Consolidated Groups and Controlled GroupsIntercompany Transactions and Related Rules

DEPARTMENT OF THE TREASURY

Internal Revenue Service

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 proposed rulemaking.

-----------------------------------------------------------------------

SUMMARY: This document proposes regulations revising the intercompany

transaction system of the consolidated return regulations to more

clearly reflect consolidated taxable income. The proposed regulations

also revise the regulations under section 267(f), limiting losses and

deductions from comparable transactions between members of a controlled

group. Amendments to other related regulations are also proposed in

this document.

DATES: Comments must be received by July 18, 1994. Because the proposed

regulations affect a broad range of transactions, two public hearings

will be held. A preliminary hearing to respond to general comments and

questions by speakers will be held on May 4, 1994, beginning at 10

a.m., and a second hearing to receive comments will be held on August

8, 1994, beginning at 10 a.m. Requests to speak at the first hearing

must be received by April 20, 1994. Outlines of topics to be discussed

at the second hearing must be received by July 18, 1994. See the notice

of public hearings on proposed rulemaking published elsewhere in this

issue of the Federal Register.

ADDRESSES: 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, submissions may be delivered to:

CC:DOM:CORP:T:R (CO-11-91), room 5228, Internal Revenue Service, 1111

Constitution Avenue NW., Washington, DC. 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 Internal Revenue Building Auditorium, Seventh Floor,

7400 Corridor, Internal Revenue Service 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. Paperwork Reduction Act

The collections of information contained in this notice of proposed

rulemaking has been submitted to the Office of Management and Budget

for review in accordance with the Paperwork Reduction Act of 1980 (44

U.S.C. 3504(h)). Comments on the collection of information should be

sent to the Office of Management and Budget, Attn: Desk Officer for the

Department of the Treasury, Office of Information and Regulatory

Affairs, Washington, DC 20503, with copies to the Internal Revenue

Service, Attn: IRS Reports Clearance Officer, PC:FP, Washington, DC

20224.

The collections of information are found in Sec. 1.1502-13 (e)(3),

(f)(5)(v), and (j)(5). This information is required by the IRS to

comply with section 1502 and the regulations thereunder, and to

simplify the operation of the proposed regulations. This information

will be used to assure that the amount, location, timing, character,

source, and other attributes of intercompany items and corresponding

items are properly determined. The respondents are members of

consolidated groups.

The estimated total annual reporting burden is 2,500 hours.

The estimated annual reporting burden per respondent is .50 hour.

The estimated number of respondents is 5,000.

The estimated annual frequency of responses is once per year, if

necessary.

B. Background

This document proposes amendments to the regulations under section

1502 of the Internal Revenue Code of 1986 (Code) that are applicable to

transactions between members of a consolidated group (intercompany

transactions). 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. Amendments are also proposed to related

regulations, including the regulations under section 267(f), which are

applicable to transactions between members of a controlled group.

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. In general,

the amount, location, character, and source of items from an

intercompany transaction are 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).

For a discussion of the issues considered in developing the

proposed regulations, see the notice of hearings on the proposed

regulations that appears elsewhere in this issue of the Federal

Register. The topics discussed in the notice of hearings include:

1. Separate and single entity treatment.

2. Location of items within the group (and alternative

comprehensive single entity treatment).

3. Mechanical rules.

4. Matching and acceleration rules (including nonrecognition

transactions, subgroups, and possible simplifying rules).

5. Stock of members.

6. Obligations of members.

No inference is intended by the proposed regulations as to the

operation of the current regulations or other rules.

C. Explanation of Proposed Intercompany Transaction Rules

1. In General

The purpose of the proposed intercompany transaction regulations is

to clearly reflect the taxable income (and tax liability) of the group

as a whole by preventing intercompany transactions from creating,

accelerating, avoiding, or deferring consolidated taxable income (or

consolidated tax liability).

The proposed regulations retain the basic approach of the current

regulations by accounting for intercompany transactions through a

deferred sale system. The principal focus of single entity treatment

under the current regulations is on the timing of items from

intercompany transactions. The proposed regulations expand this focus

by redetermining the character, source, and other attributes of the

items on a single entity basis. Only the amount and location of items

remain on a separate entity basis.

The proposed regulations eliminate many inconsistent combinations

of single and separate entity treatment under the current regulations

that lead to inappropriate results. Nevertheless, the rules of the

proposed regulations reflect the basic principles underlying the

current regulations. Accordingly, the results of most common

intercompany transactions are not affected by the proposed regulations

even though the analysis is changed.

The proposed regulations replace the mechanical rules of the

current regulations with a matching rule and an acceleration rule.

These rules apply uniformly to ``period'' transactions (e.g., payment

of currently deducted interest), sales of property and performance of

capitalized services, and transactions involving the stock or

obligations of members. Because the proposed regulations generally

unify the rules for all intercompany transactions, many of the

distinctions drawn by the current regulations between intercompany

transactions, deferred intercompany transactions, and transactions

involving stock or obligations of members, are eliminated as no longer

necessary.

The proposed regulations include numerous examples, but the first

few examples under the matching and acceleration rules provide the

guidance necessary for most common intercompany transactions.

Additional examples illustrate the application of the proposed rules to

less common transactions.

The proposed regulations are a method of accounting to the extent

they determine the timing of items. An item taken into account under

these rules can be deferred, disallowed, or eliminated under other

applicable law.

A group's ability to change its manner of applying the final

intercompany transaction regulations will be subject to the generally

applicable rules for accounting method changes. Whether a change in

method will be applied with an adjustment under section 481(a) or

applied on a cut-off approach will be determined by the IRS. See also

``Proposed effective dates,'' discussed at F. of this preamble for the

application of the final intercompany transaction regulations on a cut-

off basis.

2. Definitions: Intercompany Transaction, Intercompany Item, and

Corresponding Item

In general, an intercompany transaction is a transaction between

corporations that are members of the same consolidated group

immediately after the transaction. The proposed regulations provide

further guidance largely through examples. S is the member transferring

property or providing services, and B is the member receiving the

property or services.

Each party to an intercompany transaction can have items of income,

gain, deduction, and loss from the transaction (or from property

acquired in the transaction). S's items are referred to as intercompany

items and B's items are referred to as corresponding items. These items

are generally taken into account under the matching and acceleration

rules.

For most transactions, S's intercompany items and B's corresponding

items are their items from the intercompany transaction (or from

property acquired in the intercompany transaction) determined on a

separate entity basis. Issues arise under the current regulations

regarding the effect of certain costs and expenses on the determination

of intercompany items and corresponding items. For example, if S

performs services for B, the extent to which S's costs are included in

determining its intercompany income may not always be clear. The

proposed regulations retain the approach of the current regulations by

providing guidance largely through examples.

The proposed regulations also continue the current approach of

treating certain amounts as S's intercompany items even though S has

not yet recognized or incurred them under its own method of accounting.

Thus, in certain situations the rules can accelerate as well as defer

intercompany items. S generally is not required, however, to take into

account amounts that it will never recognize under its method of

accounting merely to match B's corresponding items. Additional

adjustments are made to the extent necessary to clearly reflect the

group's income, including treating certain basis adjustments under the

Code as items required to be taken into account.

The matching rule of the proposed regulations generally focuses on

B to redetermine the time S's intercompany items are taken into

account. This approach is similar to the approach of the current

regulations for deferred intercompany transactions. However, the

matching rule applies to a wider range of transactions, and the roles

of the parties might vary. For example, a single business arrangement

may be composed of related transactions, with one member being S for

one transaction and B for another. The proposed regulations require

each transaction to be separately analyzed, and provide examples to

identify which member is B and which is S in a transaction.

The roles of the parties might also vary over time. For example, if

two members engage in an interest rate notional principal contract, the

member that is obligated to make the net payment in each period under

the contract will vary depending on changes in interest rates. Because

the net payment for each period is treated as a separate transaction, a

member may be B in one period (as the payor) and S in another period

(as the payee).

3. Matching Rule

Under the proposed regulations, the matching rule is the principal

rule for redetermining the timing and attributes of S's intercompany

items and B's corresponding items on a single entity basis. In general,

S's intercompany items and B's corresponding items are taken into

account to produce the same effect on consolidated taxable income as if

S and B were divisions of a single corporation.

For purposes of treating S and B as divisions under the matching

rule, S and B are treated as engaging in their actual transaction and

owning any actual property in the transaction, operating separate

trades or businesses, and having any special status (e.g., as a bank or

insurance company) that they have under the Code.

In addition to timing, the matching rule conforms the character and

other attributes of S's intercompany items and B's corresponding items.

For example, S might sell investment property to B, and B might hold

the property for sale to customers in the ordinary course of business.

S and B redetermine the attributes of their intercompany items and

corresponding items to produce the same effect on consolidated taxable

income as if they were divisions of a single corporation. Thus, the

redetermination of character is based on the activities of both S and B

and may require both S's items and B's items to be ordinary or capital.

Because the attributes are redetermined by treating S and B as

divisions, the matching rule also generally aggregates the holding

periods of S and B with respect to property transferred in an

intercompany transaction.

For each consolidated return year, the matching rule requires S to

take into account its intercompany items to reflect 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). Comparing B's corresponding

items and its recomputed items ordinarily will not be difficult.

For example, if S sells property with a $70 basis to B for $100,

and B later resells the property to a nonmember for $90, S's $30 gain

is not taken into account until the resale. At that time, S's gain is

taken into account to reflect the $30 difference between the $10 loss B

takes into account and the recomputed $20 gain B would take into

account if B had succeeded to S's $70 basis in a transfer between

divisions of a single corporation. The character of S's $30 gain and

B's $10 loss (and their holding period for the property) are

redetermined by taking into account the activities of both S and B with

respect to the property.

Treatment as divisions of a single corporation applies only to S

and B as the parties to the intercompany transaction. The activities of

other members are generally not taken into account. Moreover, because

treatment as divisions is solely for purposes of taking into account

items from intercompany transactions, the treatment generally does not

affect determinations by S and B with respect to items or holding

periods in other transactions.

The matching rule continues the trend of recent amendments to the

intercompany transaction system by reducing the reliance on particular

events and transactions to take items into account. Compare current

Sec. 1.1502-13(l) with current Sec. 1.1502-13 (d) through (f). Because

the matching rule focuses on B's items, if S sells land to B at a gain

and B transfers the land outside the group in an exchange to which

section 1031 applies, S's gain is not taken into account under the

matching rule, even though the property is disposed of outside the

group, if there is no difference between B's actual and recomputed

items resulting from the exchange. Instead, S's gain remains deferred

and is taken into account based on B's items with respect to the

replacement property.

The current regulations redetermine timing on a single entity

basis, but generally determine character on a separate entity basis.

This dual approach may result in conflicts because timing and character

cannot always be separately analyzed under the Code. The current

regulations only partially resolve these conflicts. See, e.g.,

Secs. 1.1502-13(c)(4)(ii) and (d)(3) (the character of S's deferred

gain or loss taken into account as a result of B's depreciation is

redetermined), and 1.1502-13(m)(1) (S is treated as disposing of

property at the same time and in the same manner as B disposes of the

property outside the group).

The proposed regulations generally eliminate potential conflicts

between timing and character by redetermining both the timing and the

attributes of items on a single entity basis. This approach eliminates

the need for the special rules under the current regulations. For

example, if S sells depreciable property to B at a gain, B depreciates

the property for a period, and B then resells it to a nonmember, no

special rules are needed to redetermine the recapture income of S or B.

Instead, the recapture income is redetermined as if S and B were

divisions of a single corporation. This prevents the intercompany

transaction from affecting consolidated taxable income, but preserves

the location of each member's items. Redetermining attributes on a

single entity basis is not expected to affect most intercompany

transactions.

Preserving the location of S's items, but redetermining their

attributes on a single entity basis, may in certain cases require S's

intercompany income or gain to be treated as excluded from gross income

(or its intercompany deductions or losses to be treated as noncapital,

nondeductible amounts). For example, if S has intercompany interest

income from B, but B's corresponding interest deduction is disallowed

under section 265, S's intercompany income must be excluded from gross

income.

This approach prevents an intercompany transaction from having an

effect on consolidated taxable income, but preserves the location of

items for stock basis and earnings and profits adjustments under

Secs. 1.1502-32 and 1.1502-33. However, because of administrability

concerns, S's intercompany income or gain generally can be treated as

excluded from gross income only if B's corresponding item is a

deduction or loss that, in the taxable year the item is taken into

account, is permanently disallowed directly under another provision of

the Code or regulations.

Because it has the same effect as a deduction or loss that is

permanently disallowed, exclusion is also permitted if B has a

corresponding loss that is not recognized under section 311. For

example, if S has property with a $70 basis and sells it to B for $100,

and the property is subsequently distributed to a nonmember when it has

a value of $90, B's $10 loss is not recognized under section 311(a).

B's distribution results in all of S's $30 gain being taken into

account, but $10 of the gain is excluded from gross income. Additional

corresponding items that permit S's intercompany income or gain to be

excluded from gross income may be identified by the Commissioner in

future guidance, to the extent consistent with administrability

concerns.

Under the proposed regulations, the special asset basis rules of

current Sec. 1.1502-31(a) are not needed. These rules originally were

adopted to contrast with the intercompany transaction system applicable

to pre-1966 consolidated return years. They are now encompassed by the

general approach of the proposed regulations to use the provisions of

the Code where possible. Consequently, the special asset basis rules

were not included in recently proposed revisions to Sec. 1.1502-31. See

CO-30-92 [1992-2 C.B. 627].

4. Acceleration Rule

The acceleration rule takes items into account immediately to the

extent that they cannot be taken into account under the matching rule

to produce the effect of treating S and B as divisions of a single

corporation. The effect cannot be produced to the extent either the

matching rule will not fully account for the items from an intercompany

transaction in consolidated taxable income, or the intercompany

transaction will be reflected by a nonmember.

For example, if S or B becomes a nonmember, any remaining

intercompany items and corresponding items can no longer be matched in

the determination of consolidated taxable income. Moreover, S or B

would reflect the intercompany transaction as a nonmember. The

intercompany items are therefore taken into account immediately before

S or B becomes a nonmember.

Similar results would be required if B purchases property from S

and transfers it to a partnership in a transaction to which section 721

applies (or to nonmember corporation in a transaction to which section

351 applies), because the partnership reflects the intercompany

transaction by succeeding to B's cost basis in the property. 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. The acceleration rule requires S to take its

intercompany items into account immediately before the event rendering

single entity treatment impossible. (If B had disposed of the property

in an exchange with a nonmember to which section 1031 applies, the

intercompany items would not be taken into account under the

acceleration rule because the nonmember would not succeed to B's cost

basis.)

In limited circumstances, the acceleration rule will apply without

the occurrence of an event separate from the intercompany transaction.

This might occur if S's gain or loss from the sale of property to B

exceeds the effect of the intercompany transaction on the basis of the

property. For example, if B owns a building that is destroyed by fire

and B uses its insurance proceeds to buy a replacement building from S,

S's gain or loss will not conform to B's basis in the building because

B's basis is determined under section 1033. If the amount of S's gain

or loss exceeds the effect of the intercompany sale on the building's

basis, S's gain or loss will not be fully taken into account under the

matching rule because there will not be a sufficient difference between

the corresponding items B takes into account and its recomputed items.

Consequently, the acceleration rule applies at the time of the

intercompany sale to take the excess amount into account. S's gain or

loss is accelerated because it is not possible to treat S and B as

divisions of a single corporation, and acceleration is the only

administrable alternative.

The acceleration rule has two provisions for determining the

attributes of S's intercompany items. For intercompany transactions

involving property, the attributes are redetermined under the

principles of the matching rule by deeming B to resell the property to

a nonmember affiliate (a transaction comparable to S's intercompany

transaction). Thus, the attributes of S's intercompany items reflect

B's activities with respect to the property. For example, if S was an

investor in land sold to B, and B holds the land for sale to customers

in the ordinary course of business at the time B becomes a nonmember,

S's gain or loss taken into account under the acceleration rule may be

ordinary. Because B is deemed to sell to a nonmember affiliate, any

rules applicable to related party transactions apply to determine the

attributes of S's items. See, e.g., section 1239 (relating to

depreciable property).

