No country stands immune to the global recession, even as the degree of its impact may vary. Companies world over are reeling under the brunt of declining revenues resulting in a consequential drop in bottomlines and even resulting in operating losses in some cases.
Though companies cannot often control the revenue or the top line in the current economic scenario, however, they may want to optimise the cash through cost control measures and efficient utilisation of incentives, such as tax losses.
In fact, some of the advanced tax jurisdictions provide for carry back of losses so as to utilise the available tax losses and thereby resulting in release of cash which is blocked in the form of taxes.
In the current times where several MNCs are facing the issue of operating losses (the term ‘operating losses’ for the purpose of this article denotes business losses) in various jurisdictions, it becomes imperative for them to evaluate the provisions on utilisation of tax losses in these jurisdictions so as to optimise the overall tax cost. Considering the above, this article contains a broad overview of provisions prevalent in certain key jurisdictions on utilisation of tax losses. However, it should be noted that there could be certain conditions prescribed under the respective tax laws which may need to be followed before offsetting the tax losses.
Before diving straight into the provisions prevalent in certain key jurisdictions on utilisation of tax losses, let us take a brief look at the relevant provisions prevalent in India.
India :
Indian tax laws provide for a distinction between operating losses and capital losses. In the year of losses, operating losses can be set off against capital income. However, capital losses can not be set off against the operating income.
Unutilised operating losses can be carried forward for a period of eight years to be set off against any future business income. Continuity of same business is not essential to set off carry forward operating losses.
Unutilised capital losses can be carried forward for a period of eight years to be set off against future capital gains. Indian tax laws classify capital gains as long-term capital gains or short-term capital gains depending on the period of holding of the capital asset. Accumulated long-term capital losses can be set off only against long-term capital gains and not against short-term capital gains. However, carry forward short-term capital losses can be set off against any capital gains i.e., long-term or short-term capital gains.
There are no provisions for carry back of tax losses to set off against the profit of earlier years.
Impact on carry over/utilisation of losses on change in ownership
Generally, Indian tax laws do not provide for any condition for continuity of ownership for utilisation of accumulated tax losses except in case of companies in which public are not substantially interested (i.e., Private Limited Companies).
In case of companies in which public are not substantially interested, there is a condition of continuity of a specified percentage of ownership in the year in which the losses are incurred and the year in which such losses are set off. There has to be a continuity of ownership of at least 51% in the year in which the losses are incurred and the year in which such losses are set off in order to set off accumulated tax losses.
Indian tax laws provide for carry over of tax losses to the resulting company in the event of business reorganisation viz. merger and demerger. In case of a merger which meets with the conditions specified under the Income-tax Act, the carry forward operating loss of the merged entity is rolled over to the surviving entity/resulting entity. However, there are certain specified conditions especially with respect to continuity of the merged business which need to be met, so as to avail the carry over benefit.
In case of demerger/hive-off, which meets the conditions specified in the Income-tax Act, the carry forward operating losses of the undertaking being hived off are transferred to the resulting company which can be set off against the profit of the resulting company. In the event, the carry forward operating losses do not pertain entirely to the undertaking being hived off, the carry forward operating losses of the demerged entity are allocated between demerged entity and the resulting entity on the basis of assets retained in the demerged entity and the assets transferred to resulting entity.
The provisions on continuity of ownership discussed hereinabove do not restrict the carry over of operating losses in case of the aforesaid reorganisation.
Transfer of losses to other group entities
Indian tax laws do not contain provisions for surrender/transfer of losses to other group entities for set off against their profit. In effect, Indian tax laws do not contain any provisions for group consolidation. Each of the group entities needs to file its tax return separately.
After evaluating the provisions under the Indian tax laws, let us now look at the provisions on utilisation of tax losses prevalent under certain key jurisdictions.
United States (US) :
Generally, US tax laws provide for a distinction between operating losses and capital losses. In general, capital losses can be set off only against capital gains and not ordinary income. Capital losses can be carried back for three years and carried forward for five years to be set off against capital gains in such years.
