American Bar Association

1

Important Developments

• American Bar Association
• Committee on Affiliated Related Corporations
• Washington, D.C.
• May 7, 2004

Derek E. Cain Chief Counsel - IRS Theresa
Abell Chief Counsel - IRS Michael N.
Kaibni Ernst Young LLP
Jeffrey Paravano Baker Hostetler,
LLP Stephanie Robinson U.S. Treasury
Department Don Leatherman University of
Tennessee College of Law
2
Summary

• Proposed Legislation
• 2003-2004 Priority Guidance Plan
• Section 1504 Value Fluctuations
• Final 1.1502-31, Stock Basis After a Group
  Structure Change
• Consolidated worthless stock deduction rules
• Administration of 1.337(d)-2T
• Other Matters
• Consolidated 108(b)

3
HR 2896 THE AMERICAN JOBS CREATION ACT OF 2003

• AFFIRMATION OF CONSOLIDATED RETURN REGULATION
  AUTHORITY.
• (a) IN GENERAL. -- Section 1502 is amended by
  adding at the end of the following new sentence
  In carrying out the preceding sentence, the
  Secretary may prescribe rules that are different
  from the provisions of chapter 1 that would apply
  if such corporations filed separate returns.
• (b) RESULT NOT OVERTURNED. -- Notwithstanding the
  amendment made by subsection (a), the Internal
  Revenue Code of 1986 shall be construed by
  treating Treasury Regulation section
  1.1502-20(c)(1)(iii) (as in effect on January 1,
  2001) as being inapplicable to the factual
  situation in Rite Aid Corporation and Subsidiary
  Corporations v. United States, 255 F.3d 1357
  (Fed. Cir. 2001).
• (c) EFFECTIVE DATE. -- This section, and the
  amendment made by this section, shall apply to
  taxable years beginning before, on, or after the
  date of the enactment of this Act.

4
WORKING TAXPAYER FAIRNESS RESTORATION ACT(June
4, 2003)

• (2) LIMITATION ON TRANSFER OF BUILT-IN LOSSES IN
  SECTION 351 TRANSACTIONS.
• (A) IN GENERAL. -- If --
• (i) property is transferred by a transferor in
  any transaction which is described in subsection
  (a) and which is not described in paragraph (1)
  of this subsection, and
• (ii) the transferees aggregate adjusted bases
  of such property so transferred would (but for
  this paragraph) exceed the fair market value of
  such property immediately after such transaction,
  then, notwithstanding subsection (a), the
  transferees aggregate adjusted bases of the
  property so transferred shall not exceed the fair
  market value of such property immediately after
  such transaction.
• (B) ALLOCATION OF BASIS REDUCTION. -- The
  aggregate reduction in basis by reason of
  subparagraph (A) shall be allocated among the
  property so transferred in proportion to their
  respective built-in losses immediately before the
  transaction.
• . . . .
• EXCEPTION FOR TRANSFERS WITHIN AFFILIATED GROUP.
  -- Subparagraph (A) shall not apply to any
  transaction if the transferor owns stock in the
  transferee meeting the requirements of section
  1504(a)(2). In the case of property to which
  subparagraph (A) does not apply by reason of the
  preceding sentence, the transferors basis in the
  stock received for such property shall not exceed
  its fair market value immediately after the
  transfer.
• (c) EFFECTIVE DATE. -- The amendments made by
  this section shall apply to transactions after
  February 13, 2003.

5
Other Legislative Developments

• Partnership Contributions
• (SEE COPIES AT BACK OF PACKET)

6
2003-2004 Priority Guidance Plan guidance under
1502 regarding

• Transactions involving obligations of
  consolidated group members.
• Rate or discount subsidy payments.
• Treatment of member stock.
• Section 1504(a)(5) guidance regarding fluctuation
  in value.

7
Section 1504 Value Fluctuations

• 1504(a)(2)
• Affiliation requires 80 of total voting power
  80 of total value.
• Value Fluctuations Terminating Group

CP
Unrelated
Voting Preferred
Common Stock
S
S issues voting preferred to Unrelated for 15 at
a time when CPs common in S is worth 85.
Subsequently, the value of the common stock drops
to 50. Does S remain a member of the CP
consolidated group?
8
Section 1504 Value Fluctuations

• 1504(a)(5) Granting authority to issue
  regulations which,
• (a)(5)(C) provide that the requirements of
  paragraph (2)(B) 80 value requirement shall be
  treated as met if the affiliated group, in
  reliance on a good faith determination of value,
  treated such requirements as met,
• (a)(5)(D) disregard an inadvertent ceasing to
  meet the requirements of paragraph (2)(B) by
  reason of changes in relative values of different
  classes of stock,

9
Section 1504 Value Fluctuations

• 1504(a)(5)(C) Good Faith
• How to establish good faith? Duty to appraise,
  if so, how often?
• Presumption that standard cant be satisfied if
  values exceed a certain threshold (e.g., common
  worth 10)?
• Requirement to cure? What standards?
• 1504(a)(5)(D) Inadvertent
• What is inadvertent?
• Presumption that standard cant be satisfied if
  values exceed certain threshold?
• Culpability?
• Requirement to cure? What standards?
• Other issues
• To what extent is value fluctuation disregarded
  loss sharing, investment adjustments, ELAs?
• Similar treatment for prior and post periods?
• What if both apply, trump rule?

10
1.1502-31

• Background
• 1.1502-31 applies to determine a groups basis
  in stock where one corporation succeeds another
  corporation as the common parent in a group
  structure change (See 1.1502-75(d)(2)(3)).
• Generally, basis in the former common parents
  stock is determined with reference to its net
  inside basis (See 1.1502-31(b)(1)(2)).
• Preexisting basis in stock owned prior to a
  reverse acquisition was disregarded under
  former regulations (example next slide).
• Final 1.1502-31 excepts cost basis stock from
  the general rule.

