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Loss Carryback Revival Could Prompt M&A Renegotiations

Posted on Apr. 22, 2020

The net operating loss carryback provision in the coronavirus relief package could send dealmakers in corporate buyouts back to the negotiating table.

That’s because corporations generally haven’t contemplated potential refunds from NOL carrybacks in stock acquisitions since the Tax Cuts and Jobs Act eliminated the two-year carryback provision, according to practitioners who spoke with Tax Notes.

Before the TCJA, refunds related to transaction-year NOL carrybacks were negotiated in structuring some mergers and acquisitions, and often “sellers would successfully argue that they were entitled to those pre-closing tax refunds from the carrybacks,” Todd Reinstein of Pepper Hamilton LLP said.

The acquiring companies focused on preserving the target company’s NOLs to the extent possible to offset future taxable income, subject to some limitations, such as those under section 382 that restrict the use of losses following an ownership change of a loss corporation.

David W. Zimmerman of Miller & Chevalier Chtd. said that in pre-TCJA transactions involving a consolidated group’s acquisition of a member of another group, the parties might have agreed — depending on the deal structure and other facts and circumstances of the transaction — that the acquiring group would elect to waive NOL carrybacks for losses the target generates after joining the group.

That carryback waiver election under reg. section 1.1502-21, which references section 172(b)(3), prevents the acquiring group from carrying back any of the target corporation’s losses to consolidated return years of the selling group when the target was a member of the selling group, Zimmerman added.

But the TCJA changed the landscape for valuing and negotiating NOLs in stock acquisitions by amending section 172 to, in most circumstances, eliminate NOL carrybacks, limit NOLs to 80 percent of taxable income, and allow carryforwards indefinitely.

Thus, beginning in 2018, sellers with transaction-year losses could only negotiate with the buyer for payment for the use of the NOLs carried forward, Reinstein said.

Buyers became less enamored with newly generated NOLs because they were worth less under the corporate rate reduction from 35 percent to 21 percent and the annual NOL limit.

Fast-forward two years, and suddenly a pandemic crisis triggers a $2 trillion-plus stimulus package — the Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136) — that, among other things, pulled a five-year loss carryback provision from the playbooks used during past economic downturns, albeit without some of the twists.

More Prominent Change

Before 2018, target losses could be carried back two years, so the parties generally specified in the agreement whether the acquired corporation’s losses could be carried back to the selling group’s consolidated return years, Zimmerman said. The only surprise with the 2002 and 2009 economic relief legislative packages was that the losses could be carried back five years instead of two, he said. 

Nevertheless, companies had to contend with the economics of the extended carryback period that hadn’t been accounted for in M&A deals, according to Zimmerman. And in some cases, the parties executed post-deal NOL agreements to share the additional refunds that could be generated from the five-year carryback period, he said.

With the CARES Act, the surprise is that all the target’s post-2017 losses through 2020 can be carried back at all, let alone five years, and the parties might not have prevented loss carrybacks in the purchase agreements like they generally did before the TCJA, Zimmerman said.

What the temporary five-year carryback provision means under existing deal agreements is a “hot topic right now,” according to Keith Kechik of Alvarez & Marsal Taxand.

“The first wave of looking under the rocks on prior deals” will likely be the pre-acquisition losses, Kechik said.

 Who Gets the Benefit?

Eric Solomon of Steptoe and Johnson LLP described a scenario in which a consolidated group acquires a member of another consolidated group on January 1, 2020. The target corporation has a share of a 2019 consolidated NOL (CNOL) attributable to it that it carries into the acquiring consolidated group.

In that case, the buyer acquired the target with an NOL that can be carried forward subject to the section 382 rules and the TCJA’s 80 percent limitation on use, Solomon said.

But the CARES Act changed the rules and the selling group presumably could carry back the pre-acquisition loss — which it couldn’t do when the agreement was executed — and file a refund claim, Solomon said.

Whether the seller can take that action and what the buyer can do depends on the terms of the purchase agreement, he said.

Kechik explained that for pre-acquisition NOLs related to transaction expenses, such as compensation deductions, the seller generally tries to “harvest those benefits by essentially having the buyer write them a check” as the NOL is used to offset future income.

Some deals also have sunset provisions such that the seller won’t receive the benefit of the deductions from the transaction expenses if the buyer can’t use the losses within a specified time, such as two, three, or four years, Kechik said.

If a deal closed December 31, 2019, for example, that resulted in a transaction-related loss being transferred to the buying group for which it compensates the seller as the NOL is used against future income, “I’m sure there’s going to be conversations about carrying that net operating loss back” if the target company has taxable income to offset during the five-year carryback period, Kechik said.

The seller will likely suggest that rather than the buyer carrying the NOL forward to future years, the seller would carry back the loss, accessing the cash earlier and perhaps obtaining more cash if carried back to a 35 percent tax rate year.

“I think if I were a buyer, I would be willing to accommodate [the seller] on that, because I wasn’t getting the benefit of that NOL anyway because I had to pay [the seller] the benefit as I used it prospectively,” Kechik said.

Post-Acquisition NOLs

NOLs generated on the buyer’s watch after acquiring the target corporation represent a different situation, Kechik said, noting that the purchase agreement typically provides language that governs the ability of a buying group to carry back NOLs to the selling group’s pre-acquisition consolidated return years, Kechik said.

“Counsel would have to review the provisions, and if there are any restrictions, I would imagine a dialogue would take place amongst the parties,” he said.

