Originally published October, 2003. To read this article in full, please go to the bottom of this page.

TABLE OF CONTENTS

INTRODUCTION

I. STOCK BASIS ADJUSTMENTS

A. Comparison of Current and Historical Rules

B. Amount of Adjustment

  1. General
  2. Timing of Adjustments
  3. The Adjustments
  4. Taxable Income and Tax Loss
  5. Tax-Exempt Income
  6. Noncapital, Nondeductible Expenses
  7. Distributions
  8. Anti-Earnings Stripping Rule
  9. Tiering Up of Adjustments
  10. Adjustments for Taxes
  11. Waiver of Loss Carryovers from Separate Return Limitation Years

C. Allocation of Adjustments

  1. Varying Interests
  2. Allocation Between Classes of Preferred and Common Stock -- General
  3. Allocations to Preferred Stock
  4. Allocations to Common Stock
  5. Allocations Between Classes of Common Stock
  6. Reallocation of Adjustments
  7. Definitions

D. Anti-Avoidance Rules

E. Predecessors and Successors

F. Effective Date

  1. General
  2. Dispositions Before Effective Date
  3. Deemed Dividend Election

II. CIRCULAR BASIS ADJUSTMENTS

A. General

B. Circular Basis Adjustment Rule

  1. Losses

C. Special Situations.

  1. Deferred Gain or Loss from Prior Dispositions
  2. Disposition of Chains
  3. Brother-Sister Dispositions

III. EXCESS LOSS ACCOUNTS

A. General

B. Inclusion of ELA in Income

C. Nonrecognition or Deferral of Inclusion

D. Legislative Developments

  1. Application of Anti-Avoidance Rules

E. Inclusion of ELA Notwithstanding Nonrecognition or Deferral

  1. Inclusion upon Worthlessness
  2. Inclusion upon Insolvency
  3. Inclusion upon Deconsolidation
  4. Exception for Acquisition of Entire Group

F. Disposition of Chains

G. Substituted Basis Transactions

H. Allocation of Basis Adjustments to ELA Stock

I. Repeal of Basis Reduction Election

J. Character of Gain from Inclusion of ELA

K. Effective Date

IV. INTERCOMPANY TRANSACTIONS

A. Basis of Property Following a Group Structure Change

  1. Definition of Group Structure Change
  2. Adjustments to Basis

B. Transactions Other Than Group Structure Changes

  1. Repeal of Rules Relating to Other Intercompany Transactions
  2. Old Rules

V. ALLOCATING ITEMS BETWEEN SHORT PERIODS

A. General

B. End of Separate Return Year and Start of Consolidated Return Year

C. Allocation of Items – General

D. Ratable Allocation Method

  1. Ordinary Items
  2. Extraordinary Items

E. Taxes

F. Consistency Rules

G. Passthrough Entities

H. Repeal of the 30-Day Rules

I. Effective Date

VI. EARNINGS AND PROFITS

A. General

B. Amount of E&P

C. Allocation of E&P

D. Basis for E&P Purposes

E. Allocation of Federal Income Tax Liability for E&P Purposes

  1. Wait-and-See Method
  2. Percentage Method
  3. Additional Methods
  4. Default Method -- § 1552 Allocation

F. Deconsolidation

  1. Acquisition of Entire Group
  2. Certain Separations and Reorganizations
  3. Other Uses of E&P

G. Group Structure Changes

  1. Definition of Group Structure Change
  2. General Rules

H. Anti-Avoidance Provisions

I. Predecessors and Successors

J. Effective Date

  1. General Rule
  2. Special Effective Date Rules

VII. CODE SECTIONS EFFECTIVELY REPEALED

INTRODUCTION

The consolidated return investment adjustment system is a comprehensive set of rules for adjusting the basis of the stock of a subsidiary held by a member of a consolidated group. The investment adjustment system also provides rules for determining earnings and profits ("E&P") and excess loss accounts with respect to members of consolidated groups. The investment adjustment system is comprised of various regulations, including Reg. § 1.1502-32 (investment adjustments); Reg. § 1.1502-33 (E&P); Reg. § 1.1502-19 (excess loss accounts); and Reg. § 1.1502-11 (circular basis adjustments).

Although the investment adjustment system dates back to 1966, the current rules were promulgated in August 1994 1 and are effective generally for consolidated return years beginning on or after January 1, 1995. The current regulations represent a complete overhaul of the 1966 regulations. The purpose of this outline is to describe the rules that make up the investment adjustment system.2

I. STOCK BASIS ADJUSTMENTS

A. Comparison of Current and Historical Rules. The stock basis adjustment rules represent a dramatic change from the old rules. Under the old rules, P’s basis in S’s stock was adjusted to reflect S’s current increase or deficit in E&P. In contrast, the current rules are similar to those governing the basis of partnership interests and stock in a subchapter S corporation (an "S corporation"). See §§ 705, 1367. Thus, P’s basis in S’s stock is measured by reference to S’s taxable income, tax-exempt income, nondeductible expenses, and certain other items, rather than S’s E&P.

While both the current and the old rules purport to treat P and S as a single entity, the old rules actually treated P and S as if they filed separate returns, with S annually distributing its current E&P to P, which then contributed it back to S. In addition, because basis adjustments were measured by S’s E&P and because of the disparity between taxable income and E&P, the old rules could not reflect the results that would obtain if P and S were truly a single entity.

The current rules more closely approximate single-entity treatment by borrowing the basis adjustment principles from pass-through entities. In this way, the amount of the adjustment to the basis of S’s stock will more closely reflect S’s economic performance. One of the results of this approach is that S’s outside and inside basis should be identical (except for pre-consolidation differences). Therefore, to the extent that P forms S, the current rules eliminate much of the difference between a sale of S stock and a sale of S’s assets.

Under the old rules, little guidance was provided for determining the allocation of S’s E&P to shares of S stock. For preferred stock, the only adjustments allowed were to reflect dividend arrearages (positive) and distributions of dividends (negative). The current rules retain the same general adjustments, but require reallocations if, for instance, a current year’s loss indicates that a prior year’s allocation of an adjustment to common stock should have been allocated to the preferred.

B. Adjustments

1. General. The adjustments under Reg. § 1.1502-32 are designed so that P’s basis in S’s stock will reflect S’s economic performance. Therefore, the adjustments prevent items that are recognized by S from being recognized again when P disposes of S’s stock. The adjustments also reflect S’s tax-exempt income and nondeductible expenditures in order to prevent these items from creating gain or loss when P disposes of S’s stock.

EXAMPLE 1

Facts: At the start of Year 1, P buys all of S’s stock for $200. During Year 1, P and S file a consolidated return. For the year, S has $100 of taxable income and $50 of tax-exempt income. At the end of the year, the fair market value of the S stock is $350.

Results: If no basis adjustment were made and P sold its S stock, the $100 of taxable income would be taxed twice: once when it came into consolidated taxable income for Year 1, and again on the sale. By reflecting taxable income in basis, the investment basis adjustment rules prevent double taxation: P’s basis in S’s stock is increased by $100, thereby reducing gain on the sale by the same amount. Similarly, if no basis adjustment were made to reflect S’s tax-exempt income, then such income would eventually be taxed when P sold its S stock. Because this would frustrate Congress’s purpose in granting such income its tax-exempt status, the investment basis adjustment rules increase P’s basis in S’s stock by $50, just as with taxable income, to resolve the problem. At the end of Year 1, then, P’s basis in S’s stock is $350. While the group as a whole is taxed on S’s $100 of taxable income, the group would recognize no gain if it were to sell its S stock at that time.

2. Timing of Adjustments. Under Reg. § 1.1502-32(b)(1), all net stock basis adjustments are made at the close of each consolidated return year. Adjustments are also to be made whenever the tax liability of any person (not just P) depends on P’s basis in S’s stock. Reg. § 1.1502-32(b)(1). For example, if P disposes of any S stock prior to the end of the year, adjustments to P’s basis in its S stock must be made. An interim adjustment may be necessary even if the tax liability will not be affected until some later time. Reg. § 1.1502-32(b)(1) provides two examples of this latter situation:

- If P sells 50% of S’s stock and is treated under Reg. § 1.1502- 19(c)(1)(ii)(B) as disposing of the balance of S’s stock, then adjustments are to be made for the retained stock as of the time of disposition; and

- If S liquidates during a consolidated return year, and P’s adjustments tier up to a higher tier member, then adjustments are to be made as of the time of liquidation (even if the liquidation is tax free under § 332).

