OREANDA-NEWS. Lack of harmonization among EU tax regimes and the different treatment of deferred tax assets (DTA) are causing regulatory uncertainty for bank debt investors, Fitch Ratings says. Formal investigations into whether some banks benefited from state aid as a result of DTA credit conversion have not yet been launched by the European Commission but diverging tax regimes across the EU provide opportunities for questions about whether this constitutes state aid, which is not permitted.

Should formal investigations be launched and they conclude that some banks in Greece, Italy, Portugal and Spain (GIPS) benefited from state aid, this could hurt their ratings, particularly if capital (both regulatory capital and core capital as measured by Fitch) includes a high proportion of DTAs. Detailed analysis would be required to determine any ratings impact because banks have various mechanisms available to address capital considerations and their profit generating capabilities differ widely.

The Capital Requirements Regulation (CRR), the EU's implementation of Basel III, complies with the global standards, but it introduced additional flexibility for DTA recognition. Without this flexibility, certain GIPS banks would have failed to comply with prudential solvency ratios.

To take advantage of added flexibility, amendments to national tax laws were required, a step taken by Italy in 2011, followed by Spain (2013), Portugal and Greece (2014). New tax laws changed the nature of DTAs by introducing an unconditional right to a tax claim from government, thereby transforming certain DTAs into a tax credit. Unlike some other DTAs, tax credits are not deducted from regulatory capital.

Amended tax laws apply to all companies and not just banks. However, in practice, banks benefited more because the bulk of temporary DTAs arise from bank-specific accounting matters, such as credit impairments and foreclosed asset acquisitions. This opens up questions about whether this would qualify as state aid.

In our view, CRR's flexibility is positive as it removes some advantages enjoyed by banks operating in countries that allow immediate tax deductions and it also allows DTAs to absorb losses when banks are under stress. However, introducing an element of regulatory uncertainty about banks' capital, particularly in GIPS, at this stage might be confusing for investors.

A common capital framework under the CRR for banks is positive; however, divergent tax regimes across countries cause material discrepancies in the amount and timing of tax obligations due. Discrepancies feed through to capital calculations.

Some tax jurisdictions allow companies to deduct all losses and expenses in the year in which they are incurred. This immediately reduces tax obligations. Other jurisdictions force companies to carry forward losses and expenses and offset them against future profits. This reduces future tax payments and creates a DTA. For regulatory capital purposes, this is known as a 'tax loss DTA'. Timing gaps between financial accounting rules and tax rules also give rise to DTAs, known as 'temporary difference DTAs'. For banks, such DTAs are generally linked to loan impairment charges.

Tax regimes in GIPS allow no immediate deductions. As a result, GIPS banks traditionally stockpiled DTAs. Accumulation worsened in recent years as sizeable impairment provisions were made and some banks reported losses.

DTAs are important because Basel III deducts them from regulatory capital. Tax loss DTAs are always deducted but some leniency for temporary difference DTAs is allowed.

Fitch's opinion on the divide between tax regimes in Southern (GIPS) and Northern Europe, and whether this distorts the playing field for banks, is covered in a report, 'Extending Southern European Banks' Tax Credits', published in November 2014 and available at www.fitchratings.com or by clicking the link above.