October 10, Dina Maher Assistant Vice President Federal Reserve Bank of New York 33 Liberty Street 22nd Floor New York, NY 10045

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1 Francisca N. Mordi October 10, 2014 Vice President & Sr. Tax Counsel Phone: Fax: Dina Maher Assistant Vice President Federal Reserve Bank of New York 33 Liberty Street 22nd Floor New York, NY Joseph Cox Federal Reserve 20th and C Streets NW Washington, DC Re: Tax Rate Calculations under the DFA Stress Test Process Dear Ms. Maher and Mr. Cox: Thank you for meeting with the ABA 1 Tax Administrative Committee in June. Our discussions were productive, and we look forward to continuing our dialogue on the tax rate calculations used in the Dodd-Frank Act Stress Test (DFAST). We respect your cautions about these discussions and understand that you are not opining on the validity of any methodologies or making any commitments on behalf of the Federal Reserve ( Fed ). The purpose of this letter is to: Illustrate the unexplained capital variances between the banks and the Fed s calculations which we believe are largely attributable to the Fed s simplifying tax rate assumption. Explain the potential issues caused by using the simplifying tax rate assumption and provide an illustrative example. Recommend a potential solution that should significantly improve the accuracy using a simplifying approach. Industry Concerns: As we discussed at our meeting in June, DFAST filers have identified unexplained material Fed capital adjustments, which most filers believe include material tax-related differences. The enclosed ABA document tabulates summary data accumulated from public information comparing levels of capital pursuant to filers methodology versus the Fed s published DFAST results. The resulting gross adjustments have a material impact on capital, which in some cases, is in excess of 100 basis points. We believe that a relatively slight modification of the Fed s 1 The ABA represents banks of all sizes and charters and is the voice for the nation s $13 trillion banking industry and its two million employees.

2 calculation can mitigate the vast majority of the tax-related portion of the unexplained differences and more accurately forecast the tax impacts on capital under the prescribed rules. Based on the disclosures related to the Fed s tax rate assumptions in the DFAST 2014: Supervisory Stress Test Methodology and Results, 2 we believe there are several important fact patterns that result in the simplifying tax rate assumption materially understating ending capital: 1. Tax-Preferred Investments A bank s tax expense is not merely determined by applying a tax rate to pre-tax income or loss. There are tax expense components that are not a function of income, such as low income housing credits, new markets credits and municipal security income. While including these recurring tax preference items in a bank s tax expense may result in incremental deferred tax assets (DTAs), those incremental DTAs will not universally result in incremental disallowance, due to the reasons below. 2. Recoverable Tax History Tax benefits from operating losses and credits can be monetized through loss carrybacks to the extent of the taxes paid in the current and previous two years. Such monetized losses would result in a current tax benefit and not in incremental DTAs. Accordingly a simplifying assumption that these benefits would not increase capital due to being DTAs that were offset by more DTA disallowance may lead to a materially inappropriate reduction to capital Net Deferred Tax Liability (DTL) Many banks enter the measurement period with a net DTL. Operating losses would initially decrease the DTL. Such losses absorbed by a DTL would not result in an incrementally disallowed DTA. 4. Threshold Limitation Capacity Gross DTLs are prorated to reduce DTA carryforwards and the temporary difference DTA. Because of this pro ration, incremental operating losses and credits will attract additional DTL. In effect, a portion of the incremental carryforward DTA will not result in an immediate write off of the DTA, but instead, the DTA will be tested in the threshold limitation. Since most banks entering the cycle are not in a threshold limitation, the incremental DTA can be partially or fully 2 The DFAST 2014: Supervisory Stress Test Methodology and Results, published in March 2014, refers to the 2013 discussion describing how taxes were determined by the Fed as follows: [A]fter-tax net income (or loss) is calculated by applying a consistent tax rate to pre-tax net income (or loss) for all BHCs. This assumed tax rate is also used to determine certain aspects of the allowable deferred tax asset (DTA) included in regulatory capital. The discussion continues the tax assessment by stating: Changing the tax rate assumption has a limited effect on minimum projected capital levels.. Adjusting the assumed tax rate by 15 percentage points in either direction leads to only a small change in aggregate tier 1 common capital at the end of the planning horizon. The effect of changing the tax rate assumption is limited because nearly all BHCs participating in DFAST 2013 are in a cumulative net loss position over the planning horizon. Net losses are reduced by the tax rate, but these tax benefits are largely reversed due to restrictions on deferred tax assets under current regulatory capital rules. 3 Many banks have paid significant taxes in the current and previous two years. The recovery of these taxes provides a material benefit to capital in the idiosyncratic scenarios. 2

