The increasing role of taxation with respect to the tightened capital requirements for banks Eveline Gerrits, Michèle van der Zande 1 November 15, 2013 1. Introduction In December 2010 the Basel Committee for Banking Supervision published its definitive proposals for an adapted solvency supervision structure for banks (Basel III). These measures, drawn up in response to the financial crisis, are intended in part to achieve quantitative and qualitative improvements in the capital in the banking sector. The Capital Requirements Regulation ( "CRR") 2 was published in the Official Journal of the European Union on June 27, 2013. 3 The CRR is part of Capital Requirements Directive IV ("CRD IV"), which encompasses the regulations implementing Basel III within the European Union. This means that the tightening of the capital requirements for banks 4 will become a reality with effect from January 1, 2014 with major consequences for banks in the European Union. Taxation plays a prominent role in the calculation of the capital to be held by banks. In this paper we will describe the adverse effects of deferred tax assets on the capital ratio for banks under the new rules 5. In addition, we will explain in what sense the CRR deviates from IFRS (International Financial Reporting Standards) as regards deferred tax assets and tax liabilities, causing the CRR to generate additional work for banks in this field too. This paper discusses the interaction between tax regulations, the tax position in the financial statements and the capital requirements for banks. 2. Context Under the rules that applied before the CRR came into effect (Basel II), deferred tax assets with respect to tax losses counted in full towards the capital held by a bank. The Basel Committee studied the question of whether this approach was still justified, given the losses incurred by many banks, and whether it might have created an unduly positive picture of the banks' capital position. Pursuant 1 Michèle van der Zande and Eveline Gerrits both work at the Financial Services Group of KPMG Meijburg & Co. In addition, Eveline is associated with the Tilburg Tax Institute (FIT) of Tilburg University where, among other duties, she is carrying out doctoral research with respect to the mutual influence of tax accounting to taxation. 2 As an EU regulation the CRR will have immediate effect, which means that, unlike a directive, it will not have to be implemented in national legislation first. 3 Following publication in the OJ on June 27, 2013 a corrigendum was published on August 2, 2013. 4 Pursuant to Article 4(3) of the CRR, these requirements apply to credit institutions and/or investment firms; hence, their scope of application is considerably wider than the banks referred to in this paper. 5 As regards other articles on this subject that appeared prior to publication of the CRR, we refer to the WFR article by E. de Gunst (WFR 2013/691), and to his article entitled 'Bazel III and Banking Supervision: Taxes are of Capital Importance', published in the March/April 2013 issue of Derivatives/Financial Instruments.
to the CRR, deferred tax assets that rely on future profitability must be deducted from the Common Equity Tier 1 capital. 6 This represents a fundamental change from the rules that have applied thus far. Under the very first Basel agreement it was already mandatory for banks to calculate their riskweighted capital ratio. This refers to the amount of capital that a bank must hold, depending on the risks associated with its assets. In order to calculate the capital ratio, the assets are then multiplied by their (standard) risk weight. The resulting figure is known as the risk-weighted assets. Banks must satisfy the own funds requirements for banks at all times. 7 As before, they are required to apply a capital ratio of 8%. This means that the risk-weighted assets of a bank must be balanced by at least 8% in capital held by the bank. The Common Equity Tier 1 capital must amount to at least 4.5% of the risk-weighted assets, compared with 2.5% under Basel II. This paper also describes the changes in the weighting of deferred tax assets when determining the risk-weighted assets in accordance with the CRR. These rules, too, have been tightened relative to the rules that have applied thus far. As a result of the CRR, therefore, taxation will have far-reaching consequences for the capital ratios of banks, as it affects the determination of both the level of own funds (the numerator) and the riskweighted assets (the denominator). 3. Types of deferred tax assets under IAS 12 As regards the definition of deferred tax assets, the CRR refers to the applicable accounting standards. 8 Banks generally apply IFRS. The IFRS standard that concerns income taxes is IAS 12, which prescribes banks when to recognize deferred tax assets in their balance sheets. There are three types of deferred tax assets 9 : 1. deductible temporary differences; 2. the carryforward of unused tax losses; 3. the carryforward of unused tax credits. Re 1. Deductible temporary differences Temporary differences arise when there is a difference between the carrying amount (the bookvalue in the statement of financial position) and the value for tax purposes, hereafter the tax base. A deductible temporary difference is deemed to exist when, at the moment the carrying amount is realized, this results in a deduction from the profit for tax purposes. When the tax base is higher than its carrying amount, this will result in a deferred tax asset. In practice this may occur when, for example, real estate for own use which can only be written down for tax purposes to 50% of its 6 Under Basel III, a bank's own funds comprise its Tier 1 capital (which is the sum of the Common Equity Tier 1 capital and the Additional Tier 1 capital) and its Tier 2 capital. The Common Equity Tier 1 capital consists of paidup ordinary share capital, share premium and retained profit. 7 A Common Equity Tier 1 capital ratio of 4.5%, a Tier 1 capital ratio of 6% and an overall capital ratio of 8%. The numerator is the capital and the denominator is the total of risk-weighted assets. Example: if the risk-weighted assets amount to 60,000, the total capital must be at least 4,800 (8% of 60,000). 8 Article 4(106) CRR. 9 IAS 12.5.
