89 T.C. 207">*208 OPINION

In a timely statutory notice of deficiency dated August 25, 1983, respondent determined deficiencies in the consolidated Federal income tax liabilities of petitioners Wyman-Gordon Co. and Rome Industries, Inc., members of an affiliated group of corporations, as follows:

After concessions and resolution of all issues pertaining to 1977 and 1979, the sole issue for1987 U.S. Tax Ct. LEXIS 108">*110 decision concerns the effect of discharge of indebtedness income on the computation of earnings and profits and on the computation of a taxpayer's excess loss account balance under the consolidated 89 T.C. 207">*209 tax return provisions of the Code. All of the facts have been stipulated, and this case was submitted for decision under Rule 122, Tax Court Rules of Practice and Procedure.

Petitioner Wyman-Gordon Co., a publicly held corporation the stock of which is traded on the over-the-counter market, is organized under the laws of the State of Massachusetts and maintained its principal office in Worchester, Massachusetts, at the time of filing the petition in this case. Wyman-Gordon is a manufacturer of metal products and is the common parent of an affiliated group of manufacturing corporations that filed consolidated Federal income tax returns for each of the years at issue herein. The affiliated group included Rome Industries, Inc. (hereinafter referred to as Rome), a first-tier subsidiary of Wyman-Gordon, and Woods & Copeland Manufacturing, Inc. (hereinafter referred to as Woods & Copeland), a second-tier subsidiary wholly owned by Rome. ¹

1987 U.S. Tax Ct. LEXIS 108">*111 Rome is organized under the laws of the State of Georgia, and its principal office is in Cedartown, Georgia. Woods & Copeland was organized under the laws of the State of Texas, and its principal office was also in Cedartown, Georgia, before its liquidation in 1978.

Rome acquired all of the stock of Woods & Copeland in August of 1976 from unrelated third parties at a cost of $ 484,000. Shortly thereafter, Wyman-Gordon made the first of several loans to Woods & Copeland to provide it with operating capital. Woods & Copeland executed a recourse promissory note to Wyman-Gordon for the principal amount of each loan. The promissory notes generally matured in 90 days, after which they became payable to Wyman-Gordon on demand. The promissory notes bore simple interest at varying market rates. Of the total amount Wyman-Gordon loaned to Woods & Copeland from 1976 to 1978, $ 4,542,208 remained outstanding as of December 14, 1978. ²

1987 U.S. Tax Ct. LEXIS 108">*112 89 T.C. 207">*210 Rome also made loans to Woods & Copeland in 1978 in the total principal amount of $ 425,000. Of that amount, $ 248,289 was repaid in 1978, and $ 176,711 remained unpaid as of December 14, 1978. The loans from Rome to Woods & Copeland were reflected by recourse promissory notes, matured in 90 days, and bore simple interest at varying market rates. Upon expiration of 90 days, Woods & Copeland's promissory notes to Rome became payable on demand.

On November 30, 1978, Wyman-Gordon demanded payment from Woods & Copeland of $ 4,542,208, representing the total outstanding principal on the promissory notes of Woods & Copeland. On December 14, 1978, Woods & Copeland transferred all of its assets to Wyman-Gordon in partial satisfaction of the $ 4,542,208 due on the promissory notes. The net value of the assets that Woods & Copeland transferred to Wyman-Gordon pursuant to the demand made on its indebtedness to Wyman-Gordon was $ 2,504,047, which Wyman-Gordon applied against Woods & Copeland's outstanding debt, and Wyman-Gordon then canceled or discharged Woods & Copeland's remaining $ 2,038,161 indebtedness to it. Thereafter, Woods & Copeland was formally dissolved, but its businesses1987 U.S. Tax Ct. LEXIS 108">*113 were continued by Rome. On its 1978 consolidated Federal income tax return, Wyman-Gordon claimed a bad debt deduction in the amount of $ 2,038,161, reflecting the principal amount of the Woods & Copeland indebtedness discharged by Wyman-Gordon.

