United Dominion: the Supreme Court enters the consolidated return fray.

Earlier this summer, the Supreme Court of the United States issued its first opinion relating to the consolidated return provisions in 67 years. Although narrowly written, the Court's decision in United Dominion Industries v. United States, No. 00-157, 2001 U.S. LEXIS 4124 (June 4, 2001), is likely to be cited by taxpayers and the Internal Revenue Service for years to come.

The specific question before the Court in United Dominion concerned the 10-year carryback rules for product liability losses (PLLs). In an 8-1 opinion, the Court ruled that in a consolidated group, a PLL is calculated on a consolidated (single-entity) basis, not a member-by-member (separate-member) basis. The United Dominion decision may well have implications far beyond those PLL carryback rules.

Background

Section 172 of the Internal Revenue Code allows a corporate taxpayer to carry net operating losses (NOLs) backward or forward. During the years at issue, the general carryback period was three years, but section 172(b)(1)(I) provided a ten-year carryback for PLLs. A PLL was defined as the lesser of the taxpayer's NOL or its deductible product liability expenses (PLEs). Thus, a taxpayer with no NOL could have no PLL, even though the taxpayer incurred PLEs.

Under Treas. Reg. [sections] 1.1502-11, a group's consolidated taxable income (CTI) or consolidated NOL (CNOL) is computed by first adding together the separate taxable incomes (STIs) of each member. STI of a member -- including a case in which deductions exceed income -- is defined under Treas. Reg. [sections] 1.1502-12 as the member's taxable income computed in accordance with the Code, with certain adjustments. The adjustments eliminate items that are determined on a consolidated basis, and modify taxable income to take into account special consolidated return rules. The sum of the STIs is then combined with the items determined on a consolidated basis (e.g., capital gain net income, section 1231 net losses, charitable contribution deductions, dividends received deductions, and section 247 deductions) to compute CTI (or CNOL).

United Dominion was the parent of a consolidated group and reported CNOLs in excess of aggregate PLEs for the years 1983 through 1986. The five group members that generated a substantial portion of the PLEs, however, reported positive STI during each of those same years.

In tax refund claims, United Dominion asserted that it had PLLs for each of those years, calculated by comparing the group's total PLEs against the CNOL. The IRS disallowed the claim, contending that each member's PLE should be compared to that member's STI, determined under Treas. Reg. [sections] 1.1502-12. Since each member with PLEs had positive STI, the refund claims were denied.

The U.S. District Court for the Western District of North Carolina ruled in favor of the taxpayer, concluding that the group's CNOL -- including its product liability losses -- could be carried back to offset the group's earlier year consolidated taxable income. The Fourth Circuit reversed, agreeing with the IRS's conclusion that the single-entity approach of computing a consolidated group's product liability loss was inappropriate. But the Fourth Circuit rejected the IRS's attempt to apply the STI rules for determining each member's separate NOL (SNOL) and instead applied the rules under Treas. Reg. [sections] 1.1502-79A(a)(3) (the predecessor to Treas. Reg. [sections] 1.1502-21(b)(2)) which includes the rules for allocating a portion of the group's CNOL to a member when that member's portion would be carried to a separate return year.

The difference between the STI approach proposed by the IRS and the SNOL employed by the Fourth Circuit is that STI does not take into account each member's contribution to items such as consolidated net capital gain or loss, consolidated section 1231 loss, consolidated charitable contribution deduction, or the consolidated dividends received deduction.

The Fourth Circuit's decision in United Dominion conflicted with the subsequent holding of the Sixth Circuit in Internet Corporation & Subsidiaries v. Commissioner, 209 F. 3d 901 (6th Cir. 2000), rev'g 111 T.C. 294 (1998), relating to specified liability losses (the successor provision to the PLL rule). The Sixth Circuit held that a CNOL may be carried back ten years and may offset the group's consolidated taxable income if, in the loss year, any member of the group incurs the requisite types of expenses, regardless whether that member generates a loss on a separate company basis. To resolve the apparent conflict among the circuits, the Supreme Court granted United Dominion's petition for a writ of certiorari.

