April 20, 2020
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Under the Coronavirus Aid, Relief and Economic Security Act (the CARES Act), corporations, partnerships and certain other taxpayers are permitted to carryback net operating losses (NOLs) up to five years from taxable years 2018, 2019 and 2020. In addition, the Internal Revenue Service (the IRS) released Revenue Procedure 2020-24 addressing how taxpayers can make various elections in connection with such NOL carrybacks. This article addresses the major issues corporations face in determining the amount of their permitted NOL carrybacks, how to claim them and how to evaluate what elections to make to maximize their NOL carryback claims. As described in more detail below, the changes made to the Code in connection with the Tax Cuts and Jobs Act (the TCJA) at the end of 2017 significantly complicate NOL carryback claims being made today. The section 965 transition tax, in particular, creates challenges for taxpayers seeking to optimize their elections in making NOL carryback claims. This alert discusses how to approach NOL carrybacks to years that precede (pre-section 965 years), include (section 965 years) or follow (post-section 965 years) the section 965 transition tax years. In addition, it addresses the issues faced by corporations that may have been a member of a different consolidated group during the carryback years than the one they are in today due to having been sold or spun-off during the potential carryback period. While the possibility of carrying back NOLs for up to five years to claim a tax refund presents a great opportunity, every corporation should evaluate the benefit of making such a claim based on its own situation in order to maximize the benefit of any claim.
Prior to the TCJA, a corporate taxpayer could carryback its NOLs for two years to obtain a refund and could carryforward its NOLs for 20 years to offset taxable income. To obtain a quick tentative tax refund based on a NOL carryback under the pre-TCJA carryback provisions, a corporate taxpayer needed to file an application for a tentative carryback adjustment on Form 1139 within 12 months of the close of the taxable year in which the NOL arose. The TCJA changed the NOL rules by generally eliminating NOL carrybacks and allowing NOL carryforwards indefinitely. However, the TCJA limited a corporation’s ability to use NOL carryforwards generated post-2017 by only permitting NOLs to offset 80-percent of its taxable income in a given year.
Under the CARES Act, taxpayers can carryback NOLs generated in taxable years beginning after December 31, 2017 and before January 1, 2021, for up to five years. Further, the CARES Act entirely eliminates the taxable income limitation on the use of NOL carryforwards for post-TCJA taxable years through 2020. Notice 2020-26 extends the 12-month time period to file an application for a quick tentative tax refund with respect to NOLs that arose during a taxable year that began during calendar year 2018 and that ended on or before June 30, 2019 by six months. These changes are especially beneficial to corporate taxpayers because they may be able to use NOLs that arose in a post-TCJA taxable year in which the corporate tax rate was 21-percent, to obtain a refund at a 35-percent rate in a pre-TCJA taxable year.
The CARES Act offers additional benefits related to the section 965 one-time transition tax imposed under the TCJA on a U.S. shareholder’s share of the earnings and profits of a deferred foreign income corporation (DFIC). Section 965 taxed accumulated offshore earnings and profits of DFICs held in cash at a 15.5% rate and other accumulated offshore earnings and profits of DFICs at an 8% rate. Under the TCJA, U.S. shareholders of DFICs were permitted to make a section 965(n) election not to apply their NOLs to their transition tax liability. The CARES Act provides that if taxpayers carry back losses to section 965 years, they will be deemed to have made the section 965(n) election with respect to those NOL carrybacks regardless of whether they made such an election in their initial section 965 year. Additionally, The CARES Act allows taxpayers to entirely exclude or skip years that are section 965 years from the five-year NOL carryback period, potentially increasing the amount of the available refund.
Under the general operating rules for NOL carrybacks in section 172, a NOL is first carried back to the earliest of the taxable years to which it is allowed to be carried to offset income. The amount of the NOL that is not used to offset income in such year, can then be carried back to the other taxable years in the carryback period in a similar manner. As a result, if a corporation that had income every year from 2015-2019, a section 965 inclusion in 2017, and a NOL in 2020, waives the carryback to section 965 years, it would carryback its NOL first to 2015 and then 2016. It would then skip 2017 and carry any remaining NOL back to 2018 and 2019.
