More on consolidated returns and the single entity-theory: the new intercompany transaction proposed regs.

• Author: Choate, Gary M.

On Apr. 8, 1994, the IRS issued proposed regulations(1) under Sec. 1502 that revise the intercompany transaction system of the consolidated return regulations. The goal is to ensure, when 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.

The authors' article published in November 19942 discussed the general rules for intercompany income, gains, deductions and losses, including the matching and acceleration rules, anti-avoidance rules and general effective date provisions. This article will discuss the proposed rules for stock and obligations of group members, revisions to the Sec. 267(f) regulations, and other rules.

Stock of Members

Regs. Secs. 1. 1502-14 and 1. 1502-31(b) provide special rules for distributions and other transactions with respect to stock of members. The proposed regulations generally apply the Code and the matching and acceleration rules to such transactions. They also provide specific rules for intercompany Sec. 301 distributions, boot received in intercompany reorganizations, a member's acquisition of its own stock and limited elective relief from intercompany gain or loss recognition that would otherwise be required in certain liquidations and distributions.

* Intercompany Sec. 301 distributions

Regs. Sec. 1.1502-14 eliminates intercompany dividends from the gross income of the distributee; in contrast, Prop. Regs. Sec. 1.1502-13(f)(2)(ii) provides that an intercompany distribution is not included in the gross income of the distributee member. This exclusion only applies, however, to the extent there is a corresponding negative adjustment reflected under Regs. Sec. 1.1502-32 in the distributee member's basis in the distributing member's stock.(3) Such exclusion is intended to have the same effect as elimination under the existing regulations.(4)

The matching and acceleration rules apply to the distributing member's gain under Sec. 311(b) from intercompany distributions of property. In addition, Prop. Regs. Sec. 1.1502-13(f)(2)(iii) effectively overrides Sec. 311(a) (for loss on intercompany distributions) by providing that the distributing member's loss from an intercompany distribution of property is recognized under Sec. 311(b) and is taken into account under the matching and acceleration rules. Essentially, this places intercompany distributions on par with intercompany sales.

An intercompany distribution is treated as taken into account when the shareholding member becomes entitled to it (generally, on the record date) or, if earlier, when it is taken into account under another Code provision (e.g., under Sec. 305(c)). This contrasts with the normal income tax rules on distributions, which generally include distributions in income when they are actually distributed. Therefore, Prop. Regs. Sec. 1.1502-13(f)(2)(iv) provides that if the distribution is not actually made, it should be reversed as of the date the distribution was taken into account.

Example 1:(5) Dividend exclusion and property distribution. S owns land with a basis of $70 and a fair market value (FMV) of $100. On Jan. 1, 1995, P's basis in S's stock is $100. In 1995, S declares and makes a dividend distribution of the land to P. In 1998, P sells the land to X, an unrelated party, for $110. S's distribution to P is an intercompany distribution. P does not include the $100 dividend in income; rather, P's basis in S's stock is reduced from $100 to $0 in 1995. P's basis in the land is $100. In 1998, S takes its $30 gain into account to reflect the $30 difference between P's $10 gain taken into account and its $40 recomputed gain. P's basis in S's stock is increased from $0 to $30 in 1998.(6)

Example 2: Loss property. The facts are the same as in Example 1, except that S has a $130 (rather than a $70) basis in the land. S has a $30 loss that is taken into account under the matching rule in 1998 to reflect the difference between P's $10 gain taken into account and its $20 recomputed loss. P's basis in S's stock is reduced from $100 to $0 in 1995 and from $0 to a $30 excess loss account in 1998. If P, instead of selling the land to X, distributes it to a nonmember shareholder, the $20 of S's loss that does not offset P's gain is nondeductible under Sec. 311(a).

* Boot received in intercompany reorganizations

Prop. Regs. Sec. 1.1502-13(f)(3) provides that non-qualifying property (i.e., boot) received as part of a reorganization involving only consolidated group members (an intercompany reorganization) is treated as received in a separate transaction rather than as part of the intercompany reorganization (e.g., Secs. 302 and 311 apply, respectively, to the stockholder and distributor, rather than Secs. 356 and 361). Boot received in a transaction to which Sec. 354 would otherwise apply (e.g., acquisitive A, C, D or F asset reorganizations) is deemed received immediately after the reorganization.(7) Boot received in a Sec. 355 transaction is deemed received immediately before the reorganization. In Clark,(8) the Supreme Court applied the Sec. 356 boot-dividend test by assuming that only stock is issued in the reorganization and that after the reorganization, a portion of such stock is redeemed by the acquiring corporation in exchange for the boot. The Clark approach has been adopted in the proposed regulations for acquisitive reorganizations involving members of a consolidated group. However, the proposed regulations take the opposite position with respect to a Sec. 355 transaction between members of a consolidated group by testing the boot payment for dividend equivalence as a pretransaction distribution.

