Net Operating Losses
Net operating losses (NOLs) are created when the expenses incurred by a company exceed its revenues, generating negative taxable income. NOLs can be carried back 2 years to recover past tax payments, and forward 20 years to reduce future taxable income. After 20 years, any remaining NOL balance expires and the NOLs are no longer usable. NOLs carried forward are recorded on the balance sheet as deferred tax assets (DTA).
Loss companies can elect not to carry back their NOLs. However, NOLs should generally be carried back as far as possible and any remaining NOLs should be used at the earliest opportunity in subsequent years to maximize the present value (PV) of the NOLs. Assuming a corporate tax rate of 35%, a $100 NOL is worth $35 today, but will be worth less in the future. The following example illustrates the benefit of an NOL carryback:
Example 3.4 – NOL Utilization
Tango corporation records a pre-tax loss of $8 for its fiscal year ending today, December 31, 2009. The corporate tax rate is 35% and the discount rate is 8%. Prior to FY09, Tango had no NOLs. Tango's book and tax historical and projected pre-tax incomes are identical and provided below.
(A) If Tango elects not to carry back its FY09 NOLs, what is the PV of expected tax savings resulting from its FY09 NOLs?
(B) What journal entry will Tango make at the end of FY09 to record the NOL?
|dr. DTA - NOL||$2.8|
|cr. Income Tax Expense||$2.8|
(C) Assume instead that Tango does carry back its NOLs to the maximum of 2 years. Also, assume that any tax refund due Tango in connection with the carryback is received immediately. What is the PV of expected tax refunds/savings resulting from Tango's FY09 NOLs?
(D) What journal entry will Tango make at the end of FY09 to record the NOL?
|dr. Income Tax Receivable||$2.1|
|dr. DTA - NOL||$0.7|
|cr. Income Tax Expense||$2.8|
Download the solution to this problem.
The discount rate used to calculate the PV of NOLs should reflect the probability that the loss company can generate pre-tax income in the future that is sufficiently positive to utilize the NOLs; otherwise, the NOLs will be lost. If pre-tax income is expected to be steadily positive in the future, a lower discount rate may be used.
Treatment of NOLs in M&A Transactions
The treatment of a target's tax attributes (e.g. NOLs) in an acquisition depends on the tax structure of the deal. In taxable acquisitions in which the acquired net assets are stepped-up for tax purposes, the target's NOLs may generally be used immediately by the acquirer to offset the gain on the actual or deemed asset sale. Any remaining NOLs of the target do not survive the transaction and are lost. Therefore, when the target has substantial NOLs, the deal is often structured to achieve a step-up in the acquired net assets.
For deals in which there is not a step-up for tax purposes, such as a stock acquisition without a Section 338 election, the target's NOLs may be used by the acquirer in future years subject to limitation under Internal Revenue Code (IRC) Section 382, which severely restricts the use of acquired NOLs following a change in ownership.
Since NOLs may be one of a target company's most desirable features, the structure of a transaction may be dictated by the target's tax attributes. The IRS created Section 382 to prevent acquisitions of companies with substantial NOLs solely to reduce the buyers' taxable incomes, without any valid business purpose whatsoever other than tax avoidance.
Section 382 is triggered when a change in ownership occurs, defined loosely as an increase in ownership interest of at least 50% by shareholders owning 5% or more of the target's stock, over a 3-year period. The precise definition of a qualifying ownership change is complex, but it is sufficient to assume that in any taxable or non-taxable business combination, a qualifying ownership change under Section 382 occurs.
Section 382 imposes an annual limit on the use of NOLs in the hands of the acquirer equal to the minimum of:
- The market value of the target's stock multiplied by the long-term tax-exempt rate
- Taxable income of the combined company
- The amount of unused NOLs remaining
To find the current long-term tax-exempt rate, visit the IRS' web site and search for "Applicable Federal Rate". Download the IRS' most recent revenue ruling on Applicable Federal Rates to find the long-term tax-exempt rate (see image below). The long-term tax-exempt rate for ownership changes in any given month is the highest of the adjusted federal long-term rates for that month and the prior two months.
