INSIGHT: Sears’ Net Operating Losses Will Survive Bankruptcy

Sears Holdings Corp. has accumulated a $1.76 billion net operating loss deferred tax asset (NOL DTA) and a nearly $1 billion credit DTA. The NOL DTA implies a net operating loss balance of approximately $5 billion. These valuable “assets” will not be extinguished as a result of Sear’s bankruptcy but, instead, will be inherited, for potential future use, by the purchaser of Sears’s assets, ESL Investments Inc.

The arrangement approved by the bankruptcy court is referred to as the “Asset Purchase Agreement.” Sears, the arrangement recites, owns and operates, among other things, a national network of retail stores and pharmacies, a national network of specialty stores, and various websites, collectively the “business.” On Oct. 15, 2018, Sears filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code. According to the agreement, Sears, its unsecured creditors, and ESL intend that the transactions together with the bankruptcy plan, will constitute one or more plans of reorganization under tax code Section 368(a) and also qualify as one or more reorganizations and satisfy the ownership requirements of tax code Section 382(l)(5)(A)(ii).

The plan provides that Sears will sell to an affiliate of ESL Investments aptly named “Transform Holdco LLC” (ESL). ESL will purchase the business, comprised of designated assets. ESL will assume designated liabilities. The aggregate purchase price will consist of:

(a) cash, including (i) an upfront payment in the amount of $1.41 billion, and (ii) a credit bid release consideration;

(b) a credit bid consisting of obligations held by ESL and its affiliates;

(c) the “securities consideration”; and

(d) the assumption of designated liabilities.

The securities consideration is vaguely defined as debt or equity securities in ESL in an amount and form to be determined by ESL. However, if reorganization treatment is to be secured, it is essential that at least some of such securities consideration consists of the ESL’s equity securities.

’G’ Reorganization

In order for Sears’s “tax attributes” to be inherited by ESL, the “asset movement” the plan envisions must constitute a “reorganization.” One variety of reorganization, specially enacted for the purpose of allowing bankrupt entities to effectuate a reorganization, is a reorganization under tax code Section 368(a)(1)(G), a so-called “G” reorganization.

A “G” reorganization is defined “a transfer by a corporation (Sears) of all or part of its assets to another corporation (ESL) in a bankruptcy or similar case; but only if, in pursuance of the plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction which qualifies under section 354 … ” (emphasis added). Tax code Section 354(b)(1) provides that Section 354(a) “shall not apply to an exchange in pursuance of a plan of reorganization within the meaning of … (G) of section 368(a)(1) unless—(A) the corporation to which the assets are transferred acquires substantially all of the assets of the transferor; and (B) the stock, securities, and other properties received by such transferor, as well as the other properties of such transferor, are distributed in pursuance of the plan of reorganization.”

Thus, for the instant transaction to qualify as a “G” reorganization, the requirements of Section 354 must be adhered to. These requirements will be met if (i) Buyer acquires substantially all of Sears’s assets (the Internal Revenue Service has ruled that, in the context of a “G” reorganization, substantially all of the assets means at least 50 percent of the fair market value of the transferor’s gross assets and at least 70 percent of the fair market value of such transferor’s operating assets); (ii) Sears liquidates in pursuance of the plan of reorganization, and (iii) at least one Sears shareholder receives ESL stock; or at least one security holder of Sears receives ESL stock or securities.

Continuity of Interest

In addition, a “G” reorganization, like any other “acquisitive” reorganization, must satisfy the “continuity of interest” requirement. To do so, a portion of the transaction consideration will have to consist of the ESL’s equity securities. Continuity of interest requires that “a substantial part” of the value of the proprietary interests in the target corporation be “preserved” in the potential reorganization. See Treasury Regulation Section 1.368-1(e)(1)(i). A proprietary interest is so preserved if it is exchanged for a proprietary interest in the issuing corporation.

Who owns the proprietary interests in an insolvent entity? Treas. Reg. Section 1.368-1(e)(6) provides that “a creditor’s claim may be a proprietary interest in the target corporation if, as here, the target corporation is in a” bankruptcy or similar case. In such cases, if any creditor receives a proprietary interest in the issuing corporation in exchange for its claims, every claim of that class of creditors and every claim of all equal and junior classes of creditors is a proprietary interest in the target corporation prior to the potential reorganization.

For a claim of the most senior class of creditors receiving a proprietary interest in the issuing corporation (ESL), the value of the proprietary interest in the target corporation (Sears) represented by the claim is determined by multiplying the fair market value of the claim by a fraction, the numerator of which is the fair market value of the proprietary interests received, and the denominator of which is the fair market value of all consideration received in exchange for the claims. The value of a proprietary interest in the target corporation held by a creditor whose claim is junior to the claims of other classes of creditors who are receiving proprietary interests is the fair market value of the claim.

Once one determines the aggregate value of the proprietary interests in the target corporation, it must then be determined whether a substantial part of such value has been preserved in the potential reorganization. This is done by constructing another fraction, the numerator of which is the value of the issuing corporation’s proprietary interests conveyed in the transaction; and the denominator of which is the value of the proprietary interests in the target corporation, as determined above. If the quotient is at least 40 percent, the requisite substantial part of the value of the proprietary interests in the target corporation will have been preserved, with the result that the transaction qualifies as a reorganization, a designation that permits the acquiring party to succeed to, and take into account, the acquired corporation’s “tax attributes,” most notably its net operating loss and credit carryovers. See tax code Section 381(a) and (c).

Ownership Change

There is one more piece to the puzzle. Where, as here, a loss corporation experiences an “ownership change,” within the meaning of tax code Section 382(g), limitations are placed on the amount of taxable income, for any taxable year ending after the change date, that can be offset by the pre-change net operating losses. This limitation is known as the “Section 382 limitation.” However, here, the Section 382 limitation will not be applicable.

If, as is the case here, the loss corporation is under court jurisdiction in a bankruptcy “or similar case,“ and if its old shareholders and ”qualified creditors“ own, immediately after the ownership change, at least 50 percent of the ”new loss corporation’s stock,“ by both voting power and value, then Section 382(l)(5) provides that ”the section 382 limitation shall not apply.“ A qualified creditor, in general, is a creditor who has held his or her claim for at least 18 months before the filing of the bankruptcy or similar case; and a creditor whose claim arose ”in the ordinary course“ of the debtor’s trade or business and who has always held such claim.

The parties are confident that the instant arrangement will qualify for this so-called ”bankruptcy exception.“ Accordingly, not only will ESL succeed to Sears’s net operating losses, it will do so without the burden of the Section 382 limitation. In other words, there should be no limits imposed on the amount of taxable income earned by the Buyer that can be offset by Sears’s pre-change net operating losses.

In a transaction that qualifies for the bankruptcy exception, the net operating losses to which the acquirer succeeds are required to be reduced by interest paid or accrued during a specified period on debt converted into stock in the bankruptcy case, i.e., the period from the first day of the third taxable year preceding the taxable year in which the ownership change occurs through and including the change date. In addition, Section 382(l)(5)(5)(D) will completely eliminate the net operating loss carryovers, from the period before the first ownership change, if a second ownership change were to occur within two years of the first ownership change.

Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.