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Uncle Sam has extended the time frame for loss carrybacks. Should you take advantage?
Marie Leone, CFO Magazine
March 1, 2010
When companies closed their books on 2008, the financial crisis made itself very apparent: 3,700 publicly held corporations reported losses, a 9% increase over the previous year. Enter Congress, which offered a corporate tax break on a scale not seen since the aftermath of the terrorist attacks of September 11, 2001.
Last November, lawmakers ordered the Internal Revenue Service to temporarily amend the tax code to give all companies more flexibility in turning net operating losses (NOLs) into cash.
The tax-code alchemy conjured up by Congress and the Treasury Department extended what is known as the NOL carryback period, stretching it from two years to five for corporate losses incurred in 2008 and 2009. That means that corporate losses reported in those two years can be used to offset taxable income already reported during the prior five years.
In practical terms, that means companies can file for a cash refund from Uncle Sam for taxes they've already paid. And they can now do so for years that saw the highest corporate profits in the nation's history — 2005 and 2006 — when an aggregate $3.4 trillion in corporate profits was reported.
But weighing the benefits of the immediate cash infusion against the irreversible decision to forgo other potential tax benefits and credits is no simple matter. Although it's too early to tell how many companies will take advantage of the new NOL provision, Congress's Joint Committee on Taxation estimates that the extension will accelerate some $33 billion worth of corporate tax refunds.
The ability to "recover cash taxes" will help companies — especially those in such hard-hit sectors as retail, real estate, and manufacturing — sustain business operations and make investments during uncertain economic times, contends Ernst & Young tax partner John McMahon. Credit Suisse, in a report released a week after the rule was issued, estimated that S&P 500 companies will be eligible to apply for an aggregate $5 billion in refunds related to taxes paid in 2008 alone. Seventy-seven companies in the S&P 500 reported a loss in 2008, nearly triple the number from the year before, according to an analysis by CFO (see "Loss Leaders," below).
TARP Not Covered
The NOL carryback extension is part of the Worker, Homeownership, and Business Assistance Act of 2009, but temporarily extending the NOL carryback period to restock cash accounts is not a new concept. After 9/11, Congress granted a temporary five-year extension. In early 2009, it offered another five-year extension, but only for businesses with $15 million or less in sales.
Under the latest extension, companies of all sizes are permitted to carry back losses from either 2008 or 2009, but not both years. Small companies that benefited from the earlier extension can also take advantage of the new change, as long as they don't use losses from the same year twice. (For example, if a small company has already applied NOLs from 2008 to a prior taxable year, only a loss from 2009 can be carried back under the new legislation.)
The November 2009 extension has a few other restrictions. For example, companies that received bailout money under the government's Troubled Asset Relief Program are ineligible to use the NOL extension. "TARP beneficiaries were singled out for punishment" with regard to the extended carryback period, says Robert Willens, a tax expert who heads tax advisory service Robert Willens LLC.
Another twist: if a company elects to look back to the fifth taxable year, NOLs can be used to offset only 50% of the taxable income earned that year, notes David Culp, a senior manager with KPMG. If NOLs remain after offsetting the fifth year's income, then the company is permitted to apply the leftover NOLs to year four, three, and so on, until the offset is used up.
The fifth-year "haircut" was probably included to allay any congressional budget concerns, explains Darrell Poplock, a tax partner at PricewaterhouseCoopers, who says the new carryback provision is expected to cost the U.S. Treasury $10.4 billion over 10 years. According to the White House, however, the NOL portion of the bill is being paid for by several other measures, including a delay until 2018 of a tax break for corporations that involves interest allocation, an increase in penalties for failure to file S corporation and partnership tax returns, and a temporary increase in corporate estimated tax payments due to be paid from July to September 2014.
Cash in Hand
Credit Suisse calculates that the carryback extension increased the pool of taxes eligible for refund for S&P 500 companies by $270 billion for 2008, and by $338 billion for 2009 NOLs. The health-care industry appears to be the sector with the highest refund potential, says Credit Suisse, which estimates the industry could claim a total of $1.5 billion in refunds based on 2008 NOLs (see "Money in the Bank," above). Information-technology and energy companies are next in line, with possible refunds totaling $940 million and $766 million, respectively. Financial companies that didn't take TARP funds have the fourth highest refund pool for 2008, at $514 million.
But report co-author Christopher Cornett, a Credit Suisse equity analyst, warns against overstating the rule's impact on company valuations. "When the rule change was announced, a lot of people thought this was a dollar-for-dollar increase in the enterprise value of a company. It is not." Cornett explains that the real benefit of the tax change is having the cash today, versus having to wait for the company to start generating profits again before claiming an NOL refund in the future.
He says the immediate cash infusion may help reduce uncertainty among companies currently suffering from liquidity problems. Indeed, a better cash position could lower the market's perception of risk and, in turn, increase a company's valuation.
The IRS has made filing for the refund easy, saying firms can make a claim on their tax return for the NOL year, amend prior returns, or file a "quick" carryback claim. But companies still face two complicated, if basic, questions: Which year's NOL should they carry back, and how far back should they carry it?
