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Final Section 482 Reg Invalid; Fails to Satisfy "Reasoned Decision Making" Standard.

(Parker Tax Publishing August 11, 2015)

Neither the Code nor the consolidated return regulations provide authority for an affiliated group to allocate and apportion a consolidated NOL to the consolidated group members for purposes of reducing tax attributes pursuant to Code Sec. 108(b)(2)(A) and, thus, a consolidated group's entire consolidated NOL had to be treated as the NOL subject to reduction. Marvel Entertainment, LLC v. Comm'r, 145 T.C. No. 2 (2015).

Background

On December 27, 1996, Marvel Entertainment Group, Inc. (MEG) and certain of its operating and inactive subsidiaries filed for bankruptcy under chapter 11 of the Bankruptcy Code. On April 24, 1997, MEG and its subsidiaries became a separate affiliated group (MEG Group) and filed consolidated federal income tax returns for the short taxable years ending December 31, 1997, and October 1, 1998. On October 1, 1998, the MEG Group was acquired by Toy Biz, Inc. and became members of a new consolidated group, Marvel Group, of which Toy Biz was the common parent. In MEG Group's short taxable year ending October 1, 1998, four consolidated group members realized total cancellation of debt (COD) income of approximately $171 million resulting from bankruptcy filings under chapter 11. Each of the four MEG Group debtor members excluded the COD income from gross income under Code Sec. 108(a)(1)(A).

Pursuant to Code Sec. 108(b)(2)(A), on its consolidated federal income tax return for the short taxable year ending October 1, 1998, MEG Group reduced the share of consolidated NOL (CNOL) separately attributable to each of the four members in the group by the lesser of (1) each member's excluded COD income, or (2) each member's allocable share of CNOL. As a result, MEG Group reduced $187 million of CNOL by $89.6 million of the $171 million in excluded COD income.

MEG Group joined the Marvel Group on October 2, 1998, and carried forward into the Marvel Group a CNOL of $96 million. For tax years ending in 1999-2002, $49 million of this CNOL was used by the Marvel Group to offset income. The Marvel Group claimed a CNOL carryforward of $47 million into its taxable year ending December 31, 2003.

The IRS challenged the computation of the CNOL carryforward and assessed deficiencies for Marvel Group's 2003 and 2004 tax returns. According to the IRS, the MEG Group NOL that should have been reduced under Code Sec. 108 was the entire CNOL of the consolidated group. Thus, the IRS said, the MEG Group should have reduced its CNOL as of October 1, 1998, by the total excluded COD income for each of its four members, resulting in a remaining CNOL as of October 2, 1998, of $15.7 million. The IRS concluded that this method of tax attribute reduction would have resulted in no CNOL carryover into the Marvel Group consolidated return for taxable years ending December 31, 2003, and December 31, 2004.

Analysis

For COD income discharged after August 29, 2003, Reg. Sec. 1.1502-28T, prescribes a hybrid approach to attribute reduction. First, tax attributes of the member are reduced and then a look-through rule applies to reduce attributes of the member entity's subsidiaries. Lastly, attributes of the consolidated group are reduced. With slight modifications, this regulation was adopted as final and effective for COD income discharged after March 21, 2005. The Marvel Group argued that the pre-2003 consolidated return regulations allowed for a separate-entity approach under Code Sec. 108(b)(2)(A).

The case went to the Tax Court where the sole issue for decision was whether the NOL subject to reduction under Code Sec. 108(b)(2)(A) was the entire CNOL of a consolidated group (single-entity approach) or a portion of a consolidated group's CNOL allocable to each group member (separate-entity approach).

Citing the Supreme Court's decision in United Dominion Industries, Inc. v. U.S., 532 U.S. 822 (2001), the Tax Court held that where a member of a consolidated group has excluded COD income during a consolidated return year before the adoption of Reg. Sec. 1.1502-28T, the NOL subject to reduction under Code Sec. 108(b)(2)(A) is the entire CNOL of the consolidated group.

The court dismissed the Marvel Group's argument that the pre-2003 consolidated return regulations allowed for the separate-entity approach under Code Sec. 108(b)(2)(A). The court noted that the matter at hand involved the tax year ending October 1, 1998, which was before the IRS's issuance of Reg. Sec. 1.1502-28T or the adoption of Reg. Sec. 1.1502-28. The pre-2003 consolidated return regulations, the court stated, did not specifically articulate how a consolidated group should reduce its tax attributes under Code Sec. 108(b). However, the Supreme Court in United Dominion Indus., Inc. v. Comm'r, 532 U.S. 822 (2001), found that the pre-2003 consolidated return regulations did in fact prohibit the allocation of separate NOLs for consolidated group members unless it was within the ambit of a specific regulatory provision.

The issue in the current case, the court said, which was central to the opinion of the Supreme Court in United Dominion, was identifying the appropriate NOL in the consolidated return context. Although the Tax Court acknowledged that the Marvel Group's application of the separate-entity approach in filing its 1998 consolidated tax return was plausible at the time, it was contrary to the rule in the consolidated return regulations as interpreted by the Supreme Court in United Dominion. Thus, the Marvel Group's application of the separate-entity approach for purposes of defining its NOL not only conflicted with the binding precedent of United Dominion, the court said, but also was the approach specifically rejected by the Supreme Court in that case. Because United Dominion clarified that a separate NOL does not exist in the consolidated return regulations, the court found no remaining ambiguity as to this issue for the Marvel Group's consolidated return for the short taxable year ending October 1, 1998. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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