[Federal Register Volume 59, Number 73 (Friday, April 15, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-8488]


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[Federal Register: April 15, 1994]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[CO-11-91]
RIN 1545-AL63

 

Consolidated Groups and Controlled Groups--Intercompany 
Transactions and Related Rules

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document proposes regulations revising the intercompany 
transaction system of the consolidated return regulations to more 
clearly reflect consolidated taxable income. The proposed regulations 
also revise the regulations under section 267(f), limiting losses and 
deductions from comparable transactions between members of a controlled 
group. Amendments to other related regulations are also proposed in 
this document.

DATES: Comments must be received by July 18, 1994. Because the proposed 
regulations affect a broad range of transactions, two public hearings 
will be held. A preliminary hearing to respond to general comments and 
questions by speakers will be held on May 4, 1994, beginning at 10 
a.m., and a second hearing to receive comments will be held on August 
8, 1994, beginning at 10 a.m. Requests to speak at the first hearing 
must be received by April 20, 1994. Outlines of topics to be discussed 
at the second hearing must be received by July 18, 1994. See the notice 
of public hearings on proposed rulemaking published elsewhere in this 
issue of the Federal Register.

ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (CO-11-91), room 5228, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. In the alternative, submissions may be delivered to: 
CC:DOM:CORP:T:R (CO-11-91), room 5228, Internal Revenue Service, 1111 
Constitution Avenue NW., Washington, DC. The first public hearing will 
be held in room 2615 of the Internal Revenue Building, 1111 
Constitution Avenue NW, Washington, DC. The second public hearing will 
be held in the Internal Revenue Building Auditorium, Seventh Floor, 
7400 Corridor, Internal Revenue Service Building, 1111 Constitution 
Avenue NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the hearings, Carol 
Savage of the Regulations Unit, Assistant Chief Counsel 
(Corporate), (202) 622-8452 or (202) 622-7180; concerning the 
regulations relating to consolidated groups generally, Roy 
Hirschhorn or David Kessler of the Office of Assistant Chief 
Counsel (Corporate), (202) 622-7770; concerning stock of members of 
consolidated groups, Rose Williams of the Office of Assistant Chief 
Counsel (Corporate), (202) 622-7550; concerning obligations of 
members of consolidated groups, Victor Penico of the Office of 
Assistant Chief Counsel (Corporate), (202) 622-7750; concerning 
insurance issues, Gary Geisler of the Office of Assistant Chief 
Counsel (Financial Institutions and Products), (202) 622-3970; 
concerning international issues relating to members of consolidated 
groups, Philip Tretiak of the Office of Associate Chief Counsel 
(International), (202) 622-3860; and concerning controlled groups, 
Martin Scully, Jr. of the Office of Assistant Chief Counsel (Income 
Tax and Accounting), (202) 622-4960. (These numbers are not toll-
free numbers.)

SUPPLEMENTARY INFORMATION:

A. Paperwork Reduction Act

    The collections of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1980 (44 
U.S.C. 3504(h)). Comments on the collection of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, PC:FP, Washington, DC 
20224.
    The collections of information are found in Sec. 1.1502-13 (e)(3), 
(f)(5)(v), and (j)(5). This information is required by the IRS to 
comply with section 1502 and the regulations thereunder, and to 
simplify the operation of the proposed regulations. This information 
will be used to assure that the amount, location, timing, character, 
source, and other attributes of intercompany items and corresponding 
items are properly determined. The respondents are members of 
consolidated groups.
    The estimated total annual reporting burden is 2,500 hours.
    The estimated annual reporting burden per respondent is .50 hour.
    The estimated number of respondents is 5,000.
    The estimated annual frequency of responses is once per year, if 
necessary.

B. Background

    This document proposes amendments to the regulations under section 
1502 of the Internal Revenue Code of 1986 (Code) that are applicable to 
transactions between members of a consolidated group (intercompany 
transactions). Sections 1.1502-13, 1.1502-13T, 1.1502-14, 1.1502-14T, 
and 1.1502-31 contain most of the rules of the current intercompany 
transaction system. Amendments are also proposed to related 
regulations, including the regulations under section 267(f), which are 
applicable to transactions between members of a controlled group.
    The current consolidated return regulations use a deferred sale 
approach that treats the members of a group as separate entities for 
some purposes and as a single entity for other purposes. In general, 
the amount, location, character, and source of items from an 
intercompany transaction are determined as if separate returns were 
filed (separate entity treatment), but the timing of items is 
determined more like the timing that would apply if the participants 
were divisions of a single corporation (single entity treatment).
    For a discussion of the issues considered in developing the 
proposed regulations, see the notice of hearings on the proposed 
regulations that appears elsewhere in this issue of the Federal 
Register. The topics discussed in the notice of hearings include:
    1. Separate and single entity treatment.
    2. Location of items within the group (and alternative 
comprehensive single entity treatment).
    3. Mechanical rules.
    4. Matching and acceleration rules (including nonrecognition 
transactions, subgroups, and possible simplifying rules).
    5. Stock of members.
    6. Obligations of members.
    No inference is intended by the proposed regulations as to the 
operation of the current regulations or other rules.

C. Explanation of Proposed Intercompany Transaction Rules

1. In General

    The purpose of the proposed intercompany transaction regulations is 
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).
    The proposed regulations retain the basic approach of the current 
regulations by accounting for intercompany transactions through a 
deferred sale system. The principal focus of single entity treatment 
under the current regulations is on the timing of items from 
intercompany transactions. The proposed regulations expand this focus 
by redetermining the character, source, and other attributes of the 
items on a single entity basis. Only the amount and location of items 
remain on a separate entity basis.
    The proposed regulations eliminate many inconsistent combinations 
of single and separate entity treatment under the current regulations 
that lead to inappropriate results. Nevertheless, the rules of the 
proposed regulations reflect the basic principles underlying the 
current regulations. Accordingly, the results of most common 
intercompany transactions are not affected by the proposed regulations 
even though the analysis is changed.
    The proposed regulations replace the mechanical rules of the 
current regulations with a matching rule and an acceleration rule. 
These rules apply uniformly to ``period'' transactions (e.g., payment 
of currently deducted interest), sales of property and performance of 
capitalized services, and transactions involving the stock or 
obligations of members. Because the proposed regulations generally 
unify the rules for all intercompany transactions, many of the 
distinctions drawn by the current regulations between intercompany 
transactions, deferred intercompany transactions, and transactions 
involving stock or obligations of members, are eliminated as no longer 
necessary.
    The proposed regulations include numerous examples, but the first 
few examples under the matching and acceleration rules provide the 
guidance necessary for most common intercompany transactions. 
Additional examples illustrate the application of the proposed rules to 
less common transactions.
    The proposed regulations are a method of accounting to the extent 
they determine the timing of items. An item taken into account under 
these rules can be deferred, disallowed, or eliminated under other 
applicable law.
    A group's ability to change its manner of applying the final 
intercompany transaction regulations will be subject to the generally 
applicable rules for accounting method changes. Whether a change in 
method will be applied with an adjustment under section 481(a) or 
applied on a cut-off approach will be determined by the IRS. See also 
``Proposed effective dates,'' discussed at F. of this preamble for the 
application of the final intercompany transaction regulations on a cut-
off basis.

2. Definitions: Intercompany Transaction, Intercompany Item, and 
Corresponding Item

    In general, an intercompany transaction is a transaction between 
corporations that are members of the same consolidated group 
immediately after the transaction. The proposed regulations provide 
further guidance largely through examples. S is the member transferring 
property or providing services, and B is the member receiving the 
property or services.
    Each party to an intercompany transaction can have items of income, 
gain, deduction, and loss from the transaction (or from property 
acquired in the transaction). S's items are referred to as intercompany 
items and B's items are referred to as corresponding items. These items 
are generally taken into account under the matching and acceleration 
rules.
    For most transactions, S's intercompany items and B's corresponding 
items are their items from the intercompany transaction (or from 
property acquired in the intercompany transaction) determined on a 
separate entity basis. Issues arise under the current regulations 
regarding the effect of certain costs and expenses on the determination 
of intercompany items and corresponding items. For example, if S 
performs services for B, the extent to which S's costs are included in 
determining its intercompany income may not always be clear. The 
proposed regulations retain the approach of the current regulations by 
providing guidance largely through examples.
    The proposed regulations also continue the current approach of 
treating certain amounts as S's intercompany items even though S has 
not yet recognized or incurred them under its own method of accounting. 
Thus, in certain situations the rules can accelerate as well as defer 
intercompany items. S generally is not required, however, to take into 
account amounts that it will never recognize under its method of 
accounting merely to match B's corresponding items. Additional 
adjustments are made to the extent necessary to clearly reflect the 
group's income, including treating certain basis adjustments under the 
Code as items required to be taken into account.
    The matching rule of the proposed regulations generally focuses on 
B to redetermine the time S's intercompany items are taken into 
account. This approach is similar to the approach of the current 
regulations for deferred intercompany transactions. However, the 
matching rule applies to a wider range of transactions, and the roles 
of the parties might vary. For example, a single business arrangement 
may be composed of related transactions, with one member being S for 
one transaction and B for another. The proposed regulations require 
each transaction to be separately analyzed, and provide examples to 
identify which member is B and which is S in a transaction.
    The roles of the parties might also vary over time. For example, if 
two members engage in an interest rate notional principal contract, the 
member that is obligated to make the net payment in each period under 
the contract will vary depending on changes in interest rates. Because 
the net payment for each period is treated as a separate transaction, a 
member may be B in one period (as the payor) and S in another period 
(as the payee).

3. Matching Rule

    Under the proposed regulations, the matching rule is the principal 
rule for redetermining the timing and attributes of S's intercompany 
items and B's corresponding items on a single entity basis. In general, 
S's intercompany items and B's corresponding items are taken into 
account to produce the same effect on consolidated taxable income as if 
S and B were divisions of a single corporation.
    For purposes of treating S and B as divisions under the matching 
rule, S and B are treated as engaging in their actual transaction and 
owning any actual property in the transaction, operating separate 
trades or businesses, and having any special status (e.g., as a bank or 
insurance company) that they have under the Code.
    In addition to timing, the matching rule conforms the character and 
other attributes of S's intercompany items and B's corresponding items. 
For example, S might sell investment property to B, and B might hold 
the property for sale to customers in the ordinary course of business. 
S and B redetermine the attributes of their intercompany items and 
corresponding items to produce the same effect on consolidated taxable 
income as if they were divisions of a single corporation. Thus, the 
redetermination of character is based on the activities of both S and B 
and may require both S's items and B's items to be ordinary or capital. 
Because the attributes are redetermined by treating S and B as 
divisions, the matching rule also generally aggregates the holding 
periods of S and B with respect to property transferred in an 
intercompany transaction.
    For each consolidated return year, the matching rule requires S to 
take into account its intercompany items to reflect the difference 
between the corresponding items B takes into account and B's recomputed 
items (the corresponding items B would have taken into account if S and 
B were divisions of a single corporation). Comparing B's corresponding 
items and its recomputed items ordinarily will not be difficult.
    For example, if S sells property with a $70 basis to B for $100, 
and B later resells the property to a nonmember for $90, S's $30 gain 
is not taken into account until the resale. At that time, S's gain is 
taken into account to reflect the $30 difference between the $10 loss B 
takes into account and the recomputed $20 gain B would take into 
account if B had succeeded to S's $70 basis in a transfer between 
divisions of a single corporation. The character of S's $30 gain and 
B's $10 loss (and their holding period for the property) are 
redetermined by taking into account the activities of both S and B with 
respect to the property.
    Treatment as divisions of a single corporation applies only to S 
and B as the parties to the intercompany transaction. The activities of 
other members are generally not taken into account. Moreover, because 
treatment as divisions is solely for purposes of taking into account 
items from intercompany transactions, the treatment generally does not 
affect determinations by S and B with respect to items or holding 
periods in other transactions.
    The matching rule continues the trend of recent amendments to the 
intercompany transaction system by reducing the reliance on particular 
events and transactions to take items into account. Compare current 
Sec. 1.1502-13(l) with current Sec. 1.1502-13 (d) through (f). Because 
the matching rule focuses on B's items, if S sells land to B at a gain 
and B transfers the land outside the group in an exchange to which 
section 1031 applies, S's gain is not taken into account under the 
matching rule, even though the property is disposed of outside the 
group, if there is no difference between B's actual and recomputed 
items resulting from the exchange. Instead, S's gain remains deferred 
and is taken into account based on B's items with respect to the 
replacement property.
    The current regulations redetermine timing on a single entity 
basis, but generally determine character on a separate entity basis. 
This dual approach may result in conflicts because timing and character 
cannot always be separately analyzed under the Code. The current 
regulations only partially resolve these conflicts. See, e.g., 
Secs. 1.1502-13(c)(4)(ii) and (d)(3) (the character of S's deferred 
gain or loss taken into account as a result of B's depreciation is 
redetermined), and 1.1502-13(m)(1) (S is treated as disposing of 
property at the same time and in the same manner as B disposes of the 
property outside the group).
    The proposed regulations generally eliminate potential conflicts 
between timing and character by redetermining both the timing and the 
attributes of items on a single entity basis. This approach eliminates 
the need for the special rules under the current regulations. For 
example, if S sells depreciable property to B at a gain, B depreciates 
the property for a period, and B then resells it to a nonmember, no 
special rules are needed to redetermine the recapture income of S or B. 
Instead, the recapture income is redetermined as if S and B were 
divisions of a single corporation. This prevents the intercompany 
transaction from affecting consolidated taxable income, but preserves 
the location of each member's items. Redetermining attributes on a 
single entity basis is not expected to affect most intercompany 
transactions.
    Preserving the location of S's items, but redetermining their 
attributes on a single entity basis, may in certain cases require S's 
intercompany income or gain to be treated as excluded from gross income 
(or its intercompany deductions or losses to be treated as noncapital, 
nondeductible amounts). For example, if S has intercompany interest 
income from B, but B's corresponding interest deduction is disallowed 
under section 265, S's intercompany income must be excluded from gross 
income.
    This approach prevents an intercompany transaction from having an 
effect on consolidated taxable income, but preserves the location of 
items for stock basis and earnings and profits adjustments under 
Secs. 1.1502-32 and 1.1502-33. However, because of administrability 
concerns, S's intercompany income or gain generally can be treated as 
excluded from gross income only if B's corresponding item is a 
deduction or loss that, in the taxable year the item is taken into 
account, is permanently disallowed directly under another provision of 
the Code or regulations.
    Because it has the same effect as a deduction or loss that is 
permanently disallowed, exclusion is also permitted if B has a 
corresponding loss that is not recognized under section 311. For 
example, if S has property with a $70 basis and sells it to B for $100, 
and the property is subsequently distributed to a nonmember when it has 
a value of $90, B's $10 loss is not recognized under section 311(a). 
B's distribution results in all of S's $30 gain being taken into 
account, but $10 of the gain is excluded from gross income. Additional 
corresponding items that permit S's intercompany income or gain to be 
excluded from gross income may be identified by the Commissioner in 
future guidance, to the extent consistent with administrability 
concerns.
    Under the proposed regulations, the special asset basis rules of 
current Sec. 1.1502-31(a) are not needed. These rules originally were 
adopted to contrast with the intercompany transaction system applicable 
to pre-1966 consolidated return years. They are now encompassed by the 
general approach of the proposed regulations to use the provisions of 
the Code where possible. Consequently, the special asset basis rules 
were not included in recently proposed revisions to Sec. 1.1502-31. See 
CO-30-92 [1992-2 C.B. 627].

4. Acceleration Rule

    The acceleration rule takes items into account immediately to the 
extent that they cannot be taken into account under the matching rule 
to produce the effect of treating S and B as divisions of a single 
corporation. The effect cannot be produced to the extent either the 
matching rule will not fully account for the items from an intercompany 
transaction in consolidated taxable income, or the intercompany 
transaction will be reflected by a nonmember.
    For example, if S or B becomes a nonmember, any remaining 
intercompany items and corresponding items can no longer be matched in 
the determination of consolidated taxable income. Moreover, S or B 
would reflect the intercompany transaction as a nonmember. The 
intercompany items are therefore taken into account immediately before 
S or B becomes a nonmember.
    Similar results would be required if B purchases property from S 
and transfers it to a partnership in a transaction to which section 721 
applies (or to nonmember corporation in a transaction to which section 
351 applies), because the partnership reflects the intercompany 
transaction by succeeding to B's cost basis in the property. If S and B 
had been divisions of a single corporation, S's transfer to B generally 
could not have created a cost basis to be reflected by the partnership 
in the property. The acceleration rule requires S to take its 
intercompany items into account immediately before the event rendering 
single entity treatment impossible. (If B had disposed of the property 
in an exchange with a nonmember to which section 1031 applies, the 
intercompany items would not be taken into account under the 
acceleration rule because the nonmember would not succeed to B's cost 
basis.)
    In limited circumstances, the acceleration rule will apply without 
the occurrence of an event separate from the intercompany transaction. 
This might occur if S's gain or loss from the sale of property to B 
exceeds the effect of the intercompany transaction on the basis of the 
property. For example, if B owns a building that is destroyed by fire 
and B uses its insurance proceeds to buy a replacement building from S, 
S's gain or loss will not conform to B's basis in the building because 
B's basis is determined under section 1033. If the amount of S's gain 
or loss exceeds the effect of the intercompany sale on the building's 
basis, S's gain or loss will not be fully taken into account under the 
matching rule because there will not be a sufficient difference between 
the corresponding items B takes into account and its recomputed items. 
Consequently, the acceleration rule applies at the time of the 
intercompany sale to take the excess amount into account. S's gain or 
loss is accelerated because it is not possible to treat S and B as 
divisions of a single corporation, and acceleration is the only 
administrable alternative.
    The acceleration rule has two provisions for determining the 
attributes of S's intercompany items. For intercompany transactions 
involving property, the attributes are redetermined under the 
principles of the matching rule by deeming B to resell the property to 
a nonmember affiliate (a transaction comparable to S's intercompany 
transaction). Thus, the attributes of S's intercompany items reflect 
B's activities with respect to the property. For example, if S was an 
investor in land sold to B, and B holds the land for sale to customers 
in the ordinary course of business at the time B becomes a nonmember, 
S's gain or loss taken into account under the acceleration rule may be 
ordinary. Because B is deemed to sell to a nonmember affiliate, any 
rules applicable to related party transactions apply to determine the 
attributes of S's items. See, e.g., section 1239 (relating to 
depreciable property).
    For intercompany transactions involving services or rentals, or 
other nonproperty transactions, the attributes of S's accelerated items 
are determined on a separate entity basis. For example, if S performs 
services that are capitalized by B, there is no deemed sale by B for 
purposes of determining the attributes of S's items. Instead, S's 
accelerated items remain ordinary items from its performance of 
services. The proposed regulations do not deem a sale to occur because 
S did not engage in a property transaction and B may never engage in 
the sale or exchange of property that would require S's items to be 
recharacterized as items from a property transaction.
    Like the current regulations, and consistent with the treatment 
under the intercompany transaction system of a consolidated group as a 
single entity, the proposed regulations do not accelerate items if the 
entire consolidated group is acquired by another consolidated group.

5. Simplifying Rules

a. Inventory
    The current regulations generally treat intercompany transactions 
involving inventory like intercompany transactions involving other 
property. But see Secs. 1.1502-13(f)(1) (iv) and (viii) (a deferred 
amount attributable to stock in trade or inventory is taken into 
account as the result of a separate return year or a value write-down), 
and 1.1502-18 (special inventory adjustment).
    The proposed regulations continue to generally treat inventory 
transactions like other intercompany transactions. However, if S or B 
uses a dollar-value LIFO method of inventory accounting, the matching 
rule might be unadministrable because dollar-value LIFO measures 
aggregate inventory changes in terms of base-year dollars, and does not 
separately identify the items from particular transactions. For 
example, B is not able to determine when corresponding items with 
respect to each separate intercompany transaction are taken into 
account because of the substitution of inventory units and costs within 
the dollar-value LIFO method.
    Intercompany inventory transactions are typically routine 
transactions that occur in the normal course of business. Applying the 
matching and acceleration rules to dollar-value LIFO methods may be 
burdensome because of the potential for numerous additional 
computations and the inconsistencies with financial reporting of 
intercompany transactions. For example, S may compute intercompany 
inventory income and corresponding elimination for financial reporting 
purposes using a FIFO cost-flow assumption even though S and B use 
dollar-value LIFO for Federal income tax purposes.
    To simplify the matching computations, the proposed regulations 
permit S or B to use any reasonable method to take into account their 
items from intercompany inventory transactions. However, adjustments 
are required if the cumulative amount of intercompany items not taken 
into account by S under the method used significantly exceeds the 
cumulative amount that would not be taken into account by S under 
methods specifically provided in the proposed regulations. For example, 
a group may be able to use its current accounting methods or develop 
other simplified methods. However, the use of a FIFO cost-flow 
assumption could result in deferral that significantly exceeds the 
deferral that would be achieved under a LIFO cost-flow assumption. If a 
method is expected to be reasonable, but in fact produces a significant 
cumulative excessive deferral in any year, S must take into account an 
amount for that year which will eliminate the excess and make 
appropriate adjustments thereafter to reflect the amount taken into 
account.
    The proposed regulations specifically provide an ``increment 
averaging method'' and an ``increment valuation method.'' Under the 
increment averaging method, B determines the portion of its total 
inventory costs for the current year that are included in a layer of 
increment under its LIFO inventory method, and S defers a comparable 
portion of its intercompany inventory items from sales to B for the 
year. B computes the ratio of current-year costs of its layer of 
increment over total inventory costs incurred for the year. B's 
current-year costs are computed in a manner consistent with its method 
for valuing LIFO increments (e.g., earliest, latest, or average costs). 
If B uses a simplified method to allocate section 263A costs to 
inventory and does not allocate additional section 263A costs to 
specific items of LIFO inventory, B may compute the portion of its 
costs included in an increment without including section 263A costs in 
either the total costs or the costs included in a layer. B must compute 
its costs separately for each LIFO pool that receives intercompany 
purchases, and if more than one selling member transfers inventory into 
that pool in intercompany transactions, each selling member must take 
into account a comparable portion of its intercompany items.
    To the extent S defers its intercompany inventory items under the 
increment averaging method, S layers the items based on the 
corresponding layers of B's costs. S takes the deferred items into 
account under the matching rule as B takes into account its 
corresponding layers through subsequent decrements.
    The increment valuation method is similar to the increment 
averaging method. Under the increment valuation method, a ratio is 
determined based on the current-year costs of the layer of increment 
over the total costs incurred in the appropriate period used to value 
the increment. The appropriate period is the period of B's year used to 
determine current-year costs. This ratio is applied to S's intercompany 
inventory items computed with respect to intercompany inventory sales 
during the appropriate period. For example, if B determines current-
year costs by reference to its earliest costs, and only the inventory 
costs incurred in B's first inventory turn are included for this 
purpose, the appropriate period is the period of B's year that includes 
its first inventory turn.
    S determines the amount of its total intercompany inventory items 
for a year under any reasonable method for allocating its inventory 
costs to intercompany transactions. If S uses a dollar-value LIFO 
inventory method and a decrement occurs for the year, S must reasonably 
take into account the costs of prior layers of increment. For example, 
S may compute its intercompany inventory income using its most recent 
costs incurred if S has an increment for the year and S uses the 
earliest acquisitions cost method to value increments. Similarly, S may 
use an average of its costs incurred during the year if S uses this 
method to value increments or if S does not experience a significant 
increment or decrement for the year.
    The current regulations determine whether inventory is disposed of 
outside the group by reference to B's method of inventory 
identification (e.g., FIFO, LIFO, or specific identification). Because 
the current regulations require B to consider the effect of its use of 
dollar-value LIFO, it is not anticipated that the proposed regulations 
will result in a significant change. Taxpayers can continue to use 
their current methods after the final intercompany transactions 
regulations apply if the current methods are reasonable.
b. Reserve Accounting
    Reserve accounting is permitted only for special status members, 
and it is inappropriate to apply some aspects of reserve accounting on 
a single entity basis (e.g., where both parties to an intercompany 
transaction do not have the same special status). To the extent that 
reserve accounting should apply to intercompany transactions, the 
necessary adjustments to produce single entity results may be complex.
    The proposed regulations provide that a member's addition to, or 
reduction of, a reserve for bad debts that is maintained under section 
585 or 593 is generally taken into account on a separate entity basis. 
But see ``Obligations of members,'' discussed at C.7. of this preamble 
(special rules for reserve deductions with respect to intercompany 
obligations). Similarly, if a member provides insurance to another 
member in an intercompany transaction, the transaction is taken into 
account by both members on a separate entity basis.
c. Elections
    Section 1.1502-13(c)(3) of the current regulations provides that a 
group may elect with the consent of the Commissioner not to defer 
intercompany gain or loss from deferred intercompany transactions with 
respect to all or any classes of property. See also Rev. Proc. 82-36, 
1982-1 C.B. 490 (a checklist and guidelines for requests under 
Sec. 1.1502-13(c)(3)).
    The proposed regulations continue to permit groups to request that 
items from intercompany transactions (other than transactions with 
respect to stock or obligations of members), be taken into account on a 
separate entity basis rather than under the intercompany transaction 
system. Any election under current Sec. 1.1502-13(c)(3) will remain in 
effect. As under current law, an election to take items into account on 
a separate entity basis does not apply for purposes of taking losses 
into account under section 267(f).
    Current Sec. 1.1502-13(f)(3) provides that the IRS may enter into a 
closing agreement with a group required to divest itself of a member by 
order of law. The closing agreement generally allows the group to take 
into account deferred gain or loss as if it had not disposed of the 
member (but not over more than 10 years). Closing agreements generally 
will not be entered into where the divestiture is occasioned by an 
acquisition after August 31, 1966. Consequently, this provision is 
eliminated under the proposed regulations as deadwood.
    Current Sec. 1.1502-13(j) provides that the IRS may enter into a 
closing agreement providing special treatment for public utilities. The 
proposed regulations also eliminate this provision as deadwood, because 
a request for a closing agreement must have been made on or before 
November 15, 1966.
    Any groups currently subject to a closing agreement under a 
deadwood provision eliminated by the proposed regulations will remain 
subject to the terms of the closing agreement.

6. Stock of Members

    Sections 1.1502-14 and 1.1502-31(b) of the current regulations 
provide special rules for distributions and other transactions with 
respect to stock of members. These stock rules combine single and 
separate entity treatment.
    The current regulations eliminate intercompany dividends from the 
gross income of the distributee. Section 301 distributions (whether or 
not dividends) first reduce the distributee member's basis in the 
distributing member's stock to zero, and then create an excess loss 
account in the stock.
    If appreciated property is distributed in a distribution to which 
section 301 applies, the current regulations provide that the 
distributing member recognizes gain under section 311 that is deferred 
and taken into account in the same manner as if it were recognized in a 
deferred intercompany transaction. The distributee's basis in the 
property received is generally its fair market value.
    No special rules are provided under the current regulations for 
reorganization transactions and transactions to which section 355 
applies.
    Liquidating distributions are governed by either section 331 or 332 
as to the distributee, and section 336 or 337 as to the distributing 
member. Under Sec. 1.1502-34, the stock ownership of all members is 
aggregated to determine whether section 332 applies to the distributee. 
Under section 337(c), however, the ownership is not aggregated to 
determine whether section 337 applies to the distributing member. Gain 
or loss recognized by the distributing member under section 336 is 
deferred under the current regulations and taken into account as if it 
were recognized in an intercompany transaction. If the distributee 
member would recognize gain or loss from the liquidation under section 
331, the distributee's gain or loss is limited under the current 
regulations, but preserved by determining the distributee's basis in 
the distributed property by reference to the distributee's basis in the 
stock surrendered.
    Other recent consolidated return regulation projects address 
aspects of intercompany distributions and other transactions with 
respect to stock of members. See, e.g., Sec. 1.1502-80(b) (non-
applicability of section 304 to transactions between members), proposed 
Sec. 1.1502-80(c) (deferral of section 165(g)), and proposed 
Sec. 1.1502-80(d) (replacing current Sec. 1.1502-14(a)(2), and 
providing for the non-applicability of section 301(c)(3) to transfers 
between members).
    The proposed regulations generally apply the rules of the Code and 
the matching and acceleration rules to transactions with respect to 
stock of members. For example, if S sells to B the stock of another 
member (T) at a gain, S's gain is taken into account under the matching 
and acceleration rules.
    The proposed regulations provide that intercompany distributions 
are generally not included in the gross income of the distributee 
member. However, this exclusion applies to a distribution from a 
subsidiary only to the extent there is a corresponding negative 
adjustment reflected under Sec. 1.1502-32 in the distributee's basis in 
the distributing member's stock. By conditioning the exclusion on a 
negative adjustment, the concerns with dividend stripping transactions 
illustrated by current Sec. 1.1502-32(k) are minimized. Intercompany 
distributions are taken into account for all Federal income tax 
purposes when the members become entitled to them (generally the record 
date) or, if earlier, when they are taken into account under the Code 
(e.g., under section 305(c)).
    Excluding intercompany dividends from gross income is intended to 
have the same effect as eliminating them under the current regulations, 
but it conforms to the terminology generally used under the Code. For 
example, the holdings in Revenue Ruling 72-230, 1972-1 C.B. 209 (the 
effect of dividend elimination on the source of dividends paid for 
purposes of section 861(a)(2)) and Revenue Ruling 79-60, 1979-1 C.B. 
211 (the effect of dividend elimination on personal holding company 
status), and the application of section 1059, are not affected.
    The matching and acceleration rules apply to the distributing 
member's gain under section 311(b) from intercompany distributions of 
property. The proposed regulations provide that the distributing 
member's loss from an intercompany distribution of property is also 
recognized under the principles of section 311(b) and is taken into 
account under the matching and acceleration rules. In effect, 
intercompany distributions are equated with intercompany sales.
    The recognition of loss from distributions applies only to 
intercompany distributions. For example, S's loss from distributing 
property to B is recognized, but S's loss from distributing the 
property to a nonmember is not recognized. Under the matching rule, a 
buying member's nonrecognition of loss from the distribution of 
property to a nonmember may result in prior intercompany gain (or loss) 
from the property being recharacterized as excluded from gross income 
(or as a noncapital, nondeductible amount). For example, if S sells 
property to B at a loss, and B later distributes it to a nonmember at 
no gain or loss, S's intercompany loss is recharacaterized as a 
noncapital, nondeductible amount. In effect, a group is treated as a 
single entity with respect to the nonrecognition of loss under section 
311 on distributions to nonmembers.
    The proposed regulations provide special rules to minimize the 
effect on consolidated taxable income of boot in intercompany 
reorganizations. Boot received by a member as a shareholder in an 
intercompany reorganization is treated as received in a separate 
transaction. Thus, consolidated taxable income is generally the same 
whether the boot is distributed as part of the reorganization, before 
it, or after it.
    The proposed boot rules do not apply to a reorganization if any 
participant becomes a member or becomes a nonmember as part of the same 
plan or arrangement. The proposed rules do not reflect any decisions 
about boot received in other reorganizations such as those involving 
unrelated corporations or affiliated corporations filing separate 
returns. The tax results of reorganizations straddling consolidation 
remain under study because of the significant differences between boot 
transferred between members of a consolidated group and boot 
transferred between separate return corporations.
    The proposed regulations provide that if a member acquires its own 
stock in an intercompany transaction, its basis in that stock is 
treated as eliminated for purposes of taking intercompany items into 
account with respect to the stock. Thus, if S distributes B stock to B, 
S's gain or loss from the distribution is taken into account 
immediately to reflect the elimination of basis. Compare Gen. Coun. 
Mem. 39,608 (March 5, 1987) (S's gain from the distribution of B stock 
to B is deferred until, for example, B sold the same shares to a 
nonmember). On the other hand, if S transfers to B the stock of T, and 
B subsequently transfers the stock to T in exchange for new T stock in 
a recapitalization to which section 368(a)(1)(E) applies, S's 
intercompany gain or loss remains deferred and is taken into account by 
reference to the replacement stock. See ``Successor corporations and 
property,'' discussed at C.9. of this preamble.
    Under the current regulations, intercompany gain or loss from 
transferring the stock of a member is taken into account when that 
member liquidates under section 332. For example, if S sells all of the 
stock of T to B at a gain, and T later liquidates in an unrelated 
transaction to which section 332 applies, S's gain is taken into 
account. If the basis of T's assets conformed to the basis of its stock 
before S's sale, S's gain from the T stock will be duplicated by gain 
that the group later recognizes from the former T assets (because B 
succeeds to T's basis in the assets).
    The proposed regulations provide relief from this duplication in 
limited circumstances. Under the first rule, if section 332 applies to 
T's liquidation and B transfers substantially all of T's assets to a 
new member (new T), the transfer to new T is treated as pursuant to the 
same plan or arrangement as the liquidation and S's gain generally will 
not be taken into account. Instead, S's gain is taken into account by 
reference to the stock of new T. New T must be formed and the relief 
elected by the group within specified time periods. Similar principles 
apply if B's basis in the T stock is eliminated in a transaction 
comparable to the section 332 liquidation (e.g., a downstream merger).
    Under the second rule, if T's liquidation is deemed to occur under 
section 338(h)(10) as a result of a qualified stock purchase of T, B is 
treated, subject to certain limitations, as recognizing any loss or 
deduction it would recognize (determined after adjusting stock basis 
under Sec. 1.1502-32) if section 331 applied to the deemed liquidation. 
In effect, S's income or gain is offset by B's deduction or loss in 
determining consolidated taxable income (although S and B must take 
into account their separate items). Similar principles apply if T 
transfers all of its assets to a nonmember and completely liquidates in 
a transaction comparable to a section 338(h)(10) transaction.
    The third rule applies if member stock is transferred in an 
intercompany transaction and subsequently distributed in a second 
intercompany transaction to which section 355 applies. S's gain or loss 
might otherwise be taken into account under the proposed regulations 
because the basis adjustments to the T stock under section 358 may 
result in an inability to match the T stock basis with S's gain. Relief 
is provided by permitting the group to elect to treat B's distribution 
as subject to sections 301 and 311 rather than section 355, so that 
matching with S's gain remains possible. This prevents S's gain from 
being taken into account immediately if matching remains possible, but 
B's gain or loss from its distribution will also be taken into account 
under the matching and acceleration rules.