Operating losses can be carried back two years and forward twenty years to offset taxable income in those years. Operating losses can be set off against business income as well as capital gains.
Impact on carry over/utilisation of losses on change in ownership
There is a limitation on the amount of operating losses that can be utilised to offset against taxable income on ownership change. This limitation is provided in Section 382 of the Internal Revenue Code (IRC). Generally, an ownership change occurs when more than 50% of the beneficial stock ownership of a corporation in loss had changed hands over a prescribed period (generally three years). The three-year period can be shortened to the extent that the losses were incurred within the three year period or there was an ownership change within the three year period. Thus, Section 382 Limitation effectively prevents shifting of unfettered loss deduction from one group of corporate owners to a new group.
Generally, the limitation amount equals the value of the stock of the corporation immediately before the ownership change, multiplied by the long-term tax exempt rate. The long-term exempt rate changes monthly and is published by the Internal Revenue Service in the Internal Revenue Bulletin. Losses that cannot be deducted in a particular tax year due to aforesaid limitation can be carried forward.
In case of business reorganisation i.e., merger, generally, all the tax attributes of the merged corporation, induding net operating losses, transfer to the surviving corporation in a tax-free merger. The surviving corporation in a statutory merger can carry forward the net operating losses of the absorbed companies to reduce its taxable income in twenty subsequent tax years from the tax year in which the loss was incurred. Net operating losses can be carried back two years. Generally in case of merger, the net operating losses are not ‘ring fenced’. Such losses can be utilised against the income from business of the merged entity and the merging entity. However, such losses can not be offset against the income from business of the existing subsidiary of the resulting entity in case of consolidation. The limitation rules as discussed hereinabove would equally apply if there is a change in the ownership beyond a specified percentage pursuant to merger.
Transfer of losses to other group entities
US tax laws provide for group consolidation on fulfilment of certain stock ownership criteria. An affiliated group of US corporations may elect to determine its taxable income and tax liability on a consolidated basis.
Losses incurred by members of a group during the period of consolidation can be used to offset profits of other members of the group. However, losses incurred by a corporation prior to joining the group, referred to as separate return limitation year losses (SRLY losses), may not be used to offset profits of other group members or be carried back by such members to pre-consolidation taxable years. The SRLY loss rules also apply to built-in losses, i.e., losses realised during the first five years of consolidation to the extent attributable to assets with a value below adjusted tax basis at the time the member joined the group.
United Kingdom (UK) :
UK tax laws provide for a distinction between operating loss/trading loss and a capital loss. Generally, capital loss can be offset against capital gains of the same accounting period or can be carried forward indefinitely. However, capital loss cannot be carried back. Capital loss cannot be used to reduce the trading profits.
A trading loss incurred by a company in any accounting period may be set off against the total taxable profits (including capital gains) of the period and against the total taxable profits of an immediately preceding period, provided the same trade was then carried on. Losses can also be carried forward indefinitely for relief against future income from the same trade. Thus, losses can be set off only against the future profit from the same trade. Considering the above, a company with several trades or businesses may be required to keep separate accounts for each trade or business.
A company that ceases trading can carry back trading losses and offset them against profit of previous thirty-six months.
Impact on carry over/utilisation of losses on change in ownership
There is an important restriction on the carry-over of trading losses on a merger or acquisition if within any period of three years there is both a change in the ownership of a company and a major change in the nature or conduct of the trade carried on by the company to which the losses relate.
In case of change of ownership of the company and a major change in the nature or conduct of the relevant trade within a three-year period, trading losses otherwise available for carry forward are forfeited with effect from the date of the change of ownership.
Similar restrictions on the carryover of losses also apply if, at any time after the scale of activities in the trade carried on by the company has become small or negligible and before any considerable revival of the trade, there is a change in the ownership of the company.
