NOTE 15. INCOME TAXES

We file a federal consolidated income tax return with our eligible subsidiaries. Our federal consolidated income tax return also includes the taxable results of certain grantor trusts described below. The components of income tax expense were as follows (in millions):



	For the Years Ended December 31,
	2012		2011			2010
Current:
Federal	$	4	$	(12	)	$	(11	)
State	8		6			13
Foreign	3		4			2
Total current	15		(2		)	4
Deferred:
Federal	11		22			38
State	—		8			(17		)
Foreign	—		—			(1		)
Total deferred	11		30			20
Total income tax expense	$	26	$	28		$	24

Domestic and foreign pre-tax income was as follows (in millions):



	For the Years Ended December 31,
	2012			2011			2010
Domestic	$	141		$	121		$	89
Foreign	(7		)	(14		)	(32		)
Total	$	134		$	107		$	57

The effective income tax rate was 19.3%, 26.8%, and 41.1% for the years ended December 31, 2012, 2011, and 2010 respectively. The decrease in the effective tax rate for the year ended December 31, 2012, compared to the year ended December 31, 2011, was primarily due to the impact in 2012 of the net gain on the settlement of the pre-existing lease, not recognized for tax, resulting from the Delaware Valley EfW acquisition. For additional information, see Note 3. Business Development and Acquisitions. The decrease in the effective tax rate for the year ended December 31, 2011, compared to the year ended December 31, 2010, was primarily a result of the release of the liability for uncertain tax positions related to the lapse of the statute of limitations with respect to tax issues arising at the time Covanta Energy emerged from bankruptcy.

A reconciliation of our income tax expense at the federal statutory income tax rate of 35% to income tax expense at the effective tax rate is as follows (in millions):



	For the Years Ended December 31,
	2012			2011			2010
Income tax expense at the federal statutory rate	$	47		$	37		$	20
State and other tax expense	8			8			(2		)
Change in valuation allowance	—			(3		)	(2		)
Grantor trust income (loss)	1			1			(2		)
Subpart F income and foreign dividends	1			1			1
Tax impact of Dublin impairment	—			—			8
Tax rate differential on foreign earnings	5			9			4
Production tax credits/R&E tax credits	(5		)	(5		)	(5		)
Liability for uncertain tax positions	3			(22		)	(2		)
Stock-based compensation	—			—			4
Non-deductible expense incurred to pre-petition claimants from Covanta Energy’s bankruptcy	—			5			—
Below market lease write-off	(33		)	—			—
Other, net	(1		)	(3		)	—
Total income tax expense	$	26		$	28		$	24

We had consolidated federal NOLs estimated to be approximately $392 million for federal income tax purposes as of the end of 2012. These consolidated federal NOLs will expire, if not used, in the following amounts in the following years (in millions):




	Amount of Carryforward Expiring
2023	$	22
2024	—
2025	—
2026	2
2027	—
2028	332
2029	—
2030	35
2031	1
	$	392

In addition to the consolidated federal NOLs, as of December 31, 2012, we had state NOL carryforwards of approximately $303 million, which expire between 2012 and 2031, net foreign NOL carryforwards of approximately $29 million expiring between 2015 and 2031, and federal tax credit carryforwards, including production tax credits of $48 million expiring between 2014 and 2022, and minimum tax credits of $7 million with no expiration. These deferred tax assets are offset by a valuation allowance of approximately $34 million.

The tax effects of temporary differences that give rise to the deferred tax assets and liabilities are presented as follows (in millions):



	As of December 31,
	2012			2011
Deferred Tax Assets:
Loss reserve discounting	$	2		$	2
Capital loss carryforward	—			2
Net operating loss carryforwards	43			50
Accrued expenses	16			17
Prepaids and other costs	25			27
Deferred tax assets attributable to pass-through entities	10			10
Other	2			3
AMT and other credit carryforwards	55			51
Total gross deferred tax asset	153			162
Less: valuation allowance	(34		)	(22		)
Total deferred tax asset	119			140
Deferred Tax Liabilities:
Unbilled accounts receivable	14			18
Property, plant and equipment	588			528
Intangible assets	67			65
Deferred tax liabilities attributable to pass-through entities	68			75
Accrued original issue discount and related deferral on convertible debt	32			36
Prepaid expenses	22			22
Other, net	2			—
Total gross deferred tax liability	793			744
Net deferred tax liability	$	(674	)	$	(604	)

We employ the permanent reinvestment exception whereby we do not provide deferred taxes on the undistributed earnings of our international subsidiaries. We intend to permanently reinvest our international earnings outside of the United States in our existing international operations and in any new international business which may be developed or acquired. Cumulative undistributed foreign earnings for which United States taxes were not provided were included in consolidated retained earnings in the amount of approximately $324 million and $359 million as of December 31, 2012 and 2011, respectively. Determining the unrecognized deferred tax liability for these undistributed foreign earnings is not practicable.

Deferred tax assets relating to employee stock based compensation deductions were reduced to reflect exercises of non-qualified stock option grants and vesting of restricted stock. Some exercises of non-qualified stock option grants and vesting of restricted stock resulted in tax deductions in excess of previously recorded benefits resulting in a "windfall". Although these additional deductions were reported on the corporate tax returns and increased NOLs, these related tax benefits were not recognized for financial reporting purposes. These windfalls will not be recognized until the related deductions result in a reduction of taxes payable and cash tax payments. Accordingly, since the tax benefit does not reduce our current taxes payable, these tax benefits were not reflected in deferred tax assets for financial reporting purposes for 2012 and 2011. Such benefits included in NOLs but not reflected in deferred tax assets were approximately $17 million for both 2012 and 2011.

A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows (in millions):



Balance at December 31, 2009	$	131
Additions based on tax positions related to the current year	—
Additions for tax positions of prior years	1
Reductions for lapse in applicable statute of limitations	(2		)
Reductions for tax positions of prior years	—

Balance at December 31, 2010	$	130
Additions based on tax positions related to the current year	3
Additions for tax positions of prior years	5
Reductions for lapse in applicable statute of limitations	(19		)
Reductions for tax positions of prior years	—

Balance at December 31, 2011	$	119
Additions based on tax positions related to the current year	2
Additions for tax positions of prior years	6
Reductions for lapse in applicable statute of limitations	(3		)
Reductions for tax positions of prior years	—

Balance at December 31, 2012	$	124

The uncertain tax positions, exclusive of interest and penalties, were $124 million and $119 million as of December 31, 2012 and December 31, 2011, respectively, which also represent potential tax benefits that if recognized, would impact the effective tax rate.

For the year ended December 31, 2011, the income tax provision included a $24 million benefit due to the reversal of uncertain tax positions, following the expiration of applicable statutes of limitations related to pre-emergence tax matters in the Covanta Energy bankruptcy. Since March 2004, we had held $20 million in restricted funds intended to cover those uncertain tax positions. The restricted funds were included in other assets on our consolidated balance sheet. The expiration of the statutes of limitations triggered a liability to pre-petition claimants of approximately 73% of the restricted fund balance. Therefore, we recorded approximately $15 million as other expense during the year ended December 31, 2011. As of December 31, 2012, $12 million of the noncurrent funds were paid to claimants and $3 million of these funds were reclassified to other current assets on our consolidated balance sheet and are expected to be paid to third party claimants. The remaining $5 million was reclassified to cash and cash equivalents on our consolidated balance sheet as of December 31, 2011.

We record interest accrued on liabilities for uncertain tax positions and penalties as part of the tax provision. As of December 31, 2012 and 2011, we had accrued interest and penalties associated with liabilities for uncertain tax positions of $1 million and $2 million, respectively. We continue to reflect interest accrued on uncertain tax positions and penalties as part of the tax provision.

