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Basel III Treatment of DTAs and MSAs

We have heard, read and seen (and internally had) some confusion regarding the joint proposed rulemaking regarding the potential simplification of the capital rules as they relate to Mortgage Servicing Assets (MSAs) and certain Deferred Tax Assets (DTAs).

In addition to simply being complicated regulations, the regulators also have two proposed rulemakings outstanding related to these items. In August 2017, the banking regulators jointly sought public comment on proposed rules (the “Transition NPR“) that proposed to extend the treatment of MSAs and certain DTAs based on the 2017 transition period. Then, in September 2017, the banking regulators jointly sought comment on proposed rules (the “Simplification NPR“) that proposed to alter the limitations on treatment of MSAs and certain DTAs (and also addressed High Volatility Commercial Real Estate or HVCRE loans).

The Simplification NPR also addressed the interplay of the Simplification NPR and the Transition NPR. The Simplification NPR provided that the Transition NPR, if finalized, would only remain effective until such time as the Simplification NPR became effective. Accordingly, the Simplification NPR, if adopted, will ultimately control, with no transition periods for MSAs and certain DTAs following January 1, 2018.

Net Operating Loss DTAs

Importantly, neither the Transition NPR nor the Simplification NPR have any affect on the Basel III capital treatment net operating loss (NOL) DTAs. DTAs that arise from NOL and tax credit carryforwards net of any related valuation allowances and net of deferred tax liabilities must be deducted from common equity tier 1 capital. Through the end of 2017, the deduction for NOL DTAs are apportioned between common equity tier 1 capital and tier 1 capital. In 2017, 80% of the NOL DTA is deducted directly from common equity tier 1 capital, while the remaining 20% is separately deducted from additional tier 1 capital. Starting in 2018, 100% of the NOL DTA will be deducted from common equity tier 1 capital.

The end of the transition period will have the effect of lowering the common equity tier 1 capital ratio of all institutions with NOL DTAs, although the tier 1 capital and leverage ratios should remain unchanged. This impact is entirely unaffected by the adoption (or non-adoption) of the Transition NPR and/or Simplification NPR.

Similarly, other aspects of NOL DTAs are unaffected by the proposed rules. Specifically, (i) GAAP still controls the appropriateness of valuation allowances in connection with the DTA, (ii) tax laws still control the length of time over which DTAs can be carried forward, and (iii) Section 382 of the Internal Revenue Code still controls the limitation (and potential loss) of DTAs upon a change in control of the taxpayer.

Temporary Difference DTAs

Unlike Net Operating Loss DTAs, DTAs arising from temporary differences between GAAP and tax accounting, such as those associated with an allowance for loan losses and other real estate write-downs, can be included in common equity tier 1 capital, subject to certain restrictions. To the extent that such DTAs could be realized through NOL carryback if all those temporary differences were deemed to have been reversed, such DTAs are includable in their entirety in common equity tier 1 capital. Essentially, to the extent the temporary difference DTAs could be realized by carrying back against taxes already paid, then such DTAs are fully includable in capital. Carryback rules vary by jurisdiction; while federal law generally permits a bank to carry back NOLs two years, many states do not allow carrybacks.

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Summary of Tax Impact of Economic Stimulus Legislation

The American Recovery and Reinvestment Act of 2009 (the “Act”) contained a number of tax provisions that are likely to be of particular interest to and will directly impact most, if not all, of our bank and other financial institution clients.  One of the tax provisions, the provision increasing the period that a net operating loss (“NOL”) can be carried back from two (2) to up to five (5) years, saw the addition of a provision that will substantially limit the number of taxpayers eligible to take advantage of the expanded carryback period.  The new limitation makes it likely that only smaller financial institutions will be able to take advantage of the expanded carryback period allowed by the Act.  The Act also repealed (with limited transitional protection) the relief provided in Notice 2008-83 issued by the Internal Revenue Service (“IRS”) in the fall of 2008 that exempted certain losses on loans and foreclosure property incurred by banks from the NOL limitation rules applicable to built-in losses.

Increase in the Net Operating Loss Carryback Period

Original provisions coming out of the tax writing committees of the House and Senate included a provision extending the period in which 2008 and 2009 NOLs could be carried back from two (2) to up to five (5) years.  The provision also eliminated the 90% limitation on the use of AMT NOLs that were carried back from 2008 or 2009.  The limitations in the original provisions were that the expanded carryback period did not apply (i) if the bank or other financial institution received any money under the Troubled Assets Relief Program (TARP) (ii) to Fannie Mae, Freddie Mac, or (iii) any corporation that is a member of the same affiliated group for income tax purposes as a bank or other financial institution that received TARP funds.

The Act retains the expanded carryback period for NOLs, but only for those generated in 2008 (or, at the election of the taxpayer, taxable years beginning in 2008).  Further, only taxapayers that are “eligible small businesses” may take advantage of the expanded carryback period.  An “eligible small business” that elects may carryback a 2008 NOL for up to five (5) years.  An eligible small business is a taxpayer having less than $15,000,000 in average annual gross receipts for the three (3) years prior to the year in which the NOL occurs.  Thus, the usefulness to most financial institutions of the expanded NOL carryback provisions appears to have been severely limited by the change in eligibility requirements.

Repeal of IRS Notice 2008-83

The Act retains the provisions repealing IRS Notice 2008-83 originally included in the House bill and subsequently added to the Senate bill.  An explanation of these provisions is set forth below.

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Tax Impact of Stimulus Bills for Community Banks

The current versions of the economic stimulus tax bills under consideration by the Senate Finance and the House Ways and Means Committees contain two (2) provisions that are likely to be of particular interest to and will directly impact most, if not all, of our bank and other financial institution clients.  The provisions are (i) changes in the rules allowing for the carryback of a net operating loss (“NOL”) of up to five (5) years instead of the current carryback period of only two (2) years, and (ii) a repeal (with limited transitional protection) of the relief provided in Notice 2008-83 issued by the Internal Revenue Service (“IRS”) in the fall of 2008 that exempted certain losses on loans and foreclosure property incurred by banks from the NOL limitation rules applicable to built-in losses.

Increase in the Net Operating Carryback Period

The provisions of the Senate Finance and the House Ways and Means Committees’ bills increasing the NOL carryback period to two (2) to five (5) years are essentially identical.  The increased carryback period only applies to NOLs arising in 2008 and 2009.  In addition, the 90% limitation (or the 10% haircut  required) on the use of NOL carrybacks when computing a corporation’s alternative minimum tax is suspended.  For those banks or other financial institutions with NOLs in 2008 and 2009, the bill will provide three (3) additional years (i.e., 2003, 2004, and 2005) from which they can obtain a refund of federal income taxes paid.

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