In March 2020, the Coronavirus Aid, Relief and Economic Security, or CARES, Act[1] was signed into law, in part, to create fiscal stimulus programs intended to address the economic fallout from the global COVID-19 pandemic.

While the Payroll Protection Program received much of the attention, there are many changes to the Internal Revenue Code contained in the CARES Act. Among these changes is a provision that undoes some of the restrictive net operating loss, or NOL, carryback rules that were created by the Tax Cuts and Jobs Act[2] enacted in December 2017.

Now that the use of NOLs has been expanded by the CARES Act, merger and aquisition advisers should revisit whether a NOL carryback is available when evaluating a potential transaction.

Further, for closed transactions, the CARES Act may provide opportunities to unlock newly created economic benefits.

This article is intended to provide an overview of various considerations when evaluating and negotiating the carryback of NOLs. It is not a complete discussion of the technical tax rules that apply.

Tax Cuts and Jobs Act General Prohibition of NOL Carrybacks

The NOL provisions of the Code have undergone significant changes over the past several years. Prior to the effective date of the TCJA in December 2017, NOLs were allowed to be carried back two years and carried forward twenty.

Corporations, however, were also subject to an alternative minimum tax, which generally limited utilization of NOLs to 90% of alternative minimum taxable income. Thus, full utilization of a NOL often resulted in an AMT credit carryforward.

With passage of the TCJA, significant changes were made to the NOL rules. For example, the TCJA limited the utilization of NOLs to 80% of taxable income. In addition, the TCJA eliminated NOL carrybacks altogether and allowed indefinite carryforwards.

The TCJA also eliminated the AMT for corporations and allowed existing AMT credit carryforwards to be refunded over a four-year period ending in 2021.

Thus, prior to the passage of the CARES Act, the topic of NOL carrybacks and the potential value of NOLs was not typically a focus in M&A transactions.

Changes to the NOL Rules in the CARES Act

As a result of the CARES Act, the TCJA's 80% taxable income limitation on a corporation's use of NOLs was eliminated for tax years beginning before January 1, 2021. The CARES Act also accelerated the refund of AMT credits for tax years 2018 and 2019.

Because of the elimination of the 80% limitation and the modification of the AMT refund rules for the 2018, 2019 and 2020 taxable years, the potential tax benefit created by a NOL has increased.

Perhaps more significantly, the CARES Act provides that a NOL arising in a tax year beginning in 2018, 2019 or 2020 can be carried back up to five years. These changes are intended to allow corporations to amend prior year returns and utilize losses, providing cash flow and liquidity during the pandemic-induced recession.

The new NOL carryback rules create negotiation opportunities for parties to M&A transactions closing in 2020 and should be added back to the list of deal issues to be evaluated. In addition, the new NOL carryback rules create an opportunity to evaluate transactions completed in 2018, 2019 and 2020 to determine if historic tax returns can and should be amended to realize potential NOL benefits.

NOL Eligible Transaction Structure

As a threshold issue, not all transaction structures allow for the carryback of a target corporation's NOLs. Accordingly, among the first set of issues to consider is whether the proposed deal structure will allow for the carryback of losses.

There are, of course, a host of other considerations that will drive deal structure. However, identifying the types of deal structures that will allow for the carryback of NOLs should become part of the deal structure analysis for 2020 M&A transactions.

Generally speaking, the acquisition of the stock of a target corporation will preserve the target corporation's tax attributes. Accordingly, if the transaction is structured as a taxable stock purchase, a "B" reorganization or a reverse triangular merger, the ability to carryback NOLs of the target corporation will generally be preserved.

On the other hand, stock transactions and mergers that are treated as asset acquisitions for U.S. federal income tax purposes, will generally not preserve the target's ability to carryback a NOL.

Accordingly, asset sales, asset reorganizations, forward cash mergers and transactions in which an election is made under Internal Revenue Code Section 338[3] or 336[4] to treat the stock purchase as an asset sale will not create a NOL carryback-friendly structure.

NOL Carryback Treatment Will Depend Upon Whether Target Company Was Part of a Consolidated Group at Time of Acquisition

If the transaction structure preserves the target corporation's tax attributes, additional analysis is required to determine the desirability of a NOL carryback. For example, the NOL carryback analysis is different depending on whether the target corporation was a member of a consolidated return group at the time of the transaction.