Example 3:(9) Intercompany reorganization. P has a basis of $250 in each of S and B. S and B each have $50 of earnings and profits (E&P). In 1996, when the FMV of S's assets and its stock is $500, S merges into B in a tax-free reorganization. P receives B stock with an FMV of $350 and $150 of cash. P is treated as receiving additional B stock with an FMV of $500 and a basis of $250. Immediately after the merger, $150 of the stock received is treated as redeemed, and the redemption is treated under Sec. 302(d) as a distribution to which Sec. 301 applies. Because B is treated as receiving S's E&P (sec. 381(c)(2)) and the redemption is treated as occurring after the merger, $100 is treated as a dividend and P's basis in B is reduced accordingly. The remaining $50 distribution further reduces P's basis in B.

Example 4:(10) Divisive transaction. The facts are the same as in Example 3, except that S distributes the stock of a lower-tier subsidiary in a spin-off to which Sec. 355 applies, together with $150 of cash. P is treated as having received the $150 cash immediately before the Sec. 355 distribution, as a distribution to which Sec. 301 applies. Sec. 356(b) does not apply and no basis adjustments are required under Sec. 358. Since the $150 cash distribution is treated as made before the spin-off, P's basis in S is reduced and then allocated between S and the lower-tier subsidiary under Sec. 358(c).

* Member's acquisition of its own stock

Under Prop. Regs. Sec. 1.1502-13(f)(4), if a member acquires its own stock, the member's basis in that stock is treated as eliminated for purposes of taking intercompany items into account with respect to the stock. Thus, if S distributes B stock to B, S's gain or loss from such distribution is taken into account immediately to reflect the elimination of basis.(11) However, under Prop. Regs. Sec. 1.1502-13(c)(3)(iv)(B), S's intercompany gain is excluded from gross income if B's corresponding item is one of the following: (1) a deduction or loss that, in the tax year the item is taken into account, is permanently disallowed directly under another Code provision; (2) a loss realized, but not recognized, under Sec. 311(a); or (3) limited, eliminated, offset, or has no effect on the computations of its taxable income under any provision identified by the IRS. An exception to elimination applies if the stock is exchanged for other stock in a recapitalization or other nonrecognition transaction. Arguably, if S and B were divisions of a single corporation, no gain would be included by a division on the sale of intercompany stock.

Example 5: Recapitalization. S transfers to B the stock of T, and B subsequently transfers the stock to T in exchange for new T stock in an E recapitalization. S's intercompany gain or loss remains deferred and is taken into account by reference to the replacement stock.

Example 6: Member's acquisition of its own stock. S owns P stock with a basis of $130. On Jan. 1, 1995, P purchases all the stock of S. On Jan. 1, 1997, P redeems the P stock held by S for $100 in a transaction that results in a $30 loss under Sec. 302(a). Because P acquires its own stock, P's basis in the stock is treated as eliminated, and this elimination is treated as a corresponding item. S's intercompany loss is not deductible from taxable income; rather, it is taken into account as a noncapital, nondeductible amount. Thus, another one-way street favoring the government is created: intercompany gains on stock are taken into account, but intercompany losses are not.

* Elective relief for certain liquidations and distributions

Prop. Regs. Sec. 1.1502-13(f)(5) provides special limited relief provisions for certain liquidations and distributions.

Sec. 332 liquidations and downstream mergers:

Under Regs. Sec. 1.1502-13(f)(1), the gain deferred on an intercompany sale or distribution of member stock is restored if the member is liquidated under Sec. 332. For example, if S sells all of its stock of wholly owned subsidiary T to B at a gain, and T later liquidates into B in an unrelated transaction to which Sec. 332 applies, S's gain is taken into account on T's liquidation.(12)

Prop. Regs. Sec. 1.1502-13(f)(5)(i) provides an election to allow S's...