ALI-ABA Course of Study Consolidated Tax Return Regulations. Cosponsored by the ABA Section of Taxation September 25-26, 2008 Washington, D.C.

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1 2791 ALI-ABA Course of tudy Consolidated Tax Return Regulations Cosponsored by the ABA ection of Taxation eptember 25-26, 2008 Washington, D.C. The Consolidated Return Loss Disallowance and Loss Duplication Rules By Mark J. ilverman Lisa M. Zarlenga teptoe & Johnson LL Washington, D.C Mark J. ilverman and Lisa M. Zarlenga. All Rights Reserved.

2 i - TABLE OF CONTENT Internal Revenue ervice Circular 230 Disclosure: As provided for in IR regulations, advice (if any) relating to federal taxes that is contained in this document (including attachments) is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any plan or arrangement addressed herein. age I. BACKGROUND AND HITORY OF LO DIALLOWANCE AND LO DULICATION RULE...1 A. Investment Adjustment Rules...1 B. Targeted roblems roblems Relating to the Repeal of General Utilities...2 a. on of Mirrors Transaction...2 b. Wasting Assets roblem Loss Duplication roblem...6 C. rior Loss Disallowance Rules History of Treasury Regulation ection Regulatory Authority Notice Original et of Loss Disallowance Regulations Amended et of Regulations Final Regulations ummary...12 D. Rite Aid Case Background Facts of Rite Aid Court of Federal Claims Decision The Federal Circuit Decision Notice Legislative Response...15 E. Loss Disallowance Regulations - Treasury Regulation ection 1.337(d) F. Current Loss Duplication Regulations - Treasury Regulation ection Notice roposed Treasury Regulation ection

3 ii - age II. 3. Temporary Treasury Regulation ection T Final Treasury Regulation New roposed Regulation LO DIALLOWANCE RULE ADDREING CONCERN RELATING TO THE REEAL OF GENERAL UTILITIE...20 A. General Rule...20 B. Deconsolidations...22 B. Allowable Loss General Rules Determination of Built-In Gain Disposition of an Asset Recognition of Built-In Gain Examples Applying Allowable Loss Exception...36 a. Example 15 Built-In Gain Asset Appreciates in Value...36 b. Example 16 Built-In Gain in After-Acquired Asset...37 c. Example 17 Gain Recognized By rior Consolidated Group...38 d. Example 18 Carryover Basis in tock...39 e. Example 19 Intragroup Acquisition...40 f. Example 20 Built-In Gain Asset Contributed to ubsidiary...42 g. Example 21 Built-In Gain at Time of Intragroup pin-off Offsetting Gains and Losses...44 b. Example 22 - Built-In Loss Offsets Built-In Gain...45 c. Example 23 - ost-acquisition Depreciation Offsets ost- Acquisition Appreciation...47 d. Example 24 ost-acquisition Appreciation Removes Taint of Built-In Gain...48 e. Example 25 - ost-acquisition Appreciation Removes Taint of Built-In Gain Lower Tier ubsidiary afe Harbors Circumstances Under Which Gain hould Not Be Considered Built-In Allowable Loss Under rior Rules...52 C. Netting Rule...56

4 iii - age D. Coordination with Loss Deferral and Other Loss Disallowance Rules...59 E. uccessor Rule...61 F. Anti-Avoidance Rules rior Rules Apply General Anti-Avoidance Rule Anti-tuffing Rule...64 G. No Tiering Up of Certain Adjustments...65 H. Reg (i) Transition Rules General Rule Election Cascading Losses Reattribution Rule Waiver of Loss Carryovers Determining Whether and Which Election to Make...79 III. Treasury Regulation Addressing Loss Duplication Concerns...80 A. Background...80 B. Basis Redetermination Rule Effect of Investment Adjustment Rules Basis Redetermination Where ubsidiary Remains Member of the Group Basis Redetermination Where ubsidiary Is Deconsolidated Lower Tier ubsidiaries Basis Adjustments for Higher Tier tock Ordering Rules Basis Redetermination Examples...87 C. Loss uspension Rule General Rule Duplicated Loss Lower Tier ubsidiaries Treatment of uspended Loss Reduction of uspended Loss Allowance of Loss pecial Rule for uccessor Assets...98

5 iv - age IV. 8. Coordination With Other Deferral or Disallowance Rules Ordering Rules Loss uspension Examples...99 D. Worthlessness and Dispositions Not Followed by eparate Return Years General Rule roposed Regulations pecial Transition Election in Temporary Regulations E. Anti-Avoidance Rules Transfer of hare Without Loss in Avoidance Transfer of Loss roperty in Avoidance Anti-Loss Reimportation Avoidance of Gain Recognition Other Anti-Abuse Rules UNIFIED RULE FOR LO ON UBIDIARY TOCK A. Background B. General Rule: rop. Reg C. Basis Redetermination to Reduce Disparity urpose and scope of basis redetermination rule: Basis Redetermination Rule: Limits to Basis Redetermination Basis Redetermination Examples a. Example 52: Basis Redetermination (To revent Noneconomic Loss) b. Example 53: Basis Redetermination (To revent Duplicated Loss) c. Example 54: Basis Redetermination (Increase In Basis of Transferred Loss hare) D. tock Basis Reduction to revent Noneconomic Loss Background: Basis Reduction Rule: Netting of Gains and Losses: a. Netting Rule:...133

