Final Regs on 'Bump-and-Strip' Transactions Issued

 [4830-01]

 ACTION: Final and temporary regulations.

 SUMMARY: This document contains final regulations relating to deferred intercompany transactions and distributions of property among members of a consolidated group. The final regulations provide rules concerning the creation and restoration of deferred gain or loss and assure that intragroup transfers generally do not affect the overall income of the group.

 EFFECTIVE DATE: [Date these regulations are filed with the Federal Register].

 FOR FURTHER INFORMATION CONTACT: Roy A. Hirschhorn or Sharon Bomgardner at (202) 622-7770 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

The collection of information contained in these final regulations has been reviewed and approved by the Office of Management and Budget in accordance with the requirements of the Paperwork Reduction Act (44 U.S.C. 3504(h)) under control number 1545-1161. The estimated annual burden per respondent varies from 1 1/2 to 2 1/2 hours, depending on individual circumstances, with an estimated average of 2 hours.

 These estimates are an approximation of the average time expected to be necessary for a collection of information. They are based on such information as is available to the Internal Revenue Service. Individual respondents may require greater or less time, depending on their particular circumstances.

 Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be directed to the Internal Revenue Service, Attn: IRS Reports Clearance Officer T:FP, Washington, DC 20224, and to the Office of Management and Budget, Attention: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, D.C. 20503.

BACKGROUND

1. INTRODUCTION

Sections 1.1502-13T and 1.1502-14T, which modify certain consolidated return deferred gain or loss rules, were amended by regulations filed with the Office of the Federal Register on March 9, 1990 (T.D. 8295; see 55 FR 9420; 1990-1 C.B. 165) and March 13, 1992 (T.D. 8402; see 57 FR 9384; 1992-1 C.B. 302). Corresponding proposed regulations were filed with the Office of the Federal Register on March 9, 1990 (see 55 FR 9462; 1990-1 C.B. 559) and July 24, 1991 (see 56 FR 34044; 1991-2 C.B. 906), respectively.

 This document contains final regulations under sections 1.1502-13 and 1.1502-14. The final regulations retain the general approach and the effective dates of the temporary regulations.

2. THE DEFERRAL SYSTEM.

Under sections 1.1502-13, 1.1502-13T, 1.1502-14, and 1.1502-14T, gain or loss recognized on a transfer of property from one member of a consolidated group (the selling member) to another member (the purchasing member) is deferred and taken into account by the selling member when, for example, the property is depreciated or disposed of outside the group. The deferral system is intended to prevent intercompany transactions from affecting the timing of consolidated taxable income, and to fix the location, character, and source of the deferred gain or loss, generally with reference to the selling member. The temporary and final regulations assure that the deferral provisions operate as they were intended so that the group's overall income or loss generally is not affected by transactions between members.

3. COMMENTS

Treasury and the Service received several comments regarding the regulations.

 a. THE BUMP-AND-STRIP TRANSACTION. Some comments criticized section 1.1502-14T(c)(1)(i) as it applies to a transaction commonly known as the bump-and-strip transaction. In a typical bump-and-strip transaction, the consolidated group indirectly sells the appreciated stock of a subsidiary (the target) by having the owning member distribute the target stock to another member, the target distribute cash (or other property) to the distributee member, and the target then issue enough new target stock to disaffiliate. Some taxpayers argued that, under the consolidated return regulations as they existed before the temporary regulations, the transaction permitted the group to indefinitely defer income that otherwise would result from the cash distribution and the disaffiliation.

 The comments did not suggest that the position taken in the regulation was substantively incorrect but did argue that taxpayers had not been given adequate notice of the position adopted by the temporary regulations. The temporary regulations are effective for any taxable year for which the due date (without extensions) of the return is after March 14, 1990.

 The effective date of the temporary regulations is consistent with section 1503(a), which specifically provides that the tax liability of corporations that file consolidated returns "shall be determined . . . in accordance with the regulations . . . prescribed before the last day prescribed by law for the filing of [the consolidated] return." The effective date was chosen because the bump-and-strip transaction was determined to be abusive. In effect, the transaction resulted in the realization of gain on a sale of stock outside of the consolidated group; this gain should not go untaxed because of intragroup transfers of stock preceding the sale. It is inconsistent with the purposes of the deferral systems in the consolidated return regulations that intragroup transactions generally would affect the overall tax liability of the group. Thus, the final regulations retain the effective date of the temporary regulations.

