Proposed Regulations May Devalue Certain Loss Corporations

Net operating losses (NOLs) are valuable corporate assets that can generally be used to offset future profits.

In corporate acquisition transactions, buyers may ascribe value to NOLs as business assets, counting on the ability to offset tax on future profits to enhance expected after-tax rates of return. Proposed regulations issued recently under Internal Revenue Code Section 382 could significantly reduce the value of these attributes when a corporate ownership change occurs in the future.

Background

Section 382 imposes limits on the amount of NOLs available to offset future profits after there is a greater than 50% increase in ownership by 5% shareholders over a specified period (three years). Section 382 was enacted in 1986 in response to transactions that were viewed as “trafficking in NOLs.” Despite 30 plus years since enactment and hundreds of pages of regulations, IRS and Treasury continue to issue guidance, introducing additional complexity and uncertainty in certain areas.

Section 382 applies to all loss corporations, including corporations with NOLs, credits, capital losses, or other deductible carryforwards (e.g., Sec. 163(j) carry forwards) following an ownership change. An ownership change may be obvious, as in the case of a 100% acquisition of stock, or it may be less obvious if it involves increases in ownership by a number of 5% shareholders.

The computation of the annual Sec. 382 NOL limitation following an ownership change is complex, but generally it is the product of the value of the loss corporation immediately before the ownership change and IRS tax-exempt interest rate (currently 1.59%, December 2019). Consequently, a corporation valued at $20 million undergoing an ownership change today would have an annual limitation of $318,000 on its NOLs generated prior to the ownership change date. This means its NOL utilization is limited to $318,000 per tax year until the pre-change NOLs are utilized or expire unused (generally, under the Tax Cuts and Jobs Act (TCJA) post-2017 NOLs do not expire). At a 21% corporate tax rate, this results in approximately $66,780 of annual tax savings.

In situations where the loss corporation has a net unrealized built-in gain (NUBIG) in its assets, the annual limitation may be increased for recognized built-in-gains (RBIG), where assets with a fair market value greater than tax basis as of the ownership change date are disposed of within five years following the ownership change. Similar rules apply to situations where the loss corporation has a net unrealized built-in loss (NUBIL) in its assets (i.e., assets have a fair market value lower than tax basis and any recognized built-in losses (RBIL) are subject to the Sec. 382 limitation).

Historically, the measurement and composition of NUBIG, NUBIL, RBIG, and RBIL was a source of controversy. In response, IRS issued Notice 2003-65, providing methodologies for how to measure NUBIG, NUBIL, RBIG, and RBIL. One methodology, the Section 338 Approach, allows an increase in the annual limitation for the first five years following an ownership change with respect to NUBIG corporations. This increase is computed through a hypothetical asset purchase as of the ownership change date under the principles of Sec. 338, measuring hypothetical increases in depreciation and amortization deductions on the corporation’s assets. This hypothetical increase in cost recovery deductions is treated as RBIG, even though the underlying assets may not be disposed of during the five-year period.

Any increase to RBIG under the Section 338 Approach is taxpayer favorable. Continuing the prior example, assume that the loss corporation has a NUBIG and $15,000,000 of the $20,000,000 value is attributable to intangible assets that have no tax basis (i.e., were created by the corporation, not acquired). Under the Section 338 Approach, the intangibles would hypothetically be amortizable over 15 years at $1 million per year. Therefore, the corporation’s annual limitation would be increased by $1 million each year for the first five years following the ownership change, resulting in a total annual limitation during that period of $1,318,000 (compared to $318,000) and annual tax savings of $276,780 (compared to $66,780). Consequently, the Section 338 Approach provides significant value by increasing the available NOL to offset future profits.

Proposed Section 382(h) Guidance

On September 9, 2019, the Treasury Department issued proposed regulations under Sec. 382(h), which would bring significant changes to existing guidance that taxpayers have relied upon for over a decade, and negatively impact the Sec. 382 computation for many corporations going forward. Under the proposed regulations, for changes of ownership after the regulations are finalized, the Section 338 Approach would no longer be available, generally leaving only gains recognized as RBIG to increase the annual limitation. Since few corporations dispose of assets such as goodwill following an ownership change, the proposed regulations could create significant economic disadvantages for those companies that are acquiring loss corporations and loss corporations undergoing creeping ownership changes. In addition, the proposed regulations would significantly expand the definition of RBILs, particularly with respect to deductions attributable to contingent liabilities, making Sec. 382 more onerous for NUBIL corporations.

Many commentators view the proposed changes as inappropriate as well as unfair with respect to transactions that may be in progress. Some are calling for transition rules for transactions under letter of intent (or similar) when the proposed regulations were released but will close and trigger ownership changes after the finalization. In response to taxpayer comments, Treasury recently issued a statement indicating a transition rule will be added to the proposed regulations but offered no specificity on what it will look like or how broadly it might apply to pending transactions.

The Takeaway

Any loss corporation that may be acquired, that is anticipating shifts in ownership, or has undertaken multiple rounds of equity financing could be negatively impacted if a change in ownership occurs after finalization of the proposed regulations. The resulting devaluation of NOLs could impact operating cash-flow, and diminish value paid by purchasers regarding these attributes. As a result, loss corporations raising equity capital or shifting ownership might consider accelerating transactions or other actions that would trigger an ownership change now, prior to the finalization of the proposed regulations. Buyers should be very wary of this change in the calculation of the Sec. 382 limitation and understand its impact on the value of the transaction.