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E*Trade's Debt Swap Triggers Ownership Change

The online-trading hub triggers a technical change of ownership by swapping out its debt. But it should be able to hang on to its long-term tax benefits.
Robert Willens, | US
December 7, 2009

E*Trade Financial Corp. disclosed on November 4 that during the third quarter it exchanged about $1.76 billion in principal amount of "interest-bearing debt" for an equal principal amount of noninterest-bearing convertible debentures.

Subsequent to the completion of this exchange offer, some $592 million of new debentures were promptly converted into 572 million shares of E*Trade's common stock. As a result, the company reports, "we believe we experienced an ownership change."

As of September 30, 2009, E*Trade had net operating losses (NOLs) totaling approximately $1.6 billion. Not surprisingly, the company observes that "the ownership change will extend the period of time it will take to fully utilize our NOL but will not limit the total amount of NOL we can utilize." As a result, E*Trade calculates that the "Sec. 382 limitation" precipitated by the ownership change is approximately $111 million.1

Accordingly, since the statutory carryforward period is 20 years, the company believes it will be able to fully use these NOLs. This claim seems valid: if the $1.6 billion in NOLs is "absorbed" at the rate of $111 million per year, the NOL balance will be fully exhausted in just over 14 years.

It is possible that the amount of NOLs subject to this limitation may increase. That will be the case if E*Trade has, at the time of the ownership change, "net unrealized built-in losses" (NUBILs), and those losses are recognized during the five-year period beginning on the date of the ownership change. These recognized built-in losses (RBILs) are treated as if they were prechange losses, with the result that the amount to be absorbed, at the rate of $111 million per year, will be increased.

"The massive issuance of stock by E*Trade to the holders of its convertible debentures triggered an ownership change because the parties to whom the stock was issued are treated, collectively, as a single 5% shareholder." — Robert Willens

As a result, E*Trade will have NUBILs if, as of the date of the ownership change (triggered by the issuance of stock to holders of its convertible debentures), the fair-market value of the company's assets2 is less than the aggregate adjusted basis of those assets. Note that the assets have to be less than the adjusted assets by more than a specified threshold.

The massive issuance of stock by E*Trade to the holders of its convertible debentures triggered an ownership change because the parties to whom the stock was issued are treated, collectively, as a single 5% shareholder. Tax regulations state that increases in stock by shareholders that own at least 5% of the corporate shares must be taken into account in determining whether an ownership change has occurred.

Frequently when a corporation issues stock, the so-called segregation rules, which treat the acquirers of the stock as a separate 5% shareholder, are mitigated by the application of the "cash issuance" exception. Here, however, the segregation rules were unreservedly applicable because the stock E*Trade issued was not issued "solely for cash." Stock is not issued solely for cash when the stock is acquired upon exercise of an "option" (the conversion privilege ingrained in a convertible security is considered an option for tax purposes)3 that was not issued solely for cash or distributed with respect to the loss corporation's stock.

Contributing editor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for

1 The $111 million represents the amount of taxable income for any taxable year ending after the ownership change date that can be offset by the loss corporation's preownership change NOLs. It is calculated by multiplying the value of the loss corporation's stock immediately before the ownership change by the long-term tax-exempt rate.
2 For this purpose, assets exclude cash and cash items and certain marketable securities.
3 See Revenue Ruling 68-601 and Revenue Ruling 77-201.