IRS Issues Proposed Regulations on Built-in Gains and Losses
The IRS has issued proposed regulations (REG-125710-18) on the treatment of built-in gains and losses under Section 382(h). The proposed regulations would make mandatory a modified Section 1374 approach to computing items of income and deduction that are included in the calculation of built-in gains and losses. The Section 1374 approach is one of two safe harbors provided for under Notice 2003-65, the long-standing interim guidance available to taxpayers applying Section 382(h) to Section 382 ownership changes. If finalized, the proposed regulations would withdraw the Section 338 approach, the alternative safe harbor under Notice 2003-65, and provide specific guidance regarding the treatment of cancellation of indebtedness (COD) income, contingent liabilities, disallowed business interest carryforwards under Section 163(j), and cost recovery deductions.
Previous Guidance
When an ownership change occurs, loss corporations are subject to potential limitations on the use of tax attributes under Sections 382 and 383. A loss corporation is generally a corporation that has (i) carryforwards, including net operating losses (NOLs), capital losses, disallowed business interest, and certain credit carryovers; (ii) one of such attributes for the taxable year during which an ownership change occurs; or (iii) a net unrealized built-in loss (NUBIL) as of the ownership change date. An ownership change occurs where the cumulative ownership of the corporation’s 5-percent shareholders increases by more than 50 percentage points within a three-year period. When an ownership change occurs, a limitation is imposed on the corporation’s use of pre-change losses in each year beginning with the year of change equal to the fair market value of the corporation’s stock immediately prior to the change multiplied by the long-term tax-exempt rate.
The limitation on pre-change losses or the use of post-change built-in losses is further adjusted by the built-in gain and loss provisions of Section 382(h). Immediately prior to an ownership change, it must first be determined if the corporation has a net unrealized built-in gain or loss (NUBIG or NUBIL). In the case of loss corporation having a NUBIG, the annual Section 382 limitation may be increased by recognized built-in gains (RBIG) occurring during a five-year recognition period. Where a loss corporation has a NUBIL, the corporation is required to treat recognized built-in losses (RBIL) occurring within the recognition period as pre-change losses, subject to the annual Section 382 limitation. RBIG can only be used to enhance the loss corporation’s limitation to the extent of its NUBIG, and RBIL is treated as a pre-change loss only to the extent of its NUBIL.
Following the enactment of Section 382(h), the IRS provided interim guidance on how taxpayers may compute NUBIG/NUBIL and identify items of income or deduction constituting RBIG and RBIL. Notice 2003-65 specifically provided two safe harbor approaches for applying Section 382(h): the Section 1374 approach and the Section 338 approach. The Section 1374 approach generally employs the accrual method of accounting to determine what constitutes recognized built-in gain or loss. Under this approach, RBIG generally occurs when there is an actual sale of NUBIG property. The Section 338 approach identifies built-in gain and loss items by comparing the corporation's actual items of income and loss during the recognition period with what they would have been if a Section 338 election had been made for a hypothetical purchase of all the stock on the change date. Under either method, gains and losses from transactions treated as sales or exchanges, i.e., generally from the actual disposition of assets, are treated as RBIG or RBIL. Generally, the Section 338 approach yields a more favorable answer for taxpayers when a NUBIG exists, while the Section 1374 approach results in a more favorable answer for taxpayers when a NUBIL exists.
Proposed Regulations
The proposed regulations would make mandatory the Section 1374 method of Notice 2003-65, with certain adjustments. In computing NUBIG or NUBIL under the proposed regulations, the loss corporation is treated as transferring assets supporting inadequately secured nonrecourse debt, and then selling the remainder of its Section 382 assets (generally, assets other than cash and certain marketable securities and receivables) at fair market value to a third party. No liabilities are treated as assumed in such hypothetical sale. The realized amount is then reduced by tax basis, deductible non-contingent liabilities, and the estimated value of any contingent deductible liabilities. This amount is further adjusted for any remaining Section 481 adjustments and certain RBIG and RBIL items. Once NUBIG or NUBIL is determined, RBIG and RBIL are identified at the time of recognition by determining if such items of income and deduction would have been taken into account by an accrual-method taxpayer prior to the date of the ownership change.
Under the proposed regulations, cost recovery assets (plant, property, equipment, and amortizable intangibles) only result in RBIG to the extent they are disposed of within the recognition period or in RBIL to the extent they are either disposed of or depreciated within the recognition period. This eliminates the hypothetical cost recovery benefit provided for under the Section 338 approach of Notice 2003-65, in which the corporation could record RBIG on the positive difference between depreciation or amortization computed as if the assets were stepped up to fair market value and actual depreciation or amortization. In addition, the proposed regulations would modify the cost recovery calculations under the Section 1374 approach in Notice 2003-65 by allowing the loss corporation to compute adjusted fair market value recovery based on the same depreciation schedule actually used by the corporation. Under Notice 2003-65, hypothetical cost recovery was applied as if assets were placed in service on the ownership change date, resulting in distortions and anomalous results on assets with a shorter remaining life as compared to the hypothetical period.
The proposed regulations also provide significant clarity on the treatment of COD income with respect to both NUBIG/NUBIL and RBIG. As a general rule, COD income is excluded from both the NUBIG/NUBIL and RBIG computations. However, the proposed regulations allow COD income realized within 12 months of an ownership change to be included in the calculation of NUBIG/NUBIL, and where applicable, as RBIG upon recognition. This exception is limited in several ways. For example, excepted COD income (COD income excluded for gross income under one of the provisions of Section 108) is not included in the computation of NUBIG unless the excluded COD is offset by post-change tax attributes, or results in a basis reduction to assets under Section 1017. Further, if the basis reduction applies to assets held on the change date, COD is included in the computation of NUBIG, but RBIG is only included to the extent the assets are disposed of at a gain (as opposed to when the COD is recognized). The proposed regulations also include a specific ceiling computation for RBIG associated with COD income based on whether the corporation is in bankruptcy and provide specific rules regarding the treatment of nonrecourse debt.
Under Notice 2003-65, contingent liabilities are included in NUBIG/NUBIL computations to the extent of the estimated value of such liabilities on the change date. However, payments with respect to such liabilities within the recognition period are not treated as RBIL. Under the proposed regulations, payments with respect to contingent liabilities within the recognition period are treated as RBIL to the extent of the estimated value of the contingent liability as of the change date. The proposed regulations require value to be determined based on the most recently issued applicable financial statement if such liability is reflected therein.
The proposed regulations also deal with the treatment of disallowed business interest under Section 163(j). Such carryforwards are subject to Section 382 as pre-change losses pursuant to Section 382(d)(3). As a result, if the same attribute was subject to limitation as RBIL, the loss corporation may experience a double limitation. The proposed regulations treat disallowed business interest incurred prior to an ownership change and deducted after a change neither as part of the NUBIG/NUBIL computation, nor as RBIL in the recognition period. The proposed regulations also provide guidance on the treatment of excess business interest expense of partnerships owned by the loss corporation. Generally, when an excess business interest expense is incurred in the recognition period, either because the corporation sells substantially all of its partnership interests, or because the loss corporation can deduct the excess business interest expense, such amount is treated as RBIL.
For corporations with multinational activity, the proposed regulations include clarification on income inclusions from foreign subsidiaries, for example, inclusions under the global intangible low-taxed income, or GILTI, rules of Section 951A. Although these inclusions may result from an asset disposal at a foreign subsidiary, the proposed regulations do not treat such items as RBIG even in cases where assets disposed of were owned as of the change date. The same rule applies to amounts treated as dividends under Section 1248.
Effective Date
The proposed regulations are effective for ownership changes incurred after the publication of the regulations as final or temporary in the Federal Register. Taxpayers can apply the proposed regulations in advance of the effective date to any ownership change occurring during a taxable year for which the Section 6511(a) period has not expired (the period in which a refund is available). Comments and hearing requests are due by November 12.
BDO Insights
The proposed regulations provide much needed clarity on the uncertain or potentially improper treatment of items with respect to Section 382(h) under existing guidance. However, the cost of such clarity appears to be the elimination of the Section 338 approach safe harbor, which generally has been extremely favorable to loss corporations with built-in gains, primarily companies with significant research and development activity. For most corporations having a NUBIG, any RBIG benefit will be limited to asset disposals, which will simplify computation at the expense of the hypothetical step-up benefit under Notice 2003-65. For NUBIL corporations, the changes to cost recovery for computing RBIL are likely to be taxpayer-friendly, but deductions flowing from contingent liabilities will need to be tracked in the recognition period, which may be a difficult exercise in practice.
From a financial reporting perspective, there is no change required to the ASC 740 reporting of prior ownership changes, as the regulations are only effective for ownership changes following publication of the regulations as final or temporary. For ownership changes after such date, the proposed regulations would potentially reduce deferred tax assets associated with NOLs generated prior to enactment of the 2017 tax reform known as the Tax Cuts and Jobs Act, which removed the 20-year expiration on NOLs generated for taxable years ending after December 31, 2017. Although corporations can adopt the proposed regulations prior to their final publication, it seems unlikely a corporation in a NUBIG would do so given the elimination of the Section 338 approach.
It remains to be seen whether the proposed regulations, if adopted in their current form, would have a chilling effect on M&A activity when it comes to both taxable and tax-free stock acquisitions, or at least the price buyers are willing to pay for loss corporations with presumably diminished near-term NOL availability. The regulations may also have an impact on structures that monetize NOLs, for example, where an NOL tax receivable agreement or TRA would otherwise be a viable option to compensate legacy owners in an IPO structure. At a minimum, the regulations will change the calculations underlying the sale of stock or assets decision tree and may result in more domestic Section 338(g) elections as the net present value of NOLs is potentially decreased comparative to a potential asset basis step-up.
The comment period is likely to bring heavy criticism of the elimination of the Section 338 approach, and nuances of the proposed regulations, such as the elimination of foreign income inclusions from RBIG. However, the regulations resolve much of the ambiguity present in the Notice 2003-65 era and will be easier to administer from a tax practitioner perspective in most situations. Any changes in the final regulations are likely to be judged against administrative simplicity, which is an ongoing theme in the preamble to the proposed regulations.
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