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Supplemental comments on loss disallowance regulations.

Supplemental Comments on Loss Disallowance Regulations

I am writing to follow up on the discussion during the recent Treasury-TEI liaison meeting on the proposed loss disallowance regulations. You will recall that our meeting ended with a spirited exchange on the efficacy of a refined "tracing" regime as an alternative to the rules contained in the November 19, 1990, regulations.

Specifically, you advised us that no taxpayer, group of taxpayers, or professional or industry group had yet responded positively to Terrill Hyde's January 25, 1991, invitation for taxpayers to express a preference for a tracing system, which would apply to gains as well as losses, over the modified loss disallowance rules. After observing that tracing would produce a theoretically better and more precise result, you requested TEI's views on wether the costs of tracing would be "worth it." Stated simply, TEI believes that tax rules should be designed to reach the "right" result. Thus, to the extent that a choice is necessary, we believe tracing would be preferable.

As is clear from TEI's three sets of comments on the loss disallowance regulations,(1) the Institute does not believe the question is properly framed as either a Hobson's choice (effectively no choice because of all the conditions laden on one of the supposed alternatives) or a black-or-white proposition. The revised regulations, though marginally better than the March 1990 version, continue to deny taxpayers the ability to deduct true economic losses. They thus effectively abrogate section 165 of the Code in respect of taxpayers that elect to file consolidated returns. We believe that changes are absolutely necessary not only to vindicate the policy underlying section 165 but also to more closely effectuate Congress's intent in repealing the General Utilities doctrine. We also believe that revised rules can be crafted that achieve these goals without imposing undue burdens on either taxpayers or the Internal Revenue Service. The key to accomplishing this end lies in keeping focused on the legitimate scope of the regulations and in resisting the temptation to wield section 337(d) as a sword against perceived or chimerical abuses in subchapter C of the Code.

To summarize our previous comments, we believe that an administrable, evenhanded, and fair tracing regime can be developed. The heaviest administrative burdens would dissipate if the Treasury and IRS were to rethink their devotion to the "consumption of wasting assets" concept. Certainly, the need for annual appraisals and a separate set of earnings and profits books would vanish if the "wasting assets" concept were abandoned. As we stated in our January 23, 1991, comments: To our mind's eye, the "wasting assets" 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 recognition of pre-acquisition built-in gains underscores why the "wasting assets" rules should be jettisoned.

Thus, TEI believes that the Treasury and IRS have constructed a false dichotomy in presenting system-wide mandatory tracing as the only possible alternative to being subjected to the full force of the loss disallowance rules. As we discussed at the liaison meeting, we continue to believe that taxpayers should be permitted to elect tracing to demonstrate that a loss did not result from the recognition of built-in gain. Any legitimate government concern about "adverse selection" (i.e., that the election would only be made when advantageous to the taxpayer) could be obviated by requiring the taxpayer to make a binding election whether to trace at the time it acquires subsidiary stock (or within a specified period following the acquisition).(2)

As to the question whether taxpayers are willing to have the tracing rules apply to gain disposition as well as to those generating losses, we believe that the answer is "yes" in respect of a mandatory system where the alternative is the loss disallowance rules as currently proposed. More fundamentally, we believe there is a tax policy issue whether the application of a tracing requirement to gain dispositions would be justified. Our August 10, 1990, letter (which was prompted by questions raised at the public hearing ) dealt specifically and exclusively with that issue. Again, however, the manner in which the question has been posed - a veritable throwing down of the gauntlet - seems designed less to stimulate thoughtful debate than to spook taxpayers into accepting the loss disallowance rule in fear that the threatened alternative would be worse.

In summary, TEI acknowledges that the regulation writer's task is a difficult one - crafting a rule that hews to Congress's purpose in repealing General Utilities while steering taxpayers and the IRS between the Scylla of a draconian loss disallowance rule and the Charybdis of an unnecessarily onerous tracing rule. We sincerely believe, however, that the task is not an impossible one.(3) Thus, we renew our recommendation for the development of an elective tracing regime, augmented by the adoption of of certain presumptive rules, as outlined in our earlier submissions. Even if the use of tracing were mandatory (which we do not believe it should be), it would be preferable to the rules set forth in the current regulations.

If you have any questions, please do not hesitate to call Lester D. Ezrati, chair of TEI's Federal Tax Committee, at (415) 857-2089 or the Institute's professional staff (Timothy J. McCormally or Mary L. Fahey) at (202) 638-5601.

(1) On June 19, 1990, the Institute filed comments on the March 9, 1990, proposed and temporary regulations; on August 10, 1990, we submitted a letter responding to certain questions that were posed at the June 26, 1990, public hearing on the regulations; and on January 23, 1991, we filed comments on the revised loss disallowance regulations.

(2) During the liaison meeting, you expressed concern over the "junction box" problems that could arise under an elective system where a consolidated group that had elected tracing acquired or was acquired by another group that had not made the election. Although such issues obviously must be addressed (as they have been in respect of other elections afforded by the Code or regulations), we respectfully suggest that they should not be invoked as a shibboleth with which to dismiss the election alternative out of hand.(3) This is especially the case if the rules were made effective in respect of basis adjustments made after the issuance of Notice 88-17 and were augmented by a reasonable materiality (or de minimis) rule.
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Author:Nitschke, David F.
Publication:Tax Executive
Date:Mar 1, 1991
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