The following article is adapted and reprinted from the M&A Tax Report, Vol. 11, No. 8, March 2003, Panel Publishers, New York, NY.
DON'T FORGET BANKRUPTCY NOL RULES
By Robert W. Wood
Except for bankruptcy lawyers, advisors, and trustees, the rise in bankruptcies, (especially, the rise of truly gargantuan bankruptcies) is hardly a good thing. Tax lawyers and advisors want deals, not workouts. Even so, tax advisors would do well to remember the couple of special tax rules that apply in the context of bankruptcy, particularly in bankruptcy reorganizations. True, every tax advisor is not going to be faced with a bankruptcy of the magnitude of United Airlines. Nonetheless, some reminder of the two sets of special tax rules that apply in this context is worth while.
There are two primary concerns from a tax viewpoint in dealing with a distressed company. The first tax issue relates to the discharge or cancellation of debt, often referred to as "COD." As a general proposition, the taxpayer realizes income when the taxpayer's debt to another is cancelled. In the context of bankruptcy or insolvency, this general principle operates in a somewhat different fashion, either eliminating the COD income, or at least deferring it for later recognition through a reduction in the debtor's tax attributes.
The second main issue that arises when dealing with a troubled entity concerns net operating losses. If a business finds itself in, or on the brink of, bankruptcy, it frequently will have significant NOLs. After all, usually the business has been having financial problems for some time, and this produces NOLs. In a very real sense, these NOLs represent an asset of the company.
Why? Because, subject to various limits, they may be used to offset future income once the business has been set back on its feet. Detailed restrictions under Code section 382 govern the ability of NOLs to survive a change in stock ownership. Special and more favorable rules apply in the bankruptcy context. Interestingly, these special NOL rules apply only bankruptcy, and not in insolvency. In contrast, the COD rules can be of advantage to insolvent companies as well as to bankrupt ones.
To put the magnitude of these issues in perspective, consider the United Airlines bankruptcy. A day after UAL filed for bankruptcy protection under Chapter 11, United won a court order blocking large shareholders from selling their stock. There are doubtless several reasons United would want to get this kind of protection, but the stated reason was to seek to protect tax benefits that would be reduced or eliminated (more on this below).
Interestingly, the manager of United's 401(k) program, AON Fiduciary Counselors, got in under the wire, selling all 12.7 million UAL shares it had held for employees. In contrast, 75,000 workers and retirees who held share in United's ESOP were not so lucky. State Street Bank & Trust, the ESOP manager, sold 24.1 million shares ahead of the bankruptcy filling, but still holds 32.5 million shares. State Street tried to get the court order lifted so it could sell the rest of its UAL shares, but State Street could not persuade the court to do so.
Why would a bankrupt company (UAL or any other) care about share transfers? The answer — at least from a tax perspective — lies in the rules governing NOLs.
It is axiomatic that a cancellation of debt produces income to the debtor. Notwithstanding this general rule, a debtor in a bankruptcy case can escape COD income recognition. Plus, this same avenue of escape applies to an insolvent debtor even outside the context of bankruptcy.
The protection from COD income can be absolute in a bankruptcy case. Predictably, it is more limited with insolvency, shielding the taxpayer from COD income only up to the amount of the insolvency in the case insolvent taxpayer. Insolvency for this purpose is defined as the excess of liabilities over the fair market value of assets. The determination of insolvency is based on the value of the taxpayer's assets and liabilities immediately before the discharge of the debt.
The favorable rule applicable to COD income for debtors in bankruptcy and to insolvent taxpayers has one rather important catch. Although the debtor in bankruptcy (or the insolvent taxpayer) can escape COD income, the debtor or insolvent taxpayer must reduce its tax attributes to the extent it is entitled to exclude income under the bankruptcy or insolvency exception.
The basic policy of this rule is that even though it is inappropriate to force a debtor in bankruptcy or an insolvent taxpayer to immediately recognize COD income, it is also inappropriate to let such a taxpayer escape the sting of COD income altogether. Consequently, the debtor must reduce its tax attributes now (at the time of the discharge). Then, at some later point, the effect of the cancellation of debt will be take into account for income tax purposes, since the reduced tax attributes will no longer be available.
The tax attribute reduction is required in the following order:
First, NOLs are reduced for the year of the cancellation and/or discharge, and then NOL carryovers are reduced.
Second, general business credits are reduced for the year of the discharge, and then carryover credits are reduced.
Third, net capital losses for the year are reduced, and then capital loss carryovers.
Fourth, the bases of the taxpayers assets are reduced (but not below the taxpayer's liabilities immediately after the cancellation and/or discharge.)
Finally, foreign tax credits for the year are reduced, and then any carryover.
The discharge of indebtedness rules are complex, and this overview is by no means a complete course. One of the especially controversial areas of COD income lore concerns exchanges of different financial and equity instruments, especially the tax rules governing a taxpayer's swapping of debt for stock. Space limitations prevent us from going through the magnus opus that would need to be developed to cover this episodic mess.
NOLs: Whose Is it Anyway?
Apart from COD income questions, the other significant tax inquiry in a typical bankruptcy concerns the survival of tax attributes. The most important of these tax attributes is generally the debtor's NOLs. As M&A Tax Report readers know, section 382 sets out a detailed limitation on the use of NOLs following stock ownership changes.
Yet, as with COD income, special considerations apply to NOLs in bankruptcy. To begin with, the section 382 limitations on the use of NOLs apply only if there is a change in ownership of the corporation with the NOLs. A change occurs if immediately after an "owner shift involving a 5% shareholder or equity structure shift" the percentage of stock and the loss corporation owned by one or more or 5 percent shareholders has increased by more than 50 percentage points over the lowest percentage of stock owned by those shareholders at any time during the prior three years.
If section 382 applies, it limits the amount of taxable income that can be offset by NOL carryovers to an amount equal to the value of the loss corporation multiplied by the long-term tax exempt rate. Thus, even where section 382 applies, it does not disallow or eradicate NOLs. Rather, it limits the NOLs that can be used in any one year to offset income following the ownership change.
Not surprising, one of the key features of section 382 is a definition of what constitutes an owner shift. It seems like this would be simple, but it isn't. In fact, the definitional questions go beyond the owner shift question. We also must know: what constitutes a 5 percent shareholder; the events that can produce owner shifts; the way in which shareholders are aggregated, the treatment of stock options; and so on. Section 382 and its panoply of regulations are terribly complex. Even more fundamentally, the definition of "stock" for the purposes of applying section 382 is critical. Although the definition is broad, the Treasury has the authority to disregard interests that might qualify as stock, and conversely, to treat non-stock interests as stock. A variety of rules applies to preferred stock (and there is actually something known as "pure preferred stock"), and a set of exclusionary rules applies to certain stock that will not (for this purpose) be treated as stock. Naturally, convertible instruments are covered, as are various forms of indirect ownership.
The most important portion of section 382 in the bankruptcy context is section 382(l)(5). Under this provision, the section 382 limits on the use of NOLs following an ownership change will not apply if:
1. The corporation is under the jurisdiction of the court in a bankruptcy case before the ownership change; and
2. The corporation's pre-change shareholders and qualified creditors (determined immediately before the ownership change) own at least 50 percent of the value and voting power of the loss corporation's stock immediately after the ownership change and as a result of being pre-change shareholders or qualified creditors immediately before the ownership change.
This second requirement actually encompasses a whole list of requirements, including some important definitions. Before we get to those all-important definitions, though, note what the bankruptcy NOL exception means in the event it applies. Instead of being limited in using NOL's post bankruptcy (and post ownership change) by the long-term tax exempt rate, the NOLs will be available in a unrestricted fashion. The only price tag for using the NOL's in this way is that they will be reduced to the extent of interest deducted during the three year period that precedes the tax year in which the ownership change occurs, and during the portion of the year of the ownership change (but before that change occurs). See I.R.C. §382(l)(5)(B).
One of the key aspects of qualifying for NOL relief is determining just who the "qualified creditors" are. After all, it is simple to determine the identity of the pre-change shareholders. These pre-change shareholders, together with the "qualified creditors," must own at least 50 percent of both the value and voting power of the loss corporation's stock when the smoke clears. Comparing the shareholders before and after the ownership change is fairly straightforward.
Significantly, it is not even important what the percentage is between the portion of the company owned by the pre-change shareholders and the ownership interests held by the qualified creditors. Thus, it may be that the qualified shareholders will own all of the corporation after the smoke clears, and that the common shareholders will be frozen out entirely. That actually occurs with some frequency. This is still okay under section 382(l)(5). NOL relief will still be available.
To be a qualified creditor, a creditor must meet one of two tests. The creditor must have been a creditor at least 18 months before the date of the filing of the bankruptcy case. Alternatively, the debt must have arisen in the ordinary course of the business of the debtor, and be held by the person who at all times held the beneficial interest in that indebtedness.
This second wing of the "qualified creditor" definition focuses on trade debt, debt that is acquired by the debtor in the ordinary course of the debtor's business (not in the ordinary course of the creditor's business). Thus, lenders who may acquire claims in the ordinary course of their own lending business would not constitute qualified creditors for this purpose, unless they held their debt for at least 18 months prior to the bankruptcy filing date.
Interestingly, there is no statutory continuity of interest requirement before the section 382(l)(5) exception is available. This means that the business of the old debtor corporation need not be continued insofar as the preservation of the NOLs is concerned.
Advantages of Section
The advantages of these rules set forth in section 382(l)(5) are fairly obvious: a corporation can maintain its NOLs (and maintain them in unrestricted fashion) notwithstanding the fact that the company's stock might otherwise be deemed to have been the subject of an ownership change and therefore be limited in the subsequent use of its NOLs. Although the section 382(l)(5) provision is available only in a bankruptcy case (or similar proceeding), this provision allows the corporation to exchange outstanding debt for new stock without falling subject to the dreaded 382 limitations. (It's always been puzzling what a proceeding "similar" to a bankruptcy case might be, but it doesn't appear to expand the availability of the provision in any substantial way.)
In evaluation whether the ability to extinguish debt with stock (without triggering section 382 limits) is significant in a particular case, other factors should be considered. Predominately non-tax considerations will likely govern the appropriateness of the bankruptcy filing. Moreover, the importance of avoiding the section 382 limits can only be thoroughly evaluated by calculating the 382 limits in a particular case.
Disadvantages of Section
Apart from the obvious advantages of saving NOLs, there is a decided downside to using this provision. There is a subsequent ownership change rule that has caught more than a few tax practitioners asleep. If within two years following a change in ownership to with the 382(l)(5) exemption applies, there is yet another ownership change, the 382 limits will apply with a vengeance.
On the second change within two years, the 382 limit will be zero! that means the NOLs you've worked so hard to preserve will be zero. Ouch!
There is also a special valuation rule. If a corporation chooses not to avail itself of section 382(l)(5) (or is unable to do so), the value of the corporation that is used to determine the section 382 limit will be increased to reflect the surrender or cancellation of creditor's claims in a G reorganization, or the exchange of stock for debt in the bankruptcy case. This special bankruptcy valuation rule applies to a corporation that either cannot qualify for section 382(l)(5) relief, or chooses not to use it. On the latter point, there is a special elect-out provision that entitles a corporation that would otherwise qualify for 382(l)(5) relief to affirmatively avoid this provision.
Bankruptcy isn't anyone's idea of fun. Still, the couple of tax benefits available in this setting are worth noting. Of course, some tax liabilities can even be extinguished in bankruptcy, but that's a topic for another day.
Don't Forget Bankruptcy NOL Rules, Vol. 11, No. 8, The M&A Tax Report (March 2003), p. 1.