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Proposed investment adjustment regulations.

On October 19, 1993, Tax Executives Institute submitted the following comments to the Internal Revenue Service on proposed regulations under section 1502 of the Internal Revenue Code, relating to the investment adjustment rules for consolidated return purposes. The comments were prepared under the aegis of TEI's Federal Tax Committee, whose chair is Michael A. DeLuca of Household International, Inc. David F. Nitschke of Amerada Hess Corporation, former chair of the committee, materially contributed to the preparation of the Institute's comments.

On November 10, 1992, the Internal Revenue Service issued proposed regulations under section 1502 of the Internal Revenue Code, concerning the rules for affiliated groups filing a consolidated return. The proposed regulations would amend the existing regulations under Treas. Reg. 1.1502-32, -33, and a host of related provisions that govern the rules for computing the investment adjustments and stock basis with respect to the companies that join in filing a consolidated return. The proposed regulations would generally eliminate the use of earnings and profits as the initial and principal adjustment under the stock basis system, substituting instead a modified taxable income calculation.

The proposed regulations (C0-3092) were published in the Federal Register on November 12, 1992 (57 Fed. Reg. 53634), and in the Cumulative Bulletin (1992-2 C.B. 627).(1) Notice 9259, 1992-2 C.B. 386, delayed until February 15, 1993, the effective date of the repeal of the 30-day rules of Prop. Reg. 1.1502-76(b)(5). Public hearings on the proposed rules as emended by the Notice were held on December 18, 1992, and March 4, 1993.


Tax Executives Institute is the principal association of business tax executives in North America. The Institute's approximately 4,700 members represent more than 2,400 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--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 investment adjustments affecting affiliated groups filing consolidated tax returns.


Under current Treas. Reg. 1.1502-32, an owning member (P) of an affiliated group of corporations must adjust its basis in the stock of its subsidiary (S) to reflect S's earnings and profits (E&P), whether positive or negative. Under current Treas. Reg. 1.1502-33, P must also adjust its own E&P account to reflect the adjustments to its basis in S stock. As a result, S's E&P "tiers up" to P indirectly through the investment adjustment system.

Under the proposed investment adjustment regulations, P's adjustments to its stock basis in S would generally be calculated using S's modified taxable income instead of E&P. The modifications to taxable income to properly reflect the effect of taxexempt income and non-deductible, non-capital expenditures on P's basis in S stock are also prescribed. Finally, under the proposed rules, S's E&P would be tiered up directly in P's E&P account.

Consequently, the proposed consolidated return regulations would comprehensively revise the investment adjustment system under Treas. Reg. 1.1502-19,-32, and -33, including the rules for earnings and profits and excess loss accounts. Moreover, the proposed regulations would delink the adjustments to stock basis of subsidiaries of an affiliated group from the adjustments required for E&P purposes. As a result, the proposed regulations would create separate, parallel systems for making simultaneous adjustments to the basis in a subsidiary's stock and the owning member's E&P accounts.

The Preamble states that the new modified taxable income method for calculating subsidiary basis adjustments prescribed by Prop. Reg. 1.1502-32 is adapted from the method of calculating basis adjustments for partnership interests and shares in a Subchapter S corporation.(2) Indeed, Bittker and Eustice acknowledge the close similarity between the current investment adjustment system and the rules for Subchapter S corporations by stating that investment adjustment rules under the current consolidated return regulations "resemble the fluctuating basis rules for shareholders of Subchapter S corporations who likewise increase the basis of their stock for undistributed earnings and reduce basis for losses and distributions.(3) Similarly, the authors note that "comparable treatment" is given to partnerships.(4) Thus, the new method could be viewed as a restatement of the current E&P method for making investment adjustments, combined with additional adjustments mandated by enactment of section 1503(e) in 1987.

