NOLs can be hard to understand

Net operating losses, or NOLs, accumulate when a business has tax losses in a given year rather than profits. They are typically carried back to earlier profits but may be accumulated in as carry-forwards for up to 20 years. Sirius, after recently merging with XM, has an unfortunate asset: accumulated NOLs of about $6 billion.

Absent such changes, Liberty would then be free to acquire the rest of Sirius in three years and use all the losses to shelter taxable profits elsewhere.

This quote is the final paragraph in a recent WSJ article on the potential tax benefits to Liberty Media in an acquisition of Sirius that might be triggered in part by the value of these NOLs to the combined entity. However, the actual situation is a bit more complicated. The three-year trigger that Section 382 of the Code provides is a rolling period, and any ownership change triggers the limitations of that Section. With Liberty already at a 40% stake, an acquisition of the remaining 60% would be an increase of greater than 50% and therefore a change of control that would trigger the 382 limitations.

Liberty would be, playing this game, limited to another 49+% increase after the first three-year period elapses, followed by a three-year standstill, and then could acquire the small amount of stock outstanding at that point. Here’s the schedule:

Month 0 — acquire 49%. Cumulative: 49%.
Month 36 — Section 382 lookback period expires.
Month 37 — acquire next 49%. Cumulative: 98%.
Month 73 — Section 382 lookback period expires.
Month 74 — acquire 2%. Cumulative: 100%.

As you can see, this path to acquisition is six-plus years. Depending on the loss profile (the distribution of losses over time), it is possible that some of the losses will have expired during their 20-year lifetime. That is a cost, but the greater one is typically the simple time value of money.A $6 billion loss is worth approximately $2 billion if fully offset against profits. (Obviously marginal tax rates are critical, but the analysis is the same.)

$2 billion today is $2 billion. But if the losses cannot be used to offset income for 6 years, at a mere 5% discount rate, then the net present value of that $2 billion sinks to less than $1.5 b. With a more realistic discount rate (you might choose a rate comparable to the company’s WACC or expected returns from alternative uses for the investment funds) of 10%, the NPV of those NOLs is a little more than $1.1 billion, barely more than half of the original amount. (Those of you not used to building these calculations in Excel or a similar tool can use this online NPV calculator for a simple introduction.)

Finding ways to legitimately use net operating losses can be difficult; the reason for this timing is to separate those companies doing acquisitions for business reasons from those “merely” trafficking in NOLs. Of course, if the transaction satisfies the law, then the goals are generally achieved, even though the Service has a catch-all provision, Section 269, to sort through deals that have troubling characteristics and fine-tune the legislation after the fact.

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  1. […] to consider. Liberty cannot close any such offer until March 2012, which would be the end of the section 382 lookback period. This suggests that an announcement as early as March 6 of this year is unlikely, yet it is also […]

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