NOLs Planning Through M&A and Tax Structure Changes

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1 COST 46 th Annual Meeting/Fall Audit Session NOLs Planning Through M&A and Tax Structure Changes Presented by: Jaye Calhoun Jeremy Jester 1 Overview State income tax laws often closely follow the federal income tax laws However, when they don t conform, special considerations can arise Significant areas of concern: Conformity to Internal Revenue Code Statutory Decoupling Filing Methodologies, including nontraditional taxes Modifications to Tax Base Tax Attributes Transactional Concerns Judicial Interpretation 2 1

2 IRC Conformity Starting Point: Line 28 vs. Line 30 Types of General Conformity: Rolling Conformity Static Conformity Even if a state conforms to the I.R.C., do they conform to judicial and administrative interpretations and guidance States vary in their adoption of judicial and administrative guidance. Conformity may also be affected by both state and federal constitutional concerns 3 Statutory Decoupling Filing Methodologies Federal Methodology vs. State Methodology State Methodologies Separate Filing Consolidated Filing Combined/Unitary Filings State statutory, regulatory, and judicial guidance, including U.S. Supreme Court guidance Other issues can arise with unitary filings that have no federal counterpart: Instant Unity Partnership Income Worldwide/water s edge reporting 4 2

3 Non-Traditional Taxes Tax bases differ significantly from federal tax base Franchise/Capital Stock/Net Worth Taxes Imposed for the privilege of doing business in a state Based on book value rather than income Gross Receipts Taxes Lower Rate Larger Base Examples Ohio CAT Texas Margins Tax Washington B&O 5 State Decoupling - Modification to Tax Base Interest on State/Municipal Obligations Federal treatment allows deduction of all interest State treatment varies: Complete federal conformity deduction of interest on own bonds, but not other states No deduction allowed for interest on own or other state bonds Depreciation Federal rules often change Bonus depreciation, Sec. 179 depreciation For their own policy reasons, state may or may not follow each federal change 6 3

4 Modification to Tax Base Dividends Federal deduction for a certain percentage of dividends received from other corporations States generally follow the federal policy goal to limit double taxation, but do so through different methods Strict conformity Only for wholly-owned subsidiaries No deduction allowed Special rules apply to dividends received from controlled foreign corporations 7 Modification to Tax Base State Income Tax Deduction Federal deduction for state and local income taxes States often decouple from or limit this provision Limitation on deduction by only allowing a portion to be added back Complete deduction requiring addback Section 199 DPAD Federal Domestic Production Activities Deduction Given scope, states have often decoupled from this provision 8 4

5 Tax Attributes Capital Losses Federal treatment Carryback 3 years Carryforward 5 years States often decouple from this provision Modifying time limits for carryforward/carryback Disallowing carryback Disallowing entire loss 9 Tax Attributes Cancellation of Indebtedness Income (CODI) Federal tax consequences of CODI: Receipt of CODI results in recognition of income unless statutory exclusion applies (e.g., CODI paid to discharge bankruptcy or insolvency) If income is excluded, the amount excluded is used to reduce federal tax attributes as payment : NOL s first, then in order, general business credit, minimum tax credits, capital loss carryovers, basis of property, passive activity loss and credit carryovers, and finally, foreign tax credit carryovers Taxpayer can elect to reduce basis of depreciable assets first IRC Section 108(i) allows deferral of income with no effect on tax attributes Lots of decoupling on 108(i) 10 5

6 Tax Attributes Cancellation of Indebtedness Income (CODI) State tax consequences of CODI: Nearly all states conform to the federal CODI rules, but the reduction for state tax attributes is far less consistent (e.g. IL has its own NOL reduction calculation) Nonconformity between state and federal asset basis or a disconnect between state and federal NOL reductions makes tracking attributes difficult To the extent a state NOL is considered to be different than a federal NOL, and a state does not have explicit guidance on reducing a state-specific attribute, a taxpayer may not have to reduce its state NOL tax attribute (NJ) However, that may lead to a larger reduction in the basis of its assets and in other tax attributes Similarly, in states where NOL is calculated on a post-apportioned basis, reduction in NOL attribute could be smaller than what would have been the case for federal tax purposes Only a few states explicitly provide for ordering rules when reducing tax attributes 11 Tax Attributes Net Operating Losses Federal treatment Carryback 2 years Carryforward 20 years States often decouple from this provision, tying to starting point conformity Line 30 Starting point Line 30 starting point, eliminating federal NOL, but providing for state NOL Line 28 starting point with separate state NOL Other Limitations Some states employing the year of use methodology do not require that the loss entity was doing business in the state during the year the loss was sustained - e.g., Virginia. States may limit percentages of NOLs that may be used for state purposes e.g., Louisiana 12 6

