Timing of Deductions for Subsidiaries Joining a New Consolidated Return

Editor: Kevin D. Anderson, CPA, J.D.

Consolidated Returns

Under the consolidated return rules, special considerations apply when a subsidiary member (Sub) joins or leaves a consolidated group during the tax year. A consolidated return includes the parent’s items of income, gain, deduction, loss, and credit for the entire consolidated return year, and each of Sub’s items for the part of the year it was a group member. The part of Sub’s income that is not included in the consolidated return is included in a separate return (including the consolidated return of another group).

To provide greater certainty and prevent inconsistent allocations, the original tax year of a subsidiary that joins or leaves the group during the year will be treated for all federal income tax purposes as ending as of the close of the day it becomes or ceases to be a member of a consolidated group (Regs. Sec. 1.1502-76(b)(1)). Absent an election to the contrary, income or loss is allocated on the basis of an actual closing of the books as of the end of its short tax year (Regs. Sec. 1.1502-76(b)(2)). However, inasmuch as a midyear closing can be burdensome, the regulations allow an election under which Sub could ratably allocate items of income, gain, deduction, loss, and credit (Regs. Sec. 1.1502-76(b)(2)(ii)(D)(1)).

Ratable Allocation

Regs. Sec. 1.1502-76(b)(2)(ii)(D)(1) requires the election to ratably allocate items be made on a separate statement and filed with the returns including the items for the years ending and beginning with Sub’s status change.

Regs. Sec. 1.1502-76(b)(2)(iii) provides an alternate allocation approach that can be applied if a ratable allocation is not elected. This provision allows a ratable allocation of Sub’s items in the month of its status change but generally requires an actual closing of the books as of the end of the previous month and the end of the month in which the change occurred.

End-of-the-Day Rule

If Sub becomes or ceases to be a member during a consolidated return year, it becomes or ceases to be a member at the end of the day on which its status as a member changes, and its tax year ends for all federal income tax purposes at the end of that day (Regs. Sec. 1.1502-76(b)(1)(ii)(A)(1)).

Next-Day Rule

If, on the day of Sub’s change in status as a member, a transaction occurs that is properly allocable to the portion of Sub’s income after the event resulting in the change, Sub must treat the transaction for all federal tax purposes as occurring at the beginning of the following day. A determination of whether a transaction is properly allocable to the portion of the day after the event, or the next day, is respected if it is reasonable and consistently applied to similar items (Regs. Sec. 1.1502-76(b)(1)(ii)(B)).

Extraordinary Items

Certain “extraordinary items” cannot be prorated and must be allocated to the day they are taken into account (Regs. Sec. 1.1502-76(b)(2)(ii)(B)(1)). Extraordinary items include, among others, (1) items from the disposition or abandonment of a capital asset, (2) any item from the discharge or cancellation of debt, (3) any item from the settlement of a tort or similar third-party liability, (4) any compensation-related deduction in connection with Sub’s status change, (5) any payment for financial advisory and investment banking services, and (6) any payments to retire any of Sub’s outstanding debt (Regs. Sec. 1.1502-76(b)(2)(ii)(C)). The last three items are addressed in the new guidance discussed below.

Coordination With Change-in-Ownership Rules

For purposes of the limitations under Sec. 382 following an ownership change, a loss corporation can allocate net operating loss (NOL) or taxable income and net capital loss or gain for the change year between the prechange period and the post-change period by ratably allocating an equal portion to each day in the change year. As an alternative, a corporation may elect to allocate these items based on a closing of its books as of the change date (Regs. Sec. 1.382-6).

For these purposes, the allocation of items is determined after applying the consolidated return rules under Regs. Sec. 1.1502-76. For example, if the date a corporation becomes a member of a consolidated group is both a change date under Sec. 382 and the end of a short tax year under Regs. Sec. 1502-76, then Regs. Sec. 1.1502-76 overrides the Sec. 382 regulations for purposes of applying the allocation rules. Consequently, these items would be allocated to the short tax year ending on the change date (Regs. Sec. 1.382-6(d)).

