DEPARTMENT OF THE TREASURY Office of the Comptroller of the Currency 12 CFR Part 3 [Docket No. 93Ä20] Capital Adequacy: Deferred Tax Assets AGENCY: Office of the Comptroller of the Currency, Treasury. ACTION: Notice of proposed rulemaking. SUMMARY: The Office of the Comptroller of the Currency (OCC) is proposing to amend its capital adequacy rules with respect to deferred tax assets of national banks. The proposed amendment would limit the amount of certain deferred tax assets that may be included in a national bank's Tier 1 capital for risk-based and leverage capital purposes. The proposal was developed jointly by the OCC, the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation (FDIC), and the Office of Thrift Supervision (OTS) (hereafter, the "agencies'') to respond to the Financial Accounting Standards Board's (FASB) issuance of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes'' (FAS 109) in February 1992. The agencies have adopted the provisions of FAS 109 for reporting in quarterly Consolidated Reports of Condition and Income and Thrift Financial Reports beginning January 1, 1993. In conjunction with this reporting change, the proposed amendment is expected to increase the amount of net deferred tax assets that a national bank may include when computing its regulatory capital. The OCC invites comments on all aspects of the proposed amendment. DATES: Comments should be submitted on or before January 24, 1994. ADDRESSES: Comments on the OCC's proposal may be submitted to Docket No. 93Ä20, Communications Division, Ninth floor, Office of the Comptroller of the Currency, 250 E Street, SW., Washington, DC 20219. Comments will be available for inspection and photocopying at that address. FOR FURTHER INFORMATION CONTACT: Eugene W. Green, Deputy Chief Accountant, Office of the Chief National Bank Examiner, (202) 874Ä5180; Elizabeth B. Salomon, Professional Accounting Fellow, Office of the Chief National Bank Examiner, (202) 874Ä5180; Roger Tufts, Senior Economic Advisor, Office of the Chief National Bank Examiner, (202) 874Ä5070; Ronald Shimabukuro, Senior Attorney, Bank Operations and Assets Division, (202) 874Ä4460, Office of the Comptroller of the Currency. SUPPLEMENTARY INFORMATION: I. Background and Discussion Origins of This Rule In February 1992, the Financial Accounting Standards Board (FASB) issued Statement No. 109, "Accounting for Income Taxes'' (FAS 109). The new statement provides guidance on how to account for income taxes, including deferred tax assets. It superseded Accounting Principles Board (APB) Opinion No. 11 (APB 11) and FASB Statement No. 96 (FAS 96), and was effective for fiscal years beginning on or after December 15, 1992. The FASB encouraged companies to adopt the statement even before the required date. FAS 109 generally allows banks to report certain deferred tax assets they could not previously recognize. The OCC and the other federal banking and thrift agencies had certain supervisory concerns about the effect of the change on the institutions they regulate, especially with regard to their reported capital levels. FAS 109 Under FAS 109, banks can report deferred tax assets that arise from: (1) tax carryforwards and (2) deductible temporary differences. Tax carryforwards are deductions or credits that banks cannot use for current tax purposes, but which banks can carry forward to reduce taxable income or income taxes payable in a future period or periods. For example, when a bank's tax deductions exceed its tax revenues, the result is a net operating loss. Such losses may be used to recover taxes paid in prior years (the carryback period) or may be carried forward to reduce a bank's taxable income in a future period. The situation is similar for certain tax credits that cannot be used in the current tax period. The bank will realize the benefit of deferred tax assets arising from tax carryforwards if it generates sufficient taxable income in the permissible carryforward period. Temporary differences arise when a bank records financial events or transactions in one period on the bank's books and recognizes them in another period, or periods, on its tax return. There are two types of temporary differences deductible and taxable. Deductible temporary differences reduce a bank's future taxable income. When a bank records an addition to its allowance for possible loan losses, the amount is recorded as an expense on the bank's books during the period the allowance is established or increased. The tax deductions for such losses, however, may not be taken until the losses are actually realized when the loan is charged off. The charge-off typically occurs in a subsequent period. A deferred tax asset is created for many banks when an amount has been added to the bank's allowance on the books but has not yet been charged off. Taxable temporary differences produce additional taxable income in future periods. For example, a bank may depreciate its bank building using an accelerated depreciation method on its tax return but may use a straight-line method when recording depreciation on its books. As a result, the bank's tax depreciation will be less than its book depreciation in certain future periods. This taxable temporary difference will cause the bank to have higher taxable income in those future periods. Deferred tax assets arising from deductible temporary differences can be realized only by: (1) Recovering taxes paid in prior years, (2) offsetting taxable temporary differences, or (3) reducing