[Federal Register Volume 59, Number 73 (Friday, April 15, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-8489]
[[Page Unknown]]
[Federal Register: April 15, 1994]
-----------------------------------------------------------------------
DEPARTMENT OF THE TREASURY
26 CFR Part 1
[CO-11-91]
RIN 1545-AL63
Consolidated Groups and Controlled Groups--Intercompany
Transactions and Related Rules
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of public hearings on proposed rulemaking.
-----------------------------------------------------------------------
SUMMARY: This document contains a notice of two public hearings on
proposed amendments to the consolidated return intercompany transaction
system and to related rules. Because the proposed regulations affect a
broad range of transactions, a preliminary hearing will be held to
respond to general comments and questions by speakers, and a second
hearing will be held to receive comments on the proposed regulations.
Background information relating to the issues considered in developing
the proposed regulations is provided in this document to facilitate
comments.
DATES: A preliminary hearing will be held on May 4, 1994, beginning at
10 a.m. Requests to speak at this hearing must be received by April 20,
1994. A second hearing will be held on August 8, 1994, beginning at 10
a.m. Comments, requests to speak, and outlines of topics to be
discussed at this hearing must be received by July 18, 1994.
ADDRESSES: The first public hearing will be held in room 2615 of the
Internal Revenue Building, 1111 Constitution Avenue, NW., Washington
DC. The second public hearing will be held in the Auditorium, Internal
Revenue Building, Seventh Floor, 7400 Corridor, Internal Revenue
Service Building, 1111 Constitution Avenue, NW., Washington DC. Send
submissions to: CC:DOM:CORP:T:R (CO-11-91), room 5228, Internal Revenue
Service, POB 7604, Ben Franklin Station, Washington, DC 20044. In the
alternative, outlines may be hand delivered to: CC:DOM:CORP:T:R (CO-11-
91), room 5228, Internal Revenue Building, 1111 Constitution Avenue,
NW., Washington, DC.
FOR FURTHER INFORMATION CONTACT: Concerning the hearings, Carol Savage
of the Regulations Unit, Assistant Chief Counsel (Corporate), (202)
622-8452 or (202) 622-7180; concerning the regulations relating to
consolidated groups generally, Roy Hirschhorn or David Kessler of the
Office of Assistant Chief Counsel (Corporate), (202) 622-7770;
concerning stock of members of consolidated groups, Rose Williams of
the Office of Assistant Chief Counsel (Corporate), (202) 622-7550;
concerning obligations of members of consolidated groups, Victor Penico
of the Office of Assistant Chief Counsel (Corporate), (202) 622-7750;
concerning insurance issues, Gary Geisler of the Office of Assistant
Chief Counsel (Financial Institutions and Products), (202) 622-3970;
concerning international issues relating to members of consolidated
groups, Philip Tretiak of the Office of Associate Chief Counsel
(International), (202) 622-3860; and concerning controlled groups,
Martin Scully, Jr. of the Office of Assistant Chief Counsel (Income Tax
and Accounting), (202) 622-4960. (These numbers are not toll-free
numbers.)
SUPPLEMENTARY INFORMATION:
A. Hearing Procedures
The subject of the public hearings is the notice of proposed
rulemaking (CO-11-91) that appears elsewhere in this issue of the
Federal Register. Because the proposed regulations affect a broad range
of transactions, two public hearings are scheduled.
The rules of 26 CFR 601.601(a)(3) apply to both hearings.
The first hearing on May 4, 1994 will be devoted to general
comments and questions by speakers, and policy discussions by the
government panel to facilitate further evaluation of the proposed
regulations. No outline of topics or comments is required of speakers
at the first hearing, but persons wishing to present oral comments at
the first hearing must submit their requests to speak by April 20,
1994.
The second hearing on August 8, 1994 is scheduled to receive
comments after a reasonable opportunity has been provided to review the
proposed regulations and evaluate the comments at the first public
hearing. Persons wishing to present oral comments at the second hearing
must submit written comments, requests to speak, and outlines of the
topics to be discussed by July 18, 1994.
A period of 10 minutes will be allotted to each person for making
comments at each hearing.
An agenda showing the scheduling of the speakers at each hearing
will be prepared after the deadline for receiving submissions has
passed. Copies of the agenda will be available free of charge at each
hearing.
Because of access restrictions, visitors will not be admitted
beyond the lobby of the Internal Revenue Building before 9:45 a.m.
B. Background for Comments
The preamble in the notice of proposed rulemaking on the proposed
revision of the intercompany transaction system describes the operation
of the proposed regulations. See the notice of proposed rulemaking that
appears elsewhere in this issue of the Federal Register. To assist in
the preparation of comments, this document describes many of the
significant issues and alternatives that were considered in developing
the proposed regulations but does not repeat the discussion in the
preamble.
Sections 1.1502-13, 1.1502-13T, 1.1502-14, 1.1502-14T, and 1.1502-
31 contain most of the rules of the current intercompany transaction
system. Developments in business practices and the tax law since the
adoption of these rules in 1966 have greatly increased the problem of
accounting for intercompany transactions. In addition, the consolidated
return regulations have received increased attention in recent years
because of their potential to facilitate circumvention of changes in
tax law, such as repeal of the General Utilities doctrine by the Tax
Reform Act of 1986. See Public Law 99-514.
Recent amendments to the intercompany transaction system have
responded to specific problems but have not attempted a comprehensive
revision. See, e.g., TD 8295 [1990-1 C.B. 165] (amendments to better
coordinate the parties to an intercompany transaction), and TD 8402
[1992-1 C.B. 302] (inapplicability of section 304 to intercompany
transactions).
The deferred sale approach of the current intercompany transaction
system is retained in the proposed regulations, but the manner in which
deferral is achieved is comprehensively revised. The proposed
regulations reflect developments since 1966, including issues that are
partially addressed in other recent consolidated return regulation
projects. See, e.g., CO-30-92 [1992-2 C.B. 627] (proposed elimination
of the current Sec. 1.1502-31(b) special basis rules for in-kind
distributions between members). The proposed regulations also
incorporate many of the comments received in connection with recent
proposals to amend the consolidated return regulations.
