As noted in our last report, tax reform will impact the media industry in many ways, including those in the industry responsible for reporting on the widespread effects of these sweeping changes to existing tax law. In this installment, we will explore new limitations which will specifically impact media companies’ restructuring, acquisition and disposition strategies.
The Tax Cuts and Jobs Act (TCJA) contains new limits on a corporation’s ability to take advantage of its net operating losses (NOLs), which may harm traditional media companies disproportionately operating as corporations (click here for more). As a result of the TCJA, corporations generally will be able to utilize NOL carryovers against only 80% of their taxable income in future years, and carrybacks are eliminated. Notably, this change affects losses arising in 2018, so NOL carryforwards from 2017 and earlier are not subject to the 80% limit (or carryback repeal) – which may accelerate business transactions that originally were contemplated to occur further down the road for media companies than 2018. While we already expect to see more M&A activity in this sector due to the 40% decrease in the corporate tax rate, target media companies with large NOLs otherwise may be considered less attractive due to the limited opportunity to use prior losses in future years. Of course, taxpayers already had been subject to limits in their ability to “traffic” in losses by purchasing such “loss companies” – namely, Code Section 382 limits the ability of a corporation, following an “ownership change” (a defined term, but one that includes most M&A activity) to use “pre-change” losses against “post-change” income. Because the limitation is the value of the corporation at the time of the change multiplied by a prescribed rate, there may be circumstances where it is not a material impediment (i.e., where the value of the enterprise is high). However, even there, and certainly where the Code Section 382 limitation already is severe, this new NOL limit further devalues the tax benefit. As a result, 2018 may be a banner year for media acquisitions, as companies try to close transactions ahead of this change.
The new NOL limitation also may have a large impact on strategic decisions media companies must make on whether to restructure their debt. Generally, when debt is forgiven or reduced, borrowers are taxed on the amount of debt from which they are, or are deemed to be, relieved (cancellation of indebtedness, or COD, income). As noted here, a company looking to restructure its debt and facing the possibility of COD income could rely on: (1) large NOL carryovers to shield taxable COD income and (2) an exclusion of COD income from taxable income for a debtor who is in a bankruptcy case or insolvent (but, in the latter case, only to the extent the debtor’s liabilities exceed its assets). Where the COD income is excluded, such exclusion is at the cost of reducing certain attributes of the debtor, notably NOLs and depreciable tax basis. As we have explored previously, but revisit here in the context of media restructurings, the new NOL limitation is a new headache for a taxpayer that cannot exclude COD income (in whole or in part). If the taxpayer has (noncash) taxable income from cancellation of debt and insufficient current year losses to shield such income, it could have tax for the year of the restructuring as a result of no longer having a full NOL carryover – and no related cash with which to pay it.
Again, given that the 80% limitation (and carryback repeal) applies to losses arising in taxable years beginning in 2018, more restructurings in 2018 may be expected. Of course, many restructurings will continue to result in excluded COD income. Though not specifically addressed in the new law, we would expect the entire NOL (i.e., not limited to 80% of current taxable income) to be available for reduction against such excluded COD income. Considering that insolvent media companies not in bankruptcy only can exclude COD income (and reduce its tax assets) to the extent of insolvency, following 2018 we may see more media workouts in bankruptcy (possibly prepackaged) to avoid the direct impact of the 80% limitation.
The new interest deduction limits also could be an issue for media companies. Under the TCJA, interest on indebtedness generally may be deducted only up to an amount equal to the sum of business interest income and 30 percent of adjusted gross income (the Interest Deduction Limit) (click here for more). The disallowed interest may be carried forward indefinitely to succeeding taxable years and also may impact media companies’ restructuring decisions. As media companies do not typically function as lenders or invest in debt, the new limit effectively is 30 percent of adjusted gross income (and, beginning in 2021, without deduction for depreciation, amortization or depletion). Thus, the new provisions may act as a 30% taxable income limit (with no interest income buffer). However, media companies incur debt and, whereas the new NOL limitations may impact future restructurings, the Interest Deduction Limit may alter the manner in which media companies borrow and restructure existing debt. Generally, there is no COD income recognized to the extent the payment of a liability would have given rise to a deduction. Under prior law, this meant that interest generally was not included as COD income if it was deductible. As we discuss here, it may be this exception could be read to apply only to the extent that the interest is deductible in the year after the Interest Deduction Limitation is applied. On the other hand, the indefinite carryover could be interpreted to mean that the interest will be deductible at some point (assuming no other limits apply), thus any unpaid interest should continue to be excluded from COD income. To the extent this issue remains unclear, it could impact the ability of media companies to restructure.
As we discussed in our first Bracewell Tax Report (click here), we may see more companies looking to preferred equity investment (rather than debt) as a result of the Interest Deduction Limitation (and the NOL limits, to the extent otherwise deductible interest creates or increases NOLs that now may be viewed as less valuable). Going forward, we may see both debt for preferred equity exchanges as well as new placements of preferred equity. Given to whom this type of investment typically is attractive, the media industry may be well-positioned to be an exciting new area for private equity investment.
Finally, the repeal of like-kind exchange treatment other than for real estate also stands to disproportionately affect media transactions. Prior to the TCJA, Code Section 1031 allowed for tax-free treatment where property held for use in a trade or business or for investment was exchanged for like-kind property (also held for use in a trade or business or for investment). Television and radio station owners historically switched stations amongst themselves in order to better take advantage of broadcast areas which provided them with more conducive audiences, often in multi-party transactions. This became especially attractive after 2000 once the IRS began ruling (albeit privately) that FCC licenses – even television and radio licenses – were like kind, a point that had been greatly debated due to the differing range, geography and demographics each station could provide.1 However, new Code Section 1031(a)(1) limits like-kind exchanges to real property, leaving owners of personal property, such as FCC licenses, out in the cold. Moreover, as FCC licenses are not tangible personal property, they will not be eligible for the new immediate expensing provisions of Code Section 168(k) (click here for more) which would have offset the loss of like-kind exchange treatment. This repeal will likely have a chilling effect on such transactions, generally seen as beneficial and promoting efficiency the industry.