future taxable income. Deferred tax assets arising from deductible temporary differences that exceed the sum of taxable temporary differences and the amount the bank could recover from taxes paid in the permissible carryback period will be realized only if the bank generates sufficient taxable income in the permissible carryforward period. Hereafter, these deferred tax assets, as well as deferred tax assets arising from tax carryforwards, will be referred to as "deferred tax assets that are dependent upon future taxable income.'' FAS 109 permits banks to record deferred tax assets that are dependent upon future taxable income. However, banks must establish a valuation allowance to adjust the recorded deferred tax asset to an amount that is more likely than not (i.e., likelihood of more than 50 percent) to be realized. Previous GAAP and Regulatory Policy Until FAS 109 was issued, generally accepted accounting principles (GAAP) generally did not permit banks to recognize deferred tax assets that are dependent upon future taxable income. APB 11 allowed banks to report deferred tax assets arising from tax carryforwards only if their realization was "assured beyond any reasonable doubt.'' OCC supervisory policy, outlined in Banking Circular 202 (BC 202), limited the net deferred tax assets national banks may report in their quarterly Consolidated Reports of Condition and Income (Call Reports) to the amount of taxes previously paid that the bank could recover through carryback of net operating losses or unrealized tax credits. This "carryback approach'' also did not permit the reporting of deferred tax assets that are dependent upon future taxable income. Supervisory Concerns Regarding Deferred Tax Assets The OCC is concerned about including deferred tax assets that are dependent upon future taxable income as part of regulatory capital. Whether or not the bank can realize such assets depends on whether it generates enough taxable income during the carryforward period. As new products evolve and market conditions change, a bank's current financial condition and outlook for future income can change rapidly. Such changes make predicting future taxable income more difficult. Therefore, for many banks, including sound and well-managed banks, the judgment about the likelihood that the bank will be able to realize deferred tax assets that are dependent upon future taxable income will be highly subjective. The OCC has additional concerns about the effect of these changes on banks that are experiencing financial difficulty. Such banks often have net operating loss carryforwards. As a result, these troubled institutions could potentially record deferred tax assets under FAS 109, even though their realistic prospects for generating sufficient future taxable income are uncertain. As a troubled bank's condition deteriorates, it is less likely to be able to realize deferred tax assets that are dependent upon future taxable income. In such instances, FAS 109 generally requires the bank to reduce its recorded net deferred tax asset by increasing the asset's valuation allowance. The result is a charge to earnings that will reduce the bank's regulatory capital at precisely the time it needs capital the most. The OCC also has concerns about deferred tax assets of consolidating institutions. When one bank merges with another, its ability to realize deferred tax assets that are dependent upon future taxable income becomes more uncertain. In acquisitions structured as taxable asset purchases under the federal tax code, any net operating loss carryforwards available to the acquired bank before the purchase are generally extinguished. In an acquisition or change in control that qualifies as a tax-free reorganization, the tax code generally limits the net operating loss carryforwards of the acquired bank that can be used by the acquiring bank. These tax rules may make the ultimate realization of deferred tax assets more uncertain. These concerns led the OCC and the other agencies to direct the institutions they supervise to delay adopting FAS 109 for regulatory reporting purposes until the agencies had determined the appropriate regulatory reporting and capital treatment. FFIEC Request for Comment On August 3, 1992, the agencies, under the auspices of the Federal Financial Institutions Examination Council (FFIEC), requested public comment (57 FR 34135) on four alternative approaches for the regulatory reporting and the regulatory capital treatments of deferred tax assets of depository institutions. The four alternatives were (1) to adopt FAS 109 for regulatory reporting and capital calculations, (2) to adopt most provisions of FAS 109, but limit the amount of reported deferred tax assets for regulatory reporting and capital calculations to the amount allowed under the carryback approach, (3) to adopt FAS 109, but limit banks' ability to recognize deferred tax assets for regulatory reporting and capital calculations, and (4) to adopt FAS 109 for regulatory reporting and adopt one of the limits for regulatory capital calculations. In the request for comment, the FFIEC indicated that, while no final decision would be made until all comments were received, they would prefer the second alternative. The FFIEC indicated they would prefer to adopt most provisions of FAS 109, but limit the recognition of deferred tax assets for regulatory reporting and capital calculations to the amount allowed under the carryback approach, which would be consistent with FDIC