SERVICE SCHEDULES TWO HEARING ON PROPOSED INTERCOMPANY TRANSACTION REGS.

Notice 94-49

                             [4830-01-u]

ACTION: Notice of public hearings on proposed rulemaking.

SUMMARY: This document contains a notice of two public hearings on proposed amendments to the consolidated return intercompany transaction system and to related rules. Because the proposed regulations affect a broad range of transactions, a preliminary hearing will be held to respond to general comments and questions by speakers, and a second hearing will be held to receive comments on the proposed regulations. Background information relating to the issues considered in developing the proposed regulations is provided in this document to facilitate comments.

DATES: A preliminary hearing will be held on May 4, 1994, beginning at 10:00 a.m. Requests to speak at this hearing must be received by April 20, 1994. A second hearing will be held on August 8, 1994, beginning at 10:00 a.m. Comments, requests to speak, and outlines of topics to be discussed at this hearing must be received by July 18, 1994.

ADDRESSES: The first public hearing will be held in Room 2615 of the Internal Revenue Building, 1111 Constitution Avenue, NW, Washington DC. The second public hearing will be held in the Auditorium, Internal Revenue Building, Seventh Floor, 7400 Corridor, Internal Revenue Service Building, 1111 Constitution Avenue, NW, Washington DC. Send submissions to: CC:DOM:CORP:T:R (CO-11-91), room 5228, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. In the alternative, outlines may be hand delivered to: CC:DOM:CORP:T:R (CO-11-91), room 5228, Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the hearings, Carol Savage of the Regulations Unit, Assistant Chief Counsel (Corporate), (202) 622-8452 or (202) 622-7180; concerning the regulations relating to consolidated groups generally, Roy Hirschhorn or David Kessler of the Office of Assistant Chief Counsel (Corporate), (202) 622-7770; concerning stock of members of consolidated groups, Rose Williams of the Office of Assistant Chief Counsel (Corporate), (202) 622-7550; concerning 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 relating to members of consolidated groups, 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. HEARING PROCEDURES

The subject of the public hearings is the notice of proposed rulemaking (CO-11-91) that appears elsewhere in this issue of the Federal Register. Because the proposed regulations affect a broad range of transactions, two public hearings are scheduled.

The rules of 26 CFR 601.601(a)(3) apply to both hearings.

The first hearing on May 4, 1994 will be devoted to general comments and questions by speakers, and policy discussions by the government panel to facilitate further evaluation of the proposed regulations. No outline of topics or comments is required of speakers at the first hearing, but persons wishing to present oral comments at the first hearing must submit their requests to speak by April 20, 1994.

The second hearing on August 8, 1994 is scheduled to receive comments after a reasonable opportunity has been provided to review the proposed regulations and evaluate the comments at the first public hearing. Persons wishing to present oral comments at the second hearing must submit written comments, requests to speak, and outlines of the topics to be discussed by July 18, 1994.

A period of 10 minutes will be allotted to each person for making comments at each hearing.

An agenda showing the scheduling of the speakers at each hearing will be prepared after the deadline for receiving submissions has passed. Copies of the agenda will be available free of charge at each hearing.

Because of access restrictions, visitors will not be admitted beyond the lobby of the Internal Revenue Building before 9:45 a.m.

B. BACKGROUND FOR COMMENTS

The preamble in the notice of proposed rulemaking on the proposed revision of the intercompany transaction system describes the operation of the proposed regulations. See the notice of proposed rulemaking that appears elsewhere in this issue of the Federal Register. To assist in the preparation of comments, this document describes many of the significant issues and alternatives that were considered in developing the proposed regulations but does not repeat the discussion in the preamble.

Sections 1.1502-13, 1.1502-13T, 1.1502-14, 1.1502-14T, and 1.1502-31 contain most of the rules of the current intercompany transaction system. Developments in business practices and the tax law since the adoption of these rules in 1966 have greatly increased the problem of accounting for intercompany transactions. In addition, the consolidated return regulations have received increased attention in recent years because of their potential to facilitate circumvention of changes in tax law, such as repeal of the General Utilities doctrine by the Tax Reform Act of 1986. See Pub. L. 99- 514.

Recent amendments to the intercompany transaction system have responded to specific problems but have not attempted a comprehensive revision. See, e.g., TD 8295 [1990-1 C.B. 165] (amendments to better coordinate the parties to an intercompany transaction), and TD 8402 [1992-1 C.B. 302] (inapplicability of section 304 to intercompany transactions).

The deferred sale approach of the current intercompany transaction system is retained in the proposed regulations, but the manner in which deferral is achieved is comprehensively revised. The proposed regulations reflect developments since 1966, including issues that are partially addressed in other recent consolidated return regulation projects. See, e.g., CO-30-92 [1992-2 C.B. 627] (proposed elimination of the current section 1.1502-31(b) special basis rules for in-kind distributions between members). The proposed regulations also incorporate many of the comments received in connection with recent proposals to amend the consolidated return regulations.

1. SEPARATE AND SINGLE ENTITY TREATMENT

The current consolidated return regulations use a deferred sale approach that treats the members of a group as separate entities for some purposes and as a single entity for other purposes. For example, the amount, location, character, and source of items from an intercompany transaction are generally determined as if separate returns were filed (separate entity treatment), but the timing of items is determined more like the timing that would apply if the participants were divisions of a single corporation (single entity treatment).

If a selling member (S) sells property to a buying member (B), S must determine its own gain or loss, and B's basis in the property is generally its cost basis. These determinations treat the members as separate entities and they preserve the location within the group of income, gain, deduction, and loss from intercompany transactions. However, because consolidated taxable income is determined under sections 1.1502-11 and 1.1502-12 by aggregating the income, gain, deduction, and loss of the members, the group's consolidated taxable income is clearly reflected only by generally matching the timing of S's and B's items from the intercompany transaction.

