaction regulations expand the shift from the separate-entity theory of the 1966 consolidated return regulations to the single-entity theory. Under the proposed rules, transactions between the separate members of a consolidated group are treated as though they occur between divisions of a single entity for purposes of timing, character, source, and other tax attributes. "Only the amount and location of items remain on a separate entity basis."(3)
The proposed rules substantially alter the theoretical and conceptual framework and terminology governing the treatment of intercompany transactions for corporate groups filling consolidated returns. In many circumstances, the proposed rules produce the same result on taxable income as the current regulations. Consequently, the recognition of gain or loss from intercompany transactions will be generally deferred until a subsequent event or transaction occurs. Consistent with the current philosophy governing the promulgation of tax regulations, the framework of the proposed rules is set forth in general principles, supplemented by, in this case at least, a staggering number of examples illustrating the operation of the rules in specific cases. Finally, in keeping with the trend in regulatory guidance, the proposed rules are back-stopped by a general anti-abuse rule of broad and uncertain scope.(4)
Prefatorily, TEI observes that the general principles of the proposed rules are as dauntingly abstruse to apply as they are simple to state. The myriad examples, while providing concrete guidance in the specific fact patterns presented, provide precious little aid for transactions falling outside of their restricted scope. Moreover, in some examples the longstanding tax treatment of certain transactions has been upended by a seemingly purposeful result-oriented view that is inconsistent with sound economic or tax policy. In addition, the opaque nature of the general rules will prove confusing or even contradictory where the non-consolidated tax principles underlying the basic examples change. At a minimum, the IRS should develop additional guidance to fill in the regulatory interstices and should continue to revise or refine the intercompany transaction examples as the Code and regulations evolve.(5)
Change in Method
Prop. Reg. [sections] 1.1502-13(a)(3) states that "[t]he timing rules of this section are a method of accounting that overrides otherwise applicable accounting methods." The preamble explains that the "proposed regulations are a method of accounting to the extent they determine the timing of items" and adds that "[a] group's ability to change its manner of applying the final intercompany transaction regulations will be subject to the generally applicable rules for accounting method changes."
These statements represent a radical departure from the current consolidated return regulations, the applicable case law (both pre- and post-1966), private rulings that consistently hold that the consolidated return regulations establish methods of reporting rather than methods of accounting. No explanation, discussion, illustration, or rationale is set forth in either the proposed regulations or the preamble. In addition, despite extensive public debate and commentary concerning the need generally to revise and update the consolidated return rules, there has never been a public discussion or suggestion that the general requirement to maintain books and records in order to document intercompany transactions should be supplemented with an accounting-method rule. Indeed, the absence of any explanation of the rationale for such a drastic change makes impossible the task of commenting on the validity of what the IRS believes must be cured or to comment on the propriety of the medicine.
Under the current consolidated return regulations, adjustments may be made by the Commissioner to ensure proper reporting of taxable income for every taxable year. Under the rules governing changes in accounting methods, however, adjustments are generally made to later years identified by the Commissioner or her agents. Thus, accounting errors will not be corrected in the year they arise (because it is rare for an erroneous accounting method to be identified prior to a taxpayer's filing a return and thereby "locking in" the erroneous accounting method), but in years identified by the Commissioner or her agents.(8)TEI believes that the principal effect of engrafting the accounting method rules on intercompany transactions will be to unduly burden taxpayers. Specifically, they will be required either (i) to perpetuate accounting methods that are erroneous or less than optimal from an accounting perspective or (ii) to file applications to change methods of accounting for transactions that, by definition, represent deferred income or deductions. Neither burden is justified. We thus recommend that the IRS abandon the position in the proposed regulations and continue, instead, to treat intercompany transactions as methods of reporting rather than methods of accounting.
Actual or Deemed
Section 332 Liquidations
Prop. Reg. [sections] 1.1502-13(f)(5)(i) states that, in an affiliated group consisting of, parent, P, and first-tier subsidiaries, S and B, and S's subsidiary, T, "S's intercompany items from an intercompany transfer to B of the stock of . . . T are taken into account under this section in certain circumstances even though the T stock is never held by a nonmember after the intercompany transaction. For example, if S sells all of T's stock to B at a gain, and T subsequently liquidates into B in a separate transaction to which section 332 applies, S's gain is taken into account under this section." The proposed regulations provide "limited administrative relief" under circumstances outlined in Prop. Reg. [sub-sections] 1.1502-13(f)(5)(ii) and (iii).
