[Federal Register Volume 59, Number 73 (Friday, April 15, 1994)] [Unknown Section] [Page 0] From the Federal Register Online via the Government Publishing Office [www.gpo.gov] [FR Doc No: 94-8488] [[Page Unknown]] [Federal Register: April 15, 1994] ======================================================================= ----------------------------------------------------------------------- DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1 [CO-11-91] RIN 1545-AL63 Consolidated Groups and Controlled Groups--Intercompany Transactions and Related Rules AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Notice of proposed rulemaking. ----------------------------------------------------------------------- SUMMARY: This document proposes regulations revising the intercompany transaction system of the consolidated return regulations to more clearly reflect consolidated taxable income. The proposed regulations also revise the regulations under section 267(f), limiting losses and deductions from comparable transactions between members of a controlled group. Amendments to other related regulations are also proposed in this document. DATES: Comments must be received by July 18, 1994. Because the proposed regulations affect a broad range of transactions, two public hearings will be held. A preliminary hearing to respond to general comments and questions by speakers will be held on May 4, 1994, beginning at 10 a.m., and a second hearing to receive comments will be held on August 8, 1994, beginning at 10 a.m. Requests to speak at the first hearing must be received by April 20, 1994. Outlines of topics to be discussed at the second hearing must be received by July 18, 1994. See the notice of public hearings on proposed rulemaking published elsewhere in this issue of the Federal Register. ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (CO-11-91), room 5228, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. In the alternative, submissions may be delivered to: CC:DOM:CORP:T:R (CO-11-91), room 5228, Internal Revenue Service, 1111 Constitution Avenue NW., Washington, DC. The first public hearing will be held in room 2615 of the Internal Revenue Building, 1111 Constitution Avenue NW, Washington, DC. The second public hearing will be held in the Internal Revenue Building Auditorium, Seventh Floor, 7400 Corridor, Internal Revenue Service Building, 1111 Constitution Avenue NW., Washington, DC. FOR FURTHER INFORMATION CONTACT: Concerning the hearings, Carol Savage of the Regulations Unit, Assistant Chief Counsel (Corporate), (202) 622-8452 or (202) 622-7180; concerning the regulations relating to consolidated groups generally, Roy Hirschhorn or David Kessler of the Office of Assistant Chief Counsel (Corporate), (202) 622-7770; concerning stock of members of consolidated groups, Rose Williams of the Office of Assistant Chief Counsel (Corporate), (202) 622-7550; concerning obligations of members of consolidated groups, Victor Penico of the Office of Assistant Chief Counsel (Corporate), (202) 622-7750; concerning insurance issues, Gary Geisler of the Office of Assistant Chief Counsel (Financial Institutions and Products), (202) 622-3970; concerning international issues relating to members of consolidated groups, Philip Tretiak of the Office of Associate Chief Counsel (International), (202) 622-3860; and concerning controlled groups, Martin Scully, Jr. of the Office of Assistant Chief Counsel (Income Tax and Accounting), (202) 622-4960. (These numbers are not toll- free numbers.) SUPPLEMENTARY INFORMATION: A. Paperwork Reduction Act The collections of information contained in this notice of proposed rulemaking has been submitted to the Office of Management and Budget for review in accordance with the Paperwork Reduction Act of 1980 (44 U.S.C. 3504(h)). Comments on the collection of information should be sent to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503, with copies to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, PC:FP, Washington, DC 20224. The collections of information are found in Sec. 1.1502-13 (e)(3), (f)(5)(v), and (j)(5). This information is required by the IRS to comply with section 1502 and the regulations thereunder, and to simplify the operation of the proposed regulations. This information will be used to assure that the amount, location, timing, character, source, and other attributes of intercompany items and corresponding items are properly determined. The respondents are members of consolidated groups. The estimated total annual reporting burden is 2,500 hours. The estimated annual reporting burden per respondent is .50 hour. The estimated number of respondents is 5,000. The estimated annual frequency of responses is once per year, if necessary. B. Background This document proposes amendments to the regulations under section 1502 of the Internal Revenue Code of 1986 (Code) that are applicable to transactions between members of a consolidated group (intercompany transactions). Sections 1.1502-13, 1.1502-13T, 1.1502-14, 1.1502-14T, and 1.1502-31 contain most of the rules of the current intercompany transaction system. Amendments are also proposed to related regulations, including the regulations under section 267(f), which are applicable to transactions between members of a controlled group. The current consolidated return regulations use a deferred sale approach that treats the members of a group as separate entities for some purposes and as a single entity for other purposes. In general, the amount, location, character, and source of items from an intercompany transaction are determined as if separate returns were filed (separate entity treatment), but the timing of items is determined more like the timing that would apply if the participants were divisions of a single corporation (single entity treatment). For a discussion of the issues considered in developing the proposed regulations, see the notice of hearings on the proposed regulations that appears elsewhere in this issue of the Federal Register. The topics discussed in the notice of hearings include: 1. Separate and single entity treatment. 2. Location of items within the group (and alternative comprehensive single entity treatment). 3. Mechanical rules. 4. Matching and acceleration rules (including nonrecognition transactions, subgroups, and possible simplifying rules). 5. Stock of members. 6. Obligations of members. No inference is intended by the proposed regulations as to the operation of the current regulations or other rules. C. Explanation of Proposed Intercompany Transaction Rules 1. In General The purpose of the proposed intercompany transaction regulations is 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 consolidated tax liability). The proposed regulations retain the basic approach of the current regulations by accounting for intercompany transactions through a deferred sale system. The principal focus of single entity treatment under the current regulations is on the timing of items from intercompany transactions. The proposed regulations expand this focus by redetermining the character, source, and other attributes of the items on a single entity basis. Only the amount and location of items remain on a separate entity basis. The proposed regulations eliminate many inconsistent combinations of single and separate entity treatment under the current regulations that lead to inappropriate results. Nevertheless, the rules of the proposed regulations reflect the basic principles underlying the current regulations. Accordingly, the results of most common intercompany transactions are not affected by the proposed regulations even though the analysis is changed. The proposed regulations replace the mechanical rules of the current regulations with a matching rule and an acceleration rule. These rules apply uniformly to ``period'' transactions (e.g., payment of currently deducted interest), sales of property and performance of capitalized services, and transactions involving the stock or obligations of members. Because the proposed regulations generally unify the rules for all intercompany transactions, many of the distinctions drawn by the current regulations between intercompany transactions, deferred intercompany transactions, and transactions involving stock or obligations of members, are eliminated as no longer necessary. The proposed regulations include numerous examples, but the first few examples under the matching and acceleration rules provide the guidance necessary for most common intercompany transactions. Additional examples illustrate the application of the proposed rules to less common transactions. The proposed regulations are a method of accounting to the extent they determine the timing of items. An item taken into account under these rules can be deferred, disallowed, or eliminated under other applicable law. A group's ability to change its manner of applying the final intercompany transaction regulations will be subject to the generally applicable rules for accounting method changes. Whether a change in method will be applied with an adjustment under section 481(a) or applied on a cut-off approach will be determined by the IRS. See also ``Proposed effective dates,'' discussed at F. of this preamble for the application of the final intercompany transaction regulations on a cut- off basis. 2. Definitions: Intercompany Transaction, Intercompany Item, and Corresponding Item In general, an intercompany transaction is a transaction between corporations that are members of the same consolidated group immediately after the transaction. The proposed regulations provide further guidance largely through examples. S is the member transferring property or providing services, and B is the member receiving the property or services. Each party to an intercompany transaction can have items of income, gain, deduction, and loss from the transaction (or from property acquired in the transaction). S's items are referred to as intercompany items and B's items are referred to as corresponding items. These items are generally taken into account under the matching and acceleration rules. For most transactions, S's intercompany items and B's corresponding items are their items from the intercompany transaction (or from property acquired in the intercompany transaction) determined on a separate entity basis. Issues arise under the current regulations regarding the effect of certain costs and expenses on the determination of intercompany items and corresponding items. For example, if S performs services for B, the extent to which S's costs are included in determining its intercompany income may not always be clear. The proposed regulations retain the approach of the current regulations by providing guidance largely through examples. The proposed regulations also continue the current approach of treating certain amounts as S's intercompany items even though S has not yet recognized or incurred them under its own method of accounting. Thus, in certain situations the rules can accelerate as well as defer intercompany items. S generally is not required, however, to take into account amounts that it will never recognize under its method of accounting merely to match B's corresponding items. Additional adjustments are made to the extent necessary to clearly reflect the group's income, including treating certain basis adjustments under the Code as items required to be taken into account. The matching rule of the proposed regulations generally focuses on B to redetermine the time S's intercompany items are taken into account. This approach is similar to the approach of the current regulations for deferred intercompany transactions. However, the matching rule applies to a wider range of transactions, and the roles of the parties might vary. For example, a single business arrangement may be composed of related transactions, with one member being S for one transaction and B for another. The proposed regulations require each transaction to be separately analyzed, and provide examples to identify which member is B and which is S in a transaction. The roles of the parties might also vary over time. For example, if two members engage in an interest rate notional principal contract, the member that is obligated to make the net payment in each period under the contract will vary depending on changes in interest rates. Because the net payment for each period is treated as a separate transaction, a member may be B in one period (as the payor) and S in another period (as the payee). 3. Matching Rule Under the proposed regulations, the matching rule is the principal rule for redetermining the timing and attributes of S's intercompany items and B's corresponding items on a single entity basis. In general, S's intercompany items and B's corresponding items are taken into account to produce the same effect on consolidated taxable income as if S and B were divisions of a single corporation. For purposes of treating S and B as divisions under the matching rule, S and B are treated as engaging in their actual transaction and owning any actual property in the transaction, operating separate trades or businesses, and having any special status (e.g., as a bank or insurance company) that they have under the Code. In addition to timing, the matching rule conforms the character and other attributes of S's intercompany items and B's corresponding items. For example, S might sell investment property to B, and B might hold the property for sale to customers in the ordinary course of business. S and B redetermine the attributes of their intercompany items and corresponding items to produce the same effect on consolidated taxable income as if they were divisions of a single corporation. Thus, the redetermination of character is based on the activities of both S and B and may require both S's items and B's items to be ordinary or capital. Because the attributes are redetermined by treating S and B as divisions, the matching rule also generally aggregates the holding periods of S and B with respect to property transferred in an intercompany transaction. For each consolidated return year, the matching rule requires S to take into account its intercompany items to reflect the difference between the corresponding items B takes into account and B's recomputed items (the corresponding items B would have taken into account if S and B were divisions of a single corporation). Comparing B's corresponding items and its recomputed items ordinarily will not be difficult. For example, if S sells property with a $70 basis to B for $100, and B later resells the property to a nonmember for $90, S's $30 gain is not taken into account until the resale. At that time, S's gain is taken into account to reflect the $30 difference between the $10 loss B takes into account and the recomputed $20 gain B would take into account if B had succeeded to S's $70 basis in a transfer between divisions of a single corporation. The character of S's $30 gain and B's $10 loss (and their holding period for the property) are redetermined by taking into account the activities of both S and B with respect to the property. Treatment as divisions of a single corporation applies only to S and B as the parties to the intercompany transaction. The activities of other members are generally not taken into account. Moreover, because treatment as divisions is solely for purposes of taking into account items from intercompany transactions, the treatment generally does not affect determinations by S and B with respect to items or holding periods in other transactions. The matching rule continues the trend of recent amendments to the intercompany transaction system by reducing the reliance on particular events and transactions to take items into account. Compare current Sec. 1.1502-13(l) with current Sec. 1.1502-13 (d) through (f). Because the matching rule focuses on B's items, if S sells land to B at a gain and B transfers the land outside the group in an exchange to which section 1031 applies, S's gain is not taken into account under the matching rule, even though the property is disposed of outside the group, if there is no difference between B's actual and recomputed items resulting from the exchange. Instead, S's gain remains deferred and is taken into account based on B's items with respect to the replacement property. The current regulations redetermine timing on a single entity basis, but generally determine character on a separate entity basis. This dual approach may result in conflicts because timing and character cannot always be separately analyzed under the Code. The current regulations only partially resolve these conflicts. See, e.g., Secs. 1.1502-13(c)(4)(ii) and (d)(3) (the character of S's deferred gain or loss taken into account as a result of B's depreciation is redetermined), and 1.1502-13(m)(1) (S is treated as disposing of property at the same time and in the same manner as B disposes of the property outside the group). The proposed regulations generally eliminate potential conflicts between timing and character by redetermining both the timing and the attributes of items on a single entity basis. This approach eliminates the need for the special rules under the current regulations. For example, if S sells depreciable property to B at a gain, B depreciates the property for a period, and B then resells it to a nonmember, no special rules are needed to redetermine the recapture income of S or B. Instead, the recapture income is redetermined as if S and B were divisions of a single corporation. This prevents the intercompany transaction from affecting consolidated taxable income, but preserves the location of each member's items. Redetermining attributes on a single entity basis is not expected to affect most intercompany transactions. Preserving the location of S's items, but redetermining their attributes on a single entity basis, may in certain cases require S's intercompany income or gain to be treated as excluded from gross income (or its intercompany deductions or losses to be treated as noncapital, nondeductible amounts). For example, if S has intercompany interest income from B, but B's corresponding interest deduction is disallowed under section 265, S's intercompany income must be excluded from gross income. This approach prevents an intercompany transaction from having an effect on consolidated taxable income, but preserves the location of items for stock basis and earnings and profits adjustments under Secs. 1.1502-32 and 1.1502-33. However, because of administrability concerns, S's intercompany income or gain generally can be treated as excluded from gross income only if B's corresponding item is a deduction or loss that, in the taxable year the item is taken into account, is permanently disallowed directly under another provision of the Code or regulations. Because it has the same effect as a deduction or loss that is permanently disallowed, exclusion is also permitted if B has a corresponding loss that is not recognized under section 311. For example, if S has property with a $70 basis and sells it to B for $100, and the property is subsequently distributed to a nonmember when it has a value of $90, B's $10 loss is not recognized under section 311(a). B's distribution results in all of S's $30 gain being taken into account, but $10 of the gain is excluded from gross income. Additional corresponding items that permit S's intercompany income or gain to be excluded from gross income may be identified by the Commissioner in future guidance, to the extent consistent with administrability concerns. Under the proposed regulations, the special asset basis rules of current Sec. 1.1502-31(a) are not needed. These rules originally were adopted to contrast with the intercompany transaction system applicable to pre-1966 consolidated return years. They are now encompassed by the general approach of the proposed regulations to use the provisions of the Code where possible. Consequently, the special asset basis rules were not included in recently proposed revisions to Sec. 1.1502-31. See CO-30-92 [1992-2 C.B. 627]. 4. Acceleration Rule The acceleration rule takes items into account immediately to the extent that they cannot be taken into account under the matching rule to produce the effect of treating S and B as divisions of a single corporation. The effect cannot be produced to the extent either the matching rule will not fully account for the items from an intercompany transaction in consolidated taxable income, or the intercompany transaction will be reflected by a nonmember. For example, if S or B becomes a nonmember, any remaining intercompany items and corresponding items can no longer be matched in the determination of consolidated taxable income. Moreover, S or B would reflect the intercompany transaction as a nonmember. The intercompany items are therefore taken into account immediately before S or B becomes a nonmember. Similar results would be required if B purchases property from S and transfers it to a partnership in a transaction to which section 721 applies (or to nonmember corporation in a transaction to which section 351 applies), because the partnership reflects the intercompany transaction by succeeding to B's cost basis in the property. If S and B had been divisions of a single corporation, S's transfer to B generally could not have created a cost basis to be reflected by the partnership in the property. The acceleration rule requires S to take its intercompany items into account immediately before the event rendering single entity treatment impossible. (If B had disposed of the property in an exchange with a nonmember to which section 1031 applies, the intercompany items would not be taken into account under the acceleration rule because the nonmember would not succeed to B's cost basis.) In limited circumstances, the acceleration rule will apply without the occurrence of an event separate from the intercompany transaction. This might occur if S's gain or loss from the sale of property to B exceeds the effect of the intercompany transaction on the basis of the property. For example, if B owns a building that is destroyed by fire and B uses its insurance proceeds to buy a replacement building from S, S's gain or loss will not conform to B's basis in the building because B's basis is determined under section 1033. If the amount of S's gain or loss exceeds the effect of the intercompany sale on the building's basis, S's gain or loss will not be fully taken into account under the matching rule because there will not be a sufficient difference between the corresponding items B takes into account and its recomputed items. Consequently, the acceleration rule applies at the time of the intercompany sale to take the excess amount into account. S's gain or loss is accelerated because it is not possible to treat S and B as divisions of a single corporation, and acceleration is the only administrable alternative. The acceleration rule has two provisions for determining the attributes of S's intercompany items. For intercompany transactions involving property, the attributes are redetermined under the principles of the matching rule by deeming B to resell the property to a nonmember affiliate (a transaction comparable to S's intercompany transaction). Thus, the attributes of S's intercompany items reflect B's activities with respect to the property. For example, if S was an investor in land sold to B, and B holds the land for sale to customers in the ordinary course of business at the time B becomes a nonmember, S's gain or loss taken into account under the acceleration rule may be ordinary. Because B is deemed to sell to a nonmember affiliate, any rules applicable to related party transactions apply to determine the attributes of S's items. See, e.g., section 1239 (relating to depreciable property). For intercompany transactions involving services or rentals, or other nonproperty transactions, the attributes of S's accelerated items are determined on a separate entity basis. For example, if S performs services that are capitalized by B, there is no deemed sale by B for purposes of determining the attributes of S's items. Instead, S's accelerated items remain ordinary items from its performance of services. The proposed regulations do not deem a sale to occur because S did not engage in a property transaction and B may never engage in the sale or exchange of property that would require S's items to be recharacterized as items from a property transaction. Like the current regulations, and consistent with the treatment under the intercompany transaction system of a consolidated group as a single entity, the proposed regulations do not accelerate items if the entire consolidated group is acquired by another consolidated group. 5. Simplifying Rules a. Inventory The current regulations generally treat intercompany transactions involving inventory like intercompany transactions involving other property. But see Secs. 1.1502-13(f)(1) (iv) and (viii) (a deferred amount attributable to stock in trade or inventory is taken into account as the result of a separate return year or a value write-down), and 1.1502-18 (special inventory adjustment). The proposed regulations continue to generally treat inventory transactions like other intercompany transactions. However, if S or B uses a dollar-value LIFO method of inventory accounting, the matching rule might be unadministrable because dollar-value LIFO measures aggregate inventory changes in terms of base-year dollars, and does not separately identify the items from particular transactions. For example, B is not able to determine when corresponding items with respect to each separate intercompany transaction are taken into account because of the substitution of inventory units and costs within the dollar-value LIFO method. Intercompany inventory transactions are typically routine transactions that occur in the normal course of business. Applying the matching and acceleration rules to dollar-value LIFO methods may be burdensome because of the potential for numerous additional computations and the inconsistencies with financial reporting of intercompany transactions. For example, S may compute intercompany inventory income and corresponding elimination for financial reporting purposes using a FIFO cost-flow assumption even though S and B use dollar-value LIFO for Federal income tax purposes. To simplify the matching computations, the proposed regulations permit S or B to use any reasonable method to take into account their items from intercompany inventory transactions. However, adjustments are required if the cumulative amount of intercompany items not taken into account by S under the method used significantly exceeds the cumulative amount that would not be taken into account by S under methods specifically provided in the proposed regulations. For example, a group may be able to use its current accounting methods or develop other simplified methods. However, the use of a FIFO cost-flow assumption could result in deferral that significantly exceeds the deferral that would be achieved under a LIFO cost-flow assumption. If a method is expected to be reasonable, but in fact produces a significant cumulative excessive deferral in any year, S must take into account an amount for that year which will eliminate the excess and make appropriate adjustments thereafter to reflect the amount taken into account. The proposed regulations specifically provide an ``increment averaging method'' and an ``increment valuation method.'' Under the increment averaging method, B determines the portion of its total inventory costs for the current year that are included in a layer of increment under its LIFO inventory method, and S defers a comparable portion of its intercompany inventory items from sales to B for the year. B computes the ratio of current-year costs of its layer of increment over total inventory costs incurred for the year. B's current-year costs are computed in a manner consistent with its method for valuing LIFO increments (e.g., earliest, latest, or average costs). If B uses a simplified method to allocate section 263A costs to inventory and does not allocate additional section 263A costs to specific items of LIFO inventory, B may compute the portion of its costs included in an increment without including section 263A costs in either the total costs or the costs included in a layer. B must compute its costs separately for each LIFO pool that receives intercompany purchases, and if more than one selling member transfers inventory into that pool in intercompany transactions, each selling member must take into account a comparable portion of its intercompany items. To the extent S defers its intercompany inventory items under the increment averaging method, S layers the items based on the corresponding layers of B's costs. S takes the deferred items into account under the matching rule as B takes into account its corresponding layers through subsequent decrements. The increment valuation method is similar to the increment averaging method. Under the increment valuation method, a ratio is determined based on the current-year costs of the layer of increment over the total costs incurred in the appropriate period used to value the increment. The appropriate period is the period of B's year used to determine current-year costs. This ratio is applied to S's intercompany inventory items computed with respect to intercompany inventory sales during the appropriate period. For example, if B determines current- year costs by reference to its earliest costs, and only the inventory costs incurred in B's first inventory turn are included for this purpose, the appropriate period is the period of B's year that includes its first inventory turn. S determines the amount of its total intercompany inventory items for a year under any reasonable method for allocating its inventory costs to intercompany transactions. If S uses a dollar-value LIFO inventory method and a decrement occurs for the year, S must reasonably take into account the costs of prior layers of increment. For example, S may compute its intercompany inventory income using its most recent costs incurred if S has an increment for the year and S uses the earliest acquisitions cost method to value increments. Similarly, S may use an average of its costs incurred during the year if S uses this method to value increments or if S does not experience a significant increment or decrement for the year. The current regulations determine whether inventory is disposed of outside the group by reference to B's method of inventory identification (e.g., FIFO, LIFO, or specific identification). Because the current regulations require B to consider the effect of its use of dollar-value LIFO, it is not anticipated that the proposed regulations will result in a significant change. Taxpayers can continue to use their current methods after the final intercompany transactions regulations apply if the current methods are reasonable. b. Reserve Accounting Reserve accounting is permitted only for special status members, and it is inappropriate to apply some aspects of reserve accounting on a single entity basis (e.g., where both parties to an intercompany transaction do not have the same special status). To the extent that reserve accounting should apply to intercompany transactions, the necessary adjustments to produce single entity results may be complex. The proposed regulations provide that a member's addition to, or reduction of, a reserve for bad debts that is maintained under section 585 or 593 is generally taken into account on a separate entity basis. But see ``Obligations of members,'' discussed at C.7. of this preamble (special rules for reserve deductions with respect to intercompany obligations). Similarly, if a member provides insurance to another member in an intercompany transaction, the transaction is taken into account by both members on a separate entity basis. c. Elections Section 1.1502-13(c)(3) of the current regulations provides that a group may elect with the consent of the Commissioner not to defer intercompany gain or loss from deferred intercompany transactions with respect to all or any classes of property. See also Rev. Proc. 82-36, 1982-1 C.B. 490 (a checklist and guidelines for requests under Sec. 1.1502-13(c)(3)). The proposed regulations continue to permit groups to request that items from intercompany transactions (other than transactions with respect to stock or obligations of members), be taken into account on a separate entity basis rather than under the intercompany transaction system. Any election under current Sec. 1.1502-13(c)(3) will remain in effect. As under current law, an election to take items into account on a separate entity basis does not apply for purposes of taking losses into account under section 267(f). Current Sec. 1.1502-13(f)(3) provides that the IRS may enter into a closing agreement with a group required to divest itself of a member by order of law. The closing agreement generally allows the group to take into account deferred gain or loss as if it had not disposed of the member (but not over more than 10 years). Closing agreements generally will not be entered into where the divestiture is occasioned by an acquisition after August 31, 1966. Consequently, this provision is eliminated under the proposed regulations as deadwood. Current Sec. 1.1502-13(j) provides that the IRS may enter into a closing agreement providing special treatment for public utilities. The proposed regulations also eliminate this provision as deadwood, because a request for a closing agreement must have been made on or before November 15, 1966. Any groups currently subject to a closing agreement under a deadwood provision eliminated by the proposed regulations will remain subject to the terms of the closing agreement. 