In an effort to curtail the generation of losses among related corporations within a “controlled group,” the Internal Revenue Service (IRS) recently released proposed regulations under Section 267(f) of the Internal Revenue Code (IRC). The Notice of Proposed Rulemaking REG-118761-09 (April 20, 2011) attempts to articulate better the so-called Supersecret Rule buried in the current regulations (Treas. Reg. Sec. 1.267(f)-1). But it leaves ambiguous, and perhaps even draws into question, the current state of the law regarding certain types of intercorporate transactions. Comments and requests for a public hearing on the proposed regulations are due by July 20, 2011.

To appreciate the tax issues the proposed regulations address, it is necessary to understand how tax law distinguishes  between a “consolidated return group” and a “controlled group” and how that distinction affects the determination of taxable income from related party transactions. Both groups are defined to include corporations connected directly or indirectly through common ownership and thus often share members. In many instances, however, a consolidated return group will be a subset of a “larger” controlled group—for example when the IRC excludes foreign corporations from belonging to a consolidated return group even though they are members of a related controlled group. These somewhat esoteric distinctions in group definition become important when considering the tax consequences of a transaction involving related parties.

Differing Tax Consequences of Group Membership

Membership in a consolidated return group is elective and generally requires the determination of taxable income under single entity principles. Thus, a gain or loss realized in a transaction between two members of a consolidated return group is not taken into account if it produces a tax result different from the one that would be achieved by treating the group as a single entity.  Membership in a controlled group is not elective, and controlled group members generally determine their taxable income on a separate company (rather than a single entity) basis. For example, gain realized on an intercompany transaction between controlled group members is generally recognized immediately. By comparison, where the controlled group is congruent with the consolidated return group, the consolidated return group rules govern and gain is usually deferred because it is “internal” to the group viewed as a single entity.

Loss within a Controlled Group

Interpretive difficulties have arisen where a loss (rather than a gain) is generated within a controlled group. In that circumstance, the current regulations pick and choose among the principles of the consolidated return regulations that they apply to controlled group transactions.  Even though the parties to the transaction are not within a consolidated return group, the current regulations state that such a loss is to be taken into account under “the timing principles” of the consolidated return regulations governing intercompany transactions. In particular, the “matching and acceleration rules” of the consolidated return regulations are to be applied to the realized loss with modifications, while the “attribute rules” of these regulations are generally not to be taken into account. The outcome of this belabored choice of regulatory principles is that a loss realized within the controlled group will generally be deferred until the asset generating the loss leaves the controlled group in a subsequent transaction, and the use of the asset in the seller’s hands will govern the nature of the loss as a capital or ordinary deduction when it is ultimately allowed.

The ‘Supersecret Rule’

The “Supersecret Rule” is a byproduct of the textual obscurity of the current controlled group regulations. This rule applies to loss involving stock of subsidiaries. When a loss is realized with respect to subsidiary stock under the consolidated return regulations and the stock is subsequently canceled as a consequence of the subsidiary’s liquidation under IRC Section 332 (a Section 332 liquidation), the loss is “redetermined” under the attribute rules to be a “noncapital, nondeductible amount.” The Supersecret Rule first states that the controlled group regulations will not redetermine the attributes of the loss—but then provides that a loss that would otherwise be so redetermined will be deferred until the parties to the controlled group transaction that generated the loss (S and B) are no longer members of the same controlled group, a very tortuous route to the end result.

An example in the current regulations indicates that a loss generated by a controlled group sale of all the stock of a corporate subsidiary will be subject to the Supersecret Rule upon the subsidiary’s liquidation, and taxpayers may reasonably be forewarned (because of the statutory requirements of IRC Section 332) that the Supersecret Rule applies to any loss-generating sale of 80 percent or more of a subsidiary’s stock.

By contrast, if less than 80 percent of the subsidiary stock was sold in a loss-generation transaction, a subsequent liquidation of the subsidiary would ordinarily be governed by IRC Section 331 (and not by IRC Section 332), and an additional loss (or even a gain) would be recognized by the parent corporation (B) in the liquidation. Within a consolidated return group, Section 332 would still be applicable to a less-than-80 percent sale because of a special rule in Treas. Reg. Sec. 1.1502-34 aggregating the stock held by all group members. However, this aggregation rule is not a “timing principle” or “a matching and acceleration rule” that the current regulations purport to incorporate in deferring losses generated within controlled groups.  Therefore, taxpayers might reasonably conclude that an internally generated loss could be recognized by the parent corporation in the liquidation that would not be redetermined under the consolidated return regulations (if applied without regard to the aggregation rule) and that the Supersecret Rule requiring additional deferral would not be applicable. The proposed regulations “clarify” that the Supersecret Rule nevertheless still applies to transactions of this type.

How Much Change Is Being Proposed?

Specifically, the proposed regulations indicate that the determination of whether a particular liquidation falls under Section 332 or 331 is to be made by aggregating the stock held by S, the stock held by B, the stock held by all members of S’s consolidated return group, and the stock held by any member of a controlled group of which S is a member that was acquired from a member of S’s consolidated return group. This rule stops short of a full controlled group aggregation rule that would be analogous to the consolidated return aggregation rule of Treas. Reg. §1.1502-34, but it is sufficient to capture a loss-generating transaction in which S sells less than 80 percent of the stock of a soon-to-be liquidated subsidiary to B. Thus, use of this internal loss-generating technique within a controlled group will be effectively blocked if the proposed regulations are adopted in their present form. Although the preamble to the proposed regulations states that the IRS “believes” that losses generated through the use of this technique should be deferred until S and B are no longer in a controlled group relationship, taxpayers may question that this belief is expressed in the text of the current regulations or reflects the current state of the law.

Finally, notwithstanding their amplification of the Supersecret Rule, the proposed regulations do not purport to change the tax consequences of the Section 331 liquidation with respect to B. The Supersecret Rule relates only to a loss generated by an intecompany transaction between controlled group members and does not affect a loss realized by a member with respect to an asset that it owns (in this case, the subsidiary stock). Therefore, B may recognize gain or loss on a Section 331 liquidation (IRC 267(a)(1)(last sentence), both with respect to appreciation or depreciation in the value of the stock acquired from S and with respect to stock of the subsidiary that B has historically owned. In addition, the proposed regulations contain a taxpayer-favorable provision that will permit S to utilize a loss that would otherwise be deferred under the Superscret Rule to the extent that B recognizes gain. In this regard, the preamble to the proposed regulations recognizes that their adoption would be a modification of current law.