INCOME TAXES

12 Months Ended

Dec. 31, 2016

NOTE 26 – INCOME TAXES

Income tax expense includes Puerto Rico and USVI income taxes as well as applicable U.S. federal and state taxes. The Corporation is subject to Puerto Rico income tax on its income from all sources. As a Puerto Rico corporation, First BanCorp. is treated as a foreign corporation for U.S. and USVI income tax purposes and is generally subject to U.S. and USVI income tax only on its income from sources within the U.S. and USVI or income effectively connected with the conduct of a trade or business in those regions. Any such tax paid in the U.S. and USVI is also creditable against the Corporation’s Puerto Rico tax liability, subject to certain conditions and limitations.

Under the Puerto Rico Internal Revenue Code of 2011, as amended (the “2011 PR Code”), the Corporation and its subsidiaries are treated as separate taxable entities and are not entitled to file consolidated tax returns and, thus, the Corporation is not able to utilize losses from one subsidiary to offset gains in another subsidiary. Accordingly, in order to obtain a tax benefit from a net operating loss (“NOL”), a particular subsidiary must be able to demonstrate sufficient taxable income within the applicable NOL carry-forward period. The 2011 PR Code provides a dividend received deduction of 100% on dividends received from “controlled” subsidiaries subject to taxation in Puerto Rico and 85% on dividends received from other taxable domestic corporations.

The Corporation has maintained an effective tax rate lower than the maximum statutory rate mainly by investing in government obligations and mortgage-backed securities exempt from U.S. and Puerto Rico income taxes and by doing business through an International Banking Entity (“IBE”) unit of the Bank, and through the Bank’s subsidiary, FirstBank Overseas Corporation, whose interest income and gain on sales is exempt from Puerto Rico income taxation. The IBE and FirstBank Overseas Corporation were created under the International Banking Entity Act of Puerto Rico, which provides for total Puerto Rico tax exemption on net income derived by IBEs operating in Puerto Rico on the specific activities identified in the IBE Act. An IBE that operates as a unit of a bank pays income taxes at the corporate standard rates to the extent that the IBE’s net income exceeds 20% of the bank’s total net taxable income.

The components of income tax expense are summarized below:

		Year Ended December 31,
		2016		2015		2014
(In thousands)
Current income tax expense	$	(13,151)	$	(6,339)	$	(5,361)
Deferred income tax (expense) benefit		(23,879)		(80)		306,010
Total income tax (expense) benefit	$	(37,030)	$	(6,419)	$	300,649

	The differences between the income tax expense applicable to income before the provision for income taxes and the amount computed by applying the statutory tax rate in Puerto Rico were as follows:

		Year Ended December 31,
		2016					2015					2014
		Amount		% of Pretax Income			Amount		% of Pretax Income			Amount		% of Pretax Income
(Dollars in thousands)

Computed income tax at
statutory rate		$	(50,801)		(39.0)	%	$	(10,810)		(39.0)	%	$	(35,738)		(39.0)	%
Federal and state taxes			-		-	%		(190)		(0.7)	%		(117)		(0.1)	%
Adjustment in deferred tax due
to change in tax rate			-		-	%		-		-	%		(346)		(0.4)	%
Benefit of net exempt income			14,995		11.5	%		9,780		35.3	%		15,202		17.0	%
National receipts tax, net			-		-	%		-		-	%		628		0.7	%
Effect of capital losses subject to preferential rates			(727)		(0.6)	%		(3,019)		(10.9)	%		-		-	%
Disallowed NOL carryforward resulting from
	net exempt income		(6,396)		(4.9)	%		(7,717)		(27.8)	%		-		-	%
Nontax deductible expenses			(212)		(0.2)	%		365		1.3	%		(193)		(0.2)	%
(Decrease) increase in
unrecognized tax benefits,
including interest			-		-	%		-		-	%		1,763		2.0	%
Return to provision adjustments			(434)		(0.3)	%		1,174		4.2	%		-		-	%
Deferred tax valuation allowance			5,976		4.6	%		2,881		10.4	%		318,380		347.0	%
Other-net			569		0.3	%		1,117		4.0	%		1,070		1.2	%
Total income tax
(expense) benefit		$	(37,030)		(28.6)	%	$	(6,419)		(23.2)	%	$	300,649		328.2	%

For 2016, the Corporation recorded an income tax expense of $37.0 million compared to an income tax expense of $6.4 million for 2015. The increase in income tax expense for 2016, when compared to 2015, was mainly driven by higher taxable income, as the year 2015 was impacted by an incremental pre-tax loss of $48.7 million on the bulk sale of assets. The effective tax rate for the year ended December 31, 2016 was 28% compared to 23% for the year ended December 31, 2015.

Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and their tax bases. Significant components of the Corporation's deferred tax assets and liabilities as of December 31, 2016 and 2015 were as follows:

		December 31,
		2016		2015
(In thousands)
Deferred tax asset:
Net operating loss carryforward	$	374,091	$	378,160
Allowance for loan and lease losses		79,330		87,769
Tax credits available for carryforward		8,006		10,714
Unrealized loss on OREO valuation		11,467		11,633
Unrealized net loss on equity investment		187		6,236
Settlement payment-closing agreement		7,313		7,313
Legal reserve		1,807		2,953
Impairment on investment		4,438		3,178
Unrealized loss on available-for-sale securities, net		502		739
Reserve for insurance premium cancellations		724		631
Unrealized losses on derivatives activities		78		48
Other		15,642		17,993
Gross deferred tax assets		503,585		527,367
Less: Valuation allowance		(207,216)		(201,706)
Total deferred tax assets, net of valuation allowance		296,369		325,661

Deferred tax liabilities:
Differences between the assigned values and tax bases of assets
and liabilities recognized in purchase business combinations		5,247		5,712
Unrealized gain on other investments		468		468
Servicing assets		8,997		8,218
Gross deferred tax liabilities		14,712		14,398
Net deferred tax assets	$	281,657	$	311,263

Accounting for income taxes requires that companies assess whether a valuation allowance should be recorded against their deferred tax asset based on an assessment of the amount of the deferred tax asset that is “more likely than not” to be realized. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount that is more likely than not to be realized. Management assesses the valuation allowance recorded against deferred tax assets at each reporting date. The determination of whether a valuation allowance for deferred tax assets is appropriate is subject to considerable judgment and requires the evaluation of positive and negative evidence that can be objectively verified. Consideration must be given to all sources of taxable income available to realize the deferred tax asset, including, as applicable, the future reversal of existing temporary differences, future taxable income forecasts exclusive of the reversal of temporary differences and carryforwards, taxable income in carryback years and tax planning strategies. In estimating taxes, management assesses the relative merits and risks of the appropriate tax treatment of transactions taking into account statutory, judicial, and regulatory guidance.

In 2010, the Corporation established a valuation allowance for substantially all of the deferred tax assets of its banking subsidiary, FirstBank, primarily due to significant operational losses driven by charges to the provision for loan losses, a three-year cumulative loss position as of the end of the year 2010, and uncertainty regarding the amount of future taxable income that the Bank could forecast. As of December 31, 2014, based upon the assessment of all positive and negative evidence, management concluded that it was more likely than not that FirstBank will generate sufficient taxable income within the applicable NOL carry-forward periods to realize $308.2 million of its deferred tax assets and, therefore, reversed $302.9 million of the valuation allowance.

The Corporation’s net deferred tax assets amounted to $281.7 million as of December 31, 2016, net of a valuation allowance of $207.2 million. The net deferred tax assets of the Corporation’s banking subsidiary, FirstBank, amounted to $277.4 million as of December 31, 2016, net of a valuation allowance of $171.0 million, compared to $306.4 million as of December 31, 2015. During 2016, management reassessed the need for a valuation allowance and concluded, based upon the assessment of all positive and negative evidence, that it is more likely than not that FirstBank will generate sufficient taxable income within the applicable NOL carry-forward periods to realize $277.4 million of its deferred tax asset. The positive evidence considered by management to conclude on the adequacy of the valuation allowance as of December 31, 2016 includes factors such as: FirstBank’s three-year cumulative gain position of $206.7 million; forecasts of future profitability under several potential scenarios that support the partial utilization of NOLs prior to their expiration between 2021 through 2024; two consecutive years of taxable income (taxable year 2015 being the first year with taxable income since 2008); and sustained pre-tax pre-provision for loan losses income. These factors demonstrate demand for FirstBank’s products and services and improvements in credit quality measures that have resulted in reduced credit exposures, when compared to the period that led to the full valuation allowance, and have resulted in improvements in both sustainability of profitability and management’s ability to forecast future losses. The negative evidence considered by management includes: Puerto Rico’s current economic conditions, which resulted in the enactment of the Puerto Rico Oversight Management and Economic Stability Act (“PROMESA”), the uncertainty related to government loan concentration and the still elevated levels of non-performing assets.

In determining whether management’s projections of future taxable income used to determine the valuation allowance reversal are reliable, management considered objective evidence supporting the forecast’s assumptions as well as recent experience to conclude as to the Bank’s ability to reasonably project future results of operations. The analysis included the evaluation of multiple financial scenarios, including scenarios where credit losses remain elevated. Further, while Puerto Rico’s economy is expected to remain challenging due to inherent uncertainties, the Corporation believes that it can reasonably forecast future taxable income at sufficient levels over the future period of time that FirstBank has available to realize part of the December 31, 2016 net deferred tax asset as further described below.