TEI submits that the rules need to be rethought. We believe that the approach of the proposed regulations will lead to numerous traps for unwary taxpayers in nonabusive, corporate restructuring transactions where assets never leave the affiliated group. One of the purposes of section 332 is to permit groups of corporations to reorganize their assets into the most efficient form free of tax that may otherwise result from liquidation of a corporate entity.(9) In lieu of a general rule that causes a prior intercompany transfer of stock to trigger gain upon the subsequent liquidation (or downstream merger) of an entity (T) whose stock was transferred, TEI believes that a liquidation of a subsidiary pursuant to section 332 (or a deemed section 332 liquidation as a result of an election under section 338(h)(10)) or a downstream merger should not be triggering events for the recognition of gain. The proposed rule is misguided because any gain that is taxed is very likely phantom income that will not materialize unless and until the underlying T assets are disposed of by B. Where the P group has not received cash or property for the stock of T upon its liquidation or merger, there is no economic or policy reason to subject the P group to tax.
In essence, then, TEI recommends that S's prior intercompany gain be eliminated. To preserve the recognition of future gain or loss, of course, T's basis in its assets should carryover to B. The need for the "limited administrative relief" provisions - and the need to address questions about their limited scope (see below) - would be obviated if the broader approach is adopted. Finally, if the IRS or Treasury perceive potential abuses arising from the espoused position, we submit that the abusive transactions should be identified and addressed with a targeted anti-abuse provision.
Prop. Reg. [sections] 1.1502-13(f)(5)
1. Sale of Subsidiary Stock with Section 338(h)(10) Election Following An Intercompany Transaction. The congressional objective in enacting section 338(h)(10) was to afford taxpayers flexibility in structuring the purchase and sale of business units without unduly fettering the form of the transaction with tax requirements. Thus, where business reasons compel a taxpayer to structure a transaction for the sale of a company as a sale of stock, section 338(h)(10) permits the buyer and seller to elect to recast the form of the transaction for tax purposes as though it were an asset sale. Where the election is made, the seller's gain or loss is computed with respect to the underlying or inside basis of the assets rather than the basis in the stock of the subsidiary.
Under the current intercompany transaction regulations, a deferred gain created upon a sale or distribution of stock of a subsidiary member of the consolidated group may result in a duplicated gain where, following an intercompany sale or distribution of stock of a subsidiary member, the subsidiary whose stock was sold or distributed is deemed liquidated as a result of a section 338(h)(10) election.(10) For example, assume the following:
P is the common parent of a consolidated group that includes B, S, and T, with T being a second-tier subsidiary of S. S's basis in T stock is $10 and T's basis in its assets is also $10. In connection with a restructuring of the P group, in year 1 S sells the stock of T to B for its fair value of $200, creating a deferred intercompany gain to S of $190.
In year 3, B desires to sell the business to unrelated corporate group X for the appreciated fair value of $400 (for which the assets' bases remains $10). For business reasons, B sells the stock of T to X, and P and X agree to elect under section 338(h)(10) to treat the acquisition as a sale of assets.
Currently, T is deemed liquidated under section 332, and the P group is required to recognize $580 of taxable gain (rather than the $390 of economic gain) because the $190 deferred gain from the prior sale of T stock by S to B must be restored to income when the stock of old T is canceled. The deferred gain from the prior stock sale ($190) is thus duplicated when the P group elects the deemed asset sale treatment (the $390 total gain on the asset sale to X includes $200 of appreciation attributable to B's holding period for T plus the $190 attributable to S's holding period for T).
Under Prop. Reg. [sections] 1.1502-13(f)(5)(iii), a special election permits P to treat the deemed liquidation of T as not qualifying under section 332. Making the election produces a loss under section 331 to B, but only to the extent of the prior deferred intercompany gain recognized by S.(11) The elective relief is not available, however, where either (i) T has made a substantial noncash distribution within the 12-month period ending on the date of the qualified stock purchase(12) or (ii) a minority interest existed at any time between the date of the intercompany transaction and the subsequent triggering transaction.(13)
TEI submits that the limited administrative relief is too circumscribed. In particular, the prohibition on noncash distributions within the 12-month period preceding the date of the triggering event should not apply to distributions occurring prior to the date the proposed regulations were promulgated because taxpayers had no notice that such a condition would apply. In addition, the proscription against non-cash distributions should be liberalized to permit corporate groups to "clean up" the balance sheets of target affiliates holding intercompany debt obligations. Thus, the distribution of intercompany receivables during the pre-sale 12-month period should not be considered abusive. Finally, where a nonmember shareholder of T (a minority shareholder of T) exists at anytime between the date of the intercompany transaction and the date of the subsequent triggering transaction, the proper rule should be for the IRS to reduce the amount of the relief permitted to the P group (to account for the minority interest) rather than to disqualify the transaction completely from the relief.
