In Search of the Holy Grail

In general, a corporation can use all of its NOLs to offset taxable income even if its income, and its regular tax, are reduced to zero. In such case, the corporation may, however, owe Alternative Minimum Tax or AMT since the use of NOLs in calculating AMT is limited. Since NOLs can be carried back 2 years (except in the case of so-called specified liability losses that can be carried back for 10 years) and carried forward 20 years with only an AMT “charge” for their use, maximizing the availability and use of NOLs is of critical importance to a corporation.

Where the ownership of the stock of a corporation with NOLs (a “loss corporation”) changes by more than 50 percentage points (a so-called “ownership change”), however, Section 382 of the Code will apply to limit the amount of NOLs that can be used to offset taxable income in each year following the ownership change. Any NOLs not used by the end of the 20-year carry forward period expire and are lost. The determination of whether an ownership change has occurred is made by comparing the stock ownership of shareholders (or shareholder groups) that own at least 5% of the stock of the loss corporation (so-called “5% shareholders”) before and after various stock transactions, and takes into account all changes in stock ownership during a rolling 3-year period. In addition, complex constructive ownership, aggregation and segregation rules apply in making this determination.

If an ownership change has occurred, the amount of NOL that can be used by a loss corporation in each year following the ownership change is generally determined by multiplying the “equity value” (the value of the stock or the gross value of the assets minus the value of the debt) of the corporation immediately before the ownership change by the “long-term tax-exempt rate” published monthly by the Internal Revenue Service. The annual limitation will be zero, however, if the company fails to continue its historic business for at least 2 years after the ownership change.

The annual limitation so determined may, however, be increased if the assets of the loss corporation have appreciated in value (so-called “net unrealized built-in gain”) and such built-in gain is recognized (or treated as having been recognized under a favorable administrative pronouncement) during the 5-year recognition period following the ownership change. Conversely, if the assets of the loss corporation have declined in value (so-called “net unrealized built-in loss”) depreciation and amortization deductions are functionally treated as NOLs and will be subject to the annual limitation determined in connection with the ownership change. The application of the built-in gain or built-in loss rules can have a dramatic affect on the present value of the NOLs.

Special Rules for Bankrupt Companies — In General

Corporations seeking to reorganize under the protection of bankruptcy courts may be eligible for a special rule under Section 382 of the Code. This rule, which is found in Section 382(l)(5) of the Code, requires a bankrupt corporation to meet special eligibility requirements. Corporations which do not meet these eligibility requirements, or which affirmatively elect not to have Section 382(l)(5) of the Code apply, can utilize another special rule. This other special rule, which is found in Section 382(l)(6) of the Code, allows the bankrupt corporation to take any debt reduction resulting from any exchange of stock for debt pursuant to its plan of reorganization into consideration in determining the annual limitation under Section 382 of the Code. Thus, unlike the general rule of Section 382, which calculates the annual limitation using the company's equity value immediately before the ownership change, the Section 382(l)(6) rule calculates the annual limitation using the company's equity value after cancellation of debt under the plan of reorganization. This can dramatically increase the value of the NOLs.

Unless a bankrupt corporation opts out of Section 382(l)(5) of the Code, this special rule automatically applies if certain historical creditors and shareholders own at least 50% (by vote and value) of the stock of the bankrupt corporation (or any corporation controlling the bankrupt corporation) immediately after such ownership change. If Section 382(l)(5) of the Code applies, the annual imitation on the use of NOLs under Section 382 of the Code (as well as the built-in gain and loss rules) does not apply and its NOLs can be used to offset future taxable income without limitation. Although the NOLs can be used without limitation, however, the bankrupt corporation's NOLs must be reduced dollar for dollar by interest expense deductions taken for interest on any debt of the bankrupt corporation that is exchanged for stock in a plan of reorganization and that was paid or accrued during 1) the 3 years preceding the year in which the ownership change occurs; and 2) any short tax year preceding the change. After calculating and deducting this interest “haircut” from the available NOLs, such NOLs can be used without further limitation under Section 382 of the Code.

The amount of interest attributable to debt converted to stock, and the timing of the issuance of stock, may be critical in the calculation of this NOL interest “haircut.” Thus, for example, since interest on certain debt of a bankrupt company may be suspended, delay in implementing a plan may serve to reduce the interest “haircut” if such non-performing debt is exchanged for stock. Similarly, implementing a plan at the beginning or end of a year would eliminate any short period interest “haircut.”