In the case of multi-tier groups, the basis adjustments are made first to the lower level subsidiaries and then tier up before adjustments are made to higher level entities. Thus, if P owns all the stock of S, and S owns all the stock of T, any adjustments to S’s basis in T’s stock are made before determining the adjustments to P’s basis in S’s stock. Reg. § 1.1502- 32(a)(3)(iii).

3. The Adjustments. Basis is increased by S’s taxable income and tax-exempt income. Basis is decreased by S’s tax loss, nondeductible expenses, and distributions with respect to S’s stock. Reg. § 1.1502- 32(b)(2). The following sections discuss these items in more detail.

In contrast, under the old rules, stock basis was increased by the sum of: (a) S’s E&P; (b) net operating losses ("NOLs") and capital losses that are not carried back and absorbed in prior tax years; and (c) any net positive adjustment tiering up from lower tier members whose stock S owns. Stock basis was decreased by the sum of the stock’s allocable share of: (a) any deficit in S’s E&P; (b) NOLs and capital loss carryovers that are absorbed in the current tax year; (c) any distributions in respect of S’s stock out of accumulated E&P (other than distributions of E&P accumulated during a separate return year in which S was a member of the affiliated group); and (d) any net negative adjustment tiering up from lower tier members whose stock S owns. Former Reg. § 1.1502-32(b).

4. Taxable Income and Tax Loss. S’s taxable income is determined by taking into account S’s items of income, gain, deduction, and loss. S’s deductions and losses are taken into account only to the extent they are absorbed by S or another member of the group. Reg. § 1.1502-32(b)(3)(i). If S’s deductions and losses exceed its gross income, the excess is referred to as S’s tax loss.

If S’s tax loss is absorbed in the year in which it arises (by a group member other than S), the loss is treated as a tax loss in that year.

If S’s tax loss is carried back to a prior year (whether consolidated or separate) and absorbed (by any group member, including S), the loss is treated as a tax loss in the year in which it arises.

If S’s tax loss is carried forward and absorbed in a future year (by any group member, including S), the loss is treated as a tax loss in the year in which it is absorbed.

EXAMPLE 2

Facts: At the start of Year 1, P purchases all the stock of S for $500. During Year 1, S has $100 of taxable income and $100 of passive activity losses, which are suspended under § 469.

Results: The suspended passive activity losses will not produce negative basis adjustments until they are absorbed. The $100 of taxable income, however, causes a current basis adjustment, so that P’s basis in S’s stock as of the end of Year 1 is $600.

In contrast, under the old rules, E&P was reduced by passive activity losses, even if they were suspended. Thus, during Year 1, S would have no current E&P, and hence P’s basis in S’s stock would have been unchanged as of the end of Year 1.

5. Tax-Exempt Income

a. Income Recognized but Excluded from Gross Income. The regulations define S’s tax-exempt income for purposes of stock basis adjustments as income that is recognized by S but that is permanently excluded from S’s gross income. Thus, interest excluded from gross income under § 103 is tax-exempt income, while income realized but not recognized under § 1031 is not tax-exempt income, because recognition is merely deferred.3 Reg. § 1.1502-32(b)(3)(ii)(A).

Tax-exempt income includes income that is forgiven by operation of another section. See F.S.A. 200215002 (Dec. 13, 2001) (when § 846 provided for forgiveness of certain income from a property and casualty insurance subsidiary’s year-end reserves, parent company should increase its basis by amount of forgiven income because it is tax-exempt income under Reg. § 1.1502-32(b)(3)(ii)).

b. Income Permanently Offset by Deduction. The regulations also include within the definition of tax-exempt income certain other items. Specifically, they provide that to the extent an item of income is permanently offset by an item that does not represent a recovery of basis (whether through a deduction, loss, cost, expense, or otherwise), that item of income is treated as tax-exempt income for basis adjustment purposes. Reg. § 1.1502- 32(b)(3)(ii)(B).

EXAMPLE 3

Facts: S receives a $500 dividend and takes a $350 dividends-received deduction under § 243. S is not required to reduce basis under § 1059 or any other provision of the Code.

Results: For purposes of the basis adjustment rules, P’s basis in S’s stock increases by $500. This is calculated as: $150 of taxable income (the dividend less the dividends-received deduction) plus $350 in tax-exempt income (the portion of the dividend permanently offset by a deduction).