Woods & Copeland reported net operating losses for 1977 and 1978 in the respective amounts of $ 1,251,775 and $ 1,655,746. These losses were used to offset 1977 and 1978 consolidated taxable income of the affiliated group. ³

Because Woods & Copeland was insolvent at the end of 1978, Woods & Copeland did not include in its 1978 taxable income the $ 2,038,161 discharge of indebtedness income. Woods & Copeland, however, included the $ 2,038,161 discharge of indebtedness income in its earnings and profits for 1978, and the earnings and profits of Woods & Copeland89 T.C. 207">*211 were used by Rome to make adjustments to Rome's basis in the stock of Woods & Copeland.

1987 U.S. Tax Ct. LEXIS 108">*114 Due to net operating losses realized by Woods & Copeland in 1976 and 1977, and the resulting adjustments to the basis of Rome's stock in Woods & Copeland at the end of each of those years, Rome had established an "excess loss account" in the amount of $ 939,669 with respect to its stock in Woods & Copeland.

Generally, a corporation that joins in filing a consolidated Federal income tax return is required to include in taxable income the balance of its excess loss account, if any, upon the occurrence of specified "disposition" events. Rome, however, eliminated the $ 939,669 balance in its excess loss account at the end of 1978 with respect to its investment in Woods & Copeland by including the $ 2,038,161 discharge of indebtedness income in Woods & Copeland's 1978 earnings and profits (even though such amount was excluded from Woods & Copeland's taxable income due to its insolvency).

In addition, Rome claimed on the 1978 consolidated Federal income tax return a worthless stock deduction in the amount of $ 398,584, with respect to its basis in the Woods & Copeland stock. Rome also claimed on the 1978 consolidated Federal income tax return a bad debt deduction in the amount of $ 176,711, 1987 U.S. Tax Ct. LEXIS 108">*115 with respect to the unpaid loans Rome had made to Woods & Copeland in 1978.

In his notice of deficiency, respondent determined that Woods & Copeland was not entitled to include the $ 2,038,161 discharge of indebtedness income in its earnings and profits computation for 1978 and that Rome therefore must include in its 1978 taxable income the redetermined balance (namely, $ 1,384,155) of Rome's excess loss account with respect to its stock in Woods & Copeland. Respondent also disallowed Rome's claimed worthless stock loss of $ 398,584 on the ground that Rome had no remaining basis in its stock in Woods & Copeland.

Pursuant to Congress' express delegation of authority in section 1502, ⁴ the Secretary of the Treasury has promulgated regulations governing the filing of consolidated Federal income tax returns by affiliated corporations. The 89 T.C. 207">*212 Secretary's consolidated return regulations are thus legislative in character and carry the force and effect of law. Woods Investment Co. v. Commissioner, 85 T.C. 274">85 T.C. 274, 85 T.C. 274">279 (1985); Georgia-Pacific Corp. v. Commissioner, 63 T.C. 790">63 T.C. 790, 63 T.C. 790">801-802 (1975).

1987 U.S. Tax Ct. LEXIS 108">*116 Under those regulations, the losses of a subsidiary may be used without limitation within a consolidated Federal income tax return to offset the profits of other members of the affiliated group, even though the losses of the subsidiary exceed the parent's basis in the subsidiary's stock. As a result, the taxable income or loss of the affiliated group may become distorted because losses of the subsidiary used to offset income of the consolidated group may exceed true economic losses (i.e., tax losses of a subsidiary used by the affiliated group may exceed the total cost of the affiliated group's investment in the subsidiary). To compensate in part for this potential distortion, the regulations under the consolidated return provisions of the Code require yearend adjustments to the parent's cost basis of its investment in the stock of a subsidiary where tax losses of the subsidiary are included in the consolidated taxable income of the affiliated group. Secs. 1.1502-19 and 1.1502-32, Income Tax Regs.; Covil Insulation Co. v. Commissioner, 65 T.C. 364">65 T.C. 364, 65 T.C. 364">370 (1975).

