Excluded Income Can Still Hit Group NOLs

A member company that excludes cancellation of debt income from its gross income still reduces the consolidated group's net operating loss, says the IRS.

New guidance pertaining to net operating losses was released in August by the chief counsel’s office of the Internal Revenue Service. At issue was whether income recorded from the discharge of debt reduces the NOL for an entire consolidated group (CNOL) or just for the group member associated with the loss. Basing its conclusion, in part, on a 2001 Supreme Court case, the chief counsel’s office noted that the CNOL is the NOL “subject to reduction” under the tax code.

The issue is discussed at length in guidance labeled Chief Counsel Advice 2010-33031. First the memo sets the stage: a consolidated tax-return group realizes income from the cancellation of indebtedness (COD). In this case, the tax code has two different ways of treating income arising from COD. Under
Section 61(a)(12) of the Internal Revenue Code, the taxpayer is required to include in gross income any COD income. Meanwhile, Section 108(a)(1)(A) permits a taxpayer to exclude COD income from gross income if, as in this case, the discharge occurs in a “Title 11 case.”

However, the law also states that under
Section 108(b)(1), the amount of COD income excluded from gross income — as defined in Section 108(a)(1)(A) — must be applied to “reduce the tax attributes of the taxpayer.” In other words, the taxpayer must first reduce any NOL for the taxable year in which the discharge occurs, and any NOL carryover to that taxable year.1

The IRS acknowledges that the reference to “the taxpayer” in Section 108(b)(1) refers to the member with excluded COD income (“the debtor member”), rather than the entire group. The sole issue is the determination of “the debtor member’s NOL” that is subject to reduction under Section 108(b), notes the chief counsel’s memo. Essentially, that is why the IRS ruled that the CNOL is the NOL that is subject to such reduction.

The memo goes on to say that in United Dominion Indus., Inc. v. United States, 532 US 822 (2001), the Supreme Court emphasized that the Internal Revenue Code and regulations governing affiliated groups filing consolidated returns provide only one definition of the NOL: the CNOL. No definition of separate NOL exists for a member of a consolidated group. Neither the code nor the regulations allocate and apportion the CNOL to a group member for purposes of reducing attributes under
Section 108(b)(2)(A). Thus, for periods before the CNOL approach was certified (prior to Regulation
Section 1.1502-28T), application of Section 108(b)(2)(A) and the consolidated return regulations require that the entire CNOL of the consolidated group be treated as “the NOL of the member” with excluded COD income.

In United Dominion Indus, the Supreme Court concluded that a group member does not have a separate NOL for a consolidated return year except when a specific consolidated return regulation allocates and apportions a part of the CNOL to that member. In the case discussed in the August memo, no such allocation rule exists. As a result, the CNOL must be the pertinent NOL available for reduction under Section 108(b)(2)(A).

Willens 09-13-10

The taxpayer appears to argue that the text of
Section 108(b)(2) is “clear on its face” and requires that only an allocable portion of the CNOL be reduced. The taxpayer cites The Limited, Inc. v. Commissioner, 286 F.3d 324 (6th Cir. 2002), for the rule of statutory construction that requires a statute to be interpreted by assigning an ordinary and natural meaning to an undefined term.

Here, however, the “ordinary meaning” rule does not apply because the term at issue, NOL, is expressly treated in the consolidated return regulations. Under those regulations, the CNOL is not apportioned and allocated to a member except as specifically provided by the regulations. Therefore, absent such a special allocation rule, the only NOL is the CNOL.

The exclusion of a member’s COD income from gross income reduces the consolidated taxable income (CTI) of the entire group. Because attribute reduction is a substitute for income inclusion, the “deferral policy” of Section 108 is served by reducing the tax attributes that are available to reduce the group’s CTI in future consolidated return years. In fact, under Section 172, a consolidated group may carry forward a CNOL to offset CTI in future years. Therefore, the entire CNOL should be available to offset the excluded COD income that stands in the place of taxable income.

At the time of the enactment of the Bankruptcy Tax Act of 1980, the consolidated return regulations provided that the only NOL that a consolidated group member could have from a consolidated return year was the CNOL. So, if Congress had intended for Section 108(b)(2)(A) to be applied to group members by reducing an NOL determined at the separate-member level, it would have enacted a specific rule to allocate and apportion the CNOL to members for that purpose.

In the end, the high court said it was “fair to say that the concept of separate NOL…simply does not exist.” Therefore, the Supreme Court provided the answer to the central question in this case: the CNOL is the NOL subject to reduction when a member of a consolidated group realizes excluded COD income.

Contributing editor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.


Footnote


1 See Section 108(b)(2)(A).

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