A similar result would obtain in the case of mineral properties: income that is offset by percentage depletion deductions in excess of basis is treated as tax-exempt income for stock basis adjustment purposes. However, income that is offset by depreciation deductions is not tax-exempt, because the deductions represent a recovery of basis.

c. Discharge of Indebtedness Income. Discharge of indebtedness income that is excluded from gross income under § 108(a) is treated as tax-exempt income to the extent the discharged amount is applied to reduce tax attributes (including tax credits) attributable to any member of the group under §§ 108(b) or 1017 or Temp. Reg. § 1.1502-28T.4 (Generally, the attribute reduction is taken into account separately as a noncapital, nondeductible expense.) Temp. Reg. § 1.1502-32T(b)(3)(ii)(C)(1).5 Discharge of indebtedness income that is excluded from gross income, but for which no attribute reduction occurs, is not treated as tax-exempt income. However, to the extent a loss carryover expires without tax benefit, the expiration is taken into account as a noncapital, nondeductible expense, and the carryover would have been reduced if it had not expired, the discharge will be treated as reducing attributes. Reg. § 1.1502-32(b)(3)(ii)(C)(2).

EXAMPLE 4

Facts: P forms S on January 1 of Year 1 with a nominal capital contribution and S borrows $200. During Year 1, the P group has a $100 consolidated NOL when determined by taking into account only S’s items of income, gain, deduction, and loss. None of the loss is absorbed in Year 1, and, at the close of Year 1, S is discharged from $100 of indebtedness at a time when S is insolvent. Under § 108(a), S’s $100 of discharge of indebtedness is excluded from the P group’s gross income. Under § 108(b), S’s $100 NOL is reduced to zero.

Results: Under Temp. Reg. § 1.1502-32T(b)(3)(ii)(C), all $100 of the discharge is treated as tax-exempt income, because the discharge results in a $100 reduction to S’s NOL. Under Temp. Reg. § 1.1502-32T(b)(3)(iii), the reduction of the NOL is treated as a noncapital, nondeductible expense, because the NOL is permanently disallowed as a result of § 108(b). Consequently, the loss of the borrowed funds and the cancellation of the indebtedness result, in the aggregate, in no positive or negative adjustment to P’s basis in S’s stock under Reg. § 1.1502-32(b)(2) for Year 1.

EXAMPLE 5

Facts: P forms S on January 1 of Year 1 with a nominal capital contribution, and S borrows $200. During Year 1, the P group has a $100 consolidated NOL when determined by taking into account only S’s items of income, gain, deduction, and loss. $70 of S’s NOL is absorbed in Year 1, offsetting P’s income for that year. At the beginning of Year 2, S is discharged from $100 of indebtedness at a time when S is insolvent. Under § 108(a), S’s $100 of discharge of indebtedness is excluded from the P group’s gross income. Under § 108(b), however, S’s $30 NOL is reduced to zero. The P group has no other tax attributes to reduce.

Results: Under Reg. § 1.1502-32(b)(3)(i), the $70 of S’s loss absorbed in Year 1 reduces P’s basis in S’s stock by $70 as of the close of Year 1. Under Temp. Reg. § 1.1502-32T(b)(3)(ii)(C), only $30 of the discharge of indebtedness is treated as tax-exempt income, because only that amount is applied to reduce attributes. Under Temp. Reg. § 1.1502-32T(b)(3)(iii), the $30 NOL permanently disallowed as a result of § 108(b) is treated as a noncapital, nondeductible expense. Therefore, in Year 2, the $30 positive adjustment for tax-exempt income cancels out the $30 negative adjustment for the nondeductible expense.

EXAMPLE 6

Facts: P forms S on January 1 of Year 1 with a nominal capital contribution, and S borrows $200. During Year 1, S’s assets decline in value and the P group has a $100 consolidated net operating loss. Of that amount, $10 is attributable to P and $90 is attributable to S under the principles of Temp. Reg. § 1.1502-21T(b)(2)(iv). None of the loss is absorbed by the group in Year 1, and S is discharged from $100 of indebtedness at the close of Year 1. P has a $0 basis in the S stock. P and S have no attributes other than the consolidated net operating loss. Under § 108(a), S’s $100 of discharge of indebtedness is excluded from gross income because of insolvency. Under § 108(b) and Temp. Reg. § 1.1502- 28T, the consolidated net operating loss is reduced to $0.