2. Effective Date of Relief Provisions. The proposed intercompany transaction regulations will be effective generally for transactions occurring in years beginning on or after the date of adoption of final regulations.(14) It is unclear whether the elective relief provisions in Prop. Reg. [sections] 1.1502-13(f)(5) apply where the intercompany transaction occurs prior to the date of adoption of the intercompany transaction regulations and the subsequent triggering event occurs after adoption of the regulations.
TEI believes that the potential for the creation and taxation of duplicative gains is so onerous - and so unjustified - that the relief provisions should be expanded. Ideally, Prop. Reg. [sections] 1.1502-13(f) would be made retroactive to all open tax years to provide relief to taxpayers who fell into the trap of duplicated gain.(15) At a minimum, though, the effective date of the proposed regulations should be clarified to apply to all triggering transactions specified in Prop. Reg. [sections] 1.1502-13(f)(5) that occur after the date of announcement of the proposed regulations (April 8, 1994).(16)
We urge the IRS to clarify the effective date of the relief provisions in a manner that minimizes the exposure of taxpayers to double counting of gains.
The proposed regulations define two terms, "intercompany items" and "corresponding items," very broadly to describe the income, gain, deduction, or loss amount arising from an intercompany transaction between S and B.(17) In addition, the newly created terms "deemed intercompany items" and "deemed corresponding items" are defined broadly to permit the matching rule of Prop. Reg. [sections] 1.1502-13(c) to apply where either S's or B's intercompany transaction item is reflected in the basis (or the equivalent of basis in a loss carryover or excess loss account) of the other member. In other words, for every intercompany or deemed intercompany item to S, there is a corresponding item for B; and for every corresponding or deemed corresponding item to B, there is an intercompany item for S.
The scope and application of these rules are difficult to determine. Indeed, Example 15 of Prop. Reg. [sections] 1.1502-13(c)(4)(ii), illustrating the application of the rules in the context of a manufacturer's rebate, reaches a conclusion that simultaneously is at odds with the economics of the transaction, conflicts with the proper application of the matching principle, is contrary to the tax result achieved where the related parties file separate returns, and violates the avowed principle of the proposed regulations in treating transactions between S and B as though they were divisions of a single entity. In the example, manufacturer B and finance subsidiary S file a consolidated return. Manufacturer B sells its products to independent dealers. Finance subsidiary S purchases products from the dealers in order to provide lease financing to the dealer's customers. Under the rebate program, finance subsidiary S buys a $100 product from a dealer and leases it to the dealer's customer, paying $90 cash and assigning the $10 rebate from manufacturer B to the dealer.
Generally, rebates paid by a manufacturer to customers are deductible as business expenses for the manufacturer, and customers in turn must reduce the basis in their assets by an equivalent amount.(18) Indeed, the example confirms that under separate-entity accounting, the manufacturer (B) deducts the entire $10 rebate in the year of payment and the finance subsidiary (S) takes a $90 basis in the product. The example, however, applies the "deemed intercompany item" rule to treat the rebate as an intercompany transaction and concludes that S (finance subsidiary) must include $10 in income (offsetting B's (the manufacturer's) rebate deduction) and increase S's basis in the product to $100. The basis, increased by the deemed intercompany item amount, is recovered through depreciation deductions by S.
To be an effective sales incentive, the economic benefit of a rebate must accrue to a customer outside of the consolidated group. As a result, the expense of the rebate should properly be matched to the income attributable to a sale of product to the manufacturer's customer, the dealer. That this is the proper application of the matching principle is confirmed by comparing the result where the manufacturer either provides the rebate to a dealer directly or assigns the rebate to an unrelated finance company. In the case of a direct rebate from the manufacturer to the dealer (or the dealer's customer), Rev. Rul. 76-96 achieves the proper matching of income and expense by permitting the manufacturer to deduct its rebate costs as part of the cost of selling the product to the dealer. The result would be the same where the finance and manufacturing operations are divisions of the same legal entity. Finally, where a manufacturer provides a rebate to an unrelated finance company, the unrelated finance company is clearly entitled to take a basis in the asset purchased (or financed) net of the rebate amount where it assigns the rebate to the dealer.