11
Example 1, Former 1.1502-31
P Shareholders
P Shareholders
T Shareholders
368(a)(1)(B)
gt 50
P
lt 50
P
P stock
T Shareholders

• 10
• Higher tier adjustment, -31(d)(4)

100 basis
110 Basis
S
S
T stock
90 50 aggregate basis
10 50 basis old cold
Net inside basis
60 basis
T
60 asset basis 100 FMV
T
Results same w/o regard as to whether Ss old
cold is cost. Results the same if acquisition
of T stock is taxable.
T Subs
T Subs
12
Final 1.1502-31

• Final 1.1502-31(b)(2)
• If a corporation acquires stock of the former
  common parent a group structure change, the basis
  of the members in the former common parents
  stock immediately after the group structure
  change (including any stock of the former common
  parent owned before the group structure change)
  that is, or would otherwise be, transferred basis
  property is redetermined
• Final regs. adopt the proposed regulations
  without substantive changes.

13
Example 2, Final 1.1502-31
P Shareholders
P Shareholders
T Shareholders
368(a)(1)(B)
gt 50
P
lt 50
P
P stock
T Shareholders

• 54
• Higher tier adjustment, -31(d)(4)

100 basis
154 basis
S
S
T stock
90 50 aggregate basis
10 50 cost basis old cold
50 basis in old 10 block
54 basis in new 90 block
T
60 asset basis 100 FMV
T
If the acquisition is taxable, S retains is 50
basis in its 10 old cold T stock, and takes a
90 basis in its newly acquired T stock (140
total basis).
14
Example 3, Final 1.1502-31
P Shareholders
P Shareholders
T Shareholders
gt 50
P
lt 50
P
T Shareholders
?
100 basis
S
S
T
60 asset basis 500 FMV
?
60 basis
T

• P purchases 20 of the stock of T for 100.
• P later contributes its T stock to S in an
  unrelated 351 exchange.
• Finally, S acquires the remaining T stock in an
  unrelated triangular B.

15
Consolidated Worthless Stock Deduction Rules

• Revised
• Temp. Reg. 1.1502-35T(f)
• and
• Temp. Reg. 1.1502-80T(c)

16
Temp. Reg. 1.1502-35T(f)Worthlessness and
Certain Dispositions

• Losses attributable to a subsidiary (S) under
  the principles of 1.1502-21T(b)(2)(iv) may be
  treated as expired if either
• A group member treats S stock as worthless under
  165 and 1.1502-80(c) and on the first day of
  the groups next year, S (or its successor) is a
  group member or
• A group member recognizes a loss on S stock and
  on the following day S is not a group member and
  does not have a separate return year.
• Those losses expire as of the beginning of the
  groups consolidated return year that follows the
  year in which the stock loss or worthless stock
  deduction was claimed.
• The losses that are treated as expired will not
  result in a noncapital, nondeductible expense
  under Reg. 1.1502-32(b)(3)(iii).

17
Temp. Reg. 1.1502-35T(f)Dissolution Basic
Example
P
P
70 assets
50
50
100 Bank
S
S
Bank
(dissolution)

• P forms S by contributing 50 and S borrows an
  additional 100 from Bank.
• S loses 80 (not utilized by the group) (i.e.,
  80 NOL).
• S dissolves and transfers its assets (with a 70
  basis and value) to Bank.
• Because S has dissolved, P may claim a 50
  worthless stock deduction on its S stock.
• Ss 80 NOL disappears.

18
Temp. Reg. 1.1502-35T(f)Two-step dissolution
P
P
69.30 assets
50
50
Bank 1
99 Bank 1
S
S
70 assets
1 Bank 2
Bank 2
(dissolution)

• P forms S by contributing 50 and S borrows an
  additional 99 from Bank 1 and 1 from Bank 2. S
  loses 80 (not utilized by the group) (i.e., 80
  NOL).
• S transfers an asset (with a 69.30 basis and
  value) to Bank 1. Later but during the same
  year, S dissolves, transferring its remaining
  asset (with a 70 basis and value) to Bank 2.
• Following the first transfer, P may claim a 50
  worthless stock deduction on its S stock, because
  S has transferred substantially all of its
  assets.
• Can the P group continue to use Ss 80 NOL after
  the dissolution?

19
Temp. Reg. 1.1502-80T(c)

• Stock of a member is not treated as worthless
  under section 165 before the stock is treated as
  disposed of under the principles of
  1.1502-19(c)(1)(iii). If stock of a member would
  otherwise be treated as worthless under the
  principles of section 165, then, notwithstanding
  the preceding sentence, such stock may be treated
  as worthless under section 165 immediately prior
  to the time such member ceases to be a member of
  the group

20
Temp. Reg. 1.1502-35T(f)Worthless Stock
Deduction Allowed
P
P
S stock
50
50
100
S
S
Bank
Bank

• P forms S by contributing 50 and S borrows an
  additional 100 from Bank. S loses 80 (not
  utilized by the group) (i.e., 80 NOL).
• Instead of S transferring its asset to Bank, P
  transfers the S stock to Bank and Bank cancels
  the 100 loan.
• Under the Temp. Reg. 1.1502-80T(c), P may claim
  a W/L stock deduction when S ceases to be a
  member.

21
Temp. Reg. 1.1502-35T(f)Worthless Stock
Deduction Deferred
P
50
(business cessation)
100
S
Bank
Asset FMV 70

• The basic facts are the same, except that no
  assets are transferred to Bank and S merely
  ceases business.
• Ss liabilities exceed the FMV of its assets
  (i.e., 100 loan gt 70 of assets), and there is
  no possibility of rehabilitation. P would be
  precluded from claiming a 50 worthless stock
  deduction because S has not yet disposed of
  substantially all of its assets.
• Is there still a consolidated return rationale
  for deferral?

