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

• Author: Axelrod, Lawrence M.
• Position: Part 2

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5. Simplifying Rules

   The proposed intercompany transaction rules have not been touted as simplification rules. The regulation writers readily concede that an added degree of complexity has been introduced to the system. But they assert that the regulation is nevertheless justified on the grounds of clear reflection of income and prevention of tax avoidance. In some common transactions, however, the opportunity for abuse is minimal and the administrative difficulty of tracking assets may be extreme. Accordingly, the drafters have provided what are termed "simplifying rules," in Prop. Reg. [sections] 1.1502-13(e).

   1. Inventory

      Under current law, if S sells property to B, which is inventory in the hands of B, the restoration of S's gain or loss on the intercompany sale will occur based upon B's disposition of the inventory, and determined by reference to B's inventory method, e.g., LIFO or FIFO.(59) Other special rules for inventory are provided to prevent the group from obtaining an indefinite deferral of intercompany gain on inventory sold during the first year for which the group elects to file a consolidated return.(60)

      Under Prop. Reg. [sections] 1.1502-13(e)(1), a special rule is provided for the situation in which S sells inventory to B and either member uses dollar-value LIFO to account for intercompany transactions. Dollar-value LIFO is a LIFO inventory method that requires a taxpayer to combine a wide variety of goods in inventory into a single pool. These pools are broader than specific goods groupings. Each year, to the extent that the base-year cost of ending inventory exceeds the base-year cost of opening inventory, a "layer of increment" is created.

      If B includes all its inventory costs for the year in the cost of goods sold (which allows B to minimize its income), S must take into account all of the gain or loss from intercompany transactions during the year. The theory is that the inventory acquired from S during the year has been disposed of outside the group. If B includes less than all its inventory costs in the cost of goods sold for the year, only a percentage of S's net intercompany inventory income or loss for the year will be taken into account. The percentage not taken into account may be determined under the "increment average method," the "increment valuation method," or any other method that is expected to reasonably take into account intercompany items and corresponding items from intercompany inventory transactions.(61) Similarly, if S uses a dollar-value LIFO inventory method to account for its intercompany inventory sales, S can use any reasonable method of allocating its LIFO inventory costs to intercompany transactions.(62)

   2. Reserve Accounting--Special Status Companies

      1. Financial Institutions

         The Tax Reform Act of 1986 generally prohibited taxpayers from using the reserve method to account for bad debts. Exceptions were provided for banks and thrift institutions under sections 585 and 593 respectively. Given their special status, financial institutions are permitted under the proposed regulations to take into account the bad debt reserve on a separate entity basis rather than as an intercompany item or corresponding item under the proposed regulations. To the extent the sale of a loan from one member to another is not attributable to recapture of the reserve, however, any gain or loss is taken into account under the general rules.(63)

      2. Insurance Companies

         As is the case with financial institutions, insurance companies are accorded special status in the Code. Life insurance companies may set up reserves for claims under section 807(c) and property and casualty companies may set up reserves pursuant to section 832(b)(5). Consider the case in which a consolidated group includes a property and casualty company that does business with the general public, but also insures the property of other members of the group. The payment of the premium by the insured member is full deductible under section 162, and the receipt of the payment by the insurance company is currently includible. If the insurance company may claim a current deduction for its addition to reserves, however, the net effect to the group will be a deduction. Nevertheless, the proposed regulations allow the payment of the premium (i.e., the intercompany transaction) to be determined on a separate member basis, not under the matching and acceleration principles of the proposed regulations.(64)

         The regulation writers' generosity, however, did not extend to intercompany reinsurance transactions. If one member assumes all or a portion of an insurance contract written by another member, all aspects of the transaction (including reinsurance premiums, benefit payments, reimbursed policyholder dividends, experience rate adjustments, and similar items) are taken into account under the matching principle of the proposed regulations.(65)

   3. Obtaining Permission Not to Defer

      As under current law, the proposed regulations contain a procedure whereby a taxpayer may obtain permission not to account for income or gain under the intercompany transaction system described by the proposed regulations, but rather to account for those items on a separate entity basis.(66) Under the proposed regulations, this option is not available for intercompany transactions involving stock and obligations.

