The NYT displayed some confusion about finance realities in this older column about net operating losses, a perennial “favorite” topic of ours.
We’ve done some complex planning (aka invent new deal structures) for a corporation and its shareholders that held as an unfortunate asset a vast amount of net operating losses (NOLs). We reviewed a number of possible transactions, including some proposed by third parties that didn’t pass muster with the Internal Revenue Code.
In that case, the likelihood was that the original company that incurred the losses (the “lossco” in NOL parlance) would not be able to generate organic profits to offset the NOLs. The typical model for dealing with losses is that they can be carried backwards a few years, allowing for the recovery of taxes already paid, and forward for much longer (generally 20 years for most NOLs).
There are specific restrictions on using NOLs when there is a change of control; these are referenced in Section 382.
The NYT article relates to this experience of ours. The structure described is interesting because it avoids the issues triggered by an actual change of control by having the loss corporation be the party effectively acquiring the corporation with the gains. However, as you see here, the transaction at issue was for just a small chunk of shares not already owed. This is more like when me, you, your brother, and your dad own parts of a business in some unequal shares and I buy/borrow just enough to put us over the 50% threshold to meet some requirement such as a veteran-owned number.
The lossco here already owned ~74%, so it was more of a tweak than anything else. And if there’s a “loophole,” it is found in creating rules that are triggered by brightline tests. Those tests are beneficial in that they produce clarity, but they also create people who complain when their transaction falls on one side and they want different results. So here, we don’t know why the first company didn’t own 80%+ in the first place. But now that they acquire some more stock, someone complains. Let’s not forget, though, that the other shareholders lost money. So, absent this transaction, the businesses will pay tax on the income but not get a corresponding deduction/offset (at least not this year) for the losses. Heads you lose, tails you lose. Imagine if the IRS didn’t let you combine losses on one mutual fund against gains on another. You would always owe tax even if your net was actually a loss. (In fact, gambling taxes are treated this way theoretically, but no one does as a practical matter: you are taxed on winnings but separately deduct losses, on a different part of the form, so that you might actually end up with different treatment because of phase-outs, etc.) The 80% ownership rule is a line that was picked. There are all sorts of tests about whether or not you own a stock, that have already been tested against a zillion sneaky ideas, so it’s sort of silly to complain about them in this instance.
As for whether this transaction is legit because of the form, we already went through this with the whole empty voting/vote buying discussions with hedge funds selling/buying economic interests in shares without attendant voting rights. There’s the multifactor test referred to in the article, and just because you hedge a position with an option, say, doesn’t mean that you don’t have risk of loss. I’m covered by insurance, but I still own the risk of loss. Usually, we find that it’s fruitless to reach through all these possibilities since they are (a) endless and (b) generally would interfere with typical securities transactions.
I like it, though – it allows the company to advance the use of those deductions. The real benefit isn’t the $400 million or so; that benefit was already “earned” through the loss. The actual benefit is the time value of money because the deduction was used now versus being used to offset future income by the lossco. And that gets calculated by the ROIC of the business – where does the cash go? How will it be invested?
So, to sum up, Morgenstern tells a half-truth, as far as the economic analysis goes, to drum up some fervor. She did a similar boo-boo when complaining about supposed insider trading on PIPES deals. The math for that one’s in an earlier post on showing your work in financial analysis.