- IRS Issues Loss Preservation Guidance in the Wake of Financial Rescue Activities - Calling Off Certain of the Section 382 Rules for Some
- October 25, 2008 | Author: Annette M. Ahlers
- Law Firm: Pepper Hamilton LLP - Washington Office
In concert with recent extraordinary efforts by the current administration and Congress to respond to the turmoil in the financial markets, including the Federal Housing Finance Agency (FHFA) takeover over of Fannie Mae and Freddie Mac, the Federal Deposit Insurance Corporation (FDIC) takeover and sale of certain banks either wholesale or in pieces, and the contemplated purchase of distressed loan portfolios from certain financial institutions, the Internal Revenue Service (IRS) and Treasury recently issued interim guidance to minimize certain negative tax consequences that would otherwise result from such actions. To that end, Notices 2008-78, 2008-83 and 2008-84 relax certain limitations on a loss corporation’s ability to utilize its net operating loss carryovers following an ownership change. Notice 2008-78 provides general guidance in applying Section 382(l)(1) for any loss corporation undergoing an ownership change, Notice 2008-83 is specifically targeted to banks, and Notice 2008-84 clarifies Notice 2008-76 and focuses on entities in which the federal government is a shareholder or could be a shareholder through option exercises.1 This article provides an overview of each Notice and its potential implications for loss corporations, but is not intended to be a comprehensive discussion of all issues that may arise in situations to which each of the Notices may apply.
Section 382 — Generally
In general, Section 382 limits a loss corporation’s ability to utilize its net operating losses against taxable income when the loss corporation undergoes an ownership change. An ownership change occurs when the loss corporation’s 5-percent shareholders increase their ownership in the loss corporation by more than 50 percentage points within a three-year period. If such a change has occurred, then the amount of pre-change losses that can be used to offset taxable income in post-change years will be limited. Such limit (Section 382 Limitation) is generally equal to the value of the target corporation at the time of the “ownership change” multiplied by the applicable federal long-term tax-exempt interest rate.
The value of the loss corporation is critical to the overall analysis of the impact of an ownership change because it impacts the calculation of the Section 382 limitation under Section 382(b).2 Section 382(l)(1) provides that the value of the loss corporation may not include capital contributions made to a loss corporation as part of a plan a principal purpose of which is to avoid or increase the limitation under Section 382. That section also creates a presumption that any capital contribution made during the two-year period ending on the change date was made as part of such a plan, except as provided in the regulations. To date, the Treasury has not issued regulations providing exceptions to the statutory presumption.
Although no regulations have been issued, the IRS has recognized exceptions to Section 382(l)(1) in a number of published rulings and guidance based upon the legislative history of that Section.3 For example in Technical Advice Memorandum (TAM) 9332004, (April 30, 1993), the Service stated, “[t]he fact that regulations have yet to be issued under Section 382(l)(1)(B)... will not preclude the [Service] from applying an exception to the two-year rule... if it is appropriate to do so.”
On numerous occasions, including during the prior banking turmoil that resulted from the failure of many savings and loans, the IRS has issued private letter rulings that addressed Section 382(l)(1) issues relevant to banks, savings institutions, and insurance companies in the process of workouts.4 In each of these rulings, the IRS recognized and applied the exception suggested in the legislative history to Section 382(l)(1) for capital contributions made “to continue the basic operations of the corporation’s business” and concluded that for purposes of applying Section 382(l)(1), the capital contributions will not be considered a contribution received by the banking or savings institution or the insurance company as part of a plan a principal purpose of which is to avoid or increase any Section 382 limitation.5
Notice 2007-78 — Changes the Rules
In Notice 2008-78 the IRS indicates that it intends to issue regulations under Section 382(l)(1), and that pending the issuance of further guidance, taxpayers may rely upon the rules in the Notice for ownership changes on or after September 26, 2008.
