Unified Rule for Loss on Subsidiary Stock, 2964-3020 [07-187]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 72, Number 14 (Tuesday, January 23, 2007)]
[Proposed Rules]
[Pages 2964-3020]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 07-187]



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Part III





Department of the Treasury





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Internal Revenue Service



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26 CFR Part 1



Unified Rule for Loss on Subsidiary Stock; Proposed Rule

Federal Register / Vol. 72, No. 14 / Tuesday, January 23, 2007 / 
Proposed Rules

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-157711-02]
RIN 1545-BB61


Unified Rule for Loss on Subsidiary Stock

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations under sections 
358, 362(e)(2) and 1502 of the Internal Revenue Code (Code). The 
regulations apply to corporations filing consolidated returns. The 
regulations implement aspects of the repeal of the General Utilities 
doctrine by redetermining members' bases in subsidiary stock and 
requiring certain reductions in subsidiary stock basis on a transfer of 
the stock. The regulations also promote the clear reflection of income 
by redetermining members' bases in subsidiary stock and reducing the 
subsidiary's attributes to prevent the duplication of loss. 
Additionally, the regulations provide guidance limiting the application 
of section 362(e)(2) with respect to transactions between members of a 
consolidated group.

DATES: Written or electronic comments or a request for a public hearing 
must be received by April 23, 2007.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-157711-02), room 
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
157711-02), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC, or sent electronically, via the IRS 
Internet site at www.irs.gov/regs or via the Federal eRulemaking Portal 
at www.regulations.gov (IRS/REG-157711-02).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Theresa Abell (202) 622-7700 or Phoebe Bennett (202) 622-7770; 
concerning submissions of comments, Richard Hurst, 
Richard.A.Hurst@irscounsel.treas.gov, (202) 622-7180 (not toll-free 
numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collection of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, 
Washington, DC 20224. Comments on the collection of information should 
be received by March 26, 2007.
    Comments are specifically requested concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the IRS, including whether the 
information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information;
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collection of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    The collection of information in these proposed regulations is in 
Sec. Sec.  1.1502-13(e)(4)(v) and 1.1502-36(d)(7). The respondents are 
corporations filing consolidated returns. The collection of information 
is required to allow a corporation to preserve a subsidiary's 
attributes by foregoing a stock loss. The collection of information is 
required to obtain a benefit.
    Estimated total annual reporting and/or recordkeeping burden: 25 
hours.
    Estimated average annual burden per respondent and/or recordkeeper: 
15 minutes.
    Estimated number of respondents and/or recordkeepers: 100.
    Estimated annual frequency of responses: Once.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to the collection of information must be 
retained as long as their contents may become material in the 
administration of any Internal Revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    The discussion in this preamble begins with an overview of the 
history of the regulatory attempts to address both the circumvention of 
General Utilities repeal and the duplication of loss by consolidated 
groups, in particular, in Sec.  1.1502-20 (the Loss Disallowance Rule, 
or LDR). The discussion then turns to Rite Aid Corp. v. United States, 
255 F.3d 1357 (2001), which rejected the loss duplication rule in the 
LDR. Section A.4 of this preamble discusses the immediate 
administrative responses to Rite Aid. Section A.5 of this preamble 
discusses the legislative response to Rite Aid. Following the Rite Aid 
decision, the IRS and Treasury Department undertook a study to 
reconsider the issues addressed by Sec.  1.1502-20. Section B of this 
preamble discusses the various issues considered in that study, 
including both the original noneconomic and duplicated stock loss 
specifically addressed by the LDR and certain related issues with which 
the Internal Revenue Service and Treasury Department have grown 
concerned since the LDR was promulgated. Section C of this preamble 
describes the various approaches that were considered to address 
noneconomic stock loss and sets forth the conclusions reached regarding 
each. Section D of this preamble describes the various approaches that 
were considered to address loss duplication and sets forth the 
conclusions reached regarding each. Section E of this preamble 
describes the various approaches that were considered to address the 
noneconomic and duplicated loss that can arise from the general 
operation of the investment adjustment system and sets forth the 
conclusions reached regarding each. Section F of this preamble 
describes the specific provisions of this proposed regulation Sec.  
1.1502-36. Section G of this preamble discusses the proposed removal of 
Sec. Sec.  1.337(d)-1, 1.337(d)-2, and 1.1502-35.
    The IRS and Treasury Department are also proposing regulations to 
address the application of section 362(e)(2) to members of consolidated 
groups. These proposed regulations are described in section H of this 
preamble.
    Finally, the IRS and Treasury Department are proposing various 
technical and administrative revisions to the consolidated return 
regulations. These proposed regulations are described in section I of 
this preamble.

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    The IRS and Treasury Department request comments on the proposed 
regulations and other approaches that could be adopted, as well as 
other issues currently under study. See section J of this preamble for 
further discussion of comments requested.