6. Stock of Members Sections 1.1502-14 and 1.1502-31(b) of the current regulations provide special rules for distributions and other transactions with respect to stock of members. These stock rules combine single and separate entity treatment. The current regulations eliminate intercompany dividends from the gross income of the distributee. Section 301 distributions (whether or not dividends) first reduce the distributee member's basis in the distributing member's stock to zero, and then create an excess loss account in the stock. If appreciated property is distributed in a distribution to which section 301 applies, the current regulations provide that the distributing member recognizes gain under section 311 that is deferred and taken into account in the same manner as if it were recognized in a deferred intercompany transaction. The distributee's basis in the property received is generally its fair market value. No special rules are provided under the current regulations for reorganization transactions and transactions to which section 355 applies. Liquidating distributions are governed by either section 331 or 332 as to the distributee, and section 336 or 337 as to the distributing member. Under Sec. 1.1502-34, the stock ownership of all members is aggregated to determine whether section 332 applies to the distributee. Under section 337(c), however, the ownership is not aggregated to determine whether section 337 applies to the distributing member. Gain or loss recognized by the distributing member under section 336 is deferred under the current regulations and taken into account as if it were recognized in an intercompany transaction. If the distributee member would recognize gain or loss from the liquidation under section 331, the distributee's gain or loss is limited under the current regulations, but preserved by determining the distributee's basis in the distributed property by reference to the distributee's basis in the stock surrendered. Other recent consolidated return regulation projects address aspects of intercompany distributions and other transactions with respect to stock of members. See, e.g., Sec. 1.1502-80(b) (non- applicability of section 304 to transactions between members), proposed Sec. 1.1502-80(c) (deferral of section 165(g)), and proposed Sec. 1.1502-80(d) (replacing current Sec. 1.1502-14(a)(2), and providing for the non-applicability of section 301(c)(3) to transfers between members). The proposed regulations generally apply the rules of the Code and the matching and acceleration rules to transactions with respect to stock of members. For example, if S sells to B the stock of another member (T) at a gain, S's gain is taken into account under the matching and acceleration rules. The proposed regulations provide that intercompany distributions are generally not included in the gross income of the distributee member. However, this exclusion applies to a distribution from a subsidiary only to the extent there is a corresponding negative adjustment reflected under Sec. 1.1502-32 in the distributee's basis in the distributing member's stock. By conditioning the exclusion on a negative adjustment, the concerns with dividend stripping transactions illustrated by current Sec. 1.1502-32(k) are minimized. Intercompany distributions are taken into account for all Federal income tax purposes when the members become entitled to them (generally the record date) or, if earlier, when they are taken into account under the Code (e.g., under section 305(c)). Excluding intercompany dividends from gross income is intended to have the same effect as eliminating them under the current regulations, but it conforms to the terminology generally used under the Code. For example, the holdings in Revenue Ruling 72-230, 1972-1 C.B. 209 (the effect of dividend elimination on the source of dividends paid for purposes of section 861(a)(2)) and Revenue Ruling 79-60, 1979-1 C.B. 211 (the effect of dividend elimination on personal holding company status), and the application of section 1059, are not affected. The matching and acceleration rules apply to the distributing member's gain under section 311(b) from intercompany distributions of property. The proposed regulations provide that the distributing member's loss from an intercompany distribution of property is also recognized under the principles of section 311(b) and is taken into account under the matching and acceleration rules. In effect, intercompany distributions are equated with intercompany sales. The recognition of loss from distributions applies only to intercompany distributions. For example, S's loss from distributing property to B is recognized, but S's loss from distributing the property to a nonmember is not recognized. Under the matching rule, a buying member's nonrecognition of loss from the distribution of property to a nonmember may result in prior intercompany gain (or loss) from the property being recharacterized as excluded from gross income (or as a noncapital, nondeductible amount). For example, if S sells property to B at a loss, and B later distributes it to a nonmember at no gain or loss, S's intercompany loss is recharacaterized as a noncapital, nondeductible amount. In effect, a group is treated as a single entity with respect to the nonrecognition of loss under section 311 on distributions to nonmembers. The proposed regulations provide special rules to minimize the effect on consolidated taxable income of boot in intercompany reorganizations. Boot received by a member as a shareholder in an intercompany reorganization is treated as received in a separate transaction. Thus, consolidated taxable income is generally the same whether the boot is distributed as part of the reorganization, before it, or after it. The proposed boot rules do not apply to a reorganization if any participant becomes a member or becomes a nonmember as part of the same plan or arrangement. The proposed rules do not reflect any decisions about boot received in other reorganizations such as those involving unrelated corporations or affiliated corporations filing separate returns. The tax results of reorganizations straddling consolidation remain under study because of the significant differences between boot transferred between members of a consolidated group and boot transferred between separate return corporations. The proposed regulations provide that if a member acquires its own stock in an intercompany transaction, its basis in that stock is treated as eliminated for purposes of taking intercompany items into account with respect to the stock. Thus, if S distributes B stock to B, S's gain or loss from the distribution is taken into account immediately to reflect the elimination of basis. Compare Gen. Coun. Mem. 39,608 (March 5, 1987) (S's gain from the distribution of B stock to B is deferred until, for example, B sold the same shares to a nonmember). On the other hand, if S transfers to B the stock of T, and B subsequently transfers the stock to T in exchange for new T stock in a recapitalization to which section 368(a)(1)(E) applies, S's intercompany gain or loss remains deferred and is taken into account by reference to the replacement stock. See ``Successor corporations and property,'' discussed at C.9. of this preamble. Under the current regulations, intercompany gain or loss from transferring the stock of a member is taken into account when that member liquidates under section 332. For example, if S sells all of the stock of T to B at a gain, and T later liquidates in an unrelated transaction to which section 332 applies, S's gain is taken into account. If the basis of T's assets conformed to the basis of its stock before S's sale, S's gain from the T stock will be duplicated by gain that the group later recognizes from the former T assets (because B succeeds to T's basis in the assets). The proposed regulations provide relief from this duplication in limited circumstances. Under the first rule, if section 332 applies to T's liquidation and B transfers substantially all of T's assets to a new member (new T), the transfer to new T is treated as pursuant to the same plan or arrangement as the liquidation and S's gain generally will not be taken into account. Instead, S's gain is taken into account by reference to the stock of new T. New T must be formed and the relief elected by the group within specified time periods. Similar principles apply if B's basis in the T stock is eliminated in a transaction comparable to the section 332 liquidation (e.g., a downstream merger). Under the second rule, if T's liquidation is deemed to occur under section 338(h)(10) as a result of a qualified stock purchase of T, B is treated, subject to certain limitations, as recognizing any loss or deduction it would recognize (determined after adjusting stock basis under Sec. 1.1502-32) if section 331 applied to the deemed liquidation. In effect, S's income or gain is offset by B's deduction or loss in determining consolidated taxable income (although S and B must take into account their separate items). Similar principles apply if T transfers all of its assets to a nonmember and completely liquidates in a transaction comparable to a section 338(h)(10) transaction. The third rule applies if member stock is transferred in an intercompany transaction and subsequently distributed in a second intercompany transaction to which section 355 applies. S's gain or loss might otherwise be taken into account under the proposed regulations because the basis adjustments to the T stock under section 358 may result in an inability to match the T stock basis with S's gain. Relief is provided by permitting the group to elect to treat B's distribution as subject to sections 301 and 311 rather than section 355, so that matching with S's gain remains possible. This prevents S's gain from being taken into account immediately if matching remains possible, but B's gain or loss from its distribution will also be taken into account under the matching and acceleration rules. 7. Obligations of Members Current Sec. 1.1502-13 provides that the general rules for intercompany transactions apply to the payment of interest and premium on intercompany obligations. Current Sec. 1.1502-14(d) provides for the deferral of a member's gain or loss from the disposition of another member's obligation. Similar rules apply to a member's deduction for the worthlessness of an obligation and the deduction for an addition to a reserve for bad debts with respect to an obligation. If a member's obligation is transferred to a nonmember (or the holding member becomes a nonmember), the deferred amount is generally taken into account ratably over the remaining term of the obligation. In effect, the deferred amount is reflected in consolidated taxable income under rules similar to the rules that existed under the Code in 1966 for original issue discount or amortizable bond premium. If the obligation remains within the group, the deferred amount is generally not taken into account until the obligation is redeemed. Thus, the gains and losses of the members with respect to the obligation generally offset each other in determining consolidated taxable income. Section 108(e)(4) adopts a limited single entity approach by treating the acquisition of debt by a person related to the debtor as comparable to the debtor's acquisition of its own debt. The regulations implementing section 108(e)(4) include some circumstances in which the holder of the debt becomes a person related to the debtor. Under the proposed regulations, the matching and acceleration rules apply to intercompany obligations. An obligation is defined to include securities described in section 475(c)(2) (D) and (E), and comparable securities with respect to commodities. For example, an interest rate notional principal contract between members is an obligation between the counterparties. An obligation is an intercompany obligation during the period its parties are members. The proposed regulations continue to treat each payment or accrual of interest (and each payment or accrual of premium) on an intercompany debt as a separate intercompany transaction, and the income is matched with the deduction. Similarly, each periodic and nonperiodic payment with respect to an intercompany notional principal contract is a separate intercompany transaction. Special rules are proposed for two categories of transactions: (1) Transactions in which an intercompany obligation becomes a nonintercompany obligation (or remains an intercompany obligation but gain or loss is realized with respect to it); and (2) transactions in which a nonintercompany obligation becomes an intercompany obligation. In both categories, an obligation is generally deemed to be satisfied and, if it remains outstanding, reissued. There are, however, significant differences as to how the transactions are deemed to occur. Under the first category, if S holds a note of B with a $100 basis and stated redemption price at maturity, and S sells the note to a nonmember for $75, B is treated as satisfying its obligation to S for $75 immediately before S's sale, and issuing a new note directly to the nonmember for $75 with a $100 stated redemption price at maturity. The proposed regulations match both the timing and the attributes of S's items and B's items resulting from the deemed satisfaction. Similar principles apply if the note is transferred by S to another member in an intercompany transaction, the note is marked to market under section 475, or if S or B becomes a nonmember (i.e., the note is deemed to be satisfied by B and reissued). Similar principles also apply if the obligation is a notional principal contract or other nondebt intercompany obligation. The effect on consolidated taxable income for transactions in the first category is similar to the effect under current Sec. 1.1502- 14(d). In both cases, reflection of the net gain or loss on consolidated taxable income is deferred in a manner consistent with time value of money principles. Under the proposed regulations, however, if S sells B's obligation to a nonmember at a loss, S's loss and B's gain from the deemed satisfaction are taken into account immediately and offset each other, and the discount from the deemed reissuance is taken into account over time by B (as the issuer) rather than by S. This approach more accurately adjusts the stock basis of S and B each year, and is closer to the results under common law principles for debtors and creditors in a parent-subsidiary relationship. The approach of the proposed regulations in many respects treats B's obligation as first existing only after it is sold by S to the nonmember. Thus, if a nonmember buys B's note from S at a discount, the nonmember will hold the note with original issue discount to which section 1272 applies, rather than market discount to which sections 1276 through 1278 apply. Under the second category, if a nonmember (X) holds B's note with a $100 basis and stated redemption price at maturity, and X sells the note to S for $75, B is treated as satisfying its obligation to S for $75 immediately after S's purchase, and issuing a new note to S for $75 with a $100 stated redemption price at maturity. The treatment for transactions under the second category is similar in many respects to the treatment of B under section 108(e)(4). Because the focus of section 108(e)(4) is to prevent avoidance of discharge of indebtedness income, however, that section does not adequately address the single entity treatment of consolidated groups. Consequently, the proposed regulations apply to cases beyond the scope of section 108(e)(4), such as to the acquisition of debt at a premium and to all cases in which a corporation holding B's debt becomes a member (whether or not there is an avoidance view, and whether or not the holder is already a related party). The deemed satisfaction and reissuance under the proposed regulations applies to both the issuer and the holder, and the character of their respective items under the Code is not modified (and therefore may not match). Nevertheless, the amount at which an obligation is satisfied under Sec. 1.108-2 represents a compromise that is incorporated into the proposed regulations. In addition, the proposed regulations adopt the exceptions to section 108(e)(4) for special cases, such as securities dealers. Because a member's adjustments to a reserve for bad debts under section 585 or 593 reflect its general bad debt experience, rather than the value of any particular intercompany obligation that it holds, the proposed regulations provide special rules. Reserve deductions with respect to intercompany obligations are deferred in a manner similar to the treatment of reserves under current Sec. 1.1502-14(d). This approach prevents the reserve accounting method of one member from affecting the income of another member (or affecting consolidated taxable income) through a bad debt reserve deduction with respect to an intercompany debt. Section 163(e)(5) provides special rules for original issue discount on an applicable high yield discount obligation (AHYDO). The concerns reflected in the AHYDO rules do not apply to intercompany debt, and the Code provides only a partial recast for the dividend equivalent portion of the disqualified portion of the original issue discount. Consequently, to simplify the applicable rules, the proposed regulations exclude intercompany obligations from the application of section 163(e)(5). 8. Anti-Avoidance Rules Although the proposed regulations shift the emphasis of the intercompany transaction system toward single entity treatment, tension remains between the single entity and separate entity treatment of consolidated groups. The proposed regulations do not address every interaction with other consolidated return regulations and other rules of law. To ensure that the proposed regulations achieve neutrality in the overall determination of consolidated taxable income, adjustments may be required. For example, if the approach of the proposed regulations in matching the attributes of S's intercompany items and B's corresponding items facilitates ``mirror subsidiary'' transactions determined by Congress to be inappropriate, adjustments must be made. See H.R. Rep. No. 391, 100th Cong., 1st Sess. 1081-84 (1987). Adjustments must be made under the proposed regulations if a transaction is engaged in or structured with a principal purpose to avoid treatment as an intercompany transaction, or to avoid the purposes of the proposed regulations. For example, in the case of a ``mirror subsidiary'' transaction, the adjustments would generally conform to the intent of the mirror legislation to ``require the recognition of corporate-level gain whenever an appreciated subsidiary is sold or distributed outside the economic unit of [a consolidated] group.'' Id. In addition to these adjustments, the Code (e.g., sections 337(d), 446, and 482) and general principles of tax law (e.g., the substance- over-form doctrine, and the tax benefit rule) can apply to require proper measurement of taxable income (and tax liability). 9. Successor Corporations and Property Under the current regulations, if S's assets are acquired in a transaction to which section 381(a) applies, its deferred gains and losses are inherited by the member that receives the ``greatest portion of the assets (measured by fair market value).'' Commentators have suggested that this rule can be used to facilitate the breakup of acquired corporations without corporate-level tax, contrary to the intent of the ``mirror'' subsidiary legislation. Moreover, they have raised questions as to the operation of this rule in many circumstances. For example, the reference to fair market value does not identify whether liabilities are to be taken into account to determine the value on a net basis. The proposed regulations generally incorporate successor asset and successor person principles. References under the proposed regulations to an asset or to a member include, as the context may require, references to a successor asset or person. The proposed regulations provide that, if there is more than one successor, the successors take into account the predecessor's intercompany items in a manner that is consistently applied and reasonably carries out the purposes of the proposed regulations and applicable provisions of law. No inference is intended by this rule as to the application of section 381 or other successor principles to attributes other than intercompany items and corresponding items. The proposed regulations retain the basic approach of the current regulations by not requiring acceleration solely because a group terminates from its acquisition by another consolidated group. Unlike the current regulations, however, the proposed regulations do not require all of the members immediately before the acquisition to become members of the surviving consolidated group. Instead, the proposed regulations accelerate only the items from transactions involving corporations that do not become members of the surviving consolidated group. D. Explanation of Proposed Section 267(f) Rules Section 267(a) disallows loss on certain sales or exchanges of property between related parties. Section 267(f) provides for deferral of loss on the sale or exchange of property between members of a controlled group, rather than disallowance of the loss under section 267(a). The section 267(f) rules are generally intended to conform to the intercompany transaction rules applicable to consolidated groups even though the definition of a controlled group is broader than that of a consolidated group. The legislative history indicates that exceptions to deferral might be provided to properly reflect the amount of net income from a transaction. For example, if an accrual method member of a controlled group takes into account income with respect to the face amount of a note receivable, and later recognizes loss from the sale of that note to another member of the controlled group at a discount, the loss would not be deferred to the extent it does not exceed the income taken into account. See H.R. Rep. No. 861, 98th Cong., 2d Sess. 1032-34 (1984). The current regulations applicable to controlled groups generally conform to the basic intercompany transaction rules applicable to consolidated groups. See Secs. 1.267(f)-1T and 1.267(f)-2T. Modifications are made to reflect the broader application of section 267(f). For example, although there are no subgroup rules for intercompany transactions between members of a consolidated group, deferral of loss continues under section 267(f) as long as S and B remain in a controlled group relationship with each other. The current regulations also provide that if S sells property to B at a loss, and the property is still owned by B when S ceases to be a member of the same controlled group, S never takes the loss into account. Instead, B's basis in the property is increased by an amount equal to S's unrestored loss. The proposed regulations retain the basic approach of the current regulations but simplify their operation by more generally incorporating the consolidated return rules. The proposed regulations eliminate the rule that transforms S's loss into additional basis in the transferred property when S ceases to be a member of the controlled group. Instead, the proposed regulations generally allow S's loss immediately before it ceases to be a member. This conforms to the consolidated return rules, and eliminates the need for special rules. An anti-avoidance rule is adopted, however, to prevent the purposes of section 267(f) from being circumvented, for example, by using the proposed rule to accelerate S's loss. E. Other Applicable Rules 1. Methods of Accounting Under current Sec. 1.1502-17(a), each member is generally permitted to determine its own method of accounting as if separate returns were filed. Thus, the members may have different methods for similar trades or businesses. If, however, B acquires assets from S in a transaction to which section 381 applies, B might be required to use the same method of accounting as S. See, e.g., section 381(c)(4). The matching rule proposed in Sec. 1.1502-13 relies on the accounting methods of B to determine the timing of S's intercompany items. Because B's accounting methods generally control S's timing, a group might be able to frustrate the principles of single entity treatment under Sec. 1.1502-13 by rearranging its activities to use an accounting method that would not be available if S and B were divisions of a single corporation. Under the proposed regulations, if B directly or indirectly acquires an activity of S or undertakes S's activity, with the principal purpose to avail the group of an accounting method that would be unavailable without securing the Commissioner's consent if S and B were treated as divisions of a single corporation, B may be required to use S's accounting method for the acquired or undertaken activity or secure consent from the Commissioner for a different method. 2. Special Inventory Adjustment Current Sec. 1.1502-18 requires a special adjustment relating to intercompany profit from inventory transactions if an affiliated group filing separate returns elects to file consolidated returns. This adjustment has historically been included in the consolidated return regulations. It is intended to prevent the members' income from being reduced when the group switches from separate to consolidated returns. For example, if S and B are affiliated but file separate returns for Year 1 and S manufactures inventory for $75 that is sold to B for $100, S's $25 intercompany profit is taken into account in Year 1 and B has a $100 cost basis in the inventory. If S recognizes another $25 of intercompany profit in Year 2, and B sells the inventory purchased from S in Year 1, S's additional $25 profit is taken into account in Year 2 and B recovers its cost basis in the inventory purchased in Year 1. If, however, the group shifts to consolidated returns for Year 2, S's additional $25 profit is deferred under Sec. 1.1502-13 but B still recovers its cost basis. Thus, the shift to consolidated returns reduces the group's aggregate income in Year 2. If S and B continue the same intercompany activity year after year, the one-time reduction is effectively a permanent reduction. To prevent a reduction in taxable income, the current regulations provide for a special inventory adjustment to increase the group's consolidated taxable income for Year 2 by S's $25 intercompany profit from Year 1, to the extent that it is reflected in B's opening inventory for Year 2. The adjustment might ultimately be reversed in later years if, for example, B's ending inventory purchased from S is reduced or the group ceases to file consolidated returns. Commentators argue that Sec. 1.1502-18 reaches an inappropriate result, and that its effect can be avoided, for example, by causing S to transfer its assets to a lower-tier member in a transaction to which section 351 applies (or otherwise to cease its intercompany sales). To simplify the intercompany transaction system, the proposed regulations eliminate the special inventory adjustment. Any remaining unrecovered inventory amount under Sec. 1.1502-18(c) (or its equivalent under Sec. 1.1502-18(f)) is recovered under the principles of those rules in the first taxable year ending on or after the date final regulations are filed with the Federal Register. The unrecovered inventory amount can be recovered only to the extent it was previously included in taxable income. 3. Attribute Reduction (Section 108(b)) The proposed regulations provide rules to prevent avoidance of the attribute reduction required under section 108(b). Several issues regarding the application of section 108 to consolidated groups are under study. For example, single entity treatment for consolidated group attribute reduction under section 108(b) is being considered in connection with regulations being developed. The proposed regulations are not intended to affect any other aspects of the application of section 108. 4. Applicability of Section 1031 The current regulations do not provide special rules for intercompany transactions to which section 1031 applies. Section 1031 treatment for intercompany transactions is inconsistent with the general approach of the proposed regulations. If the members had been divisions of a single corporation, the basis of one property could not be substituted as the basis for another property. Although section 1031(f) limits the planning opportunities from certain basis shifts, the limitations do not adequately address the single entity treatment of consolidated groups under the proposed regulations. To conform the treatment of like-kind exchanges more closely to the general treatment of intercompany transactions under the proposed regulations, the proposed regulations provide that section 1031 does not apply to intercompany transactions. Any gain or loss of the members will be taken into account under the matching and acceleration rules. F. Proposed Effective Dates The proposed intercompany transaction regulations generally apply to intercompany transactions occurring in years beginning on or after the date the final regulations are filed with the Federal Register. Prior intercompany transactions will generally continue to be subject to the prior regulations under section 1502 as in effect with respect to the transaction. Because an intercompany transaction can occur in part under the current regulations and in part under the proposed regulations, the current regulations (rather than the proposed regulations) will continue to apply to take into account transactions that have already been taken into account in part under the current regulations. This approach prevents duplication or omission of items from a transaction, and treats items consistently. To prevent manipulation, the final regulations (and not prior law) apply to certain transactions engaged in or structured on or after April 8, 1994. The final regulations apply if the transaction is engaged in or structured with a principal purpose to avoid the final regulations, to duplicate, omit, or eliminate an item in determining taxable income (or tax liability), or to treat items inconsistently. In these cases, appropriate adjustments must be made in years beginning on or after [the date the final regulations are filed with the Federal Register], to prevent the avoidance, duplication, omission, elimination, or inconsistency. The methods of accounting provided in the final regulations will be required of all groups. If the final regulations are adopted on the proposed ``cut-off'' basis, no request for permission to make the change, or to make an adjustment under section 481(a), will be necessary. Special Analyses It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Code, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business. Comments and Public Hearing Before these proposed regulations are adopted, consideration will be given to any written comments that are submitted timely (preferably a signed original and eight copies) to the IRS. All comments will be available for public inspection and copying in their entirety. Two public hearings on the proposed regulations will be held. See the notice of public hearings on proposed rulemaking published elsewhere in this issue of the Federal Register. List of Subjects in 26 CFR Part 1 Income taxes, Reporting and recordkeeping requirements. Proposed Amendments to the Regulations Accordingly, 26 CFR part 1 is proposed to be amended as follows: PART 1--INCOME TAXES Paragraph 1. The authority citation for part 1 is amended by removing the entries for sections ``1.469-1, 1.469-1T, 1.469-2, 1.469- 2T, 1.469-3, 1.469-3T, 1.469-5, 1.469-5T and 1.469-11'', ``1.1502-13'', ``1.1502-13T'', ``1.1502-14'', and ``1.1502-14T'' and adding the following: Authority: 26 U.S.C. 7805 * * * Section 1.108-3 also issued under 26 U.S.C. 108, 267, and 1502. * * * Section 1.267(f)-1 also issued under 26 U.S.C. 267 and 1502. * * * Section 1.460-4 also issued under 26 U.S.C. 460 and 1502. * * * Section 1.469-1, 1.469- 1T, 1.469-2, 1.469-2T, 1.469-3, 1.469-3T, 1.469-5, 1.469-5T, and 1.469-11 also issued under 26 U.S.C. 469. * * * Section 1.1502-13 also issued under 26 U.S.C. 108, 337, 446, 1275, 1502 and 1503. * * * Section 1.1502-17 also issued under 26 U.S.C. 446 and 1502. Section 1.1502-18 also issued under 26 U.S.C. 1502. * * * Section 1.1502-26 also issued under 26 U.S.C. 1502. * * * Section 1.1502-33 also issued under 26 U.S.C. 1502. * * * Par. 2. In the list below, for each location indicated in the left column, remove the language in the middle column from that section, and add the language in the right column. ------------------------------------------------------------------------ Affected section Remove Add ------------------------------------------------------------------------ 1.167(a)-(11)(d)(3)(v)(b) Paragraph (c) of........ , 1st sentence. 1.263A-1T(b)(2)(vi)(B), A deferred intercompany An intercompany 2nd sentence. transaction. transaction. 1.263A-1T(e)(1)(ii), 1st A deferred intercompany An intercompany sentence. transaction. transaction. 1.263A-1T(e)(1)(ii), 4th 1.1502-13(c)(2)......... 1.1502-13. sentence. 1.263A-1T(e)(1)(ii), 4th Deferred. sentence. 1.263A-1T(e)(1)(ii), 7th Deferred intercompany Intercompany sentence. transaction. transaction. 1.263A-1T(e)(1)(ii), 7th Defined................. As used. sentence. 1.263A-1T(e)(1)(iii)(A) 1.1502-13(c)............ 1.1502-13. Example, 2nd sentence. 1.263A-1T(e)(1)(iii)(A) 1.1502-13(c)............ 1.1502-13. Example, 4th sentence. 1.338-4(f)(4) Example (2) 1.1502-13(f)............ 1.1502-13. (a). 1.341-7(e)(10)........... Paragraph (c)(1) of Sec. Sec. 1.1502-13. 1.1502-14. 1.861-8T(d)(2)(i), 1.1502-13(c)(2)......... 1.1502-13. concluding text. 1.861-8T(d)(2)(i), Deferred. concluding text. 1.861-8T(d)(2)(i), 1.1502-13(a)(2)......... 1.1502-13. concluding text. 1.861-9T(g)(2)(iv), Deferred. paragraph heading. 1.861-9T(g)(2)(iv), 1st Deferred intercompany Intercompany sentence. transactions transactions. 1.1502-3(a)(2)........... 1.1502-13(a)(1)......... 1.1502-13(b). 1.1502-4(j) Example (1), Paragraph (d), (e), or 1.1502-13. 8th sentence. (f) of Sec. 1.1502-13. 1.1502-4(j) Example (1), Paragraph (d), (e), or 1.1502-13. 2nd sentence after chart. (f) of Sec. 1.1502-13. 1.1502-9(f) Example (6).. 1.1502-13(f)............ 1.1502-13. 1.1502-12(a)............. Secs. 1.1502-13 and Sec. 1.1502-13. 1.1502-14. 1.1502-12(g)(2).......... A deferred intercompany An intercompany transaction as defined transaction as in Sec. 1.1502-13(a)(2). defined in Sec. 1.1502-13. 1.1502-22(a)(3).......... 1.1502-14,.............. ................... 1.1502-22(a)(5) Example Paragraph (d), (e), or Sec. 1.1502-13. (i). (f) of Sec. 1.1502-13. 1.1502-26(b)............. Paragraph (a)(1) of Sec. Sec. 1.1502-13. 1.1502-14. 1.1502-47(e)(4)(iii)..... Secs. 1.1502-13(f), Secs. 1.1502-13, 1.1502-14, 1.1502-18,. 1.1502-18. 1.1502-47(e)(4)(iv) Deferred intercompany Intercompany Example 4, 3d sentence. transactions (see Sec. transactions (see 1.1502-13(a)(2)). Sec. 1.1502-13). 1.1502-47(e)(4)(iv) 1.1502-13(f)(1)(iv)..... 1.1502-13. Example 4, 4th sentence. 1.1502-47(e)(4)(iv) Deferred intercompany Intercompany Example 4, chart header. transactions between. transactions between. 1.1502-47(e)(4)(iv) 1.1502-13(f)(1)(iv)..... 1.1502-13. Example 4, chart header. 1.1502-47(f)(3).......... 1.1502-14. 1.1502-47(r), 2nd Deferred. sentence. 1.1503-2(d)(4) Example 1 Deferred. (iii), 4th sentence. 1.1503-2(d)(4) Example 1 1.1502-13(a)(2)......... 