Tax Reporting by Affiliated Corporations

Tax Reporting by Affiliated Corporations [excerpted from Chapter 13 in Bittker, Emory & Streng: Federal Income Taxation of Corporations & Shareholders: Forms (WG&L)] Introduction Possible Limitations on Multiple-Corporation Structures “Affiliated corporations” are several corporations that have the necessary amount of joint ownership to be categorized as related for federal income tax purposes. In the affiliated corporations context, at least three basic areas of consideration are relevant: (1) the effect of affiliated corporation status on the income tax computations and liabilities of the several group members; (2) the applicability of the intercompany transfer pricing (or IRC § 482) rules; and (3) the availability of consolidated return reporting. Tax Advantages of Multiple-Corporation Structures As noted in Bittker & Eustice, ¶ 13.01[2], the following tax advantages can possibly be achieved through the use of multiple corporations: 1. The creation of separate elections for each corporation for such matters as accounting methods, taxable years, depreciation methods, inventory valuation methods, and the foreign tax credit 2. The opportunity to shift some activities to a corporation where the activities will be subject to a more favorable federal income tax regime than the remainder of the taxpayer's activities (e.g., segregating foreign-source income or insurance or banking income in a separate corporation subject to special taxation rules) 3. Avoidance of personal holding company status by segregating activities (such as renting) that can qualify for exemption by themselves but that can taint other activities if all of the activities are combined in a single taxable entity 4. Segregation of deductions and losses from particular activities in an S corporation, if this status is not wanted for other segments of the business 5. Favorable treatment for anticipated or potential sales, mergers, liquidations, intrafamily gifts or bequests, and other adjustments that can be effected on a tax-free basis for some operations but not for others or that will trigger the recognition of only a limited amount of income if confined to assets segregated in a separate corporation However, certain limitations are applicable to the utilization of multiple corporations in these contexts. Limitations on Multiple Tax Benefits The corporate income tax is imposed on the taxable income of every U.S. corporation. This statement gives the impression that every corporation is a separate taxable entity, whether or not it is affiliated with other corporations. However, federal income tax limitations are imposed on the use of multiple corporations. Such limitations are premised on the concern that a single business enterprise might be artificially divided between two or more related corporations, so as to enable the multiple use of statutory tax allowances and to take advantage of other provisions, such as progressive income tax rates. A further factor is the premise that transactions between related corporations do not usually have the same economic effect as transactions between an affiliated group member and an unrelated enterprise. If corporate income is taxed at two or more rates, income tax advantages can be obtained by dividing income of a business enterprise into two or more corporations (assuming that no limitation rule is applicable). Multiple availability of the lower tax rates could be obtained. However, federal income tax rules specify that limitations apply to the use of multiple

1 corporations to achieve this objective. Therefore, on the basis of “affiliated groups,” certain limitations are imposed on (1) the amounts available in each taxable income bracket that is less than the maximum rate; (2) the minimum allowance in computing the accumulated earnings credit; (3) the alternative minimum tax (AMT) exemption (including its phaseout); and (4) similar provisions. The applicability of these limitation rules depends on the actual existence of a “controlled group of corporations.” This term is defined in IRC § 1563(a) to include two categories of affiliation: (1) a parent-subsidiary controlled group, where one or more chains of corporations are connected with a common parent corporation through stock ownership (determined by voting power or value) of 80 percent or more and (2) a brother-sister controlled group, where two or more corporations with five or fewer persons who are individuals, estates, or trusts own 80 percent (by voting power or value) of each corporation, and more than 50 percent (by voting power or value) of each corporation is identical with respect to each corporation. This might also include a combined group (i.e., where three or more corporations exist, each of which is a member of a parent-subsidiary group or a brother-sister group, and one is a common parent corporation). Intercompany Pricing Adjustments The affiliated relationship may also trigger the applicability of the intercompany pricing rules (IRC § 482). This provision concerns the allocation (or reallocation) of income and deductions between related taxpayers. Section 482 allocation problems can arise from various dealings between related enterprises, including (1) arrangements for the sharing of facilities, properties, and services among the members of an affiliated group without proper allocation of the costs to the members in proportion to the benefits received; (2) the transfer of various income-producing assets or activities to a related entity; and (3) loans, leases, licenses, sales, or service transactions between related enterprises that are concluded in a non-arm's length manner. The application of these rules is particularly pertinent when some related corporations are organized and operate outside the United States, enabling income to be deflected beyond the net of U.S. income taxation. Consolidated Tax Returns This chapter also deals with certain aspects of consolidated tax returns. Section 1501 provides that an “affiliated group of corporations” may elect to file a consolidated federal income tax return in lieu of a separate return for each member of that group. The basic principle of the consolidated return is that the group is taxed on its consolidated taxable income, representing principally the results of the group's dealings with the outside world, after the elimination of intercompany profit and loss. Expenses in Transactions Between Related Taxpayers IRC § 267 provides certain limitations on the deductibility of losses, expenses, and interest with respect to transactions between related taxpayers. IRC § 267(a)(2) (relating to the matching of deductions and payee income in the case of expenses and interest) specifies that if (1) by reason of the method of accounting of the person to whom the payment is to be made, the amount is not (unless paid) includable in the gross income of that person, (2) at the close of the taxable year of the taxpayer for which (but for this provision) the amount would be deductible, and (3) the payor and payee are related, the deduction for the payment is postponed until includible in the income of the person to whom the payment is made. This limitation will be applicable even when the interest expense is accrued by a U.S. subsidiary and payable to a foreign parent corporation and that interest is tax exempt to the recipient under the provisions of an applicable

U.S. income tax treaty. See Square D Co. v. Comm'r , 438 F3d 739 (7th Cir. 2006).

