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‘Turbocharged’ Financing Structures Could Boost NOL Benefits

Posted on June 9, 2020

The business challenges inherent in the current economic environment coupled with the coronavirus stimulus relief package have spurred consideration of alternative financing structures, but time is of the essence.

“There’s a number of unusual factors, obviously, that are going on right now, and they are converging in a way that presents some [tax planning] opportunities,” David S. Peck of Vinson & Elkins LLP said during his firm’s June 4 webinar.

Some companies have “maxed out their traditional borrowing sources and are looking to alternative or creative financing,” while alternative lenders are exploring creative ways to deploy excess funds, Peck said.

Peck also pointed out that corporate tax rates are relatively low, with the possibility of future increases, and the Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136) provides rate arbitrage opportunities for a limited time, particularly for companies with tax attributes that could be monetized by carrying back a loss incurred in a 21 percent tax rate year to one in which the rate was 35 percent.

The confluence of those events has prompted questions concerning, for example, what kinds of transactions a corporation could engage in that would give it a tax loss in 2020 — but not a real economic loss — that it could carry back and “reverse with income in subsequent years, when at least under the current rates, the income would be taxed at the lower rate, allowing for that investment to be partially subsidized through the rate arbitrage,” Peck said.

According to Gary R. Huffman, also of Vinson & Elkins, the current economic environment has spawned “a great need for liquidity . . . often in the form of a nontraditional financing structure” that can be “turbocharged by the combination of the [Tax Cuts and Jobs Act] and the CARES Act.”

The TCJA amended section 168(k) to allow taxpayers to write off the asset basis with 100 percent bonus depreciation for qualifying new assets and newly acquired used assets for property acquired and placed in service between September 27, 2017, and January 1, 2023.

The CARES Act modified section 172 to address liquidity issues arising from the COVID-19 pandemic by, among other things, allowing companies to carry back losses arising in tax years from 2018 through 2020 for up to five years before the year of the loss.

Sharing the Benefit

A sale-leaseback transaction is one example of an alternative financing structure in which buyers and sellers could mutually benefit from the 14 percent tax rate arbitrage provided by the CARES Act, Huffman said.

In that transaction, the sellers or lessees get the liquidity they need from the sale of property at its fair market value, recognize taxable gain or loss on the transaction, and later get a deduction for their rent payments, Huffman said. He noted that because companies seeking liquidity are often generating losses, the possibility that the transaction might generate a gain “is probably not a deterrent to engage in this kind of financing structure.” 

Huffman cautioned that the financial accounting treatment for companies that are SEC registrants, or otherwise must provide audited financial statements, can vary, so those organizations must confirm with their accountants whether the sale-leaseback transaction would result in debt or a debtlike liability on their balance sheet. “But there are ways to manage these transactions in which that’s not the accounting result,” he added.

The interesting aspect of the traditional sale-leaseback transaction right now occurs from the buyer or lessor perspective when the CARES Act provision is coupled with the immediate expensing provision under section 168(k), Huffman said. 

“When the buyer acquires [section] 168(k) eligible property, [it] is entitled to take 100 percent bonus depreciation in 2020 with respect to the acquisition of the property, and that 100 percent bonus deduction may either create or enhance a net operating loss that the buyer could then carry back to pre-TCJA years” and get a refund at a 35 percent tax rate, Huffman said. “But as the buyer/lessor receives rent payments in the future from the lessee, those rent payments will . . . be taxed at 21 percent,” absent any rate changes, he added. 

That 14 percent rate arbitrage “might provide the opportunity to split some of that benefit in the form of a lower financing cost for the seller/lessee,” Huffman said.

Buyers or lessors should also confirm the accounting treatment of the transaction if they are required to produce audited financial statements, according to Huffman.

For the sale-lease transaction to work from a tax perspective, it’s crucial that the “buyer be treated as acquiring tax ownership of the property . . . and not be treated as simply providing debt financing to the seller/lessee,” Huffman warned. 

