INCOME TAXES

The Company uses an asset and liability (balance sheet) approach for financial accounting and reporting of income taxes. This results in two components of income tax expense: current and deferred. Current income tax expense approximates taxes to be paid or refunded for the current period. Deferred income tax expense results from changes in deferred tax assets and liabilities between periods. These gross deferred tax assets and liabilities represent decreases or increases in taxes expected to be paid in the future because of future reversals of temporary differences in the bases of assets and liabilities, as measured by tax laws, and their bases, as reported in the Consolidated Financial Statements.

The Company also assesses the probability that the positions taken, or expected to be taken, in its income tax returns will be sustained by taxing authorities. A “more likely than not” (more than 50 percent) recognition threshold must be met before a tax benefit can be recognized. Tax positions that are more likely than not to be sustained are reflected in the Company’s Consolidated Financial Statements.

Total income tax expense is presented below:



	Year Ended December 31,
(in millions)	2017			2016			2015
Income tax expense		$260			$489			$423
Tax effect of changes in OCI	(7		)	(168		)	(12		)
Total comprehensive income tax expense		$253			$321			$411

Components of income tax expense are presented below:



(in millions)	Current		Deferred			Total
Year Ended December 31, 2017
U.S. federal		$376		($142	)		$234
State and local	20		6			26
Total		$396		($136	)		$260
Year Ended December 31, 2016
U.S. federal		$292		$159			$451
State and local	44		(6		)	38
Total		$336		$153			$489
Year Ended December 31, 2015
U.S. federal		$162		$225			$387
State and local	12		24			36
Total		$174		$249			$423

The effective income tax rate differed from the U.S. federal income tax rate of 35% in 2017, 2016 and 2015 as presented below:



	Year Ended December 31,
	2017					2016					2015
(in millions, except ratio data)	Amount			Rate		Amount			Rate		Amount			Rate
U.S. Federal income tax expense and tax rate		$669		35.0	%		$537		35.0	%		$442		35.0	%
Increase (decrease) resulting from:
2017 Tax Legislation	(331		)	(17.3	%)	—			—		—			—
State and local income taxes (net of federal benefit)	46			2.4		38			2.5		27			2.1
Bank-owned life insurance	(19		)	(1.0	)	(19		)	(1.2	)	(20		)	(1.6	)
Tax-exempt interest	(21		)	(1.1	)	(19		)	(1.3	)	(17		)	(1.3	)
Tax advantaged investments (including related credits)	(51		)	(2.7	)	(31		)	(2.0	)	(16		)	(1.2	)
Other tax credits	(3		)	(0.1	)	(14		)	(0.9	)	—			—
Adjustments for uncertain tax positions	(23		)	(1.2	)	—			—		—			—
Non-deductible expenses	—			—		—			—		8			0.6
Other	(7		)	(0.4	)	(3		)	(0.2	)	(1		)	(0.1	)
Total income tax expense and tax rate		$260		13.6	%		$489		31.9	%		$423		33.5	%

On December 22, 2017, President Trump signed the 2017 Tax Legislation which included a reduction in the corporate tax rate from 35% to 21%. For Citizens, this required a revaluation of the Company’s net deferred tax liability with a corresponding adjustment to current tax expense, and resulted in a $331 million net tax benefit. Included in this net tax benefit was $145 million of expense related to the revaluation of the Company’s deferred tax assets associated with unrealized losses in AOCI. FASB standards in-place at December 31, 2017 required the Company to revalue all deferred taxes, including those related to balances in AOCI, through current tax expense. As a result, the Company’s unrealized loss balance in AOCI was not revalued to reflect the new corporate tax rate. This impact, commonly referred to as the “stranded tax effect”, was taken under consideration by FASB in January 2018 to address concerns primarily raised by banking institutions, including distortion of net income and regulatory capital. In February 2018, to address the “stranded tax effect”, FASB issued ASU 2018-02, Income Statement-Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income, which provides entities the election to reclassify the difference between the new and old corporate tax rates resulting from the 2017 Tax Legislation between retained earnings and AOCI for fiscal years beginning after December 15, 2018, with early adoption permitted. The Company has retrospectively adopted ASU 2018-02, elected to reclassify $145 million between AOCI and retained earnings, including indirect impacts from the decreased federal tax effect on future state tax benefits, and reflected this reclassification in the Company’s 2017 Consolidated Financial Statements, included in this report.

The decrease in the effective tax rate from 2015 to 2016 is primarily attributable to the benefits of federal and state tax credits.

