The following article is adapted and reprinted from the M&A Tax Report, Vol. 10, No. 2, September 2001, Panel Publishers, New York, NY.


By Robert W. Wood

The Federal Circuit Court of Appeals in Rite Aid Corp., et al. v. United States; 88 A.F.T.R.2d Par. 2001-5025 (No. 00-5098), held that the loss disallowance regulations under Section 1.1502-20 are invalid. Since Treasury Regulations are not struck down too often, this is a significant and important development for M&A practitioners. The Federal Circuit, reversing the Court of Federal Claims, has held that reg. Section 1.1502-20 and the duplicated loss factors under the Section are not within the authority delegated by Congress under Section 1502.

Good Facts Make Good Law?

In 1984 Rite Aid Corp. purchased 80 percent of the stock of Penn Encore, and it purchased the balance in 1988. After the 1984 stock purchase, Rite Aid included Encore in its affiliated group for purposes of filing consolidated tax returns. Encore had net negative E&P during 1985-1994 and borrowed from Rite Aid. In 1994 Rite Aid adopted a restructuring plan and sold Encore. Rite Aid contributed the debt owed to it by Encore to capital, raising Rite Aid's basis in the stock. Rite Aid asserted that it had a loss on the sale but that Section 1.1502-20(a) of the Regulations denied it recognition of the loss because Encore was a member of an affiliated group filing a consolidated return. Encore's duplicated loss (calculated under Section 1.1502-20) exceeded Rite Aid's claimed $22 million economic loss. Thus, Rite Aid was denied any loss deduction on the sale under reg. Section 1.1502-20.

The Court of Federal Claims rejected Rite Aid's arguments that reg. Section 1.1502-20 denies corporate shareholders the benefit of a loss on investment without furthering the purpose of clearly reflecting tax liability. The court noted that the correct standard for review of the regulations is whether the regulation is arbitrary, capricious, or manifestly contrary to law. The court held that the regulation wasn't arbitrary or manifestly contrary to the law, and that the regulation serves to clearly reflect income tax liability for the parent and the subsidiary by prohibiting possible loss deductions by a consolidated group and its former subsidiary for the same transaction. Rite Aid Corp., et al. v. United States, No. 98-492 T (Fed. Cl. Apr. 21, 2000) (For a summary, see Tax Notes, May 1, 2000, p. 644; for the full text, see Doc 2000-11836, 2000 TNT 81-7 , or H&D, Apr. 27, 2000, p. 861.)

Federal Circuit

Chief Circuit Judge Haldane Robert Mayer noted that the delegation of rulemaking power under Section 1502 provides for the promulgation of legislative regulations that are entitled to "controlling weight unless they are arbitrary, capricious, or manifestly contrary to the statute." The court noted that a regulation is contrary to a statute if it is outside the scope of authority delegated. The court noted that absent a problem created by the filing of consolidated returns, the secretary lacks authority to change the application of tax provisions to corporations filing consolidated returns.

Rite Aid argued that the duplicated loss factor of reg. Section 1.1502-20(c) imposed a tax on income of corporations filing consolidated returns that wouldn't otherwise be taxed, and that it denied it the loss allowed under Section 165. Rite Aid argued that the realization of the loss doesn't stem from the filing of a consolidated return, and that the denial of the deduction imposes a tax on income that wouldn't otherwise be taxed.

Judge Mayer, dismissing the government's argument, noted that taking "'the bitter with the sweet' does not include taking the invalid." The court stated that the loss realized on the sale of a former subsidiary's assets after the consolidated group sells the subsidiary's stock isn't a problem resulting from the filing of consolidated income tax returns. The court stated that the duplicated loss factor addresses a situation that arises from the sale of stock regardless of whether corporations filed consolidated returns. Judge Mayer concluded that Sections 382 and 383 address the government's concerns by limiting the subsidiary's future deduction and not the parent's loss on the sale. Judge Mayer concluded that the duplicated loss factor distorts (rather than reflects) the tax liability of consolidated groups, and contravenes congressional intent.

Reactions Abound

Some of the reaction to the Federal Circuit's decision has been predictable. For example, the peripatetic Lee Shepherd of Tax Analysts criticized the brevity of the opinion, and pointed out her view that the decision conflicts with a Supreme Court opinion (no less), calling for single entity treatment of a group filing a consolidated return. See United Dominion Industries, Inc. v. U.S., No. 00-157 (U.S. S.Ct., June 4, 2001), 2001 TNT 104-14, Tax Analysts Doc. No. 2001-15742. Ms. Shepherd wrote a predictably scathing review of the case. See Shepherd, "Federal Circuit Invalidates Loss Disallowance Rule," Tax Notes, July 16, 2001, p. 334.

To be fair, there are some points in Ms. Shepherd's account that we must agree with. For example, although she may call the opinion "exceedingly brief" too many times, it is, after all, a short opinion. And when one considers that the consolidated return rules are some of the more convoluted and lengthy rules in the regs, perhaps there is a subtle (or blatant) irony about that by itself. Ms. Shepherd is also right to note the standard of review for regulations. It is not an easy thing (as M&A Tax Report readers know) to have regulations overturned. In the lower court opinion in Rite Aid (before the Court of Federal Claims), the IRS argued correctly that legislative regulations are upheld as valid unless they are arbitrary,capricious, or manifestly contrary to the statute. See Chevron, U.S.A., Inc. v. Natural Resources Defense Council, 467 U.S. 837 (1984). The Court of Federal Claims had found that the loss disallowance rule was "well within the four corners of Section 1502."