The Corporation expects to realize approximately $171.5 million of deferred tax assets associated with FirstBank’s NOLs prior to their expiration periods, compared to $182.1 million expected to be realized as of December 31, 2015. In addition, as of December 31, 2016, approximately $117.0 million of the deferred tax assets of the Corporation are attributable to temporary differences or tax credit carry-forwards that have no expiration date, compared to $127.8 million in 2015. Approximately $20.5 million of other non-NOLs, related deferred tax assets of the Corporation are fully reserved with a valuation allowance, compared to $19.4 million as of December 31, 2015, given limitations and uncertainties as to their future utilization. The increase in fully reserved deferred tax assets is related to the increase in cumulative other-than-temporary impairments on investment securities. The ability to recognize the remaining deferred tax assets that continue to be subject to a valuation allowance will be evaluated on a quarterly basis to determine if there are any significant events that would affect the ability to utilize these deferred tax assets.

Management’s estimate of future taxable income is based on internal projections that consider historical performance, multiple internal scenarios and assumptions, as well as external data that management believes is reasonable. If events are identified that affect the Corporation’s ability to utilize its deferred tax assets, the analysis will be updated to determine if any adjustments to the valuation allowance are required. If actual results differ significantly from the current estimates of future taxable income, even if caused by adverse macro-economic conditions, the remaining valuation allowance may need to be increased. Such an increase could have a material adverse effect on the Corporation’s financial condition and results of operations. Conversely, better than expected results and continued positive results and trends could result in further releases to the deferred tax valuation allowance; any such decreases could have a material positive effect on the Corporation’s financial condition and results of operations.

As of December 31, 2016, the Corporation did not have UTBs recorded on its books. During 2014, the Corporation reached a final settlement with the IRS in connection with the 2007-2009 examination periods. As a result, during 2014, the Corporation released a portion of its reserve for uncertain tax positions, resulting in a tax benefit of $1.8 million, and paid $2.5 million to settle the tax liability resulting from the audit.

The following table reconciles the balance of UTBs:
		2016		2015		2014
(In thousands)
Balance at January 1,	$	-	$	-	$	4,310
(Decrease) increase related to positions taken during
prior years		-		-		(1,763)
Decrease related to settlement with taxing authorities		-		-		(2,547)
Balance at December 31,	$	-	$	-	$	-

During the second quarter of 2015, the Corporation settled the previously accrued interest of $1.3 million related to the aforementioned IRS examination. The Corporation classifies all interest and penalties, if any, related to tax uncertainties as income tax expense. Audit periods remain open for review until the statute of limitations has passed. The statute of limitations under the 2011 PR code is four years; the statute of limitations for Virgin Islands and U.S. income tax purposes are each three years after a tax return is due or filed, whichever is later. The completion of an audit by the taxing authorities or the expiration of the statute of limitations for a given audit period could result in an adjustment to the Corporation’s liability for income taxes. Any such adjustment could be material to the results of operations for any given quarterly or annual period based, in part, upon the results of operations for the given period. For Virgin Islands and U.S. income tax purposes, all tax years subsequent to 2012 remain open to examination. During 2015 and 2016, the IRS audited the US income tax return for the year 2012. During the first quarter of 2017, the IRS completed such audit without adjustments. For Puerto Rico tax purposes, all tax years subsequent to 2011 remain open to examination.

During 2013, the Puerto Rico government approved Act No. 40, which imposed a national gross receipts tax. The national gross receipts tax for financial institutions was computed on the basis of 1% of gross income net of allowable exclusions. Subject to certain limitations, a financial institution was able to claim a credit of 0.5% of its gross income against its regular income tax or the alternative minimum tax. However, on December 22, 2014, the Governor of Puerto Rico signed Act No. 238, which amended the 2011 PR Code. Act No. 238 clarifies that the national gross receipts tax was not applicable to taxable years starting after December 31, 2014. Accordingly, the Corporation did not record national gross receipts tax expense for 2015 or 2016. During 2014, a $5.7 million gross receipts tax expense was included as part of “Taxes, other than income taxes” in the consolidated statement of income and a $2.9 million benefit related to this credit was recorded as a reduction to the provision for income taxes.

On May 28 and September 30, 2015, the Puerto Rico legislature approved Act 72-2015 and Act 159-2015, respectively, which enacted amendments to the 2011 PR Code. The amendments related to the income tax provision include changes to the alternative minimum tax computation, and changes to the use limitation on NOLs and capital losses for 2015 and future taxable years. The change in the tax law affected the Corporation’s income tax computation by limiting the NOL deduction to 80% of taxable income, compared to a 90% limitation in prior years.