Consolidated returns: post-tax reform developments.

• Author: DeLuca, Michael A.

Consolidated Returns: Post-Tax Reform Developments (*1)

1. Introduction

   A basic principle of the consolidated return regulations is that members of an affiliated group [1] should be treated as a single entity for income tax purposes. For example, losses of one member of an affiliated group may be offset against the profits of other members, and intercompany gains may be deferred until the property involved or the selling member leaves the group.

   The drafters of the consolidated return regulations now face the burdensome task of implementing, and in some instances reconciling, this single entity theory with the vast legislative reform of the separate entity rules in 1986 and 1987. Most notably, this task involves (a) applying the single entity theory to the new net operating loss ("NOL") and credit carryover rules (sections 382-84 of the Internal Revenue Code), and (b) determining the extent to wich the investment adjustment rules of the consolidated return regulations should be used to conform the outside stock basis of a subsidiary member's stock to the member's inside net asset basis after repeal of the section 312(k) benefit in determining stock basis (section 1503 (e)) and the General Utilities doctrine (amendments to sections 336-38). These issues are discussed in Part II below.

   In keeping with the pace of legislative developments, the Internal Revenue Service has been active in amending the consolidated return regulations. The most significant of these amendments involve (a) deferral provisions for taxable mirror liquidations (Temp. Reg. [subsection] 1.1502-13T and 1.1502-14T); (b) more focused anti-dividend-stripping rules that eliminate the harsh consequences of the previous rules when an owning member continues to own stock of a former subsidiary member (Treas, Reg. [subsection] 1.1502-32T); and (c) new reverse acquisition and intragroup restructuring rules aimed primarily at potential abuses when an affiliated group has a new common parent (Temp. Reg. [subsection] 1.1502-31T, 1.1502-33T, and 1.1503-77T). These new provisions are outlined in Part III below.

2. Single Entity Theory

   1. Amendments to Section 382

      and New Section 383

      Section 382, as amended by the Tax Reform Act of 1986 (the "1986 Act"), provides for a "section 382 imitation" on the ability of a loss corporation to utilize its pre-change losses after an ownership change. In general, the section 382 limitation for any post-change year is equal to the value of the loss corporation immediately before the ownership change multiplied by the long-term tax-exempt rat. In addition, if the loss corporation does not continue its business enterprise for two years after the ownership change, the section 382 limitation is generally zero. Special rules also are provided for built-in losses, built-in gains, and section 338 gain. Section 383 directs the Treasury Department to adopt conforming rules for credit carryovers.

      Example 1 was used by Robert J. Mason, Branch Chief, Legislation and Regulations Division, Office of Chief Counsel, Internal Revenue Service, at the IRS National Office--Tax Practitioner's Technical Roundtable (May 15, 1988) to illustrate the single entity approach for applying IRC section 382 in a consolidated return context. According to Mr. Mason:

      1. An ownership change as to P would be an ownership change as to all members of P's affiliated group. Thus, even if B had purchased only 51 percent of P, S2 would be subject to the section 382 limitation even though the indirect stock ownership off B in S2 would be less than 50 percent.

      2. A consolidated section 382 limitation of $160 per year ($1,500 fair market value of P, plus the $500 value of the minority interest in S2, multiplied by 8 percent would apply after the ownership change. The theory for including the value of the S2 minority interest in the loss corporation value is that S2's losses available to the affiliated group are not limited by the existence of the minority interest.

      3. A consolidated continuity of business enterprise rule would apply after the ownership change. Thus, if S1 discontinued its business within two years after the purchase of P's sock by B, the continuity of business requirement of section 382(c)(1) could be satisfied with respect to the entire consolidated loss carryover by either P or S2.

      The Conference Report to the 1986 section 382 amendments supports continued application of the separate return limitation year ("SRLY") and consolidated return change-of-ownership ("CRCO") limitations of the consolidated return regulations. See H. Rep. No. 99-841, 99th Cong., 2d Sess., II-194 (1986). Under the SRLY rule, the net operating loss carryovers or carrybacks of a new or former member of an affiliated group can only be used against the portion of the group's consolidated taxable income that, under the applicable rules, is attributable to that member. Treas. Rep. $S 1.1502-21(c). Mr. Mason predicted, however, that if the SRLY rule is continued, it probably should be changed to apply on a subgroup basis rather than a company-by-company basis. Thus, if the P group in Example 1 were purchased by another common parent filing a consolidated return, the income of all members of the former P group should be available, subject to the section 382 limitation, to absorb the P group's SRLY loss.