 The final regulations do not limit the application, to transactions occurring before or after the effective date of the regulations, of other sections of the Code or general principles of tax law, including sections 337(d) and 482, the substance-over-form doctrine (e.g., application of Commissioner v. Waterman Steamship Corp., 430 F.2d 1185 (5th Cir. 1970), cert. denied, 401 U.S. 939 (1971)), and the tax benefit rule.

 b. EXAMPLE 2 OF SECTION 1.1502-14T(c)(2). Some comments argued that Example 2 of section 1.1502-14T(c)(2) reached an incorrect result under the consolidated return regulations. In the example, P, S, and T are members of a consolidated group. P owns all of the S stock, and S owns all of the T stock. T distributes cash to S, resulting in S having an excess loss account (ELA) in the T stock, and S then distributes the T stock to P. The example provides that, following the distribution, the ELA is treated as deferred gain to S. The comments argued that the correct result in Example 2 should be that P succeeds to the ELA and that the ELA is not treated as S's deferred gain.

 Section 1.1502-14T(c) deals with bump-and-strip and similar transactions, no matter how constructed. Treasury and the Service continue to believe that the result in Example 2 is consistent with the general approach to bump-and-strip transactions and intend to revise other parts of the consolidated return regulations consistent with Example 2.

 c. OTHER COMMENTS. Several comments also objected to section 1.1502-14T(c)(1)(ii). Under this paragraph, deferred gain with respect to stock of a target is taken into account following the disaffiliation of the target to the extent that post-disaffiliation distributions with respect to target stock, in the aggregate, exceed the owning member's basis in the stock, reduced by the deferred gain with respect to the stock, at the time of the disaffiliation. Under the temporary regulations, the deferred gain is taken into account even if the distributions occur several years after the disaffiliation. Comments suggested that post-disaffiliation distributions taken into account be limited, for example, to those within two years of the disaffiliation.

 Under the final regulations, distributions taken into account are limited to those to which the owning member becomes entitled (e.g., as of the record date) before two years after the disposition. However, in computing its consolidated taxable income with respect to distributions to which a member becomes entitled before March 9, 1993, a group may apply the temporary regulations (i.e., choose to take gain into account earlier).

 The Service received a number of other comments dealing more generally with the regulations. These comments generally concern issues beyond the substantive provisions of sections 1.1502-13T and 1.1502-14T and are being considered as part of a comprehensive project to revise sections 1.1502-13 and 1.1502-14.

4. EFFECTIVE DATES.

The regulations are generally effective for any taxable year for which the due date (without extensions) of the income tax return is after March 14, 1990. Transition rules sections 1.1502-13(m)(4)(ii) and 1.1502-14(g)(3)(ii)(A) apply to certain dispositions outside the group occurring before March 9, 1990. Further, section 1.1502-13(n) applies only to deferred intercompany transactions attributable to long term contracts entered into after June 20, 1988. Finally, section 1.1502-13(o) applies to acquisitions of stock of a subsidiary in an intercompany transaction occurring on or after July 24, 1991.

SPECIAL ANALYSES

 It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It also has been determined that these regulation do not have a significant impact on a substantial number of small entities and, therefore, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply to these regulations and a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notices of proposed rulemaking were submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on the impact of the rules on small business.

LIST OF SUBJECTS

26 CFR 1.1501-1 through 1.1502-27

 Income taxes, Reporting and recordkeeping requirements.

26 CFR part 602

 Reporting and recordkeeping requirements.

Treasury Decision 8478

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR parts l and 602 are amended as follows:

PART 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority citation for part 1 is amended in part by adding the following citations:

Authority: 26 U.S.C. 7805 * * *

Section 1.1502-13 also issued under 26 U.S.C. 1502 * * *

Section 1.1502-14 also issued under 26 U.S.C. 1502 * * *

Par. 2. Section 1.1502-13 is amended by:

1. Removing the reference "paragraphs (d), (e), and (f)" and adding "paragraphs (d), (e), (f), (l), (m), (n), and (o)" in its place in paragraph (c)(1)(iii).

