Bank of America (BAC) more than doubled its profits in 2012 — with some help from the tax code.
What the bank calls "restructuring" of its non-U.S. operations yielded $1.7 billion in foreign tax credits, or 41% of the $4.2 billion the company reported in 2012 earnings, according to securities documents including the form 10-K it filed Feb. 28. While the maneuvers didn't provide an immediate cash tax benefit for Bank of America, the foreign tax credits count toward net income under accounting rules.
The transactions and the bank's decision to take some risk that the credits will expire unused indicate the sometimes contradictory incentives that companies have under the U.S. tax code's treatment of income earned overseas.
Bank of America, the second-largest U.S. bank by assets, hasn't explained in any detail the structure of the transactions or its reasons for generating foreign tax credits that it can't use immediately. None of the other six largest U.S. banks reported similar tax credit transactions in annual filings for 2012, though Citigroup (NYSE:C) already had a larger stockpile of foreign tax credits, which increased during the year.
For Bank of America, the most likely explanation behind the foreign tax credits is that the bank had foreign income that had been previously taxed and later incurred losses, leaving it with relatively low cumulative profits and high taxes that accompany such income, said Richard Harvey, a tax professor at Villanova University's law school in Pennsylvania. That's a typical result after a financial crisis.
"Obviously, the order of magnitude at BofA was rather large," he said.
Jerry Dubrowski, a spokesman for Charlotte, North Carolina- based Bank of America, declined to provide details of the transactions beyond what the company has said in securities filings.
Multinational corporations are required to pay U.S. taxes on their worldwide income with a top rate of 35%. Companies can defer U.S. taxation until they bring profits home, and they can receive foreign tax credits for payments to other governments.
U.S.-based multinationals have been lobbying Congress and the administration to back a so-called territorial system that would exempt most foreign income from U.S. taxation. Bank of America supports such a system, Dubrowski said in an e-mail.
"We believe this makes sense from a competitiveness standpoint, and we also believe reforms can greatly simplify our current international rules," he said.
Under a territorial system, companies would have little or no tax incentive to hold earnings offshore and thus would be less likely to end up in the situation that Bank of America encountered.
Without changes, the U.S. tax system creates an incentive for companies to stockpile untaxed profits outside the country. Over the past year, 83 large U.S.-based multinational corporations added $183 billion to their untaxed offshore profits, which now total $1.46 trillion, according to data compiled by Bloomberg on U.S. companies with the largest accumulated foreign assets.
The system encourages companies to find ways to bring back their income and tax credits when they can do so with little or no cost or when they must repatriate earnings for other reasons.
"What you want to do is somehow find a way to bring the foreign tax credits without bringing the income that would be highly taxed in the U.S.," said Douglas Shackelford, a tax professor at the University of North Carolina's Kenan-Flagler Business School.
Among the 83 U.S.-based multinationals with overseas stockpiles exceeding $4 billion in recent years, Bank of America was one of 12 that had a declining balance of offshore profits, according to Bloomberg data. As of the end of 2011, Bank of America had $18.5 billion in untaxed offshore profits. The company reported that repatriating all of the money would have cost $2.5 billion in taxes.
By the end of 2012, after the transactions, the company had $17.2 billion in accumulated offshore earnings, which would cost $4.3 billion in taxes to repatriate.
Bank of America almost tripled its stockpile of foreign tax credits to $6.2 billion in 2012. The credits sit on its books as deferred tax assets. They can be used to reduce future U.S. tax bills only after the company generates enough taxable income to exhaust $4.9 billion in U.S. deductions for losses.
Those numbers show that what the company effectively did through the transactions was bring home tax credits and income that had already been taxed while isolating lightly taxed income outside the U.S. Repeating that pattern this year would require finding more foreign tax credits within a pool of income that has a lower overall tax rate.
Bank of America's Dubrowski wouldn't say how much money the company repatriated or whether the company will undertake similar future transactions.
The largest U.S. companies, such as Bank of America, are under routine audit by the IRS, which analyzes tax-related transactions and their legality. Those audits can take years. The company and the IRS are still trying to resolve Bank of America's taxes from as far back as 2001, according to the bank's securities filings.
Bank of America hasn't filed its tax return for 2012, Dubrowski said.
The company provided no detail in securities filings or an investor call on exactly how it generated the tax credits.
Bruce Thompson, the company's chief financial officer, referred to the transactions as "restructurings" during a January call with investors.
As part of a companywide reorganization, Bank of America has been divesting businesses outside its core mission and trying to bolster its capital cushion to satisfy regulators.
Brian Moynihan, the company's 53-year-old chief executive officer, has presided over the sale of more than $60 billion in assets since taking over the company in 2010. Businesses that were sold or shuttered included the company's Canadian and European credit-card units, Merrill Lynch wealth management units in Europe, Asia, the Middle East and Latin America, and stakes of Chinese, Brazilian and Mexican lenders.
The moves helped the company focus on core customer groups and boost capital to conform to shifting international rules, Moynihan has said. His predecessor, Kenneth Lewis, spent more than $130 billion for acquisitions that gave Bank of America leading positions in deposits, credit cards, mortgages and investment banking.
Outside the U.S., some of those businesses may have recorded gains with attached foreign tax credits and others may have had losses. When combined, they may have created a situation in which the bank received relatively little net income and was able to obtain the foreign tax credits.
As a simplified example, if the company had $100 of income in a country with a 20% tax rate, it would have a $20 foreign tax credit and would still have to pay $15 in tax to the U.S. if the profits were repatriated.
If that income were combined with $90 of losses, then the company would have $10 of income to repatriate and a U.S. tax liability of $3.50. The company would still have paid $20 in taxes, creating $16.50 of excess foreign tax credits.
The bank can start using the foreign tax credits it has stockpiled only after it generates enough U.S. taxable income to exhaust its net operating loss deductions. Deductions are subtractions from taxable income. Credits, which are typically more valuable, offset tax payments.
The transactions started a 10-year clock, after which the tax credits expire.
"What you want to make sure is you always get to fully utilize all those foreign tax credits," Shackelford said.
The loss carry-forwards start expiring after 2027 and the foreign tax credits begin expiring after 2017, according to securities filings. The filings show that Bank of America has taken a $271 million valuation allowance against the foreign tax credits, which means that executives think it is likely that the company will generate enough income to use up almost all of the credits before they expire.
Typically, Harvey said, companies don't want to trigger foreign tax credits any earlier than necessary because of the 10-year clock.
"It's sad that in order to get a financial statement benefit, Bank of America may have needed to do something that was potentially detrimental to them," said Harvey, who was a senior adviser to former IRS Commissioner Douglas Shulman.
In addition, Bank of America has $8.5 billion in U.K. net operating losses and $3.3 billion in other credits.
Bank of America's net deferred tax assets are more limited than those of competitor Citigroup which has exhausted its net operating loss carry-forwards and now has $22 billion in foreign tax credits.
In securities filings, Citigroup said it will be able to use all of the credits and provides details of several maneuvers available to increase taxable income before the credits begin to expire. For example, the company could accelerate recognition of U.S. taxable income, defer deductions and replace tax-exempt assets with taxable ones.