Note 7. Income Taxes

The Company is subject to the tax laws and regulations of the United States (“U.S.”) and the foreign countries in which it operates. The Company files a consolidated U.S. Federal tax return, which includes all domestic subsidiaries and the U.K. Branch. The income from the foreign operations is designated as either U.S. connected income or non-U.S. connected income. Lloyd’s is required to pay U.S. income tax on U.S. connected income written by Lloyd’s syndicates. Lloyd’s and the Internal Revenue Service (“IRS”) have entered into an agreement whereby the amount of tax due on U.S. connected income is calculated by Lloyd’s and remitted directly to the IRS. These amounts are then charged to the corporate member in proportion to its participation in the relevant syndicates. The Company’s corporate member is subject to this agreement and will receive U.K. tax credits in the United Kingdom (“U.K.”) for any U.S. income tax incurred up to the U.K. income tax charged on the U.S. connected income. The non-U.S. connected insurance income would generally constitute taxable income under the Subpart F income section of the U.S. Internal Revenue Code (“Subpart F”) since less than 50% of Syndicate 1221’s premiums are derived within the U.K. and would therefore be subject to U.S. taxation when the Lloyd’s year of account closes. Taxes are accrued at a 35% rate on the Company’s foreign source insurance income and foreign tax credits, where available, are utilized to offset U.S. tax as permitted. The Company’s effective tax rate for Syndicate 1221 taxable income could substantially exceed 35% to the extent the Company is unable to offset U.S. taxes paid under Subpart F tax regulations with U.K. tax credits on future underwriting year distributions. U.S. taxes are not accrued on the earnings of the Company’s foreign agencies as these earnings are not includable as Subpart F income in the current year. These earnings were subject to taxes under U.K. tax regulations at a 26% rate through March 31, 2012. A finance bill was enacted in the U.K. that reduced the U.K. corporate tax rate from 26% to 24% effective April 2012. The effect of such tax rate change was not material.

The components of current and deferred income tax expense (benefit) are as follows:


	Year Ended December 31,
In thousands	2012			2011		2010
Current income tax expense (benefit):
Federal and foreign	$	39,242		$	573	$	11,965
State and local		146			340		97

Subtotal		39,388			913		12,062

Deferred income tax expense (benefit):
Federal and foreign		(11,414	)		6,224		17,189
State and local		—			—		—

Subtotal		(11,414	)		6,224		17,189

Total income tax expense (benefit)	$	27,974		$	7,137	$	29,251

A reconciliation of total income taxes applicable to pre-tax operating income and the amounts computed by applying the federal statutory income tax rate to the pre-tax operating income were as follows:


	Year Ended December 31,
In thousands	2012					2011					2010
Computed expected tax expense	$	32,109		35.0	%	$	11,457		35.0	%	$	34,590		35.0	%
Tax-exempt interest		(4,443	)	-4.8	%		(4,437	)	-13.6	%		(5,992	)	-6.1	%
Dividends received deduction		(799	)	-0.9	%		(1,065	)	-3.3	%		(718	)	-0.7	%
Proration		786		0.9	%		825		2.5	%		1,006		1.0	%
Current state and local income taxes, net of federal income tax		95		0.1	%		221		0.7	%		63		0.1	%
Other		226		0.2	%		136		0.5	%		302		0.3	%

Actual tax expense and rate	$	27,974		30.5	%	$	7,137		21.8	%	$	29,251		29.6	%

The tax effects of temporary differences that give rise to federal, foreign, state and local deferred tax assets and deferred tax liabilities were as follows:


	December 31,
In thousands	2012			2011
Deferred tax assets:
Loss reserve discount	$	29,687		$	31,687
Unearned premiums		22,860			19,253
Compensation related		5,285			2,695
State and local net deferred tax assets		499			242
Other		4,245			664

Total gross deferred tax assets		62,576			54,541
Less: Valuation allowance		(499	)		(242	)

Total deferred tax assets		62,077			54,299

Deferred tax liabilities:
Deferred acquisition costs		(16,903	)		(16,939	)
Net unrealized gains on securities		(36,200	)		(32,782	)
Other		(5,758	)		(10,869	)

Total deferred tax liabilities		(58,861	)		(60,590	)

Net deferred income tax asset (liability)	$	3,216		$	(6,291	)

The Company has not provided for U.S. income taxes on approximately $17.9 million of undistributed earnings of its non-U.S. subsidiaries since it is intended that those earnings will be reinvested indefinitely in those subsidiaries. If a future determination is made that those earnings no longer are intended to be reinvested indefinitely in those subsidiaries, U.S. income taxes of approximately $1.8 million, assuming all foreign tax credits are realized, would be included in the tax provision at that time and would be payable if those earnings were distributed to the Company.

Unrecognized tax benefits are differences between tax positions taken in the tax returns and benefits recognized in the financial statements. The Company has no unrecognized tax benefits as of December 31, 2012 and 2011. The Company did not incur any interest or penalties related to unrecognized tax benefits for the years ended December 31, 2012 and 2011. The Company currently is under examination by the Internal Revenue Service for taxable year 2010 and generally is subject to U.S. Federal, state or local, or foreign tax examinations by tax authorities for 2009 and subsequent years.

The Company recorded income tax expense of $28.0 million, $7.1 million and $29.3 million for the years ended December 31, 2012, 2011 and 2010, respectively. The effective tax rates were 30.5%, 21.8% and 29.6% for the years ended December 31, 2012, 2011 and 2010. The effective tax rate on net investment income was 26.8%, 27.6% and 27.0% for the years ended December 31, 2012, 2011 and 2010.

The Company had state and local deferred tax assets amounting to potential future tax benefits of $0.5 million and $0.2 million as of December 31, 2012 and 2011, respectively. Included in the deferred tax assets are state and local net operating loss carry-forwards of $0.2 million for both December 31, 2012 and 2011. A valuation allowance was established for the full amount of these potential future tax benefits due to the uncertainty associated with their realization. The Company’s state and local tax carry-forwards as of December 31, 2012 expire from 2023 to 2031.

In assessing the realization of deferred tax assets, management considers whether it is more likely than not that the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, tax planning strategies and anticipated future taxable income in making this assessment and believes it is more likely than not that the Company will realize the benefits of its deductible differences as of December 31, 2012, net of any valuation allowance.