In a case involving Rite Aid’s ability to deduct a loss sustained on a sale of the stock of a subsidiary, the Court of Appeals for the Federal Circuit, in allowing the loss deduction, invalidated a portion of the I.R.S.’s controversial “loss disallowance rules”, found in Reg. Sec. 1.1502-20.
These rules were designed to bolster the repeal of the General Utilities doctrine. The I.R.S. felt, before their enactment, that such repeal was being undermined by the use of techniques such as “son of mirror” transactions. Accordingly, these regulations provide that a loss sustained on the disposal of a subsidiary’s stock, in cases where a consolidated tax return is filed, will only be deductible to the extent that such loss exceeds the sum of:
The duplicated loss element of the rule operates in cases where the subsidiary disposed of has a basis in its assets that exceeds the fair market value of those assets; the excess is the amount of the duplicated loss. The purpose of the duplicated loss factor is adequately described by its very title; to prevent a selling parent from claiming a loss on the sale of the subsidiary’s stock where the same loss would then be made available to the purchaser of such stock in connection with the later sale of the subsidiary’s assets.
However, in an unusual step—in light of the fact that consolidated return regulations are “legislative” in character, not merely interpretative—the court ruled that the duplicated loss element of the regulations was invalid because it was “plainly contrary” to the statute.
The court employed this logic to reach its conclusion: The purpose of Sec. 1502 is to give the I.R.S. the authority (through the promulgation of regulations) to correct instances of tax avoidance created by the filing of consolidated tax returns.
But, in this regard a loss on sale of assets after a consolidated group sells a subsidiary’s stock is not a problem resulting from the filing of consolidated tax returns: The “duplicated loss factor”, in fact, addresses a situation that arises from the sale of stock regardless of whether corporations file consolidated or separate returns.
In fact, Congress has addressed this very situation, in Sec. 382, by limiting the subsidiary’s future deductions (with respect to the loss it sustains on the sale of its assets) and not the parent’s loss on sale of such subsidiary’s stock. Accordingly, the duplicated loss factor is an unauthorized exercise of the I.R.S.’s powers in this area: This portion of the regulation, therefore, must fall; it distorts, rather than “reflects”, the tax liability of the group.
It remains to be seen whether the other elements of the loss disallowance rule will be found invalid—It does seem promising, however, because taxpayers, in challenging such other elements, will, almost certainly, make the same arguments that Rite Aid successfully advanced; that the loss disallowance rule does more than merely guard against tax avoidance opportunities stemming from the filing of consolidated tax returns. In fact, it penalizes consolidated filers by imposing taxes on income of such filers that would not, otherwise, have been taxed.
Robert Willens is a Managing Director and Tax & Accounting Analyst at Lehman Brothers.