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Partial loss refundability: how are corporate tax losses used?

Article Excerpt
INTRODUCTION

The asymmetric treatment of tax losses is an attribute common to all corporate income tax systems. If a corporation s income exceeds allowable deductions, then its net income is taxed at the statutory rate. However, if the reverse holds true, a corporation does not receive a refund equal to the tax value of its loss. Instead, corporations must carry losses backward or forward in time to offset prior or future payments of tax. In most cases, firms are forced to carry some portion of their tax loss forward. Carryforward firms receive only a partial refund of their tax loss because the real value of the loss erodes over time. For certain firms, losses that are carried forward have no inherent value as the firm is unable to generate sufficient taxable income to ever utilize the loss.

The partial refundability of tax losses has important implications for researchers interested in corporate investment and financing decisions. Firms that carry losses forward may face very different marginal tax rates on investment compared to firms that do not carry losses forward. If the investment is debt financed, then any marginal tax rate discrepancy could increase. Researchers who ignore the implications of the corporate loss regime risk omitting a key factor that may explain why otherwise similar firms have different investment patterns. It may also explain why certain industries appear to be less responsive to tax incentives such as accelerated deprecation.

Whether the corporate loss regime has a perceptible impact on marginal tax rates depends upon the prevalence of loss carryforward firms and the relative size of firms' loss carryforward stock. (1) In general, longer delays between the generation and utilization of a tax loss can manifest itself through larger marginal tax rate differentials between loss carryforward and taxable firms. Using corporate tax return data for tax years 1993-2003, we construct a unique dataset to measure how quickly corporations use tax losses. For most tax years, we find that approximately 10-15 percent of losses generated in a given year are carried back for an immediate tax refund. Carryback firms suffer no inherent penalty from the partial refund regime. Over a ten-year window, we find that approximately 40-50 percent of losses are used as a loss carryforward deduction, approximately 25-30 percent are lost (i.e., the firm no longer exists) and 10-20 percent remain unused. For losses that are used as a loss carryforward deduction, we find that there can be substantial delays between the generation and utilization of the tax loss. Based on these results, it appears that many firms incur a significant penalty from partial refundability due to a reduction in the real value of their tax loss or the inability to ever use the tax loss.

This paper proceeds as follows. The second section discusses how the US tax system treats corporate tax losses and provides a brief comparison of full and partial loss refund regimes. The third section discusses the methodology and dataset used for this analysis. The fourth section provides a comparison of our dataset to the C corporation population to provide context for our results. The fifth section illustrates how firms included in our dataset used tax losses that were generated in tax years 1993-2003. It also provides detail on the time pattern of loss carryforward deductions that originate from a specific loss year.

FULL VERSUS PARTIAL LOSS REFUNDABILITY

In theory, corporate income tax systems could allow any degree of loss utilization ranging from zero to full loss refundability. Currently, all Organisation for Economic Co--operation and Development (OECD)countries with a corporate income tax reside somewhere in the middle of this continuum; no country completely disallows losses or grants full and immediate refunds. A key factor that determines a tax system's position on this continuum is the time parameters in which a firm may use a tax loss. (2) More generous carryback and carryforward rules will move a system closer to full loss refundability. All OECD countries allow firms to carry tax losses forward in time: approximately two--thirds allow firms to carry losses forward from five to ten years; the remainder allow indefinite loss carryforward. By contrast, only eight OECD countries allow firms to carry losses back to offset prior payments. (3) For countries that allow carryback, tax losses may be carried back between one and three tax years. (4)

Despite the fact that no tax system allows full loss refundability, the partial refund system has many well-known shortcomings. A conspicuous flaw is that firms that carry losses forward can face very different marginal tax rates on investment than taxable firms. Some carryforward firms may face higher marginal tax rates because the reduction in tax liability attributable to accelerated tax depreciation allowances may be effectively delayed. If the stock of loss carryforwards is large enough for the firm to achieve non-taxable status, then the beneficial effect of additional depreciation allowances is not realized until some future year, thereby increasing the firm's cost of capital. Alternatively, it is possible that carryforward firms face lower marginal tax rates. For example, a persistent loss carryforward firm essentially faces a marginal tax rate of zero. Which outcome is realized depends upon the number of years a firm is expected to be non-taxable (i.e., the size of a firm's loss stock) and the degree of accelerated depreciation allowed under tax law. (5)

It is also well known that a partial refund system discriminates against certain types of firms, industries and investments. As shown by Mintz (1988), new firms with "start-up" or standalone investments may face especially high marginal tax rates because the taxing authority shares in the profits of the firm, but does not share in the downside risk of the investment. Unlike a diversified and mature firm, the new firm cannot offset the loss against profits from other lines of business. If the investment does not generate a profit, it is possible that the new firm will expire and will never utilize the tax loss over its short life. Less extreme is the penalty incurred by cyclical industries that must carry losses forward in time. For those industries, the penalty arises from the erosion in the real value of their tax loss. Finally, partial refundability discriminates...