Although there may be rare instances where the effect of a particular transaction on corporate earnings and profits is unclear, the Code, regulations, and rulings generally provide ample authority from which to obtain guidance. Furthermore, the current rules relating to investment adjustments and E&P of members of an affiliated group filing consolidated returns are well known to revenue agents and taxpayers alike. TEl believes that the proposed regulations represent an undue departure from a long-established system and may introduce uncertainty from new terms and definitions that, notwithstanding the assertions in the Preamble, might complicate the measurement of investment adjustments.

TEI believes that an overriding objective of regulatory guidance should be to provide rules simple enough to achieve the objectives of a statute, thereby enhancing compliance and increasing the administrability of the law. The proposed regulations would in many respects improve upon the existing regulations by providing a straightforward statement of the rationale and principle underlying many sections of the proposed regulations. By articulating these principles, the regulations would provide a means of filling in interstices among the detailed rules.

The cost associated with the proposed regulations, however, would not be cheap. They would achieve their objectives by substantially increasing the reporting and record-keeping burdens of taxpayers. By delinking investment adjustments from the E&P adjustments, the proposed regulations would require taxpayers to make and maintain dual (and possibly more) sets of computations and records for lower-tier subsidiaries for purposes of making basis adjustments and ascertaining the tax consequences of corporate distributions.(5) Concededly, section 1503(e) virtually mandates a secondary set of basis calculations upon a disposition of a member's stock, but the current system is without question simpler than that envisioned by the proposed regulations. Under the current system, the effect of section 1503(e) is limited to recomputing the basis of the subsidiary whose stock is sold. The proposed system, though, would expand the multiple recordkeeping and computations to all subsidiaries of the consolidated group.

TEI believes that the current investment adjustment rules, with modifications required by section 1503(e) for computing gain or loss on the sale of a subsidiary, should be maintained. Thus, TEI recommends that only incremental changes to Treas. Reg. 1.1502-32 and 1.1502-33 that are minimally necessary to reflect the adoption of section 1503(e) be made. A wholesale revision of the investment adjustment system would interject elements of uncertainty where the results under current law are well settled.(6)

Effective Dates

The "Disposition Approach"

The proposed rules would apply generally to determinations of stock basis on or after the date the final rules are filed with the Federal Register.(7) Prop. Reg. 1.1502-32(h)(1) states, in part:

This section applies with respect to determinations (e.g., for purposes of determining basis in connection with a sale of stock) on or after the date the final regulations are filed with the Federal Register. If this section applies, basis and excess loss accounts must be determined or redetermined as if this section were in effect for all consolidated return years of the group.(8)

According to the Preamble, the IRS chose the "disposition approach" over the "lock-in approach"(9) for a number of reasons including: (1) to eliminate the practical need for costly E&P studies to determine stock basis; (2) to eliminate the need for transitional rules to address whipsaw and planning opportunities arising from duplication or omission of items under duplicate systems; (3) to eliminate the need to maintain both systems for an indefinite time, and thereby avoiding significant compliance and guidance burdens for both the taxpayers and the government; and (4) to give force to section 1503(e)(1)(A), which requires modifications to stock basis-- retroactive to 1972--that are similar to modifications under the proposed rules.

Other justifications offered for adopting the disposition approach include the Treasury and IRS's belief that the disposition approach would not materially alter the stock basis adjustments for most subsidiaries and that few groups actually make annual determinations except when contemplating a stock disposition. Finally, Treasury and IRS contend that the benefits associated with the application of the uniform rules prospectively to all taxpayers would outweigh the disadvantages incurred by particular taxpayers as a result of the retroactive features of the regulations.(10)

The Preamble goes to great pains to build the case for the disposition approach over the lock-in approach. The Preamble, however, proves too much for it either dismisses or unduly minimizes the real problems and administrative burdens engendered by the disposition approach.

For example, prior to 1966 basis adjustments were unnecessary for subsidiaries that were part of a consolidated group. The proposed rules would supersede the 2966 transition rules contained in Treas. Reg. 1.1502-32(f)(1) and 1.1502-19(a)(4). Consequently, under the proposed regulations, the common parents of consolidated groups in existence before 2966 would face the daunting task of performing a substantial and costly "basis study" (as opposed to an E&P study) to compute the effects of pre1966 consolidated tax years' results on their basis in subsidiaries.