7. Obligations of Members

    Current Sec. 1.1502-13 provides that the general rules for 
intercompany transactions apply to the payment of interest and premium 
on intercompany obligations. Current Sec. 1.1502-14(d) provides for the 
deferral of a member's gain or loss from the disposition of another 
member's obligation. Similar rules apply to a member's deduction for 
the worthlessness of an obligation and the deduction for an addition to 
a reserve for bad debts with respect to an obligation.
    If a member's obligation is transferred to a nonmember (or the 
holding member becomes a nonmember), the deferred amount is generally 
taken into account ratably over the remaining term of the obligation. 
In effect, the deferred amount is reflected in consolidated taxable 
income under rules similar to the rules that existed under the Code in 
1966 for original issue discount or amortizable bond premium. If the 
obligation remains within the group, the deferred amount is generally 
not taken into account until the obligation is redeemed. Thus, the 
gains and losses of the members with respect to the obligation 
generally offset each other in determining consolidated taxable income.
    Section 108(e)(4) adopts a limited single entity approach by 
treating the acquisition of debt by a person related to the debtor as 
comparable to the debtor's acquisition of its own debt. The regulations 
implementing section 108(e)(4) include some circumstances in which the 
holder of the debt becomes a person related to the debtor.
    Under the proposed regulations, the matching and acceleration rules 
apply to intercompany obligations. An obligation is defined to include 
securities described in section 475(c)(2) (D) and (E), and comparable 
securities with respect to commodities. For example, an interest rate 
notional principal contract between members is an obligation between 
the counterparties. An obligation is an intercompany obligation during 
the period its parties are members.
    The proposed regulations continue to treat each payment or accrual 
of interest (and each payment or accrual of premium) on an intercompany 
debt as a separate intercompany transaction, and the income is matched 
with the deduction. Similarly, each periodic and nonperiodic payment 
with respect to an intercompany notional principal contract is a 
separate intercompany transaction.
    Special rules are proposed for two categories of transactions: (1) 
Transactions in which an intercompany obligation becomes a 
nonintercompany obligation (or remains an intercompany obligation but 
gain or loss is realized with respect to it); and (2) transactions in 
which a nonintercompany obligation becomes an intercompany obligation. 
In both categories, an obligation is generally deemed to be satisfied 
and, if it remains outstanding, reissued. There are, however, 
significant differences as to how the transactions are deemed to occur.
    Under the first category, if S holds a note of B with a $100 basis 
and stated redemption price at maturity, and S sells the note to a 
nonmember for $75, B is treated as satisfying its obligation to S for 
$75 immediately before S's sale, and issuing a new note directly to the 
nonmember for $75 with a $100 stated redemption price at maturity. The 
proposed regulations match both the timing and the attributes of S's 
items and B's items resulting from the deemed satisfaction. Similar 
principles apply if the note is transferred by S to another member in 
an intercompany transaction, the note is marked to market under section 
475, or if S or B becomes a nonmember (i.e., the note is deemed to be 
satisfied by B and reissued). Similar principles also apply if the 
obligation is a notional principal contract or other nondebt 
intercompany obligation.
    The effect on consolidated taxable income for transactions in the 
first category is similar to the effect under current Sec. 1.1502-
14(d). In both cases, reflection of the net gain or loss on 
consolidated taxable income is deferred in a manner consistent with 
time value of money principles. Under the proposed regulations, 
however, if S sells B's obligation to a nonmember at a loss, S's loss 
and B's gain from the deemed satisfaction are taken into account 
immediately and offset each other, and the discount from the deemed 
reissuance is taken into account over time by B (as the issuer) rather 
than by S. This approach more accurately adjusts the stock basis of S 
and B each year, and is closer to the results under common law 
principles for debtors and creditors in a parent-subsidiary 
relationship. The approach of the proposed regulations in many respects 
treats B's obligation as first existing only after it is sold by S to 
the nonmember. Thus, if a nonmember buys B's note from S at a discount, 
the nonmember will hold the note with original issue discount to which 
section 1272 applies, rather than market discount to which sections 
1276 through 1278 apply.
    Under the second category, if a nonmember (X) holds B's note with a 
$100 basis and stated redemption price at maturity, and X sells the 
note to S for $75, B is treated as satisfying its obligation to S for 
$75 immediately after S's purchase, and issuing a new note to S for $75 
with a $100 stated redemption price at maturity.
    The treatment for transactions under the second category is similar 
in many respects to the treatment of B under section 108(e)(4). Because 
the focus of section 108(e)(4) is to prevent avoidance of discharge of 
indebtedness income, however, that section does not adequately address 
the single entity treatment of consolidated groups. Consequently, the 
proposed regulations apply to cases beyond the scope of section 
108(e)(4), such as to the acquisition of debt at a premium and to all 
cases in which a corporation holding B's debt becomes a member (whether 
or not there is an avoidance view, and whether or not the holder is 
already a related party).
    The deemed satisfaction and reissuance under the proposed 
regulations applies to both the issuer and the holder, and the 
character of their respective items under the Code is not modified (and 
therefore may not match). Nevertheless, the amount at which an 
obligation is satisfied under Sec. 1.108-2 represents a compromise that 
is incorporated into the proposed regulations. In addition, the 
proposed regulations adopt the exceptions to section 108(e)(4) for 
special cases, such as securities dealers.
    Because a member's adjustments to a reserve for bad debts under 
section 585 or 593 reflect its general bad debt experience, rather than 
the value of any particular intercompany obligation that it holds, the 
proposed regulations provide special rules. Reserve deductions with 
respect to intercompany obligations are deferred in a manner similar to 
the treatment of reserves under current Sec. 1.1502-14(d). This 
approach prevents the reserve accounting method of one member from 
affecting the income of another member (or affecting consolidated 
taxable income) through a bad debt reserve deduction with respect to an 
intercompany debt.
    Section 163(e)(5) provides special rules for original issue 
discount on an applicable high yield discount obligation (AHYDO). The 
concerns reflected in the AHYDO rules do not apply to intercompany 
debt, and the Code provides only a partial recast for the dividend 
equivalent portion of the disqualified portion of the original issue 
discount. Consequently, to simplify the applicable rules, the proposed 
regulations exclude intercompany obligations from the application of 
section 163(e)(5).

8. Anti-Avoidance Rules

    Although the proposed regulations shift the emphasis of the 
intercompany transaction system toward single entity treatment, tension 
remains between the single entity and separate entity treatment of 
consolidated groups. The proposed regulations do not address every 
interaction with other consolidated return regulations and other rules 
of law. To ensure that the proposed regulations achieve neutrality in 
the overall determination of consolidated taxable income, adjustments 
may be required. For example, if the approach of the proposed 
regulations in matching the attributes of S's intercompany items and 
B's corresponding items facilitates ``mirror subsidiary'' transactions 
determined by Congress to be inappropriate, adjustments must be made. 
See H.R. Rep. No. 391, 100th Cong., 1st Sess. 1081-84 (1987).
    Adjustments must be made under the proposed regulations if a 
transaction is engaged in or structured with a principal purpose to 
avoid treatment as an intercompany transaction, or to avoid the 
purposes of the proposed regulations. For example, in the case of a 
``mirror subsidiary'' transaction, the adjustments would generally 
conform to the intent of the mirror legislation to ``require the 
recognition of corporate-level gain whenever an appreciated subsidiary 
is sold or distributed outside the economic unit of [a consolidated] 
group.'' Id.
    In addition to these adjustments, the Code (e.g., sections 337(d), 
446, and 482) and general principles of tax law (e.g., the substance-
over-form doctrine, and the tax benefit rule) can apply to require 
proper measurement of taxable income (and tax liability).

9. Successor Corporations and Property

    Under the current regulations, if S's assets are acquired in a 
transaction to which section 381(a) applies, its deferred gains and 
losses are inherited by the member that receives the ``greatest portion 
of the assets (measured by fair market value).'' Commentators have 
suggested that this rule can be used to facilitate the breakup of 
acquired corporations without corporate-level tax, contrary to the 
intent of the ``mirror'' subsidiary legislation. Moreover, they have 
raised questions as to the operation of this rule in many 
circumstances. For example, the reference to fair market value does not 
identify whether liabilities are to be taken into account to determine 
the value on a net basis.
    The proposed regulations generally incorporate successor asset and 
successor person principles. References under the proposed regulations 
to an asset or to a member include, as the context may require, 
references to a successor asset or person.
    The proposed regulations provide that, if there is more than one 
successor, the successors take into account the predecessor's 
intercompany items in a manner that is consistently applied and 
reasonably carries out the purposes of the proposed regulations and 
applicable provisions of law. No inference is intended by this rule as 
to the application of section 381 or other successor principles to 
attributes other than intercompany items and corresponding items.
    The proposed regulations retain the basic approach of the current 
regulations by not requiring acceleration solely because a group 
terminates from its acquisition by another consolidated group. Unlike 
the current regulations, however, the proposed regulations do not 
require all of the members immediately before the acquisition to become 
members of the surviving consolidated group. Instead, the proposed 
regulations accelerate only the items from transactions involving 
corporations that do not become members of the surviving consolidated 
group.

D. Explanation of Proposed Section 267(f) Rules

    Section 267(a) disallows loss on certain sales or exchanges of 
property between related parties. Section 267(f) provides for deferral 
of loss on the sale or exchange of property between members of a 
controlled group, rather than disallowance of the loss under section 
267(a). The section 267(f) rules are generally intended to conform to 
the intercompany transaction rules applicable to consolidated groups 
even though the definition of a controlled group is broader than that 
of a consolidated group.
    The legislative history indicates that exceptions to deferral might 
be provided to properly reflect the amount of net income from a 
transaction. For example, if an accrual method member of a controlled 
group takes into account income with respect to the face amount of a 
note receivable, and later recognizes loss from the sale of that note 
to another member of the controlled group at a discount, the loss would 
not be deferred to the extent it does not exceed the income taken into 
account. See H.R. Rep. No. 861, 98th Cong., 2d Sess. 1032-34 (1984).
    The current regulations applicable to controlled groups generally 
conform to the basic intercompany transaction rules applicable to 
consolidated groups. See Secs. 1.267(f)-1T and 1.267(f)-2T. 
Modifications are made to reflect the broader application of section 
267(f).
    For example, although there are no subgroup rules for intercompany 
transactions between members of a consolidated group, deferral of loss 
continues under section 267(f) as long as S and B remain in a 
controlled group relationship with each other. The current regulations 
also provide that if S sells property to B at a loss, and the property 
is still owned by B when S ceases to be a member of the same controlled 
group, S never takes the loss into account. Instead, B's basis in the 
property is increased by an amount equal to S's unrestored loss.
    The proposed regulations retain the basic approach of the current 
regulations but simplify their operation by more generally 
incorporating the consolidated return rules.
    The proposed regulations eliminate the rule that transforms S's 
loss into additional basis in the transferred property when S ceases to 
be a member of the controlled group. Instead, the proposed regulations 
generally allow S's loss immediately before it ceases to be a member. 
This conforms to the consolidated return rules, and eliminates the need 
for special rules. An anti-avoidance rule is adopted, however, to 
prevent the purposes of section 267(f) from being circumvented, for 
example, by using the proposed rule to accelerate S's loss.

E. Other Applicable Rules

1. Methods of Accounting

    Under current Sec. 1.1502-17(a), each member is generally permitted 
to determine its own method of accounting as if separate returns were 
filed. Thus, the members may have different methods for similar trades 
or businesses. If, however, B acquires assets from S in a transaction 
to which section 381 applies, B might be required to use the same 
method of accounting as S. See, e.g., section 381(c)(4).
    The matching rule proposed in Sec. 1.1502-13 relies on the 
accounting methods of B to determine the timing of S's intercompany 
items. Because B's accounting methods generally control S's timing, a 
group might be able to frustrate the principles of single entity 
treatment under Sec. 1.1502-13 by rearranging its activities to use an 
accounting method that would not be available if S and B were divisions 
of a single corporation.
    Under the proposed regulations, if B directly or indirectly 
acquires an activity of S or undertakes S's activity, with the 
principal purpose to avail the group of an accounting method that would 
be unavailable without securing the Commissioner's consent if S and B 
were treated as divisions of a single corporation, B may be required to 
use S's accounting method for the acquired or undertaken activity or 
secure consent from the Commissioner for a different method.

2. Special Inventory Adjustment

    Current Sec. 1.1502-18 requires a special adjustment relating to 
intercompany profit from inventory transactions if an affiliated group 
filing separate returns elects to file consolidated returns. This 
adjustment has historically been included in the consolidated return 
regulations. It is intended to prevent the members' income from being 
reduced when the group switches from separate to consolidated returns.
    For example, if S and B are affiliated but file separate returns 
for Year 1 and S manufactures inventory for $75 that is sold to B for 
$100, S's $25 intercompany profit is taken into account in Year 1 and B 
has a $100 cost basis in the inventory. If S recognizes another $25 of 
intercompany profit in Year 2, and B sells the inventory purchased from 
S in Year 1, S's additional $25 profit is taken into account in Year 2 
and B recovers its cost basis in the inventory purchased in Year 1. If, 
however, the group shifts to consolidated returns for Year 2, S's 
additional $25 profit is deferred under Sec. 1.1502-13 but B still 
recovers its cost basis. Thus, the shift to consolidated returns 
reduces the group's aggregate income in Year 2. If S and B continue the 
same intercompany activity year after year, the one-time reduction is 
effectively a permanent reduction.
    To prevent a reduction in taxable income, the current regulations 
provide for a special inventory adjustment to increase the group's 
consolidated taxable income for Year 2 by S's $25 intercompany profit 
from Year 1, to the extent that it is reflected in B's opening 
inventory for Year 2. The adjustment might ultimately be reversed in 
later years if, for example, B's ending inventory purchased from S is 
reduced or the group ceases to file consolidated returns.
    Commentators argue that Sec. 1.1502-18 reaches an inappropriate 
result, and that its effect can be avoided, for example, by causing S 
to transfer its assets to a lower-tier member in a transaction to which 
section 351 applies (or otherwise to cease its intercompany sales).
    To simplify the intercompany transaction system, the proposed 
regulations eliminate the special inventory adjustment. Any remaining 
unrecovered inventory amount under Sec. 1.1502-18(c) (or its equivalent 
under Sec. 1.1502-18(f)) is recovered under the principles of those 
rules in the first taxable year ending on or after the date final 
regulations are filed with the Federal Register. The unrecovered 
inventory amount can be recovered only to the extent it was previously 
included in taxable income.

3. Attribute Reduction (Section 108(b))

    The proposed regulations provide rules to prevent avoidance of the 
attribute reduction required under section 108(b). Several issues 
regarding the application of section 108 to consolidated groups are 
under study. For example, single entity treatment for consolidated 
group attribute reduction under section 108(b) is being considered in 
connection with regulations being developed. The proposed regulations 
are not intended to affect any other aspects of the application of 
section 108.

4. Applicability of Section 1031

    The current regulations do not provide special rules for 
intercompany transactions to which section 1031 applies.
    Section 1031 treatment for intercompany transactions is 
inconsistent with the general approach of the proposed regulations. If 
the members had been divisions of a single corporation, the basis of 
one property could not be substituted as the basis for another 
property. Although section 1031(f) limits the planning opportunities 
from certain basis shifts, the limitations do not adequately address 
the single entity treatment of consolidated groups under the proposed 
regulations.
    To conform the treatment of like-kind exchanges more closely to the 
general treatment of intercompany transactions under the proposed 
regulations, the proposed regulations provide that section 1031 does 
not apply to intercompany transactions. Any gain or loss of the members 
will be taken into account under the matching and acceleration rules.

F. Proposed Effective Dates

    The proposed intercompany transaction regulations generally apply 
to intercompany transactions occurring in years beginning on or after 
the date the final regulations are filed with the Federal Register. 
Prior intercompany transactions will generally continue to be subject 
to the prior regulations under section 1502 as in effect with respect 
to the transaction.
    Because an intercompany transaction can occur in part under the 
current regulations and in part under the proposed regulations, the 
current regulations (rather than the proposed regulations) will 
continue to apply to take into account transactions that have already 
been taken into account in part under the current regulations. This 
approach prevents duplication or omission of items from a transaction, 
and treats items consistently.
    To prevent manipulation, the final regulations (and not prior law) 
apply to certain transactions engaged in or structured on or after 
April 8, 1994. The final regulations apply if the transaction is 
engaged in or structured with a principal purpose to avoid the final 
regulations, to duplicate, omit, or eliminate an item in determining 
taxable income (or tax liability), or to treat items inconsistently. In 
these cases, appropriate adjustments must be made in years beginning on 
or after [the date the final regulations are filed with the Federal 
Register], to prevent the avoidance, duplication, omission, 
elimination, or inconsistency.
    The methods of accounting provided in the final regulations will be 
required of all groups. If the final regulations are adopted on the 
proposed ``cut-off'' basis, no request for permission to make the 
change, or to make an adjustment under section 481(a), will be 
necessary.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in EO 12866. Therefore, 
a regulatory assessment is not required. It has also been determined 
that section 553(b) of the Administrative Procedure Act (5 U.S.C. 
chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do 
not apply to these regulations, and, therefore, a Regulatory 
Flexibility Analysis is not required. Pursuant to section 7805(f) of 
the Code, this notice of proposed rulemaking will be submitted to the 
Chief Counsel for Advocacy of the Small Business Administration for 
comment on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted, consideration will 
be given to any written comments that are submitted timely (preferably 
a signed original and eight copies) to the IRS. All comments will be 
available for public inspection and copying in their entirety. Two 
public hearings on the proposed regulations will be held. See the 
notice of public hearings on proposed rulemaking published elsewhere in 
this issue of the Federal Register.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by 
removing the entries for sections ``1.469-1, 1.469-1T, 1.469-2, 1.469-
2T, 1.469-3, 1.469-3T, 1.469-5, 1.469-5T and 1.469-11'', ``1.1502-13'', 
``1.1502-13T'', ``1.1502-14'', and ``1.1502-14T'' and adding the 
following:

    Authority: 26 U.S.C. 7805 * * * Section 1.108-3 also issued 
under 26 U.S.C. 108, 267, and 1502. * * * Section 1.267(f)-1 also 
issued under 26 U.S.C. 267 and 1502. * * * Section 1.460-4 also 
issued under 26 U.S.C. 460 and 1502. * * * Section 1.469-1, 1.469-
1T, 1.469-2, 1.469-2T, 1.469-3, 1.469-3T, 1.469-5, 1.469-5T, and 
1.469-11 also issued under 26 U.S.C. 469. * * * Section 1.1502-13 
also issued under 26 U.S.C. 108, 337, 446, 1275, 1502 and 1503. * * 
* Section 1.1502-17 also issued under 26 U.S.C. 446 and 1502. 
Section 1.1502-18 also issued under 26 U.S.C. 1502. * * * Section 
1.1502-26 also issued under 26 U.S.C. 1502. * * * Section 1.1502-33 
also issued under 26 U.S.C. 1502. * * *

    Par. 2. In the list below, for each location indicated in the left 
column, remove the language in the middle column from that section, and 
add the language in the right column.

------------------------------------------------------------------------
    Affected section                Remove                   Add        
------------------------------------------------------------------------
1.167(a)-(11)(d)(3)(v)(b)  Paragraph (c) of........                     
 , 1st sentence.                                                        
1.263A-1T(b)(2)(vi)(B),    A deferred intercompany   An intercompany    
 2nd sentence.              transaction.              transaction.      
1.263A-1T(e)(1)(ii), 1st   A deferred intercompany   An intercompany    
 sentence.                  transaction.              transaction.      
1.263A-1T(e)(1)(ii), 4th   1.1502-13(c)(2).........  1.1502-13.         
 sentence.                                                              
1.263A-1T(e)(1)(ii), 4th   Deferred.                                    
 sentence.                                                              
1.263A-1T(e)(1)(ii), 7th   Deferred intercompany     Intercompany       
 sentence.                  transaction.              transaction.      
1.263A-1T(e)(1)(ii), 7th   Defined.................  As used.           
 sentence.                                                              
1.263A-1T(e)(1)(iii)(A)    1.1502-13(c)............  1.1502-13.         
 Example, 2nd sentence.                                                 
1.263A-1T(e)(1)(iii)(A)    1.1502-13(c)............  1.1502-13.         
 Example, 4th sentence.                                                 
1.338-4(f)(4) Example (2)  1.1502-13(f)............  1.1502-13.         
 (a).                                                                   
1.341-7(e)(10)...........  Paragraph (c)(1) of Sec.  Sec. 1.1502-13.    
                            1.1502-14.                                  
1.861-8T(d)(2)(i),         1.1502-13(c)(2).........  1.1502-13.         
 concluding text.                                                       
1.861-8T(d)(2)(i),         Deferred.                                    
 concluding text.                                                       
1.861-8T(d)(2)(i),         1.1502-13(a)(2).........  1.1502-13.         
 concluding text.                                                       
1.861-9T(g)(2)(iv),        Deferred.                                    
 paragraph heading.                                                     
1.861-9T(g)(2)(iv), 1st    Deferred intercompany     Intercompany       
 sentence.                  transactions              transactions.     
1.1502-3(a)(2)...........  1.1502-13(a)(1).........  1.1502-13(b).      
1.1502-4(j) Example (1),   Paragraph (d), (e), or    1.1502-13.         
 8th sentence.              (f) of Sec. 1.1502-13.                      
1.1502-4(j) Example (1),   Paragraph (d), (e), or    1.1502-13.         
 2nd sentence after chart.  (f) of Sec. 1.1502-13.                      
1.1502-9(f) Example (6)..  1.1502-13(f)............  1.1502-13.         
1.1502-12(a).............  Secs. 1.1502-13 and       Sec. 1.1502-13.    
                            1.1502-14.                                  
1.1502-12(g)(2)..........  A deferred intercompany   An intercompany    
                            transaction as defined    transaction as    
                            in Sec. 1.1502-13(a)(2).  defined in Sec.   
                                                      1.1502-13.        
1.1502-22(a)(3)..........  1.1502-14,..............  ...................
1.1502-22(a)(5) Example    Paragraph (d), (e), or    Sec. 1.1502-13.    
 (i).                       (f) of Sec. 1.1502-13.                      
1.1502-26(b).............  Paragraph (a)(1) of Sec.  Sec. 1.1502-13.    
                            1.1502-14.                                  
1.1502-47(e)(4)(iii).....  Secs. 1.1502-13(f),       Secs. 1.1502-13,   
                            1.1502-14, 1.1502-18,.    1.1502-18.        
1.1502-47(e)(4)(iv)        Deferred intercompany     Intercompany       
 Example 4, 3d sentence.    transactions (see Sec.    transactions (see 
                            1.1502-13(a)(2)).         Sec. 1.1502-13).  
1.1502-47(e)(4)(iv)        1.1502-13(f)(1)(iv).....  1.1502-13.         
 Example 4, 4th sentence.                                               
1.1502-47(e)(4)(iv)        Deferred intercompany     Intercompany       
 Example 4, chart header.   transactions between.     transactions      
                                                      between.          
1.1502-47(e)(4)(iv)        1.1502-13(f)(1)(iv).....  1.1502-13.         
 Example 4, chart header.                                               
1.1502-47(f)(3)..........  1.1502-14.                                   
1.1502-47(r), 2nd          Deferred.                                    
 sentence.                                                              
1.1503-2(d)(4) Example 1   Deferred.                                    
 (iii), 4th sentence.                                                   
1.1503-2(d)(4) Example 1   1.1502-13(a)(2).........  1.1502-13.         
 (iii), 4th sentence.                                                   
------------------------------------------------------------------------

    Par. 3. Section 1.108-3 is added to read as follows:


Sec. 1.108-3  Intercompany losses and deductions.

    (a) General rule. This section applies to certain losses and 
deductions from the sale, exchange, or other transfer of property 
between corporations that are members of a consolidated group or a 
controlled group (an intercompany transaction). See section 267(f) 
(controlled groups) and Sec. 1.1502-13 (consolidated groups) for 
applicable definitions. For purposes of determining the attributes to 
which section 108(b) applies, a loss or deduction not yet taken into 
account under section 267(f) or Sec. 1.1502-13 (an intercompany loss or 
deduction) is treated as basis described in section 108(b) that the 
transferor retains in property. For example, if S and B are 
corporations filing a consolidated return, and S sells land with a $100 
basis to B for $90 and the $10 loss is deferred under section 267(f) 
and Sec. 1.1502-13, the deferred loss is treated for purposes of 
section 108(b) as $10 of basis that S has in land (even though S has no 
remaining interest in the land sold to B) and is subject to reduction 
under section 108(b)(2)(E). To the extent S's loss is reduced, it can 
not thereafter be taken into account under section 267(f) or 
Sec. 1.1502-13. Similar principles apply, with appropriate adjustments, 
if S and B are members of a controlled group and S's loss is deferred 
only under section 267(f).
    (b) Effective date. This section applies with respect to discharges 
of indebtedness occurring on or after [the date that is 60 days after 
final regulations are filed with the Federal Register.


Sec. 1.167(a)-11  [Amended]

    Par. 4. Section 1.167(a)-11(d)(3)(v)(e) is amended by removing the 
second sentence of Example (3).
    Par. 5. Section 1.267(f)-1 is revised to read as follows:


Sec. 1.267(f)-1  Controlled groups.

    (a) In general--(1) Purpose. This section provides rules under 
section 267(f) to defer losses and deductions from certain transactions 
between members of a controlled group (intercompany sales). The purpose 
of the deferral is to prevent tax avoidance from allowing the loss or 
deduction of the selling member (S) without the corresponding inclusion 
of the buying member (B).
    (2) Application of consolidated return principles. Under this 
section, S's loss or deduction from an intercompany sale is taken into 
account under the timing principles of Sec. 1.1502-13 (intercompany 
transactions between members of a consolidated group), treating the 
intercompany sale as an intercompany transaction. For this purpose:
    (i) The matching and acceleration rules of Sec. 1.1502-13(c) and 
(d), the definitions and operating rules of Sec. 1.1502-13(b) and (j), 
and the simplifying rules of Sec. 1.1502-13(e)(1) apply with the 
adjustments in paragraphs (b) and (c) of this section to reflect that 
this section--
    (A) Applies on a controlled group basis rather than consolidated 
group basis; and
    (B) Generally affects only the timing of a loss or deduction, and 
not its attributes (e.g., its source and character) or the holding 
period of property.
    (ii) The special rules under Sec. 1.1502-13(f) (stock of members) 
and (g) (obligations of members) apply under this section only to the 
extent that the transaction is also an intercompany transaction to 
which Sec. 1.1502-13 applies.
    (iii) Any election under Sec. 1.1502-13 to take items into account 
on a separate entity basis does not apply under this section. See 
Sec. 1.1502-13(e)(3).
    (3) Other law. The rules of this section apply in addition to other 
applicable law. For example, to the extent a loss or deduction deferred 
under this section is from a transaction that is also an intercompany 
transaction under Sec. 1.1502-13(b)(1), the loss or deduction is also 
subject to recharacterization under Sec. 1.1502-13. See also sections 
269 (acquisitions to evade or avoid income tax) and 482 (allocations 
among commonly controlled taxpayers). Any loss or deduction taken into 
account under this section can be deferred, disallowed, or eliminated 
under other applicable law. See, e.g., section 1091 (loss eliminated on 
wash sale).
    (4) Construction. The rules of this section must be applied in a 
consistent manner that reasonably carries out their purposes, taking 
into account all of the facts and circumstances, the underlying 
economic arrangement, and applicable Federal income tax accounting 
principles. For example, the rules must not be applied to accelerate or 
duplicate S's losses or deductions.
    (b) Definitions and operating rules. The definitions in 
Sec. 1.1502-13(b) and the operating rules of Sec. 1.1502-13(j) apply 
under this section with appropriate adjustments, including the 
following:
    (1) Intercompany sale. An intercompany sale is a sale, exchange, or 
other transfer of property between members of a controlled group, if it 
would be an intercompany transaction under the principles of 
Sec. 1.1502-13, determined by treating the references to a consolidated 
group as references to a controlled group and by disregarding whether 
any of the members join in filing consolidated returns.
    (2) S's losses or deductions. Unless the intercompany sale is also 
an intercompany transaction to which Sec. 1.1502-13 applies, S's losses 
or deductions subject to this section are determined on a separate 
entity basis. For example, the principles of Sec. 1.1502-13(b)(2)(i)(C) 
(treating certain amounts not yet recognized as items to be taken into 
account) do not apply. A loss or deduction is from an intercompany sale 
whether it is directly or indirectly from the intercompany sale.
    (3) Controlled group; member. For purposes of this section, a 
controlled group is defined in section 267(f). Thus, a controlled group 
includes a FSC (as defined in section 922) and excluded members under 
section 1563(b)(2), but does not include a DISC (as defined in section 
992). Because corporations may be controlled group members without 
joining in the filing of consolidated returns or being owned through a 
common parent, corporations remain members of a controlled group as 
long as they remain in a controlled group relationship with each other. 
For example, corporations become nonmembers with respect to each other 
when they cease to be in a controlled group relationship with each 
other, rather than by having a separate return year (described in 
Sec. 1.1502-13(j)(4)). Further, the principles of Sec. 1.1502-13(j)(3) 
(former common parent treated as continuation of group) apply to any 
corporation if, immediately before it becomes a nonmember, it is both 
the selling member and the owner of property with respect to which a 
loss or deduction is deferred (whether or not it becomes a member of a 
different controlled group filing consolidated or separate returns).
    (4) Consolidated taxable income. References to consolidated taxable 
income (and consolidated tax liability) include references to the 
combined taxable income of the members (and their combined tax 
liability). For corporations filing separate returns, it ordinarily 
will not be necessary to actually combine their taxable incomes (and 
tax liabilities) because the taxable income (and tax liability) of one 
corporation does not affect the taxable income (or tax liability) of 
another corporation.
    (c) Matching and acceleration principles of Sec. 1.1502-13--(1) 
General rule. Under this section, S's losses and deductions are 
deferred until they are taken into account under the timing principles 
of the matching and acceleration rules of Sec. 1.1502-13 (c) and (d), 
with appropriate adjustments. For example, if S sells depreciable 
property to B at a loss, S's loss is deferred and taken into account 
under the principles of the matching rule of Sec. 1.1502-13(c) to 
reflect the difference between B's depreciation taken into account with 
respect to the property and the depreciation that B would take into 
account if S and B were divisions of a single corporation; if S and B 
subsequently cease to be in a controlled group relationship with each 
other, S's remaining loss is taken into account under the principles of 
the acceleration rule of Sec. 1.1502-13(d). The matching and 
acceleration rules are not applied under this section to affect the 
attributes of an item, or cause it to be taken into account before it 
is taken into account under the member's method of accounting on a 
separate entity basis. Similarly, the matching and acceleration rules 
are not applied under this section to affect the timing or attributes 
of B's items.
    (2) Adjustments to the timing principles of Sec. 1.1502-13 (c) and 
(d). For purposes of this section, the adjustments to Sec. 1.1502-13 
(c) and (d) include the following:
    (i) Different taxable years. If S and B have different taxable 
years, the taxable years that include a December 31 are treated as the 
same taxable years. If S or B has a short taxable year that does not 
include a December 31, the short year is treated as part of the 
succeeding taxable year that does include a December 31.
    (ii) Transfer to a section 267(b) related person. To the extent S's 
loss or deduction is taken into account under this section as a result 
of B's transfer to a nonmember that is a person related to any member 
under section 267(b), the loss or deduction is taken into account but 
allowed only to the extent of any income or gain taken into account as 
a result of the transfer. The balance not allowed is treated as a loss 
referred to in section 267(d) if it is from a sale or exchange by B 
(rather than from a distribution).
    (iii) Circularity of references. References to deferral or 
elimination under the Internal Revenue Code or regulations do not 
include references to section 267(f) or this section. See, e.g., 
Sec. 1.1502-13(a)(3) (applicability of other law).
    (d) Intercompany sales of inventory involving foreign persons--(1) 
General rule. Section 267(a)(1) and this section do not apply to an 
intercompany sale of property that is inventory (within the meaning of 
section 1221(1)) in the hands of both S and B, if--
    (i) The intercompany sale is in the ordinary course of S's trade or 
business; and
    (ii) S or B is a foreign corporation, any income or loss realized 
on the intercompany sale by S or B is not income or loss that is 
recognized as effectively connected with the conduct of a trade or 
business within the United States within the meaning of section 864 
(unless the income is exempt from taxation pursuant to a treaty 
obligation of the United States).
    (2) Intercompany sales involving related partnerships. For purposes 
of paragraph (d)(1) of this section, a partnership and a foreign 
corporation described in section 267(b)(10) are treated as members, 
provided the foreign corporation is described in paragraph (d)(1)(ii) 
of this section.
    (3) Intercompany sales in ordinary course. For purposes of this 
paragraph (d), whether an intercompany sale is in the ordinary course 
of business is determined under all the facts and circumstances.
    (e) Treatment of a creditor with respect to a loan in nonfunctional 
currency. Sections 267(a)(1) and this section do not apply to an 
exchange loss realized with respect to a loan of nonfunctional currency 
if--
    (1) The loss is realized by a member with respect to nonfunctional 
currency loaned to another member;
    (2) The loan is described in Sec. 1.988-1(a)(2)(i);
    (3) The loan is not in a hyperinflationary currency as defined in 
Sec. 1.988-1(f); and
    (4) The transaction does not have as a significant purpose the 
avoidance of Federal income tax.
    (f) Receivables. If S has income or gain from a receivable acquired 
as a result of selling goods or services to a nonmember, and S sells 
the receivable at fair market value to B, any loss or deduction of S 
from its sale to B is not deferred under this section to the extent it 
does not exceed S's income or gain from the sale to the nonmember.
    (g) Earnings and profits. A loss or deduction deferred under this 
section is not reflected in S's earnings and profits before it is taken 
into account under this section. See, e.g., Secs. 1.312-6(a), 1.312-7, 
and 1.1502-33(c)(2).
    (h) Anti-avoidance rule. If a transaction is engaged in or 
structured with a principal purpose to avoid the application of this 
section, or to affect the timing of losses or deductions (or tax 
liability) under this section, adjustments must be made to carry out 
the purposes of this section.
    (i) [Reserved]
    (j) Examples. For purposes of the examples in this paragraph (j), 
unless otherwise stated, corporation P owns 75% of the only class of 
stock of subsidiaries S and B, X is a person unrelated to any member of 
the P controlled group, the taxable year of all persons is the calendar 
year, all persons use the accrual method of accounting, tax liabilities 
are disregarded, the facts set forth the only activity, and no member 
has a special status. If a member acts as both a selling member and a 
buying member (e.g., with respect to different aspects of a single 
transaction, or with respect to related transactions), the member is 
referred as to M (rather than as S or B). This section is illustrated 
by the following examples.