1.1502-13. (iii), 4th sentence. ------------------------------------------------------------------------ Par. 3. Section 1.108-3 is added to read as follows: Sec. 1.108-3 Intercompany losses and deductions. (a) General rule. This section applies to certain losses and deductions from the sale, exchange, or other transfer of property between corporations that are members of a consolidated group or a controlled group (an intercompany transaction). See section 267(f) (controlled groups) and Sec. 1.1502-13 (consolidated groups) for applicable definitions. For purposes of determining the attributes to which section 108(b) applies, a loss or deduction not yet taken into account under section 267(f) or Sec. 1.1502-13 (an intercompany loss or deduction) is treated as basis described in section 108(b) that the transferor retains in property. For example, if S and B are corporations filing a consolidated return, and S sells land with a $100 basis to B for $90 and the $10 loss is deferred under section 267(f) and Sec. 1.1502-13, the deferred loss is treated for purposes of section 108(b) as $10 of basis that S has in land (even though S has no remaining interest in the land sold to B) and is subject to reduction under section 108(b)(2)(E). To the extent S's loss is reduced, it can not thereafter be taken into account under section 267(f) or Sec. 1.1502-13. Similar principles apply, with appropriate adjustments, if S and B are members of a controlled group and S's loss is deferred only under section 267(f). (b) Effective date. This section applies with respect to discharges of indebtedness occurring on or after [the date that is 60 days after final regulations are filed with the Federal Register. Sec. 1.167(a)-11 [Amended] Par. 4. Section 1.167(a)-11(d)(3)(v)(e) is amended by removing the second sentence of Example (3). Par. 5. Section 1.267(f)-1 is revised to read as follows: Sec. 1.267(f)-1 Controlled groups. (a) In general--(1) Purpose. This section provides rules under section 267(f) to defer losses and deductions from certain transactions between members of a controlled group (intercompany sales). The purpose of the deferral is to prevent tax avoidance from allowing the loss or deduction of the selling member (S) without the corresponding inclusion of the buying member (B). (2) Application of consolidated return principles. Under this section, S's loss or deduction from an intercompany sale is taken into account under the timing principles of Sec. 1.1502-13 (intercompany transactions between members of a consolidated group), treating the intercompany sale as an intercompany transaction. For this purpose: (i) The matching and acceleration rules of Sec. 1.1502-13(c) and (d), the definitions and operating rules of Sec. 1.1502-13(b) and (j), and the simplifying rules of Sec. 1.1502-13(e)(1) apply with the adjustments in paragraphs (b) and (c) of this section to reflect that this section-- (A) Applies on a controlled group basis rather than consolidated group basis; and (B) Generally affects only the timing of a loss or deduction, and not its attributes (e.g., its source and character) or the holding period of property. (ii) The special rules under Sec. 1.1502-13(f) (stock of members) and (g) (obligations of members) apply under this section only to the extent that the transaction is also an intercompany transaction to which Sec. 1.1502-13 applies. (iii) Any election under Sec. 1.1502-13 to take items into account on a separate entity basis does not apply under this section. See Sec. 1.1502-13(e)(3). (3) Other law. The rules of this section apply in addition to other applicable law. For example, to the extent a loss or deduction deferred under this section is from a transaction that is also an intercompany transaction under Sec. 1.1502-13(b)(1), the loss or deduction is also subject to recharacterization under Sec. 1.1502-13. See also sections 269 (acquisitions to evade or avoid income tax) and 482 (allocations among commonly controlled taxpayers). Any loss or deduction taken into account under this section can be deferred, disallowed, or eliminated under other applicable law. See, e.g., section 1091 (loss eliminated on wash sale). (4) Construction. The rules of this section must be applied in a consistent manner that reasonably carries out their purposes, taking into account all of the facts and circumstances, the underlying economic arrangement, and applicable Federal income tax accounting principles. For example, the rules must not be applied to accelerate or duplicate S's losses or deductions. (b) Definitions and operating rules. The definitions in Sec. 1.1502-13(b) and the operating rules of Sec. 1.1502-13(j) apply under this section with appropriate adjustments, including the following: (1) Intercompany sale. An intercompany sale is a sale, exchange, or other transfer of property between members of a controlled group, if it would be an intercompany transaction under the principles of Sec. 1.1502-13, determined by treating the references to a consolidated group as references to a controlled group and by disregarding whether any of the members join in filing consolidated returns. (2) S's losses or deductions. Unless the intercompany sale is also an intercompany transaction to which Sec. 1.1502-13 applies, S's losses or deductions subject to this section are determined on a separate entity basis. For example, the principles of Sec. 1.1502-13(b)(2)(i)(C) (treating certain amounts not yet recognized as items to be taken into account) do not apply. A loss or deduction is from an intercompany sale whether it is directly or indirectly from the intercompany sale. (3) Controlled group; member. For purposes of this section, a controlled group is defined in section 267(f). Thus, a controlled group includes a FSC (as defined in section 922) and excluded members under section 1563(b)(2), but does not include a DISC (as defined in section 992). Because corporations may be controlled group members without joining in the filing of consolidated returns or being owned through a common parent, corporations remain members of a controlled group as long as they remain in a controlled group relationship with each other. For example, corporations become nonmembers with respect to each other when they cease to be in a controlled group relationship with each other, rather than by having a separate return year (described in Sec. 1.1502-13(j)(4)). Further, the principles of Sec. 1.1502-13(j)(3) (former common parent treated as continuation of group) apply to any corporation if, immediately before it becomes a nonmember, it is both the selling member and the owner of property with respect to which a loss or deduction is deferred (whether or not it becomes a member of a different controlled group filing consolidated or separate returns). (4) Consolidated taxable income. References to consolidated taxable income (and consolidated tax liability) include references to the combined taxable income of the members (and their combined tax liability). For corporations filing separate returns, it ordinarily will not be necessary to actually combine their taxable incomes (and tax liabilities) because the taxable income (and tax liability) of one corporation does not affect the taxable income (or tax liability) of another corporation. (c) Matching and acceleration principles of Sec. 1.1502-13--(1) General rule. Under this section, S's losses and deductions are deferred until they are taken into account under the timing principles of the matching and acceleration rules of Sec. 1.1502-13 (c) and (d), with appropriate adjustments. For example, if S sells depreciable property to B at a loss, S's loss is deferred and taken into account under the principles of the matching rule of Sec. 1.1502-13(c) to reflect the difference between B's depreciation taken into account with respect to the property and the depreciation that B would take into account if S and B were divisions of a single corporation; if S and B subsequently cease to be in a controlled group relationship with each other, S's remaining loss is taken into account under the principles of the acceleration rule of Sec. 1.1502-13(d). The matching and acceleration rules are not applied under this section to affect the attributes of an item, or cause it to be taken into account before it is taken into account under the member's method of accounting on a separate entity basis. Similarly, the matching and acceleration rules are not applied under this section to affect the timing or attributes of B's items. (2) Adjustments to the timing principles of Sec. 1.1502-13 (c) and (d). For purposes of this section, the adjustments to Sec. 1.1502-13 (c) and (d) include the following: (i) Different taxable years. If S and B have different taxable years, the taxable years that include a December 31 are treated as the same taxable years. If S or B has a short taxable year that does not include a December 31, the short year is treated as part of the succeeding taxable year that does include a December 31. (ii) Transfer to a section 267(b) related person. To the extent S's loss or deduction is taken into account under this section as a result of B's transfer to a nonmember that is a person related to any member under section 267(b), the loss or deduction is taken into account but allowed only to the extent of any income or gain taken into account as a result of the transfer. The balance not allowed is treated as a loss referred to in section 267(d) if it is from a sale or exchange by B (rather than from a distribution). (iii) Circularity of references. References to deferral or elimination under the Internal Revenue Code or regulations do not include references to section 267(f) or this section. See, e.g., Sec. 1.1502-13(a)(3) (applicability of other law). (d) Intercompany sales of inventory involving foreign persons--(1) General rule. Section 267(a)(1) and this section do not apply to an intercompany sale of property that is inventory (within the meaning of section 1221(1)) in the hands of both S and B, if-- (i) The intercompany sale is in the ordinary course of S's trade or business; and (ii) S or B is a foreign corporation, any income or loss realized on the intercompany sale by S or B is not income or loss that is recognized as effectively connected with the conduct of a trade or business within the United States within the meaning of section 864 (unless the income is exempt from taxation pursuant to a treaty obligation of the United States). (2) Intercompany sales involving related partnerships. For purposes of paragraph (d)(1) of this section, a partnership and a foreign corporation described in section 267(b)(10) are treated as members, provided the foreign corporation is described in paragraph (d)(1)(ii) of this section. (3) Intercompany sales in ordinary course. For purposes of this paragraph (d), whether an intercompany sale is in the ordinary course of business is determined under all the facts and circumstances. (e) Treatment of a creditor with respect to a loan in nonfunctional currency. Sections 267(a)(1) and this section do not apply to an exchange loss realized with respect to a loan of nonfunctional currency if-- (1) The loss is realized by a member with respect to nonfunctional currency loaned to another member; (2) The loan is described in Sec. 1.988-1(a)(2)(i); (3) The loan is not in a hyperinflationary currency as defined in Sec. 1.988-1(f); and (4) The transaction does not have as a significant purpose the avoidance of Federal income tax. (f) Receivables. If S has income or gain from a receivable acquired as a result of selling goods or services to a nonmember, and S sells the receivable at fair market value to B, any loss or deduction of S from its sale to B is not deferred under this section to the extent it does not exceed S's income or gain from the sale to the nonmember. (g) Earnings and profits. A loss or deduction deferred under this section is not reflected in S's earnings and profits before it is taken into account under this section. See, e.g., Secs. 1.312-6(a), 1.312-7, and 1.1502-33(c)(2). (h) Anti-avoidance rule. If a transaction is engaged in or structured with a principal purpose to avoid the application of this section, or to affect the timing of losses or deductions (or tax liability) under this section, adjustments must be made to carry out the purposes of this section. (i) [Reserved] (j) Examples. For purposes of the examples in this paragraph (j), unless otherwise stated, corporation P owns 75% of the only class of stock of subsidiaries S and B, X is a person unrelated to any member of the P controlled group, the taxable year of all persons is the calendar year, all persons use the accrual method of accounting, tax liabilities are disregarded, the facts set forth the only activity, and no member has a special status. If a member acts as both a selling member and a buying member (e.g., with respect to different aspects of a single transaction, or with respect to related transactions), the member is referred as to M (rather than as S or B). This section is illustrated by the following examples. Example 1. Matching and acceleration rules. (a) Facts. S holds land for investment with a basis of $130. On January 1 of Year 1, S sells the land to B for $100. On a separate entity basis, S's loss is long-term capital loss. B holds the land for sale to customers in the ordinary course of business. On July 1 of Year 3, B sells the land to X for $110. (b) Matching rule. Under paragraph (b)(1) of this section, S's sale of land to B is an intercompany sale. Under paragraph (c)(1) of this section, S's $30 loss is taken into account under the timing principles of the matching rule of Sec. 1.1502-13(c) to reflect the difference for the year between B's corresponding items taken into account and B's recomputed corresponding items (the corresponding items that B would take into account for the year if S and B were divisions of a single corporation). If S and B were divisions of a single corporation and the intercompany sale were a transfer between the divisions, B would succeed to S's $130 basis in the land and would have a $20 loss from the sale to X. Consequently, S takes no loss into account in Years 1 and 2, and takes the entire $30 loss into account in Year 3 to reflect the $30 difference in that year between the $10 gain B takes into account and its $20 recomputed loss. The attributes of S's intercompany items and B's corresponding items are determined on a separate entity basis. Thus, S's $30 loss is long-term capital loss and B's $10 gain is ordinary income. (c) Acceleration resulting from sale of B stock. The facts are the same as in paragraph (a) of this Example 1, except that on July 1 of Year 3 P sells all of its B stock to X (rather than B's selling the land to X). Under paragraph (c)(1) of this section, S's $30 loss is taken into account under the timing principles of the acceleration rule of Sec. 1.1502-13(d) immediately before the effect of treating S and B as divisions of a single corporation cannot be produced. Because the effect cannot be produced once B becomes a nonmember, S takes its $30 loss into account in Year 3 immediately before B becomes a nonmember. S's loss is long-term capital loss. (d) Subgroup principles applicable to sale of S and B stock. The facts are the same as in paragraph (a) of this Example 1, except that on July 1 of Year 3 P sells all of its S and B stock to X (rather than B's selling the land to X). Under paragraph (b)(3) of this section, S and B are considered to remain members of a controlled group as long as they remain in a controlled group relationship with each other (whether or not in the original controlled group). P's sale of their stock does not affect the controlled group relationship of S and B with each other. Thus, S's loss is not taken into account as a result of P's sale of the stock. Instead, S's loss is taken into account based on subsequent events (e.g., B's sale of the land to a nonmember). Example 2. Distribution of loss property. (a) Facts. S holds land with a basis of $130 and value of $100. On January 1 of Year 1, S distributes the land to P in a transaction to which section 311 applies. On July 1 of Year 3, P sells the land to X for $110. (b) No loss taken into account. Under paragraph (b)(2) of this section, because P and S are not members of a consolidated group, Sec. 1.1502-13(f)(2)(iii) does not apply to cause S to recognize a $30 loss under the principles of section 311(b). Thus, S has no loss to be taken into account under this section. (If P and S were members of a consolidated group, Sec. 1.1502-13(f)(2)(iii) would apply to S's loss in addition to the rules of this section, and the loss would be taken into account in Year 3 as a result of P's sale to X.) Example 3. Loss not yet taken into account under separate entity accounting method. (a) Facts. S holds land with a basis of $130. On January 1 of Year 1, S sells the land to B at a $30 loss but does not take into account the loss under its separate entity method of accounting until Year 4. On July 1 of Year 3, B sells the land to X for $110. (b) Timing. Under paragraph (b)(2) of this section, the determination S's loss is made on a separate entity basis. Under paragraph (c)(1) of this section, S's loss is not taken into account before it is taken into account under S's separate entity method of accounting. Thus, although B takes its corresponding gain into account in Year 3, S has no loss to take into account until Year 4. Once S's loss is taken into account in Year 4, it is not deferred under this section because B's corresponding gain has already been taken into account. (If S and B were members of a consolidated group, S would be treated under Sec. 1.1502-13(b)(2)(i)(C) as taking the loss into account in Year 3.) Example 4. Consolidated groups. (a) Facts. P owns all of the stock of S and B, and the P group is a consolidated group. S holds land for investment with a basis of $130. On January 1 of Year 1, S sells the land to B for $100. B holds the land for sale to customers in the ordinary course of business. On July 1 of Year 3, P sells 25% of B's stock to X. As a result of P's sale, B becomes a nonmember of the P consolidated group but S and B remain in a controlled group relationship with each other for purposes of section 267(f). Assume that if S and B were divisions of a single corporation, the items of S and B from the land would be ordinary by reason of B's activities. (b) Timing and attributes. Under paragraph (a)(3) of this section, S's sale to B is subject to both Sec. 1.1502-13 and this section. Under Sec. 1.1502-13, S's loss is recharacterized as an ordinary loss by reason of B's activities. Under paragraph (b)(3) of this section, because S and B remain in a controlled group relationship with each other, the loss is not taken into account under the acceleration rule of Sec. 1.1502-13(d) as modified by paragraph (c) of this section. See Sec. 1.1502-13(a)(3). Nevertheless, S's loss is recharacterized by Sec. 1.1502-13 as an ordinary loss, and the character of the loss is not further redetermined under this section. Thus, the loss continues to be deferred under this section, and will be taken into account as ordinary loss based on subsequent events (e.g., B's sale of the land to a nonmember). (c) Resale to controlled group member. The facts are the same as in paragraph (a) of this Example 4, except that P owns 75% of X's stock, and B resells the land to X (rather than P's selling any B stock). The results for S's loss are the same as in paragraph (b) of this Example 4. Under paragraph (b) of this section, X is also in a controlled group relationship, and B's sale to X is a second intercompany sale. Thus, S's loss continues to be deferred and is taken into account under this section as ordinary loss based on subsequent events (e.g., X's sale of the land to a nonmember). Example 5. Intercompany sale followed by installment sale. (a) Facts. S holds land for investment with a basis of $130x. On January 1 of Year 1, S sells the land to B for $100x. B holds the land for investment. On July 1 of Year 3, B sells the land to X in exchange for X's $110x note. The note bears a market rate of interest in excess of the applicable Federal rate, and provides for principal payments of $55x in Year 4 and $55x in Year 5. Section 453A applies to X's note. (b) Timing and attributes. Under paragraph (c) of this section, S's $30x loss is taken into account under the timing principles of the matching rule of Sec. 1.1502-13(c) to reflect the difference in each year between B's gain taken into account and its recomputed loss. Under section 453, B takes into account $5x of gain in Year 4 and in Year 5. Therefore, S takes $20x of its loss into account in Year 3 to reflect the $20x difference in that year between B's $0 loss taken into account and its $20x recomputed loss. In addition, S takes $5x of its loss into account in Year 4 and in Year 5 to reflect the $5x difference in each year between B's $5x gain taken into account and its $0 recomputed gain. Although S takes into account a loss and B takes into account a gain, the attributes of B's $10x gain are determined on a separate entity basis, and therefore the interest charge under section 453A(c) applies to B's $10x gain on the installment sale beginning in Year 3. Example 6. Section 721 transfer to a section 267(b) nonmember. (a) Facts. S owns land with a basis of $130. On January 1 of Year 1, S sells the land to B for $100. On July 1 of Year 3, B transfers the land to a partnership in exchange for a 40% interest in capital and profits in a transaction to which section 721 applies. P also owns a 25% interest in the capital and profits of the partnership. (b) Timing. Under paragraph (c)(2)(ii) of this section, S's $30 loss is taken into account in Year 3 but disallowed because the partnership is a nonmember that is a related person under section 267(b). In addition, any subsequent gain recognized by the partnership with respect to the property is limited under section 267(d). (The results would be the same if the P group were a consolidated group, and S's sale to B were also subject to Sec. 1.1502-13.) Example 7. Receivables. (a) Controlled group. S owns goods with a $60 basis. In Year 1, S sells the goods to X for X's $100 note. The note bears a market rate of interest in excess of the applicable Federal rate, and provides for payment of principal in Year 5. S takes into account $40 of income in Year 1 under its method of accounting. In Year 2, the fair market value of X's note falls to $90 due to an increase in prevailing market interest rates, and S sells the note to B for its $90 fair market value. (b) Loss not deferred. Under paragraph (f) of this section, S takes its $10 loss into account in Year 2. (If the sale were not at fair market value, paragraph (f) of this section would not apply and none of S's $10 loss would be taken into account in Year 2.) (c) Consolidated group. Assume instead that P owns all of the stock of S and B, and the P group is a consolidated group. In Year 1, S sells to X goods having a basis of $90 for X's $100 note (bearing a market rate of interest in excess of the applicable Federal rate, and providing for payment of principal in Year 5), and S takes into account $10 of income in Year 1. In Year 2, S sells the receivable to B for its $85 fair market value. In Year 3, P sells 25% of B's stock to X. Although paragraph (f) of this section provides that $10 of S's loss (i.e., the extent to which S's $15 loss does not exceed its $10 of income) is not deferred under this section, S's entire $15 loss is subject to Sec. 1.1502-13 and none of the loss is taken into account in Year 2 under the matching rule of Sec. 1.1502-13(c). See paragraph (a)(3) of this section (continued deferral under Sec. 1.1502-13). P's sale of B stock results in B becoming a nonmember of the P consolidated group in Year 3. Thus, S's $15 loss is taken into account in Year 3 under the acceleration rule of Sec. 1.1502-13(d). Nevertheless, B remains in a controlled group relationship with S and paragraph (f) of this section permits only $10 of S's loss to be taken into account in Year 3. See Sec. 1.1502-13(a)(3) (continued deferral under section 267). The remaining $5 of S's loss continues to be deferred under this section and taken into account under this section based on subsequent events (e.g., B's collection of the note or P's sale of the remaining B stock to a nonmember). Example 8. Selling member ceases to be a member. (a) Facts. P owns all of the stock of S and B, and the P group is a consolidated group. S has several historic assets, including land with a basis of $130 and value of $100. The land is not essential to the operation of S's business. On January 1 of Year 1, S sells the land to B for $100. On July 1 of Year 3, P transfers all of S's stock to newly formed X in exchange for a 20% interest in X stock as part of a transaction to which section 351 applies. Although X holds many other assets, a principal purpose for P's transfer is to accelerate taking S's $30 loss into account. P has no plan or intention to dispose of the X stock. (b) Timing. Under paragraph (c) of this section, S's $30 loss ordinarily is taken into account immediately before P's transfer of the S stock, under the timing principles of the acceleration rule of Sec. 1.1502-13(d). Although taking S's loss into account results in a $30 negative stock basis adjustment under Sec. 1.1502-32, because P has no plan or intention to dispose of its X stock, the negative adjustment will not immediately affect taxable income. P's transfer accelerates a loss that otherwise would be deferred, and an adjustment under paragraph (h) of this section is required. Thus, S's loss is never taken into account, and S's stock basis and earnings and profits are reduced by $30 under Secs. 1.1502-32 and 1.1502-33 immediately before P's transfer of the S stock. (c) Nonhistoric assets. Assume instead that, with a principal purpose to accelerate taking loss into account, P forms M with a $100 contribution on January 1 of Year 1 and S sells the land to M for $100. On December 1 of Year 1, M sells the land to B for $90. On July 1 of Year 3, while B still owns the land, P sells all of M's stock to X and M becomes a nonmember. Under paragraph (c) of this section, M's $10 loss ordinarily is taken into account under the timing principles of the acceleration rule of Sec. 1.1502-13(d) immediately before M becomes a nonmember. (S's $30 loss is not taken into account under the timing principles of Sec. 1.1502-13(c) or Sec. 1.1502-13(d) as a result of M becoming a nonmember, but is taken into account based on subsequent events such as B's sale of the land to a nonmember or P's sale of the stock of S or B to a nonmember.) The land is not an historic asset of M and, although taking M's loss into account reduces P's basis in the M stock under Sec. 1.1502-32, the negative adjustment only eliminates the $10 duplicate stock loss. Under paragraph (h) of this section, M's loss is never taken into account. M's stock basis, and the earnings and profits of M and P, are reduced by $10 under Secs. 1.1502-32 and 1.1502-33 immediately before P's sale of the M stock. (k) Cross-reference. For additional rules applicable to the disposition or deconsolidation of the stock of members of consolidated groups, see Secs. 1.337(d)-1, 1.337(d)-2, and 1.1502-20. (l) Effective dates--(1) In general. This section applies with respect to transactions occurring in S's years beginning on or after [the date the final regulations are filed with the Federal Register]. If both this section and prior law apply to a transaction, or neither applies, with the result that items are duplicated, omitted, or eliminated in determining taxable income (or tax liability), or items are treated inconsistently, prior law (and not this section) applies to the transaction. (2) Avoidance transactions. This paragraph (l)(2) applies if a transaction is engaged in or structured on or after April 8, 1994, with a principal purpose to avoid the rules of this section applicable to transactions occurring in years beginning on or after [the date the final regulations are filed with the Federal Register], to duplicate, omit, or eliminate an item in determining taxable income (or tax liability), or to treat items inconsistently. If this paragraph (l)(2) applies, appropriate adjustments must be made in years beginning on or after [the date the final regulations are filed with the Federal Register], to prevent the avoidance, duplication, omission, elimination, or inconsistency. (3) Prior law. For transactions occuring in S's years beginning before [the date the final regulations are filed with the Federal Register] see the applicable regulations issued under sections 267 and 1502. See, e.g., Secs. 1.267(f)-1, 1.267(f)-1T, 1.267(f)-2T, 1.267(f)- 3, 1.1502-13, 1.1502-13T, 1.1502-14, 1.1502-14T, and 1.1502-31 (as contained in the 26 CFR part 1 edition revised as of April 1, 1994). Secs. 1.267(f)-1T, 1.267(f)-2T, and 1.267(f)-3 [Removed] Par. 6. Sections 1.267(f)-1T, 1.267(f)-2T, and 1.267(f)-3 are removed. Par. 7. Section 1.460-0 is amended in the table of contents by revising the section heading for Sec. 1.460-4, and adding entries for that section to read as follows: Sec. 1.460-0 Outline of regulations under section 460. * * * * * Sec. 1.460-4 Methods of accounting for long-term contracts. (a) through (i) [Reserved] (j) Consolidated groups and controlled groups. (1) Intercompany transactions. (i) In general. (ii) Definitions and nomenclature. (2) Example. (3) Effective date. (i) In general. (ii) Prior law. * * * * * Par. 8. Section 1.460-4 is amended by revising the section heading, adding and reserving paragraphs (a) through (i), and adding paragraph (j) to read as follows: Sec. 1.460-4 Methods of accounting for long-term contracts. (a) through (i) [Reserved] (j) Consolidated groups and controlled groups--(1) Intercompany transactions--(i) In general. Section 1.1502-13 does not apply to the income, gain, deduction, or loss from an intercompany transaction between members of a consolidated group, and section 267(f) does not apply to these items from an intercompany sale between members of a controlled group, to the extent-- (A) The transaction or sale directly or indirectly benefits, or is intended to benefit, another member's long-term contract with a nonmember; (B) The selling member is required under section 460 to determine any part of its gross income from the transaction or sale under the percentage-of-completion method (PCM); and (C) The member with the long-term contract is required under section 460 to determine any part of its gross income from the long- term contract under the PCM. (ii) Definitions and nomenclature. The definitions and nomenclature under Sec. 1.1502-13 and Sec. 1.267(f)-1 apply for purposes of this paragraph (j). (2) Example. The following example illustrates the principles of paragraph (j)(1) of this section. Example. Corporations P, S, and B file consolidated returns on a calendar-year basis. In 1996, B enters into a long-term contract with X, a nonmember, to manufacture 5 airplanes for $500 million, with delivery scheduled for 1999. Section 460 requires B to determine the gross income from its contract with X under the PCM. S enters into a contract with B to manufacture for $50 million the engines that B will install on X's airplanes. Section 460 requires S to determine the gross income from its contract with B under the PCM. S estimates that it will incur $40 million of total contract costs during 1997 and 1998 to manufacture the engines. S incurs $10 million of contract costs in 1997 and $30 million in 1998. Under paragraph (j) of this section, S determines its gross income from the long-term contract under the PCM rather than under section 267(f) or Sec. 1.1502-13. Thus, S includes $12.5 million of gross receipts and $10 million of contract costs in gross income in 1997 and includes $37.5 million of gross receipts and $30 million of contract costs in gross income in 1998. (3) Effective date--(i) In general. This paragraph (j) applies with respect to transactions and sales occurring in years beginning on or after [the date the final regulations are filed with the Federal Register]. (ii) Prior law. For transactions and sales occurring in years beginning before [the date final regulations are filed with the Federal Register], see the applicable regulations issued under sections 267(f) and 1502, including Secs. 1.267(f)-1T, 1.267(f)-2T, and 1.1502-13(n) (as contained in the 26 CFR part 1 edition revised as of April 1, 1994). Par. 9. Section 1.469-0 is amended in the table of contents by revising entries for paragraphs (a) through (d)(1), (g)(5) through (h)(3), and (h)(5) through (k) under Sec. 1.469-1 and revising entries for paragraphs (c)(8), (h)(1), (h)(2), and (h)(6) under Sec. 1.469-1T to read as follows: Sec. 1.469-0 Table of contents. * * * * * Sec. 1.469-1 General rules. (a) through (c)(7) [Reserved] (c)(8) Consolidated groups. (c)(9) through (d)(1) [Reserved] * * * * * (g)(5) [Reserved] (h)(1) In general. (h)(2) Definitions. (h)(3) [Reserved] * * * * * (h)(5) [Reserved] (h)(6) Intercompany transactions. (i) In general. (ii) Example. (iii) Effective dates. (h)(7) through (k) [Reserved] Sec. 1.469-1T General rules (temporary). * * * * * (c)(8) [Reserved] * * * * * (h)(1) [Reserved] (h)(2) [Reserved] * * * * * (h)(6) [Reserved] * * * * * Par. 10. Section 1.469-1 is amended by revising paragraphs (a) through (d)(1), (g)(5) through (h)(3), and (h)(5) through (k) to read as follows: Sec. 1.469-1 General rules. (a) through (c)(7) [Reserved] (c)(8) Consolidated groups. Rules relating to the application of section 469 to consolidated groups are contained in paragraph (h) of this section. (c)(9) through (d)(1) [Reserved] * * * * * (g)(5) [Reserved] (h)(1) In general. This paragraph (h) provides rules for applying section 469 in computing a consolidated group's consolidated taxable income and consolidated tax liability (and the separate taxable income and tax liability of each member). (2) Definitions. The definitions and nomenclature in the regulations under section 1502 apply for purposes of this paragraph (h). See, e.g., Secs. 1.1502-1 (definitions of group, consolidated group, member, subsidiary, and consolidated return year), 1.1502-2 (consolidated tax liability), 1.1502-11 (consolidated taxable income), 1.1502-12 (separate taxable income), 1.1502-13 (intercompany transactions), 1.1502-21 (consolidated net operating loss), and 1.1502- 22 (consolidated net capital gain or loss). (3) [Reserved] * * * * * (5) [Reserved] (6) Intercompany transactions--(i) In general. Section 1.1502-13 applies to determine the treatment under section 469 of intercompany items and corresponding items from intercompany transactions between members of a consolidated group. For example, the matching rule of Sec. 1.1502-13(c) treats the selling member (S) and the buying member (B) as divisions of a single corporation for purposes of determining whether S's intercompany items and B's corresponding items are from a passive activity. Thus, for purposes of applying Sec. 1.469- 2(c)(2)(iii) and Sec. 1.469-- 2T(d)(5)(ii) to property sold by S to B in an intercompany transaction-- (A) S and B are treated as divisions of a single corporation for determining the uses of the property during the 12-month period preceding its disposition to a nonmember, and generally have an aggregate holding period for the property; and (B) Section 1.469-2(c)(2)(iv) does not apply. (ii) Example. The following example illustrates the application of this paragraph (h)(6). Example. (i) P, a closely held corporation, is the common parent of the P consolidated group. P owns all of the stock of S and B. X is a person unrelated to any member of the P group. S owns and operates equipment that is not used in a passive activity. On January 1 of Year 1, S sells the equipment to B at a gain. B uses the equipment in a passive activity and does not dispose of the equipment before it has been fully depreciated. Assume that if S and B were divisions of a single corporation, S's gain would be passive income attributable to a passive activity. (ii) Under the matching rule of Sec. 1.1502-13(c), S's gain taken into account as a result of B's depreciation is treated as gain from a passive activity even though S used the equipment in a nonpassive activity. (iii) The facts are the same as in paragraph (a) of this Example, except that B sells the equipment to X on December 1 of Year 3 at a further gain. To the extent of B's depreciation before the sale, the results are the same as in paragraph (ii) of this Example. S's remaining gain taken into account as a result of B's sale is treated as attributable to a passive activity. (iv) The facts are the same as in paragraph (iii) of this Example, except that B recognizes a loss on the sale to X. As in paragraph (iii) of this Example, S's gain taken into account as a result of B's sale is treated as attributable to a passive activity. (iii) Effective dates. This paragraph (h)(6) applies with respect to transactions occurring in years beginning on or after [the date the final regulations are filed with the Federal Register]. For transactions occurring in years beginning before [the date the final regulations are filed with the Federal Register], see Sec. 1.469- 1T(h)(6) (as contained in the 26 CFR part 1 edition revised as of April 1, 1994). (h)(7) through (k) [Reserved] Sec. 1.469-1T [Amended] Par. 11. Section 1.469-1T is amended by removing and reserving paragraphs (c)(8), (h)(1), (h)(2), and (h)(6). Par. 12. Section 1.1502-13 is revised to read as follows: Sec. 1.1502-13 Intercompany transactions. (a) In general--(1) Purpose. This section provides rules for taking into account the items of income, gain, deduction, and loss of members from intercompany transactions. The purpose of this section 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 consolidated tax liability). (2) Separate entity and single entity treatment. Under this section, the selling member (S) and the buying member (B) are treated as separate entities for some purposes but as divisions of a single corporation for other purposes. The amount and location of S's intercompany items and B's corresponding items are determined on a separate entity basis (separate entity treatment). For example, S determines its gain or loss from a sale of property to B on a separate entity basis, and B has a cost basis in the property. The timing, character, source, and other attributes of the intercompany items and corresponding items, although initially determined on a separate entity basis, are redetermined under this section to produce the effect of transactions between divisions of a single corporation (single entity treatment). For example, if S sells land to B at a gain and B resells the land to a nonmember, S does not take its gain into account until the resale. (3) Other law. The rules of this section apply in addition to other applicable law, such as sections 269 (acquisitions to evade or avoid income tax), 482 (allocations among commonly controlled taxpayers), and 7701(f) (use of related persons). The timing rules of this section are a method of accounting that overrides otherwise applicable accounting methods. For example, if S sells property to B in exchange for B's note, the rules of this section apply instead of the installment sale rules of section 453. However, an item taken into account under this section can be deferred, disallowed, or eliminated under other applicable law such as section 267 (losses from transactions between related persons). (4) Construction. The rules of this section must be applied in a consistent manner that reasonably carries out their purposes, taking into account all of the facts and circumstances, the underlying economic arrangement, and applicable Federal income tax accounting principles. For example, the rules of this section must not be applied to take S's intercompany items into account more than once. (5) Overview--(i) In general. The principal rules of this section that implement single entity treatment are the matching rule and the acceleration rule of paragraphs (c) and (d) of this section. Under the matching rule of paragraph (c) of this section, S and B are generally treated as divisions of a single corporation for purposes of taking into account their items from intercompany transactions. The acceleration rule of paragraph (d) of this section provides additional rules for taking the items into account if the effect of treating S and B as divisions cannot be achieved (e.g., if S or B becomes a nonmember). Paragraph (b) of this section provides definitions, including the definitions of intercompany transaction, intercompany item, and corresponding item. Paragraph (e) of this section provides simplifying rules for certain transactions. Paragraphs (f) and (g) of this section provide additional rules for stock and obligations of members. Paragraphs (h) and (j) of this section provide anti-avoidance rules and miscellaneous operating rules. (ii) Table of examples. Set forth below is a table of the examples contained in this section. Matching rule. (Sec. 1.1502-13(c)(4)(ii)) Example 1. Intercompany sale of land followed by resale; intercompany sale followed by section 1031 exchange with nonmember; intercompany sale followed by section 351 transfer to nonmember. Example 2. Dealer activities. Example 3. Intercompany section 351 transfer. Example 4. Depreciable property. Example 5. Intercompany sale followed by installment sale. Example 6. Intercompany sale of installment obligation. Example 7. Performance of services. Example 8. Rental of property. Example 9. Back-to-back intercompany sales. Example 10. Intercompany sale of a partnership interest. Example 11. Net operating losses subject to section 382 or the SRLY rules. Example 12. Special inventory accounting election. Example 13. Section 475. Example 14. Section 1092. Example 15. Manufacturer rebates. Example 16. Cancellation of debt and attribute reduction under section 108(b). Example 17. Source of items from a section 863 sale. Example 18. Section 1248. Acceleration rule. (Sec. 1.1502-13(d)(3)) Example 1. Becoming a nonmember--timing. Example 2. Becoming a nonmember--attributes. Example 3. Back-to-back