Tax Loss Carryback and Carryforward
Tax loss carryback is when a corporation retrospectively adjusts its tax returns for prior periods if it incurs a net operating loss (NOL) in current period. Tax carryforward is when a corporation subtracts net operating loss from future period income.
A corporation pays tax at the statutory tax rate on its taxable income. When its taxable deductions are higher than its taxable revenues, a corporation is said to have incurred net operating loss (NOL). The year in which a corporation incurs net operating loss is called an NOL year. In such a situation, many tax jurisdictions allow corporations (and individuals) to use the net operating loss to reduce their tax obligations related to prior and/or future periods. For example, corporations in US which incur net operating loss are allowed to revise their tax returns from two prior years (starting with the earlier year) and claim tax refund from the IRS. If the tax loss exceeds the taxable income of the prior two years, corporations are allowed to subtract it from any operating income generated in future periods for a maximum period of 20 years.
Tax loss carryback
Tax loss carryback is when NOL year net operating loss is set off against taxable income in past periods. In US, tax loss carryback is optional i.e. a corporation may waive its right to carryback NOL and instead may opt to just carryforward the losses. Tax loss carryback results in recognition of income tax refund receivable.
Let’s say your company incurred a net operating loss of $40 million in 2017. Your taxable income for 2015 and 2016 were $10 million and $5 million. Assume a tax rate of 40% is applicable to 2015, 2016 and 2017.
You can use the $40 million NOL in 2017 to revise the tax return for 2015. This would result in a tax refundable of $4 million (=$10 million × 40%). You are left with NOL of $30 million, $5 million of which you can set-off by retrospectively adjusting tax return for 2016 and claiming a tax refund related to 2016 of $2 million (=$5 million × 40%). After exhausting the 2-year carryback option, you are still left with NOL of $25 million which you must carryforward to future period i.e. tax year 2018 onwards.
You will need to pass the following journal entry to recognize the tax carryback:
|Income tax refund receivable ($4 million +$2 million)||$6 million|
|Income tax expense (benefit)||$6 million|
This would result in a negative income tax year for 2017 i.e. a tax benefit and your net income will be higher than earnings before income taxes.
Tax loss carryforward
Tax loss carryforward is when net operating loss is a year is carried forward to reduce taxable income and income tax obligation in future periods. US allows corporations to carry forward losses for a maximum period of 20 years. Tax loss carryforward results in recognition of a deferred tax asset.
Let’s continue with our example above. $25 million of net operating loss related to 2017 couldn’t be carried back because the corporation ran out of available taxable income. The remainder of the NOL which can’t be carried back can be carried back for 20 years. If we expect enough taxable income to be available in future periods, a deferred tax asset must be recognized based on the statutory tax rates expected in future periods. Let’s assume expected taxable income is 2018, 2019 and 2020 is $8 million, $10 million and $20 million and the associated tax rates are 40%, 35% and 30%.
The following table summarizes the calculation of the deferred tax asset that can be recognized in 2017:
|USD in million||Calculation||2018||2019||2020|
|NOL balance at the start of the year||BNOL||25||17||7|
|NOL balance at the end of the year||ENOL = BNOL - A||17||7||-|
|Deferred tax asset||DTA = A × R||3.20||3.50||2.10|
Total deferred tax asset is $8.8 million. Please note that this is lower than the product of NOL balance at the start of the tax year 2018 and the 2017 tax rate because statutory tax rate has decreased in future periods thereby reducing the value of the tax loss carryforward.
The following journal entry would recognize the deferred tax asset arising from the tax loss carryforward:
|Deferred tax asset||$8.8 million|
|Income tax expense (benefit)||$8.8 million|
You may refer to IRS Publication 536 for detailed guiadance on US tax loss carryback and carryforward.