The Intersection of Subchapter K and Consolidated Returns Part II

Transcription

1 The Intersection of Subchapter K and Consolidated Returns art II Affiliated & Related Corporations Committee American Bar Association Tax Section Lawrence Axelrod Internal Revenue Service Washington, DC Kevin Babitz Internal Revenue Service Washington, DC Rebeca Holtje KMG LL Washington, DC hilip Wright Bryan Cave LL St. Louis, MO Don Leatherman University of Tennessee Knoxville, TN Los Angeles, CA January 29, 2016

2 Overview Intercompany Transactions urpose. The purpose of is to provide rules to clearly reflect the taxable income (and tax liability) of the group as a whole by preventing intercompany transactions from creating, accelerating, avoiding, or deferring consolidated taxable income (or CTI). Single entity and separate entity treatment. The amount and location of S s intercompany items and B s corresponding items are determined on a separate entity basis, while the timing, character, source and other attributes are redetermined to produce the effect of a transaction between divisions of a single corporation (a)(1)-(2). 2

3 Definitions -- Intercompany Transactions An intercompany transaction is a transaction between corporations that are members of the same consolidated group immediately after the transaction. These transactions may include -- Sales of property erformance of services License or rental of property Loan of money Distributions with respect to stock In an intercompany transaction, S is the member transferring the property or providing the services and B is the member receiving the property of services. S s intercompany items are its income, gain, deduction, and loss from an intercompany transaction. B s corresponding items are its income, gain, deduction, and loss from an intercompany transaction or from property acquired in an intercompany transaction. The 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 (b)(1)-(4). 3

4 Definitions Intercompany Transactions (cont d) The attributes of an intercompany item and a corresponding item are all of the item s characteristics, except amount, location, and timing, necessary to determine the item s effect on taxable income (and tax liability). Examples: Character Source Treatment of an item as Excluded from gross income A noncapital, nondeductible amount Built-in gain or loss under 382 and (b)(6). 4

5 Matching rule in general Attributes. The separate entity attributes of S s intercompany items and B s corresponding items are redetermined to the extent necessary to produce the same effect on consolidated taxable income (and CTI) as if S and B were divisions of a single corporation and the intercompany transaction were a transaction between divisions. Timing B takes its corresponding item into account under its accounting method, but that timing may be affected by a redetermination of that item s attributes. S takes its intercompany item into account to reflect the difference for the year between B s corresponding item taken into account and the recomputed corresponding item (c)(1)-(2). 5

6 Example S Land Basis = $70 Sale of Land for $100 in Year 1 B roperty Basis = $100 Sale of Land for $110 in Year 3 The Year 1 sale is an intercompany transaction. S s intercompany item is its $30 gain on the sale. B s corresponding item is its $10 gain on the Year 3 sale. Assume that S and B each hold the land for investment. Thus, to produce the same effect on CTI as if S and B were divisions of a single corporation, the group s overall $40 gain must be long-term capital gain. Under the matching rule, S takes no gain into account in Years 1 and 2 but takes its entire $30 gain into account in Year 3, equal to the difference between B s corresponding item (B s recognized $10 gain on the Year 3 sale) and its recomputed corresponding item ($40, or B s gain if S and B had been divisions). See (c)(7), Ex. 1. X 6

7 Acceleration Rule S s Treatment S s intercompany items are taken into account immediately before it first becomes impossible to achieve the effect of treating S and B as divisions of a single corporation (e.g., if S or B becomes a nonmember or to the extent a nonmember reflects any aspect of the intercompany transaction). Thus, in the example above, S would take its deferred $30 gain into account if B contributed the land to a partnership, even if all partnership interests are owned by group members. The attributes of S s intercompany item are determined as follows: If the item is from an intercompany sale, exchange, or distribution, the principles of the matching rule apply and If the property is owned by a nonmember immediately after the intercompany item is taken into account, B is treated as selling the property to that nonmember; or If the property is not then owned by a nonmember, B is treated as selling the property to an affiliated corporation that is not a member. Otherwise, S s attributes are determined on a separate entity basis (d)(1) 7

8 Acceleration Rule B s Treatment The attributes of B s corresponding items are determined under the principles of the matching rule with the following adjustments: If S and B continue to join with others in filing consolidated returns, the attributes are determined by continuing to treat S and B as divisions of a single corporation. Once S and B no longer are members of the same consolidated group, those attributes are determined as if the S division were transferred by the single corporation to an unrelated person. B continues to take its corresponding items into account under its accounting method. Note that that timing may be affected by the attribute redetermination described above (d)(2). 8