Some comments have suggested broadening the single entity treatment of consolidated groups for many purposes under the Internal Revenue Code of 1986 (Code) other than intercompany transactions. These suggestions generally have not been adopted in the proposed intercompany transaction regulations because they involve aspects of related-party and substance-over-form issues that are beyond the scope of the intercompany transaction system. The proposed regulations implement only those single entity principles that are essential to taking into account items from intercompany transactions to clearly reflect the taxable income (and tax liability) of the group as a whole. The taxable income (and tax liability) is clearly reflected by preventing intercompany transactions from creating, accelerating, avoiding, or deferring income (or tax liability) for the group.

2. LOCATION OF ITEMS WITHIN THE GROUP

a. IN GENERAL

If the members of a consolidated group remained constant, they had uniform status and accounting methods, and the only investment in the group were through the common parent, it would generally not be necessary to preserve the location of items within a group. Because these conditions are generally not present, however, preserving the location of items within a group is essential to the operation of the Code and consolidated return regulations.

Members of a consolidated group generally retain their treatment as separate entities for many purposes. Members may engage in unrelated activities, use different accounting methods, maintain separate status as a bank or insurance company, have nonmember investors in their stock and obligations, and enter or leave the group retaining their asset basis, their carryovers, and their special status.

Fixing the location of each member's items from intercompany transactions prevents circumvention of many Code provisions. For example, section 355 imposes exacting requirements for S to transfer appreciated assets without recognizing gain. If the intercompany transaction system permitted S's gain to be shifted to B, the benefits of section 355 would be available without satisfying the requirements of that section. Rather than transferring appreciated assets to a controlled subsidiary and distributing the stock to B under section 355, S could simply distribute the appreciated assets to B in an intercompany transaction without recognizing gain.

Similarly, members having a special status under the Code (e.g., a bank or an insurance company) must make separate determinations of their income and deductions. For example, because section 1503(c) limits the use of consolidated group losses by life insurance company members, gain or loss cannot be transferred to or from a life insurance company member in circumvention of the limitation.

Fixing the items of each member is also essential to the operation of many consolidated return provisions outside the intercompany transaction system. See, e.g., sections 1.1502-15 and 1.1502-21 (limitation on losses carried from separate return limitation years), 1.1502-32 and 1.1502-33 (adjustments to stock basis and earnings and profits), 1.1502-79 and 1.1552-1 (allocation among members of amounts computed on a consolidated basis).

For example, if S could shift the gain or loss in its assets to B, the related stock basis adjustments under section 1.1502-32 could also be shifted to eliminate any gain or loss to be recognized from a subsequent sale of the B stock. Similarly, direct interest of a creditor or nonmember shareholder in a subsidiary could be affected under a group tax sharing agreement by shifting gain or loss to or from the subsidiary through intercompany transactions. The distortions could extend into the separate return years of members (including consolidated return years of another group) by affecting the allocation of carryovers under section 1.1502-79 to a member leaving the group.

Commentators have suggested alternatives to the current deferred sale system that permit the shifting of items between members. These approaches are appealing because they simplify the operation of the intercompany transaction system by eliminating the need to value assets and services transferred between members.

The most common suggestion is to return to a carryover basis system similar to the pre-1966 intercompany transaction system. Under a carryover basis approach, the gain or loss of S from the sale of an asset to B is eliminated, and B succeeds to S's basis in the asset instead of taking a cost basis. All of the group's gain or loss from the asset would be taken into account by B, and the character and other attributes of the gain or loss would be determined solely by reference to B. This approach is consistent with generally accepted accounting principles (GAAP), which eliminate gross profit or loss from intercompany transactions in the preparation of consolidated financial statements.

A second suggestion has been to treat an intercompany transaction as if it had not occurred. Gain or loss from the transfer of an asset would be taken into account by S, and the timing and attributes of the gain or loss would be determined solely by reference to S. See, e.g., section 1.267(f)-1T(d) (deferred loss on depreciable property is restored based on the depreciation that would have been allowable to S if the transfer to B had not occurred).

The current deferred sale system was adopted in 1966 because of the many problems with the prior carryover basis system. The prior system permitted intercompany items to be recognized by the wrong member and at the wrong time, to be characterized improperly, and sometimes to be eliminated completely. See, e.g., Beck Builders, Inc. v. Commissioner, 41 T.C. 616 (1964), appeal dismissed (10th Cir. 1965) (intercompany income from the performance of services was eliminated without any corporate or shareholder level tax).

The problems with the alternatives to a deferred sale system have increased with the increasing complexity of the Code since 1966. Any system that allocates to one member the entire gain or loss from assets transferred in an intercompany transaction must compensate with numerous adjustments to accommodate each Code or regulatory provision that relies on location. For example, a carryover basis system might permit appreciated assets of S to be sold outside the group without gain recognition, by forming B with a cash contribution, selling S's asset to B for the cash, and then selling the B stock or S stock without recognizing the asset gain. This would be contrary to "mirror subsidiary" legislation. See, e.g., H.R. Rep. No. 391, 100th Cong., 1st Sess. 1081-84 (1987).

Although many of the problems could be addressed through supplemental adjustments to conform the outside stock basis of a member to changes in its inside asset basis, these adjustments would not eliminate all of the problems and would introduce new problems. See "Stock of members," discussed in this notice of hearing at B.5. Because each of the necessary adjustments would vary greatly as to its purpose and scope, the rules would be complex in the aggregate. By contrast, the deferred sale system under the proposed regulations will result in less complexity because it is based on separate return accounting and the rules required for single entity treatment have a common purpose that is more easily understood.

b. COMPREHENSIVE SINGLE ENTITY TREATMENT

It is generally acknowledged that greater single entity treatment reduces anomalies and planning opportunities, and better reflects the economic unity of a consolidated group. See, e.g., CO- 30-92, supra (investment adjustment regulations); CO-78-90 [1991-1 C.B. 757], and CO-132-87 [1991-1 C.B. 728] (limitations on the use of losses); and IA-57-89 [1993-6 I.R.B. 50] (alternative minimum tax computations). Single entity treatment has also been emphasized in the amendments to the intercompany transaction system since 1990.

