In 2010 and 2011, depending on maturities, ratings and call features, bank investment portfolio managers could purchase tax exempt municipal bonds with a stated interest rate that varied between 5.5 percent and 6.5 percent. That stated rate exceeded the rate of similar taxable securities. Due to the economic conditions of the day, many banks loaded their portfolios with tax exempt municipal bonds. As it turned out, tax exempt did not mean totally devoid of tax due to a nasty provision called the alternative minimum tax (aka the stealth tax).
Most bank tax returns are calculated under two taxation methods, the regular method and the alternative minimum tax method. Whichever method yields the larger tax is the one used to determine the amount you send to the government. The AMT is an extremely convoluted system.
The calculation for AMT begins with regular taxable income. There are 15 initial adjustments to that number most of which are of little significance to the banking world. There are adjustments for certain depreciation, intangible drilling costs and other preference items. But there is a final adjustment to regular taxable income that definitely affects the bank tax return.
Adjusted Current Earnings Adjustment
There is an adjustment called the Adjusted Current Earnings (ACE) adjustment. The ACE adjustment measures the difference between book income and taxable income and either adds or subtracts 75 percent of the difference to alternative minimum taxable income. This is where we tie everything back to tax exempt income. Due to the large amount of tax exempt income dictated by market conditions of this period, many banks had little or no regular taxable income. However, since you had to add back 75 percent of the difference in book and taxable income, AMT income was basically increased by 75 percent of your tax exempt income. The AMT rate being 20 percent, the result is that many banks had to pay 20 percent of 75 percent of their otherwise tax‐exempt income.
This is not the end of the story. Remember earlier that we said the ACE adjustment could either be added or subtracted from alternative minimum taxable income? What would happen if the bank sold the tax exempt securities and had no tax exempt income? The difference between book and alternative minimum taxable income can reverse itself thereby creating an alternative minimum tax credit. Thus, theoretically, the bank could eventually recover the AMT paid in prior years.
We still are not to the end of the story. We haven’t discussed how to account for all of this activity. Generally Accepted Accounting Principles (GAAP) dictate that the tax created or saved from a temporary timing difference will generate a deferred tax asset or a deferred tax liability. In the case of paying AMT generated by the ACE adjustment, the bank would normally create a deferred tax asset rather than an expense. Be advised that regulators will not recognize a deferred tax asset unless that deferred tax asset will be realized by the bank within one year. For capital purposes regulators have priority over GAAP.
Does this mean that banks should not have purchased tax exempt bonds during that period or that they should sell the tax exempts they now own? Absolutely not. It simply means that you have to consider the fact that you may have a temporary 15 percent tax rate on the income from the securities. Most of the AMT tax was paid due to the large drop in earnings of many banks. As earnings continue to improve, the negative effects of the alternative minimum tax should lessen and in fact, turn into a tax advantage. Based upon current market conditions, tax exempts still can be an integral part of any investment portfolio.