Report of the American Bar Association Tax Section Task Force on the Tax Recommendations of the National Bankruptcy Review Commission

FRESH START NOL PROPOSAL

(COMMISSION TRACK NUMBER 4312)

Present Law

Bankruptcy Code Section 505(b)(1) provides:

Under current law, if a corporation is reorganized pursuant to a Chapter 11 plan, that corporation will not include in income any cancellation of indebtedness realized as a result of the plan (fn. 185). It will, however, be required to reduce its tax attributes, including net operating loss carryforwards ("NOLs"), capital loss and credit carryforwards, and asset basis in excess of post reorganization liabilities (fn. 186).

Until January 1, 1995, the "stock-for-debt exception" provided an exception to the requirement that tax attributes be reduced by the amount of any excluded cancellation of indebtedness. It provided that, to the extent the cancellation of indebtedness was the result of the issuance by the corporation of its stock to the creditors in satisfaction of the corporation's debt and certain other requirements were met, no attribute reduction was required (fn. 187). However, this "stock for debt" provision was repealed by the Omnibus Budget and Reconciliation Act of 1993 ("OBRA 93").

Furthermore, if a plan of reorganization under Chapter 11 results in a change of ownership of the debtor corporation within the meaning of section 382 of the Internal Revenue Code, the ability of that corporation to use its pre-reorganization tax attributes (primarily "NOLs") to reduce its annual tax liability with respect to post-reorganization income will be subject to additional limitations (fn. 188). To the extent the annual Section 382 limitation is not used in any year, the unused amount will be added to the succeeding year's limitation. Unless the corporation qualifies for and does not elect out of the benefits of section 382(l)(5) of the Internal Revenue Code, (fn. 189) these limitations are determined under section 382(l)(6). Section 382(l)(6) requires that the value of the loss corporation shall be increased to reflect any cancellation of debt which occurred in a Title 11 case (fn. 190). Under regulations, the equity value of the corporation immediately after the reorganization will generally be equal to the lesser of: (i) the aggregate value of the corporation's stock immediately after the reorganization and (ii) the value of the corporation's assets immediately before the reorganization (with certain adjustments).

Therefore, under the current law, a corporation which issues stock to its creditors realizes substantial income from debt cancellation which must then be applied to reduce tax attributes including net operating losses, capital losses and credits as well as the basis of property. In cases in which there is substantial debt canceled and the value of the stock on the date of issuance is low, there have arisen cases in which the attribute reduction is so substantial as to eliminate all NOLs and reduce the basis of assets. The result in these cases is that the company emerges from bankruptcy with a tax balance sheet lower than its financial balance sheet with inordinate levels of income for tax purposes, resulting in effective tax rates significantly in excess of the 34-35% federal rate generally applicable. Depending on the nature of the business, these high effective tax rates can occur over a varying period of time post-reorganization.

In these cases, the "horizontal equity" purportedly sought by the repeal of the stock for debt exception has produced an inequity and put these companies at a competitive disadvantage as compared to their peers. It is also believed that in some cases, the repeal of the stock for debt exception and the effects thereof have created tax disincentives which weigh in favor of liquidation and against reorganization, thus making tax policy inconsistent with general bankruptcy policy favoring reorganization as appropriate.

Proposals Before the Commission

Commission Track Number 4312. This proposal. Please note that this is not an original proposal of this Task Force. The proposed bill attached as Appendix C is the product of the efforts of an ad hoc group to obtain legislative response to the repeal of the "stock for debt" exception. This legislation has not yet been introduced.