    Example 1. Matching and acceleration rules. (a) Facts. S holds 
land for investment with a basis of $130. On January 1 of Year 1, S 
sells the land to B for $100. On a separate entity basis, S's loss 
is long-term capital loss. B holds the land for sale to customers in 
the ordinary course of business. On July 1 of Year 3, B sells the 
land to X for $110.
    (b) Matching rule. Under paragraph (b)(1) of this section, S's 
sale of land to B is an intercompany sale. Under paragraph (c)(1) of 
this section, S's $30 loss is taken into account under the timing 
principles of the matching rule of Sec. 1.1502-13(c) to reflect the 
difference for the year between B's corresponding items taken into 
account and B's recomputed corresponding items (the corresponding 
items that B would take into account for the year if S and B were 
divisions of a single corporation). If S and B were divisions of a 
single corporation and the intercompany sale were a transfer between 
the divisions, B would succeed to S's $130 basis in the land and 
would have a $20 loss from the sale to X. Consequently, S takes no 
loss into account in Years 1 and 2, and takes the entire $30 loss 
into account in Year 3 to reflect the $30 difference in that year 
between the $10 gain B takes into account and its $20 recomputed 
loss. The attributes of S's intercompany items and B's corresponding 
items are determined on a separate entity basis. Thus, S's $30 loss 
is long-term capital loss and B's $10 gain is ordinary income.
    (c) Acceleration resulting from sale of B stock. The facts are 
the same as in paragraph (a) of this Example 1, except that on July 
1 of Year 3 P sells all of its B stock to X (rather than B's selling 
the land to X). Under paragraph (c)(1) of this section, S's $30 loss 
is taken into account under the timing principles of the 
acceleration rule of Sec. 1.1502-13(d) immediately before the effect 
of treating S and B as divisions of a single corporation cannot be 
produced. Because the effect cannot be produced once B becomes a 
nonmember, S takes its $30 loss into account in Year 3 immediately 
before B becomes a nonmember. S's loss is long-term capital loss.
    (d) Subgroup principles applicable to sale of S and B stock. The 
facts are the same as in paragraph (a) of this Example 1, except 
that on July 1 of Year 3 P sells all of its S and B stock to X 
(rather than B's selling the land to X). Under paragraph (b)(3) of 
this section, S and B are considered to remain members of a 
controlled group as long as they remain in a controlled group 
relationship with each other (whether or not in the original 
controlled group). P's sale of their stock does not affect the 
controlled group relationship of S and B with each other. Thus, S's 
loss is not taken into account as a result of P's sale of the stock. 
Instead, S's loss is taken into account based on subsequent events 
(e.g., B's sale of the land to a nonmember).
    Example 2. Distribution of loss property. (a) Facts. S holds 
land with a basis of $130 and value of $100. On January 1 of Year 1, 
S distributes the land to P in a transaction to which section 311 
applies. On July 1 of Year 3, P sells the land to X for $110.
    (b) No loss taken into account. Under paragraph (b)(2) of this 
section, because P and S are not members of a consolidated group, 
Sec. 1.1502-13(f)(2)(iii) does not apply to cause S to recognize a 
$30 loss under the principles of section 311(b). Thus, S has no loss 
to be taken into account under this section. (If P and S were 
members of a consolidated group, Sec. 1.1502-13(f)(2)(iii) would 
apply to S's loss in addition to the rules of this section, and the 
loss would be taken into account in Year 3 as a result of P's sale 
to X.)
    Example 3. Loss not yet taken into account under separate entity 
accounting method. (a) Facts. S holds land with a basis of $130. On 
January 1 of Year 1, S sells the land to B at a $30 loss but does 
not take into account the loss under its separate entity method of 
accounting until Year 4. On July 1 of Year 3, B sells the land to X 
for $110.
    (b) Timing. Under paragraph (b)(2) of this section, the 
determination S's loss is made on a separate entity basis. Under 
paragraph (c)(1) of this section, S's loss is not taken into account 
before it is taken into account under S's separate entity method of 
accounting. Thus, although B takes its corresponding gain into 
account in Year 3, S has no loss to take into account until Year 4. 
Once S's loss is taken into account in Year 4, it is not deferred 
under this section because B's corresponding gain has already been 
taken into account. (If S and B were members of a consolidated 
group, S would be treated under Sec. 1.1502-13(b)(2)(i)(C) as taking 
the loss into account in Year 3.)
    Example 4. Consolidated groups. (a) Facts. P owns all of the 
stock of S and B, and the P group is a consolidated group. S holds 
land for investment with a basis of $130. On January 1 of Year 1, S 
sells the land to B for $100. B holds the land for sale to customers 
in the ordinary course of business. On July 1 of Year 3, P sells 25% 
of B's stock to X. As a result of P's sale, B becomes a nonmember of 
the P consolidated group but S and B remain in a controlled group 
relationship with each other for purposes of section 267(f). Assume 
that if S and B were divisions of a single corporation, the items of 
S and B from the land would be ordinary by reason of B's activities.
    (b) Timing and attributes. Under paragraph (a)(3) of this 
section, S's sale to B is subject to both Sec. 1.1502-13 and this 
section. Under Sec. 1.1502-13, S's loss is recharacterized as an 
ordinary loss by reason of B's activities. Under paragraph (b)(3) of 
this section, because S and B remain in a controlled group 
relationship with each other, the loss is not taken into account 
under the acceleration rule of Sec. 1.1502-13(d) as modified by 
paragraph (c) of this section. See Sec. 1.1502-13(a)(3). 
Nevertheless, S's loss is recharacterized by Sec. 1.1502-13 as an 
ordinary loss, and the character of the loss is not further 
redetermined under this section. Thus, the loss continues to be 
deferred under this section, and will be taken into account as 
ordinary loss based on subsequent events (e.g., B's sale of the land 
to a nonmember).
    (c) Resale to controlled group member. The facts are the same as 
in paragraph (a) of this Example 4, except that P owns 75% of X's 
stock, and B resells the land to X (rather than P's selling any B 
stock). The results for S's loss are the same as in paragraph (b) of 
this Example 4. Under paragraph (b) of this section, X is also in a 
controlled group relationship, and B's sale to X is a second 
intercompany sale. Thus, S's loss continues to be deferred and is 
taken into account under this section as ordinary loss based on 
subsequent events (e.g., X's sale of the land to a nonmember).
    Example 5. Intercompany sale followed by installment sale. (a) 
Facts. S holds land for investment with a basis of $130x. On January 
1 of Year 1, S sells the land to B for $100x. B holds the land for 
investment. On July 1 of Year 3, B sells the land to X in exchange 
for X's $110x note. The note bears a market rate of interest in 
excess of the applicable Federal rate, and provides for principal 
payments of $55x in Year 4 and $55x in Year 5. Section 453A applies 
to X's note.
    (b) Timing and attributes. Under paragraph (c) of this section, 
S's $30x loss is taken into account under the timing principles of 
the matching rule of Sec. 1.1502-13(c) to reflect the difference in 
each year between B's gain taken into account and its recomputed 
loss. Under section 453, B takes into account $5x of gain in Year 4 
and in Year 5. Therefore, S takes $20x of its loss into account in 
Year 3 to reflect the $20x difference in that year between B's $0 
loss taken into account and its $20x recomputed loss. In addition, S 
takes $5x of its loss into account in Year 4 and in Year 5 to 
reflect the $5x difference in each year between B's $5x gain taken 
into account and its $0 recomputed gain. Although S takes into 
account a loss and B takes into account a gain, the attributes of 
B's $10x gain are determined on a separate entity basis, and 
therefore the interest charge under section 453A(c) applies to B's 
$10x gain on the installment sale beginning in Year 3.
    Example 6. Section 721 transfer to a section 267(b) nonmember. 
(a) Facts. S owns land with a basis of $130. On January 1 of Year 1, 
S sells the land to B for $100. On July 1 of Year 3, B transfers the 
land to a partnership in exchange for a 40% interest in capital and 
profits in a transaction to which section 721 applies. P also owns a 
25% interest in the capital and profits of the partnership.
    (b) Timing. Under paragraph (c)(2)(ii) of this section, S's $30 
loss is taken into account in Year 3 but disallowed because the 
partnership is a nonmember that is a related person under section 
267(b). In addition, any subsequent gain recognized by the 
partnership with respect to the property is limited under section 
267(d). (The results would be the same if the P group were a 
consolidated group, and S's sale to B were also subject to 
Sec. 1.1502-13.)
     Example 7. Receivables. (a) Controlled group. S owns goods with 
a $60 basis. In Year 1, S sells the goods to X for X's $100 note. 
The note bears a market rate of interest in excess of the applicable 
Federal rate, and provides for payment of principal in Year 5. S 
takes into account $40 of income in Year 1 under its method of 
accounting. In Year 2, the fair market value of X's note falls to 
$90 due to an increase in prevailing market interest rates, and S 
sells the note to B for its $90 fair market value.
    (b) Loss not deferred. Under paragraph (f) of this section, S 
takes its $10 loss into account in Year 2. (If the sale were not at 
fair market value, paragraph (f) of this section would not apply and 
none of S's $10 loss would be taken into account in Year 2.)
    (c) Consolidated group. Assume instead that P owns all of the 
stock of S and B, and the P group is a consolidated group. In Year 
1, S sells to X goods having a basis of $90 for X's $100 note 
(bearing a market rate of interest in excess of the applicable 
Federal rate, and providing for payment of principal in Year 5), and 
S takes into account $10 of income in Year 1. In Year 2, S sells the 
receivable to B for its $85 fair market value. In Year 3, P sells 
25% of B's stock to X. Although paragraph (f) of this section 
provides that $10 of S's loss (i.e., the extent to which S's $15 
loss does not exceed its $10 of income) is not deferred under this 
section, S's entire $15 loss is subject to Sec. 1.1502-13 and none 
of the loss is taken into account in Year 2 under the matching rule 
of Sec. 1.1502-13(c). See paragraph (a)(3) of this section 
(continued deferral under Sec. 1.1502-13). P's sale of B stock 
results in B becoming a nonmember of the P consolidated group in 
Year 3. Thus, S's $15 loss is taken into account in Year 3 under the 
acceleration rule of Sec. 1.1502-13(d). Nevertheless, B remains in a 
controlled group relationship with S and paragraph (f) of this 
section permits only $10 of S's loss to be taken into account in 
Year 3. See Sec. 1.1502-13(a)(3) (continued deferral under section 
267). The remaining $5 of S's loss continues to be deferred under 
this section and taken into account under this section based on 
subsequent events (e.g., B's collection of the note or P's sale of 
the remaining B stock to a nonmember).
    Example 8. Selling member ceases to be a member. (a) Facts. P 
owns all of the stock of S and B, and the P group is a consolidated 
group. S has several historic assets, including land with a basis of 
$130 and value of $100. The land is not essential to the operation 
of S's business. On January 1 of Year 1, S sells the land to B for 
$100. On July 1 of Year 3, P transfers all of S's stock to newly 
formed X in exchange for a 20% interest in X stock as part of a 
transaction to which section 351 applies. Although X holds many 
other assets, a principal purpose for P's transfer is to accelerate 
taking S's $30 loss into account. P has no plan or intention to 
dispose of the X stock.
    (b) Timing. Under paragraph (c) of this section, S's $30 loss 
ordinarily is taken into account immediately before P's transfer of 
the S stock, under the timing principles of the acceleration rule of 
Sec. 1.1502-13(d). Although taking S's loss into account results in 
a $30 negative stock basis adjustment under Sec. 1.1502-32, because 
P has no plan or intention to dispose of its X stock, the negative 
adjustment will not immediately affect taxable income. P's transfer 
accelerates a loss that otherwise would be deferred, and an 
adjustment under paragraph (h) of this section is required. Thus, 
S's loss is never taken into account, and S's stock basis and 
earnings and profits are reduced by $30 under Secs. 1.1502-32 and 
1.1502-33 immediately before P's transfer of the S stock.
    (c) Nonhistoric assets. Assume instead that, with a principal 
purpose to accelerate taking loss into account, P forms M with a 
$100 contribution on January 1 of Year 1 and S sells the land to M 
for $100. On December 1 of Year 1, M sells the land to B for $90. On 
July 1 of Year 3, while B still owns the land, P sells all of M's 
stock to X and M becomes a nonmember. Under paragraph (c) of this 
section, M's $10 loss ordinarily is taken into account under the 
timing principles of the acceleration rule of Sec. 1.1502-13(d) 
immediately before M becomes a nonmember. (S's $30 loss is not taken 
into account under the timing principles of Sec. 1.1502-13(c) or 
Sec. 1.1502-13(d) as a result of M becoming a nonmember, but is 
taken into account based on subsequent events such as B's sale of 
the land to a nonmember or P's sale of the stock of S or B to a 
nonmember.) The land is not an historic asset of M and, although 
taking M's loss into account reduces P's basis in the M stock under 
Sec. 1.1502-32, the negative adjustment only eliminates the $10 
duplicate stock loss. Under paragraph (h) of this section, M's loss 
is never taken into account. M's stock basis, and the earnings and 
profits of M and P, are reduced by $10 under Secs. 1.1502-32 and 
1.1502-33 immediately before P's sale of the M stock.

    (k) Cross-reference. For additional rules applicable to the 
disposition or deconsolidation of the stock of members of consolidated 
groups, see Secs. 1.337(d)-1, 1.337(d)-2, and 1.1502-20.
    (l) Effective dates--(1) In general. This section applies with 
respect to transactions occurring in S's years beginning on or after 
[the date the final regulations are filed with the Federal Register]. 
If both this section and prior law apply to a transaction, or neither 
applies, with the result that items are duplicated, omitted, or 
eliminated in determining taxable income (or tax liability), or items 
are treated inconsistently, prior law (and not this section) applies to 
the transaction.
    (2) Avoidance transactions. This paragraph (l)(2) applies if a 
transaction is engaged in or structured on or after April 8, 1994, with 
a principal purpose to avoid the rules of this section applicable to 
transactions occurring in years beginning on or after [the date the 
final regulations are filed with the Federal Register], to duplicate, 
omit, or eliminate an item in determining taxable income (or tax 
liability), or to treat items inconsistently. If this paragraph (l)(2) 
applies, appropriate adjustments must be made in years beginning on or 
after [the date the final regulations are filed with the Federal 
Register], to prevent the avoidance, duplication, omission, 
elimination, or inconsistency.
    (3) Prior law. For transactions occuring in S's years beginning 
before [the date the final regulations are filed with the Federal 
Register] see the applicable regulations issued under sections 267 and 
1502. See, e.g., Secs. 1.267(f)-1, 1.267(f)-1T, 1.267(f)-2T, 1.267(f)-
3, 1.1502-13, 1.1502-13T, 1.1502-14, 1.1502-14T, and 1.1502-31 (as 
contained in the 26 CFR part 1 edition revised as of April 1, 1994).


Secs. 1.267(f)-1T, 1.267(f)-2T, and 1.267(f)-3  [Removed]

    Par. 6. Sections 1.267(f)-1T, 1.267(f)-2T, and 1.267(f)-3 are 
removed.
    Par. 7. Section 1.460-0 is amended in the table of contents by 
revising the section heading for Sec. 1.460-4, and adding entries for 
that section to read as follows:


Sec. 1.460-0  Outline of regulations under section 460.

* * * * *

Sec. 1.460-4  Methods of accounting for long-term contracts.

    (a) through (i) [Reserved]
    (j) Consolidated groups and controlled groups.
    (1) Intercompany transactions.
    (i) In general.
    (ii) Definitions and nomenclature.
    (2) Example.
    (3) Effective date.
    (i) In general.
    (ii) Prior law.
* * * * *
    Par. 8. Section 1.460-4 is amended by revising the section heading, 
adding and reserving paragraphs (a) through (i), and adding paragraph 
(j) to read as follows:


Sec. 1.460-4  Methods of accounting for long-term contracts.

    (a) through (i) [Reserved]
    (j) Consolidated groups and controlled groups--(1) Intercompany 
transactions--(i) In general. Section 1.1502-13 does not apply to the 
income, gain, deduction, or loss from an intercompany transaction 
between members of a consolidated group, and section 267(f) does not 
apply to these items from an intercompany sale between members of a 
controlled group, to the extent--
    (A) The transaction or sale directly or indirectly benefits, or is 
intended to benefit, another member's long-term contract with a 
nonmember;
    (B) The selling member is required under section 460 to determine 
any part of its gross income from the transaction or sale under the 
percentage-of-completion method (PCM); and
    (C) The member with the long-term contract is required under 
section 460 to determine any part of its gross income from the long-
term contract under the PCM.
    (ii) Definitions and nomenclature. The definitions and nomenclature 
under Sec. 1.1502-13 and Sec. 1.267(f)-1 apply for purposes of this 
paragraph (j).
    (2) Example. The following example illustrates the principles of 
paragraph (j)(1) of this section.

    Example. Corporations P, S, and B file consolidated returns on a 
calendar-year basis. In 1996, B enters into a long-term contract 
with X, a nonmember, to manufacture 5 airplanes for $500 million, 
with delivery scheduled for 1999. Section 460 requires B to 
determine the gross income from its contract with X under the PCM. S 
enters into a contract with B to manufacture for $50 million the 
engines that B will install on X's airplanes. Section 460 requires S 
to determine the gross income from its contract with B under the 
PCM. S estimates that it will incur $40 million of total contract 
costs during 1997 and 1998 to manufacture the engines. S incurs $10 
million of contract costs in 1997 and $30 million in 1998. Under 
paragraph (j) of this section, S determines its gross income from 
the long-term contract under the PCM rather than under section 
267(f) or Sec. 1.1502-13. Thus, S includes $12.5 million of gross 
receipts and $10 million of contract costs in gross income in 1997 
and includes $37.5 million of gross receipts and $30 million of 
contract costs in gross income in 1998.

    (3) Effective date--(i) In general. This paragraph (j) applies with 
respect to transactions and sales occurring in years beginning on or 
after [the date the final regulations are filed with the Federal 
Register].
    (ii) Prior law. For transactions and sales occurring in years 
beginning before [the date final regulations are filed with the Federal 
Register], see the applicable regulations issued under sections 267(f) 
and 1502, including Secs. 1.267(f)-1T, 1.267(f)-2T, and 1.1502-13(n) 
(as contained in the 26 CFR part 1 edition revised as of April 1, 
1994).

    Par. 9. Section 1.469-0 is amended in the table of contents by 
revising entries for paragraphs (a) through (d)(1), (g)(5) through 
(h)(3), and (h)(5) through (k) under Sec. 1.469-1 and revising entries 
for paragraphs (c)(8), (h)(1), (h)(2), and (h)(6) under Sec. 1.469-1T 
to read as follows:


Sec. 1.469-0  Table of contents.

* * * * *

Sec. 1.469-1  General rules.

    (a) through (c)(7) [Reserved]
    (c)(8) Consolidated groups.
    (c)(9) through (d)(1) [Reserved]
* * * * *
    (g)(5) [Reserved]
    (h)(1) In general.
    (h)(2) Definitions.
    (h)(3) [Reserved]
* * * * *
    (h)(5) [Reserved]
    (h)(6) Intercompany transactions.
    (i) In general.
    (ii) Example.
    (iii) Effective dates.
    (h)(7) through (k) [Reserved]

Sec. 1.469-1T  General rules (temporary).

* * * * *
    (c)(8) [Reserved]
* * * * *
    (h)(1) [Reserved]
    (h)(2) [Reserved]
* * * * *
    (h)(6) [Reserved]
* * * * *
    Par. 10. Section 1.469-1 is amended by revising paragraphs (a) 
through (d)(1), (g)(5) through (h)(3), and (h)(5) through (k) to read 
as follows:


Sec. 1.469-1  General rules.

    (a) through (c)(7) [Reserved]
    (c)(8) Consolidated groups. Rules relating to the application of 
section 469 to consolidated groups are contained in paragraph (h) of 
this section.
    (c)(9) through (d)(1) [Reserved]
* * * * *
    (g)(5) [Reserved]
    (h)(1) In general. This paragraph (h) provides rules for applying 
section 469 in computing a consolidated group's consolidated taxable 
income and consolidated tax liability (and the separate taxable income 
and tax liability of each member).
    (2) Definitions. The definitions and nomenclature in the 
regulations under section 1502 apply for purposes of this paragraph 
(h). See, e.g., Secs. 1.1502-1 (definitions of group, consolidated 
group, member, subsidiary, and consolidated return year), 1.1502-2 
(consolidated tax liability), 1.1502-11 (consolidated taxable income), 
1.1502-12 (separate taxable income), 1.1502-13 (intercompany 
transactions), 1.1502-21 (consolidated net operating loss), and 1.1502-
22 (consolidated net capital gain or loss).
    (3) [Reserved]
* * * * *
    (5) [Reserved]
    (6) Intercompany transactions--(i) In general. Section 1.1502-13 
applies to determine the treatment under section 469 of intercompany 
items and corresponding items from intercompany transactions between 
members of a consolidated group. For example, the matching rule of 
Sec. 1.1502-13(c) treats the selling member (S) and the buying member 
(B) as divisions of a single corporation for purposes of determining 
whether S's intercompany items and B's corresponding items are from a 
passive activity. Thus, for purposes of applying Sec. 1.469-
2(c)(2)(iii) and Sec. 1.469-- 2T(d)(5)(ii) to property sold by S to B 
in an intercompany transaction--
    (A) S and B are treated as divisions of a single corporation for 
determining the uses of the property during the 12-month period 
preceding its disposition to a nonmember, and generally have an 
aggregate holding period for the property; and
    (B) Section 1.469-2(c)(2)(iv) does not apply.
    (ii) Example. The following example illustrates the application of 
this paragraph (h)(6).

    Example. (i) P, a closely held corporation, is the common parent 
of the P consolidated group. P owns all of the stock of S and B. X 
is a person unrelated to any member of the P group. S owns and 
operates equipment that is not used in a passive activity. On 
January 1 of Year 1, S sells the equipment to B at a gain. B uses 
the equipment in a passive activity and does not dispose of the 
equipment before it has been fully depreciated. Assume that if S and 
B were divisions of a single corporation, S's gain would be passive 
income attributable to a passive activity.
    (ii) Under the matching rule of Sec. 1.1502-13(c), S's gain 
taken into account as a result of B's depreciation is treated as 
gain from a passive activity even though S used the equipment in a 
nonpassive activity.
    (iii) The facts are the same as in paragraph (a) of this 
Example, except that B sells the equipment to X on December 1 of 
Year 3 at a further gain. To the extent of B's depreciation before 
the sale, the results are the same as in paragraph (ii) of this 
Example. S's remaining gain taken into account as a result of B's 
sale is treated as attributable to a passive activity.
    (iv) The facts are the same as in paragraph (iii) of this 
Example, except that B recognizes a loss on the sale to X. As in 
paragraph (iii) of this Example, S's gain taken into account as a 
result of B's sale is treated as attributable to a passive activity.

    (iii) Effective dates. This paragraph (h)(6) applies with respect 
to transactions occurring in years beginning on or after [the date the 
final regulations are filed with the Federal Register]. For 
transactions occurring in years beginning before [the date the final 
regulations are filed with the Federal Register], see Sec. 1.469-
1T(h)(6) (as contained in the 26 CFR part 1 edition revised as of April 
1, 1994).
    (h)(7) through (k) [Reserved]


Sec. 1.469-1T  [Amended]

    Par. 11. Section 1.469-1T is amended by removing and reserving 
paragraphs (c)(8), (h)(1), (h)(2), and (h)(6).
    Par. 12. Section 1.1502-13 is revised to read as follows:


Sec. 1.1502-13  Intercompany transactions.

    (a) In general--(1) Purpose. This section provides rules for taking 
into account the items of income, gain, deduction, and loss of members 
from intercompany transactions. 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).
    (2) Separate entity and single entity treatment. Under this 
section, the selling member (S) and the buying member (B) are treated 
as separate entities for some purposes but as divisions of a single 
corporation for other purposes. The amount and location of S's 
intercompany items and B's corresponding items are determined on a 
separate entity basis (separate entity treatment). For example, S 
determines its gain or loss from a sale of property to B on a separate 
entity basis, and B has a cost basis in the property. The timing, 
character, source, and other attributes of the intercompany items and 
corresponding items, although initially determined on a separate entity 
basis, are redetermined under this section to produce the effect of 
transactions between divisions of a single corporation (single entity 
treatment). For example, if S sells land to B at a gain and B resells 
the land to a nonmember, S does not take its gain into account until 
the resale.
    (3) Other law. The rules of this section apply in addition to other 
applicable law, such as sections 269 (acquisitions to evade or avoid 
income tax), 482 (allocations among commonly controlled taxpayers), and 
7701(f) (use of related persons). The timing rules of this section are 
a method of accounting that overrides otherwise applicable accounting 
methods. For example, if S sells property to B in exchange for B's 
note, the rules of this section apply instead of the installment sale 
rules of section 453. However, an item taken into account under this 
section can be deferred, disallowed, or eliminated under other 
applicable law such as section 267 (losses from transactions between 
related persons).
    (4) Construction. The rules of this section must be applied in a 
consistent manner that reasonably carries out their purposes, taking 
into account all of the facts and circumstances, the underlying 
economic arrangement, and applicable Federal income tax accounting 
principles. For example, the rules of this section must not be applied 
to take S's intercompany items into account more than once.
    (5) Overview--(i) In general. The principal rules of this section 
that implement single entity treatment are the matching rule and the 
acceleration rule of paragraphs (c) and (d) of this section. Under the 
matching rule of paragraph (c) of this section, S and B are generally 
treated as divisions of a single corporation for purposes of taking 
into account their items from intercompany transactions. The 
acceleration rule of paragraph (d) of this section provides additional 
rules for taking the items into account if the effect of treating S and 
B as divisions cannot be achieved (e.g., if S or B becomes a 
nonmember). Paragraph (b) of this section provides definitions, 
including the definitions of intercompany transaction, intercompany 
item, and corresponding item. Paragraph (e) of this section provides 
simplifying rules for certain transactions. Paragraphs (f) and (g) of 
this section provide additional rules for stock and obligations of 
members. Paragraphs (h) and (j) of this section provide anti-avoidance 
rules and miscellaneous operating rules.
    (ii) Table of examples. Set forth below is a table of the examples 
contained in this section.

Matching rule. (Sec. 1.1502-13(c)(4)(ii))
    Example 1. Intercompany sale of land followed by resale; 
intercompany sale followed by section 1031 exchange with nonmember; 
intercompany sale followed by section 351 transfer to nonmember.
    Example 2. Dealer activities.
    Example 3. Intercompany section 351 transfer.
    Example 4. Depreciable property.
    Example 5. Intercompany sale followed by installment sale.
    Example 6. Intercompany sale of installment obligation.
    Example 7. Performance of services.
    Example 8. Rental of property.
    Example 9. Back-to-back intercompany sales.
    Example 10. Intercompany sale of a partnership interest.
    Example 11. Net operating losses subject to section 382 or the 
SRLY rules.
    Example 12. Special inventory accounting election.
    Example 13. Section 475.
    Example 14. Section 1092.
    Example 15. Manufacturer rebates.
    Example 16. Cancellation of debt and attribute reduction under 
section 108(b).
    Example 17. Source of items from a section 863 sale.
    Example 18. Section 1248.
Acceleration rule. (Sec. 1.1502-13(d)(3))
    Example 1. Becoming a nonmember--timing.
    Example 2. Becoming a nonmember--attributes.
    Example 3. Back-to-back intercompany transactions.
    Example 4. Selling member's disposition of proceeds.
    Example 5. Section 481.
Simplifying rules--inventory. (Sec. 1.1502-13(e)(1)(v))
    Example 1. Increment averaging method.
    Example 2. Increment valuation method.
    Example 3. Other reasonable inventory methods.
Stock of members. (Sec. 1.1502-13(f)(6))
    Example 1. Dividend exclusion and property distribution.
    Example 2. Excess loss accounts.
    Example 3. Intercompany reorganization.
    Example 4. Stock redemptions and distributions.
    Example 5. Intercompany stock sale followed by section 332 
liquidation.
Obligations of members. (Sec. 1.1502-13(g)(6))
    Example 1. Interest and premium on intercompany debt.
    Example 2. Intercompany debt becomes nonintercompany debt.
    Example 3. Bad debt deduction or loss with respect to 
intercompany debt.
    Example 4. Nonintercompany debt becomes intercompany debt.
    Example 5. Notional principal contracts.
Anti-avoidance rules. (Sec. 1.1502-13(h)(2))
    Example 1. Sale of a partnership interest.
    Example 2. Sale to a related party.
    Example 3. Sale and leaseback.
    Example 4. Transitory status as an intercompany obligation.
Miscellaneous operating rules. (Sec. 1.1502-13(j)(6))
    Example 1. Intercompany sale followed by section 351 transfer to 
member.
    Example 2. Intercompany sale of member stock followed by 
recapitalization.
    Example 3. Successor group.
    Example 4. Liquidation--80% distributee.
    Example 5. Liquidation--no 80% distributee.

