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Investment Credit Recapture in a Consolidated Group Transfer Followed by a Section 368(a)(1)(D) Split-Off

JAN. 18, 1982

GCM 38816

DATED JAN. 18, 1982
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Citations: GCM 38816

January 18, 1982

 

 

In re: Investment Credit Recapture in a

 

Consolidated Group Transfer Followed

 

by a Section 368(a)(1)(D) Split-Off

 

Rev. Rul. 82-20, 1982-4 IRB 6

 

 

TO: GERALD G. PORTNEY

 

Assistant Commissioner (Technical)

 

 

Attention: Corporation Tax Division

 

 

This is in reply to a memorandum dated October 21, 1980, forwarding a proposed revenue ruling (Control No. 7902274145) to this office for formal consideration.

 

ISSUE

 

 

Whether there is investment credit recapture under I.R.C. section 47 when there is a transfer from one member of a consolidated return group to another member of the group and the transferee is split-off in a reorganization that qualifies under sections 368(a)(1)(D) and 355.

 

CONCLUSION

 

 

The proposed revenue ruling concludes that there is investment credit recapture to the transferor corporation and that the exception contained in Treas. Reg. section 1.1502-3(f)(2)(i) does not apply. We agree with this conclusion but for a different reason than that stated in the proposed ruling.

 

FACTS

 

 

P corporation, the stock of which is equally owned by A and B, has been actively engaged in two separate businesses for more than five years. P also owns 100 percent of the stock of S corporation. S has also been actively engaged in business for more than five years. P and S both use the accrual method of accounting and file a consolidated federal income tax return on a calendar year basis.

Because of conflicting opinions between A and B on the expansion and administration of P, it was decided that one of the businesses of P and the stock of S should be transferred to A. Pursuant to the plan, P transferred all the assets of one of the businesses necessary to conduct the trade or business, including section 38 property, to S solely in exchange for additional shares in S and immediately thereafter distributed all of the stock of S to A. S will continue to use the assets in the same trade or business. The transaction qualified under sections 355(a)(1) and 368(a)(1)(D). A surrendered all of its stock in P as part of the transaction.

 

ANALYSIS

 

 

Section 47(a)(1) of the Code provides that if any property is disposed of, or otherwise ceases to be section 38 property with respect to a taxpayer before the close of the useful life on which the credit under section 38 was computed, the federal income tax shall be adjusted for the taxable year in which the disposition or cessation took place.

Section 47(b) provides exceptions to the recapture rules. One exception is that property shall not be treated as ceasing to be investment tax credit property with respect to the taxpayer by reason of a mere change in the form of conducting the trade or business so long as the property is retained in such trade or business as investment tax credit property and the taxpayer retains a substantial interest in such trade or business. In addition, Treas. Reg. section 1.47-3(f)(1)(i) states that four requirements listed in Treas. Reg. section 1.47-3(f)(1)(ii) must be satisfied in order to avoid recapture. The four requirements listed in Treas. Reg. section 1.47-3(f)(1)(ii) are:

 

(a) The investment tax credit property is retained as investment tax credit property in the same trade or business;

(b) The transfer (or in a case where the transferor is a partnership, estate, trust, or electing small business corporation, the partner, beneficiary, or shareholder) of such investment tax credit property retains a substantial interest in such trade or business;

(c) Substantially all the assets (whether or not investment tax credit property) necessary to operate such trade or business are transferred to the transferee to whom such investment tax credit property is transferred; and

(d) The basis of the investment tax credit property in the hands of the transferee is determined in whole or in part by reference to the basis of such investment tax credit property in the hands of the transferor.