A primary objective of this "investment adjustment" is to prevent the affiliated group from1987 U.S. Tax Ct. LEXIS 108">*117 obtaining a double tax benefit -- first, when the group's consolidated income is reduced by the subsidiary's losses, and second, when the stock of the subsidiary is disposed of at a loss or at a reduced gain. Ilfeld Co. v. Hernandez, 292 U.S. 62">292 U.S. 62, 292 U.S. 62">68 (1934). The required investment adjustment also prevents income of a subsidiary that was included in consolidated income from being subject to tax a second time when the parent disposes of the subsidiary's stock. See generally J. Crestol, K. Hennessey, & A. Rua, The Consolidated Tax Return, par. 6.03[1], at 6-7 (1980); F. Peel, Consolidated Tax Returns, sec. 16:02, at 4 (3d ed. 1984); H. Lerner, R. Antes, R. Rosen & B. Finkelstein, Federal Income Taxation of Corporations Filing Consolidated Returns, sec. 18:01, at 18-2, 18-3 (1986).

89 T.C. 207">*213 The amount of the yearend investment adjustment is described in the regulations as the difference between the required "positive adjustment" and the required "negative adjustment." Sec. 1.1502-32(a), Income Tax Regs.⁵ Generally, 89 T.C. 207">*214 the amount of a subsidiary's yearend undistributed earnings and profits that increases consolidated taxable income results in1987 U.S. Tax Ct. LEXIS 108">*118 a positive adjustment and increases the parent's basis in the stock. Sec. 1.1502-32(b)(1)(i), Income Tax Regs. A loss of a subsidiary that is used to reduce the affiliated group's consolidated income results in a negative adjustment and decreases the parent's basis in the subsidiary's stock. Sec. 1.1502-32(b)(2)(i), Income Tax Regs.; 65 T.C. 364">Covil Insulation Co. v. Commissioner, supra at 371.

1987 U.S. Tax Ct. LEXIS 108">*119 The positive and negative adjustments are netted at the end of each taxable year. If a yearend net negative adjustment exceeds the parent's basis in the stock of a subsidiary, the parent must establish an "excess loss account" with respect to the stock it owns in the subsidiary. Sec. 1.1502-32(e)(1), Income Tax Regs.

When a parent corporation sells or otherwise "disposes" of stock in a subsidiary, the parent is required under section 1.1502-19(a)(1), Income Tax Regs., to include in income the balance of any excess loss account outstanding with respect to its stock in that subsidiary immediately before the disposition event occurred. ⁶ In most cases, upon the occurrence of a disposition event, the balance of an excess loss 89 T.C. 207">*215 account will be taken into income as capital gain. Sec. 1.1502-19(a)(2)(i), Income Tax Regs. Where the subsidiary is insolvent, however (as was Woods & Copeland at the end of 1978), the balance of an excess loss account is to be taken into income as ordinary income. Sec. 1.1502-19(a)(2)(ii), Income Tax Regs.

1987 U.S. Tax Ct. LEXIS 108">*120 To summarize the above basis adjustment rules insofar as they are pertinent to the issue before us, an affiliated group of corporations that files a consolidated Federal income tax return is able to reduce its consolidated taxable income each year by deducting tax losses of a subsidiary that are in excess of the group's true economic losses (i.e., in excess of the amount invested in the subsidiary). If the losses are temporary and if the subsidiary has sufficient undistributed earnings and profits in later years, the balance in the excess loss account may be eliminated. Where, however, the parent disposes of the stock in the subsidiary before the subsidiary's economic turnaround, the balance in the excess loss account immediately before the disposition event occurred is treated as the equivalent of an "amount realized" by the parent (because the parent was allowed to reduce consolidated taxable income by that amount even though the losses exceeded the parent's adjusted basis in the subsidiary). Accordingly, in that situation, the balance in the excess loss account is to be included in the parent's consolidated taxable income.