Task Force Position

The Task Force proposes that Section 108 of the Internal Revenue Code be amended to provide that a corporation undergoing a reorganization in bankruptcy be allowed to make a "fresh start" election. Under the Fresh Start proposal, any corporation reorganizing in a bankruptcy proceeding will have the option of either applying current law or making a "fresh start" election, with the following consequences:

The electing corporation ("Old Debtor") will be treated as having sold all of its assets at fair market value in a single transaction to a new corporation (the "New Debtor") after the close of business on the consummation date of the reorganization. Old Debtor's status as a taxpayer will terminate on that date and the New Debtor will be treated as a newly organized corporation, unrelated to Old Debtor, that acquired all of the Old Debtor's assets and assumed such of Old Debtor's liabilities (including tax liabilities) that were not extinguished under the plan of reorganization as of the opening of business of the next following day. It is expected that the details of such deemed sale rule will be modeled, as closely as is appropriate, on the deemed sale rules of Section 338 of the Internal Revenue Code.

The deemed sale would be treated as a taxable event to Old Debtor and any resulting income, gain or loss will be included in determining Old Debtor's tax liability for its final taxable year. Solely with respect to any gain recognized due to the deemed sale, section 56(d)(1)(A), which limits the amount of the alternative tax net operating loss deduction to 90% of alternative minimum taxable income, would be inapplicable and would not limit the Section 172 deduction for alternative minimum tax purposes. No cancellation of indebtedness arising out of the plan of reorganization will be included in Old Debtor's taxable income.

New Debtor will not succeed to any of Old Debtor's tax attributes. New Debtor will have a fair market value basis for all of its assets and be entitled to a "fresh start net operating loss carryforward" which will be equal to 5 times New Debtor's annual limit under Section 382, as determined using equity value as set forth in Section 382(l)(6) and accompanying regulations. The total amount of NOL shall not exceed the NOL remaining after the effect of the gain or loss recognition in the deemed sale event. The net operating loss will be treated for all purposes of the Internal Revenue Code as if it were a net operating loss carryforward under Section 172 of the Code that arose in the year prior to New Debtor's first taxable year, except that the NOL will have a five year carryforward period. The limitation of Section 382(l)(6) would apply to this deemed NOL.

To mitigate the potential for debtor's using this provision to freshen expiring NOLs, the fresh start election would be available only to companies undergoing a substantial equity reorganization as evidenced by an ownership change in the context of a bankruptcy plan where at least 50% of equity is issued to creditors.

Proposed statutory language implementing this proposal is attached as Appendix C.

Reasons for Position

It is believed that the tax inequities created by the repeal of the stock-for-debt exception are an unintended effect of the repeal and that remedial legislative action is necessary. The proposal is an elective provision designed to permit those companies inordinately disadvantaged under current law to obtain a fairer tax treatment postreorganization and a period of tax benefit consistent with the economics of the business under Section 382(l)(6). Anti-abuse provisions requiring creditor continuity should prevent the possibility of windfall benefits to inappropriate companies and creditor groups. In addition, sizing the post-reorganization tax benefits to equity value under Section 382(l)(6) is consistent with incentives to recapitalize through equity rather than heavy debt. Finally, with respect to companies which will elect this treatment, the provision is also consistent with bankruptcy "fresh start" policy and financial "fresh start" accounting treatment.

Other Institutional Positions

The draft is supported by the Business Bankruptcy Committee of the American Bar Association's Section of Business Law with referral to the Section of Taxation. It was also presented at the Spring Meeting of the American Bankruptcy Institute.

***********************FOOTNOTES************************************

fn. 185: I.R.C. Section 108(a)(1)(A) (applicable to all federal bankruptcy cases, not just chapter 11).

fn. 186: I.R.C. Section 108(b).

fn. 187: The stock for debt rule contines to be available to a corporation undergoing a Chapter 11 reorganization if that corporation filed its original bankruptcy petition on or before December 31, 1993.

fn. 188: I.R.C. Section 382(b). The limitation for any post change year is an amount equal to the value of the old loss corporation multiplied by the long term tax exempt rate.

fn. 189: I.R.C. Section 382(1)(5). This section provides some relief from the general 382 limitations in the event the ownership occurred in a Title 11 case. However, after repeal of stock for debt rule, it is only in a rare set of circumstances that a debtor corporation would get any material benefit for choosing to have this section apply.

fn. 190: I.R.C. Section 382(1)(6).

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Last updated July 6, 1997