intercompany transactions. Example 4. Selling member's disposition of proceeds. Example 5. Section 481. Simplifying rules--inventory. (Sec. 1.1502-13(e)(1)(v)) Example 1. Increment averaging method. Example 2. Increment valuation method. Example 3. Other reasonable inventory methods. Stock of members. (Sec. 1.1502-13(f)(6)) Example 1. Dividend exclusion and property distribution. Example 2. Excess loss accounts. Example 3. Intercompany reorganization. Example 4. Stock redemptions and distributions. Example 5. Intercompany stock sale followed by section 332 liquidation. Obligations of members. (Sec. 1.1502-13(g)(6)) Example 1. Interest and premium on intercompany debt. Example 2. Intercompany debt becomes nonintercompany debt. Example 3. Bad debt deduction or loss with respect to intercompany debt. Example 4. Nonintercompany debt becomes intercompany debt. Example 5. Notional principal contracts. Anti-avoidance rules. (Sec. 1.1502-13(h)(2)) Example 1. Sale of a partnership interest. Example 2. Sale to a related party. Example 3. Sale and leaseback. Example 4. Transitory status as an intercompany obligation. Miscellaneous operating rules. (Sec. 1.1502-13(j)(6)) Example 1. Intercompany sale followed by section 351 transfer to member. Example 2. Intercompany sale of member stock followed by recapitalization. Example 3. Successor group. Example 4. Liquidation--80% distributee. Example 5. Liquidation--no 80% distributee. (b) Definitions. For purposes of this section-- (1) Intercompany transactions--(i) In general. An intercompany transaction is a transaction between corporations that are members of the same consolidated group immediately after the transaction. S is the member transferring property or providing services, and B is the member receiving the property or services. Intercompany transactions include-- (A) S's sale of property (or other transfer, such as an exchange or contribution) to B, whether or not gain or loss is recognized; (B) S's performance of services for B, and B's payment or accrual of its expenditure for S's performance; (C) S's licensing of technology, rental of property, or loan of money to B, and B's payment or accrual of its expenditure; and (D) S's distribution to B with respect to S stock. (ii) Time of transaction. If a transaction occurs in part while S and B are members and in part while they are not members, the transaction is treated as occurring when performance by either S or B takes place, or when payment for performance would be taken into account under the rules of this section if it were an intercompany transaction, whichever is earliest. Appropriate adjustments must be made in such cases by, for example, dividing the transaction into two separate transactions reflecting the extent to which S or B has performed. (iii) Separate transactions. Each transaction is analyzed separately. For example, if S simultaneously sells two properties to B, one at a gain and the other at a loss, each property is sold in a separate transaction. Similarly, each payment or accrual of interest with respect to a loan is a separate transaction. If two members exchange property, each member is S with respect to the property it transfers and B with respect to the property it receives. (2) Intercompany items and corresponding items--(i) Intercompany items--(A) In general. S's income, gain, deduction, and loss from an intercompany transaction are its intercompany items. For example, S's gain from the sale of property to B is intercompany gain and, if the sale results in both ordinary income and capital gain (or other attribute disparities), each is treated as a separate intercompany item. An item is an intercompany item whether it is directly or indirectly from an intercompany transaction. (B) Related costs or expenses. S's costs or expenses related to an intercompany transaction are included in determining its intercompany items. For example, if S sells inventory to B, S's direct and indirect costs properly includible under section 263A are included in determining its intercompany income. Similarly, in addition to other related costs, deductions for employee wages are included in determining S's income from performing services for B, and depreciation deductions are included in determining S's income from renting property to B. (C) Amounts not yet recognized or incurred. S's items from intercompany transactions are taken into account under this section even if S has not yet taken them into account under its separate entity method of accounting. For example, if S is a cash method taxpayer, S's intercompany income is taken into account under this section even if the cash is not yet received. (ii) Corresponding items--(A) In general. B's income, gain, deduction, and loss from an intercompany transaction, or from property acquired in an intercompany transaction, are its corresponding items. For example, if B pays rent to S, B's deduction for the rent is a corresponding deduction. If B buys property from S and resells it to a nonmember, B's gain or loss from the resale is a corresponding gain or loss; alternatively, if B recovers the cost of the property through depreciation, B's depreciation deductions are corresponding deductions. An item is a corresponding item whether it is directly or indirectly from an intercompany transaction (or from property acquired in an intercompany transaction). (B) Disallowed or eliminated amounts. B's corresponding items include amounts that are permanently disallowed or permanently eliminated, whether directly or indirectly. For example, corresponding items include amounts disallowed under section 265 (expenses relating to tax-exempt income), amounts offset under section 171(e) (amortizable bond premium offset), and amounts not recognized under section 311 (nonrecognition of loss on distributions) or 332 (nonrecognition on liquidating distributions). (See paragraph (c)(3)(iv) of this section, under which certain of these amounts may cause S's intercompany income or gain to be treated as excluded from gross income.) (iii) Effect of basis adjustments. This paragraph (b)(2)(iii) provides additional rules for intercompany items and corresponding items. (A) Deemed intercompany items. An adjustment reflected in basis (or to an amount equivalent to basis, such as a loss carryover or an excess loss account) that is a substitute for an intercompany item is treated as an intercompany item. For example, a reduction in S's basis in property that preserves S's income for a later period and relates to B's corresponding deduction is treated as intercompany income of S. However, if the adjustment is made pursuant to a nonrecognition provision of the Code or regulations unrelated to S's method of accounting, the adjustment is not treated as an intercompany item. (B) Deemed corresponding items. An adjustment reflected in basis (or in an amount equivalent to basis, such as a loss carryover or an excess loss account) that is a substitute for a corresponding item is treated as a corresponding item for purposes of taking S's intercompany items into account. However, an adjustment is not treated as a corresponding item to the extent that the adjustment reflects a comparable amount not recognized by S, or to the extent that the only effect of the adjustment is to preserve B's items for a later period (rather than, for example, affecting the overall amount of items taken into account or to be taken into account). (C) Amounts deemed not to be items. A deduction or loss is not treated as an intercompany item or corresponding item to the extent it does not reduce basis (or have an equivalent effect, such as decreasing a loss carryover or increasing an excess loss account). For example, if B has percentage depletion in excess of basis under section 613 or 613A with respect to mineral property purchased from S, the depletion in excess of basis is not treated as a corresponding item for purposes of this section. Similar principles apply to income or gain that does not increase basis (or have an equivalent effect). (3) Treatment as a separate entity. Treatment as a separate entity means treatment without application of the rules of this section, but with the application of the other consolidated return regulations. For example, if S sells the stock of another member to B, S's gain or loss on a separate entity basis is determined with the application of Sec. 1.1502-80(b) (nonapplicability of section 304), but without redetermination under paragraph (c) or (d) of this section. (4) Attributes. The attributes of an intercompany item or corresponding item are all of the item's characteristics necessary to determine its effect on taxable income (and tax liability) except amount, location, and timing. For example, attributes include character, source, treatment as excluded from gross income or as a noncapital, nondeductible amount, and treatment as built-in gain or loss under section 382(h) or 384. A member's holding period in property, or the fact that property is included in the inventory of a member, is not an attribute of an item, but these factors do affect the determination of the attributes of items from the property. (c) Matching rule. S's intercompany items and B's corresponding items are taken into account for each consolidated return year under the following rules: (1) Attributes and holding periods--(i) General rule. The attributes of S's intercompany items and B's corresponding items are redetermined to produce the same effect on consolidated taxable income (and consolidated tax liability) as if S and B were divisions of a single corporation, and the intercompany transaction were a transaction between divisions. Thus, the activities of both S and B affect the attributes of both intercompany items and corresponding items. For example, if S holds property for sale to unrelated customers in the ordinary course of its trade or business and sells the property to B, S's intercompany items and B's corresponding items may be ordinary items solely by reason of S's activities. Similar principles apply if S performs services, rents property, or engages in any other intercompany transaction. (ii) Holding periods. The holding period of property transferred in an intercompany transaction is the aggregate of the holding periods of S and B. However, if the basis of the property is determined by reference to the basis of other property, the property's holding period is determined by reference to the holding period of the other property. For example, the holding period of stock distributed in an intercompany distribution to which section 355 applies is determined by reference to the holding period of the distributing member's stock. (2) Timing--(i) B's items. B takes its corresponding items into account under its accounting method. However, the redetermination of the attributes of a corresponding item may affect its timing. For example, if B's resale of property acquired from S is treated as a dealer disposition solely by reason of S's activities, section 453(b) prevents any corresponding income of B from being taken into account under the installment method. (ii) S's items. S takes its intercompany items into account to reflect the difference for the year between B's corresponding items taken into account and B's recomputed corresponding items (the corresponding items that B would take into account for the year if S and B were divisions of a single corporation). For example, if S sells property with a $70 basis to B for $100, and B later resells the property to a nonmember for $90, B's corresponding item taken into account is its $10 loss, B's recomputed corresponding item is a $20 recomputed gain, and the $30 difference is the amount of S's intercompany gain that is taken into account for the year of the resale. Although B does not actually take the recomputed corresponding items into account, they are computed as if they were taken into account (based on reasonable and consistently applied assumptions, including any provision of the Internal Revenue Code (Code) or regulations that would affect their timing or attributes). (3) Operating rules for single entity adjustments. For purposes of this paragraph (c)-- (i) Divisions of a single corporation. As divisions of a single corporation, S and B are treated as engaging in their actual transaction and owning any actual property in the transaction (rather than treating the transaction as not occurring). For example, S's sale of property to B for cash is not disregarded, but is treated as an exchange of property for cash between divisions (and B therefore ordinarily does not have a cost basis). Similarly, if S transfers property to B in exchange for B's stock, S is treated as owning the stock it receives in the exchange. Although treated as divisions, S and B nevertheless are treated as: (A) Operating separate trades or businesses. See, e.g., Sec. 1.446- 1(d) (accounting methods for a taxpayer engaged in more than one business). (B) Having any special status that they have under the Internal Revenue Code. For example, a bank defined in section 581, a domestic building and loan association defined in section 7701(a)(19), and an insurance company to which section 801 or 831 applies are treated as divisions having separate special status. On the other hand, the fact that a member holds property for sale to customers in the ordinary course of its trade or business is not a special status. (ii) Multiple intercompany items or corresponding items--(A) Multiple triggers. If more than one corresponding item can cause an intercompany item to be taken into account under this paragraph (c), the intercompany item is taken into account in connection with the corresponding item most consistent with the treatment of members as divisions of a single corporation. For example, if S sells a truck to B, its intercompany gain from the sale is not taken into account by reference to B's depreciation if the depreciation is capitalized under section 263 as part of B's cost for a building; instead, S's gain relating to the capitalized depreciation is taken into account when the building is sold or as it is depreciated. If B purchases appreciated land from S and transfers the land to a lower-tier member in exchange for stock, thereby duplicating the basis of the land in the basis of the stock, items with respect to both the stock and the land can cause S's intercompany gain to be taken into account; if the lower-tier member becomes a nonmember as a result of the sale of its stock, the attributes of S's intercompany gain are determined with respect to the land rather than the stock. (B) Aggregation of transactions. If a member's intercompany item or corresponding item affects the accounting for more than one intercompany transaction, appropriate adjustments are made to treat all of the intercompany transactions as transactions between divisions of a single corporation. For example, if land is transferred in successive intercompany transactions, all of the participating members are treated as divisions of a single corporation for purposes of determining the timing and attributes of each of the items from the land. Similar principles apply with respect to intercompany transactions that are part of the same plan or arrangement. For example, if S sells separate properties to different members as part of the same plan or arrangement, all of the participating members are treated as divisions of a single corporation for purposes of determining the timing and attributes of the intercompany items and corresponding items from each of the properties. (iii) Conflict of attributes or allocation--(A) In general. If it is not possible to determine the attributes of an item, or the allocation of attributes between S and B, by treating S and B as divisions of a single corporation, the determination or allocation is made as follows-- (1) The attributes of B's corresponding items on a separate entity basis control the attributes of offsetting intercompany items of S (e.g., B's interest expense controls S's interest income); and (2) If the corresponding items and intercompany items do not offset (e.g., both S and B have gain from the same property), their attributes are determined on a separate entity basis to the extent not inconsistent with the purposes of this section. (B) Special status. To the extent an item's attributes determined under this section are permitted or not permitted to a member under the Internal Revenue Code or regulations by reason of the member's special status, the attributes required under the Internal Revenue Code or regulations apply to that member (but not the other member). For example, if S is a bank to which section 582(c) applies, and sells debt securities at a gain to B, a nonbank, the character of S's intercompany gain is ordinary as required under section 582(c), but the character of B's corresponding items as capital or ordinary is determined under paragraph (c)(1) of this section without the application of section 582(c). For other special status issues, see, e.g., sections 595(b) (foreclosure on property securing loans), 818(b) (life insurance company treatment of capital gains and losses), 1032 (nonrecognition with respect to an issuer's stock) and 1503(c) (limitation on absorption of certain losses). (iv) Limitation on treatment of intercompany income or gain as excluded from gross income--(A) In general. Redetermining the attributes of intercompany items and corresponding items under this paragraph (c) may result in S's intercompany items being treated as excluded from gross income or as noncapital, nondeductible amounts. For example, S's intercompany loss from the sale of property to B is treated as a noncapital, nondeductible amount if B distributes the property to a nonmember shareholder at no further gain or loss (because of the nonrecognition of loss under section 311(a)). See also Secs. 1.1502-32 and 1.1502-33 (adjustments to S's stock basis and earnings and profits to reflect amounts so treated). (B) Limitation. S's intercompany income or gain may be treated under this paragraph (c) as excluded from gross income only to the extent one of the following applies: (1) Disallowed amounts. B's corresponding item is a deduction or loss that, in the taxable year the item is taken into account under this section, is permanently disallowed directly under another provision of the Internal Revenue Code or regulations. An amount is not permanently disallowed for this purpose if, for example-- (i) The disallowance or elimination is not permanent because an equivalent amount might be taken into account by B, such as under section 280B (demolition costs recoverable as capitalized amounts), or by another taxpayer, such as under section 267(d) (disallowed loss under section 267(a) may result in nonrecognition of gain for a related person); (ii) The amount is realized but not recognized under section 332; (iii) The amount is a deemed item under paragraph (b)(2)(iii) of this section; or (iv) The amount is a loss that is part of a carryforward that expires in a later year. (2) Section 311. The corresponding item is a loss that is realized, but not recognized under section 311(a). (3) Other amounts. The corresponding item is otherwise limited, eliminated, offset, or has no effect on the computation of taxable income under any provision identified by the Commissioner. (4) Examples--(i) In general. For purposes of the examples in this section, unless otherwise stated, P is the common parent of the P consolidated group, P owns all of the only class of stock of subsidiaries S and B, X is a person unrelated to any member of the P group, the taxable year of all persons is the calendar year, all persons use the accrual method of accounting, tax liabilities are disregarded, the facts set forth the only corporate activity, and no member has any special status. If a member acts as both a selling member and a buying member (e.g., with respect to different aspects of a single transaction, or with respect to related transactions), the member is referred to as M (rather than as S or B). (ii) Matching rule. The matching rule of this paragraph (c) is illustrated by the following examples. Example 1. Intercompany sale of land followed by resale; intercompany sale followed by section 1031 exchange with nonmember; intercompany sale followed by section 351 transfer to nonmember. (a) Facts. S holds land for investment with a basis of $70. On January 1 of Year 1, S sells the land to B for $100. B also holds the land for investment. On July 1 of Year 3, B sells the land to X for $110. (b) Definitions. Under paragraph (b)(1) of this section, S's sale of the land to B is an intercompany transaction, S is the selling member, and B is the buying member. Under paragraph (b)(2) of this section, S's $30 gain from the sale to B is its intercompany gain, and B's $10 gain from the sale to X is its corresponding gain. (c) Timing. Under the matching rule of paragraph (c) of this section, S takes its intercompany items into account to reflect the difference for the year between B's corresponding items taken into account and B's recomputed corresponding items (the corresponding items that B would take into account for the year if S and B were divisions of a single corporation). If S and B were divisions of a single corporation and the intercompany sale were a transfer between the divisions, B would succeed to S's $70 basis in the land and would have a $40 gain from the sale to X instead of a $10 gain. Consequently, S takes no gain into account in Years 1 and 2, and takes the entire $30 gain into account in Year 3 to reflect the $30 difference in that year between the $10 gain B takes into account and its $40 recomputed gain (B's recomputed corresponding item). Under Secs. 1.1502-32 and 1.1502-33, P's basis in its S stock and the earnings and profits of S and P do not reflect S's $30 gain until the gain is taken into account in Year 3. (Under paragraph (b)(2)(i)(C) of this section, the results would be the same if S sold the land to B in an installment sale to which section 453 would otherwise apply, because S must take its intercompany gain into account under this section.) (d) Attributes. Under the matching rule, S's $30 intercompany gain and B's $10 corresponding gain are taken into account to produce the same effect on consolidated taxable income (and consolidated tax liability) as if S and B were divisions of a single corporation. In addition, the holding periods of S and B for the land are aggregated. Thus, both are long-term capital gain. (e) Intercompany loss and resale gain. The facts are the same as in paragraph (a) of this Example 1, except that S's basis in the land is $130 (rather than $70). The timing and attributes of S's intercompany loss and B's corresponding gain are determined in the manner provided in paragraphs (c) and (d) of this Example 1. If S and B were divisions of a single corporation and the intercompany sale were a transfer between the divisions, B would succeed to S's $130 basis in the land and would have a $20 loss from the sale to X instead of a $10 gain. Thus, S takes its entire $30 loss into account in Year 3 to reflect the $30 difference between B's $10 gain taken into account and its $20 recomputed loss. (The results are the same under section 267(f).) S's $30 loss is long-term capital loss, and B's $10 gain remains long-term capital gain. (f) Intercompany gain and resale loss. The facts are the same as in paragraph (a) of this Example 1, except that B sells the land to X for $90 (rather than $110). The timing and attributes of S's intercompany gain and B's corresponding loss are determined in the manner provided in paragraphs (c) and (d) of this Example 1. If S and B were divisions of a single corporation and the intercompany sale were a transfer between the divisions, B would succeed to S's $70 basis in the land and would have a $20 gain from the sale to X instead of a $10 loss. Thus, S takes its entire $30 gain into account in Year 3 to reflect the $30 difference between B's $10 loss taken into account and its $20 recomputed gain. S's $30 gain is long-term capital gain, and B's $10 loss is long-term capital loss. (g) Intercompany sale followed by section 1031 exchange with nonmember. The facts are the same as in paragraph (a) of this Example 1, except that, instead of selling the land to X, B exchanges the land for land owned by X in a transaction to which section 1031 applies. There is no difference in Year 3 between B's corresponding items taken into account and its recomputed items. Thus, none of S's intercompany gain is taken into account under the matching rule as a result of the section 1031 exchange. Instead, B's gain is preserved in the land received from X and, under the successor asset rule of paragraph (j)(1)(i) of this section, S's intercompany gain is taken into account by reference to the replacement property. (If B takes gain into account as a result of boot received in the exchange, S's intercompany gain would be taken into account under the matching rule to the extent the boot causes a difference between B's gain taken into account and its recomputed gain.) (h) Intercompany sale followed by section 351 transfer to nonmember. The facts are the same as in paragraph (a) of this Example 1, except that, instead of selling the land to X, B transfers the land to X in a transaction to which section 351 applies and X remains a nonmember. There is no difference in Year 3 between B's corresponding items taken into account and its recomputed items. Thus, none of S's intercompany gain is taken into account under the matching rule as a result of the section 351 transfer. However, S's entire gain is taken into account in Year 3 under the acceleration rule of paragraph (d) of this section (because X reflects B's $100 cost basis in the land under section 362). Example 2. Dealer activities. (a) Facts. S holds land for investment with a basis of $70. On January 1 of Year 1, S sells the land to B for $100. B develops the land as residential real estate, and sells developed lots to customers during Year 3 for an aggregate amount of $110. (b) Attributes. S and B are treated under the matching rule as divisions of a single corporation for purposes of determining the attributes of B's corresponding items and S's intercompany items. Thus, although S held the land for investment, whether the land is property described in section 1221(1) is based on the activities of both S and B. If the land is described in section 1221(1), both S's gain and B's gain are ordinary income. Example 3. Intercompany section 351 transfer. (a) Facts. S holds land with a $70 basis for sale to customers in the ordinary course of business. On January 1 of Year 1, S transfers the land to B in exchange for B stock and $10 cash in a transaction to which section 351 applies. See Sec. 1.1502-34 (aggregate stock ownership rules). S has a $10 gain under section 351(b), and its basis in the B stock is $70 under section 358. Under section 362, B's basis in the land is $80. B holds the land for investment. On July 1 of Year 3, B sells the land to X for $100. Assume that if S and B were divisions of a single corporation, B's gain from the sale would be ordinary income by reason of S's activities. (b) Timing and attributes. Under paragraph (c)(3)(i) of this section, S is treated as transferring the land for B's stock even though, as divisions, S could not own stock of B. S takes its $10 gain into account in Year 3 to reflect the $10 difference between B's $20 gain taken into account and its $30 recomputed gain. Both S's $10 gain and B's $20 gain are ordinary income. (c) Partial disposition. The facts are the same as in paragraph (a) of this Example 3, except B sells only a one-half, undivided interest in the land to X for $50. The timing and attributes are determined in the manner provided in paragraph (b) of this Example 3, except that S takes only $5 of its gain into account in Year 3 to reflect the $5 difference between B's $10 gain taken into account and its $15 recomputed gain. (d) No boot. The facts are the same as in paragraph (a) of this Example 3, except that there is no boot in the section 351 transaction. Under paragraph (b)(1) of this section, S's transfer to B is an intercompany transaction. Under paragraph (b)(2) of this section, S has no intercompany items, but B's $30 gain from its sale of the land to X is a corresponding item because the land was acquired in an intercompany transaction. B's $30 gain is ordinary income. Example 4. Depreciable property. (a) Facts. During Year 1, S buys 10-year recovery property for $80 and depreciates it under the straight-line method with the half- year convention. On July 1 of Year 6, S sells the property to B for $100. Under section 168(i)(7), B is treated as S for purposes of section 168 to the extent that B's $100 basis does not exceed S's adjusted basis at the time of the sale. B's additional basis is treated as new 10-year recovery property subject to the half-year convention, for which B elects the straight-line method of recovery. (b) Depreciation in Year 6 and intercompany gain. S takes into account $4 of depreciation for Year 6, and S has a $40 basis at the time of the sale to B ($80 minus $36 of prior years' depreciation and $4 of Year 6 depreciation). Thus, S has a $60 intercompany gain from its sale to B. For Year 6, B has the remaining $4 of depreciation with respect to $40 of its basis (the portion of its $100 basis not exceeding S's adjusted basis). In addition, B has another $3 of depreciation with respect to the $60 of its additional basis that exceeds S's adjusted basis (under the half-year convention). For purposes of treating S and B as divisions of a single corporation under the matching rule, the $8 of recomputed depreciation for Year 6 is also allocated $4 to S and $4 to B. (c) Timing. S's $60 gain is taken into account to reflect the difference for each consolidated return year between B's depreciation taken into account with respect to the property and its recomputed depreciation. For Year 6, B takes $7 of depreciation into account. If the intercompany transaction had been a transfer between divisions of a single corporation, B would have succeeded to S's adjusted basis in the property and taken into account only its $4 allocable share of the property's $8 of depreciation for Year 6. Thus, S takes $3 of gain into account in Year 6. In each subsequent year that B operates the property and takes into account $14 of depreciation ($8 with respect to $40 of basis, and $6 with respect to $60 of basis), S takes into account $6 of gain to reflect the $6 difference between B's $14 of depreciation taken into account and its recomputed $8 of depreciation (the depreciation that B would take into account if the intercompany sale were a transfer between divisions). (d) Attributes. S's gain taken into account as a result of B's depreciation is ordinary income. (e) Resale of property. The facts are the same as in paragraph (a) of this Example 4, except that B sells the property to X at the beginning of Year 10 for an amount equal to its $44 adjusted basis (applying the half-year convention). To the extent of B's $56 of depreciation before the sale ($32 with respect to the $40 of basis corresponding to S's adjusted basis, and $24 with respect to the $60 of additional basis), the timing and attributes of S's gain are determined in the manner provided in paragraphs (c) and (d) of this Example 4, and S takes into account $24 of gain in Years 6 through 10 as ordinary income. The $36 balance of S's gain is taken into account in Year 10 as a result of B's sale to X, to reflect the $36 difference between B's $0 gain taken into account and its $36 recomputed gain ($44 sale proceeds minus the $8 basis B would have if the intercompany sale were a transfer between divisions of a single corporation). The attributes of the remaining $36 of S's gain are determined by treating S and B as divisions of a single corporation. Thus, the entire $36 of gain is recapture income under section 1245. Example 5. Intercompany sale followed by installment sale. (a) Facts. S holds land for investment with a basis of $70x. On January 1 of Year 1, S sells the land to B for $100x. B also holds the land for investment. On July 1 of Year 3, B sells the land to X in exchange for X's $110x note. The note bears a market rate of interest in excess of the applicable Federal rate, and provides for principal payments of $55x in Year 4 and $55x in Year 5. The interest charge under section 453A(c) applies to X's note. (b) Timing and attributes. S takes its $30x gain into account in each consolidated return year to reflect the difference between B's gain taken into account for the year and its recomputed gain. Under section 453, B takes into account $5x of gain in Year 4 and $5x of gain in Year 5. Thus, S takes into account $15x of gain in Year 4 and $15x of gain in Year 5. This reflects the $15x difference in Year 4 and in Year 5 between B's $5x gain taken into account and its $20x recomputed gain. Both S's $30x gain and B's $10x gain are subject to the section 453A(c) interest charge beginning in Year 3. (c) Election out under section 453(d). If, under the facts in paragraph (a) of this Example 5, the P group wishes to elect not to apply section 453 with respect to S's gain, an election under section 453(d) must be made for Year 3 with respect to B's gain. This election will cause B's $10x gain to be taken into account in Year 3. Under the matching rule, this in turn will result in S's $30 gain being taken into account in Year 3. (An election by the P group solely with respect to S's gain has no effect because the gain from S's sale to B is taken into account under the matching rule, and therefore must reflect the difference between B's gain taken into account and its recomputed gain.) (d) Resale loss, but overall gain. The facts are the same as in paragraph (a) of this Example 5, except that B sells the land to X in exchange for X's $90x note (rather than $110x note). B's $10x loss is taken into account in Year 3 and is not subject to installment reporting under section 453 (only gain may be reported on the installment method). There is an aggregate $30x difference between B's $10x loss taken into account and its $20x recomputed gain. Under paragraph (c)(2)(ii) of this section, however, B's $20x recomputed gain is treated as taken into account in Years 4 and 5 under the installment method. Thus, S takes $10x of gain into account in Year 3 to reflect the $10x difference between B's $10x loss taken into account and its $0 recomputed gain for Year 3. (None of B's $20 recomputed gain is treated as taken into account in Year 3 under the installment method). S takes $10x of gain into account in each of Years 4 and 5 to reflect the difference in those years between B's $0 gain taken into account and B's $10x recomputed gain under the installment method. Only the $20x of S's gain taken into account in Years 4 and 5 is subject to the interest charge under section 453A(c) beginning in Year 3. (If the P group elects under section 453(d) for Year 3 to not apply section 453 with respect to S's gain, the election will be given effect under paragraph (c)(2)(ii) of this section.) (e) Intercompany loss, installment gain. The facts are the same as in paragraph (a) of this Example 5, except that S has a $130x (rather than $70x) basis in the land. S takes $20x of its loss into account in Year 3 to reflect the $20x difference between B's $0 loss taken into account (under section 453) and its $20x recomputed loss. Of the $10x remaining balance of S's loss, $5x is taken into account in each of Years 4 and 5 to reflect the $5x difference between B's $5x gain taken into account and its $0 recomputed gain. (The results are the same under section 267(f).) S's $20x loss taken into account in Year 3 is treated like the $20x recomputed loss B would have taken into account if S and B were divisions of a single corporation, and S's remaining $5x loss in each of Years 4 and 5 offsets B's gain taken into account. Because B's $5x of gain in each of Years 4 and 5, and S's $5x of loss in each of Years 4 and 5, are taken into account at the same time and offset in determining consolidated taxable income, the gain is not subject to the interest charge under section 453A(c) for Years 4 and 5. (If B had sold the land to X for more than $130x, B's gain in excess of S's $30x loss would be subject to the interest charge under section 453A(c).) (f) Recapture income. The facts are the same as in paragraph (a) of this Example 5, except that S bought depreciable property for $100x and its depreciation deductions reduced the property's basis to $70x before Year 1, S sells the depreciable property (rather than land) to B for $100x on January 1 of Year 1, and S's $30x of gain is recapture income on a separate entity basis under section 1245. S's gain is treated as recapture income that is ineligible under section 453(i) for installment reporting. Thus, S takes $30x ordinary income into account in Year 3. B takes its $10 gain into account in Years 4 and 5, and the gain is subject to the interest charge under section 453A(c). (If S has bought the depreciable property for $110x and its recomputed basis under section 1245 had been $110x (rather than $100x), B's $10x gain and S's $30x gain would both be recapture income ineligible under section 453(i) for installment reporting.) Example 6. Intercompany sale of installment obligation. (a) Facts. S holds land for investment with a basis of $70x. On January 1 of Year 1, S sells the land to X in exchange for X's $100x note, and S reports its gain on the installment method under section 453. X's note bears interest at a market rate of interest in excess of the applicable Federal rate, and provides for principal payments of $50x in Year 5 and $50x in Year 6. Section 453A applies to X's note. On July 1 of Year 3, S sells X's note to B for $100x, and under section 453B(a) S is considered to recognize the $30x gain from its prior sale of the land to X. (b) Timing and attributes. S's sale of X's note to B is an intercompany transaction, and S's $30x gain is intercompany gain. S takes $15x of the gain into account in each of Years 5 and 6 to reflect the $15x difference in each year between B's $0 gain taken into account and its $15x recomputed gain. S's gain continues to be treated as its gain from the sale to X, and the deferred tax liability remains subject to the interest charge under section 453A(c). (c) Worthlessness. The facts are the same as in paragraph (a) of this Example 6, except that X's note becomes worthless on December 1 of Year 3 and B has a $100x short-term capital loss under section 165(g) on a separate entity basis. Under the matching rule, B's loss is a long-term capital loss because B's holding period for X's note is aggregated with S's holding period. In addition, S takes its $30x gain into account in Year 3 to reflect the $30x difference between B's $100x loss taken into account and its $70x recomputed loss. S's gain is long-term capital gain. (d) Pledge. The facts are the same as in paragraph (a) of this Example 6, except that, on December 1 of Year 3, B borrows $100x from an unrelated bank and secures the indebtedness with X's note. X's note remains subject to section 453A(d) following the sale to B. Under section 453A(d), B's $100x of proceeds from the secured indebtedness is treated as an amount received on December 1 of Year 3 by B on X's note. Thus, S takes its entire $30x gain into account in Year 3. Example 7. Performance of services. (a) Facts. S is a driller of water wells. B operates a ranch in a remote location, and B's taxable income from the ranch is not subject to section 447. B's ranch requires water to maintain its cattle. During Year 1, S drills an artesian well on B's ranch in exchange for $100 from B, and S incurs $80 of expenses (e.g., for employees and equipment). B capitalizes its $100 cost for the well under section 263, and takes into account $10 of cost recovery deductions in each of Years 2 through 11. Under its separate entity method of accounting, S would take its income and expenses into account in Year 1. (b) Definitions. Under paragraph (b)(1) of this section, the service transaction is an intercompany transaction, S is the selling member, and B is the buying member. S has $100 of income and $80 of related expenses. Under paragraph (b)(2)(i)(B) of this section, S's income and expense are both included in determining its intercompany income of $20. (c) Timing and attributes. S's $20 of income is taken into account under the matching rule to reflect the $20 difference between B's items to be taken into account (based on its $100 cost basis in the well) and B's recomputed items (based on the $80 basis B would have if S and B were divisions of a single corporation and B's basis were determined by reference to S's $80 of expenses). In Year 1, S takes into account $80 of its income and the $80 of expenses. In each of Years 2 though 11, S takes $2 of its remaining $20 of income into account to reflect the annual $2 difference between B's $10 of cost recovery deductions taken into account and its $8 of recomputed cost recovery deductions. S's intercompany income and related expenses, and B's cost recovery deductions, are ordinary items. (d) Sale of capitalized services. The facts are the same as in paragraph (a) of this Example 7, except that B sells the ranch before Year 11 and recognizes gain attributable to the well. To the extent of the offsetting $80 income and expense and S's income taken into account as a result of B's cost recovery deductions, the timing and attributes are determined in the manner provided in paragraph (c) of this Example 7. The remainder of S's $20 of income is treated like the recomputed gain B would have taken into account if S and B were divisions of a single corporation (recapture income or section 1231 gain, even though it is from S's performance of services). Example 8. Rental of property. B operates a ranch that requires grazing land for its cattle. S owns undeveloped land adjoining B's ranch. On January 1 of Year 1, S leases grazing rights to B for Year 1. B's $100 rent expense is deductible for Year 1 under its separate entity accounting method. Under paragraph (b)(1) of this section, the rental transaction is an intercompany transaction, S is the selling member, and B is the buying member. S takes its $100 of income into account in Year 1 to reflect the $100 difference between B's rental deduction taken into account and its $0 recomputed rent deduction. S's income and B's deduction are ordinary items. Example 9. Back-to-back intercompany sales. (a) Facts. S holds land for investment with a basis of $70. On January 1 of Year 1, S sells the land to M for $90. M also holds the land for investment. On July 1 of Year 3, M sells the land for $100 to B, and B holds the land for sale to customers in the ordinary course of business. During Year 5, B sells all of the land to customers for $105. (b) Timing. Under paragraph (b)(1) of this section, S's sale of the land to M and M's sale of the land to B are both intercompany transactions. S is the selling member and M is the buying member in the first intercompany transaction, and M is the selling member and B is the buying member in the second intercompany transaction. Under paragraph (c)(3)(ii)(B) of this section, S, M and B are treated as divisions of a single corporation for purposes of determining the timing of their items from the intercompany transactions. See also paragraph (j)(1)(ii) of this section (B is treated as a successor to M for purposes of taking S's intercompany gain into account). Thus, S's $20 gain and M's $10 gain are both taken into account in Year 5 to reflect the difference between B's $5 gain taken into account with respect to the land and its $35 recomputed gain (i.e., the gain that B would have taken into account if the intercompany sales had been transfers between divisions of a single corporation, and B succeeded to S's $70 basis). (c) Attributes. Under paragraphs (c)(3)(ii)(B) of this section, the attributes of the intercompany items and corresponding items of S, M, and B are also determined by treating S, M, and B as divisions of a single corporation. For example, S and M must take B's activities into account in determining the character of their gains. Example 10. Intercompany sale of a partnership interest. (a) Facts. S owns a 20% interest in the capital and profits of a general partnership. The partnership holds land for investment with an equal basis and value, and operates depreciable assets which have value in excess of basis. S's basis in its partnership interest equals its share of the adjusted basis of the partnership's land and depreciable assets. The partnership has an election under section 754 in effect. On January 1 of Year 1, S sells its partnership interest to B at a gain. During Years 1 through 10, the partnership depreciates the operating assets, and B's depreciation deductions from the partnership reflect the increase in the basis of the depreciable assets under section 743(b). (b) Timing and attributes. S's gain is taken into account during Years 1 though 10 to reflect the difference in each year between B's depreciation deductions from the partnership taken into account and B's recomputed depreciation deductions from the partnership. S's gain taken into account is ordinary income. (The acceleration rule of paragraph (d) of this section does not apply to S's gain as a result of the section 743(b) adjustment, because the adjustment is solely with respect to B and therefore no nonmember reflects any part of the intercompany transaction.) (c) Partnership sale of assets. The facts are the same as in paragraph (a) of this Example 10, and the partnership sells some of its depreciable assets to X at a gain on December 31 of Year 4. In addition to the intercompany gain taken into account as a result of the partnership's depreciation, S takes intercompany gain into account in Year 4 to reflect the difference between B's partnership items taken into account from the sale (which reflect the basis increase under section 743(b)) and B's recomputed partnership items. S's additional gain is treated like the recomputed gain B would have taken into account if S and B were divisions of a single corporation (recapture income or section 1231 gain). (d) B's sale of partnership interest. The facts are the same as in paragraph (a) of this Example 10, and on December 31 of Year 4, B sells its partnership interest to X at no gain or loss. In addition to the intercompany gain taken into account as a result of the partnership's depreciation, the remaining balance of S's intercompany gain is taken into account in Year 4 to reflect the difference between B's $0 gain taken into account from the sale of the partnership interest and its recomputed gain. Whether any of S's remaining balance is treated as ordinary income depends on the application of section 751 at the time of B's sale. (e) No section 754 election. The facts are the same as in paragraph (a) of this Example 10, except that the partnership does not have a section 754 election in effect, and B recognizes a capital loss from its sale of the partnership interest to X on December 31 of Year 4 (B initially had a cost basis in the partnership interest equal to its value, but the partnership's built-in income and gain increased B's basis in excess of the value). Because there is no difference between B's depreciation deductions from the partnership taken into account and its recomputed depreciation deductions, S does not take any of its gain into account during Years 1 through 4 as a result of B's partnership's items. Instead, S's entire intercompany gain is taken into account in Year 4 to reflect the difference between B's loss taken into account from the sale to X and its recomputed gain or loss. Example 11. Net operating losses subject to section 382 or the SRLY rules. (a) Facts. On January 1 of Year 1, P buys all of S's stock. S has net operating loss carryovers from prior years. P's acquisition results in an ownership change under section 382 with respect to S's loss carryovers, and S has a net unrealized built-in gain (within the meaning of section 382(h)(3)). S owns nondepreciable property with a $70 basis and $100 value. On July 1 of Year 3, S sells the property to B for $100, and its $30 gain is recognized built-in gain (within the meaning of section 382(h)(2)) on a separate entity basis. On December 1 of Year 5, B sells the property to X for $90. (b) Timing and attributes. S's $30 gain is taken into account in Year 5 to reflect the $30 difference between B's $10 loss taken into account and its recomputed $20 gain. Treating S and B as divisions of a single corporation for purposes of determining the attributes of B's loss and S's gain, the single corporation has losses subject to limitation under section 382, and this limitation may be increased under section 382(h) if the single corporation has recognized built-in gain with respect to those losses from either of its divisions. Of S's $30 of gain, $20 is treated as recognized built-in gain, and the remaining $10 that is offset by B's loss is treated as not being recognized built-in gain. Thus, $10 of S's gain does not increase the section 382 limitation applicable to S's losses. (c) B's recognized built-in gain. The facts are the same as in paragraph (a) of this Example 11, except that the property declines in value after S becomes a member of the P group, S sells the property to B for its $70 basis, and B sells the property to X for $90 during Year 5. Treating S and B as divisions of a single corporation, S's sale to B does not cause the property to cease to be built-in gain property. Thus, B's $20 gain from its sale to X is recognized built-in gain that increases the section 382 limitation applicable to S's losses. (d) Depreciable property. The facts are the same as in paragraph (a) of this Example 11, except that S's property is depreciable property, and S's $30 gain is taken into account as a result of B's depreciation of the property. Treating S and B as divisions of a single corporation, both B's depreciation and S's gain taken into account as a result of B's depreciation are treated as not being recognized built-in amounts. Thus, S's gain taken into account as a result of the depreciation does not increase the section 382 limitation applicable to S's losses. (e) SRLY limitation. The facts are the same as in paragraph (a) of this Example 11, except that S's net operating loss carryovers are subject to the separate return limitation year (SRLY) rules. See Sec. 1.1502-21(c). Although the matching rule redetermines the timing and attributes of items, the amount and location of items are not redetermined. Because S's SRLY limitation is determined solely by its contribution to consolidated taxable income (as determined under Sec. 1.1502-21(c)), S's SRLY limitation in Year 5 includes its entire $30 gain taken into account. Example 12. Special inventory accounting election. (a) Facts. S operates a farming business (within the meaning of section 263A(e)(4)) of growing and selling grapes to customers, including B. S is not required to use an inventory method, and uses the cash method of accounting. See sections 446 to 448 and 471, and Sec. 1.1502-17. On a separate entity basis, S does not capitalize its employee costs for the production of grapes pursuant to an election under section 263A(d)(3). B uses grapes purchased from S to produce wine for sale to customers. B uses the accrual method of accounting, and includes the cost of S's grapes in inventory under its inventory method. During Year 1, S sells grapes to B, incurring employee production costs. During Year 2, B converts the grapes into wine. In December of Year 3, based on its inventory method, B sells the wine produced with S's grapes and recognizes ordinary income. (b) Related costs and expenses. Under paragraph (b)(2)(i)(B) of this section, S costs related to its sale of grapes to B are included in the determination of its intercompany items. Because the timing of S's costs may differ from the timing of S's income, it is necessary to determine whether S's costs are to be accounted for separate from, rather than combined with, S's income from B in determining its intercompany income or loss deferred until Year 3. The determination depends on whether S's election under section 263A(d)(3) would continue to permit deduction of the costs if S were engaged in a separate farming business as part of a single corporation that includes B. See, e.g., sections 447 and 448. If the costs are separately accounted for, they are taken into account in Year 1 rather than deferred until Year 3. Example 13. Section 475. (a) Facts. S, a dealer in securities within the meaning of section 475(c), purchases a security for $100. The security is held for sale to customers and is not identified under section 475(b) as within an exception to marking to market, and S recognizes $30 of net mark-to-market decreases before Year 1. On July 1 of Year 1, S sells the security to B for $100. B is not a dealer and holds the security for investment. On December 31 of Year 1, the fair market value of the security is $100. On July 1 of Year 2, B sells the security to X for $110. (b) Treatment as a single corporation. Under section 475, a dealer in securities can treat a security as within an exception to marking to market under section 475(b) only if it identifies the security on the day of its acquisition. S's intercompany gain is taken into account by treating section 475 as applying to S and B as a single corporation that is a dealer with respect to securities as a result of S's activities. Thus, B's recomputed items are determined by B's continuing to treat the security as not within an exception to marking to market. However, under section 475(d)(3), it is possible for the character of S's intercompany items to differ from the character of B's corresponding items. (c) Timing and attributes. S has a $30 gain when it disposes of the security by selling it to B. This gain is intercompany gain that is taken into account in Year 1 to reflect the $30 difference between B's $0 gain taken into account and its recomputed $30 gain that would be taken into account as a result of marking to market under section 475. Under section 475(d)(3), S's gain is ordinary income. B has a $10 gain as a result of its sale to X, and this gain is taken into account in Year 2. Under section 475(d)(3), B's gain is capital gain. (d) Nondealer to dealer. The facts are the same as in paragraph (a) of this Example 13, except that S is not a dealer and holds the security for investment with a $70 basis, B is a dealer to which section 475 applies and, immediately after acquiring the security from S for $100, B holds the security for sale to customers in the ordinary course of its trade or business. Treating S and B as divisions of a single corporation, the security is treated as properly identified as held for investment under section 475(b)(1) until it is sold to B. Under section 475(b)(3), the security thereafter ceases to be described in section 475(b)(1) because B holds the security for sale to customers, and the mark-to-market requirement applies only to changes in the value of the security after B's acquisition. None of S's gain is taken into account in Year 1 as a result of B's marking the security to market in Year 1. B's mark-to-market gain taken into account and its recomputed mark- to-market gain are both determined based on changes from the $100 value of the security at the time of B's acquisition. There is no difference between B's $0 mark-to-market gain taken into account in Year 1 and its $0 recomputed mark-to-market gain. In Year 2, B has a $10 gain when it disposes of the security by selling it to X, but would have had a $40 gain if S and B were divisions of a single corporation. Thus, S takes its $30 gain into account in Year 2 under the matching rule. Under section 475(d)(3), S's gain is capital gain even though B's subsequent gain or loss from marking to market or disposing of the security is ordinary gain or loss. (If B had held the security for investment, and had so identified the security under section 475(b)(1), the security would continue to be excepted from marking to market.) Example 14. Section 1092. (a) Facts. On July 1 of Year 1, S enters into offsetting long and short positions with respect to actively traded personal property. The positions are not section 1256 contracts, and they are the only positions taken into account for purposes of applying section 1092. On August 1 of Year 1, S sells the long position to B at an $11 loss, and there is $11 of unrealized gain in the offsetting short position. On December 1 of Year 1, B sells the long position to X at no gain or loss. On December 31 of Year 1, there is still $11 of unrealized gain in the short position. On February 1 of Year 2, S closes the short position at an $11 gain. (b) Timing and attributes. S's $11 loss is taken into account in Year 1 under the matching rule to reflect the difference between B's corresponding items taken into account and B's recomputed items. Under paragraph (a)(3) of this section, however, an item taken into account under this section can be deferred, disallowed, or eliminated under other applicable law. Under section 1092, S's loss continues to be deferred until Year 2 notwithstanding this section. (The results are the same under section 267(f).) Example 15. Manufacturer rebates. (a) Facts. B is a manufacturer that sells its products to independent dealers for resale. S is a credit company that offers financing, including financing to customers of the dealers. S also purchases the product from dealers for lease to customers of the dealers. During Year 1, B initiates a program of rebates to the dealers' customers. Under B's program, S buys a $100 product from a dealer and leases it to another. S pays $90 to the dealer for the product, and assigns to the dealer its $10 rebate from B. Under their separate entity accounting methods, B deducts the $10 rebate in Year 1 and S takes a $90 basis in the product. (b) Timing and attributes. Under paragraph (b)(1) of this section, the rebate transaction is an intercompany transaction. S's $90 basis in the product reflects a $10 adjustment for the rebate from B. Under paragraph (b)(2)(iii)(A) of this section, S is treated as having $10 of intercompany income that is to be taken into account under this section. S's income is taken into account in Year 1 to reflect the $10 difference between B's $10 deduction taken into account and its $0 recomputed deduction. S's $10 of income and B's $10 deduction are ordinary items. Because the rebate is treated as income to S, S's basis in the product is $100 rather than $90. S's additional $10 of basis in the product is recovered based on subsequent events (e.g., S's cost recovery deductions or its sale of the product). Example 16. Cancellation of debt and attribute reduction under section 108(b). (a) Facts. S holds land for investment with a basis of $0. On January 1 of Year 1, S sells the land to B for $100. B also holds the land for investment. During Year 3, due to the declining value of B's assets, B's nonmember creditors discharge $60 of B's indebtedness. Because of insolvency, B's $60 discharge is excluded from B's gross income under section 108(a). B's elimination of $60 of basis in the land under sections 108(b) and 1017 preserves $60 of other attributes. (b) Matching rule. Under paragraph (b)(2)(iii)(B) of this section, B's $60 basis reduction under section 108(b) is an adjustment that is a substitute for a corresponding item and is therefore treated as a corresponding item for purposes of taking S's intercompany gain into account. Although the basis reduction in effect preserves $60 of B's discharge of indebtedness income, the reduction also preserves other attributes that subsequently may be taken into account and therefore affects the overall amount of items to be taken into account. Thus, S takes $60 of its gain into account as a result of the basis reduction. The $60 gain is treated as ordinary income because the basis reduction has the effect of offsetting ordinary income from the discharge of indebtedness. (c) Purchase price adjustment. Assume instead that S sells the land to B in exchange for B's $100 purchase money note, B remains solvent, and S subsequently agrees to discharge $60 of the note as a purchase price adjustment to which section 108(e)(5) applies. A purchase price adjustment is not equivalent to a deduction or loss that offsets discharge of indebtedness income. Instead, under applicable principles of tax law, $60 of S's gain and $60 of B's basis in the land are eliminated and never taken into account. Example 17. Source of items from a section 863 sale. (a) Facts. S manufactures inventory in the United States that it sells to distributors for resale to customers. B is a distributor with a foreign branch in country Y that purchases and resells the inventory outside the United States. During Year 1, S manufactures inventory, sells it to B's country Y branch at an arm's length price, and has $75 of income. There is no independent factory or production price for the sale. Also during Year 1, B's country Y branch resells the inventory to X, an unrelated foreign person, with title passing abroad. B recognizes $25 of income. S's United States manufacturing assets have a value of $900, and B's country Y branch assets have a value of $100. (b) Timing. S's $75 of intercompany income is taken into account in Year 1 to reflect the difference between B's $25 of corresponding income taken into account and its $100 of recomputed income. (c) Attributes. The attributes of S's intercompany income and B's corresponding income are determined as if S and B were divisions of a single corporation. Thus, section 863 applies to S's intercompany sale as if S and B were divisions of a corporation manufacturing in the United States and selling in country Y. Two steps are required to source S's $75 of income and B's $25 of income. First, the $100 of combined income must be divided into foreign and U.S. source income portions. Of the combined income, $50 is sourced based on the aggregate asset values of S and B, with $45 of the $50 treated as United States source income ($50 multiplied by $900/$1,000) and $5 treated as foreign source income ($50 multiplied by $100/$1,000). The remaining $50 of combined income is treated as foreign source income, based on the passage of title to X outside the United States. See Sec. 1.863-3T(b), Example 2. Thus, $55 of the $100 of combined income is treated as foreign source income and $45 is treated as United States source income. Second, consistent with the treatment of S and B as divisions of a single corporation, the foreign and United States source income is allocated between S and B based on their intercompany income and corresponding income. Because S earned $75 and B earned $25, $41.25 of the $55 of foreign source income is allocated to S ($55 multiplied by 75/100), and $13.75 is allocated to B ($55 multiplied by 25/100). Similarly, $33.75 of the $45 of United States source income is allocated to S ($45 multiplied by 75/100), and $11.25 is allocated to B ($45 multiplied by 25/100). Example 18. Section 1248. (a) Facts. On January 1 of Year 1, S forms FT, a wholly owned foreign subsidiary, with a $10 contribution. During Years 1 through 3, FT has earnings and profits of $40. None of the earnings and profits is taxed as subpart F income under section 951, and FT distributes no dividends to S during this period. On January 1 of Year 4, S sells its FT stock to B for $50. While B owns FT, FT has a deficit in earnings and profits of $10. On July 1 of Year 6, B sells its FT stock for $70 to X, an unrelated foreign corporation. (b) Timing. S's $40 of intercompany gain is taken into account in Year 6 to reflect the difference between B's $20 of gain taken into account and its $60 recomputed gain. (c) Attributes. Section 1248 applies to determine the attributes of S's intercompany gain and B's corresponding gain as if S and B were divisions of a single corporation. The portions of S's gain and B's gain characterized as dividends under section 1248 is determined on the basis of FT's $30 of earnings and profits at the time of B's sale to X. Treating S and B as divisions of a single corporation, this $30 amount is allocated between S and B based on their respective gains. Because S has a $40 gain and B has a $20 gain, S is allocated $20 of the $30 section 1248 amount ($30 multiplied by $40/$60), and B is allocated the remaining $10 of the section 1248 amount ($30 multiplied by $20/$60). S's $20 of gain in excess of its $20 section 1248 amount, and B's $10 of gain in excess of its $10 section 1248 amount, are each treated as gain from the sale or exchange of a capital asset. Thus, $20 of S's intercompany gain is treated as a dividend and the remaining $20 is treated as capital gain, and $10 of B's corresponding gain is treated as a dividend and the remaining $10 is treated as capital gain. (d) No deficit in earnings and profits. The facts are the same as in paragraph (a) of this Example 18, except that FT has no earnings and profits or deficit in earnings and profits while B owns FT, and B sells the FT stock to X for $40. Because S has gain from its sale of the FT stock to B, and B has loss from its sale of the FT stock to X, none of FT's $40 section 1248 amount is allocated to B. Moreover, because FT's $40 section 1248 amount exceeds the $30 net gain of S and B (the sum of S's $40 gain and B's $10 loss), the section 1248 amount allocated to S is limited to $30. See section 1248(a). Thus, $30 of S's intercompany gain is treated as a dividend. The remaining $10 of S's gain and all of B's $10 loss are treated as a capital gain and loss. (d) Acceleration rule. S's intercompany items and B's corresponding items are taken into account under this paragraph (d) to the extent they cannot be taken into account to produce the effect of treating S and B as divisions of a single corporation. For this purpose, the following rules apply: (1) S's items--(i) Timing. S takes its intercompany items into account to the extent they cannot be taken into account to produce the effect of treating S and B as divisions of a single corporation. The items are taken into account immediately before it first becomes impossible to achieve this effect. For this purpose, the effect cannot be achieved-- (A) To the extent an intercompany item or corresponding item will not be taken into account in determining the group's consolidated taxable income (or consolidated tax liability) under the matching rule of paragraph (c) of this section (e.g., if S or B becomes a nonmember); or (B) To the extent a nonmember reflects, directly or indirectly, any aspect of the intercompany transaction (e.g., if B's cost basis in property purchased from S is reflected by a nonmember under section 362 following a section 351 transaction). (ii) Attributes. The attributes of S's intercompany items taken into account under this paragraph (d)(1) are determined as follows: (A) If the item is from a sale, exchange, or distribution of property, its attributes are determined under the principles of the matching rule of paragraph (c) of this section as if B resold the property to a nonmember affiliate at the time the item is taken into account, for a cash payment equal to B's adjusted basis in the property. (B) If the item is from an intercompany transaction other than a sale, exchange, or distribution of property (e.g., income from S's services capitalized by B), its attributes are determined on a separate entity basis. (2) B's items--(i) Timing. If paragraph (d)(1) of this section applies to S, B nevertheless continues to take its corresponding items into account under its accounting method. However, the redetermination of the attributes of a corresponding item under this paragraph (d)(2) may affect its timing. (ii) Attributes. The attributes of B's corresponding items continue to be redetermined under the principles of the matching rule of paragraph (c) of this section, with the following adjustments: (A) If S and B continue to join with each other in the filing of consolidated returns, the attributes of B's corresponding items (and any applicable holding periods) are determined by continuing to treat S and B as divisions of a single corporation. (B) Once S and B no longer join with each other in the filing of consolidated returns, the attributes of B's corresponding items are determined as if the S division (but not the B division) were transferred by the single corporation to an unrelated person. Thus, S's activities (and any applicable holding period) before the intercompany transaction continue to affect the attributes of the corresponding items (and any applicable holding period). (3) Examples. The acceleration rule of this paragraph (d) is illustrated by the following examples. Example 1. Becoming a nonmember--timing. (a) Facts. S owns land with a basis of $70. On January 1 of Year 1, S sells the land to B for $100. On July 1 of Year 3, P sells 60% of S's stock to X for $60 and, as a result, S becomes a nonmember. (b) Matching rule. Under the matching rule of paragraph (c) of this section, none of S's $30 gain is taken into account in Years 1 through 3 because there is no difference between B's $0 gain or loss taken into account and its recomputed gain or loss. (c) Acceleration of S's intercompany items. Under the acceleration rule of paragraph (d) of this section, S's $30 gain is taken into account in computing consolidated taxable income (and consolidated tax liability) immediately before the effect of treating S and B as divisions of a single corporation cannot be produced. Because the effect cannot be produced once S becomes a nonmember, S takes its $30 gain into account in Year 3 immediately before becoming a nonmember. S's gain is reflected under Sec. 1.1502-32 in P's basis in the S stock immediately before P's sale of the stock. Under Sec. 1.1502-32, P's gain is reduced (or loss is increased) by $18 (60% of $30). See also Secs. 1.1502-33 and 1.1502-76(b). (The results would be the same if S sold the land to B in an installment sale to which section 453 would otherwise apply, because S must take its intercompany gain into account under this section.) (d) B's corresponding items. Notwithstanding the acceleration of S's gain, B continues to take its corresponding items into account under its accounting method. Thus, B's items from the land are taken into account based on subsequent events (e.g., its sale of the land). (e) Sale of B's stock. The facts are the same as in paragraph (a) of this Example 1, except that P sells 60% of B's stock (rather than S stock) to X for $60 and, as a result, B becomes a nonmember. Because the effect of treating S and B as divisions of a single corporation cannot be produced once B becomes a nonmember, S takes its $30 gain into account under the acceleration rule immediately before B becomes a nonmember. (The results would be the same if S sold the land to B in an installment sale to which section 453 would otherwise apply, because S must take its intercompany gain into account under this section.) (f) Discontinue filing consolidated returns. The facts are the same as in paragraph (a) of this Example 1, except that the P group receives permission under Sec. 1.1502-75(c) to discontinue filing consolidated returns beginning in Year 3. Under the acceleration rule, S takes its $30 gain into account on December 31 of Year 2. (g) No subgroups. The facts are the same as in paragraph (a) of this Example 1, except that P simultaneously sells all of the stock of both S and B to X (rather than 60% of S's stock), and S and B become members of the X consolidated group. Because the effect of treating S and B as divisions of a single corporation in the P group cannot be produced once S and B become nonmembers, S takes its $30 gain into account under the acceleration rule immediately before S and B become nonmembers. (Paragraph (j)(2) of this section does not apply to treat the X consolidated group as succeeding to the P group because the X group acquired only the stock of S and B.) However, so long as S and B continue to join with each other in the filing of consolidated returns, B continues to treat S and B as divisions of a single corporation for purposes of taking its corresponding items from the land into account. Example 2. Becoming a nonmember--attributes. (a) Facts. S holds land for investment with a basis of $70. On January 1 of Year 1, S sells the land to B for $100. B holds the land for sale to customers in the ordinary course of business, and expends substantial resources over a two-year period subdividing, developing, and marketing the land. On July 1 of Year 3, before B has sold any of the land, P sells 60% of S's stock to X for $60 and, as a result, S becomes a nonmember. (b) Attributes. Under the acceleration rule, the attributes of S's gain are redetermined under the principles of the matching rule as if B resold the land to a nonmember affiliate for a cash payment equal to B's adjusted basis in the land. (The deemed resale is solely for purposes of determining attributes, and therefore does not apply for purposes of determining timing.) Thus, whether S's gain is capital gain or ordinary income depends on the activities of both S and B. Because S and B no longer join with each other in the filing of consolidated returns, the attributes of B's corresponding items (e.g., from its subsequent sale of the land) are redetermined under the principles of the matching rule of paragraph (c) of this section as if the S division (but not the B division) were transferred by the single corporation to an unrelated person at the time of P's sale of the S stock. Thus, B continues to take into account the activities of S with respect to the land before the intercompany transaction. (c) Depreciable property. The facts are the same as in paragraph (a) of this Example 2, except that the property sold by S to B is depreciable property. Section 1239 applies to treat all of S's gain as ordinary income because it is taken into account as a result of B's deemed resale of the property to a nonmember affiliate (a related person within the meaning of section 1239(b)). (The results would be the same if P sells 60% of B's stock (rather than S's stock) to X.) Example 3. Back-to-back intercompany transactions. (a) Facts. During