The most notable rule is that the Notice “turns off” the presumption by providing that notwithstanding Section 382(l)(1)(B), capital contributions will not be presumed to be part of a plan to increase the Section 382 limitation solely as a result of having been made within the two-year period ending on the date of the ownership change. The determination is based upon all the facts and circumstances of the contribution unless excepted from Section 382(l)(1) through one of four safe harbors provided in the Notice. Interestingly, Notice 2008-78 draws upon Treas. Reg. Section 1.355-7 for many of the important defined terms in the safe harbors.6
The safe harbors apply if: (a) the contribution is not made by a controlling shareholder (a holder of 10 percent or more of the loss corporation), no more than 20 percent of the loss corporation’s stock is issued in connection with the contribution, the contribution is not made when there is an agreement, understanding, arrangement or substantial negotiation regarding a transaction that would result in an ownership change, and any ownership change occurs more than six months after the contribution; (b) the contribution is made by a related party, but no more than 10 percent of the loss corporation’s stock is issued in connection with the contribution, or by a non-related party, and in either case there was no agreement, understanding, arrangement or substantial negotiations at the time of the contribution regarding a transaction that would result in an ownership change, and any ownership change occurs more than one year after the contribution; (c) the contribution is made in exchange for stock issued in connection with the performance of services, or acquired by a retirement plan under terms described in Treas. Reg. Section 1.355-7(d)(8) or (9); or (d) the contribution is received on the formation of the loss corporation (without the contribution of built-in loss assets), or is received before the first year that the corporation is a loss corporation.
Thus, while the IRS did not address the more typical fact pattern of capital contributions made to continue basic operations (the primary subject of the PLRs referred to above), they did remove the presumption that a capital contribution within the two-year period ending on the date of the ownership change is automatically considered to have the purpose of increasing the Section 382 limitation, and they provided significant safe harbors for contributions made by non-controlling shareholders or formation transactions. As a result, these rules should eliminate the automatic reduction in value of many loss corporations upon an ownership change, and thus should reduce the pressure on taxpayers, their financial statement auditors, and tax advisors to self-assess very low Section 382 limitations in many routine situations.
Notice 2008-83 — Section 382(h) Now Has Limited Applicability to Banks
IRS Notice 2008-83, issued on September 30, 2008 and effective immediately, provides significant relief from the impact of corporate federal income tax rules that arise in a change in ownership of a bank. Specifically, the notice generally provides that any deduction properly allowed to a bank after an ownership change with respect to losses on loans or bad debts (including any deduction for a reasonable addition to a reserve for bad debts) will not be subject to limitation under Section 382(h).
As part of the consequences of taking an ownership change into account, and determining what losses of the acquired corporation will be limited, an acquired corporation must determine whether it is in a “built-in gain” or “built-in loss” position at the time of the ownership change. Section 382(h) of the Code provides rules for determining whether or not a corporation undergoing an ownership change has a net unrealized built-in gain or net unrealized built-in loss. To make this determination, the acquired corporation generally must compare the tax basis of its assets to the value of its assets. If the tax basis of its assets is higher than the value of its assets, and certain thresholds are met, the acquired corporation is considered to be in a net unrealized built-in loss position (NUBIL).
The main consequence of being considered in a NUBIL position is that if some of the unrecognized built-in losses are recognized by the corporation during the five-year period after the ownership change, all or a portion of those losses may be considered “pre-change” losses subject to the Section 382 limitation. The normal application of the rules to the banking industry would limit the ability of an acquiring bank to use certain built-in losses of an acquired bank. However, the Notice provides banks with an exception for losses on loans or bad debts.
The case most likely contemplated by Treasury and the IRS is where a consolidated group of which Bank A (a profitable bank) is the common parent acquires Bank B (a bank in a NUBIL position with significant bad loans on its books) in a transaction resulting in an ownership change of Bank B, and shortly after the acquisition, Bank B disposes of many of its bad loans for an amount less than its tax basis in such loans. Such disposition would generally result in a loss for federal income tax purposes. Under the normal application of Section 382(h), such loss would be subject to the Section 382 limitation that resulted from the ownership change. Under Notice 2008-83, however, Treasury and IRS will not impose the typical rule of Section 382(h), but will instead treat the loss recognized from the disposition of the bad loans as an event that created a post-change loss that is not subject to the Section 382 limitation, thereby allowing the Bank A consolidated group to offset its income by this loss and reduce its consolidated tax liability.
While this Notice will provide significant relief from the impact of Section 382 with respect to losses generated from the disposition of loans and bad debts, it does not eliminate the Section 382 rules with respect to tax losses already recognized by acquired banks prior to an ownership change. Thus, the impact of Section 382 still needs to be considered in connection with the acquisition of a bank.
