The Treasury Department and Internal Revenue Service (IRS) recently issued proposed regulations that address the way in which companies with net operating losses (NOLs) will calculate their ability to use such losses following an ownership change. Along with additional limits on NOL usage in the wake of the 2017 Tax Cuts and Jobs Act, these proposed regulations would withdraw favorable guidance that loss corporations have used since 2003 and could significantly scale back their ability to use pre-change losses. The result could substantially diminish the valuation of this tax asset in M&A transactions and hinder reorganizations of distressed companies with substantial built-in losses as well as start-ups with significant development-phase losses that experience an ownership change once they raise critical venture capital investment.
Note: The proposed new IRS regulations would only apply to ownership changes that take effect after publication of the final ruling.
If a company has more than a 50% change in ownership over a rolling three-year period, Section 382 of the IRS Code imposes an annual limit on the corporation’s ability to offset future income with existing NOLs. This limitation is typically equal to the fair market value of the corporation immediately before the ownership change, multiplied by the applicable long-term tax-exempt rate, as specified rate by the IRS, which is currently modest.
This annual limitation is then either increased by the amount of any recognized built-in gain (RBIG) or reduced by the amount of any recognized built-in loss (RBIL) during the five-year period following the date of ownership change. Section 338 under the IRS Code “permits a corporation to determine realized gain by comparing the deemed depreciation/amortization that would result from a hypothetical sale of the corporation’s assets to the corporation’s actual (and often lower) depreciation/amortization. The difference between the above amounts represents realized gain even though no assets are sold.” [JD Supra]
The proposed regulations would eliminate the Section 338 approach and significantly change the determination of overall net unrealized gain and realized gain. The new regulations would eliminate a company’s ability to increase realized gain without actual dispositions of assets, as outlined under Section 1374. The new calculations would also limit consideration of many liabilities in measuring asset value, reducing the amount (or existence) of overall net unrealized gain. Additionally, the proposed regulations would make various technical changes, including how contingent liabilities and debt cancellation income are treated for these purposes.
In essence, loss corporations would no longer be able to utilize significant portions of their carry-forwards and built-in losses after an ownership change, resulting in an increased income tax burden for loss corporations and their acquirers. Without careful and advanced planning, the proposed IRS regulations may reduce the after-tax cash flow of many loss corporations following a change in ownership, and negatively impact either the value of the loss corporation or the ability of the loss corporation to participate in M&A activity outside bankruptcy.
It’s important for companies to discuss the proposed IRS changes in detail with a tax advisor and the potential impact they can have on the company’s value.
Owens Group specializes in helping Private Equity clients with all aspects of the merger and acquisition process: from due diligence through a final sale. We can help clients understand and evaluate risks and strategically manage those risks. For more information about our services, please contact Joe Ehrlich at 201-408-3512 or Dorene Stockman at 201-408-3504.
Sources: IRS, Jones Day, RSM, Kirkland & Ellis, O’Melvey, JD Supra, Proskauer, PwC, Skadden, Lexology