So You Are Thinking About Buying a Loss Company?

So You Are Thinking About Buying a Loss Company? Annette Ahlers Todd Reinstein Bryan Keith Page 1 Featured Speaker Annette M. Ahlers Partner Peppe...
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So You Are Thinking About Buying a Loss Company? Annette Ahlers Todd Reinstein Bryan Keith

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Featured Speaker

Annette M. Ahlers Partner Pepper Hamilton LLP

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Featured Speaker

Bryan D. Keith Project Manager Pepper Hamilton LLP

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Featured Speaker

Todd B. Reinstein Partner Pepper Hamilton LLP

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Loss Companies AGENDA • Section 382 Overview • Annual Limitation • Previously Acquired NOLs • Five-Percent Shareholders • “Equity” under Section 382 • Example of Equity Rollforward • Public Documents – What do they reveal? • Monitoring for an Ownership Change • Planning Once an Ownership Change Occurs • Self-help • Contract Negotiating

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Loss Companies – Overview Net Operating Loss Issues: • Target companies often have significant net operating losses (NOLs) for federal tax purposes • Purchasers might overvalue the target’s NOLs or sellers might undervalue the NOLs • The target’s net operating losses are often limited by various tax provisions, including Section 382 • NOLs can generally be carried forward 20 years

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Various NOL Limitations • Section 382 Limitation • Other Limitations – Section 381 – Section 383 – Section 384 – Section 269 – Consolidated Return Regs (SRLY Rules) – CERT Rules Page 7

Section 382 Overview Purpose of Section 382: • Originally enacted to prevent “trafficking” in NOLs • Limits ability of new shareholders to benefit from corporate NOLs when the new shareholders were not around when the losses were incurred Page 8

Section 382 Overview Section 382 Basics: • Limits a “loss corporation” • That undergoes an “ownership change” • During a 3-year “testing period” • From utilizing “pre-change losses” • Against “post-change” income Page 9

Section 382 Overview “Loss Corporation” Example: • Widget Corp. Tax Returns – – – – –

TYE 12/31/02 TYE 12/31/03 TYE 12/31/04 TYE 12/31/05 TYE 12/31/06

50,000 taxable income 100,000 taxable income (200,000) net operating loss 25,000 taxable income (75,000) net operating loss

• Widget Corp. is a “loss corporation” as of 1/1/04, the 1st day of the 1st tax year that it had a net operating loss or built-in loss Page 10

Section 382 Limitation Section 382 Annual Limitation: • Fair Market Value of old loss corporation times a published IRS rate (long term tax exempt rate) • Value does not include any new investment being made on the change date • May be required to back out value of capital contributions made within 2 years of ownership change Page 11

Section 382 Limitation Section 382 Limitation Example: • • • • • • • •

Value on change date $800,000 Change date investment ($300,000) Value immediately before change $500,000 Capital Contributions (2 yrs) ($200,000) Adjusted value $300,000 Published rate (L.T. tax exempt) 5.00% Annual NOL Limitation $15,000 Annual limitation accrues, even if unused Page 12

Section 382 Limitation Why Section 382 matters: • NOL companies that undergo an ownership change do not have unfettered use of their NOLs as an offset to future taxable income • Purchase price modeling should account for limits on NOLs • Equity transactions should be monitored to make sure the limitations are not tripped inadvertently • Cumulative annual limitations may be greater than the NOL carryforward Page 13

Previously Acquired NOLs Self-generated versus acquired NOLs and successive ownership changes: • Targets, especially large consolidated groups, may have NOL “pools” from various acquired entities • Purchasers should trace Target’s NOLs to determine the source of the NOLs • Purchasers should determine whether different 382 limits already apply to the Target’s various sources of NOLs, prior to the planned acquisition • Special rules apply when successive ownership changes – must apply most restrictive limitation to the pool of NOLs that are around on any change date

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Acquired NOLs EXAMPLE – Acquired NOLs: P

S1 ('04)

S2 ('05)

Total

TYE 12/31/2004

5

40

50

95

TYE 12/31/2005

5

20

40

65

TYE 12/31/2006

5

15

20

40

Total NOL

15

75

110

200

Post-change NOLs

15

35

20

70

0

40

90

130

n/a

10

3

Pre-change NOLs (LIMITED) Initial 382 Limitation

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Equity Under 382 What generally counts as “equity” when determining a Section 382 ownership change? • Common voting stock • Convertible preferred stock • Voting preferred stock • Certain convertible options or instruments issued in an attempt to avoid Section 382 • Certain options issued deep in the money Page 16