It is sometimes suggested that the consolidated return regulations could be greatly simplified by adopting a comprehensive single entity approach. For example, the acquisition, disposition, or deconsolidation of a member's stock could be treated for all Federal income tax purposes as the acquisition or disposition of its assets in a manner similar to section 338(h)(10). Because the basis of the subsidiary's stock would then be irrelevant, the stock basis adjustment system under section 1.1502-32 could be eliminated, and the potential for "mirror subsidiary" transactions would be greatly reduced. Even this system would not completely eliminate the importance of the location of items within a group if, for example, members do not have uniform status or accounting methods, or nonmember shareholders or creditors have an interest in the group other than through the common parent.

Another approach to single entity treatment would be to completely ignore the separate existence of the members. This approach would significantly affect the application of many Code provisions to consolidated groups: members generally would not be permitted to have separate accounting methods; status as a bank or insurance company would be determined by treating all of the members as a single corporation; and losses and other carryovers would remain with the group in which they arose rather than be carried to separate return years as the members left the group. See also "Stock of members," discussed in this notice of hearing at B.5.

Comprehensive application of single entity treatment could be limited to specific activities of the members or to specific Code provisions. For example, if a group operates an integrated enterprise through subsidiaries, the members could be viewed as divisions to which single entity treatment would apply. Predominantly separate entity treatment would apply to members engaging in unrelated activities. Differentiating between related and unrelated activities would present numerous definitional problems, and the treatment of members would have to be responsive to changes in their activities. Any approach that applies for only limited Code purposes would require numerous rules to coordinate with other Code provisions and to prevent inconsistent treatment.

3. MECHANICAL RULES

Until 1990, the intercompany transaction regulations were presented as a series of mechanical rules. See, e.g., section 1.1502-13(b) (intercompany transactions), and section 1.1502-13(c) through (f) (deferred intercompany transactions). These rules reflect inconsistently applied single and separate entity principles.

For example, S's gain from the sale of property to B is taken into account under current section 1.1502-13(f) when B disposes of the property outside the group. Because the rule does not distinguish between different types of dispositions, S's restoration is required even if B disposes of the property in a like-kind exchange to which section 1031 applies. Restoring S's gain as a result of a section 1031 exchange by B does not, however, reflect single entity principles because a single entity generally would not recognize gain on the exchange. Moreover, the nonmember participating in the exchange does not succeed to B's cost basis from the intercompany transaction.

Beginning in 1990, the mechanical rules were supplemented by more uniform, but narrowly focused rules. See, e.g., section 1.1502- 13(l) and (m). These new rules responded to specific transactions and were intended to limit inconsistent combinations of single and separate entity treatment under the mechanical rules. Because the 1990 amendments did not replace the fundamental mechanical approach, problems remain.

For example, section 1.1502-13(m)(2) does not address the special issues presented by the disposition of property outside the group in a transaction that is a nonrecognition transaction under the Code. The proper treatment of these transactions cannot be uniform because they present a wide range of issues. Nonrecognition could reflect the deferral of gain or loss (e.g., because replacement property is received under section 1031 and the gain or loss will be taken into account by reference to the replacement property), duplication of gain or loss (e.g., through the operation of sections 358 and 362), or elimination or disallowance of gain or loss (e.g., section 301(d) provides for a fair market value basis even if the distributing member's loss is not recognized under section 311).

Some commentators have suggested that the current regulations be retained, but fine-tuned to address problems as they arise. Recent amendments have not been comprehensive revisions, and they have increased the already existing complexity because their interaction with the mechanical rules is unclear. For example, if S sells depreciable property to B, B's depreciation deductions result in restoration under both section 1.1502-13(d) and (l) and these rules may restore S's gain at different rates.

Because mechanical rules cannot envision all the combinations of transactions and provisions of law that continue to develop, an approach based on mechanical rules will inevitably produce inappropriate results. Consequently, the proposed regulations adopt uniform rules of general application that reflect principles underlying the current mechanical rules.

The uniform rules are flexible enough to apply to the broad range of transactions that can be intercompany transactions. For example, the proposed 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 are consistent with the approach of recent guidance on tax accounting issues generally. See, e.g., section 1.461-4 (economic performance rules) and proposed section 1.446-4 (hedging transactions). Because the proposed regulations are flexible, they adapt to changes in the tax law and reduce the need for continuous updating. Thus, they should ultimately be easier to apply than mechanical rules.

4. MATCHING AND ACCELERATION RULES

a. MATCHING RULE

The matching rule provides single entity treatment for the timing, character, source, and other attributes of items from intercompany transactions. For each consolidated return year, the matching rule requires S and B to take into account their intercompany items and corresponding items to reflect the treatment of S and B as divisions of a single corporation.

S generally determines its items taken into account based on the difference between the corresponding items B takes into account and B's recomputed items (the corresponding items B would have taken into account if S and B were divisions of a single corporation). One alternative that was considered would have determined the difference between the group's consolidated taxable income (rather than only B's items) and the group's recomputed consolidated taxable income (rather than only B's recomputed items). This approach was not adopted because determining the group's recomputed consolidated taxable income (determined by treating S and B as divisions of a single corporation) would be more complex than determining only B's recomputed items. For example, it would require interactive computations (e.g., the effect on absorption of a carryover loss), require numerous adjustments (e.g., for noncapital, nondeductible amounts), and involve circular computations in some cases (e,g., if S sells property to B, and B sells property to S).

