Case reversed and remanded by
Supreme Court opinion filed 6/4/01
PUBLISHED

UNITED STATES COURT OF APPEALS

FOR THE FOURTH CIRCUIT

UNITED DOMINION INDUSTRIES,
INCORPORATED,
Plaintiff-Appellee,
                                                                 No. 98-2380
v.

UNITED STATES OF AMERICA,
Defendant-Appellant.

Appeal from the United States District Court
for the Western District of North Carolina, at Charlotte.
Graham C. Mullen, Chief District Judge.
(CA-95-341-MU)

Argued: December 2, 1999

Decided: March 24, 2000

Before TRAXLER and KING, Circuit Judges, and
Margaret B. SEYMOUR, United States District Judge
for the District of South Carolina,
sitting by designation.

_________________________________________________________________

Reversed and remanded by published opinion. Judge King wrote the
opinion, in which Judge Traxler and Judge Seymour joined.

_________________________________________________________________

COUNSEL

ARGUED: Richard Farber, United States Department of Justice,
Washington, D.C. for Appellant. Eric R. Fox, IVINS, PHILLIPS &
BARKER, Washington, D.C. for Appellee. ON BRIEF: Edward T.
Perelmuter, U. S. Department of Justice, Washington, D.C. for Appel-
lant. Dirk J. J. Suringa, IVINS, PHILLIPS & BARKER, Washington,
D.C. for Appellee.

_________________________________________________________________

OPINION

KING, Circuit Judge:

The question in this case arises from the filing of consolidated tax
returns by the predecessor of plaintiff United Dominion Industries,
Incorporated (the "taxpayer" or "AMCA" 1). The taxpayer and the
Government (the "IRS") disagree on how to determine the amount of
the taxpayer's product liability expenses that may be characterized as
"product liability loss."

The IRS appeals from the district court's judgment ordering tax
refunds and statutory interest payments to the taxpayer. This dispute
involves AMCA's consolidated tax returns for tax years 1983, 1984,
1985, and 1986. On those returns, AMCA characterized the product
liability expenses incurred by five of AMCA's twenty-six group
members as "product liability loss," which permitted a ten-year carry-
back of those losses. The five group members, however, each had
positive "separate taxable income," as defined by the consolidated
return regulations, in each of the relevant tax return years. The issue
on appeal is whether, under these circumstances, these five group
members' product liability expenses are properly characterized as
"product liability loss" on AMCA's consolidated returns.

The district court entered summary judgment in favor of the tax-
payer after the IRS and the taxpayer filed cross-motions for summary
judgment. We possess jurisdiction pursuant to 28 U.S.C. § 1291. For
the reasons explained below, we reverse and remand.
_________________________________________________________________

1 "AMCA" (AMCA International Corporation) was the predecessor
corporation of United Dominion Industries, Incorporated.

                  2
I.

AMCA was the parent of an affiliated group of corporations that
properly elected to file consolidated tax returns for tax years 1983
through 1986. In those consolidated tax returns, relying on 26 U.S.C.
§ 172 (defining "product liability loss" and relevant carryback period,
for individual tax returns), AMCA claimed "product liability loss"
deductions arising from its group members' product liability expenses.2 2
The product liability expenses of five of AMCA's twenty-six group
members are at issue in this case. Those members are: Jesco, Inc.; the
Cherry-Burrell Corp.; Amtel, Inc.; and Amtel's two subsidiaries, Lit-
win Corp. and Litwin Panamerican Corp.

