Limitations on the use of tax loss carryforwards following a corporate acquisition
One of the tools available to companies for optimising their tax burden is the use of tax loss carryforwards. However, this mechanism cannot always be applied.
Article 26.4 of Law 27/2014 of 27 November on Corporation Tax (hereinafter, the “CIT Law”) sets out a series of restrictions that prevent the utilisation of tax loss carryforwards in certain circumstances, particularly in the context of corporate acquisitions or restructuring processes.
This article explains when accumulated tax losses may not be offset, and what situations must be considered if a company is undergoing an acquisition or restructuring (such as mergers).
Which situations limit the use of tax loss carryforwards?
According to Article 26.4 of the CIT Law, a company may not apply tax loss carryforwards from previous accounting periods if the following conditions occur simultaneously:
1. Change of control in the company:
Following the end of the tax period to which the tax loss carryforwards relate, an individual or legal entity, or a group of related individuals or entities, acquires a majority shareholding or the majority of the rights to participate in the profits of the company.
2. The acquirer held less than 25% of the company prior to the acquisition:
Before the close of the tax period in which the losses were generated, the persons or entities acquiring the company held less than a 25% stake. In other words, they were not significantly involved in the company’s share capital at the time the losses were incurred.
3. The acquired company falls within one of the following categories:
The company did not carry out any economic activity during the three months prior to the acquisition.
The company qualifies as a passive holding entity.
The company has been removed from the official register of entities due to non-compliance with tax obligations, specifically, for failing to file Corporation Tax returns for three consecutive tax years.
- In the two years following the acquisition, the company carries out a different or additional economic activity to that which was previously conducted, and this results in an increase of 50% or more in turnover compared to the two preceding years. A change of activity is deemed to have occurred where there is a change in the company’s classification under the National Classification of Economic Activities (CNAE).
Why do these limitations exist?
The regulation aims to prevent abusive practices whereby inactive or low-activity companies are acquired solely for the purpose of taking advantage of their accumulated tax losses.
These restrictions are intended to ensure that tax loss carryforwards are not used as an artificial tax benefit following an acquisition.
What should be considered prior to a corporate acquisition or restructuring?
- Review the target company’s tax position prior to the acquisition: If you are considering acquiring a company with accumulated tax losses, and the restrictions in Article 26.4 of the CIT Law apply, those losses may not be available for offset.
- Ensure proper documentation of the company’s economic activity: To avoid falling within the aforementioned restrictions, it is essential to demonstrate that the company continues to carry out genuine economic activity, or that any changes do not have a material tax effect.
In conclusion, tax loss carryforwards are a legitimate tax planning tool, but they are neither automatically transferable nor always usable. The Corporation Tax regulations impose important limitations where there is a change of corporate control, to prevent the misuse of tax losses.
These types of transactions involve complex considerations that warrant professional assessment. Do you need advice? Access our areas related to limitations on the offsetting of tax losses following a business acquisition: