[Federal Register Volume 72, Number 188 (Friday, September 28, 2007)]
[Proposed Rules]
[Pages 55139-55152]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E7-19134]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-107592-00; REG-105964-98]
RIN 1545-BA11; RIN 1545-AW30


Consolidated Returns; Intercompany Obligations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and withdrawal of proposed 
regulations.

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SUMMARY: This document contains proposed regulations that provide 
guidance regarding the treatment of transactions involving obligations 
between members of a consolidated group and the treatment of 
transactions involving the provision of insurance between members of a 
consolidated group. The regulations will affect corporations filing 
consolidated returns.

DATES: Written or electronic comments and requests for a public hearing 
must be received by December 27, 2007.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-107592-00), 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-
107592-00), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC, or sent electronically via the Federal 
eRulemaking Portal at http://www.regulations.gov (IRS REG-107592-00).

FOR FURTHER INFORMATION CONTACT: Concerning submissions of comments 
and/or requests for a public hearing, Kelly Banks (202) 622-7180; 
concerning the proposed regulations, Frances L. Kelly (202) 622-7770 
(not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    On July 18, 1995, final regulations (TD 8597) under Sec.  1.1502-13 
were published in the Federal Register [60 FR 36671], amending the 
intercompany transaction system of the consolidated return regulations. 
These final regulations included rules under Sec.  1.1502-13(e) 
governing the treatment of insurance transactions between members of a 
consolidated group and rules under Sec.  1.1502-13(g) governing the 
treatment of obligations between members of a consolidated group (the 
Current Regulations).
    On December 21, 1998, a notice of proposed rulemaking (REG-105964-
98) was published in the Federal Register [63 FR 70354], which proposed 
amendments to the intercompany obligation rules of Sec.  1.1502-13(g) 
(the 1998 Proposed Regulations). After consideration of comments 
received regarding the Current Regulations and the 1998 Proposed 
Regulations, the IRS and the Treasury Department believe that the rules 
governing the treatment of intercompany obligations need to be revised. 
Accordingly, the IRS and the Treasury Department are withdrawing the 
1998 Proposed Regulations and issuing these new proposed regulations in 
their place. However, for purposes of determining the tax treatment of 
transactions undertaken prior to the finalization of these proposed 
regulations, taxpayers may continue to rely upon the form and timing of 
the recast transaction, as clarified by the 1998 Proposed Regulations.
    In addition, the IRS and the Treasury Department propose to revise 
certain of the rules under Sec.  1.1502-13(e) that apply to 
intercompany transactions involving the provision of insurance between 
group members.

Explanation of Provisions

I. Intercompany Obligation Regulations

A. General Application
    Section 1.1502-13(g) prescribes rules relating to the treatment of 
transactions involving intercompany obligations. An intercompany 
obligation is generally defined as an obligation between members of a 
consolidated group, but only for the period during which both the 
creditor and debtor are members of the group.
    Section 1.1502-13(g) can apply to three types of transactions: (1) 
Transactions in which an obligation between a group member and a 
nonmember becomes an intercompany obligation, such as the purchase by a 
consolidated group member of another member's debt from a nonmember 
creditor or the acquisition by a consolidated group member of stock of 
a nonmember creditor or debtor (inbound transactions); (2) transactions 
in which an intercompany obligation ceases to be an intercompany 
obligation, such as the sale by a creditor member of another member's 
debt to a nonmember or the deconsolidation of either the debtor or 
creditor member (outbound transactions); and (3) transactions in which 
an intercompany obligation is assigned or extinguished within the 
consolidated group (intragroup transactions).

[[Page 55140]]

B. The Deemed Satisfaction-Reissuance Model--Current Regulations and 
1998 Proposed Regulations
    For all three types of transactions--inbound, outbound, and 
intragroup--the Current Regulations and the 1998 Proposed Regulations 
generally provide that an obligation is treated as satisfied and, if 
the obligation remains outstanding, reissued as a new obligation (the 
deemed satisfaction-reissuance model). These regulations are intended 
to minimize the effects of intercompany obligations on a consolidated 
group's taxable income.
    For inbound transactions, the deemed satisfaction-reissuance model 
mirrors the mechanics and single-entity policies underlying the section 
108(e)(4) regulations. However, in contrast to those regulations, the 
deemed satisfaction-reissuance model also applies to obligations 
acquired for a premium and governs the treatment of the creditor as 
well as the debtor.
    For outbound transactions, the deemed satisfaction-reissuance model 
furthers single-entity treatment by treating a consolidated group as a 
single issuer, and an intercompany obligation acquired or assumed by a 
nonmember as newly-issued debt. Thus, if a nonmember purchases an 
intercompany obligation at a discount, the nonmember will be treated as 
having acquired a new instrument with original issue discount to which 
section 1272 applies rather than market discount to which sections 1276 
through 1278 apply.
    For all three types of transactions, the deemed satisfaction-
reissuance model preserves the location of a creditor and debtor 
member's items from an intercompany obligation, matches the timing of 
such items, and ensures that future items of original issue discount or 
premium between the creditor and debtor will similarly correspond in 
amount and timing.
    Since the issuance of the 1998 Proposed Regulations, the IRS and 
the Treasury Department have considered whether, with respect to 
intragroup transactions, the objectives of Sec.  1.1502-13(g) could be 
better accomplished without a deemed satisfaction-reissuance model, and 
could instead be achieved solely through the matching and acceleration 
principles of Sec.  1.1502-13. After considering this approach, it was 
determined that special rules (in addition to the matching rule of 
Sec.  1.1502-13(c) and the acceleration rule of Sec.  1.1502-13(d)) 
would be necessary to ensure that transactions involving intercompany 
obligations clearly reflect consolidated taxable income. For example, 
if an intercompany obligation is sold to another member, the special 
rules and elections of the various debt regimes (that is, the rules for 
original issue discount, market discount, and acquisition premium) 
would have to be reconciled with the intercompany transaction rules 
through coordinating adjustments among the selling creditor, debtor, 
buying creditor, and any subsequent member creditors. The IRS and the 
Treasury Department have concluded that the deemed satisfaction-
reissuance model is preferable to the complexity inherent in any such 
special rules.
    Nonetheless, the IRS and the Treasury Department also have 
concluded that the deemed satisfaction-reissuance model can be improved 
in several respects. First, with respect to intragroup and outbound 
transactions, the mechanics of the model can be simplified and the 
amount for which an intercompany obligation is satisfied and reissued 
can be clarified. Second, the application of the model can be limited 
to those transactions for which its purposes are essential. 
Accordingly, these proposed regulations provide several exceptions to 
the application of the deemed satisfaction-reissuance model.
    With respect to inbound transactions, the IRS and the Treasury 
Department have concluded that the mechanics of the deemed 
satisfaction-reissuance model and its application produce appropriate 
results and, therefore, no change has been proposed (except for the 
addition of a subgroup exception described in part I.H. of this 
preamble).
C. Revised Deemed Satisfaction-Reissuance Model for Intragroup and 
Outbound Transactions
1. Simplified Mechanics
    Under the Current Regulations, and as revised under the 1998 
Proposed Regulations, the mechanics of the deemed satisfaction and 
reissuance model are the same for both intragroup and outbound 
transactions. These mechanics generally treat an intercompany 
obligation as satisfied before an intragroup or outbound transaction 
and, if the obligation remains outstanding, reissued immediately after 
the transaction. Because these mechanics may affect the treatment of 
the actual transaction, they create uncertainties that have raised 
concerns among taxpayers.
    To address these concerns, these proposed regulations adopt new and 
more precise mechanics for the application of the deemed satisfaction-
reissuance model to certain intragroup and outbound transactions (or 
``triggering transactions'' as described in part I.D. of this 
preamble). In general, the new model deems the following sequence of 
events to occur immediately before, and independently of, the actual 
transaction: (1) The debtor is deemed to satisfy the obligation for a 
cash amount equal to the obligation's fair market value; and (2) the 
debtor is deemed to immediately reissue the obligation to the original 
creditor for that same cash amount. The parties are then treated as 
engaging in the actual transaction but with the new obligation. For 
example, assume that S holds a B note with an adjusted issue price and 
basis of $100 and a fair market value of $70, and that S sells the B 
note to nonmember X for $70. Under the new deemed satisfaction-
reissuance model, B is deemed, immediately before the sale to X, to 
satisfy the note for its fair market value of $70, resulting in $30 of 
cancellation of indebtedness income for B and $30 of loss for S (which 
is treated as ordinary loss under the attribute redetermination rule of 
Sec.  1.1502-13(c)(4)(i)). B is then treated as reissuing to S a new 
note with identical terms for $70 and S is treated as selling this new 
note to X.
    By separating the deemed satisfaction and reissuance from the 
actual transaction in which the obligation is transferred, the new 
model avoids confusion regarding whether or how the deemed satisfaction 
proceeds are integrated with the actual transaction. The new model 
operates to trigger all built-in items arising from the obligation, and 
then reissue the obligation with an issue price equal to its basis (and 
generally, its fair market value) before the actual transaction. Thus, 
no further gain, loss, income, or deduction with respect to the 
obligation will result from the actual transaction. In the example 
above, because S has a basis in the new B note of $70, S recognizes no 
gain or loss in the actual sale of the note to X, and X acquires the 
new B note with original issue discount of $30. See section 
1278(a)(2)(B) (coordination where bond has original issue discount). 
After the obligation is deemed satisfied and reissued, the occurrence 
of the actual transaction does not result in an additional deemed 
satisfaction and reissuance.
2. The Deemed Satisfaction-Reissuance Amount
    The Current Regulations and the 1998 Proposed Regulations provide 
that the deemed satisfaction and reissuance amount generally should be 
determined using the original issue discount principles of sections 
1273 and 1274. The IRS and the Treasury Department

