Insight Center: Publications

Protecting Your NOL Carryforward with a Poison Pill

Tax Update

Authors: Robert A. Friedel and Todd B. Reinstein


As a result of the recent downturn in the economy, many companies have been incurring significant operating and tax losses. At the same time, corporate stock values have plunged. This confluence of events creates the potential for a company to lose the potentially valuable future tax benefits that may be realized from federal tax net operating loss (NOL) carryforwards.

Over an extended period of economic weakness, NOL carryforwards can become one of the largest assets on a company’s balance sheet. Under normal circumstances, the NOLs can serve to offset future taxable income, resulting in tax savings as the company begins to be profitable. However, current tax laws impose significant limits on the ability to use NOLs to offset taxable income in the event of an ownership change. Thus, a company can be in a situation in which one of its largest assets can become impaired if ownership changes. Recent steep declines in equity markets have made it less expensive for investors to acquire significant percentages of a company’s publicly traded stock, aggravating the risk of a possible limitation.

Section 3821 limits a loss corporation’s ability to use its tax net operating losses following an "ownership change." An ownership change is triggered if one or more 5-percent shareholders of the loss corporation increases their ownership in the aggregate by more than 50 percentage points during a testing period.2 Once an ownership change has occurred, the amount of NOLs that the corporation may use to offset taxable income in any year is limited to the "Section 382 limitation" resulting from the ownership change.3 Thus, corporations with large NOL carryforwards are concerned with monitoring shareholder shifts that might trigger an ownership change and impair the NOL asset on their books. Boards of directors of publicly traded companies with large NOL carryforwards are increasing their efforts to protect this asset, and some companies are adopting "poison pill" plans to restrict the ability of shareholders to take actions that could trigger a Section 382 ownership change.4

Poison Pills

Since the 1980s, corporate America has used "poison pills" as a tool to discourage hostile and unsolicited investors from taking large stakes in a corporation’s publicly traded stock. Most corporate poison pills take the form of a stockholder rights plan where purchase rights are distributed to existing shareholders, entitling them to acquire one share of common stock (or a preferred stock equivalent) for each share owned, at a specified purchase price that exceeds the market price on the date of adoption. The key deterrent effect of the plan is realized if any investor (herein the "hostile investor") acquires beneficial ownership of more than a specified trigger amount. In that event, in exchange for payment of the purchase right’s exercise price, all shareholders other than the hostile investor are permitted to purchase shares of common stock (or preferred stock equivalents) having a fair market value equal to two times the exercise price. This effectively allows the public shareholders to buy common shares at a 50 percent discount, while denying the hostile investor the same benefit. A trigger of the poison pill will thus significantly dilute the percentage of the company’s common stock owned by the hostile investor, making it more expensive for the hostile investor to acquire control of the company.

Typically, the anti-dilution rights in a poison pill are set to be triggered once a shareholder acquires beneficial ownership of more than a 10, 15 or 20 percent stake in the corporation. Since Section 382 is concerned with tracking the increases in 5-percent shareholders, many of the NOL poison pills have a lower triggering percentage ranging from 4.75 to 4.99 percent. These lower threshold triggers are designed to deter further acquisitions by stockholders whose share purchases or sales might affect the ownership change calculation. Some NOL poison pills include additional provisions imposing an outright prohibition against exceeding the threshold percentage of beneficial ownership without obtaining pre-approval for a proposed share acquisition.

Some loss corporations have been reluctant to adopt rights plans with low triggering percentage levels, fearing it will discourage future investment in their stock. The existence of a low percentage trigger, as exists in NOL rights plans, is thought by some to dissuade institutional investors from taking a position in the stock. To avoid an unwanted trigger of the rights plans and encourage investment, some companies have included discretionary controls in the plans. Many shareholder rights plans also provide for automatic termination of the plans if the board determines that the NOLs have been fully used to offset taxable income. Other plans include rules allowing a board to waive the application of the discount purchase provisions upon a triggering acquisition at the discretion of the board.

Rights Plans under the Option Rules

Under Section 382, an option to acquire stock is treated as exercised if the exercise would result in an ownership change.5 The regulations provide an extensive set of rules for option attribution. Generally, the option attributions rules reverse the presumption that an option is deemed exercised, if doing so causes an ownership change, and treats only options issued for a principal purpose of avoiding or accelerating the impact of an ownership change as deemed exercised and counted as stock under Section 382. These attribution rules can bring about unfortunate results when a seemingly benign equity issuance can be counted for Section 382 owner shift purposes. For example, the shareholder rights distributed to the existing shareholders under a poison pill are considered options under the regulations and thus, an analysis must be performed to determine whether or not they would be considered exercised for Section 382 purposes.

