LIFE AFTER THE FINAL REGULATIONS: CONSOLIDATED SECTION 382 AND SRLY STUART J. GOLDRING SCOTT M. SONTAG. Weil, Gotshal & Manges LLP New York, New York

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1 LIFE AFTER THE FINAL REGULATIONS: CONSOLIDATED SECTION 382 AND SRLY STUART J. GOLDRING SCOTT M. SONTAG Weil, Gotshal & Manges LLP New York, New York June 27, 2005 Copyright 2005, Stuart J. Goldring and Scott M. Sontag All rights reserved.

2 Life After the Final Regulations: Consolidated Section 382 and SRLY By: Stuart J. Goldring Scott M. Sontag* Weil, Gotshal & Manges LLP New York, New York June 27, 200 Trafficking in tax losses the ever-looming evil. Neutrality the noble goal. The single entity theory the essence of consolidation. With these concepts in mind, we approach the regulations governing the use of tax loss and credit carryforwards within the consolidated return context. A practitioner seeking to advise on the use of tax loss and credit carryforwards within a consolidated group must be aware of several provisions, not all of which may be particularly relevant at any given time. These include: Section 382, which (in combination with Section 383) limits the use of tax loss and credit carryforwards (and, in certain cases, built-in losses) of a corporation following an ownership change of the corporation. The separate return limitation year ( SRLY ) rules, which limit the use of certain carryforwards (and, in certain cases, built-in losses) of newly acquired members of a consolidated group against the income of other members. Section 384, which, following an acquisition, may limit the use of one company s carryforwards and built-in losses (whether it be the acquiring corporation or the target) against the other company s built-in gains. The consolidated return change in ownership ( CRCO ) rules, now largely of prurient interest. Section 269, applicable to certain tax avoidance acquisitions. * The authors gratefully acknowledge the assistance of their colleague David M. Maryles, in an earlier version of this outline to incorporate the final SRLY regulations.

3 2 Special rules applicable to closely held corporations, such as the Section 469 passive loss rules and the Section 465 at risk rules. Other special rules, such as insurance company related limitations under Reg applicable to life/non-life consolidated groups, the limitations on dual consolidated losses under Section 1503(d), the limitation under Section 1503(f) applicable to the issuance of subsidiary preferred stock, the separate company treatment of Section 7701(i) taxable mortgage pools, etc. This outline discusses the most pervasive of these provisions namely, the regulations relating to (i) the application of Section 382 to consolidated groups (the Consolidated 382 Regulations ) and (ii) the SRLY rules (the SRLY Regulations ) and certain problems and pitfalls related thereto. In both instances, this outline will focus on the current regulations, which became final on June 25, 1999 (except for the portion of the SRLY Regulations applicable to tax credits, which became final on May 25, 2000), and the former temporary regulations. Although Section 382 and the SRLY rules are, generally speaking, provisions of long standing, they have in the past decade undergone fundamental changes. The current statutory version of Section 382 (still referred to by many as new Section 382) became effective on January 1, Although the statute did not address consolidated groups, the legislative history states that the SRLY and CRCO principles under the regulations governing the filing of consolidated returns will continue to apply. H.R. Rep. No , 99th Cong., 1st Sess. 272 (1985); S. Rep. No , 99th Cong., 2d Sess. 247 (1986). And so they did, at least until January 29, 1991 when Treasury issued proposed regulations (i) addressing the application of new Section 382 to consolidated groups, and (ii) as relates to net operating loss ( NOL ) and capital loss carryforwards (as well as built-in losses), modifying the SRLY rules and repealing the CRCO rules. The proposed regulations did not alter the application of the SRLY and CRCO rules with respect to tax credits. Despite having received numerous comments and suggestions with respect to the proposed regulations, Treasury, on June 27, 1996, adopted the proposed regulations in temporary form without substantive change other than for the effective date provisions (which were generally prospective in effect but provided taxpayers with the ability to apply the regulations retroactively if certain consistency requirements were satisfied). The preamble to the temporary regulations stated that all of the comments received with respect to the proposed regulations would be considered in finalizing the temporary regulations. In January 1998, Treasury issued additional temporary regulations extending the application of the modified SRLY rules to general business credits and the minimum tax credits, and prospectively repealing the SRLY rules for foreign tax credits and overall foreign losses. On June 25, 1999 two days shy of the three year sunset on the 1996 temporary regulations Treasury finalized the Consolidated 382 Regulations and the SRLY Regulations (other than, in the case of SRLY, as applicable to tax credits which became final on May 25, 2000). Although the final regulations incorporated in most respects the provisions of the former temporary regulations, significant changes nevertheless were made. Among these was the partial repeal of the SRLY rules in certain cases where the initial implementation of SRLY rules overlapped with that of Section 382. Treasury adopted this

4 3 approach for dealing with the potential overlap of SRLY and Section 382 after considering taxpayer and practitioner comments. See Notice (raising the possibility of replacing the SRLY rules with a new approach modeled on Section 382), and the preamble to the final SRLY Regulations. In response to additional taxpayer comments, the IRS and Treasury, on September 1, 2000, issued Notice announcing their intent to issue regulations allowing elective transitional relief with respect to certain subsidiary sales adversely effected by the overlap rule. On May 25, 2000, Treasury finalized the SRLY Regulations with respect to tax credits. These regulations made permanent the changes previously adopted in the January 1998 temporary regulations, and extended to general business credits and minimum tax credits the elimination of the SRLY rules in certain Section 382 overlap situations. See T.D I. Overview of Consolidated 382 Regulations: Reg et seq. The following overview assumes a basic knowledge of the operation of Section 382 outside the consolidated return context. Pursuant to Reg , the principles of the Consolidated 382 Regulations apply, with appropriate adjustments, to capital losses and to tax credits to which Section 383 applies (namely, foreign tax credits, general business credits and minimum tax credits), as well as to NOL carryforwards. However, for ease of discussion, all references herein shall only be to NOL carryforwards. The following discussion is of the final Consolidated 382 Regulations (T.D. 8824), issued on June 25, 1999, and the prior temporary regulations. Several significant changes were made in the final regulations. These are indicated as appropriate. In general, the final Consolidated 382 Regulations apply to all transactions occurring on or after June 25, Certain special effective dates and transitional rules apply, however, particularly in the case of liberalizing changes. The final Consolidated 382 Regulations are at Reg through -99. For easy reference, Treasury redesignated the former temporary regulations as Reg A through -99A. A. Single Entity Approach. The Consolidated 382 Regulations generally take a single entity approach to consolidation. This approach reflects the ability of corporations that file consolidated returns to use each other s losses in computing consolidated taxable income as if they were divisions of a single corporation rather than separate corporations. As such, all corporations in a consolidated group are generally treated for purposes of Section 382 as one entity and referred to as a loss group. The regulations also adopt the concept of a loss subgroup to refer generically to an

5 4 acquired group of affiliated corporations that enters a consolidated group at the same time. 1. Multiple Definitions. Complicating matters, the Consolidated 382 Regulations employ a different definition of loss group and loss subgroup with respect to NOL carryforwards from that used for the determination of built-in losses (and, as discussed below, employ different definitions for purposes of the SRLY rules). In addition, under the temporary Consolidated 382 Regulations the subgrouping rules applicable for purposes of determining a loss subgroup s net built-in gain were unclear. According to the preamble to the 1991 proposed changes to the SRLY rules, the different definitions of loss group and loss subgroup with respect to NOL carryforwards and built-in losses are due to Treasury s attempt to avoid the administrative complexity of identifying where built-in losses have economically accrued and to provide a transition from separate return to consolidated return status as it becomes more appropriate to view a group s investment in a new member as an investment in its assets and operations rather than its stock. The preamble to the 1999 final Consolidated 382 Regulations reaffirmed this purpose, and rejected a more generic definition of loss group and loss subgroup for fear that it would be too easily abused. 2. Loss Group. a. In General. Reg (c)(1) defines a loss group as a consolidated group that meets one of three tests: the group has an NOL carryforward that did not arise in a SRLY (and is not treated, under the SRLY rules, as arising in a SRLY). The SRLY qualification only applies (i) if the SRLY member did not undergo an ownership change within the 6-month period prior to becoming a member of the group and (ii) until the SRLY member undergoes an ownership change or, if earlier, 5 years has passed since the SRLY member joined the group (i.e., for the period during which the so-called separate tracking or fold-in rules of the Consolidated 382 Regulations apply). See Reg (c)(2), -96(a). Note that, under the former temporary regulations, a pre-consolidation ownership change of the SRLY member only preempted separate tracking if it occurred in connection with becoming a member of the group, rather than simply if it occurred within the prior 6-month period. See Reg A(a).

6 5 the group has a consolidated NOL for the taxable year in which a testing date occurs; or the group has a net unrealized built-in loss ( NUBIL ) on a testing date. b. Built-In Gains and Losses. In determining whether a loss group has a net unrealized built-in gain ( NUBIG ) or a NUBIL under Section 382(h)(3) (taking into account the 15% or $10 million administrative threshold), the final Consolidated 382 Regulations require independent computations: For NUBIG purposes (which is applicable only to loss groups with NOLs), the built-in gains and losses of all members of the consolidated group are taken into account. Reg (g)(2)(i), (v). For NUBIL purposes, the built-in gains and losses of only the following members are taken into account: (1) the common parent; (2) those members that have been affiliated with the common parent for the 5-year period ending on the testing date (determined after appropriate adjustments for any change in the common parent due to a reverse acquisition or change in group structure); (3) any other member (or loss subgroup) that has a NUBIL on the testing date that is not required to be separately tracked; and (4) any member (or loss subgroup) that had a NUBIL when it joined the group, for which it is still technically subject to separate tracking, but has a NUBIG on the testing date. Reg (g)(2)(ii), (6), -92(b)(3), -96. The net result of these regulations is to exclude from the computation of a loss group s NUBIL (i) any member that joined the group within the preceding five years and had a NUBIG at the time, unless such member has a NUBIL on the testing date or is a successor to another group member, and (ii) all new loss members (and loss subgroups) that had a NUBIL that is subject to separate tracking, which NUBIL still exists.