PROPOSED AMENDMENTS TO CONSOLIDATED RETURN REGS WOULD MODIFY STOCK BASIS RULES.

[Editor's Note: At 59 F.R. 41666-41704, Aug. 15, 1994, the IRS published T.D. 8560 which adopted these proposed regs with several changes.]

ACTION: Notice of proposed rulemaking.

SUMMARY: This document proposes amendments to the consolidated return regulations revising the investment adjustment system, including the rules for earnings and profits and excess loss accounts. The amendments delink the adjustments to stock basis from the adjustments to earnings and profits. Instead, stock basis is adjusted under rules similar to the rules for adjusting the basis of partnership interests and stock in S corporations. Amendments are also proposed to the rules limiting absorption of a member's losses and deductions when it leaves a consolidated group, modifying the basis of the stock of members in certain group structure changes, allocating a corporation's items of income, gain, deduction, loss, and credit, when it joins or leaves a consolidated group, and allowing a worthless stock loss with respect to the stock of members.

DATES: Written comments, requests to appear, and outlines of oral comments to be presented at a public hearing that will be held on December 18, 1992, beginning at 1:00 p.m., in the Internal Revenue Service Auditorium, Seventh Floor, 7400 Corridor, Internal Revenue Building, 1111 Constitution Avenue, N.W., Washington D.C., must be received by November 27, 1992. See notice of hearing published elsewhere in this issue of the Federal Register.

ADDRESSES: Send comments, requests to appear, and outlines of oral comments to: Internal Revenue Service, Attention CC:CORP:T:R (CO-30-92), Room 5228, P.O. Box 7604, Ben Franklin Station, Washington, D.C. 20044. In the alternative, comments and requests (with outlines) may be delivered to: Internal Revenue Service, CC:CORP:T:R (CO-30-92), Room 5228, 1111 Constitution Avenue, N.W., Washington, D.C. 20224. The public hearing will be held in the Internal Revenue Service Auditorium, Seventh Floor, 7400 Corridor, Internal Revenue Building, 1111 Constitution Avenue, N.W., Washington D.C.

FOR FURTHER INFORMATION CONTACT: Concerning the hearing, Carol Savage, Regulations Unit, (202) 622-8452; concerning the regulations relating to stock basis, excess loss accounts, and earnings and profits generally, absorption of losses and deductions, and worthless stock loss, Steven B. Teplinsky, (202) 622-7770; concerning the regulations relating to effects of group structure changes, Rose L. Williams (202) 622-7550; and concerning the regulations relating to the allocation of items when a corporation joins or leaves a group, Roy A. Hirschhorn, (202) 622-7770, or Sharon J. Bomgardner, (202) 622-7770. (The above numbers are not toll-free numbers.)

SUPPLEMENTARY INFORMATION:

A. PAPERWORK REDUCTION ACT

The collections of information contained in this notice of proposed rulemaking have been submitted to the Office of Management and Budget for review in accordance with the Paperwork Reduction Act of 1980 (44 U.S.C. 3504(h)). Comments on the collections of information should be sent to the Office of Management and Budget, Attention: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, D.C. 20503, with copies to the Internal Revenue Service, Attention: IRS Reports Clearance Officer T:FP, Washington, D.C. 20224.

The collections of information in these proposed regulations are in sections 1.1502-32(g), 1.1502-33(d)(5), and 1.1502- 76(b)(2)(ii)(D). The information is required by the Internal Revenue Service to assure the accuracy of stock basis adjustments of members of consolidated groups, appropriate allocations of tax liability among the members, and proper allocation of the income of corporations joining or leaving a consolidated group. The respondents are members of consolidated groups.

The following estimates are an approximation of the average time expected for a collection of information. The estimates are based on such information as is available to the Internal Revenue Service. Individual respondents may require more or less time, depending on their particular circumstances.

Estimated total annual reporting burden: 154,063 hours.

Estimated burden per respondent varies from 1 hour to 3 hours, depending on individual circumstances, with an estimated average of approximately 2 hours.

Estimated number of respondents: 74,247.

Estimated frequency of responses: Once a year.

B. BACKGROUND

This document proposes amendments to the consolidated return regulations under section 1502 of the Internal Revenue Code of 1986 (the Code). The principal focus of the proposed rules is on the determination and adjustment of stock basis. The proposed rules simplify the current rules, conform the current rules to recent Code amendments, and correct anomalies.

C. THE CURRENT INVESTMENT ADJUSTMENT SYSTEM

1. IN GENERAL

The current investment adjustment system (sections 1.1502-19, 1.1502-32, and 1.1502-33) combines single entity and separate entity treatment of subsidiaries in consolidated groups. Unlike a single corporation with divisions, a consolidated group must determine gain or loss from the disposition of a subsidiary's stock, and each subsidiary must maintain a separate earnings and profits account. These requirements reflect the group's treatment as a collection of separate entities. The investment adjustment system was developed to modify the separate entity treatment of subsidiaries in favor of single entity treatment.

Under current section 1.1502-32, an owning member (P) must adjust its basis in the stock of a subsidiary (S) to reflect S's earnings and profits, whether positive or negative (E&P). P's basis is also reduced by the amount of any dividends distributed by S to P, if the distributed E&P is deemed to be reflected in P's basis in S's stock (e.g., if S's E&P arose in a prior consolidated return year and is reflected in stock basis through investment adjustments). To the extent reductions exceed P's basis in S's stock, they result in an excess loss account in the stock. P must include its excess loss account in income under current section 1.1502-19, generally when S's stock is sold to a nonmember or becomes worthless. These rules reflect the treatment of P and S as a single entity by causing P's basis (or excess loss account) in S's stock to reflect amounts recognized by S and taken into account in determining consolidated taxable income, and S's distributions to P.

Under current section 1.1502-33, P must adjust its E&P account to reflect the adjustments to its basis in S's stock. As a result, S's E&P is currently "tiered up" to P's E&P through the investment adjustment system. If P is also a subsidiary, P's E&P (which includes S's E&P) is also tiered up through the investment adjustment system and ultimately reflected in the E&P of the common parent. Each member retains its own E&P, however, including its share of the E&P of lower tier members.

P's stock basis and E&P adjustments are generally determined separately for each share of S's stock and are limited to the share's "allocable part" of S's E&P. For example, if the group owns 80 percent of S's only class of stock, only 80 percent of S's E&P tiers up.

The current rules are expressed as a series of complex, mechanical adjustments. The purposes of the investment adjustment system are not articulated in the regulations, and tax policy concerns with respect to stock basis adjustments (e.g., to prevent overstatement of stock basis) often conflict with those for E&P adjustments (e.g., to prevent understatement of E&P). As a result, the current rules do not easily accommodate changes in the tax law, particularly those giving rise to the growing disparity between taxable income and E&P.

2. TAX AND E&P DISPARITIES

The current investment adjustment system, as adopted in 1966, was designed to reflect single entity treatment of consolidated groups by simultaneously adjusting both the stock basis of members and their E&P. Because consolidated groups typically are owned through the stock of the common parent, single entity treatment requires the E&P account of the common parent to reflect the group's share of each member's E&P. When the current system was adopted in 1966, E&P was also useful for determining stock basis adjustments. Most of the differences between E&P and taxable income were attributable to items of tax-exempt income and noncapital, nondeductible expenses that, in determining consolidated taxable income on a single entity basis, would be inappropriate to take into account as gain or loss on P's disposition of S's stock. However, the interdependence of the stock basis and E&P rules began to create undesirable results in the investment adjustment system after 1969, when the enactment of section 312(k) (and later section 312(n)) introduced significant timing disparities between E&P and taxable income.

Section 312(k) requires E&P determinations to be based on straight-line depreciation rather than the depreciation actually deducted in determining taxable income. Section 312(n) prevents other items that defer income or accelerate deductions (such as intangible drilling costs, mineral exploration and development costs, and installment reporting of gain) from affecting the determination of E&P. The objective of conforming E&P more closely to economic income was to provide a better measure of the dividend-paying capacity of corporations and prevent corporations from passing tax preferences on to shareholders through nondividend distributions.

These E&P refinements produced unintended effects under the investment adjustment system. A principal purpose of the investment adjustment system is to adjust P's basis (or excess loss account) in S's stock to reflect amounts recognized by S and taken into account in determining consolidated taxable income. Although the refinements conform E&P more closely to economic income, they do not reflect amounts taken into account in determining consolidated taxable income.

The application of section 312(k) to stock basis adjustments was confirmed in Woods Investment Co. v. Commissioner, 85 T.C. 274 (1985), acg., 1986-1 C.B. 1, which held that P's basis in S's stock must reflect straight-line E&P depreciation under section 312(k), rather than the accelerated cost recovery deducted by S in determining consolidated taxable income. As a result, groups were not required to account for the accelerated depreciation.

Section 1503(e)(1)(A) was enacted in 1987 to overrule Woods and reverse the effects of sections 312(k) and (n) on stock basis adjustments. Under section 1503(e)(1)(A), stock basis adjustments must generally be determined without regard to section 312(k) and (n) for purposes of determining gain or loss on dispositions of subsidiary stock after December 15, 1987. See also section 301(e) (modifying E&P for purposes of distributions from subsidiaries).

Because section 1503(e)(1)(A) does not apply for purposes of tiering up S's E&P, adjustments to stock basis and to E&P have been delinked. Thus, two separate systems are currently required -- one for determining stock basis and the other for determining E&P.

Congress expected that the principles of section 1503(e)(1) would be incorporated into the investment adjustment system. The legislative history states --

The investment adjustment system has recently been supplemented by sections 1.1502-31T, 1.1502-32T, and 1.1502-33T. These temporary rules were issued to prevent dividend stripping and to deal with the basis and E&P effects of certain group structure changes. Because these rules supplement the present system, they must be modified and integrated into the revised investment adjustment system.

D. OVERVIEW OF PROPOSED RULES

1. IN GENERAL

The proposed rules represent a comprehensive revision of the investment adjustment system, as well as a revision of the related consolidated return rules for the determination and adjustment of P's basis in S's stock. It is anticipated that related rules for determining stock basis in certain triangular reorganizations will be provided in subsequent guidance. See proposed section 1.358-6. It is also anticipated that stock basis and E&P issues will be addressed as part of a later revision of the intercompany transaction rules for consolidated groups.

In connection with the revision of the investment adjustment system, several methods for adjusting stock basis and E&P were considered, and the policies underlying the present system were reexamined. For example, consideration was given to conforming basis and partial conforming basis regimes. Under a conforming basis regime, the basis of a subsidiary's stock would conform to the net asset basis of the subsidiary (generally, the basis of its assets, minus its liabilities). Under a partial conforming basis regime, changes in stock basis would be measured by changes in the member's net asset basis.

Each system has significant sources of complexity and presents significant policy issues. The Treasury Department and the Service concluded that the greatest simplification would be achieved by adopting, to the extent feasible, the existing principles for adjusting the basis of partnership interests (section 705) and stock in S corporations (section 1367). The adjustments under these other systems are similar to the adjustments under the current investment adjustment system, and groups therefore should be familiar with the approach. Additional modifications have been adopted to simplify operation of the current rules and to correct anomalies. Comments are solicited on the general approach of the proposed system, as well as on specific issues.

The proposed rules delink stock basis adjustments from E&P adjustments. Separating these systems prevents policies specific to one system from distorting the other. Stock basis adjustments and E&P continue to tier up, but under separate systems.

In general, P's stock basis adjustments are measured by reference to S's taxable income rather than S's E&P. As in the case of partnerships and S corporations, the rules also take into account tax-exempt income and expenditures that are not deductible or chargeable to capital account.

Because the proposed rules conform the investment adjustment system to recent Code amendments under section 1503(e), the Treasury Department and the Service anticipate that the proposed rules will not materially alter the investment adjustments of most subsidiaries as determined under current law. However, because of the proposed effective dates, simplifying rules, and the correction of anomalies, certain groups will be adversely or favorably affected.

No inference is intended by the proposed rules as to the operation of the current rules.

2. SECTION 1503(e)(3)

As discussed above, section 1503(e)(1) was enacted in 1987 to reverse the effects of section 312(k) and (n) on stock basis. Section 1503(e)(3) was enacted in 1988 to provide regulatory authority to limit the application of section 1503(e)(1). Under the limitation, the adjustments under section 1503(e)(1) would not apply, and therefore section 312(k) and (n) would apply, in the case of any property acquired by the corporation before consolidation. The application would account for the difference between the adjusted basis of the property for purposes of computing taxable income and its adjusted basis for purposes of computing earnings and profits. The legislative history states that --

Section 1503(e)(3) can be interpreted as having other purposes, including authorizing a transitional rule under which benefits conferred on a selling group by Woods before the effective date of section 1503(e)(1) could be offset by detriments to the buying group. Implementing section 1503(e)(3) as a transitional rule under the proposed rules would produce substantial administrative and audit burdens for consolidated groups and for the Service.

The Treasury Department and the Service have concluded that, because of the loss disallowance rule and the substantial complexity and burdens that would result from implementing section 1503(e)(3) as a transitional rule, section 1503(e)(3) should not be further implemented under the proposed rules. Thus, as proposed, section 1503(e)(3) would not apply to any disposition on or after the date the final rules are filed with the Federal Register.

E. PROPOSED STOCK BASIS ADJUSTMENT RULES (SECTION 1.1502-32)

Under the proposed rules, P's stock basis adjustments with respect to S's stock are determined by reference to S's taxable income or loss, certain tax-exempt and noncapital, nondeductible items, and distributions. As under the current system, a positive adjustment increases, and a negative adjustment decreases, P's basis in S's stock. If a negative adjustment exceeds P's basis, the excess is referred to as P's excess loss account.

Section 1.1502-32(a) describes the basic purposes of the stock basis adjustment rules as reflecting the treatment of P and S as a single entity. Thus, stock basis adjustments prevent items recognized by S from being recognized a second time on P's disposition of S's stock. In addition, even if the adjustments are not necessary to prevent duplication of S's items (e.g., the items are attributable to unrealized loss of S that is reflected in P's cost basis for S's stock), the adjustments have the effect of causing P to recapture the items. (But see section 1.1502-20, disallowing certain stock losses to implement the repeal of the General Utilities doctrine.)

1. AMOUNT OF ADJUSTMENT

The adjustment is the net amount (treating income and gain items as increases and losses, deductions, and distributions as decreases) of S's --

(i) Taxable income or tax loss;

(ii) Tax-exempt income;

(iii) Noncapital, nondeductible expenses; and

(iv) Distributions with respect to S's stock.

a. TAXABLE INCOME AND TAX LOSS. S's taxable income or tax loss is consolidated taxable income determined by taking into account only S's items. S's losses and deductions are taken into account whether or not they are absorbed by S. By referring to consolidated taxable income, the rules take into account such provisions as the deferral of intercompany items under section 1.1502-13 and the elimination of intercompany dividends under section 1.1502-14.

b. TAX-EXEMPT INCOME. P's basis in S's stock is also increased by the amount of S's tax-exempt income, to prevent the income from being indirectly taxed as gain on P's disposition of S's stock. Tax- exempt income is income that is recognized by S but is permanently excluded from (i.e., never taken into account in determining) S's gross income.

An item of income is treated as tax-exempt income for purposes of stock basis adjustments if it is permanently offset by a deduction or other item and the offsetting item does not represent a recovery of basis (whether through a deduction, loss, cost, expense, or otherwise) or an expenditure of money. For example, if S receives a $100 dividend with respect to which a $70 dividend-received deduction is allowed under section 243, both the $100 dividend and the $70 deduction are taken into account in computing taxable income. In addition, $70 of the dividend is treated as tax-exempt income (assuming that no corresponding stock basis reduction is required under section 1059 or otherwise). As a result, P's basis in S's stock increases by $100, $30 because of S's taxable income and $70 because of its tax-exempt income.

Similarly, income offset by percentage depletion deductions in excess of basis is tax-exempt. In contrast, income offset by an asset's accelerated depreciation deductions is not tax-exempt because the deductions represent a recovery of S's basis in the asset.

The proposed rules incorporate section 1503(e)(1)(B) by treating discharge of indebtedness income that is excluded from S's gross income under section 108(a) as tax-exempt only to the extent the discharged amount is applied to reduce tax attributes under sections 108(b) and 1017 and the attribute reduction results in a corresponding reduction to the basis in stock of members.

c. NONCAPITAL, NONDEDUCTIBLE EXPENSES. P's basis in S's stock is also decreased by the amount of its noncapital, nondeductible expenses, to prevent the expenses from being indirectly recovered on the disposition of S's stock. A noncapital, nondeductible expense is a deduction or loss that is recognized by S (whether through a cost, expense, expenditure of money, or otherwise) but is permanently disallowed in determining S's taxable income or loss. For example, federal taxes described in section 275 are noncapital, nondeductible expenses.

d. BASIS POPS. Under the current rules, E&P is useful to determine stock basis adjustments because E&P reflects many items of tax-exempt income and noncapital, nondeductible expenses that, on a single entity basis, should not be reflected in consolidated taxable income through P's disposition of S's stock. In addition to S's recognized items of tax-exempt income and noncapital, nondeductible expense, S's basis in its assets or S's other tax attributes may be adjusted even though the adjustments are not recognition events for S. These adjustments are taken into account under the current rules through the E&P mechanism (although the proper E&P treatment may be unclear in many cases). Because the proposed stock basis adjustments are generally based on recognized items, special rules are provided to reflect these adjustments in stock basis.

