Consolidated Groups and Controlled GroupsIntercompany Transactions and Related Rules

DEPARTMENT OF THE TREASURY

26 CFR Parts 1 and 602

[TD 8597]

RIN 1545-AT58

Consolidated Groups and Controlled Groups--Intercompany

Transactions and Related Rules

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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

SUMMARY: This document contains final regulations amending the

intercompany transaction system of the consolidated return regulations.

The final regulations also revise the regulations under section 267(f),

limiting losses and deductions from transactions between members of a

controlled group. Amendments to other related regulations are also

included in this document.

DATES: These regulations are effective July 18, 1995.

For dates of applicability, see the Effective dates section under

the SUPPLEMENTARY INFORMATION portion of the preamble and the effective

date provisions of the new or revised regulations.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations relating to

consolidated groups generally, Roy Hirschhorn of the Office of

Assistant Chief Counsel (Corporate), (202) 622-7770; concerning stock

and 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, 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 these final regulations

have been reviewed and approved by the Office of Management and Budget

in accordance with the requirements of the Paperwork Reduction Act (44

U.S.C. 3504(h)) under control number 1545-1433. The estimated average

annual burden per respondent is .5 hours.

Comments concerning the accuracy of this burden estimate and

suggestions for reducing this burden should be sent to the Internal

Revenue Service, Attn: IRS Reports Clearance Officer, PC:FP,

Washington, DC 20224, and 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.

B. Background

This document contains final regulations under section 1502 of the

Internal Revenue Code of 1986 (Code) that comprehensively revise the

intercompany transaction system of the consolidated return regulations.

Amendments are also made to related regulations, including the

regulations under section 267(f), which apply to transactions between

members of a controlled group.

The proposed regulations were published in the Federal Register on

April 15, 1994 (59 FR 18011). The notice of hearing on the proposed

regulations, Notice 94-49, 1994-1 C.B. 358, 59 FR 18048, contains an

extensive discussion of the issues considered in developing the

proposed regulations. The IRS received many comments on the proposed

regulations and held public hearings on May 4, 1994 and August 8, 1994.

After consideration of the comments and the statements made at the

hearings, the proposed regulations are adopted as revised by this

Treasury decision. The principal comments and revisions are discussed

below. However, a number of other changes have been made to the

proposed regulations. References in the preamble to P, S, and B are

references to the common parent, the selling member, and the buying

member, respectively. No inference is intended as to the operation of

the prior regulations or other rules.

[[Page 36672]]

C. Principal Issues Considered in Adopting the Final Regulations

1. Retention and modification of the deferred sale approach

The proposed regulations generally retain the deferred sale

approach of prior law but comprehensively revise the manner in which

deferral is achieved to eliminate many of the inconsistent combinations

of single and separate entity treatment under prior law.

Notwithstanding these revisions, the results for most common

intercompany transactions remain unchanged.

Commentators uniformly supported the retention of the deferred sale

approach. Some comments, however, suggested that the rules of prior law

should be retained, with modifications only where necessary to address

a specific problem. Since the adoption of the prior regulations in

1966, however, developments in business practice and the tax law have

greatly increased the problems of accounting for intercompany

transactions. Although additional amendments could have been made to

the prior regulations, further amendments would risk raising additional

inconsistencies or uncertainties without providing a unified regime. By

comprehensively revising the intercompany transaction system, the

proposed regulations provide a unified regime and eliminate many of the

inconsistencies of prior law, without changing the results of most

common transactions. The final regulations therefore generally retain

the approach of the proposed regulations.

2. General v. Mechanical Rules

The prior intercompany transaction regulations were generally

mechanical in operation. The proposed regulations rely less on

mechanical rules and, instead, provide broad rules of general

application based on the underlying principles of the regulations. To

supplement the broad rules, the proposed regulations provide examples

illustrating the application of the rules to many common intercompany

transactions.

Some commentators supported the proposed regulations' use of broad

rules based on principles. Others suggested that the final regulations

should retain the mechanical rules of prior law. Mechanical rules

provide more certainty for transactions clearly covered by those rules.

For transactions that are not clearly covered, however, mechanical

rules provide much less guidance.

The final regulations retain the approach of the proposed

regulations. This approach is flexible enough to apply to the wide

range of transactions that can be intercompany transactions. For

example, the final regulations do not require special rules to

coordinate with the depreciation rules under section 168, the

installment reporting rules under sections 453 through 453B, and the

limitations under sections 267, 382, and 469. Flexible rules adapt to

changes in the tax law and reduce the need for continuous updating of

the regulations.

3. Timing Rules of Sec. 1.1502-13 as a Method of Accounting

The proposed regulations provide that ``the timing rules of this

section are a method of accounting that overrides otherwise applicable

accounting methods.'' A group's ability to change the manner of

applying the intercompany transaction regulations is therefore subject

to the generally applicable rules for accounting method changes.

Several comments objected to this treatment.

Commentators pointed out that treating the timing provisions of

these regulations as a group's method of accounting may increase the

burden and complexity of correcting improper applications of the

regulations (for example, necessitating requests for accounting method

changes for the treatment of intercompany transactions). This treatment

also raises questions about members coming into a group and leaving a

group (for example, whether requests to change a method of accounting

are required when a taxpayer becomes, or ceases to be, a member).

Various technical points were also raised as to the effect of a shared

accounting method on each member of a group, the propriety of applying

accounting method rules only to certain transactions or classes of

transactions, the interaction of the intercompany transaction rules

with separate entity accounting methods of members, and the linkage of

the selling member's method of accounting for its intercompany items

with the buying member's method of accounting for its corresponding

items.

The intercompany transaction regulations provide guidance on the

appropriate time for taking into account items of income, deduction,

gain, and loss from intercompany transactions to clearly reflect the

consolidated taxable income of the group. Clear reflection of income is

the central principle of section 446. Under section 446, any treatment

that does or could change the taxable year in which taxable income is

reported is a method of accounting. See Rev. Proc. 92-20, 1992-1 C.B.

685. The timing rules of the intercompany transaction regulations

affect the taxable year in which items from intercompany transactions

are taken into account in the computation of consolidated taxable

income. Accordingly, the timing rules of these regulations are properly

viewed as a method of accounting. Moreover, treating the timing rules

as a method of accounting assures that the provisions will be applied

consistently from year to year under the principles of section 446.

The final regulations retain the general approach of the proposed

regulations, treating the timing rules of Sec. 1.1502-13 as a method of

accounting under section 446. The regulations also contain several

provisions intended to reduce the administrative burden that

commentators believe might result from this treatment. The final

regulations treat the timing rules as an accounting method for

intercompany transactions, to be applied by each member, and not as an

accounting method of the group as a whole. However, an application of

the timing rules of this section to an intercompany transaction will be

considered to clearly reflect income only if the effect of the

transaction on consolidated taxable income is clearly reflected. This

treatment more closely conforms to the general practice of separate

taxpayers having their own methods of accounting, thereby alleviating

technical and administrative issues that were raised with respect to

characterization of the method as the method of the group as a whole,

rather than as the method of each member.

To reduce potential administrative burdens further, the final

regulations generally provide automatic consent under section 446(e) to

the extent changes in method are required when a member enters or

leaves a group. In addition, for the first taxable year of the group to

which the final regulations apply, consent is granted for any changes

in method that are necessary to comply with the final regulations. For

other years, members must obtain the Commissioner's consent to change

their methods of accounting for intercompany transactions under

applicable administrative procedures of section 446(e), currently Rev.

Proc. 92-20. The regulations provide that changes will generally be

effected on a cut-off basis (that is, the new method will apply to

intercompany transactions occurring on or after the first day of the

consolidated return year for which the change is effective). Changes in

methods of accounting for intercompany transactions generally will

otherwise be subject to the terms and conditions of applicable

administrative procedures. The IRS may determine, however, that other

terms and conditions are

[[Page 36673]]

appropriate in the interest of sound tax administration (for example,

if a taxpayer misapplies the regulations to avoid matching S's

intercompany item with B's corresponding item). See section 10 of Rev.

Proc. 92-20.

Paragraph (e)(3) of the final regulations continues the procedure

whereby the common parent may request consent from the IRS to report

intercompany transactions on a separate entity basis. Rev. Proc. 82-36

(1982-1 C.B. 490), which provides procedures for obtaining consent

under the prior regulations, will be updated and revised. Until new

procedures are provided, taxpayers may rely on the principles of Rev.

Proc. 82-36 in making applications under these final regulations.

If consent under paragraph (e)(3) of these regulations is obtained

or revoked, the final regulations provide the Commissioner's consent

under section 446(e) for each member to make any changes in methods of

accounting necessary to conform members' methods of accounting to the

consent or revocation. Any change in method under this provision must

be made as of the beginning of the first year for which the consent (or

revocation of consent) under paragraph (e)(3) is effective.

A group that has received consent under the prior intercompany

transaction regulations not to defer items from deferred intercompany

transactions will be considered to have obtained the consent of the

Commissioner to take items from the same class (or classes) of

intercompany transactions into account on a separate entity basis under

these regulations.

4. Single Entity Treatment of Attributes

a. In General

The prior intercompany transaction system used a deferred sale

approach that treated the members of a consolidated 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 were given separate entity treatment, but

the timing of items was determined under rules that produced a single

entity effect.

The matching rule of the proposed regulations expands single entity

treatment by requiring the redetermination of the attributes (such as

character and source) of items to produce a single entity effect.

Several comments supported the broader single entity approach taken by

the proposed regulations. Other comments asked that separate entity

treatment of attributes be retained.

The commentators arguing for retention of separate entity treatment

claimed that single entity treatment does not always result in more

rational tax treatment, and may not reflect the economic results of a

group's activities as accurately as separate entity treatment. They

also argued that taxpayers should have the ability to avoid arbitrary

results or administrative burdens by separately incorporating business

operations. The Treasury and the IRS believe that single entity

treatment of both timing and attributes generally results in a clear

reflection of consolidated taxable income. In particular, single entity

treatment minimizes the effect of an intercompany transaction on

consolidated taxable income. In addition, single entity treatment

minimizes the tax differences between a business structured

divisionally and one structured with separate subsidiaries. The final

regulations therefore retain the approach of the proposed regulations

and generally adopt single entity treatment of attributes.

Nevertheless, in certain situations it may be appropriate to

provide separate entity treatment. The Treasury and the IRS believe

that these situations are relatively rare, and that any exceptions from

single entity treatment should be specifically provided in regulations.

For example, a separate entity election is permitted under Prop. Reg.

Sec. 1.1221-2(d) (published in the Federal Register on July 18, 1994,

59 FR 36394) in the case of certain hedging transactions. See also

Sec. 1.263A-9(g)(5). The Treasury and the IRS welcome comments on other

situations in which this type of relief might be appropriate.

b. Conflict or Allocation of Attributes

The proposed regulations provide specific rules for certain cases

in which separate entity attributes are redetermined under the matching

rule. Some commentators believe that the proposed regulations do not

provide sufficient guidance as to the manner in which these rules are

to be applied. In response to these comments, the attribute

redetermination provisions of the matching rule have been revised.

For example, the regulations have been revised to clarify that the

separate entity attributes of S's intercompany item and B's

corresponding item are redetermined under the matching rule only to the

extent necessary to produce the same effect on consolidated taxable

income as if the intercompany transaction had been between divisions.

Thus, the redetermination is required only to the extent the separate

entity attributes differ from the single entity attributes.

The final regulations generally retain the rule of the proposed

regulations under which the attributes of B's corresponding item

control the attributes of S's intercompany items to the extent the

corresponding and intercompany items offset in amount. However, the

final regulations provide an exception to this rule to the extent its

application would lead to a result that is inconsistent with treating S

and B as divisions of a single corporation. To the extent B's

corresponding item on a separate entity basis is excluded from gross

income or is a noncapital, nondeductible amount (such as a deduction

disallowed under section 265), however, the attribute of B's item will

always control. This assures the proper operation of attribute

limitation provisions contained elsewhere in the regulations.

To the extent B's corresponding item and S's intercompany item do

not offset in amount, the final regulations provide that redetermined

attributes are allocated to S's intercompany item and B's corresponding

item using a method that is reasonable in light of all of the facts and

circumstances, including the purposes of these regulations and any

other rule affected by the attributes of S's items or B's items. This

rule provides taxpayers considerable flexibility to allocate

attributes, but the regulations also provide that an allocation method

will be treated as unreasonable if it is not used consistently by all

members of the group from year to year.

c. Source of Income

Several commentators opposed single entity treatment for

determining the source of income or loss from an intercompany

transaction, arguing that the separate entity treatment under prior law

more accurately measures the source of income of the members of the

group. The final regulations, however, retain the single entity

treatment of source for the same reasons that the single entity

treatment of other attributes is retained. The final regulations modify

the example in the proposed regulations to reflect the changes made to

the attribute allocation rules.

Some comments suggested that a single entity approach would

inappropriately reduce the foreign source income of consolidated groups

that produce a natural resource abroad and sell it to customers within

the United States. For example, assume that one member extracts a

commodity

[[Page 36674]]

abroad and sells it to a second member, with title passing within a

foreign country. The second member sells the commodity to unrelated

customers with title passing in the United States. Assume that the

first member's income is 80 percent of the group's income and would be

treated solely as foreign source income under a separate entity

approach. Under a single entity approach, the intercompany transaction

is treated as occurring between divisions of a single corporation. If

the special sourcing rule for production and sale of natural resources

under the section 863 regulations does not apply because of ``peculiar

circumstances,'' the income of the group will be subject to the so-

called 50/50 rule of the section 863 regulations, and a portion of the

group's foreign source income could be recharacterized as domestic

source. Revisions to the section 863 regulations are being considered

to address these issues. The Treasury and the IRS welcome comments

regarding possible revisions to the section 863 regulations.

Another commentator noted that under the single entity approach, a

pro rata allocation of the group's foreign and U.S. source income (as

illustrated in Example 17 of paragraph (c) of the proposed regulations)

could cause a member that qualified as an ``80/20'' company under

section 861(a)(1)(A) to lose that status. As a result, the member could

be required to withhold Federal income tax on interest payments to a

foreign lender. As indicated above, the final regulations revise the

attribute rules to clarify that a redetermination is made only to the

extent it is necessary to achieve the effect of treating S and B as

divisions of a single corporation and to provide that redetermined

attributes are allocated to S and B using a method that is reasonable

in light of the purposes of Sec. 1.1502-13 and any other affected rule.

Thus, the group is not required to allocate U.S. and foreign source

income on a pro rata basis, and a member that qualifies as an 80/20

company under current law generally need not lose that status solely as

the result of the allocation from a transaction similar to that

described in the example.

Commentators also suggested that the pro rata allocation

methodology of the proposed regulations could be inconsistent with U.S.

income tax treaties that require the United States to treat income that

may be taxed by the treaty partner as derived from sources within the

treaty partner. As revised, the attribute rules do not require the

group to allocate U.S. and foreign source income on a pro rata basis.

Thus, the regulations will generally be consistent with any source

rules contained in U.S. income tax treaties. To the extent, however,

that a U.S. income tax treaty provides benefits to a taxpayer, these

regulations do not prevent a taxpayer from claiming those benefits.

The final regulations expand the example to illustrate the

determination of source if an independent factory or production price

exists, and also for a sale of mixed source property within the group

that is subsequently sold outside the group if, incident to the sale,

services are performed by one member for another member or intangibles

are licensed from one member to another member. Example 18 of paragraph

(c) of the proposed regulations (Example 15 of the final regulations)

addresses the application of section 1248 to intercompany transactions

and has been revised to reflect the changes made to the attribute

allocation provisions. Issue 3 of Rev. Rul. 87-96 (1987-2 C.B. 709)

will no longer be applicable to the extent it is inconsistent with

Example 15 and these regulations.

d. Limitation on attribute redetermination

The proposed regulations contain a provision limiting the treatment

of S's intercompany income or gain as excluded from gross income under

the matching rule to situations in which B's corresponding item is a

deduction or loss that is permanently disallowed directly under other

provisions of the Code or regulations. The final regulations clarify

that the Code or regulations must explicitly provide for the

disallowance of B's deduction or loss. Thus, B's amount that is

realized but not recognized under any provision of the Code or

regulations, such as in a liquidation under section 332, is not

permanently and explicitly disallowed, notwithstanding that the amount

may be considered a corresponding item because it is a ``disallowed or

eliminated amount.''

5. Deemed Items

The proposed regulations provide rules under which certain basis

adjustments are deemed to be items, and certain amounts are deemed not

to be items. Under the proposed regulations an adjustment reflected in

S's basis that is a substitute for an intercompany item is generally

treated as an intercompany item (the ``deemed intercompany item

rule''). An adjustment reflected in B's basis that is a substitute for

a corresponding item is generally treated as a corresponding item (the

``deemed corresponding item rule''). In addition, a deduction or loss

is not treated as an intercompany item or a corresponding item to the

extent it does not reduce basis (the ``amounts not deemed to be items

rule''). Commentators found these rules to be confusing. In addition,

the rules generally overlap with other rules of the proposed

regulations.

For example, the deemed intercompany item rule overlaps with the

rule of the proposed regulations under which S's items must be taken

into account even if they have not yet been taken into account under

S's separate entity accounting method. If, under its method of

accounting, S's income from an intercompany transaction is treated as a

basis reduction, both rules could apply.

Similarly, the deemed corresponding item rule overlaps with the

acceleration rule. S's intercompany item is taken into account under

the acceleration rule to the extent it will not be taken into account

under the matching rule. Thus, an adjustment to B's basis may result in

accelerating S's intercompany item, to the extent the intercompany item

is not reflected in B's basis following the adjustment. Because this is

the same result that would occur under the deemed corresponding item

rule, it is not necessary to treat the basis adjustment as a

corresponding item under the matching rule. For example, B's reduction

in the basis of property acquired from S under section 108(b) will

cause S's intercompany gain to be accelerated to the extent the basis

reduction exceeds S's basis in the property prior to the intercompany

transaction.

The amounts deemed not to be items rule treats certain amounts that

are within the definition of intercompany items as not being

intercompany items to achieve a result consistent with these

regulations and other Code provisions. Commentators indicated that this

rule has limited application, does not achieve its desired effect in

all cases, and is confusing to readers.

For these reasons, the deemed item rules and the amounts deemed not

be items rule have been eliminated in the final regulations. Because

the deemed item rules overlap with other provisions, their effects have

been retained in the final regulations. In addition, to achieve the

intended effect of the amounts deemed not be items rule, the attribute

provisions of the final regulations have been modified to permit the

Commissioner to treat intercompany gain as excluded from gross income

when that treatment is consistent with these regulations and other

applicable provisions of the Code.

[[Page 36675]]

6. The Acceleration Rule

The acceleration rule requires S and B to take into account their

items from an intercompany transaction to the extent the items cannot

be taken into account to produce the effect of treating S and B as

divisions of a single corporation. The acceleration rule applies, for

example, when either S or B leaves the group. Under the proposed

regulations, the attributes of S's items from intercompany property

transactions are determined under the principles of the matching rule

``as if B resold the property to a nonmember affiliate.'' Under this

rule, S's gain from the sale of depreciable property is always treated

as ordinary income under section 1239. This treatment is appropriate if

the property remains in the group, as it would, for example, if the

acceleration rule applies because S leaves the group. Many commentators

objected to this treatment of S's attributes in other situations,

arguing, for example, that if B leaves the group while it still owns

the property, the rules should treat the property as sold to a person

whose relationship to the group is the same as B's relationship to the

group after it becomes a nonmember. The commentators argued that

section 1239 should not apply if B is unrelated.

In response to these comments, the final regulations revise the

acceleration rule to provide that if the property is owned by a

nonmember immediately after the event causing acceleration occurs, S's

attributes are determined under the principles of the matching rule as

if B had sold the property to that nonmember. In applying this rule, if

the nonmember is related for purposes of any provision of the Code or

regulations to any party to the intercompany transaction (or any

related transaction) or to P, the nonmember is treated as related to B

for purposes of that provision. Accordingly, that relationship may

affect the attributes of S's intercompany item.

Under both the prior regulations and the proposed regulations, if S

sells an asset to B at a gain and B then transfers the asset to a

partnership, S's gain is taken into account under the acceleration

rule. Some commentators argued that gain should not be taken into

account, at least to the extent of the member's share of the asset

owned through the partnership, treating the partnership, in effect, as

an aggregate of its partners, rather than as an entity. One commentator

argued that continued deferral would be similar to the treatment

currently available under the remedial allocation method under

Sec. 1.704-3 if appreciated property is transferred to the partnership

without a prior intercompany transfer.

The final regulations retain the rule of the proposed regulations.

One of the purposes of the acceleration rule is to prevent basis

created in an intercompany transaction from affecting nonmembers prior

to the time the group takes into account the transaction that created

the basis. Allowing property that B purchased from S at a gain to be

contributed to a partnership without acceleration would allow the basis

created in the intercompany transaction to be reflected by the

partnership prior to the group taking into account the gain. While

rules could be developed to prevent this basis from affecting

nonmembers in most circumstances, the rules would be unduly complex.

For example, the rules would have to take into account the allocation

of liabilities under section 752 and basis adjustments under section

755. Moreover, these rules would not resemble the remedial allocation

method under Sec. 1.704-3 but instead would more closely resemble the

deferred sale method under the proposed regulations under section

704(c). However, this method was explicitly rejected when final

regulations were issued. See Sec. 1.704-3(a)(1).

7. Transactions Involving Stock of Members

a. Single Entity Treatment of Stock

In contrast to their predominantly single entity approach, the

proposed regulations generally retain separate entity treatment of

stock of members. For example, section 1032, which enables a member to

sell its own stock without recognition of gain or loss, is not extended

to sales of the stock of other members. Notice 94-49 (1994-1 C.B. 358)

discusses the difficulties of extending single entity treatment to

stock.

Several comments recommended greater single entity treatment of

stock. Some recommended a limited approach under which single entity

treatment would apply only to stock of the common parent. Under this

approach section 1032 treatment would be expanded so that any member

could sell stock of the common parent without recognizing any gain or

loss. As a corollary, gain or loss would be recognized when a

corporation owning stock of the common parent joined the group,

treating the stock, in effect, as redeemed.

This suggestion was generally not adopted in the final regulations,

because single entity treatment of P stock would significantly increase

the complexity of the regulations and would require significant

additional guidance dealing with the effect of this treatment on other

provisions of the Code. For example, the regulations would have to

coordinate single entity treatment of P stock with the reorganization

provisions of the Code and applicable case law. Similarly, the

regulations would have to address situations in which the common parent

of the group changes, as well as a variety of collateral consequences.

Nevertheless, the Treasury and the IRS believe that limited single

entity treatment of stock is needed to prevent disparities caused by

separate entity treatment. Therefore, temporary regulations published

elsewhere in this issue of the Federal Register provide a limited

single entity approach to P stock that generally limits the ability of

a group to create loss with respect to P stock and eliminates gain in

certain circumstances. The feasibility of expanding single entity

treatment for stock of members will continue to be studied. Comments

and suggestions on this subject are welcome.

b. Liquidations

The proposed regulations provide that if S sells stock of a

corporation (T) to B and T later liquidates into B in a transaction to

which section 332 applies, S's intercompany gain is taken into account

under the matching rule, even though the T stock is never held by a

nonmember after the intercompany transaction. This treatment is similar

to the treatment under prior regulations and has applied to

liquidations under section 332 since 1966 and to deemed liquidations

under 338(h)(10) since 1986, although the proposed regulations provide

relief not previously available for these transactions.

Some commentators suggested that this rule should be eliminated

because it could lead to two layers of tax inside the consolidated

group. The final regulations, however, retain the rule (with the

elective relief as described below). As more fully explained in Notice

94-49, the location of items within a group is a core principle

underlying the operation of these regulations, which like the prior

regulations, adopt a deferred sale approach, not a carryover basis

approach. Taking intercompany gain into account in the event of a

subsequent nonrecognition transaction is necessary to prevent the

transfer and liquidation of subsidiaries from being used to affect

consolidated taxable income or tax liability by changing the location

of items within a group (a result that would be equivalent to a

[[Page 36676]]

carryover basis system). For example, assume that S has an asset with a

zero basis and a $100 value. The group would like to shift this built-

in gain to B. To do so, S could transfer the asset to T, a newly formed

subsidiary. After the transfer, S has a zero basis in the T stock under

section 358, and T has a zero basis in the asset under section 362. S

then sells the T stock to B for $100 and realizes a $100 gain, which is

not taken into account. T later liquidates into B, which receives the

asset with a zero basis under section 334. If the transaction is not

recharacterized as a direct transfer of assets or is not subject to

adjustment under section 482, and S's gain on the sale of the T stock

is treated as tax-exempt (or if it is indefinitely deferred), the

series of transactions has the effect of a transfer of the asset by S

to B in a carryover basis transaction.

The Treasury and the IRS rejected a carryover basis system for the

reasons detailed in Notice 94-49. While a carryover basis system might

be feasible in limited circumstances, extensive rules to prevent

avoidance transactions would be required. The result would be to burden

the consolidated return regulations with an unworkable combination of

rules for both a deferred sale approach and a carryover basis approach.

Accordingly, the rule of the proposed regulations has been retained.

The regulations have been modified, however, to permit S to determine

the amount of its taxable gain by offsetting intercompany gain with

intercompany loss on shares of stock having the same material terms.

c. Liquidation Relief

The proposed regulations provide elective relief that, in certain

circumstances, eliminates or offsets gain taken into account under the

matching rule as a result of a section 332 liquidation (or a comparable

nonrecognition transaction, such as a downstream merger). In response

to comments, the final regulations broaden the circumstances under

which this relief is available by eliminating the requirements that T

have no minority shareholders and that T not have made substantial

noncash distributions during the previous 12-month period.

The available relief depends on the form of the transaction that

causes S's intercompany gain to be taken into account. In the case of a

liquidation of T under section 332, relief is provided by treating the

formation by B of a new subsidiary (new T) as if it were pursuant to

the same plan or arrangement as the liquidation (thus allowing

treatment as a reorganization if other applicable requirements are

met). The final regulations expand the scope of this relief over that

provided in the proposed regulations by allowing the transfer of assets

to new T to be completed up to 12 months after the timely filing

(including extensions) of the group's return for the year of T's

liquidation, so long as the transaction occurs pursuant to a written

plan, a copy of which is attached to the return. In the case of a

deemed liquidation of T as the result of an election under section

338(h)(10) in connection with B's sale of the T stock to a nonmember,

relief is provided by treating the deemed liquidation as if it were

governed by section 331 instead of section 332. The amount of loss

taken into account on the deemed liquidation is limited to the amount

of the intercompany gain with respect to the T stock that is taken into

account as a result of the deemed liquidation.

Some commentators requested that the relief applicable for a deemed

liquidation resulting from a section 338(h)(10) election be extended to

actual liquidations under section 332--that is, the liquidation would

be a taxable event both to T and to B (with T's gain or loss not

deferred, and B's basis in the T stock adjusted under Sec. 1.1502-32 to

reflect T's gain or loss from the taxable liquidation). This suggestion

was not adopted. The suggestion would result in the group currently

taking into account gain from, and increasing the basis of, property

that continues to be held within the group. Adopting the commentators'

suggestion could give groups the ability to selectively avoid the

deferral of gain on intercompany transactions by instead engaging in

stock sales and liquidations. Such selectivity would be contrary to the

purpose of these regulations and could create the potential for abusive

transactions.

d. Effective Date of Relief Provisions

As proposed, the effective date of the relief provisions follows

the general effective date of the regulations, applying only if both

the intercompany transaction and the triggering event occur in years

beginning after the final regulations are filed with the Federal

Register. Commentators requested retroactive application of the relief

provisions to varying degrees. For example, some commentators suggested

that the relief should extend to transactions after the date the

regulations are finalized. Others suggested that the relief should

apply for any open year.

In response to these comments, the final regulations adopt an

effective date that allows groups to elect to apply the relief

provisions to certain transactions that occur on or after July 12,

1995, regardless of whether the sale of the T stock from S to B

occurred prior to July 12, 1995.

The final regulations neither provide relief for duplicated gains

nor preclude losses taken into account under the prior regulations in

periods prior to the effective date of the regulations. Broader

retroactivity would result in significant additional administrative

burdens for the IRS. In addition to an increase in amended returns,

taxpayers that made elections to avoid triggering S's gain (for

example, under section 338) might seek to revoke these elections.

Revocation of these elections could raise difficult valuation issues

for assets that were disposed of long ago, as well as questions with

respect to other rules that have since been amended. In addition,

relief for prior years would be somewhat arbitrary. For example, many

taxpayers, such as those whose gain was taken into account from a

liquidation of T into B, would be unable to benefit from the relief

(because the relief requires T to be reformed within a limited time

period). By allowing elective relief only for transactions occurring

after the date the regulations are filed, the final regulations provide

the most relief possible without creating these problems.

8. Obligations of Members

a. Deemed Satisfaction and Reissuance

In addition to the general matching provisions, the proposed

regulations provide rules applicable to intercompany obligations that

generally operate to match an obligor's items with an obligee's items

from intercompany obligations. This matching results from a deemed

satisfaction and reissuance of an intercompany obligation when either

member realizes income or loss with respect to the intercompany

obligation from the assignment or extinguishment of all or part of the

remaining rights or obligations under the intercompany obligation, or

from a comparable transaction, such as marking to market. For example,

if one member is a dealer in securities that holds a security issued by

another member, the dealer might be required to market the security

issued by the other member at year-end under section 475. Under the

proposed regulations, to market the other member's security will result

in a deemed satisfaction and reissuance of the security, so that the

marking member and the issuing member take offsetting gain and loss

into account.

Commentators objected to the deemed satisfaction and reissuance

provision as requiring significant recordkeeping and

[[Page 36677]]

burdensome computations that are not required for financial statement

or internal management reporting purposes. Commentators suggested that

Prop. Reg. Sec. 1.446-4(e)(9) (published in the Federal Register on

July 18, 1994, 59 FR 36394), which permits separate entity treatment

for certain hedging transactions between members, should be extended

beyond hedging transactions to other intercompany obligations, provided

one party to the transaction marks its position to market. Separate

entity treatment would avoid the deemed satisfaction and reissuance

rule if one member is a dealer in securities required to mark its

securities to market.

The final regulations do not adopt this suggestion. The rules of

Sec. 1.446-4 limit the nonmarking member's ability to selectively

recognize gain or loss on its position in the intercompany obligation.

Without a limitation of this type, separate entity treatment would

allow taxpayers to achieve results that are contrary to the purposes of

these regulations (for example, by allowing a member to mark a loss

position in an intercompany obligation while the other member defers

realization of the associated gain). Accordingly, separate entity

treatment is not made available in the final regulations to other types

of intercompany obligations.

The Treasury and the IRS recognize that Prop. Reg. Sec. 1.446-

4(e)(9) provides an important exception to the general single entity

treatment of these final regulations. The Treasury and the IRS

anticipate that the proposed section 446 regulations will be finalized

shortly.

b. Cancellation of Intercompany Indebtedness

The proposed regulations do not affect the application of section

108 to the cancellation of intercompany indebtedness. For example,

under the proposed regulations if S loans money to B, a cancellation of

the loan subject to section 108(a) may result in: (i) excluded income

to B; (ii) a noncapital, nondeductible expense to S (under the matching

rule); and (iii) a reduction of B's tax attributes (such as its basis

in depreciable property). As a result, B's tax attributes are reduced

even though the group has not excluded any income on a net basis.

Accordingly, the final regulations provide that section 108(a) does not

apply to the cancellation of intercompany indebtedness. As a result of

this change, the general principles of the matching rule will prevent

transactions to which section 108(a) would otherwise apply from having

inappropriate effects on basis and consolidated taxable income. In the

preceding example, S and B will have offsetting ordinary income and

ordinary loss, and B's tax attributes will not be reduced. However, no

inference is intended as to whether the extinguishment of a loan

between S and B would be properly characterized as a transaction giving

rise to cancellation of indebtedness income within the meaning of

sections 61(a)(12) and 108, or as a contribution to capital, a dividend

or other transaction.

c. Obligations Becoming Intercompany Obligations

Under the proposed regulations, if an obligation becomes an

intercompany obligation, it is treated as satisfied and reissued

immediately after the obligation becomes an intercompany obligation.

This treatment applies to both the issuer and the holder. The

attributes of the issuer's items and the holder's items are separately

determined, and thus may not match. Commentators requested that the

rules be revised to allow for single entity treatment of attributes, to

avoid the mismatch of ordinary income with capital loss.

This suggestion was not adopted. The use of separate return

attributes for gain and loss assures that the attributes of gain or

loss will be the same whether the obligation is retired immediately

before the transaction in which the obligation becomes an intercompany

obligation, or is deemed retired as a result of that transaction.

Providing for the use of single entity attributes would result in undue

selectivity. In addition, the separate entity treatment of attributes

in these circumstances best reflects the fact that the income and loss

taken into account accrued before the issuer and the holder joined in

filing a consolidated return.

Commentators also noted that, under Sec. 1.1502-32, downward stock

basis adjustments would be required upon the expiration of any capital

losses created by the deemed satisfaction if a member joins the group

while holding an obligation of another member. Because the proposed

regulations provide that the deemed satisfaction and reissuance is

treated as occurring immediately after the obligation becomes an

intercompany obligation, these losses could not be waived under

Sec. 1.1502-32(b)(4). In response to this comment, the final

regulations provide that, solely for purposes of Sec. 1.1502-32(b)(4)

and the effect of any elections under that provision, the joining

member's loss from the deemed satisfaction and reissuance is treated as

a loss carryover from a separate return limitation year. Thus, the

group may elect to waive the capital losses and avoid the downward

basis adjustment.

d. Warrants and Similar Instruments

The proposed regulations do not provide special rules for the

treatment of warrants to acquire a member's stock. The proposed

regulations could, however, be read to include warrants within the

definition of intercompany obligations.

Under section 1032, warrants and other positions in stock of the

issuer are treated like stock. See, for example, Rev. Rul. 88-31, 1988-

1 C.B. 302. The treatment of warrants as intercompany obligations

subject to a single entity regime is inconsistent with the general

separate entity treatment of stock under these regulations.

Accordingly, the final regulations provide that warrants and other

positions with respect to a member's stock are not treated as

obligations of that member. Instead, these instruments are governed by

the rules generally applicable to stock of a member. In addition, the

final regulations provide that the deemed satisfaction and reissuance

rule for intercompany obligations will not apply to the conversion of

an intercompany obligation into the stock of the obligor.

9. Anti-avoidance Rule

The purpose of the 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 provide that

transactions which are engaged in or structured with a principal

purpose to achieve a contrary result are subject to adjustment under

the anti-avoidance rule, notwithstanding compliance with other

applicable authorities. Some commentators criticized this rule as being

overly broad, unnecessary, and more appropriately placed in other

regulations, such as Sec. 1.701-2 (the partnership anti-abuse

regulation). Other commentators supported the use of anti-avoidance

rules but criticized the particular examples. The Treasury and the IRS

continue to believe that the anti-avoidance rule is necessary to

prevent transactions that are designed to achieve results inconsistent

with the purpose of the regulations and therefore the final regulations

retain the rule. Routine intercompany transactions that are undertaken

for legitimate business purposes generally will be unaffected by the

anti-avoidance rule.

The anti-avoidance provision can apply to transactions that are

structured

[[Page 36678]]

to avoid treatment as intercompany transactions. For example, if

property is indirectly transferred from one member to another using a

nonmember intermediary to achieve a result that could not be achieved

by a direct transfer within the group, the anti-avoidance rule might

apply. Thus, transactions that take place indirectly between members

but are not intercompany transactions (including, for example,

transactions involving the use of fungible property, trusts,

partnerships, and intermediaries) will be analyzed to determine whether

they are substantially similar (in whole or in part) to an intercompany

transaction, in which case the anti-avoidance rule might apply.

The examples from the proposed regulations have been revised to

better illustrate the effect of the anti-avoidance rule. Example 2 of

the proposed regulations, which involved a transfer outside of the

group to a partnership, has been eliminated. However, the transaction

described in that example, as with any other transaction, is subject to

challenge under other authorities. See, for example, Sec. 1.701-2.

10. Transitional Anti-avoidance Rule

To prevent manipulation, the proposed regulations provide that if a

transaction is engaged in or structured on or after April 8, 1994, 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, appropriate adjustments must be made

in years to which the final regulations apply to prevent the avoidance,

duplication, omission, elimination, or inconsistency.

Commentators objected to this rule, arguing that it had the effect

of treating the proposed regulation as an immediately effective

temporary regulation. These commentators also raised questions as to

when the rule applies and what ``appropriate adjustments'' will be

necessary.

Because of the prospective application of the regulations, and

particularly because members could otherwise engage in transactions

entirely within the group with a principal purpose to avoid the

application of the final regulations with almost no transaction costs,

this rule is retained in the final regulations, with minor

clarifications.

11. Dealers in Securities

If S is a dealer in securities under section 475 and sells

securities to B, a nondealer, the proposed regulations require S to

treat any gain or loss on the sale as an intercompany item.

Furthermore, under the single entity approach of the matching rule, B

must continue to mark to market securities acquired from S.

Several commentators argued that this approach is inconsistent with

proposed regulations under section 475, which require S to mark to

market the security immediately before the transfer, and take any gain

or loss into account immediately (that is, the gain or loss is not

subject to deferral under the prior intercompany transaction

regulations).

Although the rules applicable to these types of transactions under

the proposed regulations and the proposed section 475 regulations

differ, the effects of these transactions on consolidated taxable

income are generally the same. That is, the dealer's gain or loss is

taken into account in the taxable year of the transfer.

The approach of the proposed intercompany transaction regulations

is consistent with the general single entity principle, and has been

retained in the final regulations. Nevertheless, the Treasury and the

IRS will continue to consider the most appropriate treatment of these

transactions, in view of the underlying purposes of these regulations

and section 475. The Treasury and the IRS anticipate that upcoming

regulations under section 475 will address any remaining

inconsistencies in the approach, and will provide exceptions to the

single entity approach if appropriate. Comments and suggestions on this

subject are welcome.

12. Changes to Section 267 Regulations

The proposed regulations under section 267(f) generally provide

that losses from sales or exchanges of property between related parties

are taken into account in the same manner as is provided in the timing

provisions of the regulations under Sec. 1.1502-13. Several technical

changes have been incorporated into the final regulations under section

267.

For example, the regulations clarify that to the extent S's loss

would have been treated as a noncapital, nondeductible amount under the

attribute rules of the regulations under Sec. 1.1502-13, the loss is

deferred under section 267(f) until S and B are no longer in a

controlled group relationship with each other. Section 267 is intended

to prevent a taxpayer from taking a loss into account from the sale or

exchange of property when the property continues to be held by a member

of the same controlled group. Under Sec. 1.1502-13, S's loss might be

taken into account but redetermined to be noncapital or nondeductible,

permanently preventing the loss from being taken into account. It could

be argued that this is the result of the attribute provisions of

Sec. 1.1502-13, which do not apply under section 267(f), not a result

of the timing provisions of Sec. 1.1502-13, and thus, a controlled

group member could take its loss into account. The change made in the

final regulations assures that the purpose of section 267 is not

defeated as a result of the non-application of the attribute

redetermination rules of Sec. 1.1502-13 for purposes of section 267(f).

The proposed regulations also require loss deferral similar to

section 267(d) when B transfers property acquired at a loss from S to a

nonmember related party. This provision has been modified in the final

regulations to include parties described in section 707(b) as related

parties to prevent avoidance of the rules of section 267 through the

use of related partnerships.

13. Election to Deconsolidate

Section 1.1502-75 authorizes the Commissioner to grant all groups,

or groups in a particular class, permission to discontinue filing

consolidated returns if any provision of the Code or regulations has

been amended and the amendment could have a substantial adverse effect

relative to the filing of separate returns. The Commissioner has

determined that it is generally appropriate to grant permission to

discontinue filing consolidated returns as a result of the amendments

made in these regulations. To lessen taxpayer burden and ease

administrability, permission will be granted without requiring the

group to demonstrate any adverse effect. The Treasury and the IRS

intend to issue, prior to January 1, 1996, a revenue procedure pursuant

to which groups may receive permission to deconsolidate effective for

their first taxable year to which these regulations apply. Permission

for a group to deconsolidate will be granted under terms and conditions

similar to those prescribed in Rev. Proc. 95-11 (1995-4 I.R.B. 48).

D. Effective Dates

The regulations are effective in years beginning on or after July

12, 1995. For dates of applicability, see Sec. 1.1502-13(l).

E. Special Analyses

It has been determined that this Treasury Decision is not a

significant regulatory action as defined in EO 12866. Therefore, a

regulatory assessment is not required. It is hereby certified that

these regulations do not have a significant economic impact on

[[Page 36679]]

a substantial number of small entities. This certification is based on

the fact that these regulations will primarily affect affiliated groups

of corporations that have elected to file consolidated returns, which

tend to be larger businesses. The regulations also govern certain

transactions between members of controlled groups of corporations, but

generally produce the same results for such transactions as current

law. The regulations do not significantly alter the reporting or

recordkeeping duties of small entities. Therefore, a Regulatory

Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C.

chapter 6) is not required. Pursuant to section 7805(f) of the Internal

Revenue Code, the notice of proposed rulemaking preceding these

regulations was submitted to the Small Business Administration for

comment on its impact on small business.

List of Subjects

26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

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

revising the entries for Secs. 1.1502-13, 1.1502-33, and 1.1502-80, as

set forth below; by removing the entries for sections ``1.469-1'',

``1.469-1T'', ``1.1502-13T'', ``1.1502-14'', and ``1.1502-14T''; and

adding the remaining entries in numerical order to read as follows:

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 also issued under 26 U.S.C. 469. * * *

Section 1.469-1T 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. * * *

Section 1.1502-79 also issued under 26 U.S.C. 1502. * * *

Section 1.1502-80 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)( which results in

b), 1st sentence. ``deferred gain or

loss'' within the

meaning of paragraph

(c) of 1.1502-13.

1.167(c)-1(a)(5)....... , 1.1502-13, and 1.1502- and 1.1502-13

14.

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

2nd sentence. transaction. transaction

1.263A-1T(e)(1)(ii), a deferred intercompany an intercompany

1st sentence. transaction. transaction

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

4th sentence.

1.263A-1T(e)(1)(ii), deferred...............

4th sentence.

1.263A-1T(e)(1)(ii), ''deferred intercompany ``intercompany

7th sentence. transaction''. transaction''

1.263A-1T(e)(1)(ii), defined................ as used

7th 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.

1.279-6(b)(4).......... , Sec. 1.1502-13T,

Sec. 1.1502-14, or

Sec. 1.1502-14T.

1.337(d)-1(a)(5) 1.1502-13(c)........... 1.1502-13

Example 8(i), 5th

sentence.

1.337(d)-1(a)(5) 1.1502-13(c)........... 1.1502-13

Example 8(ii), 1st

sentence.

1.337(d)-1(a)(5) 1.1502-13(f)(1)(i), 1.1502-13, 1.267(f)-1

Example 8(ii), 2nd 1.267(f)-2T(e)(1).

sentence.

1.337(d)-2(g)(1), 2nd 1.1502-13T, 1.1502-14, and 1.1502-14 (as

sentence. and 1.1502-14T. contained in the 26

CFR part 1 edition

revised as of April

1, 1995)

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

(2)(a).

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

Sec. 1.1502-14 for the treatment

the deferral.

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 Under Sec. 1.1502-13.. Under Sec. 1.1502-13

(1), 8th sentence. (as contained in the

26 CFR part 1 edition

revised as of April

1, 1995)

1.1502-9(f) Example (6) a restoration event the intercompany gain

under section 1.1502- is taken into account

13(f) occurs. under Sec. 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- defined in Sec.

13(a)(2). 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), second paragraph (a)(1) of Sec. 1.1502-13

sentence. Sec. 1.1502-14.

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

first sentence. 1.1502-14,.

1.1502-47(e)(4)(iv) deferred intercompany intercompany

Example 4, third transactions (see Sec. transactions (see

sentence. 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, fourth

sentence.

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

Example 4, chart transactions between. transactions between

header.

[[Page 36680]]

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

Example 4, chart

header.

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

sentence.

1.1502-47(r), second deferred...............

sentence.

1.1503-2(d)(4) Example deferred...............

1 (iii), fourth

sentence.

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

1 (iii), fourth

sentence.

1.1552-1(a)(2)(ii)(c).. 1.1502-14.............. 1.1502-13 (f) and (g)

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

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. To the extent a loss not yet taken into

account is reduced under this section, it cannot subsequently be taken

into account under section 267(f) or Sec. 1.1502-13. 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). 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 September 11, 1995.

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. In Sec. 1.263A-1, paragraph (j)(1)(ii)(B), the last

sentence is revised to read as follows:

Sec. 1.263A-1 Uniform capitalization of costs.

* * * * *

(j) * * *

(1) * * *

(ii) * * *

(B) * * * See Sec. 1.1502-13.

* * * * *

Par. 6. 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 this section is to prevent members of a controlled group from taking

into account a loss or deduction solely as the result of a transfer of

property between a selling member (S) and a 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 it's 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 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 (including nonstatutory authorities). 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), attributes of the loss or deduction are 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, for example, section 1091 (loss

eliminated on wash sale).

(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. Except to the extent 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)(iii) (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). 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)(7)).

[[Page 36681]]

Further, the principles of Sec. 1.1502-13(j)(6) (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).

Thus, for example, if S and B merge together in a transaction described

in section 368(a)(1)(A), the surviving corporation is treated as the

successor to the other corporation, and the controlled group

relationship is treated as continuing.

(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)

Adjustments to the timing rules. 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). For

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

include the following:

(i) Application on controlled group basis. The matching and

acceleration rules apply on a controlled group basis, rather than a

consolidated group basis. Thus if S and B are wholly-owned members of a

consolidated group and 21% of the stock of S is sold to an unrelated

person, S's loss continues to be deferred under this section because S

and B continue to be members of a controlled group even though S is no

longer a member of the consolidated group. Similarly, S's loss would

continue to be deferred if S and B remain in a controlled group

relationship after both corporations become nonmembers of their former

consolidated group.

(ii) 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.

(iii) Transfer to a section 267(b) or 707(b) related person. To the

extent S's loss or deduction from an intercompany sale of property is

taken into account under this section as a result of B's transfer of

the property to a nonmember that is a person related to any member,

immediately after the transfer, under sections 267(b) or 707(b), or as

a result of S or B becoming a nonmember that is related to any member

under section 267(b) (for example, if S or B becomes an S corporation),

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).

(iv) B's item is excluded from gross income or noncapital and

nondeductible. To the extent S's loss would be redetermined to be a

noncapital, nondeductible amount under the principles of Sec. 1.1502-13

but is not redetermined because of paragraph (c)(2) of this section,

then, if paragraph (c)(1)(iii) of this section does not apply, S's loss

continues to be deferred and is not taken into account until S and B

are no longer in a controlled group relationship. For example, if S

sells all of the stock of corporation T to B at a loss and T

subsequently liquidates into B in a transaction qualifying under

section 332, S's loss is deferred until S and B (including their

successors) are no longer in a controlled group relationship. See

Sec. 1.1502-13(c)(6)(ii).

(v) 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)(4) (applicability of other law).

(2) Attributes generally not affected. The matching and

acceleration rules are not applied under this section to affect the

attributes of S's intercompany item, or cause it to be taken into

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

method of accounting. However, the attributes of S's intercompany item

may be redetermined, or an item may be taken into account earlier than

under S's separate entity method of accounting, to the extent the

transaction is also an intercompany transaction to which Sec. 1.1502-13

applies. Similarly, except to the extent the transaction is also an

intercompany transaction to which Sec. 1.1502-13 applies, the matching

and acceleration rules do not apply to affect the timing or attributes

of B's corresponding items.

(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;

(ii) S or B is a foreign corporation; and

(iii) 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 that the income or loss of the foreign corporation is

described in paragraph (d)(1)(iii) 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 acquires a receivable from the sale of goods

or services to a nonmember at a gain, and S sells the receivable at

fair market

[[Page 36682]]

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 that has been taken into account

at the time the receivable is sold to B.

(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 purposes of this

section (including, for example, by avoiding treatment as an

intercompany sale or by distorting the timing of losses or deductions),

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 the recomputed corresponding items. 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 in Year 3.

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, S's loss is

determined 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)(iii) 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 redetermined to be 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)(4).

Nevertheless, S's loss is redetermined by Sec. 1.1502-13 to be 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

[[Page 36683]]

$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 related 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)(1)(iii) of this section, because

the partnership is a nonmember that is a related person under

sections 267(b) and 707(b), S's $30 loss is taken into account in

Year 3, but only to the extent of any income or gain taken into

account as a result of the transfer. Under section 721, no gain or

loss is taken into account as a result of the transfer to the

partnership, and thus none of S's loss is taken into account. 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)(4) (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 into account any further loss that may

accrue in the value of the land without disposing of the land

outside of the controlled group, 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, when the value of the land has decreased to

$90, 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, 1.1502-13T(f)(6), 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

July 12, 1995. 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 July 12, 1995, 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 July 12, 1995, to prevent the avoidance, duplication,

omission, elimination, or inconsistency.

(3) Prior law. For transactions occurring in S's years beginning

before July 12, 1995 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, 1995).

Secs. 1.267(f)-1T, 1.267(f)-2T, and 1.267(f)-3 [Removed]

Par. 7. Sections 1.267(f)-1T, 1.267(f)-2T, and 1.267(f)-3 are

removed.

Par. 8. Section 1.460-0 is amended in the table of contents by

revising the entries for Sec. 1.460-4 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.

[[Page 36684]]

(2) Example.

(3) Effective dates.

(i) In general.

(ii) Prior law.

(4) Consent to change method of accounting.

* * * * *

Par. 9. Section 1.460-4 is amended by:

1. Revising the section heading.

2. Adding and reserving paragraphs (a) through (i).

3. Adding paragraph (j).

The revisions and additions 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 taking its income

or loss into account 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 dates--(i) In general. This paragraph (j) applies

with respect to transactions and sales occurring pursuant to contracts

entered into in years beginning on or after July 12, 1995.

(ii) Prior law. For transactions and sales occurring pursuant to

contracts entered into in years beginning before July 12, 1995, 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, 1995).

(4) Consent to change method of accounting. For transactions and

sales to which this paragraph (j) applies, the Commissioner's consent

under section 446(e) is hereby granted to the extent any changes in

method of accounting are necessary solely to comply with this section,

provided the changes are made in the first taxable year of the taxpayer

to which the rules of this paragraph (j) apply. Changes in method of

accounting for these transactions are to be effected on a cut-off

basis.

Par. 10. In Sec. 1.469-0, the table of contents is amended by:

1. Revising the entries for Sec. 1.469-1:

a. Paragraphs (a) through (d)(1).

b. Paragraphs (g)(5) through (h)(3).

c. Paragraphs (h)(5) through (k).

2. Revising the entries for Sec. 1.469-1T, paragraphs (c)(8), and

(h)(1), (2), and (6). The revisions 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. 11. Section 1.469-1 is amended by adding paragraphs (c)(8),

(h)(1), (h)(2) and (h)(6) to read as follows (paragraphs (a) through

(c)(7), (c)(9) through (d)(1), (g)(5), (h)(3), (h)(5) and (h)(7)

through (k) continue to be reserved):

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

[[Page 36685]]

(B) Sec. 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.

(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. Assume that if S and B were divisions of a

single corporation, gain from the sale to X would be passive income

attributable to a passive activity. To the extent of B's

depreciation before the sale, the results are the same as in

paragraph (ii) of this Example. B's gain and S's remaining gain

taken into account as a result of B's sale are 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. B's loss

and S's gain taken into account as a result of B's sale are 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 July 12, 1995.

For transactions occurring in years beginning before July 12, 1995, see

Sec. 1.469-1T(h)(6) (as contained in the 26 CFR part 1 edition revised

as of April 1, 1995).

(h)(7) through (k) [Reserved]

Sec. 1.469-1T [Amended]

Par. 12. Section 1.469-1T is amended by removing and reserving

paragraphs (c)(8), (h)(1), (2), and (6).

Par. 13. 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 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, and

the 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

sells the land to a nonmember, S does not take its gain into account

until B's sale to the nonmember.

(3) Timing rules as a method of accounting--(i) In general. The

timing rules of this section are a method of accounting for

intercompany transactions, to be applied by each member in addition to

the member's other methods of accounting. See Sec. 1.1502-17. To the

extent the timing rules of this section are inconsistent with a

member's otherwise applicable methods of accounting, the timing rules

of this section control. For example, if S sells property to B in

exchange for B's note, the timing rules of this section apply instead

of the installment sale rules of section 453. S's or B's application of

the timing rules of this section to an intercompany transaction clearly

reflects income only if the effect of that transaction as a whole

(including, for example, related costs and expenses) on consolidated

taxable income is clearly reflected.

(ii) Automatic consent for joining and departing members--(A)

Consent granted. Section 446(e) consent is granted under this section

to the extent a change in method of accounting is necessary solely by

reason of the timing rules of this section--

(1) For each member, with respect to its intercompany transactions,

in the first consolidated return year which follows a separate return

year and in which the member engages in an intercompany transaction;

and

(2) For each former member, with respect to its transactions with

members that would otherwise be intercompany transactions if the former

member were still a member, in the first separate return year in which

the former member engages in such a transaction.

(B) Cut-off basis. Any change in method of accounting described in

paragraph (a)(3)(ii)(A) of this section is to be effected on a cut-off

basis for transactions entered into on or after the first day of the

year for which consent is granted under paragraph (a)(3)(ii)(A) of this

section.

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

applicable law (including nonstatutory authorities). For example, this

section applies in addition to sections 267(f) (additional rules for

certain losses), 269 (acquisitions to evade or avoid income tax), and

482 (allocations among commonly controlled taxpayers). Thus, an item

taken into account under this section can be deferred, disallowed, or

eliminated under other applicable law, for example, section 1091

(losses from wash sales).

(5) References. References in other sections to this section

include, as appropriate, references to prior law. For effective dates

and prior law see paragraph (l) of this section.

(6) 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, 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 provides additional

rules for taking the items into account if the effect of treating S and

B as divisions cannot be achieved (for example, if S or B becomes a

nonmember). Paragraph (b) of this section provides definitions.

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)(7)(ii))

Example 1. Intercompany sale of land.

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. Intercompany sale of a partnership interest.

Example 10. Net operating losses subject to section 382 or the

SRLY rules.

Example 11. Section 475.

Example 12. Section 1092.

[[Page 36686]]

Example 13. Manufacturer incentive payments.

Example 14. Source of income under section 863.

Example 15. Section 1248.

Acceleration rule. (Sec. 1.1502-13(d)(3))

Example 1. Becoming a nonmember--timing.

Example 2. Becoming a nonmember--attributes.

Example 3. Selling member's disposition of installment note.

Example 4. Cancellation of debt and attribute reduction under

section 108(b).

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)(7))

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.

Example 6. Intercompany stock sale followed by section 355

distribution.

Obligations of members. (Sec. 1.1502-13(g)(5))

Example 1. Interest on intercompany debt.

Example 2. Intercompany debt becomes nonintercompany debt.

Example 3. Loss or bad debt deduction 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. Transitory status as an intercompany obligation.

Example 3. Corporate mixing bowl.

Example 4. Partnership mixing bowl.

Example 5. Sale and leaseback.

Miscellaneous operating rules. (Sec. 1.1502-13(j)(9))

Example 1. Intercompany sale followed by section 351 transfer to

member.

Example 2. Intercompany sale of member stock followed by

recapitalization.

Example 3. Back-to-back intercompany transactions--matching.

Example 4. Back-to-back intercompany transactions--acceleration.

Example 5. Successor group.

Example 6. Liquidation--80% distributee.

Example 7. 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. Except as otherwise provided in this

section, 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 treated as sold in a separate transaction.

Thus, the gain and loss cannot be offset or netted against each other

for purposes of this section. Similarly, each payment or accrual of

interest on a loan is a separate transaction. In addition, an accrual

of premium is treated as a separate transaction, or as an offset to

interest that is not a separate transaction, to the extent required

under separate entity treatment. 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. If two members enter into a

notional principal contract, each payment under the contract is a

separate transaction and the member making the payment is B with

respect to that payment and the member receiving the payment is S. See

paragraph (j)(4) of this section for rules aggregating certain

transactions.

(2) Intercompany items--(i) 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. An item is an intercompany item whether it is

directly or indirectly from an intercompany transaction.

(ii) 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, related costs or

expenses that are not capitalized under S's separate entity method of

accounting are included in determining its intercompany items. For

example, deductions for employee wages, in addition to other related

costs, are included in determining S's intercompany items from

performing services for B, and depreciation deductions are included in

determining S's intercompany items from renting property to B.

(iii) Amounts not yet recognized or incurred. S's intercompany

items include amounts from an intercompany transaction that are not yet

taken into account under its separate entity method of accounting. For

example, if S is a cash method taxpayer, S's intercompany income might

be taken into account under this section even if the cash is not yet

received. Similarly, an amount reflected in basis (or an amount

equivalent to basis) under S's separate entity method of accounting

that is a substitute for income, gain, deduction or loss from an

intercompany transaction is an intercompany item.

(3) Corresponding items--(i) 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 sells it to a

nonmember, B's gain or loss from the sale to the nonmember 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).

(ii) Disallowed or eliminated amounts. B's corresponding items

include amounts that are permanently disallowed or permanently

eliminated, whether directly or indirectly. Thus, corresponding items

include amounts disallowed under section 265 (expenses relating to tax-

exempt income), and amounts not recognized under section 311(a)

(nonrecognition of loss on distributions), section 332

[[Page 36687]]

(nonrecognition on liquidating distributions), or section 355(c)

(certain distributions of stock of a subsidiary). On the other hand, an

amount is not permanently disallowed or permanently eliminated (and

therefore is not a corresponding item) to the extent it is not

recognized in a transaction in which B receives a successor asset

within the meaning of paragraph (j)(1) of this section. For example,

B's corresponding items do not include amounts not recognized from a

transaction with a nonmember to which section 1031 applies or from

another transaction in which B receives exchanged basis property.

(4) Recomputed corresponding items. The recomputed corresponding

item is the corresponding item that B would take into account if S and

B were divisions of a single corporation and the intercompany

transaction were between those divisions. For example, if S sells

property with a $70 basis to B for $100, and B later sells the property

to a nonmember for $90, B's corresponding item is its $10 loss, and the

recomputed corresponding item is $20 of gain (determined by comparing

the $90 sales price with the $70 basis the property would have if S and

B were divisions of a single corporation). Although neither S nor B

actually takes the recomputed corresponding item into account, it is

computed as if B did take it into account (based on reasonable and

consistently applied assumptions, including any provision of the

Internal Revenue Code or regulations that would affect its timing or

attributes).

(5) Treatment as a separate entity. Treatment as a separate entity

means treatment without application of the rules of this section, but

with the application of the other consolidated return regulations. For

example, if S sells the stock of another member to B, S's gain or loss

on a separate entity basis is determined with the application of

Sec. 1.1502-80(b) (non-applicability of section 304), but without

redetermination under paragraph (c) or (d) of this section.

(6) Attributes. The attributes of an intercompany item or

corresponding item are all of the item's characteristics, except

amount, location, and timing, necessary to determine the item's effect

on taxable income (and tax liability). For example, attributes include

character, source, treatment as excluded from gross income or as a

noncapital, nondeductible amount, and treatment as built-in gain or

loss under section 382(h) or 384. In contrast, the characteristics of

property, such as a member's holding period, or the fact that property

is included in inventory, are not attributes of an item, but these

characteristics might affect the determination of the attributes of

items from the property.

(c) Matching rule. For each consolidated return year, B's

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

under the following rules:

(1) Attributes and holding periods--(i) Attributes. The separate

entity attributes of S's intercompany items and B's corresponding items

are redetermined to the extent necessary to produce the same effect on

consolidated taxable income (and consolidated tax liability) as if S

and B were divisions of a single corporation, and the intercompany

transaction were a transaction between divisions. Thus, the activities

of both S and B might affect the attributes of both intercompany items

and corresponding items. For example, if S holds property for sale to

unrelated customers in the ordinary course of its trade or business, S

sells the property to B at a gain and B sells the property to an

unrelated person at a further gain, S's intercompany gain and B's

corresponding gain might be ordinary because of S's activities with

respect to the property. Similar principles apply if S performs

services, rents property, or engages in any other intercompany

transaction.

(ii) Holding periods. The holding period of property transferred in

an intercompany transaction is the aggregate of the holding periods of

S and B. However, if the basis of the property is determined by

reference to the basis of other property, the property's holding period

is determined by reference to the holding period of the other property.

For example, if S distributes stock to B in a transaction to which

section 355 applies, B's holding period in the distributed stock is

determined by reference to B's holding period in the stock of S.

(2) Timing--(i) B's items. B takes its corresponding items into

account under its accounting method, but the redetermination of the

attributes of a corresponding item might affect its timing. For

example, if B's sale of property acquired from S is treated as a dealer

disposition because of S's activities, section 453(b) prevents any

corresponding income of B from being taken into account under the

installment method.

(ii) S's items. S takes its intercompany item into account to

reflect the difference for the year between B's corresponding item

taken into account and the recomputed corresponding item.

(3) Divisions of a single corporation. As divisions of a single

corporation, S and B are treated as engaging in their actual

transaction and owning any actual property involved in the transaction

(rather than treating the transaction as not occurring). For example,

S's sale of land held for investment to B for cash is not disregarded,

but is treated as an exchange of land for cash between divisions (and B

therefore succeeds to S's basis in the property). Similarly, S's

issuance of its own stock to B in exchange for property is not

disregarded, B is treated as owning the stock it receives in the

exchange, and section 1032 does not apply to B on its subsequent sale

of the S stock. Although treated as divisions, S and B nevertheless are

treated as:

(i) Operating separate trades or businesses. See, e.g., Sec. 1.446-

1(d) (accounting methods for a taxpayer engaged in more than one

business).

(ii) Having any special status that they have under the Internal

Revenue Code or regulations. For example, a bank defined in section

581, a domestic building and loan association defined in section

7701(a)(19), and an insurance company to which section 801 or 831

applies are treated as divisions having separate special status. On the

other hand, the fact that a member holds property for sale to customers

in the ordinary course of its trade or business is not a special

status.

(4) Conflict or allocation of attributes. This paragraph (c)(4)

provides special rules for redetermining and allocating attributes

under paragraph (c)(1)(i) of this section.

(i) Offsetting amounts--(A) In general. To the extent B's

corresponding item offsets S's intercompany item in amount, the

attributes of B's corresponding item, determined based on both S's and

B's activities, control the attributes of S's offsetting intercompany

item. For example, if S sells depreciable property to B at a gain and B

depreciates the property, the attributes of B's depreciation deduction

(ordinary deduction) control the attributes of S's offsetting

intercompany gain. Accordingly, S's gain is ordinary.

(B) B controls unreasonable. To the extent the results under

paragraph (c)(4)(i)(A) are inconsistent with treating S and B as

divisions of a single corporation, the attributes of the offsetting

items must be redetermined in a manner consistent with treating S and B

as divisions of a single corporation. To the extent, however, that B's

corresponding item on a separate entity basis is excluded from gross

income, is a noncapital, nondeductible amount, or

[[Page 36688]]

is otherwise permanently disallowed or eliminated, the attributes of

B's corresponding item always control the attributes of S's offsetting

intercompany item.

(ii) Allocation. To the extent S's intercompany item and B's

corresponding item do not offset in amount, the attributes redetermined

under paragraph (c)(1)(i) of this section must be allocated to S's

intercompany item and B's corresponding item by using a method that is

reasonable in light of all the facts and circumstances, including the

purposes of this section and any other rule affected by the attributes

of S's intercompany item and B's corresponding item. A method of

allocation or redetermination is unreasonable if it is not used

consistently by all members of the group from year to year.

(5) Special status. Notwithstanding the general rule of paragraph

(c)(1)(i) of this section, to the extent an item's attributes

determined under this section are permitted or not permitted to a

member under the Internal Revenue Code or regulations by reason of the

member's special status, the attributes required under the Internal

Revenue Code or regulations apply to that member's items (but not the

other member). For example, if S is a bank to which section 582(c)

applies, and sells debt securities at a gain to B, a nonbank, the

character of S's intercompany gain is ordinary as required under

section 582(c), but the character of B's corresponding item as capital

or ordinary is determined under paragraph (c)(1)(i) of this section

without the application of section 582(c). For other special status

issues, see, for example, sections 595(b) (foreclosure on property

securing loans), 818(b) (life insurance company treatment of capital

gains and losses), and 1503(c) (limitation on absorption of certain

losses).

(6) Treatment of intercompany items if corresponding items are

excluded or nondeductible--(i) In general. Under paragraph (c)(1)(i) of

this section, S's intercompany item might be redetermined to be

excluded from gross income or treated as a noncapital, nondeductible

amount. For example, S's intercompany loss from the sale of property to

B is treated as a noncapital, nondeductible amount if B distributes the

property to a nonmember shareholder at no further gain or loss

(because, if S and B were divisions of a single corporation, the loss

would not have been recognized under section 311(a)). Paragraph

(c)(6)(ii) of this section, however, provides limitations on the

application of this rule to intercompany income or gain. See also

Secs. 1.1502-32 and 1.1502-33 (adjustments to S's stock basis and

earnings and profits to reflect amounts so treated).

(ii) Limitation on treatment of intercompany items as excluded from

gross income. Notwithstanding the general rule of paragraph (c)(1)(i)

of this section, S's intercompany income or gain is redetermined to be

excluded from gross income only to the extent one of the following

applies:

(A) Disallowed amounts. B's corresponding item is a deduction or

loss and, in the taxable year the item is taken into account under this

section, it is permanently and explicitly disallowed under another

provision of the Internal Revenue Code or regulations. For example,

deductions that are disallowed under section 265 are permanently and

explicitly disallowed. An amount is not permanently and explicitly

disallowed, for example, to the extent that--

(1) The Internal Revenue Code or regulations provide that the

amount is not recognized (for example, a loss that is realized but not

recognized under section 332 or section 355(c) is not permanently and

explicitly disallowed, notwithstanding that it is a corresponding item

within the meaning of paragraph (b)(3)(ii) of this section (certain

disallowed or eliminated amounts));

(2) A related amount might be taken into account by B with respect

to successor property, such as under section 280B (demolition costs

recoverable as capitalized amounts);

(3) A related amount might be taken into account by another

taxpayer, such as under section 267(d) (disallowed loss under section

267(a) might result in nonrecognition of gain for a related person);

(4) A related amount might be taken into account as a deduction or

loss, including as a carryforward to a later year, under any provision

of the Internal Revenue Code or regulations (whether or not the

carryforward expires in a later year); or

(5) The amount is reflected in the computation of any credit

against (or other reduction of) Federal income tax (whether allowed for

the taxable year or carried forward to a later year).

(B) Section 311. The corresponding item is a loss that is realized,

but not recognized under section 311(a) on a distribution to a

nonmember (even though the loss is not a permanently and explicitly

disallowed amount within the meaning of paragraph (c)(6)(ii)(A) of this

section).

(C) Other amounts. The Commissioner determines that treating S's

intercompany item as excluded from gross income is consistent with the

purposes of this section and other applicable provisions of the

Internal Revenue Code and regulations.

(7) Examples--(i) In general. For purposes of the examples in this

section, unless otherwise stated, P is the common parent of the P

consolidated group, P owns all of the only class of stock of

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

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

persons use the accrual method of accounting, tax liabilities are

disregarded, the facts set forth the only corporate activity, no member

has any special status, and the transaction is not otherwise subject to

recharacterization. If a member acts as both a selling member and a

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

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

referred to as M, M1, or M2 (rather than as S or B).

(ii) Matching rule. The matching rule of this paragraph (c) is

illustrated by the following examples.

Example 1. Intercompany sale of land followed by sale to a

nonmember. (a) Facts. S holds land for investment with a basis of

$70. S has held the land for more than one year. On January 1 of

Year 1, S sells the land to B for $100. B also holds the land for

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

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

sale of the land to B is an intercompany transaction, S is the

selling member, and B is the buying member. Under paragraphs (b)(2)

and (3) of this section, S's $30 gain from the sale to B is its

intercompany item, and B's $10 gain from the sale to X is its

corresponding item.

