Checkpoint Contents Federal Library Federal Editorial Materials WG&L Journals Corporate Taxation/Journal of Corporate Taxation (WG&L) Journal of Corporate Taxation (WG&L) 1996 Volume 23, Number 1, Spring 1996 Articles The Final Intercompany Transaction Regulations: Out With the Mechanical and in With the Conceptual, Journal of Corporate Taxation (WG&L), Spring 1996

The Final Intercompany Transaction Regulations: Out With the Mechanical and in With the Conceptual

Author: Bryan P. Collins and Mark A. Schneider

Bryan P. Collins, who regularly writes the Consolidated Returns column in this journal, is a partner in the Arthur Andersen Office of Federal Tax Services, in Washington, D.C. Mark A. Schneider is a manager in the Arthur Andersen Office of Federal Tax Services in Washington, D.C.

An analysis of the final intercompany transaction regulations, with a focus on key changes from the current rules contained in the old regulations, differences between the final regulations and the proposed regulations, the basic operational rules, the special rules regarding transactions involving the stock or obligations of members of the consolidated group, the anti-avoidance rules, and the controlled group rules under Section 267(f).

Introduction

On July 12, 1995, the Internal Revenue Service (IRS) and the Treasury Department took a significant step toward completing a process begun in early 1991: the overhaul of the regulations under Section 1502 1 governing the taxation of members of a consolidated group. 2 This most recent step was the issuance of final regulations amending the consolidated return rules governing the taxation of transactions between members of a consolidated group (Final Regulations). 3 These regulations finalize the rules proposed on April 15, 1994, (Proposed Regulations) and make a limited number of changes, most of which were intended to make the regulations easier to apply and administer. 4

Overview

The Final Regulations, in large measure, adopt without change the purpose, approach, and organization of the Proposed Regulations. The basic purpose of the Final Regulations is “to prevent intercompany transactions from affecting the overall taxable income of the consolidated group” in order to achieve a clear reflection of consolidated taxable income and consolidated tax liability. 5 The IRS and the Treasury determined that this purpose would be furthered by significantly expanding the single-entity approach to the taxation

of intercompany transactions, and replacing the mechanical rules of Former Regulation Sections 1.1502-13 and 1.1502-14 (Old Regulations) with broad, conceptual rules and antiabuse provisions. Nevertheless, the Preamble to the Final Regulations suggests that the tax results of most intercompany transactions will remain unchanged. 6 Although this statement may seem to invite taxpayers and practitioners to devote little attention to the new rules, choosing such a course is perilous because the tax results of a variety of transactions have been changed by the Final Regulations and discerning the affected transactions will require considerable study of the new rules.

Single Entity Versus Separate Entity

The fundamental concept that is at the heart of the Final Regulations is the single-entity theory of a consolidated group. The Final Regulations significantly expand the circumstances where this concept controls the taxation of a consolidated group and this policy shift explains many, if not all, of the substantive changes that are made by the Final Regulations. Seemingly borrowed from the aggregate/entity dichotomy in the partnership area, the single-entity/separate-entity theories of consolidated groups differ in that, under a single-entity approach, the separate existences of the members of the consolidated group are ignored and the members are treated as divisions of one corporation. By contrast, under a separate-entity approach, the separate existences of the members of the consolidated group are respected.

Applying these two concepts to the various components of an intercompany transactions may be enlightening. For example, two of the four identified components of an intercompany transaction are the “location” (i.e., which member of the group is affected) and the “amount” of gain or loss from the transaction. If the single-entity theory were applied to these two components, an intercompany sale of property would not result in recognition and deferral of gain or loss to the selling member, but rather would result in a carryover of the selling member's basis in the property to the buying member. 7 Neither the Old Regulations nor the Final Regulations extend single-entity concepts this far; both the Old Regulations and the Final Regulations use the separate-entity theory to determine the amount and location of S's gain or loss from an intercompany transaction. 8 This so-called deferred sale approach causes the consolidated group to determine the amount of S's gain or loss from the intercompany transaction and to preserve the location of that gain or loss with S. 9

In contrast, the Old Regulations and the Final Regulations deal quite differently with the other two components of an intercompany transaction: the “timing” of the recognition of gain or loss and the “attributes” of such gain or loss (e.g., capital or ordinary). Although both the Old Regulations and the Final Regulations employ single-entity concepts to determine the timing of the recognition of S's gain or loss (e.g., S's gain is not taken into account when S sells property to B, but rather when B sells the property outside the group), the Final Regulations extend the single-entity treatment of the timing of gain or loss one step further. In particular, the Final Regulations provide that S and B are treated as divisions of a single corporation for purposes of determining the timing of recognition of both S's and B's gain or loss relating to the intercompany transaction. For example, if either S or B is a dealer in the property that is the subject of the intercompany transaction, the Final Regulations make installment sale treatment unavailable to both, regardless of the timing of either S's or B's receipt of the purchase price of the property. 10

Finally, one of the most significant changes from the Old Regulations is the change to single-entity treatment for the last component of an intercompany transaction—the “attributes” of the members' gain or loss. This change is best illustrated with a simple

example. Assume that S sold property with a basis of $70 for $100 to B. Assume further that S is not a dealer in the property but that B is a dealer. Under the Old Regulations, S's $30 gain was deferred until the occurrence of a specific restoration event (e.g., a subsequent sale by B of the property to an unrelated party). 11 S's holding period in the property and the character of S's gain were determined on a single-entity basis; B's holding period and activities would have no bearing on that determination. Thus, assuming the sale otherwise qualified, S would have reported a $30 capital gain with respect to the sale (in the year of the restoration event), notwithstanding that B is a dealer in the property. Under the Final Regulations, S's gain would still be deferred but, in determining the character of S's gain, B's dealer activities would be taken into account as if S and B were divisions of a single corporation. Therefore, if considering S and B as divisions of a single corporation would cause S's $30 gain to be characterized as ordinary income, then the Final Regulations would cause the “attributes” of S's gain to be “redetermined” to be ordinary income. In adopting this approach, the Preamble states that the Treasury and the IRS believe that single-entity treatment generally results in a clearer reflection of consolidated taxable income because single-entity treatment minimizes the effect of an intercompany transaction on consolidated taxable income, as well as the tax differences between a business structured divisionally and one structured with separate U.S. subsidiaries. 12 This approach, however, may create a significant difference between the treatment of S's sale to B and S's sale to a related party that is not part of its consolidated group (e.g., a partnership, foreign corporation, or less-than-80-percent-owned domestic subsidiary).

Mechanical Rules Versus Conceptual Principles

The second fundamental change that the Final Regulations makes with regard to the taxation of intercompany transactions is to shift the approach from mechanical rules toward broad conceptual standards that are fleshed out by numerous examples. This approach was a reaction to a growing amount of uncertainty under the Old Regulations regarding the application of the mechanical rules in the face of subsequently enacted legislation, as well as perceived abuses resulting from the literal application of the mechanical rules. 13 Thus, the Final Regulations rely on broad principles of general application based on the underlying purposes of the regulations, rather than on specific mechanical rules for every situation.

Modifications to the Proposed Regulations

While the Final Regulations generally follow the Proposed Regulations very closely, certain key changes have been made. For example, the Proposed Regulations provided that the rules governing the timing of reporting gain or loss from an intercompany transaction is a method of accounting. In response to commentators concerns that such a rule would create undue complexity, the Final Regulations make a number of substantive changes. Among these changes are provisions permitting taxpayers in certain situations to automatically change their method of accounting for intercompany transactions in order to avoid the necessity of requesting the Service's permission to change to the requisite method of accounting. In addition, although the Final Regulations retain the single-entity approach to redetermining S's and B's attributes from intercompany transactions, these “attribute redetermination” rules have been limited and simplified. The Final Regulations have also made changes in the examples illustrating its anti-abuse rule, eliminating certain examples (relating primarily to Section 382) and adding others. Finally, in order to prevent potential double taxation, the Final Regulations make Section 108(a) inapplicable to transactions between members of a consolidated group. These changes, as well as the general operation of the Final Regulations, are discussed in detail below.

Definitions

The Old Regulations

The Old Regulations, which were found in Former Regulation Sections 1.1502-13, 1.1502-13T, 1.1502-14, and 1.1502-14T, applied to any “intercompany transaction.” “Intercompany transaction” was defined as a transaction during a consolidated return year between corporations that are members of the same consolidated group immediately after such transaction. 14 The Old Regulations went on to define “deferred intercompany transactions” as a subset of intercompany transactions; only gain or loss from a deferred intercompany transaction was deferred. 15 These transactions included the sale or exchange of property, the performance of services where the amount of the expenditure was capitalized, or any other expenditure that was capitalized. 16 Transactions involving the stock or obligations of members were excluded from this definition but were effectively treated as deferred intercompany transactions under Former Regulation Sections 1.1502-14 and 1.1502-14T.