    (b) Definitions. For purposes of this section--
    (1) Intercompany transactions--(i) In general. An intercompany 
transaction is a transaction between corporations that are members of 
the same consolidated group immediately after the transaction. S is the 
member transferring property or providing services, and B is the member 
receiving the property or services. Intercompany transactions include--
    (A) S's sale of property (or other transfer, such as an exchange or 
contribution) to B, whether or not gain or loss is recognized;
    (B) S's performance of services for B, and B's payment or accrual 
of its expenditure for S's performance;
    (C) S's licensing of technology, rental of property, or loan of 
money to B, and B's payment or accrual of its expenditure; and
    (D) S's distribution to B with respect to S stock.
    (ii) Time of transaction. If a transaction occurs in part while S 
and B are members and in part while they are not members, the 
transaction is treated as occurring when performance by either S or B 
takes place, or when payment for performance would be taken into 
account under the rules of this section if it were an intercompany 
transaction, whichever is earliest. Appropriate adjustments must be 
made in such cases by, for example, dividing the transaction into two 
separate transactions reflecting the extent to which S or B has 
performed.
    (iii) Separate transactions. Each transaction is analyzed 
separately. For example, if S simultaneously sells two properties to B, 
one at a gain and the other at a loss, each property is sold in a 
separate transaction. Similarly, each payment or accrual of interest 
with respect to a loan is a separate transaction. If two members 
exchange property, each member is S with respect to the property it 
transfers and B with respect to the property it receives.
    (2) Intercompany items and corresponding items--(i) Intercompany 
items--(A) In general. S's income, gain, deduction, and loss from an 
intercompany transaction are its intercompany items. For example, S's 
gain from the sale of property to B is intercompany gain and, if the 
sale results in both ordinary income and capital gain (or other 
attribute disparities), each is treated as a separate intercompany 
item. An item is an intercompany item whether it is directly or 
indirectly from an intercompany transaction.
    (B) Related costs or expenses. S's costs or expenses related to an 
intercompany transaction are included in determining its intercompany 
items. For example, if S sells inventory to B, S's direct and indirect 
costs properly includible under section 263A are included in 
determining its intercompany income. Similarly, in addition to other 
related costs, deductions for employee wages are included in 
determining S's income from performing services for B, and depreciation 
deductions are included in determining S's income from renting property 
to B.
    (C) Amounts not yet recognized or incurred. S's items from 
intercompany transactions are taken into account under this section 
even if S has not yet taken them into account under its separate entity 
method of accounting. For example, if S is a cash method taxpayer, S's 
intercompany income is taken into account under this section even if 
the cash is not yet received.
    (ii) Corresponding items--(A) In general. B's income, gain, 
deduction, and loss from an intercompany transaction, or from property 
acquired in an intercompany transaction, are its corresponding items. 
For example, if B pays rent to S, B's deduction for the rent is a 
corresponding deduction. If B buys property from S and resells it to a 
nonmember, B's gain or loss from the resale is a corresponding gain or 
loss; alternatively, if B recovers the cost of the property through 
depreciation, B's depreciation deductions are corresponding deductions. 
An item is a corresponding item whether it is directly or indirectly 
from an intercompany transaction (or from property acquired in an 
intercompany transaction).
    (B) Disallowed or eliminated amounts. B's corresponding items 
include amounts that are permanently disallowed or permanently 
eliminated, whether directly or indirectly. For example, corresponding 
items include amounts disallowed under section 265 (expenses relating 
to tax-exempt income), amounts offset under section 171(e) (amortizable 
bond premium offset), and amounts not recognized under section 311 
(nonrecognition of loss on distributions) or 332 (nonrecognition on 
liquidating distributions). (See paragraph (c)(3)(iv) of this section, 
under which certain of these amounts may cause S's intercompany income 
or gain to be treated as excluded from gross income.)
    (iii) Effect of basis adjustments. This paragraph (b)(2)(iii) 
provides additional rules for intercompany items and corresponding 
items.
    (A) Deemed intercompany items. An adjustment reflected in basis (or 
to an amount equivalent to basis, such as a loss carryover or an excess 
loss account) that is a substitute for an intercompany item is treated 
as an intercompany item. For example, a reduction in S's basis in 
property that preserves S's income for a later period and relates to 
B's corresponding deduction is treated as intercompany income of S. 
However, if the adjustment is made pursuant to a nonrecognition 
provision of the Code or regulations unrelated to S's method of 
accounting, the adjustment is not treated as an intercompany item.
    (B) Deemed corresponding items. An adjustment reflected in basis 
(or in an amount equivalent to basis, such as a loss carryover or an 
excess loss account) that is a substitute for a corresponding item is 
treated as a corresponding item for purposes of taking S's intercompany 
items into account. However, an adjustment is not treated as a 
corresponding item to the extent that the adjustment reflects a 
comparable amount not recognized by S, or to the extent that the only 
effect of the adjustment is to preserve B's items for a later period 
(rather than, for example, affecting the overall amount of items taken 
into account or to be taken into account).
    (C) Amounts deemed not to be items. A deduction or loss is not 
treated as an intercompany item or corresponding item to the extent it 
does not reduce basis (or have an equivalent effect, such as decreasing 
a loss carryover or increasing an excess loss account). For example, if 
B has percentage depletion in excess of basis under section 613 or 613A 
with respect to mineral property purchased from S, the depletion in 
excess of basis is not treated as a corresponding item for purposes of 
this section. Similar principles apply to income or gain that does not 
increase basis (or have an equivalent effect).
    (3) Treatment as a separate entity. Treatment as a separate entity 
means treatment without application of the rules of this section, but 
with the application of the other consolidated return regulations. For 
example, if S sells the stock of another member to B, S's gain or loss 
on a separate entity basis is determined with the application of 
Sec. 1.1502-80(b) (nonapplicability of section 304), but without 
redetermination under paragraph (c) or (d) of this section.
    (4) Attributes. The attributes of an intercompany item or 
corresponding item are all of the item's characteristics necessary to 
determine its effect on taxable income (and tax liability) except 
amount, location, and timing. For example, attributes include 
character, source, treatment as excluded from gross income or as a 
noncapital, nondeductible amount, and treatment as built-in gain or 
loss under section 382(h) or 384. A member's holding period in 
property, or the fact that property is included in the inventory of a 
member, is not an attribute of an item, but these factors do affect the 
determination of the attributes of items from the property.
    (c) Matching rule. S's intercompany items and B's corresponding 
items are taken into account for each consolidated return year under 
the following rules:
    (1) Attributes and holding periods--(i) General rule. The 
attributes of S's intercompany items and B's corresponding items are 
redetermined to produce the same effect on consolidated taxable income 
(and consolidated tax liability) as if S and B were divisions of a 
single corporation, and the intercompany transaction were a transaction 
between divisions. Thus, the activities of both S and B affect the 
attributes of both intercompany items and corresponding items. For 
example, if S holds property for sale to unrelated customers in the 
ordinary course of its trade or business and sells the property to B, 
S's intercompany items and B's corresponding items may be ordinary 
items solely by reason of S's activities. Similar principles apply if S 
performs services, rents property, or engages in any other intercompany 
transaction.
    (ii) Holding periods. The holding period of property transferred in 
an intercompany transaction is the aggregate of the holding periods of 
S and B. However, if the basis of the property is determined by 
reference to the basis of other property, the property's holding period 
is determined by reference to the holding period of the other property. 
For example, the holding period of stock distributed in an intercompany 
distribution to which section 355 applies is determined by reference to 
the holding period of the distributing member's stock.
    (2) Timing--(i) B's items. B takes its corresponding items into 
account under its accounting method. However, the redetermination of 
the attributes of a corresponding item may affect its timing. For 
example, if B's resale of property acquired from S is treated as a 
dealer disposition solely by reason of S's activities, section 453(b) 
prevents any corresponding income of B from being taken into account 
under the installment method.
    (ii) S's items. S takes its intercompany items into account to 
reflect the difference for the year between B's corresponding items 
taken into account and B's recomputed corresponding items (the 
corresponding items that B would take into account for the year if S 
and B were divisions of a single corporation). For example, if S sells 
property with a $70 basis to B for $100, and B later resells the 
property to a nonmember for $90, B's corresponding item taken into 
account is its $10 loss, B's recomputed corresponding item is a $20 
recomputed gain, and the $30 difference is the amount of S's 
intercompany gain that is taken into account for the year of the 
resale. Although B does not actually take the recomputed corresponding 
items into account, they are computed as if they were taken into 
account (based on reasonable and consistently applied assumptions, 
including any provision of the Internal Revenue Code (Code) or 
regulations that would affect their timing or attributes).
    (3) Operating rules for single entity adjustments. For purposes of 
this paragraph (c)--
    (i) Divisions of a single corporation. As divisions of a single 
corporation, S and B are treated as engaging in their actual 
transaction and owning any actual property in the transaction (rather 
than treating the transaction as not occurring). For example, S's sale 
of property to B for cash is not disregarded, but is treated as an 
exchange of property for cash between divisions (and B therefore 
ordinarily does not have a cost basis). Similarly, if S transfers 
property to B in exchange for B's stock, S is treated as owning the 
stock it receives in the exchange. Although treated as divisions, S and 
B nevertheless are treated as:
    (A) Operating separate trades or businesses. See, e.g., Sec. 1.446-
1(d) (accounting methods for a taxpayer engaged in more than one 
business).
    (B) Having any special status that they have under the Internal 
Revenue Code. For example, a bank defined in section 581, a domestic 
building and loan association defined in section 7701(a)(19), and an 
insurance company to which section 801 or 831 applies are treated as 
divisions having separate special status. On the other hand, the fact 
that a member holds property for sale to customers in the ordinary 
course of its trade or business is not a special status.
    (ii) Multiple intercompany items or corresponding items--(A) 
Multiple triggers. If more than one corresponding item can cause an 
intercompany item to be taken into account under this paragraph (c), 
the intercompany item is taken into account in connection with the 
corresponding item most consistent with the treatment of members as 
divisions of a single corporation. For example, if S sells a truck to 
B, its intercompany gain from the sale is not taken into account by 
reference to B's depreciation if the depreciation is capitalized under 
section 263 as part of B's cost for a building; instead, S's gain 
relating to the capitalized depreciation is taken into account when the 
building is sold or as it is depreciated. If B purchases appreciated 
land from S and transfers the land to a lower-tier member in exchange 
for stock, thereby duplicating the basis of the land in the basis of 
the stock, items with respect to both the stock and the land can cause 
S's intercompany gain to be taken into account; if the lower-tier 
member becomes a nonmember as a result of the sale of its stock, the 
attributes of S's intercompany gain are determined with respect to the 
land rather than the stock.
    (B) Aggregation of transactions. If a member's intercompany item or 
corresponding item affects the accounting for more than one 
intercompany transaction, appropriate adjustments are made to treat all 
of the intercompany transactions as transactions between divisions of a 
single corporation. For example, if land is transferred in successive 
intercompany transactions, all of the participating members are treated 
as divisions of a single corporation for purposes of determining the 
timing and attributes of each of the items from the land. Similar 
principles apply with respect to intercompany transactions that are 
part of the same plan or arrangement. For example, if S sells separate 
properties to different members as part of the same plan or 
arrangement, all of the participating members are treated as divisions 
of a single corporation for purposes of determining the timing and 
attributes of the intercompany items and corresponding items from each 
of the properties.
    (iii) Conflict of attributes or allocation--(A) In general. If it 
is not possible to determine the attributes of an item, or the 
allocation of attributes between S and B, by treating S and B as 
divisions of a single corporation, the determination or allocation is 
made as follows--
    (1) The attributes of B's corresponding items on a separate entity 
basis control the attributes of offsetting intercompany items of S 
(e.g., B's interest expense controls S's interest income); and
    (2) If the corresponding items and intercompany items do not offset 
(e.g., both S and B have gain from the same property), their attributes 
are determined on a separate entity basis to the extent not 
inconsistent with the purposes of this section.
    (B) Special status. To the extent an item's attributes determined 
under this section are permitted or not permitted to a member under the 
Internal Revenue Code or regulations by reason of the member's special 
status, the attributes required under the Internal Revenue Code or 
regulations apply to that member (but not the other member). For 
example, if S is a bank to which section 582(c) applies, and sells debt 
securities at a gain to B, a nonbank, the character of S's intercompany 
gain is ordinary as required under section 582(c), but the character of 
B's corresponding items as capital or ordinary is determined under 
paragraph (c)(1) of this section without the application of section 
582(c). For other special status issues, see, e.g., sections 595(b) 
(foreclosure on property securing loans), 818(b) (life insurance 
company treatment of capital gains and losses), 1032 (nonrecognition 
with respect to an issuer's stock) and 1503(c) (limitation on 
absorption of certain losses).
    (iv) Limitation on treatment of intercompany income or gain as 
excluded from gross income--(A) In general. Redetermining the 
attributes of intercompany items and corresponding items under this 
paragraph (c) may result in S's intercompany items being treated as 
excluded from gross income or as noncapital, nondeductible amounts. For 
example, S's intercompany loss from the sale of property to B is 
treated as a noncapital, nondeductible amount if B distributes the 
property to a nonmember shareholder at no further gain or loss (because 
of the nonrecognition of loss under section 311(a)). See also 
Secs. 1.1502-32 and 1.1502-33 (adjustments to S's stock basis and 
earnings and profits to reflect amounts so treated).
    (B) Limitation. S's intercompany income or gain may be treated 
under this paragraph (c) as excluded from gross income only to the 
extent one of the following applies:
    (1) Disallowed amounts. B's corresponding item is a deduction or 
loss that, in the taxable year the item is taken into account under 
this section, is permanently disallowed directly under another 
provision of the Internal Revenue Code or regulations. An amount is not 
permanently disallowed for this purpose if, for example--
    (i) The disallowance or elimination is not permanent because an 
equivalent amount might be taken into account by B, such as under 
section 280B (demolition costs recoverable as capitalized amounts), or 
by another taxpayer, such as under section 267(d) (disallowed loss 
under section 267(a) may result in nonrecognition of gain for a related 
person);
    (ii) The amount is realized but not recognized under section 332;
    (iii) The amount is a deemed item under paragraph (b)(2)(iii) of 
this section; or
    (iv) The amount is a loss that is part of a carryforward that 
expires in a later year.
    (2) Section 311. The corresponding item is a loss that is realized, 
but not recognized under section 311(a).
    (3) Other amounts. The corresponding item is otherwise limited, 
eliminated, offset, or has no effect on the computation of taxable 
income under any provision identified by the Commissioner.
    (4) Examples--(i) In general. For purposes of the examples in this 
section, unless otherwise stated, P is the common parent of the P 
consolidated group, P owns all of the only class of stock of 
subsidiaries S and B, X is a person unrelated to any member of the P 
group, the taxable year of all persons is the calendar year, all 
persons use the accrual method of accounting, tax liabilities are 
disregarded, the facts set forth the only corporate activity, and no 
member has any special status. If a member acts as both a selling 
member and a buying member (e.g., with respect to different aspects of 
a single transaction, or with respect to related transactions), the 
member is referred to as M (rather than as S or B).
    (ii) Matching rule. The matching rule of this paragraph (c) is 
illustrated by the following examples.

