Federal Circuit Invalidates Duplicated-Loss Factor of Loss-Disallowance Regs.

In Rite Aid Corp., 255 F3d 1357 (2001), the Federal Circuit ruled invalid the duplicated-loss factor of the loss-disallowance regulations under Regs. Sec. 1.1502-20(c)(1)(iii) and (c)(2)(vi). This factor, which purportedly sought to ensure that a parent and its subsidiary did not both benefit from a loss in the value of the subsidiary's assets, failed to reflect the consolidated group's tax liability and, therefore, was not within Treasury's authority under Sec. 1502.

Loss-Disallowance Regulations

Sec. 1501 allows affiliated corporations to file consolidated returns. By making a consolidated return, the consolidated corporations are deemed to have consented to all the regulations prescribed under Sec. 1502. One such regulation is Regs. Sec. 1.1502-20 (the loss-disallowance regulation), which disallows a loss on the sale of a subsidiary's stock to the extent the loss does not exceed the sum of (1) extraordinary-gain dispositions, (2) positive investment adjustments and (3) duplicated losses.

Extraordinary-gain dispositions disallow any loss on the sale of a subsidiary's stock to the extent that the subsidiary, while a member of the group, recognized income or gain (which causes a positive stock-basis adjustment) on certain clearly identifiable transactions occurring after Nov. 18, 1990. These transactions include (1) gain on the disposition of certain assets described in Secs. 1221, 1231 and 1060; (2) positive Sec. 481(a) adjustments; (3) discharge of debt income (to the extent it gives rise to a positive stock-basis adjustment); and (4) any other event (or item) identified in guidance published in the Internal Revenue Bulletin. The amount of any recognized income or gain is reduced by the expenditures directly related to the extraordinary-gain disposition, including allocable Federal income taxes. The extraordinary-gain-disposition factor applies even to assets the subsidiary acquired after joining the group.

Positive investment adjustments disallow any loss on the disposition of a subsidiary's stock, to the extent stock basis increased by positive earnings in any given year. Positive investment adjustments are defined as the sum of modified taxable income (as defined in Regs. Sec. 1.1502-32(b)(2)), not including distributions and taking into account only years in which the amount is positive. Thus, negative adjustments to stock basis during loss years are disregarded in computing the positive investment adjustment. To avoid double counting, positive investment adjustments for any single year are reduced by any amount taken into account as an extraordinary-gain disposition for that year.

The duplicated-losses component disallows any loss on the disposition of a subsidiary's stock to the extent of the subsidiary's duplicated losses. The regulations define "duplicated loss" as the excess (if any) of (A) the sum of (1) the aggregate adjusted basis of the subsidiary's assets (other than its stock and securities), (2) losses carried to the subsidiary's first tax year following a disposition or deconsolidation and (3) deferred deductions, over (B) the sum of (1) the value of the subsidiary's stock, (2) its liabilities and (3) any other relevant items.

The stated rationale behind the duplicated-loss rules is that, without the duplicated-loss component, not only can the parent claim a deduction for its loss on the sale of a subsidiary's stock, but the subsidiary can claim a loss on the sale of its "loss" assets after leaving the parent's group. The validity of the duplicated-loss factor was the subject at issue in the Rite Aid appeal.

In Rite Aid, the taxpayer purchased 80% of Encore's stock in 1984 and the remaining 20% in 1988, for a purchase price totaling approximately $4.5 million. Rite Aid later sold Encore to an unrelated party. The buyer, however, refused to make a Sec. 338(h)(10) election to treat the transaction as an asset sale for tax purposes. Rite Aid realized a tax loss on the sale, calculated at approximately $22.2 million.

Under the loss-disallowance regulations, the entire loss was disallowed. Rite Aid's disallowed loss was a function of the three components of the loss-disallowance regulations, and Rite Aid originally challenged the validity of all three of those components. However, according to the Court of Federal Claims, the parties orally agreed that any issues related to the extraordinary-gain and positive-investment-adjustment factors would be moot if the court were to uphold the validity of the duplicated-loss provision, as the duplicated-loss factor alone exceeded Rite Aid's entire incurred loss. Specifically, Rite Aid had a "duplicated loss" of $28.5 million–the excess of Encore's adjusted basis in its assets over the value of its assets immediately after the sale–compared to the $22.2 million loss claimed on the stock sale.

