Chapter 6 INTERCOMPANY TRANSACTIONS. Consolidated Tax Return Fundamentals -37-

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1 Consolidated Tax Return Fundamentals -37- Chapter 6 INTERCOMPANY TRANSACTIONS An intercompany transaction is any transaction between corporations that are members of the same consolidated group immediately after the transaction. 1 The purpose for requiring special intercompany transaction rules is to ensure that the taxable income of the affiliated group is clearly reflected and to prevent transactions between group members that could create, accelerate, avoid, or defer consolidated taxable income. In July 1995 the IRS finalized a comprehensive set of regulations that substantially modified the long-standing regulations governing intercompany transactions. 2 The new regulations are effective for tax years beginning on or after July 12, These new regulations are written in a unique and unprecedented style. The group members are treated as separate entities (a separate-company basis) for certain purposes and as divisions of a single corporation (a single-entity basis) for other purposes. For example, the location of intercompany items is determined on a separate-company basis; the timing, character, and source of transactions are treated as if they occurred on a single-entity basis. While the new regulations retain the basic deferred sale approach of the old regulations, they employ a more expansive approach in redetermining the character and timing of income recognition. The new regulations replace the "deferred intercompany transaction rules" of the old regulations with a "matching rule" and an "acceleration rule." Because these new regulations simplify the rules for many types of intercompany transactions, the need for special intercompany inventory rules, deferred intercompany transactions, and transactions involving stock or obligations of members are eliminated after the effective date of these changes. DEFINITIONAL AND SPECIAL RULES The new regulations are written and defined using a transactional approach that refers to S (the seller) as the member transferring property or providing services and to B (the buyer) as the member receiving the property or services. Thus, S's sale of property to B, S's performance of services for B, and S's rental of property or loan of money to B are all intercompany transactions that must be accounted for under the new regulations. The regulations also introduce new terminology to the intercompany transaction arena. S's items are referred to as intercompany items, B's items are referred to as corresponding items, and a new fictitious determination is made that is referred to as a recomputed corresponding item. These items are paired under matching and acceleration rules to determine when gains, losses, income, and 1 2 Reg (b)(1). Throughout the remainder of this chapter, the prior long-standing regulations will be referred to as the "old regulations.

2 deductions will be reported for tax purposes. Intercompany items. Intercompany items are defined as S's income, gain, deduction, and loss from an intercompany transaction that S realizes on a transaction. 3 Expenses and costs (e.g., capitalized costs) related to an intercompany transaction are taken into account in determining intercompany items. S's intercompany items may take into account amounts that are not yet taken into account under its separate method of accounting, in order to match B's corresponding items. Thus, cash-basis S may have to take into account income even in situations where the cash has not yet been received. Note that the computation of the intercompany item to be recognized is the residual (or by-product) of the difference between the corresponding item and the recomputed corresponding item, as will be demonstrated later in Diagram 10. Corresponding Items. A corresponding item is defined as B's income, gain, deduction, or loss that is both realized and recognized in an intercompany transaction or from property acquired in an intercompany transaction. For example, if B buys property from S and resells it to an unrelated party, B's gain or loss from the resale is a corresponding gain or loss that B realizes and reports on its tax return (recognizes). Similarly, if B does not sell the property but recovers its cost through depreciation, its depreciation deductions are corresponding items. 4 A corresponding item may result directly or indirectly from an intercompany transaction, and the amount of the corresponding item is determined on a separate-company basis. Corresponding items include amounts that are permanently disallowed or permanently eliminated. For example, amounts disallowed under 265 are still classified as corresponding items. 5. Example 19 Corporation S sells an asset (basis $4,000) to Corporation B for $12,000. S s $8,000 gain on sale is the intercompany item realized on the transaction. B sells the asset to an unrelated party for $10,500. B s $1,500 loss ($10,500 - $12,000) on sale is the corresponding item to be recognized on its tax return. Recomputed Corresponding Items. A recomputed corresponding item is the corresponding item that B would take into account if S and B were divisions of a single corporation and the intercompany transaction were between those divisions (i.e., a single-entity basis). For example, if S sells property with a $70 basis to B for $100, and B later sells the property to a nonmember for $90, B's recomputed corresponding item is a $20 gain (determined by comparing the $90 sales price with the $70 basis the property would have if S and B were divisions of a single corporation). Note that the computation of the recomputed corresponding item is a "fictitious computation." While neither S nor B actually takes the recomputed corresponding item into account on either tax return, it becomes a necessary element in computing S's intercompany item to be recognized. 3 Reg (b)(2)(i)(A). 4 Reg (b)(2)(ii)(A). 5 Reg (b)(2)(ii)(B).

