WorldComs NOL Plans Extinguished?

By the AICPA Tax Divisions
Corporations & Shareholders Taxation
Technical Resource Panels
Consolidated Tax Issues Task Force

A recent article¹ claimed WorldCom Inc. is exploiting the Code to preserve its net operating losses (NOLs) as it emerges from bankruptcy. In an unstated reference to Sec. 382, the article notes that WorldCom is changing its bylaws to preclude, for two years, any party from acquiring more than a 4.75% stock interest.

WorldCom appears to think it will have a post-bankruptcy Sec. 382 problem, even though its bankruptcy filing is the largest in history. There is a quid pro quo for the debt relief obtained. In exchange for excluding the debt relief from income under Sec. 108(a), a debtor must reduce its tax attributes under Sec. 108(b)primarily NOLsto get a fresh start (not a head start) over solvent taxpayers that had to use their tax attributes to offset debt discharge income not excluded under Sec. 108(a).

Why does WorldCom expect to emerge from bankruptcy with significant NOLs? As a consolidated return filer, the WorldCom group apparently takes the position that Sec. 108 attribute reduction can be done on a separate-company (i.e., member-by-member) basis. In response, Sen. Rick Santorum (R-PA) introduced S. 1331.² In the accompanying floor statement,³ he claimed that WorldCom will obtain $35 billion in debt relief from its bankruptcy filing, but will not reduce its NOLs by a comparable amount. According to Sen. Santorum, Worldcoms separate-company argument would leave its principal subsidiary, MCI, with its $10$15 billion NOL largely intact, thus permitting MCI to shelter that much future income.

This prospect is understandably alarming to MCIs competitors. S. 1331 would require attribute reduction on a consolidated basis. As support for the bill, Sen. Santorum cites United Dominion Industries, Inc.,⁴ in which the Supreme Court, in the absence of specific rules, applied a consolidated approach to the determination of the 10-year carryback for product liability losses provided by former Sec. 172(b)(1)(I). The difference between the two approaches is illustrated below.

Example 1: P Corp. is the common parent of a group filing a consolidated return with its two wholly owned subsidiaries, S1 and S2. At the end of 2002, the P group had a $50 million consolidated net operating loss (CNOL); $10 million was attributable to S1 and $40 million to S2. However, S2s fortunes continued to decline during 2003; it was forced to file for bankruptcy, and was relieved of $50 million of debt in the bankruptcy proceeding. Which P group tax attributes are reduced under Sec. 108(b)?

A straight consolidated approach would exclude S2s debt relief from income under Sec. 108(a). The amount excluded eliminates the entire $50 million CNOL. A separate-company approach would also exclude S2s debt relief from income under Sec. 108(a). However, only $40 million of the CNOL would be eliminated, leaving S1s portion ($10 million) intact. As-suming S2 had no other separate tax attributes, its remaining $10 million debt discharge would not be subject to tax.

IRS Guidance

Until very recently, consolidated return filers like WorldCom/MCI were not compelled to use the more onerous consolidated approach, because no regulation had ever required it. However, Treasury recently issued temporary regulations⁵ mandating a modified consolidated approach. The new regulations are effective immediately, and apply to debt discharges occurring after Aug. 29, 2003 (the date of publication in the Federal Register). Thus, the new regulations may trap WorldCom before its debts are formally discharged.