How will the final tax rule under Basel III affect financial institutions?
FINANCIAL INSTITUTIONS INSIGHTS |
On Oct. 11, 2013, the Office of the Comptroller of the Currency (OCC) and the board of governors of the Federal Reserve System (Fed) adopted a final rule that revises their risk-based and leverage capital requirements for banking institutions. The final rule consolidates proposed rulemaking that was published in the Federal Register on Aug. 30, 2012. These rules apply to virtually all banking institutions, with the exception of bank holding companies with less than $500 million in total consolidated assets.
These new rules likely will require significantly more analysis of deferred taxes in determining tier one and risk-based capital.
Accumulated other comprehensive income (AOCI) opt-out
Non-advanced approaches financial institutions (generally those with less than $250 billion in total consolidated assets) are able to make a one-time permanent AOCI opt-out election that is consistent with current rules. This election is available for the first report for which the institution is subject to these new risk-based capital rules. For an existing institution, this election must be made on its March 31, 2015 regulatory filing.
This opt-out election includes gains and losses on available for sale (AFS) debt securities, gains on AFS equity securities, accumulated gain and losses on cash-flow hedges, and amounts attributed to defined benefit post retirement plans. Consistent with current practice, AFS losses on equity securities are not eligible for AOCI opt-out in the determination of tier one capital. The failure of an institution to make a timely opt-out election will require most components of AOCI to be reflected in the determination of regulatory capital for all future reporting periods. The only exception relates to gains and losses from cash-flow hedges, which are not included regardless of whether an institution makes an opt-out election.
The final rules provide guidance with respect to merger and acquisition transactions. If two organizations involved in a merger or acquisition each made an opt-out election, the surviving entity must continue with this election. Similarly, if nether institution made an opt-out election, the surviving entity must continue with non opt-out treatment. However, in situations where there is divergent treatment between the acquirer and target with respect to the opt-out election, the surviving entity may make a new opt-out election. This new election must be made on the first call report filed after the effective date of the merger or acquisition.
A top-tier depository institution holding company that makes an opt-out election will be required to make an opt-out election for all insured depository institutions under common control. The regulatory agencies are concerned with capital arbitrage that an institution could deploy with divergent opt-out elections.
Notwithstanding the availability of the opt-out election, regulatory agencies reserve the right to require an institution’s capital ratio be in excess of stated minimums. This is particularly true with a large portfolio of AFS debt securities.
Allowable deferred taxes for tier one capital
Prior to the implementation of Basel III, deferred tax assets were supported by recoverable taxes paid and the lesser of the tax on the next 12 months of taxable income or 10 percent of tier one capital. Temporary differences are assumed to reverse at the report date, and the institution should calculate one overall limit that includes all tax jurisdictions.
Basel III approach to deferred taxes
The ability to use the tax liability on 12 months of future earnings to support deferred tax assets is no longer available under Basel III. Additionally, the determination of recoverable taxes is done on a jurisdictional basis. There will no longer be the ability to net federal, recoverable taxes against state- deferred tax assets. As a result, institutions will need to understand state-by-state carryback provisions to determine whether or not a state-deferred tax asset is realizable.
The approach to adjustments to tier one capital and the risk-based capital calculation under Basel III is as follows:
- Financial statement deferred taxes are adjusted for AOCI items not reflected in tier one capital.
- Goodwill and nonmortgage servicing intangible assets, net of associated deferred tax liabilities, are written off against capital consistent with current practice.
- Remaining deferred tax liabilities are allocated between net operating losses, tax credit carryforwards and deductible temporary differences that could not be realized from a hypothetical carryback.
- Net operating loss and tax credit carryforwards, net of related valuation allowances and allocated liabilities, are written off against capital.
- If the following items exceed 10 percent of tier one capital individually or 15 percent in the aggregate, they are written off against capital:
- Remaining net deferred tax assets that cannot be supported by recoverable taxes
- Mortgage servicing assets net of associated deferred tax liabilities
- Significant investments in the capital of unconsolidated financial institutions in the form of common stock
- Deferred tax assets that are not supported by tax history and do not exceed 10 percent of tier one capital individually or 15 percent in the aggregate are subject to 250 percent weighting for the risk-based capital calculation. However, deferred tax assets that are supported by tax history are subject to a more favorable 100 percent weighting reflective of their risk profile.
Deferred tax liability uncertainty regarding carryback calculation
The guidance is unclear under the final rule regarding whether the netting of allocated liabilities occurs before or after the hypothetical carryback. However, section 22(e)(3) of the final rule provides insight into the 10 percent and 15 percent common equity tier one capital deduction threshold calculations. This section states in part that, “the amount of DTAs that arise from operating loss and credit carryforwards, net of related valuation allowances, and of DTAs arising from temporary differences that the Bank could not realize through net operating loss carrybacks, net of related valuation allowances, may be offset by DTLs.”
Although not free from doubt, this language seems to indicate that the hypothetical carryback is done without consideration of deferred tax liabilities. This is further supported under section 22(e)(3)(ii), which requires allocation of deferred tax liabilities after determining the amount of deferred tax assets not realizable from a hypothetical carryback.
Whatever approach an institution uses for deferred tax netting should be applied consistently for all future periods, and approval should be requested from its primary regulator before making a change.
Transitional rules for capital adjustments
A phase-in of disallowed tax attributes and the 10 percent and 15 percent threshold deductions are to be recognized during years 2015 through 2018. The phase-in percentages over these years will increase from 40 percent to 100 percent in 20 percent increments.
Quarterly call report issues
Quarterly regulatory filings will likely reflect different carryback histories to support the institution’s deferred tax assets. A calendar-year corporation will have 27, 30, 33 and 36 months of tax history over quarters one through four, respectively. This will result in a higher amount of disallowed deferred tax assets written off or subject to 250 percent risk-based weighting in the earlier quarters versus the later quarters.
Although many institutions only adjust their deferred taxes for AOCI items on a quarterly basis, consideration should be given to adjusting tax attributes on a more frequent basis. Assuming an institution is realizing the benefit of these tax attributes, this process will help improve its capital ratio throughout the year. Deferred taxes that are reflected in the financial statements are the basis for determining amounts subject to write-off or risk weighting. Institutions should consult with their regulatory tax advisors regarding any questions associated with the implementation of these rules.