CERTs and consolidated groups: where avoided cost means avoided benefit.

The significant number of highly leveraged transactions in recent years, coupled with the more recent economic recession, may place many once profitable corporations in a net operating loss (NOL) position. Unfortunately, some may find NOL carryback claims jeopardized by the corporate equity reduction transaction (CERT) provisions enacted in the Omnibus Budget Reconciliation Act of 1989 (OBRA) and included in Sec. 172(b)(1)(E) and (h).

The CERT provisions were enacted to stop profitable corporations from obtaining tax refunds by carrying back NOLs created by certain debt-financed transactions occurring after Aug. 2, 1989. While Sec. 382 does keep profitable corporations from using acquired NOLs, the CERT rules prevent highly leveraged transactions from being financed, in part, by tax refunds from carrying back postacquisition NOLs.

Although this objective is easily understood, a lack of regulatory guidance, coupled with sparse legislative history, provides traps for the unwary, particularly when consolidated groups are involved. Use of an "avoided cost" method to allocate interest to a CERT widens the trap for leveraged taxpayers. However, statutory language, committee reports and modifications made by the Revenue Reconciliation Act of 1990 (RRA) may provide certain opportunities to lessen the negative impact of the CERT provisions. Definition of a CERT A CERT occurs when there is a major stock acquisition or an excess distribution. A major stock acquisition is defined as the acquisition by a corporation (or a group of persons acting in concert with the corporation)of 50% or more (by vote or value) of the stock of another corporation within a 24-month period, except for qualified stock purchases for which a Sec. 338 election has been made (Sec. 172(h)(3)(B)and (D)(ii)). An excess distribution is any distribution to shareholders during the tax year (including a redemption) that exceeds the greater of 150% of the average of distributions made during the three preceding tax years or 10% of the stock's fair market value (Sec. 172(h)(3)(C)). Furthermore, all members of an affiliated group filing a consolidated return are to be treated as one taxpayer for purposes of applying the CERT provisions (Sec. 172(h)(4)(C)).

Once a CERT has occurred, any portion of an NOL attributable to "excess interest loss" incurred in the year of the CERT or the two succeeding tax years (the "limitation years") is not permitted to be carried back to a year preceding the CERT, but may be carried forward (Sec. 172(b)(1)(E)). To determine the amount of excess interest loss, Sec. 172(h)(2)(B) requires the use of an avoided cost method, in the manner prescribed under Sec. 263A(f)(2)(A)(ii). Under the avoided cost method, interest expense is allocated to the CERT to the extent total interest expense could have been reduced if the CERT had not occurred. Furthermore, the allocable interest deduction is limited to increases in interest expense over average interest expense for the three years preceding the year of the CERT, and a de minimis rule allows taxpayers to ignore allocable interest of less than $1 million in any limitation year (See 172(h)(2)(C) and (D)).

Initially, the OBRA excluded from the CERT rules acquisitions in which a corporation acquires stock of another corporation which, immediately before the acquisition, was a member of an affiliated group other than the common parent. Under this rule, the target and acquiror were not required to be members of the same affiliated group. However, the RRA eliminated this exclusion for stock acquisitions occurring after Oct. 9, 1990.

Although it is not apparent why this.exception was originally created, certain commentators suggested that the acquisition by one corporation of the stock of a subsidiary of an affiliated group does not affect the combined corporate equity of the parties to the transaction, and thus the corporate tax base remains intact. This analysis appears consistent with the OBRA committee reports, which indicated that regulations should exempt transactions when corporate equity has not been replaced by debt. The repeal of the affiliated group exception by the RRA, however, may have impaired this committee report mandate.

Traps

Trap #1: Because direct tracing of interest expense to debt incurred in connection with the CERT has not been considered, both debt incurred in a major stock acquisition or to fund an excess distribution, as well as debt incurred before or after the CERT, could be tainted. As a result, once profitable corporations may find circumstances totally unrelated to a major stock acquisition, redemption or major distribution that could draw them into the CERT trap.

