United States: Regulations Governing Intercompany Transactions Within Consolidated Groups

Originally published October, 2003

1. INTRODUCTION

I. INTRODUCTION

A. In General

1. On July 18, 1995, the Internal Revenue Service (the "Service") published final regulations that revise the manner in which consolidated groups account for transactions occurring between members of the group (the "current rules"). T.D. 8597, 60 Fed. Reg. 36,671 (Jul. 18, 1995). The current rules contain various changes from the proposed regulations published in 1994 (the "proposed rules"). Notice of Proposed Rulemaking, CO-11-91, 59 Fed. Reg. 18,011 (Apr. 15, 1994).

2. In addition to revising the rules for intercompany transactions, the current rules make minor conforming revisions to the regulations under § 108(b) (attribute reduction for debt discharge of an insolvent corporation), § 460 (accounting for long-term contracts) and § 469 (applying passive loss rules to consolidated groups). The current rules also include extensively revised regulations under § 267(f) (loss deferral on property sales between members). In addition, the Service simultaneously published temporary and proposed regulations governing the treatment of sales of stock of the common parent by consolidated group members. Temp. Reg. § 1.1502- 13T, 60 Fed. Reg. 36,669 (Jul. 18, 1995); Prop. Reg. § 1.1502-13(f)(6), 60 Fed. Reg. 36,755 (Jul. 18, 1995). These regulations were finalized on March 14, 1996. T.D. 8660, 61 Fed. Reg. 10,447 (March 14, 1996).

3. The purpose of this outline is to describe the current rules, including any changes made to the proposed rules, and to contrast them to the old rules addressing the treatment of intercompany transactions. The outline is intended to be an overview of the current rules and is not an exhaustive discussion of every aspect of the current rules.

B. Summary of the Current Intercompany Transaction Rules

1. In general. The current rules extend the application of the single-entity theory to intercompany transactions, including intercompany transactions involving stock or other obligations of members. Thus, whereas the amount and location of items with respect to intercompany transactions continue to be accounted for on a separate-entity basis, attributes, holding periods, timing, source, and character are redetermined as necessary to produce the effect of treating the selling and buying members as divisions of a single entity. Reg. § 1.1502-13(a)(2).

2. Avoid specific mechanical rules. The approach of the current rules represents a significant departure from that of the old rules, in that the current rules eschew specific mechanical rules in favor of broad rules that can only be applied with a view to the purposes of the intercompany transaction rules and the single-entity theory.

3. Eliminate distinction between deferred and non-deferred intercompany transactions. The current rules eliminate the distinction between "deferred" and "non-deferred" intercompany transactions, and between transactions unrelated to the corporate/shareholder relationship and those that are incident to this relationship. The current rules analyze all transactions under the same general principles.

4. Outline of regulations. Paragraph (a) of Reg. § 1.1502-13 discusses the purpose and theory underlying the current rules, as well as the status of the timing rules as a method of accounting. Paragraph (b) of Reg. § 1.1502- 13 provides definitions of certain key terms and concepts. The primary rules that achieve single-entity treatment under Reg. § 1.1502-13, however, are the "matching rule" of paragraph (c) and the "acceleration rule" of paragraph (d). Paragraph (e) provides simplifying rules for certain transactions. Paragraphs (f) and (g) provide special rules for transactions involving member stock and member obligations, respectively. Paragraphs (h) and (j) provide anti-avoidance rules and miscellaneous operating rules, respectively. Paragraph (k) makes cross-references to certain other applicable provisions of the Code or regulations. Paragraph (l) contains the effective date rules, including a special anti-avoidance rule. Paragraph (i) is reserved.

5. Fundamental principles. The fundamental principle of the current regulations is reflected in the matching rule, which requires the selling member to take intercompany items into account as the buying member takes into account corresponding items from the intercompany transaction. The selling member must take its intercompany items into account at the time and in the manner consistent with treating the selling and buying members as divisions of a single entity. See Reg. § 1.1502-13(c). The acceleration rule requires items deferred under the matching rule to be taken into account when it first becomes clear that it is no longer possible to achieve single-entity treatment under the matching rule, generally when the selling or buying member leaves the group. See Reg. § 1.1502-13(d).

C. Summary of the Old Intercompany Transaction Rules

1. In general. The prior intercompany transaction rules were found at Reg. §§ 1.1502-13 and 1.1502-14 and Temp. Reg. §§ 1.1502-13T and 1.1502- 14T (the "old rules"). These rules continue to be generally effective for transactions occurring during tax years beginning prior to July 12, 1995. Thus, the old rules continue to be effective in most instances for transactions occurring during 1995.

