Income Taxes

Certain assets and liabilities are reported differently for income tax purposes than they are for financial statement purposes. The tax effect of these differences is recorded as deferred taxes. We calculate deferred taxes using currently enacted income tax rates.

APS has recorded regulatory assets and regulatory liabilities related to income taxes on its Balance Sheets in accordance with accounting guidance for regulated operations. The regulatory assets are for certain temporary differences, primarily the allowance for equity funds used during construction, investment tax credit basis adjustment and tax expense of Medicare subsidy. The regulatory liabilities primarily relate to deferred taxes resulting from investment tax credits (“ITC”) and the change in income tax rates.

In accordance with regulatory requirements, APS ITCs are deferred and are amortized over the life of the related property with such amortization applied as a credit to reduce current income tax expense in the statement of income.

Net income associated with the Palo Verde sale leaseback VIEs is not subject to tax (see Note 18). As a result, there is no income tax expense associated with the VIEs recorded on the Pinnacle West Consolidated and APS Consolidated Statements of Income.

The following is a tabular reconciliation of the total amounts of unrecognized tax benefits, excluding interest and penalties, at the beginning and end of the year that are included in accrued taxes and unrecognized tax benefits (dollars in thousands):



	Pinnacle West Consolidated									APS Consolidated
	2015			2014			2013			2015			2014			2013
Total unrecognized tax benefits, January 1	$	44,775		$	41,997		$	133,422		$	44,775		$	41,997		$	133,241
Additions for tax positions of the current year	2,175			4,309			3,516			2,175			4,309			3,516
Additions for tax positions of prior years	—			751			13,158			—			751			13,158
Reductions for tax positions of prior years for:
Changes in judgment	(10,244		)	(2,282		)	(108,099		)	(10,244		)	(2,282		)	(107,918		)
Settlements with taxing authorities	—			—			—			—			—			—
Lapses of applicable statute of limitations	(2,259		)	—			—			(2,259		)	—			—
Total unrecognized tax benefits, December 31	$	34,447		$	44,775		$	41,997		$	34,447		$	44,775		$	41,997

During the year ended December 31, 2013, Internal Revenue Service ("IRS") guidance was released which provided clarification regarding an APS tax accounting method change approved by the IRS in the third quarter of 2009. As a result of this guidance, uncertain tax positions decreased $67 million. Additionally, the IRS finalized the examination of tax returns for the years ended December 31, 2008 and 2009, which further reduced uncertain tax positions by approximately $41 million. These reductions in uncertain tax positions, materially offset by an increase in deferred tax liabilities, resulted in a cash refund that was received in the first quarter of 2014.

Included in the balances of unrecognized tax benefits are the following tax positions that, if recognized, would decrease our effective tax rate (dollars in thousands):



	Pinnacle West Consolidated						APS Consolidated
	2015		2014		2013		2015		2014		2013
Tax positions, that if recognized, would decrease our effective tax rate	$	9,523	$	11,207	$	9,827	$	9,523	$	11,207	$	9,827

As of the balance sheet date, the tax year ended December 31, 2012 and all subsequent tax years remain subject to examination by the IRS. With a few exceptions, we are no longer subject to state income tax examinations by tax authorities for years before 2011.

We reflect interest and penalties, if any, on unrecognized tax benefits in the Pinnacle West Consolidated and APS Consolidated Statements of Income as income tax expense. The amount of interest expense or benefit recognized related to unrecognized tax benefits are as follows (dollars in thousands):



	Pinnacle West Consolidated								APS Consolidated
	2015			2014		2013			2015			2014		2013
Unrecognized tax benefit interest expense/(benefit) recognized	$	(161	)	$	752	$	(3,716	)	$	(161	)	$	752	$	(3,716	)

Following are the total amount of accrued liabilities for interest recognized related to unrecognized benefits that could reverse and decrease our effective tax rate to the extent matters are settled favorably (dollars in thousands):



	Pinnacle West Consolidated						APS Consolidated
	2015		2014		2013		2015		2014		2013
Unrecognized tax benefit interest accrued	$	804	$	965	$	213	$	804	$	965	$	213

Additionally, as of December 31, 2015, we have recognized less than $1 million of interest expense to be paid on the underpayment of income taxes for certain adjustments that we have filed, or will file, with the IRS.

The components of income tax expense are as follows (dollars in thousands):



	Pinnacle West Consolidated								APS Consolidated
	Year Ended December 31,								Year Ended December 31,
	2015			2014		2013			2015		2014		2013
Current:
Federal	$	(12,335	)	$	25,054	$	(81,784	)	$	6,485	$	40,115	$	(97,531	)
State	4,763			10,382		10,537			7,813		15,598		11,983
Total current	(7,572		)	35,436		(71,247		)	14,298		55,713		(85,548		)
Deferred:
Federal	221,505			167,365		279,973			208,326		165,027		305,389
State	23,787			17,904		21,865			23,217		16,620		25,254
Total deferred	245,292			185,269		301,838			231,543		181,647		330,643
Income tax expense	$	237,720		$	220,705	$	230,591		$	245,841	$	237,360	$	245,095

On the APS Consolidated Statements of Income, federal and state income taxes are allocated between operating income and other income.

