United States: IRS Proposes Regulations That Would Limit Utilization Of NOLs After Acquisitions And Other Ownership Changes

On September 9, 2019, the U.S. Treasury Department (Treasury) and the Internal Revenue Service (IRS) issued proposed regulations1 (the Proposed Regulations) that, if finalized, would significantly change the way corporations that are acquired or undergo certain other ownership changes calculate and recognize existing net operating losses (NOLs) and other tax attributes for purposes of Section 382 following the ownership change.2 Notably, the new rules would require taxpayers to use the accrual-based "Section 1374" approach to calculate built-in gain and loss, thereby eliminating the alternative, generally taxpayer-favorable, "Section 338" approach previously approved by the IRS. These changes are likely to affect corporations in the technology and life sciences industries that have significant NOLs and self-created intangible assets.

Section 382 and Built-In Items

Section 382 generally limits the ability of a corporation that undergoes an "ownership change" to use its NOLs to offset its taxable income in taxable years after the ownership change. An "ownership change" generally occurs if there has been a cumulative increase in the corporation's ownership by certain "5-percent shareholders" that exceeds 50 percentage points over a rolling three-year period. Mergers or acquisitions typically are ownership changes, but financing rounds or other transactions may also trigger sufficient shifts in a corporation's ownership. After an ownership change, Section 382 generally limits taxable income that may be offset annually by pre-change NOLs to the product of: i) the fair market value of the corporation immediately before the ownership change and ii) the "long-term tax-exempt rate" for the month of the ownership change (the Section 382 limitation).3

Section 382(h) governs how a corporation determines and subsequently recognizes built-in gain or loss on assets it owned immediately before an ownership change. A corporation generally may increase its Section 382 limitation if the corporation had a "net unrealized built-in gain" (NUBIG) immediately before the ownership change, subject to a de minimis threshold. In such case, when the corporation recognizes gain within five years of the ownership change (the "recognition period") that is attributable to an asset the corporation owned immediately before the ownership change, the gain is considered "recognized built-in gain" (RBIG) that increases the Section 382 limitation for the relevant year. If the corporation had sold the asset before the ownership change, the corporation's NOLs would have been unlimited by Section 382 and available to offset the gain. Section 382(h) generally prevents the corporation from being penalized on a later sale of the same asset by increasing the Section 382 limitation by the same, unlimited amount of NOLs. In computing RBIG, Section 382(h)(6) further requires corporations to include items of income "properly taken into account during the recognition period" but "attributable to periods before" the ownership change. Converse rules generally apply to post-change "recognized built-in loss" (RBIL) traceable to assets with built-in losses a corporation held immediately before an ownership change.

Notice 2003-65

In Notice 2003-65, the IRS announced two alternative approaches to determine built-in items under Section 382(h)—the Section 1374 approach and the Section 338 approach—and confirmed that taxpayers could rely on either approach until regulations were issued.4

The Section 1374 approach is based on the rules under Section 1374 for determining the recognized built-in gain of a C corporation that has elected to become an S corporation. Under the Section 1374 approach, the amount of gain or loss a corporation actually recognizes during the recognition period from the sale of an asset is generally RBIG or RBIL. Items of income or deduction included in income or allowed as deductions during the recognition period are considered attributable to periods before the ownership change and, thus, are treated as RBIG or RBIL, respectively, only if an accrual method taxpayer would have included the items in income or been allowed deductions for the items before the ownership change. The Section 1374 approach does not treat income from a built-in gain asset, such as a patent with significant built-in gain that generates royalty income, during the recognition period as RBIG because such income did not accrue before the change date.

In contrast, the Section 338 approach generally identifies items of RBIG and RBIL by comparing the corporation's actual items of income, gain, deduction, and loss with those that would have resulted if a Section 338 election had been made with respect to a hypothetical purchase of the corporation's stock on the ownership change date. Under the Section 338 approach, built-in gain assets may be treated as generating RBIG even if they are not actually sold at a gain during the recognition period. The Section 338 approach assumes that, for any taxable year, an asset that had a built-in gain on the ownership change date generates income equal to the cost recovery deduction that would have been allowed for the asset if a Section 338 election had been made. This approach treats as RBIG the excess of i) the cost recovery deduction that would have been allowable with respect to a built-in gain asset had a Section 338 election been made over ii) the corporation's actual allowable cost recovery deduction. Since 2003, this approach has been particularly beneficial to taxpayers with substantial goodwill or self-created intangibles that have a low tax basis (and thus low or no actual cost recovery deductions) but significant built-in gain.

Proposed Changes

Section 338 Approach Eliminated

The Proposed Regulations provide the first significant guidance regarding Section 382(h) since Notice 2003-65. Most importantly, the Proposed Regulations would eliminate the Section 338 approach and make the Section 1374 approach, with certain modifications, mandatory. Citing the "historical weaknesses" of the Section 338 approach, the preamble to the Proposed Regulations notes that under this approach, depreciation deductions on certain built-in gain assets give rise to RBIG, even though no actual recognition of gain or income has occurred, and asserts that Section 382(h) does not authorize this treatment.

Eliminating the Section 338 approach is likely to be particularly detrimental to corporations in the technology and life sciences industries, which have been the target of significant M&A activity in recent years. Such corporations often have sizable NOLs due to the high cost of, and number of years required for, research and development, as well as the widespread use of equity incentive compensation. In addition, a significant portion of the value of such corporations may be attributable to self-developed intangible property, in which they have no tax basis and no corresponding cost recovery deductions. The Section 338 approach generally allows a post-ownership change corporation to capture a portion of the built-in value of the intangibles through increased RBIG and a corresponding increase in the Section 382 limitation. Without this approach, such corporations would generally be restricted to the basic Section 382 limitation, which may be a significant constraint if the long-term tax-exempt rate remains below 2 percent.

Coordinating Changes

The Proposed Regulations would make various other amendments intended to coordinate the calculation of built-in items with the changes enacted by the Tax Cuts and Jobs Act in 2017. Such changes include clarifying that disallowed business interest carryforwards under Section 163(j) that are subject to the Section 382 limitation are not treated as RBIL, if the amounts are allowable as a deduction during the recognition period, to avoid double counting. In addition, the Proposed Regulations clarify when certain cancellation of debt income recognized by a corporation following an ownership change is included in the computation of NUBIG or "net unrealized built-in loss".

Effective Date

If adopted, the Proposed Regulations would be effective for ownership changes occurring after the date the rules are finalized. Taxpayers may submit comments on the Proposed Regulations through November 12, 2019. The preamble invites the public to comment on the proposed elimination of the Section 338 approach, as well as other aspects of the proposal.


1 Regulations Under Section 382(h) Related to Built-In Gain and Loss, 84 Fed. Reg. 175, 47455 (Sept. 10, 2019).

2 All "Section" references herein are to the U.S. Internal Revenue Code of 1986, as amended.

3 The IRS publishes the long-term tax-exempt rate monthly. It is 1.89 percent for September 2019.

4 Notice 2003-65, 2003-2 C.B. 747

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