Income Taxes

9 Months Ended

Sep. 30, 2017

Note 10: Income Taxes

The Company’s income taxes and the related effective tax rates for the three and nine months ended September 30, 2017 and 2016 are as follows:

	Three Months Ended September 30,				Nine Months Ended September 30,
In millions	2017		2016		2017		2016
Income (loss) before income taxes	$	(273)	$	55	$	(603)	$	(101)
Provision (benefit) for income taxes	$	(6)	$	24	$	965	$	(28)
Effective tax rate		2.2%		43.6%		-160.0%		27.7%

For the nine months ended September 30, 2017, the Company’s effective tax rate applied to its loss before income taxes is less than the U.S. statutory tax rate primarily due to a full valuation allowance against its net deferred tax asset. For the nine months ended September 30, 2016, the Company’s effective tax rate applied to its loss before income taxes is less than the U.S. statutory effective tax rate primarily due to a foreign tax credit adjustment, partially offset by the fluctuation of the value of nontaxable warrants issued by the Company and tax exempt interest income.

Deferred Tax Asset, Net of Valuation Allowance

The Company recognizes deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Deferred tax assets and liabilities are determined based on the differences between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on tax assets and liabilities is recognized in income in the period that includes the enactment date. Valuation allowances are established to reduce deferred tax assets to the amount that more likely than not will be realized.

The tax effects of temporary differences that give rise to deferred tax assets and liabilities as of September 30, 2017 and December 31, 2016 are presented in the following table:


		As of
In millions		September 30, 2017		December 31, 2016
Deferred tax liabilities:
	Unearned premium revenue	$	139	$	143
	Deferral of cancellation of indebtedness income		28		46
	Deferred acquisition costs		34		42
	Net gains on financial instruments at fair value and foreign exchange		-		4
	Net unrealized gains in accumulated other comprehensive income		10		-
	Partnership basis difference		29		36
	Basis difference in foreign subsidiaries		1		64
	Net deferred taxes on VIEs		13		-
	Other		28		27
Total gross deferred tax liabilities			282		362

Deferred tax assets:
	Compensation and employee benefits		15		19
	Accrued interest		208		177
	Loss and loss adjustment expense reserves		121		142
	Net operating loss		996		929
	Foreign tax credits		62		7
	Other-than-temporary impairments		28		4
	Net unrealized losses on insured derivatives		28		29
	Net losses on financial instruments at fair value and foreign exchange		30		-
	Net unrealized losses in accumulated other comprehensive income		-		6
	Alternative minimum tax credit carryforward		30		26
Total gross deferred tax assets			1,518		1,339
	Valuation allowance		1,236		7
Net deferred tax asset		$	-	$	970

On June 26, 2017, S&P downgraded the financial strength rating of National, which led the Company to cease its efforts to actively pursue writing new financial guarantee business. In addition to National’s cessation of new business activity, there was an increase in loss and LAE due to changes in assumptions on certain Puerto Rico credits. As a result of the increase in loss and LAE, the Company has a three-year cumulative loss, which is considered significant negative evidence in the assessment of its ability to use its deferred tax assets. In addition, the Company considered all available positive and negative evidence as required by GAAP, to estimate if sufficient taxable income will be generated to use its deferred tax assets. After considering all positive and negative evidence, including the Company’s inability to objectively identify and forecast future sources of taxable income, the Company concluded in the second quarter of 2017 it did not have sufficient positive evidence to support its ability to use its deferred tax assets before they would expire. Accordingly, the Company has a full valuation allowance against its net deferred tax asset of $1.2 billion in the nine months ended September 30, 2017. The Company will continue to analyze the valuation allowance on a quarterly basis.

Accounting for Uncertainty in Income Taxes

The Company’s policy is to record and disclose any change in unrecognized tax benefits (“UTB”) and related interest and/or penalties to income tax in the consolidated statements of operations. The Company includes interest as a component of income tax expense. As of September 30, 2017 and December 31, 2016, the Company had no UTB.

Federal income tax returns through 2011 have been examined or surveyed.

As of September 30, 2017, the Company’s net operating loss (“NOL”) is approximately $2.8 billion. The NOL will expire between tax years 2031 through 2037. As of September 30, 2017, the Company has a foreign tax credit carryforward of $62 million, which will expire between tax years 2019 through 2027. As of September 30, 2017, the Company has an alternative minimum tax credit carryforward of $30 million, which does not expire.