Distressed Companies Would Suffer Under Proposed Gain and Losses Regs

October 3, 2019

Department of Treasury
Internal Revenue Service — CC:PA:LPD: PR (REG-125710-18)
Room 5203, Post Office Box 7604
Ben Franklin Station, Washington, DC 20044.

Re: Comments on Proposed Regulations Under Section 382(h)

Dear Ladies & Gentlemen:

The National Bankruptcy Conference ("NBC") is a voluntary, non-partisan, not-for-profit organization composed of approximately 60 of the nation's leading bankruptcy judges, professors and practitioners. It was organized at the request of Congress and has provided advice to Congress on bankruptcy legislation for nearly 80 years. We enclose a Fact Sheet, which provides further information about the NBC.

We write on behalf of the NBC to urge the Department of Treasury (Treasury") and the Internal Revenue Service (the "Service) to modify the Proposed Regulations that it issued on September 9, 2019 (the "Proposed Regulations" or "Regulations") under Section 382(h) of the Internal Revenue Code (the "code). In particular, we urge Treasury and the Service to preserve taxpayers ability to elect the "Section 338 Approach" in calculating the amount of a taxpayer's annual limitation for net operating losses ("NOLs") under Section 382 following an "ownership change."

The perspective of our Conferees on the Proposed Regulations comes from our collective years of experience in working with companies (as advisers, judges, debtor counsel, and creditor counsel) that need to delever and restructure. A fundamental purpose of the federal bankruptcy laws (and also a fundamental purpose of the bankruptcy-specific provisions in the Code (such as Code § 382(l)(6)) is to permit troubled companies to continue as a going concern, to minimize job disruption and job loss, and to strengthen the communities in which troubled companies and their employees work and live. When a troubled company seeks to restructure and recover, the company's tax assets (especially NOLs) are a critical aspect of that recovery. Without tax assets that can be utilized at least in part by the post-reorganization entity, creditors of the troubled company will be less willing to exchange their debt claims for equity, and potential new investors will be less willing to put new capital at risk. We believe that the elimination of the Section 338 Approach will materially restrict a troubled company's utilization of tax assets in a manner not intended by Congress, and we cannot help but believe that the Regulations will make it more difficult and time-consuming for companies to restructure.

By way of background, Section 382 imposes an annual limitation on a corporation's ability to use tax attributes after an "ownership change." Congress adopted Section 382 to avoid trafficking in NOLs, i.e., to prevent profitable companies from acquiring loss corporations in order to access their NOLs. When companies restructure under the federal bankruptcy code, the exchange of debt for equity that invariably occurs almost always results in an ownership change for tax purposes. The bankruptcy fact pattern differs from a "voluntary" transaction where a profitable corporation acquires a loss corporation, in the sense that an ownership change in bankruptcy is usually "involuntary." The existing equity is diluted and existing creditors take control, in a transaction that neither group desired when the debt and equity were issued.

Congress intended that when an ownership change occurs, the acquirer of the loss corporation generally should not be able to offset its income with the NOLs of the loss corporation, except for an amount of NOLs that represent a risk-free return on the loss corporation's assets. But Congress also recognized that a loss corporation's NOLs should be allowed to offset "built-in gain" assets that were owned by the loss corporation before the ownership change, and that the loss corporation should also be able to use its NOLs to offset any of its own income that is "attributable to" the period before the ownership change. See Code § 382(h) & 382(h)(6). Put differently, the rules are intended to ensure that a loss corporation is not compelled to sell its built-in gain assets, and is not compelled to accelerate the recognition of any income from an existing asset, before an ownership change occurs.

For all practical purposes, outside of an actual sale of assets, the Proposed Regulations eliminate the ability to offset pre-change NOLs against post-change income that is attributable to the pre-change period. The Proposed Regulations also represent a significant deviation from historic practice. In Notice 2003-65, 2003-2 C.B. 747, the IRS adopted two different permissible methods for determining the amount of income that a corporation recognizes after an ownership change that is "attributable ton periods before the date of the change. One of those two methods was the Section 338 Approach. The Section 338 Approach essentially allows a loss corporation to determine the amount of its "net unrealized built-in gain" (an important statutory term) based on the hypothetical gain that the loss corporation would realize if it were to sell all of its assets for their fair market value and the buyer were to assume the loss corporation's liabilities (both recourse and nonrecourse). The loss corporation's annual Section 382 limitation amount could then be determined by calculating the increased cost recovery deductions that the hypothetical buyer of the loss corporation would have recognized over the five-year period immediately following the ownership change. The Proposed Regulations completely eliminate the Section 338 Approach, reversing sixteen years of established guidance under Notice 2003-65.

