# Consolidated Groups and Controlled GroupsIntercompany Transactions and Related Rules

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## Record

- **Collection:** Federal Register
- **Document type:** Uncategorized Document
- **Published:** April 15, 1994

## Text

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.

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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

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A94-8488. Public record. Not legal advice.