March 2002

Consolidated Return Loss Disallowance Rules Saga

Nancy Berk, CPA, Grant Thornton, LLP

The comprehensive and complex loss disallowance rule is often cited as the major disadvantage in electing to file a consolidated tax return. The benefit of filing a consolidated return is clear: treatment of the consolidated group as a single taxable entity for purposes of computing tax.

IRC section 1502 grants the Treasury Department the right to promulgate regulations necessary to compute the tax liability of a consolidated group in order to clearly reflect income and to prevent tax avoidance. The loss disallowance rules of Treasury Regulations section 1.1502-20 were issued under this authority, but many question whether certain aspects of these rules have exceeded the scope of the statute. In a recent decision, the Federal Circuit Court of Appeals concluded that the rules did exceed this scope, specifically the “duplicated loss factor,” and reversed the original Court of Federal Claims decision (Rite Aid v. US, No. 00-5098, Fed. Cir. July 6, 2001).

The Justice Department, in petitioning for a rehearing en banc, has noted its objection to this decision. In addition, the IRS has advised all chief counsel attorneys that it disagrees with Rite Aid. The government believes that the duplicated loss aspect of the loss disallowance rule is a valid regulation. In its petition, the Justice Department argued that the court circumscribed the scope of authority to issue regulations too narrowly, only allowing it to address problems created by the filing of consolidated tax returns.


In a case of first impression, Rite Aid Corp. claimed a loss for what it maintained was an economic loss on the disposition of its subsidiary, Encore Books, which had been a part of its affiliated group filing a consolidated income tax return. Under IRC section 165, Rite Aid noted, it would be permitted to deduct its loss on the sale of subsidiary stock. However, Treasury Regulations section 1.1502-20 prevents this by disallowing, in this set of facts, a shareholder’s investment loss to the extent of the subsidiary’s duplicated loss factor: the excess of the subsidiary’s adjusted basis in its assets over the value of its assets immediately after the sale.

In 1994, Rite Aid sold its interest in Encore Books, which it had acquired in two separate transactions beginning 10 years earlier. Rite Aid asserted it suffered a real economic loss of more than $22 million on the sale. Encore Books had net operating losses from 1985 to 1994, which had been claimed in the consolidated returns of the Rite Aid group. Encore Books had also borrowed approximately $44.9 million from Rite Aid during that period.
Rite Aid was unable to negotiate a sale of Encore Books’ assets with the buyer, and instead sold its shares. Furthermore, as a condition of the sale, the buyer required that Rite Aid contribute the debt to Encore’s capital, thereby increasing its basis in the Encore stock. After taking into account all of the negative and positive basis adjustments, Rite Aid realized a loss on the sale. Pursuant to the loss disallowance rule calculation in Treasury Regulations section 1.1502-20(a), the “duplicated loss” exceeded the claimed “economic loss.” Thus, Rite Aid was denied its deduction for a loss on the sale.


The Court of Federal Claims noted that because Rite Aid had agreed to the sale of shares rather than assets, it had created the form of the transaction. The court held that application of the loss disallowance rule would deny the deduction. Furthermore, the court held that the regulation was not arbitrary, capricious, or manifestly contrary to the law; in other words, it was within the scope of the IRS’s authority to issue regulations.

The Federal Circuit, however, didn’t agree. Noting that legislative regulations are entitled to controlling weight, the court indicated that a regulation would be “contrary to a statute” if it were outside the scope of authority delegated. The court concluded that the secretary would not have the authority to change the application of tax provisions to corporations filing consolidated returns unless there was a problem created by the filing of consolidated returns. Rite Aid’s argument was that the realization of the loss did not arise from filing a consolidated return and that the denial of the deduction imposes a tax on income that wouldn’t otherwise be taxed.

The government’s position was that the duplicated loss factor prohibits the double benefit of the same economic loss when a consolidated group realizes a loss on the sale of an affiliate’s stock and the purchaser realizes the same loss when selling the assets of that subsidiary. The regulation therefore “restores symmetry to the tax code.”

The Circuit Court stated that the loss realized on the sale of a former subsidiary’s assets after the consolidated group sold the subsidiary’s stock isn’t a problem resulting from the filing of consolidated income tax returns. It noted that the duplicated loss factor addresses a situation arising from the sale of stock, regardless of whether the corporations filed consolidated returns, and added that IRC sections 382 and 383 address the government’s concerns by limiting the subsidiary’s future deductions and not the parent’s loss on the sale.

The court concluded that “rather than creating symmetry in the tax code, the duplicated loss factor distorts rather than reflects the tax liability of consolidated groups and contravenes Congress’ otherwise uniform treatment of limiting deductions for the subsidiary’s losses. Because the regulation does not reflect the tax liability of the consolidated group, the regulation is manifestly contrary to the statute.”

IRS Response

Given that the “invalidation of the duplicated loss rule is a matter of exceptional importance for the federal fisc,” this case will probably not be the last hearing on the matter. The IRS has instructed Chief Counsel attorneys to continue to work with examining agents to identify, develop, and pursue these issues without regard to Rite Aid.

As we go to press, the IRS announced its plans for new loss disallowance regulations. In Notice 2002-11, released January 31, 2002, the IRS announced its plans to issue interim regulations that will require consolidated groups to determine the allowable loss on a sale or disposition of subsidiary stock under an amended Treasury Regulations section 1.337(d)-2 instead of the current Treasury Regulations section 1.1502-20. Although the IRS believes that the court’s analysis and holding in Rite Aid were incorrect, it concluded that “the interests of sound tax administration will not be served by continuing to litigate the validity of the loss duplication factor.” The notice articulated the IRS position that Rite Aid implicated only the loss duplication aspect of the loss disallowance regulation, and that the authority to prescribe consolidated return regulations conferred on the Treasury Secretary is limited only by the requirement that the Secretary, at his discretion, has determined such rules necessary clearly to reflect consolidated tax liability.

Because of the interrelationship in the operation of all of the loss disallowance factors, the IRS decided that the new rules should be implemented under the authority granted pursuant to IRC section 337(d).

The interim regulations will be prospective, but for transactions (including those for which a return has been filed) completed before the issue date of interim regulations, or transactions for which there is a binding contract before the issue date, groups will be allowed certain choices with respect to a disposition of subsidiary stock.

The IRS and Treasury Department are undertaking a broader study of the regulatory provisions necessary to implement IRC section 337(d) in the context of affiliated groups filing consolidated returns and will request comments upon issuance of the interim regulations.


Edwin B. Morris, CPA
Rosenberg Neuwirth & Kuchner

Contributing Editor:

Ira H. Inemer

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