6 v - age b. Example 55 Netting Rule Application (Allocation of Gain Amount to Determine Net Loss): Basis Reduction Examples a. Example 56 Basis Reduction (Appreciation Reflected in tock Basis at Acquisition - Appreciation Recognized As Gain): b. Example 57 - Basis Reduction (Appreciation Recognized As Income Instead of Gain): c. Example 58 - Basis Reduction (ost-acquisition Appreciation Eliminates tock Loss): d. Example 59 Basis Reduction (Distributions): e. Example 60 Basis Reduction (Loss of Appreciation Reflected in Basis) f. Example 61 Basis Reduction (Recognition of Loss Accruing After Becomes a Member) g. Example 62 Basis Reduction (Recognition of Gain Accruing After Becomes a Member) h. Example 63 Basis Reduction (Computing the Disconformity Amount Unrecognized Loss Reflected in tock Basis) i. Example 64 Basis Reduction (Lower-Tier ubsidiary/no Transfer of Lower-Tier tock) E. Attribute Reduction to revent Duplication of Loss Background: Attribute Reduction Rule: Attribute Reduction Amount: Application of Attribute Reduction: pecial Rules for Lower Tier ubsidiaries Elections to Reduce the otential for Loss Duplication: Examples a. Example 65 (Computation of Attribute Reduction Amount/Transfer of All hares) b. Example 66 (Transfer of less than all shares) c. Example 67 (roportionate Allocation of Attribute Reduction Amount) d. Example 68 (ublicly Traded roperty)...147

7 vi - age e. Example 69 (Wholly Owned Lower-Tier ubsidiary) F. Anti-Abuse Rule - rop. Reg (g) Transactions Triggering Anti-Abuse Rule a. Gain tuffing b. Loss Trafficking c. reventing Attribute Reduction...151

8 iv - TABLE OF EXAMLE age Example 1 Basic Investment Adjustment Rules...1 Example 2 Basic on of Mirrors Transaction...3 Example 3 on of Mirrors Transaction Bust Up...3 Example 4 Wasting Assets...5 Example 5 Loss Duplication: Unrelated Taxpayers...6 Example 6 Loss Duplication: tuffing/outside Loss Recognized Before Inside Loss...7 Example 7 Loss Duplication: tuffing/inside Loss Recognized Before Outside Loss...8 Example 8 Deconsolidation Rule...22 Example 9 Definition of Deconsolidation...23 Example 10 Using the Deconsolidation Rule to Avoid Gain Recognition...25 Example 11 Loss Attributable to Disposition of Built-In Gain Asset...31 Example 12 Loss Attributable to ost-acquisition Loss...32 Example 13 Built-In Gain Asset Depreciates in Value...33 Example 14 ection 1031 Exchange of Built-In Gain Asset...34 Example 15 Built-In Gain Asset Appreciates in Value...35 Example 16 Built-In Gain in After-Acquired Asset...36 Example 17 Gain Recognized By rior Consolidated Group...37 Example 18 Carryover Basis in tock...38 Example 19 Intragroup Acquisition...39 Example 20 Built-In Gain Asset Contributed to ubsidiary...41 Example 21 Built-In Gain at Time of Intragroup pin-off...42 Example 22 Built-In Loss Offsets Built-In Gain...43 Example 23 ost-acquisition Depreciation Offsets ost-acquisition Appreciation...46 Example 24 ost-acquisition Appreciation Removes Taint of Built-In Gain...47 Example 25 ost-acquisition Appreciation Removes Taint of Built-In Gain Lower Tier ubsidiary...48 Example 26 Netting Gains and Losses...55 Example 27 Netting Under the Deconsolidation Rule...56 Example 28 Coordination With Loss Deferral Rules...58 Example 29 uccessor Rule...60 Example 30 hifting of Value...61 Example 31 Basic tuffing Case...63 Example 32 Deconsolidation of arent in ame Transaction as ubsidiary...65 Example 33 Reattribution Rule...70 Example 34 No Deconsolidation...85 Example 35 No Deconsolidation artial Duplicated Loss Allowed...87 Example 36 No Deconsolidation Economic Loss Disallowed...88 Example 37 Deconsolidation Example 38 Deconsolidation to Avoid Basis Redetermination...89 Example 39 Deconsolidation Economic Loss Disallowed...90 Example 40 Basis Redetermination to Eliminate an ELA...91

9 2799 I. BACKGROUND AND HITORY OF LO DIALLOWANCE AND LO DULICATION RULE A. Investment Adjustment Rules 1. The investment adjustment rules under Reg require that annual positive or negative adjustments be made to the basis of the stock of each subsidiary of a consolidated group to reflect gain or loss recognized by the subsidiary. a. pecifically, basis is increased by s taxable income and taxexempt income. Basis is decreased by s tax loss, nondeductible expenses, and distributions with respect to s stock. Reg (b)(2). b. If has more than one class of stock outstanding, the adjustments must be allocated between the classes. An adjustment attributable to a distribution is allocated to the shares of s stock entitled to the distribution. If the remainder of the adjustments are positive, the adjustments are allocated first to preferred stock (and only to the extent of dividend arrearages and distributions to which the preferred stock becomes entitled), and second to s common stock. If the remainder of the adjustments not attributable to distributions are negative, they are allocated solely to the common stock. Reg (c)(1). c. The adjustments are designed to ensure that consolidated group members pay a single corporate tax on the group s income and use losses only once. 2. Example 1 - Basic Investment Adjustment Rules tock $120 $100 basis X a. Facts: acquires all of the stock of for $100. and elect to file a consolidated return. earns $20 in Year 1. In Year 2, sells its stock to X for $120. 1

