1.1502-13: Rules for Intercompany Transactions

Related corporations that function as a single enterprise can file a consolidated federal income tax return, combining the incomes and losses of all affiliated companies. Because these companies often transact with each other, special rules are needed for these internal dealings. These regulations, found in Treasury Regulation § 1.1502-13, prevent the artificial creation of gains or losses from transactions within the corporate group.

The rules are built on a single-entity principle, treating the consolidated group as if it were one company. This approach neutralizes the tax effects of internal transactions until a transaction occurs with an entity outside the group. By controlling the timing and character of income and losses, the regulations ensure the group’s tax liability accurately reflects its economic activity with the outside world.

Core Principles of Intercompany Transaction Treatment

An “intercompany transaction” is any transaction between corporations that are members of the same consolidated group immediately after it occurs. This includes a wide array of dealings, from the sale of property and performance of services to the licensing of technology and lending of money. To apply the rules, the member transferring property or services is the “selling member” (S), and the member receiving them is the “buying member” (B).

The regulations track two components for each transaction. The first is S’s gain or loss, known as its “intercompany item.” For example, if S sells an asset to B for a profit, that profit is S’s intercompany item. This can be income, gain, deduction, or loss, and it includes related costs and expenses. Even if S uses a cash-basis accounting method, it may have to recognize an intercompany item before receiving cash.

The second component is B’s “corresponding item.” This is B’s gain, loss, deduction, or income related to the property or service it acquired from S. A common corresponding item is the depreciation deduction B claims on an asset purchased from S. Another example is the gain or loss B recognizes when it eventually sells that same asset to a company outside the consolidated group.

Under the single-entity approach, S’s intercompany items are deferred and do not affect the group’s taxable income until certain later events occur. This deferral mechanism is central to preventing the group from manipulating its tax liability through internal transfers. The timing rules are a required method of accounting for each member, and they take precedence over a member’s usual accounting method if a conflict arises.

The Matching Rule Explained

The matching rule governs the timing and character of S’s intercompany items and B’s corresponding items. It synchronizes the recognition of items from both sides of the transaction to mimic the outcome that would occur if S and B were divisions of one corporation. S takes its intercompany item into account based on the difference between B’s actual corresponding item and a hypothetical “recomputed corresponding item.”

The recomputed corresponding item is what B’s gain or loss would have been if S and B were divisions of a single entity. S’s deferred gain or loss is triggered as B recognizes its own related tax items, such as through depreciation or a sale of the asset to an outside party. For example, a parent company, P, owns S and B. S sells land to B for $100,000. S’s basis was $70,000, creating a $30,000 intercompany gain for S, which is deferred. B now holds the land with a $100,000 basis.

Two years later, B sells the land to an unrelated party, X, for $110,000. B recognizes a $10,000 gain ($110,000 price – $100,000 basis), which is its corresponding item. To apply the matching rule, we determine the recomputed corresponding item. If S and B were one entity, the basis in the land would have been S’s original $70,000. The sale to X for $110,000 would have resulted in a total gain of $40,000 ($110,000 – $70,000). This $40,000 is the recomputed corresponding item.

S must recognize its intercompany item equal to the difference between the recomputed item ($40,000) and B’s actual item ($10,000). Therefore, S recognizes its $30,000 deferred gain. The group reports a total gain of $40,000 ($10,000 from B and $30,000 from S), matching the single-entity outcome.

The matching rule also handles attribute redetermination. The character of S’s and B’s items (e.g., ordinary income or capital gain) is determined as if they were divisions of a single corporation. If S held the land for investment (capital asset) but B held it as inventory for sale to customers (ordinary income asset), the group’s overall activity is considered. The entire $40,000 group gain would likely be ordinary income, meaning S’s $30,000 gain is redetermined to be ordinary income.

The Acceleration Rule Explained

When an event makes it impossible to treat S and B as divisions of a single corporation, the acceleration rule applies. This rule forces S to take its remaining intercompany items into account immediately, preventing them from being deferred indefinitely. This is triggered when the matching rule can no longer be applied.

The most common trigger is when either S or B ceases to be a member of the consolidated group, breaking the link required for the matching rule. For example, if a parent company sells the stock of S to an unrelated company, S must take its entire deferred gain into account on the group’s consolidated return immediately before it becomes a nonmember.

The same result occurs if the parent sells the stock of B instead of S. Once B leaves the group, the property it acquired from S is no longer owned by a member of the consolidated group. Because B’s future actions, such as selling the property, will no longer be reported on the group’s return, the connection for the matching rule is severed. S’s deferred gain is accelerated and must be recognized immediately before B becomes a nonmember.

Another trigger involves the property itself. Acceleration occurs if the property is transferred to a nonmember in a transaction where the nonmember’s basis does not preserve the deferred gain or loss. This can happen in certain nonrecognition transactions, such as a contribution of property to a partnership under Section 721 or to a corporation under Section 351.

When the acceleration rule is triggered, S’s item is taken into account immediately. The character of the item is determined as if B had sold the property to the party that now holds it. If B sold it to a related party outside the group, specific rules might treat S’s gain as ordinary income.

Application to Specific Transaction Types

Intercompany Obligations

The single-entity principle also extends to financial instruments, like loans, between group members. These “intercompany obligations” are subject to special rules. A “deemed satisfaction and reissuance” model applies when an intercompany obligation is transferred to a nonmember or when a party to the obligation leaves the group. This ensures the group’s income is not distorted by transactions involving internal debt.

When such an event occurs, the obligation is treated as if it were satisfied for its fair market value and then reissued as a new obligation to the new holder. This creates offsetting tax items for the debtor and creditor members that net to zero on the consolidated return. For instance, S lends $1,000 to B. Later, when the note’s value is $900, S sells it to an unrelated party, X, for $900.

The regulations treat B as having satisfied its $1,000 debt for $900. This creates $100 of cancellation of debt income for B and a $100 loss for S. The character of these items is redetermined to be ordinary, so they offset each other with no net effect on the group’s taxable income. B is then treated as issuing a new $900 note to X. This mechanism prevents the group from selectively recognizing losses on intercompany debt, though exceptions exist for events like a tax-free liquidation under Section 332.

Stock of Members

Transactions involving the stock of a member corporation are subject to specific rules. A member’s stock value reflects its underlying assets, creating the potential for gain or loss duplication within the group. The regulations prevent this by deferring gain or loss on intercompany stock sales and sometimes eliminating it entirely.

When one member (S) sells the stock of another member (T) to a third member (B), S’s gain or loss is deferred. This deferred item is taken into account when B later sells the T stock outside the group. Special rules apply if T is liquidated, such as in a tax-free transaction, which may trigger S’s deferred gain.

In some situations, intercompany gain on member stock can be permanently excluded from gross income. This relief applies when the stock basis reflecting the gain is eliminated without the group receiving a tax benefit from that basis. These rules work with the stock basis adjustment rules under § 1.1502-32, which adjust a parent’s basis in a subsidiary’s stock for its earnings. This coordination ensures the group’s investment in a subsidiary is accounted for only once.