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Applying attribute reduction under Sec. 108(b) in a consolidated group.

In United Dominion Industries, Inc., 532 US 822 (2001), rev'g 208 F3d 452 (4th Cir. 2000), the Supreme Court held that in a consolidated group, a product liability loss (PLL) is calculated on a consolidated (single-entity) basis, not a separate-member (member-by-member) basis, as the government argued. Although the taxpayers prevailed, the Court's adoption of that approach may have implications for other issues facing consolidated groups, such as the Sec. 108(b) attribute reduction that results from the exclusion of cancellation of debt (COD) income when a member is insolvent or in bankruptcy. Specifically, in determining a group member's attributes to be reduced, the issue becomes whether the member-by-member or the single-entity approach applies.


Sec. 108(b) attribute reduction. Sec. 61(a)(12) ordinarily requires a taxpayer to include COD income in gross income. However, Sec. 108(a) excludes COD income to the extent of an insolvency (if applicable), or entirely when the discharge occurs in a Title 11 case (i.e., pursuant to a bankruptcy plan). However, under Sec. 108(b), the taxpayer must then reduce its tax attributes (e.g., loss carryovers, credits and property basis) to the extent of the exclusion.

Tax attributes are reduced under Sec. 108(b) to the extent of the debt discharge excluded from income under Sec. 108(a)(1); taxable income generally -s not created if that amount exceeds the taxpayer's attributes available for reduction; see S. Rep't No. 96-1035, 96th Cong., 2d Sess. 14 (1980) ("Senate Report"). Stated differently, once all the attributes are reduced, no further action is required; the remaining amount of excluded debt discharge is disregarded. However, if the excluded COD exceeds a subsidiary's attributes, and the owning member has an excess loss account (ELA) as to the subsidiary's stock, the member must include the ELA in income under Regs. Sec. 1.1502-19(c)(1)(iii)(B).

Under Sec. 108(b)(2), a taxpayer's tax attributes are reduced in the following order:

1. Net operating losses (NOLs);

2. General business credits;

3. Minimum tax credits;

4. Capital-loss carryovers;

5. Property basis;

6. Passive activity loss and credit carry-overs; and

7. Foreign tax credit carryovers.

A taxpayer may elect under Sec. 108(b)(5) to reduce the basis of depreciable assets before reducing other attributes. Additional rules for asset-basis reductions are provided in Sec. 1017.

United Dominion. The Supreme Court held in United Dominion that a consolidated group's 10-year carryback of PLLs is computed on a single-entity basis, not by segregating such losses on a company-by-company, separate-member basis. It found there was no definition of a separate NOL for a member of an affiliated group and rejected the Fourth Circuit's attempt to apply the apportionment rules under former Regs. Sec. 1.1502-79(a) (3) (the predecessor to Regs. Sec. 1.1502-21(b)(2)(iv)), in determining one. In describing the inapplicability of the apportionment rules, the Court stated, "Section 1.1502-79(a) (3) unbakes the cake for only one reason, and that reason has no application here. "Actually, as is discussed later, the apportionment rules slice the cake for reasons that did not apply in United Dominion.

Although the Court correctly determined that the apportionment rules did not apply, it was an overstatement to maintain that they exist for only one-reason. For example, apportionment is necessary to determine a subsidiary's share of a consolidated NOL (CNOL) for stock-basis-adjustment purposes; see Regs. Sec. 1.1502-32. The allocation is based on the CNOL multiplied by a fraction, the numerator of which is the separate NOL of such corporation; the denominator is the sum of the separate NOLs of all group members with losses; see Regs. Sec. 1.1502-21.When considering carrybacks and carryovers, the apportionment rules apply only if the loss would be carried over to a separate return year, a condition not present in United Dominion.

United Dominion's effect. The appropriate use of the apportionment rules is significant to the application of Sec. 108 to consolidated groups. Although the amount of a group's CNOL attributable to a member may be easily determined under Regs. Sec. 1.1502-21, United Dominion creates uncertainty as to the appropriateness of the regulation's application when not determining separate-return-year carrybacks and carryovers. Applying the regulation beyond separate return years, however, is critical to a member-by-member application of Sec. 108. Without a proper determination of a member's share of the CNOL, the reduction of its separate attributes under Sec. 108 would be impossible.

