Consolidated Returns
On June 25, 2010, the IRS Office of Chief Counsel issued Chief Counsel Advice (CCA) 201025046, rejecting a parent corporation’s argument that it was entitled to take into account a loss arising from its sale of domestic subsidiary (Sub1) stock to a foreign subsidiary, which had been properly deferred under Sec. 267(f)(2), as a result of the domestic subsidiary’s later liquidation. The question was whether the liquidation of Sub1 triggers the recognition of the loss Parent incurred from its sale of Sub1 stock to Foreign Sub2.
In summary, the CCA states that the answer is determined by the appropriate application of Regs. Sec. 1.267(f)-1(c)(1)(iv), which “requires an analysis of the hypothetical treatment of the transactions at issue under the principles of the intercompany transaction rules of Treas. Reg. §1.1502-13. If such hypothetical treatment would result in S’s [the member of the consolidated group selling the property or providing the services] item being redetermined to be a noncapital, nondeductible item, such item will continue to be deferred.”
Facts and Background
Parent conducts business in the United States and abroad via its direct and indirect affiliates. In addition, Parent is the common parent of a group of domestic subsidiaries that file a consolidated U.S. federal income tax return. Parent and its subsidiaries engaged in the following steps to centralize the management of its intangible assets and obtain cost efficiencies and additional value from those assets:
- Parent purchased certain assets from domestic Sub1.
- Foreign Sub1 subscribed to ordinary shares of Foreign Sub2 stock and immediately paid for the shares using funds borrowed pursuant to a promissory note.
- Parent sold shares of common stock in Sub1 to Foreign Sub2 in exchange for shares of preferred stock.
- Taxpayer conceded that any such loss on this sale would be deferred under Sec. 267(f).
- Sub1’s board of directors adopted a plan of complete liquidation, which was approved by the Sub1 shareholders (Parent and Foreign Sub2) on that date.
- Sub1 distributed all its assets to Parent and Foreign Sub2 in redemption and cancellation of their equity interests.
- Sub1 dissolved under state law.
- Parent took the position that it was entitled to take into account its loss when Sub1 was liquidated.
Losses Deferred Under Sec. 267(f)
Generally, losses between controlled group members are deferred under Regs. Sec. 1.267(f)-1 and may not be taken into account until the timing principles of the matching and acceleration rules of Regs. Secs. 1.1502-13(c) and (d) are met. Regs. Sec. 1.267(f)-1(a)(1) provides that “[t]he 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).”
Regs. Sec. 1.267(f)-1(c)(1)(iv) states:
To the extent S’s loss would be redetermined to be a noncapital, nondeductible amount under the principles of §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.
Intercompany Transaction Rules Under Regs. Sec. 1.1502-13
The purpose of the intercompany transaction regulations 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 (Regs. Sec. 1.1502-13(a)(1)). These regulations define “intercompany transaction” broadly. Specifically, an intercompany transaction is any “transaction between corporations that are members of the same consolidated group immediately after the transaction.” The regulations further define “S” as the member transferring property or providing services and “B” as the member receiving the property or services (Regs. Sec. 1.1502-13(b)(1)).
The intercompany transaction rules provide that the treatment of an item as excluded from gross income or as a noncapital, nondeductible amount constitutes an “attribute” (Regs. Sec. 1.1502-13(b)(6)). Under Regs. Sec. 1.1502-13(c), the attributes of intercompany items and corresponding items are redetermined to the extent necessary to produce the same effect on consolidated taxable income and consolidated tax liability as though the parties to the transaction were divisions of a single corporation and the intercompany transaction were a transaction between divisions.
Application of the Regulations
Following the rules noted above, losses and deductions are deferred until they are taken into account under the timing principles of the matching and acceleration rules of Regs. Secs. 1.1502-13(c) and (d) with the appropriate adjustments under Regs. Sec. 1.267(f)-1(c). Therefore, an initial analysis of the matching rule under the principles of Regs. Sec. 1.1502-13 is required.
The matching rule requires that the attributes of the intercompany item and the corresponding item be redetermined to the extent necessary to produce the effect of a transaction between divisions of a single corporation. For purposes of applying this rule, Parent’s intercompany item is the amount of loss that it had on the intercompany sale of the Sub1 stock. Foreign Sub2’s corresponding item is the amount that Foreign Sub2 actually recognizes on a separate entity basis as a result of Sub1’s liquidation. Normally, this amount would then be taken into account based on Foreign Sub2’s own separate method of accounting. However, assuming that Foreign Sub2’s basis in the Sub1 stock is equal to its fair market value at the time of the liquidation, Foreign Sub2 would recognize no gain or loss as a result of the liquidation. Therefore, Foreign Sub2’s corresponding item for this purpose is $0.
Once both the intercompany item and the corresponding item are calculated, the recomputed corresponding item must then be calculated. The recomputed corresponding item is the corresponding item that Foreign Sub2 would take into account if Foreign Sub2 (B) and Parent (S) were divisions of a single corporation. In this case, if both Foreign Sub2 and Parent were divisions of a single corporation, Foreign Sub2 would take no basis increase in the Sub1 stock on the transfer of the shares from Parent.
Regardless, solely for purposes of calculating the recomputed corresponding item, upon liquidation the CCA assumes that Foreign Sub2 is treated as realizing some amount of loss. For illustration purposes only, assume Foreign Sub2 is treated as realizing $1,000 of loss. The formula for calculating the intercompany item is:
recomputed corresponding item (RCI) – corresponding item (CI) = intercompany item (II).
Following the formula, $1,000 unrecognized RCI – $0 CI = $1,000 unrecognized intercompany item that constitutes an attribute. Consistent with the intercompany transaction rules noted above, the intercompany item must be redetermined as being excluded as a noncapital, nondeductible item in order to ensure that both the corresponding item and the intercompany item together equal the recomputed corresponding item, ensuring single entity treatment. Thus, under Regs. Sec. 1.267(f)-1(c)(1)(iv), the loss on the sale of the Sub1 stock to Foreign Sub2 by Parent continues to be deferred after the liquidation of Sub1.
Conclusion
The purpose of these rules is to prevent the existence of an intercompany transaction from “creating, accelerating, avoiding, or deferring consolidated taxable income” (Regs. Sec. 1.1502-13(a)(1)). Therefore, while Parent is taking the position that it was entitled to take into account its loss when Sub1 is liquidated, the IRS conclusion is consistent with the stated intent of the intercompany transaction regulations.
Because step 3 noted above is treated as the movement of an asset within a single corporation, the liquidation is controlled by Sec. 332 instead of Sec. 331, and the loss will continue to be deferred. The overall tax impact on the group should not change based on whether the initial intercompany stock sale occurs, and its mere existence does not change this answer.
EditorNotes
Mark Cook is a partner at Singer Lewak LLP in Irvine, CA.
For additional information about these items, contact Mr. Cook at (949) 261-8600, ext. 2143, or mcook@singerlewak.com.
Unless otherwise noted, contributors are members of or associated with Singer Lewak LLP.
