Consolidated GroupsIntercompany Transactions and Related Rules

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8660]

RIN 1545-AT51

Consolidated Groups--Intercompany Transactions and Related Rules

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations disallowing losses

and excluding gain for certain dispositions and other transactions

involving stock of the common parent of a consolidated group.

DATES: These regulations are effective March 14, 1996.

For dates of applicability, see the effective date provision of

these regulations.

FOR FURTHER INFORMATION CONTACT: Victor Penico or Richard Osborne of

the Office of Assistant Chief Counsel (Corporate), (202) 622-7750 or

(202) 622-7770 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

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 Paperwork Reduction Act (44 U.S.C. 3507) under

control number 1545-1433. Responses to these collections of information

are required to obtain a benefit, the avoidance of a possible gain

because of basis adjustments relating to built-in loss.

An agency may not conduct or sponsor, and a person is not required

to respond to, a collection of information unless the collection of

information displays a valid control number.

The estimated average annual burden per respondent is 15 minutes.

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, T: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

[[Page 10448]]

Regulatory Affairs, Washington, D.C. 20503.

Books or records relating to this collection of information must be

retained as long as their contents may become material in the

administration of any internal revenue law. Generally, tax returns and

tax return information are confidential, as required by 26 U.S.C. 6103.

Background

On July 12, 1995, the IRS and Treasury issued proposed and

temporary regulations disallowing loss incurred by a member (M) of a

consolidated group with respect to the stock of the common parent (P

stock). The regulations also eliminate gain in certain transactions by

M with respect to P stock. The regulations are effective for

transactions occurring on or after July 12, 1995.

The IRS received comments on the proposed regulations and held a

public hearing on December 11, 1995. After consideration of the

comments and the statements made at the hearing, the IRS and Treasury

adopt the proposed regulations with revisions in this Treasury

decision. The significant comments and changes are discussed below.

Explanation of Provisions

Scope of the regulations

The proposed regulations disallow all losses on P stock and

eliminate gain in specified circumstances. Some commentators suggested

that the regulations should treat gain and loss more symmetrically.

Some suggested the regulations should achieve this goal by eliminating

gain in all circumstances. Others suggested the regulations should

disallow loss only in ``abusive'' circumstances.

Eliminating gain in all circumstances would effectively require

complete single entity treatment of P stock. Implementing such a system

would significantly increase the complexity of the consolidated return

regulations. Notice 94-49 (1994-1 C.B. 358), included a detailed

discussion of issues relating to the single entity treatment of P

stock.

Limiting the loss disallowance rule to ``abusive situations'' would

allow consolidated groups to rely on the separate-entity treatment of

stock to claim losses and single-entity treatment to avoid gains. For

example, taxpayers might plan to take advantage of separate entity

treatment by having M purchase P stock. If the value of the stock has

gone down at a time when the group wants to issue equity, M will sell

its P stock at a loss (and claim the loss). If the value of the stock

has gone up, the group can take advantage of single entity treatment by

having P sell the stock, and no gain would be recognized under section

1032. The same would hold true if instead P had acquired M already

owning P stock. Commentators did not suggest any generally applicable

method of distinguishing between transactions in which loss should be

allowed and those in which loss should not be allowed.

The IRS and Treasury have therefore concluded that the final

regulations should retain the general approach of the proposed

regulations.

Built-in Losses

Some commentators suggested that if M joins the group at a time

when it holds P stock with a built-in loss the loss should be allowed

because it accrued outside the group. The final regulations do not

allow this loss because doing so without ensuring that the built-in

gain is taxed would allow the same selectivity and inconsistencies that

the regulation is designed to prevent. In addition, allowing the loss

would require tracing, which is inconsistent with the approaches to

similar issues in Secs. 1.1502-20 and 1.1502-32.

Commentators further suggested that interactions between the

proposed regulations and Sec. 1.1502-32 could cause the group to

recognize an artificial gain from the purchase of a corporation owning

depreciated P stock. If M joins the group at a time when it holds P

stock with a built-in loss and M subsequently sells the stock, P will

have a downward basis adjustment in its M stock because of the

disallowed loss. See Sec. 1.1502-32(b)(3)(iii)(A). The commentators

asserted that this basis adjustment would be inappropriate if the group

has a cost basis in M stock because the basis of M will reflect the

value of the P stock at the time of acquisition (rather than M's basis

in the P stock). To address this problem, the final regulations allow

the built-in loss to be waived immediately before M joins the group.

The loss waiver is modeled after a similar provision in Sec. 1.1502-

32(b)(4). The election, however, is limited to direct acquisitions of a

corporation holding P stock in a cost basis transaction.

Gain Relief

Commentators suggested that the gain relief should be broadened.

Some suggested that the requirement that M receive the P stock in a

capital contribution or section 351(a) transaction be eliminated.

Others suggested elimination of the requirement that M dispose of the P

stock immediately. Commentators also suggested that the gain relief

should apply to options and warrants in P stock, and not merely to P

stock.

The final regulations retain the requirements for gain relief but

extend the relief to positions in P stock. Any further expansion of the

gain relief would require additional limitations and complexities.

For instance, if M were not required to dispose of the P stock

immediately, the regulations would have to require that M have no

minority shareholders. If M had minority shareholders, the gain relief

mechanism (treating cash as contributed to M followed by a purchase of

the stock by M) would allow P a full basis adjustment in M stock for

post-contribution appreciation rather than a pro rata adjustment as

required by Sec. 1.1502-32 in the case of minority shareholders.

Amending the mechanism to allow only pro rata adjustments (for example,

through a direct basis adjustment rather than a cash transaction) would

create further complexities, such as the interaction with Sec. 1.1502-

20.

Expanding gain relief would require further adjustments if M stock

were sold to another member of the group. For example, if B purchases

the stock of M from another member, B's basis in M will reflect the

value of any P stock held by M. Thus, an increase to B's basis in the

stock of M when M disposes of P stock would be unwarranted. Additional

special rules would be needed if M were permitted to acquire P stock by

purchase rather than through a capital contribution. Moreover, the IRS

and Treasury believe that in many cases gain on P stock is avoidable

without further expansion of the regulations. See, e.g., Sec. 1.1032-

2(b) (no gain or loss on M's use of certain P stock in triangular

reorganizations). Therefore, the final regulations retain the

requirements of the proposed regulations for gain relief.

In addition, commentators claimed that the relief when M is newly

formed was unclear. The final regulations clarify that M can be newly

formed as part of the plan to dispose of P stock.

Dealers in P Stock

Some commentators suggested that if a subsidiary is a dealer in P

stock, it should be allowed to recognize losses from its dealing

activity. They argued that dealing in P stock increases the liquidity

of the stock and that the proposed regulations would curtail this

activity by forcing the recognition of gain but disallowing loss with

respect to P stock.

[[Page 10449]]

In response to these comments, the final regulations include an

exception for dealers in P stock or positions in P stock. Under the

final regulations, a dealer in P stock or positions recognizes both

gain and loss on shares of the stock to the extent taken into account

because of section 475(a) (or 1256(a) in the case of dealer equity

options). To be eligible for this exception, M must regularly trade in

P stock (of the same class) in the ordinary course of its business as a

dealer. In addition, the gain or loss on a share is eligible only to

the extent it is taken into account under section 475(a) (or in the

case of dealer equity options, section 1256(a) to the extent that it

would be taken into account under the principles of section 475), and

the basis of the share of stock must not be adjusted by reference to

the basis of any other property (for example, under Sec. 1.302-2) or by

reference to income, gain, deduction or loss from other property. For

example, loss that is suspended under section 475(b)(3) and that is

recognized under section 1001 as the result of a disposition of the

security is not eligible for the relief, but loss taken into account

under section 475(a) immediately before a taxpayer ceases to be the

owner of the security is eligible for relief. Finally, relief is not

available if either M or any other member of the group has structured

or engaged in any transaction while a member (or in anticipation of

becoming a member) during the taxable year or in any year within the

preceding five taxable years that is open for assessment under section

6501 with a principal purpose of avoiding gain or creating loss on P

stock subject to section 475(a).

Positions in P Stock

In response to comments, the final regulations clarify that the

scope of loss disallowance is coextensive with the scope of section

1032. For example, cash-settled options are within the scope of loss

disallowance. See Rev. Rul. 88-31 (1988-1 C.B. 302). No inference is

intended as to the extent to which section 1032 and these regulations

apply to derivative positions in P stock other than options.

One commentator argued that the loss disallowance rule should not

apply to options in P stock because the selectivity available for stock

is not present with respect to options. The final regulations do not

adopt this approach. If M purchases an option to acquire P stock and

the option expires when it is worthless, M has a loss. If the option is

in the money, M can purchase the P stock and hold it indefinitely.

Thus, the group would have the ability to recognize losses while

avoiding gains.

Effective Dates

The final regulations apply to gain or loss taken into account on

or after July 12, 1995, and to transactions (such as a member leaving

the group) occurring on or after July 12, 1995. Thus, the regulations

are intended to cover the same gain, loss and transactions covered by

the rules published in 1995--32 I.R.B. 47. If, however, a taxpayer

takes a gain or loss into account, or engages in a transaction, on or

after July 12, 1995, during a tax year ending prior to December 31,

1995, the taxpayer may treat the gain, loss or transaction under the

rules of the temporary rules published in 1995--32 I.R.B. 47 instead of

under the rules of the final regulations.

Special Analysis

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 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 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 in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

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

revising the entry for Sec. 1.1502-13 to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.1502-13 also issued under 26 U.S.C. 1502. * * *

Par. 2. In Sec. 1.267(f)-1(k), the first sentence is amended by

removing the reference ``1.1502-13T(f)(6)'' and adding ``1.1502-

13(f)(6)'' in its place.

Par. 3. Section 1.1502-13(f)(6) is added to read as follows:

Sec. 1.1502-13 Intercompany transactions.

* * * * *

(f) * * *

(6) Stock of common parent. In addition to the general rules of

this section, this paragraph (f)(6) applies to parent stock (P stock)

and positions in P stock held or entered into by another member. For

this purpose, P stock is any stock of the common parent held by another

member or any stock of a member (the issuer) that was the common parent

if the stock was held by another member while the issuer was the common

parent.

(i) Loss stock--(A) Recognized loss. Any loss recognized, directly

or indirectly, by a member with respect to P stock is permanently

disallowed and does not reduce earnings and profits. See Sec. 1.1502-

32(b)(3)(iii)(A) for a corresponding reduction in the basis of the

member's stock.

(B) Other cases. If a member, M, owns P stock, the stock is

subsequently owned by a nonmember, and, immediately before the stock is

owned by the nonmember, M's basis in the share exceeds its fair market

value, then, to the extent paragraph (f)(6)(i)(A) of this section does

not apply, M's basis in the share is reduced to the share's fair market

value immediately before the share is held by the nonmember. For

example, if M owns shares of P stock with a $100x basis and M becomes a

nonmember at a time when the P shares have a value of $60x, M's basis

in the P shares is reduced to $60x immediately before M becomes a

nonmember. Similarly, if M contributes the P stock to a nonmember in a

transaction subject to section 351, M's basis in the shares is reduced

to $60x immediately before the contribution. See Sec. 1.1502-

32(b)(3)(iii)(B) for a corresponding reduction in the basis of M's

stock.

(C) Waiver of built-in loss on P stock--(1) In general. If a

nonmember that owns P stock with a basis in excess of its fair market

value becomes a member of the P consolidated group in a qualifying cost

basis transaction, the group may make an irrevocable election to reduce

the basis of the P stock to its fair market value immediately before

the nonmember becomes a member of the P group. If the nonmember was a

member of another consolidated group immediately before becoming a

member of the P group, the reduction in basis is treated as occurring

immediately after it ceases to be a member of the prior group. A

qualifying cost basis transaction is the purchase (i.e., a transaction

in which basis is determined

[[Page 10450]]

under section 1012) by members of the P consolidated group (while they

are members) in a 12-month period of an amount of the nonmember's stock

satisfying the requirements of section 1504(a)(2).

(2) Election. The election described in this paragraph (6)(i)(C)

must be made in a separate statement entitled ``ELECTION TO REDUCE

BASIS OF P STOCK UNDER Sec. 1.1502-13(f)(6).'' The statement must be

filed with the P consolidated group's return for the year in which the

nonmember becomes a member, and it must be signed by both P and the

nonmember. The statement must identify the fair market value of, and

the amount of the basis reduction in, the P stock.

(ii) Gain stock. If a member, M, would otherwise recognize gain on

a qualified disposition of P stock, then immediately before the

qualified disposition, M is treated as purchasing the P stock from P

for fair market value with cash contributed to M by P (or, if

necessary, through any intermediate members). A disposition is a

qualified disposition only if--

(A) The member acquires the P stock directly from the common parent

(P) through a contribution to capital or a transaction qualifying under

section 351(a) (or, if necessary, through a series of such transactions

involving only members);

(B) Pursuant to a plan, the member transfers the stock immediately

to a nonmember that is not related, within the meaning of section

267(b) or 707(b), to any member of the group;

(C) No nonmember receives a substituted basis in the stock within

the meaning of section 7701(a)(42);

(D) The P stock is not exchanged for P stock;

(E) P neither becomes nor ceases to be the common parent as part

of, or in contemplation of, the disposition or plan; and

(F) M is neither a nonmember that becomes a member nor a member

that becomes a nonmember as part of, or in contemplation of, the

disposition or plan.

(iii) Mark-to-market of P stock. Paragraphs (f)(6)(i) and (ii) of

this section shall not apply to any gain or loss from a share of P

stock held by a member, M, if--

(A) M regularly trades in P stock (of the same class) with

customers in the ordinary course of its business as a dealer;

(B) The gain or loss on the share is taken into account by M

pursuant to section 475(a);

(C) M's basis in the share is not adjusted by reference to the

basis of any other property or by reference to income, gain, deduction,

or loss from other property; and

(D) Neither M nor any other member of the group has structured or

engaged in any transaction while a member (or in anticipation of

becoming a member), during the taxable year or in any year within the

preceding five taxable years that is open for assessment under section

6501, with a principal purpose of avoiding gain or creating loss on P

stock subject to section 475(a).

(iv) Options, warrants, and other positions--(A) In general. This

paragraph (f)(6) applies with appropriate adjustments to positions in P

stock to the extent that P's gain or loss from an equivalent position

would not be recognized under section 1032. Thus, if M purchases an

option to buy or sell P stock and sells the option at a loss, the loss

is permanently disallowed under paragraph (f)(6)(i)(A) of this section.

Similarly, if M is the grantor of such an option and becomes a

nonmember, then the principles of paragraph (f)(6)(i)(B) of this

section apply to the extent that M would recognize loss from cash

settlement of the option at its fair market value immediately before M

becomes a nonmember, and proper adjustments must be made in the amount

of any gain or loss subsequently realized from the position by M. If P

grants M an option to acquire P stock in a transaction meeting the

requirements of paragraph (f)(6)(ii) of this section, M is treated as

having purchased the option from P for fair market value with cash

contributed to M by P.

(B) Mark-to-market of positions in P stock. For purposes of

paragraph (f)(6)(iii) of this section, gain or loss with respect to a

position taken into account under section 1256(a) is treated as taken

into account under section 475(a) to the extent that the gain or loss

would be taken into account under the principles of section 475. -

(v) Effective date. This paragraph (f)(6) applies to gain or loss

taken into account on or after July 12, 1995, and to transactions

occurring on or after July 12, 1995. For example, if S sells P stock to

B at a loss prior to July 12, 1995, and B sells the P stock to a

nonmember after July 12, 1995, S's loss is disallowed because it is

taken into account after July 12, 1995. If a taxpayer takes a gain or

loss into account or engages in a transaction on or after July 12,

1995, during a tax year ending prior to December 31, 1995, the taxpayer

may treat the gain or loss or the transaction under the rules published

in 1995-32 I.R.B. 47, instead of under the rules of this paragraph

(f)(6).

* * * * *

Par. 4. In Sec. 1.1502-13(g)(2)(i)(B), the last sentence is amended

by removing the language ``paragraph (f)(4) of this section and

Sec. 1.1502-13T(f)(6)'' and adding ``paragraphs (f)(4) and (6) of this

section.''

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved: March 8, 1996.

Leslie Samuels,

Assistant Secretary of the Treasury (Tax Policy).

[FR Doc. 96-6151 Filed 3-13-96; 8:45 am]

BILLING CODE 4830-01-P