A. History of General Utilities Repeal and Loss Disallowance Under 
Sec.  1.1502-20

1. The Repeal of the General Utilities Doctrine
    In 1986, Congress enacted section 337(d), which directs the 
Secretary to prescribe such regulations as may be necessary or 
appropriate to carry out the repeal of the General Utilities doctrine 
(GU repeal). See Tax Reform Act of 1986, Public Law 99-514 (100 Stat. 
2085 (1986)). The legislative history states that Congress was 
concerned that the General Utilities doctrine allowed ``assets to leave 
corporate solution and to take a stepped-up basis in the hands of the 
transferee without the imposition of a corporate-level tax'' and thus 
``tend[ed] to undermine the corporate income tax.'' H.R. Rep. No. 99-
426, 99th Cong., 1st Sess. 282 (1985). The General Utilities doctrine 
and GU repeal are discussed extensively in the Treasury Decisions 
referenced in this preamble; in addition, see generally, H.R. Rep. No. 
99-426 at 274-282 for a discussion of the history of the General 
Utilities doctrine; see also General Utilities & Operating Co. v. 
Helvering, 296 U.S. 200 (1935).
2. The Administrative Response to GU Repeal: Sec.  1.1502-20
    The IRS and Treasury Department first responded to GU repeal by 
issuing Notice 87-14 (1987-1 CB 445), which set forth the intent to 
promulgate regulations affecting adjustments to members' bases in stock 
of any subsidiary acquired when the subsidiary held an appreciated 
asset. Notice 87-14 indicated that, in general, adjustments to 
subsidiary stock basis would not reflect gains on such assets. Thus, 
Notice 87-14 implied that a tracing-based regime would be adopted to 
determine adjustments to member's bases in shares of subsidiary stock.
    After several years of study, the IRS and Treasury Department 
concluded that any approach relying on the identification and tracing 
of appreciation on particular assets, while theoretically accurate, 
would impose substantial administrative burdens on taxpayers and on the 
government. See TD 8294 (1990-1 CB 69), 55 FR 9426, 9428 (March 14, 
1990). As a result, the tracing-based approach envisioned in Notice 87-
14 was implemented only in regulations promulgated under section 
337(d). Those regulations applied only for the period of time between 
the issuance of Notice 87-14 and the effective date of final 
regulations under Sec.  1.1502-20 (February 1, 1991). See TD 8364 
(1991-2 CB 43), 56 FR 47379 (September 19, 1991), Sec. Sec.  1.337(d)-1 
and 1.337(d)-2 (as contained in 26 CFR part 1 revised as of April 1, 
1991).
    In lieu of tracing, the LDR used certain operating presumptions to 
determine the extent to which investment adjustments would be permitted 
to give rise to allowable stock loss. Because the LDR only disallowed 
loss, noneconomic investment adjustments were able to increase stock 
basis and thus reduce gain without limitation. As a result, the LDR 
reduced the duplication of gain in the tax system. The IRS and Treasury 
Department considered the reduction of gain duplication an important 
balance to the imprecision inherent in the LDR's use of irrebuttable 
presumptions.
    The study following the issuance of Notice 87-14 led the IRS and 
Treasury Department to consider the issue of loss duplication by 
members of consolidated groups. Their conclusion was that loss 
duplication was inappropriate in the consolidated setting. Further, the 
IRS and Treasury Department recognized that there were administrative 
advantages to addressing both issues in a single integrated rule. Thus, 
unlike the regulations under section 337(d), the LDR was at once 
directed at both the circumvention of GU repeal through the use of 
noneconomic stock loss and the duplication of loss. See TD 8294 and TD 
8364.
3. The Rite Aid Opinion
    Ten years after the promulgation of the LDR, the validity of the 
duplicated loss component of the LDR was considered in Rite Aid, supra. 
Under the duplicated loss component of the LDR, Rite Aid had been 
disallowed a deduction for an economic loss on subsidiary stock solely 
because the stock loss could be duplicated by the subsidiary after it 
left the group. The Federal Circuit stated that the Secretary's 
authority to change the application of a Code provision to a 
consolidated group was limited to situations in which the change was 
necessary to address a problem created by the filing of a consolidated 
return. Because duplicated stock loss occurs and is allowable in the 
separate return setting, the court concluded that the duplicated loss 
component of the LDR was not addressing a problem arising from the 
filing of a consolidated return. Accordingly, the court held that the 
Secretary did not have the authority to change the Code rule allowing a 
deduction for the stock loss.
4. The Administrative Response to Rite Aid
    In response to the Rite Aid decision, on February 19, 2002, the IRS 
announced that it would not continue to litigate the validity of the 
duplicated loss rule in Sec.  1.1502-20. See Notice 2002-11 (2002-1 CB 
526). On March 7, 2002, the IRS and Treasury Department promulgated 
Sec.  1.1502-20T(i) (to suspend the application of the LDR) and Sec.  
1.337(d)-2T (to provide an interim rule addressing noneconomic stock 
loss). See TD 8984 (2002-1 CB 668), 67 FR 11034 (March 12, 2002). 
Concurrently with the promulgation of Sec. Sec.  1.337(d)-2T and 
1.1502-20T(i), the IRS issued Notice 2002-18 (2002-1 CB 644), 
announcing that loss duplication regulations would also be promulgated. 
Following the publication of TD 8984, the IRS and Treasury Department 
undertook a study of the issues underlying both noneconomic and 
duplicated loss on subsidiary stock.
    In general, Sec.  1.337(d)-2T disallowed stock loss and reduced 
stock basis (to value) upon the disposition or deconsolidation of 
subsidiary stock by a member of a consolidated group. However, under 
Sec.  1.337(d)-2T(c)(2), loss disallowance and basis reduction were 
avoided to the extent the taxpayer could establish that the loss or 
basis ``is not attributable to the recognition of built-in gain on the 
disposition of an asset.'' Section 1.337(d)-2T(c)(2) defined the term 
``built-in gain'' as gain that is ``attributable, directly or 
indirectly, in whole or in part, to any excess of value over basis that 
is reflected, before the disposition of the asset, in the basis of the 
share, directly or indirectly, in whole or in part.''
    On March 14, 2003, the IRS and Treasury Department promulgated 
Sec.  1.1502-35T as an interim measure to address the problem of loss 
duplication in consolidated groups. See TD 9048 (2003-1 CB 644), 68 FR 
12287 (March 14, 2003). In the preamble to TD 9048, the IRS and 
Treasury Department announced that the issues addressed in Sec.  
1.1502-35T were still under study. The provisions of Sec.  1.1502-35 
are discussed in more detail in section D.1 of this preamble.
    Further guidance on the interim rules was issued August 25, 2004, 
in the form of Notice 2004-58 (2004-2 CB 520). In Notice 2004-58, the 
IRS announced that it would accept the ``basis disconformity'' method 
as an alternative approach to determining whether stock

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loss or basis was attributable to ``built-in gain'' within the meaning 
of Sec.  1.337(d)-2T.
    Under the basis disconformity method described in Notice 2004-58, 
stock loss or basis is treated as attributable to built-in gain to the 
extent of the least of (i) the net positive investment adjustment 
applied to the stock basis (disregarding distributions), (ii) the 
aggregate gain (net of directly related expenses) recognized on asset 
dispositions by the subsidiary, and (iii) the disconformity amount 
(generally, the amount by which the basis of the share exceeds the 
share's proportionate interest in the subsidiary's net inside asset 
basis; for this purpose, net inside asset basis is defined as the 
excess of the sum of the subsidiary's money, asset basis, loss 
carryforwards, and deferred deductions over its liabilities). Notice 
2004-58 also requested comments on the general scope of GU repeal and 
on other approaches that could be adopted to safeguard the purposes of 
GU repeal in the consolidated return context.
5. The Legislative Response to Rite Aid
    Congress responded to the Rite Aid opinion on October 22, 2004, in 
the American Jobs Creation Act (the AJCA), Public Law 108-357 (118 
Stat. 1418 (2004)). In the AJCA, Congress added a sentence at the end 
of section 1502 of the Code, so that the section now reads:

    The Secretary shall prescribe such regulations as he may deem 
necessary in order that the tax liability of any affiliated group of 
corporations making a consolidated return and of each corporation in 
the group, both during and after the period of affiliation, may be 
returned, determined, computed, assessed, collected, and adjusted, 
in such manner as clearly to reflect the income tax liability and 
the various factors necessary for the determination of such 
liability, and in order to prevent avoidance of such tax liability. 
In carrying out the preceding sentence, the Secretary may prescribe 
rules that are different from the provisions of chapter 1 that would 
apply if such corporations filed separate returns.