(c) Attributes. Under the matching rule of paragraph (c) of this

section, S's $30 intercompany gain and B's $10 corresponding gain

are taken into account to produce the same effect on consolidated

taxable income (and consolidated tax liability) as if S and B were

divisions of a single corporation. In addition, the holding periods

of S and B for the land are aggregated. Thus, the group's entire $40

of gain is long-term capital gain. Because both S's intercompany

item and B's corresponding item on a separate entity basis are long-

term capital gain, the attributes are not redetermined under

paragraph (c)(1)(i) of this section.

(d) Timing. For each consolidated return year, S takes its

intercompany item into account under the matching rule to reflect

the difference for the year between B's corresponding item taken

into account and the recomputed corresponding item. If S and B were

divisions of a single corporation and the intercompany sale were a

transfer between the divisions, B would succeed to S's $70 basis in

the land and would have a $40 gain from the sale to X in Year 3,

instead of a $10 gain. Consequently, S takes no gain

[[Page 36689]]

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

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

between the $10 gain B takes into account and the $40 recomputed

gain (the recomputed corresponding item). Under Secs. 1.1502-32 and

1.1502-33, P's basis in its S stock and the earnings and profits of

S and P do not reflect S's $30 gain until the gain is taken into

account in Year 3. (Under paragraph (a)(3) of this section, the

results would be the same if S sold the land to B in an installment

sale to which section 453 would otherwise apply, because S must take

its intercompany gain into account under this section.)

(e) Intercompany loss followed by sale to a nonmember at a gain.

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

that S's basis in the land is $130 (rather than $70). The attributes

and timing of S's intercompany loss and B's corresponding gain are

determined under the matching rule in the manner provided in

paragraphs (c) and (d) of this Example 1. If S and B were divisions

of a single corporation and the intercompany sale were a transfer

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

and would have a $20 loss from the sale to X instead of a $10 gain.

Thus, S takes its entire $30 loss into account in Year 3 to reflect

the $30 difference between B's $10 gain taken into account and the

$20 recomputed loss. (The results are the same under section

267(f).) S's $30 loss is long-term capital loss, and B's $10 gain is

long-term capital gain.

(f) Intercompany gain followed by sale to a nonmember at a loss.

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

that B sells the land to X for $90 (rather than $110). The

attributes and timing of S's intercompany gain and B's corresponding

loss are determined under the matching rule. If S and B were

divisions of a single corporation and the intercompany sale were a

transfer between the divisions, B would succeed to S's $70 basis in

the land and would have a $20 gain from the sale to X instead of a

$10 loss. Thus, S takes its entire $30 gain into account in Year 3

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

account and the $20 recomputed gain. S's $30 gain is long-term

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

(g) Intercompany gain followed by distribution to a nonmember at

a loss. The facts are the same as in paragraph (a) of this Example

1, except that B distributes the land to X, a minority shareholder

of B, and at the time of the distribution the land has a fair market

value of $90. The attributes and timing of S's intercompany gain and

B's corresponding loss are determined under the matching rule. Under

section 311(a), B does not recognize its $10 loss on the

distribution to X. If S and B were divisions of a single corporation

and the intercompany sale were a transfer between divisions, B would

succeed to S's $70 basis in the land and would have a $20 gain from

the distribution to X instead of an unrecognized $10 loss. Under

paragraph (b)(3)(ii) of this section, B's loss that is not

recognized under section 311(a) is a corresponding item. Thus, S

takes its $30 gain into account under the matching rule in Year 3 to

reflect the difference between B's $10 corresponding unrecognized

loss and the $20 recomputed gain. B's $10 corresponding loss offsets

$10 of S's intercompany gain and, under paragraph (c)(4)(i) of this

section, the attributes of B's corresponding item control the

attributes of S's intercompany item. Paragraph (c)(6) of this

section does not prevent the redetermination of S's intercompany

item as excluded from gross income. (See paragraph (c)(6)(ii)(B) of

this section). Thus, $10 of S's $30 gain is redetermined to be

excluded from gross income.

(h) Intercompany sale followed by section 1031 exchange with

nonmember. The facts are the same as in paragraph (a) of this

Example 1, except that, instead of selling the land to X, B

exchanges the land for land owned by X in a transaction to which

section 1031 applies. There is no difference in Year 3 between B's

$0 corresponding item taken into account and the $0 recomputed

corresponding item. Thus, none of S's intercompany gain is taken

into account under the matching rule as a result of the section 1031

exchange. Instead, B's gain is preserved in the land received from X

and, under the successor asset rule of paragraph (j)(1) of this

section, S's intercompany gain is taken into account by reference to

the replacement property. (If B takes gain into account as a result

of boot received in the exchange, S's intercompany gain is taken

into account under the matching rule to the extent the boot causes a

difference between B's gain taken into account and the recomputed

gain.)

(i) Intercompany sale followed by section 351 transfer to

nonmember. The facts are the same as in paragraph (a) of this

Example 1, except that, instead of selling the land to X, B

transfers the land to X in a transaction to which section 351(a)

applies and X remains a nonmember. There is no difference in Year 3

between B's $0 corresponding item taken into account and the $0

recomputed corresponding item. Thus, none of S's intercompany gain

is taken into account under the matching rule as a result of the

section 351(a) transfer. However, S's entire gain is taken into

account in Year 3 under the acceleration rule of paragraph (d) of

this section (because X, a nonmember, reflects B's $100 cost basis

in the land under section 362).

Example 2. Dealer activities. (a) Facts. S holds land for

investment with a basis of $70. On January 1 of Year 1, S sells the

land to B for $100. B develops the land as residential real estate,

and sells developed lots to customers during Year 3 for an aggregate

amount of $110.

(b) Attributes. S and B are treated under the matching rule as

divisions of a single corporation for purposes of determining the

attributes of S's intercompany item and B's corresponding item.

Thus, although S held the land for investment, whether the gain is

treated as from the sale of property described in section 1221(1) is

based on the activities of both S and B. If, based on both S's and

B's activities, the land is described in section 1221(1), both S's

gain and B's gain are ordinary income.

Example 3. Intercompany section 351 transfer. (a) Facts. S holds

land with a $70 basis and a $100 fair market value for sale to

customers in the ordinary course of business. On January 1 of Year

1, S transfers the land to B in exchange for all of the stock of B

in a transaction to which section 351 applies. S has no gain or loss

under section 351(a), and its basis in the B stock is $70 under

section 358. Under section 362, B's basis in the land is $70. B

holds the land for investment. On July 1 of Year 3, B sells the land

to X for $100. Assume that if S and B were divisions of a single

corporation, B's gain from the sale would be ordinary income because

of S's activities.

(b) Timing and attributes. Under paragraph (b)(1) of this

section, S's transfer to B is an intercompany transaction. Under

paragraph (c)(3) of this section, S is treated as transferring the

land in exchange for B's stock even though, as divisions, S could

not own stock of B. S has no intercompany item, but B's $30 gain

from its sale of the land to X is a corresponding item because the

land was acquired in an intercompany transaction. B's $30 gain is

ordinary income that is taken into account under B's method of

accounting.

(c) Intercompany section 351 transfer with boot. The facts are

the same as in paragraph (a) of this Example 3, except that S

receives $10 cash in addition to the B stock in the transfer. S

recognizes $10 of gain under section 351(b), and its basis in the B

stock is $70 under section 358. Under section 362, B's basis in the

land is $80. S takes its $10 intercompany gain into account in Year

3 to reflect the $10 difference between B's $20 corresponding gain

taken into account and the $30 recomputed gain. Both S's $10 gain

and B's $20 gain are ordinary income.

(d) Partial disposition. The facts are the same as in paragraph

(c) of this Example 3, except B sells only a one- half, undivided

interest in the land to X for $50. The timing and attributes are

determined in the manner provided in paragraph (b) of this Example

3, except that S takes only $5 of its gain into account in Year 3 to

reflect the $5 difference between B's $10 gain taken into account

and the $15 recomputed gain.

Example 4. Depreciable property. (a) Facts. On January 1 of Year

1, S buys 10-year recovery property for $100 and depreciates it

under the straight-line method. On January 1 of Year 3, S sells the

property to B for $130. Under section 168(i)(7), B is treated as S

for purposes of section 168 to the extent B's $130 basis does not

exceed S's adjusted basis at the time of the sale. B's additional

basis is treated as new 10-year recovery property for which B elects

the straight-line method of recovery. (To simplify the example, the

half-year convention is disregarded.)

(b) Depreciation through Year 3; intercompany gain. S claims $10

of depreciation for each of Years 1 and 2 and has an $80 basis at

the time of the sale to B. Thus, S has a $50 intercompany gain from

its sale to B. For Year 3, B has $10 of depreciation with respect to

$80 of its basis (the portion of its $130 basis not exceeding S's

adjusted basis). In addition, B has $5 of depreciation with respect

to the $50 of its additional basis that exceeds S's adjusted basis.

(c) Timing. S's $50 gain is taken into account to reflect the

difference for each

[[Page 36690]]

consolidated return year between B's depreciation taken into account

with respect to the property and the recomputed depreciation. For

Year 3, B takes $15 of depreciation into account. If the

intercompany transaction were a transfer between divisions of a

single corporation, B would succeed to S's adjusted basis in the

property and take into account only $10 of depreciation for Year 3.

Thus, S takes $5 of gain into account in Year 3. In each subsequent

year that B takes into account $15 of depreciation with respect to

the property, S takes into account $5 of gain.

(d) Attributes. Under paragraph (c)(1)(i) of this section, the

attributes of S's gain and B's depreciation must be redetermined to

the extent necessary to produce the same effect on consolidated

taxable income as if the intercompany transaction were between

divisions of a single corporation (the group must have a net

depreciation deduction of $10). In each year, $5 of B's

corresponding depreciation deduction offsets S's $5 intercompany

gain taken into account and, under paragraph (c)(4)(i) of this

section, the attributes of B's corresponding item control the

attributes of S's intercompany item. Accordingly, S's intercompany

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

deduction is ordinary income.

(e) Sale of property to a nonmember. The facts are the same as

in paragraph (a) of this Example 4, except that B sells the property

to X on January 1 of Year 5 for $110. As set forth in paragraphs (c)

and (d) of this Example 4, B has $15 of depreciation with respect to

the property in each of Years 3 and 4, causing S to take $5 of

intercompany gain into account in each year as ordinary income. The

$40 balance of S's intercompany gain is taken into account in Year 5

as a result of B's sale to X, to reflect the $40 difference between

B's $10 gain taken into account and the $50 of recomputed gain ($110

of sale proceeds minus the $60 basis B would have if the

intercompany sale were a transfer between divisions of a single

corporation). Treating S and B as divisions of a single corporation,

$40 of the gain is section 1245 gain and $10 is section 1231 gain.

On a separate entity basis, S would have more than $10 treated as

section 1231 gain, and B would have no amount treated as section

1231 gain. Under paragraph (c)(4)(ii) of this section, all $10 of

the section 1231 gain is allocated to S. S's remaining $30 of gain,

and all of B's $10 gain, is treated as section 1245 gain.

Example 5. Intercompany sale followed by installment sale. (a)

Facts. S holds land for investment with a basis of $70x. On January

1 of Year 1, S sells the land to B for $100x. B also holds the land

for investment. On July 1 of Year 3, B sells the land to X in

exchange for X's $110x note. The note bears a market rate of

interest in excess of the applicable Federal rate, and provides for

principal payments of $55x in Year 4 and $55x in Year 5. The

interest charge under section 453A(c) applies to X's note.