22
Temp. Reg. 1.1502-35T(f)Worthlessness Absent
Dissolution or Disposition

• Temp. Reg. 1.150280T(c) generally defers a
  worthless stock deduction until a deemed
  disposition under Reg. 1.150219(c)(1)(iii),
  which requires, in part, that the subsidiary
  dispose of substantially all of its assets.
• If the subsidiary is dormant and otherwise
  worthless but has not disposed of substantially
  all of its assets, the deduction is deferred.
• Reg. 1.1502-80(c) was promulgated in part to
  prevent the duplicated loss rule of Reg.
  1.1502-20(c)(2)(vi) from effectively eliminating
  the benefit to the group of a subsidiary loss.
• With the elimination of that duplicated-loss
  rule, is continued deferral of a worthless stock
  deduction justified?
• Does section 382(g)(4)(D) protect the government
  from a potential double deduction?
• Is self-help available under Rev. Rul. 2003-125?
• If the rule for the worthless stock deduction is
  expanded, should the trigger for an ELA be
  correspondingly expanded?

23
Temp. Reg. 1.1502-35T(f)Duplicate Loss Allowed?
P

• P, the common parent of a consolidated group,
  owns all S common stock with a 100 basis and all
  S preferred stock with a 50 basis and 50
  liquidation preference.
• S owns one asset with a 150 basis and 10 value.
• S liquidates, distributing the asset to P.

S

• Under Spaulding Bakeries, the liquidation cannot
  be described under 332.
• Thus, under 336(a), S recognizes a 140 loss,
  under 331, P recognizes a 40 loss on its
  preferred stock, and under 165 and
  1.1502-80T(c), P has a 100 worthless stock
  deduction on its common stock.
• How are those amounts taken into account if
• P has other subsidiaries?
• P has no other subsidiaries so that the P group
  terminates on the liquidation?

24
Amendment to Temp. Reg. 1.337(d)-2T(c)

• Under Reg. 1.337(d)-2T(c)(2), subsidiary stock
  loss is not disallowed to the extent the group
  establishes that the loss is not attributable to
  the recognition of built-in gain.
• Under that provision, as amended, the group makes
  that determination by reducing built-in gain by
  expenses directly related to the recognition of
  that gain.
• The amendment also states that Federal income
  taxes may be directly related to built-in gain
  on the disposition of an asset only to the extent
  of the excess (if any) of --
• The groups tax liability actually imposed for
  the disposition year, over
• The groups tax liability redetermined by
  excluding the built-in gain recognized on the
  disposition of the asset.

25
Amendment to Temp. Reg. 1.337(d)-2T(c)
P
4
130
97.50
1
(100)
S
3
T
2
100
A1100 0
A2 100 0
FMVA/B

• P purchases T for 130. T holds 2 assets (FMV
  100, A/B 0, each).
• P sells Asset 1 and recognizes 100 of taxable
  income. For that year, S incurs a 100 loss
  and, pursuant to the groups tax sharing
  agreement, T pays S 35. Ps basis in T becomes
  195.
• The value of Asset 2 declines to 50 and P sells
  T for 97.50.
• Prior to the amendment, only 65 of Ps loss
  would have been disallowed. How much of Ps
  97.50 loss is disallowed after the amendment?

26
Administration of 1.337(d)-2T
27

• The purpose of 1.1502-32
• (the investment adjustment system)
• To treat P and S as a single entity so
  consolidated taxable income reflects the groups
  income
• To prevent Ss items of income, gain, deduction,
  and loss from being taken into account on a
  disposition of S stock to the extent they have
  already been taken into account by the group
  (i.e., to shelter such items from further
  recognition)

28
1.1502-32 basic example
P
P
AB 100 FMV 100
AB 110 FMV 110
Sale of S for 110
S
S
100
110
P forms S with 100 cash. S earns 10 and the P
Group reports the income. Under 1.1502-32, Ps
basis in S is increased by 10 (to 110). P sells
S for 110, no gain or loss on the stock sale. ?
The 1.1502-32 adjustment shelters the 10 of
earnings so that the group is not taxed on that
gain again when it disposes of the S stock.
29
The General Utilities Doctrine

• Permitted appreciated assets to be removed from
  corporate solution with a stepped-up basis and no
  imposition of corporate level tax.
• Final remnants repealed in 1986.
• I.R.C. 337(d) Secretary shall promulgate
  regulations to prevent circumvention of GU Repeal
  through the consolidated return regulations.

30
Eliminating corporate level tax classic Son of
Mirrors
P
P
Sale of S for 100, P recognizes 50 loss
AB 100 FMV 100
AB 150 FMV 100
S
Sale of A1 for 100
S
A1 AB 50 FMV 100
Cash 100
? To the extent of disconformity between Ps
basis in S and Ss basis in A1, the gain on A1
was already sheltered by Ps basis in S before
the 1.1502-32 adjustment the adjustment
therefore created a noneconomic stock loss that
offset the gain on A1effectively eliminating the
corporate level tax on A1s appreciationand
circumventing GU Repeal OBSERVATION If the 50
taken into account was not attributable to the
disposition or consumption of gain reflected in
basis, i.e., if it were a genuine accretion to
wealth, no stock loss would result (because the
stock would be worth 150).
31

• Disallowance to the extent of adjustments from
  built-in gain evolution of the concept
• Notice 87-14
• Built-in gain asset An asset that at the time
  of acquisition of target stock has a value in
  excess of its adjusted basis.
• 1.337(d)-1
• Built-in gain of a transitional subsidiary means
  gain attributable, directly or indirectly, in
  whole or in part, to any excess of value over
  basis, determined immediately before the
  transitional subsidiary became a subsidiary, with
  respect to any asset owned directly or indirectly
  by the transitional subsidiary at that time.

32

• 1.337(d)-2T
• Subsidiary stock loss is disallowed, and
  subsidiary stock basis is reduced to, but not
  below, FMV
• except to the extent a taxpayer can establish
  that the loss (or any excess of stock basis over
  value on a deconsolidation) is not attributable
  to the recognition of built-in gain on the
  disposition of an asset.
• Query is (should) there be a nexus between
• (1) specific appreciation, and
• (2) specific items of recognized gain?

33
Limitations of a nexus approach to preventing
circumvention of GU RepealTechnical

• Extent of disconformity
• is affected by
• 351 exchanges
• 355 distributions
• 368 reorganizations
• Acquisitions of lower tier entities
• Subsequent acquisitions of subsidiary stock
• Etc.

• Extent of sheltering is not affected by
• Fluctuations in asset value
• Appreciation in substitute asset
• Characterization of items as income or gain
• Etc.