7 Tax Attributes Section 381 Provision allows a transferred corporation to succeed to tax attributes of a distributor transferor corporation Section 382 Provision limits amount of NOL a corporation can utilize following change of control Variety of state conformity avenues, both statutory and judicial For both provisions, the variety of state treatment can cause significant differences between federal and state returns, as well as differences between state returns 13 Transactional Concerns Asset Sales Generally subject to tax for both state and federal purposes Differences can occur with asset basis for federal state purpose Sales and use tax implications Stock Sales For federal purposes, sale of stock by parent results in recognition of gain/loss I.R.C. 338 allows for deduction 338(h)(10) election allows for tax-free treatment Successor liability concerns 14 7

8 Transactional Concerns Stock Sales, continued State conformity varies Complete Conformity Disallowance of some or all of 338(h)(10) benefits Effect of federal 338(h) (10) election on state returns General Mills v. Comm r of Rev., 795 N.E.2d 552 (Ma. 2003): Massachusetts Supreme Court held that, due to conformity to I.R.C. 338, then a federal 338(h)(10) election controlled for state purposes. N.C. Corp. Inc. Tax Dir. No. CD-02-3 (May 31, 2002): If a valid election is made for federal purposes, that taxpayer is bound for state purposes Conagra Foods, Inc. v. Bridges, 48 So.3d 1249 (La. Ct. App. 2010): finding that the entity that was deemed to be the owner of tax attributes after a 338(h)(10) election for federal purposes was also the owner for Louisiana purposes given Louisiana s adoption of language similar to that in I.R.C Transactional Concerns Stock Sales, continued Effect of federal 338(h) (10) election on state returns (cont d) Ill. Private Letter Ruling No. IT PLR (5/24/1989); IT GIL (3/9/1994): Corporate taxpayers electing 338 may make similar election for Illinois income tax purposes but income tax on capital gain arising from the deemed sale from the Section 338(h)(10) election will only apply to the selling group if the target corporation files an Illinois combined return with the selling group for the tax period immediately before the sale of the target stock. Cal. Rev. & Tax. Code (e)(3): Corporate taxpayers may choose to have a federal sec. 338 election not apply for California tax purposes or may choose a California-only 338(h)(10) type election (without federal). Until recently, New Jersey did not recognize Section 338 Elections. See Gen. Building Products Corp. v. New Jersey, 14 N.J. Tax 232 (1994), aff d, 664 A.2d 1291 (N.J. Super. Ct. App. Div. 1995). However, when the federal practice changed to no longer require the filing of a consolidated return as a prerequisite for a Section 338 election, New Jersey amended its corporate business tax regulations to make them consistent with the federal treatment of Section 338 Elections. See Mandelbaum v. Dir., Div. of Taxation, 20 N.J. Tax 141, (2002). 16 8

9 Transactional Concerns State Corporate Tax Credits Popular state tax credits based to some extent on federal tax credits include: Research and development credit Investment tax credits Energy credits Also many state-specific credits designed to spur job creation through targeted programs, including: Empowerment / development zone credits Industry-specific credits Limitations on use of credits, potential recapture provisions and carryfoward / carryback provisions vary 17 Transactional Concerns State Corporate Tax Credits Recapture provisions Mostly geared to capital and job improvement. So states can come back and recapture if requirements are not met. Taxpayers recommended to track credits to ensure meeting thresholds What should taxpayer s do if not in line to meet requirements? 18 9

10 Questions? 19 10