Court Defers Loss Deduction on Redemption of Intercompany Debt.

• Author: Weinberger, Mark

The Tax Court has ruled under prior consolidated return regulations that a consolidated group member may not take a capital loss deduction on a redemption of an intercompany note (Textron Inc., 115 TC No. 6). The case is a conspicuous departure from the literal approach recently taken by the Tax Court in interpreting the consolidated return regulations.

In 1977, AVCO, then the common parent of a consolidated group, redeemed its own stock held by one of its subsidiaries (S) in exchange for an AVCO note. S's loss on the transaction was not recognized; under Regs. Sec. 1.1502-31(b)(2) (ii), as then in effect, S's basis in the AVCO stock became its basis in the AVCO note. As a result, S had an unrealized loss in the note. In 1985, Textron acquired the AVCO group. In 1987, AVCO redeemed the AVCO note and S claimed a $15 million capital loss on the redemption.

The IRS argued that the loss should be deferred under former Kegs. Sec. 1.1502-14(d)(4), which applied if (1) a member received an obligation of another member in exchange for property, (2) the basis of the obligation was determined in whole or in part by reference to the basis of the property exchanged and (3) the obligation had never been held by a nonmember.

Among other arguments, Textron asserted that the exception applies only if the obligation has never been held by a nonmember, and that S held the note as a member of the AVCO group for seven years before it became a member of the Textron group. This seems to be a convincing argument, but exposes an apparent flaw in the regulation. In general, a net loss cannot be made available merely by rearranging a consolidated group's assets that are never outside the group. The never-held-by-a-non-member requirement could be considered inappropriate if a debt were always held as intercompany debt in a predecessor group and came into the current group under an exception that prevented triggering of all deferred gain or loss. In that situation, the debt was always under the same single-entity regime and presumably should not be treated as held by a nonmember. Nevertheless, the AVCO and Textron groups were separate groups and a literal-minded court might have sided with Textron.

The court, however, took a very broad view of its responsibilities in interpreting the regulations, stating:

Petitioner's reading is incongruous with the purpose of the consolidated return regulations and leads to an unreasonable result. The...