Importantly, however, if a second ownership change occurs within 2 years after the ownership change to which the Section 382(l)(5) special bankruptcy rule applies, the annual limitation with respect to the second ownership change will be zero and the company will not be allowed to use any of its historic NOLs after the second ownership change.

Qualifying Stock and Indebtedness

As noted above, to qualify for Section 382(l)(5), 50% (by vote and value) of the stock of the bankrupt company must be received by received by certain historical creditors and shareholders. For this purpose, stock is taken into account only if it was owned by a shareholder immediately before the ownership change or if it was received pursuant to the plan of reorganization in exchange for so-called “qualified indebtedness” that was held immediately before the ownership change. “Qualified indebtedness” includes only debt that is held by a creditor continuously during a period commencing 18 months before a petition in bankruptcy was filed by the bankrupt corporation and ending on the effective date of the plan of reorganization (so-called “old and cold” debt) or debt that arose in the ordinary course of business and is held by the same creditor since the debt was incurred (so-called “ordinary course” debt).

'Old and Cold' Debt

As discussed above, the first form of debt that will be treated as “qualified indebtedness” for purposes of Section 382(l)(5) of the Code is “old and cold” debt. The requirement that debt must be held for 18 months prior to the filing of a petition in bankruptcy and until the effective date of the plan of reorganization in order to qualify as “old and cold” debt would require a company to track the ownership of its debt during such period so as to prevent dispositions of debt which might render Section 382(l)(5) of the Code inapplicable. Although lock-up agreements which would prevent dispositions can be negotiated with significant creditors, where debt is publicly traded it would seem difficult, if not impossible, to satisfy the “old and cold” holding period. Recognizing this problem, the Internal Revenue Service has issued regulations that ameliorate this harsh rule. These regulations provide two exceptions to the “old and cold” holding period.

The first exception permits a corporation which is about to undergo an ownership change to treat debt as always having been held by the person who owns the debt immediately before the ownership change if that person is not a 5% shareholder or an entity through which a 5% shareholder owns an interest immediately after the ownership change. Thus, transfers among creditors before an ownership change may be disregarded, unless the creditor's participation in the formulation of the bankruptcy plan makes it clear that the creditor has not held the debt for the requisite period. Although it is not clear, this limitation on the scope of the exception to the “old and cold” holding period would appear to exclude debt that is acquired by known vulture funds. Similarly, this generous exception to the “old and cold” holding period does not apply to debt acquired by creditors who acquired their debt, as a consequence of some formal or informal understanding, for the express purpose of acquiring the stock of the bankrupt company. Any debt acquired by creditors for such purpose is aggregated and treated as having been acquired by a single entity.

The second exception permits holding periods to be “tacked” or added, allowing transferees to step into the shoes of transferors for purposes of satisfying the “old and cold” holding period even if the creditor ends up being a 5% shareholder. Under this exception, holding periods may be tacked when the transferor and the transferee bear certain designated relationships to each other. Thus, for example, if debt changes hands as a consequence of a syndication or underwriting, the holding period of the syndicate leader or underwriter and the ultimate purchaser of the debt are “tacked” so that their joint ownership counts toward satisfying the “old and cold” holding period. Similarly, holding periods may be tacked where new debt is exchanged for old debt held by the same creditor.

Ordinary Course Debt

As discussed above, the second form of debt that will be treated as “qualified indebtedness” for purposes of Section 382(l)(5) of the Code is “ordinary course” debt. The Internal Revenue Service regulations provide that debt arises in the ordinary course of business if it is incurred in the normal or customary conduct of business and includes trade debt, liabilities which arise out of employment relationships, business relationships with suppliers or customers, or from tort, breach of warranty or breach of statutory duties. Importantly, ordinary course debt also includes liabilities incurred to fund deductible expenses. Debt that is acquired for the principal purpose of acquiring stock pursuant to a plan or reorganization, however, does not count as “ordinary course” debt. Thus, the concept is broad enough to cover almost any trade claim and should cover tort liabilities (such as asbestos claims) even if the claims are transferred to a 524(g) trust and even if the claims have not all been asserted on the date of the transfers to the 524(g) trust. Similarly, the concept should be broad enough to cover workmen's compensation and OPEB liabilities satisfied for stock. Finally, since the regulations refer to debt incurred to fund deductible expenses, the concept should be broad enough to cover draw downs under short-term revolvers or lines of credit that do not qualify as “old and cold” debt if the proceeds are used for ordinary course expenses. Although far from clear, one may also be able to argue that this category of “ordinary course” debt might be broad enough to include debtor in possession or “DIP” financing.

