By Frank J. Vari, Practice Leader, FJV Tax Consulting, Boston, Massachusetts
Recently released US proposed IRC §382 regulations would dramatically reduce an acquiring corporation’s ability to use a target’s built-in losses, US net operating loss (NOL) carryforwards, and similar tax attributes following a substantial change in ownership.
Combined with new rules limiting NOL use adopted in the 2017 Tax Cuts and Jobs Act, the proposed regulations, issued September 9, would effectively withdraw favorable guidance taxpayers have relied upon since 2003, significantly reducing the value of acquired NOLs in many cases.
To those involved in the tax merger and acquisition (M&A) practice area, these rules are critically important in the start-up, venture capital, private equity, and distressed practice areas.
IRC §382 and tax losses
The IRC §382 rules are generally intended to prevent the trafficking of United States tax assets, namely target loss corporation NOLs, where the buyer wishes to use the target’s pre-existing NOLs against their own post-acquisition taxable income.
In today’s M&A marketplace, target NOLs, particularly for mid- to late-stage start-ups, often represent one of the target’s more valuable assets. Considerable tax planning efforts are made, often as early as the tax due diligence stage, to unlock these assets for post-transaction use.
IRC §382 and related authority in IRC §§383 and 384 significantly restrict the aforementioned use of a loss corporation’s NOLs and other tax attributes following a “change in ownership.”
A “change in ownership” is defined under highly technical and complicated rules to occur whenever any one or more five percent shareholders collectively increase their ownership of the corporation’s stock by more than 50 percentage points in any three-year period.
The loss corporation’s use of its NOLs to shelter post-change taxable income is generally limited each year to the value of its stock times the US federal long-term tax-exempt interest rate. Given that global interest rates are at almost all-time lows, the general rule of IRC §382 will often serve to materially limit the use of a loss corporation’s NOLs following a change/acquisition.
IRC §382(h) provides an exception to the general rule above for loss corporations with a significant net unrealized built-in-gain (NUBIG) or significant net unrealized built-in-loss (NUBIL) in their assets on the ownership change date. Where the loss corporation has a NUBIG, and it recognizes built-in-gain with respect to its assets on its change date in the five years after the ownership change, aka a “realized built-in gain” (RBIG), the IRC §382 limitation increases by the amount of the RBIG.
The rationale of the IRC §382(h) rule is to make the loss corporation neutral between selling its assets and recognizing gain before and after the ownership change. The planning key here is to maximize the RBIG, which unlocks the loss corporation’s pre-change NOLs for post-change use.
Notice 2003-65 and the RBIG calculation
IRS Notice 2003-65 has allowed taxpayers wishing to avoid the base IRC §382 limitation calculation to elect between two different approaches to calculating RBIG under Section 382(h).
First, under what is known as the IRC §1374 approach, the loss corporation calculates RBIG based on actual recognized gains and losses from the sale of assets during the recognition period, requiring a tracing approach.
Alternatively, under the IRC §338 methodology, the loss corporation calculates RBIG as equal to the difference between its actual taxable income during the recognition period, as compared to the taxable income it would have had if it had made an IRC §338 election.
Where the loss corporation holds appreciated property, very common in mid to late range start-ups and private equity targets, the IRC §338 approach is favorable in generating RBIG without an actual sale of the loss corporation’s assets.
Notice 2003-65 at work
Let’s examine a common loss corporation acquisition with some assumed facts. USB, a US corporation, purchases UST, also a US corporation, in a $100 million share purchase with no corresponding IRC §338 election.
UST has $10 million of basis in its tangible assets with no liabilities and $40 million of NOLs. The remaining $90 million of assets consist of self-created IRC §197 intangibles with no tax basis to UST.
Under the IRC §1374 approach, UST would only generate RBIG if it sold the self-created intangibles and actually recognized gain during the five-year recognition period. This is a highly unlikely scenario for either a strategic or financial buyer or a venture capital investor.
Without an actual asset sale, USB can only use the IRC §382 base loss limitation rule of the share price purchase multiplied by the federal long-term tax-exempt interest rate. Thus, USB faces a Cornelian dilemma between selling the crown jewels of the acquisition or using a formula featuring a return based on a minuscule interest rate to use the pre-change NOLs.
Using the IRC §338 approach permitted by Notice 2003-65, UST would be deemed to have additional RBIG in each of the five years of the recognition period equal to the additional depreciation and amortization it would have enjoyed if it had made an IRC §338 election. This is a very nice result as USB never has to address IRC §338 with the seller and gets to keep and exploit the self-created intangible assets that were likely the driver for the acquisition of UST in the first place.
