The IRS has taken another step to remove one of the many traps for the unwary in undertaking corporate restructurings. Effective March 7, new temporary regulations reduce slightly the number of situations in which cumulative taxes might apply to affiliated corporations. The temporary regulations may offer a reprieve from multiple taxation for corporations undergoing divisional restructuring that have elected to file consolidated income tax returns.

It is well known that the same economic gain within a corporation may be subject to federal income tax at both the corporate and shareholder levels because of the existence of separate corporate and personal income taxes. A less acknowledged fact is that the same gain may be subject to multiple corporate income taxes where the gain has accrued within the assets of a lower-tier subsidiary of an affiliated group of corporations. In cases involving extended ownership chains of subsidiaries, the sum of these multiple taxes, each at the current corporate income tax rate of 35 percent, could be equivalent to almost one hundred percent of the gain.

The multiple taxes arise because corporate subsidiaries preserve separate tax identities from their parent corporations, even where they consolidate their operations and income for financial and tax purposes. In particular, gain may be recognized within a consolidated return group on a sale or distribution of either (or both) of a member corporation’s stock or assets to other group members, in spite of the fact that all of the gain may have economically accrued during periods of tax consolidation. However, the tax consequences of such transactions are softened by a "matching rule" that defers taking the gain into account until it is "matched" by the consolidated group's recognition of an equivalent item of loss or deduction.

Where asset gain is recognized by a member before gain is recognized from an intra-group transaction that involves its stock, the investment adjustment rules of the current regulations effectively eliminate the duplication of taxable gain when a matching stock transaction occurs. This happens because the investment adjustment rules cause an equivalent, upward adjustment of the basis of the selling corporation's shares that are held by other group members. Less relief from gain duplication is provided where an intra-group sale or distribution of member stock precedes an intra-group sale of the member's assets. When the member's assets are distributed in complete liquidation to other members of the group and its stock legally ceases to exist, for example, any gain arising from a prior intra-group sale or distribution of its stock is, as a general rule, immediately subject to tax under the current regulations even though the group may potentially recognize the same gain a second time when the assets of the liquidated subsidiary are sold to a non-affiliate. The IRS has some discretion under the current regulations to eliminate gain duplication by issuing private-letter rulings but has rarely (if ever) done so.

The new temporary regulations permit inter-company gain from a prior transaction involving the stock of a liquidating corporation that is a member of a consolidated group to be eliminated to the extent that the gain would otherwise be taken into account by the parent corporation of the consolidated group, the parent corporation holds the stock of the liquidating corporation, no federal tax benefit has been or will be derived from the inter-company transaction and certain other requirements are met. If the temporary regulations are adopted as final, they would remove any IRS discretion to exclude gain from other intra-group transactions because the IRS does not foresee any circumstance in which its discretion would be exercised. Nevertheless, the IRS invites comments as to whether the final regulations should exempt other situations that could result in the duplication of gain, in particular transactions involving nonmember stock as well as member stock.

If you wish to submit a written comment to the IRS about these regulations before they are adopted in final form, call the Tax Group of Ballard Spahr Andrews & Ingersoll, LLP. In addition to helping write and submit comments to the IRS, we also advise corporate groups on the restructuring of divisional operations to minimize current and future federal income taxes. Please contact Ballard Spahr partners Wayne Strasbaugh or Jeffrey Davine for additional information and assistance.

Copyright © 2008 by Ballard Spahr LLP.
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