As noted above, the CARES Act generally permits NOLs generated in taxable years 2018, 2019 and 2020 to be carried back to each of the five preceding taxable years, unless an irrevocable election is made to waive the NOL carryback arising in a particular taxable year under section 172(b)(3). Accordingly, if a taxpayer had taxable income in a taxable year preceding a section 965 year, the taxpayer may generally carryback NOLs to such year. While the carryback of NOLs to pre-section 965 years will generally be advantageous to corporations, corporations should closely analyze the effects of the NOL carryback on other deductions and credits claimed in such years.
The ability to carryback losses from post-TCJA taxable years (in which the corporate tax rate is currently 21 percent) to pre-TCJA taxable years (in which the top marginal corporate tax rate was 35 percent) is generally more favorable to taxpayers than carrying the NOLs forward or back to post-TCJA taxable years. Where the NOL carryback does not cause the taxpayer to lose other deductions or credits, a NOL carryback to a pre-TCJA year will result in a refund that is approximately 67% larger than a refund arising from a carryback or carryforward of a NOL to a post-TCJA year.
Taxpayers looking to carryback NOLs to pre-TCJA taxable years (including pre-section 965 years) will need to consider the impact of NOL carrybacks on their alternative minimum tax (AMT) liability. Fortunately, for post-TCJA taxable years, the corporate AMT has been repealed. However, corporations were subject to the AMT in pre-TCJA taxable years. Because of the repeal of the corporate AMT, absent additional guidance from the IRS, it appears that there would not be a NOL carryback from post-TCJA taxable years for purposes of calculating a corporation’s AMT liability. Accordingly, a carryback of NOLs from a post-TCJA taxable year to a pre-TCJA taxable year may generate an AMT liability in the pre-2018 taxable year (in lieu of the regular corporate income tax liability previously paid for such taxable year). However, section 53 makes minimum tax credits (MTCs) available to taxpayers for AMT paid in prior years. In connection with the repeal of the corporate AMT, the TCJA provided that corporate taxpayers were permitted to recover their remaining MTCs between 2018 and 2021 through a refundable tax credit. Furthermore, the CARES Act permits a corporate taxpayer to elect to recover all remaining MTCs for its 2018 taxable year by filing a Form 1139 with the IRS by December 31, 2020. While the mechanics of carrying back NOLs to pre-TCJA years are likely to result in complicated mechanics for recovering any resulting AMT, the net results are still likely to be favorable.
In addition, a taxpayer carrying NOLs back to pre-section 965 years will need to consider the impact of the NOL carryback on its utilization of FTCs in pre-section 965 years and other deductions, credits and limitations in pre-section 965 years. For example, the NOL carryback may impact section 199 deductions claimed under pre-TCJA law, foreign tax credit limitations (particularly if the NOL carryback is wholly or partially attributable to a foreign-source loss), utilization of MTCs, charitable contribution deductions and any other deductions limited by taxable income.
Taxpayers considering NOL carrybacks to pre-section 965 years will want to carefully consider the relevant statutes of limitations. The IRS has announced that it is reevaluating its position regarding the applicable statute of limitations period in instances in which NOL carrybacks result in FTC carrybacks to earlier periods under section 904(c). For instance, an NOL carryback to a 2015 taxable year could result in FTCs previously claimed in 2015 being displaced and carried back to the 2014 taxable year (Excess FTCs). In Revenue Ruling 71-533, the IRS took the position that refund claims for such Excess FTCs had to be filed within ten years of the un-extended due date for the return for the taxable year in which the foreign taxes giving rise to such Excess FTCs were paid or accrued under section 6511(d)(3)(A). On the other hand, section 6511(d)(2)(A) provides that, in the case of a claim for refund arising from an NOL carryback, taxpayers have three years from the extended due date of the tax return for the taxable year in which the NOL was generated. In Revenue Ruling 2020-8, the IRS announced that it was suspending Revenue Ruling 71-533 in order to consider whether the three-year limitation period set forth in 6511(d)(2)(A) should apply in lieu of the ten-year limitation period set forth in section 6511(d)(3)(A). Revenue Ruling 71-553 did not consider whether the three-year limitation period under section 6511(d)(2)(A) applied to refund claims arising from the carryback of Excess FTCs. If the IRS were to determine that the three-year limitation period set forth in 6511(d)(2)(A) was applicable to refund claims arising from the carryback of Excess FTCs, in some instances, the time period for filing the carryback claim for the Excess FTCs under section 6511(d)(2)(A) could elapse before the time period for filing refund a claim under section 6511(d)(3)(A) and Revenue Ruling 71-533. The IRS indicated that it will not interpret its historic position with regard to these statute of limitation provisions in a manner that is adverse to taxpayers that filed, or file, a claim for refund within the limitations period of section 6511(d)(3)(A) in accordance with Revenue Ruling 71-533 while it reconsiders its position.
Accordingly, while the NOL carryback to pre-section 965 years is generally beneficial to a corporate taxpayer, particularly due to the top 35% corporate tax rate in pre-section 965 years, taxpayers should still consider how the NOL carryback may affect the taxpayer’s AMT liability and utilization of various deductions and credits. As discussed below in more detail, taxpayers that were formerly members of an affiliated group of corporations filing a consolidated U.S. federal income tax return and were either acquired from such a group without a section 338(h)(10) election or spun-out of such a group may consider waiving the carryback of NOLs that would otherwise be carried back to pre-section 965 years.
A carrybacks of NOLs to section 965 years is complicated by a number of factors. First, some corporations had their section 965 inclusions in 2017, some had their section 965 inclusions in 2018, and some had their section 965 inclusions in both 2017 and 2018. Having section 965 inclusions during both 2017 and 2018 was a common situation both for fiscal year taxpayers and for calendar year taxpayers that had previously elected November 30 as the year end for some of their controlled foreign corporations (CFCs). Second, for calendar year taxpayers, 2017 was a taxable year primarily governed by pre-TCJA tax law (when the top marginal corporate tax rate was 35 percent), whereas 2018 was a taxable year governed by post-TCJA tax law (and thus a 21 percent tax rate applied). As a result, determining the value of NOL carrybacks to 2017 and 2018 presents a number of challenges.
The NOL carryback provisions of the CARES Act have three provisions that specifically modify the way in which the NOL carryback provisions work for section 965 years. First, the CARES Act treats taxpayers as having made a section 965(n) election for such years even if they did not make one initially. As a result, NOL carrybacks to section 965 years will not offset section 965 inclusions. Second, the CARES Act permits taxpayers to waive all NOL carrybacks to section 965 years. Third, fiscal year taxpayers are permitted to elect to waive NOL carrybacks, reduce NOL carryback periods or revoke prior waivers of NOL carrybacks for taxable years that began before December 31, 2017 and ended after January 1, 2018.
Congress appears to have included an option to waive NOL carrybacks to section 965 years in part to prevent taxpayers from losing their NOL carryback refunds to unpaid future installments of their section 965 liability. Section 965(h) permitted taxpayers to pay their section 965 transition tax liability in installments over an eight year period. However, the Office of Chief Counsel took the position that the IRS was required to keep overpayments of 2017 estimated taxes and apply them towards taxpayers section 965 installments due in future years. For taxpayers that continue to have significant section 965 installments due in future years, it is likely worth waiving the carryback to section 965 inclusion years.
Even for taxpayers who have little or no remaining section 965 installment payments that could be offset by NOL carrybacks, it may still make sense to waive carrybacks to such years if 2018 is a section 965 year. In particular, taxpayers will need to determine the impact of a NOL carryback on its ability to utilize FTCs arising in the section 965 year. Additionally, taxpayers should consider whether carrying back NOLs to 2018 could result in a significantly higher tax liability for 2018 as compared to other taxable years to which the NOL would either be carried back or carried forward. This could happen as a result of the interaction of the NOL carryback with either the section 250 deduction or the Base Erosion and Anti-Abuse Tax (the BEAT). The section 250 deduction provides taxpayers with foreign derived intangible income (FDII) or global intangible low taxed income (GILTI) with a deduction of up to 37.5% of FDII and 50% of GILTI. However, the section 250 deduction for both FDII and GILTI is income limited. As a result, carrying back NOLs to 2018 could result in taxpayers losing some or all of their section 250 deduction and using NOLs carried back to those years to offset FDII or GILTI instead. In addition, the BEAT is an anti-base erosion tax calculated as an alternative minimum tax on taxpayers that make deductible payments to related parties that are viewed under the BEAT as eroding the U.S. tax base. Because it is calculated in part based on a comparison between a corporation’s BEAT liability calculated without permitting deductions for certain otherwise deductible payments and a corporation’s regular tax liability, carrying back NOLs to such years can result in corporations owing more BEAT than they did previously. In some instances, it may cause corporations to owe BEAT when they previously had no BEAT liability. For corporations whose only section 965 year was 2017, they will not have to consider the impact of this waiver on their section 250 deduction or their BEAT liability because those provisions were not yet in effect.