Concededly, not all taxpayers may calculate the annual investment adjustments required under the current regulations. But a substantial number of companies have, in fact, made the required calculation on a timely basis every year. For taxpayers that have diligently updated their records especially, the effort required to reestablish basis would be substantial, if they could do it at all. The pre-1966 records required to recompute the basis in subsidiaries may have been lost or misplaced even in respect of the most diligent of taxpayers, let alone the supposed majority of taxpayers that have not made annual E&P adjustments under the current system.

TEl recognizes that section 1503(e) would have to be applied retroactively to 1972 in respect of all post-1987 dispositions, even if the lock-in approach were adopted. The proposed regulations, however, would go beyond the pale of what is necessary to properly implement section 1503(e). Should the IRS adopt the proposed rules concerning the substitution of modified taxable income for E&P in computing investment adjustments, TEl recommends that the IRS reconsider its position on the disposition or lock-in approaches.

Annual Reporting


Under Prop. Reg. 1.1502-32(g), the common parent of an affiliated group would have to attach a statement to the group's consolidated return each year reflecting the net investment adjustment with respect to each subsidiary joining in the consolidated return. Furthermore, under Prop. Reg. 2.1502-32(b)(2), the statement would have to disclose the allocation of the basis adjustment among the subsidiaries' stock and a description of any reallocation of adjustments or redeterminations. These requirements would apply to taxable years beginning after the date final regulations are issued. As a result, a consolidated group would have to calculate an annual investment adjustment for each subsidiary and report it, irrespective of whether the stock basis information were meaningful in the calculation of the group's current year's tax liability.

The Preamble states that an annual reporting requirement is necessary to ensure that determinations of investment adjustments for all subsidiaries are made while the necessary information is available.(11) The Preamble avers that the annual reporting requirement would not significantly increase compliance burdens because "the proposed rules are based on items that generally are determined in connection with the preparation of the annual consolidated tax return."(12)

TEl recommends that the IRS reconsider the annual reporting of investment adjustments for each subsidiary. Upon a sale of shares of a member, the consolidated group must support its calculation of the tax basis in the shares in determining gain or loss recognized. Should the group fail to satisfy its burden of proof, the IRS is rarely shy about proposing adjustments to a taxpayer's income. TEI believes the imposition of an annual basis adjustment reporting requirement is unnecessary and unwarranted because (i) the information would be largely superfluous to the determination of the current year's tax liability and (ii) might therefore not be subjected to the same degree of scrutiny as information that is relevant. Such scrutiny will be exercised upon a sale or deconsolidation of a member, thereby producing adjustments to previously reported annual basis adjustments to the extent necessary to correct that information. Consequently, taxpayers likely will report gain (or determine disallowed loss) on the basis of revised figures; since these figures would differ from the amounts reported on the annual return reports, the result will likely be needless controversy with examining agents. Indeed, in many circumstances the proposed regulations themselves would require the taxpayer to redetermine its basis in subsidiary stock.(13)

Not withstanding the assertions in the Preamble, annual reporting of basis adjustments would represent an additional and substantial administrative burden for groups filing consolidated returns. As the Preamble recognizes, the sale of stock of a subsidiary is not a common occurrence for every affiliated group. In most cases, the calculation of investment adjustments each year for each group member would be an unnecessary and unproductive step in the return preparation process. Yet the IRS proposes to require such a calculation for each subsidiary for each year. This calculation would not, as the Preamble implies, be as simple as calculating taxable income for each subsidiary. Rather, the process would involve making numerous adjustments to each subsidiary's taxable income employing the new rules of the proposed regulations.(14) Making the adjustments would require that both time and money be spent on education, training, and the development of computer systems to track and record the basis adjustments. One putative reason for the annual reporting requirement is to alleviate the need for costly E&P studies upon the disposition of a subsidiary. We question whether most corporate taxpayers share the IRS's view of which burden is preferable. Indeed, we believe that the approach of the proposed regulations in requiring annual reporting of basis adjustments for all subsidiaries, coupled with duplicate basis calculations for E&P and gain or loss purposes and redeterminations of prior allocations of basis for subsidiaries disposed of, would represent a substantial and unjustified enlargement of the corporate reporting burden.

