Income taxes

6 Months Ended

Jun. 30, 2018

Note 31 – Income taxes

The reason for the difference between the income tax expense applicable to income before provision for income taxes and the amount computed by applying the statutory tax rate in Puerto Rico, were as follows:

		Quarters ended
		June 30, 2018				June 30, 2017
(In thousands)		Amount	% of pre-tax income			Amount	% of pre-tax income
Computed income tax expense at statutory rates	$	97,977	39	%	$	51,464	39	%
Net benefit of tax exempt interest income		(22,407)	(9)			(18,841)	(14)
Deferred tax asset valuation allowance		4,186	2			5,064	4
Difference in tax rates due to multiple jurisdictions		(2,238)	(1)			(831)	(1)
Effect of income subject to preferential tax rate^[1]		(103,008)	(41)			(3,493)	(3)
State and local taxes		1,718	1			1,585	1
Others		(4,788)	(2)			784	1
Income tax (benefit) expense	$	(28,560)	(11)	%	$	35,732	27	%
[1] For the quarter ended June 30, 2018, includes the impact of the Tax Closing Agreement entered into in connection with the Westernbank FDIC-assisted Transaction.

		Six months ended
		June 30, 2018				June 30, 2017
(In thousands)		Amount	% of pre-tax income			Amount	% of pre-tax income
Computed income tax expense at statutory rates	$	142,234	39	%	$	100,585	39	%
Net benefit of tax exempt interest income		(45,400)	(12)			(36,845)	(14)
Deferred tax asset valuation allowance		11,412	3			10,120	4
Difference in tax rates due to multiple jurisdictions		(5,197)	(2)			(1,790)	(1)
Effect of income subject to preferential tax rate^[1]		(106,056)	(29)			(6,512)	(2)
State and local taxes		3,081	1			2,864	1
Others		(6,479)	(2)			316	-
Income tax (benefit) expense	$	(6,405)	(2)	%	$	68,738	27	%
[1] For the six months ended June 30, 2018, includes the impact of the Tax Closing Agreement entered into in connection with the Westernbank FDIC-assisted Transaction.

The income tax benefit of $28.6 million reflects the impact of the Termination Agreement with the FDIC, discussed in Note 9. In June 2012, the Puerto Rico Department of the Treasury and the Corporation entered into a Tax Closing Agreement (the “Tax Closing Agreement”) to clarify the tax treatment related to the loans acquired in the FDIC Transaction in accordance with the provisions of the Puerto Rico Tax Code. The Tax Closing Agreement provides that these loans are capital assets and any principal amount collected in excess of the amount paid for such loans will be taxed as a capital gain. The Tax Closing Agreement further provides that the Corporation’s tax liability upon the termination of the Shared-Loss Agreements be calculated based on the “deemed sale” of the underlying loans. As a result, in connection with the Termination Agreement with the FDIC, the Corporation recognized an additional income tax expense of $49.8 million associated with the “deemed sale” incremental tax liability at the capital gains rate per the Tax Closing Agreement. In addition, the Corporation recognized an income tax benefit of $158.7 million related to the increase in deferred tax assets due to increase in the tax basis of the loans as a result of the “deemed sale” for a net tax benefit of $108.9 million. Also, the Corporation recorded an income tax expense of $45.0 million related to the gain resulting from the Termination Agreement, mainly related to the reversal of net deferred tax liability of the true-up payment obligation and the FDIC Loss Share Asset.

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

			June 30, 2018
(In thousands)			PR		US		Total
Deferred tax assets:
Tax credits available for carryforward		$	16,500	$	7,859	$	24,359
Net operating loss and other carryforward available			119,578		739,724		859,302
Postretirement and pension benefits			82,886		-		82,886
Deferred loan origination fees			3,583		(348)		3,235
Allowance for loan losses			586,457		23,741		610,198
Deferred gains			-		2,733		2,733
Accelerated depreciation			1,300		7,461		8,761
FDIC-assisted transaction			108,327		-		108,327
Intercompany deferred (loss) gains			1,512		-		1,512
Difference in outside basis from pass-through entities			28,257		-		28,257
Other temporary differences			27,869		6,978		34,847
	Total gross deferred tax assets		976,269		788,148		1,764,417
Deferred tax liabilities:
Indefinite-lived intangibles			33,713		38,199		71,912
Unrealized net gain (loss) on trading and available-for-sale securities			15,949		(16,861)		(912)
Other temporary differences			10,735		845		11,580
	Total gross deferred tax liabilities		60,397		22,183		82,580
Valuation allowance			78,676		419,408		498,084
Net deferred tax asset		$	837,196	$	346,557	$	1,183,753

