New Rules Prevent Duplicated Losses

IRS Responds to Consolidated Return Defeat in Rite Aid

By Nick Morrow

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Background

Generally, the loss disallowance rules, which the Treasury Department issued in 1991, serve to disallow losses on the sale of subsidiary stock by a corporate group that files a consolidated return. The aim of these regulations was twofold. First, the regulations were intended to prevent corporate taxpayers from avoiding the recognition of corporate income tax on distributions of appreciated property. Thus, the intent was to thwart transactions that had been devised to use the consolidated return rules to circumvent the portion of the Tax Reform Act of 1986 that repealed the so-called General Utilities doctrine [General Utilities Co. and Operating Co. v. Helvering, 296 U.S. 200 (1935)]. (The “Son of Mirror” technique could be used to allow a consolidated group to circumvent the repeal of General Utilities. Typically, such a transaction enabled corporate taxpayers to dispose of unwanted assets in an acquisition without recognizing taxable gain or loss.)

The second aim of the loss disallowance rules was to prevent taxpayers from using the consolidated return rules to generate duplicated losses. Duplicated losses occur when the corporate taxpayer uses the consolidated return rules to achieve two tax deductions from a single economic loss.

Example 1: Basic example. In Year 1, P forms S with a capital contribution of $500, and in return receives all of the S stock. S purchases an asset for $500; the asset subsequently declines in value to $300 (assume, for simplicity, that no depreciation is allowed or allowable on the asset). In Year 2, P sells the S stock to an unrelated third party for $300 and recognizes a $200 loss ($300 realized on the sale, less P’s $500 basis). Subsequently, S sells the asset for $300 and also recognizes a $200 loss ($300 realized on the sale, less the $500 basis that S held). Other sections of the IRC, such as section 382, could apply to affect the ability of S to use the loss on the sale of its asset. Often these impediments to use the loss could be overcome with planning.

The Treasury Department and the IRS consider it unreasonable for a tax benefit to be obtained twice when in fact only one economic loss has occurred. The loss disallowance rules of Treasury Regulations section 1.1502-20 took care of this perceived abuse by disallowing losses on sales of subsidiary stock. In Example 1, the loss disallowance rules of section 1.1502-20 as issued in 1991 would have disallowed the loss of $200 that P would have realized on its sale of S stock. Only a single tax benefit—the loss on the asset sale by S—would be allowed, because economically only one loss had occurred.

Some tax planners have devised other creative transactions to generate duplicated losses and to keep them within the same consolidated group. Note that in Example 1, S achieves the tax benefit of the loss on the asset sale after it has left the P group. Thus, different owners benefit from the duplicated loss: P benefits from the loss on the sale of S stock (absent application of the loss disallowance rule), and S benefits on the sale of the asset only after it has been sold by P to new owners. Taxpayer P could undertake certain tax planning steps to keep both the tax benefit of the loss on the sale of S stock and the loss on the sale of the asset within the P consolidated group, and thereby obtain two tax benefits from a single economic loss.

Such creative transactions might involve selling high-basis common or preferred stock in S for a tax loss while P retains ownership of sufficient common stock in S such that the subsidiary remains a member of the P consolidated group. On the subsequent sale of the loss asset by S, the P group again receives a tax benefit, duplicating the loss recognized previously on the sale of stock. Ultimately, the temporary regulations section 1.1502-35T that the IRS adopted in 2003 (replacing certain facets of the loss disallowance rules of 1.1502-20) aims to prevent the duplication of losses if the tax benefits are enjoyed by the same consolidated group. Losses generated by sales of the stock of a member of a consolidated group, such as the one described in Example 1, would not be disallowed under the temporary regulations of 2003, because the tax benefits of the stock sale and the loss asset are achieved by two different, unrelated taxpayers.

