Many hurdles will have to be overcome before a business combination of Delta AirLines, Inc. and Northwest Airlines Corp. can take off. Apparently, each carrier’s pilots will have to be assuaged, and there is also the potential for careful scrutiny regarding the anti-trust aspects of the deal.
Perhaps less well-known is the effect such a deal can have on the net operating losses (NOL) accumulated by each of the carriers. The significance of generating an NOL is that it allows companies to take tax deductions to offset future income — or a tax credit to apply against past tax payments.
In Delta’s case, the NOL amounts to a whopping $9.1 billion, while Northwest’s NOL, as last disclosed, amounted to some $3.3 billion. Press reports suggest that the parties are discussing a stock swap, which may or may not involve a premium to the market values of the two companies on the date the deal is announced.
If this was the case, and today’s market capitalizations was used to apportion the stock of the surviving corporation among the former Delta and Northwest shareholders, it would appear that Delta’s former shareholders would emerge with a comfortable majority of such stock. Thus, for financial accounting purposes, Delta would be treated as the acquiring corporation and, therefore, Northwest’s assets and liabilities would be subjected to the purchase accounting process.
Each of the parties to the deal is a “loss corporation” within the meaning of Section 382(k)(1) of the tax code, which means that each is a corporation entitled to use a NOL carryover. However, as is the case here, when a loss corporation undergoes an ownership change — within the meaning of Section 382(g) — certain penalties are exacted. Specifically, the amount of taxable income for any year ending after the date of the ownership change, which may be offset by pre-change losses (NOLs in this case), shall not exceed an amount known as the “Section 382 limitation.”
This limitation is calculated by multiplying two numbers: the value of the loss corporation’s stock immediately before the ownership change, and the “long-term tax-exempt rate.” For ownership changes occurring in February 2008, for example, the relevant rate is just slightly above 4.2 percent. Thus, since the value of an NOL is primarily a function of how quickly it can be employed to offset otherwise taxable income, placing limits on the amount of taxable income that the NOL may offset has a correspondingly depressing effect on the value of such NOL.
Figuring that the situation remains relatively unchanged, and taking into consideration merger ownership and segregation tax rules, it appears that Delta should be able to keep its monstrous NOL. Here’s why.
What Constitutes an Ownership Change?
A loss corporation experiences an ownership change if one or more of its five percent shareholders has increased ownership by more than 50 percentage points (not percent) relative to the lowest percentage ownership of the loss corporation’s stock at any time during the “testing period.” In general, the testing period refers to the three-year period which ends on the date of the “owner shift.”