Deloitte Comments on Net Unrealized Built-In Gain or Loss Rules

From: Zimet, Lee (US - New York) [lzimet@deloitte.com]

Subject: Comments on Notice 2003-65

Dear Sir or Madam,

[1] Attached are comments on issues raised by Notice 2003-65 with respect to the ACE built-in loss rules. If you have any questions or comments please call me at 212-436-2317.

Lee G. Zimet

Background

[4] On October 6,2003, the Internal Revenue Service (the. "IRS") issued Notice 2003-65 regarding the correct application of the net unrealized built-in gain or loss ("NUBIG" or "NUBIL") rules under section 382(h) of the Code. The IRS in the notice invited comments regarding other issues under section 382(h) that should be addressed in regulations.

[5] Regulations regarding the correct determination of a corporation's adjusted current earnings ("ACE") were promulgated by Treasury and the IRS in 1991. TD 8340 (Mar. 14, 1991). Rules regarding the application of section 56(g)(4)(G) can be found in section 1.56(g)-1(k) of the Treasury regulations. These regulations were promulgated over a decade ago and do not take into account policy decisions that are being currently decided with respect to the correct application of the NUBIL rules contained in section 382(h) (the "Section 382 NUBIL Rules"). Since it appears that the two NUBIL regimes were intended, to a certain extent, to parallel each other, we believe it makes sense to revisit the ACE NUBIL Rules as part of the ongoing project to provide guidance with respect to the Section 382 NUBIL Rules.

[6] The alternative minimum tax ("AMT") is a tax regime that is an alternative regime to the regular income tax. Generally, a corporation pays the higher of the AMT or the regular tax in any taxable year. The AMT is a tax at a lower rate (20%) on a higher tax base.

[7] To the extent a corporation pays the AMT in any taxable year, the excess over the regular tax is generally allowed as a credit to offset future year's regular tax liability. (The AMT credit generally can only be used to offset regular tax in later years to the extent the regular tax exceeds the AMT in that year.) From an economic standpoint, the corporate AMT is generally only a timing difference (i.e., a prepayment of the regular tax liability).

[8] The AMT tax regime starts with regular taxable income and requires various adjustments. One such adjustment is for ACE. Alternative minimum taxable income ("AMTI") includes 75% of the excess of a corporation's ACE over its AMTI (computed without regard to ACE or net operating loss ("NOL") deductions) (i.e., "pre-adjustment AMTI"). IRC § 56(c)(1), (g)(1). From an economic standpoint, the ACE regime results in a 15% tax on ACE (20% AMT rate times 75%), if higher than the AMT or regular tax liability.

[9] To the extent, a corporation has a positive ACE adjustment in any taxable year, the adjustment is allowed as a negative adjustment to offset future year's AMT liability. (A negative ACE adjustment can only be used to offset pre-adjustment AMTI to the extent the pre-adjustment AMTI exceeds the ACE in that year.) From an economic standpoint, the ACE regime is generally only a timing difference (i.e., a prepayment of the AMT tax liability).

[10] The computation of ACE starts with pre-adjustment AMTI and requires various adjustments. IRC § 56(g)(3). One such adjustment is for a corporation undergoing an ownership change (for purposes of section 382 of the Code) in a taxable year beginning after 1989 with a NUBIL. IRC § 56(g)(4)(G).

[11] A corporation will generally have a NUBIL, for ACE purposes, if the aggregate basis of the corporation's assets (for ACE purposes) exceeds the fair market value of such assets. The determination as to whether a corporation has a NUBIL is generally made immediately before the ownership change. IRC § 382(h)(3)(A)(i); Treas. Reg. § 156(g)-1(k)(3).¹

[12] Under a de minimis rule, the NUBIL (for ACE purposes) will generally be zero if the amount of the NUBIL would otherwise be less than or equal to the lesser of (i) 15% of the fair market value of the corporation's assets (immediately before the ownership change), or (ii) $10 million. IRC § 382(h)(3)(13)(i); Treas. Reg. § 1.56(g)-1(k)(3). It should be noted that the de minimis rule is applied separately for regular tax and ACE purposes. Treas. Reg. § 1.56(g)-1(k)(4) Example (ii).