Accordingly, at first glance, the Court's adoption of the single-entity approach to PLLs appears to support that approach to the application of Sec. 108 to consolidated returns. However, on closer examination, the United Dominion reasoning should not apply to Sec. 108(b) attribute reduction; that section should be applied on a member-by-member basis.

Application to Sec. 108(b)

Similar to the issues raised in United Dominion, a debate rages as to whether Sec. 108(b) attribute reduction applies on a separate-member or a single-entity basis. It is significant in determining whether a consolidated group must reduce its CNOL as the debtor member's tax attribute, even if no portion (or only a small portion) of the CNOL is attributable to the debtor member who realized the excluded COD income.

Sec. 108(b) refers to the reduction of the taxpayer's tax attributes; no guidance is contained in the Code, the regulations or court opinions. Treasury has been aware of this issue since the mid-1990s. When the intercompany-transaction regulations were made final in 1995, the package included Regs. Sec. 1.108-3, which provided that any loss or deduction not yet taken into account under Sec. 267(f) or Regs. Sec. 1.1502-13, "is treated as basis described in section 108(b) that the transferor retains in property." The preamble to the proposed regulations, issued in 1994, stated, "[s]everal issues regarding the application of section 108 to consolidated groups are under study. For example, single entity treatment for consolidated group attribute reduction under section 108(b) is being considered in connection with regulations being developed."

In determining the proper approach, two issues must be resolved:

1. Whether the term taxpayer refers to the member or the consolidated group for Sec. 108(b) purposes; and

2. If the taxpayer is the separate member, what are its attributes?

Who is the taxpayer? Sec. 108(b) refers to the reduction of the taxpayer's tax attributes. In some consolidated-return contexts, the taxpayer, not the group, is the separate member; see, e.g., Insilco Corp., 73 TC 589 (1979), aff 'd, 2d Cir., 1981; Specialty Restaurants Corp., TC Memo 1992-221; Letter Ruling (TAM) 9725004. In others, the taxpayer is the group; see, e.g., H. Enterprises Int'l, 183 F3d 907 (8th Cir. 1999), aff'g TC Memo 1998-97.

There are two important justifications for treating a member (not the consolidated group) as the taxpayer. First, an individual group member can enter into bankruptcy without the entire group doing so. Similarly, insolvency is that of the debtor member's assets and liabilities, not the consolidated group's. Second, the Sec. 108 legislative history uses the terms debtor and taxpayer interchangeably; see the Bankruptcy Tax Act of 1980; H. Rep't No. 96-833, 96th Cong., 2d Sess. (1980); and the Senate Report. In one example, the Senate Report parenthetically defines the debtor as the subsidiary; see Senate Report at 20, note 23. Accordingly, it appears that for Sec. 108(b) purposes, the taxpayer should be the single member, not the consolidated group.

Member-by-member or single entity? In support of a member-by-member approach, the Service has issued two letter rulings, in which (1) for Sec. 108(b) purposes, a determination of whether a taxpayer is insolvent or in a Title 11 case is made on a member-by-member basis; and (2) attribute reduction occurs on a member-by-member basis; see Letter Rulings 9121017 and 9650019.

However, starting in 1998, the Service adopted a single-entity approach, at least for NOL reductions under Sec. 108(b). In Field Service Advice (FSA) 199912007, it concluded that a CNOL was a reducible tax attribute for a debtor subsidiary, even though no portion of it was attributable to the member having the excluded income.

The IRS relied on the fact that Regs. Sec. 1.1502-6 expressly provides that each group member is severally liable for the group's tax. Additionally, under Regs. Sec. 1.1502-11 (a) (2) and -21, the only NOL that any group member has that can reduce the group's tax liability for a carryback or carryover year is the CNOL. Because each member is liable for the consolidated tax, a CNOL deduction reduces the tax liability of every group member, regardless to which member the CNOL is attributable.

Further, the Service stated that the part of the CNOL attributable to a member is not apportioned to the member for the carryback year, unless a special rule (such as Regs. Sec. 1.1502-79 (a)(3), the predecessor to Regs. Sec. 1.1502-21 (b) (2) (iv), which relates to carryovers and carrybacks of CNOLs to separate return years) provides for such apportionment. As the CNOL is a tax attribute potentially usable by every group member, the IRS concluded that, under Sec. 108(b), it could reduce the group's CNOL, even if the insolvency generated no portion of it.

