By Anthony Diosdi
A corporation generally determines its taxable income or loss without reference to the taxable income or loss of its shareholders or other entities, The theory that each corporation is a separate taxpayer is limited, however, in certain situations in which corporations are “affiliated” (i.e., subject to common control or joined through interlocking ownership). In the case of affiliated corporations. Internal Revenue Code restrictions limit the ability to obtain multiple tax benefits and to manipulate intercompany transactions to reduce tax liability. The Internal Revenue Code also recognizes that the identities of affiliated corporations may merge at certain very high levels of common control. For tax purposes, it is permissible to treat the corporation as a single entity in which intercompany transactions are disregarded. This article discusses the taxation of affiliated corporations.
Component Members of a Controlled Group of Corporation
The affiliated group rules apply only to the “component members of a controlled group of corporations.” See IRC Section 1561. The terms “component members” and “controlled group of corporations” are defined in Section 1563 of the Internal Revenue Code. Section 1563(a) generally defines three principal types of controlled groups of corporations: a parent-subsidiary controlled group, a brother-sister controlled group, and a combined group.
Parent-Subsidiary Controlled Group
A parent-subsidiary controlled group generally is defined as one or more chains of corporations connected through stock ownership to a common parent, if (1) each corporation (other than the parent) is at least 80% owned (by voting power or value) by one or more of the other corporation and (2) the parent directly owns at least 80% (by voting power or value) of at least one of the other corporation. See IRC Section 1563(a)(1). Thus, if corporation X owns 80 percent of the total combined voting power of corporations Y and Z, Y and Z are members of a parent-subsidiary controlled group. See Treas. Reg. Section 1.1563-1(a)(2)(ii) Example 1.
Brother-Sister Controlled Group
A brother-sister controlled group is two or more corporations having five or fewer persons who are individuals, estates, or trusts that own (1) at least 80% (by voting power or value) of each corporation, and (2) more than 50% (by voting power or value) of each corporation taking into account the stock ownership of each person only to the extent it is identical, or overlapping, in each corporation. See IRC Section 1563(a)(2). For example, if an individual owns 80% of the total combined voting power of corporations X and Y, and Y owns 80 percent of the total combined voting power of corporation Z, then X, Y and Z are members of a combined group. See Treas. Reg. Section 1.1563-1(a)(4)(ii) Example 1.
Component Member
A corporation generally qualifies as a “component member” of a controlled group of corporations for a tax year if it is a member on December 31 that falls within that taxable year. See IRC Section 1563(b)(1)(A). If a corporation is not a member on December 31, it still can be treated as a member for its taxable year if it was a member at some point during the calendar year and was a member for at least one-half of the number of days during its taxable year that preceded December 31. See IRC Section 1563(b)(1)(B); IRC Section 1563(b)(3). Nonvoting preferred stock, treasury stock and “excluded stock” are not considered in applying the parent-subsidiary and brother-sister ownership tests. See IRC Section 1563(c). Various constructive ownership rules are applied to test stock ownership. In general, every member of a controlled group of corporations on December 31 is a “component member” of the group. Special rules apply to corporations which are not members of the group for the full year and corporations taxed under other statutory schemes, such as tax-exempt and foreign corporations, are excluded from the group. See IRC Section 1563(b).
Transactions Involving Related Corporations
Without some limitations, commonly controlled business organizations could engage in transactions designed to reduce their overall tax liability. Income shifting and recognization in transactions between controlled entities are the most avoidance strategies. The Internal Revenue Code has a number of provisions designed to prevent tax avoidance in transactions between related taxpayers and many of those provisions apply to controlled and commonly owned corporations. For example, the loss disallowance and matching of income and deduction rules in Section 267(a) apply to corporations which are members of the same controlled group.
Allocations of Income and Deductions Section 482
Under Section 482 of the Internal Revenue Code, the IRS may distribute, apportion, or allocate tax items between or among organizations, trades, or businesses which are owned or controlled, directly or indirectly, by the same interests when the reallocation of the items is necessary to prevent the evasion of tax.
Section 482 applies to transactions involving two or more “organizations, trades, or businesses,” regardless of whether they are incorporated, domestic or foreign, or file consolidated returns. “Organizations” is defined expansively and includes sole proprietorships, partnerships, trusts, estates, associations, and corporations. Two or more organizations, trades or businesses are considered “controlled” for Section 482 purposes if there is control of any kind, direct or indirect, whether legally enforceable or not
Transactions between controlled taxpayers are subject to special scrutiny under Section 482 of the Internal Revenue Code and the IRS has the authority to make adjustments in cases involving inadvertence as well as those motivated by tax avoidance considerations. In testing transactions under Section 482, the standard applied is that of an uncontrolled taxpayer dealing at arm’s length with another uncontrolled taxpayer. Whether a controlled transaction produces an arm’s length result is generally evaluated by comparing the results of that transaction to those realized by uncontrolled taxpayers engaged in comparable transactions under comparable circumstances. The comparability of transactions and circumstances must be evaluated considering all factors that could affect prices or profits in arm’s length dealings, including functions, contractual terms, risks, economic conditions, and property or services. To be considered comparable to a controlled transaction, an uncontrolled transaction does not have to be identical to a controlled transaction, but it must be sufficiently similar that it provides a reliable measure of an arm’s length result. See Treas. Reg. Section 1.482-1(d)(2).
Although the IRS has the authority to apply Section 482 to almost any type of transaction between commonly controlled entities, the regulations under Section 482 set forth five categories of transactions that are most likely to result in adjustments by the IRS. These categories are as follows: 1) loans and advances; 2) the performance of services; 4) sales of tangible property; and 5) the sale or use of intangible property. See Treas. Reg. Section 1.482-4.
