Comments on revised loss disallowance regulations (T.D. 8294 and CO-93-90) January 23 1991.

Comments on Revised Loss Disallowance Regulations (T.D. 8294 and CO-93-90)

ONovember 19, 1990, the Internal Revenue Service Took several actions in respect of the temporary consolidated return loss disallowance regulations (T.D. 8294) that were filed with the Federal Register on March 9, 1990. Specifically, the IRS withdrew Temp. Reg. [section] 1.1502-20T and issued Prop. Reg. [section] 1.1502-20 in its place; the IRS also issued Prop. Reg. [section] 1.337(d)-1 as final regulations and promulgated new Temp. Reg. [section] 1.337(d)-2T.

The proposed regulations (CO-93-90) were publised in the Federal Register on November 26, 1990 (55 Fed. Reg. 49075) and reprinted in the December 17, 1990, issue of the Internal Revenue Bulletin (1990-51 I.R.B. 20); the temporary and final regulations (T.D. 8319 were published in the Federal Register on November 26, 1990 (55 Fed. Reg. 49029) and reprinted in the December 17, 1990, issue of the Internal Revenue Bulletin (1990-51 I.R.B.4). (1)

Tax Executives Institute submitted written comments on the initial loss disallowance regulations on June 19, 1990; testified at the IRS's June 26, 1990, public hearing on the regulations; and filed follow-up comments with the IRS on August 10, 1990. Although the revised regulations represent an improvement over the IRS's initial regulations, TEI remains convinced that the modified rules do not go far enough in responding to both the tenor and the substance of the comments that were filed with the IRS. In this letter, we set forth our concerns.

Overview and Concerns

about the process

The revised regulations provide a somewhat more reasonable transition period and a slightly milder ongoing loss disallowance rule than the initial regulations. In a very real sense, therefore, they represent a step in the right direction --both in terms of the process by which they were promulgated and the substantive rules they contain. They do not, however, sufficiently ameliorate the scope, or otherwise temper the basic unfairness and overreaching nature, of the initial loss disallowance regulations. Further revisions are clearly necessary.

The primary effect of the revised loss disallowance regulations may be to cure the Administrative Procedure Act (APA) problems of the initial regulations. The initial rules -- which were issued as immediately effective temporary regulations -- flouted the APA's notice-and-comment and public hearing requirements. In contrast, the revised section 1.1502-20 regulations were issued in proposed form with a prospective effective date (February 1, 1991). TEI questions, however, whether the revised regulations, while abiding by the letter of the APA, nevertheless mock its spirit.

Specifically, we are concerned that the exceptionally short time period between the deadline for comments (January 15, 1991), the scheduled public hearing (January 25, 1991), and the effective date of the revised regulations (February 1, 1991) signals an IRS intent not to make further changes. We respectfully submit that such an approach to the loss disallowance comment and hearing process is contrary to the total quality management and customer service principles the IRS has in recent years espoused. They deprive the hearing process of its intended remedial effect.

TEI continues to believe that the loss disallowance regulations exceed what Congress contemplated in repealing the General Utilities doctrine. We also believe that the IRS have over-stepped its regulatory mandate in promulagating a broard loss duplication rule and conjuring up an entirely new, exceedingly complicating concept -- the consumption of "wasting assets."

The modified loss disallowance rule remains an example of regulatory overkill and, if adopted in its current form, will operate to disallow economic losses in many cases. The IRS has suggested that Prop. Reg. [section] 1.1502-20(c) provides taxpayers substantial relief from loss disallowance (at leat compared with that permitted under the initial regulations) because it allows taxpayers to claim the benefit of losses to the extent that they exceed --

(1) earnings and profits derived from extraordinary gain dispositions,

(2) earnings and profit resulting in annual net positive adjustments, and

(3) the amount of any "duplicated loss."

We recommend, however, that the rules go much further. Specifically, the reach of the loss disallowance rule should be limited to the recognition - or the presumed recognition - of the net built-in gain in assets held by the subsidiary at the time the subsidiary joined the consolidated return group.