Year 1, S performs services for M in exchange for $10 from M. M capitalizes the $10 cost of S's services under section 263 as part of M's cost to acquire real property from X. S incurs $8 of employee expenses that would be taken into account in Year 1 under its separate entity method of accounting. M holds the real property for investment and, on July 1 of Year 5, M sells it to B at a gain. B also holds the real property for investment. On December 1 of Year 8, while B still owns the real property, P sells all of M's stock to X and M becomes a nonmember. (b) M's items. M takes its gain into account immediately before it becomes a nonmember. The acceleration rule redetermines the attributes of M's gain under the principles of the matching rule as if B resold the real property to a nonmember affiliate for a cash payment equal to B's adjusted basis in real property, and S, M, and B were divisions of a single corporation. Thus, M's gain is capital gain. (c) S's items. Under paragraph (b)(2) of this section, S includes the $8 of expenses in determining its intercompany income. In Year 1, S takes into account $8 of its income and the $8 of expenses. Under paragraph (c)(3)(ii)(B) of this section, appropriate adjustments must be made to treat both S's performance of services for M and M's sale to B as occurring between divisions of a single corporation. Thus, S's remaining $2 of intercompany income is not taken into account as a result of M becoming a nonmember, but instead will be taken into account based on subsequent events (e.g., under the matching rule based on B's sale of the real property to a nonmember, or under the acceleration rule based on P's sale of the stock of S or B to a nonmember). See the successor person rules of paragraph (j)(1)(ii) of this section (B is treated as a successor to M for purposes of taking S's intercompany income into account). (d) Sale of S's stock. The facts are the same as in paragraph (a) of this Example 3, except that P sells all of S's stock (rather than M's stock) and S becomes a nonmember on July 1 of Year 5. S's remaining $2 of intercompany income is taken into account immediately before S becomes a nonmember. Because S's intercompany income is not from an intercompany sale, exchange, or distribution of property, the attributes of the intercompany income are determined on a separate entity basis. Thus, S's $2 of intercompany income is ordinary income. M does not take any of its intercompany gain into account as a result of S becoming a nonmember. (e) Intercompany income followed by intercompany loss. The facts are the same as in paragraph (a) of this Example 3, except that M sells the real property to B at a $1 loss (rather than a gain). M takes its $1 loss into account under the acceleration rule immediately before M becomes a nonmember. But see Sec. 1.267(f)-1. Under paragraph (c)(3)(ii)(B) of this section, P's sale of M stock also results in S taking into account $1 of intercompany income as capital gain to offset M's $1 of corresponding capital loss. The remaining $1 of S's intercompany income is taken into account based on subsequent events. Example 4. Selling member's disposition of proceeds. (a) Facts. S owns land with a basis of $70. On January 1 of Year 1, S sells the land to B in exchange for B's $110 note. The note bears a market rate of interest in excess of the applicable Federal rate, and provides for principal payments of $55 in Year 4 and $55 in Year 5. On July 1 of Year 3, S sells B's note to X for $110. (b) Timing. S's intercompany gain is taken into account under this section, and not under the rules of section 453. Consequently, S's sale of B's note does not result in its intercompany gain being taken into account (e.g., under section 453B). The sale does not prevent S's intercompany items and B's corresponding items from being taken into account in determining the group's consolidated taxable income under the matching rule, and X does not reflect any aspect of the intercompany transaction (X has its own cost basis in the note). S will take the intercompany gain into account under the matching rule or acceleration rule based on subsequent events (e.g., B's sale of the land). See also paragraph (g) of this section for additional rules applicable to B's note as an intercompany obligation. Example 5. Section 481. (a) Facts. S operates several trades or businesses, including a manufacturing business. S receives permission to change its method of accounting for valuing inventory for its manufacturing business. S increases the basis of its ending inventory by $100, and the related $100 positive section 481(a) adjustment is to be taken into account ratably over six taxable years, beginning in Year 1. During Year 3, S sells all of the assets used in its manufacturing business to B at a gain. Immediately after the transfer, B adopts and uses the same inventory valuation method as S. On a separate entity basis, S's sale results in an acceleration of the balance of the section 481(a) adjustment to Year 3. (b) Timing and attributes. Under paragraph (b)(2)(i) of this section, the balance of S's section 481(a) adjustment accelerated to Year 3 is intercompany income. However, S's $100 basis increase before the intercompany transaction eliminates the related difference between B's corresponding items taken into account and its recomputed items in subsequent periods. Because the accelerated section 481(a) adjustment will not be taken into account in determining the group's consolidated taxable income (and consolidated tax liability) under the matching rule, the balance of S's section 481 adjustment is taken into account under the acceleration rule as ordinary income at the time of the intercompany transaction. (If S's sale had not resulted in accelerating S's section 481(a) adjustment on a separate entity basis, S would have no intercompany income to be taken into account under this section.) (e) Simplifying rules--(1) Dollar-value LIFO inventory methods--(i) In general. This paragraph (e)(1) applies if either S or B uses a dollar-value LIFO inventory method to account for intercompany transactions. Rather than applying the matching rule of paragraph (c) of this section separately to each intercompany inventory transaction, this paragraph (e)(1) provides methods to apply an aggregate approach that is based on dollar-value LIFO inventory accounting. Any method selected under this paragraph (e)(1) must be applied consistently. (ii) B uses dollar-value LIFO--(A) In general. If B uses a dollar- value LIFO inventory method to account for its intercompany inventory purchases, and includes all of its inventory costs incurred for a year in its cost of goods sold for the year, S takes into account all of its intercompany inventory items for the year. If B does not include all of its inventory costs incurred for the year in its cost of goods sold for the year, S does not take into account a percentage of its net intercompany inventory income or loss. The percentage not taken into account is determined under either the increment averaging method or the increment valuation method. Separate computations are made for each pool of B that receives intercompany purchases from S. (B) Increment averaging method. The percentage not taken into account equals B's current-year costs of its layer of increment, divided by B's total inventory costs incurred for the year under its LIFO inventory method. S's amount not taken into account is layered based on B's LIFO inventory layers. If B includes more than its inventory costs incurred during any subsequent year in its cost of goods sold (a decrement), S takes into account the intercompany inventory income or loss layers in the same manner and proportion as B takes into account its inventory decrements. (C) Increment valuation method. The percentage not taken into account equals B's current-year costs of its layer of increment, divided by B's total inventory costs incurred in the appropriate period under its LIFO inventory method. The principles of paragraph (e)(1)(ii)(B) of this section otherwise apply. The appropriate period is the period of B's year used to determine its current-year costs. (iii) S uses dollar-value LIFO. If S uses a dollar-value LIFO inventory method to account for its intercompany inventory sales, S can use any reasonable method of allocating its LIFO inventory costs to intercompany transactions. LIFO inventory costs include costs of prior layers if a decrement occurs. For example, a reasonable allocation of most recent costs incurred during the consolidated return year can be used to compute S's net intercompany inventory income or loss for the year if S has an inventory increment and uses the earliest acquisitions costs method, but S must apportion costs from the most recent appropriate layers of increment if an inventory decrement occurs for the year. (iv) Other reasonable methods. S or B can use a method not specifically provided in this paragraph (e)(1) that is expected to reasonably take into account intercompany items and corresponding items from intercompany inventory transactions. However, if the method used results, for any year, in a cumulative amount of intercompany inventory items not taken into account by S that significantly exceeds the cumulative amount that would not be taken into account under paragraph (e)(1) (ii) or (iii) of this section, S must take into account for that year the amount necessary to eliminate the excess. The method is thereafter applied with appropriate adjustments to reflect the amount taken into account. (v) Examples. The inventory rules of this paragraph (e)(1) are illustrated by the following examples. Example 1. Increment averaging method. (a) Facts. Both S and B use a double-extension, dollar-value LIFO inventory method, and both value inventory increments using the earliest acquisitions cost valuation method. During Year 2, S sells 25 units of product Q to B on January 15 at $10/unit, and another 25 units on September 15 at $12/unit. S's earliest cost of product Q is $7.50/unit and S's most recent cost of product Q is $8.00/unit. B's total inventory costs incurred during Year 2 are $3,333. The S and B inventory computations for Year 2 and prior years are as follows: (i)(A) S's Year 2 computations: ---------------------------------------------------------------------------------------------------------------- (2) base- (3) current- Item (1) ending year cost/ (1)x(2) year cost/ (1)x(3) quantity unit total unit total ---------------------------------------------------------------------------------------------------------------- Q.............................................. 50 $5 $250 $7.50 $375 Y.............................................. 150 2 300 3.00 450 ---------------------------------------------------------------- xl............................................. xl xl $550 xl $825 ---------------------------------------------------------------------------------------------------------------- Year 1--Ending inventory at base-year cost=$500. Year 2--Price index = $825/$550=1.5. (B) S's $7.50 current-year cost/unit of product Q is based on its earliest acquisitions cost of 50 units. ------------------------------------------------------------------------ Base- year Price LIFO cost index cost ------------------------------------------------------------------------ Base layer................................ $450 1.000 $450 Year 1 layer.............................. 50 1.200 60 Year 2 layer.............................. 50 1.500 75 ----------------------------- 585 ------------------------------------------------------------------------ (ii)(A) B's Year 2 computations: ---------------------------------------------------------------------------------------------------------------- (2) Base- (3) Current- Item (1) Ending year cost/ (1)x(2) year cost/ (1)x(3) quantity unit total unit total ---------------------------------------------------------------------------------------------------------------- Q.............................................. 50 $8 $400 $11 $550 Z.............................................. 50 10 500 13 650 ---------------------------------------------------------------- $900 $1,200 ---------------------------------------------------------------------------------------------------------------- Year 1--Ending inventory at base-year cost=$650 Year 2--Price index=$1,200/$900=1.333. (B) B's $11 current-year cost/unit of product Q is based on its earliest acquisitions cost (25 units purchased from S at $10/unit, and 25 units from X at $12/unit). ------------------------------------------------------------------------ Base- year Price LIFO cost index cost ------------------------------------------------------------------------ Base layer................................ $400 1.000 $400 Year 1 layer.............................. 250 1.100 275 Year 2 layer.............................. 250 1.333 333 --------- 1,008 ------------------------------------------------------------------------ (b) Intercompany inventory income. Under paragraph (e)(1)(iii) of this section, S must use a reasonable method of allocating its LIFO inventory costs to intercompany transactions. Because S has an inventory increment for Year 2 and uses the earliest acquisitions cost method, a reasonable method of determining its intercompany cost of goods sold for product Q is to use its most recent costs. Thus, its intercompany cost of goods sold is $400 ($8.00 most recent cost, multiplied by 50 units sold to B), and its intercompany income is $150 ($550 sale proceeds from B minus $400 cost). (c) Timing. (i) Under the increment averaging method of paragraph (e)(1)(ii)(B) of this section, $15 of S's $150 of intercompany inventory income is not taken into account in Year 2, computed as follows:![]()
TP15AP94.001 (ii) Thus, $135 of S's intercompany inventory income is taken into account in Year 2 ($150 of total intercompany inventory income minus $15 not taken into account). (d) S incurs a decrement. The facts are the same as in paragraph (a) of this Example 1, except that S's Year 2 ending inventory at base-year cost is $475, and therefore S incurs a $25 decrement (50% of the Year 1 layer in terms of base-year cost) in its inventory for Year 2. Under paragraph (e)(1)(iii) of this section, S must reasonably allocate the LIFO cost of the decrement (50% of $60, or $30) to the cost of goods sold to B to determine S's intercompany income. (e) B incurs a decrement. The facts are the same as in paragraph (a) of this Example 1, except that B incurs a decrement in Year 2 of $50 in base-year costs. S must take into account the entire $150 of Year 2 intercompany inventory income because all 50 units of product Q are deemed sold by B in Year 2. Example 2. Increment valuation method. (a) Facts. Both S and B use a dollar-value LIFO inventory method. Under B's LIFO method, layers of increment are valued with respect to earliest costs. For Year 2, B has a layer of increment in its pool that receives intercompany purchases from S. To compute its increment valuation index, B values its year-end inventory mix using costs incurred from January through March. B values its increment at $250. B's costs incurred from January through March and from April through December are $750 and $3,300, respectively. For the period from January through March and from April through December, S's intercompany inventory income is $100 and $500, respectively. (b) Timing. (i) Under the increment valuation method of paragraph (e)(1)(ii)(C) of this section, $33 of S's $600 of intercompany inventory income is not taken into account in Year 2, computed as follows: ![]()
TP15AP94.002 (ii) Thus, $567 of S's intercompany inventory income is taken into account in Year 2 ($600 of total intercompany inventory income minus $33 not taken into account). (c) B incurs a subsequent decrement. Assume that, in Year 3, B experiences a decrement in its pool that receives intercompany purchases from S. B's decrement equals 20% of the base-year costs for its Year 2 layer, or $50 in terms of LIFO value (20% of $250). S's intercompany inventory income from its Year 3 sales is $400. Because B includes all of its inventory costs incurred for Year 3 in its cost of goods sold for the year, S takes into account its entire $400 of intercompany income from its Year 3 sales. In addition, S takes into account $6.60 of its Year 2 layer of intercompany inventory income not already taken into account (20% of $33). Example 3. Other reasonable inventory methods. (a) Facts. Both S and B use a dollar-value LIFO inventory method for their inventory transactions. During Year 1, S sells inventory to B and to X. Under paragraph (e)(1)(iv) of the section, to compute its intercompany inventory income and the amount of this income not taken into account, S computes its intercompany inventory income using the transfer price of the inventory items less a FIFO cost for the goods, takes into account these items based on a FIFO cost flow assumption for B's corresponding items, and the LIFO methods used by S and B are ignored for these computations. These computations are comparable to the methods used by S and B for financial reporting purposes, and the book methods and results are used for tax purposes. S adjusts the amount of intercompany inventory items not taken into account as required by section 263A. (b) Reasonable method. The method used by S is a reasonable method under paragraph (e)(1)(iv) of this section if the cumulative amount of intercompany inventory items not taken into account by S is not significantly greater than the cumulative amount that would not be taken into account under the methods specifically described in paragraph (e)(1) of this section. If, for any year, the method results in a cumulative amount of intercompany inventory items not taken into account by S that significantly exceeds the cumulative amount that would not be taken into account under the methods specifically provided, S must take into account for that year the amount necessary to eliminate the excess. The method is thereafter applied with appropriate adjustments to reflect the amount taken into account (e.g., to prevent the amount from being taken into account more than once). (2) Reserve accounting--(i) Bad debts. Except as provided in paragraph (g)(5) of this section (deferral of items from an intercompany obligation), a member's addition to, or reduction of, a reserve for bad debts that is maintained under section 585 or 593 is taken into account on a separate entity basis. For example, if S makes a loan to a nonmember and subsequently sells the loan to B, any deduction for an addition to a bad debt reserve under section 585 and any recapture income (or reduced deductions) are taken into account on a separate entity basis rather than as intercompany items or corresponding items taken into account under this section. Any gain or loss of S from its sale of the loan to B is taken into account under this section, however, to the extent it is not attributable to recapture of the reserve. (ii) Insurance companies--(A) Direct insurance. If a member provides insurance to another member in an intercompany transaction, the transaction is taken into account by both members on a separate entity basis. For example, if one member provides life insurance coverage for another member with respect to its employees, the premiums, reserve increases and decreases, and death benefit payments are determined and taken into account by both members on a separate entity basis rather than taken into account under this section as intercompany items and corresponding items. (B) Reinsurance--(1) In general. Paragraph (e)(2)(ii)(A) of this section does not apply to a reinsurance transaction that is an intercompany transaction. For example, if a member assumes all or a portion of the risk on an insurance contract written by another member, the amounts transferred as reinsurance premiums, expense allowances, benefit reimbursements, reimbursed policyholder dividends, experience rating adjustments, and other similar items are taken into account under the matching rule of paragraph (c) of this section. (2) Reserves determined on a separate entity basis. For purposes of determining the amount of a member's increase or decrease in reserves, the amount of any reserve item listed in section 807(c) or 832(b)(5) resulting from a reinsurance transaction that is an intercompany transaction is determined on a separate entity basis. But see section 845, under which the Commissioner may allocate between or among the members any items, recharacterize any such items, or make any other adjustments necessary to clearly reflect the separate taxable income of a member. (3) De minimis or ordinary course intercompany transactions--(i) General rule. The common parent may request consent to take items from intercompany transactions into account on a separate entity basis, other than intercompany transactions with respect to stock or obligations of members. Consent may be granted for all items, or for items from a class or classes of transactions. The consent has no effect unless granted in writing by the Internal Revenue Service. Unless revoked with the written consent of the Internal Revenue Service, the separate entity treatment applies to all applicable intercompany transactions in the consolidated return year for which consent is granted and in all subsequent consolidated return years. Consent under this paragraph (e)(3) will not apply for purposes of deferring losses and deductions under section 267(f). (ii) Time and manner for requesting consent. The request for consent described in paragraph (e)(3)(i) of this section must be made in the form of a ruling request. The request must be signed by the common parent, include any information required by the Internal Revenue Service, and be filed on or before the due date of the consolidated return (not including extensions of time) for the first consolidated return year to which the consent is to apply. The Internal Revenue Service may impose terms and conditions for granting consent. A copy of the consent must be attached to the consolidated returns (or amended returns) as required by the terms of the consent. (f) Stock of members--(1) In general. In addition to the general rules of this section, the rules of this paragraph (f) apply to stock of members. (2) Intercompany distributions to which section 301 applies--(i) In general. This paragraph (f)(2) provides rules for intercompany transactions to which section 301 applies (intercompany distributions). For purposes of determining whether a distribution is an intercompany distribution, it is treated as occurring under the principles of the entitlement rule of paragraph (f)(2)(iv) of this section. A distribution is not an intercompany distribution to the extent it is deducted by the distributing member. See, e.g., section 1382(c)(1). (ii) Distributee member. An intercompany distribution is not included in the gross income of the distributee member. However, this exclusion applies to a distribution from a subsidiary only to the extent there is a corresponding negative adjustment reflected under Sec. 1.1502-32 in the distributee member's basis in the distributing member's stock. See Secs. 1.1502-26(b) (applicability of the dividends received deduction to distributions not excluded from gross income) and 1.1502-80(d) (non-applicability of section 301(c)(3)). (iii) Distributing member. The principles of section 311(b) apply to the distributing member's loss, as well as gain, from an intercompany distribution of property. Thus, the distributing member's loss is taken into account, for example, under the matching rule of paragraph (c) of this section if the property is subsequently sold to a nonmember. However, section 311(a) continues to apply to distributions to nonmembers (e.g., the distributing member's loss is not recognized). (iv) Entitlement rule. For all Federal income tax purposes, an intercompany distribution is treated as taken into account when the shareholding member becomes entitled to it (generally on the record date) or, if earlier, when it is taken into account under the Internal Revenue Code (e.g., under section 305(c)). For example, if the distributee member becomes entitled to a cash distribution before it is made, the distribution is treated as made when the distributee member becomes entitled to it. Appropriate adjustments must be made (e.g., to determine the earnings and profits of the distributing corporation) if nonmembers own stock of the distributing corporation at the time the distribution is treated as occurring. If it is later established, based on all of the facts and circumstances, that the distribution will not be made (or will be made only in part), the initial taking into account of the distribution is reversed as of the date the distribution was taken into account. (3) Boot in an intercompany reorganization--(i) Application. This paragraph (f)(3) provides additional rules for an intercompany transaction in which money or other property (nonqualifying property) is received that results in the application of section 356. For example, the distribution of stock of a lower-tier member to a higher tier member in an intercompany transaction to which section 355 would otherwise apply but for the receipt of nonqualifying property, is an intercompany reorganization to which this paragraph (f)(3) applies. For this purpose, a transaction is not an intercompany reorganization if a party to the transaction becomes a member or nonmember as part of the same plan or arrangement. For example, if S merges into a nonmember in a transaction described in section 368(a)(1)(A), this paragraph (f)(3) does not apply (under paragraph (j)(1) of this section, the nonmember is a successor to S). (ii) General rule. Nonqualifying property received as part of an intercompany reorganization is treated as received by the shareholder in a separate transaction rather than as part of the intercompany reorganization. See, e.g., sections 302 and 311 (rather than sections 356 and 361). The nonqualifying property is treated as taken into account immediately after the intercompany reorganization if it is received in a transaction to which section 354 would otherwise apply but for the fact that nonqualifying property is received. It is treated as taken into account immediately before the intercompany reorganization if it is received in a transaction to which section 355 would otherwise apply but for the fact that nonqualifying property is received. The treatment under this paragraph (f)(3)(ii) applies for all Federal income tax purposes. (4) Acquisition by issuer of its own stock. If a member acquires its own stock in an intercompany transaction, the member's basis in that stock is treated as eliminated, and the elimination is taken into account for purposes of applying the rules of this section. For example, S's intercompany items from the stock of B are taken into account under this section if B acquires the stock in an intercompany transaction (unless, for example, B acquires the stock in exchange for successor property within the meaning of paragraph (j)(1) of this section in a nonrecognition transaction). (5) Relief for certain liquidations and distributions--(i) Scope. S's intercompany items from an intercompany transfer to B of the stock of another member (T) are taken into account under this section in certain circumstances even though the T stock is never held by a nonmember after the intercompany transaction. For example, if S sells all of T's stock to B at a gain, and T subsequently liquidates into B in a separate transaction to which section 332 applies, S's gain is taken into account under this section. If the rules of this paragraph (f)(5) are elected, certain transactions that are (in whole or in part) nonrecognition transactions will not result in S's items being taken into account. This paragraph (f)(5) applies only if, throughout the period beginning as of S's transfer and ending as of the completion of the nonrecognition transaction, no T stock is owned by a nonmember and T does not become a nonmember. (ii) Section 332--(A) In general. If section 332 applies to T's liquidation into B, and B transfers T's assets to a new member (new T) in a transaction not otherwise pursuant to the same plan or arrangement as the liquidation, the transfer is nevertheless treated for all Federal income tax purposes as pursuant to the same plan or arrangement as the liquidation. For example, if T liquidates into B, but B forms new T by transferring substantially all of T's former assets to new T, S's intercompany gain or loss generally is not taken into account solely as a result of the liquidation if the liquidation and transfer would qualify as a reorganization described in section 368(a). (Under paragraph (j)(1) of this section, B's stock in new T would be a successor asset to B's stock in T, and S's gain would be taken into account based on the new T stock.) (B) Time limitation and adjustments. The transfer of an asset to new T not otherwise pursuant to the same plan or arrangement as the liquidation is treated under this paragraph (f)(5)(ii) as pursuant to the same plan or arrangement only if B transfers it to new T on or before the timely filing (including extensions of time) of the group's return for the year of T's liquidation. Appropriate adjustments are made for any assets not transferred to new T as part of the same plan or arrangement. See, e.g., paragraph (f)(3) of this section (if B retains an asset in the reorganization, the asset is treated as acquired by new T but distributed to B immediately after the reorganization). (C) Downstream merger, etc. The principles of this paragraph (f)(5)(ii) apply, with appropriate adjustments, if B's basis in the T stock is eliminated in a transaction comparable to the section 332 liquidation described in paragraph (f)(5)(ii)(A) of this section. For example, if S and B are subsidiaries, and S sells all of T's stock to B at a gain followed by B's merger into T in a separate transaction described in section 368(a), S's gain is not taken into account solely as a result of the merger if the group forms new B with substantially all of B's former assets (including all of the stock of T). The merger is not treated as a comparable transaction if, for example, any B stock is owned by nonmembers immediately before the merger, or any new B stock is owned by nonmembers immediately after the merger. (iii) Section 338(h)(10)--(A) In general. This paragraph (f)(5)(iii) applies to a deemed liquidation of T under section 332 as the result of an election under section 338(h)(10). This paragraph (f)(5)(iii) does not apply if T has made substantial noncash distributions during the 12-month period ending on the date of the qualified stock purchase, or if paragraph (f)(5)(ii) of this section is applied to the deemed liquidation. B is treated with respect to each share of its T stock as recognizing as a corresponding item any loss or deduction it would recognize (determined after adjusting stock basis under Sec. 1.1502-32) if section 331 applied to the deemed liquidation. For all other Federal income tax purposes, the deemed liquidation remains subject to section 332. (B) Noncash distribution. For purposes of this paragraph (f)(5)(iii), a noncash distribution is a distribution of anything other than cash or a cash item, any marketable stock or security, or any debt of the distributor or distributee member. (C) Limitation on amount of loss. The amount of B's loss or deduction under this paragraph (f)(5)(iii) is limited as follows-- (1) The amount taken into account with respect to each T share cannot exceed the net amount of intercompany income or gain with respect to the share from all intercompany transactions before T's deemed liquidation that is taken into account as a result of the deemed liquidation; and (2) The aggregate amount taken into account under this paragraph (f)(5)(iii) from T's deemed liquidation cannot exceed the net amount of deduction or loss (if any) that would be taken into account from the deemed liquidation if section 331 applied with respect to all T shares. (D) Asset sale, etc. The principles of this paragraph (f)(5)(iii) apply, with appropriate adjustments, if T transfers all of its assets to a nonmember and completely liquidates in a transaction comparable to the section 338(h)(10) transaction described in paragraph (f)(5)(iii)(A) of this section. For example, if S sells all of T's stock to B at a gain followed by T's merger into a nonmember in exchange for a cash payment to B in a transaction treated for Federal income tax purposes as T's sale of its assets to the nonmember and complete liquidation, the merger is ordinarily treated as a comparable transaction. The merger is not treated as a comparable transaction if, for example, T makes substantial noncash distributions during the 12- month period ending on the date of the merger. (iv) Section 355. If, instead of T liquidating into B, B distributes the T stock in an intercompany transaction to which section 355 applies (including an intercompany transaction to which 355 applies because of the application of paragraph (f)(3) of this section), the redetermination of the basis of the T stock under section 358 could cause S's gain or loss to be taken into account under this section. This paragraph (f)(5)(iv) applies to treat B's distribution as subject to section 301 and 311 (as modified by this paragraph (f)), rather than section 355. The election will avoid S's gain or loss being taken into account immediately if matching remains possible, but B's gain or loss from the distribution will also be taken into account under this section. (v) Election. An election to apply this paragraph (f)(5) is made in a separate statement entitled ``[Insert Name and Employer Identification Number of Common Parent] HEREBY ELECTS THE APPLICATION OF Sec. 1.1502-13(f)(5).'' The election must include a description of S's intercompany transaction and T's liquidation (or other transaction). It must specify which application of Sec. 1.1502-13(f)(5) applies and how it alters the otherwise applicable results under this section (including, for example, the amount of S's intercompany items and the amount deferred or offset as a result of this Sec. 1.1502- 13(f)(5)). A separate election must be made for each application of this paragraph (f)(5). The election must be signed by the common parent and filed with the group's income tax return for the year of T's liquidation (or other transaction). The Commissioner may impose reasonable terms and conditions to the application of this paragraph (f)(5) that are consistent with the purposes of this section. (6) Examples. The application of this section to intercompany transactions with respect to stock of members is illustrated by the following examples. Example 1. Dividend exclusion and property distribution. (a) Facts. S owns land with a $70 basis and $100 value. On January 1 of Year 1, P's basis in S's stock is $100. During Year 1, S declares and makes a dividend distribution of the land to P. Under section 311(b), S has a $30 gain. Under section 301(d), P's basis in the land is $100. On July 1 of Year 3, P sells the land to X for $110. (b) Dividend elimination and stock basis adjustments. Under paragraph (b)(1) of this section, S's distribution to P is an intercompany distribution. Under paragraph (f)(2)(ii) of this section, P's $100 of dividend income is not included in gross income. Under Sec. 1.1502-32, P's basis in S's stock is reduced from $100 to $0 in Year 1. (c) Matching rule and stock basis adjustments. Under the matching rule of paragraph (c) of this section (treating P as the buying member and S as the selling member), S takes its $30 gain into account in Year 3 to reflect the $30 difference between P's $10 gain taken into account and its $40 recomputed gain. Under Sec. 1.1502-32, P's basis in S's stock is increased from $0 to $30 in Year 3. (d) Loss property. The facts are the same as in paragraph (a) of this Example 1, except that S has a $130 (rather than $70) basis in the land. Under paragraph (f)(2)(iii) of this section, the principles of section 311(b) apply to S's loss from the intercompany distribution. Thus, S has a $30 loss that is taken into account under the matching rule in Year 3 to reflect the $30 difference between P's $10 gain taken into account and its $20 recomputed loss. (The results are the same under section 267(f).) Under Sec. 1.1502- 32, P's basis in S's stock is reduced from $100 to $0 in Year 1, and from $0 to a $30 excess loss account in Year 3. (If P had distributed the land to its shareholders, rather than selling the land to X, P would take its $10 gain under section 311(b) into account, and S would take its $30 loss into account under the matching rule with $10 offsetting P's gain and $20 recharacterized as a noncapital, nondeductible amount.) (e) Entitlement rule. The facts are the same as in paragraph (a) of this Example 1, except that, after P becomes entitled to the distribution but before the distribution is made, S issues additional stock to the public and becomes a nonmember. Under paragraph (f)(2)(i) of this section, the determination of whether a distribution is an intercompany