Advantages and Disadvantages of Filing Consolidated Returns
Internal Revenue Service (IRS), agency of the U.S. Department of the Treasury, originally established in 1862, responsible for enforcing the internal revenue laws. The IRS is administered by the commissioner of internal revenue, who is appointed by the president with the consent of the Senate. Its main functions are to encourage voluntary compliance with the tax laws and regulations by providing information and assistance to taxpayers and to take action where necessary and appropriate to enforce the laws. Revenues are collected through individual income taxes; corporation taxes; excise, estate, and gift taxes; and social security taxes.
The IRS is divided into three organizational levels: the national office, the regional offices, and the district offices. The national office in Washington, D.C., is responsible for nationwide policies and programs and for the direction of the field organization. The office of the commissioner supervises the assessment and collection of all taxes imposed by law. The commissioner is assisted by a deputy commissioner; a chief counsel who provides legal services; and eight assistant commissioners, who each oversee a functional area, including taxpayer service and returns processing, compliance, and inspection.
Most IRS personnel are assigned to the field organization. There are seven regional offices, each headed by a commissioner, that supervise all field operations. The regions are divided into 62 districts, administered by directors. The district offices collect taxes, ascertain delinquent and additional tax liability, investigate violations of internal revenue laws, and aid the public in preparing tax returns. Ten service centers also process tax returns and maintain records of taxes collected.
In 1997 and 1998 the IRS became the subject of dramatic congressional hearings. Several taxpayers testified that the agency had persecuted them for years for taxes that they did not owe. Some former IRS agents told Congress of questionable management practices within the agency. Some agents claimed, for example, that IRS managers set quotas for the collection of back taxes, which led some agents to use very aggressive collection tactics in an effort to meet the quotas. In mid-1998 the House and the Senate each passed bills that would curtail many of the abuses and give taxpayers more rights in disputes with the IRS. The two chambers then tried to work out differences between the two bills so they could approve a final bill and send it on to the White House.
Consolidated Tax Return
Although most corporations are required to file their own separate tax returns, certain related corporations (e.g., a parent corporation and its 80% owned subsidiary) are entitled to file a consolidated tax return. The consolidated tax return is essentially a method by which to determine the tax liability of a group of affiliated corporations. The tax computation is based on the view that the businesses of the related corporations represent but a single enterprise.
Accordingly, it is appropriate to tax the aggregate income of the group rather than the separate income of each corporation. This is not to say, however, that a consolidated return simply reports the sum of each member corporation's taxable income as if the group were one enlarged single corporation. The applicable Treasury Regulations1 modify the aggregate results by providing special rules requiring the statement of certain items on a consolidated basis (e.g., capital gains) and adjustments for intercompany transactions
What is Consolidated Tax Return?
A single tax return filed for all companies in an affiliated group, such as a parent and its subsidiaries.
The aspects of the consolidation rules that will have the biggest potential impact on financing transactions are the introduction of joint and several liability of each member of a consolidated group for tax purposes (a consolidated group), for any income tax liabilities that are not paid on time by the 'head company' of that group, and the appropriation by the head company of tax losses and franking credits generated by a borrowing vehicle. This article explains the impact of these changes and discusses some solutions to the risks identified.( James C. Warner, 2003)
The origin of the consolidated tax return can be found in the early Regulations concerning the tax imposed on excess profits during World War I. These Regulations authorized the Commissioner of the Internal Revenue Service to prescribe rules necessary to prevent corporations from avoiding the tax by eliminating their “excess profits” by arbitrarily shifting income to another corporation where it would not be considered excessive. As early as 1917, the
Commissioner used this power to require the filing of consolidated tax returns by affiliated corporations to limit the benefits of multiple corporations. By 1918, Congress had made the filing of consolidated returns mandatory for affiliated groups for purposes of not only the excess profits tax but also the income tax. In addition, the Commissioner’s authority to issue Regulations governing consolidated returns was codified. (W. Elliot Brownlee, 1996)
The end of the war produced several changes affecting consolidated returns. The war's end eliminated the need for the excess profits tax and consequently it was repealed. At the same time, the forerunner of § 482 was enacted. This provision permitted the IRS to apportion income, expenses, or credits between two or more organizations that are under common control in order to prevent tax avoidance and clearly reflect income. The repeal of the excess profits tax and the extension of the Commissioner's authority to reallocate income reduced the opportunity for distorting income and thus the need for mandatory consolidated returns for affiliated groups.