2. Removing the last sentence of paragraph (c)(1)(iii).

3. Adding and reserving paragraph (k).

Par. 3. Paragraphs (l) through (o) of section 1.1502-13T are redesignated as paragraphs (l) through (o) of section 1.1502-13, respectively; and, adding new paragraphs (l) through (o) to section 1.1502-13T to read as follows:

SECTION 1.1502-13T TEMPORARY REGULATIONS FOR CERTAIN INTERCOMPANY TRANSACTIONS.

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(l) through (o) [Reserved] For further guidance see section 1.1502-13(l) through (o).

Par. 4. Newly designated paragraph (o) of section 1.1502-13, is revised to read as follows:

SECTION 1.1502-13 INTERCOMPANY TRANSACTIONS.

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(o) ADDITIONAL RESTORATION OF GAIN DEFERRED ON THE SALE OF STOCK OF A MEMBER -- (1) RESTORATION RULE. For purposes of this section, deferred gain with respect to an acquisition of stock of a subsidiary in an intercompany transaction shall be taken into account --

(i) Upon a disposition (as defined in section 1.1502-19(b)(2)) of the stock of the subsidiary in an amount equal to the amount that would have created or increased the excess loss account if the adjustment to basis (or excess loss account) of the stock of the subsidiary resulting from the acquisition had not occurred; or

(ii) Following a disposition (as defined in section 1.1502-19(b)(2)) of the stock of the subsidiary, to the extent distributions with respect to the stock to which a member becomes entitled (e.g., as of the record date) no later than 24 months after the disposition would exceed the basis of the stock if the adjustment to the basis of the stock resulting from the acquisition had not occurred.

(2) EXAMPLE. This paragraph (o) may be illustrated by the following example:

EXAMPLE. (i) Corporations P, S1, S2, and S3 file consolidated returns on a calendar year basis. P owns all of the outstanding stock of S1 and S2. S1 owns all 100 shares of the outstanding stock of S3. The S3 shares have an adjusted basis of $1,000 and value of $10,000. S1 sells all 100 shares of the S3 stock to S2 for $10,000 and recognizes $9,000 of gain. The gain is deferred under section 1.1502-13(c). S2 takes a $10,000 basis in the S3 stock under section 1.1502-31(a).

(ii) S3 borrows $5,000 in 1992 and distributes the $5,000 to S2 in the same year. S3 has no current earnings and profits, and the distribution reduces S2's basis in the S3 stock from $10,000 to $5,000.

(iii) In 1993, S3 has no current earnings and profits. At the end of 1993, S3 issues 100 shares of stock to X, an unrelated third party. As a result, S2 no longer owns 80 percent or more of the S3 stock and S3 ceases to be a member of the group. S3's ceasing to be a member of the group is a disposition of the S3 stock under section 1.1502-19(b)(2)(i). If the basis of the S3 stock had not been adjusted as a result of the sale of the S3 stock by S1 to S2, the $5,000 distribution would have resulted in a $4,000 excess loss account with respect to the S3 stock. Accordingly, S1 is required to take into account $4,000 of the deferred gain (the amount that would have been in the excess loss account but for the adjustment to the basis of the S3 stock resulting from its sale)

(iv) In 1994, S2 sells its 100 shares of S3 stock to X for $6,000. S2 recognizes gain of $1,000 on the sale. Further, under section 1.1502-13(f)(1)(i), because the S3 stock is disposed of outside the group, S1 must take into account the remaining $5,000 of deferred gain on the S3 stock.

(3) EFFECTIVE DATE. This paragraph (o) applies to acquisitions of stock of a subsidiary in an intercompany transaction occurring on or after July 24, 1991.

Par. 5. Paragraph (c) of section 1.1502-14T is redesignated as paragraph (g) of section 1.1502-14; and, new paragraph (c) is added to section 1.1402-14T to read as follows:

SECTION 1.1502-14T TREATMENT OF DISTRIBUTING CORPORATION (TEMPORARY).

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(c) [Reserved] For further guidance see section 1.1502-14(g)

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Par. 6. Newly designated paragraph (g) of section 1.1502-14 is revised to read as follows:

SECTION 1.1502-14 STOCKS, BONDS, AND OTHER OBLIGATIONS OF MEMBERS.

