CARES Act Business Tax Provisions Potentially Impact Recent and Future Transactions

On March 27, 2020, President Trump signed the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) into law.  The CARES Act contains several tax provisions that potentially impact structuring and negotiations of future transactions and may provide opportunities for recently completed transactions.  Most significantly, the temporary changes to the net operating loss (“NOL”) rules may require taxpayers to review the provisions of completed deals and adopt new strategies to maximize the value of tax attributes in future deals. 

Temporary NOL Changes

Overview

The CARES Act provides a five-year carryback for certain NOLs and temporarily removes the existing 80 percent taxable income limitation on the use of NOLs.

In 2017, the Tax Cuts & Jobs Act (the “TCJA”) modified the NOL rules significantly to provide that a NOL arising in a taxable year beginning after December 31, 2017, could be carried forward indefinitely to offset 80 percent of taxable income for a given tax year but could not be carried back to any prior tax year.  These rules deviate significantly from pre-TCJA law, which allowed pre-2018 NOLs to fully offset taxable income and permitted a taxpayer to carry such NOLs back to the two prior tax years and forward to any of the next 20 tax years.

The CARES Act temporarily restores pre-TCJA law to allow NOLs to fully offset taxable income in any tax year beginning before January 1, 2021.  A NOL that arose in a tax year beginning after December 31, 2017, can be carried forward to a post-2020 tax year, but can only be used to offset 80 percent of taxable income in such tax year (after the taxable income for the post-2020 year has been reduced by NOLs carried forward to such year from taxable years beginning before 2018).  However, this 80 percent taxable income limitation will be applied without considering certain deductions that were enacted under the TCJA (e.g., qualified business income, global intangible low-taxed income, etc.).  A NOL that arose on or before December 31, 2017, can fully offset taxable income in any tax year (even if the NOL is carried forward to a post-2020 tax year).

In addition, the CARES Act provides that a NOL arising in any tax year beginning in 2018, 2019 or 2020 may be carried back to any of the five tax years preceding the tax year of the loss that gave rise to the NOL.  This rule does not apply to any NOL that arose in a tax year when the taxpayer was a “real estate investment trust.”  If a NOL arose in a tax year beginning before January 1, 2018, the pre-TCJA rules continue to apply such that those NOLs may be carried back two years and forward 20 years.  The ability to carry back NOLs that arise prior to January 1, 2021 to a pre-2018 tax year will be particularly valuable because the corporate federal income tax rate in those tax years was 35 percent (rather than the current 21 percent federal income tax rate for corporations).

M&A Considerations

The impact of these NOL provisions on transactions will differ depending on whether the deal is structured as a stock sale or an asset sale (including a deemed asset sale) for tax purposes. 

For any deal that is structured as a stock sale for tax purposes, taxpayers should consider the impact of any negotiated provisions that allocate tax refunds or deductions among the parties.  Deal terms typically address tax deductions that arise from transaction-related expenses (“transaction tax deductions”) and tax deductions attributable to expenses arising in pre-closing tax years (“pre-closing tax deductions”) and may also specifically address NOLs.  Many definitive agreements allocate transaction tax deductions and pre-closing tax deductions to the seller and entitle the seller to any tax refunds with respect to a pre-closing period.  Definitive agreements that specifically address NOLs may provide that buyer will pay seller for any post-closing tax savings attributable to a NOL carryforward for a pre-closing tax period and/or that the target may not waive any NOL carryback on a pre-closing tax return that is filed post-closing. 

Given that these NOL rule changes certainly were not anticipated, parties should carefully review acquisition agreements for recently completed transactions to determine whether the buyer or seller may be entitled to NOLs and other tax deductions.  If the definitive agreement is silent on these matters, a buyer may argue that it is entitled to the full use of pre-closing and transaction year NOLs (subject to ownership change limits under Section 382 of the Internal Revenue Code (discussed below)) on the premise that when a transaction is treated as a stock sale for tax purposes, the buyer purchases the target corporation including its tax attributes.  On the other hand, the seller may argue that it is entitled to the full use of pre-closing NOLs that arose in any tax year beginning after December 31, 2017, on the ground that such NOLs now may be carried back to prior tax years.  Future regulations likely will clarify the use of NOLs in the M&A context because a NOL carryback by a prior owner (such as a seller in a transaction) may be inconsistent with the intent of the CARES Act.

