[Federal Register Volume 70, Number 54 (Tuesday, March 22, 2005)]
[Rules and Regulations]
[Pages 14395-14411]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 05-5528]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9192]
RIN 1545-BC38; RIN 1545-BC74; RIN 1545-BC95


Guidance Under Section 1502; Application of Section 108 to 
Members of a Consolidated Group

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations, temporary regulations, and removal of 
temporary regulations.

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SUMMARY: This document contains final regulations under section 1502 of 
the Internal Revenue Code that govern the application of section 108 
when a member of a consolidated group realizes discharge of 
indebtedness income. These final regulations affect corporations filing 
consolidated returns.

DATES: Effective Date: These regulations are effective March 21, 2005.
    Applicability Dates: For dates of applicability, see Sec.  1.1502-
11(c)(7), Sec.  1.1502-13(g)(3)(i)(A) and (ii)(C), Sec.  1.1502-
19(h)(2)(ii), Sec.  1.1502-21(h)(6), Sec.  1.1502-28(d), and Sec.  
1.1502-32(h)(7).

FOR FURTHER INFORMATION CONTACT: Concerning Sec.  1.1502-11 of the 
final regulations, Candace B. Ewell at (202) 622-7530 (not a toll-free 
number), concerning all other sections of the final regulations, Amber 
R. Cook at (202) 622-7530 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background and Explanation of Provisions

    This document contains amendments to 26 CFR part 1 under section 
1502 of the Internal Revenue Code (Code). On September 4, 2003, 
temporary regulations (TD 9089) (the first temporary regulations) 
relating to the

[[Page 14396]]

application of section 108 to members of a consolidated group were 
published in the Federal Register (68 FR 52487). A notice of proposed 
rulemaking (REG-132760-03) cross-referencing the first temporary 
regulations was published in the Federal Register for the same day (68 
FR 52542). The first temporary regulations added Sec.  1.1502-28T, 
which provides guidance regarding the determination of the attributes 
that are available for reduction when a member of a consolidated group 
realizes discharge of indebtedness income that is excluded from gross 
income (excluded COD income) and the method for reducing those 
attributes. Section 1.1502-28T reflects a consolidated approach that is 
intended to reduce all attributes that are available to the debtor 
member.
    Because the first temporary regulations may not have provided for 
the reduction of all the attributes that are available to the debtor 
member, on December 11, 2003, the IRS and Treasury Department published 
in the Federal Register (68 FR 69024) temporary regulations (TD 9098) 
(the second temporary regulations) under section 1502 amending Sec.  
1.1502-28T. A notice of proposed rulemaking (REG-153319-03) cross-
referencing the second temporary regulations was published in the 
Federal Register for the same day (68 FR 69062). The second temporary 
regulations clarify that certain attributes that arise (or are treated 
as arising) in a separate return year are subject to reduction when no 
SRLY limitation applies to the use of such attributes.
    On March 15, 2004, the IRS and Treasury Department published in the 
Federal Register (69 FR 12069) temporary regulations (TD 9117) (the 
third temporary regulations) under section 1502 amending Sec. Sec.  
1.1502-13 and 1.1502-28T. A notice of proposed rulemaking (REG-167265-
03) (the 2004 proposed regulations) cross-referencing the third 
temporary regulations was published in the Federal Register for the 
same day (69 FR 12091). The third temporary regulations address certain 
technical issues relating to the application of excluded COD income to 
reduce attributes under sections 108 and 1017 and Sec.  1.1502-28T.
    The 2004 proposed regulations, in addition to cross-referencing the 
third temporary regulations, proposed amendments to Sec. Sec.  1.1502-
28T and 1.1502-11 to provide a methodology for computing consolidated 
taxable income and for effecting attribute reduction when there is a 
disposition of the stock of a member in a year during which any member 
realizes excluded COD income.
    No public hearing was requested or held for any of the regulations 
described above. Written and electronic comments responding to the 
notices of proposed rulemaking were received. After consideration of 
all the comments, the proposed regulations are adopted as revised by 
this Treasury decision, and the affected provisions in the 
corresponding temporary regulations are removed. The more significant 
revisions are discussed below.

A. Apportionment of Net Operating Losses

    In addition to adding Sec.  1.1502-28T, the first temporary 
regulations added several provisions to Sec.  1.1502-21T. Sections 
1.1502-21 and 1.1502-21T include rules relating to the amount of 
consolidated net operating losses apportioned to a subsidiary when a 
subsidiary departs from the group. The provisions added to Sec.  
1.1502-21T require a recomputation of the percentage of a consolidated 
net operating loss attributable to a member when a portion of the loss 
is carried back to a separate return year or is reduced in respect of 
excluded COD income, or when a member departs. Questions have arisen 
regarding the timing of the recomputation of the percentage of a 
consolidated net operating loss attributable to a member in cases in 
which a portion of a consolidated net operating loss is carried back to 
a separate return year or a portion is reduced in respect of excluded 
COD income. Therefore, these final regulations clarify the timing of 
the recomputation in these cases.

B. Timing of Asset Basis Reduction

    Section 108(b)(4)(A) requires the reduction of the tax attributes 
listed in section 108(b)(2), including basis in property, in respect of 
excluded COD income after the determination of the tax imposed for the 
taxable year of the discharge. Section 1017(a) provides that when any 
portion of excluded COD income is to be applied to reduce basis, then 
such portion is applied to reduce the basis of any property held by the 
taxpayer at the beginning of the taxable year following the taxable 
year in which the discharge occurs. As a result of the reference in 
section 1017(a) to the property held by the taxpayer at the beginning 
of the taxable year following the taxable year in which the discharge 
occurs, questions have arisen regarding the appropriate time to reduce 
the basis of property of the taxpayer.
    The IRS and Treasury Department believe that the reference in 
section 1017 to the property held by the taxpayer at the beginning of 
the taxable year following the taxable year in which the discharge 
occurs merely identifies those properties the basis of which are 
subject to reduction. It does not prescribe that basis of property 
should not be reduced until the beginning of the taxable year following 
the taxable year in which the discharge occurs. Accordingly, these 
regulations clarify that basis of property is subject to reduction 
pursuant to the rules of sections 108 and 1017 and Sec.  1.1502-28 
after the determination of tax for the year during which the member 
realizes excluded COD income (and any prior years) and coincident with 
the reduction of other attributes pursuant to section 108 and Sec.  
1.1502-28. However, only the basis of property held as of the beginning 
of the taxable year following the taxable year during which the 
excluded COD income is realized is available for reduction.

C. Application of Look-Through Rule

    The first temporary regulations include a look-through rule that 
applies if the attribute of the debtor member reduced is the basis of 
stock of another member of the group. In these cases, corresponding 
reductions must be made to the attributes attributable to the lower-
tier member. To effect those corresponding reductions, the lower-tier 
member is treated as realizing excluded COD income in the amount of the 
stock basis reduction. Questions have arisen regarding whether the 
look-through rule applies when there is a reduction in the basis of 
stock of a corporation that is a member of the group on the last day of 
the debtor's taxable year during which the excluded COD income is 
realized, but is not a member of the group on the first day of the 
debtor's following taxable year. For example, suppose P1 owns all of 
the stock of S1 and S1 owns all of the stock of S2. P1, S1, and S2 file 
a consolidated return. In Year 1, P1 realizes excluded COD income. On 
the last day of Year 1, P1 sells 50 percent of the stock of S1 to P2. 
P1 reduces its basis in the 50 percent of the S1 stock that it owns on 
the first day of Year 2 in respect of its excluded COD income. 
Commentators have questioned whether the look-through rule applies to 
reduce S1's attributes.
    The IRS and Treasury Department believe that because S1 and S2 were 
members of the same group on the last day of the debtor's taxable year 
during which the excluded COD income was realized, it is appropriate to 
apply the single entity principles reflected in the look-through rule. 
The IRS and Treasury Department have also considered whether the look-
through rule applies when there is a reduction in the basis

[[Page 14397]]

of stock of a corporation that is not a member of the group on the last 
day of the debtor's taxable year during which the excluded COD income 
is realized (by reason of the application of the next day rule of Sec.  
1.1502-76), but is a member of the group on the first day of the 
debtor's following taxable year. In these cases too, the IRS and 
Treasury Department believe that it is appropriate to apply the single 
entity principles reflected in the look-through rule. Therefore, these 
regulations provide that, if the basis of stock of a corporation (the 
lower-tier member) that is owned by another corporation (the higher-
tier member) is reduced and both of such corporations are members of 
the same consolidated group on the last day of the higher-tier member's 
taxable year that includes the date on which the excluded COD income is 
realized or the first day of the higher-tier member's taxable year that 
follows the taxable year that includes the date on which the excluded 
COD income is realized, the look-through rule will apply to reduce the 
attributes of the lower-tier member.

D. Attributes Available for Reduction on Departure of Debtor Member

    Questions have arisen regarding the identification of the 
attributes available for reduction in cases in which the member that 
realizes the excluded COD income leaves the group (for example, by 
reason of a stock acquisition) or the assets of the member are acquired 
by a corporation that is not a member of the group in a transaction to 
which section 381(a) applies on or prior to the last day of the 
consolidated return year during which the excluded COD income is 
realized. At least one commentator has questioned whether the 
attributes of other members of the group from which the debtor member 
departs are available for reduction in these cases. These final 
regulations confirm that, in such cases, the tax attributes that remain 
after the determination of the tax imposed on the group that belong to 
members of the group are available for reduction.

E. Intragroup Reorganizations and Group Structure Changes

    Questions have also arisen regarding the application of the 
attribute reduction rules when a taxpayer that is a member of a 
consolidated group realizes excluded COD income during the same 
consolidated return year during which it transfers assets in a 
transaction to which section 381(a) applies to a corporation that is a 
member of the group immediately after the transaction. Section 1.108-7 
provides that if a taxpayer realizes excluded COD income either during 
or after a taxable year in which the taxpayer is the distributor or 
transferor of assets in a transaction described in section 381(a), any 
tax attributes to which the acquiring corporation succeeds, including 
the basis of property acquired by the acquiring corporation in the 
transaction, must reflect the reductions required by section 108(b). If 
a member of the group transfers assets in a transaction to which 
section 381(a) applies to a corporation that is a member of the group 
immediately after the transaction and, as a result, the taxable year of 
the transferor member ends prior to the end of the consolidated return 
year, the basis of the transferred property following the transfer may 
generate depreciation deductions that are allowed in computing the 
group's consolidated taxable income for the entire consolidated return 
year that includes the date of the discharge. Requiring the basis of 
the transferred property to reflect a reduction in respect of the 
excluded COD income immediately after the transfer could arguably 
violate the directive of section 108(b)(4)(A) that attributes 
(including basis) be reduced only after the determination of tax for 
the taxable year of the discharge. However, if attributes were reduced 
after the determination of the group's tax for the taxable year of the 
discharge, it may be difficult to determine which attributes of the 
combined entity are attributable to the debtor member and available for 
reduction. For example, if after the transaction to which section 
381(a) applies the acquiring corporation purchases property, it may be 
difficult to determine whether that property is property of the debtor 
the basis of which is available for reduction or property of the 
acquiring corporation the basis of which may not be available for 
reduction. Similar issues may arise with respect to other attributes of 
the transferor.
    To address this issue, these final regulations provide that, if the 
taxable year of a member during which such member realizes excluded COD 
income ends prior to the last day of the consolidated return year and, 
on the first day of the taxable year of such member that follows the 
taxable year during which such member realizes excluded COD income, 
such member has a successor member, the successor member is treated as 
if it had realized the excluded COD income. Accordingly, all attributes 
of the successor member listed in section 108(b)(2) (including 
attributes that were attributable to the successor member prior to the 
date such member became a successor member) are subject to reduction 
prior to the attributes attributable to other members of the group. For 
this purpose, a successor member means a person to which the member 
that realizes excluded COD income transfers its assets in a transaction 
to which section 381(a) applies if such transferee is a member of the 
group immediately after the transaction. This rule avoids the 
difficulty of tracing attributes and property of the debtor member once 
the debtor member has been acquired by another member and recognizes 
that the direction of a transaction to which section 381(a) applies in 
a group may not be meaningful. These regulations provide a similar rule 
for cases in which a member of the group acquires the assets of another 
member in a transaction to which section 381(a) applies that is also a 
group structure change.

F. Application of Next Day Rule

    Under Sec.  1.1502-76, a consolidated return must include the 
common parent's items of income, gain, deduction, loss, and credit for 
the entire consolidated return year, and each subsidiary's items for 
the portion of the year for which it is a member. A corporation that 
leaves a consolidated group during the tax year must generally file a 
short period separate return (or join in the consolidated return of 
another group) for the portion of the year not included in the 
consolidated return. If a corporation ceases to be a member during a 
consolidated return year, it ceases to be a member at the end of the 
day on which its status as a member changes, and its tax year ends at 
the end of that day. Under the next day rule, however, any transaction 
that occurs on the day the member ceases to be affiliated with the 
group that is properly allocable to the portion of the subsidiary's day 
after the event terminating affiliation must be treated as occurring at 
the beginning of the following day. Commentators have questioned 
whether the next day rule can be applied when the debt of a subsidiary 
is discharged in exchange for stock of the subsidiary and, as a result 
of the issuance of the subsidiary's stock to the creditor, the 
subsidiary ceases to be a member of the group. As a result of the 
application of that rule, the excluded COD income would be treated as 
realized at the beginning of the day following the day the subsidiary 
ceases to be a member of the group, rather than on the day it ceases to 
be a member of the group.
    The IRS and Treasury Department believe that because the excluded 
COD income accrued in the group, it is not

[[Page 14398]]

appropriate to apply the next day rule in these cases. Therefore, these 
regulations provide that the next day rule cannot be applied to treat 
excluded COD income as realized at the beginning of the day following 
the day on which it is realized.

G. Timing of Investment Adjustments

    Under Sec.  1.1502-32, excluded COD income of a subsidiary results 
in a positive basis adjustment to the extent it is applied to reduce 
attributes and the reduction of the subsidiary's attributes (other than 
credits) in respect of excluded COD income will generally result in a 
negative basis adjustment. Commentators have requested clarification 
regarding when these basis adjustments are effective in cases in which 
a subsidiary ceases to be a member of the group on or prior to the end 
of the consolidated return year during which a member realizes excluded 
COD income. Therefore, these regulations clarify that, in those cases, 
basis adjustments resulting from the realization of excluded COD income 
and from the reduction of attributes in respect thereof are made 
immediately after the determination of tax for the group for the 
consolidated return year during which the excluded COD income is 
realized (and any prior years) and are effective immediately before the 
beginning of the day following the day the member departs from the 
group. Therefore, if the departing member becomes a member of another 
group (the new group), the adjustments to the basis of the departing 
member's stock in respect of the excluded COD income will not cause 
stock basis adjustments in the new group.

