Consolidated return intercompany transaction regulations: clearly reflecting income is clearly not simple.

• Author: Axelrod, Lawrence M.
• Position: Part 1

Editor's Note: In this article, Lawrence M. Axelrod analyzes the Department of the Treasury and In Service's proposed consolidated return regulations relating to intercompany transactions. Because of complexity of the proposed regulations, the article is itself quite lengthy. Consequently, The Tax E Axelrod's article in two parts. For reference purposes, the table of contents for the entire article parts A through D are contained in this issue. Part II of the article will appear in the September-O Executive.

Table of Contents

Part I

1. Overview B. Definitions

   1. Intercompany Transactions

   2. Intercompany Items

   3. Corresponding Items

   4. Deemed Intercompany Items

   5. Deemed Corresponding Items

   6. Treatment as a Separate Entity

   7. Attributes C. Matching Rule

   1. Attributes

   2. Holding Period

   3. Timing

   4. Special Status Corporations

   5. Multiple Triggers

   6. Disallowance or Exclusion Resulting from Corresponding Item

   7. Examples

   1. Non-Recognition Transactions

   2. Section 1031 Exchanges

   3. Recapitalizations

   4. Transactions under Sections 351 and 721

   5. Depreciation and Recapture

   6. Intercompany Sale Followed by Installment Sale

   7. Intercompany Sale of Installment Obligations

   8. Capitalized Services

   9. Intercompnay Sale of Partnership Interest

   10. Section 382 and Recognized Built-In Gains

   11. Bump-and-Strip

   12. Other Specific Examples D. The Acceleration Rule

   1. S's Items

   2. B's Items

   3. No Subroups

   4. B's Attributes

   Part II

5. Simplifying Rules

   1. Inventory

   2. Reserve Accounting--Special Status

   Companies

   1. Financial Institutions

   2. Insurance Companies

      3. Obtaining Permission Not to Defer F. Stock of Members

      1. Distributions

   1. Exclusion of Intercompany Dividends

   2. Requisite Stock Basis Reduction

   3. Amount and Basis of a

      Property Distribution

      2. Boot in Intercompany Reorganizations

      3. Acquisition by Issuer of its Own Stock

      4. Elective Relief in Certain Stock

      Transactions

   1. Liquidations of Members

      Previously Transferred in an Intercompany Transaction b. Downstream Mergers

   3. Section 338(h)(10) Transactions

   4. Cash Mergers

   5. Spin-Offs

   6. Time and Manner for Making Election G. Obligations of Members

      1. Definition of Intercompany Obligations

      2. Accrual of Interest

      3. Disposition Outiside Group Treated

      as Satisfaction Reissuance

      4. Acquisition by Member of Other

      Member's Obligation

      5. Non-Application of AHYDO Rules H. Drafting Convetions I. Miscellaneous Operating Rules

      1. Successor Assets

      2. Successor Persons

      3. Lonely-Parent Rule

      4. Acquisition of Group

      5. Recordkeeping Requirement J. Anti-Avoidance Rules

      1. General Rule

      2. Purported Location. Abuse

      3. Mirror Transactions

   1. 80-Percent Distributee

   2. No 80-Percent Distributee K. Effective Dates

      1. General Rule

      2. Anti-Avoidance Rule L. Concluduing Observations

1. Overview

   On April 8, 1994, the Department of the Treasury and Internal Revenue Service promulgated proposed regulations that would revise the manner in which a corporation's gain or loss on a transaction with a related corporation is taken into account.(1)(*) In addition to revising the consolidated return regulations, the regulation package proposes amendments to the regulations under section 108(b) (relating to attribute reduction for debt discharge of an insolvent corporation), section 267(f) (deferral of loss on sales of property between members of a controlled group), section 460 (accounting for long-term contracts), and section 469 (applying the passive loss rules to consolidated groups). The major changes, however, and those that are the focus of this article, are the proposed changes to the consolidated return regulations.

