Proposed consolidated return stock basis and E & P systems.

• Author: Warner, James C.

The current consolidated return stock basis system (Treas. Reg. [sections] 1.1502-32 and related provisions) provides rules for adjusting the basis of the stock of a subsidiary (S) by another member (P). The starting point for adjusting P's S stock basis is S's undistributed earnings and profits (E&P), or deficit thereof, for the consolidated return year (CRY). This adjustment generally reflects amounts recognized by S and taken into account in determining consolidated taxable income and amounts distributed out of current E&P by S to P. The purpose of the adjustment is (1) to prevent these items from being recognized a second time upon P's disposition of its S stock and (2) to cause P to recapture certain losses recognized by S when P has a negative S stock basis (a so-called excess loss account). The adjustment for E&P also takes into account S's tax-exempt income and noncapital, nondeductible expenses in order to prevent these items from resulting in income, gain, or loss from the disposition of P's S stock.(1) *

In a Notice of Proposed Rulemaking (CO-30-92, 1992-48 I.R.B. 27), the Department of the Treasury and the Internal Revenue Service proposed amendments to the stock basis system that would delink it from E&P and create a new E&P system. This article summarizes and explains the most important aspects of the proposed amendments.(2) Part I.A explains Prop. Reg. [sections] 1.1502-32. The principal differences between the current and proposed rules are, follows:

* The proposed rules generally would use S's taxable

income (or loss), adjusted for tax-exempt income and

noncapital, nondeductible expenses -- instead of S's

current E&P (or deficit thereof) -- as the starting

point for making basis adjustments. Because current

law requires similar adjustments to convert taxable

income to current E&P -- and section 1503(e) of the

Internal Revenue Code already requires that depreciation

and certain other E&P adjustments to taxable

income be ignored in computing stock basis -- use of

the proposed adjusted taxable income concept is not

intended to alter materially stock basis adjustments.

* The proposed negative adjustments to account for S's

section 301 distributions (including nondividend distributions

now addressed by Treas. Reg. [sections] 1.1502-14

rather than Treas. Reg. [sections] 1.1502-32) would not depend

on any assumptions regarding whether the distribution

was out of E&P previously reflected in P's S

stock basis. This could adversely affect consolidated

groups that have not distributed S's E&P accumulated

in an affiliated but separate return year.

Part I.B discusses a number of special rules contained in Prop. Reg. [sections] 1.1502-32 and 1.1502-19 that are designed to --

* correct certain anomalies in

the timing of basis adjustments

(especially section 332

liquidations of lower-tier

subsidiaries);

* cure problems in the allocation

of adjustments between

preferred and common stock

(especially preferred dividends

in arrears paid out of

current E&P);

* impose an annual reporting

requirement for stock basis

adjustments;

* narrow the circumstances

under which P would recapture

any S excess loss account

because of S's becoming

worthless; and

* eliminate P's election to reduce an excess loss account

in exchange for reducing its basis in other S stock.(3)

Part I.C analyzes the effective date of the proposed stock basis system. The proposed rules generally would apply to determinations of stock basis and excess loss accounts on or after the date the final rules are filed with the Federal Register; when applicable, however, the rules apply retroactively. Because the proposed rules could apply retroactively to all CRYs (even pre-1966 CRYs for which stock basis was adjusted for losses but not for income), consolidated groups with older subsidiaries may be benefitted by the proposed changes.

Part II.A-D analyzes Prop. Reg. [sections] 1.1502-33, which would create a separate E&P system. These rules would --

* tier up E&P of S to P, directly rather than by treating

an investment adjustment to P's S stock basis as E&P'

of P;

* restate the effects of the allocation of federal taxes as

E&P;

* replace the anti-dividend stripping rules that had

been adopted in 1988 to replace earlier overreaching

rules(4); and

* modify the E&P effects of certain group structure

changes.

Part II.E addresses the effective date of the new E&P system. The proposed E&P rules generally would apply with respect to determinations of E&P on or after the date the final rules are filed with the Federal Register.