Rite Aid maintained that it suffered a true economic loss of over $22 million. The company contended that the loss was permanently denied solely by virtue of its election to file a consolidated return. It argued that the loss would have been deductible under Sec. 165 if a consolidated return had not been elected and "the denial of the deduction imposes a tax on income that would otherwise not be taxed."

Rite Aid claimed that Sec. 1502 grants authority to the Secretary to promulgate regulations only so "as to clearly reflect the income tax liability...and in order to prevent avoidance of such tax liability" by the group and the members. To the extent that the loss-disallowance regulations deny a deduction for an economic loss that the Code allows to nonconsolidated filers, Rite Aid maintained that the regulations are inconsistent with the grant of authority and therefore invalid.

The government argued that the duplicated-loss factor "prohibits a consolidated group of corporations from recognizing a loss on the sale of an affiliate's stock and the purchaser from recognizing the same loss when selling the assets of the purchased subsidiary."

Additionally, the government maintained that the regulations clearly disallow the loss and that the plaintiff had the burden of overcoming the well-established rule of judicial deference to regulations promulgated by rulemaking agencies, particularly "legislative regulations." Given the high level of deference afforded legislative regulations, the government argued that the regulation must be upheld unless it is "arbitrary, capricious, or manifestly contrary to the statute."

The Court of Federal Claims ruled in favor of the government, finding that the loss-disallowance regulations fell "within the four corners of section 1502." However, the Federal Circuit reversed, agreeing with Rite Aid that the regulation is "manifestly contrary to the statute." In rendering its decision, the court wrote, "in the absence of a problem created from the filing of consolidated returns, the Secretary is without authority to change the application of other tax code provisions to a group of affiliated corporations filing a consolidated return." Additionally, citing American Standard, Inc., 220 Ct. Cl. 411 (1979), the court stated, "section 1502 'does not authorize the Secretary to choose a method that imposes a tax on income that would not otherwise be taxed.'"

Moreover, the court wrote:

The loss realized on the sale of a former subsidiary's assets after the consolidated group sells the subsidiary's stock is not a problem resulting from the filing of consolidated income tax returns. The scenario also arises where a corporate shareholder sells the stock of a non-consolidated subsidiary. The corporate shareholder could realize a loss under I.R.C. 1001, and deduct the loss under I.R.C. 165. The subsidiary could then deduct any losses from a later sale of assets. The duplicated loss factor, therefore, addresses a situation that arises from the sale of stock regardless of whether corporations file separate or consolidated returns.

Consequently, the court held that the Secretary lacked the authority to deny the application of Sec. 165 to Rite Aid's loss on the stock sale.

Further, the government attempted to invoke the statutory language requiring consolidated corporations to consent to all prescribed regulations–what the government called taking "the bitter with the sweet." The Federal Circuit disagreed with the government, holding that a taxpayer is not required to "acquiesce in a regulation promulgated outside the authority delegated by Congress. The 'bitter with the sweet' does not include the invalid."

Impact of Rite Aid

The court's decision raises questions about the validity of the extraordinary-gain-disposition and positive-investment-adjustment factors of the loss-disallowance regulations, as well as consolidated return regulations that may change the application of other Code provisions to a consolidated group, absent a problem created from filing a consolidated return.

Finally, Regs. Sec. 1.1502-20(g) provides an election for the reattribution of a subsidiary's losses to the common parent. If a member disposes of a subsidiary's stock at a loss, to the extent the loss would be disallowed, the common parent may elect to attribute to itself any of the subsidiary's net operating losses (NOLs) or net capital losses. If the election is made, the common parent would succeed to the reattributed losses as if they were transferred in a Sec. 381 transaction.

The election is particularly attractive, because it allows the common parent to carry over NOLs that could offset ordinary income, while a loss on the disposition of a subsidiary's stock would be capital in nature. Therefore, the Rite Aid decision may have an adverse effect for certain taxpayers that may actually prefer to have their loss disallowed so they could make the reattribution election.

From Jeremy B. Blank, CPA, MLT, and Marshall S. Solomon, CPA, Washington, DC