If UST had actually made an IRC §338(g) election there would have been $90 million of amortizable basis in the self-created IRC §197 intangibles, which would have generated $6 million more per year of amortization deductions using the 15-year amortization rules. The IRC §338 approach would give rise to $6 million of RBIG for five years resulting in $30 million of total additional IRC §382 loss usage limitation. Not an insignificant tax result with little or no operational downside.
Proposed IRC §382(h) regulations & Notice 2003-65
The proposed IRC §382(h) regulations would effectively withdraw the Notice 2003-65 IRC §338 methodology prospectively and leave loss corporations with only the base IRC §382 and IRC §1374 methodologies to calculate RBIG, meaning a loss corporation would have to settle for the base limitation calculation or sell or otherwise dispose of its assets during the post-closing recognition period to generate RBIG.
In the example above, using the IRC §382 base limitation calculation, USB’s use of UST’s pre-change NOLs would be limited to approximately $2 million per annum (based on the $100 million share value multiplied by an assumed skimpy 2 percent tax-exempt rate). That forever locks up $20 million in economic tax losses as a result.
International tax impact
The proposed regulations also add a new international tax rule that’s not generating much buzz but which could significantly affect acquisitions involving controlled foreign corporations (CFCs). The new rule is proposed regulation §1.382-6(d)(2)(ii), which excludes IRC §951A Global Low Taxed Intangible Income (GILTI), Subpart F, and IRC §1248 deemed dividends from RBIG.
Under existing rules, if an acquired CFC sells its underlying assets and generates either GILTI or Subpart F income in the process, as is usually the case, one would reasonably conclude that RBIG would be generated in the same manner as if the CFC shares were sold. Unfortunately, this would not be the case under the aforementioned proposed rule as use of GILTI or Subpart F as RBIG would be precluded.
The new rule also excludes IRC §1248 gain from the sale of CFC stock held on the ownership change date from RBIG. Those practicing in this area realize that this effectively eliminates a tax planning position long supported by Private Letter Ruling 201051020. The logic seems to be that IRC §1248 deemed dividends are eligible for the IRC §245A dividends received deduction and treating them as RBIG is a mischaracterization. That makes sense except that the new rules also exclude IRC §1248 dividends from RBIG whether or not Section 245A applies.
One can easily see where these new rules will affect tax planning in the very common case where a buyer wishes to sell off an acquired CFCs appreciated assets following an ownership change. One could navigate the GILTI and Subpart F exclusions by simply selling the CFC shares. However, the often-resulting IRC §1248 gain would be excluded from RBIG as well.
Other issues
The proposed regulations have additional features affecting the scope of a corporation’s income subject to IRC §382.
Most notable are proposed rules addressing cancellation of debt (COD) income recognized after an ownership change, another common event. Other implications include disallowed interest expense deductions under the new IRC §163(j) rules and depreciation expensing under IRC §168(k) as well as the treatment of contingent liabilities in IRC §382 transactions.
Moving forward
The upshot here is that if one practices M&A tax or is modeling a transaction based on existing rules, these proposed regulations must be considered because they undoubtedly impact any IRC §382 analysis. Not only would the proposed regulations significantly change the determination of overall net unrealized gain and realized gain, they would also eliminate a buyer’s ability to increase realized gain without actual dispositions of assets.
These proposed rules disproportionately impact start-ups with substantial development-stage losses that experience an ownership change upon, amongst other triggering events, attracting vital venture capital investment.
This may also incentivize some US companies to sell their IP to non-US or offshore affiliates to trigger the realized gain in those assets, which is certainly not the goal of tax reform.
The comment deadline is November 12, 2019, and the proposed regulations generally are not effective until finalized. Practitioners are wise to understand and follow these regulations based on their potential to affect a range of US and international M&A transactions.
Frank J. Vari, B.Sci.Acc., JD, MTax, CPA, is a tax, finance, and legal professional with over 25 years of experience advising global businesses ranging from technology start-ups, large private equity investors, to Fortune 100 corporations. He provides unique and innovative solutions to complex international tax and business issues.
Frank has designed and implemented complex tax planning strategies for both U.S. based and international clients. Frank coordinated the worldwide tax, accounting, finance, and cash flow aspects of these transactions as well as the coordination of client finance, legal, and audit teams.
Frank has also been a Professor of Taxation to collegiate law and business students on international tax and corporate mergers and acquisitions. He is a frequent speaker and author on complex international tax topics and issues.
Frank is the Practice Leader at FJV Tax Consulting in Boston and Wellesley, Massachusetts. You can learn more about FJV Tax Consulting at fjvtax.com or contact Frank via email at [email protected] or telephone at 617-770-7266 / 800-685-2324.
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