Deloitte Tax Comments on Proposed Regs on Unified Rule for Loss on Subsidiary Stock

Dear Eric:

On January 23, 2007, the Treasury Department and the Internal Revenue Service proposed regulations under sections 358, 362(e)(2), and 1502 of the Internal Revenue Code. The preamble to the proposed regulations requests comments on various aspects of these proposed rules. This letter contains comments on the proposed rules regarding the determination and treatment of loss on the transfer of subsidiary stock.

Second, the netting rule contained in Prop. Reg. § 1.1502-36(c)(7) should be clarified to provide that net positive adjustments with respect to a subsidiary's stock are determined by taking into account investment adjustments regardless of the owning member at the time of the adjustment for purposes of the limitation on basis reduction in paragraph (c)(3)(ii). Paragraph (c)(7), as drafted, appears intended to neutralize the effect of an intercompany sale of a subsidiary's stock on a group's basis reduction and ultimately its consolidated taxable income. This result would be consistent with the principles of Treas. Reg. § 1.1502-13. The aggregation of all investment adjustments, irrespective of the identity of the owning member at the time of the adjustment, would be consistent with that approach.

Third, we question the policy underlying the non-elective system of reducing attributes and the specific order in which attributes are reduced under the attribute reduction rule. The preamble to the proposed regulations states that the order in which attributes are reduced reflects the Treasury Department's and the IRS's principal goal of addressing the issues of noneconomic and duplicated stock loss in a manner that is as readily administrable as possible. However, this system is a drastic departure from former Treas. Reg. § 1.1502-20(g).

We understand that the particular order of attribute reduction is intended to mirror the order in which attributes are reduced under section 108. However, the policies underlying section 108(b) (reduction in future benefits from the use of tax attributes in exchange for current exclusion from gross income of COD income) differ significantly from those underlying the rules to prevent loss duplication.

In the event that an elective system is not adopted, we recommend two changes to the attribute reduction rule. First, we recommend that capital losses be reduced before net operating losses. Capital losses are the type of losses that a taxpayer would have recognized on a sale of subsidiary stock without regard to any rules limiting losses on subsidiary stock. Thus, it would be appropriate to reduce these types of losses first. Second, a final category of assets should be added to the list of assets the basis of which may be reduced, namely, fast-pay assets as described in Treas. Reg. § 1.338-6(b)(2)(iv). The intent of paragraph (d) of Prop. Reg. § 1.1502-36 is to prevent taxpayers from claiming duplicated loss, not to create gain. Thus, under Prop. Reg. § 1.1502-36(d)(4)(i)(D), the reduction to the basis of publicly traded property is limited by the amount that basis exceeds value. To prevent gain, the basis of fast-pay assets should be reduced only as a last resort when the basis of all other assets has been exhausted.

Fourth, we propose that any income, deduction, gain, or loss with respect to an intercompany obligation by reason of Treas. Reg. § 1.1502-13(g)(3) should not be taken into account in determining net positive adjustments under Prop. Reg. § 1.1502-36(c)(3). Stated differently, the basis reduction rule should disregard income or deductions that result from the cancellation (or deemed cancellation) of an intercompany obligation (other than events that result when a non-intercompany obligation becomes an intercompany obligation). Such amounts are economically the equivalent of capital contributions or distributions and should not result in an increase or decrease in loss disallowance. In addition, taking into account positive investment adjustments from COD income arising from an intercompany obligation would undermine the policy of maintaining single entity treatment with respect to obligations held by other members under Treas. Reg. § 1.1502-13(g)(3). Our proposed change is inherently neither pro-government nor pro-taxpayer, as illustrated by the following examples:

Finally, we note that there appears to be an error in one of the examples illustrating the application of the attribute reduction rule. Specifically, in part (B) of Example 6 in Prop. Reg. § 1.1502-36(d)(7), the example states that the disconformity amount is $120. We believe that the amount should be $140, representing the excess of P's $220 basis in the S share over the S share's allocable portion of S's net inside attribute amount of $80.

Thank you for your attention. We would be happy to meet with you to discuss these proposals in person. If you have any questions, please feel free to call Larry Axelrod at (202) 879-4969 or Lisa Leong at (202) 879-4934.