Notice 98-38: separate return limitation years

Notice 98-38: separate return limitation years – IRS Notice 98-38

April 15, 1999

On April 15, 1999, Tax Executives Institute filed the following comments with the Internal Revenue Service, regarding IRS Notice 98-38, a proposal to replace the current separate return limitation year (SRLY) rules of the consolidated return regulations with an approach modeled after section 382 of the Internal Revenue Code. TEI’s comments were prepared under the aegis of its Federal Tax Committee, whose chair is Philip G. Cohen of Unilever United States Inc. Contributing substantially to the development of TEI’s submission were Douglas J. McCormack of Eastman Kodak Company and George G. Bauernfeind of Humana Inc.

On August 3, 1998, the Treasury Department and the Internal Revenue Service released Notice 98-38, inviting comments on a proposal to replace the current separate return limitation year (SRLY) rules of the consolidated return regulations with an approach modeled after section 382. The Notice was published in the INTERNAL REVENUE BULLETIN (1998-34 I.R.B. 7). Tax Executives Institute is pleased to provide the following comments on the issues surrounding the approach proposed in the Notice.


Tax Executives Institute is the preeminent association of business tax executives in North America. Our more than 5,000 members represent 2,800 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works — one that is administrable and with which taxpayers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by Notice 98-38. Indeed, most TEI members work for affiliated groups filing consolidated returns and the issues raised in the Notice are a practical, day-to-day concern.

Overview of the Regulations and Notice 98-38

In 1991, the Treasury Department and the Internal Revenue Service issued proposed regulations concerning the application of the SRLY rules to net operating loss and capital loss carryovers and carrybacks and built-in loss deductions. Most of the changes reflected in those proposed rules were reissued as temporary and proposed regulations in June 1996.(1) In January 1998, the IRS published temporary and proposed regulations extending the principles of the 1996 temporary regulations to the general business tax credit, minimum tax credit, and related attributes.(2) In addition, the latter set of rules eliminated the application of the SRLY rules to foreign tax credits, overall foreign losses, and separate limitation losses. Pursuant to section 7805(e)(2), the temporary SRLY rules adopted in 1996 will sunset in June 1999.

In Notice 98-38, the IRS and Treasury Department pose the question whether the current SRLY rules limiting the utilization of operating losses should be replaced with an approach modeled after section 382 (hereinafter “section-382 approach”). The professed goal of revising the approach of the SRLY rules is to eliminate redundant or superfluous limitations, thereby reducing the complexity of the current rules and simplifying tax compliance and administration.

Simplification is a laudable goal that TEI supports. Hence, we commend the government for reviewing the efficacy of the SRLY rules. We believe, however, that the government’s suggested section-382 approach is misdirected. TEI recommends instead that, in situations where section 382 and SRLY overlap, i.e., where a new member joins a group in a transaction constituting an ownership change within the meaning of section 382(g), the SRLY rules should not apply. In all other situations, i.e., where either section 382 or the SRLY rules — but not both — apply, there is little merit in substituting a new and complex approach to SRLY based on a section-382 approach. Hence, the current approach should be retained where the section 382 and SRLY rules do not overlap. Adopting TEI’s recommended approach will yield a fair measure of simplification without the attendant uncertainty or unforeseen circumstances that the wholesale adoption of a section-382 approach to the SRLY rules might engender.


When a corporation (or a corporate group) joins an affiliated group (or a different group) filing a consolidated tax return, the SRLY rules generally prevent the new member’s preexisting tax attributes from being used by the acquiring group. Similarly, the SRLY rules apply when a member departs an affiliated group and files separately or as part of a different affiliated group. For example, a loss carryforward is subject to a SRLY limitation if it arises in a pre-affiliation year (or post-affiliation year for a carryback) of a member. The SRLY rules generally limit the use of a new member’s pre-existing net operating losses to the actual, post-affiliation income of that member and preclude the pre-existing losses from being absorbed by the other members’ income. The SRLY rules apply to net operating losses, capital losses, certain business tax credits, and other tax attributes incurred in a tax year before the member with the attribute becomes a member of an affiliated group (in respect of the new member’s carryforwards) or after a member leaves the group (in respect of carrybacks). Similarly, the SRLY rules apply to built-in losses attributable to a tax year of a member before it joins an affiliated group.

Section 382 also limits the ability of a loss corporation to use its NOL carryovers to offset taxable income generated after an ownership change, but applies a different metric and produces a different limitation from the SRLY result. Specifically, under sections 382(g) and (i), an ownership change occurs when the percentage of stock of the loss corporation owned by one or more 5-percent shareholders increases by more than 50 percentage points during a testing period of up to three years. When an ownership change occurs, use of prechange losses generally is limited by section 382(b)(1) to the value of the loss corporation immediately before the ownership change multiplied by the federal long-term tax-exempt rate.

Hence, section 382 limits the incentive of corporations to “traffic” in, or purchase, the net operating losses of target companies by limiting the acquirer to an expected rate of return no better than can be achieved by parking an equivalent amount of money in tax-exempt securities. In a similar fashion, section 383 extends section 382’s reach to certain net capital losses and business, foreign, and minimum tax credits. Taxpayers subject to the section 382 and 383 limitations are often also subject to the SRLY rules.(3)

The overlapping SRLY and section 382 limitations engender considerable complexity as well as compliance and recordkeeping burdens for taxpayers. Notice 98-38 acknowledges this, explaining that, in response to the proposed, and then temporary and proposed, SRLY rules issued in 1991, 1996, and 1998, some commentators have asserted that the SRLY rules are anachronisms obviated by the 1986 Act’s revisions to sections 382 and 383.(4) These commentators urge the government to abandon the SRLY rules entirely. Other commentators aver that the SRLY rules serve a broader purpose than limiting loss trafficking, contending that the SRLY rules protect the integrity of the separate return and consolidated return systems by preventing affiliated groups from selectively claiming the benefits of both systems, while avoiding their detriments.(5) Those commentators generally urge the government to retain the current SRLY rules, notwithstanding the overlap with sections 382 and 383.

