Capital Infusion Doesn't Limit Use of Company's Pre-Change Losses

LEGEND

[5] In * * *, Company had a net operating loss of d that was carried back to * * * and * * *. In * * *, Company had taxable income of e. In * * *, Company had a net operating loss of f that was carried back to * * *. For the * * * taxable year Company's return showed taxable income of g. For each of the years * * * through * * *, Company had negative cash flows from both investing activities and financing activities.

[6] On Date 2, Purchaser Group entered into an agreement of plan of merger with Company under which Company would be acquired by Purchasing Group. The transaction was contingent upon the Purchasing Group's successfully completing a cash tender offer for Company's outstanding common stock and publicly held debt. The purchase of the Company debt was contingent on the purchase of Company stock.

[7] On Date 3, the merger was transacted. On that date, Company was not insolvent. On the day before Date 3, Purchaser Group acquired the publicly held debt of Company. This debt was purchased at a discount from face, and the debt remained outstanding after the merger. As a result of Purchaser Group's acquisition of Company's debt and stock, the Revenue Agent proposes to include in Company's income in Purchaser Group C.O.D. income of x.

[8] For the short taxable year ending on Date 3, Company had a net operating loss of i. Company also had j excess foreign tax credits. Purchaser Group elected Date 2 as the change date (within the meaning of section 382(j)). As a result, Company had total pre- change losses of y carried over into the Date 2 Post-Change Period.

LAW

[9] Section 382(a) provides that the amount of taxable income of any new loss corporation for any post-change year which may be offset by pre-change losses shall not exceed the section 382 limitation for such year.

[10] A concept generally underlying section 382 is that the new loss corporation should not to be able to use its pre-change loss at a rate faster than that at which the old loss corporation could have used it. In determining this ceiling on the rate of use of pre-change loss, section 382 prescribes an objective rate of return for the loss corporation, i.e., the section 382 limitation, which is the value of the loss corporation's stock on the change date, multiplied by the long-term tax exempt rate. Sections 382(b)(1) and (e)(1). Concerned that the loss corporation's value could be inflated by means of capital contributions, Congress enacted section 382(1)(1).

[11] Section 382(l)(1)(A) provides that any capital contribution to the old loss corporation is not taken into account for purposes of section 382 if it is part of a plan a principal purpose of which is to avoid or increase any limitation under this section. Section 382(l)(1)(B) provides that any capital contribution made within the two-year period ending on the change date shall, except as provided in regulations, be treated as part of such a plan ("two-year rule"). No regulations have been issued under this section.

[12] The Conference Committee report for the Tax Reform Act of 1986 states that, "except as provided in regulations, a capital contribution made during the two-year period ending on the change date is irrebuttably presumed to be part of a plan to avoid the limitations." H.R. Rep. No. 841, 99th Cong., 2nd Sess., at II-189 (1986) ("Conference Report").

[13] The Conference Report also indicates that Congress contemplated that regulations would provide certain exceptions to the two-year rule. The Conference Report says:

[14] Section 108(e)(4) and Treas. Reg. section 1.108-2(a) provide a trigger of C.O.D. income when a holder acquires a related debtor's debt. Treas. Reg. section 1.108-2(a) provides that these related party discharge of indebtedness rules apply not only if the indebtedness is acquired directly by a person related to the debtor in a direct acquisition, but also if a holder of indebtedness becomes related to the debtor in an indirect acquisition. For purposes of Treas. Reg. section 1.108-2(a), Treas. Reg. section 1.108-2(c) provides that an indirect acquisition is a transaction in which a holder of outstanding indebtedness becomes related to the debtor, if the holder acquired the indebtedness in anticipation of becoming related to the debtor.

[15] Section 382(h)(i)(A) provides that if the loss corporation has a net unrealized built-in gain, the section 382 limitation for a taxable year within the five year recognition period defined under section 382(h)(7)(A) shall be increased by recognized built-in gains for the taxable year.

[16] Section 382(h)(7)(A) provides that the term "recognition period" means, with respect to any ownership change, the 5-year period beginning on the change date.

[17] Section 382(h)(3) provides, in part, that the term "net unrealized built-in gain means, with respect to any old loss corporation, the amount by which --

[21] The facts indicate that Purchaser Group's purchase of Company debt was contingent on Purchaser Group's purchase of Company stock. As a result, we believe Purchaser Group acquired Company debt "in anticipation of becoming related to the debtor" (within the meaning of Treas. Reg. section 1.108-2(c)). Consequently, we believe Company recognized C.O.D. income on Date 3 when Purchaser Group, which had just acquired Company's debt, acquired Company's stock. Additionally, we agree with the Revenue Agent that this C.O.D. income was recognized by Company in Purchasing Group. See section 108(e)(4); Treas. Reg sections 1.108-2(a) & (c).

[22] We understand that on Date 2 Company had a net unrealized built-in gain (within the meaning of section 382(h)(1)(A)). As a result, the C.O.D. income that Company recognized on Date 3 was built-in income (see section 382(h)(6)) that increased Company's section 382 limitation for the Date 2 Post-Change Period. See section 382(h)(1)(A). The facts also indicate that Company's section 382 limitation for the Date 2 Post-Change Period increased by x as a result of the inclusion of the C.O.D. income; whereas, the total amount of Company's pre-change losses carried over into the Date 2 Post-Change Period was only y. Therefore, even IF the two year rule of section 382(l)(1) applies to reduce Company's section 382 limitation for this Date 2 Post-Change Period, section 382 does not effectively limit the use of Company's pre-change losses in the Date 2 Post-Change Period.

[24] If you have any further questions concerning this field service advice, please contact Mary E. Goode at (202) 622-7930.

² If you determine that you also need assistance on whether the two year rule of section 382(l)(1) applies to reduce Company's section 382 limitation for any other Date 2 post-change period (other than the Date 2 Post-Change Period addressed in this advice), you should contact our office and we will determine whether this section 382(l)(1) issue is more appropriately the issue of a TAM or a Field Service Advice.