The parties agree that the product liability expenses incurred by the
five group members in the relevant years total $1,618,306. The parties
also agree that during each of the relevant tax years, AMCA's "con-
solidated net operating loss" was much larger than the product liabil-
ity expenses that are in dispute. However, with respect to the
challenged refunds, the five group members also had positive "sepa-
rate taxable income" in each of the relevant tax years.3
                                                       3

The taxpayer seeks to apply product liability expenses deductions
to AMCA's consolidated tax returns for four years (1983, 1984, 1985,
and 1986) for each of these five group members, except in two cases
-- Amtel in 1983, and Litwin in 1984.4
                                     4 The taxpayer sought to char-
_________________________________________________________________
2 The citations to the Internal Revenue Code and Treasury Regulations
in this opinion refer to the respective versions thereof that were in effect
between 1983 and 1986.
3 Of note, see infra Part III.B.2, the record does not reflect the five
group members' "separate net operating loss" for each of the relevant
years, although Amtel, Litwin, and Litwin Panamerican each appear to
have had zero separate net operating loss in 1985. See Amtel, Inc. v.
United States, 31 Fed. Cl. 598, 601 (1994) (applying Treas. Reg.
§ 1.1502-79(a)(3) to calculate AMCA's group members' separate net
operating loss), aff'd, 59 F.3d 181 (Fed. Cir. 1995) (table).
4 The taxpayer concedes that AMCA is not entitled to claim on its 1984
consolidated return a $4,198 product liability loss attributable to one of
its group members, Litwin, even though for that year Litwin had a large
net operating loss. See Brief for Plaintiff-Appellee at 26. The regulations

                  3
acterize all of the five group members' product liability expenses
deductions as "product liability loss." Further, the taxpayer seeks to
carryback these deductions ten years, pursuant to§ 172(b), to
AMCA's corresponding consolidated tax returns for tax years 1973
through 1976.5  5 The IRS contends that this position is erroneous,
asserting that because the group members each had positive "separate
taxable incomes," their product liability expenses are not "product lia-
bility loss." Consequently, according to the IRS, these expenses may
not be carried back more than three years.

After the parties agreed there was no genuine issue of material fact,
the district court granted summary judgment to the taxpayer on the
question of law presented by the cross-motions for summary judg-
ment. In doing so, the court determined that the taxpayer may prop-
erly characterize all of its group members' product liability expenses
as "product liability loss," because the five group members' aggre-
gated product liability expenses were less than AMCA's consolidated
net operating loss. The court accordingly ordered the IRS to refund
the taxpayer the sum of $1,618,306 in disputed tax payments, plus
statutory interest. We find this decision to be in error, for the reasons
explained below.
_________________________________________________________________

disallow a ten-year carryback of this $4,198 on AMCA's consolidated
return, because Litwin was not a member of AMCA's affiliated group in
1974; the loss must therefore be carried back to Litwin's 1974 separate
return year. See Treas. Regs. §§ 1.1502-21(b)(1)(permitting "consoli-
dated net operating loss" carryovers and carrybacks); 1.1502-
79(a)(directing that certain "consolidated net operating loss" carryovers
and carrybacks be allocated to separate return years).

5 Cherry-Burrell was formed by AMCA in 1975. The remaining four
group members were acquired by AMCA after 1976. Whether these
members existed or had been acquired by AMCA at that earlier time is
not material to our decision today on whether a group member's product
liability expenses are properly characterized as"product liability loss,"
although such facts may be relevant to whether deductions must be car-
ried back to a separate or to a consolidated return year. See supra note
4.

                  4
II.

A.

In the case of a taxpayer who files a separate individual tax return,
the tax code establishes a basic framework for determining the
amount of product liability expenses that may be characterized as
"product liability loss." The difference between the taxpayer's gross
income and its allowable deductions reflects either the taxpayer's tax-
able income, or -- if the allowable deductions exceed the gross
income -- its net operating loss. See, e.g., 26 U.S.C. §§ 63(a) (defin-
ing taxable income), 172(c) (defining net operating loss). If a net
operating loss results, the taxpayer may characterize its product liabil-
ity expenses as "product liability loss," to the extent that such
expenses do not exceed the taxpayer's net operating loss. See 26
U.S.C. § 172(j) (defining "product liability loss" on an individual tax
return).66 Under § 172(j), any "product liability loss" cannot exceed the
taxpayer's "net operating loss."