Huffman pointed to Rev. Proc. 2001-28, 2001-1 C.B. 1156, for the fundamental principles for determining whether the buyer or lessor in the sale-leaseback transaction would be treated as the tax owner, specifically noting that the buyer must bear some risk regarding the property’s residual value at the end of the lease term. 

Other requirements under Rev. Proc. 2001-28 — the IRS’s guidelines for advance rulings on leveraged lease transactions — include that the lessor must make an initial “minimum unconditional ‘at risk’ investment” that’s at least 20 percent of the property’s cost, and maintain that investment level throughout the lease term.

Drilling for Oil

The financing of oil and gas drilling is another area in which similar principles could “create attractive financing opportunities in which the benefit of the rate arbitrage might be shared between the investor and the person obtaining the liquidity,” Huffman said. 

If an oil and gas company has attractive drilling prospects but doesn’t have the liquidity or budget to drill the wells, it could consider creating a tax partnership with an investor, to which it would contribute several drill sites and to which the investor would contribute money for the drilling, Huffman suggested. 

Under section 263(c) — which allows a taxpayer to elect expensing rather than capitalizing intangible drilling and development costs — the tax partnership would allocate 100 percent of its deductions for those costs back to the investor, Huffman explained. And like in the sale-leaseback transaction, the investor has an immediate deduction that might create or enhance an NOL that could be carried back to a pre-TCJA year, he added. 

The oil and gas company would receive “out-of-budget cash to drill attractive wells” without recognizing a gain or loss unless it extracts some cash upfront, Huffman said. 

Peck said there are “undoubtedly other transactions that generate losses where [the rate] arbitrage could be used,” but he pointed out that these transactions — the sale-leaseback and oil and drilling financing — require immediate attention because the window is rapidly closing. 

Because the NOL carryback provision doesn't extend beyond 2020, transactions being considered should be those that don’t “require a tremendous amount of diligence,” Peck said. 

The sale-leaseback and oil and drilling financing are “not that unusual and relatively low risk, or can be,” which means they could get done in the second half of the year, Peck added. 

Tapping Foreign Collateral

U.S.-based multinational corporations with fully collateralized domestic assets could consider leveraging their foreign assets as collateral for additional financing if they can navigate uncertainties inherent in complex tax rules, according to Peck

Mary Alexander of Vinson & Elkins pointed out that “multinational groups typically do not pledge their interest in [controlled foreign corporations] or have their CFCs guarantee their U.S. loans to avoid paying U.S. income tax on the CFC’s undistributed earnings” under section 956

That provision treats a CFC’s investment of earnings in U.S. property as gross income that should be included by U.S. shareholders.

In the borrowing context, an investment in U.S. property includes a U.S. borrower’s pledge of two-thirds or more of the voting power of a CFC, a CFC’s guarantee of the payment obligation, or a CFC’s grant of a security interest in its assets to the lender to secure the obligation, Alexander explained. 

Alexander pointed out that section 956 triggers a deemed dividend that’s not eligible for the section 245A 100 percent dividends received deduction for the foreign-sourced component. However, she noted that the 2019 final regulations (T.D. 9859) “reduce the 956 inclusion by the section 245A deduction that would hypothetically be allowed if the 956 inclusion amount were an actual dividend.” 

Because collateral packages in the traditional financing market excluded guarantees from CFCs and limited pledges in CFC stock to 65 percent of voting stock, some U.S. borrowers have substantial assets that aren’t being used for collateral to support additional borrowings but could be without adverse tax consequences, according to Alexander

Some private equity firms are considering whether those assets are available to support financing without tax consequences, but they must navigate “the complexities of [section] 245A that are layered into the 956 analysis . . . through the final regulations,” Alexander said. 

Peck agreed, saying that for multinationals with foreign subsidiaries not currently providing credit support, determining the tax consequences for providing a guarantee or principal is “extremely complicated [and] there’s some uncertainty.”

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