Absorption of members’ losses, circular basis rules for consolidated returns

Circular basis rules for consolidated returns

The Treasury Department and IRS today released for publication in the Federal Register proposed amendments (REG-101652-10) to the consolidated return regulations under section 1502.

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The proposed regulations [PDF 279 KB] contain guidance regarding the absorption of members’ losses in a consolidated return year, and provide guidance to address the use of a subsidiary’s losses in the year of the subsidiary’s disposition, which are intended to eliminate a “circular basis problem” in a broader class of transactions than under current law.

The proposed regulations also would amend Reg. section 301.6402-7(g) (relating to claims for refunds and application for tentative carryback adjustments involving consolidated groups that include financial institutions) by revising the definition of separate net operating loss (NOL) of a member in light of the proposed amendments to Reg. section 1.1502-21 (relating to the determination and treatment of consolidated and separate NOLs, carrybacks, and carryovers).

Allocation and absorption of members’ losses

In general, the consolidated taxable income (CTI) or consolidated net operating loss (CNOL) of a consolidated group is the sum of each member’s separately computed taxable income or loss (computed pursuant to Reg. section 1.1502-12) and certain items of income and deduction that are computed on a consolidated basis pursuant to Reg. section 1.1502-11.

Reg. section 1.1502-21(b)(2)(i) generally provides that if a consolidated group has a CNOL, a portion of which could be carried to a member’s separate return year, the CNOL must be apportioned between the group and the member in accordance with the amount of the CNOL attributable to the member by applying a formula set forth in the regulations.

Although generally providing appropriate results, the apportionment may produce anomalies if capital gains are present.

Moreover, the current regulations do not expressly provide a methodology for computing each member’s absorbed loss that is used to offset the income of member’s with positive separate taxable income or net capital gain for the consolidated return year in which the loss is recognized.

Both to provide an absorption rule for apportioning ordinary and capital losses incurred in the same consolidated return year and to address the CNOL apportionment issue, the proposed regulations would amend the current regulations, as follows:

 

  • First, the proposed regulations would add language clarifying that the absorption of members’ losses to offset income of other members in the consolidated return year is made on a pro rata basis, consistent with the pro rata absorption of losses from tax years ending on the same date that are carried back or forward under the rules of Reg. sections 1.1502-21(b) and 1.1502-22(b) (relating to net capital loss carrybacks and carryovers).
  • Second, the proposed regulations would provide that the separate net operating loss of a member, solely for apportionment purposes, is its loss determined without regard to capital gains (or losses) or amounts treated as capital gains.

A conforming amendment is also made to Reg. section 301.6402-7(g)(2)(ii) (relating to refunds to certain statutory or court-appointed fiduciaries of an insolvent financial institution) which contains a similar allocation rule.

Circular adjustments to basis

To prevent the income, gain, deduction, or loss of a subsidiary from being reflected more than once in a consolidated group’s income, the consolidated return regulations adjust an owning member’s basis in a subsidiary’s stock to reflect those items. As a group takes into account a subsidiary’s items of income or gain, an owning member’s basis in the subsidiary’s stock increases. Similarly, as a group absorbs a subsidiary’s deductions or losses, an owning member’s basis in the subsidiary’s stock decreases. These adjustments take place under what is generally referred to as the investment adjustment system.

If a group absorbs a portion of a subsidiary’s loss in the same consolidated return year in which an owning member disposes of that subsidiary’s stock, the owning member’s basis in the subsidiary’s stock is reduced immediately before the disposition. As a result, the amount of the owning member’s gain or loss on the disposition may be affected. Any change in the amount of gain or loss resulting from the disposition may in turn affect the amount of the subsidiary’s loss that the group absorbs. Any further absorption of the subsidiary’s loss triggers further adjustments to the basis in the member’s stock. These iterative computations—that may completely eliminate the benefit of the disposed of member’s losses—are referred to as the “circular basis problem.”

The current regulations contain rules that prevent the circular basis problem in certain situations. However, the current circular basis rules do not prevent iterative computations in all cases—not even all cases in which the stock of a single subsidiary with a loss is disposed of. This has led taxpayers to take a broad range of approaches when the circular basis problem persists. The proposed regulations would provide relief and certainty to instances when the circular basis problem persists, yet adhere to underlying consolidated return concepts “without undue complexity.”

To prevent iterative computations for a consolidated return year in which the stock of one or more subsidiaries is disposed of, the proposed regulations require a group first to determine the amount of each disposed subsidiary’s loss that will be absorbed by computing CTI without regard to gain or loss on the disposition of the stock of any subsidiary (the absorbed amount). Once the amount of a subsidiary’s absorbed loss is determined under that computation, the absorbed amount for each disposed of subsidiary is not redetermined.

Determining each disposed of subsidiary’s absorbed amount establishes an immutable number that will also be the amount of reduction to the basis of member’s stock taken into account in computing the owning member’s gain or loss on the disposition of the member’s stock.

After the absorbed amount is determined, the owning member’s basis of the stock is adjusted under Reg. section 1.1502-32 (and Reg. section 1.1502-36 as relevant). The actual computation of CTI can then be made, taking into account losses of each disposed of subsidiary equal to that amount.

As noted in the preamble, in some instances applying the generally applicable rules would result in less than all of a disposed of subsidiary’s absorbed amount being used. The proposed regulations aim to prevent such a result by providing for an alternative four-step computation of CTI if, applying the general ordering rules, less than all of a disposed of subsidiary’s absorbed amount would be used. The proposed regulations include several examples to illustrate application of the revised circular basis approach.

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