For example, a taxpayer with a net operating loss of fifty dollars
and product liability expenses of seventy-five dollars may character-
ize no more than fifty dollars of its product liability expenses as
"product liability loss." The advantage of such a characterization to
the taxpayer is that a deduction for "product liability loss" may be car-
_________________________________________________________________
6 In the context of separate tax returns, § 172 defines the portion of
product liability expenses that may be characterized as "product liability
loss":

         The term "product liability loss" means, for any taxable year, the
         lesser of -

         (A) the net operating loss for such year . . ., or

         (B) the sum of the amounts allowable as deductions under sec-
         tion 162 and 165 which are attributable to -

         (i) product liability, or

         (ii) expenses incurred in the investigation or settlement of, or
         opposition to, claims against the taxpayer on account of
         product liability.

26 U.S.C. § 172(j)(1).

                     5
ried backward or forward for up to ten years, rather than the three-
year period that is generally available for loss deductions. See 26
U.S.C. § 172(b)(1)(A), (I) (defining carryover and carryback time peri-
ods).7
     7 Because on an individual tax return, a taxpayer with positive
taxable income has no "net operating loss," a corollary is that a tax-
payer with positive taxable income must have zero"product liability
loss," notwithstanding the amount of its product liability expenses.
This is true because the taxpayer must have a net operating loss
before any of its product liability expenses may be classified as "prod-
uct liability loss."

B.

An affiliated group of corporations may properly elect to file a con-
solidated tax return through the parent corporation, rather than filing
individual tax returns for each of the group members. See 26 U.S.C.
§§ 1501-1505 (authorizing consolidated tax returns). Consolidated tax
return calculations have both similarities to, and certain distinctions
from, those applicable to individual tax returns.

The consolidated tax return regulations require that some informa-
_________________________________________________________________
7 For a separate tax return, § 172 also defines the net operating loss car-
ryback provisions:

        (b) Net operating Loss Carrybacks and Carryovers. -

        (1) Years to which loss may be carried. --

        (A) Except as provided in subparagraphs . . . (I), .. ., a net
        operating loss for any taxable year shall be a net operating
        loss carryback to each of the 3 taxable [years preceding] the
        taxable year of such loss.

        ...

        (I) Product liability losses. -- In the case of a taxpayer
        which has a product liability loss (as defined in subsection
        (j)[)] for a taxable year beginning after September 30, 1979
        (referred to in this subparagraph as the "loss year"), the prod-
        uct liability loss shall be a net operating loss carryback to
        each of the 10 taxable years [preceding] the loss year.

26 U.S.C. § 172(b).

                      6
tion be calculated separately for each group member, similar to calcu-
lations that would be necessary had that member filed its own
individual tax return. The "separate taxable income" for a group mem-
ber is calculated in accordance with the tax code provisions covering
the determinations of taxable income of separate corporations, subject
to modifications. See Treas. Reg. § 1.1502-12 (defining "separate tax-
able income").8
              8 One such modification, for example, is that no net
operating loss deduction may be taken into account when computing
a group member's "separate taxable income." See id.

Thus, pursuant to the consolidated returns regulations, some impor-
tant and relevant tax return information from the group members is
not included in these per-group-member calculations. Instead, that tax
return information is separately designated and utilized in consoli-
dated form. These consolidated amounts and the per-group-member
amounts are then combined into the parent corporation's "consoli-
dated taxable income," which accumulates all the relevant informa-
tion by taking into account: (i) the "separate taxable income of each
member of the group;" and (ii) deductions attributable to seven differ-
ent consolidated amounts, e.g., any "consolidated net operating loss"
deduction, and any consolidated charitable contributions deduction.
See Treas. Reg. § 1.1502-11(a) (generally defining "consolidated tax-
able income").9
              9
_________________________________________________________________
8 The "separate taxable income" of a group member excludes deduc-
tions that are attributable to certain consolidated amounts, as specified in
Treas. Reg. § 1.1502-12 subsections:

       (h) (net operating loss);

       (j) (capital gains or losses);

       (k) (gains or losses subject to section 1231);

       (l) (section 170 charitable contributions);

       (m) (section 922 (relating to the deduction for Western Hemi-
       sphere trade corporations)); and

       (n) (dividends received and dividends paid, pursuant to sections
       243(a)(1), 244(a), 245, or 247).

