Income Taxes

12 Months Ended

Dec. 31, 2015

NOTE 17 — INCOME TAXES

The Company is subject to the dispositions of the 2011 Internal Revenue Code of the New Puerto Rico, as amended (the Code). Among others, the Code imposes a maximum corporate tax rate of 39%. Recent Code amendments have been incorporated to increase government collections in order to alleviate the governmental structural deficit. One of the Code’s amendments is Act No. 77-2014 known as “Ley de Ajustes al Sistema Contributivo” (Act of Adjustments to the Tax System). The most relevant provisions of the Act of Adjustments to the Tax System, as applicable to the Company, and effective for transactions held after June 30, 2014 are as follows: (1) the capital tax rate was increased from 15% to 20% and (2) for an asset to be considered long term capital asset, the holding period must be over a year, which before was defined with a holding period of over six months.

On May 29, 2015 the Governor signed Act No. 72 of 2015. The most relevant provisions of the Act No. 72, as applicable to the Company, for taxable years beginning after December 31, 2014, are as follows: (1) establishes a new definition of “large taxpayers,” which require them to file their tax return following a special procedure established by the Secretary of the Treasury, (2) net operating losses carried forward may be deducted up to 70% of the alternative minimum net income for purposes of computing the alternative minimum tax, and (3) net operating losses carried forward may be deducted up to 80% of the net income for purposes of computing the regular corporate income tax.

Other Code amendments applicable during 2015 are the increase of the Sales and Use Tax (SUT) from 7% to 11.5% beginning July 1st, 2015 and a special SUT to business to business transactions of 4%, beginning October 1st, 2015. These were implemented as a transitional phase to the enacted Value Added Tax (VAT) of 10.5%, which will be in place on April 1st, 2016, along with a Municipal SUT of 1% on certain taxable items.

Under Puerto Rico law, all companies are treated as separate taxable entities and are not entitled to file consolidated tax returns. The Company and its subsidiaries are subject to Puerto Rico regular income tax or 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.

The components of income tax expense (benefit) for the years ended December 31, 2015, 2014 and 2013 are as follows

	Year Ended December 31,
	2015		2014			2013
	(In thousands)
Current income tax expense	$	19,775	$	13,097	$	2,357
Deferred income tax (benefit) expense		(37,329)		24,155		(11,066)
Total income tax (benefit) expense	$	(17,554)	$	37,252	$	(8,709)

	Year Ended December 31,
	2015			2014			2013
	Amount		Rate	Amount		Rate	Amount		Rate
	(Dollars in thousands)
Tax (benefit) expense at statutory rates	$	(7,823)	-39.00%	$	47,749	39.00%	$	34,997	39.00%
Tax effect of exempt income, net		(8,625)	-43.00%		(10,002)	-26.85%		(4,652)	-4.90%
Effect of tax rate on capital loss carryforwards		-	0.00%		-	0.00%		840	0.94%
Disallowed net operating loss carryover		556	2.77%		8,289	22.25%		-	0.00%
Change in valuation allowance		(2,219)	-11.06%		(958)	-2.57%		1,896	2.11%
Release of unrecognized tax benefits, net		(385)	-1.92%		(1,093)	-2.94%		(1,559)	-1.57%
Effect in deferred taxes due to increase in tax rates
from 30.00% to 39.00%		-	0.00%		-	0.00%		(38,068)	-43.04%
Loan tax basis change effect		-	0.00%		(7,642)	-20.51%		-	0.00%
Effect of change in tax of IBE		-	0.00%		-	0.00%		148	0.17%
Unrealized capital loss		283	1.41%		-	0.00%		-	0.00%
Other items, net		659	3.28%		909	2.00%		(2,311)	-2.58%
Income tax (benefit) expense	$	(17,554)	-87.52%	$	37,252	10.82%	$	(8,709)	-9.70%

The Company classifies unrecognized tax benefits in income taxes payable. These gross unrecognized tax benefits would affect the effective tax rate if realized. At December 31, 2015 was $2.2 million (December 31, 2014 - $2.6 million). The Company had accrued $175 thousand at December 31, 2015 (December 31, 2014 - $470 thousand) for the payment of interest and penalties relating to unrecognized tax benefits. During 2015, $560 thousand was released based on negotiations with the IRS related to taxable dividends from the Federal Home Loan Bank. These negotiations concluded and the subject is settled with the IRS.

The following table presents a reconciliation of unrecognized tax benefits:

	Year Ended December 31,
	2015		2014		2013
	In thousands)
Balance at beginning of year	$	2,560	$	4,042	$	5,452
Additions for tax positions of prior years		175		187		287
Reduction for tax positions as a result of settlements		(560)		(1,388)		-
Reduction for tax positions as a result of lapse of statute of limitations		-		(281)		(1,697)
Balance at end of year	$	2,175	$	2,560	$	4,042

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 the Company’s net deferred tax assets assumes that the Company will be able to generate sufficient future taxable income based on estimates and assumptions. If these estimates and related assumptions change in the future, the Company 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,
	2015		2014
	(In thousands)
Deferred tax asset:
Allowance for loan and lease losses and other reserves	$	129,234	$	90,090
Loans and other real estate valuation adjustment		10,759		9,295
Net capital and operating loss carry forwards		11,043		28,973
Alternative minimum tax		16,240		16,208
Deposit and borrowings valuation adjustment		133		390
Unrealized net loss included in other comprehensive income		1,680		3,273
S&P option contracts		393		1,882
Acquired portfolio		37,523		46,146
FDIC shared-loss indemnification asset		2,802		-
Other assets allowances		1,547		1,424
Other deferred tax assets		5,612		6,262
Total gross deferred tax asset		216,966		203,943

Deferred tax liability:
FDIC shared-loss indemnification asset		-		(21,809)
FDIC-assisted acquisition, net		(47,956)		(40,740)
Customer deposit and customer relationship intangibles		(3,057)		(3,800)
Loans and building valuation adjustment		(9,991)		(11,656)
Unrealized net gain on available-for-sale securities		(2,566)		(3,799)
Servicing asset		(2,907)		(5,457)
Other deferred tax liabilities		(1,446)		(2,703)
Total gross deferred tax liabilities		(67,923)	$	(89,964)
Less: valuation allowance		(3,142)		(5,271)
Net deferred tax asset	$	145,901	$	108,708

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 the Company will realize the benefits of these deductible differences, net of the existing valuation allowances at December 31, 2015. 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.

The Company and its subsidiaries have operating and capital loss carry-forwards for income tax purposes which are available to offset future taxable income and capital gains. Operating loss carry-forwards are available until December 2025 and capital loss carry-forwards are available until December 2020. The majority of these operating and capital loss carry-forwards are at the Company and at the Bank amounting to approximately $27.6 million as of December 31, 2015.

The Company 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.

The Company is potentially subject to income tax audits in the Commonwealth of Puerto Rico for taxable years 2011 to 2014, until the applicable statute of limitations expire. Tax audits by their nature are often complex and can require several years to complete.