Mulling over different NOL-carryback scenarios to determine "the ancillary effects" on a company's other tax positions is a complex matter, says Paul Manning, a principal in KPMG's tax practice. For instance, if a company carries back a loss to a year in which foreign tax credits were used — and the carryback wipes out the taxable income for that year — the company may want to elect to deduct foreign taxes for that year, rather than taking a credit, depending on its particular situation.
The five-year carryback provision also may affect a company's ability to use general business credits, such as the research-and-development credit or the work-opportunity credit (used to encourage companies to hire veterans or young persons not enrolled in school).
Another area to consider is Section 199 of the tax code, which permits a deduction for a small percentage of income generated by manufacturing activities. But the deduction isn't allowed to create or produce an NOL, warns KPMG's Culp. That means companies also must decide whether using the new carryback is worth more than forfeiting the Section 199 deduction.
It also may be worthwhile for companies to recalculate their alternative minimum tax (AMT), says Laurie Asch, a tax attorney with Thomson Reuters, because doing so may show that a company has the opportunity to offset an additional 10% of AMT income. The NOL applies to AMT calculations, but generally, when a company carries back a loss, it can offset only up to 90% of its AMT income. But under this new carryback extension, explains Asch, that limitation is lifted in most cases, and companies that elect to carry back 2008 or 2009 NOLs can offset up to 100% of their AMT income. She points out, however, that the 50% limit on the fifth-year carryback is still enforced.
Of course, companies also have the option of not using the loss carryback at all, instead carrying the loss forward in anticipation of offsetting income in good years to come. Yet Willens argues that it is always preferable to carry back an NOL to prior years. This is true even if corporations expect tax rates to increase. That's because the carryback places cash into corporate coffers immediately, he says, while a carryforward is useful only if the corporation generates taxable income against which the NOLs can be offset. "That is always an iffy proposition," says Willens. "In this case, 'a bird in the hand is worth two in the bush.'"
Marie Leone is senior editor for accounting at CFO.
Many companies have not yet announced their plans for NOL carrybacks, or have said they are still deciding whether to cash in now versus later. But some have moved swiftly to claim the cash refund and bolster battered balance sheets.
• Pulte Homes was hammered by the subprime crisis, and at press time was still calculating exactly how bad its 2009 losses were. But the company said using those losses to offset profits booked in rosier times would result in a cash refund of more than $450 million.
• For Schnitzer Steel Industries, a combination of the carryback extension and a manufacturing tax break effectively reduced the company's 2009 tax rate by 12.8%. Schnitzer, which reported $2 billion in revenues last year, claimed a $49 million tax refund.
• Pier 1 Imports was quick to file its carryback with the IRS and received a tax refund in January of $56 million.
• Jewelry purveyor Zale carried back operating losses from 2009 and filed for a $17 million refund.
• Recreational vehicle maker Winnebago Industries wasn't able to carry back all of its 2009 net operating losses until the government extension, which allowed the company to realize an additional refund of $4.8 million.
• Bank of Granite estimated that the benefit of the extended carryback could "approximate $4.0 million," adding that "the refund will also supplement the Bank's liquidity."
• William Lyon Homes is "considering" applying its 2009 losses to its 2004 taxable year. To maximize those losses (and, therefore, the refund), the company said it also might defer booking "cancellation of indebtedness" income that resulted from its repurchase of its own bonds during 2009.
• Palm said its total potential tax benefit from the carryback would amount to $200 million. — M.L.
Companies covet net operating losses (NOLs), which can be used up to 20 years into the future to reduce the amount of income subject to taxes. But thanks to Section 382 of the Internal Revenue Code, much of their benefit can be wiped out if a company is acquired.
Last year, Citigroup enacted a poison pill in hopes of protecting $44 billion worth of NOLs from acquisition. A year earlier, homebuilder Hovnanian crafted a poison pill to shield $392 million in NOLs.
When a company is acquired, the amount of income it can offset with existing NOLs becomes subject to a cap, which is calculated by multiplying the company's market capitalization by the long-term tax-exempt rate as prescribed by the tax code (which in January was 4.14%). That means a target company with a $1 billion market cap on the day of an ownership change could use NOLs to offset only $41.4 million of income in any subsequent years.
Section 382 is a "harsh" rule put in place to prevent "the trafficking of losses," says tax expert Robert Willens. He says the IRS didn't like the idea that a financially fit company could buy companies with huge operating losses just to get their hands on a target company's NOLs. "The rule makes NOLs neutral in an acquisition," adds Willens.
Neutral, that is, unless the government itself is the acquirer. General Motors and Chrysler effectively sold themselves to the government when they accepted bailout funds from the Treasury Department's Automotive Industry Financing Program. That should have wiped out most of their NOLs, but the IRS issued guidance last April saying the bailout would not trigger Section 382 restrictions for the carmakers. Meanwhile, Ford Motor Co., which took no government money, was forced to turn to a poison pill to protect its $19 billion worth of NOLs. — M.L.