Net operating losses (NOLs) of a corporation are often one of its most significant tax attributes and may be a meaningful economic driver in a disposition of the corporation or its assets. The Tax Cuts and Jobs Act (the TCJA) made changes to the NOL provisions of section 172 that meaningfully changed the ability of taxpayers to use NOLs. More recently, the Coronavirus Aid, Relief, and Economic Security Act (the CARES Act) further revised section 172, in some cases reversing changes the TCJA had made. The ability to use NOLs is a significant driver of both structure and value in M&A transactions and while these changes are obviously relevant to future deals, they are also relevant to taxpayers that have engaged in executed M&A transactions in recent years. 

Before the TCJA

Prior to the TCJA, taxpayers were (subject to the application of the corporate alternative minimum tax (AMT)) able to use NOLs to offset 100% of taxable income. Taxpayers were able to carry NOLs back two years and carry forward NOLs twenty years to offset taxable income in those years. Section 382 limits the ability of a corporation to use NOLs when there is a change of control, such as an acquisition of the corporation. 

In the M&A context, NOLs drove both structure and value. Because of section 382 and the time value of money (the ability to reduce cash taxes now or, better yet, get a refund of previously paid taxes, is worth more than the ability to reduce taxable income in the future) more value could be captured by using a target corporation’s NOLs before, or in, the transaction. This could be achieved by structure the transaction as an actual or deemed (e.g., as a result of a section 338(h)(10) or section 336(e) election) asset sale where the NOLs could be used to reduce the tax cost of the asset sale to the corporation – and deliver a stepped up basis in those assets to the buyer.  

Alternatively, the parties could agree to have the target carry back an NOL to a prior year and claim a refund of previously paid taxes. For example, if the target had significant transaction related deductions (e.g., bonuses, vesting equity compensation, a portion of investment banker fees and legal fees) in the taxable period of its acquisition, the parties could cause the target to carry back the resulting NOL and claim a refund of previously paid taxes, contractually allocating the resulting benefit.

Purchase agreements would reflect the parties’ chosen structure and would likely govern the current and future use of any pre-closing NOL. In the case of an acquisition of stock, the governing agreement would be a stock purchase agreement or a merger agreement. In any case, the purchase agreement would likely address, among many other things, who was responsible for preparing tax returns, who was permitted to file amended tax returns for pre-closing tax periods (generally, consent of the seller was required to amend pre-closing tax returns) and who was entitled to refunds of pre-closing taxes (generally, the seller was entitled to refunds of pre-closing taxes). Absent such provisions, an acquired corporation would be able to amend its tax returns and would receive any refunds of taxes it previously paid. However, if the target was sold by an affiliated group which filed consolidated tax returns, absent an agreement to the contrary, the selling consolidated group would generally have the right to file a refund claim based on the carryback of a pre-closing NOL and to retain any refund received.

The ability to carry back an NOL to the two preceding taxable years also gave rise to the potential for a post-closing NOL of the target to be carried back to a pre-closing year and generate a refund of taxes paid for such year. Some purchase agreements had provisions specifically addressing this possibility. For example, in some cases the purchaser was required to waive the carryback period under Section 172(b)(3), while in other cases the agreements provided that the purchaser would be entitled to any refund resulting from the carryback of a post-closing NOL.

The TCJA 

The TCJA amended section 172 by putting in place an 80% limitation (determined without regard to the deduction) on the deductibility of NOLs carryforwards that arose in taxable years beginning after December 31, 2017. The TCJA also eliminated the ability of taxpayers to carry back NOLs, but permitted taxpayers could carry forward NOLs indefinitely. The effect of 80% limitation was that corporations could not fully offset their current year taxable income with NOLs carried forward from taxable years beginning after December 31, 2017 (NOLs carried forward from taxable years beginning before January 1, 2018 could still be used to offset 100% of current year taxable income).  

The TCJA eliminated the corporate AMT for taxable years beginning after December 31, 2017 (but permitted taxpayers to carry forward and claim unused AMT credits in subsequent years). The TCJA also added, among other provisions, section 59A (the base erosion and anti-abuse tax (BEAT)), section 250 (the deduction against foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI)), section 951A (subjecting GILTI to current tax) and section 965 (the transition tax). NOLs impact each of these provisions, which were drafted for an environment where NOLs could not be carried back.  

Since NOLs could no longer be carried back, parties could no longer cause a target corporation to carry back an NOL. While provisions providing for such carry backs disappeared from purchase agreements, such agreements generally continued to address preparation and amendment of tax returns as well as the entitlement to refunds of pre-closing taxes.  

The CARES Act

The CARES Act provides that NOLs arising in a taxable year beginning after December 31, 2017, and before January 1, 2021 (generally, 2018, 2019, or 2020) are to be carried back five years. Further, the CARES Act eliminates the 80% taxable income limitation for taxable years beginning before January 1, 2021. Taxpayers generally have until June 30, 2020 to file a “quickie” refund claim to carry back their 2018 NOLs. An election to waive the carryback period for an NOL arising in 2018 or 2019 and carry such losses forward is required to be filed by the due date (including extensions) of the taxpayer’s return for its first taxable year ending after March 27, 2020.¹

NOLs arising in taxable years beginning after December 31, 2017 and before December 31, 2020 that are carried forward to taxable years beginning after December 31, 2020 will be subject to the 80% limitation that was enacted as part of the TCJA (NOLs carried forward from taxable years beginning before January 1, 2018 can still be used to offset 100% of current year taxable income).

As a result of the COVID-19 crisis, many corporations will likely have significant NOLs for the 2020 taxable year. Since the CARES Act permits corporations to carry back such NOLs up to five taxable years, such corporations may be able to amend prior-year returns and seek a cash refund of taxes previously paid. Carrying NOLs back to pre-TCJA years is especially attractive as the corporate tax rate was 35%. However, doing so entails additional complexity as the corporate AMT still applied in such years. Taxpayers consideration carrying back NOLs should model the consequences of such carryback, among other things, taking into account the impact on BEAT, FDII, GILTI, the transition tax and ability to utilize foreign tax credits in the taxable years to which the NOLs would be carried.

In addition to considering whether to carry back any such NOLs themselves, parties to post-TCJA transactions should consider the impact of these changes on both executed and contemplated transactions.  

For executed transactions, the parties will need to determine whether there are pre-closing or post-closing NOLs which can now be carried back to pre-closing periods, claiming refunds of previously paid taxes. If so, they will need to review the relevant purchase agreement and understand whether, and how, it limits their ability to do so without the participation of the other party. If the other party’s consent is required, or if the purchase agreement does not allocate pre-closing refunds in the desired manner, it may be possible for the parties to negotiate an agreement on how to proceed and how to share the benefit of any refund.    

For transactions that have not been executed, the parties should consider whether to cause the target to carry back an NOL and claim a refund of previously paid taxes, as they were able to do prior to the TCJA. Further, in conducting diligence, purchasers will need to understand the impact of any carrybacks by the target corporation.

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¹ Revenue Procedure 2020-23 permits partnership subject to the Bipartisan Budget Act of 2015, which had previously not been able to file amended tax returns, in certain circumstances to file amended tax returns to take into account the CARES Act changes as well as any other attributes to which the partnership is entitled.

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