On September 9, 2019, the U.S. Department of the Treasury issued proposed regulations that would limit the ability of certain corporations to utilize prior year losses, potentially increasing the tax burden of such corporations.
Section 382 of the Internal Revenue Code of 1986, as amended, imposes certain limitations on the ability of a “loss corporation” to offset taxable income in periods following an “ownership change” with pre-ownership change losses. In simplified terms, a “loss corporation” is a corporation with certain loss attributes (e.g., net operating losses, credit carryovers, etc.) and an “ownership change” occurs if there is more than a 50% change in ownership of a loss corporation within a certain period of time (special rules apply in calculating this ownership change). If an ownership change occurs, the Section 382 limitation imposed on a loss corporation’s use of pre-change losses for each subsequent year generally equals the fair market value of the loss corporation immediately before the ownership change multiplied by the applicable long-term tax exempt rate. If such corporation is in a built-in gain position at the time of the ownership change (i.e., fair market value exceeds basis), then the annual Section 382 limitation during the five-year period following the ownership change is increased by any built-in gain that is recognized during a tax year. If such corporation is in a built-in loss position at the time of the ownership change, then such built-in losses are subject to the Section 382 limitation.
In 2003, the IRS issued Notice 2003-65 and provided taxpayers with two different safe harbor approaches—the so called 338 Approach and the so called 1374 Approach—for calculating built-in gain and built-in losses and for identifying when such built-in gains and built-in losses are recognized post-ownership change until applicable temporary or final regulations were issued. The nuances of these approaches are beyond the scope of this summary, although we note that the 338 Approach may have allowed corporations, depending on the fact situation, to increase their Section 382 limitation when compared to the 1374 Approach. The proposed regulations eliminate the 338 Approach and modify the 1374 Approach, including disallowing the use of cancellation of debt income in the calculation of built-in gains, with certain minor exceptions. As a result of these changes, a loss corporation’s ability to offset its built-in gain with prior losses may be significantly restricted, thereby increasing the tax burden of such loss corporation and its acquirer, thus effectively reducing any incentive to engage in certain mergers and acquisitions involving a change in ownership of a loss corporation.
These proposed regulations would likely significantly impact start-up corporations and corporations operating in industries that generate substantial losses and regularly tap into the equity capital markets (e.g., corporations operating in the technology and life science industries). It is unclear how much additional revenue the Treasury will generate from this de facto tax hike. These proposed regulations are proposed to be effective for ownership changes occurring after the proposed regulations are published as final regulations. Until such final regulations are published, taxpayers can either use the approaches set forth in Notice 2003-65 (including the favorable 338 Approach) or use the less favorable approach set forth in the proposed regulations. The proposed regulations do not contemplate any extension of the effectiveness of Notice 2003-65 beyond the date final regulations are published. Unless the Treasury changes its position in the final regulations, this means that taxpayers can use the safe harbor approaches noted in Notice 2003-65 for transactions that close prior to publication of the final regulations but cannot use the 338 Approach for transactions that are in process (i.e., signed but not closed) as of the time the final regulations are published. Assuming no other changes or direction, Taxpayers may want to consider expediting the closing of such transactions to ensure they can utilize the 338 Approach, to the extent it is beneficial doing so. The Treasury will accept taxpayer comments on the proposed regulations until November 12, 2019. We anticipate that there will be a significant number of comments on the proposed regulations, particularly since they reverse long standing IRS practice.