Citigroup's past losses may have helped it win Costco business

By David Henry

NEW YORK (Reuters) - Citigroup Inc had at least one advantage in its successful bid for the exclusive right to issue credit cards for Costco Wholesale Corp, rivals and tax specialists say: it lost so much money during the financial crisis that it has billions of dollars of tax credits.

Citigroup and Costco have not disclosed terms of the deal, and outsiders can only speculate about the reasons Citigroup bid aggressively enough to win the business.

But officials at two rival banks said they suspect Citigroup's tax credits allowed it to offer Costco better terms than competitors could. They declined to be identified because the negotiations were confidential.

At the end of last year, Citigroup had $49.5 billion in net tax credits, known as "deferred tax assets." They are a boon to the bank because they can reduce - or even eliminate - its federal income tax liability. Other banks could pay as much as 35 percent of their U.S. income in federal tax, though many also use tax-reduction strategies that push their rates lower.

American Express said last month that it would not renew its deal with Costco because the retailer was demanding terms that were not economic, an indication that the profit margins for anyone taking on the business were likely to be razor thin.

"The deferred tax assets would be quite a dramatic advantage," said Robert Willens, an independent accounting and taxation consultant. Citigroup, he said, may well have won the deal by being able to offer far better terms to Costco than banks that pay more in taxes.

Citigroup responded to questions about its tax advantage in the deal with a written statement: "As the world's largest issuer of consumer credit cards, Citi has unrivaled scale, expertise and capabilities in servicing our partnerships with industry leaders. Costco brings the opportunity for consumer spending growth - when you add Costco's customer loyalty with increased Visa acceptance, it is a win for all parties."

It declined to comment on whether its tax credits helped in winning the business.

In 2014, Citigroup used about $3 billion of deferred tax assets to reduce tax liability.

To competitors, the bank's tax credits are an irritant. A big chunk of the bank's deferred tax assets stem from the billions of dollars of losses it generated during the financial crisis. Citigroup was rescued three times by the U.S. government between 2008 and 2009, and one of the rescues threatened to wipe out some of the bank's deferred tax assets. However, the Treasury and the Internal Revenue Service - which were concerned about the stability of the banking system - relaxed the rules governing such assets to help Citigroup and other banks during the crisis.

The government's tax rules were relaxed again for Citigroup when the United States looked to sell its roughly one-third stake of the company after the crisis, Willens said.

In both cases, the bank came close to triggering a 1986 tax rule designed to prevent healthy corporations from avoiding taxes by buying weak companies with large deferred tax assets.

"In an odd kind of way, the U.S. government essentially put Citigroup in a more competitive position" to bid for business like the Costco deal, said Charles Peabody, a veteran bank analyst at Portales Partners, a broker focused on research.

The Costco transaction is not without risks for Citigroup, especially in the event of an economic downturn that would cause more cardholders to default on payments. But such deals typically last for five to seven years, so Citigroup will have an out down the road.

Citigroup could continue to benefit from its deferred tax assets in bidding for assets in the future, Willens said, and the bank has done so in the past. In 2013, the bank bought a portfolio of about $7 billion of credit card loans to customers of Best Buy Inc.

Banks, like all U.S. companies, keep two sets of books, one for financial markets and a second for the Internal Revenue Service. Many of the losses on loans and securities that Citigroup recognized during the financial crisis were reported on the bank's books for investors, but cannot be reported for tax purposes until the loss actually happens. When the loss happens and the bank has enough taxable income, Citigroup gets a tax credit, but until then, the bank keeps a deferred tax asset on its books, to recognize the future benefit.

The bank's $50 billion of tax credits expire over several decades starting in 2017.

Based on how credit card deals are typically negotiated, Citigroup would have factored a number of considerations into its bid for the Costco portfolio: how generous to make rewards programs for the store's customers, how much of a break it would give the retailer on transaction processing costs and how much revenue it would share with the company from fees for processing transactions when Costco cardholders use their cards outside of the store.

Banks have been competing intensely for the right to issue cards with retailers, airlines and hotel companies. [ID:nL1N0VN1XK] In the next year or so American Airlines is expected to review its current deal with Citigroup, which issues cards carrying both the bank and the airline's brand.

(Reporting by David Henry in New York; Editing by Dan Wilchins, Martin Howell and Sue Horton)