Finally, fiscal year taxpayers who are permitted to reverse NOL carryback waivers from or waive NOL carrybacks to taxable years beginning before January 1, 2018 and ending after December 31, 2017 face unique issues based on the way TCJA provisions were effective in part during this period. Many fiscal year corporations were able to benefit from the section 245A deduction for dividends from CFCs having taken effect during this period while other potentially more negative aspects of the TCJA did not apply to such taxpayers until the following fiscal year. Even fiscal year taxpayers with little or no remaining unpaid section 965 installments will want to carefully consider their positions with respect to these issues before carrying back NOLs to this period.
While corporations instinctively will be tempted to carry back NOLs to the maximum extent possible, several factors limit the benefit of carrying NOLs back to post-section 965 years.
First, as explained in the previous section, carrybacks of NOLs to post-TCJA years, including post-section 965 years, can result in increased FDII or GILTI liability from the loss of section 250 deductions or increased BEAT liability.
Second, the benefit of a NOL carryback to a post-section 965 year may be diminished by deferral of the utilization of foreign tax credits (FTCs) or by the loss of FTCs. A NOL carryback reduces FTC limitations under section 904, for example, if and to the extent (i) the carryback is attributable to foreign source losses, or (ii) the carryback reduces entire taxable income below the amount of taxable income from foreign sources. The resulting FTC carryforwards, if any, generally are carried forward, though they may be carried back one year or carried forward and used no more than ten years after the year in which the foreign taxes were paid (or deemed paid), and they may expire unused. One exception is that FTCs attributable to GILTI other than passive category income (section 951A category income) cannot be carried back or forward, so that the benefit of NOLs carried back to a post-section 965 year may be diminished (or possibly eliminated) through a combination of the resulting inability to deduct amounts under section 250 and/or the resulting inability to use FTCs attributable to section 951A category income. Because NOL carrybacks to post-section 965 years could reduce the utilization of FTCs, taxpayers should consider whether a waiver of the carryback period might result in a greater overall tax benefit.
Third, given recent federal spending increases in response to the COVID-19 pandemic and other political and social factors, corporate tax rates may be more likely to increase than decrease in future years. As a result, NOLs generated in post-TCJA years may be worth more if they can be used to offset income that would be taxed at a higher rate in the future.
The NOL carryback rules may create an unexpected trap for corporations that were previously members of affiliated group of corporations electing to file a consolidated U.S. federal income tax return (a prior consolidated group). This trap may impact corporations that were previously members of a prior consolidated group and ceased being members of the prior consolidated group, either as a result of a stock sale without a section 338(h)(10) election or a spin-off, within five taxable years of the taxable year that the 2018, 2019 or 2020 NOL was generated.
Treasury regulations promulgated under section 1502 permit the portion of a consolidated NOL (a CNOL) that is apportioned to a member of a consolidated group for a taxable year in which the carryback of NOLs is permitted under section 172 to be carried back to a separate return year of the member (including a tax return of the prior consolidated group), provided that the carryback of such NOL is not waived and the carryback is permitted under the separate return limitation year (SRLY) rules set forth in section 1.1502-21(c) of the Treasury regulations. Accordingly, the portion of a CNOL arising in 2018, 2019 or 2020 that is apportioned to a member that was previously a member of the prior consolidated group may be required to be carried back to the prior consolidated group’s U.S. federal income tax return. If the CNOL apportioned to a member must be carried back to a tax return of the prior consolidated group, it would be the common parent of the prior consolidated group that would be required to file the claim for refund or amended tax return for the carryback year and that would receive the tax refund resulting from the carryback.
