Proposed and Temporary Regs Providing a Loss Disallowance Rule for Son-of-Mirror Transactions

 [4830-01]

 ACTION: Temporary regulations.

 SUMMARY: This document contains temporary regulations under sections 337(d) and 1502 that implement the repeal of the General Utilities doctrine and eliminate duplication of loss with respect to members of affiliated groups filing consolidated returns. The regulations apply on a disposition or deconsolidation of stock of a subsidiary of the group. The text of the temporary regulations set forth in this document also serves as the text of the proposed regulations cross-referenced in the notice of proposed rulemaking in the Proposed Rules section of this issue of the Federal Register.

 DATES: The regulations in this document are effective March 9, 1990. Section 1.337(d)-1T applies with respect to dispositions occurring after January 6, 1987, of stock of a corporation that became a member of an affiliated group after January 6, 1987, if the disposition is not subject to section 1.1502-20T.

 FOR FURTHER INFORMATION CONTACT: Mark S. Jennings, 202-566-2455 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

These regulations are being issued without prior notice and public procedure pursuant to the Administrative Procedure Act (5 U.S.C. 553). For this reason, the collections of information contained in these regulations have been reviewed and, pending receipt and evaluation of public comments, approved by the Office of Management and Budget (OMB) under control number 1545-1160. The estimated average annual burden per respondent varies from 1-1/2 to 2-1/2 hours, depending on individual circumstances, with an estimated average of 2 hours.

 These estimates are an approximation of the average time expected to be necessary for a collection of information. They are based on such information as is available to the Internal Revenue Service. Individual respondents may require greater or less time, depending on their particular circumstances.

 For further information concerning these collections of information, and where to submit comments on these collections of information and the accuracy of the estimated burden, and suggestions for reducing this burden, please refer to the preamble to the cross- referenced notice of proposed rulemaking published in the Proposed Rules section of this issue of the Federal Register.

A. INTRODUCTION

 This document adds temporary regulations sections 1.1502-20T, 1.1502-1T, and 1.337(d)-1T to Part 1 of Title 26 of the Code of Federal Regulations, and adds cross-references to sections 1.1502-12, 1.1502-32, 1.1502-33 and 1.1502-79. The temporary regulations added by this document will remain in effect until superseded by later temporary or final regulations relating to these matters.

 Temporary regulations section 1.1502-20T adds to the consolidated return regulations a general rule that disallows all losses on the disposition by a member of stock of a subsidiary when both are members of the same affiliated group filing consolidated returns (the "loss disallowance rule"). The regulations also provide a number of related rules to ensure the proper application of the loss disallowance rule (e.g., a "basis reduction" rule that applies on deconsolidation of stock of a subsidiary and an "anti-stuffing" rule). Also provided is a rule that permits reattribution of a subsidiary's (or lower-tier subsidiary's) losses to the common parent to the extent, if any, of the loss disallowed to the selling member on the sale of the subsidiary's stock. These rules generally apply with respect to dispositions occurring on or after March 9, 1990.

 Temporary regulations section 1.337(d)-1T adds a transition rule that generally disallows loss on the disposition by a member of a subsidiary's stock if the subsidiary became a member of the group after January 6, 1987, and if the disposition is not subject to section 1.1502-20T, but permits the loss to the extent the selling member establishes that the loss is not attributable to the recognition of "built-in gain" on the disposition of assets owned, directly or indirectly, by the subsidiary.

 These temporary regulations implement Notice 87-14, 1987-1 C.B. 445, in which the Internal Revenue Service announced its intention to publish regulations that would, in effect, prevent utilization of the investment adjustment rules of sections 1.1502-32 and 1.1502-33(c) (the "investment adjustment rules") to circumvent the repeal of the General Utilities doctrine by the Tax Reform Act of 1986 (the "1986 Act"). The loss disallowance rule of section 1.1502-20T also addresses another problem by preventing a subsidiary's losses from being duplicated as investment losses of the parent when the parent disposes of the subsidiary's stock.

B. THE INVESTMENT ADJUSTMENT RULES AND GENERAL UTILITIES REPEAL

1. THE INVESTMENT ADJUSTMENT RULES

 The investment adjustment rules are designed to prevent income or loss that has been recognized at the subsidiary level from again being recognized as investment gain or loss by the subsidiary's parent upon disposition of the subsidiary's stock. This is generally accomplished by requiring positive or negative adjustments to the basis of the subsidiary's stock owned by members of the group to reflect the increase or decrease in value of the subsidiary resulting from income or loss that has been taken into account by the group.

EXAMPLE 1. Corporation P forms corporation S by transferring $100 cash to S in exchange for all of S's stock. P and S elect to file consolidated returns. S earns $50 during the next 5 years, which is included in the consolidated taxable income of the P group. Under the investment adjustment rules, P's basis in its S stock is increased by $50. Thus, if P sells S for $150 at the end of Year 5, the P group does not recognize any further gain or loss.

Without the increase to the basis of the S stock provided under the investment adjustment rules, the P group would, in effect, recognize S's $50 of income twice, once when it was earned by S and again as an investment gain when P sold the S stock.

2. THE GENERAL UTILITIES DOCTRINE

 In general, income earned by a corporation is taxed twice, once to the corporation when the income is earned and a second time to the corporation's shareholders when the earnings are distributed. For many years, the General Utilities doctrine provided an exception to this two-level system of taxation. Under this doctrine, which takes its name from General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935), corporations were not required to recognize gain or loss when they distributed appreciated or depreciated property to their shareholders, either in liquidation or simply as a part of ongoing operations (e.g., as a dividend), or when they sold the property and distributed the proceeds in liquidation. Subject to certain exceptions, this doctrine permitted the permanent elimination of corporate-level tax on the disposition of appreciated assets because the transferee received a fair market value basis in the assets as they left corporate solution, despite the fact that no corporate-level tax had been paid on the appreciation. The General Utilities doctrine was codified in sections 311, 336 and 337 of the Internal Revenue Code of 1954.

3. REPEAL OF THE GENERAL UTILITIES DOCTRINE

 The scope of the General Utilities doctrine was restricted by a series of amendments beginning in 1969 (relating generally to non- liquidating distributions governed by section 311) and the doctrine was ultimately repealed by the 1986 Act, which amended sections 336 and 337 to require, with limited exceptions, that corporations recognize gain or loss when property is distributed in liquidation or sold in connection with a liquidation.

 The legislative history of the 1986 Act indicates that the principal reason for the repeal of the General Utilities doctrine was that it tended to undermine the corporate income tax because "[u]under normally applicable tax principles, nonrecognition of gain is available only if the transferee takes a carryover basis in the transferred property, thus assuring that a tax will eventually be collected on the appreciation." H.R. Rep. No. 99-426, 99th Cong., 1st Sess. 282 (1985). See also H.R. Conf. Rep. No. 99-841, 99th Cong., 2d Sess. II-202 (1986), which states as the rationale for continuing tax-free treatment under section 332 for liquidating distributions of assets of controlled subsidiaries that, because the carryover basis rules apply, "the corporate level tax will be paid if the distributed property is disposed of by the recipient corporation to a person outside of the group."

 Thus, it is clear that the principal purpose for the repeal of the General Utilities doctrine was to require the payment of a corporate-level tax in a transaction that results in a stepped-up basis to the new owner.

4. RESULTS UNDER INVESTMENT ADJUSTMENT RULES CONFLICT WITH GENERAL UTILITIES REPEAL IN SOME CASES

 The investment adjustment rules reflect the application of the General Utilities doctrine and can therefore be used to obtain a stepped-up basis in corporate assets without the payment of corporate-level tax.

EXAMPLE 2. Corporation S has one asset with a basis of $0 and a value of $100. Corporation P buys all the stock of S for $100 and P and S elect to file consolidated returns. S then sells the asset for $100 and recognizes gain of $100. Under the investment adjustment rules, P's basis in the stock of S is increased to $200 because the sale of the asset generated $100 of earnings and profits to S. This basis increase permits P to recognize a loss of $100 if P sells the S stock, thus offsetting the gain on the sale of the asset.

The increase in the basis of P's stock in S is inconsistent with the repeal of the General Utilities doctrine. The failure to require the P group to fully account for S's recognized built-in gain in effect permits the elimination of corporate-level tax on this gain, because the increase in P's basis for the S stock is attributable to S's recognition of built-in gain (gain already reflected in P's cost basis for the S stock) and not to earnings that increase S's value. Moreover, P's loss does not represent an economic loss of either P or S.

