[Federal Register Volume 72, Number 14 (Tuesday, January 23, 2007)]
[Proposed Rules]
[Pages 2964-3020]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 07-187]



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Part III





Department of the Treasury





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Internal Revenue Service



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26 CFR Part 1



Unified Rule for Loss on Subsidiary Stock; Proposed Rule

  Federal Register / Vol. 72, No. 14 / Tuesday, January 23, 2007 / 
Proposed Rules  

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-157711-02]
RIN 1545-BB61


Unified Rule for Loss on Subsidiary Stock

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations under sections 
358, 362(e)(2) and 1502 of the Internal Revenue Code (Code). The 
regulations apply to corporations filing consolidated returns. The 
regulations implement aspects of the repeal of the General Utilities 
doctrine by redetermining members' bases in subsidiary stock and 
requiring certain reductions in subsidiary stock basis on a transfer of 
the stock. The regulations also promote the clear reflection of income 
by redetermining members' bases in subsidiary stock and reducing the 
subsidiary's attributes to prevent the duplication of loss. 
Additionally, the regulations provide guidance limiting the application 
of section 362(e)(2) with respect to transactions between members of a 
consolidated group.

DATES: Written or electronic comments or a request for a public hearing 
must be received by April 23, 2007.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-157711-02), room 
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
157711-02), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC, or sent electronically, via the IRS 
Internet site at www.irs.gov/regs or via the Federal eRulemaking Portal 
at www.regulations.gov (IRS/REG-157711-02).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Theresa Abell (202) 622-7700 or Phoebe Bennett (202) 622-7770; 
concerning submissions of comments, Richard Hurst, 
[email protected], (202) 622-7180 (not toll-free 
numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collection of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, 
Washington, DC 20224. Comments on the collection of information should 
be received by March 26, 2007.
    Comments are specifically requested concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the IRS, including whether the 
information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information;
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collection of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    The collection of information in these proposed regulations is in 
Sec. Sec.  1.1502-13(e)(4)(v) and 1.1502-36(d)(7). The respondents are 
corporations filing consolidated returns. The collection of information 
is required to allow a corporation to preserve a subsidiary's 
attributes by foregoing a stock loss. The collection of information is 
required to obtain a benefit.
    Estimated total annual reporting and/or recordkeeping burden: 25 
hours.
    Estimated average annual burden per respondent and/or recordkeeper: 
15 minutes.
    Estimated number of respondents and/or recordkeepers: 100.
    Estimated annual frequency of responses: Once.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to the collection of information must be 
retained as long as their contents may become material in the 
administration of any Internal Revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    The discussion in this preamble begins with an overview of the 
history of the regulatory attempts to address both the circumvention of 
General Utilities repeal and the duplication of loss by consolidated 
groups, in particular, in Sec.  1.1502-20 (the Loss Disallowance Rule, 
or LDR). The discussion then turns to Rite Aid Corp. v. United States, 
255 F.3d 1357 (2001), which rejected the loss duplication rule in the 
LDR. Section A.4 of this preamble discusses the immediate 
administrative responses to Rite Aid. Section A.5 of this preamble 
discusses the legislative response to Rite Aid. Following the Rite Aid 
decision, the IRS and Treasury Department undertook a study to 
reconsider the issues addressed by Sec.  1.1502-20. Section B of this 
preamble discusses the various issues considered in that study, 
including both the original noneconomic and duplicated stock loss 
specifically addressed by the LDR and certain related issues with which 
the Internal Revenue Service and Treasury Department have grown 
concerned since the LDR was promulgated. Section C of this preamble 
describes the various approaches that were considered to address 
noneconomic stock loss and sets forth the conclusions reached regarding 
each. Section D of this preamble describes the various approaches that 
were considered to address loss duplication and sets forth the 
conclusions reached regarding each. Section E of this preamble 
describes the various approaches that were considered to address the 
noneconomic and duplicated loss that can arise from the general 
operation of the investment adjustment system and sets forth the 
conclusions reached regarding each. Section F of this preamble 
describes the specific provisions of this proposed regulation Sec.  
1.1502-36. Section G of this preamble discusses the proposed removal of 
Sec. Sec.  1.337(d)-1, 1.337(d)-2, and 1.1502-35.
    The IRS and Treasury Department are also proposing regulations to 
address the application of section 362(e)(2) to members of consolidated 
groups. These proposed regulations are described in section H of this 
preamble.
    Finally, the IRS and Treasury Department are proposing various 
technical and administrative revisions to the consolidated return 
regulations. These proposed regulations are described in section I of 
this preamble.

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    The IRS and Treasury Department request comments on the proposed 
regulations and other approaches that could be adopted, as well as 
other issues currently under study. See section J of this preamble for 
further discussion of comments requested.

A. History of General Utilities Repeal and Loss Disallowance Under 
Sec.  1.1502-20

1. The Repeal of the General Utilities Doctrine
    In 1986, Congress enacted section 337(d), which directs the 
Secretary to prescribe such regulations as may be necessary or 
appropriate to carry out the repeal of the General Utilities doctrine 
(GU repeal). See Tax Reform Act of 1986, Public Law 99-514 (100 Stat. 
2085 (1986)). The legislative history states that Congress was 
concerned that the General Utilities doctrine allowed ``assets to leave 
corporate solution and to take a stepped-up basis in the hands of the 
transferee without the imposition of a corporate-level tax'' and thus 
``tend[ed] to undermine the corporate income tax.'' H.R. Rep. No. 99-
426, 99th Cong., 1st Sess. 282 (1985). The General Utilities doctrine 
and GU repeal are discussed extensively in the Treasury Decisions 
referenced in this preamble; in addition, see generally, H.R. Rep. No. 
99-426 at 274-282 for a discussion of the history of the General 
Utilities doctrine; see also General Utilities & Operating Co. v. 
Helvering, 296 U.S. 200 (1935).
2. The Administrative Response to GU Repeal: Sec.  1.1502-20
    The IRS and Treasury Department first responded to GU repeal by 
issuing Notice 87-14 (1987-1 CB 445), which set forth the intent to 
promulgate regulations affecting adjustments to members' bases in stock 
of any subsidiary acquired when the subsidiary held an appreciated 
asset. Notice 87-14 indicated that, in general, adjustments to 
subsidiary stock basis would not reflect gains on such assets. Thus, 
Notice 87-14 implied that a tracing-based regime would be adopted to 
determine adjustments to member's bases in shares of subsidiary stock.
    After several years of study, the IRS and Treasury Department 
concluded that any approach relying on the identification and tracing 
of appreciation on particular assets, while theoretically accurate, 
would impose substantial administrative burdens on taxpayers and on the 
government. See TD 8294 (1990-1 CB 69), 55 FR 9426, 9428 (March 14, 
1990). As a result, the tracing-based approach envisioned in Notice 87-
14 was implemented only in regulations promulgated under section 
337(d). Those regulations applied only for the period of time between 
the issuance of Notice 87-14 and the effective date of final 
regulations under Sec.  1.1502-20 (February 1, 1991). See TD 8364 
(1991-2 CB 43), 56 FR 47379 (September 19, 1991), Sec. Sec.  1.337(d)-1 
and 1.337(d)-2 (as contained in 26 CFR part 1 revised as of April 1, 
1991).
    In lieu of tracing, the LDR used certain operating presumptions to 
determine the extent to which investment adjustments would be permitted 
to give rise to allowable stock loss. Because the LDR only disallowed 
loss, noneconomic investment adjustments were able to increase stock 
basis and thus reduce gain without limitation. As a result, the LDR 
reduced the duplication of gain in the tax system. The IRS and Treasury 
Department considered the reduction of gain duplication an important 
balance to the imprecision inherent in the LDR's use of irrebuttable 
presumptions.
    The study following the issuance of Notice 87-14 led the IRS and 
Treasury Department to consider the issue of loss duplication by 
members of consolidated groups. Their conclusion was that loss 
duplication was inappropriate in the consolidated setting. Further, the 
IRS and Treasury Department recognized that there were administrative 
advantages to addressing both issues in a single integrated rule. Thus, 
unlike the regulations under section 337(d), the LDR was at once 
directed at both the circumvention of GU repeal through the use of 
noneconomic stock loss and the duplication of loss. See TD 8294 and TD 
8364.
3. The Rite Aid Opinion
    Ten years after the promulgation of the LDR, the validity of the 
duplicated loss component of the LDR was considered in Rite Aid, supra. 
Under the duplicated loss component of the LDR, Rite Aid had been 
disallowed a deduction for an economic loss on subsidiary stock solely 
because the stock loss could be duplicated by the subsidiary after it 
left the group. The Federal Circuit stated that the Secretary's 
authority to change the application of a Code provision to a 
consolidated group was limited to situations in which the change was 
necessary to address a problem created by the filing of a consolidated 
return. Because duplicated stock loss occurs and is allowable in the 
separate return setting, the court concluded that the duplicated loss 
component of the LDR was not addressing a problem arising from the 
filing of a consolidated return. Accordingly, the court held that the 
Secretary did not have the authority to change the Code rule allowing a 
deduction for the stock loss.
4. The Administrative Response to Rite Aid
    In response to the Rite Aid decision, on February 19, 2002, the IRS 
announced that it would not continue to litigate the validity of the 
duplicated loss rule in Sec.  1.1502-20. See Notice 2002-11 (2002-1 CB 
526). On March 7, 2002, the IRS and Treasury Department promulgated 
Sec.  1.1502-20T(i) (to suspend the application of the LDR) and Sec.  
1.337(d)-2T (to provide an interim rule addressing noneconomic stock 
loss). See TD 8984 (2002-1 CB 668), 67 FR 11034 (March 12, 2002). 
Concurrently with the promulgation of Sec. Sec.  1.337(d)-2T and 
1.1502-20T(i), the IRS issued Notice 2002-18 (2002-1 CB 644), 
announcing that loss duplication regulations would also be promulgated. 
Following the publication of TD 8984, the IRS and Treasury Department 
undertook a study of the issues underlying both noneconomic and 
duplicated loss on subsidiary stock.
    In general, Sec.  1.337(d)-2T disallowed stock loss and reduced 
stock basis (to value) upon the disposition or deconsolidation of 
subsidiary stock by a member of a consolidated group. However, under 
Sec.  1.337(d)-2T(c)(2), loss disallowance and basis reduction were 
avoided to the extent the taxpayer could establish that the loss or 
basis ``is not attributable to the recognition of built-in gain on the 
disposition of an asset.'' Section 1.337(d)-2T(c)(2) defined the term 
``built-in gain'' as gain that is ``attributable, directly or 
indirectly, in whole or in part, to any excess of value over basis that 
is reflected, before the disposition of the asset, in the basis of the 
share, directly or indirectly, in whole or in part.''
    On March 14, 2003, the IRS and Treasury Department promulgated 
Sec.  1.1502-35T as an interim measure to address the problem of loss 
duplication in consolidated groups. See TD 9048 (2003-1 CB 644), 68 FR 
12287 (March 14, 2003). In the preamble to TD 9048, the IRS and 
Treasury Department announced that the issues addressed in Sec.  
1.1502-35T were still under study. The provisions of Sec.  1.1502-35 
are discussed in more detail in section D.1 of this preamble.
    Further guidance on the interim rules was issued August 25, 2004, 
in the form of Notice 2004-58 (2004-2 CB 520). In Notice 2004-58, the 
IRS announced that it would accept the ``basis disconformity'' method 
as an alternative approach to determining whether stock

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loss or basis was attributable to ``built-in gain'' within the meaning 
of Sec.  1.337(d)-2T.
    Under the basis disconformity method described in Notice 2004-58, 
stock loss or basis is treated as attributable to built-in gain to the 
extent of the least of (i) the net positive investment adjustment 
applied to the stock basis (disregarding distributions), (ii) the 
aggregate gain (net of directly related expenses) recognized on asset 
dispositions by the subsidiary, and (iii) the disconformity amount 
(generally, the amount by which the basis of the share exceeds the 
share's proportionate interest in the subsidiary's net inside asset 
basis; for this purpose, net inside asset basis is defined as the 
excess of the sum of the subsidiary's money, asset basis, loss 
carryforwards, and deferred deductions over its liabilities). Notice 
2004-58 also requested comments on the general scope of GU repeal and 
on other approaches that could be adopted to safeguard the purposes of 
GU repeal in the consolidated return context.
5. The Legislative Response to Rite Aid
    Congress responded to the Rite Aid opinion on October 22, 2004, in 
the American Jobs Creation Act (the AJCA), Public Law 108-357 (118 
Stat. 1418 (2004)). In the AJCA, Congress added a sentence at the end 
of section 1502 of the Code, so that the section now reads:

    The Secretary shall prescribe such regulations as he may deem 
necessary in order that the tax liability of any affiliated group of 
corporations making a consolidated return and of each corporation in 
the group, both during and after the period of affiliation, may be 
returned, determined, computed, assessed, collected, and adjusted, 
in such manner as clearly to reflect the income tax liability and 
the various factors necessary for the determination of such 
liability, and in order to prevent avoidance of such tax liability. 
In carrying out the preceding sentence, the Secretary may prescribe 
rules that are different from the provisions of chapter 1 that would 
apply if such corporations filed separate returns.

    In the legislative history to the AJCA, Congress stated that the 
Secretary is authorized to change the application of a Code provision 
when the Secretary determines it is necessary to clearly reflect the 
income tax liability of the group and each corporation in the group, 
both during and after the period of affiliation. See H.R. Conf. Rep. 
No. 108-755, 108th Cong., 2d Sess. 653 (2004). Congress thus rejected 
the suggestion in the Rite Aid opinion that the Secretary's authority 
to change the general application of the Code is limited to 
promulgating regulations that address problems created by the filing of 
a consolidated return.
    In the AJCA legislative history, Congress also spoke to the proper 
scope of future regulations. Regarding the promulgation of regulations 
addressing noneconomic stock loss, Congress stated that ``presumptions 
and other simplifying conventions'' could be used to prevent the 
circumvention of GU repeal. See H.R. Conf. Rep. No. 108-755, fn. 595. 
In addition, Congress indicated two acceptable methods for addressing 
loss duplication by group members. The first would disallow subsidiary 
stock loss to the extent it duplicates losses that remain available to 
the group. The second would reduce the subsidiary's attributes in order 
to prevent the subsidiary from using losses outside the group, to the 
extent the losses duplicate stock loss. But Congress also stated its 
intention that the result of the Rite Aid decision is to be preserved. 
The IRS and Treasury Department interpret this statement to mean that 
regulations addressing loss duplication by consolidated groups must not 
disallow a deduction for an economic loss on subsidiary stock solely 
because the stock loss duplicates unrecognized or unabsorbed losses 
that later could be used outside the group.
6. Further Administrative Response to Rite Aid
    On March 3, 2005, the IRS and Treasury Department finalized Sec.  
1.337(d)-2. See TD 9187 (2005-13 IRB 778), 70 FR 10319 (March 3, 2005). 
In TD 9187, the IRS and Treasury Department stated that the issues 
addressed in Sec.  1.337(d)-2 were still under study and that an 
alternative approach would be proposed. On March 14, 2006, the IRS and 
Treasury Department finalized Sec.  1.1502-35. See TD 9254 (2006-13 IRB 
662), 71 FR 13008 (March 14, 2006). In TD 9254, the IRS and Treasury 
Department stated that both noneconomic and duplicated loss were still 
under study, and that regulations would be proposed adopting a singe 
integrated approach to addressing both issues. The results of that 
study and the proposed integrated approach are described below in 
sections D through H of this preamble.

B. Issues Considered in the Post-Rite Aid Study.

1. GU Repeal and Noneconomic Investment Adjustments Under the LDR
    Section 337(d) generally directs the Secretary to prescribe 
regulations to prevent the circumvention of GU repeal and, in 
particular, section 337(d)(1) directs the Secretary to promulgate 
regulations to prevent the circumvention of GU repeal through the use 
of the consolidated return regulations. Congress' concern stems from 
the general operation of the investment adjustment system of Sec.  
1.1502-32.
    The purpose of the investment adjustment system is to promote the 
clear reflection of the group's income. See Sec.  1.1502-32(a)(1). One 
of the principal ways that the investment adjustment system promotes 
clear reflection is by preventing a subsidiary's items of income, gain, 
deduction and loss from giving rise to duplicative gain or loss on the 
subsidiary's stock. To that end, the investment adjustment system 
adjusts members' bases in shares of subsidiary stock to reflect such 
items once they have been taken into account by the group. See TD 8560 
(1994-2 CB 200), 59 FR 41666 (August 15, 1994).

    Example 1. Economic adjustment to stock basis prevents 
duplication. P, the common parent of a consolidated group, purchases 
all 100 outstanding shares of S common stock for $100 cash, taking a 
basis of $1 in each share. At the time, S owns one asset, A1, with a 
basis and value of $100. Later, the value of A1 increases to $150. S 
sells A1 to a nonmember for $150 and recognizes a $50 gain, which 
the P group takes into account. Under the investment adjustment 
system, P increases its basis in its S stock to reflect the $50 
taken into account by the group. As a result, the basis of each 
share increases to $1.50, its fair market value. P can then sell all 
or any portion of its S stock for its fair market value without 
recognizing duplicative gain on the disposition.

    The result in Example 1 is that the group takes its economic gain 
into account only once, on the disposition of S's asset, and not again 
on the subsequent disposition of the S stock. Thus the group's income 
is clearly reflected and there is no circumvention of GU repeal.
    The investment adjustment system is not a tracing regime. Rather, 
it is a presumptive regime based on certain operating assumptions. A 
principal assumption is that all of a subsidiary's items taken into 
account represent economic accruals (of gain or loss) to the group. 
Another principal assumption is that all such items accrue equally to 
all outstanding shares, at least within a class. When these assumptions 
correspond to the facts of a particular situation, as in Example 1, the 
investment adjustment system produces appropriate results: stock basis, 
which reflects only the investment in the stock, increases to reflect 
economic accrual (the group's return on its stock investment), and, as 
a result, stock basis can then shelter that return on the group's 
investment, protecting it from being taken into account again when the 
stock is sold.

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    The assumptions, however, do not correspond to the facts of all 
situations. For example, if stock of a subsidiary is purchased for its 
fair market value when the subsidiary holds appreciated assets, the 
items of income or gain generated when that appreciation is recognized 
do not represent an economic accrual on the group's investment (because 
the appreciation was already reflected in the basis of the stock). 
Nevertheless, the presumptive rules of the investment adjustment system 
treat such items as economic accruals and include them in the 
investment adjustment to be applied to the basis of the stock.

    Example 2. Noneconomic adjustment to stock basis creates 
noneconomic stock loss. Assume the same facts as in Example 1 except 
that P does not purchase the stock of S until the value of A1 has 
increased to $150. Accordingly, P purchases the stock for $150, 
taking a basis of $1.50 in each share. As in Example 1, when S sells 
A1, the investment adjustment system again increases P's basis in 
its S stock to reflect the $50 taken into account by the group. As a 
result, P's basis in each of its shares increases to $2, even though 
the fair market value of each share remains $1.50. If P were then to 
sell all or some portion of the S stock for its fair market value, P 
would recognize a $.50 loss on each share ($50 loss in the 
aggregate).

    In this situation, a deduction for the stock loss would be 
inappropriate because neither the group nor its members have suffered 
any economic loss. If P were allowed to deduct that noneconomic loss, 
the deduction would offset the gain recognized on S's asset and, 
effectively, eliminate the corporate-level tax on the gain on S's 
asset. This is the circumvention of GU repeal that concerned Congress 
in 1986.
    At the time Notice 87-14 was issued, the IRS and Treasury 
Department had identified the creation of noneconomic stock loss in 
situations similar to those illustrated in Example 2. Thus, Notice 87-
14 referred specifically to investment adjustments attributable to the 
disposition of assets that, at the time of the acquisition of the 
subsidiary stock, had a fair market value in excess of adjusted basis. 
For that reason, Sec.  1.337(d)-1, which implemented Notice 87-14, 
disallowed subsidiary stock loss unless the taxpayer could show that 
the loss was not attributable to the recognition of appreciation on 
assets owned, directly or indirectly, by a subsidiary when it became a 
member.
2. Duplicated Loss and the Clear Reflection of Group Income Under the 
LDR
    In the study that followed the issuance of Notice 87-14, the IRS 
and Treasury Department also considered the issue of loss duplication 
by members of a consolidated group. The specific concern of the IRS and 
Treasury Department was the loss duplication that occurs when an 
economic loss is reflected in both a member's basis in subsidiary stock 
and in the subsidiary's assets or operations, and the loss is first 
recognized with respect to the stock.

    Example 3. Duplication of loss. P forms S by contributing $110 
to S in exchange for all 100 outstanding shares of S stock. S uses 
the cash to purchase an asset, A1. The value of A1 later declines to 
$10. If P were then to sell all or some portion of the S stock for 
its fair market value, P would recognize a $1 loss on each share.

    In this situation, even though P would have recognized the group's 
economic loss on its disposition of the S stock, the loss continues to 
be reflected in the basis of A1. As a result, that loss would remain 
available for use by P (if the stock sale did not deconsolidate S) or S 
(if the stock sale deconsolidated S). Upon the disposition of A1, the 
group's single economic loss would thus be recognized and taken into 
account more than once by the group and its members or former members.
    In contrast, if the duplicated loss had first been taken into 
account with respect to A1, the investment adjustment system would have 
prevented a duplicative benefit to the group and its members by 
reducing P's basis in S stock by the amount of the loss. In that case, 
the group would have enjoyed the tax benefit attributable to the loss, 
but that benefit would not remain available for another use by the 
group and its members or former members.
    The IRS and Treasury Department concluded that the duplication of a 
group's tax benefit (represented by a single economic loss) distorts 
income without regard to whether the duplicated loss is taken into 
account first with respect to the subsidiary's stock or first with 
respect to the subsidiary's assets and operations. The IRS and Treasury 
Department further concluded that, even if the duplicated loss is used 
by a former member outside the group, that duplicative use distorts the 
income of the group and its members. Accordingly, the IRS and Treasury 
Department decided to promulgate regulations that would complement the 
investment adjustment system by addressing the stock-first recognition 
of a duplicated loss and that such regulations would apply to both 
deconsolidating and nondeconsolidating dispositions. Recognizing the 
administrative benefits of addressing both noneconomic and duplicated 
stock loss in a single integrated rule, the IRS and Treasury Department 
promulgated the LDR as a single rule with components directed at both.
    The method adopted by the LDR to address loss duplication was the 
disallowance of stock loss (or reduction of stock basis) that 
duplicated unrecognized inside loss, such as that illustrated in 
Example 3. However, groups had several mechanisms available to 
recognize or preserve the inside loss and thereby avoid loss 
disallowance (by eliminating loss duplication). Inside losses could be 
recognized through an actual asset sale or a deemed asset sale under 
section 338(h)(10), and, following the sale, the subsidiary's 
unabsorbed losses would be available to the group. In addition, the LDR 
allowed the common parent to elect to reattribute the subsidiary's 
losses (to itself) under Sec.  1.1502-20(g). If the group chose not to 
exercise those options, then the stock loss was denied, but the inside 
loss was preserved for a nonduplicative use by the subsidiary, in or 
out of the group.
    At the time the LDR was promulgated, the duplication potential 
illustrated in Example 3 was the principal form of loss duplication 
with which the IRS and Treasury Department were concerned. Thus it is 
the only form of loss duplication specifically addressed by the LDR. 
The anti-abuse rule in the LDR did, however, provide a limited 
mechanism for expanding the scope of that provision.
3. Noneconomic and Duplicated Loss Resulting from Investment 
Adjustments Allocated to Shares With Disparate Bases
    Since the promulgation of the LDR, the IRS and Treasury Department 
have become increasingly concerned with the noneconomic and duplicated 
loss potential arising from the interaction of Sec.  1.1502-32 and the 
disparate reflection of gain or loss in members' bases in individual 
shares of subsidiary stock.
    As discussed in section B.1 of this preamble, the investment 
adjustment system is a presumptive regime that allocates a subsidiary's 
items of income, gain, deduction, and loss taken into account by the 
group. It operates in accordance with the assumption that all such 
items reflect economic accruals to all shares equally within each 
class. When its underlying assumptions correspond to the facts of a 
particular situation, the investment adjustment system produces 
appropriate results, as illustrated in Example 1. But when its 
underlying assumptions do not correspond to the facts of a situation 
because shares held by members have disparate bases, the general 
operation of

[[Page 2968]]

the investment adjustment system can give rise to both noneconomic and 
duplicated loss on individual shares of subsidiary stock.

    Example 4. Noneconomic loss. P and M (a member of the P group) 
form S by contributing property to S in exchange for all 100 
outstanding shares of S stock. P contributes A1, with a basis and 
value of $80, in exchange for 80 shares of S stock. M contributes 
A2, with a basis of $0 and a value of $20, to S in exchange for 20 
shares of S stock. S then sells A2 for $20 and recognizes a $20 gain 
that is taken into account by the group. As a result, the basis of 
each share increases by $.20. P's basis in each of its shares is 
then $1.20 (or, $96 in the aggregate), and M's basis in each of its 
shares is then $.20 (or, $4 in the aggregate), even though the value 
of each share remains $1. P then sells all or some portion of its 
shares to X, a nonmember, and, under general principles of tax law, 
recognizes a $.20 noneconomic loss on each share, effectively 
eliminating up to $16 of the gain on A2.
    Example 5(a). Duplicated loss, inside recognition precedes stock 
disposition. P forms S with $100 and receives all 50 shares of S 
common stock. S uses the $100 to buy A1, which then declines in 
value to $50. P contributes another $50 for a second 50 shares of 
common stock. S then sells A1 and recognizes a loss of $50 that is 
taken into account on the P group return. The absorption of the $50 
loss results in a $.50 reduction to the basis of each share 
(original and newly issued). P then sells all or some portion of the 
original shares to X for $1 each (each with a basis of $1.50) and 
recognizes a $.50 loss on each share (up to $25 total). Although the 
$50 asset loss and the $25 stock loss both reflect an economic loss 
of the group, they are both reflecting the same loss. The group has 
actually experienced only $50 of economic loss. Therefore, the $.50 
loss recognized on each of the original shares (up to $25 total) is 
duplicative.
    Example 5(b). Duplicated loss, stock disposition precedes inside 
recognition. The facts are the same as in Example 5(a), except that, 
before S sells A1, P sells 20 of its original 50 shares to X for $20 
(aggregate basis $40), recognizing a $20 loss that is taken into 
account on the P group return, and S remains a member of the group. 
S then sells A1, recognizing a $50 loss that is taken into account 
on the P group return. Although the $50 asset loss and the $20 stock 
loss both reflect an economic loss of the group, they are both 
reflecting the same loss. As in Example 5(a), the group has actually 
experienced only $50 of economic loss. Therefore, $20 of the 
recognized loss is duplicative. Alternatively, if P sold all its 
original 50 shares, P would recognize a $50 loss even though the 
entire $50 group loss would remain available to S for a duplicative 
use against its separate year income.

    The IRS and Treasury Department recognize that, in each case where 
the disproportionate reflection of an item in a particular share causes 
an inappropriate stock loss, whether noneconomic or duplicated, that 
loss is offset by unrecognized gain in other shares. However, that gain 
can be deferred indefinitely or even eliminated by the group. 
Accordingly, the IRS and Treasury Department do not believe that the 
system is appropriately balanced in such cases.
    The IRS and Treasury Department further recognize that these issues 
could be addressed by adopting a tracing-based approach to the 
allocation of investment adjustments. However, the complexity and 
burden of a tracing-based approach would render such an approach 
generally inadministrable for consolidated taxpayers and for the 
government. As a result, the system would be prone to error and, in 
practice, inconsistently applied. Moreover, the IRS and Treasury 
Department continue to believe that the assumptions on which the 
investment adjustment system is based are appropriate for typical 
commercial transactions, as the IRS and Treasury Department understand 
that typically subsidiaries have only common stock outstanding, that 
their stock is wholly owned by group members, and that members' bases 
in shares of subsidiary stock are uniform, as under the facts of 
Example 1. See section E.2 of the preamble of CO-30-92 (1992-2 CB 627), 
57 FR 53634, 53639 (November 12, 1992).
    Because a tracing-based approach to the allocation of investment 
adjustments would not be administrable, the IRS and Treasury Department 
are not considering revising the investment adjustment system to adopt 
such an approach. Instead, the IRS and Treasury Department have 
considered various presumptive approaches that could be adopted to 
mitigate the creation of noneconomic and duplicated loss when members 
hold subsidiary stock with disparate bases. The approaches considered 
and decisions reached are discussed in section E of this preamble.
4. Redetermination Events: Changes in the Extent That Unrecognized Gain 
or Loss Is Effectively Reflected in the Basis of Individual Shares
    Because the investment adjustment system adjusts the basis of each 
share in accordance with its proportionate interest in S's assets and 
operations, the relationship between a share's basis and its allocable 
portion of unrecognized appreciation or depreciation determines the 
extent to which such amounts are effectively reflected in the basis of 
the share. This relationship, however, is not fixed at the time that 
stock is acquired. The reason is that there are many transactions, 
referred to here as redetermination events, that alter either the basis 
of a share or the interest it represents. These events generally occur 
in one of three types of situations.
    a. Stock basis is reallocated.
    The relationship between the basis of a share and the interest 
represented by the share can be altered whenever stock basis is 
reallocated among shares, including when it is allocated to shares of 
stock of other members.

    Example 6. Intragroup spin-off. P forms S by contributing $100 
to S in exchange for all the stock of S. S purchases two assets, A1 
and A2, for $50 each. Subsequently, A1 appreciates to $75 and A2 
depreciates to $25. In a transaction qualifying under sections 355 
and 368(a)(1)(D), S transfers A2 to C in exchange for all of the C 
stock and S then distributes all the C stock to P. Under section 358 
and Sec.  1.358-2, P's basis in the S stock is allocated among the S 
and C stock in proportion to the value of the stock of S and C. As a 
result, P's basis in its S stock is $75 (\75/100\ x $100) and P's 
basis in its C stock is $25 (\25/100\ x $100). S sells A1 for $75, 
recognizing a $25 gain that is taken into account on the P group 
return. P's basis in its S stock increases by $25, from $75 to $100. 
P then sells its S stock for $75 and recognizes a $25 loss.

    In this Example 6, after the reallocation of stock basis, P's basis 
in its S stock reflects the unrecognized appreciation on A1, just as 
P's basis in its S stock reflected unrecognized appreciation on A1 in 
Example 2. As a result, P's reallocated S stock basis protects the 
appreciation on A1 from being recognized as both asset gain and stock 
gain. Increasing P's basis in its S stock to reflect the recognition of 
S's gain on A1 is not only unnecessary, it inflates stock basis and 
thereby gives rise to either noneconomic loss or noneconomic reduction 
of gain when the stock is sold.
    Basis reallocations, and the consequences described, can occur for 
a number of reasons, including, for example, under rules like Sec.  
1.1502-32(c)(4) (cumulative redetermination of investment adjustments) 
and Sec.  1.1502-35(b) (basis redetermination to reduce disparity) and 
the corresponding provision in these proposed regulations.
    b. Capital transactions expand or contract the subsidiary's pool of 
assets.
    The relationship between the basis of a share and the nature of the 
interest represented by the share can also be altered by capital 
transactions that have no effect on the basis or value of outstanding 
shares, but that nevertheless alter the interest represented by those 
shares. Some common examples arise in the context of section 351 
exchanges, even though, as illustrated in Example 7(a), a section 351 
exchange in its simplest form cannot give rise to stock basis that 
reflects unrecognized appreciation.


[[Page 2969]]


    Example 7(a). Contribution of appreciated asset in section 351 
exchange. P forms S by contributing an asset, A1, to S in exchange 
for all 80 outstanding shares of S stock. The basis of A1 is $40 and 
its value is $80. S sells A1 and recognizes a $40 gain that is taken 
into account by the P group. As a result, P's aggregate basis in its 
S shares is increased by $40, from $40 to $80. Subsequently, P sells 
its S stock for $80, the stock's fair market value and recognizes $0 
on the sale. The group is thus taxed once on its $40 economic gain.

    In Example 7(a), P holds appreciated S stock and S holds an 
appreciated asset, but that appreciation is not reflected in either P's 
basis in its S stock or S's basis in its asset. Each share has a basis 
of $.50 and an interest in 1/80 of S's asset, A1, which has $40 of 
unrecognized appreciation (allocable $.50 to each share). If this 
relationship between P's basis in its S shares and the interest 
represented by the shares remains constant, as in Example 7(a), the 
investment adjustment system produces appropriate results. But if there 
is a change in that relationship, the underlying assumptions of the 
investment adjustment system may no longer correspond to the facts of 
the situation and, as a result, the general operation of the system 
could produce inappropriate results. Such changes can occur whenever S 
acquires property in exchange for additional shares of its stock.

    Example 7(b). Contribution of appreciated asset in subsequent 
section 351 exchange creates disconformity in original shares. The 
facts are the same as in Example 7(a), except that, before A1 is 
sold, P contributes a second asset, A2, to S in exchange for an 
additional 20 shares of S stock. A2 has a basis of $0 and a value of 
$20. S sells both assets and recognizes a $60 gain that is taken 
into account by the P group. As a result, P's basis in its original 
shares increases by $48 ($.60 per share), from $40 to $88 (or, from 
$.50 to $1.10 per share), and P's basis in its new shares increases 
by $12, from $0 to $12 (or, from $0 to $.60 per share). P then sells 
20 of its original shares (basis of $22) for $20, their fair market 
value, and recognizes a $2 loss.

    In Example 7(b), P's basis in the original S stock reflected no 
unrecognized appreciation when the stock was issued. After the second 
contribution, however, P's basis in those shares reflects a portion of 
the unrecognized appreciation on A2. The reason is that each share 
represents an interest in S's entire pool of assets. When the pool 
changes, the nature of the interest represented by the shares changes, 
even though the share's basis and value remain constant. Thus, in 
Example 7(b), while each original share's basis ($.50) and value ($1) 
remain constant, the interest represented by each share changed from 1/
80 of an asset with unrecognized appreciation of $40 (or, $.50 per 
share), to 1/100 of assets with unrecognized appreciation of $60 (or, 
$.60 per share). This shift causes the basis of each original share to 
reflect $.10 of unrecognized appreciation. When the gain is recognized, 
$.10 of the gain allocated to each original share under the investment 
adjustment system is a noneconomic increase in the share's basis. That 
increase will give rise to noneconomic stock loss or gain reduction. 
Although this (noneconomic) allocation of the (economic) item results 
in an offsetting stock gain on the basis of the new shares, that gain 
can be indefinitely deferred and even eliminated.
    The principles that increase the reflection of unrecognized 
appreciation in the original shares in Example 7(b) can also cause the 
reflection of unrecognized appreciation in the basis of shares that are 
received in exchange for property that is not appreciated, including 
cash. Although such shares would have a substituted basis (which 
generally precludes the reflection of unrecognized appreciation, as 
illustrated in Example 7(a)), the reflection of unrecognized 
appreciation is prevented only if the shares represent, wholly and 
solely, the transferee's interest in its transferred property. If there 
are previously issued shares outstanding, or if other shares are issued 
in the exchange, the shares represent an interest in a pool of assets 
that includes more than the transferred assets. As a result, the 
interest represented by each such share may be significantly different 
from what it would be if the subsidiary held only the transferred 
property.

    Example 7(c). Multiple transferors in single section 351 
exchange. The facts are the same as in Example 7(a), except that, 
when P contributes A1 to S in exchange for 80 shares of S stock, M 
(another member in the group) also contributes $20 cash to S in 
exchange for 20 shares of S stock. S sells A1 for $80 and recognizes 
a $40 gain that is taken into account by the group. Accordingly, P's 
aggregate basis in its shares increases by $32 (\80/100\ x $40), 
from $40 to $72, and M's aggregate basis in its shares increases by 
$8 (\20/100\ x $40), from $20 to $28. M then sells its shares for 
$20, their fair market value, and recognizes an $8 noneconomic loss.

    Similar changes in the extent to which unrecognized amounts are 
reflected in basis can occur whenever the subsidiary's pool of assets 
is increased or decreased by a capital transaction. The reason is that 
the interest represented by each share, and thus the relationship 
between a share's basis and the interest represented by the share, 
changes whenever the subsidiary's pool of assets changes. Such 
transactions include acquisitive reorganizations (if new shares are 
issued) and redemptions.
    c. Assets are acquired with a basis that reflects unrecognized 
appreciation.
    The relationship between the basis of a share and the nature of the 
interest represented by the share can also be altered by transactions 
in which S acquires assets with a basis that reflects unrecognized 
appreciation, such as stock of a new member. The reason is that, after 
the lower-tier acquisition, the S shares have an interest in 
unrecognized appreciation and the investment adjustment system will 
increase the basis of the S shares when those lower-tier items are 
recognized.

    Example 8. Acquisition of lower-tier subsidiary with appreciated 
assets. P forms S by contributing $100 to S in exchange for all the 
stock of S. S then purchases all the stock of T for $100 when T 
holds one asset, A1, with a basis of $0 and a value of $100. T sells 
A1, recognizing a $100 gain that is taken into account on the P 
group return. As a result, both S's basis in its T stock and P's 
basis in its S stock are increased by $100, from $100 to $200. P 
then sells its S stock, recognizing a $100 loss.

    The result is the same noneconomic loss illustrated in Example 2.
    d. Other redetermination events.
    The IRS and Treasury Department expect that other transactions and 
events can alter the extent to which unrecognized asset appreciation is 
reflected in stock basis. Accordingly, the preceding discussion is not 
intended to present an exhaustive list of possible redetermination 
events.
    e. Conclusions regarding redetermination events.
    The IRS and Treasury Department recognize that redetermination 
events occur as the result of bona fide business transactions engaged 
in frequently and routinely throughout the time a share is held by any 
member of the group, and that these transactions are typically not tax-
structured transactions. Still, these events generate a significant 
potential for noneconomic stock loss or gain reduction that facilitates 
the circumvention of GU repeal. Accordingly, the IRS and Treasury 
Department believe that all such events, whether described in this 
preamble or not, must be taken into account in any model that is 
adopted to address the circumvention of GU repeal.
    Nevertheless, the IRS and Treasury Department recognize, and are 
concerned that, the factual analysis necessary to identify all 
redetermination events for all members' shares would be an extensive, 
complex, difficult, and,

[[Page 2970]]

therefore, expensive undertaking and, as such, would impose a 
substantial burden on both taxpayers and the government. Moreover, the 
nature of the undertaking would make it prone to error and, as a 
result, the rule would be unevenly administered and similarly situated 
taxpayers would not be similarly treated.
    The IRS and Treasury Department recognize that redetermination 
events can also create or increase the extent to which the basis of an 
individual share duplicates an inside loss. However, because duplicated 
loss is measured at the time that a stock loss is either recognized or 
preserved for later use, loss duplication rules by their operation 
account for redetermination events. Accordingly, regulations addressing 
loss duplication do not generally require specific provisions to 
address redetermination events.

C. Methods Considered To Implement GU Repeal

    The IRS and Treasury Department considered a number of approaches 
to address the circumvention of GU repeal independently from the issue 
of loss duplication. The approaches fall into two broad categories: 
tracing-based and presumptive approaches.
1. Tracing-Based Methods
    Under a tracing-based method, the extent to which a member can 
enjoy the benefit of subsidiary stock basis attributable to the 
recognition of an item of income or gain is determined by the extent to 
which the recognized item is reflected in the basis of the share and 
thus already protected from duplicative recognition on a later 
disposition of the stock. The IRS and Treasury Department continue to 
believe that tracing is a theoretically correct method for implementing 
GU repeal in the consolidated return setting and so considered various 
tracing-based proposals.
    a. Pure tracing.
    In general, a tracing approach would look solely to the connection 
between a subsidiary's recognized items and any appreciation reflected 
in stock basis in order to determine the extent to which the group will 
be allowed the benefit of stock basis attributable to those items. 
However, such an approach would require taxpayers to create and 
maintain (and the IRS to examine) records to establish:
     The identity of every ``tainted asset,'' that is, every 
asset held by the subsidiary and any lower-tier subsidiaries on every 
``measuring date,'' which includes the date on which the member (or its 
predecessor) purchased the share and all subsequent dates on which the 
subsidiary has a redetermination event;
     The ``tainted appreciation,'' that is, the appreciation on 
each tainted asset held by the subsidiary and any lower-tier 
subsidiaries on each measuring date; and
     The extent to which tainted appreciation is recognized, 
whether as income or gain, and included in an adjustment to the basis 
of the share.
    In addition, to fully benefit from a tracing regime, taxpayers 
would need to create and maintain similar records for tainted assets 
with unrecognized depreciation on a measuring date, because the 
recognition of that depreciation would be allowed to reduce the amount 
of recognized appreciation treated as tainted.
    These records would have to be created and maintained for each 
share of stock of each subsidiary and each share of lower-tier 
subsidiary stock held by a subsidiary on each measuring date. In 
addition, these records would need to be created and maintained not 
just for subsidiaries, but for all corporations the stock of which is 
acquired by a member, because the information would be necessary if the 
corporation becomes a member at some later date.
    In administering the various temporary and final regulations 
promulgated as loss limitation rules under Sec.  1.337(d)-1 and Sec.  
1.337(d)-2, the IRS has found that taxpayers encounter substantial 
difficulty in attempting to satisfy these requirements.
    To begin, taxpayers are generally unable to accurately identify all 
of a subsidiary's tainted assets. One reason is simply the vast number 
of assets implicated. Another reason is that many assets are accounted 
for in mass accounts and thus cannot be separately identified. Problems 
are exacerbated if appropriate records are not created 
contemporaneously; taxpayers have found this a particular concern when 
subsidiaries have been acquired with inadequate records.
    Furthermore, the commonplace nature of many redetermination events 
makes it difficult to identify all such dates. For example, many 
taxpayers routinely issue stock when a member contributes cash or 
property to a subsidiary, even if the issuance of stock would not be 
required for section 351 to apply, and each such occurrence is a 
redetermination event.
    Valuation also imposes significant financial and administrative 
burdens on both taxpayers and the government. These problems are 
exacerbated because the corporation's assets are not themselves the 
subject of an arms-length transaction and, in most cases, the date on 
which the assets are actually valued is long after the stock 
transaction.
    The most problematic aspect of tracing, however, has typically been 
establishing the connection, or lack thereof, between items taken into 
account by the group and particular amounts of tainted appreciation. If 
much time has elapsed between a measuring date and the disposition of a 
tainted asset, or if an asset is held in a mass account, this can be 
difficult or even impossible. If tainted appreciation is recognized as 
income earned through the wasting or consumption of the appreciation, 
instead of as gain on the disposition of the asset, there are 
additional difficulties. In those cases, tracing is possible only if 
the tainted appreciation generates an identifiable stream of income. 
However, this is frequently not the case. For example, intangible 
assets, like patents or goodwill, are the source of significant tainted 
appreciation and they typically do not generate identifiable income 
streams.
    i. Conclusions regarding tracing.
    For all the reasons set forth in this preamble, the IRS and 
Treasury Department have again, as in 1990, concluded that tracing is 
not a viable method for preventing the circumvention of GU repeal in 
consolidation. This conclusion, while arguably based on theoretical 
concerns in 1990, is now based on several years of administering Sec.  
1.337(d)-2 (in both its temporary and final form) as a tracing regime. 
The IRS found that the difficulties encountered, by taxpayers and the 
government alike, in administering Sec.  1.337(d)-2 as a tracing-based 
rule were overwhelmingly greater than those encountered in 
administering it as a presumption-based rule under the basis 
disconformity method permitted under Notice 2004-58. Accordingly, the 
IRS and Treasury Department are not proposing to adopt a tracing-based 
approach.
    ii. Tracing in other contexts.
    The IRS and Treasury Department recognize that tracing-based 
regimes are used to implement other provisions in the Code. For 
example, section 382(h), which prescribes the tax treatment of built-in 
items recognized by a corporation that has had an ownership change, and 
section 1374, which prescribes the tax treatment of built-in items 
recognized by an S corporation that was formerly a C corporation, both 
use tracing-based regimes. Further, the IRS and Treasury Department are 
proposing regulations implementing section 362(e)(2) in a consolidated 
return context that require certain items

[[Page 2971]]

to be traced. See section H of this preamble.
    The tracing regimes appropriate for those sections, however, do not 
present compliance and administrative concerns of the scope and 
magnitude presented by a tracing regime appropriate for GU repeal in 
the consolidated setting for at least three reasons.
    To begin, both sections 382(h) and 1374 apply only for a limited 
period of time--five years in the case of section 382(h) and ten years 
in the case of section 1374--and so whatever burden is imposed is more 
limited in nature.
    More importantly, sections 382(h) and 1374 are generally concerned 
only with the unrecognized appreciation and depreciation in a pool of 
assets held by a corporation on a single date--the date the C 
corporation converts to an S corporation or the date the S corporation 
acquires assets of a C corporation in the case of section 1374, and the 
date a corporation has an ownership change in the case of section 
382(h). Similarly, section 362(e)(2) is only concerned net unrecognized 
depreciation in a pool of assets on the date of the transaction to 
which section 362(e)(2) applies. But the ability to circumvent GU 
repeal using the consolidated return provisions can be created any time 
the subsidiary has a redetermination event. Thus, any rule implementing 
GU repeal in the consolidated context, unlike rules implementing 
sections 362(e)(2), 382(h), and 1374, must trace the pool of assets 
held on all measuring dates, and not just the pool of assets held when 
subsidiary stock is acquired (or when assets are transferred).
    Finally, unlike regulations implementing GU repeal, regulations 
implementing those other sections do not need to take into account the 
changing relationship between the basis in a particular share of stock 
and the unrecognized appreciation and depreciation in the corporation's 
assets.
    For these reasons, any tracing-based regime appropriately 
implementing GU repeal in the consolidated setting would be much more 
expansive and complex, and therefore much less administrable, than the 
tracing regimes appropriately implementing sections 382(h) or 1374 (or 
proposed to implement section 362(e)(2)).
    b. Modified tracing.
    The IRS and Treasury Department considered several approaches that 
could be adopted to modify a tracing model by limiting the extent to 
which tracing would be required, in order to mitigate the 
administrative burdens of a pure tracing model.
    i. Exclusion for items attributable to after-acquired assets.
    Several commentators have suggested an approach, generally called 
the ``after-acquired asset exception,'' which allows taxpayers to 
identify assets acquired after the acquisition of subsidiary stock, in 
order to treat any gain realized on those assets as economic to the 
group. In general, all other items of gain and income would be deemed 
to be noneconomic, that is, attributable to the recognition of 
appreciation that was already reflected in basis. Stock loss would be 
allowed only to the extent that stock basis was attributable to the 
amounts deemed economic to the group. In response to concerns raised by 
the IRS and Treasury Department about redetermination events, the 
proposal was modified to provide that only assets acquired after the 
latest measuring date would be treated as giving rise to economic 
amounts. The principal advantage of this approach is that it identifies 
some untainted items with no need for valuation.
    To begin, the IRS and Treasury Department are concerned with the 
burden and error potential presented by the need to identify all 
redetermination events. Moreover, because these events can occur with 
considerable frequency in the ordinary course of business, it is 
unlikely that a great deal of time will typically elapse between the 
last redetermination date and the date of a stock disposition. Thus, 
the amount of gain recognized on an asset acquired and sold during such 
periods of time will not likely be significant. As a result, it appears 
unlikely that this approach would afford much relief to taxpayers (in 
terms of administrative burden or reducing the disallowance amount) or 
to the government (in terms of administrative burden).
    Furthermore, in order to implement GU repeal appropriately, such an 
approach must take into account not only gains, but also losses, 
recognized on after-acquired assets. But the identification of such 
losses imposes an additional administrative burden that taxpayers have 
no incentive to facilitate. In any event, a requirement to take losses 
into account could be easily manipulated by the timing and structuring 
of redetermination events.
    ii. Exclusion for items recognized after prescribed period of time.
    Several commentators also suggested a tracing-based approach that 
would apply to investment adjustments taken into account only during a 
prescribed period of time following the acquisition of a share. The 
chief advantage to this approach is that, regardless how burdensome the 
administration of the rule, it would not extend indefinitely.
    Like the proposed after-acquired-asset approach, however, this 
approach would need to take redetermination events into account. The 
tracing period would then begin again on the date of each 
redetermination event. Thus, like the after-acquired-asset exception, 
this approach is unlikely to afford much relief to taxpayers (in terms 
of administrative or tax burden) or the government (in terms of 
administrative burden) because the period for tracing may never close.
    Moreover, the IRS and Treasury Department are concerned that such 
an approach does not adequately respond to GU repeal. The reason is 
that noneconomic investment adjustments circumvent GU repeal whenever 
they are taken into account. Thus, the IRS and Treasury Department 
continue to believe that, in the absence of any direction from 
Congress, such as in the case of section 1374, imposing time limits on 
the implementation of GU repeal would be inappropriate. See TD 8294.
    iii. Exclusion for basis conforming acquisitions.
    Commentators have also suggested adopting a tracing-based approach 
that excepted any stock acquired in either a section 351 exchange or a 
qualified stock purchase for which an election was made under section 
338. The rationale for this approach is that, by operation of statute, 
the basis of stock acquired in these transactions can reflect no 
unrecognized appreciation.
    The IRS and Treasury Department agree that, in certain 
circumstances, the structure of a stock acquisition will, by operation 
of law, preclude the reflection of unrecognized appreciation in stock 
basis. The IRS and Treasury Department are concerned, however, that 
many acquisitions under section 351 or section 338 actually do not 
preclude the reflection of unrecognized asset appreciation in stock 
basis. For example, if subsidiary stock is acquired in a section 351 
exchange in multiple transactions or by multiple transferors, as 
illustrated in Example 7(b) and Example 7(c), respectively, the basis 
of the shares received can reflect unrecognized appreciation. 
Similarly, because only 80 percent of the stock of a subsidiary need be 
acquired to elect section 338 treatment, the basis of up to 20 percent 
of a subsidiary's shares may reflect unrecognized appreciation. 
Moreover, even if the initial acquisition precludes the reflection of 
unrecognized gain, once there is a redetermination event, the form of 
the acquisition no longer prevents the reflection of

[[Page 2972]]

unrecognized appreciation in stock basis. Thus, very few, if any, such 
transactions would ultimately qualify for this exception.
    Thus, like the two previously described approaches to modified 
tracing, this approach has the inaccuracy and burden associated with 
identifying redetermination dates and a limited potential for relief to 
either taxpayers or the government.
    iv. Conclusions regarding modified tracing.
    Each approach considered would increase the administrative burden 
significantly without significantly increasing precision or relief. 
Accordingly, the IRS and Treasury Department are not proposing to adopt 
any of these approaches.
2. Hybrid Tracing-Presumptive Model: Asset Tracing.
    The IRS and Treasury Department also considered a hybrid tracing-
presumption approach that would identify all assets held when a share 
is acquired and on each redetermination date thereafter (again, the 
``tainted assets'') and then presume all items of income, gain, 
deduction, and loss traced to those assets to be tainted. The intent 
was to design an approach that would be more precise than either a 
modified tracing or purely presumptive approach, while being more 
administrable than a pure tracing-based approach. The chief advantages 
of this approach are that it may enhance precision and, like the after-
acquired asset exception described in section C.1.b.i of this preamble, 
may eliminate any need for valuation.
    However, like the modified tracing approaches described above, this 
approach would require the identification of all redetermination 
events. Furthermore, it would require the identification of all assets 
held at the time of each such event and the tracing of those assets to 
particular investment adjustments. Thus, it presents even more 
complexity, burden, and expense than the modified tracing regimes 
considered. Furthermore, the IRS and Treasury Department are concerned 
that this approach could be easily abused, either by the manipulation 
of redetermination dates or the use of intercompany transactions to 
make valuation elective. (That is, taxpayers could selectively engage 
in intercompany transactions so that, in effect, some assets would be 
valued and not others.)
    Finally, the IRS and Treasury Department are not convinced that the 
approach in fact significantly enhances the precision of a pure 
presumptive model in light of the fact that there is no actual 
valuation (and therefore no actual determination that there was any 
gain reflected in stock basis).
    For all these reasons, the IRS and Treasury Department concluded 
that the potential advantages of this hybrid tracing-presumptive 
approach are outweighed by its disadvantages. Accordingly, the IRS and 
Treasury Department are not proposing to adopt this approach.
3. Presumption-Based Models
    Recognizing that even the hybrid tracing-presumptive model would 
present significant burden and imprecision, the IRS and Treasury 
Department considered various presumptive models that, like the LDR, 
would eliminate all elements of tracing. A principal advantage of such 
approaches is that they are readily administrable by both taxpayers and 
the IRS. Thus, the rules can apply uniformly and consistently, with the 
result that similarly situated taxpayers will be similarly treated, 
increasing the overall fairness of the system. The elimination of any 
tracing element, however, increases the importance of limitations, 
where appropriate, on the nature and amount of items treated as 
noneconomic to a share. The approaches considered are discussed in this 
section C.3 and in section C.4 of this preamble.
    a. Basis disconformity under Notice 2004-58.
    One model considered was the basis disconformity model described in 
Notice 2004-58, presently available as a method to avoid disallowance 
under Sec.  1.337(d)-2. As noted in section A.4 of this preamble, the 
basis disconformity model treats as built-in gain (within the meaning 
of Sec.  1.337(d)-2) the smallest of three amounts. The first is the 
basis disconformity amount (which identifies the minimum amount of 
built-in gain that could be reflected in the share), the second is the 
net positive adjustment amount (which identifies the actual amount of 
stock basis attributable to the consolidated return system), and the 
total gains on property dispositions (which responds to the definition 
of the term built-in gain in Sec.  1.337(d)-2). A significant advantage 
of this approach is that both taxpayers and the IRS find it readily 
administrable with information that taxpayers are already required to 
maintain.
    However, the Notice 2004-58 basis disconformity model, because it 
is an interpretation of the current loss limitation rule in Sec.  
1.337(d)-2, reflects limitations that inhibit the extent to which the 
rule addresses the circumvention of GU repeal and promotes the clear 
reflection of group income. For example, the model did not account for 
the consumption of unrecognized appreciation reflected in stock basis 
(the ``wasting asset'' problem). Thus, if unrealized gain reflected in 
stock basis was recognized as income (for example through a lease, 
instead of a disposition of the property), the resulting noneconomic 
stock loss was not disallowed under the current rule. In addition, the 
model did not address the problem of basis disparity. (See for example, 
Example 4.)
    A more significant concern, however, is that the basis 
disconformity approach is underinclusive in that it can only address 
noneconomic stock loss to the extent of net appreciation reflected in 
stock basis, which is, by its nature, reduced by unrecognized 
depreciation reflected in basis. As a result, a potentially significant 
amount of noneconomic stock loss remained unaddressed, particularly in 
deconsolidating dispositions of subsidiary stock.

