Rite Aid: potentially historic.

Faster than a speeding bullet, in a single bound, the Rite Aid case (1) has:

* destroyed more than 100 carefully developed paragraphs of Treas. Reg. [section] 1.1502-20, dealing with the disallowance of losses related to consolidated subsidiaries;

* endangered about a dozen other consolidated return provisions; and

* displaced the current judicial deference standard of Chevron with the National Muffler standard.

Rite Aid has the potential to be an historic case -- a Supercase by any standard. This article attempts to sort out the implications and the opportunities.

I. Brief Summary of The Rite Aid Decision

At issue in Rite Aid was whether a $22 million economic loss incurred by the company on the purchase and sale of a failed investment (in the stock of a discount bookstore chain) would be disallowed by the "loss duplication" arm of Treas. Reg. [section] 1.1502-20, the so-called loss disallowance regulations (LDR). Loss duplication, simply put, means that the mere possibility, no matter how remote, that the purchaser of the stock could utilize that same economic loss (in the form of either a net operating loss; carryover or a built-in loss in the assets) requires that the loss economically accruing to the Seller must be disallowed. The Treasury Department of Internal Revenue Service had admitted loss duplication was "another problem," unconnected with section 337 of the Internal Revenue Code, which repealed General Utilities in 1986 to insure a tax on built-in gain at the corporate level.

The Federal Circuit, reversing the Court of Federal Claims, wrote a brief opinion, resting on two points:

A. The consolidated return regulations can only deal with consolidated return problems. No fewer than four times, the Federal Circuit insisted the loss duplication rule went beyond the IRS's delegated power of writing rules which can only fix consolidated return problems:

(i) "[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";

(ii) "Realization of the loss does not stem from filing consolidated returns"....;

(iii) "The loss realized on the sale of a former subsidiary ... is not a problem resulting from the filing of a consolidated return. The scenario also arises where a corporate shareholder sells stock of a non-consolidated subsidiary"; and

(iv) Since section 165 "allows a deduction of losses" from the sale of property, the Court found for the taxpayer since "realization of the loss does not stem from the filing of a consolidated returns."

This concept, one that has never before been articulated so precisely, (2) is sure to bedevil the IRS and Treasury, as well as the consolidated return filer, for years.

B. Distortion of income. In addition, the Federal Court believed Rite Aid's taxable income was distorted, producing a result precisely the opposite of the IRS and Treasury's statutory mandate in section 1502 to provide regulations which clearly reflect tax liability:

   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. (Emphasis added.)

A clean, devastating knockout punch -- Superman could not have done it any better. Arguably, this "distortion" argument was the only rationale necessary.

II. The Government's Swift Decision to Completely Revise Treas. Reg. [section] 1.1502-20

Once it decided not to seek certiorari, the IRS and Treasury took bold, decisive steps. (3) They eliminated the loss duplication arm of LDR (at least for now) and, temporarily, will deal with the G.U. built-in gain problem under the tracing regime of Treas. Reg. [section] 1.337(d)-2, as amended. It has also been conceding pending cases, including Square D Company v. Commissioner, in the Tax Court, Docket No. 6067-97 (a case primarily involving a wasting asset, goodwill), and FPL Group, Inc. v. Commissioner, T.C. Docket Nos. 5271-96, 6653-00, and 10811-00 (involving the disposition of an insurance subsidiary that allegedly was exposed to all three prongs of the loss disallowance rules). Cases in the field also are being dropped at the audit or appeals level (such as a case involving the no netting rules). William Alexander, acting Associate Chief Counsel (Corporate), explained the concessions, as follows: "[T]he three factors [extraordinary gains, positive investment adjustments and loss duplication] are inextricably bound to each other, making defending any one factor difficult." Tax Notes, March 18, 2002, at 1395.

A. Description of Treas. Reg. [section] 1.337(d)-2T

1. Overview. Treas. Reg. [section] 1.337(d)-2, first conceived of as a transition rule prior to the full effect of LDR, will now govern all dispositions or deconsolidations of subsidiaries on or after March 7, 2002. Critically, such rules will also be available for all open prior years on an elective basis.