and OCC policy at that time. This approach would not allow depository institutions to report deferred tax assets that are dependent upon future taxable income as assets in the Call Report. These assets, therefore, would be excluded from calculations of regulatory capital. The FFIEC requested comment on which of the four alternative approaches, or any other approach, would be appropriate. They also requested comment on whether some deferred tax assets possess characteristics that could alleviate their concerns, and what criteria could distinguish institutions that are likely to be able to realize net deferred tax assets that are dependent upon future taxable income. The request included a third question about whether it would be appropriate to grandfather certain deferred tax assets for state member banks and savings associations if the approach adopted was more conservative than existing GAAP. The FFIEC received 198 comments in response to its request. The comments were primarily from banks, thrifts and holding companies. The FFIEC carefully reviewed these comments. Many commenters did not explicitly address the specific questions in the request for comment, but did so indirectly. The vast majority of the commenters indicated that they believe there are strong reasons to adopt FAS 109 for regulatory reporting and for calculating regulatory capital. Many commenters asserted that deferred tax assets that are dependent upon future taxable income are valuable assets, particularly for healthy institutions that are likely to realize these assets. The commenters stated that FAS 109 provides criteria to measure deferred tax assets, and thereby distinguish institutions that will be able to realize such assets. Further, the commenters asserted that, in recommending the carryback approach, the agencies effectively were proposing a liquidation value approach to deferred tax assets. The commenters found this approach inconsistent with the going concern concept used in measuring other assets and liabilities. Commenters noted that tax laws have changed significantly since the OCC and FDIC policies were developed. Beginning in 1994, losses attributable to bad debts will be able to be carried forward 15, rather than 5 years, for federal income tax purposes. Extending the carryforward period increases the likelihood that carryforwards will be realized. Commenters also pointed out that changes in tax laws that require some banking organizations to deduct charge-offs (rather than their provisions for loan losses) mean that even strong banking organizations may have large amounts of deferred tax assets that are dependent upon future taxable income. The carryback approach would not allow these institutions to recognize those assets. Commenters expressed concern that adopting the carryback approach would create a difference between GAAP and regulatory reporting. Such a difference, they said, would create an additional reporting burden for institutions. Commenters questioned whether banking organizations would be able to compete equally with finance companies and other organizations if the carryback approach were adopted. Some commenters indicated that they preferred the fourth alternative of allowing net deferred tax assets that are dependent upon future taxable income to be reported in the Call Report, but limiting the amount of such assets that could be included in regulatory capital. This approach, they said, would be consistent with GAAP, and would address the supervisory concerns relating to regulatory capital. II. Proposal The OCC and the other agencies believe that many of the comments received have merit. Many financially sound banks will have net deferred tax assets arising from deductible temporary differences that exceed their taxable temporary differences and the bank's carryback potential. Under the carryback approach, the banks could not record those assets. Yet, it is highly likely that many banks will actually realize these assets. Therefore, the agencies believe that banks should be able to recognize some amount of net deferred tax assets that are dependent upon future taxable income. The OCC and the other agencies, however, continue to be concerned about the realizability of certain deferred tax assets. The agencies are concerned because estimating future taxable income, particularly beyond the near term, is very subjective. Inaccurate estimates could cause a bank to overstate its deferred tax assets and its capital position. Allowing banks to recognize significant amounts of assets that are based on subjective estimates could pose a risk to the deposit insurance funds. As a result, the agencies propose to retain some limit on deferred tax assets that are dependent upon future taxable income. The OCC and the other agencies are primarily concerned with the impact that deferred tax assets that are dependent upon future taxable income have on regulatory capital. Therefore, the agencies believe their supervisory concerns can be adequately addressed by limiting the amount of such assets that may be included in regulatory capital. This approach maintains consistency between GAAP and regulatory reporting. The agencies also believe this approach minimizes additional reporting burden on depository institutions. Accordingly, after careful consideration of the comments received, the FFIEC instructed banks and savings associations to adopt FAS 109 for reporting in bank Call Reports and Thrift Financial Reports beginning in the first