The Court's decision in United Dominion, which adopted the single-entity method as to the application of the 10-year NOL carryback rules, could be read to support a single-entity approach in all consolidated return situations, including the Service's position on Sec. 108(b) attribute reduction. Such a broad reading of the Court's opinion, however, is not justified. As the consolidated return regulations demonstrate, a consolidated group may be treated as a single entity for some purposes and as a collection of separate corporations for others.

United Dominion presented a narrow question on the proper application of the 10-year NOL carryback rules under Sec. 172 for consolidated returns; the Court avoided making any general statements that could be read as supporting the single-entity method for al] future consolidated return controversies.

The majority's analysis rests heavily on the statute's literal language and on the consolidated return regulations on CNOLs. The court stated that the CNOL apportionment rules apply "for only one reason" and that reason had no application to the facts in United Dominion. Rather, the rules allocate the CNOL to members that generated a loss, taking into account each member's items of income, gain, deduction or loss, reflected in the computation of consolidated taxable income for the year. The allocation formula does not delve into the character of the gains or losses that each member contributed to the resulting CNOL.

When considering carrybacks and carryovers, the apportionment rules apply only if the loss would be carried to a separate return year, a condition not present in United Dominion. The Court's careful exploration of the two proxies for a "separate NOL" suggests that the resolution of future cases (including any controversy involving consolidated attribute reduction under Sec. 108(b)) would greatly depend on the wording of the applicable statute and relevant regulations (and, perhaps, on the legislative history).

Perhaps the most persuasive argument in support of the member-by-member approach is that Sec. 108(a)(1)(A) and (B) intend to exclude discharged COD income to the extent the taxpayer is in bankruptcy or is insolvent. Often, one group member is in bankruptcy, but others are not. Similarly, insolvency is based on the debtor member's assets and liabilities, not the consolidated group's.

Sec. 1017. Alternatively, support for a member-by-member approach can be found in Sec. 1017. Under Sec. 108(b)(5), a taxpayer may first elect to reduce its aggregate adjusted basis of depreciable property under Sec. 1017. Sec. 1017(b)(3)(D) provides that a higher-tier member could treat the stock of a lower-tier member as depreciable property for this purpose if the latter consents to a corresponding reduction in the basis of its depreciable property. Absent an election, only the depreciable assets held directly by the debtor member are subject to basis reduction. It is difficult to reconcile the single-entity approach with this election, which ostensibly would not be necessary if Sec. 108(b) applied on a single-entity basis in the consolidated context.

However, reliance on Sec. 1017(b)(3)(D) to support the member-by-member approach for the reduction of attributes may be challenged. Specifically, the basis in a depreciable asset is a member's separate attribute; a CNOL can offset income of any group member; thus, it may be deemed to be an attribute of every group member.

Nevertheless, there appears to be no policy justification to treat depreciable assets differently from NOLs for purposes of Sec. 108(b) attribute reduction. A depreciable asset ordinarily produce future depreciation expense and, potentially, future NOLs. Thus, arguably, the differences between a depreciable asset and an NOL could largely be due to timing.

The analysis of the Sec. 1017 (b) (3) (D) election is particularly important, because it is directly cross-referenced in Sec. 108(b). When combined with the fact that for Sec. 108(a) purposes, insolvency or a Title 11 determination is made on a member-by-member basis and the Service's prior rulings apply the member-by-member approach, it is difficult to argue that Sec. 108(b) attribute reduction, as it relates to NOLs, should be made based on a single-group approach. The better view appears to be that such attribute reduction (including NOLs) should be made on a member-by-member basis. If such an approach is used, an allocation of the CNOL attributable to the member to which Sec. 108(b) applies under Regs. Sec. 1.1502-21 (b)(2)(iv) (allocation of a CNOL for losses carried to separate return years) is appropriate.

ELAs. Congress's intent to defer recognition of COD income is preserved in the consolidated group setting by Regs. Sec. 1.1502-19(c)(1)(iii)(B). Specifically, to the extent that excluded COD income does not reduce a debtor's NOLs (regardless of how computed), capital losses or asset bases, the COD would not be treated as tax-exempt income under the Regs. Sec. 1.1502-32(b)(3) investment adjustment rules and the COD event would trigger any ELA as to the debtor's stock, under Regs. Sec. 1.1502-19 (c)(1)(iii)(B).