As a result, in 1921 Congress made the filing of a consolidated return optional.( Cch Tax Law, 2007)
For the next 14 years, consolidated returns remained optional, although an additional 1 percent tax was imposed on the privilege of filing a consolidated return in 1932. In 1934, influenced by the effects of the Great Depression and the ability of a loss corporation to offset the income of a profitable one, Congress abolished the use of the consolidated tax return. The consolidated tax return soon reappeared with the beginning of World War II as Congress extended corporations the privilege of filing a consolidated return in 1942. This time, however, the cost for filing a consolidated return was increased. Congress imposed a 2 percent penalty on consolidated taxable income–a penalty that was to remain until its repeal in 1964. Since 1942, the filing of a consolidated return has been elective.
Although certain benefits could be gained through filing consolidated returns, for many years affiliated groups often opted to file separate returns to obtain the benefits accorded multiple corporations.
P, S, and T are an affiliated group of corporations. Each corporation had taxable income of $50,000 for the year. The group's major competitor, Z, a separate corporation, had taxable income of $150,000.
If P, S, and T file their own separate returns reporting $50,000 of taxable income on each return, their combined tax liability will be $22,500 ($7,500 x 3). In contrast, Z’s tax liability for its $150,000 of taxable income is $41,750, which is $19,250 greater than the combined liability of P, S, and T. Note that the taxes saved are attributable to the fact that the group's taxable incomes are never taxed at the higher rate (i.e., 34%) or subject to the additional 5% surtax.
In 1969 the benefits of multiple corporations illustrated above were severely curtailed. Under the Tax Reform Act of 1969,3 affiliated corporations were effectively treated as a single corporation (e.g., in the example above, P, S, and T would be treated like Z) not withstanding the fact that each corporation filed a separate return. With the elimination of these benefits, there has been increasing interest in the filing of consolidated returns.
THE CONSOLIDATED RETURN REGULATIONS
As previously mentioned, Congress granted the Commissioner (IRS) the authority to promulgate regulations for filing a consolidated tax return. Specifically, Code § 1502 states:
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. It takes little imagination to see that Congress has granted the IRS broad authority to write regulations governing the filing of a consolidated tax return. These Regulations, referred to as legislative regulations, grant a nearly absolute power to the Secretary of the Treasury to prescribe the rules for consolidated tax returns. Although not statutory in form, these regulations have the force and effect of law and remain effective unless overturned by the courts or restricted by Congress.
As early as 19286 and then again in 1954, Congress contemplated codifying the consolidated return regulations. In 1954 the House Ways and Means Committee wanted the regulations written into the statutes on the grounds that the Regulations had become generally accepted and should be formalized. The Senate Finance Committee, however, rejected this notion. The Senate felt that the detailed consolidated return rules should remain in regulation format. By leaving the Regulations in that form, any rule or tax law change could be readily addressed by the IRS without requiring further action by Congress.
In 1966 the IRS completely overhauled the existing system governing consolidated returns by replacing the old Regulations with a lengthy and intricate set of new Regulations. These "new" Regulations rejected the accounting principles that had served as the basis of the old Regulations and adopted a different approach. The new Regulations remain in effect today and provide the rules for consolidated tax returns, having gone relatively unchanged since their adoption. In fact, the majority of the changes made to the Regulations since 1965 primarily reflect changes passed by Congress that were applicable to all corporations, not just affiliated groups.
In 2006, the U.S. income tax system celebrated its 93rd birthday, and for nearly all its four score years (beginning in 1917), the concept of consolidated returns has been part of it. Like the tax system as a whole, however, consolidated return principles have not become simpler and more understandable over time. Indeed, complexity has been piled upon complexity, change upon change, and the regulations emanating from the fairly simple mandate of section 1502 of the Internal Revenue Code--"The Secretary shall prescribe such regulations as he may deem necessary..." without question dwarf most other regulations in scope and intricacy. (Perhaps only section 482 has generated greater pages-of-regulations to words-of-statute ratio.) The web of consolidated return provisions can, pardon the pun, tax the most seasoned tax professional, and can leave the novice with his or her head aching.