 Although the taxpayer that sold the S stock to P may have recognized gain on the sale that corresponded to S's built-in gain, if the taxpayer was not a corporation, no corporate-level tax would have been paid in connection with the basis step up. However, even if the seller was a corporation, transferee taxpayers generally are not given credit for tax on gain recognized by unrelated transferor taxpayers.

 The problem is not limited to dispositions of built-in gain assets, but also arises when built-in gain assets are consumed.

EXAMPLE 3. The facts are the same as in Example 2, except that S uses the asset in business operations rather than selling it. The asset earns $20 and declines in value by $20 in each year over a 5-year period. As in Example 2, P's basis in the stock of S is increased by the earnings to $200, but the value of S remains $100 and P may recognize a loss of $100 if P sells the S stock.

 In Examples 2 and 3, disallowing P's $100 loss eliminates the possibility that investment adjustments caused by S's recognition of built-in gain, whether from dispositions or operations, will result in elimination of the gain. Disallowing P's loss therefore gives effect to General Utilities repeal by assuring that a corporate-level tax will be imposed on S's recognized built-in gain.

C. LOSS DUPLICATION

 In addition to resolving the problems created under the investment adjustment rules by General Utilities repeal, the loss disallowance rule also resolves a problem involving the duplication of losses. Under current rules, there are several situations in which a loss may be duplicated by a parent and its subsidiary.

EXAMPLE 4. Corporation P forms subsidiary S with a contribution of $100 and P and S elect to file consolidated returns. S has an operating loss of $60. The group is unable to use the loss and it becomes a consolidated net operating loss carryover attributable to S. P sells S for $40. A special adjustment under section 1.1502-32(b)(1)(ii) prevents S's unused $60 loss from reducing P's $100 basis in its S stock. Accordingly, P recognizes a $60 loss on the sale of S. P's $60 loss reflects P's economic loss on its investment in S (P contributed $100 to S and sold it for $40 without using S's inside loss on its consolidated return). S's loss carryover is apportioned to S for use after leaving the P group (subject to any limitation imposed by section 382 or otherwise). P's loss on the sale of the S stock is therefore duplicated when S uses its loss after leaving the P group.

 This duplication may be offset at a later date. If S uses its loss carryover in the consolidated return of another group (P1), the use reduces the basis of S's stock in the hands of P1 under section 1.1502-32(b)(2)(ii). As a result of this reduction, there is a potential offsetting gain if P1 sells the S stock. However, in some circumstances P1 may use self-help measures to postpone recognition of the gain indefinitely (by retaining the S stock) or to avoid recognition of the gain altogether (by liquidating S or by selling the S stock and electing deemed asset sale treatment under section 338(h)(10)).

 Loss duplication also occurs in Example 4 if S uses the $100 contributed by P to purchase an asset and the asset declines in value by $60. Because the loss is unrealized, it is not reflected in S's earnings and profits and P's basis in its S stock therefore remains $100. When P sells the S stock to P1, it recognizes a $60 loss. S later recognizes a loss of $60 when it sells the built-in loss asset. Although P1 must reduce the basis of S's stock when the loss is used, establishing the potential for an offsetting gain if P1 sells the stock, once again P1 can use self-help measures to postpone or totally avoid recognizing the gain by retaining the S stock indefinitely, by liquidating S or by selling the S stock in a transaction in which section 338(h)(10) is elected.

 Duplication of gain can also occur under the current rules. If an asset of S simply increases in value by $60, P will recognize $60 of gain when it sells the S stock to P1 and S will recognize $60 of gain when it subsequently sells the asset. When S sells the asset, P1 basis in its S stock is increased by $60, thereby establishing the potential for an offsetting loss if P1 sells the S stock. In contrast to the two loss duplication situations, however, P1 has no incentive to avoid recognizing this loss because recognizing the loss eliminates gain duplication.

 As noted, duplication of gain and loss can be avoided under the current rules if S's assets, rather than its stock, are sold either by S or by P after a liquidation of S) or if the P group and P1 elect deemed asset sale treatment under section 338(h)(10). Because the structure of many transactions is generally elective as between stock sales and asset sales (or stock sales treated as asset sales), taxpayers will often be able to use these self-help measures to avoid duplication of gain, but will avoid using them in order to preserve duplication of loss. Disallowing loss on P's sale of the S stock eliminates this selective duplication of loss.

D. APPROACHES NOT ADOPTED

 Notice 87-14 announced that the investment adjustment rules would be amended to "prevent recognition of losses that are attributable to the subsidiary's recognition of built-in gains." Implementation of Notice 87-14 requires either a rule that would eliminate positive basis adjustments of the type illustrated in Examples 2 and 3 or a rule that would disallow losses resulting from such adjustments.

 Following the publication of Notice 87-14, the Treasury Department and the Service undertook an intensive study of the various methods for reconciling the results under the consolidated return regulations with the intent of Congress in repealing the General Utilities doctrine. The study also took into account the effect of each method on the problem of loss duplication.

1. TRACING

 The most accurate method of eliminating losses resulting from the recognition of built-in gain would be to eliminate positive basis adjustments under the investment adjustment rules when those adjustments are from earnings attributable to the recognition of built-in gain and to reduce stock basis if a distribution of current earnings and profits is attributable to such gain. This method is commonly referred to as "tracing."

 The theoretical accuracy that would be achieved by tracing is undermined, however, by the fact that it would impose tremendous administrative burdens on both taxpayers and the Service. In order to determine the extent of built-in gain or loss in each asset, all assets and liabilities of an acquired subsidiary (and of any lower tier subsidiaries) would have to be appraised at the time the subsidiary's stock is acquired. Furthermore, each asset with built-in gain or loss would have to be traced to determine the extent to which the built-in gain or loss was recognized while the group held the stock of the subsidiary. Although appraisals and tracing might be relatively simple in a few cases (e.g., when the acquired subsidiary has only one asset or relatively few assets), most cases would present extremely difficult problems because of the number and nature of the assets held by the acquired subsidiary.

 Tracing involves other burdens in addition to requiring taxpayers to appraise assets and trace their disposition. For example, by using up or wearing out an asset in the process of earning income, the subsidiary is, in effect, disposing of the asset in exchange for the income. Accordingly, if the subsidiary, rather than selling a built-in gain asset, uses it in its business, the wearing out or obsolescence of the asset must be matched with the earnings generated by its use. In practice, to restrict basis adjustments to those derived from the subsidiary's earnings that are not related to the effective disposition of built-in gain assets, it would be necessary to appraise the subsidiary's assets, mark their bases to market (for earnings and profits purposes), and depreciate those bases over the assets' remaining economic life (also for earnings and profits purposes). Recurring appraisals may be required to deal with creeping acquisitions and fluctuations in the value of assets.

 The possibility of adopting a tracing rule, but limiting the tracing of assets to a particular period was rejected because it would fail to prevent the elimination of corporate-level tax on income earned from the sale or operation of corporate assets.

 Because of the administrative burdens that tracing would place on both taxpayers and the Service and because tracing relies heavily on accurate appraisals, tracing was rejected as a solution to the problems presented by the repeal of the General Utilities doctrine.

2. BUILT-IN GAIN PRESUMPTIONS

 A simpler, but less accurate, method of preventing the investment adjustment rules from eliminating corporate-level tax would be to create a presumption concerning the extent to which a subsidiary's recognized gain is built-in gain and to eliminate positive adjustments to the basis of the subsidiary's stock to that extent. The presumption would be irrebuttable because the ability to rebut the presumption would entail tracing and its administrative burdens.

 For example, such a presumption might apply to disallow positive adjustments for 50 percent of the subsidiary's post-acquisition income, up to the amount of its built-in gain. If this were the rule, a subsidiary that had $50 or more of built-in gain and $100 of post- acquisition income would be permitted positive adjustments, for earnings and profits purposes, of only $50. The presumption would not necessarily have to relate to all post-acquisition income. It could instead apply to a percentage of all gains recognized on dispositions of assets by the subsidiary or be restricted to extraordinary dispositions of assets.

