Limitations on the Utilization of Net Operating Losses

Congress has long been concerned about the ability of companies to offset profits by purchasing low-value corporations with net operating loss (“NOL”) carryforwards (“C/F”).  Congress initially enacted rules under Section 382 to combat this perceived abuse over 50 years ago.

The current NOL C/F limitation rules under Section 382 were enacted in 1986 to deter "trafficking" in corporations with NOL C/F's (“LossCo”).  The rules focus on stock "ownership changes" in a LossCo and limit the annual amount of a LossCo's NOL C/F and Built-In Losses (“BIL”) that can be used against the purchaser's profits after an ownership change occurs.  Note that the limitations still apply even if the NOL's are not used against the purchaser's profits.  NOL's are eligible for a 20 year C/F period.

Ownership Change
An ownership change occurs if the stock ownership of one or more shareholders who own at least 5% of LossCo increases by more than 50 percentage points over a 3 year period.   An ownership change includes stock purchases as well as corporate reorganizations (such as mergers). 

An ownership change occurs on January 1, 2008 if a corporation that previously was not a shareholder purchases the following stock of a LossCo:

(1)     20% on January 1, 2006,
(2)     20% on January 1, 2007, and
(3)     11% on January 1, 2008.

NOL C/F Limitation
When there is an ownership change the total amount of the LossCo NOL C/F generally is not formally reduced or eliminated; however, as the example below illustrates, the company may run out of time to fully utilize the NOL.  The rules operate to limit the amount of the LossCo NOL C/F that can be used annually by the purchaser, based on a mechanical calculation:

(1)     The fair market value (FMV) of the LossCo is multiplied by
(2)     A specified interest rate (the long term tax exempt rate under IRC § 1274).

As a result, the rules reduce the availability of NOL C/F's as the value of a LossCo decreases, and large NOLs typically indicate a lower value.

Assume that a LossCo with a $200 million NOL C/F is purchased for $40 million, and the applicable interest rate is 4%. 

(1)      The annual amount of the NOL C/F that can be utilized by the purchaser is $1,600,000 ($40 million FMV x 4%). 
(2)      Only $32 million of the NOL C/F will be available over a 20 year C/F period to offset the purchaser's profits ($1,600,000 x 20). 
(3)      The remaining $168 million portion of the NOL C/F can never be used, and as a result, is essentially worthless.

Built-In Loss Limitation
A BIL is a loss or an expense that:

(1)     Economically accrued before the ownership change, and
(2)     Is recognized within 5 years after the date of the ownership change.

A recognized BIL is treated as a pre-change loss that is subject to the Section 382 limitation.  The BIL of a particular asset is computed as its tax basis less its FMV on the date of the ownership change. 

Assume that a company acquires a LossCo that purchased raw land as follows:

FMV              $30,000,000
Cost             $100,000,000 
Built-in loss   $70,000,000

If the land is then sold for $30,000,000 and the interest rate is 4%:

(1)     Only $1,200,000 of the loss can be used annually to offset the purchaser's profits ($30 million FMV x 4%). 
(2)     Only $24 million of the loss on sale can be used by the purchaser over 20 years ($1,200,000 x 20).
(3)     The remaining $46 million loss can never be used.

Built-In Loss Controversy
Last fall, a day after the Citigroup deal to acquire Wachovia was announced and the House defeat of the first bank bailout bill plunged the panic stricken Dow 7%, Treasury quietly issued Notice 2008-83.  The Notice effectively repealed the BIL rules for banks. 

This greatly facilitated several very large bank mergers.  Wells Fargo outbid Citigroup by 600%, amid tax savings of around $25 billion.  It was estimated that it would have taken Wells almost 800 years to obtain the Wachovia tax benefits if the BIL rules applied.  It was also estimated that the Notice's total cost to taxpayers could top $140 billion.    

Treasury did not discuss the Notice with the Congressional tax writing committees prior to issuance, since it was viewed as an "administrative guidance."  Treasury said that it studied the new rules for 2 months, and "received absolutely no requests from any bank or financial institution to do this."  Treasury concluded that it was authorized by Section 382(m) to "prescribe regulations…to carry out the purposes of this section.”

There has been growing concern over the enormous power granted to Treasury to combat the financial crisis.  Tax committee staffers privately believed the Notice was illegal, but were concerned that going public might make them responsible for derailing the stabilization of the financial markets.  Most tax commentators likewise concluded that Treasury did not have proper authority. 

Many legislators were outraged when they learned about the Notice in newspapers.  Within weeks several bills were introduced to rescind the Notice.  A group of Democratic Ways and Means Committee representatives sent a stern letter to Treasury Secretary Paulson last December, stating that Treasury did not have the authority to issue the Notice. 

The BIL banking furor was just resolved by the American Recovery and Reinvestment Act of 2009.  Congress repealed the Notice and issued a searing rebuke to Treasury, stating that Section 382(m):

(1)      Does not authorize Treasury to provide exemptions or special rules that are restricted to particular industries or taxpayer classes,
(2)      Congressional intent is inconsistent with the Notice, and
(3)      Legal authority for the Notice is doubtful.

The Notice was repealed for transactions occurring after January 16, 2009 (unless there was a binding contract in place), while prior transactions will be respected.

Poison Pills
Recognizing the importance and value of their tax losses, companies have been adopting poison pill provisions in their corporate documents to protect their NOLs.  These poison pills have low triggers of 4.99%, in order to ensure compliance with the Section 382. The net effect is that shareholders cannot go over the 4.99% threshold without board approval, or they will trigger the poison pill (typically the company would dilute the purchasing shareholder until its stock went below 5%).  Some provisions allow the company to simply unwind the ownership over 4.99% rather than having to go through the difficult mechanics of triggering a pill and diluting out the offending shareholder.  These provisions can also have the ancillary effect of preventing takeover attempts and dissuading activist shareholders from pursuing equity increases, all justified for viable economic reasons.

Any company with substantial NOLs, including those considering bankruptcy, need to carefully consider how best to preserve and utilize those NOLs in the future.  As you can see from the NOL utilization example above, the loss of $168 million of NOL C/Fs could cost a company over $67 million in cash.  CBIZ MHM has extensive experience in performing Section 382 analyses, and we stand prepared to help you navigate these extremely complicated provisions.

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