On September 9, 2019, the U.S. Treasury Department (Treasury) and the Internal Revenue Service (IRS) issued proposed regulations1 (the Proposed Regulations) that, if finalized, would significantly change the way corporations that are acquired or undergo certain other ownership changes calculate and recognize existing net operating losses (NOLs) and other tax attributes for purposes of Section 382 following the ownership change.2 Notably, the new rules would require taxpayers to use the accrual-based "Section 1374" approach to calculate built-in gain and loss, thereby eliminating the alternative, generally taxpayer-favorable, "Section 338" approach previously approved by the IRS. These changes are likely to affect corporations in the technology and life sciences industries that have significant NOLs and self-created intangible assets.
Section 382 and Built-In Items
Section 382 generally limits the ability of a corporation that undergoes an "ownership change" to use its NOLs to offset its taxable income in taxable years after the ownership change. An "ownership change" generally occurs if there has been a cumulative increase in the corporation's ownership by certain "5-percent shareholders" that exceeds 50 percentage points over a rolling three-year period. Mergers or acquisitions typically are ownership changes, but financing rounds or other transactions may also trigger sufficient shifts in a corporation's ownership. After an ownership change, Section 382 generally limits taxable income that may be offset annually by pre-change NOLs to the product of: i) the fair market value of the corporation immediately before the ownership change and ii) the "long-term tax-exempt rate" for the month of the ownership change (the Section 382 limitation).3
Section 382(h) governs how a corporation determines and subsequently recognizes built-in gain or loss on assets it owned immediately before an ownership change. A corporation generally may increase its Section 382 limitation if the corporation had a "net unrealized built-in gain" (NUBIG) immediately before the ownership change, subject to a de minimis threshold. In such case, when the corporation recognizes gain within five years of the ownership change (the "recognition period") that is attributable to an asset the corporation owned immediately before the ownership change, the gain is considered "recognized built-in gain" (RBIG) that increases the Section 382 limitation for the relevant year. If the...