Making the most of the loss carry back offset

The two-tiered corporate tax rate system and the decreasing corporate tax rate for base rate entities can give rise to circumstances where differing tax benefits can arise dependent upon whether a corporate tax entity chooses to either deduct tax losses, carry them forward or carry them back under the Loss Carry Back Offset provisions. The differing tax benefits presents corporate tax entities an opportunity to get more out of their tax losses.

Overview of the Loss Carry Back Offset

Before discussing the options available to corporate tax entities that may allow them to maximise the tax benefits received from their tax losses we will briefly outline the Loss Carry Back Offset (‘LCBO’) provisions.

The LCBO was announced as part of the 2020–21 Federal Budget (which was handed down on 6 October 2020) and was promptly enacted, along with a raft of other COVD-19 recovery measures, when it received royal assent on 14 October 2020. An extension to the LCBO was later announced on 11 May 2021, as part of the 2021-22 Federal Budget, whereby eligible corporate tax entities will be allowed to carry back losses from the 2023 income year to any of the four previous financial years. As at the time of this article being published, the extension has not been passed into law.

Broadly, a corporate tax entity (a company, limited partnership or public trading trust) is entitled to an LCBO in either or both of the 2021 or 2022 income years (the current year) if:

1. It has incurred a tax loss in one or more of the following years:
   1. 2020 income year;
   2. 2021 income year; or
   3. 2022 income year (if the current year is the 2022 income year).
2. The corporate tax entity had an income tax liability in one or more of the following years:
   1. 2019 income year; or
   2. 2020 income year;
   3. 2021 income year (if the current year is the 2022 income year).
3. The corporate tax entity has satisfied its lodgement requirements or assessments have been made for the current year and each of the five income years before the current year; and
4. The corporate tax entity makes a ‘loss carry back choice’ for the current year.

Despite the above an entity is not able to carry back a tax loss arising in an income year unless during the income year in which the tax loss arose the corporate tax entity was either:

1. A small business entity; or
2. Would have been a small business entity if the aggregate turnover threshold was $5 billion instead of $10 million.

The LCBO is calculated as the amount of losses carried back multiplied by the corporate tax rate that was applicable to the corporate tax entity in the year in which the tax loss arose. For example if a base rate entity chose, in the 2021 income year, to carry back $100,000 of losses arising in the 2020 income year to the 2019 income year, its LCBO for the 2021 income year would be $27,500, calculated as the  $100,000 loss multiplied by the 27.5% corporate tax rate applicable to base rate entities for the 2020 income year.

However, the LCBO is capped at the lesser of:

• The corporate tax entity’s franking account balance at the end of the current year, being the year in which the corporate tax entity claims the LCBO; or
• The corporate tax entity’s income tax liability in the income year(s) which losses are carried back to.

Following on from the above example, if at the 30 June 2021, the base rate entity had a franking account balance of $20,000, its LCBO for the 2021 income year would be capped at $20,000. Likewise if its income tax liability for the 2019 income year was $15,000, its LCBO would be capped at $15,000.

In addition to the above a corporate tax entity cannot carry back a tax loss that:

• Arose due to excess franking credits;
• Were transferred between companies in the same foreign banking group;
• Were transferred to a head company of a consolidated group by an entity joining the group.

Planning opportunities

As the LCBO is applied using the company’s corporate tax rate in the year in which the tax loss arose, there are some planning opportunities that may arise where the corporate tax entity has been subject to varying corporate tax rates or where due to the impacts of COVID-19, the corporate tax entity has temporarily satisfied the base rate entity conditions allowing access to the lower corporate tax rate.

These planning opportunities are illustrated using the below examples, which identify circumstances where it may be beneficial for a corporate tax entity to choose to either deduct, carry back or carry forward its tax losses.

An important aspect of the planning opportunities is the ability for a corporate tax entity to choose how much of its prior year’s tax losses to deduct in the current year (including a nil amount).

Example 1

Small Co carries on business and is a base rate entity for each of the 2019, 2020, 2021 and 2022 income years.

Small Co had a tax liability of $500,000 in the 2019 year, a tax loss of $1,000,000 in the 2020 income year and a taxable income (prior to the application of tax losses) of $2,000,000 in the 2021 income year. Its franking account balance at the end of the 2021 income year is $500,000.

Whilst preparing its 2021 income tax return Small Co is faced with the choice of whether to deduct its 2020 income year tax losses in the 2021 income year (current year) or carry them back to the 2019 income year. If Small Co chooses to deduct the tax losses in the current year its tax benefit will be $260,000 calculated as $1,000,000 multiplied by the 26% corporate tax rate applicable to base rate entities for the 2021 income year. However, if Small Co chooses to carry back its tax losses to the 2019 year its tax benefit (being the LCBO) will be $275,000 calculated as $1,000,000 multiplied by 27.5% (the corporate tax rate applicable to base rate entities for the loss year i.e., the 2020 income year).