    Example 1. Intercompany sale of land followed by resale; 
intercompany sale followed by section 1031 exchange with nonmember; 
intercompany sale followed by section 351 transfer to nonmember. (a) 
Facts. S holds land for investment with a basis of $70. On January 1 
of Year 1, S sells the land to B for $100. B also holds the land for 
investment. On July 1 of Year 3, B sells the land to X for $110.
    (b) Definitions. Under paragraph (b)(1) of this section, S's 
sale of the land to B is an intercompany transaction, S is the 
selling member, and B is the buying member. Under paragraph (b)(2) 
of this section, S's $30 gain from the sale to B is its intercompany 
gain, and B's $10 gain from the sale to X is its corresponding gain.
    (c) Timing. Under the matching rule of paragraph (c) of this 
section, S takes its intercompany items into account to reflect the 
difference for the year between B's corresponding items taken into 
account and B's recomputed corresponding items (the corresponding 
items that B would take into account for the year if S and B were 
divisions of a single corporation). If S and B were divisions of a 
single corporation and the intercompany sale were a transfer between 
the divisions, B would succeed to S's $70 basis in the land and 
would have a $40 gain from the sale to X instead of a $10 gain. 
Consequently, S takes no gain into account in Years 1 and 2, and 
takes the entire $30 gain into account in Year 3 to reflect the $30 
difference in that year between the $10 gain B takes into account 
and its $40 recomputed gain (B's recomputed corresponding item). 
Under Secs. 1.1502-32 and 1.1502-33, P's basis in its S stock and 
the earnings and profits of S and P do not reflect S's $30 gain 
until the gain is taken into account in Year 3. (Under paragraph 
(b)(2)(i)(C) of this section, the results would be the same if S 
sold the land to B in an installment sale to which section 453 would 
otherwise apply, because S must take its intercompany gain into 
account under this section.)
    (d) Attributes. Under the matching rule, S's $30 intercompany 
gain and B's $10 corresponding gain are taken into account to 
produce the same effect on consolidated taxable income (and 
consolidated tax liability) as if S and B were divisions of a single 
corporation. In addition, the holding periods of S and B for the 
land are aggregated. Thus, both are long-term capital gain.
    (e) Intercompany loss and resale gain. The facts are the same as 
in paragraph (a) of this Example 1, except that S's basis in the 
land is $130 (rather than $70). The timing and attributes of S's 
intercompany loss and B's corresponding gain are determined in the 
manner provided in paragraphs (c) and (d) of this Example 1. If S 
and B were divisions of a single corporation and the intercompany 
sale were a transfer between the divisions, B would succeed to S's 
$130 basis in the land and would have a $20 loss from the sale to X 
instead of a $10 gain. Thus, S takes its entire $30 loss into 
account in Year 3 to reflect the $30 difference between B's $10 gain 
taken into account and its $20 recomputed loss. (The results are the 
same under section 267(f).) S's $30 loss is long-term capital loss, 
and B's $10 gain remains long-term capital gain.
    (f) Intercompany gain and resale loss. The facts are the same as 
in paragraph (a) of this Example 1, except that B sells the land to 
X for $90 (rather than $110). The timing and attributes of S's 
intercompany gain and B's corresponding loss are determined in the 
manner provided in paragraphs (c) and (d) of this Example 1. If S 
and B were divisions of a single corporation and the intercompany 
sale were a transfer between the divisions, B would succeed to S's 
$70 basis in the land and would have a $20 gain from the sale to X 
instead of a $10 loss. Thus, S takes its entire $30 gain into 
account in Year 3 to reflect the $30 difference between B's $10 loss 
taken into account and its $20 recomputed gain. S's $30 gain is 
long-term capital gain, and B's $10 loss is long-term capital loss.
    (g) Intercompany sale followed by section 1031 exchange with 
nonmember. The facts are the same as in paragraph (a) of this 
Example 1, except that, instead of selling the land to X, B 
exchanges the land for land owned by X in a transaction to which 
section 1031 applies. There is no difference in Year 3 between B's 
corresponding items taken into account and its recomputed items. 
Thus, none of S's intercompany gain is taken into account under the 
matching rule as a result of the section 1031 exchange. Instead, B's 
gain is preserved in the land received from X and, under the 
successor asset rule of paragraph (j)(1)(i) of this section, S's 
intercompany gain is taken into account by reference to the 
replacement property. (If B takes gain into account as a result of 
boot received in the exchange, S's intercompany gain would be taken 
into account under the matching rule to the extent the boot causes a 
difference between B's gain taken into account and its recomputed 
gain.)
    (h) Intercompany sale followed by section 351 transfer to 
nonmember. The facts are the same as in paragraph (a) of this 
Example 1, except that, instead of selling the land to X, B 
transfers the land to X in a transaction to which section 351 
applies and X remains a nonmember. There is no difference in Year 3 
between B's corresponding items taken into account and its 
recomputed items. Thus, none of S's intercompany gain is taken into 
account under the matching rule as a result of the section 351 
transfer. However, S's entire gain is taken into account in Year 3 
under the acceleration rule of paragraph (d) of this section 
(because X reflects B's $100 cost basis in the land under section 
362).
    Example 2. Dealer activities. (a) Facts. S holds land for 
investment with a basis of $70. On January 1 of Year 1, S sells the 
land to B for $100. B develops the land as residential real estate, 
and sells developed lots to customers during Year 3 for an aggregate 
amount of $110.
    (b) Attributes. S and B are treated under the matching rule as 
divisions of a single corporation for purposes of determining the 
attributes of B's corresponding items and S's intercompany items. 
Thus, although S held the land for investment, whether the land is 
property described in section 1221(1) is based on the activities of 
both S and B. If the land is described in section 1221(1), both S's 
gain and B's gain are ordinary income.
    Example 3. Intercompany section 351 transfer. (a) Facts. S holds 
land with a $70 basis for sale to customers in the ordinary course 
of business. On January 1 of Year 1, S transfers the land to B in 
exchange for B stock and $10 cash in a transaction to which section 
351 applies. See Sec. 1.1502-34 (aggregate stock ownership rules). S 
has a $10 gain under section 351(b), and its basis in the B stock is 
$70 under section 358. Under section 362, B's basis in the land is 
$80. B holds the land for investment. On July 1 of Year 3, B sells 
the land to X for $100. Assume that if S and B were divisions of a 
single corporation, B's gain from the sale would be ordinary income 
by reason of S's activities.
    (b) Timing and attributes. Under paragraph (c)(3)(i) of this 
section, S is treated as transferring the land for B's stock even 
though, as divisions, S could not own stock of B. S takes its $10 
gain into account in Year 3 to reflect the $10 difference between 
B's $20 gain taken into account and its $30 recomputed gain. Both 
S's $10 gain and B's $20 gain are ordinary income.
    (c) Partial disposition. The facts are the same as in paragraph 
(a) of this Example 3, except B sells only a one-half, undivided 
interest in the land to X for $50. The timing and attributes are 
determined in the manner provided in paragraph (b) of this Example 
3, except that S takes only $5 of its gain into account in Year 3 to 
reflect the $5 difference between B's $10 gain taken into account 
and its $15 recomputed gain.
    (d) No boot. The facts are the same as in paragraph (a) of this 
Example 3, except that there is no boot in the section 351 
transaction. Under paragraph (b)(1) of this section, S's transfer to 
B is an intercompany transaction. Under paragraph (b)(2) of this 
section, S has no intercompany items, but B's $30 gain from its sale 
of the land to X is a corresponding item because the land was 
acquired in an intercompany transaction. B's $30 gain is ordinary 
income.
    Example 4. Depreciable property. (a) Facts. During Year 1, S 
buys 10-year recovery property for $80 and depreciates it under the 
straight-line method with the half- year convention. On July 1 of 
Year 6, S sells the property to B for $100. Under section 168(i)(7), 
B is treated as S for purposes of section 168 to the extent that B's 
$100 basis does not exceed S's adjusted basis at the time of the 
sale. B's additional basis is treated as new 10-year recovery 
property subject to the half-year convention, for which B elects the 
straight-line method of recovery.
    (b) Depreciation in Year 6 and intercompany gain. S takes into 
account $4 of depreciation for Year 6, and S has a $40 basis at the 
time of the sale to B ($80 minus $36 of prior years' depreciation 
and $4 of Year 6 depreciation). Thus, S has a $60 intercompany gain 
from its sale to B. For Year 6, B has the remaining $4 of 
depreciation with respect to $40 of its basis (the portion of its 
$100 basis not exceeding S's adjusted basis). In addition, B has 
another $3 of depreciation with respect to the $60 of its additional 
basis that exceeds S's adjusted basis (under the half-year 
convention). For purposes of treating S and B as divisions of a 
single corporation under the matching rule, the $8 of recomputed 
depreciation for Year 6 is also allocated $4 to S and $4 to B.
    (c) Timing. S's $60 gain is taken into account to reflect the 
difference for each consolidated return year between B's 
depreciation taken into account with respect to the property and its 
recomputed depreciation. For Year 6, B takes $7 of depreciation into 
account. If the intercompany transaction had been a transfer between 
divisions of a single corporation, B would have succeeded to S's 
adjusted basis in the property and taken into account only its $4 
allocable share of the property's $8 of depreciation for Year 6. 
Thus, S takes $3 of gain into account in Year 6. In each subsequent 
year that B operates the property and takes into account $14 of 
depreciation ($8 with respect to $40 of basis, and $6 with respect 
to $60 of basis), S takes into account $6 of gain to reflect the $6 
difference between B's $14 of depreciation taken into account and 
its recomputed $8 of depreciation (the depreciation that B would 
take into account if the intercompany sale were a transfer between 
divisions).
    (d) Attributes. S's gain taken into account as a result of B's 
depreciation is ordinary income.
    (e) Resale of property. The facts are the same as in paragraph 
(a) of this Example 4, except that B sells the property to X at the 
beginning of Year 10 for an amount equal to its $44 adjusted basis 
(applying the half-year convention). To the extent of B's $56 of 
depreciation before the sale ($32 with respect to the $40 of basis 
corresponding to S's adjusted basis, and $24 with respect to the $60 
of additional basis), the timing and attributes of S's gain are 
determined in the manner provided in paragraphs (c) and (d) of this 
Example 4, and S takes into account $24 of gain in Years 6 through 
10 as ordinary income. The $36 balance of S's gain is taken into 
account in Year 10 as a result of B's sale to X, to reflect the $36 
difference between B's $0 gain taken into account and its $36 
recomputed gain ($44 sale proceeds minus the $8 basis B would have 
if the intercompany sale were a transfer between divisions of a 
single corporation). The attributes of the remaining $36 of S's gain 
are determined by treating S and B as divisions of a single 
corporation. Thus, the entire $36 of gain is recapture income under 
section 1245.
    Example 5. Intercompany sale followed by installment sale. (a) 
Facts. S holds land for investment with a basis of $70x. On January 
1 of Year 1, S sells the land to B for $100x. B also holds the land 
for investment. On July 1 of Year 3, B sells the land to X in 
exchange for X's $110x note. The note bears a market rate of 
interest in excess of the applicable Federal rate, and provides for 
principal payments of $55x in Year 4 and $55x in Year 5. The 
interest charge under section 453A(c) applies to X's note.
    (b) Timing and attributes. S takes its $30x gain into account in 
each consolidated return year to reflect the difference between B's 
gain taken into account for the year and its recomputed gain. Under 
section 453, B takes into account $5x of gain in Year 4 and $5x of 
gain in Year 5. Thus, S takes into account $15x of gain in Year 4 
and $15x of gain in Year 5. This reflects the $15x difference in 
Year 4 and in Year 5 between B's $5x gain taken into account and its 
$20x recomputed gain. Both S's $30x gain and B's $10x gain are 
subject to the section 453A(c) interest charge beginning in Year 3.
    (c) Election out under section 453(d). If, under the facts in 
paragraph (a) of this Example 5, the P group wishes to elect not to 
apply section 453 with respect to S's gain, an election under 
section 453(d) must be made for Year 3 with respect to B's gain. 
This election will cause B's $10x gain to be taken into account in 
Year 3. Under the matching rule, this in turn will result in S's $30 
gain being taken into account in Year 3. (An election by the P group 
solely with respect to S's gain has no effect because the gain from 
S's sale to B is taken into account under the matching rule, and 
therefore must reflect the difference between B's gain taken into 
account and its recomputed gain.)
    (d) Resale loss, but overall gain. The facts are the same as in 
paragraph (a) of this Example 5, except that B sells the land to X 
in exchange for X's $90x note (rather than $110x note). B's $10x 
loss is taken into account in Year 3 and is not subject to 
installment reporting under section 453 (only gain may be reported 
on the installment method). There is an aggregate $30x difference 
between B's $10x loss taken into account and its $20x recomputed 
gain. Under paragraph (c)(2)(ii) of this section, however, B's $20x 
recomputed gain is treated as taken into account in Years 4 and 5 
under the installment method. Thus, S takes $10x of gain into 
account in Year 3 to reflect the $10x difference between B's $10x 
loss taken into account and its $0 recomputed gain for Year 3. (None 
of B's $20 recomputed gain is treated as taken into account in Year 
3 under the installment method). S takes $10x of gain into account 
in each of Years 4 and 5 to reflect the difference in those years 
between B's $0 gain taken into account and B's $10x recomputed gain 
under the installment method. Only the $20x of S's gain taken into 
account in Years 4 and 5 is subject to the interest charge under 
section 453A(c) beginning in Year 3. (If the P group elects under 
section 453(d) for Year 3 to not apply section 453 with respect to 
S's gain, the election will be given effect under paragraph 
(c)(2)(ii) of this section.)
    (e) Intercompany loss, installment gain. The facts are the same 
as in paragraph (a) of this Example 5, except that S has a $130x 
(rather than $70x) basis in the land. S takes $20x of its loss into 
account in Year 3 to reflect the $20x difference between B's $0 loss 
taken into account (under section 453) and its $20x recomputed loss. 
Of the $10x remaining balance of S's loss, $5x is taken into account 
in each of Years 4 and 5 to reflect the $5x difference between B's 
$5x gain taken into account and its $0 recomputed gain. (The results 
are the same under section 267(f).) S's $20x loss taken into account 
in Year 3 is treated like the $20x recomputed loss B would have 
taken into account if S and B were divisions of a single 
corporation, and S's remaining $5x loss in each of Years 4 and 5 
offsets B's gain taken into account. Because B's $5x of gain in each 
of Years 4 and 5, and S's $5x of loss in each of Years 4 and 5, are 
taken into account at the same time and offset in determining 
consolidated taxable income, the gain is not subject to the interest 
charge under section 453A(c) for Years 4 and 5. (If B had sold the 
land to X for more than $130x, B's gain in excess of S's $30x loss 
would be subject to the interest charge under section 453A(c).)
    (f) Recapture income. The facts are the same as in paragraph (a) 
of this Example 5, except that S bought depreciable property for 
$100x and its depreciation deductions reduced the property's basis 
to $70x before Year 1, S sells the depreciable property (rather than 
land) to B for $100x on January 1 of Year 1, and S's $30x of gain is 
recapture income on a separate entity basis under section 1245. S's 
gain is treated as recapture income that is ineligible under section 
453(i) for installment reporting. Thus, S takes $30x ordinary income 
into account in Year 3. B takes its $10 gain into account in Years 4 
and 5, and the gain is subject to the interest charge under section 
453A(c). (If S has bought the depreciable property for $110x and its 
recomputed basis under section 1245 had been $110x (rather than 
$100x), B's $10x gain and S's $30x gain would both be recapture 
income ineligible under section 453(i) for installment reporting.)
    Example 6. Intercompany sale of installment obligation. (a) 
Facts. S holds land for investment with a basis of $70x. On January 
1 of Year 1, S sells the land to X in exchange for X's $100x note, 
and S reports its gain on the installment method under section 453. 
X's note bears interest at a market rate of interest in excess of 
the applicable Federal rate, and provides for principal payments of 
$50x in Year 5 and $50x in Year 6. Section 453A applies to X's note. 
On July 1 of Year 3, S sells X's note to B for $100x, and under 
section 453B(a) S is considered to recognize the $30x gain from its 
prior sale of the land to X.
    (b) Timing and attributes. S's sale of X's note to B is an 
intercompany transaction, and S's $30x gain is intercompany gain. S 
takes $15x of the gain into account in each of Years 5 and 6 to 
reflect the $15x difference in each year between B's $0 gain taken 
into account and its $15x recomputed gain. S's gain continues to be 
treated as its gain from the sale to X, and the deferred tax 
liability remains subject to the interest charge under section 
453A(c).
    (c) Worthlessness. The facts are the same as in paragraph (a) of 
this Example 6, except that X's note becomes worthless on December 1 
of Year 3 and B has a $100x short-term capital loss under section 
165(g) on a separate entity basis. Under the matching rule, B's loss 
is a long-term capital loss because B's holding period for X's note 
is aggregated with S's holding period. In addition, S takes its $30x 
gain into account in Year 3 to reflect the $30x difference between 
B's $100x loss taken into account and its $70x recomputed loss. S's 
gain is long-term capital gain.
    (d) Pledge. The facts are the same as in paragraph (a) of this 
Example 6, except that, on December 1 of Year 3, B borrows $100x 
from an unrelated bank and secures the indebtedness with X's note. 
X's note remains subject to section 453A(d) following the sale to B. 
Under section 453A(d), B's $100x of proceeds from the secured 
indebtedness is treated as an amount received on December 1 of Year 
3 by B on X's note. Thus, S takes its entire $30x gain into account 
in Year 3.
    Example 7. Performance of services. (a) Facts. S is a driller of 
water wells. B operates a ranch in a remote location, and B's 
taxable income from the ranch is not subject to section 447. B's 
ranch requires water to maintain its cattle. During Year 1, S drills 
an artesian well on B's ranch in exchange for $100 from B, and S 
incurs $80 of expenses (e.g., for employees and equipment). B 
capitalizes its $100 cost for the well under section 263, and takes 
into account $10 of cost recovery deductions in each of Years 2 
through 11. Under its separate entity method of accounting, S would 
take its income and expenses into account in Year 1.
    (b) Definitions. Under paragraph (b)(1) of this section, the 
service transaction is an intercompany transaction, S is the selling 
member, and B is the buying member. S has $100 of income and $80 of 
related expenses. Under paragraph (b)(2)(i)(B) of this section, S's 
income and expense are both included in determining its intercompany 
income of $20.
    (c) Timing and attributes. S's $20 of income is taken into 
account under the matching rule to reflect the $20 difference 
between B's items to be taken into account (based on its $100 cost 
basis in the well) and B's recomputed items (based on the $80 basis 
B would have if S and B were divisions of a single corporation and 
B's basis were determined by reference to S's $80 of expenses). In 
Year 1, S takes into account $80 of its income and the $80 of 
expenses. In each of Years 2 though 11, S takes $2 of its remaining 
$20 of income into account to reflect the annual $2 difference 
between B's $10 of cost recovery deductions taken into account and 
its $8 of recomputed cost recovery deductions. S's intercompany 
income and related expenses, and B's cost recovery deductions, are 
ordinary items.
    (d) Sale of capitalized services. The facts are the same as in 
paragraph (a) of this Example 7, except that B sells the ranch 
before Year 11 and recognizes gain attributable to the well. To the 
extent of the offsetting $80 income and expense and S's income taken 
into account as a result of B's cost recovery deductions, the timing 
and attributes are determined in the manner provided in paragraph 
(c) of this Example 7. The remainder of S's $20 of income is treated 
like the recomputed gain B would have taken into account if S and B 
were divisions of a single corporation (recapture income or section 
1231 gain, even though it is from S's performance of services).
    Example 8. Rental of property. B operates a ranch that requires 
grazing land for its cattle. S owns undeveloped land adjoining B's 
ranch. On January 1 of Year 1, S leases grazing rights to B for Year 
1. B's $100 rent expense is deductible for Year 1 under its separate 
entity accounting method. Under paragraph (b)(1) of this section, 
the rental transaction is an intercompany transaction, S is the 
selling member, and B is the buying member. S takes its $100 of 
income into account in Year 1 to reflect the $100 difference between 
B's rental deduction taken into account and its $0 recomputed rent 
deduction. S's income and B's deduction are ordinary items.
    Example 9. Back-to-back intercompany sales. (a) Facts. S holds 
land for investment with a basis of $70. On January 1 of Year 1, S 
sells the land to M for $90. M also holds the land for investment. 
On July 1 of Year 3, M sells the land for $100 to B, and B holds the 
land for sale to customers in the ordinary course of business. 
During Year 5, B sells all of the land to customers for $105.
    (b) Timing. Under paragraph (b)(1) of this section, S's sale of 
the land to M and M's sale of the land to B are both intercompany 
transactions. S is the selling member and M is the buying member in 
the first intercompany transaction, and M is the selling member and 
B is the buying member in the second intercompany transaction. Under 
paragraph (c)(3)(ii)(B) of this section, S, M and B are treated as 
divisions of a single corporation for purposes of determining the 
timing of their items from the intercompany transactions. See also 
paragraph (j)(1)(ii) of this section (B is treated as a successor to 
M for purposes of taking S's intercompany gain into account). Thus, 
S's $20 gain and M's $10 gain are both taken into account in Year 5 
to reflect the difference between B's $5 gain taken into account 
with respect to the land and its $35 recomputed gain (i.e., the gain 
that B would have taken into account if the intercompany sales had 
been transfers between divisions of a single corporation, and B 
succeeded to S's $70 basis).
    (c) Attributes. Under paragraphs (c)(3)(ii)(B) of this section, 
the attributes of the intercompany items and corresponding items of 
S, M, and B are also determined by treating S, M, and B as divisions 
of a single corporation. For example, S and M must take B's 
activities into account in determining the character of their gains.
    Example 10. Intercompany sale of a partnership interest. (a) 
Facts. S owns a 20% interest in the capital and profits of a general 
partnership. The partnership holds land for investment with an equal 
basis and value, and operates depreciable assets which have value in 
excess of basis. S's basis in its partnership interest equals its 
share of the adjusted basis of the partnership's land and 
depreciable assets. The partnership has an election under section 
754 in effect. On January 1 of Year 1, S sells its partnership 
interest to B at a gain. During Years 1 through 10, the partnership 
depreciates the operating assets, and B's depreciation deductions 
from the partnership reflect the increase in the basis of the 
depreciable assets under section 743(b).
    (b) Timing and attributes. S's gain is taken into account during 
Years 1 though 10 to reflect the difference in each year between B's 
depreciation deductions from the partnership taken into account and 
B's recomputed depreciation deductions from the partnership. S's 
gain taken into account is ordinary income. (The acceleration rule 
of paragraph (d) of this section does not apply to S's gain as a 
result of the section 743(b) adjustment, because the adjustment is 
solely with respect to B and therefore no nonmember reflects any 
part of the intercompany transaction.)
    (c) Partnership sale of assets. The facts are the same as in 
paragraph (a) of this Example 10, and the partnership sells some of 
its depreciable assets to X at a gain on December 31 of Year 4. In 
addition to the intercompany gain taken into account as a result of 
the partnership's depreciation, S takes intercompany gain into 
account in Year 4 to reflect the difference between B's partnership 
items taken into account from the sale (which reflect the basis 
increase under section 743(b)) and B's recomputed partnership items. 
S's additional gain is treated like the recomputed gain B would have 
taken into account if S and B were divisions of a single corporation 
(recapture income or section 1231 gain).
    (d) B's sale of partnership interest. The facts are the same as 
in paragraph (a) of this Example 10, and on December 31 of Year 4, B 
sells its partnership interest to X at no gain or loss. In addition 
to the intercompany gain taken into account as a result of the 
partnership's depreciation, the remaining balance of S's 
intercompany gain is taken into account in Year 4 to reflect the 
difference between B's $0 gain taken into account from the sale of 
the partnership interest and its recomputed gain. Whether any of S's 
remaining balance is treated as ordinary income depends on the 
application of section 751 at the time of B's sale.
    (e) No section 754 election. The facts are the same as in 
paragraph (a) of this Example 10, except that the partnership does 
not have a section 754 election in effect, and B recognizes a 
capital loss from its sale of the partnership interest to X on 
December 31 of Year 4 (B initially had a cost basis in the 
partnership interest equal to its value, but the partnership's 
built-in income and gain increased B's basis in excess of the 
value). Because there is no difference between B's depreciation 
deductions from the partnership taken into account and its 
recomputed depreciation deductions, S does not take any of its gain 
into account during Years 1 through 4 as a result of B's 
partnership's items. Instead, S's entire intercompany gain is taken 
into account in Year 4 to reflect the difference between B's loss 
taken into account from the sale to X and its recomputed gain or 
loss.
    Example 11. Net operating losses subject to section 382 or the 
SRLY rules. (a) Facts. On January 1 of Year 1, P buys all of S's 
stock. S has net operating loss carryovers from prior years. P's 
acquisition results in an ownership change under section 382 with 
respect to S's loss carryovers, and S has a net unrealized built-in 
gain (within the meaning of section 382(h)(3)). S owns 
nondepreciable property with a $70 basis and $100 value. On July 1 
of Year 3, S sells the property to B for $100, and its $30 gain is 
recognized built-in gain (within the meaning of section 382(h)(2)) 
on a separate entity basis. On December 1 of Year 5, B sells the 
property to X for $90.
    (b) Timing and attributes. S's $30 gain is taken into account in 
Year 5 to reflect the $30 difference between B's $10 loss taken into 
account and its recomputed $20 gain. Treating S and B as divisions 
of a single corporation for purposes of determining the attributes 
of B's loss and S's gain, the single corporation has losses subject 
to limitation under section 382, and this limitation may be 
increased under section 382(h) if the single corporation has 
recognized built-in gain with respect to those losses from either of 
its divisions. Of S's $30 of gain, $20 is treated as recognized 
built-in gain, and the remaining $10 that is offset by B's loss is 
treated as not being recognized built-in gain. Thus, $10 of S's gain 
does not increase the section 382 limitation applicable to S's 
losses.
    (c) B's recognized built-in gain. The facts are the same as in 
paragraph (a) of this Example 11, except that the property declines 
in value after S becomes a member of the P group, S sells the 
property to B for its $70 basis, and B sells the property to X for 
$90 during Year 5. Treating S and B as divisions of a single 
corporation, S's sale to B does not cause the property to cease to 
be built-in gain property. Thus, B's $20 gain from its sale to X is 
recognized built-in gain that increases the section 382 limitation 
applicable to S's losses.
    (d) Depreciable property. The facts are the same as in paragraph 
(a) of this Example 11, except that S's property is depreciable 
property, and S's $30 gain is taken into account as a result of B's 
depreciation of the property. Treating S and B as divisions of a 
single corporation, both B's depreciation and S's gain taken into 
account as a result of B's depreciation are treated as not being 
recognized built-in amounts. Thus, S's gain taken into account as a 
result of the depreciation does not increase the section 382 
limitation applicable to S's losses.
    (e) SRLY limitation. The facts are the same as in paragraph (a) 
of this Example 11, except that S's net operating loss carryovers 
are subject to the separate return limitation year (SRLY) rules. See 
Sec. 1.1502-21(c). Although the matching rule redetermines the 
timing and attributes of items, the amount and location of items are 
not redetermined. Because S's SRLY limitation is determined solely 
by its contribution to consolidated taxable income (as determined 
under Sec. 1.1502-21(c)), S's SRLY limitation in Year 5 includes its 
entire $30 gain taken into account.
    Example 12. Special inventory accounting election. (a) Facts. S 
operates a farming business (within the meaning of section 
263A(e)(4)) of growing and selling grapes to customers, including B. 
S is not required to use an inventory method, and uses the cash 
method of accounting. See sections 446 to 448 and 471, and 
Sec. 1.1502-17. On a separate entity basis, S does not capitalize 
its employee costs for the production of grapes pursuant to an 
election under section 263A(d)(3). B uses grapes purchased from S to 
produce wine for sale to customers. B uses the accrual method of 
accounting, and includes the cost of S's grapes in inventory under 
its inventory method. During Year 1, S sells grapes to B, incurring 
employee production costs. During Year 2, B converts the grapes into 
wine. In December of Year 3, based on its inventory method, B sells 
the wine produced with S's grapes and recognizes ordinary income.
    (b) Related costs and expenses. Under paragraph (b)(2)(i)(B) of 
this section, S costs related to its sale of grapes to B are 
included in the determination of its intercompany items. Because the 
timing of S's costs may differ from the timing of S's income, it is 
necessary to determine whether S's costs are to be accounted for 
separate from, rather than combined with, S's income from B in 
determining its intercompany income or loss deferred until Year 3. 
The determination depends on whether S's election under section 
263A(d)(3) would continue to permit deduction of the costs if S were 
engaged in a separate farming business as part of a single 
corporation that includes B. See, e.g., sections 447 and 448. If the 
costs are separately accounted for, they are taken into account in 
Year 1 rather than deferred until Year 3.
    Example 13. Section 475. (a) Facts. S, a dealer in securities 
within the meaning of section 475(c), purchases a security for $100. 
The security is held for sale to customers and is not identified 
under section 475(b) as within an exception to marking to market, 
and S recognizes $30 of net mark-to-market decreases before Year 1. 
On July 1 of Year 1, S sells the security to B for $100. B is not a 
dealer and holds the security for investment. On December 31 of Year 
1, the fair market value of the security is $100. On July 1 of Year 
2, B sells the security to X for $110.
    (b) Treatment as a single corporation. Under section 475, a 
dealer in securities can treat a security as within an exception to 
marking to market under section 475(b) only if it identifies the 
security on the day of its acquisition. S's intercompany gain is 
taken into account by treating section 475 as applying to S and B as 
a single corporation that is a dealer with respect to securities as 
a result of S's activities. Thus, B's recomputed items are 
determined by B's continuing to treat the security as not within an 
exception to marking to market. However, under section 475(d)(3), it 
is possible for the character of S's intercompany items to differ 
from the character of B's corresponding items.
    (c) Timing and attributes. S has a $30 gain when it disposes of 
the security by selling it to B. This gain is intercompany gain that 
is taken into account in Year 1 to reflect the $30 difference 
between B's $0 gain taken into account and its recomputed $30 gain 
that would be taken into account as a result of marking to market 
under section 475. Under section 475(d)(3), S's gain is ordinary 
income. B has a $10 gain as a result of its sale to X, and this gain 
is taken into account in Year 2. Under section 475(d)(3), B's gain 
is capital gain.
    (d) Nondealer to dealer. The facts are the same as in paragraph 
(a) of this Example 13, except that S is not a dealer and holds the 
security for investment with a $70 basis, B is a dealer to which 
section 475 applies and, immediately after acquiring the security 
from S for $100, B holds the security for sale to customers in the 
ordinary course of its trade or business. Treating S and B as 
divisions of a single corporation, the security is treated as 
properly identified as held for investment under section 475(b)(1) 
until it is sold to B. Under section 475(b)(3), the security 
thereafter ceases to be described in section 475(b)(1) because B 
holds the security for sale to customers, and the mark-to-market 
requirement applies only to changes in the value of the security 
after B's acquisition. None of S's gain is taken into account in 
Year 1 as a result of B's marking the security to market in Year 1. 
B's mark-to-market gain taken into account and its recomputed mark-
to-market gain are both determined based on changes from the $100 
value of the security at the time of B's acquisition. There is no 
difference between B's $0 mark-to-market gain taken into account in 
Year 1 and its $0 recomputed mark-to-market gain. In Year 2, B has a 
$10 gain when it disposes of the security by selling it to X, but 
would have had a $40 gain if S and B were divisions of a single 
corporation. Thus, S takes its $30 gain into account in Year 2 under 
the matching rule. Under section 475(d)(3), S's gain is capital gain 
even though B's subsequent gain or loss from marking to market or 
disposing of the security is ordinary gain or loss. (If B had held 
the security for investment, and had so identified the security 
under section 475(b)(1), the security would continue to be excepted 
from marking to market.)
    Example 14. Section 1092. (a) Facts. On July 1 of Year 1, S 
enters into offsetting long and short positions with respect to 
actively traded personal property. The positions are not section 
1256 contracts, and they are the only positions taken into account 
for purposes of applying section 1092. On August 1 of Year 1, S 
sells the long position to B at an $11 loss, and there is $11 of 
unrealized gain in the offsetting short position. On December 1 of 
Year 1, B sells the long position to X at no gain or loss. On 
December 31 of Year 1, there is still $11 of unrealized gain in the 
short position. On February 1 of Year 2, S closes the short position 
at an $11 gain.
    (b) Timing and attributes. S's $11 loss is taken into account in 
Year 1 under the matching rule to reflect the difference between B's 
corresponding items taken into account and B's recomputed items. 
Under paragraph (a)(3) of this section, however, an item taken into 
account under this section can be deferred, disallowed, or 
eliminated under other applicable law. Under section 1092, S's loss 
continues to be deferred until Year 2 notwithstanding this section. 
(The results are the same under section 267(f).)
    Example 15. Manufacturer rebates. (a) Facts. B is a manufacturer 
that sells its products to independent dealers for resale. S is a 
credit company that offers financing, including financing to 
customers of the dealers. S also purchases the product from dealers 
for lease to customers of the dealers. During Year 1, B initiates a 
program of rebates to the dealers' customers. Under B's program, S 
buys a $100 product from a dealer and leases it to another. S pays 
$90 to the dealer for the product, and assigns to the dealer its $10 
rebate from B. Under their separate entity accounting methods, B 
deducts the $10 rebate in Year 1 and S takes a $90 basis in the 
product.
    (b) Timing and attributes. Under paragraph (b)(1) of this 
section, the rebate transaction is an intercompany transaction. S's 
$90 basis in the product reflects a $10 adjustment for the rebate 
from B. Under paragraph (b)(2)(iii)(A) of this section, S is treated 
as having $10 of intercompany income that is to be taken into 
account under this section. S's income is taken into account in Year 
1 to reflect the $10 difference between B's $10 deduction taken into 
account and its $0 recomputed deduction. S's $10 of income and B's 
$10 deduction are ordinary items. Because the rebate is treated as 
income to S, S's basis in the product is $100 rather than $90. S's 
additional $10 of basis in the product is recovered based on 
subsequent events (e.g., S's cost recovery deductions or its sale of 
the product).
    Example 16. Cancellation of debt and attribute reduction under 
section 108(b). (a) Facts. S holds land for investment with a basis 
of $0. On January 1 of Year 1, S sells the land to B for $100. B 
also holds the land for investment. During Year 3, due to the 
declining value of B's assets, B's nonmember creditors discharge $60 
of B's indebtedness. Because of insolvency, B's $60 discharge is 
excluded from B's gross income under section 108(a). B's elimination 
of $60 of basis in the land under sections 108(b) and 1017 preserves 
$60 of other attributes.
    (b) Matching rule. Under paragraph (b)(2)(iii)(B) of this 
section, B's $60 basis reduction under section 108(b) is an 
adjustment that is a substitute for a corresponding item and is 
therefore treated as a corresponding item for purposes of taking S's 
intercompany gain into account. Although the basis reduction in 
effect preserves $60 of B's discharge of indebtedness income, the 
reduction also preserves other attributes that subsequently may be 
taken into account and therefore affects the overall amount of items 
to be taken into account. Thus, S takes $60 of its gain into account 
as a result of the basis reduction. The $60 gain is treated as 
ordinary income because the basis reduction has the effect of 
offsetting ordinary income from the discharge of indebtedness.
    (c) Purchase price adjustment. Assume instead that S sells the 
land to B in exchange for B's $100 purchase money note, B remains 
solvent, and S subsequently agrees to discharge $60 of the note as a 
purchase price adjustment to which section 108(e)(5) applies. A 
purchase price adjustment is not equivalent to a deduction or loss 
that offsets discharge of indebtedness income. Instead, under 
applicable principles of tax law, $60 of S's gain and $60 of B's 
basis in the land are eliminated and never taken into account.
    Example 17. Source of items from a section 863 sale. (a) Facts. 
S manufactures inventory in the United States that it sells to 
distributors for resale to customers. B is a distributor with a 
foreign branch in country Y that purchases and resells the inventory 
outside the United States. During Year 1, S manufactures inventory, 
sells it to B's country Y branch at an arm's length price, and has 
$75 of income. There is no independent factory or production price 
for the sale. Also during Year 1, B's country Y branch resells the 
inventory to X, an unrelated foreign person, with title passing 
abroad. B recognizes $25 of income. S's United States manufacturing 
assets have a value of $900, and B's country Y branch assets have a 
value of $100.
    (b) Timing. S's $75 of intercompany income is taken into account 
in Year 1 to reflect the difference between B's $25 of corresponding 
income taken into account and its $100 of recomputed income.
    (c) Attributes. The attributes of S's intercompany income and 
B's corresponding income are determined as if S and B were divisions 
of a single corporation. Thus, section 863 applies to S's 
intercompany sale as if S and B were divisions of a corporation 
manufacturing in the United States and selling in country Y. Two 
steps are required to source S's $75 of income and B's $25 of 
income. First, the $100 of combined income must be divided into 
foreign and U.S. source income portions. Of the combined income, $50 
is sourced based on the aggregate asset values of S and B, with $45 
of the $50 treated as United States source income ($50 multiplied by 
$900/$1,000) and $5 treated as foreign source income ($50 multiplied 
by $100/$1,000). The remaining $50 of combined income is treated as 
foreign source income, based on the passage of title to X outside 
the United States. See Sec. 1.863-3T(b), Example 2. Thus, $55 of the 
$100 of combined income is treated as foreign source income and $45 
is treated as United States source income. Second, consistent with 
the treatment of S and B as divisions of a single corporation, the 
foreign and United States source income is allocated between S and B 
based on their intercompany income and corresponding income. Because 
S earned $75 and B earned $25, $41.25 of the $55 of foreign source 
income is allocated to S ($55 multiplied by 75/100), and $13.75 is 
allocated to B ($55 multiplied by 25/100). Similarly, $33.75 of the 
$45 of United States source income is allocated to S ($45 multiplied 
by 75/100), and $11.25 is allocated to B ($45 multiplied by 25/100).
    Example 18. Section 1248. (a) Facts. On January 1 of Year 1, S 
forms FT, a wholly owned foreign subsidiary, with a $10 
contribution. During Years 1 through 3, FT has earnings and profits 
of $40. None of the earnings and profits is taxed as subpart F 
income under section 951, and FT distributes no dividends to S 
during this period. On January 1 of Year 4, S sells its FT stock to 
B for $50. While B owns FT, FT has a deficit in earnings and profits 
of $10. On July 1 of Year 6, B sells its FT stock for $70 to X, an 
unrelated foreign corporation.
    (b) Timing. S's $40 of intercompany gain is taken into account 
in Year 6 to reflect the difference between B's $20 of gain taken 
into account and its $60 recomputed gain.
    (c) Attributes. Section 1248 applies to determine the attributes 
of S's intercompany gain and B's corresponding gain as if S and B 
were divisions of a single corporation. The portions of S's gain and 
B's gain characterized as dividends under section 1248 is determined 
on the basis of FT's $30 of earnings and profits at the time of B's 
sale to X. Treating S and B as divisions of a single corporation, 
this $30 amount is allocated between S and B based on their 
respective gains. Because S has a $40 gain and B has a $20 gain, S 
is allocated $20 of the $30 section 1248 amount ($30 multiplied by 
$40/$60), and B is allocated the remaining $10 of the section 1248 
amount ($30 multiplied by $20/$60). S's $20 of gain in excess of its 
$20 section 1248 amount, and B's $10 of gain in excess of its $10 
section 1248 amount, are each treated as gain from the sale or 
exchange of a capital asset. Thus, $20 of S's intercompany gain is 
treated as a dividend and the remaining $20 is treated as capital 
gain, and $10 of B's corresponding gain is treated as a dividend and 
the remaining $10 is treated as capital gain.
    (d) No deficit in earnings and profits. The facts are the same 
as in paragraph (a) of this Example 18, except that FT has no 
earnings and profits or deficit in earnings and profits while B owns 
FT, and B sells the FT stock to X for $40. Because S has gain from 
its sale of the FT stock to B, and B has loss from its sale of the 
FT stock to X, none of FT's $40 section 1248 amount is allocated to 
B. Moreover, because FT's $40 section 1248 amount exceeds the $30 
net gain of S and B (the sum of S's $40 gain and B's $10 loss), the 
section 1248 amount allocated to S is limited to $30. See section 
1248(a). Thus, $30 of S's intercompany gain is treated as a 
dividend. The remaining $10 of S's gain and all of B's $10 loss are 
treated as a capital gain and loss.

    (d) Acceleration rule. S's intercompany items and B's 
corresponding items are taken into account under this paragraph (d) 
to the extent they cannot be taken into account to produce the 
effect of treating S and B as divisions of a single corporation. For 
this purpose, the following rules apply:
    (1) S's items--(i) Timing. S takes its intercompany items into 
account to the extent they cannot be taken into account to produce the 
effect of treating S and B as divisions of a single corporation. The 
items are taken into account immediately before it first becomes 
impossible to achieve this effect. For this purpose, the effect cannot 
be achieved--
    (A) To the extent an intercompany item or corresponding item will 
not be taken into account in determining the group's consolidated 
taxable income (or consolidated tax liability) under the matching rule 
of paragraph (c) of this section (e.g., if S or B becomes a nonmember); 
or
    (B) To the extent a nonmember reflects, directly or indirectly, any 
aspect of the intercompany transaction (e.g., if B's cost basis in 
property purchased from S is reflected by a nonmember under section 362 
following a section 351 transaction).
    (ii) Attributes. The attributes of S's intercompany items taken 
into account under this paragraph (d)(1) are determined as follows:
    (A) If the item is from a sale, exchange, or distribution of 
property, its attributes are determined under the principles of the 
matching rule of paragraph (c) of this section as if B resold the 
property to a nonmember affiliate at the time the item is taken into 
account, for a cash payment equal to B's adjusted basis in the 
property.
    (B) If the item is from an intercompany transaction other than a 
sale, exchange, or distribution of property (e.g., income from S's 
services capitalized by B), its attributes are determined on a separate 
entity basis.
    (2) B's items--(i) Timing. If paragraph (d)(1) of this section 
applies to S, B nevertheless continues to take its corresponding items 
into account under its accounting method. However, the redetermination 
of the attributes of a corresponding item under this paragraph (d)(2) 
may affect its timing.
    (ii) Attributes. The attributes of B's corresponding items continue 
to be redetermined under the principles of the matching rule of 
paragraph (c) of this section, with the following adjustments:
    (A) If S and B continue to join with each other in the filing of 
consolidated returns, the attributes of B's corresponding items (and 
any applicable holding periods) are determined by continuing to treat S 
and B as divisions of a single corporation.
    (B) Once S and B no longer join with each other in the filing of 
consolidated returns, the attributes of B's corresponding items are 
determined as if the S division (but not the B division) were 
transferred by the single corporation to an unrelated person. Thus, S's 
activities (and any applicable holding period) before the intercompany 
transaction continue to affect the attributes of the corresponding 
items (and any applicable holding period).
    (3) Examples. The acceleration rule of this paragraph (d) is 
illustrated by the following examples.

    Example 1. Becoming a nonmember--timing. (a) Facts. S owns land 
with a basis of $70. On January 1 of Year 1, S sells the land to B 
for $100. On July 1 of Year 3, P sells 60% of S's stock to X for $60 
and, as a result, S becomes a nonmember.
    (b) Matching rule. Under the matching rule of paragraph (c) of 
this section, none of S's $30 gain is taken into account in Years 1 
through 3 because there is no difference between B's $0 gain or loss 
taken into account and its recomputed gain or loss.
    (c) Acceleration of S's intercompany items. Under the 
acceleration rule of paragraph (d) of this section, S's $30 gain is 
taken into account in computing consolidated taxable income (and 
consolidated tax liability) immediately before the effect of 
treating S and B as divisions of a single corporation cannot be 
produced. Because the effect cannot be produced once S becomes a 
nonmember, S takes its $30 gain into account in Year 3 immediately 
before becoming a nonmember. S's gain is reflected under 
Sec. 1.1502-32 in P's basis in the S stock immediately before P's 
sale of the stock. Under Sec. 1.1502-32, P's gain is reduced (or 
loss is increased) by $18 (60% of $30). See also Secs. 1.1502-33 and 
1.1502-76(b). (The results would be the same if S sold the land to B 
in an installment sale to which section 453 would otherwise apply, 
because S must take its intercompany gain into account under this 
section.)
    (d) B's corresponding items. Notwithstanding the acceleration of 
S's gain, B continues to take its corresponding items into account 
under its accounting method. Thus, B's items from the land are taken 
into account based on subsequent events (e.g., its sale of the 
land).
    (e) Sale of B's stock. The facts are the same as in paragraph 
(a) of this Example 1, except that P sells 60% of B's stock (rather 
than S stock) to X for $60 and, as a result, B becomes a nonmember. 
Because the effect of treating S and B as divisions of a single 
corporation cannot be produced once B becomes a nonmember, S takes 
its $30 gain into account under the acceleration rule immediately 
before B becomes a nonmember. (The results would be the same if S 
sold the land to B in an installment sale to which section 453 would 
otherwise apply, because S must take its intercompany gain into 
account under this section.)
    (f) Discontinue filing consolidated returns. The facts are the 
same as in paragraph (a) of this Example 1, except that the P group 
receives permission under Sec. 1.1502-75(c) to discontinue filing 
consolidated returns beginning in Year 3. Under the acceleration 
rule, S takes its $30 gain into account on December 31 of Year 2.
    (g) No subgroups. The facts are the same as in paragraph (a) of 
this Example 1, except that P simultaneously sells all of the stock 
of both S and B to X (rather than 60% of S's stock), and S and B 
become members of the X consolidated group. Because the effect of 
treating S and B as divisions of a single corporation in the P group 
cannot be produced once S and B become nonmembers, S takes its $30 
gain into account under the acceleration rule immediately before S 
and B become nonmembers. (Paragraph (j)(2) of this section does not 
apply to treat the X consolidated group as succeeding to the P group 
because the X group acquired only the stock of S and B.) However, so 
long as S and B continue to join with each other in the filing of 
consolidated returns, B continues to treat S and B as divisions of a 
single corporation for purposes of taking its corresponding items 
from the land into account.
    Example 2. Becoming a nonmember--attributes. (a) Facts. S holds 
land for investment with a basis of $70. On January 1 of Year 1, S 
sells the land to B for $100. B holds the land for sale to customers 
in the ordinary course of business, and expends substantial 
resources over a two-year period subdividing, developing, and 
marketing the land. On July 1 of Year 3, before B has sold any of 
the land, P sells 60% of S's stock to X for $60 and, as a result, S 
becomes a nonmember.
    (b) Attributes. Under the acceleration rule, the attributes of 
S's gain are redetermined under the principles of the matching rule 
as if B resold the land to a nonmember affiliate for a cash payment 
equal to B's adjusted basis in the land. (The deemed resale is 
solely for purposes of determining attributes, and therefore does 
not apply for purposes of determining timing.) Thus, whether S's 
gain is capital gain or ordinary income depends on the activities of 
both S and B. Because S and B no longer join with each other in the 
filing of consolidated returns, the attributes of B's corresponding 
items (e.g., from its subsequent sale of the land) are redetermined 
under the principles of the matching rule of paragraph (c) of this 
section as if the S division (but not the B division) were 
transferred by the single corporation to an unrelated person at the 
time of P's sale of the S stock. Thus, B continues to take into 
account the activities of S with respect to the land before the 
intercompany transaction.
    (c) Depreciable property. The facts are the same as in paragraph 
(a) of this Example 2, except that the property sold by S to B is 
depreciable property. Section 1239 applies to treat all of S's gain 
as ordinary income because it is taken into account as a result of 
B's deemed resale of the property to a nonmember affiliate (a 
related person within the meaning of section 1239(b)). (The results 
would be the same if P sells 60% of B's stock (rather than S's 
stock) to X.)
    Example 3. Back-to-back intercompany transactions. (a) Facts. 
During Year 1, S performs services for M in exchange for $10 from M. 
M capitalizes the $10 cost of S's services under section 263 as part 
of M's cost to acquire real property from X. S incurs $8 of employee 
expenses that would be taken into account in Year 1 under its 
separate entity method of accounting. M holds the real property for 
investment and, on July 1 of Year 5, M sells it to B at a gain. B 
also holds the real property for investment. On December 1 of Year 
8, while B still owns the real property, P sells all of M's stock to 
X and M becomes a nonmember.
    (b) M's items. M takes its gain into account immediately before 
it becomes a nonmember. The acceleration rule redetermines the 
attributes of M's gain under the principles of the matching rule as 
if B resold the real property to a nonmember affiliate for a cash 
payment equal to B's adjusted basis in real property, and S, M, and 
B were divisions of a single corporation. Thus, M's gain is capital 
gain.
    (c) S's items. Under paragraph (b)(2) of this section, S 
includes the $8 of expenses in determining its intercompany income. 
In Year 1, S takes into account $8 of its income and the $8 of 
expenses. Under paragraph (c)(3)(ii)(B) of this section, appropriate 
adjustments must be made to treat both S's performance of services 
for M and M's sale to B as occurring between divisions of a single 
corporation. Thus, S's remaining $2 of intercompany income is not 
taken into account as a result of M becoming a nonmember, but 
instead will be taken into account based on subsequent events (e.g., 
under the matching rule based on B's sale of the real property to a 
nonmember, or under the acceleration rule based on P's sale of the 
stock of S or B to a nonmember). See the successor person rules of 
paragraph (j)(1)(ii) of this section (B is treated as a successor to 
M for purposes of taking S's intercompany income into account).
    (d) Sale of S's stock. The facts are the same as in paragraph 
(a) of this Example 3, except that P sells all of S's stock (rather 
than M's stock) and S becomes a nonmember on July 1 of Year 5. S's 
remaining $2 of intercompany income is taken into account 
immediately before S becomes a nonmember. Because S's intercompany 
income is not from an intercompany sale, exchange, or distribution 
of property, the attributes of the intercompany income are 
determined on a separate entity basis. Thus, S's $2 of intercompany 
income is ordinary income. M does not take any of its intercompany 
gain into account as a result of S becoming a nonmember.
    (e) Intercompany income followed by intercompany loss. The facts 
are the same as in paragraph (a) of this Example 3, except that M 
sells the real property to B at a $1 loss (rather than a gain). M 
takes its $1 loss into account under the acceleration rule 
immediately before M becomes a nonmember. But see Sec. 1.267(f)-1. 
Under paragraph (c)(3)(ii)(B) of this section, P's sale of M stock 
also results in S taking into account $1 of intercompany income as 
capital gain to offset M's $1 of corresponding capital loss. The 
remaining $1 of S's intercompany income is taken into account based 
on subsequent events.
    Example 4. Selling member's disposition of proceeds. (a) Facts. 
S owns land with a basis of $70. On January 1 of Year 1, S sells the 
land to B in exchange for B's $110 note. The note bears a market 
rate of interest in excess of the applicable Federal rate, and 
provides for principal payments of $55 in Year 4 and $55 in Year 5. 
On July 1 of Year 3, S sells B's note to X for $110.
    (b) Timing. S's intercompany gain is taken into account under 
this section, and not under the rules of section 453. Consequently, 
S's sale of B's note does not result in its intercompany gain being 
taken into account (e.g., under section 453B). The sale does not 
prevent S's intercompany items and B's corresponding items from 
being taken into account in determining the group's consolidated 
taxable income under the matching rule, and X does not reflect any 
aspect of the intercompany transaction (X has its own cost basis in 
the note). S will take the intercompany gain into account under the 
matching rule or acceleration rule based on subsequent events (e.g., 
B's sale of the land). See also paragraph (g) of this section for 
additional rules applicable to B's note as an intercompany 
obligation.
    Example 5. Section 481. (a) Facts. S operates several trades or 
businesses, including a manufacturing business. S receives 
permission to change its method of accounting for valuing inventory 
for its manufacturing business. S increases the basis of its ending 
inventory by $100, and the related $100 positive section 481(a) 
adjustment is to be taken into account ratably over six taxable 
years, beginning in Year 1. During Year 3, S sells all of the assets 
used in its manufacturing business to B at a gain. Immediately after 
the transfer, B adopts and uses the same inventory valuation method 
as S. On a separate entity basis, S's sale results in an 
acceleration of the balance of the section 481(a) adjustment to Year 
3.
    (b) Timing and attributes. Under paragraph (b)(2)(i) of this 
section, the balance of S's section 481(a) adjustment accelerated to 
Year 3 is intercompany income. However, S's $100 basis increase 
before the intercompany transaction eliminates the related 
difference between B's corresponding items taken into account and 
its recomputed items in subsequent periods. Because the accelerated 
section 481(a) adjustment will not be taken into account in 
determining the group's consolidated taxable income (and 
consolidated tax liability) under the matching rule, the balance of 
S's section 481 adjustment is taken into account under the 
acceleration rule as ordinary income at the time of the intercompany 
transaction. (If S's sale had not resulted in accelerating S's 
section 481(a) adjustment on a separate entity basis, S would have 
no intercompany income to be taken into account under this section.)