The crucial issues that need to be considered in determining whether the above restrictions on the carry-over of trading losses apply on a merger or acquisition are: firstly whether there is a change of ownership and secondly whether or not there is a major change in the nature or conduct of the trade. There are specified provisions which define change of ownership for aforesaid purpose. The change of ownership is disregarded when the ownership is merely transferred between members of a 75% group.
The circumstances where there will be a major change in the nature or conduct of the trade for the purposes of these provisions are not exhaustively defined in the legislation. However, there are some indicative factors which can be used as reference to determine whether there is a major change in the nature or conduct of trade.
Transfer of losses to other group entities
UK tax laws do not provide for tax consolidation. However, a trading loss incurred by one company within a 75% owned group of companies may be grouped with profits for the same period realised by another member of the group.
Germany:
German corporate tax laws do not provide for distinction between operating losses and capital losses. Capital losses are generally deductible.
However, capital losses resulting from transactions which are exempt from tax are not deductible. In particular, this rule applies to capital loss from sale of shares or from write-down on shares. This, effectively, means that the capital loss on sale of shares is not tax deductible.
Net operating losses of up to EUR 511,500 may be optionally carried back for one year prior to the year in which the losses have been incurred for corporate tax purposes. Remaining tax losses can be carried forward indefinitely. However, the amount of loss carried forward is restricted to EUR 1 million of net income in a given year. Any remaining loss can only be set off against up to 60% of the net income exceeding this limit. This essentially means that 40% of the net income exceeding Euro 1 million is subject to tax even if there are available tax losses (so-called minimum taxation). There is no condition of continuity of same business to set off accumulated tax losses.
Impact on carry over/utilisation of losses on change in ownership
The 2008 Business Tax Reforms introduced new rules regarding the treatment of tax losses on changes of ownership in the loss company. These rules are effective from 1 January 2008. Under the new rules, tax losses expire proportionally if, within a 5-year period, more than 25% of the shares of a loss entity are directly or indirectly transferred to one acquirer or an entity related to such acquirer. If more than 50% of shares are transferred within a 5-year period, the entire tax losses will be lost. The new rules include a measure under which investors with common interests acting together are deemed to be one acquirer for the purpose of these rules.
The German Bundesrat Committee has proposed some changes to the loss carry forward limitation rules. The proposed rule includes an insolvency restructuring exception. Under the restructuring exception, a change in ownership would not result in forfeiture of a loss carry forward if :
i) the transfer of shares in a loss corporation is part of a plan to make the loss corporation solvent, and
ii) the plan preserves the ‘structural integrity’ of the loss corporation’s business. A preservation of structural integrity is deemed to exist if :
o there is an agreement with the German Workers’ Council of the loss corporation
concerning the preservation of jobs and that agreement has been honoured; or
o the company continued to pay a certain amount of gross salaries over a period of five years following the change in own:rship; or
o the shareholders made significant contributions to the equity of the loss corporation.
The insolvency restructuring exception would not apply if the loss corporation’s business was already shut down at the time of the share transfer, or if during a period of five years following the share transfer the loss corporation discontinues its historic business and engages in a different business sector.
Under the proposal, the insolvency restructuring exception would become effective for the year 2008
and would apply (also retroactively) to all ownership changes that occurred between December 31, 2007, and December 31, 2010.
In the event of business reorganisation e.g., merger, carry forward tax losses of the transferring entity are forfeited and cannot be further used by the receiving entity.
In the event of a spin-off wherein a part of the business is hived off into a separate company, carry forward tax losses relating to the business which is transferred is generally forfeited. However, carry forward tax losses relating to the existing business which has not moved will remain intact and can be utilised subject to German change of ownership rules discussed hereinabove.
Transfer of losses to other group entities
German tax laws provide for the filing of a consolidated tax return for a German group of companies which allow losses of group companies to be offset against profits of other group companies. The German parent company must file
the consolidated tax return. Only German companies in which the German parent company holds the majority of the voting shares at the beginning of the fiscal year of the subsidiary can be included in the group consolidation. In order to achieve group taxation, a profit and loss pooling agreement must be concluded. The profit and loss pooling agreement requires that the controlled company transfers all its profits to the controlled parent and that the controlling parent actually covers the losses of the controlled company.
