by Mary Fung, manager, KPMG's Washington National Tax Practice—Mergers & Acquisitions Group

A corporation that has a net operating loss for a tax year can either carry the NOL back to offset income in the prior two years and obtain a refund of taxes paid in those years, or the corporation can carry the NOL forward to offset taxable income in the next 20 years. (The two-year carryback and 20-year carryforward periods are applicable to NOLs generated in tax years beginning after August 5, 1997.) Thus, a corporation's NOL carryover is generally a favorable tax attribute. In fact, if a member of a consolidated group purchases the stock of a corporation that has a NOL carryover, the price paid for the stock may reflect the consolidated group's hope of using the NOL carryover to offset future income. Subject to certain limitations, the consolidated group can use the NOL carryover to offset future taxable income of the group. Among those limitations are the limitations imposed by section 382 and the separate return limitation year (SRLY) rules of the consolidated return regulations. Because of the "Overlap Rule" discussed below, many corporate tax departments may be more concerned with the section 382 limitation than the limitation imposed by the SRLY rules. Thus, this article focuses on the computation of the section 382 limitation.

Overview of Section 382 and SRLY Rules
In general, a section 382 ownership change occurs when the percentage of stock held by one or more 5-percent shareholders of a loss corporation increases by more than 50 percentage points over the lowest stock ownership held by such shareholders on a particular testing date within a prescribed period (usually a three-year period). When an ownership change occurs, section 382 limits the ability of the corporation to use pre-ownership change losses, including NOL carryovers and certain built-in losses, to offset post-ownership change taxable income. The section 382 rules do not reduce the amount of the corporation's pre-ownership change losses. Rather, the section 382 rules place an annual limitation (the section 382 annual limitation) on how much of the corporation's pre-ownership change losses can be used to offset income in a post-ownership change year. The section 382 annual limitation is a formulary amount based on the value of the corporation immediately before the ownership change. Section 383 provides similar limitation rules for pre-ownership change credits and capital loss carryovers.

The SRLY rules apply if a corporation with losses, including NOL carryovers, capital loss carryovers, and certain built-in losses, becomes a member of a consolidated group. For example, the SRLY rules generally limit the amount of the consolidated group's taxable income that may be offset by NOL carryovers that the acquired corporation brings with it into the consolidated group (separate return limitation year losses). In general, the SRLY rules limit the consolidated group's use of separate return limitation year losses to the amount of income generated by the acquired corporation after it becomes a member of the group (the SRLY limitation).

In general, if a corporation is acquired by a consolidated group, the acquired corporation's pre-ownership change (or separate return year) losses are subject to the lesser of (i.e., the more restrictive) the section 382 annual limitation and the SRLY limitation. The SRLY limitation has often been the more restrictive limitation, because the acquired corporation did not generate income and the SRLY limitation was therefore zero. But, for tax years with an unextended due date after June 25, 1999, the "Overlap Rule" generally makes the SRLY limitation inapplicable to NOLs, capital losses, and built-in losses of corporations joining a consolidated group within six months of (i.e., either before or after) a section 382 ownership change. See Treas. Reg. Sections 1.1502-21(g), -22(g) and -15(g). In these situations, the Overlap Rule makes the computation of the section 382 annual limitation an essential task for many corporate tax departments.

The section 382 provisions are among the most complex rules contained in the Code, providing detailed and thorny rules to calculate the section 382 annual limitation. This article is intended to provide taxpayers with a general guideline for computing basic section 382 limitations. Nevertheless, some intricacies of applying the mechanical section 382 rules are highlighted. The discussion is in a question and answer format. Unless otherwise indicated, assume that LossCo is a corporation with NOL carryovers that has had a section 382 ownership change and that LossCo is not a member of a consolidated group or controlled group prior to the section 382 ownership change.

1. What is the amount of the section 382 annual limitation?
The section 382 annual limitation is intended to approximate the amount of income that LossCo could have produced as a return on equity, absent the acquisition, had it invested its capital in tax-exempt securities. In general, the section 382 annual limitation equals the product of (a) the value of LossCo immediately before the ownership change and (b) the applicable interest factor. The computation of the value of LossCo is addressed in Question 2. The applicable interest factor is the highest long-term tax-exempt bond rate determined under section 1274(d) for the three-month period ending with the month of the section 382 ownership change. For example, if the ownership change occurred in October 2000, the applicable rate would be 5.53 percent.

The section 382 annual limitation for a given year may be increased for various items, including any unused portion of prior years' section 382 annual limitations. As discussed in Question 7, the limitation may also be increased by "recognized built-in gains."