Notices 2008-76 and 2008-84 — If the Government Is Your Owner, Testing Dates Are Ignored
Notice 2008-76 provides that the IRS and Treasury will issue regulations under Section 382 that address the application of Section 382 in the case of certain acquisitions by the U.S. government of stock or options of Fannie Mae or Freddie Mac pursuant to the Housing and Economic Recovery Act of 2008. The Notice provides that once the government acquires stock or an option to acquire stock in Fannie Mae or Freddie Mac, subsequent equity events effecting such corporations will not be treated as testing dates under Section 382. Thus, the Notice effectively prevents any equity events of Fannie Mae and Freddie Mac that occur on or after the acquisitions of stock or options by the U.S. government from creating new Section 382 limitations applicable to such corporations.
Notice 2008-84, expands upon Notice 2008-76 and provides that the IRS and Treasury will issue regulations under Section 382 that address the application of Section 382 in the case of certain acquisitions where the government becomes a direct or indirect owner of a “more-than-50-percent interest” in a loss corporation. For this purpose, a more-than-50-percent interest is defines as stock of the loss corporation possessing more than 50 percent of the total combined voting power of all classes of stock entitled to vote, or an option to acquire such stock. The Notice provides that if the government meets the stock ownership thresholds, or holds an option that would entitle them to receive an amount of stock to meet the more than 50 percent threshold, then equity events effecting that loss corporation will not be treated as testing dates under Section 382. These Notices provide significant benefits to such loss corporations by effectively preventing any equity events of such loss corporations that occur while the U.S. government owns a more-than-50-percent interest from creating new Section 382 limitations applicable to such corporations.
The IRS and Treasury have significantly lifted the burden of a Section 382 ownership change for selected loss corporations in particular (banks and companies owned by the U.S. government), and to loss corporations in general (removing the presumption in 382(l)(1)). This guidance will create fewer impediments for loss corporations who ultimately become profitable or are acquired by profitable companies to use the losses generated in prior years to offset income on a going-forward basis, or to provide an immediate benefit by allowing a carryback of losses to profitable years.
1 All Code Section references are to the Internal Revenue Code, as amended, unless otherwise noted.
2 Section 382 was originally enacted to prevent the trafficking of net operating losses by corporations. The Section 382 limitation is a formulaic calculation that is basically equal to the product of the value of the acquired corporation and the long-term tax-exempt rate. The long-term tax-exempt rate is published on a monthly basis by the Internal Revenue Service and can be found in IRS publications, including the Internal Revenue Bulletin. Taxpayers are required to use the long-term tax-exempt rate for the month in which the ownership change occurs when calculating their Section 382 limitation for any ownership change.
3 See H.R. 3838, 99th Cong., 1st Sess. (1985); H.R. Rep. No. 426, 99th Cong., 1st Sess., at 269 (1985); H.R. 3838, 99th Cong., 2nd Sess. Section 621 (1986); S. Rep. 313, 99th Cong., 2nd Sess., at 244 (1986); H.R. Rep. No. 841, 99th Cong. 2d. Session 189 (1986). See also Joint Committee on Taxation, 99th Cong., General Explanation of the Tax Reform Act of 1986 318-319 (1987).
4 See, e.g., PLR 9508035 (November 30, 1994); PLR 9541019 (July 10, 1995); PLR 9835027, (May 29, 1998); PLR 200730003 (April 27, 2007).
5 For similar results, see PLR 9630038, (May 1, 1996), where the Service excluded from the presumptions of 382(l)(1) a capital contribution made to fund research and development costs, working capital to support sales of the one commercial line, and for general corporate purposes, and PLR 9706014, (November 13, 1996), where the taxpayer received two capital contributions from its shareholder, and the Service concluded that the capital contributions made to fund basic operations and research and development activities were not excluded from the value of the loss corporation in calculating the Section 382 limitation.
6 Treas. Reg. Section 1.355-7 provides rules to assist taxpayers in determining whether or not an acquisition of stock of a corporation involved in a Section 355 distribution is part of a plan or arrangement to cause the owners of the stock of the relevant corporation to decrease their ownership interest below 50 percent after a distribution which otherwise qualifies as tax-free under Section 355.