2 Redemption of Parent's Stock Held by Subsidiary An intercompany technique being used, and also being challenged, is for a subsidiary to purchase shares of the parent corporation with (1) the parent then repurchasing most of those shares, (2) the dividend equivalent being treated as excluded from gross income because it is sourced to a subsidiary, (3) the allocation of tax basis for the redeemed shares being made to the remaining shares, and (4) the capital loss being realized upon the sale of the remaining shares to an outsider. This was the factual scenario in HJ Heinz Co. v. United States , 76 Fed. Cl. 570 (2007) , where the Court of Federal Claims held that the transaction was a sham. The company appealed to the Court of Appeals for the Federal Circuit, asserting that the Court of Federal Claims erred in dismissing its $42 million refund suit in which the company sought to claim capital losses from a subsidiary's purchase and sale of stock, insisting that the transactions were not shams and that the step transaction doctrine did not apply. See U.S. Court of Appeals for the Federal Circuit, Dkt. No. 2007-5146. A fundamental component of the planning in this context is that the tax basis for the redeemed shares be allocated to the remaining shares. Therefore, those shares, when sold, will probably generate a significant capital loss. See also

Yale, “Was Heinz's Two Step Redemption A Sham?” 117 Tax Notes 345 (Oct. 22, 2007). Rate-Bracket-Amount Apportionment Plan

Affiliated group—Single tax rate bracket amounts—Allocation to group members Generally Section 11 provides multiple tax rate brackets for corporations. These brackets were increased significantly with the enactment in the Omnibus Budget Reconciliation Act of 1993 (1993 OBRA) (Pub. L. No. 103-66, § 13236) of a 34 percent bracket applicable to income between $75,000 and $10 million, after which a 35 percent rate applies. The tax rate bracket amounts applicable under IRC § 11 are allocable to the entire consolidated group. IRC § 1561(a)(1). These bracket amounts may be earmarked to each member corporation in whatever proportions are elected by the affiliated group. See Reg. § 1.1561-3. If, however, the group fails to make an election, the rate bracket amounts will be allocated equally to each corporation. Allocation Among Component Members of a Controlled Group of Depreciable Business Assets Expense Allowance [Note: the following discussion does not reflect changes implemented by the Small Business Jobs Act of 2010.] A taxpayer may elect to deduct each year up to $17,500 of depreciable business assets that are acquired during that year. IRC §§ 179(a), 179(b)(1). However, as specified in IRC §§ 179(b)(2), this amount is reduced by the amount by which the cost of the IRC § 179 property placed in service during the taxable year exceeds $200,000. HR 3448, the “Small Business Job Protection Act of 1996,” Pub. L. No. 104-188, § 1111, provided for a gradual increase in this expense amount, as follows: If the taxable year begins in: The expense amount is: 2001 or 2002 $24,000 2003 or thereafter $25,000

Thereafter, periodic revisions have been made to this provision. See IRC § 179, which was amended by the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), Pub. L. No. 108-27, 117 Stat. 752, § 202(a), to provide that this limitation is raised to $100,000 for each of the taxable years beginning after 2002 and before 2006. Under IRC § 179(b)(5), in 2004, this

3 $100,000 amount began to be indexed for inflation. For 2007, the amount eligible to be treated as an expense was $112,000. See Rev. Proc. 2006-53, 2006-2 CB 996, § 3.19. For 2008, the amount eligible to be treated as an expense was $128,000. See Rev. Proc. 2007-66, 2007-2 CB 970, § 3.20. For 2009, the amount eligible to be treated as an expense was $133,000. Rev. Proc. 2008-66, 2008-2 CB 1107, § 3.20. For 2010, the $100,000 amount was indexed to $135,000. See Rev. Proc. 2009-50, 2009-45 IRB 617, § 3.20. The $100,000 amount (as adjusted for inflation) was reduced by the cost of IRC § 179 property exceeding $400,000. In 2004, this $400,000 amount also began to be indexed for inflation. For 2007, the amount was $450,000. For 2008, the amount was $510,000. For 2009, this amount was $530,000. For 2010, the $400,000 amount was indexed to $530,000 (this latter amount being unchanged from 2010). The definition of “Section 179 property” was expanded to include off-the-shelf computer software (a category of intangible property). Under the American Jobs Creation Act of 2004 (the 2004 Jobs Act), this increased IRC § 179 expense deduction was extended for two additional years (i.e., for property placed into service before 2008). Act § 201. The maximum dollar amount was to be reduced (but not below zero) by the amount by which the cost of the qualifying property placed into service during the tax year exceeds $400,000 (as indexed for inflation for the pertinent year). These increased limits were further extended for property placed into service before 2010 in the Tax Increase Prevention and Reconciliation Act of 2005, Pub. L. No. 109-222, 120 Stat. 345, § 101. In the Economic Stimulus Act of 2008, Pub. L. No. 110-185, 122 Stat. 613, the small business expensing limit (authorized in IRC § 179) was increased (beginning in 2008) to $250,000. Act § 102(a). The IRC § 179(b)(2) phase-out level commenced at $800,000. Furthermore, an additional first-year depreciation deduction for qualified property acquired after 2007 and placed in service before 2009 has been increased to 50 percent from 30 percent. IRC § 168(k); Act § 103. Rev. Proc. 2008-54, 2008-38 IRB 722, describes these tax depreciation allowance changes. Further changes to these depreciation allowance amounts were made in the Hiring Incentives to Restore Employment Act of 2010, Pub. L. No. 111-147, 125 Stat. 71 (the HIRE Act). Section 201 of the HIRE Act changes the $125,000 and the $500,000 amounts to $250,000 and $800,000, respectively, for taxable years beginning in 2010. Section 201 of the HIRE Act also provides that these amounts will not be adjusted for inflation for taxable years beginning in 2010. Rev. Proc. 2010-24, 2010-25 IRB 764, provides that Rev. Proc. 2009-50, supra, § 3.20, is modified to provide that the amount a taxpayer may elect to treat as an expense cannot exceed $250,000 and that the $250,000 limitation is reduced by the amount by which the cost of property placed in service during the 2010 taxable year exceeds $800,000. The maximum dollar amount for an immediate deduction under IRC § 179 for sport utility vehicles (SUVs) has been limited to $25,000. IRC § 179(b)(6); Act § 910(a). This provision applies to property placed into service after the date of enactment of the 2004 Jobs Act. This provision is intended to limit the opportunity to take an immediate deduction for a heavy SUV (e.g., a Hummer) since, previously, IRC § 280F provided for a limit on the maximum amount of depreciation only for a luxury automobile weighing less than 6,000 pounds (but not for a heavier automobile). Regulations have been promulgated to provide guidance for making and revoking elections under IRC § 179 for the taxable years beginning after 2002 and before 2006. TD 9146, 69 Fed. Reg. 46,982 (Aug. 4, 2004). Consistent with JGTRRA, taxpayers are permitted to make or revoke IRC § 179 elections on amended federal tax returns without the Commissioner's consent. The IRS has noted in the preamble to these regulations that such a process will provide flexibility to small business taxpayers in determining whether the IRC § 179 election is to their advantage or disadvantage. Reg. § 1.179-5T(c)(2) provides that an IRC § 179 election made on an amended federal tax return must specify the item of IRC § 179 property to which the election applies and the portion of the cost of each such item to be taken into account under IRC § 179. Further, if a taxpayer elected to expense only a portion of the cost basis of an item of IRC § 179 property for a particular taxable year (or did not elect to expense any portion of the cost basis of an item of IRC § 179 property), Reg. § 1.179-5T(c)(2) allows the taxpayer to file an amended federal tax return and expense any portion of the cost basis of an item of IRC § 179 property that was not