(b) Timing and attributes. S takes its $30x gain into account to

reflect the difference in each consolidated return year between B's

gain taken into account for the year and the recomputed gain. Under

section 453, B takes into account $5x of gain in Year 4 and $5x of

gain in Year 5. Thus, S takes into account $15x of gain in Year 4

and $15x of gain in Year 5 to reflect the $15x difference in each of

those years between B's $5x gain taken into account and the $20x

recomputed gain. Both S's $30x gain and B's $10x gain are subject to

the section 453A(c) interest charge beginning in Year 3.

(c) Election out under section 453(d). If, under the facts in

paragraph (a) of this Example 5, the P group wishes to elect not to

apply section 453 with respect to S's gain, an election under

section 453(d) must be made for Year 3 with respect to B's gain.

This election will cause B's $10x gain to be taken into account in

Year 3. Under the matching rule, this will result in S's $30x gain

being taken into account in Year 3. (An election by the P group

solely with respect to S's gain has no effect because the gain from

S's sale to B is taken into account under the matching rule, and

therefore must reflect the difference between B's gain taken into

account and the recomputed gain.)

(d) Sale to a nonmember at a loss, but overall gain. The facts

are the same as in paragraph (a) of this Example 5, except that B

sells the land to X in exchange for X's $90x note (rather than $110x

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

succeed to S's basis in the land, and the sale to X would be

eligible for installment reporting under section 453, because it

resulted in an overall gain. However, because only gains may be

reported on the installment method, B's $10x corresponding loss is

taken into account in Year 3. Under paragraph (b)(4) of this section

the recomputed corresponding item is $20x gain that would be taken

into account under the installment method, $0 in Year 3 and $10x in

each of Years 4 and 5. Thus, in Year 3 S takes $10x of gain into

account to reflect the difference between B's $10x loss taken into

account and the $0 recomputed gain for Year 3. Under paragraph

(c)(4)(i) of this section, B's $10x corresponding loss offsets $10x

of S's intercompany gain, and B's attributes control. S takes $10x

of gain into account in each of Years 4 and 5 to reflect the

difference in those years between B's $0 gain taken into account and

the $10x recomputed gain that would be taken into account under the

installment method. Only the $20x of S's gain taken into account in

Years 4 and 5 is subject to the interest charge under section

453A(c) beginning in Year 3. (If P elects under section 453(d) for

Year 3 not to apply section 453 with respect to the gain, all of S's

$30x gain will be taken into account in Year 3 to reflect the

difference between B's $10x loss taken into account and the $20x

recomputed gain.)

(e) Intercompany loss, installment gain. The facts are the same

as in paragraph (a) of this Example 5, except that S has a $130x

(rather than $70x) basis in the land. Under paragraph (c)(1)(i) of

this section, the separate entity attributes of S's and B's items

from the intercompany transaction must be redetermined to produce

the same effect on consolidated taxable income (and tax liability)

as if the transaction had been a transfer between divisions. If S

and B were divisions of a single corporation, B would succeed to S's

basis in the land and the group would have $20x loss from the sale

to X, installment reporting would be unavailable, and the interest

charge under section 453A(c) would not apply. Accordingly, B's gain

from the transaction is not eligible for installment treatment under

section 453. B takes its $10x gain into account in Year 3, and S

takes its $30x of loss into account in Year 3 to reflect the

difference between B's $10x gain and the $20x recomputed loss.

(f) Recapture income. The facts are the same as in paragraph (a)

of this Example 5, except that S bought depreciable property (rather

than land) for $100x, claimed depreciation deductions, and reduced

the property's basis to $70x before Year 1. (To simplify the

example, B's depreciation is disregarded.) If the intercompany sale

of property had been a transfer between divisions of a single

corporation, $30x of the $40x gain from the sale to X would be

section 1245 gain (which is ineligible for installment reporting)

and $10x would be section 1231 gain (which is eligible for

installment reporting). On a separate entity basis, S would have

$30x of section 1245 gain and B would have $10x of section 1231

gain. Accordingly, the attributes are not redetermined under

paragraph (c)(1)(i) of this section. All of B's $10x gain is

eligible for installment reporting and is taken into account $5x

each in Years 4 and 5 (and is subject to the interest charge under

section 453A(c)). S's $30x gain is taken into account in Year 3 to

reflect the difference between B's $0 gain taken into account and

the $30x of recomputed gain. (If S had bought the depreciable

property for $110x and its recomputed basis under section 1245 had

been $110x (rather than $100x), B's $10x gain and S's $30x gain

would both be recapture income ineligible for installment

reporting.)

Example 6. Intercompany sale of installment obligation. (a)

Facts. S holds land for investment with a basis of $70x. On January

1 of Year 1, S sells the land to X in exchange for X's $100x note,

and S reports its gain on the installment method under section 453.

X's note bears interest at a market rate of interest in excess of

the applicable Federal rate, and provides for principal payments of

$50x in Year 5 and $50x in Year 6. Section 453A applies to X's note.

On July 1 of Year 3, S sells X's note to B for $100x, resulting in

$30x gain from S's prior sale of the land to X under section

453B(a).

(b) Timing and attributes. S's sale of X's note to B is an

intercompany transaction, and S's $30x gain is intercompany gain. S

takes $15x of the gain into account in each of Years 5 and 6 to

reflect the $15x difference in each year between B's $0 gain taken

into account and the $15x recomputed gain. S's gain continues to be

treated as its gain from the sale to X, and the deferred tax

liability remains subject to the interest charge under section

453A(c).

(c) Worthlessness. The facts are the same as in paragraph (a) of

this Example 6, except that X's note becomes worthless on December 1

of Year 3 and B has a $100x short-term capital loss under section

165(g) on a separate entity basis. Under paragraph (c)(1)(ii) of

this section, B's holding period

[[Page 36691]]

for X's note is aggregated with S's holding period. Thus, B's loss is a

long- term capital loss. S takes its $30x gain into account in Year

3 to reflect the $30x difference between B's $100x loss taken into

account and the $70x recomputed loss. Under paragraph (c)(1)(i) of

this section, S's gain is long-term capital gain.

(d) Pledge. The facts are the same as in paragraph (a) of this

Example 6, except that, on December 1 of Year 3, B borrows $100x

from an unrelated bank and secures the indebtedness with X's note.

X's note remains subject to section 453A(d) following the sale to B.

Under section 453A(d), B's $100x of proceeds from the secured

indebtedness is treated as an amount received on December 1 of Year

3 by B on X's note. Thus, S takes its entire $30x gain into account

in Year 3.

Example 7. Performance of services. (a) Facts. S is a driller of

water wells. B operates a ranch in a remote location, and B's

taxable income from the ranch is not subject to section 447. B's

ranch requires water to maintain its cattle. During Year 1, S drills

an artesian well on B's ranch in exchange for $100 from B, and S

incurs $80 of expenses (e.g., for employees and equipment). B

capitalizes its $100 cost for the well under section 263, and takes

into account $10 of cost recovery deductions in each of Years 2

through 11. Under its separate entity method of accounting, S would

take its income and expenses into account in Year 1. If S and B were

divisions of a single corporation, the costs incurred in drilling

the well would be capitalized.

(b) Definitions. Under paragraph (b)(1) of this section, the

service transaction is an intercompany transaction, S is the selling

member, and B is the buying member. Under paragraph (b)(2)(ii) of

this section, S's $100 of income and $80 of related expenses are

both included in determining its intercompany income of $20.

(c) Timing and attributes. S's $20 of intercompany income is

taken into account under the matching rule to reflect the $20

difference between B's corresponding items taken into account (based

on its $100 cost basis in the well) and the recomputed corresponding

items (based on the $80 basis that B would have if S and B were

divisions of a single corporation and B's basis were determined by

reference to S's $80 of expenses). In Year 1, S takes into account

$80 of its income and the $80 of expenses. In each of Years 2

through 11, S takes $2 of its $20 intercompany income into account

to reflect the annual $2 difference between B's $10 of cost recovery

deductions taken into account and the $8 of recomputed cost recovery

deductions. S's $100 income and $80 expenses, and B's cost recovery

deductions, are ordinary items (because S's and B's items would be

ordinary on a separate entity basis, the attributes are not

redetermined under paragraph (c)(1)(i) of this section). If S's

offsetting $80 of income and expense would not be taken into account

in the same year under its separate entity method of accounting,

they nevertheless must be taken into account under this section in a

manner that clearly reflects consolidated taxable income. See

paragraph (a)(3)(i) of this section.

(d) Sale of capitalized services. The facts are the same as in

paragraph (a) of this Example 7, except that B sells the ranch

before Year 11 and recognizes gain attributable to the well. To the

extent of S's income taken into account as a result of B's cost

recovery deductions, as well as S's offsetting $80 of income and

expense, the timing and attributes are determined in the manner

provided in paragraph (c) of this Example 7. The attributes of the

remainder of S's $20 of income and B's gain from the sale are

redetermined to produce the same effect on consolidated taxable

income as if S and B were divisions of a single corporation.

Accordingly, S's remaining intercompany income is treated as

recapture income or section 1231 gain, even though it is from S's

performance of services.

Example 8. Rental of property. B operates a ranch that requires

grazing land for its cattle. S owns undeveloped land adjoining B's

ranch. On January 1 of Year 1, S leases grazing rights to B for Year

1. B's $100 rent expense is deductible for Year 1 under its separate

entity accounting method. Under paragraph (b)(1) of this section,

the rental transaction is an intercompany transaction, S is the

selling member, and B is the buying member. S takes its $100 of

income into account in Year 1 to reflect the $100 difference between

B's rental deduction taken into account and the $0 recomputed rental

deduction. S's income and B's deduction are ordinary items (because

S's intercompany item and B's corresponding item would both be

ordinary on a separate entity basis, the attributes are not

redetermined under paragraph (c)(1)(i) of this section).

Example 9. Intercompany sale of a partnership interest. (a)

Facts. S owns a 20% interest in the capital and profits of a general

partnership. The partnership holds land for investment with a basis

equal to its value, and operates depreciable assets which have value

in excess of basis. S's basis in its partnership interest equals its

share of the adjusted basis of the partnership's land and

depreciable assets. The partnership has an election under section

754 in effect. On January 1 of Year 1, S sells its partnership

interest to B at a gain. During Years 1 through 10, the partnership

depreciates the operating assets, and B's depreciation deductions

from the partnership reflect the increase in the basis of the

depreciable assets under section 743(b).

(b) Timing and attributes. S's gain is taken into account during

Years 1 through 10 to reflect the difference in each year between

B's depreciation deductions from the partnership taken into account

and the recomputed depreciation deductions from the partnership.

Under paragraphs (c)(1)(i) and (c)(4)(i) of this section, S's gain

taken into account is ordinary income. (The acceleration rule does

not apply to S's gain as a result of the section 743(b) adjustment,

because the adjustment is solely with respect to B and therefore no

nonmember reflects any part of the intercompany transaction.)

(c) Partnership sale of assets. The facts are the same as in

paragraph (a) of this Example 9, and the partnership sells some of

its depreciable assets to X at a gain on December 31 of Year 4. In

addition to the intercompany gain taken into account as a result of

the partnership's depreciation, S takes intercompany gain into

account in Year 4 to reflect the difference between B's partnership

items taken into account from the sale (which reflect the basis

increase under section 743(b)) and the recomputed partnership items.

The attributes of S's additional gain are redetermined to produce

the same effect on consolidated taxable income as if S and B were

divisions of a single corporation (recapture income or section 1231

gain).

(d) B's sale of partnership interest. The facts are the same as

in paragraph (a) of this Example 9, and on December 31 of Year 4, B

sells its partnership interest to X at no gain or loss. In addition

to the intercompany gain taken into

This text is long and has been trimmed here. Open the source document for the complete record.