Target Is Not a Member of a Consolidated Group

If the target corporation is not a member of a consolidated return group and has a net operating loss in the year of sale or in a post-acquisition period beginning after Dec. 31, 2017, and before Jan. 1, 2021, the NOL may carried back to each of the target corporation's five taxable years preceding the taxable year of the loss.

In fact, unless the target corporation makes an affirmative election to relinquish the entire carryback period, the NOLs generated during the period beginning after Dec. 31, 2017, and before Jan. 1, 2021, must be carried back to the earliest taxable year to which they may be applied.

If the transaction structure preserves the tax attributes of the target corporation (e.g., a stock purchase) and the target corporation was not a member of a consolidated group prior to its acquisition, amending prior returns to claim NOL carrybacks should be within the control of the acquiring company (as the sole owner of the target corporation), provided that the carryback is not prohibited by the purchase agreement.

For transactions that closed prior to the passage of the CARES Act, the purchaser should evaluate whether there is an opportunity to amend prior target returns to take advantage of the new NOL carryback provisions.

For transactions closing in 2020, if the transaction structure preserves the tax attributes of the nonconsolidated target corporation, the new NOL carryback rules provide an opportunity for negotiations between the seller and the purchaser on amending prior returns to claim the benefit of a NOL carryback and the allocation of the economic benefits and timing of any NOL carrybacks between the purchaser and the seller.

Practitioners should evaluate the risks and collateral concerns in respect of amending prior-year tax returns (e.g., amending an earlier return could subject such returns to additional Internal Revenue Service scrutiny). Additional considerations regarding these negotiations are provided later in this article.

Target Is a Member of a Consolidated Group

A different and more complex set of tax rules will apply where the target corporation was a member of a consolidated group prior to its acquisition. In general, when a member of a consolidated return group leaves the consolidated group, it becomes or ceases to be a member at the end of the day of the acquisition, and its tax year ends for all federal income tax purposes.

In these circumstances, the net operating loss carryovers attributable to the leaving member are first carried to the consolidated return year, then are reduced for certain cancellation of indebtedness events and may be reduced under the unified loss rules.

Absent the making of an affirmative election, if the target corporation is leaving a consolidated return group, its apportioned NOL remaining after running this gauntlet is carried back to prior periods, and then any remaining NOL is carried forward to its post-acquisition separate return year.

Where the target corporation was a member of a consolidated return group at the time of its acquisition, if the target corporation recognizes a post-acquisition NOL in 2018 through 2020, absent the making of an election to waive the carryback, the target's NOL must first be carried back to the earliest return year available, which may be a consolidated return year of its former parent.

In such a case, the refund would apparently inure to the former consolidated group parent (as agent for the group) rather than to the target.

However, the target corporation can waive the carryback. Accordingly, there may be room to negotiate an allocation of the benefits of the NOL carryback between the parties notwithstanding the complexities associated with the effect of the carryback on the selling consolidated group's broader tax return.

Additional NOL Rules to Consider

Ownership Change Limitation

Section 382 of the Code provides for an ownership change limitation on the use of NOL carryforwards of the target company.

Under Code Section 382,[5] when a loss corporation undergoes an ownership change, the amount of its taxable income for any post-change year, which may be offset by prechange losses, may not exceed the Code Section 382 limitation for such year, plus an amount equal to any unused limitation from previous years.

The Code Section 382 limitation is the value of the old loss corporation, multiplied by the long-term tax-exempt rate which is published monthly.[6]

Given the historically low interest rates over the last several years, an ownership change can have a very detrimental effect on the time value of a target corporation's preacquisition NOL carryforwards. However, the limitation only affects the use of prechange NOL's to offset post-change income.

Accordingly, losses attributable to the portion of the tax year preceding the change date can be carried back to prechange years without being subject to an ownership change limitation. Post-acquisition date losses, of course, should not be subject to ownership change limitations upon carryback.

Collateral Effects of the NOL Carryback

A carryback of a NOL can have a number of collateral consequences in the carryback years. For example, the carryback of a NOL can affect the calculation of available foreign tax credits.

Specifically, if a NOL carryback offsets foreign source income or creates a domestic loss, the amount of the foreign tax credit that could be utilized in the carryback year may be reduced or eliminated.

