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By George L. White, Esq.
Actually, the sobriquet used by some practitioners to characterize the §267(f) regs was "supersecret."1 The sobriquet may not have been seriously intended by practitioners, and the regs writers were probably not amused, but nonetheless it has stuck.
Whatever, the regs are secret no more. This spring, IRS and Treasury published the proposed regulations. Prop. Regs. §1.267(f)-1(c)(1)(iv).2
Section 267(a) disallows losses on the sale or exchange of property between certain related persons. Section 267(f)(2) provides an exception for losses on the sale or exchange of property between members of a controlled group. Under the exception in §267(f)(2), such losses are deferred rather than disallowed. Generally, the loss is deferred until the property is disposed of outside the controlled group.
A year before the proposed regs were published, they had been foreshadowed by IRS in a 2010 legal memorandum. CCA 201025046 (3/12/10). Even though not mentioned in either the CCA or the proposed regs, the backdrop to both is the venerable decision in Granite Trust Co. v. U.S..3
In Granite Trust, parent (P) owned 100% of the stock of subsidiary (S). The value of S stock had declined and P wanted to recognize its loss on the liquidation of S, i.e., P wanted to avoid the non-recognition of loss upon liquidation of an 80% (or more) owned subsidiary. Toward that objective, prior to liquidating S, P sold slightly more than 20% of its S stock to a friendly buyer. In deciding in favor of Granite Trust, the court gave effect to the pre-liquidation sale of S stock.4
Recently, there has been considerable discussion among practitioners regarding the possible application of the economic substance doctrine (ESD) to Granite Trust-type transactions. There are two prongs to ESD:
It's easy to see the reason for practitioners' concern. It's difficult to discern a non-tax purpose for the first step in the Granite Trust transaction: the pre-liquidation sale of S stock. The tax motivation for the first step stands out, given the close timing of the two steps, both of which occurred during the same calendar month. Nevertheless, government officials have disavowed any intent to challenge Granite Trust-type transactions by asserting ESD.6
Assuming Granite Trust-type transactions will withstand challenge when the S stock is sold to an unrelated (if friendly) buyer, that is one end of the spectrum of transactions. At the other end is the sale of S stock within a consolidated group. If the objective is to set the stage for a recognized loss upon subsequent liquidation of S, that would be a pointless exercise. So long as S stock is owned solely by members of the consolidated group, ownership is aggregated by Regs. §1.1502-34 for purposes of the non-recognition provisions of §332. Thus, the loss recognition provisions of §331 are unattainable.
What about Granite Trust-type transactions in the middle of the spectrum, i.e., where the S stock is sold to a related buyer outside the consolidated group? That transaction, where the buyer is within P's controlled group, is the subject of CCA 201025046 and the proposed regulation.
In CCA 201025046, P owned 100% of S1. P also owned indirectly 100% of foreign subsidiary, FS2. The value of S1 had declined and P sought to recognize its loss through a series of transactions. First, P sold more than 20% of S1 stock to FS2, retaining its less-than 80% stake in S1. Subsequently S1 completely liquidated.
The sole issue in the CCA was the treatment of P's loss on the sale of S1 stock to FS2. P conceded that this loss was deferred by §267(f) but argued that the loss should be taken into account when was liquidated. (P's loss on S1's complete liquidation was not at issue because §267 has no application to §331 liquidations.)
The CCA advised that the deferred loss on the sale of S1 stock to FS2 was not triggered by the subsequent complete liquidation of S1. Instead, the CCA ruled that loss deferral must continue until P and FS2 are no longer in a controlled group relationship.
