Protecting Tax Assets – Considering an NOL Rights Plan

A corporation’s net operating losses (NOLs)[1] are important assets that can be used to reduce future taxable income. But certain changes in a corporation’s ownership can significantly reduce the value of those NOLs.

An NOL rights plan (also known as an NOL poison pill or a tax benefit preservation plan) is intended to discourage problematic ownership changes and can be an effective tool to help public companies preserve value for their stockholders.

This article (i) provides an overview of NOLs and the limitations applicable to their use,

(ii) discusses the mechanics and distinctive features of NOL rights plans and (iii) lays out important considerations a board of directors should keep in mind when determining whether to adopt an NOL rights plan.

Creating and Using NOLs

A corporation generates NOLs when its allowable tax deductions exceed its taxable income in a given tax year. NOLs generated in one taxable year are available to offset taxable income or gain in future taxable years. While the tax laws related to NOLs have undergone significant changes in recent years, under current law, a corporation’s NOLs generated prior to 2018 can be used to offset up to 100% of a corporation’s taxable income and those generated post-2018 can be used to offset up to 80% of future taxable income.[2]

To illustrate, if a corporation has generated $25 million in pre-2018 NOLs and $25 million in post-2018 NOLs, and then incurs pre-tax income of $35 million in a future taxable year, the corporation would be able to reduce its pre-tax income from $35 million to $2 million by using all $25 million of pre-2018 NOLs to offset the first $25 million of pre-tax income plus

$8 million of post-2018 NOLs to offset up to 80% of the remaining $10 million of pre-tax income. At a 21% corporate tax rate, the corporation would pay $0.4 million in taxes and the NOLs would provide the corporation with an undiscounted tax shield of ~$6.9 million.[3]

Corporations, however, can find that the ability to use their NOLs has become subject to limitations that significantly reduce their value. Section 382 of the Internal Revenue Code of 1986, as amended (the “Code”) limits a corporation’s ability to use NOLs to offset future taxable income when the corporation undergoes a defined “ownership change.” An ownership change for Section 382 purposes occurs when stockholders that own (or are deemed to own) at least 5% of a corporation’s stock increase their cumulative ownership in the corporation by more than 50% in the aggregate over their lowest ownership percentage within a rolling three-year period. Congress originally enacted Section 382 of the Code to prevent the trafficking in NOLs through the sale of corporations the only significant asset of which was their NOLs. However, the rule also applies to non-abusive changes in a corporation’s stock ownership.

Specific tax rules apply to determine which stockholders are considered as owning at least 5% of a corporation’s stock for purposes of an ownership change calculation. For example, all stockholders that individually own less than 5% are aggregated and treated as a separate 5% stockholder often referred to as a “public group.” Similarly, investors that share certain relationships or act in a coordinated manner can be aggregated. It can be difficult to monitor whether a corporation has experienced an ownership change, primarily because the required calculation is subject to complex tax rules. Importantly, however, the Code and relevant tax regulations allow a public corporation to rely on the existence or absence of filings under Schedules 13D and 13G to identify the corporation’s 5% stockholders.

When a 50% ownership change occurs, the Code limits the corporation’s ability to use its then-existing NOLs to offset future taxable income. Moreover, that limitation cannot be undone once triggered. The limitation is generally calculated by multiplying the corporation’s stock value immediately prior to the ownership change by the federal long-term tax-exempt interest rate then in effect. Certain unrealized built-in gains or losses can also increase or reduce the annual limitation on losses that can be used.[4]  Taking the prior example—and assuming the corporation had an equity value of $150 million, a federal long-term tax-exempt rate of 3.01% and no unrealized built-in gains—the limitation would be ~$4.5 million. So, if the corporation suffered an ownership change, the corporation would owe ~$6.4 million in taxes for that same fiscal year rather than the $0.4 million that would have been owed had the losses not become subject to limitation.

In summary, there may be material financial consequences if a corporation that has accumulated significant NOLs becomes subject to the Section 382 limitation.

NOL Rights Plans: Mechanics and Features

To mitigate the risk of an ownership change, many corporations have adopted NOL rights plans—15 in the first half of 2023, 22 in 2022, and 31 in 2021.[5] These plans are a variation of a traditional anti-takeover rights plan that are specifically designed to deter an ownership change and, as a result, preserve a corporation’s ability to fully utilize its NOL carryforwards.

The mechanics of an NOL rights plan operate like those of a traditional rights plan. A corporation issues rights to its stockholders to purchase newly issued shares from the corporation (usually shares of a new series of preferred stock). If someone acquires ownership above a specified ownership threshold, the rights plan is triggered, and the stockholders (other than the triggering acquiror) can purchase shares at 50% of the market price. The board can also exchange the rights for shares of stock, rather than allowing stockholders to exercise the rights. Either result significantly dilutes the triggering acquiror, thus discouraging a person from exceeding that specified threshold without the prior approval of the corporation’s board.

Although the structure and effect of NOL rights plans are comparable to traditional rights plans, the following key features of NOL rights plans differ from traditional rights plans:

• Trigger Threshold. NOL rights plans typically set the triggering percentage between 4.9%-4.99%, because Section 382 aggregates changes in ownership by 5% stockholders to determine whether an “ownership change” has occurred. This is lower than the 10%-20% triggering percentage in a traditional rights plan.
• Beneficial Ownership Definition. The definition of “Beneficial Ownership” of stock under an NOL rights plan is typically narrower than a traditional rights plan and is modified to take into account relevant tax rules.
  
  At a minimum, all NOL rights plans include a definition of “Beneficial Ownership” that encompasses the definition under Section 382, including both constructive ownership and certain coordinated acquisitions. For practical purposes, most NOL rights plans also define “Beneficial Ownership” with the definition in Rule 13d-3 of the General Rules and Regulations under the Exchange Act, which provides a clearer test for calculation than those set forth in Section 382.[6]
  
  While some NOL plans include broader definitions of Beneficial Ownership that are similar to what would be found in a traditional anti-takeover rights plan—such as “acting in concert” provisions that capture formal and informal coordination among stockholders and “derivative contract” provisions that cover notional shares under derivatives contracts—many do not because such ownership activities generally do not count as ownership under Section 382.

• Exemption Process. Many NOL rights plans set forth a process by which a stockholder, a group of stockholders, or a particular acquisition of shares can be exempted from triggering the plan. The board can grant the exemption if the board determines that the relevant stockholder, group of stockholders, or acquisition would not jeopardize the corporation’s ability to use its NOLs. This exemption process is not usually seen in traditional rights plans.
• Duration. Traditional rights plans often have a term of less than one year. NOL rights plans, however, typically have a three-year duration, in line with the rolling three-year basis that underlies the ownership change calculation in Section 382. That said, some plans have shorter durations to match plan expiration with the conclusion of the period in which material risk of an ownership change exists. For NOL rights plans with a three- year term, most will automatically terminate if the plan is not approved by stockholders within 12 months of adoption. This automatic termination is designed to fit within Institutional Shareholder Services (ISS) and Glass Lewis guidance.
• Sunset Provision. Unlike traditional rights plans, most NOL rights plans will include a sunset provision tied to the expected useful life of the NOLs, with earlier expiration if the board determines that the NOLs are fully utilized or the plan is no longer necessary.

Although NOL rights plans are employed to prevent ownership changes under Section 382, they are an imperfect solution given that they only discourage acquisitions above a specified threshold, rather than guarantee that they will not occur. Additionally, NOL rights plans do not prohibit sales of stock by large stockholders that can also cause, or contribute to, the occurrence of an ownership change under Section 382. Notwithstanding the limitations to their protection, NOL rights plans remain a popular choice for corporations seeking to preserve the value of their NOLs.

Courts have also affirmed the use of an NOL rights plan as a means of protecting against the loss of potentially valuable tax assets. In 2010, the Delaware Supreme Court held that the protection of NOLs may be an appropriate corporate policy that merits a defensive response when threatened.[7] The Court’s decision made clear, however, that the validity of NOL rights plans will continue to be analyzed on a case-by-case basis and within the specific factual context of each case.

Key Considerations When Adopting an NOL Rights Plan

There are several key considerations a board should be mindful of in determining whether a corporation needs the protection of an NOL rights plan, including:

• Value of NOLs. NOL rights plans are most relevant for corporations with significant NOLs to protect.
• Future Taxable Income. NOLs only have value to the extent they can be used to offset future taxable income. The board should review the corporation’s financial projections and understand when the business may begin to generate taxable income.
• Likelihood of an Ownership Change. The board should determine whether there is a material risk that future stock accumulations could trigger Section 382 by analyzing the cumulative shift in corporation ownership by 5% holders over the last three years—i.e., how close the corporation is to an “ownership change” under Section 382.
• Potential Harm of 382 Limitation. The board should understand the annual limit that would be imposed on the amount of NOLs that could be used to offset income taxes if the corporation triggered Section 382. The board should then weigh, within the broader business context, the potential harm that the Section 382 limitation would have on the corporation and stockholder value. This examination should take into account the difference between pre-2018 losses (that may offset income 100%) and post-2017 losses (that are limited to an 80% income offset).

Because the above considerations involve the application of complex tax provisions, most corporations engage a tax advisor to conduct a “382 analysis,” which includes determining the cumulative shift to date in ownership and calculating the potential Section 382 limitation.

In addition, the board should account for the policies of proxy advisory firms ISS and Glass Lewis. Both evaluate NOL rights plans on a case-by-case basis and determine their recommendation on the basis of certain criteria, such as the value of the NOLs, the disclosed rationale for adopting the plan, and specific provisions of the plan, including the specified threshold and stockholder protection mechanisms (such as plan termination upon exhaustion of NOLs).

Finally, the board should understand that it takes longer to implement an NOL rights plan compared to a traditional anti-takeover rights plan. Indeed, traditional rights plans can be deployed very quickly (often in a day or two), particularly if a corporation has it “on the shelf.”[8] By contrast, an NOL rights plan requires more time because the corporation and its advisors must first calculate the cumulative shift in corporation ownership by 5% holders over the last three years, the Section 382 limitation, and the expected value to the corporation of adopting the plan.

In the end, NOLs normally are a valuable corporate asset and, under the right circumstances, an NOL rights plan can be a useful tool to preserve that value for a corporation and its stockholders.

[1] Note that, in addition to NOLs, corporations can generate other tax assets that are valuable and that can become subject to use limitations based on a change in ownership. However, for simplicity purposes, this article refers to all such tax assets as NOLs

[2] NOLs from tax years 2018, 2019 and 2020 can be carried back for five years to offset taxable income, while NOLs generated in 2021 and forward cannot be carried back.

[3] This example disregards the application of the alternative minimum tax (AMT).

[4] IRS Notice 2003-65 provides a safe harbor for determining the extent to which the ability to use NOLs may be increased as the result of a net unrealized built-in gain (NUBIG) immediately prior to an ownership change. Although the IRS some time ago suggested it might repeal some of the beneficial rules contained in this authority, to date no such action has been taken.

[5] Deal Point Data.

[6] Defining “Beneficial Ownership” by reference to Rule 13d-3 may prohibit institutional investors (e.g., index funds) from acquiring additional shares even though they hold such ownership for their customers rather than for themselves. In those cases, they could avail themselves to the process for exemption to acquire additional shares if their holdings on behalf of customers do not present an issue under Section 382.

[7] See Versata Enterprises, Inc. v. Selectica, Inc., 5 A.3d 586 (Del. 2010). The board’s decision to adopt an NOL rights plan was reviewed under Delaware’s “enhanced scrutiny” standard, which applies to defensive measures and requires the board to show that (i) it had reasonable grounds for identifying a legitimate threat to the corporate enterprise and (ii) its action was reasonable in relation to the threat posed.

[8] An “on the shelf” rights plan means that a draft rights agreement (and all ancillary documents) has been prepared but has not actually been adopted by the board and executed with the rights agent.