Both the current regulations and the matching rule of the proposed regulations apply single entity treatment to redetermine the timing of S's intercompany items. The matching rule also redetermines the character, source, and other attributes of intercompany items and corresponding items on a single entity basis, while the current regulations redetermine attributes only in limited cases. The approach of the proposed regulations better reflects the economic unity of the members and coordinates single entity treatment with various systems under the Code. For example, if only timing is determined on a single entity basis, it must be distinguished from character, and the distinction is not always clear under the Code. See, e.g., section 469 (the passive activity rules may be viewed as character rules because they limit absorption of losses, or as timing rules because the losses ultimately will be absorbed).

In determining attributes, the proposed regulations take into account the activities of both S and B with respect to the intercompany transaction. Some argue that locking in character at the time of each intercompany transaction more accurately reflects the source and nature of the group's income. However, a single taxpayer generally does not lock in the character of its economic income as the use of its property changes. Instead, character is generally determined under common law principles based on all of the facts and circumstances. For example, the conversion of investment property to property held for sale to customers in the ordinary course of business generally causes any economically accrued gain or loss from the investment period to become dealer gain or loss when later recognized.

b. ACCELERATION RULE

(i) IN GENERAL

Under the acceleration rule, S's intercompany items are taken into account to the extent either the matching rule will not fully account for the items in consolidated taxable income, or the intercompany transaction is reflected by a nonmember. The acceleration rule reflects the conclusion that matching is appropriate only if the effect of treating S and B as divisions of a single corporation can be achieved.

Alternatives to the acceleration rule were considered, but none presented a satisfactory solution. Although it is possible to continue matching the items of S and B, matching would be inappropriate once S and B no longer join in the consolidated return of the group. In addition, continuing to integrate their accounting presents substantial administrative problems.

Another alternative would be for S and B to take their remaining items into account under their separate accounting methods. This approach would be administratively complex, because it would require numerous rules to resolve the issues that arise because of the differences between separate entity accounting and the matching rule. For example, if S sells a depreciable asset at a gain to B in exchange for a note, B depreciates the asset, and then the stock of B is sold to an unrelated person, S's remaining gain might be taken into account under the installment method. The limitations under section 453(g) (sale of depreciable property to a controlled entity) might not apply to S's gain if S is no longer related to B. If B's depreciation has caused S to restore more or less gain than S would have taken into account under the installment method, the difference would have to be reconciled.

Because separate entity accounting would produce the same results as the acceleration rule in most cases, the additional complexity is unwarranted.

(ii) NONRECOGNITION TRANSACTIONS

Under the current regulations, S's intercompany gain or loss from the sale of property is taken into account on the disposition of the property outside the group, even if the disposition is a nonrecognition transaction. By contrast, only certain nonrecognition dispositions by B result in S's intercompany gain being taken into account under the acceleration rule.

For example, if B transfers property to a nonmember in an exchange to which section 1031 applies, the acceleration rule would not apply because the intercompany transaction would have no effect on the nonmember, and S's intercompany items would continue to be matched with B's corresponding items from the replacement property. On the other hand, if B transfers the property to a partnership in a transaction to which section 721 applies, S's gain is accelerated because the partnership succeeds to B's cost basis under section 723. This result is inconsistent with single entity treatment because, if S and B had been divisions of a single corporation, S's transfer to B generally could not have created a cost basis to be reflected by the partnership in the property.

Some commentators argue that an intercompany sale of property from S to B, followed by a section 351 or 721 contribution of the property to a nonmember (including deemed contributions under section 708), warrants special rules. It is suggested that single entity treatment could be achieved by continuing the deferral of S's intercompany items, and adjusting the nonmember's basis in the property as if the order of events had been reversed. Thus, S would be treated as making the section 351 or 721 contribution to the nonmember and selling the stock or partnership interest in the nonmember to B. S's intercompany gain or loss would therefore be taken into account by reference to the stock or partnership interest in the nonmember rather than by reference to the asset.

Reversing the order of events may require numerous adjustments to reflect all of the resulting tax consequences. For example, results that could not have been achieved under the reverse order must be eliminated. If depreciable property is involved, the group would have to shift to the nonmember all depreciation deductions following the intercompany transaction because the property is treated as transferred by S to the nonmember before the intercompany transaction). Discontinuities would have to be addressed (e.g., if B contributes the property to a nonmember corporation subject to its own liabilities, treating S as contributing the property before the intercompany transaction might cause section 357 to apply to the nonmember's assumption of B's liability together with associated basis consequences. Different rules may be required for losses and gains (e.g., if S is a dealer but B is not, and B contributes the property to a partnership, reordering the events may allow the group to select the character of the property based on the rules under section 724). See also "Stock of members," in this notice of hearing at B.5. (problems with reversing the order of transactions).

Another alterative would continue deferral following B's contribution of the property to a partnership if the partnership adopts special allocations to prevent nonmember partners from being affected by B's cost basis. (Sections 704(c) and 737 would not address the problem.) Although special partnership allocations might be adopted, additional adjustments would be required to override otherwise applicable rules that might result in nonmembers reflecting the intercompany transaction.

(iii) SUBGROUPS

The current regulations do not restore S's items if the group terminates by reason of its acquisition by another consolidated group (provided that all of the members immediately before the acquisition become members of the acquiring group). Consideration was given to expanding this successor rule to encompass subgroup principles. See, e.g., section 301.6402-7(h)(2) (insolvent financial institution subgroups), and proposed section 1.1502-21(c)(2) (subgroup rules under the separate return limitation year rules). For example, if another consolidated group simultaneously acquires only the stock of S and B, S's intercompany items could continue to be deferred and taken into account in the acquiring group under the matching rule. (S's intercompany items from intercompany transactions with members other than B would be accelerated.)

