As governments struggle to bring COVID-19 under control, they are also amending tax and other laws to mitigate the pandemic’s economic impact. Some experts say revising tax carryforward laws could play an important role.
In recent years complaints that multinational companies employ slick tax avoidance strategies to lower their corporate tax liabilities have led to calls for minimum taxes. One way to increase a company’s tax liability is by limiting the amount of operating loss in one taxable period that can be used to offset profits in another, which is what happened in the United States with the passage of the Tax Cuts and Jobs Act in 2017. The Senate voted to reverse that March 25, when it approved the Coronavirus Aid, Relief, and Economic Security Act (H.R. 748). After days of negotiations, congressional leaders reached bipartisan agreement on H.R. 748, which includes a lengthy list of tax incentives, including provisions restoring NOL carrybacks.
“Tomorrow we’ll bring the bill to the floor. It will pass with strong bipartisan support,” House Speaker Nancy Pelosi, D-Calif., said during a March 26 press conference.
The question of whether tax loss carrybacks or carryforwards should be allowed is complicated by the accounting convention of evaluating a company’s results in 12-month increments. Eric Pichet, a professor of economics at the Kedge Business School in France, said it makes sense to treat each year as a separate period for tax purposes, instead of looking at a company as an ongoing concern that can have both profitable and unprofitable years.
“Tax law is not completely autonomous [with respect] to the other business disciplines,” Pichet said in an email. “Treating taxes each year is just using the accountancy slot of time necessary to give official information to the shareholders and stakeholders of a company, so it is a practical issue. In France, we have developed a theory about ‘the autonomy of tax law,’ which is generally considered [by] tax researchers as a ‘cream pie,’ something [that is] delicious for French intellectuals but not really necessary to understand reality.”
Stuart Adam, a senior research economist at the Institute for Fiscal Studies in London, said he doesn’t agree that tax law should ignore the fact that a company can have cumulative losses exceeding a given year’s profits. “It doesn't make sense to treat each period separately, unless you're going to go whole hog and give outright refunds for losses, which governments are understandably wary of doing,” he said. “It is very important that genuine losses can be offset to avoid discouraging risk-taking. If you're not going to give immediate refunds, then you have to look at the loss-making period alongside other, profit-making, periods.”
Eric Zwick, a finance professor at the University of Chicago, said loss carryforward provisions attempt to compensate for a mismatch between current-year taxable profits and accumulated losses. “I agree that they're now somewhat limited, but I would argue that it's still closer to providing some insurance across years,” he said.
Eugene Seago, Curling Professor Emeritus of Accounting and Information Systems at Virginia Tech, said net operating loss carryback and carryforward laws serve as “an averaging system” to deal with the problem of current-year profits reported by a company with cumulative losses. “The ability to carry losses to prior years has the advantage of serving as an automatic economic stabilizer; that is, when the economy is in the down period of the economic cycle, businesses can receive tax refunds that are used to stimulate economic activity when it is most needed,” he said. “The ability to carry losses forward, after loss carrybacks have been exhausted, simply gives recognition to the concept that an entity should not be taxed on one year’s income when the lifetime income is negative.”
Loss carryforward provisions can provide economic stimulus when no stimulus is required because a rebounding economy might be the reason a company has otherwise taxable income in a later current period, Seago said. “Therefore, allowing a loss carryback is countercyclical,” he said. “Carryforwards are pro-cyclical but are justified by the concept that the tax should be levied on the basis of the ability to pay.”
Laws Limiting Loss Offset
Pichet said that while French law places no restrictions on the number of years a loss can be carried forward to offset future profits, companies are limited to an annual offset of €1 million, plus 50 percent of current-year profits.
Adam said U.K. laws limiting loss offsets are complicated. “Some are necessary to prevent abuse, while others, I think, are undesirable,” he said. “In recent years there have been significant moves toward further restricting loss offsets, albeit with some minor relaxations too, which on the whole I think are unfortunate.”
Adam cited as an example the 2016 budget, which restricted carryforward loss offsets to 50 percent of profits when they exceed £5 million. “I would like to see loss offsets restricted only where really necessary to prevent abuse,” Adam said.
John D. Fitzgerald, an adjunct professor of economics at Trinity College Dublin, said Ireland allows loss carryforwards, which have been a recent subject of controversy for the country’s financial sector since its recovery from the recession of the late 2000s and early 2010s. In 2014 the government allowed banks to carry forward 100 percent of their losses for up to 20 years. Previously, banks could deduct only 50 percent of a year’s losses against taxable income in future periods.
“As a result of losses in the 2008-2013 period, banks still pay very little corporation tax,” Fitzgerald said. “One party in the recent election proposed limiting [carryforwards] for banks. However, they seem unlikely to be in government.” The party — Sinn Fein — secured one fewer seat in the February 8 parliamentary election than the Fianna Fáil party, which came in first by capturing 38 constituencies.
Adam said loss offset limitations could hinder companies' ability to rebound from the pandemic. “They could also affect firms' behavior during the crisis itself — their willingness to take on losses — if they're not sure they'll be able to offset them,” he said.
Fitzgerald said he doubts that more liberal tax carryforward rules would be very helpful. “I don't think this is a major issue in tackling the crisis,” he said. “The key challenge is to ensure that companies survive.”
Pichet agreed, saying French tax carryforward laws will not make it more difficult for companies to recover from the impact of COVID-19.
Zwick said the ability to carry back losses to offset prior-year profits has been used to soften the impact of prior recessions in the United States. “That option was abolished in the Tax Cuts and Jobs Act,” he said. The TCJA abolished the two-year loss carryback provision of section 172. The legislation also reduced from 100 percent to 80 percent the amount of loss in a tax year that could be carried forward, and did away with the limitation that losses could be carried forward for no more than 20 years.
Legislative Action to Counter COVID-19
On March 21 the OECD outlined emergency tax measures, including loss carryback provisions, that governments can adopt to respond quickly to the economic fallout of the coronavirus pandemic.
Adam said it's possible that the U.K. government will relax loss offset restrictions in some way. “During the 2008-2009 crisis, they temporarily allowed more liberal carryback of losses, for example,” he said. But I don't know what they're likely to do, and I'd guess it might not be their number one priority at the moment.”
Seago said NOL carryforwards should be allowed because they are consistent with the concept of taxing on the basis of ability to pay. “Perhaps more important, the ability to carry losses to prior years should be reinstated in our tax laws because of the extraordinary economic conditions that are being created by the coronavirus,” he said, shortly before the Senate passed H.R. 748. “Congress should restore the net operating loss carryback [because it] would be a countercyclical force, providing tax refunds when businesses are strapped for cash due to the loss of revenue caused by the coronavirus.”
Seago said a reasonable way of delivering the countercyclical benefits of a loss carryback under current economic conditions would be to allow businesses to claim a “tentative” refund in 2020 of prior taxes paid. “The refund would be based on an estimated loss for 2020, calculated by using the assumption that the business will have the same expenses in 2020 as the average for the three previous years, but gross profits from sales for 2020 will be two-thirds of the average three preceding years,” he said. “The use of two-thirds of revenue is based on the realistic assumption that businesses in general will lose four months of usual revenues in 2020 because of the widespread closures of businesses. If the actual loss for 2020 is greater or less than the tentative calculations, adjustments can be made similar to amended returns.”
The carryback system should be modified by applying losses on a last-in, first-out basis, instead of the first-in, first-out basis previously in effect, Seago said. “Furthermore, as in 2008, it would be appropriate to allow the carryback for five years rather than the three-year carryback period used for over 50 years,” he said.
According to the Senate Finance Committee, H.R. 748 allows NOLs arising in a tax period beginning in 2018, 2019, or 2020 to be carried back five years. The legislation also temporarily removes the taxable income limitation of 80 percent to allow an NOL to fully offset income. “These changes will allow companies to utilize losses and amend prior-year returns, which will provide critical cash flow and liquidity during the COVID-19 emergency,” the Senate Finance Committee said March 25 in a statement explaining the bill’s key provisions.