S's basis in its assets or S's other tax attributes may be adjusted for a variety of reasons. The adjustments may have the effect of noncapital, nondeductible expenses. For example, the reduction in the basis of investment credit property under section 50(c)(1) eliminates a part of S's cost recovery deductions with respect to the property, thereby increasing its taxable income (or decreasing its tax loss), and section 1503(e)(3)(B) requires the reduction to be reflected in the basis of S's stock. The adjustments may also have the effect of tax-exempt income. For example, if S's basis in an asset is increased under section 167(e)(3)(B) because another member's basis in a related asset is reduced, S's increased cost recovery has the effect of causing S's otherwise taxable income to be tax-exempt.

To reflect adjustments that are not recognition events for S, rules are provided in paragraphs (b)(4)(ii)(D) and (iii)(B) of the proposed rules. Under paragraph (b)(4)(ii)(D), an increase in S's attributes is treated as tax-exempt income only to the extent that it corresponds to a basis decrease taken into account in determining a member's stock basis.

Under paragraph (b)(4)(iii)(B), a decrease in S's attributes may be treated as a noncapital, nondeductible expense to the extent that it is permanently disallowed in determining S's taxable income or tax loss. Whether a decrease is so treated is determined by taking into account both the purposes for requiring the decrease and the purposes of the investment adjustment system. For example, a basis reduction under sections 108(b) and 1017 is required to be treated as a noncapital, nondeductible expense under section 1503(e)(1)(B).

On the other hand, the repayment of debt is generally not a noncapital, nondeductible expense. When S receives a loan, it incurs an offsetting obligation, and S's repayment of the loan eliminates the obligation. Incurring and repaying the loan are generally not recognition events. Moreover, treatment of groups as single entities generally does not require the repayment to be treated as a noncapital, nondeductible expense because incurring and repaying debt generally result in corresponding adjustments to liabilities.

Similarly, a distribution by S to P to which section 355 applies is generally not a noncapital, nondeductible expense. Instead, specific adjustments to P's basis in S's stock are provided under section 358.

Comments are solicited as to the approach to special adjustments under the proposed rules, and to the identification of particular adjustments for which the treatment under the proposed rules should be changed or clarified. Comments are also solicited as to whether greater certainty can be provided regarding the proper treatment of special adjustments.

e. DISTRIBUTIONS. Under the current rules, P's basis in S's stock is reduced by all distributions to P of E&P accumulated by S in post-1965 consolidated return years, because the E&P is deemed to be reflected in P's basis in S's stock under the investment adjustment system. Basis is also reduced for distributions to P of E&P accumulated by S in separate return limitation years (generally years before S became a member of the affiliated group), because the E&P is deemed to be reflected in P's cost basis in S's stock. Basis reductions generally are not made for distributions to P of E&P accumulated in pre-1966 consolidated return years and in separate return years after S becomes a member of an affiliated, nonconsolidated group, because this E&P is deemed to not be reflected in P's basis in S's stock. These rules apply not only to actual distributions, but also to distributions deemed to be made (e.g., under section 305).

A deemed dividend election under current section 1.1502-32(f)(2) has the effect of causing pre-1966 consolidated E&P and separate return affiliated E&P to be reflected in P's basis in S's stock. This election is available only if the group owns all of S's stock. Under the election, an amount equal to all of S's E&P is treated as distributed as a dividend and immediately recontributed to the capital of S. To the extent E&P was accumulated in pre-1966 consolidated return years or in affiliated, separate return years, there is no negative adjustment for the distribution and the recontribution increases the basis of S's stock.

Under the proposed rules, P's basis in S's stock is reduced by all of S's distributions to P to which section 301 applies, and the deemed dividend election is eliminated. These changes do not prevent pre-1966 consolidated E&P from being reflected in stock basis. The proposed rules apply to S as if the rules were in effect for all consolidated return years of the group, and therefore pre-1966 income corresponding to the E&P is reflected in P's basis in S's stock without the need for a deemed dividend. See the discussion of effective dates in E, 5, below.

The proposed rules for distributions have a significant effect, however, on E&P accumulated in years for which an affiliated group files separate returns. Under the current rules, stock basis is not increased for E&P from these separate return years, but, if the group later files a consolidated return, basis is increased if a deemed dividend is elected. Thus, a significant consolidated return benefit may be achieved with respect to E&P from separate return years.

Implicit in the current rules is the presumption that E&P from affiliated, separate return years is not reflected in the basis of S's stock. This presumption is often inaccurate, and refining the presumption would result in significant additional complexity. For example, section 1503(e) provides that stock basis adjustments are not determined solely by reference to E&P, and therefore the current rules would have to be modified to reflect disparities between E&P and taxable income. See also section 301(e). In addition, special rules would be required to implement section 1059(e)(2)(B) in the case of earnings and profits arising in affiliated, separate return years but attributable to gain accrued before affiliation.

Greater distinctions have arisen in recent years between separate and consolidated returns, and the Treasury Department and the Service do not believe that rules should be developed to extend consolidated return benefits to E&P from separate return years. A distribution always results in a decrease in the value of S's stock, and the basis adjustments reflect this decrease. The simplified approach of the proposed rules is consistent with the approach discussed above with respect to adjustments to S's attributes. See E, 1, d, above.

The proposed negative stock basis adjustment for all distributions does not apply to distributions, made before the effective date of the proposed rules, of E&P accumulated in affiliated, nonconsolidated return years. See E, 5, below. In addition, a deemed distribution and recontribution pursuant to current section 1.1502-32(f)(2) in a consolidated return year ending before the effective date of the proposed rules will continue to be treated as an actual distribution and recontribution. Thus, the reflection of the distribution in stock basis and the elimination of E&P pursuant to an election under the current rules is generally preserved, although the amount may be changed by the proposed rules.

Because the proposed rules treat all distributions as reducing basis, a deemed distribution and recontribution after the effective date of the proposed rules would not affect stock basis. In addition, as described below, a subsidiary's E&P from consolidated return years is eliminated on leaving a group. See F, 3, a, below. Consequently, the only effect of a deemed dividend under the proposed rules would be to eliminate separate return E&P, a result that is not justified by the single entity principles of the proposed rules. Therefore, the deemed dividend election is not retained after the effective date of the proposed rules.

The current rules, like the separate return rules, generally reflect dividend distributions in stock basis at the time they are made. Current sections 1.1502-32(k) and 1.1502-32T, however, provide special rules to eliminate dividend stripping opportunities through straddles of the consolidated and separate return rules. To avoid the complexities of these current rules, the proposed rules generally take section 301 distributions into account as negative adjustments when the shareholders becomes entitled to them (generally on the record date).

While the approach of the proposed rules eliminates tax planning opportunities in a broader range of cases, it generally does not affect distributions in the ordinary course. If it is later established, based on all of the facts and circumstances, that a distribution will not be made, the initial adjustment is reversed as of the date it was made.

Comments are solicited as to the effects of the proposed rules. For example, section 1504(c)(2) prohibits a life insurance company from joining a consolidated group until it has been affiliated for at least 5 years. No special rules are provided for distributions after the 5-year period of earnings accumulated during the 5-year period. Comments are solicited as to whether special rules would be appropriate in this or other cases, and how special rules, if adopted, could be made administrable.

f. VARYING INTERESTS. Under the current rules, if S's E&P is to be determined before the end of a taxable year, the E&P for the year is prorated on a daily basis.

Under the proposed rules, stock basis adjustments are based on the inclusion of S's items in consolidated taxable income, and S's items are allocated within a year under the applicable principles of proposed section 1.1502-76(b). See K, below. By conforming stock basis adjustments to the inclusion of S's items, the purposes of the investment adjustment system are better achieved.

In addition to being taken into account if S becomes a nonmember, stock basis adjustments may have to be taken into account if P's interest in S changes, even if S remains a member (e.g., S's stock is sold from one chain to another within the group, or S issues additional stock to a nonmember but remains a member). Consequently, the principles of proposed section 1.1502-76(b) are also applied to these transactions, but the ratable allocation principles of proposed section 1.1502-76(b)(2)(ii) may be used without filing an election.

g. TAX SHARING AGREEMENTS. Section 1552 and current section 1.1502-33(d) provide methods of allocating federal income tax liability among members. Because federal income tax liability is reflected in E&P, this allocation is reflected through the investment adjustment system in the basis of the stock of members.

Under the proposed rules, taxes continue to be taken into account in determining stock basis adjustments. Rather than relying on the E&P rules, however, the proposed stock basis adjustment rules treat a group as having a tax sharing agreement in effect providing for a 100 percent allocation of any decreased tax liability. See F, 2, below.

The treatment of tax sharing amounts allocated under the proposed rules is analogous to the treatment of allocations under section 1.1552-1(b)(2). For example, if one member owes a payment for taxes to a second member, the first member is treated as indebted to the second member. If the indebtedness is not paid, the amount not paid is generally treated as a distribution, contribution, or both, depending on the relationship between the members.

By determining stock basis adjustments as if a tax sharing agreement is in effect, S's tax savings or burdens that should be borne by or benefit minority shareholders are taken into account. For example, if P owns 80 percent of S's stock, and P saves $34 of tax because its $100 of income is offset by S's loss, but P does not compensate S for this use of the loss, S is treated as having been paid $34 by P for the tax savings and then as having distributed $34 back to P. Thus, P's basis in the S stock is reduced by 80 percent of S's $66 after-tax loss (S's $100 loss minus P's $34 deemed payment), and by the entire $34 tax savings deemed distributed back to P, a total of $86.80. Similar principles apply to S's tax burdens. This is consistent with the approach discussed above with respect to adjustments to S's attributes. See E, 1, d, above.

2. ALLOCATION OF ADJUSTMENTS

The current rules provide that the basis of each share of S's stock must be adjusted to reflect its "allocable part" of S's E&P, but the rules do not specify how the allocable part is determined. Only limited rules are provided for allocations between common and preferred stock; positive adjustments are allocated to preferred stock only to reflect dividends in arrears and negative adjustments only to reflect distributions of dividends.

The Treasury Department and the Service understand that most subsidiaries have only common stock outstanding and are wholly owned within a group, and that the basis of members in a subsidiary's stock is generally uniform. Where subsidiaries have issued preferred stock, the stock is generally described in section 1504(a)(4). Thus, rules for allocating stock basis adjustments among shares in unusual circumstances are generally not necessary. For those cases in which P owns less than all of S's stock or has different bases in different blocks of stock, or in which S has more than one class of stock outstanding, the proposed rules provide additional guidance.

The negative adjustment for distributions is allocated to the shares of S's stock entitled to the distributions. The remainder of the adjustment with respect to S's stock (the portion described in proposed section 1.1502-32(b)(3)(i) to (iii)) is allocated among the shares of S's stock, including shares owned by nonmembers. However, the allocation to nonmembers has no effect on their basis in S's stock. If the adjustment under proposed section 1.1502-32(b)(3) (without taking distributions into account) is positive, it is allocated first to any preferred stock to cover distributions and arrearages, and then to the common stock. If it is negative, it is allocated only to common stock. An allocation is then made among the classes of preferred and common stock and then among the shares within each class.

a. COMMON STOCK. Adjustments allocable to a class of common stock are generally allocated equally to each share in the class. However, P must allocate its adjustments with respect to a class to minimize the amount of its excess loss account with respect to any shares within the class. Distributions and any adjustments or determinations under the Code (e.g., a basis increase resulting from a capital contribution) are taken into account before the allocation is made.

If S has more than one class of common stock, the allocation of a stock basis adjustment is determined by taking into account the terms of each class and all other facts and circumstances relating to the overall economic arrangement. An adjustment is generally allocated to reflect the manner in which the classes participate in the economic benefit or burden (if any) corresponding to the income, gain, deduction, or loss allocated.

b. PREFERRED STOCK. Positive stock basis adjustments (determined without taking distributions into account) are allocated to preferred stock to the extent required, when aggregated with prior allocations during the period that S is a member of the consolidated group, to reflect distributions described in section 301 to which the preferred stock becomes entitled, and arrearages arising, during the period that S is a member of the consolidated group. A positive amount that is allocated to a share with respect to a period when the share is owned by a nonmember is not reflected in the basis of the share.

These rules apply automatically if the preferred stock is described in section 1504(a)(4). They also apply to other preferred stock, such as stock with a vote, conversion feature, or other equity interest, unless members own less than 80 percent of each class of common stock. Preferred stock that is not subject to these rules is treated as a second class of common stock for purposes of determining the stock basis adjustments allocable to it. Thus, a group has considerable flexibility in issuing preferred stock to nonmembers without uncertainty as to stock basis adjustments, but if the stock is held by members in unusual situations, basis adjustments must be allocated under the facts and circumstances relating to the overall economic arrangement.

c. CUMULATIVE REDETERMINATIONS. P's basis (or excess loss account) in each share of S's stock must be redetermined as of a deconsolidation (as defined in proposed section 1.1502-19(c)(1)(ii)) and as of any other time necessary to determine a tax liability of any person. The redetermination will generally not affect stock basis, however, unless the adjustments are allocated among different classes of stock. Adjustments are first reallocated to preferred stock to reflect distributions and arrearages as of the redetermination. Adjustments not reallocated to preferred stock are reallocated to common stock.

For purposes of administrability, only the actual amounts allocated in previous years can be reallocated, and then only to the extent they have not been previously used. For example, a basis increase originally allocated to common stock in Year 1 can be reallocated to preferred stock to cover dividend arrearages arising in Year 2. However, the group's cost basis in a share of common stock may not be reallocated to cover the dividend in arrears on the preferred stock.

Because reallocations will generally affect P's basis in the shares of S's stock only if S has different classes of stock, and because only actual amounts allocated in previous years (which, as noted in E, 4, below, must be reported annually) may be reallocated, the Treasury Department and the Service do not anticipate that reallocations will be burdensome. Unlike the current rules, which rely on annual determinations of E&P, the proposed rules generally rely on amounts that can be derived from tax return schedules and worksheets.

In revising the stock basis adjustment rules, consideration was given to simplifying the rules by, for example, reflecting S's entire adjustment determined under proposed section 1.1502-32(b)(3) in S's common stock owned by members. Under this approach, allocations would not be made to preferred stock (except, perhaps if distributions were made with respect to the preferred stock, or the preferred stock is treated as common stock for purposes of stock basis adjustments), and the entire adjustment amount would be reflected in S's common stock owned by members even if nonmembers also owned S's common stock. This approach would reflect the fact that S's income and loss on which the adjustments are based is fully included in the consolidated tax return.

Significant distortions may result from allocating all adjustments to common stock owned by members. For example, allocations of all of S's negative adjustments to the group may result in gain on P's disposition of S's stock that exceeds the group's actual gain. Consequently, this approach to simplification has not been adopted in the proposed rules. Instead, the approach of the current rules is retained with modifications to improve accuracy while preserving administrability.

Comments are solicited on ways to simplify the proposed rules without significant distortions, or to otherwise improve their operation.

3. OVERRIDING ADJUSTMENTS

Unlike the current mechanically stated rules, the proposed rules are expressed, to the extent feasible, as general principles. Nevertheless, the principles may not encompass every circumstance or provide every necessary interaction with other rules of law.

To prevent avoidance of the purposes of the investment adjustment system, the rules require the adjustments necessary to carry out their purposes. More specific guidance is provided for transfers or distributions of appreciated or depreciated property, and for corporations that cease to be members when the stock of the corporation continues to be owned by members.

Comments are solicited on ways to provide additional guidance on the overriding adjustments or to otherwise improve their operation.

4. ANNUAL REPORTING

The current rules require stock basis and E&P adjustments to be made annually (or earlier, if stock is disposed of). The principal effect is to tier up E&P to the common parent at least annually. However, taxpayers have commented in connection with other proposed rules that groups are unlikely to make annual determinations if the characterization of a group's distributions as dividends is not affected by precise annual determinations of E&P. Thus, costly E&P studies may be required when P ultimately disposes of S's stock.

Although disposition of the stock of subsidiaries may not be a frequent occurrence, the failure to make the necessary determinations annually may result in a permanent loss of the requisite information. The proposed rules require annual reporting of stock basis adjustments to ensure that determinations are made while the necessary information is available.

Unlike the current rules, which depend on E&P that may not have to be determined otherwise, the proposed rules are based on items that generally are determined in connection with the preparation of the annual consolidated tax return. Thus, the reporting requirement requires compiling information currently available, and it is not anticipated that it will significantly increase compliance burdens. The reporting requirement generally applies on a prospective basis, only to annual adjustments arising after the effective date of the proposed rules. However, if a subsidiary's stock is disposed of and the allocation of its basis adjustments must be redetermined (see E, 2, c, above) the adjustments and redeterminations under the proposed rules for all years must be reported at that time.

Comments are solicited as to the burdens imposed by the reporting requirements, and as to alternatives that would assure compliance with the stock basis adjustment rules.

5. PROPOSED EFFECTIVE DATES

The proposed rules generally would apply to determinations of stock basis on or after the date the final rules are filed with the Federal Register. If the proposed rules apply, basis (and excess loss accounts) generally must be determined or redetermined as if the proposed rules were in effect for all consolidated return years of the group.