The current consolidated return regulations can trace their origin to 1966, but the rules that have been amended, revised, and clarified so many times since their original promulgation that many would argue that not much remains of 1966 regulations.
Advantages of Filing Consolidated Return
One of the major advantages of consolidated taxation is the opportunity to offset positive taxable income against negative taxable bases of group companies. The group is entitled to include only the tax losses of the year for which it exercised the consolidated taxation option in the consolidation. Any tax losses accrued in years prior to the group taxation may be used only by the companies that suffered such losses.
If tax losses of controlled companies are included in the consolidated taxable basis, the parent company will benefit from a tax saving and could recognize a consideration to the controlled company for the saving. In this case, the law expressly states that any amounts received and paid among consolidated companies as consideration for the tax benefits received or granted are not included in the calculation of the taxable income.
An additional advantage of consolidated taxation is the exclusion of dividends distributed by consolidated companies from the consolidated taxable base. Accordingly, the parent company will reduce the taxable base by an amount corresponding to the taxable portion of the distributed dividends, even if they originate from profits taxed in years prior to the beginning of the option. Advantages to filing consolidated returns include:
(1) offsetting operating losses of one company against the profits of another;
(2) offsetting capital losses of one company against the capital gains of another;
(3) the avoidance of tax on intercompany dividends;
(4) the deferral of income on intercompany transactions;
(5) use by the consolidated group of the excess of one member's foreign tax credit over its limitation on that credit;
(6) use by the group of the excess of one member's soil and water conservation expense over 25% of its gross income from farming; and
(7) The designation of the parent company as agent of the group for all tax purposes.
The advantage of filing a consolidated return where one or more of the affiliates has an operating loss for the tax year is obvious. On a consolidated return, the loss may be offset against the profits of the successful affiliates. Furthermore, because intercompany dividends are eliminated, this has the effect of increasing the amount of the net operating loss over the amount shown on separate returns. However, there are limitations on net operating loss carryovers and carry backs from separate return limitation years
Advantages of Filing Consolidated Return
Filing a consolidated return also has certain disadvantages. Losses on intercompany transactions must be deferred. Accounting for consolidated taxable income and deferral of intercompany transactions can be perplexing. Another problem is that the consolidated returns filed for tax purposes and the consolidated financial statements may not include the same corporations. For example, most foreign corporations cannot be consolidated for Federal income tax purposes but should be consolidated when preparing financial statements. This variance will cause some compliance problems in computing the taxable income and the AMT of the group. Some of the more important disadvantages of filing a consolidated return include the following:
1. Electing to file consolidated returns requires compliance with the consolidated return Regulations. This could create additional costs and administrative burdens.
2. The consolidated return election is binding for future years. This election can only be terminated by disbanding the affiliated group or by obtaining permission from the IRS to file separate returns.
3. In the initial consolidated return year, a double counting of inventory profit can occur if any of the group members had intercompany transactions in an affiliated separate return year.
4. Separate return credits and capital losses can be limited by operating losses and capital losses from other members of the group. Thus, the credit and loss carryovers may expire unused due to heavy losses by an affiliated member.
5. A subsidiary member is required to change its tax year to the same year as that of the common parent corporation. This can create a short tax year that is considered a complete tax year for purposes of carry backs or carryovers in the case of unused losses and credits.
6. Losses of a subsidiary that reduce the tax liability of the group also decrease the parent's tax basis in the subsidiary. This serves to increase a gain or decrease a loss by the parent corporation on the sale of its subsidiary.
7. Under controversial loss disallowance rules, losses on the sale of a subsidiary's stock are not allowed to be recognized for tax purposes.
8. The rights of minority shareholders must be respected both legally and ethically. As a result, the presence of minority shareholders may create situations that may have adverse effects for the affiliated group.
Finally consolidated taxation neutralizes provisions that make the part of financial charges relating to the loan obtained to finance the acquisition of shareholdings not deductible. It also allows for the adoption of a neutral tax regime for inter-company transactions involving assets other than the ones that generate revenue, including transfers and contributions of lines of business.