Notice 2002-11: IRS reversal on Rite Aid.

• Author: Packard, Pamela
• Position: Consolidated tax returns

On Jan. 31, 2002, Treasury issued Notice 2002-11, discussing the IRS's position on Rite Aid Corp., 25 F3d 1357 (Fed. Cir. 2001).

Rite Aid addressed the loss-disallowance rules (LDR) that apply to sales of stock of a consolidated group member. In Rite Aid, the Federal Circuit held that the duplicated-loss component of Regs. Sec. 1.1502-20, which disallows certain losses on sales of stock of a consolidated group member, was an invalid exercise of regulatory authority.

Regs. Sec. 1.1502-20 disallows a deduction for a consolidated group member's investment loss on the sale of a subsidiary, to the extent of the parent's positive investment adjustments in its subsidiary in prior years, any extraordinary-gain dispositions and what Treasury believes is a duplicated-loss factor (DLF). A DLF is the excess of the subsidiary's adjusted basis in its assets over the value of its assets immediately after the sale, combined with net operating losses (NOLs) that leave the group with the subsidiary. Since Rite Aid's subsidiary's DLF exceeded its investment loss, the LDR regulations prohibited an otherwise valid deduction for Rite Aid's loss on the sale of the subsidiary's stock.

Rite Aid argued that the DLF of the LDR regulations taxes income of corporations filing consolidated returns that would not otherwise be taxed. The reasons put forth were that Sec. 165 allows a deduction of losses from the sale of property; the loss would be allowed if the subsidiary was not part of the consolidated return group; other provisions police any duplication of tax benefits (i.e., Sec. 382); and the denial of the deduction imposes a tax on income that would not otherwise be taxed.

The Federal Circuit found the LDR regulations to be manifestly contrary to the Code. In the absence of a problem created from filing consolidated returns, the court determined that the Service has no authority to change the application of other Code provisions for a group of affiliated corporations filing a consolidated return.

In a Chief Counsel Notice (CC-2001-42) issued in August 2001, the IRS advised chief counsel attorneys that it disagreed with the appellate court's decision in Rite Aid. The Justice Department then filed a petition for rehearing en banc with the Federal Circuit. The en banc hearing was unanimously rejected.

Despite the rehearing rejection, Notice 2002-11 indicates that the Service still believes that the court's analysis and holding were incorrect. However, absent a split...