value under the Dutch Valuation of Immovable Property Act has already been subject to further write-downs or depreciation for financial accounting purposes. When the value of a liability for tax purposes is lower than its carrying amount, this will result in a deductible temporary difference. This situation may arise, for example, when a provision is not recognized for tax purposes, or only for a lower amount than for financial accounting purposes. Re 2. Carry forward of unused tax losses At the moment a bank incurs a tax loss, the loss can be set off if it can be carried back to a prior year. Under Dutch tax law, a loss incurred in a particular year may be carried back one year. If this possibility does not exist, the losses can be carried forward and set off against fiscal profits made in the subsequent nine years. In that case, the losses are referred to as tax losses that have not been carried back. Re 3. Other tax credits 10 In the case of banks, these include unsettled profits from foreign branches. Until 2011, the Netherlands applied the proportional exemption method for non-resident branch offices. Basically, according to this method the profits generated by the branch were included in the Dutch taxable result, but on the other hand qualified in full for double tax relief. However, if the Dutch head office recognized a tax loss (including the profits from the branches), this method prevented the double tax relief from being granted. As a result, the profits from the branch office were deferred and could be set off as soon a the Dutch head office started to report taxable profits again. Such unsettled profits for double tax relief could be set off indefinitely. With effect from 2012, this method was replaced by the object exemption method, but many banks are still likely to have unsettled profits from foreign branches which can be set off indefinitely against future profits. Deferred tax assets can only be recognized on the balance sheet if it is probable (i.e. if there is a more than 50% chance) that in future the bank will generate sufficient taxable profit against which the tax asset can be set off. 11 Note that in determining whether the taxable profit is sufficient, under IAS 12 the following should be taken into account. The taxable profit will in any case be deemed sufficient if the bank has deferred tax liabilities that reverse in the same period as the deferred tax assets. Only when the deferred tax liabilities available are not sufficient to compensate for the deductible amounts resulting from the deferred tax assets will it have to be determined whether any other taxable profit will be available (or may be generated through a tax planning approach). 12 4. Types of deferred tax liabilities under IAS 12 Deferred tax liabilities can arise in only one way: they result from taxable temporary differences. 13 Such differences result in taxable amounts at the moment the carrying amount for financial accounting purposes is realized. If the tax base of an asset is lower than its carrying amount, a 10 This is the general English term for this third category. 11 IAS 12.24 and IAS 12.34. 12 IAS 12.28-30 and IAS 12.35-36. 13 IAS 12.5.