The importance of the distinction between the single-entity and separate-member approaches in computing a group's PLL can be demonstrated by the following example:

P, a holding company, has three first-tier subsidiaries
X, Y, and Z. Each member has been part of the P
group since it was formed in 1979 and has never filed
separate year returns. For the 1989 tax year, the P
group had a CNOL of $800 and $600 of PLEs, as
follows:

                                 Separate
                                 [sections]
Member   PLE     Share of CNOL   172(f) Loss

X        $ 100   $ 700           $ 100
Y        $ 200   $ 100           $ 100
Z        $ 300   $   0           $   0
Totals   $ 600   $ 800           $ 200

Using a single-entity approach, the P group would
have incurred a PLL of $600, the lesser of the P
group's CNOL ($800) and product liability expenses
($600). Under the Fourth Circuit's separate-member
approach, the P group would have a $200 PLL, equal
to the aggregate of each member's separate PLL (i.e.,
$100, $100, and $0 for X, Y, and Z, respectively). Thus,
a group's PLL can significantly differ depending on
the approach used.

The Court's Opinion

In an opinion by Justice Souter, the Supreme Court adopted the single-entity approach, finding that neither the Government's nor the Fourth Circuit's method for computing a group's PLL "squares with the notion of comparability as applied to consolidated return regulations." The Court observed that, in the context of consolidated groups, the NOL against which PLEs should be measured is the CNOL, because "the Code and regulations governing affiliated groups of corporations filing consolidated returns provide only one definition of NOL: `consolidated' NOL.... [T]here is no definition of separate NOL for a member of an affiliated group."

The Court rejected (as did the Fourth Circuit) the government's use of STI as an appropriate means for computing a member's PLL and its contention that a group member's STI is analogous to a "separate" NOL. Because of the specific items that are excluded from the calculation of STI, Justice Souter pointed out that "an affiliate's STI will tend to be inflated by eliminating deductions it would have taken if it had filed separately, or deflated by eliminating an income item like capital gain."

Similarly, the Court held that the Fourth Circuit's use of SNOL in computing a member's PLL "fares no better." In a slight overstatement, the Court declared that the regulatory provision defining the SNOL applies only to provide a method to allocate a CNOL to a group member that seeks to carry a loss to a separate return year. Because United Dominion involved the carryback of a CNOL from the consolidated return year to another consolidated return year, the Court concluded that the application of Treas. Reg. [sections] 1.1502-79A was inappropriate.

In describing the inapplicability of the apportionment rule, Justice Souter stated, "Section 1.1502-79[A](a)(3) unbakes the cake for only one reason, and that reason has no application here." While the Court was correct in determining that Treas. Reg. [sections] 1.1502-79A(a)(3) was not applicable in United Dominion, the statement may go too far. Rather than unbaking the cake, the apportionment rule slices the CNOL, retaining the character of the CNOL as determined on a consolidated basis. Additionally, the apportionment rules are applicable for purposes other than determining carrybacks and carryovers of CNOLs to separate return years. For example, apportionment is necessary to determine the amount of absorption of a subsidiary's share of a CNOL for stock basis adjustment purposes.

In arguing against the single-entity approach, the government claimed that such an approach would allow a double deduction to affiliated groups because PLEs are absorbed in computing a member's STI. The Court unimpressed with the government's line of reasoning -noted that STI is simply a step along the way to computing a group's consolidated taxable income or CNOL and "has no other purpose":

   It makes no difference whatsoever whether the affiliate's PLEs are (1)
   first netted against each member's income and then aggregated or (2) first
   aggregated and then netted against the group's combined income: under
   either method, AMCA's CNOL is the same.... There is no more of a double
   deduction with a 10-year carryback than one for three years.

Additionally, the government argued that the single-entity approach was not appropriate because the consolidated return regulations specified certain items to be accounted for on a single-entity basis, but PLEs were not one of those enumerated items. The Court observed that when the consolidated return regulations were first issued, there was no 10-year carryback for PLLs. Furthermore, the Court recognized "[t]he Treasury's relaxed approach to amending its regulations to track Code changes...." Accordingly, the Court concluded that any failure by the Treasury to draft regulations was "more likely a reflection of the Treasury's inattention than any affirmative intention on its part to say anything at all."