4 expensed pursuant to a prior IRC § 179 election. Any such increase in the amount expensed under IRC § 179 is not deemed to be a revocation of the prior election for that particular taxable year. Reg. § 1.179-5T(c)(3) provides that any election under IRC § 179, or specification of such election, for any taxable year beginning after 2002 and before 2006 for any item of IRC § 179 property may be revoked by the taxpayer on an amended federal tax return without the Commissioner's consent and that such revocation, once made, is irrevocable. These regulations were finalized in TD 9209, 70 Fed. Reg. 40,189 (July 13, 2005), with adjustments being made for the subsequent changes made in the 2004 Jobs Act. Allocation of Deduction Among Controlled Group Members For purposes of this provision, all members of a controlled group are to be treated as one taxpayer. IRC § 179(d)(6)(A). The $17,500 limit can be apportioned among the members of the controlled group in the manner prescribed in the regulations. Treasury Regulations § 1.179-2(b) (1) provides that the IRC § 179 expense deduction may be taken by any one member of a controlled group or may be allocated among the several members in any manner, pursuant to an allocation by the common parent corporation, if a consolidated return is filed for all members. A more expansive definition of “controlled group” is provided in this context. IRC § 179(d)(7). Alternatively, if separate returns are filed, this deduction can be allocated in accordance with an agreement entered into by the members of the group. If a consolidated return is filed by some members of the group and separate returns are filed by other members, the common parent of the group filing the consolidated return may enter into an agreement with the group not filing the consolidated return allocating the amount between the group filing and the group not filing. HR 3448, the Small Business Job Protection Act of 1996 , Pub. L. No. 104-188, § 1111, provides for a gradual increase in this expense amount to $25,000. See IRC § 179, which was amended by the Jobs and Growth Tax Relief Reconciliation Act of 2003 , Pub. L. No. 108-27, 117 Stat. 752, § 202(a), to provide that this limitation is raised to $100,000 for each of the taxable years beginning after 2002 and before 2006. Under IRC § 179(b)(5), in 2004, this $100,000 amount began to be indexed for inflation. For 2004, the amount eligible to be treated as an expense was $102,000. See Rev. Proc. 2003-85, 2003-2 CB 1184. For 2006, the amount eligible to be treated as an expense was $108,000. See Rev. Proc. 2005-70, 2005-2 CB 979. For 2007, the amount eligible to be treated as an expense was $112,000. See Rev. Proc. 2006-53, 2006-2 CB 996, § 3.19. For 2008, the amount eligible to be treated as an expense is $128,000. See Rev. Proc. 2007-66, 2007-2 CB 970, § 3.20. For 2009, the amount eligible to be treated as an expense was $133,000. Rev. Proc. 2008-66, 2008-2 CB 1107, § 3.20. For 2010, the $100,000 amount is indexed to $135,000. See Rev. Proc. 2009-50, 2009-45 IRB 617, § 3.20. In the Economic Stimulus Act of 2008, Pub. L. No. 110-185, 122 Stat. 613 (Feb. 13, 2008), for any taxable year beginning in 2008, IRC § 179 was changed to provide for an increase of the amount of this deduction to $250,000, with the IRC § 179(b)(2) phase-out level commencing at $800,000. Act § 102. Furthermore, an additional first-year depreciation deduction for qualified property acquired after 2007 and placed in service before 2009 has been increased to 50 percent from 30 percent. IRC § 168(k); Act § 103. Rev. Proc. 2008-54, 2008-2 CB 722, describes these tax depreciation allowance changes. Further changes to these depreciation allowance amounts were made in the Hiring Incentives to Restore Employment Act of 2010, Pub. L. No. 111-147, 125 Stat. 71 (the HIRE Act). Section 201 of the HIRE Act changes the $125,000 and the $500,000 amounts to $250,000 and $800,000, respectively, for taxable years beginning in 2010. Section 201 of the HIRE Act also provides that these amounts will not be adjusted for inflation for taxable years beginning in 2010. Rev. Proc. 2010-24, 2010-25 IRB 764, provides that Rev. Proc. 2009-50, supra, § 3.20, is modified to provide that the amount a taxpayer may elect to treat as an expense cannot exceed $250,000 and that the $250,000 limitation is reduced by the amount by which the cost of property placed in service during the 2010 taxable year exceeds $800,000.

