Federal Taxation Developments Blog : Federal Taxation Lawyer & Attorney : Fox Rothschild Law Firm : Federal Income Taxation & Tax Litigation

On March 4, 2011, the Treasury issued T.D.9515, containing final regulations on the treatment of certain intercompany gains with respect to stock owned by members of a consolidated group. The regulations provide for the redetermination of intercompany gain excluded from gross income in certain transactions involving stock transfers between members of a consolidated group. The temporary regulations portion of T.D. 9515 were included solely for the purpose of retaining the portion of the existing temporary regulations that are not being promulgated as final regulations at this time.  As background, on March 7, 2008, the IRS and the Treasury Department published temporary regulations § 1.1502-13T. See TD 9383, 2008-15 IRB 738. Also on March 7, 2008, the IRS and the Treasury Department published a notice of proposed rulemaking cross-referencing those temporary regulations. See REG-137573-07, 2008-15 IRB 750.

The 2008 temporary regulations addressed the treatment of certain intercompany gain with respect to consolidated group member stock. Treas. Reg. Section 1.1502-13 provides rules governing the timing and characterization of items resulting from transactions between consolidated group members. Treas. Reg. Section 1.1502-13(c) provides general rules under which the timing and character of those items can be deferred or recharacterized to clearly reflect the taxable income (and tax liability) of the group as a whole. These rules, in general, require application of a  “matching” principle under which the timing of inclusion of gain on the sale of property by the seller is linked to the buyer's recovery of its basis in the property and the seller’s and the buyer’s characterization are subject to redetermination in order to treat both seller and buyer as divisions of a single corporation.

The proposed regulations provide that intercompany gain with respect to member stock may be permanently excluded from gross income following certain stock basis elimination transactions such as in a tax-free spin off or section 332 liquidation. The IRS and the Treasury Department, in issuing the final regulations, reconsidered the requirement contained in the proposed regulations that, immediately before intercompany gain would otherwise be taken into account, the common parent  must be the member that holds the member stock with respect to which the intercompany gain was realized, and that the gain must be common parent’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. The final regulations, therefore,  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) the buyer or seller, as a successor to the other party (either buyer or seller); or (ii) a third member that is the successor to both the buyer and seller corporate members.  

Previously, the preamble to the proposed regulations requested comments as to whether the “Commissioner's Discretionary Rule” ( Treas. Reg. Section 1.1502-13(c)(6)(ii)(D)) should be retained. The preamble also stated that the IRS and Treasury Department were considering eliminating the Commissioner's Discretionary Rule. Upon further consideration, T.D. 9515 states there may be circumstances where application of such discretion is warranted. Thus, for example, the final regulations do not provide automatic relief for transactions involving property other than member stock (such as the stock of non-members), but relief may be available after review by the IRS under the Commissioner's Discretionary Rule. The final regulations retain the Commissioner's Discretionary Rule in a form revised to describe the conditions to be satisfied for that discretion to be exercised, and to indicate that relief is available only through a request for a letter ruling. Finally, the final regulations provide that excluded gain is not treated as tax exempt income for purposes of  Treas. Reg. Section  § 1.1502-32 and does not increase earnings and profits.

An example from the final regulations is quoted.

 

“ Example 16. Intercompany stock distribution followed by section 332 liquidation. (a) Facts. P owns all of the stock of S, S owns all the stock of T, a member of the P group, and T owns all of the stock of T1, also a member of the P group. On January 1 of Year 1, S distributes all of the T stock to P in a distribution to which section 301 applies. At the time of this distribution, the value of the T stock is $100 and S has a $40 basis in the T stock. Under section 311(b), the distribution creates $60 of intercompany gain to S. Under section 301(d), P's basis in the T stock is $100. S will take its $60 intercompany gain into account under the matching rule. On January 1 of Year 4, in an independent transaction, S distributes all of its assets to P in a complete liquidation to which section 332 applies, and, under paragraph (j)(2) of this section, P succeeds to S's $60 gain. On January 1 of Year 7, T distributes all of its T1 stock to P in a transaction to which  section 355 applies. At the time of this distribution, P has a basis in the T stock of $100, the value of the T stock (without regard to T1) is $75, and the value of the T1 stock is $25. Under section 358, P allocates $25 of its $100 basis in the T stock to the T1 stock, and, under paragraph (j)(1) of this section, the T1 stock becomes a successor asset to the T stock. On January 1 of Year 9, in an independent transaction, T distributes all of its assets to P in a complete liquidation to which section 332 applies.