Consolidated Returns
Even if two or more corporations constitute an affiliated group, the corporations must file separate returns unless they elect to file a consolidated return. The term “affiliated group” is defined in Section 1504(a) of the Internal Revenue Code to include one or more chains of “includible corporations” connected through stock ownership to a common parent that is an includible corporation, if 1) the common parent owns directly stock possessing at least 80 percent of the total voting power and total value of the stock of at least one of the other includible corporations, and 2) stock possessing at least 80 percent of the total voting power and total value of the stock of each includible corporation is owned directly by one or more of the other includible corporations. See IRC Section 1504(a)(1), (2).
The Internal Revenue Code permits controlled corporations to be treated as a single entity for tax purposes on the theory that at very high levels of common ownership a family of corporations may be viewed as a single economic unit which should be eligible to compute joint, or “consolidated,” tax liability. The principal advantages of filing a consolidated return are: 1) losses of one member of the group may be used to offset income of other members; 2) intercompany dividend distributions are eliminated from income; and 3) income from intercompany transactions may be deferred.
A consolidated return must be filed on the basis of the common parent’s taxable year, and each subsidiary in the group must adopt the common parent’s taxable year beginning with the first consolidated return year for which the subsidiary’s income is included in the consolidated return. However, the method of accounting that each member of the group must use in determining its income and deductions is determined without considering the method used by the parent corporation.
Once the IRS grants permission to file a consolidated return, a consolidated return for an affiliated group must continue for all succeeding years unless the group no longer remains in existence or the IRS grants permission to discontinue filing for “good cause.” The IRS typically only grants permission to discontinue filing for good cause only when there are certain changes to the Internal Revenue Code or its regulations which have a substantial negative effect on the group’s consolidated tax liability in the aggregate or when certain factors demonstrate that there exists good cause for the discontinuance. See Treas. Reg. Section 1.1502-75(c)(1)(ii), (c)(1)(iii).
Eligibility to File a Consolidated Return
Under Section 1501 of the Internal Revenue Code, an “affiliated group of corporations” is eligible to file a consolidated return in lieu of separate returns. All corporations who are members of the group must consent to application of all of the consolidated return regulations under Section 1502.
An “affiliated group” is one or more chains of “includible corporations” in which a parent corporation owns directly at least 80% (by vote and value) of at least one includible corporation and at least 80% (by vote and value) of each includible corporation is owned directly by one or more other includible corporations. For purposes of the ownership test, nonconvertible preferred stock which has redemption and liquidation rights limited to its issue price is disregarded.
Computing Consolidated Taxable Income
The first step in determining a group’s consolidated taxable income is to determine the separate taxable income or loss of each member. In computing its separate taxable income, each member of the group uses the common parent’s taxable year and its own accounting method. The separate taxable incomes of the members are aggregated and combined with certain items that must be determined on a consolidated basis, and tax liability is computed based upon consolidated taxable income. The second step in determining a group’s consolidated income is to example intercompany transactions. The regulations governing intercompany transactions contain a “matching rule” and an “acceleration rule” that generally attempt to approximate the results of a transaction between divisions of a single corporation. Examples include sales or rentals of property, the performance of services, the licensing of technology and the lending of money. The regulations also require adjustments for “intercompany distributions.” An example of an intercompany distribution would be an ordinary cash distribution made by corporation S to its parent, corporation P, both of whom are members of the same affiliated group immediately after the distribution. Incompany distributions generally are excluded from the gross income of the distributee member. This exclusion is available only to the extent that there is a corresponding negative adjustment in the distributee member’s basis in the stock of the distributing member.
In calculating consolidated taxable income, certain items of income and deductions are taken into account on a consolidated basis. That is, these items generally are omitted in calculating the separate taxable income of each consolidated member and aggregated with items from the other member. The net amount of each item is added to or subtracted from the sum of the members’ separate taxable incomes. The items that must be taken into account on a consolidated basis include capital gain or loss, gain or loss deductions, and deductions for net operating losses.
Once the total tax liability of a consolidated group is determined, the liability must be allocated among members for purposes of determining each member’s earnings and profits or E&P. Section 1552 of the Internal Revenue Code provides three methods pursuant to which an affiliated group can make an allocation method to each member of the group. Under the first method, the group’s tax liability generally is allocated based on the ratio of each member’s separate taxable income to the sum of the separate taxable incomes of all members. See Treas. Reg. Section 1.1552-1(a)(1). Under the second method, the group’s tax liability is allocated using a ratio, but under this method, each member’s separately computed tax liability is compared to the sum of the members’ separately computed tax liabilities. See Treas. Reg. Section 1.1552-1(a)(2). The third method generally compares each member’s tax liability determined on both a consolidated basis and a separate basis and reallocates any increase in tax liability resulting from the consolidation. See Treas. Reg. Section 1.1552-1(a)(3).
Conclusion
The advantages of filing a consolidated return includes the ability to offset income of one member with the losses of another. It also includes the ability to exclude taxable dividends from a distributee member’s gross income and the ability in some cases to defer the recognition of gain on intercompany transactions. The disadvantages of filing consolidated returns is the expense of having such a return prepared. The filing a consolidated return for an affiliated group requires detailed compliance with a complex set of regulations. The disadvantages of filing a consolidated return may also result in the disallowance of deductions for certain losses incurred by a member of an affiliated group.
Given the highly complex rules governing the filing of consolidated returns, a tax attorney well versed in this area should be consulted to carefully assess the potential pros and cons of filing a consolidated return.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.