quarter of 1993 (or the beginning of their first fiscal year thereafter, if later). The FFIEC also recommended that the agencies amend their capital adequacy rules to limit the amount of deferred tax assets that may be used to meet regulatory capital requirements. Based on the FFIEC's recommendations, the OCC is proposing to limit the amount of deferred tax assets that are dependent upon future taxable income which may be included in a national bank's Tier 1 capital to the lesser of: (1) the amount of deferred tax assets that is expected to be realized within one year of the quarter-end report date, based on a national bank's estimate of future taxable income for that year (not including tax carryforwards expected to be used and existing temporary differences expected to reverse), or (2) 10 percent of Tier 1 capital before the deduction of any disallowed purchased mortgage servicing rights, purchased credit card relationships, and deferred tax assets. To determine the limit, the OCC proposes that national banks should assume that all temporary differences fully reverse. Also, estimates of future taxable income should include the effect of tax planning strategies the bank is planning to implement within one year of the quarter-end report date. Except for these provisions and the one-year limit for projecting future taxable income, national banks should follow FAS 109 in determining capital adequacy. The OCC does not propose to limit deferred tax assets that can be realized from taxes paid in prior carryback years and from future reversals of existing taxable temporary differences. Any net deferred tax assets, included in bank Call Reports in accordance with FAS 109, over the proposed limitation should be deducted from Tier 1 capital, from total assets, and from risk-weighted assets in calculating regulatory capital. Deferred tax assets that are included in regulatory capital continue to be assigned a risk weight of 100 percent. Consistent with the recommendations of the FFIEC, FAS 109 and longstanding policy of the OCC and the other agencies, the OCC proposes that the capital limit be determined separately for each national bank. Under this "separate entity'' method, a national bank subsidiary of a holding company (together with its consolidated subsidiaries) is treated as a separate taxpayer, rather than as part of the holding company group. The bank's income taxes, therefore, are calculated as if it were a separate taxpayer. In some cases, a national bank's holding company may not be able to ensure that the bank will be reimbursed for tax benefits from its potential carryback of net operating losses or tax credits. In these cases, the bank should limit the carryback potential it considers when calculating the capital limit on deferred tax assets to the amount it could reasonably expect to have refunded by its parent. The OCC proposes that the capital limit should be determined on a tax jurisdiction-by-tax jurisdiction basis. That is to say, any excess over the limit that applies in one jurisdiction (e.g., federal) may not be used to increase the amount of the limit for other jurisdictions (e.g., state). This position is the same as the FAS 109 requirement that deferred tax assets and related amounts be determined separately for each tax jurisdiction. The proposed approach allows banks to include in regulatory capital deferred tax assets that are realizable based on the their estimate of taxable income during the next year. The OCC is proposing this one-year limit because, in general, national banks' projections up to 12 months into the future are generally reliable. However, the OCC believes the reliability of such projections decreases significantly for periods farther in the future. The proposal further limits deferred tax assets that are dependent upon future taxable income to 10 percent of Tier 1 capital. This proposal reflects the OCC's belief that such assets should not make up a large portion of a national bank's capital base because they are less than certain to be realized and typically cannot be sold apart from the bank. Questions for Comment While the OCC is seeking public comment on all aspects of its proposal for the regulatory reporting and regulatory capital treatment of deferred tax assets, it is seeking specific comment on the following questions. (1) Previous GAAP, as set forth in APB Opinion No. 16, "Business Combinations'' (APB 16), adjusts the reported value of an asset (other than goodwill) acquired in a purchase business combination to reflect the tax effect of the difference between the asset's market or appraised value and its tax basis. FAS 109 changes this treatment by requiring assets acquired in a purchase business combination to be recorded at their fair value and the related tax effect of the difference between the book and tax basis to be recorded separately in a deferred tax account. Under FAS 109, assets acquired in nontaxable purchase business combinations, including identifiable intangible assets (e.g., core deposit intangibles), will be recorded at higher amounts than previous accounting standards would require for the same transaction. This increase in intangible assets is offset by an equal increase in deferred tax liabilities (or decrease in deferred tax assets). Some of these additional intangible assets may not qualify for inclusion in regulatory capital. Because such nonqualifying intangible assets must be deducted from regulatory capital, institutions acquiring such assets may have