 Adoption of any presumption produces the correct result only if the actual facts correlate with the facts presumed -- for example, if 50 percent of a subsidiary's $100 of post-acquisition income is in fact from the disposition or consumption of built-in gain assets. If the facts do not correlate -- for example, if all $100 of a subsidiary's post-acquisition income represents operating income not attributable to built-in gain or, on the other hand, operating income entirely attributable to built-in gain -- the basis of the subsidiary's stock would increase by $50 in both cases, but its value would increase by either $100 (where all of the income was not attributable to built-in gain) or $0 (where all of the income was attributable to built-in gain). Thereafter, if the stock of the subsidiary is sold for its fair market value, there will either be a $50 gain, in which case $50 of the subsidiary's income will have been taxed twice, or a $50 loss, in which case $50 of the subsidiary's income will not have been taxed at all. Thus, a presumption rule would impose harsh results in some cases while failing to prevent the elimination of corporate-level tax in other cases.

 Other presumption rules were also considered, but rejected. For example, a presumption based on the amount of net built-in gain at the time a subsidiary is acquired would permit the elimination of corporate-level tax where the built-in gain actually recognized exceeds the built-in loss actually recognized by more than the amount of the net built-in gain. On the other hand, a presumption based on gross built-in gain would prevent the elimination of corporate-level tax in all cases, but would amount to an unduly harsh restriction of positive basis adjustments in many cases.

3. TRACING/PRESUMPTION COMBINATIONS

 Several approaches involving the combination of tracing with some form of presumption rule were determined to be unsatisfactory because of the degree of inaccuracy involved in any presumption rule and because of concern that the availability of tracing as an alternative would effectively require taxpayers to compare results, thereby compounding the complexity and administrative burdens occasioned by a pure tracing rule.

4. LOSS DISALLOWANCE COMBINED WITH TRACING (LOSS LIMITATION)

 Consideration was also given to adopting a loss disallowance rule (discussed below), but permitting taxpayers to avoid disallowance of their losses by establishing that the loss was not attributable to investment adjustments resulting from the recognition of built-in gain in the subsidiary's assets. This approach, referred to as the loss limitation approach, was rejected because it was concluded that taxpayers, in order to take advantage of the rule, would b forced to resort to tracing, with all of its attendant complexity and administrative burdens for both taxpayers and the Service.

5. SUMMARY

 Each of the approaches discussed above presents either significant administrative burdens for taxpayers and the Service or permits an unacceptable level of elimination of corporate-level tax. In addition, none of these approaches addresses the problem of loss duplication.

E. THE LOSS DISALLOWANCE RULE

 The regulations retain the present investment adjustment rules, but disallow any loss on the sale or other disposition by a member of the stock of a subsidiary. This loss disallowance rule eliminates the possibility that gain recognized on the disposition or consumption of an acquired subsidiary's built-in gain assets can be offset by a loss at the parent level created by an investment adjustment caused by the subsidiary's recognition of built-in gain, as in Examples 2 and 3. The rule therefore assures the imposition of a corporate-level tax on the subsidiary's recognized built-in gains.

 The loss disallowance rule also prevents losses of the subsidiary (either unrealized losses or realized losses that have not been utilized by the group) from being duplicated as investment losses of the parent when the parent disposes of the subsidiary's stock. Although it can be argued that it is inappropriate to address the problem of loss duplication only as it relates to consolidated returns because the problem also occurs in the context of separate returns, this argument ignores the fact that the consolidated return regulations adopt a comprehensive approach to gain and loss duplication that represents a fundamental departure from separate return treatment. For example, the double taxation of a subsidiary's earnings in separate return situations has never been advanced as a rationale for not resolving the problem in the context of consolidated returns.

1. EFFECT OF LOSS DISALLOWANCE RULE ON POST-ACQUISITION GAIN

 Although the loss disallowance rule disallows all loss on the sale of a subsidiary's stock by a member, it has no impact in situations in which basis increases resulting from the recognition of built-in gain do not create (or contribute to) an overall loss on the sale. This aspect of the rule will in many cases permit the parent to shelter post-acquisition appreciation in stock of an acquired subsidiary.

EXAMPLE 5. Corporation S has two assets, one with a basis of $0 and a value of $100 and the other with a basis and value of $0. P buys all the stock of S for $100 and P and S elect to file consolidated returns. S sells the first asset for $100. The second asset appreciates in value to $100. P then sells the S stock for $200. Because P's basis in its S stock was increased from $100 to $200 as a result of the sale of the first asset, P has no gain or loss on the sale of S's stock.

 In Examples 2 and 3, the basis increase resulting from S's recognition of built-in gain created a loss on P's sale of the S stock that would, but for the operation of the loss disallowance rule, offset the gain recognized by S. In Example 5, because of the post-acquisition increase in value of the second asset, the basis increase does not create a loss, but instead shelters P's investment gain on the sale of the S stock.

 There is, however, a crucial distinction between Examples 2 and 3, and Example 5. In Examples 2 and 3, permitting the basis increase resulting from S's recognition of built-in gain to create a loss on P's sale of the S stock would mean that a corporate-level tax would NEVER be collected with respect to the gain realized by S (because the purchaser would take a stepped-up basis in the S assets). In Example 5, however, the investment gain that is not taxed to P on the sale of S's stock is a duplication of gain that remains preserved in the low basis of S's second asset. Thus, the loss disallowance rule would permit the elimination of gain on the sale of the S stock that would be duplicated when S sells its assets.

 To prevent taxpayers from aligning post-acquisition gain with loss otherwise subject to disallowance, the regulations provide an "anti-stuffing" rule that prevents avoidance of potential loss on the sale of a subsidiary's stock through the transfer of built-in gain assets to increase the value of the stock. The rule applies only to assets transferred to a subsidiary by any member of the group within the two years preceding the group's disposition of the subsidiary's stock.

2. EFFECT OF LOSS DISALLOWANCE RULE ON POST-ACQUISITION LOSS

 As previously discussed, the investment adjustment rules were designed to prevent "inside" gain or loss on the disposition of a subsidiary's assets from being duplicated as "outside" gain or loss when the group disposes of the subsidiary's stock. However, the present rules do not eliminate this duplication when the group recognizes its outside gain or loss (by selling the subsidiary's stock) before the subsidiary recognizes its inside gain or loss (by selling its assets).

 The loss disallowance rule eliminates loss duplication. It also eliminates gain duplication in situations such as Example 5, in which basis adjustments resulting from the recognition of built-in gain by the subsidiary provide shelter for the parent if it sells the subsidiary's stock before the subsidiary recognizes post-acquisition appreciation in its assets. This results in an exception to the general rule that gain or loss is recognized when a taxpayer liquidates its investment (such as when P sells the S stock in Examples 4 and 5). This exception is necessary to avoid the complexities and administrative burdens of tracing. In these cases, the recognition of post-acquisition gain or loss is deferred until the subsidiary disposes of the assets.

 Because taxpayers are generally free to arrange their affairs to minimize the tax cost, they have an incentive to structure their transactions to preserve the deferral of post-acquisition gain permitted by the loss disallowance rule. This does not mean, however, that the benefit of post-acquisition loss must also always be deferred. The selling group may be able to elect deemed asset sale treatment under section 338(h)(10) on the sale of a subsidiary. Under section 338(h)(10), the group's stock sale is ignored and its gain or loss is determined by reference to the gain or loss inherent in the subsidiary's assets. Thus, although the loss disallowance rule does not permit a stock loss to duplicate the unrealized loss in a subsidiary's assets, the selling group may nevertheless realize the tax benefit of this unrealized loss through a section 338(h)(10) election.

 The selling group may also avoid the effect of the loss disallowance rule by causing the subsidiary to sell assets reflecting post-acquisition loss or built-in loss and using the losses on the group's consolidated return. If losses have been recognized but not used, the temporary regulations provide a special rule which permits the common parent of the group to retain such losses of the subsidiary (or of any lower-tier subsidiary) to the extent loss is disallowed on the sale of the subsidiary's stock. Thus, recognized losses may be retained by the selling group or apportioned to the subsidiary that is sold, at the election of the common parent. This provides the group additional flexibility to avoid the effects of the loss disallowance rule, for example, in situations where selective sales of the subsidiary's loss assets or the election of deemed asset sale treatment under section 338(h)(10) is not desirable or feasible.

3. LOSS OF BUILT-IN GAIN

 In arriving at the decision to adopt a loss disallowance rule, the Treasury Department and the Service considered cases in which a group has an economic loss on its investment in a subsidiary because built-in gain in the subsidiary's assets has been "lost" as a result of a decline in the value of the assets.