To the extent that a carryback of a portion of a CNOL to a prior consolidated group is available for a CNOL arising in 2018, 2019 or 2020 (meaning the carryback has not been waived, the prior consolidated group has taxable income within the carryback period and the carryback is permitted under the SRLY rules), taxpayers would need to review the terms of the applicable transaction agreements, including any applicable tax sharing agreements that remain in place following the transaction, in order to determine whether such agreements address the rights of the parties to refunds arising from the carryback of NOLs. Many purchase agreements involving acquisitions of subsidiaries from consolidated groups (even those entered into post-2017) expressly prohibit the carryback of CNOLs apportioned to the target company to a tax return of the prior consolidated group (and some agreements expressly state that any refunds received by the prior consolidated group as a result of the carryback are to be retained by the prior consolidated group). However, it may be possible to reach an agreement with the prior consolidated group to file an amended return and share the refund.
Taxpayers that would otherwise be required to carryback losses to a prior consolidated group may consider waiving the carryback of the entire CNOL generated by the taxpayer’s consolidated group (not just the portion of the CNOL apportioned to the acquired member). Additionally, consolidated groups acquiring target corporations may make an irrevocable election to waive, with respect to any CNOLs attributable to a member, the portion of the carryback period for which a member was a member of another consolidated group (a split carryback election). The split carryback election must be filed with the buyer consolidated group’s original tax return for the taxable year of the acquisition. While the split carryback election may still be made on a timely basis for acquisitions occurring in 2019 (assuming that the 2019 tax return has not yet been filed) and 2020, the split carryback does not appear to be eligible for acquisitions occurring in 2018 and prior years absent additional guidance from the IRS.
Accordingly, taxpayers that acquired corporations from consolidated groups without a section 338(h)(10) election or taxpayers that were spun-out of consolidated tax groups within the NOL carryback period should determine whether the attributed portion of the CNOL is required to be carried back to the prior consolidated group, taking into account the SRLY rules and the tax profile of the prior consolidated group in the carryback years. If it is determined that a carryback is available, taxpayers should review the applicable transaction documents in order to determine the rights and obligations of the parties with respect to any CNOL carrybacks from the buyer’s consolidated group and consider waiving the CNOL carrybacks. Additionally, taxpayers that acquired members from consolidated groups in 2019 or 2020 should consider making the split carryback election on the original tax return for the year of the acquisition.
Revenue Procedure 2020-24 provides guidance to taxpayers regarding how to make or revoke NOL carryback waivers. Elections to waive carrybacks of NOLs under section 172(b)(3) for 2018 and 2019 can generally be made on the first tax return to be filed after March 27, 2020. Similarly, elections to waive carrybacks of NOLs to section 965 years for NOLs generated in 2018 or 2019 can generally be made on the first tax return filed after March 27, 2020. Elections to waive carrybacks of NOLs to section 965 years for NOLs generated in 2020 can be made no later than the filing of the 2020 tax return. However, the election must be filed no later than the earliest of the filing of the federal income tax return for the year in which the NOL arises, the filing of a tentative claim for refund on Form 1139, or the filing of an amended return for a NOL carryback to a year that is not a section 965 year. Fiscal year taxpayers seeking to make elections with respect to NOLs for taxable years beginning before January 1, 2018 and ending after December 31, 2017 must make such elections no later than July 27, 2020. Fiscal year taxpayers filing claims for refund for such years may make such elections on Form 1139. Revenue Procedure 2020-24 provides additional instructions for fiscal year taxpayers wanting to make elections for such years that are not filing claims for refund on such forms. The IRS has released a list of frequently asked questions with respect to temporary procedures for faxing Forms 1139 in order to obtain tax refunds arising from NOL carrybacks and tax refunds of remaining MTCs.
The NOL carrybacks permitted under the CARES Act provide welcome tax relief to many corporations, but those NOL carrybacks can in many instances come with some trade-offs. The various waiver elections provided in the CARES Act provide taxpayers with a chance to mitigate those trade-offs and should be carefully considered in connection with any NOL carryback claim. In addition, because those waivers are provided in the form of statutory, rather than regulatory, elections, the IRS may not be willing to provide relief for elections that are not filed correctly by the due date. As a result, it is critically important to evaluate all of the possible advantages and disadvantages of the NOL carryback provisions before filing a claim.