3 absorbed by threshold limitation capacity. However, there are some loss absorption capabilities that could create a different capital result. 5. Marginal Tax Rate Many DFAST banks operate primarily within the U.S. and will have a marginal federal tax rate of 35%, plus some small additional percentage for state taxes. Therefore, a consistent tax rate of 37% could generally be reasonable for most filers. However, because several of the larger filers have material international activities 4, it is very possible that significant portions of income or loss are being taxed at generally lower marginal rates. Once a bank monetizes losses through carrybacks, eliminates net DTLs, and becomes subject to the loss carryforward DTA limitation and the threshold limitation, we agree with your position that tax benefits are largely reversed due to restrictions on deferred tax assets under current regulatory capital rules. Therefore, once a bank s DTA is fully limited, any incremental P&L tax expense or benefit will be wholly offset by a decrease or increase to the DTA capital adjustments. However, the simplifying assumption is only valid after all loss absorption capabilities have been exhausted. Recommendations: We appreciated your comments at our June meeting regarding the importance of the detailed calculations prepared by filers in connection with their projections. Our recommendation to address this issue incorporates the integrity and complexity of those calculations with a workable solution to marginally tax-effect changes in pre-tax income and accumulated other comprehensive income (AOCI) that may be driven by the Fed s independent modeling efforts. 5 The bank capital Worksheet Template in the DFAST submission provides all the necessary details for determining the DTA carryfoward and Threshold limitation. We recommend the following steps: 1. Continue utilizing a simplifying rate assumption. (We recommend 37% combined U.S. federal and state tax expense or benefit.) 2. Apply the simplified rate only to the marginal change in pre-tax income (loss) and to the marginal change in pre-tax other comprehensive income (OCI). 3. Adjust the Capital Worksheet DTA and Threshold calculations to reflect the P&L and OCI changes in Step 2. (We recommend a simplifying assumption that all pre-tax P&L changes solely affect Carryforward DTAs and that OCI changes solely affect Threshold DTAs. 6 ) 4 As you are aware, these filers are required to account for each material jurisdiction and report accumulated results. Since the current reporting does not provide a mechanism to account for multiple jurisdictions, we believe that this is an issue for which we should explore long-term solutions during the upcoming November 3 meeting. 5 We omitted recommendations to address the concerns of multijurisdictional DFAST filers in order meet your stated goals of a model with broad application and to facilitate the ease of implementation of changes that will materially improve the accuracy of the calculations. We do however believe the concerns of large multijurisdictional filers should be separately evaluated in a longer-term evaluative process. 6 However, for banks that are not an advanced approach banks and have made the opt-out election, OCI changes will not have an impact on the DTA. 3

4 Assuming a bank is subject to full DTA limitations in its submission, the resulting capital adjustment (in step 2 above) will be completely offset by the Step 3 adjustment. If a bank is not subject to both limitations, some portion of the Step 2 capital adjustment will pass through to the ending capital determination. We appreciate your time on this issue and are looking forward to meeting with you on November 3, We are in the process of identifying our industry participants and will provide that information as soon as possible. In the meantime, please do not hesitate to call me at or me at fmordi@aba.com if you have questions or need any additional information. Sincerely, Francisca N. Mordi Encl: ABA Document The Use of Simplifying Tax Rate Assumptions in CCAR/DFAST 4

5 The Use of Simplifying Tax Rate Assumptions in CCAR/DFAST October 2014

6 Discussion Agenda Issue description Specific concerns around tax rate assumptions Review of data that suggests the simplifying tax rate assumption may have a material impact on a financial institution s capital ratios Review of situations through example in which the simplifying assumption may impact the calculation of capital ratios Suggestions around additional information that could be provided by financial institutions to mitigate effects of the simplifying assumption 2

7 Issue Description In connection with the Dodd-Frank Act Stress Test (DFAST) process, our financial institutions are required to prepare a variety of projections using varying assumptions. In that process, significant effort is expended to determine an accurate estimate of tax related income statement (income tax expense) and related balance sheet accounts (deferred tax assets and liabilities, etc.) pursuant to Generally Accepted Accounting Principles (GAAP). Further, balances derived from these calculations are then used in the calculation of various capital ratios. In the DFAST 2014: Supervisory Stress Test Methodology and Results published in March 2014, there is a brief discussion about the use of a consistent tax rate applied to taxable income in the projection period. There is a reference to a more expansive discussion in the March 2013 results summary about this assumption. In this discussion, there is a table that purports to dimension a limited effect on capital ratios from using a simplifying assumption. We are not aware that the consistent rate has been formally announced. In industry discussions, there seems to be a belief it is 35%. Depending on how the consistent rate is applied, there is concern among financial institutions that this assumption may have an important impact on after tax income and capital ratio calculations. Accordingly, we believe having a dialogue on this topic may help both the financial institutions and Federal Reserve have a better understanding of the impact of using this assumption. 3