Results: Under Temp. Reg. § 1.1502-32T(b)(3)(iii)(A), the reduction of $90 of the consolidated net operating loss attributable to S is treated as a noncapital, nondeductible expense in Year 1 because that loss is permanently disallowed by § 108(b) and Temp. Reg. § 1.1502-28T. Under Temp. Reg. § 1.1502-32T(b)(3)(ii)(C)(1), all $100 of S’s discharge of indebtedness income is treated as tax-exempt income in Year 1 because the discharge results in a $100 reduction to the consolidated net operating loss. Consequently, the loss and the cancellation of the indebtedness result in a net positive $10 adjustment to P’s basis in its S stock.

d. Certain Basis Increases. Finally, under Reg. § 1.1502- 32(b)(3)(ii)(D), an increase in the basis of S’s assets (or an equivalent item, such as an increase in a loss carryover or a decrease in an excess loss account for stock owned by S), is treated as tax-exempt income under the following set of conditions:

- the increase is not otherwise taken into account in determining stock basis;

- the increase is determined directly by reference to a noncapital, nondeductible expense that is taken into account for purposes of adjusting P’s basis in S’s stock (or which is incurred by the common parent of P and S); and

- the increase has the effect (when viewing the consolidated group as a whole and netting the increase against the noncapital, nondeductible expense) of causing the expense to be deferred rather than permanently disallowed.

(An example showing the adjustments attributable both to basis increases and decreases appears at the end of Section I.B.6.b., below.)

6. Noncapital, Nondeductible Expenses

a. Expense Recognized but Permanently Disallowed. As the flipside to tax-exempt income, the regulations require a negative basis adjustment for any noncapital, nondeductible expense. Such an expense is defined as a deduction or loss that is recognized by S (as a cost, expense, expenditure of money, or otherwise), but which is permanently disallowed under the law in determining S’s taxable income or loss. Thus, federal taxes for which a deduction is denied under § 275 is a noncapital, nondeductible expense. Whereas, if S is involved in a wash sale subject to § 1091, the disallowed loss is not a noncapital, nondeductible expense, because the basis adjustment under § 1091 defers the loss rather than permanently disallowing it. Temp. Reg. § 1.1502-32T(b)(3)(iii)(A).

b. Certain Basis Decreases. A decrease in the basis of S’s assets (or a similar attribute such as a decrease in a loss carryover, a denial of basis for taxable income, or an increase in an excess loss account in stock owned by S) is treated as a noncapital, nondeductible expense under the following set of conditions: (A) the decrease is not otherwise taken into account in determining stock basis; and (B) the decrease is permanently disallowed in determining S’s taxable income or tax loss. Reg. § 1.1502-32(b)(3)(iii)(B).

For example, the following basis decreases would be subject to this rule:

- basis decreases under §§ 50(c)(1), 1017, and 1059, and Temp. Reg. §§ 1.337(d)-2T(b)6 and 1.1502-35T;7 and

- the amount of any gross-up for taxes paid by another taxpayer that S is deemed to have paid under § 852(b)(3)(D)(ii).

These basis decreases are intended to permanently eliminate S’s basis recovery. Therefore, negative stock basis adjustments are required to reflect these losses. In contrast, the following basis decreases do not require negative stock basis adjustments:

- a basis decrease because S redeems stock in a transaction to which § 302(a) applies;

- a basis decrease because S’s basis in assets received in a § 332 liquidation is less than S’s basis in the canceled stock; and

- a basis decrease because S distributes the stock of a subsidiary in a § 355 distribution.

In these cases, the basis decrease is not treated as a noncapital, nondeductible expense for purposes of adjusting P’s basis in S’s stock. Reg. § 1.1502-32(b)(3)(iii)(B).

EXAMPLE 7

Facts: Assume that a general business investment credit of 10% is applicable and that, at the start of Year 1, S buys $1000 of investment credit property. Under § 50(c)(1), S reduces its basis in the property to $900. The decrease in the basis of the investment credit property is reflected in the basis of S’s stock (as a noncapital, nondeductible expense) in Year 1. In the middle of Year 2, S sells the property for $1500. Under § 50(a), this triggers an investment credit recapture of $80. Under § 50(c)(2), the recaptured amount of the credit is added back to the basis of the property before determining gain or loss on the sale. Thus, S recognizes $520 in gain on the sale.

