Banks and Savings Institutions

16.03 Definition of a bank for tax purposes. IRC Section 581 defines a bank for tax purposes and provides special rules governing bank taxation.

16.04 Definition of a savings institution for tax purposes. Savings institutions are considered to be mutual savings banks (IRC Section 591), domestic building and loan associations (IRC Section 7701[a][19]), or cooperative banks (IRC Section 7701[a][32]). The failure of an institution to qualify as a savings institution may affect the financial accounting standards that apply.

16.05 Securities gains and losses. IRC Section 582 provides banks special treatment for certain asset dispositions. Gains and losses on bonds, debentures, notes, certificates, and other evidences of indebtedness held by banks generally are treated under IRC Section 582 as ordinary (rather than capital) gains and losses. Equity securities and other investments generally are not afforded IRC Section 582 ordinary treatment. IRC Section 582 generally is not applicable to nonbank subsidiaries, including, for example, investment companies or insurance agencies.

16.06 Tax bad-debt deductions. IRC Section 585 provides that a bank or savings institution with $500 million or less in assets is allowed a tax bad-debt deduction for reasonable additions to the bad-debt reserve. This asset test generally is based upon the average adjusted tax basis of all assets. If the institution is a member of a controlled group (as defined), all assets of the group are taken into account. The annual addition to the reserve generally cannot exceed the greater of the amount computed using actual experience percentages or the base year fill-up method (as defined).

16.07 A bank or savings institution with assets exceeding $500 million generally is allowed to claim a tax bad-debt deduction only under the general rule of IRC Section 166, which generally permits taxpayers to deduct any debt that becomes worthless, in whole or in part, during the taxable year (that is, the specific charge-off method).² Treasury Regulation 1.166-2(d) provides circumstances under which a bank may presume a debt to have become worthless, in whole or in part including, if a bank makes a conformity election under Regulation 1.166-2(d)(3), that a debt or portion thereof charged off for regulatory purposes is presumed to be worthless for tax purposes as well. The conformity election must be formally adopted and requires a financial institution to obtain an express determination letter from its primary federal regulator during each examination. Presence of the conformity election can also support the non-recognition, for tax purposes, of contractually accrued interest that has not been recorded for financial reporting purposes, but only to the extent that no cash has been received that is required to be applied to the debtor’s contractual balance of such outstanding interest.

16.08 According to IRC Section 593 and the accompanying regulations, a qualifying thrift institution that, prior to 1996, was permitted to establish a reserve for bad debts based on a percentage of taxable income may be required to recapture a portion of such bad-debt reserve if it makes distributions to shareholders that exceed earnings and profits accumulated after 1951. Additionally, if such an institution makes a distribution in redemption of stock or in partial or complete liquidation, notwithstanding the existence of earnings and profits, a portion of the reserve may have to be recaptured.

16.09 Net operating losses. For taxable years beginning after August 5, 1997, net operating losses (NOLs) of banks and savings institutions generally are carried back 2 years and then forward 20 years under the provisions of IRC Section 172. For taxable years prior to 1994, banks and savings institutions also had various special provisions in the IRC that determined the appropriate carryback and carryforward periods. Legislation was passed in 2009 that allowed financial institutions that had not received assistance under the Troubled Asset Relief Program to make a one-time election to carry back NOLs generated in 2008 or 2009 up to 5 years instead of 2.

Other

16.10 Alternative minimum tax. Beginning in 1987, corporations must compute their federal tax liability under both the regular tax and alternative minimum tax (AMT) systems and pay the higher amount. The AMT system is a separate but parallel tax system that regular taxable income is increased or decreased by certain AMT adjustments and preference items to arrive at AMT income. A rate of tax generally lower than the regular tax rate is applied to AMT income. The AMT adjustments and preference items most common for banks include tax-exempt interest income on private activity bonds issued after August 7, 1986 (reduced by any related interest expense disallowance), and accelerated depreciation and cost recovery. An adjustment is also required for the adjusted current earnings amount (defined), that frequently includes additional modifications for all tax-exempt interest income, the dividends received deduction, and the increase in the cash surrender value of life insurance over the premiums paid. Further, only 90 percent of AMT income may be offset by a NOL. Any excess of tax computed under the AMT system over the regular system generally is eligible to reduce future regular tax (a minimum tax credit).