The basic rule in Temp. Reg. [section] 1.337(d)-2T(a) is overbroad and provides that no loss is allowed for any loss recognized with respect to the disposition of a consolidated subsidiary. To the extent "the taxpayer establishes that the loss or basis is not attributable to the recognition of built-in gain or the disposition of an asset," however, the loss will be allowed -- but only if a separate statement entitled "[section] 1.337(d)-2T(c) statement" is included "with or part of the taxpayer's return in the year of the disposition or deconsolidation." (4) See Temp. Reg. [subsections] 1.337(d)-2T(c)(2) and (3).

The only flesh placed on the "attributable to" bone is the following additional sentence:

   For purposes of this section, gain recognized on the disposition of an
   asset is built-in gain to the extent attributable, directly or indirectly,
   in whole or in part, to any excess of value over basis that is reflected,
   before the disposition of the asset, in the basis of the share, directly or
   indirectly, in whole or in part, after applying section 1503(e) and other
   applicable provisions of the Internal Revenue Code and regulations."
   (Emphasis added.)

"Reflected in basis" and "recognized on the disposition" are important concepts and are discussed in some detail below.

Gone, thankfully, are the overbearing presumptions, such as all post-acquisition earnings being deemed to be built-in gain and all losses deemed to be post-acquisition losses. While the recordkeeping and valuation skills of corporate America will be tested, putting reality back into the tax system is a welcome relief. Query: Will reality include a Cohan-type rule allowing the taxpayer to prevail (with a small haircut) if it appears the taxpayer has satisfied its burden of proof, or will a "clear and convincing" standard be invoked?

The decision to abandon the LDR litigation, swiftly followed by a tracing rule similar to that originally envisioned after the repeal of G.U. (i.e., Notice 87-14), is bold and eminently fair, (5) deserving of a spot in the Tax Policy Hall of Fame.

2. Some specific issues.

(a) Assets with no possibility of a built-in gain. Although not explicit, it seems clear that the following acquisitions should be per se exempt from the new temporary loss disallowance rules: (i) assets acquired after the date of acquiring the member; (ii) assets acquired in a section 338(h)(10) transaction; and (iii)corporations formed with cash or cash equivalents with no built-in gain. For insufficient reasons, all such cases could have been caught by Treas. Reg. [section] 1.1502-20.

(b) Wasting Assets. The LDR trigger is a "disposition" of an asset with a built-in gain. Although the term "disposition" is a tad ambiguous with respect to assets that are consumed (such as goodwill or subscription lists), it seems reasonably clear that an asset that is consumed or wastes away is not covered by the term. Moreover, if this were not intended, there would have been no reason for the IRS and Treasury's request for comments on dealing with the consumption of built-in gain assets. See Hearing Notice on Loss Limitation Rules.

(c) Netting of gains and losses. Built-in gains and losses on hand at the date of acquisition should be netted. That is partially acknowledged in Example 4 in Treas. Reg. [section] 1.337(d)-1, which is entitled "Stacking Rules -- built-in loss offsets built-in gain" and which is adopted by Temp. Reg. [section] 1.337(d)-2T. This example treats NOL carryovers and built-in losses on the same footing. The netting works to eliminate a potential loss disallowance only if both the built-in loss and the built-in gain are recognized prior to the stock disposition.

(d) Reflected in basis. This could be one of the most important aspects of the tracing regime. It suggests that there is a built-in gain issue only to the extent such gain has been paid for and is part of the parent's stock basis. The basic fact pattern calling for loss disallowance is, as follows: Parent pays $100 for T and T has an asset with a $0 basis and $100 value. The theory is that the $100 gain is already reflected in Parent's basis in T, and a realization of that inside gain -- followed by a basis step-up via the investment adjustment rules -- would eliminate that gain from the tax base, the very target of the repeal of G.U.

The reflected-in basis analysis will come into play in many cases, including carryover basis transactions. The current regulations under Treas. Reg. [section] 1.337(d)-1 provide a carryover basis example (Treas. Reg. [section] 1.337(d)-1(a)(5) Ex. 5 "Outside basis partially corresponds to inside basis"), and effectively limits the potential loss disallowance to the amount of the carryover basis, even though the built-in gain of the underlying asset is much greater. This example is incorporated in new Temp. Reg. [section] 1.337(d)-2T.