10 2800 B. Targeted roblems b. Under the investment adjustment rules, s basis in its stock is increased by the $20 of taxable income in Year 1 to $120. Reg (b)(2)(i). c. Then, when sells in Year 2, it recognizes no gain or loss. Because of the $20 positive basis adjustment, the group pays only one tax on its earned income. 1. roblems Relating to the Repeal of General Utilities a. on of Mirrors Transaction (1) The Tax Reform Act of 1986, ub. L. No , repealed the General Utilities doctrine by requiring corporate-level gain recognition on a corporation s sale or distribution of appreciated property, regardless of whether it occurs in a liquidating or nonliquidating context. 1 (2) After the repeal of the General Utilities doctrine, the operation of the investment adjustment rules permitted consolidated groups to sell assets without paying a corporate-level tax. The transaction became known as the son of mirrors transaction. 1 In General Utilities and Operating Co. v. Helvering, 296 U (1936), the upreme Court held that corporations could distribute appreciated property to their shareholders tax-free. The Tax Reform Act of 1986 repealed the General Utilities doctrine by amending section 311(b) of the Code. ection 311(b) imposes a corporate-level tax on the distribution of appreciated property to shareholders, as if the corporation sold such property for its fair market value. 2

11 2801 (3) Example 2 - Basic on of Mirrors Transaction X (1) tock $200 tock $200 Z $200 basis $400 basis (2) Land Y Land $200 Value $0 Basis $200 $200 Cash (a) Facts: purchases the stock of from X for $200. s only asset is land with a value of $200 and a basis of zero. causes to sell the land to Y for its fair market value of $200. subsequently sells the stock to Z for its fair market value of $200. (b) recognizes $200 gain on the sale of the land to Y. Under the investment adjustment rules, increases its basis in the stock by $200 to $400. Reg (b)(2)(i). (c) When subsequently sells, it recognizes a $200 loss, which offsets the gain recognized by. (4) Example 3 - on of Mirrors Transaction - Bust Up X (1) tock $200 $200 basis (2) Wanted Asset $100 Value $50 Basis $100 basis tock $100 Y Unwanted Asset $100 Value $50 Basis 3 Unwanted Asset $100 Value $50 Basis

12 2802 (a) Facts: purchases the stock of from X for $200. has two assets, Unwanted Asset and Wanted Asset, each with a $100 fair market value and a $50 basis. wants to keep Wanted Asset and dispose of Unwanted Asset. distributes Wanted Asset to, and subsequently sells the stock to Y for its fair market value of $100. (b) When distributes Wanted Asset to, it results in $50 of section 311(b) gain to, which is deferred. ee Reg (c)(2)(ii). s basis in its stock is reduced by $100 to $100 as a result of the distribution. Reg (f)(2)(ii), (b)(2)(iv). (c) s subsequent sale of stock triggers s $50 deferred gain. Reg. l (d)(1)(i), (f)(2)(iii). This gain increases s basis in its stock by $50 to $150. Reg (b)(2)(i). Thus, recognizes a $50 loss on the sale of its T stock. The $50 loss offsets the $50 section 311(b) gain. (5) In these examples, s built-in gain in its asset was already reflected in s initial cost basis in the stock. Thus, the positive investment adjustment for the gain on the sale or distribution of s asset artificially increases s basis in its stock and permits to recognize an offsetting loss, in effect eliminating s gain from corporate-level tax. (6) Arguably, the lack of a tax on the disposition of s asset in these examples is appropriate. In Example 2, invested $200 in and receives $200 cash when is sold. In Example 3, invested $200 in and receives a Wanted Asset worth $100 and $100 in cash when is sold. (7) However, the lack of a tax is inconsistent with the purpose of the repeal of the General Utilities doctrine: no corporate-level tax has been paid on the built-in gain in s asset, yet the asset has a stepped-up basis in the hands of the buyer. 4

13 2803 b. Wasting Assets roblem (1) The Internal Revenue ervice (the ervice ) became concerned that the General Utilities repeal could also be avoided where assets are not actually disposed of but instead are used up in the process of earning income. Thus, where assets are expected to decline in value over time, all or a portion of the income earned from the asset is economically a return of capital. (2) Example 4 - Wasting Assets X tock $200 tock $200 Y $200 basis $300 basis Income $20/year for 5 years atent $200 Value $0 Basis atent $100 Value $0 Basis $100 Cash (a) Facts: purchases the stock of from X for $200. s only asset is a patent with a value of $200 and a basis of zero. s asset earns $20 and declines in value by $20 in each year over a five-year period. subsequently sells the stock to Y for its fair market value of $200. (b) Under the investment adjustment rules, increases its basis in the stock by $20 each year, or $100 over the five-year period. Reg (b)(2)(i). (c) When subsequently sells, it recognizes a $100 loss, which offsets s income. Note, however, that the time value of money reduces the effect of this offset. 5

14 Loss Duplication roblem a. The ervice is also concerned with the ability to duplicate losses of consolidated group members. b. Example 5 - Loss Duplication: Unrelated Taxpayers tock $40 X $100 Cash tock $100 Basis $60 NOL $60 NOL (1) Facts: forms with a contribution of $100. has an operating loss of $60, which the group is unable to use on its consolidated return. subsequently sells to X for $40. (2) s basis in its stock remains at $100, because s loss has not been absorbed by the group. Reg (b)(3)(i)(A). (3) When sells the stock to X for $40, recognizes a $60 loss. is apportioned its $60 net operating loss carryover when it leaves the group. Reg (a), (b)(2). (4) s loss on the sale of is thus duplicated when uses its loss after leaving the group. However, is restricted in its use of its apportioned losses by section 382, Reg , (RLY rules), etc. (5) Loss duplication can also occur if uses the $100 contributed by to purchase an asset and the asset declines in value to $40. (6) This sort of loss duplication is not unique to consolidated returns; it also exists when separate returns are filed. Arguably, Congress has already addressed the problem in 6