16.11 Mark to market. IRC Section 475 generally requires any company that is a dealer in securities to mark its securities to market. A dealer in securities is broadly defined as any taxpayer that regularly purchases securities from, or sells securities to, customers in the ordinary course of business or regularly offers to enter into, assume, offset, assign or otherwise terminate positions in securities with customers in the ordinary course of a trade or business. The definition of securities in the IRC differs from and is generally more expansive than the definition of securities in the FASB Accounting Standards Codification (ASC) glossary. For example, a bank regularly selling loans into the secondary market would be considered a dealer. Further, institutions that are dealers generally may not exempt any security held for investment from mark to market accounting for tax purposes, unless there is a proper identification statement in place and the security is identified as exempt at the date it is acquired. A window (sometimes as much as 30 days) has generally been allowed for identification of certain loans.

16.12 Interest expense relating to tax-exempt income. IRC Section 291 generally provides that 20 percent of the allocable interest expense attributable to tax-exempt obligations acquired by a financial institution after 1982 and before August 8, 1986, is not deductible. For tax-exempt obligations acquired after August 7, 1986, IRC Section 265 generally requires that all of the interest expense attributable to the obligation be nondeductible. An exception exists for certain "qualified small issuer" obligations (as defined), that are subject to IRC Section 291. To be a qualified small issuer, the issuer must either be a state or local government or issue bonds on behalf of a state or local government. The issuer also must reasonably expect to issue not more than $10 million of tax-exempt obligations (other than certain private activity bonds) within a year. The American Recovery and Reinvestment Act of 2009 that was passed by Congress and signed into law on February 17, 2009, increases the $10 million limit to $30 million for tax-exempt obligations issued in 2009 and 2010 to finance new projects and to refund prior obligations.

Credit Union

16.13 Federal credit unions are exempt from federal and state income tax. State chartered credit unions may be subject to state income tax. Credit union service organizations, that are subsidiaries of federal or state credit unions, may be subject to income tax for federal and state purposes.

Deferred Tax Assets and Liabilities

16.21 Subject to certain specific exceptions identified in FASB ASC 740-10-25-3, FASB ASC 740-10-55-7 establishes that a deferred tax liability is recognized for all taxable temporary differences. Deferred tax assets are to be recognized for all deductible temporary differences and operating loss and tax credit carryforwards. In accordance with the definition in the FASB ASC glossary, a deferred tax asset is reduced by a valuation allowance (as defined in the FASB ASC glossary) if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. (The term more likely than not means a likelihood of more than 50 percent as established in FASB ASC 740-10-25-6.)

16.22 An example of a deferred tax liability includes book and tax basis differences of assets and liabilities that will result in future taxable amounts. An example of a deferred tax asset includes book and tax basis differences of assets and liabilities that will result in future deductible amounts.

16.23 FASB ASC 740-10-45-20 requires that the effect of a change in the beginning-of-the-year balance of a valuation allowance that results from a change in circumstances that causes a change in judgment about the realizability of the related deferred tax asset in future years ordinarily should be included in income from continuing operations.

Temporary Differences

16.24 A temporary difference, as defined in the FASB ASC glossary, is a difference between the tax basis of an asset or liability computed pursuant to the requirements in FASB ASC 740-10 for tax positions, and its reported amount in the financial statements that will result in taxable or deductible amounts in future years when the reported amount of the asset or liability is recovered or settled, respectively. FASB ASC 740-10-25-20 cites eight examples of temporary differences.