5 Election to File Consolidated Tax Return Generally Section 1501 specifies that an affiliated group of corporations may elect to file a consolidated income tax return, rather than each group member filing a separate return. The basic principle of the consolidated return is that the entire related group is taxed on its consolidated taxable income. This income represents the group's dealings with the outside world, after the elimination of intercompany profit and loss. The tax is computed at the usual rates, except that only one graduated bracket benefit is allowed, regardless of the number of includable corporations. Concept of “Affiliated Group” A consolidated return may be filed by an “affiliated group” of corporations. This term is defined in IRC § 1504 to mean certain includable corporations connected in a specified manner through stock ownership. The stock ownership rule of IRC § 1504(a) requires that the affiliated group consist of one or more chains of includable corporations that are connected through stock ownership with a common parent corporation. Stock with at least 80 percent of the total voting power and at least 80 percent of the total value of each of the includable corporations (other than the common parent) must be owned directly by one or more of the other includable corporations. The common parent must directly own stock with at least 80 percent of the total voting power and 80 percent of the total value of at least one of the other includable corporations. Stock ownership can be aggregated under certain circumstances. See Reg. § 1504- 34. For an analysis of TAM 9452002, in which the IRS ruled that control over management rather than a mechanical election of directors was the applicable test for determining whether corporations are affiliated, see Huber, Lubozynski & Pellervo, “IRS Offers Insight on 80%-of- Voting-Power Test for Affiliated Groups,” 83 J. Tax'n 12 (1995) . Pursuant to IRC § 1504(a)(4), parent corporations can exclude certain types of preferred when they calculate whether the corporation controls 80 percent of the vote and value of the subsidiary. Exploring precisely what type of stock is so excluded, see Winston, “What Is Section 1504(a)(4) Preferred Stock?” 76 Tax Notes 111 (July 7, 1997). The issue of what stock is to be counted in determining the 80 percent requirement (particularly when stock-based incentive compensation is involved) is discussed in Raby & Raby, “What Stock Counts—And When?” 79 Tax Notes 741 (May 11, 1998). See Alumax, Inc. v. Comm'r , 165 F3d 822 (11th Cir. 1999) , defining the term “voting power” and concluding that the power to elect the board was not sufficient unless it also included “the power to operate the subsidiary as part of a common enterprise,” which, in this case, was lacking. Indirect Ownership Arrangements The determination of share ownership in this context is dependent on equitable rights, rather than nominal ownership. For example, in Priv. Ltr. Rul. 8919014, the IRS held that stock subject to proxy agreements to avoid foreign ownership restrictions was considered to be directly owned for purposes of determining affiliated group status and eligibility to join in a consolidated return. The proxy was necessary because certain government regulations required this as a condition of obtaining security clearances for several subsidiaries. Even though the proxy existed, no economic interest in the subsidiaries had been transferred. Further, the right of the proxy holders could be terminated, and, accordingly, the IRS concluded that the U.S. parent corporation had beneficial ownership of the voting rights for purposes of determining voting rights. Similarly, in Priv. Ltr. Rul. 8901010, the stock of a purchased subsidiary was held in trust while the parent corporation awaited state approval for the purchase. The parent corporation could, however, instruct the trustee to vote the shares in any manner and was entitled to the dividends. The IRS ruled that during the time the stock was held in trust, the parent's beneficial

6 ownership of the subsidiary's stock constituted direct ownership of the stock for purposes of IRC § 1504(a) (which defines affiliation status requirements). Accordingly, the subsidiary could be included in the parent's consolidated tax return as soon as the purchase was made. Certain Corporations Not Eligible for Inclusion in Affiliated Group Certain corporations are not “includable corporations” for this purpose. The excludable corporations include tax-exempt corporations, insurance companies, foreign corporations, possessions (or IRC § 936) corporations, regulated investment companies, and other specialized pass-through entities, S corporations, domestic international sales corporations, and foreign sales corporations. See IRC § 1502(b). See FSA 200117019, where the IRS Chief Counsel advised that a corporation could not have the benefits of both membership in a U.S. consolidated return and treaty benefits as a foreign resident because both the treaty and U.S. law precluded taking such inconsistent positions. Consolidated Return Election Required A timely consolidated return election must be filed. However, a time extension for making this election may be possible. See Rev. Proc. 2010-1, 2010-1 IRB 1, § 5.03, noting that the IRS National Office will consider a request for an extension of time under Reg. § 301.9100-1. Note also Rev. Proc. 92-85, 1992-2 CB 490, specifying that requests for extension of time to file elections will be granted when the taxpayer provides evidence that (1) the taxpayer acted reasonably and in good faith and (2) granting relief would not prejudice the interests of the government. The IRS has granted extensions for filing the consolidated return extension. See Priv. Ltr. Rul. 9206017, where the IRS granted an extension of time for the parent corporation, along with the subsidiaries, to elect to file a consolidated return (and to file the return) for the particular tax year. The IRS determined that good cause was shown for the failure to timely file the election and that the other requirements of Temp. Reg. § 301.9100-1T(a) were satisfied. See Priv. Ltr. Rul. 9329008, where the IRS granted a parent corporation an extension to elect to file a consolidated return, finding good cause for relief. However, the IRS conditioned the extension on the parent's and subsidiary's tax liability being no lower than if the election had been timely made. Similarly, see Priv. Ltr. Rul. 9323011, where the IRS granted an extension for a consolidated return election. For a ruling in which the IRS waived the required five-year period (IRC § 1504(a)(3)(B)) that must elapse before a disaffiliated corporation may reconsolidate with the same group, see Priv. Ltr. Rul. 9448008. Similarly, see Priv. Ltr. Rul. 200748005, where the IRS ruled that a disaffiliated corporation could reconsolidate with the former group before the statutory five-year waiting period. The purpose of the restructuring was to enable the common parent of the old group to elect to be treated as a REIT. See, further, Rev. Proc. 2002-32, 2002-1 CB 959, where the IRS indicated that certain qualifying corporations that request an automatic waiver by complying with the requirements set forth in the revenue procedure are automatically granted a waiver under IRC § 1504(a)(3)(B) so that the corporation may be included in the consolidated return filed (or required to be filed) by the affiliated group of which it is a member. The corporations eligible for this automatic approval are those where various ownership changes have occurred. Any corporation that does not or cannot comply with the requirements for automatic approval may request a waiver of the application of the general rule of IRC § 1504(a) (3)(A) pursuant to other requirements specified in this revenue procedure. To obtain an automatic waiver of IRC § 1504(a)(3)(A), the deconsolidated corporation must be included in a timely filed consolidated return (including extensions) of the affiliated group with respect to which the waiver request relates (the current group) for the taxable year that includes the date on which such corporation most recently became a member of such affiliated group. In addition, a statement including various prescribed information must be attached to the return. That

