Citi’s deferred tax – an asset of dubious worth

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The FT notes that Citigroup is at the centre of a dispute among analysts and accounting experts over whether it should set aside funds to cover $50bn of deferred taxes, a move that would reduce its capital buffer and weaken its balance sheet. As it says:

The assets, a product of the accounting principles applied by US tax authorities to companies, are crucial to Citi’s financial health. At the end of the second quarter, deferred tax assets made up more than a third of Citi’s tangible equity — a measure of balance sheet strength.

The US bank has rebuffed calls to reserve for its DTAs — the biggest held by a US company — arguing that it will earn enough money in the future to justify keeping the assets on its books.

Under accounting rules, Citi has to be confident it will earn $99bn in taxable income during the next two decades to avoid making provisions for DTAs. In the 2002-2006 period Citi had annual pre-tax profits of at least $20bn.

However, some argue Citi is being too optimistic given its recent record — its pre-tax losses in 2008 and 2009 topped $60bn — and continued global economic uncertainty.

Deferred tax calculation is at best a black art. In this case Citi says that because it has either losses it can carry forward or the benefit of allowances it has not yet claimed their cash value for tax purposes. As a note to its accounts says:

The most significant source of these timing differences is the loan loss reserve build, which accounts for approximately $15 billion of the net DTA. In general, Citi would need to generate approximately $86 billion of taxable income during the respective carryforward periods to fully realize its U.S. federal, state and local DTAs.

Two generic things to note there first of all. Note that it’s clear future tax revenues from banks are going to be severely limited by the carry forward of tax losses. Second, note the injustice in this: those losses were already state funded.

More specifically, note the required profits: Citi has earned $20 billion in a year, but will it again?

Third, note something stranger still: these assets are stated at their cash value as far as I can tell from the accounts, there appears to be no discounting for the fact they may not be realised for many years to come. How very odd: a bank not noticing the value of money over time.

And finally, an issue not noticed in the report is this note in Citi’s accounts:

Citigroup’s ability to utilize its deferred tax assets (DTAs) to offset future taxable income may be significantly limited if it experiences an “ownership change” under the Internal Revenue Code.

As of December 31, 2009, Citigroup had recognized net DTAs of approximately $46.1 billion, which are included in its tangible common equity. Citigroup’s ability to utilize its DTAs to offset future taxable income may be significantly limited if Citigroup experiences an “ownership change” as defined in Section 382 of the Internal Revenue Code of 1986, as amended (the Code). In general, an ownership change will occur if there is a cumulative change in Citigroup’s ownership by “5-percent shareholders” (as defined in the Code) that exceeds 50 percentage points over a rolling three-year period.

The common stock issued pursuant to the exchange offers in July 2009, and the common stock and tangible equity units issued in December 2009 as part of Citigroup’s TARP repayment, did not result in an ownership change under the Code. However, these common stock issuances have materially increased the risk that Citigroup will experience an ownership change in the future. On June 9, 2009, the Board of Directors of Citigroup adopted a Tax Benefits Preservation Plan. This Plan is subject to shareholders’ approval at the 2010 Annual Meeting. The purpose of the Plan is to minimize the likelihood of an ownership change occurring for Section 382 purposes. Despite adoption of the Plan, future transactions in Citigroup stock that may not be in its control may cause Citigroup to experience an ownership change and thus limit its ability to utilize its DTAs, as well as cause a reduction in Citigroup’s tangible common equity and stockholders’ equity.

So on third of the value of Citi’s tangible equity is dependent upon Citi’s equity not being trade — for which reason it is having to restrict trade in its shares.

To say this is an asset of dubious worth is generous: how did KPMG satisfy themselves, I wonder? 

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