    (e) Simplifying rules--(1) Dollar-value LIFO inventory methods--(i) 
In general. This paragraph (e)(1) applies if either S or B uses a 
dollar-value LIFO inventory method to account for intercompany 
transactions. Rather than applying the matching rule of paragraph (c) 
of this section separately to each intercompany inventory transaction, 
this paragraph (e)(1) provides methods to apply an aggregate approach 
that is based on dollar-value LIFO inventory accounting. Any method 
selected under this paragraph (e)(1) must be applied consistently.
    (ii) B uses dollar-value LIFO--(A) In general. If B uses a dollar-
value LIFO inventory method to account for its intercompany inventory 
purchases, and includes all of its inventory costs incurred for a year 
in its cost of goods sold for the year, S takes into account all of its 
intercompany inventory items for the year. If B does not include all of 
its inventory costs incurred for the year in its cost of goods sold for 
the year, S does not take into account a percentage of its net 
intercompany inventory income or loss. The percentage not taken into 
account is determined under either the increment averaging method or 
the increment valuation method. Separate computations are made for each 
pool of B that receives intercompany purchases from S.
    (B) Increment averaging method. The percentage not taken into 
account equals B's current-year costs of its layer of increment, 
divided by B's total inventory costs incurred for the year under its 
LIFO inventory method. S's amount not taken into account is layered 
based on B's LIFO inventory layers. If B includes more than its 
inventory costs incurred during any subsequent year in its cost of 
goods sold (a decrement), S takes into account the intercompany 
inventory income or loss layers in the same manner and proportion as B 
takes into account its inventory decrements.
    (C) Increment valuation method. The percentage not taken into 
account equals B's current-year costs of its layer of increment, 
divided by B's total inventory costs incurred in the appropriate period 
under its LIFO inventory method. The principles of paragraph 
(e)(1)(ii)(B) of this section otherwise apply. The appropriate period 
is the period of B's year used to determine its current-year costs.
    (iii) S uses dollar-value LIFO. If S uses a dollar-value LIFO 
inventory method to account for its intercompany inventory sales, S can 
use any reasonable method of allocating its LIFO inventory costs to 
intercompany transactions. LIFO inventory costs include costs of prior 
layers if a decrement occurs. For example, a reasonable allocation of 
most recent costs incurred during the consolidated return year can be 
used to compute S's net intercompany inventory income or loss for the 
year if S has an inventory increment and uses the earliest acquisitions 
costs method, but S must apportion costs from the most recent 
appropriate layers of increment if an inventory decrement occurs for 
the year.
    (iv) Other reasonable methods. S or B can use a method not 
specifically provided in this paragraph (e)(1) that is expected to 
reasonably take into account intercompany items and corresponding items 
from intercompany inventory transactions. However, if the method used 
results, for any year, in a cumulative amount of intercompany inventory 
items not taken into account by S that significantly exceeds the 
cumulative amount that would not be taken into account under paragraph 
(e)(1) (ii) or (iii) of this section, S must take into account for that 
year the amount necessary to eliminate the excess. The method is 
thereafter applied with appropriate adjustments to reflect the amount 
taken into account.
    (v) Examples. The inventory rules of this paragraph (e)(1) are 
illustrated by the following examples.

    Example 1. Increment averaging method. (a) Facts. Both S and B 
use a double-extension, dollar-value LIFO inventory method, and both 
value inventory increments using the earliest acquisitions cost 
valuation method. During Year 2, S sells 25 units of product Q to B 
on January 15 at $10/unit, and another 25 units on September 15 at 
$12/unit. S's earliest cost of product Q is $7.50/unit and S's most 
recent cost of product Q is $8.00/unit. B's total inventory costs 
incurred during Year 2 are $3,333. The S and B inventory 
computations for Year 2 and prior years are as follows:
    (i)(A) S's Year 2 computations:

----------------------------------------------------------------------------------------------------------------
                                                               (2) base-                (3) current-            
                     Item                         (1) ending   year cost/     (1)x(2)    year cost/    (1)x(3)  
                                                  quantity       unit         total        unit         total   
----------------------------------------------------------------------------------------------------------------
Q..............................................           50           $5         $250        $7.50         $375
Y..............................................          150            2          300         3.00          450
                                                ----------------------------------------------------------------
xl.............................................           xl           xl         $550           xl         $825
----------------------------------------------------------------------------------------------------------------
Year 1--Ending inventory at base-year cost=$500.                                                                
Year 2--Price index = $825/$550=1.5.                                                                            

    (B) S's $7.50 current-year cost/unit of product Q is based on 
its earliest acquisitions cost of 50 units. 

------------------------------------------------------------------------
                                              Base-                     
                                              year      Price     LIFO  
                                              cost     index      cost  
------------------------------------------------------------------------
Base layer................................      $450     1.000      $450
Year 1 layer..............................        50     1.200        60
Year 2 layer..............................        50     1.500        75
                                           -----------------------------
                                                                     585
------------------------------------------------------------------------

    (ii)(A) B's Year 2 computations: 

----------------------------------------------------------------------------------------------------------------
                                                               (2) Base-                (3) Current-            
                     Item                         (1) Ending   year cost/    (1)x(2)     year cost/    (1)x(3)  
                                                  quantity       unit         total        unit         total   
----------------------------------------------------------------------------------------------------------------
Q..............................................           50           $8         $400          $11         $550
Z..............................................           50           10          500           13          650
                                                ----------------------------------------------------------------
                                                                                  $900                   $1,200 
----------------------------------------------------------------------------------------------------------------
Year 1--Ending inventory at base-year cost=$650                                                                 
Year 2--Price index=$1,200/$900=1.333.                                                                          

    (B) B's $11 current-year cost/unit of product Q is based on its 
earliest acquisitions cost (25 units purchased from S at $10/unit, 
and 25 units from X at $12/unit). 

------------------------------------------------------------------------
                                              Base-                     
                                              year      Price     LIFO  
                                              cost     index      cost  
------------------------------------------------------------------------
Base layer................................      $400     1.000      $400
Year 1 layer..............................       250     1.100       275
Year 2 layer..............................       250     1.333       333
                                                               ---------
                                                                   1,008
------------------------------------------------------------------------

    (b) Intercompany inventory income. Under paragraph (e)(1)(iii) 
of this section, S must use a reasonable method of allocating its 
LIFO inventory costs to intercompany transactions. Because S has an 
inventory increment for Year 2 and uses the earliest acquisitions 
cost method, a reasonable method of determining its intercompany 
cost of goods sold for product Q is to use its most recent costs. 
Thus, its intercompany cost of goods sold is $400 ($8.00 most recent 
cost, multiplied by 50 units sold to B), and its intercompany income 
is $150 ($550 sale proceeds from B minus $400 cost).
    (c) Timing. (i) Under the increment averaging method of 
paragraph (e)(1)(ii)(B) of this section, $15 of S's $150 of 
intercompany inventory income is not taken into account in Year 2, 
computed as follows:

TP15AP94.001

    (ii) Thus, $135 of S's intercompany inventory income is taken 
into account in Year 2 ($150 of total intercompany inventory income 
minus $15 not taken into account).
    (d) S incurs a decrement. The facts are the same as in paragraph 
(a) of this Example 1, except that S's Year 2 ending inventory at 
base-year cost is $475, and therefore S incurs a $25 decrement (50% 
of the Year 1 layer in terms of base-year cost) in its inventory for 
Year 2. Under paragraph (e)(1)(iii) of this section, S must 
reasonably allocate the LIFO cost of the decrement (50% of $60, or 
$30) to the cost of goods sold to B to determine S's intercompany 
income.
    (e) B incurs a decrement. The facts are the same as in paragraph 
(a) of this Example 1, except that B incurs a decrement in Year 2 of 
$50 in base-year costs. S must take into account the entire $150 of 
Year 2 intercompany inventory income because all 50 units of product 
Q are deemed sold by B in Year 2.
    Example 2. Increment valuation method. (a) Facts. Both S and B 
use a dollar-value LIFO inventory method. Under B's LIFO method, 
layers of increment are valued with respect to earliest costs. For 
Year 2, B has a layer of increment in its pool that receives 
intercompany purchases from S. To compute its increment valuation 
index, B values its year-end inventory mix using costs incurred from 
January through March. B values its increment at $250. B's costs 
incurred from January through March and from April through December 
are $750 and $3,300, respectively. For the period from January 
through March and from April through December, S's intercompany 
inventory income is $100 and $500, respectively.
    (b) Timing. (i) Under the increment valuation method of 
paragraph (e)(1)(ii)(C) of this section, $33 of S's $600 of 
intercompany inventory income is not taken into account in Year 2, 
computed as follows:

TP15AP94.002

    (ii) Thus, $567 of S's intercompany inventory income is taken 
into account in Year 2 ($600 of total intercompany inventory income 
minus $33 not taken into account).
    (c) B incurs a subsequent decrement. Assume that, in Year 3, B 
experiences a decrement in its pool that receives intercompany 
purchases from S. B's decrement equals 20% of the base-year costs 
for its Year 2 layer, or $50 in terms of LIFO value (20% of $250). 
S's intercompany inventory income from its Year 3 sales is $400. 
Because B includes all of its inventory costs incurred for Year 3 in 
its cost of goods sold for the year, S takes into account its entire 
$400 of intercompany income from its Year 3 sales. In addition, S 
takes into account $6.60 of its Year 2 layer of intercompany 
inventory income not already taken into account (20% of $33).
    Example 3. Other reasonable inventory methods. (a) Facts. Both S 
and B use a dollar-value LIFO inventory method for their inventory 
transactions. During Year 1, S sells inventory to B and to X. Under 
paragraph (e)(1)(iv) of the section, to compute its intercompany 
inventory income and the amount of this income not taken into 
account, S computes its intercompany inventory income using the 
transfer price of the inventory items less a FIFO cost for the 
goods, takes into account these items based on a FIFO cost flow 
assumption for B's corresponding items, and the LIFO methods used by 
S and B are ignored for these computations. These computations are 
comparable to the methods used by S and B for financial reporting 
purposes, and the book methods and results are used for tax 
purposes. S adjusts the amount of intercompany inventory items not 
taken into account as required by section 263A.
    (b) Reasonable method. The method used by S is a reasonable 
method under paragraph (e)(1)(iv) of this section if the cumulative 
amount of intercompany inventory items not taken into account by S 
is not significantly greater than the cumulative amount that would 
not be taken into account under the methods specifically described 
in paragraph (e)(1) of this section. If, for any year, the method 
results in a cumulative amount of intercompany inventory items not 
taken into account by S that significantly exceeds the cumulative 
amount that would not be taken into account under the methods 
specifically provided, S must take into account for that year the 
amount necessary to eliminate the excess. The method is thereafter 
applied with appropriate adjustments to reflect the amount taken 
into account (e.g., to prevent the amount from being taken into 
account more than once).

    (2) Reserve accounting--(i) Bad debts. Except as provided in 
paragraph (g)(5) of this section (deferral of items from an 
intercompany obligation), a member's addition to, or reduction of, a 
reserve for bad debts that is maintained under section 585 or 593 is 
taken into account on a separate entity basis. For example, if S makes 
a loan to a nonmember and subsequently sells the loan to B, any 
deduction for an addition to a bad debt reserve under section 585 and 
any recapture income (or reduced deductions) are taken into account on 
a separate entity basis rather than as intercompany items or 
corresponding items taken into account under this section. Any gain or 
loss of S from its sale of the loan to B is taken into account under 
this section, however, to the extent it is not attributable to 
recapture of the reserve.
    (ii) Insurance companies--(A) Direct insurance. If a member 
provides insurance to another member in an intercompany transaction, 
the transaction is taken into account by both members on a separate 
entity basis. For example, if one member provides life insurance 
coverage for another member with respect to its employees, the 
premiums, reserve increases and decreases, and death benefit payments 
are determined and taken into account by both members on a separate 
entity basis rather than taken into account under this section as 
intercompany items and corresponding items.
    (B) Reinsurance--(1) In general. Paragraph (e)(2)(ii)(A) of this 
section does not apply to a reinsurance transaction that is an 
intercompany transaction. For example, if a member assumes all or a 
portion of the risk on an insurance contract written by another member, 
the amounts transferred as reinsurance premiums, expense allowances, 
benefit reimbursements, reimbursed policyholder dividends, experience 
rating adjustments, and other similar items are taken into account 
under the matching rule of paragraph (c) of this section.
    (2) Reserves determined on a separate entity basis. For purposes of 
determining the amount of a member's increase or decrease in reserves, 
the amount of any reserve item listed in section 807(c) or 832(b)(5) 
resulting from a reinsurance transaction that is an intercompany 
transaction is determined on a separate entity basis. But see section 
845, under which the Commissioner may allocate between or among the 
members any items, recharacterize any such items, or make any other 
adjustments necessary to clearly reflect the separate taxable income of 
a member.
    (3) De minimis or ordinary course intercompany transactions--(i) 
General rule. The common parent may request consent to take items from 
intercompany transactions into account on a separate entity basis, 
other than intercompany transactions with respect to stock or 
obligations of members. Consent may be granted for all items, or for 
items from a class or classes of transactions. The consent has no 
effect unless granted in writing by the Internal Revenue Service. 
Unless revoked with the written consent of the Internal Revenue 
Service, the separate entity treatment applies to all applicable 
intercompany transactions in the consolidated return year for which 
consent is granted and in all subsequent consolidated return years. 
Consent under this paragraph (e)(3) will not apply for purposes of 
deferring losses and deductions under section 267(f).
    (ii) Time and manner for requesting consent. The request for 
consent described in paragraph (e)(3)(i) of this section must be made 
in the form of a ruling request. The request must be signed by the 
common parent, include any information required by the Internal Revenue 
Service, and be filed on or before the due date of the consolidated 
return (not including extensions of time) for the first consolidated 
return year to which the consent is to apply. The Internal Revenue 
Service may impose terms and conditions for granting consent. A copy of 
the consent must be attached to the consolidated returns (or amended 
returns) as required by the terms of the consent.
    (f) Stock of members--(1) In general. In addition to the general 
rules of this section, the rules of this paragraph (f) apply to stock 
of members.
    (2) Intercompany distributions to which section 301 applies--(i) In 
general. This paragraph (f)(2) provides rules for intercompany 
transactions to which section 301 applies (intercompany distributions). 
For purposes of determining whether a distribution is an intercompany 
distribution, it is treated as occurring under the principles of the 
entitlement rule of paragraph (f)(2)(iv) of this section. A 
distribution is not an intercompany distribution to the extent it is 
deducted by the distributing member. See, e.g., section 1382(c)(1).
    (ii) Distributee member. An intercompany distribution is not 
included in the gross income of the distributee member. However, this 
exclusion applies to a distribution from a subsidiary only to the 
extent there is a corresponding negative adjustment reflected under 
Sec. 1.1502-32 in the distributee member's basis in the distributing 
member's stock. See Secs. 1.1502-26(b) (applicability of the dividends 
received deduction to distributions not excluded from gross income) and 
1.1502-80(d) (non-applicability of section 301(c)(3)).
    (iii) Distributing member. The principles of section 311(b) apply 
to the distributing member's loss, as well as gain, from an 
intercompany distribution of property. Thus, the distributing member's 
loss is taken into account, for example, under the matching rule of 
paragraph (c) of this section if the property is subsequently sold to a 
nonmember. However, section 311(a) continues to apply to distributions 
to nonmembers (e.g., the distributing member's loss is not recognized).
    (iv) Entitlement rule. For all Federal income tax purposes, an 
intercompany distribution is treated as taken into account when the 
shareholding member becomes entitled to it (generally on the record 
date) or, if earlier, when it is taken into account under the Internal 
Revenue Code (e.g., under section 305(c)). For example, if the 
distributee member becomes entitled to a cash distribution before it is 
made, the distribution is treated as made when the distributee member 
becomes entitled to it. Appropriate adjustments must be made (e.g., to 
determine the earnings and profits of the distributing corporation) if 
nonmembers own stock of the distributing corporation at the time the 
distribution is treated as occurring. If it is later established, based 
on all of the facts and circumstances, that the distribution will not 
be made (or will be made only in part), the initial taking into account 
of the distribution is reversed as of the date the distribution was 
taken into account.
    (3) Boot in an intercompany reorganization--(i) Application. This 
paragraph (f)(3) provides additional rules for an intercompany 
transaction in which money or other property (nonqualifying property) 
is received that results in the application of section 356. For 
example, the distribution of stock of a lower-tier member to a higher 
tier member in an intercompany transaction to which section 355 would 
otherwise apply but for the receipt of nonqualifying property, is an 
intercompany reorganization to which this paragraph (f)(3) applies. For 
this purpose, a transaction is not an intercompany reorganization if a 
party to the transaction becomes a member or nonmember as part of the 
same plan or arrangement. For example, if S merges into a nonmember in 
a transaction described in section 368(a)(1)(A), this paragraph (f)(3) 
does not apply (under paragraph (j)(1) of this section, the nonmember 
is a successor to S).
    (ii) General rule. Nonqualifying property received as part of an 
intercompany reorganization is treated as received by the shareholder 
in a separate transaction rather than as part of the intercompany 
reorganization. See, e.g., sections 302 and 311 (rather than sections 
356 and 361). The nonqualifying property is treated as taken into 
account immediately after the intercompany reorganization if it is 
received in a transaction to which section 354 would otherwise apply 
but for the fact that nonqualifying property is received. It is treated 
as taken into account immediately before the intercompany 
reorganization if it is received in a transaction to which section 355 
would otherwise apply but for the fact that nonqualifying property is 
received. The treatment under this paragraph (f)(3)(ii) applies for all 
Federal income tax purposes.
    (4) Acquisition by issuer of its own stock. If a member acquires 
its own stock in an intercompany transaction, the member's basis in 
that stock is treated as eliminated, and the elimination is taken into 
account for purposes of applying the rules of this section. For 
example, S's intercompany items from the stock of B are taken into 
account under this section if B acquires the stock in an intercompany 
transaction (unless, for example, B acquires the stock in exchange for 
successor property within the meaning of paragraph (j)(1) of this 
section in a nonrecognition transaction).
    (5) Relief for certain liquidations and distributions--(i) Scope. 
S's intercompany items from an intercompany transfer to B of the stock 
of another member (T) are taken into account under this section in 
certain circumstances even though the T stock is never held by a 
nonmember after the intercompany transaction. For example, if S sells 
all of T's stock to B at a gain, and T subsequently liquidates into B 
in a separate transaction to which section 332 applies, S's gain is 
taken into account under this section. If the rules of this paragraph 
(f)(5) are elected, certain transactions that are (in whole or in part) 
nonrecognition transactions will not result in S's items being taken 
into account. This paragraph (f)(5) applies only if, throughout the 
period beginning as of S's transfer and ending as of the completion of 
the nonrecognition transaction, no T stock is owned by a nonmember and 
T does not become a nonmember.
    (ii) Section 332--(A) In general. If section 332 applies to T's 
liquidation into B, and B transfers T's assets to a new member (new T) 
in a transaction not otherwise pursuant to the same plan or arrangement 
as the liquidation, the transfer is nevertheless treated for all 
Federal income tax purposes as pursuant to the same plan or arrangement 
as the liquidation. For example, if T liquidates into B, but B forms 
new T by transferring substantially all of T's former assets to new T, 
S's intercompany gain or loss generally is not taken into account 
solely as a result of the liquidation if the liquidation and transfer 
would qualify as a reorganization described in section 368(a). (Under 
paragraph (j)(1) of this section, B's stock in new T would be a 
successor asset to B's stock in T, and S's gain would be taken into 
account based on the new T stock.)
    (B) Time limitation and adjustments. The transfer of an asset to 
new T not otherwise pursuant to the same plan or arrangement as the 
liquidation is treated under this paragraph (f)(5)(ii) as pursuant to 
the same plan or arrangement only if B transfers it to new T on or 
before the timely filing (including extensions of time) of the group's 
return for the year of T's liquidation. Appropriate adjustments are 
made for any assets not transferred to new T as part of the same plan 
or arrangement. See, e.g., paragraph (f)(3) of this section (if B 
retains an asset in the reorganization, the asset is treated as 
acquired by new T but distributed to B immediately after the 
reorganization).
    (C) Downstream merger, etc. The principles of this paragraph 
(f)(5)(ii) apply, with appropriate adjustments, if B's basis in the T 
stock is eliminated in a transaction comparable to the section 332 
liquidation described in paragraph (f)(5)(ii)(A) of this section. For 
example, if S and B are subsidiaries, and S sells all of T's stock to B 
at a gain followed by B's merger into T in a separate transaction 
described in section 368(a), S's gain is not taken into account solely 
as a result of the merger if the group forms new B with substantially 
all of B's former assets (including all of the stock of T). The merger 
is not treated as a comparable transaction if, for example, any B stock 
is owned by nonmembers immediately before the merger, or any new B 
stock is owned by nonmembers immediately after the merger.
    (iii) Section 338(h)(10)--(A) In general. This paragraph 
(f)(5)(iii) applies to a deemed liquidation of T under section 332 as 
the result of an election under section 338(h)(10). This paragraph 
(f)(5)(iii) does not apply if T has made substantial noncash 
distributions during the 12-month period ending on the date of the 
qualified stock purchase, or if paragraph (f)(5)(ii) of this section is 
applied to the deemed liquidation. B is treated with respect to each 
share of its T stock as recognizing as a corresponding item any loss or 
deduction it would recognize (determined after adjusting stock basis 
under Sec. 1.1502-32) if section 331 applied to the deemed liquidation. 
For all other Federal income tax purposes, the deemed liquidation 
remains subject to section 332.
    (B) Noncash distribution. For purposes of this paragraph 
(f)(5)(iii), a noncash distribution is a distribution of anything other 
than cash or a cash item, any marketable stock or security, or any debt 
of the distributor or distributee member.
    (C) Limitation on amount of loss. The amount of B's loss or 
deduction under this paragraph (f)(5)(iii) is limited as follows--
    (1) The amount taken into account with respect to each T share 
cannot exceed the net amount of intercompany income or gain with 
respect to the share from all intercompany transactions before T's 
deemed liquidation that is taken into account as a result of the deemed 
liquidation; and
    (2) The aggregate amount taken into account under this paragraph 
(f)(5)(iii) from T's deemed liquidation cannot exceed the net amount of 
deduction or loss (if any) that would be taken into account from the 
deemed liquidation if section 331 applied with respect to all T shares.
    (D) Asset sale, etc. The principles of this paragraph (f)(5)(iii) 
apply, with appropriate adjustments, if T transfers all of its assets 
to a nonmember and completely liquidates in a transaction comparable to 
the section 338(h)(10) transaction described in paragraph 
(f)(5)(iii)(A) of this section. For example, if S sells all of T's 
stock to B at a gain followed by T's merger into a nonmember in 
exchange for a cash payment to B in a transaction treated for Federal 
income tax purposes as T's sale of its assets to the nonmember and 
complete liquidation, the merger is ordinarily treated as a comparable 
transaction. The merger is not treated as a comparable transaction if, 
for example, T makes substantial noncash distributions during the 12-
month period ending on the date of the merger.
    (iv) Section 355. If, instead of T liquidating into B, B 
distributes the T stock in an intercompany transaction to which section 
355 applies (including an intercompany transaction to which 355 applies 
because of the application of paragraph (f)(3) of this section), the 
redetermination of the basis of the T stock under section 358 could 
cause S's gain or loss to be taken into account under this section. 
This paragraph (f)(5)(iv) applies to treat B's distribution as subject 
to section 301 and 311 (as modified by this paragraph (f)), rather than 
section 355. The election will avoid S's gain or loss being taken into 
account immediately if matching remains possible, but B's gain or loss 
from the distribution will also be taken into account under this 
section.
    (v) Election. An election to apply this paragraph (f)(5) is made in 
a separate statement entitled ``[Insert Name and Employer 
Identification Number of Common Parent] HEREBY ELECTS THE APPLICATION 
OF Sec. 1.1502-13(f)(5).'' The election must include a description of 
S's intercompany transaction and T's liquidation (or other 
transaction). It must specify which application of Sec. 1.1502-13(f)(5) 
applies and how it alters the otherwise applicable results under this 
section (including, for example, the amount of S's intercompany items 
and the amount deferred or offset as a result of this Sec. 1.1502-
13(f)(5)). A separate election must be made for each application of 
this paragraph (f)(5). The election must be signed by the common parent 
and filed with the group's income tax return for the year of T's 
liquidation (or other transaction). The Commissioner may impose 
reasonable terms and conditions to the application of this paragraph 
(f)(5) that are consistent with the purposes of this section.
    (6) Examples. The application of this section to intercompany 
transactions with respect to stock of members is illustrated by the 
following examples.