EXAMPLE 6. Corporation S has one asset with a basis of $0 and a value of $100. Corporation P buys all the stock of S for $100 and P and S elect to file consolidated returns. S's asset declines in value and is sold for $0. Because S's sale of its asset results in no gain or loss, P's basis in S remains $100. P then sells S for $0 and recognizes a loss of $100. The loss is disallowed by the loss disallowance rule.

 It may be argued that P's loss should not be disallowed in this case, because there is no possibility for S to duplicate the loss, as in Example 4, and there are no self-help techniques available to P. To provide this exception in a case where S has multiple assets, however, it would be necessary to require P to show that its loss on the sale of S is attributable to a decline in the amount of S's built-in gain and not a decline in value that could allow S to claim a loss. Thus, the exception would require tracing and would also entail ordering rules that would produce arbitrary results.

 In any case, the decline in the value of built-in gain assets provides the potential for eliminating corporate-level tax, as illustrated by the following example.

EXAMPLE 7. The facts are the same as in Example 6, except that, although the asset declines in value to $0, S earns $100 not attributable to built-in gain. The $100 of earnings causes P's basis in S to increase to $200. P then sells S for $100 and recognizes a $100 loss, which is disallowed by the loss disallowance rule.

In Example 7, P's $100 loss, if not disallowed, would offset S's $100 of income on the P group's consolidated return. From P's point of view, the result in Example 7 is the same as the results in Examples 2 and 3. In each case, P buys S for $100, receives a $100 basis increase because of S's $100 of income and recognizes a $100 loss on the sale of the S stock. In each case, S's $100 of income will permanently escape corporate-level taxation unless P's loss is disallowed.

 Thus, Example 7 closely resembles Examples 2 and 3. In fact, many cases that appear to be Example 7 cases are in reality Example 3 cases. These are cases in which built-in gain that appears to have been "lost," as in Example 6, has been converted into income, as in Example 3. In view of the above, it was decided not to adopt an exception to the loss disallowance rule for cases involving the loss of built-in gain.

F. TRANSITION RULE

 Notice 87-14 stated that the regulations dealing with the effect of built-in gains on investment adjustments "will be effective with respect to stock in a target that was acquired after January 6, 1987." Notice 87-14 anticipated the issuance of regulations under the authority of section 337(d), which gives the Treasury Department broad authority to prevent circumvention of General Utilities repeal. The Treasury Department and the Service believe that transitional relief is warranted because Notice 87-14 did not describe the loss disallowance rule that is adopted in these regulations.

 Accordingly, section 1.337(d)-1T provides a loss limitation rule that applies with respect to stock of corporations that became members of a group after January 6, 1987, ("transitional subsidiaries") if the stock is disposed of and temporary regulations section 1.1502-20T does not apply with respect to the disposition. This rule disallows loss on the disposition of stock of a transitional subsidiary except to the extent the taxpayer establishes that the loss is not attributable to basis increases resulting from the recognition of built-in gain by the subsidiary.

G. EXPLANATION OF PROVISIONS -- PROSPECTIVE RULES

1. LOSS DISALLOWANCE RULE

 No deduction is allowed for any loss recognized by a member with respect to the disposition of stock of a subsidiary. The rule does not affect the use by the group of "inside" losses of the subsidiary, such as operating losses. There is an exception to the rule to the extent the member recognizes gain in the same transaction with respect to stock of the same subsidiary.

2. BASIS REDUCTION ON DECONSOLIDATION

 The basis of a subsidiary's stock is reduced to its fair market value immediately before the subsidiary's stock is deconsolidated. Stock is treated as deconsolidated when it is no longer owned by a member of any consolidated group of which the subsidiary is also a member.

 The basis reduction rule complements the loss disallowance rule by eliminating loss that is built into the basis of the subsidiary's stock immediately before the stock ceases to be subject to the loss disallowance rule. For example, assume that a group sells 25 percent of a subsidiary's stock to a nonmember, thus disaffiliating the subsidiary. The group has a built-in loss in the subsidiary's stock that it continues to own, but because the stock is no longer subject to the loss disallowance rule, the basis of the stock is reduced to its fair market value to eliminate the loss.

 A special rule applies in cases in which the basis of stock of a subsidiary is reduced, and the group realizes a loss on the disposition of the Stock within 2 years after the basis reduction. The taxpayer must attach a statement to the return for the year of the disposition, disclosing the amount realized and the amount of loss on the disposition. If the statement is not attached to the return, no deduction is allowed for any loss claimed on the disposition.

3. ANTI-STUFFING RULE

 As described above in the general discussion of the loss disallowance rule, basis increases in the stock of a subsidiary resulting from the disposition or consumption of built-in gain assets can have the effect of deferring tax on unrealized post-acquisition gain of the subsidiary's assets when the subsidiary's stock is sold. The regulations contain an anti-stuffing rule to prevent a group from creating a comparable benefit by transferring appreciated property to a subsidiary and thereby avoiding the impact of the loss disallowance rule on the sale of the subsidiary's stock.

4. EARNINGS AND PROFITS AND INVESTMENT ADJUSTMENTS

 The regulations clarify that the earnings and profits of a member are reduced by the amount of a loss on the sale of a subsidiary's stock, even though the loss is disallowed.

 The regulations also provide that a member's earnings and profits are reduced by the amount of the basis reduction required on the deconsolidation of stock of a subsidiary. This rule is needed because the basis reduction eliminates a future recognition of the loss (and the associated future reduction in earnings and profits).

 Under the investment adjustment rules, these reductions in earnings and profits tier up and cause disallowed losses and basis reductions on deconsolidation to be reflected as reductions in the basis of higher tier members. Special rules are provided to prevent investment adjustments in situations where they would overlap with basis reductions under section 1.1502-20T.

 The regulations also make clear that, for purposes of the consolidated return regulations, a basis reduction under section 1.1502-20T is treated as an investment adjustment under section 1.1502-32(e). Thus, any consolidated return rule that applies to investment adjustments also is applicable to basis reductions under section 1.1502-20T. For example, a member's basis reduction account under section 1.1502-32T is determined by taking into account the net negative adjustments under section 1.1502-32(e)(1) for all consolidated return years. Accordingly, any basis reduction in the member's stock under section 1.1502-20T would be treated as a section 1.1502-32(e)(1) adjustment for purposes of determining the amount of the basis reduction account.

5. ELECTION TO RETAIN LOSSES OF SUBSIDIARY

 A common parent may elect to reattribute to itself the portion of a consolidated loss carryover attributable to a subsidiary (or to a lower-tier subsidiary) that is leaving the group. If the election is made, the carryover is not apportioned to the subsidiary under section 1.1502-7g. Instead, it remains part of the consolidated net operating loss or net capital loss of the group. This special rule applies only to the extent that a member is otherwise subject to loss disallowance with respect to the subsidiary's stock and the losses are not from separate return limitation years.

 The common parent may elect to identify particular losses of a subsidiary (or lower tier subsidiary) to retain, notwithstanding their character or the year in which they arose. Retained losses may not be carried back to any prior taxable year of the common parent.

 Solely for the purpose of the investment adjustment rules, a loss that is reattributed to the common parent is treated as absorbed by the subsidiary (or lower tier subsidiary), thereby causing a reduction in the stock basis and earnings and profits of the subsidiary whose losses are reattributed. These adjustments reduce the members' stock basis and earnings and profits to reflect the loss. The adjustments reduce or eliminate the member's loss on the disposition of the subsidiary's stock, thus reducing or eliminating the impact of the loss disallowance rule on the disposition.

6. EFFECTIVE DATES

 The loss disallowance rule and the basis reduction on deconsolidation apply with respect to stock disposed of or deconsolidated on or after March 9, 1990. The anti-stuffing rule applies only with respect to transfers of assets on or after that date.

H. EXPLANATION OF PROVISIONS -- TRANSITION RULES

1. LOSS LIMITATION RULE

 Temporary regulations section 1.337(d)-1T disallows a deduction for any loss recognized by a member with respect to the disposition of stock of a transitional subsidiary (or any subsidiaries that are higher-tier subsidiaries with respect to the transitional subsidiary), except to the extent the taxpayer establishes that the loss is not attributable to the recognition of built-in gain. A transitional subsidiary is any corporation that became a subsidiary in the group after January 6, 1987.