For intercompany transactions involving services or rentals, or

other nonproperty transactions, the attributes of S's accelerated items

are determined on a separate entity basis. For example, if S performs

services that are capitalized by B, there is no deemed sale by B for

purposes of determining the attributes of S's items. Instead, S's

accelerated items remain ordinary items from its performance of

services. The proposed regulations do not deem a sale to occur because

S did not engage in a property transaction and B may never engage in

the sale or exchange of property that would require S's items to be

recharacterized as items from a property transaction.

Like the current regulations, and consistent with the treatment

under the intercompany transaction system of a consolidated group as a

single entity, the proposed regulations do not accelerate items if the

entire consolidated group is acquired by another consolidated group.

5. Simplifying Rules

a. Inventory

The current regulations generally treat intercompany transactions

involving inventory like intercompany transactions involving other

property. But see Secs. 1.1502-13(f)(1) (iv) and (viii) (a deferred

amount attributable to stock in trade or inventory is taken into

account as the result of a separate return year or a value write-down),

and 1.1502-18 (special inventory adjustment).

The proposed regulations continue to generally treat inventory

transactions like other intercompany transactions. However, if S or B

uses a dollar-value LIFO method of inventory accounting, the matching

rule might be unadministrable because dollar-value LIFO measures

aggregate inventory changes in terms of base-year dollars, and does not

separately identify the items from particular transactions. For

example, B is not able to determine when corresponding items with

respect to each separate intercompany transaction are taken into

account because of the substitution of inventory units and costs within

the dollar-value LIFO method.

Intercompany inventory transactions are typically routine

transactions that occur in the normal course of business. Applying the

matching and acceleration rules to dollar-value LIFO methods may be

burdensome because of the potential for numerous additional

computations and the inconsistencies with financial reporting of

intercompany transactions. For example, S may compute intercompany

inventory income and corresponding elimination for financial reporting

purposes using a FIFO cost-flow assumption even though S and B use

dollar-value LIFO for Federal income tax purposes.

To simplify the matching computations, the proposed regulations

permit S or B to use any reasonable method to take into account their

items from intercompany inventory transactions. However, adjustments

are required if the cumulative amount of intercompany items not taken

into account by S under the method used significantly exceeds the

cumulative amount that would not be taken into account by S under

methods specifically provided in the proposed regulations. For example,

a group may be able to use its current accounting methods or develop

other simplified methods. However, the use of a FIFO cost-flow

assumption could result in deferral that significantly exceeds the

deferral that would be achieved under a LIFO cost-flow assumption. If a

method is expected to be reasonable, but in fact produces a significant

cumulative excessive deferral in any year, S must take into account an

amount for that year which will eliminate the excess and make

appropriate adjustments thereafter to reflect the amount taken into

account.

The proposed regulations specifically provide an ``increment

averaging method'' and an ``increment valuation method.'' Under the

increment averaging method, B determines the portion of its total

inventory costs for the current year that are included in a layer of

increment under its LIFO inventory method, and S defers a comparable

portion of its intercompany inventory items from sales to B for the

year. B computes the ratio of current-year costs of its layer of

increment over total inventory costs incurred for the year. B's

current-year costs are computed in a manner consistent with its method

for valuing LIFO increments (e.g., earliest, latest, or average costs).

If B uses a simplified method to allocate section 263A costs to

inventory and does not allocate additional section 263A costs to

specific items of LIFO inventory, B may compute the portion of its

costs included in an increment without including section 263A costs in

either the total costs or the costs included in a layer. B must compute

its costs separately for each LIFO pool that receives intercompany

purchases, and if more than one selling member transfers inventory into

that pool in intercompany transactions, each selling member must take

into account a comparable portion of its intercompany items.

To the extent S defers its intercompany inventory items under the

increment averaging method, S layers the items based on the

corresponding layers of B's costs. S takes the deferred items into

account under the matching rule as B takes into account its

corresponding layers through subsequent decrements.

The increment valuation method is similar to the increment

averaging method. Under the increment valuation method, a ratio is

determined based on the current-year costs of the layer of increment

over the total costs incurred in the appropriate period used to value

the increment. The appropriate period is the period of B's year used to

determine current-year costs. This ratio is applied to S's intercompany

inventory items computed with respect to intercompany inventory sales

during the appropriate period. For example, if B determines current-

year costs by reference to its earliest costs, and only the inventory

costs incurred in B's first inventory turn are included for this

purpose, the appropriate period is the period of B's year that includes

its first inventory turn.

S determines the amount of its total intercompany inventory items

for a year under any reasonable method for allocating its inventory

costs to intercompany transactions. If S uses a dollar-value LIFO

inventory method and a decrement occurs for the year, S must reasonably

take into account the costs of prior layers of increment. For example,

S may compute its intercompany inventory income using its most recent

costs incurred if S has an increment for the year and S uses the

earliest acquisitions cost method to value increments. Similarly, S may

use an average of its costs incurred during the year if S uses this

method to value increments or if S does not experience a significant

increment or decrement for the year.

The current regulations determine whether inventory is disposed of

outside the group by reference to B's method of inventory

identification (e.g., FIFO, LIFO, or specific identification). Because

the current regulations require B to consider the effect of its use of

dollar-value LIFO, it is not anticipated that the proposed regulations

will result in a significant change. Taxpayers can continue to use

their current methods after the final intercompany transactions

regulations apply if the current methods are reasonable.

b. Reserve Accounting

Reserve accounting is permitted only for special status members,

and it is inappropriate to apply some aspects of reserve accounting on

a single entity basis (e.g., where both parties to an intercompany

transaction do not have the same special status). To the extent that

reserve accounting should apply to intercompany transactions, the

necessary adjustments to produce single entity results may be complex.

The proposed regulations provide that a member's addition to, or

reduction of, a reserve for bad debts that is maintained under section

585 or 593 is generally taken into account on a separate entity basis.

But see ``Obligations of members,'' discussed at C.7. of this preamble

(special rules for reserve deductions with respect to intercompany

obligations). Similarly, if a member provides insurance to another

member in an intercompany transaction, the transaction is taken into

account by both members on a separate entity basis.

c. Elections

Section 1.1502-13(c)(3) of the current regulations provides that a

group may elect with the consent of the Commissioner not to defer

intercompany gain or loss from deferred intercompany transactions with

respect to all or any classes of property. See also Rev. Proc. 82-36,

1982-1 C.B. 490 (a checklist and guidelines for requests under

Sec. 1.1502-13(c)(3)).

The proposed regulations continue to permit groups to request that

items from intercompany transactions (other than transactions with

respect to stock or obligations of members), be taken into account on a

separate entity basis rather than under the intercompany transaction

system. Any election under current Sec. 1.1502-13(c)(3) will remain in

effect. As under current law, an election to take items into account on

a separate entity basis does not apply for purposes of taking losses

into account under section 267(f).

Current Sec. 1.1502-13(f)(3) provides that the IRS may enter into a

closing agreement with a group required to divest itself of a member by

order of law. The closing agreement generally allows the group to take

into account deferred gain or loss as if it had not disposed of the

member (but not over more than 10 years). Closing agreements generally

will not be entered into where the divestiture is occasioned by an

acquisition after August 31, 1966. Consequently, this provision is

eliminated under the proposed regulations as deadwood.

Current Sec. 1.1502-13(j) provides that the IRS may enter into a

closing agreement providing special treatment for public utilities. The

proposed regulations also eliminate this provision as deadwood, because

a request for a closing agreement must have been made on or before

November 15, 1966.

Any groups currently subject to a closing agreement under a

deadwood provision eliminated by the proposed regulations will remain

subject to the terms of the closing agreement.

6. Stock of Members

Sections 1.1502-14 and 1.1502-31(b) of the current regulations

provide special rules for distributions and other transactions with

respect to stock of members. These stock rules combine single and

separate entity treatment.

The current regulations eliminate intercompany dividends from the

gross income of the distributee. Section 301 distributions (whether or

not dividends) first reduce the distributee member's basis in the

distributing member's stock to zero, and then create an excess loss

account in the stock.

If appreciated property is distributed in a distribution to which

section 301 applies, the current regulations provide that the

distributing member recognizes gain under section 311 that is deferred

and taken into account in the same manner as if it were recognized in a

deferred intercompany transaction. The distributee's basis in the

property received is generally its fair market value.

No special rules are provided under the current regulations for

reorganization transactions and transactions to which section 355

applies.

Liquidating distributions are governed by either section 331 or 332

as to the distributee, and section 336 or 337 as to the distributing

member. Under Sec. 1.1502-34, the stock ownership of all members is

aggregated to determine whether section 332 applies to the distributee.

Under section 337(c), however, the ownership is not aggregated to

determine whether section 337 applies to the distributing member. Gain

or loss recognized by the distributing member under section 336 is

deferred under the current regulations and taken into account as if it

were recognized in an intercompany transaction. If the distributee

member would recognize gain or loss from the liquidation under section

331, the distributee's gain or loss is limited under the current

regulations, but preserved by determining the distributee's basis in

the distributed property by reference to the distributee's basis in the

stock surrendered.

Other recent consolidated return regulation projects address

aspects of intercompany distributions and other transactions with

respect to stock of members. See, e.g., Sec. 1.1502-80(b) (non-

applicability of section 304 to transactions between members), proposed

Sec. 1.1502-80(c) (deferral of section 165(g)), and proposed

Sec. 1.1502-80(d) (replacing current Sec. 1.1502-14(a)(2), and

providing for the non-applicability of section 301(c)(3) to transfers

between members).

The proposed regulations generally apply the rules of the Code and

the matching and acceleration rules to transactions with respect to

stock of members. For example, if S sells to B the stock of another

member (T) at a gain, S's gain is taken into account under the matching

and acceleration rules.

The proposed regulations provide that intercompany distributions

are generally not included in the gross income of the distributee

member. However, this exclusion applies to a distribution from a

subsidiary only to the extent there is a corresponding negative

adjustment reflected under Sec. 1.1502-32 in the distributee's basis in

the distributing member's stock. By conditioning the exclusion on a

negative adjustment, the concerns with dividend stripping transactions

illustrated by current Sec. 1.1502-32(k) are minimized. Intercompany

distributions are taken into account for all Federal income tax

purposes when the members become entitled to them (generally the record

date) or, if earlier, when they are taken into account under the Code

(e.g., under section 305(c)).

Excluding intercompany dividends from gross income is intended to

have the same effect as eliminating them under the current regulations,

but it conforms to the terminology generally used under the Code. For

example, the holdings in Revenue Ruling 72-230, 1972-1 C.B. 209 (the

effect of dividend elimination on the source of dividends paid for

purposes of section 861(a)(2)) and Revenue Ruling 79-60, 1979-1 C.B.

211 (the effect of dividend elimination on personal holding company

status), and the application of section 1059, are not affected.

The matching and acceleration rules apply to the distributing

member's gain under section 311(b) from intercompany distributions of

property. The proposed regulations provide that the distributing

member's loss from an intercompany distribution of property is also

recognized under the principles of section 311(b) and is taken into

account under the matching and acceleration rules. In effect,

intercompany distributions are equated with intercompany sales.

The recognition of loss from distributions applies only to

intercompany distributions. For example, S's loss from distributing

property to B is recognized, but S's loss from distributing the

property to a nonmember is not recognized. Under the matching rule, a

buying member's nonrecognition of loss from the distribution of

property to a nonmember may result in prior intercompany gain (or loss)

from the property being recharacterized as excluded from gross income

(or as a noncapital, nondeductible amount). For example, if S sells

property to B at a loss, and B later distributes it to a nonmember at

no gain or loss, S's intercompany loss is recharacaterized as a

noncapital, nondeductible amount. In effect, a group is treated as a

single entity with respect to the nonrecognition of loss under section

311 on distributions to nonmembers.

The proposed regulations provide special rules to minimize the

effect on consolidated taxable income of boot in intercompany

reorganizations. Boot received by a member as a shareholder in an

intercompany reorganization is treated as received in a separate

transaction. Thus, consolidated taxable income is generally the same

whether the boot is distributed as part of the reorganization, before

it, or after it.

The proposed boot rules do not apply to a reorganization if any

participant becomes a member or becomes a nonmember as part of the same

plan or arrangement. The proposed rules do not reflect any decisions

about boot received in other reorganizations such as those involving

unrelated corporations or affiliated corporations filing separate

returns. The tax results of reorganizations straddling consolidation

remain under study because of the significant differences between boot

transferred between members of a consolidated group and boot

transferred between separate return corporations.

The proposed regulations provide that if a member acquires its own

stock in an intercompany transaction, its basis in that stock is

treated as eliminated for purposes of taking intercompany items into

account with respect to the stock. Thus, if S distributes B stock to B,

S's gain or loss from the distribution is taken into account

immediately to reflect the elimination of basis. Compare Gen. Coun.

Mem. 39,608 (March 5, 1987) (S's gain from the distribution of B stock

to B is deferred until, for example, B sold the same shares to a

nonmember). On the other hand, if S transfers to B the stock of T, and

B subsequently transfers the stock to T in exchange for new T stock in

a recapitalization to which section 368(a)(1)(E) applies, S's

intercompany gain or loss remains deferred and is taken into account by

reference to the replacement stock. See ``Successor corporations and

property,'' discussed at C.9. of this preamble.

Under the current regulations, intercompany gain or loss from

transferring the stock of a member is taken into account when that

member liquidates under section 332. For example, if S sells all of the

stock of T to B at a gain, and T later liquidates in an unrelated

transaction to which section 332 applies, 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 proposed regulations provide relief from this duplication in

limited circumstances. Under the first rule, if section 332 applies to

T's liquidation and B transfers substantially all of T's assets to a

new member (new T), the transfer to new T is treated as pursuant to the

same plan or arrangement as the liquidation and S's gain generally will

not be taken into account. Instead, S's gain is taken into account by

reference to the stock of new T. New T must be formed and the relief

elected by the group within specified time periods. Similar principles

apply if B's basis in the T stock is eliminated in a transaction

comparable to the section 332 liquidation (e.g., a downstream merger).

Under the second rule, if T's liquidation is deemed to occur under

section 338(h)(10) as a result of a qualified stock purchase of T, B is

treated, subject to certain limitations, as recognizing any loss or

deduction it would recognize (determined after adjusting stock basis

under Sec. 1.1502-32) if section 331 applied to the deemed liquidation.

In effect, S's income or gain is offset by B's deduction or loss in

determining consolidated taxable income (although S and B must take

into account their separate items). Similar principles apply if T

transfers all of its assets to a nonmember and completely liquidates in

a transaction comparable to a section 338(h)(10) transaction.

The third rule applies if member stock is transferred in an

intercompany transaction and subsequently distributed in a second

intercompany transaction to which section 355 applies. S's gain or loss

might otherwise be taken into account under the proposed regulations

because the basis adjustments to the T stock under section 358 may

result in an inability to match the T stock basis with S's gain. Relief

is provided by permitting the group to elect to treat B's distribution

as subject to sections 301 and 311 rather than section 355, so that

matching with S's gain remains possible. This prevents S's gain from

being taken into account immediately if matching remains possible, but

B's gain or loss from its distribution will also be taken into account

under the matching and acceleration rules.

7. Obligations of Members

Current Sec. 1.1502-13 provides that the general rules for

intercompany transactions apply to the payment of interest and premium

on intercompany obligations. Current Sec. 1.1502-14(d) provides for the

deferral of a member's gain or loss from the disposition of another

member's obligation. Similar rules apply to a member's deduction for

the worthlessness of an obligation and the deduction for an addition to

a reserve for bad debts with respect to an obligation.

If a member's obligation is transferred to a nonmember (or the

holding member becomes a nonmember), the deferred amount is generally

taken into account ratably over the remaining term of the obligation.

In effect, the deferred amount is reflected in consolidated taxable

income under rules similar to the rules that existed under the Code in

1966 for original issue discount or amortizable bond premium. If the

obligation remains within the group, the deferred amount is generally

not taken into account until the obligation is redeemed. Thus, the

gains and losses of the members with respect to the obligation

generally offset each other in determining consolidated taxable income.

Section 108(e)(4) 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.

Under the proposed regulations, the matching and acceleration rules

apply to intercompany obligations. An obligation is defined to include

securities described in section 475(c)(2) (D) and (E), and comparable

securities with respect to commodities. For example, an interest rate

notional principal contract between members is an obligation between

the counterparties. An obligation is an intercompany obligation during

the period its parties are members.

The proposed regulations continue to treat each payment or accrual

of interest (and each payment or accrual of premium) on an intercompany

debt as a separate intercompany transaction, and the income is matched

with the deduction. Similarly, each periodic and nonperiodic payment

with respect to an intercompany notional principal contract is a

separate intercompany transaction.

Special rules are proposed for two categories of transactions: (1)

Transactions in which an intercompany obligation becomes a

nonintercompany obligation (or remains an intercompany obligation but

gain or loss is realized with respect to it); and (2) transactions in

which a nonintercompany obligation becomes an intercompany obligation.

In both categories, an obligation is generally deemed to be satisfied

and, if it remains outstanding, reissued. There are, however,

significant differences as to how the transactions are deemed to occur.

Under the first category, if S holds a note of B with a $100 basis

and stated redemption price at maturity, and S sells the note to a

nonmember for $75, B is treated as satisfying its obligation to S for

$75 immediately before S's sale, and issuing a new note directly to the

nonmember for $75 with a $100 stated redemption price at maturity. The

proposed regulations match both the timing and the attributes of S's

items and B's items resulting from the deemed satisfaction. Similar

principles apply if the note is transferred by S to another member in

an intercompany transaction, the note is marked to market under section

475, or if S or B becomes a nonmember (i.e., the note is deemed to be

satisfied by B and reissued). Similar principles also apply if the

obligation is a notional principal contract or other nondebt

intercompany obligation.

The effect on consolidated taxable income for transactions in the

first category is similar to the effect under current Sec. 1.1502-

14(d). In both cases, reflection of the net gain or loss on

consolidated taxable income is deferred in a manner consistent with

time value of money principles. Under the proposed regulations,

however, if S sells B's obligation to a nonmember at a loss, S's loss

and B's gain from the deemed satisfaction are taken into account

immediately and offset each other, and the discount from the deemed

reissuance is taken into account over time by B (as the issuer) rather

than by S. This approach more accurately adjusts the stock basis of S

and B each year, and is closer to the results under common law

principles for debtors and creditors in a parent-subsidiary

relationship. The approach of the proposed regulations in many respects

treats B's obligation as first existing only after it is sold by S to

the nonmember. Thus, if a nonmember buys B's note from S at a discount,

the nonmember will hold the note with original issue discount to which

section 1272 applies, rather than market discount to which sections

1276 through 1278 apply.

Under the second category, if a nonmember (X) holds B's note with a

$100 basis and stated redemption price at maturity, and X sells the

note to S for $75, B is treated as satisfying its obligation to S for

$75 immediately after S's purchase, and issuing a new note to S for $75

with a $100 stated redemption price at maturity.

The treatment for transactions under the second category is similar

in many respects to the treatment of B under section 108(e)(4). Because

the focus of section 108(e)(4) is to prevent avoidance of discharge of

indebtedness income, however, that section does not adequately address

the single entity treatment of consolidated groups. Consequently, the

proposed regulations apply to cases beyond the scope of section

108(e)(4), such as to the acquisition of debt at a premium and to all

cases in which a corporation holding B's debt becomes a member (whether

or not there is an avoidance view, and whether or not the holder is

already a related party).

The deemed satisfaction and reissuance under the proposed

regulations applies to both the issuer and the holder, and the

character of their respective items under the Code is not modified (and

therefore may not match). Nevertheless, the amount at which an

obligation is satisfied under Sec. 1.108-2 represents a compromise that

is incorporated into the proposed regulations. In addition, the

proposed regulations adopt the exceptions to section 108(e)(4) for

special cases, such as securities dealers.

Because a member's adjustments to a reserve for bad debts under

section 585 or 593 reflect its general bad debt experience, rather than

the value of any particular intercompany obligation that it holds, the

proposed regulations provide special rules. Reserve deductions with

respect to intercompany obligations are deferred in a manner similar to

the treatment of reserves under current Sec. 1.1502-14(d). This

approach prevents the reserve accounting method of one member from

affecting the income of another member (or affecting consolidated

taxable income) through a bad debt reserve deduction with respect to an

intercompany debt.

Section 163(e)(5) provides special rules for original issue

discount on an applicable high yield discount obligation (AHYDO). The

concerns reflected in the AHYDO rules do not apply to intercompany

debt, and the Code provides only a partial recast for the dividend

equivalent portion of the disqualified portion of the original issue

discount. Consequently, to simplify the applicable rules, the proposed

regulations exclude intercompany obligations from the application of

section 163(e)(5).

8. Anti-Avoidance Rules

Although the proposed regulations shift the emphasis of the

intercompany transaction system toward single entity treatment, tension

remains between the single entity and separate entity treatment of

consolidated groups. The proposed regulations do not address every

interaction with other consolidated return regulations and other rules

of law. To ensure that the proposed regulations achieve neutrality in

the overall determination of consolidated taxable income, adjustments

may be required. For example, if the approach of the proposed

regulations in matching the attributes of S's intercompany items and

B's corresponding items facilitates ``mirror subsidiary'' transactions

determined by Congress to be inappropriate, adjustments must be made.

See H.R. Rep. No. 391, 100th Cong., 1st Sess. 1081-84 (1987).

Adjustments must be made under the proposed regulations if a

transaction is engaged in or structured with a principal purpose to

avoid treatment as an intercompany transaction, or to avoid the

purposes of the proposed regulations. For example, in the case of a

``mirror subsidiary'' transaction, the adjustments would generally

conform to the intent of the mirror legislation to ``require the

recognition of corporate-level gain whenever an appreciated subsidiary

is sold or distributed outside the economic unit of [a consolidated]

group.'' Id.

In addition to these adjustments, the Code (e.g., sections 337(d),

446, and 482) and general principles of tax law (e.g., the substance-

over-form doctrine, and the tax benefit rule) can apply to require

proper measurement of taxable income (and tax liability).

9. Successor Corporations and Property

Under the current regulations, if S's assets are acquired in a

transaction to which section 381(a) applies, its deferred gains and

losses are inherited by the member that receives the ``greatest portion

of the assets (measured by fair market value).'' Commentators have

suggested that this rule can be used to facilitate the breakup of

acquired corporations without corporate-level tax, contrary to the

intent of the ``mirror'' subsidiary legislation. Moreover, they have

raised questions as to the operation of this rule in many

circumstances. For example, the reference to fair market value does not

identify whether liabilities are to be taken into account to determine

the value on a net basis.

The proposed regulations generally incorporate successor asset and

successor person principles. References under the proposed regulations

to an asset or to a member include, as the context may require,

references to a successor asset or person.

The proposed regulations provide that, if there is more than one

successor, the successors take into account the predecessor's

intercompany items in a manner that is consistently applied and

reasonably carries out the purposes of the proposed regulations and

applicable provisions of law. No inference is intended by this rule as

to the application of section 381 or other successor principles to

attributes other than intercompany items and corresponding items.

The proposed regulations retain the basic approach of the current

regulations by not requiring acceleration solely because a group

terminates from its acquisition by another consolidated group. Unlike

the current regulations, however, the proposed regulations do not

require all of the members immediately before the acquisition to become

members of the surviving consolidated group. Instead, the proposed

regulations accelerate only the items from transactions involving

corporations that do not become members of the surviving consolidated

group.

D. Explanation of Proposed Section 267(f) Rules

Section 267(a) disallows loss on certain sales or exchanges of

property between related parties. Section 267(f) provides for deferral

of loss on the sale or exchange of property between members of a

controlled group, rather than disallowance of the loss under section

267(a). The section 267(f) rules are generally intended to conform to

the intercompany transaction rules applicable to consolidated groups

even though the definition of a controlled group is broader than that

of a consolidated group.

The legislative history indicates that exceptions to deferral might

be provided to properly reflect the amount of net income from a

transaction. For example, if an accrual method member of a controlled

group takes into account income with respect to the face amount of a

note receivable, and later recognizes loss from the sale of that note

to another member of the controlled group at a discount, the loss would

not be deferred to the extent it does not exceed the income taken into

account. See H.R. Rep. No. 861, 98th Cong., 2d Sess. 1032-34 (1984).

The current regulations applicable to controlled groups generally

conform to the basic intercompany transaction rules applicable to

consolidated groups. See Secs. 1.267(f)-1T and 1.267(f)-2T.

Modifications are made to reflect the broader application of section

267(f).

For example, although there are no subgroup rules for intercompany

transactions between members of a consolidated group, deferral of loss

continues under section 267(f) as long as S and B remain in a

controlled group relationship with each other. The current regulations

also provide that if S sells property to B at a loss, and the property

is still owned by B when S ceases to be a member of the same controlled

group, S never takes the loss into account. Instead, B's basis in the

property is increased by an amount equal to S's unrestored loss.

The proposed regulations retain the basic approach of the current

regulations but simplify their operation by more generally

incorporating the consolidated return rules.

The proposed regulations eliminate the rule that transforms S's

loss into additional basis in the transferred property when S ceases to

be a member of the controlled group. Instead, the proposed regulations

generally allow S's loss immediately before it ceases to be a member.

This conforms to the consolidated return rules, and eliminates the need

for special rules. An anti-avoidance rule is adopted, however, to

prevent the purposes of section 267(f) from being circumvented, for

example, by using the proposed rule to accelerate S's loss.

E. Other Applicable Rules

1. Methods of Accounting

Under current Sec. 1.1502-17(a), each member is generally permitted

to determine its own method of accounting as if separate returns were

filed. Thus, the members may have different methods for similar trades

or businesses. If, however, B acquires assets from S in a transaction

to which section 381 applies, B might be required to use the same

method of accounting as S. See, e.g., section 381(c)(4).

The matching rule proposed in Sec. 1.1502-13 relies on the

accounting methods of B to determine the timing of S's intercompany

items. Because B's accounting methods generally control S's timing, a

group might be able to frustrate the principles of single entity

treatment under Sec. 1.1502-13 by rearranging its activities to use an

accounting method that would not be available if S and B were divisions

of a single corporation.

Under the proposed regulations, if B directly or indirectly

acquires an activity of S or undertakes S's activity, with the

principal purpose to avail the group of an accounting method that would

be unavailable without securing the Commissioner's consent if S and B

were treated as divisions of a single corporation, B may be required to

use S's accounting method for the acquired or undertaken activity or

secure consent from the Commissioner for a different method.

2. Special Inventory Adjustment

Current Sec. 1.1502-18 requires a special adjustment relating to

intercompany profit from inventory transactions if an affiliated group

filing separate returns elects to file consolidated returns. This

adjustment has historically been included in the consolidated return

regulations. It is intended to prevent the members' income from being

reduced when the group switches from separate to consolidated returns.

For example, if S and B are affiliated but file separate returns

for Year 1 and S manufactures inventory for $75 that is sold to B for

$100, S's $25 intercompany profit is taken into account in Year 1 and B

has a $100 cost basis in the inventory. If S recognizes another $25 of

intercompany profit in Year 2, and B sells the inventory purchased from

S in Year 1, S's additional $25 profit is taken into account in Year 2

and B recovers its cost basis in the inventory purchased in Year 1. If,

however, the group shifts to consolidated returns for Year 2, S's

additional $25 profit is deferred under Sec. 1.1502-13 but B still

recovers its cost basis. Thus, the shift to consolidated returns

reduces the group's aggregate income in Year 2. If S and B continue the

same intercompany activity year after year, the one-time reduction is

effectively a permanent reduction.

To prevent a reduction in taxable income, the current regulations

provide for a special inventory adjustment to increase the group's

consolidated taxable income for Year 2 by S's $25 intercompany profit

from Year 1, to the extent that it is reflected in B's opening

inventory for Year 2. The adjustment might ultimately be reversed in

later years if, for example, B's ending inventory purchased from S is

reduced or the group ceases to file consolidated returns.

Commentators argue that Sec. 1.1502-18 reaches an inappropriate

result, and that its effect can be avoided, for example, by causing S

to transfer its assets to a lower-tier member in a transaction to which

section 351 applies (or otherwise to cease its intercompany sales).

To simplify the intercompany transaction system, the proposed

regulations eliminate the special inventory adjustment. Any remaining

unrecovered inventory amount under Sec. 1.1502-18(c) (or its equivalent

under Sec. 1.1502-18(f)) is recovered under the principles of those

rules in the first taxable year ending on or after the date final

regulations are filed with the Federal Register. The unrecovered

inventory amount can be recovered only to the extent it was previously

included in taxable income.

3. Attribute Reduction (Section 108(b))

The proposed regulations provide rules to prevent avoidance of the

attribute reduction required under section 108(b). Several issues

regarding the application of section 108 to consolidated groups are

under study. For example, single entity treatment for consolidated

group attribute reduction under section 108(b) is being considered in

connection with regulations being developed. The proposed regulations

are not intended to affect any other aspects of the application of

section 108.

4. Applicability of Section 1031

The current regulations do not provide special rules for

intercompany transactions to which section 1031 applies.

Section 1031 treatment for intercompany transactions is

inconsistent with the general approach of the proposed regulations. If

the members had been divisions of a single corporation, the basis of

one property could not be substituted as the basis for another

property. Although section 1031(f) limits the planning opportunities

from certain basis shifts, the limitations do not adequately address

the single entity treatment of consolidated groups under the proposed

regulations.

To conform the treatment of like-kind exchanges more closely to the

general treatment of intercompany transactions under the proposed

regulations, the proposed regulations provide that section 1031 does

not apply to intercompany transactions. Any gain or loss of the members

will be taken into account under the matching and acceleration rules.

F. Proposed Effective Dates

The proposed intercompany transaction regulations generally apply

to intercompany transactions occurring in years beginning on or after

the date the final regulations are filed with the Federal Register.

Prior intercompany transactions will generally continue to be subject

to the prior regulations under section 1502 as in effect with respect

to the transaction.

Because an intercompany transaction can occur in part under the

current regulations and in part under the proposed regulations, the

current regulations (rather than the proposed regulations) will

continue to apply to take into account transactions that have already

been taken into account in part under the current regulations. This

approach prevents duplication or omission of items from a transaction,

and treats items consistently.

To prevent manipulation, the final regulations (and not prior law)

apply to certain transactions engaged in or structured on or after

April 8, 1994. The final regulations apply if the transaction is

engaged in or structured with a principal purpose to avoid the final

regulations, to duplicate, omit, or eliminate an item in determining

taxable income (or tax liability), or to treat items inconsistently. In

these cases, appropriate adjustments must be made in years beginning on

or after [the date the final regulations are filed with the Federal

Register], to prevent the avoidance, duplication, omission,

elimination, or inconsistency.