Equity Under 382 What does NOT count as “equity” when determining a Section 382 ownership change? • Plain vanilla preferred stock – – – – –

Not entitled to vote Not convertible Limited and preferred as to dividends Does not participate in corporate growth Redemption and liquidation rights do not exceed issue price

• Most stock options • Debt, including most convertible debt Page 17

What is a 5% Shareholder? • Any individual who owns directly or indirectly an amount of the loss corporation stock that aggregates to a 5% ownership interest by value • Certain public groups created under the Section 382 rules • Certain groups of people acting in concert such that they are treated as an “entity” under the rules • A group that consists of all shareholders who own less than 5% of the stock Page 18

Transactions Involving 5% Shareholders For example: • • • • • • •

Initial public offerings (IPO) Stock acquisitions Stock redemptions – special rules Tax-free reorganizations using stock as currency Recapitalizations Conversions of preferred into common stock Major debt issuances, especially if convertible debt or accompanied by warrants • Conversions of debt into equity • Issuances or exercises of stock options or warrants Page 19

Example of Equity Rollforward “Creeping” Ownership Change (3-year period): • Date 1: XYZ Corp capitalized with $100 in common stock issued to 1 founder for 100 shares • Date 2: XYZ issues 40 Series A convertible preferred shares for $40 to investor A (converts 1-to-1) • Date 3: XYZ issues 40 Series B convertible preferred shares for $40 to Investor B (converts 1-to-1) • Date 4: Public purchases 25 common shares from XYZ in IPO for $50

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“Creeping” Ownership Change (before IPO) 5% Shareholders

Common Stock

Series A Preferred Stock

Series B Preferred Stock

100

Founder Public Group Series A Preferred Shareholders Public Group Series B Preferred Shareholders

40

40

TOTAL

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Total Value before IPO

Testing Date %

Testing Period Low %

Shift in % Ownership

$100

55.6%

55.6%

0.0%

$40

22.2%

0.0%

22.2%

$40

22.2%

0.0%

22.2%

$180

100%

55.6%

44.4%

“Creeping” Ownership Change (after IPO) 5% Shareholders

Common Stock

Series A Preferred Stock

Series B Preferred Stock

100

Founder Public Group Series A Preferred Shareholders

40

Public Group Series B Preferred Shareholders Public Group IPO Shareholders

40

25

TOTAL

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Total Value on IPO

Testing Date %

Testing Period Low %

Shift in % Ownership

$200

48.8%

48.8%

0.0%

$80

19.5%

0.0%

19.5%

$80

19.5%

0.0%

19.5%

$50

12.2%

0.0%

12.2%

$410

100%

48.8%

51.2%

Public Documents What to look for: • FIN 48 Disclosures for Uncertain Tax Positions • Deferred tax assets (DTA) from tax NOLs • Book write downs of DTAs • Reasons for write downs, such as insufficient projected income or a severely restrictive limitation • Prior ownership changes • Built in losses • Aggressive tax positions Page 23

Public Documents - Example Sample Info, Form 10K, Financial Statements, Footnote regarding “Income Taxes”: • Deferred tax assets and valuation allowance – Loss carryforwards – Valuation allowance

20 m. (2.5 m.)

• Explanation – We have provided a valuation allowance related to the benefits of certain net operating losses that we believe are unlikely to be realized. The valuation allowance decreased by $1.9 million in fiscal 2007. The decrease was due to utilization of $1.0 million and expired losses of $0.9 million. Page 24

Public Documents - Example Sample Info, Form 10-Q: • As more fully described in Note 7 (Income Taxes) to the consolidated financial statements in the 2006 Form 10-K, all of our U.S. deferred tax assets had full valuation allowances at December 31, 2006 and this continues to be the case at June 30, 2007. We will maintain this valuation allowance until an appropriate level of profitability is sustained or we are able to develop tax planning strategies that enable us to conclude that it is more likely than not that our U.S. deferred tax assets are realizable. Page 25

Public Documents - Example Sample Info, Form 10K: • The Company experienced an ownership change as a result of the Transaction, causing a limitation on the annual use of the net operating loss carryforwards. • Utilization of the Company’s net operating loss may be subject to a substantial annual limitation due to the ownership change limitations set forth in Internal Revenue Code Section 382 and similar state provisions.