3. Transition rules. A good deal of the temporary regulation is devoted to transition issues, which will be very briefly covered here. For pre-March 7 periods, new Temp. Reg. [section] 1.1502-20T(i) permits three choices. A taxpayer can:

(i) apply Treas. Reg. [section] 1.1502-20 in its entirety;

(ii) apply Treas. Reg. [section] 1.1502-20 without the loss duplication arm; or

(iii) elect to apply the provisions of Temp. Reg. [section] 1.337(d)-2T.

The regulations preserve the valuable Treas. Reg. [section] 1.1502-20(g) election to reattribute NOLs to the seller to the extent of losses disallowed by LDR (if actually previously made timely), unless the taxpayer elects to use Temp. Reg. [section] 1.337(d)-2T. Further, if the taxpayer elects to use Treas. Reg. [section] 1.1502-20 without the loss duplication arm, the -20(g) election is preserved, except that the reattribution amount has to be reduced for the duplicated losses no longer subject to LDR.

If Temp. Reg. [section] 1.337(d)-2T is elected for prior periods, there is no ability to reattribute NOLs under Treas. Reg. [section] 1.1502-20(g). Thus, the buyer will get an unexpected bonus (more NOLs) and the selling corporation is no longer able to convert a capital loss into an operating loss. Perhaps the IRS and Treasury could be persuaded to reinstitute this sound policy for subsequent years. After all, it falls within the single entity regime.

Elaborate rules are provided to make sure any changes in reattributed losses based on new LDR elections will not result in a permanent loss of benefits, including special rules for section 382 limitation allocations and a special election to waive expiring losses.

B. What Action Needs To Be Taken In Short Run

Taxpayers should consider the following action items in the near future:

1. Taxpayers who obeyed Treas. Reg. [section] 1.1502-20 and failed to claim their economic loss should, of course, file a claim for a refund. Those who are contesting the issue with the IRS should demand the same result as Square D, etc. mentioned above.

2. Those that elected Treas. Reg. [section] 1.1502-20(g) to reattribute NOLs must evaluate their ability to use such NOLs, against the availability of economic losses under the much fairer tracing rules of Temp. Reg. [section] 1.337-2(d)T. In some cases, the Seller and the Buyer may need to renegotiate the Treas. Reg. [section] 1.1502-20(g) election. For example, the Seller may have made a -20(g) election, whereby the Buyer was not entitled to any NOL carryovers. Seller can now offer to make such NOLs available if it chooses to use Temp. Reg. [section] 1.337(d)-2T. Query: Is the Buyer willing to pay for any NOLs?

3. Taxpayers will need to put their best valuation and tracing teams in place. Remember: Taxpayers may be tracing decades of purchases and sales. When Treas. Reg. [section] 1.337-2(d) was first put in place as a transition rule, many suggested tracing relief was needed since tracing for prior years was not expected and may not then have been possible. Similar suggestions can be expected this time around.

C. Future Changes Concerning Wasting Assets, Duplicated Loss and the GAIN SIDE

The Hearing Notice offers important clues about what lies ahead:

The IRS and Treasury are undertaking a study of the various approaches that could be implemented to give full effect to section 337(d) and to reflect the single entity principles of the consolidated return rules. Among the approaches the IRS and Treasury are studying is one that would deny positive investment adjustments for gain recognized and income attributable to the disposition or consumption of built-in gain assets held by the subsidiary at the time it joined the consolidated group. In addition, the IRS and Treasury are considering allowing selling groups to deduct subsidiary stock losses that would otherwise reflect duplicated loss, if the subsidiary reduces its attributes (including net operating loss carryovers and asset basis) immediately prior to the disposition. (Emphasis added.)

One suspects even Yogi Berra would realize wasting assets and loss duplication were the most difficult and contentious issues discussed in 1990, and here we go, 12 years later, starting all over, again. The big difference, however, is that this time the resolution is likely to be far more balanced and hence not subject to obvious elements of invalidity. What follows is some free advice to the IRS and Treasury:

1. Tracing for wasting assets. Some will argue that wasting assets must be traced, otherwise it unfairly favors companies with intangible assets. They are in a position to be acquired with a free pass around the repeal of G.U. (6) Other commentators have argued that tracing of wasting assets is outside the scope of G.U. repeal. (7)

It may be possible to construct a way of tracing the realization of the built-in gain of a wasting asset on a basis which is administratively feasible but not punitive. First, the built-in gain of section 197 intangibles, such as goodwill or customer based intangibles (including customer lists), would have to be valued. That should not be a problem. The residual method under the section 338 regulations is well understood and not difficult to apply. Thus, the amounts attributable to Class VI and Class VII items could be deemed to be wasting assets (until sold).

