Responding to the new subsidiary investment and earnings and profits consolidated return regulations.

• Author: Bean, Robert L.

The consolidated return regulations promulgated by the Internal Revenue Service on August 12, 19941(1*) ("the final regulations"), contain a number of provisions that affect affiliated groups filing a consolidated federal income tax return. In selected areas, these provisions represent a dramatic change in the determination of a parent corporation's basis in the stock of its subsidiaries and in its earnings and profits (E&P) compared with the prior consolidated return regulations ("the prior regulations").(2) This article reviews the following five areas requiring special attention by all consolidated groups, including certain tax elections:(3)

* Deemed Dividend Election: Should it be made in the next (or last) tax return filing covered by the prior regulations?

* Federal Income Tax Allocations: Should the new special election be made to conform the allocation of federal income taxes for E&P purposes with the method now mandated for basis purposes?

* Federal Tax-Sharing Agreement: Should it be revised in view of the change in rules affecting the allocation of federal income taxes for tax purposes?

* Net Operating and Capital Losses of Acquired Subsidiaries: Should loss carryovers of acquired subsidiaries be waived in order to avoid a later negative adjustment to the basis in the subsidiary in the event the losses expire unused?

* Annual Recordkeeping Requirement: In what manner will annual basis adjustments be tracked?

Overview of Final Regulations

The final regulations are effective for transactions and determinations occurring in taxable years beginning on or after January 1, 1995 ("the effective date"). The final regulations generally "delink" the determination of basis of investment in subsidiary stock(4) and E&P. Although the ultimate determination of basis and E&P may be identical under both the final and prior regulations, there are a number of substantive changes that could affect affiliated groups filing a consolidated tax return. This is especially true where subsidiary net operating loss (NOL) or capital loss carryovers exist or expired previously.(6)

Like section 1503(e), the final regulations apply retroactively to dispositions occurring after the effective date. Consequently, previous calculations of basis in subsidiaries and accumulated E&P for many consolidated groups must be recomputed in light of the new rules. This may be particularly burdensome for consolidated groups that predate 1966 (in respect of which annual adjustments to basis of subsidiary investments were not required(7)) or for groups that pre-date 1976 (in respect of which tiering of E&P to the parent company was not required(8)). Thus, gain or loss on the sale of stock of a subsidiary may be quite different under the final regulations since they apply retrospectively to the entire period of ownership. In addition, some consolidated groups may face the prospect of paying nontaxable dividends because of the change in the rules that previously created "phantom E&P."(9)

Deemed Dividend Election

The final regulations eliminate the deemed dividend election,(10) which has existed since 1966. This election was typically made in order to increase the parent's basis in the stock of a subsidiary for the undistributed E&P generated in pre-1966 consolidated return years or in post-affiliation separate return years ("non-SRLY SRYs").

In the Treasury Department's view, the election is no longer necessary given the retroactive effect of the final regulations. Unlike the benefit obtained through a deemed dividend election, however, the potential for an automatic increase in basis will not be applicable to a non-SRLY SRY. Therefore, consolidated groups should consider making the deemed dividend election in the next tax return filing before the final regulations become effective. With the exception of several unique industry situations, there normally is no downside risk in making this election.(11) For those who miss this timetable, a one-year automatic extension is available.(12)

Where a deemed dividend election was previously made with respect to a subsidiary still owned by the parent, its effect should be revisited. In those instances where a loss was incurred by the subsidiary in the period subsequent to 1966 (or after the first consolidated return filing) and through the year prior to the election, the benefit of the deemed dividend election may have been diminished. A greater increase in basis may automatically result from the retroactive application of the final regulations.(13)

Federal Income Tax Allocations

The final regulations permit a consolidated group to elect to conform its tax-allocation method for E&P purposes to what is now mandated for basis purposes. This is so even where the group has previously used an allocation method that differs from the mandatory allocation method for basis calculations.(14) By making...