Second Ownership Changes

As noted above, the benefits or Section 382(l)(5) of the Code come with a significant potential cost, ie, a loss of NOLs if the bankrupt corporation undergoes a second ownership change within two years of the Section 382(l)(5) ownership change. Although this post-reorganization holding period requirement (and the risks of a failure to retain sufficient stock ownership) seems foreboding, creditors may be willing to retain ownership of the stock they receive to obtain the benefits derived by the bankrupt corporation by being able to use NOLs following a reorganization without limitation under Section 382 of the Code to offset gains on expected asset sales or expected increases in operating income where the NOLs available after application of the loss limitation rules of Section 382 (even assuming an election to apply Section 382(l)(6)) are insufficient to offset such gain or income. This may especially be the case if some sort of agreement can be negotiated with creditors which would permit periodic sales of a portion of creditors' stock positions over the 2-year period, so long as stock is not sold to a party “building” stock ownership which might become a 5% shareholder. In some situations, however, any sort of trading restriction or “lock-up” may be unacceptable to the creditors, and the bankrupt corporation may be required to opt out of Section 382(l)(5) of the Code and elect Section 382(l)(6). Thus, although every effort should be made to meet the requirements of Section 382(l)(5) of the Code and obtain the benefits attendant thereto, the benefits afforded may not be worth the risk that NOLs will be lost because creditors will dispose of the stock they receive in the reorganization within the 2-year period following emergence.

In short, it is important to “search” for the Section 382(l)(5) Holy Grail because of the material present value benefit that it may afford the debtor company. Unfortunately, the Holy Grail may not be “found” in all cases.

Where, as is generally the case, stock of a bankrupt company changes hands upon emergence, the company may undergo an “ownership change” and the use of its net operating losses (NOLs) may be subject to limitation under Section 382 of the Internal Revenue Code (Code). This article discusses the loss limitation rules, in general, and one of the special rules under Section 382 of the Code that applies to bankrupt companies, specifically.

The impact of the loss limitation rules on a debtor company is critical for its advisers to understand because of the substantial value of its NOLs. In general, a debtor company's NOLs may represent its most valuable asset because of their potential to reduce cash taxes. Since application of the Section 382 loss limitation rules to a debtor company's NOLs may materially impact the value of its NOLs, it is important for advisers to search for the “Holy Grail,” ie, to determine whether the debtor company can qualify for the special Section 382 rule for bankrupt companies, Section 382(l)(5). If Section 382(l)(5) applies, there will be no limitation on the use of the debtor company's historical NOLs to reduce cash taxes on post-emergence income.

Loss Limitation — In General

In general, a corporation can use all of its NOLs to offset taxable income even if its income, and its regular tax, are reduced to zero. In such case, the corporation may, however, owe Alternative Minimum Tax or AMT since the use of NOLs in calculating AMT is limited. Since NOLs can be carried back 2 years (except in the case of so-called specified liability losses that can be carried back for 10 years) and carried forward 20 years with only an AMT “charge” for their use, maximizing the availability and use of NOLs is of critical importance to a corporation.

Where the ownership of the stock of a corporation with NOLs (a “loss corporation”) changes by more than 50 percentage points (a so-called “ownership change”), however, Section 382 of the Code will apply to limit the amount of NOLs that can be used to offset taxable income in each year following the ownership change. Any NOLs not used by the end of the 20-year carry forward period expire and are lost. The determination of whether an ownership change has occurred is made by comparing the stock ownership of shareholders (or shareholder groups) that own at least 5% of the stock of the loss corporation (so-called “5% shareholders”) before and after various stock transactions, and takes into account all changes in stock ownership during a rolling 3-year period. In addition, complex constructive ownership, aggregation and segregation rules apply in making this determination.

If an ownership change has occurred, the amount of NOL that can be used by a loss corporation in each year following the ownership change is generally determined by multiplying the “equity value” (the value of the stock or the gross value of the assets minus the value of the debt) of the corporation immediately before the ownership change by the “long-term tax-exempt rate” published monthly by the Internal Revenue Service. The annual limitation will be zero, however, if the company fails to continue its historic business for at least 2 years after the ownership change.

