Several years ago, the Service published Temp. Reg. §1.1502-13T along with Proposed Regulations which addressed the tax consequences with respect to intercompany gains of subsidiary stock that was part of a consolidated group of corporations. The final regulations adopt the Proposed Regulations with some changes and further revises the Temporary Regulations.

Treas. Reg. 1.1502-13(c) provides general rules and principles by which the timing and characterization of intercompany transactions of between members of a consolidated group, including intercompany sales or distributions of subsidiary stock, can be deferred or recharacterized to clearly reflect income of the consolidated group as a whole. The regulations adopt what is often referred to as the “matching” where the timing for the inclusion of gain on the sale of property by the group member selling property (S) is dependent upon the recovery by the group member purchaser (B) of its basis in the property. S's and B's characterizations are subject to redetermination in order to treat S and B as divisions of a single corporation.

There was a trap for the unwary present under the consolidated return regulations prior to this set of regulations for transactions involving appreciated stock of a member of the group. For example, CP, the common parent, wholly owns two subsidiaries, S1 and S2. S1 owns 100% of T which has substantially appreciated in value. S1 transfers, perhaps inadvertently, its T stock to CP..S1 recognizes a deferred intercompany gain to the extent that the FMV of T exceeded its basis in T stock. Suppose P later liquidates T in a section 332 liquidation. Still at that time S would have to recognize the deferred intercompany gain. See former Treas. Regs. §§ 1.1502-13(c)(1)(i) and -13(f)(1)(vi),  under the former deferral and restoration intecompany rules.

The acceleration of the prior deferral also arose when the “matching” regulations were first adopted in 1995.  Relief was provided however under -13(f)(5)(ii) under the “matching” regulations where the consolidated group reincorporated T’s assets in a new member for example.

In an effort to provide a fairer relief rule, the Proposed Regulations under -13(c) announced that intercompany gain with respect to intra-group transfers of member stock might be permanently excluded from gross income following certain stock basis elimination transactions. This could arise in a non-taxable spinoff or liquidation. There was a requirement under the Proposed Regulations that to defer such gain that would otherwise be taken into account and reported in gross income, the common parent (P) must be the member that holds the member stock with respect to which the intercompany gain was realized, and that the gain must be P's intercompany item.  Some had criticized this rule as too narrow in scope. 

Other requirements were imposed under the elimination of such deferred intercompany gain: (i) the group has or will not derive any federal income tax benefit from the intercompany transaction; and (ii) the excluded gain will not be treated as tax-exempt income for purposes of the IBA rules under -32 of the consolidated return regulations. Now, under the final regulations, the intracompany gain with respect to member stock to which the intercompany gain was realized can be excluded provided: (iii) the holding member is either (B) or (s) or a third member that is a successor to both B and S. Excluded gain is not treated as tax-exempt income under -32 of the consolidated return regulations and does not increase earnings and profits.

As to Proposed Regulation §1.1502-13(c)(6)(ii)(D), the so-called “Commissioner’s Discretionary Rule”, the Treasury and the Service did not drop the provision as had been hinted. Therefore, the final regulations take the position that the government can exercise its discretion to provided for an exclusion for transactions involving property other than member stock. The final regulations retain the Commissioner’s Discretionary Rule provided certain conditions are met and a favorable ruling is received.

The Temporary Regulations issued in 2008 contained an additional relief measure where the member of the consolidated group that was being liquidated was, under the above fact pattern, S1 but not T. The Final Regulations issued this year are more expansive. The Final Regulations withdrew the limitation that the direct subsidiary having the deferred gain with respect to member stock be liquidated into the common parent and providing for relief when the target ends up as a subsidiary in the group.

The Final Regulations announced that the IRS and the Treasury Department have reconsidered the requirement of the proposed regulations that, immediately before intercompany gain would otherwise be taken into account, the common parent (P) must be the member that holds the member stock with respect to which the intercompany gain was realized, and that the gain must be P's intercompany item. Given the other requirements of the regulation, namely that (i) the group has not and will not derive any Federal income tax benefit from the intercompany transaction; and (ii) the excluded gain will not be treated as tax-exempt income for purposes of the investment adjustment regulations -- it is appropriate to provide relief where a member other than the common parent holds the subject stock. Accordingly, the Final Regulations allow the exclusion of gain where a member holds the target member stock with respect to which the intercompany gain was realized, and the holding member is either (i) B or S, as a successor to the other party (either B or S); or (ii) a third member that is the successor to both B and S.

The Final Regulations are effective on March 4, 2011.