United States: Proposed Regulations May Significantly Impact Tax Assets Of Distressed Companies

On September 9, 2019, the Treasury Department (“Treasury”) and the Internal Revenue Service (the “IRS” or “Service”) issued proposed regulations addressing the application of certain rules under Sections 382 and 383 of the Internal Revenue Code (the “Code” and, such regulations, the “Proposed Regulations” or “Regulations”).1 These Proposed Regulations would only apply to “ownership changes” occurring after the publication of final Regulations. Nevertheless, taxpayers should be aware of the potential consequences of these Proposed Regulations now, because the Regulations would make radical changes to current law that will adversely affect the value of tax attributes that exist today and may influence decisions taxpayers must make in filing their 2018 tax returns.

If the Proposed Regulations are adopted in their current form, they will significantly reduce the ability of many companies to utilize net operating losses (“NOLs”) and other tax attributes following an “ownership change”2 under Section 382. The Regulations accomplish this by adopting certain highly unfavorable rules for calculating the “annual limitation” on the ability of a company to apply pre-change tax attributes to offset post-change taxable income. The Regulations will have a particularly severe effect on financially troubled companies, whose pre-change tax attributes are often a valuable asset that supports the company’s ability to restructure. Such changes will also have an adverse effect on the value that should be ascribed to such tax attributes in M&A activity, and may increase the number of public companies that consider adopting “NOL poison pills” to avoid the application of Section 382.

These Proposed Regulations are adverse to taxpayers on a number of different levels:

First and foremost, the Regulations reverse 16 years of guidance from the Service, settled practice, and taxpayer expectations regarding the value of tax attributes in connection with ownership changes. These new rules are likely to reduce the value of NOLs and other tax attributes, including attributes that have already been “priced in” to investment decisions and contractual arrangements.

Second, the Regulations follow the enactment less than two years ago of the Tax Cuts and Jobs Act of 2017 (“TCJA”). The TCJA eliminated taxpayers’ ability to carry back net operating losses, imposed an 80% cap on the ability to offset taxable income with NOLs generated after 2018 and imposed significant limitations on the ability of distressed companies to deduct interest expense, all of which have serious negative effects on financially distressed companies. These Proposed Regulations “pile on” and make that bad situation worse.

And third, the Treasury issued these Regulations close to the time when many corporate taxpayers must file their 2018 tax returns. One of the most important issues that corporate taxpayers face in filing their 2018 returns is whether to elect bonus depreciation for capital expenditures. Given the new limitations on the value of tax attribute carryforwards that would apply if the Proposed Regulations were to be finalized in their current form, corporate taxpayers must quickly reconsider whether to elect bonus depreciation for 2018, particularly if such election would give rise to a net operating loss that could be subject to these rules upon any future ownership change.

Existing Guidance Under Section 382 

When an ownership change occurs under Section 382, unless a special bankruptcy-specific rule applies, a company’s ability to offset post-change taxable income with tax attributes (such as NOLs) attributable to the period prior to the ownership change (“Pre-Change Losses”) is subject to an annual limitation. This annual limitation has two components. The first component, typically referred to as the “base limitation,” is determined by multiplying the value of the company’s equity immediately before3 the transaction by a specified rate that is published by the IRS and applicable to such ownership change. The applicable rate has been around 2% for many years,4 which means that the base limitation is generally quite low.

The second component of the annual limitation is based on a calculation that, under existing guidance, compares the tax basis of the company’s assets to the value (or, if liabilities exceed value, the amount of the company’s liabilities) of those assets.5 If tax basis is lower than value or liabilities, the company has a “net unrealized built-in gain” (“NUBIG”). If a company has a NUBIG then its annual limitation may be increased to the extent of its “recognized built-in gains” (“RBIG”) during the five-year period following the ownership change. As discussed below, under current guidance, a favorable calculation could apply to the determination of RBIG that compares “deemed” depreciation from a hypothetical asset sale to a company’s current — often lower — depreciation schedule. As a result, this NUBIG/RBIG calculation has historically resulted in significant increases in the annual limitation for many companies. Without this NUBIG/RBIG increase, the base limitation alone typically results in virtually no ability to utilize post-change NOLs, particularly for troubled companies.6

