Tax Strategies for Corporate Acquisitions

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TAX STRATEGIES FOR CORPORATE ACQUISITIONS,

DISPOSITIONS, SPIN-OFFS, JOINT VENTURES,

FINANCINGS, REORGANIZATIONS AND

RESTRUCTURINGS 2012

The Section 382 Consolidated Return Regulations

Mark J. Silverman

Steptoe & Johnson llp

Washington, D.C

TABLE OF CONTENTS

Internal Revenue Service Circular 230 Disclosure: As provided for in IRS regulations, advice (if any) relating to federal taxes that is contained in this document (including attachments) is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any plan or arrangement addressed herein.

I.OVERVIEW OF SECTION 382......

A.Required Change in Ownership......

B.Consequences of an Ownership Change......

C.Losses Subject to Limitation......

D.Example......

E.Effective Dates......

II.CONSOLIDATED RETURN ISSUES -- OVERVIEW......

III.RULES PERTAINING TO LOSS GROUPS......

A.Definition of Loss Group......

B.Determining if a Loss Group Has an Ownership Change......

C.Effect of an Ownership Change......

IV.WHAT HAPPENS WHEN MULTIPLE CORPORATIONS JOIN A GROUP? -- THE LOSS SUBGROUP RULES

A.Definition of Loss Subgroup......

B.Determining if a Loss Subgroup Has an Ownership Change......

C.Effect of an Ownership Change......

V.WHAT HAPPENS WHEN CORPORATIONS JOIN A GROUP AND SUBGROUPING DOES NOT APPLY?

A.Definition of New Loss Member......

B.Determining if a New Loss Member Has an Ownership Change....

C.Effect of an Ownership Change......

D.Illustrations......

VI.OWNERSHIP CHANGE OF SUBSIDIARY ON A SEPARATE ENTITY BASIS...

A.Ownership Change Determination......

B.Effect of the Ownership Change......

C.Relationship to General Ownership Change Rules......

VII.END OF SEPARATE TRACKING (THE "FOLD IN RULES")AND SUBSEQUENT OWNERSHIP CHANGES

A.End of Separate Tracking......

B.Subsequent Ownership Changes......

VIII.BUILT-IN GAINS AND LOSSES -- SPECIAL RULES......

A.Determining if a Consolidated Group Has a Net Unrealized Built-in Gain or Loss

B.Intercompany Transactions......

C.Exchanged Basis Property......

D.Determination of Whether a Loss Subgroup Has a Net Unrealized Built-In Loss

E.Special Problems......

IX.WHAT HAPPENS WHEN A CORPORATION LEAVES A GROUP OR SUBGROUP?

A.Leaving a Loss Group......

B.Leaving or Ceasing to be a Member of a Loss Subgroup......

C.Filing the Election to Apportion......

D.Coordination with Loss Disallowance Rules......

X.TITLE 11 OR SIMILAR CASES......

XI.COORDINATION WITH SECTION 383......

XII.CONTROLLED GROUP RULES......

A.Background......

B.Section 382 Limitation with Respect to Controlled GroupLoss

C.Restoration of Value......

D.Disposal and Reacquisition of Controlled GroupStock...

E.Rules Preventing Double Reduction......

F.Coordination with Consolidated Section 382 Regulations......

XIII.REVISED SEPARATE RETURN LIMITATION YEAR RULES......

A.Overview......

B.Revision of SRLY Computation......

C.SRLY Limitation Computed on Cumulative Basis......

D.SRLY Subgroups......

E.Built-In Gain and Loss......

F.Overlap Rule......

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The Section 382

Consolidated Return Regulations

I.OVERVIEW OF SECTION 382

A key element in planning many transactions is the survival and subsequent use of net operating loss ("NOL") carryovers. The Tax Reform Act of 1986, P.L. 99-514, made sweeping changes in the rules governing the use and availability of NOL carryovers following certain changes in the stock ownership of a loss corporation. In particular, section 382 was substantially altered.

A.Required Change in Ownership

1.Section 382 ("section 382") applies only after a change, however effected, in ownership of more than 50 percent of the stock (by value) in a loss corporation over a prescribed period of time. See section 382(g).

a.Such a change is referred to as an "ownership change." The date on which an ownership change occurs is referred to as the "change date." See section 382(j).

b.An ownership change may occur either through an "owner shift involving a 5-percent shareholder," an "equity structure shift," or a combination of the two. See section 382(g).

c.In general, a "loss corporation" is a corporation entitled to use NOL carryovers, having an NOL in the year of the ownership change, or having a net unrealized built-in loss. See section 382(k)(1).