1. Separate and Single Entity Treatment
The current consolidated return regulations use a deferred sale
approach that treats the members of a group as separate entities for
some purposes and as a single entity for other purposes. For example,
the amount, location, character, and source of items from an
intercompany transaction are generally determined as if separate
returns were filed (separate entity treatment), but the timing of items
is determined more like the timing that would apply if the participants
were divisions of a single corporation (single entity treatment).
If a selling member (S) sells property to a buying member (B), S
must determine its own gain or loss, and B's basis in the property is
generally its cost basis. These determinations treat the members as
separate entities and they preserve the location within the group of
income, gain, deduction, and loss from intercompany transactions.
However, because consolidated taxable income is determined under
Secs. 1.1502-11 and 1.1502-12 by aggregating the income, gain,
deduction, and loss of the members, the group's consolidated taxable
income is clearly reflected only by generally matching the timing of
S's and B's items from the intercompany transaction.
Some comments have suggested broadening the single entity treatment
of consolidated groups for many purposes under the Internal Revenue
Code of 1986 (Code) other than intercompany transactions. These
suggestions generally have not been adopted in the proposed
intercompany transaction regulations because they involve aspects of
related-party and substance-over-form issues that are beyond the scope
of the intercompany transaction system. The proposed regulations
implement only those single entity principles that are essential to
taking into account items from intercompany transactions to clearly
reflect the taxable income (and tax liability) of the group as a whole.
The taxable income (and tax liability) is clearly reflected by
preventing intercompany transactions from creating, accelerating,
avoiding, or deferring income (or tax liability) for the group.
2. Location of Items Within the Group
a. In General
If the members of a consolidated group remained constant, they had
uniform status and accounting methods, and the only investment in the
group were through the common parent, it would generally not be
necessary to preserve the location of items within a group. Because
these conditions are generally not present, however, preserving the
location of items within a group is essential to the operation of the
Code and consolidated return regulations.
Members of a consolidated group generally retain their treatment as
separate entities for many purposes. Members may engage in unrelated
activities, use different accounting methods, maintain separate status
as a bank or insurance company, have nonmember investors in their stock
and obligations, and enter or leave the group retaining their asset
basis, their carryovers, and their special status.
Fixing the location of each member's items from intercompany
transactions prevents circumvention of many Code provisions. For
example, section 355 imposes exacting requirements for S to transfer
appreciated assets without recognizing gain. If the intercompany
transaction system permitted S's gain to be shifted to B, the benefits
of section 355 would be available without satisfying the requirements
of that section. Rather than transferring appreciated assets to a
controlled subsidiary and distributing the stock to B under section
355, S could simply distribute the appreciated assets to B in an
intercompany transaction without recognizing gain.
Similarly, members having a special status under the Code (e.g., a
bank or an insurance company) must make separate determinations of
their income and deductions. For example, because section 1503(c)
limits the use of consolidated group losses by life insurance company
members, gain or loss cannot be transferred to or from a life insurance
company member in circumvention of the limitation.
Fixing the items of each member is also essential to the operation
of many consolidated return provisions outside the intercompany
transaction system. See, e.g., Secs. 1.1502-15 and 1.1502-21
(limitation on losses carried from separate return limitation years),
1.1502-32 and 1.1502-33 (adjustments to stock basis and earnings and
profits), 1.1502-79 and 1.1552-1 (allocation among members of amounts
computed on a consolidated basis).
For example, if S could shift the gain or loss in its assets to B,
the related stock basis adjustments under Sec. 1.1502-32 could also be
shifted to eliminate any gain or loss to be recognized from a
subsequent sale of the B stock. Similarly, direct interest of a
creditor or nonmember shareholder in a subsidiary could be affected
under a group tax sharing agreement by shifting gain or loss to or from
the subsidiary through intercompany transactions. The distortions could
extend into the separate return years of members (including
consolidated return years of another group) by affecting the allocation
of carryovers under Sec. 1.1502-79 to a member leaving the group.
Commentators have suggested alternatives to the current deferred
sale system that permit the shifting of items between members. These
approaches are appealing because they simplify the operation of the
intercompany transaction system by eliminating the need to value assets
and services transferred between members.
The most common suggestion is to return to a carryover basis system
similar to the pre-1966 intercompany transaction system. Under a
carryover basis approach, the gain or loss of S from the sale of an
asset to B is eliminated, and B succeeds to S's basis in the asset
instead of taking a cost basis. All of the group's gain or loss from
the asset would be taken into account by B, and the character and other
attributes of the gain or loss would be determined solely by reference
to B. This approach is consistent with generally accepted accounting
principles (GAAP), which eliminate gross profit or loss from
intercompany transactions in the preparation of consolidated financial
statements.
A second suggestion has been to treat an intercompany transaction
as if it had not occurred. Gain or loss from the transfer of an asset
would be taken into account by S, and the timing and attributes of the
gain or loss would be determined solely by reference to S. See, e.g.,
Sec. 1.267(f)-1T(d) (deferred loss on depreciable property is restored
based on the depreciation that would have been allowable to S if the
transfer to B had not occurred).
The current deferred sale system was adopted in 1966 because of the
many problems with the prior carryover basis system. The prior system
permitted intercompany items to be recognized by the wrong member and
at the wrong time, to be characterized improperly, and sometimes to be
eliminated completely. See, e.g., Beck Builders, Inc. v. Commissioner,
41 T.C. 616 (1964), appeal dismissed (10th Cir. 1965) (intercompany
income from the performance of services was eliminated without any
corporate or shareholder level tax).
The problems with the alternatives to a deferred sale system have
increased with the increasing complexity of the Code since 1966. Any
system that allocates to one member the entire gain or loss from assets
transferred in an intercompany transaction must compensate with
numerous adjustments to accommodate each Code or regulatory provision
that relies on location. For example, a carryover basis system might
permit appreciated assets of S to be sold outside the group without
gain recognition, by forming B with a cash contribution, selling S's
asset to B for the cash, and then selling the B stock or S stock
without recognizing the asset gain. This would be contrary to ``mirror
subsidiary'' legislation. See, e.g., H.R. Rep. No. 391, 100th Cong.,
1st Sess. 1081-84 (1987).
