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Proposed Intercompany Obligations Regulations By George L. White, Esq. American Institute of Certified Public Accountants, Washington, DC Background Twice before, in 19951 and in 1998,2 Treasury and IRS have addressed the consolidated return issues presented by intercompany obligations.3 It's an indication of the difficult nature of these issues that it has taken three tries to settle on the correct approach. Part of the problem, no doubt, is the artificiality of an intercompany obligation under the single entity theory of consolidated returns. If members are treated merely as divisions of a single entity, debt between members lacks economic substance.4 Like the previous tries, the 2007 proposed regulations5 operate within the general framework of the matching rule in Regs. §1.1502-13(c) which is intended to minimize, if not eliminate, the impact of intercompany transactions on consolidated taxable income.6 As solid as the matching rule principle is, it has its limitations. It operates best so long as the intercompany obligation stays within the consolidated group. Problems (and distortions) arise when, for instance, an intercompany obligation leaves the consolidated group (Outbound Transaction) or, conversely, when an obligation, not previously an intercompany obligation, enters the consolidated group (Inbound Transaction). The problems are illustrated by the following example, from the current regulations, involving an Outbound Transaction: Member B borrows $100 from member S in return for B's note bearing interest at 10%. Subsequently, the value of B's note falls as interest rates climb. If S then sells B's note to unrelated X for $70, S has a $30 capital loss but B (which takes no part in the transaction between S and X) has no event to offset S's capital loss, and the matching rule would be frustrated.7 Since B has no actual offsetting transaction, it's necessary to construct one. That has been the role played by the Deemed Satisfaction and Reissuance (DSR) model since the current regulations were issued in 1995. That role is continued in the 2007 proposed regulations. Under the DSR model, before S sells B's intercompany obligation to X for $70, B is deemed to satisfy the obligation for the same amount.8 This constructive satisfaction creates $30 of discharge of indebtedness income for B under §61(a)(12), which offsets S's $30 of loss.9 This result nullifies the effect of the Outbound Transaction on consolidated taxable income.10 The second half of the DSR model - the Reissuance step - fills in the gap to account for the fact that B's note actually exists. A new note is created with an issue price equal to the $70 paid to S by X. The new B note retains its old redemption price of $100, and thus bears $30 of original issue discount. The 1998 proposed regulations attempted to “clarify” an aspect of the DSR model by changing the type of property transferred by S to X. Instead of B's note being transferred, the 1998 proposed regulations provided that the proceeds of B's note were transferred by S to X. In other words, B satisfied its obligation to S with an amount equal to X's purchase price ($70) and then S transferred the $70 proceeds to X. Finally, X lent the $70 to B for a new B note with a redemption price of $100, i.e., $30 of original issue discount.11 Complications from this attempted “clarification” quickly surfaced. For instance, one commentator noted that if B were treated as transferring the proceeds of B's note (and not the note itself, as in the actual transaction), X would lose the ability to use the installment method.12 It was apparent that the 1998 version of the DSR model was too expansive, in that it compromised the actual transaction between S and X. Accordingly, it was necessary to insulate the actual transaction from the DSR model. 