Net Operating Losses: Preserving What You Never Wanted in the First Place
by Scott R. Carpenter
One of the ironies of the modern business world is the fact that a company’s biggest asset may not be its client list or its intellectual property, but its tax losses. Those losses can be carried forward for up to twenty years and can be offset against the company’s future taxable income and tax liabilities, significantly improving its future cash position. For a company with a $100 million net operating loss, that right of offset could translate into potential future tax savings of $40 million, assuming a 40% combined federal and state tax rate.
Unfortunately, the value of a company’s tax losses can be wiped out, in whole or in part, by transactions that are outside of the company’s control, including routine share transfers and option or warrant exercises. Even the infusion of new capital into the company, unless carefully planned, can destroy the value of its losses. This article discusses one strategy for preserving that value.
The Tax Issue: Limitations on the Use of NOLs
A company’s ability to use its net operating losses (“NOLs”) and other tax attributes to reduce its future taxes is subject to the limitations described in § 382 of the Internal Revenue Code.1 If a company undergoes a change of ownership, § 382 severely restricts the company’s ability to use its NOLs. A “change of ownership” occurs if the percentage of a company’s shares held directly or indirectly by one or more of its “5% stockholders” increases by more than fifty percentage points over the lowest percentage of shares owned by those shareholders at any time during a three-year rolling test period.2 A “5% stockholder” is a shareholder who held at least 5% of the loss company’s shares during the testing period. All shareholders who do not own at least 5% of the loss company’s shares are aggregated and treated as one 5% stockholder. The percentage point increase is computed separately for each 5% stockholder and then aggregated.
The treasury regulations provide a simple example of when a “change of ownership” under § 382 occurs:
A and B each own 40 percent of the outstanding L [the loss corporation] stock. The remaining 20 percent of the L stock is owned by 100 unrelated individuals, none of whom own as much as 5 percent of L stock (“Public L”). C negotiates with A and B to purchase all of their stock in L. The acquisitions from both A and B are completed on September 13, 1990....C’s acquisition of 80 percent of L stock resulted in an ownership change because C’s percentage ownership has increased by 80 percentage points as of the testing date, compared to his lowest percentage ownership in L at any time during the testing period (0 percent).3
Section 382 was enacted to prevent companies with taxable income from reducing their tax obligations by acquiring control of another company with NOLs. It achieves that objective by limiting the amount of the taxable income that can be offset by a pre-change loss to the product of (i) the long-term tax exempt bond rate (published monthly by the U.S. Treasury) as of the date of the change of ownership, and (ii) the value of the loss company’s shares immediately before the ownership change.4
Because the limitation formula is based in part on the value of the company’s shares (which can be quite low because the company is losing money), the § 382 limitation can severely restrict the company’s ability to use its NOLs. For example, if the company described above with the $100 million in NOLs had an aggregate share value of only $50 million (because of its extensive losses) and the long-term tax exempt bond rate were 5%, it would be limited to the annual use of only $2.5 million of its NOLs (i.e., $50 million x .05 = $2.5 million) if it triggered the § 382 limitation. That may not be a significant problem if the company continues to incur losses, but if it turns its business around and has $50 million of income the next year, the effect of the limitation could be significant. Assuming a combined federal and state tax rate of 40%, the company would owe $20 million in taxes for the year of that stellar performance, but instead of being able to offset its entire tax obligation with its more-than-ample $100 million in NOLs, it would only be able to use $2.5 million of those NOLs. The company would then have to use $17.5 million of its hard-earned cash to pay the remaining tax bill.5
Determining whether an ownership change has occurred can be complicated if a company is publicly held, since there can be hundreds (or perhaps thousands) of trades a day. The complexity of the calculation is compounded by the fact that share conversions and share acquisitions under warrants, options or other purchase rights are factored into the ownership change formula.6 Adding to the problem is the fact that the threshold for exceeding the 50% change portion of the test may be relatively low because no one shareholder, or group of shareholders, controls significant blocks of the company’s shares. As a result, it is often difficult for a loss company to determine where it stands with respect to the limitation unless it has the complete cooperation of its shareholders and employs a small army of accountants.
Most companies prevent the inadvertent loss of their NOLs by prohibiting their shareholders from making trades that would trigger the § 382 limitation.7 Transfer restrictions to preserve NOLs are used extensively in bankruptcy cases (where the court has broad authority to impose restrictions on outstanding shares),8 but in other contexts a company’s ability to successfully implement them can be limited by both corporate and securities law.
The Corporate Law Issue: When is a Transfer Restriction Enforceable?
In our practice, we deal mostly with Utah and Delaware companies. The corporate codes of both states limit a company’s right to unilaterally impose transfer restrictions on its outstanding shares.9
Section 202 of Delaware General Corporation Law allows companies to impose restrictions on the transfer and ownership of their shares as long as the restrictions are noted conspicuously on the share certificates (or, in the case of uncertificated shares, a notice sent by the company to the shareholder). If shares have been issued prior to the adoption of the restrictions, however, the transfer and ownership restrictions are not binding on the holders of those outstanding shares unless the holders are parties to an agreement relating to the restrictions or voted in favor of the restrictions if they were adopted pursuant to an amendment of the certificate or bylaws of the company.10 The voting test is applied on an individual shareholder basis – even if the majority of the shareholders approves a restriction, a holder is not subject to the restriction unless the holder personally approves it. Section 202 also provides that, where a restriction is properly imposed, the restriction is conclusively presumed to be for a reasonable purpose if the restriction maintains or preserves any tax attribute, including the company’s net operating losses.11
Utah’s corporate code also allows companies to impose transfer restrictions on their shares through their articles, bylaws or agreements among their shareholders.12 If the restrictions are adopted after a shareholder receives his shares, however, they do not apply to those shares unless the holder is a party to the restriction agreement, or voted in favor of (or otherwise consented to) the restrictions.13 The Utah statute does not specifically provide that the preservation of net operating losses is a reasonable purpose, but does provide that a restriction on transfer is authorized “to preserve entitlements, benefits, or exemptions under federal, state, or local laws.”14
Unless a company has the cooperation of all of its shareholders, it is questionable whether, under either Utah or Delaware law, the company can impose enforceable transfer restrictions on its outstanding shares. As a result, companies are generally left to more indirect methods for adopting those types of restrictions.
One method for imposing transfer restrictions that has been successfully used by a number of companies is to merge the loss company with a new, wholly-owned subsidiary and impose the restrictions as part of the transaction. Under the terms of the merger, the loss company’s shareholders exchange their shares in the loss company for an equal number of shares in the subsidiary. The organizational documents for the subsidiary contain the appropriate transfer restrictions (and the existence of the restrictions is noted on the certificates that the subsidiary issues in the merger), and the loss company shareholders receive their shares in the subsidiary subject to those transfer restrictions. This structure converts the unanimity requirement generally applicable to the imposition of post-issuance transfer restrictions to a majority approval requirement.15
The Securities Law Issue: To Register, or Not to Register?
If the loss company is closely held, the securities laws implications of imposing transfer restrictions through a merger may be minimal.16 If, however, the loss company is a widely-held entity, or if it is subject to the reporting requirements imposed by the Securities and Exchange Commission, the subsidiary’s issuance of the shares in the merger could trigger a registration requirement, turning the merger into an expensive and time-consuming process.
The general registration requirement at the federal level relating to mergers is Rule 145 under the Securities Act of 1933, and the registration is accomplished using Form S-4, which is limited in use to business combinations, share exchanges, acquisitions between companies and similar transactions. A Form S-4 registration is similar to the registration statement that companies use when they initially go public, but it describes both parties to the transaction and is usually combined with a proxy statement relating to the approval of the merger at a shareholders’ meeting.
Most of companies that have imposed NOL transfer restrictions through subsidiary mergers have registered the issuance of the merger shares.17 There is another route available, however, based on an exception to Rule 145 known as the “change of domicile” exception. The “change of domicile” exception refers to a clause in sub-paragraph (a)(2) of Rule 145, and allows a company to effect a merger without registering the shares if “the sole purpose of the transaction is to change the issuer’s domicile.”18 At least one company has effected a reincorporation merger for the purpose of preserving NOLs without registering the new securities on Form S-4.19
The SEC has tacitly agreed that the clause can be applied in circumstances that are broader than the literal meaning of the words used in it, and has blessed the exception’s use in transactions where there are a variety of differences in the organic documents for the companies effecting the domicile change. The differences include not only transfer restrictions, but changes in the number of the company’s authorized shares and the classification of directors.20 The change of domicile exception has even been sanctioned in cases where there has, in fact, been no change in domicile.21 As a result, a company could take the position that, even though the SEC has not yet specifically addressed the “change of domicile” exception in connection with transfer restrictions for NOLs, its prior acquiescence in the area suggests that no registration of the shares in a change of domicile merger should be required where the differences in the organic documents for the companies include transfer restrictions for NOLs.
Under § 382, the value of a company’s NOLs can be inadvertently lost or diminished by share transfers, option and warrant exercises and capital infusions. Companies can use transfer restrictions to diminish the possibility of that happening, but there are questions about the enforceability of those restrictions if they are placed on outstanding shares. One of the ways to avoid challenges to the restrictions is to adopt them in connection with a merger. That process can trigger a registration requirement under applicable securities laws, but there is also a possibility that a company can avoid even that complication if the merger is structured properly.
1. The Internal Revenue Code of 1986 generally allows companies to carry forward their tax attributes. See, e.g., Internal Revenue Code of 1986, 26 U.S.C. §§ 39(a), 59(e), 172(b), 904(c) (2006). Unless otherwise noted, references to sections in this article are references to sections of the Internal Revenue Code.
