On September 9, 2019, the Treasury Department (Treasury) and Internal Revenue Service (IRS) released proposed regulations under Section 382(h) of the Internal Revenue Code (the Code), which, if finalized in their current form, would significantly limit the ability of a corporation to utilize its net operating loss carryforwards (NOLs) and certain other tax attributes following an ownership change. Specifically, the proposed regulations would withdraw a favorable safe harbor that taxpayers have relied upon for the past 16 years, mandate a more restrictive method in computing the annual limitation imposed by Section 382, and make a number of technical updates in light of the 2017 Tax Cuts and Jobs Act (TCJA) with generally unfavorable results to taxpayers. The proposed regulations have a 60-day comment period ending November 12, 2019.
On September 9, 2019, the Treasury Department (Treasury) and Internal Revenue Service (IRS) released proposed regulations under Section 382(h) of the Internal Revenue Code (the Code), which, if finalized in their current form, would significantly limit the ability of a corporation to utilize its net operating loss carryforwards (NOLs) and certain other tax attributes following an ownership change. Specifically, the proposed regulations would withdraw a favorable safe harbor that taxpayers have relied upon for the past 16 years, mandate a more restrictive method in computing the annual limitation imposed by Section 382, and make a number of technical updates in light of the 2017 Tax Cuts and Jobs Act (TCJA) with generally unfavorable results to taxpayers. The proposed regulations have a 60-day comment period ending November 12, 2019.These rules are critical to parties to M&A transactions and restructurings, particularly in distressed and start-up contexts. Parties considering potential transactions involving corporations with significant NOLs or insolvent corporations undergoing bankruptcy proceedings or other restructuring transactions should carefully consider the implications of these proposed rules and model out their potential impact if the proposed regulations are finalized in their current form.
Section 382 limits the ability of a corporation with NOLs and certain other tax attributes (a loss corporation) to utilize its NOLs and other tax attributes in taxable periods following an “ownership change” (generally, a greater than 50 percent shift in ownership by certain shareholders during a rolling three-year period). The annual limitation imposed by Section 382 (the Section 382 limitation) generally equals (x) the equity value of the loss corporation immediately before the ownership change multiplied by (y) the applicable long-term tax-exempt rate published by the IRS (which, in recent years, has been around 2 percent).
Under the “neutrality principle” underlying the statute, any pre-change built-in gains and losses in the assets owned by the loss corporation that are recognized after the ownership change should generally be treated in the same manner as if they had been recognized before the ownership change. Accordingly, if a loss corporation had a net unrealized built-in gain (NUBIG) in its assets immediately before the ownership change, the Section 382 limitation is increased to the extent of the associated built-in gain recognized (RBIG) during the five-year period following the ownership change (the recognition period). Conversely, for a corporation with a “net unrealized built-in loss” (NUBIL) immediately before the ownership change, the Section 382 limitation is decreased to the extent of the associated built-in loss recognized (RBIL) during the recognition period. Generally, a corporation has a NUBIG or a NUBIL if the aggregate fair market value of its assets immediately before the ownership change is more or less, respectively, than the aggregate tax basis of such assets at that time.
To provide interim guidance regarding the calculation of NUBIG and NUBIL and identifying built-in gain and loss items, the IRS published Notice 2003-65 in September 2003, which provides taxpayers with two safe harbors: the “338 approach” and the “1374 approach.”
- Both approaches determine NUBIG and NUBIL based on a hypothetical sale of the assets of the loss corporation to a third party that assumes all of the loss corporation’s liabilities (including the estimated value of contingent liabilities). NUBIG or NUBIL is the net amount of gain or loss that would be recognized by the loss corporation in the hypothetical sale.
- The two approaches differ materially, however, in the determination of RBIG and RBIL.
The 338 approach identifies RBIG or RBIL by comparing (i) the loss corporation’s actual items of income, gain, deduction, and loss during the recognition period with (ii) the items of income, gain, deduction, and loss that would result if there had been a hypothetical sale of all of the loss corporation’s assets on the date of the ownership change (the change date) pursuant to a Section 338 election made for a purchase of the loss corporation’s stock. Effectively, the 338 approach allows built-in gain assets for which depreciation, amortization, or depletion deductions can be taken (wasting assets) to generate RBIG without an actual realization event – even if the loss corporation has no actual gross income in the particular year. Under the 338 approach, cancellation of debt (COD) income that is included in gross income and that is attributable to any pre-change debt of the loss corporation is RBIG in an amount not exceeding the excess, if any, of the adjusted issue price of the discharged debt over the fair market value of the debt on the change date.
In contrast, the 1374 approach, which is based on the rules of Section 1374 of the Code and the regulations thereunder, computes RBIG and RBIL only upon an actual disposition of assets during the recognition period and generally follows the accrual method of accounting to identify other income and deduction items as RBIG or RBIL. The 1374 approach generally treats any COD income or bad debt deduction attributable to any pre-change debt as RBIG or RBIL only if such income or deduction item is properly taken into account during the first 12 months of the recognition period.