2.In general, the change in ownership of the loss corporation must occur within a three-year testing period ending on the day of any owner shift or equity structure shift. Section 382(i)(1).

3.Under the statute, the loss corporation must track the stock ownership of 5-percent shareholders.

a.To determine who the 5-percent shareholders are, the corporation must determine which ownership interests in the corporation constitute "stock." See section 382(k)(6); Treas.Reg. § 1.382-2(f)(18).

b.The corporation must then determine who owns the stock. For purposes of determining stock ownership, the constructive ownership rules of section 318 apply with certain modifications. See section 382(l)(3)(A); Treas.Reg. § 1.382-2(h).

c.Finally, once the constructive ownership rules have been applied, the corporation can determine its 5-percent shareholders based on the percentage of stock that they own.

(1)A 5-percent shareholder is any person holding 5-percent or more (by value) of the loss corporation stock at any time during the testing period. See section 382(k)(6)(C) and (7); Treas.Reg. § 1.382-2(g).

(2)Shareholders who own less than 5 percent are aggregated and treated as one 5-percent shareholder. See section 382(g)(4); Treas.Reg. § 1.382-2(j).

d.If the aggregate stock ownership of one or more of the 5-percent shareholders has increased by more than 50 percentage points during the testing period, then an ownership change has occurred. See section 382(g)(1); Treas.Reg. § 1.382-2(a)(1) and (c).

B.Consequences of an Ownership Change

1.If an ownership change occurs, section 382 places an annual limit on the amount of post-change taxable income which may be offset by the loss corporation's pre-change NOL carryovers.

a.This limitation -- known as the section 382 limitation -- is an amount equal to the product of a prescribed rate of return and the value of the loss corporation. Section 382(b)(1).

(1)The prescribed rate of return is the long-term tax-exempt rate of return. Section 382(f).

(2)The value of the loss corporation, in general, is measured by the value of the corporation's stock immediately before the ownership change. Section 382(e)(1).

b.If the loss corporation has a net unrealized built-in gain the annual limitation may be increased by recognized built-in gains of the loss corporation. Section 382(h)(1)(A).

c.If income is less than the section 382 limitation, the unused section 382 limitation amount may be carried forward to subsequent years. Section 382(b)(2).

2.If an ownership change occurs, the loss corporation must satisfy the continuity of business enterprise requirement applicable to reorganizations throughout the two-year period beginning on the change date. Otherwise, its loss carryovers, in effect, will be eliminated. Section 382(c)(1).

C.Losses Subject to Limitation

1.In general, losses incurred prior to the ownership change are subject to the section 382 limitations. That is, loss carried forward from previous years to the year of change, certain built-in losses and losses incurred during the year of change are subject to section 382. These losses are referred to as "pre-change losses." See sections 382(d)(1) and (h)(1)(B).

2.Losses generated in the year of change are allocated to the periods before and after the change. That portion allocated to the period after the ownership change is not subject to limitation; that portion allocated to the period prior to the ownership change is subject to the section 382 limitations, i.e., those losses may only offset income to the extent of the section 382 limitation. See section 382(d)(1)(B).

D.Example

1.Fact Pattern

On January 1, 1991, L corporation is wholly owned by individual A. A has held all of the L stock since L's formation in 1985. L has a $200 NOL carryover from a previous year. On December 31, 1994, A sells all of his stock to B for $500 (the fair market value of L). At that time, the long-term tax-exempt rate for section 382 purposes is 5 percent. During 1995, L generates $200 in taxable income.

2.Tax Consequences Under Section 382

a.The sale of all of the L stock by A to B is an ownership change which triggers section 382. The sale resulted in a more than 50 percentage point change in L stock ownership during the three-year testing period ending on December 31, 1994. Therefore, section 382 applies.

b.Under section 382, income generated after December 31, 1994 may be offset by L's NOL carryover only to the extent of $25 (theproduct of L's value ($500) and the rate prescribed under section 382 (5 percent)).

(1)Thus, with respect to 1995, L may not fully offset its $200 taxable income with its $200 NOL carryover. Only $25 of its 1995 taxable income may be offset by the NOL carryover.

(2)L has an NOL carryover to 1996 of $175 ($200 - $25).

c.If B caused L to sell all of its assets (assume at their book value) within two years of the change date, L's NOL carryover would be eliminated (because the continuity of business enterprise requirement would not be met).

