Addressing Proposed Section 382 Regulations in Current M&A Transactions
These revisions will impact deal terms and valuation

In September 2019, the Internal Revenue Service (IRS) and the Treasury Department issued proposed Section 382 regulations that, when finalized, would significantly reduce the value of net operating losses (NOLs) following Section 382 ownership changes, including those that occur in connection with mergers and acquisitions.¹

In particular, the proposed regulations would eliminate the Section 338 approach described in Notice 2003-65 for adjusting a Section 382 limitation following an ownership change and would mandate the Section 1374 approach.² In addition, the proposed regulations would make changes to the Section 1374 approach that would result in a lower Section 382 limitation for many loss corporations. As discussed in more detail below, although these regulations are currently in proposed form, they can materially impact the terms and valuation approaches taken in current M&A transactions.

The Unbearable Uncertainty of Net Unrealized Built-in Gains and Losses

In general, following an ownership change, a loss corporation’s NOLs are subject to a base Section 382 limit equal to the value of the loss corporation on the date of the ownership change multiplied by the long-term tax-exempt rate.³ Currently, the long-term tax-exempt rate is less than two percent.⁴ Assuming a long-term tax-exempt rate of two percent, upon an ownership change, a loss corporation with a value of $100 million would have a base Section 382 limitation of $2 million per year. If the loss corporation had hundreds of millions of dollars in NOLs at the time of the ownership change, it could literally take centuries to use all of the NOLs. And that calculation assumes that they were not pre-TCJA NOLs that would, for the most part, be certain to expire before being used.⁵

Under Section 382(h), the base Section 382 limitation can be adjusted upward for built-in gains or downward for built-in losses. If a loss corporation has a net unrealized built-in gain (NUBIG) on the ownership change date, the Section 382 limitation for any of the first five taxable years following the ownership change is increased by the amount of the realized built-in gain (RBIG) for the taxable year.⁶ Conversely, if a loss corporation has a net unrealized built-in loss (NUBIL) on the ownership change date, the Section 382 limitation is decreased for any of the first five years following the ownership change by the amount of the recognized built-in loss (RBIL) for the taxable year.⁷ The cumulative RBIG adjustment is limited to the amount of the NUBIG on the ownership change date, and the cumulative RBIL adjustment is limited to the amount of the NUBIL on the ownership change date.⁸ If a loss corporation’s NUBIG or NUBIL is not greater than the lesser of 1) fifteen percent of the fair market value of the loss corporation’s assets immediately before the ownership change or 2) $10,000,000, then the loss corporation’s NUBIG or NUBIL is zero.⁹

Prior to the proposed regulations, Notice 2003-65 was the IRS’ sole source of formal guidance regarding the application of Section 382(h) to adjust Section 382 limitation for items of NUBIG/NUBIL and RBIG/RBIL. In Notice 2003-65, the IRS provided a single method for calculating NUBIG/NUBIL based on a hypothetical sale of all of the assets of the loss corporation that assumed all of the loss corporation’s liabilities and the application of principles of Section 1374. In addition, Notice 2003-65 set forth two safe harbors for calculating RBIG/RBIL, the Section 338 approach and the Section 1374 approach.

The Section 338 approach identifies items of RBIG/RBIL by comparing the loss corporation’s actual items of income and deduction during the five-year period following the ownership change date with the items the loss corporation would have had if it had made a Section 338 election on the ownership change date. The Section 1374 approach, on the other hand, identifies items of RBIG and RBIL at the time of the actual dispositions of a loss corporation’s assets during the five years following the ownership change date. In addition, it generally applies the accrual method of accounting principles to identify items of built-in income and deduction.