The effective income tax rate for the year ended December 31, 2015 reflected the adoption of ASU No. 2014-01, Accounting for Investments in Qualified Affordable Housing Projects. The application of this guidance, which began on January 1, 2015, resulted in the reclassification of the amortization of these investments to income tax expense from noninterest income. Additionally, the 2015 effective tax rate was affected by the impact of non-deductible permanent expense items incurred by the Company in 2015.

The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and liabilities are presented below:



	December 31,
(in millions)	2017			2016
Deferred tax assets:
Other comprehensive income		$271			$409
Allowance for credit losses	310			471
State net operating loss carryforwards	88			75
Accrued expenses not currently deductible	40			129
Investment and other tax credit carryforwards	65			52
Deferred income	—			22
Fair value adjustments	27			40
Other	—			6
Total deferred tax assets	801			1,204
Valuation allowance	(105		)	(107		)
Deferred tax assets, net of valuation allowance	696			1,097
Deferred tax liabilities:
Leasing transactions	525			881
Amortization of intangibles	352			522
Depreciation	182			234
Pension and other employee compensation plans	110			103
Partnerships	37			22
Deferred Income	27			—
MSRs	34			49
Total deferred tax liabilities	1,267			1,811
Net deferred tax liability		$571			$714

Certain 2016 balances in the table above were reclassified to better conform to the current year presentation. These adjustments included presenting the deferred tax liability attributable to partnerships separately which in 2016 was presented in the other deferred tax liability category offset by certain deferred tax assets.

Deferred tax assets are recognized for net operating loss carryforwards and tax credit carryforwards. Valuation allowances are recorded as necessary to reduce deferred tax assets to the amounts that management concludes are more likely than not to be realized.

At December 31, 2017, the Company had state tax net operating loss carryforwards of $1.4 billion. Limitations on the ability to realize these carryforwards are reflected in the associated valuation allowance.

At December 31, 2017, the Company had a valuation allowance of $105 million against various deferred tax assets related to state net operating losses and state tax credits, as it is management’s current assessment that it is more likely than not that the Company will not recognize a portion of the deferred tax asset related to these items. The valuation allowance decreased $2 million during the year ended December 31, 2017.

Effective with the fiscal year ended September 30, 1997, the reserve method for bad debts was no longer permitted for tax purposes. The repeal of the reserve method required the recapture of the reserve balance in excess of certain base year reserve amounts attributable to years ended prior to 1988. At December 31, 2017, the Company’s base year loan loss reserves attributable to years ended prior to 1988, for which no deferred income taxes have been provided, was $557 million. This base year reserve may become taxable if certain distributions are made with respect to the stock of the Company or if the Company ceases to qualify as a bank for tax purposes. No actions are planned that would cause this reserve to become wholly or partially taxable.

The Company files income tax returns in the U.S. federal jurisdiction and various state and local jurisdictions. With few exceptions, the Company is no longer subject to U.S. federal or state and local income tax examinations by major tax authorities for years before 2014.

A reconciliation of the beginning and ending amount of unrecognized tax benefits is presented below:



	December 31,
(in millions)	2017			2016			2015
Balance at the beginning of the year		$42			$62			$72
Gross decrease for tax positions related to prior years	(27		)	(19		)	(6		)
Gross increase for tax positions related to prior years	—			1			—
Decreases for tax positions as a result of the lapse of the statutes of limitations	(1		)	(2		)	(3		)
Decreases for tax positions related to settlements with taxing authorities	(9		)	—			(1		)
Balance at end of year		$5			$42			$62

Tax positions are measured as the largest amount of tax benefit that is greater than 50 percent likely of being realized upon settlement with a taxing authority that has full knowledge of all relevant information. The difference between the benefit recognized for a position and the tax benefit claimed on a tax return is referred to as an unrecognized tax benefit.

Included in the total amount of unrecognized tax benefits at December 31, 2017, are potential benefits of $5 million that, if recognized, would impact the effective tax rate.

The Company classifies interest and penalties related to unrecognized tax benefits as a component of income taxes. The Company released $8 million, accrued $8 million, and accrued less than $1 million of interest expense through December 31, 2017, 2016, and 2015, respectively. The Company had approximately $1 million, $22 million, and $14 million accrued for the payment of interest at December 31, 2017, 2016, and 2015, respectively. There were no amounts accrued for penalties as of December 31, 2017, 2016, and 2015, and there were no penalties recognized during 2017, 2016, and 2015.