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How Tax-Loss Offsetting Affects Financial Reporting

July 5, 2021, 7:01 AM

Except for a few so-called tax havens, countries impose a direct tax on corporate profits, generally referred to as corporate tax or company tax. While the determination of taxation on corporate profits in practice can be quite complex and challenging, in theory, companies simply must pay a certain percentage on their corporate profit. It gets more complex, however, when companies face a loss.

Tax-Loss Offsetting

When companies are not profitable, they do not get a tax refund immediately. Instead, most countries around the world allow firms with negative taxable income in the current period to carry these losses forward to the next periods (or carry the losses back to the previous periods). These so-called net operating losses are then offset against the future taxable income, which reduces the tax burden in the respective future period.

Many countries, however, limit the amount of losses that can be offset against future profits, which directly affects firms’ liquidity and also reduces the net present value of tax-loss carryforwards. In contrast, less strict offsetting rules increase liquidity.

Strategic Timing of Asset Write-Offs

When offsetting rules become stricter, e.g. the amount of losses that can be offset is limited, firms have the incentive to reduce large discretionary expenses (e.g. asset write-offs) in loss years and postpone those expenses to profitable years. By strategically timing the asset write-offs in their tax reporting, firms thus minimize their tax payments. The details of the tax reporting are, however, only disclosed to the tax authorities.

At the same time, firms also want to inform their shareholders about the underlying economics of the firms in their financial reporting. When firms strategically time the write-offs for tax purposes, they face the choice between adjusting their financial reporting to tax accounting—also postponing the write-off—or accepting differences between the two information systems.

In theory, tax rules should not affect financial reporting to provide undistorted information to external stakeholders, i.e. if firms postpone their write-offs purely for tax reasons, the financial reporting does not accurately reflect the value of the firm and firms should therefore not adjust their financial reporting when they optimize their tax payments.

However, at the same time, the different treatment for tax and financial reporting purposes leads to reporting different levels of profits in the two information systems, which is often seen as a red flag by investors: If reported profits to the tax authorities are low but profits reported to investors are high, investors might become suspicious about whether the reported profits are artificially inflated (“earnings management”).

Eventually, when firms strategically postpone asset write-offs to minimize tax payments, they face the trade-off between financial reporting becoming less informative and investors, auditors, and enforcement agencies becoming suspicious about the quality of reported earnings.

Understanding if and how tax losses affect firms’ financial reporting is important for investors and regulators for mainly two reasons.

First, if tax-loss offsetting rules affect financial reporting, investors will receive a biased signal of the firm value. To correctly evaluate the write-off behavior of loss firms, financial statement users need to know when changes in the institutional environment affect the incentives to increase or to decrease financial reporting write-offs in specific situations. Thus, understanding the link between tax-loss carryforward rules and financial reporting helps to assess the underlying economics of a firm.

Second, the goal of the International Financial Reporting Standards (IFRS) is to achieve financial reporting comparability across countries. However, tax-loss carryforward rules differ across countries and thus potentially influence financial reporting differently. While some European countries are strict and only allow losses to be carried forward for five years or less (Bulgaria, Cyprus, Czech Republic, Greece, Hungary, Poland, Portugal, and Slovakia), other countries allow losses to be carried forward indefinitely (Austria, Belgium, Denmark, France, Germany, Ireland, Italy, Lithuania, Malta, Norway, Slovenia, Spain, Sweden, and the U.K).

Understanding how these differences affect financial reporting behavior is important not only for standard setters but also for investors comparing companies across countries and for the compensation committee benchmarking their executives against international peers.

A recently published study by researchers from the Erasmus University Rotterdam (The Netherlands) shows that firms change their financial reporting write-offs when tax-loss offsetting rules are changed.

To answer the questions if and how tax-loss offsetting rules affect financial reporting, the authors of the study compare the change in financial reporting write-off behavior in response to changes in tax-loss offsetting rules in Germany and France, as both countries changed their offsetting rules in 2004 in opposite directions.

In Germany, where the 2004 reform has restricted tax-loss carryforward offsetting to 60% of taxable income, tax losses have become costlier and firms have a stronger incentive to postpone write-offs to profitable years. In contrast, in France, where the 2004 reform has extended tax-loss offsetting from five years to infinity, tax losses have become less costly and firms have a lower incentive to postpone write-offs to profitable years.

In a nutshell, tax losses became costlier for German firms and less costly for French firms. The authors find that German loss firms reduced their financial reporting write-offs in the period after the regulation change by 0.61% of total assets, whereas French loss firms increased their write-offs by 0.15% of total assets.

Policy Maker Beware

The findings are of particular interest to policy makers in countries that plan to change or already changed tax-loss offsetting rules, and to inform financial statement users about the financial reporting consequences of changes in tax-loss offsetting. Policy makers, tax legislators, and standard setters should be aware that rules for tax-loss offsetting not only affect firms’ tax payments, but also firms’ financial reporting.

Thus, the researchers’ findings are of particular interest to governments that plan to change—or have already changed—rules for tax-loss offsetting. For example, the United States Tax Cuts and Jobs Act of 2017 (TCJA) disallowed loss carrybacks, reduced loss carryforwards offsetting to 80% of the taxable income, and extended the carryforward period from 20 years to infinity.

Similarly, the Dutch government reduced the period to offset losses from nine to six years for fiscal years 2020 and 2021 and plans to implement loss offsetting rules comparable to the German rules as from 2022 (i.e., extend tax-loss offsetting until infinity but limit it to 50% of positive taxable income).

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Saskia Kohlhase is an assistant professor with Rotterdam School of Management, Erasmus University (RSM). Saskia conducts research on economic and societal consequences of taxation. Jochen Pierk is an assistant professor at the Erasmus School of Economics, Erasmus University. His research focuses on corporate taxation and the role of financial accounting in private firms.

The authors may be contacted at: kohlhase@rsm.nl; pierk@ese.eur.nl