3 Consolidated Tax Return Fundamentals -39- Example 20 Assume the same facts as Example 19. If S and B were divisions of a single corporation, B would assume S s $4,000 basis to determine gain or loss on the sale of the asset for $10,500. Hence, B s recomputed corresponding item is a gain of $6,500 ($10,500 - $4,000). THE MATCHING RULE The matching rule provides single-entity treatment for file timing, character, and source of items from intercompany transactions. Generally, S's intercompany items and B's corresponding items are determined to produce the same effect on consolidated taxable income and consolidated tax liability as if S and B were divisions of a single corporation. Character and Holding Periods. The activities of S and B affect the attributes of both intercompany items and corresponding items. For example, if S holds property for sale to unrelated customers in the ordinary course of its trade or business and sells the property to B, S's intercompany items as well as B's corresponding items may be ordinary items solely by reason of S's activities. 6 Example 21 S sells investment property to B, and B holds the property for sale to customers in the ordinary course of business. Under the matching rule, S and B must redetermine the character attributes of their intercompany items and corresponding items to produce the same effect on consolidated taxable income as if they were divisions of a single corporation. Thus, the redetermination of character is based on the underlying activities of both S and B and may require both S s items and B's items to be ordinary or capital. Because the attributes are redetermined by treating S and B as divisions, the matching rule, with minor exceptions, aggregates the holding periods of S and B with respect to property transferred in an intercompany transaction. Timing of Transactions. The essence of the matching role is found in the timing rules. For each consolidated return year, the matching rule requires S to recognize its intercompany items to reflect the difference between the corresponding items B recognizes and B's recomputed corresponding items. 7 Thus, the matching rule is what initiates the determination of S s recognized gain, and the amount of that gain is determined by a residual computation, as illustrated in Diagram 8. 6 Reg (c)(1)(i). 7 Reg (c)(2)(ii). Although this computation is fictitious, it must be computed and based on "reasonable and consistently applied assumptions," including provisions of the Code, or regulations that would affect timing of transaction attributes.

4 Diagram 8 Example 22 Assume the same facts as Examples 20 and 21. S recognizes $8,000 gain on the sale of the asset. S s intercompany item recognized is equal to B s $6,500 recomputed corresponding item gain less the loss of the $1,500 corresponding item (note the double negative). Recomputed Item Corresponding Item Intercompany item $6,500 gain <$1,500> loss = $8,000 gain Single-entity basis Separate-company basis Residual The character of S s $8,000 gain and B s $1,500 loss (and their holding period for the property) are determined by taking into account the activities of both S and B with respect to that property. While the amount that is actually reported on S s tax return is similar (in this case exactly) to the amount that would have been determined under the prior (pre 1996) deferred intercompany transaction regulations, the matching rule of the new regulations applies to a wider range of transactions. Because the matching rule focuses solely on B's items, the reliance on particular events and transactions to take S s items into account is reduced. Accordingly, application of specific code provisions, such as nonrecognition provisions, do not require a special rule. One of the few differences in determining the amount to be taxed under the prior regulations and the new regulations is illustrated in the following example. Example 23 S sells land to B at a gain, and B transfers the land outside the group in an exchange under B's corresponding item gain is zero, and B s recomputed item gain is zero; thus, no gain is taken into account by S under the matching rule even though the property is disposed of outside the group. Instead, S s gain remains deferred and is taken into account based on B s items with respect to the replacement property. Note that under the old regulations the like-kind exchange would have triggered a restoration event requiring S s gain to be recognized. THE ACCELERATION RULE The purpose of the acceleration rule is to take items into account to the extent that they