Rite Aid

In 1984, Rite Aid purchased sufficient stock in a subsidiary, Penn Encore, for it to be included in Rite Aid’s consolidated tax filing. In 1994, Rite Aid sold its entire interest in Penn Encore to an unrelated third party, CMI Holding Corporation. Rite Aid realized a loss of approximately $22 million on the sale (net proceeds of $16.5 million, less adjusted basis in CMI shares of approximately $38.5 million). Rite Aid claimed the $22 million loss on its consolidated income tax return. The IRS disallowed the $22 million loss, citing the loss disallowance rules of Treasury Regulations section 1.1502-20. Those rules generally serve to disallow the loss on the sale of the subsidiary stock to the extent that the adjusted basis of the subsidiary’s assets exceeds the fair market value immediately preceding the sale. In the instant case, Penn Encore’s adjusted basis in its assets exceeded the fair market value immediately preceding the sale of the Penn Encore stock by Rite Aid by approximately $28 million. Because the $22 million loss realized by Rite Aid was less than this amount, the IRS cited section 1.1502-20 to disallow the entire $22 million amount.

Rite Aid disagreed with the IRS’ assessment. After losing its claim for refund on summary judgment in the U.S. Claims Court, Rite Aid appealed its case, ultimately to the Federal Circuit Court, which agreed with the taxpayer that the loss on the sale of Encore should not be disallowed on account of duplicated losses, holding that the duplicated loss factor of regulation 1.1502-20 was an invalid use of regulatory authority:

The purpose of section 1502 is to give the Secretary authority to identify and correct instances of tax avoidance created by the filing of consolidated returns. … Therefore, 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. …

In our view, there is no requirement that a taxpayer acquiesce in a regulation promulgated outside the authority delegated by Congress. The “bitter with the sweet” does not include the invalid. 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.

Because the Federal Circuit Court did not view the loss on the sale as created by the filing of a consolidated return, the operation of the loss disallowance regulation as it applied to Rite Aid was invalid.

IRS Response to Rite Aid

The IRS disagreed with the decision in Rite Aid, but stated (Notice 2002-11 IRB 2002-7, 526) that “in the interests of sound tax administration” it would not continue to litigate the validity of the loss disallowance regulations. The IRS further stated its view that the court decision invalidated only the duplicated loss element of the loss disallowance rules under Treasury Regulations section 1.1502-20, not other factors, such as the aim of the regulation to prevent circumvention of the General Utilities doctrine. In March 2002, the Treasury Department issued Temporary Regulations section 1.337(d)-2T, which was designed to prospectively supercede Treasury Regulations section 1.1502-20 and provide guidance on the application of loss disallowance on sales of stock of members of a consolidated group. More specifically, Temporary Regulations section 1.337(d)-2T applies to sales of stock for periods after March 6, 2002. Transition rules in the regulations allow for certain elections to be made [see Treasury Regulations section 1.1502-20T(i)] to permit the continued application of 1.1502-20T if a sale of subsidiary stock is made on or after March 7, 2002, pursuant to a binding written contract in effect before March 7, 2002. Generally, these rules address only two of the factors originally considered in the section 1.1502-20 regulations and do not address the “duplicated loss” factor that was invalidated in Rite Aid. The rules of section 1.1502-20 were constructed to disallow loss on the disposition of a subsidiary by a consolidated group to the extent of extraordinary gain disposition, positive investment adjustments, and duplicated loss. Temporary Regulations section 1.337(d)-2T addresses disallowance of losses attributable to built-in gains (i.e., attributable to extraordinary gain disposition and positive investment adjustments), but does not address the duplicated loss factor.

The Treasury Department proposed section 1.1502-35 in October 2002 in order to address the transactions originally covered by the duplicated loss factor of the section 1.1502-20 rules. This was adopted as a Temporary Regulation on March 11, 2003. The regulation reflects the principles advocated by the IRS in Notice 2002-18 and address the broad concept argued by the government. Notice 2002-18 was issued on March 7, 2002, simultaneous with the issuance of Temporary Regulations section 1.337(d)-2T, as public evidence of the government’s intention to address in future regulations the duplicated loss factor that was invalidated by the Rite Aid decision. The notice stated the Treasury Department’s intent to “prevent a consolidated group from obtaining a tax benefit from both the utilization of a loss from the disposition of stock (or another asset that reflects the basis of stock) and the utilization of a loss or deduction with respect to another asset that reflects the same economic loss.”