2. See § 382(g). Section 382 is also triggered by “equity structure shifts,”- essentially any tax-free reorganization other than a “D,” “G” or “F” reorganization (unless the requirements of § 354(b)(1) are satisfied in a “D” or “G” reorganization). See §§ 382(g)(1), 368(a)(1).
3. Treas. Reg. § 1.382-2T (c)(2)(i) (2006).
4. See § 382(b)(1).
5. Section 382 also limits the use of built-in losses recognized during the five-year period after the change of control date. See § 382(h). The NOLs limitation example in the text is obviously a simplified version of the way the credits, roll-overs of unused NOLs, and offsets would be computed and applied under the limitation formula.
6. See § 382(k)(6).
7. NOL transfer restrictions are typically more extensive than just a simple prohibition on transfers by “5% stockholders.” They include requirements for shareholders to notify the company if they are a “5% stockholder”, prohibitions on transfers that increase a shareholder’s ownership to the point it becomes a “5% stockholder”, and provisions that void transfers in violation of the restrictions. Restrictions typically stay in place until the board determines they are no longer necessary to preserve the company’s NOLs.
8. See, e.g., In re Delta Air Lines, Inc., Case No. 05-17923 (PCB) (Bankr. S.D.N.Y., Sept. 16, 2005); In re US Airways, Inc., Case No. 04-13819 (SSM) (Bankr. E.D.Va., Apr. 1, 2005); In re WorldCom, Inc., Case No. 02-13533 (AJG) (Bankr. S.D.N.Y., March 5, 2003); and In re W.R. Grace & Co., Case No. 01-01139 (JKF) (Bankr. D. Del., Jan 24, 2005).
9. Other states have similar statutory provisions. See, e.g., Nev. Rev. Stat. § 78.242 (2006); Colo. Rev. Stat. § 7‑106‑208 (2006).
10. See Del. Code Ann. tit. 8, § 202(b) (2006).
11. Id. at § 202(d)(1)(b).
12. See Utah Code Ann. § 16-10a-627 (2006).
13. Id. at § 16‑10a‑627(1).
14. Id. at § 16-10a-627(3)(b).
15. Compare id. at §16-10a-627 and id. at § 16-10a-1103. A variation on the structure involves the formation by the loss company of two new entities: “ParentCo” and a wholly-owned subsidiary of ParentCo. The loss company and the new subsidiary are then merged, with the shareholders of the loss company receiving shares in ParentCo in exchange for their shares in the loss company. The ParentCo articles contain the NOLs transfer restrictions and the ParentCo shares are issued subject to those restrictions. As a result of the merger, the shareholders of the loss company receive shares in ParentCo, and ParentCo owns and operates its business as a holding company through its subsidiary. ParentCo and the subsidiary can even be merged. See id. at § 16‑10a‑1104 (which allows for short-form mergers between parent corporations and 90% or more owned subsidiaries). But see note 20 regarding the SEC’s position on corporate structure changes.
16. This article focuses on securities compliance at the federal level. Companies also have to comply with applicable state securities laws.
17. See, e.g., Registration Statement on Form S-4 for Aether Holdings, Inc., dated May 27, 1005, SEC Accession No. 00000950133-05-002426; Registration statement on Form S-4 for New Thousand Trails, Inc. dated October 3, 1996. SEC Accession No. 0000930661-96-001318; and Registration Statement on Form S-4 for Presley Merger Sub., Inc., dated October 7, 1999, SEC Accession No. 0000892569-99-002622.
18. See 17 C.F.R. § 230.145 (2006).
19. See Definitive Proxy Statement dated September 11, 1997 for The Beard Company. Since most mergers require shareholder approval, even if the loss company does not elect to register the shares issued in the merger it will still probably be required to comply with the proxy rules. For public companies, the merger does not typically trigger dissenter’s rights because of the public trading exemption provided in the dissenter’s rights statutes. See, e.g., Utah Code Ann. § 16‑10a‑1302.
20. See SEC Release No. 33‑5463 (February 28, 1974). See also No Action Requests for: Russell Corporation, March 18, 2004; Adolf Coors Company, August 25, 2003; Marantz Company, Inc., June 17, 1986; and The Times Mirror Company, February 14, 1986. Cf., Division of Corporation Finance: Manual of Publicly Available Telephone Interpretations, C26 and C27 (exception does not apply to a trust that is changed to a corporation or where the basic corporate structure is changed from one corporation to two corporations). The SEC looks at a number of factors to determine if the change of domicile exception applies to a transaction. See No Action Request for Philips Electronics, N.V., April 12, 1994.
21. See SEC No Action Request for Dun & Bradstreet, Inc., February 15, 1973.