Clarification on Use of Sec. 381(c)(1)(B) in Tax-free Asset Acquisition by a Consolidated Group

The 2001 Guidance Priority List should include a project to clarify the operation of Sec. 381(c)(1)(B) in tax-free asset acquisitions by a consolidated group. Such guidance is necessitated by the recent adoption of the "overlap rule," providing for the elimination of separate return limitation year (SRLY) limits in certain transactions also giving rise to a limit under Sec. 382.

Background

Under Sec. 381(c)(1)(B), the acquiring corporation (Acquiring) in a tax-free asset reorganization may use the target corporation's (Target's) net operating loss carryovers in Acquiring's tax year of the acquisition only up to an amount that bears the same ratio to Acquiring's taxable income for that year as the number of days in that year after the date of the acquisition bears to the total number of days in that year; see also Sec. 381(c)(3)(B) and Regs. Sec. 1.381(c)(23)-1(e). Thus, if Acquiring acquires the Target assets on the 16th day before the end of Acquiring's year, the absorption of Target's loss carryovers is limited to 15/365 of Acquiring's taxable income for the year. The rule generally seeks to prevent the newly acquired loss carryovers from offsetting income generated prior to the acquisition date.

Prior to the recent promulgation of the overlap rule, when Acquiring was a member of a consolidated group that acquired the assets of a nonmember Target in a tax-free asset acquisition, the absorption of the Target losses was subject to a SRLY limit, computed with reference to Acquiring's contribution to consolidated taxable income. Be-cause Target's loss carryovers could generally be used to offset only the income of its successor, Acquiring, it made sense to compute the Sec. 381(c)(1)(B) limit by taking into account only Acquiring's contribution to consolidated taxable income (and not the income of the group as a whole); see Rev. Rul. 75-378.

The recent adoption of the overlap rule, however, has eliminated the application of SRLY limits when SRLY loss carryovers are acquired by a consolidated group in certain transactions that also cause those loss carryovers to become subject to a Sec. 382 limit. In such cases, although utilization of the loss is limited by Sec. 382, the loss may be used to offset the income generated by any member of the group, and not just Acquiring's contribution to consolidated taxable income.

There is no guidance, however, indicating whether the reference to "taxable income" in the computation of the Sec. 381(c)(1)(B) limit should be applied with respect to consolidated taxable income or on a separate-company basis in cases in which SRLY does not apply. Clarification that Sec. 381(c)(1)(B) should be applied to consolidated taxable income in the case of loss carryovers not subject to a SRLY limit would be a reading that is most consistent with the purposes of that provision. As discussed, assuming pro rata income generation throughout the tax year, the rule is intended to prevent loss carryovers acquired by a taxpayer from offsetting income generated prior to the acquisition. A rule permitting the losses to offset any group income generated after the acquisition would achieve the result of preventing the loss from offsetting preacquisition income without reimposing a surrogate SRLY limit that limits the use of the loss only to absorption of the post-acquisition income of Acquiring.

If Sec. 381(c)(1)(B) were to be interpreted as imposing a surrogate SRLY limit in the cases described above, in the year of the acquisition, taxpayers would be required to apply both SRLY and Sec. 382 limits to the acquired loss carryover. Such a rule would reinstate some of the complexity that the overlap rule was intended to remove, even though the rationale for the overlap rule (i.e., that the Sec. 382 limit is a reasonable proxy for a separate SRLY limit) applies equally in the year of the acquisition. See Sec. 382(b)(3)(B), reducing the Sec. 382 limit for the post-change period to reflect the ratio that such period bears to the tax year. Further, such a rule would re-impose a SRLY-like limit only on the year of the acquisition and not on future years, a result that would be arbitrary and would serve no apparent purpose.

Recommended Guidance Project

For the foregoing reasons, it is requested that the Service and Treasury consider issuing guidance addressing the computation of the Sec. 381(c)(1)(B) limit if a member of an acquiring group acquires loss carryovers from a nonmember in a tax-free asset acquisition. It is suggested that the rules require computation of the limit on a separate-company (or, as appropriate, subgroup) basis when the losses are subject to a SRLY limit, but that the limit be computed for the consolidated taxable income of the group as a whole when the SRLY limit does not apply.

This item was submitted by KPMG LLP to Treasury and the IRS for inclusion in the 2001 Priority Guidance List. It was developed by KPMG's Mergers and Acquisitions Tax Practice, which includes Richard Yates, a member of the AICPA Consolidated Tax Issues Task Force.