Proposed Regulations May Significantly Impact Tax Assets of Distressed Companies Publications

The hypothetical deduction is determined based on the asset’s fair market value on the change date and a new cost recovery period beginning on the change date. The reasoning underpinning the 338 approach’s inclusion of incremental hypothetical depreciation, depletion or amortization deductions with respect to built-in gain assets reflects an estimate of income generated by a wasting asset during a particular period. With respect to COD income, the 338 approach treats COD income that is included in gross income, and that is attributable to any pre-change date debt of the loss corporation, as an RBIG in an amount not exceeding the excess, if any, of the adjusted issue price of the discharged debt over the fair market value of the debt on the change date. 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.

• The Proposed Regulations would eliminate the Section 338 approach and make the use of the Section 1374 approach mandatory for purposes of computing NUBIGs and NUBILs.
• The adjustment provided under paragraph of this section for certain recourse liabilities is not available (and the cancellation of indebtedness is not recognized built-in loss) because the recourse liability does not constitute a pre-change excess recourse liability.
• This memorandum is provided by Skadden, Arps, Slate, Meagher & Flom LLP and its affiliates for educational and informational purposes only and is not intended and should not be construed as legal advice.
• After this date COVID-19 cannot be the reason to make tax free “qualified disaster relief payment under IRC Sec. 139.
• NUBIG or NUBIL is measured by the difference between the fair market value of the corporation’s assets immediately before the ownership change and the aggregate adjusted tax bases of such assets .
• 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.

Specifically, under the https://intuit-payroll.org/ regulations, the deemed buyer of a loss corporation’s assets in the hypothetical sale would not assume any liabilities of the loss corporation. Any recourse liabilities, contingent liabilities, and other deductible liabilities of the loss corporation are therefore excluded from the amount realized in the hypothetical sale, resulting in a much lower amount realized, and hence, an increased likelihood of NUBIL and decreased likelihood of NUBIG. These changes are significant for insolvent taxpayers, which often have greater liabilities than the gross value of their assets. Eliminating the ability to include liabilities in the amount realized from the hypothetical sale of assets would reduce the amount of a NUBIG for distressed corporations. Section 382 was implemented to prevent the acquisition of Loss Companies for the sole purpose of utilizing the acquired company’s NOLs post-acquisition to offset income generated by the acquired company. Very generally, when a Loss Company undergoes an ownership change,2 Section 382 limits the annual use of the Loss Company’s NOLs and certain other tax attributes after the ownership change. The Section 382 “base” limitation is measured by the value of the Loss Company on the change of control date multiplied by the then-prevailing federal long-term tax-exempt rate (1.89% for September 2019).

Proposed Changes and Affected Taxpayers

As such, for taxpayers in a NUBIL position, the proposed regulations retain the 1374 approach, modified to increase RBILs. For taxpayers in a NUBIG position, the proposed regulations eliminate all RBIGs except for actual sales of built-in gains and built-in income. The proposed regulations have been heavily criticized and would impose a de facto large tax increase, in particular, on modern life science and technology corporations who would generally not generate RBIGs through the disposition of built-in gain assets.

• If the proposed regulations are finalized in their current form, however, the ability of many loss corporations to utilize their tax attributes after an ownership change would be limited significantly, adversely impacting their after-tax cash flow and valuation.
• Under the section 1374 approach, a loss corporation identified and measured its NUBIG/NUBIL and RBIG/RBIL based on the principles for calculating net recognized built-in gain for the conversion of a C corporation to an S corporation under section 1374 (the “Section 1374 Approach”).
• The 1374 approach generally treats any COD income or bad debt deduction attributable to any pre-change debt as RBIG or RBIL only if such income or deduction item is properly taken into account during the first 12 months of the recognition period.
• As a result, unlike under the 1374 approach, under the 338 approach, built-in gain assets may be treated as generating RBIG even if they are not disposed of at a gain during the recognition period, and deductions for liabilities, in particular contingent liabilities, that exist on the change date may be treated as RBIL.
• 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.
• These adjustments include technical fixes to calculations involving COD income , deductions for contingent liabilities, and cost recovery deductions.