In Revenue Ruling 90-11, the IRS ruled that certain rights issued to shareholders to acquire loss-corporation stock at a reduced price pursuant to a poison pill adopted to fend off a hostile takeover are not subject to the option attribution rules.6 The ruling holds that such rights would be exempted from option attribution as long as the loss corporation could redeem the rights for little or no consideration without shareholder approval, a standard provision in poison pills. Although the ruling holds that the distributions of rights did not constitute stock for Section 382 purposes, corporations implementing NOL plans need to be careful when drafting their poison pills and work to ensure that rights to be granted under such plans do not carry with them attributes of equity ownership that would cause the rights to be treated as outstanding equity.7 These can include the right to vote, a seat on the board, a deep in the money exercise price, etc.8

Selectica Case

Before creating an NOL poison pill, companies should note a pending case, Selectica, Inc. v. Versata Enterprises, Inc., in the Delaware Court of Chancery involving the intentional triggering of an NOL poison pill.9 Selectica, Inc., a microcap company that provides enterprise software solutions, amended its conventional shareholder rights plan in 2008 in order to protect its NOL carryforwards from possible impairment, by lowering the triggering percentage under the plan from 15 percent to 4.99 percent. Selectica’s rights plan grandfathered all then-existing 5-percent or greater shareholders and provided that the plan would not be triggered unless they were to acquire beneficial ownership of at least an additional 0.5 percent of the common stock. Two existing shareholders – commercial competitors of Selectica that were engaged in ongoing business disputes with the company – thereafter announced that they had purchased more than the number of additional shares necessary to trigger Selectica’s rights plan. In response, Selectica exercised the exchange feature of its rights plan, issuing an additional share for each share held by every shareholder other than the triggering shareholders, in exchange for the cancellation of all outstanding rights under the plan. This doubled the number of shares held by all shareholders other than the triggering shareholders and effectively diluted the ownership percentage of the triggering shareholders by approximately half. Selectica also renewed its NOL poison pill and distributed a new purchase right to all of the non-triggering shareholders. Finally, Selectica filed a lawsuit in the Delaware Chancery Court seeking a declaratory judgment confirming the validity of its rights plan.

Aside from the obvious disruption and expense resulting from the triggering of the poison pill and the resulting litigation, Selectica suffered the additional insult of having the trading in its common stock suspended for a month while the company and its transfer agent sorted out which shareholders were entitled to receive the distribution of free shares as a result of the exchange feature, and which were affiliated with the triggering shareholders and were thus not so entitled. The word of caution here is that although most poison pills will serve as an effective deterrent to the acquisition of triggering share percentages, one or more shareholders with other than purely share-related motives, such as competitors, can subvert the intention of the rights plan and "buy through" the triggering percentage of shares, thereby putting at risk the loss corporation’s NOL carryforwards. This was the case with Selectica, and the matter is currently being litigated in Delaware.

Pepper Perspective

An NOL poison pill can be an effective tool for loss corporations looking to protect their NOL carryforward assets. Loss corporations, however, should carefully think through all of the possible ramifications, including the potential consequences associated with the administration of the plan if the pill is triggered, and the potential effect of the ownership limitation imposed by the plan on the attractiveness of their stock in the market.


1 Unless otherwise stated, all references to "Section" are to the Internal Revenue Code of 1986 (the Code), and all references to "Treas. Reg. Sec." are to the Treasury Regulations promulgated thereunder (the Regulations).

2 Section 382(g).

3 The Section 382 limitation is a formulaic calculation that is basically equal to the product of the value of the loss corporation (subject to certain adjustments) and the long-term tax-exempt rate. The long-term tax-exempt rate is published on a monthly basis by the IRS and can be found in IRS publications, including the Internal Revenue Bulletin. Taxpayers are required to use the long-term tax-exempt rate for the month in which the ownership change occurs when calculating their Section 382 limitation for any ownership change. For example, the long-term tax-exempt rate for June 2009 was 4.61 percent per Rev. Rul. 2009-16, 2009-23 IRB.

4 Recently, a number of companies have adopted rights plans to protect against limitations in their ability to use their net operating loss carryforwards. See Sirius XM Radio, Inc. Form 8-A filed with the SEC on April 29, 2009.

5 Section 382(l)(3)(A)(iv). Treas. Reg. Section 1.382-4(d).

6 Rev. Rul. 90-11, 1990-1 C.B. 10. Note that this Rev. Rul. was issued before the option attribution rules were substantially changed by T.D. 8440, 10-2-92.

7 Also See PLR 200841021 (October 10, 2008) (rights plan adopted as part of a Section 368(a)(1)(E) recapitalization will not be considered an acquisition of stock for Section 382 purposes). Under Section 6110(k) a private letter ruling may not be cited as precedent by a taxpayer who did not receive the ruling. However, a private letter ruling may be considered under Treas. Reg. Section 1.6662-4(d)(3)(iii) in determining whether a tax position is supported by substantial authority.

8 See Treas. Reg. Section 1.382-4(G)(6).

9 Amended Verified Complaint, Selectica, Inc. v. Versata Enterprises, Inc., No. 4241-VCN (Del. Ch. Jan. 3, 2009).

Robert A. Friedel and Todd B. Reinstein

The material in this publication is based on laws, court decisions, administrative rulings, and congressional materials, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship. Internal Revenue Service rules require that we advise you that the tax advice, if any, contained in this publication was not intended or written to be used by you, and cannot be used by you, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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