    In the legislative history to the AJCA, Congress stated that the 
Secretary is authorized to change the application of a Code provision 
when the Secretary determines it is necessary to clearly reflect the 
income tax liability of the group and each corporation in the group, 
both during and after the period of affiliation. See H.R. Conf. Rep. 
No. 108-755, 108th Cong., 2d Sess. 653 (2004). Congress thus rejected 
the suggestion in the Rite Aid opinion that the Secretary's authority 
to change the general application of the Code is limited to 
promulgating regulations that address problems created by the filing of 
a consolidated return.
    In the AJCA legislative history, Congress also spoke to the proper 
scope of future regulations. Regarding the promulgation of regulations 
addressing noneconomic stock loss, Congress stated that ``presumptions 
and other simplifying conventions'' could be used to prevent the 
circumvention of GU repeal. See H.R. Conf. Rep. No. 108-755, fn. 595. 
In addition, Congress indicated two acceptable methods for addressing 
loss duplication by group members. The first would disallow subsidiary 
stock loss to the extent it duplicates losses that remain available to 
the group. The second would reduce the subsidiary's attributes in order 
to prevent the subsidiary from using losses outside the group, to the 
extent the losses duplicate stock loss. But Congress also stated its 
intention that the result of the Rite Aid decision is to be preserved. 
The IRS and Treasury Department interpret this statement to mean that 
regulations addressing loss duplication by consolidated groups must not 
disallow a deduction for an economic loss on subsidiary stock solely 
because the stock loss duplicates unrecognized or unabsorbed losses 
that later could be used outside the group.
6. Further Administrative Response to Rite Aid
    On March 3, 2005, the IRS and Treasury Department finalized Sec.  
1.337(d)-2. See TD 9187 (2005-13 IRB 778), 70 FR 10319 (March 3, 2005). 
In TD 9187, the IRS and Treasury Department stated that the issues 
addressed in Sec.  1.337(d)-2 were still under study and that an 
alternative approach would be proposed. On March 14, 2006, the IRS and 
Treasury Department finalized Sec.  1.1502-35. See TD 9254 (2006-13 IRB 
662), 71 FR 13008 (March 14, 2006). In TD 9254, the IRS and Treasury 
Department stated that both noneconomic and duplicated loss were still 
under study, and that regulations would be proposed adopting a singe 
integrated approach to addressing both issues. The results of that 
study and the proposed integrated approach are described below in 
sections D through H of this preamble.

B. Issues Considered in the Post-Rite Aid Study.

1. GU Repeal and Noneconomic Investment Adjustments Under the LDR
    Section 337(d) generally directs the Secretary to prescribe 
regulations to prevent the circumvention of GU repeal and, in 
particular, section 337(d)(1) directs the Secretary to promulgate 
regulations to prevent the circumvention of GU repeal through the use 
of the consolidated return regulations. Congress' concern stems from 
the general operation of the investment adjustment system of Sec.  
1.1502-32.
    The purpose of the investment adjustment system is to promote the 
clear reflection of the group's income. See Sec.  1.1502-32(a)(1). One 
of the principal ways that the investment adjustment system promotes 
clear reflection is by preventing a subsidiary's items of income, gain, 
deduction and loss from giving rise to duplicative gain or loss on the 
subsidiary's stock. To that end, the investment adjustment system 
adjusts members' bases in shares of subsidiary stock to reflect such 
items once they have been taken into account by the group. See TD 8560 
(1994-2 CB 200), 59 FR 41666 (August 15, 1994).

    Example 1. Economic adjustment to stock basis prevents 
duplication. P, the common parent of a consolidated group, purchases 
all 100 outstanding shares of S common stock for $100 cash, taking a 
basis of $1 in each share. At the time, S owns one asset, A1, with a 
basis and value of $100. Later, the value of A1 increases to $150. S 
sells A1 to a nonmember for $150 and recognizes a $50 gain, which 
the P group takes into account. Under the investment adjustment 
system, P increases its basis in its S stock to reflect the $50 
taken into account by the group. As a result, the basis of each 
share increases to $1.50, its fair market value. P can then sell all 
or any portion of its S stock for its fair market value without 
recognizing duplicative gain on the disposition.

    The result in Example 1 is that the group takes its economic gain 
into account only once, on the disposition of S's asset, and not again 
on the subsequent disposition of the S stock. Thus the group's income 
is clearly reflected and there is no circumvention of GU repeal.
    The investment adjustment system is not a tracing regime. Rather, 
it is a presumptive regime based on certain operating assumptions. A 
principal assumption is that all of a subsidiary's items taken into 
account represent economic accruals (of gain or loss) to the group. 
Another principal assumption is that all such items accrue equally to 
all outstanding shares, at least within a class. When these assumptions 
correspond to the facts of a particular situation, as in Example 1, the 
investment adjustment system produces appropriate results: stock basis, 
which reflects only the investment in the stock, increases to reflect 
economic accrual (the group's return on its stock investment), and, as 
a result, stock basis can then shelter that return on the group's 
investment, protecting it from being taken into account again when the 
stock is sold.

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    The assumptions, however, do not correspond to the facts of all 
situations. For example, if stock of a subsidiary is purchased for its 
fair market value when the subsidiary holds appreciated assets, the 
items of income or gain generated when that appreciation is recognized 
do not represent an economic accrual on the group's investment (because 
the appreciation was already reflected in the basis of the stock). 
Nevertheless, the presumptive rules of the investment adjustment system 
treat such items as economic accruals and include them in the 
investment adjustment to be applied to the basis of the stock.

    Example 2. Noneconomic adjustment to stock basis creates 
noneconomic stock loss. Assume the same facts as in Example 1 except 
that P does not purchase the stock of S until the value of A1 has 
increased to $150. Accordingly, P purchases the stock for $150, 
taking a basis of $1.50 in each share. As in Example 1, when S sells 
A1, the investment adjustment system again increases P's basis in 
its S stock to reflect the $50 taken into account by the group. As a 
result, P's basis in each of its shares increases to $2, even though 
the fair market value of each share remains $1.50. If P were then to 
sell all or some portion of the S stock for its fair market value, P 
would recognize a $.50 loss on each share ($50 loss in the 
aggregate).

