DTAs arise in a number of circumstances:
- An application of Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) may require the recognition of a loss before the tax authorities allow it to be set against tax; since there will be a cash flow benefit in a subsequent accounting period from the reduction in tax due, the DTA is carried forward as an asset.
- Any other difference between the tax basis of an asset or liability and its GAAP or IFRS basis that will give rise to a future tax deduction when the item is settled will generate a DTA.
- Unused net operating losses or tax credits that can be used against future taxable income will also give rise to DTAs.
DTAs and regulatory capital
In normal circumstances, DTAs are assets which strengthen the balance sheet. Historically, subject to limits in some jurisdictions, bank regulators have recognized such assets as able to contribute to Core (Tier 1) regulatory capital. But such sources of capital are inherently more risky than many other assets on a bank’s balance sheet. The value of a DTA depends on the bank making operating profits in the future against which the tax liability can be reduced. If the bank is unable to generate sufficient profit, the DTA must be written down, reducing available capital. Regulators are increasingly concerned about bank balance sheet reliance on DTAs because their value in protecting depositors and absorbing operating losses may evaporate at exactly the point at which it is needed.
There is independent evidence that regulators have reason to be concerned. A recent academic study of a sample of large US commercial banks found that:
- Banks that had a larger proportion of capital composed of DTA at the start of the recession were more likely to fail, even after controlling for other precipitating factors.
- Many banks with a higher DTA percentage also have higher bond spreads and lower credit ratings.1
The examination of the worth of DTAs has become more serious following the financial crisis. As a result of continuing operating difficulties, many banks have built up large amounts of DTA. According to Fitch, DTAs grew in dollar terms by nearly 300 percent over the 12 months to 30 June 2009 to average more than 10 percent of equity for the entire US banking sector.2
There are already limits to the extent to which DTAs can contribute to regulatory capital in some jurisdictions. DTAs are treated as ‘good’ assets only if they satisfy various regulatory requirements. In the ‘Current Rules’ operating in the USA, permissible DTAs are not dependent on future taxable income determined by:
- Netting DTAs against DTLs irrespective of the tax jurisdiction to which they relate.
- Subtracting potential carry-back claims against taxes previously paid assuming the DTAs reverse at the report date. DTAs that can be absorbed against projected taxable income for the next 12 months following the report; however, these DTAs can only be counted to the extent that they do not exceed 10 percent of a bank’s Tier 1 capital.
Internationally, the rules vary by jurisdiction. However, in general DTAs recognized under IFRS or an equivalent local accounting standard are typically treated as ‘good’ assets.
Basel III and CRD3 IV
The Basel Committee has in the past not had a specific rule dealing with deferred taxes. However, under Basel III and the CRD IV proposals, DTAs may significantly impact the regulatory capital position of a bank and will be treated differently depending on their tax attributes. Under the proposed CRD IV requirements, DTAs will only be treated as ‘good’ assets if they:
- can be netted against DTLs, under certain requirements or
- arise from temporary differences, subject to the following limits:
- 10 percent of net Tier 1 common equity calculated separately for each of three items, mortgage servicing rights (MSRs), minority investments in other financial institutions and DTAs (collectively, the ‘specified items’), or
- 15 percent of Tier 1 common equity when calculated collectively for the specified items.
DTAs dependent on the future profitability of the bank, such as net operating losses or credit carry forwards, are directly deducted from Tier 1 common equity.
The Basel III rules on DTAs, from which the CRD IV proposals are drawn, are similar.
Some significant uncertainties remain over how the Basel III framework will be interpreted in practice, in particular in the US context:
- To what extent will US GAAP or the ‘Current Rules’ constitute the basis for the required calculations?
- Will the Current Rule that treats DTAs as reversing at the report date for testing carry-back potential be preserved? Will banks have the option either to net DTLs against MSRs, minority investments and similar items, or to treat them as part of the broader threshold calculations?
- What transition arrangements will be available?
In the face of these new regulations, how should banks respond, especially in view of the continuing uncertainty over interpretation and the possibility of managing the pace of implementation?
In the short- to medium-term, banks may wish to implement strategies to manage their DTAs position effectively. Accelerating income recognition from a tax perspective or deferring the tax recognition of an expense may be suitable strategies to convert “bad” DTAs into “good” ones. In the longer term, cleaning up and improving the quality of balance sheet capital will be critical. It is important to realize that assets, liabilities, regulatory capital and tax can no longer be effectively optimized on a piecemeal basis. A bank will only be able to truly to optimize its position, minimizing its cost of capital while maximizing its ability to comply with regulation by developing an integrated strategic framework to balance all of these considerations. In the end, these are no longer simply technical issues. Regulators’ concerns are increasingly reflected in closer scrutiny by markets, investors and rating agencies. Banks lacking a coherent and effective strategy will be penalized.
Three final implications:
- The success of such a strategy will depend on eliminating the silos between functions, and in particular, ensuring that tax and regulatory capital considerations are integrated into corporate decision-making at the highest level, rather than being confined to specialist departments.
- Multi-national banks face particular challenges in dealing with different local tax regulations, differing local accounting rules and differing implementations of Basel III.
- Technology and systems can help manage the necessary information flows, but could require significant additional investment.
1John Gallemore, Deferred Tax Assets and Bank Regulatory Capital, University of North Carolina, January 2012
2The Deferred Tax Asset Disaster, Financial Times, 4 November 2009
3Capital Requirements Directive of the European Commission