5 Consolidated Tax Return Fundamentals -41- cannot be taken into account under the matching rule. The acceleration rule generally applies in two situations first where the matching rule will not fully account for the items from an intercompany transaction in consolidated taxable incomes, 8 and second, where the intercompany transaction is reflected by a nonmember. 9 The first situation in which the acceleration rule can apply is where either S or B becomes a nonmember of the affiliated group, and any remaining intercompany items and corresponding items can no longer be matched. In such a case, the intercompany items are taken into account immediately before S or B becomes a nonmember. Example 24 Example 25 P, a parent corporation, owns 100% of both S and B. S owns land with a basis of $70 and a value of $100. On January 1, Year 3 S sells the land to B for $100. On July 1, 2001 P sells 60% of S's stock to unrelated X for $80 and, as a result, S becomes a nonmember. Under the matching rule, none of S s $30 gain is taken into account in years 3 through 5 because there is no difference between B s corresponding gain ($0) and B s recomputed gain (also $0). Under the acceleration rule, S s gain must be taken into account because the matching rule will never be produced once S becomes a nonmember. Thus, S takes its $30 gain into account in year 5 immediately before becoming a nonmember. In addition, S s gain is reflected in P's basis in S immediately before P s sale of the stock. Notwithstanding the acceleration of S s gain, B continues to take its corresponding items into account under its accounting method. Thus, B s corresponding items (i.e., its gain or loss on the sale of the land) are taken into account based on subsequent events on a separate-company basis. Assume the same facts as Example 24 except that P sells the B stock (rather then S stock) to X for $60 and, as a result, B becomes a nonmember of the affiliated group. Once again, because the effect of treating S and B as divisions of a single corporation cannot be produced once B becomes a nonmember, S takes its $30 gain into account under the acceleration rule immediately (the day before) before B becomes a nonmember. The second situation in which the acceleration role can apply occurs when B purchases property from S and transfers it tax-free to an entity (e.g., to a partnership under 721 or to a nonmember corporation under 351). Because the transferee entity now succeeds to B's corresponding item cost basis in the property, the acceleration rule requires S to take its intercompany items into account immediately before the event, rendering single-entity treatment impossible. 10 Under special circumstances, the acceleration rule might also apply outside the scope of the 8 Reg (d)(1)(i)(A). 9 Reg (d)(1)(i)(B). 10 The primary difference between this rule and the situation of Example 19 is that if B were to dispose of the property in an exchange with a nonmember under 1031, the intercompany items would not be taken into account under the acceleration rule because the nonmember would not succeed to B's cost basis.

6 two common situations. One such event might occur if S's gain or loss from the sale of property to B exceeds the effect of the intercompany transaction on the basis of the property. Example 26 B owns a building with a basis of $2,000,000 and a value of $5,000,000. The building is destroyed by fire, and B uses insurance proceeds to buy a replacement building from S. S's gain or loss will not conform to B's basis in the building because B takes a substituted basis under the involuntary conversion rules of If the amount of S s gain or loss exceeds the effect of the intercompany sale on the building's basis, S s gain or loss will not be fully taken into account under the matching rule because there will not be a sufficient difference between the corresponding items B takes into account and its recomputed items. Consequently the acceleration rule applies at the time of the intercompany sale to take the excess amount into account. Unfortunately, S s gain or loss is accelerated because it is not possible to treat S and B as divisions of a single corporation, and acceleration is the only justifiable alternative. SIMPLIFICATION OF INVENTORY RULES Under the new regulations, the IRS has incorporated new simplification rules that treat inventory transactions like other intercompany transactions. As a result, the special and very complicated inventory adjustment rules of the prior regulations are no longer applicable for tax years beginning on or after July 12, However, the Service determined that a special rule is warranted for certain intercompany inventory transactions where applying the matching and acceleration rules would be extremely burdensome, such as dollar-value LIFO methods. Thus, if either S or B uses the dollar-value LIFO inventory method, the proposed regulations provide several inventory accounting options to take into account their items from intercompany inventory transactions. ANTI-AVOIDANCE RULES The Service realizes that the regulations cannot address every situation where adjustments may be required to achieve neutrality in the overall determination of consolidated taxable income. Accordingly, the new regulations contain anti-avoidance rules that allow the IRS the flexibility to make adjustments where a transaction is structured with the principal purpose of avoiding treatment under the new intercompany transactions regulations. 12 The scope of this rule is illustrated with several examples in the Regulations. 13 ELECTION TO REPORT CURRENTLY With the consent of the IRS, a group may elect not to defer gain or loss on all deferred intercompany transactions. In such a case, the gain or loss is recognized at the time of the transaction. Once approved, the election is binding to all future consolidated return years unless permission to revoke is given. 14 Such an election may be useful to eliminate laborious 11 Reg (c)(1) and Reg (h)(1). 13 Reg (h)(2). 14 Reg (e)(3).

