Favorable Safe Harbor Rule in Jeopardy Under Proposed Section 382 Regulations
On September 9, 2019, the Treasury Department and the IRS issued proposed regulations under Section 382 of the Internal Revenue Code which, if finalized, will severely limit the ability of corporations to avail themselves of net operating losses (NOLs) following an ownership change.
Specifically, the regulations would eliminate a safe harbor that the IRS established more than 15 years ago that allows corporations to increase their Section 382 limitation by the gain inherent in their assets, even if those assets were not actually sold. This safe harbor has greatly benefited companies subject to a Section 382 limitation, especially software and biotech companies whose most valuable assets are oftentimes self-created intangibles.
Section 382 in general
Widely regarded as one of the most complex provisions in our tax code, Section 382 imposes restrictions on NOLs (and some other tax attributes) following an “ownership change” among the corporation’s shareholders. An ownership change is triggered when there is a greater than 50% increase in ownership across the corporation’s 5% shareholders during a rolling three-year period.
Once an ownership change is triggered, the amount by which the corporation’s post-change taxable income can be offset with pre-change NOLs is subject to limitation. The amount of the limitation generally equals the fair market value of the corporation’s equity immediately before the ownership change multiplied by a federal long-term tax-exempt rate. This “base” limitation is then subject to several potential adjustments.
Perhaps the most significant adjustment to a corporation’s base limitation occurs when the company has a net unrealized built-in gain (NUBIG). Section 382(h) generally defines a NUBIG as the amount by which the fair market value of the assets of the loss corporation immediately before an ownership change exceeds the aggregate adjusted basis of the assets at that time. If the corporation has a NUBIG, its Section 382 limitation can be increased by the amount of gain recognized from these pre-change assets over a five-year period.
Neither the Section 382 statute nor the regulations provide much guidance regarding these built-in gain computations. In response, the IRS issued Notice 2003-65, 2003-2 CB 747, which provides two safe harbor methods of calculating built-in gain and loss amounts: the 1374 approach and the 338 approach.
The 1374 approach
The 1374 approach incorporates the concepts of the built-in gain rules of Subchapter S. Under this approach, the amount by which a corporation’s Section 382 limitation may be increased is generally the amount of built-in gain triggered by the disposition of gain assets during the five-year recognition period. The logic behind this is simple: Had the loss corporation sold the built-in gain asset prior to an ownership change, its NOLs would have been available to offset such gain. Thus, the corporation should not be foreclosed from offsetting the gain only because the disposition occurred following an ownership change.
The 338 approach
The 338 approach identifies built-in gain by comparing the loss corporation's actual items of income, gain, deduction, and loss with the items of income, gain, deduction, and loss that would result if a Section 338 election had been made for a hypothetical purchase of all of the corporation’s assets.
Unlike the 1374 approach, the 338 approach does not require an actual disposition of an asset in order to “unlock” its gain and increase the Section 382 limitation. Rather, it looks to the deemed “wasting” of the corporation’s pre-change assets in order to determine the increase to the Section 382 limitation during the recognition period. In other words, these built-in gain assets are assumed to generate additional income each year equal to the additional depreciation that would result if the company had sold all of its assets for their fair market value as of the date of the ownership change.
The ability to increase a Section 382 limitation without an actual disposition of assets has been a powerful way for many corporations to substantially increase what would otherwise be restrictive limitations.
This has been particularly relevant for many software and biotech companies whose most valuable assets are their self-created intangibles. Under the 338 approach, these companies can take advantage of the deemed exploitation of these intangibles (generally in the form of amortizable goodwill) to increase their Section 382 limitations for five years following an ownership change.
The proposed regulations
The proposed regulations would completely eliminate the 338 approach and only allow only the 1374 approach. Both the Treasury Department and the IRS concluded that the 338 approach “lacks sufficient grounding in the statutory text of Section 382(h).” They go on to point out the relative simplicity and ease of administration of the accrual-based 1374 approach. They also note particular weaknesses of the 338 approach in light of certain provisions contained in the Tax Cuts and Jobs Act, including limitations on a corporation’s interest deductions under Section 163(j) and income inclusions under Section 951A, the new global intangible low-taxed income statute.
The new rules would be effective for ownership changes occurring after finalization of the proposed regulations. However, taxpayers may elect to apply them prior to finalization. Comments on the proposed rules will be accepted through November 12, 2019.
Section 338 example
Assume ABC Corp., a closely held biotech company, has $50 million in cumulative NOLs and triggers an ownership change on December 31, 2019. Assume further that the company’s Section 382 annual base limitation following the change is $250,000; however, the company has a NUBIG of $15 million, all of which is attributable to its self-created technology platform.
Using the 338 approach, ABC’s annual base limitation of $250,000 would be increased by $1 million per year during the five-year recognition period ($15 million built-in gain in intangible assets divided by 15 year tax amortization period), for a total annual limitation amount of $1.25 million. ABC would thus free up $6.25 million in NOLs during the recognition period.
However, without the 338 approach, the amount of NOLs that ABC could free up during the recognition period would only be $1.25 million ($250,000 base limitation multiplied by five) unless the company actually disposed of its technology platform during the recognition period and recognized the gain on its tax return.
The proposed regulations will have a detrimental impact on the ability of many corporations to free up NOLs following an ownership change. Moreover, the regulations will have a number of negative secondary impacts on issues such as deal valuation and the calculation of deferred tax assets.
While most practitioners were eager to see regulations that defined and solidified the built-in gain concepts under Section 382, elimination of perhaps the most taxpayer-friendly provision in an area of tax law that can otherwise seem punitive is already being met with sharp criticism. Our transaction tax professionals can help. To learn more about how the proposed regulations could impact your company, please contact us.