deferred tax liability will arise. This may be the case, for example, when R&D costs are charged to the taxable profit in one go while they are capitalized and written down for financial accounting purposes. If the tax base of a liability is higher than its carrying amount, a deferred tax liability will arise. This situation will arise, for example, when a provision is recognized for tax purposes before being recognized for financial accounting purposes, or at a higher amount. Deferred tax liabilities must always be recognized in full in the balance sheet. 14 5. Deferred tax assets and liabilities under Basel III and the CRR According to Article 36(1)(c) of the CRR, the main rule is that deferred tax assets which rely on future profitability are deducted from the Common Equity Tier 1 capital. According to Article 4(107) of the CRR, the term "deferred tax assets which rely on future profitability" means that these assets may be realized only in the event the bank generates taxable profit in the future. Article 48 of the CRR then states that under certain conditions, deferred tax assets which (rely on future profitability and) arise from temporary differences do not have to be deducted from the Common Equity Tier 1 capital. We will discuss these conditions in section 6 of this paper. Article 38 of the CRR discusses the way in which the bank should determine the amount of the deferred tax assets that rely on future profitability that is required to be deducted from Common Equity Tier 1 capital. This article points out how the deferred tax assets can be reduced by the amount of deferred tax liabilities. Eventually the amount of the deferred tax assets that rely on future profitability is deducted from the Common Equity Tier 1 capital after set-off. Below we will describe the various steps that the bank will have to take in order to determine the amount that will eventually have to be deducted (after reduction of the deferred tax liabilities) from the Common Equity Tier 1 capital. Step 1: determine which deferred tax assets can be reduced by deferred tax liabilities (Article 38(3) of the CRR). The amount of deferred tax assets may be reduced by the amount of the associated deferred tax liabilities, provided that the entity: a) has a legally enforceable right under applicable national law to set off those current tax assets against current tax liabilities; b) the deferred tax assets and the deferred tax liabilities relate to taxes levied by the same taxation authority and on the same taxable entity. The text of the CRR is more or less equal to the wording of IAS 12. 15 However, one difference occurs in a situation where different taxable entities are able to set off their current tax assets and liabilities and actually intend to do so. Under IAS 12 companies are obliged to also set off these lastmentioned deferred tax assets and liabilities. For the Netherlands, for example, the above provision permits offsetting for companies that form part of a fiscal entity, given that in this case there is a 14 IAS 12.15. 15 IAS 12.74.
legally enforceable right to set off current tax assets and liabilities (condition a). Additionally, the deferred tax assets and liabilities relate to the same entity (the parent of the fiscal entity) and to taxes levied by the same tax authority (condition b). Furthermore this also appears from the "final draft Regulatory Technical Standards" 16, a document drawn up by the European Banking Authority (EBA) which includes the following text: ( ) a taxable entity includes any member of entities which are members of the same tax group, fiscal consolidation, fiscal unity or consolidated tax return under applicable national law. The question is whether this interpretation by the EBA would also cover, for example, the "group relief" system in the United Kingdom. 17 For each entity the bank will have to determine whether the set-off or reduction can be effected. This exercise will largely coincide with procedures already carried out on behalf of the financial statements, also because IAS 12 makes the set-off mandatory if the conditions are met. Step 2: eliminate certain deferred tax liabilities for offsetting purposes (Article 38(4)). One difference with the set-off rules of IAS 12 is that under the CRR deferred tax liabilities that arise from differences in the valuation of intangible assets (including goodwill) and pension assets 18 cannot be included in the set-off. The reason for this is that these two items must be deducted from the Common Equity Tier 1 capital pursuant to other rules, which already allow a reduction of the deferred tax liabilities. Without this provision, therefore, deferred tax liabilities would be deducted twice from a single deductible item. As a result of this deviation from IAS 12, it will no longer be possible for the bank to simply copy the set-off approach used in its financial statements. For each entity that qualifies for set-off, the deferred tax liabilities will have to be adjusted for deferred tax liabilities arising from intangible assets and pension assets. Step 3: allocate deferred tax liabilities to the various types of deferred tax assets. According to Article 38(5) of the CRR, the amount of the deferred tax liabilities that qualifies for setoff must be allocated on a pro rata basis between (a) deferred tax assets that rely on future profitability and arise from temporary differences (and which are not required to be deducted in accordance with Article 48 of the CRR) and (b) all other deferred tax assets that rely on future profitability. 16 This "technical standard" was published by the EBA on July 26, 2013. 17 Pursuant to the "group relief" system in the United Kingdom, losses can be transferred, in the year in which they were incurred, to one or more other group companies with which the transferring company is affiliated either directly or indirectly through a shareholding of at least 75%. 18 This concerns assets from a defined benefit pension fund.