Congress has made several tax law changes in recent years that have had the effect of making restructurings more difficult. In the Tax Cuts and Jobs Act of 2017 (the "2017 Act), Congress repealed the NOL carryback (after nearly 100 years of tax law permitting an NOL carryback), and limited the annual utilization of post-2017 NOL carryforwards to an amount equal to 80% of a corporation's taxable income. Congress implemented these changes primarily as a revenue raiser to permit the lowering of the general federal corporate tax rate from 35% to 21%. While these changes may have been good for healthy companies, they were decidedly negative for troubled companies. The NBC wrote to Congress to express our view that the repeal of the NOL carryback would be harmful to troubled companies. The combination of these anti-NOL provisions enacted by Congress with the Regulations proposal to eliminate the Section 338 Approach (and thereby restrict NOL carrvforwards) will cause a substantial adverse impact on the restructuring of troubled companies.

We find it significant that at the time Congress was deliberating the provisions in the 2017 Act that so directly affected NOLs, the only change that Congress made regarding NOL carryforwards was effectively to reduce the utilization percentage for carryforwards to 80%. This is important because at the time of that Congressional decision, the ability of taxpayers to use the Section 338 Approach was well established. At no point in the legislative debates regarding NOLs was there any discussion of legislatively restricting the Section 338 Approach. To the contrary, we believe that Congress intended that loss corporations and troubled companies would be able to restructure and continue to use their assets as a going concern, as opposed to being forced to liquidate. We believe that this Congressional intent is particularly manifest in the bankruptcy area, where the ownership change for tax purposes is an involuntary transaction that does not involve the deliberate trafficking in NOLs.

The preamble to the Proposed Regulations suggests that the Treasury questioned whether the statutory language of Section 382(h) was broad enough to permit the Section 338 Approach. In our view, the Section 338 Approach is consistent with congressional intent and the statutory language of Section 382(h)(6). Under Section 382(h), a loss corporation may utilize its pre-change NOLs to offset both (i) built-in gains that are actually recognized post-ownership change, and (ii) any income that is recognized after the ownership change but which is attributable to periods before the ownership change. In the case of operating income (as opposed to gains from the sales of assets), it is inherently difficult to determine the precise amount of income that is attributable to pre-change periods. But that is exactly why the Section 338 Approach was so logical. By identifying the increased cost recovery deductions that a buyer of a loss corporation would have recognized if it purchased the loss corporation's assets in a hypothetical sale, the IRS offered a simple, effective means to identify the income attributable to the pre-change period. And from 2003 to 2019, troubled companies consistently used the Section 338 Approach in measuring their post-change annual limitation amounts, without any suggestion or even implication from Congress that this approach was at odds with Congressional intent. Indeed, we are aware of no legislative proposal to limit or modify the Section 338 Approach.

Without the Section 338 Approach, loss corporations are only allowed to utilize their pre-change losses to offset an amount of income equal to the corporation's equity value multiplied by the long-term tax-exempt bond rate (currently less than 2%). In our experience, as interest rates and the long-term tax exempt bond rate have dropped in the last 20 years, the Section 338 Approach has been indispensable in permitting troubled companies to utilize any loss carryforwards at all. In recent years, non-digital retailers have been the most frequent type of company to need restructuring. Retailers are labor intensive industries; candidly, such companies are sometimes unable to restructure at all and must liquidate (see, e.g., Toys r Us, Borders, Circuit City, etc.). When liquidation occurs, there is significant job displacement and community disruption. Without the ability to utilize the Section 338 Approach, the creditors of a struggling retailer may be more likely to prefer a liquidation rather than a reorganization.

Looking back further in time, to the period between 2003 and 2012, virtually every major legacy U.S. air carrier went through a Chapter 11 restructuring (United, Delta, Northwest, US Air, American, etc.). Airlines are labor intensive, and because of the relatively short depreciation period for aircraft, most of the airlines had large NOLs and substantial net unrealized built-in gains, but also had fairly low equity market capitalizations (because the airlines typically retained fairly high levels of secured debt on aircraft). The ability to preserve and utilize NOLs was a material factor in the ability of the airlines to restructure and to consolidate, which no doubt minimized substantial job disruption. Many of our conferees worked on the airline bankruptcies, and the existence of the Section 338 Approach was invaluable to the airline industry stabilization and recovery.

In sum, we urge you to modify the Proposed Regulations to preserve taxpayers' ability to elect the Section 338 Approach in calculating the amount of a taxpayers annual limitation for NOLs under Section 382 following an ownership change. The elimination of the Section 338 Approach would be very negative for distressed and troubled companies. If appropriate, we would welcome an opportunity to discuss the comments in this letter with you.

Very truly yours,

Todd F. Maynes
Chairman, Tax Committee
National Bankruptcy Conference
Fairfax, VA