7 Consolidated Tax Return Fundamentals -43- bookkeeping chores, especially for multiple intercompany transactions or transfers of long-lived assets. OTHER PROVISIONS AFFECTING DEFERRED INTERCOMPANY TRANSACTIONS For sales of assets that occur after 1983, special rules exist that may further defer a loss on the sale of those assets beyond the rules found in the consolidated return regulations. In general, the Tax Reform Act of 1984 and temporary regulations attempt to establish a relationship between Code 267(f) and the rules for controlled groups and consolidated tax returns. 15 If a member of an affiliated group ceases to be a member of that group but continues to be a member of a controlled group immediately after deconsolidation, temporary regulations under 267(f), in many instances, override the restoration rules previously discussed for deferred intercompany transactions. In addition, any election "not to defer" a loss is inapplicable and has no effect. 16 Example 27 P and its wholly owned subsidiary S join in the filing of a consolidated tax return for taxable year Year 3, in which P sells property to S for a loss. Due to the deferral requirements, the loss is eliminated in consolidation. On January 1, Year 4 all of the stock of S is transferred to P s sole shareholder. Although P and S are no longer affiliated corporations and must file separate tax returns, they remain members of a controlled group and restoration of the loss will not take place. INTERCOMPANY DISTRIBUTIONS Whether income is recognized on an intercompany distribution depends on the type of distribution that is made. As a general rule, a distribution paid out of earnings and profits (i.e., a dividend) is eliminated from gross income in the consolidated tax return. 17 Because the dividends are eliminated, no dividends-received deduction is available with respect to these dividends. 18 To the extent that a distribution is not a dividend (i.e., a return of capital under 301(c)(2) and (3)), the distributee reduces its basis in the stock of the subsidiary. Contrary to the case under the separate return rules, if the distribution exceeds basis, gain is not recognized. Instead, it is deferred in an account known as an excess loss account until the occurrence of some subsequent event such as the sale of a subsidiary's stock. The excess loss account is discussed in detail later. Example 28 P and its newly created subsidiary S file a consolidated tax return for Year 3. During the year, S distributes $12,000 cash to P. P s basis in its stock is $7,000 and S has current earnings and profits for its first year of $4,000. For Year 3 no gain is recognized. The first $4,000 is treated as a dividend and eliminated in consolidation. The next $7,000 reduces P s 15 Reg (f)-IT and 1.267(f)-2T. 16 Reg (f )-2T(c). 17 Reg (a). 18 Reg (b).

8 basis under 301(c)(2) to zero. The remaining $1,000 is not taxed as a capital gain but simply increases the excess loss account. If, as a result of a property distribution, the distributing corporation is required to recognize a gain or loss, the amount of the gain or loss is to be treated under the intercompany transaction rules The basis of the property to the distributee is the basis of the property in the hands of the distributing subsidiary increased by any gain recognized on the distribution.