2. In § 1.265-2, paragraph (c) is added to read as follows:
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(c) Special rule for consolidated groups —(1) Treatment of intercompany obligations—(i) Direct tracing to nonmember indebtedness. If a member of a consolidated group incurs or continues indebtedness to a nonmember, that indebtedness is directly traceable to all or a portion of an intercompany obligation (as defined in § 1.1502-13(g)(2)(ii)) extended to a member of the group (B) by another member of the group (S), and section 265(a)(2) applies to disallow a deduction for all or a portion of B's interest expense incurred with respect to the intercompany obligation, then § 1.1502-13(c)(6)(i) will not apply to exclude an amount of S's interest income with respect to the intercompany obligation that equals the amount of B's disallowed interest deduction.
(ii) Limitation. The amount of interest income to which § 1.1502-13(c)(6)(i) will not apply as a result of the application of paragraph (c)(1)(i) of this section cannot exceed the interest expense on the portion of the indebtedness to the nonmember that is directly traceable to the intercompany obligation.
(2) Examples. The rules of this paragraph (c) are illustrated by the following examples. For purposes of these examples, unless otherwise stated, P and S are members of a consolidated group of which P is the common parent. P owns all of the outstanding stock of S. The taxable year of the P group is the calendar year and all members of the P group use the accrual method of accounting. L is a bank unrelated to any member of the consolidated group. All obligations are on the same terms and conditions, remain outstanding at the end of the applicable year, and provide for payments of interest on December 31 of each year that are greater than the appropriate applicable Federal rate (AFR). The examples are as follows:
Example 1.
(i) Facts. On January 1, 2005, P borrows $100x from L and lends the entire $100x of borrowed proceeds to S. S uses the $100x of borrowed proceeds to purchase tax-exempt securities. P's indebtedness to L is directly traceable to the intercompany obligation between P and S. In addition, there is direct evidence that the proceeds of S's intercompany obligation to P were used to fund S's purchase or carrying of tax-exempt obligations. During the 2005 taxable year, P incurs $10x of interest expense on its loan from L, and S incurs $10x of interest expense on its loan from P. Under section 265(a)(2), the entire $10x of S's interest expense on the intercompany obligation to P is disallowed as a deduction.
(ii) Analysis. Because section 265(a)(2) permanently and explicitly disallows $10x of S's interest expense, ordinarily $10x of P's interest income on the intercompany obligation would be redetermined to be excluded from P's gross income under § 1.1502-13(c)(6)(i). However, under this paragraph (c), § 1.1502-13(c)(6)(i) will not apply to exclude P's interest income with respect to the intercompany obligation in an amount that equals S's disallowed interest deduction with respect to the intercompany obligation. Accordingly, § 1.1502-13(c)(6)(i) will not apply to exclude P's $10x of interest income on the intercompany obligation and P must include in income $10x of interest income from the intercompany obligation.
Example 2.
(i) Facts. The facts are the same as in Example 1, except that P incurs only $8x of interest expense on its loan from L.
(ii) Analysis. Section 1.1502-13(c)(6)(i) will apply to exclude only a portion of P's $10x of interest income on the intercompany obligation. Under paragraph (c)(1)(ii) of this section, the amount of P's interest income that § 1.1502-13(c)(6)(i) will not apply to exclude is $8x, the total interest expense incurred by P on its indebtedness to L. Consequently, P must include in income $8x of interest income from the intercompany obligation and § 1.1502-13(c)(6)(i) will apply to exclude $2x of interest income from the intercompany obligation.
(3) Effective date. The provisions of this section shall apply to taxable years beginning on or after the date these regulations are published as final regulations in the Federal Register .