On September 9, 2019, the Treasury Department (“Treasury”) and the Internal Revenue Service (the IRS) issued proposed section 382 regulations (REG-125710-18) (the “Proposed Regulations”) reversing certain previously taxpayer-favorable positions regarding the treatment of built-in gains and built-in losses for purposes of section 382(h). Despite being taxpayer adverse in certain respects, the Proposed Regulations address many previously unanswered questions regarding the treatment of built-in gains and built-in losses under section 382(h) and also address a number of issues related to section 382 that were raised by the Tax Cuts and Jobs Act (the TCJA).[1]

As described in more detail below, the Proposed Regulations, if finalized, would result in the withdrawal of Notice 2003-65 (the “Notice”) and eliminate the section 338 approach set forth in the Notice (the “Section 338 Approach”). This change would significantly reduce the ability of many taxpayers to utilize net operating losses (NOLs) following a section 382 ownership change, particularly in acquisitions of loss corporations with significant intellectual property or other assets with a fair market value in excess of tax basis as of the date of the ownership change date. In addition, the Proposed Regulations address certain issues raised by cancellation of debt (COD) income in adjusting a loss corporation’s section 382 limitation and the interaction of section 382 with various TCJA Code provisions, including section 163(j).

The Proposed Regulations are proposed to be effective for ownership changes occurring after the date that the Proposed Regulations are published as final Treasury regulations. Therefore, loss corporations may continue to apply the Notice and the Section 338 Approach to ownership changes occurring prior to the date that the Proposed Regulations are finalized.

The discussion below provides a high-level overview of section 382, summarizes the key provisions set forth in the Proposed Regulations and concludes by providing insights into the potential impact of the Proposed Regulations on mergers and acquisition transactions and restructurings of financially troubled companies.

Overview of Section 382

Section 382 limits the ability of a loss corporation to utilize NOL carryforwards and certain other tax attributes following an “ownership change.” A “loss corporation” is a corporation that is entitled to use a NOL carryforward, capital loss carryforward, carryforward of disallowed interest expense under section 163(j), has a net unrealized built-in loss or certain other attributes that can reduce taxable income. Section 382(a) generally limits the amount of pre-change losses of the loss corporation that can be used to offset its post-change income by an amount equal to the product of (i) the aggregate fair market value of the loss corporation’s outstanding stock immediately before the ownership change and (ii) the published long-term tax-exempt rate (the “base limitation”), which is increased or decreased, as the case may be, in the manner set forth in the immediately succeeding paragraph.

Section 382(h) provides that, if a loss corporation has a net unrealized built-in gain (NUBIG) at the time of the ownership change, such loss corporation’s base limitation is increased by any recognized built-in gain (RBIG) of the loss corporation during the five-year recognition period beginning on the date of the ownership change (the “Recognition Period”). The amount by which the loss corporation’s base limitation may be increased by RBIGs taken into account by the loss corporation during the Recognition Period cannot exceed the loss corporation’s NUBIG on the date of the ownership change. In addition, if the loss corporation has a net unrealized built-in loss (NUBIL) at the time of the ownership change, any recognized built-in loss (RBIL) of the loss corporation during the Recognition Period is treated in the same manner as pre-change losses (i.e., such losses are available to offset post-change income subject to the loss corporation’s section 382 limitation). The aggregate amount RBILs that are treated as pre-change losses may not exceed the loss corporation’s NUBIL on the date of the ownership change.

