Responding to the new subsidiary investment and earnings and profits consolidated return regulations.
* Deemed Dividend Election: Should it be made in the next (or last) tax return filing covered by the prior regulations?
* Federal Income Tax Allocations: Should the new special election be made to conform the allocation of federal income taxes for E&P purposes with the method now mandated for basis purposes?
* Federal Tax-Sharing Agreement: Should it be revised in view of the change in rules affecting the allocation of federal income taxes for tax purposes?
* Net Operating and Capital Losses of Acquired Subsidiaries: Should loss carryovers of acquired subsidiaries be waived in order to avoid a later negative adjustment to the basis in the subsidiary in the event the losses expire unused?
* Annual Recordkeeping Requirement: In what manner will annual basis adjustments be tracked?
Overview of Final Regulations
The final regulations are effective for transactions and determinations occurring in taxable years beginning on or after January 1, 1995 ("the effective date"). The final regulations generally "delink" the determination of basis of investment in subsidiary stock(4) and E&P. Although the ultimate determination of basis and E&P may be identical under both the final and prior regulations, there are a number of substantive changes that could affect affiliated groups filing a consolidated tax return. This is especially true where subsidiary net operating loss (NOL) or capital loss carryovers exist or expired previously.(6)
Like section 1503(e), the final regulations apply retroactively to dispositions occurring after the effective date. Consequently, previous calculations of basis in subsidiaries and accumulated E&P for many consolidated groups must be recomputed in light of the new rules. This may be particularly burdensome for consolidated groups that predate 1966 (in respect of which annual adjustments to basis of subsidiary investments were not required(7)) or for groups that pre-date 1976 (in respect of which tiering of E&P to the parent company was not required(8)). Thus, gain or loss on the sale of stock of a subsidiary may be quite different under the final regulations since they apply retrospectively to the entire period of ownership. In addition, some consolidated groups may face the prospect of paying nontaxable dividends because of the change in the rules that previously created "phantom E&P."(9)
Deemed Dividend Election
The final regulations eliminate the deemed dividend election,(10) which has existed since 1966. This election was typically made in order to increase the parent's basis in the stock of a subsidiary for the undistributed E&P generated in pre-1966 consolidated return years or in post-affiliation separate return years ("non-SRLY SRYs").
In the Treasury Department's view, the election is no longer necessary given the retroactive effect of the final regulations. Unlike the benefit obtained through a deemed dividend election, however, the potential for an automatic increase in basis will not be applicable to a non-SRLY SRY. Therefore, consolidated groups should consider making the deemed dividend election in the next tax return filing before the final regulations become effective. With the exception of several unique industry situations, there normally is no downside risk in making this election.(11) For those who miss this timetable, a one-year automatic extension is available.(12)
Where a deemed dividend election was previously made with respect to a subsidiary still owned by the parent, its effect should be revisited. In those instances where a loss was incurred by the subsidiary in the period subsequent to 1966 (or after the first consolidated return filing) and through the year prior to the election, the benefit of the deemed dividend election may have been diminished. A greater increase in basis may automatically result from the retroactive application of the final regulations.(13)
Federal Income Tax Allocations
The final regulations permit a consolidated group to elect to conform its tax-allocation method for E&P purposes to what is now mandated for basis purposes. This is so even where the group has previously used an allocation method that differs from the mandatory allocation method for basis calculations.(14) By making the election, the tax-allocation methodology will be the same for basis and E&P purposes. The election should be attached to the consolidated group's tax return for its first taxable year beginning after the effective date. The election must state whether conformity is to be prospective or retroactive.
Under the prior regulations, the tax-allocation method used for E&P purposes also applied for basis purposes because of the linkage between E&P and basis. Over the years, many consolidated groups changed to one of the complementary methods under the prior regulations,(15) either by requesting IRS permission to change or pursuant to the automatic approval procedures adopted in 1990.(16) Where no tax election was made, the "default" method set forth in section 1552(a)(1) (under which tax liability is allocable only to members that have taxable income) applied for all purposes.
Most consolidated groups have a tax-sharing agreement or established procedure to charge each company for its share of the group's federal taxes (computed as though a separate return was filed). In many cases, a credit is provided to a company that incurs a loss. To the extent a company is charged pursuant to the tax-sharing agreement an amount greater than its allocable share determined for tax purposes, a distribution is deemed to occur to the parent. Likewise, where the subsidiary is charged an amount that is less than its allocable share of tax under the regulations, a capital contribution by the parent is deemed to have occurred.(17) Thus, where the default tax-allocation method applies for tax purposes and the subsidiary is provided a credit for income taxes for accounting purposes (because it has incurred a loss), a capital contribution results to the full extent of the credit. The credit, of course, does not effect E&P.