2007 Proposed Regulations In General According to the 2007 proposed regulations, there are three types of transactions involving intercompany obligations: • Outbound (an intercompany obligation exits the group); • Inbound (an obligation, not previously an intercompany obligation, enters the group); and • Intragroup (a disposition of an intercompany obligation that stays within the group).13 Under the 2007 proposed regulations, the mechanism for setting in motion the revised DSR model is the “triggering” transaction. There are two such transactions:14 • Certain Intragroup transactions “in which a member realizes an amount, directly or indirectly, from the assignment or extinguishment of all or part of its remaining rights or obligations under an intercompany obligation or any comparable transaction in which a member realizes any such amount, directly or indirectly, from an intercompany obligation;”15 • Outbound.16 The revised DSR model is concluded before the actual transaction takes place, thus achieving “separation” of the two.17 Under the revised model, the following sequence of events are deemed to occur immediately before, and independently of, the actual transaction: (1) the debtor satisfies the obligation for a cash amount equal to the obligation's fair market value; and (2) the debtor reissues the obligation to the original creditor for that same cash amount. The parties would then be treated as engaging in the actual transaction but with the new obligation.18 Example: S holds a B note with an adjusted issue price of $100,000 and a fair market value of $70,000. S sells the note to X, a nonmember, for $70,000. Under the 2007 proposed regulations, B would be deemed immediately before the sale to satisfy the note for its fair market value of $70,000. The deemed satisfaction would result in $30,000 of cancellation of indebtedness income for B and a $30,000 loss for S (which would be ordinary loss under the attribute redetermination rule of Regs. §1.1502-13(c)(4)(i)). B would then be treated as reissuing to S a new note, with identical terms, for $70,000, and S would be treated as selling the new note to X. Because S would have a new basis in the new B note (i.e., $70,000), S would recognize no gain or loss on the actual sale of the note to X, and X would acquire the new B note with the original issue discount of $30,000.19 The 2007 proposed regulations generally adopt a fair market value standard for pricing B's note. This represents a rejection of the previous standard which relied on §§1273 and 1274 original issue discount principles. The reason for the change is that greater accuracy (in terms of location) is achieved with a fair market value standard.20 Subgroup Exception There is an important subgroup exception to the application of the revised DSR model for certain Outbound and Inbound transactions.21 For Outbound transactions, the subgroup exception covers transactions in which the parties to the intercompany obligation leave the group: • So long as the creditor and debtor are linked through a §1504(a)(1) relationship in both the old and new groups; and • Neither the creditor not the debtor recognizes income, gain, deduction, or loss with respect to the intercompany obligation.22 There are subgroup exceptions in other sections of the consolidated return regulations under the SRLY rules and the §382 rules.23 However, there is no subgroup exception in the intercompany transaction regulations where one would expect to find it - in the acceleration rules under Regs. §1.1502-13(d). The acceleration rules provide a “backstop” to the matching rules, and terminate deferral of intercompany items when it becomes impossible for the matching rule to operate. There is an exception to the acceleration rules in Regs. §1.1502-13(j)(5) but it is at once both broader and narrower than a subgroup exception. Broader in that it applies to all group members and not just subgroup members; narrower in that it is triggered only where the existence of the entire group terminates (“whole group” exception). Exception for Certain Intragroup Transactions Under the 1998 proposed regulations, the application of the DSR model to certain Intragroup transactions caused considerable controversy. According to commentators, it raised doubts about the status of the result in a longstanding Revenue Ruling24 dealing with the liquidation of an insolvent subsidiary.25 In order to avoid the application of the revised DSR model to run-of-the-mill Intragroup transactions, the 2007 proposed regulations exclude the following from the scope of “triggering” transactions: • Intragroup §332, §351, or §361 exchange; • Intragroup taxable assumption transaction (i.e., a transaction in which an intercompany obligation is assumed as part of the transaction);26 • transaction involving an obligation that previously became an intercompany obligation by reason of an event described in Regs. §1.108-2(e) (i.e., an event falling within an exception to application of §108(e)(4)); • transaction in which the amount realized is from reserve accounting under §585; • intragroup extinguishment (i.e., a transaction in which rights and obligations under an intercompany obligation are extinguished in an intercompany transaction, the adjusted issue price equals the creditor's basis in the obligation, and the debtor's corresponding item and the creditor's intercompany item offset each other); or routine modification of an intercompany obligation.27 Material Tax Benefit There is an exception to the Intragroup transaction exception discussed above. Under a “material tax benefit rule,” the revised DSR model will apply if, at the time of the transaction, it is “reasonably foreseeable” that the shifting of items from an obligation between members will secure a material tax benefit that otherwise would not be enjoyed.28 The “material tax benefit rule” was criticized by the New York State Bar Association report that was otherwise generally supportive of 2007 proposed regulations.29 Effective Date The effective date of the 2007 proposed regulations is for transactions involving intercompany obligations occurring in consolidated return years beginning on or after the date of final regulations.30 However, as was the case with the 1998 proposed regulations, taxpayers may rely on the “form and timing” of the deemed sale and reissuance model set forth in those 1998 proposed regulations.31 For more information, in the Tax Management Portfolios, see White, 755 T.M., Consolidated Returns--Investment in Subsidiaries, and in Tax Practice Series, see ¶5310, Consolidated Returns. 1 T.D. 8597, 60 Fed. Reg. 36671 (7/18/95) (current regulations). 2 REG-105964-98, 63 Fed. Reg. 70354 (12/21/98) (1998 proposed regulations). These proposed regulations were withdrawn when the 2007 proposed regulations were published. REG-107592-00, 72 Fed. Reg. 55139-55152 (9/28/07). 3 Regs. §1.1502-13(g)(2)(ii) defines an intercompany obligation as “an obligation between members of a consolidated group, but only for the period during which both the creditor and debtor are members of the group.” 4 See Axelrod letter to IRS of Aug. 24, 1999 (1999 TNT 171-30, 8/24/99). 5 REG-107592-00, 72 Fed. Reg. 55139-55152 (9/28/07). 6 Regs. §1.1502-13(a)(1) (“The purpose of this section is to provide rules to clearly reflect the taxable income (and tax liability) of the group as a whole by preventing intercompany transactions from creating, accelerating, avoiding, or deferring consolidated taxable income (or consolidated tax liability).”). 7 Regs. §1.1502-13(g)(5), Ex. (2). 8 Regs. §1.1502-13(g)(3)(ii). 9 The offset is fully symmetrical because S's capital loss is converted into an ordinary loss by the attribute redetermination rule of Regs. §1.1502-13(c)(4)(i). 10 See note 6 above. 11 1998 Prop. Regs. §1.1502-13(g)(3)(ii) and (iii). 12 See note 4 above. 13 See preamble to REG-107592-00, 72 Fed. Reg. 55139 (9/28/07). 14 There is no need to extend the revised DSR model to Inbound transactions because the consolidated return action occurs after the actual transaction has taken place. Id. 15 2007 Prop. Regs. §1.1502-13(g)(3)(i)(A)(1). 16 2007 Prop. Regs. §1.1502-13(g)(3)(i)(A)(2). 17 See preamble to REG-107592-00. 18 2007 Prop. Regs. §1.1502-13(g)(3)(ii). 19 2007 Prop. Regs. §1.1502-13(g)(7)(ii), Ex. (2). See also preamble to REG-107592-00. 20 Id. 21 2007 Prop. Regs. §§1.1502-13(g)(3)(i)(B)(8) (providing the exception for the Outbound category) and 1.1502-13(g)(5)(i)(B)(2) (Inbound category). 22 2007 Prop. Regs. §1.1502-13(g)(3)(i)(B)(8). 23 Regs. §1.1502-21(c)(2), and Regs. §1.1502-91 to Regs. §1.1502-99. 24 Rev. Rul. 68-602, 1968-2 C.B. 135. 25 See, e.g., note 4 above. 26 See2007 Prop. Regs. §1.1502-13(g)(7)(ii), Ex. 5. 27 See preamble to REG-107592-00. 28 2007 Prop. Regs. §1.1502-13(g)(3)(i)(C) 29 New York State Bar Association Tax Section, “Report on Proposed Treasury Regulation Section 1.1502-13(g) Relating to Intercompany Obligations,” Mar. 6, 2008 (2008 TNT 48-13). 30 2007 Prop. Regs. §1.1502-13(g)(8). 31 See preamble to REG-107592-00.

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