REVENUE RULE 90-15

1990-1 C.B. 93, 1990-7 I.R.B. 17.

Internal Revenue Service
Revenue Ruling

SEGREGATION OF OPTIONS UNDER SECTION 1.382-2T

Published: February 12, 1990

Section 382. - Limitation on Net Operating Loss Carryforwards and Certain Built- in Losses Following Ownership Change, 26 CFR 1.382-2T: Definition of ownership change under section 382, as amended by the Tax Reform Act of 1986 (temporary).
Segregation of options under section 1.382-2T. The segregation rules of section 1.382-2T(j)(2) of the temporary regulations do not apply to create separate direct public groups of shareholders with respect to options issued before September 4, 1987.

ISSUE

Whether a loss corporation has an ownership change on the issuance of warrants pursuant to the transitional rules of section 1.382-2T(m)(4) of the temporary Income Tax Regulations.

FACTS

SITUATION 1

L is the loss corporation for purposes of section 382 of the Internal Revenue Code. L had one million shares of common stock outstanding, its only class of stock. On January 1, 1987, L issued 818,000 shares of common stock to an individual investor, A. Except for investor A, no person has owned directly 5 percent or more of L common stock since May 5, 1986. On January 2, 1987, L issued warrants to acquire 400,000 shares of its common stock in a public offering. Investor A has never owned any of the warrants. The warrants have not lapsed and have not been exercised. At no time since the warrants were issued would acquisition of the L common stock subject to the warrants have caused any warrant holder to own directly 5 percent or more of L common stock.

L is required to make a determination whether an ownership change occurred on the date the warrants were issued, January 2, 1987. Section 1.382-2T(a)(2)(i) of the temporary regulations. For reasons unrelated to the warrants, L is required to make another such determination on September 4, 1987.

SITUATION 2

The facts are the same as in Situation 1, except the warrants were issued on September 4, 1987, and this is the only date on which L is required to make a determination whether an ownership change occurred.

LAW

Section 382 of the Code provides limitations on net operating loss carryovers, net operating losses, and unrealized losses of a 'loss corporation' that has an 'ownership change.' Generally, section 382(g)(1) provides that a loss corporation has an ownership change if the percentage of stock owned by one or more '5-percent shareholders' of the corporation has increased by more than 50 percentage points over the lowest percentage of stock of the corporation owned by such shareholders at any time during a 'testing period.' Generally, a testing period is the 3-year period ending on the 'testing date.' Section 1.382-2T(d)(1) of the temporary regulations; see section 382(i). The testing date is the date on which a loss corporation is required to make a determination whether an ownership change has occurred. Section 1.382- 2T(a)(2)(i).

Section 382(1)(3)(A)(iv) of the Code provides that, except as provided in regulations, options and similar interests will be treated as exercised if such exercise would cause an ownership change. Section 1.382-2T(h)(4)(i) of the temporary regulations provides that, solely for the purpose of determining whether there is an ownership change on any testing date, stock of a loss corporation that is subject to an option (or a similar interest, including a warrant) is treated as acquired by exercise of the option (warrant) on the testing date, if acquisition of this stock would result in an ownership change ('the option rule').

Section 382(k)(7) of the Code provides that the term '5-percent shareholder' means any person holding 5 percent or more of the stock of the loss corporation at any time during the testing period. However, under section 382(g)(4), persons who each own (directly or indirectly) less than 5 percent of the stock of the loss corporation may be aggregated or segregated into one or more groups that are treated as separate 5-percent shareholders. Sections 1.382-2T(g) and (j) of the temporary regulations provide rules to identify groups of such persons ('public groups') and to determine whether a public group is a 5-percent shareholder. As one example, a public group having a direct ownership interest in the loss corporation that is determined to be a 5- percent shareholder is treated as an individual unrelated to any other shareholder of the loss corporation, section 1.382-2T(j)(1)(ii) and (iii), and is referred to as a 'direct public group,' section 1.382-2T(j)(2)(ii).

