On April 20, 2011, the IRS issued proposed regulations under Treas. Reg. §1.267(f)-1(c) (the Proposed Regulations), which will become effective after they are adopted as final regulations. The Proposed Regulations modify the current deferred loss rules to allow the acceleration of a deferred loss in certain circumstances that routinely arise in international restructurings of U.S. companies. Accordingly, corporations in a controlled group that are considering a sale to another member of the controlled group should evaluate the consequences under the Proposed Regulations.
Generally, no deduction is allowed for any loss on the sale or exchange of property between related persons. However, this rule does not apply to a loss on the sale or exchange of property between members of a controlled group.1 In such a case, the loss is deferred until the property is transferred outside the controlled group and the loss is recognized under the consolidated return principles, or until such other time as prescribed in regulations.
Separate from the controlled group rules, consolidated return principles provide timing rules and attribute redetermination rules. To illustrate these rules, assume a member of a consolidated group (A) owns an autographed baseball as an investment and sells the baseball at a loss to another member of the consolidated group (B). B includes the baseball in the inventory of its sports memorabilia store and sells the baseball to an unrelated party. A will recognize its loss on the sale of the baseball to B when B sells the baseball to the unrelated party under the timing rules. Further, A’s loss will be recharacterized as an ordinary loss rather than a capital loss under the attribute redetermination rules.2
In certain situations, the asset redetermination rules eliminate a consolidated group member’s deferred loss. As an example, assume that a subsidiary in a consolidated group (X) owns all of the stock of a solvent computer corporation (Y). X sells all of the Y stock at a loss to the common parent of the consolidated group (Z). Subsequently (and before any change in the value of the Y stock), Y liquidates into Z tax-free. Consequently, X’s loss is recharacterized from a capital loss to a noncapital, nondeductible loss, which eliminates X’s loss.
These attribute redetermination rules in the consolidated return principles, however, do not apply to sales or exchanges between members of a controlled group. Instead, if an intercompany loss between members of a controlled group would have been recharacterized to be a noncapital, nondeductible amount as a result of the attribute redetermination rules had the members been in a consolidated group, then the loss is deferred until the members (and their successors) are no longer in a controlled group (the Hypothetical Attribute Determination Rule).3 Thus, if Z and X were in a controlled group and not a consolidated group, then X’s loss on the sale of the Y stock to Z would be deferred until Z and X are no longer in a controlled group in the previous example.
Taxpayers have debated whether the Hypothetical Attribute Determination Rule applies in the following two examples, which are structured to avoid nonrecognition treatment upon a liquidation. First, assume that a subsidiary in a controlled group (S) owns all of the stock of a solvent pharmaceutical corporation (T). S sells 30 percent of the stock of T at a loss to the common parent of the controlled group (Q). Subsequently (and before any change in the value of the T stock), T liquidates in a taxable transaction.4 Second, assume instead that Q is a foreign entity such that Q and S are in a controlled group but not a consolidated group. Further, assume that S owned only 50 percent of the T stock and another corporation that is in a consolidated group with S owned the remaining 50 percent of the T stock. S sells 30 percent of the T stock to Q at a loss. Subsequently, T liquidates. The liquidation is taxable. In both examples, does S recognize its loss on the sale of the T stock to Q on T’s liquidation or afterward when S and Q are no longer in the same controlled group?
The Proposed Regulations
The Proposed Regulations provide clarity and a modification to the current deferred loss rules for controlled groups. The Proposed Regulations clarify that the Hypothetical Attribute Determination Rule applies in both of the previous examples. Consequently, in both examples, S’s loss on the sale of the T stock to Q is deferred until Q and S (and their successors) are no longer in a controlled group. While this clarification is consistent with the IRS’s previous rulings, it is unfavorable for members of controlled groups.5
The Proposed Regulations also modify the current deferred loss rules to allow a member of a controlled group to recognize a loss on the sale of property to another member of the controlled group to the extent that the other member recognizes gain from the property. For example, if S sells 30 percent of the T stock to Q at a loss and the T stock appreciates after the intercompany sale and before the subsequent event that results in Q’s recognition of gain (T’s liquidation), Q would recognize gain under Section 331 and S’s loss (under the Proposed Regulations) would be taken into account to the extent that Q recognizes a corresponding gain. This modification is favorable to members of controlled groups because it allows the members to recognize a deferred loss without having to have the property transferred outside the controlled group or having a member leave the controlled group.
Overall, the Proposed Regulations will become effective after they are adopted as final regulations. Once they are effective, they will limit a member in a controlled group from recognizing a deferred loss on a sale of property to another member of the controlled group only to situations where the property is transferred outside the controlled group or where one of the members leaves the controlled group. The only exception to this rule is where the buying member of the controlled group recognizes gain from the property. Therefore, controlled group members considering transferring property to another member of the controlled group at a loss should analyze whether the Proposed Regulations will defer the recognition of the loss.