The methods of accounting provided in the final regulations will be

required of all groups. If the final regulations are adopted on the

proposed ``cut-off'' basis, no request for permission to make the

change, or to make an adjustment under section 481(a), will be

necessary.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required. It has also been determined

that section 553(b) of the Administrative Procedure Act (5 U.S.C.

chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do

not apply to these regulations, and, therefore, a Regulatory

Flexibility Analysis is not required. Pursuant to section 7805(f) of

the Code, this notice of proposed rulemaking will be submitted to the

Chief Counsel for Advocacy of the Small Business Administration for

comment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted, consideration will

be given to any written comments that are submitted timely (preferably

a signed original and eight copies) to the IRS. All comments will be

available for public inspection and copying in their entirety. Two

public hearings on the proposed regulations will be held. See the

notice of public hearings on proposed rulemaking published elsewhere in

this issue of the Federal Register.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by

removing the entries for sections ``1.469-1, 1.469-1T, 1.469-2, 1.469-

2T, 1.469-3, 1.469-3T, 1.469-5, 1.469-5T and 1.469-11'', ``1.1502-13'',

``1.1502-13T'', ``1.1502-14'', and ``1.1502-14T'' and adding the

following:

Authority: 26 U.S.C. 7805 * * * Section 1.108-3 also issued

under 26 U.S.C. 108, 267, and 1502. * * * Section 1.267(f)-1 also

issued under 26 U.S.C. 267 and 1502. * * * Section 1.460-4 also

issued under 26 U.S.C. 460 and 1502. * * * Section 1.469-1, 1.469-

1T, 1.469-2, 1.469-2T, 1.469-3, 1.469-3T, 1.469-5, 1.469-5T, and

1.469-11 also issued under 26 U.S.C. 469. * * * Section 1.1502-13

also issued under 26 U.S.C. 108, 337, 446, 1275, 1502 and 1503. * *

* Section 1.1502-17 also issued under 26 U.S.C. 446 and 1502.

Section 1.1502-18 also issued under 26 U.S.C. 1502. * * * Section

1.1502-26 also issued under 26 U.S.C. 1502. * * * Section 1.1502-33

also issued under 26 U.S.C. 1502. * * *

Par. 2. In the list below, for each location indicated in the left

column, remove the language in the middle column from that section, and

add the language in the right column.

------------------------------------------------------------------------

Affected section Remove Add

------------------------------------------------------------------------

1.167(a)-(11)(d)(3)(v)(b) Paragraph (c) of........

, 1st sentence.

1.263A-1T(b)(2)(vi)(B), A deferred intercompany An intercompany

2nd sentence. transaction. transaction.

1.263A-1T(e)(1)(ii), 1st A deferred intercompany An intercompany

sentence. transaction. transaction.

1.263A-1T(e)(1)(ii), 4th 1.1502-13(c)(2)......... 1.1502-13.

sentence.

1.263A-1T(e)(1)(ii), 4th Deferred.

sentence.

1.263A-1T(e)(1)(ii), 7th Deferred intercompany Intercompany

sentence. transaction. transaction.

1.263A-1T(e)(1)(ii), 7th Defined................. As used.

sentence.

1.263A-1T(e)(1)(iii)(A) 1.1502-13(c)............ 1.1502-13.

Example, 2nd sentence.

1.263A-1T(e)(1)(iii)(A) 1.1502-13(c)............ 1.1502-13.

Example, 4th sentence.

1.338-4(f)(4) Example (2) 1.1502-13(f)............ 1.1502-13.

(a).

1.341-7(e)(10)........... Paragraph (c)(1) of Sec. Sec. 1.1502-13.

1.1502-14.

1.861-8T(d)(2)(i), 1.1502-13(c)(2)......... 1.1502-13.

concluding text.

1.861-8T(d)(2)(i), Deferred.

concluding text.

1.861-8T(d)(2)(i), 1.1502-13(a)(2)......... 1.1502-13.

concluding text.

1.861-9T(g)(2)(iv), Deferred.

paragraph heading.

1.861-9T(g)(2)(iv), 1st Deferred intercompany Intercompany

sentence. transactions transactions.

1.1502-3(a)(2)........... 1.1502-13(a)(1)......... 1.1502-13(b).

1.1502-4(j) Example (1), Paragraph (d), (e), or 1.1502-13.

8th sentence. (f) of Sec. 1.1502-13.

1.1502-4(j) Example (1), Paragraph (d), (e), or 1.1502-13.

2nd sentence after chart. (f) of Sec. 1.1502-13.

1.1502-9(f) Example (6).. 1.1502-13(f)............ 1.1502-13.

1.1502-12(a)............. Secs. 1.1502-13 and Sec. 1.1502-13.

1.1502-14.

1.1502-12(g)(2).......... A deferred intercompany An intercompany

transaction as defined transaction as

in Sec. 1.1502-13(a)(2). defined in Sec.

1.1502-13.

1.1502-22(a)(3).......... 1.1502-14,.............. ...................

1.1502-22(a)(5) Example Paragraph (d), (e), or Sec. 1.1502-13.

(i). (f) of Sec. 1.1502-13.

1.1502-26(b)............. Paragraph (a)(1) of Sec. Sec. 1.1502-13.

1.1502-14.

1.1502-47(e)(4)(iii)..... Secs. 1.1502-13(f), Secs. 1.1502-13,

1.1502-14, 1.1502-18,. 1.1502-18.

1.1502-47(e)(4)(iv) Deferred intercompany Intercompany

Example 4, 3d sentence. transactions (see Sec. transactions (see

1.1502-13(a)(2)). Sec. 1.1502-13).

1.1502-47(e)(4)(iv) 1.1502-13(f)(1)(iv)..... 1.1502-13.

Example 4, 4th sentence.

1.1502-47(e)(4)(iv) Deferred intercompany Intercompany

Example 4, chart header. transactions between. transactions

between.

1.1502-47(e)(4)(iv) 1.1502-13(f)(1)(iv)..... 1.1502-13.

Example 4, chart header.

1.1502-47(f)(3).......... 1.1502-14.

1.1502-47(r), 2nd Deferred.

sentence.

1.1503-2(d)(4) Example 1 Deferred.

(iii), 4th sentence.

1.1503-2(d)(4) Example 1 1.1502-13(a)(2)......... 1.1502-13.

(iii), 4th sentence.

------------------------------------------------------------------------

Par. 3. Section 1.108-3 is added to read as follows:

Sec. 1.108-3 Intercompany losses and deductions.

(a) General rule. This section applies to certain losses and

deductions from the sale, exchange, or other transfer of property

between corporations that are members of a consolidated group or a

controlled group (an intercompany transaction). See section 267(f)

(controlled groups) and Sec. 1.1502-13 (consolidated groups) for

applicable definitions. For purposes of determining the attributes to

which section 108(b) applies, a loss or deduction not yet taken into

account under section 267(f) or Sec. 1.1502-13 (an intercompany loss or

deduction) is treated as basis described in section 108(b) that the

transferor retains in property. For example, if S and B are

corporations filing a consolidated return, and S sells land with a $100

basis to B for $90 and the $10 loss is deferred under section 267(f)

and Sec. 1.1502-13, the deferred loss is treated for purposes of

section 108(b) as $10 of basis that S has in land (even though S has no

remaining interest in the land sold to B) and is subject to reduction

under section 108(b)(2)(E). To the extent S's loss is reduced, it can

not thereafter be taken into account under section 267(f) or

Sec. 1.1502-13. Similar principles apply, with appropriate adjustments,

if S and B are members of a controlled group and S's loss is deferred

only under section 267(f).

(b) Effective date. This section applies with respect to discharges

of indebtedness occurring on or after [the date that is 60 days after

final regulations are filed with the Federal Register.

Sec. 1.167(a)-11 [Amended]

Par. 4. Section 1.167(a)-11(d)(3)(v)(e) is amended by removing the

second sentence of Example (3).

Par. 5. Section 1.267(f)-1 is revised to read as follows:

Sec. 1.267(f)-1 Controlled groups.

(a) In general--(1) Purpose. This section provides rules under

section 267(f) to defer losses and deductions from certain transactions

between members of a controlled group (intercompany sales). The purpose

of the deferral is to prevent tax avoidance from allowing the loss or

deduction of the selling member (S) without the corresponding inclusion

of the buying member (B).

(2) Application of consolidated return principles. Under this

section, S's loss or deduction from an intercompany sale is taken into

account under the timing principles of Sec. 1.1502-13 (intercompany

transactions between members of a consolidated group), treating the

intercompany sale as an intercompany transaction. For this purpose:

(i) The matching and acceleration rules of Sec. 1.1502-13(c) and

(d), the definitions and operating rules of Sec. 1.1502-13(b) and (j),

and the simplifying rules of Sec. 1.1502-13(e)(1) apply with the

adjustments in paragraphs (b) and (c) of this section to reflect that

this section--

(A) Applies on a controlled group basis rather than consolidated

group basis; and

(B) Generally affects only the timing of a loss or deduction, and

not its attributes (e.g., its source and character) or the holding

period of property.

(ii) The special rules under Sec. 1.1502-13(f) (stock of members)

and (g) (obligations of members) apply under this section only to the

extent that the transaction is also an intercompany transaction to

which Sec. 1.1502-13 applies.

(iii) Any election under Sec. 1.1502-13 to take items into account

on a separate entity basis does not apply under this section. See

Sec. 1.1502-13(e)(3).

(3) Other law. The rules of this section apply in addition to other

applicable law. For example, to the extent a loss or deduction deferred

under this section is from a transaction that is also an intercompany

transaction under Sec. 1.1502-13(b)(1), the loss or deduction is also

subject to recharacterization under Sec. 1.1502-13. See also sections

269 (acquisitions to evade or avoid income tax) and 482 (allocations

among commonly controlled taxpayers). Any loss or deduction taken into

account under this section can be deferred, disallowed, or eliminated

under other applicable law. See, e.g., section 1091 (loss eliminated on

wash sale).

(4) Construction. The rules of this section must be applied in a

consistent manner that reasonably carries out their purposes, taking

into account all of the facts and circumstances, the underlying

economic arrangement, and applicable Federal income tax accounting

principles. For example, the rules must not be applied to accelerate or

duplicate S's losses or deductions.

(b) Definitions and operating rules. The definitions in

Sec. 1.1502-13(b) and the operating rules of Sec. 1.1502-13(j) apply

under this section with appropriate adjustments, including the

following:

(1) Intercompany sale. An intercompany sale is a sale, exchange, or

other transfer of property between members of a controlled group, if it

would be an intercompany transaction under the principles of

Sec. 1.1502-13, determined by treating the references to a consolidated

group as references to a controlled group and by disregarding whether

any of the members join in filing consolidated returns.

(2) S's losses or deductions. Unless the intercompany sale is also

an intercompany transaction to which Sec. 1.1502-13 applies, S's losses

or deductions subject to this section are determined on a separate

entity basis. For example, the principles of Sec. 1.1502-13(b)(2)(i)(C)

(treating certain amounts not yet recognized as items to be taken into

account) do not apply. A loss or deduction is from an intercompany sale

whether it is directly or indirectly from the intercompany sale.

(3) Controlled group; member. For purposes of this section, a

controlled group is defined in section 267(f). Thus, a controlled group

includes a FSC (as defined in section 922) and excluded members under

section 1563(b)(2), but does not include a DISC (as defined in section

992). Because corporations may be controlled group members without

joining in the filing of consolidated returns or being owned through a

common parent, corporations remain members of a controlled group as

long as they remain in a controlled group relationship with each other.

For example, corporations become nonmembers with respect to each other

when they cease to be in a controlled group relationship with each

other, rather than by having a separate return year (described in

Sec. 1.1502-13(j)(4)). Further, the principles of Sec. 1.1502-13(j)(3)

(former common parent treated as continuation of group) apply to any

corporation if, immediately before it becomes a nonmember, it is both

the selling member and the owner of property with respect to which a

loss or deduction is deferred (whether or not it becomes a member of a

different controlled group filing consolidated or separate returns).

(4) Consolidated taxable income. References to consolidated taxable

income (and consolidated tax liability) include references to the

combined taxable income of the members (and their combined tax

liability). For corporations filing separate returns, it ordinarily

will not be necessary to actually combine their taxable incomes (and

tax liabilities) because the taxable income (and tax liability) of one

corporation does not affect the taxable income (or tax liability) of

another corporation.

(c) Matching and acceleration principles of Sec. 1.1502-13--(1)

General rule. Under this section, S's losses and deductions are

deferred until they are taken into account under the timing principles

of the matching and acceleration rules of Sec. 1.1502-13 (c) and (d),

with appropriate adjustments. For example, if S sells depreciable

property to B at a loss, S's loss is deferred and taken into account

under the principles of the matching rule of Sec. 1.1502-13(c) to

reflect the difference between B's depreciation taken into account with

respect to the property and the depreciation that B would take into

account if S and B were divisions of a single corporation; if S and B

subsequently cease to be in a controlled group relationship with each

other, S's remaining loss is taken into account under the principles of

the acceleration rule of Sec. 1.1502-13(d). The matching and

acceleration rules are not applied under this section to affect the

attributes of an item, or cause it to be taken into account before it

is taken into account under the member's method of accounting on a

separate entity basis. Similarly, the matching and acceleration rules

are not applied under this section to affect the timing or attributes

of B's items.

(2) Adjustments to the timing principles of Sec. 1.1502-13 (c) and

(d). For purposes of this section, the adjustments to Sec. 1.1502-13

(c) and (d) include the following:

(i) Different taxable years. If S and B have different taxable

years, the taxable years that include a December 31 are treated as the

same taxable years. If S or B has a short taxable year that does not

include a December 31, the short year is treated as part of the

succeeding taxable year that does include a December 31.

(ii) Transfer to a section 267(b) related person. To the extent S's

loss or deduction is taken into account under this section as a result

of B's transfer to a nonmember that is a person related to any member

under section 267(b), the loss or deduction is taken into account but

allowed only to the extent of any income or gain taken into account as

a result of the transfer. The balance not allowed is treated as a loss

referred to in section 267(d) if it is from a sale or exchange by B

(rather than from a distribution).

(iii) Circularity of references. References to deferral or

elimination under the Internal Revenue Code or regulations do not

include references to section 267(f) or this section. See, e.g.,

Sec. 1.1502-13(a)(3) (applicability of other law).

(d) Intercompany sales of inventory involving foreign persons--(1)

General rule. Section 267(a)(1) and this section do not apply to an

intercompany sale of property that is inventory (within the meaning of

section 1221(1)) in the hands of both S and B, if--

(i) The intercompany sale is in the ordinary course of S's trade or

business; and

(ii) S or B is a foreign corporation, any income or loss realized

on the intercompany sale by S or B is not income or loss that is

recognized as effectively connected with the conduct of a trade or

business within the United States within the meaning of section 864

(unless the income is exempt from taxation pursuant to a treaty

obligation of the United States).

(2) Intercompany sales involving related partnerships. For purposes

of paragraph (d)(1) of this section, a partnership and a foreign

corporation described in section 267(b)(10) are treated as members,

provided the foreign corporation is described in paragraph (d)(1)(ii)

of this section.

(3) Intercompany sales in ordinary course. For purposes of this

paragraph (d), whether an intercompany sale is in the ordinary course

of business is determined under all the facts and circumstances.

(e) Treatment of a creditor with respect to a loan in nonfunctional

currency. Sections 267(a)(1) and this section do not apply to an

exchange loss realized with respect to a loan of nonfunctional currency

if--

(1) The loss is realized by a member with respect to nonfunctional

currency loaned to another member;

(2) The loan is described in Sec. 1.988-1(a)(2)(i);

(3) The loan is not in a hyperinflationary currency as defined in

Sec. 1.988-1(f); and

(4) The transaction does not have as a significant purpose the

avoidance of Federal income tax.

(f) Receivables. If S has income or gain from a receivable acquired

as a result of selling goods or services to a nonmember, and S sells

the receivable at fair market value to B, any loss or deduction of S

from its sale to B is not deferred under this section to the extent it

does not exceed S's income or gain from the sale to the nonmember.

(g) Earnings and profits. A loss or deduction deferred under this

section is not reflected in S's earnings and profits before it is taken

into account under this section. See, e.g., Secs. 1.312-6(a), 1.312-7,

and 1.1502-33(c)(2).

