Note 28 – Income taxes

The reasons for the difference between the income tax (benefit) expense applicable to income before taxes and the amount computed by applying the statutory tax rate in Puerto Rico are included in the following tables.


	Quarters ended
	June 30, 2011						June 30, 2010
(In thousands)	Amount			% of pre-tax income			Amount			% of pre-tax income
Computed income tax at statutory rates	$	21,776			30	%	$	(7,065	)		41	%
Net benefit of net tax exempt interest income		(15,206	)		(21	)		(2,331	)		13
Effect of income subject to preferential tax rate		(100	)		—			(693	)		4
Deferred tax asset valuation allowance		3,945			5			28,449			(165	)
Non-deductible expenses		5,400			7			6,984			(40	)
Difference in tax rates due to multiple jurisdictions		(1,866	)		(2	)		2,226			(13	)
Recognition of tax benefits from previous years [1]		(53,615	)		(74	)		—			—
State taxes and others		1,566			2			(333	)		2

Income tax (benefit) expense	$	(38,100	)		(53	)%	$	27,237			(158	)%

[1]	Due to ruling and closing agreement discussed below


	Six months ended
	June 30, 2011						June 30, 2010
(In thousands)	Amount			% of pre-tax income			Amount			% of pre-tax income
Computed income tax at statutory rates	$	68,984			30	%	$	(45,693	)		41	%
Net benefit of net tax exempt interest income		(17,613	)		(8	)		(12,036	)		11
Effect of income subject to preferential tax rate		(332	)		—			(1,106	)		1
Deferred tax asset valuation allowance		(1,360	)		(1	)		61,728			(55	)
Non-deductible expenses		10,726			5			13,882			(12	)
Difference in tax rates due to multiple jurisdictions		(4,344	)		(2	)		6,320			(6	)
Initial adjustment in deferred tax due to change in tax rate		103,287			45			—			—
Recognition of tax benefits from previous years [1]		(53,615	)		(23	)		—			—
State taxes and others		3,394			1			(5,133	)		4

Income tax expense	$	109,127			47	%	$	17,962			(16	)%

[1]	Due to ruling and closing agreement discussed below

The results for the second quarter of 2011 reflect a tax benefit of $59.6 million related to the timing of loan charge-offs for tax purposes. In May 2011, the Puerto Rico Department of the Treasury (the “P.R. Treasury”) issued a private ruling to the Corporation (the “Ruling”) creating an agreement to establish the criteria to determine when a charge-off for accounting and financial reporting purposes should be reported as a deduction for tax purposes. On June 30, 2011, the P.R. Treasury and the Corporation signed a closing agreement in which both parties agreed that for tax purposes the deductions related to certain charge-offs recorded on the financial statements of the Corporation for the years 2009 and 2010 will be deferred until 2013, 2014, 2015 and 2016. As a result of the agreement, the Corporation made a payment of $89.4 million to the P.R. Treasury and recorded a tax benefit on its financial statements of $143 million, or $53.6 net of the payment made to the P.R. Treasury, resulting from the recovery of certain tax benefits not previously recorded during years 2009 (the benefit of reduced tax rates for capital gains) and 2010 (the benefit of exempt income) that were previously unavailable to the Corporation as a result of being in a loss position for tax purposes in such years. Also, the Corporation recorded a tax benefit of $6.0 million related to the tax benefit of the exempt income for the first quarter of 2011. The effective tax rate for the Corporation’s Puerto Rico banking operations for 2011 is estimated at 22%.

On January 31, 2011, the Governor of Puerto Rico signed into law a new Internal Revenue Code for Puerto Rico (the “2011 Tax Code”) which resulted in a reduction in the Corporation’s net deferred tax asset with a corresponding charge to income tax expense of $103.3 million due to a reduction in the marginal corporate income tax rate. Under the provisions of the 2011 Tax Code, the maximum marginal corporate income tax rate is 30% for years commenced after December 31, 2010. Prior to the 2011 Tax Code, the maximum marginal corporate income tax rate in Puerto Rico was 39%, which had increased to 40.95% due to a temporary 5% surtax approved in March 2009 for years beginning on January 1, 2009 through December 31, 2011. The 2011 Tax Code, however, eliminated the special 5% surtax on corporations for tax year 2011.

The following table presents the components of the Corporation’s deferred tax assets and liabilities.


(In thousands)	June 30, 2011		December 31, 2010
Deferred tax assets:
Tax credits available for carryforward	$	3,423	$	5,833
Net operating loss and other carryforward available		1,112,849		1,222,717
Postretirement and pension benefits		92,934		131,508
Deferred loan origination fees		6,842		8,322
Allowance for loan losses		554,187		393,289
Deferred gains		12,376		13,056
Accelerated depreciation		6,850		7,108
Intercompany deferred gains		4,822		5,480
Other temporary differences		20,074		26,063

Total gross deferred tax assets	$	1,814,357	$	1,813,376

Deferred tax liabilities:
Differences between the assigned values and the tax bases of assets and liabilities recognized in purchase business combinations		30,447		31,846
Difference in outside basis between financial and tax reporting on sale of a business		11,809		11,120
FDIC-assisted transaction		94,931		64,049
Unrealized net gain on trading and available-for-sale securities		63,192		52,186
Deferred loan origination costs		4,669		6,911
Other temporary differences		3,330		1,392

Total gross deferred tax liabilities		208,378		167,504

Valuation allowance		1,257,619		1,268,589

Net deferred tax asset	$	348,360	$	377,283

The net deferred tax asset shown in the table above at June 30, 2011 is reflected in the consolidated statements of condition as $362 million in net deferred tax assets (in the “Other assets” caption) (December 31, 2010 - $388 million) and $14 million in deferred tax liabilities in the “Other liabilities” caption (December 31, 2010 - $11 million), reflecting the aggregate deferred tax assets or liabilities of individual tax-paying subsidiaries of the Corporation.

A deferred tax asset should be reduced by a valuation allowance if based on the weight of all available evidence, it is more likely than not (a likelihood of more than 50%) that some portion or the entire deferred tax asset will not be realized. The valuation allowance should be sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized. The determination of whether a deferred tax asset is realizable is based on weighting all available evidence, including both positive and negative evidence. The realization of deferred tax assets, including carryforwards and deductible temporary differences, depends upon the existence of sufficient taxable income of the same character during the carryback or carryforward period. The analysis considers all sources of taxable income available to realize the deferred tax asset, including the future reversal of existing taxable temporary differences, future taxable income exclusive of reversing temporary differences and carryforwards, taxable income in prior carryback years and tax-planning strategies.

The Corporation’s U.S. mainland operations are in a cumulative loss position for the three-year period ended June 30, 2011. For purposes of assessing the realization of the deferred tax assets in the U.S. mainland, this cumulative taxable loss position is considered significant negative evidence and has caused management to conclude that it is more likely than not that the Corporation will not be able to realize the associated deferred tax assets in the future. At June 30, 2011, the Corporation recorded a valuation allowance of approximately $1.3 billion on the deferred tax assets of its U.S. operations (December 31, 2010 - $1.3 billion).

At June 30, 2011, the Corporation’s deferred tax assets related to its Puerto Rico operations amounted to $371 million. The Corporation assessed the realization of the Puerto Rico portion of the net deferred tax asset based on the weighting of all available evidence. The Corporation’s Puerto Rico Banking operation is in a cumulative loss position for the three-year period ended June 30, 2011. This situation is mainly due to the performance of the construction loan portfolio, including the charges related to the proposed sale of the portfolio. The Corporation’s banking operations in Puerto Rico has been historically profitable, and it is management’s view, based on that history, that the event causing this loss is not a continuing condition of the operations. In addition, as a result of the Ruling described above, the realization of the Puerto Rico net deferred tax asset has further improved. Accordingly, there is enough positive evidence to outweigh the negative evidence of the cumulative loss. As indicated earlier, in May 2011, the Corporation received a Ruling from the P.R. Treasury establishing the treatment of the loan charge-offs for tax purposes. In summary, the government ruled that the criteria to have a loan loss for taxes are more rigorous than the criteria to have a loan loss for accounting and financial reporting purposes. Based on Puerto Rico law and regulations, the P.R. Treasury ruled that if the Corporation decides to take a loan loss deduction in the tax return for the loan charge-off taken for accounting reporting purposes during the same year, a conclusive presumption is made as to the non-collectability of the loan. On the other hand, if the tax deduction is not taken in the same accounting period, eventually it will have to prove the non-collectability of the loan based on stated criteria. On June 30, 2011, the Corporation entered into a Closing Agreement with the P.R. Treasury, in which both parties agreed that pursuant to the Ruling, the Corporation’s Puerto Rico Banking operation would not take any tax deduction for bad debts related to the construction and commercial loans portfolio on the tax returns for 2009 and 2010. It was also agreed that such deferred deductions will be taken evenly over taxable years 2013 through 2016, even if the loans are sold in the future. As a result of the agreement, the Corporation adjusted its Puerto Rico banking operation taxable income previously reported to the P.R. Treasury on the 2009 return. On the other hand, the Corporation reduced its deferred tax asset related to the carryover of net operating losses previously recorded in the year 2010 and for the six months period ended June 30, 2011 and increased the deferred tax asset related to the allowance for loan losses as a result of the deferral of the construction and commercial loans charge offs. Based on the facts explained above, the Corporation has concluded that it is more likely than not that the net deferred tax asset of its Puerto Rico operations will be realized. Management reassesses the realization of the deferred tax assets each reporting period.

The reconciliation of unrecognized tax benefits was as follows:


(In millions)	2011			2010
Balance at January 1	$	26.3		$	41.8
Additions for tax positions - January through March		2.2			0.4
Reduction as a result of settlements - January through March		(4.4	)		(14.3	)

Balance at March 31	$	24.1		$	27.9
Additions for tax positions - April through June		0.8			0.2
Additions for tax positions taken in prior years - April through June		2.1			—
Reduction for tax positions - April through June		—			(1.6	)

Balance at June 30	$	27.0		$	26.5

At June 30, 2011, the related accrued interest approximated $7.2 million (December 31, 2010 - $6.1 million; June 30, 2010 - $7.1 million). Management determined that at June 30, 2011, December 31, 2010 and June 30, 2010 there was no need to accrue for the payment of penalties.

After consideration of the effect on U.S. federal tax of unrecognized U.S. state tax benefits, the total amount of unrecognized tax benefits, including U.S. and Puerto Rico, that if recognized, would affect the Corporation’s effective tax rate, was approximately $33.4 million at June 30, 2011 (December 31, 2010 - $31.6 million, June 30, 2010 - $32.1 million).

The amount of unrecognized tax benefits may increase or decrease in the future for various reasons including adding amounts for current tax year positions, expiration of open income tax returns due to the statutes of limitation, changes in management’s judgment about the level of uncertainty, status of examinations, litigation and legislative activity and the addition or elimination of uncertain tax positions.

The Corporation and its subsidiaries file income tax returns in Puerto Rico, the U.S. federal jurisdiction, various U.S. states and political subdivisions, and foreign jurisdictions. At June 30, 2011, the following years remain subject to examination in the U.S. Federal jurisdiction: 2008 and thereafter; and in the Puerto Rico jurisdiction, 2006 and thereafter. The Corporation anticipates a reduction in the total amount of unrecognized tax benefits within the next 12 months, which could amount to approximately $8 million.