7. INCOME TAXES

 

The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are summarized as follows:

 

 

Income tax expense (benefit) attributable to income from operations for the years ended December 31, 2017, 2016 and 2015, differed from the amounts computed by applying the U.S. federal tax rate of 35 percent to pretax income from continuing operations as demonstrated in the following table:

 

 

Our effective tax rates were -24.2 percent, 26.8 percent and 30.1 percent for 2017, 2016 and 2015, respectively. Effective rates are dependent upon components of pretax earnings and the related tax effects. The effective rate was significantly lower in 2017, primarily as the result of recent tax reform. Additionally, catastrophic losses incurred in the third quarter resulted in significantly lower pretax earnings and the change in accounting for excess tax benefits on share-based compensation further decreased the effective tax rate.

 

The Tax Cuts and Jobs Act of 2017 (TCJA) was signed into law on December 22, 2017. Among other provisions, the TCJA lowered the federal corporate tax rate from 35 percent to 21 percent effective January 1, 2018. As a result, we revalued deferred tax items as of year-end 2017 to reflect the lower rate. The revaluation reduced our net deferred tax liability and income tax expense by $32.8 million and decreased the effective tax rate by 38.8 percent.

 

Except for the following two aspects, we have completed the accounting for the tax effects of the enactment of the TCJA as of December 31, 2017. First, we provisionally recorded $2.3 million in deferred tax expense for an expected disallowance of deductions related to certain performance based compensation, including bonuses and stock options. As there is a lack of clarity on whether some amounts could be grandfathered in as deductible, we were unable to complete our analysis. Once the IRS provides more guidance on the deductibility of certain compensation classes, we will finalize the tax expense adjustments for this aspect of the TCJA changes. Second, the IRS has not yet published the factors for us to calculate the discount on loss reserves under the basis required by the TCJA. Although there is currently no net impact from the tax law changes, the gross deferred tax assets will likely increase as the discounting factors are expected to delay the deductibility of loss reserves. Once the revised discount factors are obtained, we can implement the new discounting methodology related to this aspect of the TCJA changes and will recognize the adjustment ratably over the allowed eight-year period beginning in 2018.

 

In 2017, the company adopted FASB ASU 2016-09, which requires the excess tax benefit on share-based compensation to flow through income tax expense. Prior to the adoption, excess tax benefits on share-based compensation were recorded directly to shareholders’ equity and had no impact on the effective tax rate. Due to the new accounting method, we recognized a $5.8 million tax benefit in 2017, decreasing the effective tax rate by 6.9 percent.

 

Our net earnings include equity in earnings of unconsolidated investees, Maui Jim and Prime. The investees do not have a policy or pattern of paying dividends. As a result, we record a deferred tax liability on the earnings at the recently revised corporate capital gains rate of 21 percent in anticipation of recovering our investments through means other than through the receipt of dividends, such as a sale. In the fourth quarter of 2017, Maui Jim gave notification that a $9.9 million dividend would be paid in January 2018. Even though no dividend was received in 2017, we were aware that the lower tax rate applicable to affiliated dividends (7.35 percent in 2018) would be applied when the dividend was paid in 2018 and we therefore recorded a $1.4 million tax benefit in 2017. We received a $9.9 million dividend from Maui Jim in the fourth quarter of 2016 and recognized a $2.8 million tax benefit from applying the lower tax rate applicable to affiliated dividends (7 percent in 2016), as compared to the corporate capital gains rate on which the deferred tax liabilities were based. No dividends were received from unconsolidated investees in 2015. Standing alone, the dividends resulted in a 1.6 percent and 1.8 percent reduction to the 2017 and 2016 effective tax rates, respectively.

 

Dividends paid to our ESOP also result in a tax deduction. Dividends paid to the ESOP in 2017, 2016 and 2015 resulted in tax benefits of $2.9 million, $3.3 million and $3.4 million, respectively. These tax benefits reduced the effective tax rate for 2017, 2016 and 2015 by 3.4 percent, 2.1 percent and 1.7 percent, respectively.

 

We have recorded our deferred tax assets and liabilities using the statutory federal tax rate of 21 percent. We believe it is more likely than not that all deferred tax assets will be recovered, given the carry back availability as well as the results of future operations, which will generate sufficient taxable income to realize the deferred tax asset. In addition, we believe when these deferred items reverse in future years, our taxable income will be taxed at an effective rate of 21 percent.

 

Federal and state income taxes paid in 2017, 2016 and 2015, amounted to $10.4 million, $26.9 million and $44.2 million, respectively.

 

Although we are not currently under audit by the Internal Revenue Service (IRS), tax years 2014 through 2017 remain open and are subject to examination.