Solomon suggested that if the purchasing group acquired the target corporation on January 1, 2020, and couldn’t use 2020 losses attributable to that entity — perhaps because the group has an overall loss in the current year — it might want to waive a carryback and carry the loss forward so the parent of the selling group doesn’t get to amend its return and get the benefit of the target’s loss, Solomon said.

However, a loss carryback to pre-2018 years yields a benefit at a 35 percent rate and can be immediate, compared with a loss carryforward that’s at a 21 percent rate and generates a refund only when there’s future taxable income to offset, Solomon said.

Solomon said that under the right conditions, the acquiring group “might consider approaching the parent of the selling group to negotiate forgoing the acquiring company’s carryback waiver and sharing a carryback refund at the 35 percent rate.”

Again, it would be important to review the provisions of the purchase agreement, Solomon said.

Carryback Waiver Options

Under the consolidated return regs, when a group acquires a member from another consolidated group, the NOL carryovers attributable to the target corporation are first carried to the old parent corporation’s consolidated return year, subject to reductions and limitations. The losses that are neither absorbed by the group nor subject to limitations may be carried to the target’s first separate return year or, if applicable, to the consolidated return year of its new group.

However, an acquiring group may make an irrevocable election under reg. section 1.1502-21(b)(3)(ii)(B) to waive all CNOLs attributable to the target corporation for the portion of the carryback period during which it was a member of another consolidated group.

That election, referred to as a split waiver, applies to all the losses of a specific target corporation that would otherwise be subject to a carryback to a former group under section 172. The election must be made in a separate statement filed with the acquiring consolidated group’s original income tax return for the year the corporation became a member.

Under a different rule (reg. section 1.1502-21(b)(3)(i)), consolidated groups may make an annual irrevocable election to waive the entire carryback period for a CNOL for any return year. The annual election applicable to the entire group can’t be made separately for any member and must be made in a separate statement filed with the group’s consolidated tax return for the year in which the loss arises.

Thus, if an acquiring group didn’t make the one-time split-waiver election for a newly acquired target corporation with its consolidated return for the year it acquired the corporation, then absent any contractual agreement, it could still make the annual waiver election for any year of the group for its entire CNOL carryback, Andrew J. Dubroff of EY explained.

But that all-or-nothing election for a group to waive the carrybacks for the entire group comes at the price of forgoing other portions of its losses that it could otherwise carry back to its own prior years under the CARES Act, Dubroff told Tax Notes.

‘Dust Off’ Expired Regs

Dubroff noted that Treasury and the IRS addressed a similar dilemma in response to the 2009 stimulus legislation that allowed corporations to extend the loss carryback period from two to five years for either their 2008 or 2009 NOL.

The government issued now-expired temporary regulations under reg. section 1.1502-21T(b)(3)(ii)(C) that provided a separate set of split-waiver election options for consolidated groups, Dubroff said.

Under those rules, if a consolidated group hadn’t made the one-time split-waiver election for a newly acquired target corporation, the group could elect to waive carrybacks by new members to their prior consolidated groups on a year-by-year NOL basis rather than having to make the one-time waiver election when they acquired members, Dubroff explained.

Further, the acquiring group could waive the carryback period for the 2008 or 2009 extended carryback NOL, for the entire portion of the five-year carryback during which a new member was a member of a prior group, or just the portion of the extended three years in which it was a member of a prior group, Dubroff said.

According to Dubroff, Treasury and the IRS wanted to provide more flexibility for split-waiver elections so that taxpayers could decide how those NOLs would be applied and enhance their liquidity through efficient use of the enhanced NOL carryback potential.

“I am sure they are going to dust off the [reg. section 1.1502-21T(b)(3)(ii)(C)] rule and use it as a model for the CARES Act adoption of the five-year carrybacks for NOLs in 2008 through 2010,” Dubroff said, noting that the now-expired temporary regs are specific to the financial crisis years and extending NOLs from two to five years.

Like Dubroff, several tax professionals with KPMG LLP recommended in an April 2 letter to the editor that, among other things, Treasury and the IRS issue guidance similar to the 2010 temporary regs that would allow groups “to make an ‘untimely’ split-waiver election for CNOLs arising in tax years beginning after December 31, 2017, but before January 1, 2021.”

Quick Refund Quirk

Treasury and the IRS should also address ambiguity in Notice 2020-26, 2020-18 IRB 1, issued April 9, concerning how the guidance for filing tentative refunds applies to consolidated groups for their CNOLs, according to Dubroff.

But “time is of the essence” because if the filing procedures apply to groups, as is hoped, that would mean a June 30 filing deadline for 2018 calendar-year CNOLs, Dubroff said.

Notice 2020-26 granted a six-month extension to file applications for a tentative carryback adjustment under section 6411 for NOLs that arose in tax years that began in calendar year 2018 and that ended on or before June 30, 2019. Corporations would file Form 1139, “Corporation Application for Tentative Refund,” which the IRS is accepting via fax.

Dubroff pointed out, however, that the notice “literally applies only to corporations and NOLs,” which is unlike the procedures (Rev. Proc. 2020-24, 2020-17 IRB 1), also issued April 9, for making an irrevocable election to waive the NOL carryback period. The revenue procedure “expressly [extends] that guidance to consolidated groups and their CNOLs,” he said.

Hopefully, any new guidance that the government is developing “will not only clarify the availability of split-waiver elections, but also the filing procedures for consolidated group tentative refund claims,” Dubroff said.

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