Effective Date

As promulgated, the revised regulations are effective in respect of dispositions and deconsolidations after January 31, 1991. Thus, taxpayers that had felt constrained by the initial regulations from selling loss subsidiaries were provided a two-and-a-half month window (from the issuance of the revised regulations on November 19, 1990, until February 1, 1991) within which to dispose of such subsidiaries and secure the benefit of the transitional rules set forth in Temp. Reg. [section] 1.337(d)-2T.

TEI submits that the effective date of Prop. Reg. [section] 1.1502-20 should be extended to provide more time for taxpayers to sell loss subsidiaries and avail themselves of the more precise tracing rules of Temp. Reg. [section] 1.337(d)-2T. The declining economy, the effect of the Persian Gulf crisis on markets, and general business exigencies (including the need to secure regulatory approval in respect of certain transactions) have made closing transactions difficult, if not impossible, within the window period allowed by the revised regulations. The IRS has informally justified the short window period by stating that window period was intended to allow transactions already in formulation when the modified rules were issued to be completed, not to permit the consummating of deals not yet begun. See Consolidated Returns: IRS Official Responds to Practitioner Comments on New Loss Disallowance Rules, DTR No. 13, at G-5 (Jan. 18, 1991) (remarks of Mark S. Jennings).) The preamble, however, decribes Temp. Reg. [section] 1.337(d)-2T as "a prospective rule which taxpayers may take into account when planning transactions." (1990-51 I.R.B. at 27 (emphasis added).)

TEI recommends that the effective date of the regulations be deferred until June 30, 1991. Moreover, the regulations should be revised to provide a binding contract rule for contracts of disposition entered into before the nominal effective date (February 1 or -as we propose -- June 30).

TEI believes that the immediate modification of the effective date of the revised regulations will inject a fuller measure of fairness into the loss disallowance regulations. Equally important, by providing a reasonable period for review and analysis following the end of the comment period and the public hearing before the regulations go into effect, the IRS can demonstrate its commitment to the hearing process.

Efficacy of Tracing

In commenting on the initial regulations, TEI took issue with the IRS's assertion that tracing would be administratively unworkable in determining loss disallowance. We continue to hold the view that an administrable tracing regime can be developed. Hence, we renew our recommendation that taxpayers be provided an election to trace in order to avoid loss disallowance by showing that the loss did not result from the recognition of built-in gain.

If the burden of proof is placed on electing taxpayers to establish that they complied with any tracing requirements, the administrative burden on the IRS in auditing compliance with the regulations will be reduced to a level not appreciably different from that which exists now in other areas of the tax law. For example, taxpayers already determine the value of acquired assets, though in-house or independent appraisals, whenever there is a sale or purchase under section 1060 or an election under section 338(h)(10).

Stated simply, tracing would clearly provide the most accurate -- and, therefore, equitable - results. It would ensure that only those losses were disallowed that were attributable to investment adjustments cause by the recognition of pre-acquisition built-in gain. To deny taxpayers the ability to substantiate their losses by the use of appraisals because of the administrative burdens that tracing could involve is to exalt the laudable goal of simplicity over economic reality and fundamental fairness. (2)

What is more, it loses sight of the inherently complex nature of the structure and dealings of large corporate groups. Because of that unavoidable, almost axiomatic complexity, the rules that govern the tax liability of corporate groups will be complex. This is not to say that efforts cannot proceed to reduce compliance and computational burdens through the development of safe harbors and sunset provisions, de minimis rules, and other regulations that alleviate the volume of paperwork and technical computations. Simple solutions should be favored over complex ones and undue complexity should be avoided, but the desire for simplicity cannot excuse wholly inequitable results and should not crowd out longstanding tax principles. Simplification is not an end unto itself.

