INCOME TAXES

Citizens 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.

Citizens 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)	2018			2017			2016
Income tax expense		$462			$260			$489
Tax effect of changes in OCI	(96		)	(7		)	(168		)
Total comprehensive income tax expense		$366			$253			$321

Components of income tax expense are presented below:



(in millions)	Current		Deferred			Total
Year Ended December 31, 2018
U.S. federal		$271		$90			$361
State and local	94		7			101
Total		$365		$97			$462
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

The effective income tax rate differed from the U.S. federal income tax rate of 21% for the year ended December 31, 2018, and 35% for the years ended December 31, 2017 and 2016, as presented below:



	Year Ended December 31,
	2018					2017					2016
(in millions, except ratio data)	Amount			Rate		Amount			Rate		Amount			Rate
U.S. Federal income tax expense and tax rate		$459		21.0	%		$669		35.0	%		$537		35.0	%
Increase (decrease) resulting from:
Federal rate change	(34		)	(1.6	)	(331		)	(17.3	)	—			—
State and local income taxes (net of federal benefit)	89			4.1		46			2.4		38			2.5
Bank-owned life insurance	(12		)	(0.5	)	(19		)	(1.0	)	(19		)	(1.2	)
Tax-exempt interest	(15		)	(0.7	)	(21		)	(1.1	)	(19		)	(1.3	)
Tax advantaged investments (including related credits)	(44		)	(2.0	)	(51		)	(2.7	)	(31		)	(2.0	)
Other tax credits	(8		)	(0.4	)	(3		)	(0.1	)	(14		)	(0.9	)
Adjustments for uncertain tax positions	1			0.1		(23		)	(1.2	)	—			—
Non-deductible FDIC premiums	21			1.0		—			—		—			—
Other	5			0.2		(7		)	(0.4	)	(3		)	(0.2	)
Total income tax expense and tax rate		$462		21.2	%		$260		13.6	%		$489		31.9	%

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)	2018			2017
Deferred tax assets:
Other comprehensive income		$366			$271
Allowance for credit losses	308			310
State net operating loss carryforwards	90			88
Accrued expenses not currently deductible	36			40
Investment and other tax credit carryforwards	74			65
Fair value adjustments	28			27
Total deferred tax assets	902			801
Valuation allowance	(110		)	(105		)
Deferred tax assets, net of valuation allowance	792			696
Deferred tax liabilities:
Leasing transactions	527			525
Amortization of intangibles	364			352
Depreciation	195			182
Pension and other employee compensation plans	127			110
Partnerships	51			37
Deferred Income	50			27
MSRs	51			34
Total deferred tax liabilities	1,365			1,267
Net deferred tax liability		$573			$571

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, 2018, 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, 2018, the Company had a valuation allowance of $110 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 assets related to these items. The valuation allowance increased $5 million during the year ended December 31, 2018.

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, 2018, 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.

Citizens 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 2015.

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



	December 31,
(in millions)	2018		2017			2016
Balance at the beginning of the year		$5		$42			$62
Gross increase for tax positions related to current year	3		—			—
Gross decrease for tax positions related to prior years	—		(27		)	(19		)
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		)
Decreases for tax positions related to settlements with taxing authorities	—		(9		)	—
Balance at end of year		$8		$5			$42

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, 2018, are potential benefits of $6 million that, if recognized, would impact the effective tax rate.

Citizens classifies interest and penalties related to unrecognized tax benefits as a component of income taxes. There was no interest expense accrued as of December 31, 2018. The Company released $8 million and accrued $8 million of interest expense for the years ended December 31, 2017 and 2016, respectively. Citizens had approximately $2 million, $1 million, and $22 million accrued for the payment of interest at December 31, 2018, 2017, and 2016, respectively. There were no amounts accrued for penalties as of December 31, 2018, 2017, and 2016, and there were no penalties recognized during the years ended December 31, 2018, 2017, and 2016.