Under Section 382 of the Internal Revenue Code, a corporation’s use of net operating losses is limited if there is an “ownership change.” On November 22, 2011, the Department of Treasury issued a Notice of Proposed Rulemaking (the “Notice”) containing proposed regulations (the “Proposed Regulations”) intended to lessen the compliance burden on taxpayers determining whether an ownership change has occurred for these purposes. The Proposed Regulations are based upon and take into account comments received in respect of Notice 2010-49, which announced an IRS study on easing the compliance burden of tracking less-than-5% shareholders for these purposes.
Under the Proposed Regulations, taxpayers no longer have to separately track:
- certain secondary transfers to a public owner;
- certain small redemptions; and
- certain shifts of ownership among small shareholders that indirectly hold shares of a corporation that has net operating losses or related tax attributes.
The Notice requests comments regarding:
- whether refinement of the current small issuance and cash issuance exceptions to the tracking requirements might be warranted; and
- circumstances under which a group of investors acquiring ownership interests should be aggregated into a single entity for purposes of these rules.
Section 382 limits the ability of a corporation to carry forward certain tax attributes (such as net operating losses and unrecognized built-in losses) after an ownership change occurs. Although intended to discourage the “trafficking” in corporations with favorable tax attributes, these provisions apply without regard to whether a change in ownership occurred for that purpose.
In general, a corporation with net operating losses or other tax attributes (a “Loss Corporation”) experiences an ownership change if, immediately after the close of a “testing date,” the percentage of stock of the corporation owned by one or more “5% shareholders” has increased by more than fifty percentage points over the lowest percentage of stock of the corporation owned by those shareholders at any time during the “testing period.” The “testing period” is generally the three years preceding the “testing date,” but can be shortened if there has been a prior ownership change or if all losses arose after the three-year period began.
For the purpose of determining who is a 5% shareholder, corporations, partnerships and other entities are generally looked through to determine the ultimate beneficial ownership of the Loss Corporation’s stock. However, persons that own less than 5% of a Loss Corporation (such shareholders, “Small Shareholders”) are typically combined under the “aggregation rules” and treated as a “Public Group” (or in certain cases, more than one Public Group) which is treated, in evaluating whether an ownership change has occurred, as if it is a 5% shareholder. Certain transactions—including some stock issuances, redemptions and transfers by 5% shareholders—can separate existing Public Groups into additional Public Groups under the so-called “segregation rules.”
On June 11, 2010, the IRS issued Notice 2010-49, announcing that it is studying the rules involving lessthan- 5% shareholders. While the current rules generally use an “Ownership Tracking Approach,” under which the Loss Corporation must track and separately account for transfers involving less-than-5% shareholders, the IRS said that it was willing to consider a more “Purposive Approach,” which is intended to “identify more specifically the circumstances in which abuses are likely to arise.”
A. The Proposed Regulations
After receiving comments responding to Notice 2010-49, the Department of Treasury has issued the Proposed Regulations, providing specified exceptions to the segregation rules in circumstances relating to less-than-5% shareholders. The exceptions discussed in the Notice are intended to be in line with the Purposive Approach. The Notice indicated that the Treasury Department does not currently want a more fundamental reform of the existing regulations, as some comments requested, because the approaches to such reform introduced a large measure of subjectivity, which, in the Treasury Department’s view, created a significant amount of uncertainty.
1. Exception for Certain Secondary Transfers
Under current law, the segregation rules apply in any situation in which a First Tier Entity or an individual that directly owns 5% or more of the Loss Corporation transfers a direct ownership interest in the Loss Corporation to public shareholders. Under the current rule, if a Loss Corporation is held partly by a Public Group and partly by a single individual, public shareholders acquiring shares from the individual are segregated and treated as a separate Public Group from the original Public Group. In addition, the same principles apply when an ownership interest in a Higher Tier Entity that owns 5% or more of the Loss Corporation is transferred to a public owner of such Higher Tier Entity, or to a 5% owner of the Higher Tier Entity who is not also a 5% shareholder of the Loss Corporation.
The Proposed Regulations would make the segregation rules in such situations inoperative such that, in the example above, no new Public Group would be created. Instead, each Public Group (or, in the example above, the sole Public Group) will be treated as acquiring its proportionate share of the transferred ownership interests. The Notice explains that this change is justified because these secondary transfers to the public do not introduce new capital into the Loss Corporation and they decrease (rather than increase) the concentration of the ownership of the Loss Corporation. In addition, the change will simplify tax compliance and administration by limiting the creation of additional Public Groups.
The Proposed Regulations also clarify that in the case of a transfer of an ownership interest of a Higher Tier Entity, the segregation rules only apply if the transferor of the ownership interest indirectly owns at least 5% of the Loss Corporation. Certain attribution rules will apply to treat the transferor as the constructive owner of shares of the Loss Corporation actually held by certain family members, corporations, or other entities related to the transferor.
2. Exception for Certain Small Redemptions
Under current law, when a Loss Corporation acquires its stock in exchange for property, the segregation rules apply so that the stock acquired in the transaction is treated as owned by a separate Public Group from each Public Group that owns the stock that is not acquired. For example, if a Loss Corporation that is entirely owned by one Public Group redeems 30% of its stock, the Public Group is effectively bifurcated immediately prior to the redemption into two groups – one holding 30% and the other holding 70%. Upon the redemption, the Public Group holding 70% is deemed to have increased its share of the Loss Corporation by 30 percentage points to 100%.