H. Elimination of Circular Stock Basis on Disposition of Member Stock

    The 2004 proposed regulations provide a methodology for computing 
consolidated taxable income and for effecting attribute reduction when 
there is a disposition of member stock during the same taxable year in 
which any member realizes excluded COD income. The methodology is 
intended to prevent the reduction of tax attributes from affecting the 
basis of the member stock that is sold, which would affect the tax 
liability of the group for the taxable year of the discharge. 
Accordingly, the methodology limits the actual reduction of tax 
attributes to the amount of tax attributes available for reduction 
following the tentative computation of taxable income (or loss).
    Commentators have noted, however, that pursuant to section 
108(b)(4)(A), attributes are reduced only after the determination of 
tax for the taxable year of the discharge. Computing the limitation on 
attribute reduction based on the tax attributes remaining after a 
tentative computation of taxable income (or loss) does not account for 
the use of credits in the computation of the group's tax liability for 
the taxable year of the discharge. Therefore, in response to these 
comments, the final regulations provide for the computation of the 
limitation on attribute reduction after the computation of the tax 
imposed by chapter 1 of the Code, rather than after the computation of 
taxable income (or loss).

I. Transactions Designed to Avoid the Application of the Attribute 
Reduction Rules

    The preamble to the first temporary regulations stated that the IRS 
and Treasury Department are considering adopting rules under section 
1502 (and possibly other Code sections) to address the effect of 
transitory transactions and other transactions designed to avoid the 
application of the rules concerning attribute reduction. The IRS and 
Treasury Department continue to believe that general principles 
(including step transaction doctrine) could be applied to disregard 
certain transactions that have the effect of changing the result of the 
application of the attribute reduction rules. Therefore, the IRS and 
Treasury Department have decided not to adopt any additional rules at 
this time.

J. Elective Retroactive Application of Final Regulation

    The portion of these regulations finalizing the rules contained in 
Sec.  1.1502-28T apply to discharges of indebtedness that occur after 
March 21, 2005. Groups, however, may apply those rules in whole, but 
not in part, to discharges of indebtedness that occur on or before 
March 21, 2005, and after August 29, 2003.
    These regulations also permit further retroactive application of a 
rule included in the third temporary regulations that prevents the 
potential duplication of ordinary income recapture under section 1245 
that could be caused by reason of the application of both section 1245 
and either section 1017(b)(3)(D) (which permits subsidiary stock to be 
treated as depreciable property to the extent that the subsidiary 
consents to a corresponding reduction in the basis of its depreciable 
property) or the look-through rule. This section 1245 rule provides 
that a reduction of the basis of subsidiary stock is treated as a 
deduction allowed for depreciation only to the extent that the amount 
by which the basis of the subsidiary stock is reduced exceeds the total 
amount of the attributes attributable to such subsidiary that are 
reduced pursuant to the subsidiary's consent under section 
1017(b)(3)(D) or as a result of the application of the look-through 
rule. The third temporary regulations made this special rule effective 
for discharges of indebtedness that occur after August 29, 2003, the 
effective date of the look-through rule. The IRS and Treasury 
Department are aware that the problem addressed by this special rule 
could have occurred in cases of discharges of indebtedness that 
occurred before August 29, 2003, if section 1017(b)(3)(D) was applied. 
Accordingly, these final regulations provide that groups may apply this 
special rule to discharges of indebtedness that occur on or before 
August 29, 2003, in cases in which section 1017(b)(3)(D) was applied.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. Further, it is 
hereby certified that these regulations will not have a significant 
economic impact on a substantial number of small entities. This 
certification is based on the fact that these regulations will 
primarily affect affiliated groups of corporations that have elected to 
file a consolidated return, which tend to be larger businesses. 
Accordingly, a regulatory flexibility analysis under the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to 
section 7805(f) of the Code, the notices of proposed rulemaking 
preceding these regulations were submitted to the Chief Counsel for 
Advocacy of the Small Business Administration for comment on their 
impact on small business.

Drafting Information

    The principal author of these regulations is Amber R. Cook of the 
Office of Associate Chief Counsel (Corporate). However, other personnel 
from the IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

[[Page 14399]]

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by removing 
the entries for Sec. Sec.  1.1502-13T, 1.1502-19T, and 1.1502-28T and 
adding the following entry in numerical order to read, in part, as 
follows:

    Authority: 26 U.S.C. 7805. * * *
    Section 1.1502-28 also issued under 26 U.S.C. 1502. * * *


0
Par. 2. Section 1.1502-11 is amended as follows:
0
1. Paragraph (b)(1) is revised.
0
2. Paragraph (c) is redesignated as paragraph (d).
0
3. New paragraph (c) is added.
    The revision and addition read as follows:


Sec.  1.1502-11  Consolidated taxable income.

* * * * *
    (b) Elimination of circular stock basis adjustments when there is 
no excluded COD income--(1) In general. If one member (P) disposes of 
the stock of another member (S), this paragraph (b) limits the use of 
S's deductions and losses in the year of disposition and the carryback 
of items to prior years. The purpose of the limitation is to prevent 
P's income or gain from the disposition of S's stock from increasing 
the absorption of S's deductions and losses, because the increased 
absorption would reduce P's basis (or increase its excess loss account) 
in S's stock under Sec.  1.1502-32 and, in turn, increase P's income or 
gain. See paragraph (b)(3) of this section for the application of these 
principles to P's deduction or loss from the disposition of S's stock, 
and paragraph (b)(4) of this section for the application of these 
principles to multiple stock dispositions. This paragraph (b) applies 
only when no member realizes discharge of indebtedness income that is 
excluded from gross income under section 108(a) (excluded COD income) 
during the taxable year of the disposition. See paragraph (c) of this 
section for rules that apply when a member realizes excluded COD income 
during the taxable year of the disposition. See Sec.  1.1502-19(c) for 
the definition of disposition.
* * * * *
    (c) Elimination of circular stock basis adjustments when there is 
excluded COD income--(1) In general. If one member (P) disposes of the 
stock of another member (S) in a year during which any member realizes 
excluded COD income, this paragraph (c) limits the use of S's 
deductions and losses in the year of disposition and the carryback of 
items to prior years, the amount of the attributes of certain members 
that can be reduced in respect of excluded COD income of certain other 
members, and the attributes that can be used to offset an excess loss 
account taken into account by reason of the application of Sec.  
1.1502-19(c)(1)(iii)(B). In addition to the purpose set forth in 
paragraph (b)(1) of this section, the purpose of these limitations is 
to prevent the reduction of tax attributes in respect of excluded COD 
income from affecting P's income, gain, or loss on the disposition of S 
stock (including a disposition of S stock that results from the 
application of Sec.  1.1502-19(c)(1)(iii)(B)) and, in turn, affecting 
the attributes available for reduction pursuant to sections 108 and 
1017 and Sec.  1.1502-28. See Sec.  1.1502-19(c) for the definition of 
disposition.
    (2) Computation of tax liability, reduction of attributes, and 
computation of limits on absorption and reduction of attributes. If a 
member realizes excluded COD income in the taxable year during which P 
disposes of S stock, the steps used to compute tax liability, to effect 
the reduction of attributes, and to compute the limitations on the 
absorption and reduction of attributes are as follows. These steps also 
apply to determine whether and to what extent an excess loss account 
must be taken into account as a result of the application of Sec.  
1.1502-19(b)(1) and (c)(1)(iii)(B).
    (i) Limitation on deductions and losses to offset income or gain. 
First, the determination of the extent to which S's deductions and 
losses for the tax year of the disposition (and its deductions and 
losses carried over from prior years) may offset income and gain is 
made pursuant to paragraphs (b)(2) and (3) of this section.
    (ii) Tentative adjustment of stock basis. Second, Sec.  1.1502-32 
is tentatively applied to adjust the basis of the S stock to reflect 
the amount of S's income and gain included, and unlimited deductions 
and losses that are absorbed, in the tentative computation of taxable 
income or loss for the year of the disposition (and any prior years) 
that is made pursuant to paragraph (b)(2) of this section, but not to 
reflect the realization of excluded COD income and the reduction of 
attributes in respect thereof.
    (iii) Tentative computation of stock gain or loss. Third, in the 
case of a disposition of S stock that does not result from the 
application of Sec.  1.1502-19(c)(1)(iii)(B), P's income, gain, or loss 
from the disposition of S stock is computed. For this purpose, the 
result of the computation pursuant to paragraph (c)(2)(ii) of this 
section is treated as the basis of such stock.
    (iv) Tentative computation of tax imposed. Fourth, the tax imposed 
by chapter 1 of the Internal Revenue Code for the year of disposition 
(and any prior years) is tentatively computed. For this purpose, in the 
case of a disposition of S stock that does not result from the 
application of Sec.  1.1502-19(c)(1)(iii)(B), the tentative computation 
of tax imposed takes into account P's income, gain, or loss from the 
disposition of S stock computed pursuant to paragraph (c)(2)(iii) of 
this section. The tentative computation of tax imposed is made without 
regard to whether all or a portion of an excess loss account in a share 
of S stock is required to be taken into account pursuant to Sec.  
1.1502-19(b)(1) and (c)(1)(iii)(B).
    (v) Tentative reduction of attributes. Fifth, the rules of sections 
108 and 1017 and Sec.  1.1502-28 are tentatively applied to reduce the 
attributes remaining after the tentative computation of tax imposed 
pursuant to paragraph (c)(2)(iv) of this section.
    (vi) Actual adjustment of stock basis. Sixth, Sec.  1.1502-32 is 
applied to reflect the amount of S's income and gain included, and 
unlimited deductions and losses that are absorbed, in the tentative 
computation of tax imposed for the year of the disposition (and any 
prior years) made pursuant to paragraph (c)(2)(iv) of this section, and 
the excluded COD income applied to reduce attributes and the attributes 
tentatively reduced in respect of the excluded COD income pursuant to 
paragraph (c)(2)(v) of this section.
    (vii) Actual computation of stock gain or loss. Seventh, the 
group's actual gain or loss on the disposition of S stock (including a 
disposition that results from the application of Sec.  1.1502-
19(c)(1)(iii)(B)) is computed. The result of the computation pursuant 
to paragraph (c)(2)(vi) of this section is treated as the basis of such 
stock.
    (viii) Actual computation of tax imposed. Eighth, the tax imposed 
by chapter 1 of the Internal Revenue Code for the year of the 
disposition (and any prior years) is computed. The actual tax imposed 
on the group for the year of the disposition is computed by applying 
the limitation computed pursuant to paragraph (c)(2)(i) of this 
section, and by including the gain or loss recognized on the 
disposition of S stock computed pursuant to paragraph (c)(2)(vii) of 
this section. However, attributes that were tentatively used in the 
computation of tax imposed pursuant to paragraph (c)(2)(iv) of this 
section and attributes that were tentatively reduced pursuant to 
paragraph (c)(2)(v) of this section

[[Page 14400]]

cannot offset any excess loss account taken into account as a result of 
the application of Sec.  1.1502-19(b)(1) and (c)(1)(iii)(B).
    (ix) Actual reduction of attributes. Ninth, the rules of sections 
108 and 1017 and Sec.  1.1502-28 are actually applied to reduce the 
attributes remaining after the actual computation of tax imposed 
pursuant to paragraph (c)(2)(viii) of this section.
    (A) S or a lower-tier corporation realizes excluded COD income. If 
S or a lower-tier corporation of S realizes excluded COD income, the 
aggregate amount of excluded COD income that is applied to reduce 
attributes attributable to members other than S and any lower-tier 
corporation of S pursuant to this paragraph (c)(2)(ix) shall not exceed 
the aggregate amount of excluded COD income that was tentatively 
applied to reduce attributes attributable to members other than S and 
any lower-tier corporation of S pursuant to paragraph (c)(2)(v) of this 
section. The amount of the actual reduction of attributes attributable 
to S and any lower-tier corporation of S that may be reduced in respect 
of the excluded COD income of S or a lower-tier corporation of S shall 
not be so limited.
    (B) A member other than S or a lower-tier corporation realizes 
excluded COD income. If a member other than S or a lower-tier 
corporation of S realizes excluded COD income, the aggregate amount of 
excluded COD income that is applied to reduce attributes (other than 
credits) attributable to S and any lower-tier corporation of S pursuant 
to this paragraph (c)(2)(ix) shall not exceed the aggregate amount of 
excluded COD income that was tentatively applied to reduce attributes 
(other than credits) attributable to S and any lower-tier corporation 
of S pursuant to paragraph (c)(2)(v) of this section. The amount of the 
actual reduction of attributes attributable to any member other than S 
and any lower-tier corporation of S that may be reduced in respect of 
the excluded COD income of S or a lower-tier corporation of S shall not 
be so limited.
    (3) Special rules. (i) If the reduction of attributes attributable 
to a member is prevented as a result of a limitation described in 
paragraph (c)(2)(ix)(B) of this section, the excluded COD income that 
would have otherwise been applied to reduce such attributes is applied 
to reduce the remaining attributes of the same type that are available 
for reduction under Sec.  1.1502-28(a)(4), on a pro rata basis, prior 
to reducing attributes of a different type. The reduction of such 
remaining attributes, however, is subject to any applicable limitation 
described in paragraph (c)(2)(ix)(B) of this section.
    (ii) To the extent S's deductions and losses in the year of 
disposition (or those of a lower-tier corporation of S) cannot offset 
income or gain because of the limitation under paragraph (b) of this 
section or this paragraph (c) and are not reduced pursuant to sections 
108 and 1017 and Sec.  1.1502-28, such items are carried to other years 
under the applicable provisions of the Internal Revenue Code and 
regulations as if they were the only items incurred by S (or a lower-
tier corporation of S) in the year of disposition. For example, to the 
extent S incurs an operating loss in the year of disposition that is 
limited and is not reduced pursuant to section 108 and Sec.  1.1502-28, 
the loss is treated as a separate net operating loss attributable to S 
arising in that year.
    (4) Definition of lower-tier corporation. A corporation is a lower-
tier corporation of S if all of its items of income, gain, deduction, 
and loss (including the absorption of deduction or loss and the 
reduction of attributes other than credits) would be fully reflected in 
P's basis in S's stock under Sec.  1.1502-32.
    (5) Examples. For purposes of the examples in this paragraph (c), 
unless otherwise stated, the tax year of all persons is the calendar 
year, all persons use the accrual method of accounting, the facts set 
forth the only corporate activity, all transactions are between 
unrelated persons, tax liabilities are disregarded, and no election 
under section 108(b)(5) is made. The principles of this paragraph (c) 
are illustrated by the following examples:

    Example 1. Departing member realizes excluded COD income. (i) 
Facts. P owns all of S's stock with a $90 basis. For Year 1, P has 
ordinary income of $30, and S has an $80 ordinary loss and $100 of 
excluded COD income from the discharge of non-intercompany 
indebtedness. P sells the S stock for $20 at the close of Year 1. As 
of the beginning of Year 2, S has Asset A with a basis of $0 and a 
fair market value of $20.
    (ii) Analysis. The steps used to compute the tax imposed on the 
group, to effect the reduction of attributes, and to compute the 
limitations on the use and reduction of attributes are as follows:
    (A) Computation of limitation on deductions and losses to offset 
income or gain. To determine the amount of the limitation under 
paragraph (c)(2)(i) of this section on S's loss and the effect of 
the absorption of S's loss on P's basis in S's stock under Sec.  
1.1502-32(b), P's gain or loss from the disposition of S's stock is 
not taken into account. The group is tentatively treated as having a 
consolidated net operating loss of $50 (P's $30 of income minus S's 
$80 loss). Thus, $30 of S's loss is unlimited and $50 of S's loss is 
limited under paragraph (c)(2)(i) of this section. Under the 
principles of Sec.  1.1502-21(b)(2)(iv), all of the consolidated net 
operating loss is attributable to S.
    (B) Tentative adjustment of stock basis. Then, pursuant to 
paragraph (c)(2)(ii) of this section, Sec.  1.1502-32 is tentatively 
applied to adjust the basis of S stock. For this purpose, however, 
adjustments attributable to the excluded COD income and the 
reduction of attributes in respect thereof are not taken into 
account. Under Sec.  1.1502-32(b), the absorption of $30 of S's loss 
decreases P's basis in S's stock by $30 to $60.
    (C) Tentative computation of stock gain or loss. Then, P's 
income, gain, or loss from the sale of S stock is computed pursuant 
to paragraph (c)(2)(iii) of this section using the basis computed in 
the previous step. Thus, P is treated as recognizing a $40 loss from 
the sale of S stock.
    (D) Tentative computation of tax imposed. Pursuant to paragraph 
(c)(2)(iv) of this section, the tax imposed for the year of 
disposition is then tentatively computed, taking into account P's 
$40 loss on the sale of the S stock computed pursuant to paragraph 
(c)(2)(iii) of this section. The group has a $50 consolidated net 
operating loss for Year 1 that, under the principles of Sec.  
1.1502-21(b)(2)(iv), is wholly attributable to S and a consolidated 
capital loss of $40 that, under the principles of Sec.  1.1502-
21(b)(2)(iv), is wholly attributable to P.
    (E) Tentative reduction of attributes. Next, pursuant to 
paragraph (c)(2)(v) of this section, the rules of sections 108 and 
1017 and Sec.  1.1502-28 are tentatively applied to reduce 
attributes remaining after the tentative computation of the tax 
imposed. Pursuant to Sec.  1.1502-28(a)(2), the tax attributes 
attributable to S would first be reduced to take into account its 
$100 of excluded COD income. Accordingly, the consolidated net 
operating loss for Year 1 would be reduced by $50, the portion of 
that consolidated net operating loss attributable to S under the 
principles of Sec.  1.1502-21(b)(2)(iv), to $0. Then, pursuant to 
Sec.  1.1502-28(a)(4), S's remaining $50 of excluded COD income 
would reduce the consolidated capital loss attributable to P of $40 
by $40 to $0. The remaining $10 of excluded COD income would have no 
effect.
    (F) Actual adjustment of stock basis. Pursuant to paragraph 
(c)(2)(vi) of this section, Sec.  1.1502-32 is applied to reflect 
the amount of S's income and gain included, and unlimited deductions 
and losses that are absorbed, in the tentative computation of the 
tax imposed for the year of the disposition and the excluded COD 
income tentatively applied to reduce attributes and the attributes 
reduced in respect of the excluded COD income pursuant to the 
previous step. Under Sec.  1.1502-32(b), the absorption of $30 of 
S's loss, the application of $90 of S's excluded COD income to 
reduce attributes of P and S, and the reduction of the $50 loss 
attributable to S in respect of the excluded COD income results in a 
positive adjustment of $10 to P's basis in the S stock. P's basis in 
the S stock, therefore, is $100.
    (G) Actual computation of stock gain or loss. Pursuant to 
paragraph (c)(2)(vii) of this section, P's actual gain or loss on 
the sale of the S stock is computed using the basis

[[Page 14401]]

computed in the previous step. Accordingly, P recognizes an $80 loss 
on the disposition of the S stock.
    (H) Actual computation of tax imposed. Pursuant to paragraph 
(c)(2)(viii) of this section, the tax imposed is computed by taking 
into account P's $80 loss from the sale of S stock. Before the 
application of Sec.  1.1502-28, therefore, the group has a 
consolidated net operating loss of $50 that is wholly attributable 
to S under the principles of Sec.  1.1502-21(b)(2)(iv), and a 
consolidated capital loss of $80 that is wholly attributable to P 
under the principles of Sec.  1.1502-21(b)(2)(iv).
    (I) Actual reduction of attributes. Pursuant to paragraph 
(c)(2)(ix) of this section, sections 108 and 1017 and Sec.  1.1502-
28 are then actually applied to reduce attributes remaining after 
the actual computation of the tax imposed. Pursuant to Sec.  1.1502-
28(a)(2), the tax attributes attributable to S must first be reduced 
to take into account its $100 of excluded COD income. Accordingly, 
the consolidated net operating loss for Year 1 is reduced by $50, 
the portion of that consolidated net operating loss attributable to 
S under the principles of Sec.  1.1502-21(b)(2)(iv), to $0. Then, 
pursuant to Sec.  1.1502-28(a)(4), S's remaining $50 of excluded COD 
income reduces consolidated tax attributes. In particular, without 
regard to the limitation imposed by paragraph (c)(2)(ix)(A) of this 
section, the $80 consolidated capital loss, which under the 
principles of Sec.  1.1502-21(b)(2)(iv) is attributable to P, would 
be reduced by $50 from $80 to $30. However, the limitation imposed 
by paragraph (c)(2)(ix)(A) of this section prevents the reduction of 
the consolidated capital loss attributable to P by more than $40. 
Therefore, the consolidated capital loss attributable to P is 
reduced by only $40 in respect of S's excluded COD income. The 
remaining $10 of excluded COD income has no effect.
    Example 2. Member other than departing member realizes excluded 
COD income. (i) Facts. P owns all of S1's and S2's stock. P's basis 
in S2's stock is $600. For Year 1, P has ordinary income of $30, S1 
has a $100 ordinary loss and $100 of excluded COD income from the 
discharge of non-intercompany indebtedness, and S2 has $200 of 
ordinary loss. P sells the S2 stock for $600 at the close of Year 1. 
As of the beginning of Year 2, S1 has Asset A with a basis of $0 and 
a fair market value of $10.
    (ii) Analysis. The steps used to compute the tax imposed on the 
group, to effect the reduction of attributes, and to compute the 
limitations on the use and reduction of attributes are as follows:
    (A) Computation of limitation on deductions and losses to offset 
income or gain. To determine the amount of the limitation under 
paragraph (c)(2)(i) of this section on S2's loss and the effect of 
the absorption of S2's loss on P's basis in S2's stock under Sec.  
1.1502-32(b), P's gain or loss from the sale of S2's stock is not 
taken into account. The group is tentatively treated as having a 
consolidated net operating loss of $270 (P's $30 of income minus 
S1's $100 loss and S2's $200 loss). Consequently, $20 of S2's loss 
from Year 1 is unlimited and $180 of S2's loss from Year 1 is 
limited under paragraph (c)(2)(i) of this section. Under the 
principles of Sec.  1.1502-21(b)(2)(iv), $90 of the consolidated net 
operating loss is attributable to S1 and $180 of the consolidated 
net operating loss is attributable to S2.
    (B) Tentative adjustment of stock basis. Then, pursuant to 
paragraph (c)(2)(ii) of this section, Sec.  1.1502-32 is tentatively 
applied to adjust the basis of S2's stock. For this purpose, 
however, adjustments to the basis of S2's stock attributable to the 
reduction of attributes in respect of S1's excluded COD income are 
not taken into account. Under Sec.  1.1502-32(b), the absorption of 
$20 of S2's loss decreases P's basis in S2's stock by $20 to $580.
    (C) Tentative computation of stock gain or loss. Then, P's 
income, gain, or loss from the disposition of S2 stock is computed 
pursuant to paragraph (c)(2)(iii) of this section using the basis 
computed in the previous step. Thus, P is treated as recognizing a 
$20 gain from the sale of the S2 stock.
    (D) Tentative computation of tax imposed. Pursuant to paragraph 
(c)(2)(iv) of this section, the tax imposed for the year of 
disposition is then tentatively computed, taking into account P's 
$20 gain from the sale of S2 stock computed pursuant to paragraph 
(c)(2)(iii) of this section. Although S2's limited loss cannot be 
used to offset P's $20 gain from the sale of S2's stock under the 
rules of this section, S1's loss will offset that gain. Therefore, 
the group is tentatively treated as having a consolidated net 
operating loss of $250, $70 of which is attributable to S1 and $180 
of which is attributable to S2 under the principles of Sec.  1.1502-
21(b)(2)(iv).
    (E) Tentative reduction of attributes. Next, pursuant to 
paragraph (c)(2)(v) of this section, the rules of sections 108 and 
1017 and Sec.  1.1502-28 are tentatively applied to reduce 
attributes remaining after the tentative computation of the tax 
imposed. Pursuant to Sec.  1.1502-28(a)(2), the tax attributes 
attributable to S1 would first be reduced to take into account its 
$100 of excluded COD income. Accordingly, the consolidated net 
operating loss for Year 1 would be reduced by $70, the portion of 
that consolidated net operating loss attributable to S1 under the 
principles of Sec.  1.1502-21(b)(2)(iv), to $0. Then, pursuant to 
Sec.  1.1502-28(a)(4), S1's remaining $30 of excluded COD income 
would reduce the consolidated net operating loss for Year 1 
attributable to S2 of $180 by $30 to $150.
    (F) Actual adjustment of stock basis. Pursuant to paragraph 
(c)(2)(vi) of this section, Sec.  1.1502-32 is applied to reflect 
the amount of S2's income and gain included, and unlimited 
deductions and losses that are absorbed, in the tentative 
computation of the tax imposed for the year of the disposition and 
the excluded COD income tentatively applied to reduce attributes and 
the attributes reduced in respect of the excluded COD income 
pursuant to the previous step. Under Sec.  1.1502-32(b), the 
absorption of $20 of S2's loss to offset a portion of P's income and 
the application of $30 of S1's excluded COD income to reduce 
attributes attributable to S2 results in a negative adjustment of 
$50 to P's basis in the S2 stock. P's basis in the S2 stock, 
therefore, is $550.
    (G) Actual computation of stock gain or loss. Pursuant to 
paragraph (c)(2)(vii) of this section, P's actual gain or loss on 
the sale of the S2 stock is computed using the basis computed in the 
previous step. Therefore, P recognizes a $50 gain on the disposition 
of the S2 stock.
    (H) Actual computation of tax imposed. Pursuant to paragraph 
(c)(2)(viii) of this section, the tax imposed is computed by taking 
into account P's $50 gain from the disposition of the S2 stock. 
Before the application of Sec.  1.1502-28, therefore, the group has 
a consolidated net operating loss of $220, $40 of which is 
attributable to S1 and $180 of which is attributable to S2 under the 
principles of Sec.  1.1502-21(b)(2)(iv).
    (I) Actual reduction of attributes. Pursuant to paragraph 
(c)(2)(ix) of this section, sections 108 and 1017 and Sec.  1.1502-
28 are then actually applied to reduce attributes remaining after 
the actual computation of the tax imposed. Pursuant to Sec.  1.1502-
28(a)(2), the tax attributes attributable to S1 must first be 
reduced to take into account its $100 of excluded COD income. 
Accordingly, the consolidated net operating loss for Year 1 is 
reduced by $40, the portion of that consolidated net operating loss 
attributable to S1 under the principles of Sec.  1.1502-
21(b)(2)(iv), to $0. Then, pursuant to Sec.  1.1502-28(a)(4), 
without regard to the limitation imposed by paragraph (c)(2)(ix)(B) 
of this section, S1's remaining $60 of excluded COD income would 
reduce S2's net operating loss of $180 to $120. However, the 
limitation imposed by paragraph (c)(2)(ix)(B) of this section 
prevents the reduction of S2's loss by more than $30. Therefore, 
S2's loss of $180 is reduced by $30 to $150 in respect of S1's 
excluded COD income. The remaining $30 of excluded COD income has no 
effect.
    Example 3. Lower-tier corporation of departing member realizes 
excluded COD income. (i) Facts. P owns all of S1's stock, S2's 
stock, and S3's stock. S1 owns all of S4's stock. P's basis in S1's 
stock is $50 and S1's basis in S4's stock is $50. For Year 1, P has 
$50 of ordinary loss, S1 has $100 of ordinary loss, S2 has $150 of 
ordinary loss, S3 has $50 of ordinary loss, and S4 has $50 of 
ordinary loss and $80 of excluded COD income from the discharge of 
non-intercompany indebtedness. P sells the S1 stock for $100 at the 
close of Year 1. As of the beginning of Year 2, S4 has Asset A with 
a fair market value of $10. After the computation of tax imposed for 
Year 1 and before the application of sections 108 and 1017 and Sec.  
1.1502-28, Asset A has a basis of $0.
    (ii) Analysis. The steps used to compute the tax imposed on the 
group, to effect the reduction of attributes, and to compute the 
limitations on the use and reduction of attributes are as follows:
    (A) Computation of limitation on deductions and losses to offset 
income or gain. To determine the amount of the limitation under 
paragraph (c)(2)(i) of this section on S1's and S4's losses and the 
effect of the absorption of S1's and S4's losses on P's basis in 
S1's stock under Sec.  1.1502-32(b), P's gain or loss from the sale 
of S1's stock is not taken into account. The group is tentatively 
treated as having a consolidated net operating loss of $400. 
Consequently,

[[Page 14402]]