However, if P disposes of S's stock before the date the final rules are filed with the Federal Register, P's income, gain, or loss and the determinations or adjustments taken into account in determining income, gain, or loss are not redetermined. Nevertheless, if determinations or adjustments to P's basis (or excess loss account) in S's stock reflect determinations or adjustments with respect to stock of a lower tier member, the determinations or adjustments are redetermined if S later disposes of the lower tier member's stock under the proposed rules even though they were previously taken into account in P's disposition of S's stock.

This "disposition approach" is in contrast to a "lock-in approach" under which the current rules would determine adjustments to P's basis in S's stock for periods before the effective date of the proposed rules.

A combination of the disposition and lock-in approaches was used when the current rules were adopted in 1966. The pre-1966 investment adjustment rules required basis decreases similar to many aspects of the 1966 rules, but did not provide for basis increases. Under a lock-in approach, the current rules generally applied the pre-1966 rules to determine P's basis in S's stock on the first day to which the 1966 rules applied. However, P could use a deemed dividend election (see E, 1, e, above) to effectively increase its basis in S's stock as if the 1966 rules had always applied.

The disposition approach offers significant administrative advantages for the proposed rules. The practical need under the current rules for costly E&P studies to determine stock basis is eliminated. The need for transitional rules to address the whipsaw and planning opportunities from the duplication or omission of items under duplicate systems is also eliminated. Maintaining both the current and proposed investment adjustment systems on an indefinite basis would result in significant compliance and guidance burdens for both taxpayers and the government. In addition, section 1503(e)(1)(A) requires modifications to stock basis adjustments, retroactive to 1972, that are similar to modifications under the proposed rules.

It is not anticipated that the disposition effective date will materially alter the stock basis adjustments for most subsidiaries. Because the proposed rules do not significantly depart from the current rules -- as amended by section 1503(e) -- the principal effect for most groups is simplification.

Because anomalies have been addressed and the stock basis adjustment rules have been simplified, however, certain groups will be adversely or favorably affected. For example, section 1.1502- 32(d)(6), as adopted in 1966, provided incorrect rules for distributions of E&P acquired in reorganizations. These rules were corrected in 1979, but some groups may have artificially high stock basis in subsidiaries because of prior distributions. This artificial basis is eliminated under the proposed rules.

The proposed rules will benefit groups in other situations. For example, if a member incurs losses that reduce its pre-1966 E&P before making a deemed dividend election, absorption of the losses reduces the member's stock basis even though its pre-1966 E&P never increased stock basis. A later deemed dividend election cannot remedy the problem because it is no longer possible to deem the pre-1966 E&P to be distributed. In contrast, the disposition approach would, by applying uniform rules to pre-1966 and post-1965 years, provide a positive adjustment for pre-1966 income that offsets the negative adjustment for post-1965 distributions.

Under the disposition approach, groups that have determined their investment adjustments annually under the current rules will have to recompute their adjustments. However, based on taxpayer comments, the Treasury Department and the Service understand that few groups actually make determinations except when contemplating a stock disposition.

Comments on other recently proposed consolidated return regulations have argued that simplification would be achieved by applying only one set of rules in the future. Assertions have been made that any expectations of maintaining the status quo are unreasonable because (i) taxpayers are unable to accurately predict the availability of future attributes, (ii) the consolidated return rules are legislative in nature and taxpayers should reasonably anticipate legislative changes, and (iii) a specific windfall or detriment may be offset by the correction of other anomalies. If new rules are fundamentally desirable and further sound tax policy, comments argue that the disadvantages to taxpayers should be relatively modest and, even if significant in particular cases, could be justified in the interests of ensuring that a uniform set of rules are applied to all taxpayers.

These principles apply to the proposed stock basis adjustment rules. The proposed rules are predominantly neutral, with a small number of groups favorably or adversely affected. After weighing the possible expectations of groups under the current rules against the complexity and burdens associated with maintaining duplicate systems, the Treasury Department and the Service believe that a disposition approach is necessary. The proposed rules would apply only to determinations of stock basis on or after the date the final rules are filed with the Federal Register, and do not redetermine income, gain, or loss from earlier dispositions. Groups will have an opportunity to take the new rules into account in planning with respect to subsidiaries they intend to dispose of.

The proposed rules preserve some aspects of the treatment of distributions made (or deemed made) under the current rules. Deemed dividends under the current rules continue to be taken into account under the proposed rules, and negative adjustments are generally not made for distributions, before the effective date, of affiliated, nonconsolidated E&P.

The reporting requirements under the proposed rules would apply to stock basis adjustments and redeterminations only for taxable years beginning after the date the final rules are filed with the Federal Register.

Comments are solicited as to modifications to the proposed effective dates and the extent of any resulting complexity. Comments should consider the feasibility of implementing section 1503(e) as of 1972 while implementing the balance of the proposed rules prospectively. Comments should also address the potential for, and the effect of, duplication or omission of items under alternative effective dates, and the rules necessary to address these issues.

F. EARNINGS AND PROFITS (SECTION 1.1502-33)

1. DIRECT TIERING UP OF E&P

A principal effect of the current investment adjustment system is to consolidate a group's E&P in the E&P account of the common parent. Because of the stock ownership requirements under section 1504, the common parent is typically the only member of a group whose stock is held largely by nonmembers. Therefore, to determine whether distributions to nonmembers should be characterized as dividends, the group's E&P must be consolidated in the common parent.

The proposed rules establish a separate system for adjusting and tiering up E&P. Consequently, anomalies resulting from the interdependence of stock basis adjustments and E&P adjustments are eliminated. For example, if S sustains an E&P deficit and a corresponding tax loss, P's basis in S's stock is not reduced to reflect the E&P deficit under the current rules until the tax loss is absorbed. Because the stock basis adjustment is deferred, the current linked system automatically defers the tiering up of the E&P deficit. The E&P result is incorrect because the group's E&P, determined on a single entity basis, should be reduced to reflect S's E&P deficit when the deficit is sustained.

The proposed rules provide for separately adjusting the basis of S's stock for E&P purposes to determine P's E&P on the disposition of S's stock. Separate stock basis adjustments for E&P purposes are necessary to avoid duplicating E&P. For example, if S earns $100 of E&P that tiers up and increases P's E&P by $100, P should not have another $100 of E&P if it subsequently sells S's stock for an additional $100 because of S's earnings.

The E&P stock basis rules reflect the general requirement under section 312(f)(1) that separate tax and E&P basis be maintained if E&P adjustments differ from tax adjustments. Moreover, section 1503(e)(1) already modifies the operation of current section 1.1502- 32 solely for purposes of determining P's tax gain or loss on the disposition of S's stock. Because current section 1.1502-32 continues to tier up E&P without the section 1503(e)(1) amendments, separate stock basis determinations are already required under current law for tax and E&P purposes.

Although parallel tax and E&P stock basis adjustment systems are required under the existing consolidated return and alternative minimum tax regimes, the use of duplicate systems runs counter to the simplification approach of the proposed rules. Comments are solicited as to whether further simplification may be achieved, for example, by replacing E&P stock basis adjustments with the adjustments under one of these other regimes. Comments should address the potential for, and the effect of, duplication or omission of items if other systems are substituted.

2. RETENTION OF TAX SHARING AGREEMENT RULES

E&P is generally reduced for federal taxes, and each member must adjust its E&P for an allocable part of the-tax liability of the group, determined under section 1552. The current E&P rules also permit groups to allocate additional amounts. For example, if P has $100 of income and section has $100 of loss, the group's consolidated taxable income is $0 and nothing is allocated under section 1552. Current section 1.1502-33(d) provides elective methods by which P may be treated as incurring a liability to S in recognition of P's income offsetting S's loss.

The elective allocation methods of current section 1.1502-33(d) are retained under the proposed rules but are rewritten to improve comprehension. Although these rules are the most complex feature of the current E&P rules, they are retained because the Treasury Department and the Service understand that groups rely on them for non-tax purposes, such as ratemaking for public utilities. It is anticipated that comparable rules for allocating tax liability other than the regular tax liability under section 26(b) will be provided in later guidance.

3. ELIMINATING AND REPLICATING E&P

a. ELIMINATING E&P. The current rules recognize the potential for dividend stripping if the basis of S's stock is increased under the investment adjustment system to reflect S's E&P and, after S becomes a nonmember, it distributes the E&P under the separate return rules without a corresponding stock basis reduction.

Before 1988, whenever S became a nonmember of the P consolidated group but P retained some or all of S's stock, the investment adjustment system eliminated P's net positive investment adjustments reflected in its retained S stock immediately before S became a nonmember. This rule applied even if, for example, S became a nonmember because the entire P group was acquired by another consolidated group. Application in this instance was harsh because P's investment adjustments with respect to S's stock would be eliminated immediately before P and S join the new group, and P would still be subject to negative adjustments if S made distributions to P while a member of the new group.

To limit dividend stripping without this harsh treatment, the rules were replaced after 1987 by a basis reduction account. Under this approach, negative adjustments are generally deferred until S actually makes distributions to P with respect to its retained S stock. Although this approach may be an improvement over the prior rule, it operates in the context of the current rules and must mirror the complex basis rules of the Code.

The proposed rules take a different approach to the dividend stripping problem. Under the proposed rules, S's stock basis adjustments in the P group are preserved but S's E&P arising in the P group is generally eliminated immediately before S becomes a nonmember. Thus, if S makes a distribution to P under the separate return rules before earning post-consolidation E&P, P's basis in S's stock may be reduced under the general basis reduction rules of section 301(c)(2) (or the distribution may be in excess of basis and taxed accordingly under section 301(c)(3)). The elimination of S's E&P does not tier up and eliminate a corresponding amount of P's E&P.

Although the proposed rules appear to dramatically depart from the current rules, groups generally have been able to achieve comparable results on an elective basis through the deemed dividend rules. Thus, the principal effect of the proposed rules is to eliminate the elective feature of the current rules. This elimination of S's E&P when it becomes a nonmember reflects the single entity treatment of groups, under which the sale of S's stock is treated as the sale of a division of P.

An exception to E&P elimination is provided if S's E&P would be eliminated by reason of an acquisition of the entire group. Consistent with the principles of section 312(h), special rules are also provided to a1locate E&P in transactions in which section 312(h) would allocate E&P if the corporations were filing separate returns.

Although limited special rules are provided, comments are solicited as to whether the elimination of E&P is believed to cause unintended benefits or detriments to taxpayers as a result of the interaction with other applicable rules or requirements. In particular, comments should consider the adjustments that are appropriate if S's stock is not wholly owned by members of the consolidated group immediately before S becomes a nonmember, or in the context of a life/nonlife consolidated group.

b. REPLICATION OF E&P. The proposed rules also retain aspects of the current rules designed to ensure that the E&P account of the common parent reflects the group's E&P. Thus, if the common parent of the group changes but the group remains in existence (e.g., in a reverse acquisition under section 1.1502-75(d)(3)), the E&P of the former common parent is replicated in the E&P of the new common parent.

The current rules for replicating E&P are limited to group structure changes where there is at least 80 percent continuity in the ownership of the group. If the group continues but there is less than 80 percent continuity, E&P is not replicated but other adjustments are provided to cause the group's E&P to be reflected in the new common parent's E&P account. In addition, section 1.1502- 33T(a)(2) requires proper adjustments to E&P if a member changes its location in the group.

Single entity treatment of a group requires the common parent's E&P account to reflect the group's E&P. This requirement depends not on continuity in the ownership of the group, but on whether the group survives. The proposed rules therefore replicate E&P in the new common parent without regard to continuity in ownership. In addition, unlike under the current rules, replication of E&P is not limited to nonrecognition transactions.

The need for section 1.1502-33T(a)(2) of the current rules, which adjusts E&P for changes in the location of a member within the group, is unclear and is not retained in the proposed rules. Comments are solicited as to the proper focus of this rule.

4. PROPOSED EFFECTIVE DATES

Consistent with proposed section 1.1502-32, the proposed rules under section 1.1502-33 generally would apply with respect to determinations of E&P (e.g., for purposes of a distribution with respect to stock, or an adjustment under section 312(h)) on or after the date the final rules are filed with the Federal Register. If the proposed rules apply, E&P must be determined or redetermined as if the proposed rules were in effect for all consolidated return years of the group.

However, if P disposes of S's stock before the date the final rules are filed with the Federal Register, P's E&P from the disposition and all other determinations or adjustments taken into account in determining P's E&P are not redetermined. Nevertheless, if determinations or adjustments to P's basis (or excess loss account) in S's stock reflect determinations or adjustments with respect to stock of a lower tier member, the determinations or adjustments are redetermined if S later disposes of the lower tier member's stock under the proposed rules even though they were previously taken into account in P's disposition of S's stock.

The proposed rules would apply only to deconsolidations and group structure changes occurring on or after the date the final rules are filed with the Federal Register. In addition, deemed dividends under the current rules are taken into account under the proposed rules.

Under the proposed effective dates, the complex transitional provisions of the current rules are no longer necessary. Because groups were not required under the current rules to tier up E&P before 1976, however, comments are solicited as to the effect of the proposed effective dates. In particular, comments are solicited as to whether the considerations for the effective date of the proposed stock basis adjustments differ from those for the effective date of the proposed E&P adjustments.

G. EXCESS LOSS ACCOUNTS (SECTION 1.1502-19)

1. IN GENERAL

The excess loss account (ELA) rules are an extension of the rules for adjusting stock basis. P's basis in S's stock is reduced as the group absorbs S's losses and as S makes distributions to P. The reductions are not limited to the group's basis in S's stock and, to the extent reductions exceed stock basis, they result in an ELA with respect to P's S stock. P's ELA is included in its income when P disposes of the stock, and the income is generally treated as gain from the sale of the stock.

An ELA ordinarily arises with respect to a share of S's stock only if S's losses and distributions are funded with capital not reflected in the basis of the share. The reductions may be funded by creditors or by other shareholders, including other members.

The proposed rules revise and simplify the current rules by applying principles. In general, an ELA is treated as negative basis for computational purposes, to eliminate the need for special ELA rules paralleling the basis rules of the Code. Similarly, the rules of the Code are generally used to determine the timing for inclusion of an ELA in income. For example, if S has an ELA in T's stock and distributes the stock to P in a transaction to which section 355 applies, section 358 eliminates S's ELA (instead, P's basis in T's stock is an allocable part of P's basis in S's stock), and section 355 provides that any gain realized by S from the disposition of T's stock is not recognized.

Although P's ELA in S's stock is generally included in income when P or S becomes nonmembers of the group, a special exception is provided if they cease to be members by reason of the acquisition of the entire group. Unlike the current rules, the proposed rules do not provide special investment adjustments to prevent income attributable to preacquisition ELAs from increasing the E&P or the stock basis of members of the acquiring group. An ELA is merely one form of built-in gain to the acquiring group, and built-in gain is more generally addressed by section 1.1502-20.

2. WORTHLESSNESS

Under the current rules, worthlessness is treated as a disposition that requires P's ELA in S's stock to be included in income. S's stock is treated as worthless under a variety of measures that are generally intended to prevent P from deferring its inclusion of the ELA in income.

If P is required to include the ELA in income before S recognizes any corresponding gain with respect to its assets and liabilities, S's gain may be duplicated in the group's computation of consolidated taxable income. For example, if S borrows and loses funds, which causes P to have an ELA in S's stock, P's inclusion of the ELA in income may duplicate the group's later income associated with S's discharge of the indebtedness. Once the ELA is included in income, section 1.1502-20 prevents S's subsequent discharge income from being offset by a loss on P's disposition of S's stock.

In addition, recent bankruptcy cases indicate a judicial tendency to protect a bankrupt subsidiary's tax attributes. For example, because section 382(g)(4)(D) may subject S's losses to a zero section 382 limitation if P treats S's stock as worthless, the courts may prevent S's stock from being treated as worthless. See, e.g., In re Prudential Lines, Inc., 928 F.2d 565 (2d Cir. 1991), cert. denied, 112 S.Ct. 82 (1991).

The proposed rules revise the worthlessness rules to more fully implement the single entity treatment of consolidated groups. Viewing P's investment in S's stock as an investment in S's assets, the proposed rules generally do not treat S's stock as worthless until substantially all of S's assets are treated as disposed of, abandoned, or destroyed within the meaning of section 165(a).

For this purpose, S's assets are not considered disposed of merely because they are subject to liabilities, unless such treatment is proper under general federal income tax principles (e.g., an abandonment or foreclosure). By deferring the treatment of S's stock as worthless, tension is alleviated with respect to the cases protecting the attributes of bankrupt subsidiaries.

Under a special rule, S's stock is treated as worthless on any day that an indebtedness of S is discharged, if the amount discharged and excluded from gross income under section 108(a) exceeds the amount of tax attributes reduced under sections 108(b) and 1017 as a result of the exclusion. This rule is needed because, after its indebtedness is discharged, S is unlikely to be treated as worthless under the general rule.

3. ELECTIVE BASIS REDUCTION

Under the investment adjustment system, S's losses result in negative adjustments only with respect to its common stock. If part of P's investment in S is in the form of S's obligations or preferred stock, P may have an ELA in the common stock before S's losses exceed P's aggregate investment. Under the current rules, P may elect to reduce the ELA in exchange for reducing its basis in other stock or obligations of S.

Section 1503(e)(4) eliminated the election to reduce P's basis in S's obligations. The election was then further limited if it had the effect of netting stock gains and losses in a manner that is inconsistent with section 1.1502-20. As a result, the election has very limited applicability.

The proposed rules eliminate the election. Under proposed section 1.1502-32, adjustments with respect to a class of S's stock are generally allocated by P among its shares within the class to minimize any excess loss account, additional rules are provided for allocating adjustments between different classes of stock, and the allocations are cumulatively redetermined when tax liability is affected.

4. PROPOSED EFFECTIVE DATES

Consistent with the effective date for the proposed rules under sections 1.1502-32 and 1.1502-33, the proposed rules generally would apply to determinations of stock basis and excess loss accounts on or after the date the final rules are filed with the Federal Register. Moreover, if the proposed rules apply, the basis (or an excess loss account) generally must be determined or redetermined as if the proposed rules were in effect for all consolidated return years of the group.

The proposed rules with respect to worthlessness of stock would apply to consolidated return years ending on or after the date the final rules are filed with the Federal Register.

H. LOSS DISALLOWANCE RULE (SECTION 1.1502-20)

The proposed rules amend section 1.1502-20 to conform it to the revised investment adjustment system. Some technical provisions and examples, particularly those relating to the effect of loss disallowance and basis reduction on investment adjustments, have been eliminated. They are no longer needed because the effect of loss disallowance on stock basis and E&P is addressed under proposed sections 1.1502-32 and 1.1502-33.

I. RECIPROCAL BASIS ADJUSTMENTS (SECTION 1.1502-11(b))

Under the current rules, the absorption of S's losses may be limited if P disposes of S's stock. For example, if P sells S's stock at a gain, S's losses may not offset the gain. Without this limitation, P's basis in S's stock would be reduced under section 1.1502-32 by the absorption of the loss, and P's gain would be increased. In effect, offsetting S's losses against the gain only increases the gain, and does not reduce the group's consolidated taxable income.

The proposed rules rewrite these provisions to simplify their operation and to improve comprehension. Rules are also provided for dispositions of chains of corporations, and for cases in which the disposition of a member's stock causes deferred gain or loss to be taken into account. No other special rules apply to limit the absorption of attributes if more than one member is disposed of in the same consolidated return year.

The proposed rules would apply to consolidated return years beginning on or after the date the final rules are filed with the Federal Register.

J. BASIS OF STOCK (SECTION 1.1502-31)

The provisions of current section 1.1502-31 are not continued in the proposed rules. It is anticipated that these rules will be modified in connection with revisions to the intercompany transaction rules for consolidated groups. In general, it is anticipated that the current rules will be replaced by rules that are consistent with the separate return rules.

The proposed rules incorporate the principles of current section 1.1502-31T. Thus, if the common parent of a group changes but the group remains in existence (e.g., in a reverse acquisition under section 1.1502-75(d)(3)), special rules apply to determine the effect of this group structure change on the basis of the stock of members. These rules coordinate with the adjustments required under proposed section 1.1502-33(f) to the E&P of the new common parent and preserve in the new common parent the relationship between the former common parent's E&P and the former common parent's basis in its assets.

Following a group structure change, the basis of the stock of the former common parent reflects the net basis of the former common parent's assets. If the former common parent merges with another corporation, the stock basis of the surviving corporation reflects both the former common parent's net asset basis and the basis of the other corporation's stock.

Unlike the current rules, the proposed rules do not depend on 80 percent continuity of ownership of the group, and are not limited to nonrecognition transactions. Thus, consistent with proposed section 1.1502-33(f), the proposed basis rules apply uniformly to all transactions in which the common parent changes, but the group remains in existence.

The proposed rules generally would apply to group structure changes occurring on or after the date the final rules are filed with the Federal Register.

K. ALLOCATION OF ITEMS BETWEEN CONSOLIDATED AND SEPARATE RETURNS (SECTION 1.1502-76(b))

1. ALLOCATION RULES

Under the current rules, a consolidated return must include the common parent's items of income, gain, deduction, loss, and credit for the entire consolidated return year, and each subsidiary's items for the portion of the year for which it is a member. If S is acquired during a consolidated return year, its income for the portion of its original taxable year (i.e., the taxable year determined without taking section 1.1502-76(b) into account) for which it is not a member must be included in a separate return (which may be the consolidated return of another group). Allocation of S's income between the consolidated and separate returns must be based on the income shown on its permanent records, and if the allocation of an item cannot be determined from its permanent records, it must be allocated ratably.

The current rules provide little guidance for allocating items that relate to both returns (e.g., real estate taxes treated as incurred on a payment date, or employee plan contributions treated as made at year-end). The rules also do not provide for the allocation of credits, items carried between years (e.g., net operating losses carried under section 172), items that have no special rules for short periods (e.g., section 1253 amortization deductions), and items arising in passthrough entities in which S has an interest.

The proposed rules revise the allocation rules to provide greater certainty and prevent inconsistent allocations. Under the proposed rules, S's original taxable year is treated for all federal income tax purposes as ending as of the close of the day it becomes or ceases to be a member of a consolidated group. This closing of S's year is consistent with the accounting treatment commonly used for contractual and financial statement purposes when a subsidiary joins or leaves a group.

Because a mid-year closing of a taxable year may be administratively burdensome to groups, the proposed rules provide an election under which S may ratably allocate items of income, gain, deduction, loss, and credit. The election is not available, however, if S is required to change its annual accounting period (for example, if S is a calendar-year taxpayer acquired by a fiscal-year consolidated group and is therefore required to adopt the fiscal year).

For purposes of determining the items to be allocated and their timing, location, character, and source, S's original taxable year in which it joins or leaves a consolidated group is generally treated as a single taxable year. However, the separate and consolidated returns are treated for all purposes as returns for different taxable years with respect to any item carried to or from these years (e.g., a net operating loss carried under section 172) and with respect to the application of section 481.

All of S's items except specified extraordinary items may be ratably allocated. Items are ratably allocated by allocating an equal portion to each day of S's original taxable year. Because the original taxable year is generally treated as a single taxable year, the rules of the Code applicable to short periods do not apply unless the original taxable year is a short period. Comments are solicited as to whether the status of S (e.g., as a dealer) should also be determined by treating the original taxable year as a single taxable year.

The extraordinary items that are not allocable include income, gain, or loss from capital assets, trade or business assets, and from bulk sales of ordinary income assets. Also treated as extraordinary items are section 481(a) adjustments and the effects of any change in accounting method initiated after becoming or ceasing to be a member, cancellation of indebtedness income, interest from certain capital transactions, certain credits, certain items of controlled foreign corporations, and other items identified by the Commissioner.

Comments are solicited as to ways in which these rules may be simplified, and to alternative allocation methods that should be considered. The comments should consider the interaction of these and other methods with limitations under the Code (e.g., section 382(b)(3)), as well as any procedural issues that the methods present (e.g., the need to share information between groups or to coordinate audits of different groups).

The proposed rules also eliminate administrative uncertainty arising under current law from what is frequently referred to as "the lunch rule," by making the time of the day that a corporation joins or leaves a group irrelevant to inclusion in the consolidated return. Under the proposed rules, unless otherwise provided under applicable law, a corporation joins or leaves a group as of the close of the date on which the event occurs that causes it to join or leave. This approach is consistent with the approach of other rules under Subchapter C of the Code that may apply to the event causing a corporation to join or leave a group. See, e.g., sections 338, 381, and 382.

In addition, the proposed rules reverse an example in the current rules requiring P to close its consolidated return year when it ceases to be affiliated with any subsidiary for an interim period during its taxable year.

2. ELIMINATION OF THE 30-DAY RULES

Under the current rules, if S becomes a member of the P group within the first 30 days of S's taxable year, S may elect to be considered to have become a member of the group as of the first day of its year. In addition, if S has been a member of the P group for less than 30 days of the P group's taxable year, S may elect not to be considered as a member for the year. The purpose of these elections is to eliminate the need for returns for these periods of less than 30 days.

The 30-day rules were intended to be rules of administrative convenience, but the Treasury Department and the Service understand that some groups use the rules to achieve unintended results. In addition, numerous issues arise where, for example, the rules conflict with statutory or regulatory rules relying on precise timing (such as effective dates), or the facts of a transaction conflict with the presumptions of the rules. For example, assume that P, a member of the X group, sells all of S's stock on January 10, P's stock is acquired by members of the Y group on January 20th, and an election is made to include P in the Y group from January 1st. Is P's gain from the sale of S's stock included in the X group's return or the Y group's return; does S become a member of the Y group; if P has attributes subject to section 382, as of what date is the section 382 limitation applied?

It is not feasible to resolve all of the issues and inconsistencies. Conflicts and inconsistencies are inevitable if the ownership of S's stock is treated as other than where the benefits and burdens reside.

Because of the significant problems presented, the proposed rules eliminate the 30-day rules. To ameliorate any resulting administrative burdens, the proposed rules make available the simplified rules described above for allocating income to the short periods that were eliminated under the 30-day rules. Comments are solicited as to whether the allocation rules adequately simplify the allocation of S's items.

3. PROPOSED EFFECTIVE DATES

The proposed rules generally would apply to corporations becoming or ceasing to be members of consolidated groups on or after the date the final rules are filed with the Federal Register. The 30- day rules are eliminated with respect to corporations becoming or ceasing to be members of consolidated groups on or after December 1, 1992.

L. APPLICABILITY OF OTHER PROVISIONS OF LAW (SECTION 1.1502-80)

1. NON-APPLICABILITY OF SECTION 165(g)

The potential for P to recognize loss with respect to the worthlessness of S's stock before any corresponding loss is recognized by S with respect to its assets and liabilities may result in the complete elimination of the loss at the corporate level. For example, if S's stock becomes worthless, section 1.1502-20(a) may disallow P's deduction under section 165(g). Nevertheless, P's basis in S's stock is reduced to zero, and S's later recognition of the corresponding loss with respect to its assets may result in P having an ELA in S's stock. If S remains worthless, the ELA is immediately included in P's income under section 1.1502-19, and effectively eliminates S's losses. Although section 1.1502-20(g) may permit S's losses to be reattributed to avoid the effect of section 1.1502- 20(a), the courts may prevent the reattribution to preserve S's attributes for its creditors. See G, 2, above; see also section 382(g)(4)(D), under which S's losses may be subjected to a zero section 382 limitation if S's stock is treated as worthless.

Under section 165(a), P may recognize a loss with respect to S's stock if the stock is sold, exchanged, or abandoned. In addition, section 165(g) provides special rules for recognizing loss with respect to wholly worthless securities. See section 1.165-5. However, no loss is allowed solely because of a decline in the value of S's stock due to fluctuations in its market price or similar causes if the stock has any recognizable value on the date claimed as the date of the loss. See sections 1.165-4, 1.165-5(f). Section 165(g)(3) treats stock in certain corporations affiliated with the taxpayer as not being a capital asset.

When stock becomes worthless is a question of fact. See, e.g., Boehm v. Commissioner, 326 U.S. 287 (1945); Norton v. Commissioner, 38 B.T.A. 1270 (1938), aff'd, 112 F.2d 320 (7th Cir. 1940). In general, P may treat S's stock as worthless even though S remains a member. See Rev. Rul. 63-104, 1963-1 C.B. 172.

Consistent with the ELA rules for worthlessness (see G, 2, above), the proposed rules adopt a single entity view of consolidated groups by generally deferring the worthlessness of S's stock until after S recognizes any corresponding loss with respect to its assets. Under the investment adjustment system, if S's loss is absorbed by the group, P's corresponding loss in S's stock is eliminated.

The proposed rules would apply for consolidated return years ending on or after the date the final rules are filed with the Federal Register.

2. NON-APPLICABILITY OF SECTION 301(c)(3)

Under current law, no gain is recognized to the distributee on a distribution between members that is described in section 301(c)(3). Instead, an ELA is created. The current rule is in section 1.1502- 14(a)(2). The proposed rules relocate the exclusion to section 1.1502-80.

3. NON-APPLICABILITY OF SECTION 357(c)

Under current law, certain transfers of property and liabilities may result in the recognition of gain under section 357(c). If the transfer is between members, the gain is deferred under section 1.1502-13 and is taken into account under that section.

Under the proposed rules, section 357(c) generally does not apply to transfers between members. If section 357(c) does not apply to P's transfer of property to S in a transaction to which section 351 applies, the excess of liabilities over basis will, under section 358, reduce P's basis in S's stock, and if the reduction exceeds P's basis in S's stock, an ELA is created. Under section 362, S's basis in the assets equals P's basis in the assets immediately before the transfer.

Section 357(c) does apply under the proposed rules if S becomes a nonmember as part of the same plan or arrangement as P's transfer to S (unless P and S continue to be members of the same consolidated group). If section 357(c) did not apply, gain attributable to the excess of liabilities over basis would be duplicated because the excess would reduce P's basis in S's stock (or cause an ELA in the stock) but would not result in a corresponding increase in the basis of S's assets. To limit the duplication of gain, section 357(c) is applied to cause P to recognize gain and allow S to take a stepped up basis in the assets. Thus, P takes gain into account rather than an ELA, and S's basis in the assets reflects P's recognition of the gain.

Comments are solicited as to whether other Code provisions, such as section 351(b), should be overridden consistent with the treatment of section 357(c), and whether special rules are necessary if P encumbers property in anticipation of its transfer of the property to S.

The proposed rules would apply to transfers between members occurring on or after the date the final rules are filed with the Federal Register.

SPECIAL ANALYSES

These proposed rules are not major rules as defined in Executive Order 12291. The rules, if issued, will apply to consolidated groups, which tend to be larger entities. Thus, they will generally not have a significant economic impact on a substantial number of small entities nor will they significantly alter reporting or recordkeeping duties of small entities. Therefore, a Regulatory Impact Analysis is not required. Pursuant to section 7805(f)(1), these regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

COMMENTS AND PUBLIC HEARING

Before these proposed regulations are adopted, consideration will be given to any written comments that are submitted timely (preferably a signed original and eight copies) to the Internal Revenue Service. All comments will be available for public inspection and copying in their entirety. Written comments, requests to appear, and outlines of oral comments to be presented at the public hearing scheduled for December 18, 1992, must be received by November 27, 1992.

LIST OF SUBJECTS IN 26 CFR 1.1501-1 THROUGH 1.1564-1

Income taxes, Reporting and recordkeeping requirements.

PROPOSED AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR part 1 is amended as follows:

PART 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority citation for part 1 is amended by removing the entries for sections "1.1502-19", "1.1502-32(k)", and "1.1502-80" and adding the following citations to read as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.1502-11 also issued under 26 U.S.C. 1502. * * * Section 1.1502-19 also issued under 26 U.S.C. 301 (e), 1502, and 1503. * * * Section 1.1502-20 also issued under 26 U.S.C. 337(d) and 1502. * * * Section 1.1502-31 also issued under 26 U.S.C. 1502. Section 1.1502-32 also issued under 26 U.S.C. 301 (e), 1502, and 1503. Section 1.1502-32T also issued under 26 U.S.C. 1502. Section 1.1502-33 also issued under 26 U.S.C. 301 (e), 1502, and 1503. * * * Section 1.1502-76 also issued under 26 U.S.C. 1502. * * * Section 1.1502-80 also issued under 26 U.S.C. 304 (b)(4) and 1502. * * *

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

     Affected               Remove                      Add

Par. 4. Section 1.1502-1 is amended by adding at the end of paragraph (a) a new sentence to read as follows:

SECTION 1.1502-1 DEFINITIONS.

(a) * * * Except as the context otherwise requires, references to a group are references to a consolidated group (as defined in paragraph (h) of this section).

* * * * * Par. 5. Section 1.1502-11 is amended by revising paragraph (b) to read as follows:

SECTION 1.1502-11 CONSOLIDATED TAXABLE INCOME.

* * * * *

(b) ELIMINATION OF CIRCULAR STOCK BASIS ADJUSTMENTS -- (1) IN GENERAL. If one member (P) disposes of the stock of another member (S), this paragraph (b) limits the use of deductions and losses in the year of disposition and the carryback of items to prior years. The purpose of the limitation is to prevent P's income or gain from the disposition of S's stock from increasing the use of S's deductions and losses, because the increased absorption would reduce P's basis (or increase its excess loss account) in S's stock under section 1.1502-32 and, in turn, increase P's income or gain. See paragraph (b)(3) of this section for the application of these principles to P's loss from the disposition of S's stock, and paragraph (b)(4) of this section for the application of these principles to multiple stock dispositions. See section 1.1502-19(c) for the definition of disposition.

(2) LIMITATION ON DEDUCTIONS AND LOSSES -- (i) DETERMINATION OF LIMITATION. If S recognizes deductions or losses in the taxable year in which P disposes of one or more shares of S's stock (or S carries over deductions or losses from a prior year to the year of disposition), the extent to which the deductions or losses offset income and gain may be limited. The limitation is determined by tentatively computing taxable income (or loss) for the year of disposition, and any prior years to which the deductions or losses may be carried, by not taking into account any income or gain P recognizes from the disposition of S's stock.