Administrative Tracing, i.e., valuation of assets
and tracking recognized items to built-in
gain, presents complex and substantial
administrative issues
34

• 1.337(d)-2T(c)(2)
• Gain is built-in gain to the extent
• attributable,
• directly or indirectly, in whole or in part,
• to any excess of value over basis
• that is reflected,
• before the disposition of the asset,
• in the basis of the share,
• directly or indirectly, in whole or in part

35

• Reflected in the basis of the share
• GU Repeal can be circumvented whenever stock
  basis is increased for amounts already adequately
  represented in, accounted for, or sheltered by
  stock basisirrespective of when and how stock
  basis became able to shelter that gain
• Gain will be considered reflected in stock
  basis within the meaning of 1.337(d)-2T if there
  is enough stock basis to shelter the gain, i.e.,
  prevent the gain from being taken into account
  (recognized) on a later disposition of the stock
• Basis conformity principles will be used to
  determine the extent to which investment
  adjustments were made with respect to gain that
  was sheltered by or reflected in stock basis
• Attributable to the recognition of built-in
  gain
• Stock loss cannot be attributable to recognized
  built-in gain if there have been offsetting
  recognized built-in losses that resulted in no
  net positive investment adjustment (see
  1.337(d)-2T(c)(4))thus, loss will be treated as
  attributable to recognized built-in gain only
  to the extent of the net positive adjustment made
  under 1.1502-32

36

• Application of basis conformity
• principles to 1.337(d)-2T
• Gain will not be treated as reflected in
  subsidiary stock basis where inside/asset basis
  equals or exceeds outside/stock basis (where
  basis is conformed) in such cases, stock basis
  is properly increased to shelter the gain from
  recognition at the shareholder level (stock
  losses attributable to such adjustments are,
  however, subject to other deferral/disallowance
  rules)
• Gain will be treated as reflected in subsidiary
  stock basis to the extent of any basis
  disconformity (excess of stock basis over asset
  basis) basis increases attributable to such gain
  give rise to noneconomic stock loss that will be
  disallowed
• Similar principles will be applied in determining
  whether a loss is built-in
• Specifically, gain will be treated as built-in
  to the extent of the lesser of
• the sum of all gains (net of directly related
  expenses) recognized on asset dispositions while
  the subsidiary is a member of the group, and
• the amount of basis disconformity, computed as
  the excess, if any, of ---
• The shares basis, over
• The shares proportionate interest in the
  subsidiarys net asset basis
• But loss will be treated as attributable to
  recognized built-in gain only to the extent of

37

• Net asset basis
• The excess of --
• (1) The sum of the subsidiarys
• money
• basis in assets other than stock of lower tier
  subsidiaries
• net operating loss carryforwards that would be
  carried to a separate return year under the
  principles of 1.1502-21
• deductions recognized but deferred
• over
• (2) The subsidiarys liabilities (that have been
  taken into account for tax purposes)
• Each of these amounts include the subsidiarys
  allocable share of corresponding amounts of lower
  tier subsidiaries. A subsidiary will be treated
  as lower tier to the extent its items adjust
  the basis of the stock of the subsidiary.

38
Time for computing basis disconformity
disconformity 25
disconformity 25
P
P
AB 100 FMV 100
AB 125 FMV 100
Sale of S for 100
S
S
Sale of A1 for 100
A1 AB 75 FMV 100
100

• Although 1.337(d)-2T provides that gain is
  built-in gain if it is reflected in stock basis
  before the disposition of the asset, the
  determination of whether gain is reflected before
  the asset sale can be made by computing the
  amount of basis disconformity before either the
  disposition of the asset or the disposition of
  the stock (or deconsolidation)the reason is that
  the disconformity amount remains constant because
  recognition of gain moves asset basis and stock
  basis in tandem
• Transactions that alter basis disconformity
  require special treatment only if they reallocate
  basis (as in the case of intragroup spins, see
  example below)

39
Stock loss attributable to built-in gain
P
P
Sale of S for 50
AB 100 FMV 100
AB 100 FMV 50
S
S
A2 AB 0 FMV 50
A1 AB 0 FMV 50
A3 AB 50 FMV 0
(A2) AB/FMV 50
A1 AB 0 FMV 0
(A3) AB/FMV 0

• S sells A2 and A3, A1 declines in value to 0
• Nexus approach allows stock loss, see
  1.337(d)-1(a)(5) Example (4) (built-in loss
  offsets built-in gain) basis conformity approach
  allows stock loss (disconformity amount is 50,
  recognized gains are 50, but the net investment
  adjustment was 0, so no stock loss is
  disallowed)
• If, in addition to the sale of A2 and A3, A1 is
  consumed in the production of 50 income, what
  result? See 1.337(d)-1(a)(5), Example (3) (any
  loss on the sale of stock is treated first as
  attributable to built-in gain)

40
Stock loss attributable to built-in gain (cont.)
P
P
Sale of S for 50
AB 100 FMV 100
AB 100 FMV 50
S
S
A2 AB 0 FMV 50
A1 AB 0 FMV 0 FMV 50
A3 AB 50 FMV 50 FMV 0
(A2) AB/FMV 50
A1 AB 0 FMV 0
(A3) AB/FMV 0

• Assume instead on acquisition, the value of A1
  was 0 and A3 was 50, but later the value of A1
  increased to 50 and A3 decreased to 0. Then A2
  and A3 are sold and A1 declines in value to 0
• Basis conformity method allows loss (same as
  above, still appropriate because S is not
  circumventing GU repeal) nexus approach will
  disallow the loss because it is attributable to
  built-in gain and not offset by built-in loss
  (only built-in loss reduces built-in gain in
  determining if stock loss is attributable to
  built-in gain the loss in this case is
  considered built-in only under the basis
  conformity approach)