Results: In Year 1, P’s basis in S’s stock decreases by $100 (the $100 noncapital, nondeductible expense). Because the $100 decrease in the basis of the investment credit property has been reflected in the basis of S’s stock, the $80 basis increase is treated as tax-exempt income. Therefore, P’s basis in its S stock increases in Year 2 by $600, calculated as: $520 of gain on the sale plus $80 of basis increase.

Thus, over the two years, P’s basis in S’s stock has increased by a net amount of $500, which is the actual amount of economic gain over the two years (i.e., S bought property for $1000 and sold it for $1500, netting $500 in profit).

c. Losses Suspended or Disallowed under New Loss Duplication Rules. Any loss suspended pursuant to Temp. Reg. § 1.1502- 35T(c) is treated as a noncapital, nondeductible expense incurred during the taxable year that includes the date of the disposition to which Temp. Reg. § 1.1502-35T(c) applies. Temp. Reg. §§ 1.1502-32T(b)(3)(iii)(C), -35T(c)(3). Consequently, the basis of a higher-tier member’s stock of P is reduced by the suspended loss in the year it is suspended. Temp. Reg. § 1.1502-32T(b)(3)(iii)(C). Furthermore, any loss or deduction the use of which is disallowed pursuant to Temp. Reg. § 1.1502-35T(g)(3)(iii) (other than a loss or deduction in Temp. Reg. § 1.1502-35T(g)(3)(i)(B)(11)), and with respect to which no loss carryover waiver described in Reg. § 1.1502-32(b)(4) is filed, is treated as a noncapital, nondeductible expense incurred during the taxable year that such loss would otherwise be absorbed. Temp. Reg. §§ 1.1502-32T(b)(3)(iii)(D), -35T( g)(3)(iv). These loss suspension and loss disallowance rules generally are effective on and after March 7, 2002 and expire on March 11, 2006. Temp. Reg. § 1.1502-32T(h)(6).

For an in-depth analysis of the new loss duplication rules of Temp. Reg. § 1.1502-35T, see MARK J. SILVERMAN & LISA M. ZARLENGA, LOSS DISALLOWANCE AND LOSS DUPLICATION RULES, in TAX STRATEGIES FOR CORPORATE ACQUISITIONS, DISPOSITIONS, SPIN-OFFS, JOINT VENTURES, FINANCINGS, REORGANIZATIONS AND RESTRUCTURINGS (MARK J. SILVERMAN & LISA M. ZARLENGA EDS., PRACTISING LAW INSTITUTE 2003).

7. Distributions. Distributions with respect to S’s stock to which § 301 applies, or which are treated as dividends under other sections of the Code, will decrease P’s basis in S’s stock. A distribution is taken into account when P becomes entitled to receive it (i.e., usually the record date), not when P actually receives it. Reg. §§ 1.1502-32(b)(3)(v), -13(f)(2)(iv). If it is later established that the distribution will not be made, the adjustment attributable to the distribution is reversed as of the date it was made.

Under the old rules, a dividend decreased basis only if it was made out of E&P from consolidated return years or separate return limitation years. Former Reg. § 1.1502-32(b)(2)(iii), (c)(2). The rationale for the former was that the E&P from which the dividend came was reflected in P’s basis when it arose. In the latter case, it was assumed that the E&P from which the dividend came was reflected in the price P paid for S. In the case of a dividend out of E&P from years during which S was affiliated with P but did not file a consolidated return, however, no negative basis adjustment was made. As noted, the current rules require negative adjustments for all dividends and do not distinguish among dividends out of E&P accumulated in affiliated, consolidated, or separate return years.

In addition, under the old rules, a deemed dividend election was available to P. Under this election, S was deemed to distribute all of its E&P as a dividend, which was then treated as contributed back to S. Former Reg. § 1.1502-32(f)(2). Under a regime in which some dividends would not reduce basis, this was a useful device to increase basis: while the portion of the deemed dividend attributable to E&P from consolidated and separate return limitation years would reduce P’s basis in S, the recontribution of an equal amount to S would restore P’s basis reduction. The portion of the deemed dividend attributable to E&P from affiliated separate return years, however, did not reduce P’s basis, and the recontribution to S increased P’s basis. In the aggregate, then, the deemed dividend election permitted P to increase its basis in S to the extent of S’s E&P that was attributable to affiliated separate return years. However, under the current regime, this election has been eliminated: because all dividends produce negative basis adjustments, such an election could not increase basis.