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(g) ADDITIONAL RESTORATION OF GAIN DEFERRED ON DISTRIBUTIONS OF STOCK OF A MEMBER -- (1) IN GENERAL. For purposes of this section and section 1.1502-13, gain deferred with respect to a distribution of stock of a subsidiary from one member to another member shall be taken into account --

(i) Upon a disposition (as defined in section 1.1502-19(b)(2)) of the stock of the subsidiary in an amount equal to the amount that would have created or increased the excess loss account if the adjustment to the basis (or the excess loss account) of the stock of the subsidiary resulting from the distribution had not occurred; or

(ii) Following a disposition (as defined in section 1.1502-19(b)(2)) of stock of the subsidiary, to the extent distributions with respect to the stock to which a member becomes entitled (e.g., as of the record date) no later than 24 months after the disposition would exceed the basis of the stock if the adjustment to the basis of the stock resulting from the distribution had not occurred.

(2) EXAMPLES. This paragraph (g) is illustrated by the following examples.

EXAMPLE 1. (i) Corporations P, S, and T file consolidated returns on a calendar year basis. P owns all 100 shares of the outstanding stock of S. S owns all 200 shares of the outstanding stock of T. The T shares have an adjusted basis of $1,000 and a value of $10,000. S distributes all of its T stock to P. As a result of the distribution, S recognizes $9,000 of gain under section 311(b) and the gain is deferred under section 1.1502-14T(a). P receives a $10,000 basis in the T stock.

(ii) T borrows $9,000 in 1989 and distributes the $9,000 to P in the same year. T has no current earnings and profits, and the distribution reduces P's basis in the T stock from $10,000 to $1,000. In 1990, T has $1,000 of earnings and profits which are not distributed. At the end of 1990, T issues 100 shares of stock to X, an unrelated third party. As a result P no longer owns 80 percent or more of the stock of T and T ceases to be a member of the group. T's ceasing to be a member of the group constitutes a disposition of the T stock under section 1.1502-19(b)(2)(i). If the basis of the T stock had not been adjusted as a result of S's distribution of the T stock to P, the $9,000 distribution to P would have resulted in a $7,000 excess loss account with respect to the T stock. Accordingly, S is required to take into account $7,000 of deferred gain (the amount that would have been in the excess loss account but for the adjustment to the basis of the T stock resulting from its distribution).

(iii) At the end of 1991, P sells its 200 shares of T stock to Y for $2,000. P recognizes no gain or loss on the sale. Under section 1.1502-13(f)(1)(i), because the T stock is disposed of outside the group, S must take into account the remaining $2,000 of deferred gain on the T stock.

EXAMPLE 2. The facts are the same as in Example 1 except that T borrows and distributes the $9,000 to S before S distributes the T stock to P. The results are the same as in Example l because P would have had an excess loss account of $7,000 with respect to the T stock at the time T ceased to be a member of the P group but for the adjustment to the excess loss account resulting from S's distribution of the T stock to P.

(3) EFFECTIVE DATES -- (i) GENERAL RULE. Except as provided in paragraph (g)(3)(ii) of this section, this paragraph (g) applies to dispositions (as defined in this paragraph (g)) of stock of a subsidiary in taxable years for which the due date (without extensions) of the income tax return is after March 14, 1990.

(ii) EXCEPTIONS. Notwithstanding paragraph (g)(3)(i) of this section --

(A) This paragraph (g) does not apply to gain deferred with respect to a distribution of stock of a subsidiary from one member to another member before January 1, 1989, if the disposition (as defined in this paragraph (g)) of the stock of the subsidiary occurs before March 9, 1990.

(B) In computing its consolidated taxable income with respect to post-disposition distributions to which a member becomes entitled (e.g., as of the record date) before [Insert the date these regulations are filed with the Federal Register], a group may apply section 1.1502-14T(c)(1)(ii) (as contained in 26 CFR part 1 edition revised as of April 1, 1992).

Par. 7. Section 1.1502-14T(a) is amended by removing the reference "section 1.1502-13T(l) and (m)" and adding "section 1.1502-13(l) and (m)" in its place.

PART 602 -- OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 8. The authority citation for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 9. Section 602.101(c) is amended by removing the entry for "1.1502-13T" and revising the entry for "1.1502-13" to read as follows:

SECTION 602.101 OMB CONTROL NUMBERS.

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(c) * * *

 CFR part or section where identified         Current OMB Control