The Notice allowed taxpayers to elect either of two approaches for determining a loss corporation’s NUBIG/NUBIL and adjusting the loss corporation’s base limitation for RBIGs and RBILs. Under the Section 338 Approach, a loss corporation identified and measured its NUBIG/NUBIL and RBIG/RBIL by comparing its actual items of income, gain, loss and deduction against those items that would have arisen had the loss corporation sold its assets to a third party that assumed all of the loss corporation’s liabilities on the ownership change date. Under this approach, the loss corporation was generally able to increase its section 382 limitation by the hypothetical depreciation and amortization deductions resulting from the step-up in tax basis that arose in connection with the hypothetical sale that exceeded the actual depreciation and amortization deductions allowable to the loss corporation with respect to its assets (regardless of whether the loss corporation sold its assets during the Recognition Period). Under the section 1374 approach, a loss corporation identified and measured its NUBIG/NUBIL and RBIG/RBIL based on the principles for calculating net recognized built-in gain for the conversion of a C corporation to an S corporation under section 1374 (the “Section 1374 Approach”). In general, the Section 1374 Approach relied on the accrual method of accounting and only permitted a taxpayer to increase its section 382 limitation on account of an RBIG arising from an asset with a built-in gain on the date of the ownership change where the loss corporation actually disposed of such asset during the Recognition Period.

Generally, the Section 338 Approach was viewed as more favorable for taxpayers that were in a NUBIG position on the date of the ownership change because it allowed for the depreciable or amortizable assets with a built-in gain on the date of the ownership change to generate RBIG in an amount equal to the excess, if any, of (i) the hypothetical depreciation or amortization deductions that would have been available to the loss corporation over the Recognition Period had an election under section 338 been made with respect to a hypothetical purchase of the stock of the loss corporation over (ii) the actual depreciation and amortization deductions allowable to the loss corporation during the recognition period. In addition, the Section 338 Approach was more favorable in its treatment of built-in COD income. The Section 1374 Approach was viewed as more favorable to loss corporations that had a NUBIL on the date of the ownership change because such approach did not treat deductions arising from the payment of contingent liabilities as RBIL items.

Overview of Proposed Regulations

As discussed below in more detail, the Proposed Regulations eliminate the Section 338 Approach and adopt the Section 1374 Approach with a number of modifications.

Changes to Measurement of NUBIG/NUBIL

In adopting a modified version of the Section 1374 Approach, the Proposed Regulations significantly change how a loss corporation’s NUBIG/NUBIL is calculated. This could result in more loss corporations having a NUBIL on the date of an ownership change due to the changes to the treatment of recourse liabilities and COD income in the calculation of the loss corporation’s NUBIG/NUBIL.

Under the Proposed Regulations, a loss corporation’s NUBIG/NUBIL is computed pursuant to a two-step process. In the first step, the loss corporation is treated as surrendering assets to creditors holding undersecured non-recourse liabilities for no consideration other than the relief of liabilities. In the second step, the loss corporation is treated as selling all remaining assets (other than cash and cash-equivalents described in 382(h)(3)(B)(ii)) to an unrelated party, with such unrelated party not assuming any of the recourse liabilities of the seller. For an insolvent loss corporation, the Proposed Regulations result in the loss corporation having a lower amount realized from the hypothetical sale and decreasing the loss corporation’s NUBIG (or potentially moving the loss corporation from a NUBIG to NUBIL position) because the unrelated purchaser is not be treated as assuming the recourse liabilities of the loss corporation.

The amount realized from the two hypothetical transactions is then (i) decreased by the fixed and contingent[2] deductible liabilities of the loss corporation, (ii) decreased by the loss corporation’s tax basis in its assets, (iii) increased or decreased, as the case may be, by the amount of RBIG or RBIL that can be recognized by the loss corporation during the Recognition Period (excluding certain items of COD income and gains from the disposition of property) and (iv) increased or decreased, as the case may be, by any positive or negative section 481 adjustments that would be required to be included in connection with the hypothetical asset sale.

