Final Regulations Ease Compliance with the Loss Trafficking Rules IRS Finalizes Regulations Limiting the Application of the Section 382 Segregation Rules in Certain Circumstances SUMMARY 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 October 22, 2013, the Internal Revenue Service adopted Final Regulations intended to lessen the compliance burden on a corporation determining whether it has experienced an ownership change for these purposes. The Final Regulations are based upon and take into account comments received in respect of the Proposed Regulations issued on November 22, 2011. The Final Regulations are generally effective from October 22, 2013 but can in some cases be applied to transactions occurring prior to that date. Under the Final Regulations, a corporation that has net operating losses no longer has to separately track: certain secondary transfers of its stock to a public owner; certain small redemptions it or its corporate shareholders make; and certain shifts of ownership among small shareholders that indirectly hold its shares. The Final Regulations also clarify rules for small issuances by corporations directly owning 5% or more of a Loss Corporation, as described below, in determining whether an ownership change with respect to such Loss Corporation has occurred. BACKGROUND Section 382 limits the ability of a corporation to use certain tax attributes (such as net operating losses and unrecognized built-in losses) after an ownership change occurs. Although intended to discourage the New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com
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, 1 the percentage of stock of the corporation owned by one or more 5% shareholders has increased by more than 50 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. 2 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) 3 which is treated, in evaluating whether an ownership change has occurred, as if it were a single 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. 4 On June 11, 2010, the IRS issued Notice 2010-49, announcing that it is studying the rules involving lessthan-5% shareholders. While the rules generally used an Ownership Tracking Approach, under which the Loss Corporation was required to 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. 5 After receiving comments responding to Notice 2010-49, the Department of Treasury issued Proposed Regulations, providing specified exceptions to the segregation rules in circumstances relating to lessthan-5% shareholders. 6 The exceptions discussed in the Notice were intended to be in line with the 1 2 3 4 5 6 A testing date generally occurs if either: (i) certain transactions occur that affect the ownership of a 5% shareholder, including the purchase or disposition of Loss Corporation stock, certain capital contributions, and other such transactions, or (ii) certain options are issued or transferred. See Treas. Reg. 1.382-2(a)(4); Treas. Reg. 1.382-2T(e)(1)(i). See Section 382(i). See Section 382(g)(4)(A); Treas. Reg. 1.382-2T(j)(1). See Treas. Reg. 1.382-2T(j)(2) & (3). See S&C publication of June 16, 2010, Guidance on Changes in Ownership that May Limit Net Operating Losses and Credit Carryforwards for a detailed description of Notice 2010-49. See S&C publication of November 23, 2011, Proposed Regulations Seek to Ease Compliance with the Loss Trafficking Rules, for a detailed description of the Proposed Regulations. -2-
Purposive Approach. The Notice indicated that the Treasury Department did not want a more fundamental reform of 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. THE REGULATIONS A. EXCEPTION FOR CERTAIN SECONDARY TRANSFERS Under prior law, the segregation rules applied in any situation in which a First Tier Entity 7 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. 8 Under the prior rule, if a Loss Corporation was held partly by a Public Group and partly by an individual 5% shareholder, public shareholders acquiring shares from the individual were segregated and treated as a separate Public Group from the original Public Group. In addition, the same principles applied when an ownership interest in a Higher Tier Entity 9 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. 10 The Final Regulations make the segregation rules in such situations inoperative such that, in the example above, no new Public Group is created. Instead, each Public Group (or, in the example above, the sole Public Group) is treated as acquiring its proportionate share of the transferred ownership interests. 11 The preamble to the Proposed Regulations explained 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 had clarified 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. 12 This clarification was not included in the Final Regulations, as the Treasury Department and IRS believed it unnecessary in light of the secondary transfer exception 7 8 9 10 11 12 A First Tier Entity is any entity that, at any time during the testing period, owns a 5% or more direct ownership interest in the Loss Corporation. See Treas. Reg. 1.382-2T(f)(9). See Treas. Reg. 1.382-2T(j)(3)(i). A Higher Tier Entity is any entity that, at any time during the testing period, owns a 5% or more direct ownership interest in a First Tier Entity or in any Higher Tier Entity. See Treas. Reg. 1.382-2T(f)(14). See Treas. Reg. 1.382-2T(j)(3)(i). See Treas. Reg. 1.382-3(j)(13). See Prop. Reg. 1.382-3(i). -3-
adopted in the Final Regulations. However, the preamble to the Final Regulations states that the IRS will not challenge application of the proposed rule to transfers occurring before October 22, 2013. B. EXCEPTION FOR CERTAIN SMALL REDEMPTIONS Under current law, when a Loss Corporation acquires its stock in exchange for property, the segregation rules generally 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. 13 For example, if a Loss Corporation that is entirely owned by one Public Group redeemed 30% of its stock, the Public Group would be 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% would be deemed to have increased its share of the Loss Corporation by 30 percentage points to 100%. As had been included in the Proposed Regulations, the Final Regulations provide an exception to this rule for certain small redemptions by the Loss Corporation. 14 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. 15 The preamble to the Proposed Regulations explained 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. In response to comments received with respect to the Proposed Regulations, the Final Regulations extend the exception to redemptions of stock of either a First Tier Entity or a Higher Tier Entity that owns (directly, indirectly, or constructively) 5% or more of the Loss Corporation. 16 In order to ensure that the exception applies only to small redemptions, the Final Regulations also provide that the 10% limitation is measured by reference to the value of the entity redeeming its stock or of the classes of stock of such entity. 13 14 15 16 See Treas. Reg. 1.382-2T(j)(2)(iii)(C). See Treas. Reg. 1.382-3(j)(14). See Treas. Reg. 1.382-3(j)(14)(iii). Generally, the rules applicable to the small redemption exception are identical to comparable existing rules applicable to the small issuance exception to the segregation rules. See Treas. Reg. 1.382-3(j)(2), (5), (8), and (12). See Treas. Reg. 1.382-3(j)(14)(vii). -4-
