Income Taxes

The components of CERC’s income tax expense were as follows:



	Year Ended December 31,
	2009			2010			2011
	(in millions)
Current income tax expense (benefit):
Federal	$	(107	)	$	(38	)	$	34
State	6			17			9
Total current expense (benefit)	(101		)	(21		)	43
Deferred income tax expense (benefit):
Federal	226			234			140
State	21			(26		)	4
Total deferred expense	247			208			144
Total income tax expense	$	146		$	187		$	187

A reconciliation of the expected federal income tax expense using the federal statutory income tax rate to the actual income tax expense and resulting effective income tax rate is as follows:



	Year Ended December 31,
	2009			2010			2011
	(in millions)
Income before income taxes	$	376		$	487		$	503
Federal statutory income tax rate	35		%	35		%	35		%
Expected federal income tax expense	132			170			176
Increase (decrease) in tax expense resulting from:
State income tax expense (benefit), net of federal income tax	18			(6		)	9
Increase (decrease) in settled and uncertain income tax positions	(1		)	5			1
Tax law change in deductibility of retiree health care costs	—			18			—
Other, net	(3		)	—			1
Total	14			17			11
Total income tax expense	$	146		$	187		$	187
Effective tax rate	38.8		%	38.4		%	37.2		%

CERC recorded a net reduction in state income tax expense of approximately $20 million related to lower blended state tax rates and a reduction of the deferred tax liability recorded in December 2011.

CERC recorded a non-cash, $19 million increase to income tax expense in 2010 as a result of a change in tax law upon the enactment in March 2010 of the Patient Protection and Affordable Care Act and the related Health Care and Education Reconciliation Act of 2010. The change in tax law, which becomes effective for tax years beginning after December 31, 2012, eliminates the tax deductibility of the portion of retiree health care costs that are reimbursed by Medicare Part D subsidies. Based upon the actuarially determined net present value of lost future retiree health care deductions related to the subsidies, CERC reduced its deferred tax asset by approximately $22 million in March 2010. The portion of the reduction that CERC believes will be recovered through the regulatory process, or approximately $2 million, was recorded as an adjustment to regulatory assets. The regulatory assets were also increased in March 2010 by approximately $1 million related to the recovery of CERC’s income taxes. The remaining $19 million of the reduction in CERC’s deferred tax asset was recorded as a charge to income tax expense in the first quarter of 2010.

In December 2010, certain subsidiaries of CERC were restructured in order to achieve a more tax-efficient reporting structure. As a result of the restructuring, CERC recorded a net reduction in income tax expense of approximately $24 million related to the remeasurement of accumulated deferred income taxes. The net reduction in income tax expense is comprised of a decrease in state income tax expense, net of federal income tax, totaling approximately $29 million and an increase in income tax expense of approximately $5 million related to uncertain income tax positions.

The state income tax expense of $18 million for 2009 included a benefit of approximately $8 million, net of federal income tax, related to adjustments in prior years’ state estimates.

The tax effects of temporary differences that give rise to significant portions of deferred tax assets and liabilities were as follows:



	December 31,
	2010			2011
	(in millions)
Deferred tax assets:
Current:
Allowance for doubtful accounts	$	10		$	9
Deferred gas costs	33			—
Other	5			(1		)
Total current deferred tax assets	48			8
Non-current:
Employee benefits	55			57
Loss and credit carryforwards	19			238
Other	30			60
Total non-current deferred tax assets before valuation allowance	104			355
Valuation allowance	(3		)	(3		)
Total non-current deferred tax assets, net of valuation allowance	101			352
Total deferred tax assets, net of valuation allowance	149			360
Deferred tax liabilities:
Non-current:
Depreciation	$	1,397		$	1,696
Regulatory assets, net	14			17
Other	9			59
Total non-current deferred tax liabilities	1,420			1,772
Accumulated deferred income taxes, net	$	1,271		$	1,412

CERC is included in the consolidated income tax returns of CenterPoint Energy. CERC calculates its income tax provision on a separate return basis under a tax sharing agreement with CenterPoint Energy.

Tax Attribute Carryforwards and Valuation Allowance. At December 31, 2011, CERC has approximately $614 million of federal net operating loss carryforwards which begin to expire in 2030 and $349 million of state net operating loss carryforwards which expire in various years between 2012 and 2031. CERC has approximately $244 million of state capital loss carryforwards which expire in 2017 for which a valuation allowance has been established. CERC has established a valuation allowance of $3 million for state net operating loss carryforwards and state capital loss carryforwards.

Uncertain Income Tax Positions. The following table reconciles the beginning and ending balance of CERC’s unrecognized tax benefits:



	December 31,
	2009			2010			2011
	(in millions)
Balance, beginning of year	$	(12	)	$	6		$	11
Tax Positions related to prior years:
Additions	18			—			(1		)
Reductions	—			(2		)	(3		)
Tax Positions related to current year:
Additions	2			7			1
Settlements	(2		)	—			—
Balance, end of year	$	6		$	11		$	8

The net increase in the total amount of unrecognized tax benefits during 2010 is primarily related to the remeasurement of accumulated deferred income taxes associated with the restructuring of certain subsidiaries of CERC.

CERC had no unrecognized tax benefits that, if recognized, would reduce the effective income tax rate for 2009. CERC had approximately $5 million and $6 million of unrecognized tax benefits that, if recognized, would reduce the effective income tax rate for 2010 and 2011, respectively. CERC recognizes interest and penalties as a component of income tax expense. CERC recognized approximately $1 million of interest benefit, $0.4 million of interest expense and $0.4 million of interest expense on uncertain income tax positions during 2009, 2010 and 2011, respectively. CERC accrued $4.5 million and $4.1 million of interest receivable on uncertain income tax positions at December 31, 2010 and 2011, respectively.

It is reasonably possible over the next 12 months that the total amount of unrecognized tax benefits could decrease by as much as $1 million or increase by as much as $17 million primarily as a result of the acceptance by the Internal Revenue Service (IRS) of a refund claim related to the timing of a deduction for debt issuance costs.

Tax Audits and Settlements. CenterPoint Energy’s consolidated federal income tax returns have been audited and settled through the 2005 tax year. CenterPoint Energy has a tentative closing agreement for tax years 2006 and 2007 with the IRS's Appeals Division pending review by the Joint Committee on Taxation. CenterPoint Energy is currently under examination by the IRS for tax years 2008 and 2009 and is at various stages of the examination process. CERC has considered the effects of these examinations in its accrual for settled issues and liability for uncertain income tax positions as of December 31, 2011.