    In this situation, a deduction for the stock loss would be 
inappropriate because neither the group nor its members have suffered 
any economic loss. If P were allowed to deduct that noneconomic loss, 
the deduction would offset the gain recognized on S's asset and, 
effectively, eliminate the corporate-level tax on the gain on S's 
asset. This is the circumvention of GU repeal that concerned Congress 
in 1986.
    At the time Notice 87-14 was issued, the IRS and Treasury 
Department had identified the creation of noneconomic stock loss in 
situations similar to those illustrated in Example 2. Thus, Notice 87-
14 referred specifically to investment adjustments attributable to the 
disposition of assets that, at the time of the acquisition of the 
subsidiary stock, had a fair market value in excess of adjusted basis. 
For that reason, Sec.  1.337(d)-1, which implemented Notice 87-14, 
disallowed subsidiary stock loss unless the taxpayer could show that 
the loss was not attributable to the recognition of appreciation on 
assets owned, directly or indirectly, by a subsidiary when it became a 
member.
2. Duplicated Loss and the Clear Reflection of Group Income Under the 
LDR
    In the study that followed the issuance of Notice 87-14, the IRS 
and Treasury Department also considered the issue of loss duplication 
by members of a consolidated group. The specific concern of the IRS and 
Treasury Department was the loss duplication that occurs when an 
economic loss is reflected in both a member's basis in subsidiary stock 
and in the subsidiary's assets or operations, and the loss is first 
recognized with respect to the stock.

    Example 3. Duplication of loss. P forms S by contributing $110 
to S in exchange for all 100 outstanding shares of S stock. S uses 
the cash to purchase an asset, A1. The value of A1 later declines to 
$10. If P were then to sell all or some portion of the S stock for 
its fair market value, P would recognize a $1 loss on each share.

    In this situation, even though P would have recognized the group's 
economic loss on its disposition of the S stock, the loss continues to 
be reflected in the basis of A1. As a result, that loss would remain 
available for use by P (if the stock sale did not deconsolidate S) or S 
(if the stock sale deconsolidated S). Upon the disposition of A1, the 
group's single economic loss would thus be recognized and taken into 
account more than once by the group and its members or former members.
    In contrast, if the duplicated loss had first been taken into 
account with respect to A1, the investment adjustment system would have 
prevented a duplicative benefit to the group and its members by 
reducing P's basis in S stock by the amount of the loss. In that case, 
the group would have enjoyed the tax benefit attributable to the loss, 
but that benefit would not remain available for another use by the 
group and its members or former members.
    The IRS and Treasury Department concluded that the duplication of a 
group's tax benefit (represented by a single economic loss) distorts 
income without regard to whether the duplicated loss is taken into 
account first with respect to the subsidiary's stock or first with 
respect to the subsidiary's assets and operations. The IRS and Treasury 
Department further concluded that, even if the duplicated loss is used 
by a former member outside the group, that duplicative use distorts the 
income of the group and its members. Accordingly, the IRS and Treasury 
Department decided to promulgate regulations that would complement the 
investment adjustment system by addressing the stock-first recognition 
of a duplicated loss and that such regulations would apply to both 
deconsolidating and nondeconsolidating dispositions. Recognizing the 
administrative benefits of addressing both noneconomic and duplicated 
stock loss in a single integrated rule, the IRS and Treasury Department 
promulgated the LDR as a single rule with components directed at both.
    The method adopted by the LDR to address loss duplication was the 
disallowance of stock loss (or reduction of stock basis) that 
duplicated unrecognized inside loss, such as that illustrated in 
Example 3. However, groups had several mechanisms available to 
recognize or preserve the inside loss and thereby avoid loss 
disallowance (by eliminating loss duplication). Inside losses could be 
recognized through an actual asset sale or a deemed asset sale under 
section 338(h)(10), and, following the sale, the subsidiary's 
unabsorbed losses would be available to the group. In addition, the LDR 
allowed the common parent to elect to reattribute the subsidiary's 
losses (to itself) under Sec.  1.1502-20(g). If the group chose not to 
exercise those options, then the stock loss was denied, but the inside 
loss was preserved for a nonduplicative use by the subsidiary, in or 
out of the group.
    At the time the LDR was promulgated, the duplication potential 
illustrated in Example 3 was the principal form of loss duplication 
with which the IRS and Treasury Department were concerned. Thus it is 
the only form of loss duplication specifically addressed by the LDR. 
The anti-abuse rule in the LDR did, however, provide a limited 
mechanism for expanding the scope of that provision.
3. Noneconomic and Duplicated Loss Resulting from Investment 
Adjustments Allocated to Shares With Disparate Bases
    Since the promulgation of the LDR, the IRS and Treasury Department 
have become increasingly concerned with the noneconomic and duplicated 
loss potential arising from the interaction of Sec.  1.1502-32 and the 
disparate reflection of gain or loss in members' bases in individual 
shares of subsidiary stock.
    As discussed in section B.1 of this preamble, the investment 
adjustment system is a presumptive regime that allocates a subsidiary's 
items of income, gain, deduction, and loss taken into account by the 
group. It operates in accordance with the assumption that all such 
items reflect economic accruals to all shares equally within each 
class. When its underlying assumptions correspond to the facts of a 
particular situation, the investment adjustment system produces 
appropriate results, as illustrated in Example 1. But when its 
underlying assumptions do not correspond to the facts of a situation 
because shares held by members have disparate bases, the general 
operation of

[[Page 2968]]

the investment adjustment system can give rise to both noneconomic and 
duplicated loss on individual shares of subsidiary stock.

    Example 4. Noneconomic loss. P and M (a member of the P group) 
form S by contributing property to S in exchange for all 100 
outstanding shares of S stock. P contributes A1, with a basis and 
value of $80, in exchange for 80 shares of S stock. M contributes 
A2, with a basis of $0 and a value of $20, to S in exchange for 20 
shares of S stock. S then sells A2 for $20 and recognizes a $20 gain 
that is taken into account by the group. As a result, the basis of 
each share increases by $.20. P's basis in each of its shares is 
then $1.20 (or, $96 in the aggregate), and M's basis in each of its 
shares is then $.20 (or, $4 in the aggregate), even though the value 
of each share remains $1. P then sells all or some portion of its 
shares to X, a nonmember, and, under general principles of tax law, 
recognizes a $.20 noneconomic loss on each share, effectively 
eliminating up to $16 of the gain on A2.
    Example 5(a). Duplicated loss, inside recognition precedes stock 
disposition. P forms S with $100 and receives all 50 shares of S 
common stock. S uses the $100 to buy A1, which then declines in 
value to $50. P contributes another $50 for a second 50 shares of 
common stock. S then sells A1 and recognizes a loss of $50 that is 
taken into account on the P group return. The absorption of the $50 
loss results in a $.50 reduction to the basis of each share 
(original and newly issued). P then sells all or some portion of the 
original shares to X for $1 each (each with a basis of $1.50) and 
recognizes a $.50 loss on each share (up to $25 total). Although the 
$50 asset loss and the $25 stock loss both reflect an economic loss 
of the group, they are both reflecting the same loss. The group has 
actually experienced only $50 of economic loss. Therefore, the $.50 
loss recognized on each of the original shares (up to $25 total) is 
duplicative.
    Example 5(b). Duplicated loss, stock disposition precedes inside 
recognition. The facts are the same as in Example 5(a), except that, 
before S sells A1, P sells 20 of its original 50 shares to X for $20 
(aggregate basis $40), recognizing a $20 loss that is taken into 
account on the P group return, and S remains a member of the group. 
S then sells A1, recognizing a $50 loss that is taken into account 
on the P group return. Although the $50 asset loss and the $20 stock 
loss both reflect an economic loss of the group, they are both 
reflecting the same loss. As in Example 5(a), the group has actually 
experienced only $50 of economic loss. Therefore, $20 of the 
recognized loss is duplicative. Alternatively, if P sold all its 
original 50 shares, P would recognize a $50 loss even though the 
entire $50 group loss would remain available to S for a duplicative 
use against its separate year income.