    Example 1. Dividend exclusion and property distribution. (a) 
Facts. S owns land with a $70 basis and $100 value. On January 1 of 
Year 1, P's basis in S's stock is $100. During Year 1, S declares 
and makes a dividend distribution of the land to P. Under section 
311(b), S has a $30 gain. Under section 301(d), P's basis in the 
land is $100. On July 1 of Year 3, P sells the land to X for $110.
    (b) Dividend elimination and stock basis adjustments. Under 
paragraph (b)(1) of this section, S's distribution to P is an 
intercompany distribution. Under paragraph (f)(2)(ii) of this 
section, P's $100 of dividend income is not included in gross 
income. Under Sec. 1.1502-32, P's basis in S's stock is reduced from 
$100 to $0 in Year 1.
    (c) Matching rule and stock basis adjustments. Under the 
matching rule of paragraph (c) of this section (treating P as the 
buying member and S as the selling member), S takes its $30 gain 
into account in Year 3 to reflect the $30 difference between P's $10 
gain taken into account and its $40 recomputed gain. Under 
Sec. 1.1502-32, P's basis in S's stock is increased from $0 to $30 
in Year 3.
    (d) Loss property. The facts are the same as in paragraph (a) of 
this Example 1, except that S has a $130 (rather than $70) basis in 
the land. Under paragraph (f)(2)(iii) of this section, the 
principles of section 311(b) apply to S's loss from the intercompany 
distribution. Thus, S has a $30 loss that is taken into account 
under the matching rule in Year 3 to reflect the $30 difference 
between P's $10 gain taken into account and its $20 recomputed loss. 
(The results are the same under section 267(f).) Under Sec. 1.1502-
32, P's basis in S's stock is reduced from $100 to $0 in Year 1, and 
from $0 to a $30 excess loss account in Year 3. (If P had 
distributed the land to its shareholders, rather than selling the 
land to X, P would take its $10 gain under section 311(b) into 
account, and S would take its $30 loss into account under the 
matching rule with $10 offsetting P's gain and $20 recharacterized 
as a noncapital, nondeductible amount.)
    (e) Entitlement rule. The facts are the same as in paragraph (a) 
of this Example 1, except that, after P becomes entitled to the 
distribution but before the distribution is made, S issues 
additional stock to the public and becomes a nonmember. Under 
paragraph (f)(2)(i) of this section, the determination of whether a 
distribution is an intercompany distribution is made under the 
entitlement rule of paragraph (f)(2)(iv) of this section. Treating 
S's distribution as made when P becomes entitled to it results in 
the distribution being an intercompany distribution. Under paragraph 
(f)(2)(ii) of this section, the distribution is not included in P's 
gross income. S's $30 gain from the distribution is intercompany 
gain that is taken into account under the acceleration rule of 
paragraph (d) of this section immediately before S becomes a 
nonmember. Thus, there is a net $70 decrease in P's basis in its S 
stock under Sec. 1.1502-32 ($100 decrease for the distribution and a 
$30 increase for S's $30 gain). See also Sec. 1.1502-20(b) 
(additional stock basis reductions applicable to certain 
deconsolidations). Under paragraph (a)(4) of this section, P does 
not take the distribution into account again under separate return 
rules when received, and P is not entitled to a dividends received 
deduction.
    Example 2. Excess loss accounts. (a) Facts. S owns all of T's 
only class of stock with a $10 basis and $100 value. S has 
substantial earnings and profits, and T has $10 of earnings and 
profits (all of which are from pre-affiliation years). On January 1 
of Year 1, S declares and distributes a dividend of all of the T 
stock to P. Under section 311(b), S has a $90 gain. Under section 
301(d), P's basis in the T stock is $100. During Year 3, T borrows 
$90 and declares and makes a $90 distribution to P to which section 
301 applies, and P's basis in the T stock is reduced under 
Sec. 1.1502-32 from $100 to $10. During Year 6, T has $5 of earnings 
that increase P's basis in the T stock under Sec. 1.1502-32 from $10 
to $15. On December 1 of Year 9, T issues additional stock to X and, 
as a result, T becomes a nonmember.
    (b) Dividend exclusion. Under paragraph (f)(2)(ii) of this 
section, P's $100 of dividend income from S's distribution of the T 
stock, and its $10 of dividend income from T's $90 distribution, are 
not included in gross income.
    (c) Matching and acceleration rules. Under the matching rule, S 
takes $75 of its $90 gain into account in Year 9 as a result of T 
becoming a nonmember, to reflect the difference between P's $0 gain 
taken into account and its $75 recomputed gain. If S's distribution 
to P were a transfer between the divisions, P would succeed to S's 
$10 basis in the T stock, and the adjustments under Sec. 1.1502-32 
for T's $90 distribution and $5 of earnings would have resulted in a 
$75 excess loss account. Thus, T's becoming a nonmember would have 
resulted in P taking into account the $75 excess loss account. See 
Sec. 1.1502-19 (excess loss accounts). S's remaining $15 of gain is 
taken into account under the matching and acceleration rules based 
on subsequent events (e.g., under the matching rule if P 
subsequently sells its T stock, or under the acceleration rule if S 
becomes a nonmember).
    (d) Reverse sequence. The facts are the same as in paragraph (a) 
of this Example 2, except that T borrows $90 and makes its $90 
distribution to S before S distributes T's stock to P. Under section 
301(d) P's initial basis in the T stock is $10 (the stock's fair 
market value), and the basis increases to $15 under Sec. 1.1502-32 
as a result of T's earnings in Year 6. Under paragraph (f)(2)(ii) of 
this section, T's $90 distribution to S ($10 of which is a dividend) 
is not included in S's gross income. The corresponding negative 
adjustment under Sec. 1.1502-32 reduces S's basis in the T stock 
from $10 to an $80 excess loss account. Under section 311(b), S has 
a $90 gain from the distribution of T stock to P. The timing and 
attributes of S's gain are determined in the manner provided in 
paragraph (c) of this Example 2. Thus, $75 of S's gain is taken into 
account under the matching rule in Year 9 as a result of T becoming 
a nonmember, and the remaining $15 is taken into account under the 
matching and acceleration rules based on subsequent events.
    (e) Partial stock sale. The facts are the same as in paragraph 
(a) of this Example 2, except that P sells 10% of T's stock to X on 
December 1 of Year 9 for $1.50 (rather than T's issuing additional 
stock and becoming a nonmember). Under the matching rule, S takes $9 
of its gain into account to reflect the difference between P's $0 
gain taken into account ($1.50 sale proceeds minus $1.50 basis) and 
its $9 recomputed gain ($1.50 sale proceeds plus $7.50 excess loss 
account).
    (f) Loss, rather than cash distribution. The facts are the same 
as in paragraph (a) of this Example 2, except that T retains the 
loan proceeds and incurs a $90 loss in Year 3 that is absorbed by 
the group. The timing and attributes of S's gain are determined in 
the same manner provided in paragraph (c) of this Example 2. Under 
Sec. 1.1502-32, the loss in Year 3 reduces P's basis in the T stock 
from $100 to $10, and T's $5 of earnings in Year 6 increase the 
basis to $15. Thus, $75 of S's gain is taken into account under the 
matching rule in Year 9 as a result of T becoming a nonmember, and 
the remaining $15 is taken into account under the matching and 
acceleration rules based on subsequent events. (The timing and 
attributes of S's gain would be determined in the same manner 
provided in paragraph (d) of this Example 2 if T incurred the $90 
loss before S's distribution of the T stock to P.)
    (g) Stock sale, rather than stock distribution. The facts are 
the same as in paragraph (a) of this Example 2, except that S sells 
the T stock to P for $100 (rather than distributing the stock). The 
timing and attributes of S's gain are determined in the same manner 
provided in paragraph (c) of this Example 2. Thus, $75 of S's gain 
is taken into account under the matching rule in Year 9 as a result 
of T becoming a nonmember, and the remaining $15 is taken into 
account under the matching and acceleration rules based on 
subsequent events.
    Example 3. Intercompany reorganization. (a) Facts. P forms S and 
B by contributing $200 to the capital of each. During Years 1 
through 4, S and B each earn $50, and under Sec. 1.1502-32 P adjusts 
its basis in the stock of each to $250. (See Sec. 1.1502-33 for 
adjustments to earnings and profits.) On January 1 of Year 5, the 
fair market value of S's assets and its stock is $500, and S merges 
into B in a tax-free reorganization. Pursuant to the plan of 
reorganization, P receives B stock with a fair market value of $350 
and $150 of cash.
    (b) Treatment as a section 301 distribution. The merger of S 
into B is an intercompany reorganization to which paragraph (f)(3) 
of this section applies. P is treated as receiving additional B 
stock with a fair market value of $500 and, under section 358, a 
basis of $250. Immediately after the merger, $150 of the stock 
received is treated as redeemed, and the redemption is treated under 
section 302(d) as a distribution to which section 301 applies. 
Because the $150 distribution is treated as not received as part of 
the merger, section 356 does not apply and no basis adjustments are 
required under section 358(a)(1)(A) and (B). Because B is treated 
under section 381(c)(2) as receiving S's earnings and profits and 
the redemption is treated as occurring after the merger, $100 of the 
distribution is treated as a dividend under section 301 and P's 
basis in the B stock is reduced correspondingly under Sec. 1.1502-
32. The remaining $50 of the distribution reduces P's basis in the B 
stock. Section 301(c)(2) and Sec. 1.1502-32. Under paragraph 
(f)(2)(ii) of this section, P's $100 of dividend income is not 
included in gross income. Under Sec. 1.302-2(c), appropriate 
adjustments are made to P's basis in its B stock to reflect its 
basis in the B stock redeemed, with the result that P's basis in the 
B stock is reduced by the entire $150 distribution.
    (c) Depreciated property. The facts are the same as in paragraph 
(a) of this Example 3, except that property of S with a $200 basis 
and $150 fair market value is distributed to P (rather than cash of 
B). As in paragraph (b) of this Example 3, P is treated as receiving 
additional B stock in the merger and a $150 distribution to which 
section 301 applies immediately after the merger. Under paragraph 
(f)(2)(iii) of this section, the principles of section 311(b) apply 
to B's $50 loss and the loss is taken into account under the 
matching and acceleration rules based on subsequent events (e.g., 
under the matching rule if P subsequently sells the property, or 
under the acceleration rule if B becomes a nonmember). The results 
are the same under section 267(f).
    (d) Divisive transaction. Assume instead that, pursuant to a 
plan, S distributes the stock of a lower-tier subsidiary in a spin-
off transaction to which section 355 applies together with $150 of 
cash. The distribution of stock is an intercompany reorganization to 
which paragraph (f)(3) of this section applies. P is treated as 
receiving the $150 of cash immediately before the section 355 
distribution, as a distribution to which section 301 applies. 
Section 356(b) does not apply and no basis adjustments are required 
under section 358(a)(1)(A) and (B). Because the $150 distribution is 
treated as made before the section 355 distribution, the 
distribution reduces P's basis in the S stock under Sec. 1.1502-32, 
and the basis allocated under section 358(c) between the S stock and 
the lower-tier subsidiary stock received reflects this basis 
reduction.
    Example 4. Stock redemptions and distributions. (a) Facts. 
Before becoming a member of the P group, S owns P stock with a $30 
basis. On January 1 of Year 1, P buys all of S's stock. On July 1 of 
Year 3, P redeems the P stock held by S for $100 in a transaction to 
which section 302(a) applies.
    (b) Gain under section 302. Under paragraph (f)(4) of this 
section, P's basis in the P stock acquired from S is treated as 
eliminated. Thus, S's $70 gain is taken into account in Year 3. S's 
gain is taken into account as capital gain. (Under paragraph 
(c)(3)(iv) of this section, S's gain cannot be excluded from gross 
income.)
    (c) Gain under section 311. The facts are the same as in 
paragraph (a) of this Example 4, except that S distributes the P 
stock to P in a transaction to which section 301 applies (rather 
than the stock being redeemed), and S has a $70 gain under section 
311(b). The timing and attributes of S's gain are determined in the 
manner provided in paragraph (b) of this Example 4.
    (d) Loss stock. The facts are the same as in paragraph (a) of 
this Example 4, except that S has a $130 (rather than $30) basis in 
the P stock and has a $30 loss under section 302(a). The limitation 
under paragraph (c)(3)(iv) of this section on recharacterization of 
items does not apply to intercompany losses. Thus, S's loss is taken 
into account in Year 3 as a noncapital, nondeductible amount.
    Example 5. Intercompany stock sale followed by section 332 
liquidation. (a) Facts. S owns all of the stock of T, with a $70 
basis and $100 value, and T's assets have a $10 basis and $100 
value. On January 1 of Year 1, S sells all of T's stock to B for 
$100. On July 1 of Year 3, T distributes all of its assets to B in 
an unrelated complete liquidation to which section 332 applies.
    (b) Timing and attributes. Under paragraph (b)(2)(ii)(B) of this 
section, B's unrecognized gain or loss under section 332 is a 
corresponding item for purposes of applying the matching rule. Thus, 
S's $30 gain is taken into account in Year 3 as a result of T's 
liquidation. Under paragraph (c)(1)(i) of this section, the 
attributes of S's gain and B's corresponding item are redetermined 
as if they were divisions of a single corporation. Although S's gain 
ordinarily would be treated as excluded from gross income to reflect 
the nonrecognition of B's gain or loss under section 332, the gain 
remains capital gain. Paragraph (c)(3)(iv) of this section permits 
S's gain to be excluded from gross income only if B has a 
corresponding deduction or loss disallowed directly under a 
provision of the Code or regulations. B's corresponding items from 
the liquidation do not satisfy this requirement. However, relief may 
be elected under paragraph (f)(5) of this section.
    (c) Intercompany sale at a loss. The facts are the same as in 
paragraph (a) of this Example 5, except that S has a $130 (rather 
than $70) basis in the T stock. The limitation under paragraph 
(c)(3)(iv) of this section on recharacterization of items does not 
apply to intercompany losses. Thus, S's intercompany loss is taken 
into account in Year 3 as a noncapital, nondeductible amount. 
However, relief may be elected under paragraph (f)(5) of this 
section.

    (g) Obligations of members--(1) In general. In addition to the 
general rules of this section, the rules of this paragraph (g) apply to 
intercompany obligations.
    (2) Definitions. For purposes of this section--
    (i) Obligation of a member. An obligation of a member is--
    (A) Any obligation of that member constituting indebtedness under 
general principles of Federal income tax law (for example, under 
section 108, section 163, section 171, or section 1275, but not an 
executory obligation to purchase or provide goods or services); and
    (B) Any security of the member described in section 475(c)(2)(D) or 
(E), and any comparable security with respect to commodities.
    (ii) Intercompany obligations. An intercompany obligation is an 
obligation between members, but only for the period during which both 
parties are members.
    (3) Deemed satisfaction and reissuance of intercompany 
obligations--(i) Application--(A) In general. If a member realizes an 
amount (other than zero) of income, gain, deduction, or loss, directly 
or indirectly, from the assignment or extinguishment of all or part of 
its remaining rights or obligations under an intercompany obligation, 
the intercompany obligation is treated for all Federal income tax 
purposes as satisfied under paragraph (g)(3)(ii) of this section and, 
if it remains outstanding, reissued under paragraph (g)(3)(iii) of this 
section. Similar principles apply under this paragraph (g)(3) if a 
member realizes any such amount, directly or indirectly, from a 
comparable transaction (e.g., a marking-to-market of an obligation or a 
bad debt deduction), or if an intercompany obligation becomes an 
obligation that is not an intercompany obligation.
    (B) Exceptions. This paragraph (g)(3) does not apply to an 
obligation if any of the following applies:
    (1) The obligation became an intercompany obligation by reason of 
an event described in paragraph (g)(4)(i)(B) of this section 
(exceptions to the application of section 108(e)(4)).
    (2) The amount realized is from reserve accounting under section 
585 or 593 (see paragraph (g)(5) of this section for special rules).
    (3) Treating the obligation as satisfied and reissued will not have 
a significant effect on any person's Federal income tax liability for 
any year. For this purpose, obligations issued in connection with the 
same transaction or related transactions are treated as a single 
obligation. However, this paragraph (g)(3)(i)(B)(3) does not apply to 
any obligation if its aggregate effect for all obligations in a year 
would be significant.
    (ii) Satisfaction--(A) General rule. If a creditor member sells 
intercompany debt to a nonmember for cash, the debt is treated as 
satisfied by the debtor immediately before the sale for the amount of 
the cash. For other transactions, similar principles apply to treat the 
intercompany obligation as satisfied immediately before the 
transaction. Thus, if the obligation is transferred for property, it is 
treated as satisfied for an amount consistent with the amount of the 
reissuance under paragraph (g)(3)(iii) of this section, and the basis 
of the property is also adjusted to reflect that amount. If this 
paragraph (g)(3) applies because the obligor or obligee becomes a 
nonmember, the obligation is treated as satisfied for cash in an amount 
equal to its fair market value immediately before the obligor or 
obligee becomes a nonmember. Similar principles apply to intercompany 
obligations other than debt.
    (B) Timing and attributes. For purposes of applying the matching 
rule of paragraph (c) of this section and the acceleration rule of 
paragraph (d) of this section--
    (1) Paragraph (c)(3)(iv) of this section (limitation on treatment 
of intercompany income or gain as excluded from gross income) does not 
apply to prevent any intercompany income or gain from being excluded 
from gross income; and
    (2) Any intercompany gain or loss is not subject to section 354 or 
1091.
    (iii) Reissuance. If a creditor member sells intercompany debt to a 
nonmember for cash, the debt is treated as a new debt (with a new 
holding period) issued by the debtor immediately after the sale for the 
amount of cash. For other transactions, if the intercompany obligation 
remains outstanding, similar principles apply to treat the obligation 
as reissued immediately after the transaction. Thus, if the obligation 
is transferred for property, it is treated as a new obligation issued 
to the nonmember for the property. If this paragraph (g)(3) applies 
because the debtor or creditor becomes a nonmember, the obligation is 
treated as a new obligation issued for an amount of cash equal to its 
fair market value immediately after the debtor or creditor becomes a 
nonmember. Similar principles apply to intercompany obligations other 
than debt.
    (4) Deemed satisfaction and reissuance of obligations becoming 
intercompany obligations--(i) Application--(A) In general. This 
paragraph (g)(4) applies if an obligation that is not an intercompany 
obligation becomes an intercompany obligation.
    (B) Exceptions. This paragraph (g)(4) does not apply to an 
obligation if--
    (1) The obligation becomes an intercompany obligation by reason of 
an event described in Sec. 1.108-2(e) (exceptions to the application of 
section 108(e)(4)); or
    (2) Treating the obligation as satisfied and reissued will not have 
a significant effect on any person's Federal income tax liability for 
any year. For this purpose, obligations issued in connection with the 
same transaction or related transactions are treated as a single 
obligation. However, this paragraph (g)(4)(i)(B)(2) does not apply to 
any obligation if its aggregate effect for all obligations in a year 
would be significant.
    (ii) Intercompany debt. If this paragraph (g)(4) applies to an 
intercompany debt--
    (A) Section 108(e)(4) does not apply;
    (B) The debt is treated for all Federal income tax purposes, 
immediately after it becomes an intercompany debt, as satisfied and a 
new debt issued to the holder (with a new holding period) in an amount 
determined under the principles of Sec. 1.108-2(f);
    (C) The attributes of all items taken into account from the 
satisfaction are determined on a separate entity basis, rather than by 
treating S and B as divisions of a single corporation; and
    (D) Any intercompany gain or loss taken into account is treated as 
not subject to section 354 or 1091.
    (iii) Other intercompany obligations. If this paragraph (g)(4) 
applies to an intercompany obligation other than debt, the principles 
of paragraph (g)(4)(ii) of this section apply to treat the intercompany 
obligation as satisfied and reissued for an amount of cash equal to its 
fair market value immediately after the obligation becomes an 
intercompany obligation.
    (5) Bad debt reserve. A member's deduction under section 585 or 593 
for an addition to its reserve for bad debts with respect to an 
intercompany obligation is not taken into account, and is not treated 
as realized under paragraph (g)(3) of this section, until the 
intercompany obligation becomes an obligation that is not an 
intercompany obligation, or, if earlier, the redemption or collection 
of less than the recorded amount of the intercompany obligation (and 
the corresponding charge off against the reserve). For purposes of this 
paragraph (g)(5) an addition to a reserve that results from charging 
off an intercompany obligation is treated as with respect to the 
intercompany obligation.
    (6) Examples. The application of this section to obligations of 
members is illustrated by the following examples.

    Example 1. Interest and premium on intercompany debt. (a) Facts. 
On January 1 of Year 1, M2 borrows $100 from M1 in return for M2's 
note providing for $10 of interest annually at the end of each year, 
and repayment of $100 at the end of Year 5. M2 fully performs its 
obligations. Under their separate entity methods of accounting, M2 
accrues a $10 interest deduction annually under section 163, and M1 
accrues $10 of interest income annually under section 61(a)(4).
    (b) Matching rule. Under paragraph (b)(1) of this section, the 
accrual of interest on M2's note is an intercompany transaction, M1 
is the selling member, and M2 is the buying member. Under the 
matching rule of paragraph (c) of this section, M1 takes its $10 of 
income into account in each of Years 1 through 5 to reflect the $10 
difference between M2's $10 of interest expense taken into account 
and its $0 recomputed expense.
    (c) Original issue discount. The facts are the same as in 
paragraph (a) of this Example 1, except that M2 borrows $90 (rather 
than $100) from M1 in return for M2's note providing for $10 of 
interest annually and repayment of $100 at the end of Year 5. The 
principles described in paragraph (b) of this Example 1 for stated 
interest also apply to the $10 of original issue discount. Thus, as 
M2 takes into account its corresponding expense under section 
163(e), M1 takes into account its intercompany income.
    (d) Premium. The facts are the same as in paragraph (a) of this 
Example 1, except that M2 borrows $110 from M1 (rather than $100), 
and M1 elects under section 171 to amortize the $10 premium. Under 
section 171(e), M1's premium deduction is allocated to its interest 
income and applied to reduce the amount of the income. Although 
there is no separate item of premium deduction to be taken into 
account, paragraph (b)(2)(ii)(B) of this section provides that M1's 
corresponding items include the premium even though it offsets 
interest income rather than being separately taken into account. 
Although M1 is the selling member with respect to the interest 
(i.e., the recipient member), M1 is the buying member with respect 
to the premium (i.e., the payor member). Thus, M2's intercompany 
premium income is taken into account under the matching rule to 
reflect the difference between M1's corresponding premium deduction 
taken into account and its recomputed premium deduction. 
Consequently, M2 takes its premium income into account in each of 
Years 1 through 5 based on M1's amortization and offset of allocable 
interest income. (If M1 does not make an election under section 171, 
but instead takes the premium into account when the debt is retired 
at the end of Year 5, M2 also does not take the premium into account 
until the debt is retired at the end of Year 5.)
    (e) Tax-exempt income. The facts are the same as in paragraph 
(a) of this Example 1, except that M2's borrowing from M1 is 
allocable under section 265 to M2's purchase of state and local 
bonds to which section 103 applies. The timing of M1's income is the 
same as in paragraph (b) of this Example 1, but that M1's income is 
treated under the matching rule as excluded from gross income 
because M2's corresponding expense is nondeductible under section 
265. See paragraph (c)(3)(iv) of this section.
    Example 2. Intercompany debt becomes nonintercompany debt. (a) 
Facts. On January 1 of Year 1, B borrows $100 from S in return for 
B's note providing for $10 of interest annually at the end of each 
year, and repayment of $100 at the end of Year 20. As of January 1 
of Year 3, B has paid the interest accruing under the note and S 
sells B's note to X for $70, reflecting a change in the value of the 
note as a result of increases in prevailing market interest rates. B 
is never insolvent within the meaning of section 108(d)(3).
    (b) Deemed satisfaction. Under paragraph (g)(3) of this section, 
B's note is treated as satisfied for $70 immediately before S's sale 
to X. Under the matching rule, B takes into account $30 of discharge 
of indebtedness income under section 61(a)(12). Although S 
ordinarily would take into account a $30 capital loss under section 
1271(a)(1), S's loss is treated as ordinary loss to conform to B's 
corresponding $30 of discharge of indebtedness income.
    (c) Deemed reissuance. Under paragraph (g)(3) of this section, B 
is also treated as reissuing, directly to X, a new note with a $70 
issue price and a $100 stated redemption price at maturity. The new 
note is not an intercompany obligation, it has a $70 issue price and 
$100 stated redemption price at maturity, and the $30 of original 
issue discount will be taken into account by B and X under sections 
163(e) and 1272.
    (d) Creditor deconsolidation. The facts are the same as in 
paragraph (a) of this Example 2, except that P sells S's stock to X 
(rather than S's selling the note of B). Under paragraph (g)(3) of 
this section, the note is treated as satisfied by B for its $70 fair 
market value immediately before S becomes a nonmember, and B is 
treated as reissuing a new note to S immediately after S becomes a 
nonmember. The results for S's $30 of loss and B's discharge of 
indebtedness income are the same as in paragraph (b) of this Example 
2. The new note is not an intercompany obligation, it has a $70 
issue price and $100 stated redemption price at maturity, and the 
$30 of original issue discount will be taken into account by B and S 
under sections 163(e) and 1272.
    (e) Debtor deconsolidation. The facts are the same as in 
paragraph (a) of this Example 2, except that P sells B's stock to X 
(rather than S's selling the note of B). The results are the same as 
in paragraph (d) of this Example 2.
    (f) Appreciated note. The facts are the same as in paragraph (a) 
of this Example 2, except that S sells B's note to X for $130 
(rather than $70), reflecting a decline in prevailing market 
interest rates. Under paragraph (g)(3) of this section, B's note is 
treated as satisfied for $130 immediately before S's sale of the 
note to X. Under the matching rule, B takes into account $30 of 
repurchase premium. Although S ordinarily would take into account a 
$30 capital gain under section 1271(a)(1), the attributes of S's 
capital gain conform to B's corresponding premium under the matching 
rule. Thus, S's gain is treated as ordinary income to conform to B's 
corresponding $30 premium. B is also treated as reissuing a new note 
directly to X which is not an intercompany obligation. The new note 
has a $130 issue price and a $100 stated redemption price at 
maturity. Under Sec. 1.61-12(c), B's $30 premium income under the 
new note is taken into account over the life of the new note. Under 
section 171, X may elect to amortize its $30 of bond premium over 
the life of the note (with corresponding reductions in its basis), 
however, the election would have no effect on B's premium income.
    Example 3. Bad debt deduction or loss with respect to 
intercompany debt. (a) Facts. On January 1 of Year 1, B borrows $100 
from S in return for B's note providing for $10 of interest annually 
at the end of each year, and repayment of $100 at the end of Year 5. 
For Year 3, S claims a $40 partial bad debt deduction under section 
166(a)(2) on a separate entity basis. B is never insolvent within 
the meaning of section 108(d)(3).
    (b) Deemed satisfaction and reissuance. Under paragraph (g)(3) 
of this section, B is treated as satisfying its note for $60 
immediately before S's bad debt deduction, and reissuing a new note 
to S with a $60 issue price and a $100 stated redemption price at 
maturity. Thus, B takes into account $40 of discharge of 
indebtedness income, and S takes into account $40 of loss as an 
ordinary loss.
    (c) Loss sale. The facts are the same as in paragraph (a) of 
this Example 3, except that S sells B's note to P for $60 (rather 
than claiming a partial bad debt deduction). The results are the 
same as in paragraph (b) of this Example 3. B's note is treated as 
satisfied immediately before the sale, and a new note reissued 
directly to P immediately after the sale. B takes into account $40 
of discharge of indebtedness income, and S takes into account $40 of 
loss as an ordinary loss.
    Example 4. Nonintercompany debt becomes intercompany debt. (a) 
Facts. On January 1 of Year 1, B borrows $100 from X in return for 
B's note providing for $10 of interest annually at the end of each 
year, and repayment of $100 at the end of Year 5. As of January 1 of 
Year 3, B has fully performed its obligations, but the note's fair 
market value is $70. On January 1 of Year 3, P buys all of X's 
stock. B is solvent within the meaning of section 108(d)(3).
    (b) Deemed satisfied and reissuance. Under paragraph (g)(4) of 
this section, B is treated as satisfying its indebtedness for $70 
(determined under the principles of Sec. 1.108-2(f)(2)) immediately 
after X becomes a member. Both X's $30 capital loss under section 
1271(a)(1) and B's $30 of discharge of indebtedness income under 
section 61(a)(12) are taken into account in determining consolidated 
taxable income for Year 3. Under paragraph (g)(4)(ii)(C) of this 
section, the attributes of items resulting from the satisfaction are 
determined on a separate entity basis. But see section 382 and 
Sec. 1.1502-15 (limitations on the absorption of built-in losses). B 
is also treated as reissuing a new note. The new note is an 
intercompany obligation, it has a $70 issue price and $100 stated 
redemption price at maturity, and the $30 of original issue discount 
will be taken into account by B and X.
    (c) Election to file consolidated returns. Assume instead that B 
borrows $100 from S during Year 1, but the P group does not file 
consolidated returns until Year 3. Under paragraph (g)(4) of this 
section, B's indebtedness is treated as satisfied and a new note 
reissued immediately after the debt becomes intercompany debt. The 
satisfaction and reissuance are on January 1 of Year 3, at the fair 
market value of the note (determined under the principles of 
Sec. 1.108-2(f)(2)) at that time.
    Example 5. Notional principal contracts. (a) Facts. On April 1 
of Year 1, M1 enters into a contract with counterparty M2 under 
which, for a term of five years, M1 is obligated to make a payment 
to M2 each April 1, beginning in Year 2, in an amount equal to the 
London Interbank Offered Rate (LIBOR), as determined on the 
immediately preceding April 1, multiplied by a $1,000 notional 
principal amount. M2 is obligated to make a payment to M1 each April 
1, beginning in Year 2, in an amount equal to 8% multiplied by the 
same notional principal amount. LIBOR is 7.80% on April 1 of Year 1. 
On April 1 of Year 2, M1 owes $78 to M2, and M2 owes $80 to M1.
    (b) Matching rule. Under Sec. 1.446-3(d), the net income (or net 
deduction) from a notional principal contract for a taxable year is 
included in (or deducted from) gross income. Under Sec. 1.446-3(e), 
the ratable daily portion of M2's fixed obligation to M1 as of 
December 31 of Year 1 is $60.27 ($80 multiplied by 275/365), and the 
ratable daily portion of M1's floating obligation as of December 31 
of Year 1 is $58.77 ($78 multiplied by 275/365). Under the matching 
rule, M1's net income for Year 1 of $1.50 is taken into account to 
reflect the difference between M2's net deduction of $1.50 taken 
into account and its $0 recomputed net deduction. Similarly, the 
$.50 balance of the $2.00 of net periodic payments made on April 1 
of Year 2 is taken into account for Year 2 in M1's and M2's net 
income and net deduction from the contract. (Note that although M1 
is the selling member with respect to the payment on April 1 of Year 
2, it may be the buying member in a subsequent period if it owes the 
net payment.)
    (c) Dealer. The facts are the same as in paragraph (a) of this 
Example 5, except that M2 is a dealer in securities, the contract 
with M1 is not inventory in the hands of M2, and on December 31 of 
Year 1 the fair market value of the contract to M2 is ($100). Under 
section 475, M2 has a $100 loss as if the contract were sold on 
December 31 for its fair market value. Under paragraph (g)(3) of 
this section, M2 is treated as making a $100 payment to M1 to 
terminate the contract immediately before section 475 is applied. 
Under the matching rule, the net periodic payment in Year 1 is taken 
into account as described in paragraph (b) of this Example 5. In 
addition, M1's $100 of income from the termination payment is taken 
into account to reflect the timing of M2's deduction (as described 
in Sec. 1.446-3(h)), and the character and other attributes of the 
income is conformed to the character and other attributes of the 
deduction. Paragraph (g)(3) of this section also provides that, 
immediately after section 475 would apply, a new contract is treated 
as reissued with an up front payment of $100. Under Sec. 1.446-3(f), 
the deemed $100 payment by M2 to M1 is taken into account over the 
term of the new contract in a manner reflecting the economic 
substance of the contract (e.g., allocating a portion of the $100 to 
the periodic payment expected to be made by M2 on April 1 of Year 2, 
and the balance under the level payment constant yield to maturity 
method). (The results would be the same if M1, rather than M2, is 
the dealer subject to section 475.)

    (h) Anti-avoidance rules--(1) In general. If a transaction is 
engaged in or structured with a principal purpose to avoid treatment as 
an intercompany transaction, or to avoid the purposes of this section, 
adjustments must be made to carry out the purposes of this section.
    (2) Examples. The anti-avoidance rules of this paragraph (h) are 
illustrated by the following examples.

    Example 1. Sale of a partnership interest. (a) Facts. S owns 
land with a $10 basis and $100 value. B has net operating losses 
from separate return limitation years (SRLYs) subject to limitation 
under Sec. 1.1502-21(c). Pursuant to a plan to absorb the losses 
without limitation by the SRLY rules, S transfers the land to an 
unrelated, calendar- year partnership in exchange for a 10% interest 
in the capital and profits of the partnership in a transaction to 
which section 721 applies. The partnership does not have a section 
754 election in effect. S later sells its partnership interest to B 
for $100. In the following year, the partnership sells the land to X 
for $100. Because the partnership does not have a section 754 
election in effect, its $10 basis in the land does not reflect B's 
$100 basis in the partnership interest. Under section 704(c), the 
partnership's $90 built-in gain is allocated to B, and B's basis in 
the partnership interest increases to $190 under section 705. In a 
later year, B sells the partnership interest to X for $100.
    (b) Adjustments. Under Sec. 1.1502-21(c), the partnership's $90 
built-in gain allocated to B ordinarily increases the amount of B's 
SRLY limitation, and B's $90 loss from its sale of the partnership 
interest ordinarily is not subject to limitation under the SRLY 
rules. Under paragraph (h)(1) of this section, however, B's 
allocable share of the partnership's gain from its sale of the land 
is treated as not increasing the amount of B's SRLY limitation.
    Example 2. Sale to a related party. (a) Facts. S and B 
manufacture complimentary products that are sold in similar markets. 
On January 1 of Year 1, S and B enter into a partnership agreement 
to engage in common distribution. The partnership is formed and 
operated for substantial nontax, business reasons and is treated as 
a general partnership for Federal income tax purposes. S has loss 
carryovers from separate return years subject to limitation under 
section 382 as a result of an ownership change on January 1 of Year 
1. S also has a net unrealized built-in gain (NUBIG) within the 
meaning of section 382(h), and S owns land with $30 of unrealized 
built-in gain that is included in the NUBIG. Pursuant to a plan to 
take into account $30 of recognized built-in gain before the end of 
the section 382(h)(7) recognition period without disposing of an 
interest in the land, the partnership buys S's land on July 1 of 
Year 3. On December 1 of Year 7, the partnership sells the land to 
X.
    (b) Adjustments. Under paragraph (b)(1) of this section, S's 
sale to the partnership ordinarily would not be an intercompany 
transaction. Under paragraph (h)(1) of this section, however, the 
transaction is treated as an intercompany transaction. Thus, S's 
gain is not taken into account until Year 7, as a result of the 
partnership's sale to X. Because the gain is not recognized during 
the section 382(h)(7) recognition period, it is not recognized 
built-in gain under section 382(h).
    Example 3. Transitory status as an intercompany obligation. (a) 
Facts. P historically has owned 70% of X's stock and the remaining 
30% is owned by unrelated shareholders. On January 1 of Year 1, S 
borrows $100 from X in return for S's note requiring $10 of interest 
annually at the end of each year, and repayment of $100 at the end 
of Year 20. As of January 1 of Year 3, the P group has substantial 
net operating loss carryovers, and the fair market value of S's note 
falls to $70 due to an increase in prevailing market interest rates. 
X is not permitted under section 166(a)(2) to take into account a 
$30 loss with respect to the note. Pursuant to a plan to permit X to 
take into account its $30 loss without disposing of the note, P 
acquires an additional 10% of X's stock, causing X to become a 
member, and P subsequently resells the 10% interest. X's $30 loss 
with respect to the note is a net unrealized built-in loss within 
the meaning of Sec. 1.1502-15.
    (b) Adjustments. Under paragraph (g)(4) of this section, X 
ordinarily would take into account its $30 loss as a result of the 
note becoming an intercompany obligation, and S would take into 
account $30 of discharge of indebtedness income. Under Sec. 1.1502-
22(c), X's loss is not combined with items of the other members and 
the loss would be carried to X's separate return years as a result 
of X becoming a nonmember. However, the transitory status of S's 
indebtedness to X as an intercompany obligation is structured with a 
principal purpose to accelerate the recognition of X's loss. Thus, 
S's note is treated under paragraph (h)(1) of this section as not 
becoming an intercompany obligation.
    Example 4. Sale and leaseback. (a) Facts. S operates a factory 
with a $70 basis and $100 value, and has loss carryovers from SRLYs. 
Pursuant to a plan to take into account the $30 unrealized gain 
while continuing to operate the factory, S sells the factory to X 
for $100 and leases it back on a long-term basis. The sale and 
leaseback are not recharacterized under general principles of 
Federal income tax law. As a result of S's sale to X, the $30 gain 
is taken into account and increases S's SRLY limitation.
    (b) No adjustments. Although S's sale was pursuant to a plan to 
accelerate the $30 gain, it is not subject to adjustment under 
paragraph (h)(1) of this section. Because S has transferred 
substantial interests in the factory to an unrelated person for 
Federal income tax purposes, the sale is not treated as engaged in 
or structured with a principal purpose to avoid treatment as an 
intercompany transaction, or to avoid the single and separate entity 
treatment that is the purpose of this section.