E.Effective Dates

In general, the section 382 rules apply to ownership changes that occur on or after January 1, 1987. The earliest testing period begins on May 6, 1986.

II.CONSOLIDATED RETURN ISSUES -- OVERVIEW

A.Prior to January 1991, the application of section 382 to consolidated groups was uncertain. In enacting section 382, Congress merely indicated that the CRCO (consolidated return change of ownership) rules (Treas.Reg. §§ 1.1502-1(g) and -21(d)) and the separate return limitation year (“SRLY”) rules (Treas.Reg. §§ 1.1502-1(f) and -21(c)) would continue to apply. No other guidance was provided.

B.Application of section 382 in a consolidated return context turns upon one overall policy decision: whether section 382 should apply to an affiliated group filing consolidated returns on a "single entity" basis, whether it should apply on a "member-by-member" basis, or whether a combination of these two approaches is best.

1.This policy decision must be made at two levels. That is, first it must be decided whether the section 382(g) ownership change test should be applied on a single entity or a member-by-member basis. Second, it must be decided whether the operating provisions of section 382 (i.e., the annual limitation under section 382(a)) should be applied on a single entity or member-by-member basis.

2.Also, one approach may be applied with respect to consolidated net operating losses and a different approach may be applied with respect to losses incurred in separate return limitation years ("SRLY" losses).

C.On January 29, 1991, Treasury issued proposed regulations (the "former proposed regulations") regarding the application of section 382 to corporations filing consolidated returns. 56 Fed. Reg. 4194 (February 4, 1991).

1.These regulations generally adopted the single entity approach with respect to losses that are not SRLY losses.

a.The single entity approach applies to determine ownership changes and the section 382 limitation with respect to such losses.

(1)This treatment reflects the general approach of the consolidated return regulations, which treats the members of a consolidated group as divisions of a single taxpayer with the common parent as the sole agent for each member of the group. See Preamble to the former proposed regulations.

(2)This treatment also reflects the ability of consolidated group members to use each other's losses.

b.The single entity approach fosters the neutrality principle in that consolidated losses of one member could offset income of another member before an ownership change, and can do so after an ownership change as well, subject only to restrictions that would be imposed on a stand-alone corporation.

2.The regulations also generally adopted the single entity approach with respect to loss subgroups (as to losses that were not SRLY losses of the subgroup).

3.The former proposed regulations generally followed a separate entity approach, however, with respect to corporations that join or leave a consolidated group. According to the Preamble, section 382 applies separately with respect to such members because their losses cannot be used by other members.

D.At the same time, Treasury also issued proposed regulations that would have substantially amended the existing consolidated return regulations. 56 Fed. Reg. 4228 (February 4, 1991).

1.The regulations revised the SRLY rules to apply on a "subgroup" basis rather than on a "fragmentation" (i.e., on a member-by-member) basis.

a.Two or more corporations that are members of a consolidated group can offset one corporation's income against the other's losses, and vice versa.

b.It was thought to be more appropriate and consistent with the single entity approach that the SRLY rules be applied to those members forming or leaving a group on an aggregate or subgroup basis, rather than on a member-by-member basis.

2.The proposed SRLY regulations retained apportionment of consolidated net operating losses for members leaving the group. There had been prior speculation that the regulations would provide that consolidated net operating losses would stay with the common parent.

3.The CRCO rules were repealed, subject to transition rules. The continued application of the CRCO rules caused considerable confusion, since those rules generally paralleled the ownership change rules of section 382 before its amendment by the Tax Reform Act of 1986.

E.On August 8, 1991, the IRS issued Notice 91-27, 1991-2 C.B. 629, which proposed transitional relief relating to the built-in gain and loss rules, as wellas clarifying the effective date for amendments to the SRLY rules.

F.New Temporary and Proposed Regulations

Substantial uncertainty arose as a result of the effective date of the former proposed regulations, which generally were proposed to be effective for consolidated return years ending on or after January 29, 1991. Because of the potentially retroactive application of the proposed regulations, taxpayers could not be sure which approach would govern their use of losses for years after January 29, 1991. To resolve this uncertainty, the proposed regulations were withdrawn on June 27, 1996 and replaced by temporary regulations (the "temporary regulations"). 61 Fed. Reg. 33,313 (June 27, 1996). The temporary regulations were issued primarily to address effective date concerns, are substantially identical to the former proposed regulations, and do not address comments received regarding the former proposed regulations. Instead, the temporary regulations were also issued as proposed regulations (the "new proposed regulations") and may be amended to reflect comments at a future date.