Example 3.5 – Section 382 Limitation
Alpha corporation acquires all of the outstanding stock of Tango, a freestanding C corporation, on December 31 of Year 0 for $500. No Section 338 election is made. Tango has $100 of NOLs. The long-term tax-exempt rate is 4.65%. Assume that the combined company's profit before tax is as shown in the spreadsheet below.
What is the combined company's taxable income in each of the next 5 years?
The buyer must identify the post-transaction period over which it may utilize the target's NOLs subject to limitation under Section 382 in determining the price it is willing to pay for the target, since NOLs that expire before use are worthless. This period is the minimum of:
- The remaining life of the NOLs
- The NOL carryforward divided by the Section 382 limitation
- 20 years
For example, suppose that the target has $20 of NOLs that expire in 6 years. A buyer acquires all of the target's stock for $40, and the long-term tax-exempt rate is 5%. The annual limitation on the use of the NOLs is $40 × 5% = $2. So, the combined company can only utilize to 6 × $2 = $12 of the target's $20 of NOLs.
Example 3.6 – Comparison of Tax Benefits Under Different Deal Structures
Alpha corporation wants to acquire Tango, a freestanding C corporation. Assume the transaction parameters given below, and that the FV of Tango's net identifiable assets equals Tango's inside basis in its assets.
What are the tax benefits to Alpha of structuring the deal as a taxable asset purchase and as a taxable stock purchase without a Section 338 election?
Under these transaction assumptions, the stock deal appears more favorable to Alpha. However, try increasing the target's assumed NOLs in the downloadable spreadsheet–you'll see that the asset deal gains appeal. Hence, in acquisitions where the target has large NOLs, the deal is often structured for a step-up in the target's assets.
Note that since the FV of Tango's net assets equals its inside basis in those assets, the excess of the purchase price over the assets' FV is attributable entirely to goodwill. Goodwill is a Section 197 intangible asset amortized over 15 years for tax purposes, so the tax benefits of the step-up will be realized over 15 years in the asset deal.
Section 382 requires that the buyer meet the continuity of business enterprise requirement; continuing use of the target's historic business or a significant portion of the target's assets in an existing business for 2 years following the transaction. If the continuity of business requirement is not met, the annual NOL limitation is zero. The continuity of business requirement, together with the annual NOL usage limitation, effectively discourage acquisitions of loss companies for their NOLs alone.
The Section 382 limitation may be circumvented if the target and buyer collaborate to sell unwanted target assets with unrealized built-in gains before the acquisition occurs. The target may then use its NOLs to offset the gain on the sale without limitation. If the unwanted asset disposal occurred after the transaction, on the other hand, the NOLs would be subject to limitation under Section 382 would not go as far in shielding the gain.
Companies with unused NOLs seeking new equity financing should be careful not to issue so much new equity as to trigger a change in ownership under Section 382. For example, an IPO of a biotech company that accumulated substantial NOLs during its start-up phase might trigger a qualifying change in ownership. Companies seeking to raise substantial equity financing should consider issuing straight preferred stock (no voting or conversion rights or participation in future earnings) rather than common stock.
If the target's basis in its assets exceeds the enterprise value of the target at the time of a qualifying change in ownership (a "built-in loss"), the excess is treated as a NOL as described above. Likewise, if a target's basis in its asset is less than its enterprise value (a "built-in gain"), the Section 382 limitation for any year following the ownership change is increased by the amount of any such gain realized in that year. So, a buyer planning to divest unwanted assets of the target following the transaction may find the Section 382 limitation less onerous than it at first appears.
Other Tax Attributes
Section 382 limitations also apply to capital loss carryforwards. However, the availability of capital gains is often the primary limitation on the use of capital loss carryfowards/carrybacks, since corporations can deduct capital losses only to the extent of capital gains. Capital losses may be carried back 3 years and forward 5 years. Other tax attributes of the target company, such as [foreign] tax credits and built-in losses, are subject to limitation under other sections of the IRC upon a qualifying change in ownership. Foreign tax credits may be carried back 2 years and forward 5 years.