Interviewers Opening Remarks

Deferred tax assets—and their inverse, deferred tax liabilities—occur when there is a mismatch between the accounting and tax treatments of assets and liabilities.

Deferred tax assets normally strengthen the balance sheet. Historically, bank regulators have recognized such assets as able to contribute to Core or Tier 1 regulatory capital.

However, regulators are increasingly concerned about bank balance sheet reliance on DTAs, prompting them to introduce complex new rules, for example, under Basel III and the EC’s Capital Requirement Directive, known as CRD IV.

Joining me today to discuss these new requirements and how banks should respond are John Bush – Partner from KPMG in the United States, Victor Mendoza – Partner from KPMG in Spain and Michele Rinaldi – Partner from KPMG in Italy.

Interviewer

John, to set the stage for us, could you provide an overview of deferred tax assets and how they affect a bank’s balance sheet?

John Bush

As you said, Deferred Tax Assets, or DTAs as we call them, result when the accounting and tax treatment of an asset or liability diverge. They can arise in a number of ways. For example, Generally Accepted Accounting Principles or International Financial Reporting Standards may require your company to recognize a loss before the tax authorities allow it to be offset against tax. Since there will be a cash flow benefit in a later accounting period from the reduction in tax due, the DTA is carried forward as an asset. More generally, differences between the tax basis of an asset or liability and its GAAP or IFRS basis that will create a future tax deduction when the item is settled will generate a DTA. Also, unused net operating losses or tax credits that can be used against future taxable income produce DTAs.

Interviewer

Why are DTAs a source of concern for the banking regulators?

John Bush

Regulators worry about banks relying on DTAs to contribute to regulatory capital and strengthen their balance sheets because they are inherently more risky than other kinds of assets on a bank’s balance sheet. The value of a DTA depends on a bank making operating profits in the future against which the tax liability can be reduced. If the bank does not generate enough profit, the DTA must be written down, reducing available capital as a result of the write down. Consequently, their value in protecting depositors and absorbing operating losses may evaporate exactly when it is needed the most.

Interviewer

And Michele, do you believe the regulators’ concerns are justified?

Michele Rinaldi

Based on the available evidence, I would say yes. You are to consider that a recent academic study from the University of North Carolina looked at a sample of large US commercial banks. The study found that banks with a higher proportion of capital composed of DTA at the start of the recession were more likely to fail, even after controlling for other factors. The study also found that many banks with a higher DTA percentage also have a higher bond spread and lower credit ratings. And as a result of continuing operating difficulties since the crisis, many banks have built up large amounts of DTA. According to the study, DTAs grew in dollar terms by nearly 300 percent over the 12 months to June 2009, to average more than 10 percent of equity for the entire US banking sector.

Interviewer

John and Victor, how are regulators addressing concerns over regulatory capital with high proportions of DTAs?

Victor Mendoza

There are already limits to the extent to which DTAs can contribute to regulatory capital in various jurisdictions. In general, DTAs are treated as good assets only if they satisfy various regulatory requirements. But what about the US, John?

John Bush

In the United States, U.S. bank regulators published proposed rules in early June designed to bring the U.S. regulatory rules dealing with DTAs into line with the Basel III accords. Under the current rules, however, DTAs can be justified, first, by netting DTAs against DTLs irrespective of the tax jurisdiction to which the DTLs or DTAs relate and by subtracting potential carry-back claims against taxes previously paid assuming the DTAs reverse at the end of the reporting date. Moreover, DTAs also can be absorbed against projected taxable income for the next 12 months following the report date, but they can only be counted to the extent they do not exceed 10 percent of a bank’s Tier 1 capital. The newly proposed U.S. rules, however, hew more closely to the rules in the Basel III accords.

Victor Mendoza

From an international perspective, the current rules vary from jurisdiction to jurisdiction but, in general, DTAs recognized under IFRS or any local accounting GAAP are typically treated as good assets from a regulatory perspective.

Interviewer

And John, how will DTAs be treated under Basel III and the CRD IV proposals?

John Bush

These rules treat DTAs differently depending on their tax attributes. They can significantly affect the bank’s regulatory capital position. Under the proposed CRD IV requirements, DTAs will only be treated as good assets if they can be netted against DTLs, under certain requirements particularly those set out in the Basel III accord. And if they arise from temporary differences, DPAs are subject to certain threshold limits based on the amount of a bank’s Tier 1 common equity. DTAs that depend on the bank’s future profitability, such as net operating losses or credit carry forwards, are directly deducted from Tier 1 common equity. The Basel III rules on DTAs, on which the CRD IV rules are based, are quite similar. The Basel III rules have a number of detailed transition provisions that are designed to give banks in countries subscribing to the accords sufficient time to satisfy the new provisions. There are significant uncertainties, however, over how the Basel III framework will be interpreted in practice. For example, to what extent will US GAAP or IFRS constitute the basis for some of the underlying calculations? Secondly, what sort of carry-back rule for testing DTAs will be permitted? Third, will banks have the option either to net DTLs against certain assets such as mortgage service rights or unconsolidated investments in other financial institutions and similar items? Or, alternatively, to treat them as part of the broader threshold limit calculations? And finally, what transition arrangements will be available in each country subscribing to the Basel III accord?

Interviewer

Victor, in light of these new regulations, how should banks respond, especially given the uncertainty over interpretation?

Victor Mendoza

Given the impact that the DTAs will have on the competition of regulatory capital in the short and I would say medium term also, banks may wish to implement strategies to manage their DTAs position effectively. For example, accelerating income recognition from a tax perspective or, the other way, 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 a critical issue. In this regard, assets, liabilities, regulatory capital and tax can no longer be effectively optimized on a piecemeal basis. And a bank will only be able to minimize its capital cost while maximizing its ability to comply with regulation by developing an integrated strategic framework to balance all of these considerations. From an operational point of view, the success of this strategy depends on eliminating the silos between functions and in particular, ensuring that tax and regulatory capital decisions are considered at the highest level, rather than being confined to specialist departments.

Interviewer

Thank you all for bringing some much-needed clarity on this complex topic. Before we sign off, Victor, do you have any final observations?

Victor Mendoza

Well, regulators’ concerns are increasingly being reflected in closer scrutiny by markets, investors and rating agencies. And, certainly, banks without a coherent and effective strategy for dealing with the impact of DTAs on their balance sheet capital will be penalized.

Interviewer

Thank you John, Victor and Michele.

Listeners can find more details on this topic in the July 2012 edition of KPMG’s frontiers in tax publication.

Other podcasts in this series include the current status and potential fate of the Financial Transactions Tax in the EU and new tax law implications for financial services in India.

Thank you and we look forward to you joining us again next time.