(ii) APPLICATION OF LIMITATION. S's losses and deductions may offset income and gain only in the amount determined under paragraph (b)(2)(i) of this section. To the extent S's items arising in the year of disposition cannot offset income or gain because of the limitation, the items are treated as a separate net operating or net capital loss (as the case may be) arising in the year of disposition. Although the limitation is computed by tentatively determining the taxable income (or loss) of all members, the limitation, once determined, does not limit the use of deductions and losses of members other than S.

(iii) EXAMPLES. For purposes of the examples in this paragraph (b), unless otherwise stated, P owns all of S's stock for the entire year, S has only one class of stock outstanding, S owns no stock of lower tier members, all groups file consolidated returns on a calendar-year basis, the facts set forth the only corporate activity, all transactions are between unrelated persons, and tax liabilities are disregarded. The principles of this paragraph (b)(2) are illustrated by the following examples.

(ii) EXAMPLE. The principles of this paragraph (b)(3) are illustrated by the following example.

(ii) EXAMPLES. The principles of this paragraph (b)(4) are illustrated by the following examples.

Par. 6. Section 1.1502-13 is amended by revising paragraph (c)(1)(iii) and EXAMPLE (17)(ii) of paragraph (h) to read as follows:

SECTION 1.1502-13 INTERCOMPANY TRANSACTIONS.

* * * * *

(c) * * *

(1) * * *

(iii) See paragraphs (d), (e), and (f) of this section, relating to the time and manner of restoring deferred gain or loss. See section 1.1502-13T, relating to the time and manner of restoring deferred gain or loss in taxable years for which the due date (without extensions) of the income tax return is after March 14, 1990.

* * * * *

(h) * *

EXAMPLE (17). * * *

(ii) P takes the entire $44,000 gain ($104,000 less $60,000) on the land into account for 1966 since the deferral rules provided in paragraph (c) of this section were not effective with respect to the sale of such land.

Par. 7. Section 1.1502-14 is amended by revising the last sentence in the Example in paragraph (a)(4) to read "P's basis in the land is $6,000.".

Par. 8. Section 1.1502-19 is revised to read as follows:

SECTION 1.1502-19 EXCESS LOSS ACCOUNTS.

(a) IN GENERAL -- (1) PURPOSE. This section provides rules for including in income the excess loss account of one member (P) in the stock of another member (S). The purpose of an excess loss account is to recapture the group's use of S's deductions and losses with respect to a share, and the group's exclusion of S's distributions with respect to the share, to the extent they exceed P's basis in the share.

(2) GENERAL PRINCIPLES. The rules of this section and other applicable provisions of law must be applied in a manner that is consistent with and reasonably carries out the purposes of this section. For example, a determination or adjustment must not have the effect of duplicating an item in P's excess loss account in S's stock. In the absence of specific guidance, determinations and adjustments must be made in a manner that reflects all of the facts and circumstances, the underlying economic arrangement, applicable federal tax accounting principles, and the purpose stated in paragraph (a)(1) of this section.

(3) Application of other provisions of law. The rules of this section are in addition to rules under other provisions of law that are not inconsistent with this section. See section 1.1502-32 for investment adjustment rules establishing and adjusting excess loss accounts and for definitions that apply under this section.

(b) REALIZATION OF INCOME -- (1) GENERAL RULE. If P is treated under this section as disposing of a share of S's stock, P's excess loss account in the share is taken into account as an amount realized by P from the disposition. Except as provided in paragraph (b)(4) of this section, the disposition is treated as a sale or exchange for purposes of determining the character of the amount realized.

(2) NONRECOGNITION OR DEFERRAL -- (i) IN GENERAL. P's income or gain under paragraph (b)(1) of this section from a disposition under paragraph (c)(1)(i) of this section (relating to P ceasing to own a share) is subject to any nonrecognition or deferral rules applicable to the disposition. For example, if P's stock in S is redeemed in a liquidation to which section 332 applies, or P transfers all of its assets (including S's stock) to S in a reorganization to which section 361 (a) applies, P's disposition is subject to these nonrecognition rules and P's income or gain is not recognized.

(ii) NONRECOGNITION OR DEFERRAL INAPPLICABLE. If P's disposition is described in paragraph (c)(1)(ii) or (iii) of this section (relating to deconsolidations and worthlessness), whether or not the disposition is also described in paragraph (c)(1)(i) of this section, P's income or gain under paragraph (b)(1) of this section is taken into account notwithstanding any nonrecognition or deferral rules to the contrary. For example, if P transfers S's stock to a nonmember in a transaction to which section 351 applies, P's gain attributable to the excess loss account is recognized on the transfer.

(3) TIERING UP IN CHAINS. If the stock of more than one subsidiary is disposed of in the same transaction, paragraph (c) of this section is applied in the order of the tiers, from the lowest to the highest.

(4) INSOLVENCY. P's gain under this section is treated as ordinary income to the extent of the lesser of --

(i) The amount by which S is insolvent (within the meaning of section 108(d)(3)) on the date of the disposition; or

(ii) P's excess loss account, redetermined without taking into account distributions with respect to S's stock under section 1.1502- 32 (b)(3)(iv). For purposes of determining S's insolvency, liabilities include the amount of preferred distributions to which holders of preferred stock would be entitled if S were liquidated on the date of the disposition, and former liabilities that were discharged but not taken into account as tax-exempt income by reason of section 1.1502-32(b)(4)(ii)(C)(special rule for discharges).

(c) Disposition of stock. For purposes of this section --

(1) IN GENERAL. P is treated as disposing of a share of S's stock --

(i) TRANSFER, CANCELLATION, ETC. When F ceases to own the share, or on the occurrence of any other event in which P recognizes gain or loss (in whole or in part) with respect to the share.

(ii) DECONSOLIDATION. When --

(A) P becomes a nonmember, or a nonmember determines its basis in the share (or any other asset) by reference to P's basis in the share, directly or indirectly, in whole or in part (e.g., under section 362); or

(B) S becomes a nonmember, or P's basis in the share is reflected, directly or indirectly, in whole or in part, in the basis of any asset other than member stock (e.g., under section 1071).

(iii) WORTHLESSNESS. On any day that --

(A) Substantially all of S's assets are treated as disposed of, abandoned, or destroyed within the meaning of section 165(a); or

(B) An indebtedness of S is discharged, if the amount discharged and excluded from gross income under section 108(a) exceeds the amount of tax attributes reduced under sections 108(b) and 1017 as a result of the exclusion. For purposes of this paragraph (c)(1)(iii), S's assets are considered to be disposed of if they are maintained for the principal purpose of avoiding a disposition of S's stock. See also section 1.1502-80(c) (deferring the treatment of stock of members as worthless under section 165(g)).

(2) BECOMING A NONMEMBER. For purposes of paragraph (c)(1)(ii) of this section, a member is treated as becoming a nonmember if it has a separate return year (including another group's consolidated return year). A disposition under paragraph (c)(1)(ii) of this section must be taken into account in the consolidated return of the group. For example, if paragraph (c)(1)(ii) of this section applies because, under section 1.1502-75 (c), a group ceases to file a consolidated return as of the close of its consolidated return year, the disposition under paragraph (c)(1)(ii) of this section is treated as occurring immediately before the close of the year. If S becomes a nonmember because P sells S's stock to a nonmember, P's sale is a disposition under both paragraphs (c)(1)(i) and (ii) of this section. If a group ceases to exist because the former common parent is the only remaining member, the former common parent is not treated as having a deconsolidation event under paragraph (c)(1)(ii) of this section.

(3) EXCEPTION FOR ACQUISITION OF GROUP. Paragraph (c)(1) of this section does not apply solely by reason of the termination of a group because it is acquired, if there is a surviving group that is, immediately thereafter, a consolidated group. This paragraph (c)(3) applies only if the terminating group ceases to exist as a result of an acquisition of the assets of its common parent in a reorganization to which section 381(a)(2) applies or an acquisition of the stock of the common parent, or the group ceases to exist under the principles of section 1.1502-75(d)(2) or (d)(3). However, this paragraph (c)(3) does not apply to the extent members of the terminating group do not become members of the succeeding group (e.g., under section 1504(c), relating to includible insurance companies).

(d) DETERMINATIONS OR ADJUSTMENTS TO BASIS -- (1) GENERAL RULE. For purposes of determining or adjusting the basis of stock, an excess loss account is treated as a negative amount included in the determination of basis.

(2) DETERMINATIONS OF BASIS. If the basis of stock of a member (or any other asset) is determined by reference to P's basis in S's stock, any resulting negative amount is treated as an excess loss account. For example, if P transfers S stock to another member in an exchange to which section 354 applies, P's excess loss account in the S stock that it surrenders in the exchange is applied under section 358 to determine P's basis (or excess loss account) in stock of the acquiring corporation that P receives in the exchange or P already owns, as well as applied under section 362 to determine the acquiring corporation's excess loss account in the S stock.

(3) ADJUSTMENTS TO BASIS. Adjustments to P's basis (or excess loss account) in S's stock are made under section 1.1502-32 and other applicable provisions of law. Any resulting negative amount is treated as an excess loss account in that stock. For example, if P owns all of S's stock with a $0 basis, and makes a capital contribution to S of property with a $100 adjusted basis (and $175 fair market value) that is subject to a $150 liability, the $50 excess of liability over basis results in a $50 negative adjustment to P's basis in S's stock under section 358 and is treated as an excess loss account. See section 1.1502-80(e) for the non- applicability of section 357(c).

(4) SPECIAL ALLOCATION OF BASIS ADJUSTMENT OR DETERMINATION. If P has an excess loss account in any share of S's stock, basis adjustments or determinations under the Internal Revenue Code with respect to S's stock of the same class owned by P are first allocated among P's shares in the class to equalize and then eliminate the excess loss account. For example, if P owns 100 shares of S's only class of stock, 50 with a $100 basis and 50 with a $100 excess loss account, and P makes a $200 capital contribution to S, the contribution first eliminates P's excess loss account. (If P contributes the $200 in exchange for an additional 100 shares of S's stock in a transaction to which section 351 applies, P's excess loss account is eliminated before P's basis in any shares is increased.) See section 1.1502-32(c) for similar allocations of investment adjustments to prevent or eliminate excess loss accounts.

(e) EXAMPLES. For purposes of the examples in this section, unless otherwise stated, P owns all of S's stock and S owns all of T's stock for the entire year, S and T have only one class of stock outstanding, T owns no stock of lower tier members, all groups file consolidated returns on a calendar-year basis, the facts set forth the only corporate activity, all transactions are between unrelated persons, and tax liabilities are disregarded. The principles of this section are illustrated by the following examples.

(g) EFFECTIVE DATE -- (1) APPLICATION. This section applies with respect to determinations (as provided under section 1.1502-32) on or after [the date the final regulations are filed with the Federal Register]. If this section applies, basis and excess loss accounts must be determined or redetermined as if this section were in effect for all consolidated return years of the group. For this purpose, if P and S cease to be members of one consolidated group and, under paragraph (c)(3) of this section (or its equivalent under prior law), P is not treated as disposing of S's stock, the consolidated return years of the terminating group are also taken into account.

(2) DISPOSITIONS OF STOCK BEFORE EFFECTIVE DATE. If P disposes of stock of S before [the date the final regulations are filed with the Federal Register], the amount of P's income, gain, or loss is not redetermined. In addition, to the extent that P's determinations or adjustments with respect to S's stock were taken into account in determining P's income, gain, or loss, the determinations or adjustments are not redetermined.

(3) DEFERRED AMOUNTS. For purposes of this paragraph (g), a disposition to which section 1.1502-13, section 1.1502-13T, section 1.1502-14, or section 1.1502-14T applies is deemed to occur at the time the income, gain, or loss is taken into account.

(4) WORTHLESSNESS. Paragraph (c)(1)(iii) of this section (and not the prior rules relating to worthlessness) applies to consolidated return years ending on or after [the date the final regulations are filed with the Federal Register]. For this purpose, the prior worthlessness rules are section 1.1502-19(b)(2)(iii), (iv), and (v)(as contained in the CFR edition revised as of April 1, 1992).

(5) PRIOR LAW. For prior determinations, see prior regulations issued under section 1502 of the Internal Revenue Code as in effect with respect to the determination.

Par. 9. Section 1.1502-20 is amended as follows:

      1. Paragraphs (a)(1) and (a)(3)(ii) are revised.

(a) LOSS DISALLOWANCE -- (1) GENERAL RULE. No deduction is allowed for any loss recognized by a member with respect to the disposition of stock of a subsidiary. See also sections 1.1502-11 (c)(stock losses attributable to certain pre-1966 distributions) and 1.1502-80(c) (deferring the treatment of stock of members as worthless under section 165(g)).

* * * * *

(3) * * *

(ii) OVERRIDING EVENTS. For purposes of paragraph (a)(3)(i) of this section, the following are overriding events:

(A) The stock ceases to be owned by a member of the consolidated group or the issuer becomes a nonmember. For this purpose, a member is treated as becoming a nonmember on the first day of its first separate return year (including another group's consolidated return year).

(B) The stock is cancelled or redeemed (regardless of whether it is retired or held as treasury stock).

(C) The stock is treated as disposed of under section 1.1502- 19(c)(1)(iii).

* * * * *

(5) EXAMPLES. For purposes of the examples in this section, unless otherwise stated, all corporations have only one class of stock outstanding, all groups file consolidated returns on a calendar-year basis, the facts set forth the only corporate activity, all transactions are between unrelated persons, and tax liabilities are disregarded. The basis of each asset is the same for determining earnings and profits adjustments and taxable income. References to the "investment adjustment system" are references to the rules of sections 1.1502-19, 1.1502-32 and 1.1502-33. The principles of this paragraph (a) are illustrated by the following examples.

* * * * *

EXAMPLE 6. * * *

(6) * * *

EXAMPLE 5. * *

(c) * * *

(1) * * *

(i) EXTRAORDINARY GAIN DISPOSITIONS. The member's income or gain (or its equivalent), net of directly related expenses, from extraordinary gain dispositions allocated to the share.

(ii) POSITIVE INVESTMENT ADJUSTMENTS. The amount of any positive adjustment with respect to the share under section 1.1502-32, but only to the extent the amount for a consolidated return year exceeds the amount described in paragraph (c)(1)(i) of this section for the same consolidated return year.

(2) * * *

(i) * * *

(A) * * *

(1) A capital asset as defined in section 1221 (determined without the application of any other provision of law).

* * * * *

(B) A positive section 481(a) adjustment.

* * * * *

(D) Any other event (or item) identified by guidance published in the Internal Revenue Bulletin.

An extraordinary gain disposition is taken into account under paragraph (c)(1)(i) of this section only if it occurs on or after November 19, 1990 and results, net of directly related expenses, in income or gain that is taken into account under section 1.1502-32 (or other applicable stock basis adjustment). * * *

(ii) POSITIVE INVESTMENT ADJUSTMENTS. For purposes of paragraph (c)(1)(ii) of this section, a positive adjustment under section 1.1502-32(b) is the sum of the amounts under section 1.1502- 32(b)(3)(i) through (iii) for the consolidated return year (or other applicable period), taking tax losses into account under section 1.1502-32(b)(3)(i) only in the year they arise.

(iii) APPLICABLE AMOUNTS. Amounts are described in paragraphs (c)(1)(i) and (ii) of this section only to the extent they are reflected in the basis of the share, directly or indirectly, immediately before the disposition or deconsolidation, after applying section 1.1502-32 and other applicable provisions of law.

* * * * *

(4) * * *

(f) INVESTMENT ADJUSTMENTS AND EARNINGS AND PROFITS -- (1) ORDER OF ADJUSTMENTS. Deconsolidation of a share is treated as a disposition of the share for purposes of determining when investment adjustments are made and earnings and profits are determined with respect to the share.

(2) NO TIERING UP OF CERTAIN ADJUSTMENTS. If the basis of stock of a subsidiary (S) owned by a another member (P) is reduced under this section on the deconsolidation of the S stock, no corresponding adjustment is made under section 1.1502-32 to the basis of the stock of P, or under section 1.1502-33 to P's earnings and profits, if there is a disposition or deconsolidation of the P stock in the same transaction. If there is a disposition or deconsolidation in the same transaction of less than all the stock of P, appropriate adjustments must be made under sections 1.1502-32 and 1.1502-33 with respect to P (and any higher tier members).

(3) EXAMPLE. The principles of this paragraph (f) are illustrated by the following example.

SECTION 1.1502-31 STOCK BASIS AFTER A GROUP STRUCTURE CHANGE.

(a) IN GENERAL -- (1) OVERVIEW. This section provides rules for adjusting the basis of members in the stock of the former common parent if another corporation succeeds as the common parent of the consolidated group in a group structure change under section 1.1502- 33(f). For example, if a corporation (P) owns all of the stock of another corporation (S), and the former common parent (T) merges into S in a group structure change to which section 368(a)(2)(D) applies, P's basis in S's stock must reflect the change in S's assets and liabilities. The rules of this section coordinate with P's earnings and profits adjustments required under section 1.1502-33(f) and preserve in P the relationship between T's earnings and profits and T's basis in its assets.

(2) GENERAL PRINCIPLES. The rules of this section and other applicable provisions of law must be applied in a manner that is consistent with and reasonably carries out the purposes of this section. For example, a determination or adjustment must not have the effect of duplicating an item in the basis of S's stock. The principles of this section apply whether or not the former common parent continues to exist after the group structure change, and references to S include, as the context may require, references to T. In addition, references in this section to basis include, as the context may require, references to an excess loss account and, if adjustments to the basis of stock result in a negative amount, the negative amount is treated as an excess loss account.

