How are Losses Treated in Corporate Tax?

Corporate income tax is collected when there is corporate income i.e. when the revenue collected by the corporation exceeds the expenses incurred by this. However, this need not always be the case. It is equally possible that a corporation may incur more expenses than it earns in revenue, thereby incurring a loss. This is truer in the current scenario wherein coronavirus has obliterated the revenues of many businesses almost overnight. However, these businesses still have to pay overhead expenses.

The tax treatment of corporate losses is important to many corporations. This is because this treatment exposes the fairness of the tax system as a whole. If a government wants its cut when the company earns a profit, it should allow some leniency when the corporation is making a loss. In this article, we will have a closer look at how losses are treated as far as tax calculation is concerned.

Tax Treatment of Corporate Losses

The American tax system, like most other tax systems in the world, allows companies to use the tax laws incurred in one year to offset the taxable income generated in certain years. However, there are certain rules which define how this offset can be done. This article explains the rules in detail.

The American tax system allows companies to use the loss generated in the current year to offset the taxable income in the past two years. For instance, if a company has made a profit in the past two years, then the present losses can be used to reduce the income in the past two years. Now, the problem is that the corporation has already paid taxes on the income, which was generated in the past two years. To overcome this problem, the tax rules allow an immediate adjustment in the previous year’s income. Such an adjustment ends up triggering a tax rebate. This system is called “carryback” of losses.

If the company does not want to carry back its losses, it also has the option to carry forward the losses. This means that the loss will not reduce the income in the previous years. Instead, it will offset the income generated in the future years.

Each country has a restriction on the number of years during which this offset can be done. In the case of the United States, the period is twenty years. This means that the company has the option to offset the losses against the future income for as long as twenty years.

Sometimes corporations wait to use the loss offset to reduce the income in a particular year when they expect high income.

However, the common wisdom is that the losses should be offset as soon as possible. This is because early offsetting provides the firm with an advantage as far as the time value of money is concerned. This offsetting of losses against future income is called “carry forward” of losses.

If a firm is not able to utilize the losses even within twenty years in the future, then such additional losses are disallowed from the tax point of view. Also, if a firm generates losses in multiple years, then the losses first generated are deemed to be utilized first i.e., the first in first out principle is used.

Treatment of Tax Losses in Acquisitions

We now know that taxes incurred by an organization can be used to reduce their taxable income in the future. Hence, tax losses are considered to be a prized asset when companies are looking for acquisition targets.

There have been several cases in the past wherein profitable companies have acquired loss-making companies for the sole purpose of being able to use the losses and reduce their own tax liabilities. This is the reason that the American tax code has some rules regarding how tax losses should be treated in order to avoid misuse.

If the organization has witnessed a change in equity control i.e., more than 50% of the equity is now owned by new investors, then there are certain limitations on the use of tax loss to reduce the income. Companies with more than 50% change in ownership are deemed to be new entities.

In such cases, the United States tax authorities have created a specific set of rules which need to be followed.

For instance, there are pre-determined rates that determine the amount of tax loss, which can be offset in any given year. This rate is determined by the government and changed from time to time. However, companies with large losses still receive a premium when they are being sold out since the acquirer can still reduce their cash outflow by using the tax advantages.

Another important point to note is that if a company is genuinely facing a loss, this section restricts the company from issuing more shares in order to generate more funds. This is because if the company were to actually do so, it would adversely affect their cash flows due to loss of tax exemption.

The bottom line is that tax losses generated in one year are not lost in that year. Companies can use these tax losses to offset income, which has been generated in the past or the one which is going to be generated in the future.