Although many of the problems could be addressed through
supplemental adjustments to conform the outside stock basis of a member
to changes in its inside asset basis, these adjustments would not
eliminate all of the problems and would introduce new problems. See
``Stock of members,'' discussed in this notice of hearing at B.5.
Because each of the necessary adjustments would vary greatly as to its
purpose and scope, the rules would be complex in the aggregate. By
contrast, the deferred sale system under the proposed regulations will
result in less complexity because it is based on separate return
accounting and the rules required for single entity treatment have a
common purpose that is more easily understood.
b. Comprehensive Single Entity Treatment
It is generally acknowledged that greater single entity treatment
reduces anomalies and planning opportunities, and better reflects the
economic unity of a consolidated group. See, e.g., CO-30-92, supra
(investment adjustment regulations); CO-78-90 [1991-1 C.B. 757], and
CO-132-87 [1991-1 C.B. 728] (limitations on the use of losses); and IA-
57-89 [1993-6 I.R.B. 50] (alternative minimum tax computations). Single
entity treatment has also been emphasized in the amendments to the
intercompany transaction system since 1990.
It is sometimes suggested that the consolidated return regulations
could be greatly simplified by adopting a comprehensive single entity
approach. For example, the acquisition, disposition, or deconsolidation
of a member's stock could be treated for all Federal income tax
purposes as the acquisition or disposition of its assets in a manner
similar to section 338(h)(10). Because the basis of the subsidiary's
stock would then be irrelevant, the stock basis adjustment system under
Sec. 1.1502-32 could be eliminated, and the potential for ``mirror
subsidiary'' transactions would be greatly reduced. Even this system
would not completely eliminate the importance of the location of items
within a group if, for example, members do not have uniform status or
accounting methods, or nonmember shareholders or creditors have an
interest in the group other than through the common parent.
Another approach to single entity treatment would be to completely
ignore the separate existence of the members. This approach would
significantly affect the application of many Code provisions to
consolidated groups: members generally would not be permitted to have
separate accounting methods; status as a bank or insurance company
would be determined by treating all of the members as a single
corporation; and losses and other carryovers would remain with the
group in which they arose rather than be carried to separate return
years as the members left the group. See also ``Stock of members,''
discussed in this notice of hearing at B.5.
Comprehensive application of single entity treatment could be
limited to specific activities of the members or to specific Code
provisions. For example, if a group operates an integrated enterprise
through subsidiaries, the members could be viewed as divisions to which
single entity treatment would apply. Predominantly separate entity
treatment would apply to members engaging in unrelated activities.
Differentiating between related and unrelated activities would present
numerous definitional problems, and the treatment of members would have
to be responsive to changes in their activities. Any approach that
applies for only limited Code purposes would require numerous rules to
coordinate with other Code provisions and to prevent inconsistent
treatment.
3. Mechanical Rules
Until 1990, the intercompany transaction regulations were presented
as a series of mechanical rules. See, e.g., Sec. 1.1502-13(b)
(intercompany transactions), and Sec. 1.1502-13 (c) through (f)
(deferred intercompany transactions). These rules reflect
inconsistently applied single and separate entity principles.
For example, S's gain from the sale of property to B is taken into
account under current Sec. 1.1502-13(f) when B disposes of the property
outside the group. Because the rule does not distinguish between
different types of dispositions, S's restoration is required even if B
disposes of the property in a like-kind exchange to which section 1031
applies. Restoring S's gain as a result of a section 1031 exchange by B
does not, however, reflect single entity principles because a single
entity generally would not recognize gain on the exchange. Moreover,
the nonmember participating in the exchange does not succeed to B's
cost basis from the intercompany transaction. Beginning in 1990, the
mechanical rules were supplemented by more uniform, but narrowly
focused rules. See, e.g., Sec. 1.1502-13 (l) and (m). These new rules
responded to specific transactions and were intended to limit
inconsistent combinations of single and separate entity treatment under
the mechanical rules. Because the 1990 amendments did not replace the
fundamental mechanical approach, problems remain. For example,
Sec. 1.1502-13(m)(2) does not address the special issues presented by
the disposition of property outside the group in a transaction that is
a nonrecognition transaction under the Code. The proper treatment of
these transactions cannot be uniform because they present a wide range
of issues. Nonrecognition could reflect the deferral of gain or loss
(e.g., because replacement property is received under section 1031 and
the gain or loss will be taken into account by reference to the
replacement property), duplication of gain or loss (e.g., through the
operation of sections 358 and 362), or elimination or disallowance of
gain or loss (e.g., section 301(d) provides for a fair market value
basis even if the distributing member's loss is not recognized under
section 311).
Some commentators have suggested that the current regulations be
retained, but fine-tuned to address problems as they arise. Recent
amendments have not been comprehensive revisions, and they have
increased the already existing complexity because their interaction
with the mechanical rules is unclear. For example, if S sells
depreciable property to B, B's depreciation deductions result in
restoration under both Sec. 1.1502-13 (d) and (l) and these rules may
restore S's gain at different rates.
Because mechanical rules cannot envision all the combinations of
transactions and provisions of law that continue to develop, an
approach based on mechanical rules will inevitably produce
inappropriate results. Consequently, the proposed regulations adopt
uniform rules of general application that reflect principles underlying
the current mechanical rules. The uniform rules are flexible enough to
apply to the broad range of transactions that can be intercompany
transactions. For example, the proposed regulations do not require
special rules to coordinate with the depreciation rules under section
168, the installment reporting rules under sections 453 through 453B,
and the limitations under sections 267, 382, and 469. Flexible rules
are consistent with the approach of recent guidance on tax accounting
issues generally. See, e.g., Sec. 1.461-4 (economic performance rules)
and proposed Sec. 1.446-4 (hedging transactions). Because the proposed
regulations are flexible, they adapt to changes in the tax law and
reduce the need for continuous updating. Thus, they should ultimately
be easier to apply than mechanical rules.
4. Matching and Acceleration Rules
a. Matching Rule
The matching rule provides single entity treatment for the timing,
character, source, and other attributes of items from intercompany
transactions. For each consolidated return year, the matching rule
requires S and B to take into account their intercompany items and
corresponding items to reflect the treatment of S and B as divisions of
a single corporation.
