Earlier this month, the IRS released proposed regulations under Section 382(h). The proposed regulations provide transition relief and a revised effective date for certain rules proposed in September 2019 which would, if finalized, eliminate a corporate taxpayer's ability to increase its Section 382 annual net operating loss (“NOL”) limitation by the amount of certain types of built-in gains. This generally will permit M&A transactions that are currently being negotiated to avoid being subjected to the proposed, more onerous, future Section 382 built-in gain rules.
Broadly speaking, if a corporate taxpayer undergoes a greater than 50% change in the ownership of its stock during a three-year period, Section 382 imposes an annual limitation on the taxpayer's ability to offset post-change taxable income with pre-change NOLs. The "base" annual Section 382 NOL limitation generally equals the fair market value of the corporate taxpayer's outstanding equity immediately prior to the ownership change, multiplied by the "long term tax exempt rate" (which currently is 1.63% for ownership changes occurring during February 2020). If the corporate taxpayer has a "net unrealized built-in gain" (“NUBIG”), the base annual NOL limitation is increased by "built-in gains" recognized during the five-year period beginning on the date of the ownership change. Such increase is limited, in the aggregate, by the amount of the NUBIG. The amount of a corporation's NUBIG for these purposes is generally equal to the amount (if any) by which the fair market value of the assets of the corporation immediately before an ownership change exceeds the aggregate adjusted basis of such assets at such time, subject to a specified threshold requirement.
In Notice 2003-65, the IRS provided guidance for applying the Section 382 rules relating to NUBIGs and net unrealized built-in losses. Among other provisions, Notice 2003-65 essentially allows a corporate taxpayer with a NUBIG to elect to treat as recognized built-in gains, for each year during the five-year period beginning on the date of the ownership change, the amount (the “Hypothetical BIG Depreciation/Amortization Amount”) of additional depreciation and amortization that would have been allowed to the corporate taxpayer for such year if the tax basis of the assets of the taxpayer had been stepped up to their respective fair market values on the date of the Section 382 ownership change. In many cases, this treatment greatly reduces the adverse impact of the Section 382 annual NOL limitation and could make the NOLs of a corporation that is acquired in an M&A transaction significantly more valuable.
September 2019 Proposed Regulations
Proposed regulations issued during September 2019 would, if finalized, eliminate a corporate taxpayer's ability to elect to treat Hypothetical BIG Depreciation/Amortization Amounts as recognized built-in gain (and, thus, eliminate the ability of the taxpayer to increase the Section 382 annual NOL limitation by Hypothetical BIG Depreciation/Amortization Amounts). When issued in September 2019, the proposed regulations were to apply to Section 382 ownership changes occurring after the publication date of the final regulations. No transition relief was provided. This effective date created two principal concerns:
- The proposed effective date (coupled with a lack of transition relief) would impose a significant burden on taxpayers evaluating and negotiating M&A and other business transactions, due to uncertainty regarding when those transactions would close and when the proposed regulations ultimately would be finalized.
- If the IRS were to issue typical transition relief (i.e., transition relief limited to transactions for which a binding agreement is in effect on or before the effective date of final regulations), such relief would be inadequate, because pending M&A transactions regularly are modified or delayed prior to closing.
New Proposed Regulations
The new proposed regulations favorably address the concerns expressed above. In particular,
- The new proposed regulations provide for a delayed effective date whereby the new rules generally will be applicable only for Section 382 ownership changes that occur after the date that is 30 days after the Treasury decision containing final regulations is published in the Federal Register (the “Delayed Effective Date”).
- The new proposed regulations provide for transition relief whereby the new rules generally will not apply (unless a taxpayer elects for such rules to apply) to a Section 382 ownership change that occurs immediately after a specific, identifiable owner shift or equity structure shift transaction which occurs:
- Pursuant to a binding agreement in effect on or before the Delayed Effective Date and at all times thereafter;
- Pursuant to a specific transaction described in a public announcement made on or before the Delayed Effective Date;
- Pursuant to a specific transaction described in a filing with the Securities and Exchange Commission submitted on or before the Delayed Effective Date;
- By order of a court (or pursuant to a plan confirmed, or a sale approved, by order of a court) in a title 11 or similar case, provided that the taxpayer was a debtor in a case before such court on or before the Delayed Effective Date; or
- Pursuant to a transaction described in a private letter ruling request submitted to the IRS on or before the Delayed Effective Date.
- The new proposed regulations clarify that, for ownership changes occurring on or prior to the Delayed Effective Date or that qualify for transition relief, taxpayers can continue to apply Notice 2003-65 and, thus, treat Hypothetical BIG Depreciation/Amortization Amounts as recognized built-in gain for applicable periods.
The Delayed Effective Date and transition relief contained in these new proposed regulations provide much needed clarity as to the extent to which M&A transactions that are currently being negotiated will avoid being subjected to the proposed, more onerous, Section 382 built-in gain rules.
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