In 2015, in the wake of the financial crisis, the Treasury Inspector General for Tax Administration published a report, detailing the policy issues involved in the administration of Net Operating Losses (NOLs). It is time to act on this report and to give corporations a straightforward way to trade their losses on an exchange, or at least in a Treasury-approved dark pool.
How This Works Now
The status quo involves two corporations collaborating on a transaction usually brought to them by a third-party advisor. The party with the NOLs has little expectation of using its losses in a timeframe that would generate significant shareholder interest. The party with taxable income has an interest in reducing its tax bill and is prepared to pay for that.
Many NOL corporations generate interest in the analyst community. They advertise their losses as strategic assets that enable them to compete favorably with their peer group and generate enhanced after-tax returns by, in effect, turning lemons into lemonade.
The value of their losses, on their face, are worth whatever the corporate tax rate is when the losses are used, multiplied by the amount of the NOLs. A NOL of $1bn, at the current corporate tax rate of 35%, should generate $350mn of after-tax cash. The $350mn represents a deferred tax asset (DTA) – in effect a promise on the face of the financial statements that the shareholders will receive $350mn of value in the future in the form of taxes saved that would otherwise have been paid to the government.
NOL companies that reasonably expect to generate taxable income within the carryforward period of the NOLs can expect to receive full value for their NOLs. If there is no expectation of full utilization, the DTAs must be written off and a charge taken against earnings.
Conversely, a company that has written off its DTAs, will show in the notes to its financial statements that it is carrying a valuation allowance - a statement that DTAs have previously been written off in a certain amount. If such company suddenly generates an income stream capable of being absorbed by the DTAs that have been written off, it will be able to write back those DTAs, and will show an immediate increase in earnings.
Have Deals Been Executed?
Deals have been done. There are two basic transaction types: the structured transactions between two independently owned entities; and strategic transactions where one party acquires the NOL company in two steps over a period of three years.
In the late ‘90s and early 2000s, a number of foreign banks entered into transactions with US banks and were able to get value from using their NOLs. The typical transaction involved the issuance by the foreign bank of preferred stock and the purchase of interest bearing assets with the proceeds. The preferred was issued to US banks who had an economic incentive to own preferred stock and receive dividends benefiting from the dividend received deduction rather than own the underlying fully taxable assets. These deals were all found acceptable on audit by the IRS.
In the strategic transactions, the acquiror, a group expecting to be a substantial taxpayer, acquires less than 50% of the NOL company and plans to acquire the remaining 50% three years later. The reason for the two steps is IRC Sec. 382 that dramatically reduces the ability of a taxpayer to use losses of a NOL company if it acquires 50% or more at one time. The testing threshold is three years. Examples of this include KKR’s acquisition of the shell of Washington Mutual and Centerbridge’s acquisition of Capmark.
Both categories of transaction required a great deal of advice and structuring before completion.
The Problem with Tax Reform
If the current administration is successful in reducing the corporate tax rate, it will have a substantially negative effect for companies that are carrying lots of DTAs on their books. Previous articles have addressed this issue. Banks are particularly at risk, as are the Fannie Mae and Freddie Mac. If the promise to shareholders is that each $1bn of income will produce $350mn of tax shelter and the tax rate is reduced to 20%, the value of the $350mn DTA will be reduced by $150mn and a charge to earnings will be required.
Many companies that have significant amounts of NOLs written off and subject to a full valuation allowance decide that they would rather enter into a transaction with a third party that can accelerate the utilization of the NOL and provide some value, albeit less than full value to the company with the NOL. The value to the counterparty is that it will be able to shelter some income on which it would otherwise have had to pay tax.
If the corporate tax rate is reduced, companies may be inclined to enter into transactions quickly before the rate changes and the value of the DTAs is reduced.