9 Anti-avoidance Rule If a transaction is engaged in or structured with a (not the) principal purpose of avoiding the purposes of (including treatment as an intercompany transaction), adjustments must be made to carry out the purposes of that section (i.e., to clearly reflect the taxable income (and tax liability) of the group as a whole by preventing intercompany transactions from creating, accelerating, avoiding, or deferring consolidated taxable income (or CTI)) (h)(1). 9

10 artnership anti-abuse rules The provisions of subchapter K and the applicable regulations must be applied in a manner that is consistent with the intent of that subchapter, including to clearly reflect the partners economic agreement and the partner s income (b). Thus, if a partnership is formed or availed of in connection with a transaction with a principal purpose to reduce substantially the partners present value federal income tax liability in a manner inconsistent with subchapter K, the Commissioner may appropriately recast the transaction. The Commissioner may treat a partnership as an aggregate of its partners in whole or in part as appropriate to carry out the purposes of the Code or regulations (e). 10

11 (h) Anti-Avoidance Rules - Sale of artnership Interest Basis: $10 Value: $100 S Land Step 1 10% interest Land Step 2 $100 10% interest Land B NOLs subject to limitation under - 21(c). Step 4 B sells the partnership interest to a nonmember for $100 Step 3 Sale of land to X for $ (h)(2), Ex. 1. S owns raw land with a $10 basis and $100 value. B has NOLs from SRLYs subject to limitation under Treas. Reg (c). ursuant to a plan to absorb the losses without limitation by the SRLY rules: 1. S transfers the land to an unrelated, calendar year partnership in a 721 exchange for a 10% interest in the partnership. The partnership does not have a 754 election in effect. 2. S sells the interest to B for $

12 (h) Anti-Avoidance Rules - Sale of artnership Interest (cont.) Basis: $10 Value: $100 S Land Step 1 10% interest Land Step 2 $100 10% interest Land B NOLs subject to limitation under - 21(c). Step 4 B sells the partnership interest to a nonmember for $100 Step 3 Sale of land to X for $ In the following year, the partnership sells the land to X for $100. Because the partnership does not have a 754 election, its $10 basis in the land does not reflect B s $100 basis in the partnership interest. Under 704(c), the partnership s $90 BIG is allocated to B, and B s basis in the partnership interest increases to $190 under In a later year, B sells the interest to a nonmember for $100. Under (c), the partnership s $90 BIG allocated to B ordinarily increases the amount of B s SRLY limitation, and B s $90 loss from its sale of the interest ordinarily is not subject to limitation under SRLY. Conclusion: Because the contribution to the partnership and the sale of the interest were part of a plan, a principal purpose of which was to achieve a reduction in CTL by creating offsetting gain and loss for B while deferring S s gain, B s allocable share of the partnership s gain from its sale of the land is treated under (h)(1) as not increasing B s SRLY limitation. 12

13 (h) Anti-Avoidance Rules Sale of artnership Interest (cont.) Observations Would apply here? See (d), Ex. 8 (absence of section 754 election considered evidence of abuse where partnership formed with a non-business principal purpose) But see (d), Ex. 9 (citing electivity of section 754 for a business-motivated partnership) Internal restructurings to avoid impact of SRLY limitation? Lack of broad SRLY anti-abuse, except regarding SRLY subgroups ( (c)(2)(iv)). Section (h)(2), Ex. 5 (sale-leaseback with non-member to increase SRLY limit not recharacterized or subject to adjustment). Section 351 stuff of BIG asset. Cf (e)(2), Ex. 2 (providing for a allocation of all BIG in a contributed asset to the contributing member when a principal purpose of the contribution was to shift a portion of the basis increase to another member). Would it make a difference in the regulatory example if B had historically owned the partnership interest and made no contribution to the partnership? The plan to sell the asset arose sometime after the contribution? S also had a SRLY loss? 13

14 (h) Anti-Avoidance Rules- artnership Mixing Bowl MI M2 Basis: $0 Value: $100 Intangible Intangible Land Land Value: $100 Basis: $100 Cash X RS Intangible Land (h)(2), Ex. 4. M1 owns a self-created, intangible asset with a $0 basis and a $100 value. M2 owns raw land with a $100 basis and $100 value. In Year 1, with a principal purpose of creating basis in the intangible asset (which would be eligible for amortization under 197), M1 and M2 form RS; M1 contributes the intangible asset and M2 contributes the land. X, an unrelated person, contributes cash to RS in exchange for a partnership interest. RS uses the contributed assets in legitimate business activities. 14