 

Treas. Reg. section 1.47-3(f)(5)(i) requires recapture to the transferor when the provisions of Treas. Reg. section 1.47-3(f)(1)(i) have been satisfied but the transferee disposes of the investment tax credit property, or the investment tax credit property ceases to qualify as investment tax credit property with respect to the transferee, prior to the close of the estimated useful life used to calculate the investment tax credit. Similarly, Treas. Reg. section 1.47-3(f)(5)(ii) requires recapture whenever the transferor does not retain a substantial interest directly or indirectly in the trade or business. Substantial interest is defined in Treas. Reg. section 1.47-3(f)(2). A transferor will be considered to have retained a substantial interest in the trade or business only if, after the change of form, the transferor's interest is substantial in relation to the total interest of all persons or is equal to or greater than his interest prior to the change in form.

Treas. Reg. section 1.1502-3 governs how an affiliated group determines its consolidated investment tax credit. Essentially, the investment tax credit for an affiliated group filing a consolidated return is calculated by determining the investment tax credit for each member of the group and then adding the separate investment tax credits together.

Rules concerning recapture of investment tax credit to members of an affiliated group are found in Treas. Reg. section 1.1502-3(f). When there is recapture of investment tax credit under section 47(a) and the affiliated group is filing on a consolidated basis, any increase in tax is added to the tax liability of the group. If there is investment tax credit recapture and the member of the group is filing on a separate return basis for that tax year, any increase to its tax caused by recapture is added to its separate tax liability.

There is a major exception to the general recapture rules that relates to transfers among members of an affiliated group. In general, when investment tax credit property is transferred from one member of the group to another member of the group during a consolidated return year, there is no recapture of investment tax credit since such transfer is not treated as a disposition or cessation of use within the meaning of section 47(a)(1). Treas. Reg. section 1.1502-3(f)(2)(i). The "no recapture" policy is based on treating the consolidated group as a single entity. Further justification is found in the fact that the investment tax credit property is still being used in a trade or business within the same economic sphere and a purpose of the investment tax credit recapture provisions -- to prevent a multiplication of credits -- would not be served if an intercompany transfer caused a triggering of section 47.*

The rules on recapture of investment tax credit are illustrated by five examples listed in Treas. Reg. section 1-1502-3(f)(3). Under the facts of example 1, a parent (P), a subsidiary (S), and another subsidiary (T) file a consolidated return for calendar years 1967 and 1968. In 1967, S placed in service investment tax credit property having an estimated useful life of more than eight years. In 1968, S sold the investment tax credit property to T. There is no recapture on the transfer from S to T. Example 5 further builds on the same facts. In 1969, P sold all of the stock of T to a third party. Example 5 holds that the sale of the T stock by P does not trigger recapture of investment tax credit.

In Rev. Rul. 74-101, 1974-1 C.B. 7, considered in G.C.M. 35572, [deleted], I-5137-72 (Nov. 26, 1972), a domestic corporation, X, operated the same business in three states. X was owned by a sole shareholder. Pursuant to a plan of reorganization that came under sections 368(a)(1)(D) and 355, X formed two new corporations, Y and Z, and transferred all of the business in one state to Y and all of the business in another state to Z. X immediately distributed its Y and Z stock to its sole shareholder. The question presented in the ruling was whether the transfer by X of investment tax credit property to the two newly formed corporations (Y and Z) caused a recapture of investment tax credit. The ruling concluded that there was investment credit recapture and that the transaction was not a mere change in form because X was not a substantial owner of Y and Z.

In the proposed revenue ruling there is a transfer of section 38 property between members of an affiliated group and an immediate split-off of the transferee corporation outside the group. The transaction qualifies under sections 355(a) and 368(a)(1)(D). Under the rationale of Rev. Rul. 74-101 and G.C.M. 35572, the change in form of ownership exception of section 47(b)(2) does not apply because the transferor does not retain substantial ownership of the transferee. The only issue, therefore, is whether the transaction comes within the exception to recapture contained in Treas. Reg. section 1.1502-3(f)(2)(i) for transfers between members of a group in a consolidated return year.