(3) APPLICATION OF OTHER PROVISIONS OF LAW. The rules of this section are in addition to rules under other provisions of law that are not inconsistent with this section. See, e.g., section 1.358-6 (stock basis in certain triangular reorganizations).

(b) GENERAL RULES. Except as otherwise provided in this section --

(1) ASSET ACQUISITIONS. If a corporation acquires the former common parent's assets (and any liabilities assumed or to which the assets are subject) in a group structure change, the basis of members in the stock of the acquiring corporation is adjusted immediately after the group structure change to reflect the acquiring corporation's allocable share of the former common parent's net asset basis. For example, if S acquires T's assets in a group structure change to which section 368(a)(2)(D) applies, P's basis in S's stock is adjusted to reflect T's net asset basis. The result is the same if P owned some of T's stock before the group structure change; P's basis in the T stock is not taken into account in determining P's basis in S's stock. See section 1.358-6 for stock basis rules applicable to certain triangular reorganizations, which may already determine adjustments based on T's net asset basis.

(2) STOCK ACQUISITIONS. If a corporation acquires stock of the former common parent in a group structure change, the corporation's basis in the former common parent's stock immediately after the group structure change (including any stock of the former common parent owned before the group structure change) is adjusted to reflect the corporation's allocable share of the former common parent's net asset basis. For example, if all of T's stock is contributed to P in a group structure change to which section 351 applies, P's basis in T's stock is T's net asset basis. Similarly, if S merges into T in a group structure change to which section 368(a)(2)(E) applies, P's basis in T's stock is the same basis that P would have in S's stock under paragraph (b)(1) of this section if T had merged into S in a group structure change to which section 368(a)(2)(D) applies.

(c) NET ASSET BASIS. The former common parent's net asset basis is the basis it would have in the stock of a newly formed subsidiary, if --

(1) The former common parent transferred its assets (and any liabilities assumed or to which the assets are subject) acquired in the group structure change to the subsidiary in a transaction to which section 351 applies;

(2) The former common parent and the subsidiary were members of the same consolidated group (see section 1.1502-80(e) for the non- application of section 357(c) to the transfer); and

(3) The asset basis taken into account is each asset's basis immediately after the group structure change (including any income or gain recognized in the group structure change and reflected in the asset's basis).

(d) ADJUSTMENTS -- (1) CONSIDERATION NOT PROVIDED BY P. A member's basis in the stock of the former common parent is adjusted to reflect the fair market value of any consideration not provided by the member. For example, if S acquires T's assets in a group structure change to which section 368(a)(2)(D) applies, and S provides an appreciated asset (including stock of P) as partial consideration in the transaction, P's basis in S's stock is reduced by the fair market value of the asset.

(2) ALLOCABLE SHARE -- (i) ASSET ACQUISITIONS. If a corporation receives less than all of the former common parent's assets and liabilities in the group structure change, the former common parent's net asset basis taken into account under paragraph (b)(1) of this section is adjusted accordingly.

(ii) STOCK ACQUISITIONS. If a corporation owns less than all of the former common parent's stock immediately after a group structure change described in paragraph (b)(2) of this section, the percentage of the former common parent's net asset basis taken into account equals the percentage (by fair market value) of the former common parent's stock owned immediately after the group structure change.

(3) MULTIPLE CLASSES OF STOCK. If a corporation has more than one class of stock outstanding immediately after the group structure change, the basis determined under this section is allocated among the classes in proportion to the fair market value of each class. See section 358(b).

(4) HIGHER TIER MEMBERS. To the extent that the former common parent is owned by members other than the new common parent, the basis of all subsidiaries owning, directly or indirectly, in whole or in part, an interest in the former common parent's assets or liabilities is adjusted consistent with the principles of this section. The adjustments are applied in the order of the tiers, from the lowest to the highest.

(e) PREDECESSORS AND SUCCESSORS. For purposes of this section, any reference to a corporation includes a reference to a successor or predecessor as the context may require. See section 1.1502-32(f) for definitions of predecessor and successor.

(f) EXAMPLES. For purposes of the examples in this section, unless otherwise stated, all corporations have only one class of stock outstanding, all groups file consolidated returns on a calendar-year basis, the facts set forth the only corporate activity, all transactions are between unrelated persons, and tax liabilities are disregarded. The principles of this section are illustrated by the following examples.

(2) PRIOR LAW. For prior basis determinations, see section 1.1502-31 (as contained in the CFR edition revised as of April 1, 1992). For prior group structure changes, see section 1.1502-31T (as contained in the CFR edition revised as of April 1, 1992).

Par. 11. Section 1.1502-31T is removed.

Par. 12. Section 1.1502-32 is revised to read as follows:

SECTION 1.1502-32 INVESTMENT ADJUSTMENTS.

(a) IN GENERAL -- (1) PURPOSE. This section provides rules for adjusting the basis of the stock of a subsidiary (S) owned by another member (P) (and any excess loss account in S's stock under section 1.1502-19). The rules of this section reflect the treatment of P and S as a single entity by adjusting P's basis (or excess loss account) in S's stock to reflect amounts recognized by S and taken into account in determining consolidated taxable income, and amounts distributed by S. Thus, the adjustments prevent items recognized by S from being recognized a second time on P's disposition of S's stock and cause P to recapture items recognized by S (e.g., excess loss accounts under section 1.1502-19). Adjustments are also made for tax- exempt income and noncapital, nondeductible expenses to prevent these items from resulting in income, gain, or loss from the sale of S's stock.

(2) GENERAL PRINCIPLES. The rules of this section and other applicable provisions of law must be applied in a manner that is consistent with and reasonably carries out the purposes of this section. For example, an adjustment must not have the effect of duplicating an item in S's stock basis. In the absence of specific guidance, adjustments must be made in a manner that reflects all of the facts and circumstances, the underlying economic arrangement, applicable federal tax accounting principles, and the purposes stated in paragraph (a)(1) of this section.

(3) APPLICATION OF OTHER PROVISIONS OF LAW. The rules of this section are in addition to rules under other provisions of law that are not inconsistent with this section. For example, a capital contribution by P to S increases P's basis in S's stock. See section 1.1502-11(b) for limitations on the use of losses. See section 1.1502-19 for rules relating to excess loss accounts.

(b) STOCK BASIS ADJUSTMENTS -- (1) TIMING OF ADJUSTMENTS. Adjustments under this section are made as of the close of each consolidated return year, and as of any other time if a determination at that time is necessary to determine a tax liability of any person. For example, adjustments are made as of P's sale of S's stock, in order to measure P's income, gain, or loss from the sale. A current adjustment may be necessary even if tax liability is not affected until a later time. Thus, if P sells only 50 percent of S's stock and is treated under section 1.1502-19(c)(1)(ii)(B) as disposing of the balance of S's stock, adjustments must be made for the retained stock as of the disposition (whether or not P has an excess loss account in that stock). Similarly, if S liquidates during a consolidated return year, adjustments must be made as of the liquidation (even if the liquidation is tax free under section 332) if P's adjustments tier up to a higher tier member. See paragraph (b)(4)(vi) of this section for rules applicable if P's interest in S's stock varies during the consolidated return year.

(2) APPLICATION OF ADJUSTMENTS -- (i) STOCK BASIS. P's basis in S's stock is increased by positive adjustments and decreased by negative adjustments under paragraph (b)(3) of this section.

(ii) EXCESS LOSS ACCOUNT. If an adjustment under paragraph (b)(3) of this section is negative and exceeds P's basis in S's stock, the excess is referred to as P's excess loss account. Subsequent negative adjustments increase P's excess loss account. Subsequent positive adjustments first eliminate the excess loss account and any remaining amount increases P's basis in S's stock. See section 1.1502-19 for rules relating to excess loss accounts, including basis determinations and adjustments under other applicable rules of law that may result in an excess loss account.

(iii) ALLOCATION. The basis adjustment under this paragraph (b)(2) must be allocated under paragraph (c) of this section among the shares of S's stock if, for example, P owns less than all of S's stock, S has more than one class of stock outstanding, or P has different bases (or excess loss accounts) in different blocks of S's stock.

(3) AMOUNT OF ADJUSTMENT. The adjustment, made as of the time of the adjustment, is the net amount (treating income and gain items as increases and losses, deductions, expenses, and distributions as decreases) of S's --

(i) Taxable income or tax loss;

(ii) Tax-exempt income;

(iii) Noncapital, nondeductible expenses; and

(iv) Distributions with respect to S's stock.

(4) OPERATING RULES. For purposes of determining P's adjustments under paragraph (b)(3) of this section for S's stock --

(i) TAXABLE INCOME AND TAX LOSS. S's taxable income is consolidated taxable income determined by taking into account only S's items of income, gain, deduction, and loss, and S's deductions and losses are taken into account whether or not they are absorbed by S. If S's deductions and losses exceed its gross income, the excess is referred to as S's tax loss. For this purpose --

(A) To the extent that S's tax loss is absorbed in the year it arises (by a member other than S) or is carried forward and absorbed in a subsequent year (by any member, including S), the loss is treated as a tax loss under paragraph (b)(3)(i) of this section in the year in which it is absorbed;

(B) To the extent that S's tax loss is carried back to a prior year (whether consolidated or separate) and absorbed (by any member, including S), the loss is treated as tax loss under paragraph (b)(3)(i) of this section in the year in which it arises and not in the year in which it is absorbed; and

(C) Any gross-up for taxes paid is not taken into account. A gross-up is an amount of taxes paid by another taxpayer that S is treated as having paid (e.g., income included under section 78 or the portion of an undistributed capital gain dividend that is treated as tax deemed to have been paid by a shareholder under section 852(b)(3)(D)(ii)).

(ii) TAX-EXEMPT INCOME -- (A) IN GENERAL. S's tax-exempt income is income that is recognized by S but is permanently excluded from (i.e., never taken into account in determining) S's gross income under applicable law. For example, interest excluded from gross income under section 103 is tax-exempt income, and income realized but not recognized under section 1031 is not.

(B) EQUIVALENT DEDUCTIONS. To the extent that an item of S's income is permanently offset by a deduction or other item that does not represent a recovery of basis (whether through a deduction, loss, cost, expense, or otherwise) or an expenditure of money, the item of income is treated as tax-exempt income and is taken into account under paragraph (b)(4)(ii)(A) of this section. In addition, the item of income and the offsetting item are taken into account under paragraph (b)(4)(i) of this section. For example, if S receives a $100 dividend with respect to which a $70 dividend-received deduction is allowed under section 243, $70 of the dividend is treated as tax- exempt income (assuming that no corresponding stock basis reduction is required under section 1059 or otherwise). Accordingly, P's basis in S's stock increases by $100 because the $100 dividend and $70 deduction are taken into account under paragraph (b)(4)(i) of this section (resulting in a $30 increase), and $70 of the dividend is also taken into account under paragraph (b)(4)(ii)(A) of this section. Similarly, income from mineral properties is treated as tax- exempt income to the extent it is offset by deductions for depletion in excess of the basis of the property.

(C) DISCHARGE OF INDEBTEDNESS INCOME. Discharge of S's indebtedness that is excluded from gross income under section 108(a) is treated as tax-exempt income to the extent the discharged amount is applied to reduce tax attributes under sections 108 b) and 1017 and the attribute reduction is taken into account under paragraph (b)(4)(iii) of this section. Discharge of S's indebtedness that is excluded from gross income but is not applied to reduce tax attributes is not treated as tax-exempt income.

(D) BASIS SHIFTS. An increase in the basis of S's assets (or its equivalent, such as an increase in a loss carryover or a decrease in an excess loss account in stock owned by S) is treated as tax-exempt income to the extent that the increase --

(1) Is not otherwise taken into account in determining stock basis;

(2) Is determined directly by reference to a noncapital, nondeductible expense that is taken into account under paragraph (b)(4)(iii) of this section (or incurred by the common parent); and

(3) Has the effect (viewing the group in the aggregate, and netting the increase and the noncapital, nondeductible expense) of causing the expense to be deferred rather than permanently disallowed. For example, a basis increase under section 50(c)(2) is treated as tax-exempt income to the extent the preceding basis reduction under section 50(c)(1) is reflected in the basis of a member's stock. See also section 167(e).

(iii) NONCAPITAL, NONDEDUCTIBLE EXPENSES -- (A) IN GENERAL. Noncapital, nondeductible expenses of S are deductions or losses that are recognized by S (whether through a cost, expense, expenditure of money, or otherwise) but are permanently disallowed (i.e., never taken into account) under applicable law in determining S's taxable income or loss. For example, federal taxes described in section 275 are noncapital, nondeductible expenses. On the other hand, if S sells and repurchases a security subject to section 1091, the disallowed loss is not a noncapital, nondeductible expense because the corresponding basis adjustment prevents the disallowance from being permanent.

(B) NONDEDUCTIBLE BASIS RECOVERY. A decrease in the basis of S's assets (or its equivalent, such as a decrease in a loss carryover, a denial of basis for taxable income, or an increase in an excess loss account in stock owned by S) may be treated as a noncapital, nondeductible expense to the extent that the decrease is not otherwise taken into account in determining stock basis and is permanently disallowed in determining S's taxable income or tax loss. Whether a decrease is so treated is determined by taking into account both the purposes for requiring the decrease and the purposes of this section. For example, S has a noncapital, nondeductible expense if the basis of its assets is decreased under section 50(c)(1), 108(b), or 167(e), or under section 1.1502-20(b), S's losses are reattributed under section 1.1502-20(g), or S's losses are realized but not recognized under section 311(a), because these provisions are intended to permanently eliminate S's recovery of the basis. In contrast, a decrease generally is not a noncapital, nondeductible expense if it results because S's basis in assets received in a liquidation to which section 332 applies is less than S's basis in the stock cancelled, or S distributes the stock of a subsidiary in a distribution to which section 355 applies.

(iv) DISTRIBUTIONS. Distributions taken into account under paragraph (b)(3)(iv) of this section are distributions with respect to S's stock to which section 301 applies. A distribution is taken into account under paragraph (b)(3)(iv) of this section when the shareholder becomes entitled to the distribution (generally on the record date). For example, if P becomes entitled to the distribution before it is made, S is treated as distributing the amount to P at the time P becomes entitled to the distribution. If it is later established, based on all of the facts and circumstances, that the distribution will not be made, the initial adjustment is reversed as of the date it was made.

(v) TIERING UP OF ADJUSTMENTS. The adjustments to S's stock under this section are taken into account in determining adjustments to higher tier stock. The adjustments are applied in the order of the tiers, from the lowest to the highest. For example, if P is a subsidiary whose stock is owned by another member, p's adjustment to S's stock is taken into account in determining the adjustments to stock of P owned by other members.

(vi) VARYING INTERESTS. If P's interest in S's stock varies during the consolidated return year (i.e., P owns S's stock for less than an entire consolidated return year, or the percentage of S's stock owned by P varies during the year), the adjustments under this section are made by taking into account P's varying interests in S's stock. If section 1.1502-76(b) applies to S for the consolidated return year, P's varying interests under this paragraph (b)(4)(vi) are determined under that section. If section 1.1502-76(b) does not apply, P's varying interests are determined under the applicable principles of section 1.1502-76(b), but ratable allocation under the principles of section 1.1502-76(b)(2)(ii) may be used without filing an election under section 1.1502-76(b)(2)(ii)(D).

(vii) TAX SHARING AGREEMENTS. For purposes of this section, taxes are taken into account by applying the principles of section 1552 and the percentage method under section 1.1502-33(d)(2) (and by assuming a 100 percent allocation of any decreased tax liability). The treatment of amounts allocated under this paragraph (b)(4)(vii) is analogous to the treatment of allocations under section 1.1552- 1(b)(2). For example, if one member owes a payment to a second member, the first member is treated as indebted to the second member. If the indebtedness is not paid, the amount not paid generally is treated as a distribution, contribution, or both, depending on the relationship between the members.

(5) EXAMPLES. For purposes of the examples in this section, unless otherwise stated, P owns all of S's stock for the entire year, S has only one class of stock outstanding, S owns no stock of lower tier members, all groups file consolidated returns on a calendar-year basis, the facts set forth the only corporate activity, preferred stock is described in section 1504(a)(4), all transactions are between unrelated persons, and tax liabilities are disregarded. The principles of this paragraph (b) are illustrated by the following examples.

(2) COMMON STOCK -- (i) ALLOCATION WITHIN A CLASS. The portion of the adjustment described in paragraph (b)(3) of this section (determined without taking distributions into account) that is allocable to a class of common stock is generally allocated equally to each share within the class. However, if P has an excess loss account in shares of a class of common stock, the portion of any positive adjustment allocable to P with respect to the class is allocated first to eliminate the excess loss account. Similarly, any negative adjustment is allocated first to reduce P's basis in shares of the class before creating or increasing P's excess loss account. Distributions and any adjustments or determinations under the Internal Revenue Code (e.g., basis increases resulting from capital contributions) are taken into account before the allocation is made under this paragraph (c)(2)(i).

