On the same day HLTH Corporation cancelled its merger with majority-owned (84 percent) subsidiary Web MD Health, the company announced a massive stock buyback. On Oct. 20, HLTH said it would repurchase fully 43 percent of its outstanding stock. But the repurchase may limit the health information company’s future tax benefits. Here’s why.

As of Dec. 31, 2007, HLTH had a net operating loss (NOL) carryover amounting to $1.3 billion. However, the buyback offering materials suggest that the tender offer may result in an “ownership change” with respect to HLTH. If that’s the case, the NOLs will become subject to the “Section 382 limitation. In a nutshell, the tax rule states that the amount of taxable income for any year ending after the date of the ownership change — which may be offset by NOLs — will be limited.

An ownership change occurs if one or more of the loss corporation’s “five percent shareholders” increase their percentage ownership interest by more than 50 percentage points, by value, over a three year “testing period.” It is not always easy to identify the five percent shareholders of a loss corporation, however. That’s because the less than five percent shareholders, who are normally “aggregated” and treated as a single five percent shareholder can be — in connection with certain transactions — segregated into groups, each of which will be treated as a separate five percent shareholder.

One such transaction which invokes the segregation rules is a redemption. According to the regulations, segregation can be triggered when a loss corporation acquires its stock in exchange for property (including cash). In such a case, the tax code stipulates the following: Each direct public group that exists immediately before the redemption shall be segregated so that the acquired stock is treated as being owned by a public group that is separate from the public group holding stock that was not acquired.

The regulations provide an example of a situation for illustrative purposes. In the example, LamdLoss Corp. is a loss corporation entirely owned by “Public Lamda” (PubLamda), and LamdaLoss repurchases 30 percent of its stock. As a result, PubLamda will be segregated into two different public groups so that the redeemed interests are treated as part of a public group that is separate from the interests not redeemed, (NonRedeem Group.)

Accordingly, the percentage ownership interest of NonRedeem Group with respect to LamdaLoss has increased by 30 percentage points (relative to its lowest percentage ownership interest in LamdaLoss at any time during the three year testing period). So, in the case of HLTH, a redemption of 43 percent of its stock would precipitate a 43 percentage point increase in ownership on the part of the five percent shareholder created by the application of the segregation rules.

This increase in ownership is not enough by itself to cause an ownership change, but does place HLTH uncomfortably close to such an event. Further, it increases the likelihood, as the offering materials predict, that HLTH will eventually undergo such an ownership change.

In fact, if an ownership change takes place, a Section 382 limitation has to be calculated. The Section 382 limitation is the product of the value of the loss corporation’s stock — immediately before the ownership change — multiplied by the long-term tax-exempt rate, currently 4.65 percent.

HLTH expresses some doubt with respect to how this figure ought to be computed in cases in which the ownership change is precipitated by a redemption. In this regard, however, Section 382(e)(2) seems to apply. That section states that in connection with an ownership change, in which a redemption or “other corporate contraction” takes place, the value of the loss corporation’s stock (for purposes of calculating the Section 382 limitation) shall be determined after taking the redemption or other corporate contraction into account.

In short, Section 382(e)(2) determines a loss corporation’s “equity value” immediately after, rather than immediately before, the ownership change. This would seem to be the case regarding HLTH, in which the redemption occurs in connection with the ownership change. As a result, if an ownership change takes place in connection with HLTH’s buyback, its Section 382 limitation might be relatively small, with the result that it will be subjected to potentially severe limitations in using its NOLs to offset otherwise taxable income.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.

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