Example: In Year 1, P incurs a $90 loss, R, a wholly owned P subsidiary, incurs a $10 loss, and G, another wholly owned subsidiary, generates $20 income. No part of the group's $80 CNOL can be carried back. P's basis in its R stock is reduced by $2 (i.e., $2 of R's loss is absorbed by the group to offset G's income.) Thus, there is an $80 CNOL carryover, of which $8 is attributable to R ($80 x ($10/$100)). In the beginning of Year 2, R becomes insolvent and its outside lender cancels $30 of debt. The group incurs another CNOL for the year, none of which is attributable to R.

Under the member-by-member approach, the only NOL carryover reduced is the $8 portion of the CNOL attributable to R; other R attributes (including its basis in property) would be reduced. If R did not have sufficient attributes to cover the $30 COD, no further attributes would be reduced. To the extent that the excluded COD did not reduce R's NOLs, capital losses or asset bases, it would not be treated as tax-exempt income under Regs. Sec. 1.1502-32 (b)(3)(ii)(C)(1). If P had an ELA as to R stock, and R had $1 of COD not treated as tax-exempt income, the entire ELA would be included in income under Regs. Sec. 1.1502-19 (c)(1)(iii)(B). The ELA recovery rule protects the IRS's interest. If, however, the debtor member is the group's common parent, the result is different (i.e., by definition, there can be no ELA as to its stock). However, P would still be required to reduce its own attributes (including, potentially, the basis in its subsidiaries' stock).

Even when P is the debtor, if the objective of Sec. 108(b) is simply to postpone income, arguably the member-by-member approach accomplishes that objective through the reduction of P's basis in its subsidiaries' stock. The preservation of the subsidiaries' portion of the CNOL carryover would allow the group to offset future income with that loss carryover, at the cost of creating an ELA on that stock at that time. The Service, of course, would argue that an ELA can be eliminated by liquidation or its recognition postponed indefinitely to support its case for single-entity treatment.

Note: the potential for abuse under a single-entity approach to Sec. 108(b) attribute reduction fares no better than the member-by-member approach. For example, what would be the stock-basis implications if one member's NOLs were reduced when another member's income was excluded under Sec. 108(a)? A member owning stock in a debtor with excluded COD income could increase its adjusted basis in the debtor's stock under Regs. Sec. 1.1502-32 (b)(3)(ii)(C)(stock-basis increase for items equivalent to tax-exempt income).

A different member owning stock in a subsidiary that had its share of the CNOL reduced would be required to reduce its basis in that subsidiary's stock under Regs. Sec. 1.1502-32 (b)(3) (iii) (A) (stock basis for items equivalent to noncapital, nondeductible expenses). Although the total amount of stock basis in the group would remain the same, basis would shift from the loss member's chain to the debtor member's chain.

Further, Regs. Sec. 1.1502-32 (b)(5)(ii), Example 4(c), strongly implies that after a subsidary's share of the group's CNOL is reduced, "[n]o other attributes are reduced." The example does not specify (and it cannot be determined from the limited facts) how the subsidiary determines its NOL share. If the government wanted to adopt a single-entity approach, it might need to amend the regulations.

Tax-sharing agreements. Finally, applying attribute reduction on a consolidated basis raises numerous collateral questions under tax-sharing agreements. Does a member with debt forgiveness have to compensate the member whose attributes were scaled back? Would a claim for payment under the tax-sharing agreement have preference over that of ah outside creditor? Such issues, for which no guidance currently exists, would need to be addressed if Sec. 108(b) attribute reduction were to be applied on a single-entity basis.


The beauty of the Court's opinion in United Dominion is that it did not expand its analysis beyond the narrow question presented. While adopting the single-entity approach endorsed by the taxpayer for the 10-year carryback rules, it refrained from making any general statements that could be interpreted to support a blanket adoption of the single-entity method in every consolidated return context. As a result, despite the strong language endorsing the single-entity method in United Dominion, taxpayers should be able to use the member-by-member approach in applying Sec. 108(b) to a consolidated group.

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Author:Sair, Edward A.
Publication:The Tax Adviser
Date:Mar 1, 2003
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