Menu
Tax Notes logo

Firm Targets Flaws in Proposed Regs on Built-In Gain and Loss

OCT. 17, 2019

Firm Targets Flaws in Proposed Regs on Built-In Gain and Loss

DATED OCT. 17, 2019
DOCUMENT ATTRIBUTES

October 17, 2019

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) Related to Built-In Gain and Loss

Dear Sir or Madam:

We appreciate the opportunity to comment on the Notice of Proposed Rulemaking, Regulations Under Section 382(h) Related to Built-In Gain and Loss, published in the Federal Register on September 10, 2019 (the “Proposed Regulations”).1 We respectfully submit that the “Section 338 approach” to calculating built-in gains should be included in the final regulations. As we will demonstrate, in many cases the elimination of the Section 338 approach adopted in Notice 2003-65, 2003-2 C.B. 747 will distort economic income, and undermine the “neutrality principle” underlying Section 382(h).

These negative effects will have real world consequences by creating business inefficiencies. When considering the effect of eliminating the Section 338 approach, the preamble to the Proposed Regulations appears to focus primarily on corporate-to-corporate mergers or acquisitions in which a target corporation's losses may potentially be used to shelter taxable income of the acquirer. The preamble to the Proposed Regulations refers to the proposed elimination of the “Section 338 approach” as only dissuading mergers or acquisitions that are “economically inefficient” and that would “not have been undertaken except for the purpose of reducing tax liability.” This is simply not correct. The Proposed Regulations will negatively impact a large number of otherwise “economically efficient” business transactions that do not involve such a corporate-to-corporate merger or acquisition and are not “for the purpose of reducing tax liability,” as discussed in more detail below. In particular, the approach of the Proposed Regulations will undermine the “neutrality” intended by Congress in two types of typical market transactions: (1) when a public corporation undergoes an ownership change, and (2) when a financial sponsor acquires a loss corporation as a portfolio investment.

Background on Section 382(h) and Neutrality Principle

The limitations imposed by Section 382 were generally intended to apply when a target is acquired in order for its losses to be used to shelter taxable income of the acquirer, as indicated in the 1986 Joint Committee Explanation:

The primary purpose of the special limitations is the preservation of the integrity of the carryover provisions.2 The carryover provisions perform a needed averaging function by reducing the distortions caused by the annual accounting system. If, on the other hand, carryovers can be transferred in a way that permits a loss to offset unrelated income, no legitimate averaging function is performed.3

Congress also recognized that too strict an approach could create inefficiencies and distort income:

A limitation based strictly on ownership would create a tax bias against sales of corporate businesses, and could prevent sales that would increase economic efficiency. For example, if a prospective buyer could increase the income from a corporate business to a moderate extent, but not enough to overcome the loss of all carryovers, no sale would take place because the business would be worth more to the less-efficient current owner than the prospective buyer would reasonably pay. A strict ownership limitation also would distort the measurement of taxable income generated by capital assets purchased before the corporation was acquired, if the tax deductions for capital costs economically allocable to post-acquisition years were accelerated into pre-acquisition years, creating carryovers that would be lost as a result of the acquisition.4

Consistent with the above, Congress recognized that a “neutrality principle” should apply by adopting Section 382(h). Under this neutrality principle, the Section 382 limitation should not apply to losses that offset built-in gain because the corporation's losses could have offset such gain if the gain had been recognized prior to the ownership change.

Congress was concerned that Section 382 would create economic distortions where net operating losses (“NOLs”) that a company created were not available to offset its own income following an acquisition. The 1986 Joint Committee Explanation makes this clear.

The Act also provides relief for loss corporations with built-in gain assets. Built-in gains are often the product of special tax provisions that accelerate deductions or defer income (e.g., accelerated depreciation or installment sales reporting). Absent a special rule, the use of NOL carryforwards to offset built-in gains recognized after an acquisition would be limited, even though the carryforwards would have been fully available to offset such gains had the gains been recognized before the change in ownership occurred. . . .5

If there is net unrealized built-in gain (“NUBIG”), the Section 382 limitation is increased by the amount of recognized built-in gains (“RBIG”) during the five-year period following the ownership change. Conversely, if there is net unrealized built-in loss, the Section 382 limitation is applied to recognized built-in losses (“RBIL”) during the recognition period.