    Example 9. Unrecognized loss reflected in stock basis. P 
purchases all the outstanding stock of S for $150. At the time, S 
owns one asset, A1, with a basis of $25 and value of $100, and one 
asset, A2, with a basis of $100 and a value of $50. S sells A1 to a 
nonmember for $100 and recognizes a $75 gain, which the P group 
takes into account. Under the investment adjustment system, P 
increases its basis in the S stock by $75, to $225, to reflect the 
$75 taken into account by the group. If P then sells the S stock for 
$150 (its fair market value), P will recognize a $75 loss. Under the 
basis disconformity approach, only $25, the excess of P's S stock 
basis ($225) over S's net inside asset basis ($100 cash plus S's 
$100 basis in A2, or, $200), of the $75 gain is treated as a 
noneconomic investment adjustment. Thus, although the entire loss is 
noneconomic, only $25 of that loss would be disallowed under this 
approach.

    b. Modified basis disconformity.
    The IRS and Treasury Department considered several modifications to 
the basis disconformity model, all of which were intended to address 
the underinclusivity of that model. One approach suggested by 
commentators would mitigate the wasting assets concern by first, for a 
prescribed period of time, treating the sum of all property gains and, 
up to the disconformity amount, all income as noneconomic (and thus 
included in the disallowance amount). After the prescribed time, all 
gains and income would be treated as noneconomic, but only to the 
extent of the disconformity amount. Other approaches considered 
reflected variations on this suggestion.
    The IRS and Treasury Department recognize that the model described, 
and

[[Page 2973]]

any similar models, would be readily administrable, but are concerned 
that such a model would not adequately preserve the group's ability to 
deduct economic loss sustained by the group. The reason is that stock 
loss could be attributable to economic investment adjustments 
(adjustments attributable to the recognition of items of income and 
gain that were not reflected in stock basis) that were followed by 
economic loss (attributable to a decline in the value of the 
subsidiary's assets). For example, assume that P contributed an asset 
to S (basis and value of $10), the asset appreciated and S sold it for 
$100 (recognizing a $90 gain that increased P's basis in S stock to 
$100), S reinvested the $100 in an asset that declined in value to $10, 
and P then sold the stock for $10. P would recognize a $90 loss that 
would be disallowed because S had a $90 gain on the disposition of an 
asset. Yet the entire loss was an economic loss. As a result, the IRS 
and Treasury Department are concerned that the result in Rite Aid (that 
the group receive the tax benefit of its economic loss) would not be 
adequately protected.
    Ultimately, the IRS and Treasury Department concluded that the 
basis disconformity model in Notice 2004-58 would not be modified, but 
that elements of the model would be incorporated in a new approach.
4. The Presumptions and Simplifying Conventions Adopted in These 
Proposed Regulations
    a. Loss limitation model.
    As discussed in section A.2 of this preamble, when the IRS and 
Treasury Department rejected a tracing approach in favor of the 
presumptive approach in 1990, the decision was made to balance the use 
of irrebuttable presumptions by adopting a loss limitation model. Under 
a loss limitation model, losses attributable to noneconomic investment 
adjustments are disallowed, but gain reduction (or elimination) 
attributable to noneconomic investment adjustments is not. The IRS and 
Treasury Department believed that allowing noneconomic gain reduction 
not only balanced the benefits and burdens of the presumptive approach, 
it also provided the considerable advantage of reducing gain 
duplication in consolidated groups.

    Example 10. Noneconomic gain reduction, elimination of gain 
duplication. P purchases all the stock of S for $150 when S holds 
one asset, A1, with a basis of $100. S sells A1 for $150, 
recognizing $50 of gain. S uses the $150 proceeds from the sale of 
A1 to purchase A2. The value of A2 appreciates to $200, and P then 
sells its S stock for $200.

    If the investment adjustment system did not adjust stock basis for 
items attributable to appreciation reflected in basis, P's basis in S 
stock would remain $150 and, when P sells the S stock, P would 
recognize a gain of $50 (reflecting the $50 appreciation in A2). When S 
sells A2, S would recognize the same $50 of economic gain a second 
time. However, because P's basis in S is increased by the $50 gain 
recognized on the sale of A1, P will recognize no gain or loss on its 
sale of S stock. The gain on A2 is therefore taxed once, when there is 
a recognition event with respect to A2.
    These proposed regulations adopt a loss limitation model for the 
same reasons such a model was adopted in 1990, in the regulations 
promulgated under section 337(d) and the LDR (to balance the use of a 
presumptive approach).
    However, the LDR, as well as Sec. Sec.  1.337(d)-1 and 1.337(d)-2, 
applied the loss limitation model by disallowing loss recognized on the 
disposition of subsidiary stock and reducing basis on the 
deconsolidation of subsidiary stock. The IRS and Treasury Department 
recognize that the effect of a loss disallowance rule can be achieved 
by applying a basis reduction rule immediately before the disposition 
of loss stock. Modifying the loss limitation model to reduce basis in 
all cases simplifies the structure of the rule by avoiding the need for 
two distinct rules.
    b. Amount of basis reduction.
    The IRS and Treasury Department considered two basic approaches to 
determining the amount of basis reduction. One would be determined with 
reference to a share's adjusted basis and the other would be determined 
with reference to the disconformity between the share's basis and its 
allocable portion of the subsidiary's attributes.
    i. Adjusted purchase price cap.
    Under this approach, the basis of a transferred loss share would be 
reduced by the amount that the subsidiary's items increased the share's 
basis, but only to the extent of the adjusted purchase price. For 
purposes of this rule, the adjusted purchase price would be defined as 
the holder's original basis in the stock, adjusted to take into account 
all redetermination events. The rationale for this rule is that the 
adjusted purchase price represents the maximum amount of unrecognized 
gain that could be reflected in stock basis. However, this cap does not 
establish that, in fact, there was any appreciation reflected in stock 
basis and, therefore, it could prove to be substantially overinclusive.
    The IRS and Treasury Department considered several rules that could 
be combined with the adjusted purchase price cap in order to mitigate 
its potential for overinclusiveness. One approach would combine this 
cap with the asset tracing model described in this preamble. Another 
approach would combine this cap with rules that treat income items as 
included in the basis reduction amount under a different rate (for 
example, using a declining percentage over time) or amount (for 
example, using an annual income cap, perhaps based on a percentage of 
the gross items). The IRS and Treasury Department ultimately concluded 
that the limitations either imposed unacceptable burdens (because of 
the need to identify redetermination dates and trace assets) or did not 
significantly increase the theoretical soundness of the approach, and 
that the potential for overinclusiveness prevented the approach from 
responding adequately to the Congressional mandate to preserve the 
result in Rite Aid.
    ii. Modified adjusted purchase price cap.
    To address the potential overinclusivity of the adjusted purchase 
price cap, the IRS and Treasury Department considered modifying the 
rule by reducing the cap by the basis of any tainted assets sold at a 
gain. The rationale for this modification is that the maximum potential 
amount of appreciation reflected in basis is reduced by the basis of 
tainted assets as they are sold. While this modification reduced the 
potential for overinclusiveness in a theoretically sound manner, it 
exacerbated the administrative difficulties by requiring not only the 
identification of all redetermination dates, but also of all assets 
held on such dates. Moreover, the IRS and Treasury Department 
ultimately concluded that the basic premise (that the limitation 
represented the maximum possible noneconomic income) remained an 
inadequate response to the Congressional directive that the group be 
allowed to deduct its economic loss.
    iii. Disconformity cap.
    This model would also reduce basis by the amount that the 
subsidiary's items increased the share's basis, but only to the extent 
of the disconformity amount. For this purpose, the disconformity amount 
would generally be the same as the basis disconformity amount described 
in Notice 2004-58. The rationale for this limitation is that the 
disconformity amount identifies the minimum amount of unrecognized 
appreciation actually reflected in the basis of a share of subsidiary 
stock at the relevant time. Thus, although the

[[Page 2974]]

amount of such appreciation could actually be considerably greater (as 
in Example 9), and could even be equal to the adjusted purchase price 
(assuming a subsidiary was purchased with no basis in any of its 
assets), it is not lower. Not only does the disconformity cap have the 
advantage of identifying an amount of appreciation actually reflected 
in stock basis, it allows for the computation of that amount with 
information taxpayers are already required to know. Additionally, it 
avoids the need to identify redetermination events because, by 
computing disconformity immediately before a transfer, this approach 
automatically takes the effect of all such events into account.
    iv. Modified disconformity cap.
    Because the use of a disconformity cap raises significant potential 
for underinclusivity, as illustrated in Example 9, the IRS and Treasury 
Department considered increasing the disconformity cap by the amount of 
unrecognized loss on any tainted assets held by the subsidiary. The 
rationale for this increase is that those losses could prevent an equal 
amount of recognized tainted appreciation from being treated as 
noneconomic. Thus, the rule would not undermine the theoretical 
foundation of the disconformity cap.
    However, this approach would require the identification of 
redetermination dates, as well as the identification and valuation of 
all assets held on the last such date. Recognizing the imprecision 
inherent in this approach, the IRS and Treasury Department considered 
increasing the disconformity cap by only a discounted portion of those 
unrecognized losses. The IRS and Treasury Department concluded that 
this approach would introduce burden and imprecision much greater than 
the potential benefit obtained by increasing the cap on basis 
reductions, at least in the majority of commercially typical cases.
    The IRS and Treasury Department also considered implementing this 
modification not as a general rule, but only as an anti-abuse rule, so 
that it would apply only in circumstances that indicated a significant 
amount of tainted income or gain might be sheltered by unrecognized 
loss on tainted assets. For example, such a rule could require an 
increase to the disconformity cap if there was a significant loss in 
stock, if the subsidiary recognized significant gain shortly before 
stock sale, or if the stock was held for only a short period of time 
before it was sold. The IRS and Treasury Department were concerned, 
however, that the increased uncertainty and burden introduced by such 
an approach could not be justified in light of the protections against 
manipulation that exist in the Code and other rules of law. For 
example, see sections 269, 362(e)(2), and 482, as well as various anti-
avoidance and anti-abuse provisions in the regulations, including these 
proposed regulations.
    v. Disconformity cap with duplication rule.
    In considering the structural potential for underinclusivity in the 
disconformity cap, the IRS and Treasury Department observed that the 
recognition of noneconomic gains in excess of the disconformity amount 
causes the subsidiary's unrecognized losses to be expressed in stock 
basis. The facts of Example 9 illustrate this point. In that example, P 
purchased S for $150 when S held A1 (basis $25, value $100) and A2 
(basis $100, value $50). S sold A1 and recognized $75 gain, which 
increased P's basis in S to $225. P then sold the S stock and 
recognized a $75 loss. At the time of the stock sale, S's net asset 
basis was $200 (the $100 received for A1 and the basis of A2), which 
exceeds the value of the stock by $50. Thus, the basis disconformity 
amount is $25 (the excess of the $225 stock basis over the $200 net 
asset basis), and so (although there is a $75 recognized gain), only 
$25 is disallowed. However, at that point, S's $200 net asset basis 
exceeds S's $150 value by $50. The $50 of unrecognized loss on A2 is 
reflected in both P's basis in S stock and S's basis in its assets. 
That is, the loss on A2 has been duplicated. As a result, the 
underinclusivity of the disconformity cap can be measured and addressed 
as duplicated loss.
    The IRS and Treasury Department recognize that addressing this loss 
as a duplicated loss allows taxpayers to accelerate the benefit of a 
subsidiary's unrecognized losses (that is, obtain the benefit of the 
loss without a recognition event with respect to its loss assets). 
However, this approach allows taxpayers the benefit of their economic 
loss while limiting any arguably excessive benefit to the ability to 
accelerate inside loss. In the end, loss duplication is prevented. (The 
IRS and Treasury Department have long recognized that it is appropriate 
for a group to offset recognized built-in gains and losses, see 
Sec. Sec.  1.337(d)-1 and 1.337(d)-2, as promulgated in 1990 and again 
as temporary and final regulations following the Rite Aid decision).
    vi. Conclusion.
    In light of the concerns raised by any method that would reduce 
basis beyond the disconformity amount, the IRS and Treasury Department 
have concluded that the amount of basis reduction should be limited to 
the disconformity amount and that combining the disconformity cap with 
a loss duplication rule to address its underinclusivity provides the 
most appropriate balancing of interests. Under this approach, the 
group's economic loss is appropriately protected and neither the group 
nor its members will receive more than one benefit for the subsidiary's 
economic loss.
    c. Items applied to reduce basis.
    i. Character of items applied to reduce basis.
    In general, the IRS and Treasury Department have concluded, and 
commentators have generally agreed, that all gains on property 
dispositions, as well as various gain equivalents, should be fully 
available to reduce basis under a presumptive rule.
    Questions arose, however, regarding whether income items should 
also be fully available to reduce basis. The reasons for these 
questions center on the general difficulty of tracing income items 
(which is limited in the best of circumstances) and the observation 
that the likelihood of a particular income item being attributable to 
tainted appreciation generally decreases over time. Accordingly, the 
IRS and Treasury Department considered several proposals to limit both 
the amount and the rate of inclusion for income items.
    All of these approaches would segregate income that could be traced 
to particular appreciation reflected in stock basis and treat those 
amounts in the same manner as items of gain. The net income remaining 
would be applied to reduce basis according to prescribed limits. For 
example, one proposal would apply net income to reduce basis for a 
prescribed period of time following a measuring date, but, after that 
time, net income would be so applied only according to a declining 
percentage.
    The IRS and Treasury Department are concerned, however, that the 
approaches considered could be readily manipulated, for example, by 
converting gain into income that cannot be readily traced to particular 
assets or by delaying the recognition of income items until after the 
applicable time period. Therefore, any such rule would inappropriately 
influence the structure of business transactions and, at the same time, 
fail to provide adequate protection for GU repeal. In addition, the 
need to account for redetermination dates would add complexity and 
diminish the potential relief afforded under any such approach. 
Moreover, the IRS and Treasury Department identified no theoretical 
basis for any particular rule and were concerned that the increased

[[Page 2975]]

precision may be more perceived than real.
    ii. Capital transfers.
    Adjustments to reflect transfers of capital, whether contributions 
or distributions, are not adjustments attributable to the recognition 
of appreciation or depreciation. Accordingly, these adjustments do not 
increase or decrease the extent to which stock basis is noneconomic or 
facilitates the circumvention of GU repeal. For that reason, such 
amounts are not taken into account in determining the extent to which 
subsidiary stock basis is subject to reduction.
    Commentators have suggested that the nature of an intercompany 
cancellation of indebtedness is similar to that of a capital 
contribution and thus should not be taken into account in determining 
basis reduction. The IRS and Treasury Department recognize that this 
may often be the case, but are concerned that, under some 
circumstances, this may not be the case. Because it will be 
administratively very difficult to identify situations in which 
intercompany cancellation of indebtedness is not similar to a capital 
contribution, and to distinguish intercompany cancellation of 
indebtedness from other arguably similar cases, these proposed 
regulations treat items related to intercompany cancellation of 
indebtedness like all other items of income or loss. However, the IRS 
and Treasury Department continue to study the issue and invite further 
comments.
    d. Netting of items from different tax periods.
    Under the LDR, there was no cross-year netting of investment 
adjustments. Positive investment adjustments were taken into account in 
determining the loss disallowance amount, negative investments were 
not. The IRS and Treasury Department have reconsidered whether items 
from different tax periods should be considered together in determining 
basis reduction.
    The IRS and Treasury Department recognize that the particular 
circumvention of GU repeal at issue here is a product of the manner in 
which the investment adjustment system adjusts stock basis to reflect a 
subsidiary's amounts that are taken into account by the group. Thus, 
IRS and Treasury Department have concluded that the appropriate measure 
of the concern must take into account the net extent to which the basis 
of a share has been increased or decreased by the investment adjustment 
system. Whether a loss is taken into account in the same year in which 
a gain is taken into account or in a separate year does not change the 
net effect of the investment adjustment system. Thus, unlike the LDR, 
these proposed regulations allow netting of all investment adjustments 
made to a share for all periods.
    e. Summary and conclusions.
    Only a presumptive approach can eliminate the substantial 
administrative burdens imposed by the tracing-based and hybrid regimes 
discussed above. As a result, only a presumptive approach can be 
applied consistently among taxpayers and thus achieve the overall 
fairness necessary to these regulations. Importantly, if presumptions 
are rebuttable, the administrative burdens associated with a tracing 
system are not avoided. In fact, they are exacerbated, because 
taxpayers will feel it necessary to be prepared to establish, and the 
government will then need to be prepared to examine, returns using both 
systems. Accordingly, the proposed regulations reflect a presumptive 
approach that does not permit the rebuttal of its operating 
presumptions. As noted in section A.5 of this preamble, Congress has 
specifically sanctioned the use of presumptions and other simplifying 
conventions to address the circumvention of GU repeal.
    To balance the use of irrebuttable presumptions, the proposed 
regulations adopt several provisions that are intended to enhance their 
overall fairness and theoretical soundness. First, the proposed 
regulations adopt the disconformity amount as the maximum amount of 
potential stock basis reduction. The reason, as discussed, is that only 
the disconformity amount both establishes the fact that the taxpayer 
had unrealized gain reflected in stock basis and identifies the minimum 
amount of such gain. Second, the proposed regulations include all items 
taken into account, from all years, in the determination of the basis 
reduction amount. Thus, basis is not reduced for certain amounts (such 
as capital transfers) that cannot be attributable to noneconomic 
investment adjustments. In addition, by presuming all items of income, 
gain, deduction and loss as attributable to appreciation or 
depreciation reflected in basis, the proposed regulations avoid the 
administrative and other concerns inherent in various tracing and 
hybrid approaches. Moreover, by presuming all items to be reflected in 
basis, the benefits and burdens inherent in the use of irrebuttable 
presumptions are fairly balanced between taxpayers and the government. 
Presuming all items of income and gain are noneconomic favors the fisc, 
while presuming all items of deduction and loss are noneconomic favors 
taxpayers.

D. Loss Duplication

    The IRS and Treasury Department continue to believe that a group's 
income is distorted when the group enjoys more than one tax benefit 
from an economic loss. Further, the IRS and Treasury Department believe 
that a subsidiary's use of a group loss in a separate return year, 
after the group has already recognized the benefit of the loss, 
distorts the subsidiary's separate year income.
    Moreover, the IRS and Treasury Department do not believe that the 
manner or order in which a group takes its losses into account affects 
the extent to which loss duplication is inappropriate. Thus, loss 
duplication is inappropriate and must be addressed whether arising in 
situations like that illustrated in Example 3 (loss reflected in both 
stock and assets) or in Example 5 (duplication attributable to 
disparate stock basis). In addition, loss duplication is inappropriate 
and must be addressed whether the group chooses to recognize loss first 
as an inside loss, on the subsidiary's assets and operations (which is 
addressed by Sec.  1.1502-32), or as a stock loss (which is currently 
addressed, at least partially, by Sec.  1.1502-35).
    Accordingly, the IRS and Treasury Department have returned to a 
fundamental premise of the LDR and again concluded that a loss 
duplication rule that operates without regard to members' continued 
affiliation is a necessary complement to the investment adjustment 
system. The IRS and Treasury Department have also concluded that such a 
rule must also address the potential for loss duplication presented 
when loss is disproportionately reflected in the bases of individual 
shares.
    Importantly, as noted in section A.5 of this preamble, Congress has 
indicated that it, too, views the prevention of loss duplication, 
including in deconsolidating stock dispositions, as an area that is 
appropriately addressed by regulation. See H.R. Conf. Rep. No. 108-755 
at 652.
    Therefore, the IRS and Treasury Department have reviewed the 
current rules and considered alternative approaches to address the 
duplication of loss.
1. Reconsideration of Sec.  1.1502-35
    Loss duplication is currently addressed in Sec.  1.1502-35. That 
rule generally applies whenever there is a disposition of loss shares 
of subsidiary stock. To address the loss duplication problems arising 
when loss is disproportionately reflected in stock

[[Page 2976]]

basis, the rule first redetermines members' bases to reduce that 
disparity (to address the problems illustrated in Example 5). Different 
rules apply depending on the subsidiary's status as a group member 
following the stock disposition. If the subsidiary remains a member, 
the full blending rule of Sec.  1.1502-35(b)(1) applies and all 
members' bases in shares of the subsidiary's stock are combined and 
then allocated evenly to preferred (to value) and then to common 
(equally). If the subsidiary ceases to be a member, the basis 
redetermination rule of Sec.  1.1502-35(b)(2) applies and members' 
bases are redetermined to reduce loss on all members' shares. However, 
this rule only redetermines basis to the extent of items of deduction 
and loss included in negative adjustments applied to nonloss shares. As 
under the full blending rule, redetermination under this rule first 
reduces or eliminates loss on preferred shares and then equalizes 
members' bases in common shares.
    The potential for loss duplication following the redetermination of 
members' bases is addressed only if the subsidiary remains a member of 
the group. In that case, stock loss (to the extent of loss duplication) 
is suspended, the suspended loss is reduced as the subsidiary's items 
of deduction and loss are taken into account, and any suspended loss 
remaining when the subsidiary ceases to be a member is allowed at that 
time. The regulation does not address the duplication of loss when the 
subsidiary ceases to be a member, other than to prevent the 
reimportation of duplicated losses back into the group.
    The IRS and Treasury Department understand that certain 
administrability concerns have arisen under Sec.  1.1502-35. For 
example, taxpayers have commented that the rules relating to the 
suspension of loss in nondeconsolidating dispositions and the treatment 
of reimported losses present substantial compliance issues. The 
experience of the IRS is consistent with those comments.
    Moreover, the IRS and Treasury Department have reconsidered the 
appropriateness of allowing subsidiaries to duplicate group losses 
after the period of consolidation. Under this approach, former members 
can use group losses (that have already been used by the group) to 
offset their separate year income. This duplicative use of group losses 
distorts the former member's separate income. Under section 1502, 
consolidated return regulations are directed to promote the clear 
reflection of not only the income of a group, but also of its members, 
including former members. Accordingly, as in 1990, the IRS and Treasury 
Department have concluded that a group loss, once used by the group, 
should not be available to a former member for a second, duplicative 
use outside the group.
    For these reasons, the IRS and Treasury Department propose to 
remove Sec.  1.1502-35 and replace it with a more easily administered 
and more comprehensive approach to addressing loss duplication among 
members of a consolidated group.
2. Other Methods Considered for Addressing Loss Duplication
    As discussed in section D of this preamble, the IRS and Treasury 
Department have concluded that loss duplication is an inappropriate 
distortion of income (of either a group or its members, including 
former members) regardless of the subsidiary's status after a transfer 
of its stock. Accordingly, these proposed regulations address loss 
duplication in both nondeconsolidating and deconsolidating stock 
transfers. Several approaches were considered.
    a. Disallowance of stock loss.
    As a general matter, the IRS and Treasury Department believe that 
disallowing duplicative stock loss better implements single entity 
principles because it results in the recognition of the subsidiaries' 
economic gain or loss on its assets and operations, instead of on its 
stock. However, to preserve the result in Rite Aid, stock loss could 
only be disallowed for nondeconsolidating transfers and additional 
rules would be necessary to address both the loss remaining in the 
group and the duplication of loss in deconsolidating transfers (which 
could not be subject to the loss disallowance rule). Thus, a rule 
implementing this approach would need to include a provision comparable 
to Sec.  1.1502-35(c), which taxpayers and the IRS have found to 
present significant compliance issues. In addition, this approach would 
need to include a provision to address loss duplication in 
deconsolidating transfers.
    b. Loss duplication accounts.
    The IRS and Treasury Department also considered an approach that 
would allow stock loss, but identify the amount of loss duplication and 
create a suspended account to limit the deductibility of items as they 
are taken into account. One advantage of this approach is that it only 
requires one set of rules to address both nondeconsolidating and 
deconsolidating transfers. This approach also has the advantage of 
increasing the precision in identifying (and disallowing) losses that 
are actually duplicated.
    However, unless the rule were to use presumptions to treat items as 
chargeable against the loss duplication account, it would present 
considerable tracing issues. In addition, this approach raises 
administrability issues comparable to those associated with the loss 
suspension regime in Sec.  1.1502-35(c). These difficulties are 
exacerbated by the need to have the account follow the subsidiary, 
possibly through subsequent acquisitions, until the account is 
eliminated.
    The IRS and Treasury Department are also concerned that, because 
this approach would reduce or eliminate duplication only when inside 
losses were recognized, taxpayers could avoid the effect of the rule by 
waiting until assets appreciated before disposing of them. To mitigate 
this concern, the rule could require the subsidiary to take into 
account the duplication account, either ratably over time or at some 
specified time, but this could give rise to income in the absence of 
any loss duplication.
    c. Attribute reduction.
    The IRS and Treasury Department also considered a presumptive rule 
that would identify the extent of duplicated loss and then reduce the 
subsidiary's attributes by that amount. This approach, like the loss 
duplication account, has the advantage of needing only one set of rules 
to govern both deconsolidating and nondeconsolidating transfers. It has 
the added advantage of being similar to regimes that are already 
familiar to taxpayers, such as the attribute reduction rules of 
sections 108 and 1017, and Sec.  1.1502-28. Although attribute 
reduction could be based on valuation, like the rule in section 
362(e)(2), the IRS and Treasury Department believe that mandatory 
valuation would present a significant administrative burden and expense 
for both taxpayers and the IRS.
    d. Conclusions.
    The IRS and Treasury Department have concluded that the complexity, 
administrative burden, and expense of the loss disallowance and the 
loss duplication account approaches outweighed their respective 
advantages. Accordingly, these proposed regulations adopt an attribute 
reduction rule. The IRS and Treasury Department recognize that the 
attribute reduction approach allows taxpayers to accelerate economic 
losses of the subsidiary, but believe that this approach best preserves 
the result in Rite Aid while addressing loss duplication. In general, 
the approach adopted operates as an irrebuttable presumption, to avoid 
the burden of

[[Page 2977]]

mandatory valuation in all cases, but taxpayers continue to have 
several mechanisms available to structure their transactions to permit 
valuation (for example, by using actual or deemed asset sales).
3. Gain Duplication
    Notwithstanding the conclusions regarding duplication of loss, for 
the reasons set forth in the LDR preambles, the IRS and Treasury 
Department have tentatively concluded that adequate protections, and 
the incentive to use them, already exist to prevent the duplication of 
gain. See TD 8294, TD 8364 and TD 8984. For example, see sections 332, 
336(e) (which is the subject of another current guidance project), and 
338(h)(10). Accordingly, the duplication of gain is not addressed in 
these proposed regulations, except as a result of the adoption of a 
loss disallowance model. The IRS and Treasury Department continue to 
study the issues, however, and invite further comment. See section J of 
this preamble for further discussion of the issues on which comments 
are requested.

E. Noneconomic and Duplicated Loss From Investment Adjustment System

    For all the reasons discussed in this preamble, IRS and Treasury 
Department believe that the approaches to noneconomic and duplicated 
loss that are adopted in these proposed regulations represent the best 
approach to the (original) noneconomic and duplicated loss concerns 
described in sections B.1 and B.2 of this preamble. However, those 
rules alone do not adequately address the problem of noneconomic and 
duplicated loss attributable to investment adjustments applied to 
shares of stock with disparate bases. This is the concern described in 
section B.3 of this preamble and illustrated in Example 4 and Example 
5, as well as Example 7(b) and Example 7(c).
    The IRS and Treasury Department believe it is essential to address 
this concern. One reason is that stock basis would be inappropriately 
eliminated when, in cases like Example 4, there is noneconomic loss on 
one share because appreciated assets were contributed to a corporation 
in exchange for other shares. In those cases, the noneconomic loss 
should not be allowed, but a rule that only prevents that loss does not 
address the problem that there is insufficient basis on the shares 
received in the exchange. The result would be noneconomic gain on the 
sale of those shares. An equally important reason is that loss could 
otherwise be duplicated when, in cases like Example 5, loss is 
disproportionately reflected in the basis of some shares. Although 
regulations could prevent duplication in such cases (by eliminating 
inside loss to the full extent of duplicated stock loss), allowing a 
deduction for disproportionate stock loss in such cases permits the 
acceleration of a disproportionate amount of inside loss. To the extent 
that loss is disproportionately reflected in the basis of an individual 
share, acceleration is generally unwarranted and should be prevented to 
the extent possible. Accordingly, the IRS and Treasury Department have 
considered various approaches to mitigating these effects.
1. Revise Investment Adjustment System To Adopt a Tracing Approach
    The IRS and Treasury Department recognize that one approach to this 
problem would be to revise the investment adjustment system so that it 
would allocate subsidiaries' items of income, gain, deduction, and loss 
to their shares in accordance with the actual reflection of those items 
in the each share's basis. This approach would be similar to the 
section 704(c) regime applicable to partnerships. However, this 
approach is a tracing model and, as discussed in section C of this 
preamble, the IRS and Treasury Department do not believe that tracing 
is administrable in the consolidated setting.
    Moreover, as noted above, the IRS and Treasury Department continue 
to believe that the presumptive-based rules of Sec.  1.1502-32 are not 
only administrable, but appropriate in the vast majority of cases 
because typically subsidiary stock is common stock owned entirely by 
members with uniform bases. Where subsidiaries have issued preferred 
stock, it is generally section 1504(a)(4) stock. In addition, the 
investment adjustment system contains some guidance for situations that 
do not reflect the general assumptions on which the rules are based 
(for example, the cumulative redetermination rule in Sec.  1.1502-
32(c)(4)). In such cases, tracing would be unnecessary. Moreover, the 
IRS and Treasury Department do not believe that typical commercial 
transactions generally require groups to alter a subsidiary's capital 
structure in a manner that would require tracing. Accordingly, the IRS 
and Treasury Department are not considering revising the investment 
adjustment system to implement a tracing regime.
2. Presumptive Approaches To Reduce Basis Disparity
    The two presumptive approaches considered to reduce basis disparity 
were a full blending rule similar to that in Sec.  1.1502-35(b)(1) and 
a rule that would redetermine investment adjustments made under Sec.  
1.1502-32, similar to the rule in Sec.  1.1502-35(b)(2).
    a. Full basis blending.
    Under the full basis blending approach, all members' bases are 
aggregated and then allocated among members' shares in a manner that 
results in the elimination of loss on preferred shares and of basis 
disparity on all other shares, at least within each class. As a result, 
members' bases are aligned with the operating premises of the 
investment adjustment system.
    Full basis blending not only mitigates the effects of previous 
noneconomic investment adjustments, addressing the concern illustrated 
in Example 4 and Example 5(a), it also prevents the acceleration of 
disproportionate amounts of unrecognized loss, addressing the concern 
illustrated in Example 5(b).
    A full basis blending rule is, however, a significant departure 
from the rules generally applicable under the Code. Commentators have 
suggested that this departure from generally applicable law may be more 
significant than is warranted in light of the extent to which the 
concerns can be addressed under the investment adjustment 
redetermination approach described in this preamble.
    b. Redetermination of Investment Adjustments Previously Made to 
Stock Basis.
    The investment adjustment redetermination approach is less a 
departure from Code provisions as it is a departure from the general 
operation of Sec.  1.1502-32. In general, this approach would 
reallocate investment adjustments previously applied to members' bases 
in subsidiary stock with the goal of reducing, to the greatest extent 
possible, the disparity in members' bases in subsidiary stock. Thus, 
like the full blending approach, this approach would bring members' 
bases closer into alignment with the assumptions underlying the 
investment adjustment system. However, it would do so to a more limited 
extent than the full blending rule and in a manner that is less of a 
departure from general Code rules.
    i. Recomputation of individual investment adjustments.
    Presently, Sec.  1.1502-35(b)(2) addresses duplicated loss by 
redetermining investment adjustments when there is a deconsolidating 
disposition of subsidiary stock. To achieve the greatest reduction in 
basis disparity possible, Sec.  1.1502-35(b)(2) in effect deconstructs 
investment adjustments in order to remove negative items (that is, 
items of deduction and expense) from

[[Page 2978]]

adjustments to the bases of gain shares and then apply those items to 
reduce members' bases in loss shares. Taxpayers have raised concerns 
with the complexity and administrability of this approach. The IRS has 
observed compliance and audit difficulties with this approach.
    Accordingly, the IRS and Treasury Department have reconsidered 
whether this general approach, redetermining investment adjustments, 
could be adopted in a simpler form. The principal method considered was 
a presumptive reallocation of entire investment adjustments (exclusive 
of distributions), instead of the individual items that comprise them. 
The approach is similar to that used in the cumulative redetermination 
rule of Sec.  1.1502-32(c)(4). A significant advantage to this 
simplified approach is that it is readily administered with information 
that taxpayers are already required to know (Sec.  1.1502-32 already 
requires taxpayers to determine investment adjustments exclusive of 
distributions).
    The IRS and Treasury Department recognize that this general 
approach, in whichever form adopted, does not address the acceleration 
illustrated in Example 5(b) to the extent that full blending would. 
However, this approach is less disruptive to the general determination 
of basis.
    ii. Reallocations to loss shares that are not transferred.
    Presently, Sec.  1.1502-35(b)(2) reallocations can result in the 
reduction of any member's basis in a loss share of subsidiary stock. 
The IRS and Treasury Department have reconsidered whether reallocated 
investment adjustments should be applied to reduce loss on shares that 
are not transferred in the transaction.
    The IRS and Treasury Department have concluded that reallocating 
investment adjustments to reduce the basis of only transferred loss 
shares better implements the loss disallowance model. The reason is 
that this approach allows subsidiary stock basis to remain intact until 
there is a taxable disposition, deconsolidation, or worthlessness of 
the share, thereby permitting that basis to enjoy the full protection 
of subsequent appreciation as long as it remains in the group and 
otherwise subject to the consolidated return system. This approach has 
the added benefit of affording the maximum potential to eliminate 
disparate reflection of loss on transferred shares because all the 
reallocations are directed to transferred shares. As a result, this 
approach reduces the amount of loss that can be accelerated (as 
illustrated in Example 5(b)).
    iii. Reallocations of positive and negative investment adjustments.
    Under the basis redetermination rule in Sec.  1.1502-35(b)(2), only 
negative items are reallocated. However, the sole purpose of Sec.  
1.1502-35, and thus the basis redetermination rules in Sec.  1.1502-
35(b), is to address the duplication of loss. (The full blending 
approach of Sec.  1.1502-35(b)(1) addresses noneconomic loss 
attributable to basis disparity as well as loss duplication, but only 
incidentally as a result of its broad operation.) The IRS and Treasury 
Department believe that, although it is appropriate for a rule 
addressing only loss duplication to reallocate just negative items (or 
negative investment adjustments), a rule addressing both noneconomic 
and duplicated loss must reallocate both negative and positive items 
(or investment adjustments). As illustrated in Example 4 and Example 5, 
reallocations of both positive and negative amounts are necessary to 
prevent the noneconomic and duplicated stock loss that results from the 
disparate reflection of unrecognized gain and to do so without causing 
inappropriate results to taxpayers (specifically, noneconomic gain).
    For the foregoing reasons, the IRS and Treasury Department have 
concluded that the reallocation of both positive and negative 
adjustments is appropriate and necessary to balance the use of a 
presumptive system. Accordingly, these proposed regulations provide for 
the reallocation of both positive and negative investment adjustments 
to minimize the potential over- and under-application of the 
noneconomic and duplicated loss rules.

