United States: Comparison of the Intercompany Obligation Rules Under Treas. Reg. § 1.1502-13(g) AND PROP. TREAS. REG. § 1.1502-13(g)

I. INTRODUCTION

The purpose of this outline is to compare the current consolidated return intercompany obligation rules set forth in Treas. Reg. §1.1502-13(g) with those contained in Prop. Reg. §1.1502-13(g). This outline contains numerous examples designed to illustrate the operation of both the current and the proposed regulations. To highlight the differences between the current and proposed regulations, each example is first analyzed under the current regulations and then analyzed under the proposed regulations where differences exist. Some of these examples are set forth in the current or proposed regulations, while others present fact patterns that have been developed to illustrate various issues, including issues associated with the "zero basis" problem.¹

Treasury and the IRS included in their 2002-2003 Priorities for Tax and Other Administrative Guidance (the "2002-2003 Business Plan") the issuance of guidance regarding transactions involving obligations of consolidated group members. See 2002 TNT 133-8 (July 10, 2002). IRS officials commented that the issuance of such guidance was not imminent. See Sheppard, "ABA Tax Section Meeting: Consolidated Return Issues and Rite Aid Discussed," 2002 TNT 92-2 (May 10, 2002) (reporting on comments by an IRS official noting that the IRS is working on new rules for the treatment of consolidated group member debt but that such rules are not imminent). To date, Treasury and the IRS have not issued such guidance, and the 2003-2004 Business Plan has not yet been issued. In the meantime, the IRS appears not to be addressing in private letter rulings the tax effects of Treas. Reg. § 1.1502-13(g). See P.L.R. 200308004 (Nov. 5, 2002); P.L.R. 200234053 (May 22, 2002).

II. SUMMARY OF THE INTERCOMPANY REGULATIONS

A. In General

The current intercompany transaction regulations were made final on July 12, 1995. The proposed regulations were issued on December 18, 1998. The proposed regulations are effective upon publication in final form in the federal register. However, taxpayers may presently rely upon the form and timing of the recast transaction, as clarified by the proposed regulations. Generally, the intercompany transaction regulations treat the separate corporations within a consolidated group as divisions of a single entity. However, while the single entity theory controls in determining the character and timing of intercompany items, these regulations utilize a separate entity theory for the purposes of determining the amount and location of intercompany items. 

The "matching rule" of Treas. Reg. §1.1502-13(c) is the primary means of achieving single entity treatment for intercompany transactions. However, when it is no longer possible to treat members of a consolidated group as divisions of a single entity, an "acceleration rule" applies to terminate the deferral of gain or loss initially created by the matching rule. A common example of an event triggering the acceleration rule is the departure of a member from the consolidated group.

B. Intercompany Obligations

The preamble to the proposed regulations provides that the regulations are generally intended to clarify the current regulations. However, the proposed regulations apply in instances in which the current regulations do not apply and the proposed regulations eliminate certain exceptions contained in the current regulations. In addition to these changes, the proposed regulations clarify both the form and the timing of the recast applied to transactions subject to the regulation.² 

1. Treas. Reg. §1.1502-13(g)(3): "Outbound" Transactions and Intragroup 

Transfers in Which Gain or Loss is Realized: Current Regulations

The current regulations recharacterize transactions in which a member realizes a gain or a loss, either directly or indirectly, on an intragroup transfer of an intercompany obligation and transactions in which an intercompany obligation becomes a non-intercompany obligation.

Under the exception set forth in Treas. Reg. §1.1502-13(g)(3)(i)(B)(4) of the current regulations, it is possible that the deemed satisfaction and reissuance provisions of Treas. Reg. §1.1502-13(g)(3) may not apply where an intercompany obligation becomes a non-intercompany obligation in a transaction in which neither gain nor loss is realized.³ If an intercompany obligation becomes a non-intercompany obligation in a transaction in which the transferring member realizes neither gain nor loss (i.e., a transfer at a time when the obligation's fair market value is equal to the transferring member's basis in the obligation), it could be argued that the transaction does not have a significant impact on any person's Federal income tax liability for any year. If this exception applies, the provisions of Treas. Reg. §1.1502-13(g)(3) would not apply even though an intercompany obligation has become a non-intercompany obligation.

a. Under the recharacterization set forth in the current regulations, the debtor is first deemed to pay the creditor member an amount of money in retirement of the obligation. Determining the amount of money deemed paid is dependent upon the transaction involved.