8 Specific Concerns Financial institutions do not have direct knowledge of the Fed rate / calculation methodology generating uncertainty Financial institutions make investments that generate tax benefits / attributes Generally Accepted Accounting Principles (GAAP) prescribe how to account for the investments and related tax attributes These investments impact the income statement and balance sheet: Tax benefits decrease tax expense below the statutory rate and increase after-tax income In stress scenarios, these investments generate losses or credits that can be monetized through carry back claims Losses and credits that can not be carried back are reflected as carryforwards that impact the calculations of deferred tax assets (DTAs) Certain expenses associated with the investments may be recorded in pre-tax income, while the related tax benefits are recorded in tax expense Assuming the Fed calculations apply a flat rate to pre-tax income and make limited related adjustments to DTAs, the following issues arise: The calculation of income may not take into account tax benefits associated with legitimate investments understating capital generation With significant income in prior years, the recovery of prior year taxes through the carryback of credits and losses provides a material benefit to capital. Thus, if the impact of these investments is ignored, the institution s capital can be materially understated. Expenses in pre-tax income associated with the generation of tax credits are not being eliminated; causing a situation in which the expenses are being recognized without the associated tax credit benefits; negatively impacting capital generation Financial institutions project the impact of NOL and credit carryforwards on DTAs. Assuming the Fed starts with the financial institution DTA, if the balances are not adjusted for the simplifying assumption, there may be a negative capital impact in that the DTAs may be limited even though the tax benefits associated with the DTA have not been reflected in after-tax income The complexity associated with the tax impact of foreign operations is not addressed in the simplified approach This treatment of tax benefits may impact the financial institution s economic interest in making important investments in communities 4

9 Capital Summary Data accumulation per attached summary Public information for period as of 9/30/13 Fed data per 3/20/14 release Company data as disclosed on websites / press releases Methodology Changes in pre-tax income and AOCI expected to drive after tax change in capital Plug to other change needed to reconcile to Fed data Potential reasons for other change Tax effect of changes in pre-tax income and AOCI Impact of simplifying tax rate assumption Other Fed adjustments that are not apparent; goodwill or other adjustments not reflected in pre-tax income? 5

10 Capital Summary Data 3

11 Example Assumes financial institution with material tax benefits Assumes carryback availability Assumes DTL allocated proportionally Compares GAAP approach with apparent Fed approach at 35% Tier one limitation info included Initial conclusions Negative capital impact driven by exclusion of perm and tax credit benefit consideration Carryback has direct impact Capital impact affected by allocation mechanics of DTL Material change in effective tax rate (90% vs 35%) Material change in the computation of tier one capital 7

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14 Recommendations Methodology Continued high reliance on financial institution GAAP info for base information Apply a standard tax rate on only the MARGINAL changes in pre-tax income or other capital changes input by Fed Add this marginal tax effect to both the income statement and balance sheet Take into account carryback availability Data accumulation See the attached proposed template and explanations Includes data currently available to the Fed Provides a recommended way for Fed to operationalize our recommendations 10

15 Data Accumulation Recalculation of Tax Impacts Inc/(Loss) Inc/(Loss) Inc/(Loss) Additional Summary of Facts: As Filed Per Fed Difference Tax Rate DTA/(DTL) Pretax Income - 37% - Transitional AOCI - Net of Tax Gain/(Loss) - Transitional AOCI Gross Gain/(Loss) % - Total Impact on Capital relating to income taxes - Incr/(Decr) - Assumptions: Assumed tax rate 37% Assume tax effect of pretax income change is all allocated to the DTA on carryforwards For Adv Approaches banks, assume tax effect of AOCI deferred tax change is allocated to the temp difference DTA. Assumes 10% and 15% Common Equity Tier 1 remains the same Assumes AOCI adjustments do not affect Fas 133 which is a regulatory adjustment AOCI adjustments may be not applicable for banks qualified to make the opt-out election Assumes RWA does not change from threshold changes (Line references are to Capital Worksheet Template in the official DFAST forms) As filed Change Revised Line 61 Deferred tax assets from NOLs and tax credit carryforwards - - Threshold Calculations: Line 101 SIFI - Line % Common Equity Tier 1 - Line % Disallowance - Line 106 MSRs net of DTL - Line % Common Equity Tier 1 - Line % Disallowance - Line 109 DTA - - Line % Common Equity Tier 1 - Line % Disallowance - Line 112 Sum of lines 101, 106 and 108 Gross Threshold - Line 114 Sum of lines 103, 108 and % Disallowance - Line 115 Line 112 less line Line % Common Equity Tier 1 - Line % Disallowance 15% Disallowance - Total Disallowance - - Summary: As filed Revised Net Change DTA on NOL and Credit Carryforwards Total threshold disallowance Total impact to Capital Gross Impact to balance sheet capital relating to income taxes from changes made Incr/(Decr by F Capital Tax on Pretax change - Total tax impact to capital on changes made by Fed - Net change to regulatory disallowance related to income taxes from changes made by - Net capital impact of income taxes relating to changes made by Fed - 11