The Covid-19 crisis has pressed the reset button in multiple dimensions. On the economic front, there is an air of gloom globally. The Indian economy, already under pressure for some time due to various reasons, finds the situation greatly exacerbated.

While almost the entire industry is grappling with its impact, among those whose survival is threatened the most are the MSMEs and start-ups.

Many companies might report losses. Is there something that can be done to ease the impact of these losses? A magical panacea may not be possible.

The need of the hour might be a series of innovative interventions. Here a new approach is outlined to deal with tax losses. While the suggested model could be beneficial under most situations, it has the potential to provide a quick relief to a bleeding industry.

Set off tax losses

In general, tax losses by itself are not an indicator of financial viability of an entity.

The tax losses could be on account of higher quantum of depreciation, particularly in the case of capital-intensive units, without commensurate earnings in the initial years of operations. Or, in some cases, it could be on account of adverse market conditions. T

he past tax losses, of course, are allowed to be set off against the future earnings to reduce tax liability.

However, the ability of the entities to set off tax losses depends entirely upon their financial and commercial viability. While the viable ones are able to take the benefits of the set-off against their future taxable income, for those with much longer lead times for a potential turnaround, the tax losses remain notional and without any economic benefit.

Further, it can also be argued that the current tax regime does not reckon the time value of tax savings arising from these tax losses. As a result, the time value of these tax savings diminishes with the efflux of time. In other words, the real value of tax saving from carried-over tax losses, say in year four, is much lower than the value of tax saving in year one.

There is one more dimension to this. Let us assume that a business group has two entities, one reporting a tax loss and the other taxable income. This group will end up paying tax on the taxable income of one entity and will have to carry over the tax losses of the other entity hoping to set off against the latter’s taxable income in the future. This group would, however, have reduced its tax burden if both the operations were in one entity. This is because each taxable entity is treated on a standalone basis for taxation purposes.

Inter-connecting entities

Can we create inter-connections between entities while determining tax liabilities?

Can we think of creating a market for ‘trading in tax losses’ like stock or commodity market? We can contemplate setting up a dedicated exchange, with all taxable entities as its participants, which will facilitate trading of ‘tax losses’ among them.

For the purpose of illustration, let us call entities with tax losses as TL and taxable income as TI. TI and TL can invite or offer bids for buying and selling tax losses through this dedicated exchange. The losses traded will be reduced from the taxable income and tax losses of the TI and TL respectively. The value of a particular quantum of tax loss will be tax-saving arising from it.

The market price (of tax losses) will naturally be less than the tax liability which would otherwise be payable to the government.

Further, the price will also depend upon the demand for and supply of tax losses available in the market. For example, let us assume that TI has a taxable income of ₹1 lakh on which it would have to pay a tax of ₹26,000. It would look to buy a tax loss of ₹ 1 lakh for a price of less than ₹26,000, say at ₹20,000.

In this process, unlike in the current regulatory regime where each taxable entity is considered as a separate unit for tax purposes, the entire “universe of entities” is considered as a single entity by facilitating setting off of tax loss of one unit against the taxable income of another unit. Further, this mechanism recognises time value of tax savings (from tax losses) as the system enables encashing the benefit of tax losses immediately.

On the face of it, the government stands to lose on its direct taxes to the extent of tax savings on tax losses traded in the exchange.

Taking the example quoted above, the TI will pay ₹20,000 to the TL selling the loss, instead of paying ₹26,000 to the government.

These tax savings are now in the hands of the market participants (instead of the government), and can be expected to be used in the economy more efficiently and swiftly.

While the viable entities will use these additional funds for further augmenting their business growth, the less viable ones might use them to ease their financial burden. Even a legislative waterfall mechanism can be thought of with regard to usage of funds generated by selling tax losses.

The target population and the boundary conditions for making each entity eligible for participation need to be carefully thought through, taking into account potential misuse of such a system.

Perhaps, the initial roll-out could be restricted to start-ups and MSMEs in the manufacturing sector. At a time when innovative ideas are required to give a boost to the economy within short time cycles, and given the urgency and emphasis on ‘Make in India’, a mechanism such as this could be a significant facilitator.

The scope of this article has been restricted to only a conceptual model. A rigorous analysis with relevant pan-India data is necessary to develop an implementation model.

This will need to be followed up by detailing of the operational modalities that could have implications across several legislations.

The writers are corporate strategy consultants