Since the advent of the financial crisis, many financial institutions have accumulated significant amounts of tax attributes in the form of net operating loss (NOL) carryforwards, tax credit carryforwards, and other forms of built-in tax losses. While these attributes may be attractive to potential acquirers or investors, the application of Internal Revenue Code (IRC) section 382 may significantly reduce the benefit of these tax attributes.
A thorough analysis of the existing tax attributes and their value going forward under IRC section 382 is an important step in determining the appropriate value for any target institution. This determination is certainly necessary for an outright acquisition of a target institution but is also relevant to those seeking to participate in a significant stock offering by such an institution.
Section 382 in a Nutshell
Section 382 applies when a corporation experiences a significant ownership change while it is a loss corporation. The provision limits a corporation’s, or its successor’s, ability to deduct any realized built-in losses and use tax loss or credit carryforwards. Due to statutory time limits on the carryforward of these items, the limitation imposed under Section 382 can lead to a permanent loss of tax benefits and a negative impact on a bank’s financial statement.
Will Ownership Change?
An acquisition, any form of stock issuance (such as public offering, private placement, or recapitalization), or a shareholder’s purchase of a significant number of shares from other shareholders can trigger an ownership change.
An ownership change generally occurs when the collective ownership of the major shareholders of a loss corporation (specifically those owning 5 percent or more of the stock) increases by more than 50 percentage points over a three-year testing period. The percentage point increase for each major shareholder is computed separately and then aggregated to determine if it is an ownership change of at least 50 percentage points. The corporation is responsible for monitoring the ownership changes among its shareholders, and the rules for determining these ownership changes are numerous and complex.
Is Your Target a Loss Corporation?
A loss corporation is any corporation with a carryforward of net operating loss, capital loss or tax credits or with net unrealized built-in loss (NUBIL)—collectively referred to as “tax attributes”—at the time of an ownership change.
NUBIL is basically the fair market value of a corporation’s assets less its tax basis in those assets, determined immediately before the ownership change. Economic losses not yet recognized for federal income tax purposes can create NUBIL. Examples of NUBIL include loan and receivable loss reserves not yet charged off for tax purposes; and impairments, or unrealized losses, of securities recorded for financial statement purposes but not tax purposes.
The provision does recognize a de minimis exception: If NUBIL does not exceed the lesser of $10 million or 15 percent of the fair market value of total assets, it is disregarded for purposes of determining if an entity is a loss corporation.
Keep in mind that a decline in asset values can create a loss corporation, as built-in losses can result from loan and receivable loss reserves not yet deducted for tax purposes, unrealized securities portfolio losses or impairments, or unrealized losses on other assets that have declined in value.
Computing the Section 382 Limitation
When an institution that qualifies as a loss corporation experiences an ownership change, it must compute its Section 382 limitation by multiplying the fair market value of its stock immediately before the ownership change by the applicable federal long-term tax-exempt rate.
The limitation determines how much of the tax attributes that existed at the date of the ownership change can be used by the institution or its successor annually after the ownership change. If NUBIL exists, any assets with built-in losses that are sold at a loss within five years of an ownership change will be subject to the annual Section 382 limitation on deductibility. Losses exceeding the annual limit may be carried forward and deducted in future years—within the confines of the annual Section 382 limitation—but could end up expiring unused.
Proceed With Caution
Section 382 can substantially limit the use of tax attributes and might be a trap for an acquirer or the unwary institution trying to increase its equity capital. The tax attributes at issue often exist on the target’s balance sheet in the form of deferred tax assets for NOL carryforwards, tax credit carryforwards, or allowance for loan losses (which can represent NUBIL). While these deferred tax assets may be offset to zero with a valuation allowance, they likely have some value. The key is to determine the precise value of these tax attributes to the acquirer to make sure this value is properly considered in determining the purchase price. The same concept holds true for investors seeking to participate in a significant stock offering that would trigger an ownership change for the issuer.