The final regulations permit only one of the complementary methods of allocating federal income taxes to be used in determining the parent's basis in stock of a subsidiary.(18) Since the regulations are retroactive in application, this mandated tax-allocation methodology is likely to produce a significantly different allocation from prior computations. Nonetheless, the interplay of the permitted method with the amount charged or credited for accounting purposes pursuant to a tax-sharing agreement should neutralize any differences. Specifically, the amount charged or credited for accounting purposes will ultimately determine the parent's basis for its investment in the stock of a wholly owned subsidiary.(19)
In summary, as many as three different federal tax allocations may be required under the final regulations, with each allocation having a separate, interdependent effect: (i) the mandatory complementary method for basis calculations; (ii) the tax-allocation method previously elected (or default method if no election was made) for E&P purposes; and (iii) amounts determined pursuant to a tax-sharing agreement, which may differ from either of the aforementioned methods.(20) For consolidated groups where the amount of E&P is not of concern or where minority interests do not exist, administrative convenience will be enhanced by making the election to conform the E&P tax-allocation methodology with the complementary method mandated for basis purposes. This is particularly so where the tax-sharing agreement mirrors the complementary method. As previously stated, the election must indicate whether conformity is to be prospective or retroactive. Assuming no overriding factors are present, simplicity concerns suggest that the election be retroactive.
Federal Tax-Sharing Agreements
In view of the new federal tax-allocation rules, a review of the methodology of allocating federal income taxes for accounting and financial reporting purposes is in order. Indeed, for many consolidated groups there may be other reasons to revisit the provisions of the extant tax-sharing agreement (e.g., complexities created by the federal alternative minimum tax and the subsequent use of the AMT credit against the regular tax, state income tax issues, and subsidiary separations).
For some consolidated groups, this may entail a review of an existing agreement; for others, it may require formalizing an otherwise established procedure for allocating federal income taxes. Since every consolidated group presents different technical tax and industry issues, it is difficult to generalize. Sample agreements, developed by commentators, may provide a useful starting point for those considering a first-time agreement.(21)
Waiver of Acquired Net
Operating and Capital Losses
The final regulations require negative adjustments to the basis of a subsidiary investment for the utilization and expiration of NOLs and capital losses. This includes carryovers from separate return limitation years (SRLYs). Requiring a negative adjustment for expiring losses was a controversial provision when promulgated in the proposed regulations and attracted many critical comments.(22) To allay taxpayer concerns, the IRS provided an election in the final regulations to permit the acquiring company to forgo the use of the acquired company's losses.(23) This election must be made by filing a statement with the tax return for the year the subsidiary is acquired.(24) By making this election, the NOL or capital loss is deemed to expire immediately before the subsidiary becomes a member of the acquiring consolidated group.
The loss carryover may be waived in whole or in part.(25) The statement attached to the tax return must identify the following: the amount of each loss carryover deemed to expire (or the amount of each loss carryover deemed not to expire, with any balance of any loss carryovers being deemed to expire), the basis of any stock reduced as a result of the deemed expiration, and the computation of the basis reduction. The final regulations permits this loss waiver on a subsidiary or taxable year basis, but precludes the use of a formula approach. The preamble to the final regulations invites comments on the use of formulas to determine the amount of waived NOLs.(26) Compliance with the above disclosure requirements may require a mini-tax basis study.
The effect of the election depends on whether the acquired corporation becomes a member of the group in a "qualifying cost basis transaction" or "nonqualifying transaction."(27) In a qualifying cost basis transaction, there is no decrease in the basis of the stock acquired. In a nonqualifying transaction, the basis of the parent in the acquired subsidiary's stock is subject to an immediate reduction to reflect the deemed expiration of the NOL or capital loss. In any deemed expiration, the basis in the acquired subsidiary stock may not be reduced below an allocable share of the subsidiary's net inside asset basis.(28) As a practical matter, no reduction in stock basis is possible where the net tax basis of assets acquired governs the initial basis of the stock (i.e., acquisitions governed by sections 368(a)(2)(D) or 368(a)(2)(E)).(29) Where the acquisition was accomplished through a section 368(a)(1)(B) transaction, the initial basis (i.e., the former shareholders' basis) may be less or greater than the subsidiary's net inside asset basis at date of acquisition.
Where the acquired corporation with the loss carryovers is itself part of a larger group being acquired, the final regulations provide for an adjustment to the basis of the stock in each of the higher-tier corporations, including - in the case of a nonqualifying transaction - the acquired corporation.(30) Where the acquired corporation is the parent of an affiliated group, a mini-tax basis study may be necessary to ascertain the initial basis in the stock of the corporation acquired as well as the basis of each of the lower-tier subsidiaries.
