Appeals Court Allows a Tax Break For Firms Selling Ugly Ducklings

The decade-long battle over federal tax relief for companies selling damaged-goods subsidiaries at a loss has taken a significant turn in favor of corporate divestors. A federal appeals court, dealing a setback to the Internal Revenue Service (IRS), ruled that both buyers and sellers of distressed operations could deduct pure economic losses on the deal from their income taxes. The decision by the Court of Appeals for the District of Columbia Circuit overturned a lower court edict in April 2000 that had gone in favor of the IRS, which historically balked at allowing many sellers to reap tax benefits from cut-rate pricing. Although the result was considered a significant victory for corporate taxpayers, the extent of the ruling was somewhat unclear. Basically, it applied to a class of divestitures that ran afoul of the controversial “loss disallowance rule” (LDR) issued by the IRS in 1991. More specifically, deductions for the sellers often were denied under a portion of the rule known as the “duplicated lossfactor,” under which only one party could claim the deduction. Tax experts said it was not immediately apparent whether the duplicate loss factor itself was erased by the decision or merely declared inapplicable in the specific case being litigated. That may be determined in future skirmishes, which, the experts say, are inevitable. They expect more litigation that might lead to resolution of the matter by the U.S. Supreme Court. Meanwhile, they report that divestors who previously got the short end of the tax stick are preparing to queue up for refunds based on the appeals court ruling. As much as $10 billion could be at stake. If the appeals court decision holds up, it will level the field on tax relief for money-losing sell-offs. One of the ironies is that not all sellers of sickly subsidiaries have been denied tax deductions. The LDR covers only sell-offs of subsidiary stock by companies that file consolidated tax returns. Companies that don’t use consolidated returns generally have been successful in taking tax deductions on fire-sale prices. Moreover, if the deal was structured as an asset sale, deductions were generally available. Those differences were instrumental in the appeals court decision. The case was brought to the D.C. circuit by Rite Aid Corp., which was denied a deduction by the IRS on the 1994 sale of its beleaguered Encore book chain at a loss of $22 million. Rite Aid appealed a decision by the Federal Court of Claims that not only agreed with the IRS that only the buyer of Encore was entitled to a future deduction but upheld the agency’s right to use the LDR to fight unreasonable tax avoidance through consolidated returns. By contrast, the appeals court said it was not fair to single out divestitures by companies filing consolidated returns, especially when the losses were purely economic and did not result from the consolidated return approach. According to the court, the loss would have occurred, irrespective of whether Rite Aid did or did not file a consolidated return. As a result, the court said, the IRS overstepped its bounds in applying the LDR so narrowly. Robert Willens, a managing director and corporate tax authority at Lehman Brothers, says that the Court of Claims virtually took the view that the IRS had “unbridled authority” to issue the regulation while the appeals court found that the agency was attacking an issue that did not grow out of consolidated returns. Rule is deemed overly broad “In fact, the court said that if Rite Aid and the subsidiary did not file consolidated returns, the ability to deduct twice would not have been questioned,” he says. “There would be no prohibition on deducting the loss on the sale of stock, and then having the acquiring company deduct the loss later on from the sale of assets. The feeling was that this regulation was overly broad because it penalized companies that filed consolidated returns rather than treated them no worse than companies that didn’t file consolidated returns.” Tax experts say it is unlikely that the IRS would give up the LDR without a fight. One possible scenario outlined by Willens involves a clash of courts. The agency would deny a tax deduction in a similar sell-off case and hope that appeals go to another circuit that would decide differently than the D.C. court. If that happens, the IRS would ask the Supreme Court to resolve the conflict.