This paragraph provides rules regarding the calculation of a loss corporation’s net unrealized built-in gain or net unrealized built-in loss for purposes of section 382 and the section 382 regulations. It is important to note that any merger or acquisition dissuaded by these proposed regulations would tend to have been economically inefficient not have been undertaken except for the purpose of reducing tax liability. Recall from Part C.1 of this section that the goal of section 382 is to ensure that NOL usage is approximately unaffected when a loss corporation is acquired by a profitable corporation.

The Proposed Section 382 Regulations

The patent is an “amortizable section 197 intangible” as defined in section 197 and has a 15-year amortization period. As of the change date in Year 0, the patent has a remaining amortization period under section 197 of 5 years.

• Note that this general exception to the “accrual” principle is mandated by the applicable statutory language.
• For more details regarding the proposed regulations and their significance, please refer to our prior articles, here and here.
• Accordingly, $30 of the Year 1 cost recovery deduction is recognized built-in loss ($55 allowed and allowable cost recovery deduction, less the $25 cost recovery deduction that would have been allowable if the adjusted basis on the change date equaled the fair market value of the patent).
• 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.

For purposes of this definition, all accounts receivable, other than those that were acquired in the ordinary course of the loss corporation’s business, are treated as items described in section 382. The sum of the fair market value of the assets that the loss corporation owns immediately before the ownership change, reduced, but not below zero, by the amount of nonrecourse liabilities that is secured by such assets immediately before the ownership change. The Treasury Department and the IRS request comments on all aspects of information collection burdens relating to these proposed regulations, including estimates for how much time it would take to comply with the paperwork burdens described earlier for each relevant form and ways for the IRS to minimize the paperwork burden. Proposed revisions to the information collections contained in these proposed regulations will not be finalized until after these regulations take effect and have been approved by OMB under the PRA.

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Notably, the new Irs Proposes New Section 382 Regulations To Further Limit Use Of Tax Losses 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.

In computing RBIG, Section 382 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” traceable to assets with built-in losses a corporation held immediately before an ownership change. In situations where the loss corporation has a net unrealized built-in gain in its assets, the annual limitation may be increased for recognized built-in-gains , where assets with a fair market value greater than tax basis as of the ownership change date are disposed of within five years following the ownership change. Similar rules apply to situations where the loss corporation has a net unrealized built-in loss in its assets (i.e., assets have a fair market value lower than tax basis and any recognized built-in losses are subject to the Sec. 382 limitation). 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. Under the 1374 approach, taxpayers need only record items of income and deductions that they already account for under well-known accrual method of accounting principles.

The 1374 Approach generally treated COD income or bad debt deductions recognized during the first 12 months after the change date as RBIG or RBIL, respectively (and had special rules for COD income excluded under Section 108 and basis reduction arising therefrom). The 338 Approach concluded that COD income attributable to pre-change debt is RBIG in an amount not exceeding the excess of the adjusted issue price of the discharged debt over the fair market value of the debt on the change date. The Proposed Regulations are another factor in a series of changes and circumstances that affect the value of tax assets such as net operating losses for corporations. 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 Proposed Regulations deviate from the 1374 Approach in the Notice by requiring deductible contingent liabilities paid or accrued during the recognition period to be treated as RBIL, using the estimated amount of these liabilities as of the change date reflected in the NUBIG or NUBIL calculation. In essence, the 1374 Approach under the Proposed Regulations incorporates the contingent liability treatment under the Notice’s 338 Approach.

Because a nonrecourse creditor has a claim only on the assets securing the indebtedness, the amount of the impairment at the time of the ownership change is the appropriate measure of built-in COD in the nonrecourse debt. Further, RBIG recognized on nonrecourse debt during the recognition period does not result in an adjustment to NUBIG/NUBIL, because the amount of the impairment to the nonrecourse debt is already built into the initial NUBIG/NUBIL computation with regard to the deemed disposition of assets. The Treasury Department and the IRS welcome public comment on the treatment of COD income on non-recourse debt, including comments on the treatment of accrued but unpaid interest.