The preamble to the revised regulations avers that the government would invariably suffer if the taxpayer were permitted to elect tracing, on the ground that the election would be made only when advantageous to the taxpayer. (1990-51 I.R.B. at 22.) Although we question the true scope of the "adverse selection" problem, we believe it would be obviated by requiring a taxpayer to make a binding election whether or not to trace at the time it acquires subsidiary stock (or within a specified period following the acquisition). TEI urges that the rule be modified to provide for this type of election.

Consumption of

"Wasting Assets"

Much of the supposed complexity associated with tracing -- the requirements of multiple appraisals and the maintenance of a separate set of earnings and profits books -- is attributable to the IRS's novel position that the consumption of built-in gain assets through operations ("wasting assets") are within the scope of General Utilities repeal. There is simply no justification, however, for including the consumption of such assets within the scope of the loss disallowance rules. Nothing in the legislative history of the Tax Reform Act of 1986 even suggests that the repeal of the General Utilities doctrine applies to earnings generated from the operation of assets with built-in gain. Such a theory has no place in the present income realization and recognition system of the Code. To our mind's eye, the "wasting assets" concept should not serve as the raison d'etre for rejecting tracing. Quite the opposite: the complexity spawned by the extension of the loss disallowance rule beyond losses attributable to the recognition of pre-acquisition built-in gain underscores why the "wasting assets" rules should be jettisoned.

Presumptive Rule:

Not Built-in Gain

In developing the revised regulations, the IRS refused to adopt presumptive rules along the lines of those offered by TEI and other commentators. TEI supported the promulgation of such rules because they would be more surgical in their disallowance of losses attributable to built-in gain recognition than would either the initial or the revised regulations. We continue to see merit in that position.

Thus, we recommend the adoption of the net built-in gain presumption set forth in our comments on the initial regulations. This rule would eliminate the need for costly and arguably contentious appraisals. It would also effectively implement congressional intent in repealing the General Utilities doctrine by not only taxing corporate level gains on corporate liquidation distributions but also allowing the deduction for most losses at this level. In arguing against this rule, the preamble mistakenly assumes that most corporations have the inclination and wherewithal to expend the time and money to sell built-in gain assets of an acquired subsidiary, but not its builtin loss assets -- all for the purpose of increasing their loss deductions if, and when, they sell the subsidiary's shares. (See 1990-51 I.R.B. at 23.) We suggest, however, that such a strategy is not realistic: taxpayers will not generally search for such "tax pinholes," selling assets of a recently acquired company solely for the purpose of increasing their loss deductions in the uncertain situation of a sale of the subsidiary's shares in the future.

The revised regulations provide no pre-acquisition built-in gain cap of any kind on the disallowed loss. TEI strongly believes the absence of an overall limitation is unjustified in view of the objective of Notice 87-14 and section 337(d) of the Code. We also suggest that more is needed to justify the revised rules than bald statements in the preamble that alternatives will not work. (3) (See 1990-51 I.R.B. at 23.e

Rather than reflexively rejecting alternatives that tie loss disallowance to reasonable approximations of builtin gain recognition, the IRS should adopt rules that fairly limit loss disallowance to that which prompted the repeal of General Utilities: recognition of pre-acquisition built-in gain. Specifically, if tracing is not acceptable, the disallowed loss should be limited to net built-in gain at the acquisition date.

Loss Duplication

In retaining a loss duplication rule in the revised regulations, the IRS disregarded a substantial body of comments that were filed on the initial regulations. TEI believes that such a rule is unnecessary because there is no true duplication of loss under the circumstances covered by the revised regulations. Stated simply, the loss duplication rule is aimed at abuses that do not exist.

The present investment adjustment rules do not allow duplication of loss in the same consolidated return with respect to a subsidiary with unrecognized net operating loss carryovers or built-in loss assets. The asset investment adjustment rules under Treas. Reg. [section] 1.1502-32 were promulgated to prevent duplication of taxable gain or deductible loss at the consolidated return level. We submit that the section 1.1502-32 regulations accomplish this objective and, hence, there is no need for an additional loss duplication rule.

