Consolidated returns and the single-entity theory: the new intercompany transaction proposed regs.

• Author: Choate, Gary M.

On Apr. 8, 1994, the IRS issued anxiously awaited proposed regulations(1) under Sec. 1502 that revise the intercompany transaction system of the consolidated return regulations. The goal is to ensure, where practical from a compliance and policy perspective, the same tax treatment to a consolidated group as if the group's business activities were conducted by separate divisions of a single corporation. This article will discuss the proposed regulations and their effect on corporations filing consolidated returns.

In addition to the revisions to the intercompany transaction system, amendments to related regulations were proposed. These additional amendments, to be discussed in a future article, include revisions to the Sec. 267(f) regulations, simplifying rules for intercompany transactions involving inventory when one or both group members use dollar-value LIFO, simplifying rules on reserve accounting, special rules for member stock and obligations, coordination with Sec. 108(b) and rules pertaining to accounting methods and the special inventory adjustment.

Background

The existing intercompany transaction rules are contained in Regs. Secs. 1.1502-13 and -14, and Temp. Regs. Secs. 1.1502-13T and -14T (existing regulations). Regs. Sec. 1.1502-13(a)(1) defines an intercompany transaction as a transaction during a consolidated return year between corporations that are members of the same group immediately after the transaction. An intercompany transaction includes, for example, a sale of property by one group member (selling member, S) to another group member (buying member, B), or the payment of interest or rent by one member (B) to another group member (S) during a consolidated return year. Under Regs. Sec. 1.1502-13(a)(2), a deferred intercompany transaction is an intercompany transaction that is a sale or exchange of property or an expenditure, including expenditures for services that must be capitalized (e.g., builders' fees, architects' fees, prepaid expenses and other expenditures properly included in the basis of property).

The existing regulations employ a deferred sale approach that results in a combination of single-and separate-entity treatment for group members in an intercompany transaction. For the most part, the amount, location, character and source of items in connection with an intercompany transaction are determined as if separate returns were filed. On the other hand, the timing of items is determined on a single-entity basis, as if the members were divisions of a single corporation. These rules were intended to produce neutral tax results for the consolidated group in an intercompany transaction; a consolidated group should be in no better or worse position as the result of such transaction. The method intended for providing this neutrality was the deferral and restoration rules contained in the existing regulations. These rules generally resulted in matching the timing of S's and B's items from the intercompany transaction.

Example 1: Intercompany rental. S owns a building, part of which is leased to B. For the 1994 tax year, B pays $750 rent to S. To achieve neutrality, the 1994 consolidated return would reflect $750 of rental income attributable to S and $750 of rental expense attributable to B, resulting in no net tax effect for the consolidated group from the intercompany transaction.

Example 2: Intercompany sale of property. During 1994, S sells depreciable property with an adjusted basis of zero to B for $500. The $500 gain that S recognizes is deferred under Regs. Sec. 1.1502-13(c). B takes a $500 basis in the property pursuant to Regs. Sec. 1.1502-31(a). The $500 deferred gain will be restored to income as B depreciates the property. If the property is depreciated ratably over a five-year period ($100 per year), $100 of the deferred gain will be restored to income in each of the five years. The net effect is zero for each of the five years ($100 gain offset by $100 depreciation). Not surprisingly, this is the same result that would have occurred had S simply kept the property and used it in its business activities for the five-year period.

While these simple examples may illustrate the above principles, they might also give the false impression that the deferral and restoration rules of the existing regulations yield the desired neutrality in all intercompany transactions. Nothing could be further from the truth. The consolidated return regulations were last significantly rewritten in 1966. Since that time, due to changes in tax law and business practices, various transactions have been devised that yield results inconsistent with the intended neutrality of the existing regulations and with the results that would have occurred had no intercompany transaction taken place. This put the IRS in the unenviable position of being reactive as these transactions surfaced. Over the last several years, transactions such as "corporate CPR," "bump and strip," "dividend stripping" and various descendants of "mirrors" took advantage of literal compliance with the existing intercompany transaction rules to produce unintended results.(2) The IRS responded with various administrative announcements and regulations to curtail these transactions. This reactive posture highlighted the need to the IRS for a complete revamping of the intercompany transaction rules.

The Proposed Regulations

* Policy considerations

As stated in the preamble, "[t]he purpose of the proposed intercompany transaction regulations is 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)." For the most part, this purpose is accomplished under the proposed regulations by viewing the respective group members as if they were divisions of a single corporation. However, the IRS did not adopt comprehensive single-entity treatment for intercompany transactions. Single-entity treatment would be expanded, however, to determine, in addition to the timing of a particular item, the character, source and other attributes. Under the proposed regulations, only the amount and location of items would be determined on a separateentity basis.

While the proposed regulations move closer to a single-entity approach, they retain the basic principles found in the existing regulations. This will lead to most intercompany transactions being treated similarly under both sets of regulations. However, while the end result may be the same, the analysis under the proposed regulations to achieve such result will be significantly different. The proposed regulations replace the essentially mechanical rules of the existing regulations with general principles and guidance on policy considerations. This approach enables application of the regulations to a wide variety of intercompany transactions under current tax law and offers sufficient flexibility to deal with changing business conditions and changes in tax law. Only time will tell the extent to which this approach is successful in providing the necessary guidance. Fortunately, the proposed regulations contain a large number of examples, many with several variations, that illustrate their application.

* Intercompany transactions

Prop. Regs. Sec. 1.1502-13(b)(1) defines an intercompany transaction as a transaction between corporations that are members of the same consolidated group after the transaction. Examples include S's sale of property (or other transfer, such as an exchange or contribution) to B, whether or not gain or loss is recognized(3); S's performance of services for B, and B's payment or accrual of its expenditure for S's performance(4); S's licensing of technology, rental of property or loan of money to B, and B's payment or accrual of its expenditure(5); and S's distribution to B with respect to S's stock.(6) If a transaction occurs in part while S and B are group members and in part while they are not, the transaction is treated under Prop. Regs. Sec. 1.1502-13(b)(1)(ii) as occurring on the earlier of performance by either S or B, or when payment for performance would be taken into account under the proposed regulations if it were an intercompany transaction. Prop. Regs. Sec. 1.1502-13(b)(1)(iii) further provides that each transaction is to be analyzed separately. For example, if S sells two properties to B, one at a gain and the other at a loss, each sale is treated as a separate transaction.

* Intercompany items and corresponding items

Prop. Regs. Sec. 1.1502-13(b)(2)(i)(A) provides that S's income, gain, deduction and loss from an intercompany transaction are its intercompany items. Further, S's gain from the sale of property to B is intercompany gain, and if such sale results in a combination of ordinary income and capital gain, each is treated as a separate intercompany item. In determining S's intercompany items, Prop. Regs. Sec. 1.1502-13(b)(2)(i)(B) provides that S's costs or expenses related to an intercompany transaction are included. For example, deductions for wages are included in determining S's income from performing services for B, and depreciation deductions are included in determining S's income from renting property to B.

B's income, gain, deduction and loss from an intercompany transaction are its corresponding items.(7) B's corresponding items include amounts permanently disallowed or eliminated, whether directly or indirectly.(8) For this purpose, corresponding items include amounts disallowed under Sec. 265, amounts offset under Sec. 171(e) and amounts not recognized under Sec. 311 or 332.

* Deemed intercompany and corresponding items

An adjustment reflected in basis (or to an amount equivalent to basis, such as a loss carryover or an excess loss account) that is a substitute for an intercompany item or a corresponding item, is treated as an intercompany item(9) or a corresponding...