Proposed Section 382 Regulations Raise International Tax Issues for Post-Acquisition Restructuring

The High-Taxed Exception and E&P Limitation to Subpart F Income topical imageThe new regulations proposed in September under Section 382(h) regarding built-in-gain raise several international tax issues that companies planning for post-acquisition integration of loss corporations should be aware of. For a U.S. corporation that buys a U.S. target corporation with net operating losses (NOLs), and either IP or foreign subsidiaries that the acquirer wants to integrate into its tax structure, the new regulations present certain disadvantages. The proposed regulations’ interpretation of the built-in-gain rules of Section 382(h) may limit an acquirer’s ability to utilize NOLs to shelter income recognized on the post-acquisition structuring. Specifically, the proposed regulations would provide that GILTI and Section 1248 deemed dividends are not “built-in-gain” under Section 382(h) that increases the acquirer’s Section 382 limitation. In addition, the repeal of the Section 338 approach will put renewed emphasis on whether a post-acquisition transfer of IP is considered to give rise to built-in-gain as well. This article explores these issues.

Although the proposed regulations — issued by the Internal Revenue Service and the U.S. Department of the Treasury on Sept. 9 — will only be effective for transactions occurring after they are issued as final regulations, they highlight issues under Section 382 that also should be considered under current law. Corporations intending to use a U.S. target corporation’s NOLs to shelter tax on post-acquisition integration may want to give these questions careful consideration.

Background on Section 382(h) and Notice 2003-65

Section 382 (and the companion provisions in Sections 383 and 384) significantly restricts the use of a loss corporation’s NOLs and other tax attributes following a “change in ownership.” A “change in ownership” is defined under highly technical and byzantine rules to occur whenever any one or more 5 percent shareholders collectively increase their ownership of the corporation’s stock by more than 50 percentage points in any three-year period. The loss corporation’s usage of its NOLs to shelter post-change taxable income is generally limited each year to the value of its stock times the tax-exempt rate. Given the low interest rate environment, the general rule of Section 382 will often significantly curtail the use of a loss corporation’s usage of its NOLs following an acquisition.

Section 382(h) provides an exception to the general rule above for loss corporations with a significant net unrealized built-in-gain (NUBIG) or significant net unrealized built-in-loss (NUBIL) in their assets on the ownership change rate. Where the loss corporation has a NUBIG, and it recognizes built-in-gain with respect to its assets on its change date in the five years after the ownership change (i.e., an RBIG), the section 382 limitation increases by the amount of the RBIG. The rationale of the Section 382(h) rule is to make the loss corporation neutral between selling its assets and recognizing gain before and after the ownership change.

Two Ways to Calculate RBIG Under Section 382(h)
Notice 2003-65 has permitted taxpayers to elect between two different approaches to calculating RBIG under Section 382(h). First, under the so-called Section 1374 approach, the loss corporation calculates RBIG based on actual recognized gains and losses from the sale of assets during the recognition period — i.e., a tracing method. Second, under the Section 338 method, the loss corporation calculates RBIG as equal to the difference between its actual taxable income during the recognition period, as compared to the taxable income it would have had if it had made a Section 338 election. Where the loss corporation holds appreciated property, the Section 338 approach will often be favorable in generating RBIG without an actual sale of the loss corporation’s assets.

For example, assume that a U.S. target is acquired for $100 million in a stock purchase without a Section 338 election. The U.S. target has $10 million of basis in its tangible assets, has no liabilities and $40 million of NOLs. Its remaining $90 million of assets consist of self-created intangibles with no tax basis.

Under the Section 1374 approach, the U.S. target would generate RBIG only if it sold its self-created intangibles and recognized gain during the five-year recognition period. This may be unlikely as a practical matter to occur.

Under the Section 338 approach of Notice 2003-65, however, the target would be deemed to have additional RBIG in each of the first five years equal to the additional depreciation and amortization it would have enjoyed if it had made a Section 338 election. Here, if the target had made a Section 338(g) election, it would have had $90 million of amortizable basis in Section 197 intangibles and generate $6 million more per year of amortization deductions. The Section 338 approach would give rise to $6 million of RBIG for each of years one through five or $30 million of total additional Section 382 limitation.

What the Proposed Regulations Would Change and the Relevant International Tax Implications

As others have discussed, the proposed regulations would withdraw IRS Notice 2003-65 prospectively and require loss corporations to use the Section 1374 approach to calculating RBIG. Thus, a loss corporation would have to sell or otherwise dispose of its assets during the post-closing recognition period to generate RBIG. In the example above, loss corporation’s use of NOLs would be limited to the base Section 382 limitation of approximately $2 million per year ($100 million stock value multiplied by an assumed 2 percent tax-exempt rate).

Characterization of Platform Contribution Transactions (PCTs) / Acquisition Buy-Ins
As a common variation on the example above, assume further that the buyer is a U.S. multinational corporation with a cost-sharing arrangement or other foreign IP ownership structure that requires it to license or sell the U.S. target’s foreign IP rights to a CFC affiliate post-closing in a platform contribution transaction (PCT). The PCT would generate taxable income in the U.S. target post-closing, and the buyer ideally would want to utilize the target’s NOLs to shelter this income from tax.

Under Notice 2003-65, the buyer could adopt the Section 338 approach and use the $6 million of NOLs freed up by the increased RBIG to offset the income generated on the license or sale of IP to the CFC. For example, if 30 percent of a target’s IP value were attributable to foreign markets, then the amount of gain on the PCT might roughly offset the RBIG generated by the Section 338 approach.

When the proposed regulations are finalized, by contrast, the buyer would be limited to RBIG on actual sales or dispositions of assets in the recognition period. Would the PCT constitute a sale or other disposition of assets for purposes of Section 382(h)? The IRS has routinely argued that PCTs are tantamount to a sale in determining the amount of income to be recognized (for example, in the “income method” set out in Treas. Reg. § 1.482-7 and in the Amazon and Veritas cases). However, does it follow that the PCT is a sale or disposition of the IP? Legally, the PCT likely would be documented as a license at least from an intellectual property perspective.

This issue will require additional focus and attention from taxpayers if the proposed regulations are finalized given the unavailability of the Section 338 approach. A prior LB&I memo involving the audit of a taxpayer that previously sought a private letter ruling on this issue may be somewhat instructive. (See LB&I Memorandum 20151701F (Feb. 2015), which addressed the issue of whether a PCT transaction gave rise to RBIG under the Section 1374 approach.) The 2015 LB&I Memorandum discusses some of the relevant factors considered at least by one division in LB&I in analyzing this issue, and argues that the PCT on the facts presented was a license that did not give rise to RBIG. The LB&I Memorandum asserts that the taxpayer’s treatment of the PCT as a license or sale should be consistent for purposes of RBIG and Section 482.

Exclusion of GILTI, Subpart F Income and Section 1248 Deemed Dividends from RBIG
The proposed regulations would add a rule (Prop. Reg. § 1.382-6(d)(2)(ii)) that provides that RBIG on the sale or disposition of an asset does not include deemed dividend income such as GILTI or subpart F income. A CFC itself would generally not be subject to Section 382 unless it has effectively connected income or NOLs connected to a U.S. trade or business. On the CFC’s sale of assets, however, the US corporate shareholder would now recognize GILTI or subpart F income in most cases. Given the breadth of GILTI, the CFC’s sale of assets held on the date of an ownership change of the US shareholder arguably should produce RBIG in the same manner as if the US shareholder sold stock of the CFC. Under the Proposed Regulations, however, GILTI and subpart F income would be excluded from RBIG.

Additionally, the proposed regulations introduce a new rule that excludes gain from the sale of CFC stock held on the ownership change date from RBIG to the extent the gain is recharacterized as a deemed dividend under Section 1248. This part of the proposed regulations reverses a more taxpayer position previously taken by the Service. See PLR 201051020. According to the preamble, this change is being made because Section 1248 deemed dividends will often be eligible for a Section 245A dividends received deduction, so that characterizing this income as RBIG is inappropriate. The Proposed Regulations’ exclude Section 1248 dividends from RBIG regardless whether Section 245A applies, however.

These new rules will create complexity if the US target decides to sell off appreciated assets of a CFC following an ownership change. For example, assume that the U.S. Target undergoing a change in ownership owned CFC stock with a $0 basis and $50 million of value. The CFC owned assets with basis of $10 million and value of $50 million, and had untaxed earnings of $10 million. Assume that Target wanted to sell CFC’s assets for $50 million, which would result in $40 million of gain. If the CFC sold the assets, this would likely produce GILTI taxed at a lower rate under Section 250 but not produce RBIG. On the other hand, on a sale of the CFC’s stock would produce up to $40 million of RBIG, but result in income taxed at a higher rate. The Section 1248 amount would be excluded from RBIG, whether or not Section 245A’s DRD actually applies. If finalized, these rules would create yet another variable in analyzing the form and appropriate structure for such a sale in the case of an NOL corporation.

Conclusion – Monitor for Finalization

The proposed regulations would introduce major and largely taxpayer unfavorable changes to Section 382(h). While the impact of the proposed regulations is largely domestic, it also raises certain international tax issues for post-acquisition restructuring. Corporations with an international tax structure that buy targets would do well to monitor the proposed regulations to see what impact the rules have on such issues when finalized.