Under section 1.382-2T(j)(2)(iii)(B) of the temporary regulations, if stock of a loss corporation is acquired pursuant to the exercise of a warrant (a transaction to which section 1032 of the Code applies), subject to the taxpayer's overcoming certain presumptions established by regulations, each direct public group that exists immediately after this transaction is segregated so that each direct public group that existed immediately before the transaction is treated separately from the direct public group that acquires stock in the transaction. Under section 1.382- 2T(j)(2)(iii)(D) of the temporary regulations, if stock of the loss corporation is treated as acquired pursuant to a deemed exercise under section 1.382-2T(h)(4)(i) of a warrant issued by the loss corporation, subject to the taxpayer's overcoming certain presumptions established by regulations, each direct public group that exists immediately after this deemed acquisition is segregated so that each direct public group that existed immediately before the transaction is treated separately from the direct public group that is deemed to acquire stock as a result of the issuance of the warrant. The determination of whether the deemed exercise rule of section 1.382-2T(h)(4)(i) applies to a warrant (that is, the determination of whether the acquisition of the stock subject to the warrant would result in an ownership change) is made after applying the segregation rule of section 1.382-2T(j)(2)(iii)(D).

Section 1.382-2T(m)(4) of the temporary regulations provides transitional rules for the application of the segregation rules in section 1.382-2T-(j). Under section 1.382-2T(m)(4)(i), section 1.382- 2T(j)(2) generally does not apply for purposes of determining whether an ownership change occurs for any testing date occurring before September 4, 1987.

An additional transitional rule is provided with respect to the application of the segregation rules for testing dates occurring on or after September 4, 1987. Section 1.382-2T(m)(4)(iii) of the temporary regulations (emphases added) provides:

For purposes of determining whether an ownership change occurs for any testing date on or after September 4, 1987, the rules of paragraphs (j)(2) and (3) of this section shall not apply to identify any public group resulting from - (A) any TRANSACTION described in such paragraphs (j)(2) and (3), unless that transaction is also described in paragraphs (m)(4)(i)(B) or (C) of this section, or (B) any disposition of stock acquired on or before May 5, 1986, but only if such disposition or other TRANSACTION occurs before September 4, 1987. Thus, for example, the rules of paragraph (j)(2)(iii)(D) of this section shall apply only to rights to acquire stock of the loss corporation issued on or after such date.

The issuance of warrants by a loss corporation to a direct public group is neither a transaction described in section 1.382- 2T(m)(4)(i)(B) or (C) of the temporary regulations (mentioned in subdivision (A) of section 1.382- 2T(m)(4)(iii), quoted above), nor a disposition of stock (mentioned in above- quoted subdivision (B)).

ANALYSIS

For section 382 of the Code to apply to a loss corporation, it must have an ownership change on the testing date; that is, one or more 5-percent shareholders of the loss corporation must experience an increase in ownership of loss corporation stock of more than 50 percentage points relative to their respective lowest ownership interests during the testing period. An increase in percentage ownership by a 5-percent shareholder can occur only if there are (or have been) at least two 5-percent shareholders of the loss corporation. Otherwise, the percentage ownership of the loss corporation by its only 5- percent shareholder would never change; it would always be 100 percent.

In Situations 1 and 2, immediately before the issuance of the warrants, L corporation had two 5-percent shareholders - the direct public group, composed of L common shareholders each of whom were less-than-5-percent shareholders, and investor A. The acquisition by A of the 818,000 shares of common stock on January 1, 1987, increased A's ownership interest in L (and decreased the direct public group's ownership interest in L) by approximately 45 percentage points (818,000 / (1,000,000 + 818,000)).

SITUATION 1

The first testing date is January 2, 1987, the date the warrants were issued. The segregation rule of section 1.382-2T(j)(2)(iii)(D) does not apply on this testing date to treat the warrant holders as a separate 5-percent shareholder because the testing date is before September 4, 1987. Section 1.382- 2T(m)(4)(i). For purposes of determining whether there is an ownership change on this testing date, L common stock subject to the warrants is treated as acquired by the warrant holders at the close of the testing date, and the warrant holders are treated as members of the direct public group, if the deemed acquisition of this L common stock by the warrant holders would result in an ownership change. Section 1.382-2T(h)(4)(i) of the temporary regulations. An exercise of the warrants on the testing date would raise the ownership interest of the direct public group of L from approximately 55 percentage points to approximately 63 percentage points ((1,000,000 + 400,000) / (1,000,000 + 818,000 + 400,000)). An exercise of the warrants on the testing date would decrease the ownership interest of investor A from approximately 45 percentage points to approximately 37 percentage points (818,000 / (1,000,000 + 818,000 + 400,000)). Thus, during the testing period, the increases in the ownership of L common stock are approximately 8 percentage points for the direct public group and 37 percentage points for investor A, for a total of only 45 percentage points. Accordingly, the warrants would not be deemed exercised under section 1.382-2T of the temporary regulations because the deemed exercise would not result in an ownership change of L.