The narrow and difficult issue we must decide in this1987 U.S. Tax Ct. LEXIS 108">*121 case is whether the $ 2,038,161 discharge of indebtedness income realized by Woods & Copeland increases the earnings and profits of Woods & Copeland and thereby reduces to zero Rome's excess loss account with respect to its stock in Woods & Copeland, even though such discharge of indebtedness income was not included in consolidated taxable income. This issue turns on whether discharge of indebtedness income may be included in the earnings and profits of a corporation even though it is excluded from taxable income where the inclusion in earnings and profits would effectively allow an affiliated group of corporations excessive tax benefits by avoiding recognition of an excess loss account balance.

89 T.C. 207">*216 Petitioners argue that such a rule exists and that any double deduction or excessive tax benefits they will receive is attributable to the Treasury's failure to specifically provide otherwise in the regulations under section 1502. Respondent argues that no such rule exists, that the result sought by petitioners is contrary to the overriding policy of the consolidated return regulations to prevent the avoidance of tax liability, and that such result is not required by the Code or1987 U.S. Tax Ct. LEXIS 108">*122 the regulations governing the computation of earnings and profits. Respondent also argues that the policies underlying the regulations applicable to excess loss accounts would be subverted if petitioners' position is adopted. For the reasons discussed below, we agree with respondent.

Section 1502 sets forth an overriding objective of the rules and regulations governing the filing of consolidated Federal income tax returns, as follows:

SEC. 1502. REGULATIONS.

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. [Emphasis added.]

An early Senate Finance Committee report concerning the consolidated tax return provisions of the Revenue Act of 1918, ⁷ still pertinent to the issue before us, stated --

So far 1987 U.S. Tax Ct. LEXIS 108">*123 as its immediate effect is concerned consolidation increases the tax in some cases and reduces it in other cases, but its general and permanent effect is to prevent evasion which can not be successfully blocked in any other way. * * * [S. Rept. 617, 65th Cong., 3d Sess. (1918), 1939-1 C.B. (Part 2) 117, 123.]

With regard to the consolidated tax return provisions of the Revenue Act of 1928, ⁸ the Senate Finance Committee report stated --

89 T.C. 207">*217 Much of the misapprehension about consolidated returns will be removed when it is realized that it is only when the corporations are really but one corporation that the permission to file consolidated returns is given, and that no ultimate advantage under the tax laws really results. * * * [S. Rept. 960, 70th Cong., 1st Sess. (1928), 1939-1 C.B. (Part 2) 409, 418.]

1987 U.S. Tax Ct. LEXIS 108">*124 With regard to the strong policy against allowing double deductions in the context of consolidated tax returns and in the context of an issue not significantly dissimilar from that presented herein, the Supreme Court, in an early case, stated:

The allowance claimed would permit petitioner twice to use the subsidiaries' losses for the reduction of its taxable income. By means of the consolidated returns in earlier years it was enabled to deduct them. And now it claims for 1929 deductions for diminution of assets resulting from the same losses. If allowed, this would be the practical equivalent of double deduction. In the absence of a provision of the Act definitely requiring it, a purpose so opposed to precedent and equality of treatment of taxpayers will not be attributed to lawmakers. * * * [Ilfeld Co. v. Hernandez, 292 U.S. 62">292 U.S. 62, 292 U.S. 62">68 (1934).]

In 1976, 1977, and 1978, Woods & Copeland realized net operating losses that reduced the consolidated taxable income of the affiliated group. As a result of those losses, Woods & Copeland had a deficit earnings and profits account, and consequently Rome's basis in the stock of Woods & Copeland was reduced below1987 U.S. Tax Ct. LEXIS 108">*125 zero and an excess loss account was created.

