IRS WILL NOT REQUIRE APPLICATION OF FRACTIONAL METHOD WITHOUT LOSSES TO COMPUTE CONSOLIDATED TAXABLE INCOME ATTRIBUTABLE TO WESTERN HEMISPHERE TRADE CORPS

Rev. Rul. 85-136

The Internal Revenue Service will no longer litigate the issue considered by the United States Court of Claims in American Standard, Inc. v. United States, 602 F.2d 256 (Ct. Cl. 1979), Union Carbide Corporation v. United States, 612 F. 2d, 558 (Ct. Cl. 1979), and Allied Corporation v. United States, 685 F.2d 396 (Ct. Cl. 1982). Specifically, the Service will no longer require application of the fractional method without losses set forth in section 1.1502-25(c) of the Income Tax Regulations for purposes of determining the "portion of the consolidated taxable income" attributable to those members of an affiliated group filing a consolidated return that are Western Hemisphere trade corporations (WHTCs). Such "portion of the consolidated taxable income" must be determined for purposes of computing the consolidated section 922 deduction, now repealed, under section 1.1502-25, and the foreign tax credit reduction under section 1503(b)(1) of the Internal Revenue Code, also now repealed.

The court in American Standard declared invalid the last sentence of section 1.1502-25(c)(2) of the regulations, which requires the exclusion of loss members of an affiliated group filing a consolidated return from a formula used to determine the portion of consolidated taxable income attributable to those member of a consolidated group that qualify as Western Hemisphere Trade Corporations (WHTCs) under repealed section 921 of the code. Under section 1.1502-25(c) of the regulations, it is necessary to determine the portion of consolidated taxable income attributable to WHTCs in order to calculate the amount of the consolidated section 922 deduction allowed against income of the WHTCs. The taxpayer's method of computing the consolidated section 922 deduction on its return was to include loss members in the fraction used to compute the portion of consolidated taxable income attributable to WHTCs, in order to calculate the amount of the consolidated section 922 deduction allowed against income of the WHTCs.

The court in Union Carbide Corporation declared the last sentence of section 1.1502-25(c)(2) of the regulations to be invalid for purposes of computing the foreign tax credit reduction required by repealed section 1503(b)(1) of the Code for affiliated groups with WHTC members. Although the court agreed with the Government that the phrase "portion of consolidated taxable income attributable to such (Western Hemisphere trade) corporation" in section 1503(b)(1) has the same meaning as it does in section 1.1502-25 of the regulations, the court held that the method of computing such amount for purposes of the consolidated section 922 deduction upheld in American Standard also applied to computing the foreign tax credit reduction required by section 1503(b)(1).

In Allied Corporation the court considered three cases, all of which involved the proper method of computing the section 922 deduction granted WHTCs when consolidated returns are filed. The court reaffirmed its decision in American Standard, and as to one of the taxpayers it held that the appropriate method by which a WHTC's net operating losses were to be carried back was the method found in section 1.1502-79(a) of the regulations.

In light of the fact that these cases were decided in a court of national jurisdiction and that the statutory provisions have been repealed, the Service will follow these decisions, in cases presenting the same facts, and subject to the conditions set forth herein, as a basis for disposing of this issue in determining the consolidated section 922 deduction, as well as the section 1503(b)(1) foreign tax credit reduction.

The American Standard opinion rejected the Service's argument that the fractional method with losses was unreasonable because it permitted "the portion of consolidated taxable income attributable to" the WHTCs to be greater than the whole. In so doing, the American Standard opinion relied by analogy on section 1.1502-27 of the regulations, stating that:

Under the AGGREGATE METHOD WITH LOSSES, the "portion of the consolidated taxable income" attributable to the corporation to which the deduction is given by section 922 or section 247 is the actual net taxable income contributed by the group, and, therefore, can be greater than actual consolidated taxable income. Defendant's argument questions, in effect, the reasonableness of section 1.1502-27. We conclude, however, that utilizing the actual net taxable income of the subgroup for which the deduction is intended, complies fully with section 922, section 247, and the consolidated return statutes.

(602 F.2d at 267.)

The phrase "portion of the consolidated taxable income" is not found in section 1.502-27 of the regulations, as it is in section 1.502-25 and section 1503(b)(1) of the Code. Moreover, in the American Standard case (and the Court of Claims cases following American Standard), the consolidated taxable income was in fact greater than the portion of the consolidated taxable income determined to be attributable to the WHTCs. Accordingly, the quoted statement was dictum, and it is the Service's position that it is erroneous.

Although the Service will follow American Standard, Union Carbide and Allied Corporation in cases having the same factual pattern as the decided cases, the Service will adhere to its position that the portion of the consolidated taxable income attributable to the members of the affiliated group that are WHTCs cannot exceed the total consolidated taxable income.

The Service will not take adverse action against those taxpayers who have relied upon, and consistently applied, section 1.1502-25(c) of the regulations. However, a taxpayer will not be permitted to choose from year to year either the method prescribed in section 1.1502-25(c) or the method approved in this ruling, whichever is more favorable.