Rite Aid precipitates issuance of prop. and temp. regs.
LDR and the Rite Aid Decision
The LDR generally applies to all dispositions and deconsolidations of subsidiary stock at a loss, occurring between Feb. 1, 1991 and March 7, 2002. Regs. Sec. 1.1502-20(a)(1) states that "no deduction is allowed for any loss recognized by a member [of a consolidated group] with respect to the disposition of stock of a subsidiary." However, losses are disallowed only to the extent of the sum of three "factors": (1) extraordinary gain dispositions, (2) positive investment adjustments and (3) duplicated losses.
For purposes of this item, only the duplicated loss factor (DLF) will be considered, because this was the factor invalidated by the Federal Circuit in Rite Aid. The DLF prevents taxpayers from recognizing the same economic loss twice--first as a loss on the sale of a subsidiary's stock (by a consolidated group member) and second as a loss on the disposition of the subsidiary's assets.
Generally, the DLF can be expressed as the excess of a subsidiary's loss carry-overs and aggregate adjusted basis in its assets, over the value of its stock (plus any liabilities) immediately after the disposition of its stock by a consolidated group member (Regs. Sec. 1.1502-20(c)(2)(vi)). The facts of Rite Aid provide a quick illustration of the application of the now-defunct DLF.
In 1984, Rite Aid purchased the stock of Penn Encore (Encore), a small discount bookstore chain. For approximately a decade, Rite Aid included Encore in its consolidated group. During this time, Encore experienced significant losses that were funded by loans from Rite Aid. In 1994, Rite Aid contributed the Encore debt to Encore's capital and sold the Encore stock to an unrelated company. Rite Aid determined that it recognized an approximate $22 million loss on the sale of Encore stock, which it sought to deduct under Sec. 165. At the time of the sale, Encore's adjusted basis in its assets exceeded the value of its stock (plus liabilities) by more than $28 million. Thus, the IRS disallowed Rite Aid's $22 million loss to the extent of its DLF, resulting in no deduction.
In the Court of Federal Claims, Rite Aid challenged the IRS's application of the DLF by asserting that the denial of its loss was invalid (Rite Aid, 46 Fed. Cl. 500 (2000)). The IRS moved for summary judgment on the ground that the application of the DLF was a proper exercise of its authority. The court found for the IRS. On appeal, however, the Federal Circuit reversed the lower court's decision. The Court of Appeals explained that "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."
Reaction to Rite Aid
In Notice 2002-11, the IRS announced that it would not challenge the appellate court's decision in Rite Aid. Further, due to the interrelationship of the three LDR factors, including the (now-defunct) DLF, it decided to promulgate interim regulations to govern sales of consolidated group members' stock at a loss. The IRS announced the issuance of these interim regulations in Notice 2002-18.
New Loss Disallowance Regulations
On March 7, 2002, the IRS released temporary and proposed regulations, to serve as interim rules until it drafts new regulations as a more "permanent fix." The temporary regulations provide as follows:
* For subsidiary stock dispositions or deconsolidations after March 6, 2002, Temp. Regs. Sec. 1.337(d)-2T applies instead of the LDR.
* For subsidiary stock dispositions or deconsolidations prior to March 7, 2002, Temp. Regs. Sec. 1.1502-20T(i) provides three alternatives for a corporation to calculate loss on the disposition of subsidiary stock:
1. Apply the LDR in its entirety;
2. Apply the LDR without regard to the DLF; or
3. Apply Temp. Regs. Sec. 1.337(d)-2T.
A taxpayer can elect to apply one of the three alternatives on its original return for the tax year that includes the later of March 7, 2002 and the date of the subsidiary's disposition or deconsolidation. As an alternative, the taxpayer can amend a prior return to make a Temp. Regs. Sec. 1.1502-20T(i) election, provided it files the amended return before the date the original return for the tax year including March 7, 2002 is due (Temp. Regs. Sec. 1.1502-20T(i)(4)).