41
Basis disconformity computation shares with
disparate basis
4
S sells A1 for 20
2
1
P sells 20 Block A shares for 20 (4 loss)
Block B 20 shares received in exchange for
A1 (AB0, FMV 20)
P
P
Block A 80 shares received in exchange for 80
cash
3
Block A shares AB 96 FMV 80 (after -32
adjustment)
Block B shares AB 4 FMV 20 (after
-32 adjustment)
S
A1 AB 0 FMV 20
S
80
The amount of loss disallowed under 1.337(d)-2T
is the lesser of (1) gains allocated to the
shares under 1.1502-32 4, and (2)
disconformity amount 4 (stock basis less
proportionate interest in Ss asset
basis) Result Entire loss is disallowed Observa
tions No tracing/704(c) regime necessary Same
if member purchases minority block when S holds
appreciated assets
42
Basis disconformity computation after
intercompany spin
P
4
P
1
C stock
AB 200 FMV 200
P forms S with 200 cash
S
S
A1 AB 100 FMV 180
A1 AB 100 FMV 100
3
2
A2
A2 AB 100 FMV 100
C
A2 AB 100 FMV 20
1. P forms S with 200 cash 2. S buys A1 and A2
for 100 each 3. After A1 appreciates to 180
and A2 depreciates to 20, S transfers A2 to C in
exchange for all of the C stock 4. S distributes
the C stock to P in a section 355 transaction
Ps basis in S is allocated between S and C in
accordance with their relative FMVs
43
Basis disconformity computation after
intercompany spin (cont.)
6
P
P
Sale of S for 180
AB 180 FMV 180
AB 20 FMV 20
AB 20 FMV 20
5
AB 260 FMV 180
C
S
Sale of A1 for 180
C
S
A1 AB 100 FMV 180
A2 AB 100 FMV 20
A2 AB 100 FMV 20
Cash 180
5. S sells A1, recognizes 80 gain Ps basis in
S increases by 80 (to 260) 6. P sells S for
180 (FMV), recognizes 80 loss (which offsets
gain on A1) The amount of loss on Ps sale of S
that is disallowed under 1.337(d)-2T is the
lesser of (1) gains allocated to the shares
under 1.1502-32 80, and (2) disconformity
amount 80 (stock basis less Ss net asset
basis) Result Entire loss is disallowed If S
had sold A1 before it distributed C, the 80
investment adjustment would be allocated between
S and C in the same manner as Ss basis was
allocated to S and C
44

• Further Observations
• The loss disallowance structure permits
  substitution of unrealized post-acquisition
  appreciation for recognized gain (cf.
  1.337(d)-1(a)(5), Ex. 7)
• Basis disconformity approach does not address
  unrecognized loss reflected in stock basis
  (duplicated loss)
• Duplicated loss is addressed by 1.1502-35T
• Anti-stuffing rule applies to transfers within
  two years of stock loss (1.337(d)-2T(e))
• Objective nature of basis disconformity analysis
  produces consistent results between substantially
  similar transactions, between similarly situated
  taxpayers

45
Other matters

• Ann. 2004-10, 2004-7 I.R.B. 501 (clarifying that
  suspended stock loss under -35T can be taken into
  account only when the subsidiary and any
  successor are no longer group members).
• The taxpayer has filed for cert. in
  Aeroquip-Vickers (6th Cir. 2003), in which the
  6th Circuit agreed with the 2nd and 9th Circuits
  that a group had to recapture ITCs when the
  common parent transferred 38 property to the
  subsidiary as part of a D/355 transaction.
• Falconwood v. United States (Ct. Fed. Cl. 2004)
  (concluding that groups consolidated taxable
  year ended on the date that the common parent
  merged into a subsidiary when the other
  subsidiaries were disposed of on the same day as,
  but after, the merger).

46

• Consolidated Section 108(b)
• Reg. 1.1502-13T, -19T, -28T, -32T
• Prop. Reg. 1.1502-11(c)

47
Section 108(b) Attributes

• NOLs
• General business credits
• Minimum tax credits
• Net Capital Losses
• Asset basis
• Passive activity losses/credits
• Foreign tax credits

Reference Section 108(b)(2) and (b)(3)(B)
48
Section 108(b) Timing/Order

• NOLs, etc.
• Reduced after determining tax for debt discharge
  year
• Compute current year tax before reduction
• Any current year NOL carried back before
  reduction
• Order of Reduction
• For NOLs, first reduce current year, and then
  reduce carryovers from earliest to most recent
  year
• For general business credits foreign tax
  credits, reduce carryovers in order taken into
  account
• Asset Basis
• Reduced at beginning of year following debt
  discharge year
• Floor based on remaining liabilities
• Election to reduce basis of depreciable property
  first

Reference Section 108(b)(4) (b)(5) Reg.
1.108-7T(b) Farley v. Commr Gitlitz v. Commr
49
Reg. 1.1502-28T

• Hybrid approach to section 108(b) that emphasizes
  the debtor members attributes, but also reduces
  certain attributes of other members
• Stacking system
• First, reduce all debtor member attributes
  ((a)(2) rule)
• Second, reduce certain attributes of subsidiaries
  ((a)(3) rule)
• Finally, reduce certain attributes of all member
  ((a)(4) rule)
• Coordinating operating rules for CNOLs, ELAs, and
  investment adjustments
• Generally applies to COD arising after August 29,
  2003
• Section 108(a) not addressed, and presumably
  applies on a separate-entity basis

Reference T.D. 9089 T.D. 9098
50
-28T(a)(2)

• Fully reduce the debtor members attributes under
  general attribute ordering rules (i.e., a
  separate-entity approach)
• Debtor members attributes include
• Its share of consolidated attributes (e.g., CNOL,
  CNCL, etc.)
• Its SRLY attributes
• Its asset basis
• Includes basis in subsidiary stock (but not
  reduced below zero)
• Includes basis in intercompany receivables

Reference Reg. 1.1502-28T(a)(2)
51
-28T(a)(3)

• If the debtor member reduces its basis in a
  subsidiarys stock, the subsidiary must reduce an
  equal amount of its own tax attributes, including
  asset basis, under general attribute ordering
  rules (i.e., a look-through rule)
• If the subsidiary, in turn, happens to reduce its
  basis in a lower-tier subsidiarys stock, the
  lower-tier subsidiary must similarly reduce its
  own tax attributes by an equal amount under
  general attribute ordering rules (and so on,
  through still lower tiers)
• If the subsidiarys outside stock basis reduction
  exceeds its available inside tax attributes, the
  excess is black hole COD that does not reduce
  attributes of any other member (i.e., a modified
  separate-entity approach)
• If a subsidiarys available inside tax attributes
  exceed its outside stock basis reduction, the
  additional attributes might still be reduced
  under the (a)(4) rule
• Sections 108(b)(5) and 1017(b)(3)(D) provide a
  separate look-through rule for the reduction of
  depreciable asset basis

Reference Reg. 1.1502-28T(a)(3)
52
-28T(a)(4)

• To the extent the debtor members excluded COD
  exceeds its attribute reduction, including the
  reduction of subsidiary stock basis, certain
  remaining attributes of all members are reduced
  (i.e., a modified single-entity approach)
• Available attributes
• Consolidated attributes attributable to other
  members (including a subsidiary of the debtor
  member)
• SRLY attributes of other members, to the extent
  the debtor member is in the same SRLY subgroup
• SRLY attributes of other members, to the extent
  not subject to limitation under the SRLY rules
• Asset basis of other members is not reduced
  (i.e., a separate-entity approach to basis)

Reference Reg. 1.1502-28T(a)(4)
53
-19T -32T Interactions

• Debtor member excluded COD income is treated as
  tax-exempt income that generates a positive
  investment adjustment only to the extent of
  corresponding attribute reduction
• It does not matter whether the attribute
  reduction is by the debtor member or another
  member
• Does it matter whether the attribute reduction
  (e.g., of asset basis) occurs after the debtor
  member leaves the group?
• Any ELA with respect to the debtor members stock
  is taken into account to the extent excluded COD
  income does not reduce tax attributes

Reference Reg. 1.1502-19T(b)(1)(ii),
-19(c)(1)(iii)(B), -32T(b)(3)(ii)(C),
-32T(b)(3)(iii)(A)
54
Example 1 Basic Rules
Minority
100 NOL
P
Bank
Basis 100
Basis 80
80
20
S2
S1
200 COD
Insolvent
100 NOL
30 NOL
Basis 10
S3
Basis 10

• Under 28T
• the (a)(2) rule reduces S1s 30 share of the
  CNOL to 0
• the (a)(3) rule reduces S1s 10 basis in S3
  stock to 0, and S3s 10 asset basis to 0
• the (a)(4) rule reduces each of Ps and S2s 100
  share of the CNOL to 20
• None of S1s COD income is black hole COD
• Under 32T(b)(3)(ii)(C) and 32T(b)(3)(iii)(A)
• S1s NOL and basis reduction increases and
  decreases Ps basis in S1 by 40 (0 net effect)
• Ps NOL reduction increases Ps basis in S1 by
  80
• S2s NOL reduction increases Ps basis in S1 by
  80, and reduces Ps basis in S2 by 64 (80 of
  the 80 NOL reduction)
• In effect, 16 of the tax attribute reduction
  burden has been shifted to Minority
• Is a tax sharing agreement likely to cover this
  type of shift?

55
T.D. 9117 REG-167265-03

• Numerous issues have arisen in connection with
  28T and the related regulations
• Three specific problems are now addressed
• Problem 1 section 1245 duplication
• Problem 2 -13(c) matching and intercompany
  receivables
• Problem 3 coordinating timing of section 108(b)
  adjustments with -19T -32T effects

56
Problem 1 Section 1245 Duplication

• If S applies the (a)(2) rule to reduce its basis
  in the stock of S1, a lower-tier member, section
  1017(d)(1) applies section 1245 recapture both
  outside S1 (to the S1 stock) and inside S1 (any
  corresponding S1 asset basis reduction)
• A similar inside/outside duplication can arise
  under sections 108(b)(5) and 1017(b)(3)(D)
• Section 1245(a) recapture overrides any
  nonrecognition provision, except as otherwise
  expressly provided
• If S1 liquidates, section 1245 overrides section
  332
• In addition, S succeeds to S1s recapture
  exposure on the S1 assets
• Under 28T(b)(4), S1 stock recapture is limited
  to any excess of S1 stock basis reduction over S1
  inside attribute reduction
• Is this an appropriate policy result in all
  cases?
• What if S1 leaves the group before suffering any
  recapture?
• What if Ss COD would otherwise have been black
  hole COD?

Reference Sections 1245(a) and (b)(3), and
Section 1017(d)(1) Reg. 1.1502-28T(b)(4)
57
Example Section 1245 Duplication
Bank
P
S
25 NOL
100 COD
Insolvent
Basis 90
S1
50 Basis

• If S realizes 100 of excluded COD income
• the (a)(2) rule reduces Ss 25 share of the CNOL
  to 0, and reduces Ss 90 basis in S1 stock to
  15
• the (a)(3) rule reduces S1s 50 asset basis to
  0
• If S1 later liquidates
• -28T(b)(4) and section 1017(d)(1) provide that
  section 1245 overrides section 332 only to the
  extent of 25 (i.e., excess of 75 stock basis
  reduction over 50 asset basis reduction)
• section 1245(b)(3) protects S1 from recapture
• S succeeds to S1s 0 asset basis under section
  334, and section 1245 applies to Ss subsequent
  disposition of the former S1 assets

58
Problem 2 -13(c) Matching and Intercompany
Receivables

• If S reduces its basis in an intercompany
  receivable, and later receives payment in excess
  of basis, its income is subject to attribute
  redetermination under the 13(c) matching rule
• Might Ss income be redetermined to be excluded
  from gross income (to simulate the results of the
  receipt being a transfer between divisions)?
• Under 13T(g)(3)(ii)(B)(4) and 28T(b)(5), Ss
  income cannot be redetermined to be excluded from
  gross income
• Under 13(g)(3)(ii)(B)(3), basis reduction is not
  a realization event for purposes of 13(g)(3)
• Is this an appropriate policy result in all
  cases?
• What if Ss COD would otherwise have been black
  hole COD?
• What is the implication if S is an intercompany
  debtor, for purposes of applying the section
  1017(b)(2) basis reduction floor?
• When is Ss taxable income taken into account
  under 13(c)?