[[Page 55141]]

have concluded, however, that for transactions where it is appropriate 
to require a deemed satisfaction and reissuance, the deemed 
satisfaction and reissuance amount generally should be equal to the 
obligation's fair market value.
    The IRS and the Treasury Department acknowledge the inherent 
difficulty in valuing intercompany obligations. Nonetheless, the use of 
fair market value pricing more accurately preserves the location of a 
creditor and debtor member's items from an intercompany obligation and 
results in less distortion of the members' income, particularly where 
the issue price and value of the obligation differ significantly. 
Furthermore, in many transactions to which the deemed satisfaction-
reissuance model applies under these proposed regulations, the group 
will often be required to determine the fair market value of the 
intercompany obligation because there is a taxable exchange of property 
for which the appropriate amount of gain or loss must be determined 
under general Internal Revenue Code (Code) principles. Accordingly, the 
IRS and the Treasury Department generally believe that requiring a 
deemed satisfaction and reissuance at fair market value will not be 
overly burdensome.
    However, these proposed regulations also provide that where the 
creditor's amount realized with respect to the intercompany obligation 
in the transaction differs from the fair market value of the 
obligation, and the transaction is not an intragroup exchange of an 
intercompany obligation for a newly issued intercompany obligation, the 
deemed satisfaction and reissuance amount is the amount realized. For 
example, the amount realized with respect to an intercompany obligation 
may differ from fair market value if the creditor sells the obligation 
in a transaction to which section 1060 applies. In such cases, the use 
of amount realized rather than fair market value as the satisfaction 
amount for the deemed satisfaction and reissuance ensures that no 
additional items with respect to the obligation will result from the 
actual transaction.
    If the transaction is an intragroup exchange of an intercompany 
obligation for a newly issued intercompany obligation, these proposed 
regulations provide that the obligation is deemed satisfied and 
reissued for its fair market value. In addition, for all such 
intragroup debt exchanges (other than routine intragroup debt 
modifications as discussed in part I.D.4 of this preamble), the newly 
issued obligation will be treated as having an issue price equal to its 
fair market value.
    In addition, if a member's amount realized with respect to an 
intercompany obligation results from a mark to fair market value under 
section 475, then the obligation will be treated as satisfied and 
reissued under these regulations but will not otherwise be marked to 
fair market value under section 475 immediately thereafter. Because the 
deemed satisfaction and reissuance causes all built-in items from the 
obligation to be recognized, there is no need for an additional mark to 
fair market value under section 475. However, the rules of section 475 
will continue to apply to the newly-reissued obligation with respect to 
future events.
    These proposed regulations do not provide specific rules for 
intercompany obligations that are not debt instruments. The regulations 
generally provide that the principles applied to debt instruments will 
similarly apply (with appropriate adjustments) to such non-debt 
instruments. The IRS and the Treasury Department request comments on 
whether additional rules are needed for such instruments.
D. Limitations on the Application of the Deemed Satisfaction-Reissuance 
Model to Intragroup Transactions
    The Current Regulations and the 1998 Proposed Regulations apply the 
deemed satisfaction-reissuance model to intragroup transactions in 
which a member realizes an amount (under the Current Regulations, an 
amount of income, gain, deduction, or loss, other than zero) with 
respect to an intercompany obligation from the assignment or 
extinguishment of all or part of its remaining rights or obligations 
under the intercompany obligation (or from a comparable transaction).
    These proposed regulations generally retain the deemed 
satisfaction-reissuance model for such intragroup transactions. 
Specifically, these proposed regulations apply the model upon a 
``triggering transaction,'' which is defined as any intercompany 
transaction in which a member realizes an amount, directly or 
indirectly, from the assignment or extinguishment of all or part of its 
remaining rights or obligations under an intercompany obligation (or 
from a comparable transaction). However, in recognition of the 
administrative burden involved in valuing intercompany obligations in 
certain transactions and in order to limit the effects of Sec.  1.1502-
13(g) on certain routine intragroup transactions involving intercompany 
obligations (such as an intragroup merger of one member into another), 
these proposed regulations provide a number of exceptions from the 
application of the deemed satisfaction and reissuance model (subject to 
the material tax benefit rule described in part I.E. of this preamble).
    In general, and as further described in this preamble, the IRS and 
the Treasury Department have sought to apply the deemed satisfaction-
reissuance model only to those intragroup transactions that have the 
greatest potential to create distortions of consolidated taxable income 
and to exclude those transactions where the administrative burdens of 
either requiring precise valuation of intercompany obligations or 
requiring the additional mechanics of the deemed satisfaction-
reissuance model outweigh the benefits of increased precision. The IRS 
and the Treasury Department request comments as to whether some or all 
of these exceptions are appropriate, as well as suggestions for other 
exceptions.
1. Intragroup Sections 332, 351, and 361 Exchanges
    Under these proposed regulations, and subject to the material tax 
benefit rule as described in part I.E. of this preamble, assignments of 
intercompany obligations in certain intragroup nonrecognition 
transactions are excepted from the application of the deemed 
satisfaction-reissuance model. These transactions include transfers and 
assumptions of intercompany obligations in intragroup exchanges to 
which section 332 or section 361 apply if neither the creditor nor the 
debtor recognizes an amount of income, gain, deduction, or loss in the 
transaction, or in intragroup exchanges to which section 351 applies if 
no such amount is recognized by the creditor.
2. Intragroup Taxable Assumption Transactions
    These proposed regulations also provide an exception to the 
application of the deemed satisfaction-reissuance model for taxable 
intragroup sales of assets where intercompany obligations are assumed 
as part of the transaction. Where indebtedness is assumed incident to a 
sale of assets, in most cases, the location of gain or loss from an 
intercompany obligation is appropriately reflected in increased or 
reduced sales proceeds for the assets. Such transactions generally 
present less potential for distortion of consolidated taxable income. 
Accordingly, subject to the material tax benefit rule as described in 
part I.E. of this preamble, the regulations do not require a deemed 
satisfaction and reissuance where an

[[Page 55142]]

intercompany obligation is assumed in a taxable intragroup sale of 
assets.
3. Intragroup Extinguishments--In General
    These proposed regulations except from the application of the 
deemed-satisfaction reissuance model many intragroup transactions in 
which an intercompany obligation is extinguished. In general, where an 
intercompany obligation is extinguished, the Code and regulations will 
cause the creditor and debtor to recognize their respective items from 
the obligation, and thus preserve the location of such items. In such 
cases, a deemed satisfaction-reissuance model is not necessary. Thus, 
under these proposed regulations and subject to the material tax 
benefit rule as described in part I.E. of this preamble, the deemed 
satisfaction-reissuance model does not apply where the adjusted issue 
price of the obligation is equal to the creditor's basis in the 
obligation and the creditor's and debtor's items from the 
extinguishment transaction offset in amount.
    These proposed regulations provide that certain Code provisions, 
such as section 108(a) and section 354 are inapplicable to gains and 
losses from intercompany obligations (and clarify that section 
355(a)(1) is also inapplicable to such gains and losses). Turning off 
these provisions ensures single entity treatment by correcting 
mismatches that occur under the Code (where, for instance, a debtor has 
discharge of indebtedness income from the retirement of a security but 
the creditor's corresponding loss is not recognized) and requiring 
immediate recognition of both the debtor's and the creditor's items. 
The Current Regulations and the 1998 Proposed Regulations also provide 
that these Code provisions are inapplicable in many circumstances.
    In the context of extinguishment transactions, the ``turn-off'' 
rule in these proposed regulations is applied first to determine 
whether the transaction is a triggering transaction. Because the rule 
imposes symmetrical treatment of the debtor and the creditor and 
requires that each member recognize their respective items, in many 
cases the debtor's and creditor's items will offset in amount and the 
exception described above will apply. For example, assume a note with 
an adjusted issue price and basis of $100 is extinguished in a fully 
taxable transaction for $20 and that the debtor's cancellation of 
indebtedness income would otherwise be excluded under section 108(a). 
Because the turn-off rule makes section 108(a) inapplicable, the 
creditor's $80 loss and the debtor's $80 of cancellation of 
indebtedness income will offset in amount and the extinguishment 
transaction will not be subject to the deemed satisfaction and 
reissuance model.
    However, the deemed satisfaction-reissuance model will continue to 
apply in those cases where, after taking into account the above-
described ``turn-off'' rule, the creditor's and debtor's items from the 
transaction do not offset in amount. In these cases, depending upon the 
circumstances, the net amount of income, gain, loss, or deduction from 
the intercompany obligation may or may not be redetermined, under the 
principles of Sec.  1.1502-13(c)(1), to be excluded from gross income 
or treated as a noncapital, nondeductible amount.
4. Routine Intragroup Modifications of Intercompany Obligations
    In general, the exchange of intercompany debt for newly issued 
intercompany debt presents a high potential for distortion of 
consolidated taxable income. Accordingly, these proposed regulations 
apply the deemed satisfaction-reissuance model at fair market value to 
such intragroup exchanges and generally provide that the newly issued 
obligation will be treated as issued for its fair market value. 
However, in order to avoid requiring valuation of intercompany 
obligations in routine debt modifications, the proposed regulations 
provide an exception for certain debt-for-debt exchanges involving a 
single issuer, subject to the material tax benefit rule as described in 
part I.E. of this preamble. Thus, if a member's intercompany debt is 
extinguished in exchange (or deemed exchange) for the member's newly 
issued intercompany debt, and the issue price of the new debt is equal 
to both the adjusted issue price and basis of the extinguished debt, 
the deemed satisfaction-reissuance model does not apply (and the newly 
issued debt is not treated as issued for its fair market value).
5. Other Exceptions for Intragroup Transactions
    These proposed regulations retain the exceptions in the Current 
Regulations for transactions involving an obligation that became an 
intercompany obligation by reason of an event described in Sec.  1.108-
2(e), and for amounts realized from reserve accounting under section 
585. However, consistent with the 1998 Proposed Regulations, these 
proposed regulations do not include the exception in the Current 
Regulations for transactions in which the deemed satisfaction and 
reissuance will not have a significant effect on any person's Federal 
income tax liability for any year.
E. Material Tax Benefit Rule
    Although these proposed regulations provide exceptions to the 
deemed satisfaction-reissuance model, the IRS and the Treasury 
Department remain concerned that the shifting of built-in items from 
intercompany obligations can give rise to significant potential for 
distortion. Intercompany obligations present special concerns because 
debt between members never increases or diminishes the wealth of the 
group (one member's economic gain is matched by the other's economic 
loss) and because, in comparison to other types of property, they can 
be easily created, transferred, modified, and extinguished within the 
group at little or no economic cost.
    Therefore, in order to prevent distortions that may result from the 
shifting of built-in items from intercompany obligations, these 
proposed regulations include a special rule (the material tax benefit 
rule) that applies to intragroup transactions otherwise excepted from 
the deemed satisfaction-reissuance model under the exceptions for 
certain intragroup nonrecognition exchanges, taxable assumption 
transactions, extinguishment transactions, and routine debt 
modifications as described in parts I.D.1, 2, 3 and 4 of this preamble. 
The rule is directed at intragroup transactions that would have a 
distortive effect on members' attributes or the basis of member stock 
using built-in items from intercompany obligations.
    The material tax benefit rule generally applies to an intragroup 
assignment or extinguishment that would otherwise be excepted from the 
deemed satisfaction-reissuance model if, at the time of the 
transaction, it is reasonably foreseeable (regardless of intent) that 
the shifting of items of built-in gain, loss, income, or deduction from 
an intercompany obligation between members will secure a material tax 
benefit that would not otherwise be enjoyed. In such cases, the 
intercompany transaction will be treated as a ``triggering 
transaction'' and will be subject to the deemed satisfaction-reissuance 
model as described in part I.C. of this preamble.
F. Off-Market Issuance Rule
    The IRS and the Treasury Department also believe that inappropriate 
distortions of consolidated taxable income could result from 
intercompany obligations that are issued at a materially off-market 
rate of interest. Such lending transactions may create