If a net operating loss generated by the subsidiary is not utilized by the consolidated return group or the subsidiary holds assets with a built-in loss that has not been recognized, the recognition of loss on the sale of the subsidiary's shares is the only loss deducted by the consolidated group. If the stock loss is denied the parent on the sale of the subsidiary's stock, it is not certain that the loss will ever be recognized by the subsidiary or the acquiring corporation.

The absence of true, rather than chimerical, loss duplication is even more apparent where a consolidated group acquires a corporation with separate return limitation year (SRLY) net operating loss carryovers, and the SRLY losses are not utlized by the consolidated group. Even if the consolidated group elects to reattribute the SRLY losses to the common parent of the group, such reattributed losses remain subject to the limitations of section 382.

Even if the loss were recognized after the sale of the subsidiary, it would be subject to the various limitations on trafficking in losses under the Code and consolidated return regulations. The IRS's argument that the trafficking in loss provisions of sections 269, 382, 383(b), and 384 are not applicable to this issue is simply not persuasive. (See 1990-51 I.R.B. at 24.) Indeed, we submit that the only case where the loss should be disallowed is under those provisions (or under other provisions of the consolidated return regulations such as Treas. Reg. [sections] 1.1502-15, 1.1502-21(c), and 1.1502-22(c)). Thus, as long as the consolidated return group does not obtain a double deduction in respect of a loss of a member, there is no duplication.

The preamble's response to the arguments against retention of the loss duplication rule is not persuasive. Certainly, loss duplication cannot be justified merely because it simplifies the rules implementing General Utilities repeal; the initial regulations' disallowance of all losses was really simple, but even the IRS now agrees that the initial rules went too far. The IRS concedes that the loss duplication rule "deprives consolidated groups of a benefit they would enjoy had they filed separate returns...." (1990-51 I.R.B. at 24.) It attempts to finesse the question of its legal authority to impose such a deprivation, however, by commenting that "[e]lecting corporations ... have historically suffered detriments unrelated to the benefits of consolidation." (1990-51 I.R.B. at 24.) We suggest, however, that the issue is much more fundamental: whether the IRS's authority under section 1502 can be distended to justify regulations that essentially rewrite corporate tax law. Obviously, the answer is no. Since there is no potential for losss duplication in the consolidated return of the selling corporation, the issue of the loss duplication is not properly an issue for the section 1502 regulations. In short, loss duplication is the product not of the consolidated return regulations but rather of our two-tier taxation system. Thus, it exists in the separate return as well as the consolidated return context.

The loss duplication rule would work such a wholesale change in tax policy that it demands a more comprehensive and evenhanded treatment than that set forth in the initial and revised regulations. (4) Indeed, we believe that the loss duplication issue lies "beyond the pale" of regulatory action: if it is to be addressed, it should be by Congress, not the IRS and Treasury.

Recommended Revisions to

Prop. Reg. [section] 1.1502-20

As proviously stated, TEI continues to support the crafting of regulations that permit taxpayers to elect tracing or adopt a net built-in gain presumption. Assuming neither of these alternatives is adopted, we recommend that Prop. Reg. [section] 1.1502-20(c) be modified to permit the netting of positive and negative investment adjustments from different years and also to allow losses from extraordinary dispositions to offset earnings from extraordinary gain dispositions.

Under the revised regulations, losses from extraordinary dispositions may be netted with other sources of income in determining investment adjustments, but may not to be taken into account in determining extraordinary gain dispositions. The preamble to the revised regulations states that the failure to allow for extraordinary losses is necessary to obviate the need for tracing. (1990-51 I.R.B. at 26.) Similarly, the rules related to positive earnings and profits permit netting of losses against profits within the same taxable year, but do not permit netting of positive and negative adjustments from different taxable years. This inconsistency, which has been described by an IRS representative as a "compromise, not a decision on the right of wrong of netting," is based on a presumption that all positive adjustments are attributable to built-in gain, including the built-in gain recognized through the wasting of built-in gain assets. (1990-51 I.R.B. at 26; see Consolidated Returns: IRS Official Responds to Practitioner Comments on New Loss Disallowance Rules, DTR No. 13, at G-5 (Jan. 18, 1991) (remarks of Mark S. Jennings).) Interestingly, the preamble does not mention that by artificially separating out "extraordinary gain dispositions" -- so they cannot be offset by recognized post-acquisition losses -- the revised regulations significantly complicate what otherwise could be a reasonably administrable rule.