15 (h) Anti-Avoidance Rules - artnership Mixing Bowl (cont.) MI M2 Land Intangible X Cash /S Intangible Land After 7 ½ years, RS liquidates, distributing the land to M1, the intangible to M2, and the cash to X. The group reports no gain under 707(a)(2)(B) or 737(a) and claims that M2 s basis in the intangible is $100 under 732 and that the asset is eligible for amortization under 197. Conclusion: A principal purpose of the formation and liquidation of RS was to create additional amortization without an offsetting increase in CTI by avoiding treatment as an intercompany transaction. Thus, appropriate adjustments must be made. 15

16 Treas. Reg (h) Anti-Avoidance Rules - artnership Mixing Bowl (cont.) Observations Where is the intercompany transaction? Does it make a difference what the nature of the nonmember s partnership interest is? Would the result change if the intangible was distributed to M1 as a result of back-end planning? Benefit obtained by virtue of Subchapter K, rather than the consolidated return regulations; Sections 704(c)(1)(B) and 737 designed to address transactions that are in substance between partners since amended to 7 years Should the transaction be tested under rather than (h)? Business motivation insufficient to prevent application of -13(h) anti-avoidance rule; Example does not specify what appropriate adjustments must be made (or which party they would affect). What are those adjustments? Note that the example appears to respect the existence of the partnership. What consolidated principle or principles explain the two partnership examples? 16

17 (f) Anti-Abuse Rule MI M2 Cash 49.5% 49.5% Land Land Value: $10,000 Basis: $1,000 Cash X 1% RS (f), Ex. 2. In Year 1, M1, M2, and X from partnership RS, with M1 contributing $10,000 cash for a 49.5% interest, M2 contributing land with a $1,000 basis and $10,000 value for a 49.5% interest, and X contributing cash for a 1% interest. M1 and M2 are s wholly owned subsidiaries and control the management of the land because of their controlling partnership interests. The partnership is formed with a principal purpose to minimize the time that M2 would have to remain a partner with a potential purchaser of the land. In Year 5, Y acquires a RS interest for $10,000. In Year 8, the land is distributed to Y in complete liquidation of its interest. 17

18 (f) Anti-Abuse Rule MI M2 Cash 49.5% 49.5% Land Land Value: $10,000 Basis: $1,000 Cash X 1% RS Section (f)(1) states that 704(c)(1)(B) and must be applied in a manner consistent with the purpose of 704(c)(1)(B). Under 704(c)(1)(B), if property contributed by a partner is distributed to a non-contributing partner within 7 years of the contribution, the contributing partner generally must recognize the gain or loss that would have been specially allocated to that partner under 704(c)(1)(A) if the partnership had sold that property for its fair market value. The example concludes that the running of the 7-year period under 704(c)(1)(B) is inconsistent with the purposes of that provision, because X s interest does not provide a sufficient pooling of interest. Allowing the 7-year period to continue to run would have the effect of substantially nullifying the [7]-year requirement... and elevating form over substance. As a result, the 7-year period is tolled until Y is admitted as a partner. 18

19 Questions What interest for X in RS would be sufficient to provide a pooling of interest and prevent a tolling of the 7-year period? 5%? 10%? 21%? 40%? Would the result change if either M1 or M2 had significant minority shareholders? Suppose that RS was not formed with a principal purpose to minimize the time that M2 was a partner with any potential buyer of the land? Would the antiabuse rule still apply? Is the result at all affected by whether M1 and M2 are members of the same consolidated group? Suppose that RS was owned solely by consolidated group members and M2 contributed the land with a principal purpose that it be distributed to another member. Would the 7-year period be tolled so that 704(c)(1)(B) would apply to the distribution of the land to the group member whenever it occurred? 19

20 Section 165(g)(3) A domestic corporation s worthless stock deduction for subsidiary stock is ordinary if The domestic corporation directly owns subsidiary stock meeting the requirements of 1504(a)(2); and More than 90% of the subsidiary s gross receipts for all taxable years are from non-passive sources. Look-through approach A subsidiary s dividend from a lower-tier member is treated as arising from passive sources to the extent attributable to the lower-tier member s gross receipts from passive sources. See.L.R (Mar. 9, 2007). A dividend is attributed pro rata to the gross receipts that gave rise to the e&p from which the dividend was distributed. The subsidiary s gross receipts from an intercompany transaction are treated as arising from passive income to the extent attributable to the counterparty s gross receipts from passive income. The counterparty must also determine the character of its gross receipts using the approach. Thus, each counterparty in a chain of intercompany transactions must apply that approach until the ultimate counterparty is reached. See.L.R (Dec. 9, 2011). 20

