Duquesne Light Holdings, Inc. v. Comm'r of Internal Revenue

• Citation: 861 F.3d 396
• Decision Date: 29 June 2017
• Docket Number: No. 14-1743,14-1743
• Parties: DUQUESNE LIGHT HOLDINGS, INC. & SUBSIDIARIES f/k/a DQE, Inc. & Subsidiaries, Duquesne Light Holdings, Inc. & Subsidiaries, Appellant v. COMMISSIONER OF INTERNAL REVENUE
• Court: United States Courts of Appeals. United States Court of Appeals (3rd Circuit)

861 F.3d 396

DUQUESNE LIGHT HOLDINGS, INC. & SUBSIDIARIES f/k/a DQE, Inc. & Subsidiaries, Duquesne Light Holdings, Inc. & Subsidiaries, Appellant

v.COMMISSIONER OF INTERNAL REVENUE

No. 14-1743

United States Court of Appeals, Third Circuit.

Argued July 12, 2016

Opinion filed: June 29, 2017

James C. Martin, Esquire (Argued), Reed Smith LLP, 225 Fifth Avenue, Suite 1200, Pittsburgh, PA 15222, Counsel for Appellant.

Caroline D. Ciraolo, Acting Assistant Attorney General, Diana L. Erbsen, Deputy Assistant Attorney General, Arthur T. Catterall, Esquire (Argued), Jonathan S. Cohen, Esquire, Gilbert S. Rothenberg, Esquire, Jennifer M. Rubin, Esquire, United States Department of Justice, Tax Division, Room 4333, 950 Pennsylvania Avenue, N.W., P.O. Box 502, Washington, DC 20044, Joseph P. Grant, Esquire, Mary H. Weber, Esquire, Internal Revenue Service, Office of Chief Counsel, 312 Elm Street, Suite 2350, Cincinnati, OH 45202, Counsel for Appellee.

Before: AMBRO, HARDIMAN, and KRAUSE, Circuit Judges

OPINION OF THE COURT

AMBRO, Circuit Judge

This appeal concerns the continued vitality of the so-called Ilfeld doctrine for interpreting the Internal Revenue Code. Taken from Charles Ilfeld Co. v. Hernandez , 292 U.S. 62, 54 S.Ct. 596, 78 L.Ed. 1127 (1934), this doctrine teaches that "the Code should not be interpreted to allow [the taxpayer] ‘the practical equivalent of a double deduction’ ... absent a clear declaration of intent by Congress." United States v. Skelly Oil Co. , 394 U.S. 678, 684, 89 S.Ct. 1379, 22 L.Ed.2d 642 (1969) (quoting Ilfeld , 292 U.S. at 68, 54 S.Ct. 596 ). Duquesne Light Holdings, Inc. ("DLH") and its subsidiaries (DLH and its subsidiaries are variously referred to as the "Duquesne group," the "Duquesne entities," or simply "Duquesne") appeal the Tax Court's grant of summary judgment to the Internal Revenue Service based on the Ilfeld doctrine. In particular, Duquesne challenges the Tax Court's holding that the consolidated entities affiliated with DLH claimed a double deduction for certain losses incurred by its AquaSource subsidiary and thus disallowed $199 million of those losses (all numbers are rounded). As we conclude that the Tax Court properly applied the Ilfeld doctrine, we affirm.¹

I. BACKGROUND

The Duquesne entities, including DLH and AquaSource, filed their tax returns as a consolidated taxpayer, meaning they filed a single tax return reflecting their joint tax liability. Despite allowing corporate groups to file a single return, the applicable tax laws require a mixed approach of calculating some aspects of the group's taxes as though the entities were a single taxpayer and calculating others as if each member of the group were a separate taxpayer. 13 Mertens Law of Federal Income Taxation § 46:1 (2016 ed.). This approach—called the "consolidated return regime"—reflects how the IRS has chosen to exercise its broad discretion to issue regulations for consolidated returns "to reflect the income-tax liability" of the group and "to prevent avoidance of such tax liability." 26 U.S.C. § 1502.

The possibility of separate treatment nonetheless creates the potential for the group to deflect its tax liability by using stock sales to claim a second deduction for a single loss at the subsidiary (such as a loss on the subsidiary's sale of an asset). See Lawrence Axelrod, 1 Consolidated Tax Returns § 18:2 (4th ed. 2015). This is known as a double deduction, or more technically as loss duplication. It may occur because by definition the parent company in a corporate group owns all or most of the stock in its subsidiaries. See 26 U.S.C. § 1504(a). All else being equal, the value of the parent's stock depends on the value of the subsidiary's assets. If the subsidiary's assets decline in value, the parent's stock will as well. If the subsidiary sells those assets (which may include stock and other securities) at a loss, it is generally able to claim a deduction for those losses. See 26 U.S.C. § 165(a) ("General rule.—There shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise"). If the parent and subsidiary are viewed as separate entities, the parent is able to sell its stock of the subsidiary at a loss and claim a deduction for that loss as well. See Axelrod, supra , § 18:2. But in fact the overall group has only suffered one economic loss though it was deducted twice. For example, suppose that parent P has a wholly owned subsidiary S and its investment in S's stock is worth $100. After one of S's assets declines in value by $50, S sells the asset and deducts a $50 loss under § 165. P's stock value in S also declines by $50, and if P and S are viewed separately, P is able to sell its stock in S and deduct a further loss of $50 under § 165. The consolidated group is thus able to deduct $100 for a single economic loss of $50 resulting from the decline in value of S's asset.