15 2805 sections 382, 384, and 269 (not to mention the Treasury s own response in Reg , , and ). c. Example 6 - Loss Duplication: tuffing/outside Loss Recognized Before Inside Loss (2) referred tock $20 X $100 Cash Common tock (1) Asset $20 Value $50 Basis Asset $20 Value $50 Basis referred tock (3) Asset $20 Y (1) Facts: In Year 1, forms with a contribution of $100 in exchange for all of the common stock of. In Year 2, contributes a built-in loss asset to with a value of $20 and a basis of $50 in exchange for a separate block of preferred stock. In Year 3, sells the preferred stock to X for $20. In Year 4, sells the asset to Y for $20. (2) recognizes a $30 loss on the sale of the preferred stock. Because continues to own all of the common stock, remains a member of the consolidated group. (3) When sells its asset for $20, the group may use the $30 loss on its return. is required to reduce its basis in the common stock by the amount of s loss absorbed by the group, which would result in a gain if subsequently disposes of the common stock. Nonetheless, could delay or avoid recognition of the gain through some planning. (4) Loss Acceleration In the context of this fact pattern, the ervice also appears concerned with the ability of the group to accelerate economic losses by recognizing the outside 7

16 2806 loss before recognizes its inside loss. ee Notice , I.R.B. 1 (Jan. 31, 2002); Reg d. Example 7 - Loss Duplication: tuffing/inside Loss Recognized Before Outside Loss (3) referred tock $20 X $100 Cash Common tock (1) Asset $20 Value $50 Basis Asset $20 Value $50 Basis referred tock (2) Asset $20 Y (1) Facts: ame facts as in Example 6, except that sells its built-in loss asset to Y in Year 3, and sells the preferred stock to X in Year 4. (2) When sells its asset for $20, it recognizes a $30 loss, which offsets income on the group s return. Under the investment adjustment rules, s basis in each share of common stock is reduced by a pro rata share of the $30 loss. Reg (c)(2)(i). s basis in the preferred shares is not, however, reduced. Reg (c)(3). (3) then recognizes a $30 loss on the sale of the preferred stock, which it uses to offset income on the group s return. (4) Note that if subsequently disposes of the common stock, it would recognize $30 additional gain. Nonetheless, could delay or avoid recognition of the gain through some planning. 8

17 2807 C. rior Loss Disallowance Rules History of Treasury Regulation ection Regulatory Authority Congress granted the ervice regulatory authority to protect the purposes behind the General Utilities repeal, including regulations to ensure that such purposes may not be circumvented through the use of any provision of law or regulations (including the consolidated return regulations... ). ection 337(d)(1). 2. Notice a. The ervice concluded that the result in the son of mirrors transaction undermined the repeal of the General Utilities doctrine and issued Notice 87-14, C.B. 445 (Jan. 6, 1987), in response. b. In Notice 87-14, the ervice announced that it intended to promulgate regulations that would deny positive basis adjustments for earnings and profits (under the former basis adjustment rules) attributable to the sale or distribution of built-in gain property, using a tracing method. c. The Notice also indicated that regulations would be effective with respect to stock in a target that was acquired after January 6, 1987, the date of the Notice. 3. Original et of Loss Disallowance Regulations a. On March 9, 1990, temporary and proposed Reg T was promulgated pursuant to Notice Temp. Reg T disallowed any loss recognized on the disposition of a consolidated subsidiary by a consolidated group member. (1) However, it contained a reattribution rule, which permitted the selling member to elect to reattribute net operating losses of the subsidiary to itself. ee rior Temp. Reg T(f)(1). (2) Thus, the regulations went far beyond Notice (a) (b) Although Notice was targeted to the son of mirrors problem, the original set of regulations reached all of the problems perceived by the ervice: son of mirrors, wasting assets, and loss duplication. In Notice 87-14, the ervice indicated that it would adopt a tracing rule to deny positive investment 9

18 2808 adjustments attributable to the recognition of builtin gain. Tracing would permit a seller of subsidiary stock to establish that it has a true economic loss. But in developing and revising the regulations, the ervice rejected tracing as too burdensome on both taxpayers and the ervice, because such a rule would require the appraisal of each asset of an acquired subsidiary to determine if built-in gain or built-in loss exists. b. Temp. Reg T applied to all consolidated subsidiary stock that was disposed of on or after March 9, 1990, regardless of when the stock was acquired. (1) A transitional rule was promulgated in temporary and proposed Reg (d)-1T(a), which generally applied to subsidiaries acquired after January 6, 1987 and disposed of before March 9, Under this rule, losses on the sale of such stock were disallowed, except to the extent that the group established that the loss was not attributable to the recognition of built-in gain. (2) Therefore, despite the reassurances of Notice 87-14, the loss disallowance rules (with one minor exception provided in Reg (d)-1T) did apply to subsidiaries acquired prior to January 7, Amended et of Regulations a. After receiving numerous comments on the loss disallowance regulations, on November 19, 1990, Treasury and the ervice promulgated revised regulations. b. Temp. Reg T was revoked, 2 and roposed Reg replaced Temp. Reg T. c. The proposed regulations generally contained the same rules as the original -20T regulations, except that subparagraph (c) added a limited loss allowance rule, which permitted losses to be recognized to the extent they exceeded (i) income or gain from extraordinary gain dispositions, (ii) the amount of positive 2 A group could, however, elect to apply the former Temp. Treas. Reg T in lieu of the transitional rules of Treas. Reg (d)-1 and -2, or with respect to pre-effective date transactions, in order to take advantage of the reattribution rule. Treas. Reg (d)- 1(e)(3), 1.337(d)-2(g)(3), (h)(4). 10

