Today the Wall Street Journal reported on an alleged loophole in EU bank capital rules. The loophole pertains to deferred tax assets (DTAs), a regulatory area where tax rules and accounting rules meet.

Apparently some countries exploit a DTA loophole: Italy, Spain, Portugal and Greece.

Uh oh, these countries, the usual suspects. There is something really wrong here.

However, actually, this is perfectly legal (but also out of whack), as I will demonstrate.

First a brief explanation of DTAs. A DTA is like a receivable, where the debtor is not a customer, but the government, or its tax authority (i.e. the IRS, HMRC, IRD). Normally you will receive money to extinguish a receivable. However, regarding DTAs, the weird thing is that the tax authority will generally not pay you any cash directly. Instead, to extinguish the receivable, the tax authority will only pay you by reducing your tax bill. So, you will only be able to “receive” your money when you have taxable income or taxable profits that give rise to a tax bill. That tax bill then can be reduced by the DTA. When you have no profit or income, you don’t have to pay taxes, so you cannot use the DTA to offset any taxes payable.

Bank regulators do not like DTAs. They force banks to deduct them from their capital buffers. This makes perfectly sense, as a DTA is a receivable that is only worth something when a bank is profitable. However, most banks with DTAs are loss making, so for these banks the DTAs are worthless.

What loophole? Some Italian, Spanish, Portuguese, and Greek banks apparently have lots of DTAs, but not sufficient taxable profit to extinguish them. These banks pushed hard for a facility to not deduct a DTA from capital buffers. This facility is now part of Basel III, see para 69: “DTAs that rely on future profitability of the bank to be realised are to be deducted in the calculation of Common Equity Tier 1. … Where these DTAs relate to temporary differences (eg allowance for credit losses) the amount to be deducted is set out in the “threshold deductions” section below.”

The first part is the default: DTAs shall be deducted from buffer capital. The second part the creates the facility: The DTA is deductible from buffer capital only after it exceeds a threshold.

Note that the facility only pertains to “temporary” differences, e.g. in case a debtor fails to pay back a loan. The bank then reports a credit loss, but the fiscal authorities may not accept this loss immediately. It may take some time before the tax collector accepts the credit loss. In cases like these, the bank knows almost certainly that the DTA will lead to a future reduction in the tax bill, the only question is … when. This is pure torture. The bank knows it will receive a discount, but sluggish tax collectors may take years to decide – in the meanwhile the ECB Asset Quality Review is impatient and relentless.

Out of whack, but legal. CRD IV, the EU implementation of Basel III, presents this facility in a way that it looks very much out of whack, see Article 39.2. This article, out of thin air, creates the concept of a DTA that does not rely on future profitability. This goes against any sane idea about the concept of a DTA, as these are meant to offset future tax bills – which depend on future profitability.

CRD IV allows banks to not deduct from capital buffers these fantasy-DTAs. Instead, a risk weight of 100% applies. That is, if conditions are met, see conditions a, b, and c below. Turns out that these conditions are important.

When I first read about the concept of DTAs that do not depend on future profitability, I thought someone in Brussels had gone insane. However, the fantasy-DTAs exist. That is, only if a country establishes rules that create them. Italy for starters. And, like the Renaissance, from Italy it started spreading. Other countries established rules that support the creation of the fantasy-DTAs: Spain, Greece, Portugal.

Therefore, the fantasy-DTAs are perfectly legal, there is no loophole as long as a country’s tax rules satisfy the requirements of Article 39.2.

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And yes, if you read through the rules below: they are state aid 😉

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Article 39.2. Deferred tax assets that do not rely on future profitability shall be limited to deferred tax assets arising from temporary differences, where all the following conditions are met:

(a)	they are automatically and mandatorily replaced without delay with a tax credit in the event that the institution reports a loss when the annual financial statements of the institution are formally approved, or in the event of liquidation or insolvency of the institution;

(b)

an institution shall be able under the applicable national tax law to offset a tax credit referred to in point (a) against any tax liability of the institution or any other undertaking included in the same consolidation as the institution for tax purposes under that law or any other undertaking subject to the supervision on a consolidated basis in accordance with Chapter 2 of Title II of Part One;

(c)	where the amount of tax credits referred to in point (b) exceeds the tax liabilities referred to in that point, any such excess is replaced without delay with a direct claim on the central government of the Member State in which the institution is incorporated.

Institutions shall apply a risk weight of 100 % to deferred tax assets where the conditions laid down in points (a), (b) and c) are met.