TEI recognizes that Prop. Reg. [section] 1.1502-20(c) operates to forestall the genuinely egregious results illustrated by Example 6 of the preamble to the initial regulations. On its face, therefore, the change is to be welcomed. In reality, however, the relief offered by the revised regulations is minimal. The great majority of taxpayers do not have subsidiaries with an Example 6 fact pattern. Instread, they have subsidiaries that carry on business with earnings in some years, losses in others, and gains and losses on asset dispositions.

In other words, although the revised regulations are theoretically more liberal than the initial regulations, the allowable loss provision remains too restrictive: it will deny real economic losses in circumstances outside of the artificial fact pattern of Example 6. Consider, for illustration purposes, the following example:

X Corporation and its subsidiary, Y Corporation, file consolidated returns. Y was acquired on January 1, 1991, for $1,000. Y has one asset, a trademark, the basis of which (in Y's hands) is 0. Y has earnings and profits of $200 in each of 1991, 1992, and 1993. Y has taxable losses of $100 in each of 1994, 1995, and 1996. No dividends were ever paid by Y to X. There were no extraordinary gain dispositions during the years X owned Y. Y is sold on January 1, 1997, for $800. The loss is attributable to a decrease in the value of the trademark.

The $500 loss (the difference between the $800 amount realized the X's $1,300 basis in Y) is disallowed under the revised regulations. Prop. Reg. [section] 1.1502-20(c)(1) provides no relief from loss disallowance because the loss is less than the positive investment adjustments. If the regulations were modified to permit netting of profits and losses from different years, then some relief (albeit less than the total economic loss incurred) would be accorded X since Prop. Reg. [section] 1.1502-20(c) would permit $200 of the loss to be recognized. (That amount recognized the excess of the loss [$500] over the "net" positive adjustments [$300]). Under the revised regulations, however, no loss is allowed since the loss from the sale of the stock ($500) is less than the positive investment adjustments ($600), even though there is no built-in gain.

TEI recommends that the regulations be revised to accord taxpayers with economic losses meaningful relief. Specifically, as suggested by the foregoing example, taxpayers should be permitted to net positive and negative investment adjustments from different years. In addition, the concept of "extraordinary gain dispositions" should be abandoned. Hence, extraordinary gains should be automatically taken into account as part of aggregate positive investment adjustments, with aggregate adjustments being net of all losses (including extraordinary losses).

Such a rule would be consistent with the congressional intent to allow losses recognized at the corporate level in a liquidation to offset the gain so recognized. Even this relief, however, does not address the fundamental problem that true economic losses will, in many instances, be disallowed because of the presumption that positive investment adjustments are always attributable to built-in gain.

Tax Executives Institute appreciates the opportunity to provide its views on the revised consolidated return loss disallowance regulations.

(1) For simplicity's sake, the loss disallowance regulations issued by the IRS on March 9, 1990, are hereinafter referred to as "the initial regulations," and the loss disallowance regulations issued on November 19, 1990, are referred to as "the revised regulations."

(2) The administrability of a tracing regime is also discussed in the text that follows in connection with the consumption of "wasting assets."

(3) For example, the preamble rejects a gross built-in gain rule on the ground that it would require an acquisition date appraisal; similarly, rates of return for particular industries are presumed too difficult to determine. (1990-51 I.R.B. at 23.)

(4) For example, the subject rightfuly requires consideration whether it should apply in the gain area to prevent the double taxation of gain.