(h) Anti-avoidance rule. If a transaction is engaged in or

structured with a principal purpose to avoid the application of this

section, or to affect the timing of losses or deductions (or tax

liability) under this section, adjustments must be made to carry out

the purposes of this section.

(i) [Reserved]

(j) Examples. For purposes of the examples in this paragraph (j),

unless otherwise stated, corporation P owns 75% of the only class of

stock of subsidiaries S and B, X is a person unrelated to any member of

the P controlled group, the taxable year of all persons is the calendar

year, all persons use the accrual method of accounting, tax liabilities

are disregarded, the facts set forth the only activity, and no member

has a special status. If a member acts as both a selling member and a

buying member (e.g., with respect to different aspects of a single

transaction, or with respect to related transactions), the member is

referred as to M (rather than as S or B). This section is illustrated

by the following examples.

Example 1. Matching and acceleration rules. (a) Facts. S holds

land for investment with a basis of $130. On January 1 of Year 1, S

sells the land to B for $100. On a separate entity basis, S's loss

is long-term capital loss. B holds the land for sale to customers in

the ordinary course of business. On July 1 of Year 3, B sells the

land to X for $110.

(b) Matching rule. Under paragraph (b)(1) of this section, S's

sale of land to B is an intercompany sale. Under paragraph (c)(1) of

this section, S's $30 loss is taken into account under the timing

principles of the matching rule of Sec. 1.1502-13(c) to reflect the

difference for the year between B's corresponding items taken into

account and B's recomputed corresponding items (the corresponding

items that B would take into account for the year if S and B were

divisions of a single corporation). If S and B were divisions of a

single corporation and the intercompany sale were a transfer between

the divisions, B would succeed to S's $130 basis in the land and

would have a $20 loss from the sale to X. Consequently, S takes no

loss into account in Years 1 and 2, and takes the entire $30 loss

into account in Year 3 to reflect the $30 difference in that year

between the $10 gain B takes into account and its $20 recomputed

loss. The attributes of S's intercompany items and B's corresponding

items are determined on a separate entity basis. Thus, S's $30 loss

is long-term capital loss and B's $10 gain is ordinary income.

(c) Acceleration resulting from sale of B stock. The facts are

the same as in paragraph (a) of this Example 1, except that on July

1 of Year 3 P sells all of its B stock to X (rather than B's selling

the land to X). Under paragraph (c)(1) of this section, S's $30 loss

is taken into account under the timing principles of the

acceleration rule of Sec. 1.1502-13(d) immediately before the effect

of treating S and B as divisions of a single corporation cannot be

produced. Because the effect cannot be produced once B becomes a

nonmember, S takes its $30 loss into account in Year 3 immediately

before B becomes a nonmember. S's loss is long-term capital loss.

(d) Subgroup principles applicable to sale of S and B stock. The

facts are the same as in paragraph (a) of this Example 1, except

that on July 1 of Year 3 P sells all of its S and B stock to X

(rather than B's selling the land to X). Under paragraph (b)(3) of

this section, S and B are considered to remain members of a

controlled group as long as they remain in a controlled group

relationship with each other (whether or not in the original

controlled group). P's sale of their stock does not affect the

controlled group relationship of S and B with each other. Thus, S's

loss is not taken into account as a result of P's sale of the stock.

Instead, S's loss is taken into account based on subsequent events

(e.g., B's sale of the land to a nonmember).

Example 2. Distribution of loss property. (a) Facts. S holds

land with a basis of $130 and value of $100. On January 1 of Year 1,

S distributes the land to P in a transaction to which section 311

applies. On July 1 of Year 3, P sells the land to X for $110.

(b) No loss taken into account. Under paragraph (b)(2) of this

section, because P and S are not members of a consolidated group,

Sec. 1.1502-13(f)(2)(iii) does not apply to cause S to recognize a

$30 loss under the principles of section 311(b). Thus, S has no loss

to be taken into account under this section. (If P and S were

members of a consolidated group, Sec. 1.1502-13(f)(2)(iii) would

apply to S's loss in addition to the rules of this section, and the

loss would be taken into account in Year 3 as a result of P's sale

to X.)

Example 3. Loss not yet taken into account under separate entity

accounting method. (a) Facts. S holds land with a basis of $130. On

January 1 of Year 1, S sells the land to B at a $30 loss but does

not take into account the loss under its separate entity method of

accounting until Year 4. On July 1 of Year 3, B sells the land to X

for $110.

(b) Timing. Under paragraph (b)(2) of this section, the

determination S's loss is made on a separate entity basis. Under

paragraph (c)(1) of this section, S's loss is not taken into account

before it is taken into account under S's separate entity method of

accounting. Thus, although B takes its corresponding gain into

account in Year 3, S has no loss to take into account until Year 4.

Once S's loss is taken into account in Year 4, it is not deferred

under this section because B's corresponding gain has already been

taken into account. (If S and B were members of a consolidated

group, S would be treated under Sec. 1.1502-13(b)(2)(i)(C) as taking

the loss into account in Year 3.)

Example 4. Consolidated groups. (a) Facts. P owns all of the

stock of S and B, and the P group is a consolidated group. S holds

land for investment with a basis of $130. On January 1 of Year 1, S

sells the land to B for $100. B holds the land for sale to customers

in the ordinary course of business. On July 1 of Year 3, P sells 25%

of B's stock to X. As a result of P's sale, B becomes a nonmember of

the P consolidated group but S and B remain in a controlled group

relationship with each other for purposes of section 267(f). Assume

that if S and B were divisions of a single corporation, the items of

S and B from the land would be ordinary by reason of B's activities.

(b) Timing and attributes. Under paragraph (a)(3) of this

section, S's sale to B is subject to both Sec. 1.1502-13 and this

section. Under Sec. 1.1502-13, S's loss is recharacterized as an

ordinary loss by reason of B's activities. Under paragraph (b)(3) of

this section, because S and B remain in a controlled group

relationship with each other, the loss is not taken into account

under the acceleration rule of Sec. 1.1502-13(d) as modified by

paragraph (c) of this section. See Sec. 1.1502-13(a)(3).

Nevertheless, S's loss is recharacterized by Sec. 1.1502-13 as an

ordinary loss, and the character of the loss is not further

redetermined under this section. Thus, the loss continues to be

deferred under this section, and will be taken into account as

ordinary loss based on subsequent events (e.g., B's sale of the land

to a nonmember).

(c) Resale to controlled group member. The facts are the same as

in paragraph (a) of this Example 4, except that P owns 75% of X's

stock, and B resells the land to X (rather than P's selling any B

stock). The results for S's loss are the same as in paragraph (b) of

this Example 4. Under paragraph (b) of this section, X is also in a

controlled group relationship, and B's sale to X is a second

intercompany sale. Thus, S's loss continues to be deferred and is

taken into account under this section as ordinary loss based on

subsequent events (e.g., X's sale of the land to a nonmember).

Example 5. Intercompany sale followed by installment sale. (a)

Facts. S holds land for investment with a basis of $130x. On January

1 of Year 1, S sells the land to B for $100x. B holds the land for

investment. On July 1 of Year 3, B sells the land to X in exchange

for X's $110x note. The note bears a market rate of interest in

excess of the applicable Federal rate, and provides for principal

payments of $55x in Year 4 and $55x in Year 5. Section 453A applies

to X's note.

(b) Timing and attributes. Under paragraph (c) of this section,

S's $30x loss is taken into account under the timing principles of

the matching rule of Sec. 1.1502-13(c) to reflect the difference in

each year between B's gain taken into account and its recomputed

loss. Under section 453, B takes into account $5x of gain in Year 4

and in Year 5. Therefore, S takes $20x of its loss into account in

Year 3 to reflect the $20x difference in that year between B's $0

loss taken into account and its $20x recomputed loss. In addition, S

takes $5x of its loss into account in Year 4 and in Year 5 to

reflect the $5x difference in each year between B's $5x gain taken

into account and its $0 recomputed gain. Although S takes into

account a loss and B takes into account a gain, the attributes of

B's $10x gain are determined on a separate entity basis, and

therefore the interest charge under section 453A(c) applies to B's

$10x gain on the installment sale beginning in Year 3.

Example 6. Section 721 transfer to a section 267(b) nonmember.

(a) Facts. S owns land with a basis of $130. On January 1 of Year 1,

S sells the land to B for $100. On July 1 of Year 3, B transfers the

land to a partnership in exchange for a 40% interest in capital and

profits in a transaction to which section 721 applies. P also owns a

25% interest in the capital and profits of the partnership.

(b) Timing. Under paragraph (c)(2)(ii) of this section, S's $30

loss is taken into account in Year 3 but disallowed because the

partnership is a nonmember that is a related person under section

267(b). In addition, any subsequent gain recognized by the

partnership with respect to the property is limited under section

267(d). (The results would be the same if the P group were a

consolidated group, and S's sale to B were also subject to

Sec. 1.1502-13.)

Example 7. Receivables. (a) Controlled group. S owns goods with

a $60 basis. In Year 1, S sells the goods to X for X's $100 note.

The note bears a market rate of interest in excess of the applicable

Federal rate, and provides for payment of principal in Year 5. S

takes into account $40 of income in Year 1 under its method of

accounting. In Year 2, the fair market value of X's note falls to

$90 due to an increase in prevailing market interest rates, and S

sells the note to B for its $90 fair market value.

(b) Loss not deferred. Under paragraph (f) of this section, S

takes its $10 loss into account in Year 2. (If the sale were not at

fair market value, paragraph (f) of this section would not apply and

none of S's $10 loss would be taken into account in Year 2.)

(c) Consolidated group. Assume instead that P owns all of the

stock of S and B, and the P group is a consolidated group. In Year

1, S sells to X goods having a basis of $90 for X's $100 note

(bearing a market rate of interest in excess of the applicable

Federal rate, and providing for payment of principal in Year 5), and

S takes into account $10 of income in Year 1. In Year 2, S sells the

receivable to B for its $85 fair market value. In Year 3, P sells

25% of B's stock to X. Although paragraph (f) of this section

provides that $10 of S's loss (i.e., the extent to which S's $15

loss does not exceed its $10 of income) is not deferred under this

section, S's entire $15 loss is subject to Sec. 1.1502-13 and none

of the loss is taken into account in Year 2 under the matching rule

of Sec. 1.1502-13(c). See paragraph (a)(3) of this section

(continued deferral under Sec. 1.1502-13). P's sale of B stock

results in B becoming a nonmember of the P consolidated group in

Year 3. Thus, S's $15 loss is taken into account in Year 3 under the

acceleration rule of Sec. 1.1502-13(d). Nevertheless, B remains in a

controlled group relationship with S and paragraph (f) of this

section permits only $10 of S's loss to be taken into account in

Year 3. See Sec. 1.1502-13(a)(3) (continued deferral under section

267). The remaining $5 of S's loss continues to be deferred under

this section and taken into account under this section based on

subsequent events (e.g., B's collection of the note or P's sale of

the remaining B stock to a nonmember).

Example 8. Selling member ceases to be a member. (a) Facts. P

owns all of the stock of S and B, and the P group is a consolidated

group. S has several historic assets, including land with a basis of

$130 and value of $100. The land is not essential to the operation

of S's business. On January 1 of Year 1, S sells the land to B for

$100. On July 1 of Year 3, P transfers all of S's stock to newly

formed X in exchange for a 20% interest in X stock as part of a

transaction to which section 351 applies. Although X holds many

other assets, a principal purpose for P's transfer is to accelerate

taking S's $30 loss into account. P has no plan or intention to

dispose of the X stock.

(b) Timing. Under paragraph (c) of this section, S's $30 loss

ordinarily is taken into account immediately before P's transfer of

the S stock, under the timing principles of the acceleration rule of

Sec. 1.1502-13(d). Although taking S's loss into account results in

a $30 negative stock basis adjustment under Sec. 1.1502-32, because

P has no plan or intention to dispose of its X stock, the negative

adjustment will not immediately affect taxable income. P's transfer

accelerates a loss that otherwise would be deferred, and an

adjustment under paragraph (h) of this section is required. Thus,

S's loss is never taken into account, and S's stock basis and

earnings and profits are reduced by $30 under Secs. 1.1502-32 and

1.1502-33 immediately before P's transfer of the S stock.

(c) Nonhistoric assets. Assume instead that, with a principal

purpose to accelerate taking loss into account, P forms M with a

$100 contribution on January 1 of Year 1 and S sells the land to M

for $100. On December 1 of Year 1, M sells the land to B for $90. On

July 1 of Year 3, while B still owns the land, P sells all of M's

stock to X and M becomes a nonmember. Under paragraph (c) of this

section, M's $10 loss ordinarily is taken into account under the

timing principles of the acceleration rule of Sec. 1.1502-13(d)

immediately before M becomes a nonmember. (S's $30 loss is not taken

into account under the timing principles of Sec. 1.1502-13(c) or

Sec. 1.1502-13(d) as a result of M becoming a nonmember, but is

taken into account based on subsequent events such as B's sale of

the land to a nonmember or P's sale of the stock of S or B to a

nonmember.) The land is not an historic asset of M and, although

taking M's loss into account reduces P's basis in the M stock under

Sec. 1.1502-32, the negative adjustment only eliminates the $10

duplicate stock loss. Under paragraph (h) of this section, M's loss

is never taken into account. M's stock basis, and the earnings and

profits of M and P, are reduced by $10 under Secs. 1.1502-32 and

1.1502-33 immediately before P's sale of the M stock.

(k) Cross-reference. For additional rules applicable to the

disposition or deconsolidation of the stock of members of consolidated

groups, see Secs. 1.337(d)-1, 1.337(d)-2, and 1.1502-20.

(l) Effective dates--(1) In general. This section applies with

respect to transactions occurring in S's years beginning on or after

[the date the final regulations are filed with the Federal Register].

If both this section and prior law apply to a transaction, or neither

applies, with the result that items are duplicated, omitted, or

eliminated in determining taxable income (or tax liability), or items

are treated inconsistently, prior law (and not this section) applies to

the transaction.

(2) Avoidance transactions. This paragraph (l)(2) applies if a

transaction is engaged in or structured on or after April 8, 1994, with

a principal purpose to avoid the rules of this section applicable to

transactions occurring in years beginning on or after [the date the

final regulations are filed with the Federal Register], to duplicate,

omit, or eliminate an item in determining taxable income (or tax

liability), or to treat items inconsistently. If this paragraph (l)(2)

applies, appropriate adjustments must be made in years beginning on or

after [the date the final regulations are filed with the Federal

Register], to prevent the avoidance, duplication, omission,

elimination, or inconsistency.

(3) Prior law. For transactions occuring in S's years beginning

before [the date the final regulations are filed with the Federal

Register] see the applicable regulations issued under sections 267 and

1502. See, e.g., Secs. 1.267(f)-1, 1.267(f)-1T, 1.267(f)-2T, 1.267(f)-

3, 1.1502-13, 1.1502-13T, 1.1502-14, 1.1502-14T, and 1.1502-31 (as

contained in the 26 CFR part 1 edition revised as of April 1, 1994).

Secs. 1.267(f)-1T, 1.267(f)-2T, and 1.267(f)-3 [Removed]

Par. 6. Sections 1.267(f)-1T, 1.267(f)-2T, and 1.267(f)-3 are

removed.

Par. 7. Section 1.460-0 is amended in the table of contents by

revising the section heading for Sec. 1.460-4, and adding entries for

that section to read as follows:

Sec. 1.460-0 Outline of regulations under section 460.

* * * * *

Sec. 1.460-4 Methods of accounting for long-term contracts.

(a) through (i) [Reserved]

(j) Consolidated groups and controlled groups.

(1) Intercompany transactions.

(i) In general.

(ii) Definitions and nomenclature.

(2) Example.

(3) Effective date.

(i) In general.

(ii) Prior law.