The Proposed Regulations provide an exception to this rule for certain small redemptions by the Loss Corporation. A redemption will qualify for this exception if it is for an amount of stock that does not exceed the Loss Corporation’s “small redemption limitation.” For each taxable year, the Loss Corporation has the option of applying the small redemption exception either (i) on a corporation-wide basis, in which case the small redemption limitation will be 10% of the total value of the Loss Corporation’s stock outstanding at the beginning of the taxable year, or (ii) on a class-by-class basis, in which case the small redemption limitation will be 10% of the number of shares of the class redeemed that are outstanding at the beginning of the taxable year. The Notice explains that the purpose of this change is to allow a Loss Corporation to plan its affairs as of the beginning of each taxable year, and to reduce administrative burden and the impact of Section 382 in transactions in which abuses are unlikely to arise.
3. Exception for Certain Shifts of Ownership of 5-Percent Entities
Under current law, the segregation rules apply to Public Groups that hold ownership interests in either a First Tier Entity or a Higher Tier Entity that owns (directly, indirectly, or constructively) more than 5% of the Loss Corporation (such First Tier Entity or Higher Tier Entity, a “5-Percent Entity”). Under this rule, if such a 5-Percent Entity is involved in a transaction to which the segregation rules apply, the Loss Corporation would have a new segregated Public Group which could result in an ownership change for the Loss Corporation.
The Notice states that the Treasury Department has received comments requesting relief from this rule, because in many cases, the 5-Percent Entity is unable or unwilling to provide the relevant information regarding its owners to the Loss Corporation. In response, the Proposed Regulations provide an exception to the segregation rules in any case where, on a testing date on which the segregation rules would otherwise apply, the 5-Percent Entity can satisfy both an ownership limitation and an asset threshold.
The ownership limitation is satisfied if the 5-Percent Entity owns no more than 10% (by value) of all outstanding stock of the Loss Corporation, either directly or constructively. Preferred Stock that is described in Section 1504(a) will be treated as stock for this calculation, despite its generally not being treated as stock for Section 382 purposes. The Loss Corporation may establish that it satisfies this ownership limitation either by actual knowledge, or, in the absence of actual knowledge, using certain presumption rules.
The asset threshold is satisfied if the 5-Percent Entity’s direct or indirect investment in the Loss Corporation does not exceed 25% of the entity’s gross assets. The entity’s cash or cash items are not taken into account for the purpose of this calculation.
The following example illustrates the application of this rule: Corporation X holds 8% of L, a Loss Corporation. X is a publicly traded corporation which has no shareholder holding 5% or more of X. Excluding cash and cash items, X’s investment in L represents 11% of X’s gross assets. Y is another unrelated corporation that is also wholly owned by public shareholders. Y does not own any interest in L. X merges into Y, with the X shareholders receiving shares of Y equal to 25% of Y’s value immediately after the merger. Absent this new exception, the original public shareholders of Y would have been deemed to have received their proportionate share of L (i.e., 75% of X’s holding, or 6% of L) and would have been treated as a separate Public Group from the Public Group of the X shareholders (which would have been treated as having decreased its share of ownership of L to 2%). Under the new exception, because after the merger Y satisfies both the ownership limitation and the asset threshold, the segregation rules will not apply. Only one Public Group will exist, and it will be treated as having always owned 8% of L.
The Proposed Regulations also provide rules for determining the amount of increase of a Public Group’s percentage of stock ownership and the lowest percentage ownership of the Public Group in cases where the operation of this exception results in the combination of one or more Public Groups.
4. Effective Date
The Proposed Regulations will apply to testing dates occurring on or after the date that they are published as final regulations in the Federal Register.
B. Request for Comments
1. Small Issuance and Cash Issuance Exceptions
Current law provides for two exceptions to the segregation rules. Under the small issuance exception, the segregation rules do not apply to issuances of stock by the Loss Corporation if all such issuances for the year (determined at the time of the issuance) are less than the small issuance limitation for the Loss Corporation – generally, less than 10% of the value of the Loss Corporation or 10% of each class of stock. Under the cash issuance exception, the segregation rules do not apply for an issuance of stock by the Loss Corporation solely for cash, to the extent of one-half of the aggregate percentage ownership interest of direct Public Groups immediately before the issuance.
The Notice states that several comments requested expansion of these rules. However, there is a concern that transactions that infuse new capital into the Loss Corporation could accelerate the use of tax attributes, even if the new investors are Small Shareholders. The IRS and Treasury Department are therefore requesting comments as to whether these rules should be refined in the context of any potential expansion of the exceptions in the Proposed Regulations.
2. Coordinated Acquisitions
Under current law, in defining an “entity” for purposes of Section 382, the Treasury Regulations provide that “an entity includes a group of persons who have a formal or informal understanding among themselves to make a coordinated acquisition of stock.” The Notice acknowledges that the new exceptions added by the Proposed Regulations increase the distinction between large and small shareholders and, thereby, make this definition more significant. The IRS and Treasury Department therefore are requesting comments concerning circumstances under which a group of investors should be aggregated into a single entity based on their understandings or communications with each other or with third persons (such as the Loss Corporation or an underwriter).