Targeted Transactions

The regulations are intended to address at least two types of transactions that may allow a consolidated group to obtain more than one tax benefit from a single economic loss. One type covers situations where a consolidated group absorbs an “inside” loss (e.g., a loss inherent in an asset: the basis of the asset exceeds its fair market value) on the sale of an asset owned by a subsidiary, and a second tax loss on the sale of the subsidiary’s stock. The regulations also target transactions whereby a tax loss is generated on the sale of shares of a subsidiary and the group subsequently recognizes a loss on the sale of the asset of the subsidiary. Generally, the regulations apply when a consolidated group disposes of shares in a subsidiary or deconsolidates, and when the basis of such shares exceeds their value at the time of disposition or deconsolidation.

A basis redetermination rule [section 1.1502-35T(b)] and a loss suspension rule [section 1.1502-35T(c)] are the two primary regulatory mechanisms used to prevent duplicated losses. The regulations also specify a basis reduction rule [section 1.1502-35T (f)] and anti-avoidance rules [section 1.1502-35T (g)] that are intended to capture situations not covered by the two primary rules.

Basis Redetermination

The basis redetermination rule requires that the basis of subsidiary stock held by members of a consolidated group be redetermined immediately before a disposition or deconsolidation of a share of such subsidiary member stock if the basis of such stock exceeds its value. The regulations provide different rules for redetermining the basis in the subsidiary stock depending upon whether the subsidiary remains a member of the consolidated group after the stock is disposed of.

If the subsidiary remains a member of the consolidated group after the disposition of the shares, the rules [section 1.1502-35T(b)(1)] require that all members of the group aggregate all their bases in the subsidiary member. Such a basis is first allocated to any preferred shares up to their fair market value and then to all of the outstanding shares of common stock in proportion to their value on the date of the disposition.

Alternatively, if the subsidiary does not remain a member of the group after the disposition or deconsolidation, the rules require reallocation of a certain amount of the basis in the stock to the other remaining members of the group. The amount of reallocated basis is linked to the basis in the disposed shares to the extent that the basis in such shares has been determined by reference to the built-in loss asset. The amount of basis is reallocated such that the loss on disposition is reduced to zero. Such an amount of reallocated basis may be reduced (allowing some or all of the loss to be recognized on disposition) depending upon the extent that certain basis adjustments had previously been made under the consolidated return rules. The operation of the basis redetermination rules in cases where the subsidiary does not remain a member of the group following disposition or deconsolidation is complex and beyond the scope of this article.

Example 2: Basis redetermination. In Year 1, P forms S and contributes $500 to the subsidiary in return for 500 shares of common stock. In Year 2, P contributes an asset with a basis of $100 and a fair market value of $20 to S in exchange for 20 shares of preferred stock. Neither capital contribution is subject to tax under IRC section 351. In Year 3, P sells the preferred stock to an unrelated third party for $20, and later S sells its asset for $20.

Absent section 1.1502-35T, P would recognize an $80 loss on the sale of the preferred stock. In addition, the P group would again recognize an $80 loss on the sale of the asset by S in Year 3, thereby obtaining two tax benefits from a single economic loss. Section 1.1502-35T(b) applies to the sale of the S preferred shares, however, because the basis in the preferred shares exceeds their value.

The regulations require that the basis in the preferred shares be redetermined immediately prior to the sale of the S preferred shares. P’s aggregate basis in the common stock and preferred stock of S is $600 (Year 1 initial capital contribution of $500 and Year 2 capital contribution of an asset with a basis of $100). The $600 of basis is reallocated first to the preferred shares, then to the common shares in proportion to their value on the date of the sale by P of the preferred shares to the unrelated third party. In this example, the preferred shares have a value of $20, and the regulations call for the basis to be adjusted down to this level. The remaining $580 of basis is allocated to the common shares ($600 of original aggregate basis, less $20 allocated to the preferred).

The operation of the regulation results in no loss on the sale of S preferred shares by P [$20 amount realized less $20 basis in the preferred shares as computed under 1.1502-35T(b)]. The loss on the sale of the asset by S in Year 3 would not be affected by the regulations, and would be included in the P group Year 3 consolidated tax return.

Loss Suspension Rule

The loss suspension rule [section 1.1502-35T(c)] prevents duplication of an economic loss by disallowing a loss on the disposition of subsidiary stock if the underlying economic loss (e.g., the ownership of an asset by the subsidiary with a built-in loss) could later be reflected on the return of the consolidated group. Thus, the loss suspension rules apply only where the subsidiary remains a member of the group after the stock is disposed of by the parent.