(b) Analysis. Under paragraphs (b)(1) and (f)(2) of this section, S's distribution in Year 1 of the T stock to P is an intercompany transaction, S is the selling member, and P is the buying member. In Year 9 when T liquidates, P has no gain or loss under section 332. Under paragraph (b)(3)(ii) of this section, P's $0 gain or loss with respect to the T stock under section 332 is a corresponding item. P takes $45 (75/100 × $60) of its intercompany gain into account under the matching rule in Year 9 to reflect the difference between P's $0 of unrecognized gain and P's $45 of recomputed unrecognized gain. (If P and S were divisions of a single corporation, P would have had a $40 basis in the T stock, and, after the Year 7 distribution of the T1 stock, would have held the T stock with a $30 basis.) However, paragraph (c)(6) of this section does not prevent the redetermination of P's intercompany gain as excluded from gross income provided P succeeds to S's intercompany item; P and S are a single entity; P's basis in the T stock that reflects the $45 intercompany gain taken into account is eliminated without the recognition of gain or loss (and this eliminated basis is not further reflected in the basis of any successor asset); the group has not derived and no taxpayer will derive any Federal income tax benefit from the basis in the T stock and will not derive any Federal income tax benefit from a redetermination of this portion of the gain; and the effects of the intercompany transaction have not previously been reflected, directly or indirectly, on the P group's consolidated return. (See paragraph (c)(6)(ii)(C) of this section.) Accordingly, under paragraph (c)(6)(ii)(C) of this section, the $45 intercompany gain that P takes into account is redetermined to be excluded from gross income. P's basis in its T1 stock continues to reflect $15 of intercompany gain.”

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The Financial Accounting Standards Board's oversight organization announced May 20 that it will test a new review process for existing standards with an analysis of FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes."

FIN 48, which was promulgated in November 2006,  clarified the guidelines for accounting of uncertainty in income taxes on financial statements of enterprises per FASB Statement No. 109, Accounting for Income Taxes, and removes uncertain income tax positions from the guidance provided under FAS 5, Accounting for Contingencies. See August, “Understanding FIN 48: Accounting for Uncertainty in Income Taxes,” Business Entities (WG&L), May/Jun 2008.

It also applies to purchase accounting in connection with a business combination. Use of a valuation allowance described in FASB Statement 109, therefore, was eliminated as an appropriate substitute for the derecognition of a tax position. The requirement to assess a valuation allowance for deferred tax assets based on the sufficiency of future taxable income was left unchanged by FIN 48. This situation would arise, for example, where a company with a large NOL carryforward is not likely to produce a sufficient level of future taxable income to fully utilize the NOL within the applicable carryover period.

When a position is taken on a tax return that reduces the amount of income taxes payable even though another interpretation of current law can be made that would not reduce current income taxes payable, the enterprise realizes an immediate economic benefit. Under FIN 48, this benefit of a favorable tax position can be recognized in the current period when the position has a more likely than not (MLTN) chance of being upheld through court review despite the presence of contrary interpretations, and the benefit to ultimately be realized can be measured in accordance with applicable rules. Only the difference between the measured benefit and the reported benefit on the tax return is required to be added to the tax reserve. On the other hand, if the position on a particular item, i.e., a so-called “unit of account,” is determined to be less likely than not correct, the full amount of the tax liability, as well as projected interest and possible penalty, must be included in the reserve as a current liability (or reduction in the NOL carryforward or claimed tax refund) where the company anticipates making payment within one year or within the company's next operating business cycle. Non-current liabilities for fully or partially unrecognized tax positions are treated as a deferred tax liability to the extent unrecognized. Such book-tax adjustments will, in certain instances, affect the tax basis of one or more assets thereby differentiating book from tax depreciation - during the applicable recovery periods.

In many instances, partial or totally unrecognized tax positions may not later be derecognized, i.e., reduce the amount of the reserve or liability for uncertain taxes, until the statute of limitations has expired for the year in which the position was taken and the position has not been challenged by the taxing authority. Conversely, previously recognized tax positions that subsequently fail the MLTN recognition standard due to an intervening change in the law are required to be derecognized and charged to liabilities in the first subsequent financial reporting period in which such determination is made.

