2012 - Issue 48 - On September 13, 2012, the Treasury Department and the IRS released proposed regulations for corporate equity reduction transactions (CERTs). Almost 23 years after the initial statutory guidance was enacted in 1989 to limit taxpayers from carrying back losses generated from interest on debt used to acquire equity in a corporation, the proposed regulations finally give more guidance to corporations that have participated in a CERT.
The issue recently resurfaced because a large number of taxpayers have filed refund claims for losses incurred in 2008 and 2009 containing large interest deductions. The long-awaited regulations address issues such as multi-step plans for acquiring stock being treated as a CERT. These proposed regulations are lengthy and significantly expand the analysis and examples of calculations involving consolidated groups.
CERT Background: IRC Section 172(b)(1)(E) and 172(h)
Internal Revenue Code Section 172 generally allows for a net operating loss to be carried back to the two years preceding the taxable year of the loss and carried forward 20 years following the taxable year of loss. However, corporate equity reduction transaction (CERT) rules were implemented to limit the use of NOLs generated or increased by interest deductions, largely because of leveraged buyouts happening in the 1980s. Many taxpayers were helping to "finance" their leveraged buyouts by carrying back new or increased net operating losses largely due to interest deductions generated from the acquisition debt. Congress believed that because these transactions caused a change in the underlying nature of the corporation, any deductions associated with the transactions should not be able to be carried back to earlier period operations. Therefore, IRC Sections 172(b)(1)(E) and (h) were implemented in 1989 to limit the carryback of NOLs generated or increased by these transactions.
A Quick Refresher on the CERT Rules
A CERT can be either a major stock acquisition or an excess distribution. More specifically, a "major stock acquisition" is the acquisition of another corporation's stock representing 50 percent or more of the vote or value of the stock. An "excess distribution" is a distribution of a corporation's stock of greater than 150 percent of the average distributions during the past three taxable years or 10 percent of the fair market value of the stock at the beginning of the distribution year (IRC Section 172(h)(3)). If either a major stock acquisition or an excess distribution has occurred, the carryback is limited by the portion of the NOL that is attributable to the "corporate equity reduction interest loss."
The CERT limitation on the net operating loss is the corporate equity reduction interest loss (CERIL). A CERIL is the excess of the NOL for the year over the NOL for the year determined without regard to any allocable interest deductions that are otherwise taken into account in computing the loss (IRC Section 172(h)(1)). Allocable interest deductions are deductions allowed for interest on the portion of the indebtedness allocable to the CERT. Interest deductions are limited to the difference between interest paid or accrued in the loss limitation year and the average interest paid or accrued in the three years preceding the year of the CERT.The statutory rules provide basic guidance about who is subject to the CERT rules, when a corporation engages in a CERT, and how much of the NOL carryback is limited by the CERT. However, the statutory guidance left many questions unanswered, and no regulations existed to address more complex situations in the case of consolidated groups. More guidance is now available on whether a CERT has occurred and computation of the CERIL. The proposed regulations also address more complex situations relating to consolidated groups, which are discussed below.
Guidance for Consolidated Groups
The proposed regulations offer guidance on specific issues affecting consolidated groups, including:
1. Deconsolidation of Members from the Consolidated Group
If a CERT member deconsolidates from the group, both the remaining CERT members and the deconsolidating member will still be considered applicable corporations for purposes of applying the CERT carryback limitation. The deconsolidating member will be apportioned a pro rata share of the group's CERT amounts incurred through the date of deconsolidation based on the relative fair market value of the deconsolidating corporation and the entire group. A deconsolidating member can elect out of the general rule of apportionment, but the remaining group waives all carrybacks of losses allocable to the deconsolidating member. This election is available even if the deconsolidating member directly engaged in the CERT.
2. Single-Entity Treatment of the Consolidated Group
The statutory guidance already regulates that all members of a consolidated group are treated as a single taxpayer for purposes of the CERT rules. Further guidance and examples are provided in the proposed regulations regarding specific situations when the single-entity treatment would apply. Single-entity concepts are applied when determining if a major stock acquisition has occurred for purposes of calculating the group's CERIL. The debt and interest deductions of all members of the consolidated group, including the member acquired during the CERT, are included in calculation of the CERIL. The proposed regulations also clarify that if a separate member pre-existing the CERT joins the consolidated group, the new member is treated as part of the consolidated group for CERT purposes in the year of acquisition and relevant succeeding years. The IRS and Department of Treasury have decided that single-entity treatment is the best way to limit complexity and administrative hardship.
3. Excess Distributions of the Consolidated Group
For purposes of calculating excess distributions for a consolidated group, only non-intercompany distributions are taken into account. In determining whether an excess distribution occurred when a member was part of the consolidated group for less than a full taxable year, the group takes into account only a pro-rata portion of the distribution history of that member. Also, once the member deconsolidates, any transactions between the group and the member are no longer considered intercompany transactions and are taken into account when calculating the average distributions over the relevant three-year period.
4. Consolidated Group's Three-Year Average Relevant to Calculating the CERIL
The single-entity concepts are also applied when calculating the interest paid or accrued in the three years preceding the CERT year. Remember, interest deductions are limited to the difference between interest paid or accrued in the loss limitation year and the average interest paid or accrued in the years preceding the year of the CERT. Calculating the three-year average can become a problem when you have members entering and leaving the consolidated group. When a corporation joins a group, its interest history is combined with the acquiring group and thereafter treated as being paid or accrued by the group and no longer separately tracked. A member that deconsolidates from the group is apportioned part of the group's entire interest history based on relative fair market values of the deconsolidating corporation and the entire group.
5. Miscellaneous Aspects
Inevitably, the proposed regulations will create as many questions as they attempt to resolve. The IRS is not providing rules for transactions occurring before the regulations are adopted as final. Although the proposed regulations offer more guidance for consolidated taxpayers, the rules still leave certain issues open. For example, the IRS has not addressed rules for applying IRC Section 172 to related parties, pass-through entities or intermediaries. Also, the regulations do not address anti-avoidance rules preventing taxpayers from trying to reduce the CERT NOL limitation. Written and electronic comments and requests for public hearing must be received by December 17, 2012.
Alvarez & Marsal Taxand Says:
Any large corporation that has been part of a corporate equity reduction transaction or has any plans for large equity purchases should understand the new guidance and examples provided in the proposed regulations. In addition, any taxpayer claiming a net operating loss carryback needs to have some analysis performed on the applicability of the CERT rules. Audits that start with unanswered or unanticipated questions don't start well. Consolidated groups should delve into the new guidance to understand if they have correctly been applying the single-entity approach when calculating their net operating carryback limitation. They will also need to model the election available to them when a member is leaving the group (including taking a worthless stock deduction with respect to a member of the group).
As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
Managing Director, New York
+1 212 763 9655