The following tax consequences may result if a taxpayer makes a retroactive election under Temp. Regs. Sec. 1.1502-20T(i). Previously, if the LDR resulted in a loss disallowance and the subsidiary whose stock was disposed of had net operating losses or capital loss carryovers, the selling corporation could make an election under Regs. Sec. 1.1502-20(g), reattributing the subsidiary's losses to the selling corporation to the extent of the disallowed loss. If a taxpayer files an amended return to retroactively elect one of the three alternatives listed in Temp. Regs. Sec. 1.1502-20T(i), the selling corporation might have a larger "allowed loss" on the subsidiary's disposition. This increase of an allowable loss to the selling corporation may retroactively decrease the amount of any loss carryovers reattributed to the selling corporation under Regs. Sec. 1.1502-20(g). Further, if the taxpayer reduces the reattributed loss, the disposed subsidiary's loss carryovers will be correspondingly increased. This explanation of the impact of a Temp. Regs. Sec. 1.1502-20T(i) retroactive election on a prior Regs. Sec. 1.1502-20(g) election serves merely to illustrate the potential tax consequences that can occur following a retroactive election. (A detailed explanation of the interplay between these two sections is beyond the scope of this item.)
To reemphasize, after March 7, 2002, the LDR regime no longer applies. Until the IRS issues further guidance, a corporation must consider Temp. Regs. Sec. 1.337(d)-2T any time it disposes of a consolidated subsidiary (or a portion of a consolidated subsidiary) at a loss. The general rule of Temp. Regs. Sec. 1.337(d)-2T provides that a corporation cannot deduct any loss recognized by a consolidated group member on the disposition of a subsidiary's stock.
A loss, however, will be allowed if a taxpayer can show that it is not attributable to the recognition of a built-in gain (BIG) on an asset's disposition. The rule also provides that immediately before the subsidiary ceases to be a member of the selling consolidated group, the subsidiary's stock basis will be reduced (not below fair market value (FMV)) in an amount equal to the recognized BIG. For purposes of applying Temp. Regs. Sec. 1.337(d)-2T, a disposition of a BIG asset is any event that triggers gain or loss recognition. Further, an asset's BIG generally equals the excess of the asset's FMV over its adjusted basis, reflected in stock basis when the corporation owning the BIG asset becomes a member of the selling consolidated group. Therefore, the new regime under Temp. Regs. Sec. 1.337(d)-2T is one of tracing and appraising. The burden now falls on the selling corporation to establish that the stock loss did not occur due to a basis increase resulting from the recognition of BIG on the subsidiary's underlying assets.
Example: P, the parent of a consolidated group, purchases all of S's stock for $100. S owns a single asset with a $50 basis and a $100 FMV. S subsequently sells its asset for $100 and recognizes a $50 gain. Pursuant to the consolidated return regulations, P increases its basis in the S stock by $50 to $150; see generally Regs. Sec. 1.1502-32. After March 6, 2002, P sells the S stock for $100 (basis of $150) and recognizes a $50 loss on the sale. Temp. Regs. Sec. 1.337(d)-2T disallows P's $50 loss, because the loss is attributable to a basis increase resulting from the disposition of a BIG asset.
Although the new regime applies a seemingly simple fix to the problem of when a corporation can recognize a loss on the disposition of its subsidiary, Temp. Regs. Sec. 1.337(d)-2T may require an extremely burdensome and difficult analysis on the selling corporation's part. A selling corporation must now track and be able to identify all dispositions made by a loss subsidiary since acquired, to determine whether any dispositions resulted in BIG recognition. However, proceeding under Temp. Regs. Sec. 1.337(d)-2T might not always require a burdensome analysis on the taxpayer's part.
If a selling corporation has acquired a subsidiary in a "qualified stock purchase" and has made a Sec. 338(h)(10) election, it could prove relatively simply that the subsidiary did not have any BIG assets at the time the subsidiary entered the seller's consolidated group. Further, if the selling corporation can establish that it formed and continued to own the loss subsidiary at all times and that the subsidiary's stock basis does not reflect the stock basis of any other subsidiary, any BIG asset dispositions should not trigger a loss disallowance under Temp. Regs. Sec. 1.337(d)-2T. Finally, if the selling corporation can prove that it acquired an asset that appreciated in value after the subsidiary was already a member of the seller's consolidated group, dispositions of such assets at a gain also should not result in a disallowed loss.
FROM THOMAS HAYES, J.D., LL.M., SEATTLE, WA
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|Title Annotation:||disposition of a loss subsidiary by a consolidated group|
|Publication:||The Tax Adviser|
|Date:||Jun 1, 2002|
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