(1) If the debt is sold for an amount of money, the amount deemed paid by the debtor member is the amount of cash actually received by the selling member on the disposition of the note.

(2) If the creditor member exchanges the intercompany note for property, then the debtor member is deemed to pay the creditor member an amount of money equal to the issue price (determined under sections 1273 and 1274) of a new obligation issued for the property with terms identical to the terms of the existing note. The critical factor in determining the issue price of a note under sections 1273 and 1274 is whether the note and the property for which it is issued are publicly traded. In the absence of public trading of either the note or the property for which it is issued, the issue price generally equals the note’s stated redemption price at maturity regardless of the property’s fair market value. Sections 1273(b)(4) and 1274(a)(1).⁴ Where there is public trading of either the note or the property for which it is issued, the issue price of the note generally equals the fair market value of the property received in the exchange. Section 1273(b)(3).

(3) If the intercompany obligation becomes a non-intercompany obligation because of the deconsolidation of the debtor or creditor member, the debtor corporation is deemed to pay the creditor member an amount of money equal to the fair market value of the obligation determined immediately before the debtor or creditor becomes a nonmember.

b. If the obligation actually remains outstanding, the debtor is then deemed to issue a new obligation to the party holding the obligation.

(1) In general, the issue price of the new obligation is determined under the rules of sections 1273 or 1274 (illustrated below).

(2) If the obligation becomes a nonintercompany obligation because the debtor or creditor becomes a nonmember, then the issue price of the obligation equals its fair market value determined immediately after the debtor or creditor becomes a nonmember. Treas. Reg. §1.1502-13(g)(3)(iii).

c. The regulation applies if a member realizes an amount from an intercompany obligation either "directly or indirectly." Treas. Reg. §1.1502-13(g)(3)(i). As the IRS has noted, neither the regulation nor the preamble to the regulation discusses the scope of the term "realizes ... indirectly." See T.A.M. 200006014 (Oct. 22, 1999). As discussed below, the IRS has concluded that transactions in which indirect realization occurs are "transactions in which the amount realized is a function of the inherent attributes of the obligation, but that neither involves the obligation directly nor effects a deconsolidation." Id.

(1) In T.A.M. 200006014, Parent was a common parent of a consolidated group including Sub1, Sub2 and Benefits. Sub2 borrowed $c from Parent in exchange for a Sub2 Note. Immediately thereafter, Parent contributed the Sub2 Note to Benefits in exchange for the newly authorized 100 shares of Benefits voting preferred stock and Benefits’ assumption of certain pension liabilities of Parent. Under the applicable tax accounting principles, however, the assumed pension liabilities were not yet taken into account in the tax system. Parent’s basis in the Benefits stock was thus determined wholly by reference to its basis in the Sub2 Note. Subsequently, Parent sold the 100 shares of Benefits stock to an unrelated Purchaser at a loss.

(2) Parent calculated the loss on the sale of the Benefits stock by excluding the Sub2 Note from the inside basis of Benefits pursuant to Treas. Reg. §1.1502- 20(c)(2)(vi)(A)(1). Having done so, Parent claimed that the loss disallowance rule of Treas. Reg. §1.1502-20 did not operate to disallow any of this loss.

(3) The IRS analyzed the meaning of the clause "realizes ... indirectly." In doing so, the IRS concluded that "[i]t appears ... that there is but a narrow range of transactions for which such a clause would be necessary." The IRS effectively determined what transactions should be covered by the clause by determining what transactions did not need to be covered by the clause. The IRS wrote:

a) "First, if a transaction actually involves an Intercompany Obligation, there is a direct realization and no need for the ‘indirect’ clause."

b) "Second, if a transaction does not involve a member obligation directly, but rather an interest in the entity holding the obligation, most cases are otherwise covered by §1.1502-13(g) and so would have no need for the ‘indirect’ clause. For example, if a transaction involves a member obligation that is held by a person or entity that is not a member of the group, §1.1502-13(g) has no application at all because the obligation is not an Intercompany Obligation. And, if the holder is a member but a disposition of its stock deconsolidates the holder, the regulation provides for a satisfaction of the obligation at fair market value, so again the ‘indirectly’ clause is not needed."

c) "What remains are transactions in which the amount realized is a function of the inherent attributes of the obligation, but that neither involves the obligation directly nor effects a deconsolidation."

