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Proposed Regulations May Significantly Reduce the Value of Net Operating Loss Carryforwards and the Value of Companies with Net Operating Losses

September 16, 2019

On September 9, 2019, the Treasury Department and IRS issued new proposed regulations (REG-125710-18) (the “Proposed Regulations”) affecting how companies with net operating losses (“NOLs” and such entities, “Loss Companies”) will calculate the ability to use such losses following an ownership change in the wake of the Tax Cuts and Jobs Act, P.L. 115-97 (2017) (TCJA).

The Proposed Regulations represent a significant departure from current law and abandon the method most commonly used by Loss Companies to calculate the annual limitation on the use of NOLs under Section 382.1


  • The Proposed Regulations eliminate a Loss Company’s ability to utilize the so-called “Section 338 approach” for purposes of determining the Loss Company’s annual Section 382 limitation. The Section 338 approach was sanctioned in guidance from the IRS in 2003 and, notwithstanding commentary in the preamble to the Proposed Regulations regarding the difficulty of applying the Section 338 approach, has been widely adopted and implemented by Loss Companies with net unrealized built-in gains since its introduction.
  • The Proposed Regulations modify the method by which a Loss Company’s assets are valued for purposes of determining the potential increase to a Loss Company’s Section 382 limitation by excluding recourse liabilities. In addition, the Proposed Regulations clarify that cancellation of indebtedness income (CODI) recognized during the first year of the ownership change is generally not treated as a recognized built-in gain for purposes of determining the increase in the Section 382 limitation unless it is included in income or used to reduce asset basis.

If enacted in their current form, the Proposed Regulations will have a significant, detrimental impact on the ability of Loss Companies to offset future income with their pre-acquisition losses and may result in substantial diminution of the value of NOL carryforwards and the equity value of Loss Companies. The Proposed Regulations may also have a chilling effect on M&A activity and influence parties to favor asset acquisitions over stock purchases.

It is important to note that the impact of the Proposed Regulations is not limited to financially-troubled companies; an otherwise healthy company may constitute a Loss Company for any number of reasons, including its decision to take advantage of bonus depreciation for capital expenditures or expensing, rather than capitalizing, R&D costs.

Although the Proposed Regulations do not apply to ownership changes that take place prior to the issuance of final regulations, Loss Companies, acquirers, and investors are advised to consider the Proposed Regulations:

  • when making decisions regarding depreciation and amortization methods;
  • when making investment and pricing decisions;
  • for purposes of drafting acquisition agreements relating to Loss Companies;
  • for purposes of analyzing the value of adopting a so-called “NOL poison pill;” and
  • for purposes of structuring new debt obligations and whether non-recourse debt (including recourse debt of a disregarded subsidiary of the issuer) may be utilized to protect the value of NOLs.


Section 382 was implemented to prevent the acquisition of Loss Companies for the sole purpose of utilizing the acquired company’s NOLs post-acquisition to offset income generated by the acquired company. Very generally, when a Loss Company undergoes an ownership change,2 Section 382 limits the annual use of the Loss Company’s NOLs and certain other tax attributes after the ownership change. The Section 382 “base” limitation is measured by the value of the Loss Company on the change of control date multiplied by the then-prevailing federal long-term tax-exempt rate (1.89% for September 2019). The base limitation alone generally is low, particularly in the relatively low interest rate environment of recent years. However, the Section 382 base limitation is increased by the amount of any recognized built-in gain (RBIG) or reduced by the amount of any recognized built-in loss (RBIL) during the five-year period following the ownership change date (the “Recognition Period”). The purpose of this adjustment to the base limitation is to provide neutrality between the tax result that would have been obtained for a Loss Company if the assets giving rise to a net unrealized built-in gain (i.e., the amount by which the fair market value of those assets exceeds the Loss Company’s adjusted basis in such assets) (NUBIG) or a net unrealized built-in loss (i.e., the amount by which the Loss Company’s adjusted tax basis in its assets exceeds their fair market value) (NUBIL) had been sold shortly prior to the ownership change and the result that would obtain if the assets in question were sold during the Recognition Period.

In order to compute the potential adjustment to the base limitation under Section 382, a Loss Company must determine the amount of its NUBIG or NUBIL as of the ownership change date. This computation is made by postulating that the acquirer assumed all of the Loss Company’s indebtedness, including recourse indebtedness that was cancelled or discharged in the transaction. Loss Companies very often have a NUBIG due to historic depreciation deductions (which in many cases constituted a substantial contributing factor in generating the NOLs in question) and the indebtedness taken into account for purposes of measuring the hypothetical gain. This NUBIG may result in a Section 382 limitation that is substantially greater than the base limitation.

