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
	2016			2015			2014			2016			2015			2014
Total unrecognized tax benefits, January 1	$	34,447		$	44,775		$	41,997		$	34,447		$	44,775		$	41,997
Additions for tax positions of the current year	2,695			2,175			4,309			2,695			2,175			4,309
Additions for tax positions of prior years	886			—			751			886			—			751
Reductions for tax positions of prior years for:
Changes in judgment	(1,953		)	(10,244		)	(2,282		)	(1,953		)	(10,244		)	(2,282		)
Settlements with taxing authorities	—			—			—			—			—			—
Lapses of applicable statute of limitations	—			(2,259		)	—			—			(2,259		)	—
Total unrecognized tax benefits, December 31	$	36,075		$	34,447		$	44,775		$	36,075		$	34,447		$	44,775

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
	2016		2015		2014		2016		2015		2014
Tax positions, that if recognized, would decrease our effective tax rate	$	11,313	$	9,523	$	11,207	$	11,313	$	9,523	$	11,207

As of the balance sheet date, the tax year ended December 31, 2013 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 2012.

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
	2016		2015			2014		2016		2015			2014
Unrecognized tax benefit interest expense/(benefit) recognized	$	529	$	(161	)	$	752	$	529	$	(161	)	$	752

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
	2016		2015		2014		2016		2015		2014
Unrecognized tax benefit interest accrued	$	1,333	$	804	$	965	$	1,333	$	804	$	965

Additionally, as of December 31, 2016, 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,
	2016		2015			2014		2016		2015		2014
Current:
Federal	$	8,630	$	(12,335	)	$	25,054	$	711	$	6,485	$	40,115
State	1,259		4,763			10,382		4,276		7,813		15,598
Total current	9,889		(7,572		)	35,436		4,987		14,298		55,713
Deferred:
Federal	201,743		221,505			167,365		215,178		208,326		165,027
State	24,779		23,787			17,904		25,677		23,217		16,620
Total deferred	226,522		245,292			185,269		240,855		231,543		181,647
Income tax expense	$	236,411	$	237,720		$	220,705	$	245,842	$	245,841	$	237,360

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,
	2016			2015			2014			2016			2015			2014
Federal income tax expense at 35% statutory rate	$	244,278		$	242,869		$	225,540		$	254,617		$	250,267		$	239,638
Increases (reductions) in tax expense resulting from:
State income tax net of federal income tax benefit	16,311			18,265			18,149			18,750			20,433			21,148
Credits and favorable adjustments related to prior years resolved in current year	—			(2,169		)	—			—			(1,892		)	—
Medicare Subsidy Part-D	844			837			830			844			837			830
Allowance for equity funds used during construction (see Note 1)	(11,724		)	(9,711		)	(8,523		)	(11,724		)	(9,711		)	(8,523		)
Palo Verde VIE noncontrolling interest (see Note 18)	(6,823		)	(6,626		)	(9,135		)	(6,823		)	(6,626		)	(9,135		)
Investment tax credit amortization	(5,887		)	(5,527		)	(4,928		)	(5,887		)	(5,527		)	(4,928		)
Other	(588		)	(218		)	(1,228		)	(3,935		)	(1,940		)	(1,670		)
Income tax expense	$	236,411		$	237,720		$	220,705		$	245,842		$	245,841		$	237,360

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, 2016, APS has recorded a regulatory liability of $74 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, 2016, 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,
	2016			2015			2016			2015
DEFERRED TAX ASSETS
Risk management activities	$	26,614		$	70,498		$	26,614		$	70,498
Regulatory liabilities:
Asset retirement obligation and removal costs	200,140			216,765			200,140			216,765
Unamortized investment tax credits	113,195			100,779			113,195			100,779
Other postretirement benefits	60,375			83,034			60,375			83,034
Other	63,311			60,707			63,311			60,707
Pension liabilities	204,436			191,028			194,981			181,787
Renewable energy incentives	56,379			60,956			56,379			60,956
Credit and loss carryforwards	75,944			59,557			1,645			—
Other	158,421			149,033			187,453			176,016
Total deferred tax assets	958,815			992,357			904,093			950,542
DEFERRED TAX LIABILITIES
Plant-related	(3,297,989		)	(3,116,752		)	(3,297,989		)	(3,116,752		)
Risk management activities	(7,594		)	(10,626		)	(7,594		)	(10,626		)
Other postretirement assets	(63,477		)	(71,737		)	(62,819		)	(70,986		)
Regulatory assets:
Allowance for equity funds used during construction	(61,088		)	(54,110		)	(61,088		)	(54,110		)
Deferred fuel and purchased power — mark-to-market	(21,396		)	(55,020		)	(21,396		)	(55,020		)
Pension benefits	(274,184		)	(240,692		)	(274,184		)	(240,692		)
Retired power plant costs (see Note 3)	(49,166		)	(53,420		)	(49,166		)	(53,420		)
Other	(123,987		)	(108,441		)	(123,987		)	(108,441		)
Other	(5,166		)	(4,984		)	(5,165		)	(4,984		)
Total deferred tax liabilities	(3,904,047		)	(3,715,782		)	(3,903,388		)	(3,715,031		)
Deferred income taxes — net	$	(2,945,232	)	$	(2,723,425	)	$	(2,999,295	)	$	(2,764,489	)

As of December 31, 2016, the deferred tax assets for credit and loss carryforwards relate primarily to federal general business credits of approximately $98 million, which first begin to expire in 2031, and other federal and state loss carryforwards of $5 million, which first begin to expire in 2019. The credit and loss carryforwards amount above has been reduced by $27 million of unrecognized tax benefits.