LossCo must satisfy a two-year continuity of business requirement (COBE requirement), or LossCo's section 382 annual limitation may be reduced to zero retroactively to the ownership change date. Section 382(c). The COBE requirement is met if LossCo either continues a significant line of its historical business or continues to use a significant portion of its historical business assets for the two-year period. Even if the COBE requirement is not satisfied, LossCo may still use its pre-ownership change losses to the extent of the amount of recognized built-in gain for the year. See Question 7.

2. What is the "value" of LossCo for purposes of computing the section 382 annual limitation?
The value of LossCo is the fair market value (FMV) of its outstanding equity immediately prior to the ownership change. In general, equity includes both common and preferred stock of LossCo and certain options to acquire LossCo stock. Absent a formal valuation, it is reasonable to use publicly trading share price to estimate the value of a publicly traded corporation. For a non-publicly traded company, the price of the stock in the transaction triggering the ownership change may be used to determine a value for the corporation.

Several special rules prevent taxpayers from increasing the section 382 annual limitation by "inappropriately" increasing the value of LossCo. In particular, the value of LossCo must be adjusted for certain capital contributions (the "anti-stuffing rule"), redemptions and other corporate contractions, and substantial nonbusiness assets. See Questions 3 - 5, respectively. In addition, there may be a controlled group adjustment. See Question 6.

2a. Can a control premium be included in computing the value of LossCo?
Yes. Control premiums and discounts may be included in the value of LossCo. In PLR 9332004, the IRS agreed that the ownership of stock could, in certain circumstances, give rise to a control premium. The IRS found that the value of the publicly traded loss corporation's stock for purposes of computing the section 382 annual limitation may be different than the amount determined by merely multiplying the publicly trading share price of the corporation's stock by the number of shares of stock outstanding.

2b. How about the value of "in the money" options?
Probably. Warrants, options, and similar interests may be treated as stock for purposes of determining the value of LossCo. In PLR 9332004, the IRS noted that to the extent warrants for a corporation's stock have value, that value derives from the potential ownership of the underlying stock. In the ruling, the IRS permitted the corporation to include the value of warrants in determining the corporation's section 382 value. Based on the ruling, it appears that the value of "in the money" options should be counted when calculating LossCo's section 382 value.

3. What is the "anti-stuffing rule?"
The anti-stuffing rule provides that capital contributions made to LossCo with a principal purpose of avoiding or increasing LossCo's section 382 annual limitation are disregarded for purposes of computing LossCo's section 382 value. Section 382(l)(1). Any capital contribution made within the two-year period preceding the section 382 ownership change is presumed to have been made for a principal purpose of increasing LossCo's value. Without this rule, shareholders could make capital contributions to a corporation in anticipation of an ownership change to increase the section 382 annual limitation.

3a. In applying the "anti-stuffing" rule, what constitutes a capital contribution?
The term capital contribution is broadly construed. It refers to any value received by LossCo in exchange for LossCo equity. Furthermore, the value of a corporation acquired by LossCo in a tax-free reorganization presumably is treated as a capital contribution.

3b. Is there a rebuttal for the two-year presumption?
Yes. The proceeds from some capital contributions made during the two-year period preceding a section 382 ownership change may be used for legitimate business reasons and should not be viewed as having a principal purpose of avoiding or increasing the section 382 annual limitation. The legislative history indicates that certain contributions should be excluded from the two-year presumption, including capital contributions (a) received when the corporation was formed (unless the formation involved a transfer of assets with built-in losses); (b) received before the corporation's NOL or built-in losses arose; and (c) necessary for working capital. See H.R. Rep. No. 841, 99th Cong., 2d Sess., at II-189 (1985).

It is important to properly document the use of capital contributions. If LossCo uses the proceeds from a capital contribution made within the two-year period to meet daily operating expenses or for another legitimate business purpose, and that purpose is documented, the capital contribution should be counted in computing the section 382 annual limitation.

4. What is the "substantial nonbusiness assets" adjustment?
The value of LossCo is adjusted if LossCo holds substantial nonbusiness assets after an ownership change. In this case, LossCo's value is reduced by the excess of the fair market value of nonbusiness assets over indebtedness allocable to those assets. Section 382(l)(4). Any assets held for investment are nonbusiness assets. Nonbusiness assets are substantial if they exceed one-third of the total asset value. High tech companies in a development stage that experience section 382 ownership changes should pay close attention to this adjustment, because these companies tend to hold a substantial amount of nonbusiness assets, such as marketable securities. To illustrate the application of this adjustment, consider the following:

The adjustment for a corporate contraction is illustrated by the following example: Individual A, the sole shareholder of LossCo stock (FMV = $100) sells 51 percent of his interest to an unrelated person, B, for $51 triggering an ownership change with respect to LossCo. As part of the transaction, LossCo redeems the remaining shares held by A for $49, resulting in B being the sole shareholder in LossCo. LossCo's value, for purpose of determining the section 382 annual limitation, is adjusted to $51 ($100 - $49 attributable to the redemption that occurred in connection with the ownership change). Because the section 382 value of LossCo is lower, so is LossCo's section 382 annual limitation.

