Rite Aid: a tough pill for the government to swallow.

• Author: Silverman, Mark J.

1. Introduction

   The loss disallowance rules of the consolidated return regulations disallow losses on the disposition of subsidiary stock to the extent such losses may be duplicated by the subsidiary subsequent to the disposition. (1) This rule has been widely criticized and was recently invalidated by the U.S. Court of Appeals for the Federal Circuit. In Rite Aid Corp. v. United States, (2) the Federal Circuit held that the loss duplication factor contained in Treas. Reg. [section] 1.1502-20 exceeds the scope of authority granted to the Internal Revenue Service and is, therefore, invalid. (3) The government filed a petition for rehearing en banc, but the Federal Circuit denied the petition on October 3, 2001. (4)

   The Federal Circuit's decision represents a victory for taxpayers. Indeed, it achieves results many practitioners urged at the time the regulations were issued. The decision, however, uses very broad language to invalidate a legislative regulation and it provides little analysis and guidance about the standard applied for determining the validity of the loss duplication factor. As a result, it creates uncertainty about the reach of the court's holding and raises questions about the validity of many consolidated return provisions. In our view, the reach of the court's holding is limited to the duplicated loss factor and does not extend to the rest of Treas. Reg. [section] 1.1502-20. In addition, we believe that before other courts extend the Rite Aid standard to other consolidated return regulations, a more careful analysis and a more clear statement of the standard should be made.

2. Overview of Loss Disallowance Rules

   1. History of Loss Disallowance Rules

   1. Notice 87-14

      Before discussing the Rite Aid case, it is helpful to review the loss disallowance rules and their history. The Tax Reform Act of 1986 repealed the General Utilities doctrine by requiring corporate-level gain recognition on a corporation's sale or distribution of appreciated property, regardless of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 non-liquidating context. (5) Congress granted the IRS 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 ... )." (6)

      A transaction, known as the "son-of-mirrors" transaction, prompted the IRS to take action pursuant to this grant of authority. The son-of-mirrors transaction is illustrated by the following example:

      Example 1. P is the common parent of a consolidated group. S is a corporation that owns two assets--a wanted asset with a $50 adjusted basis and $100 fair market value, and an unwanted asset with a $0 adjusted basis and $75 fair market value. P acquires the S stock for $175. After joining the P group, S distributes the wanted asset to P. S's $50 of section 311(b) (7) gain is deferred, and P takes a $100 basis in the asset. (8) P sells the stock of S (holding only the unwanted asset) to an unrelated person for $75. Under the investment adjustment rules, P's basis in the S stock is $125. (9) Thus, P recognizes a $50 loss.

      S's built-in gain in its assets was already reflected in P's initial cost basis in the S stock. Thus, the positive investment adjustment for S's section 311(b) gain artificially increases P's basis in its S stock and permits P to recognize an offsetting loss, in effect eliminating S's gain from corporate-level tax. (10)

      The IRS concluded that the result in the son-of-mirrors transaction undermined the repeal of the General Utilities doctrine and issued Notice 87-14 (11) in response. That notice announced that the IRS intended to promulgate regulations affecting adjustments to the basis of stock of a subsidiary that is a member of the consolidated group in cases where the stock of such subsidiary was acquired and the subsidiary had a built-in-gain asset. The Notice stated:

      In general, the adjustment to stock basis will not reflect built-in gains that are recognized by target on sales of, or by reason of distributions of, its assets. Thus, in cases where a target's stock is sold, the regulations will prevent recognition of losses that are attributable to the subsidiary's recognition of built-in gains. (12) The Notice also provided that regulations would be effective with respect to stock in a target that was acquired after January 6, 1987, the date of the Notice.