distribution is made under the entitlement rule of paragraph (f)(2)(iv) of this section. Treating S's distribution as made when P becomes entitled to it results in the distribution being an intercompany distribution. Under paragraph (f)(2)(ii) of this section, the distribution is not included in P's gross income. S's $30 gain from the distribution is intercompany gain that is taken into account under the acceleration rule of paragraph (d) of this section immediately before S becomes a nonmember. Thus, there is a net $70 decrease in P's basis in its S stock under Sec. 1.1502-32 ($100 decrease for the distribution and a $30 increase for S's $30 gain). See also Sec. 1.1502-20(b) (additional stock basis reductions applicable to certain deconsolidations). Under paragraph (a)(4) of this section, P does not take the distribution into account again under separate return rules when received, and P is not entitled to a dividends received deduction. Example 2. Excess loss accounts. (a) Facts. S owns all of T's only class of stock with a $10 basis and $100 value. S has substantial earnings and profits, and T has $10 of earnings and profits (all of which are from pre-affiliation years). On January 1 of Year 1, S declares and distributes a dividend of all of the T stock to P. Under section 311(b), S has a $90 gain. Under section 301(d), P's basis in the T stock is $100. During Year 3, T borrows $90 and declares and makes a $90 distribution to P to which section 301 applies, and P's basis in the T stock is reduced under Sec. 1.1502-32 from $100 to $10. During Year 6, T has $5 of earnings that increase P's basis in the T stock under Sec. 1.1502-32 from $10 to $15. On December 1 of Year 9, T issues additional stock to X and, as a result, T becomes a nonmember. (b) Dividend exclusion. Under paragraph (f)(2)(ii) of this section, P's $100 of dividend income from S's distribution of the T stock, and its $10 of dividend income from T's $90 distribution, are not included in gross income. (c) Matching and acceleration rules. Under the matching rule, S takes $75 of its $90 gain into account in Year 9 as a result of T becoming a nonmember, to reflect the difference between P's $0 gain taken into account and its $75 recomputed gain. If S's distribution to P were a transfer between the divisions, P would succeed to S's $10 basis in the T stock, and the adjustments under Sec. 1.1502-32 for T's $90 distribution and $5 of earnings would have resulted in a $75 excess loss account. Thus, T's becoming a nonmember would have resulted in P taking into account the $75 excess loss account. See Sec. 1.1502-19 (excess loss accounts). S's remaining $15 of gain is taken into account under the matching and acceleration rules based on subsequent events (e.g., under the matching rule if P subsequently sells its T stock, or under the acceleration rule if S becomes a nonmember). (d) Reverse sequence. The facts are the same as in paragraph (a) of this Example 2, except that T borrows $90 and makes its $90 distribution to S before S distributes T's stock to P. Under section 301(d) P's initial basis in the T stock is $10 (the stock's fair market value), and the basis increases to $15 under Sec. 1.1502-32 as a result of T's earnings in Year 6. Under paragraph (f)(2)(ii) of this section, T's $90 distribution to S ($10 of which is a dividend) is not included in S's gross income. The corresponding negative adjustment under Sec. 1.1502-32 reduces S's basis in the T stock from $10 to an $80 excess loss account. Under section 311(b), S has a $90 gain from the distribution of T stock to P. The timing and attributes of S's gain are determined in the manner provided in paragraph (c) of this Example 2. Thus, $75 of S's gain is taken into account under the matching rule in Year 9 as a result of T becoming a nonmember, and the remaining $15 is taken into account under the matching and acceleration rules based on subsequent events. (e) Partial stock sale. The facts are the same as in paragraph (a) of this Example 2, except that P sells 10% of T's stock to X on December 1 of Year 9 for $1.50 (rather than T's issuing additional stock and becoming a nonmember). Under the matching rule, S takes $9 of its gain into account to reflect the difference between P's $0 gain taken into account ($1.50 sale proceeds minus $1.50 basis) and its $9 recomputed gain ($1.50 sale proceeds plus $7.50 excess loss account). (f) Loss, rather than cash distribution. The facts are the same as in paragraph (a) of this Example 2, except that T retains the loan proceeds and incurs a $90 loss in Year 3 that is absorbed by the group. The timing and attributes of S's gain are determined in the same manner provided in paragraph (c) of this Example 2. Under Sec. 1.1502-32, the loss in Year 3 reduces P's basis in the T stock from $100 to $10, and T's $5 of earnings in Year 6 increase the basis to $15. Thus, $75 of S's gain is taken into account under the matching rule in Year 9 as a result of T becoming a nonmember, and the remaining $15 is taken into account under the matching and acceleration rules based on subsequent events. (The timing and attributes of S's gain would be determined in the same manner provided in paragraph (d) of this Example 2 if T incurred the $90 loss before S's distribution of the T stock to P.) (g) Stock sale, rather than stock distribution. The facts are the same as in paragraph (a) of this Example 2, except that S sells the T stock to P for $100 (rather than distributing the stock). The timing and attributes of S's gain are determined in the same manner provided in paragraph (c) of this Example 2. Thus, $75 of S's gain is taken into account under the matching rule in Year 9 as a result of T becoming a nonmember, and the remaining $15 is taken into account under the matching and acceleration rules based on subsequent events. Example 3. Intercompany reorganization. (a) Facts. P forms S and B by contributing $200 to the capital of each. During Years 1 through 4, S and B each earn $50, and under Sec. 1.1502-32 P adjusts its basis in the stock of each to $250. (See Sec. 1.1502-33 for adjustments to earnings and profits.) On January 1 of Year 5, the fair market value of S's assets and its stock is $500, and S merges into B in a tax-free reorganization. Pursuant to the plan of reorganization, P receives B stock with a fair market value of $350 and $150 of cash. (b) Treatment as a section 301 distribution. The merger of S into B is an intercompany reorganization to which paragraph (f)(3) of this section applies. P is treated as receiving additional B stock with a fair market value of $500 and, under section 358, a basis of $250. Immediately after the merger, $150 of the stock received is treated as redeemed, and the redemption is treated under section 302(d) as a distribution to which section 301 applies. Because the $150 distribution is treated as not received as part of the merger, section 356 does not apply and no basis adjustments are required under section 358(a)(1)(A) and (B). Because B is treated under section 381(c)(2) as receiving S's earnings and profits and the redemption is treated as occurring after the merger, $100 of the distribution is treated as a dividend under section 301 and P's basis in the B stock is reduced correspondingly under Sec. 1.1502- 32. The remaining $50 of the distribution reduces P's basis in the B stock. Section 301(c)(2) and Sec. 1.1502-32. Under paragraph (f)(2)(ii) of this section, P's $100 of dividend income is not included in gross income. Under Sec. 1.302-2(c), appropriate adjustments are made to P's basis in its B stock to reflect its basis in the B stock redeemed, with the result that P's basis in the B stock is reduced by the entire $150 distribution. (c) Depreciated property. The facts are the same as in paragraph (a) of this Example 3, except that property of S with a $200 basis and $150 fair market value is distributed to P (rather than cash of B). As in paragraph (b) of this Example 3, P is treated as receiving additional B stock in the merger and a $150 distribution to which section 301 applies immediately after the merger. Under paragraph (f)(2)(iii) of this section, the principles of section 311(b) apply to B's $50 loss and the loss is taken into account under the matching and acceleration rules based on subsequent events (e.g., under the matching rule if P subsequently sells the property, or under the acceleration rule if B becomes a nonmember). The results are the same under section 267(f). (d) Divisive transaction. Assume instead that, pursuant to a plan, S distributes the stock of a lower-tier subsidiary in a spin- off transaction to which section 355 applies together with $150 of cash. The distribution of stock is an intercompany reorganization to which paragraph (f)(3) of this section applies. P is treated as receiving the $150 of cash immediately before the section 355 distribution, as a distribution to which section 301 applies. Section 356(b) does not apply and no basis adjustments are required under section 358(a)(1)(A) and (B). Because the $150 distribution is treated as made before the section 355 distribution, the distribution reduces P's basis in the S stock under Sec. 1.1502-32, and the basis allocated under section 358(c) between the S stock and the lower-tier subsidiary stock received reflects this basis reduction. Example 4. Stock redemptions and distributions. (a) Facts. Before becoming a member of the P group, S owns P stock with a $30 basis. On January 1 of Year 1, P buys all of S's stock. On July 1 of Year 3, P redeems the P stock held by S for $100 in a transaction to which section 302(a) applies. (b) Gain under section 302. Under paragraph (f)(4) of this section, P's basis in the P stock acquired from S is treated as eliminated. Thus, S's $70 gain is taken into account in Year 3. S's gain is taken into account as capital gain. (Under paragraph (c)(3)(iv) of this section, S's gain cannot be excluded from gross income.) (c) Gain under section 311. The facts are the same as in paragraph (a) of this Example 4, except that S distributes the P stock to P in a transaction to which section 301 applies (rather than the stock being redeemed), and S has a $70 gain under section 311(b). The timing and attributes of S's gain are determined in the manner provided in paragraph (b) of this Example 4. (d) Loss stock. The facts are the same as in paragraph (a) of this Example 4, except that S has a $130 (rather than $30) basis in the P stock and has a $30 loss under section 302(a). The limitation under paragraph (c)(3)(iv) of this section on recharacterization of items does not apply to intercompany losses. Thus, S's loss is taken into account in Year 3 as a noncapital, nondeductible amount. Example 5. Intercompany stock sale followed by section 332 liquidation. (a) Facts. S owns all of the stock of T, with a $70 basis and $100 value, and T's assets have a $10 basis and $100 value. On January 1 of Year 1, S sells all of T's stock to B for $100. On July 1 of Year 3, T distributes all of its assets to B in an unrelated complete liquidation to which section 332 applies. (b) Timing and attributes. Under paragraph (b)(2)(ii)(B) of this section, B's unrecognized gain or loss under section 332 is a corresponding item for purposes of applying the matching rule. Thus, S's $30 gain is taken into account in Year 3 as a result of T's liquidation. Under paragraph (c)(1)(i) of this section, the attributes of S's gain and B's corresponding item are redetermined as if they were divisions of a single corporation. Although S's gain ordinarily would be treated as excluded from gross income to reflect the nonrecognition of B's gain or loss under section 332, the gain remains capital gain. Paragraph (c)(3)(iv) of this section permits S's gain to be excluded from gross income only if B has a corresponding deduction or loss disallowed directly under a provision of the Code or regulations. B's corresponding items from the liquidation do not satisfy this requirement. However, relief may be elected under paragraph (f)(5) of this section. (c) Intercompany sale at a loss. The facts are the same as in paragraph (a) of this Example 5, except that S has a $130 (rather than $70) basis in the T stock. The limitation under paragraph (c)(3)(iv) of this section on recharacterization of items does not apply to intercompany losses. Thus, S's intercompany loss is taken into account in Year 3 as a noncapital, nondeductible amount. However, relief may be elected under paragraph (f)(5) of this section. (g) Obligations of members--(1) In general. In addition to the general rules of this section, the rules of this paragraph (g) apply to intercompany obligations. (2) Definitions. For purposes of this section-- (i) Obligation of a member. An obligation of a member is-- (A) Any obligation of that member constituting indebtedness under general principles of Federal income tax law (for example, under section 108, section 163, section 171, or section 1275, but not an executory obligation to purchase or provide goods or services); and (B) Any security of the member described in section 475(c)(2)(D) or (E), and any comparable security with respect to commodities. (ii) Intercompany obligations. An intercompany obligation is an obligation between members, but only for the period during which both parties are members. (3) Deemed satisfaction and reissuance of intercompany obligations--(i) Application--(A) In general. 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 remaining rights or obligations under an intercompany obligation, the intercompany obligation is treated for all Federal income tax purposes as satisfied under paragraph (g)(3)(ii) of this section and, if it remains outstanding, reissued under paragraph (g)(3)(iii) of this section. Similar principles apply under this paragraph (g)(3) if a member realizes any such amount, directly or indirectly, from a comparable transaction (e.g., a marking-to-market of an obligation or a bad debt deduction), or if an intercompany obligation becomes an obligation that is not an intercompany obligation. (B) Exceptions. This paragraph (g)(3) does not apply to an obligation if any of the following applies: (1) The obligation became an intercompany obligation by reason of an event described in paragraph (g)(4)(i)(B) of this section (exceptions to the application of section 108(e)(4)). (2) The amount realized is from reserve accounting under section 585 or 593 (see paragraph (g)(5) of this section for special rules). (3) Treating the obligation as satisfied and reissued will not have a significant effect on any person's Federal income tax liability for any year. For this purpose, obligations issued in connection with the same transaction or related transactions are treated as a single obligation. However, this paragraph (g)(3)(i)(B)(3) does not apply to any obligation if its aggregate effect for all obligations in a year would be significant. (ii) Satisfaction--(A) General rule. If a creditor member sells intercompany debt to a nonmember for cash, the debt is treated as satisfied by the debtor immediately before the sale for the amount of the cash. For other transactions, similar principles apply to treat the intercompany obligation as satisfied immediately before the transaction. Thus, if the obligation is transferred for property, it is treated as satisfied for an amount consistent with the amount of the reissuance under paragraph (g)(3)(iii) of this section, and the basis of the property is also adjusted to reflect that amount. If this paragraph (g)(3) applies because the obligor or obligee becomes a nonmember, the obligation is treated as satisfied for cash in an amount equal to its fair market value immediately before the obligor or obligee becomes a nonmember. Similar principles apply to intercompany obligations other than debt. (B) Timing and attributes. For purposes of applying the matching rule of paragraph (c) of this section and the acceleration rule of paragraph (d) of this section-- (1) Paragraph (c)(3)(iv) of this section (limitation on treatment of intercompany income or gain as excluded from gross income) does not apply to prevent any intercompany income or gain from being excluded from gross income; and (2) Any intercompany gain or loss is not subject to section 354 or 1091. (iii) Reissuance. If a creditor member sells intercompany debt to a nonmember for cash, the debt is treated as a new debt (with a new holding period) issued by the debtor immediately after the sale for the amount of cash. For other transactions, if the intercompany obligation remains outstanding, similar principles apply to treat the obligation as reissued immediately after the transaction. Thus, if the obligation is transferred for property, it is treated as a new obligation issued to the nonmember for the property. If this paragraph (g)(3) applies because the debtor or creditor becomes a nonmember, the obligation is treated as a new obligation issued for an amount of cash equal to its fair market value immediately after the debtor or creditor becomes a nonmember. Similar principles apply to intercompany obligations other than debt. (4) Deemed satisfaction and reissuance of obligations becoming intercompany obligations--(i) Application--(A) In general. This paragraph (g)(4) applies if an obligation that is not an intercompany obligation becomes an intercompany obligation. (B) Exceptions. This paragraph (g)(4) does not apply to an obligation if-- (1) The obligation becomes an intercompany obligation by reason of an event described in Sec. 1.108-2(e) (exceptions to the application of section 108(e)(4)); or (2) Treating the obligation as satisfied and reissued will not have a significant effect on any person's Federal income tax liability for any year. For this purpose, obligations issued in connection with the same transaction or related transactions are treated as a single obligation. However, this paragraph (g)(4)(i)(B)(2) does not apply to any obligation if its aggregate effect for all obligations in a year would be significant. (ii) Intercompany debt. If this paragraph (g)(4) applies to an intercompany debt-- (A) Section 108(e)(4) does not apply; (B) The debt is treated for all Federal income tax purposes, immediately after it becomes an intercompany debt, as satisfied and a new debt issued to the holder (with a new holding period) in an amount determined under the principles of Sec. 1.108-2(f); (C) The attributes of all items taken into account from the satisfaction are determined on a separate entity basis, rather than by treating S and B as divisions of a single corporation; and (D) Any intercompany gain or loss taken into account is treated as not subject to section 354 or 1091. (iii) Other intercompany obligations. If this paragraph (g)(4) applies to an intercompany obligation other than debt, the principles of paragraph (g)(4)(ii) of this section apply to treat the intercompany obligation as satisfied and reissued for an amount of cash equal to its fair market value immediately after the obligation becomes an intercompany obligation. (5) Bad debt reserve. A member's deduction under section 585 or 593 for an addition to its reserve for bad debts with respect to an intercompany obligation is not taken into account, and is not treated as realized under paragraph (g)(3) of this section, until the intercompany obligation becomes an obligation that is not an intercompany obligation, or, if earlier, the redemption or collection of less than the recorded amount of the intercompany obligation (and the corresponding charge off against the reserve). For purposes of this paragraph (g)(5) an addition to a reserve that results from charging off an intercompany obligation is treated as with respect to the intercompany obligation. (6) Examples. The application of this section to obligations of members is illustrated by the following examples. Example 1. Interest and premium on intercompany debt. (a) Facts. On January 1 of Year 1, M2 borrows $100 from M1 in return for M2's note providing for $10 of interest annually at the end of each year, and repayment of $100 at the end of Year 5. M2 fully performs its obligations. Under their separate entity methods of accounting, M2 accrues a $10 interest deduction annually under section 163, and M1 accrues $10 of interest income annually under section 61(a)(4). (b) Matching rule. Under paragraph (b)(1) of this section, the accrual of interest on M2's note is an intercompany transaction, M1 is the selling member, and M2 is the buying member. Under the matching rule of paragraph (c) of this section, M1 takes its $10 of income into account in each of Years 1 through 5 to reflect the $10 difference between M2's $10 of interest expense taken into account and its $0 recomputed expense. (c) Original issue discount. The facts are the same as in paragraph (a) of this Example 1, except that M2 borrows $90 (rather than $100) from M1 in return for M2's note providing for $10 of interest annually and repayment of $100 at the end of Year 5. The principles described in paragraph (b) of this Example 1 for stated interest also apply to the $10 of original issue discount. Thus, as M2 takes into account its corresponding expense under section 163(e), M1 takes into account its intercompany income. (d) Premium. The facts are the same as in paragraph (a) of this Example 1, except that M2 borrows $110 from M1 (rather than $100), and M1 elects under section 171 to amortize the $10 premium. Under section 171(e), M1's premium deduction is allocated to its interest income and applied to reduce the amount of the income. Although there is no separate item of premium deduction to be taken into account, paragraph (b)(2)(ii)(B) of this section provides that M1's corresponding items include the premium even though it offsets interest income rather than being separately taken into account. Although M1 is the selling member with respect to the interest (i.e., the recipient member), M1 is the buying member with respect to the premium (i.e., the payor member). Thus, M2's intercompany premium income is taken into account under the matching rule to reflect the difference between M1's corresponding premium deduction taken into account and its recomputed premium deduction. Consequently, M2 takes its premium income into account in each of Years 1 through 5 based on M1's amortization and offset of allocable interest income. (If M1 does not make an election under section 171, but instead takes the premium into account when the debt is retired at the end of Year 5, M2 also does not take the premium into account until the debt is retired at the end of Year 5.) (e) Tax-exempt income. The facts are the same as in paragraph (a) of this Example 1, except that M2's borrowing from M1 is allocable under section 265 to M2's purchase of state and local bonds to which section 103 applies. The timing of M1's income is the same as in paragraph (b) of this Example 1, but that M1's income is treated under the matching rule as excluded from gross income because M2's corresponding expense is nondeductible under section 265. See paragraph (c)(3)(iv) of this section. Example 2. Intercompany debt becomes nonintercompany debt. (a) Facts. On January 1 of Year 1, B borrows $100 from S in return for B's note providing for $10 of interest annually at the end of each year, and repayment of $100 at the end of Year 20. As of January 1 of Year 3, B has paid the interest accruing under the note and S sells B's note to X for $70, reflecting a change in the value of the note as a result of increases in prevailing market interest rates. B is never insolvent within the meaning of section 108(d)(3). (b) Deemed satisfaction. Under paragraph (g)(3) of this section, B's note is treated as satisfied for $70 immediately before S's sale to X. Under the matching rule, B takes into account $30 of discharge of indebtedness income under section 61(a)(12). Although S ordinarily would take into account a $30 capital loss under section 1271(a)(1), S's loss is treated as ordinary loss to conform to B's corresponding $30 of discharge of indebtedness income. (c) Deemed reissuance. Under paragraph (g)(3) of this section, B is also treated as reissuing, directly to X, a new note with a $70 issue price and a $100 stated redemption price at maturity. The new note is not an intercompany obligation, it has a $70 issue price and $100 stated redemption price at maturity, and the $30 of original issue discount will be taken into account by B and X under sections 163(e) and 1272. (d) Creditor deconsolidation. The facts are the same as in paragraph (a) of this Example 2, except that P sells S's stock to X (rather than S's selling the note of B). Under paragraph (g)(3) of this section, the note is treated as satisfied by B for its $70 fair market value immediately before S becomes a nonmember, and B is treated as reissuing a new note to S immediately after S becomes a nonmember. The results for S's $30 of loss and B's discharge of indebtedness income are the same as in paragraph (b) of this Example 2. The new note is not an intercompany obligation, it has a $70 issue price and $100 stated redemption price at maturity, and the $30 of original issue discount will be taken into account by B and S under sections 163(e) and 1272. (e) Debtor deconsolidation. The facts are the same as in paragraph (a) of this Example 2, except that P sells B's stock to X (rather than S's selling the note of B). The results are the same as in paragraph (d) of this Example 2. (f) Appreciated note. The facts are the same as in paragraph (a) of this Example 2, except that S sells B's note to X for $130 (rather than $70), reflecting a decline in prevailing market interest rates. Under paragraph (g)(3) of this section, B's note is treated as satisfied for $130 immediately before S's sale of the note to X. Under the matching rule, B takes into account $30 of repurchase premium. Although S ordinarily would take into account a $30 capital gain under section 1271(a)(1), the attributes of S's capital gain conform to B's corresponding premium under the matching rule. Thus, S's gain is treated as ordinary income to conform to B's corresponding $30 premium. B is also treated as reissuing a new note directly to X which is not an intercompany obligation. The new note has a $130 issue price and a $100 stated redemption price at maturity. Under Sec. 1.61-12(c), B's $30 premium income under the new note is taken into account over the life of the new note. Under section 171, X may elect to amortize its $30 of bond premium over the life of the note (with corresponding reductions in its basis), however, the election would have no effect on B's premium income. Example 3. Bad debt deduction or loss with respect to intercompany debt. (a) Facts. On January 1 of Year 1, B borrows $100 from S in return for B's note providing for $10 of interest annually at the end of each year, and repayment of $100 at the end of Year 5. For Year 3, S claims a $40 partial bad debt deduction under section 166(a)(2) on a separate entity basis. B is never insolvent within the meaning of section 108(d)(3). (b) Deemed satisfaction and reissuance. Under paragraph (g)(3) of this section, B is treated as satisfying its note for $60 immediately before S's bad debt deduction, and reissuing a new note to S with a $60 issue price and a $100 stated redemption price at maturity. Thus, B takes into account $40 of discharge of indebtedness income, and S takes into account $40 of loss as an ordinary loss. (c) Loss sale. The facts are the same as in paragraph (a) of this Example 3, except that S sells B's note to P for $60 (rather than claiming a partial bad debt deduction). The results are the same as in paragraph (b) of this Example 3. B's note is treated as satisfied immediately before the sale, and a new note reissued directly to P immediately after the sale. B takes into account $40 of discharge of indebtedness income, and S takes into account $40 of loss as an ordinary loss. Example 4. Nonintercompany debt becomes intercompany debt. (a) Facts. On January 1 of Year 1, B borrows $100 from X in return for B's note providing for $10 of interest annually at the end of each year, and repayment of $100 at the end of Year 5. As of January 1 of Year 3, B has fully performed its obligations, but the note's fair market value is $70. On January 1 of Year 3, P buys all of X's stock. B is solvent within the meaning of section 108(d)(3). (b) Deemed satisfied and reissuance. Under paragraph (g)(4) of this section, B is treated as satisfying its indebtedness for $70 (determined under the principles of Sec. 1.108-2(f)(2)) immediately after X becomes a member. Both X's $30 capital loss under section 1271(a)(1) and B's $30 of discharge of indebtedness income under section 61(a)(12) are taken into account in determining consolidated taxable income for Year 3. Under paragraph (g)(4)(ii)(C) of this section, the attributes of items resulting from the satisfaction are determined on a separate entity basis. But see section 382 and Sec. 1.1502-15 (limitations on the absorption of built-in losses). B is also treated as reissuing a new note. The new note is an intercompany obligation, it has a $70 issue price and $100 stated redemption price at maturity, and the $30 of original issue discount will be taken into account by B and X. (c) Election to file consolidated returns. Assume instead that B borrows $100 from S during Year 1, but the P group does not file consolidated returns until Year 3. Under paragraph (g)(4) of this section, B's indebtedness is treated as satisfied and a new note reissued immediately after the debt becomes intercompany debt. The satisfaction and reissuance are on January 1 of Year 3, at the fair market value of the note (determined under the principles of Sec. 1.108-2(f)(2)) at that time. Example 5. Notional principal contracts. (a) Facts. On April 1 of Year 1, M1 enters into a contract with counterparty M2 under which, for a term of five years, M1 is obligated to make a payment to M2 each April 1, beginning in Year 2, in an amount equal to the London Interbank Offered Rate (LIBOR), as determined on the immediately preceding April 1, multiplied by a $1,000 notional principal amount. M2 is obligated to make a payment to M1 each April 1, beginning in Year 2, in an amount equal to 8% multiplied by the same notional principal amount. LIBOR is 7.80% on April 1 of Year 1. On April 1 of Year 2, M1 owes $78 to M2, and M2 owes $80 to M1. (b) Matching rule. Under Sec. 1.446-3(d), the net income (or net deduction) from a notional principal contract for a taxable year is included in (or deducted from) gross income. Under Sec. 1.446-3(e), the ratable daily portion of M2's fixed obligation to M1 as of December 31 of Year 1 is $60.27 ($80 multiplied by 275/365), and the ratable daily portion of M1's floating obligation as of December 31 of Year 1 is $58.77 ($78 multiplied by 275/365). Under the matching rule, M1's net income for Year 1 of $1.50 is taken into account to reflect the difference between M2's net deduction of $1.50 taken into account and its $0 recomputed net deduction. Similarly, the $.50 balance of the $2.00 of net periodic payments made on April 1 of Year 2 is taken into account for Year 2 in M1's and M2's net income and net deduction from the contract. (Note that although M1 is the selling member with respect to the payment on April 1 of Year 2, it may be the buying member in a subsequent period if it owes the net payment.) (c) Dealer. The facts are the same as in paragraph (a) of this Example 5, except that M2 is a dealer in securities, the contract with M1 is not inventory in the hands of M2, and on December 31 of Year 1 the fair market value of the contract to M2 is ($100). Under section 475, M2 has a $100 loss as if the contract were sold on December 31 for its fair market value. Under paragraph (g)(3) of this section, M2 is treated as making a $100 payment to M1 to terminate the contract immediately before section 475 is applied. Under the matching rule, the net periodic payment in Year 1 is taken into account as described in paragraph (b) of this Example 5. In addition, M1's $100 of income from the termination payment is taken into account to reflect the timing of M2's deduction (as described in Sec. 1.446-3(h)), and the character and other attributes of the income is conformed to the character and other attributes of the deduction. Paragraph (g)(3) of this section also provides that, immediately after section 475 would apply, a new contract is treated as reissued with an up front payment of $100. Under Sec. 1.446-3(f), the deemed $100 payment by M2 to M1 is taken into account over the term of the new contract in a manner reflecting the economic substance of the contract (e.g., allocating a portion of the $100 to the periodic payment expected to be made by M2 on April 1 of Year 2, and the balance under the level payment constant yield to maturity method). (The results would be the same if M1, rather than M2, is the dealer subject to section 475.) (h) Anti-avoidance rules--(1) In general. If a transaction is engaged in or structured with a principal purpose to avoid treatment as an intercompany transaction, or to avoid the purposes of this section, adjustments must be made to carry out the purposes of this section. (2) Examples. The anti-avoidance rules of this paragraph (h) are illustrated by the following examples. Example 1. Sale of a partnership interest. (a) Facts. S owns land with a $10 basis and $100 value. B has net operating losses from separate return limitation years (SRLYs) subject to limitation under Sec. 1.1502-21(c). Pursuant to a plan to absorb the losses without limitation by the SRLY rules, S transfers the land to an unrelated, calendar- year partnership in exchange for a 10% interest in the capital and profits of the partnership in a transaction to which section 721 applies. The partnership does not have a section 754 election in effect. S later sells its partnership interest to B for $100. In the following year, the partnership sells the land to X for $100. Because the partnership does not have a section 754 election in effect, its $10 basis in the land does not reflect B's $100 basis in the partnership interest. Under section 704(c), the partnership's $90 built-in gain is allocated to B, and B's basis in the partnership interest increases to $190 under section 705. In a later year, B sells the partnership interest to X for $100. (b) Adjustments. Under Sec. 1.1502-21(c), the partnership's $90 built-in gain allocated to B ordinarily increases the amount of B's SRLY limitation, and B's $90 loss from its sale of the partnership interest ordinarily is not subject to limitation under the SRLY rules. Under paragraph (h)(1) of this section, however, B's allocable share of the partnership's gain from its sale of the land is treated as not increasing the amount of B's SRLY limitation. Example 2. Sale to a related party. (a) Facts. S and B manufacture complimentary products that are sold in similar markets. On January 1 of Year 1, S and B enter into a partnership agreement to engage in common distribution. The partnership is formed and operated for substantial nontax, business reasons and is treated as a general partnership for Federal income tax purposes. S has loss carryovers from separate return years subject to limitation under section 382 as a result of an ownership change on January 1 of Year 1. S also has a net unrealized built-in gain (NUBIG) within the meaning of section 382(h), and S owns land with $30 of unrealized built-in gain that is included in the NUBIG. Pursuant to a plan to take into account $30 of recognized built-in gain before the end of the section 382(h)(7) recognition period without disposing of an interest in the land, the partnership buys S's land on July 1 of Year 3. On December 1 of Year 7, the partnership sells the land to X. (b) Adjustments. Under paragraph (b)(1) of this section, S's sale to the partnership ordinarily would not be an intercompany transaction. Under paragraph (h)(1) of this section, however, the transaction is treated as an intercompany transaction. Thus, S's gain is not taken into account until Year 7, as a result of the partnership's sale to X. Because the gain is not recognized during the section 382(h)(7) recognition period, it is not recognized built-in gain under section 382(h). Example 3. Transitory status as an intercompany obligation. (a) Facts. P historically has owned 70% of X's stock and the remaining 30% is owned by unrelated shareholders. On January 1 of Year 1, S borrows $100 from X in return for S's note requiring $10 of interest annually at the end of each year, and repayment of $100 at the end of Year 20. As of January 1 of Year 3, the P group has substantial net operating loss carryovers, and the fair market value of S's note falls to $70 due to an increase in prevailing market interest rates. X is not permitted under section 166(a)(2) to take into account a $30 loss with respect to the note. Pursuant to a plan to permit X to take into account its $30 loss without disposing of the note, P acquires an additional 10% of X's stock, causing X to become a member, and P subsequently resells the 10% interest. X's $30 loss with respect to the note is a net unrealized built-in loss within the meaning of Sec. 