The proposed ruling denies application of Treas. Reg. section 1.1502-3(f)(2)(i). The proposed revenue ruling reasons as follows. Treas. Reg. section 1.1502-3(f)(2)(i) only applies if a transaction occurs that would be a disposition under section 47(a)(1). Under the facts of the proposed ruling, the conditions required under the mere change in form test of Treas. Reg. section 1.47-3(f)(1)(ii) are considered satisfied immediately after the transfer between P and S and immediately prior to the transfer of the stock of S to A. Thus the transfer of the section 38 property is not a disposition and Treas. Reg. section 1.1502-3(f)(2)(i) does not apply. It is the subsequent transfer of the stock that then causes recapture under Treas. Reg. section 1.47-3(f)(5)(ii).

We do not believe there is any authority for so ordering the priorities of application of these two exceptions to recapture the investment credit. In fact, Treas. Reg. section 1.1502-3(f)(3) Ex. 5 is a strong indication that the reverse order of application should apply. In that example there is a sale of section 38 property between two members of a consolidated group. (Example 1 illustrates that this sale does not trigger recapture.) In the following year there is a sale of the stock of the transferee to a third party. There is still no recapture.

Presumably example 5 would apply if the initial transfer of section 38 property from one member of the group to the other had not been by sale but by a transfer that would have also qualified as a mere change in form under Treas. Reg. section 1.47-3(f)(1). Thus the subsequent transfer of the stock of the transferee member outside the group should still not trigger recapture. Under the rationale of the proposed revenue ruling, however, the section 47 rule would preclude the application of Treas. Reg. section 1.1502-3(f)(2)(i). If the transaction is under Treas. Reg. section 1.47-3(f), then the subsequent transfer of the stock outside the group would trigger recapture under Treas. Reg. section 1.47-3(f)(5)(ii) because the retention of a substantial interest in the business is a continuing requirement. The rationale of the proposed revenue ruling would lead to a different result than that required by example 5. Accordingly, we believe the rationale of the proposed revenue ruling would be inconsistent with the regulations.

Nevertheless, we agree that there should be investment credit recapture and that Treas. Reg. section 1.1502-3(f)(2)(i) should not apply under the facts of the proposed revenue ruling. Although under Treas. Reg. section 1.1502-3(f)(2)(i) a transfer from one member of a group to another member of the same group during a consolidated return year is not treated as a disposition, we believe that this exception is premised on the property staying within the group. In the present case, however, the transfer of the section 38 property is part of a single transaction the purpose of which is to remove property from the group, i.e., the transfer of the section 38 property is directly related to the split-off. Under these circumstances we believe that the exception for transfers between members of a group should not apply. Accord, 1 H. Lerner, R. Antes, R. Rosen, and B. Finkelstein, Federal Income Taxation of Corporations Filing Consolidated Returns section 14.01[9] (1980). Of course, if the split-off is independent of the transfer of the section 38 property, then Treas. Reg. sections 1.1502-3(f)(2)(i) and (f)(3) Ex. 5 should apply and prevent recapture.

We have redrafted the proposed revenue ruling in accordance with the above analysis. A copy is attached for your consideration.

JEROME D. SEBASTIAN

 

Acting Chief Counsel

 

 

By: Paul F. Kugler

 

Reviewer, Branch No. 5

 

Interpretative Division

 

Attachments: Adm. File Proposed Rev. Rul.

 

FOOTNOTES

 

 

/*/ See memorandum in T.D. 6894 entitled Consolidated return revision -- Second Package from Lawrence M. Stone, Tax Legislative Counsel, to Stanley S. Surrey, Assistant Secretary.

 

PROPOSED REVENUE RULING

 

 

Compare with Rev. Rul. 82-20, 1982-4 IRB 6

 

 

ISSUE

 

 

Is there a disposition under section 47(a)(1) of the Internal Revenue Code when section 38 property is transferred by a member of an affiliated group that files consolidated returns and the transfer is part of a transaction that qualifies as a "split-off" under sections 355(a)(1) and 368(a)(1)(D)?