Accordingly, prior to pricing NOL carrybacks into a transaction, the potential collateral costs in respect of foreign tax credits should be considered. The carryback of a NOL can also affect the application of the global intangible low-taxed income tax and the application of the base erosion and anti-abuse tax rules.

These considerations are complicated and outside the scope of this article.           

Considerations for Valuing NOL Carrybacks in Purchase Agreement Negotiations

As noted above, taking advantage of the new NOL carryback rules and the elimination of the 80% limitation on NOLs requires up front analysis.

Once the potential purchaser has examined whether the proposed structure chosen for the transaction is NOL carryback-friendly and whether, under the consolidated return rules, a NOL carryback would benefit the purchaser, the next step is to identify the value that these new NOLs rules create for the parties.

The relative desirability of a carryback depends in part on the tax rate applicable to the NOL carryback year. Because of the tax rate changes in the TCJA, post-acquisition date NOL's are potentially worth more if carried back into pre-2018 returns, provided that there is sufficient income in the prechange years since the prevailing corporate tax rate for most corporations in those years was 34 to 35%.

However, other valuation factors include the potential collateral effects of the election, the significance of ownership change limitations, if any, the collateral consequences of the carryback and the tax refund provisions of the purchase agreement.

The difference in the tax rates between post-TCJA and pre-TCJA years could produce both a cash tax benefit and, possibly, a financial statement benefit given that a post-acquisition date NOL carryforward generated in 2018 or 2019 would presumably have been valued at a 21% rate (as a deferred tax asset on the taxpayer's balance sheet).

In addition, since NOL carrybacks were previously unavailable to most corporate taxpayers in 2018 through 2019, if those NOL carryforwards would otherwise have been subject to a valuation allowance, a carryback could produce a financial statement benefit. The elimination of the TCJA's 80% taxable income limitation on the use of NOL's also may provide a benefit.

Finally, time value of money concepts are relevant since a refund today is worth more than a tax benefit tomorrow, all other things being equal.

In our experience, tax refund clauses tend to take one of several common forms. One common approach is for the transaction documents to contain a prohibition on the purchaser amending preclosing returns of the target corporation.

Alternatively, the transaction documents may state that no preclosing tax return of the target corporation can be amended unless the purchaser first obtains the consent of the seller.

For historic transactions, the purchase agreement will likely require the parties to negotiate an amendment (or consent) and an economic sharing of the benefit of the NOL carryback. For 2020 transactions for which NOLs are available, the parties may negotiate the process and mechanics of filing amended returns to achieve the intended economic result.

As the ultimate amount of 2020 NOLs will not be known until the filing of the 2020 tax return in 2021, the parties must draft the purchase agreement to contemplate a to-be-determined value and the process by which any resulting benefit is allocated.

When evaluating the benefits of a carryback, the seller (in the case of a consolidated target) and the target will need to consider the collateral effects of the carryback on its overall tax position.

In this regard, the purchaser likely will not have visibility into the seller's preclosing consolidated returns or the concerns that the seller may have with respect to reopening the target corporation's tax return to carryback the NOL.

This factor may create negotiating leverage for the seller. On the other hand, the target's ability to waive carrybacks creates leverage for the purchaser.

Conclusion

The CARES Act included several provisions that allow for the greater use of a NOL of a target corporation arising during 2018 through 2020. Accordingly, a NOL carryback analysis should be added to the issues list for 2020 M&A activity, and parties to closed corporate acquisitions should reconsider whether a NOL carryback is available and beneficial.

Although this analysis may be complicated by the collateral effects of the carryback, the purchaser's lack of visibility into some preclosing returns, the mechanics of amending previous returns and the provisions of the purchase agreement, significant benefits may be available.

[1] Coronavirus Aid, Relief, and Economic Security Act, 2020, 116 P.L. 136, 2020 Enacted H.R. 748, 116 Enacted H.R. 748, 134 Stat. 281. (requires login)

[2] Tax Cuts and Jobs Act, 115 P.L. 97. (requires login)

[3] Internal Revenue Code Section 338. (requires login)

[4] Internal Revenue Code Section 336. (requires login)

[5] Internal Revenue Code Section 338.  (requires login)

[6] For May 2020, the rate was 1.15%.