Court Defers Loss Deduction on Redemption of Intercompany Debt

The Tax Court has ruled under prior consolidated return regulations that a consolidated group member may not take a capital loss deduction on a redemption of an intercompany note (Textron Inc., 115 TC No. 6). The case is a conspicuous departure from the literal approach recently taken by the Tax Court in interpreting the consolidated return regulations.

In 1977, AVCO, then the common parent of a consolidated group, redeemed its own stock held by one of its subsidiaries (S) in exchange for an AVCO note. S's loss on the transaction was not recognized; under Regs. Sec. 1.1502-31(b)(2)(ii), as then in effect, S's basis in the AVCO stock became its basis in the AVCO note. As a result, S had an unrealized loss in the note. In 1985, Textron acquired the AVCO group. In 1987, AVCO redeemed the AVCO note and S claimed a $15 million capital loss on the redemption.

The IRS argued that the loss should be deferred under former Regs. Sec. 1.1502-14(d)(4), which applied if (1) a member received an obligation of another member in exchange for property, (2) the basis of the obligation was determined in whole or in part by reference to the basis of the property exchanged and (3) the obligation had never been held by a nonmember.

Among other arguments, Textron asserted that the exception applies only if the obligation has never been held by a nonmember, and that S held the note as a member of the AVCO group for seven years before it became a member of the Textron group. This seems to be a convincing argument, but exposes an apparent flaw in the regulation. In general, a net loss cannot be made available merely by rearranging a consolidated group's assets that are never outside the group. The never-held-by-a-nonmember requirement could be considered inappropriate if a debt were always held as intercompany debt in a predecessor group and came into the current group under an exception that prevented triggering of all deferred gain or loss. In that situation, the debt was always under the same single-entity regime and presumably should not be treated as held by a nonmember. Nevertheless, the AVCO and Textron groups were separate groups and a literal-minded court might have sided with Textron.

The court, however, took a very broad view of its responsibilities in interpreting the regulations, stating:

Petitioner's reading is incongruous with the purpose of the consolidated return regulations and leads to an unreasonable result. The provisions of the regulation in question must be construed consistently with the framework of the consolidated return regulations, in light of their overall purpose and regulatory scheme....The consolidated return regulations are built on the premise that members of a consolidated group are a single economic entity with regard to intercompany transactions and distributions and that resulting gains or losses are given effect only when the transferred property, or stock of the transacting member, leaves the consolidated group.

On this basis, the court overcame significant technical difficulties and held that S could not be considered a "nonmember" while it was a member of the AVCO group. The court's approach was far different from the literal approach of CSI Hydrostatic Testers, Inc., 103 TC 398 (1994), aff'd per curiam, 62 F3d 136 (5th Cir. 1995), in which the court said:

Respondent's argument that the inclusion of COD income in earnings and profits undermines the purpose of the excess loss account rules is a problem of respondent's own making: Respondent chose to use earnings and profits as the measuring rod of the investment basis adjustment rules of [Regs. Sec.] 1.1502-32(b), Income Tax Regs. Respondent was aware that [Sec.] 312(l), which was enacted subsequent to the adoption of section 1.1502-32,...undermined the purpose of the excess loss account rules, but respondent chose not to amend the regulations to correct the problem. As we stated in Woods, we will apply the consolidated return regulations and the Code as written.

Under the current regulations, gain or loss on the redemption of debt is taken into account under the acceleration rule of Regs. Sec. 1.1502-13(d) and is generally offset by loss or gain of other members. Loss (or gain) generally cannot be transferred from stock to debt, as it was in the AVCO group. In both redemption transactions and Sec. 351 transactions, gain or loss on stock is transferred to other stock, not to debt.

From John Broadbent, Washington, DC