$100 of S1's loss and $50 of S4's loss is limited under paragraph 
(c)(2)(i) of this section.
    (B) Tentative adjustment of stock basis. Then, pursuant to 
paragraph (c)(2)(ii) of this section, Sec.  1.1502-32 is tentatively 
applied to adjust the basis of S1's stock. For this purpose, 
adjustments to the basis of S1's stock attributable to S4's 
realization of excluded COD income and the reduction of attributes 
in respect of such excluded COD income are not taken into account. 
There is no adjustment under Sec.  1.1502-32 to the basis of the S1 
stock. Therefore, P's basis in the S1 stock for this purpose is $50.
    (C) Tentative computation of stock gain or loss. Then, P's 
income, gain, or loss from the sale of S1 stock is computed pursuant 
to paragraph (c)(2)(iii) of this section using the basis computed in 
the previous step. Thus, P is treated as recognizing a $50 gain from 
the sale of the S1 stock.
    (D) Tentative computation of tax imposed. Pursuant to paragraph 
(c)(2)(iv) of this section, the tax imposed for the year of 
disposition is then tentatively computed, taking into account P's 
$50 gain from the sale of the S1 stock computed pursuant to 
paragraph (c)(2)(iii) of this section. Although S1's and S4's 
limited losses cannot be used to offset P's $50 gain from the sale 
of S1's stock under the rules of this section, $10 of P's loss, $30 
of S2's loss, and $10 of S3's loss will offset that gain. Therefore, 
the group is tentatively treated as having a consolidated net 
operating loss of $350, $40 of which is attributable to P, $100 of 
which is attributable to S1, $120 of which is attributable to S2, 
$40 of which is attributable to S3, and $50 of which is attributable 
to S4 under the principles of Sec.  1.1502-21(b)(2)(iv).
    (E) Tentative reduction of attributes. Next, pursuant to 
paragraph (c)(2)(v) of this section, the rules of sections 108 and 
1017 and Sec.  1.1502-28 are tentatively applied to reduce 
attributes remaining after the tentative computation of the tax 
imposed. Pursuant to Sec.  1.1502-28(a)(2), the tax attributes 
attributable to S4 would first be reduced to take into account its 
$80 of excluded COD. Accordingly, the consolidated net operating 
loss for Year 1 would be reduced by $50, the portion of the 
consolidated net operating loss attributable to S4 under the 
principles of Sec.  1.1502-21(b)(2)(iv), to $300. Then, pursuant to 
Sec.  1.1502-28(a)(4), S4's remaining $30 of excluded COD income 
would reduce the consolidated net operating loss for Year 1 that is 
attributable to other members. Therefore, the consolidated net 
operating loss for Year 1 would be reduced by $30. Of that amount, 
$4 is attributable to P, $10 is attributable to S1, $12 is 
attributable to S2, and $4 is attributable to S3.
    (F) Actual adjustment of stock basis. Pursuant to paragraph 
(c)(2)(vi) of this section, Sec.  1.1502-32 is applied to reflect 
the amount of S1's and S4's income and gain included, and unlimited 
deductions and losses that are absorbed, in the tentative 
computation of tax imposed for the year of the disposition and the 
excluded COD income tentatively applied to reduce attributes and the 
attributes reduced in respect of the excluded COD income pursuant to 
the previous step. Under Sec.  1.1502-32(b), the application of $80 
of S4's excluded COD income to reduce attributes, and the reduction 
of S4's loss in the amount of $50 and S1's loss in the amount of $10 
in respect of the excluded COD income results in a positive 
adjustment of $20 to P's basis in the S1 stock. Accordingly, P's 
basis in S1 stock is $70.
    (G) Actual computation of stock gain or loss. Pursuant to 
paragraph (c)(2)(vii) of this section, P's actual gain or loss on 
the sale of the S1 stock is computed using the basis computed in the 
previous step. Accordingly, P recognizes a $30 gain on the 
disposition of the S1 stock.
    (H) Actual computation of tax imposed. Pursuant to paragraph 
(c)(2)(viii) of this section, the tax imposed is computed by taking 
into account P's $30 gain from the sale of S1 stock. Before the 
application of Sec.  1.1502-28, therefore, the group has a 
consolidated net operating loss of $370, $44 of which is 
attributable to P, $100 of which is attributable to S1, $132 of 
which is attributable to S2, $44 of which is attributable to S3, and 
$50 of which is attributable to S4.
    (I) Actual reduction of attributes. Pursuant to paragraph 
(c)(2)(ix) of this section, sections 108 and 1017 and Sec.  1.1502-
28 are then actually applied to reduce attributes remaining after 
the actual computation of the tax imposed. Pursuant to Sec.  1.1502-
28(a)(2), the tax attributes attributable to S4 must first be 
reduced to take into account its $80 of excluded COD income. 
Accordingly, the consolidated net operating loss for Year 1 is 
reduced by $50, the portion of that consolidated net operating loss 
attributable to S4 under the principles of Sec.  1.1502-
21(b)(2)(iv), to $320. Then, pursuant to Sec.  1.1502-28(a)(4), 
without regard to the limitation imposed by paragraph (c)(2)(ix)(A) 
of this section, S4's remaining $30 of excluded COD income would 
reduce the consolidated net operating loss for Year 1 by $30 ($4.12 
of the consolidated net operating loss attributable to P, $9.38 of 
the consolidated net operating loss attributable to S1, $12.38 of 
the consolidated net operating loss attributable to S2, and $4.12 of 
the consolidated net operating loss attributable to S3) to $290. 
However, the limitation imposed by paragraph (c)(2)(ix)(A) of this 
section prevents the reduction of the consolidated net operating 
loss attributable to P, S2, and S3 by more than $4, $12, and $4 
respectively. The $.62 of excluded COD income that would have 
otherwise reduced the consolidated net operating loss attributable 
to P, S2, and S3 is applied to reduce the consolidated net operating 
loss attributable to S1. Therefore, S1 carries forward $90 of loss.
    Example 4. Excess loss account taken into account. (i) Facts. P 
is the common parent of a consolidated group. On Day 1 of Year 2, P 
acquired all of the stock of S1. As of the beginning of Year 2, S1 
had a $30 net operating loss carryover from Year 1, a separate 
return limitation year. A limitation under Sec.  1.1502-21(c) 
applies to the use of that loss by the P group. For Years 1 and 2, 
the P group had no consolidated taxable income or loss. On Day 1 of 
Year 3, S1 acquired all of the stock of S2 for $10. In Year 3, P had 
ordinary income of $10, S1 had ordinary income of $25, and S2 had an 
ordinary loss of $50. In addition, in Year 3, S2 realized $20 of 
excluded COD income from the discharge of non-intercompany 
indebtedness. After the discharge of this indebtedness, S2 had no 
liabilities. As of the beginning of Year 4, S2 had Asset A with a 
fair market value of $10. After the computation of tax imposed for 
Year 3 and before the application of sections 108 and 1017 and Sec.  
1.1502-28, Asset A has a basis of $0. S2 had no taxable income (or 
loss) for Year 1 and Year 2.
    (ii) Analysis. The steps used to compute the tax imposed on the 
group, to effect the reduction of attributes, and to compute the 
limitations on the use and reduction of attributes are as follows:
    (A) Computation of limitation on deductions and losses to offset 
income or gain, tentative basis adjustments, tentative computation 
of stock gain or loss. Because it is not initially apparent that 
there has been a disposition of stock, paragraph (c)(2)(i) of this 
section does not limit the use of deductions to offset income or 
gain, no adjustments to the basis are required pursuant to paragraph 
(c)(2)(ii) of this section, and no stock gain or loss is computed 
pursuant to paragraph (c)(2)(iii) of this section or taken into 
account in the tentative computation of tax imposed pursuant to 
paragraph (c)(2)(iv) of this section.
    (B) Tentative computation of tax imposed. Pursuant to paragraph 
(c)(2)(iv) of this section, the tax imposed for Year 3 is 
tentatively computed. For Year 3, the P group has a consolidated 
taxable loss of $15, all of which is attributable to S2 under the 
principles of Sec.  1.1502-21(b)(2)(iv).
    (C) Tentative reduction of attributes. Next, pursuant to 
paragraph (c)(2)(v) of this section, the rules of sections 108 and 
1017 and Sec.  1.1502-28 are tentatively applied to reduce 
attributes remaining after the tentative computation of tax imposed. 
Pursuant to Sec.  1.1502-28(a)(2), the tax attributes attributable 
to S2 would first be reduced to take into account its $20 of 
excluded COD income. Accordingly, the consolidated net operating 
loss for Year 3 is reduced by $15, the portion of that consolidated 
net operating loss attributable to S2 under the principles of Sec.  
1.1502-21(b)(2)(iv), to $0. The remaining $5 of excluded COD income 
is not applied to reduce attributes as there are no remaining 
attributes that are subject to reduction.
    (D) Actual adjustment of stock basis. Pursuant to paragraph 
(c)(2)(vi) of this section, Sec.  1.1502-32 is applied to reflect 
the amount of S2's income and gain included, and unlimited 
deductions and losses that are absorbed, in the tentative 
computation of tax imposed for the year of the disposition and the 
excluded COD income tentatively applied to reduce attributes and the 
attributes reduced in respect of the excluded COD income pursuant to 
the previous step. Under Sec.  1.1502-32, the absorption of $35 of 
S2's loss, the application of $15 in respect of S2's excluded COD 
income to reduce attributes, and the reduction of $15 in respect of 
the loss attributable to S2 reduced in respect of the excluded COD 
income results in a negative

[[Page 14403]]

adjustment of $35 to the basis of the S2 stock. Therefore, S1 has an 
excess loss account of $25 in the S2 stock.
    (E) Actual computation of stock gain or loss. Pursuant to 
paragraph (c)(2)(vii) of this section, S1's actual gain or loss, if 
any, on the S2 stock is computed. Because S2 realized $5 of excluded 
COD income that was not applied to reduce attributes, pursuant to 
Sec.  1.1502-19(b)(1) and (c)(1)(iii)(B), S1 is required to take 
into account $5 of its excess loss account in the S2 stock.
    (F) Actual computation of tax imposed. Pursuant to paragraph 
(c)(2)(viii) of this section, the tax imposed is computed by taking 
into account the $5 of the excess loss account in the S2 stock 
required to be taken into account. See Sec.  1.1502-28(b)(6) 
(requiring an excess loss account that is required to be taken into 
account as a result of the application of Sec.  1.1502-
19(c)(1)(iii)(B) to be included in the group's tax return for the 
year that includes the date of the debt discharge). However, 
pursuant to paragraph (c)(2)(viii) of this section, such amount may 
not be offset by any of the consolidated net operating loss 
attributable to S2. It may, however, subject to applicable 
limitations, be offset by the separate net operating loss of S1 from 
Year 1.
    (G) Actual reduction of attributes. Pursuant to paragraph 
(c)(2)(ix) of this section, sections 108 and 1017 and Sec.  1.1502-
28 are then actually applied to reduce attributes remaining after 
the actual computation of the tax imposed. Attributes will be 
actually reduced in the same way that they were tentatively reduced.

    (6) Additional rules for multiple dispositions. [Reserved]
    (7) Effective date. This paragraph (c) applies to dispositions of 
subsidiary stock that occur after March 22, 2005. Taxpayers may apply 
Sec.  1.1502-11(c) of REG-167265-03 (2004-15 IRB 730) (see Sec.  
601.601(d)(2) of this chapter) in whole, but not in part, to any 
disposition of subsidiary stock that occurs on or before March 22, 
2005, if a member of the group realized excluded COD income after 
August 29, 2003, in the taxable year that includes the date of the 
disposition of such subsidiary stock.
* * * * *

0
Par. 3. Section 1.1502-13 is amended as follows:
0
1. Three sentences are added at the end of paragraph (g)(3)(i)(A).
0
2. Paragraph (g)(3)(ii)(B) is revised.
0
3. Paragraph (g)(3)(ii)(C) is added.
    The revision and additions read as follows:


Sec.  1.1502-13  Intercompany transactions.

* * * * *
    (g) * * *
    (3) * * *
    (i) * * *
    (A) * * * For purposes of the preceding sentence, a reduction of 
the basis of an intercompany obligation pursuant to sections 108 and 
1017 and 1.1502-28 is not a comparable transaction. Notwithstanding 
paragraph (l) of this section, the preceding sentence applies to 
transactions or events occurring during a taxable year the original 
return for which is due (without regard to extensions) after March 21, 
2005. For transactions or events occurring during a taxable year the 
original return for which is due (without regard to extensions) on or 
before March 21, 2005, and after March 12, 2004, see Sec.  1.1502-
13T(g)(3)(ii)(B)(3) as contained in 26 CFR part 1 revised as of April 
1, 2004.
* * * * *
    (ii) * * *
    (B) Timing and attributes. For purposes of applying the matching 
rule and the acceleration rule--
    (1) Paragraph (c)(6)(ii) 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;
    (2) Paragraph (c)(6)(i) of this section (treatment of intercompany 
items if corresponding items are excluded or nondeductible) will not 
apply to exclude any amount of income or gain attributable to a 
reduction of the basis of an intercompany obligation pursuant to 
sections 108 and 1017 and Sec.  1.1502-28; and
    (3) Any gain or loss from an intercompany obligation is not subject 
to section 108(a), section 354 or section 1091.
    (C) Effective date. Notwithstanding paragraph (l) of this section, 
paragraph (g)(3)(ii)(B) of this section applies to transactions or 
events occurring during a taxable year the original return for which is 
due (without regard to extensions) after March 12, 2004. For 
transactions or events occurring during a taxable year the original 
return for which is due (without regard to extensions) on or before 
March 12, 2004, see Sec.  1.1502-13(g)(3)(ii)(B) as contained in 26 CFR 
part 1 revised as of April 1, 2003.
* * * * *


Sec.  1.1502-13T  [Removed]

0
Par. 4. Section 1.1502-13T is removed.

0
Par. 5. Section 1.1502-19 is amended as follows:
0
1. Paragraph (b)(1) is revised.
0
2. Paragraph (h)(2)(ii) is revised.
    The revisions read as follows:


Sec.  1.1502-19  Excess loss accounts.

* * * * *
    (b) * * *
    (1) Operating rules--(i) General rule. Except as provided in 
paragraph (b)(1)(ii) of this section, if P is treated under this 
section as disposing of a share of S's stock, P takes into account its 
excess loss account in the share as income or gain from the 
disposition.
    (ii) Special limitation on amount taken into account. 
Notwithstanding paragraph (b)(1)(i) of this section, if P is treated as 
disposing of a share of S's stock as a result of the application of 
paragraph (c)(1)(iii)(B) of this section, the aggregate amount of its 
excess loss account in the shares of S's stock that P takes into 
account as income or gain from the disposition shall not exceed the 
amount of S's indebtedness that is discharged that is neither included 
in gross income nor treated as tax-exempt income under Sec.  1.1502-
32(b)(3)(ii)(C)(1). If more than one share of S's stock has an excess 
loss account, such excess loss accounts shall be taken into account 
pursuant to the preceding sentence, to the extent possible, in a manner 
that equalizes the excess loss accounts in S's shares that have an 
excess loss account.
    (iii) Treatment of disposition. Except as provided in paragraph 
(b)(4) of this section, the disposition is treated as a sale or 
exchange for purposes of determining the character of the income or 
gain.
* * * * *
    (h) * * *
    (2) * * *
    (ii) Application of special limitation. If P was treated as 
disposing of stock of S because S was treated as worthless as a result 
of the application of paragraph (c)(1)(iii)(B) of this section after 
August 29, 2003, the amount of P's income, gain, deduction, or loss, 
and the stock basis reflected in that amount, are determined or 
redetermined with regard to paragraph (b)(1)(ii) of this section. If P 
was treated as disposing of stock of S because S was treated as 
worthless as a result of the application of paragraph (c)(1)(iii)(B) of 
this section on or before August 29, 2003, the group may determine or 
redetermine the amount of P's income, gain, deduction, or loss, and the 
stock basis reflected in that amount with regard to paragraph 
(b)(1)(ii) of this section.
* * * * *


Sec.  1.1502-19T  [Removed]

0
Par. 6. Section 1.1502-19T is removed.

0
Par. 7. In Sec.  1.1502-21, paragraphs (b)(1), (b)(2)(ii)(A), 
(b)(2)(iv), (c)(2)(vii), and (h)(6) are revised to read as follows:


Sec.  1.1502-21  Net operating losses.