In that situation, the regulations under section 1502 expressly provide that upon "disposition" of the stock of a subsidiary, the parent corporation is required to recognize as income the balance of the excess loss account with respect to its subsidiary's stock. Furthermore, section 1.1502-19(b)(2), Income Tax Regs., expressly provides that the realization of discharge of indebtedness income where such income is not included in taxable income constitutes a "disposition" event and triggers recognition of the excess loss account. Section 1.1502-19(b)(2), Income Tax Regs., provides as follows:

(2) Disposition of all shares. Except as otherwise provided in paragraphs (d) and (e) of this section, a member shall be considered for purposes of this section as having disposed of all of its shares of stock in a subsidiary --

89 T.C. 207">*218 * * * *

(iii) On the last day of each taxable year of such subsidiary in which any of its stock is wholly worthless (within the meaning of section 165(g)), or in which an indebtedness of the subsidiary is discharged if such discharge would have resulted in "cancellation of indebtedness income" but for the insolvency1987 U.S. Tax Ct. LEXIS 108">*126 of the subsidiary. [Emphasis added.]

As previously explained, the regulations also provide that upon the occurrence of one of the specified disposition events, the excess loss account generally will be included in taxable income as capital gain. Sec. 1.1502-19(a)(2)(i), Income Tax Regs. Where, however, at the time of the disposition event the subsidiary is insolvent, as in the instant case, the balance of the excess loss account will be included in taxable income as ordinary income. Sec. 1.1502-19(a)(2)(ii), Income Tax Regs. The policy underlying this rule has been explained as follows:

Presumably, ordinary income treatment was provided for excess loss accounts in insolvency cases on the theory that insolvency results in avoidance of ordinary income on the cancellation of indebtedness. Put another way, the argument that income from excess loss accounts should be capital gain because selling the assets of the subsidiary would produce capital gain was thought to lose its validity to the extent the subsidiary is insolvent; with the rationale for capital gain treatment gone the Regulations treat the excess loss account as ordinary income on the premise that the losses of the subsidiary1987 U.S. Tax Ct. LEXIS 108">*127 probably were used to offset ordinary income of other members of the group. [F. Peel, supra, sec. 16:09, at 47.]

In light of the specific rules under section 1.1502-19, Income Tax Regs., governing the recognition of an excess loss account in taxable income immediately before specified disposition events, and in light of the objectives and policies of those rules, we are hesitant to make (and it would require clear and explicit authority to support) a finding herein that would allow taxpayers to avoid the intended application of those rules.

Petitioners are correct that section 1.1502-19(a)(1), Income Tax Regs., ⁹ states that the excess loss account balance shall be computed under the provisions of section 1.1502-32, Income Tax Regs. There is, however, no express statement in those provisions as to how discharge of indebtedness 89 T.C. 207">*219 income factors into the computation of earnings and profits or the excess loss account. The basis adjustment rules of section 1.1502-32, Income Tax Regs., are detailed and comprehensive. See Woods Investment Co. v. Commissioner, 85 T.C. 274">85 T.C. 274, 85 T.C. 274">279, 85 T.C. 274">282 (1985) (Court-reviewed). We do not, however, find therein1987 U.S. Tax Ct. LEXIS 108">*128 any specific provisions that would allow discharge of indebtedness income that is not included in taxable income to offset or to eliminate the very recognition of income contemplated by section 1.1502-19, Income Tax Regs. The regulations under section 1.1502-32, Income Tax Regs., do not even mention discharge of indebtedness income, and the only statements therein expressly referring to "excess loss accounts" merely indicate that a net positive adjustment under those regulations shall "reduce [the] excess loss account, if any, with respect to such stock." Sec. 1.1502-32(e)(2), Income Tax Regs.

Petitioners rely heavily on our holding in 85 T.C. 274">Woods Investment Co. v. Commissioner, supra, in which we held that under section 1.1502-32, Income Tax Regs., a subsidiary corporation within an affiliated group of corporations could compute earnings and profits utilizing straight-line depreciation, even though in 1987 U.S. Tax Ct. LEXIS 108">*129 doing so the subsidiary would benefit from a double deduction because it had utilized an accelerated method of depreciation to compute its taxable income. Our holding in Woods Investment Co. was based in large part on section 312(k), which specifically requires a corporation to compute earnings and profits on the basis of straight-line depreciation, regardless of the method of depreciation used to compute the taxable income of the corporation. ¹⁰ There exists no comparable statutory provision that requires inclusion of discharge of indebtedness income in earnings and profits in the situation before us and the holding of Woods Investment Co. is distinguishable on that basis.