* * * * *

Par. 8. Section 1.460-4 is amended by revising the section heading,

adding and reserving paragraphs (a) through (i), and adding paragraph

(j) to read as follows:

Sec. 1.460-4 Methods of accounting for long-term contracts.

(a) through (i) [Reserved]

(j) Consolidated groups and controlled groups--(1) Intercompany

transactions--(i) In general. Section 1.1502-13 does not apply to the

income, gain, deduction, or loss from an intercompany transaction

between members of a consolidated group, and section 267(f) does not

apply to these items from an intercompany sale between members of a

controlled group, to the extent--

(A) The transaction or sale directly or indirectly benefits, or is

intended to benefit, another member's long-term contract with a

nonmember;

(B) The selling member is required under section 460 to determine

any part of its gross income from the transaction or sale under the

percentage-of-completion method (PCM); and

(C) The member with the long-term contract is required under

section 460 to determine any part of its gross income from the long-

term contract under the PCM.

(ii) Definitions and nomenclature. The definitions and nomenclature

under Sec. 1.1502-13 and Sec. 1.267(f)-1 apply for purposes of this

paragraph (j).

(2) Example. The following example illustrates the principles of

paragraph (j)(1) of this section.

Example. Corporations P, S, and B file consolidated returns on a

calendar-year basis. In 1996, B enters into a long-term contract

with X, a nonmember, to manufacture 5 airplanes for $500 million,

with delivery scheduled for 1999. Section 460 requires B to

determine the gross income from its contract with X under the PCM. S

enters into a contract with B to manufacture for $50 million the

engines that B will install on X's airplanes. Section 460 requires S

to determine the gross income from its contract with B under the

PCM. S estimates that it will incur $40 million of total contract

costs during 1997 and 1998 to manufacture the engines. S incurs $10

million of contract costs in 1997 and $30 million in 1998. Under

paragraph (j) of this section, S determines its gross income from

the long-term contract under the PCM rather than under section

267(f) or Sec. 1.1502-13. Thus, S includes $12.5 million of gross

receipts and $10 million of contract costs in gross income in 1997

and includes $37.5 million of gross receipts and $30 million of

contract costs in gross income in 1998.

(3) Effective date--(i) In general. This paragraph (j) applies with

respect to transactions and sales occurring in years beginning on or

after [the date the final regulations are filed with the Federal

Register].

(ii) Prior law. For transactions and sales occurring in years

beginning before [the date final regulations are filed with the Federal

Register], see the applicable regulations issued under sections 267(f)

and 1502, including Secs. 1.267(f)-1T, 1.267(f)-2T, and 1.1502-13(n)

(as contained in the 26 CFR part 1 edition revised as of April 1,

1994).

Par. 9. Section 1.469-0 is amended in the table of contents by

revising entries for paragraphs (a) through (d)(1), (g)(5) through

(h)(3), and (h)(5) through (k) under Sec. 1.469-1 and revising entries

for paragraphs (c)(8), (h)(1), (h)(2), and (h)(6) under Sec. 1.469-1T

to read as follows:

Sec. 1.469-0 Table of contents.

* * * * *

Sec. 1.469-1 General rules.

(a) through (c)(7) [Reserved]

(c)(8) Consolidated groups.

(c)(9) through (d)(1) [Reserved]

* * * * *

(g)(5) [Reserved]

(h)(1) In general.

(h)(2) Definitions.

(h)(3) [Reserved]

* * * * *

(h)(5) [Reserved]

(h)(6) Intercompany transactions.

(i) In general.

(ii) Example.

(iii) Effective dates.

(h)(7) through (k) [Reserved]

Sec. 1.469-1T General rules (temporary).

* * * * *

(c)(8) [Reserved]

* * * * *

(h)(1) [Reserved]

(h)(2) [Reserved]

* * * * *

(h)(6) [Reserved]

* * * * *

Par. 10. Section 1.469-1 is amended by revising paragraphs (a)

through (d)(1), (g)(5) through (h)(3), and (h)(5) through (k) to read

as follows:

Sec. 1.469-1 General rules.

(a) through (c)(7) [Reserved]

(c)(8) Consolidated groups. Rules relating to the application of

section 469 to consolidated groups are contained in paragraph (h) of

this section.

(c)(9) through (d)(1) [Reserved]

* * * * *

(g)(5) [Reserved]

(h)(1) In general. This paragraph (h) provides rules for applying

section 469 in computing a consolidated group's consolidated taxable

income and consolidated tax liability (and the separate taxable income

and tax liability of each member).

(2) Definitions. The definitions and nomenclature in the

regulations under section 1502 apply for purposes of this paragraph

(h). See, e.g., Secs. 1.1502-1 (definitions of group, consolidated

group, member, subsidiary, and consolidated return year), 1.1502-2

(consolidated tax liability), 1.1502-11 (consolidated taxable income),

1.1502-12 (separate taxable income), 1.1502-13 (intercompany

transactions), 1.1502-21 (consolidated net operating loss), and 1.1502-

22 (consolidated net capital gain or loss).

(3) [Reserved]

* * * * *

(5) [Reserved]

(6) Intercompany transactions--(i) In general. Section 1.1502-13

applies to determine the treatment under section 469 of intercompany

items and corresponding items from intercompany transactions between

members of a consolidated group. For example, the matching rule of

Sec. 1.1502-13(c) treats the selling member (S) and the buying member

(B) as divisions of a single corporation for purposes of determining

whether S's intercompany items and B's corresponding items are from a

passive activity. Thus, for purposes of applying Sec. 1.469-

2(c)(2)(iii) and Sec. 1.469-- 2T(d)(5)(ii) to property sold by S to B

in an intercompany transaction--

(A) S and B are treated as divisions of a single corporation for

determining the uses of the property during the 12-month period

preceding its disposition to a nonmember, and generally have an

aggregate holding period for the property; and

(B) Section 1.469-2(c)(2)(iv) does not apply.

(ii) Example. The following example illustrates the application of

this paragraph (h)(6).

Example. (i) P, a closely held corporation, is the common parent

of the P consolidated group. P owns all of the stock of S and B. X

is a person unrelated to any member of the P group. S owns and

operates equipment that is not used in a passive activity. On

January 1 of Year 1, S sells the equipment to B at a gain. B uses

the equipment in a passive activity and does not dispose of the

equipment before it has been fully depreciated. Assume that if S and

B were divisions of a single corporation, S's gain would be passive

income attributable to a passive activity.

(ii) Under the matching rule of Sec. 1.1502-13(c), S's gain

taken into account as a result of B's depreciation is treated as

gain from a passive activity even though S used the equipment in a

nonpassive activity.

(iii) The facts are the same as in paragraph (a) of this

Example, except that B sells the equipment to X on December 1 of

Year 3 at a further gain. To the extent of B's depreciation before

the sale, the results are the same as in paragraph (ii) of this

Example. S's remaining gain taken into account as a result of B's

sale is treated as attributable to a passive activity.

(iv) The facts are the same as in paragraph (iii) of this

Example, except that B recognizes a loss on the sale to X. As in

paragraph (iii) of this Example, S's gain taken into account as a

result of B's sale is treated as attributable to a passive activity.

(iii) Effective dates. This paragraph (h)(6) applies with respect

to transactions occurring in years beginning on or after [the date the

final regulations are filed with the Federal Register]. For

transactions occurring in years beginning before [the date the final

regulations are filed with the Federal Register], see Sec. 1.469-

1T(h)(6) (as contained in the 26 CFR part 1 edition revised as of April

1, 1994).

(h)(7) through (k) [Reserved]

Sec. 1.469-1T [Amended]

Par. 11. Section 1.469-1T is amended by removing and reserving

paragraphs (c)(8), (h)(1), (h)(2), and (h)(6).

Par. 12. Section 1.1502-13 is revised to read as follows:

Sec. 1.1502-13 Intercompany transactions.

(a) In general--(1) Purpose. This section provides rules for taking

into account the items of income, gain, deduction, and loss of members

from intercompany transactions. The purpose of this section is to

provide rules to clearly reflect the taxable income (and tax liability)

of the group as a whole by preventing intercompany transactions from

creating, accelerating, avoiding, or deferring consolidated taxable

income (or consolidated tax liability).

(2) Separate entity and single entity treatment. Under this

section, the selling member (S) and the buying member (B) are treated

as separate entities for some purposes but as divisions of a single

corporation for other purposes. The amount and location of S's

intercompany items and B's corresponding items are determined on a

separate entity basis (separate entity treatment). For example, S

determines its gain or loss from a sale of property to B on a separate

entity basis, and B has a cost basis in the property. The timing,

character, source, and other attributes of the intercompany items and

corresponding items, although initially determined on a separate entity

basis, are redetermined under this section to produce the effect of

transactions between divisions of a single corporation (single entity

treatment). For example, if S sells land to B at a gain and B resells

the land to a nonmember, S does not take its gain into account until

the resale.

(3) Other law. The rules of this section apply in addition to other

applicable law, such as sections 269 (acquisitions to evade or avoid

income tax), 482 (allocations among commonly controlled taxpayers), and

7701(f) (use of related persons). The timing rules of this section are

a method of accounting that overrides otherwise applicable accounting

methods. For example, if S sells property to B in exchange for B's

note, the rules of this section apply instead of the installment sale

rules of section 453. However, an item taken into account under this

section can be deferred, disallowed, or eliminated under other

applicable law such as section 267 (losses from transactions between

related persons).

(4) Construction. The rules of this section must be applied in a

consistent manner that reasonably carries out their purposes, taking

into account all of the facts and circumstances, the underlying

economic arrangement, and applicable Federal income tax accounting

principles. For example, the rules of this section must not be applied

to take S's intercompany items into account more than once.

(5) Overview--(i) In general. 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.

(ii) Table of examples. Set forth below is a table of the examples

contained in this section.

Matching rule. (Sec. 1.1502-13(c)(4)(ii))

Example 1. Intercompany sale of land followed by resale;

intercompany sale followed by section 1031 exchange with nonmember;

intercompany sale followed by section 351 transfer to nonmember.

Example 2. Dealer activities.

Example 3. Intercompany section 351 transfer.

Example 4. Depreciable property.

Example 5. Intercompany sale followed by installment sale.

Example 6. Intercompany sale of installment obligation.

Example 7. Performance of services.

Example 8. Rental of property.

Example 9. Back-to-back intercompany sales.

Example 10. Intercompany sale of a partnership interest.

Example 11. Net operating losses subject to section 382 or the

SRLY rules.

Example 12. Special inventory accounting election.

Example 13. Section 475.

Example 14. Section 1092.

Example 15. Manufacturer rebates.

Example 16. Cancellation of debt and attribute reduction under

section 108(b).

Example 17. Source of items from a section 863 sale.

Example 18. Section 1248.

Acceleration rule. (Sec. 1.1502-13(d)(3))

Example 1. Becoming a nonmember--timing.

Example 2. Becoming a nonmember--attributes.

Example 3. Back-to-back intercompany transactions.

Example 4. Selling member's disposition of proceeds.

Example 5. Section 481.

Simplifying rules--inventory. (Sec. 1.1502-13(e)(1)(v))

Example 1. Increment averaging method.

Example 2. Increment valuation method.

Example 3. Other reasonable inventory methods.

Stock of members. (Sec. 1.1502-13(f)(6))

Example 1. Dividend exclusion and property distribution.

Example 2. Excess loss accounts.

Example 3. Intercompany reorganization.

Example 4. Stock redemptions and distributions.

Example 5. Intercompany stock sale followed by section 332

liquidation.

Obligations of members. (Sec. 1.1502-13(g)(6))

Example 1. Interest and premium on intercompany debt.

Example 2. Intercompany debt becomes nonintercompany debt.

Example 3. Bad debt deduction or loss with respect to

intercompany debt.

Example 4. Nonintercompany debt becomes intercompany debt.

Example 5. Notional principal contracts.

Anti-avoidance rules. (Sec. 1.1502-13(h)(2))

Example 1. Sale of a partnership interest.

Example 2. Sale to a related party.

Example 3. Sale and leaseback.

Example 4. Transitory status as an intercompany obligation.

Miscellaneous operating rules. (Sec. 1.1502-13(j)(6))

Example 1. Intercompany sale followed by section 351 transfer to

member.

Example 2. Intercompany sale of member stock followed by

recapitalization.

Example 3. Successor group.

Example 4. Liquidation--80% distributee.

Example 5. Liquidation--no 80% distributee.

(b) Definitions. For purposes of this section--

(1) Intercompany transactions--(i) In general. An intercompany

transaction is a transaction between corporations that are members of

the same consolidated group immediately after the transaction. S is the

member transferring property or providing services, and B is the member

receiving the property or services. Intercompany transactions include--

(A) S's sale of property (or other transfer, such as an exchange or

contribution) to B, whether or not gain or loss is recognized;

(B) S's performance of services for B, and B's payment or accrual

of its expenditure for S's performance;

(C) S's licensing of technology, rental of property, or loan of

money to B, and B's payment or accrual of its expenditure; and

(D) S's distribution to B with respect to S stock.

(ii) Time of transaction. If a transaction occurs in part while S

and B are members and in part while they are not members, the

transaction is treated as occurring when performance by either S or B

takes place, or when payment for performance would be taken into

account under the rules of this section if it were an intercompany

transaction, whichever is earliest. Appropriate adjustments must be

made in such cases by, for example, dividing the transaction into two

separate transactions reflecting the extent to which S or B has

performed.

(iii) Separate transactions. Each transaction is analyzed

separately. For example, if S simultaneously sells two properties to B,

one at a gain and the other at a loss, each property is sold in a

separate transaction. Similarly, each payment or accrual of interest

with respect to a loan is a separate transaction. If two members

exchange property, each member is S with respect to the property it

transfers and B with respect to the property it receives.

(2) Intercompany items and corresponding items--(i) Intercompany

items--(A) In general. S's income, gain, deduction, and loss from an

intercompany transaction are its intercompany items. For example, S's

gain from the sale of property to B is intercompany gain and, if the

sale results in both ordinary income and capital gain (or other

attribute disparities), each is treated as a separate intercompany

item. An item is an intercompany item whether it is directly or

indirectly from an intercompany transaction.

(B) Related costs or expenses. S's costs or expenses related to an

intercompany transaction are included in determining its intercompany

items. For example, if S sells inventory to B, S's direct and indirect

costs properly includible under section 263A are included in

determining its intercompany income. Similarly, in addition to other

related costs, deductions for employee wages are included in

determining S's income from performing services for B, and depreciation

deductions are included in determining S's income from renting property

to B.

(C) Amounts not yet recognized or incurred. S's items from

intercompany transactions are taken into account under this section

even if S has not yet taken them into account under its separate entity

method of accounting. For example, if S is a cash method taxpayer, S's

intercompany income is taken into account under this section even if

the cash is not yet received.

(ii) Corresponding items--(A) In general. B's income, gain,

deduction, and loss from an intercompany transaction, or from property

acquired in an intercompany transaction, are its corresponding items.

For example, if B pays rent to S, B's deduction for the rent is a

corresponding deduction. If B buys property from S and resells it to a

nonmember, B's gain or loss from the resale is a corresponding gain or

loss; alternatively, if B recovers the cost of the property through

depreciation, B's depreciation deductions are corresponding deductions.

An item is a corresponding item whether it is directly or indirectly

from an intercompany transaction (or from property acquired in an

intercompany transaction).

(B) Disallowed or eliminated amounts. B's corresponding items

include amounts that are permanently disallowed or permanently

eliminated, whether directly or indirectly. For example, corresponding

items include amounts disallowed under section 265 (expenses relating

to tax-exempt income), amounts offset under section 171(e) (amortizable

bond premium offset), and amounts not recognized under section 311

(nonrecognition of loss on distributions) or 332 (nonrecognition on

liquidating distributions). (See paragraph (c)(3)(iv) of this section,

under which certain of these amounts may cause S's intercompany income

or gain to be treated as excluded from gross income.)