7 information must include a description of the business purpose for the transactions that caused disaffiliation and subsequent consolidation, and information on the taxable income of the group and the deconsolidated corporation. For examples of rulings granting extensions for the basic consolidated returns election (Reg. § 1.1502-75(a)(1)), see Priv. Ltr. Ruls. 9909009 and 9913010. In addition to the basic consolidated return election under Reg. § 1.1502-75(a)(1), there are a number of other elections and/or statements required to be filed in certain consolidated situations. With respect to these situations, the IRS has generally issued favorable private letter rulings permitting extensions to file. See, e.g., Priv. Ltr. Rul. 9727020 (IRS granted an extension to file the “Annual Certification Required by Reg. § 1.1503-2(g)(2)(vi)(B) Relating to Dual Consolidated Losses”); Priv. Ltr. Rul. 9746052 (parent corporation granted extension to file “Statement of Allowed Loss Under Section 1.1502-20(c),” relating to the allowable loss of a deconsolidated subsidiary); Priv. Ltr. Rul. 9744011 (IRS granted an extension to file for “Elective Relief Under Section 1.1503-2(g)(2),” relating to a dual consolidated loss); Priv. Ltr. Rul. 9907014 (IRS granted an extension to file a statement of an allowed loss required by Reg. § 1.1502-20(c)(3)); Priv. Ltr. Rul 9910013 (IRS granted an extension to make the election under Reg. § 1.1502-13( l)(3) to apply Reg. § 1.1502- 13 to intercompany stock elimination transactions occurring after July 12, 1995). Extensions are also granted to file certain certifications required by Reg. § 1.1503-2A(d)(3) to identify the amount of losses of a separate unit. See Priv. Ltr. Ruls. 9844037, 9846040, and 9908007. The concept of extension can arise in a situation in which a corporation is inadvertently omitted from a consolidated return filed several years ago. In Priv. Ltr. Rul. 9815044, the IRS ruled that the omitted member will be treated as if it joined in the making of the consolidated return and was permitted to file amended returns. Consent of Group Members to Filing of Consolidated Return A consolidated return may be made only if all corporations that at any time during the taxable year have been members of the affiliated group consent to the consolidated return regulations. Reg. § 1.1502-75(a)(1). See Priv. Ltr. Rul. 9241013, where subsidiaries joined with the parent company in making a consolidated return. The IRS ruled that the subsidiaries would be treated under the consolidated return regulations as if they had filed an IRS Form 1122, “Authorization and Consent of Subsidiary Corporation to Be Included in a Consolidated Income Tax Return.”See also Priv. Ltr. Rul. 200521018, where the Service waived the failure to file subsidiary consents for a consolidated return because the group members' actions satisfied requirements for informal consents. In seeking this ruling the parent corporation presented the following: (1) all of the income and deductions of the parent company and its affiliated subsidiaries were included in the relevant consolidated federal income tax returns filed; (2) neither the parent company nor any of its affiliated subsidiaries filed a separate income tax return for the relevant years; and (3) each member of the affiliated group was included on an IRS Form 851 that was attached to the consolidated returns as filed by parent company for the relevant years. In Priv. Ltr. Rul. 201013028, a parent corporation wholly owned all of the stock of three subsidiaries, each of which was treated as a qualified subchapter S subsidiary (QSub). When the parent's election to be treated as an S corporation terminated by operation of law, each of the elections treating the subsidiaries as QSubs also terminated. The parent retained an accounting firm to prepare its tax return for its short taxable year and informed the accounting firm that it and the subsidiaries intended to file a consolidated Federal income tax return. The return was timely filed and included the income and deductions for the parent and each of the subsidiaries for the entire short taxable year. However, an IRS Form 1122 for each of the subsidiaries was not filed with the parent's tax return. The IRS ruled that each of the subsidiaries was treated under Reg. § 1.1502-75(b)(2) as if it had timely filed a Form 1122 with the consolidated income tax return filed by the parent. In general, the corporation that is the common parent of a consolidated group for a taxable year is the sole agent for the group with regard to the group's income tax liability for that taxable

8 year. The original common parent generally remains the agent for the group for that taxable year, even if another corporation is the common parent of the group in a later year or the group later terminates. However, the original common parent cannot act as sole agent if its own existence terminates. The IRS has published final regulations outlining who has the authority to act on behalf of a consolidated group when the common parent changes. Reg. §§ 1.1502-77(d) and 1.1502-77A(d), TD 9002, 67 Fed. Reg. 43,538 (June 28, 2002). In this case, the group may require a substitute agent to function with respect to prior open taxable years for which the original common parent was the group's agent. Reg. §§ 1.1502-77(d) and 1.1502-77A(d) provide rules regarding a substitute agent to replace a terminating or terminated common parent. Rev. Proc. 2002-43, 2002-2 CB 99, sets forth the procedures under those rules. These procedures also apply when a substitute agent's existence terminates. A terminating common parent may designate a substitute agent. See Reg. §§ 1.1502-77(d)(1) and 1.1502-77A(d). Designation by a terminating common parent is available for any and all taxable years for which the terminating common parent is agent for the group. Rev. Proc. 2002-43 provides different procedures depending on whether the terminating common parent designates its qualifying successor (see Rev. Proc. 2002-43, § 6) or another corporation (see Rev. Proc. 2002-43, § 7). If the terminating common parent designates its qualifying successor in accordance with the procedures of Rev. Proc. 2002-43, that designation is automatically approved without further communication from the IRS, and it will be effective on the later of the termination of the common parent or the filing of the designation with the IRS. Designation by the terminating common parent of its qualifying successor as substitute agent is generally available for any consolidated return year. The terminating common parent may also designate certain corporations other than its qualifying successor as substitute agent. Such a designation is subject to approval by the IRS. Designation of a corporation other than the terminating common parent's qualifying successor as substitute agent is generally available for any consolidated return year. If the terminating common parent does not designate a substitute agent, the remaining members may designate a substitute agent, but only for consolidated return years beginning before June 28, 2002. See Reg. § 1.1502-77A(d). The designation must be filed in the manner specified in Rev. Proc. 2002-43, § 8, and is not effective until the IRS approves the designation. If the terminating common parent does not designate a substitute agent, its qualifying successor, if any, may notify the IRS that it is the substitute agent by default, but only for consolidated return years beginning on or after June 28, 2002. See Reg. § 1.1502-77(d)(2). If the terminating common parent does not designate a substitute agent and has no qualifying successor, one or more members of the group may request the IRS to designate a substitute agent, but only for consolidated return years beginning on or after June 28, 2002. See Reg. § 1.1502-77(d)(3)(i). The request is made pursuant to Rev. Proc. 2002-43, § 10. If the group does not request designation of a substitute agent in this situation, the IRS may nevertheless (if it has reason to believe there is no default substitute agent) designate any group member or successor of a member as the substitute agent for the group. If the IRS designated a substitute agent for consolidated return years beginning on or after June 28, 2002, one or more members of the group may request that the IRS replace the previously designated substitute with another member (or successor of a member), in accordance with the procedures of Rev. Proc. 2002-43, § 11. All documents described in this revenue procedure are filed at the following address: Ogden Submission Processing Center, PO Box 9941, Mail Stop 4912, Ogden, UT 84409. See, further, TD 9255, 71 Fed. Reg. 13,001 (Mar. 14, 2006), providing temporary regulations under IRC § 1502 that provide the IRS with the authority to designate a domestic member of the consolidated group as a substitute agent to act as the sole agent for the group where a foreign entity is the common parent. The regulations affect corporations that join in the filing of a consolidated federal income tax return, where the common parent of the consolidated group is a foreign entity that is treated as a domestic corporation pursuant to IRC § 7874(b) or as the result of an IRC § 953(d) election. These regulations were finalized in TD 9343, 72 Fed. Reg. 40,066 (July 23, 2007), with an amendment that, unless the designation is expressly limited to a term, the domestic substitute agent will continue to be the agent for subsequent taxable years of the group until certain specified events occur.