How to Fix This
An earlier article has argued that the macro-economic effect of such transactions is neutral. If a company has generated losses and collaborates with another company to utilize those losses and accepts less than full value for its losses, the economy has not suffered. If the IRS collects tax on income and is successful in disallowing losses or those losses expire unused, the IRS has collected tax on an amount of income greater than the economic value generated in the overall economy.
The above-referenced report details measures put in place to ensure that losses are not ‘trafficked’ between taxpayers and are not duplicated. The former should not be constrained; the latter should. A mechanism to facilitate this would save a great deal of IRS administrative time and would clear NOLs from the economy quicker and more efficiently. How could this be accomplished?
One method would be to set up an exchange, sanctioned by Treasury where NOL companies could contribute their NOLs and taxpayers could bid for those losses. Market pricing at present is intransparent (the author will provide indications for those interested at email@example.com) and varies widely. An exchange would provide transparency and certainty of execution without tax risk. Treasury would have visibility on the transactions occurring and the concept of a valuation allowance would disappear: DTAs would either not exist, because the losses had been traded on an exchange, or they would be carried at a known value. If they were subsequently used at a higher value, the earnings benefit would accrue to the shareholders of the NOL company. Taxpayers may be required to trade a portion of their DTAs to demonstrate the value of those that they wish to carry on their financials.
Another method would be to set up a dark pool where a given set of criteria could be established based on previous transactions that have successfully passed tax audit. Counterparties could execute transactions within defined parameters. The tax risk would not disappear, as it would with a Treasury-approved exchange; the speed of execution may, however, be increased. Substantial market activity may incline Treasury to move quickly to an exchange.
The idea is far from radical. In the recent Ryan-Brady 2016 tax plan, which, in its proposal of a border adjustment, was radical, the problem of losses arose and was discussed. The problems would have arisen from US companies with substantial export revenues – which would have been tax exempt – and substantial domestic costs – which would have generated NOLs. Three ways of dealing with this were considered: the first would have been to allow NOLs in perpetuity subject to an inflation adjustment to preserve their value over time; the second would have been to make a payment – an immediate refund – to the companies impacted; the third would have been to allow companies to sell their NOLs.
The first choice would have been cumbersome. The second would have been politically difficult as it would have involved the government cutting checks to profitable companies. The third is rational – and an exchange would have been an obvious way of accomplishing it.
In addition to offering companies the ability to monetize tax assets quickly, it would reduce the need for complex industries such as tax-based leasing.
Renewable energy companies and companies such as airlines whose need to use capital intensive assets that generate depreciation losses greater than the taxable income the business generates, often deal with financing parties that can finance the acquisition of the assets through tax-based leasing. The deals work because the financing parties - often major banks whose businesses do not rely on large depreciable assets such as airplanes or wind farms – have taxable income in excess of the depreciation their businesses generate. They own the assets and lease them to the companies in whose businesses they are required. It is messy and complex. It also somewhat contradicts the policy goal of stimulating small business by requiring thinly capitalized companies in capital intensive industries such as renewable energy to ‘sell’ their tax benefits to banks through so-called ‘tax equity’ transactions.
If the lessees could trade the losses generated by depreciation on an exchange, they would quickly acquire capital they could use to build their capital structures.
With the promise of a declining corporate tax rate, the need for NOL companies to take more aggressive steps to monetize their losses increases. A lower tax rate will reduce the absolute amount of after-tax cash NOLs can produce and will stretch out the utilization period for tax credits.
The exchange and dark pool concepts mentioned above do not currently exist. Companies are required to engage in transactions more complex than is ideal to get value from their DTAs. Change is needed!
Neil is the CEO of Sevara Capital Advisors. He is passionate about solving tax, accounting and regulatory problems for institutions that have invested billions of dollars of capital in multiple jurisdictions. His company provides solutions for banks, insurance companies and hedge funds to tackle their problems related to tax returns, financial statements, accounting and internal finance matters. Neil holds a master’s degree in Law from the University of Cambridge.