(4) The IRS held that the transaction addressed in T.A.M. 200006014 was a transaction involving an indirect realization under Treas. Reg. §1.1502-13(g)(3)(i). Because the only economic interest represented by the Benefits stock was the intercompany obligation (the Sub2 Note), and because there would be no loss at all if the pension liabilities were taken into account, the amount realized on the Benefits stock had to be treated as an amount indirectly realized on the Sub2 Note.

(5) Accordingly, the IRS recharacterized the sale of the Benefits stock as follows:

a) Sub2 was treated as having satisfied its note for $c immediately before Parent’s sale of the Benefits stock;

b) The loss duplication calculation was made immediately after the deemed satisfaction and before any other transaction. The amount of deemed satisfaction represented duplicated loss and was disallowed;

c) Sub2 was then treated as having reissued its note to Benefits.

(6) The IRS has also recently held that the transaction described in Notice 2001-17, 2001-1 C.B. 730, involves an indirect realization under Treas. Reg. §1.1502-13(g)(3)(i).

a) The IRS has taken the position that so-called "contingent liability tax shelter" transactions, which are described in Notice 2001-17, result in a duplication of loss and thus a disallowance under Treas. Reg. §1.1502-20. The transaction typically involves the transfer of one or more assets with a basis that approximates its value in exchange for stock of the transferee corporation and the transferee’s assumption of a contingent liability that would be deductible if paid by the transferor.

i) The asset will typically be a security issued by another member of the group. The liability is only slightly less than the basis of the asset.

ii) Shortly after the exchange, the transferor sells the stock received in the exchange and claims a loss approximating the present value of the contingent liability assumed by the transferee.

b) The IRS takes the position that, at the time of the loss duplication calculation, the subsidiary holds the proceeds of the member security, not the security itself, thus resulting in a duplicated loss. The IRS reaches this conclusion through a somewhat strained interpretation of Treas. Reg. §1.1502-13(g).

i) Under Treas. Reg. §1.1502-13(g), a member security is deemed satisfied and reissued if a member realizes an amount (other than zero) of income, gain, deduction, or loss, directly or indirectly, from the assignment or extinguishment of all or part of its rights or obligations under the member security. The deemed satisfaction occurs immediately before the transaction in which the amount is realized, and the deemed reissuance occurs immediately after the transaction.

ii) The IRS takes the position that the sale of the stock in Notice 2001-17 transactions triggers Treas. Reg. §1.1502-13(g) with respect to the member security, because it produces an indirect realization of loss from the assignment of all or part of an interest in the member security.

iii) If the transfer of the member security qualifies as a tax-free section 351 exchange, the IRS additionally argues that the stock is a successor asset within the meaning of Treas. Reg. §1.1502-13(j)(1) and, therefore, Treas. Reg. §1.1502-13(g) applies to the stock.

iv) Next, the IRS takes the position that the member security is deemed satisfied immediately before the stock sale and deemed reissued after the sale, and that the loss duplication calculation is made at the time of the sale. Thus, at the time of the loss duplication calculation, the subsidiary holds the proceeds from the deemed satisfaction of the member security.

c) In addition to the technical argument based on Treas. Reg. §1.1502-13(g), the IRS argues that Notice 2001-17 transactions violate the anti-avoidance and anti-stuffing rules of Treas. Reg. §1.1502-20(e).

d) These arguments appear to have become moot, however, as a result of the Federal Circuit’s decision in Rite Aid Corp. v. United States, 255 F.3d 1357 (Fed. Cir. 2001) (holding that the duplicated loss component of Treas. Reg. §1.1502- 20 is invalid), and the issuance of new temporary loss disallowance regulations (see Temp. Reg. §1.337(d)-2T, 1.1502-20T(i), and 1.1502- 32T(b)(4)(v)). Nonetheless, the IRS has identified a number of grounds upon which to attack these transactions. See, e.g., Notice 2001-17, 2001-1 C.B. 730; F.S.A. 200121013 (Feb. 12, 2001); F.S.A. 200122022 (Feb. 23, 2001); CC-2001-033a (June 28, 2001); see also F.S.A. 200217021 (Jan. 17, 2002).

