Given all the discussion of tax reform in Washington, D.C., financial institutions should understand how tax reform, if passed, may affect their financial statements. Clearly, the impact of any tax reform won’t be fully known or measureable until the final details become available. However, financial institutions need to consider what impact proposed changes could have on their operations and earnings. In particular, institutions that have deferred tax assets (DTAs) and deferred tax liabilities (DTLs) on their books may be in for some surprises should the proposed tax reforms include changes in the overall tax rates.
DTAs consist of future deductions that corporations expect to use to reduce their tax bills, while DTLs represent future income that will be taxable. Both DTAs and DTLs typically are directly tied to the current federal and state corporate tax rates. Currently, the federal corporate tax rate can be as high as 35% (state tax rates vary by state). If the Trump tax proposal (corporate tax rates at 15%) or if the Republican House of Representatives’ proposal (corporate tax rates at 25%) is implemented, the DTAs and DTLs will have an immediate change in their carrying value. Translation: current earnings will see a one-time decrease for the change in value of DTAs or increase for the change in the value of DTLs. Both will be valued at the new tax rate versus the current rate. These changes will likely impact regulatory capital, too, so as financial institutions project the impact, they should not forget to ensure they maintain adequate capital.
Most institutions are currently in “budgeting season” and will be getting budgets approved for 2017. While we are not proposing changing the budget for the impact of future tax changes, it makes sense to inform the board that if tax rates change, there could be some significant changes in net income as a result. Management should make sure it understands the immediate financial statement impact of one-time adjustments in the year of change.
There is, however, a silver lining to these one-time changes to tax rates. Any negative impact to earnings for institutions with net DTAs will be offset by recording future tax expense at reduced tax rates; therefore, higher income over the long term will allow capital to grow faster. If institutions have DTLs, they will have positive results on both the current and future income side.
With any proposed tax reform, we are stuck with the consequences, and it may take some time to determine whether or not institutions are better or worse off. Being certain that you understand the possible ramifications up front and communicating those to your board are critical to making sure you can optimize the impacts. Consult your tax provider to ensure you are considering any opportunities to maximize tax benefits.