Powerpoint slides by: Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Michael L. Hockenstein  Commerce Department Vanier College Intermediate Accounting Thomas H. Beechy Schulich School of Business, York University Joan E. D. Conrod Faculty of Management Dalhousie University

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   17-2 Accounting for Tax Losses Chapter 17

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   17-3 Tax Benefits of a Loss  When a corporation prepares its tax return and ends up with a taxable loss instead of taxable income, the corporation is entitled to offset the loss against past and future taxable income as follows: the loss can be carried back for three years any remaining loss can be carried forward for seven years.  If the sum of the previous three years’ and next seven years’ taxable income turns out to be less than the loss, any remaining potential benefit is lost

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   17-4 Tax Benefits of a Loss (cont.)  There is no problem in accounting for the tax benefits of the loss carrybacks because there is no uncertainty about whether or not the company will actually receive the benefit  Income taxes will be reduced in future periods as a result of the tax loss carryforward  Should the benefit of reduced future taxes be recognized in the period of the loss, or only in the period in which the benefits are realized?  The general principle is that the tax benefits of tax losses should be recognized in the period of the loss, to the extent possible

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   17-5 Tax Loss vs. Tax Benefits  To help avoid confusion, it is necessary to keep track separately of the amount of the tax loss and the amount of the tax benefit  The tax loss is the final number of taxable loss on the tax return  The tax benefit is the present and future benefit that the company will be able to realize from the tax loss through a reduction of income taxes paid to governments  Basically: Tax benefit = Tax loss x Tax rate

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   17-6 Tax Loss Carrybacks  A tax loss carryback entitles the corporation to recover income taxes actually paid in the previous three years  Fabian Corporation was established in 20X1 Fifth year it suffered a tax loss of $500,000

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   17-7 Tax Loss Carrybacks (cont.)  The loss will be carried back to the preceding three years to recover taxes previously paid  Normally a loss is carried back to the earliest year first, and then applied to succeeding years until the loss is used up  Note that the tax is recovered at the rate at which it was originally paid  The tax rate in the year of the loss (i.e., 38% for 20X5) is irrelevant for determining the amount of taxes recoverable via the carryback

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   17-8 Tax Loss Carrybacks (cont.)

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   17-9 Tax Loss Carrybacks (cont.)

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   Temporary Differences in a Loss Year  It is quite possible for temporary differences (and permanent differences) to convert a pre-tax accounting profit to a tax loss. For example, assume the following facts for Michelle Ltd. for the fiscal year ending 31 December 20X8: net income before taxes of $100,000, after deducting depreciation expense of $150,000 CCA totaling $280,000 deducted on the tax return

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   Temporary Differences in a Loss Year (cont.) net book value of capital assets of $1,700,000 and UCC of $1,200,000 on 1 January 20X8, a temporary difference of $500,000 that is reflected in an accumulated future income tax liability balance of $200,000 at 1 January 20X8 no permanent differences taxable income in the three-year carryback period of $360,000 tax rate of 40% in the current and previous years

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   Temporary Differences in a Loss Year (cont.)

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   Adjusting Temporary Differences  Since the company had available taxable income in the carryback period against which the loss can be offset, good tax strategy calls for taking the maximum allowable CCA in 20X8 in order to obtain a refund of taxes previously paid  If the company did not have taxable income in the preceding three years, a tax loss in 20X8 would not permit the company to realize any tax benefit in 20X8

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   Adjusting Temporary Differences (cont.)  Instead of having a tax loss, the company can simply reduce the amount of CCA that it deducts on its tax return for 20X8 by $30,000, from $280,000 to $250,000  CCA is an optional deduction, up to the permitted limit  A company will have a higher amount of undepreciated capital cost (and CCA) in future years if it claims less CCA in the current year

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   Tax Loss Carryforwards  If the three-year carryback does not completely use up the tax loss, a company is permitted to carry the remaining loss forward and apply it against taxable income over the next seven years  The accounting question, however, is whether the future tax benefit of the carryforward can be recognized in 20X5, the period of the loss  Companies usually want to recognize the benefits of a loss carryforward because that recognition decreases the apparent accounting loss  The income tax recovery is a credit entry in the income statement, reducing the amount of the reported loss

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   Tax Loss Carryforwards (cont.)