To prevent double deductions, the IRS has promulgated numerous regulations requiring that consolidated taxpayers be treated as a single entity for stock sales. Of particular relevance to the events of this case is the former Treas. Reg. § 1.1502-20. Starting in the early 1990s, it prevented, among other things, double deductions when the parent's loss on its sale of stock occurred before the subsidiary recognized its loss. See Consolidated Return Regulations; Special Rules Relating to Dispositions and Deconsolidations of Subsidiary Stock , 55 Fed. Reg. 9426-01, 9427 (Mar. 14, 1990). In July 2001, however, the Federal Circuit's decision in Rite Aid Corp. v. United States , 255 F.3d 1357 (Fed. Cir. 2001), invalidated the pertinent portion of § 1.1502-20 as beyond the IRS's power to issue because it addressed a problem not specifically attributable to the filing of consolidated returns. Id. at 1360. Though Rite Aid has not been construed to annul any other consolidated return regulation preventing duplicated loss, invalidating § 1.1502-20 meant that in its immediate aftermath there was no regulation expressly preventing a double deduction when the parent's stock loss occurred before the subsidiary's asset loss. In contrast, Rite Aid left intact the regulatory prohibition on double deductions where the transactions are structured in such a way that the losses occur in reverse order, i.e. , the subsidiary's loss is recognized before the parent's loss. See Treas. Reg. § 1.1502-32.

In the aftermath of Rite Aid , the Duquesne group arranged a series of transactions in which DLH incurred a loss on AquaSource stock, and then AquaSource incurred losses on the sale of its assets (which were stock interests that AquaSource held directly and indirectly in eight of its own subsidiaries). DLH formed AquaSource in the late 1990s as a wholly owned subsidiary to expand into the water utility business. It funded AquaSource through a series of contributions in return for AquaSource stock. Through February 2001, DLH contributed approximately $223 million in return for 50,000 shares of AquaSource stock. Though DLH contributed a similar amount to AquaSource in the years thereafter, it increased its holdings to 1.2 million shares of AquaSource stock. AquaSource used these contributions to purchase more than 50 water utility companies, which became both its subsidiaries and its assets. It began to lose money, however, and in 2000 the Duquesne group decided to explore the sale of AquaSource's assets.

The transactions before us began on December 31, 2001, just before the deadline would expire for the IRS to file a petition for certiorari in Rite Aid . DLH transferred 50,000 shares of AquaSource stock to Lehman Brothers, which Lehman valued at $4 million, as payment for Lehman's services rendered to AquaSource. DLH determined that these particular 50,000 shares of stock were the shares that it had possessed prior to February 2001 and thus accounted for $223 million of its investment. After various adjustments, DLH claimed a capital loss of $199 million on the transfer of stock to Lehman Brothers (the "2001 loss"). On its 2001 tax return, the Duquesne group carried back $161 million of that loss to tax year 2000 and claimed a tentative refund of $35 million.

Shortly thereafter, the IRS announced the regulatory response to Rite Aid . It declined to litigate further the validity of Treas. Reg. § 1.1502-20 and instead announced that it would issue new regulations governing stock losses. I.R.S. Notice 2002-11, 2002-1 C.B. 526 (Jan. 31, 2002). It did so in early March 2002 by issuing temporary regulations that included Treas. Reg. § 1.337(d)-2T, which applied to stock losses occurring on or after March 7, 2002. See Loss Limitation Rules , 67 Fed. Reg. 11034-01, 11036-37 (Mar. 12, 2002).² Though these regulations "[did] not disallow [a] stock loss that reflects ... built-in asset losses of a subsidiary member," I.R.S. Notice 2002-18, 2002-1 C.B. 644 (Mar. 9, 2002), the IRS published as guidance a draft of a new regulation barring double deductions in October 2002. See Guidance Under Section 1502; Suspension of Losses on Certain Stock Dispositions , 67 Fed. Reg. 65060-01 (Oct. 23, 2002). The new regulation was issued in final form as Treas. Reg. § 1.1502-35T and applied retroactively to stock sales occurring on or after March 7, 2002.

In this complex and shifting regulatory environment, the Duquesne group thereafter incurred further losses on the sale by AquaSource of its assets.³ It did so through a series of transactions after March 2002 and continuing into 2003 in which AquaSource sold all of its stock in eight subsidiaries, and thus the resulting losses were also stock losses.⁴ In 2002, these transactions resulted in capital losses for AquaSource totaling $59.5 million (the "2002 loss"), all of which the Duquesne group carried back to tax year 2000 on its consolidated return. Based on the 2002 loss and additional carrybacks, the group received a tentative refund of $12 million. The sale transactions in 20...