The result of the calculation exercise is that the amount to be deducted from the Common Equity Tier 1 capital equals the amount of the deferred tax assets from losses and tax credits, adjusted on a pro rata basis for the (qualifying) deferred tax liabilities. 6. Deferred tax assets (relying on future profitability) that arise from temporary differences According to Article 48 of the CRR, under certain conditions deferred tax assets which (rely om future profitability and) arise from temporary differences do not have to be deducted from the Common Equity Tier 1 capital. The first condition is that the total amount of these deferred tax assets should not exceed 10% of the Common Equity Tier 1 capital. 19 Deferred tax assets that arise from temporary differences in excess of this amount must be deducted from the Common Equity Tier 1 capital. The second condition is that the deferred tax assets plus another deductible item 20 should not exceed 17.65% of the Common Equity Tier 1 capital 21. If the deferred tax assets and the other deductible item in aggregate 22 exceed 17.65% of the Common Equity Tier 1 capital, the amount that is not required to be deducted is then determined in accordance with the ratio of deferred tax assets/deferred tax assets plus the other deductible item. 23 Note that the deferred tax assets which, as a result of the exception, are not required to be deducted from the Common Equity Tier 1 capital are accorded a risk weight of 250%, compared with 0% under the current rules. 7. Tax overpayments, tax loss carry backs and deferred tax assets that do not rely on future profitability In addition, Article 39 of the CRR refers to a category of tax assets that are not required to be deducted from the Common Equity Tier 1 capital. This category includes the following tax assets: 1. overpayments of tax for the current year. This item will be recognized in the financial statements as a current tax asset 24 ; 2. current year tax losses carried back to previous years that give rise to a claim on a local tax authority. This item, too, will be recognized in the financial statements as a current tax asset 25 ; 19 The Common Equity Tier 1 capital must be determined with due regard for the provisions of Articles 32 through 35 and certain deductions as referred to in Article 36 of the CRR. Note that the deduction for deferred tax assets that arise from temporary differences does not have to be included in this calculation. 20 This is the deduction for investments in a financial sector entity pursuant to Article 36(l) of the CRR. 21 In this context, the Common Equity Tier 1 capital is determined following application of Articles 32 through 36 of the CRR. This means that all deferred tax assets that rely on future profitability including deferred tax assets that arise from temporary differences will have been deducted. The result of applying the 17.65% limit is that no more than 15% of the Common Equity Tier 1 capital after deductions will consist of deferred tax assets that rely on future profitability and the other deduction. For further details, see the explanatory notes to Basel III, Annex 2 (15% / 85% = 17.65%). 22 See footnote 18. 23 Article 48(3) of the CRR. 24 Under IAS 12.12, a current tax asset is defined as the amount already paid in respect of current or prior periods to the extent it exceeds the amount due for those periods. 25 According to IAS 12.13, the benefit relating to a tax loss that is available for carry-back is to be recognized as a current tax asset.
A risk weight is assigned to the current tax assets mentioned under 1 and 2, as stated in Part III of the CRR. The risk weight to be assigned is 0%, given that the assets concerned are claims on a Member State government. 26 Note that the CRR refers to tax overpayments and losses in the current year. In contrast, IAS 12 refers to a current tax asset for the current year and prior periods. It would seem logical that the CRR adopts the same perspective. After all, there is no difference between carrying back a loss from the current year (from 2013 to 2012) or from a prior year (from 2012 to 2011). 3. Deferred tax assets that do not rely on future profitability and that arise from temporary differences are not required to be deducted from the Common Equity Tier 1 capital. This is subject, however, to the following conditions in the CRR: a. The deferred tax asset is automatically and mandatorily replaced into a tax credit the moment the bank reports a loss when the financial statements are approved or in the event that the bank enters in liquidation or becomes insolvent. b. The bank can then set off this tax credit against a tax liability. c. If the tax credit exceeds the amount of the tax liability referred to in b above, this higher amount must immediately result in a claim on the central government. These deferred tax assets are then assigned a risk weight of 100%. In the Netherlands, a limited number of situations are conceivable that meet the conditions mentioned above to qualify as deferred tax assets that do not rely on future profitability. 8. Transitional arrangement The CRR provides for a transitional arrangement concerning the deduction of deferred tax assets that rely on future profitability. This arrangement applies both to deferred tax assets that (rely on future profitability and) arise from tax losses and tax credits and to deferred tax assets that arise from temporary differences. 27 If these tax assets have to be deducted in accordance with the new rules, they will be subject to a transitional arrangement. According to the CRR, the deduction percentage in 2014 falls within a range of 20% to 100%. The range increases by annual increments of 20% (40%- 100% in 2015), which means that from 2018 onwards all deferred tax assets will have to be deducted. In addition, there is a transitional arrangement for deferred tax assets that rely on future profitability and already existed before January 1, 2014. According to the CRR, the deduction percentage for these assets falls within a range of 0% to 100% in 2014 and 10% to 100% in 2015, after which the percentage increases by 10% every year. This means that these deferred tax assets will have to be deducted in full from 2024. The CRR indicates that the competent authorities (i.e. the Dutch Central Bank in the Netherlands) are responsible for setting the percentages. 28 Even though we believe the text is not entirely clear, it appears that the range applies to deferred tax assets that already existed before January 1, 2014 and arise from temporary differences. We understand that this assumption is shared by the Dutch Central Bank, at least for the time being. 26 Article 114(4) of the CRR. 27 Articles 469 and 478 of the CRR. 28 Article 478.3 of the CRR.
