IRS Withdraws Proposed Section 382(h) Regulations 

On July 2, the IRS and U.S. Department of the Treasury formally withdrew two sets of proposed regulations under Section 382(h) issued in 2019 and 2020 that would have significantly restricted a corporation’s ability to use NOLs and other tax attributes following a Section 382 ownership change.

The notice of withdrawal provides that taxpayers can continue to rely on the approaches in Notice 2003-65 to determine net unrealized built-in gains (NUBIG) or net unrealized built-in losses (NUBIL) and identify recognized built-in gain (RBIG) and recognized built-in loss (RBIL) items after an ownership change. The notice of withdrawal also states that Treasury and the IRS are continuing to study these issues and intend to issue guidance in the future, though no timeline has been provided.

Background

Section 382 limits a company’s ability to use NOLs and other tax attributes following an ownership change transaction. An ownership change transaction generally is defined for Section 382 purposes as a cumulative shift in ownership of more than 50 percentage points over a rolling three-year period. The rules aim to prevent loss shifting but are notoriously complex to apply when built-in gains and losses are involved. A Section 382 ownership change study is an invaluable tool for evaluating compliance with the built-in loss rules.

Under Section 382(h), when a corporation with tax attributes undergoes an ownership change, it must determine whether it has a NUBIG or NUBIL at the time of the ownership change. If a corporation has a NUBIG at the time of the ownership change, recognition of built-in gains tied to pre-change activity (RBIGs) during the five-year period following the ownership change (the post-change recognition period) may be used to increase the Section 382 limitation and allow for increased use of pre-change tax attributes. Alternatively, if a corporation has a NUBIL at the time of the ownership change, recognition of built-in losses tied to pre-change activity (RBILs) during the post-change recognition period may limit the taxpayer’s ability to use pre-change tax attributes.

Under Notice 2003-65, taxpayers can choose between the following two methods to determine what qualifies as RBIG or RBIL:

1. The Section 1374 approach, which follows a realization-based model that identifies RBIG and RBIL based on actual realization events – such as asset sales, income recognition, or liability discharges – during the post-change recognition period
2. The Section 338 approach, which models the tax effect of a hypothetical asset sale and treats the difference between actual post-change cost recovery deductions (based on historical tax basis) and hypothetical deductions (based on fair market value) as a proxy for RBIG or RBIL during the post-change recognition period based on a wasting asset theory

Crowe observation

In practice, the Section 338 approach often is preferred for its planning flexibility and modeling certainty. By allowing built-in gain or loss to be recognized based on a wasting asset theory rather than waiting for an actual realization event, the Section 338 approach allows a corporation to use tax attributes that otherwise would be deferred or lost under the Section 1374 approach.

Withdrawn proposed regulations

The proposed regulations that were withdrawn on July 2 would have significantly reduced a corporation’s ability to use NOLs and other tax attributes following a Section 382 ownership change by narrowing the scope of what qualifies as RBIG or RBIL. Specifically, the proposed regulations would have:

• Eliminated the more practical Section 338 approach, which typically allows more gain recognition upfront, and required exclusive use of the realization-based Section 1374 approach
• Reduced the value of post-ownership change tax attributes by disqualifying certain items, such as cancellation of debt (COD) income, contingent liabilities, and interest carryforwards under Section 163(j), from being recognized as built-in items and used to generate RBIG to support NOL use

However, withdrawal of the 2019 and 2020 proposed regulations means that these changes will not take effect, and any future changes will require new guidance.

Following are key takeaways from the withdrawal of the proposed regulations:

• Notice 2003-65 remains in effect. Taxpayers can continue to use either the Section 1374 or the Section 338 approach to compute NUBIG/NUBIL and identify RBIG/RBIL during the five-year post-change recognition period.
• Corporations are not subject to the harsh restrictions that were proposed with respect to certain tax items such as COD income, contingent liabilities, and disallowed interest carryforwards. Taxpayers can continue to determine the treatment of these items under the more flexible framework of Notice 2003-65, which might result in greater preservation of tax attributes in certain factual contexts.
• The potential for future guidance creates uncertainty. The preamble to the notice of withdrawal states that new proposed regulations could be issued in the future that include elements of the withdrawn rules. Taxpayers should continue documenting their methodology under the Notice 2003-65 framework and monitor the potential impact of future guidance.

Looking ahead

Withdrawal of the proposed regulations is a welcome development for companies with significant tax attributes and those undergoing or planning restructurings, acquisitions, or bankruptcy proceedings. The ability to continue modeling under Notice 2003-65 – particularly using the Section 338 approach – preserves taxpayer flexibility and reduces uncertainty for ongoing transactions.

However, withdrawal of the proposed regulations and the government’s continued study in this area could signal increased scrutiny and the potential for upcoming changes. Corporations can prepare for changes in this area by consulting a tax adviser to evaluate compliance with Section 382 and determine if a new or revised Section 382 study is needed.