Life science and technology would be amongst hardest hit
On Sept. 9, 2019, the Treasury Department (Treasury) and the Internal Revenue Service (IRS) released proposed regulations that, if finalized, will significantly limit the ability of many companies to utilize Net operating losses (NOLs) following an ownership change. The proposed regulations would reverse 15-year-old guidance and severely limit the utilization of NOLs and other carryovers, such as section 163(j) interest carryovers and research credits, following many Merger and Acquisitions (M&A) transactions and other ownership changes. (For the remainder of this article, the term NOL encompasses all attributes subject to limitation.) The changes would likely have a negative impact on M&A activity, as an acquirer will find it much more difficult to utilize NOLs to offset built-in gains of the target. If finalized without change, these regulations could have a greater impact on life science (biotech and pharmaceutical) and technology companies than the impact caused by the interest deferral provisions of section 163(j), enacted as part of the 2017 Tax Cuts and Jobs Act (TCJA). Moreover, these regulations, if finalized without change, will make the U.S. a less competitive country in which to do business for those companies in the affected industries.
Background: Section 382 and Built-In Gains
Section 382 generally imposes a limitation on the use of NOLs after a Company undergoes an ownership change. An ownership change under section 382 occurs when the stock ownership of one or more 5% shareholders increases by more than 50% over its lowest point during the prior three years. As a result, an ownership change may occur not only when a Company undergoes an acquisition, but also as a result of ongoing capital raises or trading on the open market. Section 382 was enacted to prevent loss trafficking by corporations with NOLs.
Once an ownership change occurs, the Company’s net operating losses and other tax attributes are subject to a limitation that is generally calculated by multiplying the Company’s equity value by the contemporaneous IRS published long-term tax-exempt interest rate (LTTR). Once the Company calculates its base limitation, it then must determine if it is in a built-in gain position (i.e., the fair market value of the Company’s assets exceed its tax basis) or a built-in loss position (the reverse). If a Company is in a built-in gain position, its annual base limitation is increased in the first five-years after the ownership change to the extent that built-in gain is recognized.
Companies in the life science and technology arena are often in a built-in gain position, as most of their value is derived from self-created intangibles with no tax basis. In 2003, the IRS issued Notice 2003-65, 2003-2 C.B. 747, which provides taxpayers with two safe harbors to calculate the recognition of built-in gain, one of which, the “section 338 approach” is favorable to built-in gain companies. This approach takes the logical position that built-in gains of assets, such as goodwill and other intangibles, will generate earnings post ownership change as the asset value is recognized i.e. wasting assets.
For the past 15 years, life science, technology, and many other companies have been able to take advantage of this section 338 approach to increase the utilization of NOLs that would have otherwise expired or been drastically reduced in value due to a lengthy time period prior to utilization.
The proposed regulations make a 180 degree turn and would withdraw and obsolete Notice 2003-65. In so doing, the IRS would completely eliminate the section 338 approach. Without the benefit of this safe harbor and absent complex transaction structuring, acquirers will inherit the income tax liability of the target's built-in gains and be unable to offset these gains by the target’s prior losses.
This change would hit life sciences and technology companies hard as these industries are generally active raising capital and are active in M&A, both areas that often trigger ownership changes. In these situations, a Company’s NOLs are not attributes being trafficked— they rather represent the value of the research, development, and experimentation activities performed by the Company, and they undoubtedly correlate to the future income generated by the Company. Without the ability to use these NOLs, acquirers may attempt to negotiate lower prices to offset the future tax hike, which could depress M&A activity.
Another concerning possible side effect of the proposed rules would be an increase of highly structured transactions attempting to alleviate the impact of the new rules by either attempting to avoid a change through the use of complex equity and debt securities, or complex sale and leaseback transactions prior to a corporate transaction in order to retain the ability to utilize the corporation’s NOLs. Such transactions would generally not be economic based decisions but rather a reaction to these regulations. These unintended consequences are something the Treasury and the IRS should consider prior to finalizing the rules, not to mention more scrutiny from both the IRS and from financial statement auditors on such transactions.
So how would the proposed rules work?
Assume that the target (T) has incurred $500 million in NOLs in the development stage through various rounds of financing. T believes it needs to raise additional capital of $50 million to reach profitability. However, the capital raise will trigger an ownership change under section 382. T currently has $300 million in debt and almost no hard assets, and the parties believe T has a pre-money equity value of $700 million. Assume that the LTTR for the month of the transaction is 2%.
Under existing guidance, T would have a base annual limitation of $14 million ($700 million equity value x 2%) plus recognized built-in gain under the section 338 approach of approximately $66 million annually, for a total annual limitation of $80 million. In total, $400 million ($80 million x 5 years) of the $500 million NOLs will be available during the five-year period following the change, with the remainder becoming available by the end of the next seven years.
Under the proposed rules, barring actual sales of built-in gain assets, in the five years following the transaction, T is limited to $14 million annually and a total of $70 million of NOL utilization. The remaining NOLs would become available at the rate of $14 million per year, and will ultimately only become fully available after 35 years (if they haven’t already expired).
As this example shows, these regulations would represent a significant tax increase to T following the transaction. For many life science and technology companies the proposed rules will negate the benefit of the reduced corporate tax rate enacted in the TCJA, which was, in part, enacted in an attempt to make US companies more competitive globally. These proposed rules would hurt innovation and research and development in the U.S. and would create a disincentive to invest domestically.
When do these rules become effective?
One bit of good news is that these rules are only proposed. There is a comment period during which it is likely that many life science and technology companies and their advisors will raise the aforementioned concerns. Note also that because the regulations would not be effective until finalized, Notice 2003-65 and the beneficial section 338 approach will remain in place until final regulations are issued. As the rules surrounding section 382 are complex, taxpayers facing the above issues should consult with their tax advisors.