In the ordinary course of our business, the Internal Revenue Service (“IRS”) and state tax authorities will periodically audit our federal and state tax returns. As issues are examined by the IRS and state auditors, we may decide to adjust the existing liability for uncertain tax positions for issues that were not previously deemed an exposure. Federal income tax returns for Covanta Energy are closed for the years through 2003. However, to the extent NOLs are utilized from earlier years, federal income tax returns for Covanta Holding Corporation, formerly known as Danielson Holding Corporation, are still open. The IRS is currently auditing our tax returns for the years 2004 through 2009, which includes years during the carryforward period including returns in which some of the losses giving rise to the NOLs that were reported. In connection with this audit, the IRS has proposed certain adjustments to our 2008 tax return. We do not believe such proposed adjustments are consistent with applicable rules, and we intend to challenge them through the IRS's administrative appeals procedures. If we are unsuccessful in challenging such adjustments, some portion of the NOLs would not be available to offset consolidated taxable income, and/or we could be required to pay federal income taxes (and potentially interest and penalties) for prior years. State income tax returns are generally subject to examination for a period of three to six years after the filing of the respective return. The state impact of any federal changes remains subject to examination by various states for a period of up to one year after formal notification to the states. We have various state income tax returns in the process of examination, administrative appeals or litigation.

Our NOLs predominantly arose from our predecessor insurance entities, formerly named Mission Insurance Group, Inc., (“Mission”). These Mission insurance entities have been in state insolvency proceedings in California and Missouri since the late 1980's. The amount of NOLs available to us will be reduced by any taxable income or increased by any taxable losses generated by current members of our consolidated tax group, which include grantor trusts associated with the Mission insurance entities.

In January 2006, we executed agreements with the California Commissioner of Insurance (the “California Commissioner”), who administers the majority of the grantor trusts, regarding the final administration and conclusion of such trusts. The agreements, which were approved by the California state court overseeing the Mission insolvency proceedings (the “Mission Court”), settled matters that had been in dispute regarding the historic rights and obligations relating to the conclusion of the grantor trusts. These included the treatment of certain claims against the grantor trusts which were entitled to distributions of an aggregate of 1.6 million shares of our common stock issued to the California Commissioner in 1990 under existing agreements entered into at the inception of the Mission insurance entities’ reorganization.

Pursuant to a claims evaluation process overseen by the Conservation and Liquidation Office, all claim holders entitled to receive distributions of shares of our common stock from the California Commissioner were identified. As a result of this process, approximately $1 billion in claims were approved pursuant to orders of the Mission Court. As part of the wind down process and final claims evaluation by the Conservation and Liquidation Office, and in accordance with the parties’ contractual obligations and the requirements of the Internal Revenue Code governing such exchanges of stock for debt, the California Commissioner distributed shares of our common stock in settlement of these claims. This distribution, which is among the final steps necessary to conclude the insolvency cases relating to the trusts being administered by the California Commissioner, was conducted in December 2008 pursuant to orders of the Mission Court. These events resulted in our recognition of $515 million of additional NOLs in 2008, or a deferred tax asset of $180 million. Of this $180 million deferred tax asset, $111 million was previously recognized on the balance sheet.

The Director of the Division of Insurance of the State of Missouri (the “Missouri Director”) administers the balance of the grantor trusts relating to the Mission Insurance entities, and we have made arrangements for distribution of the remaining 0.2 million shares of our common stock by the Missouri Director to claimants of the Missouri grantor trusts. Such shares were distributed to claimants during the fourth quarter of 2012.

While we cannot predict what amounts, if any, may be includable in taxable income as a result of the final administration of these grantor trusts, substantial actions toward such final administration have been taken and we believe that neither arrangements with the California Commissioner of Insurance nor the final administration by the Missouri Director will result in a material reduction in available NOLs.