Explanation of Provisions

F. Explanation of the Proposed Regulations

1. Overview
    The proposed regulation consists of three principal rules that 
apply when a member transfers a loss share of subsidiary stock. The 
first rule redetermines members' bases in subsidiary stock by 
reallocating Sec.  1.1502-32 adjustments (to adjust for 
disproportionate reflection of gains and losses in the bases of 
members' shares). The second rule reduces members' bases in transferred 
loss shares (but not below value) by the net positive amount of all 
investment adjustments applied to the bases of those shares, but only 
to the extent of the share's disconformity amount (to address 
noneconomic stock loss). The third rule reduces the subsidiary's 
attributes to prevent the duplication of a loss recognized on, or 
preserved in the basis of, transferred stock.
    The three rules generally apply in the order described. If members 
transfer stock of multiple subsidiaries in one transaction, the basis 
redetermination and basis reduction rules apply first with respect to 
transfers of loss shares of stock of the subsidiaries at the lowest 
tier and then successively to transferred shares at each next higher 
tier. These rules are not applied at any tier until any gain or loss 
recognized (even if disallowed) on lower-tier transfers and any items 
resulting from lower-tier adjustments (whether required by the basis 
redetermination or basis reduction rule or otherwise) are taken into 
account and reflected in stock basis. After the basis redetermination 
and reallocation rules have applied with respect to all transferred 
loss shares, the attribute reduction rule applies with respect to the 
highest-tier transferred loss shares. The attribute reduction rule then 
applies successively with respect to transferred loss shares at each 
next lower tier.
    For purposes of these proposed regulations, a transfer of stock 
includes any event in which gain or loss would be recognized (but for 
these proposed regulations), the holder of a share and the subsidiary 
cease to be members of the same group, a nonmember acquires an 
outstanding share from a member, or the share is treated as worthless. 
This rule allows the proposed regulations to prescribe one integrated 
set of rules that implement a loss limitation approach and that can be 
applied to all loss shares, regardless of the event giving rise to the 
application of the section.
2. The Basis Redetermination Rule
    When a member transfers a share of subsidiary (S) stock and, after 
the application of all other provisions of the Code and regulations, 
the share is a loss share, this rule subjects all members' shares of S 
stock to redetermination.
    Under the basis redetermination rule, investment adjustments 
(exclusive of distributions) that were previously applied to members' 
bases in S stock are generally reallocated in a manner that, to the 
greatest extent possible, first eliminates loss on preferred shares and 
then eliminates basis disparity on all shares. The rule moves both 
positive and negative adjustments, and so addresses both noneconomic 
and duplicated losses. Because it generally requires adjustments to be 
made to reduce disparity, it brings members' bases closer in line with 
the fundamental principals underlying the investment adjustment system. 
As a result, there is less likelihood for later

[[Page 2979]]

noneconomic or duplicated loss attributable to the investment 
adjustment system.
    The rule operates by first removing positive investment adjustments 
(up to the amount of the loss) from the bases of transferred loss 
shares. Then, to the extent of any remaining loss on the transferred 
shares, negative investment adjustments are removed from shares that 
are not transferred loss shares and applied to reduce the loss on 
transferred loss shares. The positive adjustments removed from the 
transferred loss shares are allocated and applied only after the 
negative items have been reallocated. The reason is to preserve the 
most flexibility possible in reallocating positive adjustments, in 
order to minimize disparity to the greatest extent. Thus, the operation 
of these rules has the effect of removing basis from transferred loss 
shares and using it to reduce disparity in members' bases in S shares.
    Redetermination is limited in several respects. First, because the 
premise of the rule is that the original allocation of an item did not 
represent the most economically appropriate allocation of the item, 
redeterminations under the rule are limited to allocations of 
investment adjustments that could have been made at the time an item 
was taken into account. Accordingly, no adjustments can be reallocated 
to shares that were not held by members in the year taken into account, 
as members' shares would not have been able to receive those 
adjustments in the original allocation.
    A related limitation on reallocation is that an investment 
adjustment cannot be reallocated except to the extent that the full 
effect of the reallocation can be accomplished. Thus, an investment 
adjustment can not be reallocated to the extent the resulting basis has 
previously been taken into account (including at a higher tier). This 
rule guards against double benefits from an adjustment (for example, by 
not allowing positive adjustments to be moved from, or negative 
adjustments be moved to, shares after the item would have affected 
basis that was taken into account in recognizing gain or loss). It also 
guards against the loss of a benefit (for example, by not allocating 
positive adjustments to previously transferred shares that can no 
longer benefit from the basis).
    The principle purpose of the rule is to reduce loss on transferred 
shares. However, because its secondary purpose is to decrease 
disconformity to the greatest extent possible, in certain fact 
patterns, the application of the rule will actually increase loss on 
some shares. Importantly, in no fact patterns will the application of 
the rule create gain on shares. Overall, the rule has no effect on the 
aggregate amount of gain or loss on members' bases in subsidiary stock.
    In the basis reallocation rule, and in several other provisions of 
the proposed regulations, there is a direction to allocate items in a 
manner that reduces disparity to the greatest extent possible. The 
regulations do not, however, prescribe the manner in which such 
determinations are to be made. The IRS and Treasury Department intend 
that taxpayers have flexibility in choosing the methods and formulas to 
be employed in making these determinations and the IRS will respect any 
reasonable method or formula so employed.
    The IRS and Treasury Department recognize that the redetermination 
of basis imposes a certain administrative burden. Thus, the rule 
contains two safe harbors that excuse taxpayers from reallocating basis 
in situations in which redetermination is deemed unnecessary. One safe 
harbor is for situations in which redetermination would have no 
ultimate effect on the basis of any share held by a member. This 
happens, for example, if only common stock is outstanding and there is 
no disparity in the bases of the shares. In such a case, any 
redetermination would result in the same bases the members' had before 
redetermination. The second safe harbor is for situations in which the 
group disposes of its entire interest in the subsidiary to an unrelated 
person in one or more fully taxable transactions. In such a case, the 
group recognizes all the gains and losses on the shares and so obtains 
no benefit from the disparate reflection of gain or loss. Transfers 
that are excepted from basis redetermination, like transfers of shares 
that remain loss shares after application of the rule, are then subject 
to the basis reduction rule.
3. The Basis Reduction Rule
    If, after basis redetermination, any member's transferred share is 
a loss share (even if the share only became a loss share as a result of 
the application of the basis redetermination rule), the basis of that 
share is subject to reduction under this rule. This rule is intended to 
eliminate stock loss that is presumed noneconomic. It operates by 
reducing the basis of each transferred loss share (but not below value) 
by the lesser of the share's disconformity amount and its net positive 
adjustment.
    A share's disconformity amount is the excess of its basis over its 
allocable portion of S's net inside attributes, determined at the time 
of the transfer. This amount identifies the net amount of unrealized 
appreciation reflected in the basis of the share. Because the 
disconformity amount is computed at the time of the transfer, the 
disconformity amount reflects the effects of all prior redetermination 
events.
    The term net inside attributes is defined as the sum of S's loss 
carryovers, deferred deductions, cash, and asset basis, reduced by S's 
liabilities. This computation is used in both this basis reduction rule 
and the attribute reduction rule described in section F.4 of this 
preamble. Both rules do, however, have special provisions that modify 
the computation of net inside attributes if S holds lower-tier 
subsidiary stock. See sections F.3.a and F.4.a of this preamble for a 
discussion of rules relating to the stock of lower-tier subsidiaries 
for purposes of basis reduction and attribute reduction, respectively.
    A share's net positive adjustment is computed as the greater of 
zero and the sum of all investment adjustments (excluding 
distributions) applied to the basis of the transferred loss share, 
including by reason of prior basis reallocations. All items of income, 
gain, deduction, and loss are included fully in the net positive 
adjustment amount. This rule identifies the extent to which basis has 
been increased by the investment adjustment provisions for items of 
income, gain, deduction and loss (whether taxable or not) that have 
been taken into account by the group.
    a. Special rules applicable when S holds stock of lower-tier 
subsidiary.
    For purposes of computing the disconformity amount, if S holds 
stock of a lower-tier subsidiary (S1) that was not transferred in the 
transaction, S's net inside attribute amount is computed by treating 
S's basis in S1 stock as ``tentatively reduced'' by the lesser of the 
S1 share's net positive adjustment and its disconformity amount. This 
reduction is made only for purposes of determining basis reduction to 
the S share, and has no other effect. The purpose of this adjustment is 
to prevent S1's recognized items from giving rise to noneconomic loss 
in S stock, for example, when S1 recognizes gain that is already 
reflected (indirectly) in P's basis in S shares. This problem is 
illustrated in Example 8 (subsidiary holding lower-tier subsidiary 
stock with a basis that reflects lower-tier unrecognized appreciation).
    When determining the disconformity amount of a share of subsidiary 
stock, no tentative reduction is made to the basis of lower-tier shares 
that were transferred in the transaction (without

[[Page 2980]]

regard to whether S retained the shares after the transaction, such as 
when S1 is transferred because S and S1 cease to be members of the same 
group but S continues to hold S1 stock). The reason is that the basis 
reduction rule applies directly to each transfer, starting with the 
lowest-tier transfer, and so any noneconomic loss in S stock that was 
attributable to S1's items has been eliminated by the time that the 
basis reduction rule applies to the S Stock. In addition, the tentative 
basis reduction rule does not apply to shares that are lower tier to 
any shares that were transferred in the transaction. The application of 
the rule to those shares is unnecessary because, when the basis 
reduction rule applied to S1, it eliminated any inappropriate effects 
from items that tiered up from subsidiaries that were lower tier to S1.
4. The Attribute Reduction Rule
    If any transferred share remains a loss share after application of 
the basis reduction rule, the subsidiary's attributes (including the 
consolidated attributes attributable to the subsidiary) are subject to 
reduction. The attribute reduction rule addresses the duplication of 
loss by members of consolidated groups. This rule is intended to insure 
that the group does not recognize more than one loss with respect to a 
single economic loss regardless of whether the group chooses to dispose 
of the subsidiary stock before or after the subsidiary recognizes the 
loss with respect to its assets or operations.
    Under this rule, S's attributes are reduced by the ``attribute 
reduction amount,'' which is computed as the lesser of the net stock 
loss and the aggregate inside loss. This amount reflects the total 
amount of unrecognized loss that is reflected in both the basis of the 
S stock and S's attributes. Net stock loss is the excess of the sum of 
the bases (after application of the basis reduction rule) of all S 
shares transferred by members in the same transaction over the value of 
such shares. S's aggregate inside loss is the excess of S's net inside 
attributes over the value of all of the S shares. Net inside attributes 
generally has the same meaning as in the basis reduction rule, subject 
to special rules for lower-tier subsidiaries (see section F.4.a of this 
preamble).
    Unlike comparable provisions in Sec.  1.1502-35 and the LDR, this 
rule does not limit its application to a share's proportionate interest 
in the subsidiary's aggregate inside loss. The reason is that when a 
member recognizes a stock loss, or preserves a stock loss for a later 
recognition (for example, when the share is retained but 
deconsolidated), the member enjoys (or preserves for later use) the 
benefit of the entire amount of that stock loss. If basis is uniform, 
the amount of stock loss will reflect a proportionate interest in the 
subsidiary's unrecognized loss. But if basis is disparate, the loss on 
a particular share can reflect any amount, even all, of the 
subsidiary's unrecognized loss. In either case, the potential loss 
duplication equals the entire amount by which the stock loss is 
duplicated in the subsidiary's attributes. Accordingly, the proposed 
regulations reduce attributes to that extent. This prevents the 
duplication (but not acceleration) of loss otherwise available in 
situations similar to Example 5(b) by reducing S's attributes by the 
entire amount by which the stock loss duplicates the aggregate inside 
loss.
    A principal goal of this regulation is to address the issues of 
noneconomic and duplicated stock loss in a manner that is as readily 
administrable as possible, by taxpayers and the government. For that 
reason, the proposed regulations generally avoid imposing valuation 
requirements whenever possible. However, the proposed regulations do, 
to the extent possible, use readily available information to identify 
the location and amount of loss, to avoid knowingly creating gain. The 
order in which attributes are reduced reflects this principle.
    After S's attribute reduction amount is determined, it is first 
applied to reduce or eliminate items that represent actual realized 
losses, such as operating loss carryovers, capital loss carryovers, and 
deferred deductions. If S's attribute reduction amount exceeds those 
items, the excess is then applied to reduce or eliminate the loss in 
the basis of property that is publicly traded (other than subsidiary 
stock, which is subject to special rules). The reason that the basis of 
publicly traded property, unlike that of other assets, is only reduced 
by the amount of loss reflected in the basis of the property is that 
such property can be readily and easily valued. Finally, if any 
attribute reduction amount remains after eliminating those attributes, 
it is applied to reduce or eliminate the basis in assets, other than 
publicly traded property (which then reflects no loss) and other than 
cash and equivalents (which also reflect no loss). This reduction is 
made proportionately according to the basis in each property.
    The proposed regulations provide a special rule that applies to the 
extent a subsidiary has liabilities that have not been taken into 
account as of the time of the transfer. Under the general rule, if the 
attribute reduction amount exceeds attributes available for reduction, 
that excess attribute reduction amount has no further effect. However, 
a special rule applies if the attribute reduction amount exceeds the 
attributes available for reduction and the subsidiary has a liability 
that has not been taken into account. Typically this will happen when 
cash or other liquid assets are held to fund future expenses related to 
the liability. Because the assets held by S do not reflect attributes 
that can be reduced, loss can be duplicated later, when the liability 
is taken into account. To prevent the duplication of loss in such 
cases, the excess attribute reduction amount is suspended and applied 
to prevent the deduction or capitalization of payments later made by S 
or another person with respect to the liability.
    a. Special rules applicable when S holds stock of lower-tier 
subsidiary.
    When S holds stock of lower-tier subsidiaries, the attribute 
reduction amount is computed in a manner that identifies the maximum 
potential amount of loss duplication and attributes are reduced to that 
extent. However, the rule incorporates two restrictions to prevent 
excessive reduction of attributes that could otherwise result from this 
approach. These rules are set forth in this section 4.a.
    First, to facilitate the computation of S's attribute reduction 
amount, all of S's shares of S1 stock are treated as a single share 
(generally referred to as the S1 stock). To identify the maximum 
potential duplication, the computation of the attribute reduction 
amount is made treating S's basis in S1 stock as its ``deemed basis'' 
in that stock. The proposed regulations define deemed basis as the 
greater of S's actual aggregate basis in the S1 shares (adjusted for 
any gain or loss recognized on a transfer of the S1 shares) and the S1 
shares' allocable portion of S1's net inside attributes. For example, 
if P owns all the stock of S with a basis of $150, S owns all the stock 
of S1 with a basis of $100, and S1 owns an asset with a basis of $150. 
S's deemed basis in S1 stock is $150, the greater of $100 (S's actual 
basis in S1 stock) and $150 (the S1 shares' allocable portion of S1's 
net inside attribute amount), which is the maximum amount of inside 
loss that S can recognize. The proposed regulation uses deemed basis 
not only to identify the maximum potential amount of loss duplication 
($150 in the example), but also to reduce attributes on the assumption 
that taxpayers will act in their best interest when deciding how lower-
tier attributes will be recognized

[[Page 2981]]

(subject to certain limits discussed in this section F.4.a).
    S's deemed basis in S1 stock is also used for purposes of 
allocating S's attribute reduction amount between S's S1 stock and S's 
other attributes. However, for this purpose, deemed basis is treated as 
reduced by certain amounts that, by their nature, do not reflect loss. 
These excluded amounts include the value of S1 shares transferred in 
the transaction and the portion of S1's cash, S1's cash equivalents, 
and the value of S1's publicly traded property (net of S1's 
liabilities) that is attributable to S's nontransferred shares of S1 
stock. The excluded amounts also include the corresponding amounts with 
respect to all shares of stock of lower-tier subsidiaries. These 
modifications prevent nonloss assets from inappropriately increasing 
the allocation of attribute reduction to S1 stock.
    The attribute reduction amount allocated to S's block of S1 stock 
is then apportioned and applied to reduce the bases of S's individual 
shares of S1 stock in a manner that, to the greatest extent possible, 
reduces disparity. This general rule is subject to two modifications. 
First, no allocated amount is apportioned to any transferred S1 share 
if gain or loss is recognized on the transfer of that share. The reason 
is that the recognition of gain or loss (even if not allowed) 
establishes that the basis of that share does not reflect (or no longer 
reflects) unrecognized loss. This modification thus directs attribute 
reduction to other shares that are the source of the potential 
duplication. The second modification is that no allocated amount that 
is apportioned to any transferred S1 share is to be applied to reduce 
the basis of the share below its value. This modification prevents 
attribute reduction from knowingly creating gain on such shares.
    To fully implement the loss duplication rule, any portion of S's 
attribute reduction amount that is allocated to S1 stock, whether or 
not it is apportioned or applied to reduce the basis of any S1 shares, 
tiers down and becomes an attribute reduction amount of S1. The 
attribute reduction rules then apply to reduce S1's attributes in the 
same manner that they apply S's attribute reduction amount to reduce 
S's attributes. However, because the attribute reduction amount 
represents the maximum potential amount of duplication in the lower-
tier subsidiary, the proposed regulations include two modifications to 
prevent the reduction of attributes beyond the amount necessary to 
eliminate duplicated loss.
    The first modification is the conforming limit rule, which prevents 
the tier down of attribute reduction from reducing S1's net inside 
attributes below the sum of the value of the S1 shares transferred by 
members and the aggregate bases that members have in nontransferred S1 
stock (after any reduction to those shares by the direct application of 
S's attribute reduction amount).
    The second modification is the basis restoration rule. This rule 
applies after the attribute reduction rule has been applied with 
respect to all transfers and all resulting reductions (whether as a 
result of direct or tier-down attribute reduction) have been given 
effect. This rule reverses stock basis reductions made by the attribute 
reduction rule, but only to the extent necessary to conform inside (net 
inside attributes) and outside (stock) basis at each tier, taking into 
account the effect of any prior section 362(e)(2) transactions. Because 
net inside attributes can be a negative number, stock basis may be a 
negative number even after basis restoration. In such cases, the basis 
of the share will remain an excess loss account in the hands of the 
owning member after the transaction (the regulations specifically 
provide that the excess loss account created by this rule is not taken 
into account under Sec.  1.1502-19). Basis restoration adjustments are 
made at each tier, but they do not give rise to any upper-tier 
adjustments.
    With these two modifications, the attribute reduction rule can 
reduce lower-tier attributes in an amount that eliminates the full 
duplication potential reflected in S's basis in S1 stock and S1's net 
inside attributes without creating a noneconomic gain in the 
corresponding attribute.
    b. Election to reduce stock basis and/or reattribute loss.
    Finally, the attribute reduction rule contains an elective 
provision under which groups can reduce the potential for loss 
duplication and thereby reduce or completely avoid attribute reduction 
under these regulations. Under this rule, the common parent of a group 
can elect to reduce stock basis, reattribute attributes, or do some 
combination of basis reduction and attribute reattribution in order to 
prevent the reduction of attributes otherwise required under these 
proposed regulations. The total amount that can be the subject of the 
election is limited to the amount that S's attributes would otherwise 
be subject to reduction.
    The election to reattribute attributes can only be made if S ceases 
to be a member of the P group as a result of the transfer. The reason 
is that the election is not intended to be merely a mechanism for 
changing location of items within a group (and its continuing members). 
The election can be made with respect to loss carryforwards and 
deferred deductions of S or any of S's lower-tier subsidiaries, but 
only to the extent and in the order that such attributes would 
otherwise have been reduced under the attribute reduction rule. 
However, P may only reattribute attributes of lower-tier subsidiaries 
that would otherwise be reduced as a result of tier-down attribute 
reduction to the extent that the reattribution does not create an 
excess loss account in the stock of any lower-tier subsidiary. When 
this election is made, P is treated as succeeding to the attributes as 
though it had acquired them in a section 381(a) transaction. Proposed 
regulations under Sec.  1.1502-32 treat the reattributed attributes as 
absorbed and tiering up to reduce the basis of shares such that the 
full amount tiers up through the transferred S shares for which the 
election is made. This amount is allocated to shares in the chain with 
positive basis in a manner that reduces the disparity in the basis of 
the shares to the greatest extent possible. However, this amount is not 
allocated to any lower-tier subsidiary shares that were transferred in 
a transfer in which gain or loss was recognized. The IRS and Treasury 
Department recognize and are concerned with the potential complexity of 
this election and request comments regarding both the administrability 
and the benefit of the election, particularly as it relates to 
attributes of lower-tier subsidiaries.
    Although the maximum amount of the election is computed by 
tentatively applying the attribute reduction rule to S, the election is 
actually given effect immediately before the application of the 
attribute reduction rule. Thus, to the extent loss duplication has not 
been eliminated by the election, the attribute reduction rules apply in 
their general manner.
5. Over-Ride Provisions
    These proposed regulations contain two over-ride provisions. One, 
found in the general introductory provisions of the proposed 
regulation, requires that the provisions of these proposed regulations 
be interpreted and applied in accordance with their stated purposes. 
The other, an anti-abuse and anti-avoidance rule, provides that 
``appropriate adjustments'' will be made if a taxpayer acts with a view 
to avoid the purposes of this section or use this section to avoid 
another rule of law. The anti-abuse rule includes several examples that 
illustrate general

[[Page 2982]]

principles. The examples are not intended to specify particular 
transactions that will be treated as abusive in all cases or to prevent 
the IRS from treating other transactions as abusive. This rule is an 
important safeguard to ensure that only transfers made in the ordinary 
course of business enjoy the benefits and avoid the burdens arising 
from the principles adopted in these proposed regulations.
6. Special Rules for Section 362(e)(2) Transactions
    The IRS and Treasury Department recognize that adjustments made 
pursuant to section 362(e)(2) (see discussion in section H of this 
preamble) alter the extent to which comparisons of stock basis, net 
inside attributes, and value can identify both the amount of 
unrecognized appreciation reflected in stock basis and the amount of 
duplicated loss. For example, a reduction to asset basis under section 
362(e)(2)(A) increases the disconformity amount of the shares received 
in the transaction subject to section 362(e)(2), but this amount does 
not represent unrealized appreciation reflected in stock basis. 
Further, the reduction to asset basis under section 362(e)(2)(A) 
decreases the amount of loss duplication that can exist with respect to 
the shares received in the transaction subject to section 362(e)(2). 
Similarly, if stock basis is reduced pursuant to an election under 
section 362(e)(2)(C), there is an increase in the subsidiary's net 
inside attribute amount that reduces the disconformity amount of all 
shares and increases aggregate inside loss, even though there has been 
neither a decrease in the amount of unrealized appreciation reflected 
in stock basis nor an increase in duplicated loss.
    Accordingly, to adjust for distortions resulting from basis 
reduction under section 362(e)(2)(A), the proposed regulations adjust 
the disconformity amount of the shares received in the transaction to 
which section 362(e)(2) applied by an amount equal to the amount the 
basis of such shares would have been reduced had an election under 
section 362(e)(2)(C) been made. Further, for purposes of computing the 
attribute reduction amount on a transfer of any shares received in the 
section 362(e)(2) transaction, and applying the conforming limitation 
on the application of tier-down attribute reduction, the basis in such 
shares is reduced by an amount equal to the amount the basis of such 
shares would have been reduced had an election under section 
362(e)(2)(C) been made Similarly, to adjust for distortions resulting 
from basis reduction under section 362(e)(2)(C), for purposes of 
computing any share's disconformity amount or the subsidiary's 
aggregate inside loss, and for purposes of determining any stock basis 
restoration, the proposed regulations reduce S's net inside attribute 
amount by an amount equal to the amount S's attributes would have been 
reduced under section 362(e)(2)(A) had no election under section 
362(e)(2)(C) been made. Further, the regulations indicate that the 
special application of section 362(e)(2) to intercompany transactions 
must be taken into account, so these adjustments only apply to the 
extent section 362(e)(2) has actually resulted in some basis reduction.
    The IRS and Treasury Department recognize that the computations in 
these proposed regulations may need to take other items into account. 
Accordingly, the proposed regulations provide that the Commissioner 
will make appropriate adjustments to account for changes in the 
relationship between stock basis and net inside attributes that are not 
the result of either Sec.  1.1502-32 or these proposed regulations and 
that are not otherwise adjusted under these proposed regulations. In 
addition, the proposed regulations provide that taxpayers may seek a 
written determination regarding the treatment of comparable items or 
adjustments.
7. Special Rules Considered But Not Adopted
    a. Discounting of losses that are limited by section 382 or other 
provisions.
    The IRS and Treasury Department considered whether losses could be 
included in the computation of the net inside attribute amount at a 
reduced rate if their use was limited, for example, by section 382. 
Ultimately no administrable and precise method was identified for 
determining the extent to which losses could be considered properly 
excluded (or included at a reduced rate), except in the most extreme 
cases. Accordingly, the proposed regulations do not provide special 
rules for limited losses. As a result, losses are fully included in net 
inside attributes.
    The IRS and Treasury Department recognize that this approach is 
extremely favorable to taxpayers as it reduces the disconformity amount 
(and thus the extent to which stock basis may be reduced) with the only 
potential cost being the elimination of the losses under the attribute 
reduction rule. The IRS and Treasury Department believe that this 
taxpayer-favorable result, when produced in the ordinary course of 
business, is not an inappropriate result as part of the overall balance 
reached by these regulations. Taxpayers that engage in transactions 
that have no bona fide purpose other than to acquire limited losses to 
avoid the purposes of the proposed regulations, however, will be 
subject to the anti-avoidance rule and the benefits of the transaction 
will be eliminated.
    b. Exceptions for basis conforming acquisitions.
    Practitioners had suggested that any proposed regulations 
addressing noneconomic loss contain an exception for transactions such 
as section 351 exchanges and acquisitions subject to a section 338 
election. These proposed regulations do not explicitly contain such an 
exception. One reason is that such an exception would introduce the 
complexity and burden of identifying all redetermination events. A more 
important reason, however, is that such an exception is unnecessary 
under the basis disconformity model because, by measuring disconformity 
immediately before the transfer of loss shares, this rule automatically 
excludes situations from basis reduction when there is inside/outside 
conformity. Thus, the effect of this suggestion is accomplished and no 
special rules are necessary.
    c. Shadow account for reduced basis.
    The proposed regulations do not contain a mechanism, suggested by 
practitioners, for restoring basis to transferred shares that are 
retained by a member and later sold at a gain (for example, when a 
member retains S shares but S ceases to be a member). The IRS and 
Treasury Department are concerned that such a rule would add undue 
complexity to the regulatory scheme. Moreover, such a rule would be 
inconsistent with a fundamental principle underlying these proposed 
regulations, specifically, that a transfer (as defined in these 
proposed regulations) is the appropriate time for these proposed 
regulations to apply. Thus, the basis reduction rules do not 
permanently reduce the basis of lower-tier subsidiary stock unless the 
stock is transferred in the transaction. And, moreover, similar to the 
general application of other provisions of the Code and regulations, 
subsequent events should not reverse the effects of such application.
8. Effective Date
    The proposed regulations would be applicable as of the date they 
are published as final regulations in the Federal Register.

[[Page 2983]]

G. Sections 1.337(d)-1, 1.337(d)-2, and 1.1502-35

    Because proposed Sec.  1.1502-36 addresses both noneconomic and 
duplicated loss on subsidiary stock, the IRS and Treasury Department 
are also proposing the removal of Sec. Sec.  1.337(d)-1, 1.337(d)-2, 
and 1.1502-35, except to the extent necessary to address losses 
suspended under Sec.  1.1502-35(c) and losses reimported under Sec.  
1.1502-35(g)(3).
    Additionally, the IRS and Treasury Department intend to publish 
temporary regulations that will modify the anti-abuse provisions of 
Sec.  1.1502-35. First, the temporary regulations will restate the loss 
reimportation rule as a principle-based rule. This change responds to 
comments received about the administrability of the current provision. 
Second, the temporary regulations will modify the loss reimportation 
rule to provide that a duplicated loss on subsidiary stock is subject 
to the loss reimportation rule even if the group deconsolidates the 
subsidiary before selling loss shares of the subsidiary stock. These 
modifications are reflected in these proposed regulations.
    These proposed regulations also revise several regulations solely 
to reflect the removal of Sec. Sec.  1.337(d)-1, 1.337(d)-2, and 
1.1502-35 (other than with respect to loss suspension and loss 
reimportation), and the addition of Sec.  1.1502-36.
    The proposed regulations described in this section G would be 
applicable as of the date they are published as final regulations in 
the Federal Register.

H. Suspension of Section 362(e)(2) in Consolidation

1. Background
    As part of the AJCA, Congress enacted section 362(e)(2) to address 
certain instances of loss duplication. Very generally, that provision 
provides that if loss property is transferred to a corporation in a 
section 351 exchange (or as a capital contribution or paid-in surplus), 
the transferee's aggregate basis in the assets will be limited to the 
properties' fair market value. However, section 362(e)(2) also permits 
the parties to elect to limit the basis of the stock received (or 
treated as received) in the exchange to its fair market value, so that 
the loss is preserved in the basis of the transferred property. Section 
362(e)(2)(C). See REG-110405-05 (2006-48 IRB 1004), 71 FR 62067 
(October 23, 2006), (``the 2006 proposal'') for a more detailed 
explanation of the general application of section 362(e)(2).
    Practitioners have questioned whether it is necessary to apply 
section 362(e)(2) to intercompany transactions where there is a 
consolidated return rule addressing loss duplication. The IRS and 
Treasury Department recognize that loss duplication in consolidated 
groups is generally addressed by Sec.  1.1502-32 (when losses are 
recognized on a subsidiary's assets or operations) and, currently, by 
Sec.  1.1502-35 (or by this proposed Sec.  1.1502-36 when it is 
finalized). In general, the IRS and Treasury believe that these 
regulations together address loss duplication in a manner that is most 
consistent with single entity principles. Nevertheless, the IRS and 
Treasury Department are concerned that, if section 362(e)(2) were not 
to apply to intercompany transfers, members of consolidated groups may 
be able to reduce gain under circumstances that separate taxpayers 
could not. Accordingly, the IRS and Treasury Department have 
tentatively concluded that section 362(e)(2) should be applied to 
intercompany transactions. However, the IRS and Treasury are concerned 
with the administrative burden imposed by section 362(e)(2) and are 
continuing to study whether its provisions should be applicable to such 
transfers. Comments are invited on this issue.
2. Suspension of Section 362(e)(2) for Intercompany Transactions.
    Although the IRS and Treasury Department have tentatively concluded 
that section 362(e)(2) should remain applicable to transfers between 
members of a consolidated group, as noted, the IRS and Treasury 
Department are concerned with the significant complexity and 
administrative burden that section 362(e)(2) adds in the consolidated 
return context. For example, if an election is made to reduce stock 
basis under section 362(e)(2)(C), a portion of the items attributable 
to the transferred loss assets can produce duplicative reductions 
unless traced and treated as duplicative of the section 362(e)(2) 
reduction to stock basis.
    Moreover, the IRS and Treasury Department recognize that basis 
reductions are not necessary in intercompany section 362(e)(2) 
transactions as long as duplication can effectively be eliminated by 
the general operation of the investment adjustment system. Accordingly, 
these proposed regulations would suspend application of section 
362(e)(2) until the occurrence of a ``section 362(e)(2) application 
event,'' and then apply the principles of section 362(e)(2) only to the 
extent the investment adjustment system has not and can no longer 
effectively eliminate any remaining duplication. The IRS and Treasury 
Department expect that this suspension will often effectively eliminate 
the application of section 362(e)(2) to most intercompany transactions.
    Nevertheless, in order to apply section 362(e)(2) upon the 
occurrence of a section 362(e)(2) application event, the group must 
determine the extent to which an intercompany transaction resulted in 
loss duplication that would have been prevented by section 362(e)(2), 
and track the extent to which this duplication is effectively 
eliminated while the transferor and the transferee are members. 
Accordingly, these proposed regulations require the group to identify 
the amount and location of basis in the transferred assets that would 
have been eliminated had section 362(e)(2)(A) applied at the time of 
the intercompany transaction. This is the amount of the net built-in 
loss that is duplicated as a result of the section 362(e)(2) 
transaction. The regulations refer to this amount of duplication as the 
``section 362(e)(2) amount.''
    The duplicated loss is reflected in both the transferor's basis in 
the transferee stock (or securities), and in the transferee's basis in 
the property received. The duplication is initially reflected in the 
basis of the transferee stock (or securities) to the extent the basis 
would have been reduced under section 362(e)(2)(C), if such an election 
was made and section 362(e)(2) was not suspended by these temporary 
regulations. The duplication is also initially reflected in the 
transferee's basis in the property received to the extent the basis of 
such property would have been reduced under section 362(e)(2)(A) if no 
election was made under section 362(e)(2)(C) and section 362(e)(2) was 
not suspended by these temporary regulations. Over time this amount can 
be reflected in other attributes of the transferee (such as unabsorbed 
losses) to the extent such attributes are attributable to the 
transferee's basis in the property received.
3. Elimination of the Section 362(e)(2) Amount
    Because the investment adjustment system reduces stock basis as a 
subsidiary's attributes are taken into account, the duplication is 
eliminated to this extent, and the section 362(e)(2) amount must be 
eliminated to this extent. Further, if the basis of the stock (or 
securities) received in the intercompany section 362(e)(2) transaction 
is reduced as the result of a section 362(e)(2)(C) election, as a 
result of attribute reduction under these

[[Page 2984]]

proposed regulations, or is otherwise eliminated without the 
recognition of gain or loss, the duplication is similarly eliminated. 
Accordingly, these types of basis reductions result in an elimination 
of all or a portion of the section 362(e)(2) amount. The proposed 
regulations provide specific guidance regarding how much of any 
remaining section 362(e)(2) amount is reflected in the basis of the 
subsidiary's stock (or securities) or the subsidiary's attributes as 
the section 362(e)(2) amount is eliminated.
4. Application of Section 362(e)(2) to Intercompany Transactions
    Upon the occurrence of a section 362(e)(2) application event, the 
regulations apply section 362(e)(2) only to the extent necessary. A 
section 362(e)(2) application event occurs when all or a portion of the 
duplicated amount can no longer be effectively eliminated by the 
operation of the investment adjustment system, and can involve either 
the stock (or securities) of the transferee or the assets transferred 
in the intercompany section 362(e)(2) transaction. Such an event is 
defined to include any transfer (as defined in proposed Sec.  1.1502-
36) of the transferee's stock received in the exchange, any 
satisfaction of a security received in the exchange, any transaction in 
which a nonmember acquires any of the transferred assets with 
substituted basis or succeeds to any attributes attributable to such 
basis, or any other transaction the result of which prevents all or a 
portion of any remaining section 362(e)(2) amount reflected in stock 
basis and attributes from being effectively eliminated by the operation 
of the investment adjustment system when taken into account.
    Further, if the transferor and the transferee in the intercompany 
section 362(e)(2) transaction continue to be members of the same group 
(including as members of another group), the investment adjustment 
system can continue to effectively eliminate the duplication. 
Accordingly, these proposed regulations provide a subgroup exception 
implicit in the definition of section 362(e)(2) application events that 
allows the transferor and transferee to become members of a new group 
without triggering the application of section 362(e)(2). In such a 
case, the transferor and transferee will continue to track the section 
362(e)(2) amount reflected in stock basis and attributes, and apply 
these provisions upon the occurrence of a section 362(e)(2) event.
    Given the fact that section 362(e)(2) is applied in this context 
only to the extent necessary, the scope of its application varies 
slightly depending upon the type of section 362(e)(2) application event 
that occurs. If the application event involves a transaction in which a 
nonmember acquires some or all of the transferee's attributes that 
reflect a section 362(e)(2) amount, section 362(e)(2) applies to the 
extent such attributes reflect all or part of any remaining section 
362(e)(2) amount. In such a case, the resulting reduction in attributes 
is applied to the attributes involved in the application event that 
reflect the section 362(e)(2) amount. If the application event involves 
all or part of the transferee stock (or securities) received in the 
section 362(e)(2) transaction, section 362(e)(2) applies to the extent 
such stock (or securities) reflect all or part of any remaining section 
362(e)(2) amount. Further, in this case, the resulting reduction in 
attributes is applied to proportionately to the transferee's attributes 
that reflect the section 362(e)(2) amount (based on the relative 
section 362(e)(2) amount reflected). The reduction in the transferee's 
attributes is not a noncapital, nondeductible expense.
    As is provided in section 362(e)(2)(C), the transferor and 
transferee may elect to reduce the basis in the transferee stock (or 
securities) received in the intercompany section 362(e)(2) transaction 
instead of reducing the transferee's attributes. Similar to the 
provisions of the proposed regulations under section 362(e)(2), the 
reduction in the basis of the transferee stock (or securities) received 
in the intercompany section 362(e)(2) transaction is equal to the 
amount of the reduction in the transferee's attributes absent the 
election. Further, if this election is made, the type of section 
362(e)(2) application event dictates which shares (or securities) 
receive the basis reduction. If the application event involves a 
transaction in which a nonmember acquires some or all of the 
transferee's attributes, the reduction is applied proportionately to 
all of the transferee stock (or securities) held by members immediately 
before the application event (based on the relative section 362(e)(2) 
amount reflected). However, if the application event involves all or a 
part of the transferee stock (or securities) received in the 
intercompany section 362(e)(2) transaction, the reduction is applied 
proportionately to the stock (or securities) so involved (based on the 
relative section 362(e)(2) amount reflected). The reduction in the 
basis of the stock of the transferee as a result of this election is 
treated as a nondeductible basis recovery item.
    Under the proposed regulations, the election to reduce stock basis 
(in lieu of attributes) under section 362(e)(2)(C) may be made for the 
intercompany transaction on either the group return for the year of the 
intercompany section 362(e)(2) transaction or the year in which the 
first section 362(e)(2) application event occurs. In either case, the 
election has effect only if and to the extent there is a section 
362(e)(2) application event, is irrevocable once made, and applies to 
all section 362(e)(2) application events with respect to such 
intercompany section 362(e)(2) transaction (even if the application 
event occurs at a time when the transferor and transferee are members 
of another consolidated group).
5. Special Allocations Under Sec.  1.1502-32
    The proposed regulations also include a special allocation 
provision in Sec.  1.1502-32 that requires all items taken into account 
by a group (including tier-ups of such amounts) that reflect a section 
362(e)(2) amount to be allocated entirely to member's shares. In other 
words, such items are allocated as if any shares held by nonmembers 
were not outstanding. The reason for these special allocation rules is 
to prevent the general Sec.  1.1502-32 allocation of items to dilute 
the elimination of duplication where shares of subsidiary stock are 
held by nonmembers.
6. Other Considerations
    In the 2006 proposal, the IRS and Treasury Department proposed 
regulations that would provide that the tracing rules in Sec.  1.358-
2(a)(2) will not apply to stock received in a section 362(e)(2) 
transaction if the transferor and transferee elect to apply section 
362(e)(2)(C). The IRS and Treasury requested comments regarding whether 
that treatment is appropriate. As noted in section H.4 of this 
preamble, these proposed regulations would allow the making of a 
section 362(e)(2)(C) election to be deferred until the year of the 
first section 362(e)(2) application event. The IRS and Treasury 
Department are aware of the potential difficulty and administrative 
burden associated with retroactively not applying the provisions of 
Sec.  1.358-2(a)(2). The IRS and Treasury Department continue to study 
this issue, and invite comments regarding whether the proposed revision 
to Sec.  1.358-2(a)(2)(viii) regarding section 362(e)(2)(C) elections 
should apply to intercompany transactions.

[[Page 2985]]

    These proposed regulations would be applicable as of the date they 
are published as final regulations in the Federal Register.

I. Other Revisions to the Consolidated Return Regulations

    The IRS and Treasury Department are also proposing various 
technical and administrative revisions to the consolidated return 
regulations.
1. Removal of Sec.  1.1502-13(f)(6)(ii)
    Section 1.1502-13(f)(6)(ii) prevents a member from recognizing gain 
on the qualified disposition of parent stock. However, Sec.  1.1502-
13(f)(6)(ii) only applies to dispositions of parent stock occurring 
prior to May 16, 2000. Thus, the provision has no current 
applicability. Nevertheless, gain on dispositions of parent stock 
occurring on or after May 16, 2000 may qualify to be prevented by Sec.  
1.1032-3, which has fewer conditions to its application than did Sec.  
1.1502-13(f)(6)(ii). To avoid confusion, the IRS and Treasury 
Department propose replacing the current provisions in Sec.  1.1502-
13(f)(6)(ii) (and references to that provision) with a reference to 
Sec.  1.1032-3.
2. Modification of Exception to Definition of Deconsolidation in Sec.  
1.1502-19
    Section 1.1502-19 provides rules for the determination and 
recapture of excess loss accounts. In general, an excess loss account 
is recaptured (taken into account) when there is a disposition of the 
stock to which the account relates. Section 1.1502-19(c) defines the 
term disposition for purposes of Sec.  1.1502-19. Under that section, 
the term disposition includes transfers, cancellations, 
deconsolidations, and worthlessness. The term deconsolidation is 
defined in Sec.  1.1502-19(c)(1)(ii).
    In general, the termination of a consolidated group will give rise 
to the deconsolidation of the members of the group. However, Sec.  
1.1502-19(c)(3)(i)(A) provides that, if a group terminates because a 
member of another group has acquired either the assets of the common 
parent of the terminating group (in a reorganization described in 
section 381(a)(2)) or the stock of the common parent, the members of 
the acquired group that become members of the acquiror's group are not 
treated as deconsolidated. Thus, there is no recapture of excess loss 
accounts in the shares of stock of subsidiaries of the acquired group 
that, after the acquisition, are held by a member of the acquiring 
group.
    The exception to deconsolidation treatment in Sec.  1.1502-
19(c)(3)(i)(A) (and therefore to the recapture of excess loss accounts) 
is warranted because its conditions ensure that the consolidated return 
provisions will continue to apply to the members of the acquired group. 
Thus, the provisions of Sec.  1.1502-19 are able to continue to 
regulate the determination and recapture of the excess loss accounts. 
However, for the continued application of the consolidated return 
provisions to the acquired group, it is only necessary that the 
acquiror be a member of a group following the acquisition. Its status 
prior to the acquisition is immaterial. The IRS and Treasury Department 
have therefore decided to revise the rule in Sec.  1.1502-
19(c)(3)(i)(A) to require only that the acquiror be a member of a group 
following the qualified acquisition.
    Thus, under the proposed regulations, the exception to 
deconsolidation treatment provided in Sec.  1.1502-19(c)(3)(i)(A) would 
be available when the acquisition is by a stand-alone corporation or a 
member of an affiliated, nonconsolidated group.
3. Clarification of ``Substantially All'' Standard in Sec.  1.1502-
19(c)(1)(iii)(A)
    Section 1.1502-19(c)(1)(iii) defines the term ``worthless'' for 
purposes of excess loss account recapture (resulting in the inclusion 
of the excess loss account in income). The definition of worthlessness 
in Sec.  1.1502-19(c)(1)(iii) is adopted for determining the time when 
subsidiary stock with positive basis may be treated as worthless (and 
therefore deductible). See Sec.  1.1502-80(c).
    Section 1.1502-19(c)(1)(iii)(A) generally provides that a share of 
subsidiary stock will be treated as worthless when substantially all 
the subsidiary's assets are treated as disposed of, abandoned, or 
destroyed for federal tax purposes. This provision prevents an excess 
loss account from being included in income (and a worthless stock 
deduction from being taken) until the subsidiary's activities have been 
taken into account by the group. As a result, the group's income is 
clearly reflected and single entity treatment is promoted.
    The current regulations do not, however, define the term 
``substantially all'' for purposes of Sec.  1.1502-19(c)(1)(iii)(A). 
Particular concerns have arisen because the term is used in many other 
areas of tax law, most notably in the area of corporate 
reorganizations. Because different policies are operative in those 
areas, the thresholds appropriate in those areas are not necessarily 
appropriate for purposes of Sec.  1.1502-19(c)(1)(iii)(A) and the 
consolidated return provisions that incorporate it.
    The IRS and Treasury Department believe that the single entity 
purpose of these consolidated return provisions is best effected by 
treating a subsidiary's stock as worthless only once the subsidiary has 
recognized all items of income, gain, deduction, and loss attributable 
to its assets and operations. Accordingly, these proposed regulations 
clarify Sec.  1.1502-19(c)(1)(iii)(A) by providing that stock of a 
subsidiary will be treated as worthless when the subsidiary has 
disposed of, abandoned, or destroyed (for Federal tax purposes) all its 
assets other than its corporate charter and those assets, if any, that 
are necessary to satisfy state law minimum capital requirements to 
maintain corporate existence.
4. Triangular Reorganizations That Are Also Group Structure Changes
    Sections 1.1502-30 and 1.1502-31 provide special rules for 
determining the basis of stock following, respectively, a triangular 
reorganization and group structure change. The provisions both 
generally adopt net asset basis rules, but, in the case of a triangular 
reorganization, taxpayers can elect other rules in certain 
transactions. The regulations do not specify whether a group structure 
change that is also a triangular reorganization is subject to the basis 
rules applicable to group structure changes (under Sec.  1.1502-31) or 
to triangular reorganizations (under Sec.  1.1502-30). Because it is 
appropriate to conform the basis of the stock of the former common 
parent to its net asset basis in the case of any group structure 
change, the IRS and Treasury Department intend the rules of Sec.  
1.1502-31 to control the determination of stock basis when a 
transaction is a group structure change, without regard to whether the 
transaction is also a triangular reorganization. Accordingly, the 
proposed regulations add a rule to clarify that Sec.  1.1502-31 governs 
the determination of basis in all cases to which it applies, even those 
that also qualify as triangular reorganizations.
5. Allocations of Investment Adjustments To Prevent or Minimize Excess 
Loss Accounts
    Under Sec.  1.1502-32(c)(2)(i), positive investment adjustments 
allocated to a member's shares of a class of common stock are allocated 
first to equalize and eliminate excess loss accounts and then equally 
to all the member's other shares in that class. In the case of a 
negative adjustment, that section provides for the reduction of a 
member's positive basis in shares of a class of common stock

[[Page 2986]]

before the creation or increase of an excess loss account in any such 
share. However, the current rule does not require that negative 
adjustments must be made first to equalize excess loss accounts before 
applying them equally to all shares. The proposed regulations add such 
a provision in order to better reflect the member's investment in its 
shares of subsidiary stock.
6. Expired Losses and Attribute Reduction Under Sec.  1.1502-28.
    Section 1.1502-32(b)(3)(ii)(C)(2) provides that, if the amount of a 
discharge of indebtedness exceeds the amount of the related attribute 
reduction under Sec.  1.1502-28, that excess is treated as applying to 
reduce attributes to the extent of certain expired losses. In general, 
this section only applies to losses that expired without tax benefit, 
that were taken into account as noncapital, nondeductible expenses when 
they expired, and that would have been reduced had they not expired. 
The effect of this rule is to create a positive adjustment to the 
extent of the expired losses. The purpose of the rule, as stated in TD 
8560, is to more fully integrate expired losses into the investment 
adjustment system.
    As currently written, however, the rule does not explicitly state 
whether this special treatment of expired losses is available to all 
members' expired losses or only to the debtor-subsidiary's expired 
losses. Allowing such treatment for all members' expired losses is 
beyond the intended scope of relief and undermines the purpose of 
sections 108 and 1017, and Sec.  1.1502-28. Accordingly, Sec.  1.1502-
32(b)(3)(ii)(C)(2) is revised to state explicitly that such treatment 
is intended only for the debtor-subsidiary's expired losses. The 
regulation is also revised to clarify that all available attributes, 
not just those of the debtor-subsidiary, must be reduced before this 
special rule for certain expired losses can apply.
7. Applicability of Other Rules of Law, Anti-Duplicative Adjustments 
Rules
    Many of the consolidated return rules include provisions stating 
that other rules of law continue to apply. These provisions are 
generally unnecessary in light of Sec.  1.1502-80(a), which provides 
that the provisions of the Code continue to apply to taxpayers filing a 
consolidated return unless specifically provided otherwise in the 
consolidated return regulations. However, these provisions often also 
contain statements that the consolidated return provisions modify other 
rules of law and that duplicative adjustments should not be made as a 
result of the consolidated return provisions. To simplify the 
regulations and remove any potential negative implication from the 
absence of such a provision in a particular provision, these proposed 
regulations incorporate all of these principles in Sec.  1.1502-80(a) 
and remove similar provisions from other sections of the consolidated 
return regulations.
8. Retention of, and Nonsubstantive Revisions to, Sec.  1.1502-80(c)
    Section 1.1502-80(c) provides that subsidiary stock is not treated 
as worthless until the earlier of the time that the subsidiary ceases 
to be a member of the group and the time that the stock is worthless 
within the meaning of Sec.  1.1502-19(c)(1)(iii). This rule, with its 
companion rule postponing the inclusion in income of excess loss 
accounts, prevents a group from recognizing any amount (whether loss or 
gain) on subsidiary stock until the subsidiary has taken into account 
all of its operating income, gain, deduction, and loss. Thus, the rule 
promotes single entity treatment by enabling the group to continue 
treating its investment in subsidiary stock as an investment in the 
subsidiary's assets and operations until the subsidiary has either 
taken all of its items into account or ceased to be a member of the 
group.
    Following the Rite Aid decision, practitioners have submitted 
comments suggesting that Sec.  1.1502-80(c) should be removed from the 
consolidated return regulations. The suggestion was based on the 
observation that Sec.  1.1502-80(c) prevented inappropriate 
disallowance under the LDR and, since LDR no longer applies to stock 
dispositions, Sec.  1.1502-80(c) is no longer necessary. While it is 
correct that there is no longer an LDR-based justification for the rule 
in Sec.  1.1502-80(c), the LDR was neither the only nor the principal 
purpose for the rule. The principal purpose of the rule was, and is, to 
promote single entity treatment. And, with its companion rule governing 
the inclusion of excess loss accounts, this rule continues to do that.
    In addition, the IRS and Treasury Department recognize that, to the 
extent a subsidiary's attributes would survive a worthlessness event 
(for example, when a subsidiary survives and is owned by its creditors 
following a bankruptcy), Sec.  1.1502-80(c) benefits the group by 
postponing the time that the subsidiary's stock is treated as 
worthless. Because section 382(g)(4)(D) could subject S's losses to a 
zero section 382 limitation if P were to treat S's stock as worthless 
during bankruptcy, a court might prevent P from treating S's stock as 
worthless in an earlier year, effectively denying P any worthlessness 
deduction. See, In re Prudential Lines, Inc., 928 F.2d 565 (2d Cir. 
1991), cert. denied, 112 S.Ct. 82 (1991).
    Accordingly, the IRS and Treasury Department have rejected the 
suggestion to remove Sec.  1.1502-80(c). The proposed regulations do, 
however, revise the language of the current rule solely for the purpose 
of clarifying its operation. No substantive change is intended.
9. Effective Dates
    The proposed regulations described in this section I would be 
applicable as of the date they are published as final regulations in 
the Federal Register.

J. Request for Comments

    As described in this preamble, many approaches and combinations of 
approaches were considered with respect to both noneconomic and 
duplicated loss and, although the IRS and Treasury Department believe 
the approach adopted in these proposed regulations best responds to and 
balances the Congressional mandates, comments are requested concerning 
both the approach adopted in these proposed regulations and other 
possible approaches.
    As noted in section D of this preamble, the IRS and Treasury 
Department are continuing to study, and invite comments on, the issue 
of gain duplication by consolidated groups. Comments are specifically 
requested concerning the circumstances under which gain duplication 
should be addressed and the mechanisms that could be adopted to do so. 
For example, comments could address whether a gain duplication rule 
could or should parallel the approach to loss duplication suggested in 
the proposed regulations, or whether some other approach would be more 
appropriate or administrable. Comments are also requested regarding 
limitations that may be necessary or appropriate to address concerns 
such as attribute churning and conversion. In addition, comments are 
requested concerning the noneconomic reduction of stock gain (that is, 
the appropriateness of the continued use of a loss disallowance model) 
and the reduction of noneconomic stock gain (that is, the reduction of 
basis through the absorption of built-in losses or net built-in 
losses), and the extent to which it would be appropriate to address 
gain duplication without addressing these issues.
    As noted in section H of this preamble, the IRS and Treasury 
Department are continuing to study the application of section 362(e)(2) 
in the consolidated setting. Comments are

[[Page 2987]]

specifically requested concerning the general application of section 
362(e)(2) to intercompany transactions, as well as the administrability 
and appropriateness of the proposed rules suspending the application of 
section 362(e)(2) to intercompany transactions and specially allocating 
items attributable to intercompany section 362(e)(2) transactions.
    Although these regulations are generally proposed to be applicable 
when published as final regulations in the Federal Register, the IRS 
and Treasury Department invite comments regarding the extent to which 
it would be appropriate and desirable to allow taxpayers to elect to 
apply these provisions retroactively.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. 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 primarily will affect 
affiliated groups of corporations that have elected to file 
consolidated returns, which tend to be larger entities. Therefore, a 
Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 
U.S.C. chapter 6) is not required. Pursuant to section 7805(f), this 
regulation has been submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
business.

Comments and Requests for Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
(8) copies) or electronic comments that are submitted timely to the 
IRS. The IRS and Treasury Department request comments on the clarity of 
the proposed regulations and how they can be made easier to understand. 
All comments will be available for public inspection and copying. A 
public hearing will be scheduled if requested in writing by any person 
that timely submits written comments. If a public hearing is scheduled, 
notice of the date, time, and place for the public hearing will be 
published in the Federal Register.

Drafting Information

    The principal authors of these regulations are Theresa Abell and 
Phoebe Bennett 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.

Proposed Amendments to the Regulations

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

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
an entry in numerical order to read in part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Section 1.1502-36 also issued under 26 U.S.C. 1502 * * *
    Section 1.1502-36 also issued under 26 U.S.C. 337(d). * * *


Sec.  1.337(d)-1  [Removed]

    Par. 2. Section 1.337(d)-1 is removed.


Sec.  1.337(d)-2  [Removed]

    Par. 3. Section 1.337(d)-2 is removed.
    Par. 4. Section 1.358-6 is amended by:
    1. Revising paragraph (e).
    2. Adding new paragraph (f)(3).
    The revision and addition reads as follows:


Sec.  1.358-6  Stock basis in certain triangular reorganizations.

* * * * *
    (e) Cross-reference regarding triangular reorganizations involving 
members of a consolidated group. For rules relating to stock basis 
adjustments made as a result of a triangular reorganization in which P 
and S, or P and T, as applicable, are, or become, members of a 
consolidated group, see Sec.  1.1502-30. However, if a transaction is a 
group structure change, even if it is also a triangular reorganization, 
stock basis adjustments are determined under Sec.  1.1502-31.
* * * * *
    (f) * * *
    (3) Special rule for triangular reorganizations involving members 
of a consolidated group. Paragraph (e) of this section shall apply to 
all transfers on or after the date these regulations are published as 
final regulations in the Federal Register.
    Par. 5. Section 1.1502-13 is amended by:
    1. Revising paragraphs (a)(4), (f)(6)(ii), and (j)(5)(i)(A).
    2. Adding new paragraph (e)(4).
    3. Revising the last sentence of paragraph (f)(6)(iv)(A).
    4. Removing the second sentence in paragraph (f)(6)(v).
    5. Adding a new last sentence to paragraph (l)(1).
    The revisions and additions read as follows:


Sec.  1.1502-13  Intercompany transactions.