Next, the government could rely on section 197, a post-LDR development, as a basis for a realization test for the built-in gain related to a wasting asset. One could feel comfortable with the congressionally endorsed annual consumption of 1/15 of the built-in gain attributable to goodwill, etc. To this effect, any positive investment adjustment for the taxable year under Treas. Reg. [section] 1.1502-32 would first be eliminated. (8) Further, the wasting asset realization should be limited to a fixed time period, perhaps 5 to 7 years. If the intangible is still producing income after 5 to 7 years, it is probably because of new values or customers created by the buyer. The five-year period is consistent with section 382.

2. Curtailing duplicated losses. The IRS and Treasury seem inclined to take another bite at the loss duplication issue -- even though the duplication occurs outside the consolidated group. (9) It will no doubt be a very tough sell.

One possible approach would allow the Seller the loss, but eliminate the possibility of loss duplication by a mandatory basis step down or reduction of operating losses that would otherwise carryover in a stock sale. This approach guarantees the loss to the Seller, the correct party, and is far more defensible than the loss duplication rule invalidated by Rite Aid. It is also consistent with a broad construction of the single entity theory that in many cases treats the members as merged. (10) One could argue it also meets the clear reflection standard of Rite Aid.

On the other hand, if the economic loss can be obtained only by effectively making the equivalent of a section 338(h)(10) election, are we back to Rite Aid since that is not the separate return rule? Two differences might separate the approaches. Arguably, mandatorily eliminating the future losses to the Buyer (as the price for allowing the Seller to claim a loss) is not very different than the ability of a Seller to unilaterally retain operating losses to the extent of stock losses disallowed under Treas. Reg. [section] 1.1502-20(g) -- which no one disputes. Extending the NOL reduction to a basis step-down is a short step, since section 382 of the Code and the consolidated return regulations (Treas. Reg. [section] 1.1502-15) place a built-in loss on the same footing as a NOL. For historical precedent, note that before 1942, the consolidated return regulations allocated the entire consolidated loss to the parent, even if the subsidiary that incurred the loss left the group. See Treas. Reg. 78, art. 41.

Another significant difference is that, unlike a section 338 (h)(10) election, the Seller presumably would be able to deduct its stock basis, which often exceeds asset basis, thus ensuring the Seller's ability to obtain its full economic loss, a defect in a mandatory section 338(h)(10) regime.

Since the specter of a second failed attempt to stop duplicated losses administratively is highly undesirable, the IRS and Treasury would be wise to take their case to Congress.

3. Adjustments for The GAIN SIDE. (Yes, you read it correctly). In perhaps the biggest surprise, the Hearing Notice suggests the IRS will no longer voluntarily limit itself to the loss side. Even if the taxpayer has a gain on the sale of a subsidiary, built-in gains reflected in stock basis will have to be pulled out of basis in computing the gain on the sale. There is little doubt this is what Congress intended. (11) Presumably, generous transition rules, caps, time limitations, etc., will be applied to render the rule administrable.

III. Other Vulnerable Consolidated Return Provisions

It is possible that a number of other consolidated return rules are vulnerable to a charge of invalidity under Rite Aid. It all depends on two factors. First, whether other courts will run with the concept of "if it's a separate return problem, a different result for those filing consolidated returns is inappropriate." Under that approach, a dozen or so sections could be vulnerable. Herein follows a catalogue culled in part from some of the commentators: (12)

* Disallowance of loss on sale of parent stock under Treas. Reg. [section] 1.1502-13(f)(6).

* The non-application of [section] 108(a) upon cancellation of indebtedness of an insolvent member's debt by another member under Treas. Reg. [section] 1.1502-13(g).

* The required carryover of member's accounting method in a section 351 transaction under Treas. Reg. [section] 1.1502-17(c).

