2013-Issue 34—As the economy continues to heat up and businesses are putting into play long-held cash, entities that acquire corporations with significant net operating losses (NOLs) need to be aware of the interplay between Internal Revenue Code Section 382 and state tax laws. Section 382 provides for the limitation on net operating loss carryforwards and certain built-in losses following an ownership change. Generally speaking, Section 382 can affect the value of certain tax attributes acquired by a purchaser, including NOLs, by limiting a corporation's ability to use an NOL carryover following an ownership change. This edition of Tax Advisor Weeklyfocuses on some of the state tax consequences of such an ownership change.
An NOL can be a significant attribute for a purchaser in the context of evaluating a transaction. NOLs, and subsequent Section 382 limitations, are prevalent in the corporate landscape and regularly pop up in mergers and acquisitions. Therefore, it is important to understand that Section 382 for federal income tax purposes does not always align with the related state rules. Further analysis needs to be completed to determine where those differences lie. Some general state issues we touch upon related to Section 382 are whether a limitation applies, if the limitation is calculated on a pre- or post-apportionment basis, the year of the apportionment calculation used to determine the limit, whether the separate return limitation year (SRLY) rules affect the loss when dealing with a unitary or combined group, and whether the state calculates the limit from the perspective of the consolidated federal group or on a separate company basis.
As an overview, a Section 382 limitation is the result of an ownership change, typically as the result of a merger or acquisition. An ownership change occurs if one or more five percent shareholders increase their ownership in the loss corporation's stock, in the aggregate, by more than 50 percentage points during a three-year testing period. That said, an ownership change under Section 382 can be triggered by an assortment of shareholder activities that may leave a corporation's structure intact, but ultimately result in an ownership change, whether expected or not.
When analyzing the effect of Section 382 on a specific transaction, it is important to consider all applicable state rules, with the first being whether the state adopts Section 382 or any part of it. While most states follow the general provisions of Section 382, either explicitly or implicitly, a group of states do not and others have other overlapping rules. For instance, Alabama's NOL statute specifically adopts Section 382. Conversely, Illinois specifically states that it does not follow Section 382. Generally speaking though, Illinois NOL provisions will allow an acquired loss to be carried forward until it expires with no limitation.
Georgia specifically references that Section 382 NOL limitations apply; however, the limitation is computed on a separate-entity basis, even when a consolidated federal income tax return is filed. Therefore, each entity must compute its own Section 382 limitation. If a business is considering acquiring a loss corporation that filed a federal consolidated return and had operations in Georgia, a separate analysis would need to be done to establish the correct amount of annual loss limitation to be applied to the NOL carry-forward in Georgia. For instance, if the loss company has only one subsidiary with operations in Georgia and this entity has been historically profitable, no loss would be attributable to Georgia.
California does not specifically address Section 382 in its statutes but its general rule is consistent with Section 382 for most purposes. However, California does specifically decouple from the IRS Notice 2008-83, related to the treatment of certain deductions from bank losses on loans or bad debts under Section 382(h) following an ownership change. Essentially, the IRS provides that these deductions can't be treated as a built-in loss or a deduction attributable to periods before the change date, but California generally provides that they can.
Apportionment and Section 382
Once a business has determined that a state follows Section 382, an additional level of complexity is that the acquiring company must determine the amount of the annual state loss limitation. As most states determine NOLs as the amount of post-apportionment loss attributable to the state, taxpayers acquiring an NOL in a transaction subject to Section 382 must determine if the state annual loss utilization limitation is also determined on a pre- or post-apportioned basis. As with apportionment adoption, the states take different approaches in quantifying the limitation. Complications arise in determining whether a corporation may use the unapportioned federal Section 382 limitation or if the corporation must apportion the limitation to the state.
There are also various approaches to the limitation in states that apply a post-apportionment limitation. For example, Georgia's limitation is applied using the post-change year (loss utilization year) apportionment percentage and is recomputed each year following the ownership change, using the apportionment percentage for the current year. Therefore, for Georgia purposes it's an ongoing process of managing the NOL. Contrast Alabama, where the apportionment factor of the loss corporation for the reporting period including the ownership change must be used to compute the Section 382 limitation applicable to Alabama multi-state taxpayers. This limitation is a fixed amount for each year following the ownership change.
In August 2012, the Minnesota Tax Court addressed the issue of the apportionment of NOLs in Express Scripts, Inc. v. Commissioner of Revenue. As a result of a corporate acquisition, Express Scripts, Inc. had federal Section 382 limited NOL carryovers of approximately $30 million. The Minnesota Department of Revenue argued that the limitation should be apportioned even though the statute clearly provided that Section 382 was applied before apportionment, resulting in a reduced NOL of $120,000. The Department had been limiting NOLs on a pre-apportioned basis under Revenue Notice 99-07, based on its interpretation of the statute. However, the Court looked to the statute in determining how the NOLs should be limited and found that the Minn. State. 290.095, subd.3 (d) provides that Section 382 will "apply to carryovers in certain corporate acquisitions and special limitations on net operating loss carryovers. The limitation amount determined under Section 382 shall be applied to net income before apportionment, in each post change year to which a loss is carried." The Minnesota Tax Court overruled the Department and sided with Express Scripts. Additionally, in January 2013, the Minnesota Supreme Court dismissed a petition filed by the Department to re-examine the case.
Other State-Specific Treatment
Arizona does not apply or make any mention of Section 382 in its statutes. Instead, it has specific provisions used to calculate the Arizona NOL and its future treatment. When computing Arizona taxable income, Arizona begins with federal taxable income and adds back certain modifications, including the federal NOL calculated under Internal Revenue Code Section 172. Arizona then subtracts NOLs specifically enumerated in the provisions. Specific provisions in the regulations provide that Arizona only allows for an NOL to be carried over from a corporation, as a result of a merger, consolidation or reorganization, if that corporation incurred the NOL and is the same entity that will use the NOL against future Arizona taxable income going forward. Additionally, an NOL can only be carried forward five years, as opposed to twenty years under federal law.
Massachusetts specifically states that any NOL that is carried over from an ownership change should not exceed the limitation imposed by Section 382. However, this limitation should be adjusted for differences between Massachusetts taxable income and federal taxable income. Additionally, an NOL can only be carried forward five years as opposed to twenty years under federal law. Massachusetts does not specifically address the treatment of combined reporting for Section 382 purposes. However, since combined reporting is required for corporations engaged in a unitary business and taxable income is calculated as such, it would be expected that the calculation of the limitation would fall under the same treatment. Furthermore, Massachusetts does not address whether the limitation should be calculated pre- or post-apportionment.
Alvarez & Marsal Taxand Says:
As demonstrated above, determining the application of Section 382 in a state context is not always straightforward and can be a complicated exercise as a result of the wide array of differences in state taxing jurisdictions. That said, if your business is considering acquiring a loss corporation or has an ownership change that triggers Section 382, remember to review the rules in all applicable states to correctly determine any potential state Section 382 limitations and the true value of the acquired asset.
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Teri Hanson, Director, and Matt Erker, Senior Associate, contributed to this article.
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