9 In CCA 200943030, the Chief Counsel's Office, pursuant to Delegation Order 4-45, advised that (1) LMSB Team Managers are authorized to designate substitute agents for consolidated groups, (2) no designation form exists for this purpose, and (3) compliance for this designation is accomplished by sending a letter to the corporation advising it that it is being designated under Reg. § 1.1502-77(d)(3) and that it is to notify the other members of the consolidated group of this designation. Continuation and Discontinuance of Consolidated Return Status The affiliated group must continue to file on a consolidated return basis in subsequent taxable years. Reg. § 1.1502-75(a)(2). However, the IRS, for good cause, may grant permission to discontinue filing consolidated returns. See Reg. § 1.1502-75(c). In Rev. Proc. 95-39, 1995-2 CB 399, declared obsolete in Rev. Rul. 2003-99, 2003-34 IRB 388, the IRS granted permission to discontinue filing consolidated returns to any consolidated group that files (or is required to file) a consolidated return for the tax year preceding the first tax year that begins on or after July 12, 1995. To obtain permission, a consolidated group must file an application with the IRS by June 30, 1996, and each member of the group must enter into a closing agreement. Members electing to discontinue filing consolidated returns will generally be prohibited from joining a consolidated return for 60 consecutive months immediately following the beginning of the first tax year that begins on or after July 12, 1995. It is stated that Rev. Proc. 95-39 does not apply to any consolidated group that is subject to Reg. § 1.338(h)(1)-1(e)(6), but it is further stated that permission for such groups to discontinue will be considered on a case-by-case basis. Allocation of Consolidated Tax Liability Among Members of Consolidated Group Reimbursement to subsidiary for benefits to other affiliates from subsidiary's preconsolidation net operating loss carryovers—Reimbursement by subsidiary, if consolidation is terminated, for tax benefits to it from losses incurred by other members of group Joint and Several Liability for Consolidated Group Members Each member of the affiliated group is severally liable for the entire income tax amount reflected on the consolidated tax return, including any deficiencies. Reg. § 1.1502-6(a). Only limited liability ordinarily attaches, however, to a subsidiary that has ceased to be a member of the consolidated group. That consolidated group cessation must result from a bona fide sale or exchange of its stock for fair value and must have occurred prior to the date upon which any deficiency is assessed. Notwithstanding this rule, a portion of a deficiency may be deemed allocable to that subsidiary if attributable to the income of the subsidiary that has departed from the consolidated group. Reg. § 1.1502-6(b). No agreement entered into by one or more members of the group with any other member of such group will have the effect of reducing this liability as enforceable by Reg. § 1.1502-6(c). Objective of Tax Allocation Agreement Notwithstanding that the members of the affiliated group cannot, through an agreement, deflect the liability owing to the IRS away from certain members of the group, they may still want to enter into a tax allocation agreement. This will allocate the ultimate responsibility for tax among the various members of the group. Such an allocation provision is a matter of economic significance particularly where any member of the group has some minority shareholders. A tax allocation may also be important if a group member's after-tax earnings must be separately computed under agreements with executives, creditors, lessors, or other parties. Further, the

10 consolidated tax burden must be allocated among the members of the affiliated group to enable a separate computation of the earnings and profits account of each member of the group. Options in Structuring Tax Allocation Agreement Section 1552(a) sets forth three acceptable methods of allocating the group's tax liability among its members in determining earnings and profits (E&P). The first method is to allocate in accordance with the ratio that that portion of the consolidated taxable income attributable to each member of the group having taxable income bears to the consolidated taxable income of the entire group. The second method is to allocate the tax liability to the several members of the group on the basis of the percentage of the total tax that the tax of such member, if computed on a separate return basis, would bear to the total amount of the taxes for all members of the group so computed. The third method is to allocate on the basis of the contribution of each member of the group to the consolidated taxable income of the group. A taxpayer may also apply to the IRS for approval of a method more suited to its requirements. IRC § 1552(a)(4). If no election is filed, the allocation method based on taxable income ratios will be applied. See Priv. Ltr. Rul. 9125051, where a consolidated group proposed to use a tax allocation method substantially identical to the elective method that is permitted under Reg. §§ 1.1552-1(a)(2) and 1.1502-33(d)(2)(ii). However, under the proposed method, the definition of the separate return tax liability of any member (as provided by Reg. § 1.1552-1(a)(2)(ii)) would be modified to mean that the member's tax liability would be computed as if the member had filed a separate federal income tax return, except that carryovers and carrybacks of certain items would be taken into account only when and to the extent that those items would be absorbed and taken into account in computing the tax liability of the group. The IRS granted approval to the group to adopt this alternative method. Section 1552 does not purport to determine the fairness of the statutory methods of allocating the consolidated tax burden if some members of the affiliated group have minority shareholders. Nor does it deal with the problem of compensating minority shareholders for tax benefits brought by their company to the consolidated group that are either appropriated by its new affiliates or lost because not available for carryforward. That might be arranged through the use of a tax allocation agreement. Required Continued Use of Elected Tax Allocation Method The method elected for the group's first consolidated return (or the IRC § 1552(a)(1) method, if no election is filed) must be used in later years. Possible Change in Tax Allocation Method The IRS has provided procedures under which an affiliated group may obtain automatic consent to elect or change its method of allocating consolidated federal income tax liability among its members. Rev. Proc. 90-39, 1990-2 CB 365, as clarified by Rev. Proc. 90-39A, 1990-2 CB 367. This revenue procedure is noted at Rev. Proc. 2010-1, 2010-1 IRB 1, App. E, as prescribing the pertinent procedures for such a request. To obtain this automatic consent, the common parent of an affiliated group filing consolidated tax returns must attach a statement to its timely filed consolidated federal income tax return. In addition to information identifying the parent and the members, the statement must contain the following information and representations: a complete description of the present method of allocating the federal income tax liability; a complete description of the proposed allocation method, specifying the fixed percentage if the method chosen is the one described in Reg. § 1.1502-33(d)(2)(ii); and a representation that adoption of the proposed allocation method will not change the taxable status of distributions made during the year of change or in any foreseeable future year to shareholders who are not members of the affiliated group. The IRS

