The IRS and Treasury issued a partial withdrawal of prior proposed regulations and a notice of proposed rulemaking (REG-125710-18) that would grant transition relief to taxpayers that must determine built-in gain and loss when a change in a loss corporation's ownership occurs for purposes of the IRC Section 382 loss limitation rules.

In addition, the January 2020 proposed regulations provide some transition relief by extending the applicability date of the new rules to 30 days after the publication of final regulations in the Federal Register. The new proposed regulations would also allow the grandfathering of certain, specified transactions/situations (e.g., deals with binding agreements in effect on or before the delayed applicability date or ongoing bankruptcy proceedings).

Background

Under IRC Section 382, the amount of a loss corporation's taxable income that may be offset by pre-change losses following an ownership change for any post-change year cannot exceed the IRC Section 382 limitation for that year. The IRC Section 382 limitation generally equals the fair market value (FMV) of the loss corporation's stock multiplied by the long-term tax-exempt rate, although certain adjustments to the stock's FMV may be required.

If the loss corporation has a net unrealized built-in gain in its assets on the change date, then the loss corporation may increase the IRC Section 382 limitation for recognized built-in income and gains during the 60-month period following an ownership change. Conversely, if the loss corporation has a net unrealized built-in loss in its assets on the change date, then any recognized built-in deductions or losses during the 60-month period following the ownership change will be subject to limitation under IRC Section 382.

In 2003, the IRS issued Notice 2003-65, allowing for two safe harbor methods (the 1374 approach and the 338 approach) that loss corporations can rely on to identify built-in income and deduction items for purposes of IRC Section 382(h), provided that either approach is consistently applied to an ownership change.

On September 10, 2019, the IRS issued proposed regulations on the items of income and deductions that are included in calculating built-in gains and losses under IRC Section 382(h) (see Tax Alert 2019-1622).

The September proposed regulations would eliminate the "338 approach" and adopt as mandatory the "1374 approach," with certain modifications, particularly for cancellation of indebtedness (COD) income and deductions for the payment of contingent liabilities.

Applicability date and transition relief

The September proposed regulations were previously set to apply to ownership changes occurring immediately after the final regulations are published in the Federal Register. The IRS acknowledged that this proposed effective date would impose a "significant burden on taxpayers evaluating and negotiating business transactions, due to their uncertainty regarding when those transactions will close and when the September 2019 proposed regulations will be finalized."

In response to comments received, the IRS and Treasury have withdrawn the prior, proposed applicability dates. The new proposed January regulations provide a 30-day grace period whereby the IRC Section 382 final regulations will apply 30 days after the final regulations are published in the Federal Register. In addition, the January proposed regulations include two exceptions to the newly proposed applicability date that would grandfather certain pre-existing transactions and events.

Transition rule for certain ownership changes

Under the transition rule, the final IRC Section 382 regulations will not apply to certain ownership changes that occur after the delayed applicability date. For the transition rules to apply and for taxpayers to continue relying on Notice 2003-65, an ownership change must occur immediately after an owner shift or equity structure shift in a specific, identifiable transaction with either:

• A binding agreement in effect on or before the delayed applicability date and thereafter
• A specific transaction described in a public announcement or a Securities and Exchange Commission filing made on or before the delayed applicability date
• An order of a court (or under a plan confirmed, or a sale approved, by order of a court) in a bankruptcy case in which the taxpayer was a debtor on or before the delayed applicability date or
• A private letter ruling request describing the transaction submitted to the IRS on or before the delayed applicability date

Exception for expenses disallowed under IRC Section 163(j)

Prop. Reg. Section §1.382-7(d)(5) from the September proposed regulations, which would eliminate the duplicative application of IRC Section 382 to certain disallowed business expense carry-forwards, will be finalized earlier — specifically when the IRC Section 163(j) regulations are finalized. Taxpayers will be allowed to retroactively apply the new rule.

Implications

This latest round of proposed regulations was a sympathetic nod to comments requesting relief from the uncertainty created when negotiating transactions and valuing net operating loss (NOL) carryforwards for ongoing and pending deals while the abrupt end of Notice 2003-65's favorable "338 approach" loomed in the background.

The January 2020 proposed regulations provide transition relief and certainty around the timing of the elimination of the "338 approach." This is welcome guidance for loss corporations, and is expected to facilitate the negotiating, structuring, and valuing of corporate- and private equity- (PE) backed transactions involving prospective targets and existing PE-backed portfolio companies with significant NOLs.

The newly delayed effective date also extends the window in which taxpayers may apply the favorable "338 approach" methodology, permitting loss corporations, including PE-backed portfolio companies, to increase their annual NOL limitation, open up more NOL carryforwards for utilization in post-close periods, and thereby reduce cash tax. In addition, currently negotiated deals that are not expected to close before the delayed applicability date may use the "338 approach" and take into account the benefit of the "wasting" of the depreciable and amortizable assets (including goodwill) as recognized built-in gain.

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