INCOME TAXES AND RELATED PAYMENTS

Oaktree is a publicly traded partnership and Oaktree Holdings, Inc. and Oaktree AIF Holdings, Inc., two of its Intermediate Holding Companies, are wholly-owned corporate subsidiaries. Income earned by these corporate subsidiaries is subject to U.S. federal and state income taxation and taxed at prevailing rates. Income earned by non-corporate subsidiaries is not subject to U.S. federal corporate income tax and is allocated to the Oaktree Operating Group’s unitholders. For periods prior to January 1, 2012, Oaktree incurred income tax expense despite reporting losses before income taxes for financial reporting purposes because the non-cash equity-based compensation expense related to the 2007 Private Offering, which caused the reported losses, was generally not deductible for income tax purposes. The final portion of the non-cash equity-based compensation expense associated with the 2007 Private Offering was charged against pre-tax income in the first quarter of 2012 and did not result in a loss before taxes for financial reporting purposes for the year ended December 31, 2012. The Company’s effective tax rate is dependent on many factors, including the estimated nature of many amounts and the mix of revenues and expenses between the two corporate subsidiaries that are subject to income tax and the three other subsidiaries that are not; consequently, the effective tax rate is subject to significant variation from period to period.

Income tax expense from operations consisted of the following:



	Year Ended December 31,
	2013		2012		2011
Current:
U.S. federal income tax	$	5,516	$	11,232	$	8,869
State and local income tax	5,148		3,737		4,786
Foreign income tax	3,195		3,351		3,588
	$	13,859	$	18,320	$	17,243
Deferred:
U.S. federal income tax	$	11,253	$	7,432	$	3,285
State and local income tax	1,120		5,106		560
	$	12,373	$	12,538	$	3,845
Total:
U.S. federal income tax	$	16,769	$	18,664	$	12,154
State and local income tax	6,268		8,843		5,346
Foreign income tax	3,195		3,351		3,588
Income tax expense	$	26,232	$	30,858	$	21,088

The Company’s income before income taxes consisted of the following:



	Year Ended December 31,
	2013		2012			2011
Domestic income (loss) before income taxes	$	6,233,758	$	6,710,286		$	(264,603	)
Foreign income (loss) before income taxes	3,206		(7,011		)	(22,954		)
Total income (loss) before income taxes	$	6,236,964	$	6,703,275		$	(287,557	)

The Company’s effective tax rate differed from the federal statutory rate for the following reasons:



	Year Ended December 31,
	2013		2012		2011
Income tax expense at federal statutory rate	35.00	%	35.00	%	35.00	%
Income passed through	(34.69	)	(34.78	)	(19.49	)
State and local taxes, net of federal benefit	0.09		0.07		(1.75	)
Foreign taxes	0.03		0.09		(4.04	)
Equity-based compensation expense	—		—		(17.44	)
Other, net	(0.01	)	0.08		0.39
Total effective rate	0.42	%	0.46	%	(7.33	)%

The income tax effect of temporary differences that give rise to significant portions of deferred tax assets and liabilities was as follows:



	As of December 31,
	2013		2012		2011
Deferred tax assets:
Investment in partnerships	$	277,039	$	157,999	$	67,918
Equity-based compensation expense	3,695		3,994		3,703
Other, net	1,822		1,697		1,365
Total deferred tax assets	282,556		163,690		72,986
Total deferred tax liabilities	3,671		4,519		4,548
Net deferred tax assets before valuation allowance	278,885		159,171		68,438
Valuation allowance	—		—		—
Net deferred tax assets	$	278,885	$	159,171	$	68,438

In assessing the realizability of deferred tax assets, the Company considers whether it is probable that some or all of the deferred tax assets will not be realized. In determining whether the deferred tax assets are realizable, the Company considers the period of expiration of the tax asset, historical and projected taxable income, and tax liabilities for the tax jurisdiction in which the tax asset is located. Although the Company had recorded pre-tax losses for financial reporting purposes in years prior to 2012, the entities that generate taxable income have generated (and are expected to generate in subsequent years) substantial book and tax basis pre-tax income. The deferred tax asset recognized by the Company, as it relates to the higher tax basis in the carrying value of certain assets compared to the book basis of those assets, will be recognized in future years by these taxable entities. Deferred tax assets are based on the amount of the asset that the Company’s management has determined is more likely than not to be realized in future periods. In determining the realizability of this asset, management has considered numerous factors which will give rise to pre-tax income in future periods. Among these are the historical and expected future book and tax basis pre-tax income of the Company and unrealized gains in the Company’s assets at the determination date. Based on these and other factors, the Company has determined that, as of December 31, 2013, all deferred tax assets are more likely than not to be realized in future periods.

The Company recognizes tax benefits related to its tax positions only where the position is “more likely than not” to be sustained in the event of examination by tax authorities. As part of its assessment, the Company analyzes its tax filing positions in all of the federal, state and foreign tax jurisdictions where it is required to file income tax returns, and for all open tax years in these jurisdictions. As of December 31, 2013, the total reserve balance including interest and penalties was $14.8 million.

The following is a reconciliation of unrecognized tax benefits (excluding interest and penalties thereon):



	Year Ended December 31,
	2013			2012		2011
Unrecognized tax benefits, January 1	$	9,472		$	8,594	$	7,955
Additions for tax positions related to the current year	1,633			72		822
Additions for tax positions related to prior years	1,029			806		—
Reductions for tax positions related to prior years	(806		)	—		—
Settlement of tax positions	—			—		—
Lapse of statute of limitations	(938		)	—		(183		)
Unrecognized tax benefits, December 31	$	10,390		$	9,472	$	8,594

The Company accrues potential interest and penalties related to uncertain tax positions as income tax expense in the consolidated statements of operations. The Company accrued $0.5 million, $1.4 million and $1.1 million in such expense for the years ended December 31, 2013, 2012 and 2011, respectively, resulting in reserves for potential interest and penalties of $4.4 million, $3.9 million and $2.5 million as of December 31, 2013, 2012 and 2011, respectively.

