Brookfield petitions Tax Court to defend Lehman bankruptcy NOL strategy

Background: Preserving NOLs Through Bankruptcy

Section 382 generally limits a corporation's ability to use pre-change losses, including NOLs, following an ownership change. The annual limitation generally equals the value of the old loss corporation's stock immediately before the ownership change multiplied by the applicable long-term tax-exempt rate, subject to various adjustments.

Section 382(l)(5), however, provides an important exception for certain restructurings in bankruptcy. In general, the section 382(a) limitation does not apply to an ownership change if (1) the loss corporation is under the jurisdiction of a court in a title 11 case immediately before the ownership change and (2) immediately after the ownership change, the corporation's pre-change shareholders and qualified creditors own, as a result of being shareholders or creditors immediately before the change, stock representing at least 50% of the corporation's stock by vote and value. In determining whether stock received by creditors counts toward the 50% threshold, the regulations generally require the stock to be received in satisfaction of “qualified indebtedness,” which generally includes indebtedness held continuously by the same beneficial owner since at least 18 months before the bankruptcy filing and indebtedness that arose in the ordinary course of the loss corporation’s trade or business and has at all times been owned by the same beneficial owner. The exception can preserve substantial NOL value, but it carries significant costs and limitations. First, the corporation’s pre-change losses and certain credits are recalculated by disallowing interest deductions taken during a statutory lookback period on indebtedness that is converted into stock in the bankruptcy. Second, if the corporation undergoes another ownership change within two years, the section 382 limitation for post-change years following that subsequent ownership change generally is zero, effectively preventing further use of the remaining pre-change NOLs.

Because of these costs, a loss corporation that qualifies for section 382(l)(5) may elect under section 382(l)(5)(H) not to apply it. In that case, section 382(l)(6) generally applies instead, and the annual limitation is computed using the value of the loss corporation's stock immediately after the ownership change, reflecting any increase in value resulting from the surrender or cancellation of creditors' claims in the bankruptcy. Choosing between the two regimes is often a central planning decision in a bankruptcy acquisition.

Separate rules must also be considered. For example, cancellation-of-debt income excluded in bankruptcy generally results in reduction of tax attributes under section 108(b), with NOLs generally reduced first unless the taxpayer elects under section 108(b)(5) to reduce the basis of depreciable property first. Attribute reduction is not among the issues raised in the Brookfield petition. 

Brookfield/Lehman Tax Court Litigation

According to Brookfield's petition, Brookfield acquired Lehman Brothers UK Holdings (Delaware) Inc. (LUK) and Lehman Pass-Through Securities Inc. (LPTSI) in two steps: an August 10, 2017 Stock and Note Purchase Agreement, in which it acquired 45% of each entity’s common stock and 100% of a note issued by each entity and held by Lehman, and a March 15, 2018 chapter 11 restructuring, in which those interests were exchanged for 100% of each entity’s common stock. At the time of the first transaction, LUK had an NOL of approximately $8.9 billion and LPTSI had an NOL of approximately $1 billion. On August 31, 2017, LUK and LPTSI filed a joint chapter 11 case, and under a plan confirmed on March 9, 2018 and effective March 15, 2018, Brookfield exchanged its stock and note interests for 100% of the common stock of each entity, while Lehman received preferred stock that was later redeemed. In confirming the plan, the bankruptcy court found that “[t]he principal purpose of the Plan is not the avoidance of taxes.” 

Although LPTSI was restructured in a similar manner, the NOL deduction at issue in the case is attributable to LUK, and the petition’s section 382(l)(5) analysis focuses on the LUK restructuring. Brookfield contends that the LUK restructuring satisfied section 382(l)(5), including because 61.33% of the LUK common stock it received was received as a result of its pre-restructuring ownership of LUK common stock, and because Lehman's preferred stock is not “stock” for section 382 purposes under section 382(k)(6)(A).

According to the petition, the IRS’s notice of deficiency (notice) asserts three grounds for reducing the NOL deduction.

Constructive Ownership and Option Treatment. According to the petition, the notice asserts that the constructive-ownership rules of section 382(l)(3)(A) apply to reduce the allowable NOL deduction. The petition states, on information and belief, that the IRS’s position is that the 2017 Stock and Note Purchase Agreement constitutes an option treated as exercised on its closing date under Treas. Reg. § 1.382-4(d). Brookfield disputes that the agreement is an option within the meaning of Treas. Reg. § 1.382-4(d)(9) and further argues, alternatively, that (i) under Treas. Reg. § 1.382-9(o)(1), the option-exercise rules of Treas. Reg. § 1.382-4(d) do not apply to an option created by the solicitation or receipt of acceptances to a plan of reorganization that is confirmed in a title 11 or similar case, (ii) any option would not be treated as exercised because none of the ownership, control or income tests is met, and (iii) the contracts-to-acquire-stock safe harbor in Treas. Reg. § 1.382-4(d)(7)(i) applies.

Substance Over Form. According to the petition, the notice asserts that substance-over-form principles apply because the acquisition of LUK “was structured to include steps undertaken for the principal purpose of avoiding application of Internal Revenue Code section 382.” The petition characterizes this language as invoking the step-transaction doctrine, and argues that neither the step-transaction doctrine nor substance-over-form principles more generally can invalidate the LUK restructuring’s qualification for the section 382(l)(5) exception. In the petition, Brookfield asserts that the substance of the transactions matched their form, that substance-over-form principles are tools of statutory interpretation that cannot be used to circumvent the plain language of section 382(l)(5), and that qualifying for section 382(l)(5), an integral part of section 382, does not constitute avoidance of section 382.

Section 269. According to the petition, the notice alternatively asserts in the notice that section 269 permits it to reduce the NOL deduction because Brookfield’s acquisition of LUK “was made for the principal purpose of avoiding Federal income tax.” Section 269 generally permits the IRS to disallow a deduction, credit, or other allowance where a person acquires control of a corporation (generally at least 50% by vote or value) and the principal purpose of the acquisition is evasion or avoidance of federal income tax by securing a benefit the person would not otherwise enjoy. In the petition, Brookfield maintains that the principal purpose of the transactions was not tax avoidance, pointing to business purposes such as acquiring Lehman assets at a favorable price, and that the Treas. Reg. § 1.269-3(d) presumption, which applies to acquisitions of control in section 382(l)(5) ownership changes, does not apply because LUK carried on more than an insignificant amount of a trade or business during and after the bankruptcy. Brookfield also argues that the other requirements of section 269 are not satisfied. Notably, although the bankruptcy court found that the plan's principal purpose was not tax avoidance, Treas. Reg. § 1.269-3(e) provides that such a determination under 11 U.S.C. § 1129(d) is not controlling for purposes of section 269.

Key Takeaways

The significance of Brookfield potentially extends beyond the particular Lehman restructuring. Although the case remains pending, the IRS position described in the petition suggests that satisfying the literal section 382(l)(5) ownership requirements may not end the inquiry where an investor acquires stock or debt prior to a bankruptcy and subsequently relies on those interests in seeking section 382(l)(5) treatment.

Accordingly, investors pursuing acquisitions of distressed companies in which NOL preservation is an important element of transaction economics should pay particular attention to:

1. acquisitions of minority equity or creditor positions preceding a contemplated bankruptcy;
2. contractual rights that could be characterized as options under section 382;
3. the relationship between the pre-bankruptcy acquisition and subsequent restructuring;
4. contemporaneous evidence supporting independent business purposes and the economic risks borne by the parties between the pre-bankruptcy acquisition and the restructuring; and
5. transaction materials that assign significant value to NOL preservation or that otherwise demonstrate that tax attributes were a significant factor in evaluating the acquisition.

Importantly, the dispute in Brookfield should not presently be viewed as narrowing planning opportunities under section 382(l)(5). The case is only at the petition stage, and Brookfield is expressly contesting the IRS's theories. Indeed, one of the important questions the litigation may ultimately address is the extent to which judicial substance-over-form principles and section 269 can limit a transaction that the taxpayer contends falls squarely within a specific statutory bankruptcy exception.

Brookfield is nonetheless an important case to monitor for investors in distressed assets, private equity funds, and other taxpayers acquiring corporations with significant NOLs. Its ultimate significance may be greatest for transactions that establish pre-bankruptcy shareholder or creditor status with a view to preserving NOLs under section 382(l)(5).

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