to reflect a lower amount of regulatory capital after deducting these intangibles than they would have under previous accounting standards for the same transaction, even though there is no additional risk to capital. The OCC is considering allowing banks to not deduct the additional amounts of identifiable intangible assets that have been acquired in nontaxable purchase business combinations and that must be recorded under FAS 109 when computing regulatory capital. The OCC seeks comment on this approach and whether any other provisions of FAS 109 suggest any different regulatory capital treatment. (2) Is the 10 percent of Tier 1 capital limit an appropriate limit? Is this secondary limit necessary? (3) Are there other ways to reduce the potential burden associated with implementing this proposal? Will the limitation, as proposed, be difficult to implement? If so, please describe implementation concerns and ways to remedy them without jeopardizing a bank's safety and soundness. III. Regulatory Flexibility Act It is hereby certified that this regulation will not have a significant economic impact on a substantial number of small entities. Accordingly, a regulatory flexibility analysis is not required. When considered with the recent change in the reporting of deferred tax assets in the Call Report, this proposed rule is likely to permit a somewhat greater amount of such assets to be included in the calculation of regulatory capital. However, this change would not have a significant impact on banks of any size. IV. Executive Order 12866 It has been determined that this document is not a significant regulatory action. In conjunction with the recent change in the reporting of deferred tax assets in the Call Report, the proposed rule could permit more deferred tax assets to be included in regulatory capital. As a result, this proposed rule should generally have a positive effect on national banks. However, the proposed changes should not result in a significant increase in the aggregate Tier 1 capital of national banks. Authority and Issuance For the reasons set out in the preamble, appendix A of title 12, chapter I, part 3 of the Code of Federal Regulations is proposed to be amended as set forth below. PART 3 MINIMUM CAPITAL RATIOS; ISSUANCE OF DIRECTIVES 1. The authority citation for part 3 continues to read as follows: Authority: 12 U.S.C. 93a, 161, 1818, 1828(n), 1828 note, 1831n note, 3907 and 3909. 2. In appendix A, section 1, paragraphs (c)(9) through (c)(28) are redesignated as paragraphs (c)(10) through (c)(29) and a new paragraph (c)(9) is added to read as follows: Appendix A Risk-Based Capital Guidelines * * * * * Section 1. Purpose, Applicability of Guidelines, and Definitions. * * * * * (c) * * * (9) Deferred tax assets mean the tax consequences attributable to tax carryforwards and deductible temporary differences. Tax carryforwards are deductions or credits that cannot be used for tax purposes during the current period, but which can be carried forward to reduce taxable income or taxes payable in a future period, or periods. Temporary differences are financial events or transactions that are recognized in one period for financial statement purposes, but are recognized in another period, or periods, for income tax purposes. Deductible temporary differences are temporary differences that result in a reduction of taxable income in a future period, or periods. * * * * * 3. In appendix A, section 2, paragraph (c)(1) is revised, new paragraph headings are added to paragraphs (c)(2) and (c)(3), and the introductory text of paragraph (c)(3) is revised to read as follows: Appendix A Risk-Based Capital Guidelines * * * * * Section 2. Components of Capital. * * * * * (c) * * * (1) Deductions From Tier 1 Capital. The following items are deducted from Tier 1 capital before the Tier 2 portion of the calculation is made: (i) All goodwill subject to the transition rules contained in section 4(a)(1)(ii) of this appendix A; (ii) Other intangible assets, except as provided in section 2(c)(2) of this appendix A; and (iii) Deferred tax assets that are dependent upon future taxable income, which exceed the lesser of either:6 ®6¯ The amount of deferred tax assets that can be realized from taxes paid in prior carryback years and from future reversals of existing taxable temporary differences generally would not be deducted from capital. However, the amount of carryback potential a bank may consider in calculating the capital limit on deferred tax assets may not exceed the amount that the bank could reasonably expect to have refunded by its parent holding company. (A) The amount of deferred tax assets that the bank expects to realize within one year of the quarter-end report date, based on its estimate of future taxable income for that year;6a or ®6¯ a Estimated future taxable income should not include net operating loss carryforwards to be used during that year or the amount of existing temporary differences expected to reverse within the year. Such projections should include the estimated effect of tax planning strategies that the bank expects to implement during the year. (B) 10% of Tier 1 capital net of goodwill and other disallowed intangible assets. (2) Qualifying Intangible Assets. * * * * * * * * (3) Deductions From Total Capital. The following terms are deducted from total capital: * * * * * Dated: November 2, 1993. Eugene A. Ludwig, Comptroller of the Currency. [FR Doc. 93Ä31131 Filed 12Ä22Ä93; 8:45 am] BILLING CODE 4810Ä33ÄP