The following chart compares pretax income at the 35% federal income tax rate to income tax expense (dollars in thousands):



	Pinnacle West Consolidated									APS Consolidated
	Year Ended December 31,									Year Ended December 31,
	2015			2014			2013			2015			2014			2013
Federal income tax expense at 35% statutory rate	$	242,869		$	225,540		$	234,695		$	250,267		$	239,638		$	246,384
Increases (reductions) in tax expense resulting from:
State income tax net of federal income tax benefit	18,265			18,149			21,387			20,433			21,148			23,970
Credits and favorable adjustments related to prior years resolved in current year	(2,169		)	—			(3,356		)	(1,892		)	—			(3,231		)
Medicare Subsidy Part-D	837			830			823			837			830			823
Allowance for equity funds used during construction (see Note 1)	(9,711		)	(8,523		)	(6,997		)	(9,711		)	(8,523		)	(6,997		)
Palo Verde VIE noncontrolling interest (see Note 18)	(6,626		)	(9,135		)	(11,862		)	(6,626		)	(9,135		)	(11,862		)
Investment tax credit amortization	(5,527		)	(4,928		)	(3,548		)	(5,527		)	(4,928		)	(3,548		)
Other	(218		)	(1,228		)	(551		)	(1,940		)	(1,670		)	(444		)
Income tax expense	$	237,720		$	220,705		$	230,591		$	245,841		$	237,360		$	245,095

During the fourth quarter of 2015, we prospectively adopted guidance requiring deferred income tax assets and liabilities to be presented as non-current on the balance sheet and eliminating the requirement to present a current portion. As a result of this guidance all deferred income tax assets and liabilities are presented as net non-current deferred income tax liabilities on the Consolidated Balance Sheet as of December 31, 2015. Prior periods have not been restated.

The following table shows the net deferred income tax liability recognized on the Consolidated Balance Sheets (dollars in thousands):



	Pinnacle West Consolidated						APS Consolidated
	December 31,						December 31,
	2015			2014			2015			2014
Current asset	$	—		$	122,232		$	—		$	55,253
Long-term liability	(2,723,425		)	(2,582,636		)	(2,764,489		)	(2,571,365		)
Deferred income taxes — net	$	(2,723,425	)	$	(2,460,404	)	$	(2,764,489	)	$	(2,516,112	)

On February 17, 2011, Arizona enacted legislation (H.B. 2001) that included a four-year phase-in of corporate income tax rate reductions beginning in 2014. As a result of these tax rate reductions, Pinnacle West has revised the tax rate applicable to reversing temporary items in Arizona. In accordance with accounting for regulated companies, the benefit of this rate reduction is substantially offset by a regulatory liability. As of December 31, 2015, APS has recorded a regulatory liability of $75 million, with a corresponding decrease in accumulated deferred income tax liabilities, to reflect the impact of this change in tax law.

On April 4, 2013, New Mexico enacted legislation (H.B. 641) that included a five-year phase-in of corporate income tax rate reductions beginning in 2014. As a result of these tax rate reductions, Pinnacle West has revised the tax rate applicable to reversing temporary items in New Mexico. In accordance with accounting for regulated companies, the benefit of this rate reduction is substantially offset by a regulatory liability. As of December 31, 2015, APS has recorded a regulatory liability of $2 million, with a corresponding decrease in accumulated deferred income tax liabilities, to reflect the impact of this change in tax law.

The components of the net deferred income tax liability were as follows (dollars in thousands):



	Pinnacle West Consolidated						APS Consolidated
	December 31,						December 31,
	2015			2014			2015			2014
DEFERRED TAX ASSETS
Risk management activities	$	70,498		$	57,505		$	70,498		$	57,505
Regulatory liabilities:
Asset retirement obligation and removal costs	216,765			229,772			216,765			229,772
Unamortized investment tax credits	100,779			96,232			100,779			96,232
Other postretirement benefits	83,034			90,496			83,034			90,496
Other	60,707			60,409			60,707			60,409
Pension liabilities	191,028			205,227			181,787			194,541
Renewable energy incentives	60,956			65,169			60,956			65,169
Credit and loss carryforwards	59,557			68,347			—			—
Other	149,033			138,729			176,016			161,379
Total deferred tax assets	992,357			1,011,886			950,542			955,503
DEFERRED TAX LIABILITIES
Plant-related	(3,116,752		)	(2,958,369		)	(3,116,752		)	(2,958,369		)
Risk management activities	(10,626		)	(12,171		)	(10,626		)	(12,171		)
Other postretirement assets	(71,737		)	(59,170		)	(70,986		)	(58,495		)
Regulatory assets:
Allowance for equity funds used during construction	(54,110		)	(48,286		)	(54,110		)	(48,286		)
Deferred fuel and purchased power	—			(2,498		)	—			(2,498		)
Deferred fuel and purchased power — mark-to-market	(55,020		)	(38,187		)	(55,020		)	(38,187		)
Pension benefits	(240,692		)	(191,747		)	(240,692		)	(191,747		)
Retired power plant costs (see Note 3)	(53,420		)	(57,255		)	(53,420		)	(57,255		)
Other	(108,441		)	(99,123		)	(108,441		)	(99,123		)
Other	(4,984		)	(5,484		)	(4,984		)	(5,484		)
Total deferred tax liabilities	(3,715,782		)	(3,472,290		)	(3,715,031		)	(3,471,615		)
Deferred income taxes — net	$	(2,723,425	)	$	(2,460,404	)	$	(2,764,489	)	$	(2,516,112	)

As of December 31, 2015, the deferred tax assets for credit and loss carryforwards relate primarily to federal general business credits of approximately $82 million, which first begin to expire in 2031, and other federal and state loss carryforwards of $3 million, which first begin to expire in 2019. The credit and loss carryforwards amount above has been reduced by $26 million of unrecognized tax benefits.