In stark contrast to those results, the proposed regulations treat a rebate assigned to a consolidated finance subsidiary and subsequently reassigned to the dealer differently. The different result confers an unjustified competitive advantage on third-party finance companies. As important, the improper result arises because of a misapprehension of the proper income and expense to be matched. The rebate enables the dealer (a non-member) to sell or lease products to its customers (also non-members); hence, the rebate - the manufacturer's cost of facilitating that sale - should be an expense when it is incurred. Any other treatment would violate both the matching principle and the principle of tax neutrality.
We recommend that Example 15 be eliminated.
Section 863(b) Source Rule
Example 17 of Prop. Reg. [sections] 1.1502-13(c)(4)(ii) illustrates the interaction of the proposed regulations with the rules under section 863 to source gain or loss on export sales. In the example, S and B are members of an affiliated group filing a consolidated return and B operates a branch outside of the United States. S sells goods that it manufactured to B, and B resells the goods to third-party customers. The example provides two conclusions. First, section 863 is to be applied to the combined income of S and B rather than to their separate results. This result, while consistent with the overarching theory of the proposed regulations to treat S and B as though they were divisions of a single corporation, represents a change from the current rules, which provide that the source of the income on the sale by S to B is determined independently of the source of the income on the sale from B to the third party. More fundamentally, the result is contrary to the longstanding tax policy on sourcing that Congress itself has consistently refrained from altering. Section 863(b) and the current intercompany transaction regulations permit companies to structure their affairs to maximize their foreign-source income in order to be more competitive in the global marketplace. We do not believe it proper for the IRS to overturn legislative intent by substituting its judgment for that of the Congress in seeking the proper balance between promoting exports (and foreign-source income) and collecting tax.
The proposed regulations will also alter the allocation of the domestic- and foreign-source income between B and S in a fashion that has (perhaps unintended) collateral effects on unrelated parties. Under the current rules, the sourcing of the income on the sale from S to B and the sale from B to the unrelated third party are determined independently. As a result, as long as its purchases and sales are both deemed to occur outside of the United States, B has no U.S.-source income. Under the proposed regulations, however, B will have U.S.-source income.
As a result of the re-sourcing of B's income, interest payments made by B to an unrelated foreign bank may now be subject to U.S. withholding tax (assuming B is disqualified as an "80-20" company under section 861(a)(1)(a)). Foreign banks financing the overseas branch operations of U.S. companies will be quite surprised - and displeased - to find that interest on loans extended to finance the local operations is subject to U.S. tax consequences. If the operations in the foreign jurisdiction are separately incorporated (as a controlled foreign corporation), there will likely be no effect, but if the local operation is a foreign branch the new intercompany transaction regulations may severely disadvantage the branch vis-a-vis local competitors. This result is improper. A U.S.-based multinational may choose to operate overseas via branches for valid non-tax reasons. Furthermore, inasmuch as operating in the branch form does not result in deferral of U.S. tax on foreign profits and also vitiates transfer-pricing and other cross-border tax issues, the IRS and Treasury should arguably encourage the establishment of foreign branches. The proposed regulations, however, go in the other direction and impose a significant and counterproductive burden on foreign branch operations.
In the event that the IRS does not withdraw Example 17 and otherwise disavow any attempt to upend the longstanding policy underlying section 863, the secondary impact could be avoided by changing the manner in which the U.S.- and foreign-source income is allocated between S and B. This allocation may be accomplished by leaving B with 100-percent foreign-source income and re-sourcing as U.S.-source income as much of S's income as is necessary to equal the result provided in the first part of Example 17. This change would at least eliminate the potential effect of the change in the sourcing on parties that are not members of the consolidated return.
TEI is pleased to have the opportunity to present its views on the subject of the proposed regulations relating to intercompany transaction adjustments. These comments were prepared under the aegis of TEI's Federal Tax Committee whose chair is Michael A. DeLuca. If you have any questions concerning these comments, please call either Mr. DeLuca of Household International, Inc. at (708) 564-6108, or Jeffery P. Rasmussen of the Institute's professional tax staff at (202) 638-5601.