2. Prop. Reg. §1.1502-13(g)(3): "Outbound" Transactions and Intragroup 

Transfers in Which Gain or Loss is Realized: Proposed Regulations

The proposed regulations, unlike the current regulations, recharacterize all transactions involving the transfer of an intercompany obligation regardless of whether a member realizes an amount of income, gain, deduction or loss as a result of the transfer. The proposed regulations also eliminate the exception contained in Treas. Reg. §1.1502-13(g)(3)(i)(B)(4) relating to situations where "[t]reating the obligation as satisfied and reissued will not have a significant effect on any person’s federal income tax liability for any year." The preamble to the proposed regulations provides that the exception was eliminated due to uncertainty as to its application and scope. The proposed regulations do not alter the treatment accorded transactions in which an intercompany obligation becomes a non-intercompany obligation.

a. Under the recharacterization set forth in the proposed regulations, the debtor is first deemed to pay the creditor member an amount of money in retirement of the obligation. Determining the amount of money deemed paid is dependent upon the transaction involved.

(1) The proposed regulations retain the rule that if the debt is sold for an amount of money, the amount deemed paid by the debtor member is the amount of cash actually received by the selling member on the disposition of the note.

(2) The proposed regulations retain the rule that if the creditor member exchanges the intercompany note for property, then the debtor member is deemed to pay the creditor member an amount equal to the issue price (determined under sections 1273 or 1274) of a note issued in exchange for the property with terms identical to the existing note. In cases in which neither the property nor the obligation are publicly traded, the issue price will generally equal the note’s stated redemption price at maturity if the note provides for adequate stated interest. See sections 1273(b)(4) and 1274(a)(1).

(3) The proposed regulations retain the rule that where an intercompany obligation becomes a non-intercompany obligation because of the deconsolidation of the debtor or creditor member, the debtor corporation is deemed to pay the member an amount of money equal to the fair market value of the obligation immediately before the debtor or creditor becomes a nonmember.

(4) The proposed regulations also clarify the amount of the deemed satisfaction in two situations not specifically covered under the current regulations. First, if a corporation assumes the debtor’s liability in exchange for property of the debtor, the debt is treated as satisfied for an amount equal to the issue price (determined under sections 1273 or 1274) of a new debt issued on the date of the transaction, with identical terms, for such property. Second, in a situation in which an intercompany obligation is extinguished, the debt is treated as satisfied for an amount equal to the issue price (determined under sections 1273 or 1274) of a new debt issued on the date of the transaction, to a third party, for property that is not publicly traded.

b. Under the proposed regulations, if the obligation actually remains outstanding following the deemed satisfaction, the creditor member is treated as transferring the deemed satisfaction proceeds to the actual transferee of the note. The transferee is then deemed to transfer this amount to the debtor in exchange for a new obligation with terms identical to the existing obligation.

(1) In general, the issue price of the new obligation is determined under the rules of sections 1273 or 1274 (illustrated below).

(2) If the obligation becomes a nonintercompany obligation because the debtor or creditor becomes a nonmember, then the issue price of the obligation equals its fair market value determined immediately after the debtor or creditor becomes a nonmember. Prop. Reg. §1.1502-13(g)(3)(iii).

c. The proposed regulations do not mention indirect realization. Prop. Reg. §1.1502-13(g)(3)(i). However, under Prop. Reg. §1.1502-13(g)(3)(iii), the result in T.A.M. 200006014, supra, would be the same as under Treas. Reg. §1.1502-13(g)(3)(i):

(1) Sub2 would be treated as having satisfied its note for $c immediately before Parent’s sale of the Benefits stock;

(2) Parent would be deemed to contribute the proceeds of the satisfaction (i.e., $c) to Benefits in exchange for the Benefits stock;

(3) Benefits would be treated as transferring the deemed proceeds to Sub2 in exchange for a new Sub2 Note.

3. Treas. Reg. §1.1502-13(g)(4) and Prop. Reg. §1.1502-13(g)(4):

In general, the proposed regulations do not alter the rules relating to "inbound transactions." Under both the current and the proposed versions of Treas. Reg. §1.1502-13(g)(4), when a non-intercompany obligation becomes an intercompany obligation (through a member's acquisition of the debt or as a result of the debtor or creditor becoming a member of the consolidated group), the obligation is treated as satisfied for its fair market value and reissued as a new obligation immediately after it becomes an intercompany obligation. This new obligation has an issue price equal to its fair market value and a stated redemption price equal to the face amount of the note.

While the general treatment of "inbound transactions" has not been altered, certain conforming changes have been made. Consistent with the elimination of the exception currently set forth in Treas. Reg. §1.1502- 13(g)(3)(i)(4) (relating to transactions that do not have a significant effect on any person’s Federal tax liability for any year), the proposed regulations eliminate the parallel exception currently set forth in Treas. Reg. §1.1502-13(g)(4)(i)(B)(2).

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