Congress explicitly chose to treat certain items of income and deductions as RBIG and RBIL. Under Section 382(h)(6), RBIG includes “[a]ny item of income which is properly taken into account during the recognition period but which is attributable to periods before the change date,” with the NUBIG adjusted for such deemed amounts of RBIG.6 Income can be treated as RBIG under this rule even if it did not accrue prior to the change of control.7 Similarly, RBIL includes amortization deductions to the extent the basis in an asset exceeds fair market value on the change of control date.8

The preamble to the Proposed Regulations acknowledges the application of the neutrality principle. According to the preamble, “[s]ection 382 attempts to ensure that the NOLs of the loss corporation can be used to the same extent whether or not the loss corporation is acquired by another corporation. . . .”9 The preamble states that the Proposed Regulations are designed to ensure that the rules “treat built-in gains and losses that are recognized after the ownership change the same as if they had been recognized before the ownership change.”10 According to the preamble, the Section 382(h)(6) rules are

intended to preserve neutrality between pre- and post-change date transactions. Income items recognized prior to the change date may have been freely offset with pre-change NOLs; thus, if those same income items were recognized after the change date, the neutrality principle requires that pre-change NOLs be allowed to freely offset it. RBIG treatment accomplishes this effect.11

Section 382 potentially violates the neutrality principle when a corporation undergoes a change of control but there is no corporate acquisition, such as a change of control of a publicly traded corporation or acquisition of a loss corporation by a partnership.12 The Section 338 approach embraced by Notice 2003-65 helps to ameliorate the impact of this fundamental violation of neutrality by increasing the amount of pre-change income and gain that can be offset with unlimited pre-change NOLs. The 1986 Joint Committee Explanation makes clear that this was Congress's intent.

The Neutrality Principle Requires the Section 338 Approach

By eliminating the Section 338 approach, the Proposed Regulations violate the principle of neutrality (1) when a public corporation undergoes an ownership change, and (2) when a financial sponsor acquires a loss company as a portfolio investment. In both circumstances, without the Section 338 approach, whether an income item can be offset with pre-change NOLs turns solely on whether the item was recognized before or after the change of control, in violation of neutrality. The following examples illustrate this point:

Example 1

PublicCo has $500 in NOL carryforwards. PublicCo has become profitable and the value of its assets equals $100. PublicCo has no debt and therefore has an equity value of $100. For simplicity, assume that PublicCo's only asset is goodwill, in which it has no tax basis. PublicCo earns $10 in year 1 and it uses its NOL carryforwards to offset 80% of such income. PublicCo has $2 of taxable income in year 1.

Example 2

Assume the same facts as Example 1, except that on January 1 of year 1, five unrelated persons acquired more than 50% of PublicCo's stock. PublicCo therefore has undergone a change of control. PublicCo still earns $10 in year 1, but applying the base limitation of Section 382 and assuming a long-term tax exempt rate of 2%, PublicCo may use only $100 (its equity value) times 2%, or $2 of its NOL carryforwards, to offset year 1 income. PublicCo has $8 of taxable income.

The principle of neutrality is therefore violated. PublicCo is taxed on an additional $6 of income because it may not use its NOLs “to the same extent whether or not the loss corporation is acquired by another corporation. . . .”13

Example 3

In contrast, if the Section 338 approach is applied, PublicCo would be able to increase the use of its NOLs as follows: PublicCo's assets (goodwill) are worth $100, reduced by $0 basis. Goodwill is amortizable over a fifteen-year period, therefore an additional $6.67 of NOL carryforwards may be used in year 1. Accordingly, PublicCo can use $8.67 of NOL carryforwards to offset 80% of its $10 of income. As in Example 1, PublicCo has $2 of taxable income and the neutrality principle is satisfied.

Example 4

Assume the same facts as Example 1, but rather than PublicCo, PrivateCo is owned by private investment Fund A. As in Example 2, PrivateCo can generally fully use its NOL carryforward to offset its $10 of income in year 1. However, Fund A sells 100% of the PrivateCo stock to private investment Fund B, which is a partnership for U.S. federal income tax purposes. Applying the base limitation of Section 382 would yield the same result as in Example 2. Again, failure to use the Section 338 approach would violate the neutrality principle because PrivateCo would be limited in the use of its NOL carryforwards in the absence of the Section 338 approach, even though PrivateCo as an entity has not changed, and its income and assets are the same before and after the acquisition. In contrast, if the Section 338 approach is used, again, the income of PrivateCo may be offset by PrivateCo's prior losses, and the neutrality principal is satisfied.