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   The Basic Principle---“More Likely Than Not ”  The criterion for recognizing the future benefits is simply that “the amount recognized should be limited to the amount that is more likely than not to be realized” [CICA ]. The recommendation is that: at each balance sheet date,...a future income tax asset should be recognized for all deductible temporary differences, unused tax losses and income tax reductions. The amount recognized should be limited to the amount that is more likely than not to be realized. [CICA ] an event is more likely than not when the probability that it will occur is greater than 50%. [CICA (i)]

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   The Basic Principle---“More Likely Than Not ” (cont.)  In deciding whether the probability is greater than 50%, management may consider “tax-planning strategies that would, if necessary, be implemented to realize a future income tax asset” [CICA (d)]  Tax planning strategies include such actions as: reducing or eliminating CCA in the year of the loss and future years amending prior years’ tax returns to reduce or eliminate CCA recognizing taxable revenues in the carryforward period that might ordinarily be recognized in later periods

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   The Basic Principle---“More Likely Than Not ” (cont.)  Favourable evidence that support recognition: existing sufficient taxable temporary differences which would result in taxable amounts against which the unused tax losses can be utilized existing contracts or firm sales backlog that will produce more than enough taxable income to realize the future income tax asset based on existing sales prices and cost structures

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   The Basic Principle---“More Likely Than Not ” (cont.) an excess of fair value over the tax basis of the enterprise’s net assets in an amount sufficient to realize the future income tax asset a strong earnings history exclusive of the loss that created the future deductible amount together with evidence indicating that the loss is an aberration rather than a continuing condition (for example, an extraordinary item)

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   The Basic Principle---“More Likely Than Not ” (cont.)  On the other hand, unfavourable evidence includes : a history of tax losses expiring before they have been used an expectation of losses in the carryforward period unsettled circumstances that, if resolved unfavourably, would adversely affect future operations and profit levels on a continuing basis in future years. [CICA ]

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   Reducing CCA  One way of increasing the likelihood that a company will fully utilize a carryforward is to eliminate CCA in the carryforward years  Not claiming CCA has the effect of increasing taxable income, against which the carryforward can be used  After the carryforward benefits have all been realized, the company can resume deducting full CCA to reduce its future net income

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   Reducing CCA (cont.)  A further strategy is to amend prior years’ returns to reduce or eliminate CCA  The relevant time frame is the three previous years to which carrybacks apply

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   Reassessment in Years Subsequent to the Loss Year  If the future benefits of loss carryforwards are recognized in the year of the loss, the benefit should be given intraperiod allocation, as appropriate to the cause of the loss  Once the future tax benefit of a tax loss carryforward has been recognized as an asset, the asset is subject to review at each balance sheet date  If the probability of realization drops to 50% or less, the future income tax asset should be reduced [CICA (a)]  If an asset is unlikely to recover its carrying value, either through use or through sale, it should be written down

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   Example of Recognition Alternatives  Suppose that Parravano Ltd., a private company that has been in business for five years, incurs a loss of $500,000 in 20X5  The company has no temporary differences, and therefore the pre-tax accounting loss is the same as the loss for income tax purposes

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   Example of Recognition Alternatives (cont.)  The history of the company’s earnings since the company began operations is as follows: the tax rate has been constant at 40% from 20X1 through 20X5 in 20X5, Parravano can carry back $170,000 of the loss to recover taxes paid in 20X3 and 20X4, a total of $68,000  Under any scenario, the starting point for recording the income tax expense is to record the carryback benefit

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   Example of Recognition Alternatives (cont.)