C. REVISION OF SMALL ISSUANCE EXCEPTION Current law provides a small issuance exception to the segregation rules. Under the 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. 17 The small issuance exception also applies to issuances of stock of a First Tier Entity or a Higher Tier Entity that owns 5% or more of the Loss Corporation. The IRS and Treasury Department determined that the same policy considerations applicable to the small redemption exception exist with regard to the application of the small issuance exception. Therefore, the Final Regulations provide that the 10% limitation in the small issuance exception is also calculated by reference to the value of the entity issuing stock or of the classes of stock of the issuing entity. 18 D. EXCEPTION FOR CERTAIN SHIFTS OF OWNERSHIP OF 5-PERCENT ENTITIES Under current law, the segregation rules generally apply to Public Groups that hold ownership interests in a First Tier or Higher Tier Entity. 19 Under this rule, if such an 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 Treasury Department had received comments requesting relief from this rule, because, in many cases, the First Tier or Higher Tier 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 First Tier or Higher Tier Entity can satisfy both an ownership limitation and an asset threshold. 20 The Final Regulations adopt the ownership limitation without change, but replaced the asset threshold with an anti-avoidance rule. The ownership limitation is satisfied if the First Tier or Higher Tier 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, notwithstanding that it is generally not otherwise treated as stock for Section 382 purposes. 21 The Loss Corporation may establish 17 18 19 20 21 See Treas. Reg. 1.382-3(j)(2). The small issuance limitation is defined in a similar manner as the small redemption limitation, discussed above. See Treas. Reg. 1.383-2(j)(11)(ii). See Treas. Reg. 1.382-2T(j)(3)(iii). See Prop. Reg. 1.382-3(j)(15)(i). See Treas. Reg. 1.382-3(j)(15)(i) and Treas. Reg. 1.382-2(a)(3). -5-
that this ownership limitation is satisfied either by actual knowledge, or, in the absence of actual knowledge, using certain presumption rules. 22 Under the anti-avoidance rule, the segregation rules will apply if the Loss Corporation, directly or through one or more persons, participated in planning or structuring the transaction with an intention to avoid the application of the segregation rules. 23 The preamble to the Final Regulations states that the rule would not be violated merely because the Loss Corporation seeks or obtains information about a proposed transaction that would change the ownership of a First Tier or Higher Tier Entity, but the Loss Corporation does not participate in planning or structuring the transaction. The following example illustrates the application of this rule: P 1 is a corporation that owns 10% of the stock of L. P 2 is owned entirely by a direct public group (Public P) and does not itself own stock of L. P 1 is planning to merge into P 2. Advisers to L, upon learning of the proposed merger, asked the management of P 1 for details of the proposed merger, including the stock ownership of P 2 after P 1 merges into P 2. After procuring that information, L and its advisers did not request any changes in the planned transaction. The ownership limitation is satisfied because P 1 does not own more than 10% of the stock of L. In addition, the anti-avoidance rule does not apply because L did not participate in planning or structuring the transaction. Accordingly, the segregation rules do not apply to cause the segregation of P 1 s public group from P 2 s public group. The Final 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. E. EFFECTIVE DATE The Final Regulations generally apply to testing dates during a testing period that begins before and ends after October 22, 2013. 24 However, taxpayers cannot apply the Final Regulations to testing dates prior to October 22, 2013 if the application would result in an ownership change that did not occur, or reverse an ownership change that did occur, under the regulations then in effect. * * * Copyright Sullivan & Cromwell LLP 2013 22 23 24 See Treas. Reg. 1.382-3(j)(15)(iv)-(v) and Treas. Reg. 1.382-2T(k)(1). See Treas. Reg. 1.382-3(j)(15)(ii). See Treas. Reg. 1.382-3(j)(17). -6-
ABOUT SULLIVAN & CROMWELL LLP Sullivan & Cromwell LLP is a global law firm that advises on major domestic and cross-border M&A, finance, corporate and real estate transactions, significant litigation and corporate investigations, and complex restructuring, regulatory, tax and estate planning matters. Founded in 1879, Sullivan & Cromwell LLP has more than 800 lawyers on four continents, with four offices in the United States, including its headquarters in New York, three offices in Europe, two in Australia and three in Asia. CONTACTING SULLIVAN & CROMWELL LLP This publication is provided by Sullivan & Cromwell LLP as a service to clients and colleagues. The information contained in this publication should not be construed as legal advice. Questions regarding the matters discussed in this publication may be directed to any of our lawyers listed below, or to any other Sullivan & Cromwell LLP lawyer with whom you have consulted in the past on similar matters. If you have not received this publication directly from us, you may obtain a copy of any past or future related publications from Stefanie Trilling (+1-212-558-4752; trillings@sullcrom.com) in our New York office. CONTACTS New York David C. Spitzer +1-212-558-4376 spitzerd@sullcrom.com London S. Eric Wang +44-20-7959-8411 wangs@sullcrom.com -7- SC1:3520013.2