When it comes to the carryover of net operating losses (NOLs) after a merger or reorganization, certain states still follow the Internal Revenue Code of 1939 and largely adopt the U.S. Supreme Court's decision in Libson Shops, Inc. v. Koehler, 353 U.S. 382 (1957).This item briefly explains the issue as applied in Arizona, Connecticut, and North Carolina. Note that certain other states, such as New Jersey and Tennessee, have their own rules for determining the carryover of NOLs following a merger or reorganization and follow neither Sec. 381 nor Libson Shops.
Life, and NOLs, Before Sec. 381
Sec. 381 permits corporations to carry over NOLs and other tax attributes following certain types of reorganizations. Prior to the adoption of Sec. 381 in 1954, no statutory provisions in the 1939 Code specified how NOLs under Sec. 172 should be treated in the context of a merger or reorganization. Several courts interpreted the 1939 Code as providing that NOLs generated by an entity that ceased to exist as a result of a statutory merger were automatically lost; i.e., only the same entity that created the NOLs could use the NOLs post-transaction (see, e.g., New Colonial Ice Co. v. Helvering, 292 U.S. 435 (1934)). This came to be known as the "entity theory" and led to cases of what was termed "minnows swallowing whales," whereby large companies with positive taxable income (whales) entered into reorganization transactions with smaller loss companies (minnows), and the loss company—with its NOLs preserved—was the surviving entity at the conclusion of the transaction (Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders, ¶ 16.02, p. 16-7 (5th ed. 1987)).
In an effort to more closely align with the legislative intent behind NOL carryovers and dispel the operational fiction created by minnows swallowing whales, the U.S. Supreme Court abandoned the entity theory in favor of the "continuity of business enterprise" theory in Libson Shops (see also F.C. Donovan, Inc., 261 F.2d 470 (1st Cir. 1958); J.G. Dudley Co., 298 F.2d 750 (4th Cir. 1962); Federal Cement Tile Co., 338 F.2d 691 (7th Cir. 1964); and Westinghouse Air Brake Co.,342 F.2d 68 (Ct. Cl. 1965)). Specifically, the Court held that NOLs generated by an entity that ceased to exist as a result of a statutory merger were not automatically lost but could be claimed only if the post-transaction income against which a carryover was claimed was produced by substantially the same business that incurred the losses.
For federal income tax NOL carryover purposes, the continuity-of-business-enterprise theory was largely rendered moot by the adoption of Sec. 381 in 1954. However, the theory lives on in certain states that still follow the 1939 Code for purposes of determining the availability of an NOL carryover.
Continued Life, and NOLs, Without Sec. 381 in Certain States
For purposes of determining the federal taxable income starting point in calculating state taxable income, states generally conform to the Internal Revenue Code as of a particular date (known as static conformity) or on a rolling basis, subject to any adjustments adopted by the state. Many states have decoupled from the federal NOL rules under Sec. 172 and provide a state-specific NOL calculation. Arizona, Connecticut, and North Carolina (the latter for tax years beginning before Jan. 1, 2015) are three such states that have their own NOL computation. Neither Arizona, Connecticut, nor North Carolina specifically decouples from Sec. 381. However, Sec. 381 specifically applies only to NOLs under Sec. 172. Thus, specific decoupling is not necessary if a given state's NOL computation is not determined by reference to Sec. 172.
Courts in Arizona, Connecticut, and North Carolina have interpreted those states' respective NOL provisions as being substantially similar to the NOL provisions under the 1939 Code (see, e.g., State Tax Comm'n of Arizona v. Oliver's Laundry, 508 P.2d 107 (Ariz. Ct. App. 1973); Golf Digest/Tennis, Inc. v. Dubno, 525 A.2d 106 (Conn. 1987); and Fieldcrest Mills, Inc. v. Coble,290 N.C. 586 (1976)). As such, courts in these states have looked to the continuity-of-business-enterprise theory and Libson Shops to determine whether an NOL should carry over following a merger or reorganization. Not surprisingly, the courts in Arizona, Connecticut, and North Carolina have slightly different views of what constitutes continuity of business enterprise.
In Oliver's Laundry, the taxpayer operated a commercial laundry and dry cleaning business and acquired an unrelated laundry and dry cleaning business (New Cascade) in July 1963. Post-acquisition, the brother-sister entities existed and operated separately for approximately 14 months, during which time New Cascade incurred losses and Oliver's Laundry operated at a profit. New Cascade was then merged into Oliver's Laundry in September 1964. With respect to the subsequent offset of Oliver's Laundry income with New Cascade losses, the Superior Court of Pima County (Ariz.) held in favor of the taxpayer on the basis that a "de facto merger" occurred at the time of purchase in July 1963 and, therefore, continuity of business enterprise had occurred. In reversing that decision, the Arizona Court of Appeals found that there was no attempt to merge until September 1964. Specifically applying the Libson Shops rationale, the appellate court concluded that New Cascade's premerger losses could not be applied against post-merger gains attributable to a different business unit (Oliver's Laundry, 508 P.2d at 112).
Notice that the court in Oliver's Laundry used the term "business unit." In 1991 and 1994, the Arizona Department of Revenue (DOR) issued policy statements (Arizona Corporate Tax Ruling No. 91-2 and Arizona Corporate Tax Ruling No. 94-11) concerning the calculation of allowable NOLs for corporations that change their Arizona income tax filing method. Both of these policy statements refer to Oliver's Laundry and the term "business unit" but also refer to a "separate corporation."
Ariz. Admin. Code R15-2D-302(B)(3) indicates that, following a merger or reorganization, NOL carryovers may be used only by the same entity that incurred the NOLs. On its face, the regulation's use of the term "same entity" points toward the entity theory (pre—Libson Shops), while the term "business unit" points toward the continuity-of-business-enterprise theory from Libson Shops. However, the Arizona DOR acknowledged in Director's Decision No. 200600161-C (6/7/07) that the above-referenced regulation was drafted based on Oliver's Laundry—i.e., with the intention that the continuity-of-business-enterprise theory in Libson Shops applies. Moreover, in Decision No. 200600161-C, the DOR concluded that the taxpayer had not demonstrated continuity of the same business that produced the loss (i.e., not whether the same entity produced the loss) (see also Wells Fargo and Co. v. Arizona Dep't of Rev., No. TX 2007-000496 (Ariz. Super. Ct. 5/19/10), in which the court upheld the regulation but did not decide whether the regulation endorses use of the entity or continuity-of-business-enterprise theory).
In contrast to Arizona, Connecticut has laid out specific continuity-of- business-enterprise tests that a taxpayer must satisfy to use post-merger or post-reorganization NOL carryovers. In Grade A Market, Inc. v. Commissioner, 688 A.2d 1364 (Conn. Super. Ct. Tax 1996), three separately incorporated supermarkets operated at three locations but used the same name, had the same vendors and clientele, shared employees interchangeably, and used the same bank account. The taxpayers demonstrated to the court's satisfaction that they operated the same business before and after the merger of two of the supermarkets into one.
In permitting the carryover of NOLs post-merger,the Connecticut Superior Court articulated in Grade A Market "four elements that will give rise to a continuity of business enterprise between a merged corporation and a surviving corporation sufficient to support the deduction of a loss carryover." They were:
- The surviving corporation has retained the same corporate identity of the premerged corporation;
- The business enterprise that produced the loss has been continued in the surviving corporation;
- There has been no substantial change in the ownership of the surviving corporation; and
- The income-producing business of the surviving corporation has not been altered, enlarged, or materially affected by the merger (Grade A Market, Inc.,688 A.2d at 1369).
The Connecticut Department of Revenue Services (DRS) expanded on the four-part test from Grade A Market and adopted a six-part continuity-of-business-enterprise test in Connecticut Legal Rulings 97-2 and 97-3 (both issued July 7, 1997). Connecticut Legal Ruling 97-2 concerned a state bank converting to a national bank in a transaction qualifying for tax-free treatment for federal income tax purposes under Sec. 368(a)(1)(F). Connecticut Legal Ruling 97-3 involved two brother-sister entities in the printer manufacturing business that were statutorily merged in a transaction qualifying for tax-free treatment for federal income tax purposes under Sec. 368(a)(1)(A), followed by the merger of the resulting entity into a newly formed subsidiary under Sec. 368(a)(1)(F) to effect a public offering.
The factors analyzed in both rulings were whether:
- The transaction is a statutory merger or consolidation;
- The ownership of the corporation that ceases to exist and the ownership of the surviving corporation are the same;
- Tax avoidance is not the primary purpose of the merger or reorganization;
- The business enterprise that produced the loss has been continued in the surviving corporation;
- The business enterprise that produced the loss has been maintained as a separate division, or its assets have been separately accounted for, such that the taxpayer can show that the nonsurviving entity or its assets generated income following the merger or reorganization; and
- The losses that are carried over are used only to offset income generated following the merger or reorganization.
In both of the above-referenced legal rulings, the DRS concluded that tests under the 1939 Code were met and, therefore, NOLs could be deducted post-transaction.
Interestingly, the four-part continuity-of-business-enterprise test under Grade A Market requires no "substantial change" in ownership, while the DRS's six-part test indicates that ownership should be the same. Although the threshold for the continuity-of-interest requirement for federal income tax purposes in a reorganization is a substantial change in ownership (i.e., 80% or more), it should be noted that the DRS and Connecticut courts have—to date—only addressed instances in which ownership (within a controlled group) was exactly the same before and after the statutory merger or reorganization. Thus, Connecticut emphasizes ownership of the surviving entity pretransaction versus post-transaction in the state's determinations of whether continuity of business enterprise exists. (Of note in Connecticut Legal Ruling No. 97-3, however, is that the disposition of legal assets to a buyer other than the surviving corporation, which assets accounted for less than 10% of the taxpayer's sales and were part of a "ribbon business" and not the taxpayer's main printer business, did not cause the taxpayer to fail the continuity-of-business-enterprise test.)
North Carolina's continuity-of-business-enterprise test focuses mainly on the generation of profit post-transaction by the assets that generated NOLs. For tax years beginning before Jan. 1, 2015, North Carolina used the concept of net economic losses (NELs), which are not the same as federal or other states' NOLs and are based on a taxpayer's actual economic losses realized rather than its operating losses. For example, North Carolina required NELs and NEL carryovers to be reduced by amounts realized but not yet recognized for income tax purposes (N.C. Gen. Stat. §105-130.8, repealed effective for tax years beginning on or after Jan. 1, 2015).
In Good Will Distributors (Northern), Inc. v. Currie, 251 N.C. 120 (1959), three corporations that had been engaged in the distribution of books, each with its own territory but with substantial overlap in the areas served, merged into one corporation. After the merger, the same character of business was conducted in the same territories in which the constituent companies had operated prior to the merger. However, relying on Libson Shops, the North Carolina Supreme Court found that there was no continuity of business enterprise because the taxpayer was attempting to offset post-merger income generated by the assets of two of the entities with premerger NELs attributable to the assets of the third entity (Good Will Distributors (Northern), Inc., 251 N.C. at 125).
Multiple North Carolina courts have subsequently indicated that the following three subtests must be satisfied for continuity of business enterprise to exist for North Carolina NEL carryover purposes:
- "But for" the transaction, the corporation suffering the loss would have been able to use the deduction;
- The group of "assets" that was previously operated at a loss is operated at a profit after the reorganization; and
- The business of the acquired corporation that sustained the loss has not been materially altered or enlarged by the merger or reorganization.
For examples, see Holly Farms Poultry Industries, Inc. v. Clayton, 9 N.C. App. 345 (N.C. Ct. App. 1970); Fieldcrest Mills v. Coble,290 N.C. 586 (1976); In the matter of Benton Woods,724 N.C. Register 2625 (N.C. Tax Review Bd. 1993); Bellsouth Telecommunications, Inc. v. Department of Revenue,485 S.E.2d 333 (N.C. Ct. App. 1997); and N.C. Department of Revenue Corporate Technical Bulletin No. II-M, "Net Economic Loss Carry-Over" (Feb. 1, 2008).
It should be noted that, effective for tax years beginning on or after Jan. 1, 2015, North Carolina has replaced its NEL regime with a more traditional NOL regime and has adopted Sec. 381. Therefore, the continuity-of-business-enterprise tests in North Carolina apply only to NELs earned in tax years beginning before Jan. 1, 2015 (N.C. Gen. Stat. §105-130.8A).
Applying rules and tests such as those employed by Arizona, Connecticut, and North Carolina to a particular fact pattern is not always easy. For example, taxpayers and their advisers may need to consider factors such as whether disposition of a portion (e.g., 10%) of an entity's legal assets to a buyer other than the surviving corporation might cause the taxpayer to fail the continuity-of-business-enterprise test. In addition, taxpayers that the IRS has confirmed meet the federal continuity-of-business-enterprise test could—in some cases—still fail the test as applied at the state level.
Mary Van Leuven is a director, Washington National Tax, at KPMG LLP in Washington.
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