The amount of the loss that is suspended cannot exceed the duplicated loss. Generally, the duplicated loss is the extent to which the basis of the assets in the subsidiary exceeds the value of the subsidiary stock (i.e., the amount by which built-in loss assets are reflected in the stock price).

The regulations reduce the tax deductibility of suspended losses to the extent that the subsidiary member’s deductions and losses are taken into account in computing the taxable income of the consolidated group. (The regulations presume that all deductions and losses of the subsidiary are first attributable to duplicated losses, but this section of the temporary regulations also permits this presumption to be rebutted. The regulations do not specify a specific method for rebuttal, but some form of tracing would be required.) The suspended losses are allowed to be used by the group in the year the subsidiary member leaves the consolidated group, to the extent such losses are otherwise allowed under applicable provisions of the IRC.

Example 3: Loss suspension rule. In Year 1, P forms S by making a capital contribution of $500 and receiving 500 shares of S common stock. S uses the $500 to purchase a building. In Year 2, the building decreases in value to $100 (assume, for simplicity, no operating expenses or depreciation are incurred). In Year 2, P also sells 100 shares of S stock to an unrelated third party for $20. S is still a member of the group following the sale of the S shares, because P still owns 80% of the stock of S. At the time of sale, the duplicated loss as computed under section 1.1502-35T (d)(4) is $400. That is, the duplicated loss is the excess of the adjusted basis of the S assets, $500 (the building) over the $100 value of the S stock (the value of the S stock is equivalent to the underlying value of the building owned by S). The portion of this duplicated loss attributable to the shares sold is $80 (20% of the shares sold, multiplied by the duplicated loss element of $400).

Prior to the application of the loss suspension rule, P’s loss on the sale of the 100 S shares is $80 ($20 realized, less $100 basis). Because the $80 duplicated loss element attributable to the shares sold equals the $80 loss on the sale of the stock, the full extent of such loss on the sale of the S shares is suspended.

Example 4: Reduction of suspended loss. Assume the same facts as Example 3, except that in Year 3, S sells the building for $100, recognizing a loss of $400. Under Treasury Regulations section 1.1502-35T(c)(4), the $80 suspended loss would be zero because the underlying built-in loss of $400 is used to offset the income of the P group.

Example 5: Allowance of suspended loss. Assume the same facts as Example 3, except that in Year 3, P sells an additional 100 shares of S stock to an unrelated third party for $20 and recognizes an additional $80 loss. Because P’s ownership percentage in S has dropped below 80%, P and S can no longer file as a consolidated group. Therefore, under Treasury Regulations section 1.1502-35T(c)(5), the $80 suspended loss incurred by P in Year 2 can be used to offset the taxable income of the P group.

Basis Reduction and Anti-Avoidance Rules

The Treasury Department and, IRS have adopted basis reduction and anti-avoidance rules to prevent the use of duplicated losses in situations not dealt with under the basis redetermination or loss suspension rules. In general, the basis reduction rule applies when, following the disposition of the stock, the subsidiary ceases to exist or is worthless. The anti-avoidance rules address situations where the Treasury Department and the IRS are concerned that taxpayers could circumvent the duplicated loss rules by, for example, making transfers of built-in loss property to a partnership or other corporation, or by “re-importing” losses to the subsidiary group member.

Exception to the Duplicated Loss Rules

Generally, the basis redetermination rules do not apply if the consolidated group disposes of all of its stock of the subsidiary member within a single taxable year. Because the loss suspension rules do not apply if the subsidiary does not remain a member of the consolidated group following the sale of the shares, the two primary mechanisms proposed by the Treasury Department and IRS will not apply to the vast majority of transactions undertaken by taxpayers. In its own summary of the regulations as originally proposed, the Treasury Department went so far as to say that “the IRS and the Treasury do not expect that the basis redetermination and loss suspension rules will apply frequently.”

The regulations would not serve to prevent the taxpayer in Rite Aid from deducting its loss on the sale of subsidiary stock, because in Rite Aid all of the subsidiary stock was disposed of (at a loss) within a single taxable year. Thus, the temporary regulations have been crafted to prevent the enjoyment of duplicated losses by a single consolidated group, but not to run afoul of the adverse decision handed down in Rite Aid.