Reference Reg. 1.1502-13(c)(1) and
13(g)(3)(ii)(B) 1.1502-28T(b)(5)
59
Example Intercompany Receivables
70 NOL
P
Bank
200 COD
S1
S2
Insolvent
100 NOL 30 Basis
30 Intercompany Obligation
Creditor
Debtor

• If S2s basis in the S1 receivable is reduced
  under -28T(a)(2), -13(g)(3)(ii)(B)(3) does not
  treat the reduction as a realization event for
  purposes of 13(g)(3)
• If S1 subsequently pays 30 to S2,
  -13(g)(3)(ii)(B)(4) and -28T(b)(5) prevent the
  redetermination under -13(c)(1) and
  -13(g)(3)(ii)(B) of any S2s 30 of income under
  sections 1245 and 1271 as tax-exempt income
• Does not matter whether S2s COD would otherwise
  be black hole COD
• Presumably, S1 similarly takes its 30 liability
  into account in applying section 1017(b)(2) floor
  with respect to any basis reduction from its own
  excluded COD

60
Problem 3 Coordinating Timing of Section 108(b)
with -19T -32T Effects
100 Yr. 1 NOL
P
Bank
Buyer
7/1/02 Sale
Basis 125 FMV 100
9/1/02 100 COD
S1
S2
100 Yr. 1 NOL
Insolvent

• If S2s NOL is reduced by section 108(b) before
  apportionment, and a mid-year 32 adjustment is
  also made, does a circularity arise because it
  changes how tax attributes are reduced under
  section 108(b)?
• Initially, Ps 100 NOL (50) is reduced to 50
  and S2s 100 NOL (50) is reduced to 50
• But, this shifts Ps 25 loss on S2 stock to a
  25 gain, requiring P to absorb 25 of its NOL
  before section 108(b) attribute reduction
• But, Ps 75 NOL (43) is reduced to 32 and S2s
  100 NOL (57) is reduced to 43
• But, this increases Ps 25 gain on S2 stock to a
  32 gain
• And so on . . .
• Similar effects can arise to the extent any S1
  ELA is taken into account

61
Problem 3 Quandary

• Should S2s NOL be reduced by section 108(b)
  before apportionment, despite any apportioned NOL
  being unavailable to S1?
• Section 108(b)(4)(A) defers attribute reduction
  until after the tax for debt discharge year has
  been determined
• If S2s NOL is reduced before apportionment, and
  there is no corresponding 32 adjustment,
  inappropriate duplication will result
• If S2s NOL is to be reduced before
  apportionment, and there is a corresponding 32
  adjustment, the reduction affects the tax
  determination for the year
• How can section 108(b)(4)(A) be coordinated with
  32 adjustments?
• Are the applicable principles different for SRLY
  attributes that do not require an apportionment?
• Are the principles for ELAs different from other
  types of stock gain/loss
• What year should an ELA be taken into account
  under 19(c)(1)(iii)(B)?
• When during the year should the ELA be taken into
  account?

62
Problem 3 Temporary Proposed Solution

• Under28T(b)(6)(i) and proposed 11(c), permit
  one, but only one, iteration through a 9-step
  process
• First, apply 11(b)
• Second, compute tentative 32, tentative stock
  gain/loss, and tentative CTI, all without
  attribute reduction, and then compute tentative
  28T
• Third, apply the tentative 28T to compute final
  32, final stock gain/loss, final CTI, and then
  final 28T, imposing limitations on tax attribute
  absorption and reduction to limit inconsistencies
  with the tentative 32 and 28T computations
• Under 28T(b)(6)(ii), an ELA taken into account
  under 19(c)(1)(iii)(B) must be taken into
  account during the COD year
• Reserve on cases involving multiple dispositions
  in a single year
• What principles apply to resolve circularity in
  these circumstances?
• Should the tentative 28T computation be after
  computation of consolidated tax liability (rather
  than consolidated taxable income)?
• No special rules addressing the effects of tax
  sharing agreements
• Are tax sharing agreements likely to address the
  effects of 28T?

Reference Reg. 1.1502-28T(b)(6) Prop. Reg.
1.1502-11(c)
63
Example 1 Departing Member COD
30 STI
P
Bank
Buyer
12/31 Sale
Basis 90 FMV 20
S
100 COD
80 NOL 0 Basis
Insolvent

• First, under 11(b), only 30 of Ss 80 NOL can
  be absorbed, and the remaining 50 is limited in
  CTI computations
• Second, tentative 32, stock gain/loss, CTI, -28T
  are computed
• Under 32, Ps 90 basis in S is reduced by the
  30 permitted absorption to 60
• Under section 1001, P recognizes a 40 capital
  loss from the S stock sale
• Under 11(a), the P group has a 50 CNOL,
  attributable to S, and 40 CNCL, attributable to
  P
• Under 28T
• the (a)(2) rule reduces Ss 50 share of the CNOL
  to 0
• the (a)(4) rule reduces Ps 40 share of the CNCL
  to 0
• Ss remaining 10 of COD income is black hole
  COD

Reference Prop. Reg. 1.1502-11(c)(5), Ex. 1
64
Example 1 (contd)
30 STI
P
Bank
Buyer
12/31 Sale
Basis 90 FMV 20
S
100 COD
80 NOL 0 Basis
Insolvent

• Third, final 32, stock gain/loss, CTI, -28T are
  computed
• Under 32, Ps 90 basis in S is increased by 10
  to 100 (-30 - 50 90)
• Under section 1001, P recognizes a 80 capital
  loss from the S stock sale
• Under 11(a), the P group has a 50 CNOL,
  attributable to S, and 80 CNCL, attributable to
  P
• Under 28T
• the (a)(2) rule reduces Ss 50 share of the CNOL
  to 0
• the (a)(4) rule would reduce Ps 80 share of the
  CNCL to 30, but this would increase Ps basis in
  the S stock from 100 to 110, and thereby risk
  additional circularity, so the reduction is
  capped at the 40 tentative amount and 40 of
  CNCL survives
• Ss remaining 10 of COD income is black hole
  COD