   Prop. Reg. [sections] 1.1502-13 tackles one of the most thorny and perennial issues in consolidated returns--when to treat the members of the group as separate corporations and when to treat them as divisions of a single corporation. In general, the proposed regulations resolve the issue by treating the members as separate entities for purposes of determining the amount and location of gain or loss. The timing, character, source, and other attributes of intercompany items and corresponding items, however, are redetermined to "produce the effect of transactions between divisions of a single corporation."(2)

   The preamble to the proposed regulations states that the results achieved under the proposed system will not differ from the results achieved under the current system for most intercompany transactions. Nevertheless, for many types of transactions the results will differ. In contrast to the existing regulations, which rely on mechanical rules, the proposed regulations contain general rules and a statement of purpose, and contain 45 examples to illustrate the not-always-so-obvious ramifications of the principles. The extraordinary reliance upon examples to provide guidance is evident from the separate "Table of Examples" in Prop. Reg. [sections] 1.1502-13(a)(5)(ii). Most of the examples do, in fact, illuminate the rules, but in a few cases, especially among the anti-avoidance examples, the results are conclusory and may create uncertainty rather than clarity. As a matter of nomenclature, the selling member in an intercompany transaction is denominated as S and the buying member is denominated as B. In examples in which a member is both a selling and a buying member, the member is labeled M.

   Structurally and stylistically the proposed regulations differ from the current regulations in a number of ways. First, under the current regulations the rules governing transactions between members are found in three sections. Treas. Reg. [sections] 1.1502-13 governs transactions between members acting in an unrelated capacity, for example, a seller and buyer of property. Treas. Reg. [sections] 1.1502-14 contains rules for transactions between members in their corporate/ shareholder relationship, e.g., payment and receipt of distributions with respect to stock, redemptions, as well as the treatment of member obligations held by other members. Finally, Treas. Reg. [sections] 1.1502-18 contains the excruciating rules regarding inventory transactions among members, which are rarely understood by taxpayers or agents and even more rarely followed.

   Prop. Reg. [sections] 1.1502-13 covers all of these areas. Furthermore, the distinction under current law between "deferred intercompany transactions" and non-deferred intercompany transactions has been eliminated. In fact, the word "deferred" has been all but expunged from the consolidated return lexicon. Instead, the mechanics of "matching" S's income, gain, deduction, and loss from an intercompany transaction--with a corresponding amount of B--is applied consistently to all types of transactions. Thus, whether the transaction is treated under current law as a deferred intercompany transaction, or as a non-deferred intercompany transaction (such as rent or interest payments), the matching principle is applied to determine when the selling member will take the item into account.

   Paragraph (a) of Prop. Reg. [sections] 1.1502-13 propounds the general rules and purposes of the intercompany transaction regulations. Paragraph (a)(5), captioned "Overview," maps out the entire section:

   The principal rules of this section that implement

   single entity treatment are the matching rule and

   the acceleration rule of paragraphs (c) and (d) of

   this section. Under the matching rule of paragraph

   (c) of this section, S and B are generally treated as

   divisions of a single corporation for purposes of

   taking into account their items from intercompany

   transactions. The acceleration rule of paragraph

   (d) of this section provides additional rules for

   taking the items into account if the effect of treating

   S and B as divisions cannot be achieved (e.g., if

   S or B becomes a nonmember). Paragraph (b) of

   this section provides definitions, including the definitions

   of intercompany transaction, intercompany

   item, and corresponding item. Paragraph (e) of

   this section provides simplifying rules for certain

   transactions. Paragraphs (f) and (g) of this section

   provide additional rules for stock and obligations

   of members. Paragraphs (h) and (j) of this section

   provide anti-avoidance rules and miscellaneous

   operating rules.

2. Definitions

   1. Intercompany Transactions

   Unlike current law, which defines an intercompany transaction in relatively narrow terms, the proposed rule states that "[a]n intercompany transaction is a transaction between corporations that are members of the same consolidated group immediately after the transaction." Thus, the term includes not merely traditional intercompany transactions such as the sale of property between members, the provision of services, and the payment of rent or interest, but also transactions described in subchapter C, such as a transaction to which section 351 applies (whether or not gain is recognized).(4)

   Furthermore, an exchange of property between members that would generally be governed by section 1031 will instead be subject to the intercompany transaction rules. Prop. Reg. [sections] 1.1502-80(g) declares section 1031 inapplicable to intercompany transactions. In the case of an exchange of property between members, each member is treated as S with respect to the property its surrenders and as B with respect to the property it acquires.5

   The effect of the requirement that the parties to the transaction be members of the same consolidated group "immediately after the transaction" may not limit the application of the section to the extent one might expect. For example, if a subsidiary is liquidated in a transaction to which section 332 does not apply (e.g., because the plan is adopted before the subsidiary becomes affiliated), the liquidated subsidiary obviously will not be a member after the liquidation. Under Prop. Reg. [sections] 1.1502-130)(1)(ii), however, the distributee is considered a successor and any reference to a member includes a reference to the successor. Since the distributee is a member immediately after the liquidation, the transaction...