    (a) * * *
    (4) Application of other rules of law. See Sec.  1.1502-80(a) 
regarding the general applicability of other rules of law and a 
limitation on duplicative adjustments.
* * * * *
    (e) * * *
    (4) Intercompany section 362(e)(2) transactions--(i) Purpose and 
scope. This paragraph (e)(4) provides simplifying rules for 
intercompany transactions that are subject to section 362(e)(2) 
(intercompany section 362(e)(2) transactions). The purpose of this 
paragraph (e)(4) is to suspend the application of section 362(e)(2) 
during the period of time that the duplication resulting from the 
intercompany section 362(e)(2) transaction (the section 362(e)(2) 
amount, as defined in paragraph (e)(4)(ii)(A) of this section) can 
effectively be eliminated by the operation of the investment adjustment 
provisions of Sec.  1.1502-32. The amount and location of this 
duplication is identified and tracked while in the consolidated group. 
When this duplication can no longer effectively be eliminated by the 
investment adjustment provisions, the principles of section 362(e)(2) 
apply to the extent necessary to eliminate all or a portion of any 
remaining section 362(e)(2) amount (as defined in paragraph 
(e)(4)(ii)(B) of this section) reflected in B's attributes or stock. 
For purposes of this paragraph (e)(4), any reference to B stock 
received in an intercompany section 362(e)(2) transaction refers to B 
stock or B securities received (or deemed received) without the 
recognition of gain or loss.
    (ii) Identification and elimination of section 362(e)(2) amount--
(A) Section 362(e)(2) amount. The section 362(e)(2) amount is the 
amount of duplication resulting from an intercompany section 362(e)(2) 
transaction, and is equal to the amount by which B's basis in the 
assets received in an intercompany section 362(e)(2) transaction would 
have, but for the application of this paragraph (e)(4), been eliminated 
under section 362(e)(2)(A) (absent an election under section 
362(e)(2)(C)). Such amount is initially reflected in both the basis of 
the B stock received in the transaction and B's basis in the assets 
received. Each share of B stock initially reflects the section 
362(e)(2) amount to the extent the basis would have been reduced under 
section 362(e)(2)(C) if such an

[[Page 2988]]

election was made and this paragraph (e)(4) did not apply. B's basis in 
each asset received initially reflects the section 362(e)(2) amount to 
the extent the basis in such asset would have been reduced under 
section 362(e)(2)(A) if no election was made under section 362(e)(2)(C) 
and this paragraph (e)(4) did not apply. However, over time the section 
362(e)(2) amount may be reflected in B's basis in assets, deferred 
items, or other unabsorbed losses (B's attributes).
    (B) Remaining section 362(e)(2) amount. The remaining section 
362(e)(2) amount is the portion of the section 362(e)(2) amount that 
has not been eliminated.
    (C) Elimination of section 362(e)(2) amount--(1) Elimination caused 
by reduction in B's attributes. The section 362(e)(2) amount is 
eliminated as B's attributes that reflect the section 362(e)(2) amount 
are taken into account by the group (including as a result of attribute 
reduction under paragraph (e)(4)(iv) of this section, or Sec.  1.1502-
36(d) to the extent it did not reduce the basis in B stock that 
reflects the section 362(e)(2) amount). The portions of B's attributes 
that reflect a section 362(e)(2) amount are generally taken into 
account by the group proportionately. However, because any reduction in 
B's attributes under paragraph (e)(4)(iv) of this section is applied to 
reduce attributes that reflect the section 362(e)(2) amount, the 
section 362(e)(2) amount is eliminated to the extent of the full amount 
of such reduction. If the section 362(e)(2) amount is eliminated 
because B's attributes that reflect the section 362(e)(2) amount are 
taken into account, each share of B stock received in the intercompany 
section 362(e)(2) transaction that is held by a member is treated as 
proportionately reflecting the remaining section 362(e)(2) amount 
(based on the section 362(e)(2) amount reflected before the 
elimination).
    (2) Elimination caused by reduction in basis in B stock. The 
section 362(e)(2) amount is also eliminated to the extent the basis in 
B stock that reflects the section 362(e)(2) amount is reduced under 
paragraph (e)(4)(v) of this section, is reduced under Sec.  1.1502-
36(d), or is otherwise is eliminated (other than under Sec.  1.1502-32) 
without the recognition of gain or loss. The portion of the basis in a 
share of B stock that reflects a section 362(e)(2) amount is so reduced 
or eliminated before any other portion of the basis in such a share. If 
the section 362(e)(2) amount is eliminated as provided in this 
paragraph (e)(4)(ii)(C)(2), each of B's attributes that reflected the 
section 362(e)(2) amount is treated as proportionately reflecting the 
remaining section 362(e)(2) amount (based on the section 362(e)(2) 
amount reflected before the elimination).
    (iii) Section 362(e)(2) application event. A section 362(e)(2) 
application event is any transaction or event that results in--
    (A) A transfer (within the meaning of Sec.  1.1502-36(f)(11)) of 
any of the B stock that was received in the intercompany section 
362(e)(2) transaction;
    (B) Any satisfaction (actual or deemed) of a security received in 
an intercompany section 362(e)(2) transaction without the recognition 
of gain or loss;
    (C) Any nonmember holding an asset with a substituted basis that 
reflects all or a portion of the remaining section 362(e)(2) amount or 
succeeding to an attribute that reflects all or a portion of the 
remaining section 362(e)(2) amount; or
    (D) Any other transaction the result of which prevents all or a 
portion of any remaining section 362(e)(2) amount reflected in stock 
basis or attributes from being effectively eliminated by the operation 
of the investment adjustment provisions of Sec.  1.1502-32 when taken 
into account.
    (iv) General rule. In the case of an intercompany section 362(e)(2) 
transaction, no adjustment to B's attributes shall be made under 
section 362(e)(2) until immediately before a section 362(e)(2) 
application event (as defined in paragraph (e)(4)(iii) of this 
section). At that time, unless an election is made under paragraph 
(e)(4)(v) of this section, B reduces its attributes that reflect the 
remaining section 362(e)(2) amount as provided in this paragraph 
(e)(4)(iv).
    (A) Amount of reduction. If the application event involves B's 
attributes that reflect all or a portion of the remaining section 
362(e)(2) amount, the amount of the reduction is equal to the remaining 
section 362(e)(2) amount reflected in the attributes so involved. If 
the application event involves all or a portion of the B stock received 
in the intercompany section 362(e)(2) transaction, the amount of the 
reduction is equal to the remaining section 362(e)(2) amount reflected 
in the B stock so involved.
    (B) Application of reduction. If the application event involves B's 
attributes that reflect all or a portion of the remaining section 
362(e)(2) amount, the reduction is applied to reduce each attribute so 
involved by the full amount of the remaining section 362(e)(2) amount 
reflected in each such attribute. If the application event involves all 
or a portion of the B stock received in the intercompany section 
362(e)(2) transaction, the reduction is applied proportionately (based 
on the remaining section 362(e)(2) amount reflected in each attribute 
prior to reduction) to all of B's attributes that reflect the remaining 
section 362(e)(2) amount.
    (C) Effect of the reduction. Any reduction to B's attributes under 
this paragraph (e)(4)(iv) is not a noncapital, nondeductible expense 
described in Sec.  1.1502-32(b)(2)(iii).
    (v) Election to reduce the basis in B stock. In lieu of reducing 
B's attributes as provided in paragraph (e)(4)(iv) of this section, S 
and B may elect to reduce the basis in the B stock received in the 
intercompany section 362(e)(2) transaction as provided in this 
paragraph (e)(4)(v).
    (A) Amount of reduction. The basis in the B stock is reduced by an 
amount equal to the amount B would otherwise be required to reduce its 
attributes under paragraph (e)(4)(iv) of this section.
    (B) Application of reduction. If the application event involves B's 
attributes that reflect all or a portion of the remaining section 
362(e)(2) amount, the reduction is applied proportionately (based on 
the remaining section 362(e)(2) amount reflected in the B stock prior 
to reduction) to all of the B stock received in the intercompany 
section 362(e)(2) transaction that is held by members immediately 
before the application event. If the application event involves all or 
a portion of the B stock received in the intercompany section 362(e)(2) 
transaction, the reduction is applied proportionately (based on the 
remaining section 362(e)(2) amount reflected in the B stock prior to 
reduction) to the B stock so involved. Any reduction in the basis of 
the B stock under this paragraph (e)(4)(v) is applied immediately 
before the section 362(e)(2) application event.
    (C) Effect of the reduction. Any reduction to the basis of the B 
stock under this paragraph (e)(4)(v) is a nondeductible basis recovery 
item described in Sec.  1.1502-32(b)(3)(iii)(B).
    (D) Election. The election is made in the manner described in 
regulations implementing section 362(e)(2). The election must be made 
for an intercompany section 362(e)(2) transaction on or with the group 
return for either the year in which the intercompany section 362(e)(2) 
transaction or the first section 362(e)(2) application event occurs. 
The election is irrevocable and applicable for all section 362(e)(2) 
application events with respect to such intercompany section 362(e)(2) 
transaction (even if the event occurs while S and B are members

[[Page 2989]]

of another consolidated group). If the election is made on or with the 
return for the year of the intercompany section 362(e)(2) transaction, 
it has effect only if and to the extent there is a remaining section 
362(e)(2) amount when there is a section 362(e)(2) application event.
    (vi) Examples. The application of this paragraph (e)(4) is 
illustrated by the following examples:

    Example 1. Section 362(e)(2) amount reflected in asset basis. 
(i) Facts. P owns the sole outstanding share of S stock. S owns 
Asset 1 with a basis of $100 and a value of $20. On January 1, year 
1, S contributes Asset 1 to newly formed B in exchange for 10 shares 
of B stock in a transaction to which section 351 applies. At the end 
of year 1, B's only item is a $10 depreciation deduction with 
respect to Asset 1, which gives rise to a $10 loss that is absorbed 
by the group. On January 1, year 2, S sells all 10 shares of B stock 
for $18. After applying and giving effect to all generally 
applicable rules of law, S's basis in each share of B stock is $9 
(the original $10 basis reduced by $1 loss attributable to the 
depreciation on Asset 1). No election is made under section 
362(e)(2)(C).
    (ii) Suspension of section 362(e)(2) in year 1. S's contribution 
of Asset 1 to B is an intercompany transaction to which section 
362(e)(2) applies. Under the general rules of section 362(e)(2)(A), 
B's basis in Asset 1 would be reduced by $80 to its value, $20. 
However, as described in this paragraph (e)(4), the transfer is an 
intercompany section 362(e)(2) transaction and therefore, under 
paragraph (e)(4)(iv) of this section, no adjustment is made under 
section 362(e)(2) until there is a section 362(e)(2) application 
event. The $80 reduction that B would have had in its basis in Asset 
1 is a section 362(e)(2) amount described in paragraph (e)(4)(ii)(A) 
of this section. This amount is reflected ratably in S's basis in 
the 10 shares of B stock, and in B's basis in Asset 1. There is no 
section 362(e)(2) application event in year 1 and so there is no 
section 362(e)(2) adjustment in year 1.
    (iii) Application of section 362(e)(2) on sale of B stock. S's 
sale of the B stock is a transfer within the meaning of Sec.  
1.1502-36(f)(11) and therefore a section 362(e)(2) application event 
under paragraph (e)(4)(iii)(A) of this section. Accordingly, under 
paragraphs (e)(4)(iv)(A) and (e)(4)(iv)(B) of this section, because 
the section 362(e)(2) application event was caused by the transfer 
of B stock received in the intercompany section 362(e)(2) 
transaction, B must reduce its basis in Asset 1 that reflects the 
remaining section 362(e)(2) amount by an amount equal to the 
remaining section 362(e)(2) amount reflected in the B stock involved 
in the application event. Because S sold all of the B stock received 
in the intercompany section 362(e)(2) transaction and this stock 
reflects all of the section 362(e)(2) amount, B must reduce its 
basis in Asset 1 by the full amount of the remaining section 
362(e)(2) amount immediately before the application event. Although 
there was originally an $80 section 362(e)(2) amount, $8 of that 
amount ($80/$100 x $10) was eliminated under paragraph 
(e)(4)(ii)(C)(1) of this section when the loss attributable to the 
depreciation deduction on Asset 1 was absorbed in year 1. Thus, at 
the time of the sale, the remaining section 362(e)(2) amount is only 
$72 ($80 less $8), and B's basis in Asset 1 is reduced by such 
amount, to $18. Under paragraph (e)(4)(iv)(C) of this section, the 
reduction in the basis of Asset 1 is not a noncapital, nondeductible 
expense described in Sec.  1.1502-32(b)(2)(iii) and so has no effect 
on S's basis in its B shares. See Sec.  1.1502-36 for additional 
rules relating to loss on shares of subsidiary stock.
    Example 2. Section 362(e)(2) amount reflected in unabsorbed 
loss. (i) Facts. The facts are the same as in Example 1, except that 
during year 1 B sells Asset 1 to an unrelated nonmember for $20, and 
recognizes an $80 loss that is not absorbed by the group.
    (ii) Suspension of section 362(e)(2) in year 1. As in paragraph 
(ii) of Example 1, S's contribution of Asset 1 to B is an 
intercompany section 362(e)(2) transaction, the section 362(e)(2) 
amount is $80, and there is no section 362(e)(2) adjustment in year 
1. This amount is reflected ratably in S's basis in the 10 shares of 
B stock, and initially in B's basis in Asset 1. Further, because the 
$80 loss recognized on the sale of Asset 1 is not absorbed by the 
group, at the end of year 1 the remaining section 362(e)(2) amount 
is $80, reflected ratably in S's basis in the 10 shares of B stock, 
and in B's unabsorbed $80 loss.
    (iii) Application of section 362(e)(2) on sale of B stock. As in 
paragraph (iii) of Example 1, S's sale of the 10 shares of B stock 
is a section 362(e)(2) application event that involves all of the B 
stock received in the intercompany section 362(e)(2) transaction. 
Accordingly, immediately before the application event, B must reduce 
the unabsorbed loss carryover that reflects the remaining section 
362(e)(2) amount by an amount equal to the remaining section 
362(e)(2) amount reflected in the B stock involved in the 
application event, $80 (all of the remaining section 362(e)(2) 
amount). The reduction of the loss carryover is not a noncapital, 
nondeductible expense described in Sec.  1.1502-32(b)(2)(iii) and so 
has no effect on S's basis in its B shares. See Sec.  1.1502-36 for 
additional rules relating to loss on shares of subsidiary stock.
    Example 3. Section 362(e)(2) amount reflected in unabsorbed 
loss, partial application. (i) Facts. The facts are the same as in 
Example 2, except that on January 1, year 2, S only sells two shares 
of the B stock to an unrelated nonmember for $4.
    (ii) Suspension of section 362(e)(2) in year 1. S's contribution 
of Asset 1 to B is an intercompany section 362(e)(2) transaction, 
the section 362(e)(2) amount is $80, and there is no section 
362(e)(2) adjustment in year 1. This amount is reflected ratably in 
S's basis in the 10 shares of B stock, and initially in B's basis in 
Asset 1. Further, because the $80 loss recognized on the sale of 
Asset 1 is not absorbed by the group, at the end of year 1 the 
remaining section 362(e)(2) amount is $80, reflected ratably in S's 
basis in the 10 shares of B stock, and in B's unabsorbed $80 loss.
    (iii) Application of section 362(e)(2) on sale of B stock. S's 
sale of two of the shares of B stock is a section 362(e)(2) 
application event that involves two shares of the B stock received 
in the intercompany section 362(e)(2) transaction. Accordingly, 
immediately before the application event, B must reduce the 
unabsorbed loss carryover that reflects the remaining section 
362(e)(2) amount by an amount equal to the remaining section 
362(e)(2) amount reflected in the B stock involved in the 
application event, $16 ($8 of the remaining section 362(e)(2) amount 
reflected in each share). The loss carryover is reduced from $80 to 
$64. This reduction is not a noncapital, nondeductible expense 
described in Sec.  1.1502-32(b)(2)(iii) and so has no effect on S's 
basis in its B shares. Additionally, under paragraph 
(e)(4)(ii)(C)(1) of this section, $16 of the remaining section 
362(e)(2) amount is eliminated, and, thereafter, the $64 remaining 
section 362(e)(2) amount is ratably reflected in S's basis in the 
remaining 8 shares of B stock and in B's $64 loss carryover. Because 
no election is made under section 362(e)(2)(C) in the year of the 
intercompany section 362(e)(2) transaction or in the year of the 
stock sale, the first section 362(e)(2) application event, no such 
election can be made with respect to the remaining shares received 
in the intercompany section 362(e)(2)(C) transaction. See Sec.  
1.1502-36 for additional rules relating to loss on shares of 
subsidiary stock.
    (iv) Application of section 362(e)(2) on sale of B stock, 
section 362(e)(2)(C) election. If S and B elect under paragraph 
(e)(4)(v) of this section to reduce S's basis in the B stock 
received in the intercompany section 362(e)(2) transaction, under 
paragraph (e)(4)(v)(A) of this section S will reduce its basis in 
the B stock by $16 (an amount equal to the amount that B would 
otherwise be required to reduce its loss carryover, or the remaining 
section 362(e)(2) amount reflected in the two shares of B stock 
sold). Under paragraph (e)(4)(v)(B) of this section, this $16 
reduction is applied proportionately to the two shares of B stock 
sold immediately before the application event, reducing the basis of 
each share to $2. The reduction in the basis of the two B shares 
sold is a nondeductible basis recovery item described in Sec.  
1.1502-32(b)(3)(iii)(B), and will effect P's basis in its share of S 
stock. Additionally, under paragraph (e)(4)(ii)(C)(2) of this 
section, $16 of the remaining section 362(e)(2) amount is 
eliminated, and, thereafter, the $64 remaining section 362(e)(2) 
amount is ratably reflected in S's basis in the remaining 8 shares 
of B stock and in B's $80 loss carryover. S recognizes no gain or 
loss on the sale of these two shares of B stock. Under paragraph 
(e)(4)(v)(D) of this section, S and B's election to reduce S's basis 
in the B stock is irrevocable and applicable to all future section 
362(e)(2) application events with respect to this intercompany 
section 362(e)(2) transaction, such as subsequent dispositions of B 
stock to an unrelated nonmember.
    Example 4. Section 362(e)(2) amount reflected in unabsorbed 
loss, subgroup exception. (i) Facts. The facts are the same as in 
Example 3, except that S does not sell any shares of B stock, and on 
January 1, year 2, P sells the sole share of the S stock to P1, the

[[Page 2990]]

common parent of another consolidated group.
    (ii) Suspension of section 362(e)(2) in year 1. S's contribution 
of Asset 1 to B is an intercompany section 362(e)(2) transaction, 
the section 362(e)(2) amount is $80, and there is no section 
362(e)(2) adjustment in year 1. This amount is reflected ratably in 
S's basis in the 10 shares of B stock, and initially in B's basis in 
Asset 1. Further, because the $80 loss recognized on the sale of 
Asset 1 is not absorbed by the group, at the end of year 1 the 
remaining section 362(e)(2) amount is $80, reflected ratably in S's 
basis in the 10 shares of B stock, and in B's unabsorbed $80 loss.
    (iii) No section 362(e)(2) application event on sale of S stock. 
P's sale of the S stock is not an application event described in 
paragraph (e)(4)(iii) of this section. Further, because S and B 
continue to be members of the same consolidated group, there is no 
transfer (within the meaning of Sec.  1.1502-36(f)(11)) of the 10 
shares of B stock. Accordingly, there is no application event and, 
under paragraph (e)(4)(iv) of this section, no section 362(e)(2) 
adjustment is required. However, adjustments will be required if a 
section 362(e)(2) application event occurs at a time when there is a 
remaining section 362(e)(2) amount.
* * * * *
    (f) * * *
    (6) * * *
    (ii) Gain stock. For dispositions of P stock occurring before May 
16, 2000, see Sec.  1.1502-13(f)(6)(ii) as contained in 26 CFR part 1 
in effect on April 1, 2000. For dispositions of P stock occurring on or 
after May 16, 2000, see Sec.  1.1032-3.
* * * * *
    (iv) * * * (A) * * * If P grants M an option to acquire P stock in 
a transaction meeting the requirements of Sec.  1.1032-3, M is treated 
as having purchased the option from P for fair market value with cash 
contributed to M by P.
* * * * *
    (j) * * *
    (5) * * * (i) * * *
    (A) The acquisition of either the assets of the common parent of 
the terminating group in a reorganization described in section 
381(a)(2), or the stock of the common parent of the terminating group; 
or
* * * * *
    (l) * * * (1) * * * Paragraphs (a)(4), (e)(4), (f)(6)(ii), 
(f)(6)(iv)(A), and (j)(5)(i)(A) of this section apply to all transfers 
on or after the date these regulations are published as final 
regulations in the Federal Register.
* * * * *
    Par. 6. Section 1.1502-19 is amended by:
    1. Revising paragraphs (a)(3), (c)(1)(iii)(A), and (c)(3)(i)(A).
    2. Adding a new last sentence to paragraph (h)(1).
    The revisions and addition reads as follows:


Sec.  1.1502-19  Excess loss accounts.

    (a) * * *
    (3) Application of other rules of law. See Sec.  1.1502-80(a) 
regarding the general applicability of other rules of law and a 
limitation on duplicative adjustments. In addition, for purposes of 
this section, the definitions in Sec.  1.1502-32 apply.
* * * * *
    (c) * * *
    (1) * * *
    (iii) * * *
    (A) All of S's assets (other than its corporate charter and those 
assets, if any, necessary to satisfy state law minimum capital 
requirements to maintain corporate existence) are treated as disposed 
of, abandoned, or destroyed for Federal income tax purposes (for 
example, under section 165(a) or Sec.  1.1502-80(c), or, if S's asset 
is stock of a lower-tier member, the stock is treated as disposed of 
under this paragraph (c)). An asset of S is not considered to be 
disposed of or abandoned to the extent the disposition is in complete 
liquidation of S under section 332 or is in exchange for consideration 
(other than in satisfaction of indebtedness);
* * * * *
    (3) * * * (i) * * *
    (A) The acquisition of either the assets of the common parent of 
the terminating group in a reorganization described in section 
381(a)(2), or the stock of the common parent of the terminating group; 
or
* * * * *
    (h) * * * (1) * * * Paragraphs (a)(3), (c)(1)(iii)(A), and 
(c)(3)(i)(A) of this section apply to all transfers on or after the 
date these regulations are published as final regulations in the 
Federal Register.
* * * * *


Sec.  1.1502-20  [Removed]

    Par. 7. Section 1.1502-20 is removed.
    Par. 8. Section 1.1502-21 is amended by:
    1. Removing the last sentence of paragraph (b)(1).
    2. Removing paragraph (b)(3)(v).
    3. Revising paragraphs (b)(2)(ii)(A), (b)(2)(iv)(B)(2), (h)(6), and 
(h)(8).
    4. Adding new paragraph (h)(1)(iii).
    The revisions and addition reads as follows:


Sec.  1.1502-21  Net operating losses.

* * * * *
    (b) * * *
    (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, then are subject to reduction 
under section 108 and Sec.  1.1502-28 (regarding discharge of 
indebtedness income that is excluded from gross income under section 
108(a)), and then are subject to reduction under Sec.  1.1502-36 
(regarding transfers of loss shares of subsidiary stock). Only the 
amount that is neither absorbed nor reduced under section 108 and Sec.  
1.1502-28 or under Sec.  1.1502-36 may be 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) * * *
    (B) * * *
    (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, is recomputed pursuant to paragraph 
(b)(2)(iv)(B)(2)(v) 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)(v) 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)(v) of this section.
    (iv) Reduction of attributes for stock loss. If during a taxable 
year a member does not cease to be a member of the group and any 
portion of the CNOL attributable to any member is reduced pursuant to 
Sec.  1.1502-36, the percentage of the CNOL attributable to each member 
immediately after the reduction of attributes pursuant to Sec.  1.1502-
36 shall be recomputed pursuant to paragraph (b)(2)(iv)(B)(2)(v) of 
this section.

[[Page 2991]]

    (v) 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 
under Sec.  1.1502-36, or that is otherwise permanently disallowed or 
eliminated, shall be treated as absorbed.
    (vi) Examples. For purposes of the examples in this section, unless 
otherwise stated, all groups file consolidated returns, all 
corporations have calendar taxable years, the facts set forth the only 
corporate activity, value means fair market value and the adjusted 
basis of each asset equals its value, all transactions are with 
unrelated persons, and the application of any limitation or threshold 
under section 382 is disregarded. * * *
* * * * *

    (h) * * * (1) * * *
    (iii) Paragraphs (b)(2)(ii)(A) and (b)(2)(iv)(B)(2) of this section 
apply to taxable years the original return for which the due date 
(without regard to extensions) is on or after the date these 
regulations are published as final regulations in the Federal Register.
* * * * *
    (6) Certain prior periods. Paragraphs (b)(1), (b)(2)(iv)(A), 
(b)(2)(iv)(B)(1), and (c)(2)(vii) of this section shall apply to 
taxable years for which the due date of the original return (without 
regard to extensions) is after March 21, 2005. Sections 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 for which the 
due date of the original return (without regard to extensions) is on or 
before March 21, 2005, and after August 29, 2003. For taxable years for 
which the due date of the original return (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.
* * * * *
    (8) Losses treated as expired under Sec.  1.1502-35(f)(1). For 
rules regarding losses treated as expired under Sec.  1.1502-35(f) on 
and after March 10, 2006, see Sec.  1.1502-21(b)(3)(v) as contained in 
26 CFR part 1 in effect on April 1, 2006. For rules regarding losses 
treated as expired before March 10, 2006, see Sec.  1.1502-21T(h)(8) as 
contained in 26 CFR part 1 in effect on April 1, 2005.
    Par. 9. Section 1.1502-30 is amended by:
    1. Revising paragraph (b)(4).
    2. Adding a new second sentence to paragraph (c).
    The revision and addition reads as follows:


Sec.  1.1502-30  Stock basis after certain triangular reorganizations.

* * * * *
    (b) * * *
    (4) Application of other rules of law. If a transaction otherwise 
subject to this section is also a group structure change subject to 
Sec.  1.1502-31, the provisions of Sec.  1.1502-31 and not this section 
apply to determine stock basis. See Sec.  1.1502-80(a) regarding the 
general applicability of other rules of law and a limitation on 
duplicative adjustments. See Sec.  1.1502-80(d) for the non-application 
of section 357(c) to P.
* * * * *
    (c) * * * However, paragraph (b)(4) of this section applies to 
reorganizations occurring on or after the date these regulations are 
published as final regulations in the Federal Register.
* * * * *
    Par. 10. Section 1.1502-31 is amended by:
    1. Revising paragraph (a)(2).
    2. Adding a new last sentence to paragraph (h)(1).
    The revision and addition reads as follows:


Sec.  1.1502-31  Stock basis after a group structure change.

    (a) * * *
    (2) Application of other rules of law. If a transaction subject to 
this section is also a triangular reorganization otherwise subject to 
Sec.  1.1502-30, the provisions of this section and not those of Sec.  
1.1502-30 apply to determine stock basis. See Sec.  1.1502-80(a) 
regarding the general applicability of other rules of law and a 
limitation on duplicative adjustments.
* * * * *
    (h) * * * (1) * * * In addition, paragraph (a)(2) of this section 
applies to group structure changes that occurred on or after the date 
these regulations are published as final regulations in the Federal 
Register.
* * * * *
    Par. 11. Section 1.1502-32 is amended by:
    1. Revising paragraphs (a)(2), (b)(3)(ii)(C)(2), (b)(3)(iii)(C), 
(b)(3)(iii)(D), (c)(1), (c)(2)(i), the first sentence in paragraph 
(c)(2)(ii)(A) introductory text, the first sentence in paragraph 
(c)(3), and the first sentence in paragraph (c)(4)(i) introductory 
text.
    2. Adding new paragraph (h)(9).
    The revisions and addition read as follows:


Sec.  1.1502-32  Investment adjustments.

    (a) * * *
    (2) Application of other rules of law. See Sec.  1.1502-80(a) 
regarding the general applicability of other rules of law and a 
limitation on duplicative adjustments.
* * * * *
    (b) * * *
    (3) * * *
    (ii) * * *
    (C) * * *
    (2) Expired loss carryovers. If the amount of the discharge exceeds 
the amount of the attribute reduction under sections 108 and 1017, and 
Sec.  1.1502-28, the excess nevertheless is treated as applied to 
reduce tax attributes to the extent a loss carryover attributable to S 
expired without tax benefit, the expiration was taken into account as a 
noncapital, nondeductible expense under paragraph (b)(3)(iii) of this 
section, and the loss carryover would have been reduced had it not 
expired.
* * * * *
    (iii) * * *
    (C) Loss suspended under Sec.  1.1502-35(c). For losses suspended 
by Sec.  1.1502-35(c) prior to the date these regulations are published 
as final regulations in the Federal Register, see 1.1502-
32(b)(3)(iii)(C) as contained in 26 CFR part 1 revised as of April 1, 
2006.
    (D) Reimported losses disallowed under Sec.  1.1502-35. Any loss or 
deduction the use of which is disallowed pursuant to Sec.  1.1502-35(b) 
(other than duplicating items that are carried back to a consolidated 
return year of the group), and with respect to which no waiver 
described in paragraph (b)(4) of this section is filed, is treated as a 
noncapital, nondeductible expense incurred during the taxable year that 
such loss would otherwise be absorbed. For losses or deductions 
disallowed under Sec.  1.1502-35(g)(3)(iii) prior to the date these 
regulations are published as final regulations in the Federal Register, 
see 1.1502-32(b)(3)(iii)(D) as contained in 26 CFR part 1 revised as of 
April 1, 2006.
* * * * *
    (c) Allocation of adjustments among shares of stock--(1) In 
general--(i) Distributions. The portion of the adjustment under 
paragraph (b) of this section that is described in paragraph (b)(2)(iv) 
of this section (negative adjustments for distributions) is allocated 
to the shares of S's stock to which the distribution relates.

[[Page 2992]]

    (ii) Special allocations in the case of certain loss transfers and 
reallocations of investment adjustments subject to prior use 
limitation--(A) Losses attributable to transfers subject to section 
362(e)(2)-(1) In general. If a nonmember holds shares of S stock, any 
amounts that directly or indirectly reflect a section 362(e)(2) amount 
(as defined in Sec.  1.1502-13(e)(4)(ii)(A)) are allocated to members' 
shares of S stock under the general principles of this paragraph (c), 
except that such allocations are made as though the shares of S stock 
held by nonmembers were not outstanding.
    (2) Example. The application of this paragraph (c) is illustrated 
by the following example:

    Example. (i) Facts. P owns four of the five outstanding shares 
of the stock of M. X, a nonmember, owns the remaining outstanding 
share of M stock. On January 1, year 1, M contributes Asset 1 to S, 
a newly formed subsidiary, in exchange for five shares of S stock in 
a transaction to which section 351 applies. At the time of the 
transfer, M's basis in Asset 1 is $100 and its value is $20. At the 
end of year 1, S's only item is a $10 depreciation deduction with 
respect to Asset 1, which gives rise to a $10 loss that is absorbed 
by the group. At the beginning of year 2, M sells one of its S 
shares to X for $3.60, and M and S elect to reduce M's basis in the 
S stock under Sec.  1.1502-13(e)(4)(v) by the amount of the 
remaining section 362(e)(2) amount ($72) (computed in paragraph 
(iii)(C) of this Example) reflected in the share. See, Sec.  1.1502-
13(e)(4). Accordingly, M's basis in the S share is reduced by $14.40 
(the portion of the $72 remaining section 362(e)(2) amount reflected 
in the share (computed in paragraph (iii)(C) of this Example)), to 
$3.60. M recognizes no gain or loss on the sale of the S share. At 
the end of year 2, S's only item is an additional $10 depreciation 
deduction with respect to Asset 1, which gives rise to an additional 
$10 loss that is absorbed by the group. At the end of year 2, M's 
only item is a $14.40 nondeductible basis recovery item resulting 
from the election to reduce its basis in the S share. See Sec.  
1.1502-13(e)(4)(v)(C).
    (ii) Application of section 362(e)(2) and Sec.  1.1502-13(e)(4) 
to the transfer of Asset 1. M's contribution of Asset 1 to S is a 
transaction described in section 362(e)(2). Under the general rules 
of section 362(e)(2)(A), S's basis in Asset 1 would be limited to 
its value ($20) and would thus be reduced by $80, from $100 to $20. 
However, the transfer is an intercompany section 362(e)(2) 
transaction and therefore, under Sec.  1.1502-13(e)(4)(iv), no 
adjustment is made to S's basis in Asset 1 under section 362(e)(2) 
until there is a section 362(e)(2) application event (within the 
meaning of Sec.  1.1502-13(e)(4)(iii)). There is no section 
362(e)(2) application event in year 1 and so there is no section 
362(e)(2) adjustment in year 1. The $80 reduction that S would have 
had in its basis in Asset 1 is a section 362(e)(2) amount described 
in Sec.  1.1502-13(e)(4)(ii)(A). This $80 section 362(e)(2) amount 
is initially reflected ratably ($16 per share) in M's basis in each 
of the five shares of S stock received in the transaction, and in 
S's basis in Asset 1. Further, under Sec.  1.1502-
13(e)(4)(ii)(C)(1), the section 362(e)(2) amount reflected in an 
attribute is generally eliminated proportionately as the attribute 
is taken into account. Accordingly, $8 ($80/$100 x $10) of the year 
1 Asset 1 depreciation deduction is attributable to the section 
362(e)(2) amount.
    (iii) Treatment of year 1 item. (A) Allocation of item among 
shares of S stock. Although no adjustment is made under section 
362(e)(2) during year 1, if any shares of S stock are held by 
nonmembers, any items taken into account that are attributable to 
the section 362(e)(2) amount must be specially allocated under the 
rules of this paragraph (c)(1)(ii). Because M owns all the shares of 
S stock, the special allocation rules of this paragraph (c)(1)(ii) 
have no application to the allocation of S's depreciation deduction 
to M's shares. Accordingly, the entire $10 of depreciation on Asset 
1 is included in the remaining adjustment to the S shares under the 
general rules in paragraphs (c)(2) through (c)(4) of this section. 
As a result, $2 is allocated to, and decreases the basis in, each 
share of S stock held by M from $20 to $18.
    (B) Allocation of tiered-up item among shares of M stock. Under 
paragraph (a)(3)(iii) of this section, adjustments to M's basis in S 
stock tier up and are taken into account in determining adjustments 
to higher-tier stock. However, because X, a nonmember, holds a share 
of M stock, any portion of the tiering-up adjustment that is 
attributable to a section 362(e)(2) amount is specially allocated 
under this paragraph (c)(1)(ii). In this case, $8 of the adjustment 
to M's basis in S stock (\80/100\ x $10) is attributable to a 
section 362(e)(2) amount and thus $8 of the tiered-up adjustment is 
indirectly attributable to a section 362(e)(2) amount. As a result, 
$8 of the tiered-up adjustment must be allocated as though X's share 
of M stock was not outstanding. Accordingly, $2 (\1/4\) of the $8 of 
the tiered-up adjustment is allocated to each of P's four shares of 
M stock and no portion of that amount is allocated to X's share of M 
stock. However, the remaining $2 of the tiered-up adjustment not 
attributable to a section 362(e)(2) amount is included in the 
remaining adjustment allocated to all outstanding shares under the 
general rules in paragraphs (c)(2) through (c)(4) of this section. 
Thus, $.40 (\1/5\) of the $2 of the tiered-up adjustment is 
allocated to each outstanding share. (Although $.40 is allocated to 
X's share of M stock, that allocation does not affect X's basis in 
the share because X is not a member of the group. See paragraph 
(c)(1)(iv) of this section.) The allocation of the tiered up year 1 
item is thus:

------------------------------------------------------------------------
                                                 Allocation
                                  --------------------------------------
               Item                  P's shares of M     X's share of M
                                     stock  (\4/5\)      stock  (\1/5\)
------------------------------------------------------------------------
Tiered-up section 362(e)(2)        $8.00 ($2.00 per    N/A.
 amount ($8 of the $10              share).
 depreciation on Asset 1).
Tiered-up non-section 362(e)(2)    $1.60 ($.40 per     $.40 ($.40 per
 amount ($2 of the $10              share).             share).
 depreciation on Asset 1).
                                  --------------------------------------
    Total allocation.............  $9.60 ($2.40 per    $.40 ($.40 per
                                    share).             share).
------------------------------------------------------------------------

    (C) Remaining section 362(e)(2) amount. After the year 1 items 
have been taken into account, the remaining section 362(e)(2) amount 
with respect to the S shares is $72 ($80 less $8 eliminated due to 
Asset 1 depreciation being taken into account). Under Sec.  1.1502-
13(e)(4)(ii)(C)(1), this $72 remaining section 362(e)(2) amount is 
reflected proportionately in the five S shares held by M, or $14.40 
per share.
    (iv) Treatment of year 2 items. (A) Elimination of a portion of 
the section 362(e)(2) amount. Under Sec.  1.1502-13(e)(4)(ii)(C)(2), 
S's remaining section 362(e)(2) amount is eliminated to the extent 
of the reduction in M's basis in the S stock under Sec.  1.1502-
13(e)(4)(v). Accordingly, S's remaining section 362(e)(2) amount is 
reduced by $14.40, to $57.60. This remaining section 362(e)(2) 
amount is reflected proportionately in the four remaining S shares 
held by M, or $14.40 per share.
    (B) Allocation of item among shares of S stock. Because X owns a 
share of S stock in year 2, the special allocation rule in paragraph 
(c)(1)(ii) of this section applies to the allocation of the portion 
of the year 2 depreciation deduction attributable to a section 
362(e)(2) amount. Under that rule, $6.40 (57.60/90 x $10) of the 
item attributable to a section 362(e)(2) amount must be allocated as 
though only the four shares of S stock held by M were outstanding. 
Accordingly, $1.60 (\1/4\) of the $6.40 of the $10 depreciation 
deduction is allocated to each of M's four shares of S stock and no 
portion of that amount is allocated to X's share of S stock. 
However, the remaining $3.60 of the $10 depreciation deduction not 
attributable to a section 362(e)(2) amount is included in the 
remaining adjustment allocated to all outstanding shares under the 
general rules in paragraphs (c)(2) through (c)(4) of this section. 
Thus, $.72 (\1/5\) of the $3.60 of the $10 depreciation deduction is 
allocated to each outstanding S share. (Although $.72 is allocated 
to X's share of S stock, that allocation does not affect X's basis

[[Page 2993]]

in the share because X is not a member of the group. See paragraph 
(c)(1)(iv) of this section.) The allocation of S's year 2 item is 
thus:

------------------------------------------------------------------------
                                                 Allocation
                                  --------------------------------------
               Item                  M's shares of S     X's share of S
                                     stock  (\4/5\)      stock  (\1/5\)
------------------------------------------------------------------------
Section 362(e)(2) amount ($6.40    $6.40 ($1.60 per    N/A.
 of the $10 depreciation on Asset   share).
 1).
Non-section 362(e)(2) amount       $2.88 ($.72 per     $.72 ($.72 per
 ($3.60 of the $10 depreciation     share).             share).
 on Asset 1).
                                  --------------------------------------
    Total allocation:............  $9.28 ($2.32 per    $.72 ($.72 per
                                    share).             share).
------------------------------------------------------------------------

    (C) Adjustments to the basis of shares of M stock. The 
adjustment to the basis of M stock includes two items: M's $14.40 
nondeductible basis recovery item resulting from the reduction in 
M's basis in the S stock under Sec.  1.1502-13(e)(4)(v); and $9.28 
tiered-up adjustment from the adjustment made to its basis in the S 
stock. The full amount of the $14.40 nondeductible basis recovery 
item, and $6.40 of the $9.28 tiered-up adjustment is attributable to 
the section 362(e)(2) amount. Therefore $20.80 ($14.40 plus $6.40) 
must be allocated entirely to P's shares of M stock. Accordingly, 
$5.20 (\1/4\) of the $20.80 is allocated to each of P's four shares 
of M stock. The remaining $2.88 of the tiered-up adjustment not 
attributable to a section 362(e)(2) amount is included in the 
remaining adjustment allocated to all outstanding shares under the 
general rules in paragraphs (c)(2) through (c)(4) of this section. 
Thus, approximately $.58 (\1/5\) of the $2.88 of the tiered-up 
adjustment is allocated to each outstanding share. (Although 
approximately $.58 is allocated to X's share of M stock, that 
allocation does not affect X's basis in the share because X is not a 
member of the group. See paragraph (c)(1)(iv) of this section.) The 
allocation of M's year 2 items is thus:

------------------------------------------------------------------------
                                                 Allocation
                                  --------------------------------------
               Item                  P's shares of M     X's share of M
                                     stock  (\4/5\)      stock  (\1/5\)
------------------------------------------------------------------------
 
Nondeductible basis recovery       $14.40 ($3.60 per   N/A.
 ($14.40 reduction in S stock       share).
 basis).
Tiered-up section 362(e)(2)        $6.40 ($1.60 per    N/A.
 amount ($6.40 of the $9.28         share).
 tiered-up adjustment).
Tiered-up non-section 362(e)(2)    $2.30 (approx.      $.58 (approx.
 amount ($2.88 of the $9.28         $.58 per share).    $.58 per share).
 tiered-up adjustment).
                                  --------------------------------------
    Total allocation:............  $23.10 (approx.     $.58 (approx.
                                    $5.78 per share).   $.58 per share).
------------------------------------------------------------------------

    (D) No duplicative adjustments to the basis of shares of M 
stock. A portion of the $2.88 of the tiered-up adjustment not 
attributable to a section 362(e)(2) amount duplicates a portion of 
the $14.40 nondeductible basis recovery item resulting from the 
reduction in M's basis in the S stock under Sec.  1.1502-
13(e)(4)(v). Consequently, under Sec.  1.1502-80(a), such portion of 
the tiered-up adjustment is not applied to reduce P's basis in its 
shares of M stock. The election to reduce M's basis in the S stock 
eliminated $14.40 of the remaining section 362(e)(2) amount. 
Accordingly, at the S level, $1.60 ($14.40/$90 x $10) of the Asset 1 
year 2 depreciation deduction is associated with this amount. This 
portion was allocated to all outstanding shares of S stock under the 
general rules in paragraphs (c)(2) through (c)(4) of this section 
($.32 per share ($1.60/5)). At the M level, $1.28 (4 x $.32) of the 
tiered-up non-section 362(e)(2) amount reflects depreciation on this 
$14.40 of Asset 1 basis. So, at the M level, approximately $.26 
($1.28/5) of this tiered-up amount is allocated to each outstanding 
share. This approximately $.26 per share amount would duplicate a 
portion of the $14.40 nondeductible basis recovery item if it is 
applied to reduce P's basis in the M shares. Accordingly, although 
approximately $5.78 of the items are allocated to each M share held 
by P, P's basis in each share of M stock is only reduced by 
approximately $5.52 ($5.78 less $.26).
    (B) Losses reattributed pursuant to an election under Sec.  1.1502-
36(d)(6). If a member transfers (within the meaning of Sec.  1.1502-
36(f)(11)) loss shares of S stock and the common parent elects under 
Sec.  1.1502-36(d)(6) to reattribute S attributes, the resulting 
noncapital, nondeductible expense is allocated to all loss shares of S 
stock transferred by members in the transaction in proportion to the 
loss in the shares, and such amount tiers up to any higher tiers under 
the general rules of this section. If lower-tier subsidiary attributes 
that would otherwise be reduced as a result of tier-down attribute 
reduction under Sec.  1.1502-36(d)(5)(ii)(D) are reattributed, the 
resulting noncapital, nondeductible expense is allocated to the shares 
of the lower-tier subsidiary (and any tier up of such amount is 
allocated to the shares of higher tier subsidiaries) that will cause 
the full amount of this expense to be applied to reduce the basis of 
the loss shares of S stock transferred by members in the transaction. 
However, this noncapital, nondeductible expense (and any tier up of 
such amount) is not allocated to shares (other than S shares) 
transferred in a transfer in which gain or loss was recognized. 
Further, this noncapital, nondeductible expense (and any tier up of 
such amount) is allocated among lower-tier shares with positive basis 
in a manner that reduces the disparity in the basis of the shares to 
the greatest extent possible. The tier up of this amount is allocated 
to the loss shares of S stock transferred by members in the transaction 
in proportion to the loss in the shares, and such amount tiers up to 
any higher tiers under the general rules of this section. For example, 
suppose P owns M1, P and M1 own M2, M2 owns S, M1 and S own S1, and M1 
and S1 own S2. If S sells a portion of the S1 shares at a gain and M2 
sells all of the S stock at a net loss (after adjusting the basis for 
the gain recognized by S on the sale of the S1 shares), and P elects 
under Sec.  1.1502-36(d)(6) to reattribute attributes of S2, the 
resulting noncapital, nondeductible expense is allocated entirely to 
the S2 shares held by S1, the tier up of this amount is allocated 
entirely to the S1 shares held by S (excluding the S1 shares sold), and 
the tier up of this amount is allocated to the loss shares of S stock 
sold by M2. This amount then tiers up from M2 to M1 and P, and from M1 
to P under the general rules of this section.

[[Page 2994]]

    (C) Reallocations of investment adjustments subject to prior use 
limitation. If the reallocation of an investment adjustment under Sec.  
1.1502-36(b)(2) is subject to the limitation in Sec.  1.1502-
36(b)(2)(iii)(B)(2) due to prior use, no amount of such reallocation 
(including as a tiered-up amount) shall be allocated to any share whose 
prior use resulted in the application of the limitation.
    (iii) Remaining adjustment. The remaining adjustment is that 
portion of the adjustment described in paragraphs (b)(2)(i) through 
(b)(2)(iii) of this section (adjustments for taxable income or loss, 
tax-exempt income, and noncapital, nondeductible expenses) that is not 
specially allocated under paragraph (c)(1)(ii) of this section. The 
remaining adjustment is allocated among the shares of S stock as 
provided in paragraphs (c)(2) through (c)(4) of this section. If the 
remaining adjustment is positive, it is allocated first to any 
preferred stock to the extent provided in paragraph (c)(3) of this 
section, and then to the common stock as provided in paragraph (c)(2) 
of this section. If the remaining adjustment is negative, it is 
allocated only to common stock as provided in paragraph (c)(2) of this 
section.
    (iv) Nonmember shares. No adjustment under this section that is 
allocated to a share for the period it is owned by a nonmember affects 
the basis of the share.
    (v) Cross-references. See paragraph (c)(4) of this section for the 
reallocation of adjustments, and paragraph (d) of this section for 
definitions. See Sec.  1.1502-19(d) for special allocations of basis 
determined or adjusted under the Code with respect to excess loss 
accounts.
    (2) Common stock--(i) Allocation within a class. The remaining 
adjustment described in paragraph (c)(1)(iii) of this section that is 
allocable to a class of common stock generally is allocated equally to 
each share within the class. However, if a member has an excess loss 
account in shares of a class of common stock at the time of a positive 
remaining adjustment, the portion of the adjustment allocable to the 
member with respect to the class is allocated first to equalize and 
eliminate that member's excess loss accounts and then to increase 
equally its basis in the shares of that class. Similarly, any negative 
remaining adjustment is allocated first to reduce the member's positive 
basis in shares of the class before creating or increasing its excess 
loss account. After positive basis is eliminated, any remaining portion 
of the negative adjustment is allocated first to equalize, to the 
greatest extent possible, and then to increase equally, the member's 
excess loss accounts in the shares of that class. Distributions and any 
adjustments or determinations under the Internal Revenue Code (for 
example, under section 358, including any modifications under Sec.  
1.1502-19(d)) are taken into account before the allocation is made 
under this paragraph (c)(2)(i).
    (ii) Allocation among classes--(A) General rule. If S has more than 
one class of common stock, the extent to which the remaining adjustment 
described in paragraph (c)(1)(iii) of this section is allocated to each 
class is determined, based on consistently applied assumptions, by 
taking into account the terms of each class and all other facts and 
circumstances relating to the overall economic arrangement. * * *
* * * * *
    (3) Preferred stock. If the remaining adjustment described in 
paragraph (c)(1)(iii) of this section is positive, it is allocated to 
preferred stock to the extent required (when aggregated with prior 
allocations to the preferred stock during the period that S is a member 
of the consolidated group) to reflect distributions described in 
section 301 (and all other distributions treated as dividends) to which 
the preferred stock becomes entitled, and arrearages arising, during 
the period that S is a member of the consolidated group. * * *
* * * * *
    (4) Cumulative redetermination--(i) General rule. A member's basis 
in each share of S's preferred and common stock must be redetermined 
whenever necessary to determine the tax liability of any person. See 
paragraph (b)(1) of this section. The redetermination is made by 
reallocating S's adjustments described in paragraphs (c)(1)(ii) and 
(c)(1)(iii) of this section (adjustments for specially allocated losses 
and remaining adjustments, respectively) for each consolidated return 
year (or other applicable period) of the group by taking into account 
all of the facts and circumstances affecting allocations under this 
paragraph (c) as of the redetermination date with respect to all of S's 
shares. * * *
* * * * *
    (h) * * *
    (9) Allocations of investment adjustments, including adjustments 
attributable to certain loss transfers; certain conforming amendments. 
Paragraphs (a)(2), (b)(3)(ii)(C)(2), (b)(3)(iii)(C), (b)(3)(iii)(D), 
(c)(1), (c)(2)(i), (c)(2)(ii)(A), (c)(3), and (c)(4)(i) of this section 
are applicable on or after the date these regulations are published as 
final regulations in the Federal Register.
* * * * *
    Par. 12. Section 1.1502-33 is amended by:
    1. Revising paragraph (a)(2).
    2. Adding a new last sentence to paragraph (j)(1).
    The revision and addition reads as follows:


Sec.  1.1502-33  Earnings and profits.