In order to address the arguments of the taxpayer, the CCA includes an extended analysis of the issues presented under the §267(f) regs. The "heart" of the dispute, according to the CCA, is the "appropriate application" of Regs. §1.267(f)-1(c)(1)(iv). That regulation provides for a limited application of the principles of the consolidated return regulations. The regulation applies the timing principles of the consolidated returns regulations, but not the attribute redetermination rules. Regs. §1.267(f)-1(a)(2), (a)(2)(i)(B).7
Regs. §1.267(f)-1(c)(1)(iv) confirms that the application of consolidated return principles is limited to the timing principles of the matching and acceleration rules of Regs. §1.1502-13, allowing for adjustment of the matching and acceleration rules to accommodate controlled groups. The conflict between the taxpayer and the IRS focused on Regs. §1.267(f)-1(c)(2) which generally turns off the application of the attribute redetermination provisions of the matching and acceleration rules. This general rule is, however, subject to an exception.
In the CCA, the taxpayer apparently argued (its argument is not entirely clear, even to IRS) that it is the attribute provisions that convert the transaction in question into a §332 liquidation. Accordingly, the taxpayer argued that such a recast is not permitted because Regs. §1.267(f)-1(c)(2) turns off the application of the attribute provisions. The CCA rejects the taxpayer argument, asserting that Regs. §1.267(f)-1(c)(1)(iv) does not recast the transaction in question into a §332 liquidation. Instead, the CCA asserts that the timing rules control here, and these rules apply as if P and FS2 were divisions of a single corporation (i.e., the single entity theory of consolidated returns). As divisions, no loss would have been recognizable because the loss is wholly internal to the group. It is this single entity theory that compels the CCA's conclusion that deferral must be maintained on P's loss until P and FS2 are no longer in a controlled group relationship.
The operation of the general rule, and its exception, is clarified in the preamble to the proposed regulation. In the context of a consolidated group, the attribute redetermination rule may have the effect of eliminating a stock loss. For example, take the base case of a loss sale (in a transaction treated as a sale or exchange for tax purposes) to P by S of 30% of T stock, followed later by T's complete liquidation. The attribute redetermination rule invokes the single entity theory to eliminate S's loss, just as though the sale were between two divisions of a single corporation. In the context of a controlled group, however, a "special rule" applies the attribute redetermination rule to defer the stock loss that would be eliminated in a consolidated group.8
It is this back-door application of the aggregation rule of Regs. §1.1502-34 in the CCA and the proposed regs that has generated discussion among consolidated return practitioners. Essentially, their concern is whether the aggregation rule of Regs. §1.1502-34 applies here or not. The IRS's response is that the rule does not actually apply, but does hypothetically.9 The rule applies in a limited sense to determine the timing of the loss on the intercompany sale that precedes complete liquidation. If the rule applied across-the-board, it would be too broad. For instance, assume that P owns 70% of T, the value of whose stock has declined. P is subsequently acquired by foreign parent (FP) that already owns the remaining 30% of T. Later, T is completely liquidated. If the aggregation rule applied, the liquidation would be covered by §332 and P's loss on T stock would not be recognized. But, so long as FP's ownership of T stock is not derived from P, the aggregation rule does not apply.
In addition to clarifying the current regulations, the proposed regulations make a change. Taxpayers had noted that the current regulations do not allow for adjustment of the amount of S's deferred loss where gain is recognized on the subsequent liquidation.10 For example, if the value of T stock appreciates between the time of its intercompany sale and its liquidation, with the result that gain is recognized on liquidation, the proposed regulation allows S's deferred loss to be taken account to the extent of gain recognized.11 This result reflects the principles of the matching rules in Regs. §1.1502-13.
For more information, in the Tax Management Portfolios, see White, 754 T.M., Consolidated Returns: Election and Filing, and in Tax Practice Series, see ¶5310, Consolidated Returns.
7 The consolidated return regulations are not imported wholesale into the §267(f) regs. If they were, the taxpayer would never have knowingly undertaken the transaction in question. The aggregation rule of Regs. §1.1502-34 would have combined the ownership interests in S1 held by P and FS2, with the result that no loss would have been recognized by P on the liquidation of S1 because the liquidation would have been covered by §332 and not §331.
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