2. EFFECTIVE DATE

 Section 1.337(d)-1T does not contain provisions comparable to the basis reduction rules of temporary regulations section 1.1502-20T. The loss limitation rule therefore applies with respect to dispositions occurring after January 6, 1987, of stock of a transitional corporation (or any equity interest the basis of which is determined, directly or indirectly, in whole or in part, by reference to the basis of stock of a transitional corporation), but only if the disposition is not subject to section 1.1502-20T.

I. ADDITIONAL RELIEF

 Losses disallowed by the temporary regulations may in some instances include economic losses in circumstances in which the taxpayer cannot utilize the self-help measures described above (or other self-help measures) to obtain deductions for the losses. The Treasury Department and the Service invite comments from taxpayers and professional groups as to appropriate circumstances for additional relief under the temporary regulations, possibly including, for example, rare and unusual circumstances in which relief would be appropriate and could be provided without heavy administrative burdens.

 The Treasury Department and the Service also invite comments on whether the relief for cases in which the loss is related to gain taken into account in the same transaction should be extended to other situations.

J. CONSIDERATION OF ANTI-BREAKUP RULE

 The Treasury Department and the Service recognize that the ability to shelter post-acquisition gain that is inherent in the loss disallowance rule might be used to facilitate corporate breakups. This is because, in many cases, the assets of a breakup target that are intended to be sold reflect separate market values not fully reflected in the price paid for the target. Although the temporary regulations do not include an anti-breakup rule, serious consideration is being given to adopting some form of anti-breakup rule in the final regulations. The rule would prevent the sheltering of post-acquisition gain when a target is disposed of within 2 years after its stock is acquired by the group. To provide such a rule without the complexity of tracing may require eliminating the net positive adjustments with respect to the target stock (and the effect of distributions of earnings and profits that do not reduce basis). It is intended that the anti-breakup rule would apply on a retroactive basis from the effective date of section 1.1502-20T.

 Public comment is invited concerning the need for an anti- breakup rule, the form such a rule might take and whether or not such a rule should be retroactive.

SPECIAL ANALYSIS

 It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It is hereby certified that these rules do not have a significant impact on a substantial number of small entities. The rules will primarily affect affiliated groups of corporations filing (or required to file) consolidated returns, which tend to be larger businesses. It will not significantly alter the reporting or recordkeeping duties of small entities. Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. Chapter 6) is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking for the regulations was submitted to the Administrator of the Small Business Administration for comment on their impact on small business.

DRAFTING INFORMATION

 The principal author of these regulations is Mark S. Jennings of the Office of Assistant Chief Counsel (Corporate), Internal Revenue Service. However, other personnel of the Internal Revenue Service and the Treasury Department participated in their development.

LIST OF SUBJECTS

26 CFR 1.301-1 through 1.383-3

 Corporate adjustments, Corporate distributions, Corporations, Income taxes, Reorganizations.

26 CFR 1.1501-1 through 1.1564-1

 Income taxes, Controlled group of corporations, Consolidated returns.

Treasury Decision 8294

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR Chapter I, Part 1 is amended as follows:

PART 1-INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1986

Paragraph 1. The authority citation for Part 1 is amended by adding the following citations:

Authority: 26 U.S.C. 7805; * * * section 1.337(d)-1T also issued under 26 U.S.C. 337 (d) * * * section 1.1502-20T also issued under 26 U.S.C. 337 (d) and 1502.

Par. 2. New section

(iii) "Built-in gain" of a transitional subsidiary means any excess of value over basis, determined immediately before the transitional subsidiary became a subsidiary, with respect to any asset (including stock) --

Par. 4. Section 1.1502-12 is amended by adding at the end a new paragraph (r) to read as follows:

SECTION 1.1502-12 SEPARATE TAXABLE INCOME.

* * * * *

(r) CROSS-REFERENCE TO TEMPORARY REGULATIONS. For rules relating to loss disallowance or basis reduction on the disposition or deconsolidation of stock of a subsidiary, see sections 1.337(d)-1T and 1.1502-20T.

Par. 5. New section 1.1502-20T is added under the heading "Computation of Separate Taxable Income"" to read as follows:

SECTION 1.1502-20T DISPOSITION OR DECONSOLIDATION OF SUBSIDIARY STOCK (TEMPORARY).

(a) GENERAL RULES -- (1) LOSS DISALLOWANCE RULE. No deduction is allowed for any loss recognized by a member with respect to the disposition of stock of a subsidiary.

(2) EXCEPTION. Paragraph (a)(1) of this section does not apply to the extent gain is recognized (but not deferred) in the same transaction by the member with respect to stock of the same subsidiary, or was recognized by any member with respect to stock of the same subsidiary in a prior transaction and is taken into account in the transaction.

(3) DISPOSITION. "Disposition" means any event in which gain or loss is recognized, in whole or in part.

(4) EXAMPLES. For purposes of the examples in this section, unless otherwise stated, the group files consolidated returns on a calendar year basis, and the facts set forth the only corporate activity. Unless otherwise stated, all sales and purchases are with unrelated buyers or sellers. The basis of each asset is the same for determining earnings and profits adjustments and taxable income. Tax liability and its effect on basis, value, and earnings and profits are disregarded. "Investment adjustment system" means the rules of sections 1.1502-32 and 1.1502-33 (c). The principles of this paragraph (a) are illustrated by the following examples:

EXAMPLE (1). LOSS ATTRIBUTABLE TO RECOGNIZED BUILT-IN GAIN. P buys all the stock of T for $100, and T becomes a member of the P group. T has an asset with a basis of $0 and a value of $100. T sells the asset for $100. Under the investment adjustment system, P's basis in the T stock increases to $200. Five years later, P sells all the stock of T for $100 and recognizes a loss of $100. Under paragraph (a)(1) of this section, no deduction is allowed to P for the $100 loss.

EXAMPLE (2). EFFECT OF POST-ACQUISITION APPRECIATION. P buys all the stock of T for $100, and T becomes a member of the P group. T has an asset with a basis of $0 and a value of $100. T sells the asset for $100. Under the investment adjustment system, P's basis in the T stock increases to $200. T reinvests the proceeds in an asset that appreciates in value to $180. Five years later, P sells all the stock of T for $180 and recognizes a $20 loss. Under paragraph (a)(1) of this section, no deduction is allowed to P for the $20 loss.

EXAMPLE (3). DISALLOWANCE OF DUPLICATED LOSS. P forms S with a contribution of $100 in exchange for all the shares of S stock, and S becomes a member of the P group. S has an operating loss of $60. The group is unable to use the loss, and the loss becomes a consolidated net operating loss carryover attributable to S. Five years later, P sells the stock of S for $40, recognizing a $60 loss. Under paragraph (a)(1) of this section, P's $60 loss on the sale of the S stock is disallowed. (See paragraph (f) of this section for the elective reattribution of S's $60 net operating loss to P in connection with the sale.)

EXAMPLE (4). DEEMED ASSET SALE ELECTION. (i) P forms S with a contribution of $100 in exchange for all the S stock, and S becomes a member of the P group. S buys an asset for $100, and the value of the asset declines to $40. P sells all the stock of S to P1 for $40. Under paragraph (a)(1) of this section, P's $60 loss on the sale of the S stock is disallowed.

(ii) If P and P1 instead elect deemed asset sale treatment under section 338(h)(10), T is treated as selling all of its assets, and no loss is recognized by P on its sale of the T stock. As a result of the recharacterization of the stock sale as an asset sale, the $60 loss in the asset is recognized. Under the section 338(h)(10) regulations, T is treated as liquidating into P following the deemed asset sale, and the $60 loss is inherited by P.

EXAMPLE (5). GAIN AND LOSS RECOGNIZED ON SALE OF STOCK IN ONE TRANSACTION. P, the common parent of a group, owns all 100 shares of the stock of T, with an aggregate basis of $50 in 50 shares and $100 in the other 50 shares. P sells all the stock of T in a secondary offering for $140. P therefore recognizes a gain of $20 on 50 shares and a loss of $30 on the other 50 shares. Under paragraph (a)(2) of this section, the amount of the $30 loss that would be disallowed under paragraph (a)(1) of this section is limited to $10 ($30 reduced by the $20 gain recognized on T stock in the same transaction).