[[Page 55143]]

built-in gain or loss in a newly issued obligation that could 
facilitate the manipulation of a member's attributes or the basis of 
member stock. Although off-market lending transactions are subject to 
various limitations under the Code and regulations (for example, 
sections 482, 1274, and 7872), the IRS and the Treasury Department 
believe that an additional rule is necessary to properly reflect 
consolidated taxable income.
    Accordingly, these proposed regulations include a special rule (the 
off-market issuance rule) that generally applies if an intercompany 
obligation is issued at a rate of interest that is materially off-
market, and at the time of issuance, it is reasonably foreseeable that 
the shifting of built-in items from the obligation from one member to 
another member will secure a material tax benefit. In such cases, the 
intercompany obligation will be treated as originally issued for its 
fair market value, and any difference between the amount loaned and the 
fair market value of the obligation will be treated as transferred 
between the creditor member and the debtor member at the time of 
issuance (for example, as a distribution or a contribution to capital). 
This rule is not intended to apply to intragroup lending at interest 
rates that approximate those that would have been charged in an arm's 
length transaction.
    The IRS and the Treasury Department are continuing to explore the 
relationship between the intragroup off-market issuance rule and the 
other limitations imposed by the Code and regulations on such lending 
transactions, and request comments in this regard.
G. Outbound Transactions
    These proposed regulations have retained the deemed satisfaction-
reissuance model (with the aforementioned new mechanics) for outbound 
transactions, as well as the exception in the Current Regulations for 
outbound transactions involving an obligation that became intercompany 
obligation in an event described in Sec.  1.108-2(e). These proposed 
regulations also include two additional exceptions applicable to 
outbound transactions.
    The first, the subgroup exception, provides that the deemed 
satisfaction and reissuance model will not apply if the creditor and 
debtor to an intercompany obligation cease to be members of a 
consolidated group in a transaction in which neither member otherwise 
recognize an item with respect to the intercompany obligation, and 
immediately after the transaction, such creditor and debtor are members 
of another consolidated group. In such cases, a deemed satisfaction and 
reissuance is unnecessary because any built-in items with respect to 
the obligation will be appropriately preserved and offset in the new 
consolidated group. However, to minimize distortions in the new group 
that may result from these built-in items (for example, if S and B are 
acquired in different chains), the exception requires that the creditor 
and the debtor bear a relationship described in section 1504(a)(1) to 
each other through an intercompany obligation subgroup parent (which 
may be the debtor or the creditor).
    These proposed regulations provide a second exception for an 
intercompany obligation that is newly issued in an intragroup 
reorganization and pursuant to the plan of reorganization, is 
distributed to a nonmember shareholder or creditor in a transaction to 
which section 361(c) applies. Because the obligation is newly issued in 
the reorganization and is distributed outside of the group as part of 
the same plan, the IRS and the Treasury Department believe that a 
deemed satisfaction and reissuance of the obligation is not necessary 
to carry out the purposes of Sec.  1.1502-13.
    These proposed regulations also provide a rule that prevents 
indirect acceleration of a loss from an intercompany obligation through 
the sale of the obligation to a nonmember in exchange for a newly-
issued obligation (the issue price of which is determined under section 
1273(b)(4) or section 1274(a)) followed by a sale of the nonmember 
obligation at a loss. The regulations under section 108(e)(4) contain a 
similar rule.
H. Inbound Transactions
    Both the Current Regulations and the 1998 Proposed Regulations 
apply a deemed satisfaction-reissuance model for transactions in which 
a nonintercompany obligation becomes an intercompany obligation. For 
such transactions, the obligation is treated as satisfied and reissued 
immediately after it becomes an intercompany obligation.
    These proposed regulations retain the deemed satisfaction-
reissuance model for inbound transactions, but also include a 
``subgroup'' exception for certain of these transactions. The subgroup 
exception for inbound transactions is similar to the subgroup exception 
for outbound transactions as described in part I.G. of this preamble.
    In addition, these proposed regulations provide a special rule to 
prevent inappropriate acceleration of a deduction for repurchase 
premium in certain inbound transactions. A single corporation that 
repurchases its own debt in exchange for a newly-issued debt, the issue 
price of which is determined under either section 1273(b)(4) or section 
1274, must amortize any repurchase premium over the term of the newly-
issued debt instrument. See Sec.  1.163-7(c). Because the IRS and the 
Treasury Department believe that it would be inconsistent with single-
entity principles to permit consolidated groups an immediate deduction 
in similar circumstances, these proposed regulations provide that if 
indebtedness of a member is acquired in exchange for the issuance of 
indebtedness to a nonmember and the issue price of the newly-issued 
indebtedness is not determined by reference to its fair market value 
(for example, the issue price is determined under section 1273(b)(4) or 
section 1274(a)), then the repurchase premium from the deemed 
satisfaction will be amortized over the term of the obligation issued 
to the nonmember.
I. Other Request for Comments
    In general, these proposed regulations retain the definition of 
intercompany obligation found in the Current Regulations and the 1998 
Proposed Regulations. This definition excludes executory obligations to 
purchase or provide goods or services. The IRS and the Treasury 
Department are considering whether this exclusion is appropriate in all 
instances, and request comments in this regard.
    As described in part I.G. of this preamble, these proposed 
regulations except from the deemed satisfaction-reissuance model 
outbound transfers of intercompany obligations where the obligation is 
newly issued in an intragroup reorganization and is then distributed to 
a nonmember shareholder or creditor in a transaction to which section 
361(c) applies. These proposed regulations do not provide an exception 
for such transactions where the newly issued obligation is distributed 
within the group to a member shareholder or creditor. The IRS and the 
Treasury Department are studying the effects of the deemed 
satisfaction-reissuance model on such intragroup distributions and are 
considering various approaches to ensure the appropriate single-entity 
treatment of such transactions. Comments are requested in this regard.
    These proposed regulations do not provide special rules for the 
treatment of intercompany obligations transferred or assumed in 
transactions under section 338. The IRS and the Treasury

[[Page 55144]]

Department request comments in this regard.
    The application of the deemed satisfaction-reissuance model and the 
matching principles of Sec.  1.1502-13(c) generally align the basis and 
issue price (or adjusted issue price) of an intercompany obligation 
and, thus, reduce potential distortions. For newly issued obligations, 
however, in certain circumstances the Code and regulations produce 
disparities between issue price and basis (such as the issuance of note 
by a subsidiary to its parent in a distribution to which section 301 
applies). The IRS and the Treasury Department are considering whether 
it would be beneficial to eliminate any such disparity created upon the 
issuance of an obligation (for example, by treating such obligations as 
issued for fair market value) and request comments in this regard.

II. Intercompany Insurance Regulations

A. Current Regulations
    Under the Current Regulations, a member's special status as an 
insurance company is respected and, in some circumstances, results in 
an exception to the general single entity treatment for intercompany 
transactions. Under Sec.  1.1502-13(e)(2)(ii)(A), if a member provides 
insurance to another member in an intercompany transaction, the 
transaction is taken into account on a separate entity basis. Thus, 
premiums, reserve increases and decreases, and other similar items are 
determined and taken into account under the members' separate entity 
method of accounting rather than under the matching rule of Sec.  
1.1502-13(c) and the acceleration rule of Sec.  1.1502-13(d). It was 
believed that such transactions would not have a substantial effect on 
consolidated taxable income, and therefore, it was appropriate to 
except these transactions from single entity treatment. This exception 
was intended to avoid the complexity that would result from adjustments 
needed to produce single entity results, and, thus, simplify 
intercompany accounting. See CO-11-91, 1994-1 CB 724 [59 FR 18011]. 
However, except with respect to the amount of any reserve item listed 
in section 807(c) or section 832(b)(5) resulting from an intercompany 
reinsurance transaction, this departure from single entity treatment 
does not extend to intercompany reinsurance transactions. See Sec.  
1.1502-13(e)(2)(ii)(B).
    Subsequent to the issuance of the Current Regulations, the IRS 
determined that it would no longer invoke the ``economic family 
theory'' in addressing whether captive insurance transactions 
constituted insurance for federal income tax purposes. Rev. Rul. 2001-
31 (2001-1 C.B. 1348), (See Sec.  601.601(d)(2)(ii)(b).) In addition, 
the IRS and the Treasury Department have become aware of the increasing 
prevalence of captive insurance arrangements within consolidated 
groups. Thus, the separate entity treatment of insurance payments from 
one member of a group to a captive insurance member may now have a 
greater effect on consolidated taxable income than was anticipated when 
the Current Regulations were issued.
B. Single Entity Treatment for Significant Insurance Members
    The IRS and the Treasury Department believe that separate entity 
treatment for direct insurance transactions is inappropriate where a 
significant amount of the insuring member's business arises from 
transactions with other group members. Accordingly, these proposed 
regulations provide that, where a significant portion (5 percent or 
more) of the business of the insuring member (in such case, a 
``significant insurance member'') arises from insuring the risks of 
other members (either by issuing insurance contracts directly to 
members or by reinsuring risks on contracts issued to members), it is 
appropriate to take into account the items from the intercompany 
transactions on a single entity basis. In such cases, the treatment of 
the members' items from the insurance transactions are subject to the 
matching and acceleration rules of Sec.  1.1502-13.
    Under these rules, the insured member's deduction and the 
significant insurance member's income from the transaction will 
generally be taken into account currently. However, the effects of the 
intercompany transaction will otherwise be treated in a manner 
comparable to ``self-insurance'' by a single corporation. For example, 
the significant insurance member's discounted unpaid losses under 
section 832(b)(5) will be determined without regard to the intercompany 
insurance transaction, and such member will instead take deductions 
with respect to losses incurred on intercompany insurance under the 
principles of sections 162 and 461. On the other hand, if a significant 
insurance member assumes all or a portion of the risk on an insurance 
contract written by another member with respect to risks of a 
nonmember, then under single entity principles, these proposed 
regulations generally permit the significant insurance member to 
increase its reserve item under section 807(c) or 832(b)(5) with 
respect to the premium payment.
    These proposed regulations continue to except intercompany 
insurance transactions from single entity treatment where intercompany 
insurance represents less than 5 percent of the insuring member's 
business.
    Reinsurance transactions engaged in by group members that attempt 
to circumvent the single entity rules of Sec.  1.1502-13(e) may be 
subject to the anti-avoidance rules of Sec.  1.1502-13(h). Thus, for 
example, if a member enters into an insurance contract with a third-
party insurer and the contract is then reinsured with a member of the 
group in order to avoid treatment as an intercompany transaction, 
appropriate adjustments will be made to carry out the purposes of the 
intercompany transaction regulations. See also section 845, which 
allows the Secretary to allocate, recharacterize, or make other 
adjustments with respect to two or more related persons who are parties 
to a reinsurance agreement in order to reflect the proper amount, 
source, or character of taxable income related to such an agreement, or 
to make proper adjustments with respect to a party to a reinsurance 
contract if the contract has a significant tax avoidance effect.
C. Request for Comments
    The determination of whether an insuring member is a ``significant 
insurance member'' and, therefore, is subject to the special rules 
described above, is made on an annual basis by comparing the amount of 
the insuring member's business that arises from insuring the risks of 
other members with its total insurance business. In making this 
determination, these proposed regulations use an amount determined 
under section 832(b)(4)(A) (gross premiums written during the taxable 
year less return premiums and premiums paid for reinsurance) to measure 
the insuring member's annual insurance business. The IRS and the 
Treasury Department request comments as to whether this is an 
appropriate measure of an insuring member's business, as well as 
suggestions for alternatives. The IRS and the Treasury Department are 
also considering whether the status of an insuring member as a 
``significant insurance member'' should be an annual determination and 
whether additional rules are needed when an insuring member's status 
changes. The IRS and the Treasury Department request comments in this 
regard, in addition to whether any additional special rules are needed 
to accomplish single entity treatment for intercompany insurance 
transactions.

