Tax losses create deferred tax assets (DTA) if the company expects to earn future profits to offset them. However, many losses expire unused. This guide covers loss carryforward mechanics, DTA recognition criteria, valuation allowances, and the audit scrutiny around realizability.
Tax Loss Carryforward Basics
When a company has a loss in a tax year, most jurisdictions allow:
- Carryback: Apply loss to prior years' profits (refund claim) — limited period, often 1 year
- Carryforward: Apply loss to future years' profits — often indefinite or 10+ years (varies by jurisdiction)
Carryforward Periods by Jurisdiction
| Country | Carryforward Period | Notes |
|---|---|---|
| UK | Indefinite (as of 2023) | Trading losses carry forward indefinitely; no time limit |
| US (Federal) | Indefinite (as of 2018 TCJA) | NOL offset capped at 80% of taxable income (limiting utilization) |
| Germany | Indefinite | Trade tax losses carryforward indefinitely |
| France | Indefinite | General rule; certain restrictions on M&A |
DTA Recognition: The "Probable" Test
Recognize a DTA for unused tax losses if it is probable that future taxable income will be available to use the loss.
Factors Supporting DTA Recognition
- Recent profitability: Company was profitable in prior years; loss is temporary
- Industry visibility: Orders/contracts on hand suggest future revenue
- Turnaround plan: Management credible plan to return to profit (with evidence)
- Cyclical business: Industry cycle suggests recovery (validated by history)
Factors Against DTA Recognition
- Sustained losses: 3+ years of consecutive losses with no improvement
- Deteriorating industry: Structural decline with no recovery visibility
- No specific turnaround plan: Or plan is aspirational, not credible
- Management credibility: Prior failed recovery attempts
- Ownership change restrictions: Acquisition triggers change-of-ownership rules that limit loss usage
Valuation Allowance
If recognition is uncertain, offset the DTA with a valuation allowance:
Example: Unused tax losses £30m
— Gross DTA at 19% tax rate: £5.7m
— Company has been loss-making for 4 years; recovery plan is weak
— Valuation allowance (100%): £5.7m
Reported DTA on balance sheet: £0
Change in Ownership Rules (Section 382 / Similar)
US Section 382 Limitation
If a company undergoes a substantial ownership change (>50% ownership change in 3-year period), use of prior losses is severely limited to:
Example: Section 382 Limitation
- Unused NOL (tax losses): £100m
- Company value (pre-acquisition): £50m
- Ownership change occurs: New owner acquires >50% stake
- Annual usage limitation: £50m × 5% = £2.5m per year (max)
- Implication: 40-year carryforward period (£100m / £2.5m/year), not indefinite
Audit impact: After an acquisition, auditors carefully assess whether Section 382 applies. If losses are limited, valuation allowance may be appropriate (losses will expire before utilization).
Acquisition-Related Loss Restrictions
Many jurisdictions (UK, EU, US) have anti-abuse rules limiting loss usage after acquisition:
- Change-of-ownership rules: Similar to Section 382 (US) or similar in other countries
- Change-of-business rules: If acquired company fundamentally changes business, losses may not be usable
- Earnings-stripping rules: Limit interest deductions (not losses directly, but affects future income available to absorb losses)
Worked Example: Tech Startup with Loss Carryforward
Scenario
Company: TechStart Ltd (private)
Tax loss carryforward: £8m (from prior 3 loss-making years)
Current year profit: £2m (just turned profitable)
5-year forecast: £2m, £3m, £4m, £3m, £2m (declining after peak)
DTA Assessment
- Gross DTA: £8m × 19% = £1.52m
- Probable future income? YES — company just returned to profit; 5-year forecast shows £14m cumulative profit
- Valuation allowance: 0% (no allowance; full DTA recognized)
- Reported DTA: £1.52m
Tax Benefit in Current Year
- Pre-tax profit: £2m
- Tax at statutory rate (19%): £380k
- Loss offset (£2m × 19%): £380k (reduces tax liability)
- Cash tax: £0 (current year loss offset by carryforward)
Audit Red Flags: Tax Loss DTA
Red Flag 1: DTA Recognized Despite Sustained Losses
Finding: Company with 6-year loss history recognizes full DTA on £20m loss carryforward; no credible turnaround plan.
Auditor action: Require substantial valuation allowance (80— 100%); if company can't articulate specific path to profit, limit DTA recognition.
Red Flag 2: Section 382 Limitation Not Assessed
Finding: Acquisition closes; £50m unused losses; no evaluation of Section 382 (US) or similar restrictions.
Auditor action: Assess ownership change; calculate annual limitation; apply valuation allowance if losses will expire before usage.
Red Flag 3: Valuation Allowance Not Adjusted
Finding: Prior year: 100% valuation allowance on £5m DTA (loss-making). Current year: Company returns to profit and forecasts £20m profit over 5 years. Valuation allowance still 100%.
Auditor action: Reassess; likely reduce valuation allowance materially, increasing reported DTA and reducing tax expense.
Red Flag 4: Change-of-Business Not Documented
Finding: Acquired company had £10m loss carryforward; post-acquisition, business model changes materially. Losses may be restricted.
Auditor action: Evaluate whether change-of-business rules apply; apply valuation allowance if losses are at risk.
Real-Life Case Study: Recognising a Deferred Tax Asset on Losses
Scenario. A start-up has accumulated £4m of tax losses. Tax rate 25%, so a potential £1m deferred tax asset. Should it be recognised?
Judgement. A DTA on losses is recognised only to the extent future taxable profits are probable. With a credible, board-approved forecast showing £2.4m of taxable profit within the carry-forward window, the company recognises a DTA on £2.4m of losses (£600k), not the full £1m.
Takeaway. Losses do not automatically create an asset, evidence of future profits does. A history of recent losses is "strong evidence" against recognition, so auditors scrutinise the forecast supporting any DTA on losses.
Illustrative composite scenario for educational purposes. Figures are indicative and do not represent any specific company.
• IAS 12 Valuation Allowances: DTA Realizability Assessment
• IAS 12 Tax Rate Changes: Remeasuring Deferred Tax Balances
• IAS 12 Deferred Tax on OCI: Recognizing Tax Effects in Other Comprehensive Income
• IAS 12 in M&A: Deferred Tax on Acquisition Fair Value Adjustments