[13] Generally, the fair market value of the assets of the loss corporation is determined, for purposes of the ACE NUBIL Rules, under general tax principles. However, if 80% or more of the stock (by value) of the loss corporation is acquired in one transaction (or in a series of related transactions), then the fair market value of the assets is limited to the grossed-up amount paid for the stock, adjusted for liabilities and other relevant items. IRC § 382(h)(8); Treas. Reg. § 1.56(g)-1(k)(3).

[14] In general, an ownership change occurs where a corporation is a "loss corporation" and there is a more than a 50% change in the stock ownership over a three-year period. IRC § 382(g); Treas. Reg. §§ 1.56(g)-1(k)(2), 1.382-2T. For this purpose, a loss corporation is a corporation that has a tax attribute that is potentially subject to limitation by either sections 382 or 383 of the Code.² Treas. Reg. § 1.382-2(a)(1).

[15] The ACE NUBIL Rules, where they apply, generally mark the basis of a loss corporation's assets to market. This generally results in a downward adjustment (on net basis) to reflect the corporation's built-in loss in the assets at the time of the ownership change. IRC § 56(g)(4)(G); Treas. Reg. § 1.56(g)-1(k)(1).

[16] The statute and regulations allocate the aggregate fair market value of the assets to each asset based upon its proportionate share of the fair market value (the "Proportionality Rule"). Under this rule, the basis of each of the corporation's assets (immediately after the ownership change) equals the proportionate share (determined on the basis of relative fair market values of each asset) of the aggregate fair market value (for purposes of the ACE NUBIL Rules) of the assets of the corporation (immediately before the ownership change).³ IRC § 56(g)(4)(G); Treas. Reg. § 1.56(g)-1(k)(1).

Section 382(l)(5) Transactions

[17] There is currently some uncertainty as to whether the ACE NUBIL Rules can apply with respect to an ownership change under section 382(l)(5). The regulations state:

[19] The policy behind section 382(l)(5) also suggests that the ACE NUBIL Rules should not apply. Congress's intent in enacting section 382(l)(5) was to grant relief from the limitation on attributes "as the creditors of an insolvent corporation frequently have borne the losses reflected in an NOL carryforward." Staff, Joint Comm. on Tax'n, General Explanation of the Tax Reform Act of 1986, p. 299 (1987) (the "1986 Blue Book"). There is no reason to believe that Congress intended to grant relief from the Section 382 NUBIL Rules but not the ACE NUBIL Rules.

Interaction with Section 382 NUBIL Rules

[20] There is currently uncertainty as to how to apply the rules where both the Section 382 NUBIL Rules and the ACE NUBIL Rules apply. Since NOLs are not an attribute for ACE purposes, it appears that the interaction of the two rules results in NOLs not being available to reduce ACE adjustments caused by the application of the ACE NUBIL Rules. See the below example.

[22] Our recommendation as to guidance would be to allow taxpayers to choose (or elect) to apply the section 382 limitation against NOLs before use against RBILs. If such an election had been made with respect to the above example, a depreciation deduction of $10M would have been allowed for regular tax, AMT, and ACE purposes. An NOL deduction of $20M would have been allowed to reduce the regular tax and AMT liability.

The Proportionality Rule

[23] Under the Proportionality Rule, the aggregate fair market value of the assets of the loss corporation is allocated among the assets held in determining basis based upon the relative fair market value of each asset. IRC § 56(g)(4)(G); Treas. Reg. § 1.56(g)-1(k)(1). The rules are relatively straight-forward in many cases. See Treas. Reg. § 1.56(g)-1(k)(4) Ex. However, there are two circumstances in which there is uncertainty as to how to apply the rules, (i) the treatment of goodwill, going concern value and other similar intangible assets, and (ii) the application with respect to so-called bargain purchases.

[24] Goodwill. The statute and regulations appear to require the application of the Proportionality Rule to all assets of the loss corporation. This appears to include assets such as goodwill, going concern value and similar intangible assets. If this interpretation is correct, a loss corporation is required to determine the fair market value of such assets (immediately before the ownership change).

[25] The determination of the fair market value of such intangible assets would be relatively simple if regulations allowed (or required) the use of the residual method. The regulations apply the residual method of the section 338 regulations where those regulations are otherwise applicable to the transaction. Treas. Reg. § 1.56(g)-1(k)(1). This implies that the residual method is not applicable to ownership changes that do not involve a section 338 election.