(1) For simplicity's sake, the proposed regulations are referred to as the "proposed regulations" or "proposed rules"; specific provisions are cited as Prop. Reg. [sections]." References to page numbers are to the proposed regulations (and preamble) as published in the Internal Revenue Bulletin. (2) 1994-38 I.R.B. 5. (3) 1994-18 I.R.B. at 49. (4) Indeed, Prop. Reg. [sections] 1.1502-13(l)(2) sets forth a secondary anti-abuse rule to prevent taxpayers from structuring transactions after April 15, 1994, with a principal purpose of avoiding the prospective effective date of the final regulations. (5) One reason for the complexity of the proposed regulations on intercompany transactions was publicly acknowledged by the drafters: the diversity and scope of intercompany transactions are as broad as the Code and regulations themselves in governing third-party transactions. To be "complete," then, the rules on intercompany transactions would need to illustrate every operative Code section or regulation - an impossible undertaking. (6) 1994-18 I.R.B. at 49. (7) Vernon C. Neal Inc., v. Commissioner, 23 T.C.M. 1338 (1964); Henry C. Beck Builders. Inc. v. Commissioner 41 T.C 616 (1964); Henry C. Beck Co. v. Commissioner, 52 T.C. 1 (1969), aff'd per curiam, 433 F.2d 309 (5th Cir. 1970); Letter Ruling No. 7820024 (Feb. 15, 1978); Letter Ruling No. 8204094 (Oct. 28, 1981); Letter Ruling No. 9002006 (Sept. 30, 1989). (8) The recently proposed changes to the regulations under section 446 confirm the IRS's administrative practice of imposing any conditions it deems proper for approving a change in accounting method. Conditions for change all too often involve, for positive adjustments to taxable income, an immediate increase in taxable income in the earliest open year, and, for negative adjustments, a spread of the adjustments (or perhaps the imposition of a "cut-off" method) to future years. (9) "Congress enacted the predecessor of [section] 332 in 1935 with the hope that it would encourage the simplification of complex corporate structures by permitting the liquidation of unnecessary subsidiaries without recognition of gain." Boris I. Bittker and James S. Eustice, Federal Income Taxation of Corporations and Shareholders 10-51 (6th ed. 1994). (10) Notice 94-49, 1994-18 I.R.B. 15. (11) Under the assumed facts, the elective relief provision operates in the following fashion: T recognizes a gain of $390 ($400 value less $10 basis) on the deemed sale of the assets to X. When the -13(f)(5)(iii) relief election is made, T is deemed to liquidate under section 331 and make a deemed cash distribution of $400 to B. B's basis in the T stock is increased to $590 ($200 cost basis for the amount paid to S in year 1, plus a $390 investment basis adjustment attributable to the gain recognized on the deemed asset sale to X), producing a loss of $190 on the liquidating distribution ($400 cash received on the deemed distribution, less the $590 basis). In summary, the tax results to the P group from the transaction are: $390 asset sale gain to T; $190 of intercompany item gain to S (restored gain in the lexicon of the current regulations), and a $190 corresponding item of loss to B. (12) Prop. Reg. [sections] 1.1502-13(f)(5)(iii)(A). (13) Prop. Reg. [sections] 1.1502-13(f)(5)(i). (14) Prop. Reg. [sections] 1.1502-13(l). (15) Indeed, wary taxpayers may have been precluded from making section 338(h)(10) elections. To remedy the duplicate gain defect of the current intercompany transaction regulations, the IRS should consider permitting affected taxpayers to apply the relief provisions of the proposed regulations in all open tax years and permit taxpayers to make out-of-time section 338(h)(10) elections. (16) In the preamble to the proposed regulations, the government acknowledges that duplicated gain recognition is improper. Thus, relief should be permitted from the date of the acknowledgment rather than being postponed. The effect of the proposed regulations' effective date may be to permanently and improperly deny relief where taxpayers have already restructured their affiliated group creating deferred intercompany gains. We believe that the loss disallowance rules of Treas. Reg. [sections] 1.1502-20 will minimize (or prevent) duplication of losses for transactions occurring in the interim between the announcement of the proposed regulations and the date they become final. (17) Prop. Reg. [sub-sections] 1.1502-13(b)(2) (i) and (ii). In the parlance of the proposed regulations, S is the member transferring property or providing services and B is the receiving member. Prop. Reg. [sections] 1.1502-13(b)(1)(i). (18) See Rev. Rul. 76-96, 1976-1 C.B. 23.
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|Title Annotation:||Tax Executives Institute Federal Tax Committee|
|Date:||Mar 1, 1995|
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