    The IRS and Treasury Department recognize that, in each case where 
the disproportionate reflection of an item in a particular share causes 
an inappropriate stock loss, whether noneconomic or duplicated, that 
loss is offset by unrecognized gain in other shares. However, that gain 
can be deferred indefinitely or even eliminated by the group. 
Accordingly, the IRS and Treasury Department do not believe that the 
system is appropriately balanced in such cases.
    The IRS and Treasury Department further recognize that these issues 
could be addressed by adopting a tracing-based approach to the 
allocation of investment adjustments. However, the complexity and 
burden of a tracing-based approach would render such an approach 
generally inadministrable for consolidated taxpayers and for the 
government. As a result, the system would be prone to error and, in 
practice, inconsistently applied. Moreover, the IRS and Treasury 
Department continue to believe that the assumptions on which the 
investment adjustment system is based are appropriate for typical 
commercial transactions, as the IRS and Treasury Department understand 
that typically subsidiaries have only common stock outstanding, that 
their stock is wholly owned by group members, and that members' bases 
in shares of subsidiary stock are uniform, as under the facts of 
Example 1. See section E.2 of the preamble of CO-30-92 (1992-2 CB 627), 
57 FR 53634, 53639 (November 12, 1992).
    Because a tracing-based approach to the allocation of investment 
adjustments would not be administrable, the IRS and Treasury Department 
are not considering revising the investment adjustment system to adopt 
such an approach. Instead, the IRS and Treasury Department have 
considered various presumptive approaches that could be adopted to 
mitigate the creation of noneconomic and duplicated loss when members 
hold subsidiary stock with disparate bases. The approaches considered 
and decisions reached are discussed in section E of this preamble.
4. Redetermination Events: Changes in the Extent That Unrecognized Gain 
or Loss Is Effectively Reflected in the Basis of Individual Shares
    Because the investment adjustment system adjusts the basis of each 
share in accordance with its proportionate interest in S's assets and 
operations, the relationship between a share's basis and its allocable 
portion of unrecognized appreciation or depreciation determines the 
extent to which such amounts are effectively reflected in the basis of 
the share. This relationship, however, is not fixed at the time that 
stock is acquired. The reason is that there are many transactions, 
referred to here as redetermination events, that alter either the basis 
of a share or the interest it represents. These events generally occur 
in one of three types of situations.
    a. Stock basis is reallocated.
    The relationship between the basis of a share and the interest 
represented by the share can be altered whenever stock basis is 
reallocated among shares, including when it is allocated to shares of 
stock of other members.

    Example 6. Intragroup spin-off. P forms S by contributing $100 
to S in exchange for all the stock of S. S purchases two assets, A1 
and A2, for $50 each. Subsequently, A1 appreciates to $75 and A2 
depreciates to $25. In a transaction qualifying under sections 355 
and 368(a)(1)(D), S transfers A2 to C in exchange for all of the C 
stock and S then distributes all the C stock to P. Under section 358 
and Sec.  1.358-2, P's basis in the S stock is allocated among the S 
and C stock in proportion to the value of the stock of S and C. As a 
result, P's basis in its S stock is $75 (\75/100\ x $100) and P's 
basis in its C stock is $25 (\25/100\ x $100). S sells A1 for $75, 
recognizing a $25 gain that is taken into account on the P group 
return. P's basis in its S stock increases by $25, from $75 to $100. 
P then sells its S stock for $75 and recognizes a $25 loss.

    In this Example 6, after the reallocation of stock basis, P's basis 
in its S stock reflects the unrecognized appreciation on A1, just as 
P's basis in its S stock reflected unrecognized appreciation on A1 in 
Example 2. As a result, P's reallocated S stock basis protects the 
appreciation on A1 from being recognized as both asset gain and stock 
gain. Increasing P's basis in its S stock to reflect the recognition of 
S's gain on A1 is not only unnecessary, it inflates stock basis and 
thereby gives rise to either noneconomic loss or noneconomic reduction 
of gain when the stock is sold.
    Basis reallocations, and the consequences described, can occur for 
a number of reasons, including, for example, under rules like Sec.  
1.1502-32(c)(4) (cumulative redetermination of investment adjustments) 
and Sec.  1.1502-35(b) (basis redetermination to reduce disparity) and 
the corresponding provision in these proposed regulations.
    b. Capital transactions expand or contract the subsidiary's pool of 
assets.
    The relationship between the basis of a share and the nature of the 
interest represented by the share can also be altered by capital 
transactions that have no effect on the basis or value of outstanding 
shares, but that nevertheless alter the interest represented by those 
shares. Some common examples arise in the context of section 351 
exchanges, even though, as illustrated in Example 7(a), a section 351 
exchange in its simplest form cannot give rise to stock basis that 
reflects unrecognized appreciation.


[[Page 2969]]


    Example 7(a). Contribution of appreciated asset in section 351 
exchange. P forms S by contributing an asset, A1, to S in exchange 
for all 80 outstanding shares of S stock. The basis of A1 is $40 and 
its value is $80. S sells A1 and recognizes a $40 gain that is taken 
into account by the P group. As a result, P's aggregate basis in its 
S shares is increased by $40, from $40 to $80. Subsequently, P sells 
its S stock for $80, the stock's fair market value and recognizes $0 
on the sale. The group is thus taxed once on its $40 economic gain.

    In Example 7(a), P holds appreciated S stock and S holds an 
appreciated asset, but that appreciation is not reflected in either P's 
basis in its S stock or S's basis in its asset. Each share has a basis 
of $.50 and an interest in 1/80 of S's asset, A1, which has $40 of 
unrecognized appreciation (allocable $.50 to each share). If this 
relationship between P's basis in its S shares and the interest 
represented by the shares remains constant, as in Example 7(a), the 
investment adjustment system produces appropriate results. But if there 
is a change in that relationship, the underlying assumptions of the 
investment adjustment system may no longer correspond to the facts of 
the situation and, as a result, the general operation of the system 
could produce inappropriate results. Such changes can occur whenever S 
acquires property in exchange for additional shares of its stock.

