This is the second installment of TIP on Tax, a series from Grant Thornton's Technology Industry Practice (TIP). The series introduces key tax issues for dynamic technology companies.

In our first article, we explored strategies for managing net operating losses (NOLs) generated in the startup phase. This article offers insights into the effective use of NOLs resulting from acquisitions of loss-making businesses.

Introduction

Despite today's difficult economic environment, technology companies continue to invest in business acquisitions to fuel innovation and growth.

In a number of cases, an acquired business may be in the early stages of developing a product and has generated sizable tax losses. Unfortunately, the buyer of that business may not be able to fully use those accumulated losses to offset future taxable income because of the limitations in §382 of the Internal Revenue Code.

As part of the acquisition due diligence, it is important for the acquirer to consider how the target company's accumulated tax losses might be restricted because:

  • this will effect how much value should be ascribed to those tax losses, which factors into pricing negotiations; and
  • with careful planning, there may be opportunities to implement strategies to maximize the benefits of the acquired tax losses.

What should acquirers be considering?

Unfortunately, it is not usually possible to avoid triggering a §382 limitation when a business is acquired. Instead, buyers should be thinking about ways to diminish the effects of the §382 limitation and to effectively use the acquired NOLs.

For instance, the §382 limitation is based on the equity value of the acquired company immediately prior to the transaction multiplied by an interest rate factor specified by the IRS. You might think that the acquisition price is the sole driver of that calculation, but this is not always the case. There actually are a number of reasons why the §382 limitation could be based on a total less than the purchase price paid by the buyer, further restricting the amount of NOLs that can be used post-acquisition. For example:

  • Capital contributions — Capital contributions received prior to the acquisition may have to be deducted from the equity value, as they may be perceived as existing solely for the purpose of "stuffing" or increasing the value of the acquired company. Such anti-stuffing rules may be particularly relevant for technology companies that have raised capital in successive rounds.
  • Non-business assets — Many technology companies hold cash or marketable securities for the purpose of financing future research and development. If these assets are significant at the time of an acquisition (i.e., more than one-third of the assets of the acquired business), then the equity value may be subject to reduction.
  • Capital redemptions or contractions — In the technology industry, companies may be acquired through leveraged buyouts known as a "bootstrap acquisitions," in which the acquisition is funded by debt leveraging the assets in the acquired company. This could be accomplished by simply using the acquired company's assets as collateral for the debt agreement related to the acquisition. In these cases, the equity value is often adjusted for the portion of the debt used to buy out the former business owners.

Key takeaways

  • Acquiring a business will almost always trigger a §382 change in ownership. Thus, if the acquired business has accumulated NOLs, there will be limitations on the amount of those losses that can be used to offset future group taxable income.
  • Not all is lost, though. In the periods before and immediately after the acquisition, there are strategies that can mitigate the effects of the §382 limitation and effectively use the deductibility of the acquired NOLs.

What can be done to increase the value of acquired NOLs?

Of course, it would be ideal for the acquisition structure to be free of leverage and other "traps" that can further limit the amount of NOLs to be used prospectively in offsetting taxable income.

But even if the deal structure can't be changed, there may still be post-acquisition strategies to expand the future benefits of acquired NOLs.

For many technology companies, the fair value of the acquired company's assets exceeds the adjusted tax basis of those assets, which can give rise to tax-planning opportunities. If these assets are sold within a five-year period after the acquisition and taxable gains are realized, the §382 limitation will be increased, therefore making more use of the pre-acquisition NOLs.

Alternatively, sometimes an acquired technology company may have distressed debt, or loans that probably cannot be fully repaid. If the lender cancels the distressed debt either at the time of acquisition or in the period shortly thereafter, a taxable gain will result. This gain will increase in the §382 annual limitation in the period when the cancellation of debt occurs.

There is one other strategy to consider. Buyers that are certain acquired NOLs will never be used can make an election — at the time of acquisition — to waive some or all of the acquired company's NOLs. Why would an acquirer want to do this? Because NOLs that expire after the acquisition reduce the basis in the target company. Therefore, when that target company is eventually sold, a larger taxable gain will result, even though the acquiring company didn't get any benefit from of the expired NOLs. By waiving the NOLs at the time of acquisition, the target company's basis will not be reduced. Deciding whether to waive NOLs is a complex issue and consultation with tax a specialist is strongly advised.

Note

As an example, assume technology company X is valued at $105 million, and investor A purchases 60 percent of the company for $65 million. The remaining 40 percent held by multiple shareholders is redeemed by the company for $40 million. The source of the $40 million is new borrowings taken out by technology company X.

The §382 limitation would not be based on a value of the company of $105 million; instead, the entity value would be calculated at $65 million.

Conclusion

When deciding to buy a loss-making company or calculating the right price to pay, a buyer should consider how the target company's accumulated tax losses may be affected by the transaction and whether there are strategies to effectively use the future benefits of the acquired NOLs.

We caution that tax regulations are complicated and there are many other matters in addition to the §382 limitation that may affect the future benefits associated with pre-acquisition losses. Therefore, companies should consider consulting with tax professionals to avoid unexpected surprises.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.