Am. Standard, Inc. v. US, 379-76.

• Decision Date: 13 June 1979
• Docket Number: No. 379-76.,379-76.
• Citation: 602 F.2d 256
• Parties: AMERICAN STANDARD, INC., Successor to Westinghouse Air Brake Co. and Subsidiaries v. The UNITED STATES.
• Court: U.S. Claims Court

602 F.2d 256

AMERICAN STANDARD, INC., Successor to Westinghouse Air Brake Co. and Subsidiaries v. The UNITED STATES.

No. 379-76.

United States Court of Claims.

June 13, 1979.

COPYRIGHT MATERIAL OMITTED

COPYRIGHT MATERIAL OMITTED

Robert B. Williams, Pittsburgh, Pa., attorney of record, for plaintiff. Carl Cherin, Steven W. McGrath, Dennis J. Lewis, Eckert, Seamans, Cherin & Mellott, Pittsburgh, Pa., of counsel.

Bruce W. Reynolds, Washington, D. C., with whom was Asst. Atty. Gen. M. Carr Ferguson, Washington, D. C., for defendant.

Before NICHOLS, KUNZIG and BENNETT, Judges.

OPINION

BENNETT, Judge.

The plaintiff, American Standard, Inc., seeks to recover overpayments of federal income taxes and interest for the taxable year ending December 31, 1966, and the taxable period ending May 31, 1968. The case concerns the proper method for computing the deduction for Western Hemisphere trade corporations (WHTC), I.R.C. §§ 921-922, when such corporations are members of an affiliated group which files a consolidated income tax return, I.R.C. §§ 1501-1563. This case is before the court on the parties' stipulations of facts. We hold for plaintiff.

Plaintiff is the successor by merger to Westinghouse Air Brake Company (WABCO). During the tax years in issue, WABCO and its affiliates filed consolidated income tax returns. The group claimed a deduction based on the portion of "consolidated taxable income" (as defined in Treas. Reg. § 1.1502-11 (1966)) allocable to the WHTCs multiplied by the fraction provided in I.R.C. § 922. Hereinafter all Treas. Regs. cited are dated 1966. The group calculated the amount of consolidated taxable income allocable to the WHTCs by the fractional method with losses.¹ In determining the fraction, the group took into consideration all members in the particular class including those whose taxable income was a net loss. This included one WHTC and several non-WHTCs which had net losses. Upon audit, the Internal Revenue Service (Service) determined, under its interpretation of Treas.Reg. § 1.1502-25, that the group's calculation of the deduction was improper because corporations whose taxable incomes resulted in a loss were not to be considered in either the numerator or denominator of the fraction.

Though plaintiff has argued that the Service's interpretation of its own regulation is incorrect, we find no merit to this contention.² Thus, plaintiff's method is clearly incorrect and plaintiff is not entitled to recover if Treas.Reg. § 1.1502-25 is valid law controlling in this case.

Plaintiff, however, advances two major theories under which, it contends, the regulation is invalid. Plaintiff's primary theory, which is directed to the substance of the regulation, is that the regulation is invalid because it is an arbitrary and unreasonable exercise of the Secretary of the Treasury's power to promulgate regulations governing consolidated income tax returns. Plaintiff's second theory, which is based on procedural grounds, is that the regulation is invalid because it was not promulgated in accordance with the Administrative Procedure Act (APA). We conclude that the regulation is invalid under both standards.

I

The concept of dealing with separate affiliated corporations on a consolidated return basis goes back as far as 1917.³ The process by which income tax liability could be determined on the basis of consolidated returns subject to legislative regulations was inaugurated by section 141 of the Revenue Act of 1928, 45 Stat. 791.

The rationale for Congress' delegation of legislative rulemaking powers was expressed by the Senate Committee report to the 1928 Act as follows:

* * * The committee believes it to be impracticable to attempt by legislation to prescribe the various detailed and complicated rules necessary to meet the many differing and complicated situations. Accordingly, it has found it necessary to delegate power to the commissioner to prescribe regulations legislative in character covering them. The standard prescribed by the section keeps the delegation from being a delegation of pure legislative power, and is well within the rules established by the Supreme Court. * * * S.Rep.No. 960, 70th Cong., 1st Sess. 15 (1928).