Similarly, on the second testing date, September 4, 1987, there can be no ownership change resulting from issuance of the warrants unless the segregation rules and the option rules apply. Under section 1.382- 2T(m)(4)(iii)(A) of the temporary regulations, the transitional rule for testing dates on or after September 4, 1987, the segregation rules of section 1.382-2T(j)(2) generally do not apply to identify a public group resulting from a 'transaction' occurring before such date. As one example of a 'transaction,' the transitional rule states that section 1.382-2T(j)(2)(iii)(D) applies only to rights to acquire stock issued on or after September 4, 1987. Because the 'transaction,' that is, L's issuance of the warrants, occurred before September 4, 1987, section 1.382-2T(j)(2)(iii)(D) does not apply to segregate the warrant holders on the second testing date. As a result, the option rules do not apply because no shift in the ownership of the loss corporation results from the hypothetical exercise of the warrants in the absence of the application of the segregation rules. Accordingly, issuance of the warrants does not result in an ownership change on the second testing date.

An actual exercise of the warrants on or after September 4, 1987, would raise the issue of whether a new transaction has occurred for purposes of section 1.382-2T(m)(4)(iii)(A). However, solely for the purpose of interpreting this transitional rule, the exercise of a warrant issued before September 4, 1987, relates back to the issue date of the warrant. Therefore, in Situation 1, regardless of when the warrants actually are exercised, the segregation rules of section 1.382-2T(j)(2)(iii)(B) of the temporary regulations do not apply to the actual exercise. For the same reason that the deemed exercise of the warrants would not cause an ownership change, the actual exercise of the warrants would not cause an ownership change.

SITUATION 2

The only testing date is September 4, 1987, the date the warrants were issued. Because the issue date is on or after September 4, 1987, the transitional rules of section 1.382-2T(m)(4) of the temporary regulations do not apply. Hence, the segregation rules of section 1.382-2T(j)(2)(iii)(D) apply to treat the warrant holders as a direct public group separate from the direct public group of L common shareholders existing immediately before the issuance.

For purposes of determining whether there is an ownership change on this testing date, L common stock subject to the warrants is treated as acquired by the warrant holders at the close of the testing date if the deemed acquisition of this L common stock by the warrant holders would result in an ownership change. Section 1.382- 2T(h)(4)(i) of the temporary regulations. Acquisition of this L common stock by the warrant holders would result in an increase in their ownership interest from zero to approximately 18 percentage points (400,000 / 1,000,000 + 818,000 + 400,000)). An exercise of the warrants on the testing date would decrease the ownership interest of investor A from approximately 45 percentage points to approximately 37 percentage points (818,000 / (1,000,000 + 818,000 + 400,000)). Such an exercise would result in increases in ownership of L common stock during the testing period of approximately 18 percentage points for the separate direct public group made up of warrant holders and 37 percentage points for investor A, for a total of 55 percentage points. Accordingly, the warrants would be deemed exercised under section 1.382-2T of the temporary regulations because the deemed exercise would result in an ownership change of L.

HOLDING

Under the transitional rules of section 1.382-2T(m)(4) of the temporary regulations, the segregation rules of section 1.382- 2T(j)(2)(iii)(B) and (D) (concerning, respectively, the actual and deemed exercise of rights to acquire stock) do not apply to treat the warrant holders as a 5-percent shareholder separate from the direct public group of L common shareholders, unless the warrants were issued on or after September 4, 1987.

In Situation 1, the segregation rules do not apply because the warrants were issued on January 1, 1987, and a deemed exercise of the warrants does not result in an ownership change on either testing date.

In Situation 2, the segregation rule of section 1.382- 2T(j)(2)(iii)(D) of the temporary regulations applies on the testing date to treat the warrant holders as a 5-percent shareholder separate from the direct public group of L common shareholders. Because increases in the percentage ownership of L common stock attributable to the purchase by A and the deemed exercise of the warrants during the testing period totals more than 50 percentage points, an ownership change of L has occurred on this date.

DRAFTING INFORMATION

The principal author of this revenue ruling is David P. Madden of the Office of Assistant Chief Counsel (Corporate). For further information regarding this revenue ruling, contact Mr. Madden at (202) 566-3205 (not a toll-free call).

Rev. Rul. 90-15, 1990-1 C.B. 93, 1990-7 I.R.B. 17.