[[Page 55145]]

Proposed Effective/Applicability Date and Reliance

    These proposed regulations under Sec.  1.1502-13(g) apply to 
transactions involving intercompany obligations occurring in 
consolidated return years beginning on or after the date these 
regulations are published as final regulations in the Federal Register. 
However, for purposes of determining the tax treatment of transactions 
undertaken prior to the finalization of these proposed regulations, 
taxpayers may continue to rely upon the form and timing of the recast 
transaction, as clarified by the 1998 Proposed Regulations (REG-105964-
98) [63 FR 70354].
    These proposed regulations under Sec.  1.1502-13(e) apply to 
intercompany transactions involving the provision of insurance 
occurring in consolidated return years beginning on or after the date 
these regulations are published as final regulations in the Federal 
Register.

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 do not have a significant economic 
impact on a substantial number of small entities. This certification is 
based on the fact that these regulations will affect affiliated groups 
of corporations that have elected to file consolidated returns, which 
tend to be larger businesses, and, moreover, that any burden on 
taxpayers is minimal. Therefore, a Regulatory Flexibility Analysis 
under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not 
required. Pursuant to section 7805(f) of the Internal Revenue Code, 
these regulations have been submitted to the Chief Counsel for Advocacy 
of the Small Business Administration for comment on their impact on 
small business.

Comments and Requests for a 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 the Treasury Department request comments on the 
clarity of the proposed regulations and how they may 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 author of these regulations is Frances L. Kelly, 
Office of Associate Chief Counsel (Corporate). However, other personnel 
from the IRS and the Treasury Department participated in their 
development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Withdrawal of Proposed Regulations

    Accordingly, under the authority of 26 U.S.C. 7805, the notice of 
proposed rulemaking (REG-105964-98) that was published in the Federal 
Register on Monday, December 21, 1998, [63 FR 70354] is withdrawn.

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 
the following entry in numerical order to read in part as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.1502-13 also issued under 26 U.S.C. 1502. * * *

    Par. 2. Section 1.1502-13 is amended by:
    1. Revising the fifth paragraph heading, each entry for Examples 1 
through 5, and adding new Examples 6 through 11 in the table of 
examples in paragraph (a)(6)(ii).
    2. Revising the first sentence of paragraph (e)(2)(i).
    3. Adding new paragraph (e)(2)(ii)(C).
    4. Revising paragraph (g).
    5. Removing paragraph (j)(9) Example 5(c).
    The addition and revisions read as follows:


Sec.  1.1502-13  Intercompany transactions.

    (a) * * *
    (6) * * *
    (ii) * * *
* * * * *
    Obligations of members. (Sec.  1.1502-13(g)(7)(ii))

Example 1. Interest on intercompany obligation.
Example 2. Intercompany obligation becomes nonintercompany 
obligation.
Example 3. Loss or bad debt deduction with respect to intercompany 
obligation.
Example 4. Intercompany nonrecognition transactions.
Example 5. Assumption of intercompany obligation.
Example 6. Extinguishment of intercompany obligation.
Example 7. Exchange of intercompany obligations.
Example 8. Material tax benefit rule.
Example 9. Issuance at off-market rate of interest.
Example 10. Nonintercompany obligation becomes intercompany 
obligation.
Example 11. Notional principal contracts.
* * * * *
    (e) * * *
    (2) * * * (i) * * * Except as provided in paragraph (g)(4)(v) of 
this section (deferral of items from an intercompany obligation), a 
member's addition to, or reduction of, a reserve for bad debts that is 
maintained under section 585 is taken into account on a separate entity 
basis. * * *
    (ii) * * *
    (C) Significant insurance member--(1) Single entity treatment for 
direct insurance and reinsurance. If a significant insurance member (as 
defined in paragraph (e)(2)(ii) (C)(2)(i) of this section) insures the 
risk of another member (the insured member) in an intercompany 
transaction, paragraphs (e)(2)(ii)(A) and (B) of this section do not 
apply and the intercompany transaction is taken into account by both 
members on a single entity basis. For example, the timing and 
attributes of items from a premium payment from an insured member to a 
significant insurance member will be taken into account under the 
matching and acceleration rules, and the premiums earned with respect 
to the intercompany payment will not be accounted for by the 
significant insurance member under the rules of section 832(b)(4). The 
significant insurance member's deduction for losses incurred with 
respect to the intercompany insurance will be taken into account under 
the rules of sections 162 and 461 (including Sec.  1.461-2), rather 
than section 832(b)(5). However, under single-entity principles, if a 
significant insurance member assumes all or a portion of the risk on an 
insurance contract written by another member with respect to risks of a 
nonmember, then the matching and acceleration rules will generally 
permit the significant insurance member to increase its reserve item 
under section 807(c) or 832(b)(5) with respect to the premium payment.
    (2) Definitions. For purposes of this paragraph (e)(2)(ii)(C), the 
following definitions apply:
    (i) Significant insurance member. A member is a significant 
insurance member if it is an insurance company subject to tax under 
subchapter L and five percent or more of the member's

[[Page 55146]]

insurance premiums written during the taxable year arise from insuring 
risks of other members of the group.
    (ii) Insurance premiums written during the taxable year means gross 
premiums written (as defined in Sec.  1.832-4(a)(4) and as reported by 
the insuring member under the method prescribed by Sec.  1.832-4(a)(5)) 
on insurance contracts during the taxable year, less return premiums 
(as defined in Sec.  1.832-4(a)(6)) and premiums paid for reinsurance.
    (3) Effective/applicability date. The rules of this paragraph 
(e)(2)(ii)(C) apply to intercompany transactions involving the 
provision of insurance occurring in consolidated return years beginning 
on or after the date of publication of the Treasury decision adopting 
these rules as final regulations in the Federal Register.
* * * * *
    (g) Obligations of members--(1) In general. In addition to the 
general rules of this section, the rules of this paragraph (g) apply to 
intercompany obligations.
    (2) Definitions. For purposes of this section, the following 
definitions apply:
    (i) Obligation of a member is a debt or security of a member.
    (A) Debt of a member is any obligation of the member constituting 
indebtedness under general principles of Federal income tax law (for 
example, under nonstatutory authorities, or under section 108, section 
163, or Sec.  1.1275-1(d)), but not an executory obligation to purchase 
or provide goods or services.
    (B) Security of a member is any security of the member described in 
section 475(c)(2)(D) or (E), and any commodity of the member described 
in section 475(e)(2)(A), (B), or (C), but not if the security or 
commodity is a position with respect to the member's stock. See 
paragraphs (f)(4) and (f)(6) of this section for special rules 
applicable to positions with respect to a member's stock.
    (ii) Intercompany obligation is an obligation between members, but 
only for the period during which both parties are members.
    (iii) Intercompany obligation subgroup is comprised of two or more 
members that include the creditor and debtor on an intercompany 
obligation if the creditor and debtor bear the relationship described 
in section 1504(a)(1) to each other through an intercompany obligation 
subgroup parent.
    (iv) Intercompany obligation subgroup parent is the corporation 
(including either the creditor or debtor) that bears the same 
relationship to the other members of the intercompany obligation 
subgroup as a common parent bears to the members of a consolidated 
group. Any reference to an intercompany obligation subgroup parent 
includes, as the context may require, a reference to a predecessor or 
successor. For this purpose, a predecessor is a transferor of assets to 
a transferee (the successor) in a transaction to which section 381(a) 
applies.
    (v) Material tax benefit is the benefit of a material net reduction 
in income or gain, or a material net increase in loss, deduction, 
credit, or allowance. A material tax benefit includes, but is not 
limited to, the use of a built-in item or items from an intercompany 
obligation to materially reduce gain or increase loss on the sale of 
member stock, or to create or absorb a material tax attribute of a 
member or subgroup.
    (3) Deemed satisfaction and reissuance of intercompany obligations 
in triggering transactions--(i) Scope--(A) Triggering transactions. For 
purposes of this paragraph (g)(3), a triggering transaction includes 
the following:
    (1) Assignment and extinguishment transactions. Any intercompany 
transaction in which a member realizes an amount, directly or 
indirectly, from the assignment or extinguishment of all or part of its 
remaining rights or obligations under an intercompany obligation or any 
comparable transaction in which a member realizes any such amount, 
directly or indirectly, from an intercompany obligation (for example, a 
mark to fair market value of an obligation or a bad debt deduction). 
However, a reduction of the basis of an intercompany obligation 
pursuant to sections 108 and 1017 and Sec.  1.1502-28 (basis reductions 
upon the exclusion from gross income of discharge of indebtedness) or 
any other provision that adjusts the basis of an intercompany 
obligation as a substitute for income, gain, deduction, or loss, is not 
a comparable transaction.
    (2) Outbound transactions. Any transaction in which an intercompany 
obligation becomes an obligation that is not an intercompany 
obligation.
    (B) Exceptions. Except as provided in paragraph (g)(3)(i)(C) of 
this section, a transaction is not a triggering transaction as 
described in paragraph (g)(3)(i)(A) of this section if any of the 
exceptions in this paragraph (g)(3)(i)(B) apply. In making this 
determination, if a creditor or debtor realizes an amount in a 
transaction in which a creditor assigns all or part of its rights under 
an intercompany obligation to the debtor, or a debtor assigns all of or 
part of its obligations under an intercompany obligation to the 
creditor, the transaction will be treated as an extinguishment and will 
be excepted from the definition of ``triggering transaction'' only if 
either of the exceptions in paragraphs (g)(3)(i)(B)(5) or (6) of this 
section apply.
    (1) Intragroup section 332, 351, or 361 exchange. The transaction 
is an intercompany exchange to which section 332 or section 361 applies 
in which no amount of income, gain, deduction or loss is recognized by 
the creditor or debtor, or an intercompany exchange to which section 
351 applies in which no such amount is recognized by the creditor 
(unless section 362(e)(2) applies to the exchange).
    (2) Intragroup assumption transaction. All of the debtor's 
obligations under an intercompany obligation are assumed in connection 
with the debtor's sale or other disposition of property (other than 
money) in an intercompany transaction to which section 1001 applies.
    (3) Exceptions to the application of section 108(e)(4). The 
obligation became an intercompany obligation by reason of an event 
described in Sec.  1.108-2(e) (exceptions to the application of section 
108(e)(4)).
    (4) Reserve accounting. The amount realized is from reserve 
accounting under section 585 (see paragraph (g)(4)(v) of this section 
for special rules).
    (5) Intragroup extinguishment transaction. All or part of the 
rights and obligations under the intercompany obligation are 
extinguished in an intercompany transaction (other than an exchange or 
deemed exchange of an intercompany obligation for a newly issued 
intercompany obligation), the adjusted issue price of the obligation is 
equal to the creditor's basis in the obligation, and the debtor's 
corresponding item and the creditor's intercompany item (after taking 
into account the special rules of paragraph (g)(4)(i)(C) of this 
section) with respect to the obligation offset in amount.
    (6) Routine modification of intercompany obligation. All of the 
rights and obligations under the intercompany obligation are 
extinguished in an intercompany transaction that is an exchange (or 
deemed exchange) for a newly issued intercompany obligation, and the 
issue price of the newly issued obligation equals both the adjusted 
issue price of the extinguished obligation and the creditor's basis in 
the extinguished obligation.
    (7) Outbound distribution of newly issued intercompany obligation. 
The intercompany obligation becomes an