Notice 2003-65

Prior to issuance of the Proposed Regulations, IRS Notice 2003-65 provided a safe harbor for purposes of measuring a Loss Company’s RBIG, RBIL, NUBIG, and NUBIL for purposes of determining the Section 382 limitation (the “Safe Harbor”). Under the Safe Harbor, the NUBIG or NUBIL is calculated based on the net amount of gain or loss that would have been recognized if the Loss Company sold all of its assets (including goodwill) immediately before the ownership change to a third party for an amount of cash equal to the assets’ fair market value. This can be done electively by application of one of two approaches: (i) the Section 1374 approach and (ii) the Section 338 approach.

The Section 1374 approach

Under the Section 1374 approach, only the amount of gain or loss actually recognized during the recognition period on an actual sale or exchange of an asset is an RBIG or RBIL, respectively, and such amount is limited to the unrealized built-in gain or loss in that asset as of the ownership change date, subject to certain adjustments.

The Section 338 approach

By contrast, under the Section 338 approach, the Loss Company measures its RBIG or RBIL by calculating the items of income, gain, deduction, and loss that would have resulted if a Section 338 election had triggered a hypothetical sale of its assets. The Loss Company then treats as additional RBIG or RBIL the positive or negative difference between the depreciation or amortization deductions that would be generated during the Recognition Period with or without giving effect to the hypothetical asset sale. In the case of a Loss Company with a NUBIG, which as mentioned above, is a common fact pattern, this generates additional Section 382 limitation (and thus enhances the ability to offset post-ownership change income with pre-acquisition losses) without regard to whether the Loss Company actually sells its assets during the Recognition Period.3

Proposed Regulations

The Proposed Regulations would eliminate the Section 338 approach and make the use of the Section 1374 approach mandatory for purposes of computing NUBIGs and NUBILs. This change is anticipated to significantly reduce the value of the NOLS of Loss Companies in most circumstances by limiting the annual increase to the base limitation to only those built-in gains recognized from actual asset dispositions.

Furthermore, the Proposed Regulations exclude recourse liabilities when determining gain or loss from the hypothetical sale of assets for purposes of calculating NUBIGs and NUBILs. This exclusion is expected to substantially reduce the NUBIG ceiling to which the base limitation can be increased for Loss Companies with significant leverage.

The Proposed Regulations also provide that CODI is not treated as an RBIG for purposes of applying the Section 1374 approach. This could have a significant detrimental effect on the ability of Loss Companies emerging from Chapter 11 or other insolvency transactions to offset future income with NOLs generated before an ownership change.

The Proposed Regulations are effective only for Loss Companies undergoing ownership changes after the date on which they are finalized, although taxpayers may elect to apply them to any transaction prior to the finalization date and any ownership change for an open tax year including ownership changes.

The Treasury Department and IRS have requested comments on the Proposed Regulations by November 12, 2019, with a specific interest in comments regarding the impact on insolvent companies and companies in bankruptcy. Based on the initial negative reaction to the Proposed Regulations, we anticipate that practitioners and interested parties will have numerous comments. It is impossible to predict whether the government will be receptive to such comments, particularly in light of the rapidly-expanding budget deficit, or what form final regulations may take. In the interim, taxpayers are encouraged to consult with their tax advisors regarding the potential impact of the Proposed Regulations to them.

1 All Section references contained herein are to the Internal Revenue Code of 1986, as amended.

2 An ownership change refers to any acquisition of more than 50% of a corporation’s equity by certain “5 percent shareholders” during a three-year testing period. Such an ownership change may occur pursuant to a restructuring in bankruptcy, an M&A transaction, or the accumulation of shares by significant holders.

3 Bonus depreciation under Section 168(k) added by the TCJA allows companies to immediately deduct certain capital expenditures. It was not clear upon enactment whether this new bonus depreciation would be permitted for purposes of determining a Loss Company’s RBIG or RBIL under the Section 338 approach. The IRS answered this question in the negative in Notice 2018-30.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Alexander Anderson, an O’Melveny partner licensed to practice law in New York, Robert Blashek, an O’Melveny partner licensed to practice law in California and New York, Robert Fisher, an O’Melveny partner licensed to practice law in California, Arthur V. Hazlitt, an O’Melveny partner licensed to practice law in New York, Luc Moritz, an O’Melveny partner licensed to practice law in California, Jeff Walbridge, an O’Melveny partner licensed to practice law in California, and Dawn Lim, an O’Melveny associate licensed to practice law in New York, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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