2. Transactions covered by old rules. The old rules defined intercompany transactions as transactions during the consolidated taxable year between corporations that were members of the same group immediately after the transaction. The old rules distinguished between transactions involving members acting in an unrelated capacity (for example as buyer and seller of property) and transactions between members acting in their corporate/shareholder capacities. The former (unrelated transactions) were governed by the rules of Former Reg. § 1.1502-13, while the latter transactions were governed by Former Reg. § 1.1502-14. Former Reg. § 1.1502-18 contained rules for inventory transactions.

3. Distinction between deferred and non-deferred intercompany transactions. The old rules distinguished between "deferred intercompany transactions" and intercompany transactions that were not "deferred." Deferred intercompany transactions generally included only sales of property and intercompany transactions involving expenditures that were capitalized. Thus, the general rules did not apply to many transactions involving intercompany debt or stock. Special rules were provided for such transactions. See, e.g., Former Reg. § 1.1502-14; Former Temp. Reg. § 1.1502-14T.

4. Generally redetermine only the timing of transactions. Under the old rules, sales or exchanges of property that were intercompany transactions were treated as "deferred." The amount, location, character, and source of items arising from intercompany transactions were determined as if separate returns were filed; i.e., on a separate-entity basis. However, the time at which intercompany items were taken into account was deferred until the occurrence of a triggering event that would cause the item to be restored. There were three general restoration rules.

a. First, gain or loss was restored to the selling member in proportion to depreciation, amortization, or depletion deductions taken by the buying member with respect to the property. Former Reg. § 1.1502-13(d), (l).

b. Second, in the case of an installment obligation sold between members, gain was restored as the obligation was satisfied. Former Reg. § 1.1502-13(e).

c. Third, the balance of any deferred gain or loss was restored when the property was disposed of outside the group or when the selling or buying member ceased to be a member of the consolidated group. Former Reg. § 1.1502-13(f).

II. DEFINITIONS

A. Denomination of Selling and Buying Member

1. Selling member. For purposes of simplicity under the current rules, the company transferring the property, or performing the services in connection with an intercompany transaction, is uniformly denominated as "S." Reg. § 1.1502-13(b)(1)(i).

2. Buying member. The company paying for the property or services in connection with an intercompany transaction is uniformly denominated as "B." Reg. § 1.1502-13(b)(1)(i).

B. Definition of an Intercompany Transaction

1. General definition. A transaction is only subject to the current regulations if it is an "intercompany transaction," defined as any transaction between corporations that are members of the same consolidated group immediately after the transaction. Reg. § 1.1502- 13(b)(1)(i).

2. Time of transaction. If a transaction occurs in part while the corporations are both members of the same group and in part while they are not, the transaction is treated as taking place at the earliest of (1) when performance by either corporation takes place, or (2) when payment for performance would be taken into account under the current rules if the transaction were an "intercompany transaction." Reg. § 1.1502- 13(b)(1)(ii).

3. Separate transactions. Each transaction must be analyzed separately and different transactions may not be "netted." For example, if S simultaneously sells appreciated property to B at a gain and depreciated property to B at a loss, it is not appropriate to net the results of the two transactions. Each is treated as a separate and independent transaction. Reg. § 1.1502-13(b)(1)(iii). Thus, the following generally are separate transactions: (1) each accrual of interest on a loan; and (2) each payment under a notional principal contract. Accrual of premium on a loan is treated either as a separate transaction or as an offset to accrued interest, whichever is appropriate to achieve single-entity treatment.

C. Intercompany Items and Corresponding Items

1. Attributes. An item’s attributes include all of the characteristics necessary to determine the item’s effect on taxable income (and tax liability), except amount, timing, and location. For example, attributes include character, source, treatment as excluded from gross income or as a noncapital, nondeductible amount, and treatment as a built-in gain or loss under § 382(h) or § 384. In contrast, characteristics of property such as its holding period or the fact that the property is included in inventory are not attributes, although these characteristics might affect the determination of the attributes of an item. For example, holding period is not an attribute, because it may have no effect on taxable income (or tax liability) in many instances. In certain cases, however, holding period may determine the character of gain or loss, which is an attribute. See Reg. § 1.1502- 13(b)(6).