[[Page 55147]]

obligation that is not an intercompany obligation in a transaction in 
which a member that is a party to the reorganization exchanges property 
in pursuance of the plan of reorganization for a newly issued 
intercompany obligation of another member that is a party to the 
reorganization and distributes such intercompany obligation to a 
nonmember shareholder or nonmember creditor in a transaction to which 
section 361(c) applies.
    (8) Outbound subgroup exception. The intercompany obligation 
becomes an obligation that is not an intercompany obligation in a 
transaction in which the members of an intercompany obligation subgroup 
cease to be members of a consolidated group, neither the creditor nor 
the debtor recognize any income, gain, deduction, or loss with respect 
to the intercompany obligation, and such members constitute an 
intercompany obligation subgroup of another consolidated group 
immediately after the transaction.
    (C) Material tax benefit rule. If an assignment or extinguishment 
of an intercompany obligation in an intercompany transaction would 
otherwise be excepted from the definition of triggering transaction 
under paragraph (g)(3)(i)(B)(1), (2), (5), or (6) of this section, but 
at the time of the assignment or extinguishment, it is reasonably 
foreseeable that the shifting of items of built-in gain, loss, income, 
or deduction from the obligation from one member to another member will 
secure a material tax benefit (as defined in paragraph (g)(2)(v) of 
this section) that the group or its members would not otherwise enjoy 
in a consolidated or separate return year, then the assignment or 
extinguishment will be a triggering transaction to which paragraph 
(g)(3)(ii) of this section applies.
    (ii) Application of deemed satisfaction and reissuance. This 
paragraph (g)(3)(ii) applies if a triggering transaction occurs.
    (A) General rule. If the intercompany obligation is debt of a 
member, then (except as provided in the following sentence) the debt is 
treated for all Federal income tax purposes as having been satisfied by 
the debtor for cash in an amount equal to its fair market value, and 
then as having been reissued as a new obligation (with a new holding 
period but otherwise identical terms) for the same amount of cash, 
immediately before the triggering transaction. However, if the creditor 
realizes an amount with respect to the debt in the triggering 
transaction that differs from the debt's fair market value, and the 
triggering transaction is not an exchange (or deemed exchange) of debt 
of a member for newly issued debt of a member, then the debt is treated 
for all Federal income tax purposes as having been satisfied by the 
debtor for cash in an amount equal to such amount realized, and 
reissued as a new obligation (with a new holding period but otherwise 
identical terms) for the same amount of cash, immediately before the 
triggering transaction. If the triggering transaction is a mark to fair 
market value under section 475, then the intercompany obligation will 
be deemed satisfied and reissued for its fair market value (as 
determined under section 475 and applicable regulations) and section 
475 will not otherwise apply with respect to that triggering 
transaction. If the intercompany obligation is a security of a member, 
similar principles apply (with appropriate adjustments) to treat the 
security as having been satisfied and reissued immediately before the 
triggering transaction.
    (B) Treatment as separate transaction. The deemed satisfaction and 
reissuance is treated as a separate transaction from the triggering 
transaction. The deemed satisfaction and reissuance of a member's debt 
will not cause the debt to be recharacterized as other than debt for 
Federal income tax purposes immediately before the triggering 
transaction.
    (4) Special rules--(i) Timing and attributes. For purposes of 
applying the matching rule and the acceleration rule to a transaction 
involving an intercompany obligation (other than a transaction to which 
paragraph (g)(5) of this section applies)--
    (A) Paragraph (c)(6)(i) of this section (treatment of intercompany 
items if corresponding items are excluded or nondeductible) will not 
apply to exclude any amount of income or gain attributable to a 
reduction of the basis of the intercompany obligation pursuant to 
sections 108 and 1017 and Sec.  1.1502-28, or any other provision that 
adjusts the basis of an intercompany obligation as a substitute for 
income or gain;
    (B) Paragraph (c)(6)(ii) of this section (limitation on treatment 
of intercompany income or gain as excluded from gross income) does not 
apply to prevent any intercompany income or gain from the intercompany 
obligation from being excluded from gross income;
    (C) Any income, gain, deduction, or loss from the intercompany 
obligation is not subject to section 108(a), section 354, section 
355(a)(1), section 1091, or, in the case of an extinguishment of an 
intercompany obligation in a transaction in which the creditor 
transfers the obligation to the debtor in exchange for stock in such 
debtor, section 351(a); and
    (D) Section 108(e)(7) does not apply upon the extinguishment of an 
intercompany obligation.
    (ii) Newly issued obligation in intragroup exchanges. If an 
intercompany obligation is exchanged (or is deemed exchanged) for a 
newly issued intercompany obligation and the exchange (or deemed 
exchange) is not a routine modification of an intercompany obligation 
(as described in paragraph (g)(3)(i)(B)(6) of this section), then the 
newly issued obligation will be treated for all Federal income tax 
purposes as having an issue price equal to its fair market value.
    (iii) Off-market issuance. If an intercompany obligation is issued 
at a rate of interest that is materially off-market (off-market 
obligation) and at the time of issuance, it is reasonably foreseeable 
that the shifting of items of built-in gain, loss, income, or deduction 
from the obligation from one member to another member will secure a 
material tax benefit (as defined in paragraph (g)(2)(v) of this 
section), then the intercompany obligation will be treated, for all 
Federal income tax purposes, as originally issued for its fair market 
value, and any difference between the amount loaned and the fair market 
value of the obligation will be treated as transferred between the 
creditor and the debtor at the time the obligation is issued. For 
example, if S lends $100 to B in return for an off-market B note with a 
value of $130, and at that time, it is reasonably foreseeable that a 
material tax benefit will be secured by the shifting of items from the 
note, then the B note will be treated as issued for $130. The $30 
difference will be treated as a distribution or capital contribution 
between S and B (as appropriate) at the time of issuance, and this 
amount will be reflected in future payments on the note as bond 
issuance premium. An adjustment to an off-market obligation under this 
paragraph (g)(4)(iii) will be made without regard to the application 
of, and in lieu of any adjustment under, section 467 (certain payments 
for the use of property or services), 482 (allocations among commonly 
controlled taxpayers), 483 (interest on certain deferred payments), 
1274 (determination of issue price for certain debt instruments issued 
for property), or 7872 (treatment of loans with below-market interest 
rates.
    (iv) Deferral of loss or deduction with respect to nonmember 
indebtedness acquired in certain debt exchanges. If a creditor 
transfers an intercompany obligation to a nonmember (former 
intercompany obligation) in exchange

[[Page 55148]]

for newly issued debt of a nonmember (nonmember debt), and the issue 
price of the nonmember debt is not determined by reference to its fair 
market value (for example, the issue price is determined under section 
1273(b)(4) or 1274(a) or any other provision of applicable law), then 
any loss of the creditor otherwise allowable on the subsequent 
disposition of the nonmember debt, or any comparable tax benefit that 
would otherwise be available in any other transaction that directly or 
indirectly results from the disposition of the nonmember debt, is 
deferred until the date the debtor retires the former intercompany 
obligation.
    (v) Bad debt reserve. A member's deduction under section 585 for an 
addition to its reserve for bad debts with respect to an intercompany 
obligation is not taken into account, and is not treated as realized 
for purposes of paragraph (g)(3)(i)(A)(1) of this section, until the 
intercompany obligation is extinguished or becomes an obligation that 
is not an intercompany obligation.
    (5) Deemed satisfaction and reissuance of obligations becoming 
intercompany obligations--(i) Application of deemed satisfaction and 
reissuance--(A) In general. This paragraph (g)(5) applies if an 
obligation that is not an intercompany obligation becomes an 
intercompany obligation.
    (B) Exceptions. This paragraph (g)(5) does not apply to an 
intercompany obligation if either of the following exceptions apply.
    (1) Exceptions to the application of section 108(e)(4). The 
obligation becomes an intercompany obligation by reason of an event 
described in Sec.  1.108-2(e) (exceptions to the application of section 
108(e)(4)); or
    (2) Inbound subgroup exception. The obligation becomes an 
intercompany obligation in a transaction in which the members of an 
intercompany obligation subgroup cease to be members of a consolidated 
group, neither the creditor nor the debtor recognize any income, gain, 
deduction, or loss with respect to the intercompany obligation, and 
such members constitute an intercompany obligation subgroup of another 
consolidated group immediately after the transaction.
    (ii) Deemed satisfaction and reissuance--(A) General rule. If the 
intercompany obligation is debt of a member, then the debt is treated 
for all Federal income tax purposes, immediately after it becomes an 
intercompany obligation, as having been satisfied by the debtor for 
cash in an amount determined under the principles of Sec.  1.108-2(f), 
and then as having been reissued as a new obligation (with a new 
holding period but otherwise identical terms) for the same amount of 
cash. If the intercompany obligation is a security of a member, similar 
principles apply (with appropriate adjustments) to treat the security, 
immediately after it becomes an intercompany obligation, as satisfied 
and reissued by the debtor for cash in an amount equal to its fair 
market value.
    (B) Treatment as separate transaction. The deemed satisfaction and 
reissuance is treated as a separate transaction from the transaction in 
which the debt becomes an intercompany obligation, and the tax 
consequences of the transaction in which the debt becomes an 
intercompany obligation must be determined before the deemed 
satisfaction and reissuance occurs. (For example, if the debt becomes 
an intercompany obligation in a transaction to which section 351 
applies, any limitation imposed by section 362(e) on the basis of the 
intercompany obligation in the hands of the transferee member is 
determined before the deemed satisfaction and reissuance.) The deemed 
satisfaction and reissuance of a member's debt will not cause the debt 
to be recharacterized as other than debt for Federal income tax 
purposes.
    (6) Special rules--(i) Timing and attributes. If paragraph (g)(5) 
of this section applies to an intercompany obligation--
    (A) Section 108(e)(4) does not apply;
    (B) The attributes of all items taken into account from the 
satisfaction of the intercompany obligation are determined on a 
separate entity basis, rather than by treating S and B as divisions of 
a single corporation; and
    (C) Any intercompany gain or loss realized by the creditor is not 
subject to section 354 or section 1091.
    (ii) Waiver of loss carryovers from separate return limitation 
years. Solely for purposes of Sec.  1.1502-32(b)(4) and the effect of 
any election under that provision, any loss taken into account under 
paragraph (g)(5) of this section by a corporation that becomes a member 
as a result of the transaction in which the obligation becomes an 
intercompany obligation is treated as a loss carryover from a separate 
return limitation year.
    (iii) Deduction of repurchase premium in certain debt exchanges. If 
an obligation to which paragraph (g)(5) of this section applies is 
acquired in exchange for the issuance of an obligation to a nonmember 
and the issue price of this newly issued obligation is not determined 
by reference to its fair market value (for example, the issue price is 
determined under section 1273(b)(4) or 1274(a) or any other provision 
of applicable law), then, under the principles of Sec.  1.163-7(c), any 
repurchase premium from the deemed satisfaction of the intercompany 
obligation under paragraph (g)(5)(ii) of this section will be amortized 
by the debtor over the term of the obligation issued to the nonmember 
in the same manner as if it were original issue discount and the 
obligation to the nonmember had been issued directly by the debtor.
    (7) Examples--(i) In general. For purposes of the examples in this 
paragraph (g), unless otherwise stated, interest is qualified stated 
interest under Sec.  1.1273-1(c), and the intercompany obligations are 
capital assets and are not subject to section 475.
    (ii) The application of this section to obligations of members is 
illustrated by the following examples:

    Example 1. Interest on intercompany obligation. (i) Facts. On 
January 1 of year 1, B borrows $100 from S in return for B's note 
providing for $10 of interest annually at the end of each year, and 
repayment of $100 at the end of year 5. B fully performs its 
obligations. Under their separate entity methods of accounting, B 
accrues a $10 interest deduction annually under section 163, and S 
accrues $10 of interest income annually under section 61(a)(4) and 
Sec.  1.446-2.
    (ii) Matching rule. Under paragraph (b)(1) of this section, the 
accrual of interest on B's note is an intercompany transaction. 
Under the matching rule, S takes its $10 of income into account in 
each of years 1 through 5 to reflect the $10 difference between B's 
$10 of interest expense taken into account and the $0 recomputed 
expense. S's income and B's deduction are ordinary items. (Because 
S's intercompany item and B's corresponding item would both be 
ordinary on a separate entity basis, the attributes are not 
redetermined under paragraph (c)(1)(i) of this section.)
    (iii) Original issue discount. The facts are the same as in 
paragraph (i) of this Example 1, except that B borrows $90 (rather 
than $100) from S in return for B's note providing for $10 of 
interest annually and repayment of $100 at the end of year 5. The 
principles described in paragraph (ii) of this Example 1 for stated 
interest also apply to the $10 of original issue discount. Thus, as 
B takes into account its corresponding expense under section 163(e), 
S takes into account its intercompany income under section 1272. S's 
income and B's deduction are ordinary items.
    (iv) Tax-exempt income. The facts are the same as in paragraph 
(i) of this Example 1, except that B's borrowing from S is allocable 
under section 265 to B's purchase of state and local bonds to which 
section 103 applies. The timing of S's income is the same as in 
paragraph (ii) of this Example 1. Under paragraph (c)(4)(i) of this 
section, the attributes of B's corresponding item of disallowed 
interest expense control the attributes of S's offsetting 
intercompany interest income. Paragraph (c)(6) of this

[[Page 55149]]

section does not prevent the redetermination of S's intercompany 
item as excluded from gross income because section 265(a)(2) 
permanently and explicitly disallows B's corresponding deduction and 
because, under paragraph (g)(4)(i)(B) of this section, paragraph 
(c)(6)(ii) of this section does not apply to prevent any 
intercompany income from the B note from being excluded from gross 
income. Accordingly, S's intercompany income is treated as excluded 
from gross income.
    Example 2. Intercompany obligation becomes nonintercompany 
obligation. (i) Facts. On January 1 of year 1, B borrows $100 from S 
in return for B's note providing for $10 of interest annually at the 
end of each year, and repayment of $100 at the end of year 5. As of 
January 1 of year 3, B has paid the interest accruing under the note 
and S sells B's note to X for $70, reflecting an increase in 
prevailing market interest rates. B is never insolvent within the 
meaning of section 108(d)(3).
    (ii) Deemed satisfaction and reissuance. Because the B note 
becomes an obligation that is not an intercompany obligation, the 
transaction is a triggering transaction under paragraph 
(g)(3)(i)(A)(2) of this section. Under paragraph (g)(3)(ii) of this 
section, B's note is treated as satisfied and reissued for its fair 
market value of $70 immediately before S's sale to X. As a result of 
the deemed satisfaction of the note for less than its adjusted issue 
price, B takes into account $30 of discharge of indebtedness income 
under Sec.  1.61-12. On a separate entity basis, S's $30 loss would 
be a capital loss under section 1271(a)(1). Under the matching rule, 
however, the attributes of S's intercompany item and B's 
corresponding item must be redetermined to produce the same effect 
as if the transaction had occurred between divisions of a single 
corporation. Under paragraph (c)(4)(i) of this section, the 
attributes of B's $30 of discharge of indebtedness income control 
the attributes of S's loss. Thus, S's loss is treated as ordinary 
loss. B is also treated as reissuing, immediately after the 
satisfaction, a new note to S with a $70 issue price, a $100 stated 
redemption price at maturity, and a $70 basis in the hands of S. S 
is then treated as selling the new note to X for the $70 received by 
S in the actual transaction. Because S has a basis of $70 in the new 
note, S recognizes no gain or loss from the sale to X. After the 
sale, the new note held by X is not an intercompany obligation, it 
has a $70 issue price, a $100 stated redemption price at maturity, 
and a $70 basis. The $30 of original issue discount will be taken 
into account by B and X under sections 163(e) and 1272.
    (iii) Creditor deconsolidation. The facts are the same as in 
paragraph (i) of this Example 2, except that P sells S's stock to X 
(rather than S selling B's note to X). Because the B note becomes an 
obligation that is not an intercompany obligation, the transaction 
is a triggering transaction under paragraph (g)(3)(i)(A)(2) of this 
section. Under paragraph (g)(3)(ii) of this section, B's note is 
treated as satisfied and reissued for its $70 fair market value 
immediately before S becomes a nonmember. The treatment of S's $30 
of loss and B's $30 of discharge of indebtedness income is the same 
as in paragraph (ii) of this Example 2. The new note held by S upon 
deconsolidation is not an intercompany obligation, it has a $70 
issue price, a $100 stated redemption price at maturity, and a $70 
basis. The $30 of original issue discount will be taken into account 
by B and S under sections 163(e) and 1272.
    (iv) Debtor deconsolidation. The facts are the same as in 
paragraph (i) of this Example 2, except that P sells B's stock to X 
(rather than S selling B's note to X). The results to S and B are 
the same as in paragraph (iii) of this Example 2.
    (v) Subgroup exception. The facts are the same as in paragraph 
(i) of this Example 2, except that P owns all of the stock of S, S 
owns all of the stock of B, and P sells all of the S stock to X, the 
parent of another consolidated group. Because B and S, members of an 
intercompany obligation subgroup, cease to be members of the P group 
in a transaction that does not cause either member to recognize an 
item with respect to the B note, and such members constitute an 
intercompany obligation subgroup in the X group, P's sale of S stock 
is not a triggering transaction under paragraph (g)(3)(i)(B)(8) of 
this section, and the note is not treated as satisfied and reissued 
under paragraph (g)(3)(ii) of this section. After the sale, the note 
held by S has a $100 issue price, a $100 stated redemption price at 
maturity, and a $100 basis. The results are the same if the S stock 
is sold to an individual and the S-B affiliated group elects to file 
a consolidated return for the period beginning on the day after S 
and B cease to be members of the P group.
    (vi) Section 338 election. The facts are the same as paragraph 
(i) of this Example 2, except that P sells S's stock to X and a 
section 338 election is made with respect to the stock sale. Under 
section 338, S is treated as selling all of its assets to X, 
including the B note, at the close of the acquisition date. The 
aggregate deemed sales price (within the meaning of Sec.  1.338-4) 
allocated to the B note is $70. Because the B note becomes an 
obligation that is not an intercompany obligation, the transaction 
is a triggering transaction under paragraph (g)(3)(i)(A)(2) of this 
section. Under paragraph (g)(3)(ii) of this section, B's note is 
treated as satisfied and reissued immediately before S's deemed sale 
to X for $70, the amount realized with respect to the note (the 
aggregate deemed sales price allocated to the note under Sec.  
1.338-6). The results to S and B are the same as in paragraph (ii) 
of this Example 2.
    (vii) Appreciated note. The facts are the same as in paragraph 
(i) of this Example 2, except that S sells B's note to X for $130 
(rather than $70), reflecting a decline in prevailing market 
interest rates. Because the B note becomes an obligation that is not 
an intercompany obligation, the transaction is a triggering 
transaction under paragraph (g)(3)(i)(A)(2) of this section. Under 
paragraph (g)(3)(ii) of this section, B's note is treated as 
satisfied and reissued for its fair market value of $130 immediately 
before S's sale to X. As a result of the deemed satisfaction of the 
note for more than its adjusted issue price, B takes into account 
$30 of repurchase premium under Sec.  1.163-7(c). On a separate 
entity basis, S's $30 gain would be a capital gain under section 
1271(a)(1). Under the matching rule, however, the attributes of S's 
intercompany item and B's corresponding item must be redetermined to 
produce the same effect as if the transaction had occurred between 
divisions of a single corporation. Under paragraph (c)(4)(i) of this 
section, the attributes of B's premium deduction control the 
attributes of S's gain. Accordingly, S's gain is treated as ordinary 
income. B is also treated as reissuing, immediately after the 
satisfaction, a new note to S with a $130 issue price, $100 stated 
redemption price at maturity, and $130 basis in the hands of S. S is 
then treated as selling the new note to X for the $130 received by S 
in the actual transaction. Because S has a basis of $130 in the new 
note, S recognizes no gain or loss from the sale to X. After the 
sale, the new note held by X is not an intercompany obligation, it 
has a $130 issue price, a $100 stated redemption price at maturity, 
and a $130 basis. The treatment of B's $30 of bond issuance premium 
under the new note is determined under Sec.  1.163-13.
    Example 3. Loss or bad debt deduction with respect to 
intercompany obligation. (i) Facts. On January 1 of year 1, B 
borrows $100 from S in return for B's note providing for $10 of 
interest annually at the end of each year, and repayment of $100 at 
the end of year 5. On January 1 of year 3, the fair market value of 
the B note has declined to $60 and S sells the B note to P for 
property with a fair market value of $60. B is never insolvent 
within the meaning of section 108(d)(3). The B note is not a 
security within the meaning of section 165(g)(2).
    (ii) Deemed satisfaction and reissuance. Because S realizes an 
amount of loss from the assignment of the B note, the transaction is 
a triggering transaction under paragraph (g)(3)(i)(A)(1) of this 
section. Under paragraph (g)(3)(ii) of this section, B's note is 
treated as satisfied and reissued for its fair market value of $60 
immediately before S's sale to P. As a result of the deemed 
satisfaction of the note for less than its adjusted issue price 
($100), B takes into account $40 of discharge of indebtedness income 
under Sec.  1.61-12. On a separate entity basis, S's $40 loss would 
be a capital loss under section 1271(a)(1). Under the matching rule, 
however, the attributes of S's intercompany item and B's 
corresponding item must be redetermined to produce the same effect 
as if the transaction had occurred between divisions of a single 
corporation. Under paragraph (c)(4)(i) of this section, the 
attributes of B's $40 of discharge of indebtedness income control 
the attributes of S's loss. Thus, S's loss is treated as ordinary 
loss. B is also treated as reissuing, immediately after the 
satisfaction, a new note to S with a $60 issue price, $100 stated 
redemption price at maturity, and $60 basis in the hands of S. S is 
then treated as selling the new note to P for the $60 of property 
received by S in the actual transaction. Because S has a basis of 
$60 in the new note, S recognizes no gain or loss from the sale to 
P. After the sale, the note is an intercompany obligation, it has a 
$60 issue price and a $100 stated redemption price at maturity, and 
the