Congressional intent is to maintain the neutrality principle. With respect to non-corporate acquisitions, retaining the Section 338 approach is required, in many cases, to achieve that intent, while the Section 1374 approach will often violate the neutrality principle.

The Section 338 Approach Reflects Economic Income

As discussed above, the intent of Section 382 is to ensure that “NOLs should not be more valuable to an acquirer than to the going concern that created them.”14 Stated differently, the economic position of a stand-alone entity's going concern should be the same before and after the acquisition with respect to its tax position. A fundamental flaw in Section 382 is that it applies to changes of control that do not involve a corporate buyer, and so, notwithstanding congressional intent, Section 382 will in many cases prevent a corporation from being in the exact same tax position following a non-corporate acquisition. However, Section 382(m) authorizes Treasury to prescribe regulations that are necessary or appropriate to carry out the purposes of Section 382. Congress clearly intended neutrality, as the preamble explicitly recognizes, and so Treasury has the authority under Section 382(m) to issue regulations achieving this intent.

The following example demonstrates that the Section 338 approach is necessary to maintain neutrality, i.e., the congressional intent of ensuring that Section 382(h) maintains the loss corporation's economic, after-tax position, as a stand-alone entity, following an acquisition by a non-corporate acquirer.

Specifically, as supported by the 1986 Joint Committee Explanation quoted above, the Section 338 approach is necessary to maintain neutrality where built-in gains are the product of accelerated depreciation.

Example 5

Individual A invests $100 into newly formed NewCo. NewCo purchases a Machine for $100. At the end of year 1, Newco has no revenues, and expenses the Machine, creating an NOL of $100. Assume the Machine economically depreciates on a straight-line basis over five years. At the beginning of year 2, Newco's economic balance sheet would show $100 of the Machine, and no liabilities. In year 2, Newco produces widgets and earns a profit of $20. Newco uses its year 1 NOL to offset 80% of the $20 of taxable income.

Example 6

Assume the same facts as in Example 5, but Individual A sells Newco to PE Fund at the beginning of year 2 for $150. PE Fund is a partnership for U.S. federal income tax purposes. There are no operational changes to NewCo. Therefore, in year 2 NewCo produces widgets and earns a profit of $20. Under the Proposed Regulations, Newco would have a limitation on the use of its NOL equal to $150 multiplied by the long-term tax exempt rate (assume 2%), or $3. Therefore, NewCo would be allowed to offset only $3 of year 2 profit of $20. This result would violate the neutrality principle as a result of accelerated depreciation, which is what the 1986 Joint Committee Explanation says is intended to be avoided by the NUBIG rules.

Example 7

In contrast, if the Section 338 approach applied, then the year 2 Section 382 limitation would achieve neutrality. There would first be a deemed sale of Newco assets for $150 on the change-of-control date. The $150 would be allocated as follows: (i) $100 to the Machine, (ii) $50 to goodwill. Assume the Machine is subject to three-year depreciation. The Section 382 limitation would therefore be increased by the sum of (i) 100/3, and (ii) 50/15 or $36.66 of deemed RBIG under Section 382(h)(6). As a result, the NOL would be available to Newco's business to the same extent as if the change or control had not occurred, maintaining neutrality.

Importantly, this would also reflect economic reality. At the end of year 2, NewCo's balance sheet would reflect $80 of value in the Machine, and $20 of cash. The wealth of NewCo has not increased between year 1 and year 2, and therefore it should not pay taxes on the shift of the value of its assets from “Machine” to “Cash.” This is the distortion caused by the annual accounting system that the 1986 Joint Committee Explanation says is intended to be avoided. The Section 338 approach successfully reflects that the use of the Machine to produce widgets, which are, in turn, reduced to cash, must be accounted for to appropriately reflect NewCo's economic income. Newco as an entity has increased in value, as reflected by the $50 of goodwill, but this merely reflects PE Fund's expectation of NewCo's future profitability, not its current economic earnings.

Effect on Marketplace of Eliminating Section 338 Approach

The Treasury asserts in the preamble to the Proposed Regulations that:

[T]he Treasury Department and the IRS have determined that, historically, most acquiring corporations behave as if section 382 will limit the ability to utilize substantially all pre-change NOLs. This heuristic behavior implies that firms will not be highly responsive to the changes set forth by these proposed regulations.