See Treas. Reg. § 1.1502-12.
9 The "consolidated taxable income" for a consolidated tax return is
determined pursuant to Treas. Reg. § 1.1502-11(a), by taking into
account:

                  7
C.

The question in this case -- how to properly determine the amount
of product liability expenses that may be characterized as "product
liability loss" on a consolidated tax return-- arises because, before
such expenses may be characterized as "product liability loss," a pre-
liminary determination must be made that a net operating loss has
occurred. Cf. 26 U.S.C. § 172(j) (defining "product liability loss" on
an individual tax return); see discussion supra Part II.A. Both the tax
code and the regulations are silent as to whether this "product liability
loss" characterization should be determined on a per-group-member
basis or on a consolidated basis. The regulations, however, lay the
groundwork for this determination by defining several relevant terms:
the group members' "separate taxable income" (see Treas. Reg.
§ 1.1502-12) and "separate net operating loss" (see Treas. Reg.
§ 1.1502-79(a)); and the parent corporation's"consolidated taxable
income" (see Treas. Reg. § 1.1502-11) and "consolidated net operat-
ing loss" (see Treas. Reg. § 1.1502-21(f)).

On a consolidated tax return, each group member has its associated
"separate taxable income." A group member's"separate taxable
income" is not analogous to a corporation's taxable income on an
_________________________________________________________________
        (1) each group member's "separate taxable income;"

       (2) any consolidated net operating loss deduction;

       (3) any consolidated capital gain net income . . .;

       (4) any consolidated section 1231 net loss;

       (5) any consolidated charitable contributions deduction;

       (6) any consolidated section 922 deduction;

       (7) any consolidated dividends received deduction;

       (8) any consolidated section 247 deduction.

See Treas. Reg. § 1.1502-11(a). The above deductions, taken into
account in calculating the parent's "consolidated taxable income" pursu-
ant to Treas. Reg. § 1.1502-11(a), mirror those deductions excluded from
the calculation of a group member's "separate taxable income" pursuant
to Treas. Reg. § 1.1502-12. See supra note 8.

                  8
individual tax return, however, because unlike the individual's taxable
income, the "separate taxable income" does not reflect the full extent
of that group member's profitability or loss. This is so because, on
consolidated tax returns, some deductible amounts attributable to the
group member are instead reflected elsewhere, in consolidated form.
See supra note 8 (e.g., net operating loss not taken into account in
group member's "separate taxable income").

The consolidated deductions that are not reflected in the group
member's "separate taxable income" but are fairly attributable to the
group member, are, however, reflected in the "separate net operating
loss" of the group member. The "separate net operating loss" of a
group member is determined from the "separate taxable income," with
adjustments for certain items, including items taken into account in
the computation of the consolidated net operating loss. See Treas.
Reg. § 1.1502-79(a)(3) (formula for apportioning "consolidated net
operating loss" to a member, when carryback must go to the mem-
ber's separate return year).1010 As a result of the incorporation of the
consolidated deduction adjustments in the group members' "separate
_________________________________________________________________
10 The "separate net operating loss" of a group member as defined in
Treas. Reg. § 1.1502-79(a)(3) (formula for apportioning "consolidated
net operating loss" to a member for allocation to a separate tax return
year), is determined from its "separate taxable income" under Treas. Reg.
§ 1.1502-12 (except that no deduction is allowed under section 242),
adjusted for the group member's portion of the following items taken
into account in the computation of the consolidated net operating loss:

        (i) consolidated dividends received deduction, consolidated
        charitable contributions deduction, and consolidated sec-
        tion 247 deduction;

        (iv) consolidated net capital loss carryover which is absorbed
        in the taxable year;

and adjusted for the following items taken into account in the consoli-
dated net operating loss computation:

        (ii) the member's capital gain net income;

        (iii) the member's net capital loss and section 1231 net loss,
        reduced by the portion of the consolidated net capital loss
        attributable to such member.

See Treas. Reg. § 1.1502-79(a)(3).

                   9
net operating loss" but not in their "separate taxable income," it is
possible that a group member may have positive "separate taxable
income" at the same time it has a positive "separate net operating loss."11
                                                                         11

The consolidated tax return regulations also define the parent cor-
poration's "consolidated taxable income," which takes into account
the group members' "separate taxable incomes" and deductions attrib-
utable to seven consolidated items. See supra note 9. Further, the reg-
ulations also define the parent's "consolidated net operating loss,"
which, like its "consolidated taxable income," combines the group
members' "separate taxable incomes" with enumerated consolidated
deductions. See Treas. Reg. § 1.1502-21(f) (defining "consolidated
net operating loss").12
                     12

Having reviewed the pertinent terminology and provisions of the
code and regulations, we now turn to the facts of this case to deter-
mine how the per-group-member and consolidated items apply to the
question before us.

III.

Our standard of review is clear: we review de novo the grant or
denial of a motion for summary judgment. Henson v. Liggett Group,
Inc., 61 F.3d 270, 274 (4th Cir. 1995).
_________________________________________________________________
11 This is importantly different from the case of an individual tax return,
where if either the individual's taxable income or net operating loss is
positive, the other value must be zero.
12 The "consolidated net operating loss" is determined pursuant to
Treas. Reg. § 1.1502-21(f) by taking into account:

        (1) the group members' "separate taxable income";

        (2) any consolidated capital gain net income . . .;

        (3) any consolidated section 1231 net loss;

        (4) any consolidated charitable contributions deduction;

        (5) any consolidated dividends received deduction; and

        (6) any consolidated section 247 deduction.

See Treas. Reg. § 1.1502-21(f).

                   10
A.

The taxpayer has adopted a single-entity approach in calculating its
"product liability loss" for AMCA's 1983 through 1986 consolidated
tax returns. The methodology is the same for each of the challenged
tax years' calculations. The taxpayer's single-entity approach does
not require a group member incurring deductible product liability
expenses to have also incurred a net operating loss. According to the
taxpayer, only AMCA's aggregated product liability expenses and net
operating loss amounts are relevant to the characterization of these
expenses as "product liability loss."

Specifically, the taxpayer applied the single-entity method as fol-
lows. First, for each tax year, the taxpayer aggregated all twenty-six
AMCA group members' product liability expenses. See 26 U.S.C.
§ 172(j) (defining "product liability loss" on an individual tax return).
The taxpayer then calculated AMCA's "consolidated net operating
loss" for that tax year. See Treas. Reg.§ 1.1502-21(f) (defining "con-
solidated net operating loss"). Because AMCA's aggregated product
liability expenses were less than AMCA's "consolidated net operating
loss" for that tax year, and since in the case of a separate tax return,
under § 172(j)(1), a corporation's product liability expenses that are
less than or equal to its "net operating loss" are characterized as
"product liability loss," the taxpayer characterized AMCA's aggre-
gated product liability expenses as "product liability loss." This char-
acterization permits the taxpayer to deduct the entirety of these
expenses from income earned up to ten years prior, and to receive tax
credits thereon. Under the taxpayer's view, for example, a group
member with fifty dollars of product liability expenses could contrib-
ute all fifty dollars toward the "product liability loss" on the parent
corporation's consolidated tax return, so long as the consolidated net
operating loss was greater than the aggregate of all the group mem-
bers' product liability expenses.

The IRS disagrees with the taxpayer's single-entity method for
defining "product liability loss" on consolidated tax returns, and
therefore rejects the taxpayer's characterization of its aggregated
product liability expenses as "product liability loss." The IRS empha-
sizes that there are fundamental differences between relevant portions

                  11
of the consolidated returns regulations and the separate returns regula-
tions, and that the consolidated regulations take precedence here.