    (a) * * *
    (2) Application of other rules of law. See Sec.  1.1502-80(a) 
regarding the general applicability of other rules of law and a 
limitation on duplicative adjustments.
* * * * *
    (j) * * * (1) * * * However, paragraph (a)(2) of this section 
applies with respect to determinations of the earnings and profits of a 
member in consolidated return years beginning on or after the date 
these regulations are published as final regulations in the Federal 
Register.
* * * * *
    Par. 13. Section 1.1502-35 is amended by:
    1. Revising paragraphs (a), (b), and (h).
    2. Removing and reserving paragraphs (f) and (g).
    3. Adding new paragraph (l).
    The revisions and addition read as follows:


Sec.  1.1502-35  Transfers of subsidiary stock and deconsolidations of 
subsidiaries.

    (a) Losses on subsidiary stock transferred or deconsolidated prior 
to the date that these regulations are published as final regulations 
in the Federal Register. If a member disposed of a loss share of stock 
of a subsidiary (S), or if S ceased to be a member (deconsolidated) 
when any member held loss shares of S stock, and if the disposition or 
deconsolidation occurred prior to the date that these regulations are 
published as final regulations in the Federal Register, see Sec.  
1.1502-35, as contained in 26 CFR part 1, revised as of April 1, 2006. 
For transfers and deconsolidations on or after the date that these 
regulations are published as final regulations in the Federal Register, 
see Sec.  1.1502-36.
    (b) Anti-loss reimportation rule applicable on or after the date 
that these regulations are published as final regulations in the 
Federal Register--(1) Conditions for application. This paragraph (b) 
applies when--
    (i) A member of a group (the selling group) recognized and was 
allowed a loss with respect to a share of stock of S, a subsidiary or 
former subsidiary in the selling group;

[[Page 2995]]

    (ii) That stock loss was duplicated (in whole or in part) in S's 
attributes (duplicating items) at the earlier of the time that the loss 
was recognized or that S ceased to be a member; and
    (iii) Within ten years of the date that S ceased to be a member, 
there is a reimportation event. For this purpose, a reimportation event 
is any event after which a duplicating item becomes directly or 
indirectly reflected in the attributes of any member of the selling 
group, including S, or, if not reflected in the attributes, would be 
properly taken into account by any member of the selling group (for 
example, as the result of a carryback) (reimported items).
    (2) Effect of application. Immediately before the time that a 
reimported item (or any portion of a reimported item) would be properly 
taken into account (but for the application of this paragraph (b)), 
such item (or such portion of the item) is reduced to zero and no 
deduction or loss is allowed, directly or indirectly, with respect to 
that item.
    (3) Operating rules. For purposes of this paragraph (b)--
    (i) The terms ``member'', ``subsidiary'', and ``group'' include 
their predecessors and successors to the extent necessary to effectuate 
the purposes of this section;
    (ii) The determination of whether a loss is duplicative is made 
under the principles of Sec.  1.1502-35, as contained in 26 CFR part 1, 
revised as of April 1, 2006; and
    (iii) The reduction of a reimported item (other than duplicating 
items that are carried back to a consolidated return year of the group) 
is a noncapital, nondeductible expense within the meaning of Sec.  
1.1502-32(b)(2)(iii).
    (4) Period of applicability. The provisions of this paragraph (b) 
apply to a reimported item if its related stock loss is recognized on 
or after the date that these regulations are published as final 
regulations in the Federal Register. The provisions of this paragraph 
(b) (other than paragraph (b)(1)(i)) also apply to a reimportation 
event if its related stock loss is recognized on or after March 7, 
2002, and is recognized in either a disposition (described in paragraph 
(g)(3)(i)(A) of this section, as contained in 26 CFR part 1, revised as 
of January 1, 2007) or a disposition otherwise subject to this section. 
For prior law, see paragraph (g)(3) of this section, as contained in 26 
CFR part 1, revised as of January 1, 2007.
* * * * *
    (h) Application of other rules of law. See Sec.  1.1502-80(a) 
regarding the general applicability of other rules of law and a 
limitation on duplicative adjustments.
* * * * *
    (l) Effective date. Paragraphs (a), (b), and (h) of this section 
apply with respect to stock transfers, deconsolidations of 
subsidiaries, determinations of worthlessness, and stock dispositions 
on or after the date these regulations are published as final 
regulations in the Federal Register. For rules applicable prior to the 
date these regulations are published as final regulations in the 
Federal Register, see Sec.  1.1502-35 as contained in 26 CFR part 1 in 
effect on April 1, 2007.


Sec.  1.1502-35T  [Removed]

    Par. 14. Section 1.1502-35T is removed.
    Par. 15. Section 1.1502-36 is added to read as follows:


Sec.  1.1502-36  Loss on subsidiary stock.

    (a) In general--(1) Scope. This section provides rules for 
adjusting members' bases in stock of a subsidiary (S) and for reducing 
S's attributes when a member (M) transfers a loss share of S stock. See 
paragraph (f) of this section for definitions of the terms used in this 
section, including transfer and loss share.
    (2) Purpose. The rules in this section have two principal purposes. 
The first is to prevent the consolidated return provisions from 
reducing a group's consolidated taxable income through the creation of 
noneconomic loss on S stock. The second is to prevent members 
(including former members) of the group from collectively obtaining 
more than one tax benefit from a single economic loss. Additional 
purposes are set forth in other paragraphs of this section. The rules 
of this section must be interpreted and applied in a manner that is 
consistent with and reasonably carries out the purposes of this 
section.
    (3) Overview--(i) General application of section. This section 
applies when M transfers a share of S stock and, after giving effect to 
all applicable rules of law other than this section, the share is a 
loss share. Paragraph (b) of this section applies first to require 
certain redeterminations of all members' bases in shares of S stock. If 
the transferred share is a loss share after any basis redetermination 
required by paragraph (b) of this section, paragraph (c) of this 
section applies to require certain reductions in M's basis in the 
transferred loss share. If the transferred share is a loss share after 
any reduction required by paragraph (c) of this section, paragraph (d) 
of this section applies to require certain reductions in S's 
attributes. Paragraphs (e), (f), and (g) of this section provide 
general operating rules (predecessor/successor rules, effects of prior 
section 362(e)(2) transactions), definitions, and an anti-abuse rule, 
respectively.
    (ii) Stock of multiple subsidiaries transferred in the 
transaction--(A) Order of application--(1) Transferred shares in lowest 
tier. If shares of stock of more than one subsidiary are transferred in 
a transaction and no transferred shares of stock of the lowest-tier 
subsidiary (S2) are loss shares, any gain recognized with respect to 
the S2 shares immediately adjusts members' bases in subsidiary stock 
under the principles of Sec.  1.1502-32. However, if any of the 
transferred S2 shares are loss shares, first paragraph (b) of this 
section and then paragraph (c) of this section apply with respect to 
the S2 shares. After giving effect to any adjustments required under 
paragraphs (b) and (c) of this section, gain or loss is computed on all 
transferred S2 shares. Any adjustments under paragraphs (b) and (c) of 
this section, any gain or loss recognized on transferred S2 shares 
(whether allowed or disallowed), and any other related or resulting 
adjustments are then applied to adjust members' bases in subsidiary 
stock under the principles of Sec.  1.1502-32.
    (2) Application of paragraphs (b) and (c) of this section to 
higher-tier stock. After giving effect to any lower-tier adjustments 
described in paragraph (a)(3)(ii)(A)(1) of this section, transfers in 
the next higher tier in which shares are transferred, and then in each 
next higher tier successively, are subject to the treatment described 
in paragraph (a)(3)(ii)(A)(1).
    (3) Application of paragraph (d) of this section. After paragraphs 
(b) and (c) of this section have been applied with respect to all 
transferred loss shares and after giving effect to all adjustments 
(whether required by paragraphs (b) and (c) of this section, by the 
recognition of gain on a transfer, or otherwise), paragraph (d) of this 
section applies with respect to the highest-tier shares that are then 
transferred loss shares. Paragraph (d) then applies with respect to 
transferred loss shares in each next lower tier successively.
    (B) Example. The rules of this paragraph (a)(3) are illustrated by 
the following example:

     Example. M owns all the outstanding shares of S stock and one 
of the two outstanding shares of S2 stock, S owns all the 
outstanding shares of S1 stock, and S1 owns the other outstanding 
share of S2 stock. As part of one transaction, M sells all the S 
shares and its S2 share, and S1 sells its S2 share. The sales are to 
unrelated individuals, S and S1 do not elect to file a consolidated 
return after the transaction, the S and S1 shares are loss shares 
and the S2 shares are gain shares. Each share is transferred within

[[Page 2996]]

the meaning of this section, the S and S2 shares because S and S2 
cease to be owned by M, and M and S1, respectively, as a result of 
taxable dispositions, and the S1 shares because S and S1 cease to be 
members of the same group. This section applies to the transfer of 
the S and S1 (loss) shares, but not to the transfer of the S2 (gain) 
shares. Accordingly, immediately before the transaction, after 
giving effect to other rules of law, the following occurs. First, 
the gain recognized on the transferred S2 shares tiers up to adjust 
members' bases in all upper-tier subsidiary shares under the 
principles of Sec.  1.1502-32. Then, if S's transferred S1 shares 
are still loss shares, paragraphs (b) and (c) of this section apply 
to those shares. The loss on the S1 shares is not recognized in the 
transfer (because there is no taxable disposition of the shares) and 
so only the adjustments to the bases of the S1 shares required by 
paragraphs (b) and (c) of this section tier up to adjust M's basis 
in the S stock. Then, if M's transferred shares of S stock are still 
loss shares, paragraphs (b) and (c) of this section apply with 
respect to those shares. If, after giving effect to any adjustments 
under paragraphs (b) and (c) of this section, any of the S shares 
are still loss shares, paragraph (d) of this section applies with 
respect to the transfer of those shares. If any transferred S1 
shares are still loss shares after the application of paragraph (d) 
of this section with respect to the transfer of S shares, paragraph 
(d) applies with respect to the transfer of the S1 shares.

    (4) Other rules of law and coordination with deferral and 
disallowance provisions. This section applies and has effect 
immediately upon the transfer of a loss share even if the loss is 
deferred, disallowed, or otherwise not taken into account under any 
other applicable rules of law. For example, if M sells loss shares of S 
stock to another member in an intercompany transaction, every member's 
bases in shares of S stock and all of S's attributes may be adjusted 
under this section even though M's loss is deferred under Sec. Sec.  
1.267(f)-1 and 1.1502-13, and S remains a member. See Sec.  1.1502-
80(a) regarding the general applicability of other rules of law and a 
limitation on duplicative adjustments.
    (5) Nomenclature, factual assumptions adopted in this section. 
Unless otherwise stated, for purposes of this section, the following 
nomenclature and assumptions are adopted. P is the common parent of a 
consolidated group and X is a nonmember of the P group. If a 
corporation has preferred stock outstanding, it is stock described in 
section 1504(a)(4). The examples set forth the only facts and 
activities relevant to the example. All transactions are between 
unrelated persons and are independent of each other. Tax liabilities 
and their effect, and the application of any loss disallowance or 
deferral provision of the Code or regulations, including but not 
limited to section 267, are disregarded. All persons report on a 
calendar year basis and use the accrual method of accounting. All 
parties comply with filing and other requirements of this section and 
all other provisions of the Code and regulations.
    (b) Basis redetermination to reduce disparity--(1) In general--(i) 
Purpose and scope. The rules of this paragraph (b) reduce the extent to 
which there is disparity in members' bases in shares of S stock. These 
rules are intended to prevent the operation of the investment 
adjustment system from creating noneconomic or duplicated loss when 
members hold S shares with disparate bases, and they operate by 
reallocating previously applied investment adjustments. The provisions 
of this paragraph (b) do not alter the aggregate amount of basis in 
shares of S stock held by members or the aggregate amount of investment 
adjustments applied to shares of S stock.
    (ii) Exemptions from basis redetermination--(A) No potential for 
redetermination. Notwithstanding the general rule in paragraph (b)(2) 
of this section, basis redetermination will not be required if 
redetermination would not result in a change to any member's basis in 
any share of S stock. For example, if S has only one class of stock 
outstanding and there is no disparity in members' bases in S shares, no 
member's basis would be changed by the application of this paragraph 
(b). Accordingly, under this paragraph (b)(1)(ii)(A), no 
redetermination would be required. Similarly, if S has preferred and 
common stock outstanding, there is no gain or loss on any member's 
preferred shares, and there is no disparity in members' bases in the 
common stock, no member's basis would be changed by the application of 
this paragraph (b). Accordingly, under this paragraph (b)(1)(ii)(A), no 
redetermination would be required.
    (B) Disposition of entire interest. Notwithstanding the general 
rule in paragraph (b)(2) of this section, basis redetermination will 
not be required if, within the group's taxable year in which the 
transfer occurs, every share of S stock held by a member is transferred 
to a nonmember in one or more fully taxable transactions.
    (iii) Transfers of stock of subsidiaries at multiple tiers. If 
stock of subsidiaries at multiple tiers is transferred in a 
transaction, see paragraph (a)(3)(ii) of this section regarding the 
order of application of this section.
    (iv) Investment adjustment. For purposes of this paragraph (b), the 
term investment adjustment means the adjustment for items described in 
Sec.  1.1502-32(b)(2), excluding Sec.  1.1502-32(b)(2)(iv) 
(distributions). The term includes all such adjustments reflected in 
the basis of the share, whether originally applied directly by Sec.  
1.1502-32 or otherwise. The term therefore includes investment 
adjustments reallocated to the share, and it does not include 
investment adjustments reallocated from the share, whether pursuant to 
this section or any other provision of law. It also includes the 
proportionate amount of investment adjustments reflected in the basis 
of a share after the basis is apportioned among shares, for example in 
a transaction qualifying under section 355.
    (2) Basis redetermination rule. If M transfers a loss share of S 
stock, all members' bases in all their shares of S stock are subject to 
redetermination under this paragraph (b). The adjustments are made in 
accordance with the following:
    (i) Decreasing the bases of transferred loss shares--(A) Removing 
positive investment adjustments from transferred loss shares. M's basis 
in each of its transferred loss shares of S stock is first reduced, but 
not below value, by removing positive investment adjustments previously 
applied to the basis of the share. The positive investment adjustments 
removed from transferred loss shares are reallocated under paragraph 
(b)(2)(ii) of this section after negative investment adjustments are 
reallocated under paragraph (b)(2)(i)(B) of this section.
    (B) Reallocating negative investment adjustments. If a transferred 
share is still a loss share after applying paragraph (b)(2)(i)(A) of 
this section, M's basis in the share is reduced, but not below value, 
by reallocating and applying negative investment adjustments to the 
transferred loss share from shares held by members that are not 
transferred loss shares. Reductions under this paragraph (b)(2)(i)(B) 
are made first to M's bases in transferred loss shares of S preferred 
stock and then to M's bases in transferred loss shares of S common 
stock.
    (ii) Increasing the bases of gain preferred and all common shares--
(A) Preferred stock. After the application of paragraph (b)(2)(i) of 
this section, the positive investment adjustments removed from 
transferred loss shares are reallocated and applied to increase, but 
not above value, members' bases in gain shares of S preferred stock.
    (B) Common stock. Any positive investment adjustments removed from 
transferred loss shares and not applied to S preferred shares are then

[[Page 2997]]

reallocated and applied to increase members' bases in shares of S 
common stock. Reallocations are made to shares of common stock without 
regard to whether a particular share is a loss share or a transferred 
share, and without regard to the share's value.
    (iii) Operating rules--(A) In general. Reallocations are made in a 
manner that reduces basis disparity among shares of preferred stock and 
among shares of common stock to the greatest extent possible (that is, 
causes the ratio of the basis to the value of each member's share to be 
as equal as possible).
    (B) Limits on reallocation--(1) Restriction to outstanding shares. 
Investment adjustments can only be reallocated to shares that were held 
by members in the period to which the adjustment is attributable.
    (2) Limitation by prior use of allocation--(i) In general. In order 
to prevent the reallocation of investment adjustments from either 
increasing or decreasing members' aggregate bases in subsidiary stock, 
no investment adjustment (positive or negative) may be reallocated 
under this paragraph (b)(2) to the extent that it was (or would have 
been) used prior to the time that it would otherwise be reallocated 
under this paragraph (b)(2). For this purpose, an investment adjustment 
was used (or would have been used) to the extent that it was reflected 
in (or would have been reflected in) the basis of a share of subsidiary 
stock and the basis of that share has already been taken into account, 
directly or indirectly, in determining income, gain, deduction, or loss 
(including by affecting the application of this section to a prior 
transfer of subsidiary stock) or in determining the basis of any 
property that is not subject to Sec.  1.1502-32. However, 
notwithstanding the general rule, if the prior use was in an 
intercompany transaction, an investment adjustment may be reallocated 
to the extent that Sec.  1.1502-13 has prevented the gain or loss on 
the transaction from being taken into account. (In that case, 
appropriate adjustments must be made to the prior intercompany 
transaction.) Further, if an investment adjustment was reflected in (or 
would have been reflected in) the basis of a share that has been taken 
into account, but the basis of that share would not change as a result 
of the reallocation (for example, because the reallocation would be 
among shares that are all lower-tier to the share with the previously 
used basis), the investment adjustment may be reallocated. See Sec.  
1.1502-32(c)(1)(ii)(C) regarding special allocations applicable if the 
reallocation of an investment adjustment is limited under this 
paragraph (b)(2)(iii)(B)(2).
    (ii) Example. The application of this paragraph (b)(2)(iii)(B)(2) 
is illustrated by the following example:

    Example. (i) Facts. P owns all 20 shares of M stock, and 10 
shares of S stock. M owns the remaining 10 shares of S stock. In 
year 1, S recognizes $200 of income that results in a $10 positive 
investment adjustment being allocated to each share of S stock. The 
group does not recognize any other items. The $100 positive 
adjustment to M's basis in the S stock tiers up, and results in a $5 
positive adjustment to each share of M stock. In year 2, P sells one 
share of M stock and recognizes a gain. In year 3, M sells one loss 
share of S stock, and paragraph (b) of this section applies and 
requires a reallocation of the year 1 positive investment 
adjustment.
    (ii) Application of limitation by prior use. M's basis in the 
transferred loss share of S stock reflects a $10 positive investment 
adjustment attributable to S's year 1 income. Under the general rule 
of this paragraph (b), that $10 would be subject to reallocation to 
reduce basis disparity. However, that $10 adjustment had originally 
tiered up to adjust P's basis in its M shares and, as a result, $.50 
of that adjustment was reflected in P's basis in each share of M 
stock. When P sold the share of M stock, the basis of that share 
(including the tiered up $.50) was used in determining the gain on 
the sale. Accordingly, $.50 of the $10 investment adjustment 
originally allocated to the S share that tiered-up to the M share 
was previously used and therefore cannot be reallocated in a manner 
that would (if it were the original allocation) affect the basis of 
the sold share. Thus, taking into account the special allocations in 
Sec.  1.1502-32(c)(1)(ii)(C), up to $9.50 of the adjustment to M's 
transferred S share could be allocated to P's shares of S stock 
(leaving $.50 on M's transferred S share, all of which would be 
treated as tiered up to P's transferred M share). Alternatively, all 
$10 could be reallocated to M's other S shares (because the tier up 
to P's M shares would have been the same regardless which of M's 
shares of S stock were adjusted.)
    (iii) Application of limitation where adjustment would have been 
used. The facts are the same as in paragraph (i) of this Example 
except that M does not sell any shares of S stock and, in year 3, P 
sells a loss share of S stock. As in paragraph (i) of this Example, 
when P sold the share of M stock, the basis of that share was used 
in determining the gain on the share. When P sells the loss share of 
S stock, the $10 positive investment adjustment from S's year 1 
income cannot be reallocated in a manner that, if it were the 
original adjustment, would have caused any amount to be reflected in 
the basis of the transferred share. If this $10 positive investment 
adjustment had originally been allocated to the S shares held by M, 
$.50 of the $10 investment adjustment would have tiered up to the M 
share P sold, would have been reflected in P's basis, and would have 
been used in determining the gain or loss on the sale. Accordingly, 
taking into account the special allocations in Sec.  1.1502-
32(c)(1)(ii)(C), up to $9.50 of the $10 adjustment to P's 
transferred S share could be allocated to M's shares of S stock (all 
of which would tier up to P's 19 retained M shares). Alternatively, 
all $10 could be reallocated to P's other S shares.

    (C) Order of reallocation. In general, reallocations are made first 
with respect to the earliest available adjustments. However, the 
overall application of this paragraph (b) to a transaction must be made 
in a manner that reduces basis disparity to the greatest extent 
possible.
    (3) Examples. The general application of this paragraph (b) is 
illustrated by the following examples:

    Example 1. Transfer of stock received in section 351 exchange. 
(i) Redetermination to prevent noneconomic loss. (A) Facts. For many 
years, P has owned two assets, Asset 1 and Asset 2. On January 1, 
year 1, P receives four shares of S common stock (the Block 1 
shares) in exchange for Asset 1, which has a basis and value of $80. 
The exchange qualifies under section 351 and, therefore, under 
section 358, P's aggregate basis in the Block 1 shares is $80 ($20 
per share). On July 1, year 1, P receives another share of S common 
stock (the Block 2 share) in exchange for Asset 2, which has a basis 
of $0 and value of $20. This exchange also qualifies as a section 
351 exchange and, under section 358, P's basis in the Block 2 share 
is $0. P's Block 1 and Block 2 shares are the only outstanding 
shares of S stock. On October 1, year 1, S sells Asset 2 for $20. On 
December 31, year 1, P sells one of its Block 1 shares for $20. 
After applying and giving effect to all generally applicable rules 
of law (other than this section), P's basis in each Block 1 share is 
$24 (P's original $20 basis increased under Sec.  1.1502-32 by $4 
(the share's allocable portion of the $20 gain recognized on the 
sale of Asset 2)). In addition, P's basis in its Block 2 share is $4 
(P's original $0 basis increased under Sec.  1.1502-32 by $4 (the 
share's allocable portion of the $20 gain recognized on the sale of 
Asset 2)). P's sale of the Block 1 share is a transfer of a loss 
share and therefore subject to the provisions of this section.
    (B) Basis redetermination under this paragraph (b). Under this 
paragraph (b), P's bases in all its shares of S stock are subject to 
redetermination. First, paragraph (b)(2)(i)(A) of this section 
applies to reduce P's basis in the transferred loss share, but not 
below value, by removing positive investment adjustments applied to 
the basis of the share. Accordingly, P's basis in the transferred 
Block 1 share is reduced by $4 (the amount of the positive 
investment adjustment applied to the share), from $24 to $20. No 
further reduction to the basis of the share is required under this 
paragraph (b) because the basis of the share is then equal to value. 
Under paragraph (b)(2)(ii)(B) of this section, the positive 
investment adjustment removed from the transferred loss share is 
reallocated and applied to increase P's bases in its S shares in a 
manner that reduces basis disparity to the greatest extent possible. 
Accordingly, the $4 positive investment adjustment removed from the 
Block 1 share is reallocated and applied to the basis of the Block 2 
share, increasing it from $4 to $8.

[[Page 2998]]

    (C) Application of paragraphs (c) and (d) of this section. 
Because P's sale of the Block 1 share is no longer a transfer of a 
loss share after the application of this paragraph (b), paragraphs 
(c) and (d) of this section do not apply.
    (ii) Redetermination to prevent duplicated loss. (A) Facts. The 
facts are the same as in paragraph (i)(A) of this Example 1, except 
that, at the time of the second contribution, the value of Asset 1 
had declined to $20 and so, instead of contributing Asset 2, P 
contributed Asset 3 to S in exchange for the Block 2 share. At the 
time of that exchange, Asset 3 had a basis and value of $5. On 
October 1, year 1, S sells Asset 1 for $20, recognizing a $60 loss 
that is absorbed by the group. On December 31, year 1, P sells one 
of its Block 1 shares for $5. After applying and giving effect to 
all generally applicable rules of law (other than this section), P's 
basis in each Block 1 share is $8 (P's original $20 basis decreased 
under Sec.  1.1502-32 by $12 (the share's allocable portion of the 
$60 loss recognized on the sale of Asset 1)). P's basis in its Block 
2 share is an excess loss account of $7 (its original basis of $5 
reduced by $12, the share's portion of the loss recognized on Asset 
1). P's sale of the Block 1 share is a transfer of a loss share and 
therefore subject to the provisions of this section.
    (B) Basis redetermination under this paragraph (b). Under this 
paragraph (b), P's bases in all its shares of S stock are subject to 
redetermination. There are no positive investment adjustments and so 
there is no adjustment under paragraph (b)(2)(i)(A) of this section. 
However, under paragraph (b)(2)(i)(B) of this section, P's basis in 
the transferred Block 1 share is reduced, but not below value, by 
reallocating negative investment adjustments from shares that are 
not transferred loss shares. In total, there were $48 of negative 
investment adjustments applied to shares that are not transferred 
loss shares. Accordingly, P's basis in the Block 1 share is reduced 
by $3, from $8 to its value of $5. Under paragraph (b)(2)(i)(B) of 
this section, the negative investment adjustments applied to the 
transferred share are reallocated from (and therefore cause an 
increase in the basis of) S shares that are not transferred loss 
shares in a manner that reduces basis disparity to the greatest 
extent possible. Accordingly, the $3 negative investment adjustment 
reallocated and applied to the transferred Block 1 share is 
reallocated entirely from the Block 2 share, increasing the basis in 
the Block 2 share from an excess loss account of $7 to an excess 
loss account of $4.
    (C) Application of paragraphs (c) and (d) of this section. 
Because P's sale of the Block 1 share is no longer a transfer of a 
loss share after the application of this paragraph (b), paragraphs 
(c) and (d) of this section do not apply.
    (iii) Nonapplicability of redetermination rule to sale of entire 
interest. The facts are the same as in paragraph (ii)(A) of this 
Example 1, except that, on December 31, year 1, P sells all its 
shares of S stock for $25. Under paragraph (b)(1)(ii)(B) of this 
section, this paragraph (b) does not apply to redetermine P's basis 
in its S shares because every S share held by a member is 
transferred to a nonmember in a fully taxable transaction. However, 
the sale of the Block 1 shares is a transfer of loss shares and 
therefore subject to paragraphs (c) and (d) of this section. 
Paragraphs (c)(7) and (d)(3)(i)(A) of this section apply netting 
principles to prevent adjustments under either paragraph (c) or 
paragraph (d) of this section.
    Example 2. Redetermination increases basis of transferred loss 
share. (i) Facts. On January 1, year 1, P owns all 10 outstanding 
shares of S common stock. Five of the shares have a basis of $20 per 
share (the Block 1 shares) and five of the shares have a basis of 
$10 per share (the Block 2 shares). S's only asset, Asset 1, has a 
basis of $50. S has no other attributes. On October 1, year 1, S 
sells Asset 1 for $100. On December 31, year 2, S sells one Block 1 
share and one Block 2 share to X for $10 per share. After applying 
and giving effect to all generally applicable rules of law (other 
than this section), P's basis in each Block 1 share is $25 (P's 
original $20 basis increased under Sec.  1.1502-32 by $5 (the 
share's allocable portion of the $50 gain recognized on the sale of 
Asset 1)), and P's basis in each Block 2 share is $15 (P's original 
$10 basis increased by $5). P's sale of the Block 1 and Block 2 
shares is a transfer of loss shares and therefore subject to the 
provisions of this section.
    (ii) Basis redetermination under this paragraph (b). Under this 
paragraph (b), P's bases in all its shares of S stock are subject to 
redetermination. First, paragraph (b)(2)(i)(A) of this section 
applies to reduce P's basis in the transferred Block 1 and Block 2 
shares, but not below value, by removing the positive investment 
adjustments applied to the bases of the transferred loss shares. 
Accordingly, the basis of the Block 1 share is reduced by $5, from 
$25 to $20. The basis of the Block 2 share is also reduced by $5, 
from $15 to $10. (Although the Block 1 share is still a loss share, 
there is no reduction to its basis under paragraph (b)(2)(i)(B) of 
this section because there were no negative investment adjustments 
to shares that are not transferred loss shares.) Next, paragraph 
(b)(2)(ii)(B) of this section applies to reallocate and apply the 
$10 of positive investment adjustments removed from the transferred 
loss shares to increase P's bases in its S shares in a manner that 
reduces basis disparity to the greatest extent possible. 
Accordingly, of the $10 positive investment adjustments to be 
reallocated, $6 is reallocated and applied to the basis of the Block 
2 share (increasing it from $10 to $16) and $4 is reallocated and 
applied equally to the basis of each of the four retained Block 2 
shares (increasing the basis of each from $15 to $16). After giving 
effect to the reallocations under this paragraph (b), P's basis in 
each retained Block 1 share is $25, P's basis in the transferred 
Block 1 share is $20, and P's basis in each Block 2 share is $16.
    (iii) Application of paragraph (c) of this section. After the 
application of this paragraph (b), P's sale of the Block 1 and Block 
2 shares is still a transfer of loss shares and, accordingly, 
subject to paragraph (c) of this section. No adjustment is required 
to the basis of the Block 1 share under paragraph (c) of this 
section because, after its basis is redetermined under this 
paragraph (b), the net positive adjustment to the basis of the share 
is $0. See paragraph (c)(3) of this section. However, paragraph (c) 
of this section reduces P's basis in the transferred Block 2 share 
(by the lesser of its net positive adjustment and its disconformity 
amount, or $6, from $16 to $10, its value).
    (iv) Application of paragraph (d) of this section. After the 
application of paragraph (c) of this section, P's sale of the Block 
1 share is still a transfer of a loss share and, accordingly, 
subject to paragraph (d) of this section. No adjustment is required 
under paragraph (d) of this section because there is no aggregate 
inside loss. See paragraph (d)(3)(iii) of this section. Because P's 
sale of the Block 2 share is no longer a transfer of a loss share 
after the application of paragraph (c) of this section, paragraph 
(d) of this section does not apply to the transfer of the Block 2 
share.
    Example 3. Application to outstanding common and preferred 
shares. (i) Facts. P owns all the stock of M and all eight 
outstanding shares of S common stock. S also has two shares of 
nonvoting preferred stock outstanding; the preferred shares have a 
$100 annual, cumulative preference as to dividends (per share). M 
owns one of the preferred shares (PS1) and P owns the other (PS2). 
On January 1, year 1, the bases and values of the outstanding S 
shares are:

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                    Preferred                                     Common
                                                               -----------------------------------------------------------------------------------------
                                                                                                               CS4      CS5
                                                                PS1 (M)  PS2 (P)  CS1 (P)  CS2 (P)  CS3 (P)    (P)      (P)    CS6 (P)  CS7 (P)  CS8 (P)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Basis.........................................................     1250      975     1025      710      550      400      375      250      215      100
Value.........................................................     1000     1000      375      375      375      375      375      375      375      375
--------------------------------------------------------------------------------------------------------------------------------------------------------

    As of January 1, year 1, there are no arrearages on the 
preferred stock. In year 1, S has a $1100 capital loss and $100 of 
ordinary income. The loss is absorbed by the group and the resulting 
negative adjustment of $1000 is allocable entirely to the common 
stock. See Sec.  1.1502-32(c)(1).

[[Page 2999]]

    In year 2, S has $700 of ordinary income and a $100 ordinary 
loss. Also, on October 1, year 2, S declares a dividend of $200 
($100 with respect to each of the preferred shares). Thus, there is 
a net positive investment adjustment for year 2 of $400. See Sec.  
1.1502-32(b)(2). Under Sec.  1.1502-32(c)(1), a negative adjustment 
of $100 is first allocated to each of the preferred shares to 
reflect the dividend declaration. Then, $400 of the $600 remaining 
adjustment (the adjustment computed without taking distributions 
into account) is allocated $200 to each of the preferred shares to 
reflect their entitlement to dividends accruing in year 1 and year 
2. See Sec.  1.1502-32(c)(3). (The year 2 investment adjustment to 
each preferred share is therefore a positive $100.) Finally, under 
Sec.  1.1502-32(c)(2), the remaining $200 of the investment 
adjustment is allocated to the common stock, equally to all 
outstanding shares. After applying and giving effect to all 
generally applicable rules of law (other than this section), the 
adjusted bases and the values of the shares as of January 1, year 3, 
are:

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                    Preferred                                     Common
                                                               -----------------------------------------------------------------------------------------
                                                                PS1 (M)  PS2 (P)  CS1 (P)  CS2 (P)  CS3 (P)  CS4 (P)  CS5 (P)  CS6 (P)  CS7 (P)  CS8 (P)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Basis.........................................................     1250      975     1025      710      550      400      375      250      215      100
Year 1 Sec.   1.1502-32 adjustments...........................      N/A      N/A     -125     -125     -125     -125     -125     -125     -125     -125
Year 2 Sec.   1.1502-32 adjustments...........................     +100     +100      +25      +25      +25      +25      +25      +25      +25      +25
Adjusted basis................................................     1350     1075      925      610      450      300      275      150      115        0
                                                               -----------------------------------------------------------------------------------------
    Value.....................................................     1100     1100      275      275      275      275      275      275      275      275
                                                               -----------------------------------------------------------------------------------------
Unrecognized gain/(loss)......................................    (250)       25    (650)    (335)    (175)     (25)        0      125      160      275
--------------------------------------------------------------------------------------------------------------------------------------------------------

    On January 1, year 3, M sells PS1 for $1100 and P sells CS2 for 
$275. The sales of PS1 and CS2 are transfers of loss shares and 
therefore subject to the provisions of this section.
    (ii) Basis redetermination under this paragraph (b). Under this 
paragraph (b), all members' bases in shares of S stock are subject 
to redetermination in accordance with the following:
    (A) Removing positive investment adjustments from transferred 
loss shares. First, paragraph (b)(2)(i)(A) of this section applies 
to reduce M's basis in PS1 and P's basis in CS2, but not below 
value, by removing the positive investment adjustments applied to 
the bases of the shares. Accordingly, M's basis in PS1 is reduced by 
$200 (the investment adjustment applied to the share without regard 
to the distribution), from $1350 to $1150, and P's basis in CS2 is 
reduced by $25, from $610 to $585.
    (B) Reallocating negative investment adjustments from shares 
that are not transferred loss shares. Because the transferred shares 
remain loss shares after the removal of positive investment 
adjustments, their bases are further reduced under paragraph 
(b)(2)(i)(B) of this section, but not below value, by negative 
investment adjustments applied to shares that are not transferred 
loss shares. Reallocations are made first to preferred shares and 
then to the common shares, in a manner that reduces basis disparity 
to the greatest extent possible. The remaining loss on PS1 is $50, 
the remaining loss on CS2 is $310, and the total amount of negative 
investment adjustments applied to shares that are not transferred 
loss shares is $875 (the sum of the adjustments made to all common 
shares other than CS2). Thus, $50 of negative investment adjustments 
are reallocated to the basis of PS1 and $310 of negative investment 
adjustments are reallocated to the basis of CS2, reducing each to 
its value ($1100 and $275, respectively). The negative investment 
adjustments are reallocated from the shares that are not transferred 
loss shares in a manner that reduces basis disparity to the greatest 
extent possible. Accordingly, of the $360 reallocated negative 
investment adjustments, $125 is reallocated from each of CS7 and 
CS8, and $110 is reallocated from CS6. As a result, the basis of CS6 
increases to $260, the basis of CS7 increases to $240, and the basis 
of CS8 increases to $125.
    (C) Increasing basis by reallocated positive investment 
adjustments. Under paragraph (b)(2)(ii)(A) of this section, the $225 
of positive investment adjustments removed from the transferred loss 
shares are then reallocated and applied to increase the basis of 
preferred shares, but not above value. Accordingly $25 of that 
amount is reallocated to PS2, increasing its basis from $1075 to 
$1100, its value. The remaining $200 is allocated among the common 
shares in a manner that reduces basis disparity to the greatest 
extent possible. Accordingly, of the $200 positive investment 
adjustment that is reallocated to common shares, $150 is reallocated 
to CS8, $35 is reallocated to CS7, and $15 is reallocated to CS6, 
increasing the basis of each to $275.
    (D) Summary of reallocation adjustments. The adjustments made 
under this paragraph (b) are therefore:

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                    Preferred                                     Common
                                                               -----------------------------------------------------------------------------------------
                                                                  PS1      PS2      CS1      CS2      CS3      CS4      CS5      CS6      CS7      CS8
                                                                  (M)      (P)      (P)      (P)      (P)      (P)      (P)      (P)      (P)      (P)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Adjusted basis Before redetermination.........................     1350     1075      925      610      450      300      275      150      115        0
Removing positive adjustments from transferred loss shares....     -200  .......  .......      -25  .......  .......  .......  .......  .......  .......
Reallocating negative adjustments.............................      -50  .......  .......     -310  .......  .......  .......     +110     +125     +125
Applying positive adjustments removed from transferred shares.  .......      +25  .......  .......  .......  .......  .......      +15      +35     +150
                                                               -----------------------------------------------------------------------------------------
    Basis after redetermination...............................     1100     1100      925      275      450      300      275      275      275      275
                                                               -----------------------------------------------------------------------------------------
    Value.....................................................     1100     1100      275      275      275      275      275      275      275      275
                                                               -----------------------------------------------------------------------------------------
Gain/(loss)...................................................        0        0    (650)        0    (175)     (25)        0        0        0        0
--------------------------------------------------------------------------------------------------------------------------------------------------------

    (iii) Application of paragraphs (c) and (d) of this section. 
Because M's sale of PS1 and P's sale of CS2 are no longer transfers 
of loss shares after the application of this paragraph (b), 
paragraphs (c) and (d) of this section do not apply.
    (iv) Higher-tier effects. The adjustments made to PS1 give rise 
to a $250 nondeductible basis recovery item (a noncapital, 
nondeductible expense under Sec.  1.1502-32(b)(3)(iii)(B)) that will 
be included in the year 3 investment adjustment

[[Page 3000]]

to be applied to reduce P's basis in its M stock.

    (c) Stock basis reduction to prevent noneconomic loss--(1) In 
general. The rules of this paragraph (c) reduce M's basis in a 
transferred share of S stock in order to prevent noneconomic stock loss 
and thereby promote the clear reflection of the group's income. The 
effect of these rules is to limit the reduction to M's basis in the S 
share to the amount of net unrealized appreciation reflected in the 
share's basis immediately before the transfer. These rules also limit 
the reduction to M's basis in the S share to the portion of the share's 
basis that is attributable to investment adjustments made pursuant to 
the consolidated return regulations.
    (2) Basis reduction rule--(i) In general. If M transfers a share of 
S stock and, after the application of paragraph (b) of this section, 
the share is a loss share, M's basis in the share is reduced, but not 
below value, by the lesser of--
    (A) The share's net positive adjustment (see paragraph (c)(3) of 
this section); and
    (B) The share's disconformity amount (see paragraph (c)(4) of this 
section).
    (ii) Transactions that adjusted stock or asset basis. See paragraph 
(e)(2) of this section for special rules that may apply if a prior 
transaction, such as an exchange subject to section 362(e)(2), adjusted 
the basis in any share of S stock or S's attributes in a manner that 
altered a share's disconformity amount.
    (iii) Transfers of stock of subsidiaries at multiple tiers. If 
stock of subsidiaries at multiple tiers is transferred in a 
transaction, see paragraph (a)(3)(ii) of this section regarding the 
order of application of this section.
    (3) Net positive adjustment. A share's net positive adjustment is 
the greater of--
    (i) Zero; and
    (ii) The sum of all investment adjustments reflected in the basis 
of the share. The term investment adjustment has the same meaning as in 
paragraph (b)(1)(iv) of this section.
    (4) Disconformity amount. A share's disconformity amount is the 
excess, if any, of--
    (i) M's basis in the share; over
    (ii) The share's allocable portion of S's net inside attribute 
amount (as defined in paragraph (c)(5) of this section).
    (5) Net inside attribute amount. S's net inside attribute amount is 
determined as of the time immediately before the transfer, taking into 
account all applicable rules of law other than this section (except as 
specifically provided otherwise in this section). S's net inside 
attribute amount is the sum of S's net operating and capital loss 
carryovers, deferred deductions, money, and basis in assets other than 
money (for this purpose, S's basis in any share of lower-tier 
subsidiary stock is S's basis in that share, adjusted to reflect any 
gain or loss recognized in the transaction and any other related or 
resulting adjustments), reduced by the amount of S's liabilities. See 
paragraph (f) of this section for definitions of the terms ``allocable 
portion'', ``deferred deduction'', ``liability'', and ``loss 
carryover''. See paragraph (c)(6) of this section for special rules 
regarding the computation of S's net inside attribute amount for 
purposes of this paragraph (c) if S holds stock of a subsidiary.
    (6) Determination of S's net inside attribute amount if S owns 
stock of a lower-tier subsidiary--(i) Overview. If a loss share of S 
stock is transferred when S holds a share of stock of another 
subsidiary (S1) and the S1 share is not transferred in the same 
transaction, S's net inside attribute amount is determined by treating 
S's basis in its S1 share as tentatively reduced under this paragraph 
(c)(6). The purpose of this rule is to reduce the extent to which S1's 
investment adjustments increased noneconomic loss on S stock (as a 
result of S1's recognition of items that are indirectly reflected in 
members' bases in S stock).
    (ii) General rule for nontransferred shares of lower-tier 
subsidiary. Solely for purposes of determining the disconformity amount 
of a share of S stock, S's basis in a share of S1 stock is treated as 
reduced by the share's tentative reduction amount. The tentative 
reduction amount is the lesser of the S1 share's net positive 
adjustment and the S1 share's disconformity amount, computed under the 
principles of paragraphs (c)(3) and (c)(4) of this section, 
respectively.
    (iii) Multiple tiers of nontransferred shares. If S directly or 
indirectly owns non-transferred shares of stock of subsidiaries in 
multiple tiers, then, subject to the limitations in paragraph 
(c)(6)(iv) of this section (regarding nontransferred shares that are 
lower-tier to transferred shares), the rules of this paragraph (c)(6) 
first apply to determine the tentatively reduced basis of stock of the 
subsidiary at the lowest tier. These rules then apply successively to 
determine the tentatively reduced basis of nontransferred shares of 
stock of subsidiaries at each next higher tier that is lower tier to S. 
The tentative reductions are treated as noncapital, nondeductible 
expenses that tier up under the principles of Sec.  1.1502-32, 
tentatively reducing the basis of stock and the net positive 
adjustments of subsidiaries that are lower tier to S.
    (iv) Nonapplicability of tentative basis reduction rule to 
transferred shares. The tentative basis reduction rule in this 
paragraph (c)(6) does not apply to any share of stock of a lower-tier 
subsidiary (S1) that is transferred in the same transaction in which 
the S share is transferred. Further, for purposes of determining the S 
share's disconformity amount, the tentative basis reduction rule in 
this paragraph (c)(6) does not apply with respect to stock of any other 
subsidiary (S2) to the extent it is lower tier to the transferred S1 
share. However, the tentative basis reduction rule may apply to S2 
stock for purposes of computing the disconformity amount of the 
transferred S1 share. The purpose of this rule is to prevent tentative 
adjustments under this paragraph (c)(6) to the extent that this 
paragraph (c) has already applied to shares of subsidiary stock, 
without regard to whether the basis of those shares was reduced under 
this paragraph (c).
    (v) Example. The rules of this paragraph (c)(6) are illustrated by 
the following example:

    Example. (i) Facts. P owns the sole outstanding share of S 
stock, S owns the sole outstanding share of S1 stock, S1 owns the 
sole outstanding share of S2 stock, S2 owns the sole outstanding 
share of S3 stock, and S3 owns the sole outstanding share of S4 
stock. The S and S1 shares are loss shares, and the S3 share is a 
gain share. In one transaction, P sells its S share to X, S1 issues 
new shares in an amount that prevents S and S1 from being members of 
the same group, and S2 sells the S3 share to an unrelated 
individual. S1 and S2 elect to file a consolidated return following 
the transaction, as do S3 and S4.
    (ii) General applicability of section. The transaction is a 
transfer of the S and S3 shares (by reason of the sales) and of the 
S1 share (because S and S1 cease to be members of the same group). 
The transfer of the S3 share is not a transfer of a loss share and 
so this section does not apply to that transfer. This section does, 
however, apply to the transfer of the S and S1 loss shares. Under 
paragraph (a)(3)(ii)(A) of this section, the application of this 
section begins with the application of paragraph (b) to the transfer 
of the loss share stock of S1, the lowest-tier subsidiary the stock 
of which is transferred in the transaction.
    (iii) Application of paragraphs (b) and (c) to transfer of S1 
stock. First, the gain recognized on the transfer of S3 tiers up to 
adjust the basis of each upper-tier share. Then, because the 
transferred S1 share is still a loss share under these facts, 
paragraph (b) of this section applies to S's transfer of S1 stock. 
However, no adjustment is required under paragraph (b) of this 
section because redetermination would change no member's basis in a 
share (members hold only one share of S1 stock). See paragraph 
(b)(1)(ii)(A)

[[Page 3001]]

of this section. The S1 share is still a loss share and so it is 
then subject to the provisions of this paragraph (c). In determining 
basis reduction under this paragraph (c), the disconformity amount 
of the S1 share is computed by treating S1's basis in S2 stock as 
tentatively reduced under this paragraph (c)(6). In determining the 
disconformity amount of the S1 share, this tentative reduction rule 
has no application with respect to S2's basis in the S3 share 
(because the S3 share is transferred in the transaction) or with 
respect to S3's basis in the S4 share (because the S4 stock is lower 
tier to the transferred S3 share). After the application of this 
paragraph (c) to the transfer of the S1 share, paragraph (b) of this 
section applies to P's transfer of the S share if the share is still 
a loss share.
    (iv) Application of section to transfer of S stock. First, 
assuming the S share has remained a loss share, paragraph (b) of 
this section applies to P's transfer of S stock. However, no 
adjustment is required under paragraph (b) of this section, either 
because there is no potential for redetermination (members hold only 
one share of S stock) or because P transfers the group's entire 
interest in S to a nonmember in a fully taxable transaction. See, 
respectively, paragraphs (b)(1)(ii)(A) and (b)(1)(ii)(B) of this 
section. The transferred share is still a loss share and therefore 
subject to the provisions of this paragraph (c). In determining the 
disconformity amount of the S share, S's net inside attributes are 
determined by taking into account S's actual basis in the S1 stock. 
The tentative reduction rule of this paragraph (c)(6) does not apply 
to S's basis in the S1 share because the S1 share is transferred in 
the transaction. All other shares are lower tier to the transferred 
S1 share and are therefore not subject to tentative reduction for 
purposes of determining the disconformity amount of the S share.

    (7) Netting of gains and losses taken into account--(i) General 
rule. Solely for purposes of computing the basis reduction required 
under this paragraph (c), the basis of each transferred loss share of S 
stock is treated as reduced proportionately (as to loss) by the amount 
of gain taken into account by members with respect to all transferred 
gain shares of S stock, provided that--
    (A) The gain and loss shares are transferred in the same 
transaction; and
    (B) The gain is taken into account in the year of the transaction.
    (ii) Example. The netting rule of this paragraph (c)(7) is 
illustrated by the following example:

    Example. Disposition of gain and loss shares. (i) Facts. P owns 
the only two outstanding shares of S common stock. Share A has a 
basis of $54 and Share B has a basis of $100. In the same 
transaction, P sells the two S shares to X for $60 each. P realizes 
a gain of $6 on Share A and a loss of $40 on Share B. P's sale of 
Share B is a transfer of a loss share and therefore subject to the 
provisions of this section. (No adjustment is required under 
paragraph (b) of this section because P transfers the group's entire 
interest in S to a nonmember in a fully taxable transaction. See 
paragraph (b)(1)(ii)(B) of this section.) The transfer is then 
subject to the provisions of this paragraph (c). However, for this 
purpose, P treats its basis in Share B as reduced by the $6 gain 
taken into account with respect to Share A. Thus, solely for 
purposes of computing the basis reduction required with respect to 
P's basis in Share B, P's basis in Share B is treated as $94 ($100 
less $6). If, after the application of this paragraph (c), the sale 
of Share B is still a transfer of a loss share, then the transfer is 
subject to paragraph (d) of this section. (Although the basis of 
Share B is not reduced by gain for purposes of paragraph (d) of this 
section, paragraph (d)(3)(i)(A) of this section applies netting 
principles to limit adjustments under paragraph (d) of this 
section.)
    (ii) Allocation of gain amount to determine net loss. The facts 
are the same as in paragraph (i) of this Example, except that, in 
addition to Share A and Share B, a third share of S stock, Share C, 
is outstanding. P's basis in Share C is $80. P sells all three 
shares of S stock to X for $60 each. P's sales of Share B and Share 
C are transfers of loss shares and therefore subject to the 
provisions of this section. (No adjustment is required under 
paragraph (b) of this section because P transfers the group's entire 
interest in S to a nonmember in a fully taxable transaction. See 
paragraph (b)(1)(ii)(B) of this section.) The transfer is then 
subject to the provisions of this paragraph (c). However, for this 
purpose, P treats its bases in Share B and Share C as reduced by the 
$6 gain taken into account on Share A. The gain is allocated to 
Share B and Share C proportionately based on the amount of loss in 
each share. Thus, $4 of gain ($40/$60 x $6) is treated as allocated 
to Share B and $2 of gain ($20/$60 x $6) is treated as allocated to 
Share C. Accordingly, P computes the basis reduction required under 
this paragraph (c) by treating its basis in Share B as $96 ($100 
less $4) and its basis in Share C as $78 ($80 less $2). If, after 
the application of this paragraph (c), the sales of Share B and 
Share C are still transfers of loss shares, then the transfers are 
subject to paragraph (d) of this section. (Although the bases of 
Share B and Share C are not reduced by gain for purposes of 
paragraph (d) of this section, paragraph (d)(3)(i)(A) of this 
section applies netting principles to limit adjustments under 
paragraph (d) of this section.)
    (iii) Disposition of stock with deferred gain. The facts are the 
same as in paragraph (i) of this Example, except that P sells the 
gain share to a member. Under Sec.  1.1502-13, P's gain recognized 
on Share A is not taken into account in the taxable year of the 
transfer and therefore cannot be treated as reducing P's loss 
recognized on Share B.

    (8) Examples. The application of this paragraph (c) is illustrated 
by the following examples.

    Example 1. Appreciation reflected in stock basis at acquisition. 
(i) Appreciation recognized as gain. (A) Facts. On January 1, year 
1, P purchases the sole outstanding share of S stock for $100. At 
that time, S owns two assets, Asset 1 with a basis of $0 and a value 
of $40, and Asset 2 with a basis and value of $60. In year 1, S 
sells Asset 1 for $40. On December 31, year 1, P sells its S share 
for $100. After applying and giving effect to all generally 
applicable rules of law (other than this section), P's basis in the 
S share is $140 (P's original $100 basis increased under Sec.  
1.1502-32 to reflect the $40 gain recognized on the sale of Asset 
1). P's sale of the S share is a transfer of a loss share and 
therefore subject to the provisions of this section.
    (B) Application of paragraph (b) of this section. No adjustment 
is required under paragraph (b) of this section, either because 
redetermination would change no member's basis in a share (members 
hold only one share of S stock) or because P transfers the group's 
entire interest in S to a nonmember in a fully taxable transaction. 
See, respectively, paragraphs (b)(1)(ii)(A) and (b)(1)(ii)(B) of 
this section. After the application of paragraph (b) of this 
section, P's sale of the S share is still a transfer of a loss share 
and therefore subject to this paragraph (c).
    (C) Basis reduction under this paragraph (c). Under this 
paragraph (c), P's basis in the S share is reduced, but not below 
value, by the lesser of the share's net positive adjustment and 
disconformity amount. The share's net positive adjustment is the 
greater of zero and the sum of all investment adjustments applied to 
the basis of the share, computed without taking distributions into 
account. There are no distributions. The only investment adjustment 
to the share is the $40 adjustment attributable to the gain 
recognized on the sale of Asset 1. Thus the share's net positive 
adjustment is $40. The share's disconformity amount is the excess, 
if any, of its basis ($140) over its allocable portion of S's net 
inside attribute amount. S's net inside attribute amount is the sum 
of S's money ($40 from the sale of Asset 1) and S's basis in Asset 2 
($60), or $100. The share is the only outstanding S share and so its 
allocable portion of the $100 net inside attribute amount is the 
entire $100. Thus, the share's disconformity amount is $40, the 
excess of $140 over $100. The lesser of the net positive adjustment 
($40) and the share's disconformity amount ($40) is $40. 
Accordingly, the basis in the share is reduced by $40, from $140 to 
$100, immediately before the sale.
    (D) Application of paragraph (d) of this section. Because P's 
sale of the S share is no longer a transfer of a loss share after 
the application of this paragraph (c), paragraph (d) of this section 
does not apply.
    (ii) Appreciation recognized as income (instead of gain). The 
facts are the same as in paragraph (i)(A) of this Example 1, except 
that, instead of selling Asset 1, the value of Asset 1 is consumed 
in the production of $40 of income in year 1 (reducing the value of 
Asset 1 to $0) Because the net positive adjustment includes items of 
income as well as items of gain, the results are the same as those 
described in paragraph (i) of this Example 1.
    (iii) Post-acquisition appreciation eliminates stock loss. The 
facts are the same as in paragraph (i)(A) of this Example 1

[[Page 3002]]

except that, in addition, the value of Asset 2 increases to $100 
before the stock is sold. As a result, P sells the S share for $140. 
Because P's sale of the S share is not a transfer of a loss share, 
this section does not apply to the transfer, notwithstanding that 
P's basis in the S share was increased by the gain recognized on 
Asset 1.
    (iv) Distributions. (A) Facts. The facts are the same as in 
paragraph (i)(A) of this Example 1 except that, in addition, S 
distributes a $10 dividend before the end of year 1. As a result, 
the value of the share decreases and P sells the share for $90. 
After applying and giving effect to all generally applicable rules 
of law (other than this section), P's basis in the S share is $130 
(P's original $100 basis increased by $30 under Sec.  1.1502-32 (the 
net of the $40 gain recognized on the sale of Asset 1 and the $10 
dividend declared and distributed)). P's sale of the S share is a 
transfer of a loss share and therefore subject to the provisions of 
this section.
    (B) Application of paragraph (b) of this section. No adjustment 
is required under paragraph (b) of this section, either because 
there redetermination would change no member's basis in a share 
(members hold only one share of S stock) or because P transfers the 
group's entire interest in S to a nonmember in a fully taxable 
transaction. See, respectively, paragraphs (b)(1)(ii)(A) and 
(b)(1)(ii)(B) of this section. After the application of paragraph 
(b) of this section, P's sale of the S share is still a transfer of 
a loss share and therefore subject to this paragraph (c).
    (C) Basis reduction under this paragraph (c). Under this 
paragraph (c), P's basis in the S share is reduced, but not below 
value, by the lesser of the share's net positive adjustment and 
disconformity amount. The share's net positive adjustment is $40 
(the sum of all investment adjustments applied to the basis of the 
share, computed without taking distributions into account). The 
share's disconformity amount is the excess of its basis ($130) over 
its allocable portion of S's net inside attribute amount. S's net 
inside attribute amount is the sum of S's money ($30, the $40 sale 
proceeds minus the $10 distribution) and S's basis in Asset 2 ($60), 
or $90. The share is the only outstanding S share and so its 
allocable portion of the $90 net inside attribute amount is the 
entire $90. The lesser of the share's net positive adjustment ($40) 
and its disconformity amount ($40) is $40. Accordingly, the basis in 
the share is reduced by $40, from $130 to $90, immediately before 
the sale.
    (D) Application of paragraph (d) of this section. Because P's 
sale of the S share is no longer a transfer of a loss share after 
the application of this paragraph (c), paragraph (d) of this section 
does not apply.
    Example 2. Loss of appreciation reflected in basis. (i) Facts. 
On January 1, year 1, P purchases the sole outstanding share of S 
stock for $100. At that time, S owns two assets, Asset 1 with a 
basis of $0 and a value of $40, and Asset 2 with a basis and value 
of $60. The value of Asset 1 declines to $0 and P sells its S share 
for $60. After applying and giving effect to all generally 
applicable rules of law (other than this section), P's basis in the 
S share remains $100. P's sale of the S share is a transfer of a 
loss share and therefore subject to the provisions of this section.
    (ii) Application of paragraph (b) of this section. No adjustment 
is required under paragraph (b) of this section, either because 
redetermination would change no member's basis in a share (members 
hold only one share of S stock) or because P transfers the group's 
entire interest in S to a nonmember in a fully taxable transaction. 
See, respectively, paragraphs (b)(1)(ii)(A) and (b)(1)(ii)(B) of 
this section. After the application of paragraph (b) of this 
section, P's sale of the S share is still a transfer of a loss share 
and therefore subject to this paragraph (c).
    (iii) Basis reduction under this paragraph (c). Under this 
paragraph (c), P's basis in the S share ($100) is reduced 
immediately before the sale, but not below value ($60), by the 
lesser of the share's net positive adjustment and disconformity 
amount. There were no adjustments to P's basis in the share and so 
the share's net positive adjustment is $0. Thus, although the 
share's disconformity amount is $40 (the excess of P's basis in the 
share ($100) over the share's allocable portion of S's net inside 
attribute amount ($60)), no basis reduction is required under this 
paragraph (c).
    (iv) Application of paragraph (d) of this section. After the 
application of this paragraph (c), P's sale of the S share is still 
a transfer of a loss share, and, accordingly, subject to paragraph 
(d) of this section. No adjustment is required under paragraph (d) 
of this section because there is no aggregate inside loss. See 
paragraph (d)(3)(iii) of this section.
    Example 3. Items accruing after S becomes a member. (i) 
Recognition of loss accruing after S becomes a member. (A) Facts. On 
January 1, year 1, P purchases the sole outstanding share of S stock 
for $100. At that time, S owns two assets, Asset 1, with a basis of 
$0 and a value of $40, and Asset 2, with a basis and value of $60. 
In year 1, S sells Asset 1 for $40. Also in year 1, the value of 
Asset 2 declines and S sells Asset 2 for $20. On December 31, year 
1, P sells its S share for $60. After applying and giving effect to 
all generally applicable rules of law (other than this section), P's 
basis in the S share is $100 (P's original $100 basis, unadjusted 
under Sec.  1.1502-32 because the $40 gain recognized on the sale of 
Asset 1 offsets the $40 loss on the sale of Asset 2). P's sale of 
the S share is a transfer of a loss share and therefore subject to 
the provisions of this section.
    (B) Application of paragraph (b) of this section. No adjustment 
is required under paragraph (b) of this section, either because 
redetermination would change no member's basis in a share (members 
hold only one share of S stock) or because P transfers the group's 
entire interest in S to a nonmember in a fully taxable transaction. 
See, respectively, paragraphs (b)(1)(ii)(A) and (b)(1)(ii)(B) of 
this section. After the application of paragraph (b) of this 
section, P's sale of the S share is still a transfer of a loss share 
and therefore subject to this paragraph (c).
    (C) Basis reduction under this paragraph (c). Under this 
paragraph (c), P's basis in the S share ($100) is reduced 
immediately before the sale, but not below value ($60), by the 
lesser of the share's net positive adjustment and disconformity 
amount. The share's net positive adjustment is $0. Thus, although 
the share has a disconformity amount of $40 (the excess of P's basis 
in the share ($100) over the share's allocable portion of S's net 
inside attribute amount ($60)), no basis reduction is required under 
this paragraph (c).
    (D) Application of paragraph (d) of this section. After the 
application of this paragraph (c), P's sale of the S share is still 
a transfer of a loss share, and, accordingly, subject to paragraph 
(d) of this section. No adjustment is required under paragraph (d) 
of this section because there is no aggregate inside loss. See 
paragraph (d)(3)(iii) of this section.
    (ii) Recognition of gain accruing after S becomes a member. (A) 
Facts. The facts are the same as in paragraph (i)(A) of this Example 
3, except that neither P nor S sells anything in year 1. In 
addition, in year 2, the value of Asset 1 declines to $0, the value 
of Asset 2 returns to $60, and S creates Asset 3 (with a basis of 
$0). In year 3, S sells Asset 3 for $40. On December 31, year 3, P 
sells its S share for $100. After applying and giving effect to all 
generally applicable rules of law (other than this section), P's 
basis in the S share is $140 (P's original $100 basis increased 
under Sec.  1.1502-32 to reflect the $40 gain recognized on the sale 
of Asset 3 in year 3).
    (B) Application of paragraph (b) of this section. No adjustment 
is required under paragraph (b) of this section, either because 
redetermination would change no member's basis in a share (members 
hold only one share of S stock) or because P transfers the group's 
entire interest in S to a nonmember in a fully taxable transaction. 
See, respectively, paragraphs (b)(1)(ii)(A) and (b)(1)(ii)(B) of 
this section. After the application of paragraph (b) of this 
section, P's sale of the S share is still a transfer of a loss share 
and therefore subject to this paragraph (c).
    (C) Basis reduction under this paragraph (c). Under this 
paragraph (c), P's basis in the S share ($140) is reduced 
immediately before the sale, but not below value ($100), by the 
lesser of the share's net positive adjustment and disconformity 
amount. The share's net positive adjustment is $40 (the year 3 
investment adjustment). The share's disconformity amount is the 
excess of its basis ($140) over its allocable portion of S's net 
inside attribute amount. S's net inside attribute amount is $100, 
the sum of S's money ($40 from the sale of Asset 3) and its basis in 
its assets ($60 (the sum of Asset 1's basis of $0 and Asset 2's 
basis of $60)). S's $100 net inside attribute amount is allocable 
entirely to the sole outstanding S share. Thus, the share's 
disconformity amount is the excess of $140 over $100, or $40. The 
lesser of the share's net positive adjustment ($40) and its 
disconformity amount ($40) is $40. Accordingly, the basis in the 
share is reduced by $40, from $140 to $100, immediately before the 
sale.
    (D) Application of paragraph (d) of this section. Because P's 
sale of the S share is no

[[Page 3003]]

longer a transfer of a loss share after the application of this 
paragraph (c), paragraph (d) of this section does not apply.
    (iii) Recognition of income earned after S becomes a member. The 
facts are the same as in paragraph (ii)(A) of this Example 3, except 
that instead of creating Asset 3, S earns $40 of income from 
services provided in year 3. Because the net positive adjustment 
includes items of income as well as items of gain, the results are 
the same as those described in paragraph (ii) of this Example 3.
    Example 4. Computing the disconformity amount. (i) Unrecognized 
loss reflected in stock basis. (A) Facts. P owns the sole 
outstanding share of S stock with a basis of $100. S owns two 
assets, Asset 1 with a basis of $20 and a value of $60, and Asset 2 
with a basis of $60 and a value of $40. In year 1, S sells Asset 1 
for $60. On December 31, year 1, P sells the S share for $100. After 
applying and giving effect to all generally applicable rules of law 
(other than this section), P's basis in the S share is $140 (P's 
original $100 basis increased under Sec.  1.1502-32 to reflect the 
$40 gain recognized on the sale of Asset 1). P's sale of the S share 
is a transfer of a loss share and therefore subject to the 
provisions of this section.
    (B) Application of paragraph (b) of this section. No adjustment 
is required under paragraph (b) of this section, either because 
redetermination would change no member's basis in a share (members 
hold only one share of S stock) or because P transfers the group's 
entire interest in S to a nonmember in a fully taxable transaction. 
See, respectively, paragraphs (b)(1)(ii)(A) and (b)(1)(ii)(B) of 
this section. After the application of paragraph (b) of this 
section, P's sale of the S share is still a transfer of a loss share 
and therefore subject to this paragraph (c).
    (C) Basis reduction under this paragraph (c). Under this 
paragraph (c), P's basis in the S share ($140) is reduced 
immediately before the sale, but not below value ($100), by the 
lesser of the share's net positive adjustment and disconformity 
amount. The share's net positive adjustment is $40 (the year 1 
investment adjustment). The share's disconformity amount is the 
excess of its basis ($140) over its allocable portion of S's net 
inside attribute amount. S's net inside attribute amount is the sum 
of S's money ($60 from the sale of Asset 1) and S's basis in Asset 2 
($60), or $120. S's net inside attribute amount is allocable 
entirely to the sole outstanding S share. Thus, the share's 
disconformity amount is the excess of $140 over $120, or $20. The 
lesser of the share's net positive adjustment ($40) and its 
disconformity amount ($20) is $20. Accordingly, the basis in the 
share is reduced by $20, from $140 to $120, immediately before the 
sale.
    (D) Application of paragraph (d) of this section. After the 
application of this paragraph (c), P's sale of the S share is still 
a transfer of a loss share, and, accordingly, subject to paragraph 
(d) of this section. Paragraph (d) of this section reduces the basis 
of Asset 2 by $20 because the loss is duplicated.
    (ii) Loss carryover. The facts are the same as in paragraph 
(i)(A) of this Example 4, except that Asset 2 has a basis of $0 
(rather than $60) and S has a $60 loss carryover (as defined in 
paragraph (f)(6) of this section). Because the net positive 
adjustment includes items of income (and not just gain), the 
analysis of the application of this paragraph (c) is the same here 
as in paragraph (i)(C) of this Example 4. Furthermore, the analysis 
of the application of this paragraph (C) would also be the same if 
the $60 loss carryover were subject to a section 382 limitation from 
a prior ownership change, and if, instead, it would subject to the 
limitation in Sec.  1.1502-21(c) on losses carried from separate 
return limitation years. However, under each alternative fact 
pattern, paragraph (d) of this section reduces the loss carryover by 
$20 because the loss is duplicated.
    (iii) Liabilities. The facts are the same as in paragraph (i)(A) 
of this Example 4, except that S borrows $100 before P sells the S 
share. S's net inside attribute amount remains $120, computed as the 
sum of S's money ($160 ($60 from the sale of Asset 1 plus the $100 
borrowed cash)) plus S's basis in Asset 2 ($60), minus its 
liabilities ($100). Thus, the S share's disconformity amount remains 
the excess of $140 over $120, or $20. The results are the same as in 
paragraph (i) of this Example 4.
    Example 5. Computing the allocable portion of the net inside 
attribute amount. (i) Facts. On January 1, year 1, P owns all five 
outstanding shares of S stock with a basis of $20 per share. S owns 
Asset with a basis of $0. In year 1, S sells Asset for $100. On 
December 31, year 1, P sells one of its shares, Share 1, for $20. 
After applying and giving effect to all generally applicable rules 
of law (other than this section), P's basis in its Share 1 is $40 
(P's original $20 basis increased by $20 under Sec.  1.1502-32 to 
reflect the share's allocable portion of the $100 gain recognized on 
the sale of Asset). P's sale of Share 1 is a transfer of a loss 
share and therefore subject to the provisions of this section.
    (ii) Application of paragraph (b) of this section. No adjustment 
is required under paragraph (b) of this section because 
redetermination would change no member's basis in a share (S has 
only one class of stock outstanding and there is no disparity in the 
basis of the shares). See paragraph (b)(1)(ii)(A) of this section. 
After the application of paragraph (b) of this section, P's sale of 
Share 1 is still a transfer of a loss share and therefore subject to 
this paragraph (c).
    (iii) Basis reduction under this paragraph (c). Under this 
paragraph (c), P's basis in Share 1 ($40) is reduced immediately 
before the sale, but not below value ($20), by the lesser of the 
share's net positive adjustment and disconformity amount. Share 1's 
net positive adjustment is $20 (the year 1 investment adjustment). 
Share 1's disconformity amount is the excess of its basis ($40) over 
its allocable portion of S's net inside attribute amount. S's net 
inside attribute amount is the sum of S's money ($100 from the sale 
of the asset), and Share 1's allocable portion of S's net inside 
attribute amount is $20 (\1/5\ x $100). Thus, Share 1's 
disconformity amount is the excess of $40 over $20, or $20. The 
lesser of the share's net positive adjustment ($20) and its 
disconformity amount ($20) is $20. Accordingly, the basis in the 
share is reduced by $20, from $40 to $20, immediately before the 
sale.
    (iv) Application of paragraph (d) of this section. Because P's 
sale of Share 1 is no longer a transfer of a loss share after the 
application of this paragraph (c), paragraph (d) of this section 
does not apply.
    Example 6. Liabilities. (i) In general. (A) Facts. On January 1, 
year 1, P purchases the sole outstanding share of S stock for $100. 
At that time, S owns Asset, with a basis of $0 and value of $100, 
and $100 cash. S also has a $100 liability. In year 1, S distributes 
$60 to P and earns $20. The value of Asset declines to $60 and, on 
December 31, year 1, P sells the S share for $20. After applying and 
giving effect to all generally applicable rules of law (other than 
this section), P's basis in the S share is $60 (P's original $100 
basis decreased under Sec.  1.1502-32 by $40 (the net of the $60 
distribution and the $20 income earned)). P's sale of the S share is 
a transfer of a loss share and therefore subject to the provisions 
of this section.
    (B) Application of paragraph (b) of this section. No adjustment 
is required under paragraph (b) of this section, either because 
redetermination would change no member's basis in a share (members 
hold only one share of S stock) or because P transfers the group's 
entire interest in S to a nonmember in a fully taxable transaction. 
See, respectively, paragraphs (b)(1)(ii)(A) and (b)(1)(ii)(B) of 
this section. After the application of paragraph (b) of this 
section, P's sale of the S share is still a transfer of a loss share 
and therefore subject to this paragraph (c).
    (C) Basis reduction under this paragraph (c). Under this 
paragraph (c), P's basis in the S share ($60) is reduced immediately 
before the sale, but not below value ($20), by the lesser of the 
share's net positive adjustment and disconformity amount. The 
share's net positive adjustment is $20 (the year 1 investment 
adjustment computed without taking the distribution into account). 
The share's disconformity amount is the excess of its basis ($60) 
over its allocable portion of S's net inside attribute amount. S's 
net inside attribute amount is negative $40, computed as the sum of 
S's money ($60 ($100 minus the $60 distribution plus the $20 income 
earned)) plus S's basis in Asset ($0), minus S's liability ($100). 
S's net inside attribute amount is allocable entirely to the sole 
outstanding S share. Thus, the share's disconformity amount is the 
excess of $60 over negative $40, or $100. The lesser of the share's 
net positive adjustment ($20) and its disconformity amount ($100) is 
$20. Accordingly, the basis in the share is reduced by $20, from $60 
to $40, immediately before the sale.
    (D) Application of paragraph (d) of this section. After the 
application of this paragraph (c), the S share is still a loss share 
and, accordingly, S's attributes are subject to reduction under 
paragraph (d) of this section. No adjustment is required under 
paragraph (d) of this section, however, because there is no 
aggregate inside loss. See paragraph (d)(3)(iii) of this section.
    (ii) Excluded cancellation of indebtedness income--insufficient 
attributes available for

[[Page 3004]]

reduction required by sections 108 and 1017, and Sec.  1.1502-28. 
(A) Facts. The facts are the same as in paragraph (i)(A) of this 
Example 6, except that P does not sell the S share. Instead, in year 
4, Asset is destroyed in a fire and S spends its $60 on deductible 
expenses that are not absorbed by the group. S's loss becomes part 
of the consolidated net operating loss (CNOL). In year 5, S becomes 
insolvent and S's debt is discharged. Because of S's insolvency, S's 
discharge of indebtedness income is excluded under section 108 and, 
as a result, S's attributes are subject to reduction under sections 
108 and 1017, and Sec.  1.1502-28. S's only attribute is the portion 
of the CNOL attributable to S ($60) and it is reduced to $0. There 
are no other consolidated attributes. In year 5, the S stock becomes 
worthless under section 165(g), taking into account the provisions 
of Sec.  1.1502-80(c). After applying and giving effect to all 
generally applicable rules of law (other than this section), P's 
basis in the S share is $60 (P's original $100 basis decreased under 
Sec.  1.1502-32 by the year 1 investment adjustment of $40 (the net 
of the $60 distribution and the $20 income earned). The investment 
adjustment for year 5 is $0 ($60 tax exempt income from the excluded 
COD applied to reduce attributes minus $60 noncapital, nondeductible 
expense from the reduction of S's portion of the CNOL). Under 
paragraph (f)(11)(i)(D) of this section, a share is transferred on 
the last day of the taxable year during which it becomes worthless 
under section 165(g), taking into account the provisions of Sec.  
1.1502-80(c). Accordingly, P transfers a loss share of S stock on 
December 31, year 5, and the transfer is therefore subject to the 
provisions of this section.
    (B) Application of paragraph (b) of this section. No adjustment 
is required under paragraph (b) of this section because 
redetermination would change no member's basis in a share. See 
paragraph (b)(1)(ii)(A) of this section. After the application of 
paragraph (b) of this section, P's transfer of the S share is still 
a transfer of a loss share and therefore subject to this paragraph 
(c).
    (C) Basis reduction under this paragraph (c). Under this 
paragraph (c), P's basis in its S share ($60) is reduced immediately 
before the sale, but not below value ($0), by the lesser of the 
share's net positive adjustment and disconformity amount. The 
share's net positive adjustment is $20 (the year 1 investment 
adjustment computed without taking the distribution into account). 
The share's disconformity amount is the excess of its basis ($60) 
over its allocable portion of S's net inside attribute amount. S's 
net inside attribute amount is $0 (S's basis in Asset). (The 
attribute reduction required under sections 108 and 1017 and Sec.  
1.1502-28 is given effect before the application of this section; 
therefore, S's portion of the CNOL was eliminated under section 108 
and Sec.  1.1502-28.) S's net inside attribute amount is allocable 
entirely to the sole outstanding S share. Thus, the share's 
disconformity amount is the excess of $60 over $0, or $60. The 
lesser of the share's net positive adjustment ($20) and its 
disconformity amount ($60) is $20. Accordingly, the basis in the 
share is reduced by $20, from $60 to $40, immediately before the 
transfer.
    (D) Application of paragraph (d) of this section. After the 
application of this paragraph (c), the S share is still a loss 
share, and, accordingly, S's attributes are subject to reduction 
under paragraph (d) of this section. No adjustment is required under 
paragraph (d) of this section, however, because there is no 
aggregate inside loss. See paragraph (d)(3)(iii) of this section.
    (iii) Excluded cancellation of indebtedness income--full 
attribute reduction under sections 108 and 1017, and Sec.  1.1502-28 
(using attributes attributable to another member). (A) Facts. The 
facts are the same as in paragraph (ii)(A) of this Example 6 except 
that P loses the $60 distributed in year 1 and the loss is not 
absorbed by the group. Thus, as of December 31, year 5, the CNOL is 
$120, attributable $60 to S and $60 to P. As a result, under Sec.  
1.1502-28(a)(4), after the portion of the CNOL attributable to S is 
reduced to $0, the remaining $40 of excluded COD applies to the 
portion of the CNOL attributable to P, reducing it from $60 to $20. 
After applying and giving effect to all generally applicable rules 
of law (other than this section), P's basis in the S share at the 
end of year 5 is $100 (P's original $100 basis decreased under Sec.  
1.1502-32 by $40 at the end of year 1 and then increased under Sec.  
1.1502-32 by $40 at the end of year 5 ($100 tax exempt income from 
the excluded COD applied to reduce attributes minus $60 noncapital, 
nondeductible expense from the reduction of S's portion of the 
CNOL). Under paragraph (f)(11)(i)(D) of this section, a share is 
transferred on the last day of the taxable year during which it 
becomes worthless under section 165(g), taking into account the 
provisions of Sec.  1.1502-80(c). Accordingly, P transfers a loss 
share of S stock on December 31, year 5, and the transfer is 
therefore subject to the provisions of this section.
    (B) Application of paragraph (b) of this section. No adjustment 
is required under paragraph (b) of this section because 
redetermination would change no member's basis in a share. See 
paragraph (b)(1)(ii)(A) of this section. After the application of 
paragraph (b) of this section, P's transfer of the S share is still 
a transfer of a loss share and therefore subject to this paragraph 
(c).
    (C) Basis reduction under this paragraph (c). Under this 
paragraph (c), P's basis in the S share ($100) is reduced 
immediately before the sale, but not below value ($0), by the lesser 
of the share's net positive adjustment and disconformity amount. The 
share's net positive adjustment is $60 (the sum of the year 1 
investment adjustment computed without taking the distribution into 
account ($20) and the year 5 investment adjustment ($40)). The 
share's disconformity amount is the excess of its basis ($100) over 
its allocable portion of S's net inside attribute amount. S's net 
inside attribute amount is $0 (S's basis in Asset). S's net inside 
attribute amount is allocable entirely to the sole outstanding S 
share. The share's disconformity amount is therefore $100. The 
lesser of the share's net positive adjustment ($60) and its 
disconformity amount ($100) is $60. Accordingly, P's basis in the 
share is reduced by $60, from $100 to $40, immediately before the 
transfer.
    (D) Application of paragraph (d) of this section. After the 
application of this paragraph (c), the S share is still a loss 
share, and, accordingly, S's attributes are subject to reduction 
under paragraph (d) of this section. No adjustment is required under 
paragraph (d) of this section, however, because there is no 
aggregate inside loss. See paragraph (d)(3)(iii) of this section.
    Example 7. Lower-tier subsidiary (no transfer of lower-tier 
stock). (i) Facts. P owns the sole outstanding share of S stock with 
a basis of $160. S owns two assets, Asset A with a basis and value 
of $100, and the sole outstanding share of S1 stock with a basis of 
$60. S1 owns one asset, Asset 1, with a basis of $20 and value of 
$60. In year 1, S1 sells Asset 1 to X for $60, recognizing $40 of 
gain. On December 31, year 1, P sells its S share to Y, a member of 
another consolidated group, for $160. After applying and giving 
effect to all generally applicable rules of law (other than this 
section), P's basis in the S share is $200 (P's original $160 basis 
increased under Sec.  1.1502-32 by $40 (to reflect the tiering up of 
the increase to S's basis in S1 under Sec.  1.1502-32 by $40 (to 
reflect the gain recognized on S1's sale of Asset 1)). P's sale of 
the S share is a transfer of a loss share and therefore subject to 
the provisions of this section. (S does not transfer the S1 share 
because S and S1 are members of the same group following the 
transfer. See paragraph (f)(11) of this section.)
    (ii) Application of paragraph (b) of this section. No adjustment 
is required under paragraph (b) of this section, either because 
redetermination would change no member's basis in a share (members 
hold only one share of S stock) or because P transfers the group's 
entire interest in S to a nonmember in a fully taxable transaction. 
See, respectively, paragraphs (b)(1)(ii)(A) and (b)(1)(ii)(B) of 
this section. After the application of paragraph (b) of this 
section, P's sale of the S share is still a transfer of a loss share 
and therefore subject to this paragraph (c).
    (iii) Basis reduction under this paragraph (c). (A) In general. 
Under this paragraph (c), P's basis in the S share ($200) is reduced 
immediately before the sale, but not below value ($160), by the 
lesser of the share's net positive adjustment and disconformity 
amount. The S share's net positive adjustment is $40. The share's 
disconformity amount is the excess, if any, of the basis of the 
share ($200) over the share's allocable portion of S's net inside 
attribute amount. S's net inside attribute amount is the sum of S's 
basis in Asset A ($100) plus S's basis in the S1 share.
    (B) S's basis in the S1 share. Although S's actual basis in the 
S1 share is $100 (S's original $60 basis increased by S1's year 1 
positive $40 investment adjustment), for purposes of computing the S 
share's disconformity amount, S's basis in the S1 share is 
tentatively reduced by the lesser of the S1 share's net positive 
adjustment and its disconformity amount. The S1 share's net positive 
adjustment is $40 (the year 1 investment adjustment). The S1 share's 
disconformity amount is the excess, if any, of its basis ($100) over 
its allocable portion of S1's net inside attribute amount. S1's net 
inside attribute amount is $60 (its cash received on the sale of 
Asset 1) and it is

[[Page 3005]]

entirely attributable to S's S1 share. The S1 share's disconformity 
amount is therefore the excess of $100 over $60, or $40. The lesser 
of the S1 share's net positive adjustment ($40) and its 
disconformity amount ($40) is $40. Accordingly, for purposes of 
computing the disconformity amount of the S share, S's basis in its 
S1 share is tentatively reduced by $40, from $100 to $60.
    (C) The disconformity amount of P's S share. S's net inside 
attribute amount is treated as the sum of its basis in Asset A 
($100) and its (tentatively reduced) basis in its S1 share ($60), or 
$160. S's net inside attribute amount is allocable entirely to P's S 
share. Thus, the S share's disconformity amount is the excess of 
$200 over $160, or $40.
    (D) Amount of reduction. P's basis in its S share is reduced by 
the lesser of the S share's net positive adjustment ($40) and 
disconformity amount ($40), or $40. Accordingly, P's basis in the S 
share is reduced by $40, from $200 to $160, immediately before the 
sale.
    (E) Effect on S's basis in its S1 share. The transaction has no 
effect on S's basis in the S1 share. Thus, S owns the S1 share with 
a basis of $100, S's original $60 basis in the share plus the $40 
adjustment for the gain recognized on the sale of Asset 1 in year 1.
    (iv) Application of paragraph (d) of this section. Because P's 
sale of the S share is no longer a transfer of a loss share after 
the application of this paragraph (c), paragraph (d) of this section 
does not apply.

    (d) Attribute reduction to prevent duplication of loss--(1) In 
general. The rules of this paragraph (d) reduce S's attributes to the 
extent they duplicate a net loss on shares of S stock transferred by 
members in a single transaction. This rule furthers single entity 
principles by preventing S from using deductions and losses to the 
extent that the group or its members (including former members) have 
either used, or preserved for later use, a corresponding loss in S 
shares. This rule applies without regard to whether S ceases to be a 
member after the transfer of its shares.
    (2) Attribute reduction rule--(i) General. If a transferred share 
is a loss share after the application of paragraph (c) of this section, 
S's attributes are reduced by S's attribute reduction amount. S's 
attribute reduction amount is determined under paragraph (d)(3) of this 
section and applied in accordance with the provisions of paragraphs 
(d)(4), (d)(5), and (d)(6) of this section.
    (ii) Transfers of stock of subsidiaries at multiple tiers. If stock 
of subsidiaries at multiple tiers is transferred in a transaction, this 
paragraph (d) (other than paragraph (d)(6) to the extent necessary to 
make the election to reattribute attributes) applies only after 
paragraphs (b) and (c) of this section have applied with respect to all 
transfers of loss shares. See paragraph (a)(3)(ii) of this section 
regarding the order of application of this section.
    (3) Attribute reduction amount--(i) General. S's attribute 
reduction amount is the lesser of--
    (A) The net stock loss (see paragraph (d)(3)(ii) of this section); 
and
    (B) S's aggregate inside loss (see paragraph (d)(3)(iii) of this 
section).
    (ii) Net stock loss. The net stock loss is the excess, if any, of--
    (A) The aggregate basis of all shares of S stock transferred by 
members in the transaction (taking into account any adjustments 
required under paragraphs (b) and (c) of this section, any gain or loss 
recognized at lower tiers, and any other related or resulting 
adjustments); over
    (B) The aggregate value of those shares.
    (iii) Aggregate inside loss--(A) General. S's aggregate inside loss 
is the excess, if any, of--
    (1) S's net inside attribute amount; over
    (2) The value of all outstanding shares of S stock.
    (B) Net inside attribute amount. S's net inside attribute amount 
generally has the same meaning as in paragraph (c)(5) of this section. 
However, if S holds stock of a lower-tier subsidiary, the provisions of 
paragraph (d)(5) of this section (and not the provisions of paragraph 
(c)(6) of this section) modify the computation of S's net inside 
attribute amount for purposes of this paragraph (d).
    (iv) Transactions that adjusted stock or asset basis. See paragraph 
(e)(2) of this section for special rules that may apply if a prior 
transaction, such as an exchange subject to section 362(e)(2), adjusted 
the basis in any share of S stock or S's attributes in a manner that 
altered the potential for loss duplication.
    (v) Lower-tier subsidiaries. See paragraph (d)(5) of this section 
for special rules relating to the application of this paragraph (d) if 
S owns shares of stock of a subsidiary.
    (4) Application of attribute reduction--(i) Attributes available 
for reduction. S's attributes available for reduction under this 
paragraph (d) are--
    (A) Category A. Net operating loss carryovers;
    (B) Category B. Capital loss carryovers;
    (C) Category C. Deferred deductions;
    (D) Category D. Basis in publicly traded property (other than stock 
of a subsidiary), but only to the extent of the amount, if any, that 
each such property's basis exceeds its value; and
    (E) Category E. Basis of assets excluding--
    (1) Money and cash equivalents, and
    (2) The basis of publicly traded property (other than stock of a 
subsidiary).
    (ii) Rules of application--(A) In general. S's attribute reduction 
amount is allocated and applied to reduce the attributes in each 
category in the order that the categories are set forth in paragraph 
(d)(4)(i) of this section. If the amount to be allocated and applied to 
any category equals or exceeds the amount of attributes in the 
category, the attributes in that category are reduced to zero and any 
excess is then allocated and applied to the attributes in the next 
category. If the amount to be allocated and applied is less than the 
amount of attributes in any category other than Category A or Category 
B, it is allocated and applied proportionately to all attributes in the 
category based on the amount of each attribute. If the amount to be 
allocated and applied to attributes in Category E exceeds the amount of 
attributes in that category, then--
    (1) To the extent of any liabilities of S (or a lower-tier 
subsidiary) that are not taken into account for tax purposes before the 
transfer, such excess is suspended and allocated and applied 
proportionately to reduce any amounts that would be deductible or 
capitalizable as a result of such liabilities later being taken into 
account by S or another person; solely for purposes of this paragraph 
(d)(4)(ii)(A)(1), liability means any liability or obligation that 
would be required to be capitalized as an assumed liability by a person 
that purchased all of S's assets and assumed all of S's liabilities in 
a single transaction; and
    (2) To the extent such excess is greater than any amount suspended 
by paragraph (d)(4)(ii)(A)(1) of this section, it is disregarded and 
has no further effect.
    (B) Order of reduction of loss carryovers. With respect to 
attributes in Category A and Category B, the attribute reduction amount 
is applied first to reduce losses carried from the first taxable year 
in which a loss carryover arose, and then to reduce loss carryovers 
that arose in each next successive year.
    (C) Time and effect of attribute reduction. In general, the 
reduction of attributes is effective immediately before the transaction 
in which there is a transfer of a loss share of S stock. If the 
reduction to a member's basis in a share of S stock exceeds the basis 
of that share, the excess is an excess loss account to which the member 
owning the share succeeds (and such excess loss account is not taken 
into account under Sec.  1.1502-19 or otherwise as a result of the 
transaction). The reductions to

[[Page 3006]]

attributes required under this paragraph (d)(4), including by reason of 
paragraph (d)(5)(ii)(D) of this section (tier down of attribute 
reduction amounts to lower-tier subsidiaries), are not noncapital, 
nondeductible expenses described in Sec.  1.1502-32(b)(2)(iii). 
Accordingly, such reductions have no effect on the basis of stock of 
upper-tier subsidiaries.
    (5) Special rules applicable if S holds stock of a lower-tier 
subsidiary (S1) immediately before a transfer of loss shares of S 
stock--(i) Computation of S's attribute reduction amount. For purposes 
of determining S's attribute reduction amount under paragraph (d)(3) of 
this section--
    (A) Single share. All of S's shares of S1 stock held immediately 
before the transaction (whether or not transferred in, or held by S 
immediately after, the transaction) are treated as a single share 
(generally referred to as the S1 stock); and
    (B) Deemed basis. S's basis in its S1 stock is treated as its 
deemed basis in the stock, which is equal to the greater of--
    (1) The sum of S's basis in each share of S1 stock (adjusted to 
reflect any gain or loss recognized on the transfer of any S1 shares in 
the transaction, whether allowed or disallowed); and
    (2) The portion of S1's net inside attribute amount allocable to 
S's shares of S1 stock.
    (C) Multiple tiers. If S owns (directly or indirectly) stock of 
subsidiaries in multiple tiers (whether or not transferred in, or held 
by S, directly or indirectly, immediately after, the transaction), S's 
deemed basis in such stock is determined first with respect to shares 
of stock of the lowest-tier subsidiary or subsidiaries. Deemed basis is 
then determined with respect to the basis of stock of subsidiaries in 
each next higher tier.
    (ii) Allocation and application of S's attribute reduction amount--
(A) Allocation of attribute reduction amount between S1 stock and other 
assets. For purposes of allocating S's attribute reduction amount, S's 
basis in S1 stock is treated as equal to its deemed basis in the S1 
stock (determined under paragraph (d)(5)(i)(B) of this section), 
reduced by--
    (1) The value of S's transferred shares of S1 stock,
    (2) The excess of the sum of S1's money, S1's cash equivalents, the 
value of S1's publicly traded property (other than stock of a 
subsidiary) and S1's transferred shares of lower-tier subsidiary (S2) 
stock, and all corresponding S2 amounts (net of S2's liabilities) that 
are allocable to S1's nontransferred shares of S2 stock, over the total 
amount of S1's liabilities, to the extent that such excess is allocable 
to S's nontransferred shares of S1 stock, and
    (3) The corresponding amounts with respect to shares of stock of 
all lower tier subsidiaries.
    (B) Application of attribute reduction amount to S's S1 stock. The 
attribute reduction amount allocated to S's S1 stock (the allocated 
amount) is apportioned among, and applied to reduce S's bases in, S's 
individual S1 shares in accordance with the following--
    (1) No allocated amount is apportioned to a share of transferred S1 
stock if gain or loss is recognized on its transfer;
    (2) The allocated amount is apportioned among all of S's other 
shares of S1 stock in a manner that, when applied to those shares, 
reduces the disparity in S's bases in the S1 shares to the greatest 
extent possible;
    (3) The allocated amount that is apportioned to any S1 share 
transferred in a transfer in which no gain or loss was recognized is 
applied only to the extent necessary to reduce the bases of that share 
to, but not below, the value of the share; and
    (4) The allocated amount that is apportioned to S1 shares not 
transferred in the transaction is applied to reduce the basis of such 
shares without limitation.
    (C) Further effects of allocated amount. Any portion of the 
allocated amount that is not applied to reduce S's basis in a share of 
S1 stock has no effect on any other attributes of S, it is not a 
noncapital, nondeductible expense of S, and it does not cause S to 
recognize income or gain. However, as provided in paragraph 
(d)(5)(ii)(D) of this section, such amounts continue to be part of the 
allocated amount for purposes of the tier down rule in paragraph 
(d)(5)(ii)(D) of this section.
    (D) Tier down of attribute reduction amount--(1) General rule. The 
portion of S's attribute reduction amount that is allocated to S1 stock 
(the allocated amount) is an attribute reduction amount of S1. Thus, 
subject to the basis conforming limitation in paragraph 
(d)(5)(ii)(D)(2) of this section, the allocated amount applies to 
reduce S1's attributes under the provisions of this paragraph (d). The 
allocated amount is an attribute reduction amount of S1 that must be 
allocated to S1's assets even if its application to S's basis in S1 
stock is limited under paragraph (d)(5)(ii)(B) of this section and even 
if its application to S1's attributes is limited under paragraph 
(d)(5)(ii)(D)(2) of this section.
    (2) Conforming limitation on reduction of lower-tier subsidiary's 
attributes. Notwithstanding the general rule in paragraph 
(d)(5)(ii)(D)(1) of this section, and subject to any modification in 
paragraph (e)(2) of this section, the application of S's attribute 
reduction amount to S1's attributes (the tier down amount) is limited 
such that, when combined with any attribute reduction amount computed 
with respect to a transfer of S1 stock, the total amount of reduction 
to S1's attributes does not exceed the excess of--
    (i) The portion of S1's net inside attributes that is allocable to 
all S1 shares held by members immediately before the transaction; over
    (ii) The sum of the value of all S1 shares transferred by members 
in the transaction and the sum of all members' bases in any other 
shares of S1 stock held immediately before the transaction (after any 
reduction under this section, including this paragraph (d)).
    (iii) Stock basis restoration. After this paragraph (d) has applied 
with respect to all shares of subsidiary stock transferred in the 
transaction, basis is restored under this paragraph (d)(5)(iii). In 
general, under this paragraph (d)(5)(iii), reductions otherwise 
required under paragraph (d)(5)(ii)(B) of this section are reversed to 
the extent necessary to restore members' bases in subsidiary stock to 
conform the basis of each member's share of subsidiary stock to the 
share's allocable portion of the subsidiary's net inside attribute 
amount as defined in paragraph (c)(5) of this section, without regard 
to paragraph (c)(6) of this section. The restoration adjustments are 
first made at the lowest tier and then at each next higher tier 
successively. Restoration adjustments do not tier up to affect the 
bases of higher-tier shares. Rather, restoration is computed and 
applied separately at each tier. For purposes of this rule--
    (A) A subsidiary's net inside attribute amount is determined by 
treating the basis in stock of a lower-tier subsidiary as the actual 
basis of the stock, as adjusted under this section;
    (B) The net inside attribute amount is treated as decreased by any 
attribute reduction amount suspended under paragraph (d)(4)(ii)(A)(1) 
of this section (liabilities not taken into account); and
    (C) If a subsidiary received property in a prior intercompany 
section 362(e)(2) transaction and the stock of such subsidiary was 
reduced as the result of an election under section 362(e)(2)(C) (taking 
into account the provisions of Sec.  1.1502-13(e)(4)), the net inside 
attribute amount must be reduced as provided in paragraph (e)(2) of 
this section.

[[Page 3007]]

    (6) Elections to reduce the potential for loss duplication--(i) In 
general. Notwithstanding the general operation of this paragraph (d), 
the common parent of the group of which S is a member immediately 
before the transaction (P) may make an irrevocable election to reduce 
the potential for loss duplication, and thereby avoid or reduce 
attribute reduction. Under this paragraph (d)(6), P may elect to reduce 
members' bases in transferred loss shares of S stock, or reattribute 
S's attributes (including attributes of lower-tier subsidiaries) to the 
extent such attributes would otherwise be subject to reduction under 
this paragraph (d), or both. The combined amount of stock basis 
reduction and reattribution of attributes may not exceed S's attribute 
reduction amount, tentatively computed without regard to any election 
under this paragraph (d)(6).
    (ii) Order of application--(A) Stock of one subsidiary transferred 
in the transaction. If shares of stock of only one subsidiary are 
transferred in the transaction, any stock basis reduction and 
reattribution of attributes (including from lower-tier subsidiaries) is 
deemed to occur immediately before the application of this paragraph 
(d), based on the tentatively computed attribute reduction amount. If a 
transferred share is still a loss share after giving effect to this 
election, the provisions of this paragraph (d) then apply with respect 
to that share.
    (B) Stock of multiple subsidiaries transferred in the transaction. 
If shares of stock of more than one subsidiary are transferred in the 
transaction and elections under this paragraph (d)(6) are made with 
respect to transfers of stock of subsidiaries in multiple tiers, effect 
is given to the elections from the lowest tier to the highest tier in 
the manner provided in this paragraph (d)(6)(ii)(B). The scope of the 
election for the transfer at the lowest tier is determined by 
tentatively applying paragraph (d) with respect to the transferred loss 
shares of this lowest-tier subsidiary immediately after applying 
paragraphs (b) and (c) of this section to the stock of such subsidiary. 
The effect of any stock basis reduction or reattribution of losses 
immediately tier up (under the principles of Sec.  1.1502-32) to adjust 
members' bases in all higher-tier shares. The process is repeated for 
elections for each next higher-tier transfer.
    (iii) Special rules for reattribution elections--(A) In general. 
Because the reattribution election is intended to provide the group a 
means to retain certain S attributes, and not to change the location of 
attributes where S continues to be a member, the election to 
reattribute attributes may only be made if S becomes a nonmember 
(within the meaning of Sec.  1.1502-19(c)(2)) as a result of the 
transaction. The election to reattribute S's attributes can only be 
made for attributes in Category A, Category B, and Category C. 
Attributes subject to the election will be reattributed to P in the 
same order, manner, and amount that they would otherwise be reduced 
under paragraph (d)(4) of this section. P succeeds to reattributed 
attributes as if such attributes were succeeded to in a transaction 
described in section 381(a). Any owner shift of the subsidiary 
(including any deemed owner shift resulting from section 382(g)(4)(D) 
or section 382(l)(3)) in connection with the transaction is not taken 
into account under section 382 with respect to the reattributed 
attributes. The reattribution of S's attributes is a noncapital, 
nondeductible expense described in Sec.  1.1502-32(b)(2)(iii). See 
Sec.  1.1502-32(c)(1)(ii)(B) regarding special allocations applicable 
to such noncapital, nondeductible expense. If P elects to reattribute S 
attributes (including attributes of a lower-tier subsidiary) and reduce 
S stock basis, the reattribution is given effect before the stock basis 
reduction.
    (B) Insolvency limitation. If S, or any higher-tier subsidiary, is 
insolvent within the meaning of section 108(d)(3) at the time of the 
transfer, S's losses may be reattributed only to the extent they exceed 
the sum of the separate insolvencies of any subsidiaries (taking into 
account only S and its higher-tier subsidiaries) that are insolvent. 
For purposes of determining insolvency, liabilities owed to higher-tier 
members are not taken into account, and stock of a subsidiary that is 
limited and preferred as to dividends and that is not owned by higher-
tier members is treated as a liability to the extent of the amount of 
preferred distributions to which the stock would be entitled if the 
subsidiary were liquidated on the date of the disposition.
    (C) Limitation on reattribution from lower-tier subsidiaries. P's 
ability to reattribute attributes of lower-tier subsidiaries is limited 
under this paragraph (d)(6)(iii)(C) in order to prevent circular 
computations of the attribute reduction amount. Accordingly, attributes 
that would otherwise be reduced as a result of tier down attribute 
reduction under paragraph (d)(5)(ii)(D) of this section may only be 
reattributed to the extent that the reduction in the basis of any 
lower-tier subsidiary stock resulting from the noncapital, 
nondeductible expense (as allocated under Sec.  1.1502-32(c)(1)(ii)(B)) 
will not create an excess loss account in any such stock.
    (iv) Special rules for stock basis reduction elections. An election 
to reduce basis in S stock is effective for all members' basis in loss 
shares of S stock that are transferred in the transaction. The 
reduction is allocated among all such shares in proportion to the 
amount of loss on each share. This reduction in S stock basis is a 
noncapital, nondeductible expense of the transferring member. The 
attribute reduction amount (determined under paragraph (d)(3)(i) of 
this section) is treated as reduced by the amount of any reduction in 
the basis of the S stock under this paragraph (d)(6). Accordingly, the 
election to reduce stock basis under this paragraph (d)(6) is treated 
as reducing or eliminating the duplication even if the shares of S 
stock are loss shares after giving effect to the election.
    (v) Form and manner of election. An election under this paragraph 
(d)(6) is made in the form of a statement titled ``Section 1.1502-36 
Election to Reattribute Attributes,'' ``Section 1.1502-36 Election to 
Reduce Stock Basis,'' or ``Section 1.1502-36 Election to Reattribute 
Attributes and Reduce Stock Basis,'' as applicable. The statement must 
include the name and employer identification number of the subsidiary 
the stock of which is transferred, the name and employer identification 
number of any lower-tier subsidiary whose attributes are reattributed, 
and the amount by which the group is electing to reattribute attributes 
and/or reduce stock basis. The statement must be included on or with 
the group's timely filed original return for the taxable year of the 
transfer of the subsidiary stock to which the election relates.
    (7) Examples. The application of this paragraph (d) is illustrated 
by the following examples:

    Example 1. Computation of attribute reduction amount. (i) 
Transfer of all S shares. (A) Facts. P owns all 100 of the 
outstanding shares of S stock with a basis of $2 per share. S owns 
land with a basis of $100, has a $120 loss carryover, and has no 
liabilities. Each share has a value of $1. P sells 30 of the S 
shares to X for $30. As a result of the sale, P and S cease to be 
members of the same group. Accordingly, P transfers all 100 S 
shares. See paragraphs (f)(11)(i)(A) and (f)(11)(i)(B) of this 
section. P's transfer of the S shares is a transfer of loss shares 
and therefore subject to the provisions of this section.
    (B) Application of paragraphs (b) and (c) of this section. No 
adjustment is required under paragraph (b) of this section either 
redetermination would not change any member's basis in an S share 
(there is only

[[Page 3008]]

one class of stock outstanding and there is no disparity in the 
basis of the shares). See paragraph (b)(1)(ii)(A) of this section. 
No adjustment is required under paragraph (c) of this section 
because the net positive adjustment is $0. See paragraph (c)(3) of 
this section. Thus, after the application of paragraph (c) of this 
section, P's transfer of the S shares is still a transfer of loss 
shares and, accordingly, subject to this paragraph (d).
    (C) Attribute reduction under this paragraph (d). Under this 
paragraph (d), S's attributes are reduced by S's attribute reduction 
amount. Paragraph (d)(3) of this section provides that S's attribute 
reduction amount is the lesser of the net stock loss and S's 
aggregate inside loss. The net stock loss is the excess of the 
aggregate bases of the transferred shares ($200) over the aggregate 
value of the transferred shares ($100), or $100. S's aggregate 
inside loss is the excess of its net inside attribute amount ($220, 
the sum of the $100 basis of the land and the $120 loss carryover) 
over the value of all outstanding S shares ($100), or $120. The 
attribute reduction amount is therefore the lesser of the net stock 
loss ($100) and the aggregate inside loss ($120), or $100. Under 
paragraph (d)(4) of this section, S's $100 attribute reduction 
amount is allocated and applied to reduce S's $120 loss carryover to 
$20. Under paragraph (d)(4)(ii)(C) of this section, the reduction of 
the loss carryover is not a noncapital, nondeductible expense and 
has no effect on P's basis in the S stock.
    (ii) Transfer of less than all S shares. (A) Facts. The facts 
are the same as in paragraph (i)(A) of this Example 1, except that P 
only sells 20 S shares to X. P's sale of the 20 S shares is a 
transfer of loss shares and therefore subject to the provisions of 
this section.
    (B) Application of paragraphs (b) and (c) of this section. No 
adjustment is required under paragraph (b) or paragraph (c) of this 
section for the reasons set forth in paragraph (i)(B) of this 
Example 1. Thus, after the application of paragraph (c) of this 
section, P's transfer of the S shares is still a transfer of loss 
shares and, accordingly, subject to this paragraph (d).
    (C) Attribute reduction under this paragraph (d). Under this 
paragraph (d), S's attributes are reduced by S's attribute reduction 
amount. Paragraph (d)(3) of this section provides that S's attribute 
reduction amount is the lesser of the net stock loss and S's 
aggregate inside loss. The net stock loss is the excess of the 
aggregate bases of the transferred shares ($40) over the aggregate 
value of the transferred shares ($20), or $20. S's aggregate inside 
loss is the excess of its net inside attribute amount ($220) over 
the value of all outstanding S shares ($100), or $120. The attribute 
reduction amount is therefore the lesser of the net stock loss ($20) 
and the aggregate inside loss ($120), or $20. Under paragraph (d)(4) 
of this section, S's $20 attribute reduction amount is allocated and 
applied to reduce S's $120 loss carryover to $100. Under paragraph 
(d)(4)(ii)(C) of this section, the reduction of the loss carryover 
is not a noncapital, nondeductible expense and has no effect on P's 
basis in the S stock.
    Example 2. Proportionate allocation of attribute reduction 
amount. (i) Facts. P owns the sole outstanding share of S stock with 
a basis of $150. S owns land with a basis of $100, a factory with a 
basis of $20, and rental property with a basis of $30. P sells its S 
share for $90. P's sale of the S share is a transfer of a loss share 
and therefore subject to the provisions of this section.
    (ii) Application of paragraphs (b) and (c) of this section. No 
adjustment is required under paragraph (b) of this section, either 
because redetermination would not change any member's basis in a 
share (members hold only one share of S stock) or because P 
transfers the group's entire interest in S to a nonmember in a fully 
taxable transaction. See, respectively, paragraphs (b)(1)(ii)(A) and 
(b)(1)(ii)(B) of this section. No adjustment is required under 
paragraph (c) of this section because the net positive adjustment is 
$0. See paragraph (c)(3) of this section. Thus, after the 
application of paragraph (c) of this section, P's sale of the S 
share is still a transfer of a loss share and, accordingly, subject 
to this paragraph (d).
    (iii) Attribute reduction under this paragraph (d). Under 
paragraph (d)(3) of this section, S's attribute reduction amount is 
determined to be $60, the lesser of the net stock loss ($60) and S's 
aggregate inside loss ($60, the excess of S's $150 net inside 
attribute amount (the $100 basis of the land plus the $20 basis of 
the factory plus the $30 basis of the rental property) over the $90 
value of the S share). Under paragraph (d)(4) of this section, the 
$60 attribute reduction amount is allocated and applied 
proportionately to reduce S's attributes as follows:

----------------------------------------------------------------------------------------------------------------
                                                                           Allocable portion of      Adjusted
                  Available attributes                      Attribute      attribute reduction      attributes
                                                             amount               amount              amount
----------------------------------------------------------------------------------------------------------------
Category E:
    Basis of land......................................            $100      (100/150 x $60) $40             $60
    Basis of factory...................................              20        (20/150 x $60) $8              12
    Basis of rental property...........................              30       (30/150 x $60) $12              18
                                                        --------------------------------------------------------
        Total attributes...............................             150                      $60              90
----------------------------------------------------------------------------------------------------------------

    Example 3. Publicly traded property. (i) Facts. The facts are 
the same as in paragraph (i) of Example 2, except that, instead of 
the factory and rental property, S holds two shares of publicly 
traded stock, Share X (basis and value of $20) and Share Y (basis of 
$30 and value of $5). P's sale of the S share is a transfer of a 
loss share and therefore subject to the provisions of this section.
    (ii) Application of paragraphs (b) and (c) of this section. No 
adjustment is made under paragraph (b) or paragraph (c) of this 
section for the reasons set forth in paragraph (ii) of Example 2. 
Thus, after the application of paragraph (c) of this section, P's 
sale of the S share is still a transfer of a loss share and, 
accordingly, subject to this paragraph (d).
    (iii) Attribute reduction under this paragraph (d). Under 
paragraph (d)(3) of this section, S's attribute reduction amount is 
determined to be $60, the lesser of the net stock loss ($60) and S's 
aggregate inside loss ($60, the excess of S's $150 net inside 
attribute amount (the $20 basis of Share X plus the $30 basis of 
Share Y plus the $100 basis of the land) over the $90 value of the S 
share). Although S has $150 of attributes, S's attributes available 
for reduction include the basis of publicly traded property only to 
the extent it exceeds the value of the property. That loss on 
publicly traded property is a Category D attribute. S's attribute 
reduction amount is allocated and applied to reduce S's attributes 
as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                  Application of
                                                                     Attribute       attribute       Adjusted
                      Available attributes                            amount         reduction       attribute
                                                                                      amount          amount
----------------------------------------------------------------------------------------------------------------
Category D:
    Loss in Share Y.............................................             $25             $25              $0
Category E:
    Basis of land...............................................             100              35              65
                                                                 -----------------------------------------------
        Total attributes........................................             125              60              65
----------------------------------------------------------------------------------------------------------------


[[Page 3009]]


              Attributes After Application of Paragraph (d)
------------------------------------------------------------------------
                        Attribute                             Amount
------------------------------------------------------------------------
Basis of Share X........................................             $20
Basis of Share Y........................................               5
Basis of land...........................................              65
------------------------------------------------------------------------

    Example 4. Attributes attributable to liability not taken into 
account. (i) S operates one business. (A) Facts. On January 1, year 
1, P forms S by exchanging $100 and land with a basis of $50 for the 
sole outstanding share of S stock. In year 1, S earns $500, spends 
$100 to build a factory on its land, and purchases $450 of publicly 
traded property. S also earns a section 38 general business credit 
of $50. However, pollution generated by S's business gives rise to a 
substantial environmental remediation liability under Federal law. 
Before any amounts have been taken into account with respect to the 
environmental remediation liability, P sells its S share to X for 
$150. At the time of the sale, the value of the publicly traded 
property was $450. If X had purchased S's assets and assumed S's 
liabilities directly, X would have been required to capitalize any 
expenses related to environmental remediation. After giving effect 
to all other provisions of law, P's basis in the S share is $650 
(the original basis of $150 increased by the $500 income earned). 
The sale is therefore a transfer of a loss share of subsidiary stock 
and subject to this section.
    (B) Application of paragraphs (b) and (c) of this section. No 
adjustment is required under paragraph (b) of this section, either 
because redetermination would not change any member's basis in a 
share (P holds only one share of S stock) or because P transfers the 
group's entire interest in S to a nonmember in a fully taxable 
transaction. See, respectively, paragraphs (b)(1)(ii)(A) and 
(b)(1)(ii)(B) of this section. No adjustment to basis is made under 
paragraph (c) of this section because, although the net positive 
adjustment is $500, the disconformity amount is $0. See paragraph 
(c)(3) of this section. Thus, after the application of paragraph (c) 
of this section, P's sale of the S share is still a transfer of a 
loss share and, accordingly, subject to this paragraph (d).
    (C) Attribute reduction under this paragraph (d). Under 
paragraph (d)(3) of this section, S's attribute reduction amount is 
the lesser of the net stock loss ($500) and the aggregate inside 
loss. The aggregate inside loss is $500, computed as the excess of 
S's net inside attribute amount ($650, the sum of $100 (basis in 
factory), $50 (basis in land), $450 (basis in publicly traded 
property), and $50 (cash remaining after purchases)) over the value 
of the S share ($150). Thus, S's attribute reduction amount is $500, 
the lesser of the net stock loss ($500) and the aggregate inside 
loss ($500). Under paragraph (d)(4) of this section, S's $500 
attribute reduction amount is allocated and applied to reduce S's 
attributes as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                     Allocable
                                                                                    portion of       Adjusted
                      Available attributes                           Attribute       attribute       attribute
                                                                      amount         reduction        amount
                                                                                      amount
----------------------------------------------------------------------------------------------------------------
Category D:
    Loss on publicly traded property............................              $0              $0              $0
Category E:
    Basis of factory............................................             100             100               0
    Basis of land...............................................              50              50               0
----------------------------------------------------------------------------------------------------------------

    Under the general rule of this paragraph (d), the remaining $350 
attribute reduction amount would have no further effect (and would 
not be applied to reduce S's general business tax credit). However, 
S has a liability that has not been taken into account, and, 
therefore, under paragraph (d)(4)(ii)(A)(1) of this section, the 
remaining $350 attribute reduction amount is suspended and allocated 
and applied to reduce any amounts that would be deductible or 
capitalizable as a result of the liability later being taken into 
account. If the liability is satisfied for an amount that is less 
than $350, under paragraph (d)(4)(ii)(A)(2) the remaining portion of 
that $350 is disregarded and has no further effect.
    (ii) S operates more than one business. (A) Facts. The facts are 
the same as in paragraph (i)(A) of Example 4, except that S operates 
a business providing environmental remediation services. Prior to 
P's sale of the S share, S transfers its environmental remediation 
services business and its $50 of cash to S1 in exchange for the sole 
outstanding share of S1 stock. (S's basis in the assets transferred 
in connection with the environmental remediation business is $0.)
    (B) Application of paragraphs (b) and (c) of this section. No 
adjustment is made under paragraph (b) or paragraph (c) of this 
section for the reasons set forth in paragraph (i)(B) of this 
Example 4. Thus, after the application of paragraph (c) of this 
section, P's sale of the S share is still a transfer of a loss share 
and, accordingly, subject to this paragraph (d).
    (C) Attribute reduction under this paragraph (d). (1) 
Computation of attribute reduction amount. Under paragraph (d)(3) of 
this section, S's attribute reduction amount is the lesser of the 
net stock loss ($500) and the aggregate inside loss. The aggregate 
inside loss is the excess of S's net inside attribute amount over 
the value of the S share. Under paragraph (d)(5)(i)(B) of this 
section, S's net inside attribute amount is determined by using S's 
deemed basis in the S1 share ($50, the greater of its basis ($50) 
and S1's net inside attribute amount ($50)). Accordingly, S's net 
inside attribute amount is $650 (the sum of $100 (basis in factory), 
$50 (basis in land), $450 (basis in publicly traded property), and 
$50 (deemed basis in S1 stock)). The aggregate inside loss is $500, 
computed as the excess of S's net inside attribute amount ($650) 
over the value of the S share ($150). Thus, S's attribute reduction 
amount is $500, computed as the lesser of the net stock loss ($500) 
and the aggregate inside loss ($500).
    (2) Allocation, apportionment, and application of attribute 
reduction amount. Under paragraphs (d)(4) and (d)(5)(ii) of this 
section, S's $500 attribute reduction amount is allocated 
proportionately (by basis) between its assets and the S1 share. 
Under paragraph (d)(5)(ii)(A) of this section, for this purpose, S's 
basis in its S1 share is its deemed basis ($50) reduced by S1's cash 
($50), or, $0. As a result, no portion of S's attribute reduction 
amount is allocated to the S1 share and the entire attribute 
reduction amount is allocated as set forth in paragraph (i)(C) of 
this Example 4. In addition, as in paragraph (i)(C) of this Example 
4, under paragraph (d)(4)(ii)(A)(1) of this section, the remaining 
$350 excess attribute reduction amount is suspended and applied to 
the extent of S's environmental remediation liability to reduce any 
amounts that would be deductible or capitalizable as a result of 
such liability later being taken into account. Alternatively, assume 
that S1 had liabilities for employee medical expenses that had not 
been taken into account for tax purposes, the $350 excess attribute 
reduction amount would be suspended and then allocated and applied 
as S's and S1's liabilities are taken into account. In either case, 
under paragraph (d)(4)(ii)(A)(2) of this section, to the extent the 
suspended amount exceeds the liabilities taken into account, that 
excess is disregarded and has no further effect.
    Example 5. Wholly owned lower-tier subsidiary (no lower-tier 
transfer). (i) Application of conforming limitation. (A)

[[Page 3010]]

Facts. P owns the sole outstanding share of S stock with a basis of 
$250. S owns Asset with a basis of $100 and the only two outstanding 
shares of S1 stock (Share A has a basis of $40 and Share B has a 
basis of $60). S1 owns Asset 1 with a basis of $50. P sells its S 
share to P1, the common parent of another consolidated group, for 
$50. The sale is a transfer of a loss share and therefore subject to 
this section.
    (B) Application of paragraphs (b) and (c) of this section. No 
adjustment is required under paragraph (b) of this section, either 
because redetermination would not change any member's basis in a 
share (members hold only one share of S stock) or because P 
transfers the group's entire interest in S to a nonmember in a fully 
taxable transaction. See, respectively, paragraphs (b)(1)(ii)(A) and 
(b)(1)(ii)(B) of this section. No adjustment is required under 
paragraph (c) of this section because, although there is a $50 
disconformity amount, the net positive adjustment is $0. See 
paragraph (c)(3) of this section. Thus, after the application of 
paragraph (c) of this section, P's sale of the S share is still a 
transfer of a loss share and, accordingly, subject to this paragraph 
(d).
    (C) Attribute reduction under this paragraph (d). (1) 
Computation of attribute reduction amount. Under paragraph (d)(3) of 
this section, S's attribute reduction amount is the lesser of P's 
net stock loss and S's aggregate inside loss. P's net stock loss is 
$200 ($250 basis minus $50 value). S's aggregate inside loss is the 
excess of S's net inside attribute amount over the value of the S 
share. Under paragraphs (d)(3)(iii)(B) and (d)(5)(i) of this 
section, S's net inside attribute amount is $200, computed as the 
sum of S's basis in Asset ($100) and its deemed basis in the S1 
stock (treated as a single share) ($100, computed as the greater of 
S's $100 total basis in the S1 shares and S1's $50 basis in Asset 
1). S's aggregate inside loss is therefore $150 ($200 net inside 
attribute amount minus $50 value of the S share). Accordingly, S's 
attribute reduction amount is $150, the lesser of the net stock loss 
($200) and the aggregate inside loss ($150).
    (2) Allocation, apportionment, and application of S's attribute 
reduction amount. Under paragraphs (d)(4) and (d)(5)(ii) of this 
section, S's $150 attribute reduction amount is allocated 
proportionately (by basis) between Asset (basis $100) and the S1 
stock (treated as a single share) (deemed basis $100). Accordingly, 
$75 of the attribute reduction amount ($100/$200 x $150) is 
allocated to Asset and $75 of the attribute reduction amount ($100/
$200 x $150) is allocated to the S1 stock. The $75 allocated to 
Asset is applied to reduce S's basis in Asset to $25. The $75 
allocated to the S1 stock is first apportioned between the shares in 
a manner that reduces disparity to the greatest extent possible. 
Thus, of the total $75 allocated to the S1 stock, $27.50 is 
apportioned to Share A and $47.50 is apportioned to Share B. The 
application of the apportioned amounts reduces the basis of each 
share to $12.50. As a result, immediately after the allocation, 
apportionment, and application of S's attribute reduction amount, 
S's basis in Asset is $25 and S's basis in each of the S1 shares is 
$12.50.
    (3) Tier down of S's attribute reduction amount, application of 
conforming limitation. Under paragraph (d)(5)(ii)(D) of this 
section, any portion of S's attribute reduction amount allocated to 
S1 stock is an attribute reduction amount of S1 (regardless of the 
extent, if any, to which it is apportioned and applied to reduce the 
basis of any shares of S1 stock). Under the general rules of this 
paragraph (d), the $75 allocated to the S1 stock would be applied to 
reduce S1's basis in Asset 1 to $0. However, under paragraph 
(d)(5)(ii)(D)(2) of this section, S1's attributes can be reduced by 
only $25 as a result of tier down attribute reduction, the excess of 
the portion of S1's net inside attribute amount that is allocable to 
all S1 shares held by members immediately before the transaction 
($50) over the sum of aggregate value of S1 shares transferred by 
members in the transaction (none) and the aggregate amount of 
members' bases in nontransferred S1 shares, after reduction under 
this paragraph ($25). Thus, of S1's $75 tier down attribute 
reduction amount, only $25 is applied to reduce S1's basis in Asset 
1, from $50 to $25. The remaining $50 of allocated amount has no 
further effect.
    (4) Basis restoration. Under paragraph (d)(5)(iii) of this 
section, after this paragraph (d) has been applied with respect to 
all transfers of subsidiary stock, any reduction made to the basis 
of a share of subsidiary stock under paragraph (d)(5)(ii)(B) of this 
section is reversed to the extent necessary to conform the basis of 
that share to the share's allocable portion of the subsidiary's net 
inside attribute amount. S1's net inside attribute amount after the 
application of this paragraph (d) is $25 and thus each of the two S1 
share's allocable portion of S1's net inside attribute amount is 
$12.50. Accordingly, the basis of each share (as reduced by this 
paragraph (d)) is already conformed with its allocable portion of 
S1's net inside attribute amount and no restoration will be required 
or permitted under paragraph (d)(5)(iii) of this section.
    (ii) Application of basis restoration rule. (A) Facts. The facts 
are the same as in paragraph (i)(A) of this Example 5, except that 
S's basis in Share A is $15 and S's basis in Share B is $35, and 
S1's basis in Asset 1 is $100.
    (B) Basis redetermination and basis reduction under paragraphs 
(b) and (c) of this section. No adjustment is required under 
paragraph (b) or paragraph (c) of this section for the reasons set 
forth in paragraph (i)(B) of this Example 5. Thus, after the 
application of paragraph (c) of this section, P's transfer of the S 
share is still a transfer of a loss share and, accordingly, subject 
to this paragraph (d).
    (C) Attribute reduction under this paragraph (d). (1) 
Computation of attribute reduction amount. Under paragraph (d)(3) of 
this section, S's attribute reduction amount is the lesser of P's 
net stock loss and S's aggregate inside loss. P's net stock loss is 
$200 ($250 basis minus $50 value). S's aggregate inside loss is the 
excess of S's net inside attribute amount over the value of the S 
share. Under paragraphs (d)(3)(iii)(B) and (d)(5)(i) of this 
section, S's net inside attribute amount is $200, computed as the 
sum of S's basis in Asset ($100) and its deemed basis in the S1 
stock (treated as a single share) ($100, computed as the greater of 
S's $50 total basis in the S1 shares and S1's $100 basis in Asset 
1). S's aggregate inside loss is therefore $150 ($200 net inside 
attribute amount minus $50 value of the S share). Accordingly, S's 
attribute reduction amount is $150, the lesser of the net stock loss 
($200) and the aggregate inside loss ($150).
    (2) Allocation, apportionment, and application of S's attribute 
reduction amount. Under paragraphs (d)(4) and (d)(5)(ii) of this 
section, S's $150 attribute reduction amount is allocated 
proportionately (by basis) between Asset (basis $100) and the S1 
stock (treated as a single share) (deemed basis $100). Accordingly, 
$75 of the attribute reduction amount ($100/$200 x $150) is 
allocated to Asset and $75 of the attribute reduction amount ($100/
$200 x $150) is allocated to the S1 stock. The $75 allocated to 
Asset is applied to reduce S's basis in Asset to $25. The $75 
allocated to the S1 stock is first apportioned between the shares in 
a manner that reduces disparity to the greatest extent possible. 
Thus, of the total $75 allocated to the S1 stock, $27.50 is 
apportioned to Share A and $47.50 is apportioned to Share B. The 
application of the apportioned amounts reduces the basis of each 
share to an excess loss account of $12.50. As a result, immediately 
after the allocation, apportionment, and application of S's 
attribute reduction amount, S's basis in Asset is $25 and S's basis 
in each of the S1 shares is an excess loss account of $12.50.
    (3) Tier down of S's attribute reduction amount, application of 
limitation. Under paragraph (d)(5)(ii)(D) of this section, any 
portion of S's attribute reduction amount allocated to S1 stock is 
an attribute reduction amount of S1 (regardless of the extent, if 
any, to which it is apportioned and applied to reduce the basis of 
any shares of S1 stock). Accordingly, under the general rules of 
this paragraph (d), the $75 allocated to the S1 stock is applied to 
reduce S1's basis in Asset 1 from $100 to $25.
    (4) Basis restoration. Under paragraph (d)(5)(iii) of this 
section, after this paragraph (d) has been applied with respect to 
all transfers of subsidiary stock, any reduction made to the basis 
of a share of subsidiary stock under paragraph (d)(5)(ii)(B) of this 
section is reversed to the extent necessary to conform the basis of 
that share to the share's allocable portion of the subsidiary's net 
inside attribute amount. S1's net inside attribute amount after the 
application of this paragraph (d) is $25 and thus each of the two S1 
share's allocable portion of S1's net inside attribute amount is 
$12.50. Accordingly, the reductions to share A and to share B under 
this paragraph (d) are reversed to restore the basis of each share 
to $12.50. Thus, $25 of the $27.50 attribute reduction applied to 
reduce the basis of share A and $25 of the $47.50 attribute 
reduction applied to reduce the basis of share B are reversed, 
restoring the basis of each share to $12.50.
    Example 6. Multiple blocks of lower-tier subsidiary stock 
outstanding. (i) Excess loss

[[Page 3011]]

account taken into account (transfer of upper-tier share causes 
disposition within the meaning of Sec.  1.1502-19(c)(1)(ii)(B)). (A) 
Facts. P owns the sole outstanding share of S stock with a basis of 
$200. S holds all five outstanding shares of S1 common stock (shares 
A, B, C, D, and E). S has an excess loss account of $20 in share A 
and a positive basis of $20 in each of the other shares. The only 
investment adjustment applied to any S1 share was a negative $20 
investment adjustment applied to share A when it was the only 
outstanding share, and this amount tiered up and adjusted P's basis 
in the S share. S1 owns one asset with a basis of $250. P sells its 
S share to P1, the common parent of a consolidated group, for $20. 
The sale of the S share is a disposition of share A under Sec.  
1.1502-19(c)(1)(ii)(B) (after the transaction, S1 will no longer be 
a member of the P group). Under paragraph (a)(3)(i) of this section, 
before the application of this section, S's excess loss account in 
share A is taken into account, increasing S's basis in share A to $0 
and P's basis in its S share to $220. After giving effect to the 
recognition of the excess loss account, P's sale of the S share is a 
transfer of a loss share and therefore subject to the provisions of 
this section.
    (B) Basis redetermination and basis reduction under paragraphs 
(b) and (c) of this section. No adjustment is made under paragraph 
(b) of this section, either because redetermination would change no 
member's basis in a share (members hold only one share of S stock) 
or because P transfers the group's entire interest in S to a 
nonmember in a fully taxable transaction. See, respectively, 
paragraphs (b)(1)(ii)(A) and (b)(1)(ii)(B) of this section. No 
adjustment is made under paragraph (c) of this section because, even 
though there is a disconformity amount of $120, the net positive 
adjustment is zero. See paragraph (c)(3) of this section. Thus, 
after the application of paragraph (c) of this section, P's sale of 
the S share remains a transfer of a loss share and, accordingly, 
subject to this paragraph (d).
    (C) Attribute reduction under this paragraph (d). (1) 
Computation of attribute reduction amount. Under paragraph (d)(3) of 
this section, S's attribute reduction amount is the lesser of P's 
net stock loss and S's aggregate inside loss. P's net stock loss is 
$200 (the S share's $220 basis minus its $20 value). S's aggregate 
inside loss is the excess of S's net inside attribute amount over 
the value of the S share. Under paragraphs (d)(3)(iii)(B) and 
(d)(5)(i) of this section, S's net inside attribute amount is $250, 
S's deemed basis in the S1 stock (treated as a single share) ($250, 
computed as the greater of S's $80 total basis in the S1 shares ($0 
basis of share A plus $20 of basis in each of the four other shares) 
and S1's $250 basis in its asset). S's aggregate inside loss is 
therefore $230 ($250 net inside attribute amount minus $20 value of 
the S share). Accordingly, S's attribute reduction amount is $200, 
the lesser of the net stock loss ($200) and the aggregate inside 
loss ($230).
    (2) Allocation, apportionment, and application of S's attribute 
reduction amount. Under paragraphs (d)(4) and (d)(5)(ii) of this 
section, S's $200 attribute reduction amount is allocated entirely 
to the S1 stock (treated as a single share) and then apportioned 
among the shares in a manner that reduces disparity to the greatest 
extent possible. Thus, $24 is apportioned to share A and $44 is 
apportioned to each of the other shares. Because there is no 
transfer of the S1 shares, the apportioned amounts are applied fully 
to reduce the basis of each share to an excess loss account of $24.
    (3) Tier down of S's attribute reduction amount. Under paragraph 
(d)(5)(ii)(D) of this section, the $200 of S's attribute reduction 
amount allocated to the S1 shares is an attribute reduction amount 
of S1 (regardless of the extent, if any, to which it is apportioned 
and applied to reduce the basis of any shares of S1 stock). 
Accordingly, under the general rules of this paragraph (d), S1's 
$200 attribute reduction amount is allocated and applied to reduce 
S1's basis in its asset from $250 to $50.
    (4) Basis restoration. Under paragraph (d)(5)(iii) of this 
section, after this paragraph (d) has been applied with respect to 
all transfers of subsidiary stock, any reduction made to the basis 
of a share of subsidiary stock under paragraph (d)(5)(ii)(B) of this 
section is reversed to the extent necessary to conform the basis of 
that share to the share's allocable portion of the subsidiary's net 
inside attribute amount. S1's net inside attribute amount after the 
application of this paragraph (d) is $50 and thus each of the five 
S1 share's allocable portion of S1's net inside attribute amount is 
$10. Accordingly, the reductions to the bases of S1 stock under this 
paragraph (d) are reversed to restore (to the extent possible) the 
basis of each share to $10. Thus, $24 of the $24 attribute reduction 
applied to reduce the basis of share A is reversed, restoring the 
basis of share A to $0, and $34 of the $44 attribute reduction 
applied to reduce the basis of each other share is reversed, 
restoring the basis of each of those shares to $10.
    (ii) Sale of gain share to member. (A) Facts. The facts are the 
same as in paragraph (i)(A) of this Example 6, except that P owns 
shares A, B, C, and D, S owns share E, S has a liability of $20, and 
S1's basis in its asset is $500. Also, as part of the transaction, S 
sells share E to P for $40. Unlike under the facts of paragraph 
(i)(A) of this Example 6, there is no disposition of share A within 
the meaning of Sec.  1.1502-19(c)(1)(ii)(B) (because the share 
continues to be held by P, and S1 continues to be a member of the P 
group). As a result, the share A excess loss account is not taken 
into account. Although S's sale of share E is a transfer of that 
share, the share is not a loss share and thus the transfer is not 
subject to this section. P's sale of the S share, however, is a 
transfer of a loss share and therefore subject to the provisions of 
this section.
    (B) Transfer in lowest tier (gain share). S's sale of share E is 
the lowest tier transfer in the transaction. Under paragraph 
(a)(3)(ii)(A)(1) of this section, because there are no transfers of 
loss shares at that tier, no adjustments are required under 
paragraphs (b) and (c) of this section. However, S's gain recognized 
on the transfer of share E is computed and immediately adjusts 
members basis in subsidiary stock under the principles of Sec.  
1.1502-32 (because P and S are not members of the same group 
immediately after the transaction the sale is not subject to Sec.  
1.1502-13). Accordingly, P's basis in its S share is increased by 
$20, from $200 to $220.
    (C) Transfers in next higher (the highest) tier (application of 
paragraphs (b) and (c) of this section). The next highest tier 
transfer is P's sale of the S stock. Because the sale is a transfer 
of a loss share, first paragraph (b) of this section and then 
paragraph (c) of this section apply to the transfer. No adjustments 
are required under paragraph (b), either because there is no 
potential for redetermination (members hold only one share of S 
stock) or because P transfers the group's entire interest in S to a 
nonmember in a fully taxable transaction. See, respectively, 
paragraphs (b)(1)(ii)(A) and (b)(1)(ii)(B) of this section. Under 
paragraph (c) of this section, P's basis in its S share is decreased 
by $20, the lesser of the disconformity amount ($200, computed as 
the excess of stock basis ($220) over S's net inside attribute 
amount ($20, the $40 value of the transferred Share E minus the $20 
liability)) and the net positive adjustment ($20). Thus, after the 
application of paragraph (c) of this section, P's basis in the S 
share is $200, and the sale remains a transfer of a loss share. 
There are no higher tier transfers and, therefore, P's transfer of 
the S share is then subject to this paragraph (d).
    (D) Attribute reduction under this paragraph (d). (1) 
Computation of attribute reduction amount. Under paragraph (d)(3) of 
this section, S's attribute reduction amount is the lesser of P's 
net stock loss and S's aggregate inside loss. After the application 
of paragraph (c) of this section, P's net stock loss is $180 (the S 
share's $200 basis minus its $20 value). S's aggregate inside loss 
is the excess of S's net inside attribute amount over the value of 
the S share. Under paragraphs (d)(3)(iii)(B) and (d)(5)(i) of this 
section, S's net inside attribute amount is $80, computed as $100 
(S's deemed basis in share E (the greater of S's basis in share E, 
adjusted for the gain recognized, ($40) and share E's allocable 
portion of S1's net inside attribute amount ($100, representing 1/5 
of S1's $500 basis in its asset)) minus S's liability ($20). 
Accordingly, S's net aggregate inside loss is $60 ($80 net inside 
attribute amount minus $20 value of the S stock). S's attribute 
reduction amount is therefore the lesser of $180 and $60, or $60.
    (2) Allocation, apportionment, and application of S's attribute 
reduction amount. Under paragraphs (d)(4) and (d)(5)(ii) of this 
section, S's $60 attribute reduction amount is allocated entirely to 
its S1 stock, share E. However, under paragraph (d)(5)(ii)(B)(1) of 
this section, none of the allocated amount is apportioned to, or 
applied to reduce the basis of share E because share E was 
transferred in a transaction in which gain or loss was recognized. 
Under paragraph (d)(5)(ii)(C) of this section, the $60 allocated 
amount not apportioned to share E has no effect on S or S's 
attributes.
    (3) Tier down of S's attribute reduction amount. Notwithstanding 
the fact that no portion of the allocated amount was apportioned to 
or applied to reduced the basis of share E, the entire $60 allocated 
amount tiers down and is an attribute

[[Page 3012]]

reduction amount of S1. See paragraphs (d)(5)(ii)(C) and 
(d)(5)(ii)(D) of this section. Under the general rules of this 
paragraph (d), S1's $60 attribute reduction amount is allocated and 
applied to reduce S1's basis in its asset from $500 to $440.
    (4) Basis restoration. Under paragraph (d)(5)(iii) of this 
section, after this paragraph (d) has been applied with respect to 
all transfers of subsidiary stock, any reduction made to the basis 
of a share of subsidiary stock under paragraph (d)(5)(ii)(B) of this 
section is reversed to the extent necessary to conform the basis of 
that share to the share's allocable portion of the subsidiary's net 
inside attribute amount. No reduction was made to the basis of any 
share of subsidiary stock under paragraph (d)(5)(ii)(B) of this 
section. Therefore, no stock basis is increased under the basis 
restoration rule in paragraph (d)(5)(iii) of this section.
    Example 7. Allocation of attribute reduction if lower-tier 
subsidiary has nonloss assets or liabilities. (i) S1 holds cash. (A) 
Facts. P owns the sole outstanding share of S stock with a basis of 
$800. S owns Asset 1 with a basis of $400 and the sole outstanding 
share of S1 stock with a basis of $300. S1 holds Asset 2 with a 
basis of $50, and $100 cash. P sells its S share to P1, the common 
parent of a consolidated group, for $100.
    (B) Application of paragraphs (b) and (c) of this section. No 
adjustment is required under paragraph (b) of this section, either 
because redetermination would change no member's basis in a share 
(members hold only one share of S stock) or because P transfers the 
group's entire interest in S to a nonmember in a fully taxable 
transaction. See, respectively, paragraphs (b)(1)(ii)(A) and 
(b)(1)(ii)(B) of this section. No adjustment is required under 
paragraph (c) of this section because the net positive adjustment is 
$0. See paragraph (c)(3) of this section. Thus, after the 
application of paragraph (c) of this section, P's sale of the S 
share is still a transfer of a loss share and, accordingly, subject 
to this paragraph (d).
    (C) Attribute reduction under this paragraph (d). (1) 
Computation of attribute reduction amount. Under paragraph (d)(3) of 
this section, S's attribute reduction amount is the lesser of P's 
net stock loss and S's aggregate inside loss. P's net stock loss is 
$700 (the S share's $800 basis minus its $100 value). S's aggregate 
inside loss is the excess of S's net inside attribute amount over 
the value of the S share. Under paragraphs (d)(3)(iii)(B) and 
(d)(5)(i) of this section, S's net inside attribute amount is the 
sum of its basis in Asset 1 of $400 and its deemed basis in the S1 
share. S's deemed basis in the S1 share is $300, the greater of S's 
basis in the S1 share ($300) and S1's net inside attribute amount 
($150, S1's $50 basis in Asset 2 plus S1's $100 cash). Therefore, 
S's net inside attribute amount is $700 and S's aggregate inside 
loss is $600 ($700 net inside attribute amount less $100 value). S's 
attribute reduction amount is $600, the lesser of the net stock loss 
($700) and the aggregate inside loss ($600).
    (2) Allocation, apportionment, and application of S's attribute 
reduction amount. Under paragraphs (d)(4) and (d)(5)(ii)(A) of this 
section, S's $600 attribute reduction amount is allocated 
proportionately (by basis) between S's basis in Asset 1 ($400) and 
its deemed basis in the S1 share. For purposes of allocating the 
attribute reduction amount, S's deemed basis in the S1 share is 
reduced by S1's $100 cash (from $300 to $200). Thus, the $600 is 
allocated $400 to Asset 1 ($400/$600 x $600) and $200 to the S1 
share ($200/$600 x $600). The $400 allocated to Asset 1 is applied 
to reduce S's basis in Asset 1 to $0. The $200 allocated to the S1 
share is apportioned and applied to reduce S's basis in the S1 share 
to $100.
    (3) Tier down of S's attribute reduction amount. Under paragraph 
(d)(5)(ii)(D) of this section, any portion of S's attribute 
reduction amount allocated to the S1 stock is an attribute reduction 
amount of S1 (regardless of the extent, if any, to which it is 
apportioned and applied to reduce the basis of any shares of S1 
stock). Accordingly, under the general rules of this paragraph (d), 
the $200 allocated to the S1 share is an attribute reduction amount 
of S1 that is allocated and applied entirely to reduce S1's basis in 
Asset 2 from $50 to $0. The remaining $150 S1 attribute reduction 
amount is disregarded and has no further effect.
    (4) Basis restoration. Under paragraph (d)(5)(iii) of this 
section, after this paragraph (d) has been applied with respect to 
all transfers of subsidiary stock, any reduction made to the basis 
of a share of subsidiary stock under paragraph (d)(5)(ii)(B) of this 
section is reversed to the extent necessary to conform the basis of 
that share to the share's allocable portion of the subsidiary's net 
inside attribute amount. S1's net inside attribute amount after the 
application of this paragraph (d) is $100 and thus the S1 share's 
allocable portion of S1's net inside attribute amount is $100. 
Accordingly, the basis of the share (as reduced by this paragraph 
(d)) is already conformed with its allocable portion of S1's net 
inside attribute amount and no restoration will be required or 
permitted under paragraph (d)(5)(iii) of this section.
    (ii) S1 borrows cash. The facts are the same as in paragraph 
(i)(A) of this Example 7 except that S1 borrows $50 from X, an 
unrelated person, immediately before P sells the S share. The 
computation of the attribute reduction amount is the same as in 
paragraph (i)(C) of this Example 7 (because the $50 cash from the 
loan proceeds and the $50 liability offset in the computation of S's 
net inside attribute amount). However, under paragraph (d)(5)(ii)(A) 
of this section, for purposes of allocating the attribute reduction 
amount, deemed basis is reduced by the amount of S1's cash, but only 
to the extent it exceeds S1's liabilities. S1's cash ($150, the 
original $100 plus the $50 loan proceeds) exceeds its liability 
($50) by $100, so S's deemed basis in the S1 share is reduced by 
$100 (from $300 to $200) for allocation purposes. The results are 
the same as in paragraph (i) of this Example 7.
    (iii) S1 borrows cash and invests in non-publicly traded 
property. (A) Facts. The facts are the same as in paragraph (ii) of 
this Example 7 except that S1 uses its $150 (the original $100 plus 
the $50 loan proceeds) to purchase Asset 3, an asset that is not 
publicly traded.
    (B) Application of paragraphs (b) and (c) of this section. No 
adjustment is required under paragraph (b) or paragraph (c) of this 
section for the reasons set forth in paragraph (i)(B) of this 
Example 7. Thus, after the application of paragraph (c) of this 
section, P's sale of the S share is still a transfer of a loss share 
and, accordingly, subject to this paragraph (d).
    (C) Attribute reduction under this paragraph (d). (1) 
Computation of attribute reduction amount. The attribute reduction 
amount is the same as computed in paragraph (i)(C)(1) of this 
Example 7 (because $50 of the basis in S1's assets and the $50 
liability offset in the computation of S1's net inside attribute 
amount of $150).
    (2) Allocation, apportionment, and application of S's attribute 
reduction amount. Under paragraphs (d)(4) and (d)(5)(ii)(A) of this 
section, S's $600 attribute reduction amount is allocated 
proportionately (by basis) between S's basis in Asset 1 ($400) and 
its deemed basis in the S1 share. For purposes of allocating the 
attribute reduction amount, deemed basis is only reduced for 
allocation purposes by cash, cash equivalents, and the value of 
publicly traded property (reduced by liabilities). Thus, there is no 
reduction to the basis of the S1 share for purposes of allocating 
the attribute reduction amount. Accordingly, S's $600 attribute 
reduction amount is allocated $343 ($400/$700 x $600) to Asset 1 and 
$257 ($300/$700 x $600) to the S1 share.
    (3) Tier down of S's attribute reduction amount, application of 
conforming limitation. Under paragraph (d)(5)(ii)(D) of this 
section, any portion of S's attribute reduction amount allocated to 
the S1 stock is an attribute reduction amount of S1 (regardless of 
the extent, if any, to which it is apportioned and applied to reduce 
the basis of any shares of S1 stock). Thus, the entire $257 of S's 
attribute reduction amount allocated to the S1 share is an attribute 
reduction amount of S1. Under the general rules of this paragraph 
(d), the entire amount is allocated to, and would be applied to 
reduce, S1's bases in Asset 2 and Asset 3, reducing the basis of 
both assets to $0. However, under paragraph (d)(5)(ii)(D)(2) of this 
section, the reduction is limited to the excess of S1's net inside 
attribute amount ($150) over S's basis in the S1 share after 
reduction under this paragraph (d) ($43). Thus, of the $257 
attribute reduction amount allocated to the S1 share, only $107 is 
applied proportionately to reduce S1's bases in Asset 2 by $26.75 
($50/$200 x $107), to $23.25, and Asset 3 by $80.25 ($150/$200 x 
$107), to $69.75. The remaining $150 S1 attribute reduction amount 
is disregarded has no further effect.
    (4) Basis restoration. Under paragraph (d)(5)(iii) of this 
section, after this paragraph (d) has been applied with respect to 
all transfers of subsidiary stock, any reduction made to the basis 
of a share of subsidiary stock under paragraph (d)(5)(ii)(B) of this 
section is reversed to the extent necessary to conform the basis of 
that share to the share's allocable portion of the subsidiary's net 
inside attribute amount. S1's net inside

[[Page 3013]]

attribute amount after the application of this paragraph (d) is $43 
($23.25 basis in Asset 2 plus $69.75 basis in Asset 3 minus $50 
liability) and thus the S1 share's allocable portion of S1's net 
inside attribute amount is $43. Accordingly, the basis of the share 
(as reduced by this paragraph (d)) is already conformed with its 
allocable portion of S1's net inside attribute amount and no 
restoration will be required or permitted under paragraph 
(d)(5)(iii) of this section.
    Example 8. Election to reduce stock basis or reattribute 
attributes under paragraph (d)(6) of this section. (i) 
Deconsolidating sale. (A) Facts. P owns the sole outstanding share 
of M stock with a basis of $1,000. M owns all 100 outstanding shares 
of S stock with a basis of $2.10 per share ($210 total). M sells all 
its S shares to X for $1 per share (total $100) and makes no 
election under paragraph (d)(6) of this section. At the time of the 
sale, S has no liabilities and the following:

------------------------------------------------------------------------
                                                             Attribute
            Category                    Attribute             amount
------------------------------------------------------------------------
Category A.....................  NOL....................             $10
Category E.....................  Basis of Asset 1.......              20
                                 Basis of Asset 2.......             180
                                ----------------------------------------
                                   Total Category E.....             200
------------------------------------------------------------------------

    (B) Application of paragraphs (b) and (c) of this section. No 
adjustment is made under paragraph (b) of this section, either 
because redetermination would change no member's basis in a share (S 
has only one class of stock outstanding and there is no disparity in 
the basis of the shares) or because P transfers the group's entire 
interest in S to a nonmember in a fully taxable transaction. See, 
respectively, paragraphs (b)(1)(ii)(A) and (b)(1)(ii)(B) of this 
section. No adjustment is required under paragraph (c) of this 
section because the net positive adjustment is $0. See paragraph 
(c)(3) of this section. Thus, after the application of paragraph (c) 
of this section, M's transfer of the S shares is still a transfer of 
loss shares and, accordingly, subject to this paragraph (d).
    (C) Attribute reduction under this paragraph (d). (1) 
Computation of attribute reduction amount. Under paragraph (d)(3) of 
this section, S's attribute reduction amount is the lesser of the 
net stock loss ($110, P's aggregate basis in the transferred S 
shares ($210) less the aggregate value of the transferred shares 
($100)) and S's aggregate inside loss. S's aggregate inside loss is 
$110 (S's $210 net inside attribute amount (the $10 NOL plus the $20 
basis of Asset 1 plus the $180 basis of Asset 2) less the $100 value 
of all outstanding S shares). Thus, the attribute reduction amount 
is $110.
    (2) Application of attribute reduction amount. S's $110 
attribute reduction amount is applied as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                     Adjusted
             Category                    Attribute          Attribute    Allocation of attribute     attribute
                                                             amount          reduction amount         amount
----------------------------------------------------------------------------------------------------------------
Category A.......................  NOL.................             $10                      $10              $0
Category E.......................  Basis of Asset 1....              20      (20/200 x $100) $10              10
                                   Basis of Asset 2....             180     (180/200 x $100) $90              90
                                  ------------------------------------------------------------------------------
                                      Total Category E.             200                     $100             100
----------------------------------------------------------------------------------------------------------------

    (D) Results. The P group realizes a $110 loss on M's sale of the 
S shares, which reduces P's basis in the M share from $1,000 to 
$890. The reduction of S's attributes is not a noncapital, 
nondeductible expense of S and does not tier up to reduce the basis 
of the S shares or M share. Immediately after the transaction, the 
entities own the following:

------------------------------------------------------------------------
             Entity                       Asset                Basis
------------------------------------------------------------------------
P..............................  M share................            $890
X..............................  100 S shares...........             100
S..............................  Asset 1................              10
                                 Asset 2................              90
------------------------------------------------------------------------

    (E) Election to reduce stock basis. The facts are the same as in 
paragraph (i)(A) of this Example 8 except that P elects under 
paragraph (d)(6) of this section to reduce M's basis in the S shares 
by the full attribute reduction amount of $110, in lieu of S 
reducing its attributes. The election is effective for all 
transferred loss shares and is allocated to such shares in 
proportion to the loss in each share. Accordingly, the basis of each 
of the 100 transferred shares is reduced from $2.10 to $1.00. After 
giving effect to the election, the S shares are not loss shares and 
this section has no further application to the transfer. The 
reduction of M's basis in the S shares pursuant to the election 
under paragraph (d)(6) of this section is a noncapital, 
nondeductible expense of M that will reduce P's basis in the M 
share. See paragraph (d)(6)(iv) of this section. Immediately after 
the transaction, the entities own the following:

------------------------------------------------------------------------
                                                              Basis/
             Entity                                          attribute
------------------------------------------------------------------------
P..............................  M share................            $890
X..............................  100 S shares...........             100
S..............................  NOL....................              10
                                 Asset 1................              20
                                 Asset 2................             180
------------------------------------------------------------------------

    (F) Election to reattribute losses. The facts are the same as in 
paragraph (i)(A) of this Example 8 except that P elects under 
paragraph (d)(6) of this section to reattribute S's attributes. 
Although S's attribute reduction amount is $110, P can only

[[Page 3014]]

reattribute attributes in Category A, Category B, and Category C. P 
can therefore elect to reattribute $10 of attributes (the NOL), and, 
as a result, will reduce S's NOL to $0. The reattribution of the $10 
NOL is a noncapital, nondeductible expense of S, and under Sec.  
1.1502-32(c)(1)(ii)(B) this expense is allocated to the loss shares 
of S stock sold in proportion to the loss in the shares, or $.10 per 
share. Further, this expense tiers up under the general rules of 
Sec.  1.1502-32 and reduces P's basis in the M stock by $10. After 
giving effect to the election, the P group would realize a $100 loss 
on M's sale of the S shares. M could recognize the $100 stock loss 
(in which case S's basis in Asset 1 and Asset 2 would be reduced to 
$10 and $90, respectively, as in paragraph (i)(C)(2) of this Example 
8) or P could elect to reduce M's basis in the S shares by all or 
any portion of the $100 stock loss (in which case S's attribute 
reduction amount would be reduced by the amount of the reduction in 
the basis of the S stock, and S's basis in Asset 1 and Asset 2 would 
be reduced proportionately).
    (ii) Nondeconsolidating sale. (A) Facts. The facts are the same 
as in paragraph (i)(A) of this Example 8, except that M only sells 
20 S shares (for a total of $20).
    (B) Application of paragraphs (b) and (c) of this section. No 
adjustment is required under paragraph (b) or paragraph (c) of this 
section for the reasons set forth in paragraph (i)(B) of this 
Example 8. Thus, after the application of paragraph (c) of this 
section, M's sale of the S shares is still a transfer of loss shares 
and, accordingly, subject to this paragraph (d).
    (C) Attribute reduction under this paragraph (d). (1) 
Computation of attribute reduction amount. Under paragraph (d)(3) of 
this section, S's attribute reduction amount is the lesser of the 
net stock loss ($22, P's aggregate basis in the transferred S shares 
($42) less the aggregate value of the transferred shares ($20)) and 
S's $110 aggregate inside loss (as calculated in paragraph (i)(C)(1) 
of this Example 8). Thus, the attribute reduction amount is $22.
    (2) Application of attribute reduction amount. S's $22 attribute 
reduction amount is applied as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                     Adjusted
             Category                    Attribute          Attribute    Allocation of attribute     attribute
                                                             amount          reduction amount         amount
----------------------------------------------------------------------------------------------------------------
Category A.......................  NOL.................             $10                      $10           $0
Category E.......................  Basis of Asset 1....              20     (20/200 x $12) $1.20           18.80
                                   Basis of Asset 2....             180   (180/200 x $12) $10.80          169.20
                                  ------------------------------------------------------------------------------
                                      Total Category E              200                      $12          188
----------------------------------------------------------------------------------------------------------------

    (D) Results. The P group realizes a $22 loss on M's sale of the 
S shares, which reduces P's basis in the M share from $1,000 to 
$978. The reduction of S's attributes is not a noncapital, 
nondeductible expense of S and does not tier up to reduce the basis 
of the S shares or M share. Immediately after the transaction, the 
entities have the following:

------------------------------------------------------------------------
             Entity                       Asset                Basis
------------------------------------------------------------------------
P..............................  M share................         $978
X..............................  20 S shares............           20
S..............................  Asset 1................           18.80
                                 Asset 2................          169.20
------------------------------------------------------------------------

    (E) Election to reduce stock basis. The facts are the same as 
paragraph (ii)(A) of this Example 8, except that P elects under 
paragraph (d)(6) of this section to reduce M's basis in the S shares 
by the full attribute reduction amount of $22, in lieu of S reducing 
its attributes. The election is effective for all transferred loss 
shares and is allocated to such shares in proportion to the loss in 
each share. Accordingly, the basis of each of the 20 transferred 
shares is reduced from $2.10 to $1.00. The P group realizes no loss 
on M's sale of the S shares. The reduction of M's basis in the S 
shares pursuant to the election under paragraph (d)(6) of this 
section is a noncapital, nondeductible expense of M that will reduce 
P's basis in the M share. Immediately after the transaction, the 
entities have the following:

------------------------------------------------------------------------
                                                              Basis/
             Entity                                          attribute
------------------------------------------------------------------------
P..............................  M share................         $978
X..............................  20 S shares............           20
S..............................  NOL....................           10
                                 Asset 1................           20
                                 Asset 2................          180
------------------------------------------------------------------------

    (F) Subsequent events. As the NOL is absorbed and/or Asset 1 or 
Asset 2 are depreciated or sold, the anti-duplication provision of 
Sec.  1.1502-80(a) prevents the inclusion of the $10 NOL and $12 of 
realized loss on Asset 1 and Asset 2 in the investment adjustment to 
any shares.
    (G) Election to reattribute attributes. The facts are the same 
as paragraph (ii)(A) of this Example 8. Because S remains a member 
of the P group following M's sale of S stock, P cannot elect under 
paragraph (d)(6) of this section to reattribute any portion of S's 
attributes in lieu of attribute reduction.
    Example 9. Transfers at multiple tiers, gain and loss shares. 
(i) Facts. P owns the sole outstanding share of S stock with a basis 
of $700. S owns Asset 1 (basis of $170) and all ten outstanding 
shares of S1 common stock ($170 basis in share 1, $10 basis in share 
2, and $15 basis in each of share 3 through share 10). S1 owns the 
sole outstanding share of S2 ($0 basis), the sole outstanding share 
of S3 ($60 basis), and the sole outstanding share of S4 ($100 
basis). S2's sole asset is Asset 2 ($75 basis). S3's sole asset is 
Asset 3 ($75 basis). S4's sole asset is Asset 4 ($80 basis). In one 
transaction, P sells its S share to P1 (the common parent of a 
consolidated group) for $240, S sells S1 share 1 to X for $20, S 
transfers S1 share 2 to a partnership in a section 721 transaction, 
and S1 sells its S2 share to Y for $50. No election is made under 
paragraph (d)(6) to reduce stock basis or reattribute attributes.
    (ii) Transfer in lowest tier (only gain share). S1's sale of the 
S2 share is a transfer of the S2 share and that is the lowest tier 
in which there is a transfer. There is no transfer of a loss share 
at that tier, and thus this section does not apply to that transfer. 
The gain recognized on the transfer of the S2 share is computed and 
is applied to adjust the basis of members' shares of subsidiary 
stock under the principles of Sec.  1.1502-32. Accordingly, $5 is 
allocated to each of S1 shares, increasing the basis of share 1 to 
$175, the basis of share 2 to $15, and the basis of each other share 
to $20. The $50 applied to S's

[[Page 3015]]

bases in S1 shares then tiers up to increase P's basis in the S 
share from $700 to $750.
    (iii) Transfers in next highest tier (loss share). S's sale of 
the S1 share 1 and S's transfer of the S1 share 2 to a partnership 
are both transfers of stock in the next higher tier. However, only 
the S1 share 1 is a loss share and so this section only applies with 
respect to the transfer of that share.
    (A) Basis redetermination under paragraph (b) of this section. 
Under paragraph (b)(2)(i)(A) of this section, members' bases in S1 
shares are redetermined by first removing the positive investment 
adjustments applied to the bases of transferred loss shares. 
Accordingly, the $5 positive investment adjustment applied to the 
basis of S1 share 1 is removed, reducing the basis of S1 share 1 
from $175 to $170. Because there were no negative adjustments made 
to the bases of S1 shares, there are no negative adjustments that 
can be reallocated to further reduce the basis of S1 share 1. 
Finally, under paragraph (b)(2)(ii)(B), the positive investment 
adjustment removed from S1 share 1 is reallocated and applied to 
increase the bases of other S1 shares in a manner that reduces 
disparity to the greatest extent possible. Accordingly, the entire 
$5 is reallocated and applied to increase the basis of S1 share 2, 
from $15 to $20. After basis is redetermined under paragraph (b) of 
this section, S1 share 1 is still a loss share and therefore subject 
to basis reduction under paragraph (c) of this section.
    (B) Basis reduction under paragraph (c) of this section. No 
adjustment is required to the basis of S1 share 1 under paragraph 
(c) of this section because, although the disconformity amount is 
$149 (the excess of the $170 stock basis over the share's $21 
allocable portion of S1's net inside attribute amount ($210, 
determined under paragraph (c)(5) of this section as S1's basis in 
the stock of S2 (adjusted for the gain recognized) ($50), S3 ($60), 
and S4 ($100))), the share's net positive adjustment is $0 (because 
the $5 positive investment adjustment originally allocated to S1 
share 1 was reallocated to S1 share 2 under paragraph (b) of this 
section). See paragraph (c)(3) of this section.
    (C) Computation of loss, adjustments to stock basis. S 
recognizes a loss of $150 on the sale of the S1 share 1 ($170 
adjusted basis minus $20 amount realized). P's basis in its S share 
is therefore decreased by the $150 loss recognized by S (on the sale 
of the S1 share) and increased by the $50 gain that tiered up from 
S1 (as a result of S1's sale of the S2 share). Following these 
adjustments, P's basis in the S share is $600 and the sale of the S 
share is still a transfer of a loss share.
    (iv) Transfer in highest tier (loss share). The sale of the S 
share is a transfer in the next higher tier, which is the highest 
tier in this transaction. Because the sale is a transfer of a loss 
share, it is subject to this section.
    (A) Basis redetermination and basis reduction under paragraphs 
(b) and (c) of this section. No adjustment is required under 
paragraph (b) of this section, either because there is no potential 
for redetermination (members hold only one share of S stock) or 
because P transfers the group's entire interest in S to a nonmember 
in a fully taxable transaction. See, respectively, paragraphs 
(b)(1)(ii)(A) and (b)(1)(ii)(B) of this section. In addition, no 
adjustment is required under paragraph (c) of this section because, 
although the disconformity amount is $230 (the excess of the $600 
stock basis over the $370 allocable portion of S's net inside 
attribute amount ($370, determined under paragraph (c)(5) of this 
section as S's basis in the stock of S1 (adjusted for the loss 
recognized) ($200) and Asset 1 ($170))), the share's net positive 
adjustment is $0. See paragraph (c)(3) of this section. Accordingly, 
the sale of the S share is still a transfer of a loss share. Because 
there are no higher-tier loss shares transferred in the transaction, 
this paragraph (d) then applies with respect to the transfer of the 
S share.
    (B) Attribute reduction under this paragraph (d). (1) 
Computation of S's attribute reduction amount. Under paragraph 
(d)(3) of this section, S's attribute reduction amount is the lesser 
of P's net stock loss and S's aggregate inside loss. P's net stock 
loss is $360 (the S share's $600 adjusted basis minus $240 amount 
realized). S's aggregate inside loss is the excess of S's net inside 
attribute amount over the value of the S share. S's net inside 
attribute amount is the sum of its bases in its assets, treating its 
S1 shares as a single share (the S1 stock) and treating S's deemed 
basis in the S1 stock as its basis in that stock. Under paragraph 
(d)(5)(i)(C) of this section, when subsidiaries are owned in 
multiple tiers, deemed basis is first determined for shares at the 
lowest tier, and then for stock in each next higher tier. S1's 
deemed basis in the S2 stock is $75 (the greater of $50 (S1's basis 
in the S2 share ($0) increased by the $50 gain recognized) and $75 
(S2's basis in Asset 2)). S1's deemed basis in the S3 stock is $75 
(computed as the greater of $60 (S1's basis in the S3 share) and $75 
(S3's basis in Asset 3)). S1's deemed basis in the S4 stock is $100 
(computed as the greater of $100 (S1's basis in the S4 share) and 
$80 (S4's basis in Asset 4)). Accordingly, S1's net inside attribute 
amount is $250 ($75 deemed basis in the S2 stock plus $75 deemed 
basis in the S3 stock plus $100 deemed basis in the S4 stock). S's 
deemed basis in the S1 stock is the greater of the sum of S's actual 
basis in each share of S1 stock (adjusted for any gain or loss 
recognized) and S1's net inside attribute amount. S's actual basis 
in the S1 stock, adjusted for the loss recognized, is $200 (the sum 
of S's $170 basis in the S1 share 1 and S's $20 basis in each other 
S1 share, reduced by the $150 loss recognized). Thus, S's deemed 
basis in the S1 stock is $250, the greater of $200 (aggregate basis 
in S1 shares, adjusted for loss recognized) and $250 (S1's net 
inside attribute amount). As a result, S's net inside attribute 
amount is $420, the sum of $250 (S's deemed basis in S1 stock) and 
$170 (S's basis in Asset 1). Accordingly, the aggregate inside loss 
is $180, the excess of S's net inside attribute amount ($420) over 
the value of all of the S stock ($240). S's attribute reduction 
amount is therefore $180, the lesser of the net stock loss ($360) 
and the aggregate inside loss ($180).
    (2) Allocation, apportionment, and application of S's attribute 
reduction amount. Under paragraphs (d)(4) and (d)(5)(ii) of this 
section, S's $180 attribute reduction amount is allocated 
proportionately (by basis) between Asset 1 and its S1 stock. Under 
paragraph (d)(5)(ii)(A) of this section, for purposes of allocating 
S's $180 attribute reduction amount, S's deemed basis in the S1 
stock is reduced by the value of any transferred S1 shares (and 
other items that are not relevant here). Additionally, for this 
purpose, S's deemed basis in S1 stock is reduced by S's 
nontransferred S1 shares' allocable portion of the value of S1's 
transferred shares of each lower-tier subsidiary's stock (and other 
items that are not relevant here). Accordingly, for purposes of 
allocating S's attribute reduction amount, S's deemed basis in the 
S1 stock must be reduced by $80 (the $40 value of the two 
transferred S1 shares, and S's eight nontransferred S1 shares' $40 
allocable portion of the $50 value of the transferred S2 share), to 
$170. Thus, $90 of the attribute reduction amount ($170/$340 x $180) 
is allocated to Asset 1 and $90 of the attribute reduction amount 
($170/$340 x $180) is allocated to the S1 stock. Under paragraph 
(d)(5)(ii)(B)(1) of this section, none of the $90 allocated to the 
S1 stock is apportioned to share 1 because loss is recognized on the 
transfer of share 1. Under paragraph (d)(5)(ii)(B)(2) of this 
section, the $90 allocated amount is apportioned among other nine 
shares of S1 stock in a manner that reduces disparity to the 
greatest extent possible. Accordingly, of the total $90 allocated 
amount, $10 is apportioned to each of the remaining shares of S1 
stock. Under paragraph (d)(5)(ii)(B)(3) of this section, however, an 
apportioned amount cannot be applied to reduce the basis of a 
transferred share below its value. Because the basis of share 2 is 
already equal to its value, none of the $10 apportioned to share 2 
is applied to reduce its basis. The amounts apportioned to the 
remaining S1 shares, however, are applied to reduce the bases of 
those shares without limitation, reducing the basis of each from $20 
to $10. As a result, immediately after the allocation and 
application of S's attribute reduction amount, S's basis in Asset 1 
is $80 ($170 minus $90), its basis in share 1 is $170, its basis in 
share 2 is $20, and its basis in each other share of S1 stock is 
$10. Under paragraph (d)(5)(ii)(D) of this section, the entire $90 
of S's attribute reduction amount that was allocated to the S1 stock 
is an attribute reduction amount of S1, regardless of the fact that 
none of the allocated amount was apportioned to share 1 and none of 
the amount apportioned to share 2 was applied to reduce the basis of 
share 2.
    (v) Attribute reduction under this paragraph (d) in next lower 
tier. (A) Computation of S1's attribute reduction amount. S's sale 
of share 1 is a transfer of a loss share and is in the next lower 
tier. Thus, this paragraph (d) next applies with respect to S's 
transfer of share 1. S1's attribute reduction amount will include 
both the $90 attribute reduction amount that tiered down from S and 
any attribute reduction amount resulting from the application of 
this paragraph (d) with respect to S's transfer of the S1 share 1 
(S1's direct attribute reduction amount). Under paragraph (d)(3) of 
this section, S1's direct attribute reduction amount is the lesser 
of the net stock loss on

[[Page 3016]]

transferred S1 shares and S1's aggregate inside loss. The net stock 
loss on transferred S1 shares is $150, computed as the excess of S's 
$190 adjusted bases in transferred shares of S1 stock ($170 in share 
1 plus $20 in share 2) over the value of those shares ($40). S1's 
aggregate inside loss is $50, the excess of S1's $250 net inside 
attribute amount (as calculated in paragraph (iv)(B)(1) of this 
Example 10) over the $200 value of all outstanding S1 shares 
(extrapolated from the amount realized on the sale of share 1). 
Therefore, S1's direct attribute reduction amount is $50, the lesser 
of the $150 net stock loss and S1's $50 aggregate inside loss. S1's 
total attribute reduction amount is thus $140, the sum of the $90 
attribute reduction amount that tiered down from S and the $50 
direct attribute reduction amount computed with respect to the 
transfer of share 1.
    (B) Allocation, apportionment, and application of S1's attribute 
reduction amount. Under paragraphs (d)(4) and (d)(5)(ii) of this 
section, S1's $140 attribute reduction amount is allocated 
proportionately (by basis) among the S2 stock, the S3 stock, and the 
S4 stock. As described in paragraph (iv)(B)(2) of this Example 10, 
under paragraph (d)(5)(ii)(A) of this section, for purposes of 
allocating S1's $140 attribute reduction amount, S1's deemed basis 
in the S2 stock is reduced by the value of the transferred S2 share. 
Accordingly, for purposes of allocating S1's attribute reduction 
amount, S1's deemed basis in the S2 stock must be reduced by $50 
(the value of the transferred S2 share), to $25. Thus, $17.50 of 
S1's attribute reduction amount ($25/$200 x $140) is allocated to 
the S2 stock, $52.50 of S1's attribute reduction amount ($75/$200 x 
$140) is allocated to the S3 stock, and $70 of S1's attribute 
reduction amount ($100/$200 x $140) is allocated to the S4 stock. 
Under paragraph (d)(5)(ii)(B)(1) of this section, none of the amount 
allocated to S2 stock is apportioned to the S2 share because gain 
was recognized on the transfer of the S2 share. However, the $52.50 
allocated to the S3 stock is apportioned and applied to reduce the 
basis in the S3 share, from $60 to $7.50, and the $70 allocated to 
the S4 stock is apportioned and applied to reduce the basis of the 
S4 share, from $100 to $30. (Note: Although the conforming 
limitation in paragraph (d)(5)(ii)(D)(2) of this section limits the 
application of tier down attribute reduction such that the total 
amount of attribute reduction applied to reduce S1's attributes does 
not exceed $130 (the excess of S1's $250 net inside attribute amount 
over $120, the value of the transferred S1 shares ($40) plus the 
basis of the nontransferred S1 shares after reduction ($80)), this 
limitation does not apply because only $122.50 ($52.50 plus $70) of 
attribute reduction is applied to reduce S1's attributes.) Under 
paragraph (d)(5)(ii)(D) of this section, the attribute reduction 
amount allocated to the S2 stock, the S3 stock, and the S4 stock 
becomes an attribute reduction amount of S2, S3, and S4, 
respectively (even though the amount allocated to S2 stock was not 
apportioned or applied to reduce the basis of the S2 share).
    (vi) Attribute reduction under this paragraph (d) in lowest 
tier. Although the sale of the S2 share is a transfer of subsidiary 
stock at the next lower tier, the S2 share is not a loss share. 
Thus, this paragraph (d) does not apply with respect to that 
transfer. However, S2, S3, and S4 have attribute reduction amounts 
that tiered down from S1 and that are applied to reduce attributes 
under the provisions of this paragraph (d).
    (A) Tier down of S1's attribute reduction amount to S2. Under 
the general rules of this paragraph (d), S2's $17.50 attribute 
reduction amount is allocated and applied to reduce S2's basis in 
Asset 2 from $75 to $57.50.
    (B) Tier down of S1's attribute reduction amount to S3. Under 
the general rules of this paragraph (d), S3's $52.50 of attribute 
reduction amount is allocated and applied to reduce S3's basis in 
Asset 3 from $75 to $22.50.
    (C) Tier down of S1's attribute reduction amount to S4, 
application of conforming limitation. Under the general rules of 
this paragraph (d), S4's $70 attribute reduction amount is allocated 
to, and would be applied to reduce, S4's basis in Asset 4. However, 
under paragraph (d)(5)(ii)(D)(2) of this section, the reduction is 
limited to the excess of S4's net inside attribute amount ($80) over 
the basis of the S4 share ($30, after reduction under this paragraph 
(d)). As a result, only $50 (the excess of $80 over $30) of S4's $70 
attribute reduction amount is applied to S4's basis in Asset 4, 
reducing it from $80 to $30. The remaining $20 of S4's attribute 
reduction amount is disregarded and has no further effect.
    (vii) Application of basis restoration rule. After all 
adjustments required under this paragraph (d) have been given 
effect, reductions made to the basis of subsidiary stock under this 
paragraph (d) are subject to reversal under the basis restoration 
rule in paragraph (d)(5)(iii) of this section. Under this rule, 
adjustments are reversed (and basis is restored) only to the extent 
necessary to conform the basis of each share with its allocable 
portion of the subsidiary's net inside attribute amount. The 
restoration adjustments are first made at the lowest tier and then 
at each next higher tier successively.
    (A) Basis restoration at lowest tier. No restoration is 
permitted with respect to the S2 share because the basis of the S2 
share was not reduced under paragraph (d)(5)(ii)(B) of this section. 
S3's net inside attribute amount ($22.50, after reduction under this 
paragraph (d)) exceeds S1's basis in the S3 share ($7.50, after 
reduction under this paragraph (d)) by $15. To conform S1's basis in 
the S3 share to S3's net inside attribute amount, the $52.50 
reduction to the basis of the S3 share under paragraph (d)(5)(ii)(B) 
of this section is reversed by $15 (restoring basis to $22.50). The 
restoration of S1's basis in the S3 share does not tier up to affect 
the basis in stock of any other subsidiary. S1's basis in the S4 
share ($30, after reduction under this paragraph (d)) is already 
conformed with S4's net inside attribute amount ($30, after 
reduction under this paragraph (d)) and no restoration will be 
required or permitted under paragraph (d)(5)(iii) of this section.
    (B) Basis restoration at next higher tier. Each share of S1 
stock has an allocable portion of S1's net inside attribute amount 
equal to $10.25 (\1/10\ x $102.50, the sum of S1's adjusted bases in 
its S2 stock ($50, $0 plus $50 gain recognized), S3 stock ($22.50 
after restoration), and S4 stock ($30)). Neither S's basis in S1 
share 1 nor S's basis in S1 share 2 was reduced under this paragraph 
(d). Accordingly the basis of neither share is subject to 
restoration under paragraph (d)(5)(iii) of this section. However, 
S's basis in each of its other shares of S1 stock was reduced by 
$10, from $20 to $10. Accordingly, the reduction to the basis of 
each of those shares is reversed to the extent of $.25, to restore 
the basis of each such share to $10.25 (its allocable portion of 
S1's net inside attribute amount).
    (vii) Results. After the application of this section, P 
recognizes a loss of $360 on the sale of the S share, S recognizes a 
loss of $150 on the sale of S1 share 1, and S1 recognizes a $50 gain 
on the sale of the S2 share. Immediately after the transaction, the 
entities each directly own the following:

----------------------------------------------------------------------------------------------------------------
              Entity                         Asset                           Basis                     Value
----------------------------------------------------------------------------------------------------------------
P1...............................  S share..................  $240..............................            $240
P................................  Proceeds of the sale of S  240...............................             240
                                    share.
S................................  Proceeds of sale of Share  20................................              20
                                    1 of S1 stock.
                                   Partnership interest       $20...............................              20
                                    received for Share 2.
                                   Shares 3 through 10 of S1  82 ($10.25 per share).............  ..............
                                    stock.
S1...............................  Proceeds of sale of S2     50................................              50
                                    share.
                                   The S3 share.............  22.50.............................  ..............
                                   The S4 share.............  30................................  ..............
S2...............................  Asset 2..................  57.50.............................  ..............
S3...............................  Asset 3..................  22.50.............................  ..............
S4...............................  Asset 4..................  30................................  ..............
X................................  Share 1 of S1 stock......  20................................              20
Y................................  The S2 share.............  50................................              50
Partnership......................  Share 2 of S1 stock......  20................................              20
----------------------------------------------------------------------------------------------------------------


[[Page 3017]]

    (e) Operating rules--(1) Predecessors, successors. This section 
applies to predecessor or successor persons, groups, and assets to the 
extent necessary to effectuate the purposes of the section.
    (2) Adjustments for prior transactions that altered stock basis or 
other attributes. In certain situations, M's basis in S stock or S's 
attributes are adjusted in a manner that alters the relationship 
between stock basis and inside attributes. Such adjustments affect the 
extent to which this relationship identifies unrecognized asset gain 
reflected in stock basis and the extent to which loss is duplicated. 
The provisions of this paragraph (e)(2) modify the computations in 
paragraphs (c) and (d) of this section to adjust for the effects of 
such adjustments.
    (i) Reductions to S's basis in assets or other attributes pursuant 
to section 362(e)(2)(A). If S's attributes have been reduced under 
section 362(e)(2) (taking into account the provisions of Sec.  1.1502-
13(e)(4)), then the disconformity amount of the S shares received (or 
deemed received) in the transaction to which section 362(e)(2) applied 
is reduced by the amount that the basis in such shares would have been 
reduced under section 362(e)(2)(C) (taking into account the provisions 
of Sec.  1.1502-13(e)(4)) had such an election been made. In addition, 
for purposes of determining the attribute reduction amount under 
paragraph (d) of this section resulting from the transfer of any S 
shares received (or deemed received) in a transaction to which section 
362(e)(2) applied, and for purposes of applying paragraph 
(d)(5)(ii)(D)(2) of this section (conforming limitation) to S, the 
basis in such shares is treated as reduced by the amount the basis in 
such shares would have been reduced under section 362(e)(2)(C) (taking 
into account the provisions of Sec.  1.1502-13(e)(4)) had such an 
election been made.
    (ii) Reductions to the basis of any share of S stock pursuant to an 
election under section 362(e)(2)(C). If the basis of any share of S 
stock has been reduced as the result of an election under section 
362(e)(2)(C) (taking into account the provisions of Sec.  1.1502-
13(e)(4)), then, for purposes of computing either any S share's 
disconformity amount or S's aggregate inside loss, and for purposes of 
applying paragraph (d)(5)(iii) of this section (stock basis 
restoration) to S, S's net inside attribute amount is reduced by the 
amount that S's attributes would have been reduced under section 
362(e)(2)(A) (taking into account the provisions of Sec.  1.1502-
13(e)(4)) in the absence of an election under section 362(e)(2)(C) 
(taking into account the provisions of Sec.  1.1502-13(e)(4)).
    (iii) Other adjustments. The Commissioner shall make such 
adjustments as appropriate if the relationship between a member's basis 
in a share of S stock and the share's allocable portion of S's 
attributes has been altered, other than by the operation of Sec.  
1.1502-32 or this section, provided that such change is not otherwise 
addressed in this section. Taxpayers may request a written 
determination from the Commissioner determining that other adjustments 
to M's basis in S stock or S's attributes are to be adjusted in a 
manner consistent with the principles of this paragraph (e)(2) for 
purposes of making the computations under paragraphs (c) and (d) of 
this section.
    (iv) Example. The application of this paragraph (e)(2) is 
illustrated by the following example:

    Example.  Adjustments for intercompany section 362(e)(2) 
transaction. (i) Adjustments for reduction of S's basis in assets. 
(A) Facts. In an intercompany section 362(e)(2) transaction (within 
the meaning of Sec.  1.1502-13(e)(4)(i)), P contributes Asset 1 to 
newly formed S in exchange for the sole outstanding share of S 
stock. At the time of the contribution, P's basis in Asset 1 was 
$100 and its value was $20. Accordingly, S's basis of A1 would have 
been reduced by $80 under section 362(e)(2) and that $80 is a 
section 362(e)(2) amount within the meaning of Sec.  1.1502-
13(e)(4)(ii)(A). P sells the S share for $20 in year 3. As of the 
time of the sale, no portion of the section 362(e)(2) amount has 
been taken into account and thus the entire $80 is a remaining 
section 362(e)(2) amount reflected in S's basis in Asset 1 and P's 
basis in the share of S stock. P's sale of the S share is a section 
362(e)(2) application event within the meaning of Sec.  1.1502-
13(e)(4)(iii) and therefore, immediately before the sale, S's basis 
in Asset 1 is reduced by $80 pursuant to section 362(e)(2) and Sec.  
1.1502-13(e)(4)(iv). Under Sec.  1.1502-13(e)(4)(iv)(C), this 
reduction is not a noncapital, nondeductible expense described in 
Sec.  1.1502-32(b)(2)(iii), and does not affect P's basis in the S 
share. The sale is also a transfer of a loss share and therefore 
subject to the provisions of this section.
    (B) Application of paragraph (b) of this section. No adjustment 
is required under paragraph (b) of this section, either because 
there is no potential for redetermination (members hold only one 
share of S stock) or because P transfers the group's entire interest 
in S to a nonmember in a fully taxable transaction. See, 
respectively, paragraphs (b)(1)(ii)(A) and (b)(1)(ii)(B) of this 
section. After the application of paragraph (b) of this section, P's 
sale of the S share is still a transfer of a loss share and 
therefore subject to this paragraph (c).
    (C) Basis reduction under paragraph (c) of this section. In 
determining the reduction of basis under paragraph (c) of this 
section, the share's disconformity amount is reduced by $80, the 
amount that the basis in the S share would have been reduced under 
Sec.  1.1502-13(e)(4)(v) had such an election been made. The 
disconformity amount (and the net positive adjustment) are $0 and so 
no basis adjustment will be made under paragraph (c) of this 
section. The transferred share is still a loss share and so is 
therefore subject to paragraph (d) of this section.
    (D) Attribute reduction under paragraph (d) of this section. In 
determining the attribute reduction amount under paragraph (d)(3) of 
this section, P's basis in the transferred share is treated as 
reduced by $80, the amount that the basis in the S share would have 
been reduced under Sec.  1.1502-13(e)(4)(v) had such an election 
been made. As a result, P recognizes an $80 loss on the sale of the 
S stock, but, for purposes of applying paragraph (d) of this 
section, the net stock loss and, therefore, the attribute reduction 
amount are $0.
    (ii) Adjustments for election to reduce stock basis under 
section 362(e)(2)(C). The facts are the same as in paragraph (i) of 
this Example, except that P and S elect to reduce P's basis in the S 
share by $80 under Sec.  1.1502-13(e)(4)(v). As a result, the basis 
of Asset 1 remains $100 and, immediately before the sale of the S 
stock, P's basis in the S share is reduced to $20. Because the share 
is then not a loss share, this section does not apply to the 
transfer. If, instead, the share were sold for less than $20, it 
would be a loss share and the transfer would be subject to this 
section. In that case, for purposes of computing the S share's 
disconformity amount, S's aggregate inside loss, and applying 
paragraph (d)(5)(iii) of this section, S's net inside attributes 
would be treated as reduced by $80,the amount that S's attributes 
would have been reduced under Sec.  1.1502-13(e)(4)(iv) had the 
election under Sec.  1.1502-13(e)(4)(v) not been made.

    (3) Plural, singular. All terms used in this section include both 
the plural and singular as the context may require.
    (f) Definitions. In addition to the definitions in other paragraphs 
of this section and in Sec.  1.1502-1, the following definitions apply 
for purposes of this section.
    (1) Allocable portion has the same meaning as in Sec.  1.1502-
32(b)(4)(iii)(B). Thus, for example, within a class of stock, each 
share has the same allocable portion of the net inside attribute amount 
and, if there is more than one class of stock, the net inside attribute 
amount is allocated to each class by taking into account the terms of 
each class and all other facts and circumstances relating to the 
overall economic arrangement.
    (2) Deferred deduction means any deduction for expenses or loss 
that would be taken into account under general tax accounting 
principles as of the time of the transfer of the share, but that is 
nevertheless not taken into account immediately after the transfer by 
reason of the application of a deferral provision. Such provisions 
include, for

[[Page 3018]]

example, sections 267(f) and 469, and Sec.  1.1502-13. Deferred 
deduction also includes equivalent amounts, such as negative 
adjustments under section 475 (mark to market accounting method for 
dealers in securities) and 481 (adjustments required by changes in 
method of accounting).
    (3) Distribution has the same meaning as in Sec.  1.1502-
32(b)(3)(v).
    (4) Higher tier, lower tier. A subsidiary (S1) (and its shares of 
stock) is higher tier with respect to another subsidiary (S2) (and its 
shares of stock) if investment adjustments made to the basis of shares 
of S2 stock under Sec.  1.1502-32 affect the investment adjustments 
made to the basis of the stock of S1. A subsidiary (S1) (and its shares 
of stock) is lower tier with respect to another subsidiary (S) (and its 
shares of stock) if investment adjustments made to the basis of shares 
of S1 stock affect the investment adjustments made to the basis of 
shares of S stock. The term lowest-tier subsidiary generally refers to 
a subsidiary that owns no stock of another subsidiary. The term 
highest-tier subsidiary generally refers to a subsidiary the stock of 
which is not lower tier to any shares transferred in the transaction.
    (5) Liability means a liability that has been incurred within the 
meaning of section 461(h), except to the extent otherwise provided in 
paragraph (d)(4)(ii)(A)(1) of this section.
    (6) Loss carryover means any net operating or capital loss 
carryover attributable to S that is or, under the principles of Sec.  
1.1502-21, would be carried to S's first taxable year, if any, 
following the year of the transfer.
    (7) Loss share, gain share. A loss share is a share of stock with a 
basis that exceeds its value. A gain share is a share of stock with a 
value that exceeds its basis.
    (8) Preferred stock, common stock. Preferred stock and common stock 
have the same meanings as in Sec.  1.1502-32(d)(2) and (3), 
respectively.
    (9) Publicly traded property. Property is publicly traded property 
if it is traded on an established market within the meaning of Sec.  
1.1273-2(f).
    (10) Transaction includes all the steps taken pursuant to the same 
plan or arrangement.
    (11) Transfer--(i) Definition. Except as provided in paragraph 
(f)(11)(ii) of this section, for purposes of this section, M transfers 
a share of S stock on the earliest of--
    (A) The date that M ceases to own the share as a result of a 
transaction in which, but for the application of this section, M would 
recognize gain or loss with respect to the share;
    (B) The date that M and S cease to be members of the same group;
    (C) The date that a nonmember acquires the share from M; and
    (D) The last day of the taxable year during which the share becomes 
worthless under section 165(g), taking into account the provisions of 
Sec.  1.1502-80(c).
    (ii) Excluded transactions. Notwithstanding paragraph (f)(11)(i) of 
this section, M does not transfer a share of S stock if--
    (A) M ceases to own the share as a result of a section 381(a) 
transaction in which any member acquires assets from S or in which S 
acquires assets from M, provided that, in either case, M recognizes no 
gain or loss with respect to the share; or
    (B) M ceases to own the share as a result of a distribution of the 
share to a nonmember in a transaction to which section 355 applies, 
provided M does not recognize any gain or loss with respect to the 
share as a result of the distribution of the share.
    (12) Value means the amount realized, if any, or otherwise the fair 
market value.
    (g) Anti-abuse rule--(1) General rule. If a taxpayer acts with a 
view to avoid the purposes of this section or to apply the rules of 
this section to avoid the purposes of any other rule of law, 
appropriate adjustments will be made to carry out the purposes of this 
section or such other rule of law.
    (2) Examples. The following examples illustrate the principles of 
the anti-abuse rule in this paragraph (g). No implication is intended 
regarding the potential applicability of any other anti-abuse rules:

    Example 1. Stuffing gain asset to eliminate loss. (i) Facts. On 
January 1, year 1, P owns Asset 1 with a basis of $0 and a value of 
$100. On that same date, P purchases the sole outstanding share of S 
stock for $100. At that time, S owns Asset 2 with a basis of $0 and 
a value of $100. In year 1, S sells Asset 2 for $100. In year 2, 
with a view to avoiding the basis reduction rule in paragraph (c) of 
this section upon the sale of the S share, P contributes Asset 1 to 
S in a transaction to which section 351 applies and receives an 
additional share of S stock with a basis of $0 under section 358. On 
December 31, year 2, P sells its two S shares for $200. After 
applying and giving effect to all generally applicable rules of law 
(other than this section), P's basis in the original share of S 
stock is $200 (P's original $100 basis, increased by $100 under 
Sec.  1.1502-32 to reflect the $100 gain recognized on the sale of 
Asset 2), and P's basis in the other share of S stock is $0.
    (ii) Analysis. Absent the application of this paragraph (g), P 
would not recognize any net gain or loss on the sale of the two S 
shares. Under paragraph (c)(7) of this section, for purposes of 
computing the basis reduction required by paragraph (c) of this 
section, P's basis in the original share of S stock would be treated 
as reduced by the gain recognized on the other share of S stock. 
Further, P would not recognize any net stock loss within the meaning 
of paragraph (d)(3)(ii) of this section. Accordingly, this section 
would not apply to the transfer of the S shares. However, because P 
contributed Asset 1 to S with a view to avoiding the basis reduction 
rule in paragraph (c) of this section, the contribution of Asset 1 
is disregarded for purpose of applying this section. Accordingly, 
this section applies to the sale of the S share without regard to 
the contribution of Asset 1, and the basis of the original S share 
is reduced by $100 under paragraph (c) of this section. P recognizes 
no gain or loss on the sale of the original S share, and $100 of 
gain on the sale of the other S share.
    Example 2. Loss Trafficking. (i) Facts. On January 1, year 1, P 
purchases the sole outstanding share of S stock for $100. At that 
time, S owns one asset, Asset 1, with a basis of $0 and a value of 
$100. In year 1, S sells Asset 1 for $100 and, with a view to 
eliminating the disconformity amount, S purchases the sole 
outstanding share of X stock, a corporation with a $100 NOL and an 
asset with a basis and value of $1, from an unrelated party for $1. 
In year 2, X is liquidated into S in a transaction to which section 
332 applies. On December 31, year 2, P sells its S share for $100. 
After applying and giving effect to all generally applicable rules 
of law (other than this section), P's basis in the S share is $200 
(P's original $100 basis, increased under Sec.  1.1502-32 to reflect 
the $100 gain recognized on the sale of Asset 1). P's sale of the S 
share is a transfer of a loss share and therefore subject to the 
provisions of this section.
    (ii) Analysis. No adjustment is required under paragraph (b) of 
this section, either because there is no potential for 
redetermination (members hold only one share of S stock) or because 
P transfers the group's entire interest in S to a nonmember in a 
fully taxable transaction. See, respectively, paragraphs 
(b)(1)(ii)(A) and (b)(1)(ii)(B) of this section. Under paragraph (c) 
of this section, P's basis in the S share ($200) is reduced, but not 
below the share's value ($100), by the lesser of the share's net 
positive adjustment and disconformity amount. The share's net 
positive adjustment is the greater of zero and the sum of all 
investment adjustments applied to the basis of the share, computed 
without taking distributions into account. There are no 
distributions. The only investment adjustment to the S share is the 
$100 positive adjustment attributable to the gain recognized on the 
sale of Asset 1. The share's net positive adjustment is therefore 
$100. The share's disconformity amount is the excess, if any, of its 
basis ($200) over its allocable portion of S's net inside attribute 
amount. Because S purchased the X stock and liquidated X with a view 
to avoiding the purposes of this section (to utilize X's attributes 
to minimize the disconformity amount of the S loss share), the 
attributes acquired from X are disregarded for purposes

[[Page 3019]]

of applying this section. Accordingly, S's net inside attribute 
amount is limited to S's money ($100 from the sale of Asset 1, less 
$1 for the purchase of the X stock), or $99. The loss share's 
allocable portion of the $99 net inside attribute amount is $99. The 
loss share's disconformity amount is therefore the excess of $200 
over $99, or $101. The lesser of the share's net positive adjustment 
($100) and disconformity amount ($101) is $100. As a result, the 
basis in the loss share is reduced by $100, and P recognizes no gain 
or loss on the sale of the S share.
    Example 3. Use of a partnership to prevent current attribute 
reduction. (i) Facts. P owns 100 shares of S stock with a basis of 
$10 each. S owns Asset 1 with a basis of $1000 and a value of $100. 
In year 1, with a view to preventing a current reduction in the 
basis of Asset 1, S and M form a partnership. S contributes Asset 1 
and M contributes Asset 2. On December 31, year 1, P sells 20 S 
shares for $1 each. After applying paragraph (c) of this section, 
P's basis in each transferred S share is still $10, and P recognizes 
a $180 loss (a $9 loss on each transferred S share).
    (ii) Analysis. No adjustment is required under paragraph (b) of 
this section because S has only one class of stock outstanding and 
there is no disparity in the basis of the shares. See paragraph 
(b)(1)(ii)(A) of this section. No adjustment is required under 
paragraph (c) of this section because the net positive adjustment is 
$0. See paragraph (c)(3) of this section. Absent the application of 
this paragraph (g), under paragraph (d) of this section S's 
attribute reduction amount of $180 would be applied to reduce S's 
basis in the partnership interest. Because S acted with a view to 
avoiding a current reduction in the basis of Asset 1 under paragraph 
(d) of this section, this section is applied by treating S as if it 
held Asset 1 at the time of the stock sale.
    Example 4.  Creation of an intercompany receivable to mitigate 
attribute reduction. (i) Facts. P owns 100 shares of S stock each 
with equal basis that exceeds value. S owns Asset 1 with a basis 
that exceeds value and cash. In year 1, with a view to mitigating a 
reduction in the basis of Asset 1, S lends the cash to M. On 
December 31, year 1, P sells 20 S shares and recognizes a loss.
    (ii) Analysis. No adjustment is required under paragraph (b) of 
this section because S has only one class of stock outstanding and 
there is no disparity in the basis of the shares. See paragraph 
(b)(1)(ii)(A) of this section. No adjustment is required under 
paragraph (c) of this section because the net positive adjustment is 
$0. See paragraph (c)(3) of this section. Absent the application of 
this paragraph (g), under paragraph (d) of this section S's 
attribute reduction amount would be applied to proportionately 
reduce the basis in S's assets. Accordingly, S's basis in both its 
intercompany receivable and Asset 1 would be reduced. Because S 
acted with a view to mitigating the reduction in the basis of Asset 
1 under paragraph (d) of this section, this section is applied 
without regard to the intercompany receivable. Accordingly, S's 
basis in Asset 1 is reduced by the full attribute reduction amount.

    (h) Effective date. This section applies to all transfers on or 
after the date these regulations are published as final regulations in 
the Federal Register. For rules applicable on and after March 10, 2006, 
and before the date these regulations are published as final 
regulations in the Federal Register, see Sec. Sec.  1.1502-35 and 
1.337(d)-2 as contained in 26 CFR part 1 in effect on January 1, 2007. 
For rules applicable on and after March 3, 2005 and before March 10, 
2006, see Sec. Sec.  1.337(d)-2T, 1.1502-20 and 1.1502-35T as contained 
in 26 CFR part 1 in effect on April 1, 2005. For rules applicable 
before March 3, 2005, see Sec. Sec.  1.337(d)-2T, 1.1502-20, and 
1.1502-35T as contained in 26 CFR part 1 in effect on April 1, 2004.
    Par. 16. Section 1.1502-80 is amended by:
    1. Revising paragraphs (a) and (c).
    2. Adding new paragraph (g).
    The revisions and addition reads as follows:


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

    (a) In general. The Internal Revenue Code, or other law, shall be 
applicable to the group to the extent the regulations do not exclude 
its application. To the extent not excluded, other rules operate in 
addition to, and may be modified by, these regulations. Thus, for 
example, in a transaction to which section 381(a) applies, the 
acquiring corporation will succeed to the tax attributes described in 
section 381(c). Furthermore, sections 269 and 482 apply for any 
consolidated year. However, in a recognition transaction otherwise 
subject to section 1001, for example, the rules of section 1001 
continue to apply, but may be modified by the intercompany transaction 
regulations under Sec.  1.1502-13. Nothing in these regulations shall 
be interpreted or applied to require an adjustment to a member's basis 
in subsidiary stock or other attributes to the extent the adjustment 
would have the effect of duplicating another adjustment required under 
the Code or other rule of law, including other provisions of these 
regulations.
* * * * *
    (c) Deferral of section 165--(1) General rule. Subsidiary stock is 
not treated as worthless under section 165 until immediately before the 
earlier of the time--
    (i) The stock is worthless within the meaning of Sec.  1.1502-
19(c)(1)(iii); and
    (ii) The subsidiary for any reason ceases to be a member of the 
group.
    (2) Cross reference. See Sec.  1.1502-36 for additional rules 
relating to stock loss.
* * * * *
    (g) Effective dates. Paragraphs (a) and (c) of this section are 
applicable on or after the date these regulations are published as 
final regulations in the Federal Register.
    Par. 17. Section 1.1502-91 is amended by revising paragraph (h)(2) 
to read as follows:


Sec.  1.1502-91  Application of section 382 with respect to a 
consolidated group.

* * * * *
    (h) * * *
    (2) Disposition of stock or an intercompany obligation of a member. 
Gain or loss recognized by a member on the disposition of stock 
(including stock described in section 1504(a)(4) and Sec.  1.382-
2T(f)(18)(ii) and (iii)) of another member is treated as a recognized 
gain or loss for purposes of section 382(h)(2) (unless disallowed) even 
though gain or loss on such stock was not included in the determination 
of a net unrealized built-in gain or loss under paragraph (g)(1) of 
this section. Gain or loss recognized by a member with respect to an 
intercompany obligation is treated as recognized gain or loss only to 
the extent (if any) the transaction gives rise to aggregate income or 
loss within the consolidated group. The first sentence of this 
paragraph (h)(2) is applicable on or after the date these regulations 
are published as final regulations in the Federal Register.
* * * * *
    Par. 18. For each section listed in the table, remove the language 
in the ``Remove'' column and add in its place the language in the 
``Add'' column as set forth below:

[[Page 3020]]



------------------------------------------------------------------------
             Section                    Remove                Add
------------------------------------------------------------------------
Sec.   1.267(f)-1(k)............  Sec.   1.337(d)-2;  Sec.   1.1502-36.
                                   Sec.   1.1502-35.
Sec.   1.597-4(g)(2)(v).........  Sec.  Sec.          Sec.   1.1502-36.
                                   1.337(d)-2 and
                                   Sec.   1.1502-
                                   35(f).
Sec.   1.1502-11(b)(3)(ii)(c)...  Sec.  Sec.          Sec.   1.1502-36.
                                   1.337(d)-2 and
                                   Sec.   1.1502-35.
Sec.   1.1502-12(r).............  Sec.  Sec.          Sec.   1.1502-36.
                                   1.337(d)-2 and
                                   Sec.   1.1502-35.
Sec.   1.1502-15(b)(2)(iii).....  Sec.  Sec.          Sec.   1.1502-36.
                                   1.337(d)-2,
                                   1.1502-35, or.
Sec.   1.1502-32(b)(3)(iii)(B)..  Sec.   1.1502-
                                   35(b) or (f)(2).
------------------------------------------------------------------------


Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 07-187 Filed 1-16-07; 10:51 am]
BILLING CODE 4830-01-P