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TAX UPDATE

IRS Addresses Application of Section 382 to Bank Merger The IRS recently released a private letter ruling that addresses the application of Section 382 to a merger involving a bank that is in a net unrealized built-in loss position. The ruling concludes that under the "1374 approach" of Notice 2003-65 the Section 382 limitation will not apply to a bad debt deduction that is properly taken more than twelve months after an ownership change. When a corporation is in a net unrealized built-in loss position, the Section 382 limitation generally applies to any portion of the built-in loss that is recognized within five years after the ownership change. This can severely impair the value of a corporation's built-in losses. Under the 1374 approach, a bad debt deduction claimed within the first twelve months after an ownership change is treated as an item of recognized built-in loss. The ruling addresses the treatment of bad debt deductions taken after the first twelve months. The ruling, PLR 201105031, was released on February 4, 2011. The ruling concludes that under the 1374 approach a bad debt deduction that is properly claimed more than twelve months after an ownership change will not be treated as an item of recognized built-in loss. The deduction, thus, will not be subject to limitation under Section 382. This could make the 1374 approach very appealing for a bank that is in a net unrealized built-in loss position.

Section 382 If a corporation has an ownership change, Section 382 of the Internal Revenue Code imposes an annual limitation on the future use of the corporation's net operating loss (NOL) carryforwards. The limitation operates as an annual ceiling on the amount of the corporation's taxable income that can be offset by its pre-ownership change NOLs. If a corporation is in a net unrealized built-in loss (NUBIL) position at the date of an ownership change, the Section 382 limitation applies to any portion of the built-in loss that is recognized within five years after the ownership change. A corporation generally is considered to be in a NUBIL position if the total tax basis in its assets exceeds the total fair market value of its assets by more than a threshold amount. The threshold amount is equal to the lesser of 15% of the fair market value of the corporation's assets or $10 million. In recent years, many banks have found themselves in a NUBIL position as a result of declines in the market value of their loan and securities portfolios. The Section 382 limitation generally is calculated by multiplying the corporation's equity value at the time of the ownership change by the "long-term tax-exempt rate" that is in effect for the month of the ownership change. The long-term tax-exempt rate is published monthly by the IRS. An ownership change is generally defined for purposes of Section 382 as a more than 50% change in ownership on the part of one or more 5%-or-greater shareholders over a testing period, which is

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generally a three-year period. A corporation's less-than-5% shareholders are generally aggregated and treated as a single 5%-or-greater shareholder (a "public group"). Certain events, such as mergers and stock issuances, can cause the less-than-5% shareholders to be segregated into separate public groups. The regulations under Section 382 provide detailed rules to determine whether, and how, the segregation rules will apply to a stock issuance. Because the determination of whether there has been a Section 382 ownership change involves looking back over a testing period, even a small increase in ownership on the part of a 5%-or-greater shareholder can trigger a Section 382 ownership change if it results in a cumulative increase in ownership over the testing period of more than 50% on the part of one or more 5%-or-greater shareholders.

Notice 2003-65 IRS Notice 2003-65 describes two permissible methods for identifying items of built-in gain and built-in loss: the "338 approach" and the "1374 approach." Under the 1374 approach, any bad debt deduction taken within the first twelve months after an ownership change that is attributable to a debt owed to the corporation at the date of the ownership change is treated as an item of recognized built-in loss. The Notice does not specifically address the treatment of bad debt deductions taken after the first twelve months.

PLR 201105031 The ruling was requested by a domestic bank holding company (the "Acquirer"). The Acquirer intends to acquire a domestic bank holding company (the "Target") in a transaction in which the Target will merge into the Acquirer. The Target has one class of common stock, which is publicly traded, and one class of preferred stock that was issued pursuant to the Troubled Asset Relief Program. In the merger, the common stock and preferred stock of the Target will be converted into common stock and preferred stock of the Acquirer. The Target has a wholly-owned subsidiary ("Sub") that is a bank. The Sub is expected to have an NOL and NUBIL as of the date of the merger. The NUBIL is primarily attributable to the Sub's debt portfolio having a fair market value less than tax basis. As a result of the merger, the Sub will become a whollyowned subsidiary of the Acquirer. The merger is expected to result in an ownership change of the Sub for purposes of Section 382. The Sub does not use the reserve method for bad debts under Section 585, and has not made, and does not intend to make, a "conformity election" under Reg. Sec. 1.166-2(d)(3). The Sub takes bad debt deductions equal to the amount of debt charged off in accordance with Reg. Sec. 1.166-2(d)(1). After the merger, the Sub anticipates that it may take one or more bad debt deductions with respect to obligations that it held before the merger. The Sub anticipates that these deductions will be taken both during and after the first twelve months after the merger. The Sub intends to use the 1374 approach under Notice 2003-65 to identify which of its deductions taken after the merger will constitute items of recognized built-in loss.

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The ruling concludes that any bad debt deductions that are properly taken more than twelve months after the date of the ownership change with respect to debts that were owed to the Sub at the date of the ownership change will not be regarded as items of recognized built-in loss.

Assessing the 1374 Approach In evaluating the 1374 approach, one factor to consider is that bad debt deductions that are taken within the first twelve months after an ownership change with respect to debts owed to the corporation at the date of the ownership change will be treated as items of recognized built-in loss even if the loss is attributable to declines in the market value of the debt obligations after the date of the ownership change. In other words, the 1374 approach causes post-ownership change economic losses that are recognized within the first twelve months after the ownership change, with respect to debt obligations that were held at the date of an ownership change, to become subject to limitation. It is also important to keep in mind that the 1374 approach provides a benefit only to the extent that losses are properly taken, under the bank's method of tax accounting for bad debts, more than twelve months after the ownership change, and only to the extent the losses are properly taken as bad debt deductions under Section 166. A bank will not necessarily know when, or how, its losses will be realized. Thus, it can be difficult to predict how much benefit a bank will actually derive from the 1374 approach.

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These materials are intended only to provide general information and cannot be relied upon with respect to the facts and circumstances of any particular transaction. The U.S. tax information contained herein was not intended or written to be used, and cannot be used, by any taxpayer for the purposes of avoiding penalties under the Internal Revenue Code or applicable U.S. state or local tax laws.

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