The essential issue raised by subgrouping is whether single entity treatment should focus on treatment of the entire consolidated group in which the intercompany transaction occurs, or only on the treatment of S and B as the parties to the transaction. It is not clear that subgroup rules would be consistent with single entity treatment under the intercompany transaction system.

For example, if S is deferring gain from a sale of property to B, and the stock of S and B are simultaneously purchased by another group, the basis of S's stock will not be increased under section 1.1502-32 for the intercompany gain unless it is accelerated before the sale. Thus, selling group's gain from the sale of S's stock may be duplicated when S's intercompany gain is later taken into account by the buying group. This gain duplication is inconsistent with treating the selling group as a single entity. See also section 1.1502-20 (the buying group will not be permitted a loss from stock basis adjustments under section 1.1502-32 attributable to S's built- in intercompany gain).

Because the purpose for single entity treatment under the intercompany transaction system is based on the effect of intercompany transactions on consolidated taxable income, it is not clear that focusing on the individual members participating in intercompany transactions (rather than on the group) is appropriate. (But see the proposed section 267(f) regulations, which provide for subgrouping because the deferral of loss is based on the relationship of S and B to each other rather than on their membership in a particular controlled group.)

Subgroup rules would increase the complexity of the intercompany transaction system. Compare proposed section 1.1502-21(c)(2) and 1.1502-91 to 1.1502-96 (subgroup rules in other contexts). Subgroup rules might require distinguishing between gain and loss, special rules might be required to apply certain Code provisions to transactions indirectly between separate consolidated groups, and coordinating rules for S's reacquisition of property sold to B would be required. Rules would also be necessary for back-to-back intercompany transactions, and it may be necessary to require the members of a subgroup to bear a section 1504 relationship to each other to minimize the effect of intercompany items and corresponding items on stock basis under section 1.1502-32.

c. SIMPLIFYING RULES

Because of the complexity associated with accounting for items under any deferred sale system, consideration was given to proposing simplifying rules for de minimis or ordinary course intercompany transactions.

Simplifying rules might be appropriate for infrequent transactions between members of small groups, because the valuation difficulties of a deferred sale system could be disproportionate to the potential effect on consolidated taxable income. The relief might be to account for the transactions under a carryover basis system. Problems would arise, however, in defining an "infrequent transaction" and "small group." Complexities could also arise concerning the treatment of fluctuations in group size, and the need for special rules to limit the cumulative effect of simplifying rules.

At the other extreme, simplifying rules might be appropriate for large groups with members that transact primarily with nonmembers, but occasionally transact with members in the ordinary course and on the same terms and conditions. The burdens on the group of accounting for intercompany transactions under rules different from the group's other accounting systems may also be disproportionate. Relief in this situation might be separate return accounting that conforms with the group's generally applicable inventory systems, but any such system would present new problems and require special rules (e.g., to prevent a group for accelerating only its intercompany losses under the separate return rules).

Any simplifying rules of general application would be in addition to the general rules. Different groups may require different forms of relief, and groups would need to be familiar with all of the systems. The burdens of simplifying rules appear to outweigh their benefits. Instead of rules of general application, limited rules are included to simplify the treatment of inventories and reserve accounting. In addition, the election under current law to not apply the intercompany transaction system is retained.

In simplifying the rules for members using a dollar-value LIFO inventory method, consideration was given to a "carryover basis method" that more precisely conforms to the matching rule. Under the carryover basis method, B would determine the difference each year between its corresponding inventory items taken into account and its recomputed corresponding inventory items (the items that B would take into account for the year if S and B were divisions of a single corporation). For this purpose, B would recompute the value of its LIFO inventory using a carryover basis amount for its intercompany purchases rather than actual costs. The cumulative difference in the LIFO inventory value of B's pool that receives intercompany purchases would be treated as the amount of intercompany inventory items not taken into account by S, because that amount is included in a LIFO layer of B. To ensure that only S's intercompany inventory items are reflected in B's LIFO value difference, B's base-year cost of recomputed inventory purchases would be the same as the actual base- year costs under B's dollar-value LIFO inventory method.

An advantage of the carryover basis method is B's familiarity with its dollar-value LIFO inventory computations. The only required recomputations are the substitution of carryover costs for the actual costs of intercompany purchases. All of the LIFO submethods of B would otherwise be used. S would make no additional computations other than computing the carryover basis amount of its inventory sold to B.

Distortions could result under the carryover basis method, however, if other costs in the LIFO computation affect B's carryover basis amount in a manner different from their affect on B's actual cost for intercompany inventory purchases. For example, if S sells raw material to B for further processing, the raw material may be allocated additional costs by B under burden rate methods that use the cost of goods as the base for allocation. Thus, costs would be allocated to the raw materials one way at their carryover basis, and another way at their actual cost. This difference would be reflected in B's LIFO inventory value. Because the carryover basis method assumes that the difference in LIFO inventory values equals the amount of S's intercompany inventory items, any additional differences would distort the results.

5. STOCK OF MEMBERS

Notwithstanding their similarities, stock is different from other assets within a group. A member's stock generally has no value independent of the member's underlying assets, yet has its own basis and holding period under the Code.

Both the current regulations and the proposed regulations generally treat a member's stock as an asset separate from the member's underlying assets. For example, if a member's stock is sold in an intercompany transaction, the gain or loss from the sale is taken into account under the matching and acceleration rules of the proposed regulations like gain or loss from any other asset.

The stock basis adjustment rules under section 1.1502-32 provide a significant degree of single entity treatment for member stock. However, the complexities of single entity treatment for member stock under the Code prevent more generally disregarding the separate existence of stock for purposes of intercompany transactions.