(iii) Effect of basis adjustments. This paragraph (b)(2)(iii)

provides additional rules for intercompany items and corresponding

items.

(A) Deemed intercompany items. An adjustment reflected in basis (or

to an amount equivalent to basis, such as a loss carryover or an excess

loss account) that is a substitute for an intercompany item is treated

as an intercompany item. For example, a reduction in S's basis in

property that preserves S's income for a later period and relates to

B's corresponding deduction is treated as intercompany income of S.

However, if the adjustment is made pursuant to a nonrecognition

provision of the Code or regulations unrelated to S's method of

accounting, the adjustment is not treated as an intercompany item.

(B) Deemed corresponding items. An adjustment reflected in basis

(or in an amount equivalent to basis, such as a loss carryover or an

excess loss account) that is a substitute for a corresponding item is

treated as a corresponding item for purposes of taking S's intercompany

items into account. However, an adjustment is not treated as a

corresponding item to the extent that the adjustment reflects a

comparable amount not recognized by S, or to the extent that the only

effect of the adjustment is to preserve B's items for a later period

(rather than, for example, affecting the overall amount of items taken

into account or to be taken into account).

(C) Amounts deemed not to be items. A deduction or loss is not

treated as an intercompany item or corresponding item to the extent it

does not reduce basis (or have an equivalent effect, such as decreasing

a loss carryover or increasing an excess loss account). For example, if

B has percentage depletion in excess of basis under section 613 or 613A

with respect to mineral property purchased from S, the depletion in

excess of basis is not treated as a corresponding item for purposes of

this section. Similar principles apply to income or gain that does not

increase basis (or have an equivalent effect).

(3) Treatment as a separate entity. Treatment as a separate entity

means treatment without application of the rules of this section, but

with the application of the other consolidated return regulations. For

example, if S sells the stock of another member to B, S's gain or loss

on a separate entity basis is determined with the application of

Sec. 1.1502-80(b) (nonapplicability of section 304), but without

redetermination under paragraph (c) or (d) of this section.

(4) Attributes. The attributes of an intercompany item or

corresponding item are all of the item's characteristics necessary to

determine its effect on taxable income (and tax liability) except

amount, location, and timing. For example, attributes include

character, source, treatment as excluded from gross income or as a

noncapital, nondeductible amount, and treatment as built-in gain or

loss under section 382(h) or 384. A member's holding period in

property, or the fact that property is included in the inventory of a

member, is not an attribute of an item, but these factors do affect the

determination of the attributes of items from the property.

(c) Matching rule. S's intercompany items and B's corresponding

items are taken into account for each consolidated return year under

the following rules:

(1) Attributes and holding periods--(i) General rule. The

attributes of S's intercompany items and B's corresponding items are

redetermined to produce the same effect on consolidated taxable income

(and consolidated tax liability) as if S and B were divisions of a

single corporation, and the intercompany transaction were a transaction

between divisions. Thus, the activities of both S and B affect the

attributes of both intercompany items and corresponding items. For

example, if S holds property for sale to unrelated customers in the

ordinary course of its trade or business and sells the property to B,

S's intercompany items and B's corresponding items may be ordinary

items solely by reason of S's activities. Similar principles apply if S

performs services, rents property, or engages in any other intercompany

transaction.

(ii) Holding periods. The holding period of property transferred in

an intercompany transaction is the aggregate of the holding periods of

S and B. However, if the basis of the property is determined by

reference to the basis of other property, the property's holding period

is determined by reference to the holding period of the other property.

For example, the holding period of stock distributed in an intercompany

distribution to which section 355 applies is determined by reference to

the holding period of the distributing member's stock.

(2) Timing--(i) B's items. B takes its corresponding items into

account under its accounting method. However, the redetermination of

the attributes of a corresponding item may affect its timing. For

example, if B's resale of property acquired from S is treated as a

dealer disposition solely by reason of S's activities, section 453(b)

prevents any corresponding income of B from being taken into account

under the installment method.

(ii) S's items. S takes its intercompany items into account to

reflect the difference for the year between B's corresponding items

taken into account and B's recomputed corresponding items (the

corresponding items that B would take into account for the year if S

and B were divisions of a single corporation). For example, if S sells

property with a $70 basis to B for $100, and B later resells the

property to a nonmember for $90, B's corresponding item taken into

account is its $10 loss, B's recomputed corresponding item is a $20

recomputed gain, and the $30 difference is the amount of S's

intercompany gain that is taken into account for the year of the

resale. Although B does not actually take the recomputed corresponding

items into account, they are computed as if they were taken into

account (based on reasonable and consistently applied assumptions,

including any provision of the Internal Revenue Code (Code) or

regulations that would affect their timing or attributes).

(3) Operating rules for single entity adjustments. For purposes of

this paragraph (c)--

(i) Divisions of a single corporation. As divisions of a single

corporation, S and B are treated as engaging in their actual

transaction and owning any actual property in the transaction (rather

than treating the transaction as not occurring). For example, S's sale

of property to B for cash is not disregarded, but is treated as an

exchange of property for cash between divisions (and B therefore

ordinarily does not have a cost basis). Similarly, if S transfers

property to B in exchange for B's stock, S is treated as owning the

stock it receives in the exchange. Although treated as divisions, S and

B nevertheless are treated as:

(A) Operating separate trades or businesses. See, e.g., Sec. 1.446-

1(d) (accounting methods for a taxpayer engaged in more than one

business).

(B) Having any special status that they have under the Internal

Revenue Code. For example, a bank defined in section 581, a domestic

building and loan association defined in section 7701(a)(19), and an

insurance company to which section 801 or 831 applies are treated as

divisions having separate special status. On the other hand, the fact

that a member holds property for sale to customers in the ordinary

course of its trade or business is not a special status.

(ii) Multiple intercompany items or corresponding items--(A)

Multiple triggers. If more than one corresponding item can cause an

intercompany item to be taken into account under this paragraph (c),

the intercompany item is taken into account in connection with the

corresponding item most consistent with the treatment of members as

divisions of a single corporation. For example, if S sells a truck to

B, its intercompany gain from the sale is not taken into account by

reference to B's depreciation if the depreciation is capitalized under

section 263 as part of B's cost for a building; instead, S's gain

relating to the capitalized depreciation is taken into account when the

building is sold or as it is depreciated. If B purchases appreciated

land from S and transfers the land to a lower-tier member in exchange

for stock, thereby duplicating the basis of the land in the basis of

the stock, items with respect to both the stock and the land can cause

S's intercompany gain to be taken into account; if the lower-tier

member becomes a nonmember as a result of the sale of its stock, the

attributes of S's intercompany gain are determined with respect to the

land rather than the stock.

(B) Aggregation of transactions. If a member's intercompany item or

corresponding item affects the accounting for more than one

intercompany transaction, appropriate adjustments are made to treat all

of the intercompany transactions as transactions between divisions of a

single corporation. For example, if land is transferred in successive

intercompany transactions, all of the participating members are treated

as divisions of a single corporation for purposes of determining the

timing and attributes of each of the items from the land. Similar

principles apply with respect to intercompany transactions that are

part of the same plan or arrangement. For example, if S sells separate

properties to different members as part of the same plan or

arrangement, all of the participating members are treated as divisions

of a single corporation for purposes of determining the timing and

attributes of the intercompany items and corresponding items from each

of the properties.

(iii) Conflict of attributes or allocation--(A) In general. If it

is not possible to determine the attributes of an item, or the

allocation of attributes between S and B, by treating S and B as

divisions of a single corporation, the determination or allocation is

made as follows--

(1) The attributes of B's corresponding items on a separate entity

basis control the attributes of offsetting intercompany items of S

(e.g., B's interest expense controls S's interest income); and

(2) If the corresponding items and intercompany items do not offset

(e.g., both S and B have gain from the same property), their attributes

are determined on a separate entity basis to the extent not

inconsistent with the purposes of this section.

(B) Special status. To the extent an item's attributes determined

under this section are permitted or not permitted to a member under the

Internal Revenue Code or regulations by reason of the member's special

status, the attributes required under the Internal Revenue Code or

regulations apply to that member (but not the other member). For

example, if S is a bank to which section 582(c) applies, and sells debt

securities at a gain to B, a nonbank, the character of S's intercompany

gain is ordinary as required under section 582(c), but the character of

B's corresponding items as capital or ordinary is determined under

paragraph (c)(1) of this section without the application of section

582(c). For other special status issues, see, e.g., sections 595(b)

(foreclosure on property securing loans), 818(b) (life insurance

company treatment of capital gains and losses), 1032 (nonrecognition

with respect to an issuer's stock) and 1503(c) (limitation on

absorption of certain losses).

(iv) Limitation on treatment of intercompany income or gain as

excluded from gross income--(A) In general. Redetermining the

attributes of intercompany items and corresponding items under this

paragraph (c) may result in S's intercompany items being treated as

excluded from gross income or as noncapital, nondeductible amounts. For

example, S's intercompany loss from the sale of property to B is

treated as a noncapital, nondeductible amount if B distributes the

property to a nonmember shareholder at no further gain or loss (because

of the nonrecognition of loss under section 311(a)). See also

Secs. 1.1502-32 and 1.1502-33 (adjustments to S's stock basis and

earnings and profits to reflect amounts so treated).

(B) Limitation. S's intercompany income or gain may be treated

under this paragraph (c) as excluded from gross income only to the

extent one of the following applies:

(1) Disallowed amounts. B's corresponding item is a deduction or

loss that, in the taxable year the item is taken into account under

this section, is permanently disallowed directly under another

provision of the Internal Revenue Code or regulations. An amount is not

permanently disallowed for this purpose if, for example--

(i) The disallowance or elimination is not permanent because an

equivalent amount might be taken into account by B, such as under

section 280B (demolition costs recoverable as capitalized amounts), or

by another taxpayer, such as under section 267(d) (disallowed loss

under section 267(a) may result in nonrecognition of gain for a related

person);

(ii) The amount is realized but not recognized under section 332;

(iii) The amount is a deemed item under paragraph (b)(2)(iii) of

this section; or

(iv) The amount is a loss that is part of a carryforward that

expires in a later year.

(2) Section 311. The corresponding item is a loss that is realized,

but not recognized under section 311(a).

(3) Other amounts. The corresponding item is otherwise limited,

eliminated, offset, or has no effect on the computation of taxable

income under any provision identified by the Commissioner.

(4) Examples--(i) In general. For purposes of the examples in this

section, unless otherwise stated, P is the common parent of the P

consolidated group, P owns all of the only class of stock of

subsidiaries S and B, X is a person unrelated to any member of the P

group, the taxable year of all persons is the calendar year, all

persons use the accrual method of accounting, tax liabilities are

disregarded, the facts set forth the only corporate activity, and no

member has any special status. If a member acts as both a selling

member and a buying member (e.g., with respect to different aspects of

a single transaction, or with respect to related transactions), the

member is referred to as M (rather than as S or B).

(ii) Matching rule. The matching rule of this paragraph (c) is

illustrated by the following examples.

Example 1. Intercompany sale of land followed by resale;

intercompany sale followed by section 1031 exchange with nonmember;

intercompany sale followed by section 351 transfer to nonmember. (a)

Facts. S holds land for investment with a basis of $70. On January 1

of Year 1, S sells the land to B for $100. B also holds the land for

investment. On July 1 of Year 3, B sells the land to X for $110.

(b) Definitions. Under paragraph (b)(1) of this section, S's

sale of the land to B is an intercompany transaction, S is the

selling member, and B is the buying member. Under paragraph (b)(2)

of this section, S's $30 gain from the sale to B is its intercompany

gain, and B's $10 gain from the sale to X is its corresponding gain.

(c) Timing. Under the matching rule of paragraph (c) of this

section, S takes its intercompany items into account to reflect the

difference for the year between B's corresponding items taken into

account and B's recomputed corresponding items (the corresponding

items that B would take into account for the year if S and B were

divisions of a single corporation). If S and B were divisions of a

single corporation and the intercompany sale were a transfer between

the divisions, B would succeed to S's $70 basis in the land and

would have a $40 gain from the sale to X instead of a $10 gain.

Consequently, S takes no gain into account in Years 1 and 2, and

takes the entire $30 gain into account in Year 3 to reflect the $30

difference in that year between the $10 gain B takes into account

and its $40 recomputed gain (B's recomputed corresponding item).

Under Secs. 1.1502-32 and 1.1502-33, P's basis in its S stock and

the earnings and profits of S and P do not reflect S's $30 gain

until the gain is taken into account in Year 3. (Under paragraph

(b)(2)(i)(C) of this section, the results would be the same if S

sold the land to B in an installment sale to which section 453 would

otherwise apply, because S must take its intercompany gain into

account under this section.)

(d) Attributes. Under the matching rule, S's $30 intercompany

gain and B's $10 corresponding gain are taken into account to

produce the same effect on consolidated taxable income (and

consolidated tax liability) as if S and B were divisions of a single

corporation. In addition, the holding periods of S and B for the

land are aggregated. Thus, both are long-term capital gain.

(e) Intercompany loss and resale gain. The facts are the same as

in paragraph (a) of this Example 1, except that S's basis in the

land is $130 (rather than $70). The timing and attributes of S's

intercompany loss and B's corresponding gain are determined in the

manner provided in paragraphs (c) and (d) of this Example 1. If S

and B were divisions of a single corporation and the intercompany

sale were a transfer between the divisions, B would succeed to S's

$130 basis in the land and would have a $20 loss from the sale to X

instead of a $10 gain. Thus, S takes its entire $30 loss into

account in Year 3 to reflect the $30 difference between B's $10 gain

taken into account and its $20 recomputed loss. (The results are the

same under section 267(f).) S's $30 loss is long-term capital loss,

and B's $10 gain remains long-term capital gain.

(f) Intercompany gain and resale loss. The facts are the same as

in paragraph (a) of this Example 1, except that B sells the land to

X for $90 (rather than $110). The timing and attributes of S's

intercompany gain and B's corresponding loss are determined in the

manner provided in paragraphs (c) and (d) of this Example 1. If S

and B were divisions of a single corporation and the intercompany

sale were a transfer between the divisions, B would succeed to S's

$70 basis in the land and would have a $20 gain from the sale to X

instead of a $10 loss. Thus, S takes its entire $30 gain into

account in Year 3 to reflect the $30 difference between B's $10 loss

taken into account and its $20 recomputed gain. S's $30 gain is

long-term capital gain, and B's $10 loss is long-term capital loss.

(g) Intercompany sale followed by section 1031 exchange with

nonmember. The facts are the same as in paragraph (a) of this

Example 1, except that, instead of selling the land to X, B

exchanges the land for land owned by X in a transaction to which

section 1031 applies. There is no difference in Year 3 between B's

corresponding items taken into account and its recomputed items.

Thus, none of S's intercompany gain is taken into account under the

matching rule as a result of the section 1031 exchange. Instead, B's

gain is preserved in the land received from X and, under the

successor asset rule of paragraph (j)(1)(i) of this section, S's

intercompany gain is taken into account by reference to the

replacement property. (If B takes gain into account as a result of

boot received in the exchange, S's intercompany gain would be taken

into account under the matching rule to the extent the boot causes a

difference between B's gain taken into account and its recomputed

gain.)

(h) Intercompany sale followed by section 351 transfer to

nonmember. The facts are the same as in paragraph (a) of this

Example 1, except that, instead of selling the land to X, B

transfers the land to X in a transaction to which section 351

applies and X remains a nonmember. There is no difference in Year 3

between B's corresponding items taken into account and its

recomputed items. Thus, none of S's intercompany gain is taken into

account under the matching rule as a result of the section 351

transfer. However, S's entire gain is taken into account in Year 3

under the acceleration rule of paragraph (d) of this section

(because X reflects B's $100 cost basis in the land under section

362).

Example 2. Dealer activities. (a) Facts. S holds land for

investment with a basis of $70. On January 1 of Year 1, S sells the

land to B for $100. B develops the land as residential real estate,

and sells developed lots to customers during Year 3 for an aggregate

amount of $110.