The reduction to basis for expired SRLY loss carryovers applies only to acquisitions occurring after the effective date. Where the acquisition takes place before the effective date, the expiration of a SRLY loss does not result in a negative basis adjustment, regardless of whether the loss expires before or after the effective date.(31) On the other hand, the expiration of consolidated losses either before or after the effective date will cause a negative basis adjustment for determinations made after the effective date.(32)
The decision to forgo a SRLY NOL or capital loss carryover will obviously depend on whether it is likely to be utilized. Among the factors to consider are the number of years remaining in the carryover period, the likelihood of the entity and the group's generating taxable income to absorb the loss, and the extent to which section 382 will otherwise limit utilization of the loss. In the last case, it would seem appropriate to forgo, at a minimum, the excess over the amount anticipated as allowable under any section 382 calculation.
The final regulations require consolidated groups to maintain permanent records (including work papers) that reflect the annual stock basis adjustments arising under the consolidated return regulations.(33) This rule relaxes a more onerous requirement contained in the proposed regulations, which would have required that the change in the basis of subsidiaries be disclosed in a schedule included in the tax return.(34)
Complying with this annual reporting requirement alone, however, will not provide the parent with the cumulative basis at the time of sale or other disposition of the subsidiary's stock. Both the initial tax basis and the annual consolidated return adjustments for years prior to the effective date must still be determined. In addition - and perhaps information more difficult to obtain - capital contributions made during the years of ownership must be ascertained. In other words, a historical tax basis analysis will still be necessary for much of corporate America.
On the surface, the new annual recordkeeping requirement seems an easy step to comply with following the preparation of the consolidated group's annual federal income tax return. Giving effect to various adjustments on a subsidiary-by-subsidiary basis, however, may not be that simple. For example, deductions are frequently claimed at the parent level that must be allocated to subsidiaries (e.g., stock option expenses(35)). Other items (such as NOLs and charitable contributions) can be determined only on a consolidated basis, but they must be attributed to each subsidiary. Moreover, as a matter of expediency in preparing the consolidated group's annual tax return, adjustments are often made at the parent level to correct information submitted by a subsidiary. Finally, the need to allocate federal income tax to each subsidiary in the consolidated group under the mandated complementary method, and to compare the allocation with the charge or credit for financial reporting purposes, will add to the burden of this recordkeeping requirement. The bottom line is that all of these items will have to be pushed back to subsidiaries in order to determine the annual adjustment to the parent's basis in stock of each subsidiary.
For affiliated groups with a limited history, the final regulations may provide the incentive to become current in tracking the basis of subsidiary investments. For groups with a long history, or where the undertaking is too intimidating, the tax return preparation procedures should be modified to track the annual change in basis arising from the consolidated return regulations, capital contributions, and other transactions affecting basis.
The most logical time to consider the effect of the new regulations is during the next tax return preparation cycle. Calendar 1994 or fiscal 1995 is the last taxable year covered by the prior regulations - and the last opportunity to make a deemed dividend election. Although some of the areas discussed here do not require the same immediate attention as the deemed dividend rules, early consideration would seem prudent. Finally, the long-term tax implications of corporate acquisitions involving loss carryovers require careful analysis.
For consolidated groups that find the final regulations too onerous, the IRS issued in January 1995 Rev. Proc. 95-11,(36) which permit certain consolidated groups to discontinue filing consolidated tax returns. Permission to deconsolidate requires the filing of an application with the IRS on or before June 30, 1995.
(1) T.D. 8560, 59 Fed. Reg. 41666 (Aug. 15, 1994). The final regulations generally follow the regulations that were proposed in November 1992 ("proposed regulations"). CO-30-92, 1992-2 C.B. 627 (Nov. 12, 1992). (2) The prior regulations, which were adopted on September 7, 1966, were prospective in effect and, hence, the pre-1966 regulations continued in force for all purposes. The pre-1966 regulations were renumbered Treas. Reg. [sub-sections] 1.1502-0A through 1.1502-51A. Throughout this article, the final regulations are cited as "Final Reg. [sections]" and the prior regulations are cited as "Prior Reg. [sections]". (3) For a more comprehensive discussion of the effect of the final regulations on E&P studies, see Bean, Earnings and Profits Studies Under the New Consolidated Return Regulations, 22 Journal of Corporate Taxation 36 (Spring 1995). (4) Final Reg. [sections] 1.1502-32. (5) Final Reg. [sections] 1.1502-33. (6) Under the prior regulations, the negative investment adjustment for a loss of a subsidiary (and, therefore, the amount of E&P deficit tiered-up to the parent) was deferred until the loss was utilized by the group. This rule continues for basis purposes under the final regulations, but E&P of the parent company is now reduced for the subsidiary's losses at the time the loss is incurred. Furthermore, as more fully discussed in the text that follows, the expiration of a loss carryover now causes a negative investment adjustment.
Under the pre-1966 regulations, however, absorbed losses of a subsidiary caused a negative adjustment to the extent they could not have been used on a separate-return basis. Treas. Reg. [sections] 1.1502-34A. (8) Tiering of E&P was first required for taxable years beginning after 1975. Prior Reg. [sections] 1.1502-33(c)(4)(ii). For taxable years beginning after 1965 and prior to 1976, tiering of E&P was elective; tiering was mandatory where an election was made to utilize one of the complementary tax-allocation methods under Prior Reg. [sections] 1.1502-33(d). See Prior Reg. [sections] 1.1502-33(d)(3)(iii). (9) Because of the linkage between the investment adjustment rules and the determination of E&P under the prior regulations, phantom E&P arose where losses incurred at the subsidiary level could not be utilized currently or as a carryback. (10) Prior Reg. [sections] 1.1502-32(f)(2). An election previously made, however, will be honored. Final Reg. [sub-sections] 1.1502-32(h)(3)(i), 1.1502-33(j)(4). (11) Because of the deemed distribution of the balance of undistributed E&P as of the end of the year preceding the year of the election, the election could trigger a Phase III tax for a life insurance company or result in the taxation of bad debt reserves of a financial institution. The election, however, allows a basis increase for E&P earned by a life insurance subsidiary during the five-year waiting period. Letter Ruling No. 9210018 (Dec. 6, 1991) and Letter Ruling No. 9403011 (Oct. 20, 1993). (12) Rev. Proc. 92-85, 1992-2 C.B. 490. (13) The preamble to the final regulations at C.13.a. acknowledges this possible benefit. (The preamble is reprinted at 1994-38 I.R.B. 5 (Sept. 19, 1994).) (14) Final Reg. [sections] 1.1502-33(d)(5)(ii)(B). (15) Prior Reg. [sections] 1.1502-33(d). (16) Rev. Proc. 90-39, 1990-2 C.B. 365, and Rev. Proc. 90-39A, 1990-2 C.B. 367. (17) Final Reg. [sections] 1.1502-32(b)(3)(iv)(D). (18) Final Reg. [sections] 1.1503-32(b)(3)(iv)(D) requires the use of the "percentage" method. This method was referred to as the "immediate payment" method in Prior Reg. [sections] 1.1502-33(d)(2)(ii). (19) For less than wholly owned subsidiaries, the required use of the complementary method may produce a basis difference. See Final Reg. [sections] 1.1502-32(c)(5), Example 1. (20) Additional tax comparisons may exist for state income tax purposes. Most states, however, do not follow the federal consolidated return rules, and in those circumstances section 1552 would appear appropriate for determining basis and E&P for state income tax purposes. (21) See, e.g., Sacks, Intercompany Federal Income Tax Allocation Agreements, 13 Journal of Corporate Taxation 54 (1986), and Crestol, Hennessey & Yates, The Consolidated Tax Return [para.] 10.06 (Fifth Edition 1993). (22) Preamble at C.3.a. (23) Final Reg. [sections] 1.1502-32(b)(4). A similar election (not discussed in this article) is provided in Final Reg. [sections] 1.1502-31(e) where a group structure change occurs. (24) Final Reg. [sections] 1.1502-32(b)(4)(iv). (25) Final Reg. [sections] 1.1502-32 (b)(4)(i). (26) Preamble at C.3.a. (27) A qualifying cost basis transaction is defined as "the purchase (i.e., a transaction in which basis is determined under section 1012) by members of the acquiring consolidated group (while they are members) in a 12-month period of an amount of S's stock satisfying the requirements of section 1504(a)(2)." Final Reg. [sections] 1.1502-32(b)(4)(ii)(A). (28) Final Reg. [sections] 1.1502-32(b)(4)(iii). (29) Prop. Reg. [sub-sections] 1.358-6 and 1.1502-30. (30) Final Reg. [sections] 1.1502-32(b)(4)(ii)(C). (31) Final Reg. [sections] 1.1502-32(h)(4). (32) Final Reg. [sections] 1.1502-32(h). (33) Final Reg. [sections] 1.1502-32(g). (34) Prop. Reg. [sections] 1.1502-32(g). (35) Anderson v. Commissioner 583 F.2d 953 (7th Cir. 1976). (36) 1995-4 I.R.B. 48 (Jan. 23, 1995). Permission to discontinue filing consolidated returns is coincident with the effective date of the final regulations (i.e., taxable years beginning on or after January 1, 1995).
Robert L. Bean is a national tax partner located in the San Franscisco office of Deloitte & Touche LLP. The author appreciates the review provided by his partner Lawrence M. Axelrod of the firms' Washington, D.C., national Office and James C. Peirano, Vice President for Transamerica Corporation, who is a member of Tax Executives Institute's San Francisco Chapter.
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|Author:||Bean, Robert L.|
|Date:||Mar 1, 1995|
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