Net Operating Loss

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Permalink Reply by David Smart on February 8, 2010 at 3:24pm

Hi Nigele,

I hope your query is in the context of taxation.

In most jurisdictions that am aware of, companies are required to prepare separate schedules (based on the current tax laws) to determine their taxable income or loss for the year. Incase they make a taxable profit, they will be required to pay tax based on that profit. Should they arrive at a taxable loss, they are allowed to "carry forward" the taxable losses for future periods.

The same jurisdictions state that in future periods, should the company have a taxable profit, they are allowed to deduct the taxable loss first, then determine their tax liability for that particular year. The tax authorities further state that you can do so for the next six financial periods after the loss.

For instance, if a company makes a taxable loss of $ 150 million in 2008, it should make cumulative taxable profit in excess of $150 million for the next six financial periodsto take advantage of the deduction - or else they loose the "advantage".

In terms of its relevance, when a company makes a taxable loss, they are allowed to recognise a deferred tax asset in their books e.g. $ 45 million if the applicable tax rate is 30%. They will be reducing this asset for the next six year depending on the taxable profits they earn in subsequent periods. For instance if the company has a taxable profit of $ 100 million in 2009, you will notice the tax expense (in the income statement) is zero while the deferred tax asset will reduce to $ 15 million.

My earlier explanation is on the assumption will be profitable for the next six years. If that assumption is false, the company is required to create what is called a valuation allowance i.e. estimate what portion of the deferred tax asset they are unlikely to claim within the six years.

In the real world, one of the reasons that caused General Motors to incur signifcant losses prior to its bankruptcy are the write-offs for deferred tax assets.

Hope this helps you.

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Permalink Reply by nigel ean gordon on February 8, 2010 at 11:40pm

Hi Thanks Guys for your learned replies much appreciated and am truly grateful. However I have this tutorial question which I need some help with. Here it is!

Question: F-Tech is a pharmaceutical company with sales of $13 million dollars at December 31, 2007. The firms cost of goods sold amounted to 80% of sales. depreciation is10% of gross profit (EBITDA) and interest expense is 1% of sales. The firm sold 50,000 shares at $8 per share on october 1, 2007. These shares were purchased a year agoo for $6 each. F-Tech received $70,000 in dividend income. Calculate the firm's tax liability if it uses the following taxable rates on income.

10% 0 - 200,000

15% $200,001 - $250,000

25% 250,001 - $350,000

30% $350,001 - $600,000

35% over $600,001.


Looking forward to your reply guys. Thanks

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Permalink Reply by David Smart on February 12, 2010 at 2:47pm

Nigel,

It will be hard to determine the tax liability using the information you have provided. Here are some of the questions that one might need clarification on

- does the tax authority recognise the depreciation expense as is or it has their own method. For instance, in USA, they use the MACRS system for depreciation which different from most of the accounting methods of computing depreciation expenses

- the same query for dividend income. In some countries. the dividend income could be exempt from taxation.

In short, I would recommend that you consult with a tax expert in the jurisdiction where F-Tech is resident (or domiciled).

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Permalink Reply by Werner Reisacher on February 8, 2010 at 8:34pm

Excellent contribution David.
Under the 2009 Economic Stimulus Provisions, the IRS (US Internal Revenue Services) allows small companies (below $ 15 Mio in revenue) to carry NOL (Net Operatin Losses) 5 years back or 20 years forward.
Werner Reisacher

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