What will the tax landscape look like post-COVID? Tax accountability starts with tax accounting
Can you explain the carry-forward losses by country and the valuation of these losses?
Hopefully, my previous blog on the build-up of the tax payable/receivable position has helped you in understanding the tax-related cash outflows, inflows, and intra-group settlements that occur during a year. If so, was the information clear? Are you now ready for some help on the fourth tax accountability question: “Can you explain the carry-forward losses by country and the valuation of these losses?”
Carrying-over tax losses
In difficult times, companies might not always remain profitable. With the so-called carry-over tax loss facility, most tax authorities will allow companies to offset a tax loss that is incurred during a fiscal year against the taxable profits derived in the past (preceding year) and/or future (subsequent years), under certain conditions. This tax loss relief deduction is a form of loss compensation that is commonly referred to as carry-back if the loss may be credited with taxable profits from the past, or carry-forward if the loss may be credited with taxable profits derived from the future profits. The future benefits of this form of tax relief are one the of the more important events in the tax accounting landscape. In principle, such a future tax benefit must be valued under the application of generally accepted accounting principles (“GAAP”), which will result in a so-called deferred tax asset (“DTA”) on the commercial balance sheet of the company. This DTA item will therefore show up in the accounts for that financial year. The value is computed as follows:
SUM ([country‘s tax rate] X [carry-forward losses]) -/- [portion disallowed / not recognized]
In practice, the biggest challenge involves the last part of the above formula, i.e., the disallowable / non-recognized portion. The positions taken may therefore result in an under- or overvaluation of the DTA item on the balance sheet.
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Undervaluation of carry-forward losses
Sometimes, carry-forward tax losses are used by a company as an excuse not to follow best tax accounting practices. For example, I get responses such as “â€¦ we will start worrying about our tax position as soon as we are profitable” or “â€¦ our carry-forward losses are not valued because of their magnitude.” I also come across situations where net deferred liabilities (i.e., expected future tax liabilities) exist – but at the same time, the losses are not valued at all. If a company expects a future tax liability, then such liability should be set-off against the available carry-forward losses (this is only different in a case where the time periods of the actual tax liability do not match the time periods when the losses can be utilized).
In my view, these types of misunderstandings come at a cost. When a company‘s loss position is converted into a profitable position, the valuation of these losses typically starts 3-5 years earlier! Furthermore, losses should always be valued to capture the future expected profits, or at a minimum to offset the deferred tax liabilities and/or tax contingencies. Although the valuation of a tax loss does not create immediate cash tax savings, it increases the equity of a multinational corporation and may therefore be commercially useful.
Overvaluation of carry-forward losses
The opposite (an overvaluation of the tax losses) can also be a cause for concern. I have come across situations where, despite having a history of recent losses, a multinational has recognized material DTAs, sometimes over a prolonged number of years, without having sufficient evidence to support their expectation that a taxable profit will be available in future periods against which the unused tax losses can be used.
The right valuation
There is no set rule of how the probability must be determined when recognizing DTAs from unused tax losses. The consensus is that the probability should be based on a “more likely than not” threshold (i.e., >50 percent) considering all the available evidence, both positive and negative. This includes:
- Losses that have occurred due to identifiable one-time/non-recurring events
- A strong earnings history, exclusive of the loss that has created the unused tax loss that is carried forward (provided that the loss is not expected to recur)
- New business opportunities, e.g., a new patent
- Restructuring or a disposal which clearly eliminates the loss sources
- Convincing tax planning strategies
- Firm sales backlog or new contracts (also considering the past realization of a sales backlog)
- Business acquisitions generating sustainable profit margins, which are sufficient to enable the issuer to utilize the existing tax losses carried forward that can be utilized for that purpose (e.g., those in the same tax jurisdiction)
- A recent history of operating losses for tax purposes
- The taxable entity is a start-up business
- History of significant variances in the actual outcomes against the business plans
- Losses of major customers and/or of significant contracts
- Uncertainty regarding the issuer‘s going concern
- History of restructuring without returning to profitability or emerging from a bankruptcy
- The taxable entity expects losses in the next few years
- The taxable entity has a history of unused tax losses and/or credits expiring
- Losses relate to the core activity of the issuer and thus may reoccur in the future
- Estimates/forecasts extend long into the future, so they are less reliable
- Tax losses have a short expiration period
Other benefits of understanding the carry-forward loss position
Alert for incorrect transfer pricing
Besides the value of the losses in the financial statements, I believe the “alert” that arises from persistent carry-forward losses is an equally important matter. Typically, a commercial business exists by virtue of being profitable. In other words, the chances that losses exist in a certain territory are often short-term or caused by incorrect transfer pricing policies.
I sometimes challenge CFOs by asking them: “If you have such persistent losses in this business entity, why don‘t you close it?” I often get a funny look and the response: “Why?” Then I say: “No good entrepreneur would keep open a long-term loss-making business.” A more interesting discussion may then start on how the business entity is suddenly of strategic value, or that the CFO is trying to penetrate a particular market, etc. My simple response is then: “Oh, so then the losses do have value and there is a likelihood that your transfer pricing is incorrect.” According to the OECD Guidelines, when a company that belongs to a multinational group consistently generates losses while its multinational parent remains profitable, the authorities will start to analyze its tax practices, paying particular attention to the transfer pricing policies.
The benefit of proper tax accounting is that it provides a helicopter view of all losses globally, by country and even by reporting entity, as well as the historical movements and valuation of these losses. In my humble view, this creates a unique opportunity to understand the state of your tax control framework. Persistent losses in multiple locations indicate that the controls and transfer pricing policies are weak and should be addressed. Besides risks, understanding the tax loss situation by country also offers an opportunity. Although in today‘s tax landscape tax planning is no longer accepted, dealing with tax losses (i.e., a better distribution of a company‘s profits and losses by managing a solid transfer pricing policy) may be the only acceptable tax optimization activity.
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Hopefully, you now have a better understanding of how to answer the question, “Can you explain the carry-forward losses by country and the valuation of these losses? I am happy if you simply remember toâ€¦
Be wary of persistent tax losses in multiple locations!
Need some help? TaxModel is contributing to a more transparent tax world. We are building TaxProof 2.0, a standardized tax accounting solution that is accessible and affordable for companies of every size!
So, as the CEO, ensure your company pays its fair share of taxes and be transparent about it! This is the only way to prove that you are a socially responsible corporation!
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