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Public Documents - Example Sample Info, Form 10K: • Our effective tax rate decreased to 25% in 2006 from 35% in 2005, primarily due to a $300 million increase in the deferred tax valuation allowance in 2005, which was reversed in 2006, related to net operating losses.

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Public Documents - Example Sample Info, Form 10K: • Section 382 of the Internal Revenue Code limits the Company’s ability to utilize the tax deductions associated with its depreciable assets as of the end of the 2005 year to offset the taxable income in future years, due to the existence of a Net Unrealized Built-In Loss (“NUBIL”) at the time of the change in control. Such a limitation will be effective for a five-year period subsequent to the change in control. Page 28

Monitoring for a Section 382 Change Monitoring Your Ownership Change Status: • Monitor 5% shareholders (evaluate “poison pill” type plans) • Conduct periodic owner shift analysis

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What can be done without having a Section 382 event? • Use cash instead of company stock in acquisitions • Use pure preferred stock to raise equity • Use convertible debt or straight debt to raise capital

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Planning Once an Ownership Change Occurs Built-in gain planning: • IRS Notice 2003-65 • Increase Section 382 limitation for recognized built-in gains and “deemed” amortization of certain assets • Do not have a second change within two years of bankruptcy • Do not sell a business within two years of change date Page 31

Planning Once an Ownership Change Occurs Built-in gain planning (continued): • Determine whether loss company has a net unrecognized built-in gain (NUBIG) or loss (NUBIL) on the change date • A loss corporation can have a NUBIG or NUBIL, but not both • NUBIG more beneficial than NUBIL • Notice 2003-65: identify items that eliminate NUBIL or adjust NUBIL into a NUBIG (e.g., C.O.D.I) Page 32

Planning Once an Ownership Change Occurs Calculation of NUBIG/NUBIL: + FMV of assets - Adjusted tax basis of assets + Built in items - Built in deductions = NUBIG or (NUBIL) Page 33

Planning Once an Ownership Change Occurs Significance: • NUBIG • NUBIL

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Section 382 Self-help Monitoring Status of Position Conducting a Section 382 Study

What is a Section 382 Study? • Determines when company became a “loss corporation” • Identifies prior equity transactions treated as “owner shifts” • Concludes on when prior ownership changes, if any, occurred • Calculates limitation from each prior ownership change • May project when certain equity events drop off the 3-year rolling “testing period” Page 35

Self-help What information is needed to complete a Section 382 Study? • • • • • • •

Federal income tax returns beginning with the first year the company incurred an NOL or had a built-in loss Baseline shareholder information from first NOL year, including identity of 5% shareholders (equity rollforward documents) Preferred shareholder schedule Convertible debt documents (conversion ratios) Financial Statements, including footnotes Details of all subsequent equity events of 5% shareholders, including 10K’s, 13D’s, 13G’s, proxy statements, and S-1’s Stock option exercises

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Contract Negotiating with Section 382 in Mind • Consider requiring a Section 382 study in the agreement if one of the parties insists on valuing the NOLs as part of the deal • Making seller “rep” that there has been no Section 382 change (or at least identify the amount of the change) • Include indemnity provisions if some aspect subject to an IRS ruling or other determination Page 37

Question and Answers

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Contact Information Annette Ahlers [email protected] 202.220.1218

Todd Reinstein [email protected] 202.220.1520

Bryan Keith [email protected] 202.220.1220

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Thank You! If you would like a copy of the slides, please email Brian Dolan at [email protected]

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About Pepper Hamilton Founded in 1890, Pepper Hamilton LLP is a multi-practice law firm with over 500 lawyers in seven states and the District of Columbia. The firm provides corporate, litigation and regulatory legal services to leading businesses, governmental entities, nonprofit organizations and individuals throughout the nation and the world. We counsel each client as if it were our only client. We: ¾

Commit our combined skills and experience to solve client problems

¾

Exercise objective and independent judgment consistent with the highest ethical standards

¾

Join with clients to identify and achieve their objectives, and

¾

Focus always on adding value with efficiency and enthusiasm

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