2. Intercompany items

a. In general. The transferor’s (S’s) items of income, gain, deduction, or loss are its "intercompany items." For example, if S sells appreciated property to B at a gain, the gain is intercompany gain. An item is an intercompany item whether it arises directly or indirectly from an intercompany transaction. Reg. § 1.1502- 13(b)(2)(i).

b. Related costs or expenses. S’s costs or expenses related to an intercompany item are included in determining its intercompany items. Generally, any costs or expenses that are related to the intercompany item that would not be capitalized under S’s separate method of accounting are included in the determination of the intercompany item. For example, if S sells appreciated inventory property to B, S’s intercompany gain is determined by including direct and indirect costs properly includible under § 263A. Deductions for employee wage costs are included in determining intercompany income items from the performance of services for B. Depreciation costs are included in the determination of intercompany income from renting property to B. See Reg. § 1.1502-13(b)(2)(ii).

c. Amounts not yet recognized or incurred. S’s intercompany items may be taken into account even if S has not yet taken them into account under its separate-entity method of accounting. If S is a cash method taxpayer, S may be required to take intercompany items into account under the current rules even if S has not received the cash. Reg. § 1.1502-13(b)(2)(iii). For example, if S, a cash method taxpayer, has sold property to B but has not yet received the cash, and B leaves the consolidated group, the acceleration rule may require S to take its intercompany gain or loss into account even though it would not have taken it into account under its separate-entity method of accounting. Thus, the current rules may operate to accelerate recognition of items relative to the time an item would have been taken into account on a separate-company basis.

3. Corresponding items

a. In general. The transferee’s (B’s) items of income, gain, deduction, and loss from an intercompany transaction, or from property acquired in an intercompany transaction, are B’s "corresponding items." Reg. § 1.1502-13(b)(3)(i). For example, if S sells appreciated property to B, S has an item of intercompany gain. When B subsequently disposes of the property, B’s gain or loss on the disposition is B’s corresponding item.

b. Disallowed or eliminated amounts. B’s corresponding items include amounts that are permanently disallowed or eliminated, directly or indirectly, under other provisions of the Code or regulations; i.e., an item is not disregarded for purposes of applying the current rules merely because a provision of the Code or regulations otherwise prevents B from taking the item into account. For example, B’s corresponding items include amounts disallowed under § 265 (expense related to tax-exempt income) and amounts not recognized under § 311(a) (nonrecognition of loss on distributions), § 332 (nonrecognition on liquidating distributions), or § 355(c) (certain distributions of stock of a subsidiary). Reg. § 1.1502-13(b)(3)(ii).

By contrast, an amount not recognized is not treated as a corresponding item to the extent B receives a "successor asset" in the nonrecognition transaction. Reg. § 1.1502-13(b)(3)(ii). Successor assets generally include any asset whose basis in B’s hands is determined in whole or in part by intercompany property. See Reg. § 1.1502-13(j)(1). In effect, this rule prevents duplication of corresponding items that could trigger S’s intercompany items, which will be taken into account only by reference to the successor property.

4. Recomputed corresponding items. In order to determine the time that S will take its intercompany items into account under the matching rule (described more fully below) it is also necessary to determine the "recomputed corresponding item." This is the amount or item that would have been taken into account if S and B had been divisions of a single corporation. Reg. § 1.1502-13(b)(4). Thus, the term is somewhat of a misnomer since the item is not, in fact, a recomputation of B’s corresponding item so much as a hypothetical single-entity item.

EXAMPLE 1 -- Items

Facts: S holds investment property with a basis of $100 and a fair market value of $200. In Year 1, S sells the property to B for $200. B holds the property for investment with a basis of $200. In Year 3, B sells the property to X, a nonmember, for $300.

Results: S’s sale to B is an intercompany transaction, because it involves a transfer of property between corporations that are members of the same consolidated group immediately after the transaction. S’s $100 gain is its intercompany item ($100 intercompany gain). B’s gain with respect to the property from the sale to X is its corresponding item ($100 corresponding gain). If S and B were divisions of a single corporation, that hypothetical corporation would ignore the transfer between its divisions for tax purposes and would keep S’s original basis of $100 in the property; the hypothetical single corporation would realize an amount of $300 upon the sale to X. Thus, if S and B were merely divisions of a single corporation, the hypothetical corporation would recognize $200 of gain in Year 3 on the sale to X. The recomputed corresponding item is, therefore, a $200 recomputed gain.