The annual limitation so determined may, however, be increased if the assets of the loss corporation have appreciated in value (so-called “net unrealized built-in gain”) and such built-in gain is recognized (or treated as having been recognized under a favorable administrative pronouncement) during the 5-year recognition period following the ownership change. Conversely, if the assets of the loss corporation have declined in value (so-called “net unrealized built-in loss”) depreciation and amortization deductions are functionally treated as NOLs and will be subject to the annual limitation determined in connection with the ownership change. The application of the built-in gain or built-in loss rules can have a dramatic affect on the present value of the NOLs.

Special Rules for Bankrupt Companies — In General

Corporations seeking to reorganize under the protection of bankruptcy courts may be eligible for a special rule under Section 382 of the Code. This rule, which is found in Section 382(l)(5) of the Code, requires a bankrupt corporation to meet special eligibility requirements. Corporations which do not meet these eligibility requirements, or which affirmatively elect not to have Section 382(l)(5) of the Code apply, can utilize another special rule. This other special rule, which is found in Section 382(l)(6) of the Code, allows the bankrupt corporation to take any debt reduction resulting from any exchange of stock for debt pursuant to its plan of reorganization into consideration in determining the annual limitation under Section 382 of the Code. Thus, unlike the general rule of Section 382, which calculates the annual limitation using the company's equity value immediately before the ownership change, the Section 382(l)(6) rule calculates the annual limitation using the company's equity value after cancellation of debt under the plan of reorganization. This can dramatically increase the value of the NOLs.

Unless a bankrupt corporation opts out of Section 382(l)(5) of the Code, this special rule automatically applies if certain historical creditors and shareholders own at least 50% (by vote and value) of the stock of the bankrupt corporation (or any corporation controlling the bankrupt corporation) immediately after such ownership change. If Section 382(l)(5) of the Code applies, the annual imitation on the use of NOLs under Section 382 of the Code (as well as the built-in gain and loss rules) does not apply and its NOLs can be used to offset future taxable income without limitation. Although the NOLs can be used without limitation, however, the bankrupt corporation's NOLs must be reduced dollar for dollar by interest expense deductions taken for interest on any debt of the bankrupt corporation that is exchanged for stock in a plan of reorganization and that was paid or accrued during 1) the 3 years preceding the year in which the ownership change occurs; and 2) any short tax year preceding the change. After calculating and deducting this interest “haircut” from the available NOLs, such NOLs can be used without further limitation under Section 382 of the Code.

The amount of interest attributable to debt converted to stock, and the timing of the issuance of stock, may be critical in the calculation of this NOL interest “haircut.” Thus, for example, since interest on certain debt of a bankrupt company may be suspended, delay in implementing a plan may serve to reduce the interest “haircut” if such non-performing debt is exchanged for stock. Similarly, implementing a plan at the beginning or end of a year would eliminate any short period interest “haircut.”

Importantly, however, if a second ownership change occurs within 2 years after the ownership change to which the Section 382(l)(5) special bankruptcy rule applies, the annual limitation with respect to the second ownership change will be zero and the company will not be allowed to use any of its historic NOLs after the second ownership change.

Qualifying Stock and Indebtedness

As noted above, to qualify for Section 382(l)(5), 50% (by vote and value) of the stock of the bankrupt company must be received by received by certain historical creditors and shareholders. For this purpose, stock is taken into account only if it was owned by a shareholder immediately before the ownership change or if it was received pursuant to the plan of reorganization in exchange for so-called “qualified indebtedness” that was held immediately before the ownership change. “Qualified indebtedness” includes only debt that is held by a creditor continuously during a period commencing 18 months before a petition in bankruptcy was filed by the bankrupt corporation and ending on the effective date of the plan of reorganization (so-called “old and cold” debt) or debt that arose in the ordinary course of business and is held by the same creditor since the debt was incurred (so-called “ordinary course” debt).

'Old and Cold' Debt

As discussed above, the first form of debt that will be treated as “qualified indebtedness” for purposes of Section 382(l)(5) of the Code is “old and cold” debt. The requirement that debt must be held for 18 months prior to the filing of a petition in bankruptcy and until the effective date of the plan of reorganization in order to qualify as “old and cold” debt would require a company to track the ownership of its debt during such period so as to prevent dispositions of debt which might render Section 382(l)(5) of the Code inapplicable. Although lock-up agreements which would prevent dispositions can be negotiated with significant creditors, where debt is publicly traded it would seem difficult, if not impossible, to satisfy the “old and cold” holding period. Recognizing this problem, the Internal Revenue Service has issued regulations that ameliorate this harsh rule. These regulations provide two exceptions to the “old and cold” holding period.