Finally, the government asserted that the single-entity approach to PLLs (and now SLLs) will encourage tax avoidance (e.g., by unprofitable companies acquiring profitable companies with PLEs to offset income from prior years). In response, the Court noted that "the separate-member approach is no better (and is perhaps worse) than the single-entity treatment...." The Court explained that the separate-member approach could potentially discourage the transfer of assets between members that should otherwise be transferred or encourage the transfer of assets between members even though such a transfer would otherwise be detrimental, in order to increase the consolidated group's PLL. Additionally, the Court found comfort in the availability of section 269 of the Internal Revenue Code to disallow a deduction that results from an acquisition, the principal purpose of which is the evasion or avoidance of federal income tax. Finally, the Court stated that if the government was truly concerned that section 269 was insufficient to combat any potential abuses, the Treasury could always use its authority under section 1502 to draft consolidated return regulations to curb any anticipated abuses.

The Dissent

Justice Stevens dissented -- not because he found the Code or regulations to clearly support the government's position, but because he found the rules to be ambiguous. He opined that ambiguous provisions that provide for an exception from a general revenue duty, as opposed to the actual revenue-raising provisions, should be resolved in the government's favor. Furthermore, Justice Stevens believed the tax-avoidance opportunity to be a sufficient policy reason to support the government's position. He further stated, "Absent a clear textual anchor, I would credit the Secretary of the Treasury's concerns about the potential for abuse created by the petitioner's reading of the statutory scheme."

In contrast to Justice Stevens's contention that the resolution of ambiguous provisions should be resolved in favor of the tax collector, Justice Thomas, in a concurring opinion, countered that all laws should be resolved against their drafter. On this point, Justice Stevens may have the stronger position because deductions (e.g., section 172(f)) are generally considered a matter of legislative grace and narrowly construed.

In his dissent, Justice Stevens suggests that deference to the Secretary is appropriate in difficult cases when the Secretary voices concern "about the potential for abuse." Such a deference standard clearly proves too much. Tax cases that reach the Supreme Court are, by definition, "difficult" since lower courts have frequently reached conflicting conclusions. If the balance could be tipped simply by the Secretary's expression of concern regarding the potential for abuse, it would be a rare day when a taxpayer could prevail.

Concern over a potential for abuse is particularly misplaced in the context of product liability losses. It does not make business sense for a profitable company to acquire a target with the potential for unlimited product liability simply to garner a tax deduction. That the government would raise the potential for abuse in this context should put the courts on notice that such claims should be closely scrutinized.

Furthermore, even if the Court had decided the case in the government's favor, as Justice Stevens advocated, the potential for abuse would not be abated. A business anticipated to generate PLEs could be acquired by a break-even company that had tax liability in prior years, using a single-member LLC. For tax purposes, a single-member LLC is treated as a division of the owner. The LLC would legally protect the acquirer from excessive losses of the target. For tax purposes, however, the LLC and the acquirer would be a single entity and PLLs could be carried back to prior years of the acquirer. Thus, the separate-member approach to section 172(f) in a consolidated return context would fare no better than a single-entity approach in preventing the alleged abuse potential.

Beyond United Dominion

Given the mechanics of the relevant statutes and regulations, the single-entity approach endorsed by the Court is the appropriate method for computing a consolidated group's PLL. Although the single-entity approach was the desired result for taxpayers in United Dominion, the Court's adoption of the single-entity approach in the context of PLLs potentially has implications for other issues facing consolidated groups (e.g., discharge of indebtedness and attribute reduction under section 108(b)). The Court's decision in United Dominion, however, should not be construed to support a position that the single-entity method should apply in all consolidated return situations. By generally refraining from sweeping statements that could be misapplied in future controversies, the Court succeeded in reaching the correct result without creating too broad a precedent.

LAWRENCE M. AXELROD is a tax partner in the Deloitte & Touche Washington National Tax Group where he leads the firm's consolidated return practice.

JEREMY B. BLANK is a manager in the Deloitte & Touche Washington National Tax Group.

The authors owe thanks to many friends and colleagues for their advice in the preparation of this article.