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As Citigroup (NYSE:C) prepares its year-end earnings report, the bank may face an uphill battle to hold onto an obscure source of its capital, industry sources told dealReporter.
At the end of the third quarter, these assets, which are known as deferred tax assets, made up USD 10.8bn of Citi’s USD 96bn in Tier 1 capital. The deferred tax assets have raised the eyebrows of some industry sources because a bank is only supposed to consider the assets as capital if it projects taxable income in the near future. This could pose a problem for New York-based Citigroup since few analysts or bankers expect the firm will do well this year.
A spokesperson for Citigroup declined to comment for this story.
Companies use deferred tax assets to account for their ability to use present losses to reduce past and future tax liabilities. A company is only allowed to claim these assets if it believes it will earn taxable profits up to 20 years in the future, a carry forward, or has earned taxable income in the past two years, a carry back. The long timeframe for carry-forwards typically gives a firm considerable flexibility in how it accounts for the tax assets.
The rules are much stricter, however, when it comes to bank’s use of deferred tax assets as a source of Tier 1 capital. Federal Reserve regulations restrict carry-forward tax deferred assets to 10% of a bank’s Tier 1 capital. Additionally, a bank must be able to show that it is likely to earn enough pre-tax income in the next four quarters to generate taxes equal to the tax assets held as Tier 1 capital.
Assuming a corporate tax rate of 35%, for Citigroup’s third quarter projections on realized tax assets to come true, the bank will have to earn USD 30.8bn in taxable income by 30 September 2009. (Comparatively, Citigroup reported earnings from continuing operations before income taxes of USD 1.7bn in 2007, USD 29.63bn in 2006, USD 29.43bn in 2005 and USD 22.73bn in 2004.)
To once again count the deferred tax assets as Tier 1 capital when it reports fourth quarter 2008 results, Citigroup will need to present a plan to its auditors and regulators that explains why it will likely be able to generate the applicable taxable income by 31 December.
Robert Willens, a tax and accounting consultant who teaches at Columbia Business School, said when a company makes projections on its ability to realize deferred tax assets, a firm and its auditors weigh positive and negative factors that they believe will impact the company’s ability to earn future taxable income. He said a difficult negative factor to overcome is a history of recent losses.
Citigroup will likely run into this problem since it has reported losses for the first three quarters of 2008 and analysts expect the same in the fourth quarter. This ”leads me to believe that unless they have specific and definite plans for realizing taxable income, their auditors are going to give them a hard time on these deferred tax assets,” Willens said. ”I cannot emphasize enough how hard it will be for them to overcome this negative evidence of a history of recent losses.”
While a source at Citigroup familiar with the tax matter declined to discuss specific budget projections, the source said the bank has held discussions with bank regulators about the tax deferred tax issue and shared with them budget projections and calculations.
One positive factor to consider when evaluating future projections, the source said, is that Citigroup’s loan loss provisioning - a large cause of Citi’s recent reported losses - is not considered an expense for tax purposes until the loans provisioned against are charged off. This means Citi’s taxable income in 2009 may be higher than the losses analysts have forecast the bank will report to investors.
Willens acknowledged this point, but said for Citigroup to boost its taxable income, the bank would also need to stop deducting loan charge offs from its taxable income, an unusual practice that would require the bank to permanently forego the charge offs’ tax benefits.
Barring other accounting maneuvers, Citi does have other options to preserve the tax deferred assets.
One way, Willens said, would be for Citigroup to convince its regulators and auditors that it has a plan to sell a greatly appreciated asset at a large profit sometime in the next four quarters.
A source familiar with Citigroup’s corporate strategy said last year the bank considered using asset sales to boost capital, but the source said Citi determined it was unlikely to find a buyer willing to pay even a modest premium for large US assets like Smith Barney or Primerica.
Now Citigroup is evaluating issuing equity or further rationalizing its global retail bank assets, according to the source. An industry banker following the situation, but not directly involved, predicted Citi might try to raise USD 15bn to 10bn in common equity in the first quarter. Citigroup sold its German retail bank operations for USD 4bn after taxes last year. Citi is reviewing its retail and asset management businesses in Asia and could sell them, said the source familiar with Citi’s corporate strategy.
Another way to hold on to the tax assets would be to hope the incoming Obama administration modifies the corporate tax code. A proposal floating around Washington would allow corporations to use present losses to offset tax bills going back five years, rather than the present two-year limit.
This change might help Citigroup by generating additional cash from refunds on taxes it paid in 2004 and 2005. However, it appears unlikely Congress will change the tax code by the time Citi reports initial fourth quarter results on 22 January. The Citi tax source said at the end of the third quarter Citigroup did not rely on carry backs as a source of Tier 1 capital.
The alternative to taking actions to preserve the tax deferred assets, of course, would be for Citigroup to deduct the assets from its Tier 1 capital. The industry banker said he expects Citi will end up being forced down this route.
In what he called the worst-case scenario, the Citi tax source said this situation would only impact the bank’s Tier 1 capital level and not its overall balance sheet - where Citi holds about USD 28bn in tax deferred assets, according to a regulatory filing.
The reduction in Tier 1 capital would not immediately push Citigroup’s capital levels below regulatory minimum thanks to the USD 40bn in capital Citi picked up from participating in the Treasury Department’s capital purchase program late last year. Still, the drop would put additional pressure on the reserves, which took considerable hits in 2008 when the bank wrote down billions in loan losses. Analysts project charge offs will continue in 2009.
The Federal Reserve announced in November a plan to cover some of Citigroup’s losses on a USD 300bn loan portfolio, but the loan guarantees only start after the portfolio takes a USD 29bn loss. The source familiar with Citi’s corporate strategy and the industry banker both predicted that Citigroup may run into trouble with is capital levels this year.
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