Put simply, we agree with the IRS that the taxpayer's single-entity
method is improper. The principal advantage in filing a consolidated
return is income blending: the losses of unprofitable group members
can offset the income of profitable group members and mitigate the
current tax liability. Amtel, Inc. v. United States, 31 Fed. Cl. 598, 600
(1994), aff'd, 59 F.3d 181 (Fed. Cir. 1995) (table). The regulations
provide for blending the group members' net operating losses, and
they explicitly define a "consolidated net operating loss" without an
accompanying reference to consolidated product liability expenses.
This omission is important here and makes clear that blending those
expenses is not permitted, i.e., that a comparison of the group mem-
bers' aggregated product liability expenses to the consolidated net
operating losses in order to derive a consolidated"product liability
loss" is not intended. Cf. 26 U.S.C.§ 172(c), (j) (defining "net operat-
ing loss" and "product liability loss" on an individual tax return). This
omission also confirms that product liability expenses are linked to
the consolidated net operating loss only through their nexus to the
group member, so that any related tax carryback benefits are therefore
also tied to the group member.13  13

The IRS further contends that under the taxpayer's single-entity
method of characterizing the group member's product liability
expenses, the parent corporation obtains a windfall tax benefit. We
agree that, were the taxpayer's reasoning to prevail, the parent corpo-
ration could obtain the extended ten-year carryback for losses
incurred by individual group members (that are reflected in the par-
ent's "consolidated net operating loss"), although the losses were not
the result of product liability expenses (and thus could not be "product
_________________________________________________________________
13 The enumerated modifications taken into account when computing a
group member's "separate taxable income" do not refer to product liabil-
ity losses. The calculation of a group member's"separate taxable
income" therefore includes the member's product liability expense
deduction. See, e.g., 26 U.S.C.§§ 162 (permitting trade or business
expense deductions), 165 (permitting deductions for loss), 172(j)(1)
(defining "product liability loss"). Further, product liability loss is not
referred to in the "consolidated net operating loss" definition.

                   12
liability loss"). This occurs by the parent corporation's characteriza-
tion of all of a group member's product liability expenses as "product
liability loss," even though some of these expenses came from group
members that incurred no "separate net operating loss." Because the
tax regulations plainly provide the ten-year carryback only for "prod-
uct liability loss" (and not for product liability expenses), we conclude
that an interpretation removing the close nexus between such
expenses and whether the affected company operated at a loss is
inconsistent with the regulations.

B.

Having rejected the taxpayer's single-entity method for determin-
ing "product liability loss" on a consolidated return, we now turn to
establishing the proper method for doing so. We conclude that deter-
mining "product liability loss" separately for each group member is
correct and consistent with the regulations. The regulations suggest
two possible methods, however, for determining "product liability
loss" from a group member's product liability expenses. Under these
possible methods of calculation, a member's "product liability loss"
may be either: (a) the amount of product liability expenses that do not
exceed the group member's negative "separate taxable income," or (b)
the amount of product liability expenses that do not exceed the group
member's "separate net operating loss."

1.

The IRS proposes that the group member's negative"separate tax-
able income," calculated pursuant to Treas. Reg.§ 1.1502-12, should
establish the threshold for determining the group's"product liability
loss" amount. To the contrary, we agree with the taxpayer that the
IRS's proposed method for determining "product liability loss" on
consolidated returns is incorrect.

The IRS contends that whether a portion of a group member's
product liability expenses can be characterized as"product liability
loss" turns on whether the group member had a negative "separate
taxable income." The IRS thus proposes that the"net operating loss"
on a separate return is most analogous to a group member's "separate
taxable income" on a consolidated return. In the IRS's view, a group

                  13
member with positive "separate taxable income" has no losses under
the consolidated return regulations, and therefore has no "product lia-
bility loss," despite having product liability expenses. For example,
the IRS urges that a group member with fifty dollars of product liabil-
ity expenses and negative ten dollars "separate taxable income" could
contribute no more than ten dollars toward the "product liability loss"
on the parent corporation's consolidated tax return.

