WorldCom's NOL plans extinguished?

BY THE AICPA TAX DIVISION'S CORPORATIONS & SHAREHOLDERS TAXATION TECHNICAL RESOURCE PANEL'S CONSOLIDATED TAX ISSUES TASK FORCE

A recent article (1) claimed WorldCom Inc. is "exploiting" the Code to preserve its net operating losses (NOLs) as it emerges from bankruptcy. In an unstated reference to Sec. 382, the article notes that WorldCom is changing its bylaws to preclude, for two years, any party flora acquiring more than a 4.75% stock interest.

WorldCom appears to think it will have a post-bankruptcy Sec. 382 problem, even though its bankruptcy filing is the largest in history. There is a quid pro quo for the debt relief obtained. In exchange for excluding the debt relief from income under Sec. 108(a), a debtor must reduce its tax attributes under Sec. 108(b)--primarily NOLs--to get a "fresh start" (not a "head start") over solvent taxpayers that had to use their tax attributes to offset debt discharge income not excluded under Sec. 108(a).

Why does WorldCom expect to emerge from bankruptcy with significant NOLs? As a consolidated return filer, the WorldCom group apparently takes the position that Sec. 108 attribute reduction can be done on a separate-company (i.e., member-by-member) basis. In response, Sen. Rick Santorum (RPA) introduced S. 1331. (2) In the accompanying floor statement, (3) he claimed that WorldCom will obtain $35 billion in debt relief from its bankruptcy filing, but will not reduce its NOLs by a comparable amount. According to Son. Santorum, Worldcom's separate-company argument would leave its principal subsidiary, MCI, with its $10-$15 billion NOL largely intact, thus permitting MCI to shelter that much future income.

This prospect is understandably alarming to MCI's competitors. S. 1331 would require attribute reduction on a consolidated basis. As support for the bill, Sen. Santorum cites United Dominion Industries, Inc., (4) in which the Supreme Court, in the absence of specific rules, applied a consolidated approach to the determination of the 10-year carryback for product liability losses provided by former Sec. 172(b)(1)(I).The difference between the two approaches is illustrated below.

Example 1: P Corp. is the common parent of a group filing a consolidated return with its two wholly owned subsidiaries, S1 and S2. At the end of 2002, the P group had a $50 million consolidated net operating loss (CNOL); $10 million was attributable to $1 and $40 million to S2. However, S2's fortunes continued to decline during 2003; it was forced to file for bankruptcy, and was relieved of $50 million of debt in the bankruptcy proceeding. Which P group tax attributes are reduced under Sec. 108(b)?

A straight consolidated approach would exclude S2's debt relief from income under Sec. 108(a). The amount excluded eliminates the entire $50 million CNOL. A separate-company approach would also exclude S2's debt relief from income under Sec. 108(a). However, only $40 million of the CNOL would be eliminated, leaving S1's portion ($10 million) intact. Assuming S2 had no other separate tax attributes, its remaining $10 million debt discharge would not be subject to tax.

IRS Guidance

Until very recently, consolidated return filers like WorldCom/MCI were not compelled to use the more onerous consolidated approach, because no regulation had ever required it. However, Treasury recently issued temporary regulations (5) mandating a modified consolidated approach. The new regulations are effective immediately, and apply to debt discharges occurring after Sept. 4, 2003 (the date of publication in the Federal Register).Thus, the new regulations may trap WorldCom before its debts are formally discharged.

(1) See Henry, "Why This Tax Loophole for Losers Should End." Business Week (5/12/03), at www.businessweek.com/@@NvXlsIcQj5npZRAA/magazine/ content/03_19/b3832100_mz020.htm.

(2) S. 1331, To Clarify Treatment of Tax Attributes Under Tax Code Section 108 for Taxpayers Which File Consolidated Returns, 108th Cong., 2d Sess (6/25/03).

(3) See Statement by Sen. Rick Santorum (R-Pa.) on Introduction of Legislation to Eliminate an Infernal Revenue Code Loophole That Allows Some Bankrupt Companies to Avoid Paying Tax on Income From Debt Cancellation. (6/25/03).

(4) United Dominion Industries, Inc., 532 US 822 (2001); for a discussion, see Blank, Weaver and Gordon, Tax Clinic, "Applying Attribute Reduction under Sec. 108(b) in a Consolidated Group." 34 The Tax Adviser 128 (March 2003) and Heffernen and Ciszczon, Tax Clinic, "Consolidated Sec. 108(b) Attribute Reduction--Post-United Dominion," 33 The Tax Adviser 422 (July 2002).

(5) TD 9089 (8/29/03).