[26] If the residual method is not available, it appears that the fair market value of each asset (including intangibles) must be determined. To the extent this interpretation is correct; the rule is relatively simple to apply with regard to "separate and distinct intangible assets" (such as trademarks and patents). See Treas. Reg. § 1.263(a)-4(b)(3). The valuation of such assets can be determined by appraisers based upon traditional methods of valuation.

[27] The rule may be difficult to apply with respect to intangibles (such as goodwill and going concern value) that are not separate and distinct assets. In our experience, appraisals of goodwill and going concern value (separated from the underlying assets) are not generally reliable.

[28] Prior to the enactment of sections 338 and 1060, goodwill and going concern value acquired in an asset sale were not explicitly required to be considered a "residual" category. Some taxpayers took the position that they could separately identify the value of such assets and allocate the excess over that amount to the remaining assets.

[29] If this point is not clarified, both taxpayers and IRS agents alike might have an incentive to take the position that the fair market value of goodwill and going concern value differs from the residual amount. Taxpayers would have an incentive to reduce the fair market value as much as possible so as to increase the basis of inventory, receivables, and machinery and equipment. The IRS would have an incentive to increase the fair market value, especially where section 382(h)(8) limits the aggregate fair market, value of the assets to the grossed-up purchase price. Such an increase would generally be amortized over 15 years and could create the bargain purchase problem described below.

[30] In conclusion, we recommend that the residual method be applied to intangible assets (other than "separate and distinct intangible assets" within the meaning of section 1.263(a)-4(b)(3) of the Treasury regulations). This would exempt from the Proportionality Rule goodwill, going concern value and similar hard to value assets and assets the creation of which capitalization is not required.⁴ Any such basis covered under the residual method should be allocated among the different assets exempt from the proportionality rule based upon the adjusted tax basis of each. For example, if a loss corporation had goodwill attributable to Business A (basis of $100M) and goodwill attributable to Business B (basis of $200M), the basis under the residual method would be allocated 1/3 to Business A and 2/3 to Business B. Such a rule would avoid having to determine the correct allocation to self-created assets.

[31] Bargain Purchase. It appears that the Proportionality Rule only has one class of assets. As a result, it appears that in a "bargain purchase" situation the basis of each asset after an ownership change would be less than its fair market value. The effect of this rule is that, immediately after the ownership change, each asset of the loss corporation has a built-in gain (i.e., its fair market value exceeds its basis) for ACE purposes.

[32] This built-in gain issue is especially problematic for loss corporations with significant inventory and receivables. The built-in gain with respect to such assets is realized typically within a short period after the ownership change.

[33] In addition, it is not at all clear as to how cash is treated. Cash is an asset that normally does not have a basis. See Treas. Reg. § 1.988-2(a)(2)(iii) (basis of nonfunctional currency). However, there is no language in either the Code or the regulations that exempts cash from the Proportionality Rule. To the extent a built-in gain was allocated under the Proportionality Rule to cash, it is possible that the gain would be immediately taken into income. See Treas. Reg. § 1.338-6(b)(1) (acquisition of assets where cash acquired exceeds purchase price).

[34] Similar issues also arose in the context of sections 338, 1017, and 1060. The regulations in each such context were drafted to avoid (to the extent possible) allocating basis to cash, inventory, and receivables in an amount below fair market value (with respect to sections 338 and 1060), Treas. Reg. § 1.338-6(b), or existing basis (with respect to section 1017). Treas. Reg. § 1.1017-1(a).

[35] We recommend that cash, receivables, and inventory be exempted from the Proportionality Rule.⁵ The aggregate fair market value should be allocated to those assets first and the excess should be allocated to the remaining assets. The assets exempted from the Proportionality Rule could either be the assets described in Classes I through IV of the regulations under section 338 and 1060, Treas. Reg. § 1.338-6(b), or the assets described in paragraphs (4) and (5) of section 1.1017-1(a) of the regulations.

[36] Below is an example, as to how such a rule would work.

Conformity with Section 1017

[38] The ACE NUBIL Rules reduce the basis of a loss corporation's assets following an ownership change. IRC § 56(g)(4)(G); Treas. Reg. § 1.56(g)-1(k)(1). If the loss corporation realizes COD income that is excluded under section 108 in conjunction with the ownership change, any reduction in basis under section 1017 occurs as of the first day of the next taxable year. IRC § 1017(a); Treas. Reg. § 1.1017-1(a). Based upon a literal reading of the statute and regulations, the assets could be reduced twice, first under the ACE NUBIL Rules and then under section 1017.

