NOTE 8. INCOME TAXES

A reconciliation of the federal statutory income tax rate to each company’s effective income tax rate follows:


	UNS Energy									TEP
	Years Ended December 31,
	2012			2011			2010			2012			2011			2010
	-Millions of Dollars-
Federal Income Tax Expense at Statutory Rate	$	51		$	62		$	66		$	37		$	48		$	58
State Income Tax Expense, Net of Federal Benefit		7			8			9			5			6			8
Deferred Tax Asset Valuation Allowance		—			—			8			—			—			—
Deferred Tax Asset Write-off Related to Unregulated Investment		—			—			3			—			—			—
AFUDC Equity		(1	)		(1	)		(1	)		(1	)		(1	)		(1	)
Domestic Production Deduction		—			—			(3	)		—			—			(3	)
Federal/State Tax Credits		(1	)		(3	)		(2	)		(1	)		(2	)		(2	)
Other		—			1			(3	)		(1	)		1			—

Total Federal and State Income Tax Expense	$	56		$	67		$	77		$	39		$	52		$	60

Effective Tax Rate		38	%		38	%		41	%		37	%		38	%		36	%

In 2010, UNS Energy recorded a $3 million out-of-period income tax expense. The out-of-period expense related to the write-off of a previously recorded deferred tax asset associated with the excess of tax over book basis difference in a consolidated unregulated investment. Management concluded that this out-of-period adjustment was not material to current and prior period financial statements.

Income tax expense included in the income statements consists of the following:

	UNS Energy									TEP
	Years Ended December 31,
	2012			2011			2010			2012			2011			2010
	-Millions of Dollars-
Current Tax Expense (Benefit)
Federal	$	(2	)	$	(7	)	$	34		$	(4	)	$	(5	)	$	28
State		(2	)		(2	)		7			(2	)		(2	)		7

Total		(4	)		(9	)		41			(6	)		(7	)		35

Deferred Tax Expense (Benefit)
Federal		51			64			32			38			50			24
Federal Investment Tax Credits		—			(1	)		(1	)		—			(1	)		(1	)
State		9			13			5			7			10			2

Total		60			76			36			45			59			25

Total Federal and State Income Tax Expense	$	56		$	67		$	77		$	39		$	52		$	60

The significant components of deferred income tax assets and liabilities consist of the following:


	UNS Energy						TEP
	December 31,						December 31,
	2012			2011			2012			2011
	-Millions of Dollars-
Gross Deferred Income Tax Assets
Capital Lease Obligations	$	141		$	169		$	141		$	169
Net Operating Loss Carryforwards		72			81			85			76
Customer Advances and Contributions in Aid of Construction		34			30			19			17
Alternative Minimum Tax Credit		43			43			24			25
Accrued Postretirement Benefits		23			23			23			23
Renewable Energy Credit Up-Front Incentive Payments		26			22			20			18
Emission Allowance Inventory		10			10			10			10
Unregulated Investment Losses		9			9			—			—
Other		44			34			43			29

Gross Deferred Income Tax Assets		402			421			365			367

Deferred Tax Assets Valuation Allowance		(7	)		(7	)		—			—

Gross Deferred Income Tax Liabilities
Plant – Net		(648	)		(585	)		(571	)		(516	)
Capital Lease Assets – Net		(34	)		(41	)		(34	)		(41	)
Pensions		(23	)		(17	)		(24	)		(18	)
PPFAC		(6	)		(19	)		(3	)		(16	)
Other		(15	)		(29	)		(15	)		(17	)

Gross Deferred Income Tax Liabilities		(726	)		(691	)		(647	)		(608	)

Net Deferred Income Tax Liabilities	$	(331	)	$	(277	)	$	(282	)	$	(241	)

The net deferred income tax liability on the balance sheet is as follows:


	UNS Energy						TEP
	December 31,						December 31,
	2012			2011			2012			2011
	-Millions of Dollars-
Deferred Income Taxes – Current Assets	$	34		$	23		$	37		$	22
Deferred Income Taxes – Noncurrent Liabilities		(365	)		(300	)		(319	)		(263	)

Net Deferred Income Tax Liability	$	(331	)	$	(277	)	$	(282	)	$	(241	)

The $9 million unregulated investment loss deferred tax asset includes $7 million of capital loss at December 31, 2012, and December 31, 2011. The deferred tax asset can only be used if the company has capital gains to offset the losses. Management believes that it is more likely than not that the company will not be able to generate future capital gains. As a result, UNS Energy recorded a $7 million valuation allowance against the deferred tax asset as of December 31, 2012, and December 31, 2011. Management believes that based on its historical pattern of taxable income, UNS Energy will produce sufficient income in the future to realize all other deferred income tax assets.

Income Tax Position

As of December 31, 2012, UNS Energy and TEP had the following carryforward amounts:


	UNS Energy			TEP
	Amount		Expiring Year	Amount		Expiring Year
	-Amounts in Millions of Dollars-
Capital Loss	$	8	2015	$	—	—
Federal Net Operating Loss		202	2031-32		233	2031-32
State Net Operating Loss		14	2032		57	2016-32
State Credits		2	2016-17		4	2016-17
AMT Credit		43	None		24	None

State Tax Rate Change

In the first quarter of 2011, the Arizona legislature passed a bill reducing the corporate income tax rate from the current rate of 6.968%. The tax rate reduction will be phased in beginning in 2014, with a reduction of approximately 0.5% per year until the income tax rate reaches 4.9% for 2017 and later years. As a result of these tax rate reductions, we reduced the net deferred tax liabilities at UNS Energy and TEP by $13 million, offset entirely by adjustments to regulatory assets and liabilities. The income tax rate change did not have an impact on UNS Energy’s and TEP’s effective tax rate for 2012 or 2011.

Excess Tax Benefit Realized from Share-Based Compensation Plans

UNS Energy records excess tax benefits as an increase to Common Stock when tax deductions for share-based compensation exceed the expense recorded in the financial statements and they result in a reduction to income taxes payable. As of December 31, 2012, UNS Energy had $2 million of excess tax benefits that were not recorded in Common Stock. The excess benefits will be recorded in Common Stock when the Federal net operating loss carryforwards of $202 million are used.

Uncertain Tax Positions

In accordance with accounting rules related to uncertain tax positions, we are required to determine whether it is more likely than not that we will sustain an income tax position under examination. Each income tax position is measured to determine the amount of benefit to recognize in the financial statements. The following table shows the changes in unrecognized tax benefits of UNS Energy and TEP:


	UNS Energy						TEP
	December 31,						December 31,
	2012			2011			2012			2011
	-Millions of Dollars-
Unrecognized Tax Benefits, Beginning of Year	$	29		$	41		$	24		$	35
Additions Based on Tax Positions Taken in the Current Year		5			9			3			8
Reductions Based on Settlements with Tax Authorities		(4	)		(22	)		(4	)		(19	)
Additions Based on Tax Positions Taken in the Prior Year		—			1			—			—

Unrecognized Tax Benefits, End of Year	$	30		$	29		$	23		$	24

Unrecognized tax benefits of $1 million, if recognized, would reduce the effective tax rate at December 31, 2012, and December 31, 2011, for both UNS Energy and TEP. The balance in unrecognized tax benefits could change in the next 12 months as a result of ongoing IRS audits, but we are unable to determine the amount of the change.

UNS Energy and TEP recognize interest accrued related to unrecognized tax benefits in Other Interest Expense in the income statements. UNS Energy and TEP did not recognize a reduction to interest expense in 2012. A reduction to Other Interest Expense of $1 million was recorded in 2011. The balance of interest payable for UNS Energy and TEP was $1 million at both December 31, 2012 and December 31, 2011. We have no penalties accrued in the years presented.

UNS Energy and TEP have been audited by the IRS through tax year 2008 and are currently under audit by the IRS for 2009 and 2010. We are unable to determine when the audits will be completed. UNS Energy and TEP are not currently under audit by any state tax agencies.