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But like in a real world, exceptions are there in a corporate world too. Net operating loss is one such exception.
- What is Net Operating Loss or NOL?
- Example 1 (without net operating losses)
- Example 2 (with Net Operating Losses)
- Carry backs & Carry forwards
- Accounting Treatment of Net Operating Losses
- Sources of Net Operating Loss
- Net operating losses and Mergers and acquisitions
- Protection of Net operating losses – Poison pills
Here we discuss Net Operating Los, however, if you want to know more about M&A, you can look at M&A (Mergers and Acquisitions) Training.
What is Net Operating Loss or NOL?
According to US Federal tax law, a net operating loss (NOL) is a loss arising in a period when the tax – deductible expenses exceed taxable revenue. This loss can be carried forward in future to set off future profits allowing the corporates to pay lesser tax then required. To put simply, Net operating loss is a blessing in disguise.
source: 2015 10K Godaddy
Let me explain you how it works with the help of simple illustration.
Example 1 (without net operating losses)
Let’s suppose, Pine- Apple Inc. in 2015 had a taxable revenue of $ 500,000, taxable expenditure of $ 600,000. In 2016, on account of change in the economic factors, it made a taxable revenue of $ 1,000,000 and taxable expenditure of $900,000. Tax rate 50%. Let’s see how much tax it has to pay in both the years. Assume carry forward of losses not allowed.
Computation of Tax expense for year 2015
|Net operating loss||(100,000)|
* Since tax is always paid on profit and not losses. Hence tax paid in 2015 is nil
Computation of Tax expense for year 2016
|Net operating Profit||100,000|
We have seen above that the total tax paid in both years (2015 & 2016) by Pine- Apple Inc. is $50,000 (0 +50,000). Please do note that in above example we have made an important assumption, carry forward of losses are not allowed. Well, this is not how things actually works. In real world, carry forward of losses are always allowed by the Federal and State Governments subject to fulfillment of certain conditions and tax provisions.
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Example 2 (with Net Operating Losses)
Let’s see the impact carry forward on tax paid.
Computation of Tax expense for year 2015
|Net operating loss||(100,000)|
* Tax loss of $ 50,000 in 2015 can be carried forward in 2016 and can be set off against the future taxable profits
Computation of Tax expense for year 2016
|Net operating Profit||100,000|
|Carry forward of tax loss from 2015*||(50,000)|
Total tax paid in both years is nil.
Thus we can see how the net operating loss of $100,000 has turned out to be a blessing in disguise in 2016, since the carry forward of tax loss of $50,000 on account of net operating loss in 2015 has lowered the net operating profit in 2016, thereby reducing the tax paid.
Carry backs & Carry forwards
The above example depicts the carry forward of net operating losses.
- The regulatory provisions also allows for the carrybacks of net operating losses.
- Net operating losses can be carried back 2 years and can be carried forward 20 years for set off against the income in past and future periods, respectively.
- Beyond and after 2 and 20 years, any remaining net operating losses pending set off expires.
- There is an option available to company for waiving off the carry back period and directly use the carry forwards, but this is hardly availed by any Company since the principle of present value dictates that the value of savings in earlier periods is greater than the value of savings in later periods.
- Corporations have a huge fluctuations in taxable income and expenses, which results in taxpayer having substantial profits in one year and losses in other year.
- In order to overcome this temporary fluctuations and provide relief to corporates against unfavorable business cycle, carry forward and carry back provisions have been provided by the Government.
Rule of set off of net operating losses in order to maximize the savings:
- First set off the NOL by carrying it back to preceding 2 years. If any losses are still available for set off then,
- Set off the NOL in next year and carry forward it for next 20 years
- Any remaining NOL expires after 20 years and has no value.
Following the above sequence while availing tax credit ensures the maximum savings to company on account of net operating losses.
Tax Carryback Example
Iron and Steel Company reports a pretax operating loss of $90,000 in 2007 for both financial reporting and income tax purposes, Financial income and taxable income for the previous 2 years is as per below.
What is the Income tax refund receivable?
Tax Carryforward Example
Forward Company reports a pretax operating loss of $60,000 in 2007 for both financial reporting and income tax purposes. The income tax rate is 30% and no change in the tax rate has been enacted for future years.
What is the deferred tax asset created?
Accounting Treatment of Net Operating Losses
Net operating losses are assets of the Company since it reduces the future tax liability. Under further asset classification, it is classified under deferred tax asset. A deferred tax asset is created on account of temporary differences, that reduces the taxable income. A deferred tax asset is created on the assumption that the company will earn sufficient profits in the future from which past net operating losses can be set off.
Company will pass following journal entries for its creation:
Deferred tax assets A/c
To Income Statement A/c
Deferred tax assets on account of net operating losses are presented and disclosed under Non – current assets in the Balance Sheet.
Sources of Net Operating Loss
One of the most important thing to note is that the net operating loss is the excess of taxable expense or deductions over the taxable income. Taxable income or expenses are different from the normal business income or expenses.