    Example 7(b). Contribution of appreciated asset in subsequent 
section 351 exchange creates disconformity in original shares. The 
facts are the same as in Example 7(a), except that, before A1 is 
sold, P contributes a second asset, A2, to S in exchange for an 
additional 20 shares of S stock. A2 has a basis of $0 and a value of 
$20. S sells both assets and recognizes a $60 gain that is taken 
into account by the P group. As a result, P's basis in its original 
shares increases by $48 ($.60 per share), from $40 to $88 (or, from 
$.50 to $1.10 per share), and P's basis in its new shares increases 
by $12, from $0 to $12 (or, from $0 to $.60 per share). P then sells 
20 of its original shares (basis of $22) for $20, their fair market 
value, and recognizes a $2 loss.

    In Example 7(b), P's basis in the original S stock reflected no 
unrecognized appreciation when the stock was issued. After the second 
contribution, however, P's basis in those shares reflects a portion of 
the unrecognized appreciation on A2. The reason is that each share 
represents an interest in S's entire pool of assets. When the pool 
changes, the nature of the interest represented by the shares changes, 
even though the share's basis and value remain constant. Thus, in 
Example 7(b), while each original share's basis ($.50) and value ($1) 
remain constant, the interest represented by each share changed from 1/
80 of an asset with unrecognized appreciation of $40 (or, $.50 per 
share), to 1/100 of assets with unrecognized appreciation of $60 (or, 
$.60 per share). This shift causes the basis of each original share to 
reflect $.10 of unrecognized appreciation. When the gain is recognized, 
$.10 of the gain allocated to each original share under the investment 
adjustment system is a noneconomic increase in the share's basis. That 
increase will give rise to noneconomic stock loss or gain reduction. 
Although this (noneconomic) allocation of the (economic) item results 
in an offsetting stock gain on the basis of the new shares, that gain 
can be indefinitely deferred and even eliminated.
    The principles that increase the reflection of unrecognized 
appreciation in the original shares in Example 7(b) can also cause the 
reflection of unrecognized appreciation in the basis of shares that are 
received in exchange for property that is not appreciated, including 
cash. Although such shares would have a substituted basis (which 
generally precludes the reflection of unrecognized appreciation, as 
illustrated in Example 7(a)), the reflection of unrecognized 
appreciation is prevented only if the shares represent, wholly and 
solely, the transferee's interest in its transferred property. If there 
are previously issued shares outstanding, or if other shares are issued 
in the exchange, the shares represent an interest in a pool of assets 
that includes more than the transferred assets. As a result, the 
interest represented by each such share may be significantly different 
from what it would be if the subsidiary held only the transferred 
property.

    Example 7(c). Multiple transferors in single section 351 
exchange. The facts are the same as in Example 7(a), except that, 
when P contributes A1 to S in exchange for 80 shares of S stock, M 
(another member in the group) also contributes $20 cash to S in 
exchange for 20 shares of S stock. S sells A1 for $80 and recognizes 
a $40 gain that is taken into account by the group. Accordingly, P's 
aggregate basis in its shares increases by $32 (\80/100\ x $40), 
from $40 to $72, and M's aggregate basis in its shares increases by 
$8 (\20/100\ x $40), from $20 to $28. M then sells its shares for 
$20, their fair market value, and recognizes an $8 noneconomic loss.

    Similar changes in the extent to which unrecognized amounts are 
reflected in basis can occur whenever the subsidiary's pool of assets 
is increased or decreased by a capital transaction. The reason is that 
the interest represented by each share, and thus the relationship 
between a share's basis and the interest represented by the share, 
changes whenever the subsidiary's pool of assets changes. Such 
transactions include acquisitive reorganizations (if new shares are 
issued) and redemptions.
    c. Assets are acquired with a basis that reflects unrecognized 
appreciation.
    The relationship between the basis of a share and the nature of the 
interest represented by the share can also be altered by transactions 
in which S acquires assets with a basis that reflects unrecognized 
appreciation, such as stock of a new member. The reason is that, after 
the lower-tier acquisition, the S shares have an interest in 
unrecognized appreciation and the investment adjustment system will 
increase the basis of the S shares when those lower-tier items are 
recognized.

    Example 8. Acquisition of lower-tier subsidiary with appreciated 
assets. P forms S by contributing $100 to S in exchange for all the 
stock of S. S then purchases all the stock of T for $100 when T 
holds one asset, A1, with a basis of $0 and a value of $100. T sells 
A1, recognizing a $100 gain that is taken into account on the P 
group return. As a result, both S's basis in its T stock and P's 
basis in its S stock are increased by $100, from $100 to $200. P 
then sells its S stock, recognizing a $100 loss.

    The result is the same noneconomic loss illustrated in Example 2.
    d. Other redetermination events.
    The IRS and Treasury Department expect that other transactions and 
events can alter the extent to which unrecognized asset appreciation is 
reflected in stock basis. Accordingly, the preceding discussion is not 
intended to present an exhaustive list of possible redetermination 
events.
    e. Conclusions regarding redetermination events.
    The IRS and Treasury Department recognize that redetermination 
events occur as the result of bona fide business transactions engaged 
in frequently and routinely throughout the time a share is held by any 
member of the group, and that these transactions are typically not tax-
structured transactions. Still, these events generate a significant 
potential for noneconomic stock loss or gain reduction that facilitates 
the circumvention of GU repeal. Accordingly, the IRS and Treasury 
Department believe that all such events, whether described in this 
preamble or not, must be taken into account in any model that is 
adopted to address the circumvention of GU repeal.
    Nevertheless, the IRS and Treasury Department recognize, and are 
concerned that, the factual analysis necessary to identify all 
redetermination events for all members' shares would be an extensive, 
complex, difficult, and,

[[Page 2970]]

therefore, expensive undertaking and, as such, would impose a 
substantial burden on both taxpayers and the government. Moreover, the 
nature of the undertaking would make it prone to error and, as a 
result, the rule would be unevenly administered and similarly situated 
taxpayers would not be similarly treated.
    The IRS and Treasury Department recognize that redetermination 
events can also create or increase the extent to which the basis of an 
individual share duplicates an inside loss. However, because duplicated 
loss is measured at the time that a stock loss is either recognized or 
preserved for later use, loss duplication rules by their operation 
account for redetermination events. Accordingly, regulations addressing 
loss duplication do not generally require specific provisions to 
address redetermination events.

