NOTE 19 — INCOME TAXES
Oriental is subject to the provisions of the PR Code, which imposes a maximum corporate tax rate of 39%. The Oriental, however, maintained a lower effective tax rate for the years ended December 31, 2017, 2016 and 2015.
Under Puerto Rico law, all companies are treated as separate taxable entities and are not entitled to file consolidated tax returns. OFG Bancorp and its subsidiaries are subject to Puerto Rico regular income tax or the alternative minimum tax (“AMT”) on income earned from all sources. The AMT is payable if it exceeds regular income tax. The excess of AMT over regular income tax paid in any one year may be used to offset regular income tax in future years, subject to certain limitations.
Oriental has operations in U.S. through its wholly owned subsidiary OPC, a retirement plan administration based in Florida. Also, in October 2017, Oriental expanded its operations in U.S. through the Bank's wholly owned subsidiary OFG USA. Both subsidiaries are subject to state and federal taxes. OPC is subject to Florida state taxes and OFG USA is subject to North Carolina state taxes. OFG USA elected to be classified as a corporation.
The components of income tax expense (benefit) for the years ended December 31, 2017, 2016 and 2015 are as follows
| Year Ended December 31, | ||||||||
| 2017 | 2016 | 2015 | ||||||
| (In thousands) | ||||||||
| Current income tax expense | $ | 19,101 | $ | 2,768 | $ | 19,775 | ||
| Deferred income tax expense (benefit) | (3,658) | 23,226 | (37,329) | |||||
| Total income tax expense (benefit) | $ | 15,443 | $ | 25,994 | $ | (17,554) | ||
In relation to the exempt income level, the Bank’s investment securities portfolio and loans portfolio generated net tax-exempt interest income of $10.0 million for 2017 and 2016, respectively, and $17.6 million for 2015. OIB generated exempt income of $9.6 million, $10.3 million and $6.3 million for 2017, 2016 and 2015, respectively.
Oriental’s income tax expense differs from amounts computed by applying the applicable statutory rate to income (loss) before income taxes as follow:
| Year Ended December 31, | ||||||||||||||
| 2017 | 2016 | 2015 | ||||||||||||
| Amount | Rate | Amount | Rate | Amount | Rate | |||||||||
| (Dollars in thousands) | ||||||||||||||
| Income tax expense (benefit) at statutory rates | $ | 26,555 | 39.00% | $ | 33,220 | 39.00% | $ | (7,823) | -39.00% | |||||
| Tax effect of exempt and excluded income, net | (9,506) | -13.96% | (11,178) | -13.12% | (8,625) | -43.00% | ||||||||
| Disallowed net operating loss carryover | 281 | 0.41% | 1,406 | 1.65% | 556 | 2.77% | ||||||||
| Change in valuation allowance | (305) | -0.45% | (9) | -0.01% | (2,219) | -11.06% | ||||||||
| Release of unrecognized tax benefits, net | (775) | -1.14% | (135) | -0.16% | (385) | -1.92% | ||||||||
| Capital (gain) loss at preferential rate | (279) | -0.41% | 2,394 | 2.81% | 283 | 1.41% | ||||||||
| Other items, net | (528) | -0.79% | 296 | 0.34% | 659 | 3.28% | ||||||||
| Income tax expense (benefit) | $ | 15,443 | 22.66% | $ | 25,994 | 30.51% | $ | (17,554) | -87.52% | |||||
Oriental classifies unrecognized tax benefits in other liabilities. These gross unrecognized tax benefits would affect the effective tax rate if realized. At December 31, 2017 the amount of unrecognized tax benefits was $1.3 million (December 31, 2016 - $2.0 million). Oriental had accrued $97 thousand at December 31, 2017 (December 31, 2016 - $229 thousand) for the payment of interest and penalties relating to unrecognized tax benefits and released $877 thousand due to statute of limitation.
The following table presents a reconciliation of unrecognized tax benefits:
| Year Ended December 31, | |||||||||||
| 2017 | 2016 | 2015 | |||||||||
| In thousands) | |||||||||||
| Balance at beginning of year | $ | 2,040 | $ | 2,175 | $ | 2,560 | |||||
| Additions for tax positions of prior years | 97 | 229 | 175 | ||||||||
| Additions (reductions) due to new tax positions | - | 999 | (560) | ||||||||
| Reduction for tax positions as a result of lapse of statute of limitations | (877) | (1,363) | - | ||||||||
| Balance at end of year | $ | 1,260 | $ | 2,040 | $ | 2,175 | |||||
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 statute of limitations, changes in management’s judgment about the level of uncertainty, status of examinations, litigation and legislative activity, and the addition elimination of uncertain tax positions.
The determination of deferred tax expense or benefit is based on changes in the carrying amounts of assets and liabilities that generate temporary differences. The carrying value of Oriental’s net deferred tax assets assumes that Oriental will be able to generate sufficient future taxable income based on estimates and assumptions. If these estimates and related assumptions change in the future, Oriental may be required to record valuation allowances against its deferred tax assets resulting in additional income tax expense in the consolidated statements of operations.
| December 31, | |||||
| 2017 | 2016 | ||||
| (In thousands) | |||||
| Deferred tax asset: | |||||
| Allowance for loan and lease losses and other reserves | $ | 97,682 | $ | 84,959 | |
| Loans and other real estate valuation adjustment | 10,457 | 11,120 | |||
| Net operating loss carry forwards | 5,169 | 9,686 | |||
| Alternative minimum tax | 15,672 | 15,799 | |||
| Acquired portfolio | 35,293 | 36,237 | |||
| FDIC shared-loss indemnification asset | - | 5,344 | |||
| Other assets allowances | 858 | 1,547 | |||
| Other deferred tax assets | 5,304 | 5,116 | |||
| Total gross deferred tax asset | 170,435 | 169,808 | |||
| Less: valuation allowance | (3,135) | (3,133) | |||
| Net gross deferred tax assets | 167,300 | 166,675 | |||
| Deferred tax liability: | |||||
| FDIC-assisted acquisition, net | (24,564) | (25,862) | |||
| Customer deposit and customer relationship intangibles | (1,828) | (2,402) | |||
| Building valuation ajustment | (9,069) | (9,522) | |||
| Servicing asset | (3,830) | (3,844) | |||
| Other deferred tax liabilities | (588) | (845) | |||
| Total gross deferred tax liabilities | (39,879) | $ | (42,475) | ||
| Net deferred tax asset | $ | 127,421 | $ | 124,200 | |
In assessing the realizability of the deferred tax asset, management considers whether it is more likely than not that some portion or the entire deferred tax asset will not be realized. The ultimate realization of the deferred tax asset is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax asset are deductible, management believes it is more likely than not that Oriental will realize the benefits of these deductible differences, net of the existing valuation allowances at December 31, 2017. The amount of the deferred tax asset considered realizable, however, could be reduced in the near term if estimates of future taxable income during the carry-forward period are reduced.
Oriental follows a two-step approach for recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals of litigation processes, if any. The second step is to measure the tax benefit as the largest amount that is more than 50% likely to be realized upon ultimate settlement.
Oriental is potentially subject to income tax audits in the Commonwealth of Puerto Rico for taxable years 2014 to 2017, until the applicable statute of limitations expire. Tax audits by their nature are often complex and can require several years to complete.