The deferred tax assets that are not yet required to be deducted by virtue of the transitional arrangement are assigned a risk weight of 0%. 29 However, deferred tax assets that rely on future profitability and arise from temporary differences that are not required to be deducted are assigned a risk weight of 250%. 30 This means that there is no transitional arrangement for this type of deferred tas asset. 9. Summary and practical consequences for banks Basel III will introduce new rules with respect to the capital requirements for tax assets. The current rules do not require tax assets to be deducted from the Common Equity Tier 1 capital and provide for a risk weight of 0%. Basel III and the CRR identify the items that must be deducted from the Common Equity Tier 1 capital. One of those items is the deferred tax assets that rely on future profitability. Under the current rules (Basel II), deferred tax assets do not have to be deducted from the Common Equity Tier 1 capital. In other words, the change is material and can have material consequences for the solvency ratio of banks. It is important to note that under certain conditions, deferred tax assets that arise from temporary differences are not required to be deducted from the Common Equity Tier 1 capital. A deferred tax asset that is not required to be deducted is assigned a risk weight of 250%, compared with a risk weight of 0% under the rules currently in force. Many banks have substantial tax losses or unsettled profits from foreign branches recognized on their balance sheets, especially in these times of crisis. Hence, the new rules constitute a material change and can have material consequences for the solvency ratio of banks. We believe these consequences will be particularly in place in two areas. First, the bank will have to design and implement a process for calculating the amount of the deferred tax assets to be deducted from the Common Equity Tier 1 capital. The deduction will have to be effected within entities that satisfy with the set-off criteria. As pointed out in section 4, the set-off system deviates from the system used in IAS 12, as a number of specific deferred tax liabilities cannot be taken into account. In addition, a pro rata allocation must be effected between deferred tax assets arising from tax losses and tax credits, on the one hand, and deferred tax assets arising from temporary differences on the other. Furthermore, it is not entirely clear when a situation involves one and the same taxable entity, because on this point, too, the text of the CRR deviates from the wording of IAS 12. Another aspect that may be relevant in this connection is the method for the settlement and recognition of deferred tax assets by entities within a fiscal unity. IFRS does not include any provisions in this regard, but other standards, such as the Dutch Guidelines for Annual Reporting (Richtlijnen voor de Jaarverslaggeving), do. 31 This aspect is particularly relevant in a situation in which not all entities within the fiscal unity are supervised. Another potential consequence of the rules is that banks will want to utilize every option to convert the deferred tax assets arising from tax losses and tax credits into deferred tax assets arising from temporary differences. Of course, this can only yield any added value if the conditions mentioned in 29 Article 472.5 of the CRR. 30 Article 470.3 of the CRR. 31 Guideline 272.8.
section 5 are met. IAS 12 provides for the recognition of deferred tax assets in the balance sheet if the bank has tax planning options that make it possible to realize taxable profits in the right periods. Under Basel III, the mere availability of such tax planning options and the possibility to implement them will not suffice. If a bank wants to prevent the deduction of deferred tax assets, it will actually have to convert deferred tax assets arising from losses or tax credits into deferred tax assets arising from temporary differences.