The first exception permits a corporation which is about to undergo an ownership change to treat debt as always having been held by the person who owns the debt immediately before the ownership change if that person is not a 5% shareholder or an entity through which a 5% shareholder owns an interest immediately after the ownership change. Thus, transfers among creditors before an ownership change may be disregarded, unless the creditor's participation in the formulation of the bankruptcy plan makes it clear that the creditor has not held the debt for the requisite period. Although it is not clear, this limitation on the scope of the exception to the “old and cold” holding period would appear to exclude debt that is acquired by known vulture funds. Similarly, this generous exception to the “old and cold” holding period does not apply to debt acquired by creditors who acquired their debt, as a consequence of some formal or informal understanding, for the express purpose of acquiring the stock of the bankrupt company. Any debt acquired by creditors for such purpose is aggregated and treated as having been acquired by a single entity.

The second exception permits holding periods to be “tacked” or added, allowing transferees to step into the shoes of transferors for purposes of satisfying the “old and cold” holding period even if the creditor ends up being a 5% shareholder. Under this exception, holding periods may be tacked when the transferor and the transferee bear certain designated relationships to each other. Thus, for example, if debt changes hands as a consequence of a syndication or underwriting, the holding period of the syndicate leader or underwriter and the ultimate purchaser of the debt are “tacked” so that their joint ownership counts toward satisfying the “old and cold” holding period. Similarly, holding periods may be tacked where new debt is exchanged for old debt held by the same creditor.

Ordinary Course Debt

As discussed above, the second form of debt that will be treated as “qualified indebtedness” for purposes of Section 382(l)(5) of the Code is “ordinary course” debt. The Internal Revenue Service regulations provide that debt arises in the ordinary course of business if it is incurred in the normal or customary conduct of business and includes trade debt, liabilities which arise out of employment relationships, business relationships with suppliers or customers, or from tort, breach of warranty or breach of statutory duties. Importantly, ordinary course debt also includes liabilities incurred to fund deductible expenses. Debt that is acquired for the principal purpose of acquiring stock pursuant to a plan or reorganization, however, does not count as “ordinary course” debt. Thus, the concept is broad enough to cover almost any trade claim and should cover tort liabilities (such as asbestos claims) even if the claims are transferred to a 524(g) trust and even if the claims have not all been asserted on the date of the transfers to the 524(g) trust. Similarly, the concept should be broad enough to cover workmen's compensation and OPEB liabilities satisfied for stock. Finally, since the regulations refer to debt incurred to fund deductible expenses, the concept should be broad enough to cover draw downs under short-term revolvers or lines of credit that do not qualify as “old and cold” debt if the proceeds are used for ordinary course expenses. Although far from clear, one may also be able to argue that this category of “ordinary course” debt might be broad enough to include debtor in possession or “DIP” financing.

Second Ownership Changes

As noted above, the benefits or Section 382(l)(5) of the Code come with a significant potential cost, ie, a loss of NOLs if the bankrupt corporation undergoes a second ownership change within two years of the Section 382(l)(5) ownership change. Although this post-reorganization holding period requirement (and the risks of a failure to retain sufficient stock ownership) seems foreboding, creditors may be willing to retain ownership of the stock they receive to obtain the benefits derived by the bankrupt corporation by being able to use NOLs following a reorganization without limitation under Section 382 of the Code to offset gains on expected asset sales or expected increases in operating income where the NOLs available after application of the loss limitation rules of Section 382 (even assuming an election to apply Section 382(l)(6)) are insufficient to offset such gain or income. This may especially be the case if some sort of agreement can be negotiated with creditors which would permit periodic sales of a portion of creditors' stock positions over the 2-year period, so long as stock is not sold to a party “building” stock ownership which might become a 5% shareholder. In some situations, however, any sort of trading restriction or “lock-up” may be unacceptable to the creditors, and the bankrupt corporation may be required to opt out of Section 382(l)(5) of the Code and elect Section 382(l)(6). Thus, although every effort should be made to meet the requirements of Section 382(l)(5) of the Code and obtain the benefits attendant thereto, the benefits afforded may not be worth the risk that NOLs will be lost because creditors will dispose of the stock they receive in the reorganization within the 2-year period following emergence.

In short, it is important to “search” for the Section 382(l)(5) Holy Grail because of the material present value benefit that it may afford the debtor company. Unfortunately, the Holy Grail may not be “found” in all cases.