In any future deal that is structured as a stock sale for tax purposes, expect the negotiation of these tax provisions to be much more contentious as a result of the CARES Act.  Sellers will want to maximize their entitlement to any pre-closing NOLs and other tax deductions in order to take advantage of the temporary expansion of the NOL rules under the CARES Act, while buyers will seek to utilize the target’s NOLs to offset income for past and future tax years.  In addition, the CARES Act may impact structuring decisions in transactions involving a target with significant NOLs.  A buyer may prefer to structure a transaction as a stock sale for tax purposes so that the buyer may utilize the target’s NOLs post-transaction (subject to ownership change limits under Section 382 of the Internal Revenue Code).  In contrast, a seller may prefer an asset sale structure in order to retain its NOLs and other valuable tax attributes.

While the CARES Act would impact a taxpayer’s use of its own NOLs in deals that are structured as asset sales or deemed asset sales for tax purposes (e.g., a stock sale with a Section 338 election, certain purchases of a partnership or limited liability company, forward taxable mergers, etc.), the parties generally don’t need to consider the impact of provisions in the agreement that allocate federal tax refunds and deductions.  A seller retains its tax attributes (including any NOLs) in an asset sale that may be available to offset any gain on the transaction.

In all cases, before carrying an NOL back to a prior tax year, a taxpayer should consider the interaction and potential impact on other tax items in the carryback year (e.g., foreign tax credits, charitable contribution deductions, alternative minimum tax (“AMT”) liability, etc.).  In particular, a taxpayer should consider that an NOL carried back to 2017 or a prior year would be available to offset only 90% of any alternative minimum taxable income for the carryback year.

In light of the increased value for certain NOLs as a result of the CARES Act, a corporation should consider using a charter provision or poison pill to protect its NOLs.  Section 382 of the Internal Revenue Code limits a company’s ability to utilize its NOLs in future years if it experiences an “ownership change” (i.e., a greater than 50% change in the ownership of stock among certain 5% shareholders over a three-year period).  If a company experiences an ownership change, its NOLs existing at the time of such ownership change are subject to an annual use limitation that is based on the company’s equity value as well as built-in gains and losses at the time of the change.  This limitation can significantly limit the NOLs that a company can use each year and effectively diminish the inherent value of the company’s NOLs. 

To avoid a Section 382 limitation, consider adding a charter provision to prohibit shareholders from acquiring a 5% or greater position in company stock and require forfeiture of shares upon exceeding this threshold.  Alternatively, consider implementing a poison pill (or “NOL rights plan”) that discourages a shareholder from accumulating a 5% or greater position in company stock (or increasing an ownership percentage that already exceeds 5% of company stock).  To do so, the plan would dilute an offending shareholder by providing all other shareholders with the right to acquire additional company stock at a discount.  Adopting one of these measures will not eliminate the possibility of a Section 382 ownership change but will decrease the likelihood that an ownership change could occur.

Modifications to Business Interest Limitation for 2019 and 2020

Overview

The CARES Act changes the business interest deduction limitation rules for the 2019 and 2020 tax years.  The TCJA limited the amount of business interest expense that a taxpayer may deduct in a tax year to the sum of the taxpayer’s business interest income for the year, plus 30% of the taxpayer’s adjusted taxable income for the year (roughly equivalent to EBITDA) and the taxpayer’s floor plan financing interest expense for the year.  For any tax year beginning in 2019 or 2020, the CARES Act increases the business interest deduction limit from 30% to 50% of adjusted taxable income.

In addition, for a tax year beginning in 2020, a taxpayer may elect to apply the adjusted taxable income limit based on its 2019 adjusted taxable income – this election may provide an opportunity to deduct more business interest in 2020 than under prior law.  A partnership is only eligible for the increased business interest deduction for tax years beginning in 2020.  Any excess business interest of the partnership for tax years beginning in 2019 is allocated among the partners and 50% of the interest allocated to a partner is deductible by such partner in its 2020 tax year.  This special rule allows partnerships to benefit from the CARES Act changes without requiring complex amendments of partnership tax returns.

The CARES Act changes to the limitations on business interest deductions generally will not result in any tax refund claims or tax return amendments for 2019 or 2020 because the changes are only effective for 2019 and 2020 tax years, but may result in, or add to, NOLs for such years that can be carried back to previous taxable years as discussed above. 

M&A Considerations

The CARES Act relaxes the limitation on business interest deductions in 2019 and 2020 by increasing the deductible amount to the sum of the taxpayer’s business interest income for the year and 50% of the taxpayer’s adjusted taxable income for the year (rather than 30%).  This temporary change may reduce the after-tax cost of debt-financed transactions in 2019 and 2020 and may allow a buyer to use more debt to finance a deal than it otherwise would have prior to the CARES Act.

Other CARES Act Rules and M&A Considerations

Certain other CARES Act provisions (described below) may result in tax refunds for a taxpayer for the 2018 tax year or create a deduction in the 2019 tax year.  A seller that has a refund claim in 2018 as a result of a CARES Act provision and is (or will be) engaged in deal negotiations should ensure that the definitive agreement allows for the amendment of prior tax returns to obtain such refunds and entitles the taxpayer to any resulting tax refunds (even if such refunds are paid post-closing).  If a seller will not have time to amend a prior tax return to obtain refunds prior to closing, the seller should negotiate to obligate the buyer to take all reasonable steps to obtain such refunds and pay those refunds over to the seller.  For a recently completed deal, the parties should carefully review the acquisition agreement to determine who may be entitled to tax refunds and the parties’ respective rights with respect to prior year tax returns. 

Modifications to Excess Business Loss Deduction Rules

The CARES Act retroactively removes the limit on deducting excess business losses that the TCJA imposed on noncorporate taxpayers for the 2018 and 2019 tax years.  The TCJA disallowed any excess business losses of noncorporate taxpayers (i.e., losses that exceed a taxpayer’s business income) if the amount of the excess loss exceeds $250,000 ($500,000 for a joint return).  The amount disallowed by the TCJA is treated as a NOL that could be carried forward to a future year (subject to the same limits on NOLs).  The CARES Act retroactively removes the prohibition on excess business loss deductions for the 2018 and 2019 tax years and provides that such prohibition only applies for tax years beginning after December 31, 2020. 

The retroactive removal of the excess business loss deduction limitation may result in tax refund claims for any excess business loss deduction that was disallowed in a prior tax year.

Accelerated recovery of alternative minimum tax (“AMT”) credits

The CARES Act accelerates a corporate taxpayer’s ability to recover refundable AMT credits.  The TCJA repealed the corporate AMT, but provided that any corporate AMT that was paid in prior years is generally available as a credit in subsequent tax years to offset taxable income.  Any remaining AMT credits would be fully refunded in 2021.  The CARES Act accelerates the recovery of AMT credits by allowing a corporation to claim the credits in 2019 or 2020.  Under the CARES Act, any AMT credit is fully refundable for a tax year beginning in 2019.

In addition, a taxpayer may elect to claim all or any portion of the AMT credit in 2018 by filing a tentative refund claim by December 31, 2020.  The Secretary of the Treasury must review the application, determine the amount of the overpayment, and apply, credit, or refund such overpayment within 90 days of the application being filed.

The AMT changes under the CARES Act may result in a tax refund claim to the extent that a taxpayer elects to claim an AMT credit in 2018.

Conclusion

The CARES Act has important implications for both future and recently completed M&A deals.  For recently completed deals, taxpayers should carefully review acquisition agreements to determine the parties’ entitlement to NOLs and other tax deductions and refunds.  When negotiating future deals, the new CARES Act provisions likely will have important implications for tax structuring decisions and covenants that address the allocation of tax deductions and refunds.

Please reach out to us with any questions about the CARES Act and its implications for the tax aspects of M&A deals.