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   Example of Recognition Alternatives (cont.)  Scenario 1 Assuming future recovery is judged to be probable in the year of the loss if the probability of realizing the future tax benefit of the carryforward is > 50% when the 20X5 financial statements are being prepared, the estimated future benefit of the carryforward is recognized in the year of the loss

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   Example of Recognition Alternatives (cont.)  Scenario 2 Now, suppose instead that, due to Parravano’s erratic earnings history, realization of the benefit of the carryforward is judged not to be probable the entry to record the tax benefit in 20X5 would then be limited to the amount of taxes recovered through the carryback

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada    Scenario 3 Partial recognition It is possible that a company’s management may decide that only part of the benefit is more likely than not to be realized the entry to record the tax benefit in 20X5 would then be limited to the future tax benefit for which the probability of the carryforward is > 50% the benefits from the remaining tax loss carryforward can be recognized in a later period, if the probability of realization becomes > 50% Example of Recognition Alternatives (cont.)

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada    Scenario 4 Write-off of previously recognized benefit Like any other asset, the future benefit of a tax loss carryforward must continue to have probable future benefit if an asset no longer is likely to be recoverable or realizable, it must be written down to its probable future benefit Example of Recognition Alternatives (cont.)

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   Which Tax Rate?  Which tax rate should be used to record the amount of a future tax asset or liability? The CICA Handbook recommends that future tax assets and liabilities should be recognized at the rate(s) that are expected to apply when the temporary differences reverse, “which would normally be those enacted at the balance sheet date” [CICA ]

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   Which Tax Rate? (cont.)  The word “normally” is used because, in Canada, the government can announce changes in tax rates prior to the legislation actually being enacted  The CICA Handbook therefore refers to the substantively enacted income tax rate, and recommends that the substantively enacted rate be used instead of the actual rate at the balance sheet date

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   Tax Rate Changes  Once a future income tax asset has been recorded for a tax loss carryforward, the balance of that account must be maintained at the tax rate that is expected to be in effect when the carryforward is utilized  Suppose that the tax rate goes down to 38% before Parravano actually uses any of the carryforward  The asset will have to be revalued to $330,000  38%, or $125,400. This change will be included as part of the annual re-evaluation of the FIT asset or liability

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   Tax Rate Changes (cont.)  Income tax expense ($132,000 - $125,400)(I/S)$6,600 Future Income Tax Asset— Carryforward Benefit (B/S) $6,600

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   Intraperiod Allocation of Tax Loss Carryforward Benefits  When the future benefit of a tax loss carryforward are recognized in the period of the loss, the benefits will be reported in the same manner as the related loss  However, if the benefits are recorded in a period following the loss, any income statement impacts will not be given intraperiod allocation

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   Intraperiod Allocation of Tax Loss Carryforward Benefits (cont.)  The income statement recognition will be as follows: if the tax loss carryforward benefit is recognized in the year of the loss, the tax benefit will be offset against the extraordinary items if the tax loss carryforward is recognized a subsequent year, the tax benefit will be reported in income before discontinued operations and extraordinary items, regardless of the classification of the loss in the prior period

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   Disclosure  The only CICA Handbook recommendation for income statement presentations is that income tax expense related to continuing operations should be shown on the face of the income statement  Further disclosure relating to tax losses consist only of the following: the current tax benefit from tax loss carrybacks and carryforwards, segregated between (1) continuing operations and (2) discontinued operations and extraordinary items the amount and expiry date of unrecognized tax losses

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   Differential Reporting  Companies that have elected to use differential reporting will report on a taxes payable basis in a loss year as well as in profitable years  When differential reporting is used, only the amount of taxes actually recovered through carrybacks in the loss year will be reported as income tax recovery  When carryforwards are used to reduce taxes in following years, the reduced amount of tax actually paid is reported as income tax expense