As noted above, under the deferred sale approach, the Old Regulations generally provided that gain or loss that was recognized by S in an intercompany transactions was deferred until a restoration event occurred. 17 In general, gain or loss was restored under the Old Regulations as (1) B depreciated, amortized, or depleted the property; 18 (2) in the case of an installment obligation sold from S to B, as B received payments on the obligation; 19 or (3) when the property, or S or B, left the group. 20

The Final Regulations

The Final Regulations eliminate the distinction between deferred intercompany transactions and intercompany transactions. Furthermore, the treatment of transactions involving stock or obligations of members is no longer broken out in a separate section of the regulations (Former Regulation Sections 1.1502-14 and 1.1502-14T are eliminated), though the Final Regulations do provide a number of special rules in those areas.

The Final Regulations begin with a statement of purpose that is consistent with the shift away from mechanical rules to principles of broad application. The Final Regulations state that their purpose is to set forth rules to clearly reflect the taxable income (and tax liability) of the group as a whole by preventing intercompany transactions from creating, accelerating, avoiding, or deferring consolidated taxable income (or consolidated tax liability). 21

Definition of “Intercompany Transaction”

Much like the Old Regulations, the Final Regulations define “intercompany transaction” as a transaction between corporations that are members of the same consolidated group immediately after the transaction. Beyond the obvious examples of S's sale of property to B and S's performance of services for B, the Final Regulations make clear that this definition also encompasses tax-free transactions such as the formation of a new corporation by a member or the liquidation of a member. 22

Intercompany Items, Corresponding Items, and Recomputed Corresponding Items

The basic operational rules of the Final Regulations are called the matching rule and the acceleration rule. Both of these rules rely on three defined terms. First, S's income, gain, deduction, and loss from an intercompany transaction are its “intercompany items.” For example, S's gain from the sale of property to B is S's “intercompany item.” An item is an intercompany item whether it results directly or indirectly from an intercompany transaction. 23 Second, B's income, gain, deduction, and loss from an intercompany transaction or from property acquired in an intercompany transaction are its “corresponding items.” The Final Regulations provide that if B pays rent to S, B's deduction for the rent is a corresponding item. Similarly, if B buys property from S and sells it to a nonmember, B's gain or loss from the sale to the nonmember is a corresponding item. Alternatively, if B recovers the cost of the property through depreciation, B's depreciation deductions are corresponding items. B's corresponding items also include items that are permanently disallowed or permanently eliminated, such as amounts disallowed under Section 265 and amounts not recognized under Section 311(a). 24

Third, B's “recomputed corresponding item” is the corresponding item that B would take into account if S and B were divisions of a single corporation and the intercompany transaction were between those divisions. This concept is critical to understanding the Final Regulations because it is the mechanism for expanding the single-entity treatment of intercompany transactions. For example, assume that S sells property with a $70 basis to B for $100 and B later sells the property to a nonmember for $90. In such a case, B's corresponding item is its $10 loss, and B's recomputed corresponding item is the $20 of gain that B would have recognized on the sale to the nonmember if S and B were divisions of a single corporation (the $90 sale price over the $70 basis the property would otherwise have had if S and B were divisions of a single corporation). 25

Mercifully, the Final Regulations remove the rules in the Proposed Regulations under which certain basis adjustments of S or B were deemed to be intercompany or corresponding items (Deemed Items). 26 The Preamble indicates that such rules were not adopted in the Final Regulations, stating that commentators found them confusing. 27

Two further points concerning the definition of “recomputed corresponding item” are worthy of note. First, the Final Regulations make clear that only S and B are considered divisions of a single corporation for this purpose, not members of the consolidated group. This is particularly important with respect to the redetermination of S's and B's attributes relating to the intercompany transaction. For example, if S sells real estate to B and neither S nor B is a dealer in real estate, S's gain will be treated as capital gain regardless of whether any other member of the group is a dealer in real estate. Second, a special gloss on this “divisional” fiction breaks down (e.g., transactions in either S's or B's stock). In this regard, the Final Regulations provide that treating S and B as divisions of a single corporation will not cause a transaction to be treated as not occurring. For example, if S transfers stock to B in exchange for B's property, B is treated as owning S's stock notwithstanding that S and B are treated as divisions of a single corporation.

Attributes. To carry out its purpose of extending the single-entity treatment of intercompany transactions, the Final Regulations contain rules that will “redetermine” the “attributes” of an intercompany item or corresponding item as if S and B were divisions of a single corporation. The Final Regulations define “attributes” as all of an item's characteristics except the amount, location, and timing of the gain or loss if such characteristics are necessary to determine the item's effect on the consolidated group's taxable income and tax liability. The term “attribute” includes characteristics such as the character, source, exclusion from gross income, treatment as a noncapital, nondeductible amount, and treatment as built-in gain or loss under Section 382(h) or Section 384. By contrast, the Final Regulations provide that the characteristics of property, such as a

member's holding period or the fact that property is included in inventory, are not attributes of an item, but that these characteristics might be relevant in determining the attributes of items. 28

Holding Period

In a significant departure from the Old Regulations, the Final Regulations provide that for purposes of characterizing both S's and B's gain or loss from the sale of property, the holding period of the property transferred in an intercompany transaction is the aggregate of the holding periods of S and B. If the basis of the property is determined by reference to the basis of other property, however, the property's holding period is determined by reference to the holding period of the other property. For example, if S distributes stock to B in a transaction in which Section 355 applies, B's holding period in the distributed stock is determined by reference to B's holding period in the stock of S. 29

Operational Rules

As noted above, the principal operational rules in the Final Regulations are the matching rule and the acceleration rule.

The Matching Rule

Timing and Attributable Redetermination

Timing. Under the matching rule, S takes its intercompany items into account to the extent of “the difference for the year between B's corresponding item taken into account for the year and the amount of B's recomputed corresponding item for the year.” 30 For example, assume S sells property with a basis of $70 to B for $100 and B subsequently sells the property to an unrelated party for $150. S's intercompany item is its $30 gain from the sale of the property. B's recomputed corresponding item is $80 ($150 − $70) because if S and B were divisions of a single corporation, B would have received a carryover basis on the transfer of the property from S to B. S's $30 intercompany item is taken into account when B recognizes its $50 gain (using B's method of accounting) in an amount equal to B's recomputed corresponding item less B's corresponding item ($80 − $50 = $30). When performing this calculation, it is important to include the correct “sign” (i.e., positive sign or negative sign) on each item. To illustrate, assume that S sold property with a basis of $140 to B for $100 and B subsequently sells the property outside the group for $80. S's intercompany item is a loss of $40, B's corresponding item is a loss of $20 and B's recomputed corresponding item is a loss of $60. When B sells the property outside the group, S must take its $40 loss into account in an amount equal to B's recomputed corresponding item, $−60, less B's corresponding item, $−20, or $−40 ($−60 −($−20) = $−40).

As discussed above, although B generally takes its corresponding items into account under its separate accounting method, the redetermination of the attributes of B's corresponding item might affect its timing. For example, the Final Regulations point out that if B's sale of property acquired from S is treated as a dealer disposition because of S's activities, Section 453B prevents B's corresponding items from being taken into account under the installment method. 31

Attribute redetermination. Under the Final Regulations, the separate-entity attributes of S's intercompany items and B's corresponding items are redetermined to the extent

necessary to produce the same effect on consolidated taxable income and consolidated tax liability as if S and B were divisions of a single corporation and the intercompany transaction were a transaction between divisions. 32 For example, the activities of both S and B are taken into account in determining the character and source of S's and B's items. In this regard, the Final Regulations provide that if S holds property for sale to unrelated customers in the ordinary course of its trade or business, S sells the property to B at a gain, and B sells the property to an unrelated person at a further gain, S's intercompany gain and B's corresponding gain might be ordinary because of S's activities with respect to the property. That is, B's gain might be ordinary because S is a dealer in the property, even though B is not a dealer.

The Preamble notes that the Final Regulations have limited the scope of attribute redetermination by providing that such redetermination will be made only “to the extent necessary” to carry out single-entity treatment. 33 The Preamble states that redetermination is necessary only to the extent the separate-entity attributes differ from the single-entity attributes.

Example 1.: Assume that S holds land for investment with a basis of $70. S has held the land for more than one year. On January 1 of Year 1, S sells the land to B for $100. B also holds the land for investment. On July 1 of Year 3, B sells the land to X for $110. S's sale of the land to B is an intercompany transaction, and S's $30 gain from the sale is its intercompany item, and B's $10 gain from the sale to X is its corresponding item. The holding periods of S and B for the land are aggregated. Thus, the group's entire $40 of gain is long-term capital gain. Because both S's intercompany item and B's corresponding item on a separate-entity basis are long-term capital gain, S's attributes are not redetermined.

Under the matching rule, S takes its intercompany item into account each year to reflect the difference in an amount equal to B's recomputed corresponding item and B's corresponding item for the year. Consequently, S takes no gain into account in Years 1 and 2 (B has no recomputed corresponding amounts in those years). S takes its entire $30 gain into account in Year 3 to reflect the $30 difference in that year between the $10 gain B takes into account and the $40 recomputed gain (the $110 sale price over the $70 basis the property would have had if the intercompany sale had been between divisions of a single corporation). 34

Example 1 illustrates a case where both S and B hold the disposed property for investment; thus, there is no need to determine if the character of the gain (capital) is appropriate. Redetermination of such character may be necessary where either S or B is a dealer in the property, as set out in the next example.

Example 2.: S holds land for investment with a basis of $70. On January 1 of Year 1, S sells the land to B for $100. B, a dealer in residential real estate, develops the land and sells developed lots to customers during Year 3 for an aggregate amount of $110. Under the matching role, S and B are treated as divisions of a single corporation for purposes of determining the attributes of S's intercompany item and B's corresponding item. Thus, although S held the land for investment, whether the gain is treated as from the sale of property described in Section 1221(1) is based on the activities of both S and B. If, based on both S's and B's activities (but not on the activities of any other member of the consolidated group), the land is described in Section 1221(1), both S's gain and B's gain are ordinary income. 35 It is interesting to note that these transactions would reach quite different results if S sold the property to a related party that is not part of its consolidated group. First, S's gain would be recognized at the time of the sale to the related party. Second, S's gain may be characterized as capital gain rather than ordinary income, unless Section 1239 or Section 707 applies.

B's attributes generally control . The Final Regulations provide that to the extent B's corresponding item offsets S's intercompany item in amount, the attributes of B's corresponding item, determined based on both S's and B's activities, control the attributes of S's offsetting intercompany item. For example, if S sells depreciable property to B at a gain and B depreciates the property, the attributes of these depreciation deductions generally control the attributes of S's offsetting intercompany gain, which would be ordinary. 36 The Final Regulations flesh out this rule in the following example. 37

Example 3.: On January 1 of Year 1, S buys ten-year recovery property for $100 and depreciates it under the straight-line method. On January 1 of Year 3, S sells the property to B for $130. Under Section 168(i)(7), B is treated as S for purposes of Section 168 to the extent B's $130 basis does not exceed S's adjusted basis at the time of the sale. B's additional basis is treated as new ten-year recovery property for which B is entitled to elect its method of recovery. Assume B elects the straight-line method of recovery. S claims $10 of depreciation for each of Years 1 and 2 and has an $80 basis at the time of the sale to B. Thus, S has a $50 intercompany gain from its sale to B ($130 over $80). For Year 3, B, has $10 of depreciation with respect to $80 of its basis (the portion of its $130 basis not exceeding S's adjusted basis). In addition, B has $5 of depreciation with respect to the $50 of its additional basis that exceeds S's adjusted basis.

Under the matching rule, S's $50 gain is taken into account to reflect the difference between B's depreciation taken into account with respect to the property and the recomputed depreciation. For Year 3, B takes $15 of depreciation into account. B's recomputed depreciation, based on an $80 basis, would have been $10. Thus, S takes $5 of gain ($−10 − ($−15)) into account in Year 3. In each subsequent year that B takes into account $15 of depreciation with respect to the property, S takes into account $5 of gain. Regarding attributes, in each year, $5 of B's corresponding depreciation deduction offsets S's $5 intercompany gain taken into account. Under the matching rule, the attributes of B's corresponding item control the attributes of S's intercompany item. As such, S's intercompany gain that is taken into account as a result of B's depreciation deduction is ordinary income.

As demonstrated in Example 3, B's attributes generally control S's attributes. In a departure from the Proposed Regulations, however, the Final Regulations provide that if the above rule yields a result inconsistent with treating S and B as divisions of a single corporation, the attributes of the offsetting item must be redetermined in a manner consistent with treating S and B as divisions of a single corporation. The Final Regulations provide no examples of where this might occur.

The Final Regulations also provide that if B's corresponding item, on a separate-entity basis, is excluded from gross income, is a noncapital, nondeductible item, or is otherwise permanently disallowed or eliminated, the attributes of B's corresponding items always control the attributes of S's offsetting intercompany items. 38 For example, if S sells property to B at a loss and B subsequently distributes the property to a nonmember shareholder at a time when the property is worth less than B's basis in the property, B's loss is permanently disallowed by Section 311(a) and, therefore, the attributes of S's loss are redetermined to treat such loss the same as B's loss (i.e., as permanently disallowed by Section 311(a)).

Finally, the Final Regulations address the situation where S's intercompany item and B's corresponding item do not offset in amount. In such a case, the attributes redetermined under the matching rule must be allocated to S's intercompany item and B's corresponding item by using a method that is reasonable in light of all facts and

circumstances as well as the purposes of the Final Regulations. The most notable situation where this provision will be invoked is where S and B are attempting to determine whether their income relating to the sale of property is foreign-source or U.S.-source income. This issue is discussed further below. The Final Regulations also provide that a method of allocating redetermined attributes is unreasonable if it is not used consistently by all members of the group from year to year. 39 This limitation is somewhat surprising, since the accounting method rules in the Final Regulations would certainly treat a consolidated group's allocation method as a method of accounting that cannot be changed without the consent of the Commissioner.

Special status. Notwithstanding the rules described above, to the extent an item's attributes determined under these rules are permitted or not permitted to a member under the Code or regulations by reason of the member's special status, the attributes required under the Code or regulations apply to that member's items (but not to the other member). For example, the Final Regulations provide that if S is a bank to which Section 582(c) applies and sells debt securities at a gain to B, a nonbank, the character of S's intercompany gain is ordinary as is required under Section 582(c). However, the character of B's corresponding item as either capital or ordinary is determined under the matching rule without regard to Section 582(c). 40

Section 475: Transactions involving securities dealers. As with the Proposed Regulations, the Final Regulations provide examples dealing with intercompany transactions involving securities that are subject to the mark-to-market rules of Section 475. Under that section, dealers in securities are required to mark-to-market securities for purposes of determining their annual income from the securities. Securities held for investment are not subject to this requirement, provided they are appropriately identified by the dealer.

The examples used in the Final Regulations, which parallel those found in the Proposed Regulations, are somewhat curious in that they limit the application of the matching rule, presumably on the ground that Section 475 does not allow for pure single-entity treatment.

Example 4.: S is a dealer in securities and owns a security with a basis of $70. On July 1 of Year 1, S sells the security to B for $100. B is not a dealer and holds the security for investment. On December 31 of Year 1, the fair market value of the security is $100. On July 1 of Year 2, B sells the security to X for $110. Under the matching rule, S's and B's attributes must be redetermined by treating S and B as divisions of a single corporation. Accordingly, as a result of S's activities, the single corporation is treated as a dealer with respect to securities, and B must continue to mark to market the security acquired from S. Thus, while it holds the security, B is treated as a dealer and, therefore, must continue to mark the security to market for purposes of determining the timing of the recognition of both S's gain and B's gain or loss. Based on the rules in Section 475(d)(3)(B)(ii), however, B's $10 gain from its sale to X is treated as capital gain. Hence, with respect to that sale, B is not treated as a dealer. 41

Example 5:: Assume instead that S is not a dealer and holds the security for investment with a $70 basis. B is a dealer to whom Section 475 applies and, immediately after acquiring the security from S for $100, B holds the security for sale to customers in the ordinary course of its trade or business. Because S is not a dealer and held the security for investment, the Final Regulations conclude that the security is treated as property identified as held for investment under Section 475(b)(1) until it is sold to B. 42 Under Section 475(b)(3), the security thereafter ceases to be described in Section 475(b)(1) because B holds the security for sale to customers. As a result, S's gain is not taken into account at the end of Year 1 when B marks the security to market; S's gain is not affected, because such gain is excluded from the mark-to-market system by Section

475(b)(3). In Year 2, B has a $10 gain when it disposes of the security by selling it to X, but would have had a $40 gain if S and B were divisions of a single corporation (using S's $70 basis). Thus, S takes its $30 gain into account in Year 2 under the matching rule. Under Section 475(d)(3), S's gain is capital gain even though B's subsequent gain or loss from marking-to-market or disposing of the security is ordinary gain or loss. Again, there is no adequate explanation as to why the matching rule would not result in S's gain being ordinary.

Excluded or nondeductible items. Under the matching rule, S's intercompany item might be redetermined to be excluded from gross income or treated as a noncapital, nondeductible amount. For example, the Final Regulations provide that S's intercompany loss from the sale of property to B is treated as a noncapital, nondeductible amount if B distributes the property to a nonmember shareholder at no further gain or loss (because, if S and B were divisions of a single corporation, the loss would not have been recognized under Section 311(a)). 43

Notwithstanding this rule, S's intercompany income or gain is redetermined to be excluded from gross income only to the extent one of the following applies: B's corresponding item is a loss that is realized but not recognized under Section 311(a) on a distribution to a nonmember; or B's corresponding item is a deduction or loss and, in the taxable year the item is taken into account, it is permanently and explicitly disallowed under another provision of the Code or Regulations (e.g., Section 265, but not deferral provisions such as Section 332 or Section 355(c)).

