DEFERRED INTERCOMPANY GAIN/LOSS FROM SALE OF PARTNERSHIP INTEREST IS RESTORED BY GROUP'S SELLING MEMBER WHEN PURCHASING MEMBER CLAIMS COST RECOVERY DEDUCTIONS.

Rev. Rul. 89-85

ISSUE

Is deferred intercompany gain or loss, resulting from the sale of a partnership interest between members of an affiliated group filing consolidated tax returns, restored by the selling member when the purchasing member claims cost recovery deductions attributable to basis adjustments under section 743(b) of the Internal Revenue Code?

FACTS

P, the common parent of an affiliated group of corporations that file consolidated income tax returns, owns a 40 percent interest in the capital and profits of PS, a general partnership. The PS partnership owns depreciable assets all of which have substantially appreciated in value. In addition, PS has an election under section 754 of the Code in effect.

During a consolidated return year, P sells the partnership interest to another member of the affiliated group, X, for a price that reflects the fair market value of the partnership assets. X is allocated cost recovery deductions on the bases of the assets as adjusted pursuant to section 743(b) of the Code.

LAW AND ANALYSTS

Section 743(b) of the Code provides that in the case of a transfer of an interest in a partnership by sale or exchange, a partnership with a section 754 election in effect (1) shall increase the adjusted basis of the partnership property by the excess of the basis to the transferee partner of the transferred interest in the partnership over the transferee partner's proportionate share of the adjusted basis of partnership property, or (2) shall decrease the adjusted basis of partnership property by the excess of the transferee partner's proportionate share of the adjusted basis of the partnership property over the basis of the transferee partner's partnership interest. Such increase or decrease shall constitute an adjustment to the basis of partnership property with respect to the transferee partner only.

Section 754 of the Code provides the manner in which a partnership shall file an election to adjust the basis of partnership property in the manner provided in section 743.

Section 755 of the Code provides the manner in which the basis adjustments pursuant to section 743(b) are allocated among a partnership's assets.

Section 1.1502-13(a) of the income tax regulations provides, in part, that the term "intercompany transaction" means a transaction during a consolidated return year between corporations that are members of the same group immediately after such transaction. Thus, for example, an intercompany transaction includes a sale of property by one member of a group to another member of the same group during a consolidated return year. The term "deferred intercompany transaction" includes the sale or exchange of property in an intercompany transaction.

Section 1.1502-13(c)(1)(i) of the regulations provides, in part, that to the extent gain or loss on a deferred intercompany transaction is recognized under the Code for a consolidated return year, such gain or loss shall be deferred by the selling member.

Section 1.1502-13(d)(1)(i) of the regulations provides that if property acquired in a deferred intercompany transaction is, in the hands of any member of the group, subject to depreciation, amortization, or depletion, then, for each taxable year for which a depreciation, amortization, or depletion deduction is allowed to any member of the group with respect to such property, a portion (as determined under section 1.1502-13(d)(1)(ii)) of the deferred gain or loss attributable to such property shall be taken into account by the selling member.

Section 1.1502-13(d)(1)(ii) of the regulations provides that the portion of the deferred gain or loss attributable to any property that shall be taken into account by the selling member shall be an amount equal to (a) the amount of gain or loss deferred by the selling member at the time of the deferred intercompany transaction (and if a member has transferred the property to another member of the group, the remaining balance at the time of such transfer), multiplied by (b) a fraction, the numerator of which is the amount of the depreciation, amortization, or depletion deduction with respect to such property allowed to any member of the group for the year, and the denominator of which is the depreciable basis of such property in the hands of such member immediately after such property was transferred to such member.

Section 1.1502-13(f)(1)(i) of the regulations provides generally that the balance of deferred gain or loss attributable to property transferred in a deferred intercompany transaction shall be taken into account by the selling member on the date such property is disposed of outside the group.