11 will not ordinarily respond to requests for waivers or consents on consolidated return issues where it has provided an administrative procedure for obtaining such waivers or consents for such issues. See Rev. Proc. 2010-3, 2010-1 IRB 110, § 6.07, referring to Rev. Proc. 90-39 (concerning allocation of the group's consolidated federal income tax liability) as one of these administrative procedures for this purpose. In some situations, the consolidated return regulations may mandate the allocation of tax items among related corporations. See TD 9376, 73 Fed. Reg. 2,416 (Jan. 15, 2008), which provides final regulations on the treatment of liquidating corporation items, other than intercompany items, succeeded to by multiple corporations in IRC § 332 liquidations in consolidated groups. For example, the full amount of deferred income items of deferred deductions of the liquidating corporation which are attributable to specific property or a specific business are allocable to the distributee member receiving the property or the business in the liquidation. By complying with these requirements, an affiliated group obtains the consent to change its allocation method to one of the basic methods described in Reg. §§ 1.1552-1(a)(1), 1.1552-1(a) (2), or 1.1552-1(a)(3), or to elect or to change to a complementary method described in Reg. §§ 1.1502-33(d)(2)(i) or 1.1502-33(d)(2)(ii) for use in conjunction with a basic method. The consent is granted for the consolidated return year for which the aforementioned statement is attached to the timely filed consolidated return. See, e.g., Priv. Ltr. Rul. 9335044, for a request to the IRS requesting approval for an affiliated group to change its method of allocating its consolidated federal income tax liability. See, further, Priv. Ltr. Rul. 9319012, where an affiliated group adopted a tax-sharing method for settlement and accounting purposes, treating each grouping of subsidiaries as a single corporation in allocating its federal tax liability. Thereafter, each group of subsidiaries would allocate its shares of the group's consolidated tax liability among its members under the method described in Reg. § 1.1552-1(a)(2). The IRS permitted the group to adopt this tax allocation method. Consolidated Returns—Deemed Dividends Election to have subsidiary treated as having made distribution—Basis increase to subsidiary stock Purpose of Investment Basis Adjustment Rules Dividend distributions between members of a consolidated group are eliminated from the computation of consolidated taxable income. Reg. § 1.1502-14(a)(1). This treatment is consistent with the theory that the group is, in effect, a single taxable enterprise and, accordingly, that such earnings have already been reflected in the consolidated return and taxed once to the group. Under the investment basis adjustment rules of Reg. § 1.1502-32, the parent corporation's basis for its common stock in the subsidiary must be reduced on account of such distributions. This reduction must occur whether the distribution is made from current earnings, from earnings accumulated in prior consolidation return years, or from pre-affiliation accumulated earnings. The theory of these tax basis rules is that these earnings have already been capitalized or reflected in an adjustment that increases the parent's basis for its stock in the subsidiary and that, therefore, a tax-free distribution of the earnings should result in a corresponding reduction of tax basis. This reduction will increase the parent's gain (or decrease its loss) upon a later sale of its stock in the subsidiary. Election of Deemed Dividend Without having actually made a distribution, a group may elect for any consolidated return year to treat a wholly owned subsidiary as having made a dividend distribution of all its accumulated

12 earnings and profits as of the first day of the taxable year. The shareholders, in turn, will be treated as having contributed those amounts to the capital of the subsidiary. Reg. § 1.1502-32(f) (2). This will result in an increase in the basis of the stock of the subsidiary. This basis increase may produce a substantial reduction of the gain that would otherwise be recognized on the sale of the stock to outsiders. Alternatively, it may eliminate an excess loss account for the subsidiary's stock. See Priv. Ltr. Ruls. 9403011 and 9309053, where taxpayers requested rulings concerning the effect of a proposed deemed dividend election pursuant to Reg. § 1.1502-32(f)(2). For an analysis of the usefulness of this election, see Warner, “Consolidated Returns: Stock Basis, Loss Disallowance and Intercompany Transactions,” § 111.023, CCH Tax Transactions Library (1993).

Consolidated Returns—Intercompany Transactions

Deferred intercompany transactions—Permission to not defer gain or loss Concept of Deferred Intercompany Transactions Transactions between the related members of a consolidated group do not ordinarily produce income tax results to be currently recognized. These deferred intercompany transactions consist of sales or exchanges of property, the performance of services where the expense is capitalized, and other capitalized expenditures that occur between members of a consolidated group. A deferral or “suspense account” approach is implemented with respect to these transactions. Intercompany profits and losses are deferred by recording them in a suspense account until the subsequent occurrence of certain specified events. These subsequent events will trigger the reporting of both the amount and the character of such items by the member of the group that originally earned the profit or sustained the loss. This treatment follows the traditional accounting practice of attributing gain or loss from an intercompany transaction to the member that actually earned or incurred it. Thus, the gain or loss is deferred and the ultimate profit or loss from the transaction is assigned to the particular member that produced it. A deferred intercompany transaction may also occur in an IRC § 351 transaction between related members of a consolidated group. The IRS proposed regulations clarifying that a transferee's assumption of certain liabilities as described under IRC § 357(c) in an IRC § 351 transfer between members of a consolidated group will not reduce the transferor's basis in the transferee's stock that was received in the transfer. Section 357(c)(3) excludes from the computation of liabilities those assumed liabilities the payment of which would give rise to a deduction, provided that the incurrence of such liabilities did not result in the creation of, or an increase in, the basis of any property. These liabilities are subject to the proposed regulations.