Footnotes

1 See T.D. 8560, 59 Fed. Reg. 41,666 (1994). Note that, in response to the Federal Circuit’s decision in Rite Aid Corp. v. United States, 255 F.3d 1357 (Fed. Cir. 2001), the Treasury added temporary loss disallowance and loss duplication regulations, which also contained certain conforming changes to Treas. Reg. § 1.1502-32. See 68 Fed. Reg. 24,404 (May 7, 2003); 68 Fed. Reg. 12,324-01 (Mar. 14, 2003); 67 Fed. Reg. 11,034 (Mar. 12, 2002). These new rules are discussed below in the appropriate Sections of the outline.

2 While undertaking the initial research for this outline, various secondary sources were consulted including: ANDREW J. DUBROFF, ET AL., FEDERAL INCOME TAXATION OF CORPORATIONS FILING CONSOLIDATED RETURNS (2d ed. 1997); FRED W. PEEL, ET AL., CONSOLIDATED TAX RETURNS (3d ed. 1992); JOHN BROADBENT, CONSOLIDATED RETURNS-INVESTMENTS IN SUBSIDIARIES (3d ed. 1990); and JERRED G. BLANCHARD, NEW INVESTMENT BASIS ADJUSTMENT AND RELATED CONSOLIDATED RETURN REGULATIONS (1992).

All section references in this outline are to the Internal Revenue Code of 1986, as amended, and the regulations thereunder. Unless the context indicates otherwise, "P" and "S" are references to a consolidated group member and its subsidiary. In addition, the pre-1995 regulations are generally referred to as the "old rules."

3 Similarly, gain whose recognition is deferred under § 332 or § 351 is not tax-exempt income. Reg. § 1.1502-32(b)(3)(ii)(A).

4 Temp. Reg. § 1.1502-28T generally requires (i) the reduction of the debtor member’s tax attributes first (including consolidated tax attributes attributable to the debtor member) and (ii) the reduction of consolidated tax attributes attributable to members of the group other than the debtor member second. Temp. Reg. § 1.1502-28T applies to discharges of indebtedness occurring after August 29, 2003.

5 Temp. Reg. § 1.1502-32T(b)(3)(ii)(C)(1) applies with respect to determinations of the basis of stock of a subsidiary in consolidated return years the original return for which is due (without extensions) after August 29, 2003. For determinations in consolidated return years the original return for which is due (without extensions) on or before August 29, 2003, groups may apply Temp. Reg. § 1.1502-32T(b)(3)(ii)(C)(1) without regard to the references to Temp. Reg. § 1.1502-28T or, alternatively, apply the prior rules. Temp. Reg. § 1.1502-32T(h)(7).

6 As further discussed below in Section I.B.11., the Service amended the loss disallowance rules effective March 7, 2002. Temp. Reg. § 1.337(d)-2T. The new regulations also provide elective relief for transactions occurring prior to the effective date. Temp. Reg. § 1.1502-20T(i). To the extent a loss that was originally disallowed under Reg. § 1.1502-20 is allowed as a result of the elective relief, a member’s basis reduction under Reg. § 1.1502-32(b)(3)(iii)(B) may be reversed. If the increased allowed loss resulting from the elective relief would have expired or been absorbed in a closed year, then the member’s basis in the subsidiary stock may be increased for purposes of determining the group’s or member’s federal income tax liability for open years. Temp. Reg. § 1.1502-20T(i)(3)(v)(B).

7 The Service issued new loss duplication rules under Temp. Reg. § 1.1502-35T effective generally for transactions that occur on or after March 7, 2002 and no later than March 11, 2006. Temp. Reg. § 1.1502-35T(j). The Service made conforming amendments to the investment basis adjustment rules as well. These amendments include the substitution in Reg. § 1.1502- 32(b)(3)(iii)(B) of basis decreases under the old loss disallowance rules of Reg. § 1.1502-20(b) with basis decreases under the new loss duplication rules of Temp. Reg. § 1.1502-35T. See T.D. 9048 (Mar. 14, 2003). These amendments also removed losses reattributed under Reg. § 1.1502- 20(g) from the list of basis decreases that qualify as noncapital, nondeductible expenses. See id.

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