19 2809 investment adjustments, and (iii) the amount of any duplicated loss. d. rop. Reg generally applied to subsidiary stock disposed of after January 31, e. The transitional rule in Temp. Reg (d)-1T was slightly amended and made final. Reg (d)-1. It is generally applicable to subsidiaries acquired after January 6, 1987 and disposed of before November 19, f. Temporary and proposed Reg (d)-2T generally carried forward the transitional rule from November 19, 1990 to January 31, Temp. Reg (d)-2T applied, however, to all subsidiaries, regardless of when they were acquired. 5. Final Regulations a. On eptember 13, 1991, Treasury and the ervice issued final regulations under Reg and 1.337(d)-2 and slightly modified Reg (d)-1 (collectively, the final 1991 regulations ). 5 b. Although the final 1991 regulations added some important provisions to Reg , they retained the same approach as in the proposed regulations. The government acknowledged that the loss disallowance rule of Reg would disallow economic losses. reamble to the final 1991 regulations, 56 Fed. Reg. 47,379, 47, (ept. 13, 1991). c. The final 1991 regulations did not change any of the effective dates. Consolidated groups could avoid the loss disallowance regulations and the window period transition rules in Temp. Reg. 3 However, this rule may apply to stock disposed of after November 18, If stock of a transitional subsidiary was deconsolidated before November 19, 1990, and the remaining subsidiary stock held by the group was not subject to Treas. Reg (d)-2 or , then the subsidiary continued to be treated as a transitional subsidiary. Treas. Reg (d)- 1(e)(1). 4 A selling group could, however, elect out of Treas. Reg (d)-2 and into the general loss disallowance regulations of Treas. Reg Treas. Reg (h)(2). 5 ee F..A (Jan. 2, 1999) (discussing the history of Treas. Reg and concluding that Treas. Reg was promulgated in accordance with the Administrative rocedure Act). 11

20 (d)-2T by seeking permission to deconsolidate pursuant to Rev. roc , C.B d. Rev. roc originally set the final date for filing an application to discontinue filing consolidated returns as June 30, e. However, in Rev. roc , C.B. 694, the ervice modified Rev. roc by providing that such applications must be filed no later than 90 days after the date proposed Reg was finalized (i.e., by December 12, 1991). 6. ummary The following table summarizes the applicable loss disallowance provisions, which apply when a subsidiary is acquired and disposed of as follows: Disposed of on or after 11/19/90 but before 2/1/91: Disposed of on or after 1/7/87 but before 11/19/90: ubsidiary acquired before 1/7/87: ubsidiary acquired on or after 1/7/87: 1.337(d) (d)-2 LDRs do not apply 1.337(d)-1 7. On January 23, 2007, the ervice published new proposed consolidated return loss disallowance rules that would both implement the repeal of the general Utilities doctrine and address the duplication of losses by members of a consolidated group (referred to herein as the proposed unified LDR regulations ). The proposed rules would therefore remove Reg (d)-1, 1.337(d)-2, and Fed. Reg. 2964, (Jan. 23, 2007). D. Rite Aid Case 1. Background a. The approach of Reg has been widely criticized in that it disallows economic losses that would otherwise be deductible in a separate return context. Indeed, taxpayers have challenged the validity of Reg ee, e.g., Rite Aid Corp. v. United tates, 46 Fed. Cl. 500 (2000), rev d, 255 F.3d 1357 (Fed. Cir. 2001); alina artnership L v. Commissioner, 80 T.C.M. (CCH) 686 (2000); FL Group, Inc. v. Commissioner, T.C. Docket No

21 2811 b. The Court of Appeals for the Federal Circuit held that the government s attempt to disallow losses capable of duplication was invalid. Rite Aid Corp. v. United tates, 255 F.3d 1357 (Fed. Cir. 2001), rev g, 46 Fed. Cl. 500 (2000). The Federal Circuit concluded that disallowing a loss that would otherwise be deductible under section 165 amounts to an imposition of tax on income that would otherwise not be taxed, which the government is not authorized to do under section Facts of Rite Aid a. Rite Aid Corporation ( Rite Aid ) is the common parent of an affiliated group of corporations that files a consolidated return. In 1984, Rite Aid acquired 80 percent of the stock of enn Encore, Inc. ( Encore ) for $3 million. A section 338 election was made with respect to the acquisition. In 1988, Rite Aid purchased the remaining 20 percent of Encore stock for $1.5 million. From 1984 through 1994, Encore experienced net negative earnings and profits of approximately $10.9 million and borrowed approximately $44.9 million from Rite Aid. b. In January 1994, Rite Aid adopted a restructuring plan, which included the sale of Encore. Rite Aid asked prospective bidders whether they would join in making an election under section 338(h)(10). The only bidder for Encore refused to join in a section 338(h)(10) election. c. On November 23, 1994, Rite Aid sold all of the Encore stock, claiming a loss of approximately $22.1 million. However, the loss was disallowed under Reg Rite Aid determined that Encore s duplicated loss factor was approximately $28.5 million, its extraordinary gain disposition factor was $9,624, and its positive investment adjustment factor was approximately $6.2 million. Because the sum of the loss disallowance factors, or approximately $34.7 million, exceeded Rite Aid s investment loss, Rite Aid s entire loss was disallowed under Reg d. Rite Aid paid the tax and filed a claim for refund in the United tates Court of Federal Claims, claiming that Reg was invalid. 3. Court of Federal Claims Decision a. The Court of Federal Claims held that Reg was not arbitrary, capricious, or manifestly contrary to law, and that it served the purpose of clearly reflecting income tax liability of both the parent and the subsidiary in a consolidated group. 13

