Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 76-88

1976-1 C.B. 52

Section 165
Section 267
Section 482
Section 1504

IRS Headnote

Losses; exchange between commonly owned subsidiaries. Losses sustained on the exchange of bonds at fair market value between a life insurance subsidiary that files a separate return and two casualty insurance subsidiaries that file a consolidated return with the parent, not a personal holding company, are allowable on both returns.

Full Text

Rev. Rul. 76-88

Advice has been requested whether, under the circumstances described below, the control inherent in the common ownership of two or more corporations in itself justifies the disallowance of deductions for losses arising out of the exchange of securities at fair market value.

S, a life insurance company as defined in section 801(a) of the Internal Revenue Code of 1954, is a wholly owned subsidiary of P and is subject to tax under section 802. P, a finance company, which is not a personal holding company or a foreign personal holding company as defined in sections 542 and 552, also owns all of the outstanding stock of S-1 and S-2, both of which are casualty insurance companies subject to Federal income tax under section 831, and which are not personal holding companies or foreign personal holding companies as defined in sections 542 and 552. P, S-1, and S-2 file consolidated returns. However, in the instant case, by reason of section 1504(b)(2), which defines an "includible corporation" for affiliated group purposes, S is precluded from joining in the filing of a consolidated return. Therefore, S files separate Federal income tax returns.

The life insurance business of S and the casualty insurance business of S-1 and S-2 are conducted separately by different operating personnel and each company is an active business corporation. However, the investment portfolios, as well as the accounting, legal, and other noninsurance functions of S, S-1, and S-2, are supervised and managed by the same personnel.

For many years the casualty companies sustained substantial operating losses so that they generally derived a lessor economic yield from tax-exempt bonds than from taxable bonds. In order to preserve the greatest economic yield, the casualty companies' portfolios during these years consisted primarily of taxable bonds. However, by 1974, the casualty companies were in a profit situation and wanted to acquire tax-exempt bonds for their portfolios. The taxable bonds that the casualty companies (S-1 and S-2) possessed and that they wanted to eliminate from their portfolios were the type of securities that S desired in order to increase the investment yield of its investment portfolio, while the tax-exempt bonds that S possessed and wanted to eliminate were those desired by the casualty companies. Because the disposition through bond dealers would result in large commissions to be paid by the companies involved, the investment managers decided to accomplish the portfolio improvements, to the extent possible, by inter-company exchanges. Pursuant to this decision, S transferred tax-exempt bonds to S-1 and S-2 in exchange for taxable bonds in 1974. All of the bonds were capital assets in the hands of S, S-1, and S-2.

All values used in the exchanges were obtained from independent market sources and reflected the fair market value of the bonds. As a result of increasing interest rates and deteriorating market values for debt obligations, losses were sustained by all parties to the exchanges. As a result of these exchanges, S's replacement of tax-exempt bonds with taxable bonds increased its pre-tax investment yield.

The specific question presented is whether, under the above circumstances, the losses incurred by S, S-1, and S-2 are allowable even though all the stock of each is held by P.

Section 165(a) of the Code provides, in general, that there shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise. Section 165(f) provides that losses from sales or exchanges of capital assets shall be allowed only to the extent allowed in sections 1211 and 1212. Section 1.165-1(b) of the Income Tax Regulations provides, in part, that to be allowable as a deduction under section 165(a), a loss must be evidenced by closed and completed transactions, fixed by identifiable events, and actually sustained during the taxable year. Only a bona fide loss is allowable. Substance and not mere form shall govern in determining a deductible loss.

Section 267(a)(1) of the Code disallows deductions in respect of losses from sales or exchanges of property between related persons specified in section 267(b). Section 267(b)(3), in effect, disallows deductions for losses from sales or exchanges between two corporations more than 50 percent in value of the outstanding stock of each of which is owned directly or indirectly, by or for the same individual, if either one of such corporations, with respect to the taxable year of the corporations preceding the date of the sale or exchange was, under the law applicable to such taxable year, a personal holding company or a foreign personal holding company.

Section 482 provides generally for the allocation of income and deduction among two or more organizations, trades, or businesses owned or controlled directly or indirectly by the same interests, in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.

In the instant case section 267 of the Code cannot apply to disallow the loss because the relationship described in section 267(b) does not exist. Further, section 482 is not applicable because no avoidance of tax or distortion of income resulted from the transactions between the commonly controlled entities. In the instant case gains or losses from the exchanges between the controlled parties are the same as would have resulted from an arm's length transaction between uncontrolled parties.

Accordingly, the losses sustained by S, S-1, and S-2 on the exchanges described above meet the requirements of section 1.165-1(b) of the regulations and such losses are allowable as capital losses under the provisions of section 165(f) of the Code.