Two Harbors Investment Corp. Annual report pursuant to Section 13 and 15(d)

Annual report pursuant to Section 13 and 15(d)

Income Taxes (Notes)

Income Taxes (Notes)

12 Months Ended

Dec. 31, 2015

For the years ended December 31, 2015, 2014 and 2013, the Company qualified to be taxed as a REIT under the Code for U.S. federal income tax purposes. As long as the Company qualifies as a REIT, the Company generally will not be subject to U.S. federal income taxes on its taxable income to the extent it annually distributes its net taxable income to stockholders and does not engage in prohibited transactions. The Company intends to distribute 100% of its REIT taxable income and comply with all requirements to continue to qualify as a REIT. The majority of states also recognize the Company’s REIT status. The Company’s TRSs file separate tax returns and are fully taxed as standalone U.S. C-Corporations. The tables below reflect the net taxes accrued at the TRS level and the tax attributes included in the consolidated financial statements. It is assumed that the Company will retain its REIT status and will incur no REIT level taxation as it intends to comply with the REIT regulations and annual distribution requirements.

Certain activities the Company performs may produce income that will not be qualifying income for REIT purposes. These activities include the designated portion of MSR treated as normal mortgage servicing, swaptions, credit default swaps, TBAs and other risk-management instruments. The Company has designated its TRSs to engage in these activities. The Company also purchases and sells mortgage loans through the secondary whole loan market and/or securitization market and has designated its TRSs to engage in these activities.

The following table summarizes the tax (benefit) provision recorded at the taxable subsidiary level for the years ended December 31, 2015, 2014 and 2013:



	Year Ended
	December 31,
(in thousands)	2015			2014			2013
Current tax (benefit) provision:
Federal	$	(4,027	)	$	6,507		$	808
State	175			16			5
Total current tax (benefit) provision	(3,852		)	6,523			813
Deferred tax (benefit) provision	(12,638		)	(80,261		)	83,598
Total (benefit from) provision for income taxes	$	(16,490	)	$	(73,738	)	$	84,411

The Company’s taxable income before dividend distributions differs from its pre-tax net income for U.S. GAAP purposes primarily due to unrealized gains and losses, the recognition of credit losses for U.S. GAAP purposes but not tax purposes, differences in timing of income recognition due to market discount, and original issue discount and the calculations surrounding each. These book to tax differences in the REIT are not reflected in the financial statements as the Company intends to retain its REIT status.

The following is a reconciliation of the statutory federal and state rates to the effective rates, for the years ended December 31, 2015, 2014 and 2013:



	Year Ended
	December 31,
	2015					2014					2013
(dollars in thousands)	Amount			Percent		Amount			Percent		Amount			Percent
Computed income tax expense at federal rate	$	166,502		35	%	$	32,691		35	%	$	225,573		34	%
State taxes, net of federal benefit, if applicable	114			—	%	10			—	%	4			—	%
Permanent differences in taxable income from GAAP net income	4,203			1	%	1,636			2	%	17,681			3	%
Dividends paid deduction	(187,309		)	(39	)%	(108,075		)	(116	)%	(158,847		)	(24	)%
(Benefit from) provision for income taxes/ Effective Tax Rate⁽¹⁾	$	(16,490	)	(3	)%	$	(73,738	)	(79	)%	$	84,411		13	%

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(1)	The (benefit from) provision for income taxes is recorded at the taxable subsidiary level.

The Company’s permanent differences in taxable income from GAAP net income in the year ended December 31, 2015 were primarily due to net losses incurred by consolidated securitization trusts that are not subject to federal taxes. The Company’s permanent differences in taxable income from GAAP net income in the year ended December 31, 2014 were due primarily to the statutory federal rate change from 34% to 35% and corresponding adjustment to the measurement of beginning deferred tax assets and liabilities. The Company’s permanent differences in taxable income from GAAP net income in the year ended December 31, 2013 were due primarily to dividends received by the REIT from the TRSs.

The Company’s consolidated balance sheets, as of December 31, 2015 and December 31, 2014, contain the following current and deferred tax liabilities and assets, which are included in other liabilities and other assets, respectively, and are recorded at the taxable subsidiary level:



(in thousands)	December 31, 2015			December 31, 2014
Income taxes receivable (payable)
Federal income taxes receivable (payable)	$	5,216		$	(1,375	)
State and local income taxes receivable (payable)	—			—
Income taxes receivable (payable), net	5,216			(1,375		)
Deferred tax assets (liabilities)
Deferred tax asset	69,441			60,575			⁽¹⁾
Deferred tax liability	(25,123		)	(19,728		)
Total net deferred tax assets	44,318			40,847
Total tax assets, net	$	49,534		$	39,472

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(1)	Net of valuation allowance of $0.1 million.

Deferred Tax Assets and Liabilities

Deferred income taxes reflect the net tax effect of temporary differences between the carrying amount of assets and liabilities for financial reporting and tax purposes at the TRS level. Components of the Company’s deferred tax assets as of December 31, 2015 and December 31, 2014 are as follows:



(in thousands)	December 31, 2015			December 31, 2014
Available-for-sale securities	$	(8,673	)	$	—
Trading securities	—			(478		)
Mortgage servicing rights	6,363			4,494
Derivative assets and liabilities	(4,492		)	5,978
Other assets	3			16
Other liabilities	978			859
Intangibles	256			277
Alternative minimum tax credit	420			98
Net operating loss carryforward	8,177			9,448
Capital loss carryforward	41,286			20,155
Total net deferred tax assets	$	44,318		$	40,847

At December 31, 2015, the Company had not recorded a valuation allowance for any portion of its deferred tax assets as it did not believe, at a more likely than not level, that any portion of its deferred tax assets would not be realized. At December 31, 2014, a $0.1 million valuation allowance was established because the Company determined that it was more likely than not that the associated deferred tax asset would not be realized. Of the TRS net operating loss carryforward of $8.2 million, $1.3 million is scheduled to expire December 31, 2033, $2.5 million is scheduled to expire December 31, 2034 and $4.4 million is scheduled to expire December 31, 2035. Of the TRS net capital loss carryforward of $41.3 million, $0.1 million is scheduled to expire December 31, 2017, $20.1 million is scheduled to expire December 31, 2019 and $21.1 million is scheduled to expire December 31, 2020. The Company estimates, based on existence of sufficient evidence, the ability to realize the remainder of its deferred tax assets. Any adjustments to such estimates will be made in the period such determination is made.

Based on the Company’s evaluation, it has been concluded that there are no significant uncertain tax positions requiring recognition in the Company’s consolidated financial statements of a contingent tax liability for uncertain tax positions. Additionally, there were no amounts accrued for penalties or interest as of or during the periods presented in these consolidated financial statements.