22 2812 b. The court rejected the taxpayer s argument that the regulation was in derogation of section 165(a), which permits a deduction for losses sustained during the taxable year, and thus exceeded the Treasury s authority. The court noted that the taxpayer had an opportunity, which it did not take, to structure the sale of the subsidiary in a way that would have allowed the taxpayer to recognize the loss (i.e., as an asset sale instead of a stock sale). c. The court also rejected the taxpayer s argument that the upreme Court s decision in Illfield Co. v. Hernandez stands for the proposition that a duplicated loss is a loss twice enjoyed by the group not by unrelated parties. The court noted that section 1502 permits the Treasury to implement regulations that clearly reflect income tax liability with respect to consolidated groups and their members both during and after the period of affiliation, which is served by prohibiting group losses that otherwise may be taken both by the group and its former member. 4. The Federal Circuit Decision a. The Court of Appeals for the Federal Circuit reversed the Court of Federal Claims decision that Reg was a proper exercise of Treasury s regulatory authority. The Federal Circuit held that duplicated loss factor of the loss disallowance rules distorts rather than reflects the tax liability of consolidated groups and, therefore, the regulation is manifestly contrary to the statute. b. The Federal Circuit held that in the absence of a problem created from the filing of consolidated returns, the ecretary is without authority to change the application of other tax code provisions to a group of affiliated corporations filing a consolidated return. Because the ability of a former consolidated subsidiary to realize a loss on its assets after the consolidated group realizes a loss on the subsidiary s stock is not limited to the consolidated return context, the ecretary is without authority to change the application of section 165 to the sale of the subsidiary s stock. (1) This standard could have broad implications with respect to other consolidated return regulations, because the consolidated return regulations change the application of many tax code provisions. ee, e.g., Reg (f)(2); -13(f)(6); -13(g)(3)(ii)(B)(2); -19; -32; -80. (2) The Federal Circuit did not offer much guidance as to when a problem is created by the filing of consolidated returns. 14

23 2813 c. The Federal Circuit noted that Congress has already addressed the problem of duplicated losses by limiting the subsidiary s potential future deduction under sections 382 and 383 not by disallowing the parent s loss on the subsidiary stock. d. The Federal Circuit rejected the government s argument that if an affiliated group elects to take advantage of the benefits of filing a consolidated return, it must take the bitter with the sweet, noting that the bitter with the sweet does not include the invalid. e. It is not clear from the court s opinion whether it invalidated all of Reg or just the duplicated loss provision. The court stated that the regulation was manifestly contrary to the statute. Nonetheless, the court s analysis clearly focuses on only the duplicated loss provision, and the ervice has interpreted the opinion to invalidate only the duplicated loss provision. ee Notice , I.R.B. 1 (Jan. 31, 2002). 5. Notice a. On January 31, 2002, the ervice issued Notice , announcing that it would not seek certiorari from the upreme Court in Rite Aid. The Notice stated that the government would not continue to litigate the validity of the loss duplication factor in the interests of sound tax administration. b. The Notice further provided that because of the interrelationship between all of the loss disallowance factors, Reg would be replaced in its entirety with interim regulations based on Reg (d)-2. c. ince it issued this Notice, the ervice pursued General Utilities repeal concerns separately from loss duplication concerns. However, the recently proposed unified LDR regulations comprehensively address both General utilities repeal and loss duplication concerns. rop. Reg , 72 Fed. Reg (Jan. 23, 2007). 6. Legislative Response ection 646 of the American Jobs Creation Act of 2004 (H.R. 4520) amended section 1502 to limit the decision in Rite Aid by adding the following sentence to section 1502: (a) IN GENERAL - In carrying out the preceding sentence, the ecretary may prescribe rules that are different from the provisions of chapter 1 that would apply if such corporations filed separate returns. 15

24 2814 (b) REULT NOT OVERTURNED Notwithstanding the amendment made by subsection (a), the Internal Revenue Code of 1986 shall be construed by treating Treasury Regulation ec (c)(1)(iii) (as in effect on January 1, 2001) as being inapplicable to the factual situation in Rite Aid Corporation and ubsidiary Corporations v. United tates, 255 F.3d 1357 (Fed. Cir. 2001). a. The Conference Report (H.R. Conf. Rep. No ) explains that the reason for the provision is the Finance Committee s concern that the language of the Rite Aid opinion may lead taxpayers to challenge other consolidated return regulations that prescribe a result that is different from the separate return result. It also states that the provision in no way prevents or invalidates the approaches Treasury has announced it will apply in lieu of Reg ee also H.R. Rep. No ;. Rep. No E. Loss Disallowance Regulations - Treasury Regulation ection 1.337(d)-2 1. On March 7, 2002, Temp. Reg (d)-2T, T(i), and T(b)(4)(v) were promulgated pursuant to Notice ee 67 Fed. Reg. 11,034 (Mar. 12, 2002). These regulations were further amended in May 2002, May 2003, and March ee 67 Fed. Reg. 37,998 (May 31, 2002); 68 Fed. Reg. 24,351 (May 7, 2003); 69 Fed. Reg. 12,799 (Mar. 18, 2004). The regulations were adopted as final regulations, without substantive change, on March 3, The regulations address only the son of mirrors problem discussed above. At the same time the temporary regulations were issued, the ervice issued Notice , I.R.B. 644, in which it announced its intention to issue regulations to address loss duplication concerns. 3. Reg (d)-2 is generally applicable for dispositions of stock occurring on or after March 3, a. Reg (d)-2 largely employs the rules that were in former Reg (d)-2. Losses on subsidiary stock are disallowed except to the extent that the parent establishes that the loss is not attributable to built-in gain on the disposition of an asset. Reg (d)-2(c)(2). b. However, Reg (d)-2 differs from former Reg (d)-2 in that the selling group is no longer required to dispose of its entire interest in the subsidiary. Reg (d)-2. 16

25 For dispositions of stock occurring before March 7, 2002, or for dispositions or deconsolidation of stock of a subsidiary after March 7, 2002 effected pursuant to a binding written contract entered into before March 7, 2002 that was in continuous effect, Temp. Reg T(i)(2) allows a parent to choose one of three regulatory schemes for each separate disposition of subsidiary stock. These regulations were adopted as final regulations, without substantive change, on March 3, a. Reg in its entirety; b. Reg without regard to the loss duplication factor; or c. Reg (d) Notice On August 25, 2004, the ervice issued Notice announcing a method that it will accept for determining the extent to which loss or basis is attributable to the recognition of built-in gain on the disposition of an asset for purposes of applying the exception to the loss disallowance rule in Reg (d)-2. a. This method, the basis disconformity method, disallows loss in an amount equal to the least of: (i) the gain amount, which is the sum of all gains recognized on asset dispositions of the subsidiary while a member of the group; (ii) the disconformity amount, which is the excess of the share s basis over the share s proportionate interest in the subsidiary s net asset basis; and (iii) the positive investment adjustment amount, which is the excess of the sum of all positive investment adjustments over the sum of all negative investment adjustments (excluding distributions) made to the share. 6. At the same time Notice was issued, Treasury and the ervice issued temporary regulations permitting taxpayers to make, amend, or revoke elections under Temp. Reg T(i). ee Temp. Reg T(i)(6). 7. The recently proposed unified LDR regulations address losses that violate the General Utilities repeal in addition to duplicated losses, and therefore propose the removal of, among other sections, Reg (d)-2 and rop Reg ee 72 Fed. Reg. 2964, 2983 (Jan. 23, 2007). F. Current Loss Duplication Regulations - Treasury Regulation ection Notice On March 7, 2002, the ervice issued Notice announcing its intention to issue regulations that will prevent a consolidated group from obtaining more than one tax benefit from a single 17

26 2816 economic loss. The Notice stated that such regulations will apply to dispositions of stock occurring on or after March 7, a. The Notice cited the following example of the type of duplicated loss to be targeted by the forthcoming regulations: A member of the consolidated group (the transferor ) contributes a built-in loss asset to another member of the group (the transferee ) in exchange for stock of the transferee in a transaction in which the basis of such stock is determined by reference to the basis of the transferred asset. The transferor then sells the transferee stock without causing a deconsolidation of the transferee, thus permitting the group to benefit from the built-in loss in the asset twice. b. The Notice appears to have been triggered in part by press surrounding a similar transaction undertaken by Bank of America. ee, e.g., heppard, Bank of America s Tax lan for Bad Loans, 2002 TNT 38-5 (Feb. 11, 2002); Mollenkamp, Rare Use of Tax Law Helps Lift Bank of America to Hefty rofit, Wall t. J., at A2 (Jan. 24, 2002). c. Thus, the Notice appears to target the stuffing-type loss duplication transactions illustrated in Examples 6 and 7, above. The loss duplication illustrated in Example 5, above, where the subsidiary s inside loss can be used by it after it leaves the group, was the fact scenario that led to the invalidation of the loss duplication factor in Rite Aid. uch duplication outside the consolidated group was not the apparent target of the Notice. 2. roposed Treasury Regulation ection a. On October 23, 2002, Treasury and the ervice issued proposed regulations to implement Notice rop. Reg Consistent with the Notice, the stated purpose of the proposed regulations was to prevent a consolidated group from obtaining more than one tax benefit from a single economic loss. b. The proposed regulations contained a complicated set of rules: (1) Basis Redetermination Rule - If a member of a consolidated group disposes of stock of a subsidiary member, or a share of subsidiary member stock is deconsolidated, at a loss, then all members bases in the subsidiary stock are aggregated and reallocated among the common and preferred stock of the subsidiary. (2) Loss uspension Rule - If after applying the basis redetermination rule, a member of a consolidated group still recognizes a loss on the disposition of stock of a 18

27 2817 subsidiary, then the selling member s loss is suspended to the extent of any duplicated loss. (3) Basis Reduction Rule - If a subsidiary s stock becomes worthless or the subsidiary disappears in a transaction in which gain or loss is recognized, then any consolidated net operating loss allocable to the subsidiary is treated as absorbed, which results in a basis reduction under the investment adjustment rules of Reg (4) The proposed regulations also contained some anti-abuse rules. c. The regulations were generally proposed to apply retroactively to transactions that occur on or after March 7, 2002, the date of Notice Temporary Treasury Regulation ection T a. Notwithstanding the criticism of the proposed regulations, see American Bar Association ection of Taxation, Comments on Consolidated Group Basis Redetermination and Loss uspension (Feb. 20, 2003); New York tate Bar Association Tax ection, Report on Temporary Regulation 1.337(d)-2T and roposed Regulation (Feb. 28, 2003), on March 14, 2003, Treasury and the ervice issued temporary regulations that were substantially similar to the proposed regulations, but reflected certain revisions based on the comments received. b. Treasury and the ervice made it clear in the preamble to the temporary regulations that they were continuing to study the comments they received and specifically requested comments on alternative regimes that they were considering. 4. Final Treasury Regulation a. On March 9, 2006, the temporary regulations were issued as final regulations without substantive change. The preamble to the final regulations states that Treasury and the ervice are continuing to study the issues raised by both Reg and Reg The preamble states that Treasury and the ervice intend to publish proposed regulations in the near term addressing both circumvention of General Utilities repeal and loss duplication in a single integrated regulation. 19

