Entity information:
Income Taxes
Arch Capital is incorporated under the laws of Bermuda and, under current Bermuda law, is not obligated to pay any taxes in Bermuda based upon income or capital gains. The Company has received a written undertaking from the Minister of Finance in Bermuda under the Exempted Undertakings Tax Protection Act 1966 that, in the event that any legislation is enacted in Bermuda imposing any tax computed on profits, income, gain or appreciation on any capital asset, or any tax in the nature of estate duty or inheritance tax, such tax will not be applicable to Arch Capital or any of its operations until March 31, 2035. This undertaking does not, however, prevent the imposition of taxes on any person ordinarily resident in Bermuda or any company in respect of its ownership of real property or leasehold interests in Bermuda.
Arch Capital and its non-U.S. subsidiaries will be subject to U.S. federal income tax only to the extent that they derive U.S. source income that is subject to U.S. withholding tax or income that is effectively connected with the conduct of a trade or business within the U.S. and is not exempt from U.S. tax under an applicable income tax treaty with the U.S. Arch Capital and its non-U.S. subsidiaries will be subject to a withholding tax on dividends from U.S. investments and interest from certain U.S. payors (subject to reduction by any applicable income tax treaty). Arch Capital and its non-U.S. subsidiaries intend to conduct their operations in a manner that will not cause them to be treated as engaged in a trade or business in the United States and, therefore, will not be required to pay U.S. federal income taxes (other than U.S. excise taxes on insurance and reinsurance premium and withholding taxes on dividends and certain other U.S. source investment income). However, because there is uncertainty as to the activities which constitute being engaged in a trade or business within the United States, there can be no assurances that the U.S. Internal Revenue Service will not contend successfully that Arch Capital or its non-U.S. subsidiaries are engaged in a trade or business in the United States. If Arch Capital or any of its non-U.S. subsidiaries were subject to U.S. income tax, Arch Capital’s shareholders’ equity and earnings could be materially adversely affected. Arch Capital has subsidiaries and branches that operate in various jurisdictions around the world that are subject to tax in the jurisdictions in which they operate. The significant jurisdictions in which Arch Capital’s subsidiaries and branches are subject to tax are the United States, United Kingdom, Ireland, Canada, Switzerland, Australia and Denmark.
The components of income taxes attributable to operations were as follows:
 
Year Ended December 31,
 
2017
 
2016
 
2015
Current expense (benefit):
 
 
 
 
 
United States
$
(51,705
)
 
$
40,300

 
$
37,186

Non-U.S.
5,969

 
10,445

 
7,008

 
(45,736
)
 
50,745

 
44,194

Deferred expense (benefit):
 
 
 
 
 
United States
169,093

 
(14,641
)
 
(4,893
)
Non-U.S.
4,211

 
(4,730
)
 
1,311

 
173,304

 
(19,371
)
 
(3,582
)
Income tax expense
$
127,568

 
$
31,374

 
$
40,612


The Company’s income or loss before income taxes was earned in the following jurisdictions:
 
Year Ended December 31,
 
2017
 
2016
 
2015
Income Before Income Taxes:
 
 
 
 
 
Bermuda
$
406,054

 
$
801,155

 
$
508,561

United States
381,157

 
51,577

 
57,527

Other
(29,934
)
 
2,820

 
1,106

Total
$
757,277

 
$
855,552

 
$
567,194


The expected tax provision computed on pre-tax income or loss at the weighted average tax rate has been calculated as the sum of the pre-tax income in each jurisdiction multiplied by that jurisdiction’s applicable statutory tax rate. The statutory tax rates by jurisdiction were as follows: Bermuda (0.0%), United States (35.0%), United Kingdom (19.25%), Ireland (12.5%), Denmark (22.0%), Canada (26.5%), Gibraltar (10.0%), Australia (30.0%), Hong Kong (16.5%) and the Netherlands (20.0%).
A reconciliation of the difference between the provision for income taxes and the expected tax provision at the weighted average tax rate follows:
 
Year Ended December 31,
 
2017
 
2016
 
2015
Expected income tax expense (benefit) computed on pre-tax income
at weighted average income tax rate
$
126,262

 
$
17,365

 
$
20,058

Addition (reduction) in income tax expense (benefit) resulting from:
 
 
 
 
 
Tax-exempt investment income
(13,330
)
 
(8,830
)
 
(9,588
)
Meals and entertainment
1,063

 
954

 
897

State taxes, net of U.S. federal tax benefit
732

 
1,073

 
858

Foreign branch taxes
5,752

 
5,496

 
1,456

Prior year adjustment
(559
)
 
(4,756
)
 