65
Example 2 Remaining Member COD
30 STI
P
Buyer
Bank
12/31 Sale
Basis 600 FMV 600
S1
S2
100 COD
100 NOL 0 Basis
200 NOL
Insolvent

• First, under 11(b), only 20 of S2s 200 NOL
  can be absorbed (Ps 30 STI is allocated 67 to
  S2, and 33 to S1), and S2s remaining 180 is
  limited in CTI computations
• Second, tentative 32, stock gain/loss, CTI, -28T
  are computed
• Under 32, Ps 600 basis in S2 is reduced by the
  20 permitted absorption to 580
• Under section 1001, P recognizes a 20 capital
  gain from the S2 stock sale
• Under 11(a), the P group has a 250 CNOL, 180
  attributable to S2, and 70 attributable to S1
• Under 28T
• the (a)(2) rule reduces S1s 70 share of the
  CNOL is to 0
• the (a)(4) rule reduces S2s 180 share of the
  CNOL by 30 to 150, and
• none of S1s COD income is black hole COD

Reference Prop. Reg. 1.1502-11(c)(5), Ex. 2
66
Example 2 (contd)
30 STI
P
Buyer
Bank
12/31 Sale
Basis 600 FMV 600
S1
S2
100 COD
100 NOL 0 Basis
200 NOL
Insolvent

• Third, final 32, stock gain/loss, CTI, -28T are
  computed
• Under 32, Ps 600 basis in S2 is reduced by 50
  to 550 (-20 - 30)
• Under section 1001, P recognizes a 50 capital
  gain from the S2 stock sale
• Under 11(a), the P group has a 220 CNOL, 180
  attributable to S2, and 40 attributable to S1
• Under 28T
• the (a)(2) rule reduces S1s 40 share of the
  CNOL to 0
• the (a)(4) rule would reduce S2s 180 share of
  the CNOL to 120, but this would reduce Ps basis
  in the S2 stock from 600 to 520, and thereby
  risk additional circularity, so the reduction is
  capped at the 30 tentative amount and 150 of
  the CNOL survives
• S1s remaining 30 of COD income is black hole
  COD

67
Example 3 Lower-Tier COD
50 NOL
P
Buyer
12/31 Sale
Basis 50 FMV 100
S3
S1
S2
Bank
100 NOL
50 NOL
150 NOL
Basis 50
S4
50 NOL 0 Basis
80 COD
Insolvent

• First, under 11(b), the entire NOLs of S1 and S4
  are limited in CTI computations
• Second, tentative 32, stock gain/loss, CTI, -28T
  are computed
• Under 32, Ps 50 basis in S1 remains 50
• Under section 1001, P recognizes a 50 capital
  gain from the S1 stock sale
• Under 11(a), the P group has a 350 CNOL, 40
  attributable to each of P and S3, 120
  attributable to S2, 100 attributable to S1, and
  50 attributable to S4
• Under 28T
• the (a)(2) rule reduces S4s 50 share of the
  CNOL to 0
• the (a)(4) rule reduces the 300 remaining CNOL
  contributions by 30 as follows--P and S3 from
  40 each to 36 each, S1 from 100 to 90, and S2
  from 120 to 108
• none of S4s COD income is black hole COD

Reference Prop. Reg. 1.1502-11(c)(5), Ex. 3
68
Example 3 (contd)
50 NOL
P
Buyer
12/31 Sale
Basis 50 FMV 100
S3
S1
S2
Bank
100 NOL
50 NOL
150 NOL
Basis 50
S4
50 NOL 0 Basis
Insolvent
80 COD

• Third, final 32, stock gain/loss, CTI, -28T are
  computed
• Under 32, Ps 50 basis in S1 is increased by
  20 to 70 ( 10 50 80)
• Under section 1001, P recognizes a 30 capital
  gain from the S1 stock sale
• Under 11(a), the P group has a 370 CNOL, 44
  attributable to each of P and S3, 132
  attributable to S2, 100 attributable to S1, and
  50 attributable to S4
• Under 28T
• the (a)(2) rule reduces S4s 50 share of the
  CNOL to 0
• the (a)(4) rule would reduce the 320 remaining
  CNOL contributions by 30 as follows--P and S3
  from 44 each to 39.88 each, S1 from 100 to
  90.62, and S2 from 132 to 119.62, but this
  would increase Ps basis in the S1 stock from 50
  to 70.62, and thereby risk additional
  circularity, so the reductions are capped at P
  and S3 from 44 each to 40 each, S2 from 132 to
  120, and S1 from 100 to 90
• none of S4s COD income is black hole COD

69
Example 4 Excess Loss Account
10 STI
P
S1
Bank
25 STI
Basis 10
S2
50 NOL 0 Basis
20 COD
Insolvent

• First, under 11(b), 15 of S2s NOL is limited
  in CTI computations
• Second, tentative 32, stock gain/loss, CTI, -28T
  are computed
• Under 32, S1s 10 basis in S2 is reduced to a
  25 ELA
• Under section 1001, there is no gain or loss
  because there is no stock disposition
• Under 11(a), the P group has a 15 CNOL
• Under 28T
• the (a)(2) rule reduces S2s 15 share of the
  CNOL to 0
• S2s remaining 5 of COD income is black hole
  COD

Reference Prop. Reg. 1.1502-11(c)(5), Ex. 4
70
Example 4 (contd)
10 STI
P
S1
Bank
25 STI
Basis 10
S2
50 NOL 0 Basis
20 COD
Insolvent

• Third, final 32, stock gain/loss, CTI, -28T are
  computed
• Under 32, S1s 10 basis in S2 is reduced to a
  25 ELA (35 15 15)
• Under 19T, S1 must take into account 5 of the
  S2 ELA (by reason of the 5 black hole COD)
• Under 11(a), the P group has a 15 CNOL and 5
  of income from S2s ELA (cannot be offset)
• Under 28T
• the (a)(2) rule reduces S2s 15 share of the
  CNOL to 0
• S2s remaining 5 of COD income is black hole
  COD