Transition Relief for Section 382 Proposed Regulations

As described in a recent client alert, proposed regulations issued in September 2019 (REG-125710-18) (the “Proposed Regulations”) presented a marked departure from existing methods employed by companies with net operating losses (“NOLs” and such entities, “Loss Companies”) in calculating their annual Section 382 limitations following an ownership change.

The Treasury Department released updated proposed regulations (the “Amended Proposed Regulations”) on January 10, 2020. The Amended Proposed Regulations modify the effective date of the Proposed Regulations and set forth certain transition rules designed to alleviate the impact of the Proposed Regulations on taxpayers involved in transactions prior to the effective date that could trigger an ownership change after the effective date of the Proposed Regulations.

1.  Background

As described in our previous client alert, the Proposed Regulations remove the safe harbor provided in Notice 2003-65 (the “Safe Harbor”), which allowed a Loss Company to use either (a) the Section 1374 approach, or (b) the Section 338 approach for determining the amount of recognized built-in gain, recognized built-in loss, net unrealized built-in gain, and net unrealized built-in loss (commonly referred to as RBIG, RBIL, NUBIG, and NUBIL, respectively) when calculating the Loss Company’s Section 382 limitation. The Proposed Regulations also modify the treatment of recourse liabilities and cancellation of indebtedness income for purposes of the Loss Company’s Section 382 limitation calculation. The rules laid out in the Proposed Regulations are expected to have a material adverse effect on the value of Loss Companies in many situations.

2.  Effective Date of Proposed Regulations

The rules of the Proposed Regulations would apply to a Loss Company experiencing an ownership change on a date after the date the Proposed Regulations are finalized and published in the Federal Register. Because it is not known when the Proposed Regulations will be finalized and published in the Federal Register, taxpayers in the midst of M&A or bankruptcy transactions are finding it difficult to value Loss Companies. This is hampering their abilities to reach agreement and close deals that may implicate an ownership change.

3.  Amended Proposed Regulations

To address the uncertainty and associated burden described above, the Treasury Department and IRS have proposed that the Proposed Regulations will not apply to a Loss Company that experiences an ownership change 30 days after the date on which the regulations are finalized and published in the Federal Register or later (the “Delayed Application Date”) if the ownership change after the Delayed Application Date is triggered by any of the following:

1. a binding agreement in effect on or before the Delayed Application Date and at all times thereafter;
2. a specific transaction described in a public announcement made on or before the Delayed Application Date;
3. a specific transaction described in a filing with the Securities and Exchange Commission submitted on or before the Delayed Application Date;
4. an order or a plan confirmed or sale approved by order of a court in a title 11 or similar case if the taxpayer was a debtor before such case on or before the Delayed Application Date; or
5. a transaction described in a private letter ruling request submitted to the IRS on or before the Delayed Application Date.

A Loss Company may continue to rely on Notice 2003-65 for purposes of determining its Section 382 limitation during the relief period or alternatively choose to apply the Proposed Regulations. For example, if the Proposed Regulations are finalized on June 1, 2020, (i) a Loss Company that entered into a binding agreement on or before June 30, 2020, may sidestep the application of the Proposed Regulations, rely instead on Notice 2003-65, and use the Safe Harbor to calculate its Section 382 limitation, but (ii) if there is no binding agreement in effect as of July 1, 2020, and none of the alternative triggers described above is available, the Loss Company must calculate its Section 382 limitation using the more restrictive rules in the Proposed Regulations.

Separately, in another taxpayer-friendly move, the Amended Proposed Regulations provide that the portion of the Proposed Regulations that sets forth rules to prevent the double counting of Section 163(j) disallowed business interest expense carryforwards for purposes of determining RBIL will be effective as of the date proposed regulations under Section 163(j) (REG-106089-18) are finalized.¹ Taxpayers will be able to apply these rules retroactively.

As discussed previously, the Proposed Regulations may substantially reduce the value of Loss Companies, and the uncertainty about their effective date created a chilling effect on transactions involving Loss Companies by impairing taxpayers’ ability to effectively negotiate price, terms, and structure for pending transactions. The Amended Proposed Regulations provide welcome relief to taxpayers currently contemplating transactions, including pursuant to a bankruptcy proceeding. The Amended Proposed Regulations, however, do not address the many questions described in our prior client alert. In addition, the Amended Proposed Regulations do not clearly state how the Proposed Regulations will apply to certain transactions, including contemplated ownership changes that occur pursuant to bankruptcy plans publicly prescribed during the relief period, but not confirmed by the court until after the Delayed Application Date. We will continue to closely monitor developments related to the Proposed Regulations.