The taxpayer points out that the group member's"separate taxable
income" is not analogous to a net operating loss on a separate return,
because "separate taxable income" by definition excludes income and
deductions that would be incorporated in calculating the group mem-
ber's taxable income or net operating loss, if the group member had
filed a separate tax return. See Treas. Reg.§ 1.1502-12 (defining
"separate taxable income"). Therefore, the taxpayer says, the "sepa-
rate taxable income" cannot be an appropriate reference for determin-
ing whether the group member incurred a loss from product liability
expenses. We agree. See discussion supra Part II.C.

On a separate tax return, the net operating loss is the amount by
which the allowable deductions exceed the taxpayer's gross income.
See 26 U.S.C. § 172(c) (defining net operating loss). Allowable
deductions include deductions attributable to, e.g., charitable contri-
butions and net operating loss.14 14See,
                                  14     e.g., 26 U.S.C. §§ 170 (charita-
ble contributions), 172(a) (net operating loss). Thus, the net operating
loss as defined on a separate return reflects that, in a broad sense, the
taxpayer had more expenditures than income. On a consolidated
return, the "separate taxable income" does not reflect an analogous
difference between a group member's income and expenses, because
expenses that are fairly attributable to the group member are excluded
from the "separate taxable income." For example, a member's charita-
ble contributions and attributable net operating loss deductions are
excluded from its "separate taxable income," and instead are included
elsewhere, in consolidated form only. See, e.g., Treas. Reg.
§§ 1.1502-12 ("separate taxable income"), 1.1502-11(a) (listing con-
solidated items). Thus, a group member may have a positive "separate
taxable income" notwithstanding that the member had a charitable
_________________________________________________________________
14 A net operating loss deduction may be available, for example, by the
taxpayer's carryback or carryforward from another tax year.

                  14
contribution of, say, two or three times the amount of its "separate
taxable income." According to the view of the IRS, the member's
positive "separate taxable income" would bar any of that member's
product liability expenses from being characterized as "product liabil-
ity loss."

We are constrained to reject the position taken by the IRS. The
result in our above example is flatly contrary to the separate tax return
analogy from § 172(j) -- there, if an individual's charitable contribu-
tion exceeds its gross income, a net operating loss results. This net
operating loss would therefore permit the individual taxpayer's prod-
uct liability expenses to be characterized as "product liability loss."15
                                                                        15
Further, the IRS presents no affirmative reason to justify using a
group member's "separate taxable income" to limit the member's con-
tribution to "product liability loss," and we conclude there is none. A
group member can, and often will, have a net operating loss (in the
sense of § 172, after accounting for all the amounts attributable to that
member), despite the member's positive "separate taxable income."
See supra note 11. In such a case, the group member's product liabil-
ity expenses may qualify as "product liability loss." Having rejected
the IRS's proposed reference to the member's "separate taxable
income" in the determination of whether the member's product liabil-
ity expenses are "product liability loss," we must go further, and con-
sider how to properly determine "product liability loss" on a
consolidated return.

The taxpayer argues that "product liability loss" is determined by
reference to net operating loss. We agree with this assertion. How-
ever, the taxpayer goes further, and claims that for a consolidated
return, the net operating loss only exists on a consolidated basis. See
26 U.S.C. § 172(j)(1) (defining "product liability loss" on an individ-
ual tax return); Treas. Reg. § 1.1502-21(f) (defining "consolidated net
operating loss"). Therefore, the taxpayer asserts, product liability
expenses must also be consolidated in order to compare those
expenses to the consolidated net operating loss, so as to calculate the
"product liability loss." On this point, we disagree with the taxpayer.
_________________________________________________________________
15 The "product liability loss" amount would be limited, of course, by
the amount of the net operating loss. See 26 U.S.C. § 172(j).

                  15
2.

The regulations governing consolidated returns provide a simple
and direct method for determining the portion of a group member's
product liability expenses that are "product liability loss." The regula-
tions define a group member's "separate net operating loss," see
Treas. Reg. § 1.1502-79(a)(3), which is analogous to an individual's
"net operating loss" on a separate return. By comparing each mem-
ber's product liability expenses to its "separate net operating loss,"
that member's "product liability loss" may be properly calculated.
The parent's "product liability loss" is then calculated as the total of
the members' "product liability loss."