      A CRCO occurs during a taxable year if, at the end of such year, (1) one or more persons described in section 382(a)(2) of the 1954 Code own a percentage of the common parent's stock that is more than 50-percentage points greater than they owned at the beginning of either the taxable year or the preceding taxble year, and (2) such increase in ownership is due to a purchase of such stock or a decrease in the amount of stock outstanding. Treas. Reg. [subsection] 1.1502-1(g). If a CRCO occurs, the NOL arising in taxable years before the CRCO can be used only to offset the income of the old members of the group. Treas. Reg. [subsection] 1.1502-21(d). Mr. Mason questioned whether the CRCO limitation should survive since revised section 382 addresses the same concept. If the CRCO rules are continued, they will need substantial redrafting. [2]

   2. New Section 384

      Section 384, added by the Revenue Act of 1987 (the "1987 Act"), limits the ability to offset built-in gains of one corporation against the preacquisition losses of a second corporation. If new section 384 applies to an acquisition, [3] income for any recognition period taxable year (to the extent attributable to recognized built-in gains) may not be offset by any preacquisition loss (other than a preacquisition loss of the gain corporation). See section 384(c) for definitions of terms. An exception to these rules is provided for preacquisition losses of a corporation if the corporation and the gain corporation were members of the same controlled group (as defined in section 384(b)) at all times during the five-year period ending on the acquisition date.

      The 1988 Bill would clarify that the single entity approach would govern the application of section 384 to an affiliated group. Under proposed section 384(c)(6), all members of the same affiliated group immediately before the acquisition date would be treated as one corporation, except as provided in regulations and certain successor rules. To the extent provided in regulations, an affiliated group for this purpose would include corporations that would be members but for the exclusions in section 1504(b).

      Example 2: All the stock of G, a gain corporation, was acquired by P, the common parent of an affiliated group, in 1986 before the effective date of IRC section 384. If proposed section 384(c)(6) is enacted, under a single entity approach all the members of the P group would be treated as a single corporation; thus, it should be possible to subsequently transfer the assets of G to another member of P's affiliated grop in a section 368(a)(1)(D) reorganization without section 384 coming into play.

   3. Inside v. Outside Basis Rules

      Under the single entity theory, subsidiaries of an affiliated group should be treated as if they were divisions of the common parent. Reconciling the actual existence of stock of subsidiaries with the single entity theory raises conceptual difficulties for the drafters of the consolidated return regulations. The 1987 legislation may have started a movement toward conforming outside stock basis of a member subsidiary to its inside net asset basis.

      1. New Section 1503(e). Under the investment adjustment rules of Treas. Reg. [section] 1.1502-32, the basis of the stock of a member subsidiary is adjusted annually. The adjustments reflect changes in the subsidiary's undistributed earnings and profits rather than its taxable income. The owning member increases its basis in the stock of a subsidiary by the amount of the subsidiary's undistributed earnings and profits for the taxable year or reduces its basis in such stock by the amount of any deficit in earnings and profits (at least where the subsidiary's loss is utilized by the affiliated group).

         Although the investment adjustment rules generally maintain the original balance between the net asset basis of a subsidiary (including its NOL carryovers) and the owning member's stock basis, section 312(k) produced glaring disparities between outside stock basis and inside net asset basis before the enactment of section 1503(e) by the 1987 Act. These disparities were due to timing differences between tax depreciation and earnings and profits depreciation. Section 312(k) generally provides that, for earnings and profits purposes, a corporation's depreciation shall be deemed to be the amount that would be allowable using the straightline method. If accelerated depreciation is used for income tax purposes, the depreciation charge to earnings and profits in the initial years of an asset's life would be less than the amount of depreciation deducted for income tax purposes. Since investment adjustments are dependent...