S generally determines its items taken into account based on the
difference between the corresponding items B takes into account and B's
recomputed items (the corresponding items B would have taken into
account if S and B were divisions of a single corporation). One
alternative that was considered would have determined the difference
between the group's consolidated taxable income (rather than only B's
items) and the group's recomputed consolidated taxable income (rather
than only B's recomputed items). This approach was not adopted because
determining the group's recomputed consolidated taxable income
(determined by treating S and B as divisions of a single corporation)
would be more complex than determining only B's recomputed items. For
example, it would require interactive computations (e.g., the effect on
absorption of a carryover loss), require numerous adjustments (e.g.,
for noncapital, nondeductible amounts), and involve circular
computations in some cases (e.g., if S sells property to B, and B sells
property to S).
Both the current regulations and the matching rule of the proposed
regulations apply single entity treatment to redetermine the timing of
S's intercompany items. The matching rule also redetermines the
character, source, and other attributes of intercompany items and
corresponding items on a single entity basis, while the current
regulations redetermine attributes only in limited cases. The approach
of the proposed regulations better reflects the economic unity of the
members and coordinates single entity treatment with various systems
under the Code. For example, if only timing is determined on a single
entity basis, it must be distinguished from character, and the
distinction is not always clear under the Code. See, e.g., section 469
(the passive activity rules may be viewed as character rules because
they limit absorption of losses, or as timing rules because the losses
ultimately will be absorbed).
In determining attributes, the proposed regulations take into
account the activities of both S and B with respect to the intercompany
transaction. Some argue that locking in character at the time of each
intercompany transaction more accurately reflects the source and nature
of the group's income. However, a single taxpayer generally does not
lock in the character of its economic income as the use of its property
changes. Instead, character is generally determined under common law
principles based on all of the facts and circumstances. For example,
the conversion of investment property to property held for sale to
customers in the ordinary course of business generally causes any
economically accrued gain or loss from the investment period to become
dealer gain or loss when later recognized.
b. Acceleration Rule
(i) In general. Under the acceleration rule, S's intercompany items
are taken into account to the extent either the matching rule will not
fully account for the items in consolidated taxable income, or the
intercompany transaction is reflected by a nonmember. The acceleration
rule reflects the conclusion that matching is appropriate only if the
effect of treating S and B as divisions of a single corporation can be
achieved.
Alternatives to the acceleration rule were considered, but none
presented a satisfactory solution. Although it is possible to continue
matching the items of S and B, matching would be inappropriate once S
and B no longer join in the consolidated return of the group. In
addition, continuing to integrate their accounting presents substantial
administrative problems.
Another alternative would be for S and B to take their remaining
items into account under their separate accounting methods. This
approach would be administratively complex, because it would require
numerous rules to resolve the issues that arise because of the
differences between separate entity accounting and the matching rule.
For example, if S sells a depreciable asset at a gain to B in exchange
for a note, B depreciates the asset, and then the stock of B is sold to
an unrelated person, S's remaining gain might be taken into account
under the installment method. The limitations under section 453(g)
(sale of depreciable property to a controlled entity) might not apply
to S's gain if S is no longer related to B. If B's depreciation has
caused S to restore more or less gain than S would have taken into
account under the installment method, the difference would have to be
reconciled.
Because separate entity accounting would produce the same results
as the acceleration rule in most cases, the additional complexity is
unwarranted.
(ii) Nonrecognition transactions. Under the current regulations,
S's intercompany gain or loss from the sale of property is taken into
account on the disposition of the property outside the group, even if
the disposition is a nonrecognition transaction. By contrast, only
certain nonrecognition dispositions by B result in S's intercompany
gain being taken into account under the acceleration rule.
For example, if B transfers property to a nonmember in an exchange
to which section 1031 applies, the acceleration rule would not apply
because the intercompany transaction would have no effect on the
nonmember, and S's intercompany items would continue to be matched with
B's corresponding items from the replacement property. On the other
hand, if B transfers the property to a partnership in a transaction to
which section 721 applies, S's gain is accelerated because the
partnership succeeds to B's cost basis under section 723. This result
is inconsistent with single entity treatment because, if S and B had
been divisions of a single corporation, S's transfer to B generally
could not have created a cost basis to be reflected by the partnership
in the property.
Some commentators argue that an intercompany sale of property from
S to B, followed by a section 351 or 721 contribution of the property
to a nonmember (including deemed contributions under section 708),
warrants special rules. It is suggested that single entity treatment
could be achieved by continuing the deferral of S's intercompany items,
and adjusting the nonmember's basis in the property as if the order of
events had been reversed. Thus, S would be treated as making the
section 351 or 721 contribution to the nonmember and selling the stock
or partnership interest in the nonmember to B. S's intercompany gain or
loss would therefore be taken into account by reference to the stock or
partnership interest in the nonmember rather than by reference to the
asset.
Reversing the order of events may require numerous adjustments to
reflect all of the resulting tax consequences. For example, results
that could not have been achieved under the reverse order must be
eliminated. If depreciable property is involved, the group would have
to shift to the nonmember all depreciation deductions following the
intercompany transaction because the property is treated as transferred
by S to the nonmember before the intercompany transaction.
Discontinuities would have to be addressed (e.g., if B contributes the
property to a nonmember corporation subject to its own liabilities,
treating S as contributing the property before the intercompany
transaction might cause section 357 to apply to the nonmember's
assumption of B's liability together with associated basis
consequences. Different rules may be required for losses and gains
(e.g., if S is a dealer but B is not, and B contributes the property to
a partnership, reordering the events may allow the group to select the
character of the property based on the rules under section 724). See
also ``Stock of members,'' in this notice of hearing at B.5. (problems
with reversing the order of transactions).
Another alterative would continue deferral following B's
contribution of the property to a partnership if the partnership adopts
special allocations to prevent nonmember partners from being affected
by B's cost basis. (Sections 704(c) and 737 would not address the
problem.) Although special partnership allocations might be adopted,
additional adjustments would be required to override otherwise
applicable rules that might result in nonmembers reflecting the
intercompany transaction.
(iii) Subgroups. The current regulations do not restore S's items
if the group terminates by reason of its acquisition by another
consolidated group (provided that all of the members immediately before
the acquisition become members of the acquiring group). Consideration
was given to expanding this successor rule to encompass subgroup
principles. See, e.g., Sec. 301.6402-7(h)(2) (insolvent financial
institution subgroups), and proposed Sec. 1.1502-21(c)(2) (subgroup
rules under the separate return limitation year rules). For example, if
another consolidated group simultaneously acquires only the stock of S
and B, S's intercompany items could continue to be deferred and taken
into account in the acquiring group under the matching rule. (S's
intercompany items from intercompany transactions with members other
than B would be accelerated.)
The essential issue raised by subgrouping is whether single entity
treatment should focus on treatment of the entire consolidated group in
which the intercompany transaction occurs, or only on the treatment of
S and B as the parties to the transaction. It is not clear that
subgroup rules would be consistent with single entity treatment under
the intercompany transaction system.
For example, if S is deferring gain from a sale of property to B,
and the stock of S and B are simultaneously purchased by another group,
the basis of S's stock will not be increased under Sec. 1.1502-32 for
the intercompany gain unless it is accelerated before the sale. Thus,
selling group's gain from the sale of S's stock may be duplicated when
S's intercompany gain is later taken into account by the buying group.
This gain duplication is inconsistent with treating the selling group
as a single entity. See also Sec. 1.1502-20 (the buying group will not
be permitted a loss from stock basis adjustments under Sec. 1.1502-32
attributable to S's built-in intercompany gain).
Because the purpose for single entity treatment under the
intercompany transaction system is based on the effect of intercompany
transactions on consolidated taxable income, it is not clear that
focusing on the individual members participating in intercompany
transactions (rather than on the group) is appropriate. (But see the
proposed section 267(f) regulations, which provide for subgrouping
because the deferral of loss is based on the relationship of S and B to
each other rather than on their membership in a particular controlled
group.)
Subgroup rules would increase the complexity of the intercompany
transaction system. Compare proposed Secs. 1.1502-21(c)(2) and 1.1502-
91 to 1.1502-96 (subgroup rules in other contexts). Subgroup rules
might require distinguishing between gain and loss, special rules might
be required to apply certain Code provisions to transactions indirectly
between separate consolidated groups, and coordinating rules for S's
reacquisition of property sold to B would be required. Rules would also
be necessary for back-to-back intercompany transactions, and it may be
necessary to require the members of a subgroup to bear a section 1504
relationship to each other to minimize the effect of intercompany items
and corresponding items on stock basis under Sec. 1.1502-32.
c. Simplifying Rules
Because of the complexity associated with accounting for items
under any deferred sale system, consideration was given to proposing
simplifying rules for de minimis or ordinary course intercompany
transactions.
Simplifying rules might be appropriate for infrequent transactions
between members of small groups, because the valuation difficulties of
a deferred sale system could be disproportionate to the potential
effect on consolidated taxable income. The relief might be to account
for the transactions under a carryover basis system. Problems would
arise, however, in defining an ``infrequent transaction'' and ``small
group.'' Complexities could also arise concerning the treatment of
fluctuations in group size, and the need for special rules to limit the
cumulative effect of simplifying rules.
At the other extreme, simplifying rules might be appropriate for
large groups with members that transact primarily with nonmembers, but
occasionally transact with members in the ordinary course and on the
same terms and conditions. The burdens on the group of accounting for
intercompany transactions under rules different from the group's other
accounting systems may also be disproportionate. Relief in this
situation might be separate return accounting that conforms with the
group's generally applicable inventory systems, but any such system
would present new problems and require special rules (e.g., to prevent
a group for accelerating only its intercompany losses under the
separate return rules).
Any simplifying rules of general application would be in addition
to the general rules. Different groups may require different forms of
relief, and groups would need to be familiar with all of the systems.
The burdens of simplifying rules appear to outweigh their benefits.
Instead of rules of general application, limited rules are included to
simplify the treatment of inventories and reserve accounting. In
addition, the election under current law to not apply the intercompany
transaction system is retained.
In simplifying the rules for members using a dollar-value LIFO
inventory method, consideration was given to a ``carryover basis
method'' that more precisely conforms to the matching rule. Under the
carryover basis method, B would determine the difference each year
between its corresponding inventory items taken into account and its
recomputed corresponding inventory items (the items that B would take
into account for the year if S and B were divisions of a single
corporation). For this purpose, B would recompute the value of its LIFO
inventory using a carryover basis amount for its intercompany purchases
rather than actual costs. The cumulative difference in the LIFO
inventory value of B's pool that receives intercompany purchases would
be treated as the amount of intercompany inventory items not taken into
account by S, because that amount is included in a LIFO layer of B. To
ensure that only S's intercompany inventory items are reflected in B's
LIFO value difference, B's base-year cost of recomputed inventory
purchases would be the same as the actual base-year costs under B's
dollar-value LIFO inventory method.
An advantage of the carryover basis method is B's familiarity with
its dollar-value LIFO inventory computations. The only required
recomputations are the substitution of carryover costs for the actual
costs of intercompany purchases. All of the LIFO submethods of B would
otherwise be used. S would make no additional computations other than
computing the carryover basis amount of its inventory sold to B.
Distortions could result under the carryover basis method, however,
if other costs in the LIFO computation affect B's carryover basis
amount in a manner different from their affect on B's actual cost for
intercompany inventory purchases. For example, if S sells raw material
to B for further processing, the raw material may be allocated
additional costs by B under burden rate methods that use the cost of
goods as the base for allocation. Thus, costs would be allocated to the
raw materials one way at their carryover basis, and another way at
their actual cost. This difference would be reflected in B's LIFO
inventory value. Because the carryover basis method assumes that the
difference in LIFO inventory values equals the amount of S's
intercompany inventory items, any additional differences would distort
the results.
5. Stock of Members
Notwithstanding their similarities, stock is different from other
assets within a group. A member's stock generally has no value
independent of the member's underlying assets, yet has its own basis
and holding period under the Code.
Both the current regulations and the proposed regulations generally
treat a member's stock as an asset separate from the member's
underlying assets. For example, if a member's stock is sold in an
intercompany transaction, the gain or loss from the sale is taken into
account under the matching and acceleration rules of the proposed
regulations like gain or loss from any other asset.
The stock basis adjustment rules under Sec. 1.1502-32 provide a
significant degree of single entity treatment for member stock.