The Company files its tax returns as prescribed by the tax laws of the jurisdictions in which it operates. In the normal course of business, the Company is subject to examination by federal, state, local and foreign tax regulators. With limited exceptions, the Company is no longer subject to income tax audits by taxing authorities for the years before 2009. Although the outcome of tax audits is always uncertain, the Company does not believe the outcome of any current audit will have a material adverse effect on the Company’s consolidated cash flows, financial position or results of operations.

U.S. and non-U.S. taxing authorities are currently examining certain income tax returns of Oaktree, with certain of these examinations at an advanced stage. The Company believes that it is reasonably possible that one outcome of these current examinations, combined with other items, may be to reduce in the next 12 months approximately $8 million to $10 million of previously accrued Operating Group income taxes. The other items are related to years with expiring statutes of limitation. The Company believes that it has adequately provided for any reasonably foreseeable outcomes related to its tax examinations and that any settlements related thereto will not have a material adverse effect on the Company's financial position or results of operations. However, there can be no assurances as to the ultimate outcomes.

Tax Receivable Agreement

Subject to certain restrictions, each holder of OCGH units has the right to exchange his or her vested units for, at the option of the Company’s board of directors, Class A units, an equivalent amount of cash based on then-prevailing market prices, other consideration of equal value, or any combination of the foregoing. Certain of the Oaktree Operating Group entities made an election under Section 754 of the U.S. Internal Revenue Code, as amended (the “Code”), which may result in an adjustment to the tax basis of the assets owned by Oaktree Operating Group at the time of an exchange. These exchanges may result in increases in tax deductions and tax basis that would reduce the amount of tax that Oaktree Holdings, Inc. and Oaktree AIF Holdings, Inc. would otherwise be required to pay in the future.

Oaktree Holdings, Inc. and Oaktree AIF Holdings, Inc. have entered into a tax receivable agreement with OCGH unitholders that, as amended, provides for the payment to an exchanging or selling OCGH unitholder of 85.0% of the amount of cash savings, if any, in U.S. federal, state, local and foreign income taxes that they actually realize (or are deemed to realize in the case of an early termination payment by Oaktree Holdings, Inc. or Oaktree AIF Holdings, Inc., or a change of control) as a result of an increase in the tax basis of the assets owned by the Oaktree Operating Group.

The May 2007 Restructuring involved Oaktree's purchase of Oaktree Operating Group units from the OCGH unitholders, resulting in an increase in the tax basis of the assets owned by the Oaktree Operating Group. As a result, the Company recorded a deferred tax asset and an associated liability for payments to OCGH unitholders under the tax receivable agreement. These payments are expected to occur over the period ending approximately in 2029. The establishment of a deferred tax asset increased additional paid-in capital because the transaction was between Oaktree and its unitholders. As a result of a change in state tax law that reduced the combined federal and state tax rate applicable to income from Oaktree Holdings, Inc. from 41% to 38%, the deferred tax asset under the tax receivable agreement associated with the May 2007 Restructuring was reduced from $64.4 million to $56.6 million in the second quarter of 2012, consequently reducing the related tax receivable agreement liability payable to OCGH unitholders by $6.3 million. The $6.3 million reduction in the tax receivable agreement payable was reflected in other income (expense), net in the consolidated statements of operations. The tax receivable agreement liability was further reduced by $3.3 million and $3.4 million as a result of payments made under the tax receivable agreement in November 2012 and November 2013, respectively, resulting in a tax receivable agreement liability related to the 2007 Private Offering payable to OCGH unitholders of $43.8 million as of December 31, 2013.

The exchange of OCGH units in connection with the Company’s initial public offering in April 2012 increased the tax basis of the tangible and intangible assets of the Oaktree Operating Group. As a result of this increase in tax basis, the Company recorded a deferred tax asset of $103.3 million and an associated liability of $87.8 million for payments to OCGH unitholders under the tax receivable agreement, which had the effect of increasing capital by $15.5 million. These payments are expected to occur over the period ending approximately in 2034. Upon the filing of the tax returns for the year ended December 31, 2012 for Oaktree Holdings, Inc. and Oaktree AIF Holdings, Inc., the Company finalized its calculation of the increased tax basis of the tangible and intangible assets of the Oaktree Operating Group resulting from the April 2012 initial public offering. As a result, the Company recorded a reduction to the deferred tax asset of $2.3 million and an associated reduction in liability of $2.0 million for payments to OCGH unitholders under the tax receivable agreement, which had the effect of decreasing capital by $0.3 million. The tax receivable agreement liability was further reduced by $2.9 million as a result of payments made under the tax receivable agreement in November 2013, resulting in a tax receivable agreement liability related to the initial public offering in April 2012 payable to OCGH unitholders of $82.9 million as of December 31, 2013.

The exchange of OCGH units in connection with the May 2013 Offering resulted in increases in the tax basis of the tangible and intangible assets of the Oaktree Operating Group. As a result, the Company recorded a deferred tax asset of $134.4 million and an associated liability of $114.2 million for payments to OCGH unitholders under the tax receivable agreement, which together increased capital by $20.2 million. These payments are expected to occur over the period ending approximately in 2035.