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Recent developments for using target's NOLs.

An acquired corporation's net operating losses (NOLs) are often subject to multiple restrictions that limit or prohibit their use by a corporate acquiror, including limitations under Secs. 382,384,269 and the separate return limitation year (SRLY) rules of Temp. Regs. Sec. 1.1502-21T. However, a recently released 1993 Field Service Advice (FSA) and expected revisions to the SRLY rules offer some hope to acquirors.

Sec. 382 Built-in Gain

Sec. 382 generally restricts use of NOLs by a loss corporation that has undergone an ownership change (a greater-than-50% change in ownership over a rolling three-year period), by limiting the annual amount of income that may be offset by pre-change loss carryforwards. This limit generally equals the product of (1) the loss corporation's value immediately before the ownership change multiplied by (2) the prevailing long-term tax-exempt interest rate. (When a corporation undergoes an ownership change, Sec. 383 imposes similar limits on the rate at which other pre-change attributes (such as capital losses and tax credits) may be absorbed.)

One somewhat pro-taxpayer aspect of this rule involves the treatment of built-in gain. Sec. 382(h)(1) provides that, if a loss corporation has a "net unrealized built-in gain" (NUBIG) on the change date, the Sec. 382 limitation may be increased by the built-in gain recognized during the five post-change years. To take advantage of this provision, the NUBIG must be greater than either (1) $10 million or (2) 15% of the gross value of the loss corporation's noncash or cash-equivalent assets.

For Sec. 382 purposes, built-in gain is recognized to the extent the loss corporation establishes that there has been a "disposition" of an asset held immediately before the change date, and the gain from the disposition does not exceed the amount of built-in gain on the change date. Sec. 382(h)(6) further provides that "any item of income which is properly taken into account during the recognition period but which is attributable to periods before the change date shall be treated as a recognized built-in gain for the taxable year in which it is properly taken into account." The legislative history to this provision gives only two examples of built-in income items: (1) pre-change accounts receivable of a cash-basis taxpayer and (2) post-change Sec. 481 adjustments attributable to pre-change periods.

1993 FSA

The IRS released FSA 1998-415, concluding that income from software licensing acquired in a nontaxable reorganization is recognized built-in gain under Sec. 382(h)(6), to the extent allocable to pre-change built-in gain. The loss corporation was acquired in a nontaxable reorganization and had NOLs attributable to its software development costs.

The FSA stated that the taxpayer "faces major hurdles" in establishing that the licensing was a "disposition" of the built-in gain asset under Sec. 382(h)(2). The Service noted, however, that the legislative history to Sec. 382(h)(6) "indicates that Congress was concerned with matching pre-change built-in gain with its associated income whether or not there was an actual disposition of the asset containing the built-in gain." The FSA concluded that a "reasonable argument" could be made that the software licensing income should be treated as recognized built-in gain.

An FSA memorandum may not be cited as precedent and does not constitute "substantial authority" for purposes of the accuracy-related penalty provisions. Thus, FSA 1998-415 does not add to or change the underlying authorities for determining whether an item may be treated as recognized built-in gain. However, it does illustrate IRS practice for income streams from certain identifiable, intangible, built-in gain assets and also may be of benefit on audit.

As with most potentially favorable news under Sec. 382, this silver lining comes with a gray Cloud. Sec. 384 would require similar treatment of such income as recognized built-in gains, which would be unfavorable to many taxpayers acquiring loss corporations. Sec. 384 generally prohibits one corporation's built-in losses from offsetting another's built-in gains. Applying the same reasoning as the FSA, software licensing income generated from expenses incurred before a loss corporation is acquired would also constitute recognized built-in gain. Sec. 384 would prevent the acquired corporation's loss carryforwards from offsetting that income.

Sunset of SRLY

Temp. Regs. Sec. 1.1502-21T was due to sunset in June 1999. Accordingly, some form of Service guidance should be forthcoming.

The SRLY rules generally apply when a consolidated group acquires a new subsidiary with loss or credit carry-forwards or a net unrealized built-in loss. The SRLY rules typically require SRLY NOLs or built-in losses to offset only the income of the member generating such loss.

Under current rules, the SRLY and the Sec. 382 limits technically are not linked together. Thus, the SRLY rules operate to limit losses carried over from SRLYs, regardless of whether the acquisition of the new member triggers an ownership change under Sec. 382. Also, both limitations may apply concurrently; when this occurs, the maximum amount of NOLs that may be absorbed cannot exceed the lesser of the Sec. 382 limitation or the SRLY limitation.

However, the IRS is currently considering (among other options) modifying or eliminating the SRLY rules for cases in which the SRLY and Sec. 382 rules overlap; see Notice 98-38. The Service initially had announced it was considering an approach that would replace the current SRLY limitation with an approach modeled on Sec. 382, but subsequently repudiated that idea. While it is quite likely that the SRLY rules will be retained in some form, the IRS may decide to limit application of the rules to those cases to which Sec. 382 does not apply (i.e., when the loss corporation joins the group in a transaction that does not trigger an ownership change).

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Title Annotation:target corporation's net operating losses
Author:Friedel, David
Publication:The Tax Adviser
Geographic Code:1USA
Date:Jul 1, 1999
Previous Article:Good news in consolidated loss disallowance rules.
Next Article:Valuation of assets transferred to entity in determining gain.

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