C. Methods Considered To Implement GU Repeal

    The IRS and Treasury Department considered a number of approaches 
to address the circumvention of GU repeal independently from the issue 
of loss duplication. The approaches fall into two broad categories: 
tracing-based and presumptive approaches.
1. Tracing-Based Methods
    Under a tracing-based method, the extent to which a member can 
enjoy the benefit of subsidiary stock basis attributable to the 
recognition of an item of income or gain is determined by the extent to 
which the recognized item is reflected in the basis of the share and 
thus already protected from duplicative recognition on a later 
disposition of the stock. The IRS and Treasury Department continue to 
believe that tracing is a theoretically correct method for implementing 
GU repeal in the consolidated return setting and so considered various 
tracing-based proposals.
    a. Pure tracing.
    In general, a tracing approach would look solely to the connection 
between a subsidiary's recognized items and any appreciation reflected 
in stock basis in order to determine the extent to which the group will 
be allowed the benefit of stock basis attributable to those items. 
However, such an approach would require taxpayers to create and 
maintain (and the IRS to examine) records to establish:
     The identity of every ``tainted asset,'' that is, every 
asset held by the subsidiary and any lower-tier subsidiaries on every 
``measuring date,'' which includes the date on which the member (or its 
predecessor) purchased the share and all subsequent dates on which the 
subsidiary has a redetermination event;
     The ``tainted appreciation,'' that is, the appreciation on 
each tainted asset held by the subsidiary and any lower-tier 
subsidiaries on each measuring date; and
     The extent to which tainted appreciation is recognized, 
whether as income or gain, and included in an adjustment to the basis 
of the share.
    In addition, to fully benefit from a tracing regime, taxpayers 
would need to create and maintain similar records for tainted assets 
with unrecognized depreciation on a measuring date, because the 
recognition of that depreciation would be allowed to reduce the amount 
of recognized appreciation treated as tainted.
    These records would have to be created and maintained for each 
share of stock of each subsidiary and each share of lower-tier 
subsidiary stock held by a subsidiary on each measuring date. In 
addition, these records would need to be created and maintained not 
just for subsidiaries, but for all corporations the stock of which is 
acquired by a member, because the information would be necessary if the 
corporation becomes a member at some later date.
    In administering the various temporary and final regulations 
promulgated as loss limitation rules under Sec.  1.337(d)-1 and Sec.  
1.337(d)-2, the IRS has found that taxpayers encounter substantial 
difficulty in attempting to satisfy these requirements.
    To begin, taxpayers are generally unable to accurately identify all 
of a subsidiary's tainted assets. One reason is simply the vast number 
of assets implicated. Another reason is that many assets are accounted 
for in mass accounts and thus cannot be separately identified. Problems 
are exacerbated if appropriate records are not created 
contemporaneously; taxpayers have found this a particular concern when 
subsidiaries have been acquired with inadequate records.
    Furthermore, the commonplace nature of many redetermination events 
makes it difficult to identify all such dates. For example, many 
taxpayers routinely issue stock when a member contributes cash or 
property to a subsidiary, even if the issuance of stock would not be 
required for section 351 to apply, and each such occurrence is a 
redetermination event.
    Valuation also imposes significant financial and administrative 
burdens on both taxpayers and the government. These problems are 
exacerbated because the corporation's assets are not themselves the 
subject of an arms-length transaction and, in most cases, the date on 
which the assets are actually valued is long after the stock 
transaction.
    The most problematic aspect of tracing, however, has typically been 
establishing the connection, or lack thereof, between items taken into 
account by the group and particular amounts of tainted appreciation. If 
much time has elapsed between a measuring date and the disposition of a 
tainted asset, or if an asset is held in a mass account, this can be 
difficult or even impossible. If tainted appreciation is recognized as 
income earned through the wasting or consumption of the appreciation, 
instead of as gain on the disposition of the asset, there are 
additional difficulties. In those cases, tracing is possible only if 
the tainted appreciation generates an identifiable stream of income. 
However, this is frequently not the case. For example, intangible 
assets, like patents or goodwill, are the source of significant tainted 
appreciation and they typically do not generate identifiable income 
streams.
    i. Conclusions regarding tracing.
    For all the reasons set forth in this preamble, the IRS and 
Treasury Department have again, as in 1990, concluded that tracing is 
not a viable method for preventing the circumvention of GU repeal in 
consolidation. This conclusion, while arguably based on theoretical 
concerns in 1990, is now based on several years of administering Sec.  
1.337(d)-2 (in both its temporary and final form) as a tracing regime. 
The IRS found that the difficulties encountered, by taxpayers and the 
government alike, in administering Sec.  1.337(d)-2 as a tracing-based 
rule were overwhelmingly greater than those encountered in 
administering it as a presumption-based rule under the basis 
disconformity method permitted under Notice 2004-58. Accordingly, the 
IRS and Treasury Department are not proposing to adopt a tracing-based 
approach.
    ii. Tracing in other contexts.
    The IRS and Treasury Department recognize that tracing-based 
regimes are used to implement other provisions in the Code. For 
example, section 382(h), which prescribes the tax treatment of built-in 
items recognized by a corporation that has had an ownership change, and 
section 1374, which prescribes the tax treatment of built-in items 
recognized by an S corporation that was formerly a C corporation, both 
use tracing-based regimes. Further, the IRS and Treasury Department are 
proposing regulations implementing section 362(e)(2) in a consolidated 
return context that require certain items

[[Page 2971]]