The Proposed Regulations provide that COD income is generally not included in the loss corporation’s NUBIG/NUBIL calculation and, as a result, is not treated as RBIG/RBIL. However, a loss corporation has the option to treat COD income as a RBIG item that increases its NUBIG/NUBIL where: (i) the COD income is recognized by the loss corporation within the first 12 months of the Recognition Period and (ii) either (A) the COD income is not excluded from the loss corporation’s gross income under section 108(a)(1) or (B) the COD income is excluded from the loss corporation’s gross income under section 108(a)(1), but the COD income results in a reduction to tax attributes of the loss corporation that are not pre-change losses (including the loss corporation’s tax basis in assets that it did not hold at the time of the ownership change). Furthermore, if the loss corporation recognizes excluded COD income during the first 12 months of the Recognition Period and such excluded COD income results in a decrease to the loss corporation’s tax basis in assets that it held at the time of the ownership change, the Proposed Regulations provide that such COD income is not an RBIG item. Instead, the amount of the tax basis reduction under section 1017 for such excluded COD income is taken into account in the loss corporation’s tax basis in its assets for purposes of the NUBIG/NUBIL calculation.[3] The Proposed Regulations also place limitations on the amount of post-ownership change COD income that can be treated as a RBIG item. The limitation differs depending on whether the indebtedness is non-recourse or recourse. In addition, in the case of recourse indebtedness, the limitation is different where the loss corporation is under the jurisdiction of a bankruptcy court under title 11 of the United States Code on the date of the ownership change.

Changes to Identification and Measurement of RBIG/RBIL

As noted above, the Proposed Regulations eliminate the Section 338 Approach. This prevents loss corporations from increasing the section 382 limitation on account of built-in gain assets that the loss corporation owns on the date of the ownership change where the asset is not disposed of by the loss corporation during the Recognition Period. This significantly reduces the value of NOLs of a loss corporation with significant intellectual property, goodwill or other intangible value.

The Proposed Regulations also adversely impact taxpayers that are in a NUBIL position. First, the Proposed Regulations treat deductions arising from the post-change payment of liabilities that were contingent at the time of the ownership change as RBIL items. This is a less taxpayer favorable treatment than that provided by the Section 1374 Approach, which did not treat payments of contingent liabilities as RBIL items. Second, the Proposed Regulations provide that deductions may be treated as RBILs where they may not be deducted by the loss corporation pre-ownership change because of limitations relating to taxable income or timing (not solely because the economic performance requirement was not satisfied, which was the case under the Section 1374 Approach). Finally, under the Section 1374 Approach, a bad debt deduction was only treated as a RBIL where the bad debt deduction arose in the first 12 months of the Recognition Period. Under the Proposed Regulations, all bad debt deductions that are recognized during the Recognition Period are treated as RBILs. On the other hand, COD income continues to be treated as a RBIG item only if it is recognized within the first 12 months of the Recognition Period.

Finally, the Proposed Regulations provide that certain items of income that are recognized by a loss corporation during the Recognition Period do not constitute RBIG items, including:

  • Dividends, including amounts treated as dividends under section 1248, received by the loss corporation with respect to stock held by the loss corporation as of the date of the ownership change (even if the stock had a built-in gain as of the date of the ownership that may be reduced or eliminated as a result of the payment of the dividend);
  • Inclusions of Subpart F income and global intangible low-taxed income (GILTI) arising with respect to stock held by a loss corporation under sections 951 and 951A, respectively; and
  • Any prepaid income that is received by the loss corporation prior to the ownership change and that is deferred until a post-change period under section 451(c) or section 455.

Interaction With Section 163(j) Provisions

Section 163(j), as modified by the TCJA, generally limits the amount of interest expense that a taxpayer may claim in a particular taxable year to an amount equal to the sum of (i) the taxpayer’s business interest income for such taxable year and (ii) 30% of the taxpayer’s adjusted taxable income for such taxable year. Section 163(j)(2) provides that disallowed interest expense may be carried forward to future taxable years (such carryovers, “Section 163(j) Carryovers”). Section 382(d)(3) treats Section 163(j) Carryovers as pre-change losses under rules similar to those contained in section 382(d)(1).

Because Section 163(j) Carryovers are generally treated as pre-change losses, the Proposed Regulations provide that interest expense arising from the utilization of Section 163(j) Carryovers during the Recognition Period will not give rise to a RBIL (in order to ensure that the same expense will not be limited twice under section 382—once as a pre-change loss and a second time as a RBIL item).