It is important to note that any merger or acquisition dissuaded by these proposed regulations would tend to have been economically inefficient [and] not have been undertaken except for the purpose of reducing tax liability.15

This assertion overlooks a large, important portion of market activity involved in acquiring corporations. In acquisitions by non-corporate persons or entities, such as when a private equity fund makes a portfolio investment, the fund will typically produce a discounted cash-flow model that takes into account the target company's tax position post-acquisition. Private equity funds typically acquire corporations with the expectation that the company may be made more profitable. If the target company has NOLs, the acquiring fund, with the help of its advisors, will determine the use of the NOLs by the target company post-transaction, including both the base Section 382 limitation, and any recognized built-in gain of the target company that will increase this limitation. Since the Section 338 approach has been in place, acquirers have considered the resulting increase in the use of NOLs following a change of control in their pricing models. It is common for sellers to expressly ask to be compensated for the value of the target's NOLs based on their post-transaction utilization by the acquired company (as a stand-alone entity). While it is true that transactions will be completed in the absence of the Section 338 approach, e.g., the elimination of the Section 338 approach will not cause acquirers to forgo the transaction, the value of the target as a stand-alone company will be impaired in violation of the neutrality principle. That was the concern expressed in the 1986 Joint Committee Explanation that economic inefficiencies would be created by violating neutrality. This is not because the transaction is economically inefficient in the absence of the Section 338 approach. Rather, limiting the target company's ability to use its NOLs following an acquisition creates an inefficiency that the Section 338 approach reduces. The application of Section 382 in the absence of the Section 338 approach puts the target in a worse after-tax cash-flow position following the transaction and therefore creates an economic distortion.

Conclusion: The Section 338 Approach Is Necessary to Retain the Neutrality Principle

The Proposed Regulations appear to focus primarily on the application of Section 382 when a corporation acquires another corporation, and the faulty assumption that the Section 338 approach generally violates the neutrality principle because it allows the acquiring corporation to use the target's NOLs to offset income of the acquiring corporation. The preamble appears to conclude, therefore, that only inefficient acquisitions, premised on this use of target NOLs, will be impaired by eliminating the Section 338 approach. However, as demonstrated above, the flaw in this assumption is that many change-of-control transactions do not include a corporate acquirer. In all such transactions, the target corporation remains as a single going concern. In these cases, the Section 338 approach is necessary, at least in part, to offset the unintended violation of the neutrality principle and ensure that the target's taxable income before and after the transaction is consistent with its economic income.

* * * * *

We very much appreciate your consideration of our comments and would be happy to answer any questions you may have.

Respectfully submitted,

Russell Pinilis
Willkie Farr & Gallagher LLP
New York, NY

FOOTNOTES

1 84 F.R. 47455 (Sept. 10, 2019).

2 The “carryover provisions” permit a company to carry over losses from one accounting period to another.

3 Staff of Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, 288, 294 (Comm. Print 1987) [hereinafter, the “1986 Joint Committee Explanation”].

4 Id. at 294-295.

5 1986 Joint Committee Explanation, supra at 298.

7 Before the final version of Section 382(h)(6) was adopted in 1988, the 1986 version of Section 382(h)(6) authorized regulations to “treat amounts which accrue on or before the change date but which are allowable as a deduction after such date as recognized built-in losses.” (Emphasis added).

9 84 F.R. at 47463-47464. (Emphasis added).

10 Id. at 47462.

11 Id. at 47463.

12 When discussing the adoption of the stock ownership test as “the best indicator of a potentially abusive transaction” the 1986 Joint Committee Explanation indicates one potential for abuse not always involving a corporate-to-corporate acquisition was that with a change of stock ownership, new shareholders may be able to “contribute income-producing assets (or divert income opportunities) to the loss corporation, and the corporation will obtain greater utilization of carryforwards than it could have had there been no change of ownership.” 1986 Joint Committee Explanation, supra at 295. In most change of control transactions, this is not the case. Rather, a change of control occurs simply because the purchaser has greater aspirations for the acquired business than do its current owners. To the extent this is a concern, rules prohibiting the use of pre-change NOLs where assets are contributed to the acquired company following the acquisition would be warranted.

13 84 F.R. at 47463-47464.

14 Id. at 47462.

15 Id. at 47464.

END FOOTNOTES

DOCUMENT ATTRIBUTES
Copy RID