 

FACTS

 

 

* * * corporation, the stock of which is equally owned by A and B, has been actively engaged in two separate businesses for more than five years. P also owns 100 percent of the stock of S corporation. S has also been actively engaged in business for more than five years. P and S both use the accrual method of accounting and file a consolidated federal income tax return on a calendar year basis.

Because of conflicting opinions between A and B on the expansion and administration of P, it was decided that one of the businesses of P and the stock of S should be transferred to A. Pursuant to the plan, P transferred all the assets of one of the businesses necessary to conduct the trade or business, including section 38 property, to S solely in exchange for additional shares in S and immediately thereafter distributed all of the stock of S to A. S will continue to use the assets in the same trade or business. The transaction qualified under sections 355(a)(1) and 368(a)(1)(D) of the Code. A surrendered all of its stock in P as part of the transaction.

 

LAW AND ANALYSIS

 

 

Section 47(a)(1) of the Code provides that if any property is disposed of, or otherwise ceases to be section 38 property with respect to a taxpayer before the close of the useful life on which the credit under section 38 was computed, the federal income tax shall be adjusted for the taxable year in which the disposition or cessation took place. See section 1.47-1(a) of the regulations.

Section 47(b) of the Code provides exceptions to the disposition provisions of section 47(a). One of the exceptions is if the transaction involves a mere change in the form of conducting the trade or business the property shall not be treated as ceasing to be section 38 property with respect to the taxpayer so long as the property is retained in such trade or business as section 38 property and the taxpayer retains a substantial interest in such trade or business.

Section 1.47-3(f)(1)(i) of the regulations provides that section 1.47-1(a) shall not apply to section 38 property that is disposed of or otherwise ceases to be section 38 property with respect to the taxpayer by reason of a mere change in the form of conducting the trade or business in which the section 38 property is used provided the conditions set forth in section 1.47-3(f)(1)(ii) are satisfied.

Section 1.47-3(f)(5)(ii) of the regulations provides that if in any taxable year the transferor of section 38 property described in section 1.47-3(f)(1)(i) does not retain, either directly or indirectly, a substantial interest in the trade or business, as defined in section 1.47-3(f)(2), then, under section 1.47-1(a) such property ceases to be section 38 property with respect to the transferor and the taxpayer must make a recapture determination.

Section 1.1502-3(f)(2)(i) of the regulations provides that a transfer of section 38 property from one member of a consolidated group to another member of the group during a consolidated return year shall not be treated as a disposition or cessation within the meaning of section 47(a)(1) of the Code.

Rev. Rul. 74-101, 1974-1 C.B. 7, provides that section 47(a)(1) of the Code applies when a corporation engaged in the same business in three states transfers its business activities in two of the states and all related assets including section 38 property to two newly formed corporations solely in exchange for all their stock and immediately thereafter transfers such stock to its sole shareholder in a section 368(a)(1)(D) reorganization.

The issue presented in Rev. Rul. 74-101 is similar to that described herein with one exception. The exception is that in the present case P and S are members of a consolidated group that files a consolidated return in the year of transfer. Thus, the specific question is whether the fact that a consolidated group is involved in the transfer should result in a different holding from that in Rev. Rul. 74-101.

Section 1.1502-3(f)(2)(i) of the regulations creates an exception for transfers of section 38 property between members of a consolidated group that would otherwise be dispositions under section 47(a)(1) of the Code. This exception is premised on the assumption that the property is remaining within the group.

In the present case, however, the transfer of the section 38 property from P to S is part of a transaction in which S is split off from the group. Since the transfer from P to S is a step in the planned transfer of the property outside the group, Treas. Reg. section 1.1502-3(f)(2)(i) does not apply.

 

HOLDINGS

 

 

Since the transfer of the section 38 property from P to S is a step in the planned transfer of the property outside the group, the exception contained in Treas. Reg. section 1.1502-3(f)(2)(i) does not apply to this transaction. Therefore, the transfer from P to S is a disposition under section 47(a)(1).
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