to be traced. See section H of this preamble.
    The tracing regimes appropriate for those sections, however, do not 
present compliance and administrative concerns of the scope and 
magnitude presented by a tracing regime appropriate for GU repeal in 
the consolidated setting for at least three reasons.
    To begin, both sections 382(h) and 1374 apply only for a limited 
period of time--five years in the case of section 382(h) and ten years 
in the case of section 1374--and so whatever burden is imposed is more 
limited in nature.
    More importantly, sections 382(h) and 1374 are generally concerned 
only with the unrecognized appreciation and depreciation in a pool of 
assets held by a corporation on a single date--the date the C 
corporation converts to an S corporation or the date the S corporation 
acquires assets of a C corporation in the case of section 1374, and the 
date a corporation has an ownership change in the case of section 
382(h). Similarly, section 362(e)(2) is only concerned net unrecognized 
depreciation in a pool of assets on the date of the transaction to 
which section 362(e)(2) applies. But the ability to circumvent GU 
repeal using the consolidated return provisions can be created any time 
the subsidiary has a redetermination event. Thus, any rule implementing 
GU repeal in the consolidated context, unlike rules implementing 
sections 362(e)(2), 382(h), and 1374, must trace the pool of assets 
held on all measuring dates, and not just the pool of assets held when 
subsidiary stock is acquired (or when assets are transferred).
    Finally, unlike regulations implementing GU repeal, regulations 
implementing those other sections do not need to take into account the 
changing relationship between the basis in a particular share of stock 
and the unrecognized appreciation and depreciation in the corporation's 
assets.
    For these reasons, any tracing-based regime appropriately 
implementing GU repeal in the consolidated setting would be much more 
expansive and complex, and therefore much less administrable, than the 
tracing regimes appropriately implementing sections 382(h) or 1374 (or 
proposed to implement section 362(e)(2)).
    b. Modified tracing.
    The IRS and Treasury Department considered several approaches that 
could be adopted to modify a tracing model by limiting the extent to 
which tracing would be required, in order to mitigate the 
administrative burdens of a pure tracing model.
    i. Exclusion for items attributable to after-acquired assets.
    Several commentators have suggested an approach, generally called 
the ``after-acquired asset exception,'' which allows taxpayers to 
identify assets acquired after the acquisition of subsidiary stock, in 
order to treat any gain realized on those assets as economic to the 
group. In general, all other items of gain and income would be deemed 
to be noneconomic, that is, attributable to the recognition of 
appreciation that was already reflected in basis. Stock loss would be 
allowed only to the extent that stock basis was attributable to the 
amounts deemed economic to the group. In response to concerns raised by 
the IRS and Treasury Department about redetermination events, the 
proposal was modified to provide that only assets acquired after the 
latest measuring date would be treated as giving rise to economic 
amounts. The principal advantage of this approach is that it identifies 
some untainted items with no need for valuation.
    To begin, the IRS and Treasury Department are concerned with the 
burden and error potential presented by the need to identify all 
redetermination events. Moreover, because these events can occur with 
considerable frequency in the ordinary course of business, it is 
unlikely that a great deal of time will typically elapse between the 
last redetermination date and the date of a stock disposition. Thus, 
the amount of gain recognized on an asset acquired and sold during such 
periods of time will not likely be significant. As a result, it appears 
unlikely that this approach would afford much relief to taxpayers (in 
terms of administrative burden or reducing the disallowance amount) or 
to the government (in terms of administrative burden).
    Furthermore, in order to implement GU repeal appropriately, such an 
approach must take into account not only gains, but also losses, 
recognized on after-acquired assets. But the identification of such 
losses imposes an additional administrative burden that taxpayers have 
no incentive to facilitate. In any event, a requirement to take losses 
into account could be easily manipulated by the timing and structuring 
of redetermination events.
    ii. Exclusion for items recognized after prescribed period of time.
    Several commentators also suggested a tracing-based approach that 
would apply to investment adjustments taken into account only during a 
prescribed period of time following the acquisition of a share. The 
chief advantage to this approach is that, regardless how burdensome the 
administration of the rule, it would not extend indefinitely.
    Like the proposed after-acquired-asset approach, however, this 
approach would need to take redetermination events into account. The 
tracing period would then begin again on the date of each 
redetermination event. Thus, like the after-acquired-asset exception, 
this approach is unlikely to afford much relief to taxpayers (in terms 
of administrative or tax burden) or the government (in terms of 
administrative burden) because the period for tracing may never close.
    Moreover, the IRS and Treasury Department are concerned that such 
an approach does not adequately respond to GU repeal. The reason is 
that noneconomic investment adjustments circumvent GU repeal whenever 
they are taken into account. Thus, the IRS and Treasury Department 
continue to believe that, in the absence of any direction from 
Congress, such as in the case of section 1374, imposing time limits on 
the implementation of GU repeal would be inappropriate. See TD 8294.
    iii. Exclusion for basis conforming acquisitions.
    Commentators have also suggested adopting a tracing-based approach 
that excepted any stock acquired in either a section 351 exchange or a 
qualified stock purchase for which an election was made under section 
338. The rationale for this approach is that, by operation of statute, 
the basis of stock acquired in these transactions can reflect no 
unrecognized appreciation.
    The IRS and Treasury Department agree that, in certain 
circumstances, the structure of a stock acquisition will, by operation 
of law, preclude the reflection of unrecognized appreciation in stock 
basis. The IRS and Treasury Department are concerned, however, that 
many acquisitions under section 351 or section 338 actually do not 
preclude the reflection of unrecognized asset appreciation in stock 
basis. For example, if subsidiary stock is acquired in a section 351 
exchange in multiple transactions or by multiple transferors, as 
illustrated in Example 7(b) and Example 7(c), respectively, the basis 
of the shares received can reflect unrecognized appreciation. 
Similarly, because only 80 percent of the stock of a subsidiary need be 
acquired to elect section 338 treatment, the basis of up to 20 percent 
of a subsidiary's shares may reflect unrecognized appreciation. 
Moreover, even if the initial acquisition precludes the reflection of 
unrecognized gain, once there is a redetermination event, the form of 
the acquisition no longer prevents the reflection of

[[Page 2972]]

unrecognized appreciation in stock basis. Thus, very few, if any, such 
transactions would ultimately qualify for this exception.
    Thus, like the two previously described approaches to modified 
tracing, this approach has the inaccuracy and burden associated with 
identifying redetermination dates and a limited potential for relief to 
either taxpayers or the government.
    iv. Conclusions regarding modified tracing.
    Each approach considered would increase the administrative burden 
significantly without significantly increasing precision or relief. 
Accordingly, the IRS and Treasury Department are not proposing to adopt 
any of these approaches.
2. Hybrid Tracing-Presumptive Model: Asset Tracing.
    The IRS and Treasury Department also considered a hybrid tracing-
presumption approach that would identify all assets held when a share 
is acquired and on each redetermination date thereafter (again, the 
``tainted assets'') and then presume all items of income, gain, 
deduction, and loss traced to those assets to be tainted. The intent 
was to design an approach that would be more precise than either a 
modified tracing or purely presumptive approach, while being more 
administrable than a pure tracing-based approach. The chief advantages 
of this approach are that it may enhance precision and, like the after-
acquired asset exception described in section C.1.b.i of this preamble, 
may eliminate any need for valuation.
    However, like the modified tracing approaches described above, this 
approach would require the identification of all redetermination 
events. Furthermore, it would require the identification of all assets 
held at the time of each such event and the tracing of those assets to 
particular investment adjustments. Thus, it presents even more 
complexity, burden, and expense than the modified tracing regimes 
considered. Furthermore, the IRS and Treasury Department are concerned 
that this approach could be easily abused, either by the manipulation 
of redetermination dates or the use of intercompany transactions to 
make valuation elective. (That is, taxpayers could selectively engage 
in intercompany transactions so that, in effect, some assets would be 
valued and not others.)
    Finally, the IRS and Treasury Department are not convinced that the 
approach in fact significantly enhances the precision of a pure 
presumptive model in light of the fact that there is no actual 
valuation (and therefore no actual determination that there was any 
gain