* * * * *
    (b) * * *
    (1) Carryovers and carrybacks generally. The net operating loss

[[Page 14404]]

carryovers and carrybacks to a taxable year are determined under the 
principles of section 172 and this section. Thus, losses permitted to 
be absorbed in a consolidated return year generally are absorbed in the 
order of the taxable years in which they arose, and losses carried from 
taxable years ending on the same date, and which are available to 
offset consolidated taxable income for the year, generally are absorbed 
on a pro rata basis. In addition, the amount of any CNOL absorbed by 
the group in any year is apportioned among members based on the 
percentage of the CNOL attributable to each member as of the beginning 
of the year. The percentage of the CNOL attributable to a member is 
determined pursuant to paragraph (b)(2)(iv)(B) of this section. 
Additional rules provided under the Internal Revenue Code or 
regulations also apply. See, e.g., section 382(l)(2)(B) (if losses are 
carried from the same taxable year, losses subject to limitation under 
section 382 are absorbed before losses that are not subject to 
limitation under section 382). See paragraph (c)(1)(iii) of this 
section, Example 2, for an illustration of pro rata absorption of 
losses subject to a SRLY limitation. See Sec.  1.1502-21T(b)(3)(v) 
regarding the treatment of any loss that is treated as expired under 
Sec.  1.1502-35T(f)(1).
    (2) * * *
    (ii) Special rules--(A) Year of departure from group. If a 
corporation ceases to be a member during a consolidated return year, 
net operating loss carryovers attributable to the corporation are first 
carried to the consolidated return year, and then are subject to 
reduction under section 108 and Sec.  1.1502-28 in respect of discharge 
of indebtedness income that is realized by a member of the group and 
that is excluded from gross income under section 108(a). Only the 
amount so attributable that is not absorbed by the group in that year 
or reduced under section 108 and Sec.  1.1502-28 is carried to the 
corporation's first separate return year. For rules concerning a member 
departing a subgroup, see paragraph (c)(2)(vii) of this section.
* * * * *
    (iv) Operating rules--(A) Amount of CNOL attributable to a member. 
The amount of a CNOL that is attributable to a member shall equal the 
product of the CNOL and the percentage of the CNOL attributable to such 
member.
    (B) Percentage of CNOL attributable to a member--(1) In general. 
Except as provided in paragraph (b)(2)(iv)(B)(2) of this section, the 
percentage of the CNOL attributable to a member shall equal the 
separate net operating loss of the member for the year of the loss 
divided by the sum of the separate net operating losses for that year 
of all members having such losses. For this purpose, the separate net 
operating loss of a member is determined by computing the CNOL by 
reference to only the member's items of income, gain, deduction, and 
loss, including the member's losses and deductions actually absorbed by 
the group in the taxable year (whether or not absorbed by the member).
    (2) Special rules--(i) Carryback to a separate return year. If a 
portion of the CNOL attributable to a member for a taxable year is 
carried back to a separate return year, the percentage of the CNOL 
attributable to each member as of immediately after such portion of the 
CNOL is carried back shall be recomputed pursuant to paragraph 
(b)(2)(iv)(B)(2)(iv) of this section.
    (ii) Excluded discharge of indebtedness income. If during a taxable 
year a member realizes discharge of indebtedness income that is 
excluded from gross income under section 108(a) and such amount reduces 
any portion of the CNOL attributable to any member pursuant to section 
108 and Sec.  1.1502-28, the percentage of the CNOL attributable to 
each member as of immediately after the reduction of attributes 
pursuant to sections 108 and 1017 and Sec.  1.1502-28 shall be 
recomputed pursuant to paragraph (b)(2)(iv)(B)(2)(iv) of this section.
    (iii) Departing member. If during a taxable year a member that had 
a separate net operating loss for the year of the CNOL ceases to be a 
member, the percentage of the CNOL attributable to each member as of 
the first day of the following consolidated return year shall be 
recomputed pursuant to paragraph (b)(2)(iv)(B)(2)(iv) of this section.
    (iv) Recomputed percentage. The recomputed percentage of the CNOL 
attributable to each member shall equal the unabsorbed CNOL 
attributable to the member at the time of the recomputation divided by 
the sum of the unabsorbed CNOL attributable to all of the members at 
the time of the recomputation. For purposes of the preceding sentence, 
a CNOL that is reduced pursuant to section 108 and Sec.  1.1502-28 or 
that is otherwise permanently disallowed or eliminated shall be treated 
as absorbed.
* * * * *
    (c) * * *
    (2) * * *
    (vii) Corporations that leave a SRLY subgroup. If a loss member 
ceases to be affiliated with a SRLY subgroup, the amount of the 
member's remaining SRLY loss from a specific year is determined 
pursuant to the principles of paragraphs (b)(2)(ii)(A) and (b)(2)(iv) 
of this section.
* * * * *
    (h) * * *
    (6) Certain prior periods. Paragraphs (b)(1), (b)(2)(ii)(A), 
(b)(2)(iv), and (c)(2)(vii) of this section shall apply to taxable 
years the original return for which the due date (without regard to 
extensions) is after March 21, 2005. Paragraph (b)(2)(ii)(A) of this 
section and Sec.  1.1502-21T(b)(1), (b)(2)(iv), and (c)(2)(vii) as 
contained in 26 CFR part 1 revised as of April 1, 2004, shall apply to 
taxable years the original return for which the due date (without 
regard to extensions) is on or before March 21, 2005, and after August 
29, 2003. For taxable years the original return for which the due date 
(without regard to extensions) is on or before August 29, 2003, see 
paragraphs (b)(1), (b)(2)(ii)(A), (b)(2)(iv), and (c)(2)(vii) of this 
section and Sec.  1.1502-21T(b)(1) as contained in 26 CFR part 1 
revised as of April 1, 2003.
* * * * *

0
Par. 8. Section 1.1502-21T is amended as follows:
0
1. Paragraphs (a) through (b)(2)(v) are revised.
0
2. Paragraphs (c)(1) through (h)(7) are revised.
    The revisions read as follows:


Sec.  1.1502-21T  Net operating losses (temporary).

    (a) through (b)(2)(v) [Reserved]. For further guidance, see Sec.  
1.1502-21(a) through (b)(2)(v).
* * * * *
    (c)(1) through (h)(7) [Reserved]. For further guidance, see Sec.  
1.1502-21(c)(1) through (h)(7).
* * * * *

0
Par. 9. Section 1.1502-28 is added to read as follows:


Sec.  1.1502-28  Consolidated section 108.

    (a) In general. This section sets forth rules for the application 
of section 108(a) and the reduction of tax attributes pursuant to 
section 108(b) when a member of the group realizes discharge of 
indebtedness income that is excluded from gross income under section 
108(a) (excluded COD income).
    (1) Application of section 108(a). Section 108(a)(1)(A) and (B) is 
applied separately to each member that realizes excluded COD income. 
Therefore, the limitation of section 108(a)(3) on the amount of 
discharge of indebtedness income that is treated as excluded COD income 
is determined based on the assets (including stock and securities of

[[Page 14405]]

other members) and liabilities (including liabilities to other members) 
of only the member that realizes excluded COD income.
    (2) Reduction of tax attributes attributable to the debtor--(i) In 
general. With respect to a member that realizes excluded COD income in 
a taxable year, the tax attributes attributable to that member (and its 
direct and indirect subsidiaries to the extent required by section 
1017(b)(3)(D) and paragraph (a)(3) of this section), including basis of 
assets and losses and credits arising in separate return limitation 
years, shall be reduced as provided in sections 108 and 1017 and this 
section. Basis of subsidiary stock, however, shall not be reduced below 
zero pursuant to paragraph (a)(2) of this section (including when 
subsidiary stock is treated as depreciable property under section 
1017(b)(3)(D) when there is an election under section 108(b)(5)).
    (ii) Consolidated tax attributes attributable to a member. For 
purposes of this section, the amount of a consolidated tax attribute 
(e.g., a consolidated net operating loss) that is attributable to a 
member shall be determined pursuant to the principles of Sec.  1.1502-
21(b)(2)(iv). In addition, if the member is a member of a separate 
return limitation year subgroup, the amount of a tax attribute that 
arose in a separate return limitation year that is attributable to that 
member shall also be determined pursuant to the principles of Sec.  
1.1502-21(b)(2)(iv).
    (3) Look-through rules--(i) Priority of section 1017(b)(3)(D). If a 
member treats stock of a subsidiary as depreciable property pursuant to 
section 1017(b)(3)(D), the basis of the depreciable property of such 
subsidiary shall be reduced pursuant to section 1017(b)(3)(D) prior to 
the application of paragraph (a)(3)(ii) of this section.
    (ii) Application of additional look-through rule. If the basis of 
stock of a corporation (the lower-tier member) that is owned by another 
corporation (the higher-tier member) is reduced pursuant to sections 
108 and 1017 and paragraph (a)(2) of this section (but not as a result 
of treating subsidiary stock as depreciable property pursuant to 
section 1017(b)(3)(D)), and both of such corporations are members of 
the same consolidated group on the last day of the higher-tier member's 
taxable year that includes the date on which the excluded COD income is 
realized or the first day of the higher-tier member's taxable year that 
follows the taxable year that includes the date on which the excluded 
COD income is realized, solely for purposes of sections 108 and 1017 
and this section other than paragraphs (a)(4) and (b)(1) of this 
section, the lower-tier member shall be treated as realizing excluded 
COD income on the last day of the taxable year of the higher-tier 
member that includes the date on which the higher-tier member realized 
the excluded COD income. The amount of such excluded COD income shall 
be the amount of such basis reduction. Accordingly, the tax attributes 
attributable to such lower-tier member shall be reduced as provided in 
sections 108 and 1017 and this section. To the extent that the excluded 
COD income realized by the lower-tier member pursuant to this paragraph 
(a)(3) does not reduce a tax attribute attributable to the lower-tier 
member, such excluded COD income shall not be applied to reduce tax 
attributes attributable to any member under paragraph (a)(4) of this 
section and shall not cause an excess loss account to be taken into 
account under Sec.  1.1502-19(b)(1) and (c)(1)(iii)(B).
    (4) Reduction of certain tax attributes attributable to other 
members. To the extent that, pursuant to paragraph (a)(2) of this 
section, the excluded COD income is not applied to reduce the tax 
attributes attributable to the member that realizes the excluded COD 
income, after the application of paragraph (a)(3) of this section, such 
amount shall be applied to reduce the remaining consolidated tax 
attributes of the group, other than consolidated tax attributes to 
which a SRLY limitation applies, as provided in section 108 and this 
section. Such amount also shall be applied to reduce the tax attributes 
attributable to members that arose (or are treated as arising) in a 
separate return limitation year to the extent that the member that 
realizes excluded COD income is a member of the separate return 
limitation year subgroup with respect to such attribute if a SRLY 
limitation applies to the use of such attribute. In addition, such 
amount shall be applied to reduce the tax attributes attributable to 
members that arose in a separate return year or that arose (or are 
treated as arising) in a separate return limitation year if no SRLY 
limitation applies to the use of such attribute. The reduction of each 
tax attribute pursuant to the three preceding sentences shall be made 
in the order prescribed in section 108(b)(2) and pursuant to the 
principles of Sec.  1.1502-21(b)(1). Except as otherwise provided in 
this paragraph (a)(4), a tax attribute that arose in a separate return 
year or that arose (or is treated as arising) in a separate return 
limitation year is not subject to reduction pursuant to this paragraph 
(a)(4). Basis in assets is not subject to reduction pursuant to this 
paragraph (a)(4). Finally, to the extent that the realization of 
excluded COD income by a member pursuant to paragraph (a)(3) does not 
reduce a tax attribute attributable to such lower-tier member, such 
excess shall not be applied to reduce tax attributes attributable to 
any member pursuant to this paragraph (a)(4).
    (b) Special rules--(1) Multiple debtor members--(i) Reduction of 
tax attributes attributable to debtor members prior to reduction of 
consolidated tax attributes. If in a single taxable year multiple 
members realize excluded COD income, paragraphs (a)(2) and (3) of this 
section shall apply with respect to the excluded COD income of each 
such member before the application of paragraph (a)(4) of this section.
    (ii) Reduction of higher-tier debtor's tax attributes. If in a 
single taxable year multiple members realize excluded COD income and 
one such member is a higher-tier member of another such member, 
paragraphs (a)(2) and (3) of this section shall be applied with respect 
to the excluded COD income of the higher-tier member before such 
paragraphs are applied to the excluded COD income of the other such 
member. In applying the rules of paragraph (a)(2) and (3) of this 
section with respect to the excluded COD income of the higher-tier 
member, the liabilities that give rise to the excluded COD income of 
the other such member shall not be treated as discharged for purposes 
of computing the limitation on basis reduction under section 
1017(b)(2). A member (the first member) is a higher-tier member of 
another member (the second member) if the first member is the common 
parent or investment adjustments under Sec.  1.1502-32 with respect to 
the stock of the second member would affect investment adjustments with 
respect to the stock of the first member.
    (iii) Reduction of additional tax attributes. If more than one 
member realizes excluded COD income that has not been applied to reduce 
a tax attribute attributable to such member (the remaining COD amount) 
and the remaining tax attributes available for reduction under 
paragraph (a)(4) of this section are less than the aggregate of the 
remaining COD amounts, after the application of paragraph (a)(2) of 
this section, each such member's remaining COD amount shall be applied 
on a pro rata basis (based on the relative remaining COD amounts), 
pursuant to paragraph (a)(4) of this section, to reduce such remaining 
available tax attributes.
    (iv) Ownership of lower-tier member by multiple higher-tier 
members. If stock

[[Page 14406]]