Small Co, being a corporate tax entity, is able to choose a nil amount of tax losses to deduct in an income year and is therefore able to choose to carry them back instead.

In these circumstances Small Co will save $15,000 in tax if it chooses to carry back its tax losses to the 2019 income year instead of choosing to deduct them in the 2021 income year.

Example 2

Medium Co carries on a business and typically has an aggregated turnover in excess of $50 million, however due to COVID-19’s impact on its turnover it was a base rate entity for the 2020 income year. In the 2021 income year its turnover increase back above $50 million resulting in it ceasing to be a base rate entity for the 2021 income year.

Medium Co had tax liability of $3 million for the 2019 income year, a tax loss of $4 million for the 2020 income year, a taxable income (before the application of tax losses) of $5 million for the 2021 income year and a franking account balance of $2 million as at 30 June 2021.

Similarly, Medium Co is faced with the choice of whether to deduct its 2020 income year tax losses in the 2021 income year (current year) or carry them back to the 2019 income year. If Medium Co chooses to deduct the tax losses in the current year its tax benefit will be $1.2 million ($4 million x 30%). Whereas, if Medium Co carries back its tax losses to the 2019 income year its tax benefit will be $1.1 million ($4 million x 27.5%, the corporate tax rate for base rate entities for the loss year).

In these circumstances Medium Co will save $100,000 in tax if it chooses to deduct its 2020 income year tax losses in the 2021 income year instead of choosing to carry them back to the 2019 income year.

Example 3

Assume the same facts as Example 2 above with the exception that Medium Co’s operations were also impacted in the 2021 income year resulting in it being a base rate entity for the 2021 income year. Medium Co’s turnover appears to be recovering to near pre-COVID-19 levels for the 2022 income year. For the 2022 income year Medium Co expects to have aggregated turnover in excess of $50 million and a taxable income (before application of tax losses) of $8.5 million.

Whilst preparing its income tax return for the 2021 income year Medium Co is faced with a similar choice as in Example 2 above. If it chooses to deduct its 2020 income year tax losses in the 2021 income year (the current year),  the tax benefit will be reduced to $1.04 million ($4 million x 26%, because it is now a base rate entity in the current year), compared to a tax  of $1.1 million ($4 million x 27.5%) if it chooses to carry back its tax losses. However, Medium Co has the third option of carrying forward its 2020 income year  tax losses with the intention of deducting all of the losses in the 2022 income year resulting in an estimated tax benefit of $1.2 million ($4 million x 30%).

Medium Co, being a corporate tax entity, is able to choose a nil amount of tax losses to deduct in an income year. It is also not required to make a choice to carry back its tax losses, therefore allowing it to carry forward its tax losses to future years.

In these circumstances Medium Co will potentially save $100,000 or $196,000 in tax if it chooses to deduct its tax losses in the 2022 income year compared to if it chooses to carry them back to the 2019 income year or deduct them in the 2021 income year, respectively.

Example 4

Medium Co carries on business and typically has an aggregated turnover in excess of $50 million. For the 2020 income year Medium Co was not a base rate entity, however it was a base rate entity for the 2021 income year.

Medium Co had tax liability of $3 million for the 2019 income year, a tax loss of $4 million for the 2020 income year, a taxable income (before the application of tax losses) of $5 million for the 2021 income year and a franking account balance of $2 million as at 30 June 2021.

Similarly, Medium Co is faced with the choice of whether to deduct its 2020 income year tax losses in the 2021 income year or carry them back to the 2019 income year. If Medium Co deducts the tax losses in the current year its tax will be $1.04 million ($4 million x 26%). Whereas, if Medium Co carries back its 2020 income year tax losses to the 2019 income year its tax benefit will be $1.2 million ($4 million x 30%, as it was not a base rate entity in the loss year).

In these circumstances Medium Co will save $100,000 in tax if it chooses to carry back its tax losses to the 2019 income year instead of deducting them in the 2021 income year.

Conclusion

Due to the potential for different tax to arise, tax advisors should take into account all of the circumstances of their corporate tax entity clients instead of simply choosing to carry back losses and claim the LCBO in a particular year. Additionally, although tax savings is a persuasive factor in determining which option a corporate tax entity chooses, consideration should also be given to the flow on tax consequences the choice has, such as the effect on the corporate tax entity’s franking account balance and its ability to pay franked dividends without incurring a franking deficit tax liability.

This article provides a general summary of the subject covered and cannot be relied upon in relation to any specific instance. Webb Martin Consulting Pty Ltd and any person connected with its production disclaim any liability in connection with any use. It is not intended to be, nor should it be relied upon as, a substitute for professional advice.