IRS has privately ruled that warrants issued from a parent corporation to a shareholder as part of an exchange for the shareholder's stock in the parent won't be treated as exercised on the date of the exchange under Code Sec. 382(l)(3)(A)(iv) and Reg. §1.382-4(d)(2). The shareholder also won't be treated as owning any stock in the parent for purposes of Reg. §1.382-3(j)(3)’s cash issuance exception immediately before the parent's subsequent issuance and sale of common stock to independent investors in order to raise capital.
Background on Code Sec. 382’s loss limitation. After an “ownership change,” Code Sec. 382 limits the amount by which a loss corporation (i.e., one with a current or carryover net operating loss (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.
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)) Among other things, the term “5% shareholder” includes:
... any person holding 5% or more of the corporation's stock, directly or indirectly, during the testing period; and
... 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.
Background on treatment of options and warrants. Under Code Sec. 382(l)(3)(A)(iv), except as provided in regs, an option to acquire stock is treated as exercised if the exercise would result in an ownership change and meets either the ownership, control, or income tests of Reg. §1.382-4(d)(2)(i). An option includes any contingent purchase, warrant, convertible debt, put, stock subject to a risk of forfeiture, contract to acquire stock, or other similar interest regardless of whether it is contingent or otherwise not currently exercisable. (Reg. §1.382-4(d)(9)(i))
An option satisfies the ownership test if a principal purpose of the issuance, transfer or structuring of the option (alone or together with other arrangements) is to avoid, or improve the impact of, an ownership change of the loss corporation by providing the holder of the option, before its exercise, with a substantial portion of the attributes of ownership of all or part of the underlying stock. The control test is satisfied if a principal purpose of the structuring of the option was to avoid the impact of an ownership change and the option holder (and related persons) have a more-than-50% interest in the loss corporation. The income test is satisfied if a principal purpose of the structuring of the option was to avoid the impact of an ownership change of the loss corporation by facilitating the creation of income (including accelerating income or deferring deductions) or value (including unrealized built-in gains) before the exercise or transfer of the option.
An option that is treated as exercised under these rules is treated as exercised for purposes of determining whether an ownership change occurs on the date of its issuance or transfer. (Reg. §1.382-4(d)(2)(i))
Background on the cash issuance exception. If a loss corporation issues stock solely for cash, the segregation rules at Reg. §1.382-2T(j)(2)(iii)(B) don't apply to stock issued in an amount equal (as a percentage of the total stock issued) to one-half of the aggregate percentage ownership interest of direct public groups immediately before the issuance. (Reg. §1.382-3(j)(3)(i)) Thus, the segregation rules don't apply to a percentage of stock issued equal to one-half of the percentage of stock owned by less-than-5% shareholders immediately before the issuance.
Facts. Parent is the common parent of an affiliated group of corporations that files a consolidated federal income tax return. The authorized and outstanding capital stock of Parent consists of one class of common stock and three classes of preferred stock, each of which qualifies as Code Sec. 1504(a)(4) preferred stock. One class of such preferred stock is Class X.
Observation: For purposes of determining whether an ownership change has taken place with respect to a loss corporation, nonvoting, nonconvertible preferred stock described in Code Sec. 1504(a)(4) is not taken into account. However, that stock is included for determining the value of the old loss corporation. (Code Sec. 382(e)(1))
On Date 1, Parent issued the Class X stock and warrants to purchase shares of common stock to Shareholder in exchange for all of Shareholder's Parent stock (“the exchange”). Shareholder is the only holder of Class X stock.
On or after Date 2, Parent will issue and sell common stock or mandatorily convertible participating preferred stock to investors through private placements (“the capital raise”). Each investor will represent that it: (i) independently decided to invest in Parent; and (ii) has not entered into any agreement or understanding with any other investor in the other private placements to act in concert for the purpose of exercising a controlling influence over Parent or any of Parent's subsidiaries, including any agreements or understandings regarding the voting or transfer of shares of Parent.
Observation: Under Reg. §1.382-3(a)(1)(i), a principal element in determining whether there is an understanding among a group of persons to make a coordinated acquisition of stock, and thus whether there is an entity for purposes of the 5% shareholder rules, is whether the decision of each member of a group to acquire stock is based on the decision of one or more other members to acquire stock.
Parent made the following representations in connection with the planned transactions:
... The Class X stock is redeemable only for cash.
... The Class X stock and warrants issued to Shareholder had a collective value at the time of the exchange equivalent to or greater than the value of the stock for which they were exchanged.
... The warrants were not issued to any person or related persons who had, in the aggregate, a greater-than-50% ownership interest in Parent (determined under Reg. §1.382-4(d)(4)(i)(B)).
... The warrants do not, and will not, facilitate the creation of income (including accelerating income or deferring deductions) or value (including unrealized built-in gains) for Parent.
... The exercise price of the warrants can be paid only in cash.
... The warrants do not, and will not, entitle the holder or a related person to (a) any voting or dividend rights with respect to the common stock, or (b) participate in the management of Parent or any subsidiary, or have other rights that ordinarily would be afforded to owners of the common stock.
... There are no, and will not be any, reciprocal options between prospective buyers and sellers of the warrants with respect to the warrants.
... At the time of the exchange, it was more likely than not that the warrants would not be exercised.
... Parent does not have actual knowledge of any group of persons who through a formal or informal understanding among themselves made, or will make, one or more coordinated acquisitions of common stock.
Conclusion. IRS determined that the warrants won't be treated as exercised on the date of the exchange under Code Sec. 382(l)(3)(A)(iv) and Reg. §1.382-4(d)(2). Shareholder won't be treated as owning any stock in Parent immediately before the issuance of common stock in the capital raise for purposes of Reg. §1.382-3(j)(3)’s cash issuance exception, and none of the investors in the capital raise will be treated as a member of a group of persons who comprise an entity under Reg. §1.382-3(a)(1)(i).
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. For when options are treated as exercised, see Federal Tax Coordinator 2d ¶F-7618; United States Tax Reporter ¶3824.09.