Furthermore, for purposes of determining a loss corporation’s NUBIG/NUBIL and RBIG/RBIL, the Proposed Regulations provide that a loss corporation’s tax basis in a partnership interest that is held by the loss corporation is increased by the Section 163(j) Carryovers that are attributable to such partnership interest.[4] This ensures that (i) interest expense arising during the Recognition Period from the utilization of such Section 163(j) Carryovers or (ii) a future loss from the sale of the partnership interest occurring within the Recognition Period, in each case, will be treated as RBIL.

Treasury and the IRS have solicited comments from practitioners as to whether interest expense that is suspended under section 704(d) should also be treated as RBIL.

Effective Date of Proposed Regulations

The Proposed Regulations are proposed to be effective for ownership changes occurring after the date that the Proposed Regulations are finalized. However, loss corporations may elect to apply the Proposed Regulations to ownership changes occurring prior to the date that the Proposed Regulations are published as final Treasury regulations. Loss corporations may continue to apply the Notice and the Section 338 Approach with respect to ownership changes occurring prior to the date that the Proposed Regulations are finalized.

Impact of Proposed Regulations

The Proposed Regulations, viewed together with the TCJA’s limitation on the utilization of post-2018 NOLs to 80% of a corporation’s taxable income, have significantly reduced the value of a loss corporation’s tax attribute carryforwards, which will impact how such carryforwards are viewed in the context of both mergers and acquisitions and restructurings.

In particular, the Section 338 Approach historically permitted many acquirers of loss corporations with built-in gain assets to use pre-change NOLs of a loss corporation far more quickly than they could have used such NOLs under section 382 or the Treasury regulations promulgated thereunder. However, in light of the Proposed Regulations’ elimination of the Section 338 Approach, buyers of loss corporations will need to carefully consider and model out the impact of section 382 and the Proposed Regulations on the loss corporation’s ability to utilize its tax attribute carryforwards post-acquisition. Furthermore, if a seller asks a buyer to pay up-front for a target’s tax attributes, the buyer will need to consider the impact of sections 382 and the Proposed Regulations when determining the value that it will ascribe to the target’s tax attributes. The Proposed Regulations, together with the limitation on the utilization of post-2018 NOL carryforwards, will also further incentivize buyers of loss corporations to attempt to acquire the assets of the loss corporation (or to make an election under section 338(h)(10) in connection with the acquisition of the stock of a loss corporation from a member of a consolidated tax group) in order to obtain additional depreciation and amortization deductions as a result of a tax basis step-up in the assets of the loss corporation in lieu of inheriting its section 382-limited NOL carryforwards.

Additionally, with respect to loss corporations that are under the jurisdiction of the court in a title 11 or similar case, the Proposed Regulations may, in certain situations, make it more attractive for a loss corporation to structure into, and elect into the application of, section 382(l)(5) (which generally provides that the section 382 limitation shall not apply to an ownership change if (i) immediately before the ownership change, the loss corporation is under the jurisdiction of the court in a title 11 or similar case and (ii) former shareholders and “qualified creditors” of the loss corporation own 50% or more of the loss corporation’s stock immediately after the ownership change as a result of being shareholders or creditors immediately before the ownership change).[5] In addition, the Proposed Regulations may, in certain situations, make the acquisition of a financially distressed loss corporation through a taxable asset transaction (i.e., a so-called Bruno’s transaction) more attractive. In these transactions, a buyer will forego the use of the loss corporation’s NOL carryforwards (which would otherwise be subject to limitation under section 382 and subject to reduction under section 108(b)) in order to generate depreciation and amortization deductions post-acquisition as a result of the tax basis step-up in the acquired assets.

Finally, the Proposed Regulations may impact whether a loss corporation will make an election to reduce its tax basis in its assets in order to create (or preserve) tax attributes, including (i) the election under section 108(b)(5) to reduce the tax basis of depreciable property by excluded COD income prior to reducing NOL carryforwards and (ii) the section 168(k) bonus depreciation election.