1. Proposed Stock Basis System

   1. Separating Stock Basis Adjustments From Current Earnings and Profits

      1. Current Rules and Reasons for Change. Under Treas. Reg. [sections] 1.1502-32, changes in P's S stock basis depend primarily on "investment adjustments" for S's undistributed E&P (or deficit thereof) for the current year. Other investment adjustments prevent P's S stock basis from being reduced by S's losses until the losses are absorbed by the P group. A negative investment adjustment generally, but not always, is also made for a dividend paid to P out of S's accumulated E&P. Whether a negative adjustment is made depends on whether the distributed earnings are deemed reflected in P's S stock basis. (See Chart 1.) No negative adjustment is made, for example, for a dividend out of (1) E&P accumulated in pre-1966 CRYs (because the investment adjustment system was not in effect prior to 1966 to provide for positive stock basis adjustments), and (2) certain pre-consolidation E&P accumulated when P and S were affiliated (because such E&P generally could have been distributed before consolidation without a tax cost or basis reduction).

         Under Treas. Reg. [sections] 1.1502-14, P eliminates any income to P from any section 301 distribution paid by S on P's S stock, and P reduces its S stock basis for any of S's nondividend section 301 distributions (which may cause P to have an S excess loss account). Under Treas. Reg. [sections] 1.1502-33(c)(4)(ii)(a), investment adjustments to P's S stock basis made under Treas. Reg. [sections] 1.1502-32 are treated as E&P of P; other basis adjustments are not so treated.

         The adjustments to P's basis in its S stock and other effects of P's undistributed E&P and section 301 distributions after August 9, 1979 -- when S's losses are fully utilized currently by the P group -- are summarized in Chart 1. Example 1 -- Stock Basis and E&P for Single Subsidiary: P, a holding company, owns all the stock of S, which formed P at the end of Year 0 with $100. The changes in P's S stock basis and P's E&P at year-end to reflect S's activities during each year are, as follows:

         Tiering up of adjustments: As illustrated in Example 1, P adjusts its current E&P to reflect the investment adjustments to its basis in its S stock. As a result, S's E&P indirectly is "tiered up" to P and becomes P's E&P through the investment adjustment system. If P is a subsidiary of the consolidated group, P's E&P in turn tiers up and ultimately is reflected in the E&P and stock basis of each higher-tier subsidiary and in the E&P of the common parent.

         Example 2 -- Stock Basis and E&P for Tiers of Subsidiaries. The facts are the same as in Example 1, except that GP, the common parent of the consolidated group, formed P with $100, and P is a subsidiary of the group. The changes in GP's P stock basis and GP's E&P at year-end to reflect S's activities during each year are reflected in the next column.

         The Government's desire to end the current stock basis system's dependence on current E&P can be traced to Treasury's, IRS's, and Congress's costly mishandling of E&P depreciation by consolidated groups and a concern about repeating any similar revenue embarrassment.

         The story began in 1969, when the enactment of section 312(k) required E&P depreciation to be determined at a slower rate than accelerated tax depreciation in order to prevent the understatement of E&P and, hence, dividends distributed to shareholders. Congress apparently had not considered the effects of section 312(k) in computing stock basis of consolidated subsidiaries. In Woods Investment Co. v. Commissioner, 85 T.C. 274 (1985), acq. 1986-2 C.B. 1, the section 312(k) benefit' to a consolidated group was confirmed: a consolidated group was not required to account for accelerated tax depreciation in computing P's basis in its S stock, so long as P sold S when S's CRY cumulative tax depreciation exceeded its CRY E&P depreciation.

         Based on a straightforward reading of the investment adjustment rules, the Tax Court held that P's basis in its S stock must reflect section 312(k) E&P depreciation rather than accelerated tax depreciation. In other words, if Treasury and the IRS did not like their own regulations, they could fix them without the court's help.(5) Until that time, no adjustment would be required in computing P's basis in its S stock.

         As the Treasury and IRS struggled over whether and how to change the investment adjustment rules after their loss in Woods Investment, an impatient Congress in 1987 clumsily attempted a legislative solution. Section 1503(e)(1)(A) was enacted to overrule Woods Investment and reverse the effects of section 312(k) (and (n)) on consolidated return stock basis adjustments, generally for dispositions of S stock after December 15, 1987. In 1988, however, Congress realized that by eliminating the section 312(k) benefit of Woods Investment in the future, it also had eliminated any "section 312(k) detriment" in transitional cases. For example, if a member of a consolidated group (say, P1) had purchased the stock of S from P and later sold the stock of S, P1 would have inherited a built-in basis reduction to its S stock that would have reduced the Government's revenue loss from Woods Investment. This is because S's P1 group's CRY E&P...