When Sub joins a new consolidated group, Regs. Sec. 1.382-6 does not apply because the change date is the last day of the short tax year. However, if the corporation has a change date on a day other than the last day of the short tax year, Regs. Sec. 1.1502-76 first applies to allocate a portion of the corporation’s items to the short tax year including the change date, and then Regs. Sec. 1.382-6 applies to allocate items within the short tax year for purposes of Sec. 382 (Regs. Sec. 1.382-6(d)).

Filing Requirements for Separate Returns

If a group files its consolidated return by the due date for Sub’s separate return, Sub must file the separate return for Sub’s income not included in the consolidated return on or before the consolidated return’s due date. If the group has not filed its consolidated return, then Sub files its separate return on or before its due date for the entire year or for the portion for which its income is not includible in the consolidated return (Regs. Sec. 1.1502-76(c)).

New Guidance

A recent Associate Chief Counsel Memorandum, AM 2012-010, provides guidance on determining the tax year in which Sub should report items of deduction for liabilities incurred on the day it leaves or joins a consolidated group under the end-of-the-day rule. This memorandum has generally been well-received by most practitioners. Many believe that the memorandum alleviates some of the previous uncertainty about which return an extraordinary expenditure should be reported on—Sub’s final stand-alone return or the first consolidated return of the acquiring corporation that Sub joins.

While some practitioners generally welcomed this guidance, others still question the reasoning behind the memorandum. Nonetheless, if practitioners follow this guidance when preparing corporate income tax returns, the memorandum may constitute “authority” for purposes of avoiding penalties that would otherwise be imposed under Sec. 6662.

Ruling Facts

The acquiring corporation (Acquiring) is a calendar-year taxpayer and the common parent of a consolidated group (Acquiring Group). On Nov. 30, a subsidiary in Acquiring Group merges with and into Target, a calendar-year, accrual-basis corporation, with Target’s shareholders exchanging their Target stock for cash (the acquisition). Since this transaction is considered a taxable stock acquisition, Target becomes a member of Acquiring Group on that day.

Nonqualified stock options: Nonqualified stock options (NQSOs) and stock appreciation rights (SARs) that Target has issued to certain of its employees that are outstanding at the time of the acquisition became deductible by Sub on Nov. 30.

The options did not have a readily ascertainable fair market value (FMV) when they were granted, and the NQSOs and SARs do not provide for a deferral of compensation under Regs. Sec. 1.409A-1(b). Under the terms of its agreements with its employees, Target is obligated to pay certain amounts for and in cancellation of their stock options and SARs in the event of a change in control, including that caused by the acquisition. As a result, Target’s obligation to pay its employees for their NQSOs and SARs becomes fixed and determinable at the time of the acquisition, and it in fact makes these payments shortly after.

This item does not qualify for the next-day rule because Sub’s obligation to pay and the amount of its liability become fixed and determinable upon closing. It is not an item “from a transaction with respect to Sub stock,” but rather an item from transactions that precede the acquisition and involve the performance of services by Sub’s employees. Accordingly, it is governed by the end-of-the-day rule and properly reported on Target’s short-year return for the tax year ending Nov. 30.

Payment for certain deductible transaction costs: Notwithstanding the capitalization rules under Regs. Sec. 1.263(a)-5, certain deductible payments for services of financial advisory and investment banking firms that Sub engaged to provide certain consulting services in connection with the acquisition were also deductible on Nov. 30.

Under the engagement letters, Target’s obligation to pay for these services is contingent upon the successful closing of the acquisition, and Target’s payment obligation becomes fixed and determinable upon closing. While not specifically mentioned in the memorandum, under Rev. Proc. 2011-29, which allows taxpayers to elect a safe-harbor treatment for success-based fees if the taxpayers are not entering a new trade or business, the taxpayers may elect to deduct up to 70% of these fees in certain covered transactions. A taxable stock acquisition is a covered transaction. In this case, the deduction would be reflected in Sub’s return before it joins the Acquiring Group.