Distributions from Separate

Return Year Earnings

and Profits

The proposed regulations would substantially alter the rules in respect of distributions from pre-1966 consolidated return year E&P, as well as for E&P generated in separate return years of an affiliated group. Under the current regulations, such distributions do not reduce the basis of P in S stock. The presumption underlying the current regulations is that the E&P from affiliated, separate return years (and pre-1966 consolidated years) are not reflected in the owning member's cost basis in its subsidiary stock.

According to the Preamble, the presumption is often inaccurate and prescribing rules to correct it would be extremely complex. Furthermore, the IRS does not believe that the benefits of filing consolidated returns should extend to E&P from separate return years. Finally, the IRS concludes, a distribution always results in a decrease in the value of a subsidiary's stock(15) Consequently, under Prop. Reg. l.1502-32(b)(3)(iv), P's basis in S's stock would be reduced by any distributions from any source of S's E&P.

TEI remains unpersuaded by the IRS's argument. The current regulations recognize that the owning member's stock basis in affiliated companies filing separate returns does not reflect the E&P of the companies earned while members of the affiliated group. In many cases, an affiliated group simply elects to begin filing consolidated returns after a period of filing separate returns. Requiring a decrease in basis for a distribution in a consolidated return year from E&P of a separate return year would be tantamount to applying consolidated return rules to separate return years. Furthermore, under section 243 a dividend from S would be excluded from P's income without a reduction in P's basis in S, thus causing disparate treatment as between corporations filing separately or on a consolidated basis.(16)Therefore, TEI believes it is improper for the IRS to treat distributions as decreasing basis in a consolidated tax year where the E&P did not generate an increase in basis.(17)

Some taxpayers would be able to avoid the adverse effect of the proposed regulations by making a deemed-dividend election for a consolidated return year ending before the date the final regulations are filed with the Federal Register. For other taxpayers, however, a deemed-dividend election might generate a significant tax liability and be efficaciously employed only where P intends to sell the stock of S. For example, if S were either a life insurance company or a savings and loan association with E&P from affiliated, separate return years, a deemed dividend by S could trigger some or all of its policyholder surplus account (under section 815(a)(2)) or its loan loss reserves (under section 593(e)), respectively, into taxable income.(18) As a result, some taxpayers might be precluded from employing the self-help remedy of the deemed-dividend election to mitigate the effect of the proposed regulations. For others, the cost of making the election would possibly be prohibitive.

Excess Loss Accounts

Under the proposed regulations, an excess loss account would be triggered as an amount realized on worthlessness only when substantially all of a subsidiary's assets are treated as disposed of, abandoned, or destroyed within the meaning of section 165(a). The change would eliminate the considerable uncertainty existing under the current regulations concerning the date that shares of members of a consolidated group become worthless. TEI commends the IRS for clarifying and simplifying the rules for determining worthlessness of a consolidated group member's stock.

Elimination of 30-Day Rules

Current Treas. Reg. 1.150276(b)(5) contains two 30-day rules that govern the filing of consolidated tax returns where members join or depart from a group within the first or last 30 days of a group's taxable year. The rules were intended--and are primarily used by taxpayers--as rules of administrative convenience. Although nominal net tax benefits accrue to taxpayers availing themselves of the rules (e.g., the elimination of a short tax year that could adversely limit the utilization of operating losses or credit carryovers (by accelerating the carryover period) or avoiding acceleration of section 481 adjustments), the benefits are principally administrative. The Preamble, however, identifies several complexities that arise as a result of transactions occurring within the 30-day period and concludes that the rules should be eliminated.(19)