In general, taxpayers with a NUBIG have found the limitation provided under the 338 approach to be much more favorable than the 1374 approach. For example, under the 338 approach, a loss company with $150 million of goodwill on the date of an ownership change would be able to increase its Section 382 limitation by $10 million per year during the five-year period following the ownership change date, because that is the amount of amortization it would have been allowed had it been acquired in a transaction for which a Section 338 election had been made. Under the 1374 approach, the increase to its Section 382 limitation is zero, because the loss company does not actually dispose of its goodwill.

The Tax Cuts and Jobs Act’s Impact on Section 382(h)

The TCJA prompted the IRS to revisit Section 382(h) and Notice 2003-65. First, in response to the interaction of Section 168(k) with Notice 2003-65, the IRS issued Notice 2018-30. Section 168(k) provides for immediate expensing of certain depreciable property. Without correction, Notice 2003-65 would have permitted loss companies to increase their base Section 382 limitation by the amount of depreciation permitted under Section 168(k) for qualified property. Notice 2018-30 made the Section 338 approach unavailable to loss companies computing the impact of Section 168(k) on their Section 382 limitation.

The TCJA made numerous other changes to the Code that create additional issues the IRS and Treasury must consider when providing guidance on Section 382(h). In particular, the IRS and Treasury must consider the interest limitation under Section 163(j), the changes to the NOL rules under Section 172, and the advent of the tax on global intangible low-taxed income (GILTI) under Section 951A. In light of these changes, the IRS and Treasury determined it would be more feasible to harmonize the Section 1374 approach with the TCJA than to harmonize the Section 338 approach with it. As a result, the proposed regulations would eliminate the Section 338 approach and instead adopt the Section 1374 approach for all loss companies.

The Proposed Section 382 Regulations

In adopting the Section 1374 approach, the proposed regulations create a multistep process for calculating NUBIG/NUBIL that will result in lower NUBIG or greater NUBIL for many loss companies depending on how each accounts for loss corporation liabilities.¹⁰ First, the loss company is satisfying all inadequately secured nonrecourse liabilities by surrendering the assets securing such debt. Second, the loss company is treated as selling its remaining assets to an unrelated third party without the third party assuming any of the loss company’s liabilities. The loss company’s amount realized is then reduced by the amount of its fixed and contingent deductible liabilities and its basis in assets. Finally, the loss company’s amount realized is increased or decreased by items of built-in income and deduction items (other than the cancellation of debt income) that could be recognized by the loss company during the five-year period following the ownership change and increased or decreased by any Section 481 adjustments required from the deemed sale of the loss company’s assets.

These changes will harm many taxpayers due to the less favorable treatment of liabilities in calculating NUBIG/NUBIL. For taxpayers with significant contingent tax liabilities, the treatment of contingent liabilities as a part of the NUBIG/NUBIL and RBIL calculation will significantly reduce or eliminate their Section 382 limitation.

The proposed regulations also change the treatment of cancellation of debt (COD) income so as to eliminate the possibility of taxpayers getting more than one tax benefit in the calculation of NUBIG and RBIG for COD income.¹¹ In general, the proposed regulations would not include COD income in the calculation of NUBIG or RBIG. However, a loss company could elect to include COD income in NUBIG and RBIG in situations in which the COD income is recognized within twelve months of the ownership change and does not result in excludable COD income that reduces pre-ownership-change NOLs.¹²

The proposed regulations also explicitly exclude from the calculation of NUBIG/NUBIL and RBIG a number of items introduced or significantly changed as items of income as a result of the TCJA. Dividends with respect to stock held by the loss company on the ownership change date are excluded from the calculation of NUBIG/NUBIL and RBIG.¹³ This exclusion extends to amounts treated as dividends as a result of the application of Section 1248, even though the loss company otherwise has a built-in gain in the stock of the foreign subsidiary on the ownership change date. In addition, items of Subpart F income, GILTI, and prepaid income described in Section 451(c) or Section 455 are excluded from the calculation of NUBIG/NUBIL and RBIG.¹⁴

Current M&A Impact

The proposed regulations are somewhat unusual in the degree to which they currently impact M&A transactions, although they have not yet been finalized. Even though the proposed regulations are to be effective only when finalized, it is impossible to know whether any pending transaction will be completed before the proposed regulations are issued in final form. As drafted, the proposed regulations do not provide a grandfathering provision. The IRS has publicly acknowledged that this was an oversight.¹⁵ However, it is impossible to know whether any grandfathering provision will apply to transactions that have not closed before the date the proposed regulations are issued in final form.

