On October 21, 2013, the U.S. Department of the Treasury and the Internal Revenue Service (IRS) issued Final Treasury Regulations to provide relief under Section 382 for small redemptions.1 These regulations provide taxpayer relief as to the administrative burden and sometimes inequitable treatment that the segregation rules can cause in certain taxpayer situations. On December 19, 2014, the IRS issued its first private letter ruling (PLR) on the small redemption limitation.
Background
Section 382 generally requires a corporation to limit the amount of its income in future years that can be offset by historic net operating losses (NOLs) after that corporation has undergone an "ownership change." An important factor in determining whether an ownership change has occurred, and therefore whether a limitation is required, is ascertaining the changes in the equity holdings of a corporation’s five-percent shareholders during the testing period.2 A five-percent shareholder, for purposes of Section 382, includes individuals, entities and "public groups." A public group is generally a five-percent holder that is composed of equity owners of the loss corporation that are not themselves five-percent shareholders and that have not acquired their shares of a loss corporation in a coordinated acquisition.3 Thus, the public group is an aggregate of non-five-percent equity owners.
The segregation rules of Section 382 and the accompanying Treasury regulations generally treat certain transactions as if a new public group separate from any preexisting public groups acquired the stock. In effect, the Section 382 rules presume that persons representing a completely new set of investors purchase such shares.4 Thus, this set of investors will generally constitute a new public group and will be treated as a five-percent shareholder separate from other five-percent shareholders or previously identified public groups that are treated as five-percent shareholders.
Small Redemption Exception
Under Treasury Regulations Section 1.382-2T(j)(2)(iii)(C), a redemption by a loss corporation of its stock from small shareholders results in the segregation of each public group into two groups — one group theoretically participating in the redemption and one that has not. The newly created public group’s holdings that are equal to the shares redeemed are eliminated in the next testing date that results in a shift in ownership percentages.
Assume a loss corporation with 1,000 shares of a single class of outstanding stock, all of which is held by small shareholders in one public group with no owner shifts for the testing period. The loss corporation redeems 80 shares from the small shareholders. These shares are segregated into a newly formed public group. Splitting the shares into two public groups will not cause any owner shifts on the testing date with the segregation event. On the next testing date, the newly created public group with the 80 redemption shares is eliminated. Because the ownership of the main public group that held the shares that were not redeemed holds the same shares as they did on the last testing date, there is an owner shift because the denominator for outstanding shares has been reduced. When the percentage is compared to the last testing date, there is an increase in ownership of eight percent.
Treasury Regulations Section 1.382-3(j)(14), however, contains an exception to the segregation rules by providing that they do not apply to "small redemptions."5 A small redemption is limited to 10 percent of the beginning of the year stock value (value measurement) or 10 percent of the number of shares of the class of stock being tested (class-by-class measurement). The limitation method is selected at the taxpayer’s option each year, and there is no consistency requirement. A "small redemption" is generally defined as a redemption from public shareholders, to the extent the amount (on an aggregate year-to-date basis) of stock redeemed does not exceed the small redemption limitation. Importantly, if a single redemption from public shareholders exceeds the limitation, no part of the redemption qualifies.
As is the case with the small issuance exception, in general, a loss corporation must treat as a single redemption those redemptions that are close in time, pursuant to the same plan or arrangement, or deliberately separated to minimize or avoid an owner shift. If the small redemption exception applies, the shares subject to the small redemption limitation are allocated to preexisting direct public groups proportionately.
Assuming the same facts as the example above and applying Treasury Regulations Section 1.382-3(j)(14), the redemption should qualify as a small redemption because the redemption amount is less than 10 percent of the shares held. Thus, no new public group is created and there is no owner shift on the following testing date. That is because there is no public group created on account of the numerator and denominator being changed on the redemption testing date.
PLR 201451015
On December 19, 2014, the IRS released PLR 201451015 to clarify the application of the Section 382 small redemption exception in the context of a loss corporation’s active stock repurchase program. In the PLR, the taxpayer was a U.S. corporation wholly owned by a non-U.S. corporation (FP) whose stock was publicly traded on a U.S. stock exchange. The majority of FP’s stock is owned by one or more public groups.
FP had a stock repurchase program in place, with the majority of repurchases occurring during a one-month "Open Trading Window" following its quarterly earnings release. FP’s stock repurchases were completed during the open trading window or shortly thereafter, pursuant to an agreement entered into during the open trading windows. The IRS ruled that FP’s repurchases of its stock completed during given open trading windows, but before the beginning of the next open trading window, will be aggregated into one redemption for purposes of the small redemption exception. The IRS came to this conclusion because the shares redeemed in each open trading window were considered to occur "at approximately same time pursuant to same plan or arrangement." The small stock buybacks were thus not aggregated on an annual basis. If the total redemptions for the year had been aggregated as part of one plan, the exception would not have applied if the total redemptions had exceeded the annual amount.
Pepper Perspective
In most cases, the new exception to the segregation rules provides taxpayer-friendly results going forward. Because the rules may be applied retroactively to open testing periods, loss companies should consider applying the rules to see if they can reduce the current owner shift. In many cases, the reduction in current shift and the knowledge that future equity transactions may not be subject to the segregation rules will allow companies more flexibility in planning corporate transactions, such as stock buybacks.
Endnotes
1 Unless otherwise stated, all references to "Section" are to the Internal Revenue Code of 1986, as amended, and all references to the "Regulations" or to "Treas. Reg." are to the Treasury Regulations promulgated thereunder.
2 Generally, the "testing period" for any testing date is the three-year period ending on the testing date. Once an ownership change occurs, the three-year testing period is reset and a new testing period begins. See Treas. Reg. § 1.382-2T(d)(1).
3 See Treas. Reg. § 1.382-3(a)(1), which provides that an entity is any corporation, estate, trust, association, company, partnership or similar organization. An entity also includes a group of persons who have a formal or informal understanding among themselves to make a coordinated acquisition of stock.
4 See Treas. Reg. § 1.382-2T(j)(2)(iii)(B)-(C). For testing dates occurring during tax years beginning after November 4, 1992, the regulations provide two key exceptions to the full segregation presumption. These special rules significantly modify the segregation rules and provide certain assumptions when the equity of the loss corporation was issued in a "small issuance" or a "cash issuance." Treas. Reg. § 1.382-3(j)(2) and (j)(3).
5 Of note, the regulations’ effective date rule provides that they apply to testing dates occurring on or after October 22, 2013. The regulations do, however, permit taxpayers to apply the provisions of the final regulations in their entirety to all testing dates that are included in a testing period beginning before and ending on or after October 22, 2013, subject to the limitations that (1) the final regulations may not be applied to any date on or before the date of any ownership change that occurred on a date before October 22, 2013, under the regulations in effect before October 22, 2013, and (2) they may not be applied if their application would result in an ownership change occurring on a date before October 22, 2013 that did not occur under the regulations in effect before October 22, 2013.
