Most transactions between members of the same consolidated group generally do not result in current recognition of federal income tax. Treasury Regulations require that "intercompany" items of income, gain, deduction, and loss that result from intercompany transactions between members are zeroed out under a single-entity approach.1 This is accomplished by "matching" the transactions and treating them as transactions that would occur as if they were divisions of a single entity, so as to clearly reflect consolidated taxable income.2 Importantly, these Treasury Regulations contain an anti-abuse rule that states that, "[i]f a transaction is engaged in or structured with a principal purpose to avoid the purposes of this section (including, for example, by avoiding treatment as an intercompany transaction), adjustments must be made to carry out the purposes of this section."3 The anti-avoidance rule would seem to treat transactions that are not intercompany transactions in form, but are intercompany transactions in substance as intercompany transactions, when they result in an abusive creation of a loss or changing the location of income that has the effect of reducing federal income tax. On November 5, 2010, the IRS released a Chief Counsel Advice Memorandum (CCA) holding that the payment of a patronage dividend by a cooperative to member patrons, who were all members of the same consolidated group, was an intercompany transaction under Treas. Reg. Section 1.1502-13 by applying the anti-abuse rule in the situation in which a partnership was interposed between the members and the cooperative.4
Background on Taxation of Cooperatives
A cooperative is permitted to claim an income tax deduction for dividend distributions to their patrons (owners) paid within eight and a half months following the close of the tax year.5 The corresponding patronage dividends are included in the taxable income of the patrons in the year of receipt.6 The patronage dividends may effectively allow a one-year deferral on the taxation of the income earned by a cooperative if timed properly. If the cooperative and the patrons are members of the same consolidated group, the payment of the patronage dividend is considered an intercompany transaction, subject to the matching rule, whereby the deduction of the payment of the patronage dividend would be treated as occurring in the same year as the inclusion of the patronage dividend by the consolidated members.7 This ensures that the timing of the items properly reflect income with no deferral of income between the group members.
In CCA 201044003, the taxpayer was the parent of a large affiliated group, which has retail operations throughout the United States, filing a consolidated federal income tax return. Procurement and merchandising functions were historically performed by the taxpayer’s general office. A tax promoter approached the taxpayer about forming a cooperative that would be owned by a newly formed partnership, which in turn would be owned by the consolidated members. The newly formed partnership had no operations and did not have any business relationship with the cooperative. Presumably the partnership was interposed between the consolidated group and the cooperative to prevent the cooperative from being in the consolidated group and having the matching rules not apply to the issuances of patronage dividends.8 As part of the plan, the taxpayer transferred employees to the cooperative to perform the procurement and merchandising functions they performed in the taxpayer’s operating company before. The cooperative performed these functions by taking delivery and title to the procured merchandise. Consolidated group members paid a surcharge for all the goods purchased by the cooperative. The promoter suggested that this strategy would eliminate certain state income taxes and create a deferral for federal income taxes for one year, because the standard application of the matching rule would not apply since a partnership broke consolidation.9
The IRS concluded that by transferring the procurement and merchandising functions to the cooperative and charging a surcharge for the same services, the patrons artificially inflated their cost of goods sold for that year and deferred income on the surcharge, which would essentially be returned to them the following year as a patronage dividend. Moreover, the taxpayer’s interjection of a partnership between the cooperative and the consolidated group member was abusive under Section 1.1502-13(h), because it deliberately excluded the cooperative from the consolidated group. Part of the IRS analysis on the application of Treas. Reg. Section 1.1502-13(h) was based on the promoter’s assertions that the transaction was done for tax purposes with no business purpose and the taxpayer did not get an opinion as to the business efficiency or viability of forming the cooperative.10
The rationale for the conclusion in the CCA is somewhat surprising, because the IRS essentially disregarded the ownership of the newly created partnership to conclude that the consolidated group essentially included the cooperative, and thus, the matching rule applied to transactions between the cooperative and the group member. By disregarding the taxpayer’s interposition of the partnership within the consolidated group, the IRS applied the anti-abuse rule beyond just normal substance over form. This type of entity disregard could discourage taxpayers from entity selection in other normal circumstances.
Moreover, the CCA leaves open a number of unanswered questions. Would the result in the CCA be the same if the cooperative were foreign, since foreign entities cannot join in the filing of a consolidated return thus nullifying the application of the matching rule’s intent? How heavily did the promoter’s actions play in the determination? Would the CCA come to a different result if the partnership was already an active partnership with which the group members had a prior business relationship?
In light of the CCA, consolidated groups that possess or seek to create wholly owned partnerships within a group that breaks consolidation should consider revisiting the structures to ensure they are not in violation of the anti-avoidance rules. They may want to consider documenting the business purpose for having the structures in place to make sure they do not have new federal income tax exposures, especially in light of the recent codification of the economic substance doctrine.