As a result, companies currently negotiating M&A transactions have to consider the possibility that the proposed regulations will apply with respect to NOLs to be acquired.
In evaluating the value of NOLs of a target corporation with a NUBIG, the parties must consider the possibility that the Section 338 approach to Notice 2003-65 could apply to significantly increase the value of NOLs or that the proposed regulations could apply to eliminate any NUBIG adjustment or even create a NUBIL. Historically, sellers have always sought to get paid up front for the value of NOLs, whereas buyers have sought to discount NOLs as much as possible.

At least two potential strategies exist for parties attempting to correctly value NOLs in pending M&A transactions. First, the parties could agree to two different prices. One price will be paid at closing if the proposed regulations have not been finalized at that time, and a second lower price could be paid if the proposed regulations have been finalized at that time. Practically speaking, the value to be placed on the NOLs if the proposed regulations have been finalized may be zero. However, it is impossible to know whether the proposed regulations will be finalized more or less as proposed or in a form that is more generous with respect to NUBIG.

Alternatively, the parties could enter into a tax receivables agreement so the buyer pays the seller for the value of the NOLs only when the buyer actually uses them. The disadvantage to the seller is that any value it receives will likely be delayed by a number of years until the buyer is able to utilize the NOLs. The buyer and seller may also remain entangled for a long time in the event that the NOLs are lost as a result of an audit adjustment. However, the advantage is that both buyer and seller are likely to be able to arrive at a price they agree is reasonable for the NOLs. Moreover, neither the buyer nor the seller is required to use a crystal ball to determine whether the proposed regulations will be finalized when the transaction closes or know what they will provide when issued in final form.

Conclusion

When finalized, the proposed regulations will likely reduce the value of NOLs in M&A transactions. Although it is impossible for anyone to know when the proposed regulations will be issued in final form or exactly what they will state, it is possible to navigate the uncertainty in M&A transactions currently by properly addressing contingencies.

Jay Singer is a partner at the law firm of Shearman & Sterling LLP.

Endnotes

1. REG-124710-18 (September 10, 2019).
2. Prop. Reg. 1.382-7.
3. Section 382(b).
4. Rev. Rul. 2019-26.
5. The TCJA modified Section 172 to eliminate NOL carrybacks and permit indefinite NOL carryforwards. See Section 172(b).
6. Section 382(h)(2)(A).
7. Section 382(h)(2)(B).
8. Section 382(h)(1).
9. Section 382(h)(3)(B).
10. Prop. Reg. Section 1.382-7(c)(3)(i).
11. Prop. Reg. Section 1.382-7(c)(3)(ii).
12. Section 108(a) permits taxpayers to exclude COD income from gross income if the discharge occurs in a Title 11 case, while the taxpayer is insolvent, and in certain other circumstances. However, Section 108(b) requires taxpayers to reduce certain tax attributes, including NOLs, by the amount of such excluded COD income. The proposed regulations are intended to ensure that COD income is not both excluded from income under Section 108(a) and providing an increase to RBIG for pre-ownership change NOLs under Section 382(h).
13. Prop. Reg. Section 1.382-7(d)(2)(ii).
14. Prop. Reg. Section 1.382-7(d)(2)(vi).
15. “IRS Working on Transition Rule for Loss Limitation Regs,” Tax Notes Today, November 18, 2019, www.taxnotes.com/tax-notes-federal/corporate-taxation/irs-working-transition-rule-loss-limitation-regs/2019/11/18/2b4dn.