The Final Regulations clarify that an amount is not permanently and explicitly disallowed if a related amount might be taken into account by B with respect to successor property such as under Section 280(B) or a related amount might be taken into account by another taxpayer such as under Section 267(d) (disallowed loss under Section 267(a) might result in nonrecognition of gain for a related person); or a related amount might be taken into account as a deduction or loss including as a carryforward to a later year under any provision of the Code or regulations whether or not the carryforward expires in a later year or the amount is reflected in the computation of any credit against or other reduction of federal income tax whether allowed for the taxable year or carried forward to a later year. 44

Changes From Proposed Regulations

Section 382. The Proposed Regulations contained an example relating to the treatment of gain from the sale of an asset as built-in gain under Section 382(h). 45 In general, a recognized built-in gain increases a Section 382 net operating loss limitation if such gain is recognized during the five-year period following a Section 382 ownership change. In the example in the Proposed Regulations, P, the parent corporation of a consolidated group, purchased all of the stock of S. S was a loss corporation within the meaning of Section 382, and also had a net unrealized built-in gain within the meaning of Section 382(h)(3)(A). S sold the built-in gain property to B and restored the gain as B took depreciation deductions with respect to the property. The example concluded that by treating S and B as divisions of a single corporation, S's gain would not be treated as Section 382 built-in gain. Thus, S was not permitted to increase its Section 382 limitation by the amount of the built-in gain. Without fanfare, the Final Regulations delete the above example. There is no mention of the deletion in the Preamble. However, government officials have indicated informally the thinking behind this change was that this situation was more properly viewed as raising a Section 382 issue (i.e., would the income from the asset be treated as built-in gain or income under Section 382(h)), as opposed to a consolidated return issue, and as such should not be addressed in a

consolidated context. Apparently, these government officials believe that in this situation, S's gain might be treated as recognized built-in gain in certain circumstances (e.g., where the income B earns from the property would be treated as built-in income under Section 382(h)(6)).

Sourcing. The Preamble notes that commentators criticized the single-entity approach used for sourcing, as reflected in Example 17 in the Proposed Regulations. The commentators argued that a separate-entity approach more accurately measures source of income. 46 Nevertheless, the single-entity approach to sourcing has been retained in the Final Regulations, but the example in the Final Regulations incorporates certain changes made to the attribute allocation rules, as set out below.

Example 6.: S manufactures inventory in the United States, and recognizes $75 of income on sales to B in Year 1, with title to the property passing to B outside the United States. B distributes the inventory in Country Y and recognizes $25 of income on sales to X in that same year. Under the matching rule, S's $75 intercompany income and B's $25 corresponding income are taken into account in Year 1. In determining the source of income, S and B are treated as divisions of a single corporation, and Section 863 applies as if $100 of income were recognized from producing the inventory in the United States and selling it in Country Y. The example in the Final Regulations assumes that applying the Section 863 regulations on a single-entity basis, $50 is treated as foreign-source income and $50 as U.S.-source income. On a separate entity basis, S would have $37.50 of foreign-source income and $37.50 of U.S.-source income, and all of B's $25 of income would be foreign-source income (assuming all of S's assets are U.S. assets). Thus, on a separate entity basis, S and B would have $62.50 of combined foreign-source income and $37.50 of U.S.-source income. Accordingly, under single-entity treatment, $12.50 that would be treated as foreign-source income on a separate entity basis is redetermined to be U.S.-source income. Under the matching rule, the redeterminated attributed ($12.50) must be allocated between S and B using a reasonable method. 47

Installment method not permitted where transaction is overall loss. The Final Regulations correct a mistaken conclusion in one of the examples of the Proposed Regulations that deals with a situation where B might otherwise seek to use the installment method to report its gain notwithstanding that the overall transaction yields a loss. 48 In the example, S holds land for investment with a basis of $130x. On January 1 of Year 1, S sells the land to B for $100x. B also holds the land for investment. On July 1 of Year 3, B sells the land to X in exchange for X's $110x note. The note bears a market rate of interest in excess of the applicable federal rate, and provides for principal payments of $55x in Year 4 and $55x in Year 5. The Proposed Regulations suggested that B could use the installment method to report its $10 gain. In the Final Regulations, however, the example notes that if B, under a single-entity approach, had succeeded to S's $130 basis, there would be no gain on its sale to X—in fact, there would have been a $20 loss. On the basis of this logic, the example precludes installment method reporting for B's actual $10 gain, which is taken into account in Year 3 along with S's actual $30 loss. 49

The Acceleration Rule

In General

Under the acceleration rule, S's intercompany items and B's corresponding items are taken into account to the extent they cannot be taken into account to produce the effect of treating S and B as divisions of a single corporation—when matching is no longer possible. 50 In such a case, S takes its intercompany items into account immediately before it becomes impossible to achieve this effect.

The Final Regulations provide that the effect of single-entity treatment cannot be achieved to the extent: (1) an intercompany item or a corresponding item will not be taken into account in determining the group's consolidated taxable income under the matching rule (e.g., S or B becomes a nonmember) or (2) a nonmember reflects, directly or indirectly, any aspect of the intercompany transaction. The latter case is illustrated by a Section 351 transfer by B of property acquired from S to a nonmember—B's cost basis and property purchased from S would be reflected by the nonmember under Section 362 following the transfer. 51 As a result, this transfer causes acceleration of the reporting of S's intercompany item.

Attributes—General Rule and Change From Proposed Regulations

The Final Regulations provide that if the item in an intercompany transaction is from an intercompany sale, exchange, or distribution of property, its attributes are determined under the principles of the matching rule as if B sold the property at the time the item is taken into account under the acceleration rule, for a cash payment equivalent to B's adjusted basis in the property (i.e., at no gain or loss). If the acceleration event occurs because the property leaves the group, B is treated as selling the property to the nonmember that actually owns the property after the acceleration event. If the nonmember is related for purposes of any provision of the regulations to any party to the intercompany transaction (or any related transaction) or to the common parent, the nonmember is treated as related to B for purposes of that provision. In such event, loss deferral, loss denial, and gain recharacterization rules such as Sections 267, 707(b), and 1239 may apply. By contrast, if the property is not owned by a nonmember immediately after S's item is taken into account, B is treated as selling the property to an affiliate corporation that is not a member of the group. 52 Here again, Sections 267, 707, and 1239 may apply.

The above rule constitutes a change from the Proposed Regulations. Under the Proposed Regulations, the attributes of S's intercompany items from intercompany property transactions were determined under the principles of the matching rules as if B resold the property to a nonmember affiliate. Under this rule, S's gain from the sale of depreciable property is always treated as ordinary income under Section 1239. The Preamble observes that this treatment is appropriate if the property remains in the group, as would be the case if S left the group. However, the Preamble notes that many commentators objected to this treatment of S's attributes in other situations arguing, for example, that if B leave the group while it still owns the property, the regulations should treat the property as having left the group. As set out above, this rule was adopted in the Final Regulations. 53

Attribute Redetermination

The attributes of B's corresponding items continue to be redetermined under the principles of the matching rule, with certain adjustments. If S and B continue to join with each other in the filing of a consolidated return, the attributes of B's corresponding items and any applicable holding periods are determined by continuing to treat S and B as a single corporation. Once S and B no longer join with each other in the filing of a consolidated return, the attributes of B's corresponding items are determined as if the S division (but not the B division) were transferred to an unrelated person. Thus, S's activities and any applicable holding period before the intercompany transaction continue to effect the attributes of B's corresponding items in any applicable holding period. 54 If the acceleration rule applies to S, B still takes its corresponding items into account under

its accounting method. The redetermination of the attributes of a corresponding item under the acceleration rule, however, might effect its timing. 55

Example 7.: S owns land for investment with a basis of $70. On January 1 of Year 1, S sells the land to B, who will also hold the land for investment, for $100. On July 1 of Year 3, B sold 60 percent of S's stock to X for $60 and, as a result, S becomes a nonmember. Under the matching rule none of S's $30 gain is taken into account in Years 1 through 3 because B has no gain or loss with respect to the property. Under the acceleration rule, however, S's $30 gain is taken into account in computing taxable income immediately before the deconsolidation because the effect of treating S and B as divisions of a single corporation can no longer be achieved. Even though S must accelerate its gain, B continues to takes its corresponding items into account under its accounting method. Thus, B's items from the land are taken into account based on subsequent events (such as a sale of the land). 56

Example 8.: The facts are the same as in Example 7 except that B holds the land for sale to customers in the ordinary course of business and incurs substantial expenses over a two-year period subdividing, developing, and marketing the land. On July 1 of Year 3 before B has sold any of the land, B issues 60 percent of its stock to X for $60 and, as a result, S becomes a nonmember. Under the acceleration rule, S's $30 gain is restored and the attributes of S's gain are redetermined under the principles of the matching rule. Thus, whether S's gain is capital or ordinary income depends on the activities of both S and B. Because S and B no longer join with each other in the filing of consolidated returns, the attributes of B's corresponding items, for example, from its subsequent sale of the land, are redetermined under the principles of the matching rule as if the S division (but not the B division) were transferred by the single corporation to an unrelated person at the time of deconsolidation. As such, B continues to take into account the activities of S with respect to the land before the intercompany transaction. 57

Method of Accounting

In General

As with the Proposed Regulations, the Final Regulations provide that their timing rules are a method of accounting under Section 446 for intercompany transactions to be applied by each member in addition to that member's other methods of accounting. 58 To the extent the timing rules of the Final Regulations are inconsistent with the member's otherwise applicable methods of accounting, the Final Regulations make clear that its rules control. They provide, for example, that if S sells property to B in exchange for B's note, the timing rules of the Final Regulations will trump the installment sale rules of Section 453. The Final Regulations further provide that S's or B's application of these timing rules to an intercompany transaction clearly reflects income only if the effect of that transaction as a whole on consolidated taxable income is clearly reflected.

As a practical matter, these new provisions may represent the single most significant change that the Final Regulations make to current law. The Preamble notes that commentators objected to this rule in the Proposed Regulations. 59 Commentators pointed out that treating the timing provisions as a method of accounting would increase the burden and complexity of correcting improper applications of the regulations, necessitating, among other things, requests for accounting method changes before the IRS National Office. Concerns were also raised about members entering or leaving a group (e.g., would a change in method of accounting be required in such cases?).

Change From Proposed Regulations

As noted above, the Final Regulations retain the approach of the Proposed Regulations and treat the timing rules as a method of accounting. However, in response to commentators, the Final Regulations also contain several provisions intended to reduce the potential administrative burden of such a rule. First, the Final Regulations treat the timing rules as an accounting method for intercompany transactions to be applied by each member and not as an accounting method of the group as a whole. This would seem to suggest that similar transactions between different members of a consolidated group may be treated differently under different accounting methods, since each member would have a method for treating the transactions rather than the entire group. To reduce potential administrative burdens, the Final Regulations generally provide automatic consent under Section 446(e) to the extent changes in method are acquired when a member enters or leaves a group. In addition, for the first taxable year of the group to which the Final Regulations apply, consent is granted for any changes in method that are necessary to comply with the regulations. For other years, members must obtain the Commissioner's consent to change their methods of accounting for intercompany transactions under applicable administrative procedures of Section 446(e), currently Revenue Procedure 92-20. 60

Transactions Involving Stock of Members

The Old Regulations

The Old Regulations relating to the treatment of transactions involving stock of members of a consolidated group were generally found in Former Regulation Sections 1.1502-14 and 1.502-14T. In general, Section 301 distributions were “eliminated” from the gross income of the distributee member. 61 Section 301 distributions including nondividend distributions, first reduced the distributee members basis in the distributing member's stock to zero and then created an excess-loss account. 62 The Old Regulations further provided that if appreciated property was distributed in a distribution to which Section 301 applies, the distributing member recognized gain under Section 311(b), but that gain was deferred and taken into account under the general restoration rules of Former Regulation Section 1.1502-13. 63 The distributee's basis in the property received was generally its fair market value. No loss, however, was permitted on such a distribution because Section 311(a) provides that losses are not allowed with respect to such distributions. In such a case, the distributee inherited the distributing corporation's basis in the property, that is, the loss was shifted to the distributee. 64 No rules were provided in the Old Regulations for tax-free reorganizations under Section 368 or divisive transactions to which Section 355 applies.

The Final Regulations

In General

The Final Regulations make key changes to the existing rules as well as to the Proposed Regulations. First, as noted above, the Final Regulations eliminate Former Regulation Section 1.1502-14 by providing that the general intercompany transaction rules (e.g., the matching and acceleration rules) apply to transactions involving the stock of members as well. Thus, if S distributes appreciated property to B, S's gain is an intercompany item that is taken into account under either the matching or acceleration rules detailed above. In addition, in a major departure from the Old Regulations, a distribution of depreciated

property is treated as an intercompany transaction, and the loss may be ultimately restored to the distributing member at the appropriate time. Other changes from the old law include relief from double taxation in the case of certain transactions (e.g., Section 332 liquidations and Section 338(h)(10) transactions where the stock liquidated or disposed of had been the subject of an intercompany gain).

Distributions of Appreciated and Depreciated Property

As under the Old Regulations, an intercompany distribution by S is not included in the gross income of B, the distributee member. The Final Regulations provide a change in terminology from the Old Regulations by stating that the distribution is “excluded” rather than eliminated. The Preamble to the Proposed Regulations indicated that this change was nonsubstantive and intended only to conform with the standard parlance in the Code (e.g., Section 243). Key Treasury personnel have confirmed that this view has not changed. Thus, for example, no amount is included in B's gross income under Section 301(c)(3) from a distribution in excess of the basis of the stock of a subsidiary that results in an excess-loss account. In a change from the Old Regulations, however, the exclusion applies to a distribution only to the extent there is a corresponding negative adjustment that is reflected under Regulation Section 1.1502-13 in B's basis in the stock of the distributing member, S. In this situation, the Final Regulations point to Regulation Section 1.1502-26(b), which addresses the applicability of the dividends-received deduction to distributions from the common parent to a subsidiary using stock of the common parent. 65

In another major change from the Old Regulations, the Final Regulations extend the principles of Section 311(b) to S's loss as well as gain from an intercompany distribution of property. Thus, S's loss on a distribution is taken into account under the matching or acceleration rules as if the property is subsequently sold to a nonmember. However, Section 311(a) continues to apply to distributions to nonmember shareholders—loss is not recognized in this case. 66 67

Example 9:: S owns land with a $70 basis and $100 value. On January 1 of Year 1, P's basis in S's stock is $100. During Year 1, S distributes the land to P as a dividend. Under Section 311(b), S has a $30 intercompany item. Under Section 301(d), P's basis in the land is $100. On July 1 of Year 3, P sells the land to X for $110. Under the Final Regulations, S's distribution to P is an intercompany distribution. P's $100 of dividend income is excluded from gross income. Under the matching rule, (treating P as the buying member and S as the selling member), S takes its $30 gain into account in Year 3 to reflect the $30 difference between P's $10 gain taken into account and the $40 recomputed gain (using S's $70 basis). 68

Example 10.: The facts are the same as in Example 9 except that S has a $130 (rather than a $70) basis in the land. Under the Final Regulations, the principles of Section 311(b) apply to S's loss from the intercompany distribution. S has a $30 loss that is taken into account under the matching rule in Year 3 to reflect the $30 difference between P's $10 gain taken into account and the $20 recomputed loss. The Final Regulations note that the results are the same under Section 267. The Final Regulations also note that if P had distributed the land to its shareholders, rather than selling the land to X, P would take into account its $10 gain under the normal rules of Section 311(b), but no loss would be allowed to S. 69

Timing of Distributions: The Entitlement Rule

For all federal income tax purposes, an intercompany distribution is treated and taken into account when the shareholder member becomes entitled to it. The Final Regulations provide that this is generally the record date. For example, if B becomes entitled to a cash distribution before it is made, the distribution is treated as made when B becomes entitled to it. The Final Regulations further provide that B is treated as entitled to a distribution no later than the time the distribution is deemed taken to account under the Code (e.g., under Section 305(c)). If the distribution is not made, appropriate adjustments must be made as of the date it was taken into account. 70

Boot in an Intercompany Reorganization

The Final Regulations, much like the Proposed Regulations, provide specific rules for the treatment of other property or “boot” in a tax-free reorganization occurring between members of the same consolidated group. 71 No such rules were provided in the Old Regulations. In general, under the Final Regulations, boot received as part of such a reorganization is treated as being received in a separate transaction. As such, Sections 301, 302, and 311 rather than Sections 356 and 361 apply. The Final Regulations provide the following example of boot in a reorganization.

Example 11.: P owns all of the stock of S and B. On January 1 of Year 5, at a time when S's fair market value is $500, S merges into B in a tax-free reorganization, with P receiving B stock with a fair market value of $350 and $150 of cash.

Under the “separate transaction” approach of the Final Regulations, P is treated as receiving only B stock in the merger—B stock having a value of $500. Immediately after the merger, $150 of the stock received is treated as redeemed, and the redemption is treated under the Section 302 rules as a distribution to which Section 301 applies. Because the $150 distribution is treated as not received as part of the merger, Section 356 does not apply and no basis adjustments are required under Section 358. However, because B is treated under Section 381(c)(2) as receiving S's earnings and profits and the redemption is treated as occurring after the merger, S's E&P may be considered in determining what portion of the Section 301 distribution is a dividend. 72

Issuer Acquires Own Stock

If a member (B) acquires its own stock or an option to buy or sell its own stock in an intercompany transaction from a second member (S), S's basis in the stock or option is treated as eliminated for all purposes. Accordingly, under the acceleration rule, S's intercompany items from the stock or options of B are taken into account if B acquires the stock or options in an intercompany transaction because S's intercompany items can no longer be matched with B's corresponding items. For example, if B redeems its stock from S in a transaction to which Section 302(a) applies, S's gain from the transaction is taken into account immediately under the acceleration rule. 73 This provision reverses the government's position in GCM 39608. 74 The concern here was that an indefinite deferral could be achieved without an immediate recognition event by having B merely hold its stock as treasury stock. This result, however, can be avoided if S is liquidated tax-free into B under Section 332 and S distributes B stock to B that has not been the subject of a prior intercompany transaction. This is the case because S recognizes no gain or loss on the liquidation so the acceleration rule has no effect.

Relief From Double Taxation

As with the Proposed Regulations, the Final Regulations provide several rules that taxpayers may elect to apply in order to prevent double taxation of the group on the same gain. A typical situation arises where the stock of a subsidiary is sold and the selling group makes an election under Section 338(h)(10) to treat the transaction as an asset sale.

Example 12.: Assume that S distributes the stock of T, which has a zero basis and a fair market value of $100 to B, giving rise to S's intercompany item of $100. Assume further that the basis of T's assets is zero and their fair market value is $100. Some time after the distribution, B desires to sell the stock of T to X and make a Section 338(h)(10) election with respect to the stock sale. In such a case, the transaction would be treated as an asset sale by T, triggering $100 of gain. In addition, on the deemed liquidation of T that occurs in connection with the Section 338(h)(10) election, S's $100 intercompany item on the stock distribution would also be taken into account. Thus, the group would be taxed twice on the same $100 of economic gain.