G.Effective Dates

The temporary regulations are generally effective for consolidated return years beginning on or after January 1, 1997. In contrast to the former proposed regulations, this effective date also applies to the amendments to the SRLY and built-in deduction rules. Under the former proposed regulations, the amendments to the SRLY and built-in deduction rules applied only to losses and deductions of corporations that became members after the effective date without regard to when such losses arose; losses and deductions of members acquired prior to that date remained subjectto the old regime. In contrast, under the temporary regulations, the amendments to the SRLY and built-in deduction rules apply to losses and deductions carried to years after the effective date, regardless of when such losses or deductions arose.

H.Transitional Effective Dates

A consolidated group may elect to apply the temporary regulations to years ending on or after January 29, 1991 and before January 1, 1997 if three conditions are met: (1) the temporary regulations must be consistently applied on the group's return (original or amended) for each such year for which the statute of limitations does not preclude the filing of an amended return; (2) the temporary SRLY and built-in deduction rules must be applied only to losses of corporations becoming members and acquisitions occurring on or after January 29, 1991; and (3) adjustments must be made to the earliest subsequent open year to reflect any inconsistency in a closed year.

I.On June 25, 1999, Treasury issued new final regulations that modify the temporary regulations.

1.In T.D. 8823, 64 Fed. Reg. 36092 (Jul. 2, 1999), Treasury finalized the SRLY rules with one significant modification. The final regulations generally eliminate the SRLY limitation when its application overlaps with the section 382 limitation. See Part XIV.F.

2.In T.D. 8824, 64 Fed. Reg. 36116 (Jul. 2, 1999), Treasury finalized the rules provided in the temporary regulations on the operation of section 382 with respect to consolidated groups. New provisions in the final regulations include: (a) an election to treat the subgroup parent requirement as satisfied (See Part IV.A.3); (b) changes in the supplemental change method (See Part III.B.2); and (c) the apportionment of a group’s net unrealized built-in gain to a departing member (See Part X.A.4.e).

3.In T.D. 8825, 64 Fed. Reg. 36175 (Jul. 2, 1999), Treasury finalized the temporary regulations with respect to the application of section 382 to controlled groups, with some modifications, including the addition of a presumption that certain built-in losses are attributable to tax years before the tax year at issue. See Part XIII.B.

J.An Overview of the Final Regulations

1.The Consolidated Section 382 Regulations

a.Treas.Reg. § 1.1502-90 -- Table of Contents

b.Treas. Reg. § 1.1502-91 -- Contains the definitions of loss group and loss subgroup, pre-change consolidated and subgroup attributes; sets forth rules on the effect of section 382 and rules regarding built-in gains and losses.

c.Treas.Reg. § 1.1502-92 -- Contains rules for determining whether an ownership change of a loss group or loss subgroup has occurred.

d.Treas.Reg. § 1.1502-93 -- Includes rules for the calculation of loss group and loss subgroup section 382 limitations.

e.Treas.Reg. § 1.1502-94 -- Sets forth rules that apply when corporations join a consolidated group.

f.Treas.Reg. § 1.1502-95 -- Contains rules that apply when a corporation ceases to be a member of a loss group or loss subgroup.

g.Treas. Reg. § 1.1502-96 -- Describes treatment under section 382 of certain SRLY losses treated as consolidated losses ("fold-in" rules), ownership change of subsidiary if certain persons hold options pursuant to a plan or arrangement, and continuing application of limitations following ownership changes.

h.Treas.Reg. § 1.1502-97 -- Deals with special rules in Title 11 cases and is Reserved.

i.Treas.Reg. § 1.1502-98 -- Describes coordination with section 383.

j.Treas.Reg. § 1.1502-99 -- Contains the effective date rules.

2.The New Consolidated Return Rules

The new regulations make significant changes to the existing consolidated return regulations. The major changes include the following.

a.Treas.Reg. § 1.1502-1 -- amending certain key definitions.

b.Treas.Reg. § 1.1502-15 -- amending the built-in loss rules.

c.Treas.Reg. § 1.1502-21 -- amending the SRLY rules with respect to net operating losses.

d.Treas.Reg. § 1.1502-22 -- amending the SRLY rules with respect to capital losses.

e.Treas.Reg. § 1.1502-23 -- amending the rules with respect to net section 1231 gains and losses.

3.Additional Regulations

Additional regulations were also released at the same time as the final regulations. These regulations made the following changes.