Changes Under Proposed Regulations 

Unfortunately, as discussed below, the Proposed Regulations make unfavorable changes to both the NUBIG and "net unrealized built-in loss" ("NUBIL") "prongs," as well as the RBIG and "recognized built-in loss" ("RBIL") “prongs” of this portion of the calculation of the annual limitation. The result is that many companies will not be permitted to use any tax attributes in excess of the base limitation when, previously, they would have received a benefit from their NUBIG under the historic calculation of RBIG outlined below. And, in many cases, companies that previously would have had a NUBIG, such that their post-ownership change depreciation, depletion and amortization deductions would not have been subject to limitation at all, will now have a NUBIL, which will cause those deductions to be limited for a five-year period.

NUBIG and NUBIL Determinations — Less Favorable for Distressed Companies

Under existing guidance,7 for purposes of calculating NUBIG or NUBIL, the value of the company’s assets is calculated by assuming that the company’s assets were sold to a third party that assumed the company’s liabilities, including liabilities that were discharged in the transaction giving rise to the ownership change.8 The existing rules essentially establish a valuation “floor” equal to the company’s outstanding liabilities and mean that a financially distressed company may be treated as having a NUBIG, even if the encumbered fair market value of the company’s assets is less than the tax basis in those assets. The Proposed Regulations, by contrast, provide that recourse liabilities are not taken into account for purposes of the asset value determination. When recourse liabilities are discharged and give rise to cancellation of indebtedness income (“CODI”), the Proposed Regulations provide that the CODI will directly or indirectly affect the company’s NUBIG in certain specified circumstances.9 However, this benefit is significantly limited compared to existing guidance. 

Unlike recourse liabilities, “nonrecourse” liabilities are included in the value determination and, as a result, they continue to set a value “floor.” As a result, for purposes of NUBIG and NUBIL determinations, nonrecourse liabilities are treated more favorably than recourse liabilities.

RBIG and RBIL Determinations — Less Favorable for Companies with NUBIGs, Resulting in Less Benefit for Section 382 Purposes

Regardless of how the Proposed Regulations determine whether a company has a NUBIG or NUBIL, the Regulations fundamentally change the methodology for calculating RBIG and RBIL. In doing so, they are likely to reduce significantly the potential value of NOLs and other tax attributes.

Under existing guidance, companies with a NUBIG could increase their annual limitation under Section 382 by utilizing a “deemed sale” approach. Under this approach, the company would calculate hypothetical depreciation, amortization and depletion deductions that could be claimed in the five years following an ownership change if a third party purchased the company’s assets for fair market value (without a “floor” set by liabilities). This hypothetical depreciation was compared to the company’s actual (and typically lower) existing depreciation, and the difference was treated as RBIG, even if no assets were actually disposed of. This RBIG would, in turn, increase the company’s annual limitation under Section 382, up to a “cap” set by the company’s overall NUBIG. This approach was referred to as the “338 Approach.” The alternative approach, which relies on actual accruals of taxable income or loss, referred to as the “1374 Approach,” was typically utilized by companies with a NUBIL and meaningful contingent liabilities, as the accrual approach typically leads to the recognition of fewer liabilities in the relevant five-year period. 

The Proposed Regulations completely eliminate the ability to rely on the comparatively favorable 338 Approach, and instead require reliance on the 1374 Approach. While the Proposed Regulations implement certain welcome “fixes” to the 1374 Approach that make it somewhat less unfavorable to taxpayers, the net effect remains a dramatic reduction in the ability of most companies — not just financially distressed companies — to utilize NOLs and other tax attributes that are subject to limitation under Section 382. 

