Income Taxes

12 Months Ended

Dec. 31, 2018

NOTE 19 — INCOME TAXES

Oriental is subject to the dispositions of the 2011 Puerto Rico Internal Revenue Code, as amended (the “Puerto Rico Code”). For 2018, the Puerto Rico Code imposed a maximum statutory corporate tax rate of 39%. 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.

Under the Puerto Rico Code, 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.

The components of income tax expense for the years ended December 31, 2018, 2017, and 2016 are as follows:

	Year Ended December 31,
	2018		2017			2016
	(In thousands)
Current income tax expense	$	33,618	$	19,101	$	2,768
Deferred income tax expense (benefit)		14,772		(3,658)		23,226
Total income tax expense (benefit)	$	48,390	$	15,443	$	25,994

In relation to the exempt income level, the Bank’s investment securities portfolio and loans portfolio generated net tax-exempt interest income of $11.0 million at 2018 and $10.0 million at both, 2017 and 2016. OIB generated exempt income of $5.3 million, $9.6 million and $10.3 million for 2018, 2017 and 2016, respectively.

Oriental maintained an effective tax rate lower than statutory rate for the year ended December 31, 2018, mainly by investing in tax-exempt obligations, doing business through its international banking entity Oriental International Bank and by expanding its subsidiary operations in the U.S., which are taxed at a lower rate.

Oriental’s income tax expense differs from amounts computed by applying the applicable statutory rate to income before income taxes as follow:

	Year Ended December 31,
	2018			2017			2016
	Amount		Rate	Amount		Rate	Amount		Rate
	(Dollars in thousands)
Income tax expense at statutory rates	$	51,792	39.00%	$	26,555	39.00%	$	33,220	39.00%
Tax effect of exempt and excluded income, net		(6,645)	-5.01%		(9,506)	-13.96%		(11,178)	-13.12%
Disallowed net operating loss carryover		269	0.20%		281	0.41%		1,406	1.65%
Change in valuation allowance		1,504	1.13%		(305)	-0.45%		(9)	-0.01%
Release of unrecognized tax benefits, net		(386)	-0.29%		(775)	-1.14%		(135)	-0.16%
Capital (gain) loss at preferential rate		(20)	-0.02%		(279)	-0.41%		2,394	2.81%
Effect of change in tax rate		4,069	3.06%		-	0.00%		-	0.00%
Other items, net		(2,193)	-1.63%		(528)	-0.79%		296	0.34%
Income tax expense	$	48,390	36.44%	$	15,443	22.66%	$	25,994	30.51%

Oriental’s effective tax rate for the years ended December 31, 2018 was 36.44%, and it was mainly affected by the discrete tax adjustments related to recent changes in the tax legislation and changes to the proportion of exempt income to total income. For the years ended December 31, 2017 and 2016, effective tax rate was 22.7% and 30.5%, respectively. On December 10, 2018, the Puerto Rico government enacted Act 257-2018 introducing several amendments to the Puerto Rico Code. Some of the most relevant income tax changes include: a reduction of the maximum corporate income tax rate to 37.5%, from 39%, and a restriction of the use of partnership gains to offset current and accumulated operating losses generated by a corporate partner. The change in tax rate resulted in the reduction of Oriental’s deferred tax assets by $4.1 million, generating a discrete tax expense for the period. In addition, the restriction on the use of partnership gains to offset the partner’s current and accumulated operating losses, resulted in a change in outlook as to the realizability of the Holding company’s deferred tax assets resulting in an increase in valuation allowance of $1.5 million. The 2018 effective tax rate included discrete items and the impact of recent tax legislation changes, that increased the effective tax rate by 2.8%. Act 257-2018 also contains other provisions, effective January 1, 2019, however Oriental’s does not expect that the recent tax legislation will result in significant changes on its 2019 effective tax rate.

Oriental classifies unrecognized tax benefits in other liabilities. These gross unrecognized tax benefits would affect the effective tax rate if realized. At December 31, 2018, the amount of unrecognized tax benefits was $875 thousand (December 31, 2017 - $1.3 million). Oriental had accrued $81 thousand at December 31, 2018 (December 31, 2017 - $97 thousand) for the payment of interest and penalties relating to unrecognized tax benefits and released $466 thousand due to expiration of statute of limitation.

The following table presents a reconciliation of unrecognized tax benefits:

	Year Ended December 31,
	2018		2017		2016
	In thousands)
Balance at beginning of year	$	1,260	$	2,040	$	2,175
Additions for tax positions of prior years		81		97		229
Additions due to new tax positions		-		-		999
Reduction for tax positions as a result of lapse of statute of limitations		(466)		(877)		(1,363)
Balance at end of year	$	875	$	1,260	$	2,040

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. The amount of unrecognized tax benefits may increase or decrease in the future due to new or current tax year positions, expiration of open income tax returns, changes in management’s judgment about the level of uncertainty, status of examinations, litigations and legislative activity.

The statute of limitations under the Puerto Rico Code is four years and the statute of limitations for federal tax purposes is three years, after a tax return is due or filed, whichever is later. 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 expires. In addition, Oriental’s US subsidiaries are potentially subject to income tax audits by the IRS for taxable years 2015 to 2017. Tax audits by their nature are often complex and can require several years to complete.

The determination of the deferred tax expense or benefit is generally 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. Significant components of Oriental’s deferred tax assets and liabilities as of December 31, 2018, and 2017 were as follows:

	December 31,
	2018		2017
	(In thousands)
Deferred tax asset:
Allowance for loan and lease losses and other reserves	$	85,227	$	97,682
Loans and other real estate valuation adjustment		7,842		10,457
Net operating loss carry forwards		5,466		5,169
Alternative minimum tax		14,631		15,672
Acquired portfolio		35,753		35,293
Other assets allowances		966		858
Other deferred tax assets		5,298		5,304
Total gross deferred tax asset		155,183		170,435
Less: valuation allowance		(4,629)		(3,135)
Net gross deferred tax assets		150,554		167,300
Deferred tax liability:
FDIC-assisted acquisition, net		(22,825)		(24,564)
Customer deposit and customer relationship intangibles		(1,263)		(1,828)
Building valuation ajustment		(8,284)		(9,069)
Servicing asset		(4,018)		(3,830)
Other deferred tax liabilities		(401)		(588)
Total gross deferred tax liabilities		(36,791)	$	(39,879)
Net deferred tax asset	$	113,763	$	127,421

As of December 31, 2018 and 2017, Oriental's net deferred tax asset, net of a valuation allowance of $4.6 million and $3.1 million, respectively, amounted to $113.8 million and $127.4 million, respectively. As discussed above, the deferred tax assets as of December 31, 2018 are affected by a change in tax legislation which resulted in a reduction of $4.1 million in deferred tax assets and an increase in valuation allowance of $1.5 million. The increase in valuation allowance was related to a change in outlook as to the realizability of the Holding company’s deferred tax assets. 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 income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future income, and tax planning strategies in making this assessment. Based upon the assessment of positive and negative evidence, 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, 2018. 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.