Net operating losses ("NOL") are a tax credit created when a company's expenses exceed its revenues, generating negative taxable income as computed for tax purposes. NOL can be used to offset positive taxable income, reducing cash taxes payable.
Carrybacks & Carryforwards
NOL can be carried back 2 years to recover past taxes paid, and forward 20 years to offset taxable income in future periods. After 20 years, any remaining NOL expire and are no longer available for use. NOL carried forward are recorded on the balance sheet as deferred tax assets ("DTA").
Companies can waive the carryback period, but it is generally advisable to carry back NOL to the extent possible, and use any remaining NOL at the earliest available opportunity in subsequent periods, to maximize the present value ("PV") of the NOL. Assuming a corporate tax rate of 35%, a $100 NOL is worth $35 today, but will be worth less in the future. The discount rate used to calculate the PV of NOL should reflect the probability that a company can generate sufficient taxable income in the future to utilize the NOL; otherwise, the NOL will expire unused and worthless. The greater the likelihood of utilizing the NOL, the lower the appropriate discount rate. The following example highlights the merits of carrying back the NOL:
If Company carries back the NOL, the journal entry it makes at the end of 20X2 to record the NOL is:
|Accounting for NOL – carryback|
|dr. Income tax receivable (A ↑)||$1.75|
|dr. DTA attributable to NOL (A ↑)||$1.05|
|cr. Income tax expense (SE ↑)||$2.80|
where $1.75 = ($3.0 + $2.0) × 35% tax rate, $1.05 = $3.0 NOL carried forward × 35% tax rate, and $2.80 = $8.0 pre-tax loss × 35% tax rate. You could assume that the income tax receivable is immediately recognized as cash, so that you don't have to worry about swapping the receivable for cash in a future period. In that case, the journal entry would be:
|Accounting for NOL – carryback|
|dr. Cash (A ↑)||$1.75|
|dr. DTA attributable to NOL (A ↑)||$1.05|
|cr. Income tax expense (SE ↑)||$2.80|
Had Company not carried back the NOL, the journal entry at the end of 20X2 would be:
|Accounting for NOL – no carryback|
|dr. DTA attributable to NOL (A ↑)||$2.8|
|cr. Income tax expense (SE ↑)||$2.8|
Note that the NOL impacts earnings at the time it is generated, not when the NOL is ultimately used.
Section 382 and M&A Considerations
The treatment of a target's tax attributes (e.g. NOL) in an acquisition depends on the tax structure of the deal. Indeed, the target's tax attributes may dictate the structure of a transaction. In taxable acquisitions in which the acquired net assets are stepped-up for tax purposes, the target's NOL may generally be used immediately by the acquirer to offset the gain on the actual or deemed asset sale. Any remaining NOL of the target do not survive the transaction and are lost. Therefore, when the target has substantial NOL, 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 NOL may be used by the acquirer in future years subject to limitation under Internal Revenue Code (IRC) Section 382.
The IRS created Section 382 to deter acquisitions of companies with substantial NOL solely motivated by tax avoidance objectives, without any valid business purpose. To accomplish this, Section 382 severely restricts the buyer's use of acquired NOL following a change in ownership, limiting annual use of such NOL to:
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 NOL to offset the gain on the sale without limitation. If the unwanted asset disposal occurred after the transaction, on the other hand, the NOL would be subject to limitation under Section 382 would not go as far in shielding the gain.
To find the current long-term tax-exempt rate used to compute the annual limit on NOL utilization under Section 382, 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.
To the extent an acquirer is unable to maximize its use of Section 382-encumbered NOL in a post-acquisition year—perhaps because a one-time charge in that period substantially reduced taxable income—the unused portion of the limitation is carried forward and available for use in subsequent periods. For example, if the Section 382 limit is $10 and taxable income is just $8, the unused limitation of $2 is carried forward so that the limit next year will be $10 + $2 = $12. Here is the actual explanation provided by Section 382:
"If the section 382 limitation for any post-change year exceeds the taxable income of the new loss corporation for such year which was offset by pre-change losses, the section 382 limitation for the next post-change year shall be increased by the amount of such excess."
When a company has both encumbered and unencumbered NOL, Section 382 calls for using the former to offset taxable income—to the extent possible—first, before using the latter. Section 382 explains as follows:
"In any case in which a (i) pre-change loss of a loss corporation for any taxable year is subject to a section 382 limitation, and (ii) a net operating loss of such corporation from such taxable year is not subject to such limitation, taxable income shall be treated as having been offset first by the loss subject to such limitation."
Now, let's apply Section 382 concepts in Example B. Company is assumed to have projected taxable income as shown, and negative taxable income in Year 1 is attributable to a one-time charge (we do not normally project one-timers, but doing so makes our example more interesting). We further assume that Company completed a $450mm stock acquisition in Year 0 and inherited $57mm of NOL from the target with a remaining life of 15 years. Company has no other NOL.
Year 1 Observations – Taxable income is negative, so we cannot utilize our NOL. Rather, we create $5mm of NOL that is unencumbered (i.e. not subject to limitation under Section 382). To the extent our use of encumbered NOL falls short of the annual Section 382 limit, the unused limitation carries forward to increase our Section 382 limit in Year 2.
Year 2 Observations – Company is profitable and can use its full Section 382 limitation, plus the entire unused limitation carried forward from Year 1, to offset the positive taxable income. In addition, Company can use some of its unencumbered NOL generated in Year 1 to offset the remaining taxable income, such that Company has no taxes payable in Year 2.
Year 3 Observations – Company uses acquired NOL equal to the Section 382 limit and exhausts its remaining unencumbered NOL to offset taxable income.
Year 4 Observations – Company exhausts its remaining acquired NOL to offset taxable income, limited by the beginning-of-period acquired NOL balance. Also, note that the DTA attributable to NOL is reduced to zero in Year 4, as expected.
In Example C, we compare the tax benefit related to a target's NOL for deals structured as taxable stock and asset acquisitions. Here, we assume that the target is a freestanding C corporation whose net identifiable assets equals its inside basis in its assets, with other assumptions as shown. No Section 338 election is assumed in the stock deal. Under these transaction assumptions, the stock deal appears more favorable to the acquirer. However, try increasing the target's assumed NOL in the downloadable spreadsheet–you'll see that the asset deal gains appeal. Hence, in acquisitions where the target has large NOL, the deal is often structured for a step-up in the target's assets. Note that since the FV of the target'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 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.
Companies with unused NOL 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 NOL 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.
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 NOL alone.
When marking the acquired balance sheet to fair value under purchase accounting, the acquirer must consider whether it can fully utilize the acquired NOL. If not, the target's DTA attributable to NOL must be written down. Whether or not the NOL can be fully utilized is a function of the Section 382 constraint and the remaining life of the NOL. For example, suppose that the target has $20 of NOL 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 NOL is $40 × 5% = $2. So, the combined company can utilize only 6 × $2 = $12 of the target's $20 of NOL. Assuming a 35% tax rate, this implies a ($20 − $12) × 35% = $2.8 write-down of the target's DTA.
Recall from the equation above that the Section 382 annual limitation is a function of the purchase price. If a prospective acquirer of a distressed, publicly traded target with large NOL waits until the target's stock price falls further to seek a deal, Section 382 may be more punitive and the NOL worth considerably less than had the acquisition been consummated at a higher purchase price. Therefore, where a target's NOL are important to an acquirer, the acquirer should be somewhat less sensitive to price and may prefer to act quickly in securing the deal before the target's stock price falls too much and destroys the value of the NOL.