28 New roposed Regulation a. On January 23, 2007, Treasury and the ervice issued new proposed unified LDR regulations. As promised in the preamble to Reg , the proposed regulations address both General Utilities repeal and loss duplication with an integrated set of rules. As a result, the proposed regulations would remove Reg (d)-1, 1.377(d)-2, and (except to the extent necessary to address losses suspended under (c) and losses reimported under (g)(3)). rop. Reg , 72 Fed. Reg. 2964, 2983 (Jan. 23, 2007). II. LO DIALLOWANCE RULE ADDREING CONCERN RELATING TO THE REEAL OF GENERAL UTILITIE A. General Rule 1. The current regulations governing the disallowance of losses on the disposition of stock of a member of a consolidated group were issued as temporary regulations on March 7, 2002 and were adopted, without substantive change, as final regulations on March 3, The final regulations are generally applicable for dispositions of stock occurring on or after March 2, The temporary regulations are generally applicable for dispositions of stock occurring on or after March 7, In general, the regulations provide 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. Reg (d)-2(a)(1). This is the same as the general rule of the prior loss disallowance regulations. ee rior Reg (a)(1). a. The regulations disallow losses on the sale of subsidiary stock, not assets. As such, the selling group should consider structuring the transaction as an asset sale or as a stock sale with a section 338(h)(10) election. If the subsidiary sells its assets at a loss, the loss will be recognized. b. If a subsidiary and buyer jointly make a section 338(h)(10) election, a stock sale will be treated as a deemed asset sale, with the following consequences: (1) The subsidiary is treated as selling its assets while it was a member of the group; (2) The subsidiary is deemed to be completely liquidated under section 332, and all of the subsidiary s tax attributes move up to the parent; 20

29 2819 (3) The buyer acquires none of the tax attributes of the subsidiary and takes a fair market value basis in the subsidiary s assets; and (4) Gain or loss on the sale of stock is ignored. c. For example, assume that owns all of the stock of. s basis in the stock is $550 and its value is $500. holds one asset, which has a basis of $550 and a value of $500. X wants to purchase the stock for $500. If the stock is sold, would recognize a $50 loss, which would be disallowed. Instead, and X make an election under section 338(h)(10) to treat the stock sale as a deemed asset sale. (1) recognizes a $50 loss that is includable on s consolidated return. (2) s tax attributes move up to. (3) X takes the asset with a step-down in basis to its value of $500, and X loses all of the tax attributes of. (4) If a section 338(h)(10) election is not made, X acquires with its tax attributes, including its built-in loss assets, preserved. As a result, even though section 382, RLY, etc. apply, X may not be willing to join in a section 338(h)(10) election or may pay less for the stock before X will agree to a section 338(h)(10) election. d. As an alternative to a section 338(h)(10) election, could merge into a single-member limited liability company ( LLC ) formed by and sell all of the LLC interests to X. Because the LLC is disregarded as an entity separate from, would be treated as selling the assets of the LLC to X. ee Reg (a). e. As another alternative, could cause to distribute its asset to before selling the stock to X. Under Reg (f)(2)(iii), the principles of section 311(b) apply to intercompany distributions. Thus, s $50 loss would be deferred under Reg (c) and triggered when leaves the group under Reg (d). would reduce its basis in the stock by the $50 loss on the distribution and by the $500 value of the asset. Reg (b)(2)(i), (iv). Because the value of is reduced by the value of the property no longer owned by, would recognize no gain or loss on the sale of the stock to X. ee F..A (Dec. 9, 1999); George White, Loss Disallowance Regulations Flanked?, 41 Tax Mgmt. Memo. 248 (June 19, 2000). 21

30 Disposition is defined in the same manner as the prior regulations as any event in which gain or loss is recognized, in whole or in part. Reg (d)-2(a)(2)(ii); cf. rior Reg (a)(2). A worthless stock deduction under section 165(g)(3) thus constitutes a disposition that triggers the general loss disallowance rule. ee rior Reg (a)(1). B. Deconsolidations 1. If a member s basis in its subsidiary stock exceeds the stock s fair market value immediately before the stock is deconsolidated, the member s basis in the subsidiary stock is reduced to the stock s fair market value. Reg (d)-2(b). 2. Deconsolidation is any event that causes a share of stock of a subsidiary that remains outstanding to be no longer owned by a member of any consolidated group of which the subsidiary is also a member. Reg (d)-2(b)(2). 3. If both a disposition and a deconsolidation occur with respect to a share in the same transaction, then the general disallowance rule of Reg (d)-2(a)(1) applies first, and the deconsolidation rule of Reg (d)-2(b)(1) applies next to the extent necessary to effectuate the purposes of the regulation. Reg (d)-2(b)(1). 4. The prior regulations provided an identical rule for the reduction of basis upon deconsolidation. rior Reg (b)(1). However, the prior regulations contained an additional requirement if a share of stock retained by a group were deconsolidated and then disposed of within two years after the date of deconsolidation, which is not contained in Reg (d)-2. a. In such cases, the group was required to file a statement with its return for the year of the disposition setting forth the amount of any prior basis reduction, the basis of the subsidiary s stock immediately before the disposition, the amount realized on the disposition, and the amount of loss recognized on the disposition. rior Reg (b)(5). b. Failure to file the statement resulted in the disallowance of a deduction for the loss. c. The preamble to the final 1991 regulations clarified that the statement must be filed regardless of whether there was a reduction in the basis of stock under the deconsolidation rule. 56 Fed. Reg. at 47,