5. Elimination of deemed items. The proposed rules contained rules regarding "deemed items," which generally were adjustments reflected in basis or as a carryover that were substitutes for an intercompany item or corresponding item. Many commentators felt that the concept was confusing and duplicative, because in most instances the general rules would reach the problems intended to be addressed by the concept of "deemed items." See, e.g., ABA Comments at 2311. Accordingly, the deemed item rules have been eliminated in the final regulations. Preamble to the final regulations, 60 Fed. Reg. at 36,674. However, because the deemed item rules overlapped with the more general rules, this should have no effect on the results.

D. Timing Rules As a Method of Accounting

The timing rules are a method of accounting for intercompany transactions that is to be applied by each member in addition to the member’s other methods of accounting. See Reg. §§ 1.1502-13(a)(3), -17; see also Reg. § 1.446-1(c)(2)(iii) (providing that, pursuant to § 446, the timing rules of Reg. § 1.1502-13 are a method of accounting for consolidated returns beginning on or after November 7, 2001). For example, if S sells property to B in exchange for B’s note, the timing rules of Reg. § 1.1502-13 apply rather than the installment sale rules of § 453. This clarifies uncertainty that had arisen from conflicting authorities and positions of the Service concerning whether the old timing rules were a method of accounting. Compare P.L.R. 9002006 (Sept. 30, 1989) (ruling that the deferral and restoration adjustments required by the old rules were not a method of accounting) with General Motors Corp. v. Comm’r, 112 T.C. 270 (1999) (rejecting the Service’s argument that the old rules were a method of accounting).

In response to questions raised by commentators when this rule was introduced in the proposed rules, the Service added a technical provision granting automatic consent under § 446(e) to any change in the method of accounting made necessary by joining or leaving a consolidated group. Such a change in accounting method is to be effected on a cut-off basis. However, this does not address concerns expressed by commentators over the complexity created by treating the timing rules as a method of accounting (e.g., whether it requires groups to obtain consent to correct an erroneous application of the current rules).

III. THE MATCHING RULE

A. In General

1. The heart of the current regulations is the matching rule contained in Reg. § 1.1502-13(c). The matching rule seeks to achieve single-entity treatment by prescribing a treatment that matches the consequences that would obtain if the transaction had been undertaken between divisions of a single corporation. Thus, S and B are treated as engaging in their actual transaction and owning any actual property involved 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 for cash between divisions. If S sells property to B in exchange for B’s stock, S will be treated as owning the B stock, even though a division of a corporation could not issue stock. See Reg. § 1.1502- 13(c)(3).

2. Although treated as divisions of a single corporation for most purposes, S and B are treated as:

a. Operating separate trades or businesses. See, e.g., Reg. § 1.446- 1(d) (permitting different accounting methods to be applied by a taxpayer in its separate and distinct trades or businesses); Reg. § 1.1502-13(c)(3)(i); and

b. Retaining any special status that they have under the Code as separate entities. For example, if B has status as a bank under § 581, a domestic building and loan association defined in § 7701(a)(19), or an insurance company to which § 801 or § 831 applies, it will be treated as such under the matching rule, despite the fact that B will generally be treated as a division of a single corporation. Reg. § 1.1502-13(c)(3)(ii). Holding property for sale to customers in the ordinary course of business, however, is not a special status for this purpose.

3. The matching rule applies to timing and attributes, but not to amount or location of items, which is determined on a separate-entity basis. See Reg. § 1.1502-13(a)(2). The application of the matching rule involves three general rules: (1) matching of timing; (2) holding period aggregation; and (3) redetermination of other attributes. There are also a number of operational rules. However, the aim of the current rules is to avoid the mechanical rules imposed by prior law. As a result, the current rules are frequently somewhat vague and can only really be understood in conjunction with the stated purposes of the current rules and specific examples. Fortunately, the current rules provide numerous examples to illustrate their application, many of which are reproduced below.

B. Timing under the Matching Rule

1. B’s timing. B is generally required to determine the timing of corresponding items as it would under its accounting method on a separate-entity basis, subject to any impact the redetermination of the attributes of those corresponding items may have on B’s timing. As described below, attributes may be redetermined so as to achieve the effect of treating S and B as divisions of a single corporation. Thus, while B’s timing will not generally be affected by the current rules, it may be affected in a few instances. For example, if S’s activities turn what normally would be a capital asset in the hands of B into dealer property, this may prevent B from taking the income into account under the installment sale method of § 453(b), thereby affecting the timing of B’s recognition of income. Reg. § 1.1502-13(c)(2)(i).

2. S’s timing. S is required to redetermine the timing of its intercompany items to reflect the difference for the year between B’s corresponding items taken into account and B’s recomputed corresponding items (the items that B would have taken into account for the year if B and S were divisions of the same corporation). Reg. § 1.1502-13(c)(2)(ii). In effect, the concept of the "recomputed corresponding item" merely provides a mechanical means to effect the requirement that S’s timing be redetermined to achieve single-entity treatment. To the extent items taken into account by B differ from items that would have been taken into account by a single entity, S "makes up the difference."

EXAMPLE 2 -- Timing of Realization

Facts: S holds investment property with a basis of $40 and a fair market value of $100. In Year 1, S sells the property to B for $100. B holds the property for investment with a basis of $100. In Year 3, B sells the property to X, a nonmember, for $200.

Results: S has a $60 intercompany gain (the difference between its basis of $40 and amount realized of $100). B has a corresponding gain of $100 (the difference between B’s basis of $100 and amount realized of $200). If S and B were divisions of a single corporation, the gain realized by B upon the sale of the property in Year 3 would be the amount realized of $200 less the original basis of $40, or $160 (which, therefore, is the recomputed corresponding item). Under the matching rule, in any given tax year, S is required to take into account the difference between B’s corresponding item and the recomputed corresponding item. In Year 1, S’s intercompany gain is $60, which is deferred. B has no corresponding item until Year 3, and if S and B were divisions of the same corporation, no gain would have been realized or recognized until Year 3. Accordingly, the corresponding and recomputed corresponding items are zero until Year 3. Thus, S is not required to take any portion of its intercompany item into account until Year 3. In Year 3, the difference between B’s corresponding gain of $100 and the recomputed corresponding gain of $160 is taken into account by S. Thus, S takes $60 of gain into account in Year 3.

EXAMPLE 3 -- Timing on Sale of Depreciable Property

Facts: S acquires a depreciable machine with a 10-year life on January 1 of Year 1 for $100. S depreciates the machine using the straight-line method, giving rise to annual depreciation deductions of $10. On January 1 of Year 5, S sells the machine to B for $100. S realizes $40 of gain. Because S and B are related, B is required under § 168, in effect, (i) to bifurcate the basis subject to depreciation into an amount equal to $60 that is depreciated as if it had a remaining useful life of six years, and (ii) an amount equal to $40 that has a remaining useful life of ten years. Therefore, during Year 5, B has a depreciation deduction of $10 with respect to the $60 basis and $4 with respect to the $40 basis. In the aggregate, B depreciates the machine at a rate of $14 in Years 5 through 10, and at a rate of $4 in Years 11 through 14.

Results: The example involves facts that may require redetermination of attributes and character. These issues are discussed below, but are ignored here for simplicity. The timing of recognition is determined as follows. S has an intercompany gain of $40 realized at the beginning of Year 5. In Year 5, B has a corresponding depreciation deduction of $14. However, if S and B had been divisions of a single corporation, the depreciation deduction would have been only $10. Therefore the recomputed corresponding item is a $10 depreciation deduction. S is required to take into account an amount equal to the difference between the corresponding item of $14 and the recomputed corresponding item of $10; i.e., S must take $4 of its intercompany gain into account in Year 5. Similarly, S will take $4 into account in Years 6 through 10. In Years 11 through 14, a hypothetical single entity would not have been entitled to any amount of depreciation. Therefore, the recomputed corresponding item for these years is zero while the corresponding item is $4. Thus, S must take $4 of gain into account in Years 11 through 14.

C. Holding Period Aggregation

1. Current rules. Under the current rules, S and B are required to account for transactions as if they were divisions of a single corporation. If S and B were divisions of a single corporation, that corporation’s holding period would include both S’s and B’s holding periods. Accordingly, the current rules provide that the holding period of property transferred from S to B is the aggregate of the separate entity holding periods in most situations. Reg. § 1.1502-13(c)(1)(ii). However, if the basis of the property transferred in an intercompany transaction is determined by reference to the basis of any other property, the property’s holding period is determined by reference to the holding period of the other property. In other words, substitute basis under another provision of the Code or regulations also requires substitution of the holding period, without regard to the aggregation otherwise required by the matching rule.

2. Old rules. Under the old rules, B’s holding period did not include S’s holding period. Former Reg. § 1.1502-13(g). Thus, if S sold investment property that it had held for seven months to B, and B sold the property, which it held for investment, seven months later to X, B’s holding period was measured from the time of the intercompany sale. Both S and B were treated as having a holding period of only seven months.

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