First, the regulations define the portion of the consolidated net
operating loss that is attributable to a group member.16
                                                       16 See Treas.
Reg. § 1.1502-79(a) (apportionment of consolidated net operating loss
to a group member, for purposes of carrying back to a separate return
year).17
      17 Application of this apportionment formula to the issue in this
case results in logical consistency of the general consolidated return
framework, and the specific resolution of the issue in this case.

A group member's "separate net operating loss" incorporates the
portion of the consolidated net operating loss allocated to that mem-
ber (calculated pursuant to Treas. Reg. § 1.1502-79(a)(3)), and is
analogous to a § 172(c) net operating loss. That is, the member's
"separate net operating loss" takes into account, for example, that
_________________________________________________________________
16 A group member's portion of the consolidated net operating loss is:

       the consolidated net operating loss multiplied by a fraction, the
       numerator of which is the separate net operating loss of such cor-
       poration, and the denominator of which is the sum of the sepa-
       rate net operating losses of all members of the group in such year
       having such losses.

Treas. Reg. § 1.1502-79(a)(3). The regulation further provides the
method for determining the "separate net operating loss" of a group
member. Id. See also supra note 10.
17 The amount of net operating loss apportioned to a group member
does not and should not depend upon whether any resulting carryback
will be applied to a separate or a consolidated return year.

                  16
member's charitable contributions and net operating loss deductions
-- and in this sense, it is unlike the member's"separate taxable
income."18
         18 Therefore, a group member's product liability expenses
that are not in excess of that group member's "separate net operating
loss" is that member's "product liability loss," analogous to § 172(j).
The sum of the group members' "product liability loss" provides the
parent corporation's total "product liability loss."1919 For example, a
group member with fifty dollars of product liability expenses, nega-
tive ten dollars "separate taxable income," and fifteen dollars "sepa-
rate net operating loss" could contribute a maximum of fifteen dollars
toward the "product liability loss" on the parent corporation's consoli-
dated tax return.

The tax carryback benefits available to the parent corporation from
the group member's product liability expenses are thus properly lim-
ited by the group member's portion of the consolidated net operating
loss, analogous to the limit that would be imposed if the group mem-
ber had filed a separate tax return. Our resolution today maintains the
required nexus between a group member's net operating loss and its
product liability expenses, as implied by the consolidated return regu-
lations, in the definition of the "product liability loss" deduction on
a consolidated return.

IV.

In conclusion, we reject the taxpayer's single-entity approach to the
determination of "product liability loss" on a consolidated return.
Instead, we conclude that each group member's "product liability
loss" must be appropriately determined, and that the parent's "product
liability loss" is calculated as the aggregate of the group members'
"product liability loss." As to the proper method to determine each
_________________________________________________________________
18 A group member's "separate net operating loss" is more analogous
than its "separate taxable income" to the§ 172 "net operating loss" on an
individual tax return. See discussion supra Part III.B.1.
19 If a group member's portion of the consolidated net operating loss
must be carried back to the group member's separate return year, pursu-
ant to Treas. Reg. § 1.1502-79, then the "product liability loss" for that
group member must likewise be carried back to the group member's sep-
arate return year. Cf. supra note 4.

                  17
group member's "product liability loss," we reject the position of the
IRS that a group member's "product liability loss" is its product lia-
bility expenses to the extent that those expenses are not in excess of
the group member's negative "separate taxable income."

We therefore hold that, on a consolidated return, a group member's
product liability expenses that do not exceed that member's "separate
net operating loss," calculated pursuant to Treas. Reg. § 1.1502-
79(a)(3), may be characterized as "product liability loss." We further
hold that the parent's "product liability loss" is properly determined
as the aggregate of its group members' "product liability loss."

Pursuant to the foregoing, we reverse the judgment of the district
court and remand this case for further proceedings consistent with this
decision.

REVERSED AND REMANDED

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