Corporate Restructuring: Federal Court Kayos Tax Relief For Selling Doggie Divisions

Restructuring companies that take haircuts in unloading sub-par divisions and soured acquisitions suffered a major setback in efforts to regain long-denied federal tax deductions for their losses. Tax relief for selling unwanted operations at discount prices has, in the main, been sharply curbed since the Internal Revenue Service issued the controversial “no-loss” rule in 1991. Although the rule was designed to spike deductions for losses manufactured by accounting gimmicks, accounting authorities say it goes much further and essentially erases tax relief even for legitimate economic losses incurred when a parent must take a fire-sale price to move a deteriorated business. Divesting companies lost a key round to the IRS in late April when a federal court, acting in a test case, ruled against them and in favor of the tax agency. The U.S. Court of Federal Claims not only denied a tax deduction for a corporate challenger, Rite Aid Corp., but broadened the scope of the decision to all divestitures by upholding the IRS’ authority to issue the “no-loss” rule. Attacks on the agency’s powers had been a centerpiece of the Rite Aid appeal and are expected to arise in other court challenges by corporate taxpayers. Robert Willens, SVP and corporate tax expert at Lehman Brothers, estimated that more than 100 companies and billions of dollars in taxes are impacted by the decision. These involve firms that sold businesses at a loss since the rule took effect nearly 10 years ago. “The court was unequivocally in the IRS’s corner with regard to its authority to issue rules like this,” Willens said. “It sets the tone for other court decisions on the same issue. People feel less confident that the rule will be overturned. They are less sanguine about selling at a loss.” As a result of the decision, Rite Aid, the Camp Hill, Pa.-based drugstore chain, must ante up $10.4 million in taxes. It had claimed the deduction after booking a $22 million loss on the 1994 sale of its money-losing Encore bookstore chain. A Rite Aid spokeswoman said that the company had not yet decided on whether it will appeal the decision to a higher court. In the instant case, Rite Aid was denied a deduction under a concept that accountants call the “duplicate loss,” i.e., both the buyer and the seller cannot take deductions on the same transaction. Rite Aid, Willens explains, had a higher basis in the Encore assets than their value at the time of the sale. That deterioration in value contributed to the loss on the sale. “The seller’s losses were not allowed because the buyer can take advantage of the same losses,” Willens says. “If the court had allowed Rite Aid to make the deduction, the buyer could not have deducted the same loss after the acquisition because Encore had a high basis relative to its value. The court disallowed the seller’s loss and allowed the buyer to take the deduction.” The rule and the court decision even apply when the parent writes down the value of the unit to be divested prior to a sale and takes a hit against earnings. “The only way they can get relief is if a court strikes down the IRS rule,” Willens said. “The court isn’t distinguishing between a legitimate loss and a manufactured loss.” The identity of the court that ruled against Rite Aid also is not encouraging to corporate taxpayers that had hoped to upset the IRS regulation. Appeals of IRS decisions generally go the U.S. Tax Court. But Willens said Rite Aid apparently chose the Court of Claims because it “has a reputation for taxpayer-friendly decisions.” In the final analysis, the absence of tax benefits may not have much of an impact on corporate divestitures or restructurings in general. Strategic experts point out that companies saddled with poor performers opt to get rid of them as quickly as possible and eat the one-time losses, rather than fiddle around with the tax consequences.