Tax Loss Carryforwards

Tax Loss Carryforwards (also known as 'Net Operating Loss Carryforwards' or 'NOLs') are a tax provision that allows a company to use its financial losses from one period to reduce its tax bill in a future period. Think of it as a get-out-of-tax-free card that a business earns for surviving a tough year. When a company's expenses exceed its revenues, it reports a net loss and, naturally, pays no corporate income tax. But the story doesn't end there. Tax authorities, like the IRS in the United States, allow the company to “carry forward” this loss. When the company returns to profitability, it can use these banked losses to offset its future profits, thereby lowering its taxable income and paying less tax. For a value investor, these NOLs can be a significant, often overlooked, asset hiding on a company's balance sheet. It’s like discovering the company has a massive pre-paid tax coupon, ready to be cashed in once the business turns a corner.

The concept is simpler than it sounds. Imagine a company, Turnaround Inc., has a terrible year and posts a pre-tax loss of $20 million. The corporate tax rate is 21%.

• In Year 1, Turnaround Inc. has a loss of $20 million. Its tax bill is $0. It now has a $20 million NOL to carry forward.
• In Year 2, business booms! The company earns a pre-tax profit of $30 million.

Without the NOL, the company would owe tax on the full $30 million profit: $30 million x 21% = $6.3 million. However, Turnaround Inc. can use its NOL from Year 1 to shield its profits. The calculation becomes:

1. Taxable Income = Profit of $30 million - NOL of $20 million = $10 million
2. Tax Owed = $10 million x 21% = $2.1 million

By using its tax loss carryforward, the company saves a whopping $4.2 million in cash ($6.3m - $2.1m). This is not an accounting trick; it's a real cash saving that directly boosts the company’s value.

Value investors love to find treasure where others only see trouble. NOLs are a classic example of such a hidden asset, for a few key reasons.

NOLs are a type of deferred tax asset (DTA). However, accounting rules require a company to be confident it will generate future profits before it can fully recognize the value of these DTAs on its books. If the market is pessimistic about a struggling company's chances of a turnaround, it will likely assign zero value to its NOLs. An investor who does their homework and concludes the company will recover can buy the stock at a discount, knowing that these NOLs represent huge, unappreciated future cash savings.

A consistently profitable company can't just create losses to avoid taxes. But it can buy a company that has a lot of them. A profitable acquirer can purchase a company with a large stockpile of NOLs and use them to shield its own profits from tax. This makes the target company more valuable to the acquirer than it is on a standalone basis, which can lead to a buyout at a premium price. The legendary investor Warren Buffett masterfully used this technique when his budding investment empire acquired Berkshire Hathaway, a failing textile manufacturer. Buffett wound down the textile operations but used the company's significant operating losses to shelter the profits generated by his new, profitable insurance businesses.

Before you go hunting for companies loaded with NOLs, you must be aware of the significant risks and limitations.

• They Can Expire or Be Limited: NOLs are not a permanent asset. Tax laws vary by country and change over time. For example, under the U.S. Tax Cuts and Jobs Act of 2017, federal NOLs generated after 2017 can be carried forward indefinitely, but their use in any single year is generally limited to 80% of taxable income. NOLs from before 2017 typically expire after 20 years. Always check the specific regulations for the jurisdiction.
• Use It or Lose It: An NOL is only valuable if a company generates future profits to offset. If the company continues to lose money or fails to become sufficiently profitable before the NOLs expire, this “asset” becomes completely worthless. Betting on NOLs is fundamentally a bet on a successful business turnaround.
• Change of Ownership Rules: Tax authorities are wise to the acquisition game. To prevent companies from being bought solely for their tax assets, rules like Section 382 of the U.S. Internal Revenue Code impose strict limits on how much of a company's NOLs can be used annually following a significant change in ownership. This can drastically reduce the present value of the NOLs to an acquirer and must be factored into any analysis.