1987 U.S. Tax Ct. LEXIS 108">*130 89 T.C. 207">*220 Petitioners argue that certain other authorities support their position, citing Rev. Rul. 75-515, 1975-2 C.B. 117; Meyer v. Commissioner, 46 T.C. 65">46 T.C. 65 (1966), affd. in part, vacated in part, and remanded 383 F.2d 883">383 F.2d 883 (8th Cir. 1967); and section 312(l), enacted subsequent to the years in issue by section 5(e)(2) of the Bankruptcy Tax Act of 1980, Pub. L. 96-589, 94 Stat. 3389, 3406. In our view, however, those authorities do not overcome the strong policy against the allowance of double deductions within the context of consolidated income tax returns. We think petitioners' interpretations of the revenue ruling and of our opinion in Meyer go too far, and we think that petitioners' interpretation of the relevant changes made by the Bankruptcy Tax Act of 1980 does not go far enough.

In Rev. Rul. 75-515, 1975-2 C.B. 117, and in 46 T.C. 65">Meyer v. Commissioner, supra, the issue was whether discharge of indebtedness income increased a corporation's earnings and profits, even though such income was not included in taxable income due to the 1987 U.S. Tax Ct. LEXIS 108">*131 taxpayer's insolvency. Of great significance, however, is the fact that the context in which that issue arose in Rev. Rul. 75-515 and in Meyer involved the computation of taxable dividends. Neither excess loss accounts nor basis adjustments under the consolidated return provisions were involved.

In holding that earnings and profits were to be increased by nontaxable discharge of indebtedness income in computing taxable dividends, Rev. Rul. 75-515 and our opinion in Meyer both produced the result of increasing the tax liabilities in question. That tax effect is quite different from the context in which the issue comes before us in this case. If we allow discharge of indebtedness income to reduce the outstanding balance in the excess loss account before Rome recognizes such balance in income, petitioners' tax liability would decrease. Petitioners would benefit from duplicate or excessive tax losses in that (1) Woods & Copeland's net operating losses in 1976, 1977, and 1978 were used to offset consolidated taxable income in an amount exceeding Rome's basis in Woods & Copeland's stock, (2) 1987 U.S. Tax Ct. LEXIS 108">*132 Wyman-Gordon was allowed a bad debt deduction in 1978 with respect to the unpaid indebtedness of Woods & Copeland, and (3) Rome would avoid recognizing the excess loss account balance 89 T.C. 207">*221 that had accumulated. See Bangor & Aroostook Ry. Co. v. Commissioner, 193 F.2d 827">193 F.2d 827, 193 F.2d 827">831 (1st Cir. 1951), affg. 16 T.C. 578">16 T.C. 578 (1951), an early First Circuit opinion that enunciates a general policy that the computation of earnings and profits should be consistent with the computation of taxable income.

These duplicate or excessive tax losses and deductions arising out of the operations and insolvency of one subsidiary distinguish our holding in Meyer and respondent's position in Rev. Rul. 75-515, and justify our adoption of a different rule in the context of the recognition of a corporation's excess loss account. For the same reason, the holding of the Eighth Circuit in Meyer v. Commissioner, 383 F.2d 883">383 F.2d 883 (8th Cir. 1967), affg. in part, vacating in part, and remanding 46 T.C. 65">46 T.C. 65 (1966), is distinguishable and provides no particular 1987 U.S. Tax Ct. LEXIS 108">*133 support for or against our decision herein.

Petitioners also argue that section 312(l), enacted subsequent to the years in issue as part of the Bankruptcy Tax Act of 1980, supports their position. Section 312(l) provides as follows:

(1) Discharge of Indebtedness Income. --

(1) Does not increase earnings and profits if applied to reduce basis. -- The earnings and profits of a corporation shall not include income from the discharge of indebtedness to the extent of the amount applied to reduce basis under section 1017.