Rite Aid: potentially historic.

• Author: Salem, Irving
• Position: Business loss deductions

Faster than a speeding bullet, in a single bound, the Rite Aid case (1) has:

* destroyed more than 100 carefully developed paragraphs of Treas. Reg. [section] 1.1502-20, dealing with the disallowance of losses related to consolidated subsidiaries;

* endangered about a dozen other consolidated return provisions; and

* displaced the current judicial deference standard of Chevron with the National Muffler standard.

Rite Aid has the potential to be an historic case -- a Supercase by any standard. This article attempts to sort out the implications and the opportunities.

1. Brief Summary of The Rite Aid Decision

   At issue in Rite Aid was whether a $22 million economic loss incurred by the company on the purchase and sale of a failed investment (in the stock of a discount bookstore chain) would be disallowed by the "loss duplication" arm of Treas. Reg. [section] 1.1502-20, the so-called loss disallowance regulations (LDR). Loss duplication, simply put, means that the mere possibility, no matter how remote, that the purchaser of the stock could utilize that same economic loss (in the form of either a net operating loss; carryover or a built-in loss in the assets) requires that the loss economically accruing to the Seller must be disallowed. The Treasury Department of Internal Revenue Service had admitted loss duplication was "another problem," unconnected with section 337 of the Internal Revenue Code, which repealed General Utilities in 1986 to insure a tax on built-in gain at the corporate level.

   The Federal Circuit, reversing the Court of Federal Claims, wrote a brief opinion, resting on two points:

   1. The consolidated return regulations can only deal with consolidated return problems. No fewer than four times, the Federal Circuit insisted the loss duplication rule went beyond the IRS's delegated power of writing rules which can only fix consolidated return problems:

      (i) "[In] the absence of a problem created from the filing of consolidated returns, the Secretary is without authority to change the application of other tax code provisions to a group of affiliated corporations filing a consolidated return";

      (ii) "Realization of the loss does not stem from filing consolidated returns"....;

      (iii) "The loss realized on the sale of a former subsidiary ... is not a problem resulting from the filing of a consolidated return. The scenario also arises where a corporate shareholder sells stock of a non-consolidated subsidiary"; and

      (iv) Since section 165 "allows a deduction of losses" from the sale of property, the Court found for the taxpayer since "realization of the loss does not stem from the filing of a consolidated returns."

      This concept, one that has never before been articulated so precisely, (2) is sure to bedevil the IRS and Treasury, as well as the consolidated return filer, for years.

   2. Distortion of income. In addition, the Federal Court believed Rite Aid's taxable income was distorted, producing a result precisely the opposite of the IRS and Treasury's statutory mandate in section 1502 to provide regulations which clearly reflect tax liability:

      Rather than creating symmetry in the tax code, ... the duplicated loss factor distorts rather than reflects the tax liability of consolidated groups and contravenes Congress' otherwise uniform treatment of limiting deductions for the subsidiary's losses. Because the regulation does not reflect the tax liability of the consolidated group, the regulation is manifestly contrary to the statute. (Emphasis added.) A clean, devastating knockout punch -- Superman could not have done it any better. Arguably, this "distortion" argument was the only rationale necessary.

2. The Government's Swift Decision to Completely Revise Treas. Reg. [section] 1.1502-20

   Once it decided not to seek certiorari, the IRS and Treasury took bold, decisive steps. (3) They eliminated the loss duplication arm of LDR (at least for now) and, temporarily, will deal with the G.U. built-in gain problem under the tracing regime of Treas. Reg. [section] 1.337(d)-2, as amended. It has also been conceding pending cases, including Square D Company v. Commissioner, in the Tax Court, Docket No. 6067-97 (a case primarily involving a wasting asset, goodwill), and FPL Group, Inc. v. Commissioner, T.C. Docket Nos. 5271-96, 6653-00, and 10811-00 (involving the disposition of an insurance subsidiary that allegedly was exposed to all three prongs of the loss disallowance rules). Cases in the field also are being dropped at the audit or appeals level (such as a case involving the no netting rules). William Alexander, acting Associate Chief Counsel (Corporate), explained the concessions, as follows: "[T]he three factors [extraordinary gains, positive investment adjustments and loss duplication] are inextricably bound to each other, making defending any one factor difficult." Tax Notes, March 18, 2002, at 1395.

   1. Description of Treas. Reg. [section] 1.337(d)-2T

      1. Overview. Treas. Reg. [section] 1.337(d)-2, first conceived of as a transition rule prior to the full effect of LDR, will now govern all dispositions or deconsolidations of subsidiaries on or after March 7, 2002. Critically, such rules will also be available for all open prior years on an elective basis.

         The basic rule in Temp. Reg. [section] 1.337(d)-2T(a) is overbroad and provides that no loss is allowed for any loss recognized with respect to the disposition of a consolidated subsidiary. To the extent "the taxpayer establishes that the loss or basis is not attributable to the recognition of built-in gain or the disposition of an asset," however, the loss will be allowed -- but only if a separate statement entitled "[section] 1.337(d)-2T(c) statement" is included "with or part of the taxpayer's return in the year of the disposition or deconsolidation." (4) See Temp. Reg. [subsections] 1.337(d)-2T(c)(2) and (3).

         The only flesh placed on the "attributable to" bone is the following additional sentence:

         For purposes of this section, gain recognized on the disposition of an asset is built-in gain to the extent attributable, directly or indirectly, in whole or in part, to any excess of value over basis that is reflected, before the disposition of the asset, in the basis of the share, directly or indirectly, in whole or in part, after applying section 1503(e) and other applicable provisions of the Internal Revenue Code and regulations." (Emphasis added.) "Reflected in basis" and "recognized on the disposition" are important concepts and are discussed in some detail below.

         Gone, thankfully, are the overbearing presumptions, such as all post-acquisition earnings being deemed to be built-in gain and all losses deemed to be post-acquisition losses. While the recordkeeping and valuation skills of corporate America will be tested, putting reality back into the tax system is a welcome relief. Query: Will reality include a Cohan-type rule allowing the taxpayer to prevail (with a small haircut) if it appears the taxpayer has satisfied its burden of proof, or will a "clear and convincing" standard be invoked?

         The decision to abandon the LDR litigation, swiftly followed by a tracing rule similar to that originally envisioned after the repeal of G.U. (i.e., Notice 87-14), is bold and eminently fair, (5) deserving of a spot in the Tax Policy Hall of Fame.

      2. Some specific issues.

         (a) Assets with no possibility of a built-in gain. Although not explicit, it seems clear that the following acquisitions should be per se exempt from the new temporary loss disallowance rules: (i) assets acquired after the date of acquiring the member; (ii) assets acquired in a section 338(h)(10) transaction; and (iii)corporations formed with cash or cash equivalents with no built-in gain. For insufficient reasons, all such cases could have been caught by Treas. Reg. [section] 1.1502-20.

         (b) Wasting Assets. The LDR trigger is a "disposition" of an asset with a built-in gain. Although the term "disposition" is a tad ambiguous with respect to assets that are consumed (such as goodwill or subscription lists), it seems reasonably clear that an asset that is consumed or wastes away is not covered by the term. Moreover, if this were not intended, there would have been no reason for the IRS and Treasury's request for comments on dealing with the consumption of built-in gain assets. See Hearing Notice on Loss Limitation Rules.

         (c) Netting of gains and losses. Built-in gains and losses on hand at the date of acquisition should be netted. That is partially acknowledged in Example 4 in Treas. Reg. [section] 1.337(d)-1, which is...