Proposed regulations, if adopted, would impose substantial restrictions in many cases on a corporation's use of existing net operating losses and similar tax attributes after a substantial change in ownership.
On September 9, 2019, the Treasury Department and Internal Revenue Service ("IRS") issued proposed regulations that may significantly limit a corporation's use of its net operating losses and similar tax attributes (collectively, "NOLs") following a substantial change in ownership. Coupled with additional limits on NOL usage adopted in the 2017 Tax Cuts and Jobs Act, the proposed regulations would withdraw favorable guidance taxpayers have relied upon since 2003 and dramatically reduce the value of NOLs in many cases. These rules are critically important in the distressed, M&A (including private equity), and start-up contexts.
Very generally, if a corporation experiences a more than 50% change in ownership over a rolling three-year period, section 382 of the Internal Revenue Code imposes an annual limit on the corporation's ability to offset future income with existing NOLs. This limit is tied to equity value and interest rates and therefore may be extremely low, particularly for a distressed company whose NOLs are often among its most valuable assets. Significantly, to the extent a corporation recognizes "built-in" gain within five years after an ownership change (realized gain), the corporation increases its annual limit up to its overall net unrealized gain on the ownership change date.
IRS Notice 2003-65 helpfully permits a corporation to determine realized gain by comparing (i) the deemed depreciation/amortization that would result from a hypothetical sale of the corporation's assets to (ii) the corporation's actual (and often lower) depreciation/amortization. The difference between the above amounts represents realized gain even though no assets are sold.
The proposed regulations would significantly change the determination of overall net unrealized gain and realized gain. They would eliminate taxpayers' ability to increase realized gain without actual dispositions of assets. The required calculations would significantly limit consideration of many liabilities in measuring asset value, reducing the amount (or existence) of overall net unrealized gain, a particularly meaningful change for distressed companies. Finally, the proposed regulations would make various technical (and generally taxpayer-unfavorable) changes, including as to the treatment of contingent liabilities and debt cancellation income for these purposes.
These rules would disproportionately impact start-ups with substantial development-stage losses that experience an ownership change upon attracting crucial venture capital investment. They may also incentivize some U.S. companies to sell their IP "offshore" to affiliates in order to trigger the realized gain in those assets.
The comment deadline is November 12, 2019. The proposed regulations generally are not effective until finalized.