1.1502-15. (b) Adjustments. Under paragraph (g)(4) of this section, X ordinarily would take into account its $30 loss as a result of the note becoming an intercompany obligation, and S would take into account $30 of discharge of indebtedness income. Under Sec. 1.1502- 22(c), X's loss is not combined with items of the other members and the loss would be carried to X's separate return years as a result of X becoming a nonmember. However, the transitory status of S's indebtedness to X as an intercompany obligation is structured with a principal purpose to accelerate the recognition of X's loss. Thus, S's note is treated under paragraph (h)(1) of this section as not becoming an intercompany obligation. Example 4. Sale and leaseback. (a) Facts. S operates a factory with a $70 basis and $100 value, and has loss carryovers from SRLYs. Pursuant to a plan to take into account the $30 unrealized gain while continuing to operate the factory, S sells the factory to X for $100 and leases it back on a long-term basis. The sale and leaseback are not recharacterized under general principles of Federal income tax law. As a result of S's sale to X, the $30 gain is taken into account and increases S's SRLY limitation. (b) No adjustments. Although S's sale was pursuant to a plan to accelerate the $30 gain, it is not subject to adjustment under paragraph (h)(1) of this section. Because S has transferred substantial interests in the factory to an unrelated person for Federal income tax purposes, the sale is not treated as engaged in or structured with a principal purpose to avoid treatment as an intercompany transaction, or to avoid the single and separate entity treatment that is the purpose of this section. (i) [Reserved] (j) Miscellaneous operating rules. For purposes of this section-- (1) Successors--(i) Assets. Any reference to an asset includes, as the context may require, a reference to any other asset the basis of which is determined, directly or indirectly, in whole or in part, by reference to the first asset. (ii) Persons--(A) In general. Any reference to a person includes, as the context may require, a reference to a predecessor or successor. For this purpose, a predecessor is a transferor of assets to a transferee (the successor) in a transaction-- (1) To which section 381(a) applies; (2) In which substantially all of the assets of the transferor are transferred to members in a complete liquidation; (3) In which the successor's basis in assets is determined (directly or indirectly, in whole or in part) by reference to the basis of the transferor, but the transferee is a successor only with respect to the assets so determined; or (4) Which is an intercompany transaction, but only with respect to assets that are being accounted for by the transferor in a prior intercompany transaction. (B) Intercompany items. If the assets of a predecessor are acquired by a successor member, the successor succeeds to, and takes into account (under the rules of this section), the predecessor's intercompany items. If two or more successor members acquire assets of the predecessor, the successors take into account the predecessor's intercompany items in a manner that is consistently applied and reasonably carries out the purposes of this section and applicable provisions of law. (2) Acquisition of group--(i) Application. This paragraph (j)(2) applies only if a consolidated group (the terminating group) ceases to exist as a result of-- (A) The acquisition by a member of another consolidated group of either the assets of the common parent of the terminating group in a reorganization described in section 381(a)(2), or the stock of the common parent of the terminating group; or (B) The application of the principles of Sec. 1.1502-75 (d)(2) or (d)(3). (ii) General rule. The group that does not cease to exist (the surviving group) is treated as the terminating group for purposes of applying this section to the terminating group. For example, intercompany items and corresponding items from intercompany transactions between members of the terminating group are treated as continuing to be reflected in the terminating group's consolidated taxable income. This paragraph (j)(2) does not apply to members of the terminating group that are not members of the surviving consolidated group immediately after the terminating group ceases to exist (e.g., under section 1504(a)(3) relating to reconsolidation, or section 1504(c) relating to includible insurance companies). (3) Former common parent treated as continuation of group. If a group terminates because the common parent is the only remaining member, the common parent succeeds to the treatment of the terminating group for purposes of applying this section so long as it is not a member of an affiliated group filing separate returns and does not become a corporation described in section 1504(b). For example, if the only subsidiary of the group liquidates into the common parent in a complete liquidation to which section 332 applies, or the common parent merges into the subsidiary and the subsidiary is treated as the common parent's successor under paragraph (j)(1)(ii)(A) of this section, the taxable income of the surviving corporation is treated as the group's consolidated taxable income in which the intercompany and corresponding items must be included. See Sec. 1.267(f)-1 for additional rules applicable to intercompany losses or deductions. (4) Becoming a nonmember. For purposes of this section, a member is treated as becoming a nonmember if it has a separate return year (including another group's consolidated return year). A member is not treated as having a separate return year if its items are treated as taken into account in computing the group's consolidated taxable income under paragraph (j) (2) or (3) of this section. (5) Recordkeeping. Intercompany and corresponding items must be reflected on permanent records (including work papers). See also section 6001, requiring records to be maintained. From such permanent records the group must be able to identify the amount, location, timing, and attributes of the items, so as to permit the application of the rules of this section for each year. (6) Examples. The operating rules of this paragraph (j) are illustrated generally throughout this section, and by the following examples. Example 1. Intercompany sale followed by section 351 transfer to member. (a) Facts. S holds land for investment with a basis of $70. On January 1 of Year 1, S sells the land to M for $100. M also holds the land for investment. On July 1 of Year 3, M transfers the land to B in exchange for all of B's stock in a transaction to which section 351 applies. Under section 358, M's basis in the B stock is $100. B holds the land for sale to customers in the ordinary course of business and, under section 362(b), B's basis in the land is $100. On December 1 of Year 5, M sells 20% of the B stock to X for $22. In an unrelated transaction on July 1 of Year 8, B sells 20% of the land for $22. (b) Definitions. Under paragraph (b)(1) of this section, S's sale of the land to M and M's transfer of the land to B are both intercompany transactions. S is the selling member and M is the buying member in the first intercompany transaction, and M is the selling member and B is the buying member in the second intercompany transaction. M has no intercompany items under paragraph (b)(2) of this section. Because B acquired the land in an intercompany transaction, B's items from the land are corresponding items to be taken into account under this section. Under the successor asset rule of paragraph (j)(1)(i) of this section, references to the land include references to M's B stock. Under the successor person rule of paragraph (j)(1)(ii) of this section, references to M include references to B with respect to the land. (c) Timing and attributes resulting from the stock sale. Under paragraph (c)(3)(i) of this section, M is treated as owning and selling B's stock for purposes of the matching rule even though, as divisions, M could not own and sell stock in B. Under paragraph (c)(3)(ii)(A) of this section, both M's B stock and B's land can cause S's intercompany gain to be taken into account under the matching rule of paragraph (c) of this section. Thus, S takes $6 of its gain into account in Year 5 to reflect the $6 difference between M's $2 gain taken into account from its sale of B stock and its $8 recomputed gain. Under paragraph (c)(3)(ii)(B) of this section, the attributes of this gain are determined by treating S, M, and B as divisions of a single corporation. Under paragraph (c)(3)(iii)(A) of this section, S's $6 gain and M's $2 gain are treated as long-term capital gain. The gain would be capital on a separate entity basis (assuming that section 341 does not apply), and this treatment is not inconsistent with treating S, M, and B as divisions of a single corporation because the stock sale and subsequent land sale are unrelated transactions and B remains a member following the sale. (d) Timing and attributes resulting from the land sale. Under paragraph (c)(3)(ii)(A) of this section, S takes $6 of its gain into account in Year 8 under the matching rule to reflect the $6 difference between B's $2 gain taken into account from its sale of an interest in the land and its $8 recomputed gain. Under paragraph (c)(3)(ii)(B) of this section, the attributes of this gain are determined by treating S, M, and B as divisions of a single corporation and taking into account the activities of S, M, and B with respect to the land. Thus, both S's gain and B's gain might be ordinary income as a result of B's activities. (If B subsequently sells the balance of the land, paragraph (a)(4) of this section limits S's gain taken into account to its remaining $18 of intercompany gain.) (e) Sale of successor stock resulting in deconsolidation. The facts are the same as in paragraph (a) of this Example 1, except that M sells 60% of the B stock to X for $66 on December 1 of Year 5 and B becomes a nonmember. Under the matching rule, M's sale of B stock results in $18 of S's gain being taken into account (to reflect the difference between M's $6 gain taken into account and its $24 recomputed gain). Under the acceleration rule of paragraph (d) of this section, however, the entire $30 gain is taken into account (to reflect B becoming a nonmember, because its basis in the land reflects M's $100 cost basis from the prior intercompany transaction). Under paragraph (c)(3)(ii)(A) of this section, S's entire $30 intercompany gain is taken into account under the acceleration rule of paragraph (d) of this section. Under paragraph (c)(3)(ii)(B) of this section, the attributes of S's gain are determined by treating S, M, and B as divisions of a single corporation. Because M's cost basis in the land will be reflected by B as a nonmember, all of S's gain is treated as from the land (rather than a portion being from B's stock), and B's activities with respect to the land may therefore result in S's gain being ordinary income. Example 2. Intercompany sale of member stock followed by recapitalization. (a) Facts. Before becoming a member of the P group, S owns P stock with a basis of $70. On January 1 of Year 1, P buys all of S's stock. On July 1 of Year 3, S sells the P stock to M for $100. On December 1 of Year 5, P acquires M's original P stock in exchange for new P stock in a recapitalization described in section 368(a)(1)(E). (b) Timing and attributes. Although paragraph (f)(4) of this section eliminates P's basis in the stock acquired from M, the new P stock received by M is exchanged basis property (within the meaning of section 7701(a)(44)) having a basis under section 358 equal to M's basis in the original P stock. Under the successor asset rule of paragraph (j)(1)(i) of this section, references to M's original P stock include references to M's new P stock. Under paragraph (c)(3)(ii)(A) of this section, if more than one corresponding item can cause S's intercompany gain to be taken into account under the matching rule, the gain is taken into account in connection with the corresponding item most consistent with the treatment of S, M, and P as divisions of a single corporation. S's gain is not taken into account as a result of the basis elimination under paragraph (f)(4) of this section. Instead, the gain is taken into account based on subsequent events with respect to M's new P stock (e.g., a subsequent distribution or redemption of the new stock). Example 3. Successor group. (a) Facts. On January 1 of Year 1, B borrows $100 from S in return for B's note providing for $10 of interest annually at the end of each year, and repayment of $100 at the end of Year 20. As of January 1 of Year 3, B has paid the interest accruing under the note. On that date, X acquires all of P's stock and the former P group members become members of the X consolidated group. (b) Successor. Under paragraph (j)(2) of this section, although B's note ceases to be an intercompany obligation of the P group, the note is not treated as satisfied and reissued under paragraph (g) of this section as a result of X's acquisition of P stock. Instead, the X consolidated group succeeds to the treatment of the P group for purposes of paragraph (g) of this section, and B's note is treated as an intercompany obligation of the X consolidated group. (c) No subgroups. The facts are the same as in paragraph (a) of this Example 3, except that X simultaneously acquires the stock of S and B from P (rather than X's acquiring all of P's stock). Paragraph (j)(2) of this section does not apply to X's acquisitions. Unless the exception in paragraph (g)(3)(i)(B) applies, B's note is treated as satisfied immediately before S and B become nonmembers, and reissued immediately after they become members of the X consolidated group. The amount at which the note is satisfied and reissued under paragraph (g)(3) of this section is based on the fair market value of the note at the time of P's sales to X. Paragraph (g)(4) of this section does not apply to the reissued B note in the X consolidated group, because the new note is always an intercompany obligation of the X consolidated group. Example 4. Liquidation--80% distributee. (a) Facts. X has had preferred stock described in section 1504(a)(4) outstanding for several years. On January 1 of Year 1, S buys all of X's common stock for $60, and B buys all of X's preferred stock for $40. X's assets have a $0 basis and $100 value. On July 1 of Year 3, X distributes all of its assets to S and B in a complete liquidation. Under Sec. 1.1502-34, section 332 applies to both S and B. Under section 337, X has no gain or loss from its liquidating distribution to S. Under sections 336 and 337(c), X has a $40 gain from its liquidating distribution to B. B has a $40 basis under section 334(a) in the assets received from X, and S has a $0 basis under section 334(b) in the assets received from X. (b) Intercompany items from the liquidation. Under the matching rule, X's $40 gain from its liquidating distribution to B is not taken into account under this section as a result of the liquidation (and therefore is not yet reflected under Secs. 1.1502-32 and 1.1502-33). Under the successor person rule of paragraph (j)(1)(ii)(A) of this section, S and B are both successors to X. S is the only successor to X under section 381(a). Under paragraph (j)(1)(ii)(B) of this section, to be consistent with the anti- avoidance rules of paragraph (h)(1) of this section, S succeeds to X's $40 intercompany gain. The gain will be taken into account by S under the matching and acceleration rules of this section based on subsequent events. (The allocation of the intercompany gain to S does not govern the allocation of any other attributes.) Example 5. Liquidation--no 80% distributee. (a) Facts. X has only common stock outstanding. On January 1 of Year 1, S buys 60% of X's stock for $60, and B buys 40% of X's stock for $40. X's assets have a $0 basis and $100 value. On July 1 of Year 3, X distributes all of its assets to S and B in a complete liquidation. Under Sec. 1.1502-34, section 332 applies to both S and B. Under sections 336 and 337(c), X has a $100 gain from its liquidating distributions to S and B. Under section 334(b), S has a $60 basis in the assets received from X and B has a $40 basis in the assets received from X. (b) Intercompany items from the liquidation. Under the matching rule, X's $100 intercompany gain from its liquidating distributions to S and B is not taken into account under this section as a result of the liquidation (and therefore is not yet reflected under Secs. 1.1502-32 and 1.1502-33). Under the successor person rule of paragraph (j)(1)(ii)(A) of this section, S and B are both successors to X. Under paragraph (j)(1)(ii)(B) of this section, to be consistent with the anti-avoidance rules of paragraph (h)(1) of this section, S succeeds to X's $40 intercompany gain with respect to the assets distributed to B, and B succeeds to X's $60 intercompany gain with respect to the assets distributed to S. The gain will be taken into account by S and B under the matching and acceleration rules of this section based on subsequent events. (The allocation of the intercompany gain does not govern the allocation of any other attributes.) (k) Cross references--(1) Section 108. See Sec. 1.108-3 for the treatment of intercompany deductions and losses as subject to attribute reduction under section 108(b). (2) Section 263A(f). See section 263A(f) for special rules regarding interest from intercompany transactions. (3) Section 267(f). See section 267(f) for special rules applicable to certain losses and deductions transactions between members of a controlled group. (4) Section 382. See Sec. 1.1502-91(g) and (h) for the treatment of intercompany items as built-in amounts under section 382. (5) Section 460. See Sec. 1.460-4(j) for special rules regarding the application of section 460 to intercompany transactions. (6) Section 469. See Sec. 1.469-1(h) for special rules regarding the application of section 469 to intercompany transactions. (7) Sec. 1.1502-80. See Sec. 1.1502-80 for the nonapplication of certain Internal Revenue Code rules. (l) Effective dates--(1) In general. This section applies with respect to transactions occurring in years beginning on or after [the date the final regulations are filed with the Federal Register]. If both this section and prior law apply to a transaction, or neither applies, with the result that items are duplicated, omitted, or eliminated in determining taxable income (or tax liability), or items are treated inconsistently, prior law (and not this section) applies to the transaction. For example, an intercompany dividend to which a shareholder becomes entitled before [the date the final regulations are filed with the Federal Register] but which is distributed after that date is taken into account under prior law (generally when distributed), because this section generally takes dividends into account when the shareholder becomes entitled to them but this section does not apply at that time. (2) Avoidance transactions. This paragraph (l)(2) applies if a transaction is engaged in or structured on or after April 8, 1994, with a principal purpose to avoid the rules of this section applicable to transactions occurring in years beginning on or after [the date the final regulations are filed with the Federal Register], to duplicate, omit, or eliminate an item in determining taxable income (or tax liability), or to treat items inconsistently. If this paragraph (l)(2) applies, appropriate adjustments must be made in years beginning on or after [the date the final regulations are filed with the Federal Register], to prevent the avoidance, duplication, omission, elimination, or inconsistency. (3) Prior law. For transactions occuring in S's years beginning before [the date the final regulations are filed with the Federal Register], see the applicable regulations issued under section 1502. See Secs. 1.1502-13, 1.1502-13T, 1.1502-14, 1.1502-14T, 1.1502-31, and 1.1502-32 (as contained in the 26 CFR part 1 edition revised as of April 1, 1994). Secs. 1.1502-13T, 1.1502-14, and 1.1502-14T [Removed] Par. 13. Sections 1.1502-13T, 1.1502-14, and 1.1502-14T are removed. Par. 14. Section 1.1502-17 is amended as follows: 1. Paragraph (c) is redesignated as paragraph (d). 2. New paragraph (c) is added. 3. Newly designated paragraph (d) is amended by: a. Revising the paragraph heading. b. Revising the introductory text. c. Designating the existing example as Example 1 and revising the heading. d. Adding Example 2, and 3. 5. The added and revised provisions read as follows: Sec. 1.1502-17 Methods of accounting. * * * * * (c) Anti-avoidance rules--(1) General rule. If one member (B) directly or indirectly acquires an activity of another member (S) or undertakes S's activity, with the principal purpose to avail the group of an accounting method that would be unavailable without securing consent from the Commissioner if S and B were treated as divisions of a single corporation, B must use the accounting method for the acquired or undertaken activity determined under paragraph (c)(2) of this section or secure consent from the Commissioner for a different method. (2) Treatment as divisions of a single corporation. B must use the method of accounting that would be required if B acquired or undertook the activity in a transaction to which section 381 applies. Thus, the principles of section 381(c)(4) and (c)(5) apply to resolve any conflicts between the accounting methods of S and B, and the acquired or undertaken activity is treated as having the accounting method used by S. Appropriate adjustments are made to treat all acquisitions or undertakings that are part of the same plan or arrangement as a single acquisition or undertaking. (3) Effective date. This paragraph (c) applies with respect to acquisitions or undertakings occurring in years beginning on or after [the date the final regulations are filed with the Federal Register]. (d) Examples. The provisions of this section are illustrated by the following examples: Example 1. Separate return treatment generally. * * * Example 2. Adopting methods. (a) Corporation P is a member of a consolidated group. P is a service provider with substantial parts and supplies on hand for use in its repair service business. P capitalizes its cost for the parts and supplies and deducts the cost under Sec. 1.162-3. P is unable to adopt a LIFO inventory method under section 472 because the parts and supplies are used solely in its service business. With the principal purpose to avail of a LIFO inventory method, P forms corporation S, and S begins to purchase and maintain all of the parts and supplies using a LIFO inventory method. P purchases the parts and supplies that it needs from S, and S's only customer is P. (b) Under paragraph (c) of this section, S must account for the parts and supplies under Sec. 1.162-3 rather than adopting a LIFO inventory method. Example 3. Changing inventory sub-method. (a) Corporation P is a member of a consolidated group. P operates a manufacturing business that uses dollar-value LIFO, and has built up a substantial LIFO reserve. P has historically manufactured all its inventory and has used one natural business unit pool. P begins purchasing goods identical to its own finished goods from a foreign supplier, and is concerned that it must establish a separate resale pool under Sec. 1.472-8(c). P anticipates that it will begin to purchase, rather than manufacture, a substantial portion of its inventory, resulting in a recapture of most of its LIFO reserve because of decrements in its manufacturing pool. With the principal purpose to avoid the decrements, P forms corporation S in Year 1. S operates as a distributor to nonmembers, and P sells all of its existing inventories to S. S adopts LIFO, and elects dollar-value LIFO with one resale pool. Thereafter, P continues to manufacture and purchase inventory, and to sell it to S for resale to nonmembers. P's intercompany gain from sales to S is taken into account under Sec. 1.1502-13. S maintains its Year 1 base dollar value of inventory to prevent the recognition of the intercompany items by P that include the LIFO reserve. (b) Under paragraph (c) of this section, S must maintain two pools (manufacturing and resale) in the manner that P would be required to maintain under Sec. 1.472-8. Par. 15. Section 1.1502-18 is amended by revising the heading for paragraph (f) and adding paragraph (g) to read as follows: Sec. 1.1502-18 Inventory adjustment. * * * * * (f) Transitional rules for years before 1966. * * * (g) Transitional rules for years beginning on or after [the date the final regulations are filed with the Federal Register]. Paragraphs (a) through (f) of this section do not apply for taxable years beginning on or after [the date the final regulations are filed with the Federal Register]. Any remaining unrecovered inventory amount of a member under paragraph (c) of this section is recovered in the first taxable year beginning on or after [the date the final regulations are filed with the Federal Register], under the principles of paragraph (c)(3) of this section by treating the first taxable year as the first separate return year of the member. The unrecovered inventory amount can be recovered only to the extent it was previously included in taxable income. The principles of this section apply, with appropriate adjustments, to comparable amounts under paragraph (f) of this section. Par. 16. Section 1.1502-20 is amended as follows: 1. Paragraph (a)(5) Example (6) is amended as follows: a. The fifth sentence of paragraph (i) is revised. b. Paragraphs (ii) and (iii) are revised. c. Paragraph (iv) is added. 2. Paragraph (b)(6) Example (5) is amended as follows: a. The fifth sentence of paragraph (i) is revised. b. A sentence is added at the beginning of paragraph (ii). c. Paragraph (iii) is revised. d. Paragraph (iv) is removed. 3. Paragraph (b)(6) Example (7) is amended as follows: a. The fourth sentence of paragraph (i) is revised. b. The first sentence of paragraph (iii) is revised. 4. Paragraph (c)(4) is amended as follows: a. Example (3) is amended by removing paragraph (iii). b. Example (9) is added. 5. Paragraph (e)(3) is amended as follows: a. Example (2) is removed. b. Example (3) through Example (8) are redesignated as Example (2) through Example (7). c. Newly designated Example (5) is revised. d. Newly designated Example (7) is removed. 6. In paragraph (h)(1), the second sentence is revised. 7. The revised and added provisions read as follows: Sec. 1.1502-20 Disposition or deconsolidation of subsidiary stock. (a) * * * (5) * * * Example (6). * * * (i) * * * S sells its T stock to P for $100 in an intercompany transaction, recognizing a $60 intercompany loss that is deferred under section 267(f) and Sec. 1.1502-13. * * * (ii) Under paragraph (a)(3)(i) of this section, the application of paragraph (a)(1) of this section to S's $60 intercompany loss on the sale of its T stock to P is deferred, because S's intercompany loss is deferred under section 267(f) and Sec. 1.1502-13. P's sale of the T stock to X ordinarily would result in S's intercompany loss being taken into account under the matching rule of Sec. 1.1502- 13(c). The deferred loss is not taken into account under Sec. 1.267(f)-1, however, because P's sale to X (a member of the same controlled group as P) is a second intercompany transaction for purposes of section 267(f). Nevertheless, paragraph (a)(3)(ii) of this section provides that paragraph (a)(1) of this section applies to the intercompany loss as a result of P's sale to X because the T stock ceases to be owned by a member of the P consolidated group. Thus, the loss is disallowed under paragraph (a)(1) of this section immediately before P's sale and is therefore never taken into account under section 267(f). (iii) The facts are the same as in (i) of this Example, except that S is liquidated after its sale of the T stock to P, but before P's sale of the T stock to X, and P sells the T stock to X for $110. Under Secs. 1.1502-13(j) and 1.267(f)-1(b), P succeeds to S's intercompany loss as a result of S's liquidation. Thus, paragraph (a)(3)(i) of this section continues to defer the application of paragraph (a)(1) of this section until P's sale to X. Under paragraph (a)(4) of this section, the amount of S's $60 intercompany loss disallowed under paragraph (a)(1) of this section is limited to $50 because P's $10 gain on the disposition of the T stock is taken into account as a consequence of the same plan or arrangement. (iv) The facts are the same as in (i) of this Example, except that P sells the T stock to A, a person related to P within the meaning of section 267(b)(2). Although S's intercompany loss is ordinarily taken into account under the matching rule of Sec. 1.1502-13(c) as a result of P's sale, Sec. 1.267(f)-1(c)(2)(ii) provides that none of the intercompany loss is taken into account because A is a nonmember that is related to P under section 267(b). Under paragraph (a)(3)(i) of this section, paragraph (a)(1) of this section does not apply to loss that is disallowed under any other provision. Because Sec. 1.267(f)-1(c)(2)(ii) and section 267(d) provide that the benefit of the intercompany loss is retained by A if the property is later disposed of at a gain, the intercompany loss is not disallowed for purposes of paragraph (a)(3)(i) of this section. Thus, the intercompany loss is disallowed under paragraph (a)(1) of this section immediately before P's sale and is therefore never taken into account under section 267(d). (b) * * * (6) * * * Example (5). * * * (i) * * * S sells its T stock to P for $100 in an intercompany transaction, recognizing a $60 intercompany loss that is deferred under section 267(f) and Sec. 1.1502-13. * * * (ii) Under paragraph (a)(3)(i) of this section, the application of paragraph (a)(1) of this section to S's intercompany loss on the sale of its T stock to P is deferred because S's loss is deferred under section 267(f) and Sec. 1.1502-13. * * * (iii) T's issuance of the additional shares to the public does not result in S's intercompany loss being taken into account under the matching or acceleration rules of Sec. 1.1502-13 (c) and (d), or under the application of the principles of those rules in section 267(f). However, the deconsolidation of T is an overriding event under paragraph (a)(3)(ii) of this section, and paragraph (a)(1) of this section disallows the intercompany loss immediately before the deconsolidation even though the intercompany loss is not taken into account at that time. Example (7). * * * (i) * * * S recently purchased its T stock from S1, a lower tier subsidiary, in an intercompany transaction in which S1 recognized a $30 intercompany gain that was deferred under Sec. 1.1502-13. * * * * * * * * (iii) Under the matching rule of Sec. 1.1502-13, S's sale of its T stock results in S1's $30 intercompany gain being taken into account. * * * * * * * * (c) * * * (4) * * * Example (9). Intercompany stock sales. (i) P is the common parent of a consolidated group, S is a wholly owned subsidiary of P, and T is a wholly owned recently purchased subsidiary of S. S has a $100 basis in the T stock, and T has a capital asset with a basis of $0 and a value of $100. T's asset declines in value to $60. Before T has any positive investment adjustments or extraordinary gain dispositions, S sells its T stock to P for $60. T's asset reappreciates and is sold for $100, and T recognizes $100 of gain. Under the investment adjustment system, P's basis in the T stock increases to $160. P then sells all of the T stock for $100 and recognizes a loss of $60. (ii) S's sale of the T stock to P is an intercompany transaction. Thus, S's $40 loss is deferred under section 267(f) and Sec. 1.1502-13. Under paragraph (a)(3) of this section, the application of paragraph (a)(1) of this section to S's $40 loss is deferred until the loss is taken into account. Under the matching rule of Sec. 1.1502-13(c), the loss is taken into account to reflect the difference for each year between P's corresponding items taken into account and P's recomputed corresponding items (the corresponding items that P would take into account for the year if S and P were divisions of a single corporation). If S and P were divisions of a single corporation and the intercompany sale were a transfer between the divisions, P would succeed to S's $100 basis and would have a $200 basis in the T stock at the time it sells the T stock ($100 of initial basis plus $100 under the investment adjustment system). S's $40 loss is taken into account at the time of P's sale of the T stock to reflect the $40 difference between the $60 loss P takes into account and P's recomputed $100 loss. (iv) Under the matching rule of Sec. 1.1502-13(c), the attributes of S's $40 loss and P's $60 loss are redetermined to produce the same effect on consolidated taxable income (and consolidated tax liability) as if S and P were divisions of a single corporation. Under Sec. 1.1502-13(b)(4), attributes of the losses include whether they are disallowed under this section. Because the amount described in paragraph (c)(1) of this section is $100, both S's $40 loss and P's $60 loss are disallowed. * * * * * (e) * * * (3) * * * Example (5). Absence of a view. (i) In Year 1, P buys all the stock of T for $100, and T becomes a member of the P group. T has 2 historic assets, asset 1 with a basis of $40 and value of $90, and asset 2 with a basis of $60 and value of $10. In Year 2, T sells asset 1 for $90. Under the investment adjustment system, P's basis in the T stock increases from $100 to $150. Asset 2 is not essential to the operation of T's business, and T distributes asset 2 to P in Year 5 with a view to having the group retain its $50 loss inherent in the asset. Under Sec. 1.1502-13(f)(2), and the application of the principles of this rule in section 267(f), T has a $50 intercompany loss that is deferred. Under Sec. 1.1502-32(b)(3)(iv), the distribution reduces P's basis in the T stock by $10 to $140 in Year 5. In Year 6, P sells all the T stock for $90. Under the acceleration rule of Sec. 1.1502-13(d), and the application of the principles of this rule in section 267(f), T's intercompany loss is ordinarily taken into account immediately before P's sale of the T stock. Assuming that the loss is absorbed by the group, P's basis in T's stock would be reduced from $140 to $90 under Sec. 1.1502-32(b)(3)(i), and there would be no gain or loss from the stock disposition. (Alternatively, if the loss is not absorbed and the loss is reattributed to P under paragraph (g) of this section, the reattribution would reduce P's basis in T's stock from $140 to $90.) (ii) A $50 loss is reflected both in T's basis in asset 2 and in P's basis in the T stock. Because the distribution results in the loss with respect to asset 2 being taken into account before the corresponding loss reflected in the T stock, and asset 2 is an historic asset of T, the distribution is not with the view described in paragraph (e)(2) of this section. * * * * * (h) * * * (1) * * * For this purpose, dispositions deferred under Sec. 1.1502-13 are deemed to occur at the time the deferred gain or loss is taken into account unless the stock was deconsolidated before February 1, 1991. * * * * * * * * Par. 17. Section 1.1502-26 is amended by revising paragraph (b) to read as follows: Sec. 1.1502-26 Consolidated dividends received deduction. * * * * * (b) Intercompany dividends. The deduction determined under paragraph (a) of this section is determined without taking into account intercompany dividends to the extent that, under Sec. 1.1502-13(f)(2), they are not included in gross income. See Sec. 1.1502-13 for additional rules relating to intercompany dividends. * * * * * Par. 18. Section 1.1502-33, as proposed to be revised at 57 FR 53663, published November 12, 1992, is further amended by revising paragraph (c)(2) to read as follows: Sec. 1.1502-33 Earnings and profits. * * * * * (c) * * * (2) Intercompany transactions. Intercompany items and corresponding items are not reflected in earnings and profits before they are taken into account under Sec. 1.1502-13. See Sec. 1.1502-13 for the applicable rules and definitions. * * * * * Sec. 1.1502-79 [Amended] Par. 19. Section 1.1502-79 is amended by removing paragraph (f). Par. 20. Section 1.1502-80, as proposed to be amended at 57 FR 53670, published November 12, 1992, is further amended by adding paragraphs (f) and (g) to read as follows: Sec. 1.1502-80 Applicability of other provisions of law. * * * * * (f) Non-applicability of section 163(e)(5). Section 163(e)(5) does not apply to any intercompany obligation (within the meaning of Sec. 1.1502-13(g)) issued in a consolidated return year beginning on or after [the date the final regulations are filed with the Federal Register]. (g) Non-applicability of section 1031. Section 1031 does not apply to any intercompany transaction occurring in consolidated return years beginning on or after [the date the final regulations are filed with the Federal Register]. Margaret Milner Richardson, Commissioner of Internal Revenue. [FR Doc. 94-8488 Filed 4-8-94; 1:03 pm] BILLING CODE 4830-01-U