Prop. Reg. § 1.1502-80(d). REG-137519-01, 66 Fed. Reg. 57,021. Elective Nondeferral of Intercompany Transactions A consolidated group may wish, however, to not defer the recognition of these intercompany gains and losses. Reg. § 1.1502-13(c)(3) specifies that a group may elect, with the consent of the Commissioner, not to defer gain or loss on any deferred intercompany transactions with respect to all property or any class or classes of property. Such an election, unless revoked with the consent of the Commissioner, will apply to all members of the group for its consolidated return year for which the election is made and for all subsequent consolidated return years ending prior to the first year for which the group does not file a consolidated return. If IRC § 267 applies (which denies loss recognition on transactions between certain related parties), this nondeferral election will not be available. See Temp. Reg. § 1.267(f)-2T(c). This denied loss can be taken into account when the property is transferred outside the group. For example, in ILM

13 200924043, the IRS concluded, for purposes of taking a subsidiary's loss into account, that property was transferred outside the group when the parent corporation was treated as liquidating under IRC § 331 as a result of converting to an LLC (and not treated thereafter as a corporation for federal tax purposes).

Application for Consent Not to Defer Applications for such a consent to make an election not to defer are to be filed with the IRS, Associate Chief Counsel (Domestic). Rev. Proc. 82-36 was updated and superseded by Rev. Proc. 97-49, 1997-2 CB 523. Rev. Proc. 97-49 outlines the procedures for a taxpayer to obtain consent to treat some or all intercompany transactions on a separate-entity basis under Reg. § 1.1502-13(e)(3). The requirements for obtaining the IRS's consent to change from separate- entity reporting to single-entity reporting where a taxpayer had not previously received the IRS's permission to report intercompany transactions on a separate-entity basis are also set forth in Rev. Proc. 97-49. Rev. Proc. 97-49 was superseded by Rev. Proc. 2009-31, 2009-27 IRB 107. The first paragraph of Rev. Proc. 2009-31 notes that it provides guidance for taxpayers (1) to obtain the IRS's consent to treat some or all intercompany transactions on a separate entity basis under Reg. §§ 1.1502-13(e)(2), 1.1502-13(e)(3) to revoke such consent, or have the consent revoked by the IRS, and (3) to obtain the IRS's consent to change from separate entity reporting to single entity reporting when a valid consent from the IRS to report intercompany transactions on a separate entity basis was not previously obtained. Section 5 of this procedure provides a checklist for the filing and handling of these requests. See Rev. Proc. 82-36, 1982-1 CB 490, which provides an information checklist and guidelines for obtaining consent not to defer gain or loss on intercompany transactions. This Revenue Procedure is referenced in Rev. Proc. 2010-1, 2010-1 IRB 1, App. E, .01, as the appropriate checklist concerning deferred intercompany transactions and the election not to defer gain or loss. The IRS has considered a number of ruling requests in this context. For example, in Priv. Ltr. Rul. 9252019, the IRS granted a parent corporation's request not to defer gains on certain intercompany transactions. However, the ruling indicated that losses from the sale or exchange of property between members of the affiliated group must continue to be deferred under IRC § 267 until the occurrence of the appropriate restoration event or events, as defined by the consolidated return regulations. Similarly, see Priv. Ltr. Rul. 9717027, where the Service consented to gain recognition but ruled that losses from intercompany transactions would continue to be deferred under IRC § 267 until the appropriate restoration event occurs under the consolidated return regulations. Consolidated Returns—Reduction of Excess Loss Recovery Amount

Other subsidiary stock or obligations—Basis reduction Concept of Investment Basis Adjustment Rules To enable the intercompany transaction deferral concept to function accurately, a system of special annual investment basis adjustments is prescribed in Reg. § 1.1502-32. These provisions require the parent corporation to make annual, year-end adjustments to the basis of its common and preferred stock in each of its subsidiaries. These adjustments are to reflect the economic results of that subsidiary's operations for the year. This adjustment mechanism implements a floating income tax basis concept. The tax basis of the common stock of a subsidiary is reduced for losses of a subsidiary that are used.

14 The purpose of these investment basis adjustment rules, and the complementary “excess loss account” rules, is to avoid duplication of income tax on the parent's investment gain attributable to accumulated earnings of its subsidiary when that income has already been taxed to the group in the consolidated return. These rules also avoid a double deduction for losses that have already been used by the consolidated group in the computation of the consolidated tax liability.

The “Excess Loss Account” Concept—Negative Basis Approach The negative adjustment to stock basis for used operating losses (or certain nondividend distributions and capital losses) is not suspended when basis for the subsidiary reaches zero. Rather, a “negative basis” can be created for the parent's stock in the subsidiary. This account, defined by Reg. § 1.1502-32(e)(1) as an “excess-loss account,” represents a potential income item to the parent. The recognition of this excess-loss account amount will occur on the happening of certain disposition events. See Reg. § 1.1502-19(b). If a disposition event triggers recognition of income from an excess-loss account, the income ordinarily will be deemed to be capital gain rather than ordinary income if the subsidiary is solvent at the time of the income recognition. However, Prop. Reg. § 1.1502-19(b)(4)(i) identifies several circumstances where ordinary income treatment might be imposed, including, to the extent that the subsidiary is insolvent, the income from the excess loss account of its shares of stock. Multiple Classes of Stock Held in Subsidiary A parent corporation may hold various classes of stock and debt issued by a subsidiary corporation. As noted previously, the excess losses will only apply to reduce the basis of the common stock. Consequently, at the time of the disposition of the common stock of a subsidiary, that disposition may trigger recognition of the excess-loss account, although a positive basis still exists in the preferred stock or debt that remains in the hands of the selling parent shareholder. A parent corporation that disposes of part or all of its common stock of a subsidiary with respect to which an excess-loss account exists may elect to apply that excess loss account to the reduction of basis of its other stock (common or preferred) and debt investment in the subsidiary that is not disposed of in the transaction. Reg. § 1.1502-19(a)(6). In effect, no excess loss account income needs to be reported by the parent corporation until a complete recovery has occurred by the parent of its entire investment (both equity and debt) in the subsidiary through distributions, use of losses, sales, and so forth. Proposed Excess Loss Account Regulations Proposed regulations would revise and simplify the present excess loss account rules. They would explicitly adopt the negative basis theory for computational purposes (thus eliminating the need for special excess loss account rules that parallel the regular tax basis rules). Prop. Reg. §§ 1.1502-19(a)(1), 1.1502-19(d)(1). The parent corporation's investment in its subsidiary's stock would be viewed as an investment in its assets. Accordingly, the worthlessness of a member would not occur until substantially all of its assets are disposed of under the loss deduction principles of IRC § 165(a). The general purpose of the new worthlessness rule is to delay the treatment of a subsidiary's stock as worthless for as long as possible.