(ii) ALLOCATION AMONG CLASSES. If S has more than one class of common stock, the extent to which the adjustment described in paragraph (b)(3) of this section (determined without taking distributions into account) is allocated to each class is determined by taking into account the terms of each class and all other facts and circumstances relating to the overall economic arrangement. The allocation generally must reflect the manner in which the classes participate in the economic benefit or burden (if any) corresponding to the items of income, gain, deduction, or loss allocated. In determining the participation, the following factors are among those to be considered --

(A) The interest of each share in economic profits and losses (if different than the interest in taxable income);

(B) The interest of each share in cash flow and other non- liquidating distributions; and

(C) The interest of each share in distributions in liquidation. Distributions and any adjustments or determinations that are made under the Internal Revenue Code are taken into account before the allocation is made under this paragraph (c)(2)(ii).

(3) PREFERRED STOCK. If the adjustment under paragraph (b)(3) of this section (determined without taking distributions into account) is positive, it is allocated to preferred stock to the extent required (when aggregated with prior allocations to the preferred stock during the period that S is a member of the consolidated group) to reflect distributions described in section 301 to which the preferred stock becomes entitled, and arrearages arising, during the period that S is a member of the consolidated group. If the amount of distributions and arrearages exceeds the positive amount (when aggregated with prior allocations), the positive amount is first allocated among classes of preferred stock to reflect their relative priorities, and the amount allocated to each class is then allocated pro rata within the class. A positive amount that is allocated to a share with respect to a period when the share is owned by a nonmember is not reflected in the basis of the share under paragraph (b)(2) of this section. For this purpose, if P and S cease to be members of one consolidated group and become members of another consolidated group, the determination under this paragraph (c)(3) is made by taking into account the consolidated return years of the prior group.

(4) CUMULATIVE REDETERMINATION. P's basis (or excess loss account) in each share of S's common and preferred stock must be redetermined whenever necessary to determine the tax liability of any person. See paragraph (b)(1) of this section. The redetermination is made by reallocating the net adjustment described in paragraph (b)(3) of this section (determined without taking distributions into account) for each consolidated return year (or other applicable period) of the group by taking into account all of the facts and circumstances affecting allocations under this paragraph (c) as of the redetermination date. The reallocation is treated for all purposes (including subsequent redeterminations) as the original allocation of an amount under this paragraph (c). An amount may not be reallocated, however, to the extent that the amount has been used. An amount has been used to the extent the reallocation would affect the amount taken into account, directly or indirectly, by any member in determining income, gain, or loss from the disposition of stock of a member, in determining the basis of any property other than stock of a member, or in determining the basis of stock of a member following a deconsolidation.

(5) EXAMPLES. The principles of this paragraph (c) are illustrated by the following examples.

(1) CLASS. The shares of a member having the same material terms (without taking into account voting rights) are treated as a single class of stock.

(2) PREFERRED STOCK. Preferred stock is stock that is limited and preferred as to dividends and has a liquidation preference. A class of stock that is not described in section 1504 (a)(4), however, is not treated as preferred stock for purposes of paragraph (c) of this section if members own less than 80 percent of each class of common stock (determined without taking this paragraph (d)(2) into account).

(3) COMMON STOCK. Common stock is stock that is not preferred stock.

(e) OVERRIDING ADJUSTMENTS -- (1) GENERAL RULE. If any person acts with a principal purpose to avoid the effect of the rules of this section, or uses the rules of this section to avoid the effect of any other provision of the consolidated return regulations, adjustments must be made as necessary to carry out the purposes of this section.

(2) APPRECIATED OR DEPRECIATED PROPERTY. If there is a transfer or distribution to or from S with a principal purpose to distort the adjustments for any member's stock, the allocations under paragraph (c) of this section must take into account all differences between the adjusted basis (or excess loss account) and fair market value of all of S's assets at the time of the transfer or distribution.

(3) DECONSOLIDATIONS. If a corporation ceases to be a member with a principal purpose to avoid negative adjustments under this section, and members continue to own stock of the corporation, directly or indirectly, the basis of that stock is adjusted (or income or gain is recognized) in accordance with the purposes of this section. For this purpose, a member is treated as owning stock indirectly if the member would be treated as owning the stock under section 318 (a)(2).

(4) EXAMPLES. The principles of this paragraph (e) are illustrated by the following examples.

(g) REPORTING REQUIREMENTS. A separate statement entitled "STATEMENT OF ADJUSTMENTS UNDER section 1.1502-32 (g)" must be filed with the group's return. This statement must contain --

(1) The name and employer identification number (E.I.N.) of each subsidiary with respect to which adjustments under this section may be made;

(2) The net amount of the adjustment with respect to the subsidiary's stock under paragraph (b)(3) of this section for the consolidated return year or other period;

(3) The allocation of the basis adjustment under paragraph (b)(2) of this section among the shares of the subsidiary's stock owned by members (the allocation might not be pro rata among the shares if, for example, the subsidiary has more than one class of stock outstanding); and

(4) A description of any reallocation of adjustments or redeterminations.

(H) EFFECTIVE DATE -- (1) GENERAL RULE. This section applies with respect to determinations (e.g., for purposes of determining basis in connection with a sale of stock) on or after [the date the final regulations are filed with the Federal Register]. If this section applies, basis and excess loss accounts must be determined or redetermined as if this section were in effect for all consolidated return years of the group. For this purpose, if P and S cease to be members of one consolidated group and become members of another consolidated group, the consolidated return years of the prior group are also taken into account.

(2) DISPOSITIONS OF STOCK BEFORE EFFECTIVE DATE. If P disposes of stock of S before [the date the final regulations are filed with the Federal Register], the amount of P's income, gain, or loss is not redetermined. In addition, to the extent that P's determinations or adjustments with respect to S's stock were taken into account by P as of the disposition, the determinations or adjustments are not redetermined. Nevertheless, S's determinations or adjustments with respect to the stock of a lower tier member are redetermined in accordance with paragraph (g)(1) of this section (even if they were previously taken into account by P and reflected in income, gain, or loss from the disposition of S's stock) if S disposes of the stock on or after [the date the final regulations are filed with the Federal Register]. Assume, for example, that P owns all of S's stock, S owns all of T's stock, and T owns all of U's stock. If S sells 80 percent of T's stock before [the date the final regulations are filed with the Federal Register] (the effective date), S's income, gain, or loss from the sale, and the stock basis adjustments taken into account by S in the sale, are not redetermined if P sells S's stock after the effective date. If S sells the remaining 20 percent of T's stock after the effective date, S's stock basis adjustments with respect to that T stock are also not redetermined. However, if T and U become members of another consolidated group and T sells U's stock after the effective date, T's stock basis adjustments with respect to U's stock are redetermined (even though some of those adjustments may have been taken into account by S in its prior sale of T's stock). See section 1.1502-19 (c) for the definition of disposition.

(3) DEFERRED AMOUNTS. For purposes of this paragraph (h), a disposition to which section 1.1502-13, section 1.1502-13T, section 1.1502-14, or section 1.1502-14T applies is deemed to occur at the time the income, gain, or loss is taken into account.

(4) DISTRIBUTIONS -- (i) DEEMED DIVIDEND ELECTIONS. If there is a deemed distribution and recontribution pursuant to section 1.1502- 32(f)(2)(as contained in the CFR edition revised as of April 1, 1992) in a consolidated return year ending before [the date the final regulations are filed with the Federal Register], this section is applied as if the deemed distribution and recontribution under the election were an actual distribution by S and recontribution by P as provided under the election.

(ii) AFFILIATED EARNINGS AND PROFITS. This section does not apply to reduce the basis (or increase the excess loss account) in S's stock as a result of a distribution of earnings and profits if the distribution is made before [the date the final regulations are filed with the Federal Register], and the distribution does not cause a negative adjustment under the investment adjustment rules in effect at the time of the distribution. See section 1.1502-32(b)(2)(iii) and (c)(2) (as contained in the CFR edition revised as of April 1, 1992) or any prior corresponding provision in effect with respect to the distribution and recontribution.

(5) REPORTING REQUIREMENTS. The reporting requirements under paragraph (g) of this section apply with respect to adjustments and redeterminations for taxable years beginning after [the date the final regulations are filed with the Federal Register].

(6) PRIOR LAW. For prior determinations, see prior final and temporary regulations issued under section 1502 of the Internal Revenue Code as in effect with respect to the determination. For example, section 1.1502-32T (a) may apply with respect to deconsolidations (as described in section 1.1502-33(e)) occurring before [the date the final regulations are filed with the Federal Register]. Thus, if P has a basis reduction account under section 1.1502-32T with respect to S's stock before [the date the final regulations are filed with the Federal Register], the basis reduction account continues to apply under section 1.1502-32T on and after [the date the final regulations are filed with the Federal Register].

Par. 13. Section 1.1502-32T is amended by revising the section heading and by adding paragraph (a)(6)(iii) to read as follows:

SECTION 1.1502-32T BASIS REDUCTION ACCOUNTS BEFORE [THE DATE THE FINAL REGULATIONS ARE FILED WITH THE FEDERAL REGISTER] (TEMPORARY).

(a) * * *

(6) * * *

(iii) TERMINATION OF APPLICATION. Notwithstanding paragraphs (a)(6)(i) and (ii) of this section, paragraph (a) of this section does not apply to stock of a subsidiary that ceases to be a member on or after [the date the final regulations are filed with the Federal Register].

* * * * *

Par. 14. Section 1.1502-33 is revised to read as follows:

SECTION 1.1502-33 EARNINGS AND PROFITS.

(a) IN GENERAL -- (1) PURPOSE. This section provides rules for determining the earnings and profits of a subsidiary (S) and any member (P) owning S's stock. In general, earnings and profits of members are determined under applicable provisions of law, including section 312. This section modifies the general determination to reflect the treatment of P and S as a single entity by causing the earnings and profits of lower tier members to be reflected in the earnings and profits of higher tier members and consolidating the group's earnings and profits in the common parent. References in this section to earnings and profits include, as the context may require, deficits in earnings and profits.

(2) GENERAL PRINCIPLES. The rules of this section and other applicable provisions of law must be applied in a manner that is consistent with and reasonably carries out the purposes of this section. For example, an adjustment must not have the effect of duplicating an item in S's earnings and profits. If S has earnings and profits that are reflected in the earnings and profits of P under paragraph (b) of this section, and S then transfers its assets to P in a liquidation to which section 332 applies, S's earnings and profits that P succeeds to under section 381 must be adjusted to prevent duplication. In the absence of specific guidance, earnings and profits must be determined and adjusted in a manner that reflects all of the facts and circumstances, the underlying economic arrangement, the principles of section 1.312-6, and the purposes stated in paragraph (a)(1) of this section.

(3) APPLICATION OF OTHER PROVISIONS OF LAW. The rules of this section are in addition to rules under other provisions of law that are not inconsistent with this section. For example, the allowance for depreciation is determined in accordance with section 312(k).

(b) TIERING UP EARNINGS AND PROFITS -- (1) GENERAL RULE. P's earnings and profits are adjusted under this section to reflect S's earnings and profits in accordance with the applicable principles of section 1.1502-32(b). For example, the adjustments are determined as of the close of each consolidated return year, and as of any other time if a determination at that time is necessary to determine the earnings and profits of any person, and they are applied in the order of the tiers, from the lowest to the highest. However, the deferral of a negative adjustment for unabsorbed losses under section 1.1502- 32(b)(4)(i) does not apply, and the tax sharing rules under paragraph (d) of this section apply rather than the principles of section 1.1502-32(b)(4)(vii). The adjustment under this paragraph (b)(1) to P's earnings and profits is treated as earnings and profits of P for the taxable year in which the adjustment occurs.

(2) ALLOCATING EARNINGS AND PROFITS AMONG SHARES OF STOCK. An allocable part of S's earnings and profits is reflected in P's earnings and profits based on P's ownership of S's stock. P's allocable part of S's earnings and profits is determined under --

(i) The varying interests principles of section 1.1502- 32(b)(4)(vi); and

(ii) The allocation principles of section 1.1502-32(c).

(3) EXAMPLES. For purposes of the examples in this section, unless otherwise stated, P owns all of S's stock for the entire year, S has only one class of stock outstanding, S owns no stock of lower tier members, all groups file consolidated returns on a calendar-year basis, the facts set forth the only corporate activity, preferred stock is described in section 1504(a)(4), all transactions are between unrelated persons, and tax liabilities are disregarded. The principles of this paragraph (b) are illustrated by the following examples.

(1) STOCK -- (i) DISPOSITIONS. For purposes of determining P's earnings and profits from the disposition of S's stock, P's basis (or excess loss account) in S's stock is adjusted to reflect the allocable part of S's earnings and profits determined under paragraph (b) of this section, rather than under section 1.1502-32. Thus, P's basis in S's stock is increased by positive earnings and profits and decreased by deficits. P may have an excess loss account in S's stock for earnings and profits purposes, and the excess loss account is determined, adjusted, and taken into account in accordance with the principles of sections 1.1502-19 and 1.1502-32.

(ii) DISTRIBUTIONS. A distribution with respect to S's stock to which section 301 applies is taken into account by members as S's shareholders become entitled to the distribution. For example, if P becomes entitled to the distribution before it is made, S is treated as distributing the amount to P at the time P becomes entitled to the distribution. If it is later established, based on all of the facts and circumstances, that the distribution will not be made, the initial adjustment is reversed as of when it was made. If S's stock is not wholly owned by members of the consolidated group, proper adjustments must be made to take this fact into account in carrying out the purposes of this paragraph (c)(1)(ii).

(2) INTERCOMPANY TRANSACTIONS. [Reserved]

(3) EXAMPLE. The principles of this paragraph (c) are illustrated by the following example.

(ii) EFFECT OF EXTENDED TAX ALLOCATIONS. The amounts allocated under this paragraph (d) are treated as allocations of tax liability for purposes of section 1.1552-1(b)(2). For example, if P's taxable income is offset by S's tax loss and tax liability is allocated under the percentage method of paragraph (d)(3) of this section, P's earnings and profits are reduced as if its income were subject to tax and P is treated as liable to S for that amount, and corresponding adjustments are made to S's earnings and profits. If the liability of one member to another is not paid, the amount not paid generally is treated as a distribution, contribution, or both, depending on the relationship between the members.

(2) WAIT-AND-SEE METHOD. The wait-and-see method under this paragraph (d)(2) is derived from Securities and Exchange Commission procedures. In the year that a member's loss or credit is absorbed, the group's consolidated tax liability is allocated in accordance with the group's method under section 1552. When, in effect, the member with the loss or credit could have absorbed the attribute on a separate return basis in a later year, a portion of the group's consolidated tax liability for the later year that is otherwise allocated to members under section 1552 is reallocated. The reallocation takes into account all consolidated return years to which this paragraph (d) applies (the "computation period"), and is determined by comparing the tax allocated to a member during the computation period with the member's tax liability determined as if it had filed separate returns.

(i) CAN ON ALLOCATION UNDER SECTION 1552. A member's allocation under section 1552 for a taxable year may not exceed the excess, if any, of --

(A) The total of the tax liabilities of the member for the computation period (including the current year), determined as if the member had filed separate returns for all the years; over

(B) The total amount allocated to the member under section 1552 and this paragraph (d) for the computation period (except the current year).

(ii) REALLOCATION OF CANNED AMOUNTS. To the extent that the amount allocated to a member under section 1552 exceeds the limitation under paragraph (d)(2)(i) of this section, the excess is allocated among the remaining members in proportion to (but not to exceed the amount of) each member's excess, if any, of --

(A) The total of the tax liabilities of the member for the computation period (including the current year), determined as if the member had filed separate returns for all the years; over

(B) The total amount allocated to the member under section 1552 and this paragraph (d) for the computation period (including for the current year only the amount allocated under section 1552).

(iii) REALLOCATION OF EXCESS CAPPED AMOUNTS. If the reductions under paragraph (d)(2)(i) of this section exceed the amounts allocable under paragraph (d)(2)(ii) of this section, the excess is allocated among the members in accordance with the group's method under section 1552 without taking this paragraph (d)(2) into account.

(3) PERCENTAGE METHOD. The percentage method under this paragraph (d)(3) allocates tax liability based on the absorption of losses or credits, without taking into account the ability of any member to subsequently absorb its own attributes. The allocation under this method is in addition to the allocation under section 1552.

(i) DECREASED EARNINGS AND PROFITS. A member's allocation under section 1552 for any year is increased, thereby decreasing its earnings and profits, by a fixed percentage (not to exceed 100 percent) of the excess, if any, of --

(A) The member's separate return tax liability for the consolidated return year as determined under section 1.1552- 1(a)(2)(ii); over

(B) The amount allocated to the member under section 1552.

(ii) INCREASED EARNINGS AND PROFITS. An amount equal to the total decrease in earnings and profits under paragraph (d)(3)(i) of this section (including amounts allocated as a result of a carryback) increases the earnings and profits of the members whose attributes are absorbed, and is allocated among them in a manner that reasonably reflects the absorption.

(4) ADDITIONAL METHODS. Tax liability may be allocated among members in accordance with any other method approved by the Commissioner.