EXAMPLE (6). DEFERRED GAIN AND RECOGNIZED LOSS. P, the common parent of a group, owns all the stock of S and S owns all the stock of T, which has a basis of $100 and a value of $150. S distributes all the T stock to P and recognizes a $50 gain under section 311, which is deferred under section 1.1502-14(c). P later sells all the T stock to a nonmember for $90 and recognizes a loss of $60. Under 1.1502-13(f), the $50 of deferred gain is taken into account on the sale of the T stock to the nonmember. Under paragraph (a)(2) of this section, the amount of the $60 loss disallowed under paragraph (a)(1) of this section is limited to $10 ($60 reduced by the $50 gain recognized on the T stock taken into account in the same transaction).

(b) BASIS REDUCTION ON DECONSOLIDATION -- (1) If a member's basis in a share of stock of a subsidiary exceeds its value immediately before a deconsolidation of the share, the basis of the share is reduced at that time to an amount equal to its value. If both a disposition and a deconsolidation occur with respect to a share in the same transaction, paragraph (a) applies and paragraph (b) does not apply to the share in connection with the transaction.

(2) DECONSOLIDATION. "Deconsolidation" means any event that causes a share of stock of a subsidiary to be no longer owned by a member of any consolidated group of which the subsidiary is also a member.

(3) VALUE. "Value" means fair market value.

(4) DISPOSITIONS WITHIN 2 YEARS AFTER BASIS REDUCTION -- (i) IN GENERAL. If the basis of stock has been reduced under paragraph (b)(1) of this section and a disposition of the stock occurs within 2 years after the date of the basis reduction, a separate statement must be filed with the taxpayer's return for the year of disposition. If the taxpayer fails to file the statement as required, no deduction is allowed for any loss recognized on the disposition.

(ii) CONTENTS OF STATEMENT. The statement required to be filed under this paragraph (b)(4) must disclose with respect to the disposition of stock the amount realized, the amount of the loss on the disposition, and the name and employer identification number (E.I.N.) of the subsidiary whose stock is disposed of.

(5) EXAMPLES. The principles of this paragraph (b) are illustrated by the following examples:

EXAMPLE (1). SIMULTANEOUS APPLICATION OF LOSS DISALLOWANCE RULE AND BASIS REDUCTION RULE TO STOCK OF THE SAME SUBSIDIARY. P forms S with $100 in exchange for all 100 shares of S stock, and S becomes a member of the P group. The value of S declines from $100 to $50, and P sells 60 shares of S stock for $30. The sale causes a deconsolidation of the remaining 40 shares held by P. Under paragraph (b)(1) of this section, P must reduce the basis of the 40 shares of S stock it continues to own from $40 to $20, the value of the shares immediately before the deconsolidation. Although P's disposition of the 60 shares also causes a deconsolidation of these shares, paragraph (b)(1) of this section provides that paragraph (a) of this section applies to the shares that are both sold and deconsolidated in the same transaction. Under paragraph (a)(1), P's $30 loss on the sale of the 60 shares is disallowed.

EXAMPLE (2). DECONSOLIDATION OF SUBSIDIARY STOCK UPON CONTRIBUTION TO A PARTNERSHIP. P buys all the stock of T for $100, and T becomes a member of the P group. P later transfers all the stock of T to partnership M in exchange for a partnership interest in M, in a transaction to which section 721 applies. At the time of the exchange, P's basis in the T stock is $100 and the T stock's value is $75. Under paragraph (b)(1) of this section, the transfer to M causes a deconsolidation of the T stock, and P must reduce its basis in the T stock to $75, the stock's value immediately before the transfer to M. As a result, P has a basis of $75 in its interest in M, and M has a basis of $75 in the stock of T.

EXAMPLE (3). SIMULTANEOUS APPLICATION OF LOSS DISALLOWANCE RULE AND BASIS REDUCTION RULE TO STOCK OF DIFFERENT SUBSIDIARIES. (i) P owns all the stock of S, which in turn owns all the stock of S1, and S and S1 are members of the P group. P's basis in S is $100 and S's basis in S1 is $100. S1 buys all the stock of T for $100, and T becomes a member of the P group. T has an asset with a basis of $0 and a value of $100. T sells the asset for $100. Under the investment adjustment system, S1's basis in T, S's basis in S1, and P's basis in S each increase from $100 to $200. S then sells all the stock of S1 for $100 and recognizes a loss of $100.

(ii) Under paragraph (a)(1) of this section, S's $100 loss on the sale of the stock of S1 is disallowed.

(iii) If S1 and T are not members of a consolidated group immediately after the sale of the stock of S1, the T stock is deconsolidated, and under paragraph (b)(1) of this section, S1 must reduce the basis of the T stock to $100, its value immediately before the sale.

(iv) If S1 and T are members of a consolidated group immediately after the sale of the stock of S1, the T stock is not deconsolidated, and no reduction is required under paragraph (b)(1).

(c) SUCCESSORS -- (1) GENERAL RULE. If a rule of this section applies to the stock of a subsidiary, it also applies to stock or other equity interests in any successor to the subsidiary to the extent necessary to effectuate the purposes of the rule. A successor is any entity the basis of whose equity interests is determined, directly or indirectly, in whole or in part, by reference to the basis of the subsidiary's stock.

(2) EXAMPLE. (i) P, the common parent of a group, buys all the stock of T for $100. T's only asset has a basis of $0 and a value of $100. T sells the asset for $100, and buys another asset for $100. Under the investment adjustment system, P's basis in the T stock increases to $200, and the earnings and profits of P increase by $100. P later transfers all the stock of T to partnership M in exchange for a partnership interest in M, in a transaction to which section 721 applies. Less than two years later, P sells its interest in M for $80.

(ii) Under paragraph (b)(1) of this section, because the stock of T is deconsolidated on the transfer to M, P reduces its basis in the T stock to $100, the amount P determines to be the value of the stock immediately before the transfer. As a result, P has a basis of $100 in its interest in M, and M has a basis of $100 in the T stock.

(iii) When P sells its interest in M for $80, it recognizes a $20 loss. Under paragraph (b)(4) of this section, P is required to file a statement with its return for the year of its disposition of its interest in M in order to deduct its loss. P does not file the required statement. The failure to file the statement described in paragraph (b)(4) results in the disallowance of P's loss on the disposition of its interest in M.

(d) ANTI-STUFFING RULE -- (1) APPLICATION. This paragraph (d) applies if --

(i) A transfer of any asset (including stock) between members is followed by a related direct or indirect disposition of stock of a subsidiary within 2 years after the transfer, and

(ii) The transfer is with a view to avoiding, directly or indirectly, in whole or in part, the disallowance of loss on the disposition (or basis reduction with respect to a deconsolidation prior to the disposition) of, or the recognition of the unrealized gain on, the transferred asset.

(2) BASIS REDUCTION. If this paragraph (d) applies, the basis of the subsidiary's stock disposed of is reduced, immediately before the disposition (or deconsolidation prior to disposition), to cause recognition of gain in an amount equal to the loss disallowance (or basis reduction) or gain recognition otherwise avoided by reason of the transfer.

(3) EXAMPLES. The principles of this paragraph (d) are illustrated by the following examples:

EXAMPLE (1). BASIC STUFFING CASE. (i) In Year 1, P buys all the stock of T for $100, and T becomes a member of the P group. T has an asset with a basis of $0 and a value of $100. T sells the asset for $100. Under the investment adjustment system, P's basis in T increases from $100 to $200. In Year 5, P transfers to T an asset with a basis of $0 and a value of $100 in a transaction to which section 351 applies, with the view described in paragraph (d)(1) of this section. In Year 6, P sells all the stock of T for $200.

(ii) Under paragraph (d)(2) of this section, P must reduce the basis in its T stock immediately before the sale to cause recognition of gain in an amount equal to the loss disallowance otherwise avoided by reason of the transfer. The amount of this basis reduction is $100, causing a $100 gain to be recognized on the sale.

EXAMPLE (2). STACKING RULES. (i) In Year 1, P buys all the stock of T for $100, and T becomes a member of the P group. T has an asset with a basis of $0 and a value of $100. T sells the asset for $100. Under the investment adjustment system, P's basis in the T stock increases from $100 to $200. In Year 5, when the value of the T stock remains $100, P transfers to T an asset with a basis of $0 and a value of $100 in a transaction to which section 351 applies, with the view described in paragraph (d)(1) of this section. Thereafter, the value of the contributed asset declines to $10. In Year 6, P sells all the T stock for $110.