(b) Attributes. S and B are treated under the matching rule as

divisions of a single corporation for purposes of determining the

attributes of B's corresponding items and S's intercompany items.

Thus, although S held the land for investment, whether the land is

property described in section 1221(1) is based on the activities of

both S and B. If the land is described in section 1221(1), both S's

gain and B's gain are ordinary income.

Example 3. Intercompany section 351 transfer. (a) Facts. S holds

land with a $70 basis for sale to customers in the ordinary course

of business. On January 1 of Year 1, S transfers the land to B in

exchange for B stock and $10 cash in a transaction to which section

351 applies. See Sec. 1.1502-34 (aggregate stock ownership rules). S

has a $10 gain under section 351(b), and its basis in the B stock is

$70 under section 358. Under section 362, B's basis in the land is

$80. B holds the land for investment. On July 1 of Year 3, B sells

the land to X for $100. Assume that if S and B were divisions of a

single corporation, B's gain from the sale would be ordinary income

by reason of S's activities.

(b) Timing and attributes. Under paragraph (c)(3)(i) of this

section, S is treated as transferring the land for B's stock even

though, as divisions, S could not own stock of B. S takes its $10

gain into account in Year 3 to reflect the $10 difference between

B's $20 gain taken into account and its $30 recomputed gain. Both

S's $10 gain and B's $20 gain are ordinary income.

(c) Partial disposition. The facts are the same as in paragraph

(a) of this Example 3, except B sells only a one-half, undivided

interest in the land to X for $50. The timing and attributes are

determined in the manner provided in paragraph (b) of this Example

3, except that S takes only $5 of its gain into account in Year 3 to

reflect the $5 difference between B's $10 gain taken into account

and its $15 recomputed gain.

(d) No boot. The facts are the same as in paragraph (a) of this

Example 3, except that there is no boot in the section 351

transaction. Under paragraph (b)(1) of this section, S's transfer to

B is an intercompany transaction. Under paragraph (b)(2) of this

section, S has no intercompany items, but B's $30 gain from its sale

of the land to X is a corresponding item because the land was

acquired in an intercompany transaction. B's $30 gain is ordinary

income.

Example 4. Depreciable property. (a) Facts. During Year 1, S

buys 10-year recovery property for $80 and depreciates it under the

straight-line method with the half- year convention. On July 1 of

Year 6, S sells the property to B for $100. Under section 168(i)(7),

B is treated as S for purposes of section 168 to the extent that B's

$100 basis does not exceed S's adjusted basis at the time of the

sale. B's additional basis is treated as new 10-year recovery

property subject to the half-year convention, for which B elects the

straight-line method of recovery.

(b) Depreciation in Year 6 and intercompany gain. S takes into

account $4 of depreciation for Year 6, and S has a $40 basis at the

time of the sale to B ($80 minus $36 of prior years' depreciation

and $4 of Year 6 depreciation). Thus, S has a $60 intercompany gain

from its sale to B. For Year 6, B has the remaining $4 of

depreciation with respect to $40 of its basis (the portion of its

$100 basis not exceeding S's adjusted basis). In addition, B has

another $3 of depreciation with respect to the $60 of its additional

basis that exceeds S's adjusted basis (under the half-year

convention). For purposes of treating S and B as divisions of a

single corporation under the matching rule, the $8 of recomputed

depreciation for Year 6 is also allocated $4 to S and $4 to B.

(c) Timing. S's $60 gain is taken into account to reflect the

difference for each consolidated return year between B's

depreciation taken into account with respect to the property and its

recomputed depreciation. For Year 6, B takes $7 of depreciation into

account. If the intercompany transaction had been a transfer between

divisions of a single corporation, B would have succeeded to S's

adjusted basis in the property and taken into account only its $4

allocable share of the property's $8 of depreciation for Year 6.

Thus, S takes $3 of gain into account in Year 6. In each subsequent

year that B operates the property and takes into account $14 of

depreciation ($8 with respect to $40 of basis, and $6 with respect

to $60 of basis), S takes into account $6 of gain to reflect the $6

difference between B's $14 of depreciation taken into account and

its recomputed $8 of depreciation (the depreciation that B would

take into account if the intercompany sale were a transfer between

divisions).

(d) Attributes. S's gain taken into account as a result of B's

depreciation is ordinary income.

(e) Resale of property. The facts are the same as in paragraph

(a) of this Example 4, except that B sells the property to X at the

beginning of Year 10 for an amount equal to its $44 adjusted basis

(applying the half-year convention). To the extent of B's $56 of

depreciation before the sale ($32 with respect to the $40 of basis

corresponding to S's adjusted basis, and $24 with respect to the $60

of additional basis), the timing and attributes of S's gain are

determined in the manner provided in paragraphs (c) and (d) of this

Example 4, and S takes into account $24 of gain in Years 6 through

10 as ordinary income. The $36 balance of S's gain is taken into

account in Year 10 as a result of B's sale to X, to reflect the $36

difference between B's $0 gain taken into account and its $36

recomputed gain ($44 sale proceeds minus the $8 basis B would have

if the intercompany sale were a transfer between divisions of a

single corporation). The attributes of the remaining $36 of S's gain

are determined by treating S and B as divisions of a single

corporation. Thus, the entire $36 of gain is recapture income under

section 1245.

Example 5. Intercompany sale followed by installment sale. (a)

Facts. S holds land for investment with a basis of $70x. On January

1 of Year 1, S sells the land to B for $100x. B also holds the land

for investment. On July 1 of Year 3, B sells the land to X in

exchange for X's $110x note. The note bears a market rate of

interest in excess of the applicable Federal rate, and provides for

principal payments of $55x in Year 4 and $55x in Year 5. The

interest charge under section 453A(c) applies to X's note.

(b) Timing and attributes. S takes its $30x gain into account in

each consolidated return year to reflect the difference between B's

gain taken into account for the year and its recomputed gain. Under

section 453, B takes into account $5x of gain in Year 4 and $5x of

gain in Year 5. Thus, S takes into account $15x of gain in Year 4

and $15x of gain in Year 5. This reflects the $15x difference in

Year 4 and in Year 5 between B's $5x gain taken into account and its

$20x recomputed gain. Both S's $30x gain and B's $10x gain are

subject to the section 453A(c) interest charge beginning in Year 3.

(c) Election out under section 453(d). If, under the facts in

paragraph (a) of this Example 5, the P group wishes to elect not to

apply section 453 with respect to S's gain, an election under

section 453(d) must be made for Year 3 with respect to B's gain.

This election will cause B's $10x gain to be taken into account in

Year 3. Under the matching rule, this in turn will result in S's $30

gain being taken into account in Year 3. (An election by the P group

solely with respect to S's gain has no effect because the gain from

S's sale to B is taken into account under the matching rule, and

therefore must reflect the difference between B's gain taken into

account and its recomputed gain.)

(d) Resale loss, but overall gain. The facts are the same as in

paragraph (a) of this Example 5, except that B sells the land to X

in exchange for X's $90x note (rather than $110x note). B's $10x

loss is taken into account in Year 3 and is not subject to

installment reporting under section 453 (only gain may be reported

on the installment method). There is an aggregate $30x difference

between B's $10x loss taken into account and its $20x recomputed

gain. Under paragraph (c)(2)(ii) of this section, however, B's $20x

recomputed gain is treated as taken into account in Years 4 and 5

under the installment method. Thus, S takes $10x of gain into

account in Year 3 to reflect the $10x difference between B's $10x

loss taken into account and its $0 recomputed gain for Year 3. (None

of B's $20 recomputed gain is treated as taken into account in Year

3 under the installment method). S takes $10x of gain into account

in each of Years 4 and 5 to reflect the difference in those years

between B's $0 gain taken into account and B's $10x recomputed gain

under the installment method. Only the $20x of S's gain taken into

account in Years 4 and 5 is subject to the interest charge under

section 453A(c) beginning in Year 3. (If the P group elects under

section 453(d) for Year 3 to not apply section 453 with respect to

S's gain, the election will be given effect under paragraph

(c)(2)(ii) of this section.)

(e) Intercompany loss, installment gain. The facts are the same

as in paragraph (a) of this Example 5, except that S has a $130x

(rather than $70x) basis in the land. S takes $20x of its loss into

account in Year 3 to reflect the $20x difference between B's $0 loss

taken into account (under section 453) and its $20x recomputed loss.

Of the $10x remaining balance of S's loss, $5x is taken into account

in each of Years 4 and 5 to reflect the $5x difference between B's

$5x gain taken into account and its $0 recomputed gain. (The results

are the same under section 267(f).) S's $20x loss taken into account

in Year 3 is treated like the $20x recomputed loss B would have

taken into account if S and B were divisions of a single

corporation, and S's remaining $5x loss in each of Years 4 and 5

offsets B's gain taken into account. Because B's $5x of gain in each

of Years 4 and 5, and S's $5x of loss in each of Years 4 and 5, are

taken into account at the same time and offset in determining

consolidated taxable income, the gain is not subject to the interest

charge under section 453A(c) for Years 4 and 5. (If B had sold the

land to X for more than $130x, B's gain in excess of S's $30x loss

would be subject to the interest charge under section 453A(c).)

(f) Recapture income. The facts are the same as in paragraph (a)

of this Example 5, except that S bought depreciable property for

$100x and its depreciation deductions reduced the property's basis

to $70x before Year 1, S sells the depreciable property (rather than

land) to B for $100x on January 1 of Year 1, and S's $30x of gain is

recapture income on a separate entity basis under section 1245. S's

gain is treated as recapture income that is ineligible under section

453(i) for installment reporting. Thus, S takes $30x ordinary income

into account in Year 3. B takes its $10 gain into account in Years 4

and 5, and the gain is subject to the interest charge under section

453A(c). (If S has bought the depreciable property for $110x and its

recomputed basis under section 1245 had been $110x (rather than

$100x), B's $10x gain and S's $30x gain would both be recapture

income ineligible under section 453(i) for installment reporting.)

Example 6. Intercompany sale of installment obligation. (a)

Facts. S holds land for investment with a basis of $70x. On January

1 of Year 1, S sells the land to X in exchange for X's $100x note,

and S reports its gain on the installment method under section 453.

X's note bears interest at a market rate of interest in excess of

the applicable Federal rate, and provides for principal payments of

$50x in Year 5 and $50x in Year 6. Section 453A applies to X's note.

On July 1 of Year 3, S sells X's note to B for $100x, and under

section 453B(a) S is considered to recognize the $30x gain from its

prior sale of the land to X.

(b) Timing and attributes. S's sale of X's note to B is an

intercompany transaction, and S's $30x gain is intercompany gain. S

takes $15x of the gain into account in each of Years 5 and 6 to

reflect the $15x difference in each year between B's $0 gain taken

into account and its $15x recomputed gain. S's gain continues to be

treated as its gain from the sale to X, and the deferred tax

liability remains subject to the interest charge under section

453A(c).

(c) Worthlessness. The facts are the same as in paragraph (a) of

this Example 6, except that X's note becomes worthless on December 1

of Year 3 and B has a $100x short-term capital loss under section

165(g) on a separate entity basis. Under the matching rule, B's loss

is a long-term capital loss because B's holding period for X's note

is aggregated with S's holding period. In addition, S takes its $30x

gain into account in Year 3 to reflect the $30x difference between

B's $100x loss taken into account and its $70x recomputed loss. S's

gain is long-term capital gain.

(d) Pledge. The facts are the same as in paragraph (a) of this

Example 6, except that, on December 1 of Year 3, B borrows $100x

from an unrelated bank and secures the indebtedness with X's note.

X's note remains subject to section 453A(d) following the sale to B.

Under section 453A(d), B's $100x of proceeds from the secured

indebtedness is treated as an amount received on December 1 of Year

3 by B on X's note. Thus, S takes its entire $30x gain into account

in Year 3.

Example 7. Performance of services. (a) Facts. S is a driller of

water wells. B operates a ranch in a remote location, and B's

taxable income from the ranch is not subject to section 447. B's

ranch requires water to maintain its cattle. During Year 1, S drills

an artesian well on B's ranch in exchange for $100 from B, and S

incurs $80 of expenses (e.g., for employees and equipment). B

capitalizes its $100 cost for the well under section 263, and takes

into account $10 of cost recovery deductions in each of Years 2

through 11. Under its separate entity method of accounting, S would

take its income and expenses into account in Year 1.

(b) Definitions. Under paragraph (b)(1) of this section, the

service transaction is an intercompany transaction, S is the selling

member, and B is the buying member. S has $100 of income and $80 of

related expenses. Under paragraph (b)(2)(i)(B) of this section, S's

income and expense are both included in determining its intercompany

income of $20.

(c) Timing and attributes. S's $20 of income is taken into

account under the matching rule to reflect the $20 difference

between B's items to be taken into account (based on its $100 cost

basis in the well) and B's recomputed items (based on the $80 basis

B would have if S and B were divisions of a single corporation and

B's basis were determined by reference to S's $80 of expenses). In

Year 1, S takes into account $80 of its income and the $80 of

expenses. In each of Years 2 though 11, S takes $2 of its remaining

$20 of income into account to reflect the annual $2 difference

between B's $10 of cost recovery deductions taken into account and

its $8 of recomputed cost recovery deductions. S's intercompany

income and related expenses, and B's cost recovery deductions, are

ordinary items.

(d) Sale of capitalized services. The facts are the same as in

paragraph (a) of this Example 7, except that B sells the ranch

before Year 11 and recognizes gain attributable to the well. To the

extent of the offsetting $80 income and expense and S's income taken

into account as a result of B's cost recovery deductions, the timing

and attributes are determined in the manner provided in paragraph

(c) of this Example 7. The remainder of S's $20 of income is treated

like the recomputed gain B would have taken into account if S and B

were divisions of a single corporation (recapture income or section

1231 gain, even though it is from S's performance of services).

Example 8. Rental of property. B operates a ranch that requires

grazing land for its cattle. S owns undeveloped land adjoining B's

ranch. On January 1 of Year 1, S leases grazing rights to B for Year

1. B's $100 rent expense is deductible for Year 1 under its separate

entity accounting method. Under paragraph (b)(1) of this section,

the rental transaction is an intercompany transaction, S is the

selling member, and B is the buying member. S takes its $100 of

income into account in Year 1 to reflect the $100 difference between

B's rental deduction taken into account and its $0 recomputed rent

deduction. S's income and B's deduction are ordinary items.

Example 9. Back-to-back intercompany sales. (a) Facts. S holds

land for investment with a basis of $70. On January 1 of Year 1, S

sells the land to M for $90. M also holds the land for investment.

On July 1 of Year 3, M sells the land for $100 to B, and B holds the

land for sale to customers in the ordinary course of business.

During Year 5, B sells all of the land to customers for $105.

(b) Timing. Under paragraph (b)(1) of this section, S's sale of

the land to M and M's sale of the land to B are both intercompany

transactions. S is the selling member and M is the buying member in

the first intercompany transaction, and M is the selling member and

B is the buying member in the second intercompany transaction. Under

paragraph (c)(3)(ii)(B) of this section, S, M and B are treated as

divisions of a single corporation for purposes of determining the

timing of their items from the intercompany transactions. See also

paragraph (j)(1)(ii) of this section (B is treated as a successor to

M for purposes of taking S's intercompany gain into account). Thus,

S's $20 gain and M's $10 gain are both taken into account in Year 5

to reflect the difference between B's $5 gain taken into account

with respect to the land and its $35 recomputed gain (i.e., the gain

that B would have taken into account if the intercompany sales had

been transfers between divisions of a single corporation, and B

succeeded to S's $70 basis).

(c) Attributes. Under paragraphs (c)(3)(ii)(B) of this section,

the attributes of the intercompany items and corresponding i

This text is long and has been trimmed here. Open the source document for the complete record.