Where the MLTN standard is not satisfied (as discussed below), no economic benefit may be claimed and recognized for financial accounting purposes, i.e., a liability is booked or reflected on the financial balance sheet for the total amount of tax due, plus associated interest and penalties.

The Financial Accounting Foundation (FAF), the private-sector organization that oversees FASB, had determined over the last few years that the board required a formal process to monitor and address the issues that can arise after implementation of new accounting standards. The review will determine whether FIN 48 is accomplishing its purpose of providing useful financial information for management’s decision making process and evaluating the standard’s implementation and associated compliance costs. 

Many companies filing GAAP financial statements have had to seek legal opinions from tax counsel on issues that present a degree of uncertainty as to wehter the position taken on the tax return can be recognized, and if so, what is its proper "measurement". Such opinions in turn raise questions of attorney-client privilege and work product protection. FIN 48 schedules are reported on financial statements as an aggregate account and adjustment, its the schedules and opinions that contain much more information that the IRS in the event of an audit may want to have the taxpayer produce.

The adoption of FIN 48 has not been without its detractors and perhaps those who want to see more relaxed standards re-introduced into GAAP are trying to gain a foothold to causing a return to the former standard used under FAS 109 for reporting uncertain tax liabilities. It may also be something that the International Accounting Standards Board wants to see eliminated so that conversion of GAAP into IFRS can be effectuated.

For a related development see August, "The Uncertain State of Uncertain Tax Positions", Business Entities (May/June 2011).

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The tax press has recently informed the professional community that “in an April 29 e-mail briefing to its members, the National Association for Publicly Traded Partnerships cited an unnamed Treasury official who said the Obama administration is interested in a plan that would tax pass through entities with [annual] revenues [gross receipts] of $50 million or more as corporations”. White House spokeswoman Amy Brundage said the process is still unfolding and “no decisions have been made about the content of any specific reform proposal or the timing or manner in which the administration” will introduce a package of corporate tax reforms for the Congress to consider. .

The proposal on taxing large revenue pass through entities as well as prior comments to reduce the corporate income tax rate in general is sure to get more attention in the weeks ahead. It is clear that corporate tax reform is on the legislative “table” as our country’s federal corporate income tax rate of 35% is the second highest in the world next to Japan’s 39.5% rate which is presently anticipated to be reduced. Some countries, such as Ireland, have a corporate tax rate that is less than one-third of the U.S. rate and significantly higher than China or certain EU countries. While there is pressure on Congress to reduce the maximum marginal rate, a GEO study released in 2008 revealed that 55% of U.S. companies paid no federal income taxes during at least one year in a seven year period that it studied. Thus, part of the Obama Administration’s thinking is to reduce the corporate income tax rate but broaden the base by denying or deferral certain deductions or cost recovery allowances. There is expected to be a set of new base broadening provisions in the taxation of U.S. persons having foreign source income.  

In going back to imposing corporate income tax on certain pass throughs, i.e., those having $50 million  gross revenue partnerships and pass through entities, which amount will most likely be aggregated with the gross revenues of affiliated entities, perhaps both corporate and non-corporate, should be subject to corporate level  income tax should be expected to be met with stiff opposition from the business community, including owners of closely held pass through companies that have high revenues, such as hedge funds and private equity firms.  Presumably the proposal would affect the favorable treatment under current law of publicly traded limited partnerships that are eligible to avoid corporate level taxation based on the predominance of passive type income.  

Taxing high revenue partnerships as corporations  will also trigger a fair amount of business restructuring both from a tax and governance standpoint. Moreover, it again opens the door to discuss the benefits of integrating the double tax system of the corporate and shareholder level income tax by  permitting dividend tax relief on in the form of a dividend deduction, imputed tax credit at the shareholder level for corporate income tax paid or elimination of taxes on dividends. It could further result in wholesale revisions to the entire set of corporate tax rules currently in place including the reorganization provisions. So it will be quite important to see whether the tax on pass throughs being discussed is a one item concept or whether it is based of a restructuring of the federal income taxation of U.S. business enterprises.

Perhaps in the haze of political bickering that is sure to follow on evaluating and commenting on  the Obama Administration’s new and controversial test balloon to tax pass throughs, it would be nice if  Congress would seize the opportunity to address our double-tax  corporate income tax system and solve the integration issue once and for all so that there could be horizontal equity achieved by taxing corporate and non-corporate business enterprises on essentially the same basis. So much for editorial comments, at least for now.

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