(ii) Because the transferred asset declined in value by $90, the transfer enabled P to avoid the disallowance of loss on the sale of T only to the extent of $10. Under paragraph (d)(2) of this section, P must reduce the basis in its T stock immediately before the sale to cause recognition of gain in an amount equal to the loss disallowance otherwise avoided by reason of the transfer. The amount of this basis reduction is $100, causing a $10 gain to be recognized on the sale.

(iii) Assume, instead, that the transferred asset did not decline in value and that T reinvests the $100 in proceeds from the asset sale in another asset that appreciates in value to $190. In Year 6, P sells T for $290. Because the new asset appreciated in value by $90, the transfer enabled P to avoid the disallowance of loss on the sale of T only to the extent of $10. Under paragraph (d)(2) of this section, P must reduce the basis in its T stock immediately before the sale to cause recognition of gain in an amount equal to the loss disallowance otherwise avoided by reason of the transfer. The amount of this basis reduction is $10, causing a $100 gain to be recognized on the sale.

EXAMPLE (3). CONTRIBUTION OF BUILT-IN LOSS ASSET. (i) In Year 1, P forms S with a contribution of $100 in exchange for all of S's stock, and S becomes a member of the P group. S buys an asset for $100, and the asset appreciates in value to $200. P then buys all the stock of T for $100, and T becomes a member of the P group. T has an asset with a basis of $0 and a value of $100. T sells the asset for $100, and under the investment adjustment system P's basis in the T stock increases from $100 to $200. In Year 5, when the value of the T stock remains $100, P transfers the T stock to S in a transaction to which section 351 applies, with the view described in paragraph (d)(1) of this section. The transfer causes P's basis in S to increase from $100 to $300 and the value of S to increase from $200 to $300. In Year 6, P sells S for $300.

(ii) Under paragraph (d)(2) of this section, P must reduce the basis in its S stock immediately before the sale to cause recognition of gain in an amount equal to the gain recognition otherwise avoided by reason of the transfer. The amount of this basis reduction is $100, causing a $100 gain to be recognized on the sale.

EXAMPLE (4). ABSENCE OF VIEW. (i) In Year 1, P forms S with a contribution of $100, and S becomes a member of the P group. S buys two assets, asset 1 with a basis of $50, which appreciates to $100, and asset 2 with a basis of $50 which declines in value to $0. S sells asset 1 for $100. Under the investment adjustment system, P's basis in S increases from $100 to $150. In Year 5, S transfers asset 2 to P in a transaction to which section 1.1502-14(a) applies, with a view to avoiding disallowance of loss on the subsequent disposition of the S stock. This transfer reduces P's basis in S from $150 to $100. In Year 6, P sells all the stock of S for $100.

(ii) Because the transfer from S to P achieves a result that could have been obtained by other methods that would not have been prevented by this section, the transfer is not with the view described in paragraph (d)(1) of this section. P is in substantially the same position holding asset 2 as it would be if S sold the asset and the resulting loss was available to the P group (either through S or by reattribution under paragraph (f) of this section).

(e) EARNINGS AND PROFITS AND INVESTMENT ADJUSTMENTS -- (1) EFFECT ON EARNINGS AND PROFITS -- (i) GENERAL RULE. For purposes of computing the earnings and profits of a member that owns stock in a subsidiary, any deduction that is disallowed, or any amount by which basis is reduced, under this section is treated as a loss allowed in the tax year in which the disallowance or basis reduction occurs.

(ii) EXAMPLE. (A) In Year 1, P forms S with a contribution of $100, and S becomes a member of the P group. S buys all the stock of T for $100. T has an asset with a basis of $0 and a value of $100. In Year 2, T sells the asset for $100. Under the investment adjustment system, S's basis in the T stock increases to $200, and P's basis in the S stock increases to $200. In Year 6, S sells all the stock of T for $100, and S's recognized loss of $100 is disallowed under paragraph (a)(1) of this section.

(B) Under paragraph (e)(1) of this section, the earnings and profits of S for Year 6 are reduced by $100, the amount of the loss disallowed under paragraph (a)(1). P's basis in the S stock is reduced from $200 to $100 under the investment adjustment system. Correspondingly, P's earnings and profits for Year 6 are reduced by $100, the amount of the loss disallowed under paragraph (a)(1) of this section.

(2) COORDINATION WITH INVESTMENT ADJUSTMENT RULES -- (i) ORDER OF ADJUSTMENTS. Deconsolidation of a share is treated as a disposition of the share for purposes of determining when investment adjustments are made to the share under sections 1.1502-32 and 1.1502-32T.

(ii) NO TIERING UP OF CERTAIN ADJUSTMENTS. If the basis of stock of a subsidiary owned by a member (the "owning member") is reduced under this section upon the deconsolidation of the stock, no corresponding adjustment is made under section 1.1502-32 to the basis of the stock of the owning member (or any higher tier member) if a disposition or deconsolidation occurs in the same transaction with respect to all the stock of the owning member. In the case of a disposition or deconsolidation in the same transaction of less than all the stock of the owning member, appropriate adjustments shall be made under section 1.1502-32 with respect to the stock of the owning member (or any higher tier member).

(iii) EXAMPLE. (A) P, the common parent of a group, owns all the stock of S, S owns all the stock of S1, and S1 owns all the stock of S2. P's basis in S is $100, S's basis in S1 is $100, and S1's basis in S2 is $100. In Year 1, S2 buys T for $100. T has an asset with a basis of $0 and a value of $100. In Year 2, T sells the asset for $100. Under the investment adjustment system, the basis of each subsidiary's stock increases from $100 to $200. In Year 6, S sells all the stock of S1 for $100 to A, an individual, and recognizes a loss of $100. S1, S2, and T are not members of a consolidated group immediately after the sale because the new S1 group does not file a consolidated return for its first taxable year.

(B) Under paragraph (a)(1) of this section, no deduction is allowed to S for its loss on the sale of the S1 stock. Under paragraph (e)(1) of this section, S's earnings and profits for Year 6 are reduced by the $100 loss that is disallowed. Correspondingly, under the investment adjustment system, S's reduction in earnings and profits causes a reduction in P's basis in S, and a reduction in P's earnings and profits for Year 6.

(C) Under paragraph (b)(1) of this section, because the stock of T and S2 is deconsolidated, S2 must reduce the basis of the T stock from $200 to $100 (its value immediately before the deconsolidation), and S1 must reduce the basis of the S2 stock from $200 to $100 (its value immediately before the deconsolidation). Under paragraph (e)(1), S2's earnings and profits for Year 6 are reduced by the $100 reduction to the basis of the T stock, and S1's earnings and profits are reduced by the $100 reduction to the basis of the S2 stock. Under paragraph (e)(2)(ii) of this section, because the stock of S2 is deconsolidated in the same transaction, the basis reduction to the T stock does not cause any corresponding investment adjustment to the stock of S2, or to the stock of any higher tier subsidiary. Similarly, because the stock of S1 is disposed of in the same transaction, the reduction to the basis of the S2 stock does not cause an investment adjustment to the stock of S1, or the stock of any higher tier subsidiary.

(iv) BASIS REDUCTION TREATED AS INVESTMENT ADJUSTMENT. For purposes of the consolidated return regulations, the amount of any basis reduction to stock under this section is treated as a net negative adjustment under section 1.1502-32(e) (in addition to the adjustment otherwise required under section 1.1502-32(e)) with respect to the stock.

(f) REATTRIBUTION OF SUBSIDIARY'S LOSSES TO COMMON PARENT -- (1) REATTRIBUTION RULE. If a member disposes of stock of a subsidiary and the member's loss is subject to disallowance under paragraph (a)(1) of this section, the common parent may elect to reattribute to itself any portion of the reattributable losses of the subsidiary without regard to the order in which they were incurred, provided the amount reattributed does not exceed the amount subject to disallowance before taking into account this paragraph (f). The common parent succeeds to the reattributed losses of the subsidiary (or the subsidiary's lower tier subsidiaries) as if the losses were succeeded to on the day of the disposition in a transaction to which section 381 applies.

(2) INVESTMENT ADJUSTMENTS. The reattributed losses are treated, solely for purposes of determining investment adjustments under section 1.1502-32 and earnings and profits under section 1.1502-33(c), as absorbed by the subsidiary (or any of its lower tier subsidiaries) immediately before the disposition. The losses, however, are not treated as absorbed for other tax purposes, such as section 172.

(3) DEFINITIONS -- (i) REATTRIBUTABLE LOSSES OF THE SUBSIDIARY. "Reattributable losses of the subsidiary" are losses that are reflected as a positive adjustment under section 1.1502-32(b)(1)(ii) immediately before the subsidiary (or its lower tier subsidiaries) ceases to be a member with respect to the group that is disposing of its stock.

(ii) LOWER TIER SUBSIDIARY. "Lower tier subsidiary" means a subsidiary owned, directly or indirectly, by the subsidiary whose stock is disposed of.

(4) EXAMPLES. The principles of this paragraph (f) are illustrated by the following examples:

EXAMPLE (1). BASIC REATTRIBUTION CASE. (i) P, the common parent of a group, forms S with a contribution of $100. S has an operating loss of $60, which produces a deficit in earnings and profits that reduces P's basis in the S stock by $60 under the investment adjustment system. The group is unable to use the loss, and the loss becomes a consolidated net operating loss carryover attributable to S. Under the investment adjustment system, P's basis in the S stock is increased by $60, the amount of the unused loss, thus preserving P's $100 basis in the S stock. The remaining assets of S appreciate in value, and P sells S for $55. Under paragraph (a)(1) of this section, but for the application of this paragraph (f), P's $45 loss on the sale of S is disallowed.

(ii) S's $60 portion of the consolidated net operating loss is reflected in stock basis as a positive adjustment of $60 to the basis of the S stock immediately before S ceases to be a member of the P group. Accordingly, under paragraph (f)(3)(i) of this section, this loss is the reattributable loss of S with respect to the disposition.

(iii) P elects under paragraph (f)(1) of this section to reattribute to itself $45 of the S loss (the maximum amount permitted). As a result, $45 of the $60 reattributable losses of S is reattributed to P. This reattributed loss may be included in the consolidated net operating loss carryover to subsequent consolidated return years of the P group. The remaining $15 of S's reattributable losses is carried over to the first separate return year of S.

(iv) The $45 reattributed loss is treated, solely for purposes of the investment adjustment system, as absorbed by S immediately before the disposition. This reduces P's basis in the S stock to $55 immediately before the disposition. As a result, P does not recognize any gain or loss on the disposition. However, this deemed absorption for purposes of determining investment adjustments does not affect the use of the loss by the P group or reduce the $45 limitation on the amount of the S loss that P may elect to reattribute.

(v) Assume that $20 of 5's losses arose in Year 1 and $40 in Year 2, and that P elects to reattribute all $40 from Year 2 and $5 from Year 1. These losses retain their character as ordinary losses arising in Years 1 and 2. The losses continue to be subject to any limitations originally applicable to S, but P succeeds to them and may absorb the losses independent of S. (For example, P's use of the Year 2 losses does not depend on S's use of the Year 1 losses that were not reattributed to P.)

EXAMPLE (2). LOWER TIER SUBSIDIARY. (i) The facts are the same as in Example (1), except that $10 of S's assets are invested in T in exchange for all of T's stock. T has an operating loss of $5, which is not used by the P group and becomes a consolidated net operating loss carryover attributable to T. Because of other appreciation, P's sale price for the S stock remains $55.

(ii) Under paragraph (f)(3)(i) of this section, all of T's loss is a reattributable loss with respect to a lower tier subsidiary of S. Therefore, T's loss is included in the losses that P may choose to reattribute, subject to the $45 limitation.

EXAMPLE (3). SEPARATE RETURN LIMITATION YEAR LOSSES. (i) The facts are the same as in Example (1), except that S buys all the stock of T for $10. T has a $30 loss carryover from a separate return limitation year.

(ii) T's loss is not reflected as a positive adjustment to the basis of its stock owned by S under section 1.1502-32(b)(1)(ii) immediately before it ceased to be a member of the P group. Therefore, T's loss is not a reattributable loss, and the results in Example (1) are unaffected.

(5) TIME AND MANNER OF MAKING THE ELECTION -- (i) IN GENERAL. (A) The election described in paragraph (f)(1) of this section must be made in a separate statement in the following (or a substantially similar) form: "THIS IS AN ELECTION UNDER SECTION 1.1502-20T(f)(1) OF THE INCOME TAX REGULATIONS TO REATTRIBUTE LOSSES OF [insert names and employer identification numbers (E.I.N.) of the subsidiary that ceased to be a member of the group and each lower tier subsidiary whose losses are reattributed] TO [insert name and employer identification number of common parent]."

(B) The statement must include the following information --

(1) For each subsidiary and lower tier subsidiary whose losses are reattributed, the amount of each net operating loss and net capital loss, and the year in which each arose, that is reattributed to the common parent, and

(2) If stock of a subsidiary (or any of its lower tier subsidiaries) is acquired by another corporation, the acquiring corporation's name and employer identification number.

The statement must be signed by the common parent and by each subsidiary and lower tier subsidiary with respect to which loss is reattributed under this paragraph (f). The statement must be filed with the consolidated group's income tax return for the tax year of the disposition and a copy delivered on or before the time that return is filed to the acquiring corporation of each subsidiary or lower tier subsidiary whose losses are reattributed. If the acquiring corporation is a subsidiary in a consolidated group, the name and employer identification number of the common parent of the group must be included in the statement, and a copy of the statement must also be delivered to the common parent.

(ii) FILING OF SUBSIDIARY'S COPY OF STATEMENT. The subsidiary (and any lower tier subsidiaries) whose losses are reattributed (or the common parent of the consolidated group that includes the subsidiary and any lower tier subsidiaries) must attach its copy of the statement described in paragraph (f)(5)(i) of this section to its return for the first year ending after the due date, including extensions, of the return in which the election required by paragraph (f)(5)(i) is to be filed.

(6) ELECTION IRREVOCABLE. An election under paragraph (f)(1) of this section is irrevocable.

(g) EFFECTIVE DATES -- (1) GENERAL RULE. Except as otherwise provided in this paragraph (g), this section applies with respect to dispositions and deconsolidations occurring on or after March 9, 1990. For this purpose, transactions deferred under sections 1.1502-13, 1.1502-13T, 1.1502-14, and 1.1502-14T are deemed to occur at the time the deferred gain or loss is taken into account.

(2) ANTI-STUFFING RULE. Paragraph (d) of this section applies only with respect to transfers occurring on or after March 9, 1990.

(3) BINDING CONTRACT RULE. For purposes of paragraphs (g)(1) and (2) of this section, if the disposition, deconsolidation, or transfer was pursuant to a binding written contract entered into and in continuous effect until the disposition, deconsolidation, or transfer, the date the contract became binding is treated as the date of the disposition, deconsolidation, or transfer.

(4) CROSS REFERENCE. For additional rules relating to loss disallowance, see section 1.337(d)-1T.

Par. 6. Section 1.1502-32 is amended by adding at the end of paragraph (a) a new sentence to read as follows:

SECTION 1.1502-32 INVESTMENT ADJUSTMENTS.

(a) In general. * * * For rules relating to loss disallowance or basis reduction on the disposition or deconsolidation of stock of a subsidiary, see sections 1.337(d)-1T and 1.1502-20T.

* * * * *

Par. 7. Section 1.1502-33(c)(6) is amended by adding a new sentence at the end to read as follows:

SECTION 1.1502-33 EARNINGS AND PROFITS.

* * * * *

(c) * * *

(6) * * * For rules relating to the effect on earnings and profits of loss disallowance or basis reduction on the disposition or deconsolidation of stock of a subsidiary, see sections 1.337(d)-1T and 1.1502-20T.

* * * * *

Par. 8. Section 1.1502-79 is amended by adding paragraph (a)(1) (iii) to read as follows:

SECTION 1.1502-79 SEPARATE RETURN YEARS.

(a) * * *

(1) * * *

(iii) For rules permitting the reattribution of losses of a subsidiary to the common parent in the case of loss disallowance or basis reduction on the disposition or deconsolidation of stock of the subsidiary, see section 1.1502-20T.

* * * * *

NEED FOR TEMPORARY REGULATIONS

Because of the need to conform the consolidated return regulations to the repeal of the General Utilities doctrine, it is impracticable and contrary to the public interest to issue these temporary regulations with notice and public procedure under section 553(b) of title 5 of the United States Code, or subject to the effective date limitation of section 553(d) of title 5.