[[Page 55150]]

$40 of original issue discount will be taken into account by B and P 
under sections 163(e) and 1272.
    (iii) Partial bad debt deduction. The facts are the same as in 
paragraph (i) of this Example 3, except that S claims a $40 partial 
bad debt deduction under section 166(a)(2) (rather than selling the 
note to P). Because S realizes a deduction from a transaction 
comparable to an assignment of the B note, the transaction is a 
triggering transaction under paragraph (g)(3)(i)(A)(1) of this 
section. Under paragraph (g)(3)(ii) of this section, B's note is 
treated as satisfied and reissued for its fair market value of $60 
immediately before section 166(a)(2) applies. The treatment of S's 
$40 loss and B's $40 of discharge of indebtedness income are the 
same as in paragraph (ii) of this Example 3. After the reissuance, S 
has a basis of $60 in the new note. Accordingly, the application of 
section 166(a)(2) does not result in any additional deduction for S. 
The $40 of original issue discount on the new note will be taken 
into account by B and S under sections 163(e) and 1272.
    (iv) Insolvent debtor. The facts are the same as in paragraph 
(i) of this Example 3, except that B is insolvent within the meaning 
of section 108(d)(3) at the time that S sells the note to P. As 
explained in paragraph (ii) of this Example 3, the transaction is a 
triggering transaction and the B note is treated as satisfied and 
reissued for its fair market value of $60 immediately before S's 
sale to P. On a separate entity basis, S's $40 loss would be 
capital, B's $40 income would be excluded from gross income under 
section 108(a), and B would reduce attributes under section 108(b) 
or section 1017 (see also Sec.  1.1502-28). However, under paragraph 
(g)(4)(i)(C) of this section, section 108(a) does not apply to 
characterize B's income as excluded from gross income. Accordingly, 
the attributes of S's loss and B's income are redetermined in the 
same manner as in paragraph (ii) of this Example 3.

    Example 4. Intercompany nonrecognition transactions. (i) Facts. 
On January 1 of year 1, B borrows $100 from S in return for B's note 
providing for $10 of interest annually at the end of each year, and 
repayment of $100 at the end of year 5. As of January 1 of year 3, B 
has fully performed its obligations, but the note's fair market 
value is $130, reflecting a decline in prevailing market interest 
rates. On January 1 of year 3, S transfers the note and other assets 
to a newly formed corporation, Newco, for all of Newco's stock in an 
exchange to which section 351 applies. The aggregate adjusted bases 
of property transferred does not exceed the fair market value of 
such property immediately after the transfer.
    (ii) No deemed satisfaction and reissuance. Because the 
assignment of the B note is an exchange to which section 351 applies 
and S recognizes no gain or loss, the transaction is not a 
triggering transaction under paragraph (g)(3)(i)(B)(1) of this 
section, and the note is not treated as satisfied and reissued under 
paragraph (g)(3)(ii) of this section.
    (iii) Receipt of other property. The facts are the same as in 
paragraph (i) of this Example 4, except that the other assets 
transferred to Newco have a basis of $100 and a fair market value of 
$260, and S receives, in addition to Newco stock, $15 of cash. 
Because S would recognize $15 of gain under section 351(b), the 
assignment of the B note is a triggering transaction under paragraph 
(g)(3)(i)(A)(1) of this section. Under paragraph (g)(3)(ii) of this 
section, B's note is treated as satisfied and reissued for its fair 
market value of $130 immediately before the transfer to Newco. As a 
result of the deemed satisfaction of the note for more than its 
adjusted issue price, B takes into account $30 of repurchase premium 
under Sec.  1.163-7(c). On a separate entity basis, S's $30 gain 
would be a capital gain under section 1271(a)(1). Under the matching 
rule, however, the attributes of S's intercompany item and B's 
corresponding item must be redetermined to produce the same effect 
as if the transaction had occurred between divisions of a single 
corporation. Under paragraph (c)(4)(i) of this section, the 
attributes of B's premium deduction control the attributes of S's 
gain. Accordingly, S's gain is treated as ordinary income. B is also 
treated as reissuing, immediately after the satisfaction, a new note 
to S with a $130 issue price, $100 stated redemption price at 
maturity, and $130 basis in the hands of S. S is then treated as 
transferring the new note to Newco for the Newco stock and cash 
received by S in the actual transaction. Because S has a basis of 
$130 in the new B note, S recognizes no gain or loss with respect to 
the transfer of the note in the section 351 exchange, and S 
recognizes $10 of gain with respect to the transfer of the other 
assets under section 351(b). After the transfer, the note has a $130 
issue price and a $100 stated redemption price at maturity. The 
treatment of B's $30 of bond issuance premium under the new note is 
determined under Sec.  1.163-13.
    (iv) Intercompany obligation transferred in section 332 
transaction. The facts are the same as in paragraph (i) of this 
Example 4, except that S transfers the B note to P in complete 
liquidation under section 332. Because the transaction is an 
exchange to which section 332 applies, and neither S nor B recognize 
gain or loss, the transaction is not a triggering transaction under 
paragraph (g)(3)(i)(B)(1) of this section, and the note is not 
treated as satisfied and reissued under paragraph (g)(3)(ii) of this 
section.

    Example 5. Assumption of intercompany obligation. (i) Facts. On 
January 1 of year 1, B borrows $100 from S in return for B's note 
providing for $10 of interest annually at the end of each year, and 
repayment of $100 at the end of year 5. The note is fully recourse 
and is incurred for use in Business Z. As of January 1 of year 3, B 
has fully performed its obligations, but the note's fair market 
value is $110 reflecting a decline in prevailing market interest 
rates. Business Z has a fair market value of $95. On January 1 of 
year 3, B transfers all of the assets of Business Z and $15 of cash 
to M in exchange for the assumption by M of all of B's obligations 
under the note. The terms and conditions of the note are not 
modified in connection with the sales transaction, and no amount of 
income, gain, loss, or deduction is recognized by S, B, or M with 
respect to the note.
    (ii) No deemed satisfaction and reissuance. Because all of B's 
obligations under the B note are assumed by M in connection with the 
sale of the Business Z assets, the assignment of B's obligations 
under the note is not a triggering transaction under paragraph 
(g)(3)(i)(B)(2) of this section, and the note is not treated as 
satisfied and reissued under paragraph (g)(3)(ii) of this section.

    Example 6. Extinguishment of intercompany obligation. (i) Facts. 
On January 1 of year 1, B borrows $100 from S in return for B's note 
providing for $10 of interest annually at the end of each year, and 
repayment of $100 at the end of year 5. The note is a security 
within the meaning of section 351(d)(2). As of January 1 of year 3, 
B has fully performed its obligations, but the fair market value of 
the B note is $130, reflecting a decline in prevailing market 
interest rates, and S transfers the note to B in exchange for $130 
of B stock in a transaction to which section 351 applies.
    (ii) No deemed satisfaction and reissuance. As a result of the 
satisfaction of the note for more than its adjusted issue price, B 
takes into account $30 of repurchase premium under Sec.  1.163-7(c). 
Although the transfer of the B note is a transaction to which 
section 351 applies, under paragraph (g)(4)(i)(C) of this section, 
any gain or loss from the intercompany obligation is not subject to 
section 351(a), and therefore, S has a $30 gain under section 1001. 
Because the note is extinguished in a transaction in which the 
adjusted issue price of the note is equal to the creditor's basis in 
the note, and the debtor's and creditor's items offset in amount, 
the transaction is not a triggering transaction under paragraph 
(g)(3)(i)(B)(5) of this section, and the note is not treated as 
satisfied and reissued under paragraph (g)(3)(ii) of this section. 
On a separate entity basis, S's $30 gain would be a capital gain 
under section 1271(a)(1). Under the matching rule, however, the 
attributes of S's intercompany item and B's corresponding item must 
be redetermined to produce the same effect as if the transaction had 
occurred between divisions of a single corporation. Under paragraph 
(c)(4)(i) of this section, the attributes of B's premium deduction 
control the attributes of S's gain. Accordingly, S's gain is treated 
as ordinary income. Under paragraph (g)(4)(i)(D) of this section, 
section 108(e)(7) does not apply upon the extinguishment of the B 
note, and therefore, the B stock received by S in the exchange will 
not be treated as section 1245 property.
    Example 7. Exchange of intercompany obligations.  (i) Facts. On 
January 1 of year 1, B borrows $100 from S in return for B's note 
providing for $10 of interest annually at the end of each year, and 
repayment of $100 at the end of year 20. As of January 1 of year 3, 
B has fully performed its obligations and, pursuant to a 
recapitalization to which section 368(a)(1)(E) applies, B issues a 
new note to S in exchange for the original B note. The new B note 
has an issue price, stated redemption price at maturity, and stated 
principal amount of $100, but contains terms that differ 
sufficiently from the terms of the original B note to cause a 
realization event under Sec.  1.1001-3. The original B note and the 
new B note are both securities (within the meaning of section 
354(a)(1)).