[39] This double reduction does not appear to be intended by Congress. One possible solution would be to only require a reduction under section 1017 to the extent the reduction under section 1017 exceeds any net reduction under the ACE NUBIL Rules. For example, if the ACE NUBIL Rules resulted in a net reduction of $50M and section 1017 requires a reduction of $60M, the loss corporation would reduce the basis of its assets under the ACE NUBIL Rules by $50M and under section 1017 for ACE purposes by $10M.

Subsidiary Stock Basis

[40] There is currently uncertainty as to how to apply the ACE NUBIL Rules in the context of a consolidated return.⁶

[41] Good policy arguments can be made for applying the ACE NUBIL Rules to reduce the assets of members of consolidated groups (but not to stock of subsidiaries). First, Treasury and the IRS have not yet decided to finalize regulations that would require separate application of the investment adjustment rules for regular tax, AMT, and ACE. Prop. Reg. § 1.1502-55(g) (requiring separate basis computations). Second, stock basis in subsidiaries is ignored for purposes of determining whether a loss corporation has a consolidated NUBIG or NUBIL. Treas. Reg. § 1.1502-91(g)(1). Third, the recognition of any loss with respect to subsidiary stock would be subject to limitation, in any case, under the Section 382 NUBIL Rules. Treas. Reg. § 1.1502-91(h)(2).

[42] If it is decided that subsidiary stock basis should be covered by the ACE NUBIL Rules, our preference would be to apply the rule by application of the investment adjustment rules. Treas. Reg. § 1.1502-32(b)(3)(ii)(D) (increase in stock basis as a result of increase in basis of S assets), (iii)(B) (decrease in stock basis as a result of decrease in basis of S assets). To apply the ACE NUBIL Rules directly to the stock basis would require complex rules to deal with the interaction of the Proportionality Rule.

² One such tax attribute is a NUBIL. In determining whether a corporation is a "loss corporation," the NUBIL is determined by using the aggregate adjusted basis of the assets for regular tax purposes and not the adjusted basis of such assets for ACE purposes. Treas. Reg. § 1.56(g)-1(k)(2). Accordingly, if a corporation is not a loss corporation because it does not have any loss or credit carryforwards, it will be a loss corporation if it has a NUBIL computed using the aggregate basis of its assets for regular tax purposes. Treas. Reg. § 1.56(g)-1(k)(4) Example (iv). However, if it has a NUBIL for ACE purposes, but not for regular tax purposes, the ACE NUBIL Rules would not apply. Id.

³ The ACE regulations state that the allocation of basis rules of the section 338 regulations apply "if otherwise applicable to the transaction." Treas. Reg. § 1.56(g)-1(k)(1). As a result, it appears that the residual method only applies where a section 338 election was made with respect to the ownership change. See IRC § 382(h)(1)(C).

⁴ The recently issued capitalization rules for intangible assets exempt from the definition of "separate and distinct intangible assets" certain assets (such as computer software and package designs). Treas. Reg. § 1.263(a)-4(b)(3). Costs incurred with respect to these assets are generally deductible when paid or incurred. It would be inconsistent with the capitalization rules for the ACE rules to treat these items as assets that receive an allocation of basis.

⁵ We understand that there may be some concern as to whether there is authority to exempt these assets from the Proportionality Rule. Congress has not granted any special regulatory authority with respect to the application of AMT or ACE. However, the ACE NUBIL Rules are sufficiently intertwined with the Section 382 NUBIL Rules. As a result, it may be possible to modify the Proportionality Rule under the authority of section 382(m) (regulations to carry out the purposes of section 382). It should be noted that, based upon the legislative history of the ACE NUBIL Rules, there is no reason to believe that Congress was aware of the potential bargain purchase situation.

⁶ Full consideration of all of the consolidated return issues impacted by the ACE NUBIL Rules are beyond the scope of these comments. The existing ACE regulations currently provide for the application of the general ACE rules to consolidated groups. Treas. Reg. § 1.56(g)-1(n). Those rules do not provide for the application of the ACE NUBIL Rules in the consolidated context. As a result, it may be appropriate to determine the application of the ACE NUBIL Rules with respect to consolidated groups before full consolidated AMT regulations are promulgated.