Carry Forward Tax Losses (and Expiries)

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It is common in a project, particularly in the early phases, for the taxable income of the project vehicle to be negative i.e. the project is in “tax losses”. This may be due to any or all of:

  • Deductions for interest during construction
  • “Ramp up” phase of the project where revenue is below “full’ levels
  • Accelerated tax depreciation or other allowances in early years

In some limited circumstances, the losses may be able to be “used’ by a project equity holder in the year which they are incurred. It is more general, however, in project analysis, for the losses to be assumed “carried forward” to future years where the taxable income is positive so that these carry forward losses can partially or totally offset the taxable income in those future years. The cumulative amount of these “unused” losses at any point in time is called the Carry Forward Loss Balance (“CFL Balance” for short).

 So how should these losses be modelled?

 The modelling of the generation and utilisation of carry forward losses and accordingly the increase and decrease in the CFL Balance is analogous to an “account” and is generally modelled as such.

Creating & Utilising Carry Forward Losses

In a year of positive taxable income, carry forward losses up to the amount of the CFL Balance can be used to offset or reduce the taxable income (but to no lower than zero)

So, if taxable income pre CFL is positive, then:

  • Losses Carried Forward for period = 0 (there is no loss)
  • CFL used to offset taxable income = minimum of taxable income pre-CFL for this period and Opening CFL balance (if any)
  • CFL Balance is decreased by any such CFL used, and
  • Taxable Income post CFL = Taxable Income pre CFL – CFL Used
  • Tax payable = Taxable Income post CFL * Tax Rate

In a year of negative taxable income, the taxable income on which tax is payable is now zero and the negative income (or tax losses) for that year are added to the CFL balance

So, If taxable income pre CFL is negative, then:

  • Taxable Income on which tax is payable = 0
  • Losses Carried Forward for period =  -taxable income
  • CFL Balance is increased by this loss
  • CFL used to offset taxable income = 0 (taxable income is not positive)
  • Tax Payable =0

Both of these cases can be combined into one formulation as follows:

  • Let Taxable Income pre CFL = TIP
  • CFL Used in period = MIN(MAX(0,TIP), Opening CFL Balance)
  • Loss Carried Forward for period = MAX(0,-TIP)
  • Taxable Income after CFL= MAX(0,TIP) – CFL Used
  • Closing CFL Balance = Opening CFL Balance – CFL Used + Losses Carried Forward

The full formulation can be found in the Excel file.

Carried Forward Tax Losses Expiries

If your transaction is in a jurisdiction where there is a time limit on the number of years that a particular year’s tax losses can be carried forward, then obviously the basic calculation of CFL Balances needs to be adjusted to reflect that.

An additional line needs to be added to the calculation of CFL Balance. This line reflects the losses which can no longer be used (i.e. which have “expired”). These losses which have expired at the end of a particular period are subtracted to reduce the Closing CFL Balance for that period.

Conceptually, if losses expire after N periods, the Losses Expired for a particular period (if any)equals the losses (if any) generated N periods ago less losses used since then which haven’t come from other periods’ losses.

Also, by definition if the period we are considering is less than the Nth one, then no losses can have expired and Losses Expired is thus zero for those periods

A Note on Tax Rate

Tax Rate may very well vary over the 20 or 30 year life of a project and so whilst tempting to define a single variable in the input sheet for “Tax Rate” and to use that variable in all formulae, it is more flexible in the first place to include tax rate as a time variable series, such that :

Tax payable in period n = Net Taxable Income in period n x Tax Rate for period n