2,510

Foreign exchange gains & losses
(572
)
 
223

 
670

Changes in applicable tax rate
7,745

 
1,209

 
40

Dividend withholding taxes
232

 
3,319

 
6,323

Change in valuation allowance
14,798

 
4,730

 
2,917

Contingent consideration
3,785

 
9,353

 
11,548

Share based compensation
(18,733
)
 
—

 
—

Uncertain tax position
—

 
—

 
2,008

Other
393

 
1,238

 
915

Income tax expense (benefit)
$
127,568

 
$
31,374

 
$
40,612


The effect of a change in tax laws or rates on deferred taxes assets and liabilities is recognized in income in the period in which such change is enacted. On December 22, 2017, the Tax Cuts Act was signed into law by the President of the United States which significantly changes the U.S. tax law in many way including a reduction of the U.S. federal income tax rate from 35% to 21% effective January 1, 2018. As a result of the Tax Cuts Act, the Company remeasured certain of its U.S. net deferred tax assets and liabilities.
On December 22, 2017, Staff Accounting Bulletin No. 118 (“SAB 118”) was issued to address the application of GAAP in situations when a registrant does not have the necessary information available, prepared or analyzed in reasonable detail to complete the accounting for certain income tax effects of the Tax Cuts Act. Pursuant to the guidance within SAB 118, the Company’s remeasurement of its deferred taxes included certain provisional effects associated with enactment of the Tax Cuts Act for which measurement could be reasonably estimated. Provisional amounts may be adjusted in 2018 during the measurement period in accordance with SAB 118 when additional information is obtained. Additional information that may affect the provisional amounts would include, completion of the Company’s U.S. subsidiaries’ 2017 tax return filings, and potential future guidance from the IRS with respect to the transitional adjustment pertaining to loss reserve discounting as well as the utilization of alternative minimum tax (“AMT”) credits.
Deferred income tax assets and liabilities reflect temporary differences based on enacted tax rates between the carrying amounts of assets and liabilities for financial reporting and income tax purposes. Significant components of the Company’s deferred income tax assets and liabilities were as follows:
 
December 31,
 
2017
 
2016
Deferred income tax assets:
 
 
 
Net operating loss
$
33,723

 
$
13,061

AMT credit carryforward
12,327

 
5,350

Discounting of net loss reserves
33,659

 
64,220

Deferred ceding commission
6,934

 
15,505

Net unearned premium reserve
47,682

 
71,760

Compensation liabilities
20,234

 
37,757

Foreign tax credit carryforward
6,610

 
6,421

Interest expense
3,815

 
2,678

Goodwill and intangible assets
3,688

 
9,269

Bad debt reserves
5,073

 
6,961

Net unrealized foreign exchange gains
464

 
1,308

Net unrealized decline of investments
1,602

 
7,384

Other, net
10,760

 
12,123

Deferred tax assets before valuation allowance
186,571

 
253,797

Valuation allowance
(30,591
)
 
(17,028
)
Deferred tax assets net of valuation allowance
155,980

 
236,769

Deferred income tax liabilities:
 
 
 
Depreciation and amortization
(2,333
)
 
(7,038
)
Deposit accounting liability
(2,392
)
 
(4,078
)
Contingency reserve
(110,632
)
 
(19,400
)
Other, net
(1,061
)
 
(1,228
)
Total deferred tax liabilities
(116,418
)
 