of a corporation is held by more than one higher-tier member of the 
group and more than one such higher-tier member reduces its basis in 
such stock, then under paragraph (a)(3) of this section the excluded 
COD income resulting from the stock basis reductions shall be applied 
on a pro rata basis (based on the amount of excluded COD income caused 
by each basis reduction) to reduce the attributes of the corporation.
    (v) Ownership of lower-tier member by multiple higher-tier members 
in multiple groups. If a corporation is a member of one group (the 
first group) on the last day of the first group's higher-tier member's 
taxable year that includes the date on which that higher-tier member 
realizes excluded COD income and is a member of another group (the 
second group) on the following day and the first group's higher-tier 
member and the second group's higher-tier member both reduce their 
basis in the stock of such corporation pursuant to sections 108 and 
1017 and this section, paragraph (a)(3) of this section shall first be 
applied in respect of the excluded COD income that results from the 
reduction of the basis of the corporation's stock owned by the first 
group's higher-tier member and then shall be applied in respect of the 
excluded COD income that results from the reduction of the basis of the 
corporation's stock owned by the second group's higher-tier member.
    (2) Election under section 108(b)(5)--(i) Availability of election. 
The group may make the election described in section 108(b)(5) for any 
member that realizes excluded COD income. The election is made 
separately for each member. Therefore, an election may be made for one 
member that realizes excluded COD income (either actually or pursuant 
to paragraph (a)(3) of this section) while another election, or no 
election, may be made for another member that realizes excluded COD 
income (either actually or pursuant to paragraph (a)(3) of this 
section). See Sec.  1.108-4 for rules relating to the procedure for 
making an election under section 108(b)(5).
    (ii) Treatment of shares with an excess loss account. For purposes 
of applying section 108(b)(5)(B), the basis of stock of a subsidiary 
that has an excess loss account shall be treated as zero.
    (3) Application of section 1017--(i) Timing of basis reduction. 
Basis of property shall be subject to reduction pursuant to the rules 
of sections 108 and 1017 and this section after the determination of 
the tax imposed by chapter 1 of the Internal Revenue Code for the 
taxable year during which the member realizes excluded COD income and 
any prior years and coincident with the reduction of other attributes 
pursuant to section 108 and this section. However, only the basis of 
property held as of the beginning of the taxable year following the 
taxable year during which the excluded COD income is realized is 
subject to reduction pursuant to sections 108 and 1017 and this 
section.
    (ii) Limitation of section 1017(b)(2). The limitation of section 
1017(b)(2) on the reduction in basis of property shall be applied by 
reference to the aggregate of the basis of the property held by the 
member that realizes excluded COD income, not the aggregate of the 
basis of the property held by all of the members of the group, and the 
liabilities of such member, not the aggregate liabilities of all of the 
members of the group.
    (iii) Treatment of shares with an excess loss account. For purposes 
of applying section 1017(b)(2) and Sec.  1.1017-1, the basis of stock 
of a subsidiary that has an excess loss account shall be treated as 
zero.
    (4) Application of section 1245. Notwithstanding section 
1017(d)(1)(B), a reduction of the basis of subsidiary stock is treated 
as a deduction allowed for depreciation only to the extent that the 
amount by which the basis of the subsidiary stock is reduced exceeds 
the total amount of the attributes attributable to such subsidiary that 
are reduced pursuant to the subsidiary's consent under section 
1017(b)(3)(D) or as a result of the application of paragraph (a)(3)(ii) 
of this section.
    (5) Reduction of basis of intercompany obligations and former 
intercompany obligations--(i) Intercompany obligations that cease to be 
intercompany obligations. If excluded COD income is realized in a 
consolidated return year in which an intercompany obligation becomes an 
obligation that is not an intercompany obligation because the debtor or 
the creditor becomes a nonmember or because the assets of the creditor 
are acquired by a nonmember in a transaction to which section 381(a) 
applies, the basis of such intercompany obligation is not available for 
reduction in respect of such excluded COD income pursuant to sections 
108 and 1017 and this section. However, in such cases, the basis of the 
debt treated as new debt issued under Sec.  1.1502-13(g)(3) is 
available for reduction in respect of such excluded COD income pursuant 
to sections 108 and 1017 and this section.
    (ii) Intercompany obligations. The reduction of the basis of an 
intercompany obligation pursuant to sections 108 and 1017 and this 
section shall not result in the satisfaction and reissuance of the 
obligation under Sec.  1.1502-13(g). Therefore, any income or gain (or 
reduction of loss or deduction) attributable to a reduction of the 
basis of an intercompany obligation will be taken into account when 
Sec.  1.1502-13(g)(3) applies to such obligation. Furthermore, Sec.  
1.1502-13(c)(6)(i) (regarding the treatment of intercompany items if 
corresponding items are excluded or nondeductible) will not apply to 
exclude any amount of income or gain attributable to a reduction of the 
basis of an intercompany obligation pursuant to sections 108 and 1017 
and this section. See Sec.  1.1502-13(g)(3)(i)(A) and (ii)(B)(2).
    (6) Taking into account excess loss account--(i) Determination of 
inclusion. The determination of whether any portion of an excess loss 
account in a share of stock of a subsidiary that realizes excluded COD 
income is required to be taken into account as a result of the 
application of Sec.  1.1502-19(c)(1)(iii)(B) is made after the 
determination of the tax imposed by chapter 1 of the Internal Revenue 
Code for the year during which the member realizes excluded COD income 
(without regard to whether any portion of an excess loss account in a 
share of stock of the subsidiary is required to be taken into account) 
and any prior years, after the reduction of tax attributes pursuant to 
sections 108 and 1017 and this section, and after the adjustment of the 
basis of the share of stock of the subsidiary pursuant to Sec.  1.1502-
32 to reflect the amount of the subsidiary's deductions and losses that 
are absorbed in the computation of taxable income (or loss) for the 
year of the disposition and any prior years, and the excluded COD 
income applied to reduce attributes and the attributes reduced in 
respect thereof. See Sec.  1.1502-11(c) for special rules related to 
the computation of tax that apply when an excess loss account is 
required to be taken into account.
    (ii) Timing of inclusion. To the extent an excess loss account in a 
share of stock of a subsidiary that realizes excluded COD income is 
required to be taken into account as a result of the application of 
Sec.  1.1502-19(c)(1)(iii)(B), such amount shall be included on the 
group's tax return for the taxable year that includes the date on which 
the subsidiary realizes such excluded COD income.
    (7) Dispositions of stock. See Sec.  1.1502-11(c) for limitations 
on the reduction of tax attributes when a member disposes of stock of 
another member (including dispositions that result from the application 
of Sec.  1.1502-

[[Page 14407]]

19(c)(1)(iii)(B)) during a taxable year in which any member realizes 
excluded COD income.
    (8) Departure of member. If the taxable year of a member (the 
departing member) during which such member realizes excluded COD income 
ends on or prior to the last day of the consolidated return year and, 
on the first day of the taxable year of such member that follows the 
taxable year during which such member realizes excluded COD income, 
such member is not a member of the group and does not have a successor 
member (within the meaning of paragraph (b)(10) of this section), all 
tax attributes listed in section 108(b)(2) that remain after the 
determination of the tax imposed that belong to members of the group 
(including the departing member and subsidiaries of the departing 
member) shall be subject to reduction as provided in section 108 and 
the regulations promulgated thereunder (including Sec.  1.108-7(c), if 
applicable) and this section.
    (9) Intragroup reorganization--(i) In general. If the taxable year 
of a member during which such member realizes excluded COD income ends 
prior to the last day of the consolidated return year and, on the first 
day that follows the taxable year of such member during which such 
member realizes excluded COD income, such member has a successor 
member, for purposes of applying the rules of sections 108 and 1017 and 
this section, notwithstanding Sec.  1.108-7, the successor member shall 
be treated as the member that realized the excluded COD income. Thus, 
all attributes attributable to the successor member listed in section 
108(b)(2) (including attributes that were attributable to the successor 
member prior to the date such member became a successor member) are 
available for reduction under paragraph (a)(2) of this section.
    (ii) Group structure change. If a member that realizes excluded COD 
income acquires the assets of the common parent of the consolidated 
group in a transaction to which section 381(a) applies and succeeds 
such common parent under the principles of Sec.  1.1502-75(d)(2) as the 
common parent of the consolidated group, the member's attributes that 
remain after the determination of tax for the group for the 
consolidated return year during which the excluded COD income is 
realized (and any prior years) (including attributes that were 
attributable to the former common parent prior to the date of the 
transaction to which section 381(a) applies) shall be available for 
reduction under paragraph (a)(2) of this section.
    (10) Definition of successor member. A successor member means a 
person to which the member that realizes excluded COD income (or a 
successor member) transfers its assets in a transaction to which 
section 381(a) applies if such transferee is a member of the group 
immediately after the transaction.
    (11) Non-application of next day rule. For purposes of applying the 
rules of sections 108 and 1017 and this section, the next day rule of 
Sec.  1.1502-76(b)(1)(ii)(B) shall not apply to treat a member's 
excluded COD income as realized at the beginning of the day following 
the day on which such member's status as a member changes.
    (c) Examples. The principles of paragraphs (a) and (b) of this 
section are illustrated by the following examples. Unless otherwise 
indicated, no election under section 108(b)(5) has been made and the 
taxable year of all consolidated groups is the calendar year. The 
examples are as follows:

    Example 1. (i) Facts. P is the common parent of a consolidated 
group that includes subsidiary S1. P owns 80 percent of the stock of 
S1. In Year 1, the P group sustained a $250 consolidated net 
operating loss. Under the principles of Sec.  1.1502-21(b)(2)(iv), 
of that amount, $125 was attributable to P and $125 was attributable 
to S1. On Day 1 of Year 2, P acquired 100 percent of the stock of 
S2, and S2 joined the P group. As of the beginning of Year 2, S2 had 
a $50 net operating loss carryover from Year 1, a separate return 
limitation year. In Year 2, the P group sustained a $200 
consolidated net operating loss. Under the principles of Sec.  
1.1502-21(b)(2)(iv), of that amount, $90 was attributable to P, $70 
was attributable to S1, and $40 was attributable to S2. In Year 3, 
S2 realized $200 of excluded COD income from the discharge of non-
intercompany indebtedness. In that same year, the P group sustained 
a $50 consolidated net operating loss, of which $40 was attributable 
to S1 and $10 was attributable to S2 under the principles of Sec.  
1.1502-21(b)(2)(iv). As of the beginning of Year 4, S2 had Asset A 
with a fair market value of $10. After the computation of tax 
imposed for Year 3 and before the application of sections 108 and 
1017 and this section, Asset A had a basis of $40 and S2 had no 
liabilities.
    (ii) Analysis--(A) Reduction of tax attributes attributable to 
debtor. Pursuant to paragraph (a)(2) of this section, the tax 
attributes attributable to S2 must first be reduced to take into 
account its excluded COD income in the amount of $200.
    (1) Reduction of net operating losses. Pursuant to section 
108(b)(2)(A) and paragraph (a) of this section, the net operating 
loss and the net operating loss carryovers attributable to S2 under 
the principles of Sec.  1.1502-21(b)(2)(iv) are reduced in the order 
prescribed by section 108(b)(4)(B). Accordingly, the consolidated 
net operating loss for Year 3 is reduced by $10, the portion of the 
consolidated net operating loss attributable to S2, to $40. Then, 
again pursuant to section 108(b)(4)(B), S2's net operating loss 
carryover of $50 from its separate return limitation year is reduced 
to $0. Finally, the consolidated net operating loss carryover from 
Year 2 is reduced by $40, the portion of that consolidated net 
operating loss carryover attributable to S2, to $160.
    (2) Reduction of basis. Following the reduction of the net 
operating loss and the net operating loss carryovers attributable to 
S2, S2 reduces its basis in its assets pursuant to section 1017 and 
Sec.  1.1017-1. Accordingly, S2 reduces its basis in Asset A by $40, 
from $40 to $0.
    (B) Reduction of remaining consolidated tax attributes. The 
remaining $60 of excluded COD income then reduces consolidated tax 
attributes pursuant to paragraph (a)(4) of this section. In 
particular, the remaining $40 consolidated net operating loss for 
Year 3 is reduced to $0. Then, the consolidated net operating loss 
carryover from Year 1 is reduced by $20 from $250 to $230. Pursuant 
to paragraph (a)(4) of this section, a pro rata amount of the 
consolidated net operating loss carryover from Year 1 that is 
attributable to each of P and S1 is treated as reduced. Therefore, 
$10 of the consolidated net operating loss carryover from Year 1 
that is attributable to each of P and S1 is treated as reduced.
    Example 2. (i) Facts. P is the common parent of a consolidated 
group that includes subsidiaries S1 and S2. P owns 100 percent of 
the stock of S1 and S1 owns 100 percent of the stock of S2. None of 
P, S1, or S2 has a separate return limitation year. In Year 1, the P 
group sustained a $50 consolidated net operating loss. Under the 
principles of Sec.  1.1502-21(b)(2)(iv), of that amount, $10 was 
attributable to P, $20 was attributable to S1, and $20 was 
attributable to S2. In Year 2, the P group sustained a $70 
consolidated net operating loss. Under the principles of Sec.  
1.1502-21(b)(2)(iv), of that amount, $30 was attributable to P, $30 
was attributable to S1, and $10 was attributable to S2. In Year 3, 
S1 realized $170 of excluded COD income from the discharge of non-
intercompany indebtedness. In that same year, the P group sustained 
a $50 consolidated net operating loss, of which $10 was attributable 
to S1 and $40 was attributable to S2 under the principles of Sec.  
1.1502-21(b)(2)(iv). As of the beginning of Year 4, S1's sole asset 
was the stock of S2, and S2 had Asset A with a $10 value. After the 
computation of tax imposed for Year 3 and before the application of 
sections 108 and 1017 and this section, S1 had an $80 basis in the 
S2 stock, Asset A had a basis of $0, and neither S1 nor S2 had any 
liabilities.
    (ii) Analysis--(A) Reduction of tax attributes attributable to 
debtor. Pursuant to paragraph (a)(2) of this section, the tax 
attributes attributable to S1 must first be reduced to take into 
account its excluded COD income in the amount of $170.
    (1) Reduction of net operating losses. Pursuant to section 
108(b)(2)(A) and paragraph (a) of this section, the net operating 
loss and the net operating loss carryovers attributable to S1 under 
the

[[Page 14408]]

principles of Sec.  1.1502-21(b)(2)(iv) are reduced in the order 
prescribed by section 108(b)(4)(B). Accordingly, the consolidated 
net operating loss for Year 3 is reduced by $10, the portion of the 
consolidated net operating loss for Year 3 attributable to S1, to 
$40. Then, the consolidated net operating loss carryover from Year 1 
is reduced by $20, the portion of that consolidated net operating 
loss carryover attributable to S1, to $30, and the consolidated net 
operating loss carryover from Year 2 is reduced by $30, the portion 
of that consolidated net operating loss carryover attributable to 
S1, to $40.
    (2) Reduction of basis. Following the reduction of the net 
operating loss and the net operating loss carryovers attributable to 
S1, S1 reduces its basis in its assets pursuant to section 1017 and 
Sec.  1.1017-1. Accordingly, S1 reduces its basis in the stock of S2 
by $80, from $80 to $0.
    (3) Tiering down of stock basis reduction. Pursuant to paragraph 
(a)(3) of this section, for purposes of sections 108 and 1017 and 
this section, S2 is treated as realizing $80 of excluded COD income. 
Pursuant to section 108(b)(2)(A) and paragraph (a) of this section, 
therefore, the net operating loss and net operating loss carryovers 
attributable to S2 under the principles of Sec.  1.1502-21(b)(2)(iv) 
are reduced in the order prescribed by section 108(b)(4)(B). 
Accordingly, the consolidated net operating loss for Year 3 is 
reduced by an additional $40, the portion of the consolidated net 
operating loss for Year 3 attributable to S2, to $0. Then, the 
consolidated net operating loss carryover from Year 1 is reduced by 
$20, the portion of that consolidated net operating loss carryover 
attributable to S2, to $10. Then, the consolidated net operating 
loss carryover from Year 2 is reduced by $10, the portion of that 
consolidated net operating loss carryover attributable to S2, to 
$30. S2's remaining $10 of excluded COD income does not reduce 
consolidated tax attributes attributable to P or S1 under paragraph 
(a)(4) of this section.
    (B) Reduction of remaining consolidated tax attributes. Finally, 
pursuant to paragraph (a)(4) of this section, S1's remaining $30 of 
excluded COD income reduces the remaining consolidated tax 
attributes. In particular, the remaining $10 consolidated net 
operating loss carryover from Year 1 is reduced by $10 to $0, and 
the remaining $30 consolidated net operating loss carryover from 
Year 2 is reduced by $20 to $10.
    Example 3. (i) Facts. P is the common parent of a consolidated 
group that includes subsidiaries S1, S2, and S3. P owns 100 percent 
of the stock of S1, S1 owns 100 percent of the stock of S2, and S2 
owns 100 percent of the stock of S3. None of P, S1, S2, or S3 had a 
separate return limitation year prior to Year 1. In Year 1, the P 
group sustained a $150 consolidated net operating loss. Under the 
principles of Sec.  1.1502-21(b)(2)(iv), of that amount, $50 was 
attributable to S2, and $100 was attributable to S3. In Year 2, the 
P group sustained a $50 consolidated net operating loss. Under the 
principles of Sec.  1.1502-21(b)(2)(iv), of that amount, $40 was 
attributable to S1 and $10 was attributable to S2. In Year 3, S1 
realized $170 of excluded COD income from the discharge of non-
intercompany indebtedness. In that same year, the P group sustained 
a $50 consolidated net operating loss, of which $10 was attributable 
to S1, $20 was attributable to S2, and $20 was attributable to S3 
under the principles of Sec.  1.1502-21(b)(2)(iv). At the beginning 
of Year 4, S1's only asset was the stock of S2, and S2's only asset 
was the stock of S3 with a value of $10. After the computation of 
tax imposed for Year 3 and before the application of sections 108 
and 1017 and this section, S1's stock of S2 had a basis of $120 and 
S2's stock of S3 had a basis of $180. In addition, none of S1, S2, 
and S3 had any liabilities.
    (ii) Analysis--(A) Reduction of tax attributes attributable to 
debtor. Pursuant to paragraph (a)(2) of this section, the tax 
attributes attributable to S1 must first be reduced to take into 
account its excluded COD income in the amount of $170.
    (1) Reduction of net operating losses. Pursuant to section 
108(b)(2)(A) and paragraph (a) of this section, the net operating 
loss and the net operating loss carryovers attributable to S1 under 
the principles of Sec.  1.1502-21(b)(2)(iv) are reduced in the order 
prescribed by section 108(b)(4)(B). Accordingly, the consolidated 
net operating loss for Year 3 is reduced by $10, the portion of the 
consolidated net operating loss attributable to S1, to $40. Then, 
the consolidated net operating loss carryover from Year 2 is reduced 
by $40, the portion of that consolidated net operating loss 
carryover attributable to S1, to $10.
    (2) Reduction of basis. Following the reduction of the net 
operating loss and the net operating loss carryovers attributable to 
S1, S1 reduces its basis in its assets pursuant to section 1017 and 
Sec.  1.1017-1. Accordingly, S1 reduces its basis in the stock of S2 
by $120, from $120 to $0.
    (B) Tiering down of stock basis reduction to S2. Pursuant to 
paragraph (a)(3) of this section, for purposes of sections 108 and 
1017 and this section, S2 is treated as realizing $120 of excluded 
COD income. Pursuant to section 108(b)(2)(A) and paragraph (a) of 
this section, therefore, the net operating loss and net operating 
loss carryovers attributable to S2 under the principles of Sec.  
1.1502-21(b)(2)(iv) are reduced in the order prescribed by section 
108(b)(4)(B). Accordingly, the consolidated net operating loss for 
Year 3 is further reduced by $20, the portion of the consolidated 
net operating loss attributable to S2, to $20. Then, the 
consolidated net operating loss carryover from Year 1 is reduced by 
$50, the portion of that consolidated net operating loss carryover 
attributable to S2, to $100. Then, the consolidated net operating 
loss carryover from Year 2 is further reduced by $10, the portion of 
that consolidated net operating loss carryover attributable to S2, 
to $0. Following the reduction of the net operating loss and the net 
operating loss carryovers attributable to S2, S2 reduces its basis 
in its assets pursuant to section 1017 and Sec.  1.1017-1. 
Accordingly, S2 reduces its basis in its S3 stock by $40 to $140.
    (C) Tiering down of stock basis reduction to S3. Pursuant to 
paragraph (a)(3) of this section, for purposes of sections 108 and 
1017 and this section, S3 is treated as realizing $40 of excluded 
COD income. Pursuant to section 108(b)(2)(A) and paragraph (a) of 
this section, therefore, the net operating loss and the net 
operating loss carryovers attributable to S3 under the principles of 
Sec.  1.1502-21(b)(2)(iv) are reduced in the order prescribed by 
section 108(b)(4)(B). Accordingly, the consolidated net operating 
loss for Year 3 is further reduced by $20, the portion of the 
consolidated net operating loss attributable to S3, to $0. Then, the 
consolidated net operating loss carryover from Year 1 is reduced by 
$20, the lesser of the portion of that consolidated net operating 
loss carryover attributable to S3 and the remaining excluded COD 
income, to $80.
    Example 4. (i) Facts. P is the common parent of a consolidated 
group that includes subsidiaries S1, S2, and S3. P owns 100 percent 
of the stock of each of S1 and S2. Each of S1 and S2 owns stock of 
S3 that represents 50 percent of the value of the stock of S3. None 
of P, S1, S2, or S3 had a separate return limitation year prior to 
Year 1. In Year 1, the P group sustained a $160 consolidated net 
operating loss. Under the principles of Sec.  1.1502-21(b)(2)(iv), 
of that amount, $10 was attributable to P, $50 was attributable to 
S2, and $100 was attributable to S3. In Year 2, the P group 
sustained a $110 consolidated net operating loss. Under the 
principles of Sec.  1.1502-21(b)(2)(iv), of that amount, $40 was 
attributable to S1 and $70 was attributable to S2. In Year 3, S1 
realized $200 of excluded COD income from the discharge of non-
intercompany indebtedness, and S2 realized $270 of excluded COD 
income from the discharge of non-intercompany indebtedness. In that 
same year, the P group sustained a $50 consolidated net operating 
loss, of which $10 was attributable to S1, $20 was attributable to 
S2, and $20 was attributable to S3 under the principles of Sec.  
1.1502-21(b)(2)(iv). At the beginning of Year 4, S3 had one asset 
with a value of $10. After the computation of tax imposed for Year 3 
and before the application of sections 108 and 1017 and this 
section, S1's basis in its S3 stock was $60, S2's basis in its S3 
stock was $120, and S3's asset had a basis of $200. In addition, 
none of S1, S2, and S3 had any liabilities.
    (ii) Analysis--(A) Reduction of tax attributes attributable to 
debtors. Pursuant to paragraph (b)(1)(i) of this section, the tax 
attributes attributable to each of S1 and S2 are reduced pursuant to 
paragraph (a)(2) of this section. Then, pursuant to paragraph (a)(3) 
of this section, the tax attributes attributable to S3 are reduced 
so as to reflect a reduction of S1's and S2's basis in the stock of 
S3. Then, paragraph (a)(4) is applied to reduce additional tax 
attributes.
    (1) Reduction of net operating losses generally. Pursuant to 
section 108(b)(2)(A) and paragraph (a) of this section, the net 
operating losses and the net operating loss carryovers attributable 
to S1 and S2 under the principles of Sec.  1.1502-21(b)(2)(iv) are 
reduced in the order prescribed by section 108(b)(4)(B).
    (2) Reduction of net operating losses attributable to S1. The 
consolidated net operating loss for Year 3 is reduced by $10,

[[Page 14409]]

the portion of the consolidated net operating loss attributable to 
S1, to $40. Then, the consolidated net operating loss carryover from 
Year 2 is reduced by $40, the portion of that consolidated net 
operating loss carryover attributable to S1, to $70.
    (3) Reduction of net operating losses attributable to S2. The 
consolidated net operating loss for Year 3 is also reduced by $20, 
the portion of the consolidated net operating loss attributable to 
S2, to $20. Then, the consolidated net operating loss carryover from 
Year 1 is reduced by $50, the portion of that consolidated net 
operating loss carryover attributable to S2, to $110. Then, the 
consolidated net operating loss carryover from Year 2 is reduced by 
$70, the portion of that consolidated net operating loss carryover 
attributable to S2, to $0.
    (4) Reduction of basis. Following the reduction of the net 
operating losses and the net operating loss carryovers attributable 
to S1 and S2, S1 and S2 must reduce their basis in their assets 
pursuant to section 1017 and Sec.  1.1017-1. Accordingly, S1 reduces 
its basis in the stock of S3 by $60, from $60 to $0, and S2 reduces 
its basis in the stock of S3 by $120, from $120 to $0.
    (B) Tiering down of basis reduction. Pursuant to paragraph 
(a)(3) of this section, for purposes of sections 108 and 1017 and 
this section, S3 is treated as realizing $180 of excluded COD 
income. Pursuant to section 108(b)(2)(A) and paragraph (a) of this 
section, therefore, the net operating loss and the net operating 
loss carryovers attributable to S3 under the principles of Sec.  
1.1502-21(b)(2)(iv) are reduced in the order prescribed by section 
108(b)(4)(B). Accordingly, the consolidated net operating loss for 
Year 3 is further reduced by $20, the portion of the consolidated 
net operating loss attributable to S3, to $0. Then, the consolidated 
net operating loss carryover from Year 1 is reduced by $100, the 
portion of that consolidated net operating loss carryover 
attributable to S3, to $10. Following the reduction of the net 
operating loss and the net operating loss carryover attributable to 
S3, S3 reduces its basis in its asset pursuant to section 1017 and 
Sec.  1.1017-1. Accordingly, S3 reduces its basis in its asset by 
$60, from $200 to $140.
    (C) Reduction of remaining consolidated tax attributes. Finally, 
pursuant to paragraph (a)(4) of this section, the remaining $90 of 
S1's excluded COD income and the remaining $10 of S2's excluded COD 
income reduce the remaining consolidated tax attributes. In 
particular, the remaining $10 consolidated net operating loss 
carryover from Year 1 is reduced by $10 to $0. Because that amount 
is less than the aggregate amount of remaining excluded COD income, 
such income is applied on a pro rata basis to reduce the remaining 
consolidated tax attributes. Accordingly, $9 of S1's remaining 
excluded COD income and $1 of S2's remaining excluded COD income is 
applied to reduce the remaining consolidated net operating loss 
carryover from Year 1. Consequently, of S1's excluded COD income of 
$200, only $119 is applied to reduce tax attributes, and, of S2's 
excluded COD income of $270, only $261 is applied to reduce tax 
attributes.
    Example 5. (i) Facts. P is the common parent of a consolidated 
group that includes subsidiaries S1, S2, and S3. P owns 100 percent 
of the stock of S1 and S2, and S1 owns 100 percent of the stock of 
S3. None of P, S1, S2, or S3 has a separate return limitation year 
prior to Year 1. In Year 1, the P group sustained a $90 consolidated 
net operating loss. Under the principles of Sec.  1.1502-
21(b)(2)(iv), of that amount, $10 was attributable to P, $15 was 
attributable to S1, $20 was attributable to S2, and $45 was 
attributable to S3. On January 1 of Year 2, P realized $140 of 
excluded COD income from the discharge of non-intercompany 
indebtedness. On December 31 of Year 2, S1 issued stock representing 
50 percent of the vote and value of its outstanding stock to a 
person that was not a member of the group. As a result of the 
issuance of stock, S1 and S3 ceased to be members of the P group. 
For the consolidated return year of Year 2, the P group sustained a 
$60 consolidated net operating loss, of which $5 was attributable to 
S1, $40 was attributable to S2, and $15 was attributable to S3 under 
the principles of Sec.  1.1502-21(b)(2)(iv). As of the beginning of 
Year 3, P's only assets were the stock of S1 and S2, S1's sole asset 
was the stock of S3, S2 had Asset A with a value of $10, and S3 had 
Asset B with a value of $10. After the computation of tax imposed 
for Year 2 and before the application of sections 108 and 1017 and 
this section, P had a $80 basis in the S1 stock and a $50 basis in 
the S2 stock, S1 had a $80 basis in the S3 stock, and Asset A and B 
each had a basis of $10. In addition, none of P, S1, S2, and S3 had 
any liabilities.
    (ii) Analysis. Pursuant to paragraph (a)(2) of this section, the 
tax attributes attributable to P must first be reduced to take into 
account its excluded COD income in the amount of $140.
    (A) Reduction of net operating losses. Pursuant to section 
108(b)(2)(A) and paragraph (a) of this section, the net operating 
loss and the net operating loss carryover attributable to P under 
the principles of Sec.  1.1502-21(b)(2)(iv) are reduced in the order 
prescribed by section 108(b)(4)(B). Accordingly, the consolidated 
net operating loss carryover from Year 1 is reduced by $10, the 
portion of that consolidated net operating loss carryover 
attributable to P, to $80.
    (B) Reduction of basis. Following the reduction of the net 
operating loss and the net operating loss carryover attributable to 
P, P reduces its basis in its assets pursuant to section 1017 and 
Sec.  1.1017-1. Accordingly, P reduces its basis in the stock of S1 
by $80, from $80 to $0, and its basis in the stock of S2 by $50, 
from $50 to $0.
    (C) Tiering down of stock basis reduction to S1. Pursuant to 
paragraph (a)(3) of this section, for purposes of sections 108 and 
1017 and this section, S1 is treated as realizing $80 of excluded 
COD income, despite the fact that it ceases to be a member of the 
group at the end of the day on December 31 of Year 2. Pursuant to 
section 108(b)(2)(A) and paragraph (a) of this section, therefore, 
the net operating loss and net operating loss carryovers 
attributable to S1 under the principles of Sec.  1.1502-21(b)(2)(iv) 
are reduced in the order prescribed by section 108(b)(4)(B). 
Accordingly, the consolidated net operating loss for Year 2 is 
reduced by $5, the portion of the consolidated net operating loss 
for Year 2 attributable to S1, to $55. Then, the consolidated net 
operating loss carryover from Year 1 is reduced by an additional 
$15, the portion of that consolidated net operating loss carryover 
attributable to S1, to $65. Following the reduction of the net 
operating loss and the net operating loss carryover attributable to 
S1, S1 reduces its basis in its assets pursuant to section 1017 and 
Sec.  1.1017-1. Accordingly, S1 reduces its basis in the stock of S3 
by $60, from $80 to $20.
    (D) Tiering down of stock basis reduction to S2. Pursuant to 
paragraph (a)(3) of this section, for purposes of sections 108 and 
1017 and this section, S2 is treated as realizing $50 of excluded 
COD income. Pursuant to section 108(b)(2)(A) and paragraph (a) of 
this section, therefore, the net operating loss and net operating 
loss carryovers attributable to S2 under the principles of Sec.  
1.1502-21(b)(2)(iv) are reduced in the order prescribed by section 
108(b)(4)(B). Accordingly, the consolidated net operating loss for 
Year 2 is reduced by an additional $40, the portion of the 
consolidated net operating loss for Year 2 attributable to S2, to 
$15. Then, the consolidated net operating loss carryover from Year 1 
is reduced by an additional $10, a portion of the consolidated net 
operating loss carryover attributable to S2, to $55.
    (E) Tiering down of stock basis reduction to S3. Pursuant to 
paragraph (a)(3) of this section, for purposes of sections 108 and 
1017 and this section, S3 is treated as realizing $60 of excluded 
COD income (by reason of S1's reduction in its basis of its S3 
stock). Pursuant to section 108(b)(2)(A) and paragraph (a) of this 
section, therefore, the net operating loss and net operating loss 
carryovers attributable to S3 under the principles of Sec.  1.1502-
21(b)(2)(iv) are reduced in the order prescribed by section 
108(b)(4)(B). Accordingly, the consolidated net operating loss for 
Year 2 is reduced by an additional $15, the portion of the 
consolidated net operating loss for Year 2 attributable to S3, to 
$0. Then, the consolidated net operating loss carryover from Year 1 
is reduced by an additional $45, the portion of that consolidated 
net operating loss carryover attributable to S3, to $10.
    Example 6. (i) Facts. P1 is the common parent of a consolidated 
group that includes subsidiaries S1, S2, and S3. P1 owns 100 percent 
of the stock of S1 and S2. S1 owns 100 percent of the stock of S3. 
None of P1, S1, S2, or S3 has a separate return limitation year 
prior to Year 1. In Year 1, the P1 group sustained a $120 
consolidated net operating loss. Under the principles of Sec.  
1.1502-21(b)(2)(iv), of that amount, $40 was attributable to P1, $35 
was attributable to S1, $30 was attributable to S2, and $15 was 
attributable to S3. On January 1 of Year 2, S3 realized $65 of 
excluded COD income from the discharge of non-intercompany 
indebtedness. On June 30 of Year 2, S3 issued stock representing 80 
percent of the vote and value of its outstanding stock to P2, the 
common parent of another group. As a result of the issuance of 
stock, S3 ceased to