* The excess loss account created in triangular reorganization if target's liabilities exceed basis of assets under Treas. Reg. [section] 1.1502-30; rule is contrary to Treas. Reg. [section] 1.358-6 if separate returns are filed.

* Determining the basis in stock of a former parent by reference to net asset basis under Treas. Reg. [section] 1.1502-31; rule is contrary to section 362(b). Also, Treas. Reg. [section] 1.1502-31 mandated the creation of E&P to a newly formed holding company.

* Eliminating sections 304, 357(c), 165(e)(5), and 1031 for transactions between members of a consolidated group under Treas. Reg. [subsections] 1.1502-80(a), (d), (e), and (f).

* A negative basis adjustment under Treas. Reg. [section] 1.1502-32(b)(3)(ii) for certain expiring NOLs.

* Deferring the normal section 165 date of worthlessness.

Notice 2002-11 indicates the IRS will resist any further erosion of the consolidated return regulations:

   It is the Service's position that the Rite Aid opinion implicates only the
   loss duplication aspect of the loss disallowance regulation and that the
   authority to prescribe consolidated return regulations conferred on the
   Secretary is limited only by the requirement that the Secretary, in his
   discretion, has determined such rules are necessary clearly to reflect
   consolidated tax liability.

The vulnerability of the above-mentioned regulations may be lessened if courts limit Rite Aid to provisions that distort economic income, regardless of a comparison to separate filers. (13) Moreover, a court may be persuaded to ignore a strict comparison to separate return filing. Such a rule proves too much. Separate return filers -- but not those filing a consolidated return -- can currently create a gain on an intercompany sale to offset an expiring loss. Are the current deferral rules invalid? Of course not.

A better approach is that a rule is valid if it is consistent with an expanded notion of the single entity theory, i.e., what would the result be if the entities were deemed to have merged. Although "single entity," is the cornerstone of most of the basic consolidated return rules, such as the loss offset privilege, and was the sine qua non of the delegation of authority from Congress (14), it must be recognized that consolidation is a hybrid, and the default rule ordinarily is separate entity. (15) Nonetheless, one could argue that while not obligated to impose a single entity regime, the regulation writer has that power if it so chooses -- provided economic income is not distorted. Indeed, the Supreme Court in United Dominion Industries Inc. v. United States, 532 U.S. 822, 838 (2001), has given the IRS and Treasury wide berth when it comes to choosing between single and separate entity theories:

   And finally, if the Government were to conclude that section 269 provided
   too little protection and that it simply could not live with the
   single-entity approach, the Treasury could exercise the authority provided
   by the Code, 26 U.S.C. section 1502, and amend the consolidated return
   regulations.

The Rite Aid result is consistent with a single entity result since, if all the assets were merged into a single corporation and the assets of the division sold, Rite Aid would be entitled to a loss. On the other hand, some of the above listed regulations cannot be reconciled with the expanded single entity theory and are vulnerable.

The second variable is how much deference will be accorded the consolidated regulations. Notice 2000-11 suggests a degree of deference (valid as long as "in his discretion" the rule is necessary to clearly reflect income) that is far too broad and should be rejected by the courts. The deference variable is discussed below.

IV. Reexamination of Judicial Deference Standard of Chevron

The courts have a lot of work ahead in applying the judicial deference concept to tax cases. In recent years, courts in tax cases generally have applied the two-step Chevron formula. In 1984, the Supreme Court in Chevron U.S.A., Inc., v. Natural Resources Defense Council Inc. 467 U.S. 837, 842-43 (1984), validated the EPA's interpretation of the Clean Air Act pursuant to a two-step procedure which has since often led courts to giving the regulations promulgated by a governmental agency significant -- indeed often controlling -- power to decide what Congress intended. The formula is, as follows:

Step 1: No deference - the court decides the law without regard to the regulations

"First, always, is the question whether Congress has directly spoken to the precise question at issue. If the intent of Congress is clear, that is the end of the matter; for the court, as well as the agency, must give effect to the unambiguously expressed intent of Congress."

Step 2: Strong deference to regulations

"If, however, the court determines Congress has not directly addressed the precise question at issue, the court does not simply impose its own construction on the statute, as would be necessary in the absence of an administrative interpretation. "Rather, if the statute is silent or ambiguous with respect to the specific issue, the question for the court is whether the agency's answer is based on a permissible [reasonable] construction of the statute." (Emphasis added.)

