Changes to the formula for determining the long-term tax-exempt rate used in a section 382 limitation calculation after a company undergoes an ownership change may lower the amount of net operating losses the company can use in the future.
Section 382 generally requires a corporation to limit the amount of its income in future years that can be offset by historic net operating losses (NOLs) once that corporation has undergone an "ownership change."1 The amount of the loss that can be used after an ownership change is generally limited to the value of the corporation immediately before the ownership change, multiplied by the "long-term tax-exempt rate" (LTTER). Under regulations that will be applicable to defining the LTTER as of August 2016 (for September 2016), the methodology for calculating the LTTER is changing, and it may well result in a lower LTTER, producing a lower section 382 limitation than under the current rules.
The intent of applying an LTTER to the net asset value under section 382 was to give a company a return that would be equivalent to the return if the company invested an amount equal to its net assets in general obligation tax-exempt bonds with a maturity of more than one year. Thus, the LTTER starts with the long-term applicable federal rate that is used to determine the imputed principal amount of obligations that are issued for property at a discount (section 1274(d)), and is adjusted to an amount similar to the yield that is generally being earned on tax-exempt bonds. As a result, the LTTER should generally be lower than the long-term applicable federal rate. Under current law, because of the low Treasury rate, at times, the LTTER has been in excess of the long-term applicable federal rate, which was not the intent.
Each month, the Internal Revenue Service publishes the long-term applicable federal rate, and, based on that, it computes and publishes the LTTER for the next month. The first month for which it will use the new rules of Treasury Regulations section 1.382-12 to compute the LTTER is August 2016, for the rate that will apply in September 2016. Thus, for a change of control in September 2016, a company would compare the LTTER for September (computed under the new rules) and August and July (both of which would be computed under the current rules), and the highest rate would be the applicable LTTER for the section 382 limitation resulting from that September 2016 ownership change.
Under Treasury Regulations section 1.382-12, which was finalized on April 25, 2016, the tax rate in the adjustment factor is the sum of the maximum individual rate under section 1 and the maximum individual rate under section 1411 for the month to which the rate applies. The fixed percentage is the amount by which that combined tax rate must be multiplied to reflect the historical relationship between the maximum tax rate and the spread between yields of taxable and tax-exempt obligations. The fixed percentage in the adjustment factor is 59 percent, because the yield on tax-exempt obligations from February 1986 to July 2007 was lower than that of comparable taxable obligations by, on average, 59 percent of the maximum individual rate in effect under section 1.
Under current rates, the adjustment factor would be 74.39 percent. This is calculated by subtracting 25.61 percent — the product of 43.4 percent, the sum of the current maximum individual rate under section 1 (39.6 percent) and the current maximum individual rate under section 1411 (3.8 percent), and 59 percent — from 100 percent. For example, if an applicable federal rate (AFR) for a given month were 5 percent, under current tax rates, the corresponding adjusted AFR would be 3.72 percent — the product of 74.39 percent and 5 percent.
These regulations apply to determine the adjusted LTTERs beginning with the rates determined during August 2016, which apply during September 2016.
The new formula for determining the LTTER used in a section 382 limitation calculation may have a dramatic effect on the amount of NOLs a loss corporation will be able to use in the future after undergoing an ownership change because the new LTTER rate will likely be lower after applying the multiplier. With a current LTTER rate of approximately 2.27 percent, the amount of NOLs that a loss corporation can utilize in future years is already very low. For example, if a loss corporation with a section 382 adjusted equity value of $10 million underwent an ownership change in May 2016, the section 382 limitation would be $227,000 ($10 million x .0227). If the rate is lowered under the new regulations, the NOLs a loss corporation can use in post-ownership change years will be reduced correspondingly. Loss corporations should thus pay extra close attention to monitoring their ownership shifts once the LTTER is adjusted because of the issuance of these final regulations.