Some commentators have argued for the elimination of any gain or loss from transactions with respect to a member's stock--in effect applying section 1032 on a single entity basis. Others would limit this treatment to transactions by a member involving the stock of the common parent (P). Thus, if P contributes its own stock to S, S should not recognize gain if it later sells the stock to a nonmember or if it later distributes the stock back to P. Compare proposed section 1.1032-2 (S's use of P stock in certain triangular reorganizations does not result in gain or loss to S).

The commentators argue that S should not recognize gain or loss from its sale of P stock because the transaction is equivalent to P selling its own stock and contributing the proceeds to S. It is argued that this single entity treatment is particularly compelling in the consolidated return context. For example, S's gain or loss on the sale of P stock is reflected in P's earnings and profits under section 1.1502-33 and P's tax liability under section 1.1502-6, even though P would have no earnings and profits or tax liability from its sale of P stock.

Treating each member's sale of P stock as a direct sale by P would be an expansive application of single entity treatment. Although commentators generally focus only on sales of P stock by members, an expansive single entity approach, if adopted, would have far reaching effects.

Consistently treating S and P as a single entity would require treating any acquisition by S of P stock as a direct acquisition by P of its own stock in a deemed redemption. The application of section 304 principles and the associated consequences (e.g., adjustments to earnings and profits) would have to be expanded to all such cases and coordinated with other Code provisions. Compare Bhada v. Commissioner, 892 F.2d 39 (6th Cir. 1989) (S stock exchanged by S for P stock is not "property" under section 304(a)(2)(A)).

Comparable results would be required in an indirect acquisition if, for example, S owns appreciated P stock when S becomes a member of the P group. The P stock owned by S would have to be treated as redeemed and taxed immediately. Compare proposed section 1.337(d)-3 (P's acquisition of an interest in a partnership that owns P stock is treated as a redemption of the stock).

Following the deemed redemption of the P stock owned by S, expansive application of single entity treatment would result in elimination of any subsequent gain or loss of S from disposing of the P stock. The gain or loss could be eliminated, for example, either by adjusting S's basis in the P stock to fair market value or by expanding the application of section 1032.

Any form of elimination will require a definition of the disposition to which the elimination applies (including indirect dispositions such as S becoming a nonmember), and rules to coordinate the effects of the elimination, including: the determination of P's basis in its S stock; the determination of each member's earnings and profits; the treatment of any interest by nonmember shareholders investing directly in S; the treatment of intermediate members if S is not a direct subsidiary of P; the treatment of stock equivalents (e.g., warrants, convertible debt, and indirect interests through passthrough entities); and the resolution of transitional problems.

Applying consistent single entity treatment for stock would raise numerous issues under the Code, including: distinguishing between intercompany transactions that are taxable (e.g., as sales) and tax-free (e.g., as deemed reorganizations); sharing the earnings and profits of all members for purposes of characterizing distributions by either S or P; expanding the application of sections 305, 306, and 354 if S issues its own preferred stock to acquire existing P stock held by nonmember P shareholders; disqualifying a liquidation by P under section 332 that includes a distribution to S because the distribution to S prevents P from completely liquidating; and treating both P and S as a party in any two-party reorganization involving a nonmember and either S or P.

Single entity treatment may ultimately compel the conclusion that S stock held by P also be treated as treasury stock held by S (and any member's ownership of the stock of another member be treated as treasury stock held by that other member). For example, if P owns 79% of S's stock and later acquires the remaining 21%, single entity treatment may require treating P's 79% interest as redeemed immediately after S becomes a member because P's stock in S would be treated as becoming treasury stock of S. Thus, P's gain or loss inherent in the 79% interest would be taken into account immediately.

The proposed regulations do not adopt expanded single entity treatment for stock of members. That approach would greatly increase the complexity of the proposed regulations and would have significant consequences for the tax liability of a group. Although complexity could be reduced (e.g., by limiting single entity treatment to a higher-tier member's ownership of a lower-tier member's stock or to common parent stock owned by a wholly-owned, first-tier subsidiary), numerous problems would remain.

One stock transaction that has received a significant amount of attention regarding single entity treatment is the liquidation of a member following an intercompany sale or distribution of its stock. Under the current regulations, if S sells all of the stock of a lower-tier member (T) to B at a gain, and T subsequently liquidates under section 332, S's gain is taken into account. If the basis of T's assets conformed to the basis of its stock before S's sale, S's gain from the T stock will be duplicated by gain that the group later recognizes from the former T assets (because B succeeds to T's basis in the assets). The problem could also arise, for example, if T is deemed to liquidate as the result of an election under section 338(h)(10), or if B merges downstream into T. Commentators have argued that single entity treatment should apply to eliminate S's gain, or to coordinate the gain with any corresponding gain inherent in the former T assets.

The proposed regulations provide limited, administrable relief that should be available in the most common circumstances. Although several more comprehensive solutions to these problems have been suggested by commentators, they are generally not feasible. The simplest solution is to eliminate S's gain when T liquidates, but this approach would permit gain that arose in S to be eliminated and is therefore inconsistent with the objectives of the proposed regulations to preserve location. See "Location of items within the group," discussed in this notice of hearing at B.2.

A second approach would provide an election under section 336(e) to eliminate S's gain by treating S's sale of T stock as a sale by T of all of its assets. The implementation of section 336(e) raises several problems. For example, each of T's assets must be separately valued and intercompany gain traced to the individual assets, special rules would be necessary for lower-tier subsidiaries and transfers of less than all of the T stock, and liquidation-reincorporation concerns would have to be resolved. If the election is required at the time of S's sale, it would not be useful to many taxpayers because the subsequent liquidation will not be anticipated. However, if an election is not required until the liquidation occurs, it might no longer be feasible to determine the consequences of the treatment or to amend the returns for all affected prior years.

