KeyBank 2006 Annual Report Download - page 97

97
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS KEYCORP AND SUBSIDIARIES
transactions generate rental income, as well as deductions from the
depreciation of the property, interest expense on nonrecourse debt
incurred to fund the transaction, and transaction costs.
Prior to 2004, LILO, QTE and Service Contract Leases were prevalent
in the financial services industry and in certain other industries. The tax
treatment that Key applied was based on applicable statutes, regulations,
and judicial authority in effect at the time Key entered into these
transactions. Subsequently, the Internal Revenue Service (“IRS”) has
challenged the tax treatment of these transactions by a number of
bank holding companies and other corporations.
The IRS has completed audits of Key’s income tax returns for the 1995
through 2000 tax years and has disallowed all deductions taken in tax years
1995 through 1997 pertaining to LILOs, and all deductions in tax years
1998 through 2000 that relate to LILOs, QTEs and Service Contract
Leases. In addition, the IRS is currently conducting audits of Key’s income
tax returns for the 2001 through 2003 tax years, and Key expects that the
IRS will disallow all similar deductions taken by Key in those tax years.
Key appealed the examination results for the tax years 1995 through
1997, which pertained to LILOs only, to the Appeals Division of the IRS.
During the fourth quarter of 2005, discussions with the Appeals
Division were discontinued without a resolution. In April 2006, Key
received a final assessment from the IRS disallowing all LILO deductions
taken in those tax years. The assessment, which relates principally to the
1997 tax year, consists of federal tax, interest and a penalty. Key paid
the assessment and filed a refund claim for the total amount. Key has also
filed an appeal with the Appeals Division of the IRS with regard to the
proposed disallowance of LILO, QTE and Service Contract Lease
deductions taken in the 1998 through 2000 tax years.
The payment of the 1997 tax year assessment did not impact Key’s
earnings since the taxes had been included in previously recorded
deferred taxes as required under GAAP. The payment of the interest and
penalty did not materially impact Key’s earnings, in part due to Key’s tax
reserves, and also because Key is recording a receivable on its balance
sheet for amounts that are not charged to Key’s tax reserve.
Management believes that these LILO, QTE and Service Contract
Lease transactions were entered into in conformity with the tax laws in
effect at the time, and Key intends to vigorously pursue the IRS appeals
process and litigation alternatives. Key cannot currently estimate the
financial outcome of this dispute, but if Key does not prevail or enters
into a settlement agreement with the IRS, Key would owe interest and
possibly penalties, which could be material in amount, in addition to
previously accrued tax amounts. Such an outcome would not have a
material effect on Key’s financial condition, but could have a material
adverse effect on Key’s results of operations in the period it occurs.
TAX-RELATED ACCOUNTING
PRONOUNCEMENTS PENDING ADOPTION
In July 2006, the FASB issued Staff Position No. 13-2, “Accounting for
a Change or Projected Change in the Timing of Cash Flows Relating to
Income Taxes Generated by a Leveraged Lease Transaction,” which
provides additional guidance on the application of SFAS No. 13,
“Accounting for Leases.” This guidance will affect when earnings from
leveraged lease transactions may be recognized when there are changes
or projected changes in the timing of cash flows, including changes due
to or expected to be due to settlements of tax matters. Previously,
leveraged lease transactions were required to be recalculated only when
a change in the total cash flows occurred. This guidance will be effective
for fiscal years beginning after December 15, 2006 (effective January 1,
2007, for Key). Management has concluded that adoption of this
guidance will result in a cumulative after-tax charge of approximately
$52 million to Key’s retained earnings. However, future earnings are
expected to increase over the remaining term of the affected leases by a
similar amount.
In July 2006, the FASB also issued Interpretation No. 48, “Accounting
for Uncertainty in Income Taxes,” which clarifies the application of
SFAS No. 109, “Accounting for Income Taxes,” by defining the minimum
threshold that a tax position must meet before any associated benefit may
be recognized in a company’s financial statements. In accordance with this
guidance, a company may recognize a benefit if management concludes
that the tax position, based solely on its technical merits, is “more
likely than not” to be sustained upon examination. If such a conclusion
is reached, the tax benefit is to be measured as the largest amount of
benefit that is greater than 50% likely to be realized upon ultimate
settlement. This interpretation also provides guidance on measurement
and derecognition of tax benefits, and requires expanded disclosures. The
interpretation will be effective for fiscal years beginning after December
15, 2006 (effective January 1, 2007, for Key). Management has concluded
that the adoption of this guidance will not have a material impact on Key’s
financial condition or results of operations.
OBLIGATIONS UNDER NONCANCELABLE LEASES
Key is obligated under various noncancelable operating leases for land,
buildings and other property consisting principally of data processing
equipment. Rental expense under all operating leases totaled $136
million in 2006 and 2005 and $138 million in 2004. Minimum future
rental payments under noncancelable operating leases at December
31, 2006, are as follows: 2007 — $123 million; 2008 — $112 million;
2009 — $96 million; 2010 — $82 million; 2011 — $65 million; all
subsequent years — $256 million.
COMMITMENTS TO EXTEND CREDIT OR FUNDING
Loan commitments provide for financing on predetermined terms as long
as the client continues to meet specified criteria. These agreements
generally carry variable rates of interest and have fixed expiration dates
or termination clauses. Generally, a client must pay a fee to obtain a loan
commitment from Key. Since a commitment may expire without resulting
in a loan, the total amount of outstanding commitments may significantly
exceed Key’s eventual cash outlay.
18. COMMITMENTS, CONTINGENT LIABILITIES AND GUARANTEES
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