However, the complexities of single entity treatment for member stock
under the Code prevent more generally disregarding the separate
existence of stock for purposes of intercompany transactions.
Some commentators have argued for the elimination of any gain or
loss from transactions with respect to a member's stock--in effect
applying section 1032 on a single entity basis. Others would limit this
treatment to transactions by a member involving the stock of the common
parent (P). Thus, if P contributes its own stock to S, S should not
recognize gain if it later sells the stock to a nonmember or if it
later distributes the stock back to P. Compare proposed Sec. 1.1032-2
(S's use of P stock in certain triangular reorganizations does not
result in gain or loss to S).
The commentators argue that S should not recognize gain or loss
from its sale of P stock because the transaction is equivalent to P
selling its own stock and contributing the proceeds to S. It is argued
that this single entity treatment is particularly compelling in the
consolidated return context. For example, S's gain or loss on the sale
of P stock is reflected in P's earnings and profits under Sec. 1.1502-
33 and P's tax liability under Sec. 1.1502-6, even though P would have
no earnings and profits or tax liability from its sale of P stock.
Treating each member's sale of P stock as a direct sale by P would
be an expansive application of single entity treatment. Although
commentators generally focus only on sales of P stock by members, an
expansive single entity approach, if adopted, would have far-reaching
effects.
Consistently treating S and P as a single entity would require
treating any acquisition by S of P stock as a direct acquisition by P
of its own stock in a deemed redemption. The application of section 304
principles and the associated consequences (e.g., adjustments to
earnings and profits) would have to be expanded to all such cases and
coordinated with other Code provisions. Compare Bhada v. Commissioner,
892 F.2d 39 (6th Cir. 1989) (S stock exchanged by S for P stock is not
``property'' under section 304(a)(2)(A)).
Comparable results would be required in an indirect acquisition if,
for example, S owns appreciated P stock when S becomes a member of the
P group. The P stock owned by S would have to be treated as redeemed
and taxed immediately. Compare proposed Sec. 1.337(d)-3 (P's
acquisition of an interest in a partnership that owns P stock is
treated as a redemption of the stock).
Following the deemed redemption of the P stock owned by S,
expansive application of single entity treatment would result in
elimination of any subsequent gain or loss of S from disposing of the P
stock. The gain or loss could be eliminated, for example, either by
adjusting S's basis in the P stock to fair market value or by expanding
the application of section 1032.
Any form of elimination will require a definition of the
disposition to which the elimination applies (including indirect
dispositions such as S becoming a nonmember), and rules to coordinate
the effects of the elimination, including: The determination of P's
basis in its S stock; the determination of each member's earnings and
profits; the treatment of any interest by nonmember shareholders
investing directly in S; the treatment of intermediate members if S is
not a direct subsidiary of P; the treatment of stock equivalents (e.g.,
warrants, convertible debt, and indirect interests through passthrough
entities); and the resolution of transitional problems.
Applying consistent single entity treatment for stock would raise
numerous issues under the Code, including: Distinguishing between
intercompany transactions that are taxable (e.g., as sales) and tax-
free (e.g., as deemed reorganizations); sharing the earnings and
profits of all members for purposes of characterizing distributions by
either S or P; expanding the application of sections 305, 306, and 354
if S issues its own preferred stock to acquire existing P stock held by
nonmember P shareholders; disqualifying a liquidation by P under
section 332 that includes a distribution to S because the distribution
to S prevents P from completely liquidating; and treating both P and S
as a party in any two-party reorganization involving a nonmember and
either S or P.
Single entity treatment may ultimately compel the conclusion that S
stock held by P also be treated as treasury stock held by S (and any
member's ownership of the stock of another member be treated as
treasury stock held by that other member). For example, if P owns 79%
of S's stock and later acquires the remaining 21%, single entity
treatment may require treating P's 79% interest as redeemed immediately
after S becomes a member because P's stock in S would be treated as
becoming treasury stock of S. Thus, P's gain or loss inherent in the
79% interest would be taken into account immediately.
The proposed regulations do not adopt expanded single entity
treatment for stock of members. That approach would greatly increase
the complexity of the proposed regulations and would have significant
consequences for the tax liability of a group. Although complexity
could be reduced (e.g., by limiting single entity treatment to a
higher-tier member's ownership of a lower-tier member's stock or to
common parent stock owned by a wholly-owned, first-tier subsidiary),
numerous problems would remain.
One stock transaction that has received a significant amount of
attention regarding single entity treatment is the liquidation of a
member following an intercompany sale or distribution of its stock.
Under the current regulations, if S sells all of the stock of a lower-
tier member (T) to B at a gain, and T subsequently liquidates under
section 332, S's gain is taken into account. If the basis of T's assets
conformed to the basis of its stock before S's sale, S's gain from the
T stock will be duplicated by gain that the group later recognizes from
the former T assets (because B succeeds to T's basis in the assets).
The problem could also arise, for example, if T is deemed to liquidate
as the result of an election under section 338(h)(10), or if B merges
downstream into T. Commentators have argued that single entity
treatment should apply to eliminate S's gain, or to coordinate the gain
with any corresponding gain inherent in the former T assets.
The proposed regulations provide limited, administrable relief that
should be available in the most common circumstances. Although several
more comprehensive solutions to these problems have been suggested by
commentators, they are generally not feasible. The simplest solution is
to eliminate S's gain when T liquidates, but this approach would permit
gain that arose in S to be eliminated and is therefore inconsistent
with the objectives of the proposed regulations to preserve location.
See ``Location of items within the group,'' discussed in this notice of
hearing at B.2.
A second approach would provide an election under section 336(e) to
eliminate S's gain by treating S's sale of T stock as a sale by T of
all of its assets. The implementation of section 336(e) raises several
problems. For example, each of T's assets must be separately valued and
intercompany gain traced to the individual assets, special rules would
be necessary for lower-tier subsidiaries and transfers of less than all
of the T stock, and liquidation-reincorporation concerns would have to
be resolved. If the election is required at the time of S's sale, it
would not be useful to many taxpayers because the subsequent
liquidation will not be anticipated. However, if an election is not
required until the liquidation occurs, it might no longer be feasible
to determine the consequences of the treatment or to amend the returns
for all affected prior years.