6. How does the "controlled group" adjustment work?
The regulations under section 382 contain a special rule for determining the value of a corporation that is a member of a controlled group of corporations on the date of the section 382 ownership change. The rule is intended to prevent members of a controlled group (50 percent or greater common ownership) that do not file a consolidated return from duplicating value in computing an individual member's section 382 annual limitation. Treas. Reg. Section 1.382-8 requires each group member (owning member) to reduce its value by the value of the stock it owns in another group member (owned member).

Nevertheless, all or a portion of the value reduction can be restored to the owning member if an election is filed to reattribute the stock value to the owning member. If such an election is made, the value of the stock of the owned member must be reduced by the value ceded to the owning member.

If the ownership change occurred in tax years beginning before January 1, 1997, no formal election was required. The controlled group and the owning member were only required to use a method that did not result in double counting. For tax years beginning after January 1, 1997, an election must be filed with the owning member's tax return in the year of the section 382 ownership change.

To illustrate, assume LossCo owns 75 percent of the stock of Sub at the time of LossCo's section 382 ownership change. LossCo must adjust the value of its own stock to eliminate the value of the Sub stock, unless Sub elects to give that value back to LossCo. If the election is made, the value of Sub's stock is reduced for purposes of computing Sub's section 382 annual limitation.

7. What constitutes a "recognized built-in gain" that increases the section 382 annual limitation?
At the time of the section 382 ownership change, LossCo may have substantially appreciated assets (i.e., built-in gain assets) despite the existence of pre-ownership change losses. If LossCo has a "substantial" net unrealized built-in gain (NUBIG) in its assets at the time of the ownership change, certain built-in gains recognized within five years after the ownership change will increase the section 382 annual limitation otherwise available. LossCo has a "substantial" NUBIG if the aggregate fair market value of its assets exceeds its aggregate tax basis in such assets by the lesser of $10 million or 15 percent of the fair market value of the assets (exclusive of cash, cash items and certain marketable securities). Section 382(h)(3)(B)(i). Certain items of income, to the extent built-in at the time of the ownership change and recognized in the following five years, will be treated as built-in gains and thus, will increase the section 382 annual limitation for the year of recognition.

The increase to the section 382 annual limitation in aggregate for the recognition of built-in gains within the five-year period cannot exceed the amount of the NUBIG at the time of the ownership change. LossCo must prove that the recognition of a built-in gain during the five-year period is attributable to appreciation in its assets that occurred prior to the ownership change. To illustrate, assume that LossCo has two assets at the time of the ownership change. Asset 1 has a built-in gain of $100—fair market value of $100 and tax basis of zero. Asset 2 has a built-in loss of $5—fair market value of $10 and a tax basis of $15. LossCo has a NUBIG of $95 ($100 built-in gain less $5 built-in loss) that is substantial. Assume that LossCo sells Asset 1 one year after the ownership change for $110, resulting in $110 of gain to LossCo. Of the $110, the recognized built-in gain that can increase LossCo's section 382 annual limitation is limited to $95 (LossCo's NUBIG). If LossCo's NUBIG was more than $100 (say $150 because LossCo had other built-in gain assets), the recognized built-in gain that can increase LossCo's section 382 annual limitation is $100 (the built-in gain in Asset 1 at the time of the ownership change). The $10 of post-ownership change appreciation is not built-in gain for section 382 purposes.

Section 382 also has special provisions if a corporation has a "substantial" net unrealized built-in loss (NUBIL) rather than a NUBIG. If a corporation has a NUBIL, section 382 provides that certain built-in losses recognized during the five-year period are subject to limitation in the same manner as pre-ownership change NOL carryovers.

8. What happens if LossCo experiences successive section 382 ownership changes?
LossCo is subject to the lowest of the applicable section 382 annual limitations.

Conclusion
Because of the Overlap Rule, computing the section 382 annual limitation will likely be more important to consolidated return groups than it has been in the past. As illustrated, the rules of section 382 are complex and taxpayers should be aware of these complexities when acquiring a corporation with losses. If the complexities of section 382 are not enough, taxpayers should also be aware that the section 382 regulations impose some onerous reporting and record keeping requirements.