Example 1: In December 1991, P, a profitable calendar-year taxpayer, purchases assets of X for $4,000 with the proceeds of a term loan. In 1992, P acquires 70% of the stock of T for $5,000 cash. P incurs a $1,000 NOL in 1992. Because P could have paid off the remaining balance of the $4,000 term loan instead of purchasing the T stock, interest on the term loan is considered allocable to the CERT.

Assuming the allocation limitations and de minimis rules of Sec. 172(h)(2)(C) and (D)do not provide relief, P would be precluded from carrying back the portion of its NOL that results from interest expense incurred on the term loan.

Trap #2: Since all affiliated group members included in a consolidated return are treated as one taxpayer for purposes of the CERT rules, a further pitfall lies in applying the avoided cost method to consolidated groups. Consider the result if in 1991 P (from Example 1), which is debt free, acquires 100% of the stock of T, also debt free, for cash. In 1992, S, another consolidated group member that is highly leveraged, incurs a substantial NOL that results in a consolidated NOL. By definition, P's 1991 acquisition of T is a CERT; under the avoided cost method, 1992 interest expense on S debt will be allocable to the CERT to the extent the cash used by P to acquire T could have been used to

down S debt. The provision limiting allocable interest to the excess over average interest expense for the preceding three years may provide relief under these circumstances.

Trap #3: The actions of lower tier subsidiaries, which may or may

contribute to a consolidated NOL, may adversely affect a parent's ability to carry back consolidated NOLs.

Example 2: P, S and T file a consolidated return. S is wholly owned by P and Tis 90% owned by S. P and S have been marginally profitable while T has been highly profitable; hence, most of the value of the P group is related to the T stock. P, S and T made no distributions in the three preceding years. In 1991, to infuse cash into P and S, T borrows money and distributes a cash dividend to its shareholders Is and the minority shareholders) which exceeds 10% of the aggregate fair market value of P group stock. In 1992, solely because of the operations of P and S, the P group generates a consolidated NOL.

Under the provision that treats all members of an affiliated group as one taxpayer, could T's 1991 distribution, made in part to a third party, taint P group's interest deduction and limit a consolidated NOL carryback? Presumably, only the 10% of T's distribution made to the minority holders should be taken into account in determining whether the distribution is an excess distribution and, if it is, to determine the amount of allocable interest. Absent regulations, however, the answer is not entirely clear.

Opportunities

Opportunity #1.' Sec. 172(h)(2)(E) provides a special rule for certain extraordinary unforeseeable adverse events occurring in a loss limitation year but after the CERT. In such circumstances, the corporation's indebtedness is first allocated to unreimbursed costs paid or incurred in connection with the unforeseeable event. There are no criteria established in the statute or committee reports to describe such events. Therefore, one may reasonably speculate whether losses due to litigation, or major business downturns necessitating restructuring charges, could meet the definition of an extraordinary unforeseeable adverse event.

Opportunity #2: Sec. 172(b)(1)(E) provides that a CERT interest loss may not be carried to a tax year preceding the tax year in which the CERT occurs. However, unlike the rules of Sec. 382, there is no requirement to allocate the CERT year results between pre-and post-CERT periods.

Example 3: P incurs debt to acquire 100% of the stock of T in September 1991. An analysis of 1991 results discloses P generated taxable income of $1,000 through the date of the CEnT and incurred a $300 NOL in the remaining portion of the year, resulting in 1991 taxable income of $700. In 1992, the P group incurs a $700 NOL, which is entirely attributable to P's interest expense and allocable to the CERT. Under Sec. 172(b)(1)(E), P is permitted to carry back the $700 NOL from 1992 to obtain a refund of 1991 tax, even though all of P's 1991 taxable income was generated before the date of the CERT.

Summary

Because the CERT provisions were enacted in 1989 and modified in 1990, many corporations may be facing these issues for the first time in filing 1991 tax returns. Some taxpayers may find NOL carryback claims in jeopardy when due consideration is given to the avoided cost method of allocating interest to a CERT and the treatment of affiliated group members as a single taxpayer. The lack of regulatory guidance in interpreting several key provisions of the statute provides not only pitfalls but also opens up opportunities to minimize the effect of the CERT provisions. From David A. Winsko, CPA, Pittsburgh, Penn.