Proposed investment adjustment regulations: consolidated return regulations "delink" basis adjustments from E & P adjustments.

• Author: Smith, Darlene A.
• Position: Earnings and profits

Current tax law concerning affiliated groups filing consolidated returns is complex, with inconsistent tax results for transactions involving the acquisition or disposition of group members. Part of the problem has resulted from the changes in the Code and the regulations made to "fix" the latest loopholes created by tax planners. The IRS now appears to be systematically revising substantial portions of the regulations, which should result in more rational and consistent law in this area.

The current system of determining a group's basis in a subsidiary and its earnings and profits (E&P) is excessively complex and probably does not meet the goal of treating a group of corporations filing a consolidated return as one taxable entity. Proposed regulations issued in November 1992 may present a comprehensive change that will provide a more rational approach to determining a group's basis and E&P. As described in the Treasury release,[1] amendments to the regulations "delink" the adjustments to determine basis from the computation of E&P.

The major change included in the proposed regulations is the amendment of Regs. Sec. 1.1502-32, "Investment adjustments." Major amendments would also be made to Regs. Sec. 1.1502-11, conforming changes for group structure changes; Regs. Sec. 1.1502-19, conforming changes to the excess loss account (ELA) rules; Regs. Sec. 1.1502-20, conforming changes to loss disallowance rules; Regs. Sec. 1.1502-33, simplification of the E&P rules and allocation of taxes continued; and Regs. Sec. 1.1502-76, allocation of income or losses between separate and consolidated return years and elimination of the 30-day rules.

Stock basis and E&P issues related to intercompany transactions are not included in these proposed regulations. The intercompany transaction rules will be revised later to address these issues. Note: For purposes of this article, unless otherwise stated, all corporations have only one class of stock outstanding; all groups file consolidated returns on a calendar-year basis; all transactions are between unrelated persons; and tax liabilities are disregarded. The term "consolidated group" refers to a affiliated group filing consolidated tax returns. P is a member of the consolidated group owning stock of another member of the group. S is a member of the group whose stock is owned, all or in part, by other members of the group

Proposed Rules for Determining Basis

in a Member's Stock

* Investment adjustments

Prop. Regs. Sec. 1.1502-32 would require that a member's basis adjustments in another member's subsidiary stock be determined by reference to taxable income rather than E&P. The stated purpose of the adjustment rules is to treat a consolidated group as a single entity. The basis of a subsidiary (S) owned by another member (P) would be adjusted to reflect amounts recognized by S and taken into account in determining the group's taxable income, and amounts distributed by S. Proper adjustment under these rules should prevent items taken into account in the computation of taxable income or as distributions from resulting in additional income or deductions a second time on P's disposition of S's stock. Items such as tax-exempt income or nondeductible expenses should not be recognized either in the computation of taxable income or as additional gain or loss on a disposition.[2]

Adjustments would be made at the close of each consolidated return year and at any other time when it is necessary to determine S's basis, such as on a disposition of S's stock. P's basis in S's stock would be increased by positive adjustments and reduced by negative adjustments. If negative adjustments result in a negative basis, an ELA would be created and the rules of Prop. Regs. Sec. 1.1502-19 should be consulted.[3]

The adjustment to P's basis in S would be the net amount of:

* Taxable income and gains (positive).

* Taxable losses, deductions and expenses (negative).

* Tax-exempt income (positive).

* Noncapital, nondeductible expenses (negative).

* Distributions with respect to S's stock (negative).[4]

Taxable income or loss: S's taxable income or loss is defined as consolidated taxable income determined by taking into account only S's items of income gain, deduction and loss. Tax losses (deductions and losses exceeding gross income) would be treated as a current negative adjustment if absorbed in the current year by other members of the group or if carried back and absorbed by S or by any member of the group in a prior separate or consolidated tax return. Tax losses carried forward would be treated as a negative adjustment in the year the loss is absorbed by S or by any member of the group. Any gross-up for taxes by operation of Sec. 78 or Sec. 852 would not be taken into consideration.[5]

Example 1: In year 1, the P group has $500 of consolidated taxable income. The P group would have a $100 net operating loss (NOL) if only S's items of income, gain, deduction and loss were considered. P's adjustment to its basis in its S stock - $100, the loss absorbed by the group. If the group could not absorb the loss in year 1 or prior years, P's basis in its S stock would not adjusted for the loss until a later year when the loss was absorbed by S or another member of the group.

Tax-exempt income: Tax-exempt income is defined as income recognized but permanently excluded from gross income under applicable law. The most common example of tax-exempt income is municipal bond interest excluded from gross income under Sec. 103.[6]

Example 2: In year 1, the P group has $500 of consolidated taxable income. The P group would have $100 of taxable income if only S's items of income, gain, deduction and loss were considered. In addition, S has $80 of tax-exempt interest income and $60 of expenses related to the production of the tax-exempt interest. P's adjustment to its basis in its S stock is computed as follows:[7]

Net taxable income in year 1 ($100) Tax-exempt income 80 Noncapital, nondeductible expenses (60) Adjustment to P's basis in S stock ($ 80) Equivalent deductions, i.e., deductions or other items that permanently offset items of income, are included in the definition of tax-exempt income.[8] A recovery of capital or an expenditure of money would not be considered an equivalent deduction. The most common example of an equivalent deduction is the dividends-received deduction under Sec. 243.

Example 3: S receives a $100 dividend from a domestic corporation in which it owns less than 20% of the stock. Since S has owned the stock for more than two years, there is no potential for a basis reduction under Sec. 1059. S is entitled to a $70 dividends-received deduction. The deduction is considered an equivalent deduction and $70 of the $100 dividend is treated as tax-exempt income. The resulting investment adjustment in P's basis in S's stock is $100, as follows:

Taxable income $30

Tax-exempt income - equivalent

deduction 70 Positive investment adjustment $100 Discharge of indebtedness that is excluded from taxable income would be treated as tax-exempt income to the extent (1) the discharge amount is used to reduce tax attributes under Secs. 108(b) and 1017, and (2) the attribute reduction is treated as a noncapital, nondeductible expense.[9]

Example 4: P forms S on January 1 of year 1 with a nominal capital contribution. S borrows $200 from an unrelated third party. During year 1, the P group has a $100 NOL when determined by taking into account only S's items of income, gain, deduction and loss. S's assets also decline in value to the point that S is considered insolvent under Sec. 108. None of S's NOL is absorbed by other groups members. In late year 1, $100 of the indebtedness is discharged. Under Sec. 108(b), the $100 NOL is reduced to zero by the discharge.

The indebtedness discharge has two equal and opposing effects on P's basis in its S stock. Because the discharge reduced the NOL under Sec. 108(b), it is treated as a nondeductible, noncapital expense and is a negative adjustment. Because the discharge is applied to reduce a tax attribute and is treated as a nondeductible, noncapital expense, the amount discharged is treated as tax-exempt income and is a positive adjustment. The two adjustments net to zero.[10]

Basis shifts would also be treated as tax-exempt income. A basis shift is an increase in the basis of S's assets to the extent that the increase (1) is not otherwise taken into account in determining P's basis in S's stock; (2) is determined directly by reference to a noncapital, nondeductible expense; and (3) has the effect of treating the expense as deferred rather...