Under the deferred intercompany transaction rules, a selling member's gain on the intercompany sale of an asset is deferred. The deferred intercompany transaction rules require that this deferred gain be restored to income as the affiliated group claims the benefit of the additional basis attributable to such gain. Thus, if the purchasing member uses the asset in its business, section 1.1502- 13(d) requires the selling member to take the deferred gain into account at the same rate that the purchasing member depreciates the asset. This matches the selling member's gain to the purchasing member's cost recovery deductions resulting from the transfer, and prevents the consolidated group from receiving a double benefit, i.e., the purchasing member's additional cost recovery deductions and the deferral of the selling member's gain.

Subchapter K of the Code is a blend of the "aggregate" and "entity" treatment for partners and partnerships. Compare section 751 of the Code WITH section 741. Moreover, for purposes of interpreting provisions of the Code not contained in Subchapter K, a partnership also may be treated either as an aggregate of its partners or as an entity distinct from its partners. Compare Casel v. Commissioner, 79 T.C. 424 (1982), with Madison Gas end Electric Co. v. Commissioner, 72 T.C. 521 (1979), aff'd, 633 F.2d 512 (7th Cir. 1980). The treatment of partnerships in each context must be determined on the basis of countervailing factors applicable to such context. See H.R. Conf. Rep. No. 2453, 83d Cong., 2d Sess. 59 (1954)

Section 754 of the Code and the related adjustments provided in section 743(b) reflect an aggregate approach to partnership taxation. See e.g., Rev. Rul. 87-115, 1987-2 C.B. 163. Upon the sale by P to X of its interest in PS, the adjusted bases of the partnership assets are increased with respect to X as a consequence of the section 743(b) adjustment. There is no express statement in the deferred intercompany transaction rules as to how adjustments under section 743(b) factor into the restoration to income of deferred gain. The application of the deferred intercompany transaction rules without taking into account the adjustments under section 743(b), however, would permit a group to avoid the intended application of the deferred intercompany transaction rules (i.e., to prevent the group from obtaining a double benefit by claiming increased cost recovery deductions resulting from a positive section 743(b) adjustment without taking into account any of the deferred gain to which that additional basis is attributable).

In the absence of a provision of the Code definitely requiring it, an intent to provide a double benefit will not be attributed to lawmakers. See Ilfeld Co. v. Hernandez, 292 U.S. 62 (1934). Moreover, there is a strong policy in favor of construing the consolidated return regulations in a manner consistent with their underlying purposes. See Wyman-Gordon Co. v. Commissioner, 89 T.C. 207 (1987). In light of these principles and the objectives of the specific rules providing for the restoration to income of deferred gain, the application of the deferred intercompany transaction rules to the sale of a partnership interest must take into account the adjustment to the basis of partnership property permitted by section 743(b) of the Code.

Accordingly, the rules provided in section 1.1502-13(d) of the regulations require that P's deferred gain be restored to income to the extent that X claims cost recovery deductions attributable to X's basis adjustment under section 743(b) of the Code.

HOLDING

Deferred intercompany gain or loss resulting from the sale of a partnership interest between members of an affiliated group filing consolidated tax returns is restored to income by the selling member when the purchasing member claims cost recovery deductions attributable to basis adjustments under section 743(b) of the Code.

The same conclusion applies if a partnership holds installment obligations or property subject to amortization or depletion. Likewise, if the partnership sells its appreciated assets after the sale of a partnership interest between members of an affiliated group, the selling member will restore to income the balance of the deferred gain at hat time to the extent of the purchasing member's section 743(b) basis adjustment with respect to such assets. Additionally, if the purchasing member disposes of the partnership interest, the balance of the deferred gain is restored to income by the selling member.

DRAFTING INFORMATION

The principal author of this revenue ruling is James F. Hogan of the Office of Assistant Chief Counsel (Passthroughs & Special Industries). For further information regarding this revenue ruling contact Mr. Hogan on (202) 566-3830 (not a toll-free call).