			December 31, 2017
(In thousands)			PR		US		Total
Deferred tax assets:
Tax credits available for carryforward		$	16,069	$	7,979	$	24,048
Net operating loss and other carryforward available			115,512		708,158		823,670
Postretirement and pension benefits			85,488		-		85,488
Deferred loan origination fees			3,669		958		4,627
Allowance for loan losses			603,462		20,708		624,170
Deferred gains			-		2,670		2,670
Accelerated depreciation			1,300		7,083		8,383
Intercompany deferred (loss) gains			224		-		224
Difference in outside basis from pass-through entities			30,424		-		30,424
Other temporary differences			25,084		6,901		31,985
	Total gross deferred tax assets		881,232		754,457		1,635,689
Deferred tax liabilities:
FDIC-assisted transaction			60,402		-		60,402
Indefinite-lived intangibles			31,973		33,009		64,982
Unrealized net gain (loss) on trading and available-for-sale securities			26,364		(7,961)		18,403
Other temporary differences			9,876		386		10,262
	Total gross deferred tax liabilities		128,615		25,434		154,049
Valuation allowance			67,263		380,561		447,824
Net deferred tax asset		$	685,354	$	348,462	$	1,033,816

The net deferred tax asset shown in the table above at June 30, 2018 is reflected in the consolidated statements of financial condition as $1.2 billion in net deferred tax assets in the “Other assets” caption (December 31, 2017 - $1.0 billion) and $1.5 million in deferred tax liabilities in the “Other liabilities” caption (December 31, 2017 - $1.3 million), reflecting the aggregate deferred tax assets or liabilities of individual tax-paying subsidiaries of the Corporation in their respective tax jurisdiction, Puerto Rico or the United States.

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.

At June 30, 2018 the net deferred tax asset of the U.S. operations amounted to $766 million with a valuation allowance of approximately $419 million, for a net deferred tax asset of approximately $347 million. As of June 30, 2018, management estimated that the U.S. operations would earn enough pre-tax Income during the carryover period to realize the total amount of net deferred tax asset after valuation allowance. After weighting all available positive and negative evidence, management concluded that is more likely than not that a portion of the deferred tax asset from the U.S. operation, amounting to approximately $347 million, will be realized. Management will continue to evaluate the realization of the deferred tax asset each quarter and adjust as any changes arises.

At June 30, 2018, the Corporation’s net deferred tax assets related to its Puerto Rico operations amounted to $837 million.

The Corporation’s Puerto Rico Banking operation is not in a cumulative three year loss position and has sustained profitability for the three year period ended June 30, 2018. This is considered a strong piece of objectively verifiable positive evidence that outweights any negative evidence considered by management in the evaluation of the realization of the deferred tax asset. Based on this evidence and management’s estimate of future taxable income, the Corporation has concluded that it is more likely than not that such net deferred tax asset of the Puerto Rico Banking operations will be realized.

The Popular, Inc., holding company (“PIHC”) operation is in a cumulative loss position taking into account taxable income exclusive of reversing temporary differences, for the three year period ended June 30, 2018. Management expects these losses will be a trend in future years. This objectively verifiable negative evidence is considered by management as strong negative evidence that will suggest that income in future years will be insufficient to support the realization of all deferred tax asset. After weighting of all positive and negative evidence management concluded, as of the reporting date, that it is more likely than not that the PIHC will not be able to realize any portion of the deferred tax assets, considering the criteria of ASC Topic 740. Accordingly, a valuation allowance is recorded on the deferred tax asset at the PIHC, which amounted to $79 million as of June 30, 2018.

The reconciliation of unrecognized tax benefits, excluding interest, was as follows:

(In millions)		2018		2017
Balance at January 1	$	7.3	$	7.4
Additions for tax positions - January through March		0.2		0.2
Balance at March 31	$	7.5	$	7.6
Additions for tax positions - April through June		0.3		0.3
Reduction as a result of settlements - April through June		-		(0.3)
Balance at June 30	$	7.8	$	7.6

At June 30, 2018, the total amount of accrued interest recognized in the statement of financial condition approximated $3.1 million (December 31, 2017 - $2.7 million). The total interest expense recognized at June 30, 2018 was $328 thousand (June 30, 2017 - $307 thousand). Management determined that at June 30, 2018 and December 31, 2017 there was no need to accrue for the payment of penalties. The Corporation’s policy is to report interest related to unrecognized tax benefits in income tax expense, while the penalties, if any, are reported in other operating expenses in the consolidated statements of operations.

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 $10.2 million at June 30, 2018 (December 31, 2017 - $9.0 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, 2018, the following years remain subject to examination in the U.S. Federal jurisdiction: 2014 and thereafter; and in the Puerto Rico jurisdiction, 2013 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 $4.7 million.