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.