Relying on the safe-harbor approaches provided by Notice 2003-65, taxpayers with a NUBIG and appreciated intangibles (including goodwill) would typically benefit from the 338 approach because a greater amount of income may be counted as RBIG, particularly with respect to wasting assets with built-in gains that are unlikely to be sold by the loss corporation; on the other hand, taxpayers with a NUBIL would tend to benefit from the 1374 approach due to its narrow definition of RBIL.
The proposed regulations
In Notice 2003-65, the IRS had indicated that it intended to publish proposed regulations “in the near future” to provide a single set of rules for identifying built-in items for the purposes of determining RBIG and RBIL. The proposed regulations released on September 9, 2019 finally address this.
Specifically, the proposed regulations would eliminate the 338 approach and mandate a modified and more restrictive 1374 approach to calculate NUBIG, NUBIL, RBIG, and RBIL. Under the proposed regulations, taxpayers would no longer be able to toggle between the two safe harbors to choose the more favorable one. In addition, the proposed regulations would make modifications to the 1374 approach, generally resulting in a reduced amount (or existence) of NUBIG and RBIG, and an increased amount of RBIL.
- Elimination of the 338 approach. Notably, as a result of the elimination of the 338 approach, the favorable RBIG calculation related to income from wasting assets would be eliminated, which could dramatically reduce a loss corporation’s ability to utilize its pre-change tax attributes after an ownership change. These changes are particularly adverse to start-ups, which often have substantial NOLs and large NUBIGs in their assets, often with significant value and zero basis in self-developed intangible assets. Under Notice 2003-65, these loss corporations are often able to rely on the 338 approach to materially increase their section 382 limitations by RBIGs and mitigate the practical impact of Section 382 after an ownership change. Loss corporations emerging from bankruptcy would also be adversely affected due to the loss of tax savings provided by the 338 approach.
- Calculation of NUBIG and NUBIL. The modified 1374 approach under the proposed regulations would significantly alter the determination of the NUBIG and NUBIL. Specifically, under the proposed regulations, the deemed buyer of a loss corporation’s assets in the hypothetical sale would not assume any liabilities of the loss corporation. Any recourse liabilities, contingent liabilities, and other deductible liabilities of the loss corporation are therefore excluded from the amount realized in the hypothetical sale, resulting in a much lower amount realized, and hence, an increased likelihood of NUBIL and decreased likelihood of NUBIG. These changes are significant for insolvent taxpayers, which often have greater liabilities than the gross value of their assets. Eliminating the ability to include liabilities in the amount realized from the hypothetical sale of assets would reduce the amount (or existence) of a NUBIG for distressed corporations.
- Other Changes. The proposed regulations include technical revisions and updates to eliminate certain “double benefits” permitted under Notice 2003-65 and ensure greater consistency between amounts that are included in NUBIG/NUBIL computation and items that could become RBIG or RBIL during the recognition period, taking into consideration the tax law changes made by the TCJA. For example, with limited exceptions, the proposed regulations would not allow the liabilities giving rise to COD income to be included in the calculation of NUBIG and NUBIL, and would clarify that COD income that is excluded from a taxpayer’s gross income under the insolvency exception would not generate RBIG. The proposed regulations would further modify the 1374 approach to include any deductible contingent liabilities paid or accrued during the recognition period in RBIL to the extent of the estimated value of those liabilities on the change date – a departure from the general principle that the 1374 approach usually follows the accrual method of accounting. In addition, under the proposed regulations, dividends (including gains taxable as dividends under Section 1248) and global intangible low-taxed income recognized by the loss corporation during the recognition period would not constitute RBIG. The proposed regulations also provide that carryovers of business interest that are disallowed under the new Section 163(j) (as amended by the TCJA) during the Recognition period would not give rise to RBIL, thus preventing double counting of these carryovers for Section 382 purposes.
The rules contained in the proposed regulations will not be effective for ownership changes that occur before final regulations are published in the Federal Register. Thus, loss corporations that undergo ownership changes before the rules are finalized can continue to rely on Notice 2003-65 and utilize the 338 approach even if final regulations are issued sometime during the recognition period.
If the proposed regulations are finalized in their current form, however, the ability of many loss corporations to utilize their tax attributes after an ownership change would be limited significantly, adversely impacting their after-tax cash flow and valuation. The proposed regulations do not provide a “grandfathering” for ownership changes that are contemplated or planned before, but completed after, the publication of final regulations, even for transactions subject to binding contracts or bankruptcy proceedings that existed before the proposed regulations were issued. It is not clear whether Treasury and the IRS will provide relief for these circumstances. Therefore, to protect their valuation projections, parties considering M&A transactions involving loss corporations may be incentivized to accelerate their transactions before these rules are finalized.
Even before the regulations are finalized, a private equity buyer considering an acquisition of a loss corporation with a view toward a future disposition of the loss corporation should carefully evaluate and model out the potential impact of the proposed rules on the valuation of the loss corporation’s tax attributes (including other typical deal value drivers such as transaction tax deductions) because a future buyer of the corporation will likely offer a much lower value for the tax assets of the loss corporation if these proposed regulations are finalized in their current form.
Loss corporations and distressed companies may also be incentivized to undertake strategies to mitigate the potential adverse impact of these proposed rules, for example, through avoiding ownership changes, structuring asset dispositions to trigger gains prior to an ownership change, or electing out of the bonus depreciation to defer tax deductions that generate additional losses.