The same double-tax result would occur if T were liquidated under Section 332 or its stock were distributed to the shareholders of the group under Section 355. These are addressed below.

Section 338(h)(10). The Final Regulations provide that to avoid the double-tax result, B may elect to be treated with respect to each share of its T stock as recognizing as a corresponding item any loss or deduction it would recognize (determined after adjusting stock basis under Regulation Section 1.1502-32) if Section 331 applied to the deemed liquidation. For all other federal income tax purposes the deemed liquidation remains subject to 332. Thus, in Example 12, B's basis in its T stock would be increased to $200 on the deemed sale of the T assets. On the liquidation, in which B would receive $100 in proceeds, B would recognize a $100 loss that would offset T's $100 gain.

The amount of B's loss or deduction under the Final Regulations is limited. The aggregate amount of loss recognized with respect to T could not exceed the amount of S's intercompany income or gain that is in excess of S's intercompany deduction or loss with respect to shares of T having the same material terms as the shares giving rise to S's intercompany gain or loss. Further, the aggregate amount of loss recognized from T's deemed liquidation cannot exceed the net amount of deduction or loss, if any, that would be taken into account from the deemed liquidation if Section 331 applied with respect to all T's shares. 75

Section 332. The double taxation situation may also arise where a subsidiary is liquidated in a Section 332 scenario. For example, the Final Regulations posit a situation where 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 would then be taken into account under the matching rule. 76 To provide relief, the Final Regulations essentially adopt a liquidation/reincorporation approach; that is, if Section 332 applies to T's liquidation into B, and B transfers T assets to a new member (new T) in a transaction not otherwise pursuant to the same plan arrangement as the liquidation, the transfer will nevertheless be treated for all federal income tax purposes as pursuant to the same plan arrangement as the liquidation. 77 In contrast to the Proposed Regulations, the Final Regulations broaden the circumstances in which this relief is available by eliminating the requirements that T have no minority shareholders and that T have not made substantial noncash distribution during the previous twelve-month period. 78

Still, there are somewhat severe time constraints on this relief provision that call into question its utility. Basically, the transfer of an asset to new T will fall within the relief

provisions only if it is transferred pursuant to a written plan that is attached to a timely filed return (including extensions) for the year of T's liquidation and the actual transfer occurs within twelve months of the filing of the return. 79 Thus, a group that discovers its error several years after the liquidation will simply be out of luck. 80

Section 355. If B distributes the T stock in an intercompany transaction to which Section 355 applies, redetermination of the basis of the T stock under the general rules of Section 358 could cause S's gain or loss to be taken into account. To prevent this result, taxpayers may elect to treat B's distribution as being subject to Sections 301 and 311 rather than Section 355. Although somewhat cryptic, the Final Regulations provide that this election will prevent S's gain or loss from being taken into account immediately to the extent matching remains possible. B's gain or loss from the distribution will also be taken into account in this manner as well, however. 81

Effective date of the relief provisions. The Proposed Regulations provided that the effective date of the relief provisions would follow the general effective date; the relief provisions would apply only if both the intercompany transaction and the triggering event occur in years beginning after the Final Regulations are filed with the Federal Register. Commentators requested retroactive application of the relief provisions to varying degrees. In response to those comments, the Final Regulations adopted an effective date that allows groups to elect to apply the relief provisions to certain transactions that occur on or after July 12, 1994, regardless of whether the sale of the stock from S to B occurred prior to that date.

However, the Final Regulations neither provide relief for duplicated gains nor preclude losses taken into account under the Old Regulations in periods prior to the effective date of the Final Regulations. Specifically, Regulation Section 1.1502-13(1)(3) provides that the above types of transactions are “stock elimination transactions.” Under this provision, a taxpayer may elect to apply the Final Regulations to a stock elimination transaction to which prior law would otherwise apply. A stock elimination transaction is a transaction where stock is (1) transferred from S and B and is canceled or redeemed on or after July 12, 1995; (2) treated as canceled in a liquidation pursuant to an election under Section 338(h)(10) with respect to a qualified stock purchase with an acquisition date on or after July 12, 1995; (3) distributed on or after July 12, 1995; (4) or exchanged on or after July 12, 1995, for stock of a member in a transaction that would cause S's gain or loss in the transaction to be taken into account under prior law.

Disallowing Loss and Certain Gain on Sale of Parent Stock

In what was generally regarded as a surprise among tax practitioners, the Service issued, along with the Final Regulations, a package of Temporary and Proposed Regulations designed to prevent certain perceived abuses involving the use of parent (P) stock. The Service issued Temporary and Proposed Regulations providing rules that disallow loss and exclude gain with respect to certain dispositions of stock of the common parent of a consolidated group by members of its group. The Temporary Regulations are designed to prevent taxpayers from recognizing certain gains and losses on P stock that would not be recognized (due to Section 1032) if the consolidated group were treated as a single entity.

The Treasury and the IRS were aware that consolidated groups were relying on the separate-entity treatment of stock to claim losses on capital raising and other transactions. As a result, the IRS issued Temporary Regulations to prevent the recognition of such losses. 82 For example, the preamble of the regulations provides that

taxpayers might seek to recognize losses by having a subsidiary of the group purchase P stock. Thereafter, if the value of the P stock declines, S might issue the P stock in order to claim a loss even though a sale of P stock by P would result in no gain or loss under Section 1032. The Temporary Regulations disallow the losses and certain gains effective for sales of P stock by members of its consolidated group on or after July 12, 1995.

Finally, to qualify for the relief from gain on the use of P stock, the member must have acquired the P stock directly from P through a contribution to capital or a transaction qualifying under Section 351. In addition, the member must, pursuant to a plan, transfer the stock immediately to an unrelated nonmember in a taxable transaction (other than in exchange for P stock). In addition, the common parent must remain the common parent and the member must remain a member. 83 P stock issued in a nontaxable transaction generally will not result in gain recognition to the consolidated group unless the member does not issue the P stock pursuant to the plan of reorganization.

Obligations of Members

Definitions: “Obligations” and “Intercompany Obligations”

The Final Regulations provide that an “obligation” is an obligation of the member constituting indebtedness under general principles of federal income tax law (e.g., under nonstatutory authorities, or under Section 108, Section 163, Section 171, or Section 1275), but not an executory obligation to purchase or provide goods or services; any security of the member described in Section 475(c)(2)(D) or Section 475(c)(2)(E); and any comparable security with respect to commodities, but not if the security is a position with respect to the member's stock. 84 An “intercompany obligation” is an obligation between members, but only for the period during which both parties are members.

Transactions between members with respect to intercompany obligations are intercompany transactions. For example, assume that on January 1 of Year 1, B borrows $100 from S in return for B's note providing for $10 of interest annually at the end of each year, and repayment of $100 at the end of Year 5. B fully performs its obligations. Under their separate entity methods of accounting, B accrues a $10 interest deduction annually under Section 163, and S accrues $10 of interest income annually under Section 61(a)(4). 85

The accrual of interest on B's note is an intercompany transaction. Under the matching rule, S takes its $10 of income into account in each of Years 1 through 5 to reflect the $10 difference between B's $10 of interest expense taken into account and the $0 recomputed expense.

Deemed Satisfaction and Reissuance of Intercompany Obligations

As with the Proposed Regulations, if a member realizes an amount (other than zero) of income, gain, deduction, or loss from the assignment or extinguishment of all or part of its remaining rights or obligations under an intercompany obligation, the intercompany obligation is treated for all federal income tax purposes as satisfied and, if it remains outstanding, reissued. Similar principles apply if a member realizes any such amount from a comparable transaction (for example, a marking-to-market of an obligation or a

bad-debt deduction), or if an intercompany obligation becomes an obligation that is not an intercompany obligation. 86

Deemed Satisfaction: Intercompany Debt becomes Nonintercompany Debt

The Final Regulations provide that if a creditor member sells intercompany debt for cash, the debt is treated as satisfied by the debtor immediately before the sale for the amount of the cash. For other transactions, similar principles apply to treat the intercompany debt as satisfied immediately before the transaction. Thus, if the debt is transferred for property, it is treated as satisfied for an amount consistent with the amount for which the debt is deemed reissued, as discussed below. If this rule applies because the debtor or creditor becomes a nonmember, the obligation is treated as satisfied for cash in an amount equal to its fair market value immediately before the debtor or creditor becomes a nonmember. Similar principles apply to intercompany obligations other than debt. 87

Deemed Reissuance: Intercompany Debt Becomes Nonintercompany Debt

As noted above, once the debt is deemed to have been satisfied, if it remains outstanding it is deemed to be reissued. Specifically, if a creditor member sells intercompany debt for cash, the debt is treated as a new debt (with a new holding period) issued by the debtor immediately after the sale for the amount of cash. For other transactions, if the intercompany debt remains outstanding, similar principles apply to treat the debt as reissued immediately after the transaction. Thus, if the debt is transferred for property, it is treated as new debt issued for the property. The Final Regulations point to Section 1273(b)(3) or Section 1274 for guidance. If this rule applies because the debtor or creditor becomes a nonmember, the debt is treated as new debt issued for an amount of cash equal to its fair market value immediately after the debtor or creditor becomes a nonmember. Similar principles apply to intercompany obligations other than debt. 88

Example 13.: On January 1 of Year 1, B borrows $100 from S in return for B's note providing for $10 of interest annually at the end of each year, and repayment of $100 at the end of Year 20. On January 1 of Year 3, S sells B's note to X for $70, a $30 loss reflecting a change in the value of the note as a result of increased market interest rates. B is never insolvent within the meaning of Section 108(d)(3).

