Section 382 can best be described as an intricate construct that usually numbs the mind with its complexity and often baffles the senses with its result. Since its revision as part of the Tax Reform Act of 1986, Section 382 has largely been a form-driven provision filled with objective rules and confusing interpretations. Taxpayers and practitioners often note both the administrative burden associated with preparing and maintaining the required analyses, as well as the lack of clarity in applying key components of the Regulations.
The Internal Revenue Service (the "Service") has strived, with varying degrees of success, to clarify and simplify the application of Section 382. The recent issuance of proposed regulations (published in November 2011) regarding the application of the segregation rules to small shareholders is the Service's latest effort to ease some of the administrative burden and provide clarity on certain Section 382 matters. This follows other recent guidance, in the form of various notices and rulings, on key Section 382 matters.
It is important for corporate taxpayers to understand how the Service is approaching these matters and whether it impacts their overall tax attribute posture. For better or worse, in today's tax world, every corporate tax department should have a clear understanding of the value and availability of its tax attributes regardless of whether it is for financial reporting purposes, determining the impact of potential merger and acquisition transactions, or basic tax planning analyses.
IRC Section 382 — In General
Section 382 imposes an annual limitation on the amount of taxable income that may be offset by net operating loss ("NOL") carryforwards to the extent a loss corporation experiences an ownership change. An "ownership change" occurs in the event one or more 5-percent shareholders increase their ownership in the loss corporation stock by more than 50 percentage points over their lowest ownership percentage during the testing period (generally the three years immediately prior to the change date). If an ownership change occurs, the annual Section 382 limitation is calculated by multiplying the fair market value of the loss corporation's stock immediately before the ownership change by the federal long-term tax-exempt rate.
Starting with Notice 2003-65, the Service has issued a fair amount of guidance — in varying forms — seemingly aimed at providing administrative conveniences in light of certain technical complexities. This effort gained even more momentum with the onset of the Great Recession and the government's attempt to further certain economic policies under the cloak of tax policy.
Notice 2008-78 and the Anti-Stuffing Rule
Notice 2008-78 crystallized a common position among practitioners in regard to the anti-stuffing rule in Section 382(l)(1), which essentially excludes from the value of a loss corporation, for purposes of determining the annual Section 382 limitation, any capital contributions made to the loss corporation during the two years immediately preceding a change date. In the absence of applicable regulations, practitioners had historically looked to the legislative history for guidance — most notably, the "working capital exception" whereby the taxpayer provides a detailed tracing to illustrate that such capital was used to pay operating expenses arising in the ordinary course of business.
Consistent with this position, Notice 2008-78 provides that a capital contribution shall not be presumed to be part of a plan whose principal purpose is to avoid or increase a Section 382 limitation solely as a result of having been made during the two-year period ending on the change date. Further, a contribution can only reduce the value of a loss corporation if it is part of a plan whose principal purpose is to avoid or increase a Section 382 limitation. The determination for whether a capital contribution is subject to such a plan is based on the facts and circumstances surrounding the contribution, unless the contribution falls within four safe harbors provided for in the notice. This Notice has been well received by practitioners and taxpayers alike as an example of guidance that is both helpful and logical.
PLR 200902007 and Reliance on Public Filings
The "investment advisor" exception has existed for quite some time; however, its application has been challenging in some respects due to the inconsistency of certain Securities and Exchange Commission (SEC) filings. The issuance of Private Letter Ruling 200902007 has helped alleviate some of this ambiguity.
The Regulations provide for certain presumptions in identifying 5-percent shareholders for purposes of Section 382. For a given testing date, a loss corporation that is also an SEC registrant may rely on the presence or absence of certain public filings to identify direct 5-percent shareholders. However, investment advisors and other entities that are the "reporting owner" of the loss corporation's stock for public reporting purposes may not be the true "economic owner" of the underlying stock for Section 382 purposes.
The Service clarified in PLR 200902007 that the economic owner is the person who has the right to the dividends and proceeds from the sale of the stock. To the extent the information reported on a Schedule 13D or 13G does not establish that a person is the economic owner of the loss corporation stock, the loss corporation can rely on this information provided that the loss corporation does not have actual knowledge to the contrary. Again, this guidance has been generally well received in the tax community.
Notice 2010-50 and Fluctuations in Value
Section 382 provides that each 5-percent shareholder's ownership is determined by comparing the relative fair market value of the stock owned in relation to the total fair market value of the corporation's outstanding stock. However, absent exceptions in the Regulations, any change in proportionate ownership of the stock of a loss corporation attributable solely to fluctuations of value shall not be taken into account.
Historically, taxpayers and practitioners have had a difficult time interpreting what was meant by the word "solely" and how to apply the operative rules accordingly. After a series of rulings attempting to address the issue, the Service provided guidance, in the form of Notice 2010-50, for measuring owner shifts of loss corporations that have multiple classes of stock outstanding. This Notice provides two permitted methodologies — the Full Value Methodology (FVM) and the Hold Constant Principle (HCP) — to account for the effect of fluctuations in the value of one class of stock to another class of stock.
(1) Full Value Method
- Under this methodology, the determination of percentage of stock owned by a shareholder is made on the basis of fair market value of the stock owned by such shareholder to the total fair market value of the outstanding stock of the corporation.
- Effectively, all shares are marked to market on each testing date, and changes in ownership resulting from fluctuations in value are taken into account.
(2) Hold Constant Principle
- Under this methodology, the value of a share relative to the value of all other shares of the corporation is established on the date that share is acquired by a particular shareholder.
- On subsequent testing dates, the percentage interest represented by the share is determined by factoring out fluctuations in the relative values of the classes of stock that have occurred since the acquisition.
This Notice essentially provides that the Service will not challenge any reasonable application of either the FVM or HCP provided that a single methodology is applied consistently to all testing dates in the consistency period. Under the consistency period rule, a taxpayer may adopt any reasonable methodology as long as any inconsistent returns in the consistency period can be and are amended. This Notice is particularly helpful for early-stage companies using preferred equity financing in lieu of debt financing.
Proposed Regulation — Application of Segregation Rules to Small Shareholders
Proposed regulations were issued in November 2011 in response to comments on Notice 2010-49, which addressed the treatment and application of the aggregation and segregation rules to less than 5-percent shareholders. Notice 2010-49 provided for two approaches - the ownership tracking approach and the purposive approach.
Proposed Regulations — Purposive Approach
The proposed regulations suggest revisions to the purposive approach and are intended to lessen the administrative burden and Section 382 implications associated with transactions that are unlikely to implicate Section 382 policy concerns.
- Segregation rules will not apply to certain secondary transfers of loss corporation stock to small shareholders by entities or individuals who are 5-percent shareholders, as the stock transferred will be treated as being acquired proportionately by the public groups existing at the time of the transfer.
- Segregation rules will not apply to certain redemptions in a manner similar to the mechanics of the small issuance exception ---- that is, the exception for redemptions exempts from segregation either 10 percent of the total value of the loss corporation's stock at the beginning of the tax year, or 10 percent of the shares of the redeemed class outstanding at the beginning of the tax year.
- Segregation rules will not apply to a transaction if, on a testing date on which the rules would otherwise apply, the 5-percent entity owns 10 percent or less by value of all the outstanding stock of the loss corporation (the ownership limitation), and the 5-percent entity's direct or indirect investment in the loss corporation does not exceed 25 percent of the entity's gross assets.
- Segregation rules will apply to transfers from a higher tier entity to less than 5-percent shareholders only if the seller indirectly owns 5 percent or more of the loss corporation.
Comments and/or requests for a public hearing concerning the proposed regulations were requested and can be made for up to 90 days after publication of the proposed regulations in the Federal Register.
Alvarez & Marsal Taxand Says:
The IRS guidance provided over the past few years has significantly changed the Section 382 landscape for the better. The IRS's efforts in this area have gone a long way toward simplifying a complex area of the Code. Taxpayers need to be mindful of these changes (and opportunities) in their tax planning, specifically with regard to understanding the ability to chose and apply various methodologies. Having your Section 382 model updated and current is no longer just a best practice but essentially a requirement in today's tax world.
- Hereinafter, unless specifically stated otherwise, all references to "Section" or "§" shall mean sections of the Internal Revenue Code of 1986, as amended from time-to-time (the "Code"), or the U.S. Treasury regulations promulgated thereunder (the "Regulations").
- Notice 2003-65, I.R.B. 2003-40 (September 12, 2003).
- Certain PLRs have ruled that "investment advisors" as disclosed on a Schedule 13D or G should not be considered the beneficial owner of such stock but rRather, its clients-investees should be considered the beneficial owners and so long as none of these individuals own more than 5 percent of the stock of the loss corporation, the ownership at the investment advisor level should be considered as part of the public. See generally PLR 200747016 (Nov. 23, 2007).
- See generally PLR 200952004 (Sept. 23, 2009), PLR 201005019 (Oct. 27, 2009), PLR 201010009 (Dec. 4, 2009), PLR 201015023 (Dec. 30, 2009), PLR 201017002 (Jan. 11, 2010), PLR 201017003 (Jan. 11, 2010), PLR 201017004 (Jan. 11, 2010).
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.