CFO Insights 2020 November
Combatting the struggling economic landscape through the effective use of tax losses
CFO Insights is a monthly publication to deliver an easily digestible and regular stream of perspectives on the challenges confronting CFOs. In this article, we describe the utilization of Net Operating Losses ("NOL") to reduce cash tax outflows.
- Overview of rules relating to carryforward and utilization of NOL
- Other restrictions on NOL utilization
- Options for utilizing NOL
COVID-19 has had a significant impact on revenues for many businesses and as a result, companies may be reporting loss positions for the current and upcoming years. Given decreased sales and the uncertain business environment, companies are seeking to mitigate cash outflows, including taxes.
One of the key mechanisms for reducing cash tax outflows is the efficient use of existing and projected net operating losses for tax purposes (“NOL”). Utilization of NOL can be achieved through a number of methods including the carryback and carryforward of NOL, offsetting of taxable income and losses within a 100% Japan parented group, or by integrating businesses and utilizing NOL through corporate reorganization.
Overview of rules relating to carryforward and utilization of NOL
A company filing blue form tax returns is generally permitted to carryforward NOL incurred in fiscal years beginning before 1 April 2018 for up to nine years. For NOL incurred in subsequent years, the carryforward period is increased to ten years.
While loss carryforward is allowed, utilization of carryforward NOL to offset taxable income in a given year is generally limited to 50% of taxable income (the “50% limitation”). However certain companies, such as a small and medium-sized enterprise (“SMEs”)1 and “newly established companies”2 , are not subject to the 50% limitation and can use NOL to fully offset their taxable income.
In addition to loss carryforward, SMEs and companies in liquidation are allowed to carryback NOL for one year to receive a refund of taxes paid in the prior year. However, due to the COVID-19 situation, the government enacted special relief measures that expanded the scope of companies eligible for the one year carryback to include a company with stated capital of JPY 1 billion or less (including its 100% direct and indirect shareholders). The special relief measures apply to NOL generated in fiscal years ending on or after 1 February 2020 until 31 January 2022, and the 50% limitation that would normally apply to a non-SME will not apply to companies qualifying for the special carryback provision.
The diagram below illustrates the NOL carryforward/carryback rules and COVID special relief measures.
Other restrictions on NOL utilization
In addition to the 50% limitation, there are other situations which may result in NOL utilization being restricted or forfeiture of NOL. These include a change of ownership in a company where a specified event occurs, certain corporate reorganizations, and joining a consolidated tax/ aggregated group.
Options for utilizing NOL
For corporate groups with only one entity in Japan, options are practically limited.
- For an eligible company, NOL carryback under the COVID relief measures.
- Accelerating the timing of revenue recognition. This may be an option for companies providing services over long-term contracts, although group accounting policies and legal and consumption tax implications should be considered.
- Disposal of non-core businesses or other assets, whether as part of a business streamlining exercise or simply to generate cash, to trigger taxable gains that may be partially or fully sheltered by NOLs.
For corporate groups with multiple entities in Japan, tax consolidation may be an option. The current tax consolidation system allows companies within a 100% Japan parented group to offset profits and losses. However, for companies with Japan subsidiaries held through multiple ownership chains, restructuring would be required to create a 100% Japan parented group. Additionally, tax consolidation is applicable only for national tax purposes, which limits the benefit of tax consolidation.
As an alternative to tax consolidation, some companies may find it beneficial to wait and elect group aggregation. The current tax consolidation system will be replaced with new group aggregation rules for fiscal years commencing on or after 1 April 2022. Similar to tax consolidation, group aggregation applies only to a Japanese group consisting of a Japanese parent company and its wholly owned Japanese subsidiaries, allowing the NOL of one group entity can be offset against the taxable income of another group entity. However, there are some differences between group consolidation and tax consolidation such as each group member being required to file its own national corporate tax return and the qualification requirements for SME status.3
Companies considering tax consolidation or group aggregation as a potential option should examine whether it may be more beneficial to join tax consolidation now and transition into group aggregation or wait to join group aggregation once the new rules take effect.
The COVID-19 pandemic and resulting focus on cost reduction may lead to companies looking at inefficient group structures, either from a cost or tax perspective. In these cases, entity rationalization may be considered primarily to simplify existing group structures, eliminate duplicative functions and reduce ongoing costs. Often, the effective utilization of NOL is a benefit of undertaking corporate reorganizations or business integrations. In most cases, a merger of one or more companies into another company is the simplest way to integrate businesses or eliminate dormant entities. From a legal perspective, upon the merger, all assets, liabilities, and employees of the disappearing company are transferred to the surviving company by operation of law, which reduces administration in terms of negotiating the transfer of contracts with counterparties and negotiating with employees regarding the change of their employer company.
If the disappearing company and the surviving company have a 100% shareholding relationship, the merger should generally be treated as tax qualified, meaning that the assets and liabilities of the disappearing company are transferred to the surviving company at tax book value such that any taxable gains or losses are deferred. For companies with shareholding relationships of less than 100%, additional conditions must be satisfied to be treated as tax qualified. After a tax qualified merger the NOL of both the disappearing and surviving company can, in principal, be utilized although certain restrictions may apply.
The ongoing pandemic has led many companies to seek options to generate tax savings and increase cash - a strategy to efficiently utilize available and future losses should be a key element of this. A number of different options for utilizing losses are available, so companies should consult with their tax adviser to evaluate the best option based on their particular circumstances. For example, companies meeting the COVID relief provisions that paid tax in the prior year may be able to increase cash flow by carrying back losses to receive a refund of the prior year taxes paid, while companies with multiple profit and loss-making entities in Japan may wish to consider tax consolidation or reorganization to allow for the offsetting of profits and losses between the various entities.
1 SMEs are defined as companies with stated capital of JPY 100 million or less whose shares are not held, directly or indirectly, by a “large company” (i.e., a company with stated capital of JPY 500 million or more) or 2 or more large companies within a 100% affiliated group.
2 Newly established companies are companies that are less than 7 years old and not wholly-owned by a large company or 2 or more large companies in a 100% affiliated group.
3 For more information regarding the group aggregation rules and differences from the current tax consolidation systems, please see our 2020 tax reform newsletter.