According to the memorandum, this item also does not qualify for the “next-day” exception because Sub’s obligation to pay and the amount of its liability become fixed and determinable upon closing. This is not an item “from a transaction with respect to Sub stock,” but rather from transactions that precede the acquisition and involve consultants performing services for Sub. Accordingly, these transaction costs are governed by the end-of-the-day rule and properly reported on Target’s short-year return for the tax year ending Nov. 30.

Retirement of outstanding debt: The last item addressed in the memorandum was amounts Sub paid to retire some of its outstanding debt, at Acquiring’s request, in contemplation of the acquisition. Before the acquisition, Sub and Acquiring agree that Sub will give its bondholders the opportunity to tender their bonds at a price that reflects a premium over the adjusted issue price.

Under the terms of the tender offer, bondholders may tender their bonds to Target (or, having done so, may withdraw their tender) by Nov. 28, but Target is not obligated to purchase any of the tendered bonds. On Nov. 30, after the acquisition has closed, Target accepts the tendered bonds for reacquisition and, later that day, retires the bonds at a premium.

In this case, the application of the next-day rule was deemed to be appropriate since Target retired the tendered bonds at a premium for cash after the closing. Since a deduction for this item arises as a result of a payment in the post-closing portion of the acquisition date, and is based on a decision made by Target after the closing, Target could reasonably report this deduction on its tax return for the short tax year beginning Dec. 1 and ending Dec. 31.

Application of New Guidance to Sec. 382

Whenever all the outstanding stock of a Target that is a loss corporation is acquired, there will usually be a change in ownership subject to Sec. 382. As a result, it is sometimes better to argue that the expense should be recorded in the subsequent return in an attempt to avoid subjecting the expenditure to the change-in-ownership rules.

This objective is not always achieved, as there continue to be nuances under Sec. 382 regarding deductions and losses that are claimed on the change date, which is the last date in the prechange period, but also the first day of the recognition period. Such a deduction might be part of a prechange NOL, or a recognized built-in loss (RBIL), but not both.

Under the right facts, it may not be either. This would occur, for example, if the deduction occurs in the post-change period when a net unrealized built-in gain existed, or when a net unrealized built-in loss (NUBIL) existed but was less than the required thresholds ($10 million or 15% of the FMV of the assets). For a corporation with a NUBIL, the determination of its RBILs may depend on which approach it uses under Notice 2003-65, which permits corporations, after an ownership change, to choose to apply either Sec. 1374 or Sec. 338 to calculate NUBIL and other items.

Failure to Follow New Guidance

If the extraordinary deduction is pushed into the post-change year and there is otherwise some refund potential in the earlier year, there is a risk that the prechange year could close under the statute of limitation for refunds (Sec. 6511) before the first post-change year closes. For example, this could occur if the deduction is taken on the subsequent consolidated return but rightfully belonged in the earlier stand-alone return.

In that case, the loss of the deduction in the earlier year may result in the loss of a tax refund. In some cases the due date for both returns may be the same due to the timing rules under Regs. Sec. 1.1502-76(c), and therefore should not pose any problems. However, where the due dates for the Acquirer and Target returns are not the same, pushing the deduction forward may pose a significant risk.

While this guidance provides a welcome road map to some, it could be a double-edged sword to others who believe certain stand-alone deductions truly belong in a later period. Some practitioners believe the compensation and consulting deductions in the memorandum should be subject to the next-day rule, as opposed to the end-of-day rule, because these payouts would not have occurred if not for the transaction successfully closing. If the closing is a condition precedent, then many believe that the deduction should be considered a condition subsequent, thus invoking the next-day rule for the first two extraordinary items covered in the new guidance.

EditorNotes

Kevin Anderson is a partner, National Tax Services, with BDO USA LLP, in Bethesda, Md.

For additional information about these items, contact Mr. Anderson at 301-634-0222 or kdanderson@bdo.com.

Unless otherwise noted, contributors are members of or associated with BDO USA LLP.