      To obtain permission not to take items into account on a separate member basis, the common parent must follow the procedures for requesting a private letter ruling. The request must be filed by the due date of the group's consolidated return (without regard to extensions). The consent must be attached to the consolidated return (or amended return) as the Internal Revenue Service may require. Consent may be granted for all items or only certain classes of items. Unless revoked with the consent of the Internal Revenue Service, the election is binding on the group for all subsequent consolidated return years. The consent procedure does not apply, as under current law, to any loss on any intercompany transaction, which is governed independently by section 267(f).(67)

      The best reason for accelerating gain from a taxpayer's perspective is to absorb a capital loss or net operating loss (NOL) that is about to expire. If the past is prologue, the IRS will not consent to accelerate gain if the taxpayer has attributes that would otherwise expire. Accordingly, the only acceptable reason for obtaining permission is to avoid the administrative complexity necessary to administer the rules.

6. Stock of Members

   Under current regulations, transactions between members of a consolidated group by virtue of their shareholder-corporate relationship are not intercompany transactions. Accordingly, transactions such as liquidations, redemptions, distributions, and contributions are addressed in Treas. Reg. [sections] 1.1502-14. By contrast, the proposed regulations include such transactions within the broader re-definition of intercompany transactions, and provide rules in paragraph (f) of Prop. Reg. [sections] 1.1502-13.

   1. Distributions

      1. Exclusion of Intercompany Dividends

         Since the consolidated return regulations were promulgated in 1966, the treatment of intercompany dividends has been slightly different from the treatment where separate returns are filed. First, a dividend from a subsidiary to an owning member is eliminated.(68) In a separate return, the dividend would be eligible for a 100-percent dividends-received deduction only if the earnings and profits (E&P) out of which the dividend was paid was accumulated in a year in which the distributor was a member of the affiliated group on each day of its taxable year.(69) Of course, if a separate return is filed, the distributee's basis in the distributor's stock is generally not reduced as a result of the distribution (unless section 1059 applies).

         The proposed regulations define the term "intercompany distribution" as an intercompany transaction to which section 301 applies.(70) A dividend that is deductible by the payer, such as a patronage dividend under section 1382(c)(1) or a dividend paid to depositors of thrift institutions that are deductible under section 591, are not intercompany distributions.(71) Under the "entitlement rule," an intercompany distribution is treated as taken into account when the shareholder member becomes entitled to it (generally, the record date). For example, if a distributee becomes entitled to a cash distribution before it is made, the distribution is treated as if made when the distributee becomes entitled to it. Thus, notwithstanding Rev. Rul. 62-131,(72) which concludes that the date of payment rather than the date of declaration is controlling for purposes of determining whether a distribution comes out of current E&P, the proposed intercompany transaction regulations apply if the distributor and the distributee are members when the distributee becomes entitled to the distribution.(73)

      2. Requisite Stock Basis Reduction

         Generally, an intercompany distribution is excluded from the distributee's gross income. This exclusion, however, applies to a distribution from a subsidiary only if the distribution causes a negative basis adjustment to the distributor's stock under Treas. Reg. [sections] 1.1502-32(b)(2)(iv).(74) Thus, if a subsidiary that is about to be sold by a consolidated group declares a dividend to shareholders of record as of the last day before the sale, the distribution will be deemed to have been made on that day (irrespective of the actual date of payment). Accordingly, the dividend will be excluded from the owning member's income, but the owning member's basis in the subsidiary's stock will be reduced under Treas. Reg. [sections] 1.1502-32.

      3. Amount and Basis of a Property Distribution

         Since 1966, the determination of the amount of an intercompany distribution of property from one member to another has varied slightly from the...