   2. Temporary and Proposed Regulations

      On March 9, 1990, the IRS issued Temp. Reg. [section] 1.1502-20T. (13) In marked contrast to the approach of Notice 87-14, which disallowed a positive investment adjustment for recognition of built-in gains, the temporary regulations adopted a blanket rule disallowing all losses on the disposition of subsidiary stock. The temporary regulations were effective for dispositions of subsidiary stock on or after March 9, 1990. (14)

      The preamble to the temporary regulations acknowledged that the loss disallowance rules could result in the disallowance of economic losses, (15) but cited two justifications for the loss disallowance rules. First, the IRS believed that the investment adjustment rules could be used to obtain a stepped-up basis in corporate assets without the payment of corporate-level tax, as in Example 1 above, thereby conflicting with the repeal of the General Utilities doctrine. (16) Second, the IRS believed that a subsidiary's losses could be duplicated as investment losses of the parent when the parent disposed of the subsidiary's stock, as illustrated in the following example:

      Example 2. P forms a subsidiary, S, with a contribution of $100, and P and S elect to file a consolidated return. S's assets decline in value to $40. Because the loss is unrealized, P's basis in its S stock is not reduced. (17) P sells the S stock for $40, recognizing a $60 loss. (18) Later, S sells its assets for $40, recognizing a $60 loss.

      Thus, P's loss oh the sale of the S stock is duplicated when S later sells its built-in loss assets. The preamble explained that gain duplication can also occur when S's assets increase in value, but that taxpayers could use self-help measures to avoid duplication of gain (i.e., through an asset sale or section 338(h)(10) election) and, at the same time, preserve duplication of loss. (19)

      The IRS went to great lengths to explain the approaches it did not adopt in the temporary regulations. First, the preamble acknowledged that the most accurate method of eliminating losses resulting from the recognition of built-in gain would be a tracing regime to eliminate positive investment adjustments to the extent such adjustments are attributable to the recognition of built-in gain. The IRS, however, rejected the tracing approach as administratively burdensome; it would require an appraisal of the subsidiary's assets at the time the subsidiary was acquired. (20) Second, the preamble noted that a simpler, but less accurate, method of preventing the investment adjustment rules from eliminating corporate-level tax would be to create a presumption concerning the extent to which a subsidiary's recognized gain is built-in gain and eliminate positive basis adjustments to that extent. This approach was rejected because it would produce harsh results in some cases while failing to prevent the elimination of corporate-level tax in other cases. (21) Third, the IRS rejected several approaches involving a combination of tracing with some form of presumption because of the degree of inaccuracy associated with the presumption rule and the complexity associated with the tracing rule. (22) Fourth, the IRS rejected a loss limitation approach, which would have disallowed a loss unless the taxpayer could establish that the loss was not attributable to investment adjustments resulting from recognition of built-in gain, because taxpayer would have to resort to tracing to take advantage of the rule. (23)

      As if contemplating taxpayers' criticism of the loss disallowance rules, the IRS tossed out a couple of other bones to taxpayers. The loss disallowance rules could, in many cases, permit the parent to shelter post-acquisition appreciation in stock of an acquired subsidiary, as illustrated in the following example: (24)

      Example 3. S has two assets, one with a basis of $0 and a value of $100 and the other with a basis and value of $0, and P buys the S stock for $100. S sells the first asset for $100, and P increases its basis in the S stock to $200. The second asset appreciates in value to $100, and P sells its S stock for $100, recognizing no gain or loss.

      Because of the post-acquisition appreciation of the second asset, P's basis increase does not create a loss, but instead shelters P's investment gain on the sale of the S stock.

      In addition, the IRS noted that the taxpayer may avoid the effect of the loss disallowance rules by either making a section 338(h)(10) election or causing the subsidiary to sell its assets before selling the stock of such subsidiary. (25)

   3. Re-Proposed Regulations

      The temporary regulations were widely criticized. (26) The duplicated loss provision was one of the most criticized features. In response, on November 19, 1990, the IRS withdrew the temporary regulations and re-proposed new regulations in their place. (27) The re-proposed regulations retained the general rule of the temporary regulations that losses on subsidiary stock were disallowed. (28) In an attempt to address the criticism that the temporary regulations disallowed economic losses, however, the re-proposed regulations added an exception that would allow all or a portion of the loss to be allowed. (29)

      The IRS continued to reject a tracing rule as unadministrable, so the computation of the allowed loss was based on a set of presumptions as to what contributes to the avoidance of corporate-level tax. (30) In general, the amount of loss disallowed would not exceed the sum of three...