In TEI’s view, the government’s goal should be to reduce the unwarranted complexity of the current rules as well as the duplication of compliance and administrative burdens engendered by the overlapping restrictions in the SRLY rules and sections 382 and 383. Above all else, the consolidated return regulations are a pragmatic set of rules governing the taxation of a single economic unit with multiple entities. Maintaining the conceptual purity of the separate and consolidated return systems should, in our view, be secondary to achieving the proper tax result with the least administrative and compliance burden. That said, we acknowledge that the government faces a daunting challenge in crafting rules that minimize the opportunity for loss trafficking while minimizing compliance burdens. The challenge is that, while the section 382 and section 383 rules are narrow in focus and afford taxpayers limited loss utilization in a fashion that generally cannot be circumvented, the broader SRLY proscriptions are more porous and can often be avoided through informed tax planning? We believe that our recommended approach will provide the proper balance to reduce compliance costs and permit acceptable tax planning, while minimizing loss trafficking.

As a practical matter, in most carryforward cases where the SRLY rules apply, a change in ownership under section 382(g) also occurs. In those rare instances where section 382 does not apply to new members joining a consolidated group (e.g., a creeping acquisition of a group where the ownership increases from, say, 49 percent to 80 percent), the current SRLY rules provide a basic level of protection against trafficking in losses or other attributes. Consequently, in TEI’s view, the goals of both sets of rules can be preserved by limiting the SRLY rules to situations where the member’s tax attributes are not otherwise limited under section 382. In other words, TEI recommends that the IRS adopt a straightforward rule stating that where an ownership change as defined in section 382 occurs, the SRLY rules do not apply to limit the attributes of the member (or group) experiencing the ownership change. Where an ownership change in the section 382 sense does not occur, the SRLY rules can still apply.(7) Under TEI’s recommendation, taxpayers would still be required to understand and plan for both sets of rules, but only one set of rules will apply to a member’s attributes on an ongoing basis. Hence, some measure of simplification in compliance and administration will be achieved by eliminating the calculation of differing annual limitation amounts under the overlapping regimes. That simplification can be achieved at little or no cost to the fisc since, in most cases where the section 382 limitation applies, that barrier erected by section 382 is generally higher than the more limited curb of the SRLY rules.

Finally, we understand that the IRS and Treasury Department are reconsidering whether it is proper to apply a section-382 approach where there is not a more-than-50-percentage-point change in ownership (e.g., where affiliation is a result of a creeping acquisition and the ownership of the new member increases from, say, a 49-percent stake to 81 percent or 79 percent to 100 percent).(8) We believe that the government is correct in eschewing this approach, but we encourage the government not to abandon its original goal: to simplify the overlapping regimes and to alleviate the attendant compliance and record-keeping burdens. We believe our recommended approach will accomplish that goal.


Tax Executives Institute appreciates this opportunity to present our views on Notice 98-38 and the possible approaches to the replacement of the SRLY rules. If you have any questions, please do not hesitate to call Philip G. Cohen, chair of TEI’s Federal Tax Committee, at (201) 871-5504, or Jeffery P. Rasmussen of the Institute’s professional staff at (202) 6385601.

(1) Treas. Reg. [sections] 1.1502-21T, T.D. 8677, 1996-2 C.B. 119.

(2) T.D. 8751, 1998-10 I.R.B. 23.

(3) Unlike the SRLY rules, which apply to both carryforwards and carrybacks of losses and credits, sections 382 and 383 address only carryforwards. As a result, the SRLY rules are the primary protection for the fisc against trafficking in carryback losses. Hence, the SRLY rules likely must be retained for carrrybacks.

(4) See, e.g., Comments of the New York State Bar Association, reprinted in 96 TAX NOTES TODAY 244-29 (Dec. 17, 1996). See also SRLY Rules Should Be Eliminated Not Replaced, NYSBA Argues, Comments of the New York State Bar Association Tax Section (Nov. 24, 1998), reprinted in 98 TAX NOTES TODAY 229-66.

(5) See Comments Regarding Retention of the Consolidated Return SRLY Rules, Individual Views of Members of the American Bar Association (April 30, 1998), reprinted in 98 TAX NOTES TODAY 93-23.

(6) IRS representatives acknowledge that the SRLY rules can be avoided or substantially diminished by merging new members into an existing member of the group or by “stuffing” a new loss member with assets or income opportunities. See, e.g., Treasury May Drop Section 382 Proposal for Some Group Acquisitions, BUREAU OF NATIONAL AFFAIRS DAILY TAX REPORT, GG-2 (Feb. 10, 1999). Avoiding the effect of the SRLY regulations, however, is more difficult for regulated businesses, including banks, insurance companies, and utilities.

(7) Even in the case of creeping acquisitions, it is questionable whether the SRLY rules should be continued. Where business reasons compel the parties to shift control of a member (or group of corporations) over an extended period of time, the buyer and seller arguably are not engaged in “loss trafficking.” The selling group should continue to be able to avail itself of the loss members attributes in any event and the buying group arguably is not engaged in an abusive transaction since it is being “patient” in the acquisition of the target.

(8) See Government Officials Ponder: To SRLY or Not to SRLY, TAX NOTES 954 (Feb. 15, 1999).

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