By: Shu-Yi Oei
Over the past few days, we here at Surly Subgroup have received several requests for a post explaining our blog name. So, here’s a Very General primer for non-tax readers, and for our tax readers who maybe don’t spend all of their waking hours staring at the consolidated return rules.
Old lawyerly disclaimer habits die hard, so I’ll just say that the following discussion is Very General and mostly for fun. Others have written about this far more exhaustively. See, e.g., Martin J. McMahon, Jr., Understanding Consolidated Returns, 12 Fla. Tax Rev. 125 (2012) and four whole BNA Tax Management Portfolios.
Here are the key points:
Everybody Wants to Belong…
The general idea behind the consolidated return is that where there’s an affiliated group of corporations, a rule that requires each corporation in the group to file its own separate tax return may create frictions and transaction costs and may give rise to weird incentives and disincentives in the case of transactions between corporations in the group.
Enter the consolidated income tax return.
The tax code and accompanying regulations allow an affiliated group of corporations to choose to file a consolidated—or grouped—tax return, rather than separate returns. See Code Section 1501 and 1502. There are, of course, complicated rules that govern when a group of corporations is considered affiliated—the group has to be connected through stock ownership with a qualified (“includible”) common parent, and certain stock ownership thresholds have to be met up and down the corporate chain. These rules are contained in Section 1504(a). Foreign subsidiaries are generally excluded from consolidated return filings. But see Code Section 1504(d).
Almost all publicly traded U.S. corporations file consolidated tax returns. According to the IRS Statistics of Income (SOI) Division Bulletin, there were around 35,000 consolidated return filings for the 2012 year. See SOI Bulletin Historical Table 13.
The consolidated return provisions provide detailed rules that deal with transactions between group members, generally treating such intra-group transactions as occurring between divisions of a single corporation. They also provide for a system of basis adjustments that prevents double counting of an affiliated group subsidiary’s income and deductions, which we nerdy tax people will sometimes refer to as the “investment adjustment system.”
But probably the most important feature of the consolidated return system is the extent to which it allows tax losses of one consolidated group member to be netted against income of a more profitable group member.
… You Can’t Take it with You (or at Least Not All of It).
Ah, losses. Our tax system generally allows business and investment losses to be deducted against income and gains. But unsurprisingly, the Treasury can be pretty…surly(!) when it comes to taxpayer attempts to use excessive losses to offset taxable income. The question of what constitutes a deductible loss is complicated enough in the context of a single taxpayer. Where there are several affiliated corporations filing a consolidated return, it’s even more hairy. The obvious question in the consolidated group context is the extent to which the net operating losses (NOLs) of one corporation in the group may be applied to offset the income of another group member. The question is perhaps most troubling where the losses derive from a time period before the loss corporation became affiliated with the consolidated group. For example, one might anticipate a prickly Treasury response in cases where a loss corporation is acquired for the specific purpose of using its losses to offset group profits, a.k.a. trafficking in losses.
Here, the “Separate Return Limitation Year,” or SRLY, limitation comes into play. The SRLY rules generally limit the manner in which pre-affiliation (i.e., separate return limitation year) losses of a loss corporation can be used in computing post-affiliation consolidated taxable income of the group. The SRLY rules reflect a tension in the consolidated return rules—while the general thrust of the rules is to treat all members of the group as a single entity, the rules maintain corporate separateness in the case of pre-affiliation losses. There are, of course, a number of important exceptions to the application of the SRLY rules, which I won’t go into.
…Do Old Friends Suffer Alone? Or Together?
While previously the SRLY limitation was applied separately for each new SRLY corporation upon joining the affiliated group, temporary regulations adopted in 1996 (and finalized in 1999) made a number of changes. These included abandoning the previous entity-by-entity application of the SRLY limitations and instead allowing the SRLY rules to be applied on a “subgroup” basis in the case of certain group members who were previously affiliated with each other while in another group but who have since joined the current group.
What’s the Big Deal Anyway?
A single persistent question lies at the heart of these complex rules: How consolidated is the consolidated group? The general rule allows consolidated return filing, effectively treating separate legal entities as a combined single taxpayer. But the tax law beats an uneasy retreat in potentially abusive situations, where a loss corporation is entering a new group after having been alone for awhile, or after having been part of another group. The SRLY rules (which reassert the separate entity status of the newly affiliated corporation) are the tax law’s way of dealing with the games corporate persons play when deciding to join a group, or when transitioning from one group to another.
On the flip side, the decision to introduce the subgroup approach to SRLY can be broadly characterized as a counter-move back towards a combined entity approach to dealing with losses, in the sense that the subgroup rules involve remembering and retaining the subgroup’s prior consolidated connection to each other in computing subgroup losses.
These choices with respect to losses pose clear normative questions, not least the question of how generous the Code ought to be with the sharing of losses between affiliated corporations. They raise conceptual questions regarding the Tax Code’s commitment to corporate separateness as a first principle in the face of the constant siren song of aggregation. Regardless of the specific answers to these questions, we must also consider how the tax rules we choose and the lines we draw in the corporate consolidation context may affect the combinatory or acquisitive decisions of corporate groups made in light of those rules and lines.
In any event, that’s where our blog name comes from! We’d like to think of ourselves as a (S(u)RLY) subgroup of a much bigger enterprise, the tax professoriat. This blog aims to tap into synergies that come from blogging with friends on a consolidated basis.
Of course, consolidated return aficionados know that there’s a punch line to all of this: When the Treasury adopted its final regulations in 1999, it made important changes to the SRLY rules. Although it retained the SRLY Subgroup approach, it partially repealed the SRLY rules in situations where the transaction also constitutes a “Section 382 ownership change.” A Section 382 ownership change generally refers to certain significant corporate ownership shifts involving a 5% shareholder as well as to certain shifts in corporate equity structure. See Code Section 382(g). Very generally, after a Section 382 ownership change, the amount of a loss corporation’s NOLs that can be used to offset the taxable income of the consolidated group will be subject to the limitation amount specified in Section 382. The final Section 1502 regulations now provide that in cases where a transaction is both a Section 382(g) ownership change and a SRLY triggering event, the Section 382 rules will apply and the SRLY rules will not. Since many transactions that involve a SRLY limitation will also involve a Section 382(g) ownership change, this “SRLY overlap rule” means that the SRLY rules and the subgroup approach to them actually have limited application.
All of this may possibly mean that we should have named this blog the “382(g) Ownership Change Blog.” But that didn’t have quite the same ring to it. So here we are instead. The Surly Subgroup.