Conclusion 

The tax attributes of a financially distressed company are frequently among its most valuable assets, and the existing guidance discussed above is one of the primary reasons these companies are able to utilize them after a restructuring. If finalized in their current form, the Proposed Regulations will significantly limit that value. For this reason, we expect that if these Regulations are finalized, transactions structured as taxable asset dispositions (so-called “Bruno’s” transactions) to new companies are likely to increase. Additionally, there may be greater appetite by Chapter 11 debtors to rely on the bankruptcy-specific rule under Section 382(l)(5). Where Section 382(l)(5) applies, it avoids the imposition of any annual limitation under Section 382. However, in order for that provision to apply, certain “holding period” requirements with respect to creditor claims must be satisfied, and that is often difficult in light of the frequency that claims against distressed companies are traded. New equityholders must be willing to agree to significant limitations in trading the equity they receive in the chapter 11 plan, and a company must, in many cases, significantly reduce the NOLs that survive the Chapter 11 process. Unfortunately, the “Bruno’s” and Section 382(l)(5) alternatives will not make up the value that the Proposed Regulations remove from financially distressed companies.

Although the Proposed Regulations will apply only to ownership changes that occur after the finalization of the Regulations, if finalized, they will affect NOLs and other tax attributes that exist now, even if the ownership change doesn’t occur until the future. As a result, decisions that taxpayers must make now, such as the decision to elect bonus depreciation for the 2018 tax year, may be affected by the mere proposal of these Regulations. It is difficult to predict what, if any, changes will be made to the Proposed Regulations prior to their finalization or the actual date upon which they will be finalized. Taxpayers have until November 12, 2019, to comment on these proposals, and the Treasury Department has specifically requested detailed comments regarding the treatment of bankrupt and insolvent taxpayers. In the meantime, taxpayers should take note of the proposals and make sure that they are included in any evaluation of a loss company’s tax attributes.

Footnotes

1. All Section references herein are to the Code, unless otherwise indicated. Section 383 applies to certain kinds of tax credits, but generally follows rules that are similar to Section 382. For ease of reference, the rest of this Alert will simply reference Section 382.

2. An “ownership change” occurs when there is a 50 percentage point increase in the ownership of “5 percent shareholders” over a rolling three-year period. As a general matter, “ownership changes” almost always occur in debt workout transactions involving significant debt-for-equity components (whether in- or out-of-court), frequently occur in M&A transactions and will often occur even in the absence of any particular transaction.

3. For ownership changes occurring pursuant to a plan of reorganization in a bankruptcy case, this test is made somewhat more favorable by looking to the lesser of (x) the equity value immediately after the transaction and (y) the gross asset value immediately before the transaction — essentially, giving credit for the increase in the company’s equity value that accrues as a result of the plan of reorganization. Even with this more favorable calculation approach, the base limitation is generally modest.

4. The exact amount varies from month to month. For illustration, the rate for ownership changes in September 2019 is 1.89%.

5. Significant complexities arise in the application of these rules to consolidated groups that are not discussed here. For the most part, the consolidated return rules were not addressed or changed by the Proposed Regulations except insofar as the basic rules have implications for those rules.

6. In addition to the basic question of comparing asset tax basis to value, certain other adjustments are made. In particular, deductible liabilities are subtracted from the calculation (causing a decrease in NUBIL or increase in NUBIG), certain accounting adjustments in connection with a deemed sale are taken into account, and certain amounts related to prior ownership changes are added into the calculation. For the sake of relative simplicity, these adjustments are ignored here. By contrast, if tax basis is more than value, the company has a “net unrealized built-in loss” (“NUBIL”). If a company has a NUBIL, there can be no increase to the base limitation. Additionally, the company’s ability to claim tax losses as well as depreciation, depletion and amortization deductions (“RBIL”) is also subject to limitation for a five-year period.

7. Notice 2003-65, 2003-2 CB 747. Notice 2003-65 will be withdrawn if the Proposed Regulations are finalized. 

8. PLR 201051019 (Sept. 14, 2010). While Private Letter Rulings cannot be relied upon by a taxpayer other than the recipient, as a practical matter, taxpayers uniformly followed this interpretation of Notice 2003-65. 

9. These cases include: (a) situations where CODI results in an elimination of asset tax basis in assets held on the date of the ownership change; (b) situations where CODI is included in taxable income because the bankruptcy and insolvency exclusions are inapplicable; and (c) situations where CODI results in the elimination of tax attributes generated after an ownership change date. 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions