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When a company exits from Chapter 11, what happens to its net operating losses?
Robert Willens, CFO.com | US
January 24, 2011
In a private letter ruling released on December 23, the Internal Revenue Service laid out conditions under which a parent company may use its net operating losses (NOLs) after it emerges from bankruptcy. With the economy apparently starting to emerge from the doldrums, more than a few companies may find needed clarification in the ruling (LTR 201051019).
The case considered by the IRS involved a corporation that was the common parent of a consolidated group of entities. On a specific date, April 1 for purposes of illustration, the parent and a disregarded entity of one of its subsidiaries filed for bankruptcy protection under Chapter 11 of the Bankruptcy Code. (A disregarded entity is one that's separate from the parent but chooses to be disregarded as separate from the business owner for federal tax purposes.) The parent company's subsidiaries, including the subsidiary that included the disregarded entity, did not file for bankruptcy.
On the following March 31 (another illustrative date), the parent company's plan of reorganization, which had been approved by the Bankruptcy Court, became effective. The plan provided that at the time of the bankruptcy, several creditors held notes or outstanding loans that were due them. The plan of reorganization involved instructions about how those notes and loans were to fare under the plan. The plan features were as follows:
• Each electing holder of an allowed claim under so-called Note 1 — or any holder of an allowed claim arising under Note 2 — received its pro rata share of New Note 1, and shares of the parent's new common stock. (Electing holders of debt instruments may choose to include in gross income all interest accrued on the instrument.)
• Each nonelecting holder of an allowed claim under Note 1 had its current claim reinstated and retained its current note.
• Each holder of an allowed claim arising under Loan 1 or Loan 2 received New Note 1 and shares of the parent's new common stock.
• Each holder of an allowed claim arising under Note 3 or Note 4 received shares of the parent's new common stock plus "contingent value rights" (CVRs). (CVRs are given to shareholders of an acquired company facing restructuring.)
• Each holder of certain notes issued by the disregarded entity received New Notes 2, which were issued by the disregarded entity and guaranteed by the parent.
• Holders of equity interests in the parent had their interests canceled, terminated, and extinguished, although holders of the parent's preferred stock received CVRs.
On March 31, the parent emerged from Chapter 11 protection with a reorganization plan that resulted in an ownership change under the tax code. Specifically, under Section 382 of the Internal Revenue Code, the parent was under the jurisdiction of the Bankruptcy Court in a "Title 11 case" immediately before April 30.
At issue was the reorganized corporation's ability to use its predecessor's NOL immediately after March 31. In the IRS ruling, the agency noted that at least 50% of the value and voting power of the common stock of the parent was owned by "qualified creditors" because they were creditors of the parent immediately before the ownership change.1 The service concluded:
• Unless the parent consolidated group elects to apply Section 382(l)(6), under Section 382(l)(5), there is no Section 382 limitation on prechange losses or built-in losses of the parent's consolidated group as a result of the ownership change on March 31.
• If the parent's consolidated group elects to apply Section 382(l)(6) to the ownership change on March 31, the group takes into account the increase in the value of the parent resulting from the surrender or cancellation of the company's creditors' claims in the transaction when it computes its Section 382 limitation.2
• If the parent consolidated group applies Section 382(l)(6) to the ownership change on May 1, with the result that its NOLs and built-in losses will be subject to the Section 382 limitation, the parent group may apply the principles for computing and allocating the Adjusted Deemed Sales Price under Regulation Section 1.338-4 and Regulation Section 1.338-6 to determine its amount realized. This amount is based on the hypothetical sale of all of its assets to a third party that assumed all of its liabilities.3
Liabilities immediately before the ownership change should be taken into account at their adjusted issue price regardless of whether they were subsequently discharged in whole or in part during the recognition period (the five-year period beginning on the date of the ownership change) or thereafter.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1 A qualified creditor is the beneficial owner, immediately before the ownership change, of qualified indebtedness (QI) of the loss corporation. Indebtedness is QI if it (i) has been owned by the same beneficial owner since the date that is 18 months before the date of the filing of the Title 11 or similar case or (ii) arose in the ordinary course of the trade or business of the loss corporation and has been owned, at all times, by the same beneficial owner. A loss corporation may treat indebtedness as always having been owned by the beneficial owner of the indebtedness immediately before the ownership change if such beneficial owner is not, immediately after the ownership change, either (i) a "five percent shareholder" or (ii) an entity through which a 5% shareholder owns an indirect ownership interest in the loss corporation.
2 The value of the loss corporation under Section 382(e), the amount that is multiplied by the long-term tax-exempt rate in order to derive the Section 382 limitation, is equal to the lesser of (i) the value of the stock of the loss corporation immediately after the ownership change or (ii) the value of the loss corporation's prechange assets. For this purpose, the value of the stock issued in connection with the ownership change cannot exceed the cash and the value of any property (including indebtedness of the loss corporation) received by the loss corporation in consideration for the issuance of that stock.
3 If the net unrealized built-in gain (the net gain that would be recognized in a hypothetical sale of the corporation's assets on the change date) is more than the lesser of (i) $10 million or (ii) 15% of the aggregate value of the loss corporation's assets, the loss corporation can increase the Section 382 limitation if, and to the extent that, such gains are recognized in any year during the recognition period. Recognized built-in gains include the excess of the cost-recovery deductions that would have been allowable if a Section 338 election had been made with respect to the loss corporation, over the cost-recovery deductions actually allowable to such corporation.