16.25 Other examples of temporary differences common to financial institutions may include the following:

• Bad-debt reserves for institutions that deduct bad-debt reserves under IRC Section 585 (that excludes the base year amount discussed at paragraph 16.26) and bad-debt reserves for financial statement purposes in excess of the bad-debt reserve for tax purposes. (For larger institutions that are covered under IRC Section 166, there is no bad-debt reserve for tax purposes and, therefore, the entire allowance for credit losses in the financial statements is a temporary difference.)
• Interest on nonperforming loans is generally not recognized in income for financial and regulatory purposes, but may be required to be included in taxable income under IRC Section 451. This would result in additional tax basis in the interest receivable.
• Unrealized gains or losses on securities recorded under FASB ASC 320, Investments—Debt and Equity Securities, are generally not recognized for tax purposes.
• Other real estate owned and other assets may reflect postacquisition impairment write-downs in the financial statements; those write-downs are generally not recognized by a bank for tax purposes until the asset is sold or disposed of.⁴
• Accrued deferred compensation is not generally deductible for tax purposes until paid.
• Accrued loss contingencies are generally not deductible for tax purposes until the liability is fixed and determinable.
• Depreciation of property, plant, and equipment and the amortization of intangible assets may be different for financial statement and tax purposes.
• Accrual of retirement liabilities is often made in the financial statements in different periods from those in which the expense is recognized for tax purposes.
• Originated mortgage servicing assets recorded in the financial statements are typically not capitalized for tax purposes to the extent not deemed to be excess serving compensation.
• Other basis differences in assets and liabilities may be caused by the following:

—  Gains and losses on sales of loans, foreclosed assets, or property, plant, and equipment recognized in financial reporting periods different from tax periods.

—  Amortization of imputed interest income from transactions involving loans recognized in different periods for financial reporting and tax purposes.

—  Accretion of discount on securities recorded currently for financial reporting purposes, but subject to tax at maturity or sale, or accreted differently for tax purposes.

—  Commitment fees included in taxable income when collected but deferred to a period when earned for financial reporting purposes.

—  Loan fee income recognized on a cash basis for tax purposes while recognized as a yield adjustment for financial reporting purposes.

—  Federal Home Loan Bank stock dividends recognized as current financial reporting income but deferred for tax purposes.

—  The timing of the recognition of income or loss for hedges and swaps that differ for financial reporting and tax purposes.

16.26 As described in FASB ASC 740-10-25-3, a deferred tax liability should not be recognized for certain types of temporary differences unless it becomes apparent that those temporary differences will reverse in the foreseeable future. These types of temporary difference include bad debt reserves for tax purposes of U.S. savings and loan associations (and other qualified thrift lenders) that arose in tax years beginning before December 31, 1987 (that is, the base-year amount). See paragraphs 1–3 of FASB ASC 942-740-25 for the specific requirements related to this exception.

Financial Statement Presentation and Disclosure⁵

16.27 FASB ASC 740-10-50 provides guidance on the financial statement disclosure requirements relating to income taxes applicable to all entities.

16.28 FASB ASC 740-10-50-10 requires that institutions disclose the amount of income tax expense or benefit allocated to continuing operations and the amounts separately allocated to other items (in accordance with the intra-period tax allocation provisions of paragraphs 2–14 of FASB ASC 740-20-45) for each year that those items are presented. For example, the amount of income tax expense or benefit allocated to certain items whose tax effects are charged or credited directly to other comprehensive income (such as translation adjustments under FASB ASC 830, Foreign Currency Matters, and changes in the unrealized holding gains and losses of securities classified as available-for-sale under FASB ASC 320) should be separately allocated and disclosed.

16.29 As established in FASB ASC 740-30-50-2, all of the following information should be disclosed whenever a deferred tax liability is not recognized because of the exceptions to comprehensive recognition of deferred taxes related to subsidiaries and corporate joint ventures:

• A description of the types of temporary differences that a deferred tax liability has not been recognized and the types of events that would cause those temporary differences to become taxable
• The cumulative amount of each type of temporary difference
• The amount of unrecognized deferred tax liability for temporary differences related to investments in foreign subsidiaries and foreign corporate joint ventures that are essentially permanent in duration if determination of that liability is practicable or a statement that determination is not practicable
• The amount of the deferred tax liability for other temporary differences that is not recognized in accordance with the provisions of FASB ASC 740-30-25-18

16.30 If a thrift institution does not recognize a deferred tax liability for the base-year amount of a tax bad debt reserve in accordance with FASB ASC 740-10-25-3, it must disclose the amount of the deferred tax liability not recorded and the types of events that would cause the temporary difference (the base-year reserve) to become taxable, per FASB ASC 942-740-50-1.

Objectives

16.31 The objectives of auditing income taxes are to obtain sufficient appropriate evidence that

Planning

16.32 In accordance with AU-C section 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement (AICPA, Professional Standards), the objective of the auditor is to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial statement and relevant assertion levels through understanding the entity and its environment, including the entity’s internal control, thereby providing a basis for designing and implementing responses to the assessed risks of material misstatement (as described in chapter 5, “Audit Considerations and Certain Financial Reporting Matters,” of this guide). Changes in specific tax laws from year to year could affect financial institutions, as well as general corporations. It is necessary for the auditor to be aware of such changes.