A third approach would effectively reverse the order of S's
intercompany stock sale and the subsequent sale of the former T assets.
S would take into account the subsequent asset gain from the former T
assets as it is recognized, instead of taking into account its own
stock gain. This approach approximates the results that would have
occurred if T's asset gain had been recognized before the intercompany
stock sale and the stock gain eliminated because of the basis
adjustments under Sec. 1.1502-32. Although the location of the group's
single gain is preserved in S, and the character of the gain is
consistent with the reversal of order, the tracing required of the
former T assets would be complex, and additional adjustments would be
required to account for S's use of the stock sale proceeds. See also
``Acceleration rule--nonrecognition transactions,'' in this notice of
hearing at B.4.b.ii. (problems with reversing the order of
transactions).
The proposed regulations provide special rules to clarify the
results if a member acquires its own stock in an intercompany
transaction. The proposed regulations generally take into account
immediately any intercompany items from transferring an issuer's stock
back to the issuer in an intercompany transaction, because future
matching is no longer possible. The results are consistent with the
separate entity treatment preserved under the proposed regulations by
not deeming P's acquisition of S stock as a deemed redemption of any P
stock that S owns. (Possible deemed redemption treatment remains under
study. See, e.g., proposed Sec. 1.337(d)-3, under which P's acquisition
of an interest in a partnership that owns P stock is treated as a
redemption of the stock.) Administrative difficulties prevent
distinguishing S's gain or loss accruing after it is a member from the
gain or loss that was built-in when it became a member, and any such
distinctions would result in inconsistent combinations of single and
separate entity treatment.
6. Obligations of Members
Legislative and judicial developments since 1966 that are
applicable to all obligations have affected the treatment of
obligations between members. For example, the Code provisions for
taking into account bond premium and discount have been comprehensively
revised to incorporate time value of money principles. See, e.g.,
Public Law 98-369, sections 41-44 (sections 163(e) and 1271 to 1288).
Section 108(e)(4) was enacted in 1980 to prevent avoidance of
discharge of indebtedness. The statute adopts a limited single entity
approach by treating the acquisition of debt by a person related to the
debtor as comparable to the debtor's acquisition of its own debt. The
regulations implementing section 108(e)(4) include some circumstances
in which the holder of the debt becomes a person related to the debtor.
The preamble to the proposed section 108(e)(4) regulations
indicates that the consolidated return regulations would be modified to
apply similar principles to any transaction in which a debtor and the
holder of the debt become members of the same consolidated group. See
CO-90-90 [1991-1 C.B. 774], clarified by Notice 91-15, 1991-1 C.B. 319.
The proposed intercompany transaction regulations implement this
treatment of members of a consolidated group.
Special consideration has been given in recent years to the issues
presented by developing markets for notional principal contracts and
other sophisticated financial instruments. These obligations are not
clearly described under the current consolidated return regulations
because their exponential growth only began over the last decade.
Section 1.446-3 provides for the timing of income and deductions from
notional principal contracts, but does not address many of the issues
arising from notional principal contracts between related parties.
Section 475 was enacted in 1993 to address problems with measuring
the income of dealers in securities, including these contracts. See
Public Law 103-66, Sec. 13223. Section 475 generally requires a dealer
to mark-to-market its position in securities, and may greatly expand
the instances in which items are recognized by a member with respect to
intercompany obligations.
Notional principal contracts and other securities are frequently
used to hedge assets or liabilities. Section 1.1221-2T generally
conforms the character of items from the contracts with the items from
the underlying assets or liabilities. Similar rules are proposed in
Sec. 1.446-4 to conform the timing of the items. The purpose of these
rules is to match the timing and character of items from hedging
transactions with the items being hedged. See TD 8493, FI- 46-93, and
FI-54-93 [1993-35 I.R.B. 16, 22, and 24]. Although these rules apply to
certain hedging of aggregate risks, they do not apply if a taxpayer
hedges the risk of a related party.
The proposed regulations provide greater single entity treatment
for intercompany obligations than for member stock. Greater single
entity treatment is possible because the separate return rules under
the Code already provide that the aggregate income and deductions of
the parties to obligations generally correspond in amount and effect on
earnings and profits. In the consolidated return context, these
provisions generally produce offsetting items whose timing and
character can be conformed. Concerns about the location of items within
a group can be addressed by making only limited adjustments to the
separate return rules. For example, the separate return regulations
under section 108(e)(4) provide essentially single entity treatment for
related-party acquisitions of debt. Only limited rules are necessary
under the proposed regulations to conform the section 108(e)(4) rules
to the single entity treatment of consolidated groups.
By contrast, there are significant differences between the
treatment of issuers and holders of stock that would entail numerous
adjustments to conform the amount, location, and collateral effects of
items, as well as timing and character. For example, section 304
treatment would be required for stock transactions that are comparable
to section 108(e)(4) transactions. Thus, section 304 principles would
have to be extended to all transactions which result in one member
owning another member's stock (e.g., an indirect acquisition in which
the holder of the stock becomes a member). Adjustments would be
necessary for earnings and profits and stock basis, and additional
rules would be necessary to treat a subsequent disposition of the stock
as an issuance that does not result in gain or loss.
Several approaches to single entity treatment were considered for
intercompany obligations. One approach would treat all gain or loss
with respect to an intercompany obligation as a transfer with respect
to stock. For example, if the debtor member retires its intercompany
debt at a discount, the creditor member's corresponding loss would be
treated as a capital contribution or distribution, as the case may be,
to the debtor member. See generally Secs. 1.61-12(a) and 1.301-1(m). If
the debtor and creditor are in a brother-sister (rather than parent-
subsidiary) relationship within a group, additional adjustments would
be required.
Treating the creditor member's loss as a capital contribution (or
distribution) ensures that the loss does not affect the overall
determination of consolidated taxable income, but it would distort the
location of items within a group. For example, if a debtor or creditor
is a subsidiary with nonmember shareholders, a portion of any decrease
in the value of the debt would be borne by these shareholders rather
than the group. Treating the creditor member's entire loss as a capital
contribution would also fail to reflect the interests of the nonmember
shareholders in the debtor or creditor for purposes of stock basis and
earnings and profits adjustments under Secs. 1.1502-32 and 1.1502-33.
The proposed regulations generally adopt a single entity approach
by requiring both parties to an intercompany obligation to take
offsetting items into account under the matching rule. Because the
income and loss of the parties are separately taken into account, their
items are separately reflected in the stock basis and earnings and
profits adjustments under Secs. 1.1502-32 and 1.1502-33 (and thereby
reflect the interests of any nonmember shareholders).
The proposed regulations provide rules for two categories of
transactions involving intercompany obligations. The first category
generally includes transactions in which an intercompany obligation is
sold to a nonmember or otherwise becomes an obligation that is not an
intercompany obligation (e.g., the debtor or creditor becomes a
nonmember). The proposed regulations treat the intercompany obligation
as satisfied immediately before the transaction and reissued
immediately after the transaction.
Treating the obligation as satisfied immediately before the
transaction results in both gain and loss of the parties from the
satisfaction being taken into account in the determination of
consolidated taxable income. The matching rule conforms the timing and
attributes of the items to prevent any effect on consolidated taxable
income.
By conforming timing and attributes in the determination of
consolidated taxable income and treating the obligation as reissued
immediately after the transaction, the intercompany obligation is
effectively treated as first existing as an obligation only after it is
held by a nonmember. Thus, if S sells B's debt obligation to a
nonmember at a discount, the debt is treated by both B and the
nonmember as having original issue discount to which section 1272
applies (rather than market discount to which sections 1276 through
1278 apply). This single entity treatment avoids mechanical rules and
accommodates any future changes in the separate return rules for the
taxation of indebtedness.
The second category includes transactions in which an existing
obligation becomes an intercompany obligation. Although section
108(e)(4) applies to many of these cases, it does not apply to all of
them.
Because the focus of section 108(e)(4) is to prevent avoidance of
discharge of indebtedness income, Sec. 1.108-2 requires only the debtor
to recognize gain or loss. The proposed regulations treat both the
debtor and creditor as recognizing gain or loss. For example, if a
nonmember creditor becomes a member, the obligation is treated as
retired and reissued immediately after the obligation becomes an
intercompany obligation. Because the amounts taken into account accrued
before the debtor and creditor joined in filing a consolidated return,
the proposed regulations preserve the separate return attributes of the
gain and loss, and these amounts might not conform in character. The
deemed satisfaction and reissuance avoids the need to expand the
mechanical rules of Sec. 1.108-2.
The separate return rules for obligations satisfied, modified, or
issued in a reorganization or other nonrecognition transaction are
under study as part of a separate project. See, e.g., Rev. Rul. 74-54,
74-1 C.B. 76 (indebtedness of a parent corporation is an asset to which
section 332 applies); Estate of Helen Gilmore v. Commissioner, 40
B.T.A. 945 (1939), acq. 1940-1 C.B. 2 (indebtedness of a shareholder is
an asset to which the predecessor of sections 331 applies); and Rev.
Rul. 93-7, 1993-1 C.B. 125 (recognition of gain or loss on distribution
of debt by creditor partnership to debtor partner). The rules for these
nonrecognition transactions will be coordinated with the rules of the
proposed regulations for the treatment of transactions in which an
existing obligation that becomes an intercompany obligation, to the
extent that the transactions are comparable. Different treatment may be
appropriate if, for example, an insolvent target is acquired by its
significant creditor, because the target's insolvency for purposes of
section 108(a) might be eliminated if the discharge were treated as
occurring immediately after the acquisition.
Although recent proposed regulations under Sec. 1.446-4 generally
attempt to match the timing of items from hedging transactions with the
items being hedged, the current consolidated return regulations might
prevent this matching. For example, S may reduce its interest rate risk
on an existing debt owed to a nonmember by entering into an
intercompany interest rate swap contract with B (the member that
centralizes the hedging activities of the group). B may, in turn,
offset its net aggregate risk by entering into an offsetting contract
with a nonmember. If B is subject to section 475, B's interest in the
intragroup contract and its interest in the contract with the nonmember
are marked-to-market. If the intragroup contract is an intercompany
obligation to which current Sec. 1.1502-14(d) applies, however, B's
marking to market gain or loss from the intragroup contract is deferred
unless section 475 requires otherwise. If S is not subject to section
475, it does not mark to market either its debt or its interest in the
intragroup contract. Thus, the timing of the items from the intragroup
contract, S's debt, and B's contract with the nonmember may not
necessarily match. Of S's two positions and B's two positions, only
gain or loss from B's contract with the nonmember would be currently
taken into account.
The proposed regulations treat B's marking to market of its
interest in the intragroup contract as resulting in the satisfaction
and reissuance of the contract. Thus, B takes into account immediately
its gain or loss from the deemed retirement of the intragroup contract,
and S takes into account an offsetting amount of loss or gain. A new
intragroup contract is then deemed to be reissued at a discount or
premium (to reflect its fair market value) that is taken into account
over time based on the applicable rules for the type of obligation. The
net timing effect on consolidated taxable income is similar to the
deferral that would be required for the obligation under the current
regulations if Sec. 1.1502-14(d) applies. It is also analogous to the
effect on consolidated taxable income if S and B had not entered into
the intragroup contract, but B nevertheless had contracted with the
nonmember by reason of S's interest rate risk (i.e., a related-party
hedge). However, the deemed satisfaction and reissuance under the
proposed regulations preserve the location of each member's items.
The proper treatment of related-party hedging transactions is also
being considered in conjunction with the finalization of regulations
under sections 446 and 1221. See, e.g., TD 8493, FI-46-93, and FI-54-93
[1993-35 I.R.B. 16, 22, and 24]. Depending on the treatment under those
final regulations of hedging transactions in which one member of a
consolidated group offsets the risk of another member, it may be
necessary to modify the consolidated return regulations to clearly
reflect consolidated taxable income.
7. Conclusion
This document was prepared to provide background information on the
issues and approaches considered in developing the proposed
regulations. Comments and questions concerning the intercompany
transaction system need not be limited to the issues discussed in this
document.
By direction of the Commissioner of Internal Revenue.
Dale D. Goode,
Federal Register Liaison Officer, Assistant Chief Counsel (Corporate).
[FR Doc. 94-8489 Filed 4-8-94; 1:03 pm]
BILLING CODE 4830-01-U
