One of the most important changes made by the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) is the temporary suspension of the 2017 Tax Cuts and Jobs Act (TCJA)’s 80% limitation on the use of net operating losses (NOLs) for tax years beginning after Dec. 31, 2017 and before Jan. 1, 2021. Under these CARES act provisions, taxpayers are permitted to carry back NOLs generated in tax years 2018, 2019 and 2020 to the five preceding years. For more information regarding the NOL carryback provisions of the CARES Act, see RSM’s prior alert.
There are various international tax issues that should be considered when analyzing the impact of the NOL carryback, in particular taxpayers should examine the impact of an NOL carry back on the foreign tax credit (FTC). Because NOLs incurred by a taxpayer may include a U.S. domestic loss or a foreign loss, an NOL deduction claimed in a carryback year can significantly affect a taxpayer’s FTC position, by generating an overall domestic loss (ODL) or overall foreign loss (OFL), depending on the source of the NOL. This could impact the taxpayer’s FTC calculation for that year and could affect FTC carrybacks or carryforwards. For example, an NOL carryback that reduces the taxpayer’s foreign source income in a prior year might result in no ability to claim a credit for foreign taxes paid or accrued in that prior year. Thus, any decision to carryback an NOL must take into account the impact on the taxpayer’s FTCs.
Overall domestic losses as a result of NOL carryback
Under section 904, U.S. source taxable income (USTI) is computed separately from foreign source taxable income (FSTI) for FTC purposes, with the latter further separated into categories or baskets. Domestic loss or foreign loss in one or more separate categories may result from the allocation and apportionment of expenses, losses, and other deductions to U.S. or foreign source income.
Section 904(g)(2)(A) provides that an overall domestic loss (ODL) is an amount by which the deductions allocated to U.S. source gross income for a taxable year exceed that gross income (a domestic source loss), but only to the extent that the domestic loss offsets FSTI for the domestic loss year or for an earlier year by a carryback (the U.S. loss should be apportioned among the separate baskets of foreign source income). When a taxpayer incurs a domestic loss that is carried back as part of an NOL, the U.S. loss is first deducted against other U.S. income in the carryback year; to the extent the U.S. loss for a taxable year exceeds U.S. income, the excess domestic loss then reduces foreign source income, thereby creating or increasing an ODL account. A taxpayer sustains an ODL only in a tax year in which it elects the foreign tax credit. Under Reg. § 1.904(g)-1(b)(2), the ODL resulting from an NOL carryback is treated as sustained as of the end of the year in which the domestic loss is incurred, not the carryback year. For example, if a taxpayer incurs a domestic loss for 2019 that it carries back to 2018 as an NOL deduction, the NOL deduction for 2018 is added to the ODL account as of the end of 2019 to the extent that it consists of domestic loss that is deducted against foreign source income.
By offsetting foreign source income, a U.S. source NOL carryback may reduce or eliminate tax liability, and therefore reduce the utilization of FTCs originally claimed in the carryback year. A domestic loss NOL carried back to a prior year may result in excess FTCs that may be carried back one year and carried forward ten years after the year in which the foreign taxes were paid (or deemed paid). While there might be a mismatch between the tax year in which the ODL is sustained (year of domestic loss) and the year in which the FTCs are reduced as a result of the NOL carryback, this should not have an adverse effect on taxpayers, as an NOL carryback may increase a taxpayer’s FTC carryover from that year, which in turn may provide additional FTCs to offset regular tax liability in subsequent years.1
Loss recapture rules are generally triggered when a U.S. loss offsets foreign source income. Taxpayers who sustain an ODL that offsets foreign source income are allowed to recapture the ODL as foreign source from U.S. source income arising in later tax years by re-characterizing future U.S. taxable income as foreign taxable income in the same category of foreign income as the category that was originally offset by the domestic loss. However, when an ODL account is created as a result of an NOL carryback, the ODL that is carried back to a prior year but treated as sustained in the year of loss cannot be re-characterized in a prior year but only in a succeeding year. The recapture rules may provide a benefit to the taxpayer in a subsequent year and, as such, can be a valuable tax attribute by increasing or generating the taxpayer’s section 904 FTC limitation (for the same category of foreign income affected by the ODL) which can absorb the excess FTCs resulting from the reduction of FTCs in the earlier tax year in which the domestic loss offset foreign income in connection with an NOL carryback.
As domestic source NOLs as a result of an NOL carryback can provide a significant tax benefit, multinational taxpayers should consult with their tax advisors to assist them with modeling the effects of the NOL provisions to their specific circumstances and evaluate their ability to claim FTCs on prior year filings as well as future returns. There are many potential consequences arising from an NOL carryback and changes to the taxpayer’s FTC position must be quantified in order to determine whether an NOL makes sense.
1 One exception is that FTCs attributable to GILTI other than passive category income (section 951A category income) cannot be carried back or forward, thus the benefit of NOLs carried back to a post-section 965 year may be diminished (or possibly eliminated).