B's note is treated as satisfied for $70 immediately before S's sale to X. As a result, B takes into account $30 of discharge of indebtness income under Section 61(a)(12). Although S's $30 loss ordinarily would be capital, under the matching rule the attributes of S's intercompany item and B's corresponding item must be redetermined as if S and B were divisions of a single corporation. Since B's corresponding item—$30 of ordinary income—completely offsets S's intercompany item in amount, S's loss is treated as ordinary. B is also treated as reissuing, directly to X, a new note with a $70 issue price and a $100 stated redemption price at maturity. The $30 of original issue discount created therein will be taken into account by B and X under Sections 163(e) and 1272. 89

Exceptions: Intercompany Debt Becomes Nonintercompany Debt

Exceptions to the deemed satisfaction and reissuance rules occur where (1) the obligation became an intercompany obligation by reason of an event described in Regulation Section 1.108-2(e) (exceptions to the application of Section 108(e)(4)); (2) the amount realized is from reserve accounting under Section 585 or Section 593; (3) the amount realized is from the conversion of an obligation into stock of the obligor; (4) treating the obligation as satisfied and reissued will not have a significant effect on any person's federal income tax liability for any year. 90

Section 108 Not Applicable

In a fairly significant change from the Proposed Regulations, the Final Regulations provide that any gain or loss from an intercompany obligation is not subject to Section 108(a), as well as Section 354 or Section 1091. 91 The Preamble provides that the change was intended to benefit taxpayers. It states that under the general rules, a cancellation of a loan to B may result in excluded discharge of indebtedness to B, a nondeductible expense to S (the matching rule would preclude a deduction under Section 166), and attribute reduction under Section 108(b) or Section 1017. Thus, the group would be required to reduce attributes without any corresponding net benefit (the Section 166 deduction).

Example 14.: On January 1 of Year 1, B borrows $100 from S in return for B's note providing for $10 of interest annually at the end of each year, and repayment of $100 at the end of Year 5. In Year 3, S sells B's note to P for $60. B is insolvent within the meaning of Section 108(d)(3) at that time. Under the matching rule, and disregarding Section 108(a), S's $40 loss is treated as ordinary and B's $40 discharge is included as ordinary income. 92

Deemed Satisfaction and Reissuance: Nonintercompany Debt Becomes Intercompany Debt

In general, the rules regarding deemed satisfaction and reissuance of debt apply as well in the case of nonintercompany debt that becomes intercompany debt. Specifically, the Final Regulations provide that if their rules apply (1) Section 108(e)(4) does not apply; (2) the debt is treated for all federal income tax purposes, immediately after it becomes an intercompany debt, as satisfied and a new debt issued to the holder (with a new holding period) in an amount determined under the principles of Regulation Section 1.108-2(f); (3) the attributes of all items taken into account from the satisfaction are determined on a separate entity basis, rather than by treating S and B as divisions of a single corporation; (4) any intercompany gain or loss taken into account is treated as not subject to Section 354 or Section 1091; and (5) any loss created on the deemed satisfaction may be waived under the investment adjustment rules. 93 Similar principles apply to intercompany obligations other than debt. 94

Regarding the exception to the matching rule (item 3 above), the Preamble notes that the attributes of the issuer's items and the holder's items are separately determined, and thus may not match. 95 Although commentators argued that matching was appropriate in such a case, the government ultimately determined that separate entity treatment of attributes in these circumstances best reflects the fact that the income and loss taken into account accrued before the issuer and the holder joined in filing a consolidated return.

The Final Regulations also make clear that the loss waiver rules of the investment adjustment system (item 5 above) apply to any loss on the deemed sale. The Preamble notes that under Regulation Section 1.1502-32 downward stock basis adjustments would

be required upon the expiration of any capital losses created by the deemed satisfaction if a member joins the group while holding an obligation of another member. Because the Proposed Regulations provide that the deemed satisfaction and reissuance is treated as occurring immediately after the obligation becomes an intercompany obligation, these losses could not be waived under Regulation Section 1.1502-32(b)(4). As noted above, the Final Regulations provide relief here, allowing the group to elect to waive the capital losses and avoid the downward basis adjustment. 96

Example 15.: On January 1 of Year 1, B borrows $100 from X in return for B's note providing for $10 of interest annually at the end of each year, and repayment of $100 at the end of Year 5. On January 1 of Year 3, when the value of the note has fallen to $70, P buys all of X's stock. B is solvent within the meaning of Section 108(d)(3).

B is treated as satisfying its indebtedness for $70 (determined under the principles of Regulation Section 1.108-2(f)(2) immediately after X becomes a member of the P group. In contrast to the general scheme of the Final Regulations, the attributes of items resulting from the satisfaction are determined on a separate entity basis. Thus, although B's income is ordinary, S's loss is capital. B is also treated as reissuing a new note with a $70 issue price and $100 stated redemption price at maturity. 97

Exceptions

The above rules do not apply if the obligation becomes an intercompany obligation by reason of an event described in Regulation Section 1.108-2(e) (exceptions to the application of Section 108(e)(4)); or treating the obligation as satisfied and reissued will not have a significant effect on any person's federal income tax liability for any year. 98

The Anti-Avoidance Rules

In General

The Final Regulations provide that if a transaction is engaged in or structured with a principal purpose of avoiding the purposes of the intercompany transaction system (including treatment as an intercompany transaction), adjustments must be made to carry out the purposes of the system. 99 While acknowledging that commentators thought this proposal to be overly broad, the Preamble provides that the Treasury and the IRS continue to believe that the anti-avoidance rule is necessary to prevent transactions that are designed to achieve results that are inconsistent with the purposes of the Final Regulations. The Preamble goes on to say that routine intercompany transactions undertaken for legitimate business reasons will be unaffected by the anti-avoidance rules. The rules are fleshed out by a number of examples.

SRLY Example Retained

The first example in the Final Regulations, which was also the first example in the Proposed Regulations, deals with NOL carryforwards from separate return limitation years that are subject to limitation under Regulation Section 1.1502-21(c). The basic thrust of the example is that through a series of transactions, one member (while remaining in existence) of the consolidated group shifts its SRLY losses to another member through the creation of a partnership and the transfer of a partnership interest. Under the anti-avoidance rules, however, the other member is precluded from using the SRLY loss. 100

The example remains controversial because it goes against the conventional wisdom that members of a consolidated group can engage in transactions that avoid SRLY limitation problems. The most common of these transactions is to merge the member with SRLY NOLs with an income-generating member. Government officials continue informally to indicate that the example was not intended to reach beyond its specific facts. Nevertheless, the breadth of this anti-avoidance rule remains a question mark.

Changes From Proposed Regulations

One example was deleted and several were added to the Final Regulations. Some of these examples are set out below.

Transfer to Partnership Example Deleted

Example 2 of the Proposed Regulations which involved a transfer of Section 382 built-in gain property outside the consolidated group to a wholly owned partnership (presumably to accelerate built-in gain) has been deleted. 101 That example treated the transfer as an intercompany transaction, even though a partnership cannot be a member of a consolidated group. Although the Final Regulations deleted this example, the Preamble warns that such a transaction is subject to challenge under other authorities, such as Regulation Section 1.701-2.

Corporate Mixing Bowl Transaction Added

The Final Regulations provide the following example of a transaction to which the anti-avoidance rules are directed.

Example 16.: M1 and M2 are subsidiaries of P. M1 operates a business on land it leases from M2, and the land is M2's only asset. P intends to dispose of the M1 business as well as the land owned by M2. P's basis in the M1 stock is equal to the stock's fair market value. M2's land has a value of $20 and a basis of $0 and P has a $0 basis in the stock of M2.

In Year 1, with a principal purpose of avoiding gain from the sale of the land, M1 and M2 form corporation T. M1 contributes cash in exchange for 80 percent of the T stock and M2 contributes the land in exchange for the remaining 20 percent of the stock. In Year 3, T liquidates, distributing $20 cash to M2 and the land (plus $60 cash) to M1. Under Regulation Section 1.1502-34, Section 332 protects both M1 and M2 from gain. In addition, under Section 337, T recognizes no gain or loss from its liquidating distribution of the land to M1 (since M1 owns 80 percent of the stock of T). In Year 4, P sells all of the stock of M1 (which now includes the land) to X and liquidates M2.

Because a principal purpose of the formation and liquidation of T was to avoid gain from the sale of M2's land, M2 must take into account $20 of gain when the M1 stock is sold to XZ. 102

Effective Dates

The Final Regulations generally are effective in tax years beginning on or after July 12, 1995. 103 The Final Regulations provide that if both they and the Old Regulations apply to a transaction, or neither applies, with the result that items may be duplicated, omitted,

or eliminated in determining taxable income, or items may be treated inconsistently, old law will apply.

The Final Regulations retain the anti-abuse effective-date rule found in the Proposed Regulations. Under this exception, the rules of the Final Regulations will apply to a transaction if it is engaged in or structured on or after April 8, 1994, with a principal purpose to avoid the rules of the Final Regulations. 104 The Final Regulations provide, somewhat cryptically, that appropriate adjustments will be made in such cases. 1

Unless specified otherwise, all section references are to the Internal Revenue Code of 1986, as amended, or to the regulations promulgated thereunder. In particular, citations to Former Regulation Section 1.1502-13 refer to the provisions in effect prior to the effective date of the Final Regulations. 2 To complete the process, the IRS and Treasury must finalize the proposed modifications to the separate return limitation year (SRLY) rules and the proposed rules governing the application of Section 382 to consolidated groups. The finalization of these projects, outstanding since 1991, is extremely important to taxpayers because of their effect on earlier tax years: Such regulations are generally proposed to be effective in 1991. In addition, the authors believe that the overhaul of the consolidated return regulations would not be complete without a rewrite of the “reverse acquisition” rules and the related provisions. See Reg. §§1.1502-75(d)(1), 1.1502-75(d)(2), 1.1502-75(d)(3). Government officials have suggested that this area is also under study. 3 T.D. 8597. 4 1994-1 C.B. 724. The authors co-authored a previous article for this journal, “The Brave New World of Consolidated Returns II: The Proposed Consolidated Intercompany Transaction Regulations,” 21 J. Corp. Tax'n 311 (1994), that contains an overview and analysis of the Proposed Regulations. A variety of other practitioners have authored similar articles. See Hennessey & Yates, “Single-Entity Concepts Also Apply to Intercompany Stock, Obligations Under Prop. Regs.,” 81 J. Tax'n 138 (1994); Hennessey & Yates, “Complex New Matching and Acceleration Rules Apply to Intercompany Transactions,” 81 J. Tax'n 80 (1994). 5 Reg. §1.1502-13(a)(1). 6 1995-2 CB 188-190. 7 Like the Final Regulations, this article will use “S” to refer to the selling member, “B” to refer to the buying member, “P” to refer to the common parent of the P consolidated group, and “X” to refer to a person unrelated to any member of the P group. 8 The consolidated return regulations in effect prior to 1966 used this approach to the treatment of intercompany transactions. The IRS, however, quickly concluded that this approach was inadvisable because in certain circumstances it permitted the group to transfer assets outside the group without recognizing gain. See Henry C. Beck Co. v. Comm'r, 41 TC 616 ; United Contractors, Inc. v. Comm'r, TC Memo 1964-68, PH TCM ¶64068, 23 CCH TCM 453 15 AFTR 2d 714, 344 F2d 123, 65-1 USTC ¶9347 aff'd ; Vernon C. Neal, Inc. v. Comm'r, TC Memo 1964-145, PH TCM ¶64145, 23 CCH TCM 873 . 9 This approach obviously places a significant amount of pressure on the determination of the pricing for the intercompany sale. Presumably, the IRS would use §482 to police this

issue. 10 The addition of Former Regulation Section §1.1502-13(l) to the Old Regulations had begun to move the Old Regulations in this direction. However, as described below, the Final Regulations extend this concept further. 11 Former Reg. §1.1502-13(a). 12 Preamble at 7. 13 See, e.g., Woods Inv. Co. v. Comm'r, 85 TC 274 acq. ; CSI Hydrostatic Testers, Inc. v. Comm'r, 103 TC 398 76 AFTR 2d 95-6104, 62 F3d 136, 95-2 USTC ¶50476 aff'd . 14 Former Reg. §1.1502-13(a)(1). 15 Former Reg. §§1.1502-13(b)(1), 1.1502-13(c)(1). 16 Former Reg. §§1.1502-13(a)(2), 1.1502-13(b)(1), 1.1502-13(c). 17 Former Reg. §1.1502-13(c)(1). 18 Former Reg. §1.1502-13(d). 19 Former Reg. §1.1502-13(e). 20 Former Reg. §1.1502-13(f). 21 Reg. §1.1502-13(a)(1). 22 Reg. §1.1502-13(b)(1)(i). 23 Reg. §1.1502-13(b)(2)(i). 24 Reg. §1.1502-13(b)(3). 25 Reg. §1.1502-13(b)(4). 26 Prop. Reg. §1.1502-13(b)(iii). 27 Preamble at 9. 28 Reg. §1.1502-13(b)(6). 29 Reg. §1.1502-13(c)(1)(ii). 30 Reg. §1.1502-13(c)(2)(ii). 31 Reg. §1.1502-13(c)(2)(i). 32 Reg. §1.1502-13(c)(1)(i). 33 Preamble at 8. 34 Reg. §1.1502-13(c)(7), Example 1. 35

Reg. §1.1502-3(c)(7), Example 2. 36 Reg. §1.1502-13(c)(4)(i)(A). 37 Reg. §1.1502-13(c)(7), Example 4. 38 Reg. §1.1502-13(c)(4)(i)(B). 39 Reg. §1.1502-13(c)(4)(ii). 40 Reg. §1.1502-13(c)(5). 41 Reg. §1.1502-13(c)(7), Example 11. We note here that the treatment of S's gain on the sale as an intercompany item is inconsistent with proposed regulations under §475, which treat the gain as arising before the intercompany transaction. Likewise, treating B as recognizing gain on the sale of the security rather than mark-to-market gain prior to such sale seems to be inconsistent with the §475 proposed regulations. 42 Reg. §1.1502-13(c)(7), Example 11(d). Property so identified is treated as not being subject §475, even when held by a dealer. 43 Reg. §1.1502-13(c)(6)(i). 44 Reg. §1.1502-13(c)(6)(ii)(A). 45 Prop. Reg. §1.1502-13(c)(4), Example 11. 46 Preamble at 8. 47 Reg. §1.1502-13(c)(4), Example 14. 48 Prop. Reg. §1.1502-13(c)(4), Example 5(e). 49 Reg. §1.1502-13(c)(7), Example 5(e). 50 Prop. Reg. §1.1502-13(d). 51 Reg. §1.1502-13(d)(1)(i). 52 Reg. §1.1502-13(d)(1)(ii). 53 Preamble at 10. 54 Reg. §1.1502-13(d)(2)(i). 55 Reg. §1.1502-13(d)(2)(ii). 56 Reg. §1.1502-13(d)(3), Example 1. 57 Reg. §1.1502-13(d)(3), Example 2. 58 Reg. §1.1502-13(a)(3). 59 Preamble at 7. 60

Reg. §1.1502-13(a)(3)(ii). 61 Former Reg. §1.1504-14(a)(1). 62 Former Reg. §1.1502-14(a)(2). 63 Reg. §1.1502-14(c)(1). 64 Reg. §1.1502-14(a)(3). See S. Rep. No. 445, 100th Cong., 2d Sess. 62 (1988); LTR 8935014. 65 Reg. §1.1502-13(f)(2)(ii). 66 Reg. §1.1502-13(f)(2)(iii). 67 Id. 68 Reg. §1.1502-13(f)(7), Example 1. 69 Id. 70 Reg. §1.1502-13(f)(2)(iv). 71 Reg. §1.1502-13(f)(3)(i). 72 Reg. §1.1502-13(f)(7), Example 3. 73 Reg. §1.1502-13(f)(4). 74 Mar. 5, 1987. 75 Reg. §1.1502-13(f)(5)(C)(1). 76 Reg. §1.1502-13(f)(5). 77 Reg. §1.1502-13(f)(2)(iv)(B)(1). 78 Preamble at 12. 79 Reg. §1.1502-13(f)(5)(ii)(B)(2). 80 Although §9100 relief might be available. 81 Reg. §1.1502-13(f)(5)(ii)(D). 82 Reg. §1.1502-13T(f)(6). 83 Reg. §1.1502-13T(f)(6)(ii). 84 Reg. §1.1502-13(g)(2). 85 Reg. §1.1502-13(g)(5), Example 1. 86 Reg. §1.1502-13(g)(3)(i)(A). 87

Reg. §1.1502-13(g)(3)(ii)(A). 88 Reg. §1.1502-13(g)(3)(iii). 89 Reg. §1.1502-13(g)(5), Example 2. 90 Reg. §1.1502-13(g)(3)(i)(B). 91 Reg. §1.1502-13(g)(3)(ii)(B). 92 Reg. §1.1502-13(g)(5), Example 3. 93 Reg. §1.1502-13(g)(4)(ii). 94 Reg. §1.1502-13(g)(4)(iii). 95 Preamble at 12. 96 Id. at 12—13. 97 Reg. §1.1502-13(g)(5), Example 4. 98 Reg. §1.1502-13(g)(4)(i). 99 Reg. §1.1502-13(h)(1). 100 Reg. §1.1502-13(h)(2), Example 1. 101 Prop. Reg. §1.1502-13. 102 Reg. §1.1502-13(h)(2), Example 3. See also Example 4, dealing with a “partnership mixing bowl” transaction. 103 Reg. §1.1502-13(l)(1). 104 Reg. §1.1502-13(l)(2). © 2009 Thomson Reuters/RIA. All rights reserved.