A third approach would effectively reverse the order of S's intercompany stock sale and the subsequent sale of the former T assets. S would take into account the subsequent asset gain from the former T assets as it is recognized, instead of taking into account its own stock gain. This approach approximates the results that would have occurred if T's asset gain had been recognized before the intercompany stock sale and the stock gain eliminated because of the basis adjustments under section 1.1502-32. Although the location of the group's single gain is preserved in S, and the character of the gain is consistent with the reversal of order, the tracing required of the former T assets would be complex, and additional adjustments would be required to account for S's use of the stock sale proceeds. See also "Acceleration rule--nonrecognition transactions," in this notice of hearing at B.4.b.ii. (problems with reversing the order of transactions).

The proposed regulations provide special rules to clarify the results if a member acquires its own stock in an intercompany transaction. The proposed regulations generally take into account immediately any intercompany items from transferring an issuer's stock back to the issuer in an intercompany transaction, because future matching is no longer possible. The results are consistent with the separate entity treatment preserved under the proposed regulations by not deeming P's acquisition of S stock as a deemed redemption of any P stock that S owns. (Possible deemed redemption treatment remains under study. See, e.g., proposed section 1.337(d)- 3, under which P's acquisition of an interest in a partnership that owns P stock is treated as a redemption of the stock.) Administrative difficulties prevent distinguishing S's gain or loss accruing after it is a member from the gain or loss that was built-in when it became a member, and any such distinctions would result in inconsistent combinations of single and separate entity treatment.

6. OBLIGATIONS OF MEMBERS

Legislative and judicial developments since 1966 that are applicable to all obligations have affected the treatment of obligations between members. For example, the Code provisions for taking into account bond premium and discount have been comprehensively revised to incorporate time value of money principles. See, e.g., Pub. L. 98-369, sections 41-44 (sections 163(e) and 1271 to 1288).

Section 108(e)(4) was enacted in 1980 to prevent avoidance of discharge of indebtedness. The statute adopts a limited single entity approach by treating the acquisition of debt by a person related to the debtor as comparable to the debtor's acquisition of its own debt. The regulations implementing section 108(e)(4) include some circumstances in which the holder of the debt becomes a person related to the debtor.

The preamble to the proposed section 108(e)(4) regulations indicates that the consolidated return regulations would be modified to apply similar principles to any transaction in which a debtor and the holder of the debt become members of the same consolidated group. See CO-90-90 [1991-1 C.B. 774], clarified by Notice 91-15, 1991-1 C.B. 319. The proposed intercompany transaction regulations implement this treatment of members of a consolidated group.

Special consideration has been given in recent years to the issues presented by developing markets for notional principal contracts and other sophisticated financial instruments. These obligations are not clearly described under the current consolidated return regulations because their exponential growth only began over the last decade. Section 1.446-3 provides for the timing of income and deductions from notional principal contracts, but does not address many of the issues arising from notional principal contracts between related parties.

Section 475 was enacted in 1993 to address problems with measuring the income of dealers in securities, including these contracts. See Pub. L. 103-66, section 13223. Section 475 generally requires a dealer to mark-to-market its position in securities, and may greatly expand the instances in which items are recognized by a member with respect to intercompany obligations.

Notional principal contracts and other securities are frequently used to hedge assets or liabilities. Section 1.1221-2T generally conforms the character of items from the contracts with the items from the underlying assets or liabilities. Similar rules are proposed in section 1.446-4 to conform the timing of the items. The purpose of these rules is to match the timing and character of items from hedging transactions with the items being hedged. See TD 8493, FI-46-93, and FI-54-93 [1993-35 I.R.B. 16, 22, and 24]. Although these rules apply to certain hedging of aggregate risks, they do not apply if a taxpayer hedges the risk of a related party.

The proposed regulations provide greater single entity treatment for intercompany obligations than for member stock. Greater single entity treatment is possible because the separate return rules under the Code already provide that the aggregate income and deductions of the parties to obligations generally correspond in amount and effect on earnings and profits. In the consolidated return context, these provisions generally produce offsetting items whose timing and character can be conformed. Concerns about the location of items within a group can be addressed by making only limited adjustments to the separate return rules. For example, the separate return regulations under section 108(e)(4) provide essentially single entity treatment for related-party acquisitions of debt. Only limited rules are necessary under the proposed regulations to conform the section 108(e)(4) rules to the single entity treatment of consolidated groups.

By contrast, there are significant differences between the treatment of issuers and holders of stock that would entail numerous adjustments to conform the amount, location, and collateral effects of items, as well as timing and character. For example, section 304 treatment would be required for stock transactions that are comparable to section 108(e)(4) transactions. Thus, section 304 principles would have to be extended to all transactions which result in one member owning another member's stock (e.g., an indirect acquisition in which the holder of the stock becomes a member). Adjustments would be necessary for earnings and profits and stock basis, and additional rules would be necessary to treat a subsequent disposition of the stock as an issuance that does not result in gain or loss.

Several approaches to single entity treatment were considered for intercompany obligations. One approach would treat all gain or loss with respect to an intercompany obligation as a transfer with respect to stock. For example, if the debtor member retires its intercompany debt at a discount, the creditor member's corresponding loss would be treated as a capital contribution or distribution, as the case may be, to the debtor member. See generally sections 1.61- 12(a) and 1.301-1(m). If the debtor and creditor are in a brother- sister (rather than parent-subsidiary) relationship within a group, additional adjustments would be required.

Treating the creditor member's loss as a capital contribution (or distribution) ensures that the loss does not affect the overall determination of consolidated taxable income, but it would distort the location of items within a group. For example, if a debtor or creditor is a subsidiary with nonmember shareholders, a portion of any decrease in the value of the debt would be borne by these shareholders rather than the group. Treating the creditor member's entire loss as a capital contribution would also fail to reflect the interests of the nonmember shareholders in the debtor or creditor for purposes of stock basis and earnings and profits adjustments under sections 1.1502-32 and 1.1502-33.