Ultimately, there are some procedural lessons in Rite Aid that tax litigators have probably known for a long time. Unlike the Tax Court, neither the Court of Federal Claims and the Federal Circuit are fully peopled with full-time tax specialists. Indeed, one of the thrusts of Lee Shepherd's article is that the Federal Circuit has generalist judges. (Is this nefarious?) If you are a tax lawyer or a taxpayer arguing for a particular position, that can be good or bad. If you prevail, it turns out to be a very good thing. Critics, of course, can yell and scream that the Federal Circuit simply did not understand that one of the primary (if not only) goals of the consolidated return rules are to treat an affiliated group filing a consolidated return as if it were a single entity. There is more than wavering on this point in the Rite Aid opinion.

Perhaps not surprisingly, not only the judges in Rite Aid but various others don't escape Lee Shepherd's scathing pen. Even Supreme Court Justice Souter in the opinion that Shepherd thinks controls (United Dominion) is accused of not being very clear, and merely characterizing the single entity approach of the consolidated return rules as "a better answer" according to Souter, but not the only answer (according to the gospel that is Lee Shepherd).

In the trenches, practitioners didn't escape criticism either. We at The M&A Tax Report noted (as I'm sure Irv did, too), that our Advisory Board Member Irving Salem of Latham & Watkins is stated by Shepherd to be "the lawyer who is the godfather of the effort to overturn the loss disallowance rules." See Tax Notes, July 16, 2001 at p. 339. (For those interested in reading the background, Shepherd cites Irv Salem's excellent article "Judicial Deference, Consolidated Returns, and a Loss Disallowance: Could LDR Survive a Court Challenge?" 43 Tax Executive 167 (1991).

Ancient History

There is some history to striking down consolidated return rules. In American Standard, Inc. v. U.S., 602 F.2d 256 (Ct. Cl. 1979), the Court of Claims (as it was then called) invalidated a consolidated return regulation. The American Standard case involved how the taxpayer (an affiliated group that included a sub-group of Western Hemisphere Trade Corporations). The question was whether the taxpayer should break out taxable income allocable to that sub-group to form the base of its Section 922 Western Hemisphere Trade Corporation deduction (a percentage of taxable income). The court in American Standard declared invalid the last sentence of the pertinent regulation (Reg. §1.1502-25(c)(2)), which had required the exclusion of loss numbers from a formula used to determine the portion of consolidated taxable income attributable to Western Hemisphere Trade Corporation qualifying members.

Obviously, American Standard involved a highly technical (and much less important) provision than the loss disallowance rules, a provision that involved government subsidies. It was the Congressional intent in bestowing this subsidy that the Court of Claims focused on in invalidating that sentence in American Standard.

Final Slap

More than a few people have noticed, including The Wall Street Journal, that the lawyer who represented Rite Aid, B. John Williams of Sherman & Sterling's Washington office, is a former Tax Court judge, plus (and here's the good part) is about to become IRS Chief Counsel. See McKinnon, "Nominee for IRS Legal Job Wins Ruling That May Hurt Tax-Shelter Crackdown," Wall Street Journal, July 11, 2001, p. A10. See also Shepherd, Tax Notes (July 16, 2001), p. 340. Apart from this issue (quite appropriately, Williams is recusing himself from any governmental request for a rehearing in the Rite Aid case). The question is where all of this leaves us now.

Some have urged the government to push for a rehearing (would you be surprised to know Lee Shepherd so states?). See Shepherd, Tax Notes (July 16, 2001), p. 340. Yet, wasn't the writing on the wall for a long time that the loss disallowance rule was perhaps duplicative? Shepherd herself acknowledges that the Treasury had been re-examining the loss disallowance rules in an effort to make them work better, possibly delinking the duplicated loss portion of them from the General Utilities repeal portion of the rules.

After all, the loss disallowance rules basically have two pieces that arguably overlap and are certainly interrelated. The General Utilities repeal portion was issued under the authority of Code Section 337(d). It was aimed at the — here's a bit of nostalgia — "Son of Mirrors" transaction, to prevent taxpayers from using number share basis increases to create artificial losses. Some of us (indeed, all of us here at The M&A Tax Report) are old enough to remember the Son of Mirrors transaction which sped along nicely until it was squelched...but now that seems ancient history.

The other portion of the loss disallowance rules is the duplicated loss portion, and that was the part under examination in the Rite Aid case. It was added to the basic mechanism that the drafters chose for General Utilities repeal. In effect, the Treasury was killing two birds with one stone (an apt metaphor that Lee Shepherd herself uses!). See Shepherd, Tax Notes (July 16, 2001), p. 340.

Taxpayer Guidance

Many are still trying to figure out exactly where we all go from here (once the Rite Aid decision is truly final). Watch for future coverage of this topic in a forthcoming edition of The M&A Tax Report.

Section 1.1502-20 Loss Disallowance Regulations Invalid!, Vol. 10, No. 2, The M&A Tax Report (September 2001), p. 1.