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.”
In the case of a “merger of equals,” like the one involving Delta and Northwest, it would appear that the Delta shareholders would emerge from the transaction with a majority of the combined corporation’s stock. The merger raises a few questions regarding tax ownership and treatment, however. First, does such a merger give rise to an ownership change with respect to Delta, Northwest or both? And, who are the five percent shareholders of the surviving corporation, and will those five percent shareholders experience the requisite increase in ownership?
Assume that the surviving corporation is widely-held and no person owns as much as five percent of the corporation’s stock. In that case, the surviving corporation will have at least one five percent shareholder: the so-called public group consisting of all less than five percent shareholders. This is so because Section 382(g)(4)(A) provides that “… in determining whether an ownership change has occurred, all stock owned by shareholders of a corporation who are not five percent shareholders… shall be treated as stock owned by one five percent shareholder.”
Thus, if these so-called “aggregation” rules alone applied, 100 percent of the stock would be owned by the same five percent shareholders both before and after the merger — the public group consisting of all less than five percent shareholders — and, accordingly, there would be no ownership change with respect to either loss corporations. Unfortunately, under Section 382(g)(4)(B) and (C), these less than five percent shareholders can and will be further “segregated” into groups each of which will be treated as a separate five percent shareholder.
The tax code, as is put forth in Reg. Section 1.382-2T(g)(1)(iii), states that the term “five percent shareholder” includes a public group identified as a five percent shareholder under Reg. Section 1.382-2T(j)(2) or (j)(3). Those references focus on transactions to which Section 381(a)(2) applies with respect to how shareholders are segregated before and after the transaction.* For example, a merger that qualifies as a reorganization under Section 368(a)(1)(A) would fall into the purview of Section 381.
For this purpose, the direct public group that acquires stock in the transaction is presumed not to include any members of any direct public group that existed immediately before the transaction. As a result, the surviving corporation will have (at the very least) two five percent shareholders: the Delta group, which is the public group consisting of all of Delta’s less than five percent shareholders; and the Northwest group, the public group comprised of all of Northwest’s less than five percent shareholders.
In addition, with respect to Northwest, the Delta group will have experienced a more than 50 percentage point increase in ownership relative to the five percent shareholder’s lowest percentage of ownership at any time during the testing period. Accordingly, under this scenario, Northwest would be the loss corporation which would experience the ownership change.
That means that it would be Northwest’s pre-change NOL which would be subjected to the Section 382 limitation. No limits would be placed on the use of Delta’s copious NOL because it would not, as a result of the merger, have undergone an ownership change.
To be sure, the Northwest group — the five percent shareholder identified under Reg. Section 1.382-2T(j)(2) — would have enjoyed less than a 50 percentage point increase in ownership with respect to Delta. And, as indicated, an ownership change necessitates a more than 50 percentage point increase in ownership of the loss corporation’s stock by one or more of its five percent shareholders.
So, assuming the deal is structured as a merger of equals, and such merger qualifies as a reorganization, it would appear that Delta’s NOL would emerge unscathed and that Northwest’s much more modest NOL would be subject to the rigors of the Section 382 limitation.**
Contributor Robert Willens, founder and principle of Robert Willens LLC, writes a weekly tax column for CFO.com.
*If there is a transaction to which Section 381(a)(2) applies that identifies the loss corporation as a “party,” each direct public group that exists immediately after the transaction shall be segregated so that each (direct public group) that existed immediately before the Section 381(a)(2) transaction is treated separately from the direct public group that acquires stock in the transaction.
**In fact, such NOL may be effectively eliminated if in connection with Northwest’s emergence from bankruptcy its ownership change qualified under Sec. 382(l)(5)(A) for the so-called “bankruptcy exception.” In these cases, the occurrence of a second ownership change within the two-year period beginning on the date of the ownership change that took place as a result of the bankruptcy has the effect of eliminating the NOL that arose prior to the first ownership change. See Section 382(l)(5)(D). If Northwest’s ownership change qualified for the bankruptcy exception, and it appeared that Northwest was heading towards a second ownership change within the period specified in Section 382(l)(5)(D), the airline would, undoubtedly, “elect out” of the bankruptcy exception. This would have the effect of subjecting its NOL arising prior to the first ownership change to the Section 382 limitation; an outcome that is certainly preferable to the elimination of the NOL that Section 382(l)(5)(D) imposes.