(31,744
)
Net deferred income tax assets
$
39,562

 
$
205,025


The Company provides a valuation allowance to reduce certain deferred tax assets to an amount which management expects to more likely than not be realized. As of December 31, 2017, the Company’s valuation allowance was $30.6 million, compared to $17.0 million at December 31, 2016. The valuation allowance in both periods was primarily attributable to: (1) a full valuation allowance on the Company’s Canadian and Australian operations; (2) unutilized foreign tax credits; and (3) certain other deferred tax assets relating to loss carryforwards that have a limited use.
At December 31, 2017, the Company has net operating loss carryforwards in its U.K. operating subsidiaries of approximately $46.4 million. Additionally, the Company’s U.K. operations have a foreign tax credit carryforward of $6.3 million at December 31, 2017. These operating losses and foreign tax credits can be carried forward without expiration. Due to uncertainty surrounding their future utilization, a valuation allowance of $14.8 million is in place. Beginning in 2017, the U.K. losses are subject to usage restrictions that will limit the amount of carried forward losses which may be utilized in a given year. Such restrictions are not expected to limit the utilization of the Company’s existing U.K. loss carryforwards that have been recognized in the financial statements.
At December 31, 2017, net operating loss carryforwards in Ireland were approximately $15.3 million. Although these losses may be carried forward indefinitely, an offsetting valuation allowance of $1.2 million exists given management’s expectation that certain losses, which are specific to an individual Irish entity, will not be utilized in the future.
At December 31, 2017, net operating loss carryforwards in Australia were approximately $19.6 million. Although these losses may be carried forward indefinitely, subject to certain business and ownership continuity requirements, the associated net deferred tax asset of $5.9 million is fully offset by a valuation allowance of $5.9 million.
At December 31, 2017, net operating loss carryforwards in Hong Kong were approximately $9.5 million. Although these losses may be carried forward indefinitely the associated net deferred tax asset is offset by a valuation allowance of $1.5 million.
At December 31, 2017, net operating loss carryforwards in the U.S. were approximately $76.9 million. This includes $4.6 million net operating loss carryforwards from Watford Re. Watford Re’s $1.0 million deferred tax asset is fully offset by a valuation allowance. The Company’s net operating loss carryforwards are currently available to offset future taxable income of the Company’s U.S. subsidiaries. Under applicable law, the U.S. net operating loss carryforwards expire between 2029-2037.
On January 30, 2014, the Company’s U.S. mortgage operations underwent an ownership change for U.S. federal income tax purposes as a result of the Company’s acquisition of the CMG Entities. As a result of this ownership change, a limitation has been imposed upon the utilization of approximately $10.8 million of the Company’s existing U.S. net operating loss carryforwards. Utilization is limited to approximately $0.6 million per year in accordance with Section 382 of the Internal Revenue Code of 1986 as amended (“the Code”). Additionally, the Company has an AMT credit carryforward in the amount of $12.3 million which, beginning in 2018, and pursuant to the Tax Cuts Act, will either be available to offset the Company’s regular tax liability or refundable.
The Company’s U.S. mortgage operations are eligible for a tax deduction, subject to certain limitations, under Section 832(e) of the Code for amounts required by state law or regulation to be set aside in statutory contingency reserves. The deduction is allowed only to the extent that the Company purchases non-interest bearing U.S. Mortgage Guaranty Tax and Loss Bonds (“T&L Bonds”) issued by the U.S. Treasury Department in an amount equal to the tax benefit derived from deducting any portion of the statutory contingency reserves. T&L Bonds are reflected in ‘other assets’ on the Company’s balance sheet and totaled approximately $177.2 million at December 31, 2017, compared to $16.2 million at December 31, 2016.
Deferred income tax liabilities have not been accrued with respect to the undistributed earnings of the Company's U.S., U.K. and Ireland subsidiaries as it is the Company’s intention that all such earnings will be indefinitely reinvested. If the earnings were to be distributed, as dividends or otherwise, such amounts may be subject to withholding tax in the jurisdiction of the paying entity. The Company no longer intends to indefinitely reinvest earnings from the Company's Canada subsidiary, however, no income or withholding taxes have been accrued as the Canada subsidiary does not have positive cumulative earnings and profits and therefore a distribution from this particular subsidiary would not be subject to income taxes or withholding taxes. Potential tax implications of repatriation from the Company’s unremitted earnings that are indefinitely reinvested are driven by facts at the time of distribution. Therefore it is not practicable to estimate the income tax liabilities that might be incurred if such earnings were remitted. Distributions from the U.K. or Ireland would not be subject to withholding tax and no deferred income tax liability would need to be accrued.
The Company recognizes interest and penalties relating to unrecognized tax benefits in the provision for income taxes. As of December 31, 2017, the Company’s total unrecognized tax benefits, including interest and penalties, were $2.0 million. If recognized, the full amount of the unrecognized tax benefit would generally decrease the current year annual effective tax rate. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:
 
December 31,
 
2017
 
2016
 
 
 
 
Balance at beginning of year
$
2,008

 
$
2,008

Additions based on tax positions related to the current year
—

 
—

Additions for tax positions of prior years
—

 
—

Reductions for tax positions of prior years
—

 
—

Settlements
—

 
—

Balance at end of year
$
2,008

 
$
2,008


The Company or its subsidiaries or branches files income tax returns in the U.S. federal jurisdiction and various state, local and foreign jurisdictions. The Company’s examination by the tax authorities in the U.S. for the 2009 through 2011 tax years closed with no change. The following table details open tax years that are potentially subject to examination by local tax authorities, in the following major jurisdictions:
Jurisdiction
 
Tax Years
United States
 
2014-2017
United Kingdom
 
2012-2017
Ireland
 
2013-2017
Canada
 
2013-2017
Switzerland
 
2011-2017
Denmark
 
2014-2017

As of December 31, 2017, the Company’s current income tax recoverable (included in “Other assets”) was $104.8 million.