Accounting net profit or net profit mentioned in the Income statement is derived after deducting all business expenses (depreciation, employee expenses, cost of goods sold and etc.) from the revenue earned by the Company. Whereas as per the tax laws, certain business expenses are not allowed to be deducted from the revenue. Hence the net profit or loss as per the tax laws will always be different from the normal profits as disclosed in the financial statements. For example, Net profit earned by the Pepsico Inc. in 2015 is $5,452 MN. This figure which is disclosed in the Pepsico financial statement is the accounting net profit which will be significantly different from the tax profit. Following tax deduction or allowances generally increases the net operating losses:
- Normal business or trade expenses
- Deductions on account of business related expenses as an employee
- Deductions for abnormal business losses
- Deductions for losses arising in the associated business companies
Net operating losses not only arises in case of Companies but also for Individuals, estates and trusts. As per the IRS code partnerships cannot use NOL. Net operating losses are generally caused by deductions from trade or business, casualty and theft losses, rental property and etc.
Net operating losses and Mergers and acquisitions
As depicted above, net operating loss deduction allows the company to carry back and forward the loss and allows setting off taxable profit against it, this minimizes the disparity that would otherwise result between businesses with stable profits and business with fluctuating profits.
This calls for the careful consideration by the Strategic decision makers while chalking out plans for mergers and acquisitions of companies. Many corporate look out for the companies that have huge accumulated net operating losses rather than operating profits. Operating losses helps to reduce the group’s tax expense thereby resulting in increase in overall net profits.
In Corporate world we can see many examples of hostile takeovers on account of net operating losses. Companies look out for the target companies with huge accumulated losses. In order to safeguard the interests of those companies IRS had modified the IRS Code. Section 382 of IRS Code limits a loss corporation ability to carry forward and set off net operating losses if an ownership change has occurred. Since IRS Code are applicable in the United States hence this restrictions are applicable for companies registered in the United States. But many countries have placed similar restrictions in their statue books.
Rules surrounding section 382 are complex and are triggered by unique facts and circumstances surrounding each particular company and transaction. These complex rules require careful analysis. The application of section 382 is further complicated by companies having multiple classes of stock outstanding.
Some of key issues financial planners needs to be concerned with at the time of mergers and acquisition are:
- Does the target have net operating losses? If yes, can it be carried forward and the number of years up to which it can be carried forward?
- The effect the change in ownership will have on the accumulated balance of net operating losses?
- Whether provisions of section 382 will allow carry forward of net operating losses? Since rules and regulations of section 382 are complex, whether independent tax expert view has been obtained?
In acquisitions, it is not only the acquiring party that will need to understand the target’s NOL. Sellers should also determine the correct value of net operating losses since their compensation amount will include the NOL’s value.
Protection of Net operating losses – Poison pills
Net operating losses are tax assets which can be carried forward or backward to set off future taxable income. Their use, however, is subject to certain restrictions. We have already seen the restriction above where they are not allowed to be carried forward in case of change in ownership of companies in case of mergers and acquisitions. As per the IRS code, change in ownership is triggered by an ownership increase of 50 percentage points by corporation’s five percentage shareholders.
- To prevent such outcome, Companies resort to a strategy known as poison pill.
- A poison pill is a strategy adopted by the Corporate to prevent or discourage hostile takeovers.
- In order to counter the trigger of ownership change, management adopts shareholders rights plans (poison pills) which limit the possibility of change in ownership by placing limitations on the accumulation of the company’s shares through amendment in its articles of association.
- A NOL poison pill plan attempts to discourage anyone from acquiring shares by providing that all the other shareholders get benefits that are not allowed to an acquiring person.
- It penalizes acquiring shareholders by devaluing the stock they have just acquired. NOL poison pills discourage both hostile and friendly takeovers.
There is also one important point to note that each country has their own rules and regulations which governs the set off and carry forward of operating losses. These rules and regulations are complex and require careful considerations of each provision. For e.g. in the United States, each state has its own rules and regulation governing the tax code. Thirty states and DC conform to the federal tax code of allowing 20 years of NOL carry forward. While Illinois allows 12 years, Kansas and Vermont allows 10 years.
Net operating loss deductions are important safeguard provided to corporation especially those businesses which operate in industries that fluctuate with the business cycle. Such cyclical business might experience significant profits during boom cycle and significant losses during recession cycle. Set off and carry forward of losses of those corporations helps them smoothen and even out their income with respect to time. During the recession of 2008, many companies had generated net operating losses and subsequently utilized it when the economy recovered from recession.
NOLs are important assets for companies. It works on the pay as you earn principle. When Company earns profits it pays taxes, when it incurs loss, it gets some relief. Hence they are valuable assets. In fact, some Companies purchase other companies solely for their net operating losses.
Famous Persian poet Rumi said “Don’t grieve. Anything you lose comes round in another form”. The same could be said with respect to Net operating losses.
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