The proposed regulations generally adopt a single entity approach by requiring both parties to an intercompany obligation to take offsetting items into account under the matching rule. Because the income and loss of the parties are separately taken into account, their items are separately reflected in the stock basis and earnings and profits adjustments under sections 1.1502-32 and 1.1502-33 (and thereby reflect the interests of any nonmember shareholders).

The proposed regulations provide rules for two categories of transactions involving intercompany obligations. The first category generally includes transactions in which an intercompany obligation is sold to a nonmember or otherwise becomes an obligation that is not an intercompany obligation (e.g., the debtor or creditor becomes a nonmember). The proposed regulations treat the intercompany obligation as satisfied immediately before the transaction and reissued immediately after the transaction.

Treating the obligation as satisfied immediately before the transaction results in both gain and loss of the parties from the satisfaction being taken into account in the determination of consolidated taxable income. The matching rule conforms the timing and attributes of the items to prevent any effect on consolidated taxable income.

By conforming timing and attributes in the determination of consolidated taxable income and treating the obligation as reissued immediately after the transaction, the intercompany obligation is effectively treated as first existing as an obligation only after it is held by a nonmember. Thus, if S sells B's debt obligation to a nonmember at a discount, the debt is treated by both B and the nonmember as having original issue discount to which section 1272 applies (rather than market discount to which sections 1276 through 1278 apply). This single entity treatment avoids mechanical rules and accommodates any future changes in the separate return rules for the taxation of indebtedness.

The second category includes transactions in which an existing obligation becomes an intercompany obligation. Although section 108(e)(4) applies to many of these cases, it does not apply to all of them.

Because the focus of section 108(e)(4) is to prevent avoidance of discharge of indebtedness income, section 1.108-2 requires only the debtor to recognize gain or loss. The proposed regulations treat both the debtor and creditor as recognizing gain or loss. For example, if a nonmember creditor becomes a member, the obligation is treated as retired and reissued immediately after the obligation becomes an intercompany obligation. Because the amounts taken into account accrued before the debtor and creditor joined in filing a consolidated return, the proposed regulations preserve the separate return attributes of the gain and loss, and these amounts might not conform in character. The deemed satisfaction and reissuance avoids the need to expand the mechanical rules of section 1.108-2.

The separate return rules for obligations satisfied, modified, or issued in a reorganization or other nonrecognition transaction are under study as part of a separate project. See, e.g., Rev. Rul. 74- 54, 74-1 C.B. 76 (indebtedness of a parent corporation is an asset to which section 332 applies); Estate of Helen Gilmore v. Commissioner, 40 B.T.A. 945 (1939), acq. 1940-1 C.B. 2 (indebtedness of a shareholder is an asset to which the predecessor of sections 331 applies); and Rev. Rul. 93-7, 1993-1 C.B. 125 (recognition of gain or loss on distribution of debt by creditor partnership to debtor partner). The rules for these nonrecognition transactions will be coordinated with the rules of the proposed regulations for the treatment of transactions in which an existing obligation that becomes an intercompany obligation, to the extent that the transactions are comparable. Different treatment may be appropriate if, for example, an insolvent target is acquired by its significant creditor, because the target's insolvency for purposes of section 108(a) might be eliminated if the discharge were treated as occurring immediately after the acquisition.

Although recent proposed regulations under section 1.446-4 generally attempt to match the timing of items from hedging transactions with the items being hedged, the current consolidated return regulations might prevent this matching. For example, S may reduce its interest rate risk on an existing debt owed to a nonmember by entering into an intercompany interest rate swap contract with B (the member that centralizes the hedging activities of the group). B may, in turn, offset its net aggregate risk by entering into an offsetting contract with a nonmember. If B is subject to section 475, B's interest in the intragroup contract and its interest in the contract with the nonmember are marked-to-market. If the intragroup contract is an intercompany obligation to which current section 1.1502-14(d) applies, however, B's marking to market gain or loss from the intragroup contract is deferred unless section 475 requires otherwise. If S is not subject to section 475, it does not mark to market either its debt or its interest in the intragroup contract. Thus, the timing of the items from the intragroup contract, S's debt, and B's contract with the nonmember may not necessarily match. Of S's two positions and B's two positions, only gain or loss from B's contract with the nonmember would be currently taken into account.

The proposed regulations treat B's marking to market of its interest in the intragroup contract as resulting in the satisfaction and reissuance of the contract. Thus, B takes into account immediately its gain or loss from the deemed retirement of the intragroup contract, and S takes into account an offsetting amount of loss or gain. A new intragroup contract is then deemed to be reissued at a discount or premium (to reflect its fair market value) that is taken into account over time based on the applicable rules for the type of obligation. The net timing effect on consolidated taxable income is similar to the deferral that would be required for the obligation under the current regulations if section 1.1502-14(d) applies. It is also analogous to the effect on consolidated taxable income if S and B had not entered into the intragroup contract, but B nevertheless had contracted with the nonmember by reason of S's interest rate risk (i.e., a related-party hedge). However, the deemed satisfaction and reissuance under the proposed regulations preserve the location of each member's items.

The proper treatment of related-party hedging transactions is also being considered in conjunction with the finalization of regulations under sections 446 and 1221. See, e.g., TD 8493, FI-46- 93, and FI-54-93 [1993-35 I.R.B. 16, 22, and 24]. Depending on the treatment under those final regulations of hedging transactions in which one member of a consolidated group offsets the risk of another member, it may be necessary to modify the consolidated return regulations to clearly reflect consolidated taxable income.

7. CONCLUSION

This document was prepared to provide background information on the issues and approaches considered in developing the proposed regulations. Comments and questions concerning the intercompany transaction system need not be limited to the issues discussed in this document.

By direction of the Commissioner of Internal Revenue:

                                   Dale D. Goode