[[Page 14410]]

be a member of the P1 group and became a member of the P2 group. For 
the consolidated return year of Year 2, the P1 group sustained a $50 
consolidated net operating loss, of which $5 was attributable to S1, 
$40 was attributable to S2, and $5 was attributable to S3 under the 
principles of Sec.  1.1502-21(b)(2)(iv). As of the beginning of its 
taxable year beginning on July 1 of Year 2, S3's sole asset was 
Asset A with a $10 value. After the computation of tax imposed for 
Year 2 on the P1 group and before the application of sections 108 
and 1017 and this section and the computation of tax imposed for 
Year 2 on the P2 group, Asset A had a basis of $0. In addition, S3 
had no liabilities. On January 1 of Year 3, P1 sold all of its stock 
of S1.
    (ii) Analysis--(A) Reduction of tax attributes attributable to 
debtor. Pursuant to paragraph (a)(2) of this section, the tax 
attributes attributable to S3 must first be reduced to take into 
account its excluded COD income in the amount of $65. Pursuant to 
section 108(b)(2)(A) and paragraph (a) of this section, the net 
operating loss and the net operating loss carryover attributable to 
S3 under the principles of Sec.  1.1502-21(b)(2)(iv) are reduced in 
the order prescribed by section 108(b)(4)(B). Accordingly, the 
consolidated net operating loss for Year 2 is reduced by $5, the 
portion of the consolidated net operating loss for Year 2 
attributable to S3, to $45. Then, the consolidated net operating 
loss carryover from Year 1 is reduced by $15, the portion of that 
consolidated net operating loss carryover attributable to S3, to 
$105.
    (B) Reduction of remaining consolidated tax attributes. Pursuant 
to paragraphs (a)(4) and (b)(8) of this section, S3's remaining $45 
of excluded COD income reduces the remaining consolidated tax 
attributes in the P1 group. In particular, the remaining $45 
consolidated net operating loss for Year 2 is reduced by an 
additional $45 to $0.
    (C) Basis Adjustments. For purposes of computing P1's gain or 
loss on the sale of the S1 stock in Year 3, P1's basis in its S1 
stock will reflect a net positive adjustment of $40, which is the 
excess of the amount of S3's excluded COD income that is applied to 
reduce attributes ($65) over the reduction of S1's and S3's 
attributes in respect of such excluded COD income ($25).
    Example 7. (i) Facts. P is the common parent of a consolidated 
group that includes subsidiaries S1 and S2. P owns 100 percent of 
the stock of S1, and S1 owns 100 percent of the stock of S2. None of 
P, S1, or S2 has a separate return limitation year prior to Year 1. 
In Year 1, the P group sustained a $50 consolidated net operating 
loss. Under the principles of Sec.  1.1502-21(b)(2)(iv), of that 
amount, $10 was attributable to P, $20 was attributable to S1, and 
$20 was attributable to S2. On January 1 of Year 2, S1 realized $55 
of excluded COD income from the discharge of non-intercompany 
indebtedness. On June 30 of Year 2, P transferred all of its assets 
to S1 in a transaction to which section 381(a) applied. As a result 
of that transaction, pursuant to Sec.  1.1502-75(d)(2)(ii), S1 
succeeded P as the common parent of the group. Pursuant to Sec.  
1.1502-75(d)(2)(iii), S1's taxable year closed on the date of the 
acquisition. However, P's taxable year did not close. On the 
consolidated return for Year 2, the group sustained a $50 
consolidated net operating loss. Under the principles of Sec.  
1.1502-21(b)(2)(iv), of that amount, $10 was attributable to S1 for 
its taxable year that ended on June 30, $15 was attributable to S1 
as the successor of P, and $25 was attributable to S2.
    (ii) Analysis. Pursuant to paragraph (a)(2) of this section, the 
tax attributes attributable to S1 must first be reduced to take into 
account its excluded COD income in the amount of $55. For this 
purpose, S1's attributes that remain after the determination of tax 
for the group for Year 2 are subject to reduction. Pursuant to 
section 108(b)(2)(A) and paragraph (a) of this section, the net 
operating loss and the net operating loss carryover attributable to 
S1 under the principles of Sec.  1.1502-21(b)(2)(iv) are reduced. 
Accordingly, the consolidated net operating loss for Year 2 is 
reduced by $25, the portion of the consolidated net operating loss 
for Year 2 attributable to S1, to $25. Then, the consolidated net 
operating loss carryover from Year 1 is reduced by $30, the portion 
of that consolidated net operating loss carryover attributable to S1 
(which includes the portion attributable to P), to $20.

    (d) Effective dates. This section applies to discharges of 
indebtedness that occur after March 21, 2005. Groups, however, may 
apply this section in whole, but not in part, to discharges of 
indebtedness that occur on or before March 21, 2005, and after August 
29, 2003. For discharges of indebtedness occurring on or before March 
21, 2005, and after August 29, 2003, with respect to which a group 
chooses not to apply this section, see Sec.  1.1502-28T as contained in 
26 CFR part 1 revised as of April 1, 2004. Furthermore, groups may 
apply paragraph (b)(4) of this section to discharges of indebtedness 
that occur on or before August 29, 2003, in cases in which section 
1017(b)(3)(D) was applied.


Sec.  1.1502-28T  [Removed]

0
Par. 10. Section 1.1502-28T is removed.

0
Par. 11. Section 1.1502-32 is amended as follows:
0
1. Paragraph (b)(1)(ii) is redesignated as paragraph (b)(1)(iii).
0
2. New paragraph (b)(1)(ii) is added.
0
3. Paragraphs (b)(3)(ii)(C)(1) and (b)(3)(iii)(A) are revised.
0
4. Paragraph (b)(5)(ii), Example 4, paragraphs (a), (b), and (c) are 
revised.
0
5. Paragraph (h)(7) is revised.
    The addition and revisions read as follows:


Sec.  1.1502-32  Investment adjustments.

* * * * *
    (b) * * *
    (1) * * *
    (ii) Special rule for discharge of indebtedness income. Adjustments 
under this section resulting from the realization of discharge of 
indebtedness income of a member that is excluded from gross income 
under section 108(a) (excluded COD income) and from the reduction of 
attributes in respect thereof pursuant to sections 108 and 1017 and 
Sec.  1.1502-28 (including reductions in the basis of property) when a 
member (the departing member) ceases to be a member of the group on or 
prior to the last day of the consolidated return year that includes the 
date the excluded COD income is realized are made immediately after the 
determination of tax for the group for the taxable year during which 
the excluded COD income is realized (and any prior years) and are 
effective immediately before the beginning of the taxable year of the 
departing member following the taxable year during which the excluded 
COD income is realized. Such adjustments when a corporation (the new 
member) is not a member of the group on the last day of the 
consolidated return year that includes the date the excluded COD income 
is realized but is a member of the group at the beginning of the 
following consolidated return year are also made immediately after the 
determination of tax for the group for the taxable year during which 
the excluded COD income is realized (and any prior years) and are 
effective immediately before the beginning of the taxable year of the 
new member following the taxable year during which the excluded COD 
income is realized. If the new member was a member of another group 
immediately before it became a member of the group, such adjustments 
are treated as occurring immediately after it ceases to be a member of 
the prior group.
* * * * *
    (3) * * *
    (ii) * * *
    (C) * * *
    (1) In general. Excluded COD income is treated as tax-exempt income 
only to the extent the discharge is applied to reduce tax attributes 
attributable to any member of the group under section 108, section 1017 
or Sec.  1.1502-28. However, if S is treated as realizing excluded COD 
income pursuant to Sec.  1.1502-28(a)(3), S shall not be treated as 
realizing excluded COD income for purposes of the preceding sentence.
* * * * *
    (iii) * * *
    (A) In general. S's noncapital, nondeductible expenses are its 
deductions and losses that are taken into account but permanently 
disallowed or eliminated under applicable law in determining its

[[Page 14411]]

taxable income or loss, and that decrease, directly or indirectly, the 
basis of its assets (or an equivalent amount). For example, S's Federal 
taxes described in section 275 and loss not recognized under section 
311(a) are noncapital, nondeductible expenses. Similarly, if a loss 
carryover (e.g., under section 172 or 1212) attributable to S expires 
or is reduced under section 108(b) and Sec.  1.1502-28, it becomes a 
noncapital, nondeductible expense at the close of the last tax year to 
which it may be carried. However, when a tax attribute attributable to 
S is reduced as required pursuant to Sec.  1.1502-28(a)(3), the 
reduction of the tax attribute is not treated as a noncapital, 
nondeductible expense of S. Finally, if S sells and repurchases a 
security subject to section 1091, the disallowed loss is not a 
noncapital, nondeductible expense because the corresponding basis 
adjustments under section 1091(d) prevent the disallowance from being 
permanent.
* * * * *
    (5) * * *
    (ii) * * *

    Example 4. Discharge of indebtedness. (a) Facts. P forms S on 
January 1 of Year 1 and S borrows $200. During Year 1, S's assets 
decline in value and the P group has a $100 consolidated net 
operating loss. Of that amount, $10 is attributable to P and $90 is 
attributable to S under the principles of Sec.  1.1502-21(b)(2)(iv). 
None of the loss is absorbed by the group in Year 1, and S is 
discharged from $100 of indebtedness at the close of Year 1. P has a 
$0 basis in the S stock. P and S have no attributes other than the 
consolidated net operating loss. Under section 108(a), S's $100 of 
discharge of indebtedness income is excluded from gross income 
because of insolvency. Under section 108(b) and Sec.  1.1502-28, the 
consolidated net operating loss is reduced to $0.
    (b) Analysis. Under paragraph (b)(3)(iii)(A) of this section, 
the reduction of $90 of the consolidated net operating loss 
attributable to S is treated as a noncapital, nondeductible expense 
in Year 1 because that loss is permanently disallowed by section 
108(b) and Sec.  1.1502-28. Under paragraph (b)(3)(ii)(C)(1) of this 
section, all $100 of S's discharge of indebtedness income is treated 
as tax-exempt income in Year 1 because the discharge results in a 
$100 reduction to the consolidated net operating loss. Consequently, 
the loss and the cancellation of the indebtedness result in a net 
positive $10 adjustment to P's basis in its S stock.
    (c) Insufficient attributes. The facts are the same as in 
paragraph (a) of this Example 4, except that S is discharged from 
$120 of indebtedness at the close of Year 1. Under section 108(a), 
S's $120 of discharge of indebtedness income is excluded from gross 
income because of insolvency. Under section 108(b) and Sec.  1.1502-
28, the consolidated net operating loss is reduced by $100 to $0 
after the determination of tax for Year 1. Under paragraph 
(b)(3)(iii)(A) of this section, the reduction of $90 of the 
consolidated net operating loss attributable to S is treated as a 
noncapital, nondeductible expense. Under paragraph (b)(3)(ii)(C)(1) 
of this section, only $100 of the discharge is treated as tax-exempt 
income because only that amount is applied to reduce tax attributes. 
The remaining $20 of discharge of indebtedness income excluded from 
gross income under section 108(a) has no effect on P's basis in S's 
stock.

* * * * *
    (h) * * *
    (7) Rules related to discharge of indebtedness income excluded from 
gross income. Paragraphs (b)(1)(ii), (b)(3)(ii)(C)(1), (b)(3)(iii)(A), 
and (b)(5)(ii), Example 4, paragraphs (a), (b), and (c) of this section 
apply with respect to determinations of the basis of the stock of a 
subsidiary in consolidated return years the original return for which 
is due (without regard to extensions) after March 21, 2005. However, 
groups may apply those provisions with respect to determinations of the 
basis of the stock of a subsidiary in consolidated return years the 
original return for which is due (without regard to extensions) on or 
before March 21, 2005, and after August 29, 2003.
    For determinations of the basis of the stock of a subsidiary in 
consolidated return years the original return for which is due (without 
regard to extensions) on or before March 21, 2005, and after August 29, 
2003, with respect to which a group chooses not to apply paragraphs 
(b)(1)(ii), (b)(3)(ii)(C)(1), (b)(3)(iii)(A), and (b)(5)(ii), Example 
4, paragraphs (a), (b), and (c) of this section, see Sec.  1.1502-
32T(b)(3)(ii)(C)(1), (b)(3)(iii)(A), and (b)(5)(ii), Example 4, 
paragraphs (a), (b), and (c) as contained in 26 CFR part 1 revised as 
of April 1, 2004.

0
Par. 12. Section 1.1502-32T is amended as follows:
0
1. Paragraph (a)(3) is added and paragraphs (b) through (b)(3)(iii)(B) 
are revised.
0
2. Paragraphs (b)(5)(i) through (h)(5)(ii) are revised.
0
3. Paragraph (h)(7) is revised.
    The revisions read as follows:


Sec.  1.1502-32T  Investment adjustments (temporary).

* * * * *
    (a)(3) through (b)(3)(iii)(B) [Reserved]. For further guidance, see 
Sec.  1.1502-32(a)(3) through (b)(3)(iii)(B).
* * * * *
    (b)(5)(i) through (h)(5)(ii) [Reserved]. For further guidance, see 
Sec.  1.1502-32(b)(5)(i) through (h)(5)(ii).
* * * * *
    (h)(7) [Reserved]. For further guidance, see Sec.  1.1502-32(h)(7).
0
Par. 13. In Sec.  1.1502-76, paragraph (b)(1)(ii)(B)(3) is revised to 
read as follows:


Sec.  1.1502-76  Taxable year of members of group.

* * * * *
    (b) * * *
    (1) * * *
    (ii) * * *
    (B) * * *
    (3) Whether the allocation is inconsistent with other requirements 
under the Internal Revenue Code and regulations promulgated thereunder 
(e.g., if a section 338(g) election is made in connection with a 
group's acquisition of S, the deemed asset sale must take place before 
S becomes a member and S's gain or loss with respect to its assets must 
be taken into account by S as a nonmember (but see Sec.  1.338-1(d)), 
or if S realizes discharge of indebtedness income that is excluded from 
gross income under section 108(a) on the day it becomes a nonmember, 
the discharge of indebtedness income must be treated as realized by S 
as a member (see Sec.  1.1502-28(b)(11))); and
* * * * *

0
Par. 14. In Sec.  1.1502-80, the second sentence of paragraph (c) is 
revised to read as follows:


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

* * * * *
    (c) * * * See Sec. Sec.  1.1502-11(d) and 1.1502-35T for additional 
rules relating to stock loss. * * *
* * * * *

0
Par. 15. In Sec.  1.1502-80T, the third sentence of paragraph (c) is 
revised to read as follows:


Sec.  1.1502-80T  Applicability of other provisions of law (temporary).

* * * * *
    (c) * * * See Sec. Sec.  1.1502-11(d) and 1.1502-35T for additional 
rules relating to stock loss. * * *
* * * * *

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.

    Approved: March 10, 2005.
Eric Solomon,
Acting Deputy Assistant Secretary of the Treasury.
[FR Doc. 05-5528 Filed 3-21-05; 8:45 am]
BILLING CODE 4830-01-P