Gulp! A Tax Play that Uses a Poison Pill

Companies are taking a page from the bankruptcy playbook to shield future tax benefits from impairment.
Marie LeoneAugust 6, 2008

It is unusual for a solvent company to threaten to swallow a poison pill to protect its tax rebates. But that is exactly what Hovnanian Enterprises did this week, in announcing its adoption of a shareholder rights plan to preserve tax benefits related to its net operating losses.

The tactic, which up until now has been used mainly by companies in bankruptcy, gives companies some assurance that recent losses can still be used to offset future gains and ultimately lower future tax bills. That’s relatively good news for the myriad companies now being pummeled by the subprime mortgage crisis, and as a result posting significant NOLs.

The tax benefit at risk is an income offset linked to NOLs. The Internal Revenue Service allows companies that have posted an NOL to save up to two years’ worth of the losses, and use them to offset income that is generated over the next 20 years. By applying the NOLs to future periods, a company’s taxable income is decreased, and the corporation pays less to Uncle Sam. Essentially, the rule takes some of the sting out of current losses.

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There is a catch, however. Under the tax code (Section 382) a change in ownership at the company could wipe out a big chunk of the NOL offset. The rule is harsh, says tax guru Robert Willens. He explains that if a corporation undergoes an ownership change, the IRS limits the amount of income that NOLs can offset in any year after the change — regardless of how much income a company earns.

The income ceiling is calculated by multiplying the company’s market capitalization by the long-term tax exempt rate, currently 4.71 percent. That would mean that a company with a $1-billion market cap on the day of an ownership change would be able to use NOL offsets against only $47 million of income for any subsequent years.

In addition to the straightforward calculation, the IRS forces companies to make other adjustments to the base amount to limit the tax benefit when there is a change in ownership. For example, financing cash has to be backed-out of income if the capital was raised as a way of increasing the Section 382 limitation. In the same way, proceeds from options issues are also disregarded.

The modern version of the rule was issued in 1986, to prevent “the trafficking of losses,” Willens asserts. In essence, the IRS didn’t want the primary reason for an acquisition to be NOLs. That is, the government didn’t like the idea that a financially fit company could snatch up loss companies just to make use of the target company’s offsets. “The rule makes NOLs neutral in an acquisition,” Willens says.

Hovnanian wasn’t the first solvent company this year to use the tactic. In May, the board of Stamps.com, an Internet postage retailer, changed the company’s articles of incorporation to thwart any change of ownership. According to Stamps.com CFO Kyle Huebner, the company has $250 million worth of federal NOLs and $150 million of state NOLs stemming from losses the company took on in 2000 and 2001 when the Internet bubble burst. Heubner says the federal NOLs won’t expire until 2020, while the state NOL expiration dates range from 2012 to 2014.

The tax breaks from the NOLs, which amount to $95 million in tax savings, are “almost as much as all of our other assets,” notes Heubner, who says that the company’s total assets in 2007 were $103 million. “We are in a unique situation — profitable, able to utilize NOLs, and the [tax savings] number is big enough that it is material to the overall value of the company.

In the case of Hovnanian, a homebuilder that suffered “significant” losses as a result of the current housing crisis, its board adopted a poison pill provision to deter a change of ownership, at least until the company is finished using the NOLs. The company, which operates in 19 states and generates $4.8 billion in revenue, reported at the end of fiscal 2007 that it had $392 million of deferred tax assets and NOL carryforwards that slated to expire between October 2008 and October 2027.

“When we discovered the 382 trigger in the tax code … we wanted to find a way of preventing the loss [of the tax benefit],” remarked Hovnanian CFO J. Larry Sorsby. The finance chief expects other housing industry companies, as well as companies in other sectors hit hard by subprime-related write-offs — such as banks — to adopt similar shareholder agreements for the same reason.

Sorbsby emphasized, however, that the plan has “nothing” to do with defending against a takeover threat. The provision is aimed at preserving the carryforward tax benefit. In fact, company CEO Ara K. Hovnanian, noted in a statement that once the company uses the NOLs, the board intends to dump the poison pill.

Hovnanian is coming off of another innovative tax move, in December. Then, the company created a valuation allowance in the same period in which it generated NOLs on a fourth quarter $638 million loss, rather than save the allownaces for the future.

In this latest tax maneuver, both Hovnanian and Stamps.com focused on the definition of change in ownership. Under the tax code, an ownership change occurs when there is a 50 percentage point “shift” in ownership, which usually happens when large existing or new shareholders (those that own or buy at least 5 percent of the company’s stock) purchase additional shares. For instance, the rule would be triggered if 10 new shareholders each buy 5 percent of a company’s shares, or if four of the company’s existing shareholders who each hold 12.5 percent of the company’s shares, purchase more stock.

To discourage 5-percent shareholders from acquiring enough stock to cause painful tax consequences, Hovnanian’s new poison pill pact stipulates that if any person or group acquires 4.9 percent or more of the outstanding shares of Class A common stock without the approval of the board, the extra shares that would have triggered the rule will be automatically diluted by 50 percent.

Stamps.com has a similar rights agreement. Board approval is required for a person or company that wants to buy 5 percent of the company shares, as well as for existing 5-percent shareholders that want to increase their holding. Without board approval, the trade is invalid, as if it never happened. In that way the IRS can never claim that the transaction occurred and an ownership change took place, even for just a few hours.

The money used to make the trade is returned to the buyer, and any profits are donated to charity. When the provision was put to a shareholder vote, 90 percent of Stamps.com holders voted, and of that group, 98 percent favored the change. “I spent a lot of time on the phone explaining the plan. It is a fairly complex area of tax law and it took a bit of time to get shareholders to understand it,” says Heubner

By his lights, the problem with the law is that smaller companies get penalized for a rule that was passed to stop the trafficking of NOLs. “The side consequences of Section 382 is that there are large investors that want to buy our stock, but I can’t let them because then I would risk impairing $95 million in assets.