Internal Control Over Financial Reporting and Possible Tests of Controls

16.33 AU-C section 315 addresses the auditor’s responsibility to identify and assess the risks of material misstatement in the financial statements through understanding the entity and its environment, including the entity’s internal control. Paragraphs .13–.14 of AU-C section 315 state that the auditor should obtain an understanding of internal control relevant to the audit and, in doing so, should evaluate the design of those controls and determine whether they have been implemented by performing procedures in addition to inquiry of the entity’s personnel. (See chapter 5 of this guide for further discussion of the components of internal control.) To provide a basis for designing and performing further audit procedures, paragraph .26 of AU-C section 315 states that the auditor should identify and assess the risks of material misstatement at the financial statement level and the relevant assertion level for classes of transactions, account balances, and disclosures.

16.34 AU-C section 330, Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained (AICPA, Professional Standards), addresses the auditor’s responsibility to design and implement responses to the risks of material misstatement identified and assessed by the auditor in accordance with AU-C section 315 and to evaluate the audit evidence obtained in an audit of financial statements.

Substantive Tests

16.35 Irrespective of the assessed risks of material misstatement, paragraph .18 of AU-C section 330 states that the auditor should design and perform substantive procedures for all relevant assertions related to each material class of transactions, account balance, and disclosure, which for a financial institution subject to income tax would generally include income taxes. In accordance with paragraph .A45 of AU-C section 330, this requirement reflects the facts that (a) the auditor’s assessment of risk is judgmental and may not identify all risks of material misstatement and (b) inherent limitations to internal control exist, including management override.

16.36 Substantive audit procedures may include the following:

• Review the tax status and consolidated return requirements of subsidiaries.
• Review the status of current-year acquisitions of other companies and their pre-acquisition tax liabilities and exposures, if acquired in a tax free acquisition.
• Obtain a schedule reconciling net income per books with taxable income for federal, state, and foreign income taxes. Agree amounts to general ledger and supporting documents as appropriate. Consider the reasonableness of the current and deferred tax account balances.
• Test the rollforward of tax balance sheet accounts. Consider vouching significant tax payments and credits.
• Review reconciliation of prior-year tax accrual to the actual filed tax returns and determine the propriety of adjustments made in this regard and consider the impact on the current-year and prior-year tax accruals.
• Consider the deductibility of transactions such as profit-sharing, bonus, contributions, or stock option transactions.
• Ascertain whether changes in income tax laws and rates have been properly reflected in the tax calculations and account balances.
• Review the allocation, apportionment, and sourcing of income and expense applicable to state tax jurisdictions with significant income or franchise taxes.
• Review classification and description of accounts to identify possible tax reporting differences such as reserves for anticipated losses or expenses.
• Review schedule of NOL and other tax credit carryforwards and their utilization.
• Review and determine the need for and appropriateness of any valuation allowance for deferred tax assets. It is important for auditors to note that institutions often may have a significant deferred tax asset resulting from the loan loss reserve. This asset should be evaluated based upon the likelihood of realization, taking into account the timing of the bad-debt deduction, and the special NOL carryovers and carryback tax rules, if applicable.
• Review tax planning strategies and assumptions utilized in the calculation of deferred income taxes under FASB ASC 740 guidance on accounting for uncertain tax positions.
• Evaluate tax positions and consider the appropriate accounting treatment and disclosure requirements for any uncertain tax positions under FASB ASC 740.
• Evaluate the adequacy of the financial statement disclosures.
• For separate financial statements of affiliates, review terms of all tax-sharing agreements between affiliated entities to determine proper disclosure and accounting treatment. The auditor should be cognizant of and consider whether the institution is in compliance with the regulatory reporting for banks and savings institutions related to intercompany tax allocations, as discussed in the entry income taxes of a bank subsidiary of a holding company in the “Glossary” section of the FFIEC’s Instructions for Preparation of Consolidated Reports of Condition and Income, and the Interagency Policy Statement on Income Tax Allocation in a Holding Company Structure.