    (i) [Reserved]
    (j) Miscellaneous operating rules. For purposes of this section--
    (1) Successors--(i) Assets. Any reference to an asset includes, as 
the context may require, a reference to any other asset the basis of 
which is determined, directly or indirectly, in whole or in part, by 
reference to the first asset.
    (ii) Persons--(A) In general. Any reference to a person includes, 
as the context may require, a reference to a predecessor or successor. 
For this purpose, a predecessor is a transferor of assets to a 
transferee (the successor) in a transaction--
    (1) To which section 381(a) applies;
    (2) In which substantially all of the assets of the transferor are 
transferred to members in a complete liquidation;
    (3) In which the successor's basis in assets is determined 
(directly or indirectly, in whole or in part) by reference to the basis 
of the transferor, but the transferee is a successor only with respect 
to the assets so determined; or
    (4) Which is an intercompany transaction, but only with respect to 
assets that are being accounted for by the transferor in a prior 
intercompany transaction.
    (B) Intercompany items. If the assets of a predecessor are acquired 
by a successor member, the successor succeeds to, and takes into 
account (under the rules of this section), the predecessor's 
intercompany items. If two or more successor members acquire assets of 
the predecessor, the successors take into account the predecessor's 
intercompany items in a manner that is consistently applied and 
reasonably carries out the purposes of this section and applicable 
provisions of law.
    (2) Acquisition of group--(i) Application. This paragraph (j)(2) 
applies only if a consolidated group (the terminating group) ceases to 
exist as a result of--
    (A) The acquisition by a member of another consolidated group of 
either the assets of the common parent of the terminating group in a 
reorganization described in section 381(a)(2), or the stock of the 
common parent of the terminating group; or
    (B) The application of the principles of Sec. 1.1502-75 (d)(2) or 
(d)(3).
    (ii) General rule. The group that does not cease to exist (the 
surviving group) is treated as the terminating group for purposes of 
applying this section to the terminating group. For example, 
intercompany items and corresponding items from intercompany 
transactions between members of the terminating group are treated as 
continuing to be reflected in the terminating group's consolidated 
taxable income. This paragraph (j)(2) does not apply to members of the 
terminating group that are not members of the surviving consolidated 
group immediately after the terminating group ceases to exist (e.g., 
under section 1504(a)(3) relating to reconsolidation, or section 
1504(c) relating to includible insurance companies).
    (3) Former common parent treated as continuation of group. If a 
group terminates because the common parent is the only remaining 
member, the common parent succeeds to the treatment of the terminating 
group for purposes of applying this section so long as it is not a 
member of an affiliated group filing separate returns and does not 
become a corporation described in section 1504(b). For example, if the 
only subsidiary of the group liquidates into the common parent in a 
complete liquidation to which section 332 applies, or the common parent 
merges into the subsidiary and the subsidiary is treated as the common 
parent's successor under paragraph (j)(1)(ii)(A) of this section, the 
taxable income of the surviving corporation is treated as the group's 
consolidated taxable income in which the intercompany and corresponding 
items must be included. See Sec. 1.267(f)-1 for additional rules 
applicable to intercompany losses or deductions.
    (4) Becoming a nonmember. For purposes of this section, a member is 
treated as becoming a nonmember if it has a separate return year 
(including another group's consolidated return year). A member is not 
treated as having a separate return year if its items are treated as 
taken into account in computing the group's consolidated taxable income 
under paragraph (j) (2) or (3) of this section.
    (5) Recordkeeping. Intercompany and corresponding items must be 
reflected on permanent records (including work papers). See also 
section 6001, requiring records to be maintained. From such permanent 
records the group must be able to identify the amount, location, 
timing, and attributes of the items, so as to permit the application of 
the rules of this section for each year.
    (6) Examples. The operating rules of this paragraph (j) are 
illustrated generally throughout this section, and by the following 
examples.

    Example 1. Intercompany sale followed by section 351 transfer to 
member. (a) Facts. S holds land for investment with a basis of $70. 
On January 1 of Year 1, S sells the land to M for $100. M also holds 
the land for investment. On July 1 of Year 3, M transfers the land 
to B in exchange for all of B's stock in a transaction to which 
section 351 applies. Under section 358, M's basis in the B stock is 
$100. B holds the land for sale to customers in the ordinary course 
of business and, under section 362(b), B's basis in the land is 
$100. On December 1 of Year 5, M sells 20% of the B stock to X for 
$22. In an unrelated transaction on July 1 of Year 8, B sells 20% of 
the land for $22.
    (b) Definitions. Under paragraph (b)(1) of this section, S's 
sale of the land to M and M's transfer of the land to B are both 
intercompany transactions. S is the selling member and M is the 
buying member in the first intercompany transaction, and M is the 
selling member and B is the buying member in the second intercompany 
transaction. M has no intercompany items under paragraph (b)(2) of 
this section. Because B acquired the land in an intercompany 
transaction, B's items from the land are corresponding items to be 
taken into account under this section. Under the successor asset 
rule of paragraph (j)(1)(i) of this section, references to the land 
include references to M's B stock. Under the successor person rule 
of paragraph (j)(1)(ii) of this section, references to M include 
references to B with respect to the land.
    (c) Timing and attributes resulting from the stock sale. Under 
paragraph (c)(3)(i) of this section, M is treated as owning and 
selling B's stock for purposes of the matching rule even though, as 
divisions, M could not own and sell stock in B. Under paragraph 
(c)(3)(ii)(A) of this section, both M's B stock and B's land can 
cause S's intercompany gain to be taken into account under the 
matching rule of paragraph (c) of this section. Thus, S takes $6 of 
its gain into account in Year 5 to reflect the $6 difference between 
M's $2 gain taken into account from its sale of B stock and its $8 
recomputed gain. Under paragraph (c)(3)(ii)(B) of this section, the 
attributes of this gain are determined by treating S, M, and B as 
divisions of a single corporation. Under paragraph (c)(3)(iii)(A) of 
this section, S's $6 gain and M's $2 gain are treated as long-term 
capital gain. The gain would be capital on a separate entity basis 
(assuming that section 341 does not apply), and this treatment is 
not inconsistent with treating S, M, and B as divisions of a single 
corporation because the stock sale and subsequent land sale are 
unrelated transactions and B remains a member following the sale.
    (d) Timing and attributes resulting from the land sale. Under 
paragraph (c)(3)(ii)(A) of this section, S takes $6 of its gain into 
account in Year 8 under the matching rule to reflect the $6 
difference between B's $2 gain taken into account from its sale of 
an interest in the land and its $8 recomputed gain. Under paragraph 
(c)(3)(ii)(B) of this section, the attributes of this gain are 
determined by treating S, M, and B as divisions of a single 
corporation and taking into account the activities of S, M, and B 
with respect to the land. Thus, both S's gain and B's gain might be 
ordinary income as a result of B's activities. (If B subsequently 
sells the balance of the land, paragraph (a)(4) of this section 
limits S's gain taken into account to its remaining $18 of 
intercompany gain.)
    (e) Sale of successor stock resulting in deconsolidation. The 
facts are the same as in paragraph (a) of this Example 1, except 
that M sells 60% of the B stock to X for $66 on December 1 of Year 5 
and B becomes a nonmember. Under the matching rule, M's sale of B 
stock results in $18 of S's gain being taken into account (to 
reflect the difference between M's $6 gain taken into account and 
its $24 recomputed gain). Under the acceleration rule of paragraph 
(d) of this section, however, the entire $30 gain is taken into 
account (to reflect B becoming a nonmember, because its basis in the 
land reflects M's $100 cost basis from the prior intercompany 
transaction). Under paragraph (c)(3)(ii)(A) of this section, S's 
entire $30 intercompany gain is taken into account under the 
acceleration rule of paragraph (d) of this section. Under paragraph 
(c)(3)(ii)(B) of this section, the attributes of S's gain are 
determined by treating S, M, and B as divisions of a single 
corporation. Because M's cost basis in the land will be reflected by 
B as a nonmember, all of S's gain is treated as from the land 
(rather than a portion being from B's stock), and B's activities 
with respect to the land may therefore result in S's gain being 
ordinary income.
    Example 2. Intercompany sale of member stock followed by 
recapitalization. (a) Facts. Before becoming a member of the P 
group, S owns P stock with a basis of $70. On January 1 of Year 1, P 
buys all of S's stock. On July 1 of Year 3, S sells the P stock to M 
for $100. On December 1 of Year 5, P acquires M's original P stock 
in exchange for new P stock in a recapitalization described in 
section 368(a)(1)(E).
    (b) Timing and attributes. Although paragraph (f)(4) of this 
section eliminates P's basis in the stock acquired from M, the new P 
stock received by M is exchanged basis property (within the meaning 
of section 7701(a)(44)) having a basis under section 358 equal to 
M's basis in the original P stock. Under the successor asset rule of 
paragraph (j)(1)(i) of this section, references to M's original P 
stock include references to M's new P stock. Under paragraph 
(c)(3)(ii)(A) of this section, if more than one corresponding item 
can cause S's intercompany gain to be taken into account under the 
matching rule, the gain is taken into account in connection with the 
corresponding item most consistent with the treatment of S, M, and P 
as divisions of a single corporation. S's gain is not taken into 
account as a result of the basis elimination under paragraph (f)(4) 
of this section. Instead, the gain is taken into account based on 
subsequent events with respect to M's new P stock (e.g., a 
subsequent distribution or redemption of the new stock).
    Example 3. Successor group. (a) Facts. On January 1 of Year 1, B 
borrows $100 from S in return for B's note providing for $10 of 
interest annually at the end of each year, and repayment of $100 at 
the end of Year 20. As of January 1 of Year 3, B has paid the 
interest accruing under the note. On that date, X acquires all of 
P's stock and the former P group members become members of the X 
consolidated group.
    (b) Successor. Under paragraph (j)(2) of this section, although 
B's note ceases to be an intercompany obligation of the P group, the 
note is not treated as satisfied and reissued under paragraph (g) of 
this section as a result of X's acquisition of P stock. Instead, the 
X consolidated group succeeds to the treatment of the P group for 
purposes of paragraph (g) of this section, and B's note is treated 
as an intercompany obligation of the X consolidated group.
    (c) No subgroups. The facts are the same as in paragraph (a) of 
this Example 3, except that X simultaneously acquires the stock of S 
and B from P (rather than X's acquiring all of P's stock). Paragraph 
(j)(2) of this section does not apply to X's acquisitions. Unless 
the exception in paragraph (g)(3)(i)(B) applies, B's note is treated 
as satisfied immediately before S and B become nonmembers, and 
reissued immediately after they become members of the X consolidated 
group. The amount at which the note is satisfied and reissued under 
paragraph (g)(3) of this section is based on the fair market value 
of the note at the time of P's sales to X. Paragraph (g)(4) of this 
section does not apply to the reissued B note in the X consolidated 
group, because the new note is always an intercompany obligation of 
the X consolidated group.
    Example 4. Liquidation--80% distributee. (a) Facts. X has had 
preferred stock described in section 1504(a)(4) outstanding for 
several years. On January 1 of Year 1, S buys all of X's common 
stock for $60, and B buys all of X's preferred stock for $40. X's 
assets have a $0 basis and $100 value. On July 1 of Year 3, X 
distributes all of its assets to S and B in a complete liquidation. 
Under Sec. 1.1502-34, section 332 applies to both S and B. Under 
section 337, X has no gain or loss from its liquidating distribution 
to S. Under sections 336 and 337(c), X has a $40 gain from its 
liquidating distribution to B. B has a $40 basis under section 
334(a) in the assets received from X, and S has a $0 basis under 
section 334(b) in the assets received from X.
    (b) Intercompany items from the liquidation. Under the matching 
rule, X's $40 gain from its liquidating distribution to B is not 
taken into account under this section as a result of the liquidation 
(and therefore is not yet reflected under Secs. 1.1502-32 and 
1.1502-33). Under the successor person rule of paragraph 
(j)(1)(ii)(A) of this section, S and B are both successors to X. S 
is the only successor to X under section 381(a). Under paragraph 
(j)(1)(ii)(B) of this section, to be consistent with the anti-
avoidance rules of paragraph (h)(1) of this section, S succeeds to 
X's $40 intercompany gain. The gain will be taken into account by S 
under the matching and acceleration rules of this section based on 
subsequent events. (The allocation of the intercompany gain to S 
does not govern the allocation of any other attributes.)
    Example 5. Liquidation--no 80% distributee. (a) Facts. X has 
only common stock outstanding. On January 1 of Year 1, S buys 60% of 
X's stock for $60, and B buys 40% of X's stock for $40. X's assets 
have a $0 basis and $100 value. On July 1 of Year 3, X distributes 
all of its assets to S and B in a complete liquidation. Under 
Sec. 1.1502-34, section 332 applies to both S and B. Under sections 
336 and 337(c), X has a $100 gain from its liquidating distributions 
to S and B. Under section 334(b), S has a $60 basis in the assets 
received from X and B has a $40 basis in the assets received from X.
    (b) Intercompany items from the liquidation. Under the matching 
rule, X's $100 intercompany gain from its liquidating distributions 
to S and B is not taken into account under this section as a result 
of the liquidation (and therefore is not yet reflected under 
Secs. 1.1502-32 and 1.1502-33). Under the successor person rule of 
paragraph (j)(1)(ii)(A) of this section, S and B are both successors 
to X. Under paragraph (j)(1)(ii)(B) of this section, to be 
consistent with the anti-avoidance rules of paragraph (h)(1) of this 
section, S succeeds to X's $40 intercompany gain with respect to the 
assets distributed to B, and B succeeds to X's $60 intercompany gain 
with respect to the assets distributed to S. The gain will be taken 
into account by S and B under the matching and acceleration rules of 
this section based on subsequent events. (The allocation of the 
intercompany gain does not govern the allocation of any other 
attributes.)

    (k) Cross references--(1) Section 108. See Sec. 1.108-3 for the 
treatment of intercompany deductions and losses as subject to attribute 
reduction under section 108(b).
    (2) Section 263A(f). See section 263A(f) for special rules 
regarding interest from intercompany transactions.
    (3) Section 267(f). See section 267(f) for special rules applicable 
to certain losses and deductions transactions between members of a 
controlled group.
    (4) Section 382. See Sec. 1.1502-91(g) and (h) for the treatment of 
intercompany items as built-in amounts under section 382.
    (5) Section 460. See Sec. 1.460-4(j) for special rules regarding 
the application of section 460 to intercompany transactions.
    (6) Section 469. See Sec. 1.469-1(h) for special rules regarding 
the application of section 469 to intercompany transactions.
    (7) Sec. 1.1502-80. See Sec. 1.1502-80 for the nonapplication of 
certain Internal Revenue Code rules.
    (l) Effective dates--(1) In general. This section applies with 
respect to transactions occurring in years beginning on or after [the 
date the final regulations are filed with the Federal Register]. If 
both this section and prior law apply to a transaction, or neither 
applies, with the result that items are duplicated, omitted, or 
eliminated in determining taxable income (or tax liability), or items 
are treated inconsistently, prior law (and not this section) applies to 
the transaction. For example, an intercompany dividend to which a 
shareholder becomes entitled before [the date the final regulations are 
filed with the Federal Register] but which is distributed after that 
date is taken into account under prior law (generally when 
distributed), because this section generally takes dividends into 
account when the shareholder becomes entitled to them but this section 
does not apply at that time.
    (2) Avoidance transactions. This paragraph (l)(2) applies if a 
transaction is engaged in or structured on or after April 8, 1994, with 
a principal purpose to avoid the rules of this section applicable to 
transactions occurring in years beginning on or after [the date the 
final regulations are filed with the Federal Register], to duplicate, 
omit, or eliminate an item in determining taxable income (or tax 
liability), or to treat items inconsistently. If this paragraph (l)(2) 
applies, appropriate adjustments must be made in years beginning on or 
after [the date the final regulations are filed with the Federal 
Register], to prevent the avoidance, duplication, omission, 
elimination, or inconsistency.
    (3) Prior law. For transactions occuring in S's years beginning 
before [the date the final regulations are filed with the Federal 
Register], see the applicable regulations issued under section 1502. 
See Secs. 1.1502-13, 1.1502-13T, 1.1502-14, 1.1502-14T, 1.1502-31, and 
1.1502-32 (as contained in the 26 CFR part 1 edition revised as of 
April 1, 1994).


Secs. 1.1502-13T, 1.1502-14, and 1.1502-14T   [Removed]

    Par. 13. Sections 1.1502-13T, 1.1502-14, and 1.1502-14T are 
removed.
    Par. 14. Section 1.1502-17 is amended as follows:
    1. Paragraph (c) is redesignated as paragraph (d).
    2. New paragraph (c) is added.
    3. Newly designated paragraph (d) is amended by:
    a. Revising the paragraph heading.
    b. Revising the introductory text.
    c. Designating the existing example as Example 1 and revising the 
heading.
    d. Adding Example 2, and 3.
    5. The added and revised provisions read as follows:


Sec. 1.1502-17   Methods of accounting.

* * * * *
    (c) Anti-avoidance rules--(1) General rule. If one member (B) 
directly or indirectly acquires an activity of another member (S) or 
undertakes S's activity, with the principal purpose to avail the group 
of an accounting method that would be unavailable without securing 
consent from the Commissioner if S and B were treated as divisions of a 
single corporation, B must use the accounting method for the acquired 
or undertaken activity determined under paragraph (c)(2) of this 
section or secure consent from the Commissioner for a different method.
    (2) Treatment as divisions of a single corporation. B must use the 
method of accounting that would be required if B acquired or undertook 
the activity in a transaction to which section 381 applies. Thus, the 
principles of section 381(c)(4) and (c)(5) apply to resolve any 
conflicts between the accounting methods of S and B, and the acquired 
or undertaken activity is treated as having the accounting method used 
by S. Appropriate adjustments are made to treat all acquisitions or 
undertakings that are part of the same plan or arrangement as a single 
acquisition or undertaking.
    (3) Effective date. This paragraph (c) applies with respect to 
acquisitions or undertakings occurring in years beginning on or after 
[the date the final regulations are filed with the Federal Register].
    (d) Examples. The provisions of this section are illustrated by the 
following examples:

    Example 1. Separate return treatment generally. * * *
    Example 2. Adopting methods. (a) Corporation P is a member of a 
consolidated group. P is a service provider with substantial parts 
and supplies on hand for use in its repair service business. P 
capitalizes its cost for the parts and supplies and deducts the cost 
under Sec. 1.162-3. P is unable to adopt a LIFO inventory method 
under section 472 because the parts and supplies are used solely in 
its service business. With the principal purpose to avail of a LIFO 
inventory method, P forms corporation S, and S begins to purchase 
and maintain all of the parts and supplies using a LIFO inventory 
method. P purchases the parts and supplies that it needs from S, and 
S's only customer is P.
    (b) Under paragraph (c) of this section, S must account for the 
parts and supplies under Sec. 1.162-3 rather than adopting a LIFO 
inventory method.
    Example 3. Changing inventory sub-method. (a) Corporation P is a 
member of a consolidated group. P operates a manufacturing business 
that uses dollar-value LIFO, and has built up a substantial LIFO 
reserve. P has historically manufactured all its inventory and has 
used one natural business unit pool. P begins purchasing goods 
identical to its own finished goods from a foreign supplier, and is 
concerned that it must establish a separate resale pool under 
Sec. 1.472-8(c). P anticipates that it will begin to purchase, 
rather than manufacture, a substantial portion of its inventory, 
resulting in a recapture of most of its LIFO reserve because of 
decrements in its manufacturing pool. With the principal purpose to 
avoid the decrements, P forms corporation S in Year 1. S operates as 
a distributor to nonmembers, and P sells all of its existing 
inventories to S. S adopts LIFO, and elects dollar-value LIFO with 
one resale pool. Thereafter, P continues to manufacture and purchase 
inventory, and to sell it to S for resale to nonmembers. P's 
intercompany gain from sales to S is taken into account under 
Sec. 1.1502-13. S maintains its Year 1 base dollar value of 
inventory to prevent the recognition of the intercompany items by P 
that include the LIFO reserve.
    (b) Under paragraph (c) of this section, S must maintain two 
pools (manufacturing and resale) in the manner that P would be 
required to maintain under Sec. 1.472-8.

    Par. 15. Section 1.1502-18 is amended by revising the heading for 
paragraph (f) and adding paragraph (g) to read as follows:


Sec. 1.1502-18   Inventory adjustment.

* * * * *
    (f) Transitional rules for years before 1966. * * *
    (g) Transitional rules for years beginning on or after [the date 
the final regulations are filed with the Federal Register]. Paragraphs 
(a) through (f) of this section do not apply for taxable years 
beginning on or after [the date the final regulations are filed with 
the Federal Register]. Any remaining unrecovered inventory amount of a 
member under paragraph (c) of this section is recovered in the first 
taxable year beginning on or after [the date the final regulations are 
filed with the Federal Register], under the principles of paragraph 
(c)(3) of this section by treating the first taxable year as the first 
separate return year of the member. The unrecovered inventory amount 
can be recovered only to the extent it was previously included in 
taxable income. The principles of this section apply, with appropriate 
adjustments, to comparable amounts under paragraph (f) of this section.
    Par. 16. Section 1.1502-20 is amended as follows:
    1. Paragraph (a)(5) Example (6) is amended as follows:
    a. The fifth sentence of paragraph (i) is revised.
    b. Paragraphs (ii) and (iii) are revised.
    c. Paragraph (iv) is added.
    2. Paragraph (b)(6) Example (5) is amended as follows:
    a. The fifth sentence of paragraph (i) is revised.
    b. A sentence is added at the beginning of paragraph (ii).
    c. Paragraph (iii) is revised.
    d. Paragraph (iv) is removed.
    3. Paragraph (b)(6) Example (7) is amended as follows:
    a. The fourth sentence of paragraph (i) is revised.
    b. The first sentence of paragraph (iii) is revised.
    4. Paragraph (c)(4) is amended as follows:
    a. Example (3) is amended by removing paragraph (iii).
    b. Example (9) is added.
    5. Paragraph (e)(3) is amended as follows:
    a. Example (2) is removed.
    b. Example (3) through Example (8) are redesignated as Example (2) 
through Example (7).
    c. Newly designated Example (5) is revised.
    d. Newly designated Example (7) is removed.
    6. In paragraph (h)(1), the second sentence is revised.
    7. The revised and added provisions read as follows:


Sec. 1.1502-20  Disposition or deconsolidation of subsidiary stock.

    (a) * * *
    (5) * * *

    Example (6). * * *
    (i) * * * S sells its T stock to P for $100 in an intercompany 
transaction, recognizing a $60 intercompany loss that is deferred 
under section 267(f) and Sec. 1.1502-13. * * *
    (ii) Under paragraph (a)(3)(i) of this section, the application 
of paragraph (a)(1) of this section to S's $60 intercompany loss on 
the sale of its T stock to P is deferred, because S's intercompany 
loss is deferred under section 267(f) and Sec. 1.1502-13. P's sale 
of the T stock to X ordinarily would result in S's intercompany loss 
being taken into account under the matching rule of Sec. 1.1502-
13(c). The deferred loss is not taken into account under 
Sec. 1.267(f)-1, however, because P's sale to X (a member of the 
same controlled group as P) is a second intercompany transaction for 
purposes of section 267(f). Nevertheless, paragraph (a)(3)(ii) of 
this section provides that paragraph (a)(1) of this section applies 
to the intercompany loss as a result of P's sale to X because the T 
stock ceases to be owned by a member of the P consolidated group. 
Thus, the loss is disallowed under paragraph (a)(1) of this section 
immediately before P's sale and is therefore never taken into 
account under section 267(f).
    (iii) The facts are the same as in (i) of this Example, except 
that S is liquidated after its sale of the T stock to P, but before 
P's sale of the T stock to X, and P sells the T stock to X for $110. 
Under Secs. 1.1502-13(j) and 1.267(f)-1(b), P succeeds to S's 
intercompany loss as a result of S's liquidation. Thus, paragraph 
(a)(3)(i) of this section continues to defer the application of 
paragraph (a)(1) of this section until P's sale to X. Under 
paragraph (a)(4) of this section, the amount of S's $60 intercompany 
loss disallowed under paragraph (a)(1) of this section is limited to 
$50 because P's $10 gain on the disposition of the T stock is taken 
into account as a consequence of the same plan or arrangement.
    (iv) The facts are the same as in (i) of this Example, except 
that P sells the T stock to A, a person related to P within the 
meaning of section 267(b)(2). Although S's intercompany loss is 
ordinarily taken into account under the matching rule of 
Sec. 1.1502-13(c) as a result of P's sale, Sec. 1.267(f)-1(c)(2)(ii) 
provides that none of the intercompany loss is taken into account 
because A is a nonmember that is related to P under section 267(b). 
Under paragraph (a)(3)(i) of this section, paragraph (a)(1) of this 
section does not apply to loss that is disallowed under any other 
provision. Because Sec. 1.267(f)-1(c)(2)(ii) and section 267(d) 
provide that the benefit of the intercompany loss is retained by A 
if the property is later disposed of at a gain, the intercompany 
loss is not disallowed for purposes of paragraph (a)(3)(i) of this 
section. Thus, the intercompany loss is disallowed under paragraph 
(a)(1) of this section immediately before P's sale and is therefore 
never taken into account under section 267(d).
    (b) * * *
    (6) * * *

    Example (5). * * *
    (i) * * * S sells its T stock to P for $100 in an intercompany 
transaction, recognizing a $60 intercompany loss that is deferred 
under section 267(f) and Sec. 1.1502-13. * * *
    (ii) Under paragraph (a)(3)(i) of this section, the application 
of paragraph (a)(1) of this section to S's intercompany loss on the 
sale of its T stock to P is deferred because S's loss is deferred 
under section 267(f) and Sec. 1.1502-13. * * *
    (iii) T's issuance of the additional shares to the public does 
not result in S's intercompany loss being taken into account under 
the matching or acceleration rules of Sec. 1.1502-13 (c) and (d), or 
under the application of the principles of those rules in section 
267(f). However, the deconsolidation of T is an overriding event 
under paragraph (a)(3)(ii) of this section, and paragraph (a)(1) of 
this section disallows the intercompany loss immediately before the 
deconsolidation even though the intercompany loss is not taken into 
account at that time.
    Example (7). * * *
    (i) * * * S recently purchased its T stock from S1, a lower tier 
subsidiary, in an intercompany transaction in which S1 recognized a 
$30 intercompany gain that was deferred under Sec. 1.1502-13. * * *
* * * * *
    (iii) Under the matching rule of Sec. 1.1502-13, S's sale of its 
T stock results in S1's $30 intercompany gain being taken into 
account. * * *
* * * * *
    (c) * * *
    (4) * * *

    Example (9). Intercompany stock sales.
    (i) P is the common parent of a consolidated group, S is a 
wholly owned subsidiary of P, and T is a wholly owned recently 
purchased subsidiary of S. S has a $100 basis in the T stock, and T 
has a capital asset with a basis of $0 and a value of $100. T's 
asset declines in value to $60. Before T has any positive investment 
adjustments or extraordinary gain dispositions, S sells its T stock 
to P for $60. T's asset reappreciates and is sold for $100, and T 
recognizes $100 of gain. Under the investment adjustment system, P's 
basis in the T stock increases to $160. P then sells all of the T 
stock for $100 and recognizes a loss of $60.
    (ii) S's sale of the T stock to P is an intercompany 
transaction. Thus, S's $40 loss is deferred under section 267(f) and 
Sec. 1.1502-13. Under paragraph (a)(3) of this section, the 
application of paragraph (a)(1) of this section to S's $40 loss is 
deferred until the loss is taken into account. Under the matching 
rule of Sec. 1.1502-13(c), the loss is taken into account to reflect 
the difference for each year between P's corresponding items taken 
into account and P's recomputed corresponding items (the 
corresponding items that P would take into account for the year if S 
and P were divisions of a single corporation). If S and P were 
divisions of a single corporation and the intercompany sale were a 
transfer between the divisions, P would succeed to S's $100 basis 
and would have a $200 basis in the T stock at the time it sells the 
T stock ($100 of initial basis plus $100 under the investment 
adjustment system). S's $40 loss is taken into account at the time 
of P's sale of the T stock to reflect the $40 difference between the 
$60 loss P takes into account and P's recomputed $100 loss.
    (iv) Under the matching rule of Sec. 1.1502-13(c), the 
attributes of S's $40 loss and P's $60 loss are redetermined to 
produce the same effect on consolidated taxable income (and 
consolidated tax liability) as if S and P were divisions of a single 
corporation. Under Sec. 1.1502-13(b)(4), attributes of the losses 
include whether they are disallowed under this section. Because the 
amount described in paragraph (c)(1) of this section is $100, both 
S's $40 loss and P's $60 loss are disallowed.
* * * * *
    (e) * * *
    (3) * * *

    Example (5). Absence of a view.
    (i) In Year 1, P buys all the stock of T for $100, and T becomes 
a member of the P group. T has 2 historic assets, asset 1 with a 
basis of $40 and value of $90, and asset 2 with a basis of $60 and 
value of $10. In Year 2, T sells asset 1 for $90. Under the 
investment adjustment system, P's basis in the T stock increases 
from $100 to $150. Asset 2 is not essential to the operation of T's 
business, and T distributes asset 2 to P in Year 5 with a view to 
having the group retain its $50 loss inherent in the asset. Under 
Sec. 1.1502-13(f)(2), and the application of the principles of this 
rule in section 267(f), T has a $50 intercompany loss that is 
deferred. Under Sec. 1.1502-32(b)(3)(iv), the distribution reduces 
P's basis in the T stock by $10 to $140 in Year 5. In Year 6, P 
sells all the T stock for $90. Under the acceleration rule of 
Sec. 1.1502-13(d), and the application of the principles of this 
rule in section 267(f), T's intercompany loss is ordinarily taken 
into account immediately before P's sale of the T stock. Assuming 
that the loss is absorbed by the group, P's basis in T's stock would 
be reduced from $140 to $90 under Sec. 1.1502-32(b)(3)(i), and there 
would be no gain or loss from the stock disposition. (Alternatively, 
if the loss is not absorbed and the loss is reattributed to P under 
paragraph (g) of this section, the reattribution would reduce P's 
basis in T's stock from $140 to $90.)
    (ii) A $50 loss is reflected both in T's basis in asset 2 and in 
P's basis in the T stock. Because the distribution results in the 
loss with respect to asset 2 being taken into account before the 
corresponding loss reflected in the T stock, and asset 2 is an 
historic asset of T, the distribution is not with the view described 
in paragraph (e)(2) of this section.
* * * * *
    (h) * * *
    (1) * * * For this purpose, dispositions deferred under 
Sec. 1.1502-13 are deemed to occur at the time the deferred gain or 
loss is taken into account unless the stock was deconsolidated before 
February 1, 1991. * * *
* * * * *
    Par. 17. Section 1.1502-26 is amended by revising paragraph (b) to 
read as follows:


Sec. 1.1502-26  Consolidated dividends received deduction.

* * * * *
    (b) Intercompany dividends. The deduction determined under 
paragraph (a) of this section is determined without taking into account 
intercompany dividends to the extent that, under Sec. 1.1502-13(f)(2), 
they are not included in gross income. See Sec. 1.1502-13 for 
additional rules relating to intercompany dividends.
* * * * *
    Par. 18. Section 1.1502-33, as proposed to be revised at 57 FR 
53663, published November 12, 1992, is further amended by revising 
paragraph (c)(2) to read as follows:


Sec. 1.1502-33  Earnings and profits.

* * * * *
    (c) * * *
    (2) Intercompany transactions. Intercompany items and corresponding 
items are not reflected in earnings and profits before they are taken 
into account under Sec. 1.1502-13. See Sec. 1.1502-13 for the 
applicable rules and definitions.
* * * * *


Sec. 1.1502-79  [Amended]

    Par. 19. Section 1.1502-79 is amended by removing paragraph (f).
    Par. 20. Section 1.1502-80, as proposed to be amended at 57 FR 
53670, published November 12, 1992, is further amended by adding 
paragraphs (f) and (g) to read as follows:


Sec. 1.1502-80  Applicability of other provisions of law.

* * * * *
    (f) Non-applicability of section 163(e)(5). Section 163(e)(5) does 
not apply to any intercompany obligation (within the meaning of 
Sec. 1.1502-13(g)) issued in a consolidated return year beginning on or 
after [the date the final regulations are filed with the Federal 
Register].
    (g) Non-applicability of section 1031. Section 1031 does not apply 
to any intercompany transaction occurring in consolidated return years 
beginning on or after [the date the final regulations are filed with 
the Federal Register].
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 94-8488 Filed 4-8-94; 1:03 pm]
BILLING CODE 4830-01-U