(5) ELECTION OF ALLOCATION METHOD. Tax liability may be allocated under this paragraph (d) only if an election is filed with the group's first return. The election must --

(i) Be made in a separate statement entitled "ELECTION TO ALLOCATE TAX LIABILITY UNDER section 1.1502-33(d)";

(ii) Identify the allocation method elected under section 1.1502-33(d) and under section 1552;

(iii) If the percentage method is elected, identify the percentage (not to exceed 100 percent) to be used; and

(iv) If a method is permitted under paragraph (d)(4) of this section, attach evidence of approval of the method by the Commissioner. A later election, or an election to change methods, may be made only with the consent of the Commissioner. If an election was made under section 1.1502-33(d) as in effect before [the date the final regulations are filed with the Federal Register] (as contained in the CFR edition revised as of April 1, 1992), that election remains in effect under this section.

(6) EXAMPLES. The principles of this paragraph (d) are illustrated by the following examples.

(2) ACQUISITION OF GROUP. Paragraph (e)(1) of this section does not apply solely by reason of the termination of a group because it is acquired, if there is a surviving group that is, immediately thereafter, a consolidated group. This paragraph (e)(2) applies only if the terminating group ceases to exist as a result of an acquisition of the assets of its common parent in a reorganization to which section 381(a)(2) applies or an acquisition of the stock of the common parent, or it ceases to exist under the principles of section 1.1502-75(d)(2) or (d)(3). However, this paragraph (e)(2) does not apply to the extent members of the terminating group do not become members of the succeeding group (e.g., under section 1504 (c), relating to includible insurance companies).

(3) CERTAIN CORPORATE SEPARATIONS AND REORGANIZATIONS. The adjustments under paragraph (e)(1) of this section must be modified to the extent necessary to effectuate the principles of section 312(h). Thus, P's earnings and profits rather than S's earnings and profits may be eliminated immediately before S becomes a nonmember. P's earnings and profits are eliminated to the extent that its earnings and profits reflect S's earnings and profits after applying section 312(h) immediately after S becomes a nonmember (determined without taking this paragraph (e)(3) into account).

(4) SPECIAL USES OF EARNINGS AND PROFITS. Paragraph (e)(1) of this section does not apply for purposes of determining --

(i) The extent to which a distribution is charged to reserve accounts under section 593(e);

(ii) The extent to which a distribution is taxable to the recipient under sections 805(a)(4) and 832; and

(iii) Any other special use identified by guidance in the Internal Revenue Bulletin (see section 601.601(d)(2)(ii)(b) of this chapter).

(5) EXAMPLE. The principles of this paragraph (e) are illustrated by the following example.

(2) MINORITY OWNERSHIP. If the other corporation's stock is not wholly owned by members of the consolidated group immediately after it ceases to be the common parent, proper adjustments must be made to take this fact into account in carrying out the purposes of this paragraph (f).

(3) HIGHER TIER MEMBERS. To the extent that the former common parent is owned by members other than P, the earnings and profits of the intermediate subsidiaries must be adjusted consistent with the principles of this section.

(4) EXAMPLES. The principles of this paragraph (f) are illustrated by the following examples.

(h) PREDECESSORS AND SUCCESSORS. For purposes of this section, any reference to a corporation or to a share includes a reference to a successor or predecessor as the context may require. A corporation is a successor if its earnings and profits are determined, directly or indirectly, in whole or in part, by reference to the earnings and profits of another corporation (the predecessor). A share is a successor if its basis (or excess loss account) is determined, directly or indirectly, in whole or in part, by reference to the basis (or excess loss account) of another share (the predecessor).

(i) [Reserved]

(j) EFFECTIVE DATE -- (1) GENERAL RULE. This section applies with respect to determinations (e. g., for purposes of a distribution with respect to stock, or an adjustment under section 312(h)) on or after [the date the final regulations are filed with the Federal Register]. If this section applies, earnings and profits must be determined or redetermined as if this section were in effect for all consolidated return years of the group. For this purpose, if P and S cease to be members of one consolidated group and become members of another consolidated group, but paragraph (e)(1) of this section does not apply, the consolidated return years of the prior group are also taken into account.

(2) DISPOSITIONS OF STOCK BEFORE EFFECTIVE DATE. If P disposes of stock of S before [the date the final regulations are filed with the Federal Register], the amount of P's earnings and profits from the disposition is not redetermined. In addition, to the extent that P's determinations or adjustments with respect to S's stock were taken into account by P as of the disposition, the determinations or adjustments are not redetermined. Nevertheless, S's determinations or adjustments with respect to the stock of a lower tier member are redetermined in accordance with paragraph (j)(1) of this section (even if they were previously taken into account by P and reflected in earnings and profits from the disposition of S's stock) if S disposes of the stock on or after [the date the final regulations are filed with the Federal Register]. Assume, for example, that P owns all of S's stock, S owns all of T's stock, and T owns all of U's stock. If S sells 80 percent of T's stock before [the date the final regulations are filed with the Federal Register] (the effective date), S's earnings and profits from the sale, and the stock basis adjustments taken into account by S in the sale, are not redetermined if P sells S's stock after the effective date. If S sells the remaining 20 percent of T's stock after the effective date, S's stock basis adjustments with respect to that T stock are also not redetermined. However, if T and U become members of another consolidated group, paragraph (e)(1) of this section did not apply, and T sells U's stock after the effective date, T's stock basis adjustments with respect to U's stock are redetermined (even though some of those adjustments may have been taken into account by S in its prior sale of T's stock). See section 1.1502-19(c) for the definition of disposition.

(3) DECONSOLIDATIONS AND GROUP STRUCTURE CHANGES -- (i) IN GENERAL. Paragraphs (e) and (f) of this section apply with respect to deconsolidations and group structure changes occurring on or after [the date the final regulations are filed with the Federal Register].

(ii) GROUP STRUCTURE CHANGES BEFORE THE DATE THE FINAL REGULATIONS ARE FILED WITH THE FEDERAL REGISTER]. If there was a group structure change before [the date the final regulations are filed with the Federal Register], and earnings and profits were not determined under section 1.1502-33T(a) (as contained in the CFR edition revised as of April 1, 1992), a distribution in a taxable year ending after September 7, 1988, of earnings and profits that are not reflected in the earnings and profits of the distributee member, but would have been so reflected if section 1.1502-33T(a) (as contained in the CFR edition revised as of April 1, 1992) had applied, no negative adjustment under paragraph (b) of this section shall offset the increase in the earnings and profits of the distributee.

(4) Deferred amounts. [Reserved.]

(5) DISTRIBUTIONS -- (i) DEEMED DIVIDEND ELECTIONS. If there is a deemed distribution and recontribution pursuant to section 1.1502- 32(f)(2) (as contained in the CFR edition revised as of April 1, 1992) in a consolidated return year ending before [the date the final regulations are filed with the Federal Register], this section is applied as if the deemed distribution and recontribution under the election were an actual distribution by S and recontribution by P as provided under the election.

(ii) AFFILIATED EARNINGS AND PROFITS. This section does not apply to prevent an increase in P's earnings and profits as a result of a distribution of S's earnings and profits if the distribution is made before [the date the final regulations are filed with the Federal Register], and the distribution does not cause a negative adjustment under the investment adjustment rules in effect at the time of the distribution. See sections 1.1502-32(b)(2)(iii) and (c)(2) and 1.1502-33 (as contained in the CFR edition revised as of April 1, 1992).

(6) PRIOR LAW. For prior determinations, see prior final and temporary regulations issued under section 1502 of the Internal Revenue Code as in effect with respect to the determination.

Par. 15. Section 1.1502-33T is removed.

Par. 16. Section 1.1502-76 is amended by revising paragraph (b) to read as follows:

SECTION 1.1502-76 TAXABLE YEAR OF MEMBERS OF GROUP.

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(b) ITEMS INCLUDED IN THE CONSOLIDATED RETURN -- (1) GENERAL RULES. A consolidated return must include the common parent's items of income, gain, deduction, loss, and credit for the entire consolidated return year, and each subsidiary's items for the portion of the year for which it is a member. If a corporation becomes, or ceases to be, a member during a consolidated return year, the corporation's taxable year is treated for all federal income tax purposes as ending as of the event causing the corporation to become or cease to be a member. If the common parent ceases to be the common parent but the group remains in existence, adjustments must be made consistent with the principles of section 1.1502-75(d)(2) and (3). Unless otherwise provided under applicable law, a corporation becomes or ceases to be a member as of the close of the date on which the event occurs. The rules of this paragraph (b) are in addition to rules under other provisions of law that are not inconsistent with this paragraph (b), and the rules of this paragraph (b) and other applicable provisions of law must be applied in a manner that is consistent with and reasonably carries out the purposes of this section. See, e.g., sections 381 and 446. Thus, this paragraph (b) must be applied so as to prevent duplication or elimination of the corporation's items.

(2) DETERMINATION OF ITEMS INCLUDED IN SEPARATE AND CONSOLIDATED RETURNS -- (i) IN GENERAL. The returns for the years ending and beginning with the event that causes this paragraph (b) to apply are subject to the rules of the Internal Revenue Code applicable to short periods. However, section 443 applies with respect to a consolidated return only to the extent that it is applicable without taking this paragraph (b) into account.

(ii) RATABLE ALLOCATION OF ITEMS -- (A) APPLICATION. Although the periods ending and beginning with the event that causes this paragraph (b) to apply are treated as different taxable years, certain items may be ratably allocated between the periods if --

(1) The member is not required to change its annual accounting period as of the event (e. g., because its stock is sold between consolidated groups that have the same annual accounting periods); and

(2) An irrevocable election to ratably allocate is made under paragraph (b)(2)(ii)(D) of this section.

(B) GENERAL RULE -- (1) ALLOCATION WITHIN ORIGINAL YEAR. Under ratable allocation, paragraph (b)(2)(i) of this section applies by allocating to each day of a member's original year (i.e., the member's taxable year determined without taking this paragraph (b) into account) an equal portion of the member's items affecting taxable income in the original year, except that extraordinary items must be allocated to the day that they affect income.

(2) Items to be allocated. Under ratable allocation, the items to be allocated and their timing, location, character, and source are generally determined by treating the original year as a single taxable year, and the items are not subject to the rules of the Internal Revenue Code applicable to short periods (unless the original year is a short period). However, the years ending and beginning with the event that causes this paragraph (b) to apply are treated as different taxable years (and as short periods) with respect to any item carried to or from these years (e.g., a net operating loss carried under section 172) and with respect to the application of section 481.

(3) MULTIPLE APPLICATIONS. If this paragraph (b) applies more than once with respect to an original year, adjustments must be made consistent with the principles of this paragraph (b). For example, if an existing corporation becomes a member of two different consolidated groups during the same original year and ratable allocation is elected with respect to both groups, ratable allocation is generally determined for both groups by treating the original year as a single taxable year; however, if ratable allocation is elected only with respect to the first group, the ratable allocation is determined by treating the original year as a short period that does not include the period that the corporation is a member of the second group. Ratable allocation is not a method of accounting, and ratable allocation with respect to one event that causes this paragraph (b) to apply does not require ratable allocation to be applied with respect to a subsequent event.

(C) EXTRAORDINARY ITEMS. An extraordinary item is --

(1) income, gain, or loss from the disposition or abandonment of a capital asset as defined in section 1221 (determined without the application of any other provision of law);

(2) Any income, gain, or loss from the disposition or abandonment of property used in a trade or business as defined in section 1231(b) (determined without the application of any holding period requirement);

(3) Any income, gain, or loss from the disposition or abandonment of an asset described in section 1221(1), (3), (4), or (5), if substantially all the assets in such category from the same trade or business are disposed of in one transaction (or series of related transactions);

(4) Any income, gain, or loss from assets disposed of in an applicable asset acquisition under section 1060(c);

(5) Any item carried to or from any portion of the original year (e.g., a net operating loss carried under section 172) and any section 481(a) adjustment;

(6) The effects of any change in accounting method initiated by the filing of Form 3115 after becoming or ceasing to be a member;

(7) Any income from a discharge of indebtedness;

(8) Any interest expense allocable under section 172(h) to a corporate equity reduction transaction causing this paragraph (b) to apply;

(9) Any credit to the extent arising from activities or items that are not ratably allocated (e.g., the rehabilitation credit under section 47, which is based on placement in service);

(10) Any deemed income inclusion from a foreign corporation, or any deferred tax amount on an excess distribution from a passive foreign investment company under section 1291; and

(11) Any item which, in the opinion of the Commissioner, would, if ratably allocated, result in a substantial distortion of income in any consolidated return or separate return in which the item is included.

(D) ELECTION. The election to ratably allocate items must be made in a separate statement entitled "THIS IS AN ELECTION UNDER section 1.1502-76(b)(2) TO RATABLY ALLOCATE ITEMS OF [insert name and employer identification number of the member]." The statement must --

(1) Identify the member's extraordinary items, their amounts, and the separate or consolidated returns in which they are included;

(2) Identify the member's aggregate amount to be ratably allocated, and the portion of the amount included in the separate and consolidated returns; and

(3) Include the name and employer identification number of the common parent (if any) of each group that must take the items into account. The statement must be signed by the member and by the common parent of any group that must take into account the items, and filed with the returns including the items for the years ending and beginning as of the event that causes this paragraph (b) to apply. A copy of the election must be retained by each corporation signing the election. If more than one member of the same consolidated group, as a consequence of the same plan or arrangement, cease to be members of that group and become members of another consolidated group, an election under this paragraph (b)(2)(ii)(D) may be made only if it is made by each such member.

(iii) TAXES. To the extent properly taken into account during the member's taxable year (determined without the application of this paragraph (b)), federal, state, local, and foreign taxes are allocated under paragraphs (b)(2)(i) and (ii) of this section on the basis of the items or activities to which the taxes relate. Thus, income tax is allocated based on the inclusion of the income (determined under the principles of this paragraph (b)) to which the tax relates. For example, if a calendar-year domestic corporation has $100 of foreign source dividend income (determined in accordance with United States tax accounting principles but without taking this paragraph (b) into account) that for purposes of section 904 is passive income, and $60 of that income is allocated under this paragraph (b) to the period of the calendar year after it becomes a member of a consolidated group, then 60 percent of the corporation's deemed paid foreign tax credit associated with its dividend income for the calendar year is taken into account in computing the group's passive basket consolidated foreign tax credit. This paragraph (b)(2)(iii) applies without regard to any determination or allocation by another taxing jurisdiction.

(iv) PASSTHROUGH ENTITIES -- (A) IN GENERAL. If a member is a partner in a partnership or an owner of a similar interest with respect to which items of the entity are taken into account by the member, the member is treated, solely for purposes of determining the year to which the entity's items are allocated under paragraphs (b)(2)(i) and (ii) of this section, as selling or exchanging its entire interest in the entity as of the event that causes this paragraph (b) to apply.

(B) TREATMENT AS A CONDUIT. For purposes of this paragraph (b)(2), if a member (together with other members) would be treated under section 318(a)(2) as owning an aggregate of at least 50 percent of any stock owned by the passthrough entity, the method that is used to determine the inclusion of the entity's items in the consolidated or separate return must be the same method that is used to determine the inclusion of the member's items in the consolidated or separate return.

(C) EXCEPTION FOR CERTAIN FOREIGN ENTITIES. This paragraph (b)(2)(iv) does not apply to any foreign corporation generating the deemed inclusion of income, or to any passive foreign investment company generating a deferred tax amount on an excess distribution under section 1291.

(3) EXAMPLES. For purposes of the examples in this paragraph (b), unless otherwise stated, P and X are common parents of calendar- year consolidated groups, P owns all of T's stock, T has only one class of stock outstanding, T owns no stock of lower tier members, the facts set forth the only corporate activity, all transactions are between unrelated persons, tax liabilities are disregarded, and any election required under paragraph (b)(2) of this section is properly made. The principles of this paragraph (b) are illustrated by the following examples.

(ii) PRIOR LAW. For corporations becoming or ceasing to be members of consolidated groups before this paragraph (b) applies, see prior section 1.1502-76(b) and (d) (as contained in the CFR edition revised as of April 1, 1992). However, section 1.1502-76(b)(5) (as contained in the CFR edition revised as of April 1, 1992) does not apply with respect to corporations becoming or ceasing to be members of consolidated groups on or after December 1, 1992.

* * * * *

Par. 17. Paragraph (d) of section 1.1502-76 is removed.

Par. 18. Section 1.1502-80 is amended by adding paragraphs (c), (d), and (e) to read as follows:

SECTION 1.1502-80 APPLICABILITY OF OTHER PROVISIONS OF LAW.

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(c) DEFERRAL OF SECTION 165(g). For consolidated return years ending on or after [the date the final regulations are filed with the Federal Register], stock of a member may not be treated as worthless under section 165(g) until the stock is treated as disposed of under section 1.1502-19(c)(1)(iii). See sections 1.1502-11(c) and 1.1502-20 for additional rules relating to stock loss.

(d) NON-APPLICABILITY OF SECTION 301(c)(3). Section 301(c)(3) does not apply to any transfer between members occurring on or after [the date the final regulations are filed with the Federal Register]. For prior transfers between members, see section 1.1502-14 (as contained in the CFR edition revised as of April 1, 1992).

(e) NON-APPLICABILITY OF SECTION 357(c). Section 357(c) does not apply to any transfer between members occurring on or after [the date the final regulations are filed with the Federal Register]. This exception does not apply if the transferee becomes a nonmember as part of the same plan or arrangement, unless the transferor and transferee continue to be members of the same consolidated group. A corporation is treated as becoming a nonmember if it has a separate return year (including another group's consolidated return year).