TEl believes that the 30-day rules provide considerable flexibility and convenience to taxpayers and recommends that they be retained with appropriate exceptions for factual situations that Treasury and IRS conclude result in exceedingly complex or abusive outcomes. Should the rules be eliminated, we recommend that the IRS permit taxpayers to structure purchase and sale agreements employing "as off dates for purposes of the consolidated return rules. The Preamble notes that "conflicts and inconsistencies [within the rules] are inevitable if the ownership of S's stock is treated as other than where the benefits and burdens reside." By employing "as of" dates, the purchaser and seller of a corporation will specifically allocate the "benefits and burdens" of ownership. Permitting taxpayers to structure their purchase and sale agreements with "as of' dates that are no more than, say, 30 days prior to or after the closing date of a transaction would restore some of the administrative convenience lost by repeal of Treas. Reg. 1.1502-76(b)(5) without reinstating the complexities that concern the IRS and Treasury.20

Expansion of the Scope of the

Loss Disallowance Rule

a. Pre-1966 E&P. Under the proposed regulations, pre-1966 taxable income of a subsidiary would cause a positive basis adjustment in P's stock in S. Under the current rules, a positive basis adjustment for such amounts occurs only where a deemed-dividend election was in respect of S's pre-1966 E&P. Following the effective date of the regulations, however, if P disposed of S for which a deemed dividend ofpre-1966 E&P was made, P's stock basis in S would be increased for purposes of the loss disallowance rules (LDR) under Treas. Reg. 1.1502-20. This would subject P to a risk of disallowed loss where no such risk would have arisen absent the proposed regulations. This represents a bald expansion of an already improper rule. At a minimum, where a taxpayer has made a deemed-dividend election distributing its pre-1966 E&P, the pre-1966 taxable income of a subsidiary should not be treated as a positive investment adjustment for purposes of computing the amount of loss subject to LDR.

b. Increased Taxable Gains on Disposition of Subsidiaries. TEI previously advocated the adoption of a "tracing" rule in lieu of the loss disallowance rule. That suggestion was rejected in favor of the broad loss disallowance rule adopted in Treas. Reg. 1.1502-20, which supposedly would be applied only to losses on dispositions of subsidiaries. As part of the LDR regime, however, built-in gains from asset sales that were subsequently reflected in stock basis of an acquired subsidiary were not to be eliminated from the subsidiary's stock basis for purposes of computing a gain on a subsequent disposition of such stock. This rule was cited as evidence that the LDR regime, on balance, was fair to taxpayers.(20)

The anti-abuse rules set forth in Prop. Reg. 1.1502-32(a)(2) and (e) seemingly undercut the Institute's previous understanding that built-in gains would not be challenged so long as an overall gain resulted on the sale of a subsidiary. Furthermore, the proposed anti-abuse rules appear to sanction the tracing of asset sales to prevent circumvention of the new stock basis rules. Specifically, Prop. Reg. 1.1502-32(e) states that "[ill any person acts with a principal purpose to avoid the effect of the rules of this section, or uses the rules of this section to avoid the effect of any other provision of the consolidated return regulations, appropriate adjustments must be made as necessary to carry out the purposes of this section." 22 Prop. Reg. 1.1502-32(a) states in part that "an adjustment must not have the effect of duplicating an item in S's stock basis."23 Read together, these rules appear to undercut the "pass" given to built-in gain assets on a subsequent sale of the subsidiary stock at a gain because the gain may have been part of original basis in the purchase of S's stock and duplicated as an adjustment to S stock on the disposition of S's built-in gain asset. Finally, to illustrate the "anti-stuffing" rule of Prop. Reg. 1.150232(e)(2), Example 3 relies upon a direct tracing of appreciated assets contributed to a subsidiary that are subsequently sold resulting in an increased basis and reduced gain on a sale of an upper tier subsidiary.