21 .L.R S FC a% F and S were members of a consolidated group. S owned an interest in the FC stock meeting the requirements of 1504(a)(2) and that stock was worthless. FC satisfied the gross receipts test under 165(g)(3)(B) only if took into account its distributive share of partnership F s gross receipts. Conclusion: FC took that distributive share into account. Under 702(a) and (a)(8)(ii), a partner must separately take into account its distributive share of any partnership item that, if separately taken into account by any partner would change that partner s tax liability. See also Rev. Rul , C.B. 318 (when an S corporation was a partner in a partnership, it determined its gross receipts from passive income under the predecessor to 1362(d)(3)(i)(II) by taking into account its distributive share of the partnership s gross receipts). 21

22 Questions How is the distributive share of partnership gross receipts determined if the partnership has special allocations? If a corporation has taken its distributive share of partnership gross receipts into account How does it treat an actual distribution? Does it matter if the distribution is debt-financed? If the corporation is a member of a consolidated group and, for example, sells property to a partnership in which it is a partner Will that sale be treated like an intercompany transaction? Does the answer to the preceding question depend on whether a non-member owns any interest in the partnership? If the corporate partner sells its partnership interest, how much of the sales proceeds will be treated as gross receipts from passive sources? ossible approaches: Aggregate approaches Broad approach -- as if the partnership sold all of its asset; or Treat the partnership as selling its assets only to the extent 751 applies. Entity approaches Do not treat the partnership interest as a security, so that none of the gross receipts are treated as passive; or Treat the partnership interest as a security so that passive receipts equal recognized gain. 22

23 Granite Trust planning within a Consolidated Group using artnership S 1 S 2 S 1 S 2 x% LLC y% LLC S 3 S 3 LLC, S1, S2, and S3 are members of the same consolidated group. S2 s basis in S3 stock > fmv of S3 stock LLC conducts business operations Step 1: S2 transfers S3 to LLC in exchange for a y% interest in LLC Step 2: S3 converts to an LLC and becomes a DRE Section 331; Granite Trust. Consider Application of ? Application of (h)? What if LLC was newly formed by S1 and S2? See 7701(o). What if S2 sold a 21% LLC interest to a non-member before S3 converted? 23

24 (g) anti-abuse rule S Asset 1 $1,000 basis a% RS and S are members of a consolidated group (g)(2), Ex. 2. owns 5 shares of S stock with a $200 basis and S owns one asset with a $1,000 basis. In year 1, with a view to preventing the current reduction in Asset 1 s basis, S contributes Asset 1 to partnership RS. sells one share of S stock to a non-member for $20. Assume that neither the basis-reduction nor basis-redetermination rule applies. Thus, S recognizes a $180 loss on its sale of the S share. Also assume that if S had not contributed Asset 1 to RS, S would have been required to reduce its basis in Asset 1 by $180. The example concludes that the anti-abuse rule under (g)(1) applies. That rule provides that if a taxpayer acts with a view to avoid the purposes of or to avoid the purposes of any other rule of law, appropriate adjustments will be made to carry out those purposes. 24

25 (g) anti-abuse rule (cont d) S Asset 1 $1,000 basis a% RS and S are members of a consolidated group Because S acted with a view to avoid attribute reduction under (d), that provision is applied by treating S as if it held Asset 1 at the time of the stock sale. Thus, Asset 1 s basis is reduced to $820 and presumably S s basis in RS is also $820. Questions What does it mean for S to act with a view to avoid attribute reduction? Can a strong non-tax business purpose for the partnership contribution preclude such a view? Would the result change if sold enough S stock for S to leave the group? Suppose instead that S had historically owned the RS interest with a $1,000 basis and RS had conforming inside and outside basis. Could the anti-abuse rule apply? If it cannot, what justifies the reduction of both inside and outside basis in the example? Stated differently, isn t the problem illustrated in the example primarily a partnership problem? Suppose instead that S contributed cash to RS to avoid a basis reduction of inventory assets? Would the anti-abuse rule apply and what would the appropriate adjustments be? 25

26 basis reduction S Asset 1 $1,000 basis a% RS and S are members of a consolidated group S s liabilities exceed the value of its assets and S enters bankruptcy. With a view to preventing the current reduction in Asset 1 s basis, S contributes Asset 1 to partnership RS. A portion of S s debts are discharged in bankruptcy. Assume if S had not contributed Asset 1 to RS, S would have been required to reduce its basis in Asset 1 by $400 under (a)(2)(i). Section has no anti-abuse rule. Could the partnership anti-abuse rule apply in this case? 26