Losses of controlled company incurred prior to group taxation cannot be used for corporate income tax purposes as long as group taxation applies. Such losses can be offset against the future profits of the controlled company after group taxation has ended.
Australia:
Australian tax laws provide for distinction between capital loss and business loss. Capital losses are calculated using the reduced cost base of assets without indexation for inflation. Capital losses are deductible only against taxable capital gains and not against ordinary income. Capital losses can be carried forward indefinitely to be offset against taxable capital gains in future. Capital losses cannot be carried back.
Operating loss is excess of allowable deductions over assessable and exempt income for a particular year. Operating loss can be carried forward indefinitely to be offset against taxable income derived during succeeding years. Operating loss can be offset against both operating income as well as capital gains. Operating losses cannot be carried back.
Impact on carry over/utilisation of losses on change in ownership
Companies must satisfy greater than 50% continuity of ownership tests for voting power, rights to returns of capital and dividend rights (COT) in order to deduct its prior year losses. Where continuity is failed losses can be deducted if the same business is carried on in the income year (the same business test). Thus, if there is a change in ownership, prior year losses can be offset provided the same business is being carried on in the year in which the prior year losses are set off. The aforesaid tests are applied with modification in the event losses are utilised on group consolidation.
Transfer of losses to other group entities
A wholly-owned group of Australian companies can choose to consolidate for income tax purposes. Where a consolidated group is formed, the group is treated as a single entity during the period of consolidation. The subsidiary entities lose their individual tax identities and are treated as part of the head company for the purposes of determining income tax liability.
Under the tax-consolidation regime, the carry forward losses of companies forming part of a consolidated group may be used by the consolidated group, subject to the limitation-of-loss rules, which limit the amount of losses that can be used, based on -a proportion of the market value of the loss-making company to the consolidated group as a whole.
Generally, losses can be transferred to the group only if the losses could have been used outside the group by the entity seeking to transfer them. Once a subsidiary member of a group transfers a loss, it is no longer available for use by the subsidiary, even if the subsidiary subsequently leaves the group.
China:
Generally, Chinese tax laws do not provide for any distinction between operating losses and capital losses. Under the Enterprise Income Tax Regulation (EITR), losses are allowed to be carried forward for a maximum of five years without any restriction. However, losses may not be carried back.
Impact on carry over/utilisation of losses on change in ownership
Generally, there is no restriction on utilisation of accumulated tax losses in the event of change in ownership. The company can set off the accumulated tax losses even if there is a change in the shareholding of the company.
In the event of merger, the amount of losses of the pre-merger entity can be rolled over to the surviving entity provided the merger qualifies under Special Restructuring (SR) defined under the corporate tax laws. The quantum of loss that can be rolled over is confined to ‘x’ times the fair value of pre-merger entity, where ‘x’ is the interest rate of the longest-term national debt issued in that year.
Transfer of losses to other group entities
There is no group consolidation provision in China. Accordingly, losses of one group entity in China cannot be set off against the profit of another group entity.
Conclusion
While most of the advanced economies provide for carry back of losses and transfer of losses within the group entities through the group consolidation mechanism, these provisions are not yet incorporated under the Indian tax laws. India today is no longer an isolated economy. It is aligned and integrated with the world economy. Further, in the current economic downturn wherein companies globally are facing heavy pressure on margins resulting in operating losses in some cases, it is just that companies are given the benefit of utilising losses against their prior year profits and also against the profit of other group entities. Further, in the current scenario where Indian companies are facing liquidity crunch, it is essential that aforesaid provisions are implemented in the Indian tax code so that companies can optimise on cash through effective utilisation of tax losses. Considering this, time is now ripe that India adopts the well-accepted international tax concept of provision of carry back of loss and group consolidation in its tax code.
For comparative purpose, the key provisions on utilisation of tax losses in key jurisdictions are tabulated below:
