In my previous two articles, we briefly covered the differences between the tax book and financial book, as well as some basic concepts related to deferred tax assets and deferred tax liabilities. In this part of the article series, I will cover one important DTA item – net operating losses (abbreviated for NOL in the following sections) because I have been asked many times how NOL creates DTA. It’s intuitive, but the theoretical support is not as straightforward.
In simple terms, NOL occurs when tax book expenses exceed tax book revenues. This is easy to understand. The good news is, IRS allows a company to carry it back for 2 years and carry it forward for 20 years. Note this has nothing to do with the financial book, i.e., you cannot use your current year financial book losses to offset past and future financial book incomes.
Therefore, the maximum amount of NOLs a company is able to use is the sum of
1. Past two years’ operating income, if any.
2. Operating income for the next 20 years.
Not all NOLs will create DTA. Usually NOLs are carried back first before they are carried forward. NOL carryback will not create DTA because DTA is the result of temporary differences that will reverse in the future. Only NOL carryforward will create DTA.
I’ve made the following table which contains all the scenarios:
| Scenario | Income effect | Cash flow effect | Dollar Amount | DTA effect |
| Carryback, Current Year | Yes | Yes (refund) | NOL Carryback* Tax Rate in Prior Years | No Effect |
| Carryforward, Current Year | Yes | No | NOL Carryforward* Expected Tax Rate in Future Profitable Years | Create DTA |
| Carryforward, Future Profitable Year | No | Yes (less taxes) | NOL Carryforward* Actual Tax Rate in Future Profitable Years | Decrease DTA |
Let me illustrate the points from the above table with an example:
| Year | Operating Income (Loss) | Tax Rate | Tax Payable Without NOLs |
| -2 | $120,000 | .40 | $48,000 |
| -1 | 40,000 | .40 | 16,000 |
| 0 | (200,000) | .45 | 0 |
| 1 | 20,000 | .35 | 7,000 |
| 2 | 40,000 | .35 | 14,000 |
Year 0 represents current year. Year 2 and 1 represents the preceding 2-year and 1-year period respectively. Year 1 and 2 represents next year and the year after that.
Here we have a company that suffered a 200,000 loss in current year. We will first carry back $120,000 to Year 2 to and $40,000 to Year 1 so we can get a tax refund. NO DTAs will be created as these are retroactive effects.
After the carryback, we are left with $40,000 available for carryforward, of which $20,000 will be used in Year 1 and $20,000 will be used in Year 2. Below is the table that shows the build up and reversal of DTA from Year 0 to Year 2.
| Year | Operating Income | NOL Carryforwad Available at Year End | Temporary Difference | Origination or Reverse | DTA |
| 0 | (200,000) | 40,000 | 40,000 | Origination | Yes: 40,000*35% = 14,000 |
| 1 | 20,000 | 20,000 | 20,000 | Partial Reverse | Yes: 14,000 - 20,000*35%= 7,000 |
| 2 | 40,000 | 0 | 0 | Total Reverse | No: 7,000 - 20,000*35%=0 |
I hope the above simple example can give the readers a sense of how NOLs work. Of course in the real world, the complexity level of NOLs are much higher than the foregoing example but suffice is to remember:
1. NOLs create tax refund and the amount can be substantial. A recent example is Blackberry’s huge tax refund as a result of massive NOLs.
2. NOLs could lower future income taxes if the company is profitable.
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