In a private letter ruling released on December 23, the Internal Revenue Service laid out conditions under which a parent company may use its net operating losses (NOLs) after it emerges from bankruptcy. With the economy apparently starting to emerge from the doldrums, more than a few companies may find needed clarification in the ruling (LTR 201051019).
The case considered by the IRS involved a corporation that was the common parent of a consolidated group of entities. On a specific date, April 1 for purposes of illustration, the parent and a disregarded entity of one of its subsidiaries filed for bankruptcy protection under Chapter 11 of the Bankruptcy Code. (A disregarded entity is one that’s separate from the parent but chooses to be disregarded as separate from the business owner for federal tax purposes.) The parent company’s subsidiaries, including the subsidiary that included the disregarded entity, did not file for bankruptcy.
On the following March 31 (another illustrative date), the parent company’s plan of reorganization, which had been approved by the Bankruptcy Court, became effective. The plan provided that at the time of the bankruptcy, several creditors held notes or outstanding loans that were due them. The plan of reorganization involved instructions about how those notes and loans were to fare under the plan. The plan features were as follows:
• Each electing holder of an allowed claim under so-called Note 1 — or any holder of an allowed claim arising under Note 2 — received its pro rata share of New Note 1, and shares of the parent’s new common stock. (Electing holders of debt instruments may choose to include in gross income all interest accrued on the instrument.)
• Each nonelecting holder of an allowed claim under Note 1 had its current claim reinstated and retained its current note.
• Each holder of an allowed claim arising under Loan 1 or Loan 2 received New Note 1 and shares of the parent’s new common stock.
• Each holder of an allowed claim arising under Note 3 or Note 4 received shares of the parent’s new common stock plus “contingent value rights” (CVRs). (CVRs are given to shareholders of an acquired company facing restructuring.)
• Each holder of certain notes issued by the disregarded entity received New Notes 2, which were issued by the disregarded entity and guaranteed by the parent.
• Holders of equity interests in the parent had their interests canceled, terminated, and extinguished, although holders of the parent’s preferred stock received CVRs.
On March 31, the parent emerged from Chapter 11 protection with a reorganization plan that resulted in an ownership change under the tax code. Specifically, under Section 382 of the Internal Revenue Code, the parent was under the jurisdiction of the Bankruptcy Court in a “Title 11 case” immediately before April 30.
At issue was the reorganized corporation’s ability to use its predecessor’s NOL immediately after March 31. In the IRS ruling, the agency noted that at least 50% of the value and voting power of the common stock of the parent was owned by “qualified creditors” because they were creditors of the parent immediately before the ownership change.1 The service concluded:
• Unless the parent consolidated group elects to apply Section 382(l)(6), under Section 382(l)(5), there is no Section 382 limitation on prechange losses or built-in losses of the parent’s consolidated group as a result of the ownership change on March 31.
• If the parent’s consolidated group elects to apply Section 382(l)(6) to the ownership change on March 31, the group takes into account the increase in the value of the parent resulting from the surrender or cancellation of the company’s creditors’ claims in the transaction when it computes its Section 382 limitation.2
• If the parent consolidated group applies Section 382(l)(6) to the ownership change on May 1, with the result that its NOLs and built-in losses will be subject to the Section 382 limitation, the parent group may apply the principles for computing and allocating the Adjusted Deemed Sales Price under Regulation Section 1.338-4 and Regulation Section 1.338-6 to determine its amount realized. This amount is based on the hypothetical sale of all of its assets to a third party that assumed all of its liabilities.3