27 T.D Final Regulations Final Regulations Largely consistent with the proposed regulations issued in 2012 New provisions ermits the Commissioner to replace an agent that fails to perform its obligations and to designate a new agent ermits agents to resign and designate a replacement agent Clarifies that an agent other than the common parent generally serves as agent under the same terms and with the same rights as the common parent Clarifies that a terminating agent without a default successor may only designate an agent with respect to a completed year Changes the default rules applicable to consolidated group members that have an interest in a TEFRA partnership 27

28 T.D Final Regulations The 2002 Regulations (current B) Specifically reserves to the subsidiary that is the TM of a TEFRA partnership the authority to take actions for such partnership ( B(a)(3)(v)). Generally provides that the Service will deal directly with a subsidiary that is a partner in a TEFRA partnership in the subsidiary's capacity as a partner in such partnership. But the common parent may request the IRS to deal directly with it as agent. The 2015 Regulations (T.D. 9715) Specifically reserves to the subsidiary that is the TM of a TEFRA partnership the authority to take actions for such partnership ( (f)(2)(iii)(B)). Generally provides that the agent (common parent) will act as agent for a subsidiary that is a partner in a TEFRA partnership but the IRS may interact directly with subsidiary, agent, or TM without breaking agency. Effective Dates The new regulations apply to consolidated return years beginning on or after April 1, Old , now B, applies to consolidated return years beginning on or after June 28, 2002 but before April 1,

29 T.D (g), Ex. 14 & rop (g), Ex. 12 (withdrawn) 11/30 fiscal year A consents to extend period of assessment for RS for tax year ending 12/31/Year 1 Extends SoL for RS items that are part of 's consolidated return for year ending 11/30/Year 2 S S1 RS TM A IRS *may* contact directly, S1 or A regarding RS However, if the IRS seeks to execute a settlement agreement with respect to S1 as a partner with respect to its liability as a partner in RS, would need to execute it calendar year 29

30 Intercompany Transfer of a artnership Interest LR (May 13, 2003) S LLC interest $ B LLC S sells its LLC interest to B, causing the LLC become a DRE. See Rev. Rul Situation 1. "Under Rev. Rul. 99-6," S is deemed to sell its LLC interest under 741, while B is deemed to purchase S's share of the LLC assets from S. Is S gain deferred under ? LR holds: Ruling (7): "The income, gain, and/or loss from the sale of [S's] partnership interest (the intercompany item) can be accounted for under the matching rule. [B's] corresponding items will be [B's] items with respect to the assets that [B] is described as acquiring [under Rev. Rul. 99-6]. Ruling (8): "[B's] recomputed corresponding items will be based on the bases that [S] would have had in the assets had those assets been received in a liquidating distribution" 30

31 Intercompany Transfer of a artnership Interest LR (Sept. 27, 2006) S1 S2 B LLC S1 and S2 sell their LLC interests to B, causing the LLC become a DRE. See Rev. Rul Situation 2. Similar language, rulings, and result as LR

32 Intercompany Distribution of a artnership Interest LR (Apr. 7, 2015) S 1 S 2 DIT % S2 distributes its LLC interest to S1, causing the LLC become a DRE. "Under the principles of Rev. Rul. 99-6," S2's 311(b) gain from the distribution of its LLC interest is determined under 741, while S1 is deemed to acquire S2's share of the LLC assets from S2 via distribution of such assets. Otherwise, similar language, rulings, and result as prior LRs The DIT is "not taken into account as income or gain under the acceleration rule of (d)." % LLC 32

33 Allocation of debt S3 1% 100% S 1 100% S 2 99% Guarantee Bank 1% 99% $10M loan LLC Bank loans $10 million to LLC (treated as a partnership) and S3 guarantees the loan. LLC buys $10 million of computers, which it leases to group members. All partnership allocations are 99% to S2 and 1% to S1 except that 99% of the depreciation deductions on the computers are allocated to S1 and 99% of any recaptured depreciation deductions on the computers are allocated to S1. Because S3 guarantees the loan, the loan is treated as a recourse liability and S1 s share of that liability under 752 is 100%. See (a)(1); (b)(2)(i) (providing that when a person is related to more than one partner, the person is treated as being related to the partner with the highest percentage of related ownership). The LLC income allocated to S2 is offset by S2 s SRLY loss. Questions Will the allocations have substantial economic effect? Cf (b)(5), Ex 1(xi). Will the guarantee by be disregarded under the anti-abuse rule of (j)(1) (disregarding an obligation where a principal purpose of the arrangement is to create the appearance of the related person bearing the economic risk of loss when the substance is otherwise). Will the partnership anti-abuse rule apply? Will the anti-abuse rule under (h) apply? Do the answers to any of these questions change if LLC is a newly formed entity? 33