In sum, the combined effect of the proposed rules with LDR would be that the government is permitted to trace appreciated asset dispositions back to their source to prevent "abusive" duplication of investment adjustments to subsidiary stock, but taxpayers are prevented from tracing an economic decline in asset values to claim actual losses on the disposition of a subsidiary. The policy implicit in a "heads the government wins, tails the taxpayer loses" approach cannot help but foster taxpayer cynicism. We recommend that the IRS reconsider its approach to implementing the repeal of General Utilities through the draconian loss disallowance rules.


TEl is pleased to have the opportunity to present its views on the subject of the proposed regulations relating to investment 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"; specific provisions are cited as "Prop. Reg. " References to page numbers are to the proposed regulations (and preamble) as published in the Cumulative Bulletin. The current consolidated return regulations are referred to as "the regulations"; specific provisions are referred to as "Treas. Reg. .. For brevity's sake, we also have adopted the convention of the proposed regulations and refer generally to P as an owning member and S as the subsidiary in the P--S consolidated group.

2. 1992-2 C.B. 627, 629.

3. B. Bittker & J. Eustice, Federal Income Taxation of Corporations and Shareholders, 15-67 to 15-68 (5th ed. 1987).

4. Id. at 15-68 n.183.

5. See Prop. Reg. 1.1502-33(c), which points up that P may have basis in S for gain or loss purposes while simultaneously having an excess loss account for E&P purposes. Delinking the investment adjustment system from E&P might represent simplification, but contemplating the effects of the proposed system on the disposition of a subsidiary for purposes of adjusted current earnings or the alternative minimum tax generally boggles the mind.

6. The primary benefit of severing the link between E&P and investment adjustments appears to be that statutory changes affecting E&P determinations would not automatically or inadvertently (and perhaps improperly) affect stock basis calculations. Thus, the Treasury and IRS's approach avoids anomalous situations such as Woods Investment Co. v. Commissioner, 85 T.C. 274 (1985), acq., 1986-1 C.B. 1, where taxpayers attain a tax benefit from discontinuities between the Code and the consolidated return regulations.

7. 1992-2 C.B. at 634.

8. Id. at 657.

9. Under a lock-in approach, the existing rules would continue to apply to determine the basis in a subsidiary's stock through the day on which the proposed rules become effective. A combination of the lock-in and disposition approaches was adopted in connection with the last major rewrite of the consolidated return regulations in 1966.

10. 1992-2 C.B. at 634.

11. Id. at 633.

12. Id.

13. See, e.g., Prop. Reg. 1.1502-32(c)(4).

14. Prop, Reg, 1.1502-32 and -33 require a calculation of each company's E&P and stock basis for purposes of the regular tax system and for E&P purposes as well. Thus, not only would the proposed regulations require multiple investment calculations for each subsidiary, but they would require the multiple investment adjustments to be reported annually with the consolidated tax return.

15. 1992-2 C.B. at 631.

16. This statement assumes that the requirements of section 1059(e)(2) were met, which would be the most likely case.

17. Indeed, the justification under the current regulations for requiring that distributions of E&P from separate return limitation years decrease basis in the distributing subsidiary's stock seems weak. See Broadbent, Consolidated Returns Investment in Subsidiaries, 203-3rd T.M., May 1989, A-10(1).

18. In addition, significant state tax liabilities could arise upon a deemed-dividend election in those states not permitting consolidated or combined reporting or otherwise not permitting the elimination of intercompany dividends from taxable income.

19. 1992-2 C.B. at 639.

20. The "as of" rule would permit taxpayers to avoid filing tax returns for extremely short periods and thus avoid the acceleration of the use of the loss carryover period or acceleration of section 481 adjustments.

21. See Minutes of April 27, 1990, TEI-IRS Liaison Meeting, 42 Tax Executive 225,226.

22. (July-August 1990) (remarks of Commissioner Goldberg.)

23. 1992-2 C.B. at 656.

24. ID. at 650.
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Author:Nitschke, David F.
Publication:Tax Executive
Date:Nov 1, 1993
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