Todd B. Reinstein
Most transactions between members of the same consolidated group
generally do not result in current recognition of federal income tax.
Treasury Regulations require that "intercompany" items of income, gain,
deduction, and loss that result from intercompany transactions between
members are zeroed out under a single-entity approach.1
This is accomplished by "matching" the transactions and treating them
as transactions that would occur as if they were divisions of a single
entity, so as to clearly reflect consolidated taxable income.2
Importantly, these Treasury Regulations contain an anti-abuse rule that
states that, "[i]f a transaction is engaged in or structured with a
principal purpose to avoid the purposes of this section (including, for
example, by avoiding treatment as an intercompany transaction),
adjustments must be made to carry out the purposes of this section."3
The anti-avoidance rule would seem to treat transactions that are not
intercompany transactions in form, but are intercompany transactions in
substance as intercompany transactions, when they result in an abusive
creation of a loss or changing the location of income that has the
effect of reducing federal income tax. On November 5, 2010, the IRS
released a Chief Counsel Advice Memorandum (CCA) holding that the
payment of a patronage dividend by a cooperative to member patrons, who
were all members of the same consolidated group, was an intercompany
transaction under Treas. Reg. Section 1.1502-13 by applying the
anti-abuse rule in the situation in which a partnership was interposed
between the members and the cooperative.4
Background on Taxation of Cooperatives
A cooperative is permitted to claim an income tax deduction for
dividend distributions to their patrons (owners) paid within eight and a
half months following the close of the tax year.5 The corresponding patronage dividends are included in the taxable income of the patrons in the year of receipt.6
The patronage dividends may effectively allow a one-year deferral on
the taxation of the income earned by a cooperative if timed properly. If
the cooperative and the patrons are members of the same consolidated
group, the payment of the patronage dividend is considered an
intercompany transaction, subject to the matching rule, whereby the
deduction of the payment of the patronage dividend would be treated as
occurring in the same year as the inclusion of the patronage dividend by
the consolidated members.7 This ensures that the timing of the items properly reflect income with no deferral of income between the group members.
In CCA 201044003, the taxpayer was the parent of a large affiliated
group, which has retail operations throughout the United States, filing a
consolidated federal income tax return. Procurement and merchandising
functions were historically performed by the taxpayer's general office. A
tax promoter approached the taxpayer about forming a cooperative that
would be owned by a newly formed partnership, which in turn would be
owned by the consolidated members. The newly formed partnership had no
operations and did not have any business relationship with the
cooperative. Presumably the partnership was interposed between the
consolidated group and the cooperative to prevent the cooperative from
being in the consolidated group and having the matching rules not apply
to the issuances of patronage dividends.8
As part of the plan, the taxpayer transferred employees to the
cooperative to perform the procurement and merchandising functions they
performed in the taxpayer's operating company before. The cooperative
performed these functions by taking delivery and title to the procured
merchandise. Consolidated group members paid a surcharge for all the
goods purchased by the cooperative. The promoter suggested that this
strategy would eliminate certain state income taxes and create a
deferral for federal income taxes for one year, because the standard
application of the matching rule would not apply since a partnership
The IRS concluded that by transferring the procurement and
merchandising functions to the cooperative and charging a surcharge for
the same services, the patrons artificially inflated their cost of goods
sold for that year and deferred income on the surcharge, which would
essentially be returned to them the following year as a patronage
dividend. Moreover, the taxpayer's interjection of a partnership between
the cooperative and the consolidated group member was abusive under
Section 1.1502-13(h), because it deliberately excluded the cooperative
from the consolidated group. Part of the IRS analysis on the application
of Treas. Reg. Section 1.1502-13(h) was based on the promoter's
assertions that the transaction was done for tax purposes with no
business purpose and the taxpayer did not get an opinion as to the
business efficiency or viability of forming the cooperative.10
The rationale for the conclusion in the CCA is somewhat surprising,
because the IRS essentially disregarded the ownership of the newly
created partnership to conclude that the consolidated group essentially
included the cooperative, and thus, the matching rule applied to
transactions between the cooperative and the group member. By
disregarding the taxpayer's interposition of the partnership within the
consolidated group, the IRS applied the anti-abuse rule beyond just
normal substance over form. This type of entity disregard could
discourage taxpayers from entity selection in other normal
Moreover, the CCA leaves open a number of unanswered questions. Would
the result in the CCA be the same if the cooperative were foreign,
since foreign entities cannot join in the filing of a consolidated
return thus nullifying the application of the matching rule's intent?
How heavily did the promoter's actions play in the determination? Would
the CCA come to a different result if the partnership was already an
active partnership with which the group members had a prior business
In light of the CCA, consolidated groups that possess or seek to
create wholly owned partnerships within a group that breaks
consolidation should consider revisiting the structures to ensure they
are not in violation of the anti-avoidance rules. They may want to
consider documenting the business purpose for having the structures in
place to make sure they do not have new federal income tax exposures,
especially in light of the recent codification of the economic substance
1 See generally Treas. Reg. Section 1.1502-13.
Unless otherwise stated, all references to "Sec." are to the Internal
Revenue Code of 1986 (the Code), and all references to "Reg. Sec." are
to the Treasury Regulations promulgated thereunder (the Regulations).
2 Treas. Reg. Section 1.1502-13(c).
3 Treas. Reg. Section 1.1502-13(h)(1).
4 See CCA 201044003 (November 5, 2010). Chief
counsel advice may not be cited as authority by a taxpayer, but it does
evidence an IRS position on the matter.
5 Section 1382(b).
6 Section 1385.
7 See CCA 200829028 (July 18, 2008).
8 For the cooperative to be included in the
consolidated group for purposes of the matching rule, the patrons
(consolidated group members) would need to directly own 80 percent of
the cooperative shares by vote and value under Section 1504(a)(2).
9 See Section 1504(a)(1) for definition of includible entities in a consolidated group.
10 Also see, CCA 200729035 (July 20, 2007)
(cooperative owned with the principal purpose to avoid purposes of
intercompany transactions regs). For background on CCA 200729035 see Pepper Hamilton LLP November 2007 Tax Update article, "New Proposed Regulations May Eliminate the Tax Benefits of Captive Insurance Companies."
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.
This article is republished with permission of Pepper Hamilton LLP. Further duplication without the permission of Pepper Hamilton LLP is prohibited. All rights reserved.
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