Income Taxes

Effective tax rates are analyzed as follows:



	2013					2012
	(dollars are in millions)
Three Months Ended June 30,
Tax expense (benefit) at the U.S. federal statutory income tax rate	$	141		35.0	%	$	(858	)	(35.0	)%
Increase (decrease) in rate resulting from:
State and local taxes, net of Federal benefit	2			.5		(42		)	(1.7	)
Adjustment with respect to tax for prior periods⁽¹⁾	14			3.5		(43		)	(1.7	)
Adjustment of tax rate used to value deferred taxes	(6		)	(1.6	)	—			—
Change in valuation allowance reserves⁽²⁾	(15		)	(3.8	)	3			.1
Other non-deductible/non-taxable items⁽⁴⁾	(5		)	(1.2	)	(2		)	(.1	)
Impact of foreign operations	2			.5		—			—
Other	—			—		3			.1
Total income tax expense (benefit)	$	133		32.9	%	$	(939	)	(38.3	)%

Six Months Ended June 30,
Tax expense (benefit) at the U.S. federal statutory income tax rate	$	300		35.0	%	$	(1,136	)	(35.0	)%
Increase (decrease) in rate resulting from:
State and local taxes, net of Federal benefit	5			.6		(45		)	(1.4	)
Adjustment with respect to tax for prior periods⁽¹⁾	4			.5		(44		)	(1.4	)
Adjustment of tax rate used to value deferred taxes	(11		)	(1.3	)	(7		)	(.2	)
Change in valuation allowance reserves⁽²⁾	(5		)	(.6	)	10			.3
Uncertain tax adjustments⁽³⁾	(5		)	(.6	)	(5		)	(.1	)
Other non-deductible/non-taxable items⁽⁴⁾	(5		)	(.6	)	(3		)	(.1	)
Impact of foreign operations	2			.1		—			—
Other	—			—		3			.1
Total income tax expense (benefit)	$	285		33.1	%	$	(1,227	)	(37.8	)%


⁽¹⁾	For 2013 and 2012, the amounts relate to corrections to current and deferred tax balance sheet accounts.


⁽²⁾	For 2013 and 2012, the amounts relate to changes in valuation allowance on states with net operating loss carryforward periods of 12 to 20 years.


⁽³⁾	For 2013 and 2012, the amounts primarily relate to the conclusion of state audits and expiration of state statutes of limitations.


⁽⁴⁾	For 2013, the amount relates to a change in the estimated deductibility of accrued costs for certain regulatory matters and a correction to share-based compensation deferred balances.

It is reasonably possible that there could be a change in the amount of our unrecognized tax benefits within the next 12 months due to settlements or statutory expirations in various tax jurisdictions. The total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate was $106 million and $113 million at June 30, 2013 and December 31, 2012, respectively.

It is our policy to recognize accrued interest related to unrecognized tax benefits in interest income in the consolidated statement of income (loss) and to recognize penalties, if any, related to unrecognized tax positions as a component of other servicing and administrative expenses in the consolidated statement of income (loss). We had accruals for the payment of interest associated with uncertain tax positions of $28 million and $36 million at June 30, 2013 and December 31, 2012, respectively. We have $7 million and $6 million in penalty accruals recorded at June 30, 2013 and December 31, 2012, respectively.

HSBC North America Consolidated Income Taxes We are included in HSBC North America's consolidated Federal income tax return and in various combined state income tax returns. As such, we have entered into a tax allocation agreement with HSBC North America and its subsidiary entities (the “HNAH Group”) included in the consolidated returns which govern the current amount of taxes to be paid or received by the various entities included in the consolidated return filings. As a result, we have looked at the HNAH Group's consolidated deferred tax assets and various sources of taxable income, including the impact of HSBC and HNAH Group tax planning strategies, in reaching conclusions on recoverability of deferred tax assets. Where a valuation allowance is determined to be necessary at the HSBC North America consolidated level, such allowance is allocated to the principal subsidiaries within the HNAH Group as described below in a manner that is systematic, rational and consistent with the broad principles of accounting for income taxes.

The HNAH Group evaluates deferred tax assets for recoverability using a consistent approach which considers the relative impact of negative and positive evidence, including historical financial performance, projections of future taxable income, future reversals of existing taxable temporary differences, tax planning strategies and any available carryback capacity.

In evaluating the need for a valuation allowance, the HNAH Group estimates future taxable income based on management approved business plans, future capital requirements and ongoing tax planning strategies, including capital support from HSBC necessary as part of such plans and strategies. The HNAH Group has continued to consider the impact of the economic environment on the U.S. businesses and the expected growth of the deferred tax assets. This evaluation process involves significant management judgment about assumptions that are subject to change from period to period.

In conjunction with the HNAH Group deferred tax evaluation process, based on our forecasts of future taxable income, which include assumptions about the depth and severity of home price depreciation and the U.S. economic environment, including unemployment levels and their related impact on credit losses, we currently anticipate that our results of future operations will generate sufficient taxable income to allow us to realize our deferred tax assets. However, since these market conditions have created losses in the HNAH Group in recent periods and volatility in our pre-tax book income, our analysis of the recoverability of the deferred tax assets significantly discounts any future taxable income expected from continuing operations and relies to a greater extent on continued capital support from our parent, HSBC, including tax planning strategies implemented in relation to such support. HSBC has indicated it remains fully committed and has the capacity and willingness to provide capital as needed to run operations, maintain sufficient regulatory capital, and fund certain tax planning strategies. As financial performance in our U.S. operations improves, it is anticipated that reliance may be placed on projected future operating income in management's evaluation of the recognition of the deferred tax assets.

Only those tax planning strategies that are both prudent and feasible, and which management has the ability and intent to implement, are incorporated into our analysis and assessment. The primary and most significant strategy is HSBC's commitment to reinvest excess HNAH Group capital to reduce debt funding or otherwise invest in assets to ensure that it is more likely than not that the deferred tax assets will be utilized.

Currently, it has been determined that the HNAH Group's primary tax planning strategy, in combination with other tax planning strategies, provides support for the realization of the net deferred tax assets recorded for the HNAH Group. Such determination is based on HSBC's business forecasts and assessment as to the most efficient and effective deployment of HSBC capital, most importantly including the length of time such capital will need to be maintained in the U.S. for purposes of the tax planning strategy.

Notwithstanding the above, the HNAH Group has valuation allowances against certain state deferred tax assets and certain Federal tax loss carryforwards for which the aforementioned tax planning strategies do not provide appropriate support.

HNAH Group valuation allowances are allocated to the principal subsidiaries, including us. The methodology allocates the valuation allowance to the principal subsidiaries based primarily on the entity's relative contribution to the growth of the HSBC North America consolidated deferred tax asset against which the valuation allowance is being recorded.

If future results differ from the HNAH Group's current forecasts or the tax planning strategies were to change, a valuation allowance against some or all of the remaining net deferred tax assets may need to be established which could have a material adverse effect on our results of operations, financial condition and capital position. The HNAH Group will continue to update its assumptions and forecasts of future taxable income, including relevant tax planning strategies, and assess the need for such incremental valuation allowances.

Absent the capital support from HSBC and implementation of the related tax planning strategies, the HNAH Group, including us, would be required to record a valuation allowance against the remaining deferred tax assets.

HSBC Finance Corporation Income Taxes We recognize deferred tax assets and liabilities for the future tax consequences related to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and for tax credits and net operating and other losses. Our net deferred tax assets, including deferred tax liabilities and valuation allowances, totaled $2.8 billion and $3.9 billion as of June 30, 2013 and December 31, 2012, respectively.

The Internal Revenue Service is currently auditing our income tax returns for the period 2006 through 2009 with an anticipated completion in the second half of 2013. We remain subject to state and local income tax examinations for years 1998 and forward. We are currently under audit by various state and local tax jurisdictions. Uncertain tax positions are reviewed on an ongoing basis and are adjusted in light of changing facts and circumstances, including progress of tax audits, developments in case law and the closing of statute of limitations. Such adjustments are reflected in the tax provision.