United States

Proposed regulations would decrease acquisition value of tax losses

New unfavorable rules would apply to acquisitions after finalization

TAX ALERT  | 

Treasury and the IRS released Proposed Regulations under section 382 on Sept. 9, 2019 (the Proposed Regulations). The proposal would have a substantial negative impact on the value of many corporations that have tax attributes such as net operating loss carryforwards (NOLs). Corporations’ use of tax attributes after an ownership change generally is restricted under section 382. The Proposed Regulations would make those restrictions tighter. 

The proposal would not be effective until it is finalized. Once finalized, its effects on merger and acquisition decision making could include making asset purchases of corporate targets with significant tax attributes more attractive than stock purchases. It would become even more important in many situations to avoid ‘creeping’ ownership changes based on multiple minority ownership transactions if the proposal becomes effective.

Section 382, NUBIG, and NUBIL

When a corporation undergoes a section 382 ownership change, its use of NOLs and other tax attributes to offset taxable income is limited. In addition to NOLs, limited attributes may include carryforwards of tax credits and interest expense disallowed under section 163(j). Annual utilization of these attributes generally is limited to the value of the corporation on the date of the ownership change multiplied by the adjusted federal long-term tax-exempt rate. Computing the corporation’s annual section 382 limitation does not stop there. The annual use of NOLs (or other attributes) generally is augmented if the company is a net unrealized built-in gain (NUBIG) corporation or reduced if the company is a net unrealized built-in loss (NUBIL) corporation. 

The Proposed Regulations’ approach to NUBIG and NUBIL

Addressing computations under the NUBIG and NUBIL rules, the Proposed Regulations would eliminate a long-standing safe-harbor approach set out by the IRS in Notice 2003-65, the ‘section 338 approach’. Many taxpayers have benefitted from applying the popular section 338 approach. The current proposal, however, would have the alternative safe harbor method in Notice 2003-65, the ‘section 1374 approach’ elevated to become the only permitted approach (as modified under the Proposed Regulations).   

The NUBIG and NUBIL computations under the Proposed Regulations generally would be based on the gain or loss realized in hypothetical disposition of all of the loss corporation’s assets (without liability assumption) immediately before the ownership change and would be adjusted for various items such as section 481 adjustments relating to accounting method changes, potentially deductible contingent liabilities and under-secured nonrecourse liabilities.  

Whether and to what extent a corporation’s cancellation of debt (COD) income should be treated as increasing NUBIG has been an open question for many years, although the IRS has previously provided at least one favorable nonprecedential ruling. The Proposed Regulations would provide a clear and less favorable answer to this question – COD income excluded under section 108 generally would not increase NUBIG, which COD income that is not excluded generally would increase NUBIG. 

The Proposed Regulations’ approach to RBIG and RBIL

One major advantage of the section 338 approach under Notice 2003-65 is the treatment of certain built-in gain amounts as recognized built-in gain (RBIG) without any realization of gain through a sale of assets. RBIG can free up additional NOLs (or other attributes) for utilization to offset taxable income by increasing the section 382 limitation. The section 338 approach applies RBIG treatment to some depreciation and amortization of appreciated assets, effectively treating specified portions of the depreciation and amortization as dispositions of those assets for purposes of the RBIG computation. 

The Proposed Regulations diverge from this prior approach; they generally would require a corporation to sell (or otherwise dispose of) its built-in gain assets to attain a similar RBIG benefit and increase its use of NOLs (or other attributes.  

Effective Date

The Proposed Regulations would be effective for section 382 ownership changes occurring after the date they are finalized. Corporations can still apply Notice 2003-65, including its favorable section 338 approach, until the Proposed Regulations are finalized. Taxpayers may elect to apply the Proposed Regulations early if they wish, so long as they consistently apply the proposed rules to all ownership that occur prior to the regulations being adopted as final. 

Conclusion

Treasury and the IRS have proposed a significant taxpayer-unfavorable shift from prior settled law under section 382. Notice 2003-65’s section 338 approach would be eliminated, and a modified form of its section 1374 approach required, as discussed above. As a result, the Proposed Regulations would have a substantial negative impact on the value of many corporations that have carryforwards of NOLs or other tax attributes. Corporations that rely on start-up funding to reach profitability, such as many pharmaceutical and technology companies, may find the value of their stock depressed since the ability to use NOLs generated during product development will often be more harshly limited. Taxpayers that may be subject to a section 382 limitation should discuss section 382 and the Proposed Regulations with their tax advisors. 

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