Intercompany Transaction and Loss Disallowance Relief Provisions

Certain transfers or dispositions of member stock can trigger tax consequences that appear to be inconsistent with the policy intentions underlying the consolidated return regulations. For this reason, the IRS included, under Regs. Sec. 1.1502-13(f)(5)(ii), three forms of relief. This item focuses on the second of those relief provisions, Regs. Sec. 1.1502-13(f)(5)(ii)(C), for cases in which member stock is transferred within a group and then disposed of in a Sec. 338(h)(10) transaction.

Example 1: A consolidated group disposes of a members stock. The parent, P, wholly owns subsidiary 1, S, which wholly owns subsidiary 2, T. P wants to divest itself of Ts business operations. Ts stock has a $100 fair market value (FMV) and a $30 adjusted basis, and the net adjusted basis of the assets inside T is $15 (leaving $85 of inside appreciation). S sells T for $100 in a Sec. 338(h)(10) transaction and distributes the proceeds to P. Old T recognizes an $85 gain on its asset appreciation, all of which is included in the calculation of the P groups consolidated taxable income. The distribution of the proceeds by S to P does not generate any additional consolidated taxable income within the P group. The P group recognizes only one level of gain on the transaction.

Example 2: The facts are the same as in Example 1, except S first distributes the T stock to P, then P sells T in a Sec. 338(h)(10) transaction. S recognizes a $70 gain on the distribution of T to P, under Sec. 311(b) (i.e., gain resulting from the outside appreciation in Ts stock (deferred momentarily under Regs. Sec. 1.1502-13)). Additionally, the sale of T in a Sec. 338(h)(10) transaction still results in old T recognizing an $85 gain (i.e., from the inside appreciation in Ts assets). Absent any other provision, distributing the stock of T before the Sec. 338(h)(10) transaction results in the P group recognizing two levels of gain.

From an economic standpoint, P ends up in the exact same financial position in Example 2 as in Example 1. However, the tax consequences of distributing the T stock before the sale differ drastically from those of distributing the proceeds resulting from the sale.

Relief for Example 2

Under Sec. 301(d), Ps basis in the T stock received in the distribution from S equals the T stocks FMV on the distribution date, or $100. This increase in the T stock basis (from the $30 basis in Ss hands) mirrors the $70 of Sec. 311(b) gain recognized (momentarily deferred) by S on the distribution of T. The distribution has no effect on the inside basis of Ts assets, which remains at $15; thus, $85 of tax appreciation inside T is still waiting to be recognized.

In Example 2 above, Ps basis in the T stock is increased by the $85 of inside gain old T recognized under the Regs. Sec. 1.1502-32 investment adjustment rules. An additional consequence of the Sec. 338(h)(10) election is a deemed liquidation of old T into P immediately after the deemed sale of old Ts assets. As a result, P would realize an $85 loss on the liquidationthe difference between the $100 distributed to P and Ps $185 adjusted basis (calculated by adding Ps original $100 adjusted basis in the T stock to the $85 basis increase resulting from the application of the investment adjustment regulations). Generally, however, P would not recognize this loss under Sec. 332, leaving the P group with two levels of gain recognition.

Fortunately, the Regs. Sec. 1.1502-13(f)(5)(ii)(C) election prevents the P group from being taxed on outside gain, by allowing P to recognize $70 of the $85 loss realized on the deemed liquidation. P may elect to apply Sec. 331 solely for purposes of determining its loss on the T stock resulting from the deemed T liquidation, in lieu of Sec. 332.

The election entitles P to recognize a loss on the T stock to the extent it or another group member recognized a gain on the same T stock. In Example 2, S realized a $70 gain on distributing the T stock to P; P realized an $85 loss on the deemed T liquidation. The Regs. Sec. 1.1502-13(f)(5)(ii)(C) election entitles the P group to net the loss incurred on the deemed liquidation against the gain recognized on the distribution, to the extent of the gain only. As a result, the P group would recognize a net gain from the entire $85 transaction, identical to the result in Example 1 above. What about the loss disallowance rules?

Loss DisallowanceMore Relief

In general, if a consolidated group member recognizes a loss on a disposition of other group members stock, the loss is disallowed under Temp. Regs. Sec. 1.337(d)-2T(a)(1). Absent an exception to the loss disallowance rule, the relief provided by the intercompany transaction regulations would not be any real relief at all. Fortunately, the IRS has provided a number of exceptions to the loss disallowance rules.

One such exception is the netting rule of Temp. Regs. Sec. 1.337(d)-2T(a)(4), under which a loss on a disposition of member stock is not disallowed to the extent that, as a consequence of the same plan or arrangement, gain is taken into account by members with respect to stock of the same subsidiary having the same material terms. This netting rule allows a selling member to claim a loss recognized on a disposition of member stock to the extent it does not exceed gain recognized by other group members for the same member stock under the same disposition plan. In other words, P can claim $70 of loss recognized on the deemed T liquidation (out of $85) to the extent of gains recognized by other group members on the T stock (i.e., Ss $70 gain on the distribution of T).

The Right Result

In Example 1 above, there was $85 of inside appreciation on Ts assets. A sale of these assets (or a sale of the T stock for which a Sec. 338(h)(10) election is made) should result in the P group recognizing $85 of gain, regardless of whether T is sold directly by S or distributed to, and sold by, P. The group would recognize only one level of gain on this transaction. The relief provided by Regs. Sec. 1.1502-13(f)(5)(ii)(C), combined with the Temp. Regs. Sec. 1.337(d)-2T netting rule, means that the P group recognizes only one level of gain on the sale of T.

From John Michalowski, CPA, Washington, DC