[[Page 55151]]

    (ii) No deemed satisfaction and reissuance. Because the original 
B note is extinguished in exchange for a newly issued B note and the 
issue price of the new B note is equal to both the adjusted issue 
price of the original B note and S's basis in the original B note, 
the transaction is not a triggering transaction under paragraph 
(g)(3)(i)(B)(6) of this section, and the note is not treated as 
satisfied and reissued under paragraph (g)(3)(ii) of this section. B 
has neither income from discharge of indebtedness under section 
108(e)(10) nor a deduction for repurchase premium under Sec.  1.163-
7(c). Although the exchange of the original B note for the new B 
note is a transaction to which section 354 applies, under paragraph 
(g)(4)(i)(C) of this section, any gain or loss from the intercompany 
obligation is not subject to section 354. Under section 1001, S has 
no gain or loss from the exchange of notes.
    Example 8. Material tax benefit rule. (i) Facts. T is a member 
with a material loss from a separate return limitation year (SRLY). 
S holds a materially appreciated B note which it transfers to T as 
part of an exchange which otherwise qualifies for nonrecognition 
treatment under section 351.
    (ii) Deemed satisfaction and reissuance. Under paragraph 
(g)(3)(i)(B)(1) of this section, absent the application of the 
material tax benefit rule of paragraph (g)(3)(i)(C) of this section, 
the assignment of the B note would not be a triggering transaction. 
However, because at the time of the assignment, it is reasonably 
foreseeable that the shifting of the built-in income or gain from 
the obligation will secure a material tax benefit that the group or 
its members would not otherwise enjoy, under paragraph (g)(3)(i)(C) 
of this section, the assignment of the B note is a triggering 
transaction to which paragraph (g)(3)(ii) of this section applies. 
Under paragraph (g)(3)(ii) of this section, B's note is treated as 
satisfied and reissued for its fair market value, immediately before 
S's transfer to T. As a result of the deemed satisfaction of the 
note for more than its adjusted issue price, S takes into account 
gain and B has a corresponding repurchase premium deduction. B is 
also treated as reissuing, immediately after the deemed 
satisfaction, a new note to S with an issue price and basis equal to 
its fair market value. S is then treated as transferring the new 
note to T as part of the section 351 exchange. Because T will have a 
fair market value basis in the reissued B note immediately after the 
exchange, T's intercompany item from the subsequent retirement of 
the B note will not reflect any of S's built-in gain (and the amount 
of SRLY loss that may be absorbed by such item will be limited to 
any appreciation in the B note accruing after the exchange).
    (iii) No material tax benefit. The facts are the same as in 
paragraph (i) of this Example 8, except that S has a SRLY loss that 
exceeds, and will expire prior to, that of T. Further, it is 
anticipated that S and T will each generate similar amounts of 
income for the foreseeable future, and there is no plan or intention 
to sell the stock of either member. Because the built-in income or 
gain from the B note could have been used to facilitate the 
absorption of S's SRLY loss (rather than an equal amount of T's SRLY 
loss), the group and its members have not secured a material tax 
benefit from the assignment that it would not have otherwise 
enjoyed. Accordingly, the assignment is not subject to the material 
tax benefit rule of paragraph (g)(3)(i)(C) of this section, and the 
B note is not deemed satisfied and reissued under paragraph 
(g)(3)(ii) of this section.
    Example 9. Issuance at off-market rate of interest. (i) Facts. T 
is a member with a material loss from a separate return limitation 
year (SRLY). T's sole shareholder, P, borrows an amount from T in 
return for a P note that provides for a materially above market rate 
of interest. As a result, the P note will generate additional 
interest income to T over the term of the note which will facilitate 
the absorption of T's SRLY loss each year and will result in a 
material tax benefit.
    (ii) Reasonably foreseeable. Because at the time of the 
issuance, it is reasonably foreseeable that the shifting of interest 
income from the off-market obligation will secure a material tax 
benefit that the group or its members would not otherwise enjoy, 
under paragraph (g)(4)(iii) of this section, the intercompany 
obligation is treated, for all Federal income tax purposes, as 
originally issued for its fair market value so T is treated as 
purchasing the note at a premium. The difference between the amount 
loaned and the fair market value of the obligation is treated as 
transferred from P to T as a capital contribution at the time the 
note is issued. Throughout the term of the note, T takes into 
account interest income and bond premium and P takes into account 
interest deduction and bond issuance premium under generally 
applicable Internal Revenue Code sections. Because paragraph 
(g)(4)(iii) of this section applies, no adjustment is made under 
section 482.
    Example 10. Nonintercompany obligation becomes intercompany 
obligation. (i) Facts. On January 1 of year 1, B borrows $100 from X 
in return for B's note providing for $10 of interest annually at the 
end of each year, and repayment of $100 at the end of year 5. As of 
January 1 of year 3, B has fully performed its obligations, but the 
note's fair market value is $70, reflecting an increase in 
prevailing market interest rates. On January 1 of year 3, P buys all 
of X's stock. B is solvent within the meaning of section 108(d)(3).
    (ii) Deemed satisfaction and reissuance. Under paragraph 
(g)(5)(ii) of this section, B's note is treated as satisfied for $70 
(determined under the principles of Sec.  1.108-2(f)(2)) immediately 
after it becomes an intercompany obligation. Both X's $30 capital 
loss (under section 1271(a)(1)) and B's $30 of discharge of 
indebtedness income (under Sec.  1.61-12) are taken into account in 
determining consolidated taxable income for year 3. Under paragraph 
(g)(6)(i)(B) of this section, the attributes of items resulting from 
the satisfaction are determined on a separate entity basis. But see 
section 382 and Sec.  1.1502-15 (as appropriate). B is also treated 
as reissuing a new note to X. The new note is an intercompany 
obligation, it has a $70 issue price and $100 stated redemption 
price at maturity, and the $30 of original issue discount will be 
taken into account by B and X in the same manner as provided in 
paragraph (iii) of Example 1 of this paragraph (g)(7).
    (iii) Amortization of repurchase premium. The facts are the same 
as in paragraph (i) of this Example 10, except that on January 1 of 
year 3, the B note has a fair market value of $130 and rather than 
purchasing the X stock, S purchases the B note from X by issuing its 
own note. The S note has an issue price, stated redemption price at 
maturity, stated principal amount, and a fair market value of $130. 
Under paragraph (g)(5)(ii) of this section, B's note is treated as 
satisfied for $130 (determined under the principles of Sec.  1.108-
2(f)(1)) immediately after it becomes an intercompany obligation. As 
a result of the deemed satisfaction of the note, S has no gain or 
loss and B has $30 of repurchase premium. Under paragraph 
(g)(6)(iii) of this section, B's $30 of repurchase premium from the 
deemed satisfaction is amortized by B over the term of the newly 
issued S note in the same manner as if it were original issue 
discount and the newly issued S note had been issued directly by B. 
B is also treated as reissuing a new note to S. The new note is an 
intercompany obligation, it has a $130 issue price and $100 stated 
redemption price at maturity, and the treatment of B's $30 of bond 
issuance premium under the new B note is determined under Sec.  
1.163-13.
    (iv) Election to file consolidated returns. Assume instead that 
B borrows $100 from S during year 1, but the P group does not file 
consolidated returns until year 3. Under paragraph (g)(5)(ii) of 
this section, B's note is treated as satisfied and reissued as a new 
note immediately after the note becomes an intercompany obligation. 
The satisfaction and reissuance are deemed to occur on January 1 of 
year 3, for the fair market value of the obligation (determined 
under the principles of Sec.  1.108-2(f)(2)) at that time.
    Example 11. Notional principal contracts. (i) Facts. On April 1 
of year 1, M1 enters into a contract with counterparty M2 under 
which, for a term of five years, M1 is obligated to make a payment 
to M2 each April 1, beginning in year 2, in an amount equal to the 
London Interbank Offered Rate (LIBOR), as determined by reference to 
LIBOR on the day each payment is due, multiplied by a $1,000 
notional principal amount. M2 is obligated to make a payment to M1 
each April 1, beginning in year 2, in an amount equal to 8 percent 
multiplied by the same notional principal amount. LIBOR is 7.80 
percent on April 1 of year 2, and therefore, M2 owes $2 to M1.
    (ii) Matching rule. Under Sec.  1.446-3(d), the net income (or 
net deduction) from a notional principal contract for a taxable year 
is included in (or deducted from) gross income. Under Sec.  1.446-
3(e), the ratable daily portion of M2's obligation to M1 as of 
December 31 of year 1 is $1.50 ($2 multiplied by 275/365). Under the 
matching rule, M1's net income for year 1 of $1.50 is taken into 
account to reflect the difference between M2's net deduction of 
$1.50 taken into account and the $0 recomputed net deduction. 
Similarly, the $.50 balance of the $2 of net periodic payments made 
on April 1 of year 2 is taken into account for year 2 in M1's and 
M2's net income and net deduction from the contract.

[[Page 55152]]

In addition, the attributes of M1's intercompany income and M2's 
corresponding deduction are redetermined to produce the same effect 
as if the transaction had occurred between divisions of a single 
corporation. Under paragraph (c)(4)(i) of this section, the 
attributes of M2's corresponding deduction control the attributes of 
M1's intercompany income. (Although M1 is the selling member with 
respect to the payment on April 1 of year 2, it might be the buying 
member in a subsequent period if it owes the net payment.)
    (iii) Dealer. The facts are the same as in paragraph (i) of this 
Example 11, except that M2 is a dealer in securities, and the 
contract with M1 is not inventory in the hands of M2. Under section 
475, M2 must mark its securities to fair market value at year-end. 
Assume that under section 475, M2's loss from marking to fair market 
value the contract with M1 is $10. Because M2 realizes an amount of 
loss from the mark to fair market value of the contract, the 
transaction is a triggering transaction under paragraph 
(g)(3)(i)(A)(1) of this section. Under paragraph (g)(3)(ii) of this 
section, M2 is treated as making a $10 payment to M1 to terminate 
the contract immediately before a new contract is treated as 
reissued with an up-front payment by M1 to M2 of $10. M1's $10 of 
income from the termination payment is taken into account under the 
matching rule to reflect M2's deduction under Sec.  1.446-3(h). The 
attributes of M1's intercompany income and M2's corresponding 
deduction are redetermined to produce the same effect as if the 
transaction had occurred between divisions of a single corporation. 
Under paragraph (c)(4)(i) of this section, the attributes of M2's 
corresponding deduction control the attributes of M1's intercompany 
income. Accordingly, M1's income is treated as ordinary income. 
Under Sec.  1.446-3(f), the deemed $10 up-front payment by M1 to M2 
in connection with the issuance of a new contract is taken into 
account over the term of the new contract in a manner reflecting the 
economic substance of the contract (for example, allocating the 
payment in accordance with the forward rates of a series of cash-
settled forward contracts that reflect the specified index and the 
$1,000 notional principal amount). (The timing of taking items into 
account is the same if M1, rather than M2, is the dealer subject to 
the mark-to-market requirement of section 475 at year-end. However 
in this case, because the attributes of the corresponding deduction 
control the attributes of the intercompany income, M1's income from 
the deemed termination payment from M2 might be ordinary or 
capital). Under paragraph (g)(3)(ii)(A) of this section, section 475 
does not apply to mark the notional principal contract to fair 
market value after its deemed satisfaction and reissuance.

    (8) Effective/applicability date. The rules of this paragraph (g) 
apply to transactions involving intercompany obligations occurring in 
consolidated return years beginning on or after the date of publication 
of the Treasury decision adopting these rules as final regulations in 
the Federal Register.
* * * * *

Kevin M. Brown,
Deputy Commissioner for Services and Enforcement.
 [FR Doc. E7-19134 Filed 9-27-07; 8:45 am]
BILLING CODE 4830-01-P