The government has a vested interest in a truncated step one analysis that affords quick access to step two since under step two the Commissioner is given the "choice among reasonable interpretations," and this can be deadly for taxpayers.

As discussed below, Rite Aid suggests a different standard -- the traditional tax standard imbedded in National Muffler. (16)

A. Chevron v. National Muffler

The Federal Circuit did not apply the Chevron deference formula. In fact, it barely mentioned Chevron and made no substantive use of it. Rather it cited and relied on Rowan Cos., Inc. v. United States, 452 U.S. 247, 253 (1981), for the proposition that a regulation is contrary to the statute if "it is outside the scope of authority delegated under the statute." Rowan in turn relies heavily on National Muffler, quoting this basic deference test from National Muffler:

   In determining whether a particular regulation carries out the
   congressional mandate in a proper manner, we look to see whether the
   regulation harmonizes with the plain language of the statute, its origin,
   and its purpose.

Rite Aid is by no means the only case with qualms about applying Chevron in tax cases. Recently, the full Tax Court in a 16-0 decision, in Walton v. Commissioner, 115 T.C. 589 (2000), invalidated a Treasury regulation. The court expressed confusion on whether Chevron or National Muffler (which it called the "traditional standard") controls, and proceeded to analyze the case without regard to the Chevron formula. The confusion of the Tax Court and the Circuit Courts was best articulated by Judge Tannenwald in Central Pennsylvania Savings Association v. Commissioner, 104 T.C. 384, 391-92 (1995):

   Chevron has had a checkered career in the tax arena. Thus, the Court of
   Appeals for the Ninth Circuit, in deciding Pacific First Federal Savings
   Bank v. Commissioner, 961 F.2d at 803, found it unnecessary to choose
   between Chevron and National Muffler, and relied on the National Muffler
   traditional standard of review. In Bell Federal, the Court of Appeals for
   the Seventh Circuit approved the Court of Appeals for the Ninth Circuit's
   reliance on National Muffler, and described the difference between the
   Chevron standard and the National Muffler standard as "negligible at best
   -- any regulation which is `based upon a permissible construction' of an
   ambiguous statute will almost always `implement the congressional mandate
   in some reasonable manner' and vice versa." See Bell Federal Savings & Loan
   Association v. Commissioner, 40 F.3d at 227. Beyond these differences, the
   Supreme Court, as well as other courts, has been inconsistent in applying
   Chevron and National Muffler, often ignoring one case and relying on the
   other. Indeed, there has even been a question as to whether Chevron applies
   to interpretive regulations. See E.I. duPont de Nemours & Co. v.
   Commissioner, 41 F.3d 130 (3d Cir. 1994), affg, 102 T.C. 1 (1994).
   (Emphasis added.)

Judge Tannenwald believed there were only "practical" or "possibly subtle differences" in the two approaches. The Rite Aid case and other recent tax cases suggest the difference can be enormous. As stated by the Fifth Circuit: "Even if we should harbor substantial doubts about whether Congress intended this result ... our review is shackled by the [Chevron] standard heretofore explained." Snap-Drape, Inc. v. Commissioner, 98 F.3d 194, 201 (5th Cir. 1996), cert. denied, 522 U.S. 821 (1997) (emphasis added).

Post-Chevron, two Supreme Court cases have examined the validity of an IRS regulation. Cottage Savings (17) mentions only National Muffler, and Atlantic Mutual (18) relies on Chevron and National Muffler (by citing Cottage Savings).

Under National Muffler, the IRS obtains deference only if its regulation "(i) bears a fair relationship to the language of the statute, (ii) reflects the views of those who sought its enactment, and (iii) matches the purpose they articulated." Thus, National Muffler clearly requires a thorough review of what Congress intended, with no need to find whether Congress "directly spoke to the precise question" in issue. That is what the Federal Circuit did.

It would be appropriate for the Supreme Court to resolve the ambiguity. As explained in the next section, the IRS and Treasury wanted to give the Court the opportunity since they perceived a split ub the circuits. (19)

B. Split in Circuits?

The Sixth Circuit in Nichols (20) recently upheld a regulation dealing with life/nonlife consolidation. The difference in result in Nichols and Rite Aid is, in large part, owing to the different approaches the courts of appeals utilized in applying the deference concept. In Nichols, the Sixth Circuit applied a narrow Chevron approach in Step One, holding Congress had not directly spoken to the precise question at issue: "Because Plaintiff has failed to point to any language in the statute that expressly allows a carryback against nonlife income we apply the Chevron rule of deference."

Conversely, as previously mentioned, in Rite-Aid the Federal Circuit barely mentioned Chevron and never analyzed the "precise question" formula under Step One.

The government is extremely unhappy with the judicial deference approach taken in the Federal Circuit. In its petition for rehearing (which was denied), the government urged the Federal Circuit to adhere to the Chevron formula as specified by the Sixth Circuit in Nichols:

And it is clear that Section 165 does not speak directly to the precise question of loss recognition by consolidated return filers upon the sale of subsidiary stock, just as the Nichols court properly concluded that Section 172 does not speak directly to the precise question of loss carrybacks for consolidated return filers. Since there is no statutory provision addressing the precise question presented by the duplicated loss rule in the consolidated return context, the Court should have considered whether there was a reasonable connection between the regulation and the Secretary's authority under Section 1502. (Emphasis added.)

This approach, which would make virtually every consolidated return case a Step Two case would rob the judiciary of its right to determine what the law is based on the structure of the Code, the intention of Congress, etc. since the Code normally only deals with separate corporations which file separate returns. One should expect the government to continue to pursue its plea for the extremely generous deference approach it failed to obtain in Rite Aid.

V. Conclusion

Oklahoma! has returned to Broadway, proclaiming, "Oh what a beautiful morning.... There's a bright golden haze on the meadow...." The same lyrics can now be sung by those that previously have been unnerved by the overreaching rules of LDR and the judicial deference approach under Chevron. It is noteworthy that the new production of Oklahoma! has some dark overtones, akin to the potential changes promised by the IRS and Treasury. But right now --everyone should congratulate Supercase and the decision makers at the IRS and Treasury and enjoy the beautiful morning.

(1) Rite Aid Corp. v. United States, 255 F.3d 1357 (Fed. Cir.), rehearing denied, 2001 U.S. App. LEXIS 2307 (Fed. Cir. Oct. 3, 2001).

(2) The closest authority cited by the Federal Circuit is a prior decision of the Court of Claims, American Standard, Inc. v. United States, 109 F.2d 256, 261 (Ct. Cl. 1979), where the court, without citing any authority, said section 1502 grants the Secretary "the power to conform the applicable income tax law of the Code to the special, myriad problems resulting from the filing of consolidated ... returns."

(3) See Notice 2002-11, issued February 1, 2002, followed by proposed and temporary regulations (T.D. 8494) under an amended Temp. Reg. [section] 1.337(d)-2T and Temp. Reg. [section] 1.1502-20T(i), issued March 8, 2002.

(4) Presumably, this means the original return of the taxpayer. This is how Treas. Reg. [section] 1.1502-20(c), dealing with allowable losses under LDR, has been interpreted. The IRS, however, has issued a number of rulings allowing extensions of time under Treas. Reg. [section] 1.9100.

(5) Consistent with the more equitable approach, Temp. Reg. [section] 1.337(d)-2T applies even it' less than all of the stock of the subsidiary is sold (unlike the prior regulation).

(6) The Preamble to the proposed LDR regulations explained the problem this way: "The problem is not limited to dispositions of built-in gain assets, but also arises when built-in gain assets are consumed."

   Example 3. The facts are the same as in Example 2, except that S uses the
   asset in business operations rather than selling it. The asset earns $20
   and declines in value by $20 in each year over a 5-year period. As in
   Example 2, P's basis in the stock of S is increased by the earnings to
   $200, but the value of S remains $100 and P may recognize a loss of $100 if
   P sells the S stock.

   ... [D]isallowing P's $100 loss eliminates the possibility that investment
   adjustments caused by S's recognition of built-in gain, whether from
   dispositions or operations, will result in elimination of the gain.
   Disallowing P's loss therefore gives effect to General Utilities repeal by
   assuring that a corporate-level tax will be imposed on S's recognized
   built-in gain.

(7) "TEI Wants Limited Built-In gain Recognition in Loss Disallowance Rules," Highlights & Documents, February 12, 1991, at 1510.

(8) The IRS and Treasury could also consider making the presumption rebuttable under a clear and convincing standard. For example, the taxpayer should be allowed to argue that virtually every customer on the acquired customer list was still a customer. Not an easy argument for those that used to embrace the opposite argument pre-section 197. See, e.g., Newark Morning Ledger Co. v. United States, 507 U.S. 546 (1993).

(9) See Notice 2002-18, which curtails duplicated losses within the consolidated group. This approach seems quite reasonable in light of Ilfeld v. Hernandez, 292 U.S. 62 (1934) (rejecting a double loss within the group without the assistance of a supporting regulation), and the elimination of certain duplicated losses by related parties in 1986 (see I.R.C. [subsections] 336(d) and 382(g)(4)(D)).

(10) See Salomon Inc. v. United States, 976 F.2d 837, 843 (2d Cir. 1992): "The Code treats consolidated return filers as a single entity principally because it assumes that, contrary to the technicalities of corporate form, they actually function as one unit." (Emphasis added.) Other recent cases confirming the single entity doctrine without benefit of a regulation include H. Enterprises Int'l, Inc. v. Commissioner, 105 T.C. 71 (1995) (I.R.C. [subsection] 246A and 265(c)(2) applied to the consolidated group as a whole), and Bowater Inc. v. Commissioner, 69 T.C.M. 2382 (1995) (business purpose determined by looking to entire group).

(11) See Irving Salem, "It's Time to Creatively Deconstruct LDR," Tax Notes, November 19, 2001, at 1111.

(12) See Kevin Duvall and James Warner, "Loss Disallowance Rules In A Post-Rite Aid World," Mergers and Acquisitions, December 12, 2001, at 13.

(13) The IRS and Treasury might argue that "consolidated issues only" limitation on the regulation writer, while persuasive to the Federal Circuit, should be viewed as obiter dictum, which Black's Law Dictionary defines, as follows: "a judicial comment made during the course of delivering a judicial opinion, but one that is unnecessary to the decision in the case and therefore not precedential (though it may be considered persuasive)."

(14) "The failure to recognize the entire business enterprise means drawing technical legal distinctions, as contrasted with the recognition of actual facts. The mere fact that by legal faction several corporations owned by the same stockholders are separate entities should not obscure the fact that they are in reality one and the same business owned by the same individuals and operated as a unit." S. Rep. No. 960, 70th Cong., 1st Sess. 29 (1928).

(15) See Treas. Reg. [section] 1.1502-80 and, e.g., Rev. Rul. 74-10, 1974-1 C.B. 251 (arm's-length coal lease between members of a group results in normal separate return treatment, including application of the capital gain provisions of section 631(c) to seller and ordinary deductions for royalties paid by purchaser).

(16) National Muffler Dealers Association v. United States, 440 U.S. 472, 488 (1979).

(17) Cottage Savings Ass'n v. Commissioner, 499 U.S. 554 (1991).

(18) Atlantic Mutual Ins. Co. v. Commissioner, 523 U.S. 382 (1998).

(19) For a very recent example of the confusion, note the majority opinion in Square D Co. v. Commissioner, 118 T.C. No. 15 (March 27, 2002), relied exclusively on Chevron in upholding the validity of Treas. Reg. [section] 1.267(a); a five judge dissent cited only Rite Aid in concluding that such regulations were invalid. Considering the confusion following the Supreme Court's decision in United States v. Mead Corp., 131 S. Ct. 2164 (2001), relating to deference for agency rulings, it may take Congress to clarify the proper judicial deference standard in tax matters.

(20) Nichols v. United States, 260 F.3d 632 (6th Cir. 2001).

IRVING SALEM is a partner in the law firm of Latham & Watkins, and practices in the firm's New York and Washington offices. He was formerly technical assistant to the Chief Counsel of the Internal Revenue Service and also served on the staff of the Treasury Department's Office of Tax Legislative Counsel. Mr. Salem is a frequent contributor to The Tax Executive, and has participated in numerous TEI meetings at the chapter and Institute level.