As noted in the committee report, the promulgation of consolidated return regulations is a legislative function. This court recognized this in Union Elec. Co. of Mo. v. United States, 305 F.2d 850, 854, 158 Ct.Cl. 479, 486 (1962), where the court concluded that consolidated return regulations "unlike ordinary Treasury Regulations, are legislative in character and have the force and effect of law." Though legislative regulations are law, they are good law only if enacted in accordance with the authority vested in the Treasury by the enabling Act. A consolidated return regulation is invalid if it be inconsistent with the Act. See, e.g., American Trans-Ocean Nav. Corp. v. Commissioner, 229 F.2d 97 (2d Cir. 1956); Commissioner v. General Mach. Corp., 95 F.2d 759 (6th Cir. 1938); Corner Broadway-Maiden Lane, Inc. v. Commissioner, 76 F.2d 106 (2d Cir. 1935).

The delegation of rulemaking power is presently found in I.R.C. § 1502, as follows:

The Secretary shall prescribe such regulations as he may deem necessary in order that the tax liability of any affiliated group of corporations making a consolidated return and of each corporation in the group, both during and after the period of affiliation, may be returned, determined, computed, assessed, collected, and adjusted, in such manner as clearly to reflect the income-tax liability and the various factors necessary for the determination of such liability, and in order to prevent avoidance of such tax liability.

Thus, the Code grants to the Secretary broad legislative authority governing the manner in which a group's tax liability is determined when a consolidated return is filed. But this power must be construed in terms of Congress' purpose that both the group's and its individual member's actual tax liability be found under the regulations "in such manner as clearly to reflect the income-tax liability * * * and in order to prevent avoidance of such tax liability." I.R.C. § 1502. Income tax liability is not imposed by the Secretary's regulations, but by the Internal Revenue Code. Thus, the purpose of the delegation of power to the Secretary can be stated more broadly as the power to conform the applicable income tax law of the Code to the special, myriad problems resulting from the filing of consolidated income tax returns. Though there may be many reasonable methods to determine a group's tax liability and the Secretary's authority is absolute when it represents a choice between such methods, the statute does not authorize the Secretary to choose a method that imposes a tax on income that would not otherwise be taxed. See Joseph Weidenhoff, Inc. v. Commissioner, 32 T.C. 1222, 1242 (1959).

We note that, as discussed in part II, infra, the Secretary did not provide any statement of the basis and purpose of the regulation. We are thus unaware of any special factual or legal problem caused by the filing of consolidated returns with which the method adopted by the regulation was meant to deal. Defense counsel has added nothing to enlighten us. All we have is the obvious inference from Treas. Reg. § 1.1502-25 and the statute under which it was promulgated that the regulation represents the Secretary's choice of a reasonable method to determine a group's tax liability or to prevent avoidance of that liability. We acknowledge that the Secretary is the expert in this complex field and that the regulation must be sustained unless it is clearly unreasonable. We must determine, however, the question of reasonableness for ourselves.

Our analysis must begin with an examination of the purposes and policy of the statute and regulations. The basic purpose behind allowing corporations to file consolidated returns is to permit affiliated corporations, which may be separately incorporated for various business reasons, to be treated as a single entity for income tax purposes as if they were, in fact, one corporation. Therefore, as provided by regulation, Treas.Reg. § 1.1502-2(a), the tax is computed solely on the basis of consolidated taxable income.

The single entity framework does not mean that all items of income, deductions, and credit for the affiliated corporations are combined into single accounts as if the corporations were one. The consolidated return regulations, in fact, primarily deal with the affiliated corporations as separate corporate entities. This treatment as separate entities under the regulations is shown by the first item in computing consolidated taxable income which is "separate taxable income." Treas.Reg. § 1.1502-11(a). Separate taxable income of a member is basically the taxable income of a member which would be reported if separate income tax returns were filed, with two types of adjustments. Treas.Reg. § 1.1502-12. The first type is for certain items that are taken into consolidated taxable income on a consolidated basis. This includes any net operating loss deduction, capital gains (and losses), I.R.C. § 1231 net losses, charitable contributions, I.R.C. § 922 WHTC deduction, I.R.C. §§ 243-245 dividends received deductions, and I.R.C. § 247 dividends paid deductions. Treas.Reg. § 1.1502-12(h), (j)-(n). These items are all taken into consideration on a consolidated basis along with members' separate taxable income in order to determine consolidated taxable income. Treas.Reg. § 1.1502-11. The second type of adjustment includes various adjustments and rules which change the amount, allowability, or manner of taking certain items, permitted when filing separate returns, into separate taxable income.

It is, however, the first type of exception to normal, separate returns that we are particularly concerned with here because the WHTC deduction is a consolidated deduction. The consolidated items are shared or...