United States: An Ounce of Prevention - Plans to Protect Loss Deduction in COVID-19 Environment

In brief

Baker McKenzie attorneys discuss the increased risks under the section 382 loss limitation rules in the COVID-19 environment. This article was previously published in Bloomberg Tax's Daily Tax Report.


In the current Covid environment, many companies are facing unprecedented net operating losses. The CARES Act generally allows companies to carry back losses incurred in 2018, 2019, and 2020 for five years in an effort to provide liquidity. Unfortunately, many companies will not be able to absorb these losses within this time frame, particularly if the company had NOLs in the years to which the five-year period relate.

Impact of Section 382 Limitations

In general, net operating losses can be carried forward for use in future years, but a company’s ability to use such losses (and certain other tax attributes) is fundamentally altered if it undergoes an ownership change under tax code Section 382. Once there has been an ownership change, Section 382 generally limits the amount of pre-change losses that can be utilized against post-change income on an annual basis. An ownership change occurs when one or more 5% shareholders increase(s) its ownership percentage by more than 50 percentage points over a testing period (generally a rolling 3 year period). A 5% shareholder generally is any person or public group owning 5% or more of the corporation’s stock. To identify 5% shareholders, a corporation must generally look through entities until it reaches a person or public group. These rules can make a change in ownership difficult to prevent, or even determine, if a company’s stock is owned by large funds or corporations.

For example, a change in ownership most clearly occurs when an acquirer takes a 51% ownership interest in a company. However, it can also occur if existing 5% shareholders increase or decrease their ownership to manage their own balance sheet positions (even if their shares are merely redeemed by the company). These examples are all the more likely in the current environment due to market volatility, dramatic swings in individual stock prices, and low interest rates (cheap money).

Regardless of why it occurs, a company’s ability to use its net operating losses to offset future cash taxes can be severely delayed or possibly forgone if an ownership change occurs. This has two important consequences. First, this delayed utilization can dramatically decrease the net present value of these net operating losses—and thus degrade the value of the company. Second, the company could be required to book a valuation allowance against those losses in the period in which the ownership change occurred. A company could have an internal control weakness if this is not done in the appropriate quarter and, if large enough, a financial restatement. While under the regulations a publicly traded company may generally rely on the existence or absence of certain SEC filings to identify 5% shareholders, the determination often remains complex due to the need to trace indirect ownership through multiple tiers of entities and aggregated public groups.

In a normal macro-economic environment, these rules may result in a costly limitation on the use of NOLs and other tax attributes. In the current macro-economic environment, the result is much worse. The annual income limitation calculated under Section 382 is generally a function of the fair market value of the old loss corporation immediately prior to the ownership change multiplied by the applicable long-term tax-exempt rate prescribed by Section 382(f) (calculated monthly by the IRS). Both of these variables are at some of their lowest levels in history due in part to Covid-19 (the May 2020 rate is 1.47%, while the May 2019 rate was 2.20%) and the valuation variable is particularly difficult to argue when the company is publicly traded. This has the effect of lowering the annual income limitation to very low levels, making the above problems more likely. Making matters worse, the Section 382 limitation is actually reduced if the new loss corporation has “substantial non-business assets”—defined as one-third of value of total assets. Cash is considered a substantial non business asset and many companies have stockpiled more of it on their balance sheet due to Covid-19.

NOL Shareholders Right Plans

Public and private companies can try to avoid a Section 382 ownership change by instituting a shareholder monitoring program and implementing an NOL shareholders rights plan or by altering their charter to prohibit large share transfers. An NOL shareholders rights plan can be used to prevent shareholders from accumulating a 4.9% or greater interest in a company’s stock by diluting their interest through the issuance of a large number of additional shares to other shareholders at a substantial discount to their future market price. Alternatively, a company can amend its charter to prohibit any 4.9% or greater transfer of shares that would be taken into account for purposes of Section 382.

These types of actions tend to subject the board to scrutiny from investors and proxy advisory firms, although legitimate NOL shareholders rights plans often attract less controversy than rights plans intended primarily as a takeover deterrent. While an NOL shareholders rights plan can generally be adopted by the board without seeking approval from shareholders, a charter amendment will require shareholder approval—potentially difficult to obtain if shareholders are unsatisfied with the company’s financial performance. Nonetheless, if a company has large net operating losses or tax credits on its books, it is important that the board consider these actions to prevent an avoidable reduction in the company’s value and potential internal control violations due to Covid-19.

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