Net operating loss (NOL) “preservation plans” are a type of poison pill plan designed to protect a corporation's NOLs by discouraging anyone from triggering a Code Sec. 382 ownership change by acquiring 5% or more of its shares. These plans, the use of which was upheld as reasonable in a 2010 Delaware Supreme Court case, have been adopted by a number of financial institutions that received bailout funds from the government and may become increasingly prevalent in light of the recent economic situation.
Background. An NOL is equal to the excess of business deductions (computed with certain modifications) over gross income in a particular tax year. The loss can be deducted, through an NOL carryback or carryover, in another tax year in which gross income exceeds business deductions. In general, NOLs may be carried back two years and forward 20 years. The NOL is first carried to the earliest tax year for which it's allowable as a carryback or a carryover, and is then carried to the next earliest tax year. However, a business may forego the entire carryback period and instead carry the NOL forward.
After an “ownership change,” Code Sec. 382 limits the amount by which a loss corporation (i.e., one with a current or carryover NOL) can offset its taxable income for post-change years by pre-change losses. The amount of the Code Sec. 382 limitation each year is equal to the product of the fair market value (FMV) of all the stock of the loss corporation immediately before the ownership change multiplied by the applicable long-term tax-exempt rate. The legislative history of Code Sec. 382 shows that its purpose was to prevent the “trafficking” of NOLs—in other words, to limit their benefit when new shareholders who did not bear the actual economic burden of the losses acquire a controlling interest in a loss corporation.
An ownership change is defined as a change in the percentage of ownership of the loss corporation's stock owned by the “5% shareholders” of more than 50 percentage points (by value) over a 3-year period. (Code Sec. 382(g), Reg. §1.382-2T(a)(1))
The term “5% shareholder” includes the following:
... any person holding 5% or more of the corporation's stock, directly or indirectly, during the testing period;
... a public group (i.e., individuals, entities, or other persons, each of whom owns less than 5% of the loss corporation) of either a first-tier entity (any corporation, estate, trust, association, company, partnership or similar organization, or group of persons having a formal or informal understanding among themselves to make a coordinated acquisition of stock) or a higher-tier entity (any entity with a 5% or more direct ownership interest in a first (or higher) tier entity at any time during the testing period), identified as a 5% shareholder under the rules which aggregate the owners (other than individual 5% shareholders) of an entity that has a 5% or interest in the loss corporation;
... a public group consisting of individuals and entities each owning less than 5%; and
... a public group of the loss corporation, a first-tier entity or a higher-tier entity identified as a 5% shareholder under Reg. §1.382-2T(j)’s segregation rules (under which the public shareholders of a loss corporation may be separated into two or more groups, each of which is treated as a 5% shareholder, as a result of certain transactions).
Observation: Corporations are required under Reg. §1.382-11(a) to file an information statement on or with their income tax returns for each taxable year in which there is an owner shift, equity structure shift, or other transaction described in Reg. §1.382-2T(a)(2)(i). However, given the complexities and expense of determining changes in ownership (which get increasingly complicated for corporations with multi-tiered ownership structures potentially involving trusts, partnerships, corporations, etc.), some loss corporations may not carefully track their ownership since Code Sec. 382’s limitations are only implicated when the corporation becomes profitable.
“Poison pill” plans. “Poison pill” plans are a device traditionally used by publicly held corporations as a defense against an unsolicited takeover. One type of poison pill plan provides shareholders with rights to acquire additional shares at a lower price upon a defined triggering event, such as a group's acquisition of a 20% of the corporation's stock without obtaining prior permission from the corporation. In general, a corporation's adoption of a poison pill plan for such defensive purposes isn't subject to the option attribution rules (and thus won't cause the shareholders to recognize any gain) because the purchase rights are conditioned upon the occurrence of a triggering event. (Rev Rul 90-11, 1990-1 CB 10)
One type of poison pill-type arrangement that has become increasingly prevalent over the past few years is an “NOL preservation plan,” also known as a “Shareholder Rights Plan.” These plans are designed to discourage anyone from acquiring 5% or more of its shares, thus deterring ownership changes that would deprive the company of otherwise usable NOLs.
One variation of such a plan could provide that, as of a certain date, existing shareholders and holders of any new shares issued after that date will receive a dividend of one preferred share purchase right for each common share. If any person or entity acquired 4.99% or more of the shares, their preferred share purchase rights would be voided, and all the other rights would be exercisable. The resulting dilution would keep the person's share under the requisite 5% level—and shareholders would likely be discouraged from purchasing enough stock to reach that level in the first place. However, it is worth noting that these types of plans merely discourage acquisitions of 5% of a corporation's shares by making it more expensive, but they don't actually prevent such an acquisition.
Observation: Because of Code Sec. 382’s ownership change rules, the threshold to trigger a NOL preservation plan is significantly lower than that of a traditional anti-takeover poison pill plan. From a non-tax viewpoint, there has long been uncertainty about the permissible threshold of a poison pill—generally, 15-20% has often been viewed as appropriate, with 10% near the bottom of the defensible range. A 4.99% (or lower) trigger has historically not been used, and its viability was addressed by the closely watched Versata case, discussed below.
The Versata case. In Versata vs. Selectica, (10/4/2010 Del. Sup. Ct.) 5 A.3d 586, the Delaware Supreme Court considered whether the corporate board of Selectica was entitled, in order to preserve its NOLs, to: (i) reduce the poison pill ownership “trigger” of its Shareholder Rights Plan from 15% to 4.99%; and (ii) cap existing 5% shareholders to a further increase of only 0.5%. In that case, a competitor (Trilogy) purchased shares in excess of the cap and triggered the poison pill, which resulted in a dilution of its interest. Selectica sought a declaratory judgment that its actions were valid. Trilogy and Versata, its subsidiary, counterclaimed that the poison pill was unlawful because the board failed to first consider whether Selectica's NOLs were usable and whether the pill was necessary in light of Selectica's history as an unprofitable company.
The court analyzed Selectica's actions under the framework generally applicable to anti-takeover poison pills—i.e., under the so-called Unocal standard. It reasoned that, regardless of the board's purpose of preventing the forfeiture of its potentially valuable NOLs, any Shareholder Rights Plan inherently operates as an anti-takeover device. The court then determined that the board reasonably concluded that the NOLs were an asset worth protecting and that Trilogy's actions threatened that asset, and further held that the board's chosen defensive measure was a “proportionate response” to that threat that was neither coercive nor preclusive. Although the court explicitly stated that its decision was based on the specific facts and circumstances of this case and should not be construed as generally approving the reasonableness of a 4.99% trigger, the decision nonetheless provides support for the proposition that a 4.99% trigger is a potentially viable method of protecting NOLs.
Connection to government bailouts. The Emergency Economic Stabilization Act of 2008 (EESA, P.L. 110-343), which was enacted in response to the subprime mortgage crisis, authorized the U.S. Treasury to spend up to $700 billion on “troubled assets” in order to stabilize the economy. This resulted in the government having substantial stock and warrants in many major financial institutions—often reflecting a controlling share—with the intent of selling such stock in later years.
In a series of Notices, most recently updated by Notice 2010-2, 2010-2 IRB 251, IRS provided guidance on how Code Sec. 382 applies under bailout programs. Essentially, the ownership represented by stock (other than preferred stock) issued to the U.S. under various EESA programs on any date on which it is held by the U.S. will not be considered to have increased U.S. ownership in the issuing corporation over its lowest percentage owned on any earlier date, and this stock is generally considered outstanding for purposes of determining the percentage of stock owned by other 5% shareholders on a testing date.
For purposes of measuring ownership shifts of any 5% shareholder on any testing date on or after the date on which an issuing corporation redeems stock held by the U.S. that was issued under the EESA programs, the redeemed stock will be treated as if it had never been outstanding. And, if the government's sale of the stock that was issued to it under the EESA programs creates a public group, that new group's ownership in the issuing corporation will not be considered to have increased solely as a result of the sale.
Observation: These rulings arguably extend tax breaks to the bailed-out firms, in that certain ownership changes are essentially disregarded and the firms are allowed to use their NOLs to offset future earnings free of the limitations ordinarily imposed by Code Sec. 382. This result has received ample criticism for giving up needed tax revenues in a down economy.
Although the Notices described above provide relief from Code Sec. 382 limitations for public groups that arise from the government's sale of EESA-issued stock, there is no similar relief available for sales of 5%-or-greater shares to individuals and entities. Thus, as the government prepares to reduce its interest in the bailed-out financial institutions, some of those institutions have adopted NOL preservation plans in order to prevent sales that would trigger a Code Sec. 382 ownership change.
Broader appeal of NOL preservation plans. NOL preservation plans are also likely to appeal to other corporations that didn't receive any bailout funds. In what can be described as a down or slowly recovering economy, NOLs are a very valuable asset that can dramatically reduce, or even eliminate, a corporation's tax liability. Adoption of an NOL preservation plan, especially in light of the Selectica decision, might be viewed as a reasonable way for corporations to make sure